Capital Review: the endgame

22 November 2019 Financial Policy

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Agenda

• Capital stack decisions
  • Info papers to be used as inputs for decision:
    1. Tier 2 capital (#8635853)
    2. Going concern – resilience vs lending rates consideration (#8636080)
    3. Cost-benefit analysis (#8627342)
    4. Response to experts (#8616913)
  • Key decision paper – Final decisions: Capital stack (#8637807)
• Transition, implementation and next steps (for decision)
  • Transitional arrangements (#8619325) – decision
  • Implementation and next steps (#8639968) – decision
• Key outputs for publishing (for noting)
  • Draft final policy papers (#8639465, #8639329)

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Key decisions for today

• Keep or remove Tier 2 from the framework
• How much resilience do you want?
  • 15 or 16% Tier 1 ratio for the D-SIBs
  • Size of CET1 vs AT1
  • CET1 and Tier 1 ratio of the small banks
• Total and minimum capital ratio requirement
• Transitional arrangements – 5 or 7 years or longer?
• Confirm earlier in-principle decisions

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Reconfirm in-principle decisions

1. Allow redeemable preference shares as AT1 capital
2. Remove contingent features from all forms of capital
3. Impose 85% output floor and higher scalar of 1.2 on IRB risk weight outcomes, to result in ~90% of standardised approach
4. Dual reporting requirements for IRB banks, along with changes to treatment of some portfolios (e.g. standardise banks and sovereigns)
5. Non-D-SIBs need to have at least 14% Tier 1 ratio (D-SIB of either 1% or 2%)
6. Set CCyB at 1.5%, with an early strategy
7. Do not require leverage ratio (disclosure or minimum)

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Key decisions

Ratio	Departure from 2018 proposal?	FSC confirmed?
Tier 1 capital requirement:
• 16% RWA for systemically important banks		?
• 14% for non-systemically important banks	Yes*
• Of which 1.5% can be made up of AT1		?
Prudential capital buffer composition:
• 2% D-SIB buffer, applied to banks deemed to be systemically important	Yes*
• 1.5% ‘early-set’ CCyB	No
Keep Tier 2, which can comprise 2% of minimum total capital ratio		?*
Total capital requirement:
• 18% RWA for systemically important banks		?*
• 16% for non-systemically important banks		?*
Allow for a longer transition period than 5 years	Yes*
Omit a leverage ratio	Yes

* indicates that the decision has not yet been made by FSC, or has provisionally been made

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Key decisions

Denominator	Departure from 2018 proposal?	FSC confirmed?
Raise RWA for IRB banks to ~90% of what would be calculated under the Standardised approach.
• 85% output floor	No
• Increase scalar from 1.06 to 1.2
Dual reporting	No
Standardised approach for IRB banks for exposures that have an external rating (e.g. banks, sovereigns).	No
Only allow standardised approach for operational risk modelling	No
Numerator
Remove contractual contingency from the definition of capital	No
Accept redeemable perpetual preference shares as AT1 capital (with suitable protections in the contract terms)	Yes
Accept long-term, subordinated debt as Tier 2	No

* indicates that the decision has not yet been made by FSC, or has provisionally been made

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Capital stack options

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Key considerations for options

• Non-DSIB requirement floored at 14% Tier 1 ratio
• Size of D-SIB range from 1 to 2%
• Keep or remove Tier 2
• AT1 range from 1.5 to 2.5%
• Total capital range from 16 to 18% (D-SIBs)
• Size of buffer
• Total minimum range from 6 to 9%

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Calibration options – DSIBs only

1. Option 1 – amended Dec 18 proposal, keep CET1 at 14.5%, Tier 1 at 16%, Total at 18%
   • Assumes 2% D-SIB buffer (so that non-D-SIBs are floored at 14% Tier 1)
2. Option 2 – remove Tier 2, keep CET1 at 14.5%, Tier 1 at 16%, Total at 16%
3. Option 3 – lower CET1 at 13.5%, more AT1 and keep Tier 1 at 16%, Total at 18%
4. Option 4 – lower CET1 at 13.5%, lower Tier 1 at 15%, lower Total at 17%
   • But reduce D-SIB buffer to 1%, so that non-D-SIBs have Tier 1 ratio of 14%

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Calibration options – 1 to 4 for D-SIBs

• Different calibrations could impact the minimum capital requirements, in particular Option 2 (remove Tier 2) and Option 3 (more AT1)

[Chart: Bar chart showing Tier 2, AT1, CET1, Other CET1 buffer, D-SIB (CET1), and Min Total Capital for Status quo, Option 1 (Dec 18), Option 2 (No Tier 2), Option 3 (More AT1), and Option 4 (lower Tier 1)]

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Calibration options – 1 to 4 for non-D-SIBs

• Option 4 has been adjusted to have only 1% D-SIB (unlike other 3 options, which assumes 2%), so that small banks have 14% Tier 1 ratio

[Chart: Bar chart showing Tier 2, AT1, CET1, Other CET1 buffer, and Min Total Capital for Status quo, Option 1 (Dec 18), Option 2 (No Tier 2), Option 3 (More AT1), and Option 4 (lower Tier 1)]

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Factors to think about

		Option 1 (Dec 18)	Option 2 (No Tier 2)	Option 3 (More AT1)	Option 4 (less buffer)
Issue-specific	Funding diversification	🟢	🔴	🟢	🟢
	Simpler regime	🟡	🟢	🟡	🟡
	Future-proofing for bail-in	🟢	🔴	🟢	🟢
	Total loss absorbing capital	🟢	🔴	🟢	🟡
	Enabling market discipline	🟡	🔴	🟢	🟡
Resilience	Protection from crisis (Tier 1)	🟢	🟢	🟡	🔴
	Larger usable CET1 buffer	🟢	🟢	🟡	🟡
Cost of reform	Lower interest rate impact	🔴	🔴	🟡	🟢
	Ease of transition for small banks	🟡	🟢	🟢	🟡
Alignment	Align with Basel minimum	🟢	🔴	🟢	🟢
	Align with APRA	\multicolumn{4}{c	}{no difference between options}
	Comparable reporting of ratio treatment between IRB / standardised	\multicolumn{4}{c	}{no difference between options}

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Decision 1: Tier 2 in or out?

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Tier 2: in or out?

• Resilience
  • Likely limited benefit on reducing probability of D-SIB failure, given high levels of CET1
  • Some merit in providing additional monitoring of small banks, since they only have ~12% CET1 and 14% Tier 1 under all options
• Loss absorption
  • Having gone concern capital alters distribution of losses: Tier 2 capital can absorb losses before unsecured debtors and depositors and will help resolution at the margin
  • Keeping Tier 2 is consistent with expected future bail-in regime, but not decisive
• Cost
  • Small impact (~0.5bps impact on net benefit, if we assume 2% Tier 2)
  • Keeping Tier 2 may involve some operational costs in managing total capital ratio

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Tier 2: in or out?

• Trans-Tasman considerations
  • Not a material issue for cost-benefit analysis of the proposal, but it will impact Trans-Tasman funding arrangements
  • Keeping or removing Tier 2 will likely not have a material impact on parent or Group capital ratios
• Basel compliance / international comparison
  • Removing Tier 2 and reducing minimum to 6% may mean we do not comply with Basel
  • Even if we remove Tier 2, total capital levels would still be around top quartile of international peer banks (both Group 1 and Group 2)

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Tier 2: in or out?

• Basel compliance / international comparison
  • Based on World Bank 2016 survey of ~160 countries, we found a few examples of countries with no Tier 2 in the capital framework (Marshall Islands, Tonga, Lesotho, Dijibouti, Kuwait)
  • All countries in the survey had at least 8% minimum total capital ratio

[Chart: Histogram showing # of countries vs Minimum total capital ratio (%)]

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Factors to consider for Tier 2

	Option 1 (Dec 18)	Option 2 (No Tier 2)	Option 3 (More AT1)	Option 4 (less buffer)
Funding diversification	🟢	🔴	🟢	🟢
Simpler regime	🟡	🟢	🟡	🟡
Future-proofing for bail-in	🟢	🔴	🟢	🟢
Total loss absorbing capital	🟢	🔴	🟢	🟡
Enabling market discipline	🟡	🔴	🟢	🟡
Lower interest rate impact	🔴	🔴	🟡	🟢
Align with Basel minimum	🟢	🔴	🟢	🟢

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Decision 2: If Tier 2 is kept, choose between options 1, 3, and 4

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Key points to note

• Any of the options likely to provide ‘optimal’ going concern capital (#8636080)
  • i.e. ‘optimal’ Tier 1 capital is around 15 – 16%
• The options reflect the feedback from External Experts (#8616913)
• Any of the options produce positive net benefits, the best option depends on how you weigh up different factors (#8637807)
• Key factors to consider are:
  1. Resilience – level of CET1 and Tier 1 ratio
  2. Cost – interest rate impact and ease of transition

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Relevant factors for three options

		Option 1 (Dec 18)	Option 3 (More AT1)	Option 4 (less buffer)
Resilience	Protection from crisis (Tier 1)	🟢	🟡	🔴
	Larger usable CET1 buffer (D-SIBs)	🟢	🟡	🟡
	Larger usable CET1 buffer (small banks)	🟢	🟡	🟢
Cost of reform	Lower interest rate impact	🔴	🟡	🟢
	Ease of transition for small banks	🟡	🟢	🟡
Other issues	Total loss absorbing capital	🟢	🟢	🟡
	Enabling market discipline	🟡	🟢	🟡

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Resilience considerations

• Tier 1 ratio used to determine resilience
• Submitters' feedback:
  • Multiplicative conservatism in our risk modelling overstates current probability of a crisis, and capital needed to reduce the probability of crisis to 0.5%.
  • We misinterpreted overseas studies and did not reasonably adjust findings for NZ context (e.g. our Pillar 1 approach to internal models conservatism).
• David Miles’ view was that, though we erred on the side of caution in our risk/probability modelling, other aspects of the net benefit calculation (e.g. cost of crisis) are on the low end of reasonableness.
• The 15-16% Tier 1 range of options is within the bounds of an optimal (net output-maximising) range.
• System Tier 1 ratio of 15% delivers roughly 1-in-200 protection, although with less confidence than Tier 1 of 16%

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Resilience – how much going concern?

[Chart: Curve showing Expected output vs Financial stability, with "15 - 16% Tier 1 is around the optimal point" marked]

Note: Expected output includes wealth transfer (a cost)*

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Resilience considerations

• Options 3 and 4 have lower CET1 buffer ratio than Option 1 (for D-SIBs)
  • Lower buffer ratio = less flexibility for intervention
  • For small banks, Options 1 and 4 are effectively the same, with 8% CET1 buffer ratio Option 3 results in less CET1 buffer ratio for small banks (7%).

[Chart: Bar chart showing Tier 2, AT1, CET1, and CET1 buffer ratio for D-SIBs and Non-D-SIBs under Option 1, 3, and 4]

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Resilience considerations

• Trade-off between CET1 and AT1
  • CET1 provides more stability benefits than AT1 (higher buffer = more losses can be absorbed before needing to intervene), but AT1 likely to be almost as effective as CET1 in ultimately absorbing losses
  • Unlike CET1, redeemable perpetual preference shares (AT1) have residual risk
  • Shareholders are likely to be the most effective at monitoring risk-taking (given they absorb losses first), followed by AT1 holders
• All four options for non-DSIBs have 14% Tier 1, so no change in risk appetite. Although Option 3 only has 11.5% CET1 for non-D-SIBs.
• Modelling work has no voluntary buffers (not included in benefits but included in cost); with voluntary buffers on top, resilience is higher (lower probability of failure)

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Cost considerations

• Key assumptions (on lending rate impact) relate to:
  • Required returns from shareholders and creditors
  • Competitive dynamics in lending markets
• Compared to Option 1, interest rate impact is marginally less under Option 3 since AT1 is cheaper than CET1
• Option 4 has lowest interest rate impact since it has the lowest Tier 1 ratio among three options
• Using monte carlo analysis with our base case inputs (#8627342) yields 84% of outcomes are positive under option 1, 87% of outcomes are positive under option 3, and 90% positive outcomes under option 4
• These monte carlo results are not materially different i.e. they are not, in themselves, a good basis for selecting one option over another

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Costs and benefits

• Costs and benefits assessment incorporates revised interest rate impacts to pick up the following factors:
  • Incorporate different tiers of capital (CET1, AT1, Tier 2) in the total stack; previous estimates were based on a simple equity/debt funding mix.
  • Use an estimated cost of equity, rather than statutory returns on equity (following David Miles and James Cummings feedback).

	Option 1 (Dec 18)	Option 2 (No Tier 2)	Option 3 (More AT1)	Option 4 (Lower CET1)
CET1 (%)	14.5	14.5	13.5	13.5
AT1 (%)	1.5	1.5	2.5	1.5
Tier 2 (%)	2	0	2	2
Lending rate impact relative to status quo (bps)	22.9	22.4	20.5	17.4

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All options have similar quantified net benefits

	Option 1 (Dec 18)	Option 2 (No Tier 2)	Option 3 (More AT1)	Option 4 (Lower CET1)
CET1 (%)	14.5	14.5	13.5	13.5
AT1 (%)	1.5	1.5	2.5	1.5
Tier 2 (%)	2	0	2	2
Lending rate impact relative to status quo (bps)	22.9	22.4	20.5	17.4
CBA net benefit	0.38%	0.39%	0.43%	0.40%

• Monte-Carlo analysis has been used to test the sensitivity of the CBA results to alternative specifications of the key inputs:
  • ‘Base Case’ in FSC paper (option 1 above) shows net positive in 84%
  • Options 2-4 all in the range of 84%-90%
  • Note: assumes AT1 is just as effective as CET1 at crisis prevention

Note: net benefit calculation subject to final QA of CBA, but no material change expected

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Other considerations

• Alignment with Basel minimum
  • Options 1 and 4 have 8% minimum total capital ratio, while Option 3 has 9% minimum total capital ratio
• Definition of AT1 and Tier 2 have changed
  • AT1 now includes Redeemable Perpetual Preference Shares (reversed previous in-principle decision)
  • Proposed instruments are simple, with no contingent triggers
  • Lack of triggers mean AT1 & T2 are likely to be Basel-compliant but non-compliant for APRA (i.e. doesn't count towards Group capital ratios)
• APS 111 changes would make all forms of capital more expensive (from parent’s perspective), but we think this impact is immaterial

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Other considerations

• Small bank considerations
  • Small banks have higher PD due to 1) lower profitability, 2) less diversification, 3) limited access to capital (partly due to choice of corporate structure)
  • Options assume floor of 14% Tier 1 for non-D-SIBs, with D-SIB buffer ranging from 1 to 2%
  • The CCyB makes up 1.5% of this 14% Tier 1
• Mutual bank capital raising – we have made a lot of progress for mutuals
  • We have altered our interpretation of ‘voting rights’, which helps with CET1
  • Dividend policies and holders’ rights in liquidation need careful navigation if funding is to qualify as ordinary shares

s 18(c)(i)

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Assessment of remaining options

[Diagram: Dec 2018 proposal -> Option 1 -> Option 3 and Option 4]

• Option 1:
  • Allow redeemable perpetual preference shares (RPPS) as AT1
  • D-SIB buffer = 2%
  • D-SIB Tier 1 = 16%
  • D-SIB Resilience ranking: 1st (best)
  • Non-D-SIB Resilience ranking: 1st (best)
  • Lending rate impact = 22.9 bps
• Option 3:
  • AT1 = 2.5%
  • D-SIB = 2%
  • D-SIB Tier 1 = 16%
  • D-SIB Resilience ranking: 2nd best
  • Non-D-SIB resilience ranking: last
  • Lending rate impact = 20.5 bps
• Option 4:
  • AT1 = 1.5%
  • D-SIB = 1%
  • D-SIB Tier 1 = 15%
  • D-SIB Resilience ranking: last
  • Non-D-SIB resilience ranking: 1st (best)
  • Lending rate impact = 17.4 bps

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Assessment of options using CET1, net benefit

[Diagram: Dec 2018 proposal -> Option 1 -> Option 3 and Option 4]

• Option 1:
  • D-SIB CET1 ratio = 14.5%
  • Non-D-SIB CET1 ratio = 12.5%
  • D-SIB Tier 1 ratio = 16%
  • D-SIB resilience ranking: 1st (best)
  • Non-D-SIB resilience ranking: 1st (best)
  • Net benefit: 0.38% of GDP
• Option 3:
  • D-SIB CET1 ratio = 13.5%
  • Non-D-SIB CET1 ratio = 11.5%
  • D-SIB Tier 1 ratio = 16%
  • D-SIB resilience ranking: 2nd best
  • Non-D-SIB resilience ranking: last
  • Net benefit: 0.43% of GDP
• Option 4:
  • D-SIB CET1 ratio = 13.5%
  • Non-D-SIB CET1 ratio = 12.5%
  • D-SIB Tier 1 ratio = 15%
  • D-SIB resilience ranking: last
  • Non-D-SIB resilience ranking: 1st (best)
  • Net benefit: 0.40% of GDP

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How we expect banks to view Options 3 and 4

[Diagram: Dec 2018 proposal -> Option 1 -> Option 3 and Option 4]

• Option 1:

  • Allow redeemable perpetual preference shares (RPPS) as AT1
  • D-SIB buffer = 2%
  • D-SIB Tier 1 = 16%
  • D-SIB Resilience ranking: 1st (best)
  • Non-D-SIB Resilience ranking: 1st (best)
  • Lending rate impact = 22.9 bps

• Option 3:

  • AT1 = 2.5%
  • D-SIB = 2%
  • D-SIB Tier 1 = 16%
  • D-SIB Resilience ranking: 2nd best
  • Non-D-SIB resilience ranking: last
  • Lending rate impact = 20.5 bps

• Option 4:

  • AT1 = 1.5%
  • D-SIB = 1%
  • D-SIB Tier 1 = 15%
  • D-SIB Resilience ranking: last
  • Non-D-SIB resilience ranking: 1st (best)
  • Lending rate impact = 17.4 bps

• Note: of course, banks’ preference is not the only consideration in weighing options

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Option 3 vs 4 (if option 1 is removed)

• Resilience
  • Option 3 (16% Tier 1) provides more resilience than Option 4 (15% Tier 1) for D-SIBs
  • But Option 4 (12.5% CET1) provides more resilience than Option 3 (11.5% CET1) for small banks; although both options have 14% Tier 1 ratio for small banks
  • Key question is whether AT1 is just as effective as CET1 at crisis prevention
• Cost, and ease of transition
  • Option 4 has lower interest rate impact (~17bps) compared to Option 3 (~21 bps)
  • Under assumption that AT1 is just as effective as CET1, Option 3 provides higher net benefit (0.43% of GDP) compared to Option 4 (0.40%)
  • However monte carlo analysis shows Option 4 has highest proportion of positive net benefits (90%)
• Basel minimum – minimum capital ratio of 8% under Option 4 vs 9% under Option 3

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Timeframe for transitional arrangements

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Background

• There are several components to the transitional arrangements for the Capital Review proposals:
  • Overall timeframe for ratio requirements (five or seven years) – discussed in #8619325.
  • Transitioning in components of the Capital Review – de-recognising cocos, implementing the IRB scalar and output floor.
  • Technical changes – exposure drafts, conditions of registration etc.
• There will be consultations on the technical changes required to implement the Capital Review changes, however this will not affect the overall policy decisions made by FSC.
• FSC is asked to decide on high-level transitional issues today; more technical matters will be addressed through BSG in the first instance or through exposure draft consultations.

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Interaction with the handbook restructure

• The Banking Supervision Handbook (BS1, 2, 3, etc.) is being restructured to provide more clarity in the regulatory framework for banks. This process has been on-going since 2016 and is nearing its final stages.
• Changes will be required to the supervision handbook (‘exposure drafts’) in order to implement some of the Capital Review changes.
• We anticipate that FSPA policy teams will need four to five months to prepare the exposure drafts for consultation (under the restructured handbook). This will mean certain components (changes in the definition of capital) of the Capital Review will not be implemented until 1 July 2020 at the earliest.
• To accommodate this, we propose to delay the implementation of initial Capital Review changes until 1 July 2020.

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Transitional arrangements

• The key considerations for transitional arrangements are the economic impacts that may occur if banks restrict credit availability to meet the requirements.
• Submitters argue we haven’t considered the costs of the proposals during the transition period, which could be much higher than the steady state costs. Many argued for a longer transition period.
• It is difficult to measure these impacts and predict how banks may react in response to the final decisions. As such our approach has been to mitigate potential transitional costs by extending the timeframe for implementing the Tier 1 ratio requirements.
• This depends largely on how much headroom banks should be given to maintain dividend payouts during the transition period.

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Current environment

• Some banks have said that they anticipate a tightening in credit availability for certain sectors (agri, commercial property).
• However, this is on the backdrop of broader changes that are unrelated to the Capital Review, such as changes in government regulation for agriculture sectors.

[Chart: Line chart showing credit availability for Mortgage, SME, Corporate, Property, and Agriculture from 2009 to 2019]

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Evidence for (and against) rationing

• Overseas, although some banks have shrunk their balance sheet in response to higher capital, other banks (with higher asset returns) have increased their asset growth. System credit growth tends to remain stable as a result.
• The BCBS monitoring exercise shows that banks maintained around 30% to 40% dividend payout ratios during the implementation of Basel III. This was for CET1 increases of 71% (for smaller Group 2 banks) to 91% (for larger Group 1 banks) over the seven year period.
• Bank reports suggest upcoming dividend payout ratios of s 18(c)(i) s 18(c)(i) note that this is on the basis of restricting their credit growth, whereas s 18(c)(i) assumes an asset growth in line with historic averages.

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Scenario analysis

• Using balance sheet and income statement data, we model what credit rationing could look like (using the CRISP model). As this is a scenario analysis, the estimates here should be seen as directional rather than precise. This analysis suggests that: i. Compared to a counterfactual growth rate of 5.10%, a five-year period would reduce credit growth to ~3.92% p.a. over the transition period. Conversely, a seven-year transition would reduce credit growth to only ~4.93% p.a., ii. The difference between the five-year and seven-year transition period is largely driven by s 18(c)(i) who are the most affected, iii. TSB and Co-op have more structural issues (unsustainably high growth rates, high cost-to-income) which cannot be addressed through the transition. Five or seven years appears to be easily achievable for other non-D-SIBs.

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Options

Option 1 (As proposed): Five years to transition in Tier 1 requirements Option 2 (Recommended): Seven years to transition in Tier 1 requirements

s 18(c)(i)

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Other key components to transition

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Other key components of the Capital Review

• There several other key components for FSC to discuss today: i. The ‘IRB Scalar’, output floor, and dual reporting timing ii. Build the Capital Stack over a 7-year transition period - Timing of the D-SIB buffer - Timing of the CCyB iii. Timeframe to de-recognise coco instruments as regulatory capital
• Decisions on these options weighs-up the need to ‘smoothen’ transitional arrangements (so as not front-load requirements), against the underlying principles of these components.

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Timeframe

[Chart: Timeline showing IRB Scalar, Output Floor & Dual Reporting, Phasing-out Cocos, D-SIB buffer changes, Conservation buffer changes, and CCyB changes from Jan 2020 to Jul 2027]

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IRB scalar, output floor, and dual reporting

• The IRB scalar, output floor and dual reporting aim to reduce the difference in measuring risks between IRB and standardised banks and make the different types of banks more comparable.
• The consultation proposed to introduce the increased IRB scalar (from 1.06 to 1.20) three quarters after decisions are announced. The output floor and dual reporting were to come into effect five quarters after decisions are announced. This was to give IRB banks time to build their standardised capital models.
• Submitter views and considerations:
  • Some banks have noted that the sudden implementation of the IRB scalar early in the transition period would have a significant impact on their capital ratios.
  • However, delaying the implementation of the IRB scalar could undermine the underlying aim to ‘level the playing field’ between banks.

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Options

Option 1 (Dec 2018 proposals): Implement the IRB scalar three quarters after announcement, and output floor, and dual reporting five quarters after. Option 2: Delay the implementation of the IRB scalar by three quarters to 1 July 2021 (output floor and dual reporting come into effect on same date). While this may provide IRB banks with more time to plan for the scalar change, the impact appears relatively immaterial.

[Charts: Two line charts showing capital ratios for ANZ, ASB, BNZ, and WNZL from 1/06/2019 to 1/12/2026]

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CCyB and D-SIB Buffers

• The key aims of the prudential buffers, and the associated components, are to:
  • Promote a sound and efficient financial system. The 16% Tier 1 ratio proposed is set to limit a banking crisis to once in every two hundred years.
  • Provide a more flexible capital framework where regulatory responses are graduated and more appropriate to the relative breaches of buffers (via the ESR). This also includes macro-prudential tools (CCyB) being used as part of capital requirements
  • Be commensurate with the relative risks posed by institutions through a D-SIB framework.
• Assessing which components of the prudential buffers are applied first (and last) depends on weighing-up the above points, as well as some practical implementation issues.

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CCyB and D-SIB Buffers

• It could be conceptually more appropriate, and practically more feasible, to implement the CCyB buffer last in the prudential buffers. This is because: i. System soundness is the underlying goal of the Capital Review, and we believe it is important that D-SIB banks first meet their other prudential buffers that do not have the prospect of being lowered, ii. We still need to consult on the indicators for the CCyB, as well as develop the framework for its use.
• There is only a marginal difference between implementing the D-SIB buffer first or phasing it in more gradually over the first few years.
• On balance we believe implementing the D-SIB buffer first could provide some benefits to non-D-SIBs as they are constrained in their ability to raise CET1.

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Options

CCyB: Option 1: Implement the CCyB portion of the prudential buffer early Option 2 (Recommended): Implement the CCyB as the last portion of the prudential buffer

DSIB: Option 1: Implement the D-SIB buffer gradually over the first few years Option 2 (Recommended): Implement the D-SIB buffer gradually as the first portion of the prudential buffers

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Phasing-out cocos

• The numerator definition changes related to the principle that capital should be able to absorb losses when needed.
• In December 2018, we proposed to de-recognise an additional 20% each year, so there would be no recognition after five years.
• Submitter views and considerations:
  • One bank has said that the Reserve Bank should fully-recognise cocos as regulatory capital until their next call date. Some small banks (Co-op and SBS) could benefit from having their Tier 2 instruments recognised for longer.
  • However, such an arrangement would likely benefit two D-SIB (ANZ and WNZL) for Tier 1 ratios and only provide reprieve for two small banks (SBS and Co-op) for Tier 2.

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Options

Option 1: Grandfather by de-recognising an additional 20% of the face-value per year (five-year phase-out) Option 2: Fully-recognise until next call date

[Charts: Two line charts showing Cocos as a share of RWA for Option 1 and Option 2]

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Next steps after the ‘Capital Review’

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Consultation required in 2020

• Escalating Supervisory Response (including dividend restrictions)
• Operationalising the CCyB
• Model change approval process for IRB banks?
• Adopting the Basel III Standardised approach for operational risk

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Key outputs and stakeholder outreach

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Key external outputs

• Draft policy decisions (#8639465, #8639329) – 10 pages
• Other external outputs:
  • Go-to-guide – 8 pages, public-level messages with graphics and factoids
  • Regulatory Impact Analysis / cost-benefit analysis (#8618251) – 100+ pages
  • Media release
  • Qs and As
  • Response to Submissions
  • Background papers (i.e. internal Committee papers)
• All will be uploaded onto the website

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Process steps and timeline

• 22 November – mocked up version of Go-to-Guide sent to Adrian, Geoff, Simone
• 28 November – near-final versions of all products sent to in-house designer
• 29 November – proofreader to review all products
• 2 December – final edits made to all products, then sent to Adrian and Geoff for sign off
• 3 December – final edits sent to designer / send all products to printer

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Engagement with key stakeholders

• 18 November – we provided Treasury with draft cost-benefit analysis
• 25 November - Conference call with the Board
• 26 November - Paper to the MOF on final decisions
• 29 November - Call to APRA
• 3 December - Brief MOF in person
• 4 December - Brief political parties; APRA/ CoFR partners
• 5 December – release of final policy:
  • Prior to policy release, brief banks, NZBA, and media
  • Release of policy documents at 12 noon
  • Press conference at 1 pm
  • Finance and Expenditure Committee at 3 pm

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Appendix

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Calibration options 1 to 4

[Chart: Bar chart showing Tier 2, AT1, and CET1 for DSIB and non-DSIB under Option 1, 2, 3, and 4]

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Transition and AT1 levels

• For the transition paper the assumption is that AT1 is 1.5% and usable (i.e. RPS and attractive to both issuers and investors).
• Having a higher AT1 at 2.5% would ease the transition, giving banks more headroom in terms of growth and/or dividends payments.
• The transition pressures when AT1 is 2.5% would be somewhere between Options 2 and 4 (option 4 having the easiest transition path).

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Potential AT1 issuance re: NZX

[Charts: Two pie charts showing AT1 vs Other NZX for 1.5% and 2.5% issuance]

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Distribution of costs and benefits

• Cost distribution is fairly narrow, whereas there’s a lot more uncertainty for benefits (e.g. more potential upside)

[Chart: Line chart showing Costs (-% of GDP) and Benefits (+% of GDP)]

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Impact of Tier 2 removal on CBA components

CBA components	Impact of Tier 2 removal	Comments
Probability of a crisis	Zero/ marginal	• Additional incentive benefits of Tier 2 likely marginal once bank has high Tier 1 capital ratio (e.g. sufficient “skin in the game”) • Difficult to quantify how much additional incentive benefits there are from having Tier 2 capital compared to other forms of debt → If we are of the view that Tier 2 has limited incentive benefits, then Tier 2 does not reduce the probability of bank failure and the probability of a crisis.
Cost of crisis	Slightly higher	• We view Tier 2 as gone concern capital, and that it aids in the resolution of a bank. → Removing Tier 2 from the framework is likely to result in a marginal increase in the cost of crisis.

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Impact of Tier 2 removal on CBA components

CBA components	Impact of Tier 2 removal	Comments
Interest rate impact	Uncertain	• Lower total capital ratio = lower funding costs for banks (banks can use cheaper forms of funding in place of Tier 2) • Operational complexity of managing Tier 2 may mean that banks need more Tier 1 capital (cost ↑) to meet total capital requirements → Removing Tier 2 and reducing total capital ratio could result in lower repricing • If proposed Tier 2 capital is not APRA compliant, Tier 2 issued by the subsidiaries will not count towards the Australian banking group’s total capital ratio (less demand for Tier 2 capital from the parent = price of Tier 2 ↑) • Proposed changes to APS 111 increase the cost of all forms of capital (including Tier 2) once the parent has more than 10% capital investment in its banking subsidiary. (cost of any intra-group capital issuance ↑) → To the extent that Trans-Tasman rule changes makes our proposed Tier 2 capital expensive for D-SIBs, interest rate repricing may be higher Other factors: • Due to removal of triggers, proposed Tier 2 capital could be cheaper (~1% above benchmark) than the current Tier 2 instrument (2-2.5% above benchmark).

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Financial ecosystem, intersect with the Capital Review and next steps.

Presentation to FSC 23 Oct 2019

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Why an interest in the financial ecosystem?

• Senior management indicated they are interested in the indirect and system-wide impacts of the bank capital proposals.
• Identifying the intersections between bank capital policies and non-bank financial firms is one way to respond to Ross Levine’s challenge to pay more attention to incentives and the dynamic effects of higher capital.
• The cost benefit analysis narrative requires us to consider qualitative as well as quantitative impacts.

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RBNZ’s legitimate interest is broad

RBNZ Act 1989

• Purpose of the legislation: promote “prosperity and well-being”
• RBNZ to be “responsible for”: promoting the maintenance of a sound and efficient financial system”

Providing the RBNZ is acting for the main purpose (as above), any relevant consideration can be explored.

Qualification: if there is any secondary purpose, this secondary purpose cannot lead to decisions that undermine the main purpose.

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[Diagram of Financial Ecosystem]

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Dimensions of intersection (not exhaustive)

Opportunities + constraints + incentives = potential dynamic intersections:

• Bank competition and barriers to entry into banking (NZ, market segments)
• Non-capital bank funding (offshore investors, ratings agencies, APRA and other regulators)
• Non-bank financial development (non-bank debt, equity, peer2peer platforms, intermediary services, listed and unlisted markets, fintech)
• Financial inclusion (access and price of debt and equity, HH indebtedness)
• Macro-stability risks (eg HH indebtedness, bank risk appetite, external balances, short-term versus medium term)
• Broader competitive considerations (finance vs other service sectors)

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Illustration 1: impact on competition

• Higher capital requirements → higher costs of lending → disintermediation to other institutions/lenders, including:
  • Non bank lending institutions: including NBDTs (finance companies that raise funds from the public, building societies, credit unions), and non-deposit-taking finance companies.
  • Fintech/P2P lending.
  • Foreign bank branches.
  • Capital markets (for large corporates).
• Greater competition but potential risks depending on the type of lending that goes to the more lightly or un-regulated sector.
  • Important to monitor these effects including through Phase II lens.
  • LVR policy implementation – disintermediation impact small.

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Illustration 2: ‘dis-intermediation’ vs ‘healthy development’

• ‘Shadow banking’, on and off-balance sheet trends
• Branches vs subs, dual registration
• Banks as non-banks (eg banks focus on managed fund business)
• Non-banks as banks (eg Kiwisaver schemes offering mortgages)
• Capital instruments intersection with local securities markets
• Large corporates (switch from banks to direct market access) vs SMEs (reduced access to any funding)
• An issue that lends itself to monitoring through time

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Next steps

• Include a discussion of the financial ecosystem impacts in the cost benefit analysis narrative (with the ecosystem defined as above), or an alternative product?
• Provide FSC with an opportunity to review the ecosystem commentary via the draft CBA (or alternative product).
• Develop a plan to monitor the wider ecosystem impacts of the capital proposal (for example, develop a list of indicators to populate through time).

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Questions for FSC

• Have we understood your interest correctly?
• Have we defined the financial ecosystem satisfactorily?
• Are there areas of intersection that we should prioritise?
• Do you agree with next steps?