Basel III BS2B consultation - standard letter to bank CEs (internal models)

10 September 2012 LETTER TO CHIEF EXECUTIVES OF LOCALLY INCORPORATED (INTERNAL MODELS) NEW ZEALAND BANKS Basel III implementation in New Zealand - update The primary purpose of this letter is to update you on the Reserve Bank’s implementation of Basel III in New Zealand and to seek your feedback on proposed changes to our Banking Supervision Handbook (the Handbook). The Reserve Bank’s website also contains up to date information on our Basel III programme and consultations. In my previous update of 8 May 2012 I noted decisions on some key aspects of Basel III taking into account the submissions we received and developments in the Basel III policy of the Australian Prudential Regulation Authority (APRA). We have now taken decisions on the remaining areas of our implementation of the Basel III capital adequacy framework (excluding the area of counterparty credit risk that is progressing on a separate track). Attached for your information is the Reserve Bank’s response to Basel III submissions. Also attached is the Reserve Bank’s cost-benefit analysis of Basel III that concludes there are net benefits in tightening our requirements to the Basel III standard. Now that our Basel III policy is finalised we are consulting on how that policy translates into detailed capital adequacy requirements within the Banking Supervision Handbook. We have therefore attached for your consideration draft changes to the Reserve Bank document “Capital adequacy framework (internal models based approach) (BS2B) for your consideration. Please note that this attachment includes: • the existing Part 1 of BS2B as context, but no changes to Part 1 are proposed; • a proposed replacement to Parts 2 and 3 of BS2B (as Basel III is largely about the definition of capital we propose to replace these sections completely); and • tracked changes to subpart 4B of BS2B (section 4.215 only), and parts 6 and 7 of BS2B (only minor changes are proposed to these sections). We have also attached proposed Basel III related changes to the Reserve Bank document “Statement of Principles” (BS1) for your consideration. The proposed changes appear as tracked changes. A secondary purpose of this letter is to see your feedback on some minor and technical changes to BS2B that are unrelated to Basel III. These changes are described in Appendix One.

2 We welcome your comments on draft changes to BS2B and BS1 by 9 October 2012. Appendix Two contains some consultation questions that may assist your considerations, but you need not restrict your comments to responding to these questions. Once the changes to the Handbook are finalised we plan to consult with you on draft changes to your bank’s conditions of registration that will require your bank to comply with the updated Handbook from 1 January 2013. Finally, we plan to consult with you later this year on proposed changes to disclosure requirements necessary to reflect the new Basel III capital requirements. Yours sincerely Toby Fiennes Head of Prudential Supervision

3 Appendix One: Proposed changes to BS2B unrelated to Basel III Changes are proposed to sections 5.4 and 5.5 of BS2B that require a covered bond SPV to be treated as part of the banking group for the purposes of the capital adequacy framework. These proposed changes appear as tracked text in the attached BS2B document. Covered bonds As an ongoing condition of accreditation to use their own models as the basis for calculating their credit risk regulatory capital requirements all internal models banks were required to develop improved housing capital models. In a letter dated 22 June 2010, the Reserve Bank advised internal models banks that once they implemented satisfactory housing models they would be subject to marginally lower minimum loss-given-default (LGD) estimates. Minimum loss-given-default estimates for residential real estate exposures The Reserve Bank has now approved new housing models for all internals models banks and so the lower LGD requirements apply to all internal model banks with approval provided in writing by the Reserve Bank. We propose to change Table 4.11 in section 4.150 of BS2B to reflect this practice in accordance with the track changes shown below: Table 4.11 Minimum LGD for residential real estate exposures LVR LGD 90-100% 40% 38.00% 80-89% 35% 33.25% 70-79% 30% 28.50% 60-69% 20% 19.00% Under 60% 10%

4 Appendix Two: Consultation questions

1. Do you consider that instruments that comply with our proposed loss absorbency at the point of non-viability requirements (in BS2B) will also comply with the loss absorbency at the point of non-viability requirements of the Australian Prudential Regulation Authority (APRA)? (This question is relevant for locally incorporated New Zealand banks that are subsidiaries of banks subject to APRA’s capital adequacy standards). Loss absorbency at the point of non-viability
2. Should your bank elect to issue an instrument with a conversion feature, do you anticipate any legal or other impediments to the issue of shares following conversion will need to be addressed before the instrument is issued (for instance, issues relating to the Takeovers Code). If so, please specify?
3. Do you consider the way the proposed loss absorbency at the point of non-viability requirements are drafted or the description in BS1 of how the requirement may operate in BS1 will result in any unintended effects? If so, please specify.
4. The draft capital adequacy standards contain loss absorbency requirements for Additional Tier 1 capital instruments. Given that these requirements only apply to instruments that are classified as a liabilities under New Zealand generally accepted accounting practice do you think they are necessary? In other words are Additional Tier 1 capital instruments that are classified as liabilities likely to be issued by your bank? Additional Tier 1 capital instruments