Consultation paper: further elements of Basel III capital adequacy requirements in New Zealand

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Consultation Paper: Further elements of Basel III capital adequacy requirements in New Zealand The Reserve Bank invites submissions on this Consultation Paper by 13 April 2012. Submissions and enquiries about the consultation should be addressed to:
Ian Woolford
Manager, Financial System Policy
Prudential Supervision Department
Reserve Bank of New Zealand
PO Box 2498
Wellington 6140
Email: ian.woolford@rbnz.govt.nz
Please note that a summary of submissions may be published. If you think any part of your submission should properly be withheld on the grounds of commercial sensitivity or for any other reason, you should indicate this clearly. March 2012

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Contents
Background...................................................................................................................................................3
Operation of the capital conservation buffer.................................................................................................4
Countercyclical capital buffer.......................................................................................................................4
Loss absorbency at the point of non-viability...............................................................................................6
Transitional arrangements.............................................................................................................................9
Consultation questions................................................................................................................................10

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Background

1. In December 2010 the Basel Committee on Banking Supervision (the Basel Committee)
   released the new global regulatory standards for bank capital adequacy and liquidity as endorsed by G20 leaders at their November 2010 summit.1 These standards are commonly known as Basel III standards.
2. In November 2011 the Reserve Bank released its first consultation paper on Basel III capital.
   That paper set out the Reserve Bank’s proposals for implementing the core Basel III capital measures relating to capital ratios, the definition of capital and the leverage ratio. The Basel III capital ratios are shown in the table below.
   Table 1: New capital ratio requirements and buffers (as a percentage of risk weighted assets)
   Common equity Tier 1 capital Total capital
   Existing minimum ratios 2.0%2
   4.0% 8.0%
   New minimum ratios 4.5% 6.0% 8.0%
   Conservation buffer 2.5%
   New minimum ratio plus conservation buffer
   7.0% 8.5% 10.5%
   Countercyclical buffer range 0-2.5%
3. The November consultation paper also noted that the Reserve Bank would consult on other
   elements of Basel III capital in 2012.
4. This consultation paper sets out the Reserve Bank’s proposals for further elements of the
   framework: the operation of the conservation buffer; the countercyclical buffer; and minimum requirements to ensure that all classes of capital instruments fully absorb losses at the point of non-viability (“loss absorbency”). This paper also proposes transitional arrangements.

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The Basel III package is available on the website of the Bank of International Settlements at:
http://www.bis.org/publ/bcbs188.htm.
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This requirement is not applied in New Zealand. However, all locally incorporated NZ banks are well above this requirement at present.

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5. For completeness, this paper also explains the interim arrangements for instruments issued
between now and when compliance with our final Basel III capital adequacy standards is required. These arrangements are not for consultation, but are included here for information.
6. The Reserve Bank will take into account submissions received on this consultation paper as
well as the first (November 2011) consultation paper in the preparation of draft Basel III capital adequacy standards. A consultation on these draft standards is expected to be released in the second quarter of 2012.
7. The Reserve Bank will consult on the remaining elements of Basel III separately. These
elements include counterparty credit risk; addressing reliance on external credit ratings and minimizing cliff effects; and disclosure requirements. Operation of the capital conservation buffer
8. Basel III introduces a capital conservation buffer of 2.5%, comprising Common Equity Tier
1, above the minimum capital requirement. Common Equity Tier 1 must first be used to meet the minimum capital requirements (including the 6% Tier 1 and 8% Total capital requirements if necessary), before the remainder can contribute to the capital conservation buffer. The purpose of the conservation buffer is to absorb losses during periods of financial and economic stress.
9. The standard Basel III framework operates in such a way that if an individual bank’s capital
ratios fall below the minimum plus the conservation buffer, restrictions would apply on the discretionary distribution of earnings. Under the Basel III framework, greater efforts should be made to rebuild the buffer the more it has been depleted. This means that constraints on distributions increase as capital falls further into the buffer towards the minimum capital ratio, whereas only minimal constraints apply to banks that have only dipped slightly into the buffer.
10. In our first consultation paper we proposed to adopt the conservation buffer. This paper sets
out our proposed approach to the operation of the buffer.
11. A bank is able to operate inside the buffer, and this would not be a breach of its conditions of
registration. However, we consider that once a bank draws on the buffer, distributions should be restricted to the extent necessary to restore capital back above the buffer. We therefore propose that under our framework a bank operating within the buffer must fully restrict distributions to the extent necessary to restore the buffer to 2.5% of Common Equity. This differs from the Basel III framework that envisages only partial restrictions on distributions unless a bank’s Common Equity Tier 1 ratio is as low as 5.125%. We also

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Ref #4674251 propose that constraints on distributions apply to the extent such distributions would result in a bank moving into the buffer.
12. Other aspects of the Reserve Bank’s proposed conservation buffer requirements are largely in
line with Basel III, as follows:
Items considered to be distributions include dividends and share buybacks and discretionary payments on other tier 1 capital instruments. Payments that do not result in the depletion of Common Equity Tier 1, which may for example include certain scrip dividends, are not considered distributions. The Reserve Bank will have the discretion to apply time limits on banks operating within the buffer range. The Reserve Bank will require banks operating within the buffer range to submit a capital plan for rebuilding the buffer. The Reserve Bank will expect the capital plan to show prudent management of costs (such as staff bonuses) and that the plan will be consistent with any time frame imposed by the Bank. The framework will be applied at the banking group level (i.e. restrictions will be imposed on distributions out of the consolidated group). However the Reserve Bank will have the option of applying the regime at the registered bank level to conserve resources in specific parts of the group. Countercyclical capital buffer
13. Basel III introduces a countercyclical capital buffer to encourage authorities to take account
of the macro-financial environment in which banks operate in setting banking sector capital requirements. Under Basel III it is envisaged that banks would be required to hold this buffer when national authorities judge that excess private sector credit growth is leading to a build￾up of system-wide risk. The buffer would then be able to be released when the credit cycle turns down and loan losses accumulate, helping to reduce the risk of a sharp contraction in the availability of credit. The focus on excess aggregate credit growth means that jurisdictions are likely to only need to deploy the buffer on an infrequent basis.
14. Under Basel III, the countercyclical buffer is made up of Common Equity Tier 1 capital or
other fully loss-absorbing capital3 and will vary between zero and 2.5% of risk-weighted assets (or at a higher level as determined by the relevant authority).

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The Basel Committee is still considering whether to permit other fully loss-absorbing capital beyond Common Equity Tier 1. Until the Committee has issued further guidance, the countercyclical capital buffer is to be met with Common Equity Tier 1 only.

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15. The Reserve Bank plans to develop a framework for the implementation of a countercyclical
buffer. This would form one tool in a broader macro-prudential framework. We propose to adopt a countercyclical buffer requirement with the following features:
It will initially apply to registered banks but could potentially be extended to other lenders (such as non-bank deposit takers) in the future. The buffer will be made up of Common Equity Tier 1. While the buffer is indicatively expected to vary between 0 and 2.5% of risk-weighted assets, no formal limit will be set on the maximum size of the buffer (i.e. the size of the buffer will be determined according to circumstances). Registered banks will be given up to 12 months notice, ahead of the countercyclical buffer requirement taking effect (to give banks time to adjust to the buffer level). Each bank will be required to submit a capital plan to the Reserve Bank once notice is given that the countercyclical buffer will apply. The plan should set out how the bank will raise the necessary capital to comply with the buffer requirement. The restrictions on distributions that apply when a bank operates within the conservation buffer (described above) will also apply when a bank operates within the countercyclical buffer. The Bank would consider a broad range of financial indicators and other evidence in determining whether application of the buffer was appropriate. The intention would be to release the buffer at an appropriate time following the peak of the credit cycle, so it would be available to absorb credit losses.
16. As this requirement is intended to apply to all banks that operate in New Zealand, in the case
of branches of overseas incorporated banks, reciprocity arrangements would need to be considered with other jurisdictions.
17. It is envisaged that the Reserve Bank will make the decision to apply the countercyclical
buffer. The Reserve Bank and Treasury plan to undertake further work to determine appropriate governance and accountability arrangements for the operation of the countercyclical capital buffer. Loss absorbency at the point of non-viability Basel III requirements
18. Basel III introduces a requirement that is designed to ensure that all regulatory capital
instruments are capable of absorbing losses. The Basel III loss absorbency requirement can be met in one to two ways, as set out below.

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Option 1: Terms and conditions
“The terms and conditions of all non-common equity Tier 1 capital and Tier 2 instruments must have a provision that requires such instruments, at the option of the relevant authority, to either be written off or converted into common equity upon the occurrence of the trigger event.” Option 2: Legislation only (1) “There is legislation that requires non-common-equity instruments to be written off upon the occurrence of the trigger event. (2) It is disclosed by the relevant regulator and by the issuing bank, in issue documents going forward, that such instruments are subject to loss under clause (1) above.”
19. The Basel III loss absorbency requirement also includes the following:
“Any compensation paid to the instrument holders as a result of the write-off must be paid immediately in the form of common stock (or its equivalent in the case of non-joint common companies). The issuing bank must maintain at all times all prior authorisation necessary to immediately issue the relevant number of shares specified in the instrument’s terms and conditions should the trigger event occur. The trigger event is the earlier of: (1) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority; and (2) the decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable, as determined by the relevant authority. The issuance of any new shares as a result of the trigger event must occur prior to any public sector injection of capital so that the capital provided by the public sector is not diluted.” Implementation in New Zealand
20. We propose to adopt the loss absorbency requirement according to Option 1 above (i.e.
provisions will be required to be included in the terms and conditions of regulatory capital instruments). We do not favour Option 2 largely because by not requiring specific terms and conditions it is less transparent than Option 1.

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Write-off versus conversion
21. The Reserve Bank proposes that the terms and conditions of all non-common equity
instruments require that the instrument be converted to equity - rather than be written-off - under certain circumstances (discussed below). We do not favour a write-off approach, as write-off with no compensation could rank debt holders below equity holders. Moreover, we do not propose to introduce any requirements about the rate of conversion. Form of exercise of power
22. In our view there are two potential mechanisms that could be used to give effect to the
conversion to equity of non-common equity instruments. Both of these options will require changes to the Reserve Bank Act. (i) Reserve Bank direction – the Reserve Bank could issue a direction to the relevant bank, if the trigger event has been met and it was considered an appropriate course of action, requiring the bank to convert to equity non-common equity instruments consistent with the terms of the contract. (ii) Statutory management – should a bank be placed into statutory management the statutory manager could have the power to convert to equity non-common equity instruments, consistent with the terms of the contract.
23. We consider that there are advantages to working within existing statutory mechanisms,
particularly as these mechanisms are already designed with appropriate accountability arrangements in place. Trigger event
24. We propose that the trigger event be one of either Option 1(a) or Option 1(b) as set out
below. We will take into account submissions on this consultation paper before we decide which option should be the trigger event. Option 1(a): allow the exercise of the powers in paragraph 22 (above) when a bank is, in the opinion of the Reserve Bank, non-viable without reference to a particular measure of non￾viability determined on an ex ante basis. One approach to doing this would allow these powers to be exercised whenever the conditions of section 113 of the Reserve Bank Act are met (or some subset of these conditions); or Option 1(b): define a quantitative trigger point that a bank must breach before the powers in paragraph 22 may be exercised. For the statutory manager to exercise this power, the trigger would be in addition to the existing conditions in section 113, which must be met before statutory management can be declared. The powers could become operative if, for example,

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Ref #4674251 the Reserve Bank is of the opinion that a bank has breached a particular capital threshold. For instance the capital threshold could be set at a Common Equity Tier 1 ratio of 5.125%.4
25. We envisage that upon the occurrence of the trigger event, application of the loss absorbency
requirement would be discretionary rather than automatic. Moreover, the application would not be conditional on conversion resulting in the bank becoming viable. Transitional arrangements
26. The November 2011 consultation paper noted our starting position that the Basel III
requirements will take effect from 1 January 2013 rather than being phased in over time as the Basel Committee contemplates. Some submissions raised concerns about being able to meet the Basel III requirements from 1 January 2013 and argued for a more phased approach.
27. While we now consider some transitional arrangements may be appropriate, we remain of the
view that Basel III should be implemented in New Zealand ahead of the Basel Committee’s timetable.5
28. The Reserve Bank proposes the following transitional arrangements:
Implementation of the capital conservation buffer in full from 1 January 2014; Implementation of the countercyclical buffer framework in full from 1 January 2014 (from this date the Reserve Bank could give notice that the countercyclical buffer is to apply at some future date); and Grand-parenting of non-qualifying instruments issued before 12 September 2010 over a three year period but no later than the first available call date. This means that recognition of non-qualifying instruments will be capped at 67% on 1 January 2013, 33% on 1 January 2014, and from 1 January 2015 there will be no recognition of non￾qualifying instruments.
29. Note that instruments that do not meet the Reserve Bank’s loss absorbency requirements will
be classified as non-qualifying from 1 January 2013.

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This threshold is the same as the Basel III threshold for full constraint of earnings distributions within the conservation buffer framework and also the threshold APRA have set for conversion of Additional Tier 1 instruments recognised as liabilities to ordinary shares. 5 Our expectation that we would implement Basel III ahead of the Basel Committee’s timeline was noted in the May 2011 edition of the Financial Stability Report (chapter 6).

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30. The Reserve Bank proposes that all other Basel III capital requirements consulted on to date
will take effect from 1 January 2013. This includes the new minimum ratios and regulatory deductions.
31. The timing for implementation of Basel III elements on counterparty credit risk and on
addressing reliance on external credit ratings and minimizing cliff effects will be proposed when we consult on these requirements. Interim arrangements
32. Within the Basel III framework there are no grand-parenting provisions available for capital
instruments issued after September 2010. However the Reserve Bank has decided that capital instruments issued prior to release of our final Basel III standards may qualify for grand￾parenting (in the event they are not compliant with our final standards) on the following basis:
The Reserve Bank determines, on a case-by-case basis that the instrument can qualify for grand-parenting (based on the consistency of the instruments characteristics with the Basel III framework). If the instrument is not consistent with our final Basel III standards the grand￾parenting arrangement that will apply is that it will be partly recognised in 2013 (67%) and not recognised from 2014 onwards. Consultation questions
33. To assist the consultation process the Reserve Bank has put forward a series of consultation
questions below. However submissions should not necessarily be limited to addressing these questions and are not required to address all (or any) of these questions. The Reserve Bank welcomes all relevant comments on the proposals outlined above. Operation of the capital conservation buffer Do you consider the proposed restrictions on banks operating within the capital conservation buffer are suitable for New Zealand circumstances? Countercyclical capital buffer The Reserve Bank proposes that registered banks be given up to 12 months notice ahead of the countercyclical buffer requirement taking effect. What length of time do you consider to be a reasonable notice period?

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Once the countercyclical buffer is removed or decreased, do you consider banks will use the buffer to absorb losses or otherwise reduce capital, or would banks be constrained in their use of the buffer by market expectations? Loss absorbency at point of non-viability Do you favour Option 1(a), Option 1(b) or Option 2 as set out in this paper? What are the advantages or disadvantages of using the Reserve Bank’s direction powers versus statutory management powers? Are there other legal or practical issues that would need to be addressed to implement the non-viability requirement? Transitional arrangements Are the proposed transitional arrangements reasonable?