Reserve Bank of New Zealand Review of Connected Exposures Policy Summary of Submissions and Final Decisions

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Review of Connected Exposures Policy. Summary of Submissions and Final Decisions 24 August 2023

1 Review of Connected Exposures: Response to Submissions on Exposure Draft Contents

1. Background _______________________________________________________________________________ 2
2. Exposure Draft Consultation Process ____________________________________________________ 3
3. Summary of Submissions_________________________________________________________________ 3
4. Reserve Bank’s Policy Position ___________________________________________________________ 4
5. Next Steps ________________________________________________________________________________ 7

2 Review of Connected Exposures: Response to Submissions on Exposure Draft

1. Background Banks incorporated and registered in New Zealand (a ‘New Zealand bank’) must comply with a range of rules put in place by the Reserve Bank of New Zealand - Te Pūtea Matua to support financial stability. Together, the rules reduce the risk of a bank failing and protect New Zealanders from the associated economic and social costs if a bank failure were to occur. The rules that are covered in the Reserve Bank’s Connected Exposures Policy limit the risks to a bank from transactions with and exposures to connected persons (e.g., conflicts of interest and failure). Connected exposures are a bank’s exposures to its connected persons – connected persons are natural or legal persons who are closely related to the bank. For example, a bank’s owners or other entities which the bank’s owners may have influence over. The Connected Exposures Policy defines a connected person, sets out requirements on a bank’s systems and controls to manage the relevant risks such as conflicts of interest, and sets a way to measure a banking group’s exposures to connected persons. The policy then requires banks to limit the size of the total connected exposures in relation to their capital. These rules help prevent bank failure in New Zealand, and ultimately helps support financial stability in New Zealand. The current version of the connected exposure policy has been in place without major policy updates for over ten years. We have become aware of some issues that banks have encountered when measuring an exposure amount under the Connected Exposures Policy. These issues are mainly due to some ambiguity and inconsistency in the current wording of the policy. In November 2021 we proposed to clarify the methods used to calculate connected exposures. We also suggested changes to bring the Connected Exposures Policy more in line with the existing standardised capital adequacy framework, while maintaining the effectiveness of the policy. The main proposals covered in the consultation material included:  Allowing banks to recognise eligible credit risk mitigations (e.g., collateral received for derivative and securities financing transactions);  Clearly setting out the eligibility conditions for recognising credit risk mitigations, and removing the gross exposure limit (note that the net exposure limits will be maintained);  Applying a flat 100% Credit Conversion Factor (CCF) to banks’ off-balance sheet contingent credit exposures to connected persons only for the purpose of connected exposure policy;  Exempting some specified interbank exposures to avoid potential constraints that banks may face given banks’ intraday operational practice; and  Expanding the definition of a connected person, in particular to include an entity in which a director of a registered bank has a substantial interest. We prepared an Exposure Draft based on the proposals from our November 2021 Consultation Paper, with some amendments following stakeholder feedback. The Exposure Draft was published in January 2023 and consultation closed in March. We have reviewed the feedback we received and considered the appropriate response. This document covers our responses to the feedback and final decisions.

3 Review of Connected Exposures: Response to Submissions on Exposure Draft 2. Exposure Draft Consultation Process The consultation on technical and workability issues of the Exposure Draft of the Connected Exposures Policy1 took place from 24 January 2021 to 8 March 2023. The Reserve Bank received two submissions, which we are publishing on our website along with this document. The submissions came from the New Zealand Bankers’ Association (NZBA) and MUFG Bank. This paper summarises the views raised in submissions and details final decisions on the policy. Readers are encouraged to refer to the actual submissions for further details. In addition to receiving written submissions, the Reserve Bank engaged with industry through bilateral meetings where requested. 3. Summary of Submissions Submitters were broadly supportive of the Exposure Draft. Specific changes requested were generally to provide greater clarity in certain clauses, along with more substantive changes to the definition of ‘connected person’. Submitters suggested that in broadening the definition of connected person from the current BS8 policy, the exposure draft captured too broad a range of entities and individuals (directors, senior managers and their relatives) leading to workability issues and a compliance burden that was disproportionate to the policy benefit. The changes requested are listed below by specific part of the Exposure Draft, along with brief commentary on the implications of some proposed wording changes. Our responses to these suggested changes are covered in Section 4 of this document. Part A: Introduction and definitions  Removing from A.3 1(a) and A.3 1(b) the reference to “associated persons” and replacing that concept with a “person who has control of the registered bank”. Control in this context includes indirect control. The effect of this change would be to reduce the range of directors and senior managers (and their relatives) captured as connected persons to those associated with the owners and indirect owners of the registered bank, rather than directors and senior managers of all entities in a wider banking group.  Changing A.3 1(b) to replace ‘relative’ with ‘close family member’ (or ‘close relative’).  Amending A.3 8 to define ‘close family member’ rather than ‘relative’, and making that definition somewhat narrower, for example by excluding siblings, parents and children aged 20 years or over. These changes along with those to A.3 1(a) and A.3 1(b) reduce the number of directors and senior managers (and their family members) who would qualify as connected persons of a registered bank, compared with the definition in the January 2023 Exposure Draft, given that the entities of which they are directors or managers are connected persons of the registered bank. Other suggested changes to A.3 1 listed below are primarily concerned with which entities will be connected persons, having only indirect effect (if any) on the directors, senior managers and family members captured.  Amending A.3 1(h) to require ‘control’ rather than ‘significant influence‘ over an entity.

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1 The Exposure Draft (and response to the November 2021 consultation) can be found here: https://www.rbnz.govt.nz/have-your-say/2021/review-of-the-connected-exposures￾policy-for-banks

4 Review of Connected Exposures: Response to Submissions on Exposure Draft  Amending A.3 1(i) phrasing to begin with a “person who has control” over the registered bank, rather than control or significant influence. A potential narrowing of the range of entities captured by the definition.  Replacing A.3 1(j) with a clause that captures entities controlled by a person who also has ‘significant influence’ over the registered bank. There are two separate changes here. One is the removal of the stipulation in the original clause that having 40% of members of a governing body in common is, in itself, enough to make two entities connected persons. The second is a potential extension in the proposed clause of the definition of connected persons that expands on A.3 1(e).  Amending A.3 3 (c) to refer to an executive who reports to the chief rather than a manager who reports to the chief executive. A potential narrowing of the ‘senior manager’ definition.  Removing definitions in A.3 4 and A.3 5. These definitions would not be needed if the removal of reference to ‘associated person’ in the policy is made, as suggested for A.3 1(a) and A.3 1(b) above.  Replacing ‘specified persons’ in A.3 9 and A.3 10 with ‘other connected persons’ and removing the definition of ‘specified persons’ at A.3 11. This potentially narrows the definition of ‘control’ and ‘significant influence’ by restricting those who will be considered to have influence or control by acting together to ‘connected persons’ acting together. Part B: Requirements  Clarify in guidance to B.2 1 the treatment of staff banking packages (not to be considered as more favourable than corresponding exposures to non-connected persons.  Suggest rewording responsibilities of bank’s board of directors, and change to title of B.3 1 to better reflect the content. Part C Exposure measurement  Suggest rewording of C.2 1 for clarity and consider relationship to other BPRs.  Reword C.2 2 for clarity.  Suggest reference to BPR131 rather than BPR140 at C.5 2 4. Reserve Bank’s Policy Position Given the consensus of agreement regarding proposals in relation to Credit Risk Mitigation and in relation to Credit Exposures we do not intend to diverge from the policies as set out in the Exposure Draft regarding these topics, aside from wording changes intended to improve clarity.

5 Review of Connected Exposures: Response to Submissions on Exposure Draft Regarding the definition of ‘Connected Person’, feedback clarified the potential costs and challenges of expanding the definition as in the Exposure Draft, and changes were suggested to appropriately scale the definition in relation to the regulatory objectives. We have considered the definitions against the two main objectives of the policy in relation to connected persons:  Prevent concentrated exposure to a set of connected persons that could present an elevated combined risk to the bank  Prevent contracts with connected persons on more favourable terms than standard for those persons, resulting from conflicts of interest. The conclusion of our assessment is that we agree with many of the points raised in submissions and have aligned the final policy document with much of that feedback. The rationale for this is discussed further below. In our Response to Submissions (January 2023), published with our Exposure Draft, we noted that submitters had wanted us to align the definition of ‘connected persons’ with definitions of ‘related persons’ in the accounting standards (IAS 24). We noted that we did not consider this to be practical, and would expand that definition further than what we originally intended. Instead we used the ‘related party’ definition from an earlier version of the Deposit Takers Bill and included some concepts from the accounting standard. We concluded that: “the perimeter in this definition is much closer to that of the related party definition in the NZ IAS 24 than what we had originally proposed in the consultation on the connected exposure policy.” However, the feedback we received disagrees with this assessment. The feedback pointed to a number of instances where the revised definition in the Exposure Draft would likely go further than the NZ IAS24 definitions. The submitter argued that the outcome of this is that we would bring in a much larger number of connected persons than what we set out in the original policy intent that we published in the initial consultation material. In short, the exposure draft was thought by the NZBA to capture too many entities and individuals (directors, managers, their relatives) making it both unworkable and reaching too widely, more than needed to achieve the intent of the policy. The specific drafting suggestions that we received included changes to reduce the range of corporate entities classified as connected persons, and in connection with those entities to reduce the scope of family members of directors and senior managers considered connected persons (while not being employees of a relevant entity themselves). Overall, after reviewing the feedback, we have concluded that the definition we proposed in the Exposure Draft was significantly wider than needed to achieve our policy objectives. We have therefore accepted most of the changes to the definition suggested in the feedback. However, there are a couple of instances where we have not fully accepted the suggestions. This largely relates to parts of the definition where we have sought to align with the definitions in the Deposit Takers Act. The table below details decisions on the definition of Connected Person.

6 Review of Connected Exposures: Response to Submissions on Exposure Draft Table 1: ‘Connected Person’ definition. Decision Comment Rely on the control and significant influence clauses to define a connected person and remove the reference to ‘associated person’ and ‘specified person’. The intent is to fulfil the original policy objective of capturing relevant persons connected to directors of the registered bank (not just to the bank itself) while not imposing an undue compliance burden or capturing persons who do not in fact pose a significant risk in terms of the financial or conduct objectives of the policy. We agree that removing the associated person and specified person clause will simplify the definition. Our assessment is that the change still meets our policy objective. This involves changes to A.3 1, A.3 4 and A.3 5, A.3 8 and A.3 11 of the exposure draft. Do not change wording from “manager” (reporting to the Chief Executive) to “executive” in definition of “senior manager”. We proposed the term “manager” (in A.3 3(c)) to align with the terms used in the Deposit Takers Act (DTA). However, consultation feedback proposed to change to “executive” in this policy. We have not made this change. This decision reflects a preference to align with the DTA where possible and hence to reduce additional changes that may otherwise be necessary when the DTA is enacted and standards issued. Other changes we have made reduce the number of directors and managers that will be captured in the ‘connected person’ definition by concentrating on those people who are directors or managers of the registered bank or its owners (direct or indirect). Implement a narrower definition of “close family member” rather than “relative” as per the Exposure Draft. We agree with the bank feedback that “relative” might greatly increase the coverage, for example, to siblings and parents of a director, with an increase in compliance costs, but with little relevance for the group of people most likely to influence directors or senior managers in some way. Banks also noted that collecting this data from non-customers might not even be possible. Reduce the range of connected entities for which their directors and senior managers (and their close family members) are also connected persons. (A.3 1(a) and A.3 1(b)) This is to focus on the individuals captured being those in a position to influence the registered bank and avoid a compliance burden associated with directors and managers of subsidiary entities in the wider group that do not have the ability to influence the bank. We do not see a strong rationale for including the widest range of group entities’ directors and managers. Implement a narrower definition of “control” and “significant influence” by replacing “specified person” with “connected person”, and for “significant influence” increasing the threshold percentages of voting rights or director appointments. This retains our focus on “connected persons” without introducing the “specified person” concept. The “specified person” concept would have created a separate category of person who acts in concert with others to influence the bank. We do not see a strong rationale for including the Specified Person concept in this policy. In the Exposure Draft to qualify as having ‘significant influence’ over an entity a person (or persons) needed 20% or more of voting rights, or ability to appoint 25 percent or more of the board of directors. ‘Significant Influence’ in the final policy has thresholds of 25 percent or more voting rights, or appointing 50% or more of the board of directors. The 25 percent and 50 percent thresholds for ‘significant influence’ in the current proposal are taken from the DTA (clause 39) to better align with the

7 Review of Connected Exposures: Response to Submissions on Exposure Draft Decision Comment Deposit Takers Act. It should also be noted that removing ‘specified person’ means the wording of BS8 does not exactly match the DTA in defining ‘significant influence’; this is an area where we assessed that diverging from the DTA wording for BS8 was warranted to achieve the policy objectives. Implement changes to A.3 1(h), A.3 1(i) and A.3 1(j) in line with submitters suggestion (see also above comments on A.3 1) These changes serve so further trim the scope of the connected person definition, with the exception of the reformulated A.3 1(j) which may capture additional entities over which persons, who have significant influence over the registered bank, have control. Other decisions:  Clarify in guidance to B.2 1 the treatment of staff banking packages (not to be considered as more favourable than corresponding exposures to non-connected persons).  Reword responsibilities of bank’s board of directors, and change to title of B.3 1 to better reflect the content, in line with submissions.  Comment: We agree with submitters that these changes improve clarity. We note also that considering restrictions on staff banking packages was not an objective of this policy review.  No changes to C.2 1  Comment: we note changes to other BPR documents are out of scope at this time. The main point made in C.2 1 is around deducting impairment allowances. We are aiming primarily for consistency with other BPR documents and so this wording does not go further.  Reword C.2 2 in line with submissions. We agree with submitters this change improves clarity.  Submitters also asked us to change the reference in C5 to exposure value for trading book positions from BPR140 to BPR131. Submitters noted that BPR140 covers the market risk capital requirement, rather than the exposure value. This is correct, however, BPR140 does include coverage of exposure values in a number of specific cases (e.g. BPR140 D1.3 in the case of equities and B1.3 for financial instruments). We have retained the BPR140 reference in the document on the basis that in instances where BPR140 specifies the exposure value, we expect this to be used for the purposes of BS8. If BPR140 contains no relevant valuation then we would expect BPR131 to be used instead. 5. Next Steps The Reserve Bank has decided to retain the BS8 title for the Connected Exposures Policy. We had intended to shift the naming convention to align with the BPRs used throughout capital adequacy requirements. However, we have decided to pause this, given the risk that other consequential changes may be needed in policy documents to reflect this change. For simplicity we will retain the BS8 title at this time. The changes will be implemented via a revised version BS8. The new requirements will be implemented through changes to banks’ Conditions of Registration. We intend to consult banks bilaterally about the required changes during September 2023. Once

8 Review of Connected Exposures: Response to Submissions on Exposure Draft this process is complete, we expect that the new policy will take effect from 1 October 2023 onwards.