Basel III BS2A Draft for Consultation: Standardised Approach Capital Methodology

Prudential Supervision Department
Document BS2A
Issued: November 2013

Part 1 Introduction

1. Introduction to Framework
   This document sets out the methodology to be used by locally incorporated registered banks that have adopted the standardised approach for calculating capital requirements. This methodology is to be used for the purposes of determining these banks compliance with conditions of registration relating to capital and for disclosing information about capital.
2. General Requirements
   Where questions arise as to whether or not particular arrangements come within the ambit of the definitions set out in this document, attention should be directed to the substance of the arrangement, not merely the legal form.
3. Application
   (1) A registered bank that has adopted the standardised approach must use this methodology to calculate the capital ratios both for the banking group and for the registered bank as defined in this section. Banking group For the purpose of calculating capital ratios, the banking group is as defined for the purpose of the registered bank s conditions of registration (subject to any adjustments required as a result of the bank s involvement in insurance, securitisation or funds management activities). Registered Bank (2) For the purposes of calculating capital ratios for the registered bank on a solo basis, subsidiaries which are both wholly owned and wholly funded by the registered bank are to be consolidated with the registered bank. In this context wholly funded by the registered bank means there are no liabilities (including off-balance sheet obligations) to anyone other than:
   (a) the registered bank;
   (b) the Inland Revenue Department; or
   (c) trade creditors, where aggregate exposure to trade creditors does not exceed 5% of the subsidiary s shareholders funds. (3) Wholly owned by the registered bank means all equity issued by the subsidiary is held by the registered bank. (4) Where there is a full, unconditional, irrevocable cross guarantee between a subsidiary and the bank, the subsidiary may be consolidated with the registered bank for the purposes of calculating the bank s solo capital position.

Part 2 Capital definition
4. Introduction to part 2
The following sections provide a definition of capital to be used in calculating capital adequacy ratios.
5. Definitions for part 2
In this part (and subparts of this part) - Act means the Reserve Bank of New Zealand Act 1989 affiliated insurance entity and affiliated insurance group have the meanings given in
part 7.
associated funds management and securitisation schemes have the meanings given in
part 6. control or significant influence means:
(i) the ability to directly or indirectly appoint 20% or more of the members of the governing body (e.g. Board of directors) of an entity; or (ii) the power to participate in the financial and operating policy decisions of an entity; or (iii)holding a direct or indirect qualifying interest in 20% or more of the voting securities of an entity. Where the employees or directors of one entity (entity A), constitute a significant portion of the Board of another entity (entity B), entity A will prima facie be considered to exert control or significant influence over the other entity B. non-bank deposit taker has the meaning given to it in the Non-Bank Deposit Takers Act 2012. related party means an entity over which any member of the banking group (or the registered bank in the case of solo capital) exercises control or significant influence or an entity which exercises control or significant influence over any member of the banking group. It includes a parent company, sister entity a subsidiary or any other affiliate. regulatory consolidation an entity will be considered to meet the requirement of regulatory consolidation if the assets of the entity are included in the calculation of risk￾weighted assets of the registered bank or banking group, as relevant, for capital adequacy purposes. risk weighted assets = risk weighted on and off-balance sheet credit exposures + 12.5 X total capital charge for market risk exposure + 12.5 X total capital requirement for operational risk. significant investment is an investment in the ordinary shares of another entity that exceeds 10% of the issued ordinary shares of that entity.

special purpose vehicle and SPV means a single purpose non-operating entity established for the sole purpose of raising regulatory capital for the banking group. third party means an entity that is not the registered bank or member of the banking group. written-off means written-off, extinguished or discharged.
6. Capital
(1) Total regulatory capital (total capital) is defined as the sum of the following categories:
(a) Tier 1 capital (going-concern capital), which comprises:
(i) Common Equity Tier 1 capital; and (ii) Additional Tier 1 capital; and (b) Tier 2 capital (gone-concern capital). (2) Each of the three categories above ((a)(i), (a)(ii) and (b)) is calculated net of associated regulatory adjustments. For each of the three categories of capital there are requirements set out in this part that instruments must meet to be included in the relevant category. (3) Capital instruments that do not meet the requirements set out in the relevant section of this part may also be included in regulatory capital subject to the following conditions:
(a) The instrument was issued before 12 September 2010.
(b) The instrument meets the requirements of the Reserve Bank of New Zealand document Capital Adequacy Framework (Standardised Approach) (BS2A) dated October 2010 . (c) The instrument does not have a call option in combination with a step-up on or after 12 September 2010 and prior to 1 January 2013. (d) If the instrument has a call option in combination with a step-up at any date from 1 January 2013 onwards it is to be included in regulatory capital only up until the date of the call option. (e) Fixing the base of the nominal amounts outstanding of instruments no longer recognised at 1 January 2013, their inclusion is capped at 80% from 1 January 2014; 60% from 1 January 2015; 40% from 1 January 2016; 20% from 1 January 2017; and from 1 January 2018 onwards the instrument must not be included in regulatory capital. (f) The base and cap referred to in (e) above must be calculated separately for the sum of all Tier 1instruments that no longer meet the criteria for recognition as Tier 1 capital and for the sum of all Tier 2 instruments that no longer meet the criteria for recognition as Tier 2 capital. (4) A registered bank must have written approval from the Reserve Bank to include capital instruments in regulatory capital in accordance with subsection (3) above.

7. Common Equity Tier 1 capital
   (1) Common Equity Tier 1 is the highest quality of capital and must:
   (a) provide a permanent and unrestricted commitment of funds; (b) be freely available to absorb losses; and (c) not impose any unavoidable servicing charge against earnings. (2) Common Equity Tier 1 capital is defined as the sum of subsections 7(a) 7(e), less subsection 7(f) as set out below:
   (a) issued and paid-up ordinary share capital that meets the criteria in subpart 2A; (b) share premium resulting from the issue of ordinary share capital included in Common Equity Tier 1; (c) retained earnings net of any appropriations such as tax payable, dividends to be paid or transfers to other reserves; (d) accumulated other comprehensive income and other disclosed reserves including, but not limited to reserves which are created or increased by appropriations of retained earnings and unrealised gains and losses on measuring available-for-sale assets in accordance with NZ IAS 39. However, the following items must be excluded from Common Equity Tier 1 capital: reserves that are earmarked to particular assets or particular categories of banking activities; reserves held on account of any assessed likelihood of loss; and revaluation reserves that may be included in tier two capital under section 9(2)(d) of this document; (e) minority interests arising from the issue of ordinary shares to third parties by a fully consolidated subsidiary (calculated in accordance with subpart 2D) that meet the eligibility criteria in subsection 4 of subpart 2D (not applicable for calculating the registered bank s solo capital ratio); (f) regulatory adjustments calculated in accordance with subsection 7(3). (3) The following items must be deducted in calculating Common Equity Tier 1:
   (a) goodwill and other intangible assets, including any goodwill included in the valuation of significant investments in banking, financial and insurance entities that are outside the scope of regulatory consolidation. The full amount is to be deducted net of any associated deferred tax liability that would be extinguished if the assets involved became impaired or derecognised under New Zealand generally accepted accounting practice; (b) deferred tax assets. The deduction for deferred tax assets may be net of deferred tax liabilities only if all of the criteria in (i) to (iii) of this subsection are met. Netting may only occur to the extent that deferred tax assets exceed deferred tax liabilities (i.e. any excess of deferred tax liabilities over assets cannot be added to Common Equity Tier 1). The criteria are:
   (i) the deferred tax assets and deferred tax liabilities arise as a result of deductible temporary differences as defined by NZ IAS 12 (deferred tax

liabilities may not be netted against deferred tax assets arising from the carry forward of unused tax losses or tax credits); (ii) the deferred tax assets or liabilities relate to taxes levied by the New Zealand Inland Revenue; and (iii)the deferred tax assets and liabilities may be offset under NZ IAS 12. (c) the amount of the cash flow hedge reserve that relates to the hedging of items that are not recorded at fair value on the balance sheet (including projected cashflows)1 ; (d) credit enhancements provided to associated funds management and securitisation vehicles which are not subject to regulatory consolidation where the credit enhancement has not been expensed (see sections 94 -102 for further details); (e) credit enhancements provided to any member of an affiliated insurance group where the credit enhancement has not been expensed (see sections 106 to 114 for further details); (f) the full amount of funding provided to an affiliated insurance group in any case where the minimum separation requirements in part 7 are not met; (g) the full amount of aggregate funding provided to all affiliated insurance groups and associated funds management and securitisation vehicles which are not subject to regulatory consolidation, in cases where the aggregate funding exceeds 10% of the Common Equity Tier 1 capital limit allowable under sections 103 and 109(g); (h) advances of a capital nature provided to connected persons, as determined in accordance with Connected Exposures Policy BS8; (i) unrealised gains and losses that have resulted from changes in the fair value of liabilities due to the changes in the creditworthiness of a member of the banking group (or the registered bank for the solo capital calculation); (j) any fair value gains and losses relating to financial instruments for which a fair value cannot reliably be calculated, except that a fair value loss which has arisen from credit impairment on a loan and which has been recognised in retained earnings must in all cases be reflected in Common Equity Tier 1 capital; (k) any defined benefit superannuation fund asset on the balance sheet. The asset should be deducted net of any associated deferred tax liability which would be extinguished if the asset should become impaired or derecognised under New Zealand generally accepted accounting practice; (l) holdings of the registered bank s own ordinary shares, whether held directly or indirectly, unless eliminated through the application of New Zealand generally accepted accounting practice. This includes any own ordinary shares that the registered bank (or a member of the banking group) could be contractually obliged to purchase, regardless of whether the holdings are recorded in the banking or trading book; 1 Any gains on hedges are to be deducted and any losses on hedges added back.

(m) unrealised revaluation losses on securities holdings where the book value of the securities exceeds the market value but the resulting unrealised loss has not been incorporated into the accounts. In such cases the full value of the difference should be deducted from capital. (4) Any defined benefit superannuation fund liability on the balance sheet must be fully recognised in the calculation of Common Equity Tier 1 capital (i.e. Common Equity Tier 1 capital cannot be increased through derecognising these liabilities). (5) Assets deducted from Common Equity Tier 1 capital should not be included in risk weighted assets. 8. Additional Tier 1 capital (1) Additional Tier 1 capital comprises high quality capital and must:
(a) provide a permanent and unrestricted commitment of funds; (b) be freely available to absorb losses in the ongoing course of business; and (c) provide for fully discretionary capital distributions. (2) Additional Tier 1 capital is defined as the sum of subsections 8(2)(a) to 8(2)(c), less subsection 8(2)(d) as set out below:
(a) instruments issued by the registered bank (or an SPV of the registered bank) that:
(i) are not included in Common Equity Tier 1; and (ii) meet the criteria for Additional Tier 1 capital instruments set out in subpart 2B; and (iii)if classified as liabilities under New Zealand generally accepted accounting practice, meet the loss absorbency requirements for Additional Tier 1 capital instruments set out in subpart 2E; (iv)meet the loss absorbency at non-viability criteria set out in subpart 2F; and (v) where the instrument is issued by an SPV, meet the criteria set out in subpart 2G. (b) share premium resulting from the issue of instruments included in Additional Tier 1 capital; (c) instruments issued by a fully consolidated subsidiary of the registered bank and held by third parties (calculated in accordance with subpart 2D) that meet the eligibility criteria in subsection 8 of subpart 2D (not applicable for calculating the registered bank s solo capital ratio); (d) regulatory adjustments applied to Additional Tier 1 capital according to the corresponding deductions approach as required under section 10 of this part. (3) An Additional Tier 1 capital instrument must not be repaid (including by way of exercise of a call, acquisition or redemption) unless:
(a) the registered bank has received the prior written approval of the Reserve Bank; and

(b) prior to or concurrent with the repayment, the instrument is replaced with a paid￾up capital instrument of the same or better quality and the terms and conditions of the replacement instrument are sustainable for the income capacity of the banking group, unless the registered bank demonstrates to the Reserve Bank s satisfaction that the banking group s capital position would be well above the minimum capital requirements after the repayment. (4) Members of the banking group must not do anything to create a market expectation that an instrument will be repaid or that supervisory approval will be granted. The Reserve Bank will not approve a repayment for the purpose of satisfying investor expectations. (5) Calling an Additional Tier 1 capital instrument and replacing it with an instrument that is more expensive will not be permitted, unless the registered bank can satisfy the Reserve Bank as to the economic and prudential rationale for the call. (6) Additional Tier 1 capital instruments without full voting rights may not constitute more than 25% of total Tier 1 capital. 9. Tier 2 capital (1) Tier 2 capital is capital which has some of the attributes of Tier 1 capital, but which is restricted in its ability to absorb losses other than in a winding up. (2) Tier 2 capital is defined as the sum of subsections 9(2)(a) - 9(2)(d), less subsection 9(2)(e) as set out below:
(a) instruments issued by the registered bank (or an SPV of the registered bank) that:
(i) are not included in Tier 1 capital;
(ii) meet the criteria for inclusion in Tier 2 capital in subpart 2C; and (iii)meet the requirements for loss absorbency at the point of non-viability in subpart 2F; and (iv) where the instrument is issued by an SPV, meet the criteria set out in subpart 2G. (b) share premium resulting from the issue of instruments included in Tier 2 capital; (c) instruments issued by a fully consolidated subsidiary of the registered bank and held by third parties (calculated in accordance with subpart 2D) that meet the eligibility criteria in subsection 13 of subpart 2D (not applicable for calculating the registered bank s solo capital ratio); (d) revaluation reserves:
(i) reserves arising from a revaluation of tangible fixed assets including owner￾occupied property, and cumulative fair value gains on investment property, which have been subject to audit or review by the registered bank s auditor. Cumulative losses below depreciated cost value on any individual property must not be netted against revaluation gains on other property. Such losses impact on Common Equity Tier 1 capital via the accounting treatment, and no regulatory adjustment should be made to that impact; (ii) foreign currency translation reserves;

(iii)reserves arising from a revaluation of security holdings. Where such reserves have not been incorporated into the accounts, they should be included at a discount of 55% (i.e. at 45% of the value of the reserves). (e) regulatory adjustments applied to Tier 2 capital according to the corresponding deductions approach as required under section 10. (3) A Tier 2 capital instrument must not be repaid (including by way of exercise of a call, acquisition or redemption) unless:
(a) the registered bank has received the prior written approval of the Reserve Bank; and (b) prior to or concurrent with the repayment, the instrument is replaced with a paid￾up capital instrument of the same or better quality and the terms and conditions of the replacement instrument are sustainable for the income capacity of the banking group, unless the registered bank demonstrates to the Reserve Bank s satisfaction that the banking group s capital position would be well above the minimum capital requirements after the repayment. (4) Members of the banking group must not do anything to create a market expectation that an instrument will be repaid or that supervisory approval will be granted. The Reserve Bank will not approve a repayment for the purpose of satisfying investor expectations. (5) Calling a Tier 2 instrument and replacing it with an instrument that is more expensive will not be permitted, unless the registered bank can satisfy the Reserve Bank as to the economic and prudential rationale for the call. 10. Deductions from total capital according to the corresponding deductions approach (1) The items in subsection 10(3) must be deducted from total capital according to the corresponding deductions approach. The corresponding deductions approach means that the deduction must be made from the category of capital (i.e. Common Equity Tier 1, Additional Tier 1 or Tier 2) for which the item would qualify if it was issued by a member of the banking group itself. Despite this, if the banking group does not have sufficient of a particular category of capital to apply a deduction to that category, the shortfall must be deducted from a higher category of capital (e.g. if the banking group does not have enough Additional Tier 1 capital the deduction must be applied to Common Equity Tier 1 capital). (2) A corresponding deduction need only be applied for a particular item to the extent that a deduction has not already been made from Common Equity Tier 1 capital in accordance with subsection 7(3). (3) The following items are to be deducted according to this approach:
(a) reciprocal cross holdings in the capital of banking, financial and insurance entities; (b) investments (whether direct or indirect or through an index) meeting the criteria in (i)-(iii) of this subsection. The amount to be deducted is the amount by which the aggregate of those investments (excluding any investment already deducted from

10 Common Equity Tier 1) exceeds 10% of the banking group s (or registered bank for solo capital) Common Equity Tier 1 capital.2 Underwriting positions held for five working days or less can be excluded. The criteria are:
(i) the investment is in the regulatory capital of a bank, non-bank deposit taker or insurance entity (or overseas equivalent); (ii) the entity is outside the scope of regulatory consolidation; and (iii)the banking group (or registered bank for the solo capital calculation) does not own more than 10% of the issued ordinary share capital of the entity. (c) investments (whether direct, indirect or through an index) meeting the criteria in (i)-(iii) of this subsection. The amount to be deducted is the full amount of the investment. Underwriting positions held for five working days or less can be excluded. The criteria are:
(i) the investment is in the regulatory capital of a bank, non-bank deposit taker or insurance entity (or overseas equivalent); (ii) the entity is outside the scope of regulatory consolidation; and (iii)the banking group (or registered bank in the case of the solo capital calculation) owns 10% or more of the issued ordinary share capital of the entity in which the investment is made or the entity is a related party of any member of the banking group (or registered bank in the case of the solo capital calculation). (d) in the case of the banking group: investments in the ordinary share capital of unconsolidated subsidiaries of the registered bank; (e) in the case of the registered bank: investments in the ordinary share capital of subsidiaries of the registered bank other than those which are both wholly owned and wholly funded by the registered bank. (See subsections 3(2) and 3(3) in part 1X for definitions of wholly owned and funded). (4) For the purposes of subsection 10(3), if the capital instrument of the entity in which the investment is made does not meet the criteria for Common Equity Tier 1 capital, Additional Tier 1 capital, or Tier 2 capital, the capital is to be considered ordinary shares for the purposes of this regulatory adjustment. (5) Assets deducted according to the corresponding deductions approach should not be included in risk weighted assets. 2 Common Equity Tier 1 capital is calculated after applying all the regulatory adjustments to Common Equity Tier 1 capital set out in subsection 7(3).

11 Subpart 2A Criteria for classification as ordinary shares 10a. Criteria for classification as ordinary shares (1) Ordinary shares included in Common Equity Tier 1 capital must satisfy the following criteria:
(a) Only the paid-up amount of the instrument, irrevocably received by the registered bank, is included as Common Equity Tier 1 capital. (b) Holders of the instrument have full voting rights arising from the ownership of the shares. (c) The instrument represents the most subordinated claim in the liquidation of the registered bank. (d) The instrument holder is entitled to a claim on the residual assets of the registered bank that is proportional to its share of issued capital, after all senior claims have been repaid in liquidation (i.e. has an unlimited and variable claim, not a fixed or capped claim). (e) The principal amount of the instrument is perpetual (i.e. it has no maturity date) and is never repaid outside of liquidation (i.e. the shares are not redeemable as defined in section 68 of the Companies Act 1993) setting aside discretionary acquisitions permitted by section 58 of the Companies Act 1993. (f) No member of the banking group does anything to create an expectation at issuance that the instrument will be repaid or cancelled, nor do the contractual terms of the instrument provide any feature which may give rise to such an expectation. (g) Distributions on the instrument must be paid out of retained earnings that are distributable. The level of distributions is not in any way linked to the amount paid at issuance and is not subject to a contractual cap (except to the extent that a registered bank is unable to pay distributions that exceed the level of distributable items). Distributions will be restricted by the registered bank s conditions of registration if the buffer ratio (as defined in part 3) of the banking group is 2.5% or less. (h) Distributions must meet the following requirements:
(i) there are no circumstances under which the distributions are obligatory and in all circumstances the registered bank is able to waive any distribution; (ii) any waived distributions are non-cumulative (i.e. they are not required to be made up by the registered bank at a later date); and (iii) non-payment of distributions must not be an event of default of the registered bank or any other member of the banking group. (i) Distributions are paid by the registered bank only after all legal and contractual obligations have been met and payments on more senior capital instruments have

12 been made. This means that there are no preferential distributions, including in respect of other elements classified as Common Equity Tier 1 capital. (j) The instrument takes the first and proportionately greatest share of any losses as they occur.3 Within Common Equity Tier 1 capital, each instrument absorbs losses on a going-concern basis proportionately and pari passu with all the other instruments included in Common Equity Tier 1 capital. (k) The instrument is classified as equity under New Zealand generally accepted accounting practice. (l) The instrument is issued by the registered bank (i.e. not out of an SPV), and neither the registered bank nor a related party over which the registered bank exercises control can have purchased the instrument, nor directly or indirectly have funded the purchase of the instrument. (m) The paid-up amount of the instrument, or any future payments related to the instrument, is neither secured nor covered by a guarantee of any member of the banking group or a related entity or subject to any other arrangement that legally or economically enhances the seniority of the claim. 3 In cases where other instruments have a permanent write-off feature, this criterion is still deemed to be met by ordinary shares.

13 Subpart 2B Criteria for classification as Additional Tier 1 capital 10b. Criteria for classification as Additional Tier 1 capital (1) To qualify as Additional Tier 1 capital, an instrument must satisfy the following criteria:
(a) Only the paid-up amount of the instrument, irrevocably received by the registered bank, is included in Additional Tier 1. (b) The instrument represents, prior to any conversion or write-off (refer subpart 2E and subpart 2F), the most subordinated claim in the liquidation of the registered bank after Common Equity Tier 1. (c) The paid-up amount of the instrument, or any future payments related to the instrument, is neither secured nor covered by a guarantee of any member of the banking group or a related entity or subject to any other arrangement that legally or economically enhances the seniority of the holder s claim vis-a-vis bank creditors. The instrument may not be subject to netting or offset claims on behalf of the holder of the instrument. (d) The principal amount of the instrument is perpetual, (i.e. there is no maturity date). The instrument may only be called or redeemed (under section 68 of the Companies Act 1993) at the initiative of the registered bank and only after a minimum of five years from the date on which the registered bank irrevocably receives the proceeds of payment for the instrument, except for the following:
(i) an instrument may provide for a call within the first five years of issuance as a result of a tax or regulatory event. The Reserve Bank will not permit such a call if it forms the view that the registered bank was in a position to anticipate the tax or regulatory event when the instrument was issued, or if it forms the view that the tax or regulatory event is minor or not applicable. (e) Under the terms of contract of the instrument the registered bank must:
(i) be required to receive the prior written approval of the Reserve Bank to make any repayment of principal (including through redemption, acquisition or as the result of a call due to a tax or regulatory event); and (ii) not provide any feature that might give rise to an expectation that the instrument will be repaid. (f) The instrument contains no step-ups or incentives to redeem. This requires that the terms of the instrument must provide for the interest or dividend rate to be fixed for the entire term of the instrument and must not provide for the rate to be altered or reviewed except for the following:
(i) where the interest payment or dividend is cancelled; and (ii) where there is a variable rate and where the formula for setting the rate is fixed (for the term of the debt) at the outset. For example, it would be acceptable to specify the interest rate as a fixed margin above a recognised market benchmark such as the bank bill rate.

14 Conversion from a fixed rate to a floating rate (or vice versa) in combination with a call option without any increase in credit spread will not in itself be viewed as in an incentive to redeem. However members of the banking group must not do anything that creates an expectation that the call will be exercised. A change in the margin will be considered to be an incentive to redeem. (g) Distributions must meet the following requirements:
(i) the registered bank has full discretion at all times to cancel distributions on the instrument. Any waived distributions are non-cumulative (i.e. waived distributions cannot be required to be made up at a later date and bonus payments to compensate for unpaid distributions are prohibited); (ii) cancellation of distributions must not be an event of default of the registered bank or any member of the banking group. Holders of the instruments must have no right to apply for the liquidation or voluntary administration of any member of the banking group or appoint a receiver of the property of any member of the banking group on the grounds that the registered bank fails to make, or may become unable to make, a distribution on the instrument; (iii) cancellation of distributions must not impose restrictions on the registered bank, or any other member of the banking group, except in relation to:
(A) the acquisition, repurchase or redemption of capital instruments; or (B) dividend stopper arrangements that stop distributions on ordinary share holders or other Additional Tier 1 capital instruments; and (iv) the registered bank must have full access to cancelled distributions to meet obligations as they fall due. (h) Distributions on the instrument must be paid out of retained earnings that are distributable. (i) The instrument cannot have a credit sensitive distribution feature, such as a distribution that is reset periodically based in whole or in part on the credit standing of any member of the banking group. (j) Neither the registered bank nor a related party over which the registered bank exercises control can have purchased the instrument, nor directly or indirectly have funded the purchase of the instrument. (k) The instrument cannot have any features that hinder recapitalisation of the registered bank or any member of the banking group.

15 Subpart 2C Criteria for classification as Tier 2 capital 10c. Criteria for classification as Tier 2 capital (1) To qualify as Tier 2 capital, an instrument must satisfy the following criteria:
(a) Only the paid-up amount of the instrument, irrevocably received by the registered bank, is included in Tier 2 capital. (b) The instrument is subordinated to depositors and general creditors of the registered bank. (c) The paid-up amount of the instrument, or any future payments related to the instrument, is neither secured nor covered by a guarantee of any member of the banking group or a related entity or subject to any other arrangement that legally or economically enhances the seniority of the claim vis-a-vis depositors and general bank creditors. The instrument may not be subject to netting or offset of claims on behalf of the holder of the instrument. (d) The instrument has a minimum original maturity of at least five years. (e) The amount of the instrument that may be recognised during the final four years to maturity is to be amortised on a straight-line basis at a rate of 20 percent per annum as follows:
Years to maturity Amount recognised
More than 4 100 percent
Less than and including 4 but more than 3 80 percent Less than and including 3 but more than 2 60 percent Less than and including 2 but more than 1 40 percent Less than and including 1 20 percent (f) The instrument may only be called or redeemed (under section 68 of the Companies Act) at the initiative of the registered bank and only after a minimum of five years from the date on which the registered bank irrevocably receives the proceeds of payment for the instrument, except for the following:
(i) an instrument may provide for a call within the first five years of issuance as a result of a tax or regulatory event. The Reserve Bank will not permit such a call if it forms the view that the registered bank was in a position to anticipate the tax or regulatory event when the instrument was issued, or if it forms the view that the tax or regulatory event is minor or not applicable. (g) Under the terms of the instrument the registered bank must:
(i) be required to receive the prior written approval of the Reserve Bank to make any repayment of principal (including through redemption, acquisition or due to a call as a result of a tax or regulatory event); and

16 (ii) not include any feature that might give rise to an expectation that the instrument will be repaid. (h) The instrument contains no step-ups or incentives to redeem. This requires that the terms of the instrument must provide for the interest or dividend rate to be fixed for the entire term of the instrument and must not provide for the rate to be altered or reviewed except for the following:
(i) where the interest payment or dividend is cancelled; and (ii) where there is a variable rate and where the formula for setting the rate is fixed (for the term of the debt) at the outset. For example, it would be acceptable to specify the interest rate as a fixed margin above a recognised market benchmark such as the bank bill rate. Conversion from a fixed rate to a floating rate (or vice versa) in combination with a call option without any increase in credit spread will not in itself be viewed as in an incentive to redeem. However members of the banking group must not do anything that creates an expectation that the call will be exercised. A change in the margin will be considered to be an incentive to redeem (i) The holder of the instrument must have no rights to accelerate the repayment of future scheduled payments (coupon or principal), except in liquidation. (j) The instrument cannot have a credit sensitive distribution feature, such as a distribution that is reset periodically based in whole or in part on the credit standing of any member of the banking group. (k) Neither the registered bank nor a related party over which the registered bank exercises control can have purchased the instrument, nor directly or indirectly have funded the purchase of the instrument. (l) The agreement should be subject to New Zealand law or a satisfactory equivalent. Where a registered bank wishes to use other than New Zealand law it will need to satisfy the Reserve Bank that the subordination provisions of the agreement will be effective under that jurisdiction.

17 Subpart 2D Recognition of minority interests and other capital issued out of fully consolidated subsidiaries that is held by third parties 10d. Recognition of minority interests and other capital issued out of fully consolidated subsidiaries that is held by third parties (1) Common Equity Tier 1, Additional Tier 1 and Tier 2 capital instruments issued to third parties out of a subsidiary that is fully consolidated for the purposes of calculating the banking group s capital ratios may be recognised as capital of the banking group subject to the requirements set out in this subpart. This subpart is not applicable to the calculation of a registered bank s solo capital ratio. (2) The amount of capital issued out of a fully consolidated subsidiary and held by third parties that may be eligible for inclusion in the capital of the banking group is determined on the basis of the relevant eligibility criteria (below) and a calculation to determine what portion of eligible capital can be recognised. This involves certain calculations regarding the capital position of the fully consolidated subsidiary. (3) If the fully consolidated subsidiary is not subject to the Reserve Bank s capital adequacy requirements for registered banks, for the purposes of the calculations in this subpart, calculations relating to the subsidiary s minimum capital requirements, conservation buffer and risk weighted assets need to be undertaken as if the subsidiary was a bank. A bank may elect to give no recognition in the consolidated capital of the banking group to the capital issued by the subsidiary to third parties. However all the exposures of the fully consolidated subsidiary must be included when calculating the total risk weighted assets of the banking group. Common Equity Tier 1 capital (minority interests) Eligibility criteria (4) Minority interests arising from the issue of ordinary shares by a fully consolidated subsidiary are eligible to receive recognition in the Common Equity Tier 1of the consolidated group only if:
(a) the subsidiary is itself a bank registered by the Reserve Bank of New Zealand; and (b) the instrument giving rise to the minority interest would, if issued by the registered bank, meet the criteria for ordinary shares set out in subsection 7(2)(a). Portion recognised (5) The amount of capital that can be recognised as Common Equity Tier 1 capital of the banking group is the total amount of capital that meets the eligibility criteria in subsection

18 10d(4) minus the amount of surplus Common Equity Tier 1 capital of the subsidiary that is attributable to the minority shareholders. (6) For the purposes of subsection 10d(5), the surplus Common Equity Tier 1 capital of the subsidiary that is attributable to the minority shareholders is calculated by multiplying the surplus Common Equity Tier 1 capital of the subsidiary by the percentage of the Common Equity Tier 1 capital of the subsidiary attributable to the minority shareholders. (7) For the purposes of subsection 10d(6), the surplus Common Equity Tier 1 capital of the subsidiary is the Common Equity Tier 1 capital of the subsidiary minus the lower of:
(1) 7.0% of the subsidiary s risk weighted assets; and (2) 7.0% of the consolidated risk weighted assets that relate to the subsidiary. Additional tier 1 capital Eligibility criteria (8) An interest arising from an instrument issued out of a fully consolidated subsidiary and held by a third party is eligible to receive recognition in Additional Tier 1 capital if the instrument would, if issued by the registered bank, meet:
(a) the criteria for ordinary share capital set out in subsection 7(2)(a);or (b) the criteria for Additional Tier 1 capital instruments set out in subsection 8(2)(a). Portion recognised (9) The amount of capital that can be recognised as Additional Tier 1 capital of the consolidated group is the total amount of capital that meets the criteria in paragraph 8 of this subpart, minus the amount of surplus Tier 1 capital of the subsidiary that is attributable to the third party investors. (10) For the purposes of subsection 10d(9), the surplus Tier 1 capital of the subsidiary that is attributable to the third party investors is calculated by multiplying the surplus Tier 1 capital of the subsidiary by the percentage of Tier 1 capital issued by the subsidiary that is attributable to third party investors or minority shareholders. (11) For the purposes of subsection 10d(10), the surplus Tier 1 capital of the subsidiary is the Tier 1 capital of the subsidiary minus the lower of: (1) 8.5% of the subsidiary s risk weighted assets; and (2) 8.5% of the consolidated risk weighted assets that relate to the subsidiary. (12) The portion recognised must exclude amounts recognised as Common Equity Tier 1 capital under subsection 10d(5).

19 Tier 2 capital
Eligibility criteria
(13) An interest arising from an instrument issued out of a fully consolidated subsidiary and held by a third party is eligible to receive recognition in the Tier 2 capital of the banking group if the instrument would, if issued by the registered bank meet:
(a) the criteria for ordinary share capital set out in subsection 7(2)(a); or (b) the criteria for Additional Tier 1 capital instruments set out in subsection 8(2)(a); or (c) the criteria for Tier 2 instruments set out in subsection 9(2)(a). Portion recognised (14) The amount of capital that can be recognised as Tier 2 capital of the banking group is the total amount of capital that meets the criteria in subsection 10d(13); minus the amount of the surplus Total Capital of the subsidiary that is attributable to the third party investors. (15) For the purposes of subsection 10d(14), the surplus Total Capital of the subsidiary that is attributable to the third party investors is calculated by multiplying the surplus Total Capital of the subsidiary by the percentage of Total Capital issued by the subsidiary that is attributable to third party investors or minority shareholders. (16) For the purposes of subsection 10d(15), the surplus Total Capital of the subsidiary is the Total Capital of the subsidiary minus the lower of: (1) 10.5% of the subsidiary s risk weighted assets; and (2) 10.5% of the consolidated risk weighted assets that relate to the subsidiary. (17) The portion recognised must exclude amounts recognised as Common Equity Tier 1 capital under subsection 10d(5)and amounts recognised as Additional Tier 1 capital under subsection 10d(9).

20 Subpart 2E Loss absorbency requirements for Additional Tier 1 capital instruments 10e. Loss absorbency requirements for Additional Tier 1 capital instruments (1) Subject to 10e(2), an Additional Tier 1 capital instrument classified as a liability under New Zealand generally accepted accounting practice must include as a term of the instrument that the instrument will, to the extent required to meet the requirements of 10e(5), be immediately and irrevocably:
(a) converted into the ordinary shares of the registered bank; or (b) written-off in a manner that meets the requirements of subsection 10e(9) when the banking group s Common Equity Tier 1 capital ratio falls below 5.125 percent of total risk weighted assets (the loss absorption trigger event). (2) Where the instrument provides for conversion, the provisions of the instrument must provide that where, following the occurrence of the loss absorption trigger event, conversion of a capital instrument:
(a) is not capable of being immediately undertaken; or (b) is revocable. the amount of the instrument must be immediately and irrevocably written-off on the occurrence of the trigger event. (3) Any compensation paid to the instrument holder as a result of the write-off must be paid only in accordance with the terms of the instrument and immediately in the form of ordinary shares of either the registered bank or of the ultimate parent. (4) In determining the value of an instrument for the purposes of regulatory capital recognition, the nominal value of an instrument must be reduced by potential tax and other offsets that occur at the time of conversion or write-off. In particular, the amount of an instrument that may be recognised in the bank s Tier 1 and Total Capital ratios is the minimum level of Common Equity Tier 1 capital that would be generated by a full conversion or write-off of the instrument and must account for potential taxation liabilities or other potential offsets at the time of conversion or write-off. Adjustments must be updated over time to reflect the best estimate of those offset values. The Reserve Bank may require a tax opinion on potential tax liabilities.

21 (5) Upon the occurrence of the loss absorption trigger event, the aggregate amount of Additional Tier 1 capital outstanding to be converted or written down must be sufficient to return the Common Equity Tier 1 ratio to above 5.125 percent of total risk weighted assets, if possible. (6) A bank may provide in issue documentation for a priority under which capital instruments are to be converted or written-off. The terms attached to such ordering must not impede the ability of the capital instrument to be immediately converted or written- off as required. (7) Where an Additional Tier 1 capital instrument provides for conversion into ordinary shares, the bank must ensure that:
(a) when the instrument is issued, there are no legal or other impediments to issuing the relevant shares and all necessary authorisations have been obtained to effect conversion; and (b) on a continuing basis, all necessary authorisations for the required conversions are maintained. (8) For the purposes of conversion or write-off of an Additional Tier 1 instrument, the amount to be converted or written-off will be the principal amount outstanding plus any accrued interest attributable to the instrument in the most recent accounting records of the bank. (9) Where an Additional Tier 1 capital instrument provides in its terms for a write-off mechanism, this mechanism must be structured so that:
(a) the holder of the instrument has no claim against the issuer and no claim in liquidation in regard to any portion of the principal that has been written-off; (b) no further distribution/payments are payable on the instrument in regards to the written-off portion of the instrument.

22 Subpart 2F Loss absorbency at the point of non-viability criteria 10f. Loss absorbency at the point of non-viability criteria (1) Subject to subsection 10f(2), an Additional Tier 1 or Tier 2 capital instrument must include as a term of the instrument a right held by the registered bank, exercisable upon the occurrence of a non-viability trigger event (as defined in subsection 10f(5)), to:
(a) convert, in part or full, the principal amount and any accrued interest owing under the instrument into the ordinary shares of the registered bank; or (b) write-off, in part or full, the principal amount and any accrued interest owing under the instrument in a manner that meets the requirements of subsection 10f(10). (2) Where the instrument provides a right of conversion, the terms of the instrument must provide that where, following the occurrence of a non-viability trigger event, conversion of a capital instrument:
(a) is not capable of being immediately undertaken; or (b) is revocable the registered bank has the right to write-off the principal amount and any accrued interest owing under the instrument. (3) Compensation may be paid to the instrument holder in the case of write-off. However, any compensation paid to the instrument holder must be paid only in accordance with the terms of the instrument and immediately in the form of ordinary shares of either the registered bank or of the ultimate parent. (4) In determining the value of an instrument for the purposes of regulatory capital recognition, the nominal value of an instrument must be reduced by potential tax and other offsets that occur at the time of conversion or write-off. In particular, the amount of an instrument that may be recognised in the bank s Tier 1 and total capital ratios is the minimum level of Common Equity Tier 1 capital that would be generated by a full conversion or write-off of the instrument, and must account for potential taxation liabilities or other potential offsets at the time of conversion or write-off. Adjustments must be updated over time to reflect the best estimate of the offset value. The Reserve Bank may require a tax opinion on potential tax liabilities. (5) A Non-Viability Trigger Event is defined as:
(a) a direction given to the registered bank by the Reserve Bank under section 113 of the Act, on any of the grounds (a)-(e) of that section, requiring the registered bank to exercise its right under the instrument to either write-off its value or to convert it into ordinary shares;

23 (b) the registered bank being made subject to statutory management by an Order in Council issued pursuant to section 117 of the Act. (6) The direction issued by the Reserve Bank or a decision of the statutory manager to exercise the right to convert or write-off the instrument may be for either full conversion or write-off, or for partial conversion or write-off. (7) A registered bank may provide in issue documentation for a priority under which capital instruments are to be converted or written-off. The terms attached to such an ordering must not impede the ability of the capital instrument to be immediately converted or written-off as required. (8) Where an instrument provides for conversion into ordinary shares, the registered bank must ensure that:
(a) when the instrument is issued, there are no legal or other impediments to issuing the relevant shares and all necessary authorisations have been obtained to effect conversion; and (b) on a continuing basis, all necessary authorisations for the required conversions are maintained. (9) For the purposes of conversion or write-off, the amount to be converted or written-off will be the principal amount outstanding plus any accrued interest attributable to the instrument in the most recent accounting records of the bank. (10) Where an instrument provides in its terms for a write-off mechanism, this mechanism must be structured so that:
(a) the holder of the instrument has no claim against the registered bank, including no claim in the event of liquidation of the registered bank, in regard to any portion of the principal or accrued interest that has been written-off; (b) no further distributions/payments are payable on the instrument in regards to the written-off portion of the instrument.

24 Subpart 2G Capital instruments issued by special purpose vehicles 10g. Capital instruments issued by special purpose vehicles (1) In order for capital instruments issued by an SPV to qualify as regulatory capital, the following criteria must be fully satisfied:
(a) the SPV issuing the instrument is fully consolidated in the banking group s financial statements in accordance with New Zealand generally accepted accounting practice. (b) the capital instruments issued by the bank to the SPV, and the capital instruments issued by the SPV to investors, must meet the criteria for classification as Additional Tier 1 capital or the criteria for classification as Tier 2 capital as set out in subpart 2B and subpart 2C respectively. (c) the capital instruments issued by the bank to the SPV, and the capital instruments issued by the SPV to investors, must meet the loss absorbency at the point of non- viability criteria as set out in subpart 2F and where relevant subpart 2E. (d) the instruments issued by the registered bank to the SPV, and by the SPV to third party investors, must be of the same category of regulatory capital (i.e. both Additional Tier 1 instruments or both Tier 2 instruments). (e) instruments issued by the registered bank to the SPV, and by the SPV to third party investors must have matching terms and conditions, including matching maturity where applicable. (f) the proceeds from the issue of the capital instrument by the SPV must be immediately and directly invested in and available without limitation to the registered bank. (g) the amount of capital issued by consolidated subsidiaries to third parties that may be included in Tier 1 or total capital is to be determined in accordance with subpart 2D. However, where the consolidated subsidiary issues the capital through an SPV, the requirements of this subpart must be met in addition to the requirements of subpart 2D. (2) Ordinary shares issued by an SPV cannot be included in Common Equity Tier 1 capital.

25 Part 3 Capital ratios and buffers
11. Introduction to part 3
This part sets out the method to be used for calculating the Common Equity Tier 1 capital ratio, the Tier 1 capital ratio and the Total Capital ratio for the registered bank and the banking group. This part also sets out the method to be used for calculating the buffer ratio for the banking group and includes definitions relevant to the operation of the buffer ratio. 11a Common Equity Tier 1 capital ratio Common Equity Tier 1 capital ratio = Common Equity Tier 1 capital / (risk weighted on and off-balance sheet credit exposures + 12.5 x total capital charge for market risk exposure + 12.5 x total capital requirement for operational risk). 12 Tier 1 capital ratio Tier 1 capital ratio = Tier 1 capital / (risk weighted on and off-balance sheet credit exposures + 12.5 x total capital charge for market risk exposure + 12.5 x total capital requirement for operational risk).
13. Total capital ratio
Total Capital ratio = Total Capital / (risk weighted on and off-balance sheet credit exposures + 12.5 x total capital charge for market risk exposure + 12.5 x total capital requirement for operational risk). 13a Buffer ratio Buffer ratio = Surplus Common Equity Tier 1 capital / (risk weighted on and off-balance sheet credit exposures + 12.5 x total capital charge for market risk exposure + 12.5 x total capital requirement for operational risk). 13b Buffer ratio definitions (1) Distributions means:
(a) Dividends;
(b) share buybacks; and
(c) discretionary payments made to holders of Additional Tier 1 capital instruments (including all payments of dividends or interest). (2) Earnings means current year distributable profits calculated:
(a) prior to the deduction of distributions; and (b) net of the tax that would have been reported had none of the distributable items been paid.

26 (3) Surplus Common Equity Tier 1 capital means any amount of Common Equity Tier 1 capital that is not required to meet minimum capital ratio requirements (if minimum capital ratio requirements are not meet there will not be any Surplus Common Equity Tier 1 capital).

27 Proposed changes are tracked
Part 6 Funds management and securitisation
94. Banks may be involved in funds management and securitisation through activities such
as:
(a) originating or supplying assets to special purpose vehicles; (b) marketing funds management and securitisation products through their branch network; (c) acting as a servicing agent; (d) acting as a fund manager; or (e) sponsoring or establishing such arrangements.
95. Banks may be exposed to risks as a result of their association with funds management and
securitisation activities. For the purposes of this policy, association means any relationship other than the provision of normal banking or commercial services on a fully arm s length basis. Some of these risks arise from implicit or moral obligations, rather than formal legal obligations. For example, a bank may feel an obligation to provide support to special purpose vehicles set up to conduct securitisation or funds management activities, because it considers that its own reputation and/or customer base will suffer if support is not provided. To the extent that a bank creates a degree of separation between itself and its funds management and securitisation activities, these implicit risks can be reduced.
96. Banks may face more explicit forms of risk where they provide credit enhancements to
special purpose vehicles. Examples of credit enhancements include (but are not limited to) the following:
(a) holding a subordinated class of securities issued by the special purpose vehicle; (b) provision of financial services (e.g. interest rate swaps) on other than arm s length terms and conditions; (c) provision of risk insurance; (d) provision of guarantees; (e) over-collateralisation; (f) repurchase or replacement of non-performing loans; (g) a one-off gift or a long-term loan, maturing after other securities issued by the special purpose vehicle; (h) payment of expenses incurred by the fund;

28 (i) management fee structures which vary with the level of non performing assets held by a special purpose vehicle or with the capital value of a managed fund such that there is potential for fees to fall to a level which would be below that which the bank would expect to receive if fees were set at market levels on arm s length terms and conditions.
97. Banks may also face funding risk as a result of involvement in securitisation schemes.
This can occur if associated special purpose vehicles issue securities with maturities which are shorter than those of the underlying assets. In such cases there is a risk that the bank will be required to fund some, or all, of the underlying assets when the securities mature.
98. A bank must treat a special purpose vehicle as part of the banking group (or the registered
bank for solo capital calculation) for the purposes of the capital adequacy framework if:
(a) the banking group (or bank for solo capital) is required by generally accepted accounting practice to consolidate the funds management or securitisation special purpose vehicle for the purposes of its group financial statements; or (b) the special purpose vehicle is a covered bond SPV as defined in the Reserve Bank of New Zealand (Covered Bonds) Amendment Bill and following its passage the Reserve Bank of New Zealand Act.
98. Where a bank is required by generally accepted accounting practice to consolidate a
funds management or securitisation special purpose vehicle for the purposes of its group financial statements, the special purpose vehicle must be treated as part of the banking group for the purposes of the capital adequacy framework.
99. Where consolidation of a funds management or securitisation special purpose vehicle is
not required by section 98 for accounting purposes the following treatment will apply for capital purposes. If there is insufficient separation between the bank and associated funds management and securitisation activities, the bank has provided some form of credit enhancement to an associated scheme, or the bank retains funding risk as a result of its involvement in a securitisation, the bank is required to hold capital against the assets of the scheme, in accordance with sections X100X, X102X and X105X. Explicit Risk
100. Where a bank provides any form of credit enhancement to an associated special purpose
vehicle and if the obligation can be quantified and does not take the form of a guarantee the bank may choose one of the following three options:
(a) deduct the maximum level of its obligation to provide support from capital; (b) expense the full amount of its obligation at the time its relationship with the special purpose vehicle commences; or (c) consolidate the assets of the special purpose vehicle for the purposes of calculating its capital adequacy ratios.

29 Where the maximum extent of the bank s obligation cannot be readily quantified or where the credit support takes the form of a full or partial guarantee, the assets of the fund should be fully consolidated for capital adequacy purposes.
101. The credit enhancement will be treated as a 100 % risk weighted exposure of the bank
where the bank is providing credit enhancements to securitisation special purpose vehicles and:
(a) the bank and parties related to the bank are not associated with the special purpose vehicle; and (b) the credit enhancement is provided on arm s length terms and conditions and at market prices. Implicit Risk
102. Where any of the following minimum separation requirements are not met, a bank will be
required to fully consolidate the assets of an associated special purpose vehicle for capital adequacy purposes. (a) Prospectuses and brochures for funds management and securitisation products must include clear, prominent disclosures of the following:
(i) that the securities do not represent deposits or other liabilities of the bank; (ii) that the securities are subject to investment risk including possible loss of income and principal invested; and (iii) that the bank does not guarantee (either partially or fully) the capital value or performance of the securities. Note however, that these requirements do not override or replace any of the issuer s obligations under the Securities Act and Regulations. (b) Unless the bank is treating financial services provided to a special purpose vehicle as a credit enhancement, the bank s disclosure statements must include a statement that financial services (including funding and liquidity support) provided by the bank (and any of its subsidiaries) are on arm s length terms and conditions and at fair value. Where the bank or its subsidiaries have purchased securities issued by a special purpose vehicle during the reporting period, or have purchased assets from a special purpose vehicle, the bank s disclosure statements must include a statement that these were purchased at fair value and on arm s length terms and conditions. (c) When securities are initially issued, investors must be required to sign an explicit acknowledgement that the securities do not constitute bank deposits or liabilities and that the bank does not stand behind the capital value and performance of the securities. (d) There must either be an independent trustee or there must be clear, prominent disclosure in all prospectuses, brochures and application forms relating to the scheme of whether or not there is a trustee, and, where applicable, that the trustee is not independent of the bank.

30 (e) Where the bank or its subsidiaries purchase assets from a special purpose vehicle the purchases must take place at fair value and on arm s length terms and conditions. (f) Where the bank or its subsidiaries provide funding or liquidity support to an associated special purpose vehicle, or purchase securities issued by an associated special purpose vehicle, the following conditions must be met:
(i) the transactions involved must take place at fair value and on arm s length terms and conditions; and (ii) the funding (including funding provided by purchase of securities issued by the special purpose vehicle) must not exceed 5% of the value of securities issued by the special purpose vehicle.
103. In addition, aggregate funding provided to:
(a) all associated special purpose vehicles not consolidated in terms of sections X98X, X100X or X102X (including funding provided by the purchase of securities issued by a special purpose vehicle); and (b) all affiliated insurance groups (see sections X106X to X114X (Part 7) for further details); must not exceed 10% of the bank s tier one Common Equity Tier 1 capital. Where the 10% limit is breached, the full amount of this aggregate funding is required to be deducted from tier one Common Equity Tier 1 capital (see section X6X(2)(f) 7(3) on deductions from tier one Common Equity Tier 1 capital).
104. While there is no requirement to hold capital against funds management and
securitisation activities where the above minimum separation has been achieved, banks will need to take into account the fact that it is very difficult to totally eliminate implicit credit risk. Thus banks will need to ensure that their capital adequacy policies take account of any residual implicit risk, particularly where funds management and securitisation activities are significant in size relative to the bank s other activities. Funding Risk
105. A bank may face funding risk as a result of its involvement in a securitisation scheme if
the securities issued by the special purpose vehicle have a shorter maturity profile than the assets against which the securities have been issued. Where a bank is subject to funding risk as a result of its involvement in a securitisation scheme it will be required to fully consolidate the securitised assets for capital adequacy purposes.

31 Part 7 Insurance business
106. Introduction to Part 7
The role of distributing or marketing insurance products underwritten by affiliated insurance entities may involve an exposure to implicit risk, i.e. to reputational risks and to moral recourse as a result of a close association with those affiliated entities. Implicit risk can be reinforced if explicit support is provided to the insurance entity. To the extent that the banking group and any affiliated insurance entities create a degree of separation between each other, these risks can be reduced.
107. Definitions for Part 7
(1) In this part
(a) insurance entity means any entity whose business predominantly consists of the conduct of insurance business as defined in registered banks conditions of registration; (b) affiliated insurance entity means any insurance entity which is not a member of the New Zealand banking group, but:
(i) which is either the ultimate parent of the New Zealand banking group; (ii) or which is a subsidiary of the ultimate parent of the New Zealand banking group; (iii) or which is an insurance entity in which the ultimate parent of the New Zealand banking group has an interest as an associate, or a direct or indirect interest as a party to a joint venture; and whose financial products are distributed or marketed by the New Zealand banking group; (c) affiliated insurance group means any affiliated insurance entity and all that entity s subsidiaries. (2) For the purposes of these definitions, the terms parent , subsidiary , associate and joint venture are determined in accordance with generally accepted accounting practice, as defined in the Financial Reporting Act 1993.
108. Credit Enhancements
The full amount of any credit enhancements provided by the banking group to any member of an affiliated insurance group is required to be either fully expensed, or deducted from Common Equity Tier 1tier one capital. Examples of credit enhancements include, but are not limited to, the following:
(a) holdings of, or investments in, equity instruments or subordinated classes of financial instruments; (b) provision of exchange rate, interest rate, or other market related contracts for hedging purposes on other than arm s length terms and conditions (for this purpose, market related contracts which are not traded in an active and liquid

32 market, or whose data inputs are not taken from an active and liquid market, are regarded as credit enhancements); (c) provision of funding and liquidity support on other than arm s length terms and conditions; (d) guarantees and other risk assumption techniques which provide support for the asset risks of any member of the insurance group (for example, asset credit risks, equity risks, or property price risks), other than market related contracts on arms length terms and conditions; (e) asset transfers from the banking group to any member of the affiliated insurance group at less than fair value; (f) repurchase or replacement of non-performing assets; (g) payment of expenses or liabilities. Implicit risk minimum separation requirements
109. Where any of the following minimum requirements are not met, the whole amount of any
funding exposures which the banking group has to the affiliated insurance group is required to be deducted from Common Equity Tier 1tier one capital:
(a) Investment statements, prospectuses and brochures for insurance products must include clear, prominent disclosures that the bank and its subsidiaries do not guarantee the affiliated entity which is the issuer of the products, nor any of that entity s subsidiaries, nor any of the products issued by that affiliated insurance group. (b) Where the insurance products are subject to the Securities Act 1978, investment statements, prospectuses and brochures must additionally include clear and prominent disclosures that:
(i) the policies do not represent deposits or other liabilities of the bank or its subsidiaries; (ii) the policies are subject to investment risk, including possible loss of income and principal; (iii)the bank and its subsidiaries do not guarantee the capital value or performance of the policies. (c) At initial issue to an insurance product purchaser, the purchaser must be required to sign an explicit acknowledgement that the bank and its subsidiaries do not guarantee the affiliated entity which is the issuer of the products, nor any of that entity s subsidiaries, nor any of the products issued by that affiliated insurance group. Where an insurance product is subject to the Securities Act 1978, the investor must also sign an explicit acknowledgement that the policies do not represent deposits or other liabilities of the bank or its subsidiaries, and that the banking group does not stand behind the capital value or performance of the policies.

33 (d) Asset purchases by the banking group from an affiliated insurance group must take place on arms-length terms and conditions, and at fair value. (e) Unless a bank is treating financial services provided to an affiliated insurance group as a credit enhancement, the bank s disclosure statements must include a statement that financial services (including funding and liquidity support) provided by the bank or any of its subsidiaries are made on arms-length terms and conditions and at fair value. Similarly, where the bank or its subsidiaries have purchased securities issued by an affiliated insurance group, or have purchased assets from it during the reporting period, the bank s disclosure statement must include a statement that these were purchased at fair value, and on arm s length terms and conditions. (f) Funding and liquidity support provided by the banking group to each affiliated insurance group must not exceed 5% of the total consolidated assets of that insurance group, and must be provided on arm s length terms and conditions, and at fair value. (g) Aggregate funding provided to all affiliated insurance groups (see section X107X) and to all associated funds management and securitisation vehicles (see sections X94X to X105X for further details) must not exceed 10% of the bank s tier one Common Equity Tier 1 capital.
110. For the purposes of section X109X, funding and liquidity support provided by the banking
group to any member of the affiliated insurance group comprises the following items:
(a) its share of policyholder liabilities;
(b) other than for credit exposures arising from market related contracts, any claims which represent senior credit exposures; (c) the undrawn portion of any commitments to provide funding or purchase assets; (d) the full amount of direct credit substitutes.
111. This definition of funding does not include credit exposures arising from the provision of
market related contracts used for hedging price movements, such as interest rate swaps, or foreign exchange risk hedging instruments (historical rate rollovers excepted). Nor will it include investments in equity instruments or other classes of subordinated financial instruments, as these are required to be deducted from tier one Common Equity Tier 1 capital (see section X6X(2)(f) and section X108X). However, it will include loans, overdrafts, revolving credit lines, money market placements, investments in senior ranking securities, forward asset purchases, guarantees of borrowings, and similar items.
112. In line with the definition of an affiliated insurance group, where there are a number of
insurance entities within a group of insurance companies, the funding limits relate to each operating life insurance or general insurance entity (and their subsidiaries) within the group. Therefore, if one operating insurance entity is controlled by another, and the banking group has a marketing role in relation to each of those operating entity s products, the funding requirements apply on a tiered sub-group/group basis.

34 113. The funding limit does not apply to the holding companies, parents, or other related parties of these affiliated insurance groups, although any credit exposures to those entities are subject to the applicable connected person exposure limits contained in registered banks conditions of registration. Likewise, all credit exposures to affiliated insurance groups, including funding exposures, are still subject to those connected person exposure limits.
114. Even where the above requirements are met, banks will need to take into account the fact
that it is very difficult to totally eliminate the implicit risks that might arise from the marketing of an affiliated insurance group s products. Accordingly, banks should ensure that their capital adequacy policies take account of any residual implicit risk, particularly where the volume of insurance products distributed is significant in relation to the banking group s other activities.