Response to Submissions on BS16 and Definition of Capital in BS2

Response to Submissions: Consultation on BS16 and Definition of Capital in BS2 Please note that this is not a consultation document. 21 August 2015

Response to submissions: consultation on BS16 and definition of capital in BS2 Introduction

1. In June 2015 the Reserve Bank released a consultation document proposing changes to BS16 (Application for capital recognition and repayment), and some changes to the definition of capital in BS2A/B. Eight submissions were received on this consultation paper. This document provides the Reserve Bank’s response to the major issues raised in submissions. An updated exposure draft is also provided. Some minor drafting suggestions were made that have been included in the documents that are not mentioned in this response to submissions.
2. The Reserve Bank intends that all regulatory capital instruments that are currently recognised as capital will continue to be recognised as capital following the changes being made. The Reserve Bank intends these changes will come into effect on 1 November 2015, consistent with other intended changes to BS2A/B.
3. This paper is divided into comments on BS16 and comments on BS2A/B. BS16
4. Registered banks that are incorporated in New Zealand are required to receive a notice of non-objection before recognising any Additional Tier 1 (AT1) or Tier 2 instrument in regulatory capital. BS16 sets out the process that banks must follow when applying for a notice of non-objection. Board attestations
5. The consultation paper proposed a more formalised process for applications for a notice of non-objection. Submitters were supportive of this process. However one of the requirements proposed in the process was that prior to the Reserve Bank issuing a notice of non-objection the registered bank must provide to the Reserve Bank certain attestations from the bank’s board.
6. Several submitters objected to this requirement as it was considered that requiring the Board to attest that the BS16 application is accurate and complies with the requirements overlays an unnecessary layer of compliance for no additional benefit. It was considered that board attestation requirements would create timing difficulties as execution timeframes are short and board meetings infrequent. Some submitters considered that regulatory capital instruments are already subject to sufficient internal processes, as they are subject to an internal due diligence process and other attestation requirements apply to capital recognition.
7. One submitter was comfortable with the requirements but considered that a board should be able to delegate final sign off authority to a board sub-committee or to senior management in order to incorporate minor changes. A submitter also queried the form of the attestation and whether it would be confirmation from the Company Secretary of the attestation or an attestation signed by either one or two directors.

Response to submissions: consultation on BS16 and definition of capital in BS2 8. The Reserve Bank considers that is it important to reinforce that the issuance of a notice of non-objection does not replace the primary responsibility of a board to ensure that the issue complies with the requirements of the relevant capital adequacy framework. Hence it is intended that the attestation requirements remain. The Reserve Bank however notes the comments about the practicality of obtaining signatures in what may be a short time frame and proposes to amend the requirement by allowing the Chair of the board (or the Chair’s delegate when the Chair is unavailable) to sign on behalf of the board. Tax ruling 9. Two submitters objected to the requirement that all debt issues must have an IRD binding ruling. The submitters considered that the compliance costs associated with this requirement did not justify the benefits. The Reserve Bank acknowledges that obtaining binding rulings does impose compliance costs. However given that the tax law in this area is complex and instruments themselves are complex and required to perform to expectations in times of stress, the Reserve bank intends to retain this requirement. 10. Some submitters asked for clarity as to when a ruling would not be required if the ruling expired shortly before the instrument matures. The Reserve Bank has clarified that a replacement ruling will not be required if the instrument matures within 1 year after the ruling expires. Notification of repayments of CET1 11. Some submitters did not consider that the notification requirement for repayments of Common Equity Tier 1 Capital (CET1) was necessary. Other submitters considered this provision appropriate and one submitter noted that banks may repay capital in circumstances that undermine solvency or liquidity. The threshold for the notification requirement is a repayment of CET1 that would result in a fall in the level of CET1 by at least 10%. The Reserve Bank considers that it has a prudential interest in knowing when a bank reduces its CET1 ratio by 10% or more and intends to keep this requirement. The Reserve Bank notes that it is not seeking to approve repayments of CET1, and that it is not imposing an onerous requirement. 12. Some submitters queried when the notification must take place. The Reserve Bank intends that the notification be at least 5 working days before the repayment takes place (which may be after board approval). 13. Some submitters asked for clarification of the CET1 calculation base. It is intended that the notification be required if the payment, or cumulative payments over the twelve months prior to the payment, result in a level of CET1 that is more than 10% lower than the CET1 level 12 months ago.

Response to submissions: consultation on BS16 and definition of capital in BS2 14. One submitter considered that in the case of a building society that is a registered bank, distributions on redeemable preference shares that the entity is contractually obliged to make should be excluded from the notification requirement as these shares constitute core customer funding and the distributions are economically more akin to interest. BS16 has been amended to exclude these payments. Bank funding own capital instruments 15. Two submissions argued that bank lending to a customer to fund the purchase of capital instruments should be excluded from the restriction on banks funding their own capital. BS16 has been amended to exclude funding of a customer for the purposes of purchasing a diversified portfolio that may contain capital instruments, consistent with the provision in Subpart 2A-C of BS2A/B. Process for obtaining notice of non-objection 16. Submitters were generally comfortable with the more formalised process for assessment of capital instruments. One submitter considered that the time between final application and notice issuance should be 3 days instead of the proposed 5 days. The Reserve Bank does not intend to make this change. Changes to BS2A/B Solvency requirement for Tier 2 instruments 17. It was proposed in respect of Tier 2 instruments that the bank must not be obligated to make payments of distributions or principal on the instrument if the bank would be insolvent following repayment. Some submitters noted that some instruments on the market have an unconditional obligation to repay on maturity. This requirement has been amended to clarify that it applies prior to maturity and liquidation. AT1 solvency condition 18. Some submitters noted that AT1 instruments do not currently include the proposed term preventing payment of principal should the bank be insolvent following repayment. However, these submitters noted that: • as the instrument is perpetual all payments of principal are subject to Reserve Bank approval; • equity instruments are already required to meet this requirement under the Companies Act; and • an AT1 debt instrument must convert to ordinary shares or be written-off if the CET1 ratio of the banking groups falls to 5.125%. 19. Further, distributions are also restricted under subparagraph (g) of subpart 2B of BS2A/B. For these reasons the Reserve Bank has decided not to make this change.

Response to submissions: consultation on BS16 and definition of capital in BS2 Regulatory calls 20. Some instruments currently on the market do not have terms that match the exact wording of the proposed requirement that the instrument must include a term that it will not be callable as a result of a tax or regulatory event that was anticipated, minor or insignificant. The requirements have been amended so that this wording will only be required as a term of the instrument for instruments issued after 1 January 2016. The Reserve Bank does not require that the exact words be used; banks may use any words that have the same meaning (e.g. minor or insignificant). Right of conversion or write-off 21. Two submitters considered that it could be clarified that the terms of the instrument only need give the registered bank the right to convert or write-off an instrument on statutory management (10(f)(6)) in respect of the contractually intended mechanism, as opposed to the write-off that occurs automatically on conversion failure (10(f)(2). This has been clarified. Limits on distributions 22. New wording was proposed requiring that the terms of AT1 instruments provide that distributions cannot be paid if this would breach requirements in banks conditions of registration (to limit distributions when common equity falls below certain thresholds). This provision has been applied to instruments after 1 January 2016 as not all instruments on issue match this exact wording (although all match the intent). Conversion of preference shares 23. Two submitters considered that the write-off provisions for preference shares should be aligned with the requirements of APS11 (the relevant prudential standards of the Australian Prudential Regulation Authority) that allows a write-off of preference shares to be effected by writing-down the instrument so that the rights approximate the rights of a holder of ordinary shares. The Reserve Bank’s policy is that a write￾off must remove all rights in respect of the instrument. However the Reserve Bank recognises that there is legal uncertainty under the currently used approaches to writing-off preference shares given Companies Act obligations. For this reason the Reserve Bank has amended the provisions in respect of write-off to allow write-off of preference shares to occur through a rights alteration under the Companies Act, provided that the result of the rights alteration is that the holder has no rights that may be exercised following the alteration. 24. Note that the wording of the write-off provisions has also been simplified. This is a formatting change and not a change to policy requirements.

Response to submissions: consultation on BS16 and definition of capital in BS2