Consultation Paper on Solo Capital Ratios for IRB Banks under Basel II

Ref #4734961 Consultation Paper: Basel II solo capital ratios for IRB/AMA banks The Reserve Bank invites submissions on this Consultation Paper by 20 June 2012. Submissions and enquiries about the consultation should be addressed to: Jeremy Richardson Senior Adviser, Financial System Policy Prudential Supervision Department Reserve Bank of New Zealand PO Box 2498 Wellington 6140 Email: jeremy.richardson@rbnz.govt.nz Please note that a summary of submissions may be published. If you think any part of your submission should properly be withheld on the grounds of commercial sensitivity or for any other reason, you should indicate this clearly. May 2012

2 Ref #4734961 1: Background

1. Until 2008, all locally-incorporated banks in New Zealand were subject to minimum capital ratio requirements under the Basel I capital adequacy framework as implemented in New Zealand. 1
2. We implemented the Basel II capital adequacy framework from Q1 2008. These minimum requirements generally applied only to each bank’s banking group on a consolidated basis. Under the Reserve Bank’s disclosure regime, banks were required to publish a breakdown of Basel I risk-weighted assets (RWAs) and of the components of capital. In their full year and half-year disclosure statements, banks were additionally required to publish this information to the same level of detail at the solo level as at the group level. (“Solo” here actually means “solo-consolidated”, as discussed further below.) 2
3. However, we required each IRB bank to continue disclosing summary capital adequacy information on a Basel I basis. This consisted just of total RWAs, Tier 1 capital ratio and total capital ratio, at both the group and solo level. This was both to allow a high-level comparison between the Basel I and Basel II calculations, and to retain disclosure of a version of banks’ solo capital adequacy position. For the other banks, which are subject to the Basel II standardised approach, the only disclosure we kept on top of the Pillar 3 group requirements was the solo total capital requirement, solo Tier 1 capital ratio, and solo total capital ratio, all on a Basel II standardised basis (BS2A). The so-called “Pillar 3” of Basel II sets out capital adequacy disclosure requirements, which we incorporated into our existing disclosure regime. Pillar 3 requires a significantly increased level of detail compared to the previous Basel I RWA disclosure, particularly for those banks accredited to use their own internal-ratings based (IRB) approach to modeling credit risk exposures. We therefore decided to apply the Pillar 3 requirements on a group basis only.
4. In 2011 we completed a major review of our disclosure requirements (the Disclosure Review). We dropped disclosure of Basel I group capital ratios for the IRB banks, on the basis that the Basel I versus Basel II comparisons had served a transitional purpose and were no longer needed. We also said that we intended to keep disclosure of solo capital ratios for IRB banks, and put it onto a BS2B basis to be comparable with the disclosed group capital ratios (note that the standardised banks were already disclosing their solo and group capital ratios on a comparable, i.e. BS2A, basis).
5. In responding to these proposals, the IRB banks raised concerns that (i) BS2B as it stands does not provide all the information needed to calculate a solo capital ratio, and

1 Set out in the RBNZ document Capital Adequacy Framework (Basel I Approach) (“BS2”). 2 Set out in the RBNZ documents Capital Adequacy Framework (Standardised Approach) (“BS2A”) and Capital Adequacy Framework (Internal Models Based Approach) (“BS2B”).

3 Ref #4734961 (ii) they might need some extra time to make system changes necessary to carry out the solo calculations. So in order not to delay the Disclosure Review as a whole, we left the IRB solo capital ratio disclosure on the Basel I basis. 6. However we think there are a number of advantages in now completing this change as proposed: (a) It will allow us to remove the last remaining reference in our supervisory framework to the outdated Basel I approach to capital adequacy. Banks’ solo capital ratios are important, and it is preferable for them to be disclosed using the superior, more risk-sensitive Basel II framework. (b) We believe that it will save costs for the IRB banks not to have to maintain Basel I categorisations in future, and that it will be more efficient for them to calculate their solo capital requirements using an approach which only needs minor adjustments to the group figure already calculated, rather than following a whole separate framework. (We request information on the cost impact in section 6 below.) (c) We think it is also preferable for banks’ solo and group capital ratios to be calculated on a comparable basis. 7. The purpose of this paper therefore is to propose the necessary calculation details to enable the IRB banks to calculate their solo capital ratios on a Basel II basis. Draft revisions to BS2B are attached. Once the approach has been determined, we will need to consult on corresponding minor changes to the disclosure Order in Council. 8. In responding to the Disclosure Review, the IRB banks also offered some more specific concerns and suggestions on how to calculate solo capital ratios on an IRB basis. We note these points and respond to them at the relevant points in this paper. 2: Rationale for solo capital adequacy calculations Rationale for disclosure of solo-consolidated capital ratios 9. The group capital approach assumes that the registered bank controls its group as a whole and assumes responsibility for all risks taken on anywhere in the group, booked in whatever entity. The bank stands ready to recapitalise any subsidiary if needed following losses, and capital held anywhere in the group is available to absorb losses anywhere in the group.

4 Ref #4734961 10. The philosophy of solo capital adequacy needs to complement the group approach. The starting point is that prudential supervisors and creditors have an interest in the survival of the registered bank itself, since it is strictly a legal entity that becomes insolvent, not a group. The solo view needs to consider what happens if the registered bank cuts loose its subsidiaries, and conversely if surplus capital in subsidiaries is not available to the parent. 11. The basic logic of this approach needs to be refined when a bank has subsidiaries which it wholly funds or guarantees (the criteria for solo-consolidation – see below). The difference from other subsidiaries is that the parent has nothing to gain by walking away from a solo-consolidated subsidiary, since it has either guaranteed all the subsidiary’s obligations, or is the only beneficiary of those obligations: the full benefit of any capital in the subsidiary thus accrues to the parent rather than helping to protect third-party creditors from losses. The solo-consolidated view thus confirms that the bank is maintaining sufficient capital within the solo-consolidation ring-fence to address risks taken on within that ring-fence: the distribution of capital and risk inside the ring-fence is largely irrelevant. 12. The RBNZ has in the past considered imposing minimum capital adequacy ratios on all locally-incorporated banks on a solo-consolidated as well as a group basis. Banking supervisors in some other jurisdictions do so. We note however that for New Zealand banks, the difference between risk assets at the group and the solo-consolidated level is currently very modest in all cases. We therefore believe that public disclosure provides sufficient discipline on banks to maintain adequate solo capital, and allows us to monitor the situation. If the difference between the group and solo-consolidated position became more significant for any particular bank, we could impose a solo capital ratio on that bank. Adding solo consolidation to BS2B 13. Both BS2 and BS2A require the calculation of a registered bank’s solo capital ratio to be on a solo-consolidated rather than a strictly solo basis. For the solo-consolidated calculation, certain subsidiaries of the registered bank meeting a strict set of criteria are consolidated with the bank. The IRB banks suggested that this approach also needs to be included in BS2B. 14. For the reasons given above, we agree that solo-consolidated rather than strictly solo capital ratios should be the relevant focus of attention. Maintaining consistency with the standardised banks and continuity with the Basel I approach also supports this suggestion. The attached draft revisions to BS2B therefore include the relevant text (see paragraphs 1.5 to 1.7), which is identical to that in BS2A.

5 Ref #4734961 3: Solo definition of capital 15. Only one question was raised in the Disclosure Review submissions on the definition of capital for the solo calculation. This was how to treat equity investments in non-solo consolidated subsidiaries. 16. The current treatments of unconsolidated subsidiaries are as follows: BS2A/ BS2 [10.] (1)The following items are to be deducted from total capital: (a) In the case of the banking group: Equity investments in unconsolidated subsidiaries of the registered bank. (b) In the case of the registered bank: Equity investments in subsidiaries of the registered bank other than those which are both wholly owned and wholly funded by the registered bank. (See section [3] for a definition of wholly owned and funded). BS2B [2.15] The following items are to be deducted from total capital: (a) Equity investments in unconsolidated subsidiaries of the registered bank. 17. One bank suggested that we should treat such equity investments the same as other equity holdings that are not publicly traded, which would mean applying a 400% risk weight (for comparison, this is equivalent to a 32% deduction rather than a 100% deduction). However, the whole rationale for looking at solo capital ratios assumes that the maximum loss arising from a subsidiary is the value of the bank’s investment in that subsidiary, together with any lending to the subsidiary (captured in risk-weighted assets): the level of risk taken on by the subsidiary is ignored. 18. BS2B already states clearly that investments in unconsolidated subsidiaries must be deducted, but it does not currently clarify what this implies in the case of the solo￾consolidated ratio. We propose to adapt BS2B accordingly, for consistency both with the approach now used by the standardised banks, and with the Basel I approach that the IRB banks have been using: see paragraphs 2.15(a) and (aa) in the attached proposed BS2B text. 19. In our separate consultation on implementing Basel III, we are proposing to adopt the “corresponding deduction” approach more generally, 3

3 See paragraphs 50 and 51 of which means for instance that if the equity in a subsidiary meets the criteria for Common Equity Tier 1 (CET1), then it will be deducted from the bank’s CET1 rather than from total capital. This will not Implementation of Basel III capital adequacy requirements in New Zealand (issued November 2011).

6 Ref #4734961 normally affect the total capital ratio, but will affect the Tier 1 ratio, and also the solo CET1 ratio if we require banks to calculate it. 4: Solo calculation of capital requirements Allocation of credit and market risk 20. From the comments we received from some of the IRB banks, our view is that the most efficient way for the IRB banks to calculate their total credit risk and market risk requirements at the solo-consolidated level is to start from the corresponding group figures they already calculate to show compliance with the minimum ratios, and adjust the total in the following two ways – • Subtract group capital requirements that arise from exposures booked in non￾consolidated subsidiaries (that is, subsidiaries of the registered bank that are within the group consolidation but outside the solo consolidation). To be able to do this, the bank needs to be able to identify each such contract, and identify the amount of the already￾calculated Basel II IRB capital requirement that is associated with that contract. • Add capital requirements arising from exposures of the bank and its solo-consolidated subsidiaries to non-consolidated subsidiaries. This requires the bank, likewise, to identify the amounts of such contracts, and then to calculate the amount of the Basel II capital requirement against this amount. 21. Our assessment of these two steps is that, with one exception, they require banks to do things that they already do: namely, to identify exposures already identified in deriving their current Basel I solo ratios, and to add or subtract amounts already calculated in calculating their Basel II group capital ratios. The one exception is that banks will need to determine the credit risk capital requirements for intra-group credit exposures using the Basel II rather than the Basel I methodology. We discuss this further under the next heading. (Note that market risk exposures have the same capital requirements under BS2B as they do under BS2.) 22. We would welcome feedback on whether this is a reasonable assessment of the processes required to adapt the group capital ratio calculations to produce solo ratios. Credit exposures to non-solo-consolidated subsidiaries 23. IRB banks already calculate Basel II credit risk capital requirements for some connected exposures in calculating their group capital ratios, but most or all of these will be to the Australian parent bank. So what needs to be clarified is how the category of “non-bank connected exposures” should be dealt with in the Basel II framework. We believe that the existing text of BS2A and BS2B, along with the precedents we have set in dealing

7 Ref #4734961 with other asset categories, already include sufficient information on the approach we expect banks to follow. The implications are as follows. 24. First, any unconsolidated subsidiary that is not itself a bank should be treated as a non￾bank corporate entity. It appears that the IRB banks are currently applying a 100% risk weight to most such exposures in their Basel I solo calculations. We see no reason why the definition of “bank” should extend to non-bank entities within banking groups in moving from Basel I to Basel II, and the Basel Committee’s framework document does not envisage such a change. Given the purpose of looking at a bank’s solo ratio, we do not accept that any concession should be made on the basis of implicit support from the parent bank. 25. Second, consistent with the approach we have followed with other exposure classes, the IRB banks may apply the standardised approach (BS2A) to credit exposures to non-bank unconsolidated subsidiaries, at least initially. This will imply a 100% risk weight, unless the exposure benefits from some form of credit risk mitigation recognised under BS2A, or the entity has a credit rating in its own right of A- or better. 26. But where the value of such intra-group credit exposures is material, we expect a bank to move them on to a modelling approach within a reasonable timeframe, and to seek accreditation from the RBNZ to use the IRB risk-weighting approach. Our first priority however is to transfer the IRB banks onto disclosure of Basel II solo ratios, and we see no need for that to be delayed by any follow-up discussions on accreditation. 27. We would welcome views on whether following the existing methodology in this way is a workable approach, and also whether banks see the need for any additional text in either BS2A or BS2B to clarify that this is the expected approach. Guarantees of non-solo-consolidated funding subsidiaries 28. We propose to carry across to Basel II an existing concession granted to the four IRB banks in their Basel I solo credit risk calculations. 29. Each of the four banks has a note-issuing subsidiary used primarily for raising offshore funding, the proceeds of which are on-lent to the bank. The bank guarantees repayment by the subsidiary to the note-holders. These subsidiaries do not qualify for solo￾consolidation since they raise external funding for their group, so such guarantees would normally have to be reflected in the solo capital ratio calculations as a “direct credit substitute”, which carries a 100% credit conversion factor (CCF). 30. In principle these guarantees create a form of double jeopardy: on maturity of a note issue, the bank repays the proceeds to the subsidiary, but the subsidiary for some reason fails to pass the money through to the note-holders, so that the bank has to make good on

8 Ref #4734961 its guarantee. However, the Reserve Bank is satisfied that the details of the arrangements in each particular case are such that this risk is negligible, and in effect the bank is guaranteeing its own liabilities. We have therefore allowed the banks to apply a 0% CCF to these guarantees in their solo capital calculations. 31. We do not think that the transfer from the Basel I to the Basel II methodology in any way affects the grounds on which each IRB bank was granted its concession. BS2A and BS2B both include the same requirement as BS2 to apply a 100% CCF to direct credit substitutes. The exact form of the concession can therefore be replicated under Basel II, by allowing the banks to continue to apply the 0% CCF to these guarantees, whether under the standardised or the IRB framework. Allocation of operational risk 32. All four IRB banks are also accredited to use the Advanced Measurement Approach (“AMA”) to operational risk (“op risk”). Currently their group op risk capital requirements are no more than 10% of their total group capital requirements, and their solo-consolidated business contributes 90-95% of their total group business. Hence decisions on calculating the solo op risk capital requirement affect an amount of the order of roughly 1% to be taken off the group total capital requirement. 33. Whereas credit and market risk arise from individual contracts entered into by specific legal entities within the banking group, it seems less likely that the banks’ AMA modelling approaches can readily allocate the op risk capital requirement entity-by￾entity. We therefore expect that it would require significant amounts of work for banks to adapt their AMA methodologies to enable them to strip out the op risk arising in the non-consolidated subsidiaries from their group total figures. 34. Our preferred approach is to require a simple pro-rating approach. Although a full solo modelling approach is theoretically the best, we think that requiring it would be disproportionate, given the limited difference we expect it would make to the answer, relative to the overall capital requirement. On the other hand a pro-rating approach is no more burdensome than just using the group total figure, is more justifiable in principle, and would handle the case where the difference between a bank’s solo and group business increased over time. 35. Various bases could be used for the pro-rating, but we propose to use the capital requirements themselves, as these numbers are readily available. The proposed formula for the solo operational risk capital requirement is thus –

9 Ref #4734961 (solo op risk cap req) = (solo “other risks” cap req ) X (group op risk cap req) (group “other risks” cap req) 36. This approach needs to be specifically catered for in BS2B: proposed revisions to Part 8 of BS2B are attached. This includes the definition of “other risks” capital requirement, which is simply the sum of all capital requirements for risks other than operational risk. We welcome views on whether this formula makes sense, and whether this approach chooses the right balance between burden and accuracy. 5: Changes to disclosure requirements 37. Once the Reserve Bank has finalised the details of how IRB banks should calculate solo capital ratios on an IRB basis, and has finalised any necessary changes to BS2B, we will go through the processes needed to amend the associated disclosure requirements. Although we will need to consult again on the exact wording of revisions to the Order, we would be grateful at this stage for comments on the following outcomes that we are planning to achieve with those revisions. 38. We propose that the only change will be that IRB banks will disclose solo ratios determined in accordance with BS2B rather than BS2. They will therefore continue to disclose Tier 1 and total capital ratios on a solo basis, in their full year and half year disclosure statements, but using the Basel II methodology agreed following this consultation. 39. Banks would also continue to disclose comparative figures for the previous corresponding period. In light of concerns raised previously, we will ensure that as long as the “previous corresponding period” relates to a date before an IRB bank has started calculating solo ratios on the new BS2B basis, the bank will provide comparative figures on the old BS2 basis (but with an explanation to that effect). 40. We are also open to the possibility of including a limited transitional period during which IRB banks could disclose solo ratios on either the old or the new basis. This may be useful if there are some banks who would benefit from switching as early as possible, while others need additional time to make necessary systems changes before they can disclose on the new basis. We would welcome views on how long your bank would need to make the changeover, and on the value of such a transitional. 41. The Reserve Bank’s implementation of the Basel III capital adequacy changes are likely to result in some changes in disclosure relating to capital adequacy. It is possible that this could include some minor changes or additions to disclosure at the solo level. We will consult on any such changes, which would also affect the standardised banks, as part of a separate consultation on Basel III-related disclosure changes as a whole.

10 Ref #4734961 6: Costs and benefits 42. We plan to publish a Regulatory Impact Assessment (RIA) if and when we put into effect the changes proposed in this consultation (with any refinements made in light of feedback). That will be when the disclosure requirements themselves are changed, as the changes will not have any impact on the banks until then. Although we do not expect the overall impact of the changes to be material, we view publication of an RIA as desirable in line with best practice. 43. The purpose of the requirement for banks to disclose their solo-consolidated capital adequacy ratio is to ensure that market discipline incentivises them to hold adequate capital at the solo level. The importance of adequate solo capital is discussed in Section 2 above. The solo capital ratios that IRB banks currently publish are not on a comparable basis with the group ratios, and use a less risk-sensitive and outdated methodology. The proposed change will address these problems, and thus ensure that the existing purpose of this disclosure requirement is met more effectively. There will thus be a benefit in terms of financial system soundness, although it is impractical to quantify and likely to be modest. 44. On the cost side we expect there to be a net cost saving, although we need some information from the IRB banks to confirm this expectation: (a) We expect there to be one-off costs for the affected banks from making any systems changes needed to be able to adjust their group Basel II capital calculations to produce solo-consolidated Basel II numbers. There will be some additional one-off costs for any IRB bank that needs to have its modelling approach for intra-group credit risk capital requirements accredited by the RBNZ: any such bank might also face minor continuing costs maintaining the model and monitoring how it performs. (b) On the other hand we expect there to be recurring cost savings. The proposals in this paper are aimed at allowing the IRB banks to calculate solo-consolidated capital ratios with the minimum possible variations from the group BS2B capital ratios. We expect that this will be more efficient than having to carry out largely separate calculations for the solo ratios. Banks will also avoid the recurring cost of having to maintain the Basel I risk-weighting framework within their reporting systems, including transferring it across to any new reporting platform they might adopt in future. 45. We do not currently have any monetary estimates of these expected costs and cost savings. We wish to include the best available cost estimates in the RIA. Please could you provide as much information as you reasonably can on the dollar value of the cost impacts of the proposed changes, with an indication of the upper and lower bounds of

11 Ref #4734961 your estimates; or failing that, other specific numerical estimates such as employee hours needed or saved. We would welcome your views in particular on whether the change in the disclosure requirement would represent a recurring cost saving, and if so whether this is sufficient to offset the changeover costs on a net present value basis. 7: Timing and next steps 46. This consultation closes on 20 June 2012. 47. To implement the proposed changes in BS2B the Reserve Bank will need to consult the IRB banks on changing their existing conditions of registration to refer to the new dated version of BS2B, which we will also publish on our website at that stage. But that will not affect banks’ calculation of group capital ratios. 48. As soon as possible after that we will consult on the minor changes needed in the text of the disclosure Order as outlined above, and go through the processes needed to get the agreed changes in the Order made so that banks can disclose solo capital ratios on the new basis. We aim to get those changes made in time to take effect for disclosure statements on and after 31 December 2012.

12 Ref #4734961 Appendix: Proposed revised text for BS2B This appendix sets out extracts from the relevant sections of BS2B, with new text shown in red and deletions shown with strike-throughs. PART 1 – INTRODUCTION 1.1 This document sets out the methodology to be used by locally incorporated registered banks that have been accredited to use the internal models based approaches to calculating capital ratio 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. GENERAL REQUIREMENTS 1.2 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. APPLICATION 1.3 A registered bank that has been accredited to use the internal models based approaches to calculating capital ratio requirements must use this methodology to calculate the capital ratios both for the banking group and for the registered bank as defined in this section. Registered banks are required to comply with minimum capital requirements for the banking group, defined as follows: Banking group 1.4 For the purpose of calculating capital ratios, the banking group is as defined for the purposes 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 1.5 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

13 Ref #4734961 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. 1.6 Wholly owned by the registered bank means all equity issued by the subsidiary is held by the registered bank. 1.7 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. ... [From Part 2 – Capital Definition] DEDUCTIONS FROM TOTAL CAPITAL 2.15 The following items are to be deducted from total capital: (a) In the case of the banking group: Equity investments in unconsolidated subsidiaries of the registered bank. (aa) In the case of the registered bank: Equity investments in subsidiaries of the registered bank other than those which are both wholly owned and wholly funded by the registered bank. (See paragraphs 1.5 and 1.6 for a definition of wholly owned and funded). (b) All holdings, whether direct or indirect, of capital instruments issued by other banks where the holdings equal or exceed 10% of the capital of the bank in which the investment is made. (c) Equity investments, whether direct or indirect, of 10% or more in other financial institutions, i.e. companies whose business is substantially the borrowing and lending of money or providing financial services, or both. (d) Unrealised revaluation losses on securities holdings: Revaluation losses which arise 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.

14 Ref #4734961 (e) Cumulative gains and losses on cash flow hedges, which have been recognised directly in tier two capital. (f) Any deductions required as a result of total expected loss being higher than total eligible allowances for impairment as set out in paragraph 4.215 below. Note: Assets deducted from total capital should not be included in risk weighted exposures. .... PART 3 – CAPITAL RATIOS 3.1 This part sets out the method to be used for calculating the tier one capital ratio and the total capital ratio for the registered bank and the banking group. …. [From Part 8 – Advanced Measurement Approach for Operational Risk] Regulatory capital requirement for operational risk 8.3 A registered bank approved by the Reserve Bank to use the AMA must use its own internal model to determine its banking group operational risk regulatory capital requirement. 8.3A For the purpose of calculating its registered bank solo capital adequacy ratios, a registered bank approved by the Reserve Bank to use the AMA must calculate its operational risk solo capital requirement as follows: Solo operational risk capital requirement = (Group operational risk capital requirement) x (Solo other risks capital requirement) (Group other risks capital requirement) where Other risks capital requirement = 8% x scalar x (risk weighted on and off balance sheet credit exposures) + total capital charge for market risk exposure + 8% x supervisory adjustment