Consultation Paper BS16: Capital Recognition, Repayment, and Related Amendments

Consultation Paper:

• BS16: Requirements for capital recognition or repayment; and
• Minor changes to the definition of capital and counterparty
  credit risk requirements in BS2A/B.
  The Reserve Bank invites submissions on this Consultation Paper by 3 August 2015. Submissions and enquiries about this consultation should be addressed to:
  Felicity Barker
  Adviser
  Prudential Supervision Department
  Reserve Bank of New Zealand
  PO Box 2498 Wellington 6140
  Email: felicity.barker@rbnz.govt.nz
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Introduction
In conjunction with the commencement of the Reserve Bank’s Basel III capital adequacy requirements in 2013 the Reserve Bank implemented a requirement that a registered bank obtain a notice of non-objection from the Reserve Bank before recognising any Additional Tier 1(AT1) or Tier 2 capital instrument in regulatory capital. This process to obtain a notice of non-objection is set out in BS16. The Reserve Bank considers that it is timely to review this process. A more formalised process is proposed, to give greater certainty as to the Reserve Bank’s expectations. In addition the Reserve Bank intends to include in BS16 some additional requirements in respect of the repayment and on-going treatment of capital instruments. The changes, and the rationale for them, are discussed in Part 1. These changes will also necessitate a change in conditions of registration. The proposed changes to conditions are set out in Part 2 of this document. In addition to this consultation paper the Reserve Bank has released the proposed amended BS16 for consultation. In addition to the changes to BS16, the Reserve Bank is proposing some minor changes to the definition of capital in BS2A and BS2B. The Reserve Bank considers that these changes largely align BS2A and BS2B with current industry practice and does not anticipate that the changes will affect the eligibility of any capital instruments currently on issue. These changes are summarised in Part 3 of this document. An exposure draft of the changes to BS2A/B is also released with these documents. A small change is also proposed in respect of the requirement on a bank that uses a qualifying central counter party indirectly through a clearing member to provide a legal opinion in respect of that arrangement. This proposal is set out in Part 4. It is intended that these changes will take effect from 1 October 2015 in order to align with other change in conditions of registration.
Part 1: Amendments to BS16
BS16 sets out the process requirements a registered bank must follow in order to obtain a notice of non-objection. Below we discuss proposed amendments to BS16 and their rationale. Requirements to obtain a notice of non-objection Role of the Board The Reserve Bank’s notice of non-objection is not a positive confirmation of eligibility of the instrument for recognition in a particular tier of capital. Rather it is a confirmation that nothing has come to the attention of the Reserve Bank that would make the instrument ineligible for capital recognition. Boards remain responsible for ensuring that the registered bank has systems in place to ensure eligibility of the instrument, both on initial recognition and on an on-going basis. The Reserve Bank is keen to ensure that this responsibility remains firmly on an issuing bank’s Board. In order to ensure that the issuance of a notice of non-objection does not undermine a Board’s incentive to undertake due diligence, it is proposed that the following attestations by Ref #6124257 v1.2

a Board must be provided before a notice of non-objection will be issued by the Reserve Bank:

• That after having made due inquiry, in the opinion of the Board,
  o the information provided in the final BS16 application is accurate; and o the issue complies with the requirements of the relevant capital adequacy framework for the relevant tier of capital;
• The Board acknowledges that the notice of non-objection is a ‘no-objections’ sign off
  and does not provide a positive confirmation of the eligibility for treatment as AT1 or Tier 2 capital. Process The Reserve Bank considers that the process for application for a notice of non-objection has been operating reasonably well. However, there are some areas where it is desirable to clarify the Reserve Bank’s expectations as to the timing of receipt of material. The draft amended BS16 sets out an expected process for consideration of applications. This proposed process has the following stages:
• Initial application. At this point the following material will be submitted:
  o BS16 self-assessment; o terms of the instrument; o draft legal opinion; and o any required additional information.
• The Reserve Bank will consider the materials and advise of any issues that arise,
  and the registered bank will respond to those issues;
• Once all issues in respect of the terms have been resolved, an internal Reserve Bank
  Committee will consider the application. If the Reserve Bank has no objection to the terms this will be communicated to the registered bank.
• The registered bank will submit a final application with the following:
  o final versions of the terms, BS16 self-assessment and opinion; o IRD binding ruling if required; and o Board approvals and attestations.
• The notice of non-objection will be issued if all requirements are met. The registered
  bank should allow 5 days between the submission of the final application and issuance of the notice of non-objection. Legal Opinion on Terms Currently BS16 only requires a legal opinion to be provided in respect of a convertible instrument. However instruments with a write-off feature also give rise to legal risk. For this reason it is intended that a legal opinion, that provides that the conversion or write-off mechanism is effective, should be provided with all applications for a notice of non-objection. Board approvals The final application must include evidence that necessary Board approvals have been obtained. BS16 currently requires that the receipt of the necessary Board approvals be evidenced in the legal opinion. It is proposed that evidence of Board approvals also be able Ref #6124257 v1.2

to be provided through provision of advice from the company secretary that the Board approvals set out in the opinion have been approved or by the provision of signed approvals. IRD tax ruling If conversion or write-off of a capital instrument would give rise to a tax liability, this must be deducted from the value of the instrument for regulatory capital purposes. Currently BS16 states that an IRD binding ruling will be required for the first issue of a convertible debt instrument under a certain structure and future issues under the same structure will not necessarily require a ruling. Given that the tax law in this area is complex, the Reserve Bank intends to require that all convertible instruments that are accounted for as debt must have a binding IRD ruling if the registered bank does not intend to apply a ‘tax haircut’ to the instrument. Binding rulings will be expected to be updated if they expire prior to the maturity of the issue (unless the time to maturity is minimal). The BS16 self-assessment will be required to include the registered bank’s assessment of the tax effects of conversion. Additional information requirements The Reserve Bank proposes to implement additional information requirements in two cases:

• Where a registered bank issues a capital instrument to a related party, the registered
  bank must provide information on any related transactions in respect of the ultimate source of funding for that instrument. This is to improve the Reserve Bank’s understanding of the transaction as a whole.

• Where the registered bank issues a capital instrument in a foreign currency the
  following additional information must be provided in order to enable the Reserve Bank to assess the risk to capital ratios associated with foreign currency funding:
  o a statement of the registered bank’s intended accounting treatment of the instrument and any associated swaps; and o forecasts of the bank’s capital ratios on a quarterly basis over 2 years that demonstrate the sensitivity to fluctuations in currency values. Repayment of CET1 (common equity tier 1) Under the capital framework the repayment of AT1 and Tier 2 instruments must be approved by the Reserve Bank. There is no requirement for the approval of repayment of ordinary shares or other reductions in CET1 capital. In order to improve our supervisory oversight the Reserve Bank proposes to implement a prior notification requirement for repayments (including dividends) of CET1 over a certain threshold. The Reserve Bank proposes this threshold be a single transaction of more than 10% of CET1, or a series of transactions in a single (rolling) year that constitute more than 10% of CET1. Repayment of AT1 and Tier 2 AT1 and Tier 2 Capital instruments may be callable if an unanticipated tax or regulatory event occurs. The rules however provide no guidance on the definition of an anticipated event. The Reserve Bank seeks to provide greater clarity as to when a tax or regulatory event will be considered to be anticipated and hence intends to include guidance to the effect that for an event to be anticipated it must be a clearly defined policy for which there is a clear intention to implement. This would require that:

• consultation has been undertaken;

• for legislation, the Bill has been introduced into Parliament; and
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• for any other regulatory tool, the relevant body has issued a statement of intention to
  implement a defined policy.
  Additional guidance has also been provided to aid with interpretation of the repayment approval requirements. Secondary market activity A registered bank or a related party of a registered bank may purchase its own capital instruments, or a related instrument, off the secondary market. Where a registered bank purchases its own capital instrument, or funds the purchase of such instruments, the instrument is immediately deducted from capital. The Reserve Bank understands there may be valid reasons for secondary market purchases. However, as such purchases reduce regulatory capital, the Reserve Bank wishes to have greater oversight of such purchases. It is hence proposed to include a requirement in BS16 that no member of the banking group may purchase or fund the purchase (directly or indirectly) of more than 5% of the value of AT1 and Tier 2 instruments on issue, without the prior approval of the Reserve Bank.
  Part 2 Changes to conditions of registration
  In order to provide clarity as to what are the obligations on the registered bank it is proposed to amend current condition 1(e) of registered bank’s conditions of registration to read:

1. That
   [...]
   (e) the Bank must not include the amount of an AT1 or Tier 2 capital instrument issued after 1 January 2013 in the calculation of its capital ratios unless it has received a notice of non￾objection to the instrument from the Reserve Bank; (f) the Bank meets the requirements of Part 3 of the Reserve Bank of New Zealand document “Requirements for capital recognition and repayment” (BS16) October 2015 in respect of its regulatory capital instruments. Currently there is a difference in conditions between banks subject to BS2A or BS2B in that banks subject to BS2B have an extra condition to the effect that the banking group complies with all the requirements set out in BS2B. It is proposed to extend an analogous requirement to banks subject to BS2A. Questions Do you have any comments on the proposed changes to BS16? Do you have any comments on the proposed changes to conditions of registration? Ref #6124257 v1.2

Part 3: Minor amendments to the definition of capital
The Reserve Bank also proposes a number of small changes to BS2A/B. These changes are either necessitated by the changes to BS16 or seek to align the capital adequacy framework better with the terms of instruments currently on issue. It is not expected that these changes will impact on the eligibility of any existing instruments. The changes are described below and a tracked change version of the changes to BS2A is provided with this consultation paper (identical changes are proposed for BS2B). Updates consequential to BS16 update The update to BS16 results in the following changes being made to BS2A/B:

• subpart 2H (and references to it1
  ) will be deleted;
• the requirement to provide the Reserve Bank with evidence that there are no
  impediments to a convertible instrument converting is removed as information requirements are set in BS16 (BS2A: subpart 2E para 10(e)7(c),subpart 2F para 10(f)9(c), BS2B: subpart 2E para 2.49(c), subpart 2F para 2.64(c));
• notification that the banking group’s CET1 ratio is below 5.125% is moved to BS16
  (BS2A: subpart 2E para 10(e)(10), BS2B para 2.52);
• requirements relating to the Reserve Bank’s assessment of whether an instrument
  may be repaid prior to maturity are moved to BS16 (BS2A: subpart 2B para 10b(1)(d),subpart C para 10c(1)(f), BS2B: subpart 2B para 2.24(d), subpart 2C para 2.25(f)). Loss absorption requirements Conversion failure Under the capital framework when a regulatory convertible instrument fails to convert the instrument must be written off. The current text requires that the registered bank obtain a legal opinion, within 5 working days, to the effect that conversion can occur. However industry practice has been to state that conversion must occur within 5 working days. In order to simplify the requirements it is proposed the requirement be amended to require write-off if conversion fails within 5 working days. Write-off The text defines requirements for write-off in relation to the registered bank. It has been clarified that following write-off the holder should have no further rights in respect of the instrument. Non-viability trigger event definition A difference exists between APRA’s and the Reserve Bank’s definition of a non-viability trigger event, in the case it is triggered when the registered bank is in statutory management. In particular, under the Reserve Bank’s rules, when a registered bank enters statutory management the statutory manager must have an option to convert/write-off the instrument. 1 Paragraph 8(3) and 9(4) of BS2A and 2.14 and 2.17 of BS2B. Ref #6124257 v1.2

Conversion/ write-off is a decision subsequent to statutory management. However, a non￾viability trigger event is defined as the occurrence of statutory management in the Reserve Bank rules. APRA defines a non-viability trigger event as the date on which conversion occurs. In order to align the definition of a non-viability trigger event with the definition used by APRA and to clarify the requirement that a conversion option for the statutory manager must be in the terms of the instrument the following amended text has been included in subpart 2F:
Under the terms of the instrument the registered bank must have the right, exercisable upon the occurrence of the statutory management of the registered bank under section 117 of the Reserve Bank Act, to irrevocably convert or write-off the instrument. A non-viability trigger event is defined as:
(a) a direction given, by notice in writing, to the registered bank by the Reserve Bank under section 113 of the Act, on the basis that the financial position of the registered bank is such that it meets any of the grounds in subsections 113(1)(a)-(e) of the Act, requiring the registered bank to either write-off or convert the instrument; or (b) the registered bank is subject to statutory management and the statutory manager announces her or his decision to convert or write-off the instrument. Consequential amendments are also made to the provisions relating to issuing by subsidiaries and SPVs. Subpart 2B and C A number of amendments are proposed to subpart 2B and C (requirements for AT1 and Tier 2 instruments) including:

• requiring that for both a Tier 2 and an AT1 instrument, that the instrument must be
  subordinated in liquidation and that distributions are not payable if the registered bank would be insolvent following repayment. This ensures that payment of distributions does not undermine subordination;
• making it a requirement that the terms of an AT1 instrument must state the
  circumstances under which the registered bank is prohibited from making distributions (i.e. for an AT1 instrument distributions are restricted in the buffer zone);
• removal of the requirement that distributions be from distributable items. We
  consider this provision unnecessary in light of the amendment proposed in the first dot point above. Buffer ratio Share buy-backs are limited if a registered bank is operating in the buffer zone. However a share buy-back may be part of a mechanism to give effect to conversion or write-off following a loss absorption trigger event or a non-viability trigger event. Therefore an amendment has been made to exclude share buy-backs that are part of a loss absorption mechanism from restrictions on distribution for the purposes of the buffer ratio. Questions Do you have any comments on the proposed changes to the definition of capital in BS2A/B? Will any of these changes effect eligibility of any instruments currently recognised as Ref #6124257 capital? v1.2

Part 4: Minor amendment to counterparty credit risk capital charge requirements
Section 55E(1)(a) of BS2A and 4.82P of BS2B require that, where a bank is a client of a
clearing member and enters into a transaction with the clearing member acting as a financial intermediary, or where the client enters into a transaction with the QCCP with a clearing member guaranteeing its performance, the client’s exposure to the clearing member may receive favourable capital treatment if certain conditions are met. One of these conditions is that the bank acting as a client must be in a position to provide, upon request, an independent, written and reasoned legal opinion to the Reserve Bank that proves that in the event of a legal challenge certain requirements are met under relevant law. A concern has been raised with the Reserve Bank that the standard of the legal opinion requirement is too high and suggests the relevant legal opinion cannot be qualified. The Reserve Bank accepts this concern and hence proposes amending the requirement to:
55E …In addition, the bank acting as a client must be in a position to provide, upon request, an independent, written and reasoned legal opinion to the Reserve Bank that provides that there is a high level of certainty that in the event of legal challenge this condition is met under relevant law… Question Do you have any comments on the proposed change to the requirement for a legal opinion from a client bank? Ref #6124257 v1.2

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