Basel III Implementation Update and Consultation on Banking Supervision Handbook Changes

10 September 2012 LETTER TO CHIEF EXECUTIVES OF LOCALLY INCORPORATED (STANDARDISED) NEW ZEALAND BANKS Basel III implementation in New Zealand - update The primary purpose of this letter is to update you on the Reserve Bank’s implementation of Basel III in New Zealand and to seek your feedback on proposed changes to our Banking Supervision Handbook (the Handbook). The Reserve Bank’s website also contains up to date information on our Basel III programme and consultations. In my previous update of 8 May 2012 I noted decisions on some key aspects of Basel III taking into account the submissions we received and developments in the Basel III policy of the Australian Prudential Regulation Authority (APRA). We have now taken decisions on the remaining areas of our implementation of the Basel III capital adequacy framework (excluding the area of counterparty credit risk that is progressing on a separate track). Attached for your information is the Reserve Bank’s response to Basel III submissions. Also attached is the Reserve Bank’s cost-benefit analysis of Basel III that concludes there are net benefits in tightening our requirements to the Basel III standard. Now that our Basel III policy is finalised we are consulting on how that policy translates into detailed capital adequacy requirements within the Banking Supervision Handbook. We have therefore attached for your consideration draft changes to the Reserve Bank document “Capital adequacy framework (standardised approach) (BS2A) for your consideration. Please note that this attachment includes: • the existing Part 1 of BS2A as context, but no changes to Part 1 are proposed; • a proposed replacement to Parts 2 and 3 of BS2A (as Basel III is largely about the definition of capital we propose to replace these sections completely); and • tracked changes to Parts 6 and 7 of BS2A (only minor changes are proposed to these sections). We have also attached proposed Basel III related changes to the Reserve Bank document “Statement of Principles” (BS1) for your consideration. The proposed changes appear as tracked changes. A secondary purpose of this letter is to see your feedback on some minor and technical changes to BS2A that are unrelated to Basel III. These changes are described in Appendix One.

2 We welcome your comments on draft changes to BS2A and BS1 by 9 October 2012. Appendix Two contains some consultation questions that may assist your considerations, but you need not restrict your comments to responding to these questions. Once the changes to the Handbook are finalised we plan to consult with you on proposed changes to your bank’s conditions of registration that will require your bank to comply with the updated Handbook from 1 January 2013. Finally, we plan to consult with you later this year on proposed changes to disclosure requirements necessary to reflect the new Basel III capital requirements. Yours sincerely Toby Fiennes Head of Prudential Supervision

3 Appendix One: Proposed changes to BS2A unrelated to Basel III Section 43(h) of BS2A is shown below: 90 days past due asset (h) “90 day past due asset” has the same meaning as in Appendix E of the New Zealand Equivalent to International Financial Reporting Standard 7 – Financial Instruments: Disclosure (NZ IFRS 7). As Appendix E of NZ IFRS 7 no longer exists we propose to replace section 43(h) with the following text that we consider has the same meaning as originally intended: (h) “90 day past due asset” means an asset that is past due, as defined in New Zealand Equivalent to International Financial Reporting Standard 7 – Financial Instruments: Disclosures (NZ IFRS 7), and which has not been operated by the counterparty within its key terms for at least 90 days. Changes are proposed to sections 98 and 99 of BS2A that require a covered bond SPV to be treated as part of the banking group for the purposes of the capital adequacy framework. These proposed changes appear as tracked text in the attached BS2A document. Covered bonds

4 Appendix Two: Consultation questions

1. Should your bank elect to issue an instrument with a conversion feature, do you anticipate any legal or other impediments to the issue of shares following conversion will need to be addressed before the instrument is issued (for instance, issues relating to the Takeovers Code). If so, please specify? Loss absorbency at the point of non-viability
2. Do you consider the way the proposed loss absorbency at the point of non-viability requirements are drafted or the description in BS1 of how the requirement may operate in BS1 will result in any unintended effects? If so, please specify.
3. The draft capital adequacy standards contain loss absorbency requirements for Additional Tier 1 capital instruments. Given that these requirements only apply to instruments that are classified as a liabilities under New Zealand generally accepted accounting practice do you think they are necessary? In other words are Additional Tier 1 capital instruments that are classified as liabilities likely to be issued by your bank? Additional Tier 1 capital instruments