This article is written by Ian Paterson, Jo Dodd and Andrew Fei.
After looking closely at international developments in relation to total loss-absorbing capacity (TLAC) principles, APRA has released a “conceptually different” proposal to increase the loss-absorbing capacity of Australian banks for resolution purposes.
On 8 November 2018, the Australian Prudential Regulation Authority (APRA) announced a proposal to increase the loss-absorbing capacity of authorised deposit-taking institutions (ADIs) to facilitate their orderly resolution (Proposal). APRA proposes to achieve this outcome by requiring the four major Australian banks (D-SIBs) and potentially some other ADIs to increase their “Total Capital”.
The Proposal contains both something new and something old.
The “something new” is represented by the following aspects of the Proposal:
- D-SIBs: The Total Capital requirement for D-SIBs would be increased by 4 to 5 percentage points of risk-weighted assets (RWAs). APRA anticipates that each D-SIB’s Total Capital requirement would be increased by the same amount. While Total Capital is made up of Common Equity Tier 1, Additional Tier 1 and Tier 2 capital, APRA anticipates that D-SIBs would predominantly satisfy the increased Total Capital requirement using Tier 2 capital instruments. On this basis, APRA estimates that the D-SIBs’ aggregate cost of funding would be increased by less than 5 basis points. The Proposal does not prevent a D-SIB from satisfying the increased Total Capital requirement using AT1 or even CET1 capital. Based on the ASX announcements made by the D-SIBs on 8 November 2018, the aggregate amount of further Total Capital that the D-SIBs need to raise is estimated to be between A$67 billion and A$83 billion.
- Non-D-SIBs: Higher Total Capital requirements would also be imposed on a small number of non-D-SIBs (i.e. smaller banks) based on an institution-by-institution assessment of the effectiveness of the ADI’s resolution planning and taking into account the complexity or nature of its critical functions. The Proposal states that the magnitude of the increased Total Capital requirement for this small group of ADIs would be commensurate with each ADI’s resolution strategy and would be no greater than that applied to the D-SIBs. According to APRA, outside of this small group of ADIs, all other non-D-SIBs are unlikely to be subject to increased Total Capital requirements.
- Designed to facilitate orderly resolution: APRA has clarified that the increased Total Capital requirement is intended to facilitate orderly resolution by ensuring that an ADI has sufficient financial resources to effect an orderly resolution when access to external funding becomes limited. According to APRA, this objective is conceptually distinct from maintaining regulatory capital for resilience purposes. As APRA Chairman Wayne Byres has stated: “no matter how resilient financial institutions are, the possibility of failure cannot be entirely removed. Therefore, in addition to strengthening the resilience of the financial system, it is prudent to plan for the unlikely event of failure.”
- Importance of effective resolution planning: In the Proposal, APRA has emphasised the importance of effective resolution planning for all ADIs and stated that it intends to consult on a framework for recovery and resolution in 2019, which would include further details on resolution planning. For non-D-SIBs that may be subject to increased Total Capital requirements, effective resolution planning can potentially reduce the magnitude of the increase.
The “something old” is reflected in APRA’s proposal to base the increased loss-absorbing capacity requirements on APRA’s existing risk-based capital framework and categories of capital instruments rather than introducing new forms of loss-absorbing instruments such as senior bond TLAC, MREL or “Tier 3” instruments (as is the case in many offshore jurisdictions).
Background to the Proposal
Since the Global Financial Crisis, APRA and other prudential regulators around the world have increased their focus on the orderly resolution of systemically important financial institutions.
The 2014 Financial System Inquiry in Australia recommended that APRA implement a framework for loss absorbing and recapitalisation capacity in line with emerging international practice in order to facilitate the orderly resolution of ADIs and minimise taxpayer support. The Australian government has endorsed this recommendation.
More recently, APRA’s statutory powers were strengthened by the passage of the Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Act 2018 (Act). Among other things, the Act gives APRA broad powers to make and enforce prudential standards on resolution. KWM’s analysis of the Act is available here.
The Proposal is designed to facilitate orderly resolution by increasing the availability of financial resources (i.e., loss-absorbing Total Capital instruments) required to implement an ADI’s resolution strategies.
A simple, flexible and Australian approach to increasing loss-absorbing capacity
According to APRA, the Proposal is simple, flexible and designed for the distinctive features of the Australian financial system.
- Simple, because it relies on the existing risk-based capital framework. APRA explains that this approach provides greater certainty than other methods and does not require the creation of new categories of instruments.
- “Flexible”, because it is based on paragraph 23 of Prudential Standard APS 110 (Capital Adequacy), which allows APRA to determine prudential capital requirements for an ADI that are higher than the minimum requirements. In this way APRA can adjust the level of the increased Total Capital requirement based on a non-D-SIB’s resolution planning. It also allows APRA to recalibrate the requirement based on revisions to APRA’s current capital framework. Note that APRA has recently consulted on proposed changes to its capital framework, which may affect both the calculation and presentation of risk-based capital ratios.
The Proposal is uniquely “Australian” in the sense that APRA proposes not to introduce a new form of loss-absorbing funding instrument, such as senior debt subject to bail-in (as has been introduced in a number of offshore jurisdictions). APRA does not propose to introduce a non-risk-based leverage ratio requirement as part of its approach to TLAC.
Another “Australian” feature of the Proposal is the calibration methodology for the increased Total Capital requirement. According to APRA, its calibration methodology involved, among other things:
- taking into account the fact that, as a result of differences in the definition of capital and determination of RWAs, risk-based capital ratios for Australian D-SIBs are materially higher when measured on an internationally harmonised basis than when measured using APRA’s regulatory capital standards;
- using past failures of global systemic banks to inform the financial resources needed to support an orderly resolution of a distressed systemically important bank;
- using frameworks implemented in other jurisdictions as a benchmark to inform the calibration of a minimum amount of loss-absorbing resources needed for an Australian D-SIB; and
- estimating the level of loss-absorbing capacity that the Australian D-SIBs’ international peers are expected to maintain as an indication of the level of loss-absorbing capacity that may be needed to support market confidence.
APRA concluded that a calibration less than the Financial Stability Board’s minimum TLAC requirement is likely to be sufficient to support an orderly resolution of Australian D-SIBs.
APRA expects to notify D-SIBs of increases to their Total Capital requirements in 2019. D-SIBs would be expected to maintain Total Capital that exceeds the heightened requirement by 2023.
APRA anticipates that it would notify non-D-SIBs of any additional loss absorbency requirement from 2019 onwards, with implementation over a four year period, or shorter if the size of the adjustment is smaller and, in APRA’s view, the ADI can meet the requirement in less than four years. Also, as APRA progresses with resolution planning it may prioritise increasing Total Capital requirements for certain ADIs. Accordingly, changes to the Total Capital requirement may occur for certain ADIs ahead of others.
Importance of effective resolution planning
It is clear from the Proposal that resolution planning is one of APRA’s top policy priorities and that for non D-SIBs the outcome of resolution planning would inform the level of their increased Total Capital requirement. Specifically, APRA would consider the provision of critical functions by non-D-SIBs, the separability of those functions and preferred resolution strategies. The less satisfactory the plan, the greater the TLAC requirement may be.
APRA stated that it plans to consult on a resolution planning framework in 2019. With the New Year just around the corner, there are many things an ADI can do now to prepare for APRA’s upcoming resolution planning requirements.
In this respect, we note that the Proposal includes the following preliminary guidance on APRA’s resolution planning expectations.
APRA expects an ADI’s resolution plan to outline how APRA would use its powers (including its enhanced powers under the Act) to manage the orderly failure of an ADI and identify steps that can be taken to remove barriers to achieving effective resolution outcomes.
An ADI’s resolution strategies are at the core of an ADI’s resolution plan. The design of a resolution strategy would depend on:
- the statutory powers available to APRA as the resolution authority;
- the effectiveness of resolution planning to make resolution strategies operational, taking into account the size, nature and complexity of the ADI; and
- the availability of financial resources to facilitate the implementation of resolution strategies, which is the focus of the Proposal.
According to APRA, orderly resolution of an ADI would occur when a problem is identified and escalated early enough to allow APRA and other financial regulators to manage and respond in a manner that protects the interests of depositors, stabilises the ADI’s critical functions and promotes financial stability. Significantly, achieving an orderly resolution does not necessarily mean a crisis is averted. Rather, orderly resolution means that the manner in which an ADI’s failure is managed would result in better outcomes given the circumstances.
The Proposal includes the following consultation questions with respect to which APRA is seeking feedback from stakeholders:
- What are the advantages and disadvantages of using the capital adequacy framework to increase the loss-absorbing capacity of ADIs by adjusting Total Capital requirements to help facilitate resolution?
- Is an increase of 4 to 5 percentage points of additional loss absorbency an appropriate calibration for the increase in the D-SIBs’ Total Capital requirements, such that the amount of loss-absorbing capacity is sufficient to facilitate orderly resolution? If not, what are the reasons for the increase not being appropriate?
- Is 4 years an appropriate transition timeframe for ADIs to meet increased Total Capital requirements?
- Are there any constraints on the capacity for ADIs to meet and maintain additional loss absorbency requirements – giving consideration to the market capacity for capital instruments?
- APRA anticipates that increasing the loss-absorbing capacity of the D-SIBs by 4 to 5 percentage points would result in additional funding costs not greater than 5 basis points of the total funding base. How might an increase in funding costs impact lending, the broader financial system and the economy?
- What are the estimated compliance costs for ADIs that would be required to meet increased Total Capital requirements?
Submissions to APRA are due by 8 February 2019.