Prudential Standard
APS 110 - Capital Adequacy
Objective
This standard aims to ensure that ADIs maintain adequate capital to support the risks associated with their activities on both a stand-alone and group basis.
This standard outlines the overall framework adopted by APRA for assessing an ADI’s capital adequacy. It should be read in conjunction with: APS 111 – Capital Adequacy: Measurement of Capital; APS 112 – Capital Adequacy: Credit Risk; and APS 113 – Capital Adequacy: Market Risk.
Note: Foreign ADIs (which have the same interpretation as in Division 1B of the Banking Act 1959) operating through branches in Australia are not subject to this Standard (and other related Capital Adequacy Standards as mentioned above). They must, however, be subject to comparable capital adequacy standards in their home country.
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Principles
Responsibility for Capital Management
1. Capital is the cornerstone of an ADI’s financial strength. It supports an ADI’s operations by providing a buffer to absorb unanticipated losses from its activities and, in the event of problems, enabling the ADI to continue to operate in a sound and viable manner while the problems are addressed or resolved. The Board of an ADI has the duty to ensure that the ADI maintains an appropriate level of capital commensurate with the level and extent of risks to which the ADI is exposed from its activities. To this end, the ADI should:
(a) have adequate systems and procedures in place to identify, measure, monitor and manage the risks arising from its activities on a continuous basis to ensure that capital is held at a level consistent with the ADI’s risk profile; and
(b) maintain and implement a capital management plan, consistent with the overall business plan, for managing its capital levels on an ongoing basis. Essentially, the plan should set out:
(i) the ADI’s strategy for maintaining capital resources over time, for example, by outlining its capital needs for supporting the degree of risks involved in the ADI’s activities, how the required level of capital is to be met, as well as the means available for sourcing additional capital where required; and
(ii) actions and procedures for monitoring the ADI’s compliance with minimum regulatory capital adequacy requirements, including the setting of trigger ratios to alert management of, and avert, potential breaches to the minimum capital ratios required by APRA.
2. Where an ADI is a member of a conglomerate group (see AGN 110.1), associations with other members in the group may expose the ADI to the potential of contagion risk – the possibility that difficulties encountered by individual entities in the group might be transmitted to the ADI (refer APS 222 – Associations with Related Entities). In determining stand-alone capital adequacy, the Board of the ADI should have regard to:
(a) group risks posed by other members in the group to the ADI;
(b) obligations (direct or indirect) arising from associations with group entities which might give rise to a call on the capital of the ADI; and
(c) the ability to readily extract capital from other members in the group should the need to recapitalise the ADI arise (this would include consideration of the integration of business within the group, the importance of subsidiaries to the group, the impact of taxation, regulatory requirements and other factors on the ability to realise investments in, or transfer surplus capital from, subsidiaries).
3. Aside from maintaining adequate capital on a stand-alone basis, ADIs that head a conglomerate group (see AGN 110.1) must also satisfy APRA that the group as a whole has sufficient capital consistent with the group’s risk profile. To this end, the Board of an ADI that heads a conglomerate group should:
(a) establish policies on group capital adequacy (which should have regard to the type and distribution of capital resources held by the group) and implement a group capital management plan (with coverage similar to those outlined in paragraph 1(b) above) to ensure that the group overall is adequately capitalised to cover the risks faced by the group and to meet regulatory, market and strategic needs;
(b) ensure that appropriate systems and adequate procedures are in place to identify, assess, measure and monitor group risks on a continuous basis; and
(c) ensure that the group has sufficient capital freely available to meet unexpected losses and adverse shocks impacting on the group.
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Measurement of Capital Adequacy
4. To ensure that ADIs are adequately capitalised on both a stand-alone and group basis, APRA adopts a tiered approach to the measurement of an ADI’s capital adequacy by assessing the ADI’s financial strength at three levels (see illustrative diagram in the Attachment):
(a) Level 1 – the ADI on a stand-alone basis;
(b) Level 2 – the consolidated banking group i.e. the ADI and all its subsidiaries other than non-consolidated subsidiaries (see AGN 110.2); and
(c) Level 3 – the conglomerate group at the widest level.
5. Level 1 and Level 2 assessments are applicable to all ADIs. Level 3 assessment applies only to ADIs prescribed by APRA (see AGN 110.3).
6. Measurement of an ADI’s capital adequacy at each of the above three levels is based on:
(a) Level 1 & Level 2 – a risk-based capital adequacy framework based on the Basel Capital Accord (see AGN 110.4); and
(b) Level 3 – the methodology agreed with APRA (see AGN 110.3).
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Minimum Capital Adequacy Requirements
7. An ADI must, at a minimum, maintain a risk-based capital ratio (see AGN 110.4) of 8 per cent at all times under Level 1 and Level 2. At least half of the ratio must take the form of Tier 1 capital (see APS 111 – Capital Adequacy: Measurement of Capital) i.e. a minimum Tier 1 capital ratio of 4 per cent must be maintained. Where considered appropriate, APRA may require an ADI to maintain a minimum capital ratio above 8 per cent (at least half of the ratio must take the form of Tier 1 capital) at Level 1 and Level 2 (see AGN 110.5). APRA expects all ADIs, as part of their capital management plans (see paragraphs 1(b) and 3(a) above), to target and maintain Level 1 and Level 2 capital ratios (both Tier 1 and total) above regulatory minimums.
8. ADIs subject to Level 3 capital adequacy assessment must meet the minimum group-wide capital adequacy benchmarks agreed with APRA on a continuous basis. APRA may impose additional or higher Level 1 and/or Level 2 capital requirements on an ADI in a conglomerate group where it is not satisfied with the methodology for measuring the group’s capital adequacy at Level 3 (see AGN 110.3).
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Notification Requirements
9. An ADI must inform APRA immediately of:
(a) any breach of the minimum capital adequacy requirements under paragraphs 7 and 8 above and any potential breach of these requirements (e.g. breaches of trigger ratios set under paragraphs 1(b)(ii) and 3(a) above), including remedial actions taken / planned to deal with the problem; and
(b) any concerns it has about its capital adequacy (whether at Level 1, 2 or 3), along with proposed measures to address these concerns.
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Reductions in Capital
10. Where an ADI proposes any reduction in its capital (whether at Level 1, 2 or 3), it must obtain APRA’s prior written consent (see AGN 110.6).
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Reporting
11. An ADI must provide APRA each quarter (or more frequently if required by APRA) with information on its Level 1 and Level 2 capital adequacy in a form to be determined by APRA from time to time.
12. ADIs subject to Level 3 capital adequacy assessment must provide APRA each quarter (or more frequently if required by APRA) with the group’s capital adequacy reports in a form agreed with APRA.
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ATTACHMENT
Application of Framework to A Simple Corporate Structure
Level 1 – An ADI assessed on a stand-alone basis
Level 2 – An ADI and all its subsidiary entities (other than non-consolidated subsidiaries) assessed on a consolidated banking group basis
Level 3 – Entire group assessed
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Guidance Note
AGN 110.1 - Conglomerate Group
1. For the purposes of this Standard, a conglomerate group is defined as a group of companies containing one or more locally incorporated ADIs. Any reference to an ADI in this Standard applies to each ADI member of a conglomerate group on an individual basis.
2. A conglomerate group must be headed by an ADI or an authorised non‑operating holding company (NOHC) and may include non-financial (commercial) as well as financial entities (regulated and unregulated). A “regulated entity” in a conglomerate group refers to any entity directly regulated by APRA or by an equivalent banking, insurance or similar prudential regulator overseas.
3. A foreign-owned locally incorporated ADI and its subsidiaries constitute a conglomerate group for the purposes of this Standard. Alternatively, where the foreign-owned ADI has a locally incorporated NOHC parent, the conglomerate group will comprise the locally incorporated NOHC and all its subsidiaries. The ADI’s foreign parent(s), the foreign parent’s overseas based subsidiaries and their directly owned non-ADI entities operating in Australia do not form part of the conglomerate group. APRA, however, expects the foreign parent to be subject to regulatory oversight broadly consistent with that applied by APRA and, should the need arise, provide APRA with information concerning activities of their subsidiaries outside the Australian conglomerate group.
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Guidance Note
AGN 110.2 - Non-consolidated Subsidiaries
1. For the purposes of determining an ADI’s capital adequacy at the consolidated banking group level (i.e. Level 2), all banking and other financial activities (both regulated and unregulated) conducted within the banking group must be consolidated.
2. Consolidation at Level 2 should be conducted in accordance with Australian accounting standards. This should cover the global operations of an ADI and its subsidiary entities, as well as any other controlled banking entities, securities entities and other financial entities (e.g. finance companies, money market corporations, stockbrokers and leasing companies), except for entities involved in the following business activities:
(a) insurance businesses (including friendly societies and health funds);
(b) acting as manager, responsible entity, approved trustee, trustee or similar role in relation to funds management or the securitisation of assets; and
(c) non-financial (commercial) operations.
3. Group entities excluded from Level 2 consolidation are to be deducted from an ADI’s Level 2 capital in accordance with paragraph 9 of APS 111 – Capital Adequacy: Measurement of Capital and AGN 111.4 – Capital Deductions.
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Guidance Note
AGN 110.3 - Level 3 Assessment
1. Only ADIs prescribed by APRA will be subject to Level 3 capital adequacy assessment. APRA will identify conglomerate groups for which Level 2 assessment is deemed not sufficient for measuring an ADI’s capital adequacy on a group-wide basis. These could be financial conglomerates containing substantial banking and insurance activity, or mixed conglomerates containing significant banking and non-financial activity.
2. ADIs subject to Level 3 assessment will need to have an APRA-approved, group-wide capital calculation that corresponds to their corporate structure. Essentially, the capital calculation should have regard to all group members (whether ADIs, insurers or unregulated entities) and the capacity of any surplus capital to be moved around the group according to need. The capital calculation may be based on the methodologies of the Joint Forum, or the ADI’s own internal capital estimation and allocation models. The ADI will need to satisfy APRA that the conglomerate group of which it is a part has sufficient capital (as defined in APS 111 – Capital Adequacy: Measurement of Capital) for the risk profile of the group as a whole.
3. Prescribed ADIs should provide to APRA a description of their current policies with regard to group capital adequacy at Level 3, including the methodology used to measure capital adequacy of the entire group.
4. In determining capital levels for the conglomerate group, the Board of an ADI that heads the group should have regard to:
(a) the potential for risk to compound across the group (as well as any proven benefits of risk diversification);
(b) concentration of capital and risk within individual entities in the group;
(c) the capital needs of individual entities in the group;
(d) the nature of capital held by the group, including its maturity, servicing costs and any double counting or upgrading of capital within the group;
(e) the ability to readily transfer surplus or free capital within the group and the type of capital which would be available to individual entities from other group members if required (this would involve consideration of the impact of taxation, regulatory requirements and other factors impinging on the ability to transfer surplus capital among individual entities); and
(f) the integration of business within the group and the ability of the group to readily realise capital through the sale of business lines and/or individual member entities without adversely impacting the group’s on-going operations.
5. Unlike Level 1 and Level 2 capital adequacy assessments, there would be no prescribed minimum capital adequacy requirements (such as the 8 per cent benchmark) for Level 3 assessment. Instead, ADIs prescribed under Level 3 would need to provide details of their own benchmarks (which might be regulatory minima or, for internal models, probability of default / time horizon parameters) and on an on-going basis, details of the extent to which these are exceeded by the conglomerate group. In instances where APRA is not satisfied with the group-wide assessment – for example, because the group’s internal benchmarks are deemed insufficiently prudent, or because APRA is not satisfied with the assumptions made (e.g. for diversification, or in relation to capital mobility) – APRA may impose additional or higher capital requirements on the ADI at Level 1 and/or Level 2.
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Guidance Note
AGN 110.4 - Risk-based Capital Adequacy
Framework
1. APRA’s approach to the assessment of an ADI’s capital adequacy at Level 1 (i.e. the stand-alone level) and Level 2 (i.e. the consolidated banking group level) is based on the risk-based capital adequacy framework set down in the Basel Capital Accord.
2. Consistent with the Basel framework, the approach provides for a quantitative measure of an ADI’s capital adequacy and focuses on three main elements:
(a) the credit risk associated with an ADI’s on- and off-balance sheet exposures;
(b) the market risk arising from an ADI’s trading activities; and
(c) the form and quality of capital held by the ADI to support these exposures.
APRA may adjust its risk-based capital adequacy framework in future to take account of developments to the Basel framework. Further elements or other types of risk may be added to this quantitative framework over time, such as the inclusion of a requirement to provide capital to cover operational risk.
3. Under the risk-based capital adequacy framework, an ADI’s Level 1 and Level 2 capital adequacy is measured by means of a risk-based capital ratio calculated by dividing its eligible capital base by its total risk-weighted exposures i.e.,
risk-based capital ratio = eligible capital base
------------------------------------
total risk-weighted exposures
4. The definition of eligible “capital base” (the numerator of the risk-based capital ratio), including qualifying criteria for individual capital elements to be included in an ADI’s Level 1 and Level 2 capital base, is set out in APS 111 – Capital Adequacy: Measurement of Capital.
5. An ADI’s “total risk-weighted exposures” (the denominator of the risk-based capital ratio) at Level 1 and Level 2 is calculated as the sum of the total risk-weighted on- and off-balance sheet credit exposures and the “adjusted” market risk exposures (see paragraph 6 below), determined in accordance with the requirements and procedures set out in APS 112 – Capital Adequacy: Credit Risk and APS 113 – Capital Adequacy: Market Risk respectively.
6. To ensure consistency in the calculation of capital requirements for credit and market risks, the amount of market risk capital charge (for both specific and general market risk) determined in accordance with APS 113 – Capital Adequacy: Market Risk must be adjusted by multiplying it by a constant factor of 12.5 (i.e. the reciprocal of the minimum capital ratio of 8 per cent) to obtain an equivalent risk-weighted exposure. The resulting figure is then added to the risk-weighted credit exposures, calculated in accordance with APS 112 – Capital Adequacy: Credit Risk, to derive the total risk-weighted exposures.
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Guidance Note
AGN 110.5 - Higher Minimum Ratios
1. In assessing an ADI’s overall capital adequacy at Level 1 and Level 2, APRA will take account of other risk factors that have not been incorporated or accounted for quantitatively in the risk-based capital adequacy framework to ensure that the minimum capital adequacy requirements for the ADI are broadly proportional to its overall risk profiles at Level 1 and Level 2. These factors include, for example, credit risk concentrations, profitability, liquidity, off-balance sheet exposures, concentration of particular types of assets or liabilities, operational risk and the effectiveness of the ADI’s management systems for monitoring and controlling risks.
2. APRA will consider the above factors in deciding how much capital an ADI needs to hold above the minimum 8 per cent requirement at Level 1 and/or Level 2. All newly established ADIs are generally subject to a higher minimum risk-based capital ratio, both at Level 1 and Level 2, in their formative years.
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Guidance Note
AGN 110.6 - Reductions in Capital
1. For the purpose of paragraph 10 of the Standard, a reduction in an ADI’s capital (whether at Level 1, 2 or 3) includes share buyback; redemption, repurchase or repayment of any qualifying Tier 1 and Tier 2 capital instruments issued by the ADI or by other entities included in the calculation of the ADI’s Level 2 or 3 capital adequacy; trading in the ADI’s own shares or capital instruments (refer paragraph 4 of AGN 111.4 – Capital Deductions); or where the ADI’s total servicing obligations on Tier 1 capital instruments exceed its after-tax earnings in the financial year to which they relate (refer paragraph 5 of APS 111 – Capital Adequacy: Measurement of Capital).
2. An ADI proposing a capital reduction (whether at Level 1, 2 or 3) should provide APRA with a relevant capital plan covering the respective level(s). The plan should extend for at least 2 years.
3. To obtain APRA’s approval for any proposed reduction in its capital (whether at Level 1, 2 or 3), an ADI will need to satisfy APRA that the ADI’s capital (at Level 1, 2 or 3 as appropriate) after the proposed reduction will remain adequate for its future needs.
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Prudential Standard
APS 111 - Capital Adequacy: Measurement
of Capital
Objective
This standard sets out the essential characteristics that an instrument must have to qualify as Tier 1 or Tier 2 (upper or lower) capital for inclusion in an ADI’s capital base for assessing Level 1 (i.e. stand-alone) and Level 2 (i.e. the consolidated banking group) capital adequacy.
This standard forms part of a comprehensive set of prudential standards that deal with the measurement of an ADI’s capital adequacy at Level 1 and Level 2. It should be read in conjunction with: APS 110 – Capital Adequacy; APS 112 – Capital Adequacy: Credit Risk; APS 113 – Capital Adequacy: Market Risk; and APS 120 – Funds Management & Securitisation.
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Principles
Capital Base
1. APRA’s approach to the measurement of an ADI’s capital adequacy at Level 1 and Level 2 (as defined in APS 110 – Capital Adequacy) is based on the risk-based capital adequacy framework developed by the Basel Committee on Banking Supervision (see AGN 110.4 – Risk-based Capital Adequacy Framework). Under this framework, an ADI’s total qualifying capital at Level 1 (i.e. the stand-alone level) and Level 2 (i.e. the consolidated banking group level) is assessed in two tiers:
(a) Tier 1 capital
Tier 1 or core capital comprises the highest quality capital elements which fully satisfy all of the following essential characteristics:
(i) provide a permanent and unrestricted commitment of funds;
(ii) be freely available to absorb losses;
(iii) not impose any unavoidable servicing charge against earnings; and
(iv) rank behind the claims of depositors and other creditors in the event of winding-up.
(b) Tier 2 capital
Tier 2 or supplementary capital includes other elements which, to varying degrees, fall short of the quality of Tier 1 capital stated in paragraph 1(a) above but nonetheless contribute to the overall strength of an entity as a going concern, and is divided into:
(i) Upper Tier 2 capital – comprising elements that are essentially permanent in nature, including some forms of hybrid capital instruments which have the characteristics of both equity and debt; and
(ii) Lower Tier 2 capital – comprising instruments which are not permanent i.e. dated or limited life instruments.
2. For capital adequacy purposes, an ADI’s Level 1 and Level 2 capital base (i.e. the numerator of the risk-based capital ratio) is defined as the sum of Tier 1 and Tier 2 (upper and lower) capital, net of all specified deductions (see paragraphs 8 and 9 below) and amortisation (see AGN 111.2) where appropriate, at the respective level and subject to the various limits (see paragraph 11 below) that apply to the different tiers of capital.
3. In assessing whether an instrument is eligible as Tier 1 or Tier 2 (upper or lower) capital, APRA will have regard to both the form and substance of the instrument. An ADI should consult APRA in advance of issuance of any capital instrument other than ordinary shares (whether to be issued directly by the ADI or by any entity at Level 2, or indirectly through a special purpose vehicle) to ensure its eligibility for inclusion in the ADI’s Level 1 or Level 2 capital base.
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Tier 1 Capital
4. For the purposes of calculating an ADI’s capital base at Level 1 and Level 2 (see paragraph 2 above), Tier 1 capital consists of:
(a) paid-up ordinary shares;
(b) general reserves;
(c) retained earnings;
(d) current year’s earnings net of expected dividends and tax expenses;
(e) minority interests arising from consolidation of Tier 1 capital of subsidiaries (only for Level 2 calculations);
(f) non-cumulative irredeemable preference shares approved by APRA (see AGN 111.1); and
(g) other innovative capital instruments (issued through special purpose vehicles) approved by APRA (see AGN 111.1 and AGN 111.3).
5. Unless otherwise approved by APRA (see paragraph 3 of AGN 111.1), an ADI’s total servicing obligations on Tier 1 capital instruments must not exceed the ADI’s after-tax earnings in the financial year to which they relate. That is, there should be no dividend or interest payments out of retained earnings without APRA’s prior approval.
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Tier 2 Capital
6. For the purposes of calculating an ADI’s capital base at Level 1 and Level 2 (see paragraph 2 above), Upper Tier 2 capital (see AGN 111.2) consists of:
(a) revaluation reserves of premises and securities;
(b) general provisions for doubtful debts (limited to a maximum of 1.25 per cent of total risk-weighted exposures);
(c) cumulative irredeemable preference shares approved by APRA;
(d) mandatory convertible notes and similar capital instruments approved by APRA;
(e) perpetual subordinated debt approved by APRA; and
(f) any other hybrid (debt/equity) capital instruments of a permanent nature approved by APRA, including any capital amounts that are ineligible for inclusion as Tier 1 capital as a result of the limit referred to in paragraph 11(a)(i) below.
7. For the purposes of calculating an ADI’s capital base at Level 1 and Level 2 (see paragraph 2 above), Lower Tier 2 capital (see AGN 111.2) consists of:
(a) term subordinated debt approved by APRA;
(b) limited life redeemable preference shares approved by APRA; and
(c) any other similar limited life capital instruments approved by APRA.
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Deductions
8. In calculating an ADI’s Level 1 (stand-alone) capital base (see paragraph 2 above), the following items are deducted (see AGN 111.4):
from Tier 1 capital
(a) intangible assets, including the intangible component of investments (e.g. purchased goodwill) in subsidiaries and other entities;
(b) future income tax benefits (other than those associated with general provisions for doubtful debts);
(c) all holdings of own Tier 1 capital instruments and any unused trading limit agreed with APRA;
(d) equity and other capital investments in associated (e.g. captive) lenders mortgage insurers;
(e) equity investments in non-subsidiary entities that are not operating in the field of finance in excess of:
(i) 0.25 per cent of the ADI’s Level 2 Tier 1 capital for an individual investment; or
(ii) 5 per cent of the ADI’s Level 2 Tier 1 capital in aggregate;
from Upper or Lower Tier 2 capital as appropriate
(f) all holdings of own Upper and Lower Tier 2 capital instruments and any unused trading limit agreed with APRA;
from Total Capital (i.e. the sum of Tier 1 and Tier 2 capital after deductions and amortisation)
(g) equity and other capital investments in other ADIs or equivalent overseas deposit-taking institutions (and their subsidiaries), except where:
(i) that other ADI or equivalent overseas deposit-taking institution is wholly owned or effectively controlled (whether directly or indirectly) by the ADI, and has been consolidated with the ADI at Level 2 for capital adequacy purposes; or
(ii) that other ADI’s or equivalent overseas deposit-taking institution’s capital instruments are held for trading purposes which, in this case, must be included in the ADI’s total risk-weighted exposures in accordance with APS 113 – Capital Adequacy: Market Risk;
(h) equity and other capital investments in authorised non-operating holding companies of ADIs unless these are held for trading purposes in which case they will be included in the ADI’s total risk-weighted exposures in accordance with APS 113 – Capital Adequacy: Market Risk;
(i) any credit support of a capital nature provided to other entities, such as provision of a first loss guarantee, including any undertakings by the ADI to absorb designated first level of losses on claims supported by it (first loss facilities associated with funds management and the securitisation of assets should be deducted in accordance with the requirements set out in APS 120 – Funds Management & Securitisation); and
(j) any non-repayable loans advanced by the ADI under APRA’s certified industry support arrangements.
9. In calculating an ADI’s Level 2 (consolidated group) capital base (see paragraph 2 above), the following items are deducted (see AGN 111.4):
from Tier 1 capital
(a) goodwill and other intangible assets, including the intangible component of investments (e.g. purchased goodwill) in non-consolidated subsidiaries (see AGN 110.2 – Non-consolidated Subsidiaries) and other entities that do not form part of the consolidated banking group at Level 2;
(b) future income tax benefits (other than those associated with general provisions for doubtful debts);
(c) all holdings of own Tier 1 capital instruments and any unused trading limit agreed with APRA;
(d) equity and other capital investments in non-consolidated captive lenders mortgage insurers (see AGN 110.2 – Non-consolidated Subsidiaries);
(e) equity investments in non-subsidiary entities that are not operating in the field of finance in excess of:
(i) 0.25 per cent of the ADI’s Level 2 Tier 1 capital for an individual investment; or
(ii) 5 per cent of the ADI’s Level 2 Tier 1 capital in aggregate;
from Upper or Lower Tier 2 capital as appropriate
(f) all holdings of own Upper and Lower Tier 2 capital instruments and any unused trading limit agreed with APRA;
from Total Capital (i.e. the sum of Tier 1 and Tier 2 capital after deductions and amortisation)
(g) equity and other capital investments in other ADIs or equivalent overseas deposit-taking institutions (and their subsidiaries) unless these are held for trading purposes in which case they will be included in the ADI’s total risk-weighted exposures in accordance with APS 113 – Capital Adequacy: Market Risk;
(h) equity and other capital investments in authorised non-operating holding companies of ADIs unless these are held for trading purposes in which case they will be included in the ADI’s total risk-weighted exposures in accordance with APS 113 – Capital Adequacy: Market Risk;
(i) equity and other capital investments in non-consolidated subsidiaries or controlled entities (other than captive lenders mortgage insurers) after any intangible component of the investment is deducted from Tier 1 capital as per item (a) above (see AGN 110.2 – Non-consolidated Subsidiaries);
(j) any credit support of a capital nature provided to other entities that do not form part of the consolidated banking group at Level 2, such as provision of a first loss guarantee, including any undertakings by the ADI or by any entity consolidated at Level 2 to absorb designated first level of losses on claims supported by them (first loss facilities associated with funds management and the securitisation of assets should be deducted in accordance with the requirements set out in APS 120 – Funds Management & Securitisation); and
(k) any non-repayable loans advanced by the ADI under APRA’s certified industry support arrangements.
10. All deductions made at Level 1 or Level 2 (see paragraphs 8 and 9 above) are excluded from total assets when calculating an ADI’s total risk-weighted assets at the respective level (see paragraph 2 of AGN 112.1 Risk-Weighted On-Balance Sheet Credit Exposures).
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Limitations
11. The amount of Tier 1 and Tier 2 (upper and lower) capital included in an ADI’s Level 1 and Level 2 capital base are subject to the following limits:
(a) Tier 1 capital
(i) A capital instrument is not eligible for inclusion in an ADI’s Tier 1 capital (before deductions), whether at Level 1 or Level 2, to the extent that its inclusion will result in the aggregate amount of items (f) and (g) described in paragraph 4 above exceeding 25 per cent of the sum of all the other Tier 1 capital components listed in paragraph 4 (i.e. items (a) to (e)). Any excess amount ineligible for inclusion as Tier 1 capital as a result of this limit will be eligible for inclusion as Upper Tier 2 capital.
(ii) Total Tier 1 capital (net of all specified deductions) must constitute at least 50 per cent of an ADI’s capital base, both at Level 1 and Level 2 (except in the formative years of mutually owned ADIs as approved by APRA).
(b) Tier 2 (upper and lower) capital
(i) Total Tier 2 capital (net of all specified deductions and amortisation) at Level 1 and Level 2 is limited to a maximum of 100 per cent of an ADI’s total Tier 1 capital (net of all specified deductions) at the respective level (except in the formative years of mutually owned ADIs as approved by APRA).
(ii) Total Lower Tier 2 capital (net of all specified deductions and amortisation) at Level 1 and Level 2 is limited to a maximum of 50 per cent of an ADI’s total Tier 1 capital (net of all specified deductions) at the respective level (except in the formative years of mutually owned ADIs as approved by APRA).
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Guidance Note
AGN 111.1 - Tier 1 Capital
Eligibility
1. To be included as Tier 1 capital at Level 1 or Level 2, capital instruments mentioned in items (f) and (g) of paragraph 4 of APS 111 must satisfy the following criteria:
(a) The instrument should normally take the form of shares unless otherwise agreed with APRA. It must be treated as equity under Australian Accounting Standards and be reported as such in the ADI’s published financial statements, except where an alternative treatment has been agreed with APRA.
(b) The instrument must be unsecured and fully paid up. Any partly paid issue is eligible only to the extent that it has been paid up. The proceeds of the issue (whether fully or partially paid up) must be immediately available to the issuer. Only the proceeds actually received from the issue are to be included.
(c) The instrument must be subordinated in right of repayment of principal and interest to all depositors and other creditors of the issuer. Issue documentation must clearly indicate this to prospective holders, and must preclude the exercise of any contractual rights of set-off between the instrument and any claims by the issuer on the holders of the instrument. Issue documentation must also clearly indicate that the instrument does not represent a deposit liability of an ADI.
(d) The instrument must have no maturity. It must not be redeemable at the initiative of the holder nor must it carry any other provision which requires future redemption by the issuer. The instrument may, however, be redeemable at the option of the issuer. Where the instrument offers a redemption option to the issuer, issue documentation must give clear and prominent notice to prospective investors that the issuer’s right to exercise any such option to redeem or purchase the instrument is subject to APRA’s prior approval.
(e) The instrument (including any unpaid dividends or interest) must be available to absorb losses incurred by the issuer in the ordinary course of business.
(f) The instrument must not provide for payment of any form of compensation to investors other than by way of a distribution of profits. Dividend (or interest) payments to the instrument must be non-cumulative. The issuer must be able to waive any dividend (or interest) payments on the instrument and alter the timing of payments. The instrument must not provide for the payment of a higher dividend (or interest) rate if dividend (or interest) payments are not made on time (nor a reduced interest rate if interest payments are made on time).
(g) The non-payment of a dividend (or interest) on the instrument must not trigger any restrictions on the issuer, other than the need to seek the holders’ approval before paying dividends on other shares, or purchasing shares (outside normal trading operations), or retiring shares.
(h) Adjustments to dividend (or interest) obligations on the instrument must not be linked to the credit standing of the issuer. This does not, however, preclude linking dividends (or interest) to movements in general market indices. The rate of dividends (or interest), or the formulae for calculating dividend (or interest) payments, must be fixed at the time of issuing the instrument and set out in the issue documentation.
(i) Where the instrument carries a “step-up” provision, the terms of the step-up must be limited, fixed at the time of issue and subject to APRA’s prior approval. “Step-ups” include the following events:
(i) a change in margin on a floating rate instrument;
(ii) a change in rate on a fixed rate instrument;
(iii) a conversion from fixed to floating rate or vice versa;
(iv) a switch in the basis index (e.g. from a 3-month to 6-month floating rate or from a 3-month LIBOR to a 3-month BBSW).
(j) The size of any proposed step-up should be modest and in line with market terms and conditions. Any increase should come within one of the following measures:
(i) 100 basis points, less the swap spread between the initial basis index and the stepped-up basis index; or
(ii) 50 per cent of the initial credit spread, less the swap spread between the initial basis index and the stepped-up basis index.
The issue documentation should specify one of the above two measures to apply to the instrument; switching between measures is not allowed.
Where the step-up involves a conversion from fixed to floating rate (or vice versa) or a switch in basis index, the swap spread should be fixed at pricing date, reflecting the differential in pricing between the indices at the time.
(k) Any step-up provision must not be operative within the first 10 years from drawdown. The rule is for one step-up over the life of the instrument. Exceptions to allow step-ups to be undertaken on multiple occasions (and/or for variable amounts) may be approved by APRA at the time of issuing the instrument.
(l) Where the instrument provides for a mandatory conversion or an option to the holders or the issuer to convert into another form of eligible Tier 1 capital instrument, it must not contain any conversion feature that effectively provides for a return of capital or compensation for unpaid dividends (or interest). The rate of conversion must be fixed (e.g. by way of a formulae) at the time of subscription to the instrument.
(m) Where an instrument provides for dividend (or interest) payments to be reset, and coincides with an option conferred on the issuer to redeem the instrument, this should not have the effect of signalling to investors an expectation that the instrument is likely to be redeemed. Should this occur, APRA will consider the instrument to be a dated instrument and ineligible for inclusion as Tier 1 capital.
(n) The instrument should not include any “repackaging” arrangements with the effect of compromising the permanency of capital raised.
(o) The instrument must not contain any terms or restrictions that could adversely inhibit the issuer’s ability to be managed in a sound and prudent manner (particularly in times of financial difficulty), or restrict APRA’s ability to resolve any problems encountered by the issuer (e.g. clauses preventing further senior debt issues).
(p) Where the instrument is subject to the laws of a jurisdiction other than Australia or its territories, an ADI must ensure that the instrument satisfy the above criteria under the laws of that jurisdiction. This is particularly relevant, for example, in the case of corporate insolvency law, which may vary across jurisdictions. APRA may, where necessary, require an ADI to provide confirmation from its legal advisers to this effect.
(q) Any subsequent modification of the terms or conditions of the instrument, which impact on its eligibility to continue qualifying as Tier 1 capital, must be subject to APRA’s prior consent.
(r) An ADI is required to provide APRA with copies of documentation associated with the issue of the instrument. Where the terms of an issue depart from established precedent, ADIs should consult APRA prior to issue.
2. Capital instruments issued through special purpose vehicles must also meet the criteria set out in AGN 111.3.
3. Although APRA limits an ADI’s total servicing obligations on Tier 1 capital instruments to a maximum of its after-tax earnings in the financial year to which they relate (refer paragraph 5 of the Standard), it is prepared to modify this requirement on a case-by-case basis depending on circumstances at the time of payment. APRA will assess whether the proposed level of dividend or interest payments is justified by reference to other considerations, such as an ADI’s on-going capital position, commitments to raise capital and core profitability.
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Guidance Note
AGN 111.2 - Tier 2 Capital
Upper Tier 2 Capital
Asset Revaluation Reserves
1. Reserves arising from the revaluation of premises are to be included in Upper Tier 2 capital subject to the following conditions:
(a) the premises must be owned by an ADI or one of the entities at Level 2;
(b) the reserves must be shown as a component of equity in the statement of financial position;
(c) the revaluations are conducted regularly and subject to audit review consistent with the Australian Accounting Standards (AASB 1010 and AASB 1041) and auditing practice; and
(d) the amount of reserves to be included in Upper Tier 2 capital must incorporate the full effect of any diminution in the values of premises (i.e. net of any devaluations), and should be after allowance for expected realisation costs and associated taxes.
2. To be eligible for inclusion in Upper Tier 2 capital, revaluation reserves of quoted, readily marketable securities must satisfy the following conditions:
(a) the securities must be directly held by an ADI or one of the entities at Level 2;
(b) the reserves must be shown as a component of equity in the statement of financial position;
(c) the reserves must incorporate the amount of any diminution in the values of the securities (i.e. net of devaluations); and
(d) only 45 per cent of the net revaluation surplus (net of devaluations) can be included in Upper Tier 2 capital.
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General Provisions for Doubtful Debts
3. The amount of general provisions for doubtful debts to be included in Upper Tier 2 capital should be net of any associated future income tax benefits on a gross basis, and is limited to a maximum of 1.25 per cent of total risk-weighted exposures (see AGN 110.4 – Risk-based Capital Adequacy Framework).
4. The amount of provisions included must be created against future, presently unidentified losses and must be freely available to meet any losses that may subsequently materialise. Any general provisions created against specific or identified losses and against identified deterioration in the value of particular assets, whether individual or grouped, foreign or domestic, are not eligible for inclusion in Upper Tier 2 capital.
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Hybrid Capital Instruments
5. Hybrid debt/equity instruments must satisfy the following criteria to be eligible as Upper Tier 2 capital:
(a) The instrument must be unsecured and fully paid up. Any partly paid issue is eligible only to the extent that it has been paid up. The proceeds of the issue (whether fully or partially paid up) must be immediately available to the issuer. Only the proceeds actually received from the issue are to be included.
(b) The instrument must be subordinated in right of repayment of principal and interest to all depositors and other creditors of the issuer, except those creditors (not depositors) expressed to rank equally with or behind the holders of the instrument. Issue documentation must clearly indicate this to prospective holders, and must preclude the exercise of any contractual rights of set-off between the instrument and any claims by the issuer on the holders of the instrument. Issue documentation must also clearly indicate that the instrument does not represent a deposit liability of an ADI.
(c) The instrument must have no maturity. It must not be redeemable at the initiative of the holder nor must it carry any other provision which requires future redemption by the issuer. The instrument may, however, be redeemable at the option of the issuer. Where the instrument offers a redemption option to the issuer, issue documentation must give clear and prominent notice to prospective investors that the issuer’s right to exercise any such option to repay, purchase or otherwise redeem the instrument is subject to APRA’s prior approval.
(d) The instrument (including any unpaid dividends or interest) must be available to participate in losses without the issuer being obliged to cease trading. This can be achieved either by conversion into ordinary shares or by treating the instrument as a class of share capital in the event that the issuer’s retained earnings become negative. Where the instrument provides for an automatic conversion into ordinary shares (including any unpaid interest), the rate of conversion must be fixed (e.g. by way of a formulae) at the time of subscription to the instrument. Alternatively, the instrument can provide for principal and unpaid interest to be treated as if it constituted a specific class of share capital of the issuer. Issue documentation must disclose to prospective investors the manner by which the instrument is to be treated in a loss situation.
(e) The instrument must not provide for payment of any form of compensation to investors other than by way of a distribution of profits. The instrument must allow the issuer an option to defer servicing obligations where profitability does not justify a dividend or interest payment. Although any unpaid dividends or interest can be accumulated, they must not be compounded. The instrument must not provide for the payment of a higher dividend (or interest) rate if dividend (or interest) payments are not made on time (nor a reduced interest rate if interest payments are made on time).
(f) Where cumulative irredeemable preference shares do not provide the issuer with the option to defer or reduce dividends when profitability does not justify payment, such shares are to be treated as a Lower Tier 2 capital instrument.
(g) Adjustments to dividend (or interest) obligations on the instrument must not be linked to the credit standing of the issuer. This does not, however, preclude linking dividends (or interest) to movements in general market indices. The rate of dividends (or interest), or the formulae for calculating dividend (or interest) payments, must be fixed at the time of issuing the instrument and set out in the issue documentation.
(h) Where the instrument carries a “step-up” provision, the terms of the step-up must be limited, fixed at the time of issue and subject to APRA’s prior approval. “Step-ups” include the following events:
(i) a change in margin on a floating rate instrument;
(ii) a change in rate on a fixed rate instrument;
(iii) a conversion from fixed to floating rate or vice versa;
(iv) a switch in the basis index (e.g. from a 3-month to 6-month floating rate or from a 3-month LIBOR to a 3-month BBSW).
(i) The size of any proposed step-up should be modest and in line with market terms and conditions. Any increase should come within one of the following measures:
(i) 100 basis points, less the swap spread between the initial basis index and the stepped-up basis index; or
(ii) 50 per cent of the initial credit spread, less the swap spread between the initial basis index and the stepped-up basis index.
The issue documentation should specify one of the above two measures to apply to the instrument; switching between measures is not allowed.
Where the step-up involves a conversion from fixed to floating rate (or vice versa) or a switch in basis index, the swap spread should be fixed at pricing date, reflecting the differential in pricing between the indices at the time.
(j) Any step-up provision must not be operative within the first 10 years from drawdown. The rule is for one step-up over the life of the instrument. Exceptions to allow step-ups to be undertaken on multiple occasions (and/or for variable amounts) may be approved by APRA at the time of issuing the instrument.
(k) In the event that the issuer defaults under the terms of the instrument, remedies available to the holders should be limited to actions for specific performance, recovery of dividend or interest amounts currently outstanding, or the winding-up of the issuer.
(l) The instrument must not provide for any accelerated repayment of principal, except in the event of liquidation or winding-up of the issuer. The winding-up must be irrevocable i.e. either by way of a court order or an effective resolution by shareholders or members. The making of an application to wind-up, or the appointment of a receiver, administrator, or official with similar powers (including the exercise of APRA’s powers under section 13A(1) of the Banking Act) are not sufficient to accelerate repayment of the instrument.
(m) Where the instrument carries a right or obligation to convert into share capital of the issuer, the conversion provisions must not be structured to provide a redemption or return of the original investment or any compensation for unpaid dividends or interest to the holders. The rate of conversion must be fixed (e.g. by way of a formulae) at the time of subscription to the instrument.
(n) Where an instrument provides for dividend (or interest) payments to be reset, and coincides with an option conferred on the issuer to redeem the instrument, this should not have the effect of signalling to investors an expectation that the instrument is likely to be redeemed. Should this occur, APRA will consider the instrument to be a dated instrument and ineligible for inclusion as Upper Tier 2 capital.
(o) The instrument should not include any “repackaging” arrangements with the effect of compromising the permanency of capital raised.
(p) The instrument must not contain any terms, covenants or restrictions that could adversely inhibit the issuer’s ability to be managed in a sound and prudent manner (particularly in times of financial difficulty), or restrict APRA’s ability to resolve any problems encountered by the issuer (e.g. clauses preventing further senior debt issues).
(q) Where the instrument is subject to the laws of a jurisdiction other than Australia or its territories, an ADI must ensure that the instrument satisfy the above criteria under the laws of that jurisdiction. This is particularly relevant, for example, in the case of corporate insolvency law, which may vary across jurisdictions. APRA may, where necessary, require an ADI to provide confirmation from its legal advisers to this effect.
(r) Any subsequent modification of the terms or conditions of the instrument, which impact on its eligibility to continue qualifying as Upper Tier 2 capital, must be subject to APRA’s prior consent.
(s) An ADI is required to provide APRA with copies of documentation associated with the issue of the instrument. Where the terms of an issue depart from established precedent, ADIs should consult APRA prior to issue.
6. Instruments issued through special purpose vehicles must also satisfy the qualifying criteria set out in AGN 111.3.
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Lower Tier 2 Capital
7. Lower Tier 2 capital instruments must satisfy the following criteria:
(a) The instrument must be unsecured and fully paid up. Any partly paid issue is eligible only to the extent that it has been paid up. The proceeds of the issue (whether fully or partially paid up) must be immediately available to the issuer. Only the proceeds actually received from the issue are to be included.
(b) The instrument must be subordinated in right of repayment of principal and interest to all depositors and other creditors of the issuer, except those creditors (not depositors) expressed to rank equally with or behind the holders of the instrument. Issue documentation must clearly indicate this to prospective holders, and must preclude the exercise of any contractual rights of set-off between the instrument and any claims by the issuer on the holders of the instrument. Issue documentation must also clearly indicate that the instrument does not represent a deposit liability of an ADI.
(c) The instrument must have a minimum term of 5 years. Where the instrument is drawn down in a series of tranches, the minimum original maturity of each tranche must be 5 years from the date of drawdown.
(d) The amount of the instrument eligible for inclusion in Lower Tier 2 capital is to be amortised on a straight line basis at a rate of 20 per cent per annum over the last 4 years to maturity as follows:
| Years to Maturity | Amount Eligible for Inclusion in Lower Tier 2 Capital |
| More than 4 | 100 per cent |
| Less than and including 4 but more than 3 | 80 per cent |
| Less than and including 3 but more than 2 | 60 per cent |
| Less than and including 2 but more than 1 | 40 per cent |
| Less than and including 1 | 20 per cent |
(e) Where the instrument provides holders with the right or option to demand repayment prior to maturity, the first possible repayment date should be regarded as the effective maturity date of the instrument.
(f) Where the instrument offers the issuer a redemption option prior to maturity, issue documentation must give clear and prominent notice to prospective investors that the issuer’s right to exercise any such option to repay, purchase, or otherwise redeem the instrument is subject to APRA’s prior approval.
(g) The instrument must not provide for the payment of a higher dividend or interest rate if dividend or interest payments are not made on time (nor a reduced rate of interest if interest payments are made on time).
(h) Adjustments to dividend (or interest) obligations on the instrument must not be linked to the credit standing of the issuer. This does not, however, preclude linking dividends (or interest) to movements in general market indices. The rate of dividends (or interest), or the formulae for calculating dividend (or interest) payments, must be fixed at the time of issuing the instrument and set out in the issue documentation.
(i) Where the instrument carries a “step-up” provision, the terms of the step-up must be limited, fixed at the time of issue and subject to APRA’s prior approval. “Step-ups” include the following events:
(i) a change in margin on a floating rate instrument;
(ii) a change in rate on a fixed rate instrument;
(iii) a conversion from fixed to floating rate or vice versa;
(iv) a switch in the basis index (e.g. from a 3-month to 6-month floating rate or from a 3-month LIBOR to a 3-month BBSW).
(j) The size of any proposed step-up should be modest and in line with market terms and conditions. Any increase should come within one of the following measures:
(i) 50 basis points, less the swap spread between the initial basis index and the stepped-up basis index, for an issue with a maturity up to 10 years;
(ii) 100 basis points, less the swap spread between the initial basis index and the stepped-up basis index, for an issue with a maturity of more than 10 years; or
(iii) 50 per cent of the initial credit spread, less the swap spread between the initial basis index and the stepped-up basis index.
The issue documentation should specify one of the above three measures to apply to the instrument; switching between measures is not allowed.
Where the step-up involves a conversion from fixed to floating rate (or vice versa) or a switch in basis index, the swap spread should be fixed at pricing date, reflecting the differential in pricing between the indices at the time.
(k) Any step-up provision must not be operative within the first 5 years from drawdown. The rule is for one step-up over the life of the instrument. Exceptions to allow step-ups to be undertaken on multiple occasions (and/or for variable amounts) may be approved by APRA at the time of issuing the instrument.
(l) In the event that the issuer defaults under the terms of the instrument, remedies available to the holders should be limited to actions for specific performance, recovery of amounts currently outstanding (i.e. overdue interest and principal on maturity provided the issuer can make such payments and remain solvent) or the winding-up of the issuer.
(m) The instrument must not provide for any accelerated repayment of principal, except in the event of liquidation or winding-up of the issuer. The winding-up must be irrevocable i.e. either by way of a court order or an effective resolution by shareholders or members. The making of an application to wind-up, or the appointment of a receiver, administrator, or official with similar powers (including the exercise of APRA’s powers under section 13A(1) of the Banking Act) are not sufficient to accelerate repayment of the instrument.
(n) Where an instrument provides for dividend (or interest) payments to be reset with a significant step-up, and coincides with an option conferred on the issuer to redeem the instrument, the instrument will be deemed to mature on the date at which the step-up provisions take effect. Where that date is less than 5 years from the date of drawdown, the instrument is not eligible for inclusion in Lower Tier 2 capital.
(o) The instrument must not contain any terms, covenants or restrictions that could adversely inhibit the issuer’s ability to be managed in a sound and prudent manner (particularly in times of financial difficulty), or restrict APRA’s ability to resolve any problems encountered by the issuer (e.g. clauses preventing further senior debt issues).
(p) Where the instrument is subject to the laws of a jurisdiction other than Australia or its territories, an ADI must ensure that the instrument satisfy the above criteria under the laws of that jurisdiction. This is particularly relevant, for example, in the case of corporate insolvency law, which may vary across jurisdictions. APRA may, where necessary, require an ADI to provide confirmation from its legal advisers to this effect.
(q) Any subsequent modification of the terms or conditions of the instrument, which impact on its eligibility to continue qualifying as Lower Tier 2 capital, must be subject to APRA’s prior consent.
(r) An ADI is required to provide APRA with copies of documentation associated with the issue of the instrument. Where the terms of an issue depart from established precedent, ADIs should consult APRA prior to issue.
8. Instruments issued through special purpose vehicles must also satisfy the qualifying criteria set out in AGN 111.3.
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Guidance Note
AGN 111.3 - Criteria for Capital Issues
Involving Use of Special Purpose Vehicles
(SPVs)
Capital instruments issued through SPVs must satisfy the following:
1. The SPV issuing the instrument must be a single purpose non-operating entity established for the sole purpose of raising capital for the ADI or for a consolidated subsidiary of the ADI. The SPV should have no liabilities outside the capital instrument it issues, and its assets should not exceed materially the amount of the capital instrument issued. The SPV must not be able to operate independently of the ADI or its relevant subsidiary.
2. The proceeds of the instrument issued by the SPV must be fully invested in the capital instrument issued by the ADI or its relevant subsidiary. The proceeds must flow immediately into the ADI or its relevant subsidiary.
3. The terms and conditions of the instrument issued by the ADI or its relevant subsidiary must mirror substantially those included in the instrument issued by the SPV. Essentially, both instruments must be unsecured, fully paid up (any partly paid issue is eligible only to the extent that it has been paid up) and subordinated to all depositors and other creditors of the ADI or its relevant subsidiary. They must have the same maturity.
4. To satisfy the essential characteristic of loss absorption for Tier 1 and Upper Tier 2 capital instruments and to activate this loss absorption ability well before any serious deterioration in the ADI’s financial position, the instrument issued by the SPV must permit the absorption of losses in the event of any of the following:
(a) APRA determines in writing that the ADI has a Tier 1 capital ratio of less than 5 per cent or a capital ratio of less than 8 per cent at Level 1 and/or Level 2;
(b) APRA issues a written directive to the ADI under section 11CA of the Banking Act 1959 for the ADI to increase its capital;
(c) APRA appoints a statutory manager to the ADI pursuant to sub-section 13A(1) of the Banking Act or proceedings are commenced for the winding-up of the ADI; or
(d) retained earnings have become negative.
5. Unless otherwise agreed with APRA, the mechanism used to satisfy the loss absorption requirement in paragraph 4 above should be mandatory conversion into ordinary shares or non-cumulative irredeemable preference shares of the ADI or its relevant subsidiary as appropriate. The rate of conversion must be fixed (e.g. by way of a formulae) at the time of subscription to the instrument. The ADI or its relevant subsidiary should maintain a sufficient margin of authorised but unissued share capital to enable such conversion to take place at any time.
6. The instrument issued by the SPV must not be covered by a guarantee of the issuer or related entity or any other arrangement that legally or economically enhances the seniority of the holders vis-à-vis depositors, other creditors and subordinated debt holders of the ADI or its relevant subsidiary.
7. The main features of the instrument issued by the SPV and the structure of the issue must be transparent and easily understood by investors. An issue is not eligible for inclusion in an ADI’s capital base at Level 1 or Level 2 where the complexity of its structure raises doubt over the legal and regulatory risk associated with it.
8. The key features of Tier 1, Upper or Lower Tier 2 capital instrument issued by the SPV should be disclosed in the ADI’s published annual accounts. This includes:
(a) the name of the entity issuing the instrument and the name of the entity receiving the ultimate proceeds of the issue;
(b) the amount and currency denomination of the instrument;
(c) the jurisdiction in which the instrument was issued and other jurisdictions whose laws might apply;
(d) the dividend (or interest) rate payable on the instrument, including any provisions for step-up or supplementary dividends (where the instrument pays a participating dividend based on dividends paid on ordinary shares, the formulae for calculating payments should be set out);
(e) any provisions for the exercise of call options or triggering conversion of the instrument; and
(f) the triggers and mechanisms used to achieve loss absorption.
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Guidance Note
AGN 111.4 - Capital Deductions
1. The amount of future income tax benefits (other than those associated with general provisions for doubtful debts) to be deducted from an ADI’s Tier 1 capital at Level 1 and Level 2 should be net of any provision for deferred income tax liabilities. Where the provision for deferred income tax liabilities exceeds the amount of future income tax benefits, the excess cannot be added to Tier 1 capital (i.e. the net deduction is zero).
2. For the purposes of paragraphs 8 and 9 of the Standard, the amount of equity investments to be deducted from capital is the book value of the investment, including any amount by which the investment has been revalued. Any intangible component of the investment (calculated as the excess of the purchase price over the net tangible assets acquired) must be deducted from Tier 1 capital.
3. Where any investments in non-consolidated subsidiaries (as listed in AGN 110.2 – Non-consolidated Subsidiaries) have been incorporated for accounting purposes into the ADI’s consolidated group accounts, the consolidation of these entities should be reversed prior to the calculation of the risk-based capital ratio at Level 2. That is, any retained earnings, other reserves or minority interests of these entities included in the consolidated group’s Tier 1 capital as a result of the accounting consolidation should be removed from the group’s Tier 1 capital for capital adequacy purposes. Goodwill and any other intangible component of the investments must be deducted from the ADI’s Tier 1 capital at Level 2.
4. An ADI may, as a result of membership of a dealer panel, trading or other activities agreed with APRA, undertake limited purchases of its own Tier 1 and/or Tier 2 capital instruments (see AGN 110.6 – Reductions in Capital). Such purchases are subject to a limit agreed with APRA, with the amount equal to the limit (or alternatively any actual holdings plus unused limit) deducted from the ADI’s Tier 1, Upper or Lower Tier 2 capital as appropriate, both at Level 1 and Level 2.
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Prudential Standard
APS 221 - Large Exposures
Objective
This standard aims to ensure that ADIs implement proper measures and prudent limits to monitor and control their large exposures on both a stand-alone and group basis.
Note: Foreign ADIs (which have the same interpretation as in Division 1B of the Banking Act 1959) operating through branches in Australia are not subject to this Standard, except for the requirements set out in paragraphs 22 and 23 below.
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Principles
Control of Large Exposures and Risk Concentrations
1. ADIs are exposed to various forms of risk concentration with the potential to incur significant losses that could materially threaten the ADIs’ financial strength. Risk concentrations may arise from excessive exposures to individual counterparties, groups of related counterparties, groups of counterparties with similar characteristics (e.g. counterparties in specific geographical regions or industry sectors) or to particular asset classes (e.g. property holdings or other investments). Safeguarding against risk concentrations to particular counterparties, industries, countries and asset classes should form an essential component of ADIs’ risk management strategies.
2. The Board of an ADI is responsible for establishing, and monitoring compliance with, policies governing large exposures and risk concentrations of the ADI. The Board should ensure that these policies are reviewed regularly (at least annually) and that they remain adequate and appropriate for the ADI. Any material changes to established policies must be approved by the Board.
3. An ADI’s large exposures policy should, as a minimum, cover the following:
(a) exposure limits for:
(i) various types of counterparties (e.g. governments, ADIs and foreign equivalents, corporate and individual borrowers);
(ii) a group of related counterparties;
(iii) individual industry sectors (where applicable);
(iv) individual countries (where applicable); and
(v) various asset classes (e.g. property holdings and other investments, etc.)
that are commensurate with the ADI’s capital base and balance sheet size;
(b) the circumstances in which the above exposure limits may be exceeded and the authority required for approving such excesses (e.g. by the ADI’s Board or a board committee); and
(c) the procedures for identifying, reviewing, controlling and reporting large exposures of the ADI.
4. The Board and senior management of an ADI should ensure that:
(a) adequate systems and controls are in place to identify, measure, monitor and report large exposures and risk concentrations of the ADI in a timely manner; and
(b) large exposures and risk concentrations of the ADI are kept under regular review.
5. An ADI should, where appropriate, conduct stress testing and scenario analysis of its large exposures and risk concentrations to assess the impact of changes in market conditions or key risk factors (e.g. economic cycles, interest rate, liquidity conditions or other market movements) on its risk profile and earnings.
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Definitions
6. A large exposure is an exposure to a counterparty or a group of related counterparties which is greater than or equal to 10% of an ADI’s capital base.
7. An exposure to a counterparty or a group of related counterparties is the aggregate of all claims, commitments and contingent liabilities arising from on- and off-balance sheet transactions (in both the banking and trading books) with the counterparty or group of related counterparties, and
(a) includes (but is not limited to):
(i) outstanding balances of all loans and advances;
(ii) holdings of debt and/or equity securities;
(iii) all unused advised off-balance sheet commitments (refer Attachment A to AGN 112.2 for examples of these commitments), whether revocable or irrevocable; and
(iv) the credit equivalent amounts of all market-related contracts (calculated in accordance with AGN 112.2 or AGN 112.3 where netting applies);
(b) excludes:
(i) exposures (e.g. claims or equity investments) deducted from an ADI’s capital (see APS 111 – Capital Adequacy: Measurement of Capital);
(ii) exposures to the extent that they are secured by cash deposits (subject to satisfying the criteria set out in Attachment B to AGN 112.1 for the purpose of this Standard);
(iii) exposures to the extent that they are guaranteed by, or secured against securities issued by, governments or central banks (subject to satisfying the conditions set out in paragraphs 9, 12, 13, 14 and 15 of AGN 112.1 for the purpose of this Standard);
(iv) exposures arising in the course of settlement of market-related contracts;
(v) exposures to an ADI required as part of a liquidity support arrangement that has been certified by APRA under section 11CB of the Banking Act; and
(vi) exposures to the extent that they have been written off or specifically provided for.
8. A group of related counterparties should be deemed to exist where two or more individual counterparties are linked by:
(a) cross guarantees;
(b) common ownership or management;
(c) the ability to exercise control (defined in accordance with Australian accounting standards) over the other(s), whether direct or indirect;
(d) financial interdependency such that the financial soundness of any of them may affect the financial soundness of the other(s); or
(e) other connections or relationships which, according to an ADI’s assessment, identify the counterparties as constituting a single risk.
As a general rule, family members are not to be treated as connected where they have independent retail relationships with an ADI (although an ADI can choose to treat such exposures as connected should it consider appropriate to do so).
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Prudential Limits
9. The aggregate exposure of an ADI to a counterparty or a group of related counterparties is subject to the following limits:
(a) external parties (other than governments, central banks and ADIs or equivalent overseas deposit-taking institutions) unrelated to the ADI – 25% of capital base;
(b) unrelated ADI (or equivalent overseas deposit-taking institution) and its subsidiaries – 50% of capital base, with aggregate exposure to non-deposit-taking subsidiaries capped at 25% of capital base; and
(c) foreign parents and their subsidiaries – 50% of capital base, with aggregate exposure to non-deposit-taking subsidiaries capped at 25% of capital base.
10. Although certain types of exposure (e.g. settlement risk, exposure secured by eligible collateral) and counterparties (governments and central banks) are excluded from the above prescribed limits, these exposures are not risk free. ADIs should have adequate procedures and controls in place (e.g. by way of internal limits) to monitor these exposures.
11. ADIs should treat the 25% limit as the upper limit for an exposure to a non-government, non-ADI counterparty. APRA expects ADIs to establish lower internal limits to any non-government, non-ADI counterparty commensurate with their risk appetite.
12. Notwithstanding paragraph 9 above, APRA may (in writing) set specific limits on an ADI’s exposures to particular counterparties, groups of counterparties, industry sectors, countries or asset classes (including property holdings and any other investments) on a case-by-case basis, having regard to the ADI’s individual circumstances.
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Approval Requirements
13. An ADI must obtain APRA’s prior approval for any proposed exposures in excess of the prescribed limits set out in paragraph 9 or alternative limit determined under paragraph 12 above. Such approval will only be granted on an exceptional basis. The ADI concerned must be able to satisfy APRA why the proposed exposure(s) might reasonably be expected not to expose the ADI to excessive risk. APRA may impose a higher minimum capital ratio on the ADI at Level 1 and/or Level 2 (see APS 110 – Capital Adequacy) to compensate for the additional risk that may be associated with the proposed exposure(s).
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Notification Requirements
14. An ADI must notify APRA immediately of any breach of the prescribed limits under paragraph 9 or other specific limits imposed by APRA under paragraph 12 above, including remedial actions taken or planned to deal with the breach.
15. An ADI must inform APRA immediately where it has concerns that its large exposures or risk concentrations have the potential to impact materially upon its capital adequacy, along with proposed measures to address these concerns.
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Prior Consultation Requirements
16. An ADI must consult with APRA prior to committing to any proposed exposures to non-government, non-ADI counterparties in excess of 10% of its capital base.
17. APRA may (in writing) set a higher consultation threshold or waive the prior consultation requirements for individual ADIs where APRA is satisfied with the robustness of the ADI’s credit risk management systems and controls.
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Concentration of Risk
18. Where an ADI has a number of large exposures (excluding exposures set out in paragraph 7(b) above and any exposure to governments and central banks) or where in APRA’s opinion, the ADI is exposed to a significant level of risk concentration, APRA may require the ADI to maintain a higher capital ratio at Level 1 and/or Level 2 (see APS 110 – Capital Adequacy). In considering whether that ADI’s capital ratio should be increased, APRA will take account of the following factors:
(a) consistency with the ADI’s policy on large exposures and risk concentrations;
(b) the number of exposures, their individual size and nature; and
(c) the characteristics of the ADI, including the nature of its business and the experience of its management.
19. APRA may also direct an ADI to take measures to reduce its level of risk concentration.
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Reporting
20. An ADI must provide APRA each quarter (or more frequently if required by APRA) with information on its large exposures (including exposures to foreign parents and their subsidiaries where applicable) in a form to be determined by APRA from time to time.
21. Where necessary, APRA may impose additional reporting requirements on an ADI in relation to its large exposures and risk concentrations.
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Application to Foreign ADIs
22. This Standard does not apply to foreign ADIs in Australia which are subject to the consolidated supervision by their home country supervisors in respect of credit concentrations and large exposure limits. However, foreign ADIs should detail their large exposure and risk concentration policies as well as the relevant high level controls in the risk management systems descriptions required under APS 310 – Audit & Related Arrangements for Prudential Reporting. As part of its prudential oversight of the Australian operations of a foreign ADI, APRA may discuss with the foreign ADI’s parent and home supervisor any undue credit risk concentrations associated with the branch’s Australian activities.
23. Foreign ADIs are required to report quarterly to APRA (or more frequently if required by APRA) on the large exposures of their Australian operations in a form to be determined by APRA from time to time.
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Prudential Standard
APS 222 - Associations with Related Entities
Objective
This standard aims to ensure that ADIs take account of risks associated with the corporate group of which they are a member and are not exposed to excessive risk as a result of their associations and dealings with related entities.
Note: Foreign ADIs (which have the same interpretation as in Division 1B of the Banking Act 1959) operating through branches in Australia are not subject to this Standard, except for the requirements set out in paragraphs 16-26 and 34 below.
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Principles
Monitoring of Contagion Risk
1. Associations between an ADI and other members of a conglomerate group (defined in accordance with AGN 110.1 – Conglomerate Group for the purposes of this Standard) to which it belongs may give rise to the potential of contagion risk. That is, the possibility that problems arising in other group members may compromise the financial and operational position of the ADI. In assessing the level of risk of such associations, APRA will have regard to the following factors:
(a) the financial strength of the group;
(b) the nature of business conducted in group entities;
(c) the quality of management and systems and particularly, risk management across the group;
(d) the level of financial and operational interdependence across the group, particularly between regulated and unregulated entities;
(e) whether other members of the group are regulated entities (i.e. any entity directly regulated by APRA or by an equivalent banking, insurance or similar prudential regulator overseas) and the quality of regulation;
(f) the ratings (where applicable) of unregulated entities in the group;
(g) badging and product distribution arrangements which might link the ADI to the fortunes of other entities in the group; and
(h) other relevant factors to be considered on a case-by-case basis.
2. To ensure that contagion risk is kept at a modest level, an ADI should have adequate systems, policies and procedures in place to manage, monitor and control all forms of risks arising from the association beyond those arising from direct financial dealings with group members. The risks range from reputational risk and legal risk arising from the use of a common brand name (group badging), cross selling of products, or perception of support provided by an ADI to group members and vice versa, to operational risk arising from the use of common services provided by or to other group members.
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Group Risk Management[22]
3. For conglomerate groups headed by an ADI, the Board of the ADI is responsible for ensuring that comprehensive policies and procedures are in place to measure, manage, monitor and report overall risk at a group level. To ensure that existing Board-approved policies and the relevant controls remain adequate and appropriate for managing and monitoring overall group risk, the Board or a board committee should review them regularly (at least annually) to take account of changing risk profiles of group entities. Any material changes to group risk management policies must be approved by the Board.
4. The Board of an ADI should ensure that the ADI establishes appropriate policies, systems and procedures to monitor compliance with APRA’s prudential requirements on a group basis. To facilitate conglomerate group supervision by APRA, an ADI should:
(a) provide APRA with the following group information:
(i) details of group members (e.g. name, place of incorporation, board composition, nature of business and any other additional information required by APRA for a better understanding of the risk profiles of individual group members);
(ii) management structure of the group (including key risk management reporting lines);
(iii) intra-group support arrangements (e.g. a specific guarantee of the obligations of an entity in the group);
(iv) intra-group exposures (see paragraph 13 below); and
(v) other information as required by APRA from time to time for effective supervision of the group;
(b) notify APRA immediately after it becomes aware of any breach of a prudential standard requirement or a condition of a banking authority (whether by an ADI in the group or by the group) and of any circumstances that might reasonably be seen as having a material impact and potentially adverse consequences for an ADI in the group or for the overall group;
(c) advise APRA in advance of any proposed changes to the composition or operations of the group with the potential to materially alter the group’s overall risk profile (this should include any proposed changes to the ADI’s stand-alone operations); and
(d) obtain APRA’s prior approval for the establishment or acquisition of a regulated presence domestically or overseas.
5. An ADI is required to provide APRA with descriptions of its group risk management policies and the procedures used to measure and control overall group risk (including any material changes thereto). The ADI should, as best practice, disclose in the group’s full published annual report each year an outline of its group risk management policies, including the policies governing dealings between the ADI and other group members.
6. Within 3 months of an ADI’s annual balance date, its chief executive should provide APRA with a declaration, endorsed by the Board, which attests that:
(a) the Board and management of the ADI have identified the key risks facing the overall group;
(b) the Board and management of the ADI have established policies addressing those risks (including where appropriate prudent limits on risk exposures) and have systems and procedures in place to monitor and manage those risks;
(c) these policies have been effectively implemented and are adequate having regard to the risks they are designed to control; and
(d) the descriptions of group risk management policies, systems and procedures provided to APRA are accurate and current.
7. If an ADI feels it needs to qualify the declaration prescribed in paragraph 6 above, it would need to explain the reasons for the qualifications, as well as provide plans for corrective action.
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Dealings with Related Entities
8. For the purpose of this Standard, all entities controlled (whether directly or indirectly) by an ADI (other than subsidiaries that form part of the “Extended Licensed Entity”), or by the ultimate domestic parent of an ADI (including the parent entity itself) represent a “related entity” of an ADI. Consistent with the definition 0of a conglomerate group set out in AGN 110.1, a “related entity” excludes the foreign parent(s) of an ADI, the foreign parent’s overseas based subsidiaries and their directly owned non-ADI entities operating in Australia. Where appropriate, APRA may deem that other entities (and their subsidiaries) represent a “related entity” of an ADI.
9. The Board of an ADI should establish, and monitor compliance with, policies governing all dealings with related entities. The policies, including any material changes thereto, should be provided to APRA.
10. Board policies on related entity dealings should, at a minimum, include:
(a) a requirement that the ADI should address risks arising from dealings with related entities as strictly as it would address its risk exposures to unrelated entities (see paragraph 11 below);
(b) prudent limits on exposures to related entities at both an individual and aggregate level (see paragraph 13 below);
(c) procedures for resolving any conflict of interest arising from such dealings;
(d) requirements relating to exposures generated from an ADI’s participation in group operations (see paragraphs 23 to 26 below); and
(e) requirements relating to the transparency of third-party dealings associated with related entities.
(As a general rule, an ADI should not undertake any third-party dealings with the prime purpose of supporting the business of related entities.)
11. Where the terms and conditions applying to an ADI’s dealings with related entities are inconsistent with the benchmark for unrelated entities, they must be approved by the Board of the ADI with justifications fully and clearly documented in a register for inspection by APRA at any time.
12. As a general rule, an ADI should not:
(a) hold unlimited exposures to related entities either in aggregate or at an individual entity level (e.g. a general guarantee of the obligations of a related entity); or
(b) enter into cross-default clauses whereby a default by a related entity on an obligation (whether financial or otherwise) is deemed to trigger a default of the ADI in its obligations.
13. In determining limits on acceptable levels of exposure to related entities, the Board of an ADI should have regard to:
(a) the level of exposures which would be approved for unrelated entities of broadly equivalent credit status; and
(b) the impact on the ADI’s stand-alone capital and liquidity positions, as well as its ability to continue operating, in the event of a failure of any related entity to which the ADI is exposed.
14. An ADI must satisfy APRA that it has adequate systems and controls in place for identifying, reviewing, monitoring and managing exposures arising from dealings with related entities. APRA may require an ADI to put in place additional internal controls, a more robust reporting mechanism and/or to maintain a higher capital ratio if it is not satisfied with the adequacy of the ADI’s systems and controls.
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Provision of Support
15. An ADI may provide support to related entities (and vice versa) provided such support is undertaken in accordance with the prudential requirements set out in paragraphs 10 to 13 above in relation to the policies governing an ADI’s dealings with related entities. An ADI must avoid giving any impression of ADI support unless there are formal legal arrangements in place providing for such support.
16. A foreign ADI may provide support to its subsidiaries operating in Australia (and vice versa). However, it must avoid giving any impression of support to these subsidiaries unless there are formal legal arrangements in place providing for such support. Where a foreign ADI wishes to give a general guarantee to its Australian subsidiaries, it should be able to demonstrate to APRA that the home supervisor is aware of the obligations and has no objection to the transaction.
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Group Badging[28]
17. An ADI and other members in the conglomerate group to which it belongs may use a common brand name provided:
(a) section 66 of the Banking Act 1959 governing the use of restricted expressions in Australia by an ADI or by any other person is complied with; and
(b) the roles and responsibilities of different group members are clearly disclosed (see paragraph 19 below) to reduce the possibility of creating an impression that a non-ADI member of the group is an ADI, or that (contrary to the legal position) a group member is guaranteed or supported by an ADI in the group.
18. APRA may require an entity not to use a particular brand name if that would give rise to a prudential concern having regard to the following factors:
(a) the presence of appropriate disclosures;
(b) the type of entities involved (whether regulated or unregulated);
(c) the manner in which various products and services are marketed; and
(d) the types of customers involved.
19. To enable counterparties to clearly distinguish dealings with an ADI and those with other non-ADI group entities, the ADI should ensure that financial transactions (e.g. sales of financial products) between unregulated group members and external counterparties are accompanied by clear, comprehensive and prominent disclosure that:
(a) the group member with whom the counterparty is dealing is not an ADI and that the member’s obligations do not represent deposits or other liabilities of the ADI in the group; and
(b) the ADI does not stand behind the group member, unless support is provided for in a formal legal agreement (see paragraphs 15 and 16 above). The nature and limit of such support should also be prominently disclosed where appropriate.
20. For group members involved in funds management and securitisation, prudential requirements in relation to disclosure and separation are set out in APS 120 – Funds Management & Securitisation.
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Distribution of Products
21. Where an ADI distributes the financial products of other group members (or third parties), it must ensure that the identity of the product provider is prominently displayed in the relevant marketing material and product documentation such that:
(a) there is no confusion created in customers’ minds about the respective roles and responsibilities of the ADI and the product provider; and
(b) it does not give any impression that the product is guaranteed or otherwise supported by the ADI, unless a formal legal agreement is in place to this effect (see paragraphs 15 and 16 above).
22. While other members of the group (or third parties) may distribute the products of an ADI member in the group in either an agent or representative capacity, the ADI concerned must ensure that:
(a) appropriate disclosures are present detailing the respective roles of the ADI and the other group members or third parties (see paragraph 21 above); and
(b) the other group members (or third parties) do not, unless otherwise agreed with APRA (and supported by appropriate contractual arrangements – see paragraph 23 below), assume any key decision-making function of the ADI (e.g. in relation to creditworthiness) in distributing the ADI products.
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Participation in Group Operations
23. An ADI may participate in group operations (e.g. share premises with other group members, centralise back-office functions, outsource services to other group members, etc.) provided:
(a) dealings with related entities (and other parties) arising from participating in group operations are appropriately documented in written agreements (outsourcing of the ADI’s material business activities to a related entity must satisfy the prudential requirements set out in APS 231 – Outsourcing and AGN 231.1 – Managing Outsourcing Arrangements);
(b) such operations do not lead to any confusion in the mind of customers;
(c) these operations do not impinge on the safety and soundness of the ADI as a stand-alone entity; and
(d) the arrangements covering participation in group operations do not impinge on the ability of APRA to obtain information required for the supervision of an ADI or pertaining to the group as a whole, and there must be a clear obligation under the written arrangements for any service provider to comply with any direction given by APRA in relation to the operations of an ADI.
24. An ADI must satisfy APRA that its ability to readily conduct its business in a sound fashion would not be jeopardised should premises or other services (such as computer systems) provided by related entities become unavailable (i.e. an ADI must have backup arrangements and contingency planning in place). An ADI should be able to demonstrate that the level of reliance placed on premises, services, etc. provided by related entities, or the provision of services to related entities, does not compromise the ability of the ADI to identify and manage its risks on a stand-alone basis.
25. The Board of an ADI should establish policies and procedures to address risks arising from the ADI’s participation in group operations. The policies, including any material changes thereto, should be provided to APRA. As a general rule, an ADI should address these risks on the same basis as it would if such operations were undertaken by unrelated entities.
26. An ADI’s participation in group operations should be approved by the ADI’s Board. In approving such activities, the Board should:
(a) have regard to the risks presented to the ADI on a stand-alone basis as a result of its participation in such activities; and
(b) be satisfied that any exposures to related entities which might arise have been appropriately captured in measures of the ADI’s exposures to related entities.
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Prudential Limits on Intra-group Exposures
27. Exposures of an ADI or, where applicable, of an Extended Licensed Entity (see AGN 222.1) to related entities (see definition in paragraph 8 above) are subject to the following limits:
(a) related ADIs (including overseas based equivalents)
(i) exposure to individual related ADI – 50% of Level 1 capital base; and
(ii) aggregate exposure to all related ADIs – 150% of Level 1 capital base;
(b) other related entities
(i) exposure to other individual regulated related entity (i.e. any related entity other than an ADI or overseas based equivalent directly regulated by APRA or by a foreign equivalent) – 25% of Level 1 capital base;
(ii) exposure to individual unregulated related entity – 15% of Level 1 capital base; and
(iii) aggregate exposure to all related entities (other than related ADIs and related overseas based equivalents) – 35% of Level 1 capital base.
28. For the purposes of paragraph 27 above, an ADI’s (or Extended Licensed Entity’s) exposure to a related entity is the aggregate of all claims, commitments and contingent liabilities arising from on- and off-balance sheet transactions (in both the banking and trading books) with the related entity, and
(a) includes (but is not limited to):
(i) outstanding balances of all loans and advances;
(ii) all unused advised off-balance sheet commitments (refer Attachment A to AGN 112.2 for examples of these commitments), whether revocable or irrevocable;
(iii) the credit equivalent amounts of all market-related contracts (calculated in accordance with AGN 112.2 or AGN 112.3 where netting applies); and
(iv) any equity investment in the related entity not deducted from the ADI’s Level 1 (stand-alone) capital for capital adequacy purposes (see APS 111 – Capital Adequacy: Measurement of Capital);
(b) excludes:
(i) exposures of the ADI to, including equity investments in, subsidiaries that form part of the Extended Licensed Entity (see AGN 222.1);
(ii) exposures (including equity investment) deducted from the ADI’s Level 1 (stand-alone) capital for capital adequacy purposes (see APS 111 – Capital Adequacy: Measurement of Capital);
(iii) exposures to the extent that they are secured by cash deposits (subject to satisfying the criteria set out in Attachment B to AGN 112.1 for the purpose of this Standard);
(iv) exposures to the extent that they are guaranteed by governments, or secured by government securities (subject to satisfying the conditions set out in paragraphs 9, 12, 13, 14 and 15 of AGN 112.1 for the purpose of this Standard);
(v) exposures arising in the course of settlement of market-related contracts; and
(vi) exposures to the extent that they have been written off or specifically provided for.
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Approval Requirements
29. An ADI must obtain APRA’s prior approval for any proposed exposures in excess of the prescribed limits set out in paragraph 27 above. Such approval will only be granted on an exceptional basis. The ADI concerned must be able to satisfy APRA why the proposed exposure(s) might reasonably be expected not to expose the ADI (or Extended Licensed Entity) to excessive risk. APRA may impose a higher minimum capital ratio on the ADI at the stand-alone level (see APS 110 – Capital Adequacy) to compensate for the additional risk that may be associated with the proposed exposure(s).
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Prior Consultation Requirements
30. An ADI should consult with APRA before:
(a) establishing or acquiring a subsidiary (other than an entity which is to be used purely as a special purpose financing vehicle for the ADI);
(b) committing to any proposal to acquire (whether directly or indirectly) more than 10% of equity interest in an entity which operates in the field of finance; and
(c) taking up equity interest in an entity arising from the work-out of a problem exposure where:
(i) this exceeds 0.25% of the ADI’s Level 2 Tier 1 capital (calculated in accordance with APS 111 – Capital Adequacy: Measurement of Capital); or
(ii) this will result in the ADI acquiring (whether directly or indirectly) more than 10% of equity interest in the entity; or
(iii) this will result in the ADI’s aggregate investment in non-subsidiary entities which are not operating in the field of finance exceeding 5% of the ADI’s Level 2 Tier 1 capital (calculated in accordance with APS 111 – Capital Adequacy: Measurement of Capital).
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Notification Requirements
31. An ADI must notify APRA immediately of any breach of the prudential limits on exposures to related entities prescribed in paragraph 27 above, including remedial actions taken or planned to deal with the breach.
32. An ADI should report any equity investments that are not subject to the prior consultation requirements set out in paragraph 30 above to APRA retrospectively.
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Reporting
33. An ADI must provide APRA each quarter (or more frequently if required by APRA) with information on its (or the Extended Licensed Entity’s) exposures to related entities (including the ADI’s exposures to subsidiaries that form part of the Extended Licensed Entity) in a form to be determined by APRA from time to time. Where necessary, APRA may impose additional reporting requirements on the ADI.
34. A foreign ADI must provide APRA each quarter (or more frequently if required by APRA) with information on its exposures to its subsidiaries operating in Australia in a form to be determined by APRA from time to time. Where necessary, APRA may impose additional reporting requirements on the foreign ADI.
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Guidance Note
AGN 222.1 - Extended Licensed Entity
1. APRA recognises that most ADIs regularly conduct some of their activities using subsidiaries and special purpose vehicles which are often established to satisfy tax requirements. While they involve separate legal entities, they are to all intents and purposes operated as a division of an ADI.
2. Subject to the specific requirements set out in paragraph 4 below, APRA may deem a subsidiary of an ADI (other than an entity regulated directly by APRA or by a foreign equivalent) to be part of the ADI itself for the purposes of measuring the ADI’s exposures to related entities. Essentially, this requires APRA to adopt a “substance over form” approach and to “look through” the legal structure involved. Under this approach, an ADI and all its eligible subsidiary entities would be “consolidated” to form an “Extended Licensed Entity” (ELE) for measuring the ADI’s exposures to all other related entities. Accordingly, the ADI’s exposures to these subsidiaries (including equity investments) are exempted from the ADI’s intra-group exposure limits prescribed by APRA.
3. An ADI may apply to APRA to have one or more subsidiaries approved as part of its ELE. In practice, APRA will agree with the ADI on a list of entities that are eligible to form part of the ELE. An ADI is required to inform APRA as soon as it becomes aware that a member of the ELE no longer meets the criteria set out in this Guidance Note.
4. In deciding whether to approve a subsidiary of an ADI as eligible for inclusion within the ELE, APRA will have regard to the ADI’s extent of control over, and integration with, the subsidiary as well as the existence of any third-party liabilities of the subsidiary. Potential complications under a scenario where underlying asset holdings must be liquidated during financial stress will also be considered. Essentially, the following criteria should be met in respect of the relationship between the ADI and the subsidiary:
(a) the subsidiary should be wholly owned by the ADI, with a board of directors that is composed entirely of members of the ADI’s Board or senior management;
(b) the ADI has complete information on the individual assets, liabilities and off-balance sheet positions of the subsidiary. The ADI should be able to furnish stand-alone accounting records for the subsidiary, and provide APRA with full and unfettered access to this and any other information at any time (including during on-site visits);
(c) the ADI is unrestricted in its ability to control the composition of the subsidiary’s assets and liabilities as it sees fit. The ADI should demonstrate to APRA that there are no legal or regulatory barriers (including cross-border issues where the subsidiary is not incorporated or established in Australia) to the transfer of the assets/funds back to the ADI. There should be no legal obstacle to the ADI instituting a wind-up of the subsidiary at any time and placing the remaining assets on the balance sheet of the ADI;
(d) the ADI manages the assets and liabilities of the subsidiary as part of its internal management practices. This includes reporting structures, accounting processes, audit arrangements, and risk management and measurement systems. Essentially, the ADI’s risk management processes, MIS systems and internal controls should be fully extended to the operations of the subsidiary. The senior management of the ADI should monitor the operations of the subsidiary to the same extent as the operations of the ADI itself. Systems for monitoring and control over the subsidiary should be included within the internal and external audit programs of the ADI;
(e) the subsidiary should not conduct any business that the ADI would otherwise be prevented from doing under its banking authority (such as insurance). It is important that the ADI is not using the ELE concept to circumvent APRA’s prudential requirements;
(f) where the subsidiary holds or invests in assets (other than claims on the ADI), the subsidiary should have no material liabilities (both on- and off-balance sheet) to entities other than those that are part of the ELE (APRA will exempt tax liabilities and employee entitlements from this requirement); and
(g) where the subsidiary borrows on behalf of the ADI, all funds should be on-lent directly to the ADI.
5. The criteria in paragraph 4 provide for a simple arrangement involving an ADI and one or more directly owned subsidiary entities. This is not intended to preclude, for example, an arrangement in which an ADI invests in a single entity as a holding company and that entity in turn invests in multiple entities. In these circumstances, APRA is prepared to “look through” the holding company to determine whether these individual entities meet all of the above criteria (this would be for the ADI seeking APRA’s approval to demonstrate) to be included as part of an ELE. Entities that fail to meet the above criteria would be excluded from the ELE.
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All paragraphs under this section also apply to foreign ADIs (and their subsidiaries operating in Australia), and to non-ADI entities operating in Australia directly owned by the foreign parent of an ADI or by the parent’s subsidiaries.