Capital Adequacy
Objective
To protect and promote the financial integrity and efficiency of the State-based financial institutions scheme and to ensure that depositors are adequately protected from the risks that credit unions incur in the process of financial intermediation. Towards this end, to ensure that individual credit unions maintain a level of capital which broadly reflects the extent of risks undertaken.
General Background
The primary role of capital in a deposit-taking institution is to provide a cushion against loss and to maintain the confidence of its depositors. While effective management systems can reduce the risk to depositors' funds, they are unlikely to eliminate risk entirely, given that risk pooling is a fundamental element of financial intermediation. Credit unions, therefore, must hold capital against a range of risks, including the loss of capital value of assets as a result of credit risk, a competitive squeeze on margins, mismatching of the characteristics of assets and liabilities, off-balance sheet exposures and concentration of particular types of assets or liabilities.
Framework
AFIC's approach to capital adequacy has three elements - capital adequacy ratio of individual institutions, quality and structure of capital and credit risk of assets.
Risk weightings focus on credit risk of assets. However, the SSA will look beyond the asset portfolio in reviewing a society and setting capital adequacy requirements. The SSA will determine a 'risk ratio' for each credit union that is consistent with its overall assessed risk rating. Under this approach, the level of capital required to support the risk-weighted assets of any credit union may increase (from a base of 8 per cent) as the overall riskiness of the credit union increases.
Capital is considered in two tiers. Tier 1 (or 'core capital') comprises the highest quality capital elements. Tier 2 (or 'supplementary capital') represents additional elements that contribute to the overall strength of the credit union as a going concern (see Prudential Standards 4.2.1 and 4.2.2). At least 50 per cent of a credit union's required capital must be core capital (Tier 1); the remainder may consist of 'supplementary' elements.
Tier 2 capital is further qualified as Upper and Lower Tier 2 capital. Upper Tier 2 capital includes elements that are essentially permanent in nature and have characteristics of both equity and debt. Lower Tier 2 capital consists of elements that are not permanent. The value of Lower Tier 2 capital that may be included in the capital adequacy calculation cannot exceed 50 per cent of Tier 1 capital (net of goodwill, other intangible assets and future income tax benefits).
It is not appropriate that the capital of a credit union be used to support the balance sheet of a building society or credit union as this could raise doubts about the adequacy of capital available to support the industries. Therefore, for the purposes of calculating capital adequacy, a credit union must deduct from its total capital (and assets) the carrying value of any holding of capital instruments of another credit union or building society.
Similarly, consistent with the requirements of Prudential Notes 4.6 and 4.7, a credit union must deduct any equity investment in a securitisation or funds management vehicle (that includes a subsidiary that acts as an approved trustee under the SIS legislation) and any subsidiary that is active in these areas of business as a manager, custodian, trustee or similar role. The deduction should be for the maximum amount of capital that may be required to be committed to the entity. This includes any guarantee that acts as a substitute for capital that would otherwise need to be provided and any uncalled amount on partly paid shares.
Consistent with the approach adopted by banking supervisors around the world, assets are risk-weighted to reflect the differing capital needs to support different types of lending activity. The focus in risk weighting is on credit risk, namely the potential for default by the borrower or counterparty and the associated potential loss. Credit risk focuses primarily on the financial strength of the borrower. However, where collateral is involved, this may have a major bearing on the extent of potential loss.
Balance sheet assets and off-balance sheet exposures are weighted according to broad categories of relative risk, based largely on the nature of the counter party. The higher the risk, the greater the capital backing required. The sum of risk-weighted assets (including risk-assessed off-balance sheet business) together with the credit union's 'risk ratio' defines the amount of capital needed to support its lending activity.
Credit exposures (on and off-balance sheet) are risk weighted according to three broad types of counter party - government, banks and FI Scheme institutions, and all others. There are five specific categories of risk weights - 0, 10, 20, 50, and 100 per cent (see Prudential Standard 4.2.4). Off-balance sheet transactions (including derivative products) are converted to balance sheet equivalents before being allocated a risk weight.
Prudential Standards
4.2.1 Capital Adequacy
4.2.1.a Each credit union and consolidated credit union group is required to maintain at all times a minimum ratio of capital to risk-weighted assets of 8 per cent (or more for an individual credit union as determined from time to time by its SSA).
4.2.1.b Capital will be considered in two tiers:
" Tier 1 (or 'core capital') comprises the highest quality capital elements (defined in Prudential Standard 4.2.2.a).
" Tier 2 (or 'supplementary capital') represents additional elements (defined in Prudential Standard 4.2.2.b) that contribute to the overall strength of the credit union.
4.2.1.c At least 50 per cent of a credit union's required capital must be core capital (Tier 1); the remainder may consist of 'supplementary' elements (Tier 2).
4.2.2 Definition of Capital
4.2.2.a Core Capital (Tier 1)1,2
" Paid up permanent share capital.
" Non-repayable share premium account.
" General reserves.
" Retained earnings.3
" Non-cumulative irredeemable preference shares.4
" Minority interests in subsidiaries that are consistent with the above Tier 1 components.
4.2.2.b Supplementary Capital (Tier 2)5
UPPER
" General provisions for doubtful debts.6
" Asset revaluation reserves.7
" Cumulative irredeemable preference shares.8
" Mandatory convertible notes and similar capital instruments.8
" Perpetual subordinated debt.8
LOWER9
" Term subordinated debt and limited life redeemable preference shares.
Any instrument or issue of subordinated debt or limited life redeemable preference shares by a credit union must be approved by the SSA, in consultation with AFIC, before the instrument may qualify for treatment as Tier 2 capital. Relevant documentation will be examined by the supervisors with particular regard to the provisions by which the instrument is subordinated to the claims of other creditors and the events or circumstances which may accelerate payment of interest and/or repayment of principal ("events of default").
As a precondition for qualification of subordinated debt as Tier 2 capital the subordinated debt instrument or other relevant documentation governing the terms of issue must, unless otherwise agreed in writing by AFIC, preclude the subordinated debt holder (and any agent, trustee or other person acting on behalf of the holder) from enforcing rights to accelerate payments or repayments in consequence of events of default except by instituting proceedings (or joining in proceedings) for the winding up of the society pursuant to the Financial Institutions Code.
The review by supervisors of terms and conditions of instruments for inclusion in Tier 2 capital will give close regard to step up rates, conditions for conversions, deferral of interest and other payments, options to repay and early repayment.
4.2.3 Hybrid (Debt/Equity) Capital Instruments
4.2.3.a A range of instruments that combine characteristics of equity capital and of debt may be included in upper Tier 2 capital. To qualify for inclusion in the capital base they must be:
(i) unsecured, subordinated and fully paid-up;
(ii) not redeemable at the initiative of the holder or without the prior consent of the SSA; and
(iii) available to participate in losses without the credit union being obliged to cease trading (unlike conventional subordinated debt).
4.2.3.b. Although these instruments may carry an obligation to pay interest that cannot permanently be reduced or waived (unlike dividends on ordinary shareholders' equity), they should allow servicing obligations to be deferred (as with cumulative preference shares) where profitability would not justify payment.
4.2.3.c As with term subordinated debt an instrument or issue of hybrid capital by a credit union must be approved by its SSA in consultation with AFIC before it may qualify for inclusion as Tier 2 capital.
4.2.4 Categories of Risk
4.2.4.a Nil Weight:
" notes and coin;
" overnight settlements, loans and other claims fully secured10 against cash;
" Commonwealth, State or Territory Government securities, including securities issued by State or Territory central borrowing authorities; and
" claims fully secured against Commonwealth or State Government securities.
4.2.4.b 10 per cent Weight:
" all other claims on, or guaranteed11 by, Commonwealth or State or Territory Governments or a State Central Borrowing Authority;
" deferred assets held in credit union contingency funds.
4.2.4.c 20 per cent Weight:
" liquidity deposits with special services providers (see Book 5);
" claims on Australian local governments or public sector entities (except those which have corporate status or operate on a commercial basis) or which are guaranteed by these entities;
" claims on, or guaranteed by, Australian or OECD banks;
" claims on, or guaranteed by, building societies or credit unions
" claims on, or guaranteed by, international banking agencies or regional development banks; and
" cash items in the process of collection.
4.2.4.d 50 per cent Weight:
" loans12 for housing, or other purposes fully secured y registered mortgage over a residential building or development (as defined in Section 3 of the FI Code) where, the mortgage falls within one of the following categories:
(i) a first registered mortgage where the ratio of the outstanding balance13 of the loan14 to the valuation of the property is no more than 80 per cent.15 If the loan is 6 months or more in arrears, the valuation must be no older than 12 months.
(ii) a first registered mortgage where the outstanding balance is 100 per cent mortgage insured.16
(iii) a second mortgage where the ratio of the outstanding balances of the loans secured by both mortgages to the valuation of the property does not exceed 80 per cent and the first mortgage cannot be extended without it being subordinated to the second mortgage.
(iv) a second mortgage where the ratio of the outstanding balances of the loans secured by both mortgages to the valuation of the property exceeds 80 per cent, where the first mortgage cannot be extended without it being subordinated to the second mortgage and the outstanding balance is 100 per cent mortgage insured.16
Elsewhere, in the standards mortgages satisfying any one of the conditions i) - iv) above will be referred to as 'qualifying' mortgages.
The 50 per cent risk weight applies to loans for housing, or for other purposes, fully secured by a registered mortgage over residential property (whether or not the property is owned by the borrower) subject to the following criteria being satisfied:
" the credit union has at all times a clear and unequivocal access to mortgaged residential properties in the event of default by borrowers;
" the credit union has been involved directly in making credit assessments of individual borrowers, including the valuations of the associated residential properties secured by mortgage;
" where security is provided by third parties (ie. parties other than the specific borrower), other than on loans in respect of which the relevant mortgage is unenforceable under the Consumer Credit Code, the building society has ensured that those parties understand fully the consequences of default on the loans and their legal obligations; and
" loans for purposes other than housing are fully secured by mortgages over existing residential property. Loans, for whatever purpose, secured against speculative residential development eg. multiple dwellings such as blocks of units do not qualify for a concessional risk weight.
Where a loan fails to satisfy any of the above criteria, the full value of the loan should be assigned a 100 per cent risk weight in the absence of any other eligible collateral or guarantees. A concessional risk weight does not apply to mortgage-backed securities which should be risk weighted as a claim on the issuer of the securities. Other asset backed paper should be risk weighted in a similar fashion.
4.2.4.e 100 per cent Weight
" other loans.17
" other assets and claims.
4.2.4.f Other considerations
Certain asset classes and investments may result in additional capital requirements if, in the opinion of the SSA, they lead to excessive risk for the credit union.
4.2.5 Off-Balance Sheet Business
Measurement of off-balance sheet business will involve a two-step process:
(i) the principal (or face value) amounts of transactions will be converted into on-balance sheet equivalents ('credit equivalent amounts') by application of credit conversion factors; and
(ii) the resulting credit equivalent amount will be assigned the risk weight appropriate to the counterparty or, if relevant, the risk weight assigned to the guarantor or the collateral security.
4.2.5.a Credit conversion factors for selected major off-balance sheet transactions:
| |
Credit Conversion Factor18 |
| Direct credit substitutes, including financial guarantees and endorsements (which do not have the prior endorsement of a bank) |
100% |
| Assets sold with recourse19 where credit risk remains with the credit union |
100% |
| Sale and repurchase agreements20 where credit risk remains with the credit union20, forward asset purchases20 placement of forward deposits, and other commitments to acquire assets20 |
100% |
| Loans approved by a credit union but not yet advanced, where there is certainty of drawdown (i.e. forward loan commitments) |
100% |
| Trade and performance-related contingent items, including warranties, bid bonds, indemnities, performance bonds and standby letters of credit related to particular non-monetary obligations |
50% |
| Other commitments (e.g. formal standby facilities and undrawn amounts under an equity credit or redraw facility21) with a residual maturity exceeding one year22 |
50% |
| Other commitments that can be unconditionally revoked without notice but are not subject to review at least annually. |
50% |
| Other commitments (eg undrawn overdraft and credit card facilities) which can be unconditionally revoked at any time without notice where the credit union provides for any outstanding unused balance to be reviewed at least annually |
0% |
| Other commitments with a residual maturity of one year or less23 |
0% |
4.2.5.bOther Items
For items not included above24, credit conversion factors should be discussed with the relevant SSA.
4.2.6 Derivative Products
4.2.6.a Under Section 120 and Section 121 (prohibitions) of the FI Code, credit unions may only enter into contracts involving derivative products for the purpose of reducing market risk. Given the nature of credit union business, the general presumption is that credit unions will only use derivative products related to interest rates. The credit risk associated with derivative products is the cost to the credit union of replacing the cash flow specified by the contract in the event of counterparty default. This will depend, among other things, on the maturity of the contract and on the price volatility of the underlying physical instrument.
4.2.6.b Credit-equivalent amounts for derivative products may be calculated in either of two ways, using a mark-to-market approach or a rule-of-thumb approach25:
Mark-to-Market approach
Credit equivalent amounts are represented by the sum of current credit exposure and potential credit exposure:
(i) Current Credit Exposure
This is the mark-to-market valuation of all contracts with a positive replacement cost. Replacement costs which are fully collateralised by cash and government securities, or backed by eligible guarantees, may be given the weight of the underlying security or guarantor.
(ii) Potential Credit Exposure
This is calculated as a percentage of the nominal principle amount of a credit union's portfolio of interest rate contracts split by residual maturity as follows:
| Remaining term to maturity |
Interest contracts |
Exchange rate contracts |
| Less than 1 year |
nil |
1.0% |
| One year or more |
0.5% |
5.0% |
Rule-of-thumb approach
Credit-equivalent amounts are calculated by applying credit conversion factors to the principal amounts of contracts according to the nature of the instrument and its original maturity.
| Original Maturity of contract |
Interest rate of contract |
Exchange rate of contract |
| Less than 1 year |
0.5% |
2.0% |
| One year and less than two years |
1.0% |
5.0% |
| For each additional year |
1.0% |
3.0% |
4.2.6.c The following derivative products are to be included in the calculation of credit-equivalent amounts:
" forward rate agreements;
" interest rate swap agreements;
" cross currency interest rate swap agreements;
" forward foreign exchange contracts;
" futures contracts;
" interest rate and foreign currency options purchased; and
" any other instruments of similar nature that give rise to credit risks.
4.2.6.d The following derivative products are excluded in the calculation of credit-equivalent amounts:
" instruments traded on futures and options exchanges that are subject to daily mark-to-market and margin payments.
4.2.7 Deductions of Certain Investments from Capital
4.2.7.a For the purpose of calculating capital adequacy, a credit union must deduct from its total capital (and assets) the carrying value of any investment (by it or a subsidiary) in the capital instruments (in the form of equity or subordinated debt26) of another credit union or building society.
4.2.7.b Where a credit union (or its subsidiary) invests capital in, or provides a guarantee or similar support to, an entity which undertakes the role of manager, responsible entity, approved trustee, trustee, custodian or similar role in relation to funds management or the securitisation of assets then the value of capital27 and guarantees should be deducted from the credit unions and the groups capital base.
4.2.7.c A credit union is required to deduct from its capital base (and risk assets) its (or its subsidiarys) equity and other capital investments in non-consolidated subsidiaries or associates which it effectively controls. Investments in life and general and lenders mortgage insurance companies, as well as friendly societies, will generally be subject to this requirement.
4.2.7.d Where a credit union (or its subsidiary) enters into an undertaking which provides for it to absorb the first level of losses28 on claims supported by the credit union (eg guarantees, up to a limit, of losses on a portfolio of loans held in a securitisation vehicle) the amount of the undertaking (or limit) should be deducted from its capital base (and risk assets) unless it has already been written off.
4.2.8 Reductions in Capital
4.2.8.a Where a credit union proposes any reduction in its capital (eg through the partial distribution of reserves repurchase of shares or subordinated debt or dividend payment exceeding current year earnings ) it must obtain the prior written agreement of its SSA. The SSA will need to be satisfied on the basis of an acceptable capital plan (which extends for at least two years) provided by the credit union that the credit unions capital will remain adequate, for its future needs, after the proposed reduction.
1 Goodwill and similar intangible assets including future tax benefits (FITB) (other than those associated with the general provision for doubtful debts) (net of any provision for deferred income tax liability(DITL) that may be offset in accordance with AASB 1020) will be deducted from 'core' capital and hence total capital. If the DITL exceeds FITB, the excess may not be added to capital.back
2 Must constitute at least -50 per cent of the capital requirement.back
3 May include measured current year earnings net of expected distributions and tax expense.back
4 Must be subordinated to depositors and unsecured creditors; must not provide for a return of capital or compensation for unpaid dividends; and dividends (the only form of compensation to investors that should be provided) should not be influenced by the credit standing of the society. The non-declaration of a dividend should not trigger any restrictions on the society other than the need to seek approval of holders of the shares before paying dividends on or retiring other shares.back
5 For the purposes of calculating capital adequacy cannot exceed the value of Tier 1 capital.back
6 General provisions, less any associated future income tax benefit, up to a value of 1.25 per cent of total risk weighted assets. The provisions must be additional to the statutory provisions (Prudential Standard 4.3.2.a) and specific provisions and must be created against future, presently unidentified losses. General provisions must be available to meet any losses that may subsequently materialise.back
7 Where the regular revaluation of property is reflected in the balance sheet and is subject to audit review, revaluation reserves are to be included in upper Tier 2 capital after allowance for capital gains and any other taxes or costs that would be incurred should the asset be sold for the revalued amount. Regular periodic valuations must be of intervals of no more than 3 years. For revaluations of other assets (including securities) not passed through the profit and loss account and irregular revaluations of property only 45 per cent of the gain may be included in upper Tier 2 capital. However, the full value of any decline in value should be reflected in upper Tier 2 capital. This applies whether revaluations or devaluations are recorded in the balance sheet or in the notes to the accounts.back
8 Must meet the criteria for Hybrid (Debt/Equity) Capital Instruments or upper Tier 2 capital instruments set out in Prudential Standard 4.2.3.back
9 The eligible amount of lower Tier 2 capital for the purposes of calculating capital adequacy is limited to 50 per cent of Tier 1 capital. Minimum original maturity must be at least five years. Lower Tier 2 capital must be amortised at a rate of 5% per quarter of the original amount during the last five years to maturity.back
10 To qualify for a particular risk weight a security arrangement must permit direct, explicit, irrevocable and unequivocal recourse to the collateral. Claims secured or collateralised in other ways eg insurance contracts, put options, forward sale contracts are not considered to be eligible collateral.back
11 For the purposes of the capital adequacy standard a guarantee must be issued formally. It must permit direct, explicit, irrevocable and unequivocal recourse to the guarantor. Indirect guarantees (such as guarantees of guarantees eg where the Commonwealth guarantees the entity which provides the guarantee) and letters of comfort are not recognised.back
12 see footnote to Prudential Standard 4.2.4.eback
13 Throughout this standard, outstanding balance includes the balance of all loans and other facilities, plus the gross value of any undrawn limits available eg redraw amount available on the loan or undrawn limit on a revolving credit facility, that are secured against the mortgage security. An "all moneys" mortgage includes all loans or facilities to the customer that are effectively secured against the mortgage. To assign capital to undrawn limits, the credit conversion factor should be taken from prudential standard 4.2.5.a. This credit equivalent may then be assigned a 50 per cent risk weight if secured by a qualifying mortgage. back
14 In calculating the outstanding balance of a loan, allowance may be made for higher ranking security. A credit union may deduct from the outstanding balance any eligible cash or Commonwealth or state government security held as collateral. Similarly, it may also deduct any part of the exposure guaranteed by a Commonwealth, State (including central borrowing authority) or local Government, a public sector entity eligible for a 20 per cent risk weight, a bank or other building society or credit union. These portions of the exposure are to be weighted according to the security or guarantee. A mortgage offset or similar account may only be netted off the loan balance where the arrangement would meet the requirements of the cash collateral guidelines.back
15 Where there is more than one property offered as security, the LVR will be assessed on the basis of the outstanding balance (after allowance for any higher ranking security) to the aggregate value of the secured properties.back
16 To qualify as mortgage insured the policy must be taken out with an authorised Lenders Mortgage Insurer with an insurance rating the equivalent of "A" or higher. A captive LMI, though unrated, may demonstrate a claim paying ability rated "A" or higher through third party guarantees. AFIC will consider non-rated LMI arrangements on a case-by-case basis.back
17 Where a specific provision for doubtful debts has been made against a loan, the risk-weight applies to the outstanding balance (including accrued interest) after deducting the specific provision.back
18 The amount to be subject to the credit conversion factor is the maximum unused portion of the facility at the time of calculation (any drawn portion will form part of balance sheet assets). For example, if a rental guarantee is provided on behalf of a customer, then all remaining lease payments (up to any limit specified in the guarantee) are included in the calculation.back
19 These items are to be risk weighted according to the type of assets or the issuer of securities and not according to the counterparty with whom the transaction is made.back
20 'Reverse repos' (i.e. purchase and resale agreements) are to be treated as collateralised loans. The risk is to be measured as an exposure to the counterparty, or according to the asset if it is recognised collateral security within the risk ratio framework.back
21 Redraw facilities that only allow redraw of advance payments should be assigned a credit conversion factor of 0%.back
22 This includes any commitment, that can only be unconditionally revoked with notice, where there is not a clear expiry date within one year.back
23 Provided the commitment can only be rolled over or extended after a full credit review is done and there is no presumption or impression conveyed to the client that an approval of a roll over or extension will be a formality. Where this test is not met the commitment will receive a 50 per cent risk weight.back
24 This includes any commitment to provide an off-balance sheet facility.back
25 Credit conversion factors are based on the Basle Supervisors' Committee's paper "International convergence of capital measurement and capital standards", July 1988.back
26 The deduction will apply to the full value of a holding of subordinated debt even if the issue of debt is being amortised in terms of the footnote to prudential standard 4.2.2.b.back
27 This includes any amount which is unpaid or callable on any shares or capital securities issued by the subsidiary and held by the credit union (or within its consolidated group).back
28 This could include situations such as the provision of subordinated debt or other capital support to a nominally capitalised entity that is not included within the consolidated group.back
