Capital Adequacy
Introduction
To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that special services providers have sufficient capital to absorb losses occasioned by loan default, adverse market movements and management error.
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.
SSPs perform a critical role in supporting the liquidity, efficiency and integrity of the State-based financial institutions system. Their soundness and safety must be beyond question. From the time of registration they must be capitalised to an extent sufficient to:
" gain and retain credibility within financial markets as financially-stable managers of liquid assets;
" absorb potential losses from a variety of sources;
" maintain standby lines of credit and other sources of external liquidity support of acceptable quality (see Prudential Note 5.4.); and
" provide an assurance of future capital commitment from its owners.
Capital Adequacy Requirements
The standards for capital adequacy required of SSPs are modified and strengthened versions of the standards applying to societies. The need to ensure adequate capital is self-evident.
The probability of insolvency increases as the level of capital falls and/or exposure to risk rises.
The approach to capital adequacy for SSPs has three elements capital requirement for the institution, quality and structure of capital and credit risk of assets.
SSPs are required to maintain at all times a minimum ratio of defined capital to risk-weighted assets. The division of capital into two tiers is identical to that required of societies. An SSP is required to hold a minimum of 50 per cent of required capital in the form of Tier 1 (or core capital). Supplementary or Tier 2 capital is further qualified as Upper and Lower Tier 2 capital.
Therefore, for the purposes of calculating capital adequacy, an SSP must deduct from its total capital (and assets) the carrying value of any holding of capital instruments of a building society or credit union. It is not appropriate that capital of an SSP be used to support other regulated entities balance sheets. Similarly, an SSP should deduct any equity investment in a securitisation or funds management vehicle (which includes a subsidiary that acts as an approved trustee under the SIS legislation) and any subsidiary which 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.
In calculating risk-weighted assets, the risk weights for an SSPs assets are similar to those applying to the assets of societies with one exception:
" secured loans made by an SSP on behalf of eligible societies to a society in pursuance of Section 46 of the AFIC Code, attract a weight equal to that on the original PLA investments for the purposes of computing capital adequacy.
This provision ensures that an SSPs capital adequacy is not compromised by the initiation of emergency liquidity support loans by AFIC under Section 46 of the Code.
In most instances, the nature of the business of an SSP, together with the restrictions placed upon the portfolios, will ensure that the risk-weighted value of assets is low. This reflects the fact that an SSP will ordinarily be exposed to very little credit risk. An SSP will still be exposed to interest rate risk and management risk. Moreover, the pivotal position of any particular SSP in its industry, even if it is one of a number of SSPs, requires that sufficient capital be available to absorb losses which might arise from sources other than credit risk.
Therefore, an SSP that provides principally financial services such as treasury management or settlement services is required to maintain at all times a capital ratio of 10 per cent of defined capital to risk-weighted assets. An SSP that provides a wider range of services and may thereby be exposed to higher aggregate risk, may be required by AFIC to maintain additional capital.
AFIC may choose to increase the risk weighted assets ratio at its discretion and for an indefinite period of time. This may reflect the nature and risks of the operation and activities of a particular SSP.
Any proposed diminution of capital, including any repayment of subordinated debt or other capital instrument or dividends in excess of current year earnings can only be made with the prior approval of AFIC.
Prudential Standards
5.2.1 Capital Adequacy
5.2.1.a Each SSP that provides principally treasury management or settlement services is required to maintain at all times a capital ratio of 10 per cent of defined capital to risk-weighted assets. An SSP that provides a wider range of services and may thereby be exposed to higher aggregate risk, may be required by AFIC to maintain additional capital.
5.2.1.b Capital will be considered in two tiers:
" Tier 1 (or 'core capital') comprises the highest quality capital elements (defined in Prudential Standard 5.2.2.a).
" Tier 2 (or 'supplementary capital') represents additional elements (defined in Prudential Standard 5.2.2.b) that contribute to the overall strength of the SSP.
5.2.1.c At least 50 per cent of an SSP's required capital must be core capital (Tier 1); the remainder may consist of 'supplementary' elements (Tier 2).
5.2.1.d AFIC may, at its discretion, by notice to the SSP, increase the risk-weighted capital-to-assets ratio required of an SSP for an indefinite period of time.
5.2.2 Definition of Capital
5.2.2.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 in prudential standard 5.2.2.a.
5.2.2.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 an SSP must be approved by AFIC before the instrument may qualify for treatment as Tier 2 capital. Relevant documentation will be examined by AFIC 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 SSP 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.
5.2.3 Hybrid (Debt/Equity) Capital Instruments
5.2.3.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 AFIC; and
(iii) available to participate in losses without the SSP's being obliged to cease trading (unlike conventional subordinated debt).
5.2.3.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.
5.2.3.c As with term subordinated debt an instrument or issue of hybrid capital by an SSP must be approved by AFIC before it may qualify for inclusions as Tier 2 capital.
5.2.4 Categories of Risk
5.2.4.a Nil Weight:
" notes and coin;
" overnight settlements, loans and other claims fully secured10 against cash;
" Commonwealth, State or Territory Government securities; and
" claims fully secured against Commonwealth or State or Territory Government securities.
5.2.4.b 10 per cent Weight:
" all other claims on, or guaranteed11 by, Commonwealth or State or Territory Governments.
5.2.4.c 20 per cent Weight:
" 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.
5.2.4.d 50 per cent Weight
" loans12 for housing or other purposes fully secured by registered mortgage against residential building and/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 SSP has at all times a clear and unequivocal access to mortgaged residential properties in the event of default by borrowers;
" the SSP 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.
5.2.4.e 100 per cent Weight
- other loans.17
- other assets and claims.
5.2.4.f Loans under the Emergency Liquidity Support Scheme
Secured loans made by a SSP on behalf of eligible societies to another society in pursuance of Section 46 of the AFIC Code attract a weight equal to that on the original PLA investments for the purposes of computing capital adequacy.
5.2.4.g Certain asset classes and investments may result in additional capital requirements if, in the opinion of AFIC, they lead to excessive risk for the SSP.
5.2.5 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.
5.2.5.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 SSP |
100% |
| Sale and repurchase agreements20 where credit risk remains with the SSP20, forward asset purchases20 placement of forward deposits, and other commitments to acquire assets20 |
100% |
| Loans approved by a SSP 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 SSP 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% |
5.2.5.b Other Items
For items not included above24, credit conversion factors should be discussed with AFIC.
5.2.6 Derivative Products
5.2.6.a SSPs may only enter into contracts involving derivative products for the purpose of reducing market risk. Given the nature of their business, the general presumption is that SSPs will only use derivative products related to interest rates or exchange rates. The credit risk associated with derivative products is the cost to the SSP 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.
5.2.6.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 approach.25
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 society's portfolio of interest rate and exchange rate related 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% |
5.2.6.c The following derivative products (interest and foreign exchange contracts) 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.
5.2.6.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.
5.2.7 Deductions of Certain Investments from Capital
5.2.7.a For the purpose of calculating capital adequacy, an SSP must deduct from its total capital (and assets) the carrying value of any investment (by it or its subsidiary) in the capital instruments (in the form of equity or subordinated debt26) of a building society or credit union.
5.2.7.b Where an SSP (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 SSPs and the groups capital base.
5.2.7.c An SSP is required to deduct from its capital base (and risk assets) its 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.
5.2.7.d Where an SSP enters into an undertaking which provides for it to absorb the first level of losses28 on claims supported by the SSP (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.
5.2.8 Reductions in Capital
5.2.8.a Where an SSP proposes any reduction in its capital (eg via the repurchase of shares or subordinated debt or payment of dividends in excess of current year earnings) it must obtain the prior written agreement of AFIC. AFIC will need to be satisfied on the basis of an acceptable capital plan (which extends for at least two years) provided by the SSP that the SSPs capital will remain adequate, for its future needs, after the proposed reduction.
5.2.9 Market Risk
5.2.9.a Market risk is defined as the risk of losses in on and off-balance sheet positions arising from movements in market prices. This standard addresses the risk pertaining to interest rate related instruments and equities in the trading book of the SSP. The trading book may include PLA and operational liquidity deposits from societies.
5.2.9.b It is the responsibility of the SSPs board and management to ensure that it has in place adequate systems to identify, measure and manage market risks incurred in both its trading and investment books and to hold appropriate capital against those risks.
5.2.9.c Each SSP will be expected to monitor and report the level of risk against which a capital requirement is to be applied. The SSPs overall assessed risk exposure to be compared against its capital base will be the credit risk requirements set out in prudential standard 5.2.1.a excluding any debt and equity securities in the SSPs trading book; plus
(a) the standardised capital charges for market risk; or
(b) the measure of market risk derived from an approved model; or
(c) a mixture of (a) and (b) summed arithmetically.
5.2.9.d To ensure consistency in the calculation of the capital requirements for credit and market risk, an explicit numeric link is created by multiplying the measure of market risk, both specific and general market risk, (as calculated according to the standards) by 12.5 and adding the resultant figure to the risk weighted assets calculated for credit risk purposes under Prudential Standard 5.2.1.a.
5.2.9.e Investments may be considered to be held with a trading intent if:
(a) they are considered trading securities by the SSP;
(b) they are marked to market on a daily basis as part of the SSPs internal risk management process;
(c) the position takers have autonomy in entering into transactions (in marketable instruments) within predetermined approved limits; and
(d) they satisfy any other criteria that AFIC applies to the composition of the trading book on a consistent basis.
5.2.9.f In assessing the method of measuring the capital required to be held against market risk the SSP will agree with AFIC the calculations and formula required to be used. The calculations and formulas that AFIC will require the SSP to use will be consistent with the Reserve Bank of Australias statement Capital Adequacy of Banks: Market Risk which is Prudential Statement No C3.
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 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 5.2.3.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 5.2.4.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 5.2.5.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. It also includes standby facilities given to societies, even though they may be reviewed annually, in order to assure certainty of availability.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
