APRA issues transition guidelines for Basel II implementation

The Australian Prudential Regulation Authority (APRA) today released its preliminary requirements for local banks, building societies and credit unions under the Basel Committee on Banking Supervisions new Basel Capital Accord, also known as Basel II, scheduled for implementation in 2007.

Todays announcement provides guidance on the options available to institutions for calculating regulatory capital under the new Accord.

Key points of the guidelines are as follows:

APRA will allow banks to use internal risk models to generate their regulatory capital requirements in accordance with the new Basel Accord proposals;

APRA expects the four largest Australian banks to adopt the Internal Ratings-Based (IRB) approach for credit risk capital;

APRA will allow other Australian banks to utilise the IRB approach. These institutions, however, will have to meet the stringent qualitative and quantitative criteria requirements necessary for IRB approval. The regulator, however, is of the view that smaller institutions may lack the extensive data necessary to validate an IRB approach.

APRA will require institutions adopting the IRB approach to credit risk capital to also use the Advanced Measurement Approach (AMA) for calculating operational risk capital. IRB banks will also need to use APRA approved rules for the other risks covered under Pillar 2 of the Basel Accord. These other risks include interest rate risk, credit concentration, business/strategic risk and cyclicality risk.

APRA will allow other institutions to adopt the standardised approach to credit risk and a less sophisticated operational risk model under Basel II and intends to simplify the standardised approach for building societies and credit unions to avoid unnecessary complexity and cost.

APRA estimates that the conversion to Basel II will create a number of positive impacts for financial institutions in Australia. IRB banks, for example, may be able to operate with lower average capital requirements if they operate a low-risk business. Conversely, higher risk business would result in increased capital requirements.

ADIs will also benefit from lower capital requirements attached to conventional home lending. This would lead to the need to hold additional capital for operational and, in some cases, interest rate risk. ADIs adopting standardised models are likely to experience a small decline in average capital levels.

Mr Charles Littrell, APRAs Executive General Manager Policy, Research and Consulting, stressed that a level playing field needed to be maintained in the Australian financial services industry.

APRA does not expect the different approaches in Basel II to produce markedly different competitive effects compared to the current rules, he said. We do, however, expect to see local entities operate more efficiently and safely in a capital and risk allocation sense under Basel II.

A copy of APRAs letter to ADIs is available on the website on www.apra.gov.au

APRA is the prudential regulator of the financial services industry including banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, friendly societies, and most members of the superannuation industry. It currently regulates $1.5 trillion in assets for 20 million Australians.

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