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Brief Counsel

Second RBNZ consultation paper on Basel III reforms

22 March 2012

The Reserve Bank of New Zealand (RBNZ) has issued its proposals on the capital conservation buffer and countercyclical capital buffer in the context of the Basel III reforms.  Submissions are due by 13 April 2012.

RBNZ has also confirmed the timing of the reforms and indicated its views on loss absorbency issues.

The second of a series of consultations

The proposals in relation to the conservation and countercyclical buffers were foreshadowed in RBNZ’s initial consultation document on the implementation of the core Basel III measures regarding capital ratios from November 2011, which we produced a commentary on last year.

These proposals continue the trend of divergence by RBNZ from the international framework in some important substantive areas.  We expect these areas to be a key focus, since a level regulatory playing field was a foundation principle of the original Basel framework.  In particular, we suggest that more analysis is needed of the potential impacts of this approach on the competitiveness of locally supervised banks, including in the critical matter of attracting capital.

Capital conservation buffer

Under Basel III, banks are required to have a capital conservation buffer of 2.5% comprised of “core” common equity tier 1 capital.  The buffer is on top of the 4.5% Basel III common equity tier 1 capital requirements and brings to 7% the total tier 1 capital requirement.

If a bank’s capital ratio falls below the capital requirements, including the conservation buffer, the bank’s ability to distribute earnings will be restricted.  The Basel III proposal is to reduce the percentage of earnings that can be distributed as the level of capital falls.  However RBNZ is proposing a blunter approach: as soon as a bank falls below the conservation buffer, the bank will be prevented from making any distributions until the full 2.5% conservation buffer is restored. 

In this respect, RBNZ’s proposals are tougher than those proposed in Australia, where APRA intends to use the Basel Committee’s sliding scale.  No explanation is offered for why New Zealand should be out of step with the international framework, including any potential competitive or other implications.

Countercyclical capital buffer

RBNZ proposes to introduce the Basel III standard requirements in relation to a countercyclical buffer.  This buffer is to be made up of common equity tier 1 capital and will vary between 0% and 2.5% of risk weighted assets. 

It is intended to enable central banks like RBNZ to ‘lean against the wind’ when the economy is showing signs of overheating, by imposing the buffer when there is excess credit growth which may lead to a build up of system-wide risk.  The additional capital would be released when the credit cycle turns down and loan losses start to accumulate within banks.

Further details on the implementation of the countercyclical capital buffer are needed, but RBNZ has made a couple of notable comments:

  • banks will be given up to 12 months' notice of the need to build up a countercyclical buffer and will be required to submit to RBNZ plans on how they intend to raise the necessary capital
  • the restrictions on distributions that apply in relation to the conservation buffer will also apply to a bank which is within the countercyclical buffer, and
  • the buffer could be extended to other lenders, such as non-bank deposit takers, bringing them further into line with the registered bank capital adequacy regime.

We note that the ‘dividend stopper’ is proposed to be automatic whereas it is only one option under the Basel rules (another being capital raising, which may be a less costly approach in the economic circumstances that would likely trigger this requirement).  The impact of shutting down dividends, subordinated debt interest payments and bonuses while the sun is shining would benefit from further thought and debate.

Loss absorbency

Under Basel III reforms, additional tier 1 capital and tier 2 capital instruments must be issued on terms they are either written off or converted into common equity on the occurrence of certain trigger events. 

The requirement for these non-equity instruments to have loss absorbing characteristics arises out of experience during the global financial crisis where a number of banks were rescued through the injection of public funds in the form of equity.  However the subordinated nature of equity meant that public funds effectively supported not only the banks’ depositors, but also investors in subordinated bonds.  Accordingly, these regulatory capital instruments did not absorb losses as had been envisaged. 

RBNZ proposes that all non-common equity tier 1 capital and tier 2 capital instruments be mandatorily convertible into common equity at RBNZ’s option where the bank’s solvency becomes doubtful.  RBNZ prefers this solution rather than the instruments being written off as it considers a straight ‘haircut’ on subordinated debt holders effectively reverses their priority against shareholders.

RBNZ is seeking comment on the relevant triggers which would allow the regulator to bring this mechanism into play.  One option is to allow RBNZ to determine that in its opinion a bank will become “non-viable” without the conversion, without any particular measure of non-viability beyond the existing RBNZ Act solvency and other triggers.  While this will provide more flexibility for RBNZ, it will create uncertainty for the holders of such instruments, potentially affecting the pricing or marketability of such instruments.  The alternative is a quantitative trigger, for example by reference to whether a bank has fallen below a particular capital threshold.  In either case, there are issues as to how these triggers line up with the triggers for placing a bank into statutory management, and how the two regimes are to interact.

We expect that the loss absorbency proposals will be of interest to banks, particularly the requirement for the instruments to be converted into equity rather than being written off.  Again, this approach is out of step with APRA which is proposing that such instruments are to be written off unless APRA agrees otherwise. 

Interestingly, APRA will not permit conversion into unlisted equity.  This recognises that there a number of ancillary issues with a conversion mechanism, such as minority shareholder rights and securities law disclosure requirements, which would need to be addressed up front on the issue of the instruments, if the shares are not freely tradable and subject to listing rules. 

Given that none of the New Zealand incorporated banks currently have their equity securities listed, we question whether the concerns that RBNZ has with the more straightforward write off process are any more problematic than the complications created with having a conversion mechanism.

Accelerated timetable

RBNZ proposes to implement the capital conservation and countercyclical buffers in full from 1 January 2014.  This is just one year after the minimum capital requirements for common equity tier 1, additional tier 1 capital and tier 2 capital, and two years ahead of the timetable set down by the Basel Committee (and proposed by APRA).

It will mean that by 2014 banks will need a total capital of 10.5% and, depending on where New Zealand is in its economic cycle, may have to raise an additional 2.5% of common equity tier 1 for the countercyclical buffer (or at least be at risk that they will need to raise this within 12 months).

We question RBNZ’s haste in implementing all the Basel reforms ahead of the Basel Committee’s recommended timeframe as it will mean that regulators and the New Zealand banking system will miss out on both the benefit of the debate and of market adjustments (including the development of instruments meeting the new design requirements) that are likely to occur in the international transitional period.

Banks will also need to consider whether existing capital instruments require amendment to include loss absorbency features.  RBNZ proposes a “grandfathering” mechanism for instruments issued before September 2010 which do not have loss absorbency provisions.  But they will be given reduced recognition of 67% in 2013 and 33% in 2014 before receiving no recognition from the beginning of 2015.  For instruments issued after September 2010, there will be a 67% recognition in 2013, but no recognition from 2014 without the inclusion of loss absorbency provisions.

Further consultation

A further consultation paper on counterparty credit risk, reliance on external credit ratings and disclosure requirements is expected later this year.  In addition, RBNZ intends consulting on the draft Basel III capital adequacy standards in the second quarter of 2012.  These will take account of submissions received on its initial consultation paper and the current proposals.

Implications

RBNZ continues to set a tight timetable for implementation of the Basel III reforms.  With the implementation of the capital conservation buffer and countercyclical capital buffer just one year after the minimum capital requirements, banks will need to reassess their capital position over the next two years. 

The implementation of the loss absorbency requirements, particularly if RBNZ maintains its view that the writing off the instruments is not an option, will raise a number of issues, both commercial and technical.  Banks will need to accept that they could become subject to a broader ownership in a stress situation. 

Further developments

Chapman Tripp will continue to monitor the introduction of the Basel III reforms and the development of a more formal set of draft capital adequacy standards later this year.

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