APRA has acted and the game is changing for Mega Bank. I’ve posted on this blog many times that banking and capital regulation should be about accountability and method disclosure, not just a set of prescriptive rules. On March 30 APRA released its draft prudential standards on the Basel III initiatives and amendments to existing standards APS 110, APS 111 and APS 116. Within those drafts contains some very significant regulatory change which may be easy to miss because of both the subtlety and the lack of interest by the main stream media.
APRA perhaps has seen the holes in the current responsibility for capital management by Mega Bank and other ADIs and is finding a few plugs. So if you want to understand the future of Mega Bank, I suggest you read on.
The Basel III implications for bank capital requirements as generally reported have focused around two new capital buffers but these are far from the most important changes. Nevertheless, I’ll summarise these new capital buffers.
From APS110 Capital Adequacy on the Capital Conservation Buffer paras 24 and 25:
From 1 January 2016, an ADI must hold a capital conservation buffer above the Prudential Capital Requirement for Common Equity Tier 1 Capital determined by APRA. The capital conservation buffer is 2.5% of the ADI’s total risk weighted assets…….
The Capital conservation buffer is a sensible initiative which will probably be applied globally. However, and as many other commentators have pointed out, the capital conservation buffer will make little difference if there is a big distortion or under calculation of risk weighted assets. Problems arise from assets deemed low risk which turn out not to be.
From APS110 on the Countercyclical Capital Buffer, from para 29:
APRA may,..require ADIs to hold additional Common Equity Tier 1 Capital of between zero and 2.5% of total risk weighted assets, as a counter cyclical buffer
The countercyclical buffer, was not designed to address an individual ADI’s risk profile, but broader macroeconomic considerations. These considerations, perhaps in consultation with the RBA, would be used by APRA to determine an extra layer of capital across all ADIs. Another sensible global initiative but for now watch this space for some of the detail because:
APRA acknowledges that the Basel Committee is continuing to review this issue and, as a member of the Committee, APRA will be participating in this review. Once the review is finalised, APRA will consider whether further changes to its Basel III proposals are required.
Whilst both new capital buffers are reasonable and are being implemented globally, I believe that they are not the most significant proposed changes in the new APS 110. For these we need to look at the basic capital management requirements and compare the details with the current APS 110 to see how APRA has turned up the accountability notch to eleven.
From the current APS110, Responsibility for capital management para 6
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, enables the ADI to continue to operate in a sound and viable manner while the problems are addressed or resolved
In the proposed APS 110, the phrase “while the problems are addressed or resolved” has been replaced with “in the face of such losses”.
Next, from the current APS110 para 6:
The Board of directors (Board) of an ADI has a duty to ensure that the ADI maintains an appropriate level and quality of capital commensurate with the level and extent of risks to which the ADI is exposed from its activities
In the proposed APS 110 para 10, APRA has added the words. “In doing so, the board must have regard to any prospective changes in the ADI’s risk profile and capital holdings”.
In simple language, APRA is laying the full responsibility for maintaining adequate capital at the feet of the board and management including forecasting future risks of loss, not just current conditions. This responsibility clearly applies to ADIs using Basel II IRB approaches. Mega Bank IRB approach uses historical statistics to determine capital requirements rather than forecast loss scenarios. This situation may create a dilemma for the boards of directors trying to maximize returns on equity today. But there’s much more.
In the current APS 110, still at para 6, (I have edited):
An ADI must have in place an Internal Capital Adequacy Assessment Process (ICAAP) that includes as a minimum:
(a) adequate systems and procedures to identify, measure, monitor and manage the risks arising from the ADI’s activities on a continuous basis to ensure that capital is held at a level consistent with the ADI’s risk profile; and
(b) a capital management plan, consistent with the ADI’s overall business plan, for managing the ADI’s capital levels on an ongoing basis. Essentially, the plan must set out:
(i) the ADI’s strategy for maintaining adequate capital over time….
(ii) actions and procedures for monitoring the ADI’s compliance with minimum regulatory capital adequacy requirements…..
APRA have replaced (b) above and added the following paras in the proposed APS 110.
(b) a strategy for ensuring adequate capital is maintained over time, including specific targets set out in the context of the ADI’s risk profile, the board’s risk appetite and regulatory requirements…..
(c) actions and procedures for monitoring the ADI’s compliance (same as (b) ii) above)
(d) stress testing and scenario analysis relating to potential risk exposures and available capital resources
(e) processes for reporting on the ICAAP and its outcomes to the board and senior management of the ADI, and for ensuring the ICAAP is taken into account in making business decisions
(f) policies to address the capital impact of material risks not covered by explicit regulatory requirements, and
(g) an ICAAP summary statement…..
Some very important words have been changed and added completely changing the responsibility dynamic. No longer must a board have a strategy to “maintain” adequate capital, the strategy must “ensure” maintenance of capital. An ADI must conduct “stress testing and scenario analysis” on potential risks in ensuring maintenance of capital. The ADI must have procedures to report ICAAP to the board and senior management and policies to address material risks that are not covered by APRA’s prudential standards or guidelines.
The final leg of APRA’s new approach to Responsibility for Capital Management is that now the ADI must provide an ICAAP report to APRA annually. APRA details what must be in the report but the following closes, the responsibility loop in para 19
The ICAAP report submitted to APRA by the ADI must be accompanied by a declaration endorsed by the board and signed by the CEO……..
Regardless of APRA or Basel regulations and internal models built within those rules, responsibility for an ADI’s capital requirements today and in whatever stressed scenario may eventuate in the future rests with the ADI. The annual ICAAP declaration ensures that both the board and senior management are accountable, if capital turns out to be inadequate.
I believe this is a game changer for Mega Bank and every other ADI. Currently, directors and senior management could rely on information from today and the past to manage capital and not be responsible for events such as another GFC or a possible steep decline in house prices. Now these known and potential risks must be taken into account when managing capital. If I were a director of Mega Bank, I’d feel very uncomfortable with the new looming accountability and responsibility.
In my opinion the changes to APS 110 represent a positive step forward and great regulation but as always the proof will be in its enforcement.
NOTE: This post does not cover all the proposed Basel III changes.