Part Capital Adequacy: Measurement of Capital - Banking (prudential standard) determination No. 4 of 2006 - Prudential Standard APS 111 - Capital Adequacy: Measurement of Capital - Capital Adequacy: Measurement of Capital | Zoe
Banking (prudential standard) determination No. 4 of 2006 - Prudential Standard APS 111 - Capital Adequacy: Measurement of Capital
Capital Adequacy: Measurement of CapitalCapital Adequacy: Measurement of Capital
Start here
Get a plain-English read of Capital Adequacy: Measurement of Capital
Turn the raw legal text into a practical explanation grounded in Banking (prudential standard) determination No. 4 of 2006 - Prudential Standard APS 111 - Capital Adequacy: Measurement of Capital.
Objective and key requirements of this Prudential Standard
For capital adequacy purposes, authorised deposit-taking institutions must hold a minimum amount of Tier 1 capital on both a stand-alone (Level 1) and consolidated banking group (Level 2) basis. In addition, they may include an amount of Tier 2 capital as part of their required capital holdings, up to the limits specified in this Prudential Standard.
This Prudential Standard sets out the essential characteristics that an instrument must have to qualify as Tier 1 or Tier 2 capital for inclusion in an authorised deposit-taking institution’s capital base for assessing Level 1 and Level 2 capital adequacy.
Tier 1 capital comprises the highest quality capital elements. Tier 2 capital includes other elements which, to varying degrees, fall short of the quality of Tier 1 capital but nonetheless contribute to the overall strength of an institution as a going concern.
For capital adequacy purposes, an authorised deposit-taking institution’s Level 1 and Level 2 capital base is defined as the sum of Tier 1 and Tier 2 capital after all specified deductions and adjustments, subject to the various limits that apply.
This Prudential Standard forms part of a comprehensive set of prudential standards that deal with the measurement of an authorised deposit-taking institution’s capital adequacy at Level 1 and Level 2.
Authority and application
This Prudential Standard, made under section 11AF of the Banking Act 1959 (the Act), applies to all authorised deposit-taking institutions (ADIs) under the Act, except foreign ADIs (within the meaning of Division 1B of Part II of the Act) operating through branches in Australia. The Guidance Notes AGN 111.1 Tier 1 Capital (AGN 111.1), AGN 111.2 Tier 2 Capital (AGN 111.2), AGN 111.3 Criteria for Capital Issues Involving Use of Special Purpose Vehicles (SPVs) (AGN 111.3), and AGN 111.4 Capital Deductions (AGN 111.4) also form part of this Prudential Standard.
Unless otherwise indicated, references to an ADI (or ADIs) in this Standard and associated Guidance Notes must be read to apply to an ADI (or ADIs) on both a Level 1 and Level 2 basis (as defined in Prudential Standard APS 110 Capital Adequacy (APS 110)).
Capital base
An ADI must, for capital adequacy purposes, hold minimum levels of capital established in APS 110. As part of these requirements an ADI must hold Tier 1 capital as defined in this Prudential Standard. In addition, an ADI may include Tier 2 capital as part of its required capital holdings up to the limits specified in this Prudential Standard.
For capital adequacy purposes, an ADI’s capital base (i.e. the numerator of the risk-based capital ratio) is defined as the sum of Tier 1 and Tier 2 capital, net of all specified deductions (refer AGN 111.2), subject to the various limits that apply.
In assessing whether an instrument is eligible as Tier 1 or Tier 2 capital, APRA will have regard to both the form and substance of the instrument. Where the terms of an instrument depart from established precedent, an ADI must consult APRA in advance of issuance, and provide APRA with adequate time to review the instrument, to ensure the eligibility of the instrument for inclusion in the ADI’s Level 1 or Level 2 capital base. An ADI must provide APRA with copies of documentation associated with the issue of all Tier 1 and Tier 2 capital instruments.
An ADI may use the Fair Value Option in valuing its financial instruments provided that:
(a) it complies with all relevant requirements of the Australian accounting standards applicable to the use of the Fair Value Option;
(b) it is only applied to financial instruments for which the ADI is able to reliably estimate fair values;
(c) it is covered by the ADI’s risk management systems, including related risk management policies, procedures and controls, both prior to the initial application for a particular activity or purpose and on an ongoing basis.
The ADI must provide information to APRA on its application of the Fair Value Option, as well as related risk management and valuation policies and procedures, including new applications of the Fair Value Option, if requested by APRA.
Specific provisions (refer Prudential Standard APS 220 Credit Quality (APS 220)), including that portion of collective provisions deemed to be a specific provision for regulatory purposes and any prescribed provisions, are ineligible to be included in Tier 1 and Tier 2 capital. To the extent that they have not already resulted in a charge to profit and loss, by way of establishment of a provision in audited published financial accounts, such provisions must be matched by a corresponding reduction in an ADI’s Tier 1 capital.
Tier 1 capital
Tier 1 capital comprises the highest quality capital elements which fully satisfy all of the following essential characteristics:
(a) provide a permanent and unrestricted commitment of funds;
(b) are freely available to absorb losses;
(c) do not impose any unavoidable servicing charge against earnings; and
(d) rank behind the claims of depositors and other creditors in the event of winding-up.
For the purposes of calculating an ADI’s capital base, Tier 1 capital is divided into:
Fundamental Tier 1 capital, which is the highest form of capital, consists of:
(ii) general reserves (excluding any General Reserve for Credit Losses which is included in Upper Tier 2 capital);
(iii) retained earnings;
(iv) current year earnings;
(v) foreign currency translation reserve;
(vi) capital profits reserve (representing realised gains on the disposal of revalued assets that have not been transferred from asset revaluation reserves to retained earnings);
(vii) minority interests arising from consolidation of Tier 1 capital of subsidiaries (only for Level 2 calculations);
Residual Tier 1 capital, which consists of all other items qualifying for Tier 1 status, is divided into:
(i) Non-innovative Residual Tier 1 capital – comprising perpetual non-cumulative preference shares that satisfy the relevant criteria set out in AGN 111.1; and
(ii) Innovative Tier 1 capital – comprising all other Residual Tier 1 capital instruments that satisfy the relevant criteria set out in AGN 111.1 and AGN 111.3.
General reserves are created after tax and include, but are not limited to:
(a) reserves from equity-settled share-based payments (share or share options) granted to employees as part of their remuneration package provided that:
(i) the share or share options granted relate only to the ordinary shares of the ADI itself; and
(ii) there are no circumstances in which such remuneration can be converted into another form (e.g. cash).
Any other reserves associated with share-based payments must be excluded from capital; and
(b) cumulative unrealised gains or losses on hedges[2] offsetting gains or losses included in Tier 1 capital (e.g. movements in the currency value of foreign currency denominated hedging instruments which offset movements in foreign currency denominated items recognised in the foreign currency translation reserve). This includes fair value gains or losses on derivatives representing effective economic hedges of assets.
Current year earnings must incorporate:
(a) negative goodwill;
(b) the unwinding of any discount on credit loss provisions (refer Guidance Note AGN 220.1 Impaired Facilities Definition);
(c) the proceeds of any dividend reinvestment plan pending the issuance of ordinary shares, as agreed with APRA; and
(d) expected dividends and tax expenses.
Current year earnings also include the full value of upfront fee income provided that:
(a) the fee income has either been received in cash or has been debited to a customer’s account or otherwise forms part of the upfront fees owed by a customer;
(b) outstanding amounts of fee income debited to customer accounts must be able to be claimed in full in the event of default by the customer, or capable of being sold as part of outstanding debts to a third party;
(c) the provider of the income has no recourse for repayment in part or full of any prepaid income;
(d) the customer is not able to cancel any fees debited to the customer’s account for which they were otherwise obliged to pay upfront; and
(e) there is no requirement for the provision of continuing additional services or products associated with the fee income concerned.
Fee income can include net positive amounts arising from the netting of deferred income and capitalised expenses associated with a product class provided the conditions set out in paragraph 13 are met.
Tier 2 capital
Tier 2 capital includes other elements which, to varying degrees, fall short of the quality of Tier 1 capital stated in paragraph 9 above but nonetheless contribute to the overall strength of an entity as a going concern. It is divided into:
(a) Upper Tier 2 capital – comprising elements that are essentially permanent in nature, including some forms of hybrid capital instrument; and
(b) Lower Tier 2 capital – comprising instruments which are not permanent i.e. dated or limited life instruments.
Upper Tier 2 capital
Upper Tier 2 capital consists of the following items that satisfy the relevant criteria set out in AGN 111.2 and AGN 111.3:
(d) any other hybrid capital instruments of a permanent nature approved by APRA, including any capital amounts otherwise meeting APRA’s requirements for Tier 1 capital instruments (refer AGN 111.1) that are ineligible for inclusion as Tier 1 capital as a result of the limits in this Prudential Standard;
(e) shares issued after 1992 by way of a fully paid bonus issue arising from capitalisation of property revaluation reserves;
(f) a General Reserve for Credit Losses (refer AGN 111.2, APS 220 and AGN 220.2 Impairment, Provisioning and the General Reserve for Credit Losses (AGN 220.2)), unless otherwise approved by APRA, in writing. The amount of this reserve able to be in included as Upper Tier 2 capital is limited to a maximum of 1.25 per cent of total risk-weighted exposures (refer paragraph 5 of AGN 110.4);
(g) 45 per cent of pre-tax revaluation reserves of each of the following (subject to satisfying the conditions specified in AGN 111.2 relevant to each reserve):[3]
(i) property, including owner-occupied and investment property, which is readily available to be sold;
(ii) readily marketable securities which are designated as available for sale in the ADI’s or the group’s published financial accounts; and
(iii) investments in subsidiaries, other than subsidiaries that APRA deems part of an Extended Licensed Entity (refer AGN 222.1 Extended Licensed Entity).
The amount recognised must be net of any fair value gains and losses and any gains or losses on hedges offsetting revaluations included in reserves.
(h) 45 per cent of the post-acquisition reserves of associates as defined in the Australian accounting standards.[4] This includes, under equity accounting, the ADI’s share of undistributed profits, plus any share of asset revaluations in associates or any other revaluation of investments in associates. The amount recognised must be net of fair value gains and losses and any gains or losses on hedges offsetting revaluations of investments in associates included in reserves.3
The amount of the General Reserve for Credit Losses to be included in Upper Tier 2 capital is on an after-tax basis. Any deferred tax asset associated with collective provisions (refer AGN 220.2) eligible to be included in the General Reserve for Credit Losses must be removed.
Where an ADI is aware that a particular asset is impaired and a loss arises, such a loss must be reflected in Tier 1 capital. However, where a particular asset belongs to a class of assets for which asset revaluation reserves are included in Upper Tier 2 capital and the asset has been identified as impaired and losses arise, the losses may be offset against any existing revaluations of the asset or class of revalued assets.
If an asset revaluation reserve included in Upper Tier 2 capital is negative after adjustment for revaluations of assets included in the reserve, losses due to impairment of assets covered by the reserve and any gains or losses on hedges offsetting revaluations of assets included in the reserve, the amount of deficit in the reserve must be reported as a deduction from Tier 1 capital.
Where an ADI is only permitted to recognise the discounted portion of a change in value of an asset in its capital, then for the purposes of:
(a) deducting from capital the value of the asset; or
(b) calculating its risk-weighted assets
the ADI need only utilise the value of the asset incorporating the discounted change in its value.
Lower Tier 2 capital
Lower Tier 2 capital consists of the following items that satisfy the relevant criteria set out in AGN 111.2 and AGN 111.3:
(a) term subordinated debt;
(b) limited life redeemable preference shares; and
(c) any other similar limited life capital instruments.
Dividend and interest payments on Tier 1 and Upper Tier 2 capital instruments
Unless otherwise approved, in writing, by APRA:
(a) the aggregate amount of dividend payments on ordinary shares must not exceed an ADI’s after-tax earnings, after taking into account any payments on more senior capital instruments, in the financial year to which they relate; and
(b) the aggregate amount of dividend or interest payments, whether whole or partial, paid on Upper Tier 2 and Residual Tier 1 capital must not exceed an ADI’s after-tax earnings, after taking into account any payments made on more senior capital instruments, calculated before any such payments are applied in the financial year to which they relate.
For these purposes ‘financial year’ refers to publicly available operating results in the 12 months preceding the date of the proposed payment of dividend or interest. For example, where an ADI makes available half-yearly operating results, a financial year will refer to the preceding two publicly available half-yearly operating results for the ADI.
Holding of shares in group members by other group members
Capital instruments[5] of an ADI, or a member of a group headed by an ADI at Level 2, that are held as direct investments by a vehicle[6] subject to consolidation within the ADI’s financial statements in accordance with Australian accounting standards, may only be included in Tier 1 capital and Tier 2 capital (on both a Level 1 and Level 2 basis as appropriate) if:
(a) the ADI (or member of the group) did not fund the acquisition of the capital instruments (i.e. acquisition of capital instruments is funded by third parties such as life insurance policyholders or other third-party investors);
(b) the risk and rewards associated with the investments are borne primarily by third parties; and
(c) the ADI can demonstrate to APRA, if required, that decisions to acquire or sell such capital instruments are made independently of the issuer of the capital instruments and in the interests of the third parties who primarily bear the risks and rewards of the investments in the instruments.
Direct investments in shares of an ADI, by a special purpose vehicle (e.g. trust) established under a share-based employee remuneration scheme, may only be included in the ADI’s Tier 1 capital (on a Level 1 and Level 2 basis) where:
(a) the shares issued to the special purpose vehicle represent ordinary shares of the ADI;
(b) the amount included in Tier 1 capital is matched by an equivalent charge to profit and loss of the ADI for expensing the issue or funding the acquisition of ordinary shares by the vehicle; and
(c) the ordinary shares issued cannot be converted to payment in another form (e.g. cash).
For the purposes of measuring capital at Level 2, the special purpose vehicle holding such shares must be excluded from the consolidated group. As a consequence, any associated change in the fair value of shares held by such a special purpose vehicle must be excluded from Level 2 capital and risk- weighted assets.
Deductions
Level 1 deductions
From Tier 1 capital
For the purposes of calculating its Level 1 capital base, an ADI must deduct the following items from Tier 1 capital (refer AGN 111.4):
(a) goodwill, and any other intangible assets arising on an acquisition, net of adjustments to profit and loss reflecting any changes arising from “impairment” of goodwill;[7]
(b) other intangible assets net of adjustments to profit and loss reflecting amortisation and impairment.[8] This includes capitalised expenses and any changes in the intangible component of investments in subsidiaries and other entities[9] that could arise after or outside of acquisitions. Intangible assets are as defined in the Australian accounting standards plus any other assets designated in this Prudential Standard to be intangible;
(c) deferred tax assets net of deferred tax liabilities (refer AGN 111.4);
(d) any portion of current year earnings or retained earnings which represents any amount deriving from the ADI’s share of undistributed profit or loss in an associate under equity accounting. This amount should be included in Upper Tier 2 capital;
(e) all holdings of own Tier 1 capital instruments, unless exempted by APRA and any unused trading limit on these instruments agreed with APRA;
(f) equity and other capital investments in associated (e.g. captive) lenders mortgage insurers;
(g) equity investments in non-subsidiary entities that are not operating in the field of finance in excess of:
(i) 0.25 per cent of the ADI’s Level 2 Tier 1 capital before deductions for an individual investment; or
(ii) 5 per cent of the ADI’s Level 2 Tier 1 capital before deductions in aggregate;
(h) any negative movement over the amount available in the respective revaluation reserves for the following items, to the extent not already accounted for in current year earnings or retaining earnings:
(i) property (owner-occupied and investment property readily available to be sold);
(ii) readily marketable securities designated as available for sale;
(iii) investments in subsidiaries; or
(iv) investments in associates, including any excess of the share of losses in associates under equity accounting;
(i) any surplus, net of deferred tax liabilities, in any ADI employer-sponsored defined benefit superannuation fund, unless otherwise approved, in writing, by APRA. Any excluded surplus must reverse any associated deferred tax liability from Tier 1 capital;
(j) any deficit in an ADI employer-sponsored defined benefit superannuation fund that is not already reflected in Tier 1 capital;
(k) any identified impairment of an asset not forming part of a class of assets, to which an asset revaluation reserve in Upper Tier 2 capital applies and where the impairment has not already been taken into account in the profit and loss. This includes any deficit in an asset revaluation reserve included in Upper Tier 2 capital after taking account of all adjustments;
(l) unrealised fair value gains, or, where applicable, adding back unrealised fair value losses, arising from changes in an ADI’s own creditworthiness;
(m) revaluations of assets not held for trading purposes that are passed through profit and loss unless the revaluations are specifically permitted to be included in Tier 1 capital for the purposes of this Prudential Standard;
(n) any amounts included in revaluation reserves in Upper Tier 2 which otherwise would have been included in Tier 1 capital are to be deducted from Tier 1 capital;
(o) any amounts included in the General Reserve for Credit Losses which have not already been deducted from retained earnings or current year earnings;
(p) cumulative fair value gains and losses on effective cash flow hedges reflected in retained earnings or reserves included in Tier 1 capital which do not offset gains or losses on revaluations in reserves included in Tier 1 capital;[10]
(q) any fair value gains and losses relating to illiquid financial instruments. Illiquid financial instruments are those financial instruments, including any instruments covered by effective economic hedges, which do not have a reliable fair value and are to be reported on an amortised cost basis. If fair values can be credibly inferred, the instrument need not be considered “illiquid”;
(r) any fair value gains and losses relating to loans and receivables not eligible to be reported using fair values.[11] Such loans and receivables are to be recognised at amortised cost for capital adequacy purposes.
From Upper or Lower Tier 2 capital (as appropriate)
Unless exempted, by APRA, all holdings of own Upper and Lower Tier 2 capital instruments and any unused trading limit agreed with APRA in such instruments must be deducted from Upper or Lower Tier 2 capital (as appropriate).
From Total Capital (i.e. the sum of Tier 1 and Tier 2 capital after deductions and amortisation)
The following items are to be deducted from Total Capital:
(a) equity and other capital investments in other ADIs or equivalent overseas deposit-taking institutions, and their subsidiaries, except where:
(i) the other ADI or equivalent overseas deposit-taking institution is wholly owned or effectively controlled, whether directly or indirectly, by the ADI, and has been consolidated with the ADI at Level 2 for capital adequacy purposes; or
(ii) the capital instruments of the other ADI or equivalent overseas deposit-taking institution are held for trading purposes which, in this case, must be included in the ADI’s total risk-weighted exposures in accordance with APS 113 Capital Adequacy: Market Risk (APS 113);
(b) equity and other capital investments in holding companies of ADIs and equivalent entities overseas unless these are held for trading purposes, in which case they must be included in the ADI’s total risk-weighted exposures in accordance with APS 113;
(c) any credit support of a capital nature provided to any entities including non-related entities, such as provision of a first loss guarantee, including any undertakings by the ADI to absorb designated first level losses on claims supported by it. First loss facilities associated with funds management and securitisation must be deducted in accordance with the requirements set out in Prudential Standard APS 120 Funds Management & Securitisation (APS 120); and
(d) any non-repayable loans advanced by the ADI under APRA’s certified industry support arrangements.
Level 2 deductions
From Tier 1 capital
For the purposes of calculating its Level 2 capital base, an ADI must deduct the following items from Tier 1 capital (refer AGN 111.4):
(a) goodwill, and any other intangible assets arising on an acquisition, net of adjustments to profit and loss reflecting any changes arising from “impairment” of goodwill;12
(b) other intangible assets net of adjustments to profit and loss reflecting amortisation and impairment.13 These include capitalised expenses and the intangible component of investments[12] in non-consolidated subsidiaries (refer AGN 110.2) and other entities that do not form part of the consolidated banking group at Level 2. Intangible assets are as defined in the Australian accounting standards plus any other assets designated in this Prudential Standard to be intangible;
(c) deferred tax assets net of deferred tax liabilities (refer AGN 111.4);
(d) any portion of current year earnings or retained earnings which represents any amount deriving from the ADI’s share of undistributed profit or loss in an associate under equity accounting. Such an amount should be included in Upper Tier 2 capital;
(e) all holdings of own Tier 1 capital instruments, unless exempted, and any unused trading limit agreed with APRA (refer AGN 111.4);
(f) equity and other capital investments in non-consolidated (i.e. captive) lenders mortgage insurers (refer AGN 110.2);
(g) equity investments in non-subsidiary entities that are not operating in the field of finance in excess of:
(i) 0.25 per cent of the ADI’s Level 2 Tier 1 capital before deductions for an individual investment; or
(ii) 5 per cent of the ADI’s Level 2 Tier 1 capital before deductions in aggregate;
(h) any negative movement over the amount available in the respective revaluation reserves for the following items, to the extent not already accounted for in current year earnings or retained earnings:
(i) property (owner-occupied and investment property readily available to be sold);
(ii) readily marketable securities designated as available for sale;
(iii) investments in unconsolidated subsidiaries; or
(iv) investments in associates, including any excess of the share of losses in associates under equity accounting;
(i) any surplus, net of deferred tax liabilities, in any ADI or other group member employer-sponsored defined benefit superannuation fund unless otherwise approved, in writing, by APRA. Any excluded surplus must reverse any associated deferred tax liability from Tier 1 capital;
(j) any deficit in an ADI or other group member employer-sponsored defined benefit superannuation fund that is not already reflected in Tier 1 capital;
(k) any identified impairment of an asset not forming part of a class of assets to which an asset revaluation reserve is included in Upper Tier 2 capital applies and where the impairment has not already been taken into account in the profit and loss. This includes any deficit in an asset revaluation reserve included in Upper Tier 2 capital after taking account of all adjustments;
(l) unrealised fair value gains (or where applicable, adding back unrealised fair value losses) arising from changes in an ADI’s own credit worthiness;
(m) revaluations of assets not held for trading purposes passed through the profit and loss account unless the revaluations are specifically permitted to be included in Tier 1 capital for the purposes of this Prudential Standard;
(n) any amounts included in revaluation reserves in Upper Tier 2 capital which otherwise would have been included in Tier 1 capital must be deducted from Tier 1 capital;
(o) any amounts included in the General Reserve for Credit Losses which have not already been deducted from retained earnings or current year earnings;
(p) cumulative fair value gains and losses on effective cash flow hedges reflected in retained earnings or reserves included in Tier 1 capital which do not offset gains or losses on revaluations in reserves included in Tier 1 capital;
(q) any fair value gains and losses relating to illiquid financial instruments;
(r) any fair value gains and losses relating to loans and receivables not eligible to be reported utilising fair values.[13] Such loans and receivables are to be recognised at amortised cost for capital adequacy purposes.
From Upper or Lower Tier 2 capital (as appropriate)
Unless exempted by APRA, all holdings of own Upper and Lower Tier 2 capital instruments and any unused trading limit agreed with APRA in such instruments (refer AGN 111.4) must be deducted from Upper or Lower Tier 2 capital (as appropriate).
From Total Capital (i.e. the sum of Tier 1 and Tier 2 capital after deductions and amortisation)
The following items are to be deducted from Total Capital:
(a) equity and other capital investments in other ADIs or equivalent overseas deposit-taking institutions and their subsidiaries, unless these are held for trading purposes in which case they must be included in the ADI’s total risk-weighted exposures in accordance with APS 113;
(b) equity and other capital investments in holding companies of ADIs and equivalent overseas entities unless these are held for trading purposes in which case they must be included in the ADI’s total risk-weighted exposures in accordance with APS 113;
(c) equity and other capital investments in non-consolidated subsidiaries or controlled entities other than captive lenders mortgage insurers after any intangible component of the investment is deducted from Tier 1 capital as per items (a) and (b) above (refer also AGN 110.2). This deduction does not apply to a subsidiary holding company where it acts as a holding company for investments only in subsidiary ADIs or equivalent overseas deposit-taking institutions. In the event that a subsidiary holding company holds investments in subsidiaries not eligible for consolidation, an ADI must deduct its investment in the holding company net of the value of the holding company’s investment in any consolidated subsidiary ADI or equivalent overseas deposit-taking institution;
(d) any credit support of a capital nature provided to entities, including those non-related entities that do not form part of the consolidated banking group at Level 2, such as provision of a first loss guarantee or any undertakings by the ADI or by any entity consolidated at Level 2 to absorb designated first level of losses on claims supported by them. First loss facilities associated with funds management and securitisation must be deducted in accordance with the requirements set out in APS 120; and
(e) any non-repayable loans advanced by the ADI under APRA’s certified industry support arrangements.
All amounts of assets corresponding to deductions from capital made at Level 1 and Level 2 are to be excluded from total assets when calculating an ADI’s total risk-weighted assets at the respective level (refer paragraph 2 of AGN 112.1 Risk-Weighted On-Balance Sheet Credit Exposures (AGN 112.1)). Notwithstanding that the changes in value of some hedges may be deducted from capital, the credit risk on these hedges must continue to be included in total risk-weighted assets in accordance with AGN 112.2 Off-Balance Sheet Credit Exposures (AGN 112.2).
Use of fair values
Fair value measures, including the use of the Fair Value Option, must only be applied to financial instruments for which an ADI is able to reliably estimate fair values.
An ADI must have risk management systems including associated policies, procedures and controls which cover the application of fair value measurement in the banking book. The ADI must be able to demonstrate that the use of fair value measurement and, in particular, the use of the Fair Value Option is managed, monitored and reported in a sound and effective manner, taking into account the scale, complexity and scope of the ADI’s operations. These risk management systems must:
(a) outline the assets and liabilities to be recognised at fair value and the processes for approving use of fair values for new items, products and transactions;
(b) enable ADIs to make choices regarding the alternative treatments for categorising financial instruments using fair value measures under accounting practice in a fully informed and disciplined manner;
(c) specify the relationship between the application of fair value measures and the ADI’s risk management framework;
(d) outline methods used for the selection and validation of valuation processes used in calculating and reporting of fair values, including where appropriate, independent review, analysis of model stability and performance over a variety of conditions, use of back testing and frequency of validation. The ADI must retain data and supporting documentation for these purposes;
(e) detail the processes for ensuring use of fair values is being applied consistently across the ADI for both reporting and risk management purposes. This should include the frequency at which fair values will be calculated and reported for those assets and liabilities recognised at fair value; and
(f) detail how the ADI determines the fair value gains and losses arising from changes in the ADI’s own creditworthiness and that of other group members at Level 2.
The ADI must supply information, if requested by APRA, to assist APRA in assessing the impact of the application of fair values, in particular the application of the Fair Value Option, on the value of financial instruments for capital adequacy and other APRA purposes.
Where APRA considers that an ADI’s policies and procedures for the use of fair values are not reliable or affect adversely its safety and soundness, APRA may require an ADI to amend its policies and procedures; to discontinue use of fair value measures for regulatory reporting; or to hold higher levels of capital.[14]
Limitations
The amount of Tier 1 and Tier 2 capital included in an ADI’s Level 1 and Level 2 capital base are subject to the following limits:
(a) Tier 1 capital
(i) Prior to 1 January 2008:
(A) Residual Tier 1 capital is limited to 20 per cent of total Tier 1 capital before deductions. Any excess amount is counted as Upper Tier 2 capital.
(ii) On and after 1 January 2008:
(A) Fundamental Tier 1 capital must constitute at least 75 per cent of net Tier 1 capital, defined as the sum of Fundamental Tier 1 and Residual Tier 1 capital less Tier 1 deductions. This requirement does not apply to mutually owned ADIs in their formative years of operation, as approved by APRA.
(B) Residual Tier 1 capital is limited to 25 per cent of net Tier 1 capital. Any excess amount is counted as Upper Tier 2 capital.
(C) Innovative Tier 1 capital is limited to 15 per cent of net Tier 1 capital, except for ADIs that are subject to APRA-approved transition arrangements (refer paragraph 2 of the Attachment to this Prudential Standard). Any excess amount is counted as Upper Tier 2 capital.
(iii) Net Tier 1 capital must constitute at least 50 per cent of an ADI’s required capital base. This requirement does not apply to mutually owned ADIs in their formative years of operation, as approved by APRA.
(b) Tier 2 capital
(i) Total Tier 2 capital (net of all specified deductions and amortisation) is limited to a maximum of 100 per cent of an ADI’s net Tier 1 capital. This requirement does not apply to mutually-owned ADIs in their formative years of operation, as approved by APRA.
(ii) Total Lower Tier 2 capital net of all specified deductions and amortisation is limited to a maximum of 50 per cent of an ADI’s net Tier 1 capital. This requirement does not apply to mutually-owned ADIs in their formative years of operation, as approved by APRA.
Attachment
IFRS transition arrangements
For the purposes of APS 111, ADIs may include a specific dollar amount as agreed by APRA, in writing, in their Tier 1 and/or Upper Tier 2 capital during the transition period from 1 July 2006 to 31 December 2007. The dollar amount of the adjustment will be based on the difference between the ADI’s total capital base as at 30 June 2006 under the pre-IFRS requirements and its total capital base at 1 July 2006 as would otherwise be reportable under this Prudential Standard. The dollar amount of the adjustment will remain constant over the transition period and will cease to apply on 1 January 2008.
For the purposes of this Prudential Standard, transitional relief may also be granted by APRA, in writing, to an ADI up to 1 January 2010 where its dollar amount of innovative capital instruments exceeds the 15 per cent limit at 1 January 2008. ADIs may include an excess amount agreed by APRA as eligible Innovative Tier 1 capital during the transition period. In determining the excess amount for transition, APRA will limit the amount to the difference between the dollar amount of the ADI’s Innovative Tier 1 capital instruments as at 31 August 2005 and the dollar amount of Innovative Tier 1 capital that the ADI would otherwise be entitled to hold had the 15 per cent limit applied to the ADI’s Tier 1 capital as at 1 July 2006. The actual excess amount for transition will be agreed with APRA, in writing, based on the ADI’s estimated capital base as at 1 January 2008 and any other factors, including other capital management measures undertaken by the ADI.
Any unrealised gains resulting from the first-time adoption of the “cost model” for owner-occupied property must be included at full value in Upper Tier 2 capital, subject to regular impairment testing.