The Australian Prudential Regulation Authority (APRA) has released a package of final measures to complete APRA's implementation of the Basel III capital reforms for authorised deposit taking institutions (ADIs) in Australia. The package includes APRA's response to submissions received on its proposed requirements for counterparty credit risk released in draft form in August 2012. The package also includes final versions of seven relevant prudential standards, two prudential practise guides and accompanying reporting standards, and revised guidelines on the recognition of External Credit Assessment Institutions.
Basel III and global regulatory reform
The Basel III reforms originated in the aftermath of the Global Financial Crisis, alongside global regulatory reforms of OTC derivatives markets. These reform packages are intended to create greater transparency in global derivatives markets by forcing derivatives transactions on market, and ensuring that banks hold relevant collateral against both market risks and counterparty credit exposures for open derivatives positions.
Features of Basel III
The key features of the Basel III capital reforms that will apply in Australia include:
● the imposition of higher capital regulatory charges for derivatives not cleared through qualifying central counterparties (QCCP);
● a new definition of regulatory capital under which common equity (see glossary for definition) is the most predominant form of tier 1 capital;
● a stricter approach to regulatory adjustments under which most deductions from capital are to be from Equity Tier 1 Capital (see glossary for definition);
● an increase in the minimum amounts of capital that ADIs must hold against risk: Common Equity Tier 1 Capital must be at least 4.5% of risk-weighted assets (up from 2% in Basel II) and the Tier 1 Capital ratio (see glossary for definition) must be at least 6% (up from 4% in Basel II);
● a new capital conservation buffer of 2.5% that places increasing constraints on capital distributions where an ADI's capital level falls within the buffer range;
● a countercyclical buffer of up to 2.5% that will apply when credit growth indicates a system-wide build up of risk; and
● a leverage ratio to help contain the build up of leverage in the banking system.
APRA will begin consultations on the Basel III disclosure requirements in 2013.
Basel III counterparty credit risk requirements
The Basel III reforms include adjustments to the existing rules for capitalising bank exposures to counterparty credit risk in respect of OTC derivatives, and the introduction of a new capital charge for potential mark-to-market losses associated with a deterioration in counterparty creditworthiness.
This new charge, known as the credit value adjustment risk capital charge (CVA charge), was introduced in response to lessons learned from the financial crisis, where it was found that over two-thirds of counterparty risk losses were due to a deterioration in counterparties' credit quality that fell short of actual counterparty defaults.
The Basel Committee released rules specifying the capital requirements for bank OTC derivatives trade exposures to central clearing counterparties (CCPs). These rules are designed to incentivise banks to clear all standardised OTC derivatives trades through CCPs, while at the same time ensuring that their credit exposures to CCPs are sufficiently capitalised.
Click here to view APRA's full suite of Basel III reforms.
● Common Equity means a measure of equity, which only takes into account the common stockholders, and disregards the preferred stockholders. It is equal to shareholder's equity minus preferred equity.
● Equity Tier 1 Capital is a measure of a bank's financial strength from the perspective of a regulator. It is comprised of core capital, which consists primarily of common stock and disclosed reserves, but may also include non-redeemable non-cumulative preferred stock. Tier 1 Capital was first defined in Basel I as a means of helping regulators assess the financial strength of banks. Theoretically, banks should hold Tier 1 Capital as a means of protection against unexpected losses.
● Tier 1 Capital ratio is the ratio of a bank's equity capital to its total risk-weighted assets (RWA). RWAs are the total of all assets held by the bank weighted by credit risk according to a formula determined by the regulator (i.e. APRA in an Australian context).