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Prudential regulation

i Relationship with the prudential regulator

APRA describes its supervisory approach as forward-looking, primarily risk-based and consultative. It also appears to view its role as being protective, with a number of APRA publications referring to depositors, insurance policyholders and superannuation fund members as its beneficiaries. Notwithstanding, APRA is obliged under its founding statute to balance the often competing objectives of financial stability and safety on the one hand, and competition, contestability and competitive neutrality on the other. APRA therefore aims to maintain a low incidence of failure among regulated institutions rather than to guarantee that a regulated institution will never fail. It recognises that primary responsibility for the financial soundness of regulated institutions lies with the management and directors of those institutions.

APRA's supervision of ADIs consists of both data analysis and on-site interaction with the ADIs being supervised. The fact that ADIs are required to obtain APRA approval for certain transactions and arrangements also facilitates close cooperation between ADIs and APRA.

In addition to general financial reporting obligations, ADIs are subject to reporting requirements under the Financial Sector (Collection of Data) Act 2001 (FSCODA), which facilitates the collection of statistical data by APRA. FSCODA applies not only to ADIs, but also to non-bank lenders who carry on a business of providing finance (although most reporting standards applying to non-bank lenders state that they apply only to named non-ADI entities or non-ADI entities if they have total assets of A$50 million or more). APRA has issued reporting standards under FSCODA that prescribe the data that ADIs must supply to APRA and the form in which it must be supplied.

The data required to be supplied to APRA under FSCODA includes both general financial information, such as a statement of financial position, and specific information about particular kinds of assets and liabilities associated with banking business. The reporting standards require monthly or quarterly reporting, ensuring that APRA has access to current data to assist its decision-making. APRA collects data under FSCODA both to assist it in performing its supervisory functions and for statistical purposes. Data collected by APRA is also shared with other regulators and the Australian Bureau of Statistics, and summary statistical data is made available to the public.

APRA regulates ADIs primarily through the imposition of prudential standards with which ADIs must comply. The prudential standards are, on the whole, concerned with risk management for an ADI. Prudential standards set by APRA address key areas of risk for ADIs, including capital adequacy, liquidity and governance, and aim to ensure that such risks are properly identified and managed. Capital adequacy (which is discussed in more detail later) is the cornerstone of risk management, ensuring that the ADI can absorb losses that arise when adverse risks materialise.

APRA's approach to dealing with regulated entities is consultative and collaborative, both in relation to the setting of standards and enforcement. Its preference has been to work with ADIs to address concerns that it has, as opposed to litigation. The Banking Royal Commission criticised APRA (and ASIC) for their approach to enforcement, suggesting that more litigation to obtain penalties is called for. Much of the misconduct considered by the Banking Royal Commission was within ASIC's field of operation rather than APRA's: it concerned unlawful and undesirable conduct towards consumers in the provision of services other than deposit accounts.

ii Management of banksCorporate governance requirements

Prudential Standard CPS 510: Governance (CPS 510) sets out governance requirements that ADIs must comply with in addition to general corporations law obligations.

Locally incorporated ADIs must have a board of directors consisting of at least five directors, which is ultimately responsible for oversight of the management of the ADI. CPS 510 sets out the following requirements for a board of a locally incorporated ADI:

  1. it must be:
    • composed of a majority of independent directors (unless the ADI is a subsidiary of another APRA-regulated entity or an equivalent overseas regulated entity):
      • composed of a majority of non-executive directors; and
      • it must have:
        • procedures for performance assessment and renewal;
        • a remuneration committee to oversee the ADI's remuneration policy composed of at least three directors, a majority of whom are non-executive directors;
        • an audit committee to oversee the internal audit function, accounting, statutory reporting and external audit composed of at least three directors, a majority of whom are independent; and
        • a risk committee to oversee and implement the ADI's risk management framework composed of at least three directors, a majority of whom are independent.

The board must comprise a majority of independent directors, and a majority of those eligible to vote at any meeting must be non-executive directors, unless the ADI is a subsidiary of another APRA-regulated entity (e.g., an NOHC) or an overseas-equivalent entity. The board must also have procedures for assessing its performance on an annual basis. The ADI must also have a policy, overseen by the board remuneration committee, setting out the structure and objectives of its remuneration arrangements, but CPS 510 does not mandate any particular division between fixed and variable remuneration. The board must also have an audit committee to oversee reporting and audit obligations, in addition to the ADI maintaining an appropriately resourced internal audit function. The board must also have a risk committee.

Foreign ADIs need only to have a senior officer outside Australia with delegated authority from the board to oversee the Australian branch operation, and a senior manager ordinarily resident in Australia to be responsible for the local operation and available to meet with APRA on request.

Prudential Standard CPS 520: Fit and Proper (CPS 520) requires responsible persons – directors, senior managers and auditors – to be fit and proper. A person is fit and proper if he or she:

  1. possesses the competence, character, diligence, honesty, integrity and judgement to perform his or her duties;
  2. is not disqualified from holding his or her position; and
  3. does not have a material conflict of interest that would affect the performance of his or her duties.

An ADI is required to maintain a fit and proper policy setting out the processes for assessing whether a responsible person is fit and proper, and the consequences that will occur if a person is not fit and proper or ceases to be fit and proper. Information about each responsible person, and a statement of whether he or she has been assessed under the ADI's fit and proper policy, must be given to APRA each time that a person is appointed to a responsible person position or if any of the particulars in the statement changes.

An applicant for ADI authorisation must, at the time of application, satisfy APRA that it fulfils the governance requirements in CPS 510 and CPS 520.

Banking executive accountability regime

In 2018, the federal government introduced a new banking executive accountability regime (BEAR) into the Banking Act. The BEAR amendments hold ADIs and their senior executives and directors accountable for heightened standards of behaviour. The regime came into force for large ADIs on 1 July 2018, and will apply to small and medium ADIs from 1 July 2019.

In assessing the size of an ADI for the purposes of the regime, calculations are based on a three-year average of total resident assets, as follows: a small ADI has less than or equal to A$10 billion in total resident assets, a medium ADI has between A$10 billion and A$100 billion in total resident assets, and a large ADI is any ADI with greater than or equal to A$100 billion in total resident assets.

The BEAR consists of four sets of obligations: accountability obligations, key personnel obligations, deferred remuneration obligations and notification obligations.

The accountability obligations under the BEAR apply to ADIs and their accountable persons: senior managers who must be registered with APRA. They require ADIs and their accountable persons to conduct their business and responsibilities with honesty, integrity, due care, skill and diligence; deal with APRA in an open, constructive and cooperative way; and prevent matters from arising that would adversely affect the ADI's prudential standing or prudential reputation. ADIs also have an obligation to ensure that their accountable persons and their non-ADI subsidiaries comply with the accountability obligations.

The key personnel obligations require an ADI to:

  1. ensure that the responsibilities of its and its subsidiaries' accountable persons cover all aspects of the corporate group's operations and all prescribed functions;
  2. ensure that all accountable persons are registered with APRA;
  3. ensure that none of their accountable persons are disqualified by APRA;
  4. comply with directions given by APRA in relation to the ADI's key persons; and
  5. ensure that its non-ADI subsidiaries comply with the key personnel obligations.

The deferred remuneration obligations require ADIs to set remuneration policies that defer a specified proportion of the variable remuneration of accountable persons for at least four years (or a shorter period approved by APRA). The proportion of variable remuneration there must be depends on the particular accountable person's role and the size of the ADI. This is intended to incentivise senior managers to make decisions for the long-term benefit of the ADI. This obligation also cannot be avoided simply by not paying variable remuneration or paying only token variable remuneration, as the thresholds are expressed in terms of both variable remuneration and total remuneration (e.g., for the CEO of a large ADI, the lesser of 60 per cent of variable remuneration or 40 per cent of total remuneration must be deferred). Deferred variable remuneration must also be withheld if the ADI considers it likely that an accountable person has failed to comply with his or her accountability obligations, pending determination of whether they have in fact failed to meet their accountability obligations.

The notification obligations require an ADI to:

  1. give to APRA an accountability statement in respect of each accountable person, setting out that person's responsibilities and the parts of the ADI's operations that they manage or control;
  2. give to APRA an accountability map identifying accountable persons, areas of responsibility and reporting lines for the ADI;
  3. notify APRA when a person ceases to be an accountable person;
  4. notify APRA when an accountable person is suspended, dismissed or has their variable remuneration reduced due to failure to comply with the accountability obligations; and
  5. notify APRA when the ADI itself or one of its subsidiaries has failed to comply with its accountability obligations.
iii Regulatory capital and liquidityCapital

Regulatory capital requirements for ADIs (other than foreign ADIs and PPF providers, who are not subject to prudential capital requirements) in Australia are imposed by Prudential Standard APS 110: Capital Adequacy (APS 110), with the different classifications of capital instruments being set out in Prudential Standard APS 111: Capital Adequacy: Measurement of Capital (APS 111). The capital requirements largely mirror Basel III requirements, with amendments where appropriate for the Australian environment and a more conservative approach to the classification of capital instruments. Basel III requirements are fully implemented in Australia, and were in fact implemented ahead of the time frame required by the Basel Committee on Banking Supervision.

According to the RBA, the effect of APRA's adjustments to Basel III standards has the effect of increasing the Common Equity Tier 1 (CET1) capital positions of banks by between 1 and 1.5 per cent of risk-weighted assets. Concern has been raised about the impact of this on Australian banks' ability to obtain international funding – because they disclose lower capital ratios than equivalent banks overseas, and it may not be known by potential funders that this is due to more conservative capital standards – and in August 2018 APRA published a discussion paper setting out the following options to improve the international comparability of Australian ADIs' capital disclosures:

  1. ADIs continue to use existing capital measurement standards, but APRA would specify a methodology to quantify certain aspects of relative conservatism in Australian capital standards to be used to estimate internationally comparable capital ratios for disclosure purposes only; or
  2. some conservatism in Australian capital measurement standards is relaxed to make them correspond more closely to international capital standards, with minimum capital ratios and capital buffers being increased to maintain ADIs' current capital positions.

APS 110 requires ADIs to meet at least the following minimum prudential capital requirements (although APRA may determine a higher minimum prescribed capital ratio for a particular ADI at any time): CET1 ratio of 4.5 per cent of risk-weighted assets (RWA), Tier 1 capital ratio of 6 per cent of RWA and total capital ratio of 8 per cent of RWA.

RADIs, however, must hold their entire capital requirement as CET1 capital, unless they are a mutually owned RADI, in which case they may hold their capital as Tier 2 capital and agree with APRA on a time frame for building up Tier 1 capital.

APS 110 also requires ADIs to hold a capital conservation buffer of CET1 capital of 2.5 per cent of RWA. This means that an ADI's CET1 capital ratio must not fall below 7 per cent of RWA at any time. ADIs must also maintain a countercyclical capital buffer of between zero and 2.5 per cent of RWA, with the precise amount determined by APRA for each ADI. ADIs are required to report their countercyclical capital buffer position quarterly under Reporting Standard ARS 110.0. If an ADI's CET1 capital is not sufficient to satisfy the capital conservation buffer and countercyclical buffer requirements, it is constrained in its ability to make distributions (including discretionary bonus payments to staff).

ADIs and authorised NOHCs must obtain APRA's written approval prior to making any planned reduction in capital (including the repayment of any Tier 1 or Tier 2 capital instrument or trading in their own shares), and in seeking that approval give to APRA projections that show that they will meet capital adequacy requirements for at least the next two years.

APS 111 classifies capital instruments as follows.

  1. CET1: a permanent and unrestricted commitment of funds, freely available to absorb losses, not imposing any unavoidable servicing charge against earnings and ranking behind the claims of depositors and other creditors in the winding up of the ADI; it includes paid up ordinary shares, retained earnings, undistributed current year earnings, accumulated other comprehensive income, land and building revaluation reserves, minority interests that are ordinary shares and regulatory adjustments.
  2. AT1: a permanent and unrestricted commitment of funds, freely available to absorb losses, providing for fully discretionary distributions and ranking behind the claims of depositors and other creditors in the winding up of the ADI; they are instruments that do not meet the requirements for CET1 capital but that rank behind everything except CET1 capital in the winding up of the ADI, are redeemable only by the ADI with the consent of APRA, and convert automatically into ordinary shares or mutual equity interests (MEIs), or are written off on the occurrence of a non-viability trigger event.
  3. Tier 2: irrevocably paid up instruments with a minimum maturity of five years, amortised on a straight-line basis, redeemable only at the option of the issuing ADI no sooner than five years after receipt of the paid up amount and only with APRA's approval, and ranking behind everything except CET1 and AT1 instruments in the winding up of the ADI; long-term preference shares or subordinated loans that convert automatically into ordinary shares, mutual equity interests or are written off on the occurrence of a non-viability trigger event.

Notably, APS 111 requires equity holdings and other capital support provided to overseas deposit-taking institutions, holdings of its own capital instruments, asset impairment not recognised in profit or loss, deferred tax assets and liabilities, equity holdings and other capital support provided to non-financial entities, guarantees and any surplus in a defined benefit superannuation scheme, to be deducted in full from CET1 capital. There is no threshold treatment for the deduction of such items. Equity holdings and other capital support provided to financial institutions and own instrument holdings must also be deducted in full from the same tier of capital that the instrument held would qualify for had it been issued by the ADI itself (so, for example, ordinary shares in another financial institution must be deducted from the ADI's CET1capital). MEIs are instruments representing a claim on the issuing ADI that rank equally with CET1 instruments (but behind the subscription price paid for member shares), and on which distributions can only be made from retained earnings and for an amount no greater than 50 per cent of the issuing ADI's net profit for the period to which the distribution relates. MEIs were defined and allowed to be included in CET1 capital to enable mutual ADIs to raise capital from external sources (that is, from persons other than their members) in order to meet increasing minimum capital ratios without compromising their mutual status or triggering the demutualisation provisions in the Corporations Act.

For capital adequacy measurement purposes, ADIs must use the standardised approach based on prescribed risk weights for different asset types, with credit risk being dependent on ratings assigned by external credit assessment agencies. ADIs may obtain approval from APRA to use their internal risk rating models to rate the risk of their assets and then apply weights prescribed in Prudential Standard APS 113: Capital Adequacy: Internal Ratings-based Approach to Credit Risk.

Liquidity

Prudential Standard APS 210: Liquidity (APS 210) governs ADI liquidity requirements. In addition to requiring ADIs to identify their liquidity risk and develop strategies to manage liquidity and liquidity risk, APS 210 requires ADIs to either meet a liquidity coverage ratio (LCR) or minimum liquidity holdings (MLH), depending on which measure APRA determines applies to the ADI.

An ADI to which an LCR applies must maintain an adequate level of unencumbered high-quality liquid assets (HQLA) to meet its liquidity needs for 30 days under a severe stress scenario. The LCR is calculated as unencumbered HQLA held divided by total net cash outflows over the next 30 days (although APS 210 differentiates between grades of HQLA, mandates at least a 15 per cent haircut to relatively lower quality asses and limits the proportion of HQLA that can comprise relatively lower quality assets). A local ADI must maintain an LCR of at least 100 per cent on both an Australian dollar and all currencies basis. A foreign ADI must maintain an LCR of at least 40 per cent on an all currencies basis. APRA may require an ADI to maintain a higher minimum LCR if it has concerns about the ADI's liquidity risk profile or the quality of its liquidity risk management. An ADI to whom LCR applies must also maintain a net stable funding ratio (NSFR) of at least 100 per cent, unless APRA specifies a higher minimum NSFR for a particular ADI.

An ADI to which MLH applies must hold unencumbered prescribed liquid assets – physical currency, Australian government securities, foreign government securities eligible for repurchase agreements with the RBA, debt securities guaranteed by the Australian government or a foreign government and eligible for repurchase agreements with the RBA, bank bills certificates of deposit and debt securities issued by ADIs and net at-call deposits with other ADIs – equivalent to 9 per cent of its liabilities (both on-balance sheet and irrevocable off-balance sheet commitments). APRA may require an ADI to maintain higher MLH if it has concerns about the ADI's liquidity risk profile or the quality of its liquidity risk management.

Unlike capital requirements, liquidity requirements apply to both locally incorporated ADIs and ADIs that are local branches of foreign banks.

Group supervision

Prudential standards generally apply both to an ADI individually and to the consolidated group of which the ADI or an authorised NOHC is the parent entity (referred to in APRA's prudential standards as Level 1 and Level 2 respectively). Individual prudential standards either specify whether the requirements apply without any difference to the corporate group or prescribe different requirements on a Level 1 and Level 2 basis. For corporate group (Level 2) purposes, APS 110 also gives APRA power to determine which entities are to be included in the group for capital measurement purposes. This enables APRA to exercise supervision over entire banking groups in addition to individual banks.

iv Recovery and resolutionPlanning for failure

Although the concept has been suggested, ADIs are currently not required to prepare or maintain recovery and resolution plans (commonly called living wills) to deal with their failure. However, to obtain RADI authorisation, applicants must have a credible exit plan that demonstrates to APRA that they will be able to exit their banking business and protect depositors without relying on the FCS or requiring the use of APRA's crisis management powers. This is because RADIs have a two year time frame in which they must either transition to full ADI authorisation or cease carrying on banking business.

Regulator's power to take control of distressed ADIs

Broadly speaking, APRA can intervene in an ADI if there is a risk of depositors suffering loss or if there is a threat to the financial system's stability. The Banking Act provides for APRA to take control of a locally incorporated ADI's business, or to appoint an administrator to take control of a locally incorporated ADI's business, if:

  1. the ADI informs APRA that it considers itself likely to be unable to meet it obligations or that it is about to suspend payment;
  2. APRA considers that, without external support, the ADI may become unable to meet its obligations, may suspend payment or is likely to be unable to carry on banking business in Australia consistently with the interests of its depositors or the stability of the financial system in Australia;
  3. the ADI becomes unable to meet its obligations or suspends payment;
  4. an external administrator has been appointed to a holding company of the ADI (whether in Australia or overseas) and APRA considers that it poses a significant threat to the soundness of the ADI, interests of depositors or financial stability in Australia; or
  5. for a foreign ADI, an external administrator or equivalent has been appointed to the ADI or an application has been made for such an appointment.

Where necessary to facilitate the resolution of an ADI or its corporate group, APRA may also take control of or appoint an administrator to the authorised NOHC of the ADI, another subsidiary of the authorised NOHC or a subsidiary of the ADI.

APRA or the administrator in control of an ADI's business (as appropriate) is referred to as a statutory manager in the legislation. The statutory manager may exercise all of the powers of the ADI during its in control of the ADI, and can compel officers of the ADI to give information to it for the purpose of investigating the affairs of the ADI and resolving the ADI. It may also sell or otherwise dispose of all or part of the ADI's business on terms that it considers appropriate. Where necessary or convenient for facilitating the performance of the statutory manager's functions and duties, the statutory manager may also unilaterally vary the ADI's corporate constitution.

If an ADI is insolvent and APRA considers that it cannot be restored to solvency within a reasonable period (whether or not a statutory manager has attempted to resolve the ADI), APRA may apply to the Federal Court of Australia for an order to wind up the ADI.

Recapitalisation

In the circumstances described above giving rise to APRA's power to take control of or appoint an administrator to an ADI, as an alternative to appointing a statutory manager, APRA may direct an ADI or an authorised NOHC to increase its capital to a specified level. The direction may require the ADI to issue shares in itself, rights to acquire shares in itself or such other kinds of capital instruments as specified by APRA in the direction. However, as a safeguard for existing shareholders of the ADI, APRA must obtain an expert's report on the fair value of shares in the ADI prior to directing an ADI to issue such shares or rights to acquire shares. While APRA must consult with the competition regulator, the Australian Competition and Consumer Commission (ACCC), before giving a recapitalisation direction, the acquisition of shares, options or other capital instruments in an ADI that were issued in compliance with a recapitalisation direction is exempt from competition legislation prohibiting mergers and acquisitions that lessen competition.

Once an ADI is under the control of a statutory manager, the statutory manager may issue shares in the ADI or rights to acquire shares in the ADI, cancel shares or rights to acquire shares in the ADI, cancel paid-up share capital that is not represented by available assets or vary the rights attached to a class of shares in order to recapitalise the bank. The statutory manager can do this of its own motion without express direction from APRA, but its recapitalisation actions are subject to the same requirement to obtain and consider an independent report on the fair value of the ADI's shares prior to taking any recapitalisation action.

Deposit guarantee: the FCS

The Banking Act was amended in 2008 to implement the FCS, a federal government deposit guarantee scheme applicable to deposit accounts held with local ADIs (including Australian incorporated subsidiaries of foreign banks, but not mere branches of foreign banks). Under the FCS, the Treasurer may declare that the FCS applies to an ADI if a statutory manager is in control of an ADI or APRA has applied for an ADI to be wound up. Operation of the FCS is not automatic; it is activated at the discretion of the Treasurer (although, in relation to a large ADI, the political pressure to do so may well be hard to avoid). Once activated, the FCS is administered by APRA.

An account holder with an ADI subject to a declaration is entitled to payment of the balance of his or her account, plus uncredited interest up to the date of the declaration, up to a maximum amount of A$250,000. The A$250,000 limit applies across all protected accounts held with an ADI, including any seemingly separate brand under which the ADI may trade, but does not extend between ADIs, so a person with accounts with multiple declared ADIs may recover more than A$250,000 in aggregate. APRA may pay FCS amounts to account holders either directly or into an account established for them (with or without their consent) at another local ADI.

Upon payment of an FCS amount to an account holder, APRA is subrogated to the account holder's claim against the ADI. If the FCS does not cover any part of the account holder's deposits with the bank (e.g., if the account balance exceeded A$250,000), it remains a debt of the ADI owing to the account holder and may be admitted in the winding up of the ADI without proof by the account holder. APRA's costs of administering the FCS are also a debt payable to APRA, provable in the winding up of the ADI.

Bail-in powers

Australia does not have any mandatory bail-in provisions for creditors of ADIs or their holding companies. The terms of particular debt instruments may provide for automatic writing-off or conversion to equity on the occurrence of certain events, providing for the same outcome in substance as a bail-in, but any such write-off or conversion occurs pursuant to the contract between the entity and the holder of the instrument, rather than a special bail-in provision. Under APS 111, instruments must provide for writing-off or conversion into ordinary shares (or mutual equity interests) on the occurrence of certain non-viability events if they are to qualify as AT1 or Tier 2 capital. The big four banks regularly issue preference shares and convertible notes on terms that provide for mandatory conversion to ordinary shares on the occurrence of certain non-viability events, so that those instruments qualify as AT1 or Tier 2 capital.

Other debts not containing write-off or conversion provisions are not subject to mandatory bail-in. However, if the statutory manager of a distressed ADI sells all or part of the ADI's business to a third party on terms that do not involve the third party assuming the liabilities associated with that business (which the statutory manager is empowered to do, and which will likely be necessary in many cases to protect depositors and maintain financial system stability), non-depositor creditors of the distressed ADI will have little prospect of recovery and will likely be in substantially the same position as if they had been bailed-in.