APRA Releases Prudential Practice Guide on Capital Buffers

On the 17th of December 2015, the Australian Prudential Regulation Authority (APRA) released for consultation a draft version of the Prudential Practice Guide for Capital Buffers (APG 110). On the 30^th of August 2016 APRA addressed the key response to this submission. The Australian Banking Association raised concerns over the ability of an Authorised Deposit-taking Institution (ADI) to make Additional Tier 1 (Hybrid) capital distributions when its Common Equity Tier 1 (CET1) capital ratio falls within the capital buffer range (i.e. if the CET1 ratio falls below 8% for the four major banks).   It is therefore of paramount importance for investors across the entire capital structure to know what an individual ADI’s CET1 ratio currently is. During the August reporting season, the CET1 ratio of the four major banks were reported to be ~9% when adjusting for the 25% Risk Weighted Adjustment capital charge on residential mortgages (that came into effect on 1 July 2016). Should an ADI’s CET1 ratio start to fall towards the 8% buffer zone, hybrid distributions unlikely to be paid (a risk that BondAdviser points out in both the security summary and negative risk factor sections of each research report for applicable securities).   This is one of the reasons why we believe that the relatively high dividend payout ratios that are being paid out by ADIs have to fall to more sustainable levels. With the exception of the ANZ (who reduced the 1H16 interim dividend by 7% to gradually consolidate the dividend payout ratio within its historic range of 60-65% of annual cash profit), the major banks are yet to acknowledge this as they currently have a cash dividend payout ratio above 75%. ANZ’s historical range is reasonable because 40% of profits must be retained if CET1 levels are between 7.375% and 8.00%. If capital levels continue to decrease during a period of financial stress, then APRA has prescribed that the profit retention level must rise to replenish capital.   Affected distributions include dividends, buybacks, staff bonuses & hybrid payments. The latter are expected to be prioritised as some instruments prevent payment of ordinary dividends if the scheduled hybrid distribution is not paid in full.   Constraints on distributions act to ensure that once an ADI is within the capital buffer range its capital position is restored in a timely manner. An ADI may apply to APRA to make payments in excess of the constraints imposed by the capital conservation buffer regime but in considering whether to approve such an application, APRA would expect an ADI to demonstrate that it has a capital top-up plan. In the absence of APRA’s approval an ADI’s distributions would be constrained. APRA has made amendments to APG 110 to clarify this process.   The submission also raised concerns regarding earnings estimates outside normal reporting cycles and the potential complexity and costs associated with doing so. APRA is not requiring an ADI to seek formal review or audit of financial information outside the normal reporting cycle but rather to determine a robust internal estimate of earnings as close as possible to the date of the distribution in question. APRA has made minor drafting changes to APG 110 to better reflect this.   Table 1. Capital Buffer Thresholds

Source: APRA   Consistency of capital distributions The submission stated that APS 110 requires earnings to be calculated prior to the deduction of items that are distributions for capital conservation buffer purposes, but is silent on whether such items should also be added back to CET1 capital for the purposes of determining the ADI’s CET1 capital ratio. It was argued that this leads to an inconsistent treatment for hybrid instruments treated as debt or equity securities for accounting purposes. In the case of hybrid instruments classified as debt securities, coupon payments are regularly accrued through profit and loss (and hence deducted from CET1 capital) but for coupon payments on hybrid instruments treated as equity securities, the coupon payment is only charged to profit and loss (and hence deducted from CET1 capital) when the coupon payment is declared.   APRA agrees with the analysis of different outcomes depending on the exact nature of a hybrid instrument. However, in APRA’s view, the position as set out in APS 110 (to allow earnings to be calculated prior to the deduction of distributions, but make no corresponding adjustment to CET1 capital) is prudent and appropriate. APRA considers this position is consistent with the international framework set out by the Basel Committee on Banking Supervision (Basel Committee) and is consistent with the treatment of such items in a number of other jurisdictions.   Non-Viability Turning to the subject of non-viability, Wayne Byres (Chairman of APRA) spoke at the Actuaries Institute Banking Conference on the 30^th of August 2016 regarding the subject ‘Finding success in failure’. He commented upon APRA’s powers in the event of a bank failure and the difference of outcomes between disorderly versus orderly failures, with an orderly failure being the preferred outcome.   Disorderly failures are hard to predict as, by definition, they catch everyone by surprise. Putting the lessons learned from the disorderly failure of HIH Insurance in 2001 into practice is one of the main reasons for APRA’s increased level of active supervision and willingness to intervene that we see today.   As part of the strategy to engineer an orderly outcome Mr Byres again made the point that the injection of capital during a period of distress, and when time is of the essence, is ideally to be avoided. With that in mind, the use of bail-in capital to provide ‘breathing space’ to allow for orderly resolution was discussed. Specifically Mr Byres made the comment:   “Viewing these capital instruments as simply higher-yielding substitutes for vanilla fixed-interest investments, let alone deposits, is something to be counselled against, since from APRA’s perspective holders of these instruments are providing the important first lines of defence that we can call into action, in some instances even ahead of shareholders, to aid an orderly resolution”.   Investors cannot say that they have not been warned.