The proposed additional prudential requirements will be applied to those groups containing two or more material entities in more than one-APRA regulated industry, and /or containing material unregulated entities. ‘Material entities’ are defined as being those that are significant to the group's capital position, financial standing or that are operationally important to the rest of the group. Therefore it need not be a financial entity but may include, for example, an internal services company supplying IT services to the group.
APRA expects 10 to 15 groups to be potentially impacted by its proposal (over 60 regulated entities). Whilst not identified this will include all major Australian banking groups, insurance groups and those entities operating significant bancassurance models. But clearly the potential impact cannot be determined simply by reference to size of financial assets, it must reflect an understanding of corporate legal structures that may in part have developed in response to the emergence of non-operating holding company (NOHC) structures of corporate organisation.
NOHC structures are widely used in the global banking industry as they offer greater operational flexibility and the ability to manage risk. These structures also provide protection of depositor interests through the legal separation between banking and non-banking activities within diversified financial conglomerates, while allowing strategic flexibility.
The additional capital impact of L3 is described by APRA as being likely to be small, but the proposed commencement date of 2012 means it will occur when significant changes to the Basel II framework are also happening, and these capital impacts will not be small. As with the proposed Basel II changes, the L3 capital will be expressed only in Tier 1 terms or an approximated equivalent.
APRA is not proposing the establishment of a public minimum L3 capital ratio or extend L1 (standalone) capital ratio requirements to ‘unregulated entities’. It is proposing that the L3 head be an APRA–regulated entity and that its board establish an L3 capital management plan covering all risks from group activities, including those from unregulated material entities. APRA will not formally approve such a plan, but the agreed capital requirements for the L3 group will reflect the outcomes of an ICAAP / SREP1 type process to establish a prudentially acceptable minimum level of capital and the holding of sufficient surplus capital above this minimum.
One means of constructing these L3 capital requirements will be through a ‘building block approach’ that uses existing (L1 and L2)2 regulatory requirements including as to capital deductions. The location of additional capital held in respect of L3 requirements will be left to the discretion of the L3 head. In establishing an acceptable group capital management plan it seems reasonable that the L3 board consider those factors outlined in the existing industry sector prudential standard 110 (eg APS 110 attachment E for ADIs).
APRA makes clear that it considers effective mitigation of potential contagion risks will depend on the expansion of the non-capital risk management and governance requirements of its prudential standards. In this respect it will be the responsibility of the L3 head entity and its board to ensure compliance with these requirements for itself, and in some cases to ensure that material unregulated entities also conform to key risk management elements of these prudential standards. APRA will not impose prudential requirements directly on unregulated entities that are part of a L3 group.
In terms of audit-related requirements, APRA proposes that these are to be developed from existing prudential standards and applied to the L3 head and to prudential reporting by the entire L3 group.
There are at this time a number of unresolved issues about the potential interaction of APRA's L3 proposals with the Basel II reforms now under discussion. These include the suggestion that systemically important institutions be required to hold higher levels of capital adequacy than smaller ones; expectations around stress testing; Tier 2 capital and the emerging broader regulatory requirements to address failing or ‘gone concerns’; pillar 3 disclosures; and the interplay of the different Basel II risk methodologies that have been accredited for use by the primary financial entity with the overall L3 capital adequacy outcome.
Finally the release of the paper indicates that APRA is comfortable with regulated institutions operating bancassurance models of business activity but at the same time it allows it to partly constrain those financial activities not directly covered by its prudential standards.
1 The ICAAP (Internal Capital Adequacy Assessment Process) is a board assessment of capital adequacy levels based on the entity’s complexity and risk exposure. The SREP (Supervisory Review Evaluation Process) is conducted by the regulator.
2 An L2 group is a consolidated group of companies, headed by either an APRA authorised entity or an APRA authorised non-operating holding company (NOHC).