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Proposed changes to the connected exposures and capital adequacy policies for registered banks

Introduction

  1. The Reserve Bank recently consulted on proposed amendments to the connected exposures and capital adequacy policies for registered banks (“banks”). The proposals centred on removing the preferential treatment of a parental guarantee in the measurement framework for connected exposures and risk weighting of assets under the capital adequacy framework. Having considered the feedback received, we have made some adjustments to the proposed policies.

  1. This paper consists of two parts:
    • summary of the proposed changes, result of consultation and the features of the final policy; and,
    • the regulatory impact assessment.

Background

  1. The proposed amendments to the connected exposures policy and capital adequacy framework cover three areas:
    • clarification of the limit and netting provision in the connected exposures policy;
    • removal of the connected exposure exemption available to banks with a parental guarantee from an AAA-rated parent; and
    • treatment of guarantees provided by connected persons for capital adequacy risk weighting purposes.

  1. Consultation letters were sent out to banks in October 2009 advising them of the proposed policy changes. The Reserve Bank received seven submissions in respect of the proposals.

  1. The proposed changes will affect the following policy documents as well as banks’ conditions of registration (CoR):
    • Statement of Principles: Bank Registration and Supervision BS1;
    • Capital Adequacy Framework (Basel I Approach) BS2;
    • Capital Adequacy Framework (Standardised Approach) BS2A;
    • Capital Adequacy Framework (Internal Models Based Approach) BS2B; and,
    • Connected Exposures Policy BS8..

Recap of proposed changes, submissions received and responses
Connected Exposures Policy

  1. Currently there is a rating-contingent framework for connected exposures which sets the limit on the total amount of credit exposures of the banking group to all connected persons based on the bank’s credit rating. Under this system, a bank with the highest possible credit rating (AA/Aa2 and above) is allowed a maximum aggregate connected party exposure not exceeding 75% of tier 1 capital whereas the limit for a bank with the lowest rating (credit rating of BBB+/Baa1 and below) is 15% of tier 1 capital. In all cases, credit exposure to non-bank connected persons must not exceed 15% of tier 1 capital. Advances of a capital nature (i.e., if the loan is booked or described as capital or is a subordinated debt instrument in the connected person’s financial statements) are deducted directly from tier 1 capital. The framework allows the use of bilateral netting arrangements, subject to certain requirements being met. The amount of gross exposures must not be greater than 125% of tier one capital.

  1. Connected persons are, broadly speaking, entities linked or bound by collective or common ownership, financial linkages or interdependency, whether directly or indirectly. Connected persons can be a source of strength or a source of weakness for a bank. On the one hand, banks that are part of a conglomerate group may be able to access capital markets that would not be accessible on a stand-alone basis. The most cited benefit of being part of a larger group is the provision of financial support during times of stress and difficulty. On the other hand, there could be a temptation for an owner to extract excessive financial benefits from subsidiaries and affiliates. Also due diligence on a related customer may not be as thorough as it would be for an unrelated customer and conflicts of interest are much more likely to arise. It may in practice be difficult for a bank to take a fully independent stance when deciding whether or not to enter into a transaction with a related party. There is also a risk of contagion direct and indirect, arising from exposures to related parties. Direct contagion arises when a connected person fails to pay money owing. Indirect contagion arises from reputational damage flowing from another entity in the group affecting even the financially stable parts of the group.

  1. The Reserve Bank’s connected exposures policy is designed to limit the aggregate amount of credit exposure to connected persons. This limits the extent to which a person can commit capital to a bank and then effectively “borrow” back that capital. There are two aspects of the connected exposures policy that we have reviewed: the exemption from connected lending limits for banks whose exposures are guaranteed by a parent entity with an AAA credit rating and the netting provisions of the policy.

Guarantee from a parent with an AAA rating

  1. Under the connected exposures policy, where a bank’s obligations are fully, irrevocably and unconditionally guaranteed by a parent entity with an AAA credit rating from a Reserve Bank approved rating agency, connected lending limits do not apply. The original rationale for the exemption was that a locally incorporated bank guaranteed by its parent bank is akin to a de facto branch, and so should be subject to the same effective conditions of registration as a branch bank—hence the non- applicability of the limits on connected lending as these do not apply to branches. The policy was to cover locally incorporated banks whose liabilities are guaranteed by an AAA-rated parent bank.

  1. Although an AAA rated guarantor would historically be considered very safe, we do not consider this justifies an exemption from the connected exposure limits, which in our view goes hand in hand with capital requirements. Also, while prudential rather than competitive issues are the main concern, excluding some banks from the connected lending limit does not create a level playing field. We therefore propose that no category of bank should be excluded from the application of the limits altogether.

Netting

  1. Netting allows for mutual set off thereby effectively reducing the amount of exposure to losses arising from the failure of the connected counterparty to perform its contractual obligation. We are aware that there has been some confusion about the way the netting provisions of the connected exposures policy are intended to work. In particular it is not clear whether the 125% limit applies to total aggregate gross exposures or just to the amount for netting.

  1. Netting can reduce credit, liquidity and operational risks. The main issue is whether a bank’s exposure is limited to the net amount after netting. There is also the concern that netting raises issues of preferential treatment to connected exposures.

  1. Aggregate gross exposures to all connected parties must not exceed 125% of tier 1 capital. This 125% limit applies to the gross amount of exposures for netting as well as the unnetted exposures. Any exposures after netting (i.e. the unnetted amount) shall then be capped by the applicable rating contingent limit prescribed below.

Credit rating[1] of the registered bank

Connected exposure limit (% of the banking group’s tier 1 capital)

AA/Aa2 and above

75

AA-/Aa3

70

A+/A1

60

A/A2

40

A-/A3

30

BBB+/Baa1 and below

15

Submissions received

  1. Removing the exemption from the connected lending limit for banks that are guaranteed by an AAA-rated parent was well accepted by the respondents. However, one submitter suggested that another category be put in place for AAA-rated banks set at 100% of tier one capital while another suggested that due consideration be given to the financial standing of the guarantor and the enforceability of the guarantee.

  1. Key comments received regarding the gross exposure cap and the treatment of netting in the connected exposures policy are summarised below:

  • Increase the gross exposure cap from 125% of tier one capital to 150% of tier one capital, given that the more fundamental concern should be on the enforceability of netting rather than the gross exposure level.

  • Ability to offset funding and derivative exposures should be allowed if covered by bilateral netting agreement and supported by independent 3rd party validation.

  • ISDA agreements should be regarded as a robust industry standard agreement without the need for additional validation which could impose additional compliance cost. Legal opinions regarding ISDA agreements for different jurisdictions including NZ are available on the ISDA website.

Discussion

  1. While the rating-contingent framework for connected exposures recognises the differences in an institution’s financial strength or credit worthiness, there is no compelling justification for raising the connected exposures limit to a level greater than current maximum of 75% of tier 1 capital, which in our view is already very generous. Furthermore, all banks have been operating well within their limits (with the exception of one bank which breached its limit in 2007 and 2008 but that is also now well within the limits). We therefore do not consider that it would be appropriate to increase the number of rating bands from what we have at present, which is six bands. It is clearly imprudent to expose a substantial amount of a bank’s capital to connected persons, notwithstanding the superior rating. Therefore, we have decided that banks should not be exempted from connected exposures limits on the basis of a guarantee from an AAA-rated parent and that the limit for all banks with a rating of AA/Aa2and above will be 75% of tier one capital.

  1. The current connected exposures policy (BS8) states that “In certain circumstances, however, aggregate connected exposures can be calculated on a net basis. Where a robust industry standard netting agreement is used, on- and off-balance sheet exposures of a non-capital nature to a connected person can be bilaterally offset against borrowings of a non-capital nature from the same legal entity. As an interim arrangement, pending the establishment of a robust industry standard netting agreement, bilateral netting agreements whose robustness has been validated by an independent third party expert to the satisfaction of the Reserve Bank will be permitted. The amount of gross exposures netted off shall not be greater than 125 percent of a banking group’s tier 1 capital”. Consistent with this intention, the Reserve Bank considers netting in line with contracts entered into under an ISDA Master Agreement as a robust industry standard netting agreement.

  1. Transactions between a bank and its related parties pursuant to ISDA may be netted for purposes of the connected exposures policy. A copy of the ISDA Agreement should be provided to the Reserve Bank prior to implementation. An independent third party opinion will not be required for this industry standard netting agreement. Further, the Reserve bank may consider other industry standard netting agreements for purposes of the connected exposures policy.

  1. We do not agree with the suggestion to raise the gross exposures cap from 125% of tier 1 capital to 150% of tier 1 capital. Although one can take the view that the fundamental issue is the enforceability of netting rather than the gross exposure level, we believe that there are still counterparty and operational risks to carefully manage. Banks may tend to underestimate these risks when dealing with a related party.

  1. The ability to net related party exposures was introduced in 2003/04, together with the rating-contingent framework. Prior to these amendments, connected exposures were measured and reported on a gross basis with a limit set at a percentage of tier one capital.

  1. With the designation of ISDA as an acceptable industry standard netting agreement and the flexibility to designate other industry standard netting agreements in the future for purposes of this policy, the Reserve Bank does not see the need to consider bespoke netting agreements.

Capital policy

  1. The capital requirements for banks allow for recognition of eligible guarantees as a credit risk mitigant. They do not preclude a situation whereby the guarantee is provided by a connected person. The Reserve Bank does not consider that an exposure with a guarantee provided by a connected person should attract a lower risk weight than an exposure with no guarantee.

  1. Typically, a connected person (to a bank) has either a significant ownership interest in the bank or some form of affiliation which allows a certain degree of influence on or control over the bank. There is usually also a close correlation between the financial health of the connected person and that of the bank and this undermines the value of the guarantee. While a guarantee by a connected person to another related party may provide some risk mitigating benefit, the current rule appears to overstate this benefit.

  1. The effect of de-recognising a guarantee from a connected person is that exposures will be risk weighted by the risk weights applicable to the counterparties to the exposures rather than according to the risk weight assigned to the protection provider or guarantor. Consequently the bank will be required to hold more capital for the same level of exposures. We do not consider that a guarantee from a connected party is equivalent to capital on the ground. In essence it is similar in substance to uncalled capital, which is not taken into account for capital adequacy purposes.

Submissions received

  1. Comments received on the proposal to risk weight exposures guaranteed by a connected person according to the risk weight of the underlying counterparty are summarised below:

  • An asset guarantee provided by a related party is still better than no asset guarantee; hence, there should be some recognition of the reduced credit risk.

  • The proposal does not recognise market practice where international banks have centralised their credit trading activities.

  • Intra-group banking guarantees are sometimes provided to customers to facilitate transactions enabling the larger banking group to provide finance to local subsidiaries of institutional customers against securities offered to the parent bank by the institutional customers in their home country. Access to the parent bank guarantee is thus essential. Credit support from the parent may come in the form of a guarantee, indemnity or standby letter of credit. Denying any risk weighting benefit for an exposure that has credit support from the parent bank will affect client pricing. Such credit support actually provides a lower risk of loss than lending on unsecured basis.

  • One would not expect any credit linkage between the financial health of a debtor and the financial health of the guarantor unless the guarantor’s exposure to the debtor constitutes a sizeable portion of the guarantor’s capital or that the debtor itself is a connected person. A formal legal agreement should be in place for any risk weighting benefit to apply.

  1. Two suggestions on how to mitigate the effect of derecognising the guarantee from a connected person:

  • Cap the eligible guarantees extended by the parent bank to its subsidiary bank at 5% of the parent bank’s tier one capital and 10% of the subsidiary bank’s tier 1 capital and provided that the exposure is not to another connected person. Any guarantee exposure above the threshold or if provided by another connected person would not be treated as an eligible guarantee.

  • Include the total value of guarantees provided by the parent bank to the subsidiary bank in the calculation of the latter’s aggregate credit exposures for the purposes of compliance to the connected lending limit. This is achieved by removing from the definition of credit exposure the exclusion relating to “contingent exposures arising as a result of risk layoffs to a bank owner”.

Discussion

  1. Generally speaking, the use of a guarantee and other credit risk mitigation techniques allows the bank or the lender to substitute or consider the credit quality of the guarantor or the provider of the credit protection for the credit quality of the underlying obligor. The guarantor should thus be better rated than the obligor. If the guarantor is a connected person to the bank, the credit exposure can be considered as being to the connected person and not to the original obligor.

  1. Although a guarantee issued by a related party provides risk mitigation benefits, it does not provide as much comfort as a guarantee from an unrelated counterparty of similar creditworthiness. Banks need to diversify and manage their risks prudently and incentives to do this may be blunted if they are overly reliant on a connected person’s guarantee. Credit risk mitigation provided by related parties via guarantees and similar arrangements represents credit exposure to the related party that is not captured under the connected exposures limit.

  1. Two alternatives were suggested in lieu of the proposed de-recognition of credit risk mitigation provided by a related party. The first option is to cap the exposure to a parent bank guarantee as a percentage of the parent bank’s capital and the subsidiary bank’s capital; and the second option is to include the total value of guarantees provided by the parent bank to the subsidiary bank as a connected party exposure for the purposes of calculating the connected exposures limit.

  1. The first option introduces a degree of complexity to the capital adequacy framework, given the need to monitor both the parent and subsidiary bank’s capital positions at any one time. There are different accounting practices and regulatory standards across the various jurisdictions where parent entities of locally incorporated banks operate. Some are subject to consolidated supervision by the banking regulator and report their financial performance on a fully consolidated basis. This could potentially influence how the proposed ceiling is measured and compared across banks.

  1. The second option links the connected exposures policy with the capital adequacy framework, particularly on the minimum requirements for guarantees to qualify for use as credit risk mitigation. Banks which use a connected person’s guarantee for credit risk mitigation would have the value of that guarantee included in connected exposure for the purposes of the connected exposures limit. The credit risk mitigation impact for capital adequacy purposes would be recognised in the same way as for a guarantee from an unrelated party to the extent allowed. If this option was adopted, i.e. recognising a guarantee or credit risk mitigation by a related party (of a bank’s credit exposure to an obligor), there would be scope for recognising some value to a guarantee (of the bank’s liabilities) from an AAA rated parent in terms of the connected exposures limit.

  1. We favour recognising only protection that is provided by a third party provider for credit risk mitigation under the capital adequacy framework.

  1. We propose that the effective date of these policy amendments be 30 September 2010, but the Reserve Bank will consider a longer transition path towards compliance for banks that are most affected by these policy changes.

Regulatory impact assessment
Executive Summary

  1. The proposal is to amend the connected exposures policy and capital adequacy framework as explained above. These changes are important for the maintenance of a sound and efficient financial system. The compliance cost depends on whether banks have heavily relied on their parental guarantee for exemption from connected exposures, as well as the consequent credit risk mitigation that such a guarantee provides. The Reserve Bank will work alongside affected banks to allow for a reasonable period of compliance through capital injection or transfer of guarantees to third party protection providers. Banks’ conditions of registrations will be amended to reflect these changes.

Adequacy statement

  1. The proposals will not have a significant impact on economic growth. This assessment has been prepared by the Reserve Bank and the Bank attests to its adequacy.

Status quo and problem

  1. The amendments relate to the role of connected parties in the connected exposures and capital adequacy policies. These policies were developed to ensure that banks have real capital on the ground to support their risk assets and that are not recycled via loans to related parties, or that risk weights of assets are not effectively scaled back if they are wrapped with a guarantee from a related party of the bank.

  1. Some tidying up however needed to be introduced to prevent misapplication of the policy, given that that the current limits could be interpreted more liberally than intended. For example, the aggregate gross limit of 125% of tier one capital and the rating contingent limit are sometimes interpreted by banks to be added together or combined which could lead up to 200% of tier one capital (125% plus 75%). The amended policy will clarify that the 125% limit applies to the aggregate gross connected exposures prior to netting and inclusive of the amount for netting and the amount that is not netted. A bank exceeded its limit in 2007 and 2008, but is now back on track.

  1. Also, the exemption from any connected lending limit that is given to banks with a guarantee from an AAA-rated parent will be removed. This is designed to achieve parity in the treatment of locally incorporated banks and to do away with excessive reliance on parental guarantee.

  1. In the same manner, the role of connected parties in the capital framework will be aligned with the changes to the connected exposures policy. Thus, any credit risk mitigation benefit arising from a guarantee extended by a related party to credit exposures of a bank will be risk weighted according to the counterparty’s risk weight. To do so otherwise, means that the exposure of the bank is to the related party --- a situation that is not captured in the connected exposures framework.

  1. As banks will no longer enjoy the credit risk mitigation benefit from connected party guarantees, they will be placed on the same footing as other banks. This may mean increasing the amount of invested capital to support the corresponding risk assets.

Objectives

  1. Basel Core Principle 10 provides that “in order to prevent abuses arising from connected lending, banking supervisors must have in place requirements that banks lend to related companies and individuals on an arm’s length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks”. The connected exposures policy is in place to support this principle. Some aspects of the policy need clarification particularly on how the limit operates and where netting is recognised. This is to prevent varying interpretations among banks and any unintended consequences that may arise from such misinterpretation.

  1. A consistent treatment of related parties is extended to the capital adequacy framework, where the benefit of credit risk mitigation attached to a guarantee from a related party is proposed to be removed.

Options

Connected exposures policy

  1. The limits set in the current policy have not been altered. The key change is in the aspect of netting by way of clarification as to how the limits operate and the designation of ISDA as robust industry standard netting agreements. The aggregate gross limit of 125% of tier one capital shall cap all credit exposures to related parties and shall include exposures that have been netted and those that have not been netted. The clarification around how the netting limit operates and regulatory recognition of ISDA will enhance or facilitate the implementation of the connected exposures policy.

  1. One alternative is to provide a checklist of standards or conditions for the recognition of netting agreements. However, there could always be some residual doubt whether the netting arrangement is legally and operationally robust in all circumstances and so it is prudent to limit regulatory recognition of netting to a designated robust industry standard netting agreement and to maintain the aggregate gross exposures limit. The Bank is amenable to considering other industry standard netting agreements aside from ISDA.

  1. Another alternative is to liberalise netting (for example recognising netting against certain types of collaterals) but accompanied by a lower gross limit. However, this could have some unintended consequences like systematic collateralisation of exposures to bring the bank within the applicable limit.

  1. The other proposed amendment is removing the exemption from the connected exposures limit if a bank has parental guarantee from an AAA-rated parent and the alternative is to retain the status quo.

Capital Framework

  1. The proposal is to amend our capital adequacy requirements such that banks’ exposures guaranteed by connected persons cannot be assigned the risk weight applicable to the protection provider (the guarantor). This would mean holding relatively more capital commensurate to the risk asset, effectively providing more certainty than a guarantee from a connected party. At the same time, this change is consistent with the treatment of related parties in the connected exposures policy.

  1. Another option is to cap the extent a connected person can guarantee the assets of a registered bank. A disadvantage of this option is that it ‘targets’ the guarantee rather than addressing directly the issue of capital support. The bank would at the end of the day be exposed to the connected party/guarantor, but which potential exposure is not captured in the connected exposures framework.

Preferred option

  1. For the connected exposures policy, the preferred option is to clarify the application of the limit and designate ISDA Agreement as a robust industry standard netting agreement with flexibility to designate other industry standard netting agreements; and remove the exemption from the connected exposures limit for banks guaranteed by an AAA-rated parent.

  1. This preference is supported by the desire to have a level playing field for NZ banks and promote greater transparency and clarity at how the limit and netting policy operate. In the case of the removal of the exemption from connected exposures limit for banks with parental guarantee from an AAA-rated parent, we are mindful that there could be deterioration in the parent bank rating that could materially affect the position of the local bank.

  1. In the capital adequacy framework, the preferred option is to recognise only those guarantees secured from a third party protection seller for credit risk mitigation purposes. The purpose of credit risk mitigation techniques is to control or contain exposures to counterparties and diversify risks, on top of the bank’s own rigorous process of credit evaluation and monitoring. We believe that the credit enhancement benefit of a guarantee is better advanced if it is secured from a third party protection provider compared to a related party. Thus, just putting a cap on the extent of related party guarantees allowed for credit risk mitigation is not a desirable course of action.

Final policy

  1. These policy changes will require amendments to our Banking Supervision Handbook and banks’ Conditions of Registration (CoR). The latter will cross reference to the new versions of relevant policy documents. It is advised that the proposed changes will apply with effect from 30 September 2010 balance date.

  1. Appendix A is the revised Connected Exposures Policy BS8.

  1. Appendix B quotes the relevant sections of the Statement of Principles Bank Registration and Supervision BS1; Capital Adequacy Framework (Basel I Approach) BS2; Capital Adequacy Framework (Standardised Approach) BS2A; and Capital Adequacy Framework (Internal Models Based Approach) BS2B.

Annex A

Connected Exposures Policy (30 September 2010)

  1. Locally incorporated banks are generally subject to standard conditions of registration relating to exposure to connected persons. This document sets out these standard requirements.
  2. The Reserve Bank reserves the right to impose a non-standard condition of registration or to vary the standard condition of registration where special circumstances apply. For example, the Reserve Bank may consider it appropriate to impose a lower than normal connected lending limit on a bank that is undercapitalised relative to the levels of risk it is facing, but which is not in a position to raise additional capital.
  3. Advances of a capital nature by a banking group to connected persons must be deducted from the banking group’s tier 1 capital. An advance will be considered to be of a capital nature if, in a connected person’s financial statements, it is described as a capital or subordinated debt instrument and/or it is counted as capital under the capital adequacy requirements imposed by a parent supervisor.
  4. Aggregate credit exposures (of a non-capital nature and net of any allowances for impairment) of the banking group to all connected persons shall not exceed the rating-contingent limit outlined in the following matrix.

Credit rating1 of the registered bank

Connected exposure limit (% of the banking group’s tier 1 capital)

AA/Aa2 and above

75

AA-/Aa3

70

A+/A1

60

A/A2

40

A-/A3

30

BBB+/Baa1 and below

15

Within the rating-contingent limit, credit exposures (of a non-capital nature and net of any allowances for impairment) to non-bank connected persons shall not exceed 15 percent of the banking group’s tier 1 capital.

For the purpose of compliance with the rating-contingent limit:

(a) The credit rating will be the rating applicable to the bank’s long-term senior unsecured New Zealand dollar obligations payable in New Zealand, in New Zealand dollars. Where a bank has more than one credit rating, the lowest rating will be used in determining the connected exposure limit.

(b) Only credit ratings produced by rating agencies approved by the Reserve Bank may be used. Those agencies are: Standard & Poor’s, Moody’s Investor Services and Fitch Ratings. (The Reserve Bank’s “Statement of Principles” (BS1), in particular Appendix Three of BS1, provides details on the approval of credit rating agencies.)

(c) A three-month grace period starting from the date of a credit rating downgrade will be allowed for the limit which applies before the downgrade to reduce to the new limit based on the above matrix. The Reserve Bank will consider allowing an extension of the limit adjustment period if a bank has structural reasons for not being able to comply within the three-month period. The limit extension would be for a specific time period (but no longer than an additional three months).

(d) “Tier 1 capital” is determined for a bank as specified in the bank’s conditions of registration under the Reserve Bank documents:

(i) “Capital Adequacy Framework (Standardised Approach)” (BS2A) dated November 2007 September 2010;

(ii) “Capital Adequacy Framework (Internal Models Based Approach)” (BS2B) dated March 2008 September 2010; or

(iii) “Capital Adequacy Framework (Basel I Approach)” (BS2) dated March 2008 September 2010.

(e) “Connected person” means any person, other than a government of a country which is a member of the Organisation for Economic Cooperation and Development, which is:

(i) an owner (which means any person who has a substantial interest in the registered bank), or

(ii) an entity in which an owner has a substantial interest (other than the registered bank and entities in which the registered bank itself has a substantial interest), or

(iii) a person which has a substantial interest in an owner, or

(iv) a director of the registered bank.

(f) A person has a “substantial interest” in an entity if that person:

(i) holds (whether directly or indirectly) more than 20 percent of the issued securities of an entity, other than securities that carry no right to participate beyond a specified amount in a distribution of either profits or capital; or

(ii) is entitled to receive (whether directly or indirectly) more than 20 percent of every dividend (or, in the case of an entity which is not a company, distributions of a similar nature) paid on securities issued by the entity, other than securities that carry no right to participate beyond a specified amount in a distribution of either profits or capital; or

(iii) is in a position to exercise, or control the exercise of, more than 20 percent of the maximum number of votes that can be exercised at a meeting of an entity or the owners of the entity; or

(iv) controls or significantly influences the composition of the board of the entity, or, if the entity does not have a board of directors, the body which has the power to manage or direct or supervise the management of the business and affairs of the company.

(g) In determining whether a person has a substantial interest in an entity, sections 7 and 8 of the Companies Act 1993 shall apply with all necessary modifications.

(h) “Non-bank connected person” means any connected person other than a bank or an entity in which a bank has a substantial interest.

(i) “Credit exposure” means the amount of the maximum loss that a party to a contract could incur as a result of the counterparty to that contract failing to discharge its obligations, without taking into account the value of collateral, guarantees, indemnities, other support arrangements, and any potential recoveries, and excluding contingent exposures arising as a result of risk lay-offs to a bank owner., where the maximum loss in relation to:

(i) a market related contract means the credit equivalent amount of the contract determined in accordance with the Reserve Bank document entitled “Capital Adequacy Framework (Standardised Approach)” (BS2A) dated November 2007.

(i) In respect of a market related contract, maximum loss means the credit equivalent amount of the contract determined in accordance with the Reserve Bank document entitled “Capital Adequacy Framework (Standardised Approach)” (BS2A) dated September 2010.

(ii) any other contract means the full value of the contract; provided that a financial liability may not be offset against any such loss even if to do so would accord with generally accepted accounting practice as defined in the Financial Reporting Act 1993.

(ii) For any other contract, maximum loss means the full value of the contract; provided that a financial liability may not be offset against any such loss even if to do so would accord with generally accepted accounting practice as defined in the Financial Reporting Act 1993.

In certain circumstances, however, aggregate connected exposures can be calculated on a net basis. Where a robust industry standard netting agreement is used, on- and off-balance sheet exposures of a non-capital nature to a connected person can be bilaterally offset against borrowings of a non-capital nature from the same legal entity. As an interim arrangement, pending the establishment of a robust industry standard netting agreement, bilateral netting agreements whose robustness has been validated by an independent third party expert to the satisfaction of the Reserve Bank will be permitted. The amount of gross exposures netted off shall not be greater than 125 percent of a banking group’s tier 1 capital.

Netting

In certain circumstances, however, credit exposures to connected persons can be calculated on a bilateral net basis. Regulatory recognition of netting arrangements for purposes of the connected exposures policy is limited to netting pursuant to a robust industry standard netting agreement. The International Swaps and Derivatives Association (ISDA) Master Agreement is considered a robust netting agreement. A copy of the netting agreement must be furnished to the Reserve Bank prior to implementation. The Reserve Bank may consider other industry standard netting agreements to be designated as a robust netting agreement for purposes of the connected exposures policy.

There is a limit on aggregate gross exposures of the banking group to connected persons. Aggregate gross exposures to connected persons must not exceed 125% of the banking group’s tier one capital. The aggregate gross exposures shall comprise of the gross amount for netting in line with a robust industry standard netting agreement plus any exposures that cannot be netted. Any exposures after netting (i.e. the unnetted amount) shall then be capped by the applicable rating contingent limit above.

(j) “Securities” shall have the same meaning as in the Reserve Bank of New Zealand Act 1989.

(k) The term person includes a corporation sole, a company or other body corporate (whether incorporated in New Zealand or elsewhere), an unincorporated body of persons and a public body.

  1. Where a bank’s obligations are fully, irrevocably and unconditionally guaranteed by a parent entity with a AAA credit rating from a Reserve Bank approved rating agency, the rating contingent limit framework will not apply.
  2. Exposures to connected persons shall not be on more favourable terms (e.g. as relates to such matters as credit assessment, tenor, interest rates, amortisation schedules, requirement for collateral) than corresponding exposures to non-connected persons.

Annex B

Statement of Principles Bank Registration and Supervision BS1 (September 2010)

  1. Connected exposures within these ratings-contingent limits are required to be calculated on a gross basis, except in certain circumstances. In particular, where a robust industry standard netting agreement is used, on-and off-balance sheet exposures of a non-capital nature to a connected person can be bilaterally offset against borrowings of a non-capital nature from the same legal entity. As an interim arrangement, pending the establishment of an industry standard netting agreement, bilateral netting agreements whose robustness has been validated by an independent third party expert to the satisfaction of the Reserve Bank will be permitted. The amount of gross exposures netted off must not exceed 125 percent of a banking group’s tier 1 capital.

Connected exposures within these ratings-contingent limits are required to be calculated on a gross basis, except where netting is allowed. Where netting is used, credit exposures to connected persons can be calculated on a bilateral net basis, but subject to an additional limit on the aggregate gross exposures of the banking group to connected persons. Aggregate gross exposure to connected persons must not exceed 125% of the banking group’s tier one capital, i.e. the gross amount of exposures that have been netted plus the unnetted exposures. The balance of connected exposures after netting is capped at the applicable rating- contingent limit.

The following is unrelated to the changes to connected exposures and capital adequacy policies but was brought in at the same time as those changes were finalised. As a member of the United Nations, New Zealand is obliged under the United Nations Charter to implement Security Council sanctions in its domestic law. The sanctions typically impose restrictions on the conduct of business involving another country and from time to time affect the conduct of banking business. In light of this, the following has been added to the Reserve Bank’s Statement of Principles:

  1. United Nations’ Sanctions

  1. In order to assess the standing of an applicant (or its owner), the Reserve Bank will additionally have regard to New Zealand’s responsibilities pursuant to resolutions made by the United Nations Security Council under Chapter VII of the Charter of the United Nations that impose sanctions relating to the banking sector, in particular, for the purposes of:

- registration of a registered bank,

- consent to a change of ownership,

- approval of the establishment of a subsidiary, branch or representative office in another country.

Annex C

Change to Capital Adequacy Framework (Basel I Approach) BS2 (September 2010)

Section 29 of Capital Adequacy Framework (Basel I Approach) BS2 will be amended as follows:

Guarantees

  1. Where a claim (including equity investments other than those which are required to be deducted from capital) has been explicitly, irrevocably, and unconditionally guaranteed by OECD central governments, OECD central banks, OECD public sector entities, or OECD incorporated banks, that claim will attract the weight applicable to a direct claim on the guarantor. Claims guaranteed by non-OECD incorporated banks will also be recognised where the underlying transaction has a residual maturity of up to one year. In the case of claims covered by partial guarantees, only that part of the claim which is fully covered by the guarantee will attract the risk weight applicable to the guarantor. The guarantor in all these cases must not be a connected person to the bank, as defined in the connected exposures policy BS8.

Changes to Capital Adequacy Framework (Standardised Approach) BS2A (September 2010)

Section 74 of Capital Adequacy Framework (Standardised Approach) BS2A will be amended by adding 74 (ab); section 81 by adding 81 (2ab); and section 86, below:

74. Minimum requirements for guarantees

Guarantees must meet the following requirements to qualify for use as credit risk mitigation—

(a) The guarantee must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures or a pool of exposures so that the extent of the cover is clearly defined and incontrovertible.

(ab) The guarantee must be issued by a guarantor or protection provider who is not a connected person of the bank. Connected person is defined in accordance with Connected Exposures Policy BS8.

(b) The guarantee must cover all types of payment the obligor is required to make under the documentation including interest, margin payments etc.

(c) The guarantee must be irrevocable, that is there must be no clause that would allow the protection provider to cancel cover unilaterally or that would increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposure.

(d) The guarantee must be unconditional, that is, there must be no provisions in the contract that could prevent the protection provider from being obliged to make immediate payment in the event that the original counterparty fails to make payments due.

(e) On the qualifying default of, non-payment by the counterparty, any monies outstanding under the documentation can be pursued immediately, without the need for legal action to be taken. The guarantor may assume the future payment obligations of the counterparty covered by the guarantee or make one lump sum payment.

81. Credit derivatives

(1) The following credit derivatives are recognised under this framework:

(a) Single name credit default and total rate of return swaps that provide credit protection equivalent to guarantees. However, where a bank buys credit protection through a total return swap and records the net value of the asset that is protected (either through reductions in fair value or by an addition to reserves), the credit protection will not be recognised.

(b) Cash-funded credit-linked notes issued by the bank against exposures in the banking book which fulfil the criteria for credit derivatives are treated as cash collateralised transactions.

(2) In order to be recognised for credit risk mitigation purposes the credit derivative contract must meet the following requirements:

(a) It must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures or a pool of exposures so that the extent of cover is clearly defined and incontrovertible.

(ab) The protection provider must not be a connected person of the bank. Connected person is defined in accordance with Connected Exposures Policy BS8.

(b) It must be irrevocable. There must be no clause that would allow the protection provider to cancel cover unilaterally or that would increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposure.

(c) It must be unconditional. There should be no clause in the contract that could prevent the protection provider from being obliged to pay out immediately in the event that the original counterparty fails to make the payments due.

(d) There must be sufficient credit risk transfer under the credit derivative contract. At a minimum this requires that credit events under the terms of the credit derivative contract cover:

(i) Failure to pay an amount due under the terms of the underlying exposure that is in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation).

(ii) The bankruptcy, insolvency, statutory management, administration or receivership of the obligor of the underlying exposure; the inability or failure of the obligor to pay its debts; the obligor’s admission in writing that it is unable to pay its debts as those debts become due; or analogous events.

(iii) The restructuring of the underlying obligation including forgiveness or postponement of principal, interest, or fees that results in a credit loss event (i.e., charge off, allowance for impairment or similar debt to the profit and loss account). However, where the restructuring of the underlying exposure is not included within the terms of the contract but all other requirements for credit risk transfer are met, 60% of the amount of credit protection purchased or 60% of the underlying exposure, whichever is the lesser, may be recognised for capital adequacy purposes.

(3) The credit derivative must not terminate prior to the expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay.

  1. Eligible protection sellers

Credit derivatives may be recognised under this framework if they are provided by eligible guarantors (see section 73 and section 74).

Changes to the Capital Adequacy Framework (Internal Models Based Approach) BS2B

We propose to amend section 4.110 of Capital Adequacy Framework (Internal Models Based Approach) BS2B by adding 4.110 (aa); section 4.118 by adding 4.118 (ab); and sections 4.123, 4.129 and 4.130 below:

Eligible Guarantees

4.109 Only guarantees provided by the following are recognised:

(a) sovereigns and central banks;

(b) local authorities (as defined for the purposes of the Local Government (Rating) Act 2002);

(c) multilateral development banks or other international organisations;

(d) banks;

(e) corporate with a rating grade of 1 or 2 (as set out in Table 4.2 and Table 4.3).

4.110 Minimum requirements for guarantees

Guarantees must meet the following requirements to qualify for use as credit risk mitigants.

(aa) The guarantee must be issued by a guarantor or protection provider who is not a connected person of the bank. Connected person is defined in accordance with Connected Exposures Policy BS8.

(a) The guarantees must be actually posted and/or provided and therefore legally enforceable. A commitment to provide a guarantee or credit derivative is not recognised as an eligible credit risk mitigation technique under the FIRB approach.

(b) The guarantee must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures or a pool of exposures so that the extent of the cover is clearly defined and incontrovertible.

(c) The guarantee must cover all types of payment the obligor is required to make under the documentation including interest, margin payments etc.

(d) The guarantee must be irrevocable. There must be no clause that would allow the protection provider to cancel cover unilaterally or that would increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposure.

(e) The guarantee must be unconditional; there must be no provisions in the contract that could prevent the protection provider from being obliged to make immediate payment in the event that that the original counterparty fails to make payments due.

(f) On the qualifying default of, or non-payment by the counterparty, any monies outstanding under the documentation can be pursued immediately, without the need for legal action to be taken. The guarantor may assume the future payment obligations of the counterparty covered by the guarantee or may make one lump sum payment.

Credit derivatives

4.117 Subject to the requirements in section 4.118, the following credit derivatives are recognised as having the same effect as a qualifying guarantee:

(a) Single name credit default and total return swaps that provide credit protection equivalent to guarantees. However, where a bank buys credit protection through a total return swap and records the net value of the exposure that is protected (either through reductions in fair value or by an addition to reserves), the credit protection will not be recognised.

(b) Cash funded credit linked notes issued by the bank against exposures in the banking book which fulfil the criteria for credit derivatives are treated as cash collateralised transactions.

4.118 In order to be recognised for credit risk mitigation purposes the credit derivative contract must meet the following requirements:

(a) It must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures or a pool of exposures so that the extent of cover is clearly defined and incontrovertible.

(ab) The protection provider must not be a connected person of the bank. Connected person is defined in accordance with Connected Exposures Policy BS8.

(b) It must be irrevocable. There must be no clause that would allow the protection provider to cancel cover unilaterally or that would increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposure.

(c) It must be unconditional. There should be no clause in the contract that could prevent the protection provider from being obliged to pay out immediately in the event that the original counterparty fails to make the payments due.

(d) There must be sufficient credit risk transfer under the credit derivative contract. At a minimum this requires that credit events under the terms of the credit derivative contract cover:

(i) Failure to pay an amount due under the terms of the underlying exposure that is in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation).

(ii) The insolvency, bankruptcy, statutory management, liquidation, voluntary administration or similar circumstances of the obligor of the underlying exposure; the inability or failure of the obligor to pay its debts; the obligor’s admission in writing that it is unable to pay its debts as those debts become due; or analogous events.

(iii) The restructuring of the underlying obligation including forgiveness or postponement of principal, interest, or fees that results in a credit loss event (i.e. charge off, allowance for impairment or similar debit to the profit and loss account). However, where the restructuring of the underlying exposure is not included within the terms of the contract but all other requirements for credit risk transfer are met, 60% of the amount of credit protection purchased or 60% of the underlying exposure, whichever is the lesser, may be recognised for capital adequacy purposes.

(e) The credit derivative must not terminate prior to the expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay.

4.123 Eligible protection sellers

Credit derivatives may be recognised under this framework if they are provided by eligible guarantors. (see sections 4.109 and 4.110)

AIRB approach

4.129 There are no in-principle restrictions as to the types of guarantors or credit protection providers that may be recognised under the AIRB substitution approach other than a restriction on the recognition of connected persons. However, The criteria for the types of guarantors and credit protection providers that are recognised for minimum capital purposes must be clearly documented.

4.130 Under the AIRB substitution approach, guarantees and credit derivatives must be:

(a) in writing and non-cancellable on the part of the guarantor or credit protection provider;

(b) in force until the debt is satisfied in full (to the extent of the amount and tenor of the guarantee or credit derivative);

(c) legally enforceable against the guarantor or credit protection provider in a jurisdiction where that party has assets to attach and enforce a judgement;

(d) be provided by a party who is not a connected person (as defined in connected exposures policy BS8)

[1] The rating scales in this column are presented as “Standard & Poor’s scale/Moody’s Investor Services scale,” noting that Fitch Ratings’ scale is identical to Standard & Poor’s.