Information relating to the capital adequacy framework in New Zealand

The capital adequacy framework in New Zealand is based on the Basel capital framework developed by the Basel Committee on Banking Supervision. The framework incorporates elements of both the Basel II and Basel III frameworks.

The capital adequacy framework incorporates the following main parts:

  • Capital ratios;
  • Determination of qualifying capital (in accordance with Basel III);
  • Determination of exposures (in accordance with Basel II);
  • Internal capital adequacy assessment process;
  • Disclosure.

Capital Ratios

Since 1 January 2013, locally incorporated registered banks have been required to comply with the following minimum capital ratios, which are calculated as the amount of capital that must be held in relation to risk-weighted exposures (including market and operation risk):

  • A Common Equity Tier 1 capital ratio of 4.5%;
  • A Tier 1 capital ratio of 6%;
  • A total capital ratio of 8%.

Additionally, since 1 January 2014, a bank that does not maintain a common equity buffer ratio of 2.5% above these minimum ratios has faced restrictions on the distributions it can make. This part of the buffer represents the "conservation buffer" that is part of the Basel III framework. The Reserve Bank has issued Guidance on the calculation of the buffer ratio (XLS 16KB). The extent of dividend restrictions is set in banks' conditions of registration, and is in accordance with the following table:

Banking group's buffer ratio

% limit to distributions of bank's earnings

0% - 0.625%

0%

>0.625% - 1.25%

20%

>1.25% - 1.875%

40%

>1.875% - 2.5%

60%

The size of the required buffer ratio may be increased in the future to take account of macroeconomic risks that pose a risk to the financial system as a whole. This part of the buffer represents the "counter-cyclical buffer" that is part of the Basel III framework.

Capital ratio requirements are imposed on banks through their conditions of registration. A bank may be subject to non-standard ratio requirements.

Qualifying capital

In December 2010 the Basel Committee on Banking Supervision released new global regulatory standards for bank capital adequacy and liquidity. These standards are commonly known as the Basel III standards and were endorsed by G20 leaders at their November 2010 summit. Basel III set new qualifying criteria that capital instruments and reserves must meet in order to qualify as regulatory capital. Capital instruments and reserves are classified as being either tier 1 capital (this category is divided into common equity and additional tier 1 capital) or tier 2 capital. Basel III also introduced new requirements for the treatment of exposures to central counterparties.

Effective 1 January 2013, the Reserve Bank released updated Banking Supervision Handbook documents Capital Adequacy Framework (Standardised approach) BS2A (PDF 1.3MB) and Capital Adequacy Framework (Internal Models Based Approach) BS2B (PDF 1.3MB), incorporating the Basel III requirements for the definition of regulatory capital for New Zealand locally incorporated registered banks.

It is a condition of registration of locally incorporated registered banks that they receive a notice of non-objection from the Reserve Bank before treating any capital instrument (aside from ordinary shares) as regulatory capital. These banks must also receive approval from the Reserve Bank prior to repaying capital instruments (aside from ordinary shares) and must notify the Reserve Bank of significant falls in common equity. The process to obtain a notice of non-objection, the requirements in respect of the repayment of capital instruments and notification requirements in respect of capital are set out in the document: Application requirements for capital recognition or repayment and notification requirements in respect of capital (BS16) (PDF 189KB).

Consultation on Basel III provides further information on the Reserve Bank consultation process in respect of Basel III, including subsequent changes to the requirements in 2015.

The Reserve Bank published the following cost benefit analysis when the Basel III capital requirements were implemented: Regulatory Impact Assessment of Basel III capital requirements in New Zealand (PDF 639KB).

Further information on the Basel III capital requirements is provided in Basel III capital adequacy requirements – frequently asked questions and the Reserve Bank Bulletin article The Reserve Bank’s application of the Basel III capital requirements for banks (PDF 562KB) (published June 2015).

Exposures

New Zealand registered locally incorporated banks calculate their exposures based on the Basel II framework. This framework is set out in Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework on the website of the Bank for International Settlements. Pillar 1 of Basel II involves the calculation of minimum capital requirements to cover credit risk, market risk and operational risk. Credit risk is determined through the calculation of risk-weighted exposures.

For an introduction to Basel II and the Reserve Bank's approach to its implementation in New Zealand, read A new capital framework (PDF 101KB) by Andrew Yeh, James Twaddle and Mike Frith (published in the Reserve Bank Bulletin, September 2005).

The Basel II framework has applied to locally incorporated New Zealand banks since the first quarter of 2008. Under Basel II, banks may, if accredited, use the internal models approach to calculate their capital requirements; otherwise they must use the standardised approach.

For banks registered as branches in New Zealand, Basel II developments have disclosure implications only.

Basel II Standardised approach

Pillar 1 standardised approach: Banks using the standardised approach under Pillar 1 are subject to conditions of registration that require capital adequacy to be calculated using the framework set out in the document Capital Adequacy Framework (Standardised Approach) BS2A (PDF 1.3MB).

A summary of the main points made in submissions on the draft version of BS2A and the Bank's responses are set out in the document: Response to Submissions from Consultation on Standardised Approach (PDF 26KB)

Basel II Internal models based approach

Banks using the internal models based approach under Pillar 1 are subject to conditions of registration that require capital adequacy to be calculated using the framework set out in the document Capital Adequacy Framework (Internal Models Based Approach) BS2B (PDF 479KB).

In March 2006, the Reserve Bank published its application requirements for banks seeking accreditation to adopt the internal models based approach. See Basel II: Application requirements for banks seeking accreditation to use the internal-models approaches – March 2006 (PDF 142KB).

The Reserve Bank also released an exposure draft Basel II: IRB national discretions – March 2006 (PDF 79KB), outlining the Reserve Bank's preliminary thinking on how to treat the national discretions available under the Basel II internal ratings-based approach to credit risk.

A summary of the main points made in submissions on the draft version of BS2B and the Bank's responses are set out in the document: Response to Submissions from Consultation on Internal Models Based Approach (PDF 33KB).

In July 2014, the Reserve Bank updated its Capital Adequacy Framework (Internal Models Based Approach) BS2B to incorporate internal model change approval requirements into its capital adequacy framework. Since October 2014 all IRB banks are required to maintain an internal models compendium that is agreed with the Reserve Bank as part of their conditions of registration.

ANZ Bank, ASB Bank, Westpac New Zealand and Bank of New Zealand have been accredited to use internal models for credit and operational risk. In order for the four banks to retain their accreditation status they must comply with a number of on-going accreditation requirements (for instance the banks are required to advise the Reserve Bank of any material changes to its models or estimates). Further explanation of the Reserve Bank's approach to Basel II implementation in New Zealand is set out in the Reserve Bank Bulletin (September 2009).

Changes to capital requirements for farm lending exposures

In June 2011 the Reserve Bank released finalised changes to the Reserve Bank's capital adequacy framework applying to internal models banks that required internal models banks to hold more regulatory capital in relation to rural lending portfolios.

The intent of the policy is to align banks' farm lending capital requirements with risk in the sector. In the years prior to implementation of the policy there had been a reduction in farm lending credit quality and an increase in debt accumulation by farmers. Details of the farm lending capital policy were published in the Reserve Bank Bulletin (September 2009).

In April 2011, the Reserve Bank issued a consultation paper (PDF 120KB) proposing changes to the Reserve Bank's capital adequacy framework. The Reserve Bank prepared a summary of submissions (PDF 51KB) received and its responses to key issues raised. Further explanation of the Reserve Bank's farm lending policy is provided in the FAQ sheet and Reserve Bank Bulletin (June 2011 edition).

Changes to capital requirements for residential mortgage loans (the Housing Review)

Stage one: adjustments to the correlation factor for high-LVR loans

On 26 March 2013 the Reserve Bank issued a consultation paper (PDF 100KB) on the first stage of the housing review. Stage one focussed on a technical adjustment to the housing correlation factor of the Basel equation that internal models banks use to calculate their capital requirements for residential mortgages. On 8 May 2013 the Reserve Bank announced it would increase the correlation factor for high loan-to-value ratio (LVR) mortgage loans, thereby increasing the capital adequacy requirements for the high LVR residential mortgage loans of internal model banks. The Reserve Bank considers this change to be necessary to give sufficient weight to the systemic risk that such loans present. The Reserve Bank published a Response to submissions (PDF 154KB) and Regulatory Impact Assessment (PDF 196KB) for this first stage of the review.

From 30 September 2013, the correlation factor was adjusted as set out below:

Prior Adjusted
Correlation for LVR under 80% 0.15 0.15
Correlation for LVR 80-89% 0.2
Correlation for LVR 90% and over 0.21

Stage two: harmonisation of definitions between BS2A and BS2B

On 20 September 2013 the Reserve Bank issued a consultation paper (PDF 614KB) on the second stage of the review. This consultation covered a number of definitional changes needed to improve the consistency and clarity of both the calculation of the loan-to-value ratio for residential mortgages, and the definition of a residential mortgage loan, between internal models and standardised banks. A summary of submissions and policy position (PDF 99KB) from this consultation was published on 20 December 2013.

On 28 March 2014 the Reserve Bank issued a consultation paper (PDF 150KB) on the wording of these proposed changes to be included in Capital Adequacy Framework (Standardised Approach) (BS2A) and Capital Adequacy Framework (Internal Models Based Approach) (BS2B), and on consequential changes to Framework for Restrictions on High-LVR Residential Mortgage Lending (BS19). A summary and response to submissions, and implementation decisions (PDF 170KB) was published on 13 June 2014.

From 1 July 2014, the Reserve Bank implemented:

  • A new definition of the loan-to-value ratio of residential mortgages for all banks;
  • A requirement for all banks to have a Board-approved property valuation policy;
  • Enhanced clarity as to the asset class boundary between residential mortgage loans and other types of loans, e.g. farm or commercial property lending.

Stage two: changes to the asset class treatment of residential property investment loans

The Reserve Bank consulted on a separate treatment of residential mortgage loans for investment purposes, with higher capital requirements, in the earlier stage two consultations. However, implementation issues with the proposed count-based definition led to a reconsideration of the policy. The rationale for higher capital requirements for loans secured by investment property is that the risk profile of loans to residential property investors differs from those to owner-occupiers. On 5 March 2015 the Reserve Bank issued a consultation paper (PDF 307KB) that covered new definitions of residential property investment loans and the asset class treatment of these loans. The changes would apply to both internal models and standardised banks. A summary of submissions and policy position (PDF 196KB) and regulatory impact assessment (PDF 301KB) were published on 29 May 2015. A change to the proposed treatment of mixed collateral loans was announced alongside the response to submissions (PDF 416KB) on related changes to the framework for high-LVR lending on 21 August 2015.

From 1 November 2015 residential mortgage loans secured by non-owner-occupied property are located in a separate sub-asset class and are subject to:

  • Increased risk weights for standardised banks;
  • Higher correlation factors and minimum LGDs for internal models banks.

Stage two: capital requirements for reverse mortgages

Alongside the changes to the asset class treatment of residential property investment loans, the Reserve Bank also consulted (PDF 307KB) on changes to the capital requirements for reverse mortgage loans. The Reserve Bank released “Summary of submissions and final policy position on capital requirements for reverse mortgage loans, QRRE and the FIRB approach in BS2A and BS2B” (PDF 113KB), and a regulatory impact assessment (PDF 119KB).

Removal of Qualifying Revolving Retail Exposures and the Foundation IRB approach from the Internal models based approach

Following a consultation, the Reserve Bank announced its intention to remove the Qualifying Revolving Retail Exposure class and the Foundation IRB approach from the BS2B (Internal Models Based Approach) Capital Adequacy Framework. A summary (PDF 113KB) of the consultation feedback and Reserve Bank decisions was published in August 2015.

Internal capital adequacy assessment process

Pillar 2 of Basel II addresses the assessment of overall capital adequacy. In December 2007 the Reserve Bank finalised its approach to implementing Pillar 2 of Basel II in New Zealand. A summary of the approach, and feedback on the comments received during the consultation, are set out in Pillar 2 approach and feedback on consultation (PDF 41KB). See also Guidelines on a bank's Internal Capital Adequacy Assessment Process ("ICAAP") BS12 (PDF 49KB).

Disclosure

Pillar 3 of Basel II is designed to reinforce market discipline on banks' capital adequacy by requiring disclosure of relevant details of banks' capital calculations. Registered banks disclosure regime provides details of the Reserve Bank's approach to disclosure.

Other implementation-related information

The high-level principles for the cross-border implementation of Basel II in Australia and New Zealand are set out in the Terms of Engagement between the Reserve Bank of New Zealand and the Australian Prudential Regulation Authority in relation to the implementation of Basel II. 

Review of the capital adequacy framework

The Reserve Bank began a review of the capital adequacy framework for locally incorporated registered banks in April 2017.