Measurement of capital - frequently asked questions

In assessing the eligibility of an existing or proposed capital instrument, APRA will need to review a complete set of relevant documents for that capital instrument. This includes: 

• a statement of compliance (refer to FAQ 1.2); 
• the prospectus, information memorandum or any other investor disclosure document; 
• any other terms and conditions of the instrument. For AT1 and Tier 2 capital instruments this may include a deed poll or trust deed.  For CET1 capital instruments, this is likely to include the Constitution and any shareholder agreements; 
• the term sheet, pricing supplement, final terms and/or subscription agreement (as applicable);  
• relevant opinions (e.g. accounting, tax and legal – refer to FAQ 1.4), rulings, advice and waivers (as applicable); and 
• any ancillary or supporting agreements (e.g. agency agreement, dealer agreement, any other agreements which impose benefits or obligations linked to the capital instrument) (refer to FAQ 1.8). 

The above is not an exhaustive list and APRA may request additional documents as needed. 

APRA’s assessment will be facilitated if all documentation for a proposed capital instrument is in the form of well-developed draft documents which are internally consistent with each other and any prior documents. Where amendments have been made to a base document over time, please provide a consolidated copy of the current draft document, with new clauses/content identified. In addition, please provide an explanation of the rationale behind the insertion of new clauses/content or innovative features or deletion of existing content and how they are consistent with the prudential requirements. 

Drafting errors in the documentation or lack of an adequate explanation of the rationale behind inclusion of new clauses/content or innovative features will inevitably lead to delays in APRA’s assessment process as the errors will need to be rectified and the documents resubmitted and an explanation for the changes provided. 

To assist APRA’s assessment of a capital instrument, a statement of compliance is required and is expected to:

• separately address each required capital eligibility criterion set out in the relevant prudential standard, including the attachments to the prudential standard;
• clearly set out references to supporting transaction documents and opinions; and
• relate to the final issue documents or at least well-developed draft versions.

Simple answers to a criterion such as “compliant”, “non-compliant”, “yes”, “no” or “n/a” are not considered by APRA to be sufficient.  APRA expects that evidence of compliance will include references to supporting transaction documents and opinions, and/or statements of intent or affirmation, along with any necessary explanations.

A senior executive of the entity is to sign and date the statement of compliance, acknowledging responsibility for the assessment when making their submission.

Where there are multiple entities involved in the instrument (including at conversion or write-off), diagrams depicting the interactions between entities in various scenarios and accompanying accounting entries may assist APRA’s assessment.

If a CET1 capital instrument is to be issued by a subsidiary within a Level 2 general insurance group or a capital instrument is to be issued by a subsidiary within an ADI Level 2 group, the regulated entity will need to determine the impact on regulatory capital of the minority interest restrictions. Provision of the full calculation will facilitate APRA’s review. (Note: The minority interest restrictions on AT1 and Tier 2 capital instruments do not apply to general insurers. There are no minority interest restrictions on capital instruments for life insurers or PHI.)  

APRA may request that an entity provide an accounting opinion, a legal opinion and a tax opinion for a CET1 capital instrument which contains innovative features.

For any new or revised AT1, Tier 2 or MEI capital instrument, APRA expects provision of opinions from independent experts on the:

• accounting treatment;
• tax treatment; and
• legal status of the instrument in all relevant jurisdictions.

Opinions need to be timely and able to be relied upon by APRA to its satisfaction. Opinions ideally will be addressed to APRA for this reason. Alternatively, where opinions are addressed to the entity, APRA expects the opinion will include a statement that the advice may be relied upon by APRA for the purpose of assessing capital eligibility under the relevant prudential standards.  The relevant engagement letters also need to be consistent with this reliance statement.

If an entity wishes to rely on an opinion provided previously, the signatory will need to confirm that the opinion remains valid in relation to the proposed capital instrument.

To facilitate assessment of whether the instrument will meet the requirements of the relevant prudential standards, the accounting opinion will need to address whether:

• the instrument constitutes equity or is a liability for accounting purposes;
• conversion of the instrument will generate an unequivocal increase in CET1 capital under APS 111, GPS 112, LPS 112 or HPS 112 on a Level 1 and Level 2 basis (as relevant);
• write-off of the instrument will generate an unequivocal increase in CET1 capital under APS 111, GPS 112, LPS 112 or HPS 112 on a Level 1 and Level 2 basis (as relevant); and
• an approval from APRA for any reserve generated by conversion or write-off under an accounting treatment which is not specifically identified as eligible CET1 capital is required.

An accounting opinion will generally be requested for MEIs but generally not for an equity instrument that clearly complies with the requirements for CET1 capital (except where it contains innovative features as discussed in FAQ 1.4 above).

To facilitate assessment of whether the instrument will meet the requirements of the relevant prudential standards, at a minimum the tax opinion will need to address any adverse tax consequences (including potential tax liabilities and tax offsets) which may arise as a result of conversion or write-off of the instrument, any outcomes from tax consolidation arrangements, as well as any other relevant issues. If the opinion concludes that there are potential tax implications arising from the primary means of loss absorption (whether conversion or write-off) including reductions in deferred tax assets, increases in deferred tax liabilities, or other offsets arising from conversion or write-off, the regulated entity will need to determine its best estimate of the offset value and consequently the net amount of CET1 capital that will be generated by full conversion or write-off of the instrument. This estimate can take account of the fact that net deferred tax assets are already deducted from CET1 capital. This analysis will typically involve scenario analysis demonstrating the potential impact of the conversion or write-off. The regulated entity will also need to determine how this best estimate will be updated during the life of the instrument. 

To facilitate assessment of whether the instrument will meet the requirements of the relevant prudential standards, the legal opinion will need to address whether:

• the issue of the instrument is legally permitted and in compliance with applicable law, including the issuer’s Constitution; 
• the issuer has obtained all approvals and authorisations required in relation to the issue of the instrument and the performance of the terms of the instrument;
• the instrument will constitute valid and legally binding obligations of the issuer, enforceable in accordance with the terms of the instrument, including subordination; 
• the conversion/write-off arrangements are legally effective and there are no legal impediments to those arrangements operating in accordance with their terms; and
• the laws of any foreign jurisdiction applying to the instrument could prevent it from satisfying the qualifying criteria for the relevant category of capital under the relevant prudential standards.

A legal opinion will generally not be needed for ordinary shares that comply with the requirements for CET1 capital (except where it contains innovative features as discussed in FAQ 1.4 above).  For mutual ADIs, additional opinions in respect of instruments that convert to MEIs will be sought. (See FAQ 11.1 below).

The capital instrument is assessed taking into account all documentation, investor disclosures and any other agreements that may impact the eligibility of the capital instrument for a particular category of capital.  For example, APRA considers whether there are provisions in any documents related to an instrument that may hinder recapitalisation of the regulated entity or any other members of the group to which the issuer belongs.

In addition, APRA assesses whether ancillary documentation is consistent with, and appropriately supports, the operation of the instrument in accordance with its terms. Where conversion into ordinary shares or MEIs is the principal loss absorbing mechanism, APRA expects entities to have a documented process in place to be followed by issuers, fiscal agents, registrars or any other party for the effective conversion within the required timeframe. An entity is expected to provide this documentation to APRA upon request.

The components of the entity’s capital must satisfy eligibility requirements in both form and substance. APRA expects that only genuine additions to the capital resources available to an entity or its consolidated group will be included in an entity’s regulatory capital. For example, an entity could report, in its capital base, ordinary shares held by a parent entity that the parent entity funded out of debt. However, where the entity may come under pressure to pay dividends to enable the parent entity to meet its debt obligations, the form of the capital instrument reported by the entity would not accord with its economic substance. In such a case, the ordinary shares could not reasonably be considered to satisfy the requirements for that category of regulatory capital. Separate agreements which have the effect of changing the characteristics of a capital instrument, for example by impacting on effective returns, or undermining the effectiveness of subordination provisions may also be considered to affect the overall economic substance.

Examples of when APRA will want to review documentation for CET1 capital instruments include: 

• when the entity is not listed and the Constitution or other constituent documents has not previously been reviewed for compliance with the CET1 capital requirements; 
• prior to the entity being licensed; 
• if there are amendments to the Constitution or other documentation that may impact on the category of capital being raised; or
• Where it contains innovative features as discussed in FAQ 1.4 above

APRA expects that all agreements relating to capital instruments will be consistent with the prudential requirements for capital instruments. It is the responsibility of an entity to ensure that it does not amend any agreements, or enter other arrangements, which negate the eligibility of any capital instrument.  An APRA-regulated entity should not be party to any agreement (including the shareholder agreement) that would impede its capacity to:

1. comply with its obligations under a prudential regulation framework law or any instrument made under those laws; or
2. raise capital in a timely manner during times of stress; or
3. be resolved in an orderly manner.

Similarly, a director of an APRA-regulated entity should not be under an obligation to act in the interests of persons that are parties to an agreement that would impede the director’s ability to make decisions:

1. to enable the APRA-regulated entity to comply with its obligations under the prudential framework; or
2. to allow the APRA-regulated entity to raise capital in a timely manner during times of stress; or
3. to allow the APRA-regulated entity to be resolved in an orderly manner.

If such an amendment or arrangement is made, the instrument is not eligible as capital from the date the amendment was made or the arrangement was entered into. Particular care should be taken where new or amended agreements assert predominance over existing agreements. The entity must act with due care and diligence when amending agreements to avoid breaching its prudential capital requirements.

APRA relies on the entity’s Constitution as the ultimate authority for the governance of the company and its operations and expects all agreements to give priority to the terms of the Constitution. However, other agreements can extend and clarify provisions in the Constitution.
 

Partly paid shares often include a payment schedule for the shares to become fully paid and investors may make payments in advance of this schedule. It is usually stated within the entity’s Constitution that the pre-paid amounts (including interest) can be returned prior to the scheduled payment date.

Provisions which allow for an amount to be prepaid by investors in advance of a payment due date, would result in the prepaid amount being classified as debt and therefore excluded from CET1 capital. This also includes provisions for the payment of interest on such prepaid amounts or the repayment of the prepaid amounts back to investors.

The amount paid in advance of payment due dates on partly paid shares is usually not considered when calculating profit or ascertaining entitlement to surplus on a winding up since these amounts have not been irrevocably received and are not eligible to be classified as CET1 capital.

Under the relevant prudential standards, eligible regulatory capital issued by a fully consolidated subsidiary of an ADI or general insurer to third parties may be included in regulatory capital at Level 2, subject to the deduction of any surplus capital amount above the minimum regulatory requirements. 

For general insurers, the minority interest restrictions only apply to CET1 capital. However, for ADIs, minority interest restrictions apply to CET1, AT1, Tier 2 and Total Capital. Where applicable, the ADI or general insurer will need to undertake an analysis of the implications for the amount of eligible capital under the relevant prudential standards and verify the calculation. If a minority interest calculation is required for an ADI, the calculation needs to be completed at each tier of capital, regardless of the tier of capital of the minority interests. 

For capital instruments issued by a subsidiary of an ADI, the ADI will also need to consider the implications under APS 111 Attachment D (Regulatory adjustments) and APS 222 in the event of conversion/write-off.

Under the relevant prudential standards, the conversion formula must be fixed in the issue documentation.

In cases where the issuer of ordinary shares is not listed, and a traded share price is not available, APRA expects it will be necessary to refer to the book value of ordinary shares as reported in the most recently available reports. Proposals for the directors or a third party to determine the valuation following the occurrence of a relevant trigger event will not be considered by APRA as acceptable.

If it is possible for the book value of ordinary shares to be equal to or less than zero, the terms would usually state that a maximum number of shares to be received upon conversion will apply in such cases.

If an issuer wishes to enable an acquirer to issue shares upon conversion of a capital instrument, the terms of the instrument need to provide for this. This includes all amendments required to issue the shares in compliance with the relevant prudential standards, including amendments to trigger events, MCNs etc., and for recapitalisation of the regulated entity. 

Yes. Each additional issuance needs to separately comply with all the requirements under the relevant prudential standards. This includes, for example, the minimum period from the additional tranche issue date to the first call date and the maximum number of ordinary shares (or MEIs) into which an instrument can convert (its MCN).  

In an additional tranche, the MCN set at the time of the initial issuance will be used, so that the tranches are fungible. That number must not exceed the price of the instrument in the additional tranche divided by 20 per cent of the issuer’s ordinary share price at the time of issue of the additional tranche. If the MCN set at the time of the initial issuance is the maximum permitted under the relevant prudential standard, an additional fungible tranche will be possible only if the issuer’s ordinary share price at the time of issue of the additional tranche is equal to or lower than the share price at the initial issuance date.

Under the relevant prudential standards, the issuer needs to ensure that there are no cross-default clauses in the documentation of any debt instrument or other capital instruments of the issuer that link performance of the issuer’s obligations under a capital instrument to default by the issuer, or another party, under any of its other obligations. 

It is not sufficient to simply state that there are no cross-default clauses contained in the capital instrument being assessed as this statement does not cover clauses in other instruments. Difficulties arising with performance of any obligations under a capital instrument must not lead to default on other debt or capital obligations. For purposes of APRA’s assessment of the eligibility of a capital instrument, confirmation of this can be provided by the issuer as part of the statement of compliance referred to in 1.2 above. 

For ADIs, these provisions on cross default clauses are in addition to the general prohibition on cross default clauses involving related entities set out in APS 222.

A change in the reference rate used in calculating the distribution from one type of rate to another type of rate (e.g. from a fixed rate to a floating rate, or to a different fixed rate basis) on an AT1 or Tier 2 capital instrument may not be regarded as an incentive to redeem where the issuer ensures that there is no amendment to the margin over the reference rate. For example, a sufficient condition for a change to be acceptable is if the margin associated with the initial rate at the time the instrument is priced and the margin applying during the subsequent new rate period are the same. In each case, the margin needs to be measured relative to a current reference rate with the same tenor as the period for which the rate is being set, and assuming no change in the basis.

APRA also expects that the type of credit risk underlying the reference rate will not change e.g. it will always be a relevant bank swap rate, or always a government bond/note rate.

Terms providing for the use of replacement reference rates and margins following the termination of the specified reference rate used to set the distribution rate may create an incentive to redeem at the time of implementation. Such terms should generally provide that the replacements are subject to no objection from APRA at the time of the change. 

Generally, it is APRA’s expectation that an entity does not redeem a capital instrument and replace it with a capital instrument of the same category of capital with a higher credit spread or that is otherwise more expensive, as it may create the expectation that the issuer will exercise a call option on other outstanding Additional Tier 1 Capital and Tier 2 Capital instruments with call options. For example, this would include an increase in margin due to a change in the credit quality of the entity as indicated by an external credit assessment institution or a change in market conditions. 

In any such circumstances, the issuer would need to satisfy APRA as to the economic and prudential rationale and that such an action will not create an expectation that other instruments will be called in similar circumstances. A rationale solely based on exercising calls to maintain access to capital markets (or limit reputational damage) would undermine the permanence and quality of capital that the Prudential Standards seek to maintain.

In satisfying itself and APRA as to the economic and prudential rationale of the call, the entity should, at a minimum, provide analysis that demonstrates: 

• the cost of issuing the replacement instrument is equal to or less than the cost of keeping the existing instrument outstanding. This analysis should consider various scenarios including, but not necessarily limited to, comparative spread levels and issuance volume. Where relevant, it should also factor in any loss of Tier 2 capital benefit due to amortisation, offset by the benefit that instrument provides as debt funding; and 
• the credit spread at which the ADI or Insurer would consider the cost of the replacement instrument to be uneconomic.

The relevant prudential standards limit the use of dividend stoppers within AT1 capital instruments. APRA expects issuers to ensure that any dividend stopper does not apply to any distributions or other payments (including redemptions or buybacks) on CET1 capital instruments which it is legally obliged to make at the time the dividend stopper is triggered.

APRA also expects regulated entities to ensure that any restriction on the payment of  distributions, or any restriction on redemptions or buybacks of CET1 capital instruments, does not result in (1) any existing holding company of the issuer restricting the payment of its distributions, or (2) any potential future holding company of the issuer, where the holding company does not undertake the role of issuer of the instrument, restricting the payment of its distributions. This includes situations where a future holding company is substituted as the issuer of ordinary shares on conversion, but not as the issuer of the instrument.

The relevant prudential standards require that capital instruments must be marketed in accordance with their prudential treatment. All marketing documentation issued by or on behalf of an issuer is relevant for this purpose. 

Material produced by third parties (such as media, dealers, investors) suggesting that an instrument has lesser capital attributes than its prudential classification should be followed up and addressed by the regulated entity to the extent they are aware, and to the extent feasible. This might include, for example, material that:

• suggests AT1 capital instruments are not permanent, such as references to term to maturity or maturity date, that APRA will approve redemption or that APRA approval is not required; 
• provides for payments to investors that do not meet the criteria for the category of capital (for example: arrangements to compensate for loss of value on the capital instrument; payments made under other contracts where a condition is that the investor holds a capital instrument; guarantees of payment of the value of an instrument; etc); 
• indicates a ranking or subordination of any capital instrument that is inconsistent with the relevant prudential standard.

The issue by a regulated entity of an instrument that converts to MEIs has additional considerations compared to the issue of an instrument that converts to ordinary shares. The regulated entity needs to ensure that the terms of the instrument, the MEIs and its Constitution align and meet the requirements of the prudential standards. These additional considerations also apply to direct issuance of MEIs.

A regulated entity seeking approval for such issuance will need to provide to APRA full documentation of the instruments, as outlined in FAQ 1.1, including the MEIs. It will also need to provide any proposed modifications to its Constitution. 

As part of the opinions referred to in FAQs 1.4 and 1.7, a regulated entity issuing a MEI or an instrument that converts to a MEI will need legal advice to confirm whether or not any modifications to its Constitution, or other aspects of the issuance, would have the effect that the regulated entity would cease to be a mutual and therefore be ineligible to issue MEIs.  The legal advice should also consider whether the proposed instrument meets the requirements in the Corporations Act 2001 (Cth) relating to mutual capital instruments, if relevant. 

APRA also expects that the Internal Capital Adequacy Assessment Process (ICAAP) of any regulated entity seeking to directly issue MEIs would need to appropriately address the issuance. This would include exploring in detail the potential investor base, the regulated entity’s ability to pay expected distributions, and the potential impact on the issuing entity’s long-term growth based on a range of anticipated distribution rates.

Distributions on MEIs are entirely discretionary, and subject to the limits set out in APS 111, GPS 112, LPS 112 and HPS 112. This does not prevent a regulated entity from using an external benchmark or index in calculating a distribution on MEIs, so long as issue documentation and marketing material do not indicate that the distribution rate will be a set amount, such as a specified margin above the bank bill swap rate applied to the face value of the instrument. That is, to appropriately reflect the equity nature of MEIs and the discretionary nature of all distributions, any reference to determining distributions by reference to a benchmark or index should be illustrative only.

The prudential standards require that distributions to holders of ordinary shares that qualify as CET1 capital in a liquidation or winding-up must be in proportion to the holder’s share of issued capital.  That is, a holder’s claim should be proportionate to the number of ordinary shares the holder owns, not the amount (i.e. issue price) the holder paid for them.

The prudential standards require that dividends paid to holders of ordinary shares that qualify as CET1 capital instruments are not linked to the amount paid up on issuance, and there are no preferential distributions.  That is, an equal dividend is paid on each instrument, rather than the dividend being based on the price of the instrument.  However, if the investor has not paid the full amount for an instrument (e.g. a partially paid share), then the dividend may be adjusted accordingly.

Where an AT1 or Tier 2 capital instrument is issued by an entity to its foreign parent or another member of its group and will not be recognised as part of group capital, APRA does not insist that the instrument include a non-viability event which is triggered by the home regulator of the foreign parent.

Where a capital instrument is issued by an ADI or general insurance subsidiary of an authorised NOHC, and the instrument will not be included in the Level 2 group capital, then the instrument need not include a non-viability event which is triggered by the non-viability of the Level 2 group.  Not including such a non-viability event in the terms of an instrument would preclude it from being included within Level 2 capital in the future.

An AT1 capital instrument must contain non-viability trigger events for the company and each statutory fund.

A Tier 2 capital instrument must contain non-viability trigger events for the company and the statutory fund to which the Tier 2 capital instrument is allocated.

AT1 capital instruments issued at the company level need to be converted or written-off prior to the conversion or write-off of any Tier 2 capital instruments referable to a statutory fund.  

For Tier 2 capital instruments, if one statutory fund is determined to be non-viable, Tier 2 capital instruments referable to any other statutory fund which is considered viable do not need to be converted or written-off at the same time.

The amount to be converted or written off is the amount necessary to enable APRA to conclude that the life company or statutory fund is viable without further conversion or write off (as relevant).  Partial conversion or write off will not be permitted where a public sector injection of funds is deemed necessary.

A Tier 2 capital instrument issued by a Life Insurance Company needs to meet the subordination requirements in LPS 112 and the Life Insurance Act 1995.  
In the case of a Tier 2 instrument issued by a statutory fund, APRA expects a mechanism is in place to ensure that holders of Tier 2 capital instruments referable to that statutory fund are not paid out any amounts in a winding up in priority to the senior creditors of the life company including policyholders in other statutory funds.

This mechanism is needed because the insurer must first comply with the Life Insurance Act 1995, s187(3) which requires that, in a winding-up of a life company, the assets of a statutory fund must be applied to discharge liabilities that are referable to the business of the fund. Without an appropriate methodology in the conditions of subordinated instruments, this could result in subordinated noteholders being repaid in priority to policyholders in other statutory funds or other senior creditors.

A capital instrument needs to be effectively subordinated to all senior creditors (including creditors in offshore jurisdictions) of the General Insurance Company.  APRA expects a mechanism is in place to ensure that holders of these instruments are not paid out of Assets in Australia in priority to any senior creditors. This mechanism is needed because the insurer must first comply with the Insurance Act 1973, s116(3) which requires that, in a winding-up, the insurer’s assets in Australia are not to be applied to discharge liabilities outside Australia unless it has no liabilities in Australia.

Without such a mechanism, subordinated note holders in Australia could be paid out ahead of senior creditors in offshore jurisdictions. Therefore, the instrument’s conditions will need to specify an appropriate mechanism should subordinated noteholders be paid ahead of senior creditors.