The Inquiry believes that implementing these recommendations, and continuing to develop policy based on these principles, will assist in ensuring Australia’s financial system remains strong and stable into the future and continues to provide its core economic functions — even in times of financial stress.
The recommendations increase the system’s resilience to institutional failure and, in doing so, reduce the likelihood of future crises. They aim to protect taxpayers and the Government balance sheet, help maintain investor confidence and increase efficiency in the economy. Where crises are unavoidable, the recommendations are designed to lessen their impact, minimising the need for taxpayer funds to be put at risk to support the financial sector and reducing the cost of a future crisis to the broader economy.
Box 6: ADI liability structures and prudential requirements
This box outlines the main components of an ADI’s liability structure. It describes the relationship of this structure with capital requirements, and loss absorbing and recapitalisation capacity.
Figure 3: ADI liability structure and prudential requirements
RWA: risk-weighted assets.
D-SIB: domestic systemically important bank.
CET1: common equity tier 1.
The liability structure is the mix of debt and equity instruments that the ADI uses to fund its activities, shown in the centre of Figure 3. Each category in the liability structure represents a layer in the creditor hierarchy. The top layer will be the first to absorb a loss. Once a layer has been depleted, further losses are applied to the next layer and so on. This means that the liability categories closest to the top of the structure are also the riskiest for investors and attract correspondingly higher rates of return. The corollary is that these instruments are also the most expensive sources of funding for the ADI.
Historically, prudential requirements have been placed on the top layers of ADIs’ liability structures to reduce the probability of failure — shown on the left-hand side of Figure 3. This includes capital requirements that mandate a minimum portion of the ADI’s funding be in the form of certain regulatory capital. This chapter includes recommendations to strengthen these requirements, which include:
- Buffers: It’s generally expected that an ADI’s capital level will be above the level specified by the buffers, but it can fall below this level if necessary. When it falls below, restrictions are placed on dividends and bonus payments.
- Hard minimums: ADI capital levels must be maintained above specified hard minimums. An ADI would likely be declared non-viable if capital dropped below these levels.
More recently, international standard-setting bodies have worked on separate requirements to minimise the cost of failures. Although no such requirements are currently in place in Australia, the right-hand side of Figure 3 shows the capacity for different instruments in the liability structure to perform this function. This chapter includes a recommendation to introduce a framework for loss absorbing and recapitalisation capacity. This aims to ensure that, where an ADI fails, its liability structure enhances the ability to feasibly impose losses on creditors and recapitalise the institution, minimising the need for taxpayer-funded bail-out.
Measures to address the goals of reducing the probability of failure and minimising the cost of failure when it does occur are complementary, and meeting one objective should not be seen as a substitute for meeting the other.
This chapter makes extensive reference to the different types of regulatory capital included in the Basel framework:
- Common Equity Tier 1 (CET1) capital comprises ‘tangible’ equity such as shareholders’ common equity. It is the primary defence against insolvency and bank failure.
- Additional Tier 1 (AT1) capital primarily refers to other forms of equity capital, such as preference shares, as well as some kinds of debt instruments with similar characteristics. Under the Basel framework, AT1 capital must be available to absorb the losses of a troubled institution before it becomes non-viable.
- Tier 2 capital includes subordinated debt that has a ‘bail-in’ clause, meaning it can be converted to equity or written off should a set trigger condition be met.