On 18 June 2020, the Senate referred the Banking Amendment (Deposits) Bill 2020 (the bill) to the Economics Legislation Committee (the committee) for inquiry and report by 24 August 2020.
Purpose of the bill
The bill amends the Banking Act 1959 (Banking Act) to confirm the conversion and write-off provisions introduced into the Banking Act by the Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Act 2018 (the Crisis Resolution Act), do not apply to deposit accounts.
In his second reading speech, Senator Malcolm Roberts stated 'the bill will avoid doubt as to the meaning and intent of various provisions in the Banking Act 1959 in relation to bail-in'.
According to Senator Roberts, the Crisis Resolution Act introduced uncertainty as to whether, during a time of crisis, money held in bank accounts could be taken and converted to shares in a bank—a 'bail-in'.
The bill's explanatory memorandum states:
Since the passing of the Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Act 2018 there have been doubts as to the meaning and intent of various provisions in the Act as to the extension by the Act of power to APRA [Australian Prudential Regulation Authority] to implement, authorise or direct bail-in to deposit accounts where the instruments relating to the creation of such accounts did not provide for a power of bail-in being the writing off or conversion of deposit accounts.
Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Act 2018
Government inquiries and reports
The Crisis Resolution Act was the government's response to a number of reports, consultations and inquiries aimed at strengthening the financial system following the 2008 Global Financial Crisis, including:
the October 2011 Financial Stability Board's (FSB) Key Attributes of Effective Resolution Regimes for Financial Institutions;
the government's 2012 consultation paper, 'Strengthening APRA's Crisis Management Powers', which included a discussion on possible changes to the 2008 Financial Claims Scheme (FCS); and
the report of the 2014 Financial System Inquiry.
Overview of the Crisis Resolution Act
In February 2018, the Senate Economics Legislation Committee tabled its report into the Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Bill 2017 [Provisions].
The subsequent Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Act 2018 (Crisis Resolution Act) contains seven schedules amending eight separate pieces of legislation to provide APRA with additional powers for crisis resolution and resolution planning of regulated entities.
The Crisis Resolution bill's explanatory memorandum explained the bill would:
enhance APRA’s statutory and judicial management regimes to ensure their effective operation in a crisis;
enhance the scope and efficacy of APRA’s existing directions powers;
improve APRA’s ability to implement a transfer under the Transfer Act;
ensure the effective conversion and write-off of capital instruments to which the conversion and write-off provisions in APRA’s prudential standards apply;
enhance stay provisions and ensure that the exercise of APRA’s powers does not trigger certain rights in the contracts of relevant entities within the same group;
enhance APRA’s ability to respond when an Australian branch of a foreign regulated entity (foreign branch) may be in distress;
enhance the efficiency and operation of the FCS and ensure that it supports the crisis resolution framework; and
enhance and simplify APRA’s powers in relation to the wind up or external administration of regulated entities under the Industry Acts, and other related matters.
Conversion and write-off of capital instruments
The Crisis Resolution Act inserted a new subdivision into the Banking Act to stipulate no law can prevent the conversion of an instrument in accordance with the terms of the instrument.
At the time of the Senate Economics Legislation Committee inquiry into the Crisis Resolution bill, the national political party, the Citizens Electoral Council (CEC—now the Australian Citizens Party), raised concerns the provisions would allow for a bail-in of bank deposits.
Under APRA’s prudential standards, regulated entities have to maintain minimum levels of regulatory capital. The regulatory capital is categorised as ‘Common Equity Tier 1’ (CET1), ‘Additional Tier 1’ (AT1), and ‘Tier 2’ (T2) capital on the basis of the risk it carries.
Prudential standards require CET1, AT1 and T2 regulatory capital to include certain conversion and write-off terms. The terms of AT1 and T2 instruments must provide that they absorb losses in the event an authorised deposit-taking institution (ADI) or insurer is in distress. When an institution is in distress, these capital instruments can be converted or written off to ensure the stability of the affected institution.
According to the government, in some situations it was unclear whether certain capital instruments would absorb losses—either by conversion or write off. This was due to potential legal impediments contained in the Corporations Act 2001 that could restrict the ability of entities to issue, vary, convert or cancel shares.
The amendments made by schedules 1–3 and 7 of the Crisis Resolution Act would, according to the government, make it certain that legal impediments could not overturn the terms of capital instruments that provide for the instrument to absorb losses by conversion or being written off.
Bank deposits and conversion and write-off provisions
Through the interpretation of a definition in the subdivision (section 11CAA), in combination with the provisions themselves, some submitters to the inquiry, including the CEC, argued that banks could potentially bail-in depositors' accounts.
Section 11CAA of the Crisis Resolution Act added a number of definitions related to the conversion and write-off provisions, including the following:
Conversion and write-off provisions means the provisions of the prudential standards that relate to the conversion or writing off of:
Additional Tier 1 and Tier 2 capital; or
any other instrument.
The CEC argued 'any other instrument' was open ended and allowed for a bail-in of deposit accounts.
Writing about these concerns raised during the Crisis Resolution bill inquiry, the Parliamentary Library stated, 'the current legal framework for conversion and write-off does not apply to deposit accounts nor does the bill allow APRA to write-off deposits or convert them to equity'. It provided a number of reasons for this.
The conversion and write-off provisions in the Crisis Resolution bill only apply 'in relation to an instrument that contains terms for the purpose of the conversion and write-off provisions'. Under APRA's powers to stipulate conversion and write-off (established in Prudential Standard APS 330 Public Disclosure), authorised deposit-taking institutions must make accurate, high quality and timely public disclosures of information about their capital instruments. The Prudential Standard ensures ADI customers do not unknowingly purchase a financial instrument to which the conversion and write-off provisions apply.
Furthermore, the Parliamentary Library noted, a 'basic deposit product', defined under section 761A of the Corporations Act 2001, must meet certain conditions, including limitations on the circumstances under which the balance of a deposit account can be reduced. These circumstances do not include conversion or write-off.
Also, APRA has a statutory obligation (that applies to its powers to issue a recapitalisation direction) to protect the interests of depositors under Division 2 of Part II of the Banking Act, which states:
It is the duty of APRA to exercise its powers and functions under this Division for the protection of the depositors of the several ADIs and for the promotion of financial system stability in Australia.
The Parliamentary Library also identified several other protections for depositors:
the Financial Claims Scheme (FSC)—the Treasurer may activate the scheme in the event a bank fails. Upon activation, APRA provides depositors with access to their deposits within seven days up to a $250,000 cap (covering around 99 per cent of deposit accounts in full and around 80 per cent of household deposits by value);
the depositor preference system—applies to deposits above the FCS cap and means in the event a bank fails, the claims of depositors rank above all equity holders and creditors (after the government has been reimbursed for any amounts paid out under the FCS); and
numerous layers of prudential regulation and interventions APRA can make to resolve financial institutions in distress (recapitalisation, statutory management, transfer powers).
In response to inquiry questions on notice, the Reserve Bank of Australia considered it unlikely financial stability would be promoted by imposing losses on deposit-holders. On the contrary, depositor protection is an important element of the financial system that promotes financial stability. The Bank stated:
Even small losses to deposit holders would increase the likelihood of disruption, including potential depositor runs on other financial institutions; that is, it could lead to contagion and potential financial instability.
The Bank also stated the legislation did not imply that losses could be imposed on deposit-holders, or give APRA any additional powers that could be used to the detriment of retail depositors.
APRA stated that under the Banking Act, it already had the power to set prudential requirements in relation to the capital instruments an ADI must hold. The bill did not change APRA's existing powers or require an ADI to meet certain capital requirements. APRA's capital requirements were set in accordance with Basel III and it had no current proposal to change that. In the event a change was proposed in the future, it would be subject to APRA's consultation processes regulatory requirements.
The Reserve Bank of Australia and APRA both indicated the information provided by the Treasury to the committee's inquiry was consistent with their views. The Treasury stated suggestions deposits were not protected under the Banking Act, that the bill provided APRA with bail-in powers, and that those powers were to be extended to deposits, were incorrect:
the bill did not include a statutory power for APRA to write-down or convert the interests of other creditors in resolution, including depositors of a failing ADI;
deposits would not be subject to the provisions in the bill that deal with the conversion and write-off of capital requirements; and
notwithstanding all this, there are additional protections for depositors, including APRA's statutory objective to protect the interests of depositors, the depositor-preference provisions, and the FSC.
The Treasury further elaborated, the intention of paragraph (b) of the definition of 'conversion and write-off provisions' in section 11CAA was to 'appropriately "future-proof" the legislation'. The use of the word 'instrument' was intended to capture any type of security or debt instrument that could be included within the capital framework in the future.
The Treasury was of the view paragraph (b) of the definition could not be interpreted to include bank deposits as an instrument that could be converted and written off. This is because the operative section to which the definition applied (11CAB), would only apply where an 'instrument' contained terms providing for conversion and/or write-off and those terms reflected requirements in APRA's prudential standards (which are disallowable by the Parliament).
As noted above, the prudential standard requires disclosures of all information about capital instruments to the effect customers would be aware they are purchasing an instrument to which the conversion and write-off provisions apply—prior to making the purchase of the instrument.
The Treasury stated:
…the definition cannot reasonably be interpreted to include deposits as an instrument that could be converted or written off. Therefore they cannot be 'bailed-in'.
Box 1.1: Key concepts
Deposit account (liabilities)
A bank, as a business, has assets and liabilities. Deposits count as liabilities (or debt) for a bank. Liabilities provide the majority of bank funding and usually require the bank to return the principal plus interest at a pre-agreed rate. Deposits comprise around 64 per cent of Australian ADI liabilities.
A bank’s assets are typically financial contracts under which a counterparty owes money to the bank. These assets are primarily loan repayments from borrowers. For Australian banks, loans and advances comprise around 69 per cent of ADI assets.
Banks use both debt funding (primarily deposits) and capital funding to fund their assets (loans).
Capital (or equity) is the difference between assets and liabilities. It acts as a buffer against unanticipated losses arising from credit, market and operational risks. For instance, if loans are not repaid or investments decline in value, a bank's balance-sheet assets have to be written down in value. These losses are absorbed through a reduction in the bank's capital.
Capital consists of a range of financial instruments, including shares. Some capital must be loss absorbing (LAC)—that is, it must contain conversion or write-off provisions so it can be included as regulatory capital.
Shareholders and other investors seek a relatively high return for bearing the risk they could lose their investment. Because it is costly for a bank to pay these returns, there is an incentive to minimise the capital on its balance sheet. As a result, APRA sets a minimum level of required capital for banks—this level is determined according to the relative riskiness of a bank's assets.
Capital is held through a range of financial instruments categorised according to the level of risk. Common Equity Tier 1 (CET1) capital (for instance, shares) is the highest quality because it does not result in any repayment or distribution obligations on the institution (for instance, the payment of dividends is at the discretion of the institution). It is therefore the riskiest for capital owners and carries the highest cost to the bank (in the payment of returns). Other classes of capital instrument are Additional Tier 1 (AT1) and Tier 2 (T2).
In Australia, AT1 is largely converting preference shares which may contain franked dividends. It can also include hybrid capital instruments. Tier 2 is typically subordinated debt.
A capital instrument is:
a form of financial security (for example, a share, note or bond). Equity instruments, such as shares, allow investors to own a portion of the company commensurate with their investment. Debt instruments, such as bonds and notes, lend money to businesses with the expectation that interest will be paid. Some capital instruments, such as preferences shares and subordinated notes, contain conversion and write-off provisions so that they can be included as regulatory capital.
Conversion and write-off provisions for capital instruments
Additional Tier 1 and Tier 2 instruments contain conversion (to ordinary equity in the bank) and write-off (loss) provisions, triggered when the bank is operating close to minimum regulatory capital requirements or in financial difficulty.
It is the intent that instruments containing write-off and conversion provisions absorb losses ahead of the use of public funds.
The purpose of a capital framework with classes of capital instruments incorporating loss-bearing features is to protect depositors who have not bargained for the risk of conversion and do not enjoy the risk premiums (higher rate of return) that apply to these instruments.
Provisions of the bill
Items 1 to 3 insert or alter definitions in the Banking Act.
Item 1 inserts an additional definition at section 11CAA—bail-in. This is defined as:
bail-in, in relation to a deposit account, means to convert or write off the deposit amount.
Item 2 of the bill amends the definition of 'conversion and write-off provisions' to specify it does not include deposit accounts:
Conversion and write-off provisions means the provision of the prudential standards that relate to the conversion of writing off of:
Additional Tier 1 and Tier 2 capital; or
any other instrument (not including a deposit account).
Item 3 defines a deposit account.
Item 4 inserts a new subsection at 11CAB which specifies the application of the conversion and write-off provisions. The new subsection states:
(1A) To avoid doubt, the reference to an instrument in subsection (1) does not include a deposit account.
Prohibition of bail-in
Item 5 adds a new section, 11CAD:
11CAD No bail-ins of deposit accounts
Nothing in this Act or any other Commonwealth law gives APRA power (whether by way of a prudential standard or otherwise) to:
implement a bail-in of deposit accounts; or
authorise or direct the implementation of a bail-in of deposit accounts; or
authorise or direct the amendment of any contract, agreement or other instrument or provide for bail-in of deposit accounts.
The Senate Standing Committee for the Scrutiny of Bills considered the bill and made no comment.
Conduct of the inquiry
The committee advertised the inquiry on its website and provided guidance on making a submission.
The committee received 196 submissions, which are listed at Appendix 1. The committee also received 339 pieces of correspondence. The committee received answers to questions on notice from the Australian Prudential Regulation Authority.