Maltese Banks: Own Funds Requirements
In terms of the authority conferred on the MFSA under the Act, it may issue ‘Own Funds Rules’ (hereafter referred to as the ‘Rules’).[2] The Rules standardise the computation and application of the ongoing ‘Own Funds Requirements’[3] as well as the ‘Capital Adequacy Requirements’[4] which the Act imposes on all licensees.[5]
The Rules seek effective standardization, by adopting and building upon an international framework of European Union Directives and guidelines issued by the Committee of European Banking Supervisors on this matter.[6] The Rules also demand that licensed companies comply with the International Accounting Standards (IASs) and the International Financial Reporting Standards (IFRSs) in the computation of own funds and capital adequacy requirements.[7]
Own funds rules for Maltese Banks: composition of own funds
The own funds of credit institutions are classified into three categories; ‘Original Own Funds’,[8] ‘Additional Own Funds’,[9] and ‘Supplementary Own Funds’.[10] Each category of assets is explained further below.[11] At this stage it is important to note that the basis for differentiating between the classes of assets is the ability of each class to respond in times of financial stress. The ability of each class to respond in times of stress is measured against to the following three (3) features:-
i. ‘Permanence’ – that is, the unrestricted and timely availability of the assets to make good the losses of creditors of a credit institution which is experiencing financial stress;
ii. ‘Loss absorption capacity’ – that is, the capacity of the assets to absorb trading losses and losses suffered in the liquidation of the credit institution, and also the capacity of these assets to support depositors’ funds if the needs arise;
iii. ‘No fixed cost’ – that is, the assets should permit in times of financial stress that any payment owed by the issuer of the asset to its holder is permanently deferred or cancelled.
Original own funds
Original Own Funds are considered ‘high quality items’. This is because the assets classifying there under are most fully compliant with the three features stated above. Therefore the assets in question represent the credit institutions’ most ‘liquid’ assets. As a result the credit institution can rely on this class of assets at any one moment to cover losses and risks immediately as they occur.
Original Own Funds are composed of the following types of assets;
i. ‘Paid-up Share Capital’ - Consisting of the (i) nominal paid-up value of the share capital, (ii) the value shown in the share premium account, (iii) the issued and paid-up non-redeemable and non-cumulative preference shares, (iv) any exchange rate revaluation adjustments on paid up capital.
ii. ‘Reserves’ – Consisting of the (i) retained profits available for distributions, (ii) interim net profits (that is, after the deduction of any foreseeable charge, tax or dividend) or year-end profits (iii) reserves which may not be distributed by law, (iv) reserves set aside for general banking risk and other unforeseeable risks related to banking, (v) any other reserves, and (vi) minority interests.
iii. ‘Other Instruments’: namely,
(a) Convertible Instruments,
(b) Innovative Instruments, and
(c) Non-Innovative Instruments
Convertible Instruments
As the name implies, this category comprises financial instruments which undergo a conversion upon the happening of an event, know as a ‘contingency’. In order to classify as a convertible instrument within the Original Own Funds, the contingency should be pre-agreed and the happening of the conversion be mandatory. That is, it should be determined against a set level of identifiable financial ‘stress’.
The MFSA does not set a threshold which triggers mandatory conversion. However, a breach of the regulatory limits, such as the capital requirements ratio, would amount to a financial stressful situation warranting the conversion. In every case a convertible instrument should be made convertible by the MFSA if and when it deems this necessary. Therefore legal conditions inhibiting or attempt to inhibit the MFSA from so acting should be avoided.[12]
Secondly, when the conversion is triggered, the financial instruments should be converted into ordinary shares. This would make available additional paid-up share capital to provide the permanent solvency needed by the credit institution. Upon triggering the conversion, losses incurred by the credit institution are suffered by the holder of the instruments in equal proportion (pari passu) to the other shareholders.
A conversion which leads to a different outcome is deemed not to provide the required degree of permanence. Such instrument would consequently not classify as a convertible instrument.
3.2. Innovative instruments
Innovative instruments have a fixed maturity date of at least 30 years from the date on which they are issued. The date of redemption may, however, be suspended. Moreover, the instruments should also provide an incentive for the credit institution to redeem them. This could be represented by an interest rate step-up if the issuer does not redeem on the call date.
3.3. Non-innovative instruments
Non-innovative instruments are quite simply instruments which although they share the characteristics of original own Funds, they are not sufficiently similar to convertible or innovative instruments in order to classify under either of those categories.
Financial Instruments need not be issued by the credit institution in order to classify as original own funds. Instruments issued by a subsidiary of a credit institution (such as an SPV) could equally form part of the innovative instruments category if they satisfy the requirements of the original own funds.[13] The holders of these instruments enjoy the same rights as if the instrument was issued directly by the parent credit institution.
Additional own funds
Additional Own Funds are considered to be ‘lower quality items’. This is because assets which classify there under do not conform to the three features as well as the components which make up the original own funds. However additional own funds share the following characteristics with original own funds:-
1. they are available to the credit institution to use at will in order to cover banking risks;
2. the assets must be shown in internal accounting records;
3. the quantity of these funds should be determined by management of the credit institutions, and subsequently verified by independent auditors. The MFSA should be informed of the determined quantity.
This category is sub-divided into ‘Upper’ and ‘Lower’ tranches reflecting the level of compliance with the said features.
Upper tranches
This refers to financial instruments which have no fixed date of maturity and with servicing costs which can be deferred or waived.
Lower tranches
This refers to financial instruments which do not have the features in point 4.1 above, such as instruments with medium to long term maturity dates.
Supplementary own funds
Assets which classify as Supplementary Own Funds are least suited to the three features established in point 2 above. Therefore if contrasted to financial instruments classified as original own funds, these financial instruments would not offer unrestricted and immediate use. The financial instruments in question would have a short maturity date, consist of lower ranking of subordinated debts and the like.
The purpose of the Rules
The provisions which apply in terms of the Rules may be used to determine the Own Funds of credit institutions in relation to:-
1. the calculation of ‘Large Exposures’. This is provided for under the Large Exposures Of Credit Institutions Authorised Under The Banking Act 1994 Rule (BR/02/2011);[14]
2. the computation of Capital Requirements in accordance with the Capital Requirements Of Credit Institutions Authorised Under The Banking Act 1994 (BR/04/2011), and the Capital Adequacy Of Credit Institutions Authorized Under The Banking Act 1994 (BR/08/2011);[15]
3. transactions which a credit institution is forbidden from carrying out in terms of the Act;[16]
[1] S.4(1), the Act.
[2] S. 16A(5), the Act.
[3] S.7 et seq the Act.
[4] See S.17(1), the Act.
[5] That is companies which have applied for a license, or which hold a license to operate as a credit institution should observe the requirements of the Rules.
[6] Chapter 2, ‘Technical instruments of prudential supervision’, Directive 2006/48/EC of the European Parliament and of the Council (14 June 2006) relating to the taking up and pursuit of the business of credit institutions (recast), CEBS, ‘Guidelines on Prudential Filters for Regulatory Capital’ (21 December 2004), CEBS, ‘Implementation Guidelines for Hybrid Capital Instruments’ (10 December 2009); and CEBS ‘Implementation Guidelines regarding Instruments, Article 57(a) of Directive 2006/48/EC recast’ (14 June 2010).
[7] These have been adopted by the EU through Regulation (EC) No. 1606/2002 of the European Parliament and of the Council of 19 July 2002 and the Commission Regulation (EC) No. 1126/2008 of 3 November 2008.
[8] Para. 1.0.0, the Rules, Appendix II.
[9] Para. 2.0.0., the Rules, Appendix II.
[10] Para. 4.0.0., the Rules, Appendix II.
[11] See point 3 to 5 below.
[12] A credit institution should seek the approval of the MFSA under S.13C(1)(d), the Act before issuing convertible instruments.
[13] See point 2 above.
[14] Issued in terms of S.16, the Act. Paragraph 23, BR/02/2011 defines large exposures in relation to a customer or a group of customers as one equal to or exceeding 10% of its funds. Paragraph 24, BR/02/2011, defines large exposures in relation to a client or group of connected clients as one which exceeds 25% of its own funds (paragraphs 41 to 48 of this Rule) provide some derogations from this threshold.
[15] These Rules have been issued in terms of S.17, the Act.
[16] S.15, the Act.
