Banking (prudential standard) determination No. 5 of 2006 Prudential Standard APS 112 Capital Adequacy: Credit Risk (Cth)

Banking (prudential standard) determination No. 5 of 2006

Prudential standard APS 112 – Capital Adequacy: Credit Risk

as amended

made under paragraphs 11AF(1)(a) and (b) of the

Banking Act 1959

This compilation was prepared on 3 September 2009
taking into account amendments up to Banking (prudential standard) determination No. 10 of 2006 – Variation to Prudential Standard APS 112

Prepared by the Office of Legislative Drafting and Publishing,
Attorney-General’s Department, Canberra

I, John Francis Laker, Chair of APRA:

(a)under paragraphs 11AF(1)(a) and (b) of the Banking Act 1959 (the Act), DETERMINE the Prudential standard APS 112 - Capital Adequacy: Credit Risk in the form set out in the Schedule, which shall apply to all authorised deposit-taking institutions (ADIs) and authorised non-operating holding companies (authorised NOHCs); and

(b)under subsection 11AF(3) of the Act, REVOKE the Prudential Standard APS 112 - Capital Adequacy: Credit Risk (and related Guidance Notes), as varied, made by an instrument dated 8 September, 2000 entitled Prudential Standard “APS112” Capital Adequacy: Credit Risk.

This instrument shall take effect from the later of 1 July 2006 and the date of registration on the Federal Register of Legislative Instruments.

Dated 30 May 2006

[Signed]

John Francis Laker

Chair

Interpretation

In this Determination

ADI has the meaning given in section 5 of the Act.

APRA means the Australian Prudential Regulation Authority.

authorised NOHC has the meaning given in section 5 of the Act.

Note 1 An ADI or authorised NOHC that does not comply with a standard may be issued with directions by APRA under paragraph 11CA(1)(a) of the Act. Non-compliance with a direction is an offence attracting a penalty of up to 250 penalty units for a body corporate (currently $27,500) for each day that the offence continues. Officers of the ADI or authorised NOHC may also be criminally liable (see section 11CG).

Note 2 Prudential Standard APS 112 - Capital Adequacy: Credit Risk made on 8 September 2000 was varied by Variation of Prudential Standard "APS 112” Capital Adequacy: Credit Risk dated 4 September 2003, by Variation of Prudential Standard "APS 112 - Capital Adequacy: Credit Risk" dated 16 September 2004, and by Banking (prudential standards) determination No. 2 of 2005 dated 21 September 2005.

Schedule

Prudential standard APS 112 - Capital Adequacy: Credit Risk comprises the 47 pages commencing on the following page.

Prudential Standard APS 112

Capital Adequacy: Credit Risk

Objective and key requirements of this Prudential Standard

This Prudential Standard aims to ensure that all locally incorporated ADIs adopt a uniform approach to the measurement of their on- and off-balance sheet credit exposures for capital adequacy purposes.

This Prudential Standard forms part of a comprehensive set of prudential standards dealing with capital adequacy.

Authority and application

This Prudential Standard, made under section 11AF of the Banking Act 1959 (the Act), applies to all authorised deposit-taking institutions (ADIs) authorised under the Act. The Guidance Notes AGN 112.1 Risk-Weighted On-Balance Sheet Credit Exposures (AGN 112.1), AGN 112.2 Risk-Weighted Off-balance Sheet Credit Exposures (AGN 112.2), AGN 112.3 Netting (AGN 112.3) and AGN 112.4 Treatment of Credit Derivatives in the Banking Book (AGN 112.4) form part of this Prudential Standard.

The procedures and requirements set out in this Prudential Standard and the guidance notes attaching to it for calculating an ADI’s risk-weighted on- and off-balance sheet credit exposures for capital adequacy purposes are applicable to all locally incorporated ADIs[1] on both a stand-alone and consolidated group basis. Reference to “an ADI” or “ADIs” includes an ADI on a stand-alone basis and the consolidated ADI group.
[1] Foreign ADI as defined in Division 1B of the Banking Act 1959.

Risk weighting approach

To ensure that all locally incorporated ADIs maintain a minimum level of capital that broadly reflects their credit risk profiles, they must risk-weight their on-balance sheet assets and off-balance sheet business (including both market-related and non-market-related transactions) according to certain risk categories.

Each on-balance sheet asset and off-balance sheet transaction is assigned to one of four categories of risk weight – 0, 20, 50 and 100 per cent, based on the riskiness of counterparty default (refer AGN 112.1). All off-balance sheet transactions which give rise to credit risk are converted into on-balance sheet equivalents according to specified credit conversion factors prior to allocating the assigned risk weight (refer AGN 112.2).

The risk weights assigned reflect broad judgements of regulators about credit risk on a portfolio basis, and should not be taken as a substitute for individual assessments of credit risks associated with particular exposures. The board of directors and management of an ADI have primary responsibility to ensure that adequate systems are in place to individually assess the credit risk in an ADI’s operations, to allocate the appropriate amount of capital to cover that risk and to suitably price the transactions to reflect the risk undertaken.

Netting

Subject to APRA-specified requirements for bilateral netting arrangements, an ADI may net off-balance sheet credit exposures arising from market-related contracts with a counterparty that are covered by eligible bilateral netting agreements (refer AGN 112.3).

Collateral and guarantees

Although the primary determinant of the risk weight of a particular on- or off-balance sheet transaction is the nature of the underlying counterparty, APRA recognises qualifying collateral (e.g. cash, securities issued by recognised entities and residential mortgages), guarantee arrangements that provide for direct, explicit, irrevocable and unequivocal recourse to the guarantors (refer AGN 112.1) and certain credit derivatives (refer AGN 112.4).

An on- or off-balance sheet credit exposure secured against eligible collateral, a guarantee or qualifying credit derivative is assigned a lower risk weight based on the collateral, guarantor or credit derivative counterparty, rather than the counterparty to the transaction.

Guidance Note AGN 112.1

Risk-Weighted On-Balance Sheet Credit Exposures

This Guidance Note sets out how to calculate the risk-weighted amount of an authorised deposit-taking institution's (ADI’s) on-balance sheet credit exposures for capital adequacy purposes.

Scope

The risk-weighting process used for measuring an ADI’s on-balance sheet credit exposures covers all on-balance sheet assets held by the ADI, except the following items which are specifically excluded:

(a)those assets or investments which are required to be deducted from Tier 1, Tier 2 or total capital as per Prudential Standard APS 111 Capital Adequacy: Measurement of Capital (APS 111);

(b)all debt and equity securities held in the trading book (the associated risk-weighted exposures are determined in accordance with Prudential Standard APS 113 Capital Adequacy: Market Risk (APS 113));

(c)all on-balance sheet positions in commodities (the associated risk-weighted exposures are determined in accordance with APS 113); and

(d)on-balance sheet unrealised gains on market-related off-balance sheet transactions (which are to be included in the calculation of an ADI’s total risk-weighted off-balance sheet credit exposures – refer Guidance Note AGN 112.2 Risk-Weighted Off-Balance Sheet Exposures).

Where only a partial amount of an increase in the value of an asset is recognised in measuring Upper Tier 2 capital, and the remainder is not elsewhere reflected in the capital of the ADI, only the corresponding partial amount of the increase in the value of the asset is added to the exposure to be risk-weighted.

Risk-weighted assets

An ADI’s total risk-weighted on-balance sheet credit exposures equal the sum of the risk-weighted amount of each on-balance sheet asset it holds.

The risk-weighted amount of an on-balance sheet item is determined by multiplying its current book value (i.e. current outstanding amount including accrued interest or revaluations, and net of any specific provision or associated depreciation) by the relevant risk weight specified in Attachment A.

Where an on-balance sheet claim on a counterparty is secured against eligible collateral and/or guarantee recognised by APRA, the secured portion of the claim should be weighted according to the risk weight appropriate to the collateral and/or the guarantor. The unsecured portion of the claim must be weighted according to the risk weight applicable to the original counterparty.

An ADI should consult APRA in case of doubt about how to determine the risk-weighted amount of a particular on-balance sheet transaction.

Eligible collateral and guarantees

The only forms of collateral which APRA recognises for capital adequacy purposes are:

(a)cash deposits (including any rights of set-off on credit balances) subject to the conditions set out in Attachment B;

(b)securities issued by the Commonwealth, State and Territory Governments (including State and Territory central borrowing authorities) in Australia; central and state governments in OECD countries; OECD central banks; international banking agencies and multilateral regional development banks; and

(c)residential mortgages subject to the criteria detailed in Attachment C.

The underlying collateral arrangements must provide for direct, explicit, irrevocable and unequivocal recourse to the collateral.

Claims secured or collateralised in other ways, for example, by insurance contracts, put options, forward sales contracts or agreements, bank paper, securities issued by public sector entities etc, are not considered to be covered by eligible collateral. Such claims must be weighted according to the risk weight applicable to the original counterparty.

The only guarantees which APRA recognises for capital adequacy purposes are:

(a)guarantees provided by the Commonwealth, State, Territory and Local Governments (including State and Territory central borrowing authorities) in Australia; central, state and local governments in OECD countries; public sector entities in Australia and OECD countries; OECD central banks and other OECD banks; ADIs in Australia; international banking agencies and multilateral regional development banks. Guarantees provided by non-OECD central governments and central banks, as well as non-OECD banks are recognised, to a limited extent, subject to the relevant conditions set out in Attachment A; and

(b)credit derivatives used for buying credit protection (refer Guidance Note AGN 112.4 Treatment of Credit Derivatives in the Banking Book).

The guarantee must be issued formally and the underlying guarantee arrangements must provide for direct, explicit, irrevocable and unequivocal recourse to the guarantor.

Claims secured against indirect guarantees and letters of comfort do not qualify as eligible guarantees. Such claims must be weighted according to the risk weight applicable to the original counterparty.

Coverage of collateral or guarantees is generally determined by the market value of the collateral or the amount of the guarantee in relation to the amount of the actual exposure supported by the collateral or guarantee.

Only collateral and/or guarantees actually posted may be used for determining risk weights. A commitment to provide collateral is not recognised as eligible collateral for risk weighting purposes.

Attachment A

Risk Weights for On-Balance Sheet Assets

Category I – Cash Items	Risk Weight
1. Notes and coins.	0%
2. Balances with and all other claims on the Reserve Bank of Australia.	0%
3. Claims to the extent that they are secured against eligible cash collateral (refer Attachment B).	0%
4. Gold bullion held in own vaults or, on an allocated basis by another party to the extent that it is backed by gold bullion liabilities. Gold held on an unallocated basis by another party, though backed by gold liabilities, is weighted as a claim on the counterparty unless a lower risk weight is approved by APRA.	0%
5. Gold held as collateral to the extent that the underlying claim being collateralised is denominated in gold.	0%
6. Cash items in the process of collection (e.g. cheques, drafts and other items drawn on other ADIs or overseas banks that are payable immediately upon presentation and that are in the process of collection).	20%
Category II – Claims on Australian & Foreign Governments
7. All claims held in the banking book[2] on, or claims to the extent that they are guaranteed by or secured against securities issued by, the Commonwealth, State or Territory Governments in Australia (including State or Territory central borrowing authorities).	0%
8. Claims on, or claims to the extent that they are guaranteed by, local governments in Australia.	20%
9. All claims held in the banking book on, or claims to the extent that they are guaranteed by or secured against securities issued by, central and state governments in OECD countries.[3]	0%
10. Claims on, or claims to the extent that they are guaranteed by, local governments in OECD countries.	20%
11. All claims held in the banking book on, or claims to the extent that they are guaranteed by, central governments in non-OECD countries, which are denominated and funded in local currency of the country concerned.	0%
12. All claims held in the banking book on, or claims to the extent that they are guaranteed by, governments in non-OECD countries other than those denominated and funded in local currency of the country concerned.	100%
Category III – Claims on Public Sector Entities & Public Trading Enterprises
13. Claims on, or claims to the extent that they are guaranteed by, public sector entities (except those which have corporate status and operate on a commercial basis) in Australia.	20%
14. Claims on public trading enterprises in Australia which have corporate status and operate on a commercial basis (notably in significant competition with private sector enterprises).	100%
15. Claims on, or claims to the extent that they are guaranteed by, non-commercial public sector entities in OECD countries.	20%
16. Claims on commercial companies owned by public sector entities in OECD countries.	100%
Category IV – Claims on Central Banks, International Banking Agencies, Regional Development Banks, ADIs in Australia and Overseas Banks[4]
17. All claims held in the banking book on, or claims to the extent that they are guaranteed by or secured against securities issued by, central banks in OECD countries.	0%
18. All claims held in the banking book on, or claims to the extent that they are guaranteed by, central banks in non-OECD countries, which are denominated and funded in local currency of the country concerned.	0%
19. All claims held in the banking book on, or claims to the extent that they are guaranteed by, central banks in non-OECD countries other than those denominated and funded in local currency of the country concerned.	100%

[2]For the purposes of this Attachment, 'all claims held in the banking book' refers to those entities which are held in the trading book are treated in accordance with Prudential Standard APS 113 Capital Adequacy: Market Risk (APS 113).

[3] For the purposes of this Attachment, 'OECD countries' include countries which have concluded special lending arrangements under the IMF’s General Arrangements to Borrow (Saudi Arabia at this stage), provided that they have not rescheduled their external debt, whether to official or private sector creditors, within the previous five years.

[4] All references to “overseas banks” under Category IV include financial institutions in a country which (i) have the power to accept deposits in the regular course of business; (ii) are supervised by the supervisor of banks; and (iii) are subject to the same prudential requirements as banks (including capital adequacy).

20. Claims (excluding subordinated debt instruments) on, or claims to the extent that they are guaranteed by or secured against securities issued by, international banking agencies and multilateral regional development banks. These include the IMF, the International Bank for Reconstruction and Development, the Bank for International Settlements and the Asian Development Bank.	20%
21. Holdings of subordinated bonds issued by international banking agencies and multilateral regional development banks. These include the IMF, the International Bank for Reconstruction and Development, the Bank for International Settlements and the Asian Development Bank.	100%
22. All claims (other than equity and debt capital investments) held in the banking book on, or claims to the extent that they are guaranteed by, ADIs (including Australian branches of foreign ADIs and overseas branches of locally incorporated ADIs) in Australia.	20%
23. All claims (other than equity and debt capital investments) held in the banking book on, or claims to the extent that they are guaranteed by, overseas banks incorporated in OECD countries. This includes claims on, or guaranteed by, their branches in all countries.	20%
24. All claims (other than equity and debt capital investments) held in the banking book on, or claims to the extent that they are guaranteed by, designated banks incorporated in non-OECD countries of the Asia-Pacific region as agreed by APRA.[5] This includes claims on, or guaranteed by, their branches in all countries.	20%
25. All claims (other than equity and debt capital investments) held in the banking book on, or claims to the extent that they are guaranteed by, overseas banks incorporated in non-OECD countries (other than a bank referred to in item 24), with a residual maturity of one year or less. This includes claims on, or guaranteed by, their branches in all countries.	20%
26. All claims (other than equity and debt capital investments) held in the banking book on overseas banks incorporated in non-OECD countries (other than a bank referred to in item 24), with a residual maturity exceeding one year. This includes claims on their branches in all countries. Claims guaranteed by these non-OECD banks (and their branches in all countries) with a residual maturity exceeding one year are weighted according to the risk weight applicable to the original counterparty.	100%
Category V – Claims Secured Against Residential Mortgages
27. Loans and all other claims secured against eligible residential mortgages (refer Attachment C).	50%
Category VI – Other Assets & Claims
28. Stockbroking positions awaiting settlement.	50%
29. All claims on private sector counterparties (other than ADIs or overseas banks). This includes e.g. personal and corporate loans; commercial and industrial loans; leasing finance and bill acceptances drawn by private sector counterparties; all other property loans (including loans secured against commercial property); holdings of corporate debt securities and shares in the banking book[6]; and claims on other financial institutions.	100%
30. Investments in premises, plant and equipment and all other fixed assets.	100%
31. Claims on all fixed assets under operating leases.	100%
32. All other assets and claims not elsewhere specified.	100%

[5] For the purposes of this Attachment, 'overseas bank' refers to a bank incorporated in the Asia-Pacific region wishing to be afforded this treatment must apply to APRA. APRA is willing to consider, on a case-by-case basis, assigning claims on, or guaranteed by, non-OECD banks from the Asia-Pacific area the same risk weight as claims on, or guaranteed by, OECD banks provided the bank is of high international standing and the parent country has a supervisory framework and standards equivalent to that applied in Australia.

[6] For the purposes of this Attachment, corporate debt securities and shares held in the trading book are treated in accordance with APS 113.

Attachment B

Eligible cash collateral

Credit exposures (on- or off-balance sheet) which are collateralised by cash deposits (including any set-off arrangements) can be weighted as equivalent to a claim on cash, subject to satisfying the following criteria:

There must be a formal written contractual agreement between the lender (or party holding a claim) and the party lodging the cash collateral which establishes the lender’s direct and unconditional recourse to the cash collateral. A common law right of set-off is insufficient on its own to satisfy this condition.

Where cash collateral is lodged by a third party, that other party must also indemnify or guarantee the borrower’s obligations (or those of the party on which a claim is held) to the lender. The lender must ensure that the arrangement will not fail for lack of consideration.

In the event of default, any requirement on the lender to serve notice on the party lodging the collateral must not impede the lender’s recourse to the collateral.

The cash collateral must not be lodged with an entity other than the lender, except where:

(a)the lender and the entity holding the collateral belong to the same consolidated group of an ADI; and

(b)the entity holding the collateral is bound to act in accordance with the agreement between the lender and the party lodging the collateral.

Subject to paragraph 4, where cash collateral is lodged with an overseas entity, the lender must ensure that legal agreements entered into are binding in the jurisdiction in which the cash is held.

Where cash collateral is lodged with the lender’s overseas branches, the branches holding the collateral must be bound to act in accordance with the agreement between the lender and the party lodging the collateral. The lender must also ensure that legal agreements entered into are binding in the jurisdiction in which the cash is held.

Where cash collateral lodged is denominated in a currency different from the underlying exposure being collateralised, it must be valued at current market exchange rates.

Where cash collateral lodged is in the form of certificate of deposits or like instruments issued by the lender or any eligible entity described in paragraph 4, the lender must retain physical possession of the instrument until the collateral obligations are extinguished.

Where the party lodging the cash retains access to the collateral, the lender must retain the right to block access to the cash collateral at any time.

Attachment C

Eligible Residential Mortgages

For capital adequacy purposes, a loan for housing or other purposes to an individual borrower, which is fully secured by registered mortgage over a residential property (whether or not the property is owned by the borrower) is assigned a concessional risk-weight of 50 per cent subject to satisfying the criteria set out below.

The concessional risk weight does not apply to mortgage‑backed securities, which are risk-weighted as a claim on the actual issuer (and not the sponsor) of the securities. Other asset-backed paper should be risk-weighted in a similar fashion.

Lending criteria

An ADI must at all times have a clear and unequivocal access to the mortgaged residential property in the event of default by the borrower.

An ADI must have procedures in place to assess the ability of borrowers to meet repayment obligations. The assessment criteria must be documented as part of the ADI’s Lending/Credit Policy and Procedures Manual.

An ADI must have in place verification procedures to substantiate critical application data provided by the borrower. Such procedures must be documented in the ADI’s Lending/Credit Policy and Procedures Manual. Essentially, these should include procedures for verifying income documentation sufficient for the ADI to make an assessment of the repayment capacity of the borrower. All material income sources and employment details of the borrower must be assessed by the ADI prior to loan approval, and documented as part of the loan origination and approval process.

Subject to paragraph 11, an ADI may apply a concessional risk weight of 50 per cent to a loan fully secured by a residential property which was originally subject to a 100 per cent risk weight because of failure to satisfy the requirements set out in paragraphs 2 and 3 above, provided the borrower has substantially met contractual loan repayments continuously over the last 36 months. Criteria defining when contractual loan repayments are substantially met must be set out in the ADI’s Lending/Credit Policy and Procedures Manual.

Where an ADI outsources any part of its credit assessment process to a third party (such as a mortgage originator or broker), the arrangement must comply with Prudential Standard APS 231 Outsourcing.[7] The ADI should undertake due diligence on all third parties it uses to make any lending decisions or that undertake assessments of borrower information on its behalf. There should be a formal agreement in place with the third party that specifies the criteria that are to be used in approving the loan. The ADI must have audit and monitoring procedures in place to ensure that its lending criteria are applied at all times by the third party credit assessor.
[7] Where an ADI uses a third party for loan administration functions only, and does not outsource any part of the credit assessment process to the third party, the responsibility for ensuring that the lending criteria are met remains with the ADI.

Where an ADI accepts the purchase price, or other means of valuation, as being an indication of the value of the residential property offered as security for a loan (in lieu of a formal valuation), the ADI must detail the criteria used to justify this use in its Lending/Credit Policy and Procedures Manual. The Manual must include clear guidelines which detail the circumstances under which the purchase price or other means of valuation are acceptable to the ADI as an indication of the property value as well as circumstances where a formal valuation of the property is required.

Where an ADI requires a formal valuation of each residential property offered as security for a loan, the valuation must be carried out by an independent accredited valuer nominated by the ADI. The ADI’s Lending/Credit Policy and Procedures Manual should document procedures for determining whether a formal valuation of one or more existing residential property security is required when the specific property or properties are to be used in support of a new loan. The ADI’s Lending/Credit Policy and Procedures Manual should also document the procedures to be followed for revaluing properties where the ADI becomes aware of a material change in the value of properties in an area or region.

Any residential property offered as security for a loan must be readily marketable. In assessing the marketability of such property, an ADI may take into account factors such as whether the property is within residential or rural residential zoning, or other evidence which can demonstrate that the property is likely to be readily sold. This would normally exclude remote rural residential properties or residential properties that could only be sold at a significant discount. An ADI must detail its policy for determining the marketability of a residential property offered as security in its Lending/Credit Policy and Procedures Manual.

Where security is provided by third parties (i.e. parties other than the specific borrower), an ADI should ensure that those parties understand fully the consequences of default on the loans and their legal obligations. Loans covered by security provided by third parties, where the relevant mortgage is unenforceable under the Consumer Credit Code, are risk-weighted at 100 per cent in the absence of any eligible collateral and guarantees.

Subject to satisfying other criteria set out in this Attachment, loans for purposes other than housing must be fully secured against mortgages over existing residential property to receive a 50 per cent risk weight. Loans, for whatever purpose, secured against speculative residential construction or property development – e.g. multiple dwellings such as blocks of units – do not qualify for a concessional risk weight.

Loan to valuation ratio

To qualify for the concessional risk-weight of 50 per cent:

(a)the loan must meet the lending criteria in paragraphs 1 to 10 and:

(i) the ratio of the outstanding amount of the loan to the value of the mortgaged residential property securing the loan must not exceed 80 per cent; or

(ii) the loan must be 100 per cent mortgage insured through an acceptable lenders mortgage insurer (LMI);[8] or
[8] All loans approved by banks prior to 5 September 1994 to an individual which are fully secured by residential properties are not subject to the 80 per cent loan-to-valuation ratio requirement and will continue to attract a concessional risk-weight of 50 per cent for capital adequacy purposes.

(b)if the loan does not meet any of the criteria in paragraphs 2, 3, 6, 7 and 8:

(i) the ratio of the outstanding amount of the loan to the value of the mortgaged residential property securing the loan must not exceed 60%; or

(ii) the loan must be 100 per cent mortgage insured through an acceptable LMI.

A loan that neither satisfies subparagraph (a) or (b) will be risk-weighted at 100 per cent in the absence of eligible collateral or guarantees.

The “outstanding amount” of the loan is calculated as the balance of all claims on the borrower that are secured against the mortgaged residential property. This includes accrued interest and fees, as well as the gross value of any undrawn limits on commitments (which cannot be cancelled at any time without notice) e.g. any redraw amount available on the loan or undrawn limit on a revolving credit facility. The outstanding amount under an “all moneys” mortgage should include all loans and other exposures to the borrower that are effectively secured against the mortgage.

Where the loan is also secured against a second mortgage, the outstanding amount of the loan is calculated as the sum of all claims on the borrower secured by both the first and second mortgages over the same residential property for the purpose of assessing the loan to valuation ratio.

Where the loan is secured by more than one property, the loan to valuation ratio is determined on the basis of the outstanding amount of the loan to the aggregate value of the mortgaged residential properties.

In calculating the outstanding amount of the loan, allowance can be made for eligible collateral (other than eligible residential mortgages) and guarantees. The portion of any balances covered by such arrangements is deducted from the outstanding amount of the loan and weighted according to the risk weight applicable to the collateral or guarantor (refer Attachment A). A mortgage offset or similar account may only be netted off against the outstanding amount of the loan where the arrangement meets the requirements for eligible cash collateral as set out in Attachment B.

Second mortgages

To qualify for a concessional risk weight, any loans secured by a second mortgage over residential property must, in addition to the requirements of loan to valuation ratio set out above, satisfy the following conditions:

(a)the first mortgage must not be able to be extended without being subordinated to the second mortgage;

(b)an ADI must obtain a written consent of the first mortgagee for the second mortgage and confirm the maximum outstanding amount of the loan secured by the first mortgage (including maximum drawdown or limit of facility) for loan to valuation ratio purposes; and

(c)an ADI must ensure that its interest as second mortgagee is noted on the title.

Mortgage insurance [9]

[9] Refer paragraphs 26 to 30 for transitional arrangements relating to these requirements.

“100 per cent mortgage insured” as described in paragraph 11 includes cover for realised losses with respect to the full value of an outstanding loan balance.

To qualify as mortgage insured by an acceptable LMI, the policy covering the loan must be taken out with an LMI:

(a)that is authorised by APRA under section 12 of the Insurance Act 1973; or

(b)in relation to which APRA has made a determination in writing that APRA is satisfied, in accordance with paragraph 21, that the LMI:

(i) is subject to comparable prudential regulation; and

(ii) is otherwise an acceptable LMI.

A loan will not be regarded as 100 per cent mortgage insured through an acceptable LMI where:

(a)the LMI or reinsurer for that policy has contractual recourse to the ADI or a member of the ADI’s consolidated group (excluding an LMI wholly or partly owned by the ADI); or

(b)the reinsurer for that policy:

(i) is wholly or partly owned by the ADI; and

(ii) either:

(A)is not authorised by APRA under section 12 of the Insurance Act 1973; or

(B)has not been determined by APRA to meet the requirements set out in subparagraphs 21 (a), (b) and (c) as applicable to reinsurers of lenders mortgage insurance business.

APRA is willing to consider other forms of mortgage insurance arrangements as satisfying this requirement where an ADI can demonstrate that the insurance arrangements leave it in the same risk position, where:

(a)in the case that the loan fails to satisfy any of the criteria set out in paragraphs 2, 3, 6, 7 and 8 above – as if the loan in question had a ratio of the outstanding amount to the value of the mortgaged residential property of 60 per cent or less;

(b)in other cases – as if the loan in question had a ratio of the outstanding amount to the value of the mortgaged residential property of 80 per cent or less.

Comparable prudential regulation

In making a determination under subparagraph 18(b) or 19(b)(i)a.i(B), APRA must be satisfied that:

(a)the relevant foreign prudential regulator for LMIs has, or regulators have, the characteristics set out in paragraph 23;

(b)the relevant foreign prudential regulatory regime for LMIs has the characteristics set out in paragraph 24; and

(c)the LMI has the characteristics set out in paragraph 25.

APRA will assess whether an LMI and the applicable overseas prudential regulatory regime meet all of the characteristics.

The characteristics which a relevant foreign prudential regulator must have are:

(a)it must operate under conditions for effective supervision, such as a policy, institutional and legal framework for supervision, a well-developed and effective financial market infrastructure and efficient financial markets;

(b)it must have an operational structure and administrative powers;

(c)it must undertake ongoing monitoring and supervisory activities that involve, at a minimum, on-site reviews, information analysis and the undertaking of risk assessments; and

(d)there must be sanctions and powers to enforce corrective action.

The characteristics which a relevant prudential regulatory regime for an LMI must have are:

(a)it must require the LMI to be licensed in the relevant jurisdiction (and licensing must be based on clear, objective and public requirements);

(b)it must require that the LMI and its corporate group be subject to group-wide supervision (where the LMI is a member of a corporate group);

(c)it must require the LMI to operate under appropriate governance standards;

(d)it must impose risk-based minimum capital adequacy and solvency requirements on the LMI;

(e)it must aim to ensure that the LMI is able to meet claims when and if they arise;

(f)it must ensure that the level of business ceded by the LMI to reinsurers is appropriate and that the quality of the reinsurer is appropriate; and

(g)it must address additional matters, or impose additional requirements, that APRA considers necessary having regard to risks associated with an LMI’s business.

The characteristics which an LMI must have are:

(a)the LMI must have a formal rating of “A” (or its equivalent) or higher by a credit ratings agency set out in Table 1 of Guidance Note AGN 113.3 The Standard Method (for this purpose, an “A” rating is the minimum, “A-” or its equivalent is not acceptable);

(b)the LMI must be licensed in the relevant jurisdiction to undertake lenders mortgage insurance business in that jurisdiction and writes or has written lenders mortgage insurance business in that jurisdiction (where that lenders mortgage insurance business must be written for policyholders domiciled in that jurisdiction); and

(c)the LMI must have provided a letter to APRA from the home supervisor confirming that the LMI meets the requirements of subparagraph 25(b).

Transitional arrangements

The requirements set out in paragraphs 18, 19, 21, 22, 23, 24 and 25 will apply on commencement of this Attachment to all ADIs.

Where an ADI does not meet capital and other associated prudential requirements imposed by APRA, as a result of paragraphs 18, 19, 21, 22, 23, 24, and/or 25, it may apply to APRA for a determination in writing granting the ADI a transitional period during which the ADI will not be required to meet some or all of the requirements.

Under a transitional arrangement determined under paragraph 27, a loan that satisfies the following criteria will qualify for the 50 per concessional risk- weight during the transitional period:

(a)the loan meets the criteria for the concessional risk weight, (except it need not meet the criteria in paragraphs 18, 19, 21, 22, 23, 24, and/or 25); and

(b)either:

(i) the loan is mortgage-insured with an LMI that has a formal rating of “A” (or its equivalent) or higher by a credit ratings agency set out in AGN 113.3 (Table 1), and is subject to supervision by an approved insurance regulator; or

(ii) the policy covering the loan is taken out with an associated, though unrated, LMI (e.g. an LMI that is wholly or partly owned by the ADI) that APRA has assessed as having claims-paying ability rated “A” or higher.

Applications for transitional arrangements must be supported by a capital management plan and other strategies or arrangements demonstrating how the ADI will meet capital and other related prudential requirements before the expiry of the requested transitional period. APRA will consider these plans and any other relevant circumstances in determining the ADI’s eligibility for a transitional arrangement and, if granted, the length of the transitional period.

If an ADI makes an application under paragraph 27 for a transitional period, APRA may, by instrument in writing, grant such a transitional period on terms specified by APRA in the instrument. The maximum transitional period that APRA will grant to an ADI is two years from the commencement date of the requirements outlined in paragraphs 18, 19, 21, 22, 23, 24, and 25.

Guidance Note AGN 112.2

Risk-Weighted Off-Balance Sheet Credit Exposures

This Guidance Note set out the procedures and requirements for calculating the risk-weighted amount of an authorised deposit-taking institution's (ADI’s) off-balance sheet credit exposures for capital adequacy purposes.

Scope

The risk-weighting process used for measuring an ADI’s off-balance sheet credit exposures covers all the ADI’s off-balance sheet business, including both market-related and non-market-related transactions.

Risk-weighted amount

An ADI’s total risk-weighted off-balance sheet credit exposures is calculated as the sum of the risk-weighted amount of all its market-related and non-market-related transactions.

The risk-weighted amount of an off-balance sheet transaction which gives rise to credit exposure is calculated by means of a two-step process:

(c)firstly, the principal amount (or face value) of the transaction is converted into an on-balance sheet equivalent (i.e. credit equivalent amount) by multiplying it with a specified credit conversion factor; and

(d)secondly, multiplying the resulting credit equivalent amount by the risk weight (refer Attachment A to Guidance Note AGN 112.1 Risk-Weighted On-Balance Sheet Exposures (AGN 112.1)) applicable to the counterparty or type of assets or where relevant, the eligible guarantor or collateral security (refer AGN 112.1) as appropriate.

The maximum risk weight that will be applied to the credit equivalent amount of an off-balance sheet credit exposure arising from a market-related transaction (including netted market-related transactions) is 50 per cent.

An ADI should consult APRA in case of doubt about the risk-weighted amount of a particular off-balance sheet transaction.

Non-market-related off-balance sheet transactions

The credit equivalent amount in relation to any non-market-related off-balance sheet transactions referred to in Attachment A (broadly categorised into direct credit substitutes, trade and performance related contingent items and other commitments) are determined by multiplying the principal amount of that particular transaction by the relevant credit conversion factor specified in the Attachment.

The amount of undrawn commitment to be included in calculating an ADI’s off-balance sheet non-market-related credit exposures is the maximum unused portion of the commitment which could be drawn during the remaining period to maturity. The drawn portion of a commitment forms part of an ADI’s on‑balance sheet credit exposure.

Irrevocable commitments to provide off‑balance sheet facilities should be assigned credit conversion factors appropriate to the underlying facilities. For example, an irrevocable commitment for six months to provide a guarantee in support of a counterparty attracts the 100 per cent credit conversion factor applicable to the guarantee.

The residual maturity of an undrawn commitment is the time remaining until the commitment will be completely extinguished by being terminated or maturing, or can be unconditionally cancelled by an ADI or be fully drawn. With regard to irrevocable commitments to provide off‑balance sheet facilities, the residual maturity is the period up until the associated facility expires. For example, an irrevocable commitment with a remaining maturity of six months to provide a commitment to provide finance with a 9-month term is deemed to have a residual maturity of 15 months.

All commitments are to be included in the capital ratio calculation regardless of whether or not they contain “material adverse change” clauses or any other provisions which are intended to relieve an ADI of its obligations under certain conditions.

For any non-market-related off-balance sheet transactions that give rise to credit risk but are not specifically identified in Attachment A, an ADI should consult APRA on the appropriate credit conversion factor to be used for calculating the credit equivalent amount of that particular transaction for capital adequacy purposes.

Market-related off-balance sheet transactions

In calculating an ADI’s risk-weighted off-balance sheet credit exposures arising from market-related transactions for capital adequacy purposes, the ADI must include all its market-related contracts held in the banking and trading books which give rise to off-balance sheet credit risk.

The credit risk on off-balance sheet market‑related contracts is the cost to an ADI of replacing the cash flow specified by the contract in the event of counterparty default. This will depend, among other things, on the maturity of the contract and on the volatility of rates underlying that type of instrument.

Market-related contracts include the following:

(a)Interest Rate Contracts: This includes single currency interest rate swaps, basis swaps, forward rate agreements, interest rate futures, interest rate options purchased and any other instruments of a similar nature.

(b)Foreign Exchange Contracts (including contracts involving gold): This includes cross currency swaps (including cross currency interest rate swaps), forward foreign exchange contracts, currency futures, currency options purchased, hedge contracts and any other instruments of a similar nature.

(c)Equity Contracts: This includes swaps, forwards, purchased options and similar derivative contracts based on individual equities or equity indices.

(d)Precious Metal Contracts (other than gold): This includes swaps, forwards, purchased options and similar derivative contracts based on precious metals such as silver, platinum and palladium.

(e)Other Commodity Contracts (other than precious metals): This includes swaps, forwards, purchased options and similar derivative contracts based on energy contracts, agricultural contracts, base metals (such as aluminium, copper and zinc) and any other non-precious metal commodity contracts.

(f)Other market-related contracts: This includes any contracts covering other items which give rise to credit risk.

16.Paragraph 15 does not intend to provide an exhaustive list of market-related contracts for capital adequacy purposes. ADIs should seek clarification where they are unclear as to which category is appropriate for a particular market-related transaction.

Exemption from capital weighting are permitted for:

(a)foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or less; and

(b)instruments traded on futures and options exchanges which are subject to daily mark-to-market and margin payments.

ADIs should not generally enter into contracts at off-market prices. This includes historical rate rollovers on foreign exchange contracts. If any contracts are undertaken at off-market prices, ADIs should contact APRA to discuss the reasons for such actions and to agree the capital (and other prudential) treatment of these transactions. APRA will need to be persuaded as to the need for dealing at off-market rates. As a starting point, where an ADI deals at off-market rates the whole of that transaction is no longer subject to the maximum risk weight applied to a market-related contract with a corporate counterparty and will receive, unless otherwise agreed with APRA, a 100 per cent risk weight.

An ADI may, for capital adequacy purposes, net off-balance sheet claims and obligations arising from market-related contracts across both the banking and trading books with a single counterparty which are covered by eligible bilateral netting agreements (refer Guidance Note AGN 112.3 Netting (AGN 112.3)).

The credit equivalent amount of an off-balance sheet market-related contract, whether held in the banking or trading book, must be determined by using the current exposure (or “mark-to-market”) method, except for interest rate and foreign exchange (including gold) contracts held in the banking book where the original exposure (or “rule-of-thumb”) method may be used with APRA’s prior approval.

Current exposure method

The credit equivalent amount of market-related contracts (not covered by eligible bilateral netting agreements) calculated using the current exposure method is the sum of current credit exposure and potential future credit exposure (the add-on) of these contracts (refer AGN 112.3 for calculation of credit equivalent amount of market-related contracts covered by eligible bilateral netting agreements).

Current credit exposure is defined as the sum of the positive mark-to-market value (or replacement cost) of these contracts.

Potential future credit exposure is determined by multiplying the notional principal amount of each of these contracts (regardless of whether the contract has a zero, positive or negative mark-to-market value) by the relevant credit conversion factor specified in Attachment B according to the nature and residual maturity of the instrument.

The notional or nominal principal amount, or value, of a contract is the reference amount used to calculate payment streams between counterparties to a contract.

Potential future credit exposure should be based on effective rather than apparent notional amounts. In the event that the stated notional amount of a contract is leveraged or enhanced by the structure of the transaction, an ADI must use the effective notional amount when calculating potential future credit exposure. For example, a stated notional amount of $1 million with payments calculated at two times LIBOR would have an effective notional amount of $2 million.

For contracts that are structured to settle outstanding exposures following specified payment dates and where the terms are reset such that the mark-to-market value of the contract is zero on these specified dates, then the residual maturity should be set equal to the time until the next reset date. In the case of interest rate contracts with these features with a remaining maturity of more than one year, the “credit conversion factor” to be applied is subject to a floor of 0.5 per cent even if there are reset dates of a shorter maturity.

For contracts with multiple exchanges of principal, the “credit conversion factors” are to be multiplied by the number of remaining payments (i.e. exchanges of principal) still to be made under the contract.

Contracts which do not fall within one of the five categories listed in Attachment B should be treated in the same way as “other commodities” contracts.

No potential future credit exposure is calculated for single currency floating/floating interest rate swaps; the credit exposure on these contracts is evaluated solely on the basis of their mark-to-market value.

Original exposure method

Where original exposure method is used, the credit equivalent amount of an off-balance sheet market-related contract is determined by multiplying the notional principal amount of the contract by the appropriate credit conversion factor specified in Attachment B according to the nature and original maturity of the instrument.

Attachment A

Credit Conversion Factors for Non-Market-Related Off-Balance Sheet Transactions

Nature of Transaction	Credit Conversion Factor
Direct Credit Substitutes Any irrevocable off-balance sheet obligations which carry the same credit risk as a direct extension of credit, such as an undertaking to make a payment to a third party in the event that a counterparty fails to meet a financial obligation, or an undertaking to a counterparty to acquire a potential claim on another party in the event of default by that party, constitutes a direct credit substitute (i.e. the risk of loss depends on the creditworthiness of the counterparty or the party on which a potential claim is acquired). This includes potential credit exposures arising from the issue of guarantees and credit derivatives (selling credit protection), confirmation of letters of credit, issue of standby letters of credit serving as financial guarantees for loans, securities and any other financial liabilities, and bills endorsed under bill endorsement lines (but which are not accepted by, or have the prior endorsement of, another ADI).	100%
Performance-Related Contingencies Contingent liabilities which involve an irrevocable obligation to pay a third party in the event that a counterparty fails to fulfil or perform a contractual non-monetary obligation, such as delivery of goods by a specified date, etc (i.e. the risk of loss depends on a future event which is not directly related to the creditworthiness of the counterparty involved). This includes issue of performance bonds, bid bonds, warranties, indemnities, and standby letters of credit in relation to a non-monetary obligation of a counterparty under a particular transaction.	50%
Trade-Related Contingencies Contingent liabilities arising from trade-related obligations which are secured against an underlying shipment of goods. This includes documentary letters of credit issued, acceptances on trade bills, shipping guarantees issued and any other trade-related contingencies.	20%

Sale & Repurchase Agreements (“Repos”)

This relates to arrangements whereby an ADI sells a loan, security or other asset to another party with a commitment to repurchase the asset at an agreed price on an agreed future date.[10]

Any assets acquired by an ADI under reverse repos (i.e. purchase and resale agreements) are to be treated as collateralised loans to the counterparty.[11]

100%

Assets Sold With Recourse

This includes any asset sales (to the extent that such assets are not included in on-balance sheet) by an ADI where the holder of the asset is entitled to “put” the asset back to the ADI within an agreed period or under certain prescribed circumstances, e.g. deterioration in the value or credit quality of the asset concerned.

100%

Forward Asset Purchases

This includes commitments to purchase at a specified future date and on pre-arranged terms, a loan, security or other asset from another party, including written put options on specified assets with the character of a credit enhancement.

Where an ADI purchasing the asset has an unequivocal right to substitute cash settlement in place of accepting delivery of the asset and the price on settlement is calculated with reference to a general market price indicator (and not to the financial condition of any specific entity), the purchase may be treated as a market-related off-balance sheet transaction.

Written put options expressed in terms of market rates for currencies or financial instruments bearing no credit risk are excluded from risk assets.

100%

Partly Paid Shares and Securities

This includes any amounts owing on the uncalled portion of partly paid shares and securities held by an ADI which represent commitments with certain drawdown by the issuer at a future date.

100%

Placements of Forward Deposits

This relates to any agreement between an ADI and another party whereby the ADI will place a deposit at an agreed rate of interest with that party at a predetermined future date.

100%

Note Issuance and Revolving Underwriting Facilities

This involves arrangements whereby a borrower may drawdown funds up to a prescribed limit over a predefined period by making repeated note issues to the market, and where, should the issue prove unable to be placed in the market, the unplaced amount is to be taken up or funds made available by an ADI being committed as an underwriter of the facility.

50%

Other Commitments

(a) Commitments with certain drawdown.

(b) Commitments (e.g. undrawn formal standby facilities and credit lines) with a residual maturity of:

(i) 1 year or less.

(ii) over 1 year.

(c) Commitments which can be unconditionally revoked at any time without notice (e.g. undrawn overdraft and credit card facilities providing that any outstanding unused balance is subject to review at least annually).

(d) Irrevocable standby commitments provided under APRA’s approved industry support arrangements.

100%

50%

[10]For the purposes of this Attachment, these transactions are risk weighted according to the type of assets or the issuer of securities and not according to the counterparty with whom the transaction is made, where the credit risk associated with the underlying asset which has been sold (temporarily under repo or with recourse) or purchased remains with an ADI.

[11]The appropriate risk weight to be applied to a reverse repo transaction is determined on the basis of the counterparty to the transaction or the underlying asset if it is an eligible collateral security (refer AGN 112.1).

Attachment B

Credit Conversion Factors for Market-Related Off-Balance Sheet Transactions

Current Exposure Method

Residual Maturity	Interest Rate Contracts	Foreign Exchange & Gold Contracts	Equity Contracts	Precious Metal Contracts (except Gold)	Other Commodities
1 year or less	nil	1.0%	6.0%	7.0%	10.0%
> 1 year to 5 years	0.5%	5.0%	8.0%	7.0%	12.0%
> 5 years	1.5%	7.5%	10.0%	8.0%	15.0%

Original Exposure Method

Original Maturity	Interest Rate Contracts	Foreign Exchange & Gold Contracts
1 year or less	0.5%	2.0%
> 1 year to 2 years	1.0%	5.0% (i.e. 2% + 3%)
For each additional year	1.0%	3.0%

Note: The credit conversion factors set out above are based on the recommendations of the Basel Committee (April 1995) which, in turn, are based on observed volatilities of particular types of instruments. These credit conversion factors are subject to review and modification in light of changing volatilities or market conditions.

Guidance Note AGN 112.3

Netting

Netting is a process by which all outstanding transactions between two counterparties are combined and reduced to a single (net) sum for a party to either pay or receive. The process is formalised in a netting agreement.

From a prudential viewpoint, the key issue is whether an authorised deposit-taking institution's (ADI’s) exposure against a counterparty (or counterparties) is effectively limited to the net sum determined by a netting agreement ensuring that the ADI’s credit risk is genuinely reduced.

Scope

An ADI may only net for capital adequacy purposes off-balance sheet market-related transactions (across both the “banking” and “trading” books) with a single counterparty that are subject to a legally valid form of bilateral netting agreement – e.g. “close-out” netting or “netting by novation” agreement. This may include netting across different market-related product types.

This does not encompass netting market-related transactions against on-balance sheet items (e.g. loan receivable against a negative revaluation on a market-related transaction) with the same counterparty. However, on-balance sheet items may qualify as cash collateral for risk weighting the net sum of market-related transactions.

The netting provisions set out in this Guidance Note include “credit derivatives” to the extent that they are recognised as market-related transactions for capital adequacy reporting purposes. However, they do not include “payments netting”. Payments netting is designed to reduce operational costs and risks associated with daily settlement of transactions and is not recognised for capital adequacy purposes since an ADI’s credit risk arising from a counterparty’s gross obligations to the ADI is not in any way affected by payments netting.

“Close out netting” (sometimes called contractual netting) is a contractual process designed to apply on the default of a counterparty when all outstanding transactions between counterparties subject to the netting agreement are combined and reduced to a single net payment. There are two stages to this process:

(e)fixing of obligations on the occurrence of an event (typically insolvency); and

(f)calculating the cost to each party in closing out transactions according to a prescribed formulae (often related to the cost of replacing a transaction by buying an equivalent position in the market at the prevailing time).

The amounts due to both counterparties may be calculated in one currency or converted to one currency and then netted to one single payment due by one party to the other.

“Netting by novation” refers to a “master” contract between two counterparties under which any obligation between the parties to deliver a given currency (or equity or debt instrument or commodity) on a given date is automatically amalgamated with all other obligations under the agreement for the same currency (pairs) and value date. The result is to legally substitute a single net amount for the previous gross obligations.

Eligible bilateral netting agreements

An ADI may only net for capital adequacy purposes, claims and obligations arising from off-balance sheet market-related contracts with a counterparty that is covered by a legally valid (i.e. eligible) bilateral netting agreement, subject to the following conditions:

(a)the bilateral netting agreement is in writing;

(b)the bilateral netting agreement creates a single legal obligation covering all transactions included in the agreement such that an ADI would have either a claim to receive or an obligation to pay only the net sum of the positive and negative mark-to-market values of individual transactions covered by the agreement in the event that either party fails to perform due to the default, liquidation or bankruptcy (or other similar circumstances);[12]
[12] In some countries there are provisions for the authorities to appoint an administrator/conservator to a troubled bank. Under statutory provisions applying in those countries, the appointment of an administrator may not constitute grounds for the triggering of netting agreements. Such provisions do not prevent the recognition of affected netting agreements for the purposes of these guidelines provided that a netting agreement can still take effect in the event the bank under administration does not meet its obligations under market-related transactions as they fall due.

(c)the ADI has obtained a written and reasoned legal opinion(s) to the effect that in the event of the default, liquidation or bankruptcy (or other similar circumstances) of a party to the bilateral netting agreement, the relevant courts and authorities would find the ADI’s claims and obligations are limited to the single net sum determined in the eligible bilateral netting agreement under:

(i) the law of the jurisdiction in which the counterparty is incorporated and, if a foreign branch of the counterparty is involved, the law of the jurisdiction in which the branch is located;

(ii) the law that governs the individual market-related transactions involved; and

(iii) the law that governs any contract or agreement necessary to give effect to the netting;

(d)the ADI has procedures in place to monitor possible changes in relevant laws or other legal developments (e.g. court decisions) to ensure that the bilateral netting agreement continues to be fully effective (in the event that legal developments adversely affect the enforceability of netting agreements, an ADI must move promptly to report the transactions affected on a gross basis rather than as a net sum);

(e)the ADI has adequate systems and controls in place to record and manage the transactions covered by the netting arrangements on a net basis in accordance with the terms of the bilateral netting agreement; and

(f)the bilateral netting agreement is not subject to a walkaway clause.[13]
[13] A walkaway clause is a provision which applies to a netting agreement that permits a non-defaulting counterparty to make only limited payments, or no payments at all, to a defaulting party, even if the defaulting party is a net creditor.

An ADI which wishes to utilise netting provisions in this Guidance Note must inform APRA of its intention to do so and provide a copy of the ADI’s netting policy and a description of its systems and controls covering netting. An ADI should inform APRA of any material changes in its netting policy and systems and controls. The description of its systems and controls should include, as a minimum, the following:

(a)who has responsibility for setting and reviewing policy on netting (and the frequency at which netting policy is reviewed);

(b)types of counterparties and transactions covered by bilateral netting agreements;

(c)types of netting being utilised (e.g. close-out, novation, etc);

(d)who has responsibility for approving the application of an individual bilateral netting agreement to transactions, to enable calculation of exposures on a net basis (including determining compliance of individual agreements with existing legal opinion or whether separate legal opinions are required for them);

(e)jurisdictions affecting netting agreements to which the ADI (or a member of the consolidated group) is a party. The ADI should note any jurisdictions in which doubt might exist as to the enforceability of netting and what action the ADI had taken as a result in reporting affected transactions for capital adequacy purposes;

(f)sources of legal opinions used by the ADI, and the basis of their expertise;

(g)how the ADI monitors legal developments affecting its netting agreements, and the need to obtain additional legal opinions for new jurisdictions;

(h)procedures for monitoring roll-off of exposures and the impact of this on the ADI’s credit exposure and capital adequacy; and

(i)processes for determining and reporting net exposures to individual counterparties.

It is the responsibility of an ADI to ensure that it has fully complied with all the requirements set out in this Guidance Note before the netting agreement(s) is utilised for capital adequacy purposes.

External auditors should include, in their opinion provided to APRA each year regarding an ADI’s compliance with minimum capital ratios, whether they are satisfied with the ADI’s compliance with the systems and records requirements set out in this Guidance Note for netting of transactions.

Legal opinion

An ADI with a general legal opinion covering the enforceability of netting in a particular jurisdiction, may rely on that opinion when assessing the enforceability of individual bilateral netting agreements involving the jurisdiction, provided the ADI has determined that the type of individual bilateral netting agreement involved is encompassed by the general legal opinion.

An ADI must satisfy itself that the bilateral netting agreement, and supporting legal opinions, are applicable to each counterparty, transaction and product type undertaken with the counterparty, and in all jurisdictions involved in such transactions (regard should be given to counterparties governed by special rules relating to insolvency e.g. local authorities, banks and insurance companies). The ADI should verify the existence of any facts referred to in the bilateral netting agreement and that all documentation is complete. It should also satisfy itself that all parties involved in a bilateral netting agreement have the capacity, power and authority in relation to the agreement and that the agreement has been properly executed.

If a positive legal opinion regarding enforceability of a bilateral netting agreement is subject to assumptions and/or qualifications, these must not be unduly restrictive. They should be specific and of a factual nature and should be adequately explained in the opinion. An ADI should review and assess all assumptions, qualifications and omissions in legal opinions on bilateral netting agreements as to whether they give rise to any material doubts as to the enforceability of a bilateral netting agreement. Where there is any material doubt as to the enforceability of a bilateral netting agreement, the agreement cannot be recognised for capital adequacy purposes.

In the event that legal developments adversely affect the enforceability of netting agreements, an ADI must move promptly to report the transactions affected on a gross basis rather than as a net sum.

Where a satisfactory legal opinion cannot be obtained regarding the enforceability of netting transactions involving a specific jurisdiction (e.g. in the case of transactions done through or with a specific branch), but that the netting of other transactions under the agreement continues to be enforceable, the former transactions will need to be excluded from netting in determining the net sum due to/from the counterparty involved. Transactions excluded from being netted must be reported on a gross basis.

Where an ADI is aware that a regulator or supervisor of a counterparty has given notice that it is not satisfied netting is enforceable under the laws of its country, the netting agreement will not qualify as an eligible bilateral netting agreement for capital adequacy purposes regardless of any opinion obtained by the ADI.

An ADI utilising netting for capital adequacy purposes must maintain records adequate to support the application of an eligible bilateral netting agreement. This includes records necessary to demonstrate compliance with the requirements set out in this Guidance Note (e.g. appropriate legal opinions, assessment of the applicability of netting agreements to counterparties, etc). Records should incorporate a copy of the netting agreement, and any other relevant legal documentation (including English translations where appropriate).

Collateral and guarantees

Where a legal agreement with a counterparty contains provisions for applying collateral and/or guarantees to netted exposures outstanding between an ADI and the counterparty, the ADI must ensure that the provisions comply with the requirements set out in Guidance Note AGN 112.1 Risk-Weighted On-Balance Sheet Exposures with respect to eligible collateral and guarantees.

Collateral and guarantees may be used in calculating the risk weight to be applied to the net sum calculated under an eligible netting agreement which is covered by the collateral and/or guarantee. Risk weights may not be assigned based on collateral and guarantees unless the collateral and/or guarantees have been posted and are legally available for all individual transactions making up the net sum of exposures involved. For example, where collateral covers only a specific class of transactions in a pool of netted transactions (e.g. US/DM foreign exchange transactions or contracts with a maturity under one year), the collateral only provides protection against those transactions and not to the net sum (which may be produced by netting all forms of foreign exchange, interest rate swaps and other transactions of multiple maturities undertaken with a counterparty). Consequently, the collateral must not be used in determining the risk weight to be applied to that net sum.

Application of eligible bilateral netting agreements

Where an ADI satisfies all the requirements in this Guidance Note for bilateral netting, it may report off-balance sheet market-related transactions with a counterparty on a net basis and calculate the credit equivalent amount of those transactions in accordance with the methodology outlined below.

Credit equivalent amount

Exposures on transactions falling under netting agreements must be calculated for capital adequacy purposes using the current exposure method.

The credit equivalent amount (CEA) of transactions subject to an eligible bilateral netting agreement is calculated as the sum of the net current credit exposure (NCCE) (i.e. net mark-to-market replacement cost) of all transactions covered by the netting agreement, if positive, plus an “add-on” (PFCE_adj) for potential future credit exposure based on the notional principal of all the individual underlying contracts (i.e. the gross potential future credit exposure) adjusted to reflect the effects of the netting agreement. Thus:
CEA = NCCE (if positive) + PFCE_adj

Net current credit exposure

NCCE is the sum of all positive and negative mark-to-market values of all individual contracts covered by an eligible bilateral netting agreement (i.e. positive mark-to-market values of transactions may be offset against negative mark-to-market values on other transactions covered by the netting agreement). If the net sum of individual mark-to-market values is positive then, the NCCE is equal to that sum. If the sum of mark-to-market values is zero or negative, then the NCCE is set equal to zero.

Potential future credit exposure

For the purposes of calculating gross potential future credit exposure, matching opposing transactions included in a netting agreement may be taken into account as a single transaction with a notional principal equivalent to the net receipts on those transactions. Matching transactions are defined to represent forward foreign exchange and other similar market-related transactions in which notional principal is equivalent to cash flows, where the cash flows fall due on the same value date and are in the same currency. Thus, the notional principal for such transactions would be the net receipts falling due on each value date in a given currency. The transactions are treated as a single transaction since offsetting transactions in the same currency maturing on the same date will have a lower future potential exposure as well as a lower current exposure.

The effects of netting agreements on potential future credit exposure are recognised through the application of a formula that produces an adjusted “add-on” amount for potential future credit exposure on all contracts subject to the netting agreement (PFCE_adj). The formula is:

PFCE_adj = 0.4(PFCE_gross) + 0.6 (NGR x PFCE_gross)

The approach makes some allowance for potential fluctuations in net current exposure arising from future price or rate movements on netted exposures which are not matched (as defined in paragraph 25).

Gross potential future credit exposure (PFCE_gross) is given by the sum of potential future credit exposure for each individual transaction covered by an eligible bilateral netting agreement with one counterparty as if no netting would occur (subject to paragraph 25). Potential future credit exposure for each transaction is calculated by multiplying the notional principal amount of the transaction by the appropriate credit conversion factor for that transaction as set out in Attachment B to Guidance Note AGN 112.2 Risk-Weighted Off-Balance Sheet Exposures.

NGR is the “net to gross ratio” – i.e. the ratio of the net current exposure of all transactions included in the bilateral netting agreement (i.e. NCCE to the gross current credit exposure (GCCE) of these same transactions). GCCE is the sum of the mark-to-market values of all transactions covered by the netting agreement with a positive mark-to-market value with no offsetting against any contracts with negative mark-to-market value (except as allowed under paragraph 25). NGR reflects the risk reducing portfolio effects of bilaterally netted transactions with respect to current credit exposure. Thus:
NGR = NCCE/GCCE
NGR may be calculated in two ways:

Counterparty by Counterparty Approach

Under this approach, a unique NGR is applied to each counterparty in calculating the credit equivalent amount of transactions conducted with that counterparty.

The NGR is defined as the net current credit exposure of all transactions with an individual counterparty covered by an eligible bilateral netting agreement (i.e. NCCE_individual) divided by the gross current credit exposure of all the transactions with that counterparty covered by the netting agreement (i.e.GCCE_individual).

In calculating GCCE_individual, negative mark-to-market values for individual transactions with the same counterparty may not be used to offset positive mark-to-market values for other transactions with the same counterparty.

Aggregate Approach

Under this approach, one NGR is calculated and applied to all counterparties in calculating the credit equivalent amounts for transactions with each counterparty separately.

The NGR is the ratio of the sum of all of the net current credit exposures of all the transactions of all counterparties subject to eligible bilateral netting agreements (i.e. NCCE_aggregate) to the sum of all of the gross current credit exposures for all the transactions of all counterparties subject to eligible netting agreements (i.e. GCCE_aggregate).

In calculating GCCE_aggregate, negative mark-to-market values of transactions with one counterparty cannot be used to offset positive mark-to-market values of transactions with that counterparty or any other counterparty included in the aggregate calculations.

An ADI must consistently use either the “counterparty by counterparty” approach or the “aggregate” approach to calculate NGR. An ADI must inform APRA which approach it intends to use.

Other criteria

An ADI may, with APRA’s prior agreement, elect to include foreign exchange contracts with an original maturity of fourteen calendar days or less with other transactions in calculating netted exposures. Where an ADI chooses to include contracts under fourteen days, it must do so for all counterparties for whom it calculates net exposures. An ADI cannot selectively include such contracts in calculating net exposures. All such foreign exchange contracts will need to be included in calculating current credit exposures and potential future credit exposures (with a credit conversion factor of 1.0%). Market-related instruments traded on recognised exchanges where they are subject to daily margining requirements, are excluded from netting.

Risk weighted amount

Once the CEA has been determined for transactions netted under an eligible bilateral netting agreement, that amount is then assigned the risk weighting appropriate to the counterparty, or if relevant, the risk weighting of a guarantor or collateral. The maximum risk weight applicable to the CEA of netted market-related transactions is 50 per cent.

A worked example of the calculation of risk-weighted amount of off-balance sheet market-related transactions involving eligible bilateral netting agreements is set out in the Attachment.

Attachment

Worked Example for Calculation of Risk-Weighted Amount of Off-Balance Sheet Market-Related Transactions Covered by Eligible Bilateral Netting Agreements

Assumptions

Assume that an ADI has a portfolio of foreign exchange transactions outstanding with four counterparties. Counterparties A and C are ADIs while counterparties B and D are corporates. The transactions with each counterparty have the following terms:

Counterparty A			Counterparty B			Counterparty C			Counterparty D
Notional Principal	Residual Maturity (Years)	Mark-to-Market (Value)	Notional Principal	Residual Maturity (Years)	Mark-to-Market (Value)	Notional Principal	Residual Maturity (Years)	Mark-to-Market (Value)	Notional Principal	Residual Maturity (Years)	Mark-to-Market (Value)
400	1	5	200	1	5	700	1	-1	100	2	-1
1,500	2	8	2,000	2	-5	200	5	-8	800	2	9
400	2	4	200	3	1	1,000	4	-7	300	5	5
300	1	1	100	3	-1	800	1	-1	100	1	3
200	3	6	900	1	9	500	1	9
1000	5	3	700	2	2	600	1	-4
800	5	-2	500	3	4

Assume in addition that certain transactions with Counterparties A and B involve the same currencies and have the same value date. In calculating capital requirements, it is assumed that an ADI has chosen to match transactions in accordance with paragraph 25 of this Guidance Note and, as a result, these transactions (contracts) have been effectively replaced by new notional transactions marked with #.

After Matching

Counterparty A			Counterparty B			Counterparty C			Counterparty D
Notional Principal	Residual Maturity (Years)	Mark-to-Market (Value)	Notional Principal	Residual Maturity (Years)	Mark-to-Market (Value)	Notional Principal	Residual Maturity (Years)	Mark-to-Market (Value)	Notional Principal	Residual Maturity (Years)	Mark-to-Market (Value)
400	1	5	200	1	5	700	1	-1	100	2	-1
1,500	2	8	2,000	2	-5	200	5	-8	800	2	9
400	2	4	100#	3	0	1,000	4	-7	300	5	5
300	1	1	800	1	-1	100	1	3
200	3	6	900	1	9	500	1	9
200#	5	1	700	2	2	600	1	-4
500	3	4
Net	25	0	-2	21
NCCE	25	0	0	21

If no bilateral netting (or matching of transactions) applied

Counterparty A	Counterparty B	Counterparty C	Counterparty D	Total
Sum of the mark-to-market value of transactions with positive replacement cost	27	6	15	26	74
Potential future credit exposure	202	117	144	72	535
Credit Equivalent Amount (CEA = net mark-to-market + potential future credit exposure)	229	123	159	98	609
Risk Weighted Assets (CEA x Counterparty Risk Weight)	45.80	61.50	31.80	49.00	188.10

Gross Potential Future Credit Exposure (PFCE_gross) Add-on for Each Individual Transaction:

For the purpose of this example, assume the gross potential future credit exposure for each individual transaction is obtained by multiplying the transaction’s notional principal by a credit conversion factor (ccf) of 1% for transactions with a residual maturity of up to (and including) one year and a ccf of 5% for those transactions with a remaining term to maturity of greater than one year and up to (and including) 5 years. Thus:

After Matching

Counterparty A	Counterparty B	Counterparty C	Counterparty D
4	2	7	5
75	100	10	40
20	5	50	15
3	8	1
10	9	5
10	35	6
25
PFCE_gross	122	107	144	72

Calculation of Risk Weighted Amounts

Counterparty A	Counterparty B	Counterparty C	Counterparty D	Total
Counterparty Risk Weight	20%	50%	20%	50%
Net Current Credit Exposure (NCCE)	25.00	0.00	0.00	21.00	46.00
Gross Current Credit Exposure (GCCE)	25.00	5.00	15.00	26.00	71.00
Gross Potential Future Credit Exposure (PFCE_gross)	122	107	144	72
If bilateral netting applied
Net to Gross Ratio (NGR = NCCE/GCCE) *Where indicates the NGR for all counterparties.**	1.00	0.00	0.00	0.81	0.65*
Applying NGR on counterparty by counterparty approach:
Potential Future Credit Exposure (Adjusted) PFCE_adj = 0.4 (PFCE_gross) + 0.6 (NGR x PFCE_gross) Where the individual NGR for a counterparty is applied for that counterparty	122.00	42.80	57.60	63.79
Credit Equivalent Amount (CEA = NCCE + PFCE_adj)	147.00	42.80	57.60	84.79
Risk Weighted Assets (CEA x Counterparty Risk Weight)	29.40	21.40	11.52	42.40	104.72

Applying NGR on a aggregate approach:
Potential Future Credit Exposure (Adjusted) PFCE_adj = 0.4 (PFCE_gross) + 0.6 (NGR x PFCE_gross) Where NGR = 0.65 for all counterparties	96.38	84.53	113.76	56.88
Credit Equivalent Amount (CEA = NCCE + PFCE_adj)	121.38	84.53	113.76	77.88
Risk Weighted Assets (CEA x Counterparty Risk Weight)	24.28	42.27	22.75	38.94	128.24

Guidance Note AGN 112.4

Treatment of Credit Derivatives in the Banking Book

This Guidance Note details the approach to be used by locally incorporated authorised deposit-taking institutions (ADIs) to determine the capital to be held against credit derivative instruments in the banking book. The capital adequacy rules pertaining to credit derivatives in ADIs’ trading books are described in Guidance Note AGN 113.4 Treatment of Credit Derivatives in the Trading Book (AGN 113.4).

When determining whether a credit derivative transaction should be allocated to the banking or trading book, consideration should be given to the trading book requirements detailed in Guidance Note AGN 113.1 The Trading Book and Trading Book Policy Statement.

The approach set out here is broadly consistent with the existing capital adequacy rules applied to other banking book instruments, with credit derivatives being regarded as similar to guarantees or other direct credit substitutes. APRA recognises that the relatively simple structure on which the existing rules are based constrains the ability to accommodate the flexibility of credit derivatives without undermining the efficacy of those rules. While the capital treatment is conservative, APRA is of the view that such an approach is justified given the uncertainties present in the global credit derivatives market.

While there are currently no internationally agreed capital adequacy guidelines for credit derivatives, work is continuing. It is APRA’s intention to be involved with, and closely monitor, any developments in this area and, if deemed necessary, amend this Guidance Note accordingly.

Scope

This Guidance Note applies to the most commonly traded credit derivatives: credit‑default swaps, total‑rate‑of‑return swaps,[14] credit‑linked notes and first‑to‑default baskets. APRA is aware that more complex credit derivative products will undoubtedly emerge. ADIs transacting in more complex credit derivatives or in structures with non‑standard features (such as those involving portfolios of reference obligations, other than first-to-default baskets) will be expected to approach APRA to discuss an appropriate capital treatment for such instruments. If, over time, these other types of credit derivative product are seen to become commonplace, APRA will, where practicable, incorporate the capital adequacy treatment of such products into this Guidance Note.
[14] All total-rate-of-return swaps, except those that are hedging an underlying banking book exposure, should be included in an ADI’s trading book. These instruments differ from typical direct credit substitutes in that they cover not only the default of the reference obligation but any changes in its market value. Changes in market value may be settled frequently, exposing an ADI to significant market risk that is not captured by the capital treatment of the banking book.

The evolution of instruments capable of transferring credit risk raises many important issues for prudential supervisors, many of which are common to a range of products. Of particular concern to APRA is the effect of credit derivatives on the transparency of individual credit portfolios. Since credit derivatives facilitate the transformation of credit risk profiles, large exposures and concentrations within ADIs’ portfolios may become increasingly difficult to identify. Where APRA considers a particular ADI to be undertaking significant credit derivative activity, as either a purchaser or seller of protection, such that large exposures and concentrations are a potential concern, APRA may require the ADI to adopt an alternative capital treatment to that which is described in this Guidance Note.

Under APRA’s current reporting framework, ADIs will be expected to provide APRA with details of credit derivative transactions that give rise to large exposures as required by the Large Exposures Return.

Where an ADI has purchased protection in the absence of an underlying asset (i.e. it has an open short position in the banking book), or where the protection is not recognised by this Guidance Note, the credit derivative is not taken into account for the purposes of capital adequacy. In general, ADIs with open short positions in credit derivatives are expected to include those positions in the trading book (refer AGN 113.4).[15]
[15] As noted in footnote 1, open long positions in total-rate-of-return swaps should also be included in the trading book.

Terminology

Credit derivatives are part of a broader family of instruments that enable users to transfer the credit risk of an asset from one party, the protection buyer, to another, the protection seller, in isolation from other risks.

In this Guidance Note, the following terminology has been used when describing a credit derivative transaction:

(a)underlying asset – the asset which is being protected by the credit derivative;

(b)protection – this reflects the extent of risk transference from the protection buyer (or risk seller) to the protection seller (or risk buyer). The protection provided by a credit derivative reduces the amount of capital that must be held by the protection buyer to cover the credit risk on the underlying asset;

(c)reference entity – the legal entity whose credit risk is being transferred by the credit derivative. In the case of first‑to‑default baskets, the reference entity is not a single entity but a ‘basket’ or portfolio of reference entities;

(d)obligation – any financial obligation of the reference entity or of an entity that is unconditionally and irrevocably guaranteed by the reference entity, as defined under the terms of the credit derivative contract, on which a credit event must occur for the credit derivative to be triggered;

(e)credit events – events affecting the reference entity that trigger a credit‑event payment under the terms of the credit derivative contract;

(f)credit‑event payment – the amount that is paid following the occurrence of a credit event. The payment can be in the form of physical settlement (payment of par in exchange for physical delivery of a deliverable obligation of the reference entity) or cash settlement (payment of a fixed amount, or payment of the par value of the reference obligation less that obligation’s recovery value);

(g)deliverable obligation – any obligation of the reference entity that can be delivered, under the terms of the contract, if a credit event occurs. A deliverable obligation is relevant for credit derivatives that are to be physically settled; and

(h)reference obligation – the obligation which determines the amount of the credit-event payment. A reference obligation is relevant for obligations that are to be cash settled (on a par less recovery basis).

Calculating the amount of protection purchased or sold

An important component of the regulatory capital calculation for credit derivatives is the amount of protection purchased by the protection buyer or the amount of protection sold by the protection seller.

The types of credit event specified in the credit derivative contract determine the extent of risk transference from the protection buyer to the protection seller. To ensure that an event of default occurs on the underlying asset with a payment occurring under the terms of the credit derivative, the set of credit events should contain as wide a range of triggers as possible. If the set of credit events is restrictive, it is possible that the credit derivative hedge will transfer insufficient risk.

For capital adequacy purposes, an ADI will only be regarded as having purchased protection if the range of specified credit events is such that it is clear the credit risk of the underlying asset has been transferred to the protection seller.[16]
[16] APRA expects that ADIs will assess, on a transaction by transaction basis, the sufficiency of the credit risk transfer. At a minimum, it is expected that the transfer of credit risk will require at least the specification of bankruptcy and failure to pay as credit events under the terms of the credit derivative contract.

Where an ADI has sold protection using a credit derivative, it should be assumed that 100 per cent of the credit risk is purchased irrespective of the range of credit events specified.

The size and nature of any materiality thresholds specified in the credit derivative contract may also reduce the amount of credit risk transferred from the protection buyer to the protection seller. Materiality thresholds require a given level of loss to occur before the credit derivative is triggered. If these thresholds are set too high, it is possible that a significant loss could be incurred on the underlying asset without a credit-event payment being made.

When determining the amount of protection purchased using a credit derivative, the ADI should take into account any materiality thresholds written into the credit derivative contract, which may reduce the protection amount. An ADI will not be regarded as having purchased protection if there exist any materiality thresholds that require a comparatively high percentage of loss to occur before the credit derivative is triggered.

When determining the amount of protection sold by the credit derivative, the ADI should assume that any materiality thresholds written into the credit derivative contract do not reduce the acquired credit risk.

The type of credit‑event payment specified in the contract will also impact on the amount of protection purchased or sold under the credit derivative. Where the credit‑event payment is defined as the par value of the reference obligation less its recovery value (i.e. the credit derivative is cash settled), or there is payment of the par value of an obligation in exchange for its physical delivery, the amount of protection purchased or sold must be set equal to the par value of that obligation. Where the credit‑event payment is defined as a fixed amount, the amount of protection purchased or sold must be set equal to that amount. While APRA acknowledges that this latter approach may be conservative in some cases, it is not possible to adopt an alternative approach within the current capital adequacy framework.

Credit derivatives that include options to extend or reduce the term of the contract may affect the protection purchased or sold. Where embedded options exist in credit derivative contracts, an ADI must adopt the most conservative approach for the purposes of calculating regulatory capital. Application of this principle implies that:

(a)where an ADI as protection buyer has purchased an option to extend the contract term, the ADI may assume that the option will be exercised; where the option is to reduce the contract term, it can be assumed that the option will not be exercised;

(b)where an ADI as protection buyer has written an option to extend the contract term, the ADI must assume that the option will not be exercised; where the option is to reduce the contract term, it must be assumed that the option will be exercised;

(c)where an ADI as protection seller has purchased an option to extend the contract term, the ADI must assume that the option will be exercised; where the option is to reduce the contract term, it must be assumed that the option will not be exercised; and

(d)where an ADI as protection seller has written an option to extend the contract term, the ADI must assume that the option will be exercised; where the option is to reduce the contract term, it must be assumed that the option will not be exercised.

Credit derivatives that include provisions to vary the cash flows paid or received (e.g. step‑up provisions) may also affect the protection purchased or sold. At this stage, ADIs transacting in credit derivatives containing these types of provisions should approach APRA to discuss an appropriate capital treatment.

Credit-default swaps

Where protection is purchased using a credit‑default swap referenced to a single reference entity, an ADI may replace the risk weight of the underlying asset with the risk weight of the protection seller. The amount of protection that may be recognised is bound by the requirements outlined in paragraphs 11-20 and 27‑35.

Where protection is sold via a credit‑default swap referenced to a single reference entity, the ADI acquires an exposure to the credit risk of that entity. In this case, the risk weight that must be applied to the exposure is the risk weight attached to the reference entity. The amount of the exposure is the maximum possible amount payable under the terms of the credit derivative contract if a credit event were to occur.

Total-rate-of-return swaps

Where protection is purchased using a total‑rate‑of‑return swap, an ADI may replace the risk weight of the underlying asset with the risk weight of the protection seller. The amount of protection that may be recognised is bound by the requirements outlined in paragraphs 11‑20 and 27‑35.

Protection sold via a total-rate-of-return swap should be included in an ADI’s trading book.

Credit-linked notes

Where protection is purchased using a credit‑linked note, the ADI may replace the risk weight of the underlying asset with the risk weight of any funded protection acquired.[17] The amount of protection that may be recognised is bound by the amount of funding received and by the requirements outlined in paragraphs 11‑20 and 27‑35.
[17] Subject to APRA’s collateral guidelines as set out in Guidance Note AGN 112.1 Risk-Weighted On-Balance Sheet Exposures.

Where protection is sold via a credit‑linked note, the ADI acquires an exposure to both the reference entity and the protection buyer, with the amount of the exposure being the face value of the note.[18] To account for this exposure, the higher of the risk weights applicable to the reference asset and the protection buyer must be applied to the exposure.
[18] Where the credit-linked note is structured such that the protection seller receives some percentage of the note’s face value if the credit derivative is triggered, the amount of exposure is the difference between the face value and this percentage amount.

First-to-default baskets

Where an ADI has purchased protection using a credit derivative that is referenced to more than one entity and that protection terminates after a credit event occurs on one or more of those entities (i.e. a first‑to‑default basket product), protection is only recognised against one entity in the basket. The ADI may choose which entity is protected, with the risk weight of that entity being replaced by the risk weight of the protection seller. The amount of protection that may be recognised is bound by the requirements outlined in paragraphs 11‑20 and 27‑35.

Where an ADI has sold protection using a first‑to‑default basket product, capital must be held against all the reference entities in the basket. The risk‑weighted exposure arising from the credit derivative will be the sum of the individual risk‑weighted exposures in the basket, with the amount of capital held capped at the maximum payout possible under the contract. An example of this treatment is provided in the Attachment.

Asset mismatches

Where an ADI has purchased protection using a credit derivative and the reference obligation (in the case of cash settlement), or deliverable obligation(s) (in the case of physical settlement), is different from the underlying asset, the amount of protection provided by the credit derivative may not be sufficient to constitute an effective hedge. For this reason, APRA requires a range of criteria to be met before the protection buyer can apply the treatment specified in paragraphs 21, 23, 25 or 27.

For credit derivative hedges requiring physical settlement, if the underlying asset is a deliverable obligation under the terms of the credit derivative contract, the ADI will be regarded as having purchased protection. Where this is not the case, the guidelines for cash settlement, detailed in paragraph 31 below, will apply.

For credit derivative hedges requiring cash settlement, an ADI may recognise the protection acquired under a credit derivative if the following criteria are met:

(e)the underlying asset and the reference obligation are obligations of the same reference entity or the underlying asset is an obligation of an entity that is unconditionally and irrevocably guaranteed by the reference entity to the credit derivative contract;

(f)the underlying asset is an obligation under the terms of the credit derivative contract; and

(g)the reference obligation is ranked pari passu or lower, in seniority of claim, relative to the underlying asset.

Where an ADI has sold protection using a credit-default swap or credit-linked note in the banking book, and hedged that exposure with another credit derivative, the ADI will be regarded as protected if the hedged credit derivative and the hedging credit derivative are equal and opposite transactions in all respects (when a maturity mismatch exists, i.e. the credit derivatives are equal and opposite in all respects other than tenor, paragraphs 33-35 apply).[19]
[19] Where the protection purchased and sold is for different amounts, the matched portion may be offset with the residual regarded as an open position.

Maturity mismatches

Where an ADI has purchased protection using a credit derivative and the maturity of the credit derivative contract is less than the maturity of the underlying asset, the amount of protection that is recognised for capital adequacy purposes must be reduced. The amount of this reduction depends on the residual maturity of the credit derivative relative to the residual maturity of the underlying exposure. For example, in the case of a ten‑year exposure hedged by a credit derivative with a residual maturity of nine years, 90 per cent of the exposure may be risk weighted on the basis of the protection seller, with the remaining 10 per cent risk weighted on the basis of the underlying exposure.

At a minimum, the credit derivative would need to have a residual maturity of at least one year to be eligible for this treatment.

Where an ADI has purchased protection using a credit derivative and the maturity of the credit derivative contract is greater than the maturity of the underlying asset, the amount of protection that is recognised for capital adequacy is unaffected by the maturity mismatch.

Currency mismatches

Where a credit derivative contract is denominated in a different currency to the underlying asset, the amount of protection purchased (as defined in paragraphs 11‑20 above) must be valued at the current exchange rate. Where the value of that protection (valued in terms of the currency of the underlying asset) is equal to or greater than the value of the underlying asset, the underlying asset may be regarded as protected. Where the mark-to-market value of that protection is less than the value of the underlying asset, the residual must be risk weighted on the basis of the underlying asset. For example, if protection on an Australian dollar denominated underlying asset is purchased via a credit derivative that pays US dollars if triggered, the amount of protection is the US dollar payment valued at the current exchange rate.

Attachment

Example

Capital Adequacy Treatment of the Protection Seller in a First-to-Default Basket Product in the Banking Book (Paragraph 28)

Assume an ADI sells protection on a basket of 10 reference entities, each risk weighted at 100%.

The terms of the credit derivative contract require the ADI to pay $100 if a credit event occurs on any one of the 10 reference entities, after which time the product will terminate.

The ADI is exposed to the 10 entities in the credit derivative basket. The amount of the exposure is $100 (because this is the amount the ADI stands to lose if a credit event occurs on any one of the 10 entities in the basket).

As per paragraph 28, the sum of the risk weights applicable to all the entities in the basket must be applied to the exposure to determine the risk‑weighted exposure. Since all entities in the basket are risk weighted at 100%, the risk‑weighted exposure of the ADI is 10 ´ 100% ´ $100 = $1,000. The amount of capital to be held against this risk‑weighted exposure is $80 (8% of $1,000).

The amount of capital held against the exposure is capped at the maximum payout possible under the contract. The maximum payout in this example is $100. Since the amount of capital required to be held against this exposure is $80, the cap will not take effect.

Suppose that the basket contained 13 entities with exposures to each entity required to be risk weighted at 100%. The risk‑weighted exposure of the ADI in this case is 13 ´ 100% ´ $100 = $1,300. The amount of capital that would normally be held against this risk‑weighted exposure is $104 (8% of $1,300). Since the Guidance Note allows the amount of capital held against the product to be capped at the maximum possible payout, the ADI need hold only $100 in capital against the position. This equates to a risk‑weighted exposure of $1,250 (i.e. $100 ´ 1/0.08). Hence, $1,250 should be added to the risk‑weighted assets of the ADI.

Notes to the Banking (prudential standard) determination No. 5 of 2006

Prudential Standard APS 112 – Capital Adequacy: Credit Risk

Note 1

The Banking (prudential standard) determination No. 5 of 2006 – Prudential Standard APS 112 – Capital Adequacy: Credit Risk (in force under paragraphs 11AF(1)(a) and (b) of the Banking Act 1959) as shown in this compilation is amended as indicated in the Tables below.

Table of Instruments

Year and Number	Date of FRLI registration	Date of commencement	Application, saving or transitional provisions
No. 5 of 2006	2 June 2006 (see F2006L01710)	1 July 2006
No. 9 of 2006	30 June 2006 (see F2006L02109)	1 July 2006	—
No. 10 of 2006	8 Aug 2006 (see F2006L02609)	8 Aug 2006	—

Table of Amendments

ad. = added or inserted am. = amended rep. = repealed rs. = repealed and substituted
Provision affected	How affected
APS 112
Para. 1...............................	am. No. 10 of 2006
AGN 112.1
Para. 4...............................	am. No. 9 of 2009
Attachment A
Attachment A....................	am. No. 10 of 2006