Banking (prudential standard) determination No. 6 of 2007 Prudential Standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk (Cth)
Banking (prudential standard) determination No. 6 of 2007
Prudential standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk
Banking Act 1959
I, John Francis Laker, Chair of APRA, under subsection 11AF(1) of the Banking Act 1959 (the Act), DETERMINE Prudential Standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk (APS 113) in the form set out in the Schedule, which applies to:
(a) all authorised deposit-taking institutions (ADIs) that are seeking or have been given approval to use an internal ratings-based approach to credit risk for the purpose of determining regulatory capital; and
(b) where an ADI to which APS 113 applies is a subsidiary of an authorised non-operating holding company (authorised NOHC), the authorised NOHC.
This instrument takes effect on 1 January 2008.
Dated 30 November 2007
[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).
Schedule
Prudential Standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk comprises the 93 pages commencing on the following page.
Prudential Standard APS 113
Capital Adequacy: Internal Ratings-based Approach to Credit Risk
Objective and key requirements of this Prudential Standard
This Prudential Standard sets out the requirements that an authorised deposit-taking institution that has approval to use an internal ratings-based approach to credit risk must meet both at the time of initial implementation and on an ongoing basis for regulatory capital purposes.
The key requirements of this Prudential Standard are that an authorised deposit-taking institution must:
quantify certain credit risk components to determine the capital requirement for a given credit exposure; and
have approval from APRA to use an internal ratings-based approach to credit risk for determining the institution’s credit risk capital requirement.
Table of contents
Prudential Standard
Authority
Application
Scope
Definitions
Key principles
Expected loss and eligible provisions
Approval process
Adoption of the IRB approach
IRB asset classes
Attachments
Attachment A - Governance and quantification requirements
Rating system design
Rating dimensions
Rating structure
Rating criteria
Rating assignment horizon
Use of statistical models in the rating process
Documentation of rating system design
Rating coverage
Integrity of the rating process
Overrides
Data maintenance
Stress tests in the assessment of capital adequacy
Governance and oversight
Use of internal ratings
General risk quantification requirements
Risk quantification requirements specific to probability of default estimation
Risk quantification requirements specific to loss given default estimation under the advanced IRB and retail IRB approaches
Risk quantification requirements specific to exposure at default estimation under the advanced IRB and retail IRB approaches
Validation of internal estimates
Disclosure requirements
Attachment B - Corporate, sovereign and bank IRB asset classes
Probability of default estimates
Loss given default estimates
Exposure at default estimates
Recognition of guarantees and credit derivatives
Treatment of maturity mismatches
Risk-weighted assets for the corporate, sovereign and bank IRB asset classes
Attachment C - Retail IRB asset class
Probability of default and loss given default estimates
Exposure at default estimates
Recognition of guarantees and credit derivatives
Risk-weighted assets for the retail IRB asset class
Attachment D - Purchased receivables
Default risk for purchased retail receivables
Default risk for purchased corporate receivables
Dilution risk
Requirements specific to estimating probability of default and loss given default (or expected losses) for purchased corporate and retail receivables
Purchase price discounts and first loss protection
Recognition of guarantees
Minimum operational requirements
Attachment E - Other assets, claims and exposures
Equity exposures
Leases
Cash items
Unsettled and failed transactions
Related-party exposures
Margin lending
Fixed assets and all other claims
Attachment F - Supervisory slotting criteria for specialised lending exposures
Authority
This Prudential Standard is made under section 11AF of the Banking Act 1959 (Banking Act).
Application
This Prudential Standard applies to authorised deposit-taking institutions (ADIs) that are seeking, or have been given approval, to use an internal ratings-based approach to credit risk for the purpose of determining regulatory capital.
A reference to an ADI in this Prudential Standard shall be taken as a reference to:
(a)an ADI on a Level 1 basis; and
(b)a group of which an ADI is a member on a Level 2 basis.
Level 1 and Level 2 have the meaning in Prudential Standard APS 110 Capital Adequacy (APS 110).
Where an ADI to which this Prudential Standard applies is a subsidiary of an authorised non-operating holding company (authorised NOHC), the authorised NOHC must ensure that the requirements in this Prudential Standard are met on a Level 2 basis, where applicable.
Scope
This Prudential Standard, subject to paragraphs 5 and 6, applies to all on-balance sheet assets held by an ADI and all its off-balance sheet exposures.
The following items are excluded from the scope of this Prudential Standard:
(a)assets or investments that are required to be deducted from Tier 1 or Tier 2 capital under Prudential Standard APS 111 Capital Adequacy: Measurement of Capital (APS 111); and
(b)securitisation exposures which are subject to the requirements of Prudential Standard APS 120 Securitisation (APS 120).
Items subject to capital requirements under Prudential Standard APS 116 Capital Adequacy: Market Risk (APS 116) are excluded for the purpose of calculating risk-weighted assets for credit risk under this Prudential Standard, but not for the purpose of calculating counterparty credit risk capital requirements (refer to Attachment B).
Definitions
The following definitions are used in this Prudential Standard:
a)corporate credit exposure - a credit obligation of a corporation, partnership or proprietorship and any other credit exposure that does not meet the criteria of any other defined internal ratings-based (IRB) asset class;
b)credit obligation - a contractual agreement in which a borrower receives something of value now (usually cash) with the agreement to repay the ADI at some stated date;
c)dilution risk - the possibility that the total amount of purchased receivables is reduced through cash or non-cash credits to the receivables’ obligors. Examples include offsets or allowances arising from returns of goods sold, disputes regarding product quality, possible debts of the obligor to obligors of the purchased receivables and any payment or promotional discounts offered by the obligor;
d)exposure at default (EAD) - the gross exposure under a facility (i.e. the amount that is legally owed to the ADI) upon default of an obligor;
e)IRB approval - the written approval from APRA for an ADI to adopt the IRB approach;
f)loss given default (LGD) - the ADI’s economic loss upon the default of an obligor;
g)probability of default (PD) - the risk of obligor default;
h)purchased receivables - a pool of receivables that have been purchased by an ADI from another entity;
i)rating system - all of the methods, processes, controls, data collection and technology that support the assessment of credit risk, the assignment of internal credit risk ratings and the quantification of associated default, exposure and loss estimates; and
j)subordinated claim - a facility that is expressly subordinated to another facility.
Key principles
An ADI that has received IRB approval from APRA may (subject to the relevant IRB approval) rely on its own internal estimates for some or all of the necessary credit risk components in determining the capital requirement for a given credit exposure. The credit risk components include measures of PD, LGD, EAD and maturity (M) and must satisfy the necessary requirements detailed in Attachment A. An ADI’s rating system must play an integral role in the ADI’s credit approval, risk management and internal capital allocation functions and meet the requirements detailed in Attachment A, including those relating to the Board of directors (Board) and senior management responsibilities.
With the exception of the exposures detailed in paragraph 14 of this Prudential Standard, the IRB approach to credit risk is based upon measures of unexpected losses (UL) and expected losses (EL). The IRB risk-weight functions detailed in this Prudential Standard produce the capital requirement for UL. For EL, the ADI must compare the sufficiency of eligible provisions (refer to paragraph 19 of this Prudential Standard) against EL amounts calculated according to paragraph 17 of this Prudential Standard. The comparison must be made in accordance with paragraph 21 of this Prudential Standard. Where a difference exists, paragraphs 22 to 23 of this Prudential Standard apply.
For the corporate, sovereign and bank IRB asset classes (defined in paragraphs 40 to 43 of this Prudential Standard), there are two IRB approaches to credit risk: the foundation IRB (FIRB) approach and the advanced IRB (AIRB) approach. Under the FIRB approach, an ADI must (subject to the relevant IRB approval) provide its own estimates of PD and M and rely on supervisory estimates for LGD and EAD. Under the AIRB approach, an ADI must (subject to the relevant IRB approval) provide its own estimates of all the credit risk components. Under both approaches, an ADI must use the relevant IRB risk-weight function, as detailed in Attachment B, for the purpose of deriving the capital requirement for UL for those IRB asset classes.
An IRB approval may provide that the FIRB or AIRB approach applies to an ADI’s corporate IRB asset class except in relation to one or more of the specialised lending (SL) sub-asset classes detailed in paragraph 41 of this Prudential Standard. In that event, specific risk-weights associated with slotting categories must be used (refer to Attachment B) for the purpose of deriving regulatory capital for UL for the relevant exposures.
For the retail IRB asset class (defined in paragraphs 44 to 46 of this Prudential Standard), an ADI that has IRB approval must (subject to the relevant IRB approval) provide its own estimates of PD, LGD and EAD. There is no explicit maturity adjustment for the retail IRB asset class nor is there a distinction between a FIRB approach and an AIRB approach. The ADI must use the risk-weight function for each retail sub-asset class as detailed in Attachment C for the purpose of deriving the capital requirement for UL for the retail IRB asset class.
The treatment of purchased receivables straddles two IRB asset classes: corporate and retail (refer to Attachment D). For both corporate and retail purchased receivables, an ADI will be required to hold regulatory capital for default risk and, where material, dilution risk.
The residual IRB asset class includes an ADI’s cash items, fixed assets, certain unsettled and failed transactions and related-party exposures, margin lending and all other claims not otherwise defined in this Prudential Standard. For the residual IRB asset class and the equity IRB asset class (refer to paragraphs 47 to 50 of this Prudential Standard), the capital requirement is based on assigned risk-weights that reflect APRA’s broad judgement about the credit risk associated with those exposures (refer to Attachment E). The risk-weights for these exposures are assumed to represent UL as EL is assumed to be zero.
For the purpose of this Prudential Standard, the risk-weighted asset amounts that are derived from the IRB risk-weight functions (refer to Attachments B and C) must be multiplied by a factor of 1.06. The ADI must sum the risk-weighted amounts for UL for all IRB asset classes (including the residual IRB asset class) to determine the total risk-weighted asset amount under the IRB approach.
An ADI that has IRB approval must consult APRA where there is doubt about how to determine the risk-weighted amount of an on-balance sheet or off-balance sheet asset or exposure.
Expected loss and eligible provisions
Other than for that portion of exposures covered by eligible guarantees or credit derivatives subject to the double default approach, an ADI that has IRB approval must separately calculate, for non-defaulted and defaulted exposures, total EL aggregated across the corporate, sovereign, bank and retail IRB asset classes.[1] Other than for SL exposures subject to the slotting approach, EL is calculated as follows:
[1] EL and relevant provisions associated with other IRB asset classes are excluded from the calculation of total EL and eligible provisions respectively.
(a)for non-defaulted exposures, the product of PD, LGD and EAD;
(b)for defaulted exposures under the AIRB approach and the IRB approach for retail exposures, the ADI’s best estimate of EL given current economic circumstances and the facility’s status (refer to paragraph 97 of Attachment A); and
(c)for defaulted corporate, sovereign and bank exposures under the FIRB approach, the product of the relevant supervisory estimates of LGD and EAD.
EL for SL exposures subject to the slotting approach must be calculated as eight per cent of the risk-weighted asset amount.[2] The risk-weight to be used in this calculation is determined by the relevant slotting category to which the exposure has been mapped (refer to Table 1).
[2] The risk-weighted asset amount consists of the total of the on-balance sheet component and the off-balance sheet equivalent multiplied by the relevant risk-weight in Table 1. For the on-balance sheet component, the amount that is multiplied by the relevant risk-weight is the book value of the exposure gross of any specific provisions. Off-balance sheet exposures are converted to on-balance sheet equivalents using the FIRB credit conversion factors detailed in Attachment B.
Table 1: Risk-weights for EL under the slotting approach
Strong Good Satisfactory Weak Default Specialised lending 5% 10% 35% 100% 625%
For exposures in the IRB asset classes detailed in paragraph 17 of this Prudential Standard (including, in all cases, SL), total eligible provisions associated with those exposures are:
(a)credit related provisions (e.g. specific provisions and General Reserves for Credit Losses net of deferred tax assets associated with those reserves (refer to Prudential Standard APS 220 Credit Quality (APS 220));[3]
[3] Any amount included in an ADI’s General Reserve for Credit Losses may only be used as an eligible provision to offset EL for non-defaulted exposures.
(b)partial write-offs; and
(c)discounts on defaulted assets (refer to paragraph 24 of Attachment B and paragraph 7 of Attachment C).
Where an ADI that has IRB approval uses the standardised approach to credit risk (refer to Prudential Standard APS 112 Capital Adequacy: Standardised Approach to Credit Risk (APS 112)) for a portion of its exposures, it must attribute total General Reserves for Credit Losses on a pro rata basis according to the proportion of risk-weighted assets subject to the standardised and IRB approaches. However, when the standardised approach to credit risk is used exclusively by an entity within the ADI consolidated banking group, all of the General Reserves for Credit Losses booked within that entity must be attributed to the standardised approach. Similarly, General Reserves for Credit Losses booked by entities within the ADI consolidated banking group that exclusively use an IRB approach to credit risk qualify as eligible provisions in terms of paragraph 19 of this Prudential Standard.
An ADI that has IRB approval must compare the total EL amount for:
(a)defaulted IRB exposures; and
(b)non-defaulted exposures
to total eligible provisions (refer to paragraph 19 of this Prudential Standard) associated with the relevant exposures.
In all cases detailed in paragraph 21 of this Prudential Standard, where the total EL amount is higher than total eligible provisions for the relevant exposures, the difference must be deducted on the basis of 50 per cent from Tier 1 capital and 50 per cent from Tier 2 capital (refer to APS 111).
For non-defaulted exposures, where the total EL amount associated with such exposures is lower than eligible provisions associated with these exposures, that amount of the difference made up of the General Reserve for Credit Losses may be included in Tier 2 capital up to a maximum of 0.6 per cent of risk-weighted assets (refer to paragraph 15 of this Prudential Standard).
Approval process
An ADI may apply for written approval from APRA to use an IRB approach for capital adequacy purposes.
In its application, the ADI must, unless exempted in writing by APRA, seek approval to use:
(a)an advanced measurement approach to operational risk for the purpose of determining the ADI’s regulatory capital for operational risk (refer to Prudential Standard APS 115 Capital Adequacy: Advanced Measurement Approaches to Operational Risk); and
(b)an internal risk measurement model for the purpose of determining the ADI’s regulatory capital for interest rate risk in the banking book (refer to Prudential Standard APS 117 Capital Adequacy: Interest Rate Risk in the Banking Book)
unless APRA has previously approved the ADI’s use of the approach or model.
APRA may, in writing, approve the use of an IRB approach by an ADI. The IRB approval may specify how the IRB approach is to apply in relation to the ADI, including approvals under other paragraphs of this Prudential Standard. Subsequent to obtaining IRB approval, an ADI must notify APRA if it intends to make changes to its rating systems that will result in a material change in the ADI’s risk-weighted asset amount for a given type of exposure or if the ADI intends to make a significant change to its modelling assumptions. APRA may impose conditions on the IRB approval.
In order to obtain IRB approval, an ADI must demonstrate to APRA that it has been using, for the relevant IRB asset or sub-asset classes, rating systems that are broadly in line with the requirements of this Prudential Standard for at least three years prior to an IRB approval being given. In the case of the AIRB approach and the IRB approach for retail exposures, the ADI must demonstrate to APRA that it has estimated and used LGD and EAD estimates in a manner that is broadly consistent with the relevant requirements of this Prudential Standard for at least three years prior to the IRB approval being given. Improvements to an ADI’s rating system will not render it non-compliant with this three-year requirement.
Once an ADI has obtained IRB approval, it must continue to employ that IRB approach on an ongoing basis unless, or except to the extent that, the IRB approval is revoked or suspended for some or all of the ADI’s operations. A return, at the ADI’s request, to the standardised approach to credit risk (refer to APS 112) or the use of the FIRB approach where the ADI has approval to use the AIRB approach, will generally only be permitted in exceptional circumstances.
APRA may, at any time in writing to the ADI, vary or revoke an IRB approval, or impose additional conditions on the IRB approval if it determines that:
(a)the ADI does not comply with this Prudential Standard; or
(b)it is appropriate, having regard to the particular circumstances of the ADI to impose the additional conditions or make the variation or revocation.
Where an IRB approval for an ADI has been varied or revoked, APRA may, in writing, require the ADI to revert to the standardised approach to credit risk for some or all of its operations, until it meets the conditions specified by APRA for returning to the IRB approach.
An ADI that has received IRB approval may become aware that it is not complying with a requirement of this Prudential Standard. Where this is the case, the ADI must notify APRA and provide the ADI’s plan for the timely return to compliance. Failure to notify APRA, produce an acceptable plan, satisfactorily implement the plan or demonstrate that the non-compliance is immaterial will result in reconsideration by APRA of the ADI’s eligibility to use the IRB approach. Furthermore, for the duration of any non-compliance, APRA may require the ADI to hold additional regulatory capital or take other supervisory action, as appropriate.
APRA may, in writing, require an ADI to reduce its level of credit risk or increase its capital if APRA considers that the ADI’s capital for credit risk under the IRB approach is not commensurate with its credit risk profile.
Adoption of the IRB approach
APRA will generally require an ADI that has IRB approval to apply the IRB approach across all asset classes of the ADI. APRA recognises, however, that for many ADIs it may not be practical to implement the IRB approach across all material IRB asset classes and business units at the same time. This may be the case, for instance, where an ADI moves from the standardised approach to credit risk (refer to APS 112) to the IRB approach, undertakes a new business activity, has acquired a new business through merger or acquisition or has certain immaterial business activities (refer to paragraph 38 of this Prudential Standard). In such circumstances, APRA’s approval of the IRB approach may permit the ADI to use a combination of the IRB approach and the standardised approach to credit risk. This approach is referred to as partial use.
An ADI must provide APRA with appropriate written information, both at the time of the ADI’s initial application for the IRB approach and subsequent to the ADI obtaining IRB approval, on any business activities for which the ADI proposes to use the standardised approach to credit risk.
Subject to approval by APRA, an ADI may adopt a phased roll-out of the IRB approach across the consolidated banking group. Notwithstanding, when an ADI adopts the IRB approach for an IRB asset or sub-asset class within a particular business unit, it will be required to apply that IRB approach to all exposures in that IRB asset or sub-asset class within that business unit.
APRA’s approval of a phased roll-out may provide for the ADI to use the slotting approach for one or more of the SL sub-asset classes and move to the FIRB or AIRB approach for other SL sub-asset classes.
An ADI that has received approval to adopt a phased roll-out of the IRB approach must have a written APRA-approved implementation plan in place that specifies the extent and timing of roll-out of the IRB approach across all significant asset or sub-asset classes and business units. During the roll-out period, no capital relief will be granted for intra-group transactions that reduce the ADI’s aggregate capital requirement by transferring credit risk among entities on the standardised approach to credit risk, FIRB approach and AIRB approach. This includes, but is not limited to, asset sales and cross-guarantees.
Permanent partial use of the IRB approach will be approved only in exceptional circumstances and where the ADI is able to demonstrate that those business activities to which the IRB approach does not apply are immaterial in terms of size and perceived risk profile. The calculated credit risk capital requirement for such business activities, if considered necessary by APRA, may be subject to additional regulatory capital.
IRB asset classes
Under the IRB approach to credit risk, an ADI must categorise banking book exposures into six broad IRB asset classes and several sub-asset classes: corporate (which includes four sub-asset classes of SL), sovereign, bank, retail (which consists of three separate sub-asset classes), equity and a residual IRB asset class (refer to paragraph 14 of this Prudential Standard). The ADI may adopt a different system of classification in its internal risk management and measurement systems; however, it must apply the appropriate treatment (under this Prudential Standard and the terms of its IRB approval) to each credit exposure for the purpose of deriving its minimum capital requirement. The ADI must ensure that its methodology for assigning credit exposures to different IRB asset classes complies with this Prudential Standard and its IRB approval and is consistent over time.
Corporate IRB asset class
The corporate IRB asset class includes all corporate credit exposures. For Level 1 purposes, the corporate IRB asset class excludes exposures to entities that are wholly-owned or effectively controlled by the ADI and that are consolidated at Level 2 for capital adequacy purposes (refer to Attachment E).
The corporate IRB asset class includes, but is not limited to, four SL sub-asset classes: project finance, object finance, commodities finance and income-producing real estate. Credit exposures in each of the SL sub-asset classes possess all of the following characteristics, either in legal form or economic substance:
(a)the exposure is typically to an entity (often a special purpose vehicle) which was created specifically to finance and/or operate specific assets;
(b)apart from the income that it receives from the assets being financed, the borrowing entity has little or no other material assets or activities and therefore has little or no independent capacity to repay the obligation;
(c)the terms of the obligation give the ADI a substantial degree of control over the assets and the income that it generates; and
(d)as a result of the factors detailed in paragraphs 41(a) to 41(c) of this Prudential Standard, the primary source of repayment of the obligation is the income generated by the assets rather than the independent capacity of a broader commercial enterprise.
Sovereign IRB asset class
The sovereign IRB asset class includes credit exposures to the counterparties detailed in paragraphs 2, 5, 6 and 7 of Attachment A of APS 112. Exposures to the institutions detailed in footnote 8 to paragraph 9 of that same Attachment of APS 112 are also included in the sovereign IRB asset class.
Bank IRB asset class
The bank IRB asset class includes credit exposures to the counterparties detailed in paragraphs 8, 9, 10 and 11 of Attachment A of APS 112. For Level 1 purposes, the bank IRB asset class excludes exposures to entities that are wholly owned or effectively controlled by the ADI and that are consolidated at Level 2 for capital adequacy purposes (refer to Attachment E).
Retail IRB asset class
An exposure is categorised as a retail exposure if it is extended to an individual (that is, a natural person) or individuals and is part of a large pool of exposures that are managed by the ADI on a pooled basis and is not margin lending.
Small-business exposures, whether or not extended to an individual, may be treated as retail exposures if the ADI treats such exposures in its internal risk management systems in the same manner as other retail exposures consistently over time. This requires that such exposures are originated in a similar manner to other retail exposures. Furthermore, the exposure must not be managed individually in a way that is comparable to an exposure in the corporate IRB asset class but rather as part of a portfolio segment or pool of exposures with similar risk characteristics for purposes of risk assessment and quantification. This does not preclude these exposures from being managed individually at some stages of the risk management process. To be regarded as a retail exposure, the total business-related exposure of the consolidated banking group to a small-business obligor or group of connected small-business obligors must be less than $1 million.[4]An ADI must have policies detailing the criteria that connect small-business obligors for this purpose. Small-business loans extended through, or guaranteed by, an individual are subject to the same exposure threshold.
[4] An exception to this is for subsidiaries in jurisdictions where a different threshold is set by the national regulator for small-business retail exposures. That threshold may be used by the ADI for relevant exposures in relation to the calculation of its Level 2 capital requirement.
Within the retail IRB asset class, an ADI is required to identify three separate sub-asset classes of exposures:
(a)exposures that are partly or fully secured by residential properties;
(b)qualifying revolving retail (QRR). The following criteria must be satisfied for a sub-portfolio to be included in the QRR sub-asset class:
(i) the exposures are revolving, unsecured and unconditionally cancellable (both contractually and in practice) by the ADI.[5]In this context, revolving exposures are defined as those where customers’ outstanding balances are permitted to fluctuate based on their decisions to borrow and repay, up to a limit established by the ADI;
[5] Exposures may be considered unconditionally cancellable if the terms of the contract permit the ADI to cancel at any time any existing credit lines or limits provided to a customer at the ADI’s discretion, and demand immediate repayment for any outstanding balance to the full extent allowable under consumer protection and related legislation.
(ii) the exposures are to individuals and not explicitly for business purposes;
(iii) the maximum exposure of an individual account in the sub-portfolio is $100,000;
(iv) the ADI must demonstrate that the use of the QRR risk-weight function is limited to exposures that have exhibited, in comparison with other types of lending products, low loss rate volatility relative to the average level of loss rates (especially within low PD bands). APRA will review the relative volatility of loss rates across relevant QRR sub-portfolios, as well as the aggregate of the QRR sub-asset class. Data on loss rates for the relevant QRR sub-portfolios and the QRR sub-asset class must be retained by the ADI in order to allow analysis of the volatility of loss rates; and
(v) the ADI is able to demonstrate to APRA that treatment of an exposure as a QRR exposure is consistent with the underlying risk characteristics of the sub-asset class; and
(c)all other retail exposures.
Equity IRB asset class
Equity exposures include both direct and indirect ownership interests,[6] whether voting or non-voting, in the assets and income of entities, including commercial enterprises and financial institutions. Equity exposures are defined on the basis of the economic substance of the instrument and include instruments that meet the following criteria:
[6] Indirect equity interests include holdings of derivative instruments tied to equity interests and holdings in corporations, partnerships, limited liability companies, trusts or other types of entities that issue ownership interests and are engaged principally in the business of investing in equity instruments.
(a)the instrument is irredeemable in that the return of invested funds can be achieved only by the sale of the investment, the sale of the rights to the investment or by the liquidation of the issuer; and
(b)the instrument does not embody an obligation of the issuer.
Debt obligations and other securities, units in trusts, derivatives or other instruments structured with the intent or effect of conveying the economic substance of equity ownership must be treated as equity exposures, including for IRB purposes.[7] This includes options and warrants on equities and short positions in equity securities. In addition, if a debt instrument is convertible into equity at the option of an ADI, it should be deemed equity on conversion. If such an instrument is convertible at the option of the issuer or automatically by the terms of the instrument, it should be categorised by the ADI as equity from inception.
[7] Equities that are recorded as a loan but arise from a debt/equity swap made as part of the orderly realisation or restructuring of the debt must be included in the equity IRB asset class.
Instruments with a return directly linked to equities should be characterised as equity exposures. Subject to written approval by APRA, an ADI may exclude these instruments from the equity IRB asset class where they are directly hedged by an equity holding such that the position does not expose the ADI to material equity risk.
Equity instruments that are structured with the intent of conveying the economic substance of debt holdings are not required to be treated as equity exposures. Similarly, for the purposes of this Prudential Standard, equity exposures required to be deducted from capital pursuant to APS 111 may be excluded from the equity IRB asset class.
Attachment A
Governance and quantification requirements
The minimum requirements set out in this Attachment apply to all IRB asset classes and the FIRB and AIRB approaches, unless noted otherwise.
The principles underlying this Attachment are that an ADI’s credit risk rating and associated risk estimation systems and processes provide for a meaningful assessment of obligor and transaction characteristics, a meaningful differentiation of risk and quantitative estimates of risk that are consistent, verifiable, relevant and soundly based. Furthermore, the internal ratings and quantitative risk estimates associated with those systems and processes must play an essential role in the ADI’s risk management and decision-making processes.
An ADI that has obtained IRB approval must produce its own estimates of PD[8] and in the case of corporate, sovereign and bank exposures, M, and adhere to the overall requirements for rating system design, operation, controls and governance as well as the requisite requirements for estimation and validation of PD and M estimates. An ADI that has approval to use the AIRB approach or the retail IRB approach must also meet the incremental minimum requirements relating to LGD and EAD as detailed in this Attachment.
[8] An ADI is not required to produce its own estimates of PD for equity exposures and other assets and claims detailed in Attachment E and specialised lending exposures where the ADI uses the slotting approach.
Rating system design
Within each relevant IRB asset class, an ADI may utilise multiple rating methodologies or systems. If the ADI chooses to use multiple methodologies or systems, the rationale for assigning an obligor to a rating methodology or system must be documented and applied in a manner that best reflects the level of risk of the obligor. The ADI must not inappropriately allocate obligors across rating methodologies or systems to minimise its capital requirement. The ADI must demonstrate that each methodology or system used for IRB purposes is in compliance with the minimum requirements at the time of approval by APRA and on an ongoing basis.
Rating dimensions
Standards for the corporate, sovereign and bank IRB asset classes
An IRB rating system for exposures in the corporate, sovereign and bank IRB asset classes must have two separate and distinct dimensions.
The first dimension (the obligor grade) must be orientated to the risk of obligor default (that is, it must solely reflect PD). Separate exposures to the same obligor must be assigned the same obligor grade, irrespective of any differences in the nature of each specific transaction. There are two exceptions to this:
(a)in the case of country transfer risk, where an ADI may assign different obligor grades depending on whether the facility is denominated in domestic or foreign currency; and
(b)where the treatment of associated guarantees or credit derivatives to a facility is reflected in an adjustment to the obligor grade.
In each case, separate exposures to the same obligor may be assigned different obligor grades.
An obligor grade must represent an assessment of obligor risk on the basis of a specified and distinct set of rating criteria from which estimates of PD are derived. An ADI’s credit policies must articulate the relationship between obligor grades in terms of the level of credit risk each grade implies. Perceived and measured credit risk must increase as credit quality declines from one grade to the next. The credit policies must articulate the credit risk of each grade in terms of both a description of the default risk typical for obligors assigned to the grade and the criteria used to distinguish that level of credit risk. Modifiers such as ‘+’ or ‘-’ to alpha or numeric obligor grades will only qualify as distinct grades if an ADI has developed complete rating descriptions and criteria for their assignment and separately quantifies PD estimates for those modified grades.
The second dimension (the facility grade) must reflect transaction-specific factors such as collateral, seniority and product type (that is, it must solely reflect LGD). Obligor characteristics may be included as LGD rating criteria to the extent that they are predictive of LGD. An exception to this is the FIRB approach where an ADI may satisfy this requirement by using a facility grade dimension that reflects both obligor and transaction-specific factors. Where a facility grade dimension reflects EL and does not separately quantify LGD, the supervisory estimates of LGD specified in Attachment B must be used.
An ADI that uses the slotting approach for one or more of the SL sub-asset classes is also exempt from the two-dimensional rating requirement for these exposures. Given the interdependence between obligor and transaction characteristics in SL, the ADI may have a single rating dimension that reflects EL by incorporating both PD and LGD considerations. This exemption does not apply to an ADI that has received approval from APRA to use either the general corporate FIRB or AIRB approach for one or more of the SL sub-asset classes.
Standards for the retail IRB asset class
Rating systems for retail exposures must be orientated to both obligor and transaction risks and must capture all relevant obligor and transaction characteristics. An ADI must assign each exposure that falls within the retail IRB asset class into a particular pool reflecting EL or particular pools separately reflecting PD, LGD and EAD. The ADI must demonstrate that this process provides for a meaningful differentiation of risk, provides for a grouping of sufficiently homogenous exposures and allows for accurate and consistent estimation of PD, LGD and EAD at the pool level.
Different pools of retail exposures may share identical PD, LGD and EAD estimates.
At a minimum, an ADI must consider the following risk drivers when assigning retail exposures to a pool:
(a)obligor risk characteristics (e.g. obligor type, demographics such as age and occupation);
(b)transaction risk characteristics including product or collateral (e.g. loan to valuation measures, seasoning, guarantees or credit derivatives and seniority (first or second liens)). The ADI must explicitly address cross-collateral provisions where present; and
(c)delinquency of exposure. The ADI must identify separately non-defaulted and defaulted exposures.
Rating structure
Standards for the corporate, sovereign and bank IRB asset classes
An ADI must have a meaningful distribution of exposures across its credit risk rating grades with no excessive concentrations on either its obligor grades and, where relevant, its facility grades.
Subject to the exception noted in paragraph 16 of this Attachment, an ADI must have a minimum of seven obligor grades for non-defaulted obligors and one for defaulted obligors. An ADI with lending activities focused on a particular market segment may satisfy this requirement with the minimum number of grades whilst ensuring that there are a sufficient number of grades to avoid undue concentrations of obligors in particular grades. Significant concentrations within a single grade or grades must be supported by empirical evidence that the grade or grades cover reasonably narrow PD bands and that the default risk posed by obligors in each grade fall within the relevant band. An ADI that lends to obligors of diverse credit quality should have a greater number of obligor grades.
There is no minimum number of facility grades for an ADI using the AIRB approach for exposures in the corporate, sovereign and bank IRB asset classes. In this case, an ADI must have a sufficient number of facility grades to avoid grouping facilities with widely varying LGD estimates into a single grade. The criteria used to define facility grades must be grounded in empirical evidence.
An ADI using the slotting approach for one or more of the SL sub-asset classes must have at least four rating grades for non-defaulted obligors and one for defaulted obligors.
Standards for the retail IRB asset class
An ADI must be able to provide quantitative measures of PD, LGD and EAD for each identified pool of retail exposures. The level of differentiation for IRB purposes must ensure that the number of exposures in a given pool is sufficient to allow for meaningful quantification and validation of the loss characteristics at the pool level. There must also be a meaningful distribution of obligors and exposures across pools, with no single pool comprising an undue concentration of the ADI’s total retail exposures.
Rating criteria
An ADI must have specific rating definitions, processes and criteria for assigning exposures to grades or pools within a rating system. The rating definitions and criteria must be both plausible and intuitive and result in a meaningful differentiation of risk.
An ADI’s internal rating descriptions and criteria must be sufficiently detailed to allow officers to assign consistently the same rating to obligors and facilities posing similar risk. This consistency should exist across lines of business, departments and geographic locations. If rating criteria and procedures differ for different types of obligors or facilities, the ADI must monitor for possible inconsistency and alter rating criteria to improve consistency where appropriate.
Written rating definitions must be clear and detailed so as to allow independent third parties, including APRA, to understand the assignment of ratings, replicate rating assignments and evaluate the appropriateness of the assignment of exposures to grades or pools. The criteria must also be consistent with the ADI’s lending standards and its policies for managing obligors and facilities that have deteriorated in credit quality.
An ADI must use all relevant and material information in assigning obligors and facilities to grades or pools. Information must be current. The less information the ADI has, the more conservative it must be in assigning exposures to obligor and facility grades or pools. An external rating may be used as an input into the assignment process; however, the ADI must ensure that it considers all other relevant material information.
Specialised lending within the corporate IRB asset class
An ADI that uses the slotting approach for one or more of the SL sub-asset classes (refer to Attachment B) must comply with the minimum requirements detailed in this Attachment, with the exception of those relating to risk quantification. In relation to risk quantification, the ADI must assign its SL exposures to its internal rating grades based on its own criteria, systems and processes. The ADI must have a documented conservative and consistent process that maps those internal rating grades into the slotting categories of strong, good, satisfactory, weak and default. The ADI must ensure that overrides of its internal criteria do not render the mapping process ineffective.
Rating assignment horizon
Although the time horizon required for PD estimation is one year (refer to paragraph 70 of this Attachment), an ADI must use a longer time horizon when assigning obligor grades to exposures.
An obligor grade must represent an ADI’s assessment of the obligor’s ability and willingness to perform contractually despite adverse economic conditions or the occurrence of unexpected events.
Given the difficulties in forecasting future events and the influence they could have on a particular obligor’s financial condition, an ADI must take a conservative view of projected information. Furthermore, where limited data are available, the ADI must adopt a conservative bias in its analysis.
Use of statistical models in the rating process
The requirements in this section apply to statistical models and other mechanical methods used to assign obligor or facility grades and in the estimation of PD, LGD and EAD.
Credit scoring models and other mechanical procedures are permissible as the primary or partial basis of rating assignments and may play a role in the estimation of loss characteristics under the IRB approach. However, judgement and oversight must also be used to ensure that all relevant and material information, including that which is outside the scope of any such model or other mechanical procedure, is also taken into consideration and that the model or other procedure is used appropriately. For the removal of doubt, purely statistical models and other mechanical methods used to assign obligor or facility grades are not acceptable. An ADI must have written guidance detailing how judgement and model results are combined.
Where an ADI uses a statistical model or other mechanical method in its rating process, the ADI must satisfy APRA that the model or procedure has good predictive power and that regulatory capital will not be distorted as a result of its use. The variables that are used in the model or procedure must form a reasonable set of predictors. On average, the model must be accurate across the range of obligors or facilities to which the ADI is exposed and there must be no known material biases.
An ADI must have in place a process for vetting data inputs into a statistical default or loss prediction model which includes an assessment of the accuracy, completeness and appropriateness of the data specific to the assignment of an obligor or facility grade.
An ADI must demonstrate that the data used to build its models are representative of the population of the ADI’s actual obligors or facilities.
An ADI must have documented policies and procedures for review of model-based rating assignments. Such procedures should focus on finding and limiting errors associated with known model weaknesses and must include credible ongoing efforts to improve the model’s performance.
An ADI must have a regular cycle of model validation that includes monitoring of model performance and stability, review of model relationships and testing of model outputs against outcomes.
Documentation of rating system design
An ADI must document the design and operational details of its rating and quantification systems.
An ADI must document the rationale for its choice of internal rating criteria and must be able to provide analysis demonstrating that rating criteria and procedures are likely to result in ratings that meaningfully differentiate risk. These rating criteria and procedures must be periodically reviewed to determine whether they remain fully applicable to the current portfolio and to external conditions.
An ADI must document the history of major changes in its credit risk rating process and such documentation must support identification of changes made to the credit risk rating process. The organisation of rating assignment, including the internal control structure, must also be documented.
An ADI must document the specific definitions of default and loss that are used internally and demonstrate consistency with the reference definitions set out in this Prudential Standard.
Where an ADI employs statistical models in its rating process, it must document its methodologies. This documentation must include:
(a)a detailed outline of the theory, assumptions or mathematical and empirical basis of the assignment of estimates to grades, individual obligors, exposures or pools and the data sources used to estimate the model;
(b)detail of the statistical process (including out-of-time and out-of-sample performance tests) for validating the model; and
(c)any circumstances under which the model does not work effectively.
Use of a third-party vendor model that claims proprietary technology or information is not a justification for exemption from documentation or any other of the requirements for rating systems. The ADI must satisfy APRA as to the model’s compliance with the requirements of this Attachment.
Rating coverage
For exposures in the corporate, sovereign and bank IRB asset classes, each obligor and eligible guarantor or credit protection provider (refer to Attachment B) must be assigned an obligor grade and each exposure must be associated with a facility grade as part of the loan approval process. Similarly, for the retail IRB asset class, each exposure must be assigned to a pool as part of the loan approval process.
Each separate legal entity to which an ADI is exposed must be separately rated. The ADI must have documented policies regarding the treatment of individual entities in a connected group, including the circumstances under which the same rating may or may not be assigned to some or all related entities.
Integrity of the rating process
Standards for the corporate, sovereign and bank IRB asset classes
Unless otherwise approved in writing by APRA, rating assignments and periodic rating reviews must be completed or approved by a party that does not directly stand to benefit from the extension of credit. Independence of the rating assignment process may be achieved through a range of practices that will be reviewed by APRA. These operational practices must be documented in the ADI’s policies and procedures manuals. Credit policies and underwriting procedures must reinforce and foster the independence of the rating process.
Obligor and facility grades must be refreshed on at least an annual basis. Certain exposures, especially higher risk obligors or problem exposures, must be subject to more frequent (than annually) rating review. In addition, an ADI must initiate a new rating review when material information on the obligor or facility comes to light.
An ADI must have an established process to obtain and update relevant and material information on the obligor’s financial condition and other characteristics that affect assigned estimates of PD, LGD and EAD. Upon receipt, the ADI must have a procedure to update the obligor’s ratings in a timely fashion.
Standards for the retail IRB asset class
An ADI must review the loss characteristics and delinquency status of each identified pool on at least an annual basis. This would include a review of the status of individual obligors within each pool as a means of ensuring that exposures continue to be assigned to the correct pool.
Overrides
For rating assignments based on expert judgement, an ADI must clearly document the situations in which officers may override the outputs of the rating process, including how and to what extent such overrides can be made and by whom.
For model-based ratings, an ADI must have guidelines and processes for monitoring cases where judgement has overridden the model’s rating, variables that were excluded or inputs that were altered. Those guidelines must include identifying personnel who are responsible for approving such overrides.
An ADI must have systems that identify overrides and separately track their nature and performance.
Data maintenance
An ADI must collect and store data on key obligor and facility characteristics to support its internal credit risk measurement and management processes, enable the ADI to meet the requirements of this Prudential Standard and serve as a basis for regulatory reporting and the relevant disclosure requirements detailed in Prudential Standard APS 330 Capital Adequacy: Public Disclosure of Prudential Information (APS 330).
Standards for the corporate, sovereign and bank IRB asset classes
An ADI must maintain rating histories on obligors and eligible guarantors or credit protection providers including the initial rating, the dates the ratings were assigned, the methodology and key data used to derive the rating and the officer responsible for the most recent rating.
In order to track the predictive power of the obligor rating system, an ADI must retain data on PD estimates, ratings migration and realised default rates associated with obligor grades.
An ADI using the AIRB approach must collect and store a history of data on the LGD and EAD estimates associated with each facility, the methodology and key data used to derive the estimate, the officer responsible for the most recent rating and the realised rates associated with each defaulted facility.
Where an ADI uses the AIRB approach and reflects the credit risk mitigating effects of guarantees or credit derivatives through its LGD estimates, it must retain data on the LGD of the facility before and after evaluation of the effects of the guarantee or credit derivative.
An ADI must retain the identity of obligors and facilities that default and information about the components of loss and recovery for each defaulted exposure including information relating to amounts and source of recoveries (e.g. collateral, liquidation proceeds and guarantees or credit derivatives), timing of cash flows and administrative costs.
An ADI using the slotting approach for one of more of the SL sub-asset classes is encouraged to retain data on realised losses for these exposures.
Standards for the retail IRB asset class
An ADI must retain data used in the process of allocating retail exposures to pools. This includes data on obligor and transaction risk characteristics used either directly, or through the use of a model, as well as data on delinquency.
An ADI must retain data on PD, LGD and EAD estimates associated with its pools of retail exposures.
For defaulted exposures, an ADI must retain data on the pools to which the retail exposure was assigned over the year prior to default and the realised outcomes on LGD and EAD.
Stress tests in the assessment of capital adequacy
An ADI must have in place sound stress testing processes for use in the assessment of its capital adequacy including the sufficiency of the IRB capital requirement. Stress testing must include identification of possible events or severe changes in economic conditions that would have unfavourable effects on the ADI’s credit exposures and assessment of the ADI’s ability to withstand such events or changes. Scenarios that could be used for this purpose are economic or industry downturns, market-risk events and liquidity conditions.
As part of its capital management planning and in addition to the more general tests described in paragraph 58 of this Attachment, an ADI must perform one or more credit risk stress tests to assess the effect of certain specific conditions on its IRB capital requirement. For this purpose, the objective is not to require the ADI to consider worst-case scenarios; however, it should at least consider the effect of mild recession scenarios. The tests to be employed would be chosen by the ADI, subject to review by APRA. The tests must be meaningful and reasonably conservative. Depending on its own circumstances, the ADI may develop different approaches to undertaking this stress test requirement.
As part of its stress testing process, an ADI that uses the double default approach for certain exposures must consider the impact of a deterioration in the credit quality of the relevant guarantors and credit protection providers and, in particular, the impact of these parties falling outside the eligibility criteria due to a change in their rating. The ADI must also consider the impact of the default of one, but not both, of the obligor and the guarantor or credit protection provider and the consequential increase in risk and its capital requirement at the time of that default.
Governance and oversight
All material aspects of an ADI’s rating and estimation processes must be approved by the ADI’s Board, or Board committee thereof, and senior management. Those parties must possess a general understanding of the ADI’s rating systems and a detailed understanding of the associated management reports. Senior management must notify the Board, or committee thereof, of material changes or exceptions from established policies that could have a material impact on the ADI’s rating system.
Senior management must understand the design and operation of the ADI’s rating systems and approve any material differences identified between established procedures and actual practice. Senior management must ensure that the rating system is operating as intended on an ongoing basis. Senior management and staff in the credit risk control function (refer to paragraphs 64 to 65 of this Attachment) must meet regularly to discuss the performance of the rating process, areas requiring improvement and the status of efforts to improve previously identified deficiencies.
Internal ratings must be an essential part of the reporting to the Board and senior management. Reporting must include risk profile by grade, migration across obligor grades, quantitative estimates of the relevant parameters for each obligor grade and where relevant, facility grade, and comparison of realised default rates (and realised LGD and EAD rates where relevant) against expectations. Reporting frequencies may vary with the significance and type of information and the level of the recipients.
Credit risk control
An ADI must have an independent credit risk control unit that is responsible for the design or selection, implementation and performance of the ADI’s rating systems. The unit must be functionally independent of the personnel and management functions responsible for originating exposures. Areas of responsibility must include:
(a)testing and monitoring internal obligor and facility grades;
(b)production and analysis of summary reports from the ADI’s rating system, including historical default data sorted by rating at the time of default and one year prior to default, migration analysis and monitoring of trends in key rating criteria;
(c)implementing procedures to verify that rating definitions are consistently applied across departments and geographic areas;
(d)reviewing and documenting any changes to the rating process, including the reasons for those changes; and
(e)reviewing the rating criteria to evaluate if they remain predictive of risk.
The credit risk control unit must actively participate in the development, selection, implementation and validation of rating models. It must assume oversight and supervision responsibilities for any models used in the rating process and have ultimate responsibility for the ongoing review of, and alterations to, the ADI’s rating models.
Independent review
An ADI’s rating system and its operations, including the operations of the credit risk control function and the estimation of PD and, where relevant, LGD and EAD, must be reviewed at least annually by an independent function. This review must include adherence to all applicable minimum requirements detailed in this Attachment. The findings of this review must be documented.
Use of internal ratings
Internal ratings, loss, default and exposure estimates must play an integral role in the credit approval, risk management, internal capital allocation and governance functions of the ADI. Rating systems and estimates designed and implemented exclusively for the purpose of qualifying for the IRB approach and used only to provide IRB inputs are not acceptable.
It is recognised that an ADI may not necessarily be using the same credit risk estimates for both regulatory capital and all internal purposes. In this case, data sources and methodologies utilised for the purposes of determining an ADI’s internal credit risk estimates must be consistent with the estimates used to determine the IRB capital requirement. Where there are differences, the ADI must be able to justify, to APRA’s satisfaction, the reasonableness of those differences.
General risk quantification requirements
Overall requirements for estimation
An ADI must estimate PD[9] for each internal obligor grade for corporate, sovereign and bank exposures and for each pool of retail exposures.
[9] An ADI is not required to produce its own estimates of PD for the SL sub-asset classes where the ADI uses the slotting approach for these exposures.
PD estimates must be calibrated to a long-run average of one-year default rates (one-year PD) for obligors in each obligor grade, with the exception of retail exposures where the definition of default can be applied at the facility, rather than obligor, level. Additional requirements specific to PD estimation are detailed in paragraphs 82 to 87 of this Attachment.
An ADI must estimate an appropriate long-run default-weighted average LGD and EAD (as detailed in paragraphs 88 to 99 and 100 to 108 respectively of this Attachment) for each relevant corporate, sovereign and bank exposure where the ADI has approval from APRA to use the AIRB approach and each retail pool.
Internal estimates of PD, LGD and EAD must be reviewed on at least an annual basis and incorporate all relevant, material and available data and other information. In determining these estimates, an ADI may utilise internal data and relevant data from external sources (including pooled data).
Estimates must be grounded in historical experience and empirical evidence and not based purely on subjective or judgmental considerations. Changes in an ADI’s lending and collection practices over the observation period must be taken into account. The ADI’s estimates must reflect the implications of new data and other information as it becomes available. Where industry estimation practices evolve and improve over time, the ADI should consider these developments in assessing its own practices. The ADI must review its estimates and estimation methodology on at least an annual basis.
In general, PD, LGD and EAD estimates are likely to involve unpredictable errors. In order to avoid over-optimism, an ADI must add a margin of conservatism to its estimates that is related to the likely range of errors. Where methods and data are less satisfactory and the likely range of errors is larger, the margin of conservatism must be larger.
Definition of default
A default is considered to have occurred with regard to a particular obligor when either or both of the two following events have taken place:
(a)the ADI considers that the obligor is unlikely to pay its credit obligations to the consolidated banking group in full, without recourse by the ADI to actions such as realising available security;
(b)the obligor is at least 90 days past due on a credit obligation to the consolidated banking group.[10]
[10]An exception to this is for subsidiaries in jurisdictions where a different number of days past due is set for retail exposures by the national regulator. That definition may be used by the ADI in relation to relevant PD, LGD and EAD estimates in the calculation of its Level 2 capital requirement.
For the purposes of paragraph 75(a) of this Attachment, elements to be taken as indications of unlikeliness to pay include:
(a)the factors set out in APS 220 relating to impairment irrespective of whether the ADI considers the credit obligations to be well secured;
(b)the ADI sells the credit obligation at a material credit-related economic loss. For the purpose of this element, the ADI must have a policy requiring:
(i) the maintenance of an internal register of credit obligations sold at a material credit-related economic loss;
(ii) data contained in the register to be considered by the ADI in its rating system design and validation processes. The subsequent inclusion in, or exclusion from, those processes of any data contained in the register must be justified by the ADI and must not result in lower LGD estimates; and
(iii) the creation and use of data contained in the register must be transparent to independent reviewers of the ADI’s rating systems, such as the ADI’s internal or external auditors and APRA.
For the purpose of paragraph 75(b) of this Attachment, the criteria for the recognition of 90 days past due are the same as those detailed in APS 220.
An ADI must record actual defaults on IRB asset classes using the reference definition of default detailed in paragraph 75 of this Attachment. The ADI must also use the reference definition of default for its PD and, where relevant, LGD and EAD estimates (though this does not preclude the possibility of materiality considerations entering into the estimation process). In arriving at its estimates, the ADI may use external data that are not consistent with that definition provided it makes appropriate adjustments to the data to achieve broad equivalence with the reference definition of default. This same condition would apply to any internal data collected prior to 1 January 2008. Internal data (including that pooled by a number of ADIs) collected subsequent to 1 January 2008 must be consistent with the reference definition of default.
If an ADI considers that a previously defaulted exposure’s status is such that the triggers in the reference definition of default no longer apply, the ADI may re-rate the obligor grade and, where relevant, the facility grade, as they would for a non-defaulted exposure. Should the reference definition be subsequently triggered, a second default would be deemed to have occurred. In the case of a restructured item (refer to APS 220), that item may not be re-rated to a non-defaulted grade or rating until the restructured item has operated in accordance with non-concessional terms and conditions for a period of at least six months.
Re-aging
An ADI must have clearly documented policies in respect of the counting of days past due and, in particular, in respect of the re-aging of facilities and the granting of extensions, deferrals, renewals and rewrites to existing accounts. These policies must be consistent with the requirements for the use of internal ratings set out in paragraphs 67 to 68 of this Attachment in that where the ADI treats a re-aged exposure in a similar fashion to other exposures that are considered to be in default, that exposure must be recorded as defaulted for regulatory capital purposes.
Treatment of overdrafts and other revolving facilities
Non-authorised overdrafts are considered to have a zero limit for IRB purposes. An ADI must, therefore, treat days past due as commencing once any credit is granted to an unauthorised customer and if such credit is not repaid within 90 days, the exposure must be considered to be in default.
Risk quantification requirements specific to probability of default estimation
Standards for the corporate, sovereign and bank IRB asset classes
When estimating the average PD for each obligor grade, an ADI must use information and techniques that take appropriate account of long-run experience. The ADI may have a primary PD estimation technique and use others as a point of comparison and potential adjustment. The mechanical application of a technique without supporting analysis is not sufficient. An ADI must recognise the importance of judgmental considerations in combining the results of techniques and in making adjustments for limitations of techniques and information.
Irrespective of the technique an ADI uses for PD estimation, the length of the underlying historical observation period used must be at least five years from at least one source. If the available observation period spans a longer period from any source, and the data are relevant and material, this longer period must be used.
Standards for the retail IRB asset class
Since an ADI will have its own particular basis for assigning retail exposures to pools, the ADI must regard internal data as the primary source of information for estimating loss characteristics for retail exposures. The ADI may use other techniques for PD quantification provided a strong link can be demonstrated between:
(a)the ADI’s process of assigning retail exposures to a pool and the process used by the other data source; and
(b) the ADI’s internal risk profile and the composition of the other data.
In all cases, the ADI must use all relevant and material data sources as points of comparison.
One method for deriving long-run average estimates of PD (and default-weighted estimates of average LGD as defined in paragraph 93 of this Attachment) for retail exposures would be based on an estimate of the expected long-run average loss rate. An ADI may:
(a)use an appropriate PD estimate to infer the long-run default-weighted average LGD; or
(b)use a long-run default-weighted average LGD to infer the appropriate PD.
In either case, the LGD used for the IRB capital calculation must not be less than the long-run default-weighted average LGD and must be consistent with the requirements of paragraphs 91 to 92 of this Attachment.
Irrespective of the technique an ADI uses for the estimation of loss characteristics of retail exposures, the length of the underlying historical observation period used must be at least five years. If the available observations from any source span a longer period, and the data are relevant, this longer period must be used. The ADI need not give equal importance to historical data if it can demonstrate that the more recent data are a better predictor of loss rates.
An ADI must anticipate the implications of rapid exposure growth and take steps to ensure that its estimation techniques are accurate and that its current capital level, earnings and funding prospects are adequate to cover its future capital needs. In order to avoid excessive movement in its required capital position arising from short-term PD horizons, the ADI must adjust PD estimates upward for anticipated material seasoning effects that may peak several years after origination, provided such adjustments are applied in a consistent fashion over time.
Risk quantification requirements specific to loss given default estimation under the advanced IRB and retail IRB approaches
Definition of loss for loss given default estimates across all IRB asset classes
An ADI must take into account all relevant factors when measuring economic loss for LGD purposes. This includes material discount effects and material direct and indirect costs associated with collecting on an exposure.
For LGD estimation purposes, an ADI must not simply measure the loss recorded in its accounting records although it must be able to reconcile accounting and economic losses.
An ADI may make adjustments to its LGD estimates to reflect its own workout and collection expertise. Such adjustments must be conservative until such time as the ADI has sufficient internal empirical evidence of the impact of its expertise.
Standards for all IRB asset classes
An ADI must take into account the potential for LGD to be higher than the default-weighted average during a period when credit losses are substantially higher than average. That is, LGD estimates must reflect economic downturn conditions, where necessary, to capture relevant risks.
For certain exposures, there may be significant cyclical variability in loss severities and an ADI must incorporate this into its LGD estimates. For this purpose, an ADI may use averages of loss severities observed during periods of high credit losses, forecasts based on appropriately conservative assumptions or other similar methods. Estimates of LGD during periods of high credit losses may be made using either internal or external data. In its analysis, the ADI must consider the extent of any dependence between the risk of the obligor and that of the collateral or collateral provider. Cases where there is a significant degree of dependence must be addressed in a conservative manner.
Where loss severities do not exhibit cyclical variability and LGD estimates do not differ materially from the long-run default-weighted average, LGD estimates must not be less than the long-run default-weighted average loss given default calculated as the average economic loss (refer to paragraphs 88 to 90 of this Attachment) of all observed defaults within the data source for that type of facility.
Currency mismatches between the underlying obligation and the collateral must be considered and treated conservatively in an ADI’s assessment of LGD.
LGD estimates must be grounded in historical recovery rates and, where applicable, must not be based solely on the estimated market value of collateral.
To the extent that LGD estimates take into account the existence of collateral, an ADI must establish internal requirements for collateral management, operational procedures, legal certainty and risk management processes that are generally consistent with those detailed in Attachment G of APS 112 and Attachment B.
The LGD assigned to a defaulted asset must reflect the possibility that an ADI may have to recognise additional UL during the recovery period. For each defaulted asset, the ADI must also construct its best estimate of the EL on that asset based on current economic circumstances and the facility’s status. The amount, if any, by which the LGD on a defaulted asset exceeds the ADI’s best estimate of EL on the asset represents the capital requirement for that asset and should be set by the ADI on a risk-sensitive basis (refer to paragraph 77 of Attachment B and paragraph 38 of Attachment C). Instances where the best estimate of EL on a defaulted asset is less than the sum of specific provisions and partial write-offs on that asset must be justified to APRA by the ADI.
Additional standards for the corporate, sovereign and bank IRB asset classes
Estimates of LGD for exposures in the corporate, sovereign and bank IRB asset classes must be based on a minimum data observation period that should ideally cover at least one complete economic cycle but, in any case, must be no shorter than a period of seven years from at least one source. If the available observation period spans a longer period from any source and the data are relevant and material, this longer period must be used.
Additional standards for the retail IRB asset class
The minimum data observation period for LGD estimates for retail exposures is five years. The less data an ADI has, the more conservative it must be in its estimation of LGD. The ADI need not give equal importance to historical data if it can demonstrate to APRA that more recent data are a better predictor of loss rates.
Risk quantification requirements specific to exposure at default estimation under the advanced IRB and retail IRB approaches
Standards for all IRB asset classes
An ADI must have procedures in place for the estimation of EAD for each type of off-balance sheet exposure, excluding those that expose the ADI to counterparty credit risk. Estimates of EAD should reflect the possibility of additional drawings by the obligor up to the time a default event is triggered. EAD estimates must also take into account additional drawings after the time of default if the ADI does not include the possibility of such drawings in its LGD estimates. Where estimates of EAD differ by facility type, the delineation of these facilities must be clear and unambiguous.
An ADI that has approval to use the AIRB approach must assign an estimate of EAD for each facility. EAD estimates must be an estimate of the long-run default-weighted average EAD for similar facilities and obligors over a sufficiently long period of time, with a margin of conservatism appropriate to the likely range of errors in the estimate. If a positive correlation can reasonably be expected between the default frequency and the magnitude of EAD, the EAD estimate must incorporate a larger margin of conservatism.
For exposures where EAD estimates are volatile over the economic cycle, an ADI must use EAD estimates that are appropriate for an economic downturn if these are more conservative than the long-run average. Where the ADI has developed its own EAD models, this could be achieved by considering the cyclical nature, if any, of the drivers of such models. Alternatively, the ADI may have sufficient internal data to examine the impact of previous recessions. In some cases, the ADI may only have the option of making conservative use of external data.
The criteria by which estimates of EAD are derived must be plausible and intuitive and represent what an ADI believes to be the material drivers of EAD. The criteria must be supported by credible internal analysis by the ADI. The ADI must be able to provide a breakdown of its EAD experience by the factors it sees as the drivers of EAD. The ADI must use all relevant and material information in its determination of EAD estimates.
An ADI must review assigned EAD estimates when material new information comes to light and, in any case, at least on an annual basis.
An ADI’s EAD estimates must give due consideration to its policies and procedures in respect of account monitoring and payment processing. The ADI must consider its ability and willingness to prevent further drawings in circumstances short of payment default, such as covenant violations or other technical default events.
An ADI must have systems and procedures in place to monitor, on a daily basis, facility amounts, outstanding amounts against committed lines and changes in outstanding amounts for each obligor and obligor grade.
Additional standards for the corporate, sovereign and bank IRB asset classes
Estimates of EAD must be based on a time period that must ideally cover a complete economic cycle but, in any case, must be no shorter than seven years. If the available observation period spans a longer period from any source and the data are relevant and material, this longer period must be used.
Additional standards for the retail IRB asset class
The minimum data observation period for EAD estimates for retail exposures is five years. The less data an ADI has, the more conservative it must be in its estimation of EAD. The ADI need not give equal importance to historical data if it can demonstrate to APRA that more recent data are a better predictor of drawdowns.
Validation of internal estimates
An ADI must have a robust and documented system in place to validate the accuracy and consistency of rating systems and processes and the estimation of all relevant credit risk components. The ADI must be able to demonstrate to APRA that the internal validation process enables it to assess the performance of its internal rating and credit risk estimation systems in a meaningful and consistent manner.
An ADI must regularly compare realised default rates with PD estimates for each obligor grade and be able to demonstrate that the realised default rates are within the expected range for each grade. An ADI using its own LGD and EAD estimates must also complete such analysis for those estimates. Comparisons must make use of historical data over as long a time period as possible. The methods and data used in these comparisons must be clearly documented. This analysis and documentation must be updated at least annually.
(a)robust risk management practices with respect to the location of the leased asset, its use, age and planned obsolescence;
(b)a robust legal framework establishing the ADI’s legal ownership of the leased asset and its ability to exercise its rights as owner in a timely manner; and
(c)the difference between the rate of depreciation of the leased asset and the rate of amortisation of the lease payments must not be so large as to overstate the CRM effect of the leased asset.
For leases that expose the ADI to residual value risk,[43] the discounted lease payment stream must be risk-weighted according to the PD and LGD[44] the ADI assigns to the lessee and the residual value must be risk-weighted at 100 per cent.
[43] Residual value risk is the risk that an ADI is exposed to potential loss due to the fair value of a leased asset declining below its residual estimate at the inception of the lease.
[44] Refer to footnote 41.
Cash items
The risk-weight for notes, coins, and gold bullion held in the ADI’s own vaults or on an allocated basis by another party to the extent that it is backed by gold bullion liabilities is zero per cent.
The risk-weight for 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) is 20 per cent.
Unsettled and failed transactions
The IRB capital requirement for unsettled and failed transactions is the same as that detailed in APS 112. Where a non-delivery-versus-payment transaction is required to be treated as an exposure under APS 112 and the ADI has no other banking book exposure to the counterparty, it may assign a PD based on the counterparty’s external rating (where available). Where the ADI uses the AIRB approach for its general corporate, sovereign or bank exposures, it may use a 45 per cent LGD estimate for a free delivery transaction that is treated as an exposure provided that it is applied to all such exposures. Alternatively, the ADI may risk-weight such exposures according to the risk-weights detailed in APS 112 or apply a 100 per cent risk-weight provided that all such exposures are risk-weighted in the same manner.
In the case of a system-wide failure of a settlement or clearing system, the failure of a counterparty to settle a trade need not be deemed a default for the purpose of this Prudential Standard.
Related-party exposures
For Level 1 purposes, exposures (other than exposures included in the equity IRB asset class) to entities that are wholly owned or effectively controlled by the ADI and that are consolidated at Level 2 for capital adequacy purposes must be risk-weighted according to the relevant risk-weights detailed in Attachment A to APS 112. The measure of such exposures on which regulatory capital is based is the current book value, including accrued interest and net of specific provisions.
Margin lending
The risk-weight for margin lending against listed instruments on recognised exchanges is 20 per cent. Where the underlying instruments are unlisted, the ADI must treat the exposure as a secured loan and determine the capital requirement according to the provisions of APS 112. The measure of such exposures on which regulatory capital is based is the current book value net of specific provisions.
Fixed assets and all other claims
The risk-weight for investments in premises, plant and equipment and all other fixed assets, including those under an operating lease and all other claims not otherwise defined in this Prudential Standard, is 100 per cent. The measure of such exposures on which regulatory capital is based is the current book value, including revaluations, net of specific provisions or associated depreciation.
Attachment F
Supervisory slotting criteria for specialised lending exposures
Table 4: Slotting criteria for project finance exposures Strong Good Satisfactory Weak Financial strength Market conditions There are few competing suppliers or there is a substantial and durable advantage in location, cost or technology. Demand is strong and growing. There are few competing suppliers or there is a better than average location, cost or technology but this situation may not last. Demand is strong and stable. The project has no advantage in location, cost or technology. Demand is adequate and stable. The project has worse than average location, cost or technology. Demand is weak and declining. Financial ratios (e.g. debt service coverage ratio (DSCR), loan life coverage ratio (LLCR), project life coverage ratio (PLCR) and debt-to-equity ratio) The project has strong financial ratios considering the level of project risk and very robust economic assumptions. The project has strong to acceptable financial ratios considering the level of project risk and robust project economic assumptions. The project has standard financial ratios considering the level of project risk. The project has aggressive financial ratios considering the level of project risk. Stress analysis The project can meet its financial obligations under sustained severely stressed economic or sectoral conditions. The project can meet its financial obligations under stressed economic or sectoral conditions. The project is only likely to default under severe economic conditions. The project is vulnerable to stresses that are not uncommon through an economic cycle and may default in a normal downturn. The project is likely to default unless conditions improve soon. Financial structure Duration of the exposure compared to the duration of the project The useful life of the project significantly exceeds the tenor of the loan. The useful life of the project exceeds the tenor of the loan. The useful life of the project exceeds the tenor of the loan. The useful life of the project may not exceed the tenor of the loan. Amortisation schedule Amortising debt. Amortising debt. Amortising debt repayments with limited balloon payment. Bullet payment or amortising debt with high balloon repayment. Political and legal environment Political risk, including transfer risk, considering project type and mitigants The project has very low exposure; there are strong mitigation instruments, if needed. The project has low exposure; there are satisfactory mitigation instruments, if needed. The project has moderate exposure; there are fair mitigation instruments. The project has high exposure; the mitigation instruments are weak or there are none. Force majeure risk (war, civil unrest, etc) Low exposure. Acceptable exposure. Standard protection. There are significant risks which are not fully mitigated. Government support and project’s importance for the country over the long term The project is of strategic importance for the country (preferably export-oriented). It has strong support from the government. The project is considered important for the country. It has a good level of support from the government. The project may not be strategic but brings unquestionable benefits for the country. Government support may not be explicit. The project is not key to the country. The support from the government, if any, is weak. Stability of legal and regulatory environment (risk of change in law) The regulatory environment is favourable and stable over the long term. The regulatory environment is favourable and stable over the medium term. Regulatory changes can be predicted with a fair level of certainty. Current or future regulatory issues may affect the project. Acquisition of all necessary supports and approvals for such relief from local content laws Strong. Satisfactory. Fair. Weak. Enforceability of contracts, collateral and security Contracts, collateral and security are enforceable. Contracts, collateral and security are enforceable. Contracts, collateral and security are considered enforceable even if certain non-key issues exist. There are unresolved key issues in respect of actual enforcement of contracts, collateral and security. Transaction characteristics Design and technology risk The project has fully proven technology and design. The project has fully proven technology and design. The project has proven technology and design; start-up issues are mitigated by a strong completion package. The project has unproven technology and design; technology issues exist and/or complex design. Construction risk Permitting and siting All permits have been obtained. Some permits are still outstanding but their receipt is considered very likely. Some permits are still outstanding but the permitting process is well defined and they are considered routine. Key permits still need to be obtained and are not considered routine. Significant conditions may be attached. Type of construction contract Fixed-price date-certain turnkey construction engineering and procurement contract (EPC). Fixed-price date-certain turnkey construction EPC. Fixed-price date-certain turnkey construction contract with one or several contractors. No or partial fixed-price turnkey contract and/or interfacing issues with multiple contractors. Completion guarantees The liquidated damages are substantial and are supported by financial substance and/or strong completion guarantee from sponsors with excellent financial standing. The liquidated damages are significant and are supported by financial substance and/or completion guarantee from sponsors with good financial standing. The liquidated damages are adequate and are supported by financial substance and/or completion guarantee from sponsors with good financial standing. The liquidated damages are inadequate or not supported by financial substance or weak completion guarantees.
Track record and financial strength of contractor in constructing similar projects
Strong. Good. Satisfactory. Weak. Operating risk Scope and nature of operations and maintenance (O & M) contracts There is a strong long-term O&M contract, preferably with contractual performance incentives and/or O&M reserve accounts. There is a long-term O&M contract and/or O&M reserve accounts. There is a limited O&M contract or O&M reserve account. There is no O&M contract. There is a risk of high operational cost overruns beyond mitigants. Operator’s expertise, track record and financial strength Very strong or committed technical assistance of the sponsors. Strong. Acceptable. Limited/weak or local operator dependent on local authorities. Off-take risk If there is a take-or-pay or fixed-price off-take contract The off-taker has excellent creditworthiness. There are strong termination clauses. The tenor of the contract comfortably exceeds the maturity of the debt. The off-taker has good creditworthiness. There are strong termination clauses. The tenor of the contract exceeds the maturity of the debt. The off-taker’s financial standing is acceptable. There are normal termination clauses. The tenor of the contract generally matches the maturity of the debt. The off-taker is considered weak and there are weak termination clauses. The tenor of the contract does not exceed the maturity of the debt. If there is no take-pay or fixed-price off-take contract The project produces essential services or a commodity sold widely on a world market. Output can readily be absorbed at projected prices even at lower than historic market growth rates. The project produces essential services or a commodity sold widely on a regional market that will absorb it at projected prices at historical growth rates. The commodity is sold on a limited market that may absorb it only at lower than projected prices. The project output is demanded by only one or a few buyers or is not generally sold on an organised market. Supply risk Price, volume and transportation risk of feed-stocks; supplier’s track record and financial strength There is a long-term supply contract with a supplier of excellent financial standing. There is a long-term supply contract with a supplier of good financial standing. There is a long-term supply contract with a supplier of good financial standing – a degree of price risk may remain. There is a short-term supply contract or long-term contract with a financially weak supplier –price risk definitely remains. Reserve risks (e.g. natural resource development) Reserves are independently audited, proven and developed and are well in excess of requirements over lifetime of the project. Reserves are independently audited, proven and developed and are in excess of requirements over lifetime of the project. Reserves are proven and can supply the project adequately through the maturity of the debt. The project relies to some extent on potential and undeveloped reserves. Strength of sponsor Sponsor’s track record, financial strength and country/sector experience The sponsor is strong with an excellent track record and high financial standing. The sponsor is good with a satisfactory track record and good financial standing. The sponsor is adequate with an adequate track record and good financial standing. The sponsor is weak with a questionable/no track record and/or financial weaknesses. Sponsor support, as evidenced by equity, ownership clause and incentive to inject additional cash if necessary Strong. The project is highly strategic for the sponsor (core business – long-term strategy). Good. The project is strategic for the sponsor (core business – long-term strategy). Acceptable. The project is considered important for the sponsor (core business). Limited. The project is not key to the sponsor’s long-term strategy or core business. Security package Assignment of contracts and accounts Fully comprehensive. Comprehensive. Acceptable. Weak. Pledge of assets, taking into account quality, value and liquidity of assets First perfected security interest in all project assets, contracts, permits and accounts necessary to run the project. Perfected security interest in all project assets, contracts, permits and accounts necessary to run the project. Acceptable security interest in all project assets, contracts, permits and accounts necessary to run the project. Little security or collateral for lenders; weak negative pledge clause. Lender’s control over cash flow (e.g. cash sweeps, independent escrow accounts) Strong. Satisfactory. Fair. Weak. Strength of the covenant package (mandatory prepayments, payment deferrals, payment cascade, dividend restrictions, etc) The covenant package is strong for this type of project. The project may issue no additional debt. The covenant package is satisfactory for this type of project. The project may issue extremely limited additional debt. The covenant package is fair for this type of project. The project may issue limited additional debt. The covenant package is insufficient for this type of project. The project may issue unlimited additional debt. Reserve funds (debt service, O & M, renewal and replacement, unforeseen events, etc) There is a longer than average coverage period, all reserve funds are fully funded in cash or letters of credit from highly rated banks. There is an average coverage period and all reserve funds fully funded. There is an average coverage period and all reserve funds fully funded. The coverage period is shorter than average and reserve funds are funded from operating cash flows.
Table 5: Slotting criteria for income-producing real estate exposures
Strong Good Satisfactory Weak Financial strength Market conditions The supply and demand for the project’s type and location are currently in equilibrium. The number of competitive properties coming to market is equal or lower than forecasted demand. The supply and demand for the project’s type and location are currently in equilibrium. The number of competitive properties coming to market is roughly equal to forecasted demand. Market conditions are roughly in equilibrium. Competitive properties are coming on the market and others are in the planning stages. The project’s design and capabilities may not be state of the art compared to new projects. Market conditions are weak. It is uncertain when conditions will improve and return to equilibrium. The project is losing tenants at lease expiration. New lease terms are less favourable compared to those expiring. Financial ratios and advance rate The property’s DSCR is considered strong (DSCR is not relevant for the construction phase) and its loan-to-valuation ratio (LVR) is considered low given its property type. Where a secondary market exists, the transaction is underwritten to market standards. The DSCR (not relevant for development real estate) and LVR are satisfactory. Where a secondary market exists, the transaction is underwritten to market standards. The property’s DSCR has deteriorated and its value has fallen, increasing its LVR. The property’s DSCR has deteriorated significantly and its LVR is well above underwriting standards for new loans. Stress analysis The property’s resources, contingencies and liability structure allow it to meet its financial obligations during a period of severe financial stress (e.g. increase in interest rates, downturn in economic growth). The property can meet its financial obligations under a sustained period of financial stress (e.g. increase in interest rates, downturn in economic growth). The property is likely to default only under severe economic conditions. During an economic downturn, the property would suffer a decline in revenue that would limit its ability to fund capital expenditures and significantly increase the risk of default. The property’s financial condition is strained and is likely to default unless conditions improve in the near term. Cash-flow predictability For complete and stabilised property The property’s leases are long-term with creditworthy tenants and their maturity dates are scattered. The property has a track record of tenant retention upon lease expiration. Its vacancy rate is low. Expenses (maintenance, insurance, security and property taxes) are predictable. Most of the property’s leases are long-term, with tenants that range in creditworthiness. The property experiences a normal level of tenant turnover upon lease expiration. Its vacancy rate is low. Expenses are predictable. Most of the property’s leases are medium-term rather than long-term with tenants that range in creditworthiness. The property experiences a moderate level of tenant turnover upon lease expiration. Its vacancy rate is moderate. Expenses are relatively predictable but vary in relation to revenue. The property’s leases are of various terms with tenants that range in creditworthiness. The property experiences a very high level of tenant turnover upon lease expiration. Its vacancy rate is high. Significant expenses are incurred preparing space for new tenants. For complete but not stabilised property Leasing activity meets or exceeds projections. The project should achieve stabilisation in the near future. Leasing activity meets or exceeds projections. The project should achieve stabilisation in the near future. Most leasing activity is within projections however, stabilisation will not occur for some time. Market rents do not meet expectations. Despite achieving target occupancy rate, cash flow coverage is tight due to disappointing revenue. For construction phase The property is entirely pre-leased through the tenor of the loan or pre-sold to an investment grade tenant or buyer or the ADI has a binding commitment for take-out financing from an investment grade lender. The property is entirely pre-leased or pre-sold to a creditworthy tenant or buyer or the ADI has a binding commitment for permanent financing from a creditworthy lender. Leasing activity is within projections but the building may not be pre-leased and take-out financing may not exist. The ADI may be the permanent lender. The property is deteriorating due to cost overruns, market deterioration, tenant cancellations or other factors. There may be a dispute with the party providing the permanent financing. Asset characteristics Location The property is located in a highly desirable location that is convenient to services that tenants desire. The property is located in a desirable location that is convenient to services that tenants desire. The property location lacks a competitive advantage. The property’s location, configuration, design and maintenance have contributed to the property’s difficulties. Design and condition The property is favoured due to its design, configuration and maintenance and is highly competitive with new properties. The property is appropriate in terms of its design, configuration and maintenance. The property’s design and capabilities are competitive with new properties. The property is adequate in terms of its configuration, design and maintenance. Weaknesses exist in the property’s configuration, design or maintenance. Property is under construction The construction budget is conservative and technical hazards are limited. Contractors are highly qualified. The construction budget is conservative and technical hazards are limited. Contractors are highly qualified. The construction budget is adequate and contractors are ordinarily qualified. The project is over budget or unrealistic given its technical hazards. Contractors may be under qualified. Strength of sponsor/developer Financial capacity and willingness to support the property The sponsor/developer made a substantial cash contribution to the construction or purchase of the property. The sponsor/developer has substantial resources and limited direct and contingent liabilities. The sponsor/developer’s properties are diversified geographically and by property type. The sponsor/developer made a material cash contribution to the construction or purchase of the property. The sponsor/developer’s financial condition allows it to support the property in the event of a cash flow shortfall. The sponsor/developer’s properties are located in several geographic regions. The sponsor/developer’s contribution may be immaterial or non-cash. The sponsor/developer is average to below average in financial resources. The sponsor/developer lacks capacity or willingness to support the property.
Reputation and track record with similar properties Management are experienced and the sponsor’s quality is high. Strong reputation, lengthy and successful record with similar properties. Appropriate management and sponsor’s quality. The sponsor or management has a successful record with similar properties. Moderate management and sponsor’s quality. The management or sponsor track record does not raise serious concerns. Ineffective management and sub-standard sponsor’s quality. The management and sponsor difficulties have contributed to difficulties in managing properties in the past. Relationships with relevant real estate agents Strong relationships with leading agents such as leasing agents. Proven relationships with leading agents such as leasing agents. Adequate relationships with leasing agents and other parties providing important real estate services. Poor relationships with leasing agents and/or other parties providing important real estate services. Security package Nature of lien Perfected first lien.[45] Perfected first lien.[46] Perfected first lien.[47] Ability of lender to foreclose is constrained. Assignment of rents (for projects leased to long-term tenants) The lender has obtained an assignment. They maintain current tenant information that would facilitate providing notice to remit rents directly to the lender, such as a current rent roll and copies of the project’s leases. The lender has obtained an assignment. They maintain current tenant information that would facilitate providing notice to the tenants to remit rents directly to the lender, such as current rent roll and copies of the project’s leases. The lender has obtained an assignment. They maintain current tenant information that would facilitate providing notice to the tenants to remit rents directly to the lender, such as current rent roll and copies of the project’s leases. The lender has not obtained an assignment of the leases or has not maintained the information necessary to readily provide notice to the building’s tenants. Quality of the insurance coverage Appropriate. Appropriate. Appropriate. Sub-standard.
[45] Lenders in some markets extensively use loan structures that include junior liens. Junior liens may be indicative of this level of risk if the total LVR inclusive of all senior positions does not exceed a typical first loan LVR.
[46]Refer to footnote 46.
[47]Refer to footnote 46.
Table 6: Slotting criteria for object finance exposures
Strong Good Satisfactory Weak Financial strength Market conditions Demand is strong and growing. There are strong entry barriers and low sensitivity to changes in technology and economic outlook. Demand is strong and stable. There are some entry barriers and some sensitivity to changes in technology and economic outlook. Demand is adequate and the entry barriers are limited and stable. There is significant sensitivity to changes in technology and economic outlook. Demand is weak and declining, vulnerable to changes in technology and economic outlook and a highly uncertain environment. Financial ratios (debt service coverage ratio and LVR) The financial ratios are strong considering the type of asset. Very robust economic assumptions. The financial ratios are strong/acceptable considering the type of asset. Robust project economic assumptions. The financial ratios are standard for the asset type. The financial ratios are aggressive considering the type of asset. Stress analysis Long-term revenues are stable and capable of withstanding severely stressed conditions through an economic cycle. Short-term revenues are satisfactory. The loan can withstand some financial adversity. Default is only likely under severe economic conditions. Short-term revenues are uncertain. Cash flows are vulnerable to stresses that are not uncommon through an economic cycle. The loan may default in a normal downturn. Revenues are subject to strong uncertainties. Even in normal economic conditions the asset may default, unless conditions improve. Market liquidity The market is structured on a worldwide basis. Assets are highly liquid. The market is worldwide or regional. Assets are relatively liquid. The market is regional with limited prospects in the short term, implying lower liquidity. The market is local and/or has poor visibility. There is low or no liquidity, particularly in niche markets. Political and legal environment Political risk, including transfer risk Very low. There are strong mitigation instruments, if needed. Low. There are satisfactory mitigation instruments, if needed. Moderate. There are fair mitigation instruments. High. The mitigation instruments, if any, are weak. Legal and regulatory risks The jurisdiction is favourable to repossession and enforcement of contracts. The jurisdiction is favourable to repossession and enforcement of contracts. The jurisdiction is generally favourable to repossession and enforcement of contracts, even if repossession might be long and/or difficult. The legal and regulatory environment is poor and/or unstable. The jurisdiction may make repossession and enforcement of contracts lengthy or impossible. Transaction characteristics Financing term compared to the economic life of the asset Full payout profile/minimum balloon. No grace period. Balloon more significant, but still at satisfactory levels. Important balloon with potential grace periods. Repayment in fine or high balloon. Operating risk Permits/licensing All permits have been obtained; the asset meets current and foreseeable safety regulations. All permits have been obtained or are in the process of being obtained; the asset meets current and foreseeable safety regulations. Most permits have been obtained or are in the process of being obtained, outstanding ones are considered routine, the asset meets current safety regulations. There are problems in obtaining all required permits, part of the planned configuration and/or planned operations might need to be revised. Scope and nature of O & M contracts There is a strong long-term O & M contract, preferably with contractual performance incentives and/or O&M reserve accounts (if needed). There is a long-term O & M contract and/or O & M reserve accounts (if needed). There is a limited O & M contract or O & M reserve account (if needed). There is no O & M contract and a risk of high operational cost overruns beyond mitigants. Operator’s financial strength, track record in managing the asset type and capability to re-market asset when it comes off-lease Excellent track record and strong re-marketing capability. Satisfactory track record and re-marketing capability. Weak or short track record and uncertain re-marketing capability. No or unknown track record and inability to re‑market the asset. Asset characteristics Configuration, size, design and maintenance (i.e. age, size for a plane) compared to other assets on the same market There is a strong advantage in design and maintenance. Configuration is standard such that the object meets a liquid market. The design and maintenance is above average. Standard configuration, possibly with very limited exceptions, such that the object meets a liquid market. The design and maintenance is average. Configuration is somewhat specific and thus might cause a narrower market for the object. The design and maintenance is below average. The asset is near the end of its economic life. Configuration is very specific. The market for the object is very narrow. Resale value The current resale value is well above debt value. The resale value is moderately above debt value. The resale value is slightly above debt value. The resale value is below debt value. Sensitivity of the asset value and liquidity to economic cycles The asset value and liquidity are relatively insensitive to economic cycles. The asset value and liquidity are sensitive to economic cycles. The asset value and liquidity are quite sensitive to economic cycles. The asset value and liquidity are highly sensitive to economic cycles. Strength of sponsor Operator’s financial strength, track record in managing the asset type and capability to re-market asset when it comes off-lease Excellent track record and strong re-marketing capability. Satisfactory track record and re-marketing capability. Weak or short track record and uncertain re-marketing capability. No or unknown track record and inability to re-market the asset. Sponsor’s track record and financial strength The sponsors have an excellent track record and high financial standing. The sponsors have a good track record and good financial standing. The sponsors have an adequate track record and good financial standing. The sponsors have a questionable/no track record and/or financial weaknesses. Security package Asset control Legal documentation provides the lender effective control (e.g. a first perfected security interest or a leasing structure including such security) on the asset or on the company owning it. Legal documentation provides the lender effective control (e.g. a perfected security interest or a leasing structure including such security) on the asset or on the company owning it. Legal documentation provides the lender effective control (e.g. a perfected security interest or a leasing structure including such security) on the asset, or on the company owning it. The contract provides little security to the lender and leaves room to some risk of losing control on the asset. Rights and means at the lender's disposal to monitor the location and condition of the asset The lender is able to monitor the location and condition of the asset at any time and place (regular reports, possibility to lead inspections). The lender is able to monitor the location and condition of the asset almost at any time and place. The lender is able to monitor the location and condition of the asset almost at any time and place. The lender has a limited ability to monitor the location and condition of the asset. Insurance against damages There is strong insurance coverage including collateral damages with top quality insurance companies. The insurance coverage is satisfactory (not including collateral damages) with good quality insurance companies. The insurance coverage is fair (not including collateral damages) with acceptable quality insurance companies. The insurance coverage is weak (not including collateral damages) or with weak quality insurance companies.
Table 7: Slotting criteria for commodities finance exposures
Strong Good Satisfactory Weak Financial strength Degree of over-collateralisation of trade Strong. Good. Satisfactory. Weak. Political and legal environment Country risk No country risk.
There is limited exposure to country risk (in particular, offshore location of reserves in an emerging country). There is some exposure to country risk (in particular, offshore location of reserves in an emerging country). There is strong exposure to country risk (in particular, inland reserves in an emerging country). Mitigation of country risks Very strong mitigation. Strong offshore mechanisms. Strategic commodity. Excellent buyer. Strong mitigation. Offshore mechanisms. Strategic commodity. Strong buyer. Acceptable mitigation. Offshore mechanisms. Less strategic commodity. Acceptable buyer. Only partial mitigation. No offshore mechanisms. Non-strategic commodity. Weak buyer. Asset characteristics Liquidity and susceptibility to damage The commodity is quoted and can be hedged through futures or over-the-counter (OTC) instruments. The commodity is not susceptible to damage. The commodity is quoted and can be hedged through OTC instruments. The commodity is not susceptible to damage. The commodity is not quoted but is liquid. There is uncertainty about the possibility of hedging. The commodity is not susceptible to damage. The commodity is not quoted. Liquidity is limited given the size and depth of the market. There are no appropriate hedging instruments. The commodity is susceptible to damage. Strength of sponsor Financial strength of trader Very strong, relative to trading philosophy and risks. Strong relative to trading philosophy and risks. Adequate relative to trading philosophy and risks. Weak relative to trading philosophy and risks. Track record, including ability to manage the logistic process Extensive experience with the type of transaction in question. Strong record of operating success and cost efficiency. Sufficient experience with the type of transaction in question. Above average record of operating success and cost efficiency. Limited experience with the type of transaction in question. Average record of operating success and cost efficiency. Limited or uncertain track record in general. Volatile costs and profits. Trading controls and hedging policies Strong standards for counterparty selection, hedging and monitoring. Adequate standards for counterparty selection, hedging and monitoring. Adequate standards for counterparty selection, hedging and monitoring. Past deals have experienced no or minor problems. Weak standards for counterparty selection, hedging and monitoring. Trader has experienced significant losses on past deals. Quality of financial disclosure Excellent. Good. Satisfactory. Financial disclosure contains some uncertainties or is insufficient. Security package Asset control First perfected security interest provides the lender legal control of the assets at any time if needed. First perfected security interest provides the lender legal control of the assets at any time if needed. At some point in the process, there is a rupture in the control of the assets by the lender. The rupture is mitigated by knowledge of the trade process or a third party undertaking as the case may be. Contract leaves room for some risk of losing control over the assets. Recovery could be jeopardised. Insurance against damages Insurance coverage is strong, including collateral damages with top quality insurance companies. Insurance coverage is satisfactory (not including collateral damages) with good quality insurance companies. Insurance coverage is fair (not including collateral damages) with acceptable quality insurance companies. Insurance coverage is weak (not including collateral damages) or with weak quality insurance companies.
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