Banking (prudential standard) determination No. 7 of 2022 (Cth)

Banking (prudential standard) determination No. 7 of 2022

Prudential Standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk

Banking Act 1959

I, John Lonsdale, a delegate of APRA:

(a)under subsection 11AF(3) of the Banking Act 1959 (the Act) REVOKE Banking (prudential standard) determination No. 6 of 2012, including Prudential Standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk, made under that determination; and

(b)under subsection 11AF(1) of the Act DETERMINE Prudential Standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk, in the form set out in the schedule, which applies to all ADIs and authorised NOHCs to the extent provided in paragraphs 2 to 4 of the prudential standard.

This instrument commences on 1 January 2023.

Dated: 8 December 2022

[Signed]

John Lonsdale

Chair

APRA

Interpretation

In this instrument:

APRA means the Australian Prudential Regulation Authority.

ADI and authorised NOHC have their respective meanings given in section 5 of the Act.

Schedule

Prudential Standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk comprises the document commencing on the following page.

Prudential Standard APS 113

Capital Adequacy: Internal Ratings-based Approach to Credit Risk

Objectives and key requirements of this Prudential Standard

This Prudential Standard sets out the requirements that an authorised deposit-taking institution that has, or is seeking, 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.

The key requirements of this Prudential Standard are that an authorised deposit-taking institution must:

· determine the capital requirement for a given credit exposure, within certain parameters set by APRA;

· develop and maintain rating and risk estimation systems and processes that provide for a meaningful assessment of borrower and transaction characteristics, meaningful differentiation of risk, and accurate and consistent quantitative estimates of risk; and

· ensure that systems and processes for the internal ratings-based approach to determining capital also play an integral role in the institution’s credit approval, risk management and internal capital allocation functions.

Table of Contents

Authority

Application and commencement

Interpretation

Adjustments and exclusions

Previous exercise of discretion

Scope

Definitions

Key principles

Governance and oversight

Asset classes

IRB approval

Attachment A - IRB risk-weight functions

Attachment B - Risk components for each asset class

Attachment C - Treatment of expected losses and provisions

Attachment D - Minimum requirements for the use of an IRB approach

Attachment E - Requirements for recognition of collateral and credit risk mitigation

Attachment F - Risk-weighted assets for purchased receivables

Attachment G - Supervisory slotting criteria

Authority

This Prudential Standard is made under section 11AF of the Banking Act 1959 (Banking Act).

Application and commencement

This Prudential Standard applies to authorised deposit-taking institutions (ADIs) that are seeking, or have been approved, to use an internal ratings-based (IRB) approach to credit risk for the purpose of determining the Regulatory Capital requirement for credit risk.

A reference to an ADI in this Prudential Standard, unless otherwise indicated, is 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.

If an ADI to which this Prudential Standard applies is:

(a)the holding company for a group, the ADI must ensure that the requirements in this Prudential Standard are met on a Level 2 basis, where applicable; or

(b)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.

This Prudential Standard commences on 1 January 2023.

Interpretation

Terms that are defined in Prudential Standard APS 001 Definitions appear in bold the first time they are used in this Prudential Standard.

Where this Prudential Standard provides for APRA to exercise a power or discretion, the power or discretion is to be exercised in writing.

In this Prudential Standard, unless the contrary intention appears, a reference to an Act, Regulations or Prudential Standard, is a reference to the Act, Regulations or Prudential Standard as in force from time to time.

Adjustments and exclusions

APRA may adjust or exclude a specific prudential requirement in this Prudential Standard in relation to one or more specified ADIs or authorised NOHCs.[1]
[1] Refer to subsection 11AF(2) of the Banking Act.

Previous exercise of discretion

An ADI must contact APRA if it seeks to place reliance, for the purposes of complying with this Prudential Standard, on a previous exemption or other exercise of discretion by APRA under a previous version of this Prudential Standard.

Scope

The following items are excluded from the scope of this Prudential Standard:

(a)non-standard retail residential mortgage exposures,[2] equity exposures, margin lending exposures, cash items, fixed assets, unsettled and failed transactions, and related-party exposures that are subject to the requirements of Prudential Standard APS 112 Capital Adequacy: Standardised Approach to Credit Risk (APS 112);
[2] For this purpose, a non-standard retail residential mortgage exposure refers to an exposure in the retail residential mortgage sub-asset class (as defined in this Prudential Standard) that is classified as a non-standard loan according to APS 112.

(b)assets or investments that are required to be deducted from Common Equity Tier 1 Capital, Tier 1 Capital or Total Capital under Prudential Standard APS 111 Capital Adequacy: Measurement of Capital (APS 111);

(c)securitisation exposures that are subject to the requirements of Prudential Standard APS 120 Securitisation (APS 120), excluding funding-only or synthetic securitisations for which an ADI must include the underlying exposures in the pool in its calculation of the Regulatory Capital requirement for credit risk under this Prudential Standard;

(d)liabilities of a covered bond special purpose vehicle to an issuing ADI as specified in Prudential Standard APS 121 Covered Bonds (APS 121); and

(e)items that are subject to capital requirements under Prudential Standard APS 116 Capital Adequacy: Market Risk (APS 116) which do not have a counterparty credit risk exposure under Prudential Standard APS 180 Capital Adequacy: Counterparty Credit Risk (APS 180).

Subject to paragraph 13 of this Prudential Standard, an ADI must apply the requirements set out in this Prudential Standard to calculate risk-weighted assets (RWA) and expected loss (EL) for any exposures of overseas banking subsidiaries that form part of the Level 2 group.

For the purpose of calculating the Level 2 Regulatory Capital requirement for exposures of an overseas banking subsidiary that is prudentially regulated by a prescribed New Zealand authority, an ADI must calculate RWA and EL using the prescribed New Zealand authority’s equivalent prudential rules as in force from time to time except that, in calculating RWA, the ADI must not apply the prescribed New Zealand authority’s:[3]
[3]prescribed New Zealand authority has the meaning given in subsection 5(1) of the Banking Act.

(a)scaling factor that is equivalent to paragraph 2 of Attachment A to this Prudential Standard, and instead must only apply a scaling factor of 1.1; and

(b)floor value and calculation that is equivalent to paragraph 4 of Attachment A to Prudential Standard APS 110 Capital Adequacy (APS 110), and instead must only apply the floor value and calculation in APS 110.

Definitions

The following definitions are used in this Prudential Standard:

(a)capital requirement (K) – means the capital requirement for unexpected loss derived from inputting the risk components to the risk-weight functions;

(b)commitment – has the meaning given in APS 112;

(c)commodities finance – has the meaning given in APS 112;

(d)corporate exposure – has the meaning given in paragraph 30 of this Prudential Standard;

(e)credit conversion factor (CCF) – means the percentage value used to convert an off-balance sheet exposure into an on-balance sheet equivalent;

(f)credit obligation – means 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;

(g)credit risk mitigation (CRM) – means a credit risk mitigation technique that meets the requirements detailed in Attachment E to this Prudential Standard and APS 112 where applicable;

(h)defaulted exposure – means a non-performing exposure as defined in Prudential Standard APS 220 Credit Risk Management (APS 220);

(i)dilution risk – means the possibility that the total amount of purchased receivables is reduced through cash or non-cash credits to the receivables’ obligors;

(j)effective maturity (M) – means the remaining effective term of a credit obligation;

(k)expected loss (EL) – means the average credit loss that the ADI is reasonably expected to experience;

(l)exposure at default (EAD) – means the gross exposure (including accrued interest) under a facility (i.e. the amount that is legally owed to the ADI) upon the default of a borrower;

(m)financial institution – has the meaning given in paragraph 34 of this Prudential Standard;

(n)group of connected borrowers – means a group of connected counterparties that is connected by control or single-risk relationships under Prudential Standard APS 221 Large Exposures (APS 221). Where an ADI assesses that a borrower may form part of more than one group of connected borrowers, the ADI may primarily assign the borrower based on a control relationship rather than a single-risk relationship for the purpose of this Prudential Standard;

(o)income-producing real estate (IPRE) – has the meaning given in paragraph 31 of this Prudential Standard;

(p)large corporate – means a corporate counterparty with total consolidated annual revenue greater than $750 million as reported in the audited financial statements of the corporate counterparty or, where the counterparty is part of a group, the audited financial statements of the group. The revenue amount must be based on the average amount calculated over the prior three years, or on the latest amount updated at least every three years by the ADI;

(q)lenders’ mortgage insurance (LMI) – has the meaning given in APS 112;

(r)loss given default (LGD) – means the ADI’s economic loss upon the default of a borrower;

(s)object finance – has the meaning given in APS 112;

(t)probability of default (PD) – means the risk of borrower default;

(u)project finance – has the meaning given in APS 112;

(v)purchased receivables – means a pool of receivables that has been purchased by the ADI from another entity;

(w)rating system – means 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;

(x)regulated financial institution – means a financial institution that is subject to prudential requirements that are broadly equivalent to APRA’s prudential requirement, or is part of a group where any material legal entity within the group is subject to prudential requirements that are broadly equivalent to those set by APRA;

(y)revolving exposure – means an exposure where a borrower’s outstanding balance is permitted to fluctuate based on their decision to borrow and repay, up to a limit established by the ADI. This does not include exposures that allow prepayments and subsequent redraws of those prepayments;

(z)risk component – means the ADI’s internal estimate, or a supervisory estimate provided in this Prudential Standard, of probability of default, loss given default, exposure at default or effective maturity required as inputs to the risk-weight functions;

(aa)risk-weight function – means the calculation method that transforms the risk components into the capital requirement for unexpected loss;

(bb)securities financing transaction (SFT) – has the meaning given in APS 112;

(cc)sovereign – has the meaning given in APS 112;

(dd)specialised lending – has the meaning given in APS 112 but also includes IPRE as defined in this Prudential Standard;

(ee)unexpected loss (UL) – means the credit loss in excess of expected loss; and

(ff)unregulated financial institution – means a financial institution that is not a regulated financial institution.

Key principles

An ADI that has received IRB approval from APRA may rely on its internal estimates for some, or all, of the risk components required as inputs to the risk-weight functions used in determining the Regulatory Capital requirement for credit exposures. The risk components include measures of PD, LGD, EAD and M.

An ADI must meet the relevant minimum requirements detailed in this Prudential Standard to use an IRB approach for a given asset class.

An ADI must apply a foundation IRB (FIRB), advanced IRB (AIRB), retail IRB or supervisory slotting approach to a given asset class in accordance with its IRB approval and subject to the constraints set out in paragraph 18 of this Prudential Standard. Where the ADI uses the:

(a)FIRB approach, it must provide its own estimates of PD and M, and rely on supervisory estimates for LGD and EAD;

(b)AIRB approach, it must provide its own estimates of PD, LGD (excluding senior unsecured and subordinated corporate exposures for which the ADI must use supervisory LGD estimates) and M, and rely on supervisory estimates for EAD;

(c)retail IRB approach, it must provide its own estimates of PD, LGD and EAD (excluding non-revolving retail exposures for which the ADI must use supervisory EAD estimates); and

(d)supervisory slotting approach, it must provide its own mapping of credit exposures to the supervisory slotting categories, and rely on supervisory risk weights for the slotting categories and supervisory estimates for EAD.

Under all approaches, the ADI must use the relevant IRB risk-weight function or schedule, as detailed in Attachment A to this Prudential Standard, to derive RWA for UL and the approach detailed in Attachment C to this Prudential Standard to derive EL.

An ADI must apply the:

(a)FIRB approach to all sovereign, financial institution and large corporate exposures, except IPRE exposures that meet the definition of a large corporate exposure where the ADI may apply a FIRB or supervisory slotting approach in accordance with its IRB approval;

(b)retail IRB approach to all retail exposures; and

(c)supervisory slotting approach to all project finance, object finance and commodities finance exposures.

An ADI may reduce its Regulatory Capital requirement through the use of CRM where it meets the requirements detailed in Attachments B, E and F to this Prudential Standard, and APS 112 where applicable.

Governance and oversight

All material aspects of an ADI’s rating and estimation processes must be approved by the ADI’s Board, or relevant Board committee, 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 Board committee, of material changes or exceptions from established policies that could have a material impact on the ADI’s rating systems.

Senior management must understand the design and operation of an ADI’s rating systems and approve any material differences identified between established procedures and actual practice. Senior management must ensure that the rating systems are operating as intended on an ongoing basis. Senior management and staff in the credit risk control function 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:

(a)risk profile by grade;

(b)migration across borrower grades;

(c)quantitative estimates of the relevant parameters for each borrower grade and, where relevant, facility grade; and

(d)comparison of realised default rates (and, where relevant, realised LGD and EAD rates) against expectations.

Reporting frequencies may vary with the significance and type of information and the level of the recipients.

An ADI must have documented policies that detail sound rating system development, validation, implementation, governance and control processes. These policies must:

(a)be approved and actively discussed by the ADI’s Board or a delegated committee;

(b)define the roles and responsibilities of parties involved in rating system development, validation, approval and implementation;

(c)be actively enforced by senior management;

(d)outline the processes for the development, validation, approval, implementation and governance of all rating and estimation processes. This must include the formation of:

(i) a register that documents the specification, application, risk classification (materiality) and owner of each rating system;

(ii) a change log covering all rating system changes; and

(iii) a centralised issues register that records issues relating to each rating system; and

(e)outline an ongoing monitoring and validation cycle for each rating system.

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 borrower and facility grades, and pools;

(b)production and analysis of summary reports from the ADI’s rating systems, including historical default data sorted by the 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 business units 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.

In order to ensure proper accountability, an ADI’s policies must clearly define and document the responsibilities of, and performance standards for, personnel within the credit risk control unit. Personnel must have the appropriate incentives to meet their performance standards and the knowledge, skills, tools and resources necessary to carry out their responsibilities.

Independent review

An ADI’s rating systems and operations must be reviewed at least annually by internal audit or an equally independent function. The review must assess whether the ADI’s development, implementation, validation, governance and control processes are effective and operating as designed. The areas of review must include:

(a)the operations of the credit risk control function;

(b)the estimation of PD and, where relevant, LGD and EAD; and

(c)the ADI’s adherence to all applicable minimum requirements detailed in this Prudential Standard.

The findings of this review must be documented.

Asset classes

For the purpose of deriving the Regulatory Capital requirement under an IRB approach, an ADI must assign its banking book exposures to one of the following IRB asset classes:

(a)corporate (which includes the four sub-asset classes of specialised lending);

(b)sovereign;

(c)financial institution; and

(d)retail (which consists of four separate sub-asset classes).

An ADI must ensure that its methodology for assigning credit exposures to different IRB asset classes complies with its IRB approval and is consistent over time.

Definition of corporate exposures

The corporate IRB asset class includes all credit exposures to corporate counterparties and public sector entities, including exposures within the four specialised lending sub-asset classes of project finance, object finance, commodities finance and IPRE. A corporate exposure means a credit obligation of a corporation, partnership, proprietorship or public sector entity, or any other credit exposure that does not meet the criteria of any other defined IRB asset class.

Income-producing real estate

IPRE means a method of providing funding for real estate where the prospects for repayment of the exposure depend primarily on the cash flows generated by the asset or other real estate assets owned by the borrower.

In order to treat an exposure as a general corporate exposure rather than IPRE, an ADI must have recourse to a borrower that meets all of the following criteria:

(a)the borrower is a corporate entity that is managed by a recognised, professional and reputable management team;

(b)the ADI’s exposure to the borrower is not specifically or substantially financing limited recourse development projects;

(c)the borrower has greater than $250 million in tangible assets, to which the ADI has unconditional recourse;

(d)real estate assets are sufficiently diversified such that:

(i) no single asset represents greater than 25 per cent of the borrower’s real estate portfolio by value; and

(ii) real estate assets are not concentrated in one particular specific geographic location; and

(e)for real estate operators or investors, tenants are sufficiently diversified such that no single tenant represents:

(i) greater than 25 per cent of portfolio net rental income for portfolios of retail shopping centres that typically require significant anchor tenants to attract speciality tenants; and

(ii) greater than 10 per cent of portfolio net rental income for all other portfolios of real estate assets (e.g. commercial offices, industrial buildings, hotels), with the exception of Government tenants.

Definition of sovereign exposures

The sovereign IRB asset class includes all credit exposures to sovereign counterparties as defined in APS 112.

Definition of financial institution exposures

The financial institution IRB asset class includes all credit exposures to financial institution counterparties. A financial institution means a legal entity whose main business includes: the management of financial assets, lending, factoring, leasing, provision of credit enhancements, securitisation, investments, financial custody, central counterparty services, proprietary trading. APRA may also determine other activities to be financial in nature. Financial institutions include, but are not limited to, banks, securities firms, insurance companies and leveraged funds.

Definition of retail exposures

The retail IRB asset class includes any exposure that:

(a)is extended to an individual (that is, a natural person) or individuals; and

(b)forms part of a large pool of exposures that is managed by the ADI on a pooled basis.

Small-business exposures or exposures secured by residential real estate, whether or not extended to an individual, may be classified as retail exposures where they satisfy the criteria in paragraphs 37 or 40 of this Prudential Standard, respectively.

An ADI must assign its retail exposures to either the retail residential mortgage, qualifying revolving retail (QRR), small- and medium-sized enterprise (SME) retail or other retail sub-asset classes.

Retail residential mortgage

The retail residential mortgage IRB sub-asset class includes exposures that are:

(a)partly or fully secured by residential real estate;

(b)managed in a similar manner to other retail exposures; and

(c)not for business purposes.

Qualifying revolving retail

The QRR IRB sub-asset class includes exposures that satisfy the following criteria:

(a)the exposures are revolving, unsecured and unconditionally cancellable (both contractually and in practice) by the ADI. 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 borrower at the ADI’s discretion, and demand immediate repayment for any outstanding balance to the full extent allowable under consumer protection and related legislation;

(b)the exposures are to individuals and not for business purposes;

(c)the maximum exposure of an individual account in the sub-portfolio is $100,000; and

(d)the exposures exhibit, in comparison with other types of retail lending products, low loss rate volatility relative to the average level of loss rates (especially within low PD bands).

QRR exposures must be further split into exposures to transactors and revolvers. For this purpose:

(a)a QRR transactor is a borrower that has repaid the balance of their facility in full at each scheduled repayment date for the previous 12 months; and

(b)a QRR revolver is a borrower that does not meet the criteria for treatment as a QRR transactor. An ADI must treat any QRR exposure with less than 12 months of repayment history as an exposure to a QRR revolver.

Small- and medium-sized enterprise retail

The SME retail IRB sub-asset class includes exposures that meet the following criteria:

(a)the total business-related exposure of the ADI to a small-business borrower or group of connected borrowers is less than $1.5 million. Small-business exposures extended to, or guaranteed by, an individual are subject to the same exposure threshold. For a subsidiary of the ADI operating in a jurisdiction that applies a different threshold for SME retail, as set by the overseas prudential regulator, the ADI may apply that jurisdiction’s threshold for the calculation of its Level 2 Regulatory Capital requirement for the relevant exposures;

(b)the reported consolidated annual revenue of a small-business borrower or group of connected borrowers is less than $75 million;

(c)both the borrower and exposure are non-complex; and

(d)the ADI treats small-business exposures in its internal risk management systems in the same manner as other retail exposures consistently over time. This requires that such exposures:

(i) are originated in a similar manner to other retail exposures; and

(ii) 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 the purposes of risk assessment and quantification. This does not preclude these exposures from being managed individually at some stages of the risk management process.

Other retail

The other retail IRB sub-asset class includes all other retail exposures.

IRB approval

APRA may approve an ADI to use an IRB approach for Regulatory Capital purposes. APRA may impose conditions on the ADI’s use of an IRB approach for Regulatory Capital purposes.

An ADI must obtain prior approval from APRA to use an IRB approach for Regulatory Capital purposes. Where APRA approves the use of an IRB approach, it will specify how the IRB approach applies in relation to the ADI.

Initial approval

In its initial application to use an IRB approach, an ADI must seek IRB approval for all material asset classes and business units of the ADI. The ADI must demonstrate that it complies with the minimum requirements of this Prudential Standard for the relevant IRB asset classes or sub-asset classes, and has been using rating systems and risk components that are broadly in line with the requirements of this Prudential Standard for at least three years prior to an IRB approval being given.[4]
[4] Improvements to an ADI’s rating systems or risk components will not render it non-compliant with this three-year requirement.

In its initial application to use an IRB approach, an ADI must, unless determined otherwise by APRA, also seek approval to use an internal risk measurement model for the purpose of determining the Regulatory Capital requirement for interest rate risk in the banking book as set out in Prudential Standard APS 117 Capital Adequacy: Interest Rate Risk in the Banking Book.

In addition to credit exposures for which an ADI must use the standardised approach to credit risk, APRA may permit the ADI to use a combination of an IRB approach and the standardised approach for Regulatory Capital purposes. This approach is referred to as ‘partial use’. Partial use may apply on a temporary or permanent basis.

An ADI seeking approval to adopt partial use must provide APRA with information on any business activities for which the ADI proposes to use the standardised approach to credit risk. This information must be provided both at the time of the ADI’s initial application for the use of an IRB approach and subsequent to the ADI obtaining IRB approval.

Phased roll-out

Where it is not practical for an ADI to implement an IRB approach across all material asset classes and business units at the same time, APRA may approve a phased roll-out of an IRB approach by the ADI. A phased roll-out is where the ADI, in accordance with a specified timetable:

(a)adopts an IRB approach across asset classes within a particular business unit;

(b)adopts an IRB approach across business units in the Level 2 group;

(c)moves from the FIRB approach to the AIRB approach, where the use of the AIRB approach is permitted; and

(d)moves from the supervisory slotting approach to the FIRB or AIRB approach for IPRE.

However, where the ADI adopts an IRB approach for an asset class or sub-asset class within a particular business unit, it must apply that IRB approach to all exposures in that asset class or sub-asset class within that business unit.

An ADI that has received approval to adopt a phased roll-out of an IRB approach must have an implementation plan in place that specifies the extent and timing of roll-out of the IRB approach across all significant asset classes or sub-asset classes and business units.

During the roll-out period:

(a)a significant portion (at APRA’s discretion) of any expected Regulatory Capital benefit from initial IRB approval may only become available after obtaining final approval. APRA may vary this percentage during the period from initial to final approval to reflect APRA’s assessment of the ADI’s ability to progress to final approval; and

(b)no capital relief will be granted for intra-group transactions that reduce an 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

APRA will approve permanent partial use of an IRB approach only in exceptional circumstances. An ADI seeking such approval must be able to demonstrate that the relevant business activities to which an IRB approach does not apply are immaterial in terms of size and perceived risk profile.

Ongoing requirements

An ADI that has obtained IRB approval must seek prior approval from APRA where it intends to make:

(a)changes to its rating systems that will result in a material change in RWA for a given type of exposure; or

(b)a significant change to its modelling assumptions.

An ADI that has obtained IRB approval must continue to employ that IRB approach on an ongoing basis except to the extent that the IRB approval is revoked or suspended for some or all of the ADI’s operations. A return to the standardised approach to credit risk, 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, vary or revoke an IRB approval, or impose additional conditions on the IRB approval if it considers that:

(a)an ADI is not complying with this Prudential Standard; or

(b)it is appropriate, having regard to the particular circumstances of the ADI.

Where APRA has varied or revoked an IRB approval, it may require the ADI to apply the standardised approach to credit risk for some or all of its operations, until it meets the conditions specified by APRA for returning to an IRB approach.

APRA may 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 an IRB approach is not commensurate with its credit risk profile.

If an ADI becomes aware that it is not complying with a requirement of this Prudential Standard, it must notify APRA and provide a plan for its timely return to compliance.

Attachment A - IRB risk-weight functions

An ADI must apply the risk-weight functions and schedules set out in this Attachment to calculate RWA for UL for corporate, sovereign, financial institution and retail exposures. In calculating RWA:

(a)PD and LGD are expressed as percentages;

(b)EAD is expressed in Australian dollars;

(c)ln denotes the natural logarithm;

(d)N(x) denotes the cumulative distribution function for a standard normal random variable (i.e. the probability that a normal random variable with mean zero and variance of one is less than or equal to x); and

(e)G(z) denotes the inverse cumulative distribution function for a standard normal random variable (i.e. the value of x such that N(x) = z).

To determine total RWA under an IRB approach, the ADI must sum:

(a)RWA for UL for all IRB asset classes, aside from those exposures excluded in (b) and (c) below, and multiply the amount by a scaling factor of 1.1;

(b)RWA for UL for exposures under the supervisory slotting approach; and

(c)RWA for UL for aggregate residual value of lease exposures which are risk weighted according to Table 2 of this Attachment.

Risk-weighted assets for corporate, sovereign and financial institution exposures

Except where the supervisory slotting approach applies to specialised lending exposures, an ADI must calculate RWA for corporate, sovereign and financial institution exposures using assigned estimates of PD, LGD, EAD and M for a given exposure. These estimates must be calculated in accordance with Attachments B and D to this Prudential Standard.

For non-defaulted corporate, sovereign and financial institution exposures, the calculation of RWA for UL is:

Correlation (R) =

Maturity adjustment (b) =

Capital requirement (K) =

RWA = K × 12.5 × EAD

If the K calculation results in a negative capital requirement, an ADI must apply a zero capital requirement for that exposure.

An ADI must set the asset value correlation multiplier (AVCM) equal to 1. However, where the exposure is to a financial institution and either of the below conditions are met, the ADI must set AVCM equal to 1.25:

(a)where the exposure is to a regulated financial institution that has total assets of greater than or equal to $125 billion. For the purpose of determining total assets, an ADI must use the amounts as reported in the most recent audited financial statements of the financial institution, or where the financial institution forms part of a group, the audited financial statements of the group; or

(b)where the exposure is to an unregulated financial institution regardless of size.

Firm-size adjustment for small- and medium-sized enterprises

Where corporate counterparties form part of a group of connected borrowers that has reported consolidated annual revenue of less than $75 million, an ADI may apply an adjustment to the corporate risk-weight function by substituting the following correlation formula for that in paragraph 4 of this Attachment:

Correlation (R) =

where:

S is expressed as total consolidated annual revenue between $7.5 million and $75 million. S has a minimum value of $7.5 million.

Where revenue data is unavailable, an ADI must apply the following minimum values:

(a)$45 million where EAD is less than $5 million; and

(b)$75 million where EAD is greater than or equal to $5 million.

Risk-weighted asset adjustment for income-producing real estate

For non-defaulted IPRE exposures subject to the FIRB or AIRB approach, the calculation of RWA for UL is:

RWA = K × 12.5 × EAD × 1.5

Risk-weighted assets for specialised lending exposures subject to the supervisory slotting approach

For non-defaulted specialised lending exposures subject to the supervisory slotting approach, an ADI must map its internal rating grades for those exposures to the slotting categories of strong, good, satisfactory and weak by applying the criteria detailed in Attachment G to this Prudential Standard.

To calculate RWA in respect of UL for non-defaulted specialised lending exposures subject to the supervisory slotting approach, an ADI must multiply EAD, calculated in accordance with Attachment B to this Prudential Standard, by the relevant risk weight in Table 1.

Table 1Risk weights for UL under the supervisory slotting approach

Supervisory category	Strong	Good	Satisfactory	Weak
Risk weight	70%	90%	115%	250%

Risk-weighted assets for retail exposures

An ADI must calculate RWA for retail exposures using assigned estimates of PD, LGD and EAD for a given exposure, calculated in accordance with Attachments B and D to this Prudential Standard.

Retail residential mortgage exposures

For non-defaulted retail residential mortgage exposures, the risk-weight function is:

Correlation (R) = 0.15

Capital requirement (K) =

This risk-weight function also applies to the unsecured portion of exposures that are partly secured by residential real estate.

For non-defaulted retail residential mortgage exposures that meet the definition of an owner-occupied, principal-and-interest residential mortgage exposure as detailed in Attachment A to APS 112, the calculation of RWA for UL is:

RWA = EAD × Max[K × 12.5 × 1.4, 0.05]

For non-defaulted retail residential mortgage exposures to borrowers that have mortgaged five or more investment properties,[5] the calculation of RWA for UL is:

RWA = EAD × Max[K × 12.5 × 2.5, 0.05]

For all other non-defaulted retail residential mortgage exposures, the calculation of RWA for UL is:

RWA = EAD × Max[K × 12.5 × 1.7, 0.05]

[5] This excludes the owner-occupied exposure of the borrower.

Qualifying revolving retail exposures

For non-defaulted QRR exposures, the calculation of RWA for UL is:

Correlation (R) = 0.04

Capital requirement (K) =

Risk-weighted assets (RWA) = K × 12.5 × EAD

Small- and medium-sized enterprise retail exposures

For non-defaulted SME retail exposures that are fully or partly secured by residential real estate, the calculation of RWA for UL is:

Correlation (R) = 0.15

Capital requirement (K) =

Risk-weighted assets (RWA) = K × 12.5 × EAD

This RWA calculation also applies to the unsecured portion of SME retail exposures that are partly secured by residential real estate.

For all other non-defaulted SME retail exposures, the calculation of RWA for UL is:

Correlation (R) =

Capital requirement (K) =

Risk-weighted assets (RWA) = K × 12.5 × EAD

Other retail exposures

For all other non-defaulted retail exposures, the calculation of RWA for UL is:

Correlation (R) =

Capital requirement (K) =

Risk-weighted assets (RWA) = K × 12.5 × EAD

Risk-weighted assets for lease exposures

Lease exposures are defined in APS 112. Leases, other than those that expose an ADI to residual value risk, may be treated in the same manner as exposures secured by the relevant collateral.[6] The ADI may use its own estimates of LGD if it uses the AIRB approach. Where the ADI uses the FIRB approach, the minimum requirements in relation to eligible collateral must be met as detailed in Attachment E to this Prudential Standard.
[6] Residual value risk means 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.

For leases that expose an ADI to residual value risk, the discounted lease payment stream must be risk weighted according to the PD and LGD the ADI assigns to the lessee, and the aggregate residual value of all lease exposures must be risk weighted according to Table 2.

Table 2Risk weights for residual value under lease exposures

Risk weight (%) applying to the portion of aggregate residual value ≤ 10% of Tier 1 capital	Risk weight (%) applying to the portion of aggregate residual value > 10% of Tier 1 capital
Exposures to residual value	100	250

Risk-weighted assets for defaulted exposures

K in respect of UL for a defaulted exposure under the AIRB or retail IRB approach is equal to the greater of zero and the amount by which the LGD estimate for that exposure exceeds an ADI’s best estimate of EL given current economic circumstances and the facility’s status. The calculation of RWA for UL is:

RWA = K × 12.5 × EAD

RWA and K in respect of UL for a defaulted exposure under the FIRB or supervisory slotting approach is zero.

Attachment B – Risk components for each asset class

An ADI must calculate the risk components PD, LGD, EAD and M in accordance with the requirements detailed in this Attachment. An ADI that uses its own PD, LGD and EAD estimates for Regulatory Capital purposes must also meet the minimum requirements detailed in Attachment D to this Prudential Standard.

Where an exposure is guaranteed by a sovereign, and the guarantee meets the requirements set out in Attachment E to this Prudential Standard, the floors that apply to the risk components do not apply to the portion of the exposure that is covered by the sovereign guarantee.

Probability of default estimates

Subject to the exceptions set out in paragraphs 4 and 5 of this Attachment, PD is the greater of the PD estimate associated with the internal borrower grade or pool to which an exposure is assigned and 0.05 per cent.

For QRR exposures, PD is the greater of:

(a)the PD estimate associated with the internal borrower grade or pool to which an exposure is assigned; and

(b)0.1 per cent for QRR revolvers or 0.05 per cent for QRR transactors.

For sovereign exposures, PD is the PD estimate associated with the internal borrower grade to which an exposure is assigned.

An ADI must assign a 100 per cent PD to defaulted exposures.

Loss given default estimates

LGD estimates must be measured as a percentage of EAD.

Senior unsecured exposures and senior exposures secured by ineligible collateral under the FIRB approach

Subject to the exceptions set out in paragraphs 9 to 11 of this Attachment, an ADI that uses the FIRB approach must assign a 50 per cent LGD to all senior exposures that are not secured by eligible collateral. For this purpose, eligible collateral is collateral that meets the minimum requirements detailed in Attachment E to this Prudential Standard.

Where an ADI uses the FIRB approach, it may assign lower LGD estimates to eligible senior exposures to sovereign counterparties, which are not secured by eligible collateral, using the ratings of external credit assessment institutions (ECAIs). Where the ECAI is S&P Global Ratings, Moody’s or Fitch Ratings, ratings and the relevant LGD must be mapped in accordance with Table 3. Where a sovereign exposure has multiple ECAI ratings that correspond to multiple credit rating grades, the ADI must apply the requirements detailed in paragraph 6 of Attachment F to APS 112. The ADI must apply the due diligence requirements in Attachment F of APS 112 when using the ratings of ECAIs.

Table 3 LGD estimates for eligible sovereign exposures

S&P Global Ratings	Moody’s	Fitch Ratings	LGD (%)
Credit rating grade of sovereign exposure	AAA AA+ AA AA-	Aaa Aa1 Aa2 Aa3	AAA AA+ AA AA-	5
Credit rating grade of sovereign exposure	A+ A	A1 A2	A+ A	25
Unrated exposure to an Australian local council				25

Where an ADI uses the FIRB approach, it may assign a 25 per cent LGD to senior exposures to operators of domestic large public infrastructure assets or utilities that:

(a)provide essential services to the economy; and

(b)have tripartite arrangements with the Australian Government or an Australian State or Territory government, or are valued based on regulatory asset base.

Where an ADI applies the FIRB approach, it may use the supervisory LGD estimates and collateral haircuts detailed in Table 4 as inputs to the LGD calculation for senior exposures that are not secured by eligible collateral but have eligible recovery value. The LGD must be calculated in accordance with the methodology detailed in paragraph 16 to 18 of this Attachment, where the LGD for the secured portion (LGD_Si) is as specified in Table 4 and the LGD for the unsecured portion (LGD_U) is as specified in paragraph 8 of this Attachment.

Table 4 Supervisory LGD estimates and collateral haircuts for exposures with eligible recovery value

LGD

(%)

H_C

(%)

Physical collateral that does not meet the minimum requirements detailed in Attachment E to this Prudential Standard

Corporate: 40

Sovereign or financial institution: 45

Australian water entitlements

Senior unsecured exposures under the AIRB approach

An ADI that uses the AIRB approach must apply a 50 per cent LGD to all senior unsecured exposures, except in the case of senior exposures to operators of domestic large public infrastructure assets or utilities that meet the requirements detailed in paragraph 10 of this Attachment where the ADI may apply a 25 per cent LGD. The ADI must have a documented policy that details its definition of a senior unsecured exposure.

Subordinated debt

An ADI must assign a 75 per cent LGD to all subordinated debt, aside from junior liens over commercial real estate or residential real estate that meet the eligibility criteria for recognition as eligible collateral as specified in Attachment E to this Prudential Standard. The ADI must have a documented policy that details its definition of subordination. At a minimum, the definition must include any facility that is expressly subordinated to another facility and also address economic subordination.

Exposures secured by eligible collateral under the FIRB approach

Where an ADI applies the FIRB approach, it must use the supervisory LGD estimates and collateral haircuts detailed in Table 5 as inputs to the LGD calculation for exposures secured by eligible collateral.

Table 5Supervisory LGD estimates and collateral haircuts for exposures secured by eligible collateral

LGD (%)	H_C (%)
Eligible financial collateral	0	APS 112 comprehensive approach
Eligible receivables	20	40
Eligible residential real estate or commercial real estate	20	40
Other eligible physical collateral	25	40

For eligible financial collateral, an ADI must apply the haircuts calculated under the comprehensive approach as set out in Attachment G to APS 112. These haircuts must be adjusted for different holding periods and non-daily remargining or revaluation as detailed in that Attachment.

Methodology for recognition of eligible collateral

Where an ADI uses the FIRB approach, the LGD applicable to a collateralised transaction must be calculated as the exposure-weighted average of the LGD for the unsecured portion (LGD_U) and the LGD for the collateralised portion (LGD_Si). Specifically:

where:

· E is the committed amount. In the case of securities lent or posted, the exposure value must be increased by applying the appropriate haircuts (H_E) according to the comprehensive approach for the recognition of financial collateral as detailed in Attachment G to APS 112.

· E_Siis the current value of the collateral after applying the appropriate haircuts for the type of collateral (H_C) and for any currency mismatch between the exposure and the collateral. The sum of E_Si across all collateral types must be capped at the value of .

For the purpose of determining E_Sifor an exposure with a junior lien, the ADI must apply the appropriate haircuts to the value of the collateral and then reduce it by the sum of all exposures with liens that rank higher than the junior liens. In cases where liens are held by third parties that rank pari passu with the lien of the ADI, only the proportion of the value of the collateral (after the application of haircuts and reductions due to exposures with liens that rank higher than the lien of the ADI) that is attributable to the ADI may be recognised.

· . The terms E_Uand E_Siare only used to calculate the LGD applicable to the collateralised transaction. The ADI must continue to calculate EAD without taking into account the presence of any collateral, unless specified otherwise.

· LGD_U is the LGD applicable to an unsecured exposure as set out in paragraphs 8 to 10 and 13 of this Attachment.

· LGD_Si is the LGD applicable to an exposure secured by that type of collateral as set out in paragraphs 11 and 14 of this Attachment.

Where eligible collateral is denominated in a different currency to that of the exposure, an ADI must apply a haircut for currency risk (H_fx) in accordance with the requirements for the comprehensive approach as detailed in Attachment G to APS 112.

For the purpose of calculating the LGD applicable to a sovereign exposure that is secured by eligible collateral, where applicable, an ADI is permitted to adopt the lower of the:

(a)relevant LGD specified in paragraph 9 of this Attachment; and

(b)LGD determined in accordance with paragraph 16 to 17 of this Attachment.

Corporate exposures under the AIRB approach

For corporate exposures subject to the AIRB approach, the LGD for each secured or partially secured exposure that is used as an input to the risk-weight function and the calculation of EL must not be less than the floors detailed in Table 6. However, the floor does not apply to the best estimate of EL for defaulted exposures.

Table 6LGD floors for corporate exposures

Collateral type
LGD

(%)

Secured

Financial collateral 0

Receivables 10

Commercial or residential real estate 10

Other physical collateral 15

All other collateral 25

Unsecured 25

The LGD floors for secured exposures specified in Table 6 must be applied where an exposure is fully secured (i.e. the value of collateral after applying the haircuts specified in Table 5 exceeds the value of the exposure).

The LGD floor for a partially secured exposure must be calculated as the exposure-weighted average of the LGD floor for the unsecured portion and the LGD floor for the secured portion. The following formula must be used for this purpose:

where:

· LGD_{U floor} and LGD_{S floor} are the floor values for unsecured and fully secured exposures as specified in Table 6.

· The other terms are as defined in paragraphs 14 and 16 of this Attachment.

Retail exposures

For retail exposures, the LGD for each exposure that is used as an input to the risk-weight function and the calculation of EL must not be less than the floors detailed in Table 7. However, the floor does not apply to the best estimate of EL for defaulted exposures.

Table 7LGD floors for retail exposures

Exposure type
LGD

(%)

Retail residential mortgage 10

Other secured

Financial collateral 0

Receivables 10

Commercial or residential real estate 10

Other physical collateral 15

All other collateral 30

Unsecured

QRR 50

All other unsecured 30

The LGD floors for secured exposures specified in Table 7 must be applied where an exposure is fully secured (i.e. the value of collateral after applying the haircuts specified in Table 5 exceeds the value of the exposure).

The LGD floor for a partially secured retail exposure must be calculated according to the formula set out in paragraph 21 of this Attachment, aside from the LGD floor for a retail residential mortgage exposure, which is fixed irrespective of the level of collateral provided.

An ADI that has approval to use its own estimates of LGD for retail residential mortgage exposures must not take into account recoveries from LMI when deriving those LGD estimates. The ADI may instead recognise the risk-mitigating effect of LMI by applying a 20 per cent reduction to its LGD estimates (subject to the floor specified in Table 7) for exposures with a loan-to-valuation ratio, as defined in APS 112, of greater than 80 per cent that have LMI cover.

An ADI that is not approved to use its own estimates of LGD for retail residential mortgage exposures or SME retail exposures secured by residential real estate must apply a 20 per cent LGD floor in place of the floor specified in Table 7.

Exposure at default estimates

EAD in respect of each exposure (both on-balance sheet and off-balance sheet) must be measured without deducting any provisions for, and partial write-offs of, that exposure.

On-balance sheet exposures

Subject to paragraph 31 of this Attachment, EAD for a drawn amount (i.e. an on-balance sheet exposure) must not be less than the current contractual amount owed by the borrower nor should it be less than the sum of:

(a)the amount by which an ADI’s Common Equity Tier 1 Capital would be reduced if the exposure were fully written-off; and

(b)any associated provisions and partial write-offs.

When the difference between EAD and the sum of the amounts specified in paragraphs 28(a) and 28(b) of this Attachment is positive, this amount is termed a discount. An ADI must not take into account such discounts when calculating RWA. Such discounts may be included in the measurement of eligible provisions for the purpose of offsetting EL in calculating the ADI’s Regulatory Capital requirement in accordance with Attachment C to this Prudential Standard.

Defaulted exposures purchased by an ADI are not subject to the floor specified in paragraph 28 of this Attachment. For those exposures, EAD must be based on the exposure’s carrying value and the discount must be set equal to zero.

An ADI may recognise on-balance sheet netting of assets and liabilities where it meets the criteria detailed in Attachment H to APS 112. Where there is a currency or maturity mismatch between the relevant assets and liabilities, adjustments must be made in accordance with the treatment set out in APS 112.

Off-balance sheet exposures except those that expose an ADI to counterparty credit risk

Where an ADI uses:

(a)supervisory estimates of EAD, EAD for an undrawn commitment is calculated as the committed but undrawn amount multiplied by a CCF; and

(b)its own estimates of EAD, EAD for an undrawn commitment may be calculated as the committed but undrawn amount multiplied by a CCF or derived from a direct estimate of the total facility EAD.

Except in the case of retail exposures, CCFs may be applied to the lower of the value of the unused committed credit line and the value of any other constraining factor on the availability of the facility, such as the existence of a ceiling on the potential lending amount that is related to a borrower’s reported cash flow or its external credit rating. If the lower value is used, an ADI must have sufficient line monitoring and management procedures to support using the lower value for Regulatory Capital purposes.

Where an ADI has given a commitment to provide an off-balance sheet exposure, it may apply the lower of the CCFs applicable to the commitment and the off-balance sheet exposure.

An ADI must apply the CCFs as specified in Attachment C to APS 112 when calculating EAD, with the exception of:

(a)non-revolving retail exposures categorised as other commitments in accordance with Attachment C to APS 112, for which the CCF is 100 per cent; and

(b)revolving retail exposures, excluding exposures subject to a CCF of 100 per cent in Attachment C to APS 112, for which the ADI may use its own estimates of EAD.

When only the drawn balances of revolving facilities have been securitised, an ADI must ensure that it continues to hold capital against the undrawn balances associated with the securitised exposure.

Revolving retail exposures

Where an ADI uses its own estimates of EAD for revolving retail exposures, EAD for each exposure that is used as an input to the risk-weight function and the calculation of EL must not be less than the sum of:

(a)the on-balance sheet amount; and

(b)50 per cent of the off-balance sheet exposure using the applicable CCF in Attachment C to APS 112.

To the extent that foreign exchange and interest rate commitments exist within an ADI’s retail IRB asset class, the ADI is not permitted to use its internal estimates of EAD for those commitments and must instead apply the CCFs as specified in Attachment C to APS 112.

Off-balance sheet exposures that expose an ADI to counterparty credit risk

For off-balance sheet exposures that expose an ADI to counterparty credit risk, including over-the-counter (OTC) derivatives (as defined in APS 112), exchange-traded derivatives, and long settlement transactions, the ADI must calculate EAD according to the requirements set out in APS 180.

Effective maturity

For corporate, sovereign and financial institution exposures, an ADI must calculate M for each facility. Subject to paragraph 42 of this Attachment, M is the greater of one year and the remaining maturity in years as defined in paragraph 41 of this Attachment. In all cases, M is no greater than five years.

For an exposure subject to a specified cash flow schedule, M is defined as:

where:

· CF_t denotes the cash flows contractually payable by the borrower in period t and t is expressed in years.

An ADI must apply a floor of zero to CF_t where the cash flow is negative (i.e. payable by the ADI to the borrower), which can occur with some derivative transactions.

Where an ADI is not able to calculate M for the contracted payments, it must use a more conservative measure that equals the maximum remaining time that the borrower is permitted to take to fully discharge its contractual obligations under the terms of the facility agreement, up to a maximum of five years.

Where amounts have been drawn by a borrower under a committed facility and the maturity of the drawn amount is less than the maturity of the facility, the maturity of the facility must be used for determining the capital requirement.

When determining M for derivatives that are subject to a master netting agreement, an ADI must use the weighted average maturity of the derivatives. In this case, the notional amount of each derivative transaction should be used for the purpose of determining the weighted average maturity.

Exceptions to the one-year maturity floor

For certain short-term exposures, the one-year floor for maturity may be replaced by a one-day floor. The maturity of such transactions must be calculated as the greater of one day and M.

The one-year floor does not apply to the following exposures:

(a)collateralised capital-market-driven transactions (e.g. OTC derivative transactions and margin lending) and SFTs with an original maturity of less than one year, where the relevant documentation contains daily remargining clauses. The relevant documentation must also require daily revaluation and include provisions that allow for the prompt liquidation or set-off of collateral in the event of default or failure to remargin. Where these transactions are subject to a master netting agreement, the effective maturity is calculated as the weighted average maturity of the transactions. In this case, a floor equal to the minimum holding period for the transaction type as set out in Table 24 of Attachment G to APS 112 will apply. Where more than one transaction type is contained in the master netting agreement, a floor equal to the highest holding period will apply to the average. The notional amount of each transaction must be used in determining the weighted-average maturity;

(b)issued and confirmed trade letters of credit and other forms of trade financing that have a maturity of less than one year and are self-liquidating; and

(c)other short-term transactions with an original maturity of less than one year that are not part of an ADI’s ongoing financing of a borrower.

The ADI must have policies that detail the transactions where the one-day maturity floor is appropriate.

Treatment of guarantees and credit derivatives

To recognise guarantees and credit derivatives as eligible CRM, an ADI must meet the minimum requirements detailed in Attachment E to this Prudential Standard.

An ADI may recognise the risk-mitigating effect of guarantees and credit derivatives by applying either a FIRB, AIRB or retail IRB substitution approach. The ADI’s application of the substitution approaches is constrained in the same manner as a direct exposure to the guarantor or credit protection provider, such that:

(a)if the ADI applies the FIRB approach to a direct exposure to a guarantor or credit protection provider, it may only recognise the guarantee or credit derivative according to the FIRB substitution approach; and

(b)if the ADI applies the standardised approach to credit risk to a direct exposure to a guarantor or credit protection provider, it may only recognise the guarantee or credit derivative by applying the standardised approach to the covered portion of the exposure. In this case, the ADI must apply the scope of guarantors and credit protection providers and minimum requirements for the recognition of guarantees and credit derivatives as set out in Attachments I and J to APS 112.

The application of CRM in the form of guarantees and credit derivatives must not reflect the effect of double default nor result in an adjusted risk weight that is less than that of a comparable direct exposure to the guarantor or credit protection provider.

In calculating the risk weight for the covered portion of the exposure:

(a)the effective maturity of a corporate, sovereign or financial institution exposure must be the same as the effective maturity of the exposure as if it were not covered;

(b)an ADI must use the same PD, LGD and EAD estimates for calculating EL as it uses for calculating RWA for UL; and

(c)where the risk-mitigating effect of guarantees or credit derivatives is recognised through PD, the ADI must use the risk-weight function appropriate to the guarantor or credit protection provider.

The uncovered portion of the exposure must be assigned a risk weight that is calculated in the same manner as a direct exposure to the underlying borrower.

Where proportional or tranched coverage exists, or where there is a currency or maturity mismatch between the underlying exposure and the guarantee or credit derivative, the approach set out in paragraphs 7 to 15 of Attachment I and paragraphs 14 to 22 of Attachment J to APS 112 must be applied.

Recognition under the FIRB substitution approach

Under the FIRB substitution approach, an ADI must determine the risk weight of the covered portion of the exposure by using the PD appropriate to the guarantor or credit protection provider’s borrower grade. The ADI may also replace the LGD of the underlying exposure with the LGD applicable to the guarantee or credit derivative taking into account its seniority and any eligible collateral calculated in accordance with this Attachment.

Recognition under the AIRB or retail IRB substitution approach

Under the AIRB or retail IRB substitution approach, an ADI may recognise the risk-mitigating effect of guarantees and credit derivatives by adjusting either PD or LGD estimates; however, in all cases, only one risk component may be adjusted. Whether adjustments are made through PD or LGD, they must be made in a consistent manner over time and for a given type of guarantee or credit derivative.

Maturity mismatch

Where a maturity mismatch exists between:

(a)the residual maturity of the term of lodgement of collateral and the maturity of the exposure covered by the collateral, the ADI must apply the adjustment detailed in paragraph 27 of Attachment G to APS 112;

(b)the residual maturity of a guarantee and the maturity of the exposure covered by the guarantee, the ADI must apply the adjustment detailed in paragraph 15 of Attachment I to APS 112; or

(c)the residual maturity of a purchased credit derivative and the maturity of the exposure covered by the derivatives, the ADI must apply the adjustment detailed in paragraph 22 of Attachment J to APS 112.

Treatment of securities financing transactions

For the purpose of calculating RWA and EL amounts for SFTs, including securities lending transactions, an ADI must calculate:

(a)the LGD of the counterparty in accordance with this Attachment;

(b)EAD in accordance with Attachment G to APS 112; and

(c)the capital requirement for the credit risk or market risk inherent in any securities the ADI lends or posts as collateral, if that risk remains with the ADI.

Attachment C - Treatment of expected losses and provisions

Calculation of expected loss

An ADI must separately calculate, for non-defaulted and defaulted exposures, the total EL amount aggregated across the corporate, sovereign, financial institution and retail IRB asset classes. Other than for specialised lending exposures subject to the supervisory slotting approach, the EL amount must be calculated as follows:

(a)for non-defaulted exposures, the product of PD, LGD and EAD;

(b)for defaulted exposures under the AIRB or retail IRB approach, the ADI’s best estimate of EL given current economic circumstances and the facility’s status;[7] and
[7] Refer to paragraph 102 of Attachment D to this Prudential Standard.

(c)for defaulted exposures under the FIRB approach, the product of the relevant supervisory estimates of LGD and EAD.

Expected loss for specialised lending exposures subject to the supervisory slotting approach

For specialised lending exposures subject to the supervisory slotting approach, the EL amount must be calculated by multiplying EAD by the relevant factor specified in Table 8.

Table 8EL under the supervisory slotting approach

Strong	Good	Satisfactory	Weak	Default
Specialised lending	0.4%	0.8%	2.8%	8%	50%

Calculation of eligible provisions

For exposures in the IRB asset classes, total eligible provisions associated with those exposures are:

(a)credit related provisions (e.g. any provisions for non-defaulted or defaulted exposures). Any amount included in an ADI’s provisions for non-defaulted exposures may only be used as eligible provisions to offset EL for non-defaulted exposures;

(b)partial write-offs; and

(c)discounts on defaulted assets.[8]
[8] Refer to paragraph 30 of Attachment B to this Prudential Standard.

Provisions held against securitisation exposures must not be included in total eligible provisions.

Where an ADI uses the standardised approach to credit risk for a portion of its exposures, it must attribute total provisions on a pro rata basis according to the proportion of RWA subject to the standardised and IRB approaches.

Where the standardised approach to credit risk is used exclusively by an entity within the Level 2 group, all of the provisions booked within that entity must be attributed to the standardised approach.

Provisions that are booked by entities within the Level 2 group that exclusively use an IRB approach to credit risk qualify as eligible provisions under paragraph 3 of this Attachment.

Treatment of expected loss and provisions

An ADI must separately compare the total EL amount for defaulted exposures and non-defaulted exposures with total eligible provisions associated with the relevant exposures.

Where the total EL amount is higher than total eligible provisions for the relevant exposures, the difference must be deducted from Common Equity Tier 1 Capital as detailed in APS 111.

For non-defaulted exposures, where the total EL amount is lower than eligible provisions associated with these exposures, the difference may be included in Tier 2 Capital up to a maximum of 0.6 per cent of credit RWA calculated under the IRB approach as detailed in APS 111.

Attachment D - Minimum requirements for the use of an IRB approach

The minimum requirements set out in this Attachment apply to all IRB exposures and the FIRB, AIRB, retail IRB and supervisory slotting approaches, unless stated otherwise. An ADI must ensure that the minimum requirements are met at the time of IRB approval by APRA and on an ongoing basis.

Composition of minimum requirements

An ADI’s credit risk rating and associated risk estimation systems and processes must provide for a meaningful assessment of borrower and transaction characteristics, a meaningful differentiation and ranking of risk, and quantitative estimates of risk that are consistent, verifiable, relevant and soundly based. 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 must adhere to the overall requirements for rating system design, operation, controls, governance and use as well as the requirements for the quantification and validation of PD estimates. An ADI that uses its own estimates of LGD and EAD must also meet the incremental minimum requirements relating to those risk components.

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 a borrower to a rating methodology or system must be documented and applied in a manner that best reflects the level of risk of the borrower. The ADI must not allocate borrowers across rating methodologies or systems for the primary purpose of minimising its capital requirement.

Rating dimensions

Requirements for corporate, sovereign and financial institution exposures

An internal rating system for corporate, sovereign and financial institution exposures must have two separate and distinct dimensions:

(a)the risk of borrower default (borrower grade); and

(b)transaction-specific factors (facility grade).

The borrower grade must be oriented to the risk of borrower default; that is, it must solely reflect PD. Subject to the exceptions set out in paragraph 7 of this Attachment, an ADI must assign the same borrower grade to separate exposures to the same borrower irrespective of any differences in the nature of each specific transaction.

An ADI may assign different borrower grades to separate exposures to the same borrower in the following circumstances:

(a)in the case of country transfer risk, the ADI may assign different borrower 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 borrower grade.

A borrower grade must represent an assessment of borrower 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:

(a)relationship between borrower 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; and

(b)credit risk of each borrower grade in terms of both a description of the default risk typical for borrowers assigned to the grade and the criteria used to distinguish that level of credit risk. Modifiers such as ‘+’ or ‘-’ to alpha or numeric borrower grades will only qualify as distinct grades if the ADI has developed complete rating descriptions and criteria for their assignment and separately quantifies PD estimates for those modified grades.

The facility grade must reflect transaction-specific factors such as collateral, seniority and product type; that is, it must solely reflect LGD. Borrower characteristics may be included as LGD rating criteria only to the extent that they are predictive of LGD. However, under the FIRB approach an ADI may satisfy this requirement by using a facility grade dimension that reflects both borrower and transaction-specific factors. The criteria used to define facility grades must be grounded in empirical evidence.

Specialised lending exposures subject to the supervisory slotting approach are excluded from the two-dimensional rating requirement. In this case, an ADI may have a single rating dimension that reflects EL by incorporating both PD and LGD considerations.

Requirements for retail exposures

Rating systems for retail exposures must be oriented to both borrower and transaction risks and capture all relevant borrower and transaction characteristics. An ADI must assign retail exposures into particular pools separately reflecting PD, LGD and EAD. The ADI must ensure that this process provides for a meaningful differentiation and ranking of risk, a grouping of sufficiently homogenous exposures, and accurate and consistent estimation of PD, LGD and EAD at the pool level. Different pools of retail exposures may share identical PD, LGD or EAD estimates.

At a minimum, an ADI must consider the following risk drivers when assigning retail exposures to a pool:

(a)borrower risk characteristics (e.g. borrower 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 the exposure. The ADI must be able to separately identify exposures that are delinquent and those that are not.

For each pool where an ADI estimates PD and LGD, it must analyse the representativeness of the age of facilities (in terms of the time since origination for PD and the time since default for LGD) in the data used to derive the estimates. The ADI must adjust its estimates upward to account for a lack of representativeness in the data as well as anticipated implications of rapid exposure growth that may lead to default rates peaking several years after origination.

Rating structure

Requirements for corporate, sovereign and financial institution exposures

An ADI must have a sufficient number of distinct rating grades to allow for a meaningful distribution of exposures, with no excessive concentrations in either its borrower grades or, where relevant, facility grades.

Subject to the exception set out in paragraph 17 of this Attachment, an ADI must have a minimum of seven borrower grades for non-defaulted borrowers and one for defaulted borrowers. An ADI with lending activities focused on a particular market segment may satisfy this requirement with the minimum number of grades. An ADI that lends to borrowers of diverse credit quality should have a greater number of borrower grades. Significant concentrations within a single borrower 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 borrowers in each grade fall within the relevant band.

There is no minimum number of facility grades for an ADI using the AIRB approach; however, the ADI must have a sufficient number of facility grades to avoid grouping facilities with widely varying LGD estimates into a single grade.

An ADI using the supervisory slotting approach for specialised lending exposures must have at least four rating grades for non-defaulted borrowers and one for defaulted borrowers.

Requirements for retail exposures

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 must ensure that the number of exposures in a given pool is sufficient to allow for meaningful quantification and validation of PD, LGD and EAD estimates at the pool level. There must also be a meaningful distribution of exposures across pools, with no single pool comprising an undue concentration of exposures.

Rating criteria

Requirements for all exposures

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 plausible, 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 consistently assign the same rating to borrowers and facilities posing similar risk, across lines of business, departments and geographic locations. If rating criteria and processes differ for different types of borrowers or facilities, the ADI must monitor for possible inconsistency in rating assignments and alter rating criteria and processes to improve consistency where appropriate.

Rating definitions must be sufficiently clear and detailed 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 rating criteria must be consistent with an ADI’s lending standards and its policies for managing borrowers and facilities that have deteriorated in credit quality.

An ADI must use all relevant, material and available information in assigning borrowers and facilities to grades or pools. The information used by the ADI must be current. The less information the ADI has, the more conservative it must be in assigning exposures to borrower 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.

Additional requirements for specialised lending exposures subject to the supervisory slotting approach

An ADI using the supervisory slotting approach must assign specialised lending exposures to its internal rating grades based on its own criteria, systems and processes. The ADI must also have a documented process that maps those internal rating grades into the slotting categories of strong, good, satisfactory, weak and default in a conservative and consistent manner. The ADI must ensure that its mapping process results in an alignment of grades that is consistent with the criteria defining the slotting categories as detailed in Attachment G to this Prudential Standard. The ADI must ensure that overrides of its internal criteria do not render the mapping process ineffective.

Table 10Slotting 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.	Perfected first lien.	Perfected first lien.	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.

Table 11Slotting 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 (e.g. 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 12Slotting 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 (including offshore location of reserves in an emerging country).	There is some exposure to country risk (including offshore location of reserves in an emerging country).	There is strong exposure to country risk (including 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 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.

Collateral type	LGD (%)
Secured
Financial collateral	0
Receivables	10
Commercial or residential real estate	10
Other physical collateral	15
All other collateral	25
Unsecured	25

Exposure type	LGD (%)
Retail residential mortgage	10
Other secured
Financial collateral	0
Receivables	10
Commercial or residential real estate	10
Other physical collateral	15
All other collateral	30
Unsecured
QRR	50
All other unsecured	30