24 This includes any commitment to provide an off-balance sheet facility.
25 Credit conversion factors are based on the Basle Supervisors' Committee's paper "International convergence of capital measurement and capital standards", July 1988.
26 The deduction will apply to the full value of a holding of subordinated debt even if the issue of debt is being amortised in terms of the footnote to prudential standard 3.2.2.b.
27 This includes any amount which is unpaid or callable on any shares or capital securities issued by the subsidiary and held by the society (or within its consolidated group).
Prudential Notes 3.3B and 3.3C
Note: see subparagraph 1(e) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 3.3 - Building Societies
Accounting and disclosure
B. Financial Reports to State Supervisory Authorities
To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that financial information provided to SSAs is complete, timely and consistent with external reporting requirements and is adequate for supervisory purposes.
Supervision of building societies by SSAs is conducted, in part, through a review of financial data provided by societies. It is appropriate that this information should be more extensive than that provided in the public financial accounts. These data should form an extension of the information contained in the annual accounts and should be consistent with them.
It is the responsibility of directors and management to oversee the internal operating procedures of the society. Each society will, for its own purposes, be expected to have adequate accounting records, registers and supporting documentation. Normal budgets, monthly financial statements and reports on loans, liquidity, capital adequacy and investments should form an integral part of any management and control process.
Much of this information, prepared for internal purposes, will provide the data for reporting to SSAs.
To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that the auditors appointed by each building society are competent, adequately resourced and given sufficient scope to complete the duties imposed by the FI Code. Further, to ensure that societies are able to provide such reports of audit as are required by SSAs as part of their supervisory role.
Section 24 - APRA transitional prudential standards - This includes any commitment to provide an off-balance sheet facility. | Zoe
Section 270 of the FI Code requires directors to ensure that the annual accounts and group accounts of building societies are audited. As well as the audit report attached to the published financial statements, auditors must provide to the directors and to the relevant SSA a report of compliance with respect to internal controls. Auditors are also required to provide a number of reports of compliance under the FI Code.
Sub-section 284(7) of the FI Code requires the auditors to report on the adequacy of systems adopted by the society:
• to ensure compliance with its primary objectives; and
• to monitor and manage the risks associated with its financial activities.
The intention of independent audit reviews is to lend credibility to the financial information presented in the annual report by the building society's directors. In carrying out their supervisory responsibilities, AFIC and the SSAs rely largely on information presented by societies. A properly planned and conducted audit should provide reasonable assurance that the financial statements are true and fair. In addition to the supervisory authorities, members and depositors should be able to place greater reliance on financial information where an audit has ascertained that the accounts are free of material misstatement and present a true and fair view of the entity.
It is important that a society’s external auditor receives timely information concerning the prudential standing of the society. Accordingly, an SSA should provide to the society’s external auditor a copy of any report following an inspection of the society and any other information the SSA may from time to time consider relevant to the auditor’s audit responsibilities in respect of the society. If the SSA considers the provision of the whole or part of the report or such other information unnecessary or undesirable in the circumstances, the SSA need not provide it to the external auditor.
All audit work should be carried out in compliance with Auditing Standards and Auditing Guidance Statements prepared by the Auditing Standards Board of the Australian Accounting Research Foundation issued by the Australian Accounting Research Foundation on behalf of the Australian Society of Certified Practising Accountants and the Institute of Chartered Accountants in Australia. Particular notice should be taken of the requirements within the standard for proper planning and completion of audit techniques which take account of the nature and risks of building societies. Directors of societies should be satisfied that auditors have sufficient understanding of the industry to enable them to adequately plan the audit and assess audit risks.
The operations of societies involve a large number of transactions. The audit approach, therefore, must emphasize the importance of transaction testing. Adequate transaction testing is regarded as critical if audits are to satisfy the requirements of the FI Code.
The audit approach must set out how evidence will be gathered. Since that evidence is the basis of audit opinion, sufficient audit evidence must be obtained to enable an opinion to be properly formed.
The responsibility for appointing an auditor of proper ability is the responsibility of the society. Building societies can expect that SSAs will communicate with their auditors annually or more frequently if it is deemed necessary. The purpose of this contact will be to establish the efficacy of audit techniques. If a SSA is not satisfied with the quality of an audit it has the power, under Section 88(4) of the FI Code to appoint an additional auditor or remove an auditor and appoint another auditor in that auditor's place, as it sees fit.
An Audit Committee should comprise a majority of non-executive directors to which has been assigned, amongst other functions, the oversight of the financial reporting and auditing process and formulation and periodic review of the disaster recovery plan. The main objectives of an appropriately established and effective independent Audit Committee include enhancing the credibility and objectivity of financial reporting and assisting the Board to discharge its responsibilities. All building societies shall, if they have not already done so, establish an Audit Committee. It is the responsibility of the directors to establish the Audit Committee and to develop clear guidelines for its operation, including its role, terms of reference, responsibilities and method of operation.
The effectiveness of the internal audit function depends on the scope and objectives of the function, degree of independence and the technical competence of staff. As with any internal control, the cost of an internal audit function must be justified by the benefits. Usually, the size of the society will play a significant part in determining the nature, scope and objectives of the internal audit function. In general, internal audits will be most effective where they are directed towards the review and testing of internal controls and risk management systems. Societies should consider the standards for the professional practice of internal auditing issued by The Institute of Internal Auditors.
Paragraphs 3.3.2a and 3.3.2b of Prudential Standard 3.3.2
Note: see subparagraph 1(f) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
3.3.2 Accounting Standards Specific to Building Societies
Provisions
3.3.2.a Statutory Provisions for Doubtful Debts
Each society shall provide for, and show in the body of its accounts, a provision for doubtful debts covering all loan advances, including revolving credit arrangements. Directors should ensure that all problem loans are reviewed regularly and that provisions are appropriate. The minimum provisions shall be the amounts specified below.
Loan Provisions
The minimum loan provisions required depend on the type of loan. Three categories of loans are distinguished.
(i) • A loan which is secured by a registered first mortgage against residential building and/or development (defined in Prudential Standard 3.2.4.d) and is insured by an authorised(a) insurer for 100 per cent of the outstanding balance;
• A loan which is secured by a registered first mortgage against residential building and/or development, where the ratio of the outstanding balance, less the amount of mortgage insurance, to the valuation of the security is no more than 80 per cent (where the loan is 6 months or more in arrears, the valuation must be no older than 12 months);
• A loan which is secured by a qualifying registered second mortgage. (A qualifying second mortgage is one which satisfies the conditions spelled out in Prudential Standard 3.2.4.d.)
No minimum provision is required for this type of loan.
(ii) A loan which is secured by a registered first mortgage against residential building and/or development, where the ratio of the outstanding balance, less the amount of mortgage insurance, to the valuation of the security is greater than 80 per cent but no more than 100 per cent (where the loan is 6 months or more in arrears, the valuation must be no older than 12 months).
For these loans, the minimum provision required is a percentage of the balance outstanding, where the percentage depends upon the loan arrears period, as shown below.
3 months and less than 6 months 5
6 months and less than 9 months 10
9 months and less than 12 months 15
12 months and over 20
Where the provision calculated under this category (ii) is greater than the provision which would have been calculated under category (iii) then the category (iii) is the minimum required.
(iii) All other loans
For all loans which do not fall into categories (i) and (ii) above, including unsecured and commercial loans, and mortgage loans where the ratio of the outstanding balance, less the amount of mortgage insurance, to the valuation of the security is greater than 100 per cent, the minimum required provision is a percentage of the balance outstanding, where the percentage depends upon the loan arrears period, as shown below.
3 months and less than 6 months 40
6 months and less than 9 months 60
9 months and less than 12 months 80
12 months and over 100
Where these loans are secured by a mortgage over real property, the provision may be adjusted to reflect a part of the collateral value. In this case, the minimum provision percentage in the table above will be applied to the difference between the outstanding balance (less any loan insurance) and 70 per cent of the security value (where the loan is 6 months or more in arrears, the valuation must be no older than 12 months).
The minimum total provision required under loan provisions is the sum of the provisions made with respect to the different types of loans.
Where a loan is otherwise secured by equivalent or better security arrangements, the society may on application to its SSA, seek to have the provision adjusted to reflect the whole or part of the collateral value. After consideration of all relevant circumstances pertaining to the loan and security the SSA may reject or may, with the consent of AFIC, agree to the application.
Revolving Credit Provisions
Unless a variation is approved by its SSA, a society will be required to provide an amount equal to 1.0 per cent of the total unsecured(a) balances outstanding for line of credit advances, credit cards, overdrafts and any other revolving credit facilities. These provisions will be in addition to any provisions required under (iii) above.
After consideration of a society’s loss experience and the level of non-statutory provisions available to cover potential losses on revolving credit facilities, an SSA may reduce the 1% requirement set out above. The SSA is to notify AFIC of any variation issued.
For overdrawn savings and overdrawn limits on credit cards, overdrafts and line of credit advances, the minimum required provision is a percentage of the balance outstanding, as shown below. Secured loans should be provisioned in accordance with Loan Provisions (i), (ii) and (iii). In calculating the minimum provision for each revolving credit facility, except overdrawn savings, the full amount of the credit drawn is to be included in the balance outstanding.
Period of Irregularity Provision (%)
14 days less than 3 months 40
3 months and less than 6 months 75
6 months and over 100
Where a revolving credit facility is both overdue (in terms of contractual repayments) and has a balance in excess of its authorised limit, the minimum provision required will be that calculated from the table above.
3.3.2.b Restructured Loans
Restructured loans are loans and other similar facilities where the original contractual terms have been modified to provide for concessions of interest, principal or repayment for reasons related to financial difficulties of the member or group of members. The following concessions are examples that would lead to a loan being classified as restructured:
a reduction in the principal amount of the loan;
a rate of interest lower than the society applies to a similar loan;
reduction of accrued interest;
a deferral or extension of interest or principal payments including interest capitalisation; or
Extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with a similar risk.
A loan extended or renewed on terms similar to those available for debt with similar risks where the member has met the originally contracted terms, is not considered a restructured loan.
Restructuring required under the provisions of the Consumer Credit Code which satisfy the above definition are not excluded from the definition of restructured loans.
Each society must develop policies to identify, monitor and manage restructured loans. Any restructuring of a loan or similar facility must be supported by a current, well documented credit assessment of the member’s financial condition and prospects for repayment under the modified terms.
Renegotiation of a loan must not be used to "hide" the poor quality of loan performance. Before any concession is made to a member, a restructure of the member’s loan should receive prior approval of the board of directors or its delegate. If there has been no prior approval, the restructured loan must be ratified by the society's board or their committee within 30 days of approval.
A restructured loan may only be returned to performing status, if it was not fully performing when restructured, for both the purposes of accrual and provisioning, when:
it has been formally restructured ie. at a minimum the customer is provided with a written agreement, signed by the society, which outlines the new terms and is complying with these terms;
there are no concessional terms applying to the facility, that is, the loan operates under the terms and conditions comparable to those applied by the society to a similar new facility; and
the member's financial condition and prospects for full repayment have improved such that the facility has been operating in accordance with the new terms and conditions for a period of at least six months.
Provisioning requirements for a loan that has been formally restructured but is yet to be considered as performing should generally be based on the arrears period as at the time of the restructure. A society may, however, take into account additional security provided under the agreement which would result in a reduction of the provisioning requirement.
A single facility cannot be split into a performing and non performing part to avoid the total facility being classed as restructured.
For the purposes of reporting under AASB1032 only formally restructured loans may be included in the restructured category. Informally restructured loans are to be reported as non-accrual loans as appropriate. If, following a restructure, the yield on a facility is less than the society’s average cost of funds, it should be reported as non-accrual.
Prudential Standard 3.3.5, other than subparagraph 3.3.5a(ii)
Note: see subparagraph 1(g) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
3.3.5 Required Returns
3.3.5.a Each building society will complete the following returns for the purposes of section 290 of the FI Code as required by notice from its SSA.
(i) Quarterly:
A general return containing the information contained in Attachment B to the Prudential Standards.
In addition to this quarterly general return, other returns on:
• Loans
• Directors' Interests
• Primary Objects
• Assets
3.3.5.b A SSA may, by notice, vary the reporting interval for any or all of the returns included in Prudential Standard 3.3.5.a for any or all societies under its jurisdiction.
3.3.5.c Any society which fails to comply with the notice of lodgement of returns by the due date will be in breach of the Prudential Standards under Section 402 of the FI Code.
Prudential Standard 3.3.6
Note: see subparagraph 1(h) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Audit
3.3.6 Audit Standards
3.3.6.a A building society is to be audited in accordance with Auditing Standards and Auditing Guidance Statements and any additional requirements considered necessary by the auditor in satisfying the various requirements of the FI Code.
3.3.6.b Directors of a building society are to satisfy themselves that the auditor has sufficient relevant expertise to audit the society properly and that the auditor maintains appropriate levels of professional indemnity insurance.
3.3.6.c Directors of a building society are to satisfy themselves that the auditor has adequate computer audit support to be able to access any and every transaction within the society, as the auditor determines.
3.3.6.d A building society is to obtain from its auditor, an engagement letter which confirms acceptance of the appointment, the objectives and scope of the audit, the extent of the auditor’s responsibilities and the form of reports and any other matters identified in AUS204 - Terms of Audit Engagements.
3.3.6.e A building society is to maintain an audit committee whose members comprise at least half non executive directors.
3.3.6.f An internal audit function should be considered by each society’s directors as part of the society’s system of internal control.
3.3.6.g Audit reports are to be forwarded directly to the audit committee in addition to any other recipients required by the society.
3.3.6.h Pursuant to section 284(7) and (8) and section 285(10) of the FI Code, an external auditor is to provide to the SSA, reports on the compliance and adequacy of the following risk management systems and internal controls:
• operational liquidity risk management systems (annually) - Prudential Standard 3.1.2.a;
• market risk management systems (annually) - Prudential Standard 3.1.3.a;
• credit risk management systems (annually) - Prudential Standard 3.1.4.a;
• data risk management systems (annually) - Prudential Standard 3.1.5.a;
• operations risk management systems (annually) - Prudential Standard 3.1.6.a; and
• internal controls within the above risk management systems.
3.3.6.i Pursuant to section 285(10) of the FI Code, an external auditor is to provide to the SSA, reports on the security for Emergency Liquidity Support Scheme (6 monthly) - Prudential Standard 3.4.6.l.
3.3.6.j An SSA is to provide to a society’s external auditor a copy of any report following an inspection of the society and any other information the SSA from time to time considers relevant to the auditor’s audit responsibilities in respect of the society. If the SSA considers the provision of the whole or part of the report or such other information to be unnecessary or undesirable, the report or the information need not be provided to the external auditor.
Prudential Notes 3.4A, 3.4C and 3.4E
Note: see subparagraph 1(i) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 3.4 - Building Societies
A. Subsidiaries
To protect and promote the financial integrity and efficiency of the State-based financial institutions scheme and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that societies are not exposed to undue risk as a result of the activities of subsidiaries or associates.
A society may choose to establish and operate a subsidiary for a variety of reasons including as a means of diversifying activities and to provide products and services that meet the demands of members and other markets. While all financial intermediation should be conducted through the holding society, there are some non-intermediation financial activities that may be better conducted through subsidiaries. An example is the provision of managed fund products1.
The prudential concern is that the operations of subsidiaries are a potential source of risk to financial institutions and, where managed improperly, have contributed to their failure both in Australia and overseas.
Section 118 of the FI Code requires a society to obtain approval from its SSA before acquiring a subsidiary. This is consistent with the requirement for a society to consult with its SSA before engaging in new activities. It is not the intention of either AFIC or the SSAs to prohibit the establishment or acquisition of subsidiaries. However, each society must give careful consideration to the potential risks that may arise from the operations of subsidiaries and be able to satisfy its SSA that policies and systems for reporting and control are adequate. Further, subsidiaries should not be overly large in comparison to the parent society, nor should there be a proliferation of subsidiaries. SSAs will be concerned with transactions between a society and its subsidiaries including, loans and extension of credit, purchase of assets, and the provision of guarantees and letters of credits. At the least, all transactions are subject to associated standards including large exposures and capital adequacy requirements.
Prudential supervisors have similar concerns where a society invests in an associate. An investment by a society that would create an interest of more than 10% of an entity involved in the field of finance should be referred to the SSA before the society enters a firm commitment. A society should also refer equity investments in non-financial businesses where the amounts invested exceed in aggregate 5% of Tier 1 capital, or an individual investment basis in excess of 0.25% of Tier 1 capital.
The SSA will review each society, its subsidiaries and associates on a case-by-case basis to make an overall risk assessment of the society. The SSA may require additional internal controls, reporting or possibly capital, if there is undue risk arising from a lack of legal, economic or moral separation of the society from subsidiary or associate operations.
C. Guarantees
To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that building societies are not exposed to undue risk as a result of guarantees made by or on behalf of the building society.
The provision of guarantees, sureties, indemnities and similar off-balance sheet facilities by a building society can generate additional income from a given asset base without the introduction of direct liabilities. A building society may also be obliged to provide guarantees or indemnities to access financial services such as cheque and card facilities for use by members. This off-balance sheet activity introduces contingent rather than direct liabilities that can nevertheless create risks for a financial institution. The dangers are particularly acute if guarantees are extended without full analysis of the potential risks.
For the purposes of the Prudential Standards, guarantees, indemnities or other, provided by a building society on its own behalf to access services, will not generally be treated as direct credit substitutes. Guarantees provided to a subsidiary or other venture associated with the building society or on behalf of members must be treated as direct credit substitutes.
Where a building society provides guarantees or other off-balance sheet facilities, it must, as part of its risk management, maintain policies with respect to the provision of guarantees, sureties, indemnities and so on and must be able to demonstrate appropriate systems to identify and manage the individual and aggregate risks. Further, off-balance sheet facilities that are direct credit substitutes must be capitalised and are subject to large exposure limitations.
E. Service Contracts
To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that societies are not exposed to undue risk or unfair practices with respect to service contracts.
Under Section 245 of the FI Code, a society must obtain prior written approval from its SSA before entering into a management contract. Management contracts are defined as arrangements whereby a third party performs the whole or a substantial part of the functions of the society. The key feature of a management contract is the abrogation of total or substantial management control to a person or entity external to the society. Examples include situations where the day-to-day operation of the society is managed through entities controlled by directors or independent third parties.
Service contracts are other arrangements entered by a society to obtain services or products without the abrogation of management control. Each society is likely to enter a variety of such contractual arrangements for valid economic and efficiency reasons, especially where the society neither has, nor seeks, the expertise. While service contracts will cover a range of relationships with external parties, supervisors are concerned with those contracts that create additional risks, create conflicts of interest or require disclosure to members and shareholders.
A conflict of interest may arise where a society enters arrangements with a director or officer (or their associates) for the provision of services. AFIC recognises that some regionally-based societies may face difficulty appointing suitably qualified directors who are not otherwise associated with the provision of services to the society in the normal conduct of business. AFIC does not intend to outlaw such arrangements but seeks to ensure arm's length dealings.
Financial and operating leases entered into in the ordinary course of business on an arm's length basis are not service contracts for the purposes of this section. However, such leases are subject to normal reporting requirements as part of the financial statements.
Prudential Standards 3.4.1, 3.4.3 and 3.4.5
Note: see subparagraph 1(j) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
3.4.1 Subsidiaries
3.4.1.a In accordance with section 118 of the FI Code, a society must obtain the approval of its SSA before establishing or acquiring a subsidiary.
3.4.1.b A society should also consult with its SSA before entering into a firm commitment in an associate as follows:
in the case of institutions in the field of finance, where the investment would create an interest in excess of 10%; or
in the case of non-financial businesses, where the investments in aggregate will exceed 5% of Tier 1 capital or an individual investment exceeds 0.25% of Tier 1 capital.
3.4.1.c A society must satisfy its SSA that there are in place adequate systems, policies and procedures to manage, monitor and control residual risk to the society arising from subsidiary’s or associate’s activities. The SSA may also seek evidence that the subsidiary or associate has sound and prudent management aimed at achieving viability within the capital resources of the subsidiary or associate.
3.4.1.d A society must ensure that the operations of a subsidiary or associate are separated sufficiently, so that the society will not be obliged, morally or commercially, to support a subidiary’s/associate’s on-going operations. In particular, a society should not give a general guarantee of the obligations of a subsidiary or associate. Other dealings with associates should be on the normal terms and conditions that would apply to unrelated entities. The society must also ensure that a subsidiary or associate does not give any impression that the society’s resources stand behind, or could be called to stand behind, its operations.
3.4.1.e While a general guarantee is not appropriate, a society may choose to provide a specific guarantee. A society must consult with its SSA before providing a guarantee of, or on behalf of, a subsidiary or associate. Where provided, guarantees are subject to Prudential Standard 3.4 C Guarantees. As part of the review process, the society should be prepared to estimate the maximum loss should the guarantee be called and also satisfy its SSA that the provision of a guarantee will not have a detrimental effect on the interests of its depositors.
3.4.1.f A society must ensure that subsidiaries comply with any directions made by its SSA.
3.4.1.g Accounts of the society and subsidiaries must be consolidated for the purpose of prudential supervision, including the application of all prudential standards.
3.4.3 Granting of Guarantees by a Society
3.4.3.a Each building society must have available for review a written description of its policies with respect to providing guarantees, indemnities or other sureties and must satisfy their SSA that it has adequate systems and procedures for managing the risks involved.
3.4.3.b AFIC may deem that certain types or classes of guarantees or other sureties are direct credit substitutes.
3.4.3.c A guarantee or other surety provided on behalf of a member is a direct credit substitute. Indemnities provided by a building society on its own behalf will not normally create direct credit substitutes.
3.4.3.d A guarantee that is a direct credit substitute:
· must be for a limited amount;
· is subject to the same large exposure restrictions as the provision of loans and other credit (see Prudential Standard 3.1.4); and
· must be capitalised (see Prudential Standard 3.2.5). An SSA may also increase a building society's capital adequacy ratio if, in the opinion of the SSA, the guarantee, or guarantees in aggregate, add significantly to the overall risk of the building society.
3.4.3.e The provision of guarantees and indemnities may create contingent liabilities and must be disclosed in the building society's financial statements in accordance with applicable accounting standards.
3.4.5 Review of Service Contracts
3.4.5.a Each society must demonstrate systems for selection, regular review and renewal of service arrangements that ensure arm's length dealings.
3.4.5.b A society must not enter service contracts that:-
· diminish control of the society by the Board;
· diminish the SSA's ability to review and supervise the society; or
3.4.5.c Before entering into a service contract a society must consider the risks arising from the proposed arrangement. This includes a documented assessment of the impact of the contract on its operational and control environment as well as the commercial risks that may arise from entering into the contract.
3.4.5.d Where a society enters into a contract (not being a management contract) that permits an external party to make decisions in its name, or on its behalf, then the society must ensure there are adequate systems and controls in place to review the decisions made and ensure they are in accordance with its board approved policies and procedures.
3.4.5.e Where an SSA has concerns with the ability of a society to comply with this standard, it may require it to consult with it, in advance, before entering into some or all future service contracts. In this consultation process the society will need to demonstrate that the proposed contract will not expose it to excessive risk.
3.4.5.f A society must advise its SSA of any service contract under which payments in a current or future year are likely to exceed 5% of non-interest expense. It must consult with its SSA in advance before entering into a service contract where the payments in a current or future year are likely to exceed 10% of non-interest expense. In this consultation process the society will need to demonstrate that the proposed contract will not expose it to excessive risk.
3.4.5.g A society must retain a register of service contracts. At a minimum this should include details of the parties involved, date of commencement, termination date, review date, fee structure, a brief description of the purpose of the contract and a reference to the location of the detailed documentation. The documentation must be made available for review upon request from an SSA
Prudential Note 3.6
Note: see subparagraph 1(k) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 3.6 - Building Societies
To protect and promote the financial integrity and efficiency of the State-based financial institutions scheme and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that a society is not exposed to undue risk as a result of involvement in the securitisation of its assets.
Since the commencement of the FI Scheme, societies have become more involved in the securitisation of assets. This standard, while based on the RBA’s Prudential Statement dealing with Funds Management and Securitisation, focuses on the transfer of risk associated with the sale of loan assets into a securitisation scheme.
Securitisation involves the pooling of assets (or interests in assets), usually in a special purpose vehicle, funded by the issue of securities. The payment of earnings, and the return of capital, to investors hinges on the cash flows from the underlying assets in which their funds are invested.
Generally a society’s involvement in securitisation activities is likely to be restricted to the sale to and subsequent servicing of assets in a securitisation program sponsored by an independent third party. Any society intending to be active in other aspects of securitisation of assets such as issuing asset backed securities on its own behalf, providing credit and liquidity support, offering other lending or treasury services, funding investor purchases of securities or securitising revolving credit facilities should first consult with its SSA. We would generally expect an SSA to discuss any approach with AFIC.
The securitisation of revolving credit facilities (eg credit cards) can create difficulties in meeting the requirements for a clean sale outlined in the standard. A society which plans to securitise revolving credits should discuss this issue with its SSA. It must be able to demonstrate that the retention of a seller’s interest does not expose it to a disproportionate share of the credit risk on the loans transferred to the securitisation scheme.
This standard sets out the process by which a society’s involvement in securitisation of assets will be reviewed and the basis of that review. In principle:
A securitisation scheme must stand clearly separate from the society.
(a) Dealings between a society, a special purpose vehicle and investors must always be conducted at arm's length and on market terms and conditions.
(b) Any undertakings given by a society to a special purpose vehicle must be subject to the usual approval and control processes within the society.
(c) Any undertakings to a special purpose vehicle must be described clearly in the legal documentation and must be fixed as to time and amount.
(d) No impression must be given, through marketing material or otherwise, that recourse to a society extends beyond its contractual legal obligations.
AFIC recognises that a society's involvement in securitisation activities can give rise to risks, such as operational and legal risks which will be difficult to quantify. Securitisation of low risk assets could also lead to a deterioration in the average quality of assets remaining on a society’s balance sheet. Against this background, where the level of a society's activities suggests that the overall level or concentration of risk within the group has become excessive relative to its capital, the SSA may, following consultation with AFIC, adjust the society’s minimum capital ratio to better reflect the additional risk borne by the society.
The prudential standard establishes the framework in which a society can expect to participate in securitisation activities and by which an SSA (and if relevant AFIC) will review the documentation and securitisation program. Despite its detailed nature, this standard cannot encompass every aspect of a society’s securitisation activities. Where a society may have plans for particular securitisation initiatives that may raise issues not covered in the standard, it should discuss them with its SSA as early as possible.
Where a particular securitisation scheme may have wide application within the industry it would be appropriate for it to be initially reviewed by AFIC, in consultation with the SSAs. Otherwise it will be subject to review by its SSA. AFIC’s review of a securitisation scheme will be for the purpose of assessing whether it has the potential to meet the technical requirements of the standard. If a particular society wishes to access the scheme, it will need to satisfy its SSA that it has adequately identified the risks arising from its participation and has adequate systems and procedures to manage the risks. In addition, the SSA will monitor its practical compliance with the standard.
The responsibility for the prudent participation of a society in securitisation rests with its board and management. A society should have in place clear strategies and board approved policies governing participation in this activity. In addition, a society must maintain appropriate systems to identify, measure and control risks arising from its participation in securitisation. A society’s SSA will need to be satisfied of this before it will endorse participation in a scheme.
Specific breaches of the standard will be handled on a case-by-case basis. It is likely however that following consultation with AFIC, an SSA will require a society to hold capital against the full value of assets committed to a securitisation program with which it is involved.
This standard applies to all securitisation even if a special purpose vehicle or the issue of securities is not involved. It is also intended to apply to origination agreements where the loans do not cross the society’s balance sheet. Unless otherwise indicated reference to a society includes any subsidiaries which exist within its consolidated group.
Prudential Standards 3.6.1 to 3.6.7 (inclusive)
Note: see subparagraph 1(l) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
3.6.1 Disclosure
3.6.1.a To safeguard against investor confusion, a society must ensure that any marketing or promotion of a securitisation scheme with which it is associated does not give any impression that it stands behind the capital value or performance of the securities issued by the scheme. It must be clear to investors that the securities in which they invest do not represent deposits or other liabilities of the society.
3.6.2.a A central tenet of this standard on securitisation is that there is clear separation between the society involved and any special purpose vehicle. To this end, a society must not without prior approval from its SSA:
(i) Have any ownership or beneficial interest (otherwise than may arise via its equity in an SSP) in a special purpose vehicle.
(ii) Act as a manager, trustee, custodian or similar role in a securitisation scheme.
(iii) Provide any credit support, other lending, liquidity or transaction facilities (such as cheque or settlement facilities) or underwrite the issue of securities.
(v) "Control" a special purpose vehicle such that it would need to be consolidated in accordance with Australian Accounting Standards.
3.6.3 Servicing
3.6.3.a A society may undertake the role of "servicer" or "servicing agent" of a pool or part of a pool of assets held by a special purpose vehicle provided:
(i) There is a formal written servicing agreement in place which specifies the services to be provided and any required standards of performance. Those standards should be reasonable and in accordance with normal market practice. There should be no recourse to the society beyond the fixed contractual obligations specified. The servicer should be under no obligation to fund payments, absorb losses on assets, or otherwise recompense investors for losses.
(ii) The services are provided on an arm's length basis, on market terms and conditions (including remuneration), and subject to the society's normal approval and review processes. The servicing fee should not be subordinated, deferred or waived (without prior approval of an SSA).
(iii) The servicing agreement is limited as to a specified time period (ie the earlier of the date on which all claims connected with the issue of securities are paid out or the society's replacement as servicer). A fixed termination date need not be specified provided the society is able, at its absolute discretion, to withdraw from its commitments at any time with a reasonable period of notice.
(iv) Subject to reasonable qualifying conditions, the special purpose vehicle has the clear right to select an alternative servicer.
(v) The servicing agreement is documented in a fashion which clearly separates it from any other service provided by the society.
(vi) The society's operational systems are adequate to meet its obligations as a servicer.
3.6.3.b A society acting as servicer should be under no obligation to remit funds to the special purpose vehicle or investors until they are received from the underlying assets. This may not preclude, subject to conditions set by its SSA, the provision of:
(i) Very limited short-term advances by a servicer, at its sole discretion, to cover unexpected cash shortfalls arising from delayed payments on assets.
(ii) An undertaking that the interest rate charged on the currently performing loans it has sold will exceed a benchmark rate, provided the benchmark rate does not depend on the actual funding cost of the scheme.
3.6.3.c A society may receive a performance-related payment (or benefit from any surplus income generated) for its role as servicer, in addition to its base fee, provided that the base fee is on market terms and conditions and any performance-related payment does not commit the society to any additional obligations. This payment should be recognised for profit and loss (and capital) purposes only if it has been irrevocably received.
3.6.3.d Where a servicing agreement does not meet the conditions above a society will be required to hold capital against the assets it is servicing as if they were held on its balance sheet.
3.6.4 Representations and Warranties
3.6.4.a Where a society undertakes to sell assets to a special purpose vehicle, it is customary to make representations and warranties concerning the assets. Where all of the following conditions are satisfied, a society will not be required to hold capital as a result of providing representations and warranties. Otherwise, it will need to hold capital against the assets to which the representations and warranties relate. The conditions are:
(i) Any representations and warranties are provided only by way of a formal written agreement and are in accordance with market practice.
(ii) The society undertakes appropriate review procedures before providing or taking on any representations and warranties.
(iii) The representations and warranties refer to an existing state of facts that the society can verify at the time services are contracted or assets sold.
(iv) Representations or warranties are not open-ended and, in particular, do not relate to the future creditworthiness of assets or the performance of the special purpose vehicle or the securities it issues.
(v) The exercise of any representation or warranty requiring the society to repurchase or replace assets sold to the special purpose vehicle, or any part of them, must be undertaken within 120 days of their transfer to the vehicle and any transfer should be conducted on the same terms and conditions as the original sale. This time limit does not preclude the subsequent payment of damages by a society as a result of breaches of representations and warranties.
3.6.4.b Any agreement by a society to pay damages as a result of a notice of claim being made must be conditional on:
(ii) The onus of proof for a breach of a representation or warranty resting with the purchaser.
The society’s SSA should be notified of any instance where a society has agreed to pay damages arising out of any representation or warranty.
3.6.5 Supply of Assets: Clean Sale
3.6.5.a A society will be relieved of the need to maintain capital in support of assets which it has sold only where their transfer is clean and final, that is:
(i) beneficial ownership of the assets has been transferred (although the society may still retain legal ownership of the assets); and
(ii) the risks and rewards on the assets have been substantially transferred,
to the purchaser of the assets. A society may, however, incur risks and rewards associated with the assets as a result of providing servicing arrangements covered by this standard. Outside of these arrangements, unless otherwise approved by its SSA, the society should have no remaining obligation or interest in respect of the assets.
3.6.5.b All of the following conditions should be satisfied if a transfer of assets is to constitute a "clean sale":
(i) The society should have no residual beneficial interest in the assets (or that part which has been transferred).
(ii) The society should have obtained advice from external auditors and legal advisers that the risks and rewards associated with the assets (outside those retained by the society arising from servicing arrangements) have been transferred to the purchaser of the assets.
(iii) The loans sold should not be subject to an offset account or other contractual arrangement under which the rights of the borrower will be affected by the sale.
(iv) The purchaser should have no recourse to the selling society for any losses or costs incurred by the scheme (except where they result from the breach of the servicing agreement or representations and warranties covered by the standard). The selling society should be under no obligation to make good (in any fashion) any dilution risk on assets transferred to a special purpose vehicle.
(v) The society must not guarantee a level, or rate, of return to any participant in the special purpose vehicle or scheme. It should not reimburse any party for taxes or other costs arising from their participation in the scheme.
(vi) Where a society transfers an undrawn commitment to lend, the transfer is effected by novation or by an assignment accompanied by a formal acknowledgment by the borrower/debtor of a transfer of obligations by the society to the purchaser of the commitment.
(vii) The society receives a fixed amount of consideration for the assets no later than at the time of their transfer to the special purpose vehicle. The sale price should reflect the current value of the assets transferred. A society must seek prior approval from its SSA if it intends to transfer assets for a value below their book value or to provide any form of overcollateralisation.
(viii) The society should have no obligation to repurchase an asset (or any part of it), at any time, except where that obligation arises under a breach of its representation or warranty.
(ix) The documented terms of the transfer of the assets should specify that, if cashflows relating to a sold asset are re-scheduled or re-negotiated, the purchaser and not the selling society will be subject to the re-scheduled or re-negotiated terms. Similarly, where payments are routed through the society, the society may not (unless permitted under the section on servicing arrangements) remit funds to the purchaser of an asset until they are received irrevocably from the borrower.
(x) The society must be under no obligation to:
(a) substitute other assets for assets purchased by the special purpose vehicle except where it is permitted by section 3.6.4 on Representations and Warranties; or
(b) provide additional assets to the special purpose vehicle to maintain a "coverage ratio" of collateral to issued securities.
3.6.5.c If any of the above conditions have not been complied with, the society will be required to hold capital against the transferred assets as if they were held on its balance sheet.
3.6.6 Spread Accounts and Like Arrangements
3.6.6.a A society involved in a securitisation scheme, through the sale of assets into a special purpose vehicle, may be entitled to share in the surplus income generated over the life of the scheme or to receive payments related to the performance of the portfolio of assets sold. This may take the form of a "residual interest", "excess servicing income", a "spread account" or like arrangement.
3.6.6.b Even though it may retain some interest in the performance of assets sold, a society will be able to treat the transfer of assets as a "clean sale" (and avoid holding capital against those assets) under the following conditions:
(i) The society makes no payment, direct or indirect, to the special purpose vehicle involved in exchange for this income stream (or if a payment is made there is no carrying value in its books ie it is written off against profit and loss (and capital)).
(ii) The society has no right or is under no obligation as a result of its entitlement to receive this income, to repurchase any non-performing asset or otherwise cover losses on assets or losses of investors in the scheme.
(iii) The society is under no obligation to return the income once received.
(iv) The society does not recognise for profit and loss (and capital) purposes the income until irrevocably received.
3.6.7 Purchase of Securities
3.6.7.a A society will be permitted to purchase securities issued by any special purpose vehicle (but may not act as a market maker in them) provided:
(i) The purchases are at the sole discretion of the society, are acquired on an arm's length basis on market terms and conditions (including price), and are subject to the society's normal credit approval and review processes.
(ii) Purchases are completed within a short time period (less than one week as a guide) from the time the society commits to purchase the securities.
(iii) Any security holding is less than 10 per cent of the stock in the specific tranche of securities issued by the special purpose vehicle.
(iv) They do not represent subordinated securities issued by the scheme.
3.6.7.b A society should have in place adequate systems and controls to ensure that it does not accumulate a disproportionate exposure (vis a vis the group's asset portfolio and capital) to securities issued by special purpose vehicles, eg large aggregate exposures arising from holdings of securities issued by associated special purpose vehicles or vehicles holding similar or related assets.
3.6.7.c A society should not purchase assets from any special purpose vehicle without first obtaining approval from its SSA. An exemption to this is the purchase of Prime Liquid Assets (PLA) from a special purpose vehicle in the normal course of a society’s liquidity management or trading operations.
3.6.7.d Should an SSA come to the view that the pattern of a society's purchases of securities (and/or assets), or its willingness to do so, suggests that the society is supporting investments in a special purpose vehicle, then the society may be required to hold capital against the value of all securities issued by the special purpose vehicle.
Prudential Note 3.7
Note: see subparagraph 1(m) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 3.7 Building Societies
Funds Management And Other Marketing Activities
To protect and promote the financial integrity and efficiency of the State-based financial institutions scheme and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that a society is not exposed to undue risk (particularly moral risk) as a result of the provision of managed funds products and the marketing of these and other products as an agent for third parties.
Funds management involves the provision of financial services to an investor or group of investors who retain beneficial ownership of the assets in which their funds have been invested. Generally the assets are pooled in a trust funded by the issue of units. The trust is established pursuant to a deed which sets out the permissible investments. The trustee is charged with enforcing the deed and will usually engage a custodian as safekeeper of the assets and a manager to exercise its discretion in making investment decisions consistent with the trust deed.
The rate of earnings paid, and the return of capital, to investors hinges on the cash flows from the underlying assets in which the manager invests the funds. This can place pressure on the manager to make payments to the trust to compensate for poor performance or to offer a guarantee (explicit or implicit) regarding performance. If this occurs when a society’s subsidiary acts as manager, then the society will be required to hold capital in support of the assets of the funds as if they were on its balance sheet.
With their extensive customer base, building societies have large scope to market products and services to their customers. They are well placed to offer funds management products, either as managers of pools of funds or as agents on behalf of other funds managers. The agency arrangements may include the badging of products in either the society’s or industry’s name. As well as funds management products such marketing could involve areas such as the sale of securities and insurance and other financial services and products.
In considering societies’ involvement in these areas, AFIC is concerned that these activities may introduce undue risk into the society’s operations. In particular the concern is with moral risk, ie the possibility that a society will feel a moral obligation or commercial need to absorb any loss to a customer that arises from investments offered, marketed by or recommended by the society.
If a building society is to avoid holding capital against funds managements activities it must not use the word building society in the name of a funds management vehicle unless prior approval has been obtained from its SSA (following consultation with AFIC). It is envisaged that such approval will only be given in very exceptional circumstances. In particular it will not be forthcoming simply on the basis of it being an industry scheme or product.
The standard focuses heavily on funds management activities. It is intended, however, that the sections on the "offering of investment advice and sale of securities" and "badging" will apply to all operations of the society, not just funds management.
The standard envisages a society’s involvement in funds management activities will be restricted to the sale of products for which a subsidiary acts as manager or for which the society acts as an agent for a third party. Any society intending to be active in other aspects of funds management such as: providing credit support, liquidity support, underwriting, other lending facilities, treasury or transaction facilities to a funds management vehicle (whether its own or an unrelated third party vehicle), or funding investor purchases of securities/units issued by a vehicle, should consult with its SSA. It will need to be able to satisfy its SSA that the risks involved in the proposed activities have been adequately identified and that it has the expertise, and adequate policies, procedures and systems in place to measure, monitor and control the risks involved.. We would generally expect an SSA to discuss any approach with AFIC.
Despite its detailed nature, this standard cannot encompass every aspect of a society’s funds management activities. Where a society may have plans for a particular initiative that may raise issues not covered in the standard, it should discuss them with its SSA as early as possible.
The introduction of this standard (by revising and superseding earlier standards) may see a society in breach of some of its requirements. Where this is the case a society should contact its SSA to discuss a timetable for achieving compliance with the new standard. Any transitional period should be kept as short as possible whilst recognising the need to avoid imposing excessive compliance costs on the society.
The prime responsibility for the prudent participation of a society and its subsidiaries in funds management rests with its board and management. A society should have in place clear strategies and board approved policies governing participation in this activity. In addition, it must maintain appropriate systems to identify, measure and control risks, including potential conflicts of interest, arising from its participation in funds management. A society’s SSA will need to be satisfied of this before it will endorse participation in a scheme.
Specific breaches of the standard will be handled on a case-by-case basis. It is likely however that following consultation with AFIC, an SSA will require a society to hold capital against the assets held by the funds management scheme as if they were held on its balance sheet.
This standard applies to all funds management activities even if a trust based vehicle and the issuing of units is not involved. Securities issued by a securitisation scheme will also fall within the ambit of the standard. Unless otherwise indicated, reference to a society includes any subsidiaries within its consolidated group.
Prudential Standards 3.7.1 to 3.7.7 (inclusive)
Note: see subparagraph 1(n) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
3.7.1 Disclosure
3.7.1.a To safeguard against investor confusion, a society must ensure that, where it is involved in funds management activities, sufficient disclosures are made so that investors in any funds management vehicle or scheme are:
(i) Given to understand clearly that the securities in which they invest do not represent deposits or other liabilities of the society or any of its subsidiaries or controlled entities.
(ii) Made aware that their holdings of securities are subject to investment risk, including possible delays in repayment and loss of income and principal invested.
(iii) Unambiguously informed that the society or its subsidiaries or controlled entities do not in any way stand behind the capital value or performance of the securities issued by the funds management vehicle or of the assets held by the vehicle except to the limited extent allowed under this standard and as specified in the documentation provided to investors.
3.7.1.b The disclosures in 3.7.1.a. must be provided in a conspicuous manner to prospective investors, and appear in any marketing document. A document inviting investment should include the disclosures as a prominent (and preferably stand alone) item on the inside front cover. It is recognised that variations in the location and form of the required disclosures could be appropriate where regulatory or statutory requirements restrict the presentation or content of disclosures. Any proposal to modify the requirements set out above must be agreed with an SSA.
3.7.1.c Investors must also provide a signed acknowledgment indicating that they have read and understood the required disclosures. To ensure this the disclosures in 3.7.1.a should also appear in close proximity to the signature on the application form in any document inviting investment.
3.7.1.d More generally, a society must ensure that the marketing or promotion of a vehicle with which it is associated does not give any impression that could be construed as being contrary to the disclosure requirements.
3.7.1.e It is possible that securities could be traded in a paperless environment. Where this is envisaged a society must discuss with its SSA (who will be expected to consult with AFIC) procedures for ensuring that the spirit of the disclosure requirements are met.
3.7.1.f Where a society has a limited involvement in a funds management scheme, its ability to ensure the required level of disclosure (and signed acknowledgments) may also be limited. In such cases, compliance with the disclosure requirements may be relaxed by its SSA (following consultation with AFIC).
This concession will not be available where the society or its subsidiary is the sponsor, manager, trustee or responsible entity of the scheme. It will also be unavailable (except in exceptional circumstances) where the society or its subsidiary or associate permits the use of its name, badge, logo or any other identifier in the marketing of the funds management scheme.
3.7.2 Structuring Funds Management Schemes
3.7.2.a The main basis of the policy on funds management is that there is a clear separation between the society involved and any funds management vehicle or scheme. To this end, a society must not without prior approval from its SSA after consultation with AFIC:
(i) Unless provided for in the standard have any ownership or beneficial interest (otherwise than may arise via its equity in an SSP) in a funds management vehicle.
(ii) Include the word "building society" in the name of the funds management vehicle.
(iii) Provide credit support, liquidity support, other lending, treasury or transaction facilities to a funds management vehicle, or underwrite the issue of units or securities by a vehicle.
(iv) Have any of its directors, officers or employees on the board of a funds management vehicle.
(v) "Control" the funds management vehicle such that it would need to be consolidated in accordance with Australian Accounting Standards.
3.7.2.b Requirements i, iv and v set out above do not apply, however, to:
An "approved trustee" or "custodian" established under the provisions of the Superannuation Industry (Supervision) Act 1993 (Cth).
"Common trust funds" established pursuant to legislation and complying with Australian Securities Commission Policy Statement 32.
3.7.2.c A society, itself, must not act in any circumstances as a manager, trustee, custodian, responsible entity or any similar role. Any participation must be through stand alone subsidiaries.
3.7.2.d Where a society’s subsidiary or other associate acts in such a role, the society should ensure that a clear distinction exists between the society and the subsidiary or associate concerned. Any documentation or marketing of funds management schemes with which a subsidiary or associate is involved should not give the impression that those entities are in any way backed by the society or any of its subsidiaries.
3.7.3 Managing
3.7.3.a A subsidiary of a society may act as a manager of funds placed in a funds management vehicle by investors, provided:
(i) There is a written management agreement in place specifying the functions which the manager is required to perform and any performance standards placed on the manager. Such standards should be reasonable and in accordance with normal market practice. The agreement must not (unless approved by its SSA, following consultation with AFIC) obligate a society or any subsidiary to buy back or otherwise purchase securities or units issued by the vehicle.
(ii) The management agreement is undertaken on an arm's length basis and is subject to the society’s normal approval and review processes. The agreement must be undertaken on market terms and conditions (including remuneration to the manager).
(iii) A society may not subordinate, defer or waive the receipt of fee or other income associated with funds management activities without obtaining approval from its SSA.
(iv) The agreement is limited as to a specified time period. A fixed termination date need not be specified provided the society is able, at its absolute discretion, to withdraw from its commitments at any time with a reasonable period of notice.
(v) Subject to reasonable qualifying conditions, the funds management vehicle and/or investors have the clear right to select an alternative party to provide the management services.
3.7.3.b The manager may receive a performance-related payment (or benefit from any surplus income generated) for its role as manager, in addition to its base fee, provided that the base fee is on market terms and conditions and any performance-related payment does not commit the society to any additional obligations. Such payment should be recognised for profit and loss (and capital) purposes only if it has been irrevocably received.
3.7.4 Offering Investment Advice and Sale of Securities
3.7.4.a In its general operations, a society may (subject to appropriate regulatory approvals) offer advice to customers regarding investments (including funds management schemes and other products such as life and general insurance policies) act as a broker in obtaining securities (and other products) on behalf of customers or market such products directly to customers.
In conducting such business, there is a risk that investors may be confused as to the relationship between a society and the issuer of a security (or other product), and a possibility of the society feeling some moral or commercial obligation to investors as a result of its actions.
To minimise such risks, a society should ensure that where it undertakes such activities:
(ii) Any decision to invest in particular securities (or acquire other products) is clearly taken by the customer alone and that the customer is aware they alone bear the risks associated with their investment decisions. The society should be careful to ensure that customers are aware of the level and type of risks they face on the investments.
(iii) Policies and procedures are in place to ensure that staff (and any agents of the society) dealing with customers are required to be appropriately trained and to avoid misleading or confusing them concerning the risks involved or the society’s relationship with (or support for) investments recommended or offered for sale by the society.
3.7.4.b Where a society makes investment decisions or purchases securities for customers at its own initiative or discretion, then the society will be deemed to be acting as a "manager" and the relevant provisions of this standard will apply.
3.7.5 Badging
3.7.5.a Where a society allows its name, logo or trade mark to be used in marketing products of third party institutions it faces risks over and above those covered in 3.7.4. In these circumstances it will also be required to ensure:
(i) The 'name' or 'badge' of the other party providing the product also features prominently in all advertising material, marketing documents and any documents inviting investment or participation in a product.
(ii) The respective roles of the parties should be explained clearly and prominently in any document inviting investment or participation in the product - including the extent to which each party is responsible for the safety and performance of the product.
(iii) The provisions of section 3.7.1 "Disclosure" are fully satisfied.
3.7.5.b A society which fails to comply with these conditions may be required, by its SSA, to discontinue its association with the relevant product.
3.7.6 Purchase of Securities
3.7.6.a Unless exempted by its SSA after consultation with AFIC, a society will only be permitted to purchase securities issued by a funds management vehicle provided:
(i) The purchases are at the sole discretion of the society, are acquired on an arm's length basis on market terms and conditions (including price), and are subject to the society’s normal credit approval and review processes.
(ii) Purchases are completed within a short time period (less than one week as a guide) from the time the society commits to purchase the securities.
(iii) Any holding is less than 10 per cent of the class of units issued by the vehicle.
3.7.6.b A society should have in place adequate systems and controls to ensure that it does not accumulate disproportionate exposure (vis a vis the group's asset portfolio and capital) to securities issued by funds management vehicles, eg large aggregate exposures arising from holdings of securities issued by associated funds management schemes or schemes holding similar or related assets.
3.7.6.c A society should not purchase assets held by a funds management vehicle without first obtaining approval from its SSA. An exemption to this is the purchase of Prime Liquid Assets (PLA) from a funds management vehicle in the normal course of a society’s liquidity management or trading operations.
3.7.6.d Should an SSA come to the view that the pattern of a society’s purchases of securities (and/or assets), or its willingness to do so, suggests that the society is supporting investments in a funds management scheme, then the society may be required to hold capital against all the assets of the scheme as if they were held on its own balance sheet.
3.7.7 Transitional Provisions
3.7.7.a The introduction of this standard may see a society in breach of some of its requirements. Where this is the case a society must contact its SSA to agree a strategy and timetable for achieving compliance. We would expect an SSA to discuss any proposal with AFIC.
Provisions of Book 4 of the Prudential Notes and Prudential Standards issued by AFIC under Part 4 of an AFIC Code, as in force immediately before the transfer date
Note: see paragraph 2 of Schedule 1 of the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 4.1
Note: see subparagraph 2(a) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 4.1 - Credit Unions
To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that credit unions incur in the process of financial intermediation. Towards this end, to ensure that credit unions are aware of the risks to which they are exposed, and that these risks are adequately measured, monitored and managed.
Pooling and managing risks for both borrowers and lenders is an important element of financial intermediation. Careful management of these risks is fundamental to the successful operation of any financial institution. As noted earlier, the primary responsibility for risk management rests firmly with the management of each credit union; the role of the supervisory authorities is limited to protecting the interests of depositors. Depositor protection, in turn, is enhanced by ensuring that credit unions approach risk management in a consistent manner and that they maintain a sufficient cushion of capital to afford depositors maximum confidence in the security of their deposits.
In assessing the appropriate level of capital, SSAs will require detailed information about the risk management procedures and practices of credit unions. Inadequate management practices in this area will meet with additional requirements in terms of capital or, in certain cases, with additional requirements with respect to the holding of liquid assets.
While there will be no set formula relating the need for additional capital to particular deficiencies in risk management, SSAs will look for adequate procedures for identifying and measuring risk, adequate procedures for monitoring risks, and appropriate techniques for managing risks.
Additional capital will also be required of credit unions in direct proportion to their overall risk rating when these ratings imply risk in excess of industry norms. SSAs will advise credit unions as to their risk ratings and capital requirements.
In a number of cases, the Prudential Standards require a credit union to consult with its SSA before particular transactions or activities can be undertaken. Consultation in this context will focus on the credit union's ability and systems to manage their risks prudently; the emphasis will be on processes rather than on the quality or otherwise of the decisions involved. Such consultation should not be taken to imply that the SSA in any sense sanctions or approves the particular activity. Decisions about the appropriate balance sheet structure for a particular credit union are its own responsibility. The SSA's role is to ensure that risk analyses are adequate and that each credit union's capital base is consistent with the risks that it undertakes.
Notwithstanding this responsibility, each credit union must, prior to the assumption of any major new risks (for example, moving into a new area of lending) first satisfy its SSA that it has:
(a) met all current prudential standards;
(b) the expertise and systems in place to manage the new risks involved; and
(c) sufficient capital in place to meet any additional requirements imposed by the authorities - this may include additional capital requirements if the proposed lending activities alter the assessed risk rating of the credit union as a whole.
Limited exemptions from this requirement may be granted under the transitional arrangements outlined earlier.
Credit unions face a number of different types of risk in conducting their businesses.
(i) Liquidity Risk - Prime Liquid Assets Requirement
Liquidity risk arises from the tendency for a credit union's deposit base to be more readily liquidated than its assets. This is partly a consequence of the longer maturity of loans relative to deposits. It is also a consequence of the fact that loans which are not in arrears are not normally callable, whereas term deposits are often callable, albeit at a penalty. Despite this asymmetry in balance sheet liquidity, the capacity to meet promptly all obligations as they fall due is fundamental to financial intermediation.
The prudential standards require credit unions to hold a minimum level of 7 per cent of their total liabilities (excluding capital) in the form of highly-liquid, high-quality assets. This prime liquid assets (PLA) ratio is to be met at all times. In day-to-day operations, however, these assets are not available to meet the ebb and flow of funds. They are intended only to provide a cushion of liquifiable funds, available in times of extreme pressure on liquidity, and then, only with the explicit approval of the SSAs.
(ii) Operational Liquidity Risk
While PLA provides a stock of high quality assets, each credit union must manage its cash flows without reliance on PLA. It is the responsibility of the board to assess its credit union's liquidity needs and determine the amount and composition of additional liquid assets required to cover day-to-day fluctuations in its operating liquidity arising from:
· withdrawals of deposits;
· increases in demands for loans, including increased drawdown of overdraft facilities;
· drawdown of credit card facilities;
· maturity mismatch of assets and liabilities; and
· unexpected operating expenses.
Each credit union is expected to have in place an appropriate management information system to allow monitoring and management of liquidity risk. Each credit union is also required to demonstrate an understanding of its deposit base (including strengths, limitations and historic volatility), the maturity mismatch between assets and liabilities and any risks arising from off-balance sheet activities. While cash flow projections, incorporating all significant cash flows and management of forward loan commitments, should form part of any liquidity management system, the sophistication of these systems will depend on the credit union's activities.
A credit union can pursue a range of strategies to manage liquidity risk including:
· holding adequate cash and readily liquefiable assets in addition to PLA;
· maintaining stand-by and overdraft facilities with banks, SSPs or other counterparties acceptable to AFIC;
· developing and maintaining a stable core of deposits;
· matching maturity structures of assets and liabilities, securitising assets and sourcing long-term funding; and
· developing sophisticated cash flow projections including improving asset and liability management.
In relation to the first point, each credit union is expected to hold 2 per cent of total liabilities (excluding capital) in one or more of the following: excess PLA, cash, funds securing settlement accounts and liquidity deposits with SSPs.
In determining liquidity needs, a credit union's board should aim at maintaining access to funds for the purpose of meeting operational demands at 6 per cent of total liabilities (less capital). Access to funds may be through off-balance sheet facilities and generally, each credit union is expected to look beyond its immediate deposit base to alternative sources of liquidity. These alternative sources include stand-by lines of credit or overdraft facilities with other financial institutions, including SSPs. Evidence that these arrangements have been firmly established and are available for immediate use will be required by SSAs.
To ensure that each SSA is aware of any weakening of a credit union's liquidity position, each credit union must advise its SSA if on-balance sheet liquid assets held to meet operating requirements falls below 2 per cent of total liabilities (excluding capital). Deviations below this liquidity trigger may occur from time to time and are not necessarily a source of concern.
Liquidity risk is also associated with large exposures to a single source of funds. Each credit union must include in its approach to liquidity management, a policy in respect of large liquidity exposures. Further, each credit union must report exposures in excess of 5 per cent of the credit union's total liabilities and, before a credit union adopts an exposure in excess of 10 per cent of total liabilities, it must consult with its SSA.
In reviewing a credit union's approach to liquidity management, the SSA may consider that the large liability exposure, or exposures in aggregate, create the potential risk for a credit union's liquidity to be strained or may consider that systems are otherwise inadequate. Under these circumstances, the SSA may require the credit union to hold higher levels of PLA or operational liquidity, report more frequently, or impose other requirements.
(iii) Market Risk
Market risk arises from the fluctuations that occur in the market values of assets and liabilities in the normal course of business. The primary source of such fluctuations is movements in interest rates. When interest rates change, the market values of loans, securities and deposits change to different extents. Whenever the interest rates paid on a financial institution’s liabilities do not adjust in line with the rates earned on assets, the institution is exposed to market risk. The net effect of these valuation changes alters the institution’s earnings and its net worth.
Financial innovations have provided credit unions with a range of techniques for managing this risk. To the extent that deposits and loans are matched, either as variable interest instruments or, in the case of fixed-interest loans and deposits, by duration, the risk may be relatively small. Where a credit union’s book is not naturally matched in the above sense or not readily adjustable, the market provides instruments for managing the mismatch, while still meeting customer preferences on the terms of loans and deposits. Interest rate futures, options and swaps are now widely used in the finance industry to manage market risk. Section 120 and the prohibitions in Section 121 of the FI Code outline the scope for credit unions to trade in these instruments for the purpose of managing market risk.
SSAs will seek detailed information about each credit union's methods for measuring and monitoring market exposures. In particular, where assets do not satisfy either the primary objects or the liquid asset tests, SSAs will look for evidence that credit unions are employing appropriate risk management techniques, including regular market value assessments and appropriate provisioning for risks (see Prudential Note 4.3 on Accounting and Disclosure).
(iv) Credit Risk
A primary source of risk for any financial institution is the risk of default. Undue concentration of loans can expose a credit union to excessive credit risk. Sensible diversification of a credit union's loan book by geographical area, type of borrower and to some extent by type of loan can reduce the risk of the overall loan portfolio.
SSAs will seek detailed information about each credit union's practices with respect to credit scoring, loan monitoring and the overall assessment of credit risk. Credit unions should be able to demonstrate an understanding of the inter-relationships between the various credit risks they are carrying. SSAs will pay special attention to credit risk policies relating to assets which lie outside the definitions of primary objects and liquid assets. In particular, credit unions inevitably carry a substantial fixed asset exposure to property through their branch network systems. In the normal course of business this exposure should not exceed the size of the credit union's capital base. Exposure beyond this level will require prior consultation with its SSA.
A particular source of credit risk is large credit exposures to single borrowers. Large exposures can accumulate indirectly through lending to associated borrowers even though the exposure to any one member of the group may appear reasonable. While 'associate' has been defined under Part 4 of the FI Code, the existence of these relationships may not represent any aggregation of risk (for example where loans to associated family members are separately collateralised). It is recognised that a number of these relationships cannot be identified from data collected in the normal course of opening and operating accounts. Therefore, credit unions will not be expected to monitor large exposures to groups of associated family members who have independent retail relationships with the credit union. In the case of commercial lending, borrowers will be assumed to be associated where they collectively control the source of credit risk to the credit union.
Each credit union will be required to provide its SSA with a copy of its policy in respect of large exposures and to report exposures to individual borrowers or groups of associated borrowers in excess of 5 per cent of the credit union's capital base. These exposures are to be measured in terms of exposures to the consolidated group where relevant. Exposures beyond 10 per cent of a credit union's capital base will require prior consultation with its SSA. Certain exemptions may be permitted with respect to lending within primary objects. Further exemptions and general approvals may be granted by SSAs in the light of experience.
(v) Data Risk
A risk to any credit union relates to the security and integrity of its data bases, both automated and non-automated. Detailed records of all financial transactions and balance sheet data should be kept in more than one location. Where records are computerised, back-up and storage procedures should be documented by the credit union and audited, as should procedures for preventing data corruption. Adequate disaster recovery procedures should be in place.
A particular risk to a society’s data exists due to the potential for damage to or misuse of date-related data, caused by the use of computer programs or code that fail to calculate correctly or record dates after a particular date. This is commonly referred to as the "Year 2000 problem" because many computer and other electronic systems cannot deal with dates after 31 December 1999. However, the problem is not confined to the year 2000 and could arise through a range of other critical dates that might be embedded in computer systems. For convenience, AFIC is referring to this matter as the "Year 2000 problem".
To ensure the security and integrity of a society’s data, the Directors of a society should ensure that a full review and assessment of the risks associated with the Year 2000 problem is undertaken. Those systems affected that are critical to using or storing the society’s data, must be corrected. Directors must:
ensure that appropriate tests are carried out to ascertain that any critical computerised systems using or storing the society’s data are not affected by the Year 2000 problem; and
obtain sufficient assurance that the society’s systems and dates will not be significantly affected by inaccurate data or failure of services by its suppliers.
It may not be possible for every internal and external system to be corrected in the short time available before the year 2000, or any other critical date, arrives. Therefore, in anticipation of possible failures, each society must have a comprehensive written statement dealing with the risks and events that may arise due to either the society or an external service provider suffering disruptions that may, in turn, disrupt the society’s normal business operations. These policies and procedures should form part of a society’s Disaster Recovery Plan in respect of managing both data risk and operations risk.
(vi) Operations Risk
Credit unions carry a range of operations risk in carrying out their day-to-day business. Many of these risks are insurable, others are not. Of particular importance in the latter category are credit unions' administrative systems and the consequences of breaches of legislation. In smaller credit unions, overdependance on a small number of key personnel can constitute a substantial risk to their operations. Other risks arise from litigation associated with a wide variety of possible events and actions, including discrimination, negligent advice and invasion of privacy. Whether or not these risks are insured or even insurable, credit unions must demonstrate an understanding of the risks involved and the capacity to measure, monitor and control them.
A particular risk to a society’s operations exists due to the Year 2000 problem. Societies are faced with the potential for impairment of normal business operations through the failure of systems dependent on computer microchips, such as communications, security, and fire protection systems.
To ensure the society’s operations risk is minimised, the Directors of a society should ensure that a full review and assessment of the risks associated with the Year 2000 problem is undertaken. Those systems affected that are critical to the society’s normal business operations must be corrected. Directors must ensure that appropriate tests are carried out to ascertain that any critical computerised systems and devices required for the society’s day-to-day operations are not affected by the Year 2000 problem.
A society must keep its insurance contracts under review to ascertain whether it is covered for interruptions to business and possible litigation, due to non-performance or disruption to business, as a result of the Year 2000 problem.
The costs and resource requirements to address the Year 2000 problem may be beyond the scope of some societies. Where directors are of the opinion that the society will be unable to address the Year 2000 problems adequately, with regard to its critical systems, the society should immediately notify its SSA. The SSA, together with the society, will then consider the appropriate action to be taken to ensure that the interests of the society’s members are not adversely affected by the society’s inability to manage Year 2000 problems adequately.
An important source of insurable operations risk arises from potential damage to the physical assets of the credit union through accident or fire. While compulsory worker's compensation covers potential loss through accidents involving staff, there is a similar risk to members of the public that is not automatically insured. Other operational risks arise from the potential for legal action against the credit union or its directors.
In addition to compulsory worker's compensation, all credit unions should carry effective insurance with a reputable insurance company to protect their personnel, operations and physical assets. At a minimum, each credit union should carry the following insurance policies:
(a) fidelity guarantee;
(b) asset protection, including fire and malicious damage;
(c) directors' and officers' liability;
(d) public liability;
(e) professional indemnity; and
(f) business interruption.
Insurance should cover the credit union and all subsidiaries (if any). SSAs will seek details of insurance policies and each credit union's approach to insurance.
Prudential Standards 4.1.1 to 4.1.6 (inclusive)
Note: see subparagraph 2(b) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
4.1.1 Prime Liquid Assets Requirement
4.1.1.a Each credit union is to maintain at all times a minimum proportion of its balance sheet in specified prime liquid assets (PLA). The required PLA ratio is to be 7 per cent of total liabilities excluding capital as defined in Prudential Note 4.2 (Capital Adequacy).
4.1.1.b The PLA ratio is to be met at all times. If a credit union finds itself in danger of breaching the minimum ratio, it must advise its SSA immediately and, in consultation with the SSA, take prompt action to correct the situation.
4.1.1.c To be eligible for inclusion in the PLA ratio, assets must be held in the credit union's own name, must be unencumbered by any pledge or restriction (other than restrictions arising from the emergency liquidity support facility) and must be readily negotiable.
4.1.1.d Assets deemed acceptable by AFIC for inclusion in the PLA ratio may change from time to time as circumstances and asset quality change. Until notice of alteration, PLA will include the following:
(iv) loans to authorised money market dealers against the security of Commonwealth Government securities;
(v) State or Territory Government issued or guaranteed securities; and
(vi) PLA deposits with special services providers (see Book 1).
4.1.1.e Given the potential for the liquidation value of some PLA to vary with market conditions, assets will be valued at market value for the purpose of calculating the PLA ratio.
4.1.1.f Credit unions must hold half of their required PLA assets in a manner that can be immediately accessed under the emergency liquidity support facility outlined in Part 6 of the AFIC Code (see also Prudential Standard 4.4.5).
4.1.2 Operational Liquidity
4.1.2.a Each credit union is to provide its SSA, on request, with a written description of its systems to measure, monitor and manage liquidity risk. These systems are to be audited annually by the credit union's external auditors and their operation in practice will be subject to review during on-site inspections by the SSA.
4.1.2.b It is the responsibility of each board to determine the liquidity needs and normal liquidity operating range of its credit union and the associated composition and liquidity of assets to be held. Notwithstanding, each credit union should aim to maintain access to funds to meet operational demands at 6 per cent or more of total liabilities (less capital) with a minimum component of on-balance sheet assets of 2 per cent of total liabilities (less capital). As part of its liquidity management, each credit union must also satisfy its SSA that it has access to appropriate levels of funding through off-balance sheet facilities provided by banks, SSPs or other entities advised by AFIC.
4.1.2.c Unless otherwise advised by Standard or Guidance Note, assets that may be included in on-balance sheet operational liquidity are:
(i) cash on hand;
(ii) PLA in excess of the required minimum;
(iii) funds securing settlement accounts; and
(iv) liquidity deposits with Special Services Providers.
4.1.2.d A credit union must advise its SSA if the level of on-balance sheet operational liquidity falls below 2 per cent of total liabilities (less capital).
4.1.2.e As part of its liquidity management system, each credit union must include a policy in respect of large liability exposures to individual lenders or a group of associated lenders. Each credit union must report quarterly liability exposures in excess of 5 per cent and must consult with its SSA prior to acceptance of a liability greater than 10 per cent of the credit union's total liabilities. The onus will be on the credit union to establish that the liability exposure does not constitute an excessive risk to the credit union.
4.1.2.f A credit union that fails to satisfy its SSA that it adequately manages its cash flows and operational liquidity may be directed to hold higher levels of liquid assets, maintain higher levels of capital, report more frequently or otherwise as determined by the SSA.
4.1.3 Managing Market Risk
4.1.3.a Each credit union is to provide its SSA, on request, with a written description of its systems to measure, monitor and control market risk. These systems are to be audited annually by the credit union's external auditors. Their operation in practice is subject to review during on-site inspections by the SSA.
4.1.3.b Failure by a credit union to satisfy its SSA that its practices are adequate to the risks involved may lead to its being required to maintain a capital adequacy ratio above the 8 per cent minimum.
4.1.4 Managing Credit Risk and Large Exposures
4.1.4.a Each credit union is to provide its SSA, on request, with written descriptions of its systems to measure, monitor and control credit risk. These systems are to be audited annually by the credit union's external auditors. Their operation in practice is subject to review during on-site inspections by its SSA.
4.1.4.b Each credit union is to include in this description a written statement of its policy with respect to acquiring assets not defined within primary objects or liquid assets.
4.1.4.c In the normal course of business, a credit union's exposure to its own fixed assets should not exceed the size of its capital base. Exposure beyond this level will require prior consultation with its SSA.
4.1.4.d Each credit union is to provide its SSA, on request, with a written statement of its policy in respect of exposures to individual members or groups of associated members.
4.1.4.e Each credit union must provide quarterly returns of all exposures of the consolidated group to individual borrowers and/or associated borrowers greater than 5 per cent of its capital base (as defined in Prudential Note 4.2). The intention of this Prudential Standard is to identify concentration of risks. SSAs will declare borrowers to be "associated" if there is any suggestion of intent to disguise concentration.
4.1.4.f Before entering into any such exposure greater than 10 per cent of a credit union's capital base (or, in the case of a group, 10 per cent of the group’s capital base), the credit union must first consult with its SSA. The onus will be on the credit union to establish that the exposure does not constitute an excessive risk. Lending within primary objects may be exempted from this process if, after examining the credit union's lending policies, the SSA is satisfied that they do not introduce excessive risk.
4.1.4.g Failure by a credit union to satisfy its SSA that its practices are adequate to the risks involved may lead to its being required to maintain a capital ratio above the 8 per cent minimum.
4.1.5 Data Risk
4.1.5.a Each credit union is to provide its SSA, on request, with a written statement of its policy in respect of managing data risk. Detailed records of all financial transactions and balance sheet data should be kept in more than one location. Where records are computerised, back-up and storage procedures should be documented by the credit union and inspected by the relevant SSA, as should procedures for preventing data corruption.
4.1.5.b The Directors of a society should ensure that a full review and assessment of the risks associated with the Year 2000 problem is undertaken. Those systems affected that are critical to using or storing the society’s data, must be corrected. Directors must:
ensure that full testing is carried out to ascertain that any critical systems for using or storing the society’s data are not affected by the Year 2000 problem; and
obtain sufficient assurance that the society’s systems and dates will not be significantly affected by inaccurate data or failure of services by its suppliers.
4.1.5.c Each society must have a comprehensive written statement dealing with the risks and events that may arise due to either the society or an external service provider suffering disruptions that may, in turn, disrupt the society’s normal business operations. These policies and procedures should form part of a society’s Disaster Recovery Plan in respect of managing both data risk and operations risk.
4.1.6 Operations Risks
4.1.6.a Each credit union is to provide its SSA annually with a written statement of its policy in respect of disaster recovery planning and insurance including details of its individual insurance policies. SSAs will monitor the adequacy and currency of these policies. At a minimum, credit unions should take out the following insurance cover:
(i) Fidelity/Bond Insurance
(ii) Fire and Specified Perils
• Physical loss or damage to tangible property due to fire and specified perils including:
• storm and tempest;
• earthquake;
• explosion;
• impact;
• water damage;
• malicious damage;
• riots; and
• strikes.
(iii) Directors' and Officers' Liability
(iv) Public Liability
• To cover the society's legal liability for bodily injury or damage to property anywhere in Australia or on society business overseas.
(v) Professional Indemnity
• To cover legal liability to members and third parties through a breach of professional duty in the conduct of the society's business, by reason of any negligence, including:
• libel and slander;
• amendment of dishonesty clause;
• retroactive cover;
• automatic reinstatement; and
• breaches of Trade Practices/Fair Trading Acts.
(vi) Business Interruption
• To cover loss of income or increased cost of working due to Interrupted business operations as a result of an insured peril.
4.1.6.b Directors of a society should ensure that a full review and assessment of the risks associated with the Year 2000 problem is undertaken. Those systems affected that are critical to the society’s normal business operations must be corrected. Directors must ensure that full testing is carried out to ascertain that any critical computerised systems and devices required for the society’s day-to-day operations are not affected by the Year 2000 problem.
4.1.6.c A society must keep its insurance contracts under review to ascertain whether it is covered for interruptions to business and possible litigation, due to non-performance or disruption to business, as a result of the Year 2000 problem.
4.1.6.d Where directors are of the opinion that the society will be unable to address the Year 2000 problems adequately, with regard to its critical systems, the society should immediately notify its SSA.
Prudential Note 4.2
Note: see subparagraph 2(c) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 4.2 - Credit Unions
To protect and promote the financial integrity and efficiency of the State-based financial institutions scheme and to ensure that depositors are adequately protected from the risks that credit unions incur in the process of financial intermediation. Towards this end, to ensure that individual credit unions maintain a level of capital which broadly reflects the extent of risks undertaken.
The primary role of capital in a deposit-taking institution is to provide a cushion against loss and to maintain the confidence of its depositors. While effective management systems can reduce the risk to depositors' funds, they are unlikely to eliminate risk entirely, given that risk pooling is a fundamental element of financial intermediation. Credit unions, therefore, must hold capital against a range of risks, including the loss of capital value of assets as a result of credit risk, a competitive squeeze on margins, mismatching of the characteristics of assets and liabilities, off-balance sheet exposures and concentration of particular types of assets or liabilities.
Framework
AFIC's approach to capital adequacy has three elements - capital adequacy ratio of individual institutions, quality and structure of capital and credit risk of assets.
Risk weightings focus on credit risk of assets. However, the SSA will look beyond the asset portfolio in reviewing a society and setting capital adequacy requirements. The SSA will determine a 'risk ratio' for each credit union that is consistent with its overall assessed risk rating. Under this approach, the level of capital required to support the risk-weighted assets of any credit union may increase (from a base of 8 per cent) as the overall riskiness of the credit union increases.
Capital is considered in two tiers. Tier 1 (or 'core capital') comprises the highest quality capital elements. Tier 2 (or 'supplementary capital') represents additional elements that contribute to the overall strength of the credit union as a going concern (see Prudential Standards 4.2.1 and 4.2.2). At least 50 per cent of a credit union's required capital must be core capital (Tier 1); the remainder may consist of 'supplementary' elements.
Tier 2 capital is further qualified as Upper and Lower Tier 2 capital. Upper Tier 2 capital includes elements that are essentially permanent in nature and have characteristics of both equity and debt. Lower Tier 2 capital consists of elements that are not permanent. The value of Lower Tier 2 capital that may be included in the capital adequacy calculation cannot exceed 50 per cent of Tier 1 capital (net of goodwill, other intangible assets and future income tax benefits).
It is not appropriate that the capital of a credit union be used to support the balance sheet of a building society or credit union as this could raise doubts about the adequacy of capital available to support the industries. Therefore, for the purposes of calculating capital adequacy, a credit union must deduct from its total capital (and assets) the carrying value of any holding of capital instruments of another credit union or building society.
Similarly, consistent with the requirements of Prudential Notes 4.6 and 4.7, a credit union must deduct any equity investment in a securitisation or funds management vehicle (that includes a subsidiary that acts as an approved trustee under the SIS legislation) and any subsidiary that is active in these areas of business as a manager, custodian, trustee or similar role. The deduction should be for the maximum amount of capital that may be required to be committed to the entity. This includes any guarantee that acts as a substitute for capital that would otherwise need to be provided and any uncalled amount on partly paid shares.
Consistent with the approach adopted by banking supervisors around the world, assets are risk-weighted to reflect the differing capital needs to support different types of lending activity. The focus in risk weighting is on credit risk, namely the potential for default by the borrower or counterparty and the associated potential loss. Credit risk focuses primarily on the financial strength of the borrower. However, where collateral is involved, this may have a major bearing on the extent of potential loss.
Balance sheet assets and off-balance sheet exposures are weighted according to broad categories of relative risk, based largely on the nature of the counter party. The higher the risk, the greater the capital backing required. The sum of risk-weighted assets (including risk-assessed off-balance sheet business) together with the credit union's 'risk ratio' defines the amount of capital needed to support its lending activity.
Credit exposures (on and off-balance sheet) are risk weighted according to three broad types of counter party - government, banks and FI Scheme institutions, and all others. There are five specific categories of risk weights - 0, 10, 20, 50, and 100 per cent (see Prudential Standard 4.2.4). Off-balance sheet transactions (including derivative products) are converted to balance sheet equivalents before being allocated a risk weight.
Prudential Standards 4.2.1 to 4.2.8 (inclusive)
Note: see subparagraph 2(d) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
4.2.1 Capital Adequacy
4.2.1.a Each credit union and consolidated credit union group is required to maintain at all times a minimum ratio of capital to risk-weighted assets of 8 per cent (or more for an individual credit union as determined from time to time by its SSA).
4.2.1.b Capital will be considered in two tiers:
• Tier 1 (or 'core capital') comprises the highest quality capital elements (defined in Prudential Standard 4.2.2.a).
• Tier 2 (or 'supplementary capital') represents additional elements (defined in Prudential Standard 4.2.2.b) that contribute to the overall strength of the credit union.
4.2.1.c At least 50 per cent of a credit union's required capital must be core capital (Tier 1); the remainder may consist of 'supplementary' elements (Tier 2).
Any instrument or issue of subordinated debt or limited life redeemable preference shares by a credit union must be approved by the SSA, in consultation with AFIC, before the instrument may qualify for treatment as Tier 2 capital. Relevant documentation will be examined by the supervisors with particular regard to the provisions by which the instrument is subordinated to the claims of other creditors and the events or circumstances which may accelerate payment of interest and/or repayment of principal ("events of default").
As a precondition for qualification of subordinated debt as Tier 2 capital the subordinated debt instrument or other relevant documentation governing the terms of issue must, unless otherwise agreed in writing by AFIC, preclude the subordinated debt holder (and any agent, trustee or other person acting on behalf of the holder) from enforcing rights to accelerate payments or repayments in consequence of events of default except by instituting proceedings (or joining in proceedings) for the winding up of the society pursuant to the Financial Institutions Code.
The review by supervisors of terms and conditions of instruments for inclusion in Tier 2 capital will give close regard to step up rates, conditions for conversions, deferral of interest and other payments, options to repay and early repayment.
4.2.3 Hybrid (Debt/Equity) Capital Instruments
4.2.3.a A range of instruments that combine characteristics of equity capital and of debt may be included in upper Tier 2 capital. To qualify for inclusion in the capital base they must be:
(ii) not redeemable at the initiative of the holder or without the prior consent of the SSA; and
(iii) available to participate in losses without the credit union being obliged to cease trading (unlike conventional subordinated debt).
4.2.3.b. Although these instruments may carry an obligation to pay interest that cannot permanently be reduced or waived (unlike dividends on ordinary shareholders' equity), they should allow servicing obligations to be deferred (as with cumulative preference shares) where profitability would not justify payment.
4.2.3.c As with term subordinated debt an instrument or issue of hybrid capital by a credit union must be approved by its SSA in consultation with AFIC before it may qualify for inclusion as Tier 2 capital.
4.2.4 Categories of Risk
4.2.4.a Nil Weight:
• overnight settlements, loans and other claims fully secured10 against cash;
• Commonwealth, State or Territory Government securities, including securities issued by State or Territory central borrowing authorities; and
• claims fully secured against Commonwealth or State Government securities.
4.2.4.b 10 per cent Weight:
• all other claims on, or guaranteed11 by, Commonwealth or State or Territory Governments or a State Central Borrowing Authority;
• deferred assets held in credit union contingency funds.
4.2.4.c 20 per cent Weight:
• liquidity deposits with special services providers (see Book 5);
• claims on Australian local governments or public sector entities (except those which have corporate status or operate on a commercial basis) or which are guaranteed by these entities;
• claims on, or guaranteed by, Australian or OECD banks;
• claims on, or guaranteed by, building societies or credit unions
• claims on, or guaranteed by, international banking agencies or regional development banks; and
4.2.4.d 50 per cent Weight:
• loans12 for housing, or other purposes fully secured y registered mortgage over a residential building or development (as defined in Section 3 of the FI Code) where, the mortgage falls within one of the following categories:
(i) a first registered mortgage where the ratio of the outstanding balance13 of the loan14 to the valuation of the property is no more than 80 per cent.15 If the loan is 6 months or more in arrears, the valuation must be no older than 12 months.
(ii) a first registered mortgage where the outstanding balance is 100 per cent mortgage insured.16
(iii) a second mortgage where the ratio of the outstanding balances of the loans secured by both mortgages to the valuation of the property does not exceed 80 per cent and the first mortgage cannot be extended without it being subordinated to the second mortgage.
(iv) a second mortgage where the ratio of the outstanding balances of the loans secured by both mortgages to the valuation of the property exceeds 80 per cent, where the first mortgage cannot be extended without it being subordinated to the second mortgage and the outstanding balance is 100 per cent mortgage insured.16
Elsewhere, in the standards mortgages satisfying any one of the conditions i) - iv) above will be referred to as 'qualifying' mortgages.
The 50 per cent risk weight applies to loans for housing, or for other purposes, fully secured by a registered mortgage over residential property (whether or not the property is owned by the borrower) subject to the following criteria being satisfied:
• the credit union has at all times a clear and unequivocal access to mortgaged residential properties in the event of default by borrowers;
• the credit union has been involved directly in making credit assessments of individual borrowers, including the valuations of the associated residential properties secured by mortgage;
• where security is provided by third parties (ie. parties other than the specific borrower), other than on loans in respect of which the relevant mortgage is unenforceable under the Consumer Credit Code, the building society has ensured that those parties understand fully the consequences of default on the loans and their legal obligations; and
• loans for purposes other than housing are fully secured by mortgages over existing residential property. Loans, for whatever purpose, secured against speculative residential development – eg. multiple dwellings such as blocks of units – do not qualify for a concessional risk weight.
Where a loan fails to satisfy any of the above criteria, the full value of the loan should be assigned a 100 per cent risk weight in the absence of any other eligible collateral or guarantees. A concessional risk weight does not apply to mortgage-backed securities which should be risk weighted as a claim on the issuer of the securities. Other asset backed paper should be risk weighted in a similar fashion.
Certain asset classes and investments may result in additional capital requirements if, in the opinion of the SSA, they lead to excessive risk for the credit union.
4.2.5 Off-Balance Sheet Business
(i) the principal (or face value) amounts of transactions will be converted into on-balance sheet equivalents ('credit equivalent amounts') by application of credit conversion factors; and
(ii) the resulting credit equivalent amount will be assigned the risk weight appropriate to the counterparty or, if relevant, the risk weight assigned to the guarantor or the collateral security.
4.2.5.a Credit conversion factors for selected major off-balance sheet transactions:
| | Credit Conversion Factor18 |
| Direct credit substitutes, including financial guarantees and endorsements (which do not have the prior endorsement of a bank) | 100% |
| Assets sold with recourse19 where credit risk remains with the credit union | 100% |
| Sale and repurchase agreements20 where credit risk remains with the credit union20, forward asset purchases20 placement of forward deposits, and other commitments to acquire assets20 | 100% |
| Loans approved by a credit union but not yet advanced, where there is certainty of drawdown (i.e. forward loan commitments) | 100% |
| Trade and performance-related contingent items, including warranties, bid bonds, indemnities, performance bonds and standby letters of credit related to particular non-monetary obligations | 50% |
| Other commitments (e.g. formal standby facilities and undrawn amounts under an equity credit or redraw facility21) with a residual maturity exceeding one year22 | 50% |
| Other commitments that can be unconditionally revoked without notice but are not subject to review at least annually. | 50% |
| Other commitments (eg undrawn overdraft and credit card facilities) which can be unconditionally revoked at any time without notice where the credit union provides for any outstanding unused balance to be reviewed at least annually | 0% |
| Other commitments with a residual maturity of one year or less23 | 0% |
4.2.5.bOther Items
For items not included above24, credit conversion factors should be discussed with the relevant SSA.
4.2.6 Derivative Products
4.2.6.a Under Section 120 and Section 121 (prohibitions) of the FI Code, credit unions may only enter into contracts involving derivative products for the purpose of reducing market risk. Given the nature of credit union business, the general presumption is that credit unions will only use derivative products related to interest rates. The credit risk associated with derivative products is the cost to the credit union of replacing the cash flow specified by the contract in the event of counterparty default. This will depend, among other things, on the maturity of the contract and on the price volatility of the underlying physical instrument.
4.2.6.b Credit-equivalent amounts for derivative products may be calculated in either of two ways, using a ‘mark-to-market’ approach or a ‘rule-of-thumb’ approach25:
This is the mark-to-market valuation of all contracts with a positive replacement cost. Replacement costs which are fully collateralised by cash and government securities, or backed by eligible guarantees, may be given the weight of the underlying security or guarantor.
This is calculated as a percentage of the nominal principle amount of a credit union's portfolio of interest rate contracts split by residual maturity as follows:
Credit-equivalent amounts are calculated by applying credit conversion factors to the principal amounts of contracts according to the nature of the instrument and its original maturity.
4.2.6.c The following derivative products are to be included in the calculation of credit-equivalent amounts:
4.2.6.d The following derivative products are excluded in the calculation of credit-equivalent amounts:
4.2.7 Deductions of Certain Investments from Capital
4.2.7.a For the purpose of calculating capital adequacy, a credit union must deduct from its total capital (and assets) the carrying value of any investment (by it or a subsidiary) in the capital instruments (in the form of equity or subordinated debt26) of another credit union or building society.
4.2.7.b Where a credit union (or its subsidiary) invests capital in, or provides a guarantee or similar support to, an entity which undertakes the role of manager, responsible entity, approved trustee, trustee, custodian or similar role in relation to funds management or the securitisation of assets then the value of capital27 and guarantees should be deducted from the credit union’s and the group’s capital base.
4.2.7.c A credit union is required to deduct from its capital base (and risk assets) its (or its subsidiary’s) equity and other capital investments in non-consolidated subsidiaries or associates which it effectively controls. Investments in life and general and lenders mortgage insurance companies, as well as friendly societies, will generally be subject to this requirement.
4.2.7.d Where a credit union (or its subsidiary) enters into an undertaking which provides for it to absorb the first level of losses28 on claims supported by the credit union (eg guarantees, up to a limit, of losses on a portfolio of loans held in a securitisation vehicle) the amount of the undertaking (or limit) should be deducted from its capital base (and risk assets) unless it has already been written off.
4.2.8 Reductions in Capital
4.2.8.a Where a credit union proposes any reduction in its capital (eg through the partial distribution of reserves repurchase of shares or subordinated debt or dividend payment exceeding current year earnings ) it must obtain the prior written agreement of its SSA. The SSA will need to be satisfied on the basis of an acceptable capital plan (which extends for at least two years) provided by the credit union that the credit union’s capital will remain adequate, for its future needs, after the proposed reduction.
1 Goodwill and similar intangible assets including future tax benefits (FITB) (other than those associated with the general provision for doubtful debts) (net of any provision for deferred income tax liability(DITL) that may be offset in accordance with AASB 1020) will be deducted from 'core' capital and hence total capital. If the DITL exceeds FITB, the excess may not be added to capital.back
2 Must constitute at least -50 per cent of the capital requirement.back
3 May include measured current year earnings net of expected distributions and tax expense.back
4 Must be subordinated to depositors and unsecured creditors; must not provide for a return of capital or compensation for unpaid dividends; and dividends (the only form of compensation to investors that should be provided) should not be influenced by the credit standing of the society. The non-declaration of a dividend should not trigger any restrictions on the society other than the need to seek approval of holders of the shares before paying dividends on or retiring other shares.back
5 For the purposes of calculating capital adequacy cannot exceed the value of Tier 1 capital.back
6 General provisions, less any associated future income tax benefit, up to a value of 1.25 per cent of total risk weighted assets. The provisions must be additional to the statutory provisions (Prudential Standard 4.3.2.a) and specific provisions and must be created against future, presently unidentified losses. General provisions must be available to meet any losses that may subsequently materialise.back
7 Where the regular revaluation of property is reflected in the balance sheet and is subject to audit review, revaluation reserves are to be included in upper Tier 2 capital after allowance for capital gains and any other taxes or costs that would be incurred should the asset be sold for the revalued amount. Regular periodic valuations must be of intervals of no more than 3 years. For revaluations of other assets (including securities) not passed through the profit and loss account and irregular revaluations of property only 45 per cent of the gain may be included in upper Tier 2 capital. However, the full value of any decline in value should be reflected in upper Tier 2 capital. This applies whether revaluations or devaluations are recorded in the balance sheet or in the notes to the accounts.back
8 Must meet the criteria for Hybrid (Debt/Equity) Capital Instruments or upper Tier 2 capital instruments set out in Prudential Standard 4.2.3.back
9 The eligible amount of lower Tier 2 capital for the purposes of calculating capital adequacy is limited to 50 per cent of Tier 1 capital. Minimum original maturity must be at least five years. Lower Tier 2 capital must be amortised at a rate of 5% per quarter of the original amount during the last five years to maturity.back
10 To qualify for a particular risk weight a security arrangement must permit direct, explicit, irrevocable and unequivocal recourse to the collateral. Claims secured or collateralised in other ways eg insurance contracts, put options, forward sale contracts are not considered to be eligible collateral.back
11 For the purposes of the capital adequacy standard a guarantee must be issued formally. It must permit direct, explicit, irrevocable and unequivocal recourse to the guarantor. Indirect guarantees (such as guarantees of guarantees eg where the Commonwealth guarantees the entity which provides the guarantee) and letters of comfort are not recognised.back
12 see footnote to Prudential Standard 4.2.4.eback
13 Throughout this standard, outstanding balance includes the balance of all loans and other facilities, plus the gross value of any undrawn limits available eg redraw amount available on the loan or undrawn limit on a revolving credit facility, that are secured against the mortgage security. An "all moneys" mortgage includes all loans or facilities to the customer that are effectively secured against the mortgage. To assign capital to undrawn limits, the credit conversion factor should be taken from prudential standard 4.2.5.a. This credit equivalent may then be assigned a 50 per cent risk weight if secured by a qualifying mortgage. back
14 In calculating the outstanding balance of a loan, allowance may be made for higher ranking security. A credit union may deduct from the outstanding balance any eligible cash or Commonwealth or state government security held as collateral. Similarly, it may also deduct any part of the exposure guaranteed by a Commonwealth, State (including central borrowing authority) or local Government, a public sector entity eligible for a 20 per cent risk weight, a bank or other building society or credit union. These portions of the exposure are to be weighted according to the security or guarantee. A mortgage offset or similar account may only be netted off the loan balance where the arrangement would meet the requirements of the cash collateral guidelines.back
15 Where there is more than one property offered as security, the LVR will be assessed on the basis of the outstanding balance (after allowance for any higher ranking security) to the aggregate value of the secured properties.back
16 To qualify as mortgage insured the policy must be taken out with an authorised Lenders Mortgage Insurer with an insurance rating the equivalent of "A" or higher. A captive LMI, though unrated, may demonstrate a claim paying ability rated "A" or higher through third party guarantees. AFIC will consider non-rated LMI arrangements on a case-by-case basis.back
17 Where a specific provision for doubtful debts has been made against a loan, the risk-weight applies to the outstanding balance (including accrued interest) after deducting the specific provision.back
18 The amount to be subject to the credit conversion factor is the maximum unused portion of the facility at the time of calculation (any drawn portion will form part of balance sheet assets). For example, if a rental guarantee is provided on behalf of a customer, then all remaining lease payments (up to any limit specified in the guarantee) are included in the calculation.back
19 These items are to be risk weighted according to the type of assets or the issuer of securities and not according to the counterparty with whom the transaction is made.back
20 'Reverse repos' (i.e. purchase and resale agreements) are to be treated as collateralised loans. The risk is to be measured as an exposure to the counterparty, or according to the asset if it is recognised collateral security within the risk ratio framework.back
21 Redraw facilities that only allow redraw of advance payments should be assigned a credit conversion factor of 0%.back
22 This includes any commitment, that can only be unconditionally revoked with notice, where there is not a clear expiry date within one year.back
23 Provided the commitment can only be rolled over or extended after a full credit review is done and there is no presumption or impression conveyed to the client that an approval of a roll over or extension will be a formality. Where this test is not met the commitment will receive a 50 per cent risk weight.back
24 This includes any commitment to provide an off-balance sheet facility.back
25 Credit conversion factors are based on the Basle Supervisors' Committee's paper "International convergence of capital measurement and capital standards", July 1988.back
26 The deduction will apply to the full value of a holding of subordinated debt even if the issue of debt is being amortised in terms of the footnote to prudential standard 4.2.2.b.back
27 This includes any amount which is unpaid or callable on any shares or capital securities issued by the subsidiary and held by the credit union (or within its consolidated group).back
28 This could include situations such as the provision of subordinated debt or other capital support to a nominally capitalised entity that is not included within the consolidated group.back
Prudential Notes 4.3B and 4.3C
Note: see subparagraph 2(e) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 4.3 - Credit Unions
Accounting and Disclosure
B. Financial Reports to State Supervisory Authorities
To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that credit unions incur in the process of financial intermediation. Towards this end, to ensure that financial information provided to SSAs is complete, timely and consistent with external reporting requirements and is adequate for supervisory purposes.
Supervision of credit unions by SSAs is conducted, in part, through a review of financial data provided by credit unions. It is appropriate that this information should be more extensive than that provided in the public financial accounts. These data should form an extension of the information contained in the annual accounts and should be consistent with them.
It is the responsibility of directors and management to oversee the internal operating procedures of the credit union. Each credit union will, for its own purposes, be expected to have adequate accounting records, registers and supporting documentation. Normal budgets, monthly financial statements and reports on loans, liquidity, capital adequacy and investments should form an integral part of any management and control process.
Much of this information, prepared for internal purposes, will provide the data for reporting to SSAs.
To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that credit unions incur in the process of financial intermediation. Towards this end, to ensure that the auditors appointed by each credit union are competent, adequately resourced and given sufficient scope to complete the duties imposed by the FI Code. Further, to ensure that credit unions are able to provide such certificates of audit as are required by SSAs as part of their supervisory role.
Section 270 of the FI Code requires directors to ensure that the annual accounts and group accounts of credit unions are audited. As well as the audit report attached to the published financial statements, auditors must provide to the directors and to the relevant SSA a report of compliance with respect to internal controls. Auditors are also required to provide a number of reports of compliance under the FI Code.
Sub-section 284(7) of the FI Code requires the auditors to report on the adequacy of systems adopted by the credit union:
• to ensure compliance with its primary objects; and
• to monitor and manage the risks associated with its financial activities.
The intention of independent audit reviews is to lend credibility to the financial information presented in the annual report by the credit union's directors. In carrying out their supervisory responsibilities, AFIC and the SSAs rely largely on information presented by credit unions. A properly planned and conducted audit should provide reasonable assurance that the financial statements are true and fair. In addition to the supervisory authorities, members and depositors should be able to place greater reliance on financial information where an audit has ascertained that the accounts are free of material misstatement and present a true and fair view of the entity.
It is important that a society’s external auditor receives timely information concerning the prudential standing of the society. Accordingly, an SSA should provide to the society’s external auditor a copy of any report following an inspection of the society and any other information the SSA may from time to time consider relevant to the auditor’s audit responsibilities in respect of the society. If the SSA considers the provision of the whole or part of the report or such other information unnecessary or undesirable in the circumstances, the SSA need not provide it to the external auditor.
All audit work should be carried out in compliance with Auditing Standards and Auditing Guidance Statements prepared by the Auditing Standards Board of the Australian Accounting Research Foundation issued by the Australian Accounting Research Foundation on behalf of the Australian Society of Certified Practising Accountants and the Institute of Chartered Accountants in Australia. Particular notice should be taken of the requirements within the standard for proper planning and completion of audit techniques which take account of the nature and risks of credit unions. Directors of credit unions should be satisfied that auditors have sufficient understanding of the industry to enable them to adequately plan the audit and assess audit risks.
The operations of credit unions involve a large number of transactions. The audit approach, therefore, must emphasise the importance of transaction testing. Adequate transaction testing is regarded as critical if audits are to satisfy the requirements of the FI Code.
The audit approach must set out how evidence will be gathered. Since that evidence is the basis of audit opinion, sufficient audit evidence must be obtained to enable an opinion to be properly formed.
The responsibility for appointing an auditor of proper ability is the responsibility of the credit union. Credit unions can expect that SSAs will communicate with their auditors annually or more frequently if it is deemed necessary. The purpose of this contact will be to establish the efficacy of audit techniques. If an SSA is not satisfied with the quality of an audit it has the power, under Sub-section 88(4) of the FI Code to appoint an additional auditor or remove an auditor and appoint another auditor in that auditor's place, as it sees fit.
An Audit Committee should comprise a majority of non-executive directors to which has been assigned, amongst other functions, the oversight of the financial reporting and auditing process and formulation and periodic review of the disaster recovery plan. The main objectives of an appropriately established and effective independent Audit Committee include enhancing the credibility and objectivity of financial reporting and assisting the Board to discharge its responsibilities. All credit unions shall, if they have not already done so, establish an Audit Committee. It is the responsibility of the directors to establish the Audit Committee and to develop clear guidelines for its operation, including its role, terms of reference, responsibilities and method of operation.
The effectiveness of the internal audit function depends on the scope and objectives of the function, degree of independence and the technical competence of staff. As with any internal control, the cost of an internal audit function must be justified by the benefits. Usually, the size of the credit union will play a significant part in determining the nature, scope and objectives of the internal audit function. In general, internal audits will be most effective where they are directed towards the review and testing of internal controls and risk management systems. Societies should consider the standards for the professional practice of internal auditing issued by The Institute of Internal Auditors.
Paragraphs 4.3.2a and 4.3.2b of Prudential Standard 4.3.2
Note: see subparagraph 2(f) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
4.3.2 Accounting Standards Specific to Credit Unions
Provisions
4.3.2.a Statutory Provisions for Doubtful Debts
Each credit union shall provide for, and show in the body of its accounts, a provision for doubtful debts covering all loan advances, including revolving credit arrangements. Directors should ensure that all problem loans are reviewed regularly and that provisions are appropriate. The minimum provisions shall be the amounts specified below.
Loan Provisions
The minimum loan provisions required depend on the type of loan. Three categories of loans are distinguished.
(i) • A loan which is secured by a registered first mortgage against residential building and/or development (defined in Prudential Standard 4.2.4.d) and is insured by an authorised insurer(a) for 100 per cent of the outstanding balance.
• A loan which is secured by a registered first mortgage against residential building and/or development, where the ratio of the outstanding balance, less the amount of mortgage insurance, to the valuation of the security is no more than 80 per cent (where the loan is 6 months or more in arrears, the valuation must be no older than 12 months).
• A loan which is secured by a qualifying registered second mortgage. (A qualifying second mortgage is one which satisfies the conditions spelled out in Prudential Standard 4.2.4.d.)
No minimum provision is required for this type of loan.
(ii) A loan which is secured by a registered first mortgage against residential building and/or development, where the ratio of the outstanding balance, less the amount of mortgage insurance, to the valuation of the security is greater than 80 per cent but no more than 100 per cent (where the loan is 6 months or more in arrears, the valuation must be no older than 12 months).
For these loans, the minimum provision required is a percentage of the balance outstanding, where the percentage depends upon the loan arrears period, as shown below.
3 months and less than 6 months 5
6 months and less than 9 months 10
9 months and less than 12 months 15
12 months and over 20
Where the provision calculated under this category (ii) is greater than the provision which would have been calculated under category (iii) then the category (iii) is the minimum required.
(iii) All other loans
For all loans which do not fall into categories (i) and (ii) above, including unsecured and commercial loans, and mortgage loans where the ratio of the outstanding balance, less the amount of mortgage insurance, to the valuation of the security is greater than 100 per cent, the minimum required provision is a percentage of the balance outstanding, where the percentage depends upon the loan arrears period, as shown below.
14 days and less than 3 months 0
3 months and less than 6 months 40
6 months and less than 9 months 60
9 months and less than 12 months 80
12 months and over 100
Where these loans are secured by a mortgage over real property, the provision may be adjusted to reflect a part of the collateral value. In this case, the minimum provision percentage in the table above will be applied to the difference between the outstanding balance (less any loan insurance) and 70 per cent of the security value (where the loan is 6 months or more in arrears, the valuation must be no older than 12 months).
The minimum total provision required under loan provisions is the sum of the provisions made with respect to the different types of loans.
Where a loan is otherwise secured by equivalent or better security arrangements, the society may on application to its SSA, seek to have the provision adjusted to reflect the whole or part of the collateral value. After consideration of all relevant circumstances pertaining to the loan and security the SSA may reject or may, with the consent of AFIC, agree to the application.
Revolving Credit Provisions
Unless a variation is approved by its SSA, a credit union will be required to provide an amount equal to 1.0 per cent of the total unsecured(a) balances outstanding for line of credit advances, credit cards, overdrafts and any other revolving credit facilities. These provisions will be in addition to any provisions required under (iii) above.
After consideration of a credit union’s loss experience and the level of non-statutory provisions available to cover potential losses on revolving credit facilities, an SSA may reduce the 1% requirement set out above. The SSA is to notify AFIC of any variation issued.
For overdrawn savings and overdrawn limits on credit cards, overdrafts and line of credit advances, the minimum required provision is a percentage of the balance outstanding, as shown below. Secured loans should be provisions in accordance with Loan Provisions (i), (ii) and (iii). In calculating the minimum provision for each revolving facility, except overdrawn savings, the full amount of the credit drawn is to be included in the balance outstanding.
Period of Irregularity Provision (%)
14 days and less than 3 months 40
3 months and less than 6 months 75
6 months and over 100
Where a revolving credit facility is both overdue (in terms of contractual repayments) and has a balance in excess of its authorised limit, the minimum provision required will be that calculated from the table above.
4.3.2.b Restructured Loans
Restructured loans are loans and other similar facilities where the original contractual terms have been modified to provide for concessions of interest, principal or repayment for reasons related to financial difficulties of the member or group of members. The following concessions are examples that would lead to a loan being classified as restructured:
a reduction in the principal amount of the loan;
a rate of interest lower than the credit union applies to a similar loan;
reduction of accrued interest;
a deferral or extension of interest or principal payments including interest capitalisation; or
extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with a similar risk.
A loan extended or renewed on terms similar to those available for debt with similar risks where the member has met the originally contracted terms, is not considered a restructured loan.
Restructuring required under the provisions of the Consumer Credit Code which satisfy the above definition are not excluded from the definition of restructured loans.
Each credit union must develop policies to identify, monitor and manage restructured loans. Any restructuring of a loan or similar facility must be supported by a current, well documented credit assessment of the member’s financial condition and prospects for repayment under the modified terms.
Renegotiation of a loan must not be used to "hide" the poor quality of loan performance. Before any concession is made to a member, a restructure of the member’s loan should receive prior approval of the board of directors or its delegate.
A restructured loan may only be returned to performing status, if it was not fully performing when restructured, for both the purposes of accrual and provisioning, when:
it has been formally restructured ie. at a minimum the customer is provided with a written agreement, signed by the credit union, which outlines the new terms and is complying with these terms;
there are no concessional terms applying to the facility, that is, the loan operates under the terms and conditions comparable to those applied by the credit union to a similar new facility; and
the member's financial condition and prospects for full repayment have improved such that the facility has been operating in accordance with the new terms and conditions for a period of at least six months.
Provisioning requirements for a loan that has been formally restructured but is yet to be considered as performing should generally be based on the arrears period as at the time of the restructure. A credit union may, however, take into account additional security provided under the agreement which would result in a reduction of the provisioning requirement.
A single facility cannot be split into a performing and non performing part to avoid the total facility being classed as restructured.
For the purposes of reporting under AASB 1032 only formally restructured loans may be included in the restructured category. Informally restructured loans are to be reported as non-accrual loans as appropriate. If, following a restructure, the yield on a facility is less than the credit union’s average cost of funds, it should be reported as non-accrual.
Prudential Standard 4.3.5, other than subparagraph 4.3.5a(ii)
Note: see subparagraph 2(g) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
4.3.5 Required Returns
4.3.5.a Each credit union will complete the following returns for the purpose of Section 290 of the FI Code as required by notice from its SSA:
Quarterly:
A general return containing the information contained in Attachment B to the Prudential Standards. In addition to this quarterly general return, other returns on:
Loans
Directors' Interests
Primary Objects
Assets
4.3.5.b An SSA may, by notice, vary the reporting interval for any or all of the returns included in Prudential Standard 4.3.5.a for any or all credit unions under its jurisdiction.
4.3.5.c Any credit union which fails to comply with the notice of lodgement of returns by the due date will be in breach of the Prudential Standards, under Section 402 of the FI Code.
Prudential Standard 4.3.6
Note: see subparagraph 2(h) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Audit
4.3.6 Audit Standards
4.3.6.a A credit union is to be audited in accordance with Auditing Standards and Auditing Guidance Statements and any additional requirements considered necessary by the auditor in satisfying the various requirements of the FI Code.
4.3.6.b Directors of a credit union are to satisfy themselves that the auditor has sufficient relevant expertise to audit the society properly and that the auditor maintains appropriate levels of professional indemnity insurance.
4.3.6.c Directors of a credit union are to satisfy themselves that the auditor has adequate computer audit support to be able to access any and every transaction within the credit union, as the auditor determines.
4.3.6.d A credit union is to obtain from its auditor, an engagement letter which confirms acceptance of the appointment, the objectives and scope of the audit, the extent of the auditor’s responsibilities and the form of reports and any other matters identified in AUS204 - Terms of Audit Engagements.
4.3.6.e A credit union is to maintain an audit committee whose members comprise at least half non executive directors.
4.3.6.f An internal audit function should be considered by each credit union’s directors as part of the credit union’s system of internal control.
4.3.6.g Audit reports are to be forwarded directly to the audit committee in addition to any other recipients required by the credit union.
4.3.6.h Pursuant to section 284(7) and (8) and section 285(10) of the FI Code, an external auditor is to provide to the SSA, reports on the compliance and adequacy of the following risk management systems and internal controls:
operational liquidity risk management systems (annually) - Prudential Standard 4.1.2.a;
market risk management systems (annually) - Prudential Standard 4.1.3.a;
credit risk management systems (annually) - Prudential Standard 4.1.4.a;
data risk management systems (annually) - Prudential Standard 4.1.5.a;
operations risk management systems (annually) - Prudential Standard 4.1.6.a; and
internal controls within the above risk management systems.
4.3.6.i Pursuant to section 285(10) of the FI Code, an external auditor is to provide to the SSA, reports on the security for Emergency Liquidity Support Scheme (6 monthly) - Prudential Standard 4.4.5.l.
4.3.6.j An SSA is to provide to a society’s external auditor a copy of any report following an inspection of the society and any other information the SSA from time to time considers relevant to the auditor’s audit responsibilities in respect of the society. If the SSA considers the provision of the whole or part of the report or such other information to be unnecessary or undesirable, the report or the information need not be provided to the external auditor.
Prudential Notes 4.4A, 4.4B and 4.4D
Note: see subparagraph 2(i) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 4.4 - Credit Unions
A. Subsidiaries
To protect and promote the financial integrity and efficiency of the State-based financial institutions scheme and to ensure that depositors are adequately protected from the risks that credit unions incur in the process of financial intermediation. Towards this end, to ensure that credit unions are not exposed to undue risk as a result of the activities of subsidiaries or associates.
A credit union may choose to establish and operate a subsidiary for a variety of reasons including as a means of diversifying activities and to provide products and services that meet the demands of members and other markets. While all financial intermediation should be conducted through the holding credit union, there are some non-intermediation financial activities that may be better conducted through subsidiaries. An example is the provision of managed fund products1.
The prudential concern is that the operations of subsidiaries are a potential source of risk to financial institutions and, where managed improperly, have contributed to their failure both in Australia and overseas.
Section 118 of the FI Code requires a credit union to obtain approval from its SSA before acquiring a subsidiary. This is consistent with the requirement for a credit union to consult with its SSA before engaging in new activities. It is not the intention of either AFIC or the SSAs to prohibit the establishment or acquisition of subsidiaries. However, each credit union must give careful consideration to the potential risks that may arise from the operations of subsidiaries and be able to satisfy its SSA that policies and systems for reporting and control are adequate. Further, subsidiaries should not be overly large in comparison to the parent credit union, nor should there be a proliferation of subsidiaries. SSAs will be concerned with transactions between a credit union and its subsidiaries including, loans and extension of credit, purchase of assets, and the provision of guarantees and letters of credits. At the least, all transactions are subject to associated standards including large exposures and capital adequacy requirements.
Prudential supervisors have similar concerns where a credit union invests in an associate2. An investment by a credit union that would create an interest of more than 10% of an entity involved in the field of finance should be referred to the SSA before the credit union enters a firm commitment. A credit union should also refer equity investments in non-financial businesses where the amounts invested exceed in aggregate 5% of Tier 1 capital, or an individual investment basis in excess of 0.25% of Tier 1 capital.
The SSA will review each credit union, its subsidiaries and associates on a case-by-case basis to make an overall risk assessment of the credit union. The SSA may require additional internal controls, reporting or possibly capital, if there is undue risk arising from a lack of legal, economic or moral separation of the credit union from subsidiary or associate operations.
B. Guarantees
To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that credit unions incur in the process of financial intermediation. Towards this end, to ensure that credit unions are not exposed to undue risk as a result of guarantees made by or on behalf of the credit union.
The provision of guarantees, sureties, indemnities and similar off-balance sheet facilities by a credit unions can generate additional income from a given asset base without the introduction of direct liabilities. A credit union may also be obliged to provide guarantees or indemnities to access financial services such as cheque and card facilities for use by members. This off-balance sheet activity introduces contingent rather than direct liabilities that can nevertheless create risks for a financial institution. The dangers are particularly acute if guarantees are extended without full analysis of the potential risks.
For the purposes of the Prudential Standards, guarantees, indemnities or other, provided by a credit union on its own behalf to access services, will not generally be treated as direct credit substitutes. Guarantees provided to a subsidiary or other venture associated with the credit union or on behalf of members must be treated as direct credit substitutes.
Where a credit union provides guarantees or other off-balance sheet facilities, it must, as part of its risk management, maintain policies with respect to the provision of guarantees, sureties, indemnities and so on and must be able to demonstrate appropriate systems to identify and manage the individual and aggregate risks. Further, off-balance sheet facilities that are direct credit substitutes must be capitalised and are subject to large exposure limitations.
D. Service Contracts
To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that credit unions incur in the process of financial intermediation. Towards this end, to ensure that credit unions are not exposed to undue risk or unfair practices with respect to service contracts.
Under Section 245 of the FI Code, a credit union must obtain prior written approval from their SSA before entering into a management contract. "Management contracts" are defined as arrangements where a third party performs the whole or a substantial part of the functions of the credit union. The key feature of a management contract is the abrogation of total or substantial management control to a person or entity external to the credit union. Examples include situations where the day-to-day operation of the credit union is managed through entities controlled by directors or independent third parties.
Service contracts are other arrangements entered by a credit union to obtain services or products without the abrogation of management control. Each credit union is likely to enter a variety of such contractual arrangements for valid economic and efficiency reasons, especially where the credit union neither has, nor seeks, the expertise. While service contracts will cover a range of relationships with external parties, supervisors are concerned with those contracts that create additional risks, create conflicts of interest or require disclosure to members and shareholders.
A conflict of interest may arise where a credit union enters arrangements with a director or officer (or their associates) for the provision of services. AFIC recognises that some regionally-based credit unions may face difficulty appointing suitably qualified directors who are not otherwise associated with the provision of services to the credit union in the normal conduct of business. AFIC does not intend to outlaw such arrangements but seeks to ensure arm's length dealings.
Financial and operating leases entered into in the ordinary course of business on an arm's length basis are not service contracts for the purposes of this section. However, such leases are subject to normal reporting requirements as part of the financial statements.
Prudential Standards 4.4.1, 4.4.2 and 4.4.4
Note: see subparagraph 2(j) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
4.4.1 Subsidiaries
4.4.1.a In accordance with section 118 of the FI Code, a credit union must obtain the approval of its SSA before establishing or acquiring a subsidiary.
4.4.1.b A credit union should also consult with its SSA before entering into a firm commitment in an associate as follows:
in the case of institutions in the field of finance, where the investment would create an interest in excess of 10%; or
in the case of non-financial businesses, where the investments in aggregate will exceed 5% of Tier 1 capital or an individual investment exceeds 0.25% of Tier 1 capital.
4.4.1.c A credit union must satisfy its SSA that there are in place adequate systems, policies and procedures to manage, monitor and control residual risk to the society arising from subsidiary’s or associate’s activities. The SSA may also seek evidence that the subsidiary or associate has sound and prudent management aimed at achieving viability within the capital resources of the subsidiary or associate.
4.4.1.d A credit union must ensure that the operations of a subsidiary or associate are separated sufficiently, so that the credit union will not be obliged, morally or commercially, to support a subidiary’s/associate’s on-going operations. In particular, a credit union should not give a general guarantee of the obligations of a subsidiary or associate. Other dealings with associates should be on the normal terms and conditions that would apply to unrelated entities. The credit union must also ensure that a subsidiary or associate does not give any impression that the credit union’s resources stand behind, or could be called to stand behind, its operations.
4.4.1.e While a general guarantee is not appropriate, a credit union may choose to provide a specific guarantee. A credit union must consult with its SSA before providing a guarantee of, or on behalf of, a subsidiary or associate. Where provided, guarantees are subject to Prudential Standard 4.4 B. Guarantees. As part of the review process, the credit union should be prepared to estimate the maximum loss should the guarantee be called and also satisfy its SSA that the provision of a guarantee will not have a detrimental effect on the interests of its depositors.
4.4.1.f A credit union must ensure that subsidiaries comply with any directions made by its SSA.
4.4.1.g Accounts of the credit union and subsidiaries must be consolidated for the purpose of prudential supervision, including the application of all prudential standards.
4.4.2 Granting of Guarantees by a Credit union
4.4.2.a Each credit union must have available for review a written description of its policies with respect to providing guarantees, indemnities or other sureties and must satisfy their SSA that it has adequate systems and procedures for managing the risks involved.
4.4.2.b AFIC may deem that certain types or classes of guarantees or other sureties are direct credit substitutes.
4.4.2.c A guarantee or other surety provided on behalf of a member is a direct credit substitute. Indemnities provided by a credit union on its own behalf will not normally create direct credit substitutes.
4.4.2.d A guarantee that is a direct credit substitute:
· must be for a limited amount;
· is subject to the same large exposure restrictions as the provision of loans and other credit (see Prudential Standard 4.1.4); and
· must be capitalised (see Prudential Standard 4.2.4). An SSA may also increase a credit union's capital adequacy ratio if, in the opinion of the SSA, the guarantee, or guarantees in aggregate, add significantly to the overall risk of the credit union.
4.4.2.e The provision of guarantees and indemnities may create contingent liabilities and must be disclosed in the credit union's financial statements in accordance with applicable accounting standards.
4.4.4 Review of Service Contracts
4.4.4.a Each credit union must demonstrate systems for selection, regular review and renewal of service arrangements that ensure arm's length dealings.
4.4.4.b A credit union must not enter service contracts that:-
· diminish control of the credit union by the board;
· diminish the SSA's ability to review and supervise the credit union; or
4.4.4.c Before entering into a service contract a credit union must consider the risks arising from the proposed arrangement. This includes a documented assessment of the impact of the contract on its operational and control environment as well as the commercial risks that may arise from entering into the contract.
4.4.4.d Where a credit union enters into a contract (not being a management contract) that permits an external party to make decisions in its name, or on its behalf, then the credit union must ensure there are adequate systems and controls in place to review the decisions made and ensure they are in accordance with its board approved policies and procedures.
4.4.4.e Where an SSA has concerns with the ability of a credit union to comply with this standard, it may require it to consult with it, in advance, before entering into some or all future service contracts. In this consultation process the credit union will need to demonstrate that the proposed contract will not expose it to excessive risk.
4.4.4.f A credit union must advise its SSA of any service contract under which payments in a current or future year are likely to exceed 5% of non-interest expense. It must consult with its SSA in advance before entering into a service contract where the payments in a current or future year are likely to exceed 10% of non-interest expense. In this consultation process the credit union will need to demonstrate that the proposed contract will not expose it to excessive risk.
4.4.4.g A credit union must retain a register of service contracts. At a minimum this should include details of the parties involved, date of commencement, termination date, review date, fee structure, a brief description of the purpose of the contract and a reference to the location of the detailed documentation. The documentation must be made available for review upon request from an SSA.
Prudential Note 4.6
Note: see subparagraph 2(k) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 4.6 - Credit Unions
To protect and promote the financial integrity and efficiency of the State-based financial institutions scheme and to ensure that depositors are adequately protected from the risks that credit unions incur in the process of financial intermediation. Towards this end, to ensure that a credit union is not exposed to undue risk as a result of involvement in the securitisation of its assets.
Since the commencement of the FI Scheme, credit unions have become more involved in the securitisation of assets. This standard, while based on the RBA’s Prudential Statement dealing with Funds Management and Securitisation, focuses on the transfer of risk associated with the sale of loan assets into a securitisation scheme.
Securitisation involves the pooling of assets (or interests in assets), usually in a special purpose vehicle, funded by the issue of securities. The payment of earnings, and the return of capital, to investors hinges on the cash flows from the underlying assets in which their funds are invested.
Generally a credit union’s involvement in securitisation activities is likely to be restricted to the sale to and subsequent servicing of assets in a securitisation program sponsored by an independent third party. Any credit union intending to be active in other aspects of securitisation of assets such as issuing asset backed securities on its own behalf, providing credit and liquidity support, offering other lending or treasury services, funding investor purchases of securities or securitising revolving credit facilities should first consult with its SSA. We would generally expect an SSA to discuss any approach with AFIC.
The securitisation of revolving credit facilities (eg credit cards) can create difficulties in meeting the requirements for a clean sale outlined in the standard. A credit union which plans to securitise revolving credits should discuss this issue with its SSA. It must be able to demonstrate that the retention of a seller’s interest does not expose it to a disproportionate share of the credit risk on the loans transferred to the securitisation scheme.
This standard sets out the process by which a credit union’s involvement in securitisation of assets will be reviewed and the basis of that review. In principle:
(a) A securitisation scheme must stand clearly separate from the credit union.
(b) Dealings between a credit union, a special purpose vehicle and investors must always be conducted at arm's length and on market terms and conditions.
(c) Any undertakings given by a credit union to a special purpose vehicle must be subject to the usual approval and control processes within the credit union.
(d) Any undertakings to a special purpose vehicle must be described clearly in the legal documentation and must be fixed as to time and amount.
(e) No impression must be given, through marketing material or otherwise, that recourse to a credit union extends beyond its contractual legal obligations.
AFIC recognises that a credit union's involvement in securitisation activities can give rise to risks, such as operational and legal risks which will be difficult to quantify. Securitisation of low risk assets could also lead to a deterioration in the average quality of assets remaining on a credit union’s balance sheet. Against this background, where the level of a credit union's activities suggests that the overall level or concentration of risk within the group has become excessive relative to its capital, the SSA may, following consultation with AFIC, adjust the credit union’s minimum capital ratio to better reflect the additional risk borne by the credit union.
The prudential standard establishes the framework in which a credit union can expect to participate in securitisation activities and by which an SSA (and if relevant AFIC) will review the documentation and securitisation program. Despite its detailed nature, this standard cannot encompass every aspect of a credit union’s securitisation activities. Where a credit union may have plans for particular securitisation initiatives that may raise issues not covered in the standard, it should discuss them with its SSA as early as possible.
Where a particular securitisation scheme may have wide application within the industry it would be appropriate for it to be initially reviewed by AFIC, in consultation with the SSAs. Otherwise it will be subject to review by its SSA. AFIC’s review of a securitisation scheme will be for the purpose of assessing whether it has the potential to meet the technical requirements of the standard. If a particular credit union wishes to access the scheme, it will need to satisfy its SSA that it has adequately identified the risks arising from its participation and has adequate systems and procedures to manage the risks. In addition, the SSA will monitor its practical compliance with the standard.
The responsibility for the prudent participation of a credit union in securitisation rests with its board and management. A credit union should have in place clear strategies and board approved policies governing participation in this activity. In addition, a credit union must maintain appropriate systems to identify, measure and control risks arising from its participation in securitisation. A credit union’s SSA will need to be satisfied of this before it will endorse participation in a scheme.
Specific breaches of the standard will be handled on a case-by-case basis. It is likely however that following consultation with AFIC, an SSA will require a credit union to hold capital against the full value of assets committed to a securitisation program with which it is involved.
This standard applies to all securitisation even if a special purpose vehicle or the issue of securities is not involved. It is also intended to apply to origination agreements where the loans do not cross the credit union’s balance sheet. Unless otherwise indicated reference to a credit union includes any subsidiaries which exist within its consolidated group.
Prudential Standards 4.6.1 to 4.6.7 (inclusive)
Note: see subparagraph 2(l) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
4.6.1 Disclosure
4.6.1.a To safeguard against investor confusion, a credit union must ensure that any marketing or promotion of a securitisation scheme with which it is associated does not give any impression that it stands behind the capital value or performance of the securities issued by the scheme. It must be clear to investors that the securities in which they invest do not represent deposits or other liabilities of the credit union.
4.6.2.a A central tenet of this standard on securitisation is that there is clear separation between the credit union involved and any special purpose vehicle. To this end, a credit union must not without prior approval from its SSA:
(i) Have any ownership or beneficial interest (otherwise than may arise via its equity in an SSP) in a special purpose vehicle.
(ii) Act as a manager, trustee, custodian or similar role in a securitisation scheme.
(iii) Provide any credit support, other lending, liquidity or transaction facilities (such as cheque or settlement facilities) or underwrite the issue of securities.
(v) "Control" a special purpose vehicle such that it would need to be consolidated in accordance with Australian Accounting Standards.
4.6.3 Servicing
4.6.3.a A credit union may undertake the role of "servicer" or "servicing agent" of a pool or part of a pool of assets held by a special purpose vehicle provided:
(i) There is a formal written servicing agreement in place which specifies the services to be provided and any required standards of performance. Those standards should be reasonable and in accordance with normal market practice. There should be no recourse to the credit union beyond the fixed contractual obligations specified. The servicer should be under no obligation to fund payments, absorb losses on assets, or otherwise recompense investors for losses.
(ii) The services are provided on an arm's length basis, on market terms and conditions (including remuneration), and subject to the credit union's normal approval and review processes. The servicing fee should not be subordinated, deferred or waived (without prior approval of an SSA).
(iii) The servicing agreement is limited as to a specified time period (ie the earlier of the date on which all claims connected with the issue of securities are paid out or the credit union's replacement as servicer). A fixed termination date need not be specified provided the credit union is able, at its absolute discretion, to withdraw from its commitments at any time with a reasonable period of notice.
(iv) Subject to reasonable qualifying conditions, the special purpose vehicle has the clear right to select an alternative servicer.
(v) The servicing agreement is documented in a fashion which clearly separates it from any other service provided by the credit union.
(vi) The credit union's operational systems are adequate to meet its obligations as a servicer.
4.6.3.b A credit union acting as servicer should be under no obligation to remit funds to the special purpose vehicle or investors until they are received from the underlying assets. This may not preclude, subject to conditions set by its SSA, the provision of:
(i) Very limited short-term advances by a servicer, at its sole discretion, to cover unexpected cash shortfalls arising from delayed payments on assets.
(ii) An undertaking that the interest rate charged on the currently performing loans it has sold will exceed a benchmark rate, provided the benchmark rate does not depend on the actual funding cost of the scheme.
4.6.3.c A credit union may receive a performance-related payment (or benefit from any surplus income generated) for its role as servicer, in addition to its base fee, provided that the base fee is on market terms and conditions and any performance-related payment does not commit the credit union to any additional obligations. This payment should be recognised for profit and loss (and capital) purposes only if it has been irrevocably received.
4.6.3.d Where a servicing agreement does not meet the conditions above a credit union will be required to hold capital against the assets it is servicing as if they were held on its balance sheet.
4.6.4 Representations and Warranties
4.6.4.a Where a credit union undertakes to sell assets to a special purpose vehicle, it is customary to make representations and warranties concerning the assets. Where all of the following conditions are satisfied, a credit union will not be required to hold capital as a result of providing representations and warranties. Otherwise, it will need to hold capital against the assets to which the representations and warranties relate.
The conditions are:
(i) Any representations and warranties are provided only by way of a formal written agreement and are in accordance with market practice.
(ii) The credit union undertakes appropriate review procedures before providing or taking on any representations and warranties.
(iii) The representations and warranties refer to an existing state of facts that the credit union can verify at the time services are contracted or assets sold.
(iv) Representations or warranties are not open-ended and, in particular, do not relate to the future creditworthiness of assets or the performance of the special purpose vehicle or the securities it issues.
(v) The exercise of any representation or warranty requiring the credit union to repurchase or replace assets sold to the special purpose vehicle, or any part of them, must be undertaken within 120 days of their transfer to the vehicle and any transfer should be conducted on the same terms and conditions as the original sale. This time limit does not preclude the subsequent payment of damages by a credit union as a result of breaches of representations and warranties.
4.6.4.b Any agreement by a credit union to pay damages as a result of a notice of claim being made must be conditional on:
(ii) The onus of proof for a breach of a representation or warranty resting with the purchaser.
The credit union’s SSA should be notified of any instance where a credit union has agreed to pay damages arising out of any representation or warranty.
4.6.5 Supply of Assets: Clean Sale
4.6.5.a A credit union will be relieved of the need to maintain capital in support of assets which it has sold only where their transfer is clean and final, that is:
(i) beneficial ownership of the assets has been transferred (although the credit union may still retain legal ownership of the assets); and
(ii) the risks and rewards on the assets have been substantially transferred,
to the purchaser of the assets. A credit union may, however, incur risks and rewards associated with the assets as a result of providing servicing arrangements covered by this standard. Outside of these arrangements, unless otherwise approved by its SSA, the credit union should have no remaining obligation or interest in respect of the assets.
4.6.5.b All of the following conditions should be satisfied if a transfer of assets is to constitute a "clean sale":
(i) The credit union should have no residual beneficial interest in the assets (or that part which has been transferred).
(ii) The credit union should have obtained advice from external auditors and legal advisers that the risks and rewards associated with the assets (outside those retained by the credit union arising from servicing arrangements) have been transferred to the purchaser of the assets.
(iii) The loans sold should not be subject to an offset account or other contractual arrangement under which the rights of the borrower will be affected by the sale.
(iv) The purchaser should have no recourse to the selling credit union for any losses or costs incurred by the scheme (except where they result from the breach of the servicing agreement or representations and warranties covered by the standard). The selling credit union should be under no obligation to make good (in any fashion) any dilution risk on assets transferred to a special purpose vehicle.
(v) The credit union must not guarantee a level, or rate, of return to any participant in the special purpose vehicle or scheme. It should not reimburse any party for taxes or other costs arising from their participation in the scheme.
(vi) Where a credit union transfers an undrawn commitment to lend, the transfer is effected by novation or by an assignment accompanied by a formal acknowledgment by the borrower/debtor of a transfer of obligations by the credit union to the purchaser of the commitment.
(vii) The credit union receives a fixed amount of consideration for the assets no later than at the time of their transfer to the special purpose vehicle. The sale price should reflect the current value of the assets transferred. A credit union must seek prior approval from its SSA if it intends to transfer assets for a value below their book value or to provide any form of overcollateralisation.
(viii) The credit union should have no obligation to repurchase an asset (or any part of it), at any time, except where that obligation arises under a breach of its representation or warranty.
(ix) The documented terms of the transfer of the assets should specify that, if cashflows relating to a sold asset are re-scheduled or re-negotiated, the purchaser and not the selling credit union will be subject to the re-scheduled or re-negotiated terms. Similarly, where payments are routed through the credit union, the credit union may not (unless permitted under the section on servicing arrangements) remit funds to the purchaser of an asset until they are received irrevocably from the borrower.
(x) The credit union must be under no obligation to:
(a) substitute other assets for assets purchased by the special purpose vehicle except where it is permitted by section 4.6.4 on Representations and Warranties; or
(b) provide additional assets to the special purpose vehicle to maintain a "coverage ratio" of collateral to issued securities.
4.6.5.c If any of the above conditions have not been complied with, the credit union will be required to hold capital against the transferred assets as if they were held on its balance sheet.
4.6.6 Spread Accounts and Like Arrangements
4.6.6.a A credit union involved in a securitisation scheme, through the sale of assets into a special purpose vehicle, may be entitled to share in the surplus income generated over the life of the scheme or to receive payments related to the performance of the portfolio of assets sold. This may take the form of a "residual interest", "excess servicing income", a "spread account" or like arrangement.
4.6.6.b Even though it may retain some interest in the performance of assets sold, a credit union will be able to treat the transfer of assets as a "clean sale" (and avoid holding capital against those assets) under the following conditions:
(i) The credit union makes no payment, direct or indirect, to the special purpose vehicle involved in exchange for this income stream (or if a payment is made there is no carrying value in its books ie it is written off against profit and loss (and capital)).
(ii) The credit union has no right or is under no obligation as a result of its entitlement to receive this income, to repurchase any non-performing asset or otherwise cover losses on assets or losses of investors in the scheme.
(iii) The credit union is under no obligation to return the income once received.
(iv) The credit union does not recognise for profit and loss (and capital) purposes the income until irrevocably received.
4.6.7 Purchase of Securities
4.6.7.a A credit union will be permitted to purchase securities issued by any special purpose vehicle (but may not act as a market maker in them) provided:
(i) The purchases are at the sole discretion of the credit union, are acquired on an arm's length basis on market terms and conditions (including price), and are subject to the credit union's normal credit approval and review processes.
(ii) Purchases are completed within a short time period (less than one week as a guide) from the time the credit union commits to purchase the securities.
(iii) Any security holding is less than 10 per cent of the stock in the specific tranche of securities issued by the special purpose vehicle.
(iv) They do not represent subordinated securities issued by the scheme.
4.6.7.b A credit union should have in place adequate systems and controls to ensure that it does not accumulate a disproportionate exposure (vis a vis the group's asset portfolio and capital) to securities issued by special purpose vehicles, eg large aggregate exposures arising from holdings of securities issued by associated special purpose vehicles or vehicles holding similar or related assets.
4.6.7.c A credit union should not purchase assets from any special purpose vehicle without first obtaining approval from its SSA. An exemption to this is the purchase of Prime Liquid Assets (PLA) from a special purpose vehicle in the normal course of a credit union’s liquidity management or trading operations.
4.6.7.d Should an SSA come to the view that the pattern of a credit union's purchases of securities (and/or assets), or its willingness to do so, suggests that the credit union is supporting investments in a special purpose vehicle, then the credit union may be required to hold capital against the value of all securities issued by the special purpose vehicle.
Prudential Note 4.7
Note: see subparagraph 2(m) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 4.7 - Credit Unions
Funds Management And Other Marketing Activities
To protect and promote the financial integrity and efficiency of the State-based financial institutions scheme and to ensure that depositors are adequately protected from the risks that credit unions incur in the process of financial intermediation. Towards this end, to ensure that a credit union is not exposed to undue risk (particularly moral risk) as a result of the provision of managed funds products and the marketing of these and other products as an agent for third parties.
Funds management involves the provision of financial services to an investor or group of investors who retain beneficial ownership of the assets in which their funds have been invested. Generally the assets are pooled in a trust funded by the issue of units. The trust is established pursuant to a deed which sets out the permissible investments. The trustee is charged with enforcing the deed and will usually engage a custodian as safekeeper of the assets and a manager to exercise its discretion in making investment decisions consistent with the trust deed.
The rate of earnings paid, and the return of capital, to investors hinges on the cash flows from the underlying assets in which the manager invests the funds. This can place pressure on the manager to make payments to the trust to compensate for poor performance or to offer a guarantee (explicit or implicit) regarding performance. If this occurs when a credit union’s subsidiary acts as manager, then the credit union will be required to hold capital in support of the assets of the funds as if they were on its balance sheet.
With their extensive customer base, credit unions have large scope to market products and services to their customers. They are well placed to offer funds management products, either as managers of pools of funds or as agents on behalf of other funds managers. The agency arrangements may include the badging of products in either the credit union’s or industry’s name. As well as funds management products such marketing could involve areas such as the sale of securities and insurance and other financial services and products.
In considering credit unions’ involvement in these areas, AFIC is concerned that these activities may introduce undue risk into the credit union’s operations. In particular the concern is with moral risk, ie the possibility that a credit union will feel a moral obligation or commercial need to absorb any loss to a customer that arises from investments offered, marketed by or recommended by the credit union.
If a credit union is to avoid holding capital against funds managements activities it must not use the word credit union in the name of a funds management vehicle unless prior approval has been obtained from its SSA (following consultation with AFIC). It is envisaged that such approval will only be given in very exceptional circumstances. In particular it will not be forthcoming simply on the basis of it being an industry scheme or product.
The standard focuses heavily on funds management activities. It is intended, however, that the sections on the "offering of investment advice and sale of securities" and "badging" will apply to all operations of the credit union, not just funds management.
The standard envisages a credit union’s involvement in funds management activities will be restricted to the sale of products for which a subsidiary acts as manager or for which the credit union acts as an agent for a third party. Any credit union intending to be active in other aspects of funds management such as: providing credit support, liquidity support, underwriting, other lending facilities, treasury or transaction facilities to a funds management vehicle (whether its own or an unrelated third party vehicle), or funding investor purchases of securities/units issued by a vehicle, should consult with its SSA. It will need to be able to satisfy its SSA that the risks involved in the proposed activities have been adequately identified and that it has the expertise, and adequate policies, procedures and systems in place to measure, monitor and control the risks involved. We would generally expect an SSA to discuss any approach with AFIC.
Despite its detailed nature, this standard cannot encompass every aspect of a credit union’s funds management activities. Where a credit union may have plans for a particular initiative that may raise issues not covered in the standard, it should discuss them with its SSA as early as possible.
The introduction of this standard (by revising and superseding earlier standards) may see a credit union in breach of some of its requirements. Where this is the case a credit union should contact its SSA to discuss a timetable for achieving compliance with the new standard. Any transitional period should be kept as short as possible whilst recognising the need to avoid imposing excessive compliance costs on the credit union.
The prime responsibility for the prudent participation of a credit union and its subsidiaries in funds management rests with its board and management. A credit union should have in place clear strategies and board approved policies governing participation in this activity. In addition, it must maintain appropriate systems to identify, measure and control risks, including potential conflicts of interest, arising from its participation in funds management. A credit union’s SSA will need to be satisfied of this before it will endorse participation in a scheme.
Specific breaches of the standard will be handled on a case-by-case basis. It is likely however that following consultation with AFIC, an SSA will require a credit union to hold capital against the assets held by the funds management scheme as if they were held on its balance sheet.
This standard applies to all funds management activities even if a trust based vehicle and the issuing of units is not involved. Securities issued by a securitisation scheme will also fall within the ambit of the standard. Unless otherwise indicated, reference to a credit union includes any subsidiaries within its consolidated group.
Prudential Standards 4.7.1 to 4.7.7 (inclusive)
Note: see subparagraph 2(n) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
4.7.1 Disclosure
4.7.1.a To safeguard against investor confusion, a credit union must ensure that, where it is involved in funds management activities, sufficient disclosures are made so that investors in any funds management vehicle or scheme are:
(i) Given to understand clearly that the securities in which they invest do not represent deposits or other liabilities of the credit union or any of its subsidiaries or controlled entities.
(ii) Made aware that their holdings of securities are subject to investment risk, including possible delays in repayment and loss of income and principal invested.
(iii) Unambiguously informed that the credit union or its subsidiaries or controlled entities do not in any way stand behind the capital value or performance of the securities issued by the funds management vehicle or of the assets held by the vehicle except to the limited extent allowed under this standard and as specified in the documentation provided to investors.
4.7.1.b The disclosures in 4.7.1.a. must be provided in a conspicuous manner to prospective investors, and appear in any marketing document. A document inviting investment should include the disclosures as a prominent (and preferably stand alone) item on the inside front cover. It is recognised that variations in the location and form of the required disclosures could be appropriate where regulatory or statutory requirements restrict the presentation or content of disclosures. Any proposal to modify the requirements set out above must be agreed with an SSA.
4.7.1.c Investors must also provide a signed acknowledgment indicating that they have read and understood the required disclosures. To ensure this the disclosures in 4.7.1.a should also appear in close proximity to the signature on the application form in any document inviting investment.
4.7.1.d More generally, a credit union must ensure that the marketing or promotion of a vehicle with which it is associated does not give any impression that could be construed as being contrary to the disclosure requirements.
4.7.1.e It is possible that securities could be traded in a paperless environment. Where this is envisaged a credit union must discuss with its SSA (who will be expected to consult with AFIC) procedures for ensuring that the spirit of the disclosure requirements are met.
4.7.1.f Where a credit union has a limited involvement in a funds management scheme, its ability to ensure the required level of disclosure (and signed acknowledgments) may also be limited. In such cases, compliance with the disclosure requirements may be relaxed by its SSA (following consultation with AFIC).
This concession will not be available where the credit union or its subsidiary is the sponsor, manager, trustee or responsible entity of the scheme. It will also be unavailable (except in exceptional circumstances) where the credit union or its subsidiary or associate permits the use of its name, badge, logo or any other identifier in the marketing of the funds management scheme.
4.7.2 Structuring Funds Management Schemes
4.7.2.a The main basis of the policy on funds management is that there is a clear separation between the credit union involved and any funds management vehicle or scheme. To this end, a credit union must not without prior approval from its SSA after consultation with AFIC:
(i) Unless provided for in the standard have any ownership or beneficial interest (otherwise than may arise via its equity in an SSP) in a funds management vehicle.
(ii) Include the word " credit union" in the name of the funds management vehicle.
(iii) Provide credit support, liquidity support, other lending, treasury or transaction facilities to a funds management vehicle, or underwrite the issue of units or securities by a vehicle.
(iv) Have any of its directors, officers or employees on the board of a funds management vehicle.
(v) "Control" the funds management vehicle such that it would need to be consolidated in accordance with Australian Accounting Standards.
4.7.2.b Requirements i, iv and v set out above do not apply, however, to:
An "approved trustee" or "custodian" established under the provisions of the Superannuation Industry (Supervision) Act 1993 (Cth).
"Common trust funds" established pursuant to legislation and complying with Australian Securities Commission Policy Statement 32.
4.7.2.c A credit union, itself, must not act in any circumstances as a manager, trustee, custodian, responsible entity or any similar role. Any participation must be through stand alone subsidiaries.
4.7.2.d Where a credit union’s subsidiary or other associate acts in such a role, the credit union should ensure that a clear distinction exists between the credit union and the subsidiary or associate concerned. Any documentation or marketing of funds management schemes with which a subsidiary or associate is involved should not give the impression that those entities are in any way backed by the credit union or any of its subsidiaries.
4.7.3 Managing
4.7.3.a A subsidiary of a credit union may act as a manager of funds placed in a funds management vehicle by investors, provided:
(i) There is a written management agreement in place specifying the functions which the manager is required to perform and any performance standards placed on the manager. Such standards should be reasonable and in accordance with normal market practice. The agreement must not (unless approved by its SSA, following consultation with AFIC) obligate a credit union or any subsidiary to buy back or otherwise purchase securities or units issued by the vehicle.
(ii) The management agreement is undertaken on an arm's length basis and is subject to the credit union’s normal approval and review processes. The agreement must be undertaken on market terms and conditions (including remuneration to the manager).
(iii) A credit union may not subordinate, defer or waive the receipt of fee or other income associated with funds management activities without obtaining approval from its SSA.
(iv) The agreement is limited as to a specified time period. A fixed termination date need not be specified provided the credit union is able, at its absolute discretion, to withdraw from its commitments at any time with a reasonable period of notice.
(v) Subject to reasonable qualifying conditions, the funds management vehicle and/or investors have the clear right to select an alternative party to provide the management services.
4.7.3.b The manager may receive a performance-related payment (or benefit from any surplus income generated) for its role as manager, in addition to its base fee, provided that the base fee is on market terms and conditions and any performance-related payment does not commit the credit union to any additional obligations. Such payment should be recognised for profit and loss (and capital) purposes only if it has been irrevocably received.
4.7.4 Offering Investment Advice and Sale of Securities
4.7.4.a In its general operations, a credit union may (subject to appropriate regulatory approvals) offer advice to customers regarding investments (including funds management schemes and other products such as life and general insurance policies) act as a broker in obtaining securities (and other products) on behalf of customers or market such products directly to customers.
In conducting such business, there is a risk that investors may be confused as to the relationship between a credit union and the issuer of a security (or other product), and a possibility of the credit union feeling some moral or commercial obligation to investors as a result of its actions.
To minimise such risks, a credit union should ensure that where it undertakes such activities:
(ii) Any decision to invest in particular securities (or acquire other products) is clearly taken by the customer alone and that the customer is aware they alone bear the risks associated with their investment decisions. The credit union should be careful to ensure that customers are aware of the level and type of risks they face on the investments.
(iii) Policies and procedures are in place to ensure that staff (and any agents of the credit union) dealing with customers are required to be appropriately trained and to avoid misleading or confusing them concerning the risks involved or the credit union’s relationship with (or support for) investments recommended or offered for sale by the credit union.
4.7.4.b Where a credit union makes investment decisions or purchases securities for customers at its own initiative or discretion, then the credit union will be deemed to be acting as a "manager" and the relevant provisions of this standard will apply.
4.7.5 Badging
4.7.5.a Where a credit union allows its name, logo or trade mark to be used in marketing products of third party institutions it faces risks over and above those covered in 4.7.4. In these circumstances it will also be required to ensure:
(i) The 'name' or 'badge' of the other party providing the product also features prominently in all advertising material, marketing documents and any documents inviting investment or participation in a product.
(ii) The respective roles of the parties should be explained clearly and prominently in any document inviting investment or participation in the product - including the extent to which each party is responsible for the safety and performance of the product.
(iii) The provisions of section 4.7.1 "Disclosure" are fully satisfied.
4.7.5.b A credit union which fails to comply with these conditions may be required, by its SSA, to discontinue its association with the relevant product.
4.7.6 Purchase of Securities
4.7.6.a Unless exempted by its SSA after consultation with AFIC, a credit union will only be permitted to purchase securities issued by a funds management vehicle provided:
(i) The purchases are at the sole discretion of the credit union, are acquired on an arm's length basis on market terms and conditions (including price), and are subject to the credit union’s normal credit approval and review processes.
(ii) Purchases are completed within a short time period (less than one week as a guide) from the time the credit union commits to purchase the securities.
(iii) Any holding is less than 10 per cent of the class of units issued by the vehicle.
4.7.6.b A credit union should have in place adequate systems and controls to ensure that it does not accumulate disproportionate exposure (vis a vis the group's asset portfolio and capital) to securities issued by funds management vehicles, eg large aggregate exposures arising from holdings of securities issued by associated funds management schemes or schemes holding similar or related assets.
4.7.6.c A credit union should not purchase assets held by a funds management vehicle without first obtaining approval from its SSA. An exemption to this is the purchase of Prime Liquid Assets (PLA) from a funds management vehicle in the normal course of a credit union’s liquidity management or trading operations.
4.7.6.d Should an SSA come to the view that the pattern of a credit union’s purchases of securities (and/or assets), or its willingness to do so, suggests that the credit union is supporting investments in a funds management scheme, then the credit union may be required to hold capital against all the assets of the scheme as if they were held on its own balance sheet.
4.7.7 Transitional Provisions
4.7.7.a The introduction of this standard may see a credit union in breach of some of its requirements. Where this is the case a credit union must contact its SSA to agree a strategy and timetable for achieving compliance. We would expect an SSA to discuss any proposal with AFIC
Provisions of Book 5 of the Prudential Notes and Prudential Standards issued by AFIC under Part 4 of an AFIC Code, as in force immediately before the transfer date
Note: see paragraph 3 of Schedule 1 of the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 5.1
Note: see subparagraph 3(a) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 5.1 - Special Services Providers
To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that special services providers are aware of the risks to which they are exposed and that these risks are adequately measured, monitored and managed so that they are kept to an absolute minimum.
Special Services Providers (SSPs) must meet high standards of financial prudence because of their key role in the operations of their constituent societies.
Risk is an inevitable component of financial intermediation and trading activity. The prime responsibility for prudent management of these risks rests with the board of directors and senior management of each SSP. AFIC's role is to confirm by observation, inspection and interview that each SSP is operating prudently and to take corrective action if required and, in doing so, protect the interests of societies and the stability of the Financial Institutions Scheme.
In general terms, AFIC must be satisfied that an SSP has in place adequate procedures for identifying and measuring risk, adequate procedures for monitoring risk and appropriate techniques for managing risk. AFIC requires detailed information about the activities of the SSP and expects a comprehensive approach to risk measurement with procedures and practices to manage the risks. Inadequate management practices in this area may result in the SSP coming under direction, additional capital requirements, additional liquidity requirements, or, suspension of or other limitations on trading or other activities.
The precise range of services provided by SSPs will determine the Prudential Standards that must be met. The sections that follow apply most readily to treasury management and settlement services. The general issues and the need to manage risk are common to all SSP activities. In all cases, AFIC will expect SSPs to exceed the minimum Prudential Standards set.
Role Of The Board Of Directors And Senior Management
It is the responsibility of the board of directors and senior management to understand fully the risks associated with the SSP's activities, to question management on the scope and prudent management of those risks and to ensure open and timely discussion regarding potential problems and actual losses.
The board of directors must approve written policies and systems that are consistent with the SSP's business and risk strategies, commitment to members and, Prudential Standards and obligations under the FI Scheme. The board should re-evaluate regularly an SSP's exposure and tolerance to risk. Senior management and those in responsible areas of dealing and settlement should understand clearly the risk measurement and management systems of the SSP. Senior management is also responsible for ensuring that the activities of the SSP are conducted within the framework of policies and systems approved. While policies and systems will differ depending on the activities of the SSP and its risk profile, AFIC expects that policies and systems will include:
clear identification of the responsibility for managing risk;
adequate systems for measuring risk;
structured limits on risk taking appropriate to personnel experience, requirements of the Prudential Standards, management and investment objectives and the SSP's tolerance for risk;
effective internal controls, including separation of operations and internal audit; and
comprehensive management information systems to ensure monitoring and reporting of exposures.
AFIC will place particular importance on policies and systems in its review of SSPs.
The business of SSPs, particularly treasury management and settlement services, gives rise to a number of risks typical of any financial intermediary. At the core of management of these risks must be the policies and systems approved by the SSP's board. These policies must be consistent with the following Prudential Standards.
5.1.1 Liquidity risk
There are two types of liquidity risk: the risk that an SSP may find it difficult to meet investment, settlement or repayment obligations arising from cash flow mismatch; and, the risk that an institution cannot easily unwind a particular position because of a lack of market depth or other market disruption, without significantly affecting the market price of the asset.
In general, liquidity risk can be reduced by matching the duration of assets and liabilities and by ensuring that an SSP is of sufficient size to benefit from pooling the liquid assets of industry to meet the liquidity demands of individual member societies. Access to standby lines of credit from sources external to the SSP and its constituents is also an important part of managing liquidity risk.
An important function of SSPs is the management of member societies’ funds, particularly the acceptance and investment for the purpose of meeting the prime liquid assets (PLA) ratio and pre-funding of settlement obligations. Effective management of liquidity risk is therefore of central importance to the sound operation of these SSPs.
In addition to applying appropriate liquidity risk management policies and systems, where an SSP accepts deposits from societies made for the purposes of meeting PLA requirements, these funds must be held by SSPs in specially designated accounts (PLA deposit accounts) and must be invested in an equivalent value of PLA assets. Assets invested to meet PLA requirements must not be encumbered with any pledge or lien, other than an encumbrance approved by AFIC under the terms of the emergency liquidity support mechanism.
Where societies deposit excess liquidity with the SSP to manage, these funds must also be invested in appropriately liquid assets in accordance with the SSP’s investment policies. Further, these funds cannot be used to finance other activities or businesses conducted by the SSP.
The nature of financial intermediation by SSPs, either for treasury management or settlement functions, means that the vast majority of funds will be held in highly liquid assets. Other SSPs may be required to hold minimum liquidity at a level to be determined by AFIC in view of the nature of the services offered by the SSP and its management systems.
Techniques of liquidity management vary widely and AFIC has no intention of limiting the scope for innovation in this area. However, SSPs must satisfy AFIC that proposed techniques are supported by experienced personnel, appropriate controls and suitable technology, particularly in any use of derivatives.
In terms of liabilities, SSPs must also recognise the risk of reliance on any one source of funding. While SSPs will be funded in the main by deposits from societies, before entering into a liability exposure to any one society or wholesale lender greater than 10 per cent of liabilities, the SSP must consult with AFIC.
AFIC requires each SSP to report details on investments and deposits, particularly mismatch, to satisfy that compliance with the Prudential Standards and policy is monitored properly. AFIC may choose to tailor this report on a case-by-case basis depending on the activities of the SSP.
5.1.2 Market risk
Market risk is the risk that the value of the financial assets of an SSP will decline as a result of changes in exchange or interest rates. Generally SSPs will not create foreign exchange exposures, so the majority of market risk arises from interest rate risk. Interest rate risk reflects the fact that financial institutions hold assets and liabilities with different term structures, market liquidity and cash flows.
To the extent that deposits and loans are matched either because both are variable rate instruments or in the case of fixed rates, duration is matched, interest rate risk may be minimised.
Where an SSP’s book is not matched naturally, or not readily adjustable, the SSP has access to a range of techniques for managing interest rate risks including the use of derivatives. Such interest rate management products include:
interest rate swaps;
• interest rate futures contracts;
• interest rate options; and
• combinations, creating caps, floors and collars.
It is likely that an SSP will tailor over-the-counter (OTC) derivatives to meet particular portfolio risks. However, the use of these products may present additional liquidity and credit risks and additional market risk in the form of basis risk. Basis risk will arise where the basis upon which rates change for the security differs from the derivative and will be especially evident where derivatives are used on a portfolio basis.
AFIC requires SSPs to demonstrate that they have adequate procedures in place to monitor and manage market risk exposures. Such procedures must:
• encompass policies that establish the level of risk that will be assumed;
• set limits and identify clear lines of responsibility for the management of interest rate risk, including any use of derivatives;
• define a measurement and control system that monitors and limits the risk and reports any breaches of those limits to senior management and the board; and
• regularly assess the market value of investments and evaluate market value risk arising from longer term positions or fixed rate exposures.
Another source of market risk is fluctuations in foreign currency exchange rates. Section 121 of the F! Code allows SSPs to raise funds subject to the requirements of the section, denominated in a foreign currency where, simply stated, the foreign currency borrowings are hedged against exchange rate movement. Whenever an SSP proposes to raise funds or create liabilities in a foreign currency, it must notify AFIC in advance. Both the borrowing and the proposed method of hedging must be agreed with AFIC. In particular, AFIC will discourage strongly any reliance on overseas borrowings or, for that matter, reliance on borrowings from any wholesale market as a source of long term funding.
5.1.3 Credit and settlement risk
A major source of risk for any financial institution is the risk of counterparty default. In terms of traded instruments, an SSP is exposed to adverse changes in the credit standing of the issuer or failure of a trading counterparty to deliver. SSPs providing settlement services are also exposed to failure-to-settle risk and SSPs providing treasury management services, particularly those lending to member societies or providing overdraft or standby facilities, carry additional counterparty risk.
Like other aspects of risk management, SSPs must provide AFIC with detailed information about lending and investment practices. In particular, management must demonstrate an understanding of the inter-relationships arising from the various credit risks the SSP is carrying and their relationship to market and liquidity risk. AFIC requires SSPs to demonstrate that adequate systems are in place to monitor credit risk. Such systems must:
• encompass policies that establish the level of credit risk that will be assumed and provide for appropriate diversification of the portfolio;
• set limits and identify clear lines of responsibility for the management of credit risk;
• define a measurement and control system that monitors and limits the risk and reports any breaches of those limits to senior management;
include regular marking to market of investments; and
• provide for the use of derivatives only with appropriate counterparties in accordance with the legislation and Prudential Standards.
While settlement risk may arise where a counterparty to a contract fails to deliver a security or not make a differential payment on time, most settlement risk resides in the provision of settlement services on behalf of member societies. Failure-to-settle risk has two parts, “internal” exposure of the SSP to a member society that fails to settle and “external” exposure to an institution in the wider financial system. SSPs must demonstrate that adequate systems are in place to minimise settlement risk. Such systems must:
• provide for timely transaction capture supported by appropriate technology;
• ensure the SSP complies with any requirements of the payment clearing system imposed by APCA;
• ensure adequate security is taken to support settlement by societies in the form of pre-funding or other appropriate security;
• minimise the exposure of a society to other societies within the network which may include the use of a credit module;
• ensure the integrity of the payment system in the event that a member society fails-to-settle by meeting the society’s obligation; and
• make provision for failure-to-settle by an institution in the wider financial system.
Where an SSP provides loans or overdraft and standby facilities to member societies, exposures must be limited such that:
• aggregate exposure to societies at any one time, including loans, overdrafts and standby facilities does not exceed the sum of the SSP’s external standby facilities plus 30 per cent of non-PLA deposits; and
• a loan to an individual society must not exceed 5 per cent of the sum of the SSPs external standby facilities and non-PLA deposits.
These restrictions may be varied at AFIC’s discretion or in the event that the emergency liquidity support scheme is activated.
SSPs must also demonstrate that they have satisfactory systems for controlling risks arising from off-balance sheet financing including obligations in the form of loans approved but undrawn, overdrafts, lines of credit, standby facilities and other similar liabilities, either direct or contingent. AFIC may on a case-by-case basis impose a limit on these commitments or require the SSP to hold additional capital or both.
5.1.4 Transaction and Technology Risk
Transaction risk is the risk that a financial loss is incurred as a result of a transaction not being executed completely and accurately and may arise from poor internal management or even possibly legal risk. Proper systems, controls and experienced personnel will minimise this risk. An SSP must demonstrate satisfactory systems for accurate and timely data capture and ensure that personnel and systems can cope with present and anticipated volumes of all types of transactions. Further, where SSPs provide treasury management functions, effective separation of front and back office operations must be established.
Technology risk is the risk of technological failure either through inadequate technological support to manage risks, for example, inappropriate software, or, at the more basic level, failure of a computer system. SSPs must have systems which safeguard the integrity and security of their data including disaster recovery plans.
A particular risk to a SSP’s data exists due to the potential for damage to or misuse of computer programs or code that fail to calculate correctly or record dates after a particular date. This is commonly referred to as the “Year 2000 problem” because many computer and other electronic systems cannot deal with dates after 31 December 1999. However, the problem is not confined to the year 2000 and could arise through a range of other critical dates that might be embedded in computer systems. For convenience, AFIC is referring to this matter as the “Year 2000 problem”.
To ensure the security and integrity of a SSP’s data, the Directors of a SSP should ensure that a full review and assessment of the risks associated with the Year 2000 problem is undertaken. Those systems affected that are critical to using or storing the SSP’s data, must be corrected. Directors must:
• ensure that appropriate tests are carried out to ascertain that any critical computerised systems using or storing the SSP’s data are not affected by the Year 2000 problem; and
• obtain sufficient assurance that the SSP’s systems and dates will not be significantly affected by inaccurate data or failure of services by its suppliers.
It may not be possible for every internal and external system to be corrected in the short time available before the year 2000, or any other critical date, arrives. Therefore, in anticipation of possible failures, each SSP must have a comprehensive written statement dealing with the risks and events that may arise due to either the SSP or an external service provider suffering disruptions that may, in turn, disrupt the SSP’s normal business operations. These policies and procedures should form part of a SSP’s Disaster Recovery Plan in respect of managing both transaction and technology risk and operations risk.
5.1.5 Operations Risk
SSPs are exposed to a range of operations risk in carrying out their day-to-day business. Many of these risks are insurable, others are not. Risks arise from a number of sources, including litigation associated with discrimination, negligent advice and invasion of privacy. Whether or not these risks are insured or even insurable, SSPs must demonstrate an understanding of the risks involved and the capacity to measure, monitor and control them.
A particular risk to SSP’s operations exists due to the year 2000 problem. SSP’s are faced with the potential for impairment of normal business operations through the failure of systems dependant on computer microchips, such as communications, security, and fire protection systems.
To ensure the SSP’s operations risk is minimised, the Directors of a SSP should ensure that a full review and assessment of the risks associated with the Year 2000 problem is undertaken. Hose systems affected that are critical to the SSP’s normal business operations must be corrected. Directors must ensure that appropriate tests are carried out to ascertain that any critical computerised systems and devices required for the SSP’s day-to-day operations are not affected by the Year 2000 problem.
A SSP must keep its insurance contracts under review to ascertain whether it is covered for interruptions to business and possible litigation, due to non-performance of disruption to business, as a result of the Year 2000 problem.
Where directors are of the option that the SSP will be unable to address the Year 2000 problems adequately, with regard to its critical systems, the SSP should immediately notify AFIC.
An important source of insurable operations risk arises from potential damage to the physical assets of the SSP through accident or fire. Further, while compulsory worker's compensation covers potential loss through accidents involving staff, there is a similar risk to members of the public that is not automatically insured. Other operational risks arise from the potential for legal action against the SSP or its directors.
In addition to compulsory worker's compensation, all SSPs should carry effective insurance with a reputable insurance company to protect their personnel, operations and physical assets. Each SSP should carry the following insurance policies with cover at an appropriate level:
fidelity guarantee;
asset protection, including fire and malicious damage;
directors' and officers' liability;
public liability;
professional indemnity; and
business interruptions.
AFIC will seek details of insurance policies and each SSP's approach to insurance.
The practices of management are a particular source of potential loss to SSPs. While there can be no doubt that management has full discretion to carry on the business as it sees fit, the pivotal role of SSPs in the lives of their constituent societies demands that certain minimum standards be observed over and above those required of societies.
Each SSP must satisfy AFIC that at all times it possesses sufficient management expertise and resources to perform its functions satisfactorily. AFIC will seek evidence that the management of each SSP can demonstrate, amongst other attributes:
an intimate knowledge of the business of the societies served;
appropriate systems to ensure adequate financial and internal control for services offered;
a proven record of experience among directors and staff in the services offered; and
the on-going commercial viability of operations.
More specifically, where an SSP offers treasury management services to societies, AFIC must be satisfied that the SSP, at all times:
retains services of personnel with experience in treasury dealing and operations;
maintains adequate financial and internal control over treasury functions, including separation of front and back office operations; and
operates within dealing limits and procedures for exposure management.
The key to the control of management risk lies in a comprehensive management process, including adequate internal controls and disclosure. The board of directors and senior management of each SSP must be fully and frequently informed of decisions and practices undertaken throughout the institution. Similarly, supervision of management risk requires full and frequent disclosure to AFIC.
Accordingly, SSPs are required to notify AFIC immediately of any breakdowns in internal controls that will cause a material departure or omission to the legal, prudential or policy obligations of the SSP. They must also have an external audit or review conducted covering matters identified by AFIC. Results of these audits must be forwarded directly by the external auditor to AFIC.
Prudential Standards 5.1, 5.1.1, 5.1.2 and 5.1.3
Note: see subparagraph 3(b) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
5.1 Risk Management
Each SSP must advise AFIC immediately if it is in breach of any Prudential Standard, stating the time and date of occurrence and when discovered, the nature of the occurrence and whether the problem has been rectified or the plans for rectification.
5.1.1 Liquidity Risk
5.1.1.a Each SSP must have comprehensive written policies and systems to measure, monitor and manage liquidity risk. The board of directors must provide initial endorsement of significant policies (and changes, as applicable) and periodic approval thereafter. Senior management is responsible for implementation of policies and systems and their regular review. Policies and systems must be audited annually by the SSP's external auditors. A current copy of these policies must be provided to AFIC and their operation and implementation may be subject to review during on-site inspections by AFIC.
5.1.1 b Where an SSP accepts deposits, made by societies for the purpose of meeting the PLA requirement of the Prudential Standards, these deposits must be held in PLA deposit accounts. The SSP must invest the equivalent amount of these funds in assets that would qualify for PLA. Assets held to meet any PLA requirement must be in the SSP's name, must be unencumbered by any pledge or restriction and must be readily negotiable. Policies to manage liquidity risk must include risk tolerances, operating limits and reporting processes.
5.1.1.c Prime Liquid Assets will include only the following:
(iv) loans to authorised money market dealers against the security of Commonwealth Government securities; and
(v) State or Territory Government issued or guaranteed securities.
5.1.1.d Where an SSP accepts additional deposits from societies such as excess liquidity or funds to meet settlement obligations, the SSP must invest these funds in highly liquid, high quality investments in accordance with the SSP’s policy. Changes to investment policy must be provided to AFIC prior to implementation. Funds deposited by societies for the purposes of operational liquidity can not be used to finance other activities or businesses conducted by the SSP.
5.1.1.e Other than standby lines of credit approved by AFIC, each SSP is to provide a monthly return detailing all liability exposures to individual lenders and/or associated lenders greater than 5 per cent of its total liabilities excluding capital and PLA deposits. In this context, the interpretation of 'associated lenders' will be extended to include concentration on any single source of funds (other than societies) including the wholesale market and overseas markets.
5.1.1.f Before entering into a liability exposure (other than standby lines of credit approved by AFIC) greater than 10 per cent of an SSP's total liabilities excluding capital and PLA deposits, the SSP must first consult with AFIC. The onus will be on the SSP to establish that the exposure does not constitute an excessive risk in the context of its overall deposit book.
5.1.1.g Each SSP must maintain operational liquidity at a level determined by AFIC as being appropriate to the nature of the services and activities conducted by the SSP.
5.1.1.h Each SSP must report monthly to AFIC details on investments and deposits, particularly mismatch, to satisfy AFIC on compliance with the standards and policy. AFIC may choose to tailor this report on a case-by-case basis depending on the activities and reporting systems of the SSP. An SSP that fails to satisfy AFIC that its practices are adequate to the risks involved may be required to maintain higher capital or liquidity, limit activities and investments, report more regularly or take such other steps deemed appropriate by AFIC.
5.1.2 Managing Market Risk
5.1.2.a Each SSP must have comprehensive written policies and systems to measure, monitor and manage market risk. The board of directors must provide initial endorsement of significant policies (and changes, as applicable) and periodic approval thereafter. Senior management is responsible for implementation of policies and systems and their regular review. Policies and systems must be audited annually by the SSP's external auditors. A current copy of these policies must be provided to AFIC and their operation and implementation may be subject to review during on-site inspections by AFIC.
5.1.2.b Depending on the nature of the services offered by an SSP, AFIC may impose gearing or other limits on the duration mismatch of the SSP's management portfolio.
5.1.2.c Where the SSP uses derivatives to manage interest rate or other risk, the SSP must demonstrate that their use is in accordance with the FI Legislation and supported by experienced personnel, appropriate controls and technology.
5.1.2.d SSPs are permitted to raise funds denominated in a foreign currency provided the foreign currency borrowings are hedged so as to minimise the risk of loss from exchange rate movements. Whenever an SSP proposes to raise funds in a foreign currency, it must notify AFIC before proceeding, detailing the proposed method of hedging the exchange rate risk exposure. Before proceeding with the borrowing, the SSP must ensure that AFIC is satisfied that the transaction complies with Section 121 of the FI Code.
5.1.3 Credit and Settlement Risk
5.1.3.a Each SSP must have comprehensive written policies and systems to measure, monitor and manage credit and settlement risk. The board of directors must provide initial endorsement of significant policies (and changes, as applicable) and periodic approval thereafter. Senior management is responsible for implementation of policies and systems and their regular review. Policies and systems must be audited annually by the SSP's external auditors. Their operation and implementation may be subject to review during on-site inspections by AFIC.
5.1.3.b Each SSP must provide AFIC with a written statement of its policies in respect of investment, particularly the quality of investments, policy on exposure limits and diversification of the portfolio. Changes to the investment policy must be provided to AFIC prior to implementation.
5.1.3.c Each SSP must provide monthly a return of all exposures to individual borrowers and/or associated borrowers greater than 5 per cent of its capital base. An exposure is the aggregate of loans drawn and the undrawn portion of committed facilities such as overdrafts, standbys or similar. The intention is to identify concentration of risks and AFIC will declare borrowers to be 'associated' if there is any suggestion of intent to disguise concentration.
5.1.3.d Before entering into an exposure greater than 10 per cent of an SSP's capital base, the SSP must first consult with AFIC. The onus will be on the SSP to establish that the exposure does not constitute an excessive risk in the context of its overall loan book.
5.1.3.e Without the prior agreement of AFIC, the value of loans, undrawn limits of overdraft and standby facilities and similar financial accommodation provided to societies at any one time must not, in aggregate, exceed the sum of standby lines available to the SSP plus other drawn commercial funding programs previously agreed to be included in this limit by AFIC plus 30 percent of the value of non-PLA deposits.
5.1.3.f Each SSP must demonstrate a satisfactory system for monitoring and controlling off-balance sheet obligations in the form of loans approved but not drawn, overdrafts, lines of credit and other similar liabilities, whether direct or contingent.
5.1.3.g In the normal course of business, an SSP's exposure to its own fixed assets should not exceed 50 per cent of the value of its capital base. Any intention to create or add to an exposure beyond this level requires prior agreement of AFIC.
5.1.3.h AFIC may vary any or all of these reporting and consultation standards in particular cases as dictated by the nature of the risks involved. Failure by an SSP to satisfy AFIC that its practices are adequate for the risks involved may lead to its being required to maintain higher capital adequacy, liquidity, restrict investment activity, report more frequently or take such other steps deemed appropriate by AFIC.
Prudential Standards 5.1.4 and 5.1.5
Note: see subparagraph 3(c) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
5.1.4 Transaction and Technology Risk
5.1.4.a Each SSP must have comprehensive written policies and systems in respect of managing transaction and technology risk. The SSP must be able to demonstrate risk management and processing systems that monitor transactions and exposures from transactions. In addition to experienced personnel, each SSP must have the necessary technological support to effect risk management techniques associated with treasury management, settlement and any use of derivatives. Before expanding into new areas of financial intermediation, an SSP must ensure that the proper systems and controls are in place supported by the appropriate technology. Policies and systems must be audited annually by the SSP’s external auditors.
5.1.4.b Each SSP must also provide for the physical security of financial transactions and information. The SSP’s policies must also identify procedures for off-site backup and other disaster recovery considerations as part of a comprehensive disaster recovery plan. These systems should be tested on a regular basis at least annually.
5.1.4.c The Directors of a SSP should ensure that a full review and assessment of the risks associated with the Year 2000 problem is undertaken. Those systems affected that are critical to using or storing the SSP’s data, must be corrected. Directors must:
ensure that full testing is carried out to ascertain that any critical systems for using or storing the SSP’s data are not affected by the Year 2000 problem; and
obtain sufficient assurance that the SSP’s systems and dates will not be significantly affected by inaccurate data or failure of services by its suppliers.
5.1.4.d Each SSP must have a comprehensive written statement dealing with the risks and events that may arise due to either the SSP or an external service provider suffering disruptions that may, in turn, disrupt the SSP’s normal business operations. These policies and procedures should form part of the SSP’s Disaster Recovery Plan in respect of managing both data risk and operations risk.
5.1.4.e All systems and procedures must be documented and available for inspection by AFIC.
5.1.5 Operations Risks
5.1.5.a Each SSP is to provide AFIC annually with a written statement of its policy in respect of insurance and details of its individual insurance policies. Policies and systems must be audited annually by the SSP’s external auditors. Each SSP should carry the following insurance policies with cover at an appropriate level:
fidelity guarantee;
asset protection, including fire and malicious damage;
directors’ and officers’ liability;
public liability;
professional indemnity; and
business interruption.
5.1.5.b Each SSP must satisfy AFIC that, at all times, it retains appropriate management expertise and resources and conducts activities prudently. AFIC will require evidence that the management of the SSP can demonstrate, amongst other attributes:
· an intimate knowledge of the business of the societies served;
· appropriate systems to ensure adequate financial and internal control over the services offered;
· a proven record of experience among directors and staff in the services offered; and
· the on-going commercial viability of operations.
5.1.5.c An SSP must notify AFIC immediately of any breakdowns in internal controls that could cause a material departure or omission from the legal, prudential or policy obligations of the SSP. Such notification should include the nature of the breakdown, impact on the operations, action to rectify problem and action to prevent similar breakdown in future.
5.1.5.d Each SSP must make a representation each month to AFIC that to the best of its knowledge and belief, no break down in internal controls has occurred that will cause a material departure or omission to the legal, prudential or policy obligations of the SSP, other than any notification made under 5.1.5.c.
5.1.5.e Directors of a SSP should ensure that a full review and assessment of the risks associated with the Year 2000 problem is undertaken. Those systems affected that are critical to the SSP’s normal business operations must be corrected. Directors must ensure that full testing is carried out to ascertain that any critical computerised systems and devices required for the SSP’s day-to-day operations are not affected by the Year 2000 problem.
5.1.5.f A SSP must keep its insurance contracts under review to ascertain whether it is covered for interruptions to business and possible litigation, due to non-performance or disruption to business, as a result of the Year 2000 problem.
5.1.6.g Where directors are of the opinion that the SSP will be unable to address the Year 2000 problems adequately, with regard to its critical systems, the SSP should immediately notify AFIC.
5.1.5.h Each SSP is required to ensure that its external auditors provide AFIC with an Audit Review Report on a quarterly basis that states whether anything has come to their attention that causes them to believe that the risk management systems have not been adhered to and are not adequate to monitor, manage and control risks associated with the SSP’s financial activities. (Negative assurance)
The Audit Statement must be provided directly to AFIC as soon as possible after the completion of the audit work for the relevant quarter.
5.1.5.i AFIC may, by notice, require the SSP to have prepared additional or specific reports from the external auditor.
Prudential Note 5.2
Note: see subparagraph 3(d) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 5.2 -Special Service Providers
Introduction
To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that special services providers have sufficient capital to absorb losses occasioned by loan default, adverse market movements and management error.
The primary role of capital in a deposit-taking institution is to provide a cushion against loss and to maintain the confidence of its depositors.
SSPs perform a critical role in supporting the liquidity, efficiency and integrity of the State-based financial institutions system. Their soundness and safety must be beyond question. From the time of registration they must be capitalised to an extent sufficient to:
• gain and retain credibility within financial markets as financially-stable managers of liquid assets;
• absorb potential losses from a variety of sources;
• maintain standby lines of credit and other sources of external liquidity support of acceptable quality (see Prudential Note 5.4.); and
• provide an assurance of future capital commitment from its owners.
Capital Adequacy Requirements
The standards for capital adequacy required of SSPs are modified and strengthened versions of the standards applying to societies. The need to ensure adequate capital is self-evident.
The probability of insolvency increases as the level of capital falls and/or exposure to risk rises.
The approach to capital adequacy for SSPs has three elements – capital requirement for the institution, quality and structure of capital and credit risk of assets.
SSPs are required to maintain at all times a minimum ratio of defined capital to risk-weighted assets. The division of capital into two tiers is identical to that required of societies. An SSP is required to hold a minimum of 50 per cent of required capital in the form of Tier 1 (or ‘core capital’). Supplementary or Tier 2 capital is further qualified as Upper and Lower Tier 2 capital.
Therefore, for the purposes of calculating capital adequacy, an SSP must deduct from its total capital (and assets) the carrying value of any holding of capital instruments of a building society or credit union. It is not appropriate that capital of an SSP be used to support other regulated entities balance sheets. Similarly, an SSP should deduct any equity investment in a securitisation or funds management vehicle (which includes a subsidiary that acts as an approved trustee under the SIS legislation) and any subsidiary which is active in these areas of business as a manager, custodian, trustee or similar role. The deduction should be for the maximum amount of capital that may be required to be committed to the entity. This includes any guarantee that acts as a substitute for capital that would otherwise need to be provided and any uncalled amount on partly paid shares.
In calculating risk-weighted assets, the risk weights for an SSP’s assets are similar to those applying to the assets of societies with one exception:
• secured loans made by an SSP on behalf of eligible societies to a society in pursuance of Section 46 of the AFIC Code, attract a weight equal to that on the original PLA investments for the purposes of computing capital adequacy.
This provision ensures that an SSP’s capital adequacy is not compromised by the initiation of emergency liquidity support loans by AFIC under Section 46 of the Code.
In most instances, the nature of the business of an SSP, together with the restrictions placed upon the portfolios, will ensure that the risk-weighted value of assets is low. This reflects the fact that an SSP will ordinarily be exposed to very little credit risk. An SSP will still be exposed to interest rate risk and management risk. Moreover, the pivotal position of any particular SSP in its industry, even if it is one of a number of SSPs, requires that sufficient capital be available to absorb losses which might arise from sources other than credit risk.
Therefore, an SSP that provides principally financial services such as treasury management or settlement services is required to maintain at all times a capital ratio of 10 per cent of defined capital to risk-weighted assets. An SSP that provides a wider range of services and may thereby be exposed to higher aggregate risk, may be required by AFIC to maintain additional capital.
AFIC may choose to increase the risk weighted assets ratio at its discretion and for an indefinite period of time. This may reflect the nature and risks of the operation and activities of a particular SSP.
Any proposed diminution of capital, including any repayment of subordinated debt or other capital instrument or dividends in excess of current year earnings can only be made with the prior approval of AFIC.
Prudential Standards 5.2.1 to 5.2.9 (inclusive)
Note: see subparagraph 3(e) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
5.2.1 Capital Adequacy
5.2.1.a Each SSP that provides principally treasury management or settlement services is required to maintain at all times a capital ratio of 10 per cent of defined capital to risk-weighted assets. An SSP that provides a wider range of services and may thereby be exposed to higher aggregate risk, may be required by AFIC to maintain additional capital.
5.2.1.b Capital will be considered in two tiers:
• Tier 1 (or 'core capital') comprises the highest quality capital elements (defined in Prudential Standard 5.2.2.a).
• Tier 2 (or 'supplementary capital') represents additional elements (defined in Prudential Standard 5.2.2.b) that contribute to the overall strength of the SSP.
5.2.1.c At least 50 per cent of an SSP's required capital must be core capital (Tier 1); the remainder may consist of 'supplementary' elements (Tier 2).
5.2.1.d AFIC may, at its discretion, by notice to the SSP, increase the risk-weighted capital-to-assets ratio required of an SSP for an indefinite period of time.
Any instrument or issue of subordinated debt or limited life redeemable preference shares by an SSP must be approved by AFIC before the instrument may qualify for treatment as Tier 2 capital. Relevant documentation will be examined by AFIC with particular regard to the provisions by which the instrument is subordinated to the claims of other creditors and the events or circumstances which may accelerate payment of interest and/or repayment of principal ("events of default").
As a precondition for qualification of subordinated debt as Tier 2 capital the subordinated debt instrument or other relevant documentation governing the terms of issue must, unless otherwise agreed in writing by AFIC, preclude the subordinated debt holder (and any agent, trustee or other person acting on behalf of the holder) from enforcing rights to accelerate payments or repayments in consequence of events of default except by instituting proceedings (or joining in proceedings) for the winding up of the SSP pursuant to the Financial Institutions Code.
The review by supervisors of terms and conditions of instruments for inclusion in Tier 2 capital will give close regard to step up rates, conditions for conversions, deferral of interest and other payments, options to repay and early repayment.
5.2.3 Hybrid (Debt/Equity) Capital Instruments
5.2.3.a A range of instruments that combine characteristics of equity capital and of debt may be included in upper Tier 2 capital. To qualify for inclusion in the capital base they must be:
(ii) not redeemable at the initiative of the holder or without the prior consent of AFIC; and
(iii) available to participate in losses without the SSP's being obliged to cease trading (unlike conventional subordinated debt).
5.2.3.b Although these instruments may carry an obligation to pay interest that cannot permanently be reduced or waived (unlike dividends on ordinary shareholders' equity), they should allow servicing obligations to be deferred (as with cumulative preference shares) where profitability would not justify payment.
5.2.3.c As with term subordinated debt an instrument or issue of hybrid capital by an SSP must be approved by AFIC before it may qualify for inclusions as Tier 2 capital.
5.2.4 Categories of Risk
5.2.4.a Nil Weight:
• overnight settlements, loans and other claims fully secured10 against cash;
• Commonwealth, State or Territory Government securities; and
• claims fully secured against Commonwealth or State or Territory Government securities.
5.2.4.b 10 per cent Weight:
• all other claims on, or guaranteed11 by, Commonwealth or State or Territory Governments.
5.2.4.c 20 per cent Weight:
• claims on Australian local governments or public sector entities (except those which have corporate status or operate on a commercial basis) or which are guaranteed by these entities;
• claims on or guaranteed by Australian or OECD banks;
• claims on, or guaranteed by, building societies or credit unions;
• claims on, or guaranteed by international banking agencies or regional development banks; and
5.2.4.d 50 per cent Weight
• loans12 for housing or other purposes fully secured by registered mortgage against residential building and/or development (as defined in Section 3 of the FI Code) where, the mortgage falls within one of the following categories:
(i) a first registered mortgage where the ratio of the outstanding balance13 of the loan14 to the valuation of the property is no more than 80 per cent.15 If the loan is 6 months or more in arrears, the valuation must be no older than 12 months;
(ii) a first registered mortgage where the outstanding balance is 100 per cent mortgage insured;16
(iii) a second mortgage where the ratio of the outstanding balances of the loans secured by both mortgages to the valuation of the property does not exceed 80 per cent and the first mortgage cannot be extended without it being subordinated to the second mortgage;
(iv) a second mortgage where the ratio of the outstanding balances of the loans secured by both mortgages to the valuation of the property exceeds 80 per cent, where the first mortgage cannot be extended without it being subordinated to the second mortgage and the outstanding balance is 100 per cent mortgage insured.16
Elsewhere in the standards, mortgages satisfying any one of the conditions i) - iv) above will be referred to as 'qualifying' mortgages.
The 50 per cent risk weight applies to loans for housing, or for other purposes, fully secured by a registered mortgage over residential property (whether or not the property is owned by the borrower) subject to the following criteria being satisfied:
• the SSP has at all times a clear and unequivocal access to mortgaged residential properties in the event of default by borrowers;
• the SSP has been involved directly in making credit assessments of individual borrowers, including the valuations of the associated residential properties secured by mortgage;
• where security is provided by third parties (ie. parties other than the specific borrower), other than on loans in respect of which the relevant mortgage is unenforceable under the Consumer Credit Code, the building society has ensured that those parties understand fully the consequences of default on the loans and their legal obligations; and
• loans for purposes other than housing are fully secured by mortgages over existing residential property. Loans, for whatever purpose, secured against speculative residential development – eg. multiple dwellings such as blocks of units – do not qualify for a concessional risk weight.
Where a loan fails to satisfy any of the above criteria, the full value of the loan should be assigned a 100 per cent risk weight in the absence of any other eligible collateral or guarantees. A concessional risk weight does not apply to mortgage-backed securities which should be risk weighted as a claim on the issuer of the securities. Other asset backed paper should be risk weighted in a similar fashion.
5.2.4.f Loans under the Emergency Liquidity Support Scheme
Secured loans made by a SSP on behalf of eligible societies to another society in pursuance of Section 46 of the AFIC Code attract a weight equal to that on the original PLA investments for the purposes of computing capital adequacy.
5.2.4.g Certain asset classes and investments may result in additional capital requirements if, in the opinion of AFIC, they lead to excessive risk for the SSP.
5.2.5 Off-Balance Sheet Business
(i) the principal (or face value) amounts of transactions will be converted into on-balance sheet equivalents ('credit equivalent amounts') by application of credit conversion factors; and
(ii) the resulting credit equivalent amount will be assigned the risk weight appropriate to the counterparty or, if relevant, the risk weight assigned to the guarantor or the collateral security.
5.2.5.a Credit conversion factors for selected major off-balance sheet transactions:
| | Credit Conversion Factor18 |
| Direct credit substitutes, including financial guarantees and endorsements (which do not have the prior endorsement of a bank) | 100% |
| Assets sold with recourse19 where credit risk remains with the SSP | 100% |
| Sale and repurchase agreements20 where credit risk remains with the SSP20, forward asset purchases20 placement of forward deposits, and other commitments to acquire assets20 | 100% |
| Loans approved by a SSP but not yet advanced, where there is certainty of drawdown (i.e. forward loan commitments) | 100% |
| Trade and performance-related contingent items, including warranties, bid bonds, indemnities, performance bonds and standby letters of credit related to particular non-monetary obligations | 50% |
| Other commitments (e.g. formal standby facilities and undrawn amounts under an equity credit or redraw facility21) with a residual maturity exceeding one year22 | 50% |
| Other commitments that can be unconditionally revoked without notice but are not subject to review at least annually. | 50% |
| Other commitments (eg undrawn overdraft and credit card facilities) which can be unconditionally revoked at any time without notice where the SSP provides for any outstanding unused balance to be reviewed at least annually | 0% |
| Other commitments with a residual maturity of one year or less23 | 0% |
5.2.5.b Other Items
For items not included above24, credit conversion factors should be discussed with AFIC.
5.2.6 Derivative Products
5.2.6.a SSPs may only enter into contracts involving derivative products for the purpose of reducing market risk. Given the nature of their business, the general presumption is that SSPs will only use derivative products related to interest rates or exchange rates. The credit risk associated with derivative products is the cost to the SSP of replacing the cash flow specified by the contract in the event of counterparty default. This will depend, among other things, on the maturity of the contract and on the price volatility of the underlying physical instrument.
5.2.6.b Credit-equivalent amounts for derivative products may be calculated in either of two ways, using a ‘mark-to-market’ approach or a ‘rule-of-thumb’ approach.25
This is the mark-to-market valuation of all contracts with a positive replacement cost. Replacement costs which are fully collateralised by cash and government securities, or backed by eligible guarantees, may be given the weight of the underlying security or guarantor.
This is calculated as a percentage of the nominal principle amount of a society's portfolio of interest rate and exchange rate related contracts split by residual maturity as follows:
Credit-equivalent amounts are calculated by applying credit conversion factors to the principal amounts of contracts according to the nature of the instrument and its original maturity.
5.2.6.c The following derivative products (interest and foreign exchange contracts) are to be included in the calculation of credit-equivalent amounts:
5.2.6.d The following derivative products are excluded in the calculation of credit-equivalent amounts:
5.2.7 Deductions of Certain Investments from Capital
5.2.7.a For the purpose of calculating capital adequacy, an SSP must deduct from its total capital (and assets) the carrying value of any investment (by it or its subsidiary) in the capital instruments (in the form of equity or subordinated debt26) of a building society or credit union.
5.2.7.b Where an SSP (or its subsidiary) invests capital in, or provides a guarantee or similar support to, an entity which undertakes the role of manager, responsible entity, approved trustee, trustee, custodian or similar role in relation to funds management or the securitisation of assets then the value of capital27 and guarantees should be deducted from the SSP’s and the group’s capital base.
5.2.7.c An SSP is required to deduct from its capital base (and risk assets) its equity and other capital investments in non-consolidated subsidiaries or associates which it effectively controls. Investments in life and general and lenders mortgage insurance companies, as well as friendly societies, will generally be subject to this requirement.
5.2.7.d Where an SSP enters into an undertaking which provides for it to absorb the first level of losses28 on claims supported by the SSP (eg guarantees, up to a limit, of losses on a portfolio of loans held in a securitisation vehicle) the amount of the undertaking (or limit) should be deducted from its capital base (and risk assets) unless it has already been written off.
5.2.8 Reductions in Capital
5.2.8.a Where an SSP proposes any reduction in its capital (eg via the repurchase of shares or subordinated debt or payment of dividends in excess of current year earnings) it must obtain the prior written agreement of AFIC. AFIC will need to be satisfied on the basis of an acceptable capital plan (which extends for at least two years) provided by the SSP that the SSP’s capital will remain adequate, for its future needs, after the proposed reduction.
5.2.9 Market Risk
5.2.9.a Market risk is defined as the risk of losses in on and off-balance sheet positions arising from movements in market prices. This standard addresses the risk pertaining to interest rate related instruments and equities in the trading book of the SSP. The trading book may include PLA and operational liquidity deposits from societies.
5.2.9.b It is the responsibility of the SSP’s board and management to ensure that it has in place adequate systems to identify, measure and manage market risks incurred in both its trading and investment books and to hold appropriate capital against those risks.
5.2.9.c Each SSP will be expected to monitor and report the level of risk against which a capital requirement is to be applied. The SSP’s overall assessed risk exposure to be compared against its capital base will be the credit risk requirements set out in prudential standard 5.2.1.a excluding any debt and equity securities in the SSPs trading book; plus
(a) the standardised capital charges for market risk; or
(b) the measure of market risk derived from an approved model; or
(c) a mixture of (a) and (b) summed arithmetically.
5.2.9.d To ensure consistency in the calculation of the capital requirements for credit and market risk, an explicit numeric link is created by multiplying the measure of market risk, both specific and general market risk, (as calculated according to the standards) by 12.5 and adding the resultant figure to the risk weighted assets calculated for credit risk purposes under Prudential Standard 5.2.1.a.
5.2.9.e Investments may be considered to be held with a trading intent if:
(a) they are considered trading securities by the SSP;
(b) they are marked to market on a daily basis as part of the SSP’s internal risk management process;
(c) the position takers have autonomy in entering into transactions (in marketable instruments) within predetermined approved limits; and
(d) they satisfy any other criteria that AFIC applies to the composition of the trading book on a consistent basis.
5.2.9.f In assessing the method of measuring the capital required to be held against market risk the SSP will agree with AFIC the calculations and formula required to be used. The calculations and formulas that AFIC will require the SSP to use will be consistent with the Reserve Bank of Australia’s statement Capital Adequacy of Banks: Market Risk which is Prudential Statement No C3.
1 Goodwill and similar intangible assets including future tax benefits (FITB) (other than those associated with the general provision for doubtful debts) (net of any provision for deferred income tax liability(DITL) that may be offset in accordance with AASB 1020) will be deducted from 'core' capital and hence total capital. If the DITL exceeds FITB, the excess may not be added to capital.back
2 Must constitute at least -50 per cent of the capital requirement.back
3 May include measured current year earnings net of expected distributions and tax expense.back
4 Must be subordinated to depositors and unsecured creditors; must not provide for a return of capital or compensation for unpaid dividends; and dividends (the only form of compensation to investors that should be provided) should not be influenced by the credit standing of the society. The non-declaration of a dividend should not trigger any restrictions on the society other than the need to seek approval of holders of the shares before paying dividends on or retiring other shares.back
5 For the purposes of calculating capital adequacy cannot exceed the value of Tier 1 capital.back
6 General provisions, less any associated future income tax benefit up to a value of 1.25 per cent of total risk weighted assets. The provisions must be created against future, presently unidentified losses. General provisions must be available to meet any losses that may subsequently materialise.back
7 Where the regular revaluation of property is reflected in the balance sheet and is subject to audit review, revaluation reserves are to be included in upper Tier 2 capital after allowance for capital gains and any other taxes or costs that would be incurred should the asset be sold for the revalued amount. Regular periodic valuations must be of intervals of no more than 3 years. For revaluations of other assets (including securities) not passed through the profit and loss account and irregular revaluations of property only 45 per cent of the gain may be included in upper Tier 2 capital. However, the full value of any decline in value should be reflected in upper Tier 2 capital. This applies whether revaluations or devaluations are recorded in the balance sheet or in the notes to the accounts.back
8 Must meet the criteria for Hybrid (Debt/Equity) Capital Instruments or upper Tier 2 capital instruments set out in Prudential Standard 5.2.3.back
9 The eligible amount of lower Tier 2 capital for the purposes of calculating capital adequacy is limited to 50 per cent of Tier 1 capital. Minimum original maturity must be at least five years. Lower Tier 2 capital must be amortised at a rate of 5% per quarter of the original amount during the last five years to maturity.back
10 To qualify for a particular risk weight a security arrangement must permit direct, explicit, irrevocable and unequivocal recourse to the collateral. Claims secured or collateralised in other ways eg insurance contracts, put options, forward sale contracts are not considered to be eligible collateral.back
11 For the purposes of the capital adequacy standard a guarantee must be issued formally. It must permit direct, explicit, irrevocable and unequivocal recourse to the guarantor. Indirect guarantees (such as guarantees of guarantees eg where the Commonwealth guarantees the entity which provides the guarantee) and letters of comfort are not recognised.back
12 see footnote to Prudential Standard 5.2.4.eback
13 Throughout this standard, outstanding balance includes the balance of all loans and other facilities, plus the gross value of any undrawn limits available eg redraw amount available on the loan or undrawn limit on a revolving credit facility, that are secured against the mortgage security. An "all moneys" mortgage includes all loans or facilities to the customer that are effectively secured against the mortgage. To assign capital to undrawn limits, the credit conversion factor should be taken from prudential standard 5.2.5.a. This credit equivalent may then be assigned a 50 per cent risk weight if secured by a qualifying mortgage. back
14 In calculating the outstanding balance of a loan, allowance may be made for higher ranking security. A credit union may deduct from the outstanding balance any eligible cash or Commonwealth or state government security held as collateral. Similarly, it may also deduct any part of the exposure guaranteed by a Commonwealth, State (including central borrowing authority) or local Government, a public sector entity eligible for a 20 per cent risk weight, a bank or other building society or credit union. These portions of the exposure are to be weighted according to the security or guarantee. A mortgage offset or similar account may only be netted off the loan balance where the arrangement would meet the requirements of the cash collateral guidelines.back
15 Where there is more than one property offered as security, the LVR will be assessed on the basis of the outstanding balance (after allowance for any higher ranking security) to the aggregate value of the secured properties.back
16 To qualify as mortgage insured the policy must be taken out with an authorised Lenders Mortgage Insurer with an insurance rating the equivalent of "A" or higher. A captive LMI, though unrated, may demonstrate a claim paying ability rated "A" or higher through third party guarantees. AFIC will consider non-rated LMI arrangements on a case-by-case basis.back
17 Where a specific provision for doubtful debts has been made against a loan, the risk-weight applies to the outstanding balance (including accrued interest) after deducting the specific provision.back
18 The amount to be subject to the credit conversion factor is the maximum unused portion of the facility at the time of calculation (any drawn portion will form part of balance sheet assets). For example, if a rental guarantee is provided on behalf of a customer, then all remaining lease payments (up to any limit specified in the guarantee) are included in the calculation.back
19 These items are to be risk weighted according to the type of assets or the issuer of securities and not according to the counterparty with whom the transaction is made.back
20 'Reverse repos' (i.e. purchase and resale agreements) are to be treated as collateralised loans. The risk is to be measured as an exposure to the counterparty, or according to the asset if it is recognised collateral security within the risk ratio framework.back
21 Redraw facilities that only allow redraw of advance payments should be assigned a credit conversion factor of 0%.back
22 This includes any commitment, that can only be unconditionally revoked with notice, where there is not a clear expiry date within one year. It also includes standby facilities given to societies, even though they may be reviewed annually, in order to assure certainty of availability.back
23 Provided the commitment can only be rolled over or extended after a full credit review is done and there is no presumption or impression conveyed to the client that an approval of a roll over or extension will be a formality. Where this test is not met the commitment will receive a 50 per cent risk weight.back
24 This includes any commitment to provide an off-balance sheet facility.back
25 Credit conversion factors are based on the Basle Supervisors' Committee's paper "International convergence of capital measurement and capital standards", July 1988.back
26 The deduction will apply to the full value of a holding of subordinated debt even if the issue of debt is being amortised in terms of the footnote to prudential standard 4.2.2.b.back
27 This includes any amount which is unpaid or callable on any shares or capital securities issued by the subsidiary and held by the credit union (or within its consolidated group).back
28 This could include situations such as the provision of subordinated debt or other capital support to a nominally capitalised entity that is not included within the consolidated group.back
Prudential Notes 5.3B and 5.3C
Note: see subparagraph 3(f) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 5.3 - Special Service Providers
Accounting and Disclosure
B. Financial Reports to AFIC
To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that financial information provided to AFIC is complete, timely and consistent with external reporting requirements and is adequate for supervisory purposes.
Supervision of SSPs by AFIC is conducted, in part, through a review of financial data provided by the SSPs. It is appropriate that this information should be more extensive than that provided in the public financial accounts. These data should form an extension of the information contained in the annual accounts and should be consistent with them.
It is the responsibility of directors and management to oversee the internal operating procedures of the SSP. Each SSP will, for its own purposes, be expected to have adequate accounting records, registers and supporting documentation. Normal budgets, monthly financial statements and reports on loans, liquidity, capital adequacy and investments should form an integral part of any management and control process.
Much of this information, prepared for internal purposes, will provide the data for reporting to AFIC.
To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that the auditors appointed by each special services provider are competent, adequately resourced and given sufficient scope to complete the duties imposed by the AFIC Code. Further, to ensure that special services providers are able to provide such certificates of audit as are required by AFIC as part of its supervisory role.
The annual accounts and group accounts of SSPs are audited. As well as the audit report attached to the published financial statements, auditors must provide to the directors and to AFIC a certificate of compliance with respect to internal controls. Auditors are also required to provide a number of certificates of compliance.
In particular, auditors are required to report on the adequacy of systems adopted by the SSP:
· to ensure compliance with the restrictions imposed by AFIC with respect to PLA accounts; and
· to monitor and manage the risks associated with its financial activities.
The intention of independent audit reviews is to lend credibility to the financial information presented in the annual report by the SSP's directors. In carrying out its supervisory responsibilities, AFIC will rely largely on information presented by the SSP. A properly planned and conducted audit should provide reasonable assurance that the financial statements are true and fair. In addition to AFIC, members and depositors should be able to place greater reliance on financial information where an audit has ascertained that the accounts are free of material misstatement and present a true and fair view of the entity.
It is important that a SSP’s external auditor receives timely information concerning the prudential standing of the SSP. Accordingly, AFIC should provide to the SSP’s external auditor a copy of any report following an inspection of the SSP and any other information AFIC may from time to time consider relevant to the auditor’s audit responsibilities in respect of the SSP. If AFIC considers the provision of the whole or part of the report or such other information is unnecessary or undesirable in the circumstances, AFIC need not provide it to the external auditor.
All audit work should be carried out in compliance with Auditing Standards and Auditing Guidance Statements prepared by the Auditing Standards Board of the Australian Accounting Research Foundation issued by the Australian Accounting Research Foundation on behalf of the Australian Society of Certified Practising Accountants and the Institute of Chartered Accountants in Australia. Particular notice should be taken of the requirements within the standard for proper planning and completion of audit techniques which take account of the nature and risks of SSPs. Directors of SSPs should be satisfied that auditors have sufficient understanding of the services involved to enable them to adequately plan the audit and assess audit risks.
The operations of SSPs involve a large number of transactions. The audit approach, therefore, must emphasize the importance of transaction testing. Adequate transaction testing is regarded as critical if audits are to satisfy AFIC's requirements.
The audit approach must set out how evidence will be gathered. Since that evidence is the basis of audit opinion, sufficient audit evidence must be obtained to enable an opinion to be properly formed.
The responsibility for appointing an auditor of proper ability is the responsibility of the SSP. SSPs can expect that AFIC will communicate with their auditors annually or more frequently if it is deemed necessary. The purpose of this contact will be to establish the efficacy of audit techniques. If AFIC is not satisfied with the quality of an audit it will appoint an additional auditor as it sees fit.
An Audit Committee should comprise a majority of non-executive directors to which has been assigned, amongst other functions, the oversight of the financial reporting and auditing process. The main objectives of an appropriately established and effective independent Audit Committee include enhancing the credibility and objectivity of financial reporting and assisting the Board to discharge its responsibilities. Each SSP will establish an Audit Committee. It is the responsibility of the directors to establish the Audit Committee and to develop clear guidelines for its operation, including its role, terms of reference, responsibilities and method of operation.
An internal audit function will be required of each SSP as part of its system of internal control. The effectiveness of the internal audit function depends on the scope and objectives of the function, degree and independence and the technical competence of staff. In general, internal audits will be most effective where they are directed towards the review and testing of internal controls and risk management systems. SSPs should consider the standards for the professional practice of internal auditing issued by The Institute of Internal Auditors.
Prudential Standard 5.3.5, other than subparagraph 5.3.5a(iii)
Note: see subparagraph 3(g) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
5.3.5 Prescribed Returns
5.3.5.a Each SSP will complete the following returns as required by notice from AFIC and in the form required from societies by SSAs (see Book 2).
(i) Monthly:
· Profit and Loss Statement
· Balance Sheet
· Cash Flow Statement
· Liquidity
· Capital adequacy
· Large exposures
· Bad and Doubtful Debts
(ii) Quarterly, in addition to monthly requirements:
· Loans to Societies Return
· Directors' Interests Return
· Assets Return
Operations Return including subsidiaries and other activities as required by AFIC.
(iv) Other returns as required from time to time by AFIC.
5.3.5.b AFIC may, by notice, vary the reporting interval for any or all of the returns included in Clause 5.3.5.a for any or all SSPs.
5.3.5.c Any SSP which fails to comply with the notice of lodgement of returns by the due date will be in breach of the Prudential Standards.
Prudential Standard 5.3.6
Note: see subparagraph 3(h) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
5.3.6 Audit Standards
5.3.6.a A SSP is to be audited in accordance with Auditing Standards and Auditing Guidance Statements and any additional requirements considered necessary by the auditor in satisfying the various requirements of the FI Code.
5.3.6.b Directors are to satisfy themselves that the auditor has sufficient relevant expertise to properly audit the SSP.
5.3.6.c Directors are to satisfy themselves that the auditor has adequate computer audit support to be able to access any and every transaction within the SSP, as the auditor determines.
5.3.6.d A SSPs is to obtain from its auditor, an engagement letter which confirms acceptance of the appointment, the objectives and scope of the audit, the extent of the auditor’s responsibilities and the form of reports and any other matters identified in AUS204 - Terms of Audit Engagements.
5.3.6.e A SSP is to maintain an audit committee whose members comprise at least half non executive directors.
5.3.6.f An internal audit function will be implemented by each SSP’s directors as part of the SSP’s system of internal control.
5.3.6.g Audit reports are to be forwarded directly to the audit committee in addition to any other recipients required by the SSP.
5.3.6.h Pursuant to section 284(7) and (8) and section 285(10) of the FI Code, an external auditor is to provide to AFIC, reports on the compliance and adequacy of the following risk management systems and internal controls:
· liquidity risk management systems (annually) - Prudential Standard 5.1.1.a;
· market risk management systems (annually) - Prudential Standard 5.1.2.a;
· credit and settlement risk management systems (annually) - Prudential Standard 5.1.3.a;
· transaction and technology risk management systems (annually) - Prudential Standard 5.1.4.a;
· operations risk management systems (annually) - Prudential Standard 5.1.5.a; and
· internal controls within the above risk management systems.
5.3.6.i AFIC is to provide to a SSP’s external auditor a copy of any report following an inspection of the SSP and any other information AFIC may from time to time consider relevant to the auditor’s audit responsibilities in respect of the SSP. If AFIC considers the provision of the whole or part of the report or such other information to be unnecessary or undesirable, the report or the information need not be provided to the external auditor.
Prudential Notes 5.4A, 5.4C, 5.4D, 5.4E, 5.4F and 5.4H
Note: see subparagraph 3(i) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 5.4 -Special Service Providers
A. Size
To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that special services providers are of a sufficient size to ensure efficient operations and risk pooling.
While the AFIC Code allows a SSP to be established to serve a minimum of two societies, it is desirable that the constituency of each SSP be considerably larger. Larger SSPs enjoy economies of scale, some of which are internal to the constituent societies, others of which confer benefits upon the industry at large.
In particular, where a SSP offers intermediation services, the larger it is, either absolutely or relative to the industry of which its constituent societies are members:
· the more likely it is that liquidity crises will be managed within the resources of the SSP, without the need to activate the liquidity support provisions of the AFIC Code or even to breach the PLA requirements of distressed societies;
· the more capable is the SSP of establishing substantial and reliable standby credit facilities; and
· the more cost efficient are the internal operations of the SSP likely to be.
While it is desirable that a SSP be large, the range of sizes of its constituent societies is of no particular consequence. A SSP may comprise a large number of small societies or a small number of large societies or some of each type, and still be viable. There is also no special significance in the geographic representation of the constituents of a SSP. It is more important that a SSP be large than that it comprise any particular mix of constituent societies or that it represent a wide regional dispersion.
A distinguishing feature of larger SSPs is their likely ability to secure external means of liquidity support through standby lines of credit negotiated domestically or offshore. This countermands any additional risk which might be incurred through an unbalanced mix of sizes of constituent societies or a narrow geographic representation.
C. Directors
To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that the directors of special services providers take proper account of the interests of all their shareholders and industry more generally.
A wide dispersion of ownership of each SSP should ensure that the elected board of directors is broadly representative of the body of shareholders. It is also important that at least some of the directors be independent of sectional interests among shareholders.
Given the pivotal role which SSPs play I the day-to-day operation of societies and the potential for misconduct within a SSP to damage the prospects of societies beyond repair, it is imperative that the board of directors be insulated from sectional interests and be seen to operate in the best interests of all societies, those who are clients of the SSP as well as those who own it.
Furthermore, given the degree of co-operation envisaged between AFIC and SSPs, it is important that the board of each SSP perceive itself as serving the industry at large, as an adjunct of the supervisory process, rather than merely serving its own constituency.
To assist boards of directors of SSPs to attain this breath of vision, it is required that at least one third of the board membership comprise persons who have no current connection or association (other than as a member) with any society served on a regular basis by the SSP, whether as an owner or as a client.
D. Standby Credit Facilities
To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that special services providers which offer intermediation services have access to adequate standby credit facilities.
Considerable importance is placed on the role of SSPs in supporting the general liquidity needs of societies. This function is greatly enhanced where a SSP has access to high quality standby credit facilities. Before commencement of operations as a SSP providing intermediation services, an entity must satisfy AFIC that it has a firm contract for standby credit with appropriate consideration in place and that this standby is of sufficient size and credibility to service its constituent societies in time of need.
E. Subsidiaries
The formation of Special Services Providers and their incorporation under the FI Scheme is unique and recognises the importance of these institutions to the industries served. Since commencement of the FI Scheme, AFIC has had the opportunity to review the operation of SSPs and particularly their operation compared with competitors both within the FI Scheme and those institutions incorporated outside the Scheme that provide similar services.
The approach to supervision of SSPs remains firmly focussed on prudential management. Originally, the Prudential Standards restricted the ownership of subsidiaries by an SSP. However, the imposition of particular corporate structures or prohibition of other structures is not considered appropriate on two grounds. First, the board and management of institutions are responsible for the commercial and prudent management of their organisations. Second, supervisory imposts should not put SSPs at a competitive disadvantage unless such imposts are warranted on prudential grounds. It is recognised that some activities may be more appropriately conducted by an SSP through a subsidiary, for example, funds management.
AFIC has reviewed its approach to SSP subsidiaries and considers that certain guiding principles for the operation of subsidiaries (adopted from the central bank approach), are more appropriate than the restrictions imposed at the commencement of the Scheme.
Activities conducted through a subsidiary will normally be financial activities other than activities described in Section 36(2)(b)(i)-(v) of the AFIC Code. Other activities should normally have substantial relevance to the SSP’s or industry’s core business. Subsidiaries should not be overly large when compared with the parent SSP; more particularly, the aggregate assets in subsidiaries should be well below 50 per cent of the parent SSP assets (that is less than 30 per cent of the group’s consolidated assets). An SSP must fund equity and financing associated with subsidiary operations from shareholders funds, having close regard to the concern that, over time, such investments should not contribute to a deterioration of the SSP’s capital position. More specifically, capital investments in, and other funding including off-balance sheet facilities provided to, subsidiaries are subject to large exposure and intergroup reporting and must not exceed, in aggregate, the value of the SSP’s capital base.
Subsidiaries should be capitalised adequately. In addition, an SSP must meet capital adequacy requirements on a consolidated basis. The exception is where a subsidiary is subject to a separate regime of supervision that expressly requires capital in support of activities. Then equity investments must be deducted from the SSP’s capital base before calculating the capital adequacy requirement. Consolidation of assets relating to trust-like or other off-balance sheet assets that are beneficially owned outside the group, such as funds management operations, will be required, if the SSP cannot satisfy AFIC that an appropriate separation policy is applied that makes clear that an entity dealing with the subsidiary has no claim on the parent SSP.
F. Guarantees
To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that special services providers are not exposed to undue risk as a result of guarantees made by or on behalf of the special services provider.
As recognised by banking supervisors, guarantees and other off-balance sheet activities introduce contingent rather than direct liabilities, which can threaten the viability of a financial institution. The dangers are particularly acute where guarantees are extended without full analysis of the potential risks. Banking supervisors now require guarantees to be treated as direct credit substitutes.
In their role as providers of liquidity services SSPs are likely to become involved with the extension of guarantees. To ensure that the provision of guarantees does not threaten the on-going viability of a SSP, guarantees and other off-balance sheet financing will be treated as direct credit substitutes for the purposes of prudential supervision. SSPs must keep AFIC advised of their policies with respect to guarantees and off-balance sheet financing and will need to demonstrate appropriate management systems and an understanding of the risks involved.
H. Service Contracts
To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that special services providers are not exposed to undue risk with respect to service contracts.
Under application of Section 245 of the FI Code, an SSP must obtain prior written approval from AFIC before entering into a management contract. Management contracts are defined as arrangements where a third party performs the whole or a substantial part of the functions of the SSP. The key feature of a management contract is the abrogation of total or substantial management control to a person or entity external to the SSP.
Examples include situations where the day-to-day operation of the SSP is managed through entities controlled by directors or by independent third parties.
Service contracts are other arrangements entered by an SSP to obtain services or products but without the abrogation of management control. Each SSP is likely to enter a variety of such contractual arrangements for valid economic and efficiency reasons, especially where the SSP neither has, nor seeks, the expertise. While service contracts will cover a range of relationships with external parties, AFIC is concerned with those contracts that create additional risks, create conflicts of interest or require disclosure to members and shareholders.
A conflict of interest may arise where an SSP enters arrangements with a director or officer (or related entity) for the provision of services. AFIC does not intend to outlaw such arrangements but seeks to ensure arm's length dealings.
Financial and operating leases entered into in the ordinary course of business on an arm's length basis are not service contracts for the purposes of this section. However, such leases are subject to normal reporting requirements as part of the financial statements.
Prudential Standards 5.4.1, 5.4.3, 5.4.4, 5.4.5, 5.4.6 and 5.4.8
Note: see subparagraph 3(j) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Size
5.4.1 Size of SSPs
5.4.1.a While there can be no objective test of minimum size applicable to all situations, AFIC will, in considering applications for registration of an entity as a SSP, pay close attention to the likely size of its balance sheet in relation to the size of the societies it proposes to serve. This will be viewed as an important factor in determining the likely financial viability of the proposed SSP and its capacity to carry out its stated objectives.
Directors
5.4.3 Composition of the Boards of Directors of SSPs
5.4.3a At least one third (or such other proportion as is agreed by AFIC) of the membership of the board of directors of every SSP shall comprise persons who are not currently connected as an officer with any society served on a regular basis by that SSP.
Standby Credit Facilities
5.4.4 Standby Credit Facilities of SSPs
5.4.4.a To be registered as a SSP offering intermediation services, an entity must satisfy AFIC that:
· a firm contract for standby credit with appropriate consideration is either in place or will be in place before commencement of operations;
· the contract provides for maximum irrevocability;
· no pledge or lien over PLA has been granted in securing this standby line;
· the standby line is secured as far as possible against non-liquid assets, leaving as large a proportion of a SSP’s non-PLA liquid assets unencumbered as possible;
· the lender is of sufficient standing and size to make a credible commitment to provide standby credit facilities even in circumstances of general credit restriction; and
· the standby line of credit is no less in total size than the SSP’s own required holding of PLA.
5.4.5 Subsidiaries
5.4.5.a Each SSP must have comprehensive written policies and systems to measure, monitor and manage risks associated with the operation of subsidiaries. The board of directors must provide initial endorsement of significant policies (and changes, as applicable) and senior management is responsible for implementation of policies and systems and their regular review. The SSP must ensure that the subsidiary has sound and prudent management aimed at achieving undoubted viability within the capital resources of the subsidiary itself. Policies and systems of the SSP must be audited annually by the SSP’s external auditors. Their operation and implementation may be subject to review during on-site inspections by AFIC.
5.4.5.b Only services other than those identified in Section 36(2)(b)(i)-(v) may be conducted through non-SSP subsidiaries.
5.4.5.c Total assets of subsidiaries should not be overly large compared with the parent SSP. More particularly, assets of subsidiaries should be well below 50 per cent of the assets of the parent SSP (that is, less than 30 per cent of the group assets).
5.4.5.d Capital investments in, and other exposures, including loans, guarantees, off-balance sheet facilities and similar are to be funded from the SSP’s shareholder’s funds and subject to large exposure limits. An SSP seeking to capitalise or otherwise fund a subsidiary to a value in excess of 10 per cent of the SSP’s capital base must first consult with AFIC.
5.4.5.e Each SSP must meet capital adequacy requirements on a consolidated basis. Subject to an adequate separation policy, the exception is where the subsidiary of the SSP is subject to a separate regime of supervision that expressly requires capital in support of activities. Such equity investments must be deducted from the SSP’s assets and capital base before calculating compliance with capital adequacy. In terms of a separation policy, an SSP must satisfy AFIC that an adequate separation policy applies that makes clear that an entity dealing with a subsidiary, such as a funds management operation, has no claim on the parent SSP.
5.4.5.f An SSP may own a subsidiary, incorporated as an SSP, company under Corporations Law or otherwise. An SSP cannot be a subsidiary of a non-SSP entity.
5.4.6 Granting of Guarantees by SSPs
5.4.6.a Where SSPs want to provide guarantees, they are to provide AFIC with written descriptions of their policies with respect to guarantees and must satisfy AFIC, prior to issuing the guarantee, that they have adequate systems and procedures for managing the risks involved.
5.4.6.b Where guarantees are provided, they must be for a fixed maximum amount.
5.4.6.c Such guarantees will be treated as direct credit substitutes and assigned risk weights appropriate to the counterparties involved (see Prudential Standard 5.2.5). AFIC may also increase the SSP's required capital adequacy ratio if, in AFIC's opinion, the guarantee adds significantly to the overall risk of the SSP.
5.4.6.d Guarantees are subject to the same large exposure restrictions as lending (see Prudential Standard 5.1.4).
5.4.8 Review of Service Contracts
5.4.8.a Each SSP must demonstrate systems for selection, review and renewal of service arrangements that ensure arm's length dealings.
5.4.8.b An SSP must not enter service contracts that:-
· diminish control of the SSP by the board;
· diminish AFIC's ability to review and supervise the SSP; or
5.4.8.c To avoid the establishment of unreasonable contingent liabilities, contract periods should not exceed two years unless approved by AFIC.
5.4.8.d Details of all material service contracts must be fully and clearly disclosed to members and shareholders. AFIC may deem a contract to be material.
Prudential Note 5.5
Note: see subparagraph 3(k) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Prudential Note 5.5 -Special Service Providers
Securitisation, Funds Management and other Marketing Activities
To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that a special services provider is not exposed to undue risk (particularly moral risk) as a result of its involvement with securitisation and managed funds products and the marketing of these and other products and services provided by third parties.
Funds management encompasses the provision of investment and related financial services for the management of investors’ funds, whereby the investors become the beneficial owners of the assets in which their funds are invested. Securitisation involves the pooling of assets (or interests in assets), usually in a special purpose vehicle, funded by the issue of securities.
In both cases, the rate of earnings paid, and the return of capital, to investors hinges on the cash flows from the underlying assets in which the funds are invested. This can place pressure on a special services provider involved in such activities to agree to arrangements under which it is required to make payments to, or absorb losses that may fall on, the investors to compensate for poor investment performance. If this occurs, unless permitted under this standard, the special services provider will be required to hold capital in support of the assets as if they were on its balance sheet.
In considering an SSP’s involvement in these areas, AFIC is concerned that these activities may introduce undue risk into its operations. In particular the concern is with moral risk, ie the possibility an SSP will feel a moral obligation or commercial need to absorb any loss to a customer that arises from investments offered, marketed by or recommended by the SSP. Similar concerns arise where an SSP markets products or services which are provided by a third party. This is particularly so when the SSP badges the product or service offered to its customers.
The standard focuses heavily on securitisation and funds management activities. It is intended, however, that the sections on the "offering of investment advice and sale of securities" and "badging" will apply to all relevant operations of an SSP.
If any aspect of a proposed securitisation or funds management initiative or transaction is inconsistent with, or not covered by, the guidelines set out in the standard, then an SSP should obtain prior approval from AFIC. An SSP (or its subsidiary) will be required to demonstrate that it has adequately identified the risks arising from the proposed transaction and has adequate expertise and systems in place to measure, manage and monitor the risks involved.
Despite its detailed nature, this standard cannot encompass every aspect of an SSP’s securitisation or funds management activities. Where an SSP may have plans for a particular initiative that may raise issues not covered in the standard, it should discuss them with AFIC as early as possible.
The introduction of this standard (by revising and superseding earlier standards) may see an SSP in breach of some of its requirements. Where this is the case the SSP should contact AFIC to discuss its position.
The prime responsibility for the prudent participation of an SSP and its subsidiaries in securitisation, funds management and other marketing activities rests with its board and management. An SSP should have in place clear strategies as well as board approved policies governing its participation in these areas. In addition, it must maintain appropriate systems to identify, measure, monitor and control risks arising from its participation in these areas.
This standard applies to all securitisation and funds management activities even if a trust based vehicle and the issuing of units is not involved. Unless otherwise indicated, reference to an SSP includes any subsidiaries within its consolidated group. Intermediation activities against which an SSP is required to hold capital do not constitute funds management or securitisation activities.
Prudential Standards 5.5.1 to 5.5.8 (inclusive)
Note: see subparagraph 3(l) of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
5.5.1 Disclosure
5.5.1.a To safeguard against investor confusion, an SSP must ensure that, where it is involved in funds management or securitisation activities, the following conditions are satisfied:
(i) Investors are given to understand clearly that the securities in which they invest do not represent deposits or other liabilities of the SSP or any of its subsidiaries.
investors are made aware that their holdings of securities are subject to investment risk, including possible delays in repayment and loss of income and principal invested.
(iii) Investors are unambiguously informed that the SSP or its subsidiaries do not in any way stand behind the capital value or performance of the securities issued by the special purpose vehicle or of the assets held by the vehicle except to the limited extent allowed under this standard and as specified in the documentation provided to investors.
5.5.1.b The disclosures in 5.5.1.a. must be provided in a conspicuous manner to prospective investors, and appear in any marketing document. A document inviting investment should include the disclosures as a prominent (and preferably stand alone) item on the inside front cover. It is recognised that variations in the location and form of the required disclosures could be appropriate where regulatory or statutory requirements restrict the presentation or content of disclosures. Any proposal to modify the requirements set out above must be agreed with AFIC.
5.5.1.c Investors must also provide a signed acknowledgment indicating that they have read and understood the required disclosures. To ensure this the disclosures in 5.5.1.a should also appear in close proximity to the signature on the application form in any document inviting investment.
5.5.1.d More generally, an SSP must ensure that the marketing or promotion of a special purpose vehicle with which it is associated does not give any impression that could be construed as being contrary to the disclosure requirements.
5.5.1.e It is possible that securities could be traded in a paperless environment. Where this is envisaged an SSP must discuss with AFIC procedures for ensuring that the spirit of the disclosure requirements are met.
5.5.1.f Where an SSP has a limited involvement in a securitisation or funds management scheme, its ability to ensure the required level of disclosure (and signed acknowledgments) may also be limited. In such cases, compliance with the disclosure requirements may be relaxed by AFIC.
This concession will not be available where the SSP or its subsidiary is the sponsor, manager, trustee or responsible entity of the scheme. It will also be unavailable (except in exceptional circumstances) where the SSP or its subsidiary or associate permits the use of its name, badge, logo or any other identifier in the marketing of the securitisation or funds management scheme.
5.5.2 Structuring Funds Management and Securitisation Schemes
5.5.2.a The main basis of the policy on funds management and securitisation is that there is a clear separation between the SSP involved and any special purpose vehicle or scheme. To this end, an SSP must not without prior approval from AFIC:
(i) Have any ownership or beneficial interest in a special purpose vehicle.
(ii) Include the word "building society" or "credit union" in the name of the special purpose vehicle or any subsidiary involved in securitisation or funds management related activities.
(iii) Provide credit support, liquidity support, other lending, treasury or transaction facilities or any other facilities or services (unless expressly provided for in this standard) to a special purpose vehicle, or underwrite the issue of units or securities by a vehicle.
(v) "Control" the special purpose vehicle such that it would need to be consolidated in accordance with Australian Accounting Standards.
5.5.2.b Requirements i, iv and v set out above do not apply (where AFIC’s prior approval has been obtained to establish the relevant entity), to:
A life insurance company and its statutory funds regulated by the Insurance and Superannuation Commission.
An "approved trustee" or "custodian" established under the provisions of the Superannuation Industry (Supervision) Act 1993 (Cth).
"Common trust funds" established pursuant to legislation and complying with Australian Securities Commission Policy Statement 32.
5.5.2.c An SSP, itself, must not act in any circumstances as a manager, trustee, custodian, responsible entity or any similar role for the purposes of managing investors’ funds or securitising assets. Any participation must be through stand alone subsidiaries that are adequately capitalised in their own right.
5.5.2.d Where an SSP’s subsidiary or other associate acts in such a role, the SSP should ensure that a clear distinction exists between the SSP and the subsidiary or associate concerned. Any documentation or marketing of a funds management or securitisation scheme with which a subsidiary or associate is involved should not give the impression the entity is in any way backed by the SSP or any of its subsidiaries (unless a formal commitment of support has been approved by AFIC).
5.5.2.e An SSP may not subordinate, defer or waive the receipt of fee or other income associated with funds management or securitisation activities without obtaining approval from AFIC.
5.5.3 Offering Investment Advice and Sale of Securities
5.5.3.a In its operations, an SSP’s subsidiary may (subject to AFIC’s and other appropriate regulatory approvals) offer advice to customers regarding investments (including in securitisation, funds management schemes and other products such as life and general insurance policies), act as a broker in obtaining securities (and other products) on behalf of customers or market such products directly to customers.
In conducting such business, there is a risk that customers may be confused as to the relationship between an SSP and the issuer of a security (or other product), and a possibility of the SSP feeling some moral or commercial obligation to customers as a result of its actions.
To minimise such risks, an SSP should ensure that where it undertakes such activities:
(ii) Any decision to invest in particular securities (or acquire other products) is clearly taken by the customer alone and that customers are aware they bear the risks associated with their investment decisions. The SSP should be careful to ensure that customers are aware of the level and type of risks they face on the investments.
(iii) Policies and procedures are in place to ensure that staff (and any agents of the SSP) dealing with customers are required to be appropriately trained and to avoid misleading or confusing them concerning the risks involved or the SSP’s relationship with (or support for) investments recommended or offered for sale by the SSP.
5.5.3.b Where an SSP makes investment decisions or purchases securities for customers at its own initiative or discretion (and is not required to hold capital against these assets), then the SSP will be deemed to be acting as a "manager" and the relevant provisions of this standard will apply.
5.5.4 Badging
5.5.4.a Where an SSP allows its name, logo or trade mark to be used in the marketing of products provided by a third party institution it faces risks over and above those covered in 5.5.3. In these circumstances it will also be required to ensure:
(i) The 'name' or 'badge' of the other party providing the product or service also features prominently in all advertising material, marketing documents and any documents inviting investment or participation in a product.
(ii) The respective roles of the parties should be explained clearly and prominently in any document inviting investment or participation in the product - including the extent to which each party is responsible for the safety and performance of the product.
(iii) For investment products, the provisions of section 5.5.1 "Disclosure" are fully satisfied.
5.5.4.b An SSP which fails to comply with these conditions may be required, by AFIC, to discontinue its association with the relevant product.
5.5.4.c In its operations an SSP or its subsidiary may provide administrative, processing and similar facilities or services to its members (eg standard documentation) which have been sourced from an external party. Where this is the case the SSP is required to ensure:
(i) The ultimate provider of the service is identified to its members and any other users.
(ii) The division of responsibility, between an SSP and the facility or service provider, for the safety and performance of the product is clearly established.
(iii) It has adequately identified the risks arising from these contracts and has appropriate policies and procedures in place to measure, monitor and manage the risks involved.
5.5.5 Purchase of Securities
5.5.5.a Unless exempted by AFIC, an SSP will only be permitted to purchase securities issued by a special purpose vehicle provided:
(i) The purchases are at the sole discretion of the SSP, are acquired on an arm's length basis on market terms and conditions (including price), and are subject to the SSP’s normal credit policies.
(ii) Purchases are completed within a short time period (less than one week as a guide) from the time the SSP commits to purchase the securities.
(iii) Any holding is less than 10 per cent of the class of securities issued by the vehicle.
5.5.5.b An SSP should have in place adequate systems and controls to ensure that it does not accumulate disproportionate exposure (vis a vis the SSP's asset portfolio and capital) to securities issued by special purpose vehicles, eg large aggregate exposures arising from holdings of securities issued by associated special purpose vehicles or vehicles holding similar or related assets.
5.5.5.c An SSP should not purchase assets held by a special purpose vehicle. Exceptions are the purchase of liquid assets from a special purpose vehicle in the normal course of an SSP’s liquidity management or trading operations and assets purchased pursuant to the exercise of representations and warranties.
5.5.5.d Should AFIC come to the view that the pattern of an SSP’s purchases of securities (and/or assets), or its willingness to do so, suggests that the SSP is supporting investments in a special purpose vehicle, then the SSP may be required to hold capital against all the securities issued by the special purpose vehicle.
5.5.6 Servicing
5.5.6.a A funds management or securitisation scheme may involve the participation of an entity acting as a "servicer" or "servicing agent". An SSP or its subsidiary may undertake the role of servicing a pool of assets held by a special purpose vehicle provided:
(i) There is a formal written servicing agreement in place which specifies the services to be provided and any required standards of performance. Those standards should be reasonable and in accordance with normal market practice. There should be no recourse to the SSP beyond the fixed contractual obligations specified. The servicer should be under no obligation to fund payments, absorb losses on assets, or otherwise recompense investors for losses.
(ii) The services are provided on an arm's length basis, on market terms and conditions (including remuneration), and subject to the SSP’s normal approval and review processes.
(iii) The servicing agreement is limited as to a specified time period (ie the earlier of the date on which all claims connected with the issue of securities are paid out or the SSP’s replacement as servicer). A fixed termination date need not be specified provided the SSP is able, at its absolute discretion, to withdraw from its commitments at any time with a reasonable period of notice.
(iv) Subject to reasonable qualifying conditions, the special purpose vehicle and/or investors have the clear right to select an alternative servicer.
(v) The servicing agreement is documented in a fashion which clearly separates it from any other service provided by the SSP. An SSP’s obligation under each facility must be stand-alone.
(vi) The SSP’s operational systems are adequate to meet its obligations as a servicer.
5.5.6.b Unless approved by AFIC, an SSP acting as servicer should be under no obligation to remit funds to the special purpose vehicle or investors until they are received from the underlying assets.
5.5.6.c An SSP may receive a performance-related payment (or benefit from any surplus income generated) for its role as servicer, in addition to its base fee, provided that the base fee is on market terms and conditions and any performance-related payment does not commit the SSP to any additional obligations. This payment should be recognised for profit and loss (and capital) purposes only if it has been irrevocably received.
5.5.6.d Where a servicing agreement does not meet the conditions above an SSP may be required to hold capital against the assets it is servicing as if they were held on its balance sheet.
5.5.7 Managing Investors Funds
5.5.7.a A subsidiary of an SSP may act as a manager of funds placed in a funds management or securitisation vehicle by investors, provided:
(i) There is a written management agreement in place specifying the functions which the manager is required to perform and any performance standards placed on the manager. Such standards should be reasonable and in accordance with normal market practice. The agreement must not (unless prior approval is received from AFIC) obligate an SSP or any subsidiary to buy back securities or units issued, or assets held, by the vehicle.
(ii) The management agreement is undertaken on an arm's length basis and is subject to the SSP’s normal approval and review processes. The agreement must be undertaken on market terms and conditions (including remuneration to the manager).
(iii) The agreement is limited as to a specified time period (ie. the earlier of the date on which all claims in connection with the issue of securities are paid out or the SSP’s replacement as manager). A fixed termination date need not be specified provided the SSP is able, at its absolute discretion, to withdraw from its commitments at any time with a reasonable period of notice.
(iv) Subject to reasonable qualifying conditions, the special purpose vehicle and/or investors have the clear right to select an alternative party to provide the management services.
(v) The management agreement is documented in a fashion which clearly separates it from any other facilities provided by the SSP. An SSP’s obligations under each facility must be stand-alone.
5.5.7.b The manager may receive a performance-related payment (or benefit from any surplus income generated) for its role as manager, in addition to its base fee, provided that the base fee is on market terms and conditions and any performance-related payment does not commit the SSP to any additional obligations. Such payment should be recognised for profit and loss (and capital) purposes only if it has been irrevocably received.
5.5.8 Representations and Warranties
5.5.8.a Where an SSP undertakes to provide facilities and services, or provide assets to a special purpose vehicle, it is customary to make representations and warranties concerning those functions or assets. Where all of the following conditions are satisfied, an SSP will not be required to hold capital as a result of providing representations and warranties. Otherwise, it will need to hold capital against the full value of securities issued by the special purpose vehicle. The conditions are:
(i) Any representations and warranties are provided only by way of a formal written agreement and are in accordance with market practice.
(ii) The SSP undertakes appropriate due diligence before providing or taking on any representations and warranties.
(iii) The representations and warranties refer to an existing state of facts that the SSP can verify at the time services are contracted or assets sold.
(iv) Representations or warranties are not open-ended and, in particular, do not relate to the future creditworthiness of assets or the performance of the special purpose vehicle or the securities it issues.
(v) The exercise of any representation or warranty requiring the SSP to repurchase or replace assets sold to the special purpose vehicle, or any part of them, must be undertaken within 120 days of their transfer to the vehicle and any transfer should be conducted on the same terms and conditions as the original sale. This time limit does not preclude the subsequent payment of damages by an SSP as a result of breaches of representations and warranties.
5.5.8.b Any agreement by an SSP to pay damages as a result of a notice of claim being made must be conditional on:
(ii) The onus of proof for a breach of a representation or warranty resting with the other party.
AFIC should be notified of any instance where an SSP has agreed to pay damages arising out of any representation or warranty.
Attachment B to the Prudential Notes and Prudential Standards issued by AFIC under Part 4 of an AFIC Code, as in force immediately before the transfer date
Note: see paragraph 4 of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Attachment B to the
Prudential Standards
This part is applicable to societies with reporting periods ending up to 30 June 1997
A general return containing:
Profit & Loss Statement
Balance Sheet
Cash Flow Statement
Capital Adequacy Return
Liquidity Return
Credit Rick Return
Other Operational Information
This part is applicable to societies with reporting periods commencing 1 July 1997
The quarterly return to SSAs will contain the following information:
In respect of Revenue and Expenses for the society and group details of:
INTEREST REVENUE FROM FINANCIAL INSTITUTIONS
INTEREST REVENUE FROM SECURITIES
INTEREST REVENUE FROM LOANS AND ADVANCES SPLIT BETWEEN:
Personal
Residential
Commercial
INTEREST REVENUE FROM OTHER SOURCES
NON INTEREST REVENUE
Dividends
Securities
- realised gains/losses
- unrealised gains/losses
Fees and Commissions
- Loan fees and other fees
- Commissions
- Facility fees – off-balance sheet
Rent and lease receipts
Bad debts recovered
Gains and losses on sale of investments, property, plant and equipment and other intangibles
INTEREST EXPENSE TO FINANCIAL INSTITUTIONS
Bank borrowings
SSP borrowings
Credit Union & Building Society borrowings
Other borrowings
INTEREST EXPENSE FOR DEPOSITS
Call deposits
Term deposits
Retirement savings accounts deposits
INTERST EXPENSE FOR BONDS, NOTES, DEBENTURES AND SUBORDINATED DEBT
OTHER INTEREST EXPENSE
Marketing and promotion
Salaries and associated costs
Information technology
Office occupancy
AFIC/SSA levy
General administration
Depreciation expense
Amortisation expense
Auditors remuneration for audit
Auditors remuneration for other services
Directors fees
Bad debts written off
Doubtful debts expense
Income tax attributable to operating profit/(loss)
Profit/(loss) on extraordinary items
Income tax attributable to extraordinary items
Outside equity interests in operating profit•
Retained profits at the beginning of the period
Aggregate of amounts transferred from reserves
Dividends provided for or paid
Aggregate of amounts transferred to reserves
Other appropriations
In respect of Assets of the society and group, details of the cost of:
CASH LIQUID ASSETS
Cash on hand
Loans and overnight settlements fully secured against cash
Cash items in process of collection
RECEIVABLES DUE FROM OTHER FINANCIAL INSTITUTIONS
Bank deposits
Building society deposits and credit union deposits
ELSS Loans
PLA deposits — SSPs
Other deposits (operational liquidity accounts/funds securing settlement account SSPs)
SECURITIES
Commonwealth Government Securities (CGS) and loans and securities fully secured by CGS: maturing < 12 months
Other Commonwealth Government Securities and loans and securities secured by guarantee from a commonwealth government authority
State Government Securities and loans and securities secured by guarantee from a state government authority
Local Government Securities
Promissory notes — State and Local Government
Promissory notes — Other
Bank bills
NCSs
Other PLA investment
Other Operational Liquidity Investment
FRNs — Commonwealth Government
FRNs — State and Local Government
FRNs — Other
OTHER RECEIVABLES
Accrued income
Sundry debtors — net
Prepayments
In respect of the above assets, details of the market value is also required.
LOANS AND ADVANCES
Personal — qualifying mortgage secured
Personal — other
Residential qualifying mortgage secured
Residential other
Commercial qualifying mortgage secured
Commercial — Other
In respect of the above loans and advances details of the amount, statutory provision and additional specific provision:
Total General Provision for Doubtful Debts
PROPERTY, PLANT AND EQUIPMENT
Land
Buildings
Accumulated Depreciation for Buildings
Leasehold Improvements
Accumulated Depreciation for Leasehold Improvements
Plant and Equipment
Accumulated Depreciation for Plant and Equipment
OTHER INVESTMENTS
Subordinated debt/equity in SSPs
shares in subsidiaries
Credit Union contingency fund
Subordinated debt/equity — building society, credit union
Subordinated debt/equity — risk related investment
Equity accounted investments
Other equity investments
OTHER ASSETS
FITB
Goodwill (at wdv)
Other intangible assets (at wdv)
Other Assets
Investments with a risk weight greater than 100%
• In respect of Liabilities and Members’ Funds of the society and group details of:
PAYABLES DUE TO OTHER FINANCIAL INSTITUTIONS
Bank borrowings
SSP borrowings
Credit union Building society borrowings
DEPOSITS
Call deposits
Term deposits
Retirement Savings Accounts deposits
BORROWINGS
Other borrowings
CREDITORS & OTHER LIABILITIES
Accrued expenses
Provision for employee entitlements
Provision for income tax
Provision for deferred tax liability
Other liabilities
SUBORDINATED DEBT, BONDS, NOTES AND DEBENTURES
Perpetual subordinated debt
Term subordinated debt
Debentures
Unsecured notes
Other supplementary capital instrument
MEMBERS’ FUNDS
Permanent share capital
Share premium A/C
Financial reserves
Statutory reserve — Building Society Fund (Queensland)
Retained profits/(Accumulated losses)
Asset revaluation reserve
Other reserves
Outside equity interests
Term subordinated debt net of required amortisation
In respect of Cash Flows of the society and group details of:
New loans made
— personal
— residential
— commercial
Principal collected on loans
Physical assets purchased
Physical assets sold
Income tax paid
In respect of the Loans in Arrears of the society and group details of:
— the number of accounts
— loan balances
— provisions split between:
LOANS IN ARREARS
Category (i) Loans
≥ 1 < 3 mths
≥ 6 < 9mths
≥ 9 < l2mths
Category (ii) Loans
≥ 1< 3 mths
≥ 6 < 9 mths
≥ 9 < 12 mths
Category (iii) Loans
≥ 1 < 3 mths
≥ 6 < 9 mths
≥ 9 < l2mths
Overdrawn Savings/Overlimits
14 days < 3 mths
≥ 3 < 6mths
≥ 6 months
Total Outstanding Balances Of All Revolving Credit Facilities
In respect of the society and group, asset exposures between 5% and 10% of capital and greater than 10% of capital, details of:.
— individual exposure
— account name
— amount of exposure
• In respect of the society and group, liability exposures between 5% and 10% of total liabilities and greater than 10% of total liabilities, details of:
— individual exposure
— counterparty name
— amount of exposure
• In respect of bad debts of the society and group, details of:
— number
— amount of bad debts written off
• In respect of impaired loans of the society and group, details of:
— non-accrual loans
— provision for non-accrual loans
— restructured loans
— provision for restructured loans
— real estate acquired via security
— provisions for real estate acquired via security
• In respect of fiduciary activities of the society and group details of:
—. funds managed
— trusteeship
— securitisation programs
• In respect of off balance sheet facilities of the society and group details of:
— amount
— risk weight of facilities provided to members
Direct credit substitutes
Assets sold with recourse
Sale and repurchase agreements
Forward assets purchases
Placement of forward deposits
LANA — qualifying mortgages
LANA — other loans
Warranties, bids and
Member commitments with maturities > 1 year
— overdrafts — limit
— standby facilities — limit
Member undrawn credit commitments cancellable at any time or less than 1 year
— overdrafts — limit
— standby facilities — limit
Other commitments
In respect of the society and group, details of facilities obtained:
Standby facilities — limit & undrawn balance
Overdraft facilities — limit & undrawn balance
Other facilities — limit & undrawn balance
In respect of the derivatives of the society and group, details of opening positions and transactions during the period:
— type
— counterparty amount
— maturity
— mark to market or rule of thumb credit equivalent amount
— detail underlying exposure being hedged
• In respect of other operational information of the society details of:
Number Of Members At End Of Period
Staff Branches and Agencies
— Full-time staff
— Part-time staff (in full-time staff equivalent)
— Number of Branches
— Number of Agencies
• In respect of unreconciled accounts details of:
— description
— discrepancy amount
— date last specified
• The lowest on balance sheet operational liquidity over period and the date on which that occurred.
• The required on balance sheet operational liquidity as assessed by the SSA.
• The required capital adequacy ratio as assessed by the SSA.
• Has the society complied with the required primary objects ratio throughout the reporting period?
• In respect of investments and loans of the society and group, details of:
— repricing analysis and
— weighted average interest rates in the following time periods:
overnight to 30 days
30-60 days
60-90 days
90-180 days
180-365 days
1-2 years
2-5 years
5 years
Overdrafts
• In respect of deposits and borrowings of the society and group, details of:
— repricing analysis and
— weighted average interest rates in the following time periods:
overnight to 30 days
30-60 days
60-90 days
90-180 days
180-365 days
1-2 years
2-5 years
> 5 years
Subsections 237(2), and 245(1) to (3) (inclusive), of a Financial Institutions Code
Note: see paragraph 5 of Schedule 1 to the Financial Sector Reform (Amendments and Transitional Provisions) Regulations 1999
Chairperson
237 (2) An employee of the society is not eligible to be the chairperson.
Management contracts
245 (1) In this section –
"management contract" means a contract or other arrangement under which-
a person who is not an officer of the society agrees to perform the whole, or a substantial part, of the functions of the society; or
a society agrees to perform the whole or a substantial part of its functions- 1. in a particular way; or
in accordance with the directions of any person; or
subject to specified restrictions or conditions.
245 (2) A society must not enter into a management contract without the prior written approval of the SSA.
Maximum penalty - $75 000
245 (3) The SSA may subject its approval under subsection (2) to conditions