Get a plain-English read of Risk-Weighted Off-Balance Sheet Credit E
Turn the raw legal text into a practical explanation grounded in Banking (prudential standard) determination No. 5 of 2006 - Prudential Standard APS 112 - Capital Adequacy: Credit Risk.
This Guidance Note set out the procedures and requirements for calculating the risk-weighted amount of an authorised deposit-taking institution's (ADI’s) off-balance sheet credit exposures for capital adequacy purposes.
Scope
The risk-weighting process used for measuring an ADI’s off-balance sheet credit exposures covers all the ADI’s off-balance sheet business, including both market-related and non-market-related transactions.
Risk-weighted amount
An ADI’s total risk-weighted off-balance sheet credit exposures is calculated as the sum of the risk-weighted amount of all its market-related and non-market-related transactions.
The risk-weighted amount of an off-balance sheet transaction which gives rise to credit exposure is calculated by means of a two-step process:
(c) firstly, the principal amount (or face value) of the transaction is converted into an on-balance sheet equivalent (i.e. credit equivalent amount) by multiplying it with a specified credit conversion factor; and
(d) secondly, multiplying the resulting credit equivalent amount by the risk weight (refer Attachment A to Guidance Note AGN 112.1 Risk-Weighted On-Balance Sheet Exposures (AGN 112.1)) applicable to the counterparty or type of assets or where relevant, the eligible guarantor or collateral security (refer AGN 112.1) as appropriate.
The maximum risk weight that will be applied to the credit equivalent amount of an off-balance sheet credit exposure arising from a market-related transaction (including netted market-related transactions) is 50 per cent.
An ADI should consult APRA in case of doubt about the risk-weighted amount of a particular off-balance sheet transaction.
Non-market-related off-balance sheet transactions
The credit equivalent amount in relation to any non-market-related off-balance sheet transactions referred to in Attachment A (broadly categorised into direct credit substitutes, trade and performance related contingent items and other commitments) are determined by multiplying the principal amount of that particular transaction by the relevant credit conversion factor specified in the Attachment.
The amount of undrawn commitment to be included in calculating an ADI’s off-balance sheet non-market-related credit exposures is the maximum unused portion of the commitment which could be drawn during the remaining period to maturity. The drawn portion of a commitment forms part of an ADI’s on‑balance sheet credit exposure.
Part Risk-Weighted Off-Balance Sheet Credit E - Banking (prudential standard) determination No. 5 of 2006 - Prudential Standard APS 112 - Capital Adequacy: Credit Risk - Risk-Weighted Off-Balance Sheet Credit Exposures | Zoe
Irrevocable commitments to provide off‑balance sheet facilities should be assigned credit conversion factors appropriate to the underlying facilities. For example, an irrevocable commitment for six months to provide a guarantee in support of a counterparty attracts the 100 per cent credit conversion factor applicable to the guarantee.
The residual maturity of an undrawn commitment is the time remaining until the commitment will be completely extinguished by being terminated or maturing, or can be unconditionally cancelled by an ADI or be fully drawn. With regard to irrevocable commitments to provide off‑balance sheet facilities, the residual maturity is the period up until the associated facility expires. For example, an irrevocable commitment with a remaining maturity of six months to provide a commitment to provide finance with a 9-month term is deemed to have a residual maturity of 15 months.
All commitments are to be included in the capital ratio calculation regardless of whether or not they contain “material adverse change” clauses or any other provisions which are intended to relieve an ADI of its obligations under certain conditions.
For any non-market-related off-balance sheet transactions that give rise to credit risk but are not specifically identified in Attachment A, an ADI should consult APRA on the appropriate credit conversion factor to be used for calculating the credit equivalent amount of that particular transaction for capital adequacy purposes.
Market-related off-balance sheet transactions
In calculating an ADI’s risk-weighted off-balance sheet credit exposures arising from market-related transactions for capital adequacy purposes, the ADI must include all its market-related contracts held in the banking and trading books which give rise to off-balance sheet credit risk.
The credit risk on off-balance sheet market‑related contracts is the cost to an ADI of replacing the cash flow specified by the contract in the event of counterparty default. This will depend, among other things, on the maturity of the contract and on the volatility of rates underlying that type of instrument.
Market-related contracts include the following:
(a) Interest Rate Contracts: This includes single currency interest rate swaps, basis swaps, forward rate agreements, interest rate futures, interest rate options purchased and any other instruments of a similar nature.
(b) Foreign Exchange Contracts (including contracts involving gold): This includes cross currency swaps (including cross currency interest rate swaps), forward foreign exchange contracts, currency futures, currency options purchased, hedge contracts and any other instruments of a similar nature.
(c) Equity Contracts: This includes swaps, forwards, purchased options and similar derivative contracts based on individual equities or equity indices.
(d) Precious Metal Contracts (other than gold): This includes swaps, forwards, purchased options and similar derivative contracts based on precious metals such as silver, platinum and palladium.
(e) Other Commodity Contracts (other than precious metals): This includes swaps, forwards, purchased options and similar derivative contracts based on energy contracts, agricultural contracts, base metals (such as aluminium, copper and zinc) and any other non-precious metal commodity contracts.
(f) Other market-related contracts: This includes any contracts covering other items which give rise to credit risk.
Paragraph 15 does not intend to provide an exhaustive list of market-related contracts for capital adequacy purposes. ADIs should seek clarification where they are unclear as to which category is appropriate for a particular market-related transaction.
Exemption from capital weighting are permitted for:
(a) foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or less; and
(b) instruments traded on futures and options exchanges which are subject to daily mark-to-market and margin payments.
ADIs should not generally enter into contracts at off-market prices. This includes historical rate rollovers on foreign exchange contracts. If any contracts are undertaken at off-market prices, ADIs should contact APRA to discuss the reasons for such actions and to agree the capital (and other prudential) treatment of these transactions. APRA will need to be persuaded as to the need for dealing at off-market rates. As a starting point, where an ADI deals at off-market rates the whole of that transaction is no longer subject to the maximum risk weight applied to a market-related contract with a corporate counterparty and will receive, unless otherwise agreed with APRA, a 100 per cent risk weight.
An ADI may, for capital adequacy purposes, net off-balance sheet claims and obligations arising from market-related contracts across both the banking and trading books with a single counterparty which are covered by eligible bilateral netting agreements (refer Guidance Note AGN 112.3 Netting (AGN 112.3)).
The credit equivalent amount of an off-balance sheet market-related contract, whether held in the banking or trading book, must be determined by using the current exposure (or “mark-to-market”) method, except for interest rate and foreign exchange (including gold) contracts held in the banking book where the original exposure (or “rule-of-thumb”) method may be used with APRA’s prior approval.
Current exposure method
The credit equivalent amount of market-related contracts (not covered by eligible bilateral netting agreements) calculated using the current exposure method is the sum of current credit exposure and potential future credit exposure (the add-on) of these contracts (refer AGN 112.3 for calculation of credit equivalent amount of market-related contracts covered by eligible bilateral netting agreements).
Current credit exposure is defined as the sum of the positive mark-to-market value (or replacement cost) of these contracts.
Potential future credit exposure is determined by multiplying the notional principal amount of each of these contracts (regardless of whether the contract has a zero, positive or negative mark-to-market value) by the relevant credit conversion factor specified in Attachment B according to the nature and residual maturity of the instrument.
The notional or nominal principal amount, or value, of a contract is the reference amount used to calculate payment streams between counterparties to a contract.
Potential future credit exposure should be based on effective rather than apparent notional amounts. In the event that the stated notional amount of a contract is leveraged or enhanced by the structure of the transaction, an ADI must use the effective notional amount when calculating potential future credit exposure. For example, a stated notional amount of $1 million with payments calculated at two times LIBOR would have an effective notional amount of $2 million.
For contracts that are structured to settle outstanding exposures following specified payment dates and where the terms are reset such that the mark-to-market value of the contract is zero on these specified dates, then the residual maturity should be set equal to the time until the next reset date. In the case of interest rate contracts with these features with a remaining maturity of more than one year, the “credit conversion factor” to be applied is subject to a floor of 0.5 per cent even if there are reset dates of a shorter maturity.
For contracts with multiple exchanges of principal, the “credit conversion factors” are to be multiplied by the number of remaining payments (i.e. exchanges of principal) still to be made under the contract.
Contracts which do not fall within one of the five categories listed in Attachment B should be treated in the same way as “other commodities” contracts.
No potential future credit exposure is calculated for single currency floating/floating interest rate swaps; the credit exposure on these contracts is evaluated solely on the basis of their mark-to-market value.
Original exposure method
Where original exposure method is used, the credit equivalent amount of an off-balance sheet market-related contract is determined by multiplying the notional principal amount of the contract by the appropriate credit conversion factor specified in Attachment B according to the nature and original maturity of the instrument.
Attachment A
Credit Conversion Factors for Non-Market-Related Off-Balance Sheet Transactions
Nature of Transaction
Credit Conversion Factor
Direct Credit SubstitutesAny irrevocable off-balance sheet obligations which carry the same credit risk as a direct extension of credit, such as an undertaking to make a payment to a third party in the event that a counterparty fails to meet a financial obligation, or an undertaking to a counterparty to acquire a potential claim on another party in the event of default by that party, constitutes a direct credit substitute (i.e. the risk of loss depends on the creditworthiness of the counterparty or the party on which a potential claim is acquired).This includes potential credit exposures arising from the issue of guarantees and credit derivatives (selling credit protection), confirmation of letters of credit, issue of standby letters of credit serving as financial guarantees for loans, securities and any other financial liabilities, and bills endorsed under bill endorsement lines (but which are not accepted by, or have the prior endorsement of, another ADI).
100%
Performance-Related ContingenciesContingent liabilities which involve an irrevocable obligation to pay a third party in the event that a counterparty fails to fulfil or perform a contractual non-monetary obligation, such as delivery of goods by a specified date, etc (i.e. the risk of loss depends on a future event which is not directly related to the creditworthiness of the counterparty involved).This includes issue of performance bonds, bid bonds, warranties, indemnities, and standby letters of credit in relation to a non-monetary obligation of a counterparty under a particular transaction.
50%
Trade-Related ContingenciesContingent liabilities arising from trade-related obligations which are secured against an underlying shipment of goods.This includes documentary letters of credit issued, acceptances on trade bills, shipping guarantees issued and any other trade-related contingencies.
20%
Sale & Repurchase Agreements (“Repos”)This relates to arrangements whereby an ADI sells a loan, security or other asset to another party with a commitment to repurchase the asset at an agreed price on an agreed future date.[10]Any assets acquired by an ADI under reverse repos (i.e. purchase and resale agreements) are to be treated as collateralised loans to the counterparty.[11]
100%
Assets Sold With RecourseThis includes any asset sales (to the extent that such assets are not included in on-balance sheet) by an ADI where the holder of the asset is entitled to “put” the asset back to the ADI within an agreed period or under certain prescribed circumstances, e.g. deterioration in the value or credit quality of the asset concerned.
100%
Forward Asset PurchasesThis includes commitments to purchase at a specified future date and on pre-arranged terms, a loan, security or other asset from another party, including written put options on specified assets with the character of a credit enhancement.Where an ADI purchasing the asset has an unequivocal right to substitute cash settlement in place of accepting delivery of the asset and the price on settlement is calculated with reference to a general market price indicator (and not to the financial condition of any specific entity), the purchase may be treated as a market-related off-balance sheet transaction.Written put options expressed in terms of market rates for currencies or financial instruments bearing no credit risk are excluded from risk assets.
100%
Partly Paid Shares and SecuritiesThis includes any amounts owing on the uncalled portion of partly paid shares and securities held by an ADI which represent commitments with certain drawdown by the issuer at a future date.
100%
Placements of Forward DepositsThis relates to any agreement between an ADI and another party whereby the ADI will place a deposit at an agreed rate of interest with that party at a predetermined future date.
100%
Note Issuance and Revolving Underwriting FacilitiesThis involves arrangements whereby a borrower may drawdown funds up to a prescribed limit over a predefined period by making repeated note issues to the market, and where, should the issue prove unable to be placed in the market, the unplaced amount is to be taken up or funds made available by an ADI being committed as an underwriter of the facility.
50%
Other Commitments(a) Commitments with certain drawdown.(b) Commitments (e.g. undrawn formal standby facilities and credit lines) with a residual maturity of:(i) 1 year or less.(ii) over 1 year.(c) Commitments which can be unconditionally revoked at any time without notice (e.g. undrawn overdraft and credit card facilities providing that any outstanding unused balance is subject to review at least annually).(d) Irrevocable standby commitments provided under APRA’s approved industry support arrangements.
100%0%50%0%0%
Attachment B
Credit Conversion Factors for Market-Related Off-Balance Sheet Transactions
Current Exposure Method
Residual Maturity
Interest Rate Contracts
Foreign Exchange &Gold Contracts
Equity Contracts
Precious Metal Contracts (except Gold)
OtherCommodities
1 year or less
nil
1.0%
6.0%
7.0%
10.0%
> 1 year to 5 years
0.5%
5.0%
8.0%
7.0%
12.0%
> 5 years
1.5%
7.5%
10.0%
8.0%
15.0%
Original Exposure Method
Original Maturity
Interest Rate Contracts
Foreign Exchange & Gold Contracts
1 year or less
0.5%
2.0%
> 1 year to 2 years
1.0%
5.0% (i.e. 2% + 3%)
For each additional year
1.0%
3.0%
Note: The credit conversion factors set out above are based on the recommendations of the Basel Committee (April 1995) which, in turn, are based on observed volatilities of particular types of instruments. These credit conversion factors are subject to review and modification in light of changing volatilities or market conditions.