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Guidance Note AGN 120.2

Credit Enhancement

1. An authorised deposit-taking institution (ADI) should hold capital against the credit risk incurred when it provides credit enhancement, explicit or implicit, to a special purpose vehicle (SPV) or its investors.
2. Credit enhancement facilities include all arrangements that could result in an ADI absorbing losses of a SPV, its investors, or any providers of liquidity and other facilities. Credit enhancement facilities may take the form of a first or a second loss facility. Such facilities may be provided to a SPV that is “sponsored” (i.e. created) by the ADI or by a third party.
3. An ADI providing credit enhancement facilities should ensure that:

(a) the extent of any undertaking provided to a SPV and/or its investors is expressly stated in a written agreement. There should be no recourse to the ADI beyond the specified contractual obligations;

(b) it is able to demonstrate that the facility is provided on an arm’s length basis, is subject to the ADI’s normal credit approval and review processes and is transacted on market terms and conditions (including price or fee);

(c) the facility is limited to a specified amount (i.e. a maximum dollar amount of the ADI’s commitment under the facility) and a specified time period (i.e. the earliest of when assets are redeemed, the securities are paid out, or the ADI’s obligations otherwise terminate). A fixed termination date need not be specified, provided the ADI has an unfettered discretion to withdraw from the commitment at any time following a reasonable period of notice. Withdrawal must not be conditional upon the appointment of an alternative facility provider. As a general rule, an ADI should be able to relinquish its role after giving 90 days notice;

(d) subject to reasonable qualifications, the SPV and/or investors have the express right to select an alternative party to provide the facility; and

(e) the facility is documented in a manner which clearly separates it from any other facility provided by the ADI. An ADI’s obligations under each facility should stand alone.

4. Where the above conditions are not satisfied, an ADI should hold capital against the full value of all securities issued by the SPV.

First loss facility

5. A “first loss facility” provides a primary level of financial support to a SPV and/or its investors. The provider of the facility bears the bulk (or all) of the risk associated with the issued securities, or the assets held by the SPV.

6. A first loss credit enhancement also arises where an ADI provides an undertaking covering the payment of interest on assets held by a SPV and/or the payment of interest to investors (except where the undertaking is provided as part of a second loss facility covering the repayment of principal and accrued interest). This includes an undertaking to provide cover against reinvestment/ prepayment/ extension risk. Any undertaking to pay interest should specify the total dollar amount that the ADI can be required to pay as a result of its undertaking.