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Prudential Standard APS 113

Capital Adequacy: Internal Ratings-based Approach to Credit Risk

Objective and key requirements of this Prudential Standard

This Prudential Standard sets out the requirements that an authorised deposit-taking institution that has approval to use an internal ratings-based approach to credit risk must meet both at the time of initial implementation and on an ongoing basis for regulatory capital purposes.

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

                quantify certain credit risk components to determine the capital requirement for a given credit exposure; and

                have approval from APRA to use an internal ratings-based approach to credit risk for determining the institution’s credit risk capital requirement.

Table of contents

Prudential Standard

Authority

Application

Scope

Definitions

Key principles

Expected loss and eligible provisions

Approval process

Adoption of the IRB approach

IRB asset classes

Attachments

Attachment A -Governance and quantification requirements

Rating system design

Rating dimensions

Rating structure

Rating criteria

Rating assignment horizon

Use of statistical models in the rating process

Documentation of rating system design

Rating coverage

Integrity of the rating process

Overrides

Data maintenance

Stress tests in the assessment of capital adequacy

Governance and oversight

Use of internal ratings

General risk quantification requirements

Risk quantification requirements specific to probability of default estimation

Risk quantification requirements specific to loss given default estimation under the advanced IRB and retail IRB approaches

Risk quantification requirements specific to exposure at default estimation under the advanced IRB and retail IRB approaches

Validation of internal estimates

Disclosure requirements

Attachment B -Corporate, sovereign and bank IRB asset classes

Probability of default estimates

Loss given default estimates

Exposure at default estimates

Recognition of guarantees and credit derivatives

Treatment of maturity mismatches

Risk-weighted assets for the corporate, sovereign and bank IRB asset classes

Attachment C - Retail IRB asset class

Probability of default and loss given default estimates

Exposure at default estimates

Recognition of guarantees and credit derivatives

Risk-weighted assets for the retail IRB asset class

Attachment D - Purchased receivables

Default risk for purchased retail receivables

Default risk for purchased corporate receivables

Dilution risk

Requirements specific to estimating probability of default and loss given default (or expected losses) for purchased corporate and retail receivables

Purchase price discounts and first loss protection

Recognition of guarantees

Minimum operational requirements

Attachment E - Other assets, claims and exposures

Equity exposures

Leases

Cash items

Unsettled and failed transactions

Related-party exposures

Margin lending

Fixed assets and all other claims

Attachment F - Supervisory slotting criteria for specialised lending exposures

Authority

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

Application

1.              This Prudential Standard applies to authorised deposit-taking institutions (ADIs) that are seeking, or have been given approval, to use an internal ratings-based approach to credit risk for the purpose of determining regulatory capital.
2.              A reference to an ADI in this Prudential Standard shall be taken as a reference to:
3.           an ADI on a Level 1 basis; and
4.           a group of which an ADI is a member on a Level 2 basis.

Level 1 and Level 2 have the meaning in Prudential Standard APS 110 Capital Adequacy (APS 110).

Where an ADI to which this Prudential Standard applies is a subsidiary of an authorised non-operating holding company (authorised NOHC), the authorised NOHC must ensure that the requirements in this Prudential Standard are met on a Level 2 basis, where applicable.

Scope

1.              This Prudential Standard, subject to paragraphs 5 and 6, applies to all on-balance sheet assets held by an ADI and all its off-balance sheet exposures.

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

3.           assets or investments that are required to be deducted from Tier 1 or Tier 2 capital under Prudential Standard APS 111 Capital Adequacy: Measurement of Capital (APS 111); and

4.           securitisation exposures which are subject to the requirements of Prudential Standard APS 120 Securitisation (APS 120).

5.              Items subject to capital requirements under Prudential Standard APS 116 Capital Adequacy: Market Risk (APS 116) are excluded for the purpose of calculating risk-weighted assets for credit risk under this Prudential Standard, but not for the purpose of calculating counterparty credit risk capital requirements (refer to Attachment B).

Definitions

1.              The following definitions are used in this Prudential Standard:

2.              corporate credit exposure - a credit obligation of a corporation, partnership or proprietorship and any other credit exposure that does not meet the criteria of any other defined internal ratings-based (IRB) asset class;

3.              credit obligation - a contractual agreement in which a borrower receives something of value now (usually cash) with the agreement to repay the ADI at some stated date;

4.              dilution risk - the possibility that the total amount of purchased receivables is reduced through cash or non-cash credits to the receivables’ obligors. Examples include offsets or allowances arising from returns of goods sold, disputes regarding product quality, possible debts of the obligor to obligors of the purchased receivables and any payment or promotional discounts offered by the obligor;

5.              exposure at default (EAD) - the gross exposure under a facility (i.e. the amount that is legally owed to the ADI) upon default of an obligor;

6.              IRB approval - the written approval from APRA for an ADI to adopt the IRB approach;

7.               loss given default (LGD) - the ADI’s economic loss upon the default of an obligor;

8.              probability of default (PD) - the risk of obligor default;

9.              purchased receivables - a pool of receivables that have been purchased by an ADI from another entity;

10.               rating system - all of the methods, processes, controls, data collection and technology that support the assessment of credit risk, the assignment of internal credit risk ratings and the quantification of associated default, exposure and loss estimates; and

11.               subordinated claim - a facility that is expressly subordinated to another facility.

Key principles

1.              An ADI that has received IRB approval from APRA may (subject to the relevant IRB approval) rely on its own internal estimates for some or all of the necessary credit risk components in determining the capital requirement for a given credit exposure. The credit risk components include measures of PD, LGD, EAD and maturity (M) and must satisfy the necessary requirements detailed in Attachment A. An ADI’s rating system must play an integral role in the ADI’s credit approval, risk management and internal capital allocation functions and meet the requirements detailed in Attachment A, including those relating to the Board of directors (Board) and senior management responsibilities.
2.              With the exception of the exposures detailed in paragraph 14 of this Prudential Standard, the IRB approach to credit risk is based upon measures of unexpected losses (UL) and expected losses (EL). The IRB risk-weight functions detailed in this Prudential Standard produce the capital requirement for UL. For EL, the ADI must compare the sufficiency of eligible provisions (refer to paragraph 19 of this Prudential Standard) against EL amounts calculated according to paragraph 17 of this Prudential Standard. The comparison must be made in accordance with paragraph 21 of this Prudential Standard. Where a difference exists, paragraphs 22 to 23 of this Prudential Standard apply.
3.          For the corporate, sovereign and bank IRB asset classes (defined in paragraphs 40 to 43 of this Prudential Standard), there are two IRB approaches to credit risk: the foundation IRB (FIRB) approach and the advanced IRB (AIRB) approach. Under the FIRB approach, an ADI must (subject to the relevant IRB approval) provide its own estimates of PD and M and rely on supervisory estimates for LGD and EAD. Under the AIRB approach, an ADI must (subject to the relevant IRB approval) provide its own estimates of all the credit risk components. Under both approaches, an ADI must use the relevant IRB risk-weight function, as detailed in Attachment B, for the purpose of deriving the capital requirement for UL for those IRB asset classes.
4.          An IRB approval may provide that the FIRB or AIRB approach applies to an ADI’s corporate IRB asset class except in relation to one or more of the specialised lending (SL) sub-asset classes detailed in paragraph 41 of this Prudential Standard. In that event, specific risk-weights associated with slotting categories must be used (refer to Attachment B) for the purpose of deriving regulatory capital for UL for the relevant exposures.
5.          For the retail IRB asset class (defined in paragraphs 44 to 46 of this Prudential Standard), an ADI that has IRB approval must (subject to the relevant IRB approval) provide its own estimates of PD, LGD and EAD. There is no explicit maturity adjustment for the retail IRB asset class nor is there a distinction between a FIRB approach and an AIRB approach. The ADI must use the risk-weight function for each retail sub-asset class as detailed in Attachment C for the purpose of deriving the capital requirement for UL for the retail IRB asset class.
6.          The treatment of purchased receivables straddles two IRB asset classes: corporate and retail (refer to Attachment D). For both corporate and retail purchased receivables, an ADI will be required to hold regulatory capital for default risk and, where material, dilution risk.
7.          The residual IRB asset class includes an ADI’s cash items, fixed assets, certain unsettled and failed transactions and related-party exposures, margin lending and all other claims not otherwise defined in this Prudential Standard. For the residual IRB asset class and the equity IRB asset class (refer to paragraphs 47 to 50 of this Prudential Standard), the capital requirement is based on assigned risk-weights that reflect APRA’s broad judgement about the credit risk associated with those exposures (refer to Attachment E). The risk-weights for these exposures are assumed to represent UL as EL is assumed to be zero.
8.          For the purpose of this Prudential Standard, the risk-weighted asset amounts that are derived from the IRB risk-weight functions (refer to Attachments B and C) must be multiplied by a factor of 1.06. The ADI must sum the risk-weighted amounts for UL for all IRB asset classes (including the residual IRB asset class) to determine the total risk-weighted asset amount under the IRB approach.
9.          An ADI that has IRB approval must consult APRA where there is doubt about how to determine the risk-weighted amount of an on-balance sheet or off-balance sheet asset or exposure.

Expected loss and eligible provisions

1.          Other than for that portion of exposures covered by eligible guarantees or credit derivatives subject to the double default approach, an ADI that has IRB approval must separately calculate, for non-defaulted and defaulted exposures, total EL aggregated across the corporate, sovereign, bank and retail IRB asset classes.[1] Other than for SL exposures subject to the slotting approach, EL is calculated as follows:

2.           for non-defaulted exposures, the product of PD, LGD and EAD;

3.           for defaulted exposures under the AIRB approach and the IRB approach for retail exposures, the ADI’s best estimate of EL given current economic circumstances and the facility’s status (refer to paragraph 97 of Attachment A); and

4.           for defaulted corporate, sovereign and bank exposures under the FIRB approach, the product of the relevant supervisor

This is an opening excerpt, not the complete document.