Prepared by John Anderson, Queensland University of Technology

Chapter Twelve

Credit Risk From

The Regulator’s

Perspective

Learning Objectives

• Understand the issues of credit risk from the perspective of the regulators

• Relate capital adequacy to credit risk considerations

• Express the issues of large exposures

Learning Objectives

• Identify securitisation issues for regulators

• Identify credit derivative issues for regulators

• Describe the credit rating process

• Discuss the new capital adequacy guidelines

Introduction

• Historically, central banks played active role in lending directions

• Since 1980s, banks given less prescriptive credit direction

• Systemic stability encouraged by setting capital requirements for different lending activities

• APRA regulates capital adequacy

Capital Adequacy

• Recent evidence shows poor credit decisions play a major part in bank failures

• Generally, banks required to allocate a minimum of 8% of a loan’s value from Capital

• As some loans riskier than others, risk weighting system adopted

Capital Adequacy

– Capital defined in two broad terms• Tier 1: Capital of a permanent nature such

as shareholder’s equity, general reserves, retained earnings etc

• Tier 2: Capital of a less permanent nature such as provisions for doubtful debts, asset revaluation reserves, convertible notes etc.

• At least 50% of capital must be Tier 1

Capital Adequacy

– To allow for different risk profiles, risk-weighted capital placed into four categories

• Category 1 (0% Weight): notes and coins, balances with RBA, Commonwealth Government securities less than 12 months to maturity

• Category 2 (10% Weight): Commonwealth Government securities greater than 12 months to maturity, claims on semi government authorities

Capital Adequacy

• Category 3 (20% Weight): Claims on other banks

• Category 4 has two components:– 50% Weight: Loans fully secured by residential

mortgages with LVR of 80% or less;– 100% Weight: Loans fully secured by residential

mortgages with LVR greater than 80%

• Risk-based capital ratio is then:

Assets Adjusted-Risk

2)Tier 1(Tier Capital Total ratio capital based-Risk

Capital Adequacy

• Capital Adequacy Example: Assume a bank has the following loan assets• Housing Loans

Risk-Weighted Asset = Notional Amt x Risk Weighting

= $75m x 50%

= $37.5m

• Commercial LoansRisk-Weighted Asset = Notional Amt x Risk Weighting

= $20m x 100%

= $20m

Capital Adequacy

• If the bank currently has total capital of $15m to support the loan assets, the banks risk based capital ratio is then:

%1.26 ratio capital based-Risk$37.5m $20m

m15$ ratio capital based-Risk

Assets Adjusted-Risk

2)Tier 1(Tier Capital Total ratio capital based-Risk

• While this approach is a useful approximation, it fails to discriminate between AAA-rated and D-rated (ie companies in default) corporates.

Large Credit Exposures

– APRA governs approved deposit-taking institutions (ADIs) and the risks of large credit exposures defined in Prudential Standard APS 221 such as:

• Individual counterparties; or• Groups of related counterparties

– For the purposes of APS 221, a large exposure must not exceed 10% of the bank’s consolidated capital base.

Securitisation

– As securitisation has the capacity to remove loan assets from the Statement of financial position, APRA has released APS 120 and Guidance Note AGN 120.3 concerning clean sales which:

• Absolves the institution from any legal recourse from the sale of loans;

• Results in the financial institution not holding capital against the loan

Securitisation

• Clean sale supply of assets:

– Should be no beneficial interest in the sold assets and absolutely no obligation on institution

– Should be no recourse (including costs) to the institution and no obligation to repurchase loan asset

Securitisation

– Amount paid for loans should be fixed and received at time asset is transferred from lending institution

– Any assets provided to the Special Purpose Vehicle (SPV) as a substitute or sold below book value do not relieve credit risk

Securitisation

• Revolving Facilities: – Defined as assets with ongoing credit

relationship such as credit cards and home loans

– Rights, details of cashflows and obligations of each party must be clearly specified

– As with normal securitisation, institution cannot supply additional assets to the pool

Securitisation

– Liquidity shortfalls for the institution share must not exceed the interest receivable

– Institution retains right to cancel undrawn amounts

– Institution must have no obligation to repurchase

Credit Derivatives

– As credit derivatives are relatively new, APRA has adopted a conservative stance through AGN 112.4

– Product must not be overly restrictive and must allow sufficient risk transfer

– Any mismatches between exposures and risk protected by the product, eg maturity mismatch, will reduce effectiveness of capital charge reduction

Developments in Regulation

– The first Basel Accord on capital standards (known as Basel I) treated all corporate loan risk the same

– Clearly inadequate for capital charges to be identical for corporations of varying credit quality

– The new proposed accord, known as Basel II addresses this by incorporating published credit ratings information

Credit Ratings

– These are provided by many companies including S&P, Moody’s, Fitch’s etc

– Generally fall into two types, short and long-term and S&P ratings are:

Long Term Short Term

AAA BBB CCC A-1 B

AA BB CC A-2 C

A B C & D A-3 D

Credit Ratings

• Ratings Criteria– Business Risks examined include:

• Industry Characteristics: Considered according to profitability, diversification factors, size, geographic and market dominance

• Management Evaluation: Management’s ability to create and follow plan and any excessive reliance on one person

• Industry-Specific Factors: Regulations, markets, operations and competitiveness

Credit Ratings

• Financial Risk– Accounting Quality: Are accounting standards

and controls of sufficient quality– Financial Policy: Does the firm have a financial

policy and how are risks treated– Profitability and Coverage: Factors include pre-

tax interest return on capital, operating income as percentage of sales and earnings on business segment’s assets. Also considers trends, reconciling historical trends with projected earnings and earnings in relation to fixed charges.

Credit Ratings

– Capital Structure/Leverage and Asset Protection: Considers following ratios:

» Total Debt / (Total Debt + Equity)» (Total Debt + Off-Balance-Sheet Liabilities) /

(Total Debt + Off-Balance-Sheet Liabilities + Equity)

» Total Debt / (Total Debt + Market Value of Equities)

– Asset Valuation: How do asset valuations affect key ratios and viability

Credit Ratings

– Off-Statement of Financial Position Financing: Techniques that may affect leverage include:

» Operating Leases» Debt of joint ventures and unconsolidated

subsidiary’s guarantees» Take or pay contracts and obligations under

throughput and deficiency agreements» Receivables that have been factored,

transferred and securitised» Contingent liabilities

– Preferred Stock: Cashflow characteristics of Preference shares issued by the firm

Credit Ratings

– Cashflow Adequacy and Ratios: As cashflow, and not accounting earnings, repays debt the following ratios are considered:

» Funds from Operations / Total Debt» EBITDA / Interest» (Free Operating Cashflow + Interest) / (Interest +

annual principal repayment obligations)» Total debt / Discretionary Cashflow» Funds from Operations / Capital Spending

Requirements » Capital Expenditure / Capital Maintenance

Credit Ratings

– The Need for Capital: Considers business requirements for equity and working capital relative to capital works needs

– Financial Flexibility: does the firm have excessive reliance on one capital source

• This list is not exhaustive, but does cover some of the main areas considered by S&P

• Exactly how all of the above ingredients are put together and the weightings of each element remains a commercial secret

Basel II

– The Bank for International Settlements (BIS) is currently evaluating the new capital proposals

– Banks can use two approaches to capital allocation, internal and external. Internal approach must possess:Objectivity International Access

Independence Resources

Transparency Recognition (BIS)

Creditability

Basel II

– Ratings information and risk-weighted capital allocations under Basel II

Sovereigns Banks Corporates

AAA to AA- 0 20 20

A+ to A- 20 50 100

BBB+ to BBB- 50 100 100

BB+ to BB- 100 100 100

Below B- 150 150 150

Unrated 100 100 100