IRB approach to Credit Risk (APS 113) to undergo a significant revision under BASEL IV

Background

The Australian Prudential Regulatory Authority (APRA) released its revised draft APS 113 Capital Adequacy: Internal Ratings Approach to Credit Risk and APS 110: Capital Adequacy along with a discussion paper in December 2020. APRA on 21st July 2021 provided an update on proposed bank capital reforms based on feedback received in April 2021.

The previous focus by APRA has been on capital while the latest reforms are concentrated on the calculation of RWA and an increased focus on reducing the gap between Standardised and the Internal Ratings Approach to Credit Risk (Internal Ratings Based (IRB) ADIs will also be required to publish their capital ratio under the standardised approach).

APRA is focussed on enhancing competition by,

• limiting differences between standardised and IRB capital outcomes, and

• implementing a floor to limit the capital benefit of IRB ADIs (72.5% of total RWA calculated under the standardised approach from 1 January 2023)

The Minimum Common Equity Tier (CET) 1 requirement for IRB ADIs is increasing from 7% to 9.5% comprising of increases in the Capital Conservation Buffer (CCB) from 2.5% to 4% and Countercyclical Capital Buffer (CCyB) from 0% to 1% default level while the Prudential Capital Requirement remains at 4.5%. Noting that for designated Domestic Systematically Important Banks (D-SIB, the four majors) the CET 1 requirement is increasing from 8% to 10.5% which includes the additional 1% for D-SIB. APRA confirmed this in their July update.

Due to the amount of changes in the APS 113 prudential standard, APRA has not released a marked up version identifying the specific changes. The standard will undergo a significant overhaul as a result of BASEL IV reform. In this article, we unpack the key changes to the standard.

“Capital floor and Scaling Factor for IRB ADIs”

APRA is limiting the capital benefit available to IRB ADIs by imposing a 72.5% floor on total RWA calculated under the standardised approach. This will require IRB ADIs to disclose capital outcomes under the standardised approach allowing improved comparability between IRB and standardised approaches. The following summarises this calculation:

APRA is proposing to include an IRB scaling factor of 1.05 applied to all asset classes (including defaulted exposures on residential mortgages and income producing real estate (IPRE)) under APS 113. The expectation that this will support aggregate RWA being calibrated above the capital floor and, along with other measures means that the capital floor will not be binding at the system level. APRA outlined in their July update that the may revisit the IRB scaling factor pending outcomes from the August 2021 QIS.

Key Principles

The key principles applied are broadly consistent with Basel III.

“Standardised vs IRB ADIs”

“Residential Mortgages under IRB”

Risk Segment Calibration

The classification of “Standard Loans” is broadly considered the same as under APS 112 in terms of Enforceability; Serviceability and Valuation to be evidenced with accurate documentation and be readily accessible.

The same segmentation of residential mortgages will apply under both the standardised and IRB approaches, except for SME loans secured by residential property as these are excluded from the residential property IRB asset class.

Multipliers under the IRB Approach

APRA have proposed to apply two multipliers under the IRB based on the same segmentation as for standardised targeting higher multipliers to the higher risk residential mortgage segments:

• lower risk owner-occupied, principal-and-interest loans; and

• higher risk loans, including all investor loans and interest-only loans.

The application of the two multipliers is to ensure that the capital difference between the two segments remains broadly the same under both the standardised and IRB approaches.

Risk-Weight Floor under the IRB Approach

APRA has proposed introducing a risk-weight floor of 5 percent for residential mortgage exposures. The floor will be applied at the exposure level and after the relevant probability of default (PD), loss given default (LGD) and exposure at default (EAD) floors.

Interest Only Transitioning Mortgages and >5 years

Consistent with the Standardised approach, APRA have removed the requirement to track loans for a period of six months following conversion from interest to principal and interest. This will impact the multiplier used on owner occupied mortgages that move to principal and interest.

LMI

APRA confirmed LMI will be recognised under the IRB approach provided the ADI has an approved LGD model.

The recognition of LMI through the application of a 20 percent reduction to LGD estimates for those exposures with an LVR greater than 80 per cent (subject to the ADI having an APRA-approved LGD model and the 10 per cent LGD floor). If the ADI does not have any approved LGD models, a simpler application of the LGD floor will be applied that does not recognise risk factors including LMI.

Off-Balance Sheet Mortgage Exposures

A Credit Conversion Factor (CCF) of 100% will apply to non-revolving residential mortgage exposures for IRB ADIs. This compares to the lower 40% CCF under the standardised approach. The difference is reflected in the fact that under the IRB ADIs, redraws/prepayments is generally recognised through a lower PD estimate.

“Income Producing Real Estate (IPRE) under IRB”

IRB Models are allowed to calculate capital requirements for commercial property exposures i.e. IPRE (not splitting out Land Acquisition, Development and Construction ADC as is the case for standardised). Noting definition of IPRE does not align to commercial property under the standardised approach.

ADI IRB (incl. FIRB) is able to use corporate risk-weight function and a RWA multiplier of 1.5 reflecting the significant historical risk for this sector provided certain conditions are met. Supervisory slotting for IPRE exposures will remain where the ADI does not have adequate property models.

Transition arrangement have been permitted by APRA to allow IRB ADIs to implement systems so ADIs can differentiate between valuations at origination and current valuations in risk-weighting calculations. APRA therefore have grandfathered existing back book exposures and that valuations at origination will only need to be applied to commercial property exposures originated after 1 January 2023.

“Lending to SMEs”

Consistent with the Standardised APS 112 SME Retail eligibility threshold of $1.5m in aggregate exposure and other eligibility criteria relating to both borrower and the exposure being non-complex. The origination and management of the exposure is in a similar manner to other retail exposures. IRB ADIs will need to separately identify SME Retail secured by residential property as they are not subject to the RWA scalars (as outlined earlier).

SME Corporate exposures are defined the same as under APS 112 with annual revenue of $75m (or SME in group) based on the most recent financial year. APRA is however intending to remove the requirement for ADIs to use audited financial statements for this purpose, although this requirement will remain for the determination of large corporate exposures and financial institutions.

“Sovereign Exposures”

Sovereign exposures will only be subjected to the Foundations Internal Ratings Based approach. APRA have introduced an additional LGD category. The LGD categories are as follows

• AAA / AA = 5%;

• A+/ A = 25%; and

• below A = 50%.

“New Zealand Exposures”

APRA requires exposures of overseas banking subsidiaries that are part of the level 2 group are required to use credit RWAs set by the Reserve Bank of New Zealand (RBNZ). Further consideration is being given to apply RBNZ’s overall IRB scalar and capital floor based on the outcome of the August QIS at Level 1 and 2 consolidations to determine a final approach.

“Qualifying revolving retail (QRR) exposures”

Retained by APRA IRB sub-asset class where the exposures are revolving, unsecured and unconditionally cancellable by the ADI along with criteria of exposure to individuals of up to $100,000 and exhibit a low loss rate in comparison to other retail products. APRA propose to introduce a higher PD floor of 0.1 per cent for those exposures that have not been repaid in full for the past twelve months.

“Estimation of PD / LGDs and EAD”

Attachment D to APS 113 outlines the minimum requirements for the use of the IRB approach. An ADI credit risk rating and associated risk estimation systems and processes must provide for a meaningful assessment of borrower and transaction characteristics, a meaningful differentiation and ranking of risk, and quantitative estimates of risk that are consistent, verifiable, relevant, and soundly based. The estimation approaches are broadly consistent with Basel III.

Other Changes of Note included in the draft APS 113

Conclusion

With the implementation due date just over 18 months away - ADI's must be well-progressed in their project planning and design phase.

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