Chapter Twelve

Credit risk from regulator’s perspective

12/13/21 978-0-7346-1164-2 1
Objectives

1. Understand the issues of credit risk from the perspective of the regulators
2. Relate capital adequacy to credit risk considerations
3. Express the issues of large exposures
4. Identify securitisation issues for regulators
5. Identify credit derivative issues for regulators
6. Describe the credit rating process
7. Discuss the new capital adequacy guidelines.
Regulators

• Reserve Bank
• System liquidity.
• Australian Prudential Regulatory Authority (APRA)
• Regulates banks, credit unions and building societies using
the Bank of International Settlements (BIS) capital adequacy
guidelines
• Australian Securities Investment Commission (ASIC)
• Market integrity
• National Consumer Credit Protection Act (for retail
borrowers):
• Those who are engaged in lending must be licensed by ASIC.
• The rights that the borrower.
• The obligations of the lender.
• The nature of the contracts.
Capital adequacy

• Capital adequacy seeks to ensure capital is put aside

depending on the credit risk to cushion potential losses.
• The general formula is:
• Risk-based capital ratio= Total capital (Tier 1+Tier
2)/Risk-adjusted assets
• See text pages 403 to 406 for risk weightings
Large credit exposures

• APRA requires that lenders recognise exposures

greater than 10% of the capital base (APS 221).
• The need to ensure of related groups need to be
recorded correctly.
• These exposures can create concentration for which
additional capital needs to be allocated (Chapter 16).
Securitisation

• Securitisation requirements are found in APS 120

• For entities supervised by APRA, the main issue is a clean sale to remove the
asset completely from the balance sheet:
• There should be no beneficial interest in the sold assets and absolutely no obligation to
the financial institution.
• There should be no recourse (including costs) to the lending institution. In addition, there
should be no obligation for the lending institution to re-purchase the lending assets.
• The amount paid for the loans should be fixed and should be received by the time the
assets are transferred from the lending institution.
• Any assets that are provided to the special-purpose vehicle as a substitute or provided at
below book value are not considered as relieving credit risk
Credit card securitisation

• Credit card securitisation has the following requirements:

• The rights, details and obligations of each party must be clearly specified, including
the distribution of cashflows.
• As with normal asset securitisation, the financial institution cannot supply additional
assets to the pool.
• Liquidity shortfalls for the financial institution share must not exceed the interest
receivable.
• The financial institution always has the right to cancel any undrawn amounts on the
revolving facilities.
• Again, like normal lending securitisation, the financial institution must be under no
obligation to re-purchase assets that have defaulted.
Credit derivatives

• The following requirements are required to get capital relief

for credit derivatives:
• The underlying and reference assets are the same.
• The underlying asset is an obligation under the terms of the
contract. An obligation is defined as a financial obligation.
• The reference asset ranks lower than the underlying asset.
• The maturity of the credit derivative is the same as the underlying
loan may be required.
Developments in regulation

• Credit ratings are now used in capital adequacy. Table

16.2 outlines the definition of credit ratings.
• They are generated by the investigation of the following:
• Business risk:
• Industry characteristics
• Evaluation of management
• Industry specific factors
• Financial risk
• Accounting quality
• Financial policy
• Profitability and coverage
• Capital structure
• Financial flexibility

• The issue of the commercial secrets behind credit ratings in public

policy