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Calculation of credit risk weighted assets – frequently asked questions

FAQ 1: What is the appropriate credit conversion factor to be used in determining the regulatory capital of insurance stand-by letters of credit? 

An insurance standby letter of credit is issued by an Authorised deposit-taking institution (ADI) to an insurer whereby the ADI ‘guarantees’ payment to the insurer in the event that its reinsurer defaults.

Paragraph 1 of Attachment B to Prudential Standard APS 112 (Capital Adequacy: Standardised Approach to Credit Risk) sets out the credit conversion factors to be applied to different categories of non-market-related off-balance sheet transactions under the standardised approach to credit risk. Paragraph 9 of Prudential Practice Guide APG 112 provides further guidance on the categorisation of non-market-related off-balance sheet transactions. 

Insurance stand-by letters of credit fall into the category of ‘direct credit substitutes’ (and therefore a 100 per cent credit conversion factor is to be applied under the standardised approach). This is because the primary purpose of the letter of credit is to support the claims paying ability of the reinsurer, which is a monetary or financial obligation.

Under paragraph 27 of Attachment B to Prudential Standard APS 113 (Capital Adequacy: Internal Ratings-based Approach to Credit Risk), ADIs using the Foundation IRB approach must generally apply the credit conversion factors in Attachment B to APS 112. Furthermore, under paragraph 31 of Attachment B to APS 113, products that are assigned a 100 per cent credit conversion factor under the standardised approach are not eligible to be modelled by ADIs using the Advanced IRB approach. 

As a result, APRA expects that all insurance stand-by letters of credit are to be assigned a credit conversion factor of 100 per cent irrespective of the approach taken by the issuing ADI to determining regulatory capital requirements.

 

FAQ 2: What is the prudential treatment of residential mortgage loans issued under the Family Home Guarantee and First Home Loan Deposit Scheme?

In 2019, APRA adjusted capital requirements for loans originated by authorised deposit-taking institutions (ADIs) under the Government’s First Home Loan Deposit Scheme (FHLDS). Consistent with that approach, APRA is extending the same treatment to loans originated by ADIs under the Government’s Family Home Guarantee (FHG) program.

Under the standardised approach to credit risk, loans subject to the FHG and FHLDS may be treated in a comparable manner to residential mortgage loans with a loan-to-valuation ratio (LVR) of 80 per cent, and accordingly risk weighted at 35 per cent. This risk weight must be applied to the total amount lent to the borrower. 

This risk weight reflects the Government guarantee and terms of the program. Once the Government guarantee ceases to apply, ADIs must revert to calculating the regulatory capital requirement in line with the existing requirements of Prudential Standard APS 112 Capital Adequacy: Standardised Approach to Credit Risk. For ADIs that use the internal ratings-based approach to credit risk, there are no adjustments to the capital treatment of loans subject to the FHG or FHLDS. 

ADIs that use the standardised approach to credit risk may report FHG and FHLDS loans as having an 80 per cent LVR for capital purposes under Reporting Standard ARS 112.1 Standardised Credit Risk – On Balance Sheet Assets. For all other regulatory reporting, ADIs must report the LVR of FHG and FHLDS mortgages according to the borrower’s actual equity contribution. This includes Reporting Standard ARS 223.0 Residential Mortgage Lending. For internal risk management, including the measurement of risk appetite, APRA similarly expects that ADIs will monitor LVRs of FHG and FHLDS residential mortgage loans based on the borrower’s actual equity contribution.