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About this standard
This standard requires an ADI to maintain adequate capital for its credit risk exposures. ADIs must obtain APRA's approval to use internal data to calculate their capital requirements.
This standard supports APS 110 Capital Adequacy, which is a core standard in the Financial Resilience Pillar. It applies to ADIs that have approval, or are seeking approval, to use an internal model to determine their capital for credit risk.
Objectives and key requirements of this Prudential Standard
This Prudential Standard sets out the requirements that an authorised deposit-taking institution that has, or is seeking, 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.
The key requirements of this Prudential Standard are that an authorised deposit-taking institution must:
- determine the capital requirement for a given credit exposure, within certain parameters set by APRA;
- develop and maintain rating and risk estimation systems and processes that provide for a meaningful assessment of borrower and transaction characteristics, meaningful differentiation of risk, and accurate and consistent quantitative estimates of risk; and
- ensure that systems and processes for the internal ratings-based approach to determining capital also play an integral role in the institution’s credit approval, risk management and internal capital allocation functions.
Banking (prudential standard) determination No. 7 of 2022
Prudential Standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk
Banking Act 1959
I, John Lonsdale, a delegate of :
under subsection 11AF(3) of the Banking Act 1959 (the Act) REVOKE Banking (prudential standard) determination No. 6 of 2012, including Prudential Standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk, made under that determination; and
under subsection 11AF(1) of the Act DETERMINE Prudential Standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk, in the form set out in the schedule, which applies to all ADIs and authorised NOHCs to the extent provided in paragraphs 2 to 4 of the prudential standard.
This instrument commences on 1 January 2023.
Dated: 8 December 2022
[Signed]
John Lonsdale
Chair
APRA
Interpretation
In this instrument:
APRA means the Australian Prudential Regulation Authority.
ADI and authorised NOHC have their respective meanings given in section 5 of the Act.
Schedule
Prudential Standard APS 113 Capital Adequacy: Internal Ratings-based Approach to Credit Risk comprises the document commencing on the following page.
Prudential Standard APS 113
Capital Adequacy: Internal Ratings-based Approach to Credit Risk
Authority
This Prudential Standard is made under section 11AF of the Banking Act 1959 (Banking Act).
Application and commencement
This Prudential Standard applies to authorised deposit-taking institutions (s) that are seeking, or have been approved, to use an internal ratings-based (IRB) approach to credit risk for the purpose of determining the Regulatory Capital requirement for credit risk.
A reference to an ADI in this Prudential Standard, unless otherwise indicated, is a reference to:
an ADI on a Level 1 basis; and
a group of which an ADI is a member on a Level 2 basis.
If an ADI to which this Prudential Standard applies is:
the holding company for a group, the ADI must ensure that the requirements in this Prudential Standard are met on a Level 2 basis, where applicable; or
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.
This Prudential Standard commences on 1 January 2023.
Interpretation
Terms that are defined in Prudential Standard APS 001 Definitions appear in bold the first time they are used in this Prudential Standard.
Where this Prudential Standard provides for APRA to exercise a power or discretion, the power or discretion is to be exercised in writing.
In this Prudential Standard, unless the contrary intention appears, a reference to an Act, Regulations or Prudential Standard, is a reference to the Act, Regulations or Prudential Standard as in force from time to time.
Adjustments and exclusions
APRA may adjust or exclude a specific prudential requirement in this Prudential Standard in relation to one or more specified ADIs or authorised NOHCs.
Previous exercise of discretion
An ADI must contact APRA if it seeks to place reliance, for the purposes of complying with this Prudential Standard, on a previous exemption or other exercise of discretion by APRA under a previous version of this Prudential Standard.
Scope
The following items are excluded from the scope of this Prudential Standard:
non-standard retail residential mortgage exposures, equity exposures, margin lending exposures, cash items, fixed assets, unsettled and failed transactions, and related-party exposures that are subject to the requirements of Prudential Standard APS 112 Capital Adequacy: Standardised Approach to Credit Risk (APS 112);
assets or investments that are required to be deducted from Common Equity Tier 1 Capital, Tier 1 Capital or Total Capital under Prudential Standard APS 111 Capital Adequacy: Measurement of Capital (APS 111);
securitisation exposures that are subject to the requirements of Prudential Standard APS 120 Securitisation (APS 120), excluding funding-only or synthetic securitisations for which an ADI must include the underlying exposures in the pool in its calculation of the Regulatory Capital requirement for credit risk under this Prudential Standard;
liabilities of a covered bond special purpose vehicle to an issuing ADI as specified in Prudential Standard APS 121 Covered Bonds (APS 121); and
items that are subject to capital requirements under Prudential Standard APS 116 Capital Adequacy: Market Risk (APS 116) which do not have a counterparty credit risk exposure under Prudential Standard APS 180 Capital Adequacy: Counterparty Credit Risk (APS 180).
Subject to paragraph 13 of this Prudential Standard, an ADI must apply the requirements set out in this Prudential Standard to calculate risk-weighted assets (RWA) and expected loss () for any exposures of overseas banking subsidiaries that form part of the Level 2 group.
For the purpose of calculating the Level 2 Regulatory Capital requirement for exposures of an overseas banking subsidiary that is prudentially regulated by a prescribed New Zealand authority, an ADI must calculate RWA and EL using the prescribed New Zealand authority’s equivalent prudential rules as in force from time to time except that, in calculating RWA, the ADI must not apply the prescribed New Zealand authority’s:
scaling factor that is equivalent to paragraph 2 of Attachment A to this Prudential Standard, and instead must only apply a scaling factor of 1.1; and
floor value and calculation that is equivalent to paragraph 4 of Attachment A to Prudential Standard APS 110 Capital Adequacy (APS 110), and instead must only apply the floor value and calculation in APS 110.
Definitions
The following definitions are used in this Prudential Standard:
capital requirement (K) – means the capital requirement for unexpected loss derived from inputting the risk components to the risk-weight functions;
commitment – has the meaning given in APS 112;
commodities finance – has the meaning given in APS 112;
corporate exposure – has the meaning given in paragraph 30 of this Prudential Standard;
credit conversion factor (CCF) – means the percentage value used to convert an off-balance sheet exposure into an on-balance sheet equivalent;
credit obligation – means 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;
credit risk mitigation (CRM) – means a credit risk mitigation technique that meets the requirements detailed in Attachment E to this Prudential Standard and APS 112 where applicable;
defaulted exposure – means a non-performing exposure as defined in Prudential Standard APS 220 Credit Risk Management (APS 220);
dilution risk – means the possibility that the total amount of purchased receivables is reduced through cash or non-cash credits to the receivables’ obligors;
effective maturity (M) – means the remaining effective term of a credit obligation;
expected loss (EL) – means the average credit loss that the ADI is reasonably expected to experience;
exposure at default (EAD) – means the gross exposure (including accrued interest) under a facility (i.e. the amount that is legally owed to the ADI) upon the default of a borrower;
financial institution – has the meaning given in paragraph 34 of this Prudential Standard;
group of connected borrowers – means a group of connected counterparties that is connected by control or single-risk relationships under Prudential Standard APS 221 Large Exposures (APS 221). Where an ADI assesses that a borrower may form part of more than one group of connected borrowers, the ADI may primarily assign the borrower based on a control relationship rather than a single-risk relationship for the purpose of this Prudential Standard;
income-producing real estate (IPRE) – has the meaning given in paragraph 31 of this Prudential Standard;
large corporate – means a corporate counterparty with total consolidated annual revenue greater than $750 million as reported in the audited financial statements of the corporate counterparty or, where the counterparty is part of a group, the audited financial statements of the group. The revenue amount must be based on the average amount calculated over the prior three years, or on the latest amount updated at least every three years by the ADI;
lenders’ mortgage insurance (LMI) – has the meaning given in APS 112;
loss given default (LGD) – means the ADI’s economic loss upon the default of a borrower;
object finance – has the meaning given in APS 112;
probability of default (PD) – means the risk of borrower default;
project finance – has the meaning given in APS 112;
purchased receivables – means a pool of receivables that has been purchased by the ADI from another entity;
rating system – means 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;
regulated financial institution – means a financial institution that is subject to prudential requirements that are broadly equivalent to APRA’s prudential requirement, or is part of a group where any material legal entity within the group is subject to prudential requirements that are broadly equivalent to those set by APRA;
revolving exposure – means an exposure where a borrower’s outstanding balance is permitted to fluctuate based on their decision to borrow and repay, up to a limit established by the ADI. This does not include exposures that allow prepayments and subsequent redraws of those prepayments;
risk component – means the ADI’s internal estimate, or a supervisory estimate provided in this Prudential Standard, of probability of default, loss given default, exposure at default or effective maturity required as inputs to the risk-weight functions;
risk-weight function – means the calculation method that transforms the risk components into the capital requirement for unexpected loss;
securities financing transaction (SFT) – has the meaning given in APS 112;
sovereign – has the meaning given in APS 112;
specialised lending – has the meaning given in APS 112 but also includes IPRE as defined in this Prudential Standard;
unexpected loss (UL) – means the credit loss in excess of expected loss; and
unregulated financial institution – means a financial institution that is not a regulated financial institution.
APRA
APRA means the Australian Prudential Regulation Authority.
ADI
ADI and authorised NOHC have their respective meanings given in section 5 of the Act.
[1]
Refer to subsection 11AF(2) of the Banking Act.
[2]
For this purpose, a non-standard retail residential mortgage exposure refers to an exposure in the retail residential mortgage sub-asset class (as defined in this Prudential Standard) that is classified as a non-standard loan according to APS 112.
EL
expected loss (EL) – means the average credit loss that the ADI is reasonably expected to experience;
[3]
prescribed New Zealand authority has the meaning given in subsection 5(1) of the Banking Act.
Key principles
An ADI that has received IRB approval from APRA may rely on its internal estimates for some, or all, of the risk components required as inputs to the risk-weight functions used in determining the Regulatory Capital requirement for credit exposures. The risk components include measures of , , and .
PD
probability of default (PD) – means the risk of borrower default;
LGD
loss given default (LGD) – means the ADI’s economic loss upon the default of a borrower;
EAD
exposure at default (EAD) – means the gross exposure (including accrued interest) under a facility (i.e. the amount that is legally owed to the ADI) upon the default of a borrower;
M
effective maturity (M) – means the remaining effective term of a credit obligation;
An ADI must meet the relevant minimum requirements detailed in this Prudential Standard to use an IRB approach for a given asset class.
An ADI must apply a foundation IRB (FIRB), advanced IRB (AIRB), retail IRB or supervisory slotting approach to a given asset class in accordance with its IRB approval and subject to the constraints set out in paragraph 18 of this Prudential Standard. Where the ADI uses the:
FIRB approach, it must provide its own estimates of PD and M, and rely on supervisory estimates for LGD and EAD;
AIRB approach, it must provide its own estimates of PD, LGD (excluding senior unsecured and subordinated corporate exposures for which the ADI must use supervisory LGD estimates) and M, and rely on supervisory estimates for EAD;
retail IRB approach, it must provide its own estimates of PD, LGD and EAD (excluding non-revolving retail exposures for which the ADI must use supervisory EAD estimates); and
supervisory slotting approach, it must provide its own mapping of credit exposures to the supervisory slotting categories, and rely on supervisory risk weights for the slotting categories and supervisory estimates for EAD.
Under all approaches, the ADI must use the relevant IRB or schedule, as detailed in Attachment A to this Prudential Standard, to derive RWA for and the approach detailed in Attachment C to this Prudential Standard to derive EL.
risk-weight function
risk-weight function – means the calculation method that transforms the risk components into the capital requirement for unexpected loss;
UL
unexpected loss (UL) – means the credit loss in excess of expected loss; and
An ADI must apply the:
FIRB approach to all , and exposures, except exposures that meet the definition of a large where the ADI may apply a FIRB or supervisory slotting approach in accordance with its IRB approval;
sovereign
sovereign – has the meaning given in APS 112;
financial institution
financial institution – has the meaning given in paragraph 34 of this Prudential Standard;
large corporate
large corporate – means a corporate counterparty with total consolidated annual revenue greater than $750 million as reported in the audited financial statements of the corporate counterparty or, where the counterparty is part of a group, the audited financial statements of the group. The revenue amount must be based on the average amount calculated over the prior three years, or on the latest amount updated at least every three years by the ADI;
lenders’ mortgage insurance (LMI) – has the meaning given in APS 112;
IPRE
income-producing real estate (IPRE) – has the meaning given in paragraph 31 of this Prudential Standard;
corporate exposure
corporate exposure – has the meaning given in paragraph 30 of this Prudential Standard;
retail IRB approach to all retail exposures; and
supervisory slotting approach to all , and exposures.
project finance
project finance – has the meaning given in APS 112;
object finance
object finance – has the meaning given in APS 112;
commodities finance
commodities finance – has the meaning given in APS 112;
An ADI may reduce its Regulatory Capital requirement through the use of where it meets the requirements detailed in Attachments B, E and F to this Prudential Standard, and APS 112 where applicable.
CRM
credit risk mitigation (CRM) – means a credit risk mitigation technique that meets the requirements detailed in Attachment E to this Prudential Standard and APS 112 where applicable;
Governance and oversight
All material aspects of an ADI’s rating and estimation processes must be approved by the ADI’s Board, or relevant Board committee, and senior management. Those parties must possess a general understanding of the ADI’s rating systems and a detailed understanding of the associated management reports. Senior management must notify the Board, or Board committee, of material changes or exceptions from established policies that could have a material impact on the ADI’s rating systems.
Senior management must understand the design and operation of an ADI’s rating systems and approve any material differences identified between established procedures and actual practice. Senior management must ensure that the rating systems are operating as intended on an ongoing basis. Senior management and staff in the credit risk control function must meet regularly to discuss the performance of the rating process, areas requiring improvement and the status of efforts to improve previously identified deficiencies.
Internal ratings must be an essential part of the reporting to the Board and senior management. Reporting must include:
risk profile by grade;
migration across borrower grades;
quantitative estimates of the relevant parameters for each borrower grade and, where relevant, facility grade; and
comparison of realised default rates (and, where relevant, realised LGD and EAD rates) against expectations.
Reporting frequencies may vary with the significance and type of information and the level of the recipients.
An ADI must have documented policies that detail sound development, validation, implementation, governance and control processes. These policies must:
rating system
rating system – means 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;
be approved and actively discussed by the ADI’s Board or a delegated committee;
define the roles and responsibilities of parties involved in rating system development, validation, approval and implementation;
be actively enforced by senior management;
outline the processes for the development, validation, approval, implementation and governance of all rating and estimation processes. This must include the formation of:
a register that documents the specification, application, risk classification (materiality) and owner of each rating system;
a change log covering all rating system changes; and
a centralised issues register that records issues relating to each rating system; and
outline an ongoing monitoring and validation cycle for each rating system.
Credit risk control
An ADI must have an independent credit risk control unit that is responsible for the design or selection, implementation and performance of the ADI’s rating systems. The unit must be functionally independent of the personnel and management functions responsible for originating exposures. Areas of responsibility must include:
testing and monitoring internal borrower and facility grades, and pools;
production and analysis of summary reports from the ADI’s rating systems, including historical default data sorted by the rating at the time of default and one year prior to default, migration analysis and monitoring of trends in key rating criteria;
implementing procedures to verify that rating definitions are consistently applied across business units and geographic areas;
reviewing and documenting any changes to the rating process, including the reasons for those changes; and
reviewing the rating criteria to evaluate if they remain predictive of risk.
The credit risk control unit must actively participate in the development, selection, implementation and validation of rating models. It must assume oversight and supervision responsibilities for any models used in the rating process and have ultimate responsibility for the ongoing review of, and alterations to, the ADI’s rating models.
In order to ensure proper accountability, an ADI’s policies must clearly define and document the responsibilities of, and performance standards for, personnel within the credit risk control unit. Personnel must have the appropriate incentives to meet their performance standards and the knowledge, skills, tools and resources necessary to carry out their responsibilities.
Independent review
An ADI’s rating systems and operations must be reviewed at least annually by internal audit or an equally independent function. The review must assess whether the ADI’s development, implementation, validation, governance and control processes are effective and operating as designed. The areas of review must include:
the operations of the credit risk control function;
the estimation of PD and, where relevant, LGD and EAD; and
the ADI’s adherence to all applicable minimum requirements detailed in this Prudential Standard.
The findings of this review must be documented.
Asset classes
For the purpose of deriving the Regulatory Capital requirement under an IRB approach, an ADI must assign its banking book exposures to one of the following IRB asset classes:
corporate (which includes the four sub-asset classes of );
specialised lending
specialised lending – has the meaning given in APS 112 but also includes IPRE as defined in this Prudential Standard;
sovereign;
financial institution; and
retail (which consists of four separate sub-asset classes).
An ADI must ensure that its methodology for assigning credit exposures to different IRB asset classes complies with its IRB approval and is consistent over time.
Definition of corporate exposures
The corporate IRB asset class includes all credit exposures to corporate counterparties and public sector entities, including exposures within the four specialised lending sub-asset classes of project finance, object finance, commodities finance and IPRE. A corporate exposure means a of a corporation, partnership, proprietorship or public sector entity, or any other credit exposure that does not meet the criteria of any other defined IRB asset class.
credit obligation
credit obligation – means 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;
Income-producing real estate
IPRE means a method of providing funding for real estate where the prospects for repayment of the exposure depend primarily on the cash flows generated by the asset or other real estate assets owned by the borrower.
In order to treat an exposure as a general corporate exposure rather than IPRE, an ADI must have recourse to a borrower that meets all of the following criteria:
the borrower is a corporate entity that is managed by a recognised, professional and reputable management team;
the ADI’s exposure to the borrower is not specifically or substantially financing limited recourse development projects;
the borrower has greater than $250 million in tangible assets, to which the ADI has unconditional recourse;
real estate assets are sufficiently diversified such that: