A. Introduction

1. Credit risk is:

(a) the risk of default by counterparties; and

(b) the risk that an asset will lose value because its credit quality has deteriorated.

2. Credit risk may result from on-balance-sheet and off-balance-sheet exposures, including loans and advances, investments, inter-bank lending, derivative transactions, securities financing transactions and trading activities. It can exist in a Bank’s Trading Book or in its Banking Book.

B. Credit Risk - Management Framework and Governance

1. This section of the BPG sets out the standards, guidance and norms required to comply with the Rules in respect of the Credit Risk management framework and governance, as specified in Chapter 5 of BBR. These elements convey the supervisory expectations of the AFSA on Credit risk management framework and its governance. Compliance with the standards and guidance detailed in this section of BPG, both in letter and in spirit, is required to demonstrate fulfillment of the regulatory obligations specified in Chapter 5 of BBR. The AFSA will use these standards, norms and key elements specified here to assess compliance with BBR Rules on Credit Risk management.

2. In order to comply with the requirements specified in BBR Rule 5.1, and considering the nature, scale and complexity of a Bank’s Credit Risk, and how often it provides credit or incurs Credit Risk, a Bank’s Credit Risk management policy is expected to include:

(a) how the Bank defines and measures Credit Risk;

(b) the Bank’s business aims in incurring Credit Risk, including:

(i) identifying the types and sources of Credit Risk that the Bank will permit itself to be exposed to (and the limits on that exposure) and those that it will not;

(ii) setting out the degree of diversification that the Bank requires, the Bank’s tolerance for risk concentrations and the limits on exposures and concentrations; and

(iii) stating the risk-return trade-off that the Bank is seeking to achieve;

(c) the kinds of credit to be offered, and ceilings, pricing, profitability, maximum maturities and ratios for each kind of credit;

(d) a ceiling for the total credit portfolio (in terms, for example, of loan-to- deposit ratio, undrawn commitment ratio, a maximum amount or a percentage of the Bank’s capital);

(e) portfolio limits for maximum gross exposures by region or country, by industry or sector, by category of counterparty (such as banks, non-bank financial entities and corporate counterparties), by product, by counterparty and by connected counterparties;

(f) limits, terms and conditions, approval and review procedures and records kept for lending to connected counterparties;

(g) types of collateral, loan-to-value ratios and criteria for accepting guarantees;

(h) the detailed limits for Credit Risk, and a Credit Risk structure, that:

(i) takes into account all significant risk factors, including intra- group exposures;

(ii) is commensurate with the scale and complexity of the Bank’s activities; and

(iii) is consistent with the Bank’s business aims, historical performance, and the amount of capital it is willing to risk;

(i) procedures for

(i) approving new products and activities that give rise to Credit Risk;

(ii) regular risk position and performance reporting; and

(iii) approving and reporting exceptions to limits

(j) allocating responsibilities for implementing the Credit Risk management policy and monitoring adherence to, and the effectiveness of, the policy; and

(k) the required information systems, staff and other resources.

3. Problem assets include impaired credits wherein the debt servicing payments are already overdue for a significant amount of time and also include assets, where there is material uncertainty about the collectability of the payments due in full or in part.

4. BBR Rule 5.1 (5) does not prevent arrangements such as an employee loan scheme, so long as the policy ensures that the scheme’s terms, conditions and limits are generally available to employees and adequately address the risks and conflicts that arise from loans under it.

5. The Credit Risk management policy of a Bank should clearly set out who has the authority to approve loans to employees. The authority of a credit committee or credit officer should be appropriate for the products or portfolio and should be commensurate with the committee’s or officer’s credit experience and expertise. Each authority to approve should be reviewed regularly to ensure that it remains appropriate for current market conditions and the committee’s or officer’s performance.

6. A Bank’s remuneration policy should be consistent with its Credit Risk management policy and should not encourage officers to attempt to generate short-term profits by taking an unacceptably high level of risk.

7. The policy must state that decisions relating to the following are made at the appropriate level of the Bank’s senior management or governing body:

(a) exposures exceeding a stated amount or percentage of the Bank’s capital;

(b) exposures that, in accordance with criteria set out in the policy, are especially risky;

(c) exposures that are outside the Bank’s core business.

8. The level at which credit decisions are made should vary depending on the kind and amount of credit and the nature, scale and complexity of the Bank’s business. For some Banks, a credit committee with formal terms of reference might be appropriate; for others, individuals with pre- assigned limits would do.

9. A Bank should ensure, through periodic independent audits, that the credit approval function is properly managed and that credit exposures comply with prudential standards and internal limits. The results of audits should be reported directly to the governing body, credit committee or senior management, as appropriate.

C. Credit Risk Management

Credit Risk Assessment

10. A Bank must establish and implement appropriate policies to enable it to assess Credit Risk when the credit is granted or the risk is incurred and afterwards. In particular, the policies must enable the Bank:

(a) to measure Credit Risk (including the Credit Risk of off-balance- sheet items, such as derivatives, in credit equivalent terms);

(b) to effectively use its internal Credit Risk assessment;

(c) to rate and risk-weight a counterparty;

(d) to monitor the condition of individual credits;

(e) to administer its credit portfolio, including keeping the credit files current, getting up-to-date financial information on counterparties, and the electronic storage of important documents;

(f) to ensure that the value of collateral and the value of the other CRM techniques used by the Bank are assessed regularly;

(g) to assess whether its CRM techniques are effective; and

(h) to calculate its Credit Risk capital requirement.

11. A Bank involved in loan syndications or consortia should not rely on other parties’ assessments of the Credit Risk involved but should carry out a full assessment based on its own Credit Risk management policy.

12. The AFSA expects that a Bank’s Credit Risk strategy will set out the approach that the Bank will take to Credit Risk management, including various quantitative and qualitative targets. It should be communicated to all relevant functions and staff within the organisation and be set out in the Bank's Credit Risk policy.

13. The AFSA expects that a Bank’s Credit Risk management policy and strategy for managing Credit Risk will take into account the need to:

(a) develop a Credit management strategy, policies and processes in accordance with the Bank’s stated Credit Risk tolerance;

(b) ensure that the Bank maintains sufficient capital to support its Credit Risk exposure at all times;

(c) determine the structure, responsibilities and controls for managing Credit Risk and for overseeing the credit portfolio of all branches and subsidiaries in the jurisdictions in which the Bank is active, and outline these elements clearly in the Bank’s Credit Risk management policy;

(d) have in place adequate internal controls to ensure the integrity of its Credit Risk management processes;

(e) ensure that stress testing of the Credit Risk portfolio is effective and appropriate for the Bank;

(f) establish a set of reporting criteria, specifying the scope, manner and frequency of reporting to various recipients (such as the Governing Body, senior management and the asset/liability committee) and who is responsible for preparing the reports

(g) establish the specific procedures and approvals necessary for exceptions to policies and limits, including the escalation procedures and follow-up actions to be taken for breaches of limits;

(h) monitor closely current trends and potential market developments that may present significant, unprecedented and complex challenges for managing Credit Risk so that appropriate and prompt changes to the Credit management strategy can be made as needed; and

(i) continuously review information on the Bank’s Credit developments and report regularly to the Governing Body

14. In respect of managing the Bank’s Credit Risk, senior management are expected to:

(a) oversee the development, establishment and maintenance of procedures and practices that translate the goals, objectives and risk tolerances approved by the governing body into operating standards that are consistent with the governing body's intent and which are understood by the relevant members of a bank's staff;

(b) adhere to the lines of authority and responsibility that the governing body has established for managing Credit Risk;

(c) oversee the establishment and maintenance of management information and other systems that identify, assess, control and monitor the Bank's Credit Risk; and

(d) oversee the establishment of effective internal controls over the Credit Risk management process.

D. Problem Assets & Impaired Assets

15. Problem assets include impaired credits wherein the debt servicing payments are already overdue for a significant amount of time and also include assets, where there is material uncertainty about the collectability of the payments due in full or in part.

16. Impaired credit means a credit that is categorised as substandard, doubtful or loss. For the purpose of applying risk-weights, interest is suspended on an impaired credit. A credit is a restructured credit if it has been re-aged, extended, deferred, renewed, rewritten or placed in a workout program.

17. The Credit Risk management system and, in particular, the systems, policies and processes aimed at classification of credits, monitoring and identification of problem credits, management of problem credits and provisioning for them must include all the on-balance sheet and off-balance sheet credit Exposures of the Bank.

18. The review of impaired credits and other problem assets may be done individually, or by class, but must be done at least once a month. A large exposure that is an impaired credit must be managed individually in terms of its valuation, categorisation and provisioning.

19. Unless there is good reason to do so, a restructured credit can never be classified as performing. A restructured credit may be reclassified to a more favourable category, but only by one level of rating up from its category before the restructure. The credit may be reclassified one further category up after 180 days of satisfactory performance under the terms of the new contract.

E. Calculation of Credit Risk-Weighted Assets (RWAs)

Using external credit rating agencies (ECRAs)

20. This section provides additional information and guidance in respect of BBR Rule 5.5. A rating is a solicited rating if the rating was initiated and paid for by the issuer of the instrument, the rated counterparty or any other entity in the same corporate group as the issuer or rated counterparty.

21. A Bank that chooses to use ratings determined by an ECRA for exposures belonging to a class must consistently use those ratings for all the exposures belonging to that class. The Bank must not selectively pick between ECRAs or ratings in determining risk- weights.

22. A Bank may use an unsolicited rating, only if it receives AFSA’s written approval to do so or in accordance with a direction from the AFSA. The AFSA may give a written direction setting out conditions that must be satisfied before a Bank may use an unsolicited rating. The Bank must ensure that the relevant rating takes into account the total amount of the exposure (that is, the principal and any interest due).

Calculation of Risk-Weighted Assets (RWAs)

23. In order to comply with the Rules in BBR 5.6 in respect of calculation of Credit RWAs and to meet the expectations of the AFSA in this regard, a Bank is expected to consider and employ the guidance, interpretations and additional information provided in this section of the BPG. Risk- weights used in the calculation of RWAs as defined in BBR Rule 5.6, are based on credit ratings or fixed risk-weights and are broadly aligned with the likelihood of counterparty default. A Bank may use the ratings determined by an ECRA if allowed to do so by these Rules and subject to the provisions of BBR 5.5.

24. In respect of table 5B, investment property is land, a building or part of a building (or any combination of land and building) held to earn rentals or for capital appreciation or both. Investment property does not include property held for use in the production or supply of goods or services, for administrative purposes, or for sale in the ordinary course of business. A real estate asset owned by a Bank as a result of a counterparty default is treated as ‘other item’ and risk-weighted at 100% but only for a period of 3 years starting from the date when the Bank records the asset on its books.

25. In respect of table 5B, the list of multilateral development banks (Item 4 in Column 1) which qualify for a 0% risk weight, are published by the Basel Committee for Banking Supervision (BCBS). The list was originally included in the document Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework—Comprehensive Version¸ published by the BCBS on 30 June 2006, and has since been updated by BCBS newsletters. As at November 2016 the list is as follows:

● the African Development Bank

● the Asian Development Bank

● the Caribbean Development Bank

● the Council of Europe Development Bank

● the European Bank for Reconstruction and Development

● the European Investment Bank

● the European Investment Fund

● the Inter-American Development Bank

● the International Development Association

● the International Finance Facility for Immunization

● the Islamic Development Bank

● the Nordic Investment Bank

● the World Bank Group (comprising the International Bank for Reconstruction and Development, the International Finance Corporation and the Multilateral Investment Guarantee Agency).

Examples of multilateral development banks that do not qualify for 0% risk weight are:

● the Arab Bank for Economic Development in Africa

● the Asian Infrastructure Investment Bank

● the Black Sea Trade and Development Bank

● the Development Bank of Latin America

● the Central American Bank for Economic Integration

● the Development Bank of Central African States

● the East African Development Bank

● the Economic Cooperation Organization Trade and Development Bank

● the Eurasian Development Bank

● the International Finance Facility for Immunisation

● the International Fund for Agricultural Development

● the International Investment Bank

● the New Development Bank

● the OPEC Fund for International Development

● the West African Development Bank.

26. For the purposes of BBR Rule 5.8, specialised lending is a lending transaction that complies with the following requirements:

(a) the purpose of the loan is to acquire an asset;

(b) the cash flow generated by the collateral is the loan’s exclusive (or almost exclusive) source of repayment;

(c) the loan represents a significant liability in the borrower’s capital structure;

(d) the Credit Risk is determined primarily by the variability of the cash flow generated by the collateral (rather than the independent capacity of a broader commercial enterprise).

27. Specialised lending is associated with the financing of projects where the repayment depends on the performance of the underlying collateral. There are 5 sub-classes of specialised lending:

(a) project finance—financing industrial projects based on the projected cash flows of the project;

(b) object finance—financing physical assets based on the projected cash flows obtained primarily through the rental or lease of the assets;

(c) commodities finance—financing the reserves, receivables or inventories of exchange-traded commodities where the exposure is paid back based on the sale of the commodity (rather than by the borrower from independent funds);

(d) income-producing real estate finance—financing real estate that is usually rented or leased

out by the debtor to generate cash flow to repay the exposure; and

(e) high-volatility commercial real estate finance—financing commercial real estate which demonstrates a much higher volatility of loss rates compared to other forms of specialised lending.

28. For the purposes of BBR Rule 5.9, eligible residential mortgage means a mortgage on a residential property that is, or will be:

(a) occupied by the counterparty for residential use; or

(b) rented out (on a non-commercial basis) for residential use.

29. For the purposes of BBR Rule 5.11:

(a) Current credit exposure is the absolute mark-to-market value (or replacement cost) of the item.

(b) Potential future credit exposure (also known as ‘the add-on’) is the amount calculated by multiplying the notional principal amount of the item by the relevant credit conversion factor in table 5D. The notional principal amount is the reference amount used to calculate payment streams between counterparties to the item.

Table E1: Credit conversion factors for market-related off-balance-sheet items

30. For the purposes of BBR Rule 5.11 & 5.12:

(a) The credit conversion factors for a protection buyer in a single-name credit default swap or single-name total-rate-of-return swap are set out in column 3 of table E2. The credit conversion factors for a protection seller are set out in column 4 of that table.

(b) The protection seller in a single-name credit default swap or single- name total-rate-of-return swap is subject to the add-on factor for a closed-out single-name swap only if the protection buyer becomes insolvent while the underlying asset is still solvent. The add-on must not be more than the amount of unpaid premiums.

(c) In the table E2, qualifying reference obligation includes obligations arising from items relating to:

(i) securities that are rated investment grade by at least 2 ECRAs; or

(ii) securities that are unrated (or rated investment grade by only 1 ECRA), but:

(1) are approved by the AFSA, on application by the Bank, to be of comparable investment quality; and

(2) are issued by an issuer that has its equity included in a main index used in a regulated exchange.

Table E2        Credit conversion factors for single-name swaps

31. For the purposes of complying with BBR Rule 5.12, the credit equivalent amount of non-market related items is calculated by the following procedures:

(a) Unless the item is a default fund guarantee in relation to clearing through a central counterparty, the credit equivalent amount of a non-market-related off-balance-sheet item is calculated by multiplying the contracted amount of the item by the relevant credit conversion factor in table E3.

(b) If the Bank arranges a repurchase or reverse repurchase or a securities lending or borrowing transaction between a customer and a third party and provides a guarantee to the customer that the third party will perform its obligations, the Bank must calculate the Credit Risk capital requirement as if it were the principal.

Table E3         Credit conversion factors for non-market-related off-balance-sheet items

(c) For item 4 of table E3, an exposure from lending securities, or lodging securities as collateral, may be treated as a collateralised transaction.

32. An illustration of the operation of BBR Rule 5.12 (5) is as follows: An irrevocable commitment with an original maturity of 6 months with an associated facility that has a nine-month term is taken to have an original maturity of 15 months.

F. Credit Risk Mitigation (CRM)

33. A Bank is able to obtain capital relief by using Credit Risk Mitigation (CRM) techniques. CRM techniques must be viewed as complementary to, rather than a replacement for, thorough Credit Risk assessment.

34. According to BBR Rule 5.6 (2), if a claim or asset to which a risk-weight must be applied is secured by eligible financial collateral or guarantee (or there is a mortgage indemnity insurance, or a credit derivative instrument or netting agreement) this Part on Credit Risk Mitigation may be used to reduce the Credit Risk capital requirement of the Bank.

35. Available CRM techniques include:

(a) accepting collateral, standby letters of credit and guarantees;

(b) using credit derivatives or other derivative instruments;

(c) using netting agreements; and

(d) purchasing insurance.

36. CRM using collateral and guarantees is usually dealt with at the time credit is granted. In contrast, credit derivatives and netting agreements are often used after the credit is granted or used to manage the Bank’s overall portfolio risk. A Bank should not rely excessively on collateral or guarantees to mitigate Credit Risk. While collateral or guarantees may provide secondary protection to the Bank if the counterparty defaults, the primary consideration for credit approval should be the counterparty’s repayment ability.

37. In choosing a CRM technique, the Bank must consider:

(a) the Bank’s knowledge of, and experience in using, the technique;

(b) the cost-effectiveness of the technique;

(c) the type and financial strength of the counterparties or issuers;

(d) the correlation of the technique with the underlying credits;

(e) the availability, liquidity and realisability of the technique;

(f) the extent to which documents in common use (for example, the ISDA Master Agreement) can be adopted; and

(g) the degree of recognition of the technique by financial services regulators.

38. In respect of employing a CRM technique:

(a) a Bank accepting eligible financial collateral for CRM, must ensure that such collateral can be enforced and any necessary legal procedures have been followed.

(b) A Bank should consider whether independent legal opinion should be sought on the enforceability of documents. The documents should be ready before the Bank enters into a contractual obligation or releases funds.

39. If a CRM technique (other than a guarantee) and the exposure covered by it are denominated in different currencies (that is, there is a currency mismatch between them), the haircut that applies is:

(a) if the mismatched currencies are both pegged to the same reference currency, or 1 of them is pegged to the other—0; or

(b) in any other case—8%.

40. If there is a currency mismatch between a guarantee and the exposure covered by it, the amount of the exposure that is covered must be reduced using the following formula:

GA = G (1- HFX)

where:

G is the nominal amount of the guarantee.

Hfx is the haircut appropriate for the currency mismatch between the credit protection and the underlying obligation, as follows:

(a) if the guarantee is revalued every 10 business days—8%;

(b) if the guarantee is revalued at any longer interval—the factor H calculated using the formula in sub-Rule (5); or

(c) if the mismatched currencies are both pegged to the same reference currency, or if 1 of them is pegged to the other—0.

41. If the guarantee is revalued at intervals longer than 10 business days, the 8% haircut must be scaled up using the following formula:

H = 8

where:

H is the scaled-up haircut.

N is the number of business days between the revaluations.

42. In respect of cash collateral, the recourse may be in the form of a contractual right of set-off on credit balances. A common-law right of set-off is, on its own, insufficient to satisfy this Rule.

43. While using collateral as a CRM technique, the Bank should have clear and robust procedures for the liquidation of collateral to ensure that the legal conditions for declaring default and liquidating the collateral are observed. The Bank should also consider whether, in the event of default, notice to the party that lodged the collateral would be needed before the Bank could have recourse to it. In respect of using collateral as a CRM technique, under BBR Rule 5.16 (3) a Bank should have policies and procedures in place to identify, monitor, control and report general wrong way risk (positively correlated with general Market risk factors) and specific wrong way risk (positively correlated with a specific counterparty).

44. In respect of using collateral as a CRM technique, under BBR Rule 5.17, Collateral accepted by a Bank must be valued at its net realisable value, taking into account prevailing market conditions. That value must be monitored at appropriate intervals, and the collateral must be regularly revalued.

45. The net realisable value of some collateral may be readily available (for example, collateral that is marked-to-market regularly). Other collateral may be more difficult to value and may require knowledge and consideration of prevailing market conditions. The method and frequency of monitoring and revaluation depend on the nature and condition of the collateral. For example, securities accepted as collateral are usually marked to market daily.

G. Use of Netting Agreements for Credit Risk Mitigation (CRM)

46. In respect of using a netting agreement to obtain capital relief under BBR Rule 5.20, a Bank must follow the guidance and criteria specified in the following paragraphs of this section.

47. The following kinds of transactions may be netted:

(a) on-balance-sheet loans and deposits, but only if:

(i) the Bank is able to determine at all times the assets and liabilities that are subject to netting under the agreement; and

(ii) the deposits satisfy the criteria for eligible financial collateral;

(b) securities financing transactions;

(c) over the counter derivative transactions.

48. Securities financing transactions are not included as part of market related transactions. A netting agreement may include the netting of over the counter derivative transactions:

(a) across both the Banking and Trading Books of a Bank (if the netted transactions satisfy the criteria in this section); and

(b) across different market-related products to the extent that they are recognised as market- related transactions.

49. To be an eligible netting agreement, a netting agreement:

(a) must be in writing;

(b) must create a single obligation covering all transactions and collateral included in the agreement and giving the Bank the following rights:

(i) the right to terminate and close-out, in a timely way, all the transactions included in the netting agreement;

(ii) the right to net the gains and losses on those transactions (including the value of any collateral) so that the Bank either has a claim to receive, or an obligation to pay, only the net sum of the close-out values of the individual transactions;

(iii) the right to liquidate or set-off collateral if either party to the agreement fails to meet its obligations because of default, liquidation, bankruptcy or other similar circumstances;

(c) must not be subject to a walkaway clause; and

(d) must be supported by a written and reasoned legal opinion that complies with norms and criteria set out particularly in paragraphs 49, 52 to 55 of this section among other paragraphs.

(e) For forward contracts, swaps, options and similar derivative transactions, the right to net gains and losses will include the positive and negative mark-to-market values of the individual transactions.

50. A Bank must not recognise a netting agreement as an eligible netting agreement if it becomes aware that a financial services regulator of the counterparty is not satisfied that the agreement is enforceable under the laws of the regulator’s jurisdiction. This Rule applies regardless of any legal opinion obtained by the Bank. A netting agreement is not an eligible netting agreement if there is doubt about its enforceability.

51. A Bank must ensure that a netted transaction is covered by an appropriate legal opinion. In calculating the net sum due to or from a counterparty, the Bank must exclude netted transactions for which it has not obtained a satisfactory legal opinion applicable in the relevant jurisdiction. An excluded transaction must be reported on a gross basis.

52. For an eligible netting agreement which meets the requirements specified in paragraph 4 of this section, the legal opinion must conclude that, in the event of default, liquidation, bankruptcy or other similar circumstances of a party to the netting agreement, the Bank’s claims and obligations are limited to the net sum calculated under the netting agreement in accordance with the applicable law.

53. The AFSA expects the legal opinion to deal with the issue of which of the following laws applies to the netting:

(a) the law of the jurisdiction in which the counterparty is incorporated or formed (or, in the case of an individual, resides)

(b) if an overseas branch of the counterparty is involved—the law of the jurisdiction in which the branch is located

(c) the law that governs the individual transactions

(d) the law that governs any contract or agreement necessary to give effect to the netting.

54. In particular, the legal opinion must conclude that, in the event of insolvency or external administration of a counterparty, a liquidator or administrator of the counterparty will not be able to claim a gross amount from the bank while only being liable to pay a dividend in insolvency to the

Bank (as separate money flows).

55. In some countries, there are provisions for the authorities to appoint an administrator to a troubled bank. Under statutory provisions applying in those countries, the appointment of an administrator might not constitute a ground for triggering a netting agreement. Such provisions do not prevent the recognition of an affected netting agreement if the agreement can still take effect if the bank under administration does not meet its obligations as they fall due.

56. Before a Bank uses a legal opinion to support a netting agreement, the Bank:

(a) must ensure that the opinion is not subject to assumptions or qualifications that are unduly restrictive;

(b) must review the assumptions about the enforceability of the agreement and must ensure that they are specific, factual and adequately explained in the opinion; and

(c) must review and assess the assumptions, qualifications and omissions in the opinion to determine whether they give rise to any doubt about the enforceability of the agreement.

57. The Bank must have procedures to monitor legal developments and to ensure that its netting agreements continue to be enforceable. The Bank must update the legal opinions about the agreements, as necessary, to ensure that the agreements continue to be eligible.

58. The Bank may rely on a legal opinion obtained on a group basis by another member of the Financial Group of which it is a member if the Bank and the other member have satisfied themselves that the opinion covers a netting agreement to which the Bank is a counterparty. The Bank must report a transaction on a gross basis if there is any doubt about, or any subsequent legal development affects, the enforceability of the agreement.

59. A Bank may rely on a general legal opinion about the enforceability of netting agreements in a particular jurisdiction if the Bank is satisfied that the type of netting agreement is covered by the opinion. The Bank must satisfy itself that the netting agreement with a counterparty and the general legal opinion are applicable to each transaction and product type undertaken with the counterparty, and in all jurisdictions where those transactions are originated.

60. A Bank may net positions across its Banking and Trading Books only if:

(a) the netted transactions are marked-to-market daily; and

(b) any collateral used in the transactions satisfies the criteria for eligible financial collateral in the banking book.

61. If directed by the AFSA, a Bank must demonstrate that its netting policy is consistently implemented, and that its netting agreements continue to be enforceable. The Bank must keep adequate records to support its use of netting agreements and to be able to report netted transactions on both gross and net bases. The Bank must monitor its netting agreements and must report and manage:

(a) roll-off risks;

(b) exposures on a net basis; and

(c) termination risks;

for all the transactions included in a netting agreement.

62. A Bank may take collateral and guarantees into account in calculating the risk-weight to be applied to the net sum under a netting agreement. The Bank may assign a risk-weight based on collateral or a guarantee only if:

(a) the collateral or guarantee has been accepted or is otherwise subject to an enforceable agreement; and

(b) the collateral or guarantee is available for all the individual transactions that make up the net sum of exposures calculated.

63. The Bank must ensure that provisions for applying collateral or guarantees to netted exposures under a netting agreement comply with the requirements for eligible financial collateral and guarantees in these Rules.

H. Securitisation and Re-securitisation

64. In respect of obtaining capital relief under BBR Rule 5.21 for securitisation and re-securitisation arrangements, a Bank must follow the guidance and criteria specified in the following paragraphs of this section.

65. A Bank’s securitisation exposures may arise from the Bank being (or acting in the capacity of) party to a securitisation. Securitisation, in relation to a Bank, is the process of pooling various kinds of contractual debt or non-debt assets that generate receivables and selling their related cash flows to third party investors as securities. In a securitisation, payments to the investors depend on the performance of the underlying pool of assets, rather than on an obligation of the originator of the assets.

66. The underlying pool in a securitisation may include 1 or more exposures. The securities usually take the form of bonds, notes, pass-through securities, collateralised debt obligations or even equity securities that are structured into different classes (tranches) with different payment priorities, degrees of Credit Risk and return characteristics.

67. A securitisation (whether traditional or synthetic) must have at least 2 tranches. Re-securitisation is a securitisation in which at least one of the underlying assets is itself a securitisation or another re- securitisation. Exposures arising from re-tranching are not re-securitisation exposures if, after the re-tranching, the exposures act like direct tranching of a pool with no securitised assets. This means that the cash flows to and from the Bank as originator could be replicated in all circumstances and conditions by an exposure to the securitisation of a pool of assets that contains no securitisation exposures.

68. A reference in this Part to securitisation includes re-securitisation.

I. Provisioning requirements

124. In relation to the expectations about the provisioning policy of a Bank as set out in the BBR Rule

5.22 (2), a review of a Bank’s write-offs can help identify whether the Bank’s provisioning policy results in over-provisioning or under-provisioning. The AFSA regularly assesses trends and concentrations in risk and risk build-up across financial entities in relation to problem assets. In making the assessment, the AFSA takes into account any observed concentration in the CRM techniques used by Banks and the potential effect on the efficacy of those techniques in reducing loss. The AFSA would consider the adequacy of provisions for a Bank (and the industry in general) in the light of the assessment.

125. The AFSA might seek the opinion of external experts in assessing the adequacy of a Bank’s policies for grading and classifying its assets and the appropriateness and robustness of the levels of its provisions. If the AFSA considers that existing or anticipated deterioration in asset quality is of concern or if the provisions do not fully reflect expected losses, the authority may require the Bank to adjust its classifications of individual assets, increase its levels of provisions or capital and, if necessary, impose other remedial measures.

J. Transactions with related parties

126. The concept of parties being related to a Bank is used in the BBR Rule 5.23 in the context of parties over which the Bank exercises control or parties that exercise control over the Bank. The concept is primarily used in relation to the requirement that the Bank’s transactions be at arm’s length. In contrast, the concept of parties being connected to one another (which is discussed with concentration in Chapter 5 of BBR) is used in these Rules to measure concentration risk and large exposures. It is of course possible for connected counterparties to be related to the Bank holding the exposure concerned. Related party is wider than a Bank’s corporate group in that it includes individuals. Related parties include the Bank’s subsidiaries and major stock holders; members of its governing body; its senior management and key employees.

127. To guard against abuses in lending to related parties and to address conflicts of interest, this Rule requires transactions with related parties to be at arm’s length and subject to appropriate supervision and limits. Related-party transactions must be interpreted broadly. Related party transactions include on-balance-sheet and off-balance-sheet credit exposures, service contracts, asset purchases and sales, construction contracts, lease agreements, derivative transactions, borrowing and write-offs. For purposes of concentration risk, the Bank’s exposure to connected counterparties (whether related or not) is taken to be a single risk.

128. Favourable terms could relate to interest rate, credit assessment, tenor, fees, amortisation schedule and need for collateral. An exception for beneficial terms could be appropriate if it is part of an employee’s remuneration package (for example, more favourable loan rates to employees).

K. Concentration Risk

129. Parties would be connected if the same persons significantly influence the Governing Body of each of them. Parties would be connected if one of them has an exposure to the other that was not incurred for the clear commercial advantage of both of them and is not on arm’s length terms. Parties would be connected if they are so closely linked that:

(a) the insolvency or default of 1 is likely to be associated with the insolvency or default of the other;

(b) it would be prudent when assessing the financial condition or creditworthiness of 1 to consider that of the other; or

(c) there is, or is likely to be, a close relationship between their financial performance.

130. Parties would be connected if a Bank has exposures to them and any loss to the Bank on any of the exposures to one of the parties is likely to be associated with a loss to the Bank with respect to at least one exposure to each of the others. Two or more individuals or legal persons would constitute a single risk if they are so connected that, if one of them were to experience financial problems, the other or others would be likely to encounter repayment difficulties. Connected counterparties should be identified and the procedures to manage the combined Credit Risk considered. A Bank may need to monitor and report the gross exposure to connected counterparties against combined limits in addition to monitoring the exposure to each counterparty.

Significant sources of concentration risk include:

(a) concentration of exposures to a single counterparty or connected counterparties;

(b) concentration of exposures to counterparties in the same industry, sector, region or country; and

(c) concentration of exposures to counterparties whose financial performance depends on the same activity or commodity.

131. A concentration of exposures would also arise if a Bank accepts collateral or credit protection provided by a single provider. A Bank’s policy should be flexible to help the Bank to identify risk concentrations. To achieve this, the systems should be capable of analysing the Bank’s credit portfolio by:

(a) size of exposure

(b) exposure to connected counterparties

(c) product

(d) geography

(e) industry or sector (for example, manufacturing and industrial)

(f) account performance management

(g) internal Credit Risk assessment

(h) funding

(i) outstandings versus commitments

(j) types and coverage of collateral.