Many of our clients are asking us about the implications of APRA’s proposed changes to the existing Prudential Standard APS 220 Credit Quality following the release of its discussion paper and draft new standard for consultation.
The majority of the changes relate to embedding into a prudential standard the credit risk management principles that APRA has been holding ADIs to over recent years via its supervisory measures. There are changes that may impact your credit risk management frameworks, origination practices, and reporting. Some will have flow on impacts to other stakeholders that are not regulated by APRA (e.g. brokers, mortgage managers, and valuers).
Whilst the draft standard is out for consultation and subsequent changes may be made, it is worthwhile considering the potential implications.
Key elements of a credit risk management framework
APRA has outlined six key elements of a credit risk management framework that are at least required to be implemented. It is worthwhile highlighting two of these elements:
- A management information system that is adequate, both under normal circumstances, and in periods of stress….
APRA has publicly highlighted weaknesses in management information systems across the industry especially with regards to measuring, assessing and reporting on credit risk. APRA expects that systems can aggregate to a portfolio level underwriting metrics taken at an individual loan level. Not having “adequate” systems in place post 1 July 2020 will be a breach of the new prudential standard.
- Independent review process to ensure that the credit risk management framework is effective in identifying, measuring, evaluating, monitoring, reporting, and controlling or mitigating credit risks. While noting the requirement for an independent review, APRA’s expectation for the scope appears to be different to an audit approach. The effectiveness of this independent review is likely to be a key area of focus for APRA going forward.
APS 220 Credit Risk Management
- March 2019 – draft Prudential Standard APS 220 Credit Risk Management and Discussion Paper for consultation.
- 28 June 2019 – written submissions due on the proposals set out in the Discussion Paper.
- 2nd Half 2019 – APRA will release an accompanying prudential practice guide and revised reporting standards for consultation.
- End of 2019 – release the final prudential standard, prudential practice guide and reporting standards.
- 1 July 2020 – implementation of changes
Outsourcing aspects of credit risk management (credit origination, processing, credit assessment and approvals)
APRA has expressly reminded ADIs to have regard to Prudential Standard CPS 231 Outsourcing for aspects of credit risk management that have been outsourced. If not already undertaken, APRA will be expecting ADIs to review existing arrangements and any new arrangements going forward against the requirements in CPS 231. It is important that these considerations are documented as evidence of complying with the requirement.
Credit origination – via third party originators
APRA is establishing requirements that relate to credit origination via third parties. This reflects the evolution of distribution channels used by ADIs. These requirements cover not only origination via brokers or third party referral channels, but also where the ADI has direct exposure through a third party, such as online lending platform, and the platform operator or other third party undertakes the credit assessment and approval of the underlying borrowers under its own credit risk policies and procedures. The key requirements relate to performing adequate due diligence on these exposures.
ADIs will be required to have sound oversight of all third parties involved in any aspect of the origination such as brokers. ADIs will need to review current arrangements to ensure they meet APRA’s expectations. ADIs are recommended to review the capability of data systems, effectiveness of processes and frameworks to oversight these activities on a regular basis.
Sound credit and approval criteria
APRA has specifically called out the requirement to have well defined criteria / underwriting standards. APRA will likely focus on the criteria in credit policies and risk appetite statements that are not detailed to an adequate level of granularity.
What should be considered in a credit assessment?
APRA has explicitly outlined the key considerations that will need to be documented in each credit assessment for exposures to individuals and exposures other than to individuals (i.e. commercial lending). The key basis for the assessment must be on the strength of a borrower’s repayment capacity (i.e. primary source of repayment).
This is likely to result in changes to credit submission templates (especially for exposures that are not individuals) used by ADIs to ensure that they can evidence that these minimum requirements are being followed. It is important to note that the proposed standard allows for the assessment to be proportionate to the nature, type and size of exposure.
It is likely that industry will require further clarification / guidance around these requirements. Implications include, Retail SME Lending (decisioning using behavioural scorecards), compliance with the new Banking Code of Practice relating to the use of financial covenants, etc.
Classification of exposures
The classification of exposures has changed substantially from the existing prudential standard. Key changes include:
- removal of reference to the existing regulatory definition of “impaired” and replacing it with the term “non-performing”. This definition does not completely align to the existing definition of “impaired”. APRA is proposing that the “non-performing” classification also applies to exposures 90 days past due but well secured;
- removal of the GRCL, as it is no longer considered necessary as provisions under accounting standards cover expected loss; and
- introduction of regulatory classifications of exposures as “performing”, “significantly deteriorated” and “non-performing”. APRA is considering aligning the new regulatory classifications with the classifications/stages in AASB9. APRA has requested feedback on the changes.
The proposed changes will result in the need for substantial changes to credit risk policies, procedures, and reporting.
Regulatory reporting of restructured exposures
APRA has materially changed the definition of a restructured exposure by broadening its application.
It specifically captures when a borrower is in temporary financial difficulty or hardship and most situations where an ADI grants a concession to the borrower including a concession on easing covenants, changing an amortising loan to an interest only, or refinancing an existing exposure with a new contract. This proposed change will increase the size of restructured exposures that will be reported, especially for borrower segments where changes have been made due to temporary factors, e.g. drought.
APRA is proposing that restructured exposures may be classified as either “significantly deteriorated” or “non-performing” categories. ADIs may want to look at introducing management reporting that breaks down the proposed new restructured exposures by the new regulatory classifications or other metrics to obtain a “true” representation of non-performance in this segment, and the materially of the concessions granted.
APRA has included the requirement for valuations to be appraised independently from an ADI’s credit origination, credit assessment and approval process. This addresses a recommendation of the Royal Commission and will impact frameworks and processes especially for ADIs that lend to the agricultural sector.
The revisions formally recognise alternative valuation methods. In particular, the revisions will require ADIs to implement capabilities for monitoring, validation and reporting of valuation data with respect to the accuracy and usage of any alternative methods.
There are areas highlighted in the discussion paper where APRA has specifically sought feedback which means there could be changes to these provisions. At the end of 2019, APRA expects to release the finalised versions of the prudential standard, prudential practice guide and reporting standards. In order for ADIs to understand the full impact of the proposed change on them, we recommend that they undertake a self- assessment against the final standard to identify any gaps that need to be addressed prior to 1 July 2020
This communication provides general information which is current at the time of production. The information contained in this communication does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information.