Regulator to rethink credit risk oversight

The Australian 12:00am March 26, 2019

Richard Gluyas

The Australian Prudential Regulation Authority has proposed the first overhaul of its approach to credit risk since 2006, including enhanced board oversight and the need for banks to maintain prudent risk practices over the entire life of a loan.

In a discussion paper released yesterday, the prudential regulator said boards should review and approve the bank’s credit risk statement and strategy “at least on an annual basis”.

They should regularly challenge and seek assurance and evidence from management that the bank’s credit risk policies, processes and practices were consistent with the overall credit strategy.

“APRA has observed deficiencies in credit risk management,” the discussion paper says.

“For most (banks), loans, particularly residential mortgage loans, are the largest and most obvious source of credit risk. However, other sources of credit risk exist throughout the activities of a bank, including in the banking book and the trading book.”

The proposed reforms, due to be implemented from July 1 next year, were prompted by APRA’s recent focus on credit standards.

Risks related to residential mortgage lending have been a key area of focus for APRA in recent years, particularly credit standards and types of higher-risk lending such as interest-only loans. Competitive pressures have also taken their toll on credit standards in commercial property lending.

APRA said contemporary credit risk management practices had to be applied over the full credit life cycle, with the implementation of changes to the accounting standard on provisioning a further consideration.

A forward-looking approach has been adopted in contrast to the old incurred-loss formula.

The discussion paper included recommendations for the valuation of collateral for loans, such as property.

Valuations, it said, should be assessed independently from credit origination, credit assessment and approval processes.

Agricultural land taken for security should take into account the likelihood of external events, such as drought and flood.

On credit assessment, the bank’s process should include consideration of the purpose and structure of the exposure and sources of repayment, including effective verification of income or cashflows and the current risk profile of the borrower.

The latter should cover all commitments and total indebtedness, the borrower’s repayment history and capacity under various scenarios, and covenants designed to limit the bank’s exposure to changes in the borrower’s risk profile.

The lender should establish appropriate limits on loan-to-valuation ratios, and where it used a third party such as a broker to undertake the credit assessment and approval, appropriate oversight processes of the third party should be implemented.

In the case of a third party such as a peer-to-peer lender, the bank should perform due diligence on those exposures.

APRA canvassed three policy options with the sector, including no change to the existing arrangements.

While that option would not involve any additional compliance costs, the regulator said the potential costs could be high.

“Peer group comparisons with banks in other jurisdictions would remain difficult since regulators in these jurisdictions are likely to take into account Basel guidance as the basis for their regulatory reporting,” APRA said.

The existing standard, it said, would continue to reflect an outdated standard which was likely to create some confusion, particularly in relation to provisioning.

The more robust — or third — update, reflecting best practice in credit risk management and the relevant recommendations from the Hayne royal commission, would result in strengthened credit quality. But banks would incur additional compliance costs, including costs associated with the introduction of modern risk management processes.