In March 2019 APRA released a draft Prudential Standard APS 220 Credit Risk Management. The new standard is intended to replace the current APS 220 Credit Quality.
The revised standard, available together with a discussion paper here, represents the first significant update since 2006. It provides APRA with the opportunity to respond to both the Banking Royal Commission, and also to recent guidance issued by the Basel Committee.
The change in the name of the standard is intended to emphasise the importance of a ‘whole of loan life’ approach, rather than just focus on origination. Some noteworthy points include:
The cost of bank recognition of borrower hardship
The definition of restructured loans will expand. Currently, restructured loans are those where loan terms have been modified “for reasons related to the financial difficulties of an entity.” Under the draft standard this would expand to loans for which “a borrower is experiencing temporary financial difficulty or hardship in meeting its financial commitments.”
Further, the rehabilitation period – the length of time for which loans must meet those modified terms to be considered as performing – will increase from 6 months to 12 months, likewise increasing the time period in which a higher risk weighting penalty is applied.
These two measures have the potential to make it more expensive for banks that grant hardship relief. Applying a cost overlay if hardship relief is granted is probably technically sound, and conservative, but might surprise those who believe that banks should be encouraged to provide hardship relief, not penalised.
Use of covenants
The draft standard makes it mandatory for banks to consider the use of “covenants designed to limit the ADI’s exposure to changes in the future risk profile of the borrower.”
The most common covenants are based around financial ratios such as interest cover ratios and loan to valuation ratios. The use of such covenants was heavily criticised by another arm of government – the office of the Small Business Ombudsman – with the result that the 2019 Banking Code of Practice no longer allow banks to use them (except in relation to specialised lending) as an event of default.
It seems that lenders to small business might need to choose between complying with the draft APS220, and complying with their own Banking Code of Practice – because they may be unable to comply with both.
The discussion paper notes that the draft standard implements one of the recommendations of the Royal Commission, requiring valuations of agricultural land taken as security to:
take into account the likelihood of external events, such as drought and flood, which may impact the valuation of the land
Prior to the Royal Commission, valuations were widely understood to be point-in-time assessments of current value under current conditions, and were not thought to be estimates of future value. In most cases, reliance beyond a three month period from the date of valuation is specifically excluded by a written disclaimer.
It will be interesting to see how valuers respond to the change if it proceeds as proposed. Some may expand their reports to include commentary on the likelihood of external events for the three month period in which the valuations are “live.” Others may add (more!) boiler-plate text to make it even clearer than they do not provide a view as to future value.
The period for feedback closed on 28 June 2019. Market feedback suggests that further, less formal, consultation processes may already be underway.