Canada’s government has this week decided introduce new banking regulations.
From mid April borrowers in Canada will have loans assessed as if they were taking out a five-year, fixed-rate mortgage, for which rates are higher than on shorter, variable-rate loan.
Equity withdrawals will also be limited where someone refinances, with an upper limit on refinancing of 90 per cent of the loan to valuation ratio.
There will also be a floor of 20 per cent on deposit required on some investment loans deemed “speculative” and where the loan is supported by the Canadian Mortgage Housing Corporation.
APRA has announced that it is looking to introduce prescribed liquidity requirements for Aussie Banks. Its early days, but it appears the proposal is that banks would be allowed to count only government and semi-government bonds as liquid assets.
Effectively, Banks will have restraints on other bank paper or bank bills in their liquid assets – funds lent between banks. APRA have concerns that these funds are correlated in the event of a banking crisis. There is concern on the impact this will have on the bank bill swap rate.
Financial institutions have been taking on more complex types of credit risk than ever before resulting in the need to be able to manage credit risk more effectively. Credit risk modeling enables these institutions to estimate how much credit is ‘at risk’ in the event of default or due to changes in credit risk factors. By doing so, it enables them to price the credit risks they face more effectively and also helps them to calculate how much capital they need to set aside to protect against such risks.
Traditionally, Banks make credit decisions on an individual basis, by utilising debt servicing ratios, financial statement ratios, credit bureau history and external credit ratings. However, more sophisticated Banks now utilise models that can credit score a loan application based upon the application details and comparing these details with previous loan applications and the subsequent performance of these similar applications.
In addition to credit scoring, credit risk models can also assess the loan application on a portfolio basis. Whilst a credit score might be low, the model could determine that the granting of the loan would not adversly affect the portfolio as the new loan is not highly correlated to the existing portfolio. Read the rest of this entry »
Securitisation is the process of converting tranches of assets, such as residential mortgages, into tradeable securities. Some banks securitise components of their loans for the following reasons;
- Reduce their regulatory capital requirement
- Achieves a lower cost funding source
- Transfers their portfolio credit risk
- Liquidity management
Securitisation options are either “traditional” or “synthetic”.
The traditional method requires the bank to sell tranches of loans to a SPV, the SPV then issues securities, most commonly these are referred to as Mortgage Backed Securities (MBS) or Asset Backed Securities (ABS). The securities come with a credit rating based on the quality of the securities.
Synthetic securitisation involves the use of credit derivatives, where the bank transfers the credit risk by using a derivative instrument, but the exposure itself remains with the bank. This type of derivative is referred to as a credit default swap (CDS).
NZ Banks have been relunctant to utilise securitsation vehicles in the past but have preferred to hold assets on balance sheet. Recently however, some banks have arranged tranches of MBS under the RBNZ facility who agreed to purchase (repo facility) these assets as a result of the recent liquidity crisis. The Australian market for securitsation is a lot more developed.
There are some “rules” around Banks holding capital for “first loss positions” under securitisation plus there are accounting rules around securitised loan books being held “on balance sheet”. I’d be keen on hearing from anyone who can elaborate on these rules – otherwise, Ill attempt to cover them off at a later point.
The following is a policy guide on appropriate employment and income evidence requirements to support personal lending:
PAYE – Full time
100% of the gross monthly income may be utilised for DTI calculation purposes subject to:
Borrower must be employed by current employer for twelve (12) months or more, alternatively a borrower may be employed by their current employer for six (6) months or more provided they have been consistently employed within the same industry for twenty four (24) months or more.
Applicants must provide two of the following to support their income
o Two of the most recent consecutive payslips or employment contract
o Most recent bank statements evidencing a minimum of 2 months worth of income being credited to the account
o Most recent PAYE tax summary
PAYE – Additional Income (Overtime, Shift allowance, Commissions, Bonuses, Car allowance)
The average gross monthly additional income received over the past 2 years may be utilised for DTI calculation purposes – However, if the additional income has been available for more than 12 months but less than 24 months, only 50% of the average gross monthly income may be utilised for DTI calculations; subject to:
Overtime is considered to be additional income to a standard 40 hour working week.
The income must be consistently received over the assessed period and be a condition of their employment.
Applicants must provide all of the following
o Two of the most recent consecutive payslips or employment contract
o Most recent bank statements evidencing a minimum of 2 months worth of income being credited to the account
o Last two year’s PAYE tax returns for each applicant
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UPDATE: Standard & Poor’s Ratings Services said today (26 Nov) that Australian major banks’ AA/Stable ratings remained unchanged in the context of recently released research on our risk-adjusted capital framework (RACF). “While Australian banks’ RAC scores are close to or slightly higher than the global average for major banks, and capital is a slight weakness to the rating profile, we consider the ‘AA’ ratings as stable and supported by other very strong business and financial considerations, as well as the evidenced flexibility to raise capital if needed,” said Standard & Poor’s credit analyst Michael Vine.
…
S&P have just developed a new risk-adjusted capital framework (RACF). Their RACF aims to provide a measure that is independent from national regulations, Basel II methodological options, and banks’ internal risk measurement systems, as well as being consistent across banks and geographic regions.
They found that the average estimated RAC ratio for large international banks was 6.7% as of June 30, 2009, more than three percentage points below their average Tier 1 ratios. Of three lenders included in the review, ANZ scored the highest rating with 7.1%. National Australia Bank was at 6.9% and Commonwealth Bank at 6.3%, the top-rated global bank was HSBC on 9.2%,
Read their report here
I had to cringe when I saw the following job recently advertised. This would be one of the primary reasons why we have seen so many failures in the Finance Company sector in NZ. There needs to be a clear segregation of duties between sales and credit.
I have just read a interesting article from the Harvard Business Review, most of their articles are “pay per view”, but this was a free one. The most interesting part for me was a small segment on the models used for assessing risk.
Pretty obvious stuff, but some of the comments were:
Models are not decision makers; people are – the issue you have is the culture around modelling.
There are 2 type of risk managers; Quantitive enthusiasts who believe in two types of risks – ones that have been successfully modelled and ones that haven’t. The other type of risk managers are quantitive sceptics who overemphasize the weakness of risk models.
I actually think I sit in the middle – I certainly appreciate the effectiveness, the low cost and high speed delivery that decisioning models provide but also acknowledge that fundamental credit analysis is best performed by professional credit analysts. The question is; have the Banks lost access to these professionals over recent times with the heavier reliance on models.
The pitfall for models is obviously the models reliance on a stable relationship between the input data and the credit risk, often this relationship is determined by past events. Relationships that seem stable during benign conditions may not be so during times of stress. Of course the qualitative nature of risk analysts also have pitfalls, such as the inconsistent views for one analyst to another and the ability to be influenced by emotional (or other) factors.
The key for Banks will be the right blend of well calibrated and consistently validated models with a good level of seasoned professional experts utilising sound judgement.
This is a short post to highlight the different loss provisioning principles between IFRS and Basel.
Basel objectives are to ensure the Bank has sufficient provisions to absorb “expected losses” and sufficient capital to absorb “unexpected losses”.
IFRS objectives are to ensure that the financial statements of the bank reflect the true financial position of the company at each “balance sheet date” – this includes loss provisions that recognize a trigger event that has already occurred that will lead to a loss.
The different requirements are a “bit of a headache” for Banks. The Basel requirement and hence the regulatory requirement is forward looking and is premised on past experiences predicting future losses – in order to undertake this exercise, Banks have generally spent millions of dollars establishing sophisticated models to calculate expected loss. These models can’t always be utilized for IFRS purposes and Banks have to either modify their regulatory models or build alternative models.
This is a high level review of loan provisioning – the recognition of potential losses is prescibed in both the Basel accord and IAS 39 (International Accounting Standards).
Note. IFRS 9 (Intl Financal Reporting Standards) is soon to replace IAS 39 and uses a single approach to determine whether a financial asset is measured at “amortized cost” or “fair value” and requires a single impairment method to be used.
Loan loss provisions are funds set aside to cover bank’s losses and ensure that both income and capital are correctly reported in the bank’s books.
In small $ loan portfolios with similar risk characteristics, loan loss provisions are estimated by using historical loss information as the starting point, which can then be tweaked dependant of external factors – such as the unemployment rate movements – these provisions are referred to as “collective provisions”
For large $ loans, a bank makes individual assessment of the likely loss, which includes an evaluation of the borrowers financial position, any guarantees and their likley value and the likely realisable value of security – these provisions are referred to as “individual provisions”
Provisions are then accounted for based upon the bank’s estimate of loss on what has occured and what is likely to occur.
When provisions are “raised” they are financially treated as an expense to the bank – which ultimately impact on shareholders equity/capital. The asset (loan portfolio) is subsequently recorded at its net value.
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