DRAFT

Prudential Standard

Credit Quality

Objective

This standard aims to ensure that all ADIs control credit risk by adopting prudentpractices with respect to the measurement and reporting of, and provisioning for,impaired assets. More broadly, it aims to promote the adoption of effective riskgrading systems for monitoring asset quality.

Principles

Overview

1. Credit risk – the risk of counterparty default – represents the single largestrisk facing an ADI. The presence of a well-functioning credit riskmanagement system is fundamental, therefore, to the safety and soundness ofan ADI. It is the responsibility of the board of directors (Board) andmanagement of an ADI to ensure that an effective credit risk managementsystem is in place and is appropriate to the needs of the institution concerned.In general, a credit risk management system should include methodologieswith respect to monitoring and grading credit quality, measuring assetimpairment, reporting impaired assets to APRA (and in published financialstatements), valuing security and provisioning.

2. An ADI should regularly review its credit risk management system, takingaccount of changing operating circumstances, activities and risks that it mayface. An ADI must inform APRA immediately of any concerns that it hasabout the overall level of its credit risk where this has the potential to impairthe capital adequacy of the institution.

DRAFT

2

3. A consistent approach to the measurement of credit risk (or asset quality) isat the heart of any good credit risk management system. Consistency isespecially critical when questions arise as to the value of assets held, or tothe ultimate collectibility of loans or other outstanding facilities to customersor related parties. Approaches to the measurement of credit risk should bealigned closely to the particulars of each ADI. The more complex thebusiness, the more reasonable it is to expect that sophisticated approaches tomeasurement of asset quality are being applied. Tailored approaches tomeasurement can also be applied where relatively simple asset portfolios areconcerned, particularly where historical data on loss or default are readilyavailable. In other cases, simpler approaches may be warranted.

4. Consistent measurement is especially important in determining appropriateprovisioning levels. Scope exists within the requirements described below(and set out in detail in the attached guidance notes) for more or lesssophisticated approaches to the determination of adequate provisions byADIs. APRA encourages institutions to apply more sophisticated or tailoredapproaches to provisioning. In some cases, however, where the cost of asophisticated approach may not be warranted, the Standard offers a moreformula-oriented alternative (see Guidance Note 1). In all cases, APRAreserves the right to assess proposed methodologies to ensure they areappropriately rigorous to the risks involved and/or comparable to bestpractice techniques in place elsewhere in the ADI sector.

Definition of Impaired Assets

5. Impaired assets are defined as all problem assets, including off-balance sheetexposures and assets brought to an ADI’s balance sheet through enforcementof security conditions. The impaired asset status should be appliedconsistently across multiple facilities extended to a single customer andacross facilities extended to related parties (where the ultimate collectibilityof principal and interest is compromised). Further details are provided inGuidance Note 2.

6. This Standard applies to exposures that are managed on an individual ortransaction basis, and those that are managed on a statistical or portfoliobasis. APRA will agree with each ADI the maximum value of individualfacilities which may be reported on a portfolio basis.

DRAFT

3

Classification of Impaired Assets

7. Impaired Assets should be recognised in three categories:

(a) non-accrual items - facilities against which a specific provision hasbeen struck, or a write-off taken (even if not in breach of the contractualrequirements), and facilities which are "90 days past due" where the"fair value" of the security is insufficient to cover payment of principaland accrued interest. The item can be restored to accrual status if itsubsequently becomes well-secured and there is no reasonable doubtabout the ultimate collectibility of principal and interest;

(b) restructured items - facilities rendered non-commercial because ofconcessional contractual changes related to financial difficulties of thecustomer. Restructured items are to be reclassified as non-accrual ifrecovery of principal and interest is in considerable doubt, or ifprovisions have subsequently been struck. A restructured item whichhas operated on non-concessional commercial terms for at least 6months may be restored to fully performing status; or

(c) other assets acquired through security enforcement, including other realestate owned.

Recognising Income on Non-Accrual Items

8. When an impaired asset is classified as non-accrual, an ADI should cease torecognise interest earned but not yet received, and any accrued but unpaidinterest should generally be reversed back to the last reporting date or thedate when interest was last paid, whichever is more recent. Unpaid interestdating back prior to the last reporting date should be reviewed to establishultimate collectibility and a provision against loss raised as appropriate.

Disclosure of Income Received on Impaired Assets

9. ADIs should disclose, separately, interest and fees received during the periodon non-accrual items, restructured items and income earned from assets

DRAFT

4

acquired through security enforcement, calculated from the date of theirclassification into that category or the first day of the reporting period.

Security Valuation

10. Each ADI should have appropriate policies, endorsed by its Board, forestablishing, recording and reviewing the value of securities held againstexposures. Security in the form of real estate and non-real estate assetsshould be valued, wherever possible, on the basis of its net current marketvalue, as defined in Guidance Note 3.

Provisioning

11. As part of its credit risk management system, an ADI should haveprovisioning policies covering the level of general and specific provisionsthat are needed to absorb estimated losses associated with the creditportfolio, and measure impaired assets, earnings and capital adequacycorrectly. The ADI’s Board should endorse these policies.

12. Estimates of credit losses should account for all significant factors that affectthe collectibility of the credit portfolio as at the evaluation date. The level ofgeneral and specific provisions should be reviewed regularly to ensure thatthe amount of provisioning is consistent with current expectations of creditlosses.

13. Where an ADI considers that the nature and scale of its operations do notwarrant the more sophisticated provisioning approach described inparagraphs 11 and 12 - or where APRA assesses the ADI’s capacity tomanage credit risk on this basis as inadequate - the ADI should apply theprovisioning framework outlined in Guidance Note 1.

Credit Risk Grading Systems

14. An ADI’s credit risk management policy should, where appropriate, includea well-structured credit risk grading system - endorsed by the Board andnotified to APRA - that provides for a systematic assessment of asset

DRAFT

5

quality and covers all individually managed commercial/corporate exposures.ADIs are not required to risk grade personal and other consumer bankingfacilities. An ADI should inform APRA if it undertakescommercial/corporate credit activities without a credit risk grading system.

Reporting

15. An ADI must provide APRA each quarter (or more frequently if required byAPRA) with information on asset quality in a form to be determined byAPRA from time to time.

DRAFT

Guidance Note 1

Prescribed Provisioning

Principles

1. This Guidance Note outlines the prescribed provisioning methodologyreferred to in paragraph 13 of the Standard.

2. Each ADI shall provide for, and report to APRA and in its publishedfinancial statements, prescribed provisions over four categories of in-arrearsfacilities as defined in this Guidance Note. The prescribed provisionscalculated will represent a minimum provisioning requirement. Where theBoard or management of an ADI believe that the prescribed provisionscalculated do not adequately address the expected loss outcome, they shouldraise further specific provisions. The prescribed provisions will depend onthe type of facility and "term of payments in-arrears" or "period ofirregularity".

“Term of payments in-arrears” is defined as the dollar value of contractualpayments of principal and/or interest in arrears for a given period of time.For example, if the dollar value of 150 days' worth of contractual paymentswere in arrears, then the amount of provision would be the amount under "91days and less than 182 days".

"Period of irregularity” is defined as the number of days for whichcontractual payments of principal and/or interest due on a revolving creditlimit are outstanding and/or the number of days where a revolving creditfacility is in excess of its authorised limit or a savings account is overdrawn.

3. Where a prescribed provision is raised against an exposure it shall berecorded as a specific provision, and the exposure reported as a non-accrualitem.

DRAFT

2

4. Where an exposure maintained by an ADI does not fall into the fourcategories of facilities outlined in this Guidance Note and is a problem asset,the amount of prescribed provision to be held against this item shall beagreed with APRA.

5. Except where otherwise stated security shall, for the purpose of thisGuidance Note, be valued at net current market value in accordance withparagraph 10 of the Standard.

6. An ADI subject to this Guidance Note is required to establish a generalprovision to address latent losses known to exist in its credit portfolio butwhich cannot be ascribed to individual facilities. Unless a variation isapproved by APRA, an ADI should raise an amount equal to at least 0.5 percent of total risk weighted credit risk assets as a general provision. This willform part of the eligible general provision for capital adequacy purposes.

Category One Facilities

7. Category one facilities include:

(a) an exposure that is secured by a registered first mortgage against aresidential building and is insured by an eligible lenders mortgageinsurer (defined in Prudential Standard on Capital) for 100 per cent ofthe outstanding balance;

(b) an exposure that is secured by a registered first mortgage against aresidential building, where the ratio of the outstanding balance, less theamount of mortgage insurance, to the valuation of the security is nomore than 80 per cent (where the exposure is 6 months or more in-arrears, the valuation must be no older than 12 months);

(c) an exposure that is secured by a qualifying registered second mortgagewhere

(i) the ratio of the outstanding balances of the facilities secured byboth mortgages to the valuation of the residential building doesnot exceed 80 per cent, and the first mortgage cannot be extendedwithout it being subordinated to the second mortgage; or

DRAFT

3

(ii) where the ratio of the outstanding balances of the facilitiessecured by both mortgages to the valuation of the residentialbuilding exceeds 80 per cent, and the first mortgage cannot beextended without it being subordinated to the second mortgage,and the outstanding balance is 100 per cent mortgage insured byan eligible lenders mortgage insurer (defined in PrudentialStandard on Capital).

8. No prescribed provisions shall be required for category one facilities.

Category Two Facilities

9. Category Two Facilities are defined as follows:

(a) an exposure that is secured by a registered first mortgage against aresidential building, where the ratio of the outstanding balance, less theamount of mortgage insurance, to the valuation of the security is greaterthan 80 per cent but no more than 100 per cent (where the loan is 6months or more in-arrears, the valuation must be no older than12 months).

10. For these facilities, the prescribed provision shall be a percentage of thebalance outstanding, where the percentage depends upon the “term ofpayments in-arrears”, as shown below.

Term of payments in-arrears Amount of Provision (%)Up to 90 days 091 days and less than 182 days 5183 days and less than 273 days 10274 days and less than 364 days 15365 days and over 20

11. Where the provision calculated under category two facilities is greater thanthe provision that would have been calculated under category three facilities,the latter shall be taken as the prescribed provision.

DRAFT

4

Category Three Facilities

12. This category applies to all facilities:

(a) that do not fall into categories one and two above, or category fourbelow. Unsecured and commercial loans, and mortgage loans wherethe ratio of the outstanding balance, less the amount of mortgageinsurance, to the valuation of the security is greater than 100 per cent, isincluded.

13. The minimum provision for these items shall be a percentage of the balanceoutstanding, where the percentage depends upon the “term of paymentsin-arrears”, as shown below.

Term of payments in-arrears Amount of Provision (%)Up to 90 days 091 days and less than 182 days 40183 days and less than 273 days 60274 days and less than 364 days 80365 days and over 100

14. Where an exposure is secured by a mortgage over a residential building, theprovision may be adjusted to reflect a part of the collateral value. When thisoccurs, the minimum provision percentage in the table above shall be appliedto the difference between the outstanding balance (less any loan insurance)and 70 per cent of the security value (where the exposure is 6 months ormore in-arrears, the valuation must be no older than 12 months). Where anexposure is secured by other real property, an ADI may approach APRA toagree on an appropriate discount for the security value.

15. Where an exposure is otherwise secured by equivalent or better securityarrangements than that described in paragraph 14 above, an ADI may onapplication to APRA, seek to have the provision adjusted to reflect the wholeor part of the collateral value. The following guidelines apply to thesesecurity arrangements:

DRAFT

5

(a) guarantees provided by Commonwealth or State Governments, orADIs, may be deducted from the exposure at full value prior toapplying the prescribed provisioning requirements;

(b) crown leases may be considered to be real property. Where anexposure is secured by a mortgage over a crown lease the outstandingbalance may be adjusted in accordance with paragraph 14 of thisGuidance Note;

(c) bank bills and Government securities held as collateral if subject toenforceable security in favour of the ADI, may be deducted from theexposure at full market value prior to applying the prescribedprovisioning requirements;

(d) cash on deposit with the ADI may only be deducted for the purposes ofprescribed provisioning where the deposits are secured by appropriatecontractual arrangements that satisfy the eligible collateral provisionscontained in the Prudential Standard on Capital. A right of offset is notconsidered to provide appropriate security per se.

Category Four Facilities

16. This category applies to overdrawn savings accounts and overdrawn limitson credit cards, overdrafts and line of credit advances. The minimumprovision on these items shall be a percentage of the balance outstanding,where the percentage depends on the “period of irregularity”, as shownbelow. In calculating the minimum provision for each item, except foroverdrawn savings accounts, the full amount of the credit drawn is to beincluded in the balance outstanding.

Period of Irregularity Amount of Provision (%)Up to 14 days 014 days and less than 90 days 4091 days and less 182 days 75183 days and over 100

DRAFT

6

Restructured Items, Assets Acquired Through Security Enforcement andOther Real Estate Owned

17. Prescribed provisioning does not apply to restructured items, assets acquiredthrough security enforcement and other real estate owned.

DRAFT

Guidance Note 2

Impaired Asset Definitions

Scope

1. The coverage of the Standard includes, but is not limited to, an ADI's lendingactivities, including retail facilities such as housing loans, personal loans,credit cards, personal finance, leases/hire purchase agreements, commercialfacilities such as business loans, commercial overdrafts, commercial bills,revolving credit lines, trade finance, agribusiness facilities, and institutionaland treasury credit exposures.

2. When a customer has multiple facilities and one is classified as impaired, theADI should place all other facilities to that customer on the same impairedstatus. Similarly, if an exposure to one of a group of related borrowers isclassified as impaired, the ADI should treat all facilities to related parties asimpaired. However, this is not required if:

(a) the various facilities are not cross-collateralised, and there are no crossguarantee arrangements between the related parties; or

(b) there are cross-collateral and guarantee arrangements but, in aggregate,there is sufficient security among the group of related parties to ensureultimate collectibility of all principal and interest.

3. The Standard addresses facilities managed on both an individual andportfolio basis. Exposures managed on a portfolio basis are typicallyhomogenous and often approved, and managed, using statistical managementtechniques. Any impaired facilities managed on a portfolio basis can remainon an accrual basis for up to 180 days. After 180 days ADIs should decidewhether they are prepared to subject the accounts to individual review or towrite them off. If they choose to conduct individual reviews, then the

DRAFT

2

facilities can remain on an accrual basis if the ADI is satisfied that thefacility is “well-secured” in terms of the definition outlined in paragraph 9 ofthis Guidance Note. Where the facility is not “well-secured”, the ADI shouldimmediately create the appropriate provision and move the facility to anon-accrual basis.

Treatment of Off-Balance Sheet Exposures

4. The principal off-balance sheet credit transactions to be captured by theStandard are likely to be direct credit substitutes and commitments.Guarantees and standby letters of credit are usually converted intoon-balance sheet exposures if the counterparty they are supporting fails butthere may be circumstances when the ADI is reasonably certain that suchinstruments will be called upon at a future date because of uncertainty aboutthe client. Loan commitments that are irrevocable should also be classifiedas impaired assets if the creditworthiness of the client has deteriorated to anextent that makes repayment of any loan drawdown (or associated interestpayments) doubtful.

5. Exposures arising from derivative transactions are also subject to theStandard. If a doubt arises as to whether an ADI will receive its cash flowentitlements from a counterparty to a derivative transaction, an ADI shouldtreat such an exposure as impaired. ADIs should calculate their derivativetransaction exposure to counterparties using the current exposure or“mark-to-market” method, or a method approved in advance by APRA.Potential exposure “add-ons” should reflect the nature of the individualexposure involved. Derivative transaction exposures should be revaluedregularly so as to measure current replacement value plus an allowance forthe potential exposure that could arise from movements in market rates.

Definitions of Impaired Assets

Non-Accrual Items

6. Non-accrual items should include all facilities against which a specificprovision has been established, or a write-off taken (except in the case ofrestructured facilities, and assets acquired through security enforcement)

DRAFT

3

even if the facility is not in breach of contractual requirements. The creationof a specific provision against an individually identified exposure gives riseto a sufficient degree of doubt about collectibility to warrant placing such afacility on a non-accrual basis. An ADI is expected to continue to raisespecific provisions against exposures on which it is still receiving interestand other payments but where the ADI may ultimately suffer a loss.

7. A facility is regarded as “90 days past due” where the exposure is in arrearsto the dollar value of 90 days worth of contractual payments of principaland/or interest. It will be recorded as a non-accrual item where the "fairvalue" of the security is insufficient to cover payment of principal andaccrued interest.

8. “Fair value” is defined as the amount that an asset could be exchanged forbetween a knowledgeable willing buyer and a knowledgeable willing sellerin an arm’s length transaction.

9. A “well-secured” exposure is defined as one that is “90 days past due”, andthe ADI judges that the “fair value” of associated security, discounted toallow for reasonable realisation costs, is sufficient to ensure that the ADI willrecover the outstanding principal and any accrued interest due. A“well-secured” facility shall be excluded from the definition of non-accrualitems.

10. In determining whether a facility should be classified as “well-secured” ADIsshould ensure that the coverage provided by the security will enable it torecoup all principal and interest on the exposure. In doing so, ADIs shouldalso take into account any additional interest that is likely to accrue until thefacility is settled. Security should include any arrangement that protects theADI from losing partially or fully the principal and/or interest on a facility.This will include mortgage insurance. It may also include cash collateral,guarantees, put options and interest servicing arrangements. Where a facilityis unsecured and “90 days past due”, it should be classified as non-accrual.

11. ADIs should place on a non-accrual basis any facility where there isreasonable doubt about the collectibility of principal and/or interest in aperiod not significantly longer than the term of the facility, irrespective ofwhether the customer concerned is currently in arrears or not. Thus, afacility should be classified as non-accruing earlier than 90 days where it isevident that full or partial recovery of the debt, including interest, is unlikely

DRAFT

4

even though the full extent of the loss cannot be clearly determined. Thiselement of the definition acknowledges the reality that recognition ofimpaired assets will always have a high degree of subjectivity attached to it.The definition covers the range of flexible financing facilities common in theAustralian financial system that may not be amenable to more prescriptiverules. It would, for example, encompass doubtful loans where repayment ofprincipal and interest occur only as a single payment at maturity; or largemoney market transactions where doubt about collectibility arisesimmediately settlement does not eventuate.

12. The definition of non-accrual items will also capture rural facilities whererepayment is dependent on returns from crop or livestock sales where failureto sell would immediately place loan repayments in doubt. However, itwould not include rural facilities where capitalisation or approved deferral ofinterest and/or further advances for working capital purposes during a badseason have been pre-arranged and approved through the normal creditapproval process.

13. Overdrafts that have remained continuously outside approved limits(including unadvised internally authorised excesses or extensions approvedas part of the initial credit extension process) for 90 or more consecutivedays, and which are not “well-secured” should be reported as non-accrualitems. The 90-day threshold should also be applied to unadvised limitsapproved as part of the normal credit extension process. Where an advisedlimit has been increased to accommodate higher business demand of a soundcustomer, the facility should not be reported as a non-accrual item, whereafter appropriate internal review, an ADI believes that the client can meet itsobligations under the higher limit.

Past Due Items

14. “Past due items” are those items that are “90 days past due” which are notclassified as impaired assets because they are "well-secured". An item shallcease to be classified as past due when arrears have been reduced so that theexposure is no longer “90 days past due”.

DRAFT

5

Restoring Non-Accrual Items to Accrual Status

15. Exposures classified as non-accrual due to being “90 days past due” may berestored to accrual status when:

(a) arrears have been reduced to below the dollar equivalent of 90 days'worth of contractual payments from the customer; and

(b) the ADI judges that the customer is capable of fully servicing its futureobligations under the facility.

A facility may also be restored to accrual status if it becomes “well-secured”.For exposures where interest is capitalised under the security buffer, ADIsshall ensure that there is a reasonable margin of comfort that would preventfacilities from slipping back to non-accrual status in the foreseeable future.

In each case, the underlying evidence should support the view that there is noreasonable doubt about the ultimate collectibility of principal or interest.This shall be appropriately documented in a written assessment thataddresses the current credit evaluation of the borrower’s financial conditionand other factors affecting prospects for repayment.

16. For revolving facilities, the clearance of excesses shall be sufficient toremove an item from the non-accrual category, provided the ADI judges thatthe customer is capable of fully servicing its future obligations under theexposure.

Restructured Items

17. A “restructured item” is defined as one in which the original contractualterms have been modified to provide for concessions of interest or principalfor reasons related to the financial difficulties of a customer. Whereconcessions are made to a customer that renders the facility “non-commercial” to the ADI, that facility shall be classified as a restructureditem. However, if the item is restructured so that it is fully expected that thecustomer will perform on terms that are considered by the ADI as similar tothose for new debt with similar risk, and no provisions are currently heldagainst the exposure, then it shall not be considered as a restructured item.

DRAFT

6

18. The following concessions can lead to an exposure being classified asrestructured:

(a) a reduction in the principal amount of the facility, or the amountpayable at maturity, as set down in the original loan agreement;

(b) a below market rate of interest;

(c) a reduction of accrued interest, including forgiveness of interest;

(d) a deferral or extension of interest and/or principal payments, includinginterest capitalisation; or

(e) an extension of the maturity date or dates at a stated interest rate lowerthan the current market rate for new debt with a similar risk.

19. For a facility to be classified as restructured, the ADI and customer shallformally agree to the new terms. Facilities that are “partially performing”but are not the subject of a formal agreement, shall be classified as non-accrual items. Each ADI shall have in place policies to identify, monitor andmanage restructured loans. Any restructuring of a loan or similar facilityshall be supported by a current, well-documented credit assessment of thecustomer’s financial condition and prospects for repayment under themodified terms. Renegotiation of a loan shall not be used to “hide” the poorquality of loan performance. Before any concession is made to a customer,the restructure shall receive prior approval from the appropriate level ofmanagement.

20. Restructurings required under the provisions of the Consumer Credit Codethat satisfy the concessions in paragraph 18 above are also included in thedefinition of restructured loans.

21. A non-Consumer Credit Code facility should not be reported as arestructured item, where it is placed on restructured terms for less thantwelve months due to temporary financial difficulty being experienced by thecustomer but where long term viability is unquestioned, eg a rural facilityencountering a bad season. The ADI should be confident that the customer is

DRAFT

7

able to fully perform with no loss of principal and the originally contractedamount of interest.

22. A restructured facility should yield a rate of interest that is equal to or greaterthan the ADI’s average cost of funds at the date of the restructuring. Theeffective interest rate being earned on restructured items should be calculatedby reference to the principal outstanding following restructuring (ie afterwrite-off, provisions or repayments in the form of assets or equity).Otherwise, the restructured facility should be classified as non-accrual. Asingle facility cannot be split into performing and non-performing parts inthe absence of a formal loan restructuring. If the facility cannot supportaccrual of all interest due under its terms and conditions, then it should beclassified as non-accrual.

23. If, after a restructuring, there still remains considerable doubt about recoveryof principal and/or interest, and the facility is not “well-secured”, it shall beregarded as a non-accrual item. If provisions are raised subsequent to therestructure, the facility shall also be classified as non-accrual.

Restoration of restructured items to full performing status

24. A restructured item may be returned to fully performing status when:

(a) the terms of the restructured facility are comparable with the marketterms required for a facility of comparable risk; and

(b) the restructured facility has operated in accordance withnon-concessional terms and conditions for a period of at least sixmonths.

25. In certain circumstances, sufficient evidence may exist to demonstraterelative improvement in the condition and debt service capacity of acustomer, apart from performance to date, which would warrant return toaccrual status prior to the six-months threshold. This might include thesigning of lease or rental contracts, or an equity injection. Where this occurs,and the terms of the restructured facility are comparable with the marketterms required for a facility of comparable risk, the ADI, following approvalfrom APRA, may return the facility to performing status.

DRAFT

8

26. A restructured item that has been re-classified as non-accrual shall revert torestructured status when all payments become fully current in terms of therestructured terms and conditions, and the appropriate level of managementhas determined that there is no reasonable doubt as to the ultimatecollectibility of principal and interest.

Assets Acquired Through Security Enforcement (Including Other Real EstateOwned)

27. These are defined as assets acquired by an ADI in full or partial settlement ofa loan or similar facility through enforcement of security arrangements. Thiscategory excludes “mortgagee in possession” assets. Assets reported in thesecategories should be recorded at their net current market values. For non-realestate assets, ADIs should apply an appropriate discount factor to net currentmarket value that addresses considerations such as market liquidity anddisposal costs.

Income Recognition and Disclosure

28. Where an ADI’s documentation stipulates the order of priority in which cashreceipts are to be treated, the ADI should follow that treatment, unlessagreement can be reached with the client to vary the requirements of thedocumentation. If loan documentation is silent, and in the absence of anylegislation, common law decisions, or regulations governing priority, cashreceived should be applied in the following priority:

(a) statutory charges;

(b) penalty interest and fees;

(c) overdue interest and fees;

(d) current interest and fees; and

(e) principal.

DRAFT

9

29. ADIs should disclose separately in their reporting of impaired assets:

(a) interest and fees brought to account during the period on non-accrualitems;

(b) income taken to account on restructured items;

(c) income earned from assets acquired through security enforcement; and

(d) income earned from other real estate owned.

Non-Accrual Facilities

30. Income taken to profit on a cash basis for non-accrual facilities should bedisaggregated according to whether a nil (or immaterial), partial, or fullpayment of interest has occurred under the relevant item. For non-accrualitems that continue to fully perform but on which a specific provision hasbeen raised, the income on these items should also be taken to profit on acash basis.

31. Where an ADI has calculated the recoverable amount of a facility byestimating future expected cash receipts from the customer and the cashreceived was anticipated in that calculation, and its receipt results in areduction in the remaining estimated recoverable amount of the facility (eg.because it represents proceeds from the sale of security), the balanceoutstanding on the facility should be reduced by the amount of the cashreceipt. However, where the cash receipt does not alter the previouslydetermined estimated future recoverable amount of the facility, the cashreceipt should be brought to account as income.

32. Interest on past due items should be accrued to income.

DRAFT

10

Restructured Items

33. Income on restructured items may be taken to income on either an accrual orcash basis. Given interest charged or received under either basis may be arate that is below market rates, and to determine the income drag from suchitems, ADIs should disclose the level of income accrued on aggregaterestructured facilities.

DRAFT

Guidance Note 3

Security Valuation and Provisioning

Security Value & Valuation Practices

The Value to Be Ascribed to Assets taken as Security

1. All assets taken as security by ADIs should be valued, wherever possible, onthe basis of net current market value. The definition of net current marketvalue is based on the definition of market value applied by the AustralianProperty Institute (API). The market vlaue is the estimated amount forwhich an asset should exchange on the date of valuation:

(a) in an arm’s length transaction;

(b) between a willing buyer and willing seller;

(c) after proper marketing; and

(d) wherein the parties had each acted knowledgeably, prudently andwithout compulsion.

2. From the market value, ADIs shall deduct the estimated costs of realising theproceeds of disposal. For those classes of security comprising non-real estateassets, ADIs shall apply an appropriate discount factor to addressconsiderations such as market liquidity, legal costs, impediments torealisation and prior charges before arriving at a net current market value.

3. The concept of “proper marketing” carries the implication that the propertybeing valued has been exposed to the market for a reasonable period of time.

DRAFT

2

ADIs should view this period as up to 12 months, although a longer period(up to a maximum of 24 months) may be adopted for specialised or unusualproperties when professional valuers advise that this is appropriate. For thepurposes of valuation, market conditions, and thus asset values, are assumedto remain static over the marketing period. To reinforce this point, marketingperiods are assumed to have elapsed at the date of valuation (ie should beretrospective), thereby eliminating any possibility for improved marketconditions to be factored into the valuations.

4. Property assets should generally be valued on the basis of existing use. Anyhigher value related to an alternative use or “element-of-hope” value arisingfrom prospects of redevelopment, and any possible increase in valueconsequent upon special investment or finance transactions, should bedisregarded.

5. In some circumstances, it may be difficult to determine the market value ofproperty assets, eg new properties, that have not yet achieved a stableincome, or properties that are experiencing drastic fluctuations in income. Insuch cases, a forecast of expected cash flows should be used to estimate thevalue of the property. The discount rates used in calculating the value ofsecurity should reflect the opportunity cost (determined by way ofcomparison with prevailing returns on competing investments) of holding theproperty, assuming a long term holding. Capitalisation rates should reflectreasonable expectations about the long term rate of return investors requireunder normal, orderly and sustainable market conditions.

6. Where security takes the form of a charge over non-property assets, whetherin the form of, say, fixed and floating charges and debenture mortgages overassets, or guarantees or cross-collateralisation arrangements involving thirdparties, ADIs should ensure that all relevant financial accounts are properlyscrutinised. Where information is provided by the client, asset values shouldbe objectively assessed to ensure security coverage is adequate. For thesereasons, ADIs should adopt a more conservative valuation procedure for thisclass of assets, for example, through the application of larger discount valuesto the estimated market values.

7. For all classes of assets, ADIs can adopt security values lower than the netcurrent market valuation to take account of any additional enforcement orcontingency costs, to build in assumptions about declines in security values,or to reflect other uncertainties that should prudently be recognised. These

DRAFT

3

methods should not be used as devices to understate earnings in the currentpeiod or overstate earrnings in future periods.

Disclosure of Security Position

8. In the reporting of asset quality, the value of security held againstnon-accrual items and restructured items should be separately disclosed.

Security Valuation Practices

9. ADIs should put in place procedures for establishing, recording andreviewing the value of loan securities. These should be linked to the loanassessment, approval and management process.

10. The assets to be taken as security should be accurately and completelyidentified, and documented in the loan documentation. The ADI’s creditadministration function should ensure that the relevant legal requirements aremet to maintain the ADI’s security position and to provide for itsenforcement.

11. Valuation of security should be undertaken prior to drawdown.

12. To provide for adequate security coverage over the exposure’s term, securityshould be periodically revalued through the life of the facility. Higher riskfacilities, eg those with a higher loan-to-valuation ratio or those involvingspecialised or non-standard security, should be subject to more frequentreview. Revaluation review processes should be structured so that they canbe activated to address adverse market developments that impact particularasset classes or business lines.

13. Valuation of security may be conducted by internal valuers or externalexperts. In both cases, an ADI should ensure that the valuers engaged havethe appropriate expertise to appraise the range of asset classes that the ADI iswilling to take as security. Where both internal staff and external valuers areused by an ADI, responsibility for each category of security valuation shouldbe outlined.

DRAFT

4

14. Where an ADI relies on external expertise for its security valuation needs, itshould establish a panel of valuers. Factors to be considered in the selectionof the panel include:

(a) professional qualifications;

(b) relevant experience (including local knowledge);

(c) breadth of expertise to cover both standard and specialised securityassessments; and

(d) appropriate professional insurances.

15. Each valuation request should be the subject of specific instructions to thevaluer. These instructions should cover issues such as: valuation purpose;valuation basis required; valuation for insurance purposes; valuation method;market summary/commentary; and form of report required. ADIs should notaccept valuations instructed by a third party.

16. Valuation reports should based on the standard format advocated by the API,or equivalent offshore bodies. ADIs should adopt the valuation standardsand practices of the API, or equivalent offshore bodies, in their securityvaluation framework.

17. ADIs should put in place review mechanisms to ensure the quality of thevaluation processes. These may involve internal reviews of valuations byappropriate management or audit staff, and formal reviews by anindependent valuer;

18. Where APRA assesses that the valuation practices being applied by an ADIresult in the incorrect measurement of impaired assets, earnings or capital, itwill discuss its concerns with the ADI. Following discussions between anADI and APRA, an ADI may be required to adjust its valuationmethodologies and/or practices.

DRAFT

5

Provisioning Practices

19. ADIs should have sound provisioning policies to ensure adequateprovisioning against all problem exposures. At the minimum, an ADI'sprovisioning policy should cover both specific and general provisions.

Specific Provisions

20. Credit deterioration in individually identified loans should be recognised in atimely manner through the establishment of specific provisions or through acharge for bad debts. The determination of specific provisions against anidentifiable impaired asset should take into account all relevant informationsuch as the economic situation and solvency of the borrower, theenforceability of guarantees and the current value of collateral. Theassessment of security should take into account the time, costs anddifficulties in obtaining repayment from such sources. When establishingspecific provisions, ADIs should not understate or overstate loan losses inorder to achieve a desired level of earnings in current or future reportingperiods. ADIs should adopt the following parameters when determiningspecific provisions:

(a) where facilities are managed on an individual basis, the specificprovision should equal the face value of the exposure less the netcurrent market value of security as defined in paragraph 1 of thisguidance note;

(b) when an ADI does not take security for facilities, relying instead onsustainable cash flow from the borrower’s business or the existence ofunencumbered assets of the borrower (perhaps under a negative pledgearrangement), it may take into account the underlying value of abusiness and/or its unencumbered assets in calculating the level ofspecific provisions. However, the ADI should ensure the assets inquestion are freely available to satisfy the debt due to it and that theassets are valued on a basis consistent with net current market value;

(c) for derivative transactions, ADIs should generally create a provision ortake a charge against profit, equal to the full amount of the currentcredit exposure and potential credit exposure. Potential exposure

DRAFT

6

‘add-ons’ should reflect the nature of the individual exposure involved;and

(d) where portfolio managed facilities exist, provisions may be determinedon a portfolio basis using an appropriate formulae approach. Theformulae approach should take into consideration factors such as ananalysis of arrears, ageing of balances, and past loss experience. Whena portfolio facility is subsequently managed on an individual basis, thelevel of specific provisioning should follow the parameters outlinedabove.

General Provisions

21. A general provision should be established to address latent losses known toexist in the credit portfolio but which cannot be ascribed to individualfacilities. When creating and determining the level of general provisions, anADI should consider the following:

(a) the general provision should not act as a substitute for the establishmentof adequate specific provisions or the recording of an appropriatecharge-off for bad debts. As soon as adequate information is availableto identify losses on individually impaired facilities, a suitable specificprovision or charge-off for bad debts should replace the generalprovision;

(b) the general provision should be calculated in a prudent andconservative, but not excessive manner, so that it addresses anacceptable range of estimated losses. Estimates for the generalprovision should be based on systematic assessments, be welldocumented and appropriately supported;

(c) the estimate of latent credit losses known to exist in the credit portfolioshould reflect consideration of all significant factors that affect thecollectibility of the loan portfolio as of the assessment date. Theseshould not be confined to historical loss experience and recent trends inlosses but should also consider any current factors that are likely tocause losses associated with the ADI’s portfolio to differ fromhistorical experience. These may include:

DRAFT

7

(i) amendments to lending policies and procedures;

(ii) changes in the ADI’s risk profile as a whole;

(iii) developments in economic, business, market and regulatoryconditions that impact an ADI’s target markets;

(iv) changes in the trend, volume and severity of impaired assets andpast due exposures; and

(v) the existence, and effect, of any concentrations of credit, andchanges in the level of such concentrations.

(d) general provisions can be determined by using one or several differentmethodologies including:

(i) applying a formula to a portfolio that takes into account factorssuch as the analysis of arrears, ageing of balances, past lossexperience, and current economic conditions;

(ii) migration analysis;

(iii) the use of statistical applications; and

(iv) estimating impairment in the consolidated group based on anADI’s judgement of the impact of recent events and changes ineconomic conditions on credit activities.

The application of the above methodologies to the credit portfolioshould be consistent with the nature and scale of an ADI’s creditoperations and management information systems. An ADI shouldreview assumptions incorporated within such methodologies againstactual experience at regular intervals.

22. While the level of general provisions will need to reflect the above variables,APRA would view 0.5 per cent of total risk weighted credit risk assets as a

DRAFT

8

benchmark against which it will assess the adequacy of an ADI’s generalprovision for credit activities.

23. Where APRA assesses that the level of general and/or specific provisionsgenerated by an ADI’s own methodology is not adequately reflecting lossexpectations in the credit portfolio, nor correctly measuring impaired assets,earnings or capital adequacy, it will discuss these concerns with the ADI.Following discussions between an ADI and APRA, the ADI may be requiredto adjust its level of general and/or specific provisions and/or amend itsprovisioning methodologies.

Disclosure of Specific Provisions on Impaired Assets

24. ADIs should provide a disaggregation of non-accrual and restructured itemson the basis of whether or not a specific provision has been raised against thefacility concerned. An ADI should also disclose the aggregate level ofspecific provisions held against total impaired assets, and disclose separatelyspecific provisions for:

(a) non-accrual items;

(b) restructured items;

(c) assets acquired through security enforcement; and

(d) other real estate owned.

25. For non-accrual items, specific provisions should be disaggregated accordingto whether a facility is non-performing, partially performing or fullyperforming.

26. Specific provisions on portfolio facilities that are effectively 90 to 180 daysin arrears and that continue to be maintained on a portfolio basis should beseparately disclosed.

DRAFT

9

27. Specific provisions for off-balance sheet exposures do not generally appearin the totals of either specific or general provisions disclosed in an ADI’sfinancial statements but are often included in “other liabilities” and aredisclosed as part of the notes to the accounts. For the purposes of reportingon asset quality to APRA, these are to be reported under the heading ofspecific provisions.

DRAFT

Guidance Note 4

Credit Risk Grading Systems

Introduction

1. Credit risk grading systems offer a number of benefits that provide for amore systematic assessment of an ADI’s asset quality and credit strategy.The benefits include:

(a) the provision of insights into the quality of an ADI’s credit portfolioand its risk appetite at a point in time;

(b) the ability to undertake migration analysis that can highlight changes inthe risk profile and trends in asset quality;

(c) acting as an early warning system for the detection of asset qualityproblems by highlighting credits with above normal risks. This oftenallows for special monitoring of such facilities, and enables thedevelopment of strategies to eliminate any weaknesses;

(d) being applied as a basis for more sophisticated provisioningmethodologies;

(e) providing a foundation for risk-based pricing mechanisms; and

(f) being used as a portfolio management tool, especially when combinedwith applications that can identify degrees of risks associated withlending on an industry, geographic or counterparty basis.

DRAFT

2

Form of Credit Risk Grading Systems

2. APRA does not favour the imposition of a standard credit risk gradingsystem for all ADIs. Rather, APRA will rely upon the system adopted byeach ADI. For ADIs intending to implement a system and those that wish toupgrade their credit functions, some factors that should be consideredinclude:

(a) as a minimum, the system should cover the individually managedcommercial/corporate lending activity of the ADI, including associatedoff-balance sheet exposures. It does not need to capture personal andother consumer banking business but a system that can objectivelycover greater amounts of an ADI’s activity would deliver more of thebenefits outlined in paragraph 1. Where ADIs undertakecommercial/corporate activity managed on a portfolio basis, they maywish to include the aggregate exposures within one or more risk bands;

(b) whether the system should focus on the risks involved with thecounterparty only, and/or the risks of the facility extended;

(c) for applicable exposures, the system should cover both performing andimpaired assets to provide for the migration of an exposure from fullyperforming to loss status;

(d) exposures involving related parties should be classified on a group basisas described in paragraph 5 of the Standard;

(e) procedures for the regular independent review of the determination ofcriteria supporting credit risk grades and the number of credit riskgrades incorporated within the system;

(f) there should be sufficient risk grades, usually 10 or more, to ensure thatthe system captures graduation of risk; and

(g) poorer quality facilities should at least include four categories along thelines indicated below:

DRAFT

3

(i) special mention, where clients are experiencing difficultieswhich, if they persisted, could result in losses – such clientsshould be subject to special monitoring, including more frequentreview and management scrutiny;

(ii) substandard, where definable weaknesses are evident whichcould jeopardise repayment, particularly of interest - the ADI isrelying heavily on available security;

(iii) doubtful, where the situation has deteriorated to such a degreethat collection of the facility amount in full is improbable and theADI expects to sustain a loss; and

(iv) loss, where facilities are considered uncollectible within areasonable time frame – this should be viewed as a transitionalcategory for facilities which have been identified as requiringwrite-off during the current accounting period.

Link Between the Credit Risk Grading and ImpairedAsset Reporting

3. Greater consistency, and some operational efficiencies, can be achievedwhere ADIs establish links between their systems and APRA guidelines formeasurement and reporting of impaired assets. By way of example, facilitiesthat are on a non-accrual basis would normally be classified as “doubtful” ina credit risk grading system while facilities that have been restructured wouldnormally be classified as “substandard”. For ease of classification, ADIsmay choose to establish automatic links between risk grades and impairedasset reporting. It is recognised, however, that there will not always be adirect correlation between the two, and some flexibility is necessary whenestablishing these links. Where relevant, APRA may discuss suchinconsistencies with an individual ADI.

DRAFT

4

Internal Reporting and Reporting to APRA

4. Internal management and Board reporting should seek to take the maximumadvantage of an ADI’s credit risk grading system. Appropriate reportsshould be generated regularly.

5. Each ADI is required to submit to APRA a quarterly break-down of its assetportfolio by credit risk grading in a format consistent with that used forinternal management information purposes. The amount of provisions heldagainst the various categories of poorer quality facilities should also beshown. The submission should be made in conjunction with the ADI’squarterly reporting of asset quality.

DRAFT

Guidance Note 5

Summary of Disclosure RequirementsBalance

Outstanding($m)

SpecificProvisions

($m)Impaired Assets1. Non-accrual items

(i) without provisions(ii) with provisions and non or partial

performance(iii) with provisions and full performance

xxx

xx

2. Restructured items(i) without provisions(ii) with provisions

xx

x3. Other real estate owned x x4. Other assets acquired through security

enforcement x x

5. Total impaired assets x x6. Past due items not included above x

DRAFT

2

Income received on impaired assetsBalance

Outstanding($m)

Interest andOther Income

($m)7. Non-accrual items

(i) no performance(ii) partial performance

(iii) full performance

Xx x

xx x

8. Restructured items x x

9. Other real estate owned x x

10. Other assets acquired through securityenforcement

x x