Today, the Australian Prudential Regulation Authority (APRA) has issued a letter to locally incorporated authorised deposit-taking institutions (ADIs) that don’t apply prescribed provisioning under Prudential Standard APS 220 Credit Risk Management (APS 220).

This letter shares some observations and guidance on the application of expected credit loss (ECL) provisioning, especially in the current macro-economic environment.

ADIs should be mindful of three key areas of provisioning practices that are addressed:

1.    Controls around model risk management

APRA expects ADIs to have strong controls and governance when making judgment-based adjustments to account for model and data limitations, such as minimal loss experience historically. Alongside this, APRA expects ongoing monitoring and improvement of credit quality assessments and provisioning models.

2.    Capturing economic uncertainty

APRA expects ADIs to regularly and promptly conduct thorough sensitivity analysis on their credit portfolios. This helps them understand how macro-economic changes impact borrowers and determine appropriate provisioning levels. This analysis should be integrated to ADI’s overall stress testing, ICAAP and risk appetite review processes.

3.    Identifying credit deterioration in vulnerable sectors and borrowers

APRA requires ADIs to establish systematic processes to identify vulnerable sectors and integrate sector-specific risks into loss estimates. These processes should involve collective assessments, models and data segmentation, and the indicators used to transfer loans in vulnerable sectors into impairment Stage 2 under Accounting Standard AASB 9 Financial Instruments.

Next steps

APRA will continue to monitor how ADIs assess credit risk, set provisions and will be in touch with ADIs as part of their supervision efforts.

This aligns with APRA’s strategy to modernise the prudential rules as new risks arise. The letter also mentions the July 2023 newsletter from the Basel Committee on Banking Supervision newsletter on credit risk issues, which APRA expects ADIs to consider.

To find out more about how this impacts your organisation, join our online Expected Credit Loss modelling workshop on 8 November.