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BFCSA: APRA and its Moral Hazard: "Bankers in 2005 do not require 100% mortgage insurance"

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Basel II and its implications for Securitisation in Australia
The implementation of Basel II in Australia has tremendous implications for the securitisation industry in this country. It has the potential to significantly shape the market, just like the original PSC2 was responsible for the widescale adoption by Australian banks of securitisation.
Basel II is scheduled to come into force at the end of 2007. Transactions closing now are likely to be affected by it and so it is important to start structuring with the new rules in mind so as to produce the optimal economic outcomes after 2007.
New Prudential Standards Implementing Basel II
On 11 April 2005, APRA released a discussion paper on its approach to credit risk and its new proposed Prudential Standard APS112 Capital Adequacy: Standardised Approach to Credit Risk. Written submissions on the proposed new Prudential Standard should be forwarded to APRA by 30 September 2005.
The Risk Weighting of Residential Mortgage Loans
The draft Prudential Standard provides new risk weightings for residential mortgage loans. APRA has rejected the Basel II Framework for two risk weights of 35% and 100%. The differential was too great and, in APRA's view, created an incentive to circumvent the capital requirements. Also, APRA felt that the increase in regulatory capital to 100% in one jump at an 80%+ LVR was a disproportionately large increase relative to the greater economic risk. ............
The new risk weights for residential mortgages are based on LVRsIn APRA's view the historical data shows a "strong significant relationship" between LVRs and the probability of default. APRA also provides for concessional risk weightings where the loan is mortgage insured. These are available if the first 40% of the loan is insured. ........
APRA did not require 100% mortgage insurance in order to be entitled to the concessional risk weighting. In its view, 100% mortgage insurance creates poor risk management incentives. The incentive to evaluate and monitor the loan is reduced when an ADI perceives that there is no risk to it of loss. This also creates "moral hazard" problems (though, this is not explained).  Interestingly, under APS 112 there will be no incentive from a capital perspective for ADIs to require 100% mortgage insurance............
APS 114 Capital Adequacy: Standardised Approach to Operational Risk
The need to hold capital against an ADI's operational risks is new and stems from the Basel II Framework.  Importantly when the new Prudential Standard comes into force capital will have to be held against the operational risks involved with securitisationAccordingly, ADIs involved in securitisation should expect from 2008 to hold additional capital in circumstances where at present this is not required...............
Operational risk is defined by the Prudential Standard as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. The definition includes legal risk (which in turn includes but is not limited to, exposures to fines, penalties or punitive damages resulting from supervisory actions as well as private settlements).Operational risk excludes strategic and reputational risk.  In addition to holding capital against operational risk, an ADI will be required to have in place a comprehensive risk management framework for operational risk. The requirements for managing operational risk by an ADI will be set out in a new Prudential Standard (as yet unpublished).
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