Capital adequacy requirements for farm lending FAQs
The four largest locally-incorporated banks were accredited to use their own internal models as a basis for determining their regulatory capital requirements under the Basel II regime that came into effect in 2008. All other locally-incorporated banks are required to comply with the more prescriptive Basel II capital adequacy framework known as the Standardised Approach.
The Reserve Bank advised the internal models (IM) banks at the time they were accredited that their farm lending models were inadequate and would be reviewed post-accreditation. In some cases it was necessary to require banks to hold a capital overlay (additional capital) pending this further work.
Changes have now been made to the IM bank capital adequacy framework to ensure that the risk associated with farm loans is properly measured.
Changes have been made to better take account of:
- the possibility of large falls in farm land prices;
- the amount of diversification in farm lending portfolios (i.e. the extent to which individual loan losses within a portfolio are correlated); and
- the contractual term of farm loans (previously shorter term loans carried lower risk weights, but the Reserve Bank has concluded that this was overstated as a risk mitigant).
Risk weights are a component of the calculation used to determine the amount of regulatory capital a bank should hold. Higher risk weights translate to high regulatory capital requirements.
The new rules will impact on the risk weights for farm loans.
This Reserve Bank Bulletin article (box 2, page 9), provides more information on how capital requirements are calculated.
The precise impact of the changes on each bank will vary depending on the make-up of their rural lending portfolio, as the exact risk weight applied varies with the risk level of individual loans (e.g. the risk weights are lower for low loan-to-value ratio loans compared to high loan–to-value loans).
The IM banks’ internal models initially calculated risk-weights of around 50 percent. However given the capital overlays noted above and the banks’ own changing view of risk in recent years, existing risk weights are generally more conservative than the banks’ starting point under the Basel II regime. From 30 June 2011, the Reserve Bank expects the system average risk weight for IM banks’ farm loans to be between 80 to 90 percent.
The Standardised Approach prescribes a risk weight of 100 percent for corporate farm loans.
Prior to 2008, all locally-incorporated banks were subject to the Basel I capital regime that prescribed a risk weight of 100 percent for all corporate loans. This regime was in place for nearly 20 years.
The Reserve Bank changes have been well signalled and anticipated by the banks and as noted above the banks’ own view of risk has changed in recent years.
However, the pricing of lending is a matter for banks, which make their own decisions based on a number of considerations, of which regulatory capital is only one.
More information about the potential pricing impact is available in this Bulletin article.