Weak governance when it comes to ‘related-party dealings’ can lead to financial reputational damage. This is the position of the Australian Prudential and Regulation Authority (APRA) and the reason behind their released Discussion Paper: Revisions to the related entities framework for ADIs, which details proposed updates to the related parties’ frameworks for authorised deposit-taking institutions (ADIs). In an official statement, the prudential regulator said some of the proposals to ‘modernise’ the framework include:
broadening the definition of related entities to include substantial shareholders, individual board directors and other related individuals;
explicitly addressing ‘step-in risk’ by incorporating guidance from the Basel Committee on Banking Supervision;
tightening certain limits on exposure to related entities in line with limits on exposures to unrelated entities in the revised APS 221 (which deals with exposures to unrelated parties);
removing the ability for certain overseas subsidiaries to be consolidated with the standalone ADI for prudential purposes; and
updating existing reporting requirements to align with the changes to the framework.
The paper suggests that the definition of any related entity should be in line with the Basel Committee’s Core Principles for effective Banking supervision. Definition A related entity of an ADI includes, but is not limited to, any of the following:
an associate of the ADI (within the meaning given in section 50 AAA of the Corporations Act 2001);
an entity which is directly or indirectly controlled by the ADI, and any of the entity’s associates;
an entity which directly or indirectly controls the ADI, and any of the entity’s associates;
a substantial shareholder of the ADI and the substantial shareholder’s associates;
a related individual of the ADI and the related individual’s relatives, and their associates; and
an entity that exposes the ADI to step-in risk to an extent that the ADI’s capital or liquidity positions would be materially impacted if the ADI were to step in to support the entity.
The proposed definition recognises the cash flow between multiple channels and this further than current definition under the current APS 222 which defines it as:
an ADI (other than subsidiaries that form part of the ELE); or
the ultimate domestic parent of an ADI (including the parent entity itself).
The paper noted that the global financial crisis highlighted some weaknesses when it comes to prudential control, and that weaknesses can expose ADIs to ‘substantial contagion’ risks:
Financial contagion: an ADI may have a concentration of exposures to its related entities. This has the potential to cause significant losses to the ADI, particularly if one or more of its related entities that share common sources of risk were to face significant difficulties. This risk is exacerbated by the potential for conflicts of interest to arise during the origination or ongoing management of an exposure to a related entity.
Reputational contagion: where an ADI’s group members face operational or financial difficulties, investors may perceive that the group member is the ADI or the ADI may step in to support its group members beyond formal legal arrangements. This is exacerbated where group members share a common brand name with the ADI and may also occur where an ADI has a material business association with another entity.
Other avenues of contagion: conflicts of interest that may lead to relaxing of risk controls and oversight for transactions with related entities; complex group structures that negatively impact the ability of an ADI’s subsidiaries to be resolved in a sound and timely manner; operational risks arising from the sharing of management and other service arrangements; the purchase or sale of assets in relation to related entities; and the transfer of risk through credit risk mitigation.
According to the discussion paper:
APRA is cognisant of the impact these reforms may have on ADIs and is particularly interested in receiving feedback on whether the proposed reforms best meet APRA’s mandate to improve financial safety and financial system stability without material adverse impacts on efficiency or competition. ADIs are encouraged to provide alternative proposals where it is considered that an alternative will better meet the prudential objectives. The consultation period for this paper is open until 28 September. The final frameworks are expected to be in place on 1 January, 2020. Click here to read discussion paper.