In a letter to the authorized deposit-taking institutions, APRA issued guidance on the management of risks associated with indemnities in divestment transactions. The principles in the guidance on prudent management and oversight apply equally to all other APRA-regulated industries, where similar risks are faced. APRA expects the Board to review and approve, as part of the oversight of significant transactions, indemnities that give rise to a material contingent liability for an institution. The guidance specifies that an appropriate level of capital should be held for such risk exposures.
In recent months, APRA has been in discussion with several deposit-taking institutions on indemnities provided to acquiring entities as part of divestment transactions. While indemnities are not a new feature of merger and acquisition activity, their scope and nature appears to be shifting in focus, particularly as entities manage matters of conduct and customer redress. Without appropriate controls, these indemnities can expose institutions to potentially significant liabilities. Thus, APRA expects the following from the authorized deposit-taking institutions:
- Indemnities are capped and timebound, as uncapped indemnities are inconsistent with the prudential requirements for authorized deposit-taking institutions that prohibit unlimited exposures.
- Indemnity types are clearly distinguished, to reflect the difference in risk profile of the underlying exposures. This is important for identifying, recording, and monitoring the risk, capital treatment, and management approach.
- Governance arrangements and accountabilities are clearly defined and implemented to ensure appropriate oversight and controls around indemnities, both in setting them and monitoring and influencing the underlying risks post-transaction.
- Institutions should assess the need to provision for each material indemnity, both at inception and during the life of the indemnity, having regard to the likelihood that the indemnity will be called upon.
- Institutions must hold an appropriate and commensurate level of operational risk capital for the financial risks associated with indemnities. They should also engage APRA to demonstrate the appropriateness of intended operational risk capital treatment for current or prospective material indemnities. Where this does not appropriately reflect the level of risk, APRA will consider an adjustment to operational risk capital requirements
- Institutions should consider gaining independent assessment and validation of provisioning and capital for material indemnities.
Keywords: Asia Pacific, Australia, Banking, Divestment Transactions, Governance, Operational Risk, Basel, Capital Requirements, APRA
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