Credit Risk Guidelines 2024

1 REGISTRAR OF FINANCIAL INSTITUTIONS CREDIT RISK GUIDELINES BANK SUPERVISION DEPARTMENT DECEMBER 2024

2 Contents PART I- PRELIMINARY....................................................................................................... 3 1 MANDATE .................................................................................................................... 3 2 OBJECTIVE.................................................................................................................. 3 3 SCOPE OF APPLICATION........................................................................................ 3 4 DEFINITIONS .............................................................................................................. 3 PART II – MEASURING CREDIT RISK............................................................................. 5 5 APPROACHES ............................................................................................................. 5 6 THE STANDARDISED APPROACH (SA) ............................................................... 5 7 CREDIT RISK WEIGHTED ASSETS....................................................................... 7 8 DUE DILIGENCE REQUIREMENTS....................................................................... 8 9 CLASSIFICATION OF EXPOSURES....................................................................... 8 10 RISK WEIGHTS FOR EXPOSURES ........................................................................ 9 11 CREDIT RISK MITIGATION TECHNIQUES ...................................................... 29 12 CAPITAL CHARGE FOR CREDIT RISK.............................................................. 33

3 PART I- PRELIMINARY 1 MANDATE These guidelines are issued pursuant to Section 96 of the Financial Services Act 2010 and implement Part III of the Financial Services (Capital Adequacy for Banks) Directive, 2018. 2 OBJECTIVE The objectives of these guidelines are to: a) assist banks to appropriately calculate and measure the capital charge for credit risk. b) provide guidance on how to complete each section of the credit risk templates in the call report. c) outline all the areas of supervisory national discretion decided by the Registrar pertaining to credit risk capital determination. 3 SCOPE OF APPLICATION These guidelines cover the calculation of capital charge for credit risk for banks and bank holding companies. 4 DEFINITIONS ‘Bank’ is as defined in the Banking Act 2010. ‘Banking Book’ refers to financial assets on a bank's balance sheet that are measured at amortised cost or at fair value through other comprehensive income (FVTOCI). ‘Bank Holding Company’ means a body corporate that owns or controls at least two financial institutions one of which is a bank, being its subsidiary or significant minority investment or interest. ‘Counter party Credit risk (CCR)’ is the risk that the counterparty to a transaction could default before the final settlement of the transaction's cash flows. Unlike the normal credit risk where a firm’s exposure is unilateral, CCR creates a bilateral risk of

4 loss, in which the market value of the transaction can be positive or negative to either counterparty to the transaction. An economic loss would therefore occur if the transactions or portfolio of transactions with the counterparty has a positive economic value at the time of default. ‘Current Exposure’ is the larger of zero, or the market value of a transaction or portfolio of transactions within a netting set with a counterparty that would be lost upon the default of the counterparty, assuming no recovery on the value of those transactions in bankruptcy. Current exposure is often also called Replacement Cost. ‘Current Market Value (CMV)’ refers to the net market value of the portfolio of transactions within the netting set with the counterparty. Both positive and negative market values are used in computing CMV. ‘Defaulted Exposure’ is an exposure that is past due for more than 90 days, or has objective evidence of impairment at the reporting date, and ought to be classified as Stage 3. ‘Minimum Capital ratio’ is as prescribed in the Directive on Capital Adequacy ‘Non-central Government Public Sector Entities’ comprise both commercial and non-commercial entities owned by the central or local government including parastatals, statutory corporations and local assemblies in Malawi. ‘Securities Financing Transactions’ are transactions such as repurchase agreements, reverse repurchase agreements, security lending and borrowing, and margin lending transactions, where the value of the transactions depends on market valuations and the transactions are often subject to margin agreements. ‘Standardised Approach’ is a set of credit risk measurement techniques which uses external credit rating agencies to quantify required capital for credit risk. ‘Tier 1 Capital’ is as defined in the Directive on Capital Adequacy

5 ‘Trading Book’ means positions in financial instruments held either with trading intent or in order to hedge other elements of the trading book1 . ‘Registrar’ means Registrar of Financial Institutions as appointed under the Financial Services Act of 2010. PART II – MEASURING CREDIT RISK 5 APPROACHES 5.1 The Basel Framework requires that a bank’s capital position be measured through a risk-based capital ratio calculated by dividing its capital base by total risk-weighted assets (RWA), as follows: Capital Adequacy Ratio = Tier 1 Capital Credit RWA + Operational Risk Equivalent Assets + Market Risk Equivalent Assets 5.2 All banks in Malawi are required to use the Standardized Approach for calculating risk-based capital requirements for credit risk. 6 THE STANDARDISED APPROACH (SA) 6.1 The Standardised Approach assigns Risk Weights (RW) to exposures using two approaches to derive risk weighted assets for credit risk and the corresponding risk￾based capital requirement: a) Non-rating based approach: uses standardized risk weights prescribed by Supervisors to determine a bank’s risk weighted assets, where external credit ratings of counterparties are non-existent or jurisdictions cannot or do not wish to rely on external credit ratings; 1 The trading book is required under Basel II and III to be marked to market daily

6 b) External ratings-based approach: uses ratings assigned by eligible External Credit Assessment Institutions (ECAIs) or Export Credit Agencies (ECAs) to determine risk weights for a bank’s exposures to counterparties. 6.2 For purposes of (b) above, the Registrar shall only recognise ECAI ratings. For an ECAI to be eligible, it has to meet the eligibility criteria in 6.3, and the Registrar shall be responsible for determining whether an ECAI meets the criteria. 6.3 Eligibility criteria - an ECAI must satisfy each of the six criteria as follows: a) Objectivity: The methodology for assigning credit ratings must be rigorous, systematic, and subject to some form of validation based on historical experience. Moreover, assessments must be subject to ongoing review and responsive to changes in financial condition. Before being recognised, an assessment methodology for each market segment, including rigorous back testing, must have been established for at least one year and preferably three years. b) Independence: an ECAI should be independent and not be subject to political or economic pressures that may influence the rating. The assessment process should be as free as possible from any constraints that could arise in situations where the composition of the board of directors or the shareholder structure of the assessment institution may be seen as creating conflict of interest. c) International access/transparency: the individual assessments should be available to both domestic and foreign institutions with legitimate interests and at equivalent terms. In addition, the general methodology used by the ECAI should be publicly available. d) Disclosure - an ECAI should disclose the following information: its assessment methodologies, including the definition of default, the time horizon, and the meaning of each rating; the actual default rates experienced in each assessment category; and the transitions of the assessments, e.g. the likelihood of ‘AA’ ratings becoming ‘A’ over time. e) Resources: an ECAI should have sufficient resources to carry out high quality credit assessments. These resources should allow for substantial ongoing contact with senior and operational levels within the entities assessed in order to add

7 value to the credit assessments. Such assessments should be based on methodologies combining qualitative and quantitative approaches. f) Credibility: to some extent, credibility is derived from the criteria above. In addition, the reliance on an ECAI’s external credit assessments by independent parties (investors, insurers, trading partners) is evidence of the credibility of the assessments of an ECAI. The credibility of an ECAI is also underpinned by the existence of internal procedures to prevent the misuse of confidential information. An ECAI does not have to assess firms in more than one country in order to be eligible. 6.4 Where two or more assessments by ECAI exist which map into different RWs, the higher of the RW will be applied. 7 CREDIT RISK WEIGHTED ASSETS 7.1 All banking book exposures (on and off-balance sheet) shall be risk weighted net of loan loss provisions (including partial write offs)2 ; 7.2 A bank’s total credit risk-weighted assets shall be equal to the sum of the risk￾weighted amount of each on- and off-balance sheet exposures it holds; 7.3 The risk-weighted amount of an on-balance sheet exposure is determined by multiplying its current book value (net of loan loss provisions including partial write offs) by the relevant risk-weight; 7.4 The risk-weighted amount of an off-balance sheet asset is determined by first multiplying its nominal value (net of loan loss provisions and partial write offs) by a credit conversion factor (CCF) and then the relevant risk-weight; 7.5 Both, on and off-balance sheet exposures shall be subjected to the appropriate CRMs as prescribed under Section 11, to determine the net exposure before applying the risk weights; 2 Trading book exposures shall not be included in the determination of credit risk weighted assets.

8 7.6 All defaulted exposures for each category should be reported on a separate line. The exposure amounts to be risk weighted therefore, should be net of defaulted exposures to avoid double counting; 7.7 All defaulted exposures shall be risk weighted based on the criteria prescribed below. 8 DUE DILIGENCE REQUIREMENTS 8.1 A bank shall perform due diligence, to ensure that it has an adequate understanding, both at origination and on an on-going basis (at least annually), of the risk profile and characteristics of its counterparties. 8.2 In cases where external ratings are used, such due diligence is necessary to assess the risk of the exposure for risk management purposes, and whether the risk weight applied appropriately and conservatively reflects the credit worthiness of the counterparty . 8.3 Where results of due diligence reflect higher risk characteristics than that implied by the external rating bucket of the exposure, the bank must assign a risk weight at least one bucket higher than the “base” risk weight determined by the external rating. 8.4 Due diligence analysis must never result in the application of a lower risk weight than that determined by the external rating. 8.5 For exposures to entities belonging to a group, the due diligence should, to the extent possible, be performed at the solo entity level to which there is a credit exposure. In evaluating the repayment capacity of the solo entity, banks are expected to take into account the support of the group and the potential for it to be adversely impacted by problems in the group. 9 CLASSIFICATION OF EXPOSURES 9.1 In line with the Standardized Approach, a bank shall classify its credit exposures into the following asset classes, for risk weighting purposes: a) exposures to sovereigns and central banks; b) exposures to non-central government public sector entities;

9 c) exposures to multilateral development banks; d) exposures to banks; e) exposures to securities firms and other financial institutions; f) exposures to corporates; g) retail exposures; h) residential real estate exposures; i) commercial real estate; j) exposures on land acquisitions, development and construction ( ADC); k) other assets; l) Subordinated debt, equity and other regulatory capital instruments; and m) Off-balance sheet items. 10 RISK WEIGHTS FOR EXPOSURES The following tables outline the specific risk weights for the various exposures as classified above. 10.1 Exposures to Sovereigns and Central Banks Table 1: Risk weights for sovereigns (national governments) and central banks Exposure Risk Weight Exposures to Malawi Government, Central Government Ministries and Departments, and RBM 0 Exposures to rated sovereigns or where External Credit Assessments are used External Rating AAA to AA￾A+ to A￾BBB+ to BBB￾BB+ to B- Below B￾Unrated Risk Weight 0 20 50 100 150 100

10 Defaulted Exposures 100 10.1.1 In case of advances to Governments/RBM through purchase of securities, the bank should only report exposures measured at amortised cost3 and fair value through other comprehensive income (FVTOCI) under Credit Risk. Any exposures classified at fair value through profit or loss (FVTPL)4 , should be reported under market risk in the bank’s trading book. 10.1.2 Exposures to rated sovereigns include all exposures to foreign sovereigns according to that sovereign’s credit rating. However, the rating must be recognised by the Registrar. 10.2 Exposures to Non-Central Government Public Sector Entities (PSEs) Exposures to domestic non-central government public sector entities shall be assigned a risk weight based on external rating of the sovereign. Where sovereign ratings exist, PSEs shall be risk weighted one category lower than that of the sovereign. Where the sovereign is unrated, PSEs shall be risk weighted as per table below: Table 2: Risk weights of PSEs Exposure Risk-weight Exposures to PSEs where the sovereign is unrated Exposures to Parastatals and Statutory Corporations5 100 Exposures to Local Assemblies (district, town, municipal or city assemblies) 100 Exposures to Other Government related entities not listed above 100 Exposures to PSEs where sovereign ratings exist and are recognised by the Registrar 3 Exposures held to maturity (IAS 39) 4 Exposures held for sale (IAS 39) 5 See Appendix II for a List of Parastatals and Statutory Corporations provided by the Ministry of Finance and Economic Affairs

11 External Rating of sovereign AAA to AA￾A+ to A- BBB+ to BBB￾BB+ to B- Below B￾Risk Weight - one category lower than sovereign 20 50 100 100 150 Defaulted Exposures 100 10.3Exposures to Multilateral Development Banks (MDBs) 10.3.1 Banks shall assign to their MDB exposures the corresponding risk weights determined by the external ratings according to table 3 below. All unrated MDBs will be risk weighted at 50%. Table 3: Risk weights based on external rating of MDBs Exposure Risk Weight MDBs meeting eligibility criteria 0 All other Multilateral Development Banks External Rating AAA to AA￾A+ to A- BBB+ to BBB￾BB+ to B￾Below B￾Unrated Risk Weight (Base) 20 30 50 100 150 50 Defaulted Exposures 100 10.3.2 A 0% risk weight will be applied to exposures to MDBs that fulfil the following eligibility criteria: a) It has very high-quality long-term issuer ratings i.e. a majority of its external assessments must be AAA; b) It has a shareholder structure comprised of a significant proportion of high-quality sovereigns with long term issuer credit assessments of AA or better; c) Must have a strong shareholder support demonstrated by the amount of paid-in capital contributed by the shareholders; the amount of further capital the MDBs have the right to call, if required, to repay their liabilities; and continued capital contributions and new pledges from sovereign shareholders;

12 d) Must have adequate level of capital and liquidity; and e) It has strict statutory lending requirements and conservative financial policies, which include among other conditions a structured approval process, internal creditworthiness and risk concentration limits (per country, sector, and individual exposure and credit category), large exposures approval by the board or a committee of the board, fixed repayment schedules, effective monitoring of use of proceeds, status review process, and rigorous assessment of risk and provisioning to loan loss reserve. 10.3.3 For purposes of 10.3.2 above, the Registrar shall only recognise MDBs listed under Appendix III, for a 0% risk weight. 10.4 Exposures to Banks 10.4.1 Banks shall assign risk weights to exposures to other banks in line with their external credit risk assessments (ECRA approach), as per table 4 below. A preferential risk weight that is one category more favourable may be applied to short term exposures with an original maturity of three months or less, subject to a floor of 20%. For exposures to unrated banks, a risk weight of 50% shall apply. Table 4: Risk weights of Banks based on ECRA approach External Rating AAA to AA– A+ to A– BBB+ to BBB– or BB+ to B– Below B– Unrated banks Base risk weight 20 30 50 100 150 50 Short term exposures 20 50 150 20 Defaulted Exposures 100 10.5 Exposures to Securities Firms and Other Financial Institutions 10.5.1 Exposures to prudentially regulated securities firms shall be risk weighted at 50% or be assigned a risk weight corresponding to their credit risk

13 assessment rating. All exposures to unrated securities firms or those not listed under appendix IV shall be risk weighted at 100%. Table 5: Risk weights for exposures to Securities Firms Claims on locally prudentially regulated securities firms6 50 Claims on securities firm not listed in Appendix IV or unrated 100 Claims on rated security firms External Rating AAA to AA– A+ to A– BBB+ to BBB– BB+ to B– Below B– Risk weight 20 50 50 100 150 Defaulted Exposures 100 10.6 Exposures to Corporates 10.6.1 Exposures to corporates include all types of exposures (loans, bonds or receivables) to incorporated entities, associations, partnerships, proprietorships, trusts, funds and other entities with similar characteristics, except those qualifying for one of the other exposure classes. 10.6.2 Exposures to corporates have been differentiated into two broad categories of General Corporates and Specialized Lending. Exposures to corporates will therefore be risk-weighted at national discretion, according to either of the following options: 10.6.3 General Corporates (GC): these include all corporate exposures not qualifying under the Specialized Lending category (see 10.6.4). For rated General Corporate exposures, risk weights shall be assigned in line with the external credit assessment of the corporate, with exposures to unrated corporates being risk weighted at 100%. Table 6: Risk weights for General Corporates External Rating AAA to AA￾A+ to A￾BBB+ to BBB￾BB+ to BB￾Below BB￾Unrated GC Base risk weight 20 50 100 150 150 100 Defaulted Exposures 100 6 See Appendix IV for a list of Security Firms

14 10.6.4 Specialized Lending: A corporate exposure will be treated as a specialized lending exposure, if such lending possesses some or all of the characteristics below, either in legal form or economic substance; a) It is not related to real estate (treatment for real estate exposures has been prescribed separately) and meets the definitions of object finance, project finance or commodities finance; b) It is to an entity (often a special purpose vehicle (SPV)) that was created specifically to finance and/or operate physical assets; c) It is to an entity that has few or no activities, hence no independent capacity to repay the obligation apart from the income that it receives from the asset(s) being financed i.e. the primary source of repayment of the obligation is the income generated by the asset(s); d) The terms of the obligation give the lender a substantial degree of control over the asset(s) and the income that it generates; 10.6.5 Specialized Lending exposures will be classified in one of the following three subcategories; a) Project Finance: refers to the method of funding in which the lender looks primarily to the revenues generated by a single project, both as the source of repayment and as security for the loan. This type of financing is usually for large, complex and expensive installations such as power plants, chemical processing plants, mines, transportation infrastructure, environment, media, and telecoms. Project finance may take the form of financing the construction of a new capital installation, or refinancing of an existing installation; b) Object Finance: refers to the method of funding the acquisition of equipment (e.g. ships, aircraft, satellites, railcars, and fleets) where the repayment of the loan is dependent on the cash flows generated by the specific assets that have been financed and pledged or assigned to the lender;

15 c) Commodity Finance; refers to short-term lending to finance reserves, inventories, or receivables of exchange-traded commodities (e.g. crude oil, metals, or crops), where the loan will be repaid from the proceeds of the sale of the commodity and the borrower has no independent capacity to repay the loan. 10.6.5.1 Banks shall assign to their Specialized Lending exposures the risk weights determined by the “issue-specific” external ratings (Issuer ratings must not be used) as per table below; Table 7: Risk weights for specialized lending exposures determined by the “issue￾specific” external ratings External Rating AAA to AA￾A+ to A- BBB+ to BBB￾BB+ to BB- Below BB￾Risk weight 20 50 75 100 150 Defaulted Exposures 100 10.6.5.2 Where “issue specific” external ratings do not exist, the following risk weights shall apply; Table 8: Risk weights for specialized lending exposures where “issue-specific” external ratings do not exist 7 Refers to the period in which the entity that was specifically created to finance the project has (i) a positive net cash flow sufficient to cover any remaining contractual obligation, and (ii) declining long term debt. 8 Refers to an exposure to a project finance entity that is able to meet its financial commitments in a timely manner and its ability to do so is assessed to be robust against adverse changes in the economic cycle and business conditions. See appendix v for a detailed criterion. Exposure Type Risk Weight Commodity financing 100 Object Finance 100 Project finance Pre-operational phase 130 Operational phase7 100 Operational phase (high quality project)8 80 Defaulted Exposures 100

16 10.7 Retail Exposures 10.7.1 Retail exposures include exposures to an individual person or persons, or to regulatory retail SMEs. These exclude residential real estate exposures, which are treated separately under 10.8. 10.7.2 To qualify as a regulatory retail exposure, and warrant a 75% risk weight, the following criteria must be met; a) Orientation criterion - The exposure is to an individual person or persons or to a small business enterprise (SMEs); b) Low value of individual exposures – the maximum aggregated retail exposure to one counterparty shall not exceed MK150 million; c) Product criterion - The exposure takes the form of the following: revolving credits (excluding overdrafts) and lines of credit (including credit cards); personal/consumer term loans and leases; student loans; education loans; and small business facilities and commitments. Derivatives and securities (such as bonds and equities), whether listed or not, are specifically excluded from this category; d) Granularity criterion – the portfolio must be sufficiently diversified to a degree that reduces risk in the portfolio. For purposes of this condition, no aggregate exposure to one counterparty should exceed 0.2% of the overall regulatory retail portfolio. If an exposure (on aggregate basis) exceeds this limit, that exposure should be assigned a risk weight of 100% under the line “exposures greater than MK150 million”. 10.7.3 All retail exposures that meet the above criteria shall be risk weighted at 75% with the following exceptions: a) All overdrafts actual drawn amounts should be risk weighted at 100%. The undrawn amount should be reported under off-

17 balance sheet items, but will have a conversion factor of 50% and risk weighted at 100% as well; b) All forex loans to individual persons or small and medium enterprises should be risk weighted at 100%; c) All retail exposures that do not meet the criteria in 10.7.2 above will be risk-weighted at 100%. 10.7.4 For unhedged foreign currency retail exposures to individuals where the lending currency differs from the currency of the borrower’s source of income, a bank shall apply a 1.5 times multiplier to the applicable risk weight, subject to a maximum risk weight of 150%. 10.7.5 Defaulted exposures shall be risk weighted at 100%. Table 9: Risk weights for retail exposures Regulatory retail exposures 75% Overdrafts 100% Forex loans 100% All other retail exposures not meeting prescribed criteria 100% Defaulted Exposures 100% 10.8 Real Estate Exposures 10.8.1 Banks shall put in place underwriting policies with respect to the granting of mortgage loans that include the assessment of the ability of the borrower to repay. Underwriting policies must also be appropriate when the repayment of the mortgage loan depends materially on the cash flows generated by the property. 10.8.2 The property must be valued according to the criteria in 10.8.3 (c) for determining the loan to value (LTV) ratio. The LTV ratio is the amount of the loan divided by the value of the property. For purposes of LTV computation, the value of the property will be maintained at the value measured at origination, subject to revisions every 3 years. However, where an extraordinary, idiosyncratic event occurs resulting in a permanent reduction of the property value, the bank shall immediately reflect this

18 change. In such event, a subsequent upwards adjustment can be made but not to a value higher than the value at origination. Modifications made to the property that unequivocally increase its value could also be considered in the LTV determination. 10.8.3 When calculating the LTV ratio, the loan amount will be reduced as the loan amortises. The LTV ratio must therefore be prudentially calculated in accordance with the following requirements; a) Amount of the loan: includes the outstanding loan amount and any undrawn committed amount of the mortgage loan. The loan amount must be calculated gross of any provisions and other risk mitigants, except for pledged cash/deposits that meet all requirements for on-balance sheet netting and have been unconditionally and irrevocably pledged for the sole purposes of redemption of the mortgage loan. b) If a bank grants multiple loans secured by the same property, the different loans should be considered as a single exposure for risk-weighting purposes, and the amount of the loans should be added to calculate the LTV ratio. c) The property valuation must be appraised independently using prudently conservative valuation criteria. To ensure that the value of the property is appraised in a prudently conservative manner, the valuation must exclude expectations on price increases and must be adjusted to take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan. 10.8.4 A guarantee or financial collateral may be recognized (e.g. mortgage insurance) as a credit risk mitigant in relation to exposures secured by real estate, if it qualifies as eligible collateral under the credit risk mitigation framework. Banks may recognize these risk mitigants in calculating the exposure amount; however, the LTV bucket and risk weight to be applied to

19 the exposure amount must be determined before the application of the appropriate credit risk mitigation technique. 10.8.5 To qualify for risk weighting as prescribed in Tables 10, 11, 12 and 13 below, an exposure must meet the following requirements; a) Finished property: the property securing the exposure must be fully completed. This requirement does not however apply to forest and agricultural land; b) Legal enforceability: any claim on the property taken must be legally enforceable in all relevant jurisdictions. The collateral agreement and the legal process underpinning it must be such that they provide for the bank to realise the value of the property within a reasonable time frame; c) Claims over the property: the loan is a claim over the property where the lender bank holds a first lien over the property, or a single bank holds the first lien and any sequentially lower ranking lien(s) (i.e. there is no intermediate lien from another bank) over the same property; d) Ability of the borrower to repay; e) Prudent value of property: the property must be valued according to the criteria in 10.8.3 for determining the value in the loan to value (LTV) ratio. Moreover, the value of the property must not depend materially on the performance of the borrower; and f) Required documentation: all the information required at loan origination and for monitoring purposes must be properly documented, including information on the ability of the borrower to repay and on the valuation of the property. 10.8.6 Residential Real Estate Exposures 10.8.6.1 A residential real estate exposure is an exposure financing an immovable property that has the nature of a dwelling and

20 satisfies all applicable laws and regulations enabling the property to be occupied for housing purposes. 10.8.6.2 To qualify for risk weighting as prescribed in table 10 and 11 below, residential real estate exposures must meet the criteria in 10.8.5 above. 10.8.6.3 Where criteria in 10.8.5 above is met, and; a) The prospects of servicing the loan is not materially dependent on the cash flows generated by the property securing the loan but the underlying capacity of the borrower to service the debt from other sources; and b) The exposure does not constitute financing of land acquisitions for development and construction purposes, or development and construction of any residential or commercial property. The risk weight to be assigned to the total exposure amount will be determined as follows; Table 10: Residential Real Estate: - repayment not materially dependent on cash flows generated by property If criteria is met If criteria not met LTV ≤ 50% 50% < LTV ≤ 60% 60% < LTV ≤ 80% 80% < LTV ≤ 90% 90% < LTV ≤ 100% LTV

100% N/A Risk Weights 20 25 30 40 50 70 100 Defaulted Exposures 100 10.8.6.4 However, where the conditions in 10.8.5. are met, but the prospects of repayment of loan materially depends on the cash flows generated by the property securing the loan rather than on the underlying capacity of the borrower to service the debt from other sources, the following risk weights shall apply;

21 Table 11: Residential Real Estate: -repayment materially dependent on cash flows generated by property If criteria is met If criteria not met LTV ≤ 50% 50% < LTV ≤ 60% 60% < LTV ≤ 80% 80% < LTV ≤ 90% 90% < LTV ≤ 100% LTV > 100% N/A Risk Weights 30 35 45 60 75 105 150 Defaulted Exposures 100 10.8.6.5 For unhedged residential real estate exposures to individuals where the lending currency differs from the currency of the borrower’s source of income, banks will apply a 1.5 times multiplier to the applicable risk weight, subject to a maximum risk weight of 150%. 10.8.7 Commercial Real Estate Exposures 10.8.7.1 A commercial real estate exposure is an exposure financing any immovable property that is not a residential real estate 10.8.7.2 To qualify for risk weighting as prescribed in table 12 and 13 below, commercial real estate exposures must meet the criteria in 10.8.5 above 10.8.7.3 Where criteria in 10.8.5 is met, and; c) The prospects of servicing the loan is not materially dependent on the cash flows generated by the property securing the loan but the underlying capacity of the borrower to service the debt from other sources; and d) The exposure does not constitute financing of land acquisitions for development and construction purposes, or development and construction of any residential or commercial property;

22 The risk weight to be assigned to the total exposure amount will be determined as follows; Table 12: Commercial real estate: -Repayment is not materially dependent on cash flows generated by property LTV ratio LTV ≤ 60% LTV> 60% Criteria not met Risk Weight Min (60, RW of Counterparty) 80% 100% Defaulted Exposures 100% 10.8.7.4 For purposes of LTV ratios of equal to or less than 60%, risk weight of counterparty shall be 75% for exposures to individuals, 85% for exposures to SMEs, and 100% for exposures to corporates. 10.8.7.5 However, where the criteria in 10.8.5 is met, but the prospects of repayment of loan materially depends on the cash flows generated by the property securing the loan rather than on the underlying capacity of the borrower to service the debt from other sources, the exposure will be risk weighted as follows; Table 13: Commercial real estate:- repayment is materially dependent on cash flows generated by property LTV ratio LTV≤ 60 60<LTV<100% LTV>100/Criteria not met Risk Weight 75% 100% 150 Defaulted Exposures 100% The primary source of these cash flows would generally be lease or rental payments, or the sale of the commercial property i.e. both the servicing of the loan and the prospects for recovery in the event of default depend materially on the cash flows generated by the property securing the exposure. 10.8.8 Land acquisition, development and construction (ADC) exposures

23 10.8.8.1 Refers to loans to companies or Special Purpose Vehicles (SPVs) financing any of the land acquisition for development and construction purposes, or development and construction of any residential or commercial property. These shall not constitute acquisition of forest or agricultural land, where there is no planning consent or intention to apply for planning consent. 10.8.8.2 ADC exposures will be risk-weighted at 150%. However, a risk weight of 100% shall apply, if such ADCs support industrialization, agricultural commercialization, import substitution and export orientation. 10.9 Other Assets Table 14: List any remaining claims under the following asset categories: Narration Risk weight Cash, gold, coins, bullion, foreign notes & coins, balances with the Reserve Bank of Malawi 0 Cheques in course of collection 20 Other Assets 100 NB: Intangible assets to be included in the risk weighting of other assets shall only constitute software, databases and systems, while all intangible assets shall be deducted from core capital e.g. brands, franchises, intellectual property etc 10.10Subordinated Debt, Equity and Other Regulatory Capital Instruments 10.10.1 This applies to subordinated debt, equity and other regulatory capital instruments issued by either corporates or banks, provided that such instruments are not deducted from regulatory capital or risk-weighted at most 250%. 10.10.2 Equity exposures are defined on the basis of the economic substance of the instrument. They include both direct and indirect ownership interests (whether voting or non-voting) in the assets and income of a commercial enterprise or of a financial institution that is not consolidated or deducted (See Appendix VI).

24 10.10.3Banks will assign a risk weight of 400% to speculative unlisted equity exposures9 and a risk weight of 250% to all other equity holdings, with the exception of those equity holdings as prescribed10 by the Registrar. 10.11 Off-Balance Sheet Items 10.11.1Off-balance sheet items shall be converted into credit exposure equivalents through the use of credit conversion factors (CCF). In the case of commitments, the committed but undrawn amount of the exposure shall be multiplied by the CCF. For these purposes, commitment means any contractual arrangement that has been offered by the bank and accepted by the client to extend credit, purchase assets or issue credit substitutes. 10.11.2In principle, the risk weight of an off-balance item is determined by the following calculation: Nominal Amount x Credit Conversion Factor x Risk Weight as set out above = Capital Requirement. Table 15: List of off-balance sheet items and respective CCFs that shall apply in deriving the credit exposure equivalents: Off Balance Sheet Exposures Credit Conversion Factors Claims to or Guaranteed by Malawi Government 0% Claims with Cash Collateral 0% Direct Credit Substitutes e.g. Guarantees, Letters of credit, Assets pledged as collateral 100% 9 Speculative unlisted equity exposures are defined as equity investments in unlisted companies that are invested for short-term resale purposes or are considered venture capital or similar investments which are subject to price volatility and are acquired in anticipation of significant future capital gains. 10 The Registrar may allow banks to assign a risk weight of 100% to equity holdings made pursuant to national legislated programmes that provide significant subsidies for the investment to the bank and involve government oversight and restrictions on the equity investments.

25 Sale and repurchase agreements and asset sales with recourse, where the credit risk remains with the bank 100% Lending of banks’ securities or posting of securities as collateral by banks including instances where these arise out of repo-style transactions 100% Forward asset purchases, forward-forward deposits and partly paid shares and securities, which represent commitments with certain drawdown 100% Off-balance sheet items that are credit substitutes not explicitly included in any other category 100% Transaction Related Contingent Items (Performance or Bid Bonds, Warranties, Standby L/Cs etc) related to specific transactions (but not as credit guarantee) 50% Short-term self-liquidating trade letters of credit arising from the movement of goods e.g. Documentary Credits 20% Other Commitments regardless of maturity of the underlying facility 40% Similar Other Commitments which can be unconditionally cancellable at any time by the bank without prior notice 10% 10.11.3 Where there is an undertaking to provide a commitment on an off-balance sheet item, banks are to apply the lower of the two applicable CCFs e.g. if a bank has a commitment to open short-term self-liquidating trade letters of credit arising from the movement of goods, a 20% CCF will be applied (instead of a 40% CCF); 10.11.4 After converting off-balance sheet items, the appropriate risk weight must be chosen depending on category of exposures.

26 10.12Treatment of Counterparty Credit Risk and Securities Financing Transactions 10.12.1 This section prescribes the methodology for estimating credit equivalent amounts for Securities Financing Transactions (SFTs) and Over the Counter (OTC) derivatives that give rise to counterparty credit risk (CCR), for credit risk weighting purposes. 10.12.2 All banks in Malawi shall use the “Current Exposure Method (CEM)” to derive credit equivalent amount for OTC derivative transactions, for purposes of credit risk weighting. A simple approach for calculating credit equivalent amount for Security Financing Transactions (SFT) has also been prescribed. 10.12.3 The following general characteristics may apply for instruments to qualify for treatment under these approaches; a) The transactions generate a current exposure or market value; b) The transactions have an associated random future market value based on market variables; c) The transactions generate an exchange of payments or an exchange of a financial instrument against payment; d) Collateral may be used to mitigate risk exposure and is inherent in the nature of some transactions; e) Short-term financing may be a primary objective in that, the transactions mostly consist of an exchange of one asset for another (cash or securities) for a relatively short period of time, usually for the business purpose of financing; f) Positions are frequently valued (commonly on a daily basis),according to market variables 10.13Determination of Credit Equivalent Amount for OTC Derivative Transactions 10.13.1 Banks shall calculate the credit equivalent amount for OTC transactions for risk weighing purposes, by summing:

27 a) The replacement cost of all OTC contracts with positive value; and b) An “Add on” amount to capture potential future credit exposure 10.13.2 The replacement cost shall be calculated by marking contracts to market, thus capturing the current exposure without any need for estimation; 10.13.3 The “add on” amount shall be calculated by multiplying the notional principal amount of the OTC transaction to an applicable add on factor, split by residual maturity as follows: 10.13.4 For purposes of 10.13 above, the following formula shall apply; RC = max {0, V – CVMr + CVMp,} Where: V is the marked to market value of the individual derivative transaction; CVMr is the cash variation margin received, and for which the amount has not already reduced the market value of the derivative transaction under the bank’s operative accounting standard; and CVMp is the cash variation margin provided by the bank. 10.13.5 The credit equivalent amount for OTC transactions with counterparty credit risk shall therefore be calculated as; [RC + ADDf] Where:

28 RC is the replacement cost ADDf is the add on factor representing the potential future credit exposure 10.13.6 For contracts with multiple exchanges of principal, the add-on factors shall be multiplied by the number of remaining payments in the contract. 10.13.7 Banks shall use the effective rather than apparent notional amount in deriving add-ons in 10.13.3 above. Where the stated notional amount is leveraged or enhanced by the structure of the transaction, banks shall ensure that the add-ons are determined based on the effective rather than apparent notional amounts. 10.13.8 Forwards, swaps, purchased options and similar derivative contracts not covered by any of the columns of the matrix in 10.13.3 above are to be treated as "other commodities". 10.13.9 Banks can obtain capital relief from eligible credit risk mitigation. For this purpose, the methodology to be used for recognition of such credit risk mitigation shall be as guided under section 11 of this guideline. 10.13.10 Once a bank has calculated the credit equivalent amounts, these shall be risk weighted according to the risk weight category of the counterparty. 10.14Determination of Credit Equivalent Amount for Security Financing Transactions (SFT) 10.14.1 Banks shall calculate the credit equivalent amount for SFTs for risk weighing purposes using the following formula: E* = Max (0, [E x (1+He) – C x (1-Hc – Hfx)]) Where; E* = credit equivalent Amount after risk mitigation E = current value of the exposure

29 He = Haircut appropriate to the exposure C = the current value of the collateral received Hc = Haircut appropriate to the collateral Hfx = Haircut appropriate for currency mismatches between the exposure and collateral 10.14.2 For purposes of 10.14.1 above, the following haircuts shall apply; a) He shall be equal to 12%; b) Hc shall be equal to 12%; and c) Hfx shall be equal to 8%, otherwise 0% where no currency mismatch exists between the exposure and collateral 10.14.3 Banks can obtain capital relief from eligible credit risk mitigation. For this purpose, the methodology to be used for recognition of such credit risk mitigation shall be as guided under section 11 of this guideline. 10.15Once a bank has calculated the credit equivalent amounts, these shall be risk weighted according to the risk weight category of the counterparty. 11 CREDIT RISK MITIGATION TECHNIQUES The framework set out in this section is applicable to banking book exposures that are risk-weighted under the standardised approach. 11.1 Banks may use a number of risk mitigation techniques, such as cash, securities, third party guarantees and deposits from same counterparty to reduce the risk-weighted amount. 11.2 For purposes of 11.1 above, all banks shall use the Simple Approach for credit risk mitigation which substitutes the risk weighting of the collateral for the risk weighting of the counterparty for the collateralised portion of the exposure; 11.3 The following general requirements must be taken into account when using credit risk mitigation techniques:

30 (i) The CRM is applied only up to the exposure amount; (ii) No transaction in which CRM techniques are used should receive a higher capital requirement than an otherwise identical transaction where such techniques are not used; (iii) The effects of the CRM should not be double counted. Therefore, no additional supervisory recognition of CRM for regulatory capital purposes will be granted on exposures for which an issue specific rating (i.e. it is possible to have credit rating on an institution as well as the specific debt instruments it issues) has been used that already reflects that CRM; (iv) The CRM must meet the following legal requirements: (1) all documentation used in collateralised transactions, on-balance sheet netting agreements and guarantees must be binding on all parties and legally enforceable; and (2) banks must have conducted sufficient legal review to verify requirement (1) above and undertake such further review as necessary to ensure continuing enforceability. (v) For collateral to be recognised for risk mitigation purposes, it must be pledged for at least the life of the exposure and must be marked to market. Therefore, a maturity mismatch, in which the residual maturity of the collateral is less than that of the exposure, shall not be allowed under the simple approach. (vi) In order for CRM techniques to provide protection, the credit quality of the counterparty must not have a material positive correlation with the employed CRM technique or with the resulting residual risks. For example, securities issued by the counterparty (or by any counterparty-related entity) provide little protection as collateral and are thus ineligible. (vii) In the case where a bank has multiple CRM techniques covering a single exposure (e.g. a bank has both collateral and a guarantee partially covering an exposure), the bank must subdivide the

31 exposure into portions covered by each type of CRM technique (e.g. portion covered by collateral, portion covered by guarantee) and the risk-weighted assets of each portion must be calculated separately. 11.4 While the use of CRM techniques reduces or transfers credit risk, it may simultaneously increase other risks (residual risks). Residual risks include legal, operational, liquidity and market risks. Therefore, it is imperative that banks employ robust procedures and processes to control these risks. Where these risks are not adequately controlled, the Registrar may impose additional capital charges or take other supervisory actions under Pillar II. 11.5 The following collateral instruments are eligible for recognition as CRMs under the Simple Approach: Type of Collateral Notes/Treatment 1 Cash (including Gold) Full value of cash collateral or Gold. For cash, the bank must have the right of set off and must be held by the bank. Mere holding of deposits by the bank of an obligor does not meet the criteria for mitigating credit exposure for capital relief. 2 Government Securities such as Treasury Bills; Treasury Notes; Treasury Bonds etc Apply face value of the paper. 3 Guarantees provided by Malawi Government Full recognition up to the amount of Guarantee. 4 Guarantees provided by other sovereigns Based on the credit rating of the sovereign. The ratings of the sovereign must be recognized by the Registrar. If sovereign is not rated, the Guarantee is

32 not recognised. 5 Guarantee provided by a bank For local banks, only 50% is recognized as credit mitigation. Where the bank is rated, in line with rating of that bank. However, rating must be recognized by the Registrar. 6 Guarantee by a parent company/non-bank Only qualifies if the Guarantor is rated and its rating replaces that of the counter party. The rating must be recognized by the Registrar. Guarantees by unrated companies are not recognised. Where the parent is another bank or regulated financial institution in Malawi, only 50% of Guarantee will be recognized. 7 Guarantee by a Multilateral Development Bank (MDBs) The rating of the MDB replaces that of the original obligor. For MDBs outlined in this guideline, full recognition up to the amount of Guarantee. 8 Commercial Paper issued by banking institutions licensed under the FSA Will qualify but scaled down by a 50% risk factor applicable to banks. Commercial Paper issued by any unrated corporate does not meet eligibility criteria and cannot be used for capital relief purposes. 9 Shares of listed companies Will qualify but scaled down by a 40% risk factor. i.e. only 60% of the market value of the share will be recognized

33 as CRM. 10 Credit Insurance Will qualify with a risk weight of 50% or depending upon the risk weight of the insurer. 12 CAPITAL CHARGE FOR CREDIT RISK The capital charge for credit risk will be determined by summing all credit risk￾weighted assets (both, on and off-balance sheet) and then multiplying the sum with the regulatory minimum prescribed ratio.

For further enquiries please contact: The Director Bank Supervision Reserve Bank of Malawi P. O. Box 565 Blantyre Tel: +265 (0) 111 820 299/444 Fax: 265 (0) 822 118 Email: basu@rbm.mw

34 APPENDIX I LIST OF CENTRAL GOVERNMENT DEPARTMENTS AND MINISTRIES

1. Office of the President and Cabinet (OPC);
2. State Residences;
3. National Audit Office;
4. The Judiciary;
5. National Assembly;
6. Asset Declaration
7. Office of the Vice President;
8. Department of Human Resources Management and Development;
9. Department of Nutrition, HIV and AIDS;
10. Civil Service Commission;
11. Directorate of Public Procurement;
12. Ministry of Defence;
13. Malawi Defence Force;
14. National Statistical Office;
15. Ministry of Local Government;
16. Local Development Fund;
17. National Local Government Finance Committee;
18. Ministry of Natural Resources and Climate Change;
19. Ministry of Youth and Sports;

35 20. Ministry of Agriculture; 21. Greenbelt Authority; 22. Ministry of Water and Sanitation; 23. Ministry of Education; 24. Ministry of Foreign Affairs; 25. Ministry of Finance and Economic Affairs; 26. Department of Accountant General; 27. Malawi Revenue Authority; 28. Roads Fund Administration; 29. Financial Intelligence Authority; 30. Ministry of Health; 31. Ministry of Gender, Community Development and Social Welfare; 32. Ministry of Information and Digitalization; 33. Ministry of Homeland Security; 34. Ministry of National Unity; 35. Malawi Police Services; 36. Malawi Prison Services; 37. Immigration Department; 38. Ministry of Justice; 39. Directorate of Public Prosecutions and State Advocacy; 40. Department of Registrar General;

36 41. Department of Administrator General; 42. Malawi Law Commission; 43. Legal Aid Bureau; 44. Minister of Tourism, Culture & Wildlife; 45. Ministry of Labour; 46. Ministry of Trade and Industry; 47. Ministry of Transport and Public Works; 48. Human Rights Commission; 49. Electoral Commission; 50. Ministry of Mining; 51. Department of Geological Survey; 52. Department of Mines; 53. Anti-Corruption Bureau; 54. Office of Ombudsman; 55. Law Commission; 56. Ministry of Lands; and 57. Ministry of Energy.

37 APPENDIX II LIST OF PARASTATALS AND STATUTORY CORPORATIONS A. COMMERCIAL CATEGORY

1. Malawi Housing Corporation (MHC);
2. Airport Development Ltd (ADL);
3. Electricity Supply Commission of Malawi Ltd (ESCOM);
4. Lilongwe Water Board (LWB);
5. Southern Region Water Board (SRWB);
6. National Lotteries Board (NLB)/ Malawi Gaming Board;
7. Malawi College of Accountancy (MCA);
8. Malawi Institute of Management (MIM);
9. Malawi Posts Corporation (MPC);
10. National Food Reserve Agency (NFRA);
11. Northern Region Water Board (NRWB);
12. Blantyre Water Board (BWB);
13. Central Region Water Board (CRWB);
14. Agricultural Development and Marketing Corporation (ADMARC);
15. National Oil Company of Malawi (NOCMA);
16. National Economic Empowerment Fund (NEEF);
17. Umodzi Holdings Limited (UHL);
18. Technical, Entrepreneurial, Vocational Education and Training Authority (TEVETA);

38 19. National Construction Industrial Council (NCIC); 20. Malawi Communications Regulatory Authority (MACRA); 21. Copyright Society of Malawi (COSOMA); 22. Tobacco Control Commission (TCC); 23. Pharmacy and Medicines Regulatory Authority (PMRA); 24. Malawi Energy Regulatory Authority (MERA); 25. Malawi Accountants Board (MAB); 26. Malawi Bureau of Standards (MBS); 27. Lilongwe Handling Company Limited (LIHACO); 28. Air Cargo Limited (ACL); 29. Power Market Limited (PML); 30. Electricity Generation Company (EGENCO); B. SEMI-SUBVENTED PARASTATALS 31. Malawi Broadcasting Corporation (MBC); 32. University of Malawi (UNIMA); 33. Malawi National Examination Board (MANEB); 34. Malawi College of Health Sciences (MCHS); 35. Malawi University of Science and Technology (MUST); 36. Mzuzu University (MZUNI); 37. Lilongwe University of Agriculture and Natural Resources (LUANAR);

39 38. Roads Authority (RA); 39. Small Medium Entrepreneurs Development Institute (SMEDI); 40. Malawi Institute of Education (MIE); 41. Medical Council of Malawi (MCM); 42. Nurses and Midwives Council of Malawi (NMCM); C. FULLY SUB VENTED PARASTATALS 43. Malawi Investment and Trade Centre (MITC); 44. Malawi National Commission for UNESCO (MNC- UNESCO); 45. National Herbarium and Botanic Gardens of Malawi (NHBG); 46. National Library Services (NLS); 47. National Youth Council of Malawi (NYCOM); 48. National Commission for Science and Technology (NCST); 49. National Council for Higher Education (NCHE); 50. National Water Resources Authority (NWRA); 51. Malawi Council for the Handicapped (MACOHA); 52. Malawi National Council of Sports (MNCS); 53. Competitions and Fair Trade Commission (CFTC); 54. Cotton Council of Malawi (CCM); 55. Malawi Digital Broadcasting Network (MDBN) Ltd; 56. Atomic Energy Regulatory Authority (AERA);

40 57. Pesticides Control Board (PCB); 58. Public Procurement and Disposal of Assets Authority (PPDA); 59. Malawi Environmental Protection Authority (MEPA); 60. Cannabis Regulatory Authority (CRA); 61. Malawi Civil Aviation Authority (MCAA); D. PARASTATALS NOT UNDER THE DEPARTMENT OF STATUTORY CORPORATIONS 62. NGO Board; 63. National Planning Commission (NPC); 64. Smallholder Farmers Fertilizer Revolving Fund of Malawi (SFFRFM); 65. Malawi Revenue Authority (MRA); 66. Reserve Bank of Malawi (RBM); 67. Central Medical Stores Trust (CMST); 68. Road Fund Administration (RFA) Sunbird Tourism Limited; 69. Public Private Partnership Commission (PPPC); and 70. Malawian Airlines.

41 APPENDIX III LIST OF MULTILATERAL DEVELOPMENT BANKS 1 International Monetary Fund (IMF); 2 The World Bank Group (International Bank for Reconstruction and Development (IBRD), the International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency (MIGA) and the International Development Association (IDA) 3 Asian Development Bank; 4 Asian Infrastructure Development Bank; 5 African Development Bank; 6 European Bank for Reconstruction and Development 7 Inter-American Development Bank 8 European Investment Bank; 9 European Investment Fund; 10 European Central Bank; 11 the Bank for International Settlement; 12 Nordic Investment Bank; 13 Caribbean Development Bank; 14 Islamic Development bank; 15 Council of Europe Development Bank; 16 Preferential Trade Bank – PTA; 17 International Finance Facility for Immunization.

42 APPENDIX IV LIST OF SECURITIES FIRMS AND OTHER FINANCIAL INSTITUTIONS 1 Alliance Stockbrokers 2 Bridgepath Capital Ltd 3 Carrick Wealth Ltd 4 Cedar Capital 5 Continental Asset Management Ltd 6 Continental Capital Ltd (stock brockers) 7 FDH Holdings Ltd 8 FINCA 9 Vision Fund 10 Dream Financial Services 11 Wealthnet 12 Lifeco Asset Management 13 Malawi Stock Exchange 14 Maximus Africa Investment Management Limited 15 NBM Capital Markets Ltd 16 NBS Limited Investment Adviser 17 NICO Asset Managers Ltd 18 Nico Capital Limited 19 Old Mutual Investment Group Limited

43 20 South Atlantic Asset Management 21 Standard Bank Limited Investment Adviser 22 Stockbrokers Malawi Ltd

44 APPENDIX V CRITERIA FOR HIGH QUALITY PROJECT FINANCE A high-quality project finance exposure refers to an exposure to a project finance entity that is able to meet its financial commitments in a timely manner and its ability to do so is assessed to be robust against adverse changes in the economic cycle and business conditions. The following conditions must also be met: a) The project finance entity is restricted from acting to the detriment of the creditors (e.g. by not being able to issue additional debt without the consent of existing creditors); b) The project finance entity has sufficient reserve funds or other financial arrangements to cover the contingency funding and working capital requirements of the project; c) The revenues are availability-based11 or subject to a rate-of-return regulation or take-or-pay contract; d) The project finance entity’s revenue depends on one main counterparty and this main counterparty shall be a central government, PSE or a corporate entity with a risk weight of 80% or lower; e) The contractual provisions governing the exposure to the project finance entity provide for a high degree of protection for creditors in case of a default of the project finance entity; f) The main counterparty or other counterparties which similarly comply with the eligibility criteria for the main counterparty will protect the creditors from the losses resulting from a termination of the project; g) All assets and contracts necessary to operate the project have been pledged to the creditors to the extent permitted by applicable law; and 11 Availability based revenues mean that once the project is completed, the project finance entity is entitled to payments from its contractual counterparties (e.g. the government) as long as contract conditions are fulfilled.

45 h) Creditors may assume control of the project finance entity in case of its default.

46 APPENDIX VI CRITERIA FOR EQUITY INSTRUMENTS An instrument is considered to be an equity exposure if it meets all of the following (a) It is irredeemable in the sense that the return of invested funds can be achieved only by the sale of the investment or sale of the rights to the investment or by the liquidation of the issuer; (b) It does not embody an obligation on the part of the issuer; and (c) It conveys a residual claim on the assets or income of the issuer. Additionally, any of the following instruments must be categorised as an equity exposure: (a)An instrument with the same structure as those permitted as Tier 1 capital for banking organisations. (b)An instrument that embodies an obligation on the part of the issuer and meets any of the following conditions:

1. The issuer may defer indefinitely the settlement of the obligation;
2. The obligation requires (or permits at the issuer’s discretion) settlement by issuance of a fixed number of the issuer’s equity shares;
3. The obligation requires (or permits at the issuer’s discretion) settlement by issuance of a variable number of the issuer’s equity shares and (ceteris paribus) any change in the value of the obligation is attributable to, comparable to, and in the same direction as, the change in the value of a fixed number of the issuer’s equity shares; or,
4. The holder has the option to require that the obligation be settled in equity shares, unless either (i) in the case of a traded instrument, the supervisor is content that the bank has demonstrated that the instrument trades more like the debt of the issuer than like its equity, or (ii) in the case of non-traded instruments, the supervisor is content that the bank has demonstrated that the instrument should be treated as a debt position. In cases (i) and (ii), the

47 bank may decompose the risks for regulatory purposes, with the consent of the supervisor.