Tier I Tier I + Tier 2 + Tier 3
CHAPTER 7 CHAPTER 7
7.7 Policies to Limit or Reduce Credit Risk
* risk management and control policies and practices;
* loans, impaired loans, and past-due loans, including respective general allowances (loan loss reserves) and specific allowances (provisions) by major categories of borrowers and geographical regions and reconciliation of movements in the allowances for
loan impairment;
* large exposures and concentration, and exposures to connected parties;
* balances and other pertinent information on loans that have been restructured or are otherwise irregular with respect to the original loan agreement.
CREDIT RISK MANAGEMENT 155
The main difficulty in defining an exposure is to quantify the extent to which less direct forms of credit exposure should be included within the exposure limit. As a matter of principle, contingent liabilities and credit substitutes, such as guarantees, acceptances, and letters of credit, as well as all future commitments should be included, although the treatment of specific instruments may vary. For example, a financial obligation guar- antee may have a different treatment compared to a performance risk guar- antee. The inclusion of collateral in an assessment of exposure limit is another contentious issue, as the valuation of collateral can be highly sub- jective. As a matter of prudence, collateral should not be considered when determining the size of an exposure.
Another conceptual question is the definition of the term "single client." According to intemational practice, a single client is an individ- ual/legal person or a connected group to which a bank is exposed. Single clients are mutually associated or control (directly or indirectly) other clients, normally through a voting right of at least 15-20 percent, a dom- inant shareholding, or the capacity to exercise in concert a controlling influence on policy making and management. In addition, these clients' cumulative exposure may represent a singular risk to a bank if financial interdependence exists and their expected source of repayment is the same.
Figure 7.5 illustrates the exposure of a bank to its 20 largest clients, including the facilities granted and utilized and the ratio of such exposures to capital and reserves. In practical terms, large exposures are usually an indication of commitment by a bank to support specific clients. Banks that become entrapped in lending to large corporate clients are sometimes not objective in appraising the risks associated with such credit.
The issue of management of large exposures involves an additional aspect: the adequacy of a bank's policies, practices, and procedures in iden- tifying common or related ownership, the existence of effective control, and reliance on common cash flows. Particularly in the case of large clients, banks must pay attention to the completeness and adequacy of information about the debtor. Bank credit officers should monitor events affecting large debtors and their performance on an ongoing basis, regard- less of whether or not a debtor is meeting its obligations. When extemal events present a cause for concem, credit officers should request addition-
Percent 20 Largest Borrowers and Collateral Percent 20 Largest Exposures (Rescheduled Amounts)
800 180
700 160
600 O. 140
500 oo00
0o00 100
400 O__
500 .~~~~~~00008
300~~~~~~~~~~.. 0
400~~~~~~~~~~~~~~~~6
200 40~~~~~~0.
Aspercentage ot As percentage of As percentage of As percentage of Aspecnaeo Aserntg Claeals
100 20O
gross loans qualitying capital gross loan portfolio gross loans qualitying ot total percentage ot portfolio and off-balance-sheet portfolio capital exposure total exposure
0 20 Largest Borrowers i Collateral
CREDIT RISK MANAGEMENT 157
al information from the debtor. If there is any doubt that the debtor might have difficulties in meeting its obligation to the bank, the concerns should be raised with the higher level of the credit risk management hierarchy and a contingency plan on how to address the issue should be developed.
Related-party lending. Lending to connected parties is a particularly dangerous form of credit risk exposure. Related parties typically include a bank's parent, major shareholders, subsidiaries, affiliate companies, direc- tors, and executive officers (Table 7.2). This relationship includes the abili- ty to exert control over or influence a bank's policies and decision-making, especially concerning credit decisions. A bank's ability to systematically identify and track extensions of credit to insiders is crucial. The issue is whether credit decisions are made on a rational basis and according to the bank's policies and procedures. An additional concern is whether credit is based on market terms or is granted on terms that are more favorable with regard to amount, maturity, rate, and collateral, than those provided to the general public.
TABLE 7.2 RELATED-PARTY LENDING
Amount of loans not in the A (pass) Amount of Amount of category
loans not loans, as as percen- Amount in the A percentage tage of
of (pass) of qualifying qualifying Collateral loans category capital capital held Shareholders holding more
than 5 percent of shares Shareholders holding less
than 5 percent of shares Shareholders of any
shareholders Board of directors Executive management Entities controlled by
the bank
Entities have control over the bank Close relative to any
of the above Total
Most regulators establish limits for aggregate lending to related par- ties, typically stipulating that total lending to related parties cannot exceed a certain percentage of tier 1 or total qualifying capital. If such a limit has not been established by prudential regulations, a bank should be expected to maintain one as a matter of board policy. A prudent banking practice would require all loans to related parties to be approved by the board.
Overexposure to geographical areas or economic sectors. Another dimension of risk concentration is the exposure of a bank to a single sec- tor of the economy or a narrow geographical region. This makes a bank vulnerable to a weakness in a particular industry or region and poses a risk that it will suffer from simultaneous failures among several clients for similar reasons. This concern is particularly relevant for regional and spe- cialized banks or banks in small countries with narrow economic profiles, such as those with predominantly agriculture-based economies or exporters of a single commodity. Figure 7.6 below illustrates aspects of a sectoral analysis that can be performed to identify such problems.
FIGURE 7.6 SECTORAL ANALYSIS OF LOANS
Current Period Prior Period
13% - 1 2% 5% 5%
10%
12%
6%
22% 7% 8%
9 1~~~6% w 6%...
8% 8% 6%
zAgriculture, water, and forestry m]Individuals MTransport and communication gConstruction
E3Services PETourism
fManufacturing *Other
;7Trade and finance
CREDIT RISK MANAGEMEN 159
It is often difficult to assess the exposure of banks to various sectors of the economy, as most bank reporting systems do not produce such information. For example, a loan to the holding company of a large, diver- sified group could be used to finance projects in various industries in which the company operates. In any case, banks, which are by nature exposed to sector risks, should have well-developed systems to monitor such risks and to assess the impact of adverse trends on their loan portfo- lio quality and on their income statements. Such banks should also have institutionalized mechanisms in place to deal with increased risk.
Renegotiated debt refers to loans that have been restructured to pro- vide a reduction of either interest or principal payments because of the bor- rower's deteriorated financial position. A loan that is extended or renewed, with terms that are equal to those applied to new debt with similar risk, should not be considered as renegotiated debt. Restructuring may involve a transfer from the borrower to the bank of real estate, receivables or other assets from third parties, a debt-to-equity swap in full or partial satisfaction of the loan, or the addition of a new debtor to the original borrower.
A good practice is to have such transactions approved by the board of directors before concessions are made to a borrower. Bank policies should also ensure that such items are properly handled from an accounting and control standpoint. A bank should measure a restructured loan by reducing its recorded investment to a net realizable value, taking into account the cost of all the concessions at the date of restructuring. The reduction should be recorded as a charge to the income statement for the period in which the loan is restructured. A significant amount of renegotiated debt is normally a sign that a bank is experiencing problems. An exception to this general approach applies in a market environment of falling interest rates, when it may be in the interest of both debtors and creditors to rene- gotiate the original credit terms.
7.8 Asset Classification
Asset classification is a process whereby an asset is assigned a credit risk grade, which is determined by the likelihood that debt obligations will be serviced and debt liquidated according to contract terms. In general, all assets for which a bank is taking a risk should be classified, including
loans and advances, accounts receivable, investments, equity participa- tions, and contingent liabilities.
Asset classification is a key risk management tool. Assets are classi- fied at the time of origination and then reviewed and reclassified as nec- essary (according to the degree of credit risk) a few times per year. The review should consider loan service performance and the borrower's financial condition. Economic trends and changes in respective markets and the price of goods also affect evaluation of loan repayment. The eval- uation of certain classes of smaller loans, however, may be based only on repayment performance, in particular small consumer loans such as resi- dential mortgages, installment loans, and credit cards. Assets classified as
"pass" or "watch" are typically reviewed twice per year, while critical assets are reviewed at least each quarter.
Banks determine classifications by themselves but follow standards that are normally set by regulatory authorities. Standard rules for asset classification that are currently used in most developed countries are out- lined in Box 7.3. The primary emphasis of these rules is placed upon a borrower's ability and willingness to repay a debt, including both interest and principal, from prospective operating cash flow. Some jurisdictions require that all credit extended to an individual borrower (or to a related group of borrowers) should be assigned the same risk classification, while differences in classification should be specifically noted and justified.
Other jurisdictions recommend that each asset be assessed on its own par- ticular merits. In cases where assets may be classified differently depend- ing on whether subjective or objective criteria are used, the more severe classification should generally apply. If supervisory authorities, and in many cases external auditors, assign more stringent classifications than the bank itself, the bank is expected to adjust the classification.
In some advanced banking systems, banks use more than one rating level for assets in the pass category. The objective of such a practice is to improve the quality of portfolio analysis and trend analysis to be able to better differentiate among credits of different types, and to improve the understanding of the relationship between profitability and the rating level.
Banks engaged in international lending face additional risks, the most important of which are country, or sovereign, and transfer risks. The for- mer encompass the entire spectrum of risks posed by the macroeconomic,
CREDIT RISK MANAGEMENT 161
BOX 7.3 ASSET CLASSIFICATIOM RULES
According to international standards, assets are normally classified in the fol- lowing categories:
E Standard, or pass. When debt service capacity is considered to be beyond any doubt. In general, loans and other assets that are fully secured (including principal and interest) by cash or cash-substitutes (e.g., bank certificates of deposit and treasury bills and notes) are usual- ly classified as standard regardless of arrears or other adverse credit fac- tors.
| Specially mentioned, or watch. Assets with potential weaknesses that may, if not checked or corrected, weaken the asset as a whole or poten- tially jeopardize a borrower's repayment capacity in the future. This, for example, includes credit given through an inadequate loan agreement, a lack of control over collateral, or withbut proper documentation. Loans to borrowers operating under economic or market conditions that may neg- atively affect the borrower in the future should receive this classification.
This also applies to borrowers with an adverse trend in their operations or an unbalanced position in the balance sheet, but which have not reached a point where repayment is jeopardized.
* Substandard. This classification indicates well-defined credit weakness- es that jeopardize debt service capacity, in particular when the primary sources of repayment are insufficient and the bank must look to second- ary sources for repayment, such as collateral, the sale of a fixed asset, refinancing, or fresh capital. Substandard assets typically take the form of term credits to borrowers whose cash flow may not be sufficient to meet currently maturing debts or loans, and advances to borrowers that are significantly undercapitalized. They may also include short-term loans and advances to borrowers for which the inventory-to-cash cycle is insuf- ficient to repay the debt at maturity. Nonperforming assets that are at least 90 days overdue are normally classified as substandard, as are renegotiated loans and advances for which delinquent interest has been paid by the borrower from his own funds prior to renegotiations and until sustained performance under a realistic repayment program has been achieved.
E Doubtful. Such assets have the same weaknesses as substandard assets, but their collection in full is questionable on the basis of existing facts. The possibility of loss is present, but certain factors that may strengthen the asset defer its classification as a loss until a more exact
BOX 7.3 (CONTINUED)
status may be determined. Nonperforming assets that are at least 180 days past due are also classified as doubtful, unless they are sufficiently secured.
* Loss. Certain assets are considered uncollectible and of such little value that the continued definition as bankable assets is not warranted. This classification does not mean that an asset has absolutely no recovery or salvage value, but rather that it is neither practical nor desirable to defer the process of writing it off, even though partial recovery may be possible in the future. Nonperforming assets that are at least one year past due are also classified as losses, unless such assets are very well secured.
political, and social environment of a country that may affect the per- formance of borrowers. Transfer risks are the difficulties that a borrower might have in obtaining, the foreign exchange needed to service a bank's loan. The classification of international loans should normally include both country and transfer risk aspects. A bank may be asked to provision for international loans on a loan-by-loan basis, whereby the level of nec- essary provisions is increased to accommodate additional risk.
Alternatively, a bank may determine aggregate exposures to country and transfer risks on a country-by-country basis, and provide special reserves to accommodate for risk exposures.
Additionally, foreign currency risk aspects may also affect loan clas- sification in cases where a debtor has borrowed in one currency but gen- erates cash flow in another currency. In effect, the foreign currency risk aspect magnifies the credit risk taken by a bank. Such cases are especial- ly relevant in emerging market economies or in economies where the domestic currency is unstable and/or lacks full convertibility. The loan classification should, in such cases, also include considerations related to the likelihood of currency devaluation, the ability of the debtor to cover or hedge the risk of devaluation, or the debtor's capacity to adjust product or service pricing.
Figure 7.7 illustrates the asset quality of a bank. When aggregate assets in the substandard to loss categories represent 50 percent or more
CREDIT RISK MANAGEMENT 163
FIGURE 7.7 CLASSIFICATION OF LOANS
Current Period Prior Period
3% 2% 5% 3%
7 0 ° % X~~~~70
Pass mWatch
[ Substandard Doubfful Loss
of a bank's capital, a strong likelihood exists that the bank's solvency and profitability is impaired. Such a bank will most likely be considered by supervisors to be a problem bank, although other factors must also be con- sidered. These include the ability or actual performance of management to strengthen or collect problem assets, and the severity of the classified assets. For example, a bank with assets that are classified as doubtful and loss would be in more serious trouble than one with a similar amount of problem assets in the substandard category. Additional considerations are the stability of funding sources and the bank's access to new capital.
Overdue interest. In order to avoid the overstatement of income and ensure timely recognition of nonperforming assets, bank policies should require appropriate action on uncollected interest. Two basic methods exist for handling both the suspension and nonaccrual of interest. First, in cases where the interest is suspended, it is accrued or capitalized and an
offsetting accounting entry is made for a category called "interest in sus- pense." For reporting purposes the two entries must be netted, otherwise the assets will be inflated.
Second, when a bank places a loan in nonaccrual status, it should reverse uncollected interest against corresponding income and balance sheet accounts. For interest accrued in the current accounting period, the deduction should be made directly from current interest income. For prior accounting periods, a bank should charge the reserve for possible loan losses or, if accrued interest provisions have not been provided, the charge should be expensed against current earnings. A nonaccruing loan is nor- mally restored to accruing status after both arrears principal and interest have been repaid or when prospects for future contractual payments are no longer in doubt.
In some jurisdictions, a bank may avoid taking action on interest in arrears if the obligation is well-secured or the process of collection is underway. A debt is considered to be well-secured if it is backed by col- lateral in the form of liens on or pledges of real or personal property. Such collateral, including securities, must have a realizable value that is suffi- cient to discharge the debt in full according to contract terms or a finan- cially responsible party. A debt is "in the process of collection" if collec- tion is proceeding in due course, either through legal action or through collection efforts that are expected to result in repayment of the debt or in its restoration to current status.