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  • 2. Mechanics of the IRB Approach

    • 2.1 Categorization of Exposures

      2.1.1Under the IRB Approach, banks should categorize exposures in the banking book into broad classes of assets with different underlying risk characteristics, subject to the definitions set out below.
       
      2.1.2The classes of assets are: (i) corporate; (ii) sovereign; (iii) bank; (iv) retail; and (v) equity. Within the corporate asset class, four sub-classes of specialized lending (see paragraph 2.2.4 below) are separately identified. Within the retail asset class, three sub-classes (see paragraph 2.5.2 below) are separately identified.
       
      2.1.3The classification of exposures mentioned above is broadly consistent with established banking practice. However, some banks may use different definitions in their internal risk management and measurement systems. While it is not the intention of SAMA to require banks to change the way they manage their business and risks, banks are required to apply the appropriate treatment to each exposure for the purpose of deriving their minimum capital requirements. Banks should demonstrate to SAMA that their methodology for assigning exposures to different asset classes is appropriate and consistent over time.
       
      2.1.4The size or exposure limits used for defining some corporate or retail exposures are denominated in local currency (see paragraphs 2.2.2, and 2.5.4 below). Banks are generally expected to re-classify such exposures when the exposures are no longer within or above the limits, as the case may be. However, SAMA will be flexible if the need for re-classification arises solely from short-term exchange fluctuations for exposures denominated in foreign currencies. Banks should have appropriate policies in place for determining the circumstances for re-classifying the exposures. For example, these may include situations in which the changes are more permanent in nature, having been caused by a major currency revaluation or a natural growth or reduction in size or exposure. Re-classification of an exposure will not be required if its outstanding balance falls below the relevant limit mainly as a result of repayments or write-offs.
       

    • 2.2 Definition of Corporate Exposures

      2.2.1In general, a corporate exposure is defined as a debt obligation of a corporation, partnership, or proprietorship. Banks are permitted to distinguish separately exposures to small- and medium-sized entities (“SMEs”).
       
       SME exposures
       
      2.2.2SME is defined as a corporate where the reported sales1 for the consolidated group of which the firm is a part are less than SR. 15 MM and the max claims on the counterparty are at SR. 10 MM. To ensure that the information used is timely and accurate, banks should obtain the consolidated sales figure from the latest available audited financial statements2 and have it updated at least annually. The basis of consolidation for the borrowing group should follow that used by Banks for their risk management purposes.
       
      2.2.2.1Banks should manage SME on a pooled basis in their internal risk management systems in the same manner as other retail exposures. This could be as part of a portfolio segment or pool of exposures with similar risk characteristics for risk assessment and quantification.
       
      2.2.2.2VIP and High Net Worth Private Accounts
      These are defined to be exposure to VIP accounts and high net worth individuals that do not meet the criteria for retail exposures under Para 2.5.
       
       Specialized lending (“SL”) exposures
       
      2.2.3Except otherwise specified, a corporate exposure should be classified as SL if it possesses all of the following characteristics, either in legal form or economic substance:
       
       •the exposure is to an entity (often a special purpose entity (“SPE”)) which was created specifically to finance and/or operate physical assets;
       
       •the borrowing entity has little or no other material assets or activities, and therefore little or no independent capacity to repay the obligation, apart from the income that it receives from the asset(s) being financed;
       
       •the terms of the obligation gives the lender a substantial degree of control over the asset(s) and the income that it generates; and
       
       •as a result of the preceding factors, the primary source of repayment of the obligation is the income generated by the asset(s), rather than the independent capacity of a broader commercial enterprise.
       
      2.2.4The five sub-classes of specialized lending are project finance, object finance, commodities finance, income-producing real estate, and high-volatility commercial real estate. Each of these sub-classes is defined below.
       
       (Refer para 220, International Convergence of Capital Measurement and Capital Standards – June 2006)
       
       Project finance
       
      2.2.5Project finance (“PF”) is a 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 exposure. This type of financing is usually for large, complex and expensive installations that might include, for example, power plants, chemical processing plants, mines, transportation infrastructure, and telecommunications infrastructure. PF may take the form of financing of the construction of a new capital installation, or refinancing of an existing installation, with or without improvements.
       
      2.2.6In such transactions, the lender is usually paid solely or almost exclusively out of the money generated by the contracts for the facility’s output, such as the electricity sold by a power plant. The borrower is usually an SPE that is not permitted to perform any function other than developing, owning, and operating the installation. The consequence is that repayment depends primarily on the project’s cash flow and on the collateral value of the project’s assets. In contrast, if repayment of the exposure depends primarily on a well-established, diversified, credit-worthy, contractually obligated end user for repayment, it is considered a secured exposure to that end user.
       
       Object finance
       
      2.2.7Object finance (“OF”) refers to a method of funding the acquisition of physical assets (e.g. ships, aircraft, etc.) where the repayment of the exposure is dependent on the cash flows generated by the specific assets that have been financed and pledged or assigned to the lender. A primary source of these cash flows might be rental or lease contracts with one or several third parties. In contrast, if the exposure is to a borrower whose financial condition and debt-servicing capacity enables it to repay the debt without undue reliance on the specifically pledged assets, the exposure should be treated as a collateralized corporate exposure.
       
       Commodities finance
       
      2.2.8Commodities finance (“CF”) refers to structured short-term lending to finance inventories, or receivables of exchange-traded commodities (e.g. crude oil, metals, or crops), where the exposure will be repaid from the proceeds of the sale of the commodity, and the borrower has no independent capacity to repay the exposure. This is the case when the borrower has no other activities and no other material assets on its balance sheet. The structured nature of the financing is designed to compensate for the weak credit quality of the borrower. The exposure’s rating reflects its self-liquidating nature and the lender’s skill in structuring the transaction rather than the credit quality of the borrower.
       
      2.2.9Such lending can be distinguished from exposures financing the inventories, or receivables of other more diversified corporate borrowers. Banks are able to rate the credit quality of the latter type of borrowers based on their broader ongoing operations. In such cases, the value of the commodity serves as a risk mitigant rather than as the primary source of repayment.
       
      2.2.10Income-producing real estate (“IPRE”) refers to a method of providing funding to real estate (such as, office buildings, retail shops, residential buildings, industrial or warehouse premises, and hotels) where the prospects for repayment and recovery on the exposure depend primarily on the cash flows generated by the asset. The primary source of these cash flows would generally be lease or rental payments or the sale of the asset. The distinguishing characteristic of IPRE versus other corporate exposures that are collateralized by real estate is the strong positive correlation between the prospects for repayment of the exposure and the prospects for recovery in the event of default, with both depending primarily on the cash flows generated by a property.
       
      2.2.11High Volatility Commercial Real Estate
       
      High-volatility commercial real estate (HVCRE) lending is the financing of commercial real estate that exhibits higher loss rate volatility (i.e. higher asset correlation) compared to other types of SL. HVCRE includes: 
       
       •Commercial real estate exposures secured by properties of types that are categorized by the national supervisor as sharing higher volatilities in portfolio default rates;
       
       •Loans financing any of the land acquisition, development and construction (ADC) phases for properties of those types in such jurisdictions; and
       
       •Loans financing ADC of any other properties where the source of repayment at origination of the exposure is either the future uncertain sale of the property or cash flows whose source of repayment is substantially uncertain (e.g. the property has not yet been leased to the occupancy rate prevailing in that geographic market for that type of commercial real estate), unless the borrower has substantial equity at risk. Commercial ADC loans exempted from treatment as HVCRE loans on the basis of certainty of repayment of borrower equity are, however, ineligible for the additional reductions for SL exposures described in paragraph 277, International Convergence of Capital Measurement and Capital Standards – June 2006
       
        (Refer para 227, International Convergence of Capital Measurement and Capital Standards – June 2006)
       
        Where SAMA would categorize certain types of commercial real estate exposures as HVCRE in their jurisdictions, it would make public such determinations. SAMA would then ensure that such treatment is then applied equally to banks under their supervision when making such HVCRE loans in that jurisdiction.
       
        (Refer para 228, International Convergence of Capital Measurement and Capital Standards – June 2006)
       

      1 This term is used interchangeably with “turnover” or “revenue”.
      2 This does not apply to those customers that are not subject to statutory audit (such as a sole proprietor). In such cases, banks should obtain their latest available management accounts

    • 2.3 Definition of Sovereign Exposures

      2.3.1This asset class covers all exposures to counterparties treated as sovereigns under the Standardised Approach, including:
       
       •Sovereigns (and their central banks);
       
       •Public sector entities (“PSEs”) that are treated as sovereigns under the Standardised Approach1;
       
       •Multilateral development banks (“MDBs”) that meet the criteria for a 0% risk weight under the Standardised Approach2; and other entities that receive a 0% risk weight under the Standardised Approach, namely, World Bank, the Bank for International Settlements, the International Monetary Fund, the European Central Bank and the European Community, Arab Monetary Fund, the Islamic Development Bank.
       

      1 These mainly refer to claims on foreign PSEs that are regarded by the relevant national supervisors as sovereigns in whose jurisdictions the PSEs were established.
      2 Eligible MDBs (Standardized Approach)”. Also refer to the section on terminology

    • 2.4 Definition of Bank Exposures

      2.4.1This asset class covers exposures to:
       
       •Banks;
       
       •Regulated securities firms (including all security firms licensed CMA) and by the relevant foreign regulators.
       
       •Domestic PSEs that are treated as banks under the Standardised Approach; and
       
       •MDBs that do not meet the criteria for a 0% risk weight under the Standardised Approach.
       

    • 2.5 Definition of Retail Exposures

       General
       
      2.5.1For an exposure to be categorized as retail, it should satisfy two general criteria:
       
       •The borrower is an individual or a small business that meets a specified exposure threshold (see paragraphs 2.5.3 and 2.5.4 below); and
       
       •The exposure should be one of a large pool of exposures, which are managed by banks on a pooled or portfolio basis1 (see paragraph 2.5.5 below).
       
      2.5.2Within the retail asset class, banks are required to identify separately three subclasses of exposures:
       
       •Exposures secured by residential properties (see paragraphs 2.5.5 to 2.5.6 below);
       
       •Qualifying Revolving Retail Exposures (QRRE) - (see paragraph 2.5.9 below); and
       
       •All other retail exposures.
       
       Exposures to individuals
       
      2.5.3Exposures to individuals are generally eligible for retail treatment regardless of exposure size. Such exposures include residential mortgage loans, revolving credits and lines of credit (e.g. credit cards, overdrafts, and retail facilities secured by financial instruments) as well as personal term loans (e.g. installment loans, auto loans, personal finance, and other exposures with similar characteristics).
       
       Small business enterprise
       
      2.5.4Loans extended to small businesses enterprise and managed as retail exposures are eligible for retail treatment provided the total exposure (On and Off) items of the banking group2 to a small business borrower (on a consolidated basis where applicable3) is less than 5 million Saudi Riyal. Small business loans extended through or guaranteed by an individual are subject to the same exposure threshold.
       
       Exposures secured by residential properties
       
      2.5.5Residential mortgage loans are eligible for retail treatment regardless of exposure size so long as the credit is extended to an individual and the property is or will be occupied by the borrower, or rented.
       
      2.5.6Other exposures secured by residential properties that do not satisfy the above requirements should be classified as other retail or corporate exposures, as appropriate.
       
       Qualifying Revolving Retail Exposures (“QRRE”)
       
      2.5.7A Bank may regard a sub-portfolio of its retail exposures (which should be consistent with the Banks segmentation of retail activities generally) as QRRE, subject to the following criteria being met:
       
       •The exposures are revolving, unsecured, and uncommitted (both contractually and in practice). In this context, revolving exposures are defined as those where customers’ outstanding balances are permitted to fluctuate based on their decisions to borrow and repay, up to a limit established by banks;
       
       •The exposures are to individuals;
       
       •The maximum exposure to a single individual in the sub-portfolio is SR. 5 million or less;
       
       •Because the asset correlation assumptions for the QRRE risk-weight function are markedly below those for the other retail risk-weight functions at low PD values, banks should demonstrate that the use of the QRRE risk-weight function is constrained to portfolios that have exhibited low volatility of loss rates, relative to their average level of loss rates, especially within the low PD bands. SAMA will, for monitoring purposes, review the relative volatility of loss rates across the QRRE sub-portfolios of banks;
       
       •Data on loss rates for the QRRE sub-portfolio should be retained in order to allow analysis of the volatility of loss rates; and
       
       •Treatment as QRRE is consistent with the underlying risk characteristics of the sub-portfolio.
       

      1 SAMA does not intend to set the minimum number of retail exposures in a portfolio. Banks should establish their internal policies to ensure the granularity and homogeneity of their retail exposures. Also refer to the Standardized Approach.
      2 The banking group should, at a minimum, cover all entities within the group that are subject to the capital adequacy regime in Saudi Arabia.
      3 The basis of consolidation should follow that used by a bank for its risk management purposes, provided that exposures to the sole proprietors or partners within the borrowing group are included in the consolidation.