Major Section 5.2: Application and Examination Procedures for Adoption of the IRB Approach
Purpose
5.2.1 This section sets out:
The application and recognition process that banks will go through if they wish to use the IRB Approach for capital adequacy purposes; and
SAMA’s preliminary approach to conducting IRB validations.
5.2.2 Self-assessment questionnaires (currently in draft form) that will be used by banks for the recognition of their internal rating systems are also provided for reference.
Background
5.2.3 Under its implementation proposals, SAMA plans to allow various IRB Approaches applicable to different asset classes to banks that are capable of meeting the relevant requirements. SAMA will aim to make available for adoption by bank the Foundation IRB Approach based on SAMA’s bi-lateral discussions
5.2.4 Banks wishing to adopt the IRB Approach are expected to discuss their plans with SAMA. Whether they will be able to use the IRB Approach for capital adequacy purposes is subject to the prior approval of SAMA and to their satisfying the minimum qualifying criteria. These criteria are set out in major Section 5.1 Entitled “Implementation Proposed for the IRB Approach”:
(i) The criteria for transition to the IRB Approach (see paragraphs 5.1.13 to 5.1.28) of major section 5.1; and
(ii) Various qualitative and quantitative requirements in relation to internal rating systems and the estimation of probability of default (“PD”) / loss given default (“LGD”) / exposure at default (“EAD”), and the controls surrounding them. (See paragraphs 5.1.29 to 5.1.38 and the guidance papers as Attachment 5.4 and Attachment 5.5 for details.
5.2.5 SAMA will conduct on-site validation and recognition exercises starting some time in 2007 to ensure that banks’ internal rating systems and the corresponding risk estimates meet the minimum requirements. It should however be stressed that a bank’s management has the primary responsibility for validating and ensuring the quality of its internal rating systems.
IRB Recognition Process
5.2.6 The first step of the IRB recognition process is to identify those banks with a firm commitment to implement the IRB Approach for capital adequacy purposes. In order to provide sufficient time for SAMA to conduct the necessary IRB validations, such banks should lodge an application with SAMA, using the IRB recognition request form attached at Attachment 5.6. In completing this form, banks are required to provide information on its IRB implementation plan, the target date for adopting the IRB Approach, the estimated level of IRB coverage, and the contact person for the IRB implementation project.
5.2.7 Banks that are planning to start using the Foundation IRB Approach or the Advanced IRB Approach for capital calculation should submit the IRB recognition request form to SAMA no later than 31 December 2006. This is to ensure that their recognition requests can be taken into account in SAMA’s validation schedule for the next few years. Banks that intend to adopt the IRB Approach in later periods may also submit this form to facilitate SAMA’s scheduling of validation visits, but the priority for conducting IRB validations will be given to those with an earlier IRB adoption date.
5.2.8 Upon receipt of the IRB recognition request, SAMA will work with the bank concerned to satisfy itself that the IRB systems/models and the risk management practices surrounding the use of such systems/models meet the minimum standards specified by SAMA. The IRB recognition process, as depicted under Attachment 5.7, generally includes the following steps:
(i) Pre-examination meeting – SAMA will arrange a meeting with the banks to discuss the details of its Implementation Plan and other matters related to the recognition process. Prior to the meeting, SAMA will provide the Bank with a set of self-assessment questionnaires for its completion;
(ii) Self-assessment – Banks will complete the questionnaire in the stipulated time frame. Completed questionnaire and supporting documentation will be submitted for SAMA’s approval.
(iii) On-site examination – SAMA will conduct the on-site examination to review both the technical details of the systems/models and the risk management practices that govern the use of such systems/models. The examination may take three weeks to a month, depending on the quality of the bank’s self-assessment, the complexity of its IRB systems and any compliance issues identified. After concluding the assessment, SAMA will issue the examination report, including the decision of whether to allow the bank to use the IRB Approach;
5.2.9 In the case of banks that are branches of foreign banking groups, SAMA will liaise with the relevant home supervisor, particularly on their Implementation Plans and validation arrangements, to assess the extent of reliance that it may place on the validation work done by the home supervisor.
Approach to IRB Recognition
5.2.10 While SAMA is still developing its detailed approach to IRB recognition, Attachment-5.8 will facilitate banks’ IRB implementation efforts.
Self-assessment Questionnaires
5.2.11 Self-assessment questionnaires are being developed by SAMA. Banks that would implement the IRB approaches will be given questionnaire. It is important for banks to make a detailed self-assessment and support the assessment with adequate documentation and internal reports.
Final Applications and Executive Procedures
5.2.12 SAMA is planning to issue before Dec. 2005 its final application and assessment procedures for IRB recognition as described in this section.
Attachment 5.6: Request for Recognition of Internal Rating Systems for Measurement of Credit Risk Capital Charge Under the Internal Ratings-Based (“IRB”) Approach
This form is to be completed by “Bank” wishing to adopt the IRB Approach for measurement of credit risk capital charge. SAMA should be notified of any subsequent changes to the information provided in this form and Table 1.
I. Name of the Bank:
___________________________________________________________
II. IRB implementation plan:
(a) Please provide information regarding the bank’s IRB implementation plan by completing Table 1.
(b) What is the bank’s target date for adopting the IRB Approach for capital adequacy purposes? In the case of a phased rollout implementation plan, please specify the target dates for the first and last phases of rollout.
___________________________________________________________
(c) What is the bank’s estimate of the percentage of credit risk-weighted assets covered under IRB on a consolidated basis? Please specify the reference date used for the estimate. In the case of a phased rollout implementation plan, please provide estimates for the first and last phases of rollout.
___________________________________________________________
III. Contact person for the IRB implementation project:
Name: ___________________
Position: ___________________
Telephone no: ___________________
Fax No: ___________________
Email address: ___________________
Signed by:
General Managers or Managing Directors: ___________________
(Name)
(Signature)
____________
Date: ___________________
Table–1 IRB Information Plan
Name of Banks
Asset classes under IRB 1 Type of IRB Approaches to be adopted Exposures as % of credit risk weighted assets ("RWAs") 2 As of ________ Geographical location of exposures Internal Rating Systems Solo basi3 Consolidated basis3 Name Centrally developed by Parent/Group (A)4 or Developed locally Date ready for SAMA's recognition 5 (I) (II) (III) (IV) (V) (VI) (B) (VII) (VIII) I. Corporate Exposures a. Small and medium sized entities (SMEs) b. Specialised lending (SL) project finance object finance commodities finance income producing real estate c. Purchase corporate receivables d. Other corporate exposures II. Bank exposures a. Banks b. Other exposures treated as bank exposures i) Securities firms ii) Public Sector Entities iii) Multilateral development bank III. Sovereign exposures a. Sovereigns (and their central banks) b. Other exposures treated as sovereign exposures i) PSEs ii) MDBs and other qualifying entities IV. Retail exposures a. Exposures secured by residential properties b. Qualifying revolving retail exposures c. Purchased retail receivables d. Other retail exposures (please specify) V. Equity exposures (please specify) VI. Assets under Securitisation (please specify) 1Banks should categories banking book exposures into different asset classes (i.e. corporate, bank, sovereign, retail and equity exposures, as well as assets under securitisation), subject to definitions set out in paragraphs 215-243, 273 and 538-542 of the ―International Convergence of Capital Measurement and Capital Standards : A Revised Framework" issued by the Basel Committee on Banking Supervision in June 2004.
2RWAs should be calculated based on the Current Basel Capital Accord
3 Missing
4In the case of banks that are branch of foreign banking groups, all or part of their IRB systems may be centrally developed by the parent bank and monitored on a group basis.
5For the purpose of this table, an internal rating system is regarded as ready for SAMA's recognition if the bank considers that it meets all the minimum qualifying criteria set out the Implementation Plan of the ―Basel II‖ in Saudi Arabia‖ issued by SAMA in May 2005.Attachment 5.7: IRB Recognition Process
Banks submits IRB recognition request to SAMA Pre-examination meeting between bank and SAMA (Self –assessment questionnaires given to bank) Completion of self-assessment by bank Review of self-assessment by SAMA SAMA conducts on-site examination on bank SAMA issues examination report, including decision on whether to allow bank to use IRB Approach SAMA follows up implementation of recommendations in examination report, and monitors performance of bank‘s systems. Attachment 5.8: The SAMA’s Preliminary Approach to IRB Recognition
Background
1. IRB systems are the cornerstone for calculating regulatory capital charges under the IRB Approach, as they form the basis of determining a borrower’s probability of default (“PD”) and, where applicable, two other risk components, namely, a facility’s loss given default (“LGD”) and exposure at default (“EAD”). As a consequence, validation of these three parameters, which are key inputs to the calculation of regulatory capital, and the underlying rating system is a major part of the IRB recognition process.
2. It is useful to differentiate from the outset a bank’s internal IRB validation from the SAMA’s IRB recognition and ongoing monitoring (which refer to the SAMA’s first evaluation exercise and subsequent reviews). The primary responsibility for conducting internal validation to ensure the quality of a bank’s internal rating systems lies with its management.
3. Explicit requirements in SAMA’s guidance paper “Minimum Requirements for Risk Quantification under IRB Approach” underline the need for banks to validate internal rating systems. Banks should demonstrate to SAMA that they can assess the performance of their internal rating and risk estimation systems consistently and meaningfully. More detailed requirements demand, for example, that realized default rates have to be within an expected range; that banks should use different quantitative validation tools; and that well-articulated internal standards should exist for situations where significant deviations occur between observed values of the key risk components and their estimates.
4. The design of a validation methodology (Figure-1 Page 124) depends on the type of rating system and its underlying data. Rating systems can differ in various ways, depending on the borrower type, the materiality of the exposure, the dynamic properties of the estimation methodology (point-in-time versus through- the-cycle), and the availability of default data and external credit quality assessments (external ratings or vendor models). For example, the ratings for retail lending will typically be of a more quantitative nature, based on a rather large quantity of data. Sovereign ratings instead will typically put more emphasis on qualitative aspects because these borrowers are more opaque and default data are scarce.
5. As a result, issues in relation to the internal IRB validation conducted by banks and the IRB recognition conducted by SAMA are relatively complex and require a good understanding of the rating system and its properties. Some of the issues are not currently well developed thus posing many challenges to both banks and supervisors. It is SAMA’s aim to work with banks to raise the standards of IRB recognition in Saudi Arabia. The following paragraphs set out the key components of IRB recognition to be conducted by SAMA.
Key components of IRB recognition
6. Figure 1 shows the key components of SAMA’s validation of IRB systems. The examination process mainly includes a review of the self-assessment questionnaires completed by a bank and an on-site examination to review both the technical details of the bank’s IRB systems/models and the risk management practices that govern the use of those systems/models.
Qualitative aspects
7. The qualitative aspects of the recognition process can be broken down into three areas:
IRB coverage of assets – This should meet the criteria for transition to the IRB Approach.
Rating system design - This involves evaluating the development of the rating method and monitoring of its ongoing performance. In the case of a model-based rating system, this includes a review of the economic plausibility of the risk factors and the treatment of problems in data quality. The stability of a rating system, whether based on expert judgment or models, is a central issue that can be analyzed (for example by looking at the rating migrations over time).
Rating assignment process and the controls surrounding it -
Important issues to be examined include the consistent application of a rating methodology across the bank and the requirement that these validation activities are subject to independent internal review. Underlying the controls should be adequate corporate governance and audit. Equally important are the transparency of the rating procedures and use of internal ratings, which should be supported by proper documentation. Use of internal ratings relates in particular to issues like internal reporting and how the rating system is being used by the credit officers. Furthermore, the rating system should be integrated into the bank’s policies and procedures, which deal with such aspects as the training of credit officers and specialists responsible for operating the rating system and measures to ensure a uniform application of the rating system across different branches and business units of the bank.
8. Banks are expected to evaluate the above aspects in their self-assessment. SAMA will review banks’ self-assessment results, and check for compliance during the on-site visit based on the criteria for transition to IRB Approach and other requirements set out in the guidance paper “Minimum Requirements for Internal Rating Systems under IRB Approach”.
Quantitative aspects – Banks’ internal validation
9. SAMA considers that internal validation of the IRB Approach should be an integral part of a bank’s rating system architecture to provide reasonable assurances about its rating system. Banks adopting the IRB Approach should have a robust system in place to validate the accuracy and consistency of their rating systems, and the estimation of all relevant risk measures (i.e. PD/LGD/EAD). In addition, Banks should demonstrate the assessment of the discriminatory power (a measure of a rating system’s ability to distinguish between good and bad credits) of their rating systems (including credit scoring systems) based on quantitative methods.1
10. In the guidance paper “Minimum Requirements for Risk Quantification under IRB Approach”, it is proposed that the internal validation process should include review of rating system developments, ongoing analysis, and comparison of predicted estimates to actual outcomes (i.e. back-testing).
Quantitative aspects – banks’ internal stress-testing
11. For the purpose of assessment of capital adequacy using stress tests, it is proposed that a stressed scenario chosen by a bank should resemble the economic recession in Saudi Arabia. (see subsection 5.5 of “Minimum Requirements for Internal Rating Systems under IRB Approach” for details) entitled stress test.
12. In reviewing the stress tests conducted by a bank, SAMA will have regard to the following:
• The complexity and level of risks of a bank’s activities;
• The adequacy of stress tests (e.g. stress scenarios and parameters chosen) employed by the bank in relation to its activities;
• The appropriateness of the assumptions used in the stress tests;
• The adequacy of the bank’s risk management policies and stress testing procedures;
• The level of oversight exercised by the Board and senior management on the stress-testing programme and results generated; and
• The adequacy of the bank’s internal review and audit of its stress testing programme.
Quantitative aspects – data quality
13. Another key component of an IRB system is an advanced data management system that produces credible and reliable risk information. The standard governing an IRB data maintenance system is that it should support the requirements for the other IRB system components, as well as the bank’s broader risk management and reporting needs. (See subsection of “Minimum Requirements for Internal Rating Systems under IRB Approach” for details.)
14. The SAMA recognizes that the data quality challenge for IRB is significant. Perfection is therefore not its goal. The underlying requirement is that data should be fit for purpose. Banks are expected to produce information that is reliable and takes proper account of the different users of the information produced (the Board and senior management, customers, shareholders, regulators and other market participants).
15. SAMA’s assessment of data accuracy and completeness will include an evaluation of the systems and controls that banks have in place to produce IRB information. SAMA will require that where an asset has a PD, LGD and EAD risk measure, this can be relied on and has been appropriately validated, captured and reported, both internally and externally.
16. Banks are encouraged to develop automated data capture processes to safeguard the integrity of the calculation and reporting process with full and appropriate levels of documentation, suitably audited. Formal documentation should also be prepared for all manual or spreadsheet based approaches, including appropriate risk mitigating action taken.
17. SAMA will require banks to self-assess against demonstrable measures (tests) on data quality as part of the overall approach to implementation of IRB. Banks should identify key risk areas in the regulatory capital calculation and underlying processes in relation to their data maintenance systems. SAMA will work with banks to establish a set of tests for assessing data quality, including the appropriate quantifiable measures that can truly reflect banks’ specific differences. It aims for a consistent approach for assessing data quality among banks through development of the set of tests, and allows banks the scope to tackle other areas of data quality in accordance with their internal priorities and scale of operations.
18. Tests on data quality should be designed principally to cover the quality and integrity of the data, including associated risk controls, used in the capital calculation processes, and the integrity of the supporting processes themselves. The challenge will be for banks to demonstrate compliance with their internal policies in a quantitative way. In addition, there are some common tests that are appropriate for all banks, for example, that all areas of the balance sheet are appropriately covered in their data maintenance systems.
Quantitative aspects – SAMA’s validation of PD/LGD//EAD estimates
19. SAMA’s validation of PD/LGD//EAD estimates can be broken down into the two areas listed below:
• Back-testing means the use of statistical methods to compare estimates of the three risk estimates to realized outcomes. It is the empirical test of the accuracy and calibration of the estimates associated with borrower and facility ratings, respectively.
• Benchmarking refers to a comparison of internal estimates across banks and/or with external benchmarks (e.g. external ratings or vendor models used by banks).
20. The data to perform comprehensive back-testing would not be available in the early stages of implementing an IRB system. This is due to the infrequency of default events and the impact of default correlation1. Even if the data requirements of Basel II for the length of time series for the risk estimates are met, the explanatory power of statistical tests will still be limited. Therefore, statistical tests alone will be insufficient to establish supervisory acceptance of an internal rating system.
21. Due to the limitations of using statistical tests to verify the accuracy of risk quantification, benchmarking can be a complementary tool for the validation and/or calibration of risk estimates. Benchmarking involves the comparison of a bank’s risk estimates to results from alternative sources. It is quite flexible in the sense that it gives banks and SAMA latitude to select an appropriate benchmark. An important technical issue is the design of the mapping from a bank’s estimates to the benchmark. Benchmarking can be a promising validation technique that would enable SAMA to make inferences about the characteristics of the internal rating system.
22. Benchmarking may also from a part of the whole process of producing internally generated estimates from banks’ IRB systems. For example, banks could use external and independent references to calibrate their own IRB systems in terms of PD. Benchmarking internal risk estimates with external and independent risk estimates is implicitly given a special credibility, and deviations from this benchmark (in particular where the internal estimates are systematically lower than the benchmarking values) provide a reason to review the internal risk estimates.
23. SAMA will work with individual banks to establish standards and techniques of benchmarking for validation purposes. It aims for a consistent approach among banks through development of such standards and techniques. The benchmarking techniques would largely be based on those used by banks internally. SAMA will also compare banks’ internal estimates of risk components (e.g. PD) across a panel. For example, it will compare PD estimates on corporates with respect to a peer group of banks. The main purpose of such comparison is to assess the correlation of the estimates or conversely the identification of potential “outliers” (e.g. variance analysis or robust regression) but not to determine if these estimates are accurate or not.
24. If bank’s benchmarking is not sufficient to establish supervisory acceptance of its internal risk estimates (for example, the requirements regarding benchmarking set out in section 5 of “Minimum Requirements for Risk Quantification under IRB Approach” have not been met), the SAMA would consider to use supervisory benchmarking models as a complementary tool for the validation of the risk estimates. SAMA will let the bank understand the methodologies (including the theories and empirical data used) of the supervisory benchmarking models.
Way Forward
25. IRB validation and recognition should be understood as an ongoing process. As rating systems become more refined, the validation methodology will also develop. It will be useful for SAMA to monitor this process by staying in close contact with the banks. In addition, there are two areas where further action is warranted. One area concerns developments of qualitative and quantitative techniques and collection of historical data that are necessary for estimation and validation. This is the responsibility of banks.
26. The other area is further guidance on the implementation of the IRB minimum requirements. In particular, the requirements for the estimation of the three risk components, which will have a strong impact on the validation/recognition methodology, are not yet fully understood by banks. Providing on-going guidance to banks is the foremost responsibility of SAMA.
1 Due to correlation between defaults in a portfolio, observed default rates can systematically exceed the critical PD values if these are determined under the assumption of independence of the default events.
Attachment-5.9
Table 2: Supervisory Slotting Criteria for Specialized Lending
Table 2.1 – Supervisory Rating Grades for Project Finance Exposures
Strong Good Satisfactory Weak I. Financial strength Market Conditions Few competing suppliers OR substantial and durable advantage in location, cost, or technology. Demand is strong and growing. Few competing suppliers OR better than average location, cost, or technology but this situation may not last. Demand is strong and stable. Project has no advantage in location, cost, or technology. Demand is adequate and stable. Project has worse than average location, cost, or technology. Demand is weak and declining. Financial ratios (e. g debt service coverage ratio (DSCR), loan life coverage ration (LLCR), project life coverage ration (PLCR), and debt-to-equity ratio) Strong financial ratios considering the level of project risk; very robust economic assumptions Strong to acceptable financial ratios considering the level of project risk; robust project economic assumptions Standard financial ratios considering the level of project risk Aggressive financial ratios considering the level of project risk Stress analysis The project can meet its financial obligations under sustained, severely stressed economic or sect oral conditions. The project can meet its financial obligations under normal stressed economic or sect oral conditions. The project is only likely to default under severe economic conditions. The project is vulnerable to stresses that are not uncommon through an economic cycle, and may default in a normal downturn. The project is likely to default unless conditions improve soon. Financial structure • Duration of the credit compared to the duration of the project Useful life of the project significantly exceeds tenor of the loan. Useful life of the project exceeds tenor of the loan. Useful life of the project exceeds tenor of the loan. Useful life of the project may not exceed tenor of the loan. • Amortization schedule Amortizing debt Amortizing debt Amortizing debt repayments with limited bullet payment Bullet repayment or amortizing debt repayments with high bullet repayment II. Political and legal environment Political risk, including transfer risk, considering project type and mitigants Very low Exposure; strong mitigation instruments, if needed Low exposure; satisfactory mitigation instruments, if needed Moderate exposure; fair mitigation instruments High exposure; no or weak mitigation instruments Force majored risk (war, civil unrest, etc) Project of strategic importance for the country (preferably export-oriented). Strong support from Government Project considered important for the country. Good level of support from Government Project may not be strategic but brings unquestionable benefits for the country. Support from Government may not be explicit Project not key to the country. No or weak support from Government Stability of legal and regulatory environment (risk of change in law) Favorable and stable regulatory environment over the long term Favorable and stable regulatory environment over the medium-term Regulatory changes can be predicted with a fair level of certainty Current of future regulatory issues may affect the project. Acquisition of all necessary supports and approvals for such relief from local content laws Strong Satisfactory Fair Weak Enforceability of contracts, collateral and security Contracts, collateral and security are enforceable. Contracts, collateral and security are enforceable. Contracts, collateral and security are considered enforceable even if certain non-key issues may exist. There are unresolved key issues in respect of actual enforcement of contracts, collateral and security. III. Transaction characteristics Design and technology risk Fully proven technology and design Fully proven technology and design Proven technology and design – startup issues are mitigated by a strong completion package Unproven technology and design; technology issues exist and/or complex design. Construction risk • Permitting and sitting All permits have been obtained. Some permits are still outstanding but their receipt is considered very likely. Some permits are still outstanding but the permitting process is well defined and they are considered routine. Key permits still need to be obtained and are not considered routine. Significant conditions may be attached. • Type of construction contract Fixed-price date-certain turnkey construction EPC (engineering and procurement contract) Fixed-price date-certain turnkey construction EPC Fixed-price date-certain turnkey construction contract with one or several contractors No or partial fixed-price turnkey contract and/or interfacing issues with multiple contractors Completion Guarantees Substantial liquidated damages supported by financial substance AND/OR strong completion guarantee from sponsors with excellent financial standing Significant liquidated damages supported by financial substance AND/OR Completion guarantee from sponsors with good financial standing Adequate liquidated damages supported by financial substance AND/OR Completion guarantee from sponsors with good financial standing Inadequate liquidated damages or not supported by financial substance OR weak completion guarantees Track record and financial strength of contractor in constructing similar projects Strong Good Satisfactory Weak Operating risk • Scope and nature of operations and maintenance (O&M) contracts Strong long-term O&M contract, preferably with contractual performance incentives, and/or O&M reserve accounts Long-term O&M contract, and/or O&M reserve accounts Limited O&M contract or O&M reserve account No O&M contract: risk of high operational cost overruns beyond mitigants • Operator‘s expertise, track record, and financial strength Very strong, OR committed technical assistance of the sponsors Strong Acceptable Limited/weak, OR local operator dependent on local authorities Off-take risk (a) If there is a take-or-pay or fixed-price offtake contract: Excellent creditworthiness of off-taker; strong termination clauses; tenor of contract comfortably exceeds the maturity of the debt. Good Credit worthiness of off-taker; strong termination clauses; tenor of contract exceeds the maturity of the debt. Acceptable financial standing of off-taker; normal termination clauses; tenor of contract generally matches the maturity of the debt. Weak off-taker; weak termination clauses; tenor of contract does not exceed the maturity of the debt. (b) If there is no take-or-pay or fixed-price offtake contract: Project produces essential services or a commodity sold widely on a world market; output can readily be absorbed at projected prices even at lower than historic market growth rates. Project produces essential services or a commodity sold widely on a regional market that will absorb it at projected prices at historical growth rates. Commodity is sold on a limited market that may absorb it only at lower than projected prices. Project output is demanded by only one or a few buyers OR is not generally sold on an organized market. Supply risk • Price, volume and transportation risk of feedstocks; supplier's track record and financial strength Long-term supply contract with supplier of excellent financial standing Long-term supply contract with supplier of good financial standing Long-term supply contract with supplier of good financial standing – a degree of price risk may remain Short-term supply contract or long-term supply contract with financially weak supplier - a degree of price risk definitely remains • Reserve risks (e.g. natural resource development) Independently audited, proven and developed reserves well in excess of requirements over lifetime of the project Independently audited, proven and developed reserves in excess of requirements over lifetime of the project Proven reserves can supply the project adequately through the maturity of the debt. Project relies to some extent on potential and undeveloped reserves. IV. Strength of sponsor Sponsor‘s track record, financial strength, and country/sector experience Strong sponsor with excellent track record and high financial standing Good sponsor with satisfactory track record and good financial standing Adequate sponsor with adequate track record and good financial standing Weak sponsor with no or questionable track record and/or financial weaknesses Sponsor support, as evidenced by equity, ownership clause and incentive to inject additional cash if necessary Strong. Project is highly strategic for the sponsor (core business -long-term strategy). Good. Project is strategic for the sponsor (core business - long-term strategy). Acceptable. Project is considered important for the sponsor (core business). Limited. Project is not key to sponsor‘s long-term strategy or core business. V. Security package Assignment of contracts and Accounts Fully comprehensive Comprehensive Acceptable Weak Pledge of assets, taking into account quality, value and liquidity of assets First perfected security interest in all project assets, contracts, permits and accounts necessary to run the project Perfected security interest In all project assets, contracts, permits and accounts necessary to run the project Acceptable security interest in all project assets, contracts, permits and accounts necessary to run the project Little security or collateral for lenders; weak negative pledge clause lender‘s control over cash flow (e.g. cash sweeps, independent escrow Accounts) Strong Satisfactory Fair Weak Strength of the covenant package (mandatory prepayments, Payment deferrals, Payment cascade, Dividend restrictions, etc) Covenant package is strong for this type of project. Project may issue no additional debt. Covenant package is satisfactory for this type of project. Project may issue extremely limited additional debt. Covenant package is fair for this type of project. Project may issue limited additional debt. Covenant package is insufficient for this type of project. Project may issue unlimited additional debt. Reserve funds (debt service, O&M, renewal and replacement, unforeseen events, etc) Longer than Average coverage period, all reserve funds fully funded in cash or letters of credit from highly rated bank Average coverage period, all reserve funds fully funded Average coverage period, all reserve funds fully funded Shorter than average coverage period, reserve funds funded from operating cash flows Table 2.2 - Supervisory Rating Grades for Income-Producing Real Estate Exposures
Strong Good Satisfactory Weak 1. Financial strength Market conditions The supply and demand for the project's type and location are currently in equilibrium. The number of competitive properties coming to market is equal or lower than forecasted demand. The supply and demand for the project‘s type and location are currently in equilibrium. The number of competitive properties coming to market is roughly equal to forecasted demand. Market conditions are roughly in equilibrium. Competitive properties are coming on the market and others are in the planning stages. The project's design and capabilities may not be state of the art compared to new projects. Market conditions are weak. It is uncertain when conditions will improve and return to equilibrium. The project is losing tenants at lease expiration. New lease terms are less favourable compared to those expiring. The supply and demand for the project‘s type and location are currently in equilibrium. The number of competitive properties coming to market is equal or lower than forecasted demand. Financial ratios and advance rate The property‘s debt service coverage ratio (DSCR) is considered strong (DSCR is not relevant for the construction phase) and its loan to value ratio (LTV) is considered low given its property type. Where a secondary market exists, the transaction is underwritten to market standards. The DSCR (not relevant for development real estate) and L TV are satisfactory. Where a secondary market exists, the transaction is underwritten to market standards. The property‘s DSCR has deteriorated and its value has fallen, increasing its L TV. The property‘s DSCR has deteriorated significantly and its L TV is well above underwriting standards for new loans. Stress analysis The property‘s resources, contingencies and liability structure allow it to meet its financial obligations during a period of severe financial stress (e.g. interest rates, economic growth). The property can meet its financial obligations under a sustained period of financial stress (e.g. interest rates, economic growth). The property is likely to default only under severe economic conditions. During an economic downturn, the property would suffer a decline in revenue that would limit its ability to fund capital expenditures and significantly increase the risk of default. The property‘s financial condition is strained and is likely to default unless conditions improve in the near term. Cashflow predictability (a) For complete and stabilised property: The property's leases are longterm with creditworthy tenants and their maturity dates are scattered. The property has a track record of tenant retention upon lease expiration. Its vacancy rate is low. Expenses (maintenance, insurance, security, and property taxes) are predictable. Most of the property‘s leases are long-term, with tenants that range in creditworthiness. The property experiences a normal level of tenant turnover upon lease expiration. Its vacancy rate is low. Expenses are predictable. Most of the property‘s leases are medium rather than long-term with tenants that range in creditworthiness. The property experiences a moderate level of tenant turnover upon lease expiration. Its vacancy rate is moderate. Expenses are relatively predictable but vary in relation to revenue. The property‘s leases are of various terms with tenants that range in creditworthiness. The property experiences a very high level of tenant turnover upon lease expiration. Its vacancy rate is high. Significant expenses are incurred preparing space for new tenants. (b) For complete but not stabilised property: Leasing activity meets or exceeds projections. The project should achieve stabilisation in the near future. Leasing activity meets or exceeds projections. The project should achieve stabilisation in the near future. Most leasing activity is within projections; however, stabilisation will not occur for some time. Market rents do not meet expectations. Despite achieving target occupancy rate, cash flow coverage is tight due to disappointing revenue. (c) For construction phase: The property is entirely preleased through the tenor of the loan or pre-sold to an investment grade tenant or buyer, or the bank has a binding commitment for take-out financing from an investment grade lender. The property is entirely preleased or presold to a creditworthy tenant or buyer, or the bank has a binding commitment for permanent financing from a creditworthy lender. Leasing activity is within projections, but the building may not be preleased and there may not exist a take-out financing. The bank may be the permanent lender. The property is deteriorating due to cost overruns, market deterioration, tenant cancellations or other factors. There may be a dispute with the party providing the permanent financing. II. Asset characteristics Location Property is located in highly desirable location that is convenient to services that tenants desire. Property is located in desirable location that is convenient to services that tenants desire. The property location lacks a competitive advantage. The property's location, configuration, design and maintenance have contributed to the property's difficulties. Design and condition Property is favoured due to its design, configuration, and maintenance, and is highly competitive with new properties. Property is appropriate in terms of its design, configuration and maintenance. The property's design and capabilities are competitive with new properties. Property is adequate in terms of its configuration, design and maintenance. Weaknesses exist in the property's configuration, design or maintenance. Property is under construction Construction budget is conservative and technical hazards are limited. Contractors are highly qualified. Construction budget is conservative and technical hazards are limited. Contractors are highly qualified. Construction budget is adequate, and contractors are ordinarily qualified. Project is over budget or unrealistic given its technical hazards. Contractors may be under qualified. III. Strength of sponsor/developer Financial capacity and willingness to support the property The sponsor/developer made a substantial cash contribution to the construction or purchase of the property. The sponsor/developer has substantial resources and limited direct and contingent liabilities. The sponsor/developer's properties are diversified geographically and by property type. The sponsor/developer made a material cash contribution to the construction of the property. The sponsor/developer's financial condition allows it to support the property in the event of a cash flow shortfall. The sponsor/developer's properties are located in several geographic regions. The sponsor/developer's contribution may be immediate or non-cash. The sponsor/developer is average to below average in financial resources. The sponsor/developer lacks capacity or willingness to support the property. Reputation and track record with similar properties Experienced management and high sponsors’ quality. Strong reputation and lengthy and successful record with similar properties. Appropriate management and sponsors’ quality. The sponsor or management has a successful record with similar properties. Moderate management and sponsors’ quality. Management or sponsor track record does not raise serious concerns. Ineffective management and substandard sponsors’ quality. Management and sponsor difficulties have contributed to difficulties in managing properties in the past. Relationships with relevant real estate actors Strong relationships with leading actors such as leasing agents. Proven relationships with leading actors such as leasing agents. Adequate relationships with leasing agents and other parties providing important real estate services. Poor relationships with leasing agents and/or other parties providing important real estate services. IV. Security package Nature of lien Perfect first lien* Perfect first lien* Perfect first lien* Ability of lender to foreclose is constrained. Assignment of rents (for projects leased to long-term tenants) The lender has obtained an assignment. They maintain current tenant information that would facilitate providing notice to remit rents directly to the lender, such as a current rent roll and copies of the project's leases. The lender has obtained an assignment. They maintain current tenant information that would facilitate providing notice to the tenants to remit rents directly to the lender, such as a current rent roll and copies of the project's leases. The lender has obtained an assignment. They maintain current tenant information that would facilitate providing notice to the tenants to remit rents directly to the lender, such as a current rent roll and copies of the project's leases. The lender has not obtained and assignment of the leases or has not maintained the information necessary to readily provide notice to the building's tenants. Quality of the insurance coverage. Appropriate Appropriate Appropriate Substandard Table 2.3 – Supervisory Rating Grades for Object Finance Exposures
Strong Good Satisfactory Weak I. Financial Strength Market conditions Demand is strong and growing, strong entry barriers, low sensitivity to changes in technology and economic outlook Demand is strong and stable, some entry barriers, some sensitivity to changes in technology and economic outlook Demand is adequate and stable, limited entry barriers, significant sensitivity to changes in technology and economic outlook. Demand is weak and declining, vulnerable to changes in technology and economic outlook, highly uncertain environment Financial ratios (debt service coverage ratio and loan-to-value ratio) Strong financial ratios considering the type of asset. Very robust economic assumptions Strong/acceptable financial ratios considering the type of asset. Robust project economic assumptions. Standard financial ratios for the asset type. Aggressive financial ratios considering the type of asset Stress analysis Stable long-term revenues, capable of withstanding severely stressed conditions through an economic cycle. Satisfactory short-term revenues. Loan can withstand some financial adversity. Default is only likely under severe economic conditions. Uncertain short-term revenues. Cash flows are vulnerable to stresses that are not uncommon through an economic cycle. The loan may default in a normal downturn. Revenues subject to strong uncertainties; even in normal economic conditions the asset may default, unless conditions improve. Market liquidity Market is structure on a world-wide basis; assets are highly liquid Market is world wide or regional; assets are relatively liquid. Market is regional with limited prospects in the short term, implying lower liquidity. Local market and/or poor visibility. Low or no liquidity, particularly on niche markets. II. Political and legal environment Political risk, including transfer risk Very low; strong mitigation instruments, if needed. Low; satisfactory mitigation instruments, if needed. Moderate; fair mitigation instruments. High; no or weak mitigation instruments. Legal and regulatory risk. Jurisdiction is favourable to repossession and enforcement of contracts. Jurisdiction is favourable to repossession and enforcement of contracts. Jurisdiction is generally favourable to repossession and enforcement of contracts, even if repossession might be long and/or difficult. Poor or unstable legal and regulatory environment. Jurisdiction may make repossession and enforcement of contracts lengthy or impossible. III. Transaction characteristics Financing term compared to the economic life of the asset. Full payout profile/minimum balloon. No grace period. Balloon more significant, but still at satisfactory levels. Important balloon with potentially grace periods. Repayment in fine or high balloon. IV. Operational Risk Permits/licensing. All permits have been obtained; asset meets current and foreseeable safety regulations. All permits obtained or in the process of being obtained; asset meets current and foreseeable safety regulations. Most permits obtained or in process of being obtained, outstanding ones considered routine, asset meets current safety regulations. Problems in obtaining all required permits, part of the planned configuration and/or planned operations might need to be revised. Scope and nature of O&M contracts. Strong long-term O&M contract, preferably with contractual performance incentives, and/or O&M reserve accounts (if needed). Long-term O&M contract, and/or O&M reserve accounts (if needed). Limited O&M contract or O&M reserve account (if needed). No O&M contract: risk of high operational cost overruns beyond mitigants. Operator's financial strength, track record in managing the asset type and capability to remarket asset when it comes off-lease. Excellent track record and strong remarketing capability Satisfactory track record and remarketing capability. Weak or short track record and uncertain remarketing capability. No or unknown track record and inability re-market the asset. V. Asset characteristics Configuration, size, design and maintenance (i.e. age, size for a plane) compared to other assets on the same market Strong advantage in design and maintenance. Configuration is standard such that the object meets a liquid market. Above average design and maintenance. Standard configuration, maybe with very limited exceptions-such that the object meets a liquid market. Average design and maintenance. Configuration is somewhat specific, and thus might cause a narrower market for the object. Below average design and maintenance. Asset is near the end of its economic life. Configuration is very specific; the market for the object is very narrow. Real value Current resale value is well above debt value. Resale value is moderately above debt value. Resale value is slightly above debt value. Resale value is below debt value. Sensitivity of the asset value and liquidity to economic cycles. Asset value and liquidity are relatively insensitive to economic cycles. Asset value and liquidity are sensitive to economic cycles. Asset value and liquidity are quite sensitive to economic cycles. Asset value and liquidity are highly sensitive to economic cycles. VI. Strength of sponsor Operators' financial strength, track record in managing the asset type and capability to remarket asset when it comes off-lease. Excellent track record and strong re-marketing capability. Satisfactory track record and re-marketing capability. Weak or short track record and uncertain re-marketing capability. No or unknown tract record and inability to remarket the asset. Sponsors' track record and financial strength. Sponsors with excellent track record and high financial standing Sponsors with good track record and good financial standing. Sponsors with adequate track record and good financial standing. Sponsors with no or questionable track record and/or financial weaknesses. VII. Security package Asset control Legal documentation provides the lender effective control (e.g. a first perfected security interest, or a leasing structure including such security) on the asset, or on the company owning it. Legal documentation provides the lender effective control (e.g. a perfected security interest, or a leasing structure including such security) on the asset, or on the company owning it. Legal documentation provides the lender effective control (e.g. a perfected security interest, or a leasing structure including such security) on the asset, or on the company owning it. The contract provides little security to the lender and leaves room to some risk of losing control on the asset. Rights and means at the lender's disposal to monitor the location and condition of the asset. The lender is able to monitor the location and condition of the asset, at any time and place (regular reports, possibility to lead inspections). The lender is able to monitor the location and condition of the asset, almost at any time and place. The lender is able to monitor the location and condition of the asset, almost at any time and place. The lender is able to monitor the location and condition of the asset is limited. Insurance against damages Strong insurance coverage including collateral damages with top quality insurance companies. Satisfactory insurance coverage (not including collateral damages) with good quality insurance companies. Fair insurance coverage (not including collateral damages) with acceptable quality insurance companies. Weak insurance coverage (not including collateral damages) or with weak quality insurance companies. Table 2.4 – Supervisory Rating Grades for Commodities Finance Exposures
Strong Good Satisfactory Weak I. Financial strength Degree of overcollateralization of trade. Strong Good Satisfactory Weak II. Political and legal environment Country risk No country risk Limited exposure to country risks (in particular, offshore location of reserves in an emerging country) Exposure to country risk (in particular, offshore location of reserves in an emerging country) Strong exposure to country risk (in particular, inland reserves in an emerging country) Mitigation of country risk Very strong mitigation: Strong offshore mechanism Strategic commodity 1st class buyer Strong mitigation: Acceptable mitigation: Only partial mitigation: Offshore mechanisms Offshore mechanisms No offshore mechanisms Strategic commodity Less strategic commodity Non-strategic commodity Strong buyer Acceptable buyer Weak buyer III. Asset characteristics Liquidity and susceptibility to damage Commodity is quoted and can be hedged through futures or OTC instruments. Commodity is not susceptible to damage. Commodity is quoted and can be hedged through OTC instruments. Commodity is not susceptible to damage. Commodity is not quoted but is liquid. There is uncertainty about the possibility of hedging. Commodity is not susceptible to damage. Commodity is not quoted. Liquidity is limited given the size and depth of the market. No appropriate hedging instruments. Commodity is susceptible to damage. IV. Strength of sponsor Financial strength of trader Very strong, relative to trading philosophy and risks. Strong Adequate Weak Track record, including ability to manage the logistic process Extensive experience with the types of transaction in question. Strong record of operating success and cost efficiency. Sufficient experience with the type of transaction in question. Above average record of operating success and cost efficiency. Limited experience with the type of transaction in question. Average record of operating success and cost efficiency. Limited or uncertain track record in general. Volatile costs and profits. Trading controls and hedging policies Strong standards for counterparty selection, hedging and monitoring. Adequate standards for counterparty selection, hedging, and monitoring. Past deals have experienced no or minor problems. Trader has experienced significant losses on past deals. Quality of financial disclosure Excellent Good Satisfactory Financial disclosure contains some uncertainties or is insufficient. V. Security package Asset control First perfected security interest provides the lender legal control of the assets at any time if needed. First perfected security interest provides the lender legal control of the assets at any time if needed. At some point in the process, there is a rupture in the control of the assets by the lender. The rupture is mitigated by knowledge of the trade process or a third party undertaking as the case may be. Contract leaves room for some risk of losing control over the assets. Recovery could be jeopardized. Insurance against damages Strong insurance coverage including collateral damages with top quality insurance companies Satisfactory insurance coverage (not including collateral damages) with good quality insurance companies Fairs insurance coverage (not including collateral damages) with acceptable quality insurance companies. Weak insurance coverage (not including collateral damages) or with weak quality insurance companies.