In order to prepare the NPL strategy, Banks should conduct a comprehensive assessment of their internal operating environment, external climate for resolution, and the impact of various resolution strategies on the bank's capital structure.
i. Internal Self-Assessment
The purpose of this self-assessment is to provide management with a full understanding of the severity of the problems together with the steps that are to be taken into consideration to correct the situation. Specific details are noted below:
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| a) | Internal Operating Assessment:
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| | A thorough and realistic self-assessment should be required and performed to determine the severity of the situation and the paces that need to be taken internally to address it, there are a number of key internal aspects that influence the bank's need and ability to optimize its management of, and thus reduce, NPLs and foreclosed assets (where relevant).
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| b) | Scale and drivers of the NPL issue:
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| | - | Size and evolution of its NPL portfolios on an appropriate level of granularity, which requires appropriate portfolio segmentation:
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| | - | The drivers of NPL in-flows and outflows, by portfolio where relevant;
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| | - | Other potential correlations and causations.
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| c) | Outcomes of NPL actions taken in the past:
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| | - | Types and nature of actions implemented, including restructuring measures;
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| | - | The success of the implementation of those activities and related drivers, including the effectiveness of restructuring treatments.
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| d) | Operational capacities:
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| | Processes, tools, data quality, IT/automation, staff/expertise, decision-making, internal policies, and any other relevant area for the implementation of the strategy) for the different process steps involved, including but not limited to:
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| | - | early warning and detection/recognition of NPLs;
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| | - | restructuring;
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| | - | provisioning;
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| | - | collateral valuations;
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| | - | recovery/legal process/foreclosure;
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| | - | management of foreclosed assets (if relevant);
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| | - | reporting and monitoring of NPLs and the effectiveness of NPL workout solutions.
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| | For each of the process steps involved, including those listed above, banks should perform a thorough self-assessment to determine strengths, significant gaps and any areas of improvement required for them to reach their NPL reduction targets. The resulting internal report should be prepared and the same to be maintained for the record purpose.
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| | Banks should monitor and reassess or update relevant aspects of the self-assessment at least annually and regularly seek independent expert views on these aspects, if necessary.
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ii. Portfolio Segmentation
Purpose and principles of portfolio segmentation
Segmentation is the process of dividing a large heterogeneous group of Nonperforming loans into smaller more homogeneous parts. It is the essential first step in developing a cost-effective and efficient approach to NPL resolution. Grouping borrowers with similar characteristics allow the bank to develop more focused resolution strategies for each group. Using basic indicators of viability and collateral values, the portfolio can be broken down at an early stage by proposed broad resolution strategies (hold/restructure, dispose, or legal enforcement). Identifying broad asset classes at an early stage of workout is also helpful for efficient set up of Workout Unit, including allocation of staffing and specialized expertise for a more in-depth analysis of borrower’s viability and design of final workout plan.
The segmentation, including initial viability assessment, should be done immediately after the non-performing loan is transferred to the Workout Unit, and before the loan is assigned to a specific workout officer. The exercise is normally performed by a dedicated team in the Workout Unit.
In order to deal with the stock of NPLs, the bank should follow the principles of proportionality and materiality. Proportionality means that adequate resources should be spent on specific segments of NPLs during the resolution process, taking into account the substantial internal costs of the workout process borne by the bank. Materiality means that more attention should be allocated to larger loans compared to smaller loans during the resolution process. These principles should guide the allocation of financial, time and human (in terms of numbers and seniority) resources in WU.
A well-developed management information system containing accurate data is an essential pre-condition for conducting effective segmentation. The exercise is expected to be performed on the basis of information already contained in the loan file when it is transferred from the originating unit to the WU.
Two-Stage segmentation process
It is recommended that the basic segmentation of the bank's NPL portfolio is done in the following two stages. The main objective is to select a smaller pool of loans relating to potentially viable borrowers, which warrant the additional (substantial in case of material loans) follow-up effort from WU, including in-depth viability analysis and re-evaluation of collateral, in order to design an appropriate workout plan.
Stage one - Segmentation by nature of business, past-due buckets, loan balance, and status of legal procedure
The bank's portfolio, segmentation can be conducted by taking multiple borrowers’ characteristics into consideration. Segmentations should have a useful purpose, meaning that different segments should generally trigger different treatments by the NPL WUs or dedicated teams within those units. Following is the list of potential segmentation criteria that can be utilized by banks:
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| i. | Nature of the business: Micro, Small and medium-sized enterprises (MSMEs), including sole traders/ partnerships and Corporates: (by asset class or sector).
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| ii. | Legal status: for existing loans already in legal proceedings or legal action has already been taken.
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| iii. | Arrears bucket/days past due (the higher the level of arrears the narrower the range of possible solutions)
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| | a) | Early arrears (>1 dpd and ≤90 dpd)
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| | b) | Late arrears of (>90 dpd)
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| | c) | Loan Recovery Cases >90 dpd or 180dpd)
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| iv. | Loan balance: Banks may decide the threshold for segmentation based on the size of the outstanding loan and cases with multiple loans;
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Stage two - initial viability assessment
Following the initial segmentation, NPLs which are currently not in legal procedure should be further screened according to two criteria: (i) financial ratios (or Cash flows based ratios in case of MSME); and (ii) loan-to-value (LTV) ratio. These ratios are generally available to the bank from the borrower's latest financial statements (or bank statements) in the loan file, and should ideally not require any additional information from the borrower.
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LTV ratio provides a good indication of the level of collateral against the outstanding loan. It is seen as a readily available indicator that captures quantitative aspect of collateralization of the loan, which should be an integral part of initial viability assessment. However, banks should consider stressed value of collateral (i.e. forced sale value in case of liquidation) for computation of these ratios. The quality of the collateral should also be considered for further assessment during later stages of restructuring process.
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Banks are expected to set up internal LTV ratios depending on the size segment (Corporate / MSME) and the nature of the industry in which it operates and annual refine/ assess parameters, with an aim to be able to compare the cost of restructuring vs the cost of foreclosure/ legal proceeding. Segmentation according to LTV at this early stage is helpful for starting to consider various workout strategies described in Chapter 6.
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Banks may consider below indicative broad benchmarks for the viability parameters as a part of initial assessment, these are intended to be indicative rather than prescriptive (i.e. determining viable, marginally-viable and non- viable borrowers):
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| • | Debt/EBITDA ratio is used as a proxy for initial viability assessment of the borrower and reflects how leveraged the company is. The company is considered highly leveraged post breaching a certain threshold and the risk of loan repayment in full and in time could be excessive.
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| • | The loan service coverage ratio should be comparable to the sector average within the restructuring period in which the unit should become viable.
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| • | Trends of the company based on historical data and future projections should be comparable with the industry. Thus, the behavior of past and future EBIDTA should be studied and compared with industry average.
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| • | For project finance and other multi-year loans, Loan life coverage ratio (LLCR), as defined below should be 1.4, which would give a cushion of 40% to the amount of loan to be serviced. For the details on the computation of LLCR , refer to Appendix 2.
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| | | Present value of total available cash flow (ACF) during the loan life period (including interest and principal) + Cash Reserves |
| LLCR | = | ----------------------------------------------------------------------------------- |
| | | Outstanding amount of loan |
The selection of thresholds for these indicators used in the initial viability assessment should be based on general market indicators.
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SAMA is cognizant that acceptable thresholds with regards to key financial and collateral coverage ratio would vary depending on the nature of the industry, its economic outlook over the life of the loan, and size of the loans, hence does not lay down prescriptive limits. However, Banks are expected to assess document the above, as part of its NPL portfolio segmentation exercise. No particular ratio should be considered in Isolation, whilst segmenting the borrower and banks are advised to develop (either expert-based or statistical) rationale.
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The following has been illustrated to provide indicative guidelines as to how a segmentation could be undertaken:
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Figure 1: Stage two of segmentation based on LTV and EBITDA (the below ratios are indicative only)
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| Borrower Segmentation | Loan-to-Value (LTV) Ratio | Earnings before Interest, Tax, Depreciation and Amortization (EBITDA) Ratio |
| Viable borrower | ≤ 80 or ≥ 80 | Debt/EBITDA ≤ 5 |
| Marginally viable borrower | ≤ 80 or ≥ 80 | Debt/EBITDA ≤ 8 ≥ 5 |
| Non-viable borrower | ≤ 80 or ≥ 80 | Debt/EBITDA ≥ 8 |
Banks should identify loans that may be non-viable as a result of primary viability assessment at this stage of the segmentation. Segregating these loans at this stage would enable banks to save time and financial resources. Identified non-viable loans should be promptly referred to legal unit under Workout Unit or considered for foreclosures.
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The remaining pool of loans, recognized as viable and marginally viable after the initial assessment, should be assigned to the Workout Unit for an in-depth viability assessment based on additional information to be collected from the borrower and collateral re-evaluation. The differentiation on the grounds of collateral value reflected in the LTV ratio at this early stage allows the Workout Unit to receive a workout file with more granular information. Following this analysis, a customized workout plan is selected based on comparison of Net Present Value (NPVs - is the difference between the present value of cash inflows and the present value of cash outflows over a period of time) of expected recoveries under various alternative options.
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Potential additional segmentation criteria:
In addition to basic segmentation using loan size, financial or collateral-based loan ratios, banks may choose to further segment the NPL portfolio using additional borrower characteristics. These include:
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| i. | Industry and subsector of industry (e.g., real estate can be treated as a separate category with office buildings, apartments, land development, construction as sub-categories);
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| ii. | Number of days past due. Higher payment interruption period could indicate a higher predisposition to legal actions;
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| iii. | Loan purpose (e.g., working capital, purchase of the real estate, or tangible assets);
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| iv. | Type of collateral (e.g., commercial or residential real estate, land plot, financial assets);
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| v. | Location of collateral;
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| vi. | Country of residence/incorporation ((a) residents, (b) non-residents); and
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| vii. | Interest coverage ratio (low ratio indicates problem with free cash flows).
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If however, further segmentation into small groups is unlikely to lead to better results and may result in lost focus, banks are advised to document the rationale for SAMA’s comfort.
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iii. External conditions and operational environment
Understanding the current and possible future external operating conditions/environment is fundamental to the establishment of an NPL strategy and associated NPL reduction targets, related developments should be closely followed by banks, which should update their NPL strategies as needed.
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The following list of external factors should be taken into account by banks when setting their strategy, however, it should not be seen as exhaustive as other factors not listed below might play an important role in specific circumstances.
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| a) | Macroeconomic conditions:
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| | Macroeconomic conditions will play a key role in setting the NPL strategy. This also includes the dynamics of the real estate market and its specific relevant sub-segments. For banks with specific sector concentrations in their NPL portfolios (e.g. Building & Construction, Manufacturing, Wholesale and Retail Trade), a thorough and constant analysis of the sector dynamics should be performed, to inform the NPL strategy.
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| b) | Market expectations:
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| | Assessing the expectations of external stakeholders (including but not limited to rating agencies, market analysts, researchers, and borrowers) with regard to acceptable NPL levels and coverage will help to determine how far and how fast banks should reduce their portfolios. These stakeholders will often use national or international benchmarks and peer analysis.
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| c) | NPL investor demand:
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| | Trends and dynamics of the domestic and international NPL market for portfolio sales will help banks make informed strategic decisions regarding projections on the likelihood and possible pricing of portfolio sales. However, investors ultimately price on a case-by-case basis and one of the determinants of pricing is the quality of documentation and loan data that banks can provide on their NPL portfolios.
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| d) | NPL servicing:
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| | Another factor that might influence the NPL strategy is the maturity of the NPL servicing industry. Specialized services can significantly reduce NPL maintenance and workout costs. However, such servicing agreements need to be well steered and well managed by the bank.
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iv. Capital implications of the NPL strategy
Capital levels and their projected trends are important inputs to determining the scope of NPL reduction actions available to banks. Banks should be able to dynamically model the capital implications of the different elements to their NPL strategy, ideally, under different economic scenarios, those implications should also be considered in conjunction with the risk appetite framework (RAF) as well as the internal capital adequacy assessment process (ICAAP).
Where capital buffers are slim and profitability low, banks should include suitable actions in their capital planning which will enable a sustainable clean-up of NPLs from the balance sheet.
