2.3 Stages of EWS Process
1. Identification:
Early warning signs are indicators that point to potential payment difficulties. These indicators could be alienated into five broad categories:
i. Economic environment,
ii. Financial indicators,
iii. Behavioral indicators,
iv. Third-party indicators, and
v. Operational indicators.
The main aim of this list is to produce a comprehensive set of signals that provides the bank an opportunity to act before the borrower’s financial condition deteriorates to the point of default. Each of these categories has been explained below from sections “i to v”.
It is the responsibility of the unit/section assigned for managing EWS process to interpret the signals received from a borrower and determine whether that borrower should be included in the watch list (prepared on the basis of EWS) for further corrective action.
In most cases, such a decision will involve the identification of groups of signals that validate one another. Taken alone, individual indicators can be too ambiguous/inconclusive to predict financial distress, but when a holistic approach is adopted the unit/ section responsible for managing EWS, may decide that the combination of certain signs anticipates serious financial distress.
Determining what combination of signs, that will trigger the scenario to classify the borrower as watch list, requires adequate knowledge of the industry and will involve some subjective judgment as well. In most cases, the specialized unit will have to identify very subtle warning signs that reinforce others in arriving at a judgment. These subtle signs might be based also on personal contacts between the bank and the borrower, especially in the context of medium-size enterprises.
For example, a trigger for the transfer to the watch list could be a signal received from only one substantial indicator, such as Debt/ Earnings before interest, taxes, depreciation and amortization (EBITDA) to be above 5 (the aforementioned example has been included for clarity purposes only and; should not be viewed as SAMA’s interpretation of the given financial ratio). However, the transfer may also be triggered by the combination of less significant indicators, e.g., an increase in the general unemployment rate, increase in days of receivables outstanding, or frequent changes of suppliers. In addition, signals received from at least two less significant indicators could trigger a deeper review of the borrower’s financial health.
The bank may expand the list of substantial indicators based on the findings from the analysis of the historical data and backtesting results. For the purpose of simple EWS approach (using one or multiple indicators with specific thresholds), the bank should define trigger points for creating signals based on good practice and analysis of historical data. In case of availability, a differentiation between the thresholds for different economic sectors would be a good practice. The bank should apply a prudent approach when selecting specific thresholds for particular indicators.
Criteria for the inclusion in the watch list should be applied at the individual level or at a portfolio level. For example, if real estate prices fall by more than 5 percent on an annual basis, for the group of loans that have real estate as collateral a review should be performed to determine if the collateral value is adequate in the light of price adjustment or not. Collateral evaluation should be done in accordance with SAMA Guidelines. In cases the collateral is no longer sufficient, a bank should take corrective action to improve collateral coverage.
An additional factor that should be considered in managing EWS is the concept of materiality. For this reason, a bank may define a level of average loan size in the NPL portfolio, determine that all loans above this indicator are material, and require more attention from the bank. The main principle behind this concept is to give a higher level of attention, scrutiny, and resources to specified cases.
i. Economic environment:
Indicators of the overall economic environment are very important for the early identification of potential deterioration of the loan portfolio. Their importance stems from the fact that they can point to the likely economic downturn. As such, they are a powerful determinant of the future direction of loan quality (as per international practices, real gross domestic product (GDP) growth is the main driver of nonperforming loan ratios) influencing not only the individual borrower's ability to pay his obligations but also collateral valuations.
Table 1 below provides major indicators that should be monitored to identify potential loan servicing difficulties early on. Data sources for these indicators should be a combination of the bank’s internal economic forecasts and (particularly, in case of smaller banks) forecasts of respected forecasting banks in the country or abroad. Indicators of economic environment are especially relevant for predicting the future payment ability of individual entrepreneurs and family business owners. Given the broad nature of these indicators, they should be monitored continuously using information collected on a monthly or quarterly basis. When a downturn is signaled, a more thorough review of those segments of the portfolio that are most likely to be affected should be undertaken.
Table 1: List of Potential Economic Environment Indicators
Indicator Description Economic sentiment indicators (early indicator on monthly basis) or GDP growth Economic growth directly influences borrowers’ (company and individuals) ability to generate cash flows and service their loans. Major changes in economic sentiment indicators and consequently growth forecasts should serve as a key flag for certain loan groups (retail, real estate, agriculture, hospitality sector, etc.). In most cases, oil prices, government spending, and inflation along with GDP growth has a good correlation with the prices of real estate. In a forecasted economic contraction, horizontal adjustments to real estate valuations (all assets classes) should be made. Inflation/deflation Above-average inflation or deflation may change consumer behavior and collateral values. Unemployment For MSME, an increased unemployment rate indicates a potential adjustment in the purchasing power of households, thus influencing businesses’ ability to generate cash flows to service their outstanding liabilities. Non-elastic consumption components (e.g., food, medicine) will be less sensitive to this indicator than elastic ones (e.g., hotels, restaurants, purchase of secondary residence and vacationing).
Note: The above has been outlined for illustrative purposes only,
ii. Financial indicators:
Financial indicators (Table 2) are a good source of information about the companies that issue financial reports. However, it is not sufficient to rely only on annual financial reports. To ensure that warning signals are generated in a timely manner, the bank may require more frequent interim financial reporting (e.g., quarterly for material loans and semi-annual for all others).
Data sources for financial indicators may be either company financial statements received directly from the borrower. For example, an increase in debt/EBITDA ratio could be due to (i) an increasing loan level, or (ii) a decrease of EBITDA. In the first case, appropriate corrective action could be the pledge of additional collateral. In the second case, it could be a short term or permanent phenomena and corrective actions could range from light restructuring to a more comprehensive restructuring of the obligations as part of the workout process. Financial indicators should be monitored continuously based on quarterly financial statements for material loans and on a semi-annual basis for others.
Table 2: List of Potential Financial Indicators
Indicator Description Debt/EBITDA The prudent ratio should be used for most companies with somewhat higher threshold possible for sectors with historically higher ratios. Capital adequacy Negative equity, insufficient proportion of equity, or rapid decline over a certain period of time. Interest coverage - EBITDA/ interest and principal expenses This ratio should be above a defined threshold. Cash flow Large decline during reporting period, or negative EBITDA. Turnover (applicable for MSME) A decrease in turnover, loss of substantial customer, expiry of patent. Changes in working capital Lengthening of days in sales outstanding and days in inventory. Increase in credit loan to customers Lengthening of days in receivables outstanding. Sales can be increased at the expense of deteriorating quality of customers.
Note: The above has been outlined for illustrative purposes only.
For the MSME portfolio, wherein the quality of financial statements is weak it may be feasible to develop financial ratios based on cash flow statements, Banks are therefore advised to require the respective borrower to disclose details of all its bank accounts maintained, so as to enable capturing the state of liquidity. However, the privacy of the borrowers has to be ensured and written consent needs to be taken in order to access their personal information.
iii. Behavioral indicators:
This group of indicators (Table 3) includes signals about potential problems with collateral adequacy or behavioral problems. Most of these signals should be monitored at a minimum on a quarterly basis with more frequent monitoring of occupancy rates and real estate indexes during downturns.
Table 3: List of potential behavioral indicators:
Indicator Description Loan to value (LTV) LTV > 100 % indicates that the value of the collateral is less than the loan amount outstanding. Reasons for this could be that collateral has become obsolescent or economic conditions have caused a rapid decrease in value. To be prudent, the ratio should be below 80 %, to provide adequate cushion to cover the substantial cost associated with collateral enforcement. Downgrade in internal credit risk category An annual review of borrower's credit profile reveals shortcomings. Breaches of contractual commitments Breach of covenants (financial or non-financial) in the loan agreement with bank or other financial institutions. Real estate indexes The bank should monitor real estate indexes in adequate-granularity. Depending on the collateral type (commercial or individual real estate) the bank needs to establish reliable, timely, and accurate tracking of changes in respective values. Decline larger than 5 percent on annual basis (y/y) should create a flag for all loans that have similar collateral. At this stage, the bank should review if LTV with the new collateral value is adequate. Credit card loans Delay in settling credit card loans or increasing reliance on provided credit line (particularly for partnerships and individual entrepreneurs).
Note: The above has been outlined for illustrative purposes only.
iv. Third-party indicators:
The bank should organize a reliable screening process for information provided by third parties (e.g. rating agencies, tax authorities, press, and courts) to identify signs that could lead to a borrower’s inability to service its outstanding liabilities. These should be monitored on a daily basis so that they can be acted on immediately upon receipt of the information.
Table 4: List of potential third party information indicators
Indicator Description Default / any negative information SIMAH Report / Negative press coverage, reputational problems, doubtful ownership. and involvement in financial scandals. SIMAH Report / Media Insolvency proceedings for major supplier or customer May have a negative impact on the borrower Information from courts and other judicial institutions. External rating assigned and trends Any rating downgrade would have been an indicator deteriorating in the borrower profile Rating Agencies
Note: The above has been outlined for illustrative purposes only.
v. Operational indicators:
In order to capture potential changes in the company’s operations, close monitoring of frequent changes in management and suppliers should be arranged.
Indicator Description Frequent changes in senior management Often rotation of senior management, particularly Chief Executive Officer (CEO), Chief Financial Officer (CFO), Chief Risk Officer (CRO), could indicate internal problems in the company. Annual report and discussion with the company. Qualified audit reports At times, auditors raise concerns about the quality of financial statements by providing modified opinions such as qualification, adverse and even some times disclaimer. Annual report Change of the ownership Changes in ownership or major shareholders (stakeholders or shareholders). Public registries and media. Major organizational change Restructuring of organizational structure (e.g., subsidiaries, branches, new entities, etc.). Public registries and media. Management and shareholder contentiousness Issues arising from the management and from the shareholders which would result in serious disputes. Public registries and media.
It is important to note that the proposed categories and indicators presented above are not exhaustive. Each bank should work to create a solid internal database of these and other indicators, which should be, utilized for EWS purposes. The indicators from the database should be backtested in order to find out the indicators with the highest signaling power. For this purpose, indicators should be tested at different stages of an economic cycle.
Note: The above has been outlined for illustrative purposes only.
2. Corrective Action:
Once an early warning signal is identified, based on the criteria explained above, the unit responsible for managing EWS, needs to flag the potentially problematic loan to the relationship officer / respective portfolio manager in charge of the borrower's relationship.
The cause and severity of the EWS is assessed and based on the assessment the borrowers can be categorized as ‘watch list'. Following are the two potential scenarios:
• Loans remain performing while on the watch list and will be brought back to regular loans after some time, and
• The credit quality of the loan continues to deteriorate and it is transferred to the bank’s Workout Unit (Remedial / Restructuring etc.).
Once the borrower is classified as watch list, the bank should decide, document and implement appropriate corrective actions (within the specified timeframe) in order to mitigate further worsening of loan's credit quality.
Corrective action might include:
i. Securing additional collateral or guarantee (if considered necessary).
ii. Performing more regular site visits.
iii. More frequent updates to the credit committee.
iv. Assessment of financial projections and forecast loan service capacity.
3. Monitoring:
Once increased credit risk is identified, it is crucial for the bank to follow up on the signal received as soon as possible, and develop a corrective action plan to pre-empt potential payment difficulties. The intensification of communication with the borrower is of utmost importance. The action plan may be as simple as collecting missing information such as an insurance policy or as complex as initiating discussions on a multi-bank restructuring of the borrower's obligations.
While the borrower remains on the watch list, bank’s primary contact with the borrower remains the business officer/portfolio manager, although the head of business as well as risk management, are expected to take a more active involvement in the decision and action process for larger, more complex loans. While on the watch list, the borrower should be classified in a lower rating than “ordinary” borrowers.
All loans in the bank's portfolio should be subject to the EWS described above. This applies to performing loans that never defaulted, but to restructured loans as well.
A. Timeline
For EWS to be effective, clear deadlines for actions should be in place, and consistently enforced (see an indicative timeline in Table below). The level and timing of the monitoring process should reflect the risk level of the loan. Large loans should be monitored closely and by the Risk department and respective Credit committees or any higher management committees.
Banks should also establish the criteria to monitor large corporate loans and at the same time importance to be provided to smaller loans, and the same should be followed by designated staff within the bank, with the results reported to the management.
Indicator Responsibility Workout (once the trigger identified) Description Any triggers identified / or any Signal received Relationship Manager (RM) / Portfolio Manager (PM). Max 1 working day. RM / PM starts analyzing the borrower details to investigate further. Follow up with the borrower and report with analysis Relationship Officer / Portfolio Manager. Max 3 working days for a material loan and 5 working days for others. RM / PM contacts borrower determines reasons, and provide analysis. Decision on further actions Relationship Manager & Head of Business; EWS manager. Max 6 working days for material loan and 10 working days for others. Decision for a loan to be: (i) put on watch list and potential request for corrective action; (ii) left without action or mitigating measures; and (iii) transferred to Workout Unit. Review of watch list Relationship Manager & Head of Business, EWS manager and Credit Committee. Every fortnightly for material loans and 1 month for others, the list is reviewed and amended, if needed. Risk manager/EWS manager (in consultation with Head of Business) monitors the performance of the borrower and agreed mitigation measures. If needed, based on the recommendation of Credit Committee or any other delegated committee takes decision to transfer to Workout Unit. Final decision Head of Business /Risk manager, EWS manager. Banks as per their internal policy can specify the maximum time a borrower can remain on watch list. Borrower can be on watch list only on a temporary basis. Banks should assess as how much time should be specified for which the borrower remains in watch list, once the specified time is completed a final decision should be taken, i.e., loan either removed from watch list (if problems are resolved), or transferred to Workout Unit. B. Establishing criteria for transfer to Workout Unit:
Banks shall establish and document a policy with clear and objective time-bound criteria for the mandatory transfer of loans from Loan Originating Units to the Workout Unit along with the specification of relevant approvals required for such transfers. The policy should include details on areas where proper collaboration is required between the Workout Unit and Loan Originating Units especially in scenarios where the borrowers are showing signs of stress but still being managed by the Loan Originating Units.
While corrective actions should be taken as soon as a problem is identified, if the problem cannot be solved within a reasonably short period, the loan should be transferred to the Workout Unit (WU) for more intensive oversight and resolution. Allowing past-due loans to remain within the originating unit for a long time perpetuates the problem, leads to increased NPL levels within the bank, and ultimately results in a lower collection/recovery rate.
C. Following are generally the key indicators for transferring to Workout Unit (not all-inclusive):
i. Days past due (DPD) based on internal thresholds and considering the nature of the borrower should be included as a mandatory trigger (For further guidance on this refer to SAMA rules on Credit Risk Classification and Provisioning).
ii. Debt to EBITDA ≥ Internally set threshold dependent on the nature and industry of the borrower (not applicable to an MSME, in cases wherein reliable financial information is not available),
iii. Net loss during any consecutive twelve-month period ≥Internally set threshold dependent on the nature and industry of the borrower,
iv. A loan classification of “Watch list ” if syndication is involved and/or reputational/legal issues are at stake;
v. Length of time on watch list (e.g., more than twelve months), or at least two unsuccessful prior restructurings;
vi. An indication of an imminent major default or materially adverse event, including government intervention or nationalization, notice of termination of operating license or concession, significant external rating downgrade of borrower or guarantor, sudden plant closure, etc.;
vii. Litigation, arbitration, mediation, or other dispute resolution mechanism involving or affecting the banks; or
viii. Evidence or strong suspicion of corruption or illegal activity involving the borrower or the borrower's other stakeholders.
Note: Banks are encouraged to develop customized indicators for the MSME sector.
The decision to transfer a loan to the Workout Unit should be based on a refined judgment that the loan will not be repaid in time, in full and urgent action is needed in view of the borrower’s deteriorating situation. The above-mentioned criteria can give a clear signal that: (i) loan-level is unsustainable; (ii) equity of a company has been severely depleted; or (iii) previous restructurings were not successful, and more drastic measures should be applied.
Exceptions to this policy should be rare, well documented in writing, and require the approval of the Board of Directors or any other bank's board designated committee.
Note: Banks should define clear and objective criteria in its internal documentation, for handing over a borrower to the workout and legal support unit, as well as the criteria for returning the borrower back to the commercial unit for regular management. The commercial unit and the workout and legal support unit must he completely separated in terms of functional, organizational and personnel issues.
The work out unit should seek to restructure the loan and maximize banks recovery for borrowers considered as viable. Borrower's viability needs to be evaluated in light of comparing the losses that may transpire in case of restructuring versus foreclosure.
However, on the other hand, foreclosure proceedings may be initiated, if the bank after due process concludes that the case is ineligible for restructuring consideration either because of financial or qualitative issues.