Skip to main content
Back Custom print Text Only Rich Text Print / Save as PDF
Download Original PDF

  • Credit Risk Management

    • Prudential Treatment of Problem Assets

      The global financial crisis highlighted the difficulties in identifying and comparing banking data, particularly regarding the quality and types of bank assets and how they are monitored in supervisory reports and disclosures. The Basel Committee on Banking Supervision recognized significant differences in practices among countries.

      Therefore, the Committee issued guidelines for managing non-performing assets, particularly non-performing loans and loans subject to forbearance, concerning the scope of evaluation standards and the level of application by banks within the current accounting and regulatory framework. These guidelines will be applied to several topics, including:

      • Monitoring and supervision of asset quality to ensure more consistent comparability across countries.
      • Internal Rating-Based (IRB) credit classification systems for banks for credit risk management purposes.
      • Pillar 3 disclosure regarding asset quality.
      • Published data related to asset quality indicators.

      Based on the above, SAMA emphasizes the importance of banks adhering to the guidelines for managing non-performing assets issued by the Basel Committee on Banking Supervision.

    • Rules on Management of Problem Loans

      No: 41033343 Date(g): 6/1/2020 | Date(h): 11/5/1441Status: In-Force

      In line with SAMA responsibilities to maintain financial stability and contribute to economic development in the Kingdom, and its commitment to fairness in banking transactions,

      We would like to inform you that Rules and Guidelines have been issued for the management of Problem Loans granted to Juristic Persons. These Rules and Guidelines aim to support banks in monitoring loans showing signs of distress, organizing procedures for restructuring such loans, and enhancing fair treatment of customers by providing appropriate solutions. Please find attached the following:

      1. Rules on Management of Problem Loans, which SAMA emphasizes must be adhered to by all banks.
         
      2. Guidelines on Management of Problem Loans, to provide guidance on best practices to help banks comply with the aforementioned Rules.
         

      For your information and action accordingly as of  01/07/2020G.

      • 1. General Requirements

        • 1.2 Objective of the Rules

          The objectives of these rules are as follows:

          i.To ensure banks put in place a conceptual framework which would facilitate rehabilitation of viable borrower, thereby supporting economic activity.
           
          ii.To ensure banks look into aspects of customer conduct and fair treatment whilst dealing with problem loans, especially in instances involving the MSMEs.
           
          iii.To ensure banks have adequate controls over non-performing and problem loan management and restructuring processes, including documented policies and procedures.
           

        • 1.3 Scope of Implementation

          These rules are applicable for all banks licensed under Banking Control Law.

        • 1.4 Definitions

          The following terms and phrases, where used in these Rules, should have the corresponding meanings, unless the context requires otherwise: 
           
          Problem loans:
                     		Loans that display well-defined weaknesses or signs of potential problems. Problem loans should be classified by the banks in accordance with accounting standards, and consistent with relevant regulations, as one or more of:
           
           a)non-performing;
           
           b)subject to restructuring on account of inability to service contractual payments;
           
           c)IFRS 9 Stages 2; and exhibiting signs of significant credit deterioration or Stage 3;
           
           d)under watch-list, early warning or enhanced monitoring measures; or
           
           e)where concerns exist over the future stability of the borrower or on its ability to meet its financial obligations as they fall due.
           
          Non-performing loans:
                     		As stipulated in BCBS 403 “Guidelines –Prudential treatment of problem assets – definitions of non-performing exposures and forbearance” endorsed by SAMA through circular no. 381000099757 dated 23/09/1438AH.
           
          Watch-list:
                     		Loans that have displayed characteristics of a recent increase in credit risk, and are subject to enhanced monitoring and review by the bank.
           
          Early Warning Signals:
                     		Quantitative or qualitative indicators, based on liquidity, profitability, market, collateral and macroeconomic metrics.
           
          Cooperating borrower:
                     		A borrower which is actively working with a bank to resolve their problem loan.
           
          Viable borrower:
                     		Is that, wherein the loss of any concessions as a result of restructuring, is considered to be lower than the loss borne due to foreclosure.
           
          Viability Assessment:
                     		An assessment of borrower’s ability to generate adequate cash flow in order to service outstanding loans.
           
          Covenant:
                     		A Borrower’s commitment that certain activities will or will not be carried out.
           
          Key performance indicators:
                     		Indicators through which bank management or supervisor can assess the institution’s performance.
           
          Collateral:
                     		Are those, whose value can be considered whilst computing the recoverable amount for workout cases or foreclosed cases, on account of meeting the stipulated conditions laid out in these rules, as would be applicable based on the nature of the collateral.
           
          Failed restructuring:
                     		Any restructuring case where the borrower failed to repay the revised contractual cash flows as agreed upon with the bank and has transitioned into default.
           
          Further to the above, Banks should adopt all requirements relating to i) Restructuring, ii) Identification of forbearance; iii) Identification of financial difficulty; iv) Identification of concession; and v) Stage allocation for forborne loans, as stipulated under SAMA Rules on Credit Risk Classification and Provisioning. 
           

      • 2. Problem Loan Prevention and Identification

        • 2.1 Early Warning Signals

          Banks should develop a clear, robust and demonstrable set of policies, procedures, tools, and governance around the establishment of Early Warning Signals (EWS) which are fully integrated into the bank’s risk management system.

          The established EWS should be comprehensive and relevant to the specific portfolios of the Banks, and should enable Banks to proactively identify potential difficulties, investigate the drivers of the borrowers stress, and act before the borrower’s financial condition deteriorates to the point of default.

          Banks should organize their EWS process in the following three stages:

          i. Identification of EWS:

          Banks’ EWS should, at a minimum, take into account indicators that point to potential payment difficulties. Individual banks should undertake an internal assessment as to which EWS are suitable for each of their lending portfolios taking into account a combination of the following:

          a.Economic environment: Banks should monitor indicators of the overall economic environment, which are relevant for determining the future direction of loan quality, and not only the individual borrower’s ability to pay their obligations but also collateral valuations.
           
           Examples of economic indicators, based on the nature of the respective portfolios, can include GDP growth, Inflation/deflation, and unemployment, as well as indicators that may be specific to certain sectors/portfolios, e.g. commodity or real estate.
           
          b.Financial indicators: Banks should establish a process in order to get frequent interim financial reports (or cash-flow/ turnover details for MSME) from their borrowers (e.g., quarterly for material loans to listed entities and semi-annual for all others), to ensure that EWS are generated in a timely manner.
           
           Examples of financial indicators, based on the nature of the respective portfolios, can include Debt/EBITDA, Capital adequacy, Interest coverage - EBITDA/ interest and principal expenses, Cash flow, Turnover (applicable for MSME).
           
          c.Behavioral indicators: Banks should institute behavioral warning signals to assess the integrity and competency of key stakeholders of the borrower. These indicators will help in the assessment of how a borrower behaves in different situations.
           
           Examples of these indicators are: regular and consistent attempts at delaying financial reporting requirements; reluctance or unwillingness to respond to various communications, any attempt at deception or misrepresentation of facts, excessive delays in responding to a request for no valid reason.
           
          d.Third-party indicators: Banks should organize a reliable screening process for information provided by third parties (e.g. rating agencies, General Authority of Zakat and Tax, press, and courts) to identify signs that could lead to a borrower’s inability to service its outstanding liabilities.
           
           Example of these indicators are: Default at other financial institutions / any negative information, insolvency proceedings for major supplier or customer, downgrade in external rating assigned and trends with respect to external ratings.
           
          e.Operational indicators: Banks should establish a process where any changes in the borrower’s operations are flagged as soon as they occur.
           
           Examples of these indicators, based on the nature of the portfolio can include, frequent changes of suppliers, frequent changes of senior management, qualified audit reports, change of the ownership, major organizational change, management and shareholder contentiousness.
           
          Banks should establish a comprehensive set of EWS that provide banks with an opportunity to act before the borrower’s financial condition deteriorates to the point of default, and enable them to proactively identify and flag other loans that have similar characteristics, i.e. multiple loan facilities extended to the same borrower, or borrowers in same sector that may be affected by the overall economic environment, or loans with similar type of collateral. 
           

          ii. Corrective action:

          Banks should have a proper written procedures to be followed in case any of the established EWS is triggered. The response procedure should clearly identify the roles and responsibilities of all the sections responsible for taking action on the triggered EWS, specific timelines for actions along with, identification of the cause and severity of the EWS.

          iii. Monitoring:

          Banks should have a robust monitoring mechanism for following up on the triggered EWS, in order to ensure that the corrective action plan has been executed to pre-empt potential payment difficulties of the borrowers. The level and timing of the monitoring process should reflect the risk level of the borrower.

      • 3. Non-performing loans (NPL) Strategy

        • 3.1 Developing the NPL Strategy

          i.Banks should develop and implement an NPL strategy that is approved by the Board of Directors or its delegated authority.
           
          ii.The NPL strategy should layout in a clear, concise manner the bank’s approach and objectives, and establish annual quantitative targets over a realistic but sufficiently ambitious timeframe, divided into short, medium and long-term horizons. It should serve as a roadmap for guiding the allocation of internal resources (human capital, information systems, and funding) and the design of proper controls (policies and procedures) to monitor interim performance and take corrective actions to ensure that the overall goals are met.
           
          iii.The NPL strategy should consider all available options to deal with problem loans, where banks review the feasibility of such options and their respective financial impact. These include hold/restructuring strategies, active portfolio reductions through either sales and/or writing off provisioned NPLs that are deemed unrecoverable, taking collateral onto the balance sheet, legal options and out-of-court options.
           
          iv.Banks should follow the principle of proportionality and materiality, while designing the NPL strategy, where adequate resources should be exhausted on specific segments of NPLs during the resolution process, including MSME’s.
           

        • 3.2 Implementing the NPL Strategy

          i.Banks should ensure that the components of the NPL strategy are communicated to relevant stakeholders across the bank, and proper monitoring protocols are established, together with performance indicators.
           
          ii.The NPL strategy should be backed by an operational plan detailing how the NPL strategy will be implemented. This should include clearly defining and documenting the roles, responsibilities, formal reporting lines and individual (or team) goals and incentives geared towards reaching the targets in the NPL strategy.
           
          iii.Banks should put in place mechanisms for a regular review of the strategy and monitoring of its operational plan effectiveness and its integration into the bank’s risk management framework.
           

      • 4. Structuring the Workout Unit

        i.Banks should establish a dedicated Workout Department/Section/or Unit to manage all workout related cases in order to effectively manage NPL resolution process. The Workout Department/Section/or Unit should be independent of the Business/Loan Originating Units to avoid any potential conflicts of interest.
         
        ii.Banks should ensure that. Workout Unit is properly staffed with resources having the required skill sets to manage workout situations, strong analytical, legal, financial analysis skills, and proper understanding of the workout process.
         

        • 4.1 Performance Management

          i.Banks should establish proper and well-defined performance matrices for Workout Unit staff that should not be based solely on the reduction in the volume of nonperforming loans; An appraisal system and compensation structures tailored for the NPL Workout Unit should be implemented and in alignment with the overall NPL strategy, operational plan and the bank’s code of conduct.
           
          ii.In addition to quantitative elements linked to the bank’s NPL targets and milestones (with a strong focus on the effectiveness of workout activities), the appraisal system should include qualitative measurements such as; level of negotiations competency, technical abilities relating to the analysis of the financial information and data received, structuring of proposals, quality of recommendations, and monitoring of restructured cases.
           
          iii.The importance of the respective weight given to indicators within the overall performance measurement framework should be proportionate to the severity of the NPL issues faced by the bank.
           

      • 5. Approaching Restructuring Cases

        • 5.1 Viability of Restructuring

          Banks should implement a well-defined restructuring policy aligned with the concept of viability that recognizes in a timely manner those borrowers who are non-viable. The policy should ensure that only viable restructuring solutions are considered, which should contribute to reducing the borrower’s balance of credit facilities. 
           
          Long-term restructuring measures should only be considered viable where the following conditions are met: 
           
          i.The bank can demonstrate, based on reasonable documented financial information, that the borrower can realistically afford the restructuring solution.
           
          ii.Outstanding arrears are addressed as part of the restructured terms. That does not necessarily mean full repayment, and should not conflict with the potential reduction in the borrower’s balance in the medium to long-term that could be required to align with the borrower’s loan service capacity.
           
          iii.In cases, where there have been previous restructuring solutions granted in respect of a loan, the bank should ensure that additional internal controls and early warning signals are implemented, so that the subsequent restructuring treatment meets the viability criteria. These controls should include, at a minimum, approval of a designated Senior Management Committee.
           
          Short-term restructuring measures should only be considered viable where the following conditions are met: 
           
          i.The bank can demonstrate, based on reasonable documented financial information, that the borrower can realistically afford the restructuring solution.
           
          ii.Short-term measures are to be applied temporarily where the bank has satisfied itself and is able to attest, based on reasonable financial information, that the borrower demonstrates the ability to repay the original or agreed modified amount on a full principal and interest basis commencing from the end of the short-term temporary arrangement.
           
          iii.The solution approved is not perceived to lead to multiple consecutive restructuring measures in the future.
           
          The bank’s assessment of viability should be based on the financial characteristics of the borrower and the restructuring measure to be granted at that time. 
           
          Whilst evaluating borrower’s viability, due consideration need be made, that any increase in pricing (for instance, over and above driven by risk-based pricing principles) with respect to the borrower’s outstanding facilities, does not make the resultant installments, unserviceable. 
           
          Banks should undertake the viability assessment irrespective of the source of restructuring, for instance, borrowers using restructuring clauses embedded in a contract, bilateral negotiation of restructuring between a borrower and the banks, public restructuring scheme extended to all borrowers in a specific situation. 
           

        • 5.2 Code of Conduct

          Banks should develop a written Code of Conduct for managing problem loans, the Code of Conduct should define a robust problem loan resolution process to ensure that viable borrowers are provided a chance for reaching a workout solution, rather than invoking outright enforcement actions. 
           
          The Code of Conduct should be based broadly on but not limited to following: 
           
          i.Communication with the borrower: Banks should establish a written procedure around initiating communication with the borrowers along with the content, format, and medium of communication that is aligned with relevant Laws and Regulations, in the event that a borrower fails to pay in part or in full the installments as per the agreed repayment schedule.
           
          ii.Information-gathering: Banks should establish a written procedure with proper timelines to collect adequate, complete and accurate information on the borrower’s financial condition from all available sources, in addition to standardized submissions such as quarterly/year-end financial statements, business/ operating plans obtained/submitted by the borrowers.
           
          iii.Financial assessment of the borrower: Banks should ensure that proper analysis is performed on the information gathered relating to the borrower, in order to assess the borrower’s current repayment capacity, the borrower’s credit record, and the borrower’s future repayment capacity over the proposed workout period. Banks should ensure that reasonable efforts are made to cooperate with the borrower throughout the assessment process with the objective of reaching a mutual agreement on an appropriate workout solution.
           
          iv.Proposal of resolution/solutions: Based on the assessment performed for the borrowers, banks should provide borrowers who are classified as cooperating a proposal for one or more alternative restructuring solutions, or if none of such solutions is agreed upon, one or more resolution and closure solutions, without this being considered as a new service to the borrower.
           
           In presenting the proposed solution or alternative solutions, banks should be open to comments and queries on the part of borrowers, providing them with standardized - to the extent possible - and comprehensive information to help them understand the proposed solution or, in the case where there is more than one proposed solution, the differences across the proposed alternatives.
           
          v.An objection-handling process: Banks should establish a clear and objective process for handling objections raised by the borrowers, and the process should be communicated to the borrowers. The process should highlight the appropriate forums for appeals and the timeframe for their closure.
           
           Banks should develop standardized forms to be used by borrowers in case they want to raise an appeal. The forms should specify the list of information and required documents necessary to review the appeal, along with timelines for the submission and review of appeals.
           
          vi.Workout fee: Banks should establish clear policy and procedure relating to charging fee for workout solution reached with borrowers. Banks should ensure that the policy and practice provide for impact analysis of the fee on borrower cash-flows, i.e. that increased cost is not going to further deteriorate the financial condition of the borrower. The rationale for charged fees should be clearly documented and transparency must be ensured through proper and clear communication with the borrower on fees charged by the banks.
           
          The Code of Conduct should be reflected in all pertinent internal documentation with reference to problem loan resolution and be effectively implemented. 
           

      • 6. Workout Plan

        i.Banks should develop a workout plan agreed between the viable borrower and the bank in order to return the non-performing borrower to a fully performing status in the shortest feasible time-frame, matching the borrower’s sustainable repayment capacity with the correct restructuring option(s).
         
        ii.The workout plan needs to be approved by a designated Management Committee based upon the bank’s delegation of authority matrix.
         
        iii.Banks should 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.
         
        iv.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.
         

        • 6.1 Negotiating and Documenting Workout Plan

          Banks should develop a process for negotiating and documenting the workout plan with a viable borrower. The process should cover the following components:

          i. Developing the negotiating strategy:

          Banks should have a proper process to manage the negotiations with viable borrowers on the potential workout solutions, the process should cover the following: 
           
          a)Identify minimum information required to objectively assess the borrower’s capacity to repay the proposed restructured solution.
           
          b)Assess the strengths and weaknesses of both the bank’s and the borrower’s positions and then develop a negotiating strategy to obtain objectives of a successful restructuring for a viable borrower.
           
          c)Where deemed essential, encourage less sophisticated borrowers to seek the advice of counsel or financial advisor to ensure they fully understand the terms and conditions of the proposed restructured solution.
           
          d)Develop covenants appropriate to the level of complexity and size of the transaction, and comprehensiveness of the information available.
           

          ii. Communicating with the borrower during the workout process:

          Communication with borrowers should be as per the procedures outlined in the bank’s code of conduct. This should include; timelines for responding to borrower’s requests/complaints, identify who within the bank is responsible/authorized to issue various types of communications to the borrowers, documenting process for all communications to/from the borrowers, signing/acknowledgement protocols with timelines, approval requirements for all workout proposals, templates to be used for communication with the borrowers.

          iii. Resolution of disputes:

          Banks should follow the objection handling process for managing disputes with the borrowers in cases where the bank and the borrower fail to reach an agreement. This should include providing the borrower with prompt and easy access to filing an appeal, along with all necessary information to review the appeal, and a timeline for its closure, it should also be ensured that the dispute is being reviewed independently of the individual or team against whom the appeal has been filled.

        • 6.2 Monitoring the Workout Plan

          i.Banks should develop proper policies and procedures for establishing a monitoring mechanism over restructured loans in order to ensure the borrowers continued ability to meet their obligations. Banks monitoring mechanism should analyze the cause of any failed restructuring, and the analysis should be used for improving the workout solutions provided to borrowers.
           
          ii.Banks should define proper and adequate key performance indicators (including workout effectiveness) comparable with their portfolios and should be monitored on a periodic basis along-with regular detailed reporting to the executive management.
           

      • 7. Collateral

        Banks should ensure proper collateral management and apply the following requirements throughout the credit process irrespective of the performance on the loan.

        • 7.1 Governance

          i.Banks should develop policies and procedures in order to ensure proper management of collateral obtained to mitigate the risk of loss associated with the potential default of the borrowers. Collateral policies and procedures should be approved by the Board of Directors or its delegated authority and should be reviewed at least every three years or more frequently if the bank deems is necessary based on the changes in the relevant regulatory requirements or business practices. Collateral policies and procedures should be fully aligned with the bank’s risk appetite statement (RAS).
           
          ii.Consistent with SAMA’s requirements on valuation of real-estate collateral, banks should institute an appropriate governance process with respect to valuers and their performance standards. Banks should monitor and review the valuations performed by internal or external valuers on a regular basis, as well as develop and implement a robust internal quality assurance of such valuations.
           
          iii.The internal audit function of banks should regularly review the consistency and quality of the collateral policies and procedures, the independence of the valuers selection process and the appropriateness of the valuations carried out by valuers.
           

        • 7.2 Types of Collateral and Guarantees

          Banks should clearly document in collateral policies and procedures the types of collateral they accept and the process in respect of the appropriate amount of each type of collateral relative to the loan amount. Banks should classify the collaterals they accept as follows: 
           
          i.Financial collateral - cash (money in bank accounts), securities (both debt and equity) and credit claims (sums owed to banks).
           
          ii.Immovable collateral - immovable object, an item of property that cannot be moved without destroying or altering it - a property that is fixed to the earth, such as land or a house.
           
          iii.Receivables - also referred to as accounts receivable, are debts owed to a company by its customers for goods or services that have been delivered or used but not yet paid for.
           
          iv.Other physical collateral - physical collateral other than immovable property.
           
          v.Treating lease exposures as collateral - exposure arising from leasing transactions as collateralized by the type of property leased.
           
          vi.Other funded credit Protection - cash on deposit with, or cash assimilated instruments held by, a third party bank should come under this category.
           
          vii.Guarantee- is a promise from a bank, corporate, any other entity or individual, that the liabilities of a borrower will be met in the event of failure to fulfil contractual obligations.
           

        • 7.3 General Requirements for Collateral

          Banks should ensure that the following requirements are incorporated with respect to the management of collaterals accepted by them: 
           
          i.Banks should properly document the collateral arrangements and have in place clear and robust procedures that ensure that any legal conditions required for declaring the default of a borrower and timely collection/ liquidation of collateral are observed.
           
          ii.Banks should fulfil any contractual and statutory requirements in respect of, and take all steps necessary to ensure, the enforceability of the collateral arrangements under the law applicable to their interest in the collateral. In connection therewith, banks should conduct sufficient legal review confirming the enforceability of the collateral arrangements in all areas of operations, for example, foreign branches and subsidiaries. They should re-conduct such review as necessary to ensure continuing enforceability.
           
          iii.The collateral policies and procedures should ensure mitigation of risks arising from the use of collateral, including risks of failed or reduced credit protection, valuation risks, risks associated with the termination of the credit protection, concentration risk arising from the use of collateral and the interaction with the bank's overall risk profile.
           
          iv.The financing agreements should include detailed descriptions of the collateral as well as detailed specifications of the manner and frequency of revaluation.
           
          v.Banks should calculate the market and the forced sale values (incorporating haircuts) of the collateral at a minimum frequency to enable it to form an objective view of borrower or workout viability; such valuations should incorporate the cost and time to realise, maintain and sell the collateral in the event of foreclosure.
           
          vi.Where the collateral is held by a third party, banks should take reasonable steps to ensure that the third party segregates the collateral from its own assets.
           
          vii.While conducting valuation and revaluation, banks should take into account any deterioration or obsolescence of the collateral.
           
          viii.Banks should have the right to physically inspect the collateral. They should also have in place policies and procedures addressing their exercise of the right to physical inspection.
           
          ix.When applicable, the collateral taken as protection should be adequately insured against the risk of damage the risk of damage.
           

        • 7.4 Specific Requirements for Each Type of Collateral and Guarantees

          A) Financial collateral

          Under all approaches and methods, financial collateral should qualify as eligible collateral where all the following requirements are met: 
           
          i.The credit quality of the borrower and the value of the collateral should not have a material positive correlation. Where the value of the collateral is reduced significantly, this should not alone imply a significant deterioration of the credit quality of the borrower. Where the credit quality of the borrower becomes critical, this should not alone imply a significant reduction in the value of the collateral.
           
           Securities issued by the borrower, or any related group entity, should not qualify as eligible collateral. Notwithstanding the aforementioned, a borrower's own issues of covered bonds qualify as eligible collateral, when they are posted as collateral for a repurchase transaction, provided that they comply with the condition set out in this paragraph.
           
          ii.Banks should ensure that sufficient resources are devoted to the orderly operation of margin agreements with OTC derivatives and securities-financing counterparties, as measured by the timeliness and accuracy of their outgoing margin calls and response time to incoming margin calls.
           

          B) Immovable property

          i.Banks should clearly document the types of residential and commercial immovable property they accept in their lending policies.
           
          ii.Immovable collateral should be classified in the following categories based on the underlying nature and behaviour:
           
           a)Investment properties;
           
           b)Owner-occupied properties;
           
           c)Development properties;
           
           d)Properties normally valued on the basis of trading potential.
           

          C) Receivables

          Receivables should qualify as eligible collateral, where all the following requirements are met: 
           
          i.Banks should have in place a sound process for determining the credit risk associated with the receivables, such a process should include analyses of a borrower's business and industry and the types of customers with whom that borrower does business. Where the bank relies on its borrowers to ascertain the credit risk of the customers, the bank should review the borrowers' credit practices to ascertain their soundness and credibility;
           
          ii.The difference between the amount of the loan and the value of the receivables should reflect all appropriate factors, including the cost of collection, concentration within the receivables pool pledged by an individual borrower, and potential concentration risk within the bank's total loans beyond that controlled by the bank's general methodology.
           
          iii.Banks should maintain a continuous monitoring process appropriate to the receivables. They should also review, on a regular basis, compliance with loan covenants, environmental restrictions, and other legal requirements;
           
          iv.Receivables pledged by a borrower should be diversified and not be unduly correlated with that borrower. Where there is a material positive correlation, banks should take into account the attendant risks in the setting of margins for the collateral pool as a whole;
           
          v.Banks should not use receivables from subsidiaries and affiliates of a borrower, including employees, as eligible credit protection:
           
          vi.Banks should have in place a documented process for collecting receivable payments in distressed situations. Banks should have in place the requisite facilities for collection even when they normally rely on their borrowers for collections.
           

          D) Other physical collateral

          Physical collateral other than immovable property should qualify as eligible collateral, when the conditions specified as general requirements for collateral are met.

          E) Treating lease exposures as collateralized

          Banks should treat exposures arising from leasing transactions as collateralized by the type of property leased, where all the following conditions are met: 
           
          i.The conditions set out for the type of asset/property leased to qualify as eligible collateral are met;
           
          ii.The lessor has in place robust risk management with respect to the use to which the leased asset is put, its location, its age and the planned duration of its use, including appropriate monitoring of its value;
           
          iii.Where this has not already been ascertained in calculating the Loss Given Default level, the difference between the value of the unamortized amount and the market value of the security is not so large as to overstate the credit risk mitigation attributed to the leased assets.
           

          F) Other funded credit protection

          Cash on deposit with, or cash assimilated instruments held by, a third-party institution should be eligible, where all the following conditions are met: 
           
          i.The borrower's claim against the third party institution is openly pledged or assigned to the lending bank and such pledge or assignment is legally effective and enforceable and is unconditional and irrevocable;
           
          ii.The third party institution is notified of the pledge or assignment;
           
          iii.As a result of the notification, the third party institution is able to make payments solely to the lending bank, or to other parties only with the lending bank's prior consent.
           

          G) Guarantees

          Credit protection deriving from a guarantee should qualify as eligible unfunded credit protection where all the following conditions are met: 
           
          i.The credit protection is direct and explicitly document the obligation assumed by the protection provider;
           
          ii.The extent of the credit protection is clearly defined and incontrovertible;
           
          iii.The credit protection contract does not contain any clause, the fulfillment of which is outside the direct control of the bank, that would:
           
           a)allow the protection provider to cancel the protection unilaterally;
           
           b)increase the effective cost of protection as a result of a deterioration in the credit quality of the protected loan;
           
           c)prevent the protection provider from being obliged to pay out in a timely manner in the event that the original borrower fails to make any payments due, or when the leasing contract has expired for the purposes of recognizing the guaranteed residual value;
           
           d)allow the maturity of the credit protection to be reduced by the protection provider.
           
          iv.The credit protection contract is legally effective and enforceable, at the time of the conclusion of the credit agreement and thereafter i.e. over the life of the exposure;
           
          v.The credit protection covers all types of payments the borrower is expected to make in respect of the claim. Where certain types of payment are excluded from the credit protection, the lending bank has to adjust, the value of credit protection to reflect the limited coverage;
           
          vi.On the qualifying default of or non-payment by the borrower, the lending bank has the right to pursue, in a timely manner, the protection provider for any monies due under the claim in respect of which the protection is provided and the payment by the protection provider should not be subject to the lending bank first having to pursue the borrower.

        • 7.5 Valuation Frequency

          i.Banks should clearly document in collateral policies and procedures the frequency of collateral valuations. The policies and procedures should also provide for the following:
           
           a)Banks monitor the value of each type of collateral on a defined frequent basis.
           
           b)More frequent valuations where the market is subject to significant negative changes and/or where there are signs of a significant decline in the value of an individual collateral.
           
           c)Defined criteria for determining that a significant decline in collateral value has taken place. These will include quantitative thresholds for each type of collateral established, based on the observed empirical data and qualitative bank experience, taking into consideration relevant factors such as market price trends or the opinion of independent valuers.
           
           d)Revaluation of collateral for restructuring cases should be done only where necessary, and should be done in accordance with the requirements of these rules.
           
          ii.Banks should have appropriate IT processes and systems in place to flag outdated valuations and to trigger valuation reports.
           

        • 7.6 Specific Requirements for Valuers

          Banks valuation process should be carried out by valuers who possess the necessary qualifications, ability and experience to execute a valuation and who are independent of the credit decision process.

          Banks should ensure compliance with SAMA circular no. 371000061185 dated 28/05/1437AH on "Obligations of Real Estate Appraisal Clients Subject to SAMA Supervision" and the revision made to the said circular through circular no. 65768/99 dated 25/10/1439AH along with all relevant regulatory requirements in that regard.

      • 8. Regulatory Reporting Requirements

        Banks are required to submit to SAMA on a quarterly basis all Restructuring Cases (Responses should only cover restructuring cases of “Problem loans” as defined in section 1.4 of these Rules) and Associated Fees as per the templates provided by SAMA. The reports should be submitted within 30 days of quarter end.

      • 9. Effective Date

        These Rules should come into force with effect from the 1st of July 2020.

    • Guidelines on Management of Problem Loans

      No: 41033343 Date(g): 6/1/2020 | Date(h): 11/5/1441Status: In-Force

      • 1. Introduction

        • 1.1 Purpose of Document

          The purpose of this document is to support the Saudi banking sector in their ongoing efforts to accelerate the resolution of non-performing loans (NPLs) associated with large corporates, micro, small and medium-sized enterprise sector. This document seeks to reflect the local and international best practices on dealing with problem loans, these guidelines also seek to take into account the specifics of Kingdom of Saudi Arabia's (KSA) economic and banking sector structure and the extensive experience accumulated by KSA banks in dealing with their corporate borrowers, as well as KSA's existing legal, regulatory and institutional framework for resolution and does not identify the possible obstacles to efficient and timely problem loan management that might still exist in this broader framework, or to propose potential improvements which would be outside the banks’ sphere of control.

          Bank loans can become “problem loan" because of problems with the borrower’s financial health, or inadequate processes within banks to restructure viable borrowers, or both. In ascertaining how to deal with a problem loan, it is important to distinguish between a borrower's “ability to pay” and “willingness to pay,” Making this distinction is not always easy and requires effort. These guidelines should guide banks staff in dealing with problem loans including non-performing loans (NPLs) extended to corporate and Micro, Small and Medium Enterprises (MSMEs). It deals with both ad-hoc and systemic financial distress and delves into how borrower problems may have arisen in the first place. It provides guidance to banks staff responsible for handling individual problem loans and to senior managers responsible for organizing portfolio-wide asset resolution.

      • 2. Problem Loan Prevention & Identification

        • 2.1 Early Warning Signals as a Tool for Preventing NPLs

          One of the keys to maintaining acceptable levels of Non-Performing Loans lies in the ability to identify potential payment difficulties of a borrower as early as possible. SAMA views instituting an effective framework within regulated entities as a mandatory requirement. The sooner the problem is identified, the easier it will be to remedy it. Early warning signals (EWS), fully integrated into the bank's risk management system, is a crucial tool to identify and manage upcoming problems with a borrower’s ability to service his loan. 
           
          The purpose of the EWS is therefore twofold: 
           
          i.To produce an early signal of potential payment difficulties of the borrower; and
           
          ii.To allow the opportunity to develop a corrective action plan at a very early stage.
           
          iii.When the borrower exhibits early warning signs, the bank should proactively identify the driver and assess whether the borrower’ case should continue to be handled by the business / commercial unit or if the Workout Unit (whether involved in a shadow capacity at first or have full control of the case) should be involved.
           
          Banks should ensure that proper training is provided to the business units on how to manage accounts with early signs of stress. 
           

        • 2.2 Scope of EWS Process

          The EWS process is organized in three stages: identification, action, and monitoring. Each of these stages is described in detail in the following sections. The timeline for implementing actions included in each of these stages is explained in section 2.3.

          #AreaDescription
          1Signal Identification•Responsibility for establishing parameters for signals and monitoring resides in a separate unit or function within risk management, middle or back office.
          •Upon identification of a signal, notification is sent to the respective relationship manager and his team leader that action is required to close the EWS breach.
          2

          Action

          		•Relationship Manager contacts the borrower and identifies the source and magnitude of a potential payment difficulty.
          •After analysis and in consultation with risk management, a corrective action plan is put in place.
          •A loan is added to the watch list prepared on the basis of EWS for the purposes of further monitoring.
          3Monitoring•Risk management approval required to remove the loan from watch list prepared on the basis of EWS.
          •A loan can remain on watch list for a time period specified by the bank. After that period, loan must be either returned to originating unit or transferred to Workout Unit.
          •While on the watch list, a loan should be classified with a lower risk rating compared to the one prior to moving to the watch list.

        • 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 
             
            IndicatorDescription
            Economic sentiment indicators (early indicator on monthly basis) or GDP growthEconomic 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/deflationAbove-average inflation or deflation may change consumer behavior and collateral values.
            UnemploymentFor 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 
             
            IndicatorDescription
            Debt/EBITDAThe prudent ratio should be used for most companies with somewhat higher threshold possible for sectors with historically higher ratios.
            Capital adequacyNegative equity, insufficient proportion of equity, or rapid decline over a certain period of time.
            Interest coverage - EBITDA/ interest and principal expensesThis ratio should be above a defined threshold.
            Cash flowLarge 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 capitalLengthening of days in sales outstanding and days in inventory.
            Increase in credit loan to customersLengthening 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: 
             
            IndicatorDescription
            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 categoryAn annual review of borrower's credit profile reveals shortcomings.
            Breaches of contractual commitmentsBreach of covenants (financial or non-financial) in the loan agreement with bank or other financial institutions.
            Real estate indexesThe 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 loansDelay 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
             
            IndicatorDescription
            Default / any negative informationSIMAH Report / Negative press coverage, reputational problems, doubtful ownership. and involvement in financial scandals.SIMAH Report / Media
            Insolvency proceedings for major supplier or customerMay have a negative impact on the borrowerInformation from courts and other judicial institutions.
            External rating assigned and trendsAny rating downgrade would have been an indicator deteriorating in the borrower profileRating 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.
             
            IndicatorDescription
            Frequent changes in senior managementOften 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 reportsAt 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 ownershipChanges in ownership or major shareholders (stakeholders or shareholders).Public registries and media.
            Major organizational changeRestructuring of organizational structure (e.g., subsidiaries, branches, new entities, etc.).Public registries and media.
            Management and shareholder contentiousnessIssues 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.
             
            IndicatorResponsibilityWorkout (once the trigger identified)Description
            Any triggers identified / or any Signal receivedRelationship 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 analysisRelationship 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 actionsRelationship 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 listRelationship 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 decisionHead 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. 
             

        • 2.4 EWS Structure and Institutional Arrangements

          Structure of EWS within the Bank

          To ensure the independence of the process, and achieve a holistic approach to credit risk monitoring, and prevent conflicts of interest, the unit responsible for managing EWS should operate outside of the loan originating unit. Best practice indicates that the responsibilities to manage the EWS process should be assigned within the credit risk management department and fully incorporated into the bank's regular risk management processes. 
           
          Since an effective EWS requires an operational IT system that draws all information available about a particular borrower, EWS benefit from being part of the bank's internal credit rating system that already contains information about the borrower, the bank should allocate enough staff and financial resources to keep the system operational and effective. 
           
          The operation of the EWS should be governed by written policies and procedures, including time thresholds for required actions, approved by the Board of Directors of the bank. They should be subject to annual review and reapproved by the Senior Management Committee to incorporate: 
           
          i.Required changes identified during previous operational periods;
           
          ii.Regulatory amendments; and
           
          iii.Additionally, independent quality assurance (e.g., review of the process by an external expert or the Internal Audit function) should be considered.
           

          Reporting:

          All actions during the EWS process should be recorded in the IT system to provide a written record of decisions and actions taken. At a minimum, the system should record: 
           
          i.Time the action was taken;
           
          ii.Name and department of those participating/approving the actions;
           
          iii.The reasons for actions taken; and
           
          iv.The decision of the appropriate approval authority, if applicable.
           
          The watch list should include, at a minimum, the following information: 
           
          i.Details of the loan;
           
          ii.Is it part of a group or related party;
           
          iii.Material or non-material loan;
           
          iv.Date added to the list;
           
          v.Reviews taken (including timestamps) and outcomes,
           
          vi.Mitigation measures; and
           
          vii.Reasons for inclusion in the watch list.
           
           The watch list (or at least material loans on it) should be presented monthly to a designated management committee (Executive Committee or Risk Committee) only or in parallel with the credit committee for information purposes and potential action. For major cases, the bank's Management Board must be included in the decision-making process. The Board should also receive monthly:
           
           a)A detailed list of material loans for information: and
           
           b)Aggregate figures for the loans on the watch list. Information about the borrower/group in potential payment difficulties must be disseminated widely and promptly within the banking group, including branches and subsidiaries. (For details on samples of EWS refer to Appendix 1).
           

      • 3. Non-performing Loans (NPLs) Strategy

        The bank's goal in the resolution process should be to reduce non-performing assets as early as possible, in order to: 
         
        i.Free up coinage and capital for new lending;
         
        ii.Reduce the bank's losses, and return assets to earning status, if possible;
         
        iii.Generate good habits and a payment culture among borrowers; and
         
        iv.Help maintain a commercial relationship with the borrower by conducting a responsible resolution process. To ensure that the goal is met, each bank should have a comprehensive, written strategy for management of the overall NPL portfolio, supported by time-bound action plans for each significant asset class. The bank must also put in place and maintain adequate institutional arrangements for implementing the strategy.
         

        • 3.1 Developing the NPL Strategy

          The NPL reduction strategy should layout in a clear, concise manner the bank's approach and objectives (i.e., maximizing recoveries, minimizing losses) as well as establish, at a minimum, annual NPL reduction targets over a realistic but sufficiently ambitious timeframe (minimum 3 years). It also serves as a roadmap for guiding the internal organizational structure, the allocation of internal resources (human capital, information systems, and funding) and the design of proper controls (policies and procedures) to monitor interim performance and take corrective actions to ensure that the overall reduction goals are met. 
           
          The strategy development process is divided into the following two components: 
           
          1.Assessment; and
           
          2.Design.
           

          • 1. Assessment

            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: 
             
            a)Internal Operating Assessment:
             
             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).
             
            b)Scale and drivers of the NPL issue:
             
             -Size and evolution of its NPL portfolios on an appropriate level of granularity, which requires appropriate portfolio segmentation:
             
             -The drivers of NPL in-flows and outflows, by portfolio where relevant;
             
             -Other potential correlations and causations.
             
            c)Outcomes of NPL actions taken in the past:
             
             -Types and nature of actions implemented, including restructuring measures;
             
             -The success of the implementation of those activities and related drivers, including the effectiveness of restructuring treatments.
             
            d)Operational capacities:
             
             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:
             
             -early warning and detection/recognition of NPLs;
             
             -restructuring;
             
             -provisioning;
             
             -collateral valuations;
             
             -recovery/legal process/foreclosure;
             
             -management of foreclosed assets (if relevant);
             
             -reporting and monitoring of NPLs and the effectiveness of NPL workout solutions.
             
             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.
             
             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.
             
            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: 
             
            i.Nature of the business: Micro, Small and medium-sized enterprises (MSMEs), including sole traders/ partnerships and Corporates: (by asset class or sector).
             
            ii.Legal status: for existing loans already in legal proceedings or legal action has already been taken.
             
            iii.Arrears bucket/days past due (the higher the level of arrears the narrower the range of possible solutions)
             
             a)Early arrears (>1 dpd and ≤90 dpd)
             
             b)Late arrears of (>90 dpd)
             
             c)Loan Recovery Cases >90 dpd or 180dpd)
             
            iv.Loan balance: Banks may decide the threshold for segmentation based on the size of the outstanding loan and cases with multiple loans;
             
            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. 
             
            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. 
             
            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. 
             
            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): 
             
            •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.
             
            •The loan service coverage ratio should be comparable to the sector average within the restructuring period in which the unit should become viable.
             
            •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.
             
            •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.
             
              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. 
             
            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. 
             
            The following has been illustrated to provide indicative guidelines as to how a segmentation could be undertaken: 
             
            Figure 1: Stage two of segmentation based on LTV and EBITDA (the below ratios are indicative only)
             
            Borrower SegmentationLoan-to-Value (LTV) RatioEarnings before Interest, Tax, Depreciation and Amortization (EBITDA) Ratio
            Viable borrower≤ 80 or ≥ 80Debt/EBITDA ≤ 5
            Marginally viable borrower≤ 80 or ≥ 80Debt/EBITDA ≤ 8 ≥ 5
            Non-viable borrower≤ 80 or ≥ 80Debt/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. 
             
            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. 
             
            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: 
             
            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);
             
            ii.Number of days past due. Higher payment interruption period could indicate a higher predisposition to legal actions;
             
            iii.Loan purpose (e.g., working capital, purchase of the real estate, or tangible assets);
             
            iv.Type of collateral (e.g., commercial or residential real estate, land plot, financial assets);
             
            v.Location of collateral;
             
            vi.Country of residence/incorporation ((a) residents, (b) non-residents); and
             
            vii.Interest coverage ratio (low ratio indicates problem with free cash flows).
             
            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. 
             
            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. 
             
            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. 
             
            a)Macroeconomic conditions:
             
             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.
             
            b)Market expectations:
             
             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.
             
            c)NPL investor demand:
             
             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.
             
            d)NPL servicing:
             
             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.
             
            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.
             

          • 2. Design

            The design phase should identify options to be used to resolve NPLs, establish specific targets for NPL reduction, together with performance indicators detailing how the NPL reduction strategy will be implemented over short, medium and long term periods. Following are key components of the design phase:
             
            i. Strategy implementation options
             
            Banks should review the range of NPL strategy implementation options available and their respective financial impact. Examples of implementation options, not being mutually exclusive, are: 
             
            •Hold/restructuring strategy: A hold strategy (A hold strategy is not to terminate the relationship with the troubled borrower) option is strongly linked to the operating model, restructuring and borrower assessment expertise, operational NPL management capabilities, outsourcing of servicing and write-off policies.
             
            •Active portfolio reductions: These can be achieved through either sales and/or writing off provisioned NPL loans that are deemed unrecoverable. This option is to be linked to provision adequacy, collateral valuations, quality loan data, and NPL investor demand.
             
            •Change of loan type: This includes foreclosure, loan to equity swapping, loan to asset swapping, or collateral substitution.
             
            •Legal options: This includes insolvency proceedings and foreclosure proceedings
             
            •Out-of-court solutions: Out-of-court debt restructuring involves changing the composition and/or structure of assets and liabilities of borrowers in financial difficulty, without resorting to a full judicial intervention, and with the objective of promoting efficiency, restoring growth, and minimizing the costs associated with the borrower’s financial difficulties (for details on out of court solutions please refer to section 5.2.2.)
             
             Banks should ensure that their NPL strategy includes not just a single strategic option but rather combinations of strategies/options to best achieve their objectives over the short, medium and long term and explore which options are advantageous for different portfolios or segments and under different conditions.
             
             Banks should also identify medium and long-term strategic options for NPL reductions which might not be achievable immediately, e.g. a lack of immediate NPL investor demand might change in the medium to long term. Operational plans might need to foresee such changes, e.g. the need for enhancing the quality of NPL loan data in order to be ready for future investor transactions.
             
             Where banks assess that the above-listed implementation options do not provide an efficient NPL reduction in the medium to long-term horizon for certain portfolios, segments or individual loans, this should be clearly reflected in an appropriate and timely provisioning approach. The bank should write off loans that are deemed to be uncollectable in a timely manner.
             
            ii. Targets
             
            Before commencing the short to medium-term target-setting process, banks should establish a clear view of what reasonable long-term NPL levels are, both on an overall basis but also on a portfolio-level basis. In spite of uncertainty around the time frame required to achieve these long-term goals, however, they are an important input to setting adequate short and medium-term targets. 
             
            Banks should include, at a minimum, clearly defined quantitative targets in their NPL strategy (where relevant including foreclosed assets), which should be approved by the senior management committee. The combination of these targets should lead to a concrete reduction, gross and net (of provisions), of NPLs, at least in the medium term. While expectations about changes in macroeconomic conditions can play a role in determining target levels (if based on solid external forecasts), they should not be the sole driver for the established NPL reduction targets. 
             
            In determining, the targets banks should establish at least the following dimensions: 
             
            •by time horizons, i.e. short-term (indicative 1 year), medium-term (indicative 3 years) and possibly long-term;
             
            •by main portfolios (e.g. retail mortgage, retail consumer, retail small businesses and professionals, MSME corporate, large corporate, commercial real estate);
             
            •by implementation option chosen to drive the projected reduction, e.g. cash recoveries from hold strategy, collateral repossessions, recoveries from legal proceedings, revenues from the sale of NPLs or write-offs.
             
            The NPL targets should at least include a projected absolute or percentage NPL reduction, both gross and net of provisions, not only on an overall basis but also for the main NPL portfolios. 
             
            Where foreclosed assets are material, a dedicated foreclosed assets strategy should be defined or, at least, foreclosed assets reduction targets should be included in the NPL strategy. It is acknowledged that a reduction in NPLs might involve an increase in foreclosed assets for the short term, pending the sale of these assets. However, this timeframe should be clearly limited as the aim of foreclosures is a timely sale of the assets concerned. 
             
            Targets shall be initially defined for all main portfolios on a quarterly basis for the first year. Each of these high-level targets is to be accompanied by a standard set of more granular monitoring items, e.g. non-performing loan ratio and coverage ratio, etc. 
             
            Below shows high-level quantitative targets as per better international practices.
             
            Sustainable solutions-oriented operational target: 
             
            •Loans with long term modifications / NPL plus performing forborne loans with Long term Modifications.
             
            Action-oriented operational targets: 
             
            •Active NPL MSMEs for which a viability analysis has been conducted in the last 12 months / Active NPL MSMEs.
             
            •MSME and Corporate NPL common borrowers for which a common restructuring solution has been implemented.
             
            •Corporate NPLs for which the bank(s) have engaged a specialist for the implementation of a company restructuring plan.
             
            Banks running the NPL strategy process for the first time should not solely focus on the short-term horizon. The aim here is to address the deficiencies identified during the self-assessment process and thus establish an effective and timely NPL management framework, which allows the successful implementation of the quantitative NPL targets approved for the medium to long-term horizon. 
             
            Note 1: 
             
            As an illustration. Banks which have internally calibrated (through the cycle) TTC PD’s against a validated rating system, should not aim to foreclose accounts, against which a viable restructuring could lead to an ECL output which is less than the internal (if the same has been internally computed) or regulatory loss given default, if legal proceeding were to be initiated against the borrower. 
             
            Hence, for instance, by forgiving 20% of the outstanding amount would lead to a risk classification into a grade, which has 16% PD, (ignoring the 12 month period, for which the restructured loan would be classified as NPL. provided performance is satisfactory) and assuming that the internally computed LGD is 36%, the ECL % expected to arise from such a transaction would be around 24.6%, (20 % concession and ((100% -20 % concession) *.16 PD * 36% LGD) = 4.6%))) vs an expected LGD for foreclosure of say 43%. 
             
            The above is a simplified illustration, SAMA is cognizant that: 
             
            •Obligors granted a material concession in course of foreclosures are classified as NPL for provisioning purposes for at least a year, which should be taken into account whilst computing the cost of foreclosure to the bank and;
             
            •Expert Level Judgement or rating system override with respect to grade classification may be warranted whilst making the above assessment
             
            However, the purpose of outlining the above is to endorse a long term vision in terms of making a balanced decision with respect to restructuring a distressed borrower ( i.e. determining the viability of a borrower) rather than seeking outright enforcement proceeding. 
             

        • 3.2 Implementing the NPL Strategy

          Banks should ensure that significant emphasis is placed on communication of the components of the approved strategy to relevant stakeholders across the bank and proper monitoring protocols are established. Following are key components of implementing an NPL strategy:
           
          i. Monitoring of Results
           
          a.Banks should establish a proper monitoring mechanism for NPL strategy to ensure it is delivering the expected results. Where any variances are identified prompt corrective action is to be taken to ensure goals/targets are met.
           
          b.The strategy to be reviewed at a minimum on an annual basis. Where collection targets and budgets will require substantial annual revisions, policies and procedures should be revised as necessary.
           
          ii. Embedding the NPL strategy
           
          As execution and delivery of the NPL strategy involve and depends on many different areas within the bank, it should be embedded in processes at all levels of an organization, including strategic, tactical and operational.
           
          All banks should clearly define and document the roles, responsibilities and formal reporting lines for the implementation of the NPL strategy, including the operational plan.
           
          Staff and management involved in NPL workout activities should be provided with clear individual (or team) goals and incentives geared towards reaching the targets agreed in the NPL strategy, including the operational plan.
           
          All relevant components of the NPL strategy should be fully aligned with and integrated into the business plan and budget. This includes, for example, the costs associated with the implementation of the operational plan (e.g. resources, IT, etc.) but also potential losses stemming from NPL workout activities. NPL strategy should be closely monitored to ensure it is delivering the expected results, variances should be identified and prompt corrective action taken to ensure longer-term goals and targets are met.
           
          iii. Operational plan
           
          The NPL strategy of banks should be back by an operational plan (which is to be approved by the senior management committee). The operational plan should clearly define how the bank would operationally implement its NPL strategy over a time horizon of at least 1 to 3 years (depending on the type of operational measures required). 
           
          The NPL operational plan should contain at a minimum: 
           
          •Clear time-bound objectives and goals;
           
          •Activities to be delivered on a segmented portfolio basis;
           
          •Governance arrangements including responsibilities and reporting mechanisms for defined activities and outcomes;
           
          •Quality standards to ensure successful outcomes;
           
          •Staffing and resource requirements;
           
          •Required technical infrastructure enhancement plan;
           
          •Granular and consolidated budget requirements for the implementation of the NPL strategy;
           
          •Interaction and communication plan with internal and external stakeholders (e.g. for sales, servicing, efficiency initiatives, etc.).
           
          •The operational plan should put a specific focus on internal factors that could present impediments to successful delivery of the NPL strategy.
           
          Implementing the operational plan
           
          The implementation of the NPL operational plans should rely on suitable policies and procedures, clear ownership and suitable governance structures (including escalation procedures). Any deviations from the plan should be highlighted and reported to the management
           

      • 4. Structuring the Workout Unit

        Effective management of NPL resolution requires that the bank establish a dedicated unit to handle workout cases. Such Workout Unit (WU) should be established as a permanent unit within the bank's organizational structure reporting directly to the Risk Management function rather than the Business / Loan Originating Units.

        The rationale for creating an independent unit for dealing with NPLs includes the elimination of potential conflicts of interest between the originating officer and the troubled borrower. The segregation of duties includes not only relationship management (negotiation of the restructuring plan, legal enforcement, etc.) but also the decision-making process along with support services (loan administration, loan and collateral files, appraisers, etc.) and technical IT resources.

        The appropriate organizational structure of the Workout Unit varies greatly depending upon the circumstances each individual bank faces. Larger banks dealing with a significant number of NPLs are likely to establish separate Working Units or create sub-divisions within a single WU to handle different asset classes such as Large Corporates, Medium Corporates, Small and Micro loans. Smaller banks may have to follow a simpler structure where a single work unit may handle a wide variety of borrowers.

        • 4.1 Staffing the Workout Unit

          Skills Required

          Banks should ensure that the managers of the WU, their team leaders and workout officers are highly qualified professionals, who would be able to discharge their functions effectively and in connection therewith, training needs should be assessed and proper training plans are to be prepared accordingly. Within the individual NPL WUs, more specialization is often useful based on the different NPL workout approaches required per relevant borrower segment.

          Such workout officers should have strong analytical and financial analysis skills, understand the depth of the restructuring process and have the ability to work well under pressure.

          Remuneration

          Compensation structures for workout staff need to be aligned with long term strategy of the bank. If compensation is based on cash recoveries, officers may choose to optimize their own short-term income at the expense of longer-term profit maximization for the bank. Conversely, basing compensation on a reduction in the volume of non- performing loans may lead to improper restructuring or the bankruptcy of otherwise viable companies as officers seek to reduce the numbers by the quickest means possible. The staff may also be reluctant to employ the full range of restructuring options (particularly with respect to loan forgiveness) without provisions to indemnify them for costs and provide legal counsel to defend them in case legal charges are brought against them.

          Assigning workload

          Banks should establish policies specifying timelines for assigning stressed accounts to Work Officers, once the account is marked to be stressed.

        • 4.2 Incorporating Legal and Support Functions Into Workout Unit

          Banks require legal advice on a variety of matters related to the origination, management, and restructuring of loans. This includes not only documenting loan and restructuring transactions but also overseeing the collection process for those defaulted loans. It is highly recommended that Banks should maintain a dedicated legal team (or legal experts) within the Workout Unit to: 
           
          i.Assist in the negotiation of the restructuring of those loans that need to be addressed; and
           
          ii.To be responsible for those loans that require legal solutions to be collected (bankruptcy or foreclosure).
           

        • 4.3 Performance Management

          For Workout Unit (WU) staff involved in the management of Nonperforming Loans (NPLs), proper performance metrics should be established which should cater not only to the individual’s performance but also assess the performance of the team as a whole. Further, the performance of the Workout Unit should be monitored and measured on a regular basis. For this purpose, an appraisal system tailored to the requirements of the NPL Workout Unit should be implemented in alignment with the overall NPL strategy and operational plan.
           
          Further to quantitative elements linked to the bank's NPL targets and milestones (probably with a strong focus on the effectiveness of workout activities), the appraisal system may include qualitative measurements such as level of negotiations competency, technical abilities relating to the analysis of the financial information and data received, structuring of proposals, quality of recommendations, or monitoring of restructured cases.
           
          It should also ensure that the higher degree of commitment, usually required of NPL WU staff is inculcated in the agreed working conditions, remuneration policies, incentives, and performance management framework.
           
          As part of the performance measurement framework, it is recommended that banks' management should include specific indicators linked to the targets defined in the NPL strategy and operational plan. The importance of the respective weight given to these indicators within the overall performance measurement frameworks should be proportionate to the severity of the NPL issues faced by the bank.
           
          Finally, given that the important role of efficient addressing of pre-arrears is a key driver for the reduction of NPL inflows, a strong commitment of relevant staff regarding the addressing of early warnings should also be fostered through the remuneration policy and incentives framework.
           
          Technical resources
           
          One of the key success factors for the successful implementation of any NPL strategy option is an adequate technical infrastructure. In this context, it is important that all NPL-related data is centrally stored in robust and secured IT systems. Data should be complete and up-to-date throughout the NPL workout process. 
           
          An adequate technical infrastructure should enable NPL WUs to: 
           
          i.Easily access all relevant data and documentation including:
           
           a)current NPL and early arrears borrower information including automated notifications in the case of updates;
           
           b)loan and collateral/guarantee information linked to the borrower; or connected borrowers;
           
           c)monitoring/documentation tools with the IT capabilities to track restructuring performance and effectiveness;
           
           d)status of workout activities and borrower interaction, as well as details on restructuring measures, agreed, etc.;
           
           e)foreclosed (foreclosure is the repayment of the outstanding loans to the extent possible through, legal enforcement by a bank) assets (where relevant); and
           
           f)tracked cash flows of the loan and collateral.
           
          ii.Efficiently process and monitor NPL workout activities including:
           
           a)automated workflows throughout the entire NPL life cycle;
           
           b)automated monitoring process ("tracking system”) for the loan status ensuring a correct flagging of non-performing and forborne loans;
           
           c)industrialized borrower communication approaches, e.g. through call centers (including integrated card payment system software on all agent desktops) or internet (e.g. file sharing system);
           
           d)incorporated early warning signals (see also EWS section);
           
           e)automated reporting throughout the NPL workout lifecycle for NPL WU management, senior management, and other relevant managers as well as the regulator;
           
           f)performance analysis of workout activities by NPL WU, sub-team and expert (e.g. cure/success rate, rollover information, effectiveness of restructuring options offered, cash collection rate, vintage analysis of cure rates, promises kept rate at call center, etc.); and
           
           g)evolution monitoring of portfolio(s) / sub-portfolio(s) / cohorts / individual borrowers.
           
          iii.Define, analyze and measure NPLs and related borrowers:
           
           a)recognize NPLs and measure impairments;
           
           b)perform suitable NPL segmentation analysis and store outcomes for each borrower;
           
           c)support the assessment of the borrower's personal data, financial position and repayment ability (borrower affordability assessment), at least for non-complex borrowers; and
           
           d)conduct calculations of (i) the net present value (NPV) and (ii) the impact on the capital position of the bank for each restructuring option and/or any likely restructuring plan under any relevant legislation (e.g. foreclosures law, insolvency laws) for each borrower.
           
            The adequacy of technical infrastructure, including data quality, should be assessed by an independent function on a regular basis (for instance internal or external audit).
           

        • 4.4 Developing a Written Policy Manual

          All the banks should have a documented Policy Manual, which evidently mentioned a clear standard timeline for NPL management and resolution. The longer a borrower remains past due, the less likely that the borrower is to repay the loan. A successful resolution, therefore, requires that the bank recognizes the problem early on and adheres to a tight but realistic timetable to ensure that the loan is restructured, sold to a third party, or collected through legal proceedings - in the case of non-viable borrowers) in a timely manner.

      • 5. Workout Plan

        • 5.1 Preparing for the Workout Process

          As the first step after receiving a new NPL, the workout team should ensure collection of all relevant and necessary information on the borrower’s loan and financial details to enable the selection of an appropriate workout plan. The Corporate/MSME team should ensure that the file is transferred with all necessary documentation and a case update summary is attached. In the best-case scenario, the bank should aim at achieving a consensual solution that satisfies the interests of both parties and results in a successful restructuring. Adopting such perspective implies not only a self-assessment of the bank’s options and legal position but also an analysis of the existing options and situation for the borrower. A comprehensive approach requires a thorough preparation process on both sides, which, if done properly, will maximize the chances of achieving a successful and mutually beneficial solution. All workout exercises should adhere to principles of restructuring outlined in Appendix 3 of this document and abide by Section 5 of the “Rules on the Management of Problem Loans”. 
           
          On the bank’s side, a thorough preparation includes: 
           
          i.Gathering all relevant information available on the borrower;
           
          ii.Perform a thorough review of the borrower’s historical financials, business viability, business plan and forecast loan service capacity.
           
          iii.Accurately assessing the value of the collateral securing the loan; and
           
          iv.Conducting a detailed analysis of the bank’s legal position.
           
          These aspects are further explained in the sections below. 
           

          • 5.1.1 Gathering of Information About the Borrower

            All borrowers and guarantors should be informed promptly (within 5 business days) that responsibility for their relationship has been transferred to the Workout Unit. This notification should be in writing and contain a complete and accurate description of all legal obligations outstanding with the bank, the amounts and dates of all past due amounts together with any fees or penalties which have been assessed. The Workout Unit should intimate the borrower with any violations and loan covenants or agreements observed at the time of information collection. 
             
            The borrower should be requested to submit the following information, preferably in electronic format: 
             
            i.Information on all loans and other obligations (including guarantees) outstanding.
             
            ii.Detailed contact information (mail, telephone, e-mail), including representatives, if applicable.
             
            iii.Detailed latest financial statements of the company (balance sheet, income statement, cash flow statement, explanatory notes). MSME’s and financially less-sophisticated enterprises may submit only aggregate financial figures.
             
            iv.Updated business plan and the proposal for repayment/restructuring of loan obligations.
             
            v.Individual entrepreneurs (for example sole proprietors), should also submit information about the household. The two additional parameters for determining the loan servicing ability of such borrowers are: (i) the borrower’s family composition (number of children, number of earners in the family) to determine justified expenses; and (ii) total net earnings.
             
            Updated financial information, together with a detailed listing of all guarantees outstanding, if any, should be also collected from the guarantors (natural or legal persons) of loans. In addition, the bank should exercise all legal efforts to acquire additional information from other sources to form an accurate, adequate, and complete view of the borrower’s loan servicing capability. 
             
            During the file review, the Workout Unit should pay close attention to identifying any other significant creditors. These may include other banks and financial institutions, Zakat/Tax authority, utilities, trade creditors and loans to shareholders, related parties, or employees. 
             
            For any missing key information identified during the file review, the Workout Unit should develop a corrective action plan to ensure collection of these documents with the help of the business team. Some of this information should be requested promptly from the borrower or third party sources such as Credit Bureaus. 
             

          • 5.1.2 Identifying Non-cooperative Borrowers:

            The Workout Unit should define non-cooperative borrowers and carefully document their non-compliance. Useful criteria to be used to identify these borrowers are: 
             
            i.Borrowers who default on their loans while having the ability to pay (“strategic defaulters") in hopes of receiving unwarranted concessions from the bank.
             
            ii.Failure to respond either orally or in writing to two consecutive requests from the bank for a meeting or financial information within 15 calendar days of each request.
             
            iii.Borrowers who deny access to their premises and/or books and records.
             
            iv.Borrowers who do not engage constructively with the bank, including those that are generally unresponsive, consistently fail to keep promises, and/or reject restructuring proposals out of hand.
             
            Non-cooperative borrowers are more likely to be transferred to the legal team as it would be difficult to reach a consensual restructuring solution if the Borrowers are not willing to cooperate with the Banks. 
             
            However, banks would have to maintain an appropriate audit trail, documenting the rationale for classifying a borrower as “non-cooperative" 
             

          • 5.1.3 Determining the Bank’s Legal Rights and Remedies

            The banks having reviewed and understood the borrower’s business plan, but before initiating restructuring negotiations with a borrower, must prepare for these negotiations and have a very clear understanding of its bargaining position from a legal standpoint. 
             
            The Workout Unit should perform a thorough review of all documents relating to the borrower, with special emphasis on the loan agreement and the security package that was formalized when the transaction took place. An accurate assessment of the bank's rights will have a critical impact on determining the resolution strategy to be adopted. 
             
            The following are general indicators that a Workout Unit could pay attention to when reviewing the documentation: 
             
            i.Whether the parties to the loan were adequately described in the loan documentation;
             
            ii.Whether all key documents were signed by the duly authorized persons under Saudi governing law;
             
            iii.Whether the bank is in possession of all original documents;
             
            iv.Whether the collateral has been duly perfected, including registration at the applicable registry
             
            v.Whether the loan documentation included non-compliance with certain financial indicators as ‘events of default’, and whether these indicators have been breached;
             
            vi.Historical financial position, driver of historical underperformance and to what extent this is expected to drive forecast performance:
             
             a)Current market challenges and outlook: The Banks should form a view on how this has impacted the borrower’s historically and how is it expected to impact its forecast performance and ability to repay the loan;
             
             b)The capabilities of the borrower’s Management team and whether they are capable of turning around the business;
             
             c)Strategy and turnaround initiatives: Does the borrower have a clear strategy or plan to turnaround the business? Has this plan been clearly documented and communicated to banks?
             
             d)Business plan and financial projections: How is the borrower expected to perform of the medium to long-term? What are the borrower's cash flow projections, which should provide an indication of his loan service capacity going forward? What is the level of sustainable versus unsustainable loan;
             
             e)Alignment with credit terms: To what extent are all of the above aligned with existing credit terms and repayment plan;
             
            vii.Whether the loan documentation included a cross-default clause and whether there are other loans that may be considered breached and/or accelerated as a result of the breach of one single loan;
             
            viii.Whether there was an obligation on the bank to notify the borrower or potential guarantors of major changes in the documentation or the terms of the loan, like changes in legislation, currency, interest rates, etc.
             
            If the borrower is not fully equipped to provide such information or if the banks would like to independently review such information, they can seek to appoint a financial advisor to perform an independent business review and clarify the above. 
             
            Once the Banks have formed a good understanding of the above, it is expected to assist them in identifying sustainable and commercial restructuring options that could align the banks' interest with that of the borrower and maximize recovery. Such options should be continuously evaluated as the WU engage in restructuring discussions and gather further information. 
             

          • 5.1.4 Ensuring Collateral’s Validity

            The workout team should ensure that the collateral taken at the time of loan agreement/origination was formalized and is still valid and enforceable. The banks should complete timely validation of legal documents to evade probable disputes or delay at the time of negotiating restructuring proposal. Furthermore, the banks should establish procedures around periodic (e.g. yearly basis) valuation and monitoring of acquired collateral

            The Bank is required to perform detailed collateral analysis for all the accounts referred to WU. The workout team should perform this analysis as detailed out in section 7 of the “Rules on Management of Problem Loans"

          • 5.1.5 Financial Viability Analysis

            Banks need to conduct a thorough financial and business viability analysis of its borrowers especially MSME NPL borrowers to determine their ability to repay their obligations. In addition, it is important to obtain sufficient insight into the business plan and projected cash flows available with the borrower for loan service. This will entail determining the borrower’s forecasted loan service capacity and assessment needs to be performed by the banks to align this with the restructured credit terms.
             
            This analysis serves as the foundation for making an informed decision on the appropriate resolution approach – restructuring, sale to a third party, change of loan type (loan-to-asset or loan-to-equity swap) or legal proceedings. This analysis is required to be conducted by WU not previously involved in the loan approval process.
             
            A. Analysis of key financial ratios
             
            Financial ratios, calculated from data provided in the balance sheet and income statement, provide an insight into a firm’s operations and are among the most readily available and easy to use indicators for determining the borrower’s viability. In case of MSME borrowers, in the absence of availability of audited and reliable financial information banks should focus on cash-flow based analysis and should also assess the reasonableness of financial information (where this information is available). 
             
            Below are four categories of financial ratios that banks may consider for their initial financial analysis (being illustrated below for indicative purposes and should not be considered prescriptive): 
             
            i.Liquidity ratios measure how easily a company can meet its short-term obligations within a short timeframe.
             
             a.Current ratio (total current assets/total current liabilities) measures a company’s ability to pay current liabilities by using current assets. It must be recognized that the distressed borrower’s ratios will be considerably lower. The Workout Unit should assess how the borrower can achieve a more normal ratio within a reasonable time frame.
             
             b.Quick ratio, which includes only liquid assets (cash, readily marketable securities and accounts receivable) in the numerator, is a measure of the firm’s ability to meet its obligations without relying on inventory.
             
            ii.Solvency or leverage ratios measure the company’s reliance on loan rather than equity to finance its operations as well as its ability to meet all its obligations and liabilities.
             
            iii.Profitability ratios measure the company’s growth and ability to generate profits or produce sufficient cash flow to survive, rate of sales growth, gross profit margin, and net profit margin are some of the key ratios to be considered.
             
            iv.Efficiency ratios measure management’s ability to effectively employ the company’s resources and assets. These include receivable turnover, inventory turnover, payable turnover and return on equity.
             
            Detailed financial analysis of the borrower needs is to be performed in order to ensure completeness and avoid ignoring important underlying trends. Banks should undertake detailed analysis to understand the interrelation of these financial ratios, which can enable identification of borrower’s real problems as well as probable corrective actions to restore the company’s financial health. 
             
            The workout team should exercise prudence in his analysis and utilize reasonable caps and floors for certain ratios, as these ratios vary across borrower segments and sectors as well as economic conditions. 
             
            B. Balance sheet analysis
             
            In addition to computing and analyzing the key ratios, the workout team should carefully review the balance sheet to develop a basic understanding of the composition of the borrower’s assets and liabilities. Primary emphasis should be placed on developing a complete understanding of all obligations outstanding to the bank and other creditors, including the purpose of the credits, their repayment terms, and current status, to determine the total debt burden of the borrower and the amount of loan that needs to be restructured.
             
            The composition of liabilities, particularly “other liabilities" and accrued expense items should be addressed. Wages payable and taxes are two particularly problematic accounts. Both represent priority claims against the borrower's assets and must be settled if a successful restructuring or bankruptcy is to take place.
             
            C. Cash flow analysis - defining financial viability
             
            When financial statements are prepared on an accrual basis, cash flow analysis ties together the income statement and the balance sheet to provide a more complete picture of how cash (both sources and uses) flows through the company. Cash is the ultimate source of loan repayment.
             
            The less cash is generated by operations, the less likely the borrower will be able to repay the loan, making it more likely that the bank will need to rely on its collateral (asset liquidation or bankruptcy) for repayment. Thus, the primary emphasis when conducting the financial analysis of the borrower should be on its forecasted cash generation capabilities. The proper analysis of cash flow involves the use of both the balance sheet and the income statement for two consecutive fiscal years to identify the sources and uses of cash within the company. Changes in working capital and fixed asset expenditures are quantified and cash needs are highlighted, providing a clear view of the many competing uses of cash within the company.
             
            With respect to MSME borrowers, in case reliable and timely financial information is not available, cash flow based assessment is recommended. Banks should incorporate a robust and efficient internal process of cash flow estimation for these borrowers.
             
            D. Business Plan
             
            A comprehensive financial analysis of the non-performing borrower includes an assessment of the company’s business plan containing a detailed description of how the owners and management are going to correct existing problems. While no one can forecast the future with certainty, a candid discussion between the borrower and the bank on new business plan and financial projections is an essential part of the viability assessment exercise. It provides both the bank and the borrower an opportunity to explore how the company will operate under different scenarios and allows management to have a contingency (or corrective action) plans in place should actual results deviate significantly from the projections. The focus of the Workout Unit will be on validating the assumptions (whether realistically conservative and in line with past performance) and performing a sensitivity analysis to see how results will vary under changed assumptions. Again, the emphasis should be placed on tracing the flow of cash through the business to determine the company’s ability to pay.
             
            E. Cash budget
             
            Cash budget is a powerful tool, which helps the borrower to limit expenditures and preserve cash to meet upcoming obligations such as taxes. It can also compensate for the poor quality of formal financial statements in the case of micro and small enterprises.
             
            In a workout, the ability to generate and preserve cash is the key to the company’s survival. All borrowers should be encouraged to prepare a short-term cash budget. The cash budget is similar to the cash flow analysis and differs, however, in two important respects: (i) it is forward-looking; and (ii) it breaks down the annual sources and uses by month to reveal the pattern of cash usage within the company. It also clearly identifies additional financing needs as well as the timing and amount of cash available for loan service. For smaller borrowers, a simple listing of monthly cash receipts and cash disbursements will suffice. Actual results need to be monitored monthly and corrective actions are taken immediately to ensure that the company remains on plan.
             

          • 5.1.6 Business Viability Analysis

            Unlike financial analysis, which is highly quantitative, the business analysis is more qualitative in nature. Its purpose is to assess the borrower's ability to survive over the longer term. It focuses not on the borrower's financial performance, but rather on the quality of its management, the nature of the products & services, facilities and the external environment in which the borrower operates (including competition).
             
            The primary cause of a business failure that has been acknowledged is the management of the business. The most common reasons include: (i) lack of necessary management skills required to run an organization; (ii) inability or unwillingness to delegate responsibilities; (iii) lack of experienced and qualified managers in key positions; (iv) lack of skills to run the business; and (v) inadequate management systems and controls.
             
            Product assessment focuses on the nature of the product and its longevity potential. The main considerations include services or products, product mix diversified or reliant on a single product, technical obsolescence, and demand of the product/service.
             
            The primary focus of the assessment of the facilities (physical plant, manufacturing units, etc.) is not on their valuation but rather on their capacity and efficiency. The attempt should be made to evaluate any requirements of significant upgrades or new facility to meet demand for the product presently and in the foreseeable future. The costs for the same should then be assessed and included in the base projections.
             
            External factors include the assessment of the general macro environment as well as overall industry and market conditions. It focuses on assessing the potential impact on the borrower of changes in the economic as well as regulatory climate; analyzing the strength of the borrower's position within the industry (market share) and its competitors; and gaining a better understanding of the borrower's market and how changes within the market might affect the company's performance.
             
            A. Use of outside expertise to prepare business viability assessment
             
            For large commercial or real estate loans, the business viability portion of the analysis may be performed or validated by an independent third party such as a consultant or a restructuring advisor.
             
            i. Micro and Small Enterprises
             
            In the case of micro and small companies and subject to the cooperation of the owner or the management, which is trustworthy and provides reliable financial and other information, the use of external consultants may not be efficient in terms of time and costs. Banks are, therefore, encouraged to build internal capacity (or engage with external service providers as necessary) to assess the business viability of this segment and enable reasonable decision making in this regard.
             
            ii. Medium-sized companies:
             
            Medium-sized companies should be analyzed in more detail and it may be reasonable to use a similar approach as in the case of large companies. This may require a guided and aligned coordination between the banks and the inclusion of an external consultant to prepare an independent overview of operations, particularly in the following cases. 
             
            The process can be followed in case where at least one of the following conditions are met: 
             
            i.There is doubt about the reliability of financial and other information;
             
            ii.There is doubt about the fairness and competence of the management;
             
            iii.Activity involved of which the bank does not have sufficient internal knowhow;
             
            iv.There is a great probability that the company will need additional financial assets.
             
            All banks should have clear procedures regarding the level of approval authority required and the process to be followed when contracting for an independent review. The procedure guidelines at a minimum should include qualifications of the advisor, selection criteria, evaluation process and approval for these appointments. Whenever possible, Workout team should request proposals from several firms. In addition, these procedures should require that the deliverables (together with their due dates) and the pricing structure, should be clearly laid out. To expedite and further standardize the onboarding process, banks may choose to establish a list of pre-approved vendors. 
             
            B. Documenting the results of the financial and business viability analysis
             
            The findings of the financial and business viability analysis should be documented in writing and communicated to the credit committee for review. The documentation should have sufficient detail to provide a comprehensive picture of the borrower's present financial condition and its ability to generate sustainable cash flows in the future. Banks will have its own standard format for documenting the analysis but should ensure that it incorporates, at a minimum, the below information: 
             
            i.Minutes of the meeting with the borrower with a clear identification of the reasons for the problems and the assessment of the ability to introduce radical changes into the operations;
             
            ii.Exposure of the banks and all other creditors (related persons, in particular);
             
            iii.The analysis of the balance sheet structure - the structure of maturity of receivables and operating liabilities, identification of assets suitable for sale and assessment of the value of this property;
             
            iv.The analysis of the trends of the key indicators of individual categories of financial statements: EBITDA margin, net financial /EBITDA, total debt/equity, interest coverage, debt service coverage ratio (DSCR), net sales revenue/operating receivables, accounts payable/total debt, quick liquidity ratio, cash flow from operations, costs of services etc. (these ratios are indicative, banks in practice are free to utilize such ratios, which they deem appropriate).
             
            v.3- to 5-year projection (time period is dependent based on the tenor of the loan) of cash flows based on conservative assumptions - the plan of operations must not be a wish list but rather a critical view of the possibilities of the company's development in its branch of industry;
             
            vi.Analysis of the necessary resources for the financing of working capital and investments (Capex);
             
            vii.Review of all indemnities (in the case of personal guarantees also an overview and an assessment of the guarantor's property);
             
            viii.Overview of the quality and assessment of the value of collaterals and the calculations of different scenarios (implementation of restructuring or the exit strategy).
             
            The results of the financial analysis should be updated at least annually or more frequently in conjunction with the receipt of the borrower's financial statements. The business assessment should be updated at least every three years or whenever major changes occur in either borrower's management or the external operating environment. 
             
            Based on the financial analysis, the business plan and the understanding of the borrower’s loan service capacity, the banks should consider various restructuring solutions that can offer a sustainable restructuring and align the credit terms with the cash flow forecasts of the business. These solutions could include, but are not limited to: 
             
            i.Grace periods.
             
            ii.Reduced interest rates or in some cases payment in kind (PIK) (PIK is the option to pay interest on debt instruments and preferred securities in kind, instead of in case.PIK interest has been designed for borrowers who wish to avoid making cash outlays during the growth phase of their business. PIK is the financial instrument that pays interest or dividends to investors of bonds, notes, or preferred stock with additional securities or equity instead of cash) interest.
             
            iii.Assessing sustainable versus unsustainable debt.
             
            iv.Agreeing repayment profiles around sustainable debt in line with forecast sensitized cash flows of the borrower.
             
            v.Agreeing an asset sale plan.
             
            vi.Agreeing a debt to equity conversion.
             
            vii.Agreeing a debt to asset swap.
             
            viii.Agreeing a cash sweep mechanism (it is the mandatory use of excess free cash flows to pay outstanding debt rather than distributing it to the shareholders) to benefit from any upsides to the borrower's business plan.
             
            ix.Longer-term tenors when the business plan and financial analysis suggest that this is necessary for a more sustainable restructuring
             

        • 5.2 Identifying the Workout Options

          • 5.2.1 Purpose of Workout

            Under a best-case workout scenario, the bank and the viable (or marginally viable) borrower will agree on the restructuring strategy aiming to return the defaulted borrower to a fully performing status in the shortest feasible time frame. This requires matching the borrower's sustainable repayment capacity with the correct restructuring option(s). There is no one standard (“one size fits all") approach and instead, the Workout Unit must choose from a variety of options to tailor a restructuring plan that meets the needs of specific borrower.

            For the bank to consider approving a restructuring plan, the borrower must meet two essential pre-conditions: (i) borrower's projected cash flows must be sufficient to repay all or a substantial portion of its past due to obligations within a reasonable time frame: and (ii) borrower must display cooperative behavior.

            Not all borrowers will be able to repay their obligations in full. However, this does not mean they should automatically be subject to legal action. Banks are advised to invoke out of court settlements for borrowers willing to cooperate with the restructuring process and are able to demonstrate that the economic loss as a result of any foreseeable restructuring is likely to be lower than seeking foreclosure. Instead, the bank should proceed with restructuring whenever it can reasonably document that the revised terms (which may include conditional loan forgiveness) will result in a greater recovery value for the bank than a legal procedure (bankruptcy or foreclosure).

            In a syndicated or multi-bank scenario, wherein minority banks don't agree to a restructured/ work out solution, dissenting banks may utilize the guidelines laid down in the Bankruptcy law.

          • 5.2.2 Workout Options

            At the initial segmentation stage, the loan-to-value and viability parameters are generally used to help identify potentially viable borrowers (Refer to Chapter 3). This group of borrowers is then subject to in-depth financial analysis and business viability assessment, which narrows the number of candidates for potential restructuring even further. At this stage, the Workout Unit should have a fully informed view as to the nature and causes of the borrower's difficulties. Based on this understanding, the Workout Unit should work with the borrower on developing a realistic repayment plan designed around the borrower's projected sustainable cash flows and/or the liquidation of assets within acceptable timeframes. Understanding and knowing when to use each of the options discussed below provides a Workout Unit with the flexibility necessary to tailor appropriate restructuring proposals.
             
            Consider personal guarantees, conversion of loans from owner(s) to equity or other subordinated form, capital increase, additional collateral, sale of excess assets, achievement of certain levels of financial indicators.
             
            Borrower TypeWorkout MeasureDescription
            ViableNormal reprogrammingFuture cash flows sufficient for repayment of loan until a sustainable level of cash flow reached within the stipulated period (Actual timeline dependent on the profile of the borrower and tenor of the loan).
              Consider personal guarantees, conversion of loans from owner(s) to equity or other subordinated form, capital increase, additional collateral, sale of excess assets, achievement of certain levels of financial indicators.
            MarginalExtended repayment periodExtended period of reprogramming (rescheduling) needed to reach a sustainable level of cash flow, i.e., with final payment in equal installments or balloon or bullet payment.
             Loan SplittingLoan is split into two parts: the first, representing the amount that can be repaid from sustainable cash flow) is repaid in equal installments (principal and interest) with a specified maturity date; the remaining portion is considered to be excess loan (which can be subordinated), which may be split into several parts/tranches. These may be non-interest bearing with interest payable either at maturity or from the proceeds of specific asset sales.
             Conditional Loan ForgivenessTo be used to encourage owners to make an additional financial contribution to the company and to ensure that their interests are harmonized with those of the bank, particularly in those cases when the net present value of the company (taking into consideration all collateral and potential cash flow) is lower than the total loan. Bank may choose to:
              i.Partial write-off in the framework of the owner's cash equity contribution, particularly in all cases where the owner(s) have not guaranteed the loan;
              ii.Partial write-off in the framework of a cash capital increase from a third-party investor where they have not assumed the role of the guarantor;
              iii.Partial write-off in the case of a particularly successful business restructuring that materially deviates from the operating plan that served as the basis for the restructuring;
              iv.Partial write-off in those cases when the above-average engagement of the owner(s) (i.e. successful sale of excess assets) guarantees a higher level of repayment to the bank(s).
              Loans can also be written off if the collateral has no economic value, and such action ensures the continuation of the borrower's operations and the bank has confidence in the management or if the cause for the problems came from objective external factors.
             Loan to Equity SwapsAppropriate for medium-sized companies where the company can be sold, has established products/services, material know-how; or significant market share, etc. However, such measures should be in-line with the requirements stipulated by Banking Control Law (Issued by SAMA) under Article 10 subsection 2 and 4.
             Loan to Asset SwapsCan be an effective tool particularly in the case of stranded real estate projects provided that the real estate is in good condition and can be economically viable managed in the future. The transaction must not be legally disputable, considering the provisions of the bankruptcy and enforcement legislation. It may also be used for other real estate cases, equity stakes, and securities with determinable market value.
             Short Term restructuringRestructuring agreements with a one-year maturity may be appropriate in those cases such as micro and small borrowers, where the bank feels closer monitoring or increased pressure to perform is necessary.
             Loan SaleSale of the loan is reasonable under the following conditions:
              •The bank does not have sufficient capacity to effectively manage the borrower;
              •The buyer has a positive reference; and
              •The buyer is a major specialist in the area of resolving non-performing loans.
            Non-Viable BorrowersCollateral Liquidation by ownerMSME owners have strong attachments to their property. They may fail to carry out the sale within the agreed-upon time frame or have unrealistic expectations regarding the value of the property. It is recommended that the bank set short deadlines; obtain a notarized power of attorney allowing it to activate the sale procedures; and have sufficient human resources within the real estate market to expedite the sales process.
             Execution or InsolvencyTo be used when the borrower is not viable or non-cooperative, and no feasible restructuring solution can be put in place.
             
            The below figure presents the various options broken into three broad categories: (i) short term measures most appropriately used in early-stage arrears to stabilize the situation and give the borrower and the bank time to develop a longer-term strategy; (ii) longer-term/ permanent solutions, which will result in the reduction of the loan: and (iii) additional measures, which do not directly lead to repayment but strengthen the bank's collection efforts.
                 

          • 5.2.3 Short Term Restructuring Measures:

            Short-term measures do not lead, in and of themselves, to the repayment of a borrower's obligations. Instead they are designed to provide: (i) temporary relief in response to a clearly identified short term disruption in a borrower's cash flow (e.g., event out of the borrower's control, like a sudden fall in demand due to external circumstances); or (ii) time for the creditor(s) to assess the situation and determine an appropriate course of action. They are most appropriate to use when there is a reasonable expectation that the borrower's sustainable cash flow will be strong enough to allow the resumption of its existing payment schedule at the end of the restructuring period. Evidence of such an event should be demonstrated in a formal manner (and not speculatively) via written documentation with defined evidence showing that the borrower's income will recover in the short-term or on the basis of the bank concluding that a long-term restructuring solution was not possible due to a temporary financial uncertainty of a general or borrower-specific nature. As these options envision that the borrower will be able to bring defaulted amounts of interest and/or principal current at the end of the restructuring period, they should not exceed a tenor of 24 months (12 months in the case of real estate or construction projects) and must be used in combination with longer-term solutions such as an extension of maturity, revision in terms and additional security. 
             
            Specific short-term measures to consider include: 
             
            i.Reduced payments - the company’s cash flow is sufficient to service interest and make partial principal repayments.
             
            ii.Interest-only - the company's cash flow can only service its interest payments, and no principal repayments are made during a determined period of time.
             
            iii.Moratorium - an agreement allowing the borrower to suspend payments of principal and/or interest for a clearly defined period. This technique is most commonly used at the beginning stages of a workout process (especially with multi-bank borrowers) to allow the bank and other creditors time to assess the viability of the business and develop a plan for moving forward. Another appropriate use is in response to natural disaster, which has temporarily interrupted the company's cash flow.
             
            The contractual terms for any restructuring solution should ensure that the bank has the right to review the agreed restructuring measures if the situation of the borrower improves and more favorable conditions for the bank (ranging from the restructuring to the original contractual conditions) could, therefore, be enforced. The bank should also consider including strict consequences in the contractual terms for borrowers who fail to comply with the restructuring agreement (e.g. additional security). 
             

          • 5.2.4 Long Term/Permanent Restructuring

            Longer-term/permanent options are designed to permanently reduce the borrower’s loan. Most borrowers will require a combination of options to ensure repayment. In all cases, the bank must be able to demonstrate (based on reasonable documented financial information) that the borrower's projected cash flow will be sufficient to meet the restructured payment terms. 
             
            Specific options that may be considered include: 
             
            i.Interest and Arrears capitalization - adds past due payments and/or accrued interest arrears to the outstanding principal balance for repayment under a sustainable revised repayment program. Workout Unit should always attempt to have the borrower bring past due payments and interest current at the time a loan is rescheduled. Capitalization, intended to be used selectively, is likely to be more widespread when borrowers have been in default for an extended period. This measure should be applied only once, and in an amount that does not exceed a pre-defined size relative to the overall principle as defined in the bank's Remedial/restructuring policy. The bank should also formally confirm that the borrower understands and accepts the capitalization conditions.
             
            ii.Interest rate reduction - involves the permanent (or temporary) reduction of the interest rate (fixed or variable) to a fair and sustainable rate. This option could be considered when the evolution of interest rates has resulted in the borrower receiving finance at an exorbitant cost, compared with prevailing market conditions. However, banks should ensure that lower interest rate is sufficient to cover the relevant credit risk.
             
            iii.Extension of maturity - extension of the maturity of the loan (i.e., of the last contractual loan installment date) allows a reduction in installment amounts by spreading the repayments over a longer period
             
            iv.Rescheduled Payments - the existing contractual payment schedule is adjusted to a new sustainable repayment program based on a realistic assessment of the borrower's cash flows, both current and forecasted. This is usually used in combination with an extension of maturity. In addition to normal rescheduling, additional repayment options include:
             
             a.Partial repayment - a payment is made against the credit facility (e.g., from a sale of assets) that is lower than the outstanding balance. This option is used to substantially reduce the loan at risk and to enable a sustainable repayment program for the remaining outstanding amount. This option is generally preferable, from the bank's standpoint to the balloon, bullet or step-up options described below.
             
             b.Balloon or bullet payments - are used in the case of more marginal borrowers whose sustainable cash flow is insufficient to fully repay the loan within the rescheduled tenor. A balloon payment is a final installment substantially larger than the regularly scheduled installments. Bullet loans carry no regular installment payments. They are payable in full at the maturity date and frequently contain provisions allowing the capitalization of interest throughout the life of the loan.
             
              These options are generally only be used/considered in exceptional circumstances, and when the bank can duly document future cash flow availability to meet the payment. Bullet loans are frequently used in conjunction with loan splitting. In this case, the unsustainable portion of the loan represented by the bullet loan should be fully provisioned and written off in accordance with bank policy.
             
             c.Step-up payments - should be used when the bank can ensure and demonstrate that there is a good reason to expect that the borrower's future cash flow will be sufficient to meet increases (step-up) in payments.
             
            v.Sale by owner/assisted sale - this option is used when the borrower agrees to voluntarily dispose of the secured assets to partially or fully repay the loan. It is usually combined with the partial repayment option or conditional loan forgiveness. The borrower must be monitored closely to ensure that the sale is conducted in a timely manner and the agreement should contain a covenant allowing the borrower to conduct the sale if the borrower fails to do so within the specified timeframe.
             
            vi.Conditional loan forgiveness - involves the bank forfeiting the right to legally recover part or the whole of the amount of an outstanding loan upon the borrower's performance of certain conditions. This measure may be used when the bank agrees to a “reduced payment in full and final settlement", whereby the bank agrees to forgive all the remaining loan if the borrower repays the reduced amount of the principal balance within an agreed timeframe. This option should be used to encourage owners to make an additional financial contribution to the company and to ensure that their interests are aligned with the banks. It is particularly appropriate in those cases where the net present value of the borrower's projected repayment capacity (taking into consideration all the collateral and potential cash flow) is lower than the total loan. In these cases the bank may consider:
             
             a)Partial write-off in return for a cash equity contribution from an owner(s), particularly in those cases where the owner(s) have not guaranteed the loan.
             
             b)Partial write-off in the framework of a cash capital increase from a third- party investor where they have not assumed the role of guarantor.
             
             c)Partial write-off in the case of a particularly successful business restructuring that materially deviates from the operating plan that served as the basis for the restructuring.
             
             d)Partial write-off in those cases when the above-average engagement of the owner(s) (i.e. successful sale of excess assets) guarantees a higher level of repayment to the bank(s).
             
             e)Loan can also be written off if: (i) the collateral has no economic value, and such action ensures the continuation of the company's operations; (ii) it is evident that the owner has invested his entire property in the business and has lost it; (iii) the borrower possesses significant “know-how", and the bank has confidence in the management; or, (iv) the problems were caused by objective external factors.
             
             Banks should apply loan forgiveness options carefully since the possibility of forgiveness can give rise to moral hazard, weaken the payment discipline, and encourage “strategic defaults". Therefore, banks should define specific forgiveness policies and procedures to ensure strong controls are in place.
             
            vii.Fresh money - providing new financing arrangements to support the recovery of a distressed borrower is usually not a standalone viable restructuring solution but should be combined with other measures addressing existing arrears. It should only be applied in exceptional cases and requires a thorough assessment of the borrower's ability to repay. For loans with significant amount, independent sector experts should be used to validate the viability of proposed business plans and cash flow projections.
             
             The Banks are recommended to have strict policies prohibiting lending new monies or allowing roll-overs. There are, however, three specific situations where it may be warranted. They are: (i) the need for fresh money to be used for working capital to restart the business; (ii) advances required to protect the bank's collateral position; or, (iii) small advances to prevent large contingent exposures (guarantees) from being called.
             
            viii.Loan splitting - is used to address collateral and cash flow shortfalls. In this option, the loan is split into two parts: (i) the portion representing the amount that can be repaid from sustainable cash flow is repaid in equal installments of principal and interest; and (ii) the remaining portion represents “excess loan" (which can be subordinated). This portion can be used in combination with payments from the sale of specific assets or bullet payments at the maturity.
             

          • 5.2.5 Additional Measures

            Additional measures are not considered to be viable stand-alone restructuring options as they do not result in an immediate reduction in the loan. However, when combined with one or more of the previously identified options, they can provide incentives for repayment or strengthen the bank's overall position. 
             
            i.Loan-to-asset swap - transfers a loan, or portion of a loan, into “other assets owned" where the ultimate collection of the original loan requires the sale of the asset. This technique is generally used in conjunction with conditional loan forgiveness or partial loan repayment and maturity extension options. The management and sale of real estate properties also requires specialized expertise to ensure that the bank maximizes its returns from these assets.
             
            ii.Loan-to-equity swap - transfers the loan, or portion of the loan, into an investment. Generally used to strengthen the capital structure of large highly indebted corporate borrowers, it is seldom appropriate for MSME borrowers due to limited access to equity markets and difficulties in determining the fair value of illiquid securities. Like the loan-to-asset swap above, this option may also require the bank to allocate additional resources for managing the new investment. However, such measures should be in-line with the requirements stipulated by Banking Control Law (Issued by SAMA) under Article 10 subsection 2 and 4.
             
            iii.Loan Consolidation - more common for small loans, entails the combination of multiple loans into a single loan or a limited number of loans. This solution should be combined with other restructuring measures addressing existing arrears. This option is particularly beneficial in situations, where combining collateral and secured cash flows provides greater overall security coverage for the entire loan than individually.
             
            iv.Other alterations of contract/covenants - when entering a restructuring agreement, it is generally necessary to revise or modify existing contracts/covenants to meet the borrower’s current financial circumstances. Examples might include revising ratios such as minimum working capital or providing additional time for a borrower to sell excess assets.
             
            Additional security - additional liens on unencumbered assets (e.g., pledge on a cash deposit, assignment of receivables, or a new/additional mortgage on immovable property) are generally obtained as additional security from a borrower to compensate for the higher risk loan or cure existing defaults in loan-to-value ratio covenants. 
             

          • 5.2.6 Utilizing New Information

            If new information is obtained after deciding on the resolving approach, the bank must re-examine and refresh it. For example, if it turns out that the borrower had been misleading it with certain material information, the approach and the measures must be more conservative. On the other hand, if the borrower puts forward or presents a repayment proposal during the measures, which would considerably improve the bank's position, the bank may mitigate the measures subject to fulfillment of certain conditions or eliminate them completely. This means that there is a certain flexibility of restructuring measures for the company. 
             
            Banks generally have a choice of choosing to restructure a loan, sell the loan (note sale), or liquidate the underlying collateral either by sale by owner or legal procedures (e.g. enforcement or insolvency). These guidelines require banks to compare the value of the proposed restructuring option against the other alternatives. The analysis will be confined to comparing the value of the proposed restructuring against enforcement and bankruptcy. Choosing the optimal option, i.e., the solution that returns the highest value to the bank is not always clear-cut. 
             
            Evaluating alternative strategies based on NPV analysis 
             
            Using a simple Net Present Value (NPV) analysis is recommended in order to provide more quantitative justification for the decision. 
             
            The general formula to calculate net present value is:
             
             
             
            Where i = interest rate per period 
             
             N = total number of periods
             
             Rt= net cash flow per period t
             
             t = period in which cash flow occurs
             
            Net present value (NPV) is the sum of the present values (PV) of a stream of payments over a period of time. It is based on the concept of time value of money - money received in the future is less valuable than money received today. To determine NPV, the net cash flow (cash payments of principal, interest, and fees less the bank’s out-of-pocket costs for legal fees, consultants, etc.) received annually is calculated. Each of these amounts or future values (FV) is then discounted to the present by using an appropriate market-based discount rate. Alternatively, the Banks may also use original effective interest rate used for computation of provisioning under International Financial Reporting Standard (IFRS) 9 guidelines. 
             
            The sum of the PVs equals the NPV. Because of its simplicity, NPV is a useful tool to evaluate which of the possible workout options results in the maximum recovery to the bank. 
             
            For NPV analysis, the bank's standard risk-adjusted discount rate should be considered. NPV from various options should be considered including below considerations in each option: 
             
            i.Restructuring: evaluation based on estimated cash-flows for a period under negotiation for new tenor of contract. The factors to be considered are interest rate of the new term, any other expenses involved in restructuring and business plan or internal estimations of the bank.
             
            ii.Enforcement (including legal): the parameters to be considered includes current value of the property, suitable haircuts to be applied, litigation charges and additional time to be taken to conclude these proceedings.
             
            iii.Insolvency: cost of insolvency procedure, length of time to conclude insolvency proceedings and estimated value to be recovered.
             

        • 5.3 Negotiating and Documenting Workout Plan

          • 5.3.1 Developing the Negotiating Strategy

            Restructuring plan should be viable and mutually acceptable. As every restructuring is unique, depending on borrower and the executing team, the notion of the strategy should keep, following things in mind before drafting the plan: 
             
            •Restructuring a loan, which is under stress, means introducing changes that will make underlying business viable and profitable once again and to implement changes so that it will generate enough cash flow to cover the service of loan and satisfactorily returns to shareholders. It is important to understand the underlying causes of the problem.
             
            •The restructuring is more than just changing the terms and structure of the facility, as it focuses on sustainable business.
             
            •Economic profitability should be priorities over accounting profitability while restructuring. The objective is to render the company viable and to ensure its continuity.
             
            A. Better Practices for approaching negotiation in an efficient manner
             
            i.Preparation is essential before the negotiation starts: Every negotiation requires preparation and a strategy to implement. During their preparation, the bank can propose and determine how the possible refinancing is going to be distributed, under what conditions, and subject to what limits and guarantees. Negotiating strategy and tactics should include identification of the negotiable points, possible counter-proposals from the banks, and matters kept in reserve (if possible) to be raised during the process.
             
             a.Be Prepared - It is not possible to draw up a restructuring strategy without a reliable resolvability analysis. The bank should review all available information of the company and current state of business sector, identify the reason and nature of the distress situation.
             
             b.Evaluate the position - Bank should evaluate its ranking in terms of security among the other creditors and stakeholders. The bank should also assess the number and value of secured claims in relation to other secured and unsecured creditors,
             
            ii.Keep the borrower informed: For a successful negotiation, the bank should inform all the stakeholders and be involved actively in talks about the negotiation progress. Successful restructuring is a team effort. Success requires that borrowers work closely with their investment partners. In a restructuring, investors are not only shareholders but also supporting financial entities. For managers the challenge is always to be a step ahead by preparing the (eventual) next round: to be transparent, and to communicate effectively.
             
            iii.Consistency will deliver results: At this crucial stage in a company's life, inconsistency in communication or strategy can be detrimental. Some ways to be consistent:
             
             a)Draw up a consistent and credible action plan to improve the company's liquidity. Determine the financial needs in the short, medium and long term.
             
             b)Be consistent in the plan: try to cover short-term needs with short-term funds, and long-term needs with long-term funds.
             
             c)Do not equate restructuring with loan renegotiation n. Long-term needs can and must be financed by converting loan to equity, whenever the level of leverage is excessive.
             
             d)When converting loan to equity, negotiate in detail the value of the stake held by the new shareholders or look for alternative sources of capital.
             
             e)Finally, the success of the restructuring depends to a large extent on the company surrounding itself by qualified advisors who can offer the benefit of their experience.
             
            iv.A restructuring process consists of reaching a private agreement in order to prevent legal proceedings. It is also possible to base the agreement on corresponding bankruptcy law, although it would have to be under judicial protection and subject to regulations that are often more rigid (creditors agreement).
             
            B. SWOT (Strengths, weaknesses, opportunities, threats) Analysis
             
            While negotiating the rehabilitation plan, the bank should identify and evaluate the strengths and weaknesses in the account. The strengths and weaknesses in the account should be thoroughly evaluated to assess and draft the strategy. Before initiating the negotiations with the borrower, bank should prepare a strategy to discuss and finalize the meaningful and successful plan.
             
            The cases where the borrower is not sound to understand the restructuring, the banks should make all the efforts to educate and represent the facts in full faith and trust. If necessary, bank should involve external party for explaining the plan and reducing the resistance by the borrower in restructuring.
             
            Bank may adopt SWOT analysis to formulate the plan. In SWOT, all internal and external factors are considered for identification of strengths and weaknesses in the account. On critical assessment of these factors, bank can build the plan into negotiating strategy. The strategy should cover the defined objectives along with needs of the borrower, reason for restructuring, root cause analysis of the problem, proposed solutions, and negotiating parameters. The strategy of the bank should be focused on incentivizing the borrower and must include fees, penalties, and interest. The structure of the new and old facility has to be clearly explained to borrower while negotiating the strategy. A good background check and through homework may reduce the last-minute surprises and enhances the chances of a successful outcome.
             
            Although the borrower should be made aware of deadlines to complete negotiations (i.e., at the specific restructuring plan being offered will expire if not accepted within 30 days), the situation should not end up into a sub-optimal restructuring.
             
            Despite the fact that negotiating with the borrower on restructuring may be heated at times, both parties must understand the need of the situation and work collaboratively in the interest of both the parties and to come to a consensual and mutually acceptable agreement. The negotiation should be drafted as win-win situations for both parties.
             
            C. Use of advisor
             
            After ascertaining the viability of business and ensuring that business plans are sustainable, both parties should come to a negotiable agreement. Depending on the complexity of structure and borrower's financial knowledge and sophistication, an external advisor may be required. Potential areas for advice are: a) drafting the entire restructuring proposal (financial and legal) and b) drafting business plans as a cornerstone for restructuring discussion with the bank.
             
            In order to build trust of borrower in the restructuring plan, especially for less sophisticated borrowers, it is recommended to involve external advisor viz. a lawyer or a financial specialist.
             
            The bank should organize borrower educational unit within the bank that would provide general financial counsel services to borrowers, including NPL resolution.
             
            The bank should also consider providing independent counseling/mediation services to borrowers for finalizing the strategy.
             
            D. Involvement of guarantor (/s)
             
            Depending on the terms of a guarantee, a guarantor is either fully or partially liable for the loan of third party (the borrower). The guarantor, therefore, should be kept fully informed about the status of the loan and the resolution process so that the guarantor is fully prepared to meet his obligations if the bank chooses to call the guarantee. New guarantees or a re-statement of the previous ones should be obtained whenever changes are made to the loan.
             
            This is to ensure that the guarantor cannot use as a defense against payment that changes were made, to which the guarantor would not have agreed, without prior knowledge or consent.
             
            E. Dealing with multi-bank borrowers
             
            The role of the coordinator should be assumed by the bank with the largest loan, but the other banks must also be willing to accept it, should the bank with the largest expose refuse such activities for objective reasons. When appointing the coordinator and setting its powers, the banks shall strive for the following: 
             
            i.As a rule, a coordinator should be appointed within 1 month.
             
            ii.The coordinator should be appointed for a certain period (no more than 6 months) with the possibility of renewal (3 months).
             
            iii.During this mandate term, the coordinator may not withdraw without a grounded reason. If the banks do not renew the coordinator's mandate term 1 month prior to expiry, the restructuring process is completed.
             
            iv.The coordinator shall be responsible for the assessment of the need to sign a Standstill Agreement, the assessment of the need to extend the coordinator's mandate, the assessment of the need for external consultant (financial or legal) and the drafting of the proposed solution for borrower restructuring.
             
            v.In the beginning of the process, the coordinator must clearly define the goals, take care of strict compliance of the deadlines, transparent communication and information of all stakeholders and cooperation by agreement
             
            vi.The coordinator takes care of the minutes of creditor meetings which sum up the decisions and the orientations of the process. In case individual creditors or the borrower constantly change their positions without reason, thereby jeopardizing the process, the coordinator transparently informs all creditors and the borrower and is entitled to withdraw as coordinator.
             
            vii.If appointment of an agent is necessary after the completion of the restructuring, this role can be assumed by the coordinator unless agreed otherwise by the creditors. The coordinator takes over all further communication with the borrower, with the purpose of limiting mutual administrative activities.
             
            It is generally agreed that a negotiated out-of-court debt restructuring is preferable to court proceedings. It tends to be both faster and less costly, hence banks are encouraged to explore the same prior to seeking legal recourse 
             
            To facilitate the process, the primary bank must familiarize themselves with the role of the coordinator and be prepared to assume the responsibilities, if necessary, when a borrower has loans from more than one bank. 
             
            Banks should strive to actively participate and cooperate in these negotiations. While banks may have genuine differences of opinion about the proper course of action to be taken with a borrower, they should state their views openly and be prepared to compromise, when warranted. 
             
            F. Bearing the costs of the workout
             
            Formalizing a workout implies incurring multiple costs that may significantly compromise the financial position of the parties involved in the workout. 
             
            This implies that the borrower does not only assume his own costs, but also the costs and fees of auditors, lawyers and financial advisors that were engaged at creditors' request to complete the restructuring. While this is standard practice, there are certain limits to this general rule that try to prevent that the amount of these external costs become excessive: 
             
            a)The borrower is only supposed to assume those costs incurred by the whole body of creditors. This implies that creditors who wish to use their own advisers shall cover their own costs.
             
            b)When engaging the external consultants, throughout the course of the workout process, creditors must strive to help the borrower control and manage such costs, and should not incur any costs that may not be considered reasonable.
             
            For MSME borrowers, banks are required to streamline workout processes, review existing processes to ensure that any cost levied to the borrower is kept at manageable levels 
             
            G. Checklists for Negotiations
             
            Best practice in the recovery of distressed business loans is based on ensuring that ample effort goes into preparing for negotiations. To prepare for negotiations bank must have a 
             
            i.Know loans and security position.
             
            ii.Know the mindset of each negotiating borrower.
             
            iii.Have a realistic assessment of counterparties’ other personal or psychological attributes.
             
            iv.Know the main negotiating points critical to the success of the workout, and how each negotiating point is likely to be perceived by the borrower.
             
            v.Determine the overall posture best to adopt in conducting the negotiations.
             
            vi.Detail the relative merits of your chosen “posture" in terms of flexibility.
             
            vii.Separate the counterparties and their representatives from the problems caused by differences in positions.
             
            viii.Focus on each borrower's needs and interests rather than their stated or presumed position.
             
            ix.Look for solutions with mutual benefits (win-win strategies).
             
            x.Push for objectivity in judging proposals.
             
            H. Pricing the workout
             
            While considering the price of the workout, the banks should consider cash flow, net present value, involvement of other banks (share, interest rate), and collateral value. The pricing should also factor in the risk in the proposal i.e. the change in risk profile of the borrower and waiver/ sacrifice amount while finalizing the work out strategy.
             
            I. Maintaining fallback strategics
             
            Fall-back strategies are important because of the potential fluidity of any workout. The following are worth keeping in mind as strategy is being developed: 
             
            a)Workout strategies can be rendered ineffective suddenly, without warning and often as the result of revisions to what were previously believed to be immutable facts.
             
            b)The importance of comparing options carefully during initial strategy selection - The scope for different views and approaches is ample. While occasionally some solutions will so clearly dominate all others as to not require deep discussion of alternatives, more often the best course of action is not so immediately obvious. In such cases, a thorough analysis and discussion of the strategy options will be an indispensable part of the asset recovery process. Best practice also involves formalizing the process, by holding the type of decision meeting appropriate for removing ambiguity as to what was decided and by recording the decision.
             
            Comparisons of the various asset recovery options should involve quantification. As a minimum, each strategy option considered should be presented in terms of its internal rate of return (IRR) and/or its net present value (NPV). However, to the extent that certain aspects of risk and uncertainty play an important role yet are not always easily quantified, the framework for analysis and presentation should accommodate important qualitative considerations as well. The SWOT framework may be useful for comparing alternative workout strategies. Regardless of the framework used, it is important to ensure that all main assumptions are set in writing. Over time, assumptions that appear obvious early on are altered and rendered inapplicable. The workout specialist will appreciate having a record of the changing assumptions as the workout plan evolves. 
             
            Clear communication helps keep market participants informed, build confidence in the resolution strategy and maintain public support. Authorities gather a large amount of information in the process of assessing the NPL problem and play a strong coordination role in the resolution strategy. They are therefore best placed to explain to market participants how the NPL crisis is developing, and to propose and implement solutions. Communication is essential to build public support, given that public sector intervention will have fiscal implications, as well as an impact on borrower companies and households. Finally, communication of the resolution strategy creates a basis for a subsequent policy review, thus keeping the authorities accountable. 
             
            J. Documentation of plan
             
            Banks must document each loan workout determination as part of the formal record. This includes documented communication with the borrower demonstrating the borrower has a renewed willingness and ability to repay the loan. Further, sufficient documentation of the ability to repay the loan must be on records for the options evaluated for assessing the borrower's ability to repay.
             
            The bank should establish comprehensive management and internal controls over loan workout activity. This includes establishing authority levels and segregation of duties over the various types of workouts (modification, refinance, adjusting due dates, etc.). In addition, the policy needs to specify volume thresholds tied to financial performance elements such as net worth, delinquency and/or net charge off rates, etc. that trigger enhanced reporting to SAMA.
             
            The contract and documentation should include a well-defined borrower milestone target schedule, detailing all necessary milestones to be achieved by the borrower in order to repay the loan over the course of the contract term. These milestones/targets should be credible, appropriately conservative and take account of any potential deterioration of the borrower's financial situation.
             
            Based on the collective monitoring of the performance of different restructuring options and on the examination of potential causes and instances of re-defaults (inadequate affordability assessment, issue with the characteristics of the restructuring treatment product, change in the borrower's conditions, external macroeconomic effects etc.), banks should regularly review their restructuring policies and products.
             
            For the cases, where the borrower has experienced an identifiable event which has caused temporary liquidity constraints. Evidence of such an event should be demonstrated in a formal manner (and not speculatively) via written documentation with defined evidence showing that the borrower's income will recover in the short-term or on the basis of the bank concluding that a long-term restructuring solution was not possible due to a temporary financial uncertainty of a general or borrower specific nature.
             
            Greater transparency on NPLs can improve the viability of all resolution options, as well as market functioning in normal times. In cases where the ownership of the NPL passes from the originating bank to an external party, information limitations play an important role. To help overcome this problem, some standardization of asset quality data, as well as completeness of legal documentation on the ownership of these loans, would help buyers and sellers agree on pricing. In addition, co-investment strategies in securities originated from a pool of NPLs may reduce information asymmetries between buyers and sellers. This could increase transaction volumes, or facilitate sales at higher prices. A third option is the establishment of databases for realized prices of real estate transactions, given that real estate is the most widely used form of collateral. A transparent and sufficiently large database on real estate sale prices would, therefore, enhance the stability and reliability of NPL valuations, ultimately facilitating the NPL disposal process and leading to smaller price discounts. This would encourage market-based solutions for NPL disposal.
             
            K. Information Access:
             
            One of the key success factors for the successful implementation of any strategy option is adequate technical infrastructure. In this context, it is important that all cases related data is centrally stored in robust and secured IT systems. Data should be complete and up-to-date throughout the workout process. An adequate technical infrastructure should enable units to easily access all relevant data and documentation including: 
             
            i.current NPL and early arrears borrower information including automated notifications in the case of updates;
             
            ii.loan and collateral/guarantee information linked to the borrower or connected borrowers;
             
            iii.monitoring/documentation tools with the IT capabilities to track restructuring performance and effectiveness;
             
            iv.status of workout activities and borrower interaction, as well as details on restructuring measures, agreed, etc.;
             
            v.foreclosed assets (where relevant);
             
            vi.tracked cash flows of the loan and collateral;
             
            vii.sources of underlying information and complete underlying documentation;
             
            viii.access to central credit registers, land registers and other relevant external data sources where technically possible.
             
            L. External Information
             
            As a minimum, the following information should be obtained when restructuring a non-retail loan: 
             
            i.latest audited financial statements and/or latest management accounts;
             
            ii.Verification of variable elements of current income; assumptions used for the discounting of variable elements;
             
            iii.overall indebtedness;
             
            iv.business plan and/or cash-flow forecast, depending on the size of the borrower and the maturity of the loan;
             
            v.latest independent valuation report of any mortgaged immovable properties securing the underlying facility;
             
            vi.information on any other collateral securing the underlying loan facilities.
             
            vii.latest valuations of any other collateral securing the underlying loan facilities;
             
            viii.historical financial data;
             
            ix.relevant market indicators (unemployment rate, GDP, inflation, etc.).
             
            x.In case of MSME's access to bank statements of all accounts maintained by the borrower may also be necessary.
             
            M. Internal Information
             
            Banks should maintain in the credit file of the transactions the documentation needed so that a third party can replicate the individual estimations of accumulated credit losses made over time. This documentation should include, inter alia, information on the scenario used to estimate the cash flows it is expected to collect (going concern vs. gone concern scenario), the method used to determine cash flows (either a detailed cash-flow analysis or other more simplified methods), their amount and timing as well as the effective interest rate used for discounting cash-flows. 
             
            Banks should maintain all internal supporting documentation, which may be made available for review by the supervisory authority upon request. It should include: 
             
            i.the criteria used to identify loans subject to an individual assessment;
             
            ii.rules applied when grouping loans with similar credit risk characteristics, whether significant or not, including supporting evidence that the loans have similar characteristics;
             
            iii.detailed information regarding the inputs, calculations, and outputs in support of each of the categories of assumptions made in relation to each group of loans;
             
            iv.rationale applied to determine the considered assumptions in the impairment calculation;
             
            v.results of testing of the assumptions against actual loss experience;
             
            vi.policies and procedures which set out how the bank sets, monitors and assesses the considered assumptions;
             
            vii.findings and outcomes of collective allowances;
             
            viii.supporting documentation for any factors considered that produce an impact on the historical loss data;
             
            ix.detailed information on the experienced judgment applied to adjust observable data for a group of financial assets to reflect current circumstances.
             
            N. Restructuring documentation
             
            Important documents in any workout will be the term sheet, the loan agreement, and the security documents. Even before the banks have determined that a going concern solution is feasible and indeed preferable and the transaction starts crystallizing, they will want to start preparing documents. 
             
            The documentation will also determine the conditions of effectiveness of the restructuring. Before these have been met, the restructuring is not complete and it is theoretically possible to revert to the default and real bankruptcy. 
             
            The proposal should contain the following elements: 
             
            i.Full description of the borrower
             
            ii.Amount(s) of the loan(s) to be restructured
             
            iii.Restructuring fees and expenses, if any
             
            iv.Name(s) of the bank(s)
             
            v.Anticipated date of closing
             
            vi.Representations and warranties
             
            vii.Repayment schedule(s)
             
            viii.Mandatory repayment(s), if any
             
            ix.Cash sweep mechanism, if any
             
            x.Interest rate(s) and applicable margin(s) if floating rate
             
            xi.Default interest
             
            xii.Interest payment dates
             
            xiii.(Revised) events of default
             
            xiv.(Additional) security
             
            xv.List of documentation
             
            xvi.Taxes
             
            xvii.Governing law
             
            O. Checklist:
             
            i.Establish parties to be part of the workout transaction
             
            ii.Establish what minimum terms acceptable to parties other than the borrower
             
            iii.Prepare draft term-sheet
             
            iv.Negotiate draft term-sheet among parties other than borrower and reach tentative agreement
             
            v.Submit draft term-sheet to borrower
             
            vi.Negotiate, agree, and initial term-sheet
             
            vii.Have lawyers prepare draft legal documents for workout, including new or amendatory loan agreement and security documents, based on initialed term-sheet
             
            viii.Negotiate, agree, and sign legal documents for workout
             
            ix.Determine when conditions of effectiveness have been met and workout is complete.
             

          • 5.3.2 Drafting the Restructuring Agreement

            A typical restructuring agreement at minimum should include: Purpose, Restructuring Fees and Expenses, banksLenders, Nature and Amount of Current Principal Loan, Role of External Counsel, Signing Date of the Loan Restructuring Agreements and other Documentation, Conditions of Effectiveness, Representations and Warranties, Repayment Schedule, Mandatory Prepayments, Cash Sweep Mechanism, Interest Rates, Applicable Margin - Base, Default Interest, Interest Periods, Shareholder Loan, Emergency Working, Deferral of Principal Payment, Undertakings, Events of Default, Security, Documentation, Taxes, Withholdings, Deductions and Relevant Governing Law.
             
            A. Determining required documentation
             
            Every restructuring transaction is different in its own way, and these differences lead to defining the type and number of documents required to formalize the workout. Factors like the number of creditors, the size of the loan restructured and the type of collateral used in the original lending transaction determine the complexity and number of documents required to formalize a workout.
             
            Regardless of the number of creditors and complexity of loan structure, the restructuring documentation will determine the conditions and effectiveness of the restructuring, and it is essential that all parties should agree and sign the documents before implementing the workout. Until all documents have been formalized, it is still possible that the restructuring negotiations fail and initiating the bankruptcy proceedings.
             
            The documentation formalizing the workout should always be prepared by a legal practitioner. While the legal practitioner should be primarily responsible for elaborating this documentation, close collaboration is required with the Workout Unit in charge of negotiating the workout.
             
            In the case of MSME workouts, the banks are encouraged to explore developing restructuring documentation, which is typically simplified in comparison with the restructuring of larger corporate borrowers. This is just a reflection of the fact that the negotiating process is simpler, and most negotiating milestones are either abridged or do not take place at all.
             
            For further guidance on relevant agreements refer to Appendix 4.
             
            B. Communicating with the borrower during the workout process
             
            The bank should have detailed internal guidelines and rules regarding bank's staff communication with the borrower. Communication with borrowers should be as per the procedures outlined in the bank's code of conduct. This should include; timelines for responding to borrower's requests/complaints, identify who within the bank is responsible/authorized to issue various types of communications to the borrowers, documenting process for all communications to/from the borrowers, signing/acknowledgement protocols with timelines, approval requirements for all workout proposals, templates to be used for communication with the borrowers. 
             
            With respect to borrowers, transferred to the specialized unit, some of the basic principles are as follows: 
             
            i.Work out unit must act honestly, fairly, and professionally at all times.
             
            ii.RM should avoid putting excessive pressure on the borrower and/or guarantor. All contacts with the borrower should take place at reasonable times) and at a mutually convenient location.
             
            iii.Documenting all the communication with the borrowers (and guarantors) and retaining for an appropriate time. Notes to the credit file should be factual.
             
            iv.Sign all communications of a legal nature such as commitment letters, demand letters, or other communications with respect to legal proceedings by those individuals authorized to do so by policy.
             
            v.All written communications from the borrower should be acknowledged within (5) business days.
             
            vi.RM should make clear from the beginning that all restructuring proposals require the approval of either one or more committees or senior managers. The borrower should be given an approximate timetable for approval and promptly notified of any delays.
             
            vii.All approved restructuring proposals should be communicated to the borrower and guarantor(s) in writing, clearly spelling out all the terms and conditions, including covenants if required together with all reasonable costs arising from the transaction.
             
            viii.Notify borrowers in writing if their restructuring proposal is declined, including the reasons for rejection.
             
            C. Resolution of disputes
             
            When the bank and the borrower fail to reach an agreement or the borrower considers the proposed restructuring plan of the bank or negotiation process does not follow the principles described in the paragraphs above, the borrower should have the right to elevate his case to the level above the specialized unit. General established practice is for the borrower to write directly to the CRO. It should be ensured that the dispute is being reviewed independently of the personnel/team against whom the appeal has been filled. 
             
            Given the nature of the resolution process, which is likely, to generate a number of such inquiries, banks may wish to consider formalizing this process. An indicative example of a more formal process can be summarized as follows: 
             
            i.An Appeals Committee consisting of at least three senior officers is formed.
             
            ii.The members of the Committee should be knowledgeable about the credit granting process but be independent of the credit origination, workout, and risk management functions.
             
            iii.A member should disclose potential conflicts of interest and recuse themselves from further discussions with respect to any relevant case being discussed by the Committee.
             
            The borrowers should have prompt and easy access to filing an appeal. Good practice in this regard includes standardized appeal forms together with a list of information or required documents needed in the review of the appeal, and deadlines for the submission and reviews of appeals. 
             
             a)Acknowledgment of submission of appeals in writing.
             
             b)The decision of the Appeals Committee should be announced within one (1) month from the date of submission and should be in writing and include the reasons for the committee's decision.
             
             c)The borrower would have a right to appeal on a specific issue only once.
             
            Educating borrowers, especially in the MSME category may be required that restructuring of loan obligations is a concession provided by the bank and not a legal right of the borrower. 
             

        • 5.4 Monitoring the Restructuring Plan

          SAMA expects banks to maintain effective controls in relation to restructured loans and in connection therewith, have laid out regulatory expectations regarding monitoring performance in accordance with the restructuring agreements once the new workout “regime” has been decided and implemented.
           
          The monitoring function will need to address several aspects, the tracking of both how and when will the cash be generated is important.
           
          The approval of the restructuring agreement is only a part of the resolution, whereas the bank must continue to monitor the borrower to ensure timely reprogramming of payments and meeting of commitments. If reasons exist on the part of the borrower to deviate from the agreement, that are reasonable and objectively justifiable, the bank may approve a waiver of commitment. In the event of material unjustified deviations, the bank must impose additional requirements, penalty interest, termination of agreement, blocking of the transaction account, execution, etc.
           
          The control over the fulfillment of all commitments and timely payments must be ensured by the bank by setting up appropriate IT and Organizational support. If there is no confidence in the management, the bank should strive to involve an external consultant or authorized person to periodically monitor the company's operations on behalf of the bank.
           
          For MSMEs, a short quarterly review may be the most cost-efficient manner, namely in the form of meetings with the key staff and inspecting the documentation, analyzing the financial statements in order to obtain an overview of a realistic business and financial situation of the borrower.
           
          Tracking financial obligations and managing cash flow during the workout
           
          Note: The below is not illustrated with a purpose of regulating borrowers, but rather as a guideline to banks to ensure that cash-flows management pertaining to restructured borrowers, is subject to adequate and proper oversight by the bank's staff, within the legal rights given by the restructuring agreement. 
           
          During a workout, managing cash becomes even more critical because the company as a borrower must concern itself not only with the overall manageability of its loan levels and timeliness of loan servicing payments but also with questions of fairness and equitable treatment among its various creditors and other payees as cash becomes available and decisions are taken as to how it is to be applied. Sales of assets, which during good times would have happened without issue, now must be subjected to additional scrutiny to ensure that they do not trigger alarms of “fraudulent conveyance.” 
           
          Careful cash flow forecasting should be accompanied by sound cash controls within the borrower company. This can be achieved either within the borrower's own systems or by introducing special organizational arrangements that effectively cordon off the cash management function. 
           
          When cash continues to be managed within the borrower company, the following is strongly advisable: 
           
          i.Establish expenditure thresholds for different levels of review and control.
           
          ii.For expenditures over a certain threshold, ensure that double signatures are required to authorize payment.
           
          iii.Depending on the nature of the business, either centralize approvals and handling of expenditures or set regular budgetary guidance and spending “envelopes" for unit or department managers with appropriate procedures for enforcing spending/budgeting reconciliation and accountability.
           
          iv.Rationalize approvals and payments system.
           
          v.Use a third-party consultant or auditor or bank's internal independent resource to perform periodic operational audits as part of an ongoing monitoring process tailored to the key aspects of the workout and distinct from other audit and financial reporting functions.
           

          • 5.4.1 Monitoring Arrangements for Restructured Loans

            Restructured borrowers should be subject to intensive monitoring to ensure their continued ability to meet their obligations, The specialized team should use the bank’s EWS system to alert business segments of any potential problems. All borrowers should be subject to periodic review, the timing of which and depth of analysis required should be proportional to the size of the loan together with the level of risk inherent in the credit. Those loans which are material in nature and pose the greatest risk to the bank should be reviewed monthly on an abbreviated basis focused on recent developments. More in-depth reviews would be done on a quarterly and annual basis in conjunction with receipt of interim and annual financial statements. Smaller loans might be monitored semi-annually for the first year with annual reviews thereafter. Finally, the smallest loans could be subject to an annual review of their financial statements.
             
            Senior management should also be monitoring closely the key performance indicators (KPIs) of specific portfolio segments to ensure that the goals embedded in the strategic plan are on track. Deviations from the plan should be identified and appropriate time-bound, corrective action plans put in place and monitored.
             
            A. Changing the risk rating of the loan
             
            All banks should have clear written policies and procedures in place which outline the specific criteria together with required cure periods which must be satisfied to upgrade (or downgrade) the risk rating on a loan. While the goal of the restructuring is to improve the loan's risk rating, the borrower must demonstrate its ability to meet the terms of the restructuring as well as show an improvement in its risk profile for a specified period of time before an upgrade is appropriate. It requires a one year waiting period after restructuring before a loan becomes eligible for consideration of an upgrade. 
             
            It is important to realize that upgrade is not automatic after the one year period, but rather should be based on the borrower's current and expected future performance. The borrowers should demonstrate that financial difficulties no longer exist. The following criteria should be met in order to dispel concerns regarding financial difficulties: 
             
            i.the borrower has made all required payments in a timely manner for at least one year;
             
            ii.the loan is not considered as impaired or defaulted;
             
            iii.there is no past-due amount on the loan;
             
            iv.the borrower has demonstrated its ability to comply with all other post restructuring conditions contained in the master restructuring agreement; and
             
            v.the borrower does not have any other loans with amounts more than 90 dpd or 180 dpd (as the case may be) at the date when the loan is reclassified.
             
            Particular attention should be paid to bullet and balloon loans (with reduced front payments). Even after one year of flawless performance, the repayment in full of a balloon loan that relies on a large payment at the end of repayment period can be questionable. 
             
            B. Transferring the borrower back to the originating unit
             
            The following criteria should be applied when transferring a borrower back to the business unit: 
             
            i.The borrower regularly meets all its obligations from the restructuring agreement;
             
            ii.At least one year has passed from the beginning of validity of the restructuring and
             
            iii.The borrower has repaid at least 10 percent of the restructured principal in that period;
             
            iv.The borrower's indebtedness, measured with the net financial liabilities/EBITDA indicator, etc.;
             
            v.The transfer had been approved on the basis of the analysis of the borrower's financial position by the competent committee of the bank.
             
            Once a borrower has demonstrated its ability to meet the all the terms of its restructured obligations for a period of at least one year, repaid at least 10 percent of its restructured loan, and no longer displays any of the signals which would cause automatic transfer to the specialized team, the loan should be transferred back to the originating unit for servicing and follow up. Borrowers need to be seen to be viable by their customers and suppliers. A bank's willingness to work with a company to resolve its problems together with the resumption of a normalized banking relationship provides the public with a level of comfort that allows them to do business with the company. 
             
            C. Monitoring of workout activities
             
            Banks should establish a robust set of metrics to measure progress in the implementation of their work out strategy for all the accounts. 
             
            The monitoring systems should be based on targets approved in the risk strategy and related operational plans which are subsequently cascaded down to the operational targets of the business and specialized teams. A related framework of key performance indicators (KPIs) should be developed to allow the senior management committee and other relevant managers to measure progress. 
             
            Clear processes should be established to ensure that the outcomes of the monitoring of restructured indicators have an adequate and timely link to related business activities such as pricing of credit risk and provisioning. 
             
            Restructuring related KPIs can be grouped into several high-level categories, including but not necessarily limited to: 
             
            i.Bad/ stressed loan KPI's;
             
            ii.Borrower engagement and cash collection;
             
            iii.Restructuring activities;
             
            iv.Liquidation activities;
             
            v.Other (e.g. NPL-related profit and loss (P&L) items, foreclosed assets, early warning signals, outsourcing activities).
             
            D. Bad/ stressed loan KPI’s:
             
            Banks should define adequate indicators comparable with the portfolio should be monitored on a periodic basis.
             
            Banks should closely monitor the relative and absolute levels of stressed loans and early arrears in their books at a sufficient level of portfolio granularity. Absolute and relative levels of foreclosed assets (or other assets stemming from workout activities), as well as the levels of performing forborne loans, should also be monitored.
             
            Another key monitoring element is the level of impairment/provisions and collateral/ guarantees overall and for different NPL cohorts. These cohorts should be defined using criteria which are relevant for the coverage levels in order to provide the senior management and other relevant managers with meaningful information (e.g. by number of years since NPL classification, type of product/loan including secured/unsecured, type of collateral and guarantees, country and region of loan, time to recovery and the use of the going and gone concern approach).
             
            Coverage movements should also be monitored and reductions clearly explained in the monitoring reports. Where possible, indicators related to the NPL ratio/level and coverage should also be appropriately benchmarked against peers in order to provide the senior management with a clear picture on competitive positioning and potential high-level shortcomings.
             
            Finally, banks should monitor their loss budget and its comparison with actual. This should be sufficiently granular for the senior management and other relevant managers to understand the drivers of significant deviations from the plan.
             
            Key figures on NPL inflows and outflows should be contained in periodic reporting to the senior management, including moves from/to NPLs, NPLs in cure period, performing, performing forborne and early arrears. Inflows from a performing status to a non-performing status appear gradually (e.g. from 0 dpd to 30dpd. 30dpd to 60dpd. 60dpd to 90dpd, or 180 days as the case may be etc.) but can also appear suddenly (e.g. event-driven). A useful monitoring tool for this area is the establishment of migration matrices, which will track the flow of loans into and out of non-performing classification.
             
            Banks should estimate the migration rates and the quality of the performing book month by month so that actions can be taken promptly (i.e. prioritize the actions) to inhibit the deterioration of portfolio quality. Migration matrices can be further elaborated by loan type (housing, consumer, real estate), by business unit or by other relevant portfolio segment to identify whether the driver of the flows is attributed to a specific loan segment.
             
            E. Borrower’s engagement and cash collection
             
            Key operational performance metrics should be implemented to assess the specialized unit or employees' (if adequate) efficiency relative to the average performance and/or standard benchmark indicators (if they exist). These key operational measures should include both activity-type measures and efficiency type measures. The list below is indicative of the type of measures, without being exhaustive: 
             
            i.Scheduled vs. actual borrower engagements;
             
            ii.Percentage of engagements converted to a payment or promise to pay;
             
            iii.Cash collected in absolute terms and cash collected vs. contractual cash obligation split by:
             
             -Cash collected from borrower payments;
             
             -cash collected from other sources (e.g. collateral sale, salary garnishments, bankruptcy proceedings);
             
            iv.promises to pay secured and promises to pay kept vs. promises to pay due;
             
            v.total and long-term restructuring solutions agreed with the borrower (count and volume).
             
            F. Workout activities
             
            One key tool available to banks to resolve or limit the impact of NPLs is restructuring if properly managed. Banks should monitor workout activity in two ways: efficiency and effectiveness. Efficiency relates mainly to the volume of credit facilities offered restructuring and the time needed to negotiate with the borrower while effectiveness relates to the degree of success of the restructuring option (i.e. whether the revised/modified contractual obligations of the borrower are met).
             
            In addition, proper monitoring of the quality of the restructuring is needed to ensure that the ultimate outcome of the restructuring measures is the repayment of the amount due and not a delaying of the assessment that the loan is uncollectable.
             
            In this regard, the type of solutions agreed should be monitored and long-term (sustainable structural) solutions should be separated from short-term (temporary) solutions.
             
            It is noted that modification in the terms and conditions of a loan or refinancing could take place in all phases of the credit life cycle; therefore, banks should ensure that they monitor the restructuring activity of both performing and non-performing loans.
             
            G. Efficiency of workout activity
             
            Depending on the potential targets set by the bank and the portfolio segmentation, key metrics to measure their efficiency could be:
             
             a)the volume of concluded evaluations (both in number and value) submitted to the authorized approval body for a defined time period;
             
             b)the volume of agreed modified solutions (both in number and value) reached with the borrower for a defined time period;
             
             c)the value and number of positions resolved over a defined time period (in absolute values and as a percentage of the initial stock).
             
            It might also be useful to monitor the efficiency of other individual steps within the workout process, e.g. length of decision-taking/approval procedure.
             
            H. Effectiveness of workout activity
             
            The ultimate target of loan modifications is to ensure that the modified contractual obligations of the borrower are met and the solution found is viable. In this respect, the type of agreed solutions per portfolio with similar characteristics should be separated and the success rate of each solution should be monitored over time. 
             
            Key metrics to monitor the success rate of each restructuring solution include: 
             
             i.Cure rate (the rate arrived at by conducting performance analysis of the forborne credit facilities after their designated cure period) and re-default rate (the rate arrived at by performing a performance analysis of the forborne credit facilities after their designated cure period):
             
              Given the fact that most of the loans will present no evidence of financial difficulties right after the modification; a cure period is needed to determine whether the loan has been effectively cured. The minimum cure period applied to determine cure rates should be minimum for 12 months. Thus, banks should conduct a vintage analysis and monitor the behavior of forborne credit facilities after 12 months from the date of modification to determine the cure rate. This analysis should be conducted per loan segment (borrower with similar characteristics or basis industry segment) and, potentially, the extent of financial difficulties prior to restructuring.
             
              Cure of arrears on facilities presenting arrears could take place either through restructuring measures of the credit facility (forborne cure) or naturally without modification of the original terms of the credit facility (natural cure). Banks should have a mechanism in place to monitor the rate and the volume of those defaulted credit facilities cured naturally. The re-default rate is another key performance indicator that should be included in internal NPL monitoring reports for the senior management and other relevant managers.
             
             ii.Type of workout measure: Banks should clearly define which types of workout measures are defined as short-term versus long-term solutions. Individual characteristics of workout agreements should be flagged and stored in the IT systems and periodic monitoring should provide the senior management and other relevant managers with a clear view on what proportion of restructuring solutions agreed are:
             
              oof a short-term versus long term nature; and
                         		 
              ohave certain characteristics (e.g. payment holidays ≥ 12 months, increase of principal, additional collateral, etc.).
             
             iii.Cash collection rate: Another key metric of workout activity is the cash collection from restructured credit facilities. Cash collection could be monitored against the revised contractual cash flows, i.e. the actual to contractual cash flow ratio, and in absolute terms. These two metrics may provide information to the bank for liquidity planning purposes and the relative success of each workout measure.
             
             iv.NPL write-off: In certain cases, as part of a workout solution, banks may proceed with a restructuring option that involves NPL write-off, either on a partial or full basis. Any NPL write-off associated with the granting of these types of restructuring should be recorded and monitored against an approved loss budget. In addition, the net present value loss associated with the decision to write off unrecoverable loans should be monitored against the cure rate per loan segment and per restructuring solution offered to help better inform the banks’ restructuring strategy and policies. All NPL write off policies developed by banks are required to follow the rules defined under the circular on “Credit Risk Classification and Provisioning”.
             
            Indicators relating to workout activities should be reported using a meaningful breakdown which could for instance include the type and length of arrears, the kind of loan, the probability of recovery, the size of the loans or the total amount of loans of the same borrower or connected borrowers, or the number of workout solutions applied in the past. 
             
            I. Liquidation activities
             
            Provided that no sustainable restructuring solution has been reached, the bank is still expected to resolve the stressed loan. Resolution may involve initiating legal procedures, foreclosing assets, loan to asset/equity swap, and/or disposal of credit facilities.
             
            Consequently, this activity should be monitored by the bank to help inform strategy and policies while also assisting with the allocation of resources.
             
            J. Legal measures and pre-closure
             
            Banks should monitor the volumes and recovery rates of legal and foreclosure cases. This performance should be measured against set targets, in terms of number of months/years and loss to the bank. In monitoring the actual loss rate, banks are expected to build historical time series per loan segment to back up the assumptions used for impairment review purposes and stress test exercises.
             
            For facilities covered with collateral or another type of security, banks should monitor the time period needed to liquidate the collateral, potential forced sale haircuts upon liquidation and developments in certain markets (e.g. property markets) to obtain an outlook regarding the potential recovery rates.
             
            In addition, by monitoring the recovery rates from foreclosure and other legal proceedings, banks will be in a better position to reliably assess whether the decision to foreclose will provide a higher net present value than pursuing a restructuring option. The data regarding the recovery rates from foreclosures should be monitored on an ongoing basis and feed potential amendments to banks' strategies for handling their loan recovery / legal portfolios.
             
            Banks should also monitor the average lengths of legal procedures recently completed and the average recovery amounts (including related recovery costs) from these completed procedures.
             
            K. Loan to asset/equity swap
             
            Banks should carefully monitor cases where the loan is swapped with an asset or equity of the borrower, at least by using the volume indicators by type of assets and ensure compliance with any limits set by the relevant national regulations on holdings. The use of this approach as a restructuring measure should be backed by a proper business plan and limited to assets where the bank has sufficient expertise and the market realistically allows the determined value to be extracted from the asset in a short to medium-term horizon. The bank should also make sure that the valuation of the assets is carried out by qualified and experienced appraisers.
             
            L. Other monitoring items
             
            i. P&L-related items
             
            Banks should also monitor and make transparent to their management bodies the amount of interest accounted for in the P&L stemming from restructured loans. Additionally, a distinction should be made between the interest payments on those restructure actually received and those not actually received. The evolution of loan loss provisions and the respective drivers should also be monitored.
             
            ii. Foreclosed assets
             
             If foreclosure is a part of banks' strategy, they should also monitor the volume, aging, coverage and flows in their portfolios of foreclosed assets (or other assets stemming from restructured loans). This should include sufficient granularity of material types of assets. Furthermore, the performance of the foreclosed assets with respect to the predefined business plan should be monitored in an appropriate way and reported to the senior management and other relevant managers on an aggregate level.
             
            iii. Miscellaneous
             
             Other aspects that might be relevant for reporting would include the efficiency and effectiveness of outsourcing/servicing agreements. Indicators used for this are most likely very similar to those applied to monitor the efficiency and effectiveness of internal units, though potentially less granular.
             
             Generally, where restructuring-related KPIs differ from a regulatory and an accounting or internal reporting viewpoint, these differences should be clearly reported to the senior management and explained.
             

          • 5.4.2 When Restructuring Fails

            It is to be expected that a certain number of restructurings will fail. If the restructured borrower does not perform his obligations, the bank needs to quickly assess if the problem is temporary in nature and easily corrected (e.g., a temporary slowdown in sales to a major customer who is moving to a new location) or more permanent in nature (e.g., the company's major product has been rendered obsolete by regulations). If the company is still viable in the long term and the problem can be easily corrected, the borrower could be allowed to restructure the terms of repayment one more time. In general, however, multiple restructurings can be an indication that the borrower is no longer viable and that there are problems in the approval process. If the problem is of a more permanent nature (e.g., as evidenced by second payment default), the borrower should be deemed non-viable and promptly referred for legal proceedings.

            The bank should closely monitor failed restructurings to determine the reasons behind them and assess the appropriateness of its strategies.

      • Appendix 1: Samples of Early Warning Signals

        The Following are illustrated for indicative purposes and are not intended to be prescriptive, as stated in the rules of Management of Problem Loans, banks should establish EWS that are suitable to their portfolio:
         
        EWS At Borrower Level from External Sources
         Debt and collateral increase in other banks
         Past-due or other NP classifications in other banks
         Guarantor default
         Debt in private central register (if any)
         Legal proceeding
        External SourcesBankruptcy
         Changes in the company structure (e.g. merger, capital reduction)
         External rating assigned and trends
         Other negative information regarding major clients/counterparties of the debtor/suppliers
        EWS at a borrower level from internal sources
         Negative trend in internal rating
         Balances not appearing in current account / lower balances in Margin account / Negative own funds
         Significant change in liquidity profile
         Liabilities leverage (e.g. equity/total < 5% or 10%)
         Number of days past due
        CompaniesNumber of months with any overdraft/overdraft exceeded
         Profit before taxes/revenue (e.g. ratio < -1%)
         Continued losses
         Continued excess in commercial paper discount
         Decrease of turnover
         Reduction in credit lines related to trade receivables (e.g. year- on-year variation, 3m average/1y average)
         Unexpected reduction in undrawn credit lines (e.g. undrawn amount/total credit line)
         Negative trend in behavioral scoring
         Negative trend in probability of default and/or internal rating
         Mortgage loan installment > x time credit balance
         Mortgage and consumer credit days past due
         Decrease in the credit balance > 95% in the last 6 months
         Average total credit balance < 0.05% of total debt balance
         Forborne Exposures
         Nationality and related historic loss rates
        Individuals / sole proprietorsDecrease in payroll in the last 3 months
        Unemployment
         Early arrears (e.g. 5-30 days of past due, depending on portfolio/borrower types)
         Reduction in bank transfers in current accounts
         Increase of loan installment over the payroll ratio
         Number of months with any overdraft exceeded
         Negative trend in behavioral scoring
         Negative trend in probability of default and/or internal rating
        EWS at a portfolio/segment level
         Size distribution and concentration level
        Portfolio DistributionTop X (e.g. 10) groups of connected borrowers and related risk indicators
         Asset class distribution
         Breakdown by industry, sector, collateral types, countries, maturities, etc.
        Risk parametersPD/LGD evolution (overall and per segment)
         PD/LGD forecasts and projections
         Default loan
         Volumes and trends of significant risk provisions on individual level
        NPL/restructuring status/foreclosureNPL volume by category (>90 past due, etc.)
         Restructuring volume and segmentation ( workout, forced prolongation, other modifications, deferrals, >90 past due, LLP)
         Foreclosed assets on total loans
         NPL ratio without foreclosed assets
        EWS by specific type of borrowers/sectors
        GeneralCustomizable index data (GDP, stock markets, commodity prices, CDS prices, etc.)
        Real estateReal estate-related indexes (segment, region, cities, rural areas, etc.)
        Rental market scores and expected market value changes
        AviationAirline-specific indicators (passenger load, revenue per passenger, etc.)
        EnergyIndex data on regional alternative energy sources (e.g. wind quantities, etc.)
        Information-gathering system on potential technical or political risks on energy

      • Appendix 2: Loan Life Coverage Ratio

        Application and computation of the ratio
         
        Loan Life Coverage Ratio (LLCR) should be used by Workout teams to assess the viability of a given amount of debt and consequently to evaluate the risk profile and the related costs. Unlike Debt Service Coverage Ratio (DSCR) which captures just a single point in time, LLCR allows for several time periods more suitable for understanding liquidity available for loans of medium to long time horizons. Thus, given its long-term nature, this ratio should be used for project finance and other multi-year loans, where long term viability needs to be assessed. 
         
        The LLCR is a financial ratio used to estimate the solvency of a firm, or the ability of a borrowing company to repay an outstanding loan. LLCR is calculated by dividing the net present value (NPV) of the money available for debt repayment by the amount of outstanding debt. 
         
        The Formula for the computation is as follows:
         
          Present value of total available cash flow (ACF) during the loan life period (including interest and principal) + cash reserve available to repay the debt (the debt reserve)
         
        LLCR=--------------------------------------------------------------------------------------
         
          Outstanding loan Amount at the time of assessment
         
         
         
        Where, CFt= cash - flows available for debt service at year t 
         
         t = the time period (year)
         
         s = the number of years expected to pay the debt back
         
         i = the weighted average cost of capital (WACC) expressed as an interest rate
         
        In this calculation, the weighted average cost of debt is the discount rate for the NPV calculation and the project "cash flows" are more specifically the cash flows available for debt service. The loan life coverage ratio is a measure of the number of times over the cash flows of a project can repay an outstanding debt over the life of a loan. The higher the ratio, the less potential risk there is for the bank. 
         

      • Appendix 3: Restructuring Principles

        The guidelines set out below a set of generic principles that banks are encouraged to follow and adopt as part of their culture in relation to restructuring activities. These principles include, but are not limited to: 
         
        i.Restructuring activities should not be viewed as a cost center. Restructuring measures can allow the banks to maximize their recovery and maintain a good and long-term relationship with their borrowers.
         
        ii.Restructuring can allow the borrowers to survive and potentially return to a sustainable and growth path that would benefit the borrower, the economy and the banks.
         
        iii.If banks are effective in identifying early warning signs, addressing the issues and engaging in early restructuring solutions, this could prevent long-term default and losses and result in higher profit for both banks and borrowers.
         
        iv.Restructuring should be done in utmost good faith and both banks and borrowers should show seriousness and commitment to lead a successful process.
         
        v.Negotiations must be in the best interest of the borrower and the bank.
         
        vi.Transparency and regular communication should take place between various stakeholders in a restructuring situation.
         
        vii.Transparency and full disclosure of information, when appropriate, should take place between the borrower and the banks to ensure both parties can make informed decisions for the best interest of both parties.
         
        viii.The banks should aim to provide a prompt response to the borrower's proposal for a restructuring solution.
         
        ix.The borrower shall have reasonable and sufficient time to provide the requested information and consider the restructuring proposal.
         
        x.Banks and borrowers should seek sustainable solutions and avoid repeated short-term fixes.
         
        xi.Confidentiality should be respected throughout the process.
         
        xii.Consensual but sustainable out-of-court restructuring solutions are considered the best and most favorable outcome when it comes to restructuring. Banks are expected to exhaust all consensual options before deciding to follow a court-led process or enforcing on securities.
         

      • Appendix 4: Details of Relevant Agreements

        Standstill Agreement
         
        In cases, where several creditors are involved, formalizing a standstill agreement is typically the first step involved in the workout process. The standstill is an agreement between the borrower and relevant creditors, typically lending banks, confirming that they will not enforce their rights against the borrower for any default during a limited period. The main purpose of the standstill is to give the borrower sufficient ‘breathing space' to collect information and prepare a survival strategy, while in parallel creditors work on formulating a joint approach. Standstill agreements may also include other obligations to be observed during the standstill period, for example, that creditors grant additional financing to the borrower to cover working capital or postpone any capital or interest payments due. 
         
        In the context of an MSME workout, it may be necessary to sign a Standstill agreement, even if the number of creditors is limited. The main advantage of formalizing such document is that it will provide sufficient certainty to both parties that a workout is being negotiated, ensuring that the borrower can focus his efforts in the operational changes needed to succeed. For those cases where it is required to formalize a Standstill agreement, a simplified template adopted to the MSME context. However, in certain cases, it may not be necessary to formalize a Standstill agreement and creditor(s) and borrower will proceed on the mutual understanding that a standstill exists. This will typically occur when there is just a single creditor that holds a close and long-standing commercial relationship with the borrower, who is being cooperative in the workout negotiations. 
         
        The contents of the standstill agreement will largely depend on the transaction at hand, but typically will imply that creditors will assume some (or all) of the following obligations, among others: 
         
        i.Not to start enforcement actions against the borrower or his assets;
         
        ii.Not to declare the loan agreement breached, or accelerate the loan;
         
        iii.Not to take additional collateral or improve his position with respect to other creditors;
         
        iv.Not to charge additional fees or penalty interests;
         
        v.Not to set-off any amounts against the borrower for pending obligations.
         
        In return, the borrower will agree not to take any action that would harm the creditors, such as the sale or transfer of assets to a third party or make payments to any creditors except in the ordinary course of business, and will allow the creditors full access to all necessary books and records. 
         
        Restructuring Agreement
         
        The restructuring agreement is the main document that regulates all the details of the workout. In the case of MSMEs, where the workout documentation will often be simplified, the restructuring agreement will many times be the only document formalized, and it is very important that all details be captured accurately, not just in connection with the payment obligations of the borrower but also with his behaviour during the lifetime of the restructuring agreement. When drafting a restructuring agreement, it should be born in mind that the main purposes of this document are (i) to explain how the borrower is going to restructure both his debt and his operations, if applicable, and (ii) to specify how and when creditors are to be repaid. 
         
        There is no standard format for how a restructuring agreement should look like. The details of the agreement will largely depend on the needs of the business and the willingness of creditors to make concessions to avoid a bankruptcy of the borrower. For example, in the case of a workout consisting of a simple rescheduling of maturities, a signed letter may be enough to document the workout. However, in case of modification in the maturity dates as well as the principal and applicable interests of the loan agreement, drafting a new agreement will probably be necessary. In this case, it is highly advisable that the legal department of the lending banks is brought on-board from the outset, since they should determine whether 
         
        i.the workout will be documented into a new agreement that will replace the existing contractual documentation existing between the borrower and creditors, or
         
        ii.the original loan agreement will remain in place but as amended by the terms and conditions included in an additional agreement.
         
        This second approach has the advantage that it will not be necessary to amend the already existing security package, which will keep its priority without the need of seeking new registrations. 
         
        In terms of the substantive content of the restructuring agreement, the document may include any of the loan restructuring techniques. These options can be combined or arranged in such a way that alternative options can be offered to several types of creditors, depending on the class to which they are allocated. Restructuring plans are consensual in nature and assume all parties to the agreement consent to the terms agreed in the document. However, a key concept for restructuring agreements to succeed is to treat all parties fairly and avoid discrimination of similarly situated creditors in terms of their collateral, priority and outstanding obligations. All creditors holding the same position vis-à-vis the borrower should obtain a similar treatment. 
         
        The Restructuring Proposal - Term Sheet
         
        The term sheet is the most important piece of the workout documentation, as all further documentation will find their origin therein. A draft term sheet drawn up right at the beginning of the workout process provides banks with a useful checklist of parties involved in the workout process and of the terms that will have to be agreed upon with the borrower, other banks, and stakeholders. The draft term sheet is revised at every stage of the workout process, particularly during negotiations. In addition, before drafting the final and formal workout documents, including the new or amendatory loan agreement, lawyers will want to make sure that they can see the full picture of the proposed workout and can iron out any discrepancies and controversial points.
         
        Term-sheets are a common feature in project lending or in the structuring of term loans. They facilitate the negotiations in that the various terms that have been discussed and agreed upon during the progress of the negotiations can be laid down until the final deal or transaction is agreed.
         
        Term-sheets are particularly useful in workouts, as they allow the borrower and bank to spell out what has been agreed upon and move on to the next item to be negotiated. In a workout, it may be necessary to include more than one creditor or stakeholder in the transaction, and the term-sheet allows the parties to agree on the main terms of the proposed restructuring transaction before the lawyers are asked to prepare the legal documents.
         
        After determining, that a workout will be feasible, banks will want to put a proposal on the table. For smaller borrowers, this may take the form of a conversation between the bank and the borrower, to be confirmed in writing. For medium to large companies, where the terms are likely to be more complex and there is a need for the borrower to carefully study and absorb them, the proposal will more typically be in the form of a draft term sheet spelling out the conditions on which the bank is willing to restructure or reschedule the loan(s).
         
        The Restructuring Documents:
         
        - Loan Agreements
         
        The complexity of the restructuring dictates which documents will be necessary. For a simple rescheduling of maturities, a letter may suffice and will have legal validity. However, if the face value of the loan and basic terms such as maturities and interest are changed, there may be a need for a new agreement. Legal practitioners are better placed to determine whether this will take the form of an amendatory agreement, where the body of the original loan agreement is left intact and the terms and conditions to be changed are covered in an additional agreement, amending the original.
         
        - Security Agreements
         
        In the event that there is additional security under negotiated strategy, additional agreements will be required to have such security registered. Particular care will be necessary to ensure that the existing rights of the senior, secured banks are honored and are not diluted or set aside in favor of those of the junior and unsecured banks.
         
        - Ancillary Agreements
         
        These will include additional overdraft agreements, guarantee agreements, share pledge agreements, security-sharing agreements, and the like, all in line with what has been agreed among the borrower and banks.
         
        Key covenants
         
        Covenants are undertakings (or promises) given by a borrower as part of a loan agreement. Their purpose is to provide the bank with an early warning sign of potential problems. They also provide another avenue of communication between the borrower and the bank.
         
        Covenants can be affirmative, negative or positive in nature. They usually cover such areas as financial performance (e.g., will maintain total debt to EBITDA not greater than 2:1, or pay all taxes as they become due); information sharing (e.g., will provide audited annual financial statements); or ownership/ management arrangements (e.g., will employ financial management with demonstrated experience, or will not pay dividends without the consent of the bank).
         
        Violation of any covenant gives the banks right to call the loan, charge fees, or collect interest at a higher rate. In practice, it has proven difficult to call a loan that is paying as agreed based on a covenant default. In this case, after developing a thorough understanding of the cause of the problem and its severity, the borrower is likely to issue either a temporary or permanent waiver in return for the borrower undertaking an agreed upon corrective action program.
         
        All restructuring agreements should contain covenants. At a minimum, they should include provisions to submit financial statements; pay taxes as they become due; prohibit sale of company, completely or in part, without prior approval of bank. Covenants for larger, more complex borrowers need to be specifically tailored to meet their individual situations. Bank should include covenants pertaining to but restricted to profitability, efficiency, liquidity, and solvency ratios; requirements to dispose of assets or raise equity within specific timeframes; or prohibit investments or restrict business activities to those currently engaged in. Bank should also develop an internal process to be able to monitor adherence to these covenants.
         

      • Appendix 5: Glossary of Technical Terms

        For the purpose of this document, the terms and phrases used in these guidelines have the following meaning:

        TermDefinition
        Balloon paymentInterest paid regularly together with only small repayments of principal so that the bulk of the loan is payable upon maturity.
        Bullet paymentPrincipal and interest paid at maturity.
        CollateralWhose value can be considered whilst computing the recoverable amount for workout cases or foreclosed cases, on account of meeting the stipulated conditions laid out in these rules, as would be applicable based on the nature of the collateral.
        Collateral enforcementThe exercise of rights and remedies with respect to collateral that is pledged against a loan.
        Conditional loan forgivenessA bank forfeiting the right to legally recover part or the whole of the amount of an outstanding loan upon the borrower's performance of certain conditions.
        Cooperative borrowerA borrower which is actively working with a bank to resolve their problem loan.
        Cure rateThe percentage of loans that previously presented arrears and,post restructuring, present no arrears.
        CovenantA borrower's commitment that certain activities will or will not be carried out.
        EBITDA (earnings before interest, taxes, depreciation and amortization)Valuation metric for comparing the income of companies with different capital structures.
        Early warning signalsQuantitative or qualitative indicators, based on liquidity, profitability, market, collateral and macroeconomic metrics.
        Failed restructuringAny restructuring case where the borrower failed to repay the revised contractual cash flows as agreed upon with the bank and has transitioned into default.
        Key performance indicatorsIndicators through which bank management or supervisor can assess the institution's performance.
        Loan to value ratioFinancial ratio expressing the value of the loan compared to the appraised value of the collateral securing the loan.
        Problem LoansLoans that display well-defined weaknesses or signs of potential problems. Problem loans shall be classified by the banks in accordance with accounting standards, and consistent with relevant regulations, as one or more of:
        a.non-performing;
        b.subject to restructuring (including forbearance) and/or rescheduling;
        c.IFRS 9 Stages 2; and exhibiting signs of significant credit deterioration or Stage 3;
        d.under watch-list, early warning or enhanced monitoring measures; or
        e.where concerns exist over the future stability of the borrower or on its ability to meet its financial obligations as they fall due
        RestructuringAn agreement between the bank and the borrower to modify the terms of loan contract so as to enable eventual repayment.
        Restructuring planA document containing the measures to be taken in order to restore borrower's viability.
        Risk management systemA centralized system that allows a bank to holistically monitor bank's risks, including credit risk.
        Unsuccessful restructuringThe cases where the bank and the borrower are not able to reach any restructuring agreement.
        Viability assessmentAn assessment of borrower's ability to generate adequate cash flow in order to service outstanding loans.
        Viable borrowerWherein the loss of any concessions as a result of restructuring, is considered to be lower than the loss borne due to foreclosure.
        Watch listLoans that have displayed characteristics of a recent increase in credit risk which are subject to enhanced monitoringand review by a bank.
        Workout UnitA bank's operational unit in charge of handling problematic loans.

    • Sound Practices for Banks’ Interactions with Highly Leveraged Institutions (HLI)-BCBS

      No: 191000000710 Date(g): 9/3/1999 | Date(h): 22/11/1419Status: In-Force
      As you are aware, in September 1998 the near collapse of Long-Term Capital Management, a highly leveraged, hedge fund posed a significant threat to the US financial markets necessitating a major response from the US Banking Supervisory Authorities. Since then there has been global scrutiny of international banks’ exposures to highly leveraged financial institutions in general and hedge funds in particular. 
       
      A Task Force established by the Basle Committee on Banking Supervision has completed a study of the risks for banks arising from their dealings with such institutions. The Committee has prepared the attached paper on “Sound Practices for Banks’ Interactions with Highly Leveraged Institutions (HLI)” that aims to encourage development of prudent approaches by banks to the assessment, measurement and risk management of credit exposures to HLIs. 
       
      In Saudi Arabia, some Banks may have dealings with institutions that meet the definitions of an HLI or a hedge fund. We expect these exposures to be managed in accordance with the Internal Control Guidelines for Commercial Banks issued by SAMA, and prudent internal credit policies and procedures of your Bank. In issuing this Basle Committee paper to Saudi Banks our expectations are as follows: 
       
       1.You should ensure that managers of your Bank’s credit, risk management, and other relevant functions are fully conversant with the best management practices outlined in this paper.
       2.The Bank should internalize these practices by ensuring that these are reflected in your credit management and risk management policies and procedures.
       3.An internal procedural framework that requires regular identification and monitoring of such exposures and their reporting to senior management should be developed.
       

      • Preface

        In recent years, the activities of highly leveraged institutions (HLIs) have grown in both magnitude and complexity. The scope of the interactions between HLIs and mainstream financial institutions, such as banks and securities firms, has also expanded, emphasising the need for a full understanding and management of the risks generated from these activities. As with other borrowers and counterparties, banks and other financial intermediaries play a key role in allocating credit to HLIs. However, in the case of HLIs this can be particularly challenging given the relative opaqueness of their activities, the significant use of leverage and the dynamic nature of their trading positions and, in some cases, their market impact. The Basel Committee on Banking Supervision recognises that not all banks deal with or have significant exposures to HLIs. Most institutions that do have exposures to HLIs appear to be reviewing and tightening their credit standards for HLIs following the near-collapse of the hedge fund LTCM in September 1998. A key motivation for issuing sound practices is to ensure that improvements in credit standards and risk management processes are "locked in” over time and that the lessons are applied to the management of counterparty credit relationships more generally. 
         
        The management of credit risk in respect of HLIs involves the same principles as management of credit risk in general, but must also take account of the particular types of counterparty risk associated with such institutions. The Committee will shortly publish general principles for the management of credit risk. This paper should be seen as complementary to that effort, and is a response to the specific challenges posed by credit risk emanating from interactions with HLIs. The Committee’s review of banks’ dealings with HLIs has revealed that in many cases there has not been an appropriate balance among the key elements of the credit risk management process, with an over reliance on collateralisation of mark-to-market exposures.1 Insufficient weight was placed on in-depth credit analyses of the HLI counterparties involved and the effective measurement and management of exposures. Moreover, in some cases, competitive forces and the desire to conduct business with certain counterparties may have led banks to make exceptions to their firm-wide credit standards. 
         
        Counterparty exposures to HLIs can take a variety of forms, including in particular secured and unsecured credits resulting from off-balance-sheet contracts. The characteristics and implications of OTC derivatives were analysed by G-10 central banks in 1994. Following that review, the Committee issued risk management guidelines for derivatives that identified the types and sources of risk to counterparties in OTC transactions and reviewed sound risk management practices for each type of risk. In September 1998, the Committee on Payment and Settlement Systems and the Euro-currency Standing Committee published a report on settlement procedures and counterparty risk management related to OTC derivatives, which provides a thorough analysis of the policies and procedures employed by OTC derivatives dealers. Where appropriate, these guidelines will draw on these earlier studies and apply them, together with other recent insights, to the specific risks posed by highly leveraged counterparties. 
         
        The Basel Committee is distributing these sound practice standards to supervisors, banks and other interested parties worldwide with the expectation that they will encourage the further development of prudent approaches to the assessment, measurement and risk management of credit exposures to HLIs. The Committee invites the financial industry to assess standards and practices and to react to the recommendations. The Committee encourages supervisors to promote the application of sound practices by banks in their interactions with HLIs. The Committee wishes to emphasise that sound internal risk management, including effective counterparty credit risk management, is essential to the prudent operations of banks. With respect to their involvement with HLIs, it may also contribute significantly to ensuring that HLIs do not assume excessive risks and leverage. Should a major HLI nevertheless default, sound risk management at the counterparty level could contribute considerably to limiting the destabilising effects on markets resulting from, for example, the rapid deleveraging and liquidation of positions. By helping to reduce the potential for stressed-market exposures, sound credit management and monitoring practices by counterparties of HLIs should contribute to greater stability in the financial system as a whole. 
         

        1 Banks ' interactions with highly leveraged institutions, Basel Committee (BIS), January 1999.

      • I Introduction

        This paper sets out sound practice standards for the management of counterparty credit risk inherent in banks’ trading and derivatives activities with highly leveraged institutions (HLIs). Its recommendations are directed at relationships with HLIs, which are defined as large financial institutions that are subject to very little or no direct regulatory oversight as well as very limited public disclosure requirements and that take on significant leverage. For the purpose of this paper, leverage is defined broadly as the ratio between risk, expressed in a common denominator, and capital. Leverage increases HLIs’ exposure to movements in market price’s and consequently can expose creditors to significant counterparty risk. Hedge funds are currently the primary example of institutions within this definition but it should be noted that many hedge funds are not highly leveraged, and that other institutions may also have some or all of the attributes of an HLI. 
         
        While this paper focuses on the management of credit risk resulting from interactions with HLIs, the issues raised are not unique to interactions with such institutions. However, it is not intended to provide a complete overview of the more general credit management practices. The sound practices set out here specifically address the following areas: (1) establishing clear policies and procedures for banks’ involvement with HLIs as part of their overall credit risk environment; (2) information gathering, due diligence and credit analysis of HLIs’ activities, risks and operations; (3) developing more accurate measures of exposures resulting from trading and derivatives transactions; (4) setting meaningful overall credit limits for HLIs; (5) linking credit enhancement tools, including collateral and early termination provisions, to the specific characteristics of HLIs; and (6) closely monitoring credit exposures vis-à-vis HLIs, including their trading activities, risk concentration, leverage and risk management processes. 
         
        In Sections II to VII the credit risk management issues highlighted above are set out in more detail. 
         

      • II Banks’ Involvement with HLIs and their Overall Credit Risk Strategy

        Before conducting business with HLIs, a bank should establish clear policies that govern its involvement with these institutions consistent with its overall credit risk strategy. Banks should ensure that an adequate level of risk management, consistent with their involvement with HLIs, is in place. 
         
        In general terms, each bank should have in place a clear credit risk strategy and an effective credit risk management process approved by the board of directors and implemented by senior management. The credit risk strategy should define the bank’s risk appetite, its desired risk return trade-off and mix of products and markets. In this context, a bank should assess whether dealings with HLIs are consistent with its credit risk strategy, its risk appetite and its diversification targets. If so, policies and procedures for interactions with HLIs must be devised that establish effective monitoring and control of such relationships. These policies and procedures should drive the credit setting process and govern banks’ relationships with HLIs, and should not be overridden by competitive pressures. 
         
        An effective credit risk management process includes appropriate documentation, comprehensive financial information, effective due diligence, use of risk mitigants such as collateral and covenants, methodologies for measuring current and future exposure, effective limit setting procedures, and ongoing monitoring of both the firm’s exposure to and the changing risk profile of the counterparty. Upholding these standards is particularly important with respect to interactions with HLI counterparties, where information has been limited, leverage may be high and risk profiles can alter rapidly. Where credit concerns are identified with regard to an HLI, a bank should either not conduct business or take appropriate steps to limit and manage the exposure consistent with their overall underwriting standards and risk appetite. HLIs that provide either insufficient information to allow meaningful credit assessments or proportionately less information about their risk profile than other counterparties should face tougher credit conditions, including, for instance, a higher level of initial margin, no loss threshold, a narrower range of assets which are deemed acceptable for collateral purposes, and a stricter range of other financial covenants. 
         
        The long-term success of a bank’s credit relationships relies heavily on effective and sophisticated risk management. This applies to banks that assume credit risks arising out of derivatives and other trading transactions with HLIs such as repurchase agreements and securities lending, as well as to banks that commit funds to HLIs through loans, credit lines or equity participations. Assuming credit exposure implies counterparty monitoring commensurate with the size of the exposure. Effective monitoring of the activities of an HLI requires thorough knowledge and understanding of its trading strategies, exposure levels, risk concentrations and risk controls. Reliance on collateral cannot substitute for day-to-day risk management and monitoring. While it can help reduce counterparty credit risk, full collateralisation of mark-to-market positions does not eliminate exposure to secondary risks (such as declines in the value of securities pledged as collateral) from a volatile market environment that could follow the default or disorderly liquidation of a major HLI. Moreover, collateral cannot fully mitigate credit risk and may add to other risks, such as legal, operational and liquidity risks. 
         

      • III Information Gathering, Due Diligence and Credit Analysis of HLIs

        A bank that deals with HLIs should employ sound and well-defined credit standards which address the specific risks associated with HLIs. 
         
        An effective credit approval process is the first line of defence against excessive counterparty credit risk. It should be a general requirement but one which assumes increasing importance with the size and/or risk of the counterparty relationship. A sound credit approval process for HLIs should begin with comprehensive financial and other information, providing a clear picture of a counterparty’s risk profile and risk management standards. The credit process should identify the purpose and structure of the transactions for which approval is requested and provide a forward-looking analysis of the repayment capacity based on various scenarios. Credit standards should articulate policy regarding the use and nature of collateral arrangements and the application of contractual provisions designed to protect the bank in the event of changes in the future risk profile of the counterparty such as covenants and close-out provisions (Section VI). Moreover, credit standards should set a clear methodology and process for establishing limits (Sections IV and V). 
         
        Before entering into any new relationship with an HLI, a bank must become familiar with the counterparty and be confident that it is dealing with an institution of sound repute and creditworthiness. This can be achieved in a number of ways, including asking for references from known parties, accessing credit registers, evaluating legal status, and becoming knowledgeable about the individuals responsible for managing the institution by, for example, checking their personal references and financial state. Banks must also have a clear view about the stability of the HLI, in terms not only of tangible factors such as earnings but also of less tangible ones such as strategy, quality of risk management practices, and staff composition and turnover. However, a bank should not grant credit solely because the counterparty, or key members of its management, are familiar to the bank or are perceived to be highly reputable. 
         
        Before establishing a credit relationship with an HLI, a bank should ensure that all information relevant to that relationship will be available to the bank on a sufficiently timely and ongoing basis. Stipulating the conditions in advance for an adequate transfer of information lays the foundation for an appropriate monitoring of credit risk and for assessing the potential need for adjustments to non-price terms or the application of termination provisions. Banks should seek to obtain information about material developments such as changes in the general direction of trading activities, profit and loss developments, significant changes to leverage, alterations to the risk management procedures or the risk measurement process and changes in key personnel. In order to secure the necessary information, banks must in turn satisfy their HLI counterparties that they have in place effective procedures to ensure the confidentiality of the information obtained through the credit review process. 
         
        Banks should obtain comprehensive financial information about an HLI; covering both on and off-balance-sheet positions, to understand the overall risk profile of the institution. Although additional efforts may be necessary to develop effective measures of leverage that relate capital to a common denominator of risk across on and off-balance-sheet positions, a starting point could be some measure of firm-wide value-at-risk (VaR), supplemented with the results of realistic stress testing. It is important that, where this information is used, the bank understand the parameters and the assumptions used in arriving at measures of risk and leverage in order to check the plausibility of the VaR and stress testing results. The bank should establish a clear understanding of the quality and integrity of the HLI’s processes and operations for measuring, managing and controlling market, credit and liquidity risks, including back-office systems, accounting and valuation policies and methodologies. The bank should also obtain information about the HLI’s liquidity profile, such as committed lines of credit and the availability of liquid, unpledged assets to meet possible increases in margin calls under adverse market conditions. Banks should periodically confirm, in various scenarios, whether the HLI’s future repayment capacity is reasonably assured or, for instance, highly dependent on specific assumptions. 
         
        Comprehensive and current financial information about an HLI is essential for an effective analysis of the counterparty’s credit quality and prudent setting of an internal rating and, consequently, the credit limits granted to the institution and the credit enhancements applied to the relationship. Credit assessment of HLIs and the monitoring and control of the associated counterparty risks are a more complex and time-consuming activity than credit management in respect of other conventional counterparties. It entails a high level of skill and a willingness to devote resources to regular updating and monitoring, resulting in costs which banks must recognise as part of doing business prudently with such institutions. 
         

      • IV Exposure Measurement

        A bank taking on OTC derivatives positions, vis-à-vis HLIs should develop meaningful measures of credit exposure and incorporate these measures into its management decision-making process. 
         
        Exposure measurement methodologies which provide meaningful information for decision making are an essential underpinning of the credit risk management process for trading and derivatives activities. They form the basis of effective limit setting and monitoring, discussed in Section V. As banks’ trading and derivatives activities grow in complexity and as banks move in the direction of relying more on firm-wide credit modelling techniques, it is increasingly important that measures of exposure be based on meaningful methodologies that are subject to continuous improvements commensurate with changing market conditions and practices and the bank’s needs. In particular, there are three areas where individual banks and the industry should focus their efforts: (1) the development of more useful measures of potential future exposure (PFE) that provide a meaningful calculation of the overall extent of a bank’s activity with a given counterparty; (2) the effective measurement of unsecured exposure inherent in OTC derivatives transactions that are subject to daily margining; and (3) realistic and timely stress testing of counterparty credit exposures. 
         
        First, the banking industry must devote further resources to developing meaningful measures of PFE. Banks generally measure total exposure to a counterparty as the sum of the current replacement cost (mark-to-market exposure) and PFE. PFE is a measure of how far a contract could move into the money over some defined horizon (typically the life of the contract) and at some specified confidence interval. When added together with the current replacement cost, measures of PFE are used to convert derivatives contracts to “loan equivalent” amounts for aggregating counterparty credit exposures across products and instruments. 
         
        Banks must have an effective measure of PFE which gives an accurate picture of the extent of their involvement with the counterparty in relation to their overall activities. Peak exposure measures should be determined to serve as true loan equivalent measures. PFE should adequately incorporate netting of long and short positions, as well as portfolio effects across products, risk factors and maturities, and be analysed across multiple time horizons. Banks should seek greater industry consensus on the appropriate confidence interval, the volatility concept and calculation period, and the frequency with which volatilities are updated. Banks should also incorporate such improved measures of PFE into their management decision-making process. This would include the ongoing monitoring of mark- to-market exposures against initial estimates of PFE. Banks should use this measure of PFE for assessing whether counterpartie’ financial capacity is sufficient to meet the level of margin calls implied by their measure of PFE. 
         
        Second, banks must develop more effective measures for assessing the unsecured risks inherent in collateralised derivatives positions. Such unsecured exposures can take many forms, for example through the use of initial loss thresholds, potential gaps or delays in the collateral/margining process, and the time it takes to liquidate collateral and rebalance positions in the event of counterparty default. Even where OTC derivatives are subject to daily payment and receipt of variation margin (including initial margin), a bank can still face significant unsecured credit exposure under volatile market conditions. 
         
        Currently there is no clear industry consensus on how to measure this type of unsecured exposure. Many banks calculate just one measure of PFE, typically over the life of the contract. While such lifetime measures of PFE are appropriate for the purpose of comparing uncollateralised derivatives and loan exposures and measuring overall activity with a given counterparty, they do not provide a meaningful measure of the unsecured credit risk inherent in collateralised derivatives positions. Shorter horizons would be necessary to capture the exposure arising over the time needed to liquidate and rebalance positions and to realise the value of collateral in the event of a failure to meet a margin call or a default by the counterparty. Moreover, shorter horizons will be more appropriate for calibrating initial margins and establishing loss threshold amounts on collateralised derivatives transactions. 
         
        Third, banks must develop more meaningful measures of credit risk exposures under volatile market conditions through the development and implementation of timely and plausible stress tests of counterparty credit exposures. Stress testing should also evaluate the impact of large market moves on the credit exposure to individual counterparties and the inherent liquidation effects. Stress testing should also consider liquidity impacts on underlying markets and positions and the effect on the value of any pledged collateral. Simply applying higher confidence intervals or longer time horizons to measures of PFE may not capture the market and exposure dynamics under turbulent market conditions, particularly as they relate to the interaction between market, credit and liquidity risk. 
         

      • V Limit Setting

        Effective limit setting depends on the availability of meaningful exposure measurement methodologies. In particular, banks should establish overall credit limits at the level of individual counterparties that aggregate different types of exposures in a comparable and meaningful manner. 
         
        Effective measures of PFE are essential for the establishment of meaningful limits, placing an upper bound on the overall scale of activity with, and exposure to, a given counterparty, based on a comparable measure of exposure across a bank’s various activities (both on and off-balance-sheet). Mark-to-market exposures should be monitored against initial limits on PFE. 
         
        Banks should monitor actual exposures against these initial limits and have in place clear procedures for bringing down exposure as such limits are reached. Moreover, limits should generally be binding and not driven by customer demand. A bank’s limit structure should cover the types of exposures discussed in Section IV. 
         
        Moreover, banks’ credit limits should recognise and reflect the risks associated with the near-term liquidation of derivatives positions in the event of a counterparty default. Where a bank has several transactions with a counterparty, its potential exposure to that counterparty is likely to vary significantly and discontinuously over the maturity over which it is calculated. PFEs should therefore be calculated over multiple time horizons. In the case of collateralised OTC derivatives exposures, limits should factor in the unsecured exposure in a liquidation scenario, that is, the amount that could be lost over the time it takes to rebalance positions and liquidate collateral (net of any initial margin received). 
         
        Finally, banks should consider the results of stress testing in the overall limit setting and monitoring process. 
         

      • VI Collateral, Early Termination and Other Contractual Provisions

        A bank interacting with HLIs should align collateral, early termination and other contractual provisions with the credit quality of HLIs, taking into account the particular characteristics of these institutions such as their ability to rapidly change trading strategies, risk profiles and leverage. In doing so, banks may be able to control credit risk more pre-emptively than is the case when such provisions are driven solely by net asset values. 
         
        Bank policies should determine the contractual provisions that govern HLI counterparty relationships. It is these contractual arrangements, together with the bank’s internal limit structure, that should determine the size of unsecured credit exposure assumed by the bank. In a number of market segments the types of collateral arrangements and covenants offered to a counterparty, rather than pricing, constitute the primary means for compensating for risk differentiation. It is therefore paramount that these contractual conditions closely relate to the credit quality of the counterparty. 
         
        The use of collateral can significantly reduce counterparty credit risks. Banks use collateral provisions in secured loans, repurchase agreements2 and OTC derivatives transactions. This includes transactions for which PFE (Section IV) is highly uncertain and transactions with less creditworthy counterparties. Nonetheless, the use of collateral does not eliminate credit risk and may entail other risks: liquidity, legal, custody and operational risks. Moreover, two-way collateral provisions could give rise to another type of credit risk. A loss could occur, for instance, when the bank has provided collateral owing to a negative exposure and the value of this collateral at the moment of the counterparty's default is larger than the mark-to-market position. 
         
        In establishing collateral provisions vis-à-vis HLIs, banks should bear in mind that HLIs are unregulated financial institutions whose leverage is not restricted by the prudential supervision of risk management practices and the capital requirement regimes that apply to regulated financial intermediaries. If a bank does not receive meaningful financial information on a sufficiently frequent basis to permit effective monitoring of counterparty credit risk, it should consider requiring the institution to post excess collateral even when the bank has no current exposure (i.e. posting of initial margin). At a minimum, banks should design and enforce clear internal guidelines for determining when initial margin will be required from counterparties. Similar prudent policies should be established for setting minimum transfer amounts (amounts of collateral below which a counterparty is not required to transfer collateral) and loss thresholds (exposures below which no collateral is posted). Similarly, the granting of two-way margining and rehypothecation rights should be a function of the credit quality of the counterparty. If banks agree to two-way collateral provisions, they should make sure that the resulting additional credit risk exposure is integrated in the overall risk management process (including measurement of the PFE). 
         
        Contractual provisions should reflect bank credit standards regarding haircuts applied to the securities taken as collateral, by discounting the collateral value relative to the current market value. Banks usually base the size of the valuation adjustments on the price volatility of the securities over the time that would be required to liquidate them on the default of a counterparty (in normal market conditions). In accepting collateral from HLIs, banks should carefully assess and take into account the correlation between the probability of counterparty default and the likelihood of the collateral being impaired owing to market, credit or liquidity developments. Experience has shown that in stressed-market conditions, all but the most liquid securities issued by the best credits worldwide may be downgraded owing to a broad-based flight to quality following, during or preceding the default of a major HLI. 
         
        With respect to OTC derivatives transactions, banks should bear in mind that the effectiveness of collateral provisions established to cover counterparty credit exposures may be significantly reduced if the value of the collateral is negatively correlated with the probability of the counterparty’s default or with the market value of the contracts. In stressed-market conditions, sizable amounts of additional collateral may have to be posted by an HLI with a concentrated portfolio. There should be clear documentation setting forth the actions to be taken in the event that a counterparty fails to meet collateral calls. 
         
        In addition, banks should include covenants which permit termination or other action in the event of a material deterioration in an HLI’s credit quality. The application and design of such early termination or close-out provisions should be a function of the counterparty’s credit quality and the ability of the bank to observe changes in (prospective) creditworthiness and to react swiftly to any negative changes. In the case of HLIs, publicly available information may be insufficiently up-to-date to permit continuous credit monitoring. The bank should set adequate standards for information disclosure during the credit relationship and establish termination provisions in relation to the counterparty’s risk profile so that it can take risk-reducing measures in a timely manner. 
         
        Banks’ standard practice in relation to conventional corporate credits is to set a range of covenants relating to financial strength. For HLIs, verifiable covenants addressing significant changes in strategy, or relating to leverage and risk concentration, appear particularly relevant. Reflecting the difficulties of measuring the absolute levels of some of these variables, covenants should be specified in terms of changes to the levels existing at the start of a credit relationship and based on agreed definitions of risk and capital. They should be designed with a view to tightening credit limits as counterparty risk increases. However, banks should realise that industry-wide use of “sudden death” termination provisions could have systemic implications. If these provisions do not affect the extent of risk-taking by HLIs ex ante, the intended credit risk reduction may not materialise, and all lenders may tighten credit terms at the same time. Covenants should ensure that banks are made aware of adverse financial developments and are able to press for adjustment well before the time when cessation of the relationship is appropriate. This pre-emptive aspect is as important as the ability to require repayment once adverse changes have occurred. 
         

        2 Although different in legal terms, the purchase (sale) of securities in combination with an agreement to reverse the transaction within a specified period amounts to a collateralised transaction in economic terms. In credit risk terms, similar risk management techniques apply to collateralised loans and (reverse) repurchase agreements.

      • VII Ongoing Monitoring of Positions Vis-À-Vis HLIs

        A bank dealing with HLIs should effectively monitor HLI creditworthiness and the development of its exposure to HLI counterparties. Banks should assess HLI risk profiles and risk management capabilities frequently, while considering the potential for stressed-market conditions. 
         
        Given the speed with which HLIs can change their risk profile, banks should conduct reviews of counterparty credit quality of material HLI exposures on a frequent basis, at least quarterly. Additional reviews should be triggered by significant increases in exposure or market volatility. With respect to HLIs, effective monitoring tools should go beyond monthly changes in net asset value and crude balance-sheet measures. There should be detailed quantitative information about risk, for instance VaR numbers supplemented with internal stress testing results. Banks should conduct regular reviews of HLI risk management capabilities. In addition, banks should have a proper understanding of concentrations of risk, including their own exposures to HLIs as a group as well as the risk concentration facing HLIs themselves. 
         
        Effective collateral management systems are important for monitoring and limiting counterparty credit exposures. Banks should ensure that collateral management systems capture all counterparty positions, that such positions and related collateral are marked to market on at least a daily basis, and that payment and receipt of (additional) collateral is conducted in a timely manner. Haircuts that apply to the various types of securities that are accepted as collateral should be revised on a regular basis, taking into account price volatility, liquidity and credit quality developments. Where banks focus on limiting credit risk resulting from OTC derivatives positions by timely collateralisation, they should monitor the unsecured part of the exposure (including PFE) particularly closely, taking into account the counterparty’s ability to meet future collateral demands. Since OTC derivatives exposures often make up a large part of the total exposure to HLIs, assessing the ability to provide additional collateral when required and setting meaningful credit limits based on such assessments may be especially relevant in dealings with HLIs. 
         
        Finally, ongoing exposure monitoring should incorporate the results of periodic stress testing of counterparty credit exposures that takes into account the interaction between market, credit and liquidity risks (Section IV). Such stress testing results should be included in senior management reports and provide sufficient information to trigger risk-reducing actions where necessary. 
         

    • General Provisions

    • Guidelines on the Regulatory Treatment of Banks' Exposures to Central Counterparties

      No: 41038270 Date(g): 26/1/2020 | Date(h): 1/6/1441Status: In-Force

       

      Based on the powers granted to the Central Bank under Bank Control Law No. M/5 dated 22/02/1386 H Simultaneously with the announcement by the Saudi Stock Exchange Company (Tadawul) regarding the establishment of the Securities Clearing Center Company (Clearing Center), the aim is to develop clearing services and ensure the settlement of all categories of securities traded in the market in line with the best practices and international standards.

      Facilities for regulatory treatment instructions regarding banks' exposures to Central Counterparties (CCPs), aimed at regulating banks' exposures to central securities clearing houses.

      • 1. Introduction

        -  Central Counterparties (CCPs) have become increasingly critical components of the financial system in recent years, due in part to the introduction of mandatory clearing for standardised OTC derivatives in some jurisdictions. Consistent with the key responsibility of guaranteeing the fulfilment of transactions to their clearing participants, CCPs play an important role in mitigating contagion risk in the event of a participant default. A CCPs ability to effectively manage a default is essential to its resilience and can help reduce systemic risk.
        -  SAMA via these guidelines, is emphasizing on the treatment of banks' trade exposures to a CCP under capital, large exposures, leverage ratio rules along with Pillar 2 framework.
        -  Banks should note that the foreign regulators would do an assessment to include Saudi CCPs in the list of their Qualifying Counterparties (QCCPs), in terms of exposures of banks under their jurisdictions to this entity.

         

         

         

      • 2. General terms

        -Central Counterparty (CCP):
         

        (As defined in the BCBS guidelines on Capital Requirements for Banks Exposures to Central Counterparties and as published via SAMA circular No. 371000101116 dated 15/09/1437 AH)

        A clearinghouse that interposes itself between counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and the seller to every buyer and thereby ensuring the future performance of open contracts. A CCP becomes counterparty to trades with market participants through novation, an open offer system, or another legally binding arrangement.

        -Qualifying Central Counterparty (QCCP):
         

        (As defined in the BCBS guidelines on Capital Requirements for Banks Exposures to Central Counterparties and as published via SAMA circular no. 371000101116 dated 15/09/1437 AH)

        An entity that is licensed to operate as a CCP (including a license granted by way of confirming an exemption), and is permitted by the appropriate regulator/overseer (CMA) to operate as such with respect to the products offered. This is subject to the provision that the CCP is based and prudentially supervised in a jurisdiction where the relevant regulator/overseer has established. (Saudi Arabia) and publicly indicated that it applies to the CCP on an ongoing basis, domestic rules and regulations that are consistent with the CPMI-IOSCO Principles for Financial Market Infrastructures.

        -Direct Clearing Member:
         

        (As defined in Securities Central Counterparties Regulations Issued by the Board of the Capital Market Authority Pursuant to its Resolution No. 3-127-2019 Dated 21/03/1441AH)

        A Clearing Member who is authorised to clear Securities which it has traded in its capacity as a member of an Exchange, including Securities it has traded on its own account or on behalf of its Client (s). A Direct Clearing Member shall not be permitted to clear for Exchange members with no clearing memberships.

        - General Clearing Member:
         

        (As defined in Securities Central Counterparties Regulations Issued by the Board of the Capital Market Authority Pursuant to its Resolution No. 3-127-2019 Dated 21/03/1441AH)

        A Clearing Member who is authorised to clear Securities on behalf of its Client(s), including Exchange members that with no clearing memberships. A General Clearing Member, to the extent that it is a member of an Exchange, shall be permitted to clear Securities which it has traded in its capacity as a member of an Exchange, including Securities it has traded on its own account or on behalf of its Client(s).

         

      • 4. SAMA Requirements for Banks Who Wish to Apply for Clearing Membership

        Banks who wish to engage in CCP activities and apply for a General Clearing Membership, to clear activities on behalf of their customers, must obtain a Non-objection from SAMA.

         

      • 5. Regulatory Treatment of a Bank's and its clients' Exposures to CCPs

        -Capital Requirements:
        Firstly, Qualifying CCP (QCCP):
         
        -Where a bank acts as a clearing member of a CCP for its own purposes, a risk weight of 2% must be applied to the bank's trade exposure to the CCP in respect of derivatives transactions.
        -Where the bank, as a clearing member, offers clearing services to clients, the 2% risk weight also applies to the clearing member's trade exposure to the CCP that arises when the clearing member is obligated to reimburse the client for any losses suffered due to changes in the value of its transactions in the event that the CCP defaults.
        -Where a client is not protected from losses in the case that the clearing member and another client of the clearing member jointly default or become jointly insolvent but all other conditions relating to offsetting and default (as stated in circular no. 371000101116 dated 15/09/1437AH) are met, a risk weight of 4% will apply to the client's exposure to the clearing member, or to the higher-level client, respectively.
        -The banks' contribution to the CCP's default fund will be risk weighted according to the methods explained in Basel rules (SAMA circular no. 371000101116 dated 15/09/1437AH).
        Secondly, Non-Qualifying CCP:
         
        -Banks must apply the standardized approach for credit risk, according to the category of the counterparty, to their trade exposure to a non-QCCP.
        -For a default fund, a risk weight of 1250% will be applied. For the purposes of this paragraph, the default fund contributions of such banks will include both the funded and the unfunded contributions which are liable to be paid should the CCP so require.
        -Large Exposures:
         
        -Banks exposures to CCPs are subject to the regulatory requirements as defined in SAMA Large Exposures Rules (circular no.1651/67 dated 09/01/1441 AH).
        -Banks' exposures to QCCPs related to clearing activities are exempted from the large exposures framework. However, these exposures are subject to the regulatory reporting requirements as defined in the rules mentioned above.
        -In the case of non-QCCPs, banks must measure their exposures as a sum of both the clearing exposures and other exposures as described in rules mentioned above, and must meet the general large exposure limit of 25% of the eligible capital base.
        - Leverage Ratio:
         Where a bank acting as clearing member offers clearing services to clients, the clearing member's derivative trade exposures to the CCP that arise when the clearing member is obligated to reimburse the client for an)/ losses suffered due to changes in the value of its transactions in the event that the CCP defaults must be captured by applying the same treatment that applies to any other type of derivative transaction. Therefore, this will be included in the exposure measure in the leverage ratio calculation. (For further guidance, refer to SAMA circular No. 351000133367 dated 29/10/1435AH and circular No. 351000155075 dated 28/12/1435AH).
        -Basel Reporting:
         

        Banks must use SAMA Q17 - Template to report their risks and exposures to the CCP in the following cells:

        SheetCellDescription
        Q17.2$B$27Exposure amount for contributions to the default fund of a Domestic CCP
        Q17.2$B$28Domestic QCCP
        Q17.2$B$29Foreign QCCP
        Q17.2$B$68Risk Relating to CCP
        Q17.4$A$12Of which: Centrally cleared through a Domestic QCCP
        Q17.4$A$13Of which: Centrally cleared through a Foreign QCCP
        Q17.4$A$162%
        Q17.4$A$174%
        Q17.5$A$26Centrally cleared through a Domestic QCCP
        Q17.5$A$27Centrally cleared through a Foreign QCCP
        Q17.5.3$A$26Centrally cleared through a Domestic QCCP
        Q17.5.3$A$27Centrally cleared through a Foreign QCCP
        Q17.9$C$127Risk Relating to CCP
        -ICAAP and ILAAP:
         Banks must capture an)/ risks arising from their CCP activities in the ICAAP and ILAAP documents in line with SAMA ICAAP and ILAAP rules issued via circulars No. 58514.BCS.27835 dated. 15/11/2011 and 381000120488, dated 03/12/1438AH. Special attention should be paid in terms of concentration risks if any, arising from a CCP.

         

      • 6. Additional Requirements

        Banks are required to report "reportable transactions" cleared through the CCP to the SAMA authorised Trade Repository Operator (as defined and stated in SAMA circular No. 16278/67 dated 13/03/1441 AH).

         

    • Rules on Credit Risk Management

      No: 341000036442 Date(g): 1/2/2013 | Date(h): 21/3/1434Status: In-Force
      1)In terms of its Charter issued by Royal Decree No. 23 dated 23-5-1377 H (15 December 1957 G), SAMA is empowered to regulate the commercial banks. In exercise of the powers vested upon it under the said Charter and the Banking Control Law, SAMA has decided to issue this Circular and the enclosed Rules on Credit Risk Management for Banks. The requirements contained in this Circular and the Rules are aimed to complement the existing regulatory requirements issued by SAMA from time to time.
       
      2)The enclosed Rules on Credit Risk Management contain, inter alia, the following major requirements for banks:
       
       i.The Board of Directors is required to provide effective oversight to ensure prudent conduct of credit activities and avoid unduly excessive risk taking by their bank;
       
       ii.The Board of Directors is responsible for formulation of a well-defined Credit Policy for the bank. The Policy should set out the overall strategy and credit risk appetite of the bank as well as the broad parameters for assuming and managing credit risk. The Policy should be reviewed regularly to take into account market developments and any changes in the operating environment;
       
       iii.The Board is also required to constitute a Board Committee headed by a non-executive director to assist the Board in overseeing the credit risk management process and to discharge such other related responsibilities as may be assigned to it by the Board;
       
       iv.Banks are required to put in place an elaborate credit risk management framework to effectively manage their credit risk. Such framework would include, inter alia, the process for Board and senior management oversight, organizational structure, and systems and procedures for identification, acceptance, measurement, monitoring and control of credit risk;
       
       v.The senior management of the bank is responsible for ensuring effective implementation of the credit policy and credit risk strategy approved by the Board. For this purpose, the management should develop and implement well-defined policies and procedures for identifying, measuring, monitoring and controlling credit risk in line with the overall strategy and credit policy approved by the Board;
       
       vi.The organizational structure/framework for credit risk management should be commensurate with the bank’s size, complexity of operations and diversification of its activities. The organizational structure should facilitate effective management oversight and proper execution of credit risk management and control processes. The structure may comprise of a credit risk management department or unit independent of credit origination function and a management committee responsible for monitoring of credit risk;
       
       vii.Banks should ensure to have in place adequate systems and procedures for credit risk management including those for credit origination, limit setting, credit approving authority, credit administration, credit risk measurement and internal rating framework, credit risk monitoring, credit risk review, and management of problem credits;
       
       viii.Banks should conduct stress tests on their credit portfolio to assess its resilience under “worst case” scenario and to analyze any inherent potential risks in individual credits or the overall credit portfolio or any components thereof. For this purpose, banks should follow the guidance provided in the SAMA Rules on Stress Testing issued on 23 November 2011;
       
       ix.Banks should ensure to have in place an effective management information system(MIS) to measure, monitor and control the credit risk inherent in the bank’s on- and off-balance sheet activities. The MIS should produce reports on measures of credit risk for appropriate levels of management, the relevant Board committee and the Board to enable them to take timely decisions on credit risk management;
       
       x.Banks should introduce effective internal controls to manage credit risk. In this regard, bank’s internal audit function should independently assess the adequacy and effectiveness of such internal controls and report findings thereof to the senior management and the Board or its relevant committee for timely corrective actions;
       
      3)The enclosed Rules shall be applicable to the locally incorporated banks as well as the branches of foreign banks. Where a locally incorporated bank has majority owned Subsidiary(ies) operating in the financial sector, it will either formulate group level Credit Policy consistent with these Rules for application across the group or will ensure that the subsidiary’s credit policies and procedures are in line with these Rules. Furthermore, in case of foreign subsidiaries, the legal and regulatory requirements of the host country shall also be taken into account while framing their credit policies and procedures. For the purpose of these rules, majority owned subsidiary(ies) include those subsidiary(ies) where a bank owns more than 50% of its shareholding. The branches of foreign banks licensed and operating in Saudi Arabia shall also follow these Rules. However, they will apply these Rules to the extent practically applicable to them and with such modifications as may be considered expedient keeping in view the size and complexity of their business activities. Further, their Credit Policy can be approved by the Chief Executive or a relevant management committee at Head Office instead of the Board of Directors.
       
      4)Banks are also required to ensure compliance with all other regulatory requirements and guidelines on credit risk management as issued by SAMA from time to time. They are also required to comply with the “Principles for the Management of Credit Risk”, “Sound credit risk assessment and valuation for loans” and “Principles for enhancing corporate governance” issued by the Basel Committee on Banking Supervision in September 2000, June 2006 and October 2010 respectively as well as any other related principles and standards including updates thereof issued by the relevant international standard setting bodies.
       
      5)The enclosed Rules shall come into force with immediate effect and banks are required to take all necessary steps to bring their existing policies, procedures and structures in line with these Rules by 30 June 2013. Furthermore, they are also required to submit a copy of their revised Credit Policy fully aligned with these Rules and duly approved by their Board of Directors to the Central bank latest by 30 June 2013. In case there are any practical issues in implementation of these rules, banks should approach SAMA to seek further guidance on addressing such issue
       

      • 1. General Requirements

        • 1.1. Overview

          Credit risk is historically the most significant risk faced by banks. It is measured by estimating the actual or potential losses arising from the inability or unwillingness of the obligors to meet their credit obligations on time. Credit risk could stem from both on and off balance sheet exposures of banks. Keeping in view the importance of effective credit risk management for the safety and soundness of banks, these Rules are being issued by SAMA to set out the regulatory requirements for further strengthening of credit risk management framework in banks. 
           
          All banks operating in Saudi Arabia are required to ensure that they have put in place an elaborate credit risk management framework to effectively manage their credit risk. Such framework would cover various types of lending including corporate, commercial, SME, retail, consumer, etc. The credit risk management framework should include, inter alia, the following components: 
           
           i.Board and senior management’s Oversight;
           
           ii.Organizational structure;
           
           iii.Systems and procedures for identification, measurement, monitoring and control of credit risk.
           
          While designing and strengthening their credit risk management framework, banks should ensure compliance of these Rules. Furthermore, banks should also take into account the requirements of the “Principles for the Management of Credit Risk”, “Sound credit risk assessment and valuation for loans”, and “Principles for enhancing corporate governance” issued by the Basel Committee on Banking Supervision in September 2000, June 2006 and October 2010 respectively, and any other related principles and standards including updates thereof issued by the relevant international standard setting bodies. 
           

        • 1.2. Objective of the Rules

          The objective of these Rules is to set out the minimum requirements for banks in the area of credit risk management. However, banks are encouraged to adopt more stringent standards beyond the minimum requirements of these Rules to effectively manage their credit risk. 
           

        • 1.3. Scope of Application

          These Rules shall be applicable to the locally incorporated banks as well as the branches of foreign banks. Where a locally incorporated bank has majority owned Subsidiary(ies) operating in the financial sector, it will either formulate group level Credit Policy consistent with these Rules for application across the group or will ensure that the subsidiary’s credit policies and procedures are in line with these Rules. Furthermore, in case of foreign subsidiaries, the legal and regulatory requirements of the host country shall also be taken into account while framing their credit policies and procedures. For the purpose of these rules, majority owned subsidiary(ies) include those subsidiary(ies) where a bank owns more than 50% of its shareholding. The branches of foreign banks licensed and operating in Saudi Arabia shall also follow these Rules. However, they will apply these Rules to the extent practically applicable to them and with such modifications as may be considered expedient keeping in view the size and complexity of their business activities. Further, their Credit Policy can be approved by the Chief Executive or a relevant management committee at Head Office instead of the Board of Directors. 
           

        • 1.4. Effective Date

          These Rules shall come into force with immediate effect. All banks are required to take all necessary steps to bring their existing policies, procedures and structures in line with these Rules by 30 June 2013. Furthermore, they are also required to submit a copy of their revised Credit Policy fully aligned with these Rules and duly approved by their Board of Directors to the Central Bank latest by 30 June 2013. In case there are any practical issues in implementation of these rules, banks should approach SAMA to seek further guidance on addressing such issues. 
           

      • 2. Board and Senior Management’s Oversight

        • 2.1. Responsibilities of the Board Of Directors

          The Board of Directors is responsible for approving the credit risk strategy of the bank in line with its overall business strategy. The credit strategy should be aimed at determining the credit risk appetite of the bank. The overall credit strategy and related policy matters shall be clearly outlined in a policy document to be called “Credit Policy”. Specifically, the Board’s responsibilities with regard to creditgranting function of the bank would include the following: 
           
           i.Developing a credit strategy for the bank to spell out its overall risk appetite in relation to credit risk;
           
           ii.Ensuring that the bank has a well-defined Credit Policy duly approved by the Board;
           
           iii.Forming a Board Committee headed by a non-executive director to assist the Board in overseeing the credit risk management process and defining its terms of reference (this Committee may also monitor other risks in addition to credit risk);
           
           iv.Ensuring that the bank has an effective credit risk management framework for the identification, measurement, monitoring and control of credit risk;
           
           v.Requiring the management to ensure that the staff involved in credit appraisal, monitoring, review and approval processes possess sound expertise and knowledge to discharge their responsibilities;
           
           vi.Ensuring that bank has adequate policies and procedures in place to identify and manage credit risk inherent in all products and activities including the risks of new products and activities before being introduced or undertaken. Such policies and procedures should also provide guidance on evaluation and approval of any new products and activities before being introduced or undertaken by the bank;
           
           vii.Ensuring that the bank’s remuneration policies do not contradict its credit risk strategy. In this regard, the board should ensure that the bank’s credit processes are not weakened as a result of rewarding unacceptable behavior such as generating short-term profits while deviating from credit policies or exceeding established limits;
           
           viii.Ensuring that the bank’s overall credit risk exposure is maintained at prudent levels;
           

        • 2.2. Responsibilities of the Senior Management

          The senior management of the bank shall be responsible, inter alia, for the following: 
           
           i.Ensuring effective Implementation of the credit policy and credit risk strategy approved by the board of directors. In this regard, the management should ensure that the bank’s credit-granting activities conform to the established strategy, that written procedures are developed and implemented, and that loan approval and review responsibilities are clearly and properly assigned;
           
           ii.Developing policies and procedures for identifying, measuring, monitoring and controlling credit risk. Such policies and procedures should be in line with the overall strategy and credit policy approved by the Board and address credit risk in all of the bank’s activities and at both the individual credit and portfolio levels. These policies and procedures should, inter alia, provide guidance to the staff on the following matters:
           
            a.Detailed and formalized credit evaluation/ appraisal process;
           
            b.Credit approval authority at various hierarchy levels including authority for approving exceptions;
           
            c.Credit risk identification, measurement, monitoring and control across all products and activities of the bank including risks inherent in new products and activities;
           
            d.Credit risk acceptance criteria;
           
            e.Credit origination, credit administration and loan documentation procedures;
           
            f.Roles and responsibilities of units/staff involved in origination and management of credit;
           
            g.Procedures for dealing with defaulted credits.
           
           iii.Communication of approved credit policy and procedures down the line to the concerned staff;
           
           iv.Ensuring that there is a periodic independent internal assessment of the bank’s credit policy and strategy as well as of the related credit-granting and management functions;
           
           v.Instituting a process for reporting any significant deviation/exception from the approved policies and procedures to the senior management/board and ensuring rectification thereof through corrective measures;
           

      • 3. Credit Policy and Procedures

        Each Bank shall formulate a Credit Policy that is approved by its Board of Directors. Such policy should be clearly defined, consistent with prudent banking practices and relevant regulatory requirements, and adequate for the nature and complexity of the bank’s activities. The Credit Policy should be applied on a consolidated bank basis and at the level of individual subsidiaries, as applicable. 
         
        The Policy should, inter-alia, cover the following: 
         
         i.Overall strategy of the bank to determine its risk appetite and risk tolerance levels in relation to credit risk;
         
         ii.Broad parameters for taking credit exposures to customers, banks, geographic areas/countries, economic sectors, related parties, etc. This should, inter alia, include obtaining a credit report from SIMAH and credit checks about the borrower from other banks;
         
         iii.Exposure limits for different categories of borrowers. Such limits should be in line with the SAMA’s “Rules on Exposure Limits” as amended from time to time;
         
         iv.Policy parameters for achieving reasonable diversification of credit portfolio. This would include diversification over client segments, loan products, economic sectors, geographical locations, lending currencies and maturities;
         
         v.Know Your Customer process for taking credit exposures. Such process should, inter alia, include obtaining information on legal and ownership structure of the corporate borrowers, their governance structure including management profile, beneficial ownership and basic financial information of their major business affiliates / subsidiaries (both local and foreign), details of their global financial commitments (both local and foreign) including the lenders and type of security/collateral provided to them, business plan/financial forecasts of the borrower covering the tenor of the credit facilities,, regular visits to owners of borrowing entities and their guarantors, monitoring involvement of owners/major shareholders in key business decisions, and the requirements for signing credit agreements and associated documents by the borrowers in the presence of bank’s staff. With regard to signing of credit documents, the Credit Policy should provide that credit agreements and associated documents in respect of all those exposures (including funded and / or non-funded facilities) exceeding one percent of total Tier-1 capital of the bank or SAR 100 million whichever is less, must be signed in the presence of bank’s senior officers. The Policy should also lay down an elaborate process for signing the credit documents in respect of all other exposures in the presence of bank’s staff to fully protect the interest of the bank;
         
         vi.Structuring of credit facilities/transactions with clearly defined purpose and monitoring end use of credit facilities. Furthermore, no financing to be provided to support speculative activities and general purpose activities or any activity which lacks a well-defined purpose for utilization of credit facilities. This will, however, not include the working capital or overdraft facilities provided the end use of such facilities is monitored by the bank to ensure their ultimate utilization for the purpose for which those were granted;
         
         vii.Broad parameters for providing financing for the subscription of initial public offering(IPO) of shares. Such financing, if provided, should be based on a clear and cautious policy and against adequate collateral with sufficient margins to mitigate the risk of volatility in share prices. The maximum financing for the subscription of IPO of shares shall be restricted to 50% of the amount to be subscribed by a single person. Banks shall also obtain complete particulars of the borrower and verify his credentials including name, identity and credibility before granting any financing (as per SAMA Circular dated 22 Shaban 1413 H);
         
         viii.Broad parameters for seeking collateral against financing facilities as well as the nature of such collateral. Furthermore, the parameters for taking any exposures without collateral should be clearly spelled out along with the procedures to cover the associated recovery/settlement risk in such exposures;
         
         ix.Requiring the Senior Management to ensure that the staff involved in credit appraisal, credit administration, credit review and other related functions are well trained to discharge their responsibilities and are periodically rotated in their assignments;
         
         x.Other related matters to spell out the credit policy parameters of the bank.
         
        A copy of the Policy duly approved by the Board shall be submitted to SAMA within 30 days of its approval. The Board of Directors or a relevant sub-committee of the Board of each bank shall review their Credit Policy as and when needed but at-least once in every three years. All significant/material changes to the Credit Policy shall be approved by the Board of Directors or a relevant sub-committee of the Board and a copy thereof submitted to the Central Bank within 30 days of such approval. In case of frequent changes in the Credit Policy, banks may choose to submit the revised Credit Policy to the Central Bank once a year incorporating all changes made during a year, within 30 days of the end of a calendar year. 
         

      • 4. Organizational Structure

        The overall structure for credit risk management should be commensurate with the bank’s size, complexity of operations and diversification of its activities. The organizational structure should facilitate effective management oversight and proper execution of credit risk management and control processes. While the organizational structure may vary from bank to bank, it would generally comprise of the following: 
         

        • 4.1. Credit Risk Management Department or a Unit

          Such department or unit can be part of the overall risk management function of the bank but should be independent of the loan origination function. This department or unit should be responsible, inter alia, for the following: 
           
            a.Monitoring adherence to the overall risk tolerance limits set out in the Credit Policy of the bank;
           
            b.Ensuring that the business lines comply with the established credit risk parameters and prudential limits;
           
            c.Establishing the systems and procedures relating to credit risk identification, internal risk rating approaches, Management Information System, monitoring of loan portfolio quality and early warning;
           
            d.undertaking portfolio evaluations and conducting comprehensive studies on the environment to test the resilience of the loan portfolio;
           
            e.Coordinating on remedial measures to address deficiencies/problems in credit portfolio;
           
            f.Other matters relating to credit risk management.
           

        • 4.2. Credit Risk Management Committee

          This Committee will be a management committee and responsible for monitoring of credit risk taking activities and overall credit risk management function. This Committee can either be a separate committee comprising of the heads of relevant functions depending upon their size, organizational structure and corporate culture or these responsibilities can be assigned to the overall Risk Management Committee of the bank. Its terms of reference may include, inter alia, the following: 
           
            a.Ensure implementation of the credit risk policy / strategy approved by the Board;
           
            b.Monitor credit risk on a bank-wide basis and ensure compliance with limits approved by the Board;
           
            c.Providing input in formulation of credit policy of the bank particularly on credit risk related issues including, for example, setting standards for presentation of credit proposals, financial covenants, rating standards and benchmarks, etc.;
           
            d.Make Recommendations to the Risk Management Committee or any other relevant committee of the Board on matters relating to delegation of credit approving powers, prudential limits on large credit exposures, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, etc. as and when required;
           
            e.Dealing with any other matters relating to credit risk management.
           
          The Credit Risk Management Department or Unit will provide necessary support to the Credit Risk Management Committee in discharging its responsibilities. 
           

      • 5. Systems and Procedures

        Banks should put in place adequate systems and procedures for credit risk management. Broad guidelines for setting systems and procedures regarding various credit related activities of a bank are provided hereunder: 
         

        • 5.1. Credit Origination

          Banks should establish sound and well-defined credit-granting criteria, which is essential to approving credit in a safe and sound manner. These criteria should include a clear indication of the bank’s target market and a thorough understanding of the borrower or counterparty, as well as the purpose and structure of the credit, and its source of repayment. 
           
          Banks should also have clearly established processes and procedures to assess the risk profile of the customer as well as the risks associated with the proposed credit transaction before granting any credit facility. These processes and procedures should be applicable for approving new credits as well as the amendment, renewal and re-financing of existing credits. The factors to be considered for origination of credit may include, inter alia, the following: 
           
            a.Credit assessment of the borrower’s industry, and macro economic factors;
           
            b.The purpose of credit and source of repayment;
           
            c.Assessing the track record / repayment history of the borrower. In case of new borrowers, assessing their integrity and repute as well as their legal capacity to assume the liability;
           
            d.Assessment/evaluation of the repayment capacity of the borrower;
           
            e.Determination of the terms and conditions and covenants of credit;
           
            f.Assessment of the adequacy and enforceability of collaterals;
           
            g.Assessment of adherence to exposure limits and determination of appropriate authority for credit approval;
           
          All extensions of credit must be made on an arm’s-length basis. In particular, credits to related borrowers must be authorized on an exception basis, monitored with particular care and other appropriate steps taken to control or mitigate the risks of non-arm’s length lending. 
           
          In case of consortium/syndication loans, it is important that other consortium members should not over rely on the lead bank and should have their own systems and procedures to perform independent analysis and review of syndication terms. 
           

        • 5.2. Limit Setting

          Banks should establish overall credit limits at the level of individual borrowers and counterparties, and groups of connected counterparties that aggregate in a comparable and meaningful manner different types of exposures, both in the banking and trading book and on and off the balance sheet. 
           
          SAMA has separately specified exposure limits for single counterparties and group of connected counterparties. While remaining within the overall limits specified by SAMA, banks can establish more conservative exposure limits. Banks are required to have well-defined policies and procedures for establishing their internal exposure limits as such limits are an important element of credit risk management. The limit structure should set the boundaries for overall risk taking, be consistent the bank’s overall risk management approach, be applied on a bank-wide basis, allow management to monitor exposures against predetermined risk tolerance levels and ensure prompt management attention to any exceptions to established limits. Banks should take into account the following parameters in establishing their exposure limits: 
           
            a.The size of the limits should be based on the credit strength of the borrower, genuine requirement of credit, economic conditions and the bank’s risk tolerance;
           
            b.The limits should be consistent with the bank’s risk management process and commensurate with its capital position;
           
            c.The limits should be established for both individual borrowers as well as groups of connected borrowers. The limits can be based on the internal risk rating of the borrower or any other basis linked to the borrower’s risk profile;
           
            d.There can be separate limits for different credit products and activities, specific industries, economic sectors or geographic regions to avoid concentration risk. The ultimate objective should be to achieve reasonable diversification of credit portfolio;
           
            e.The results of stress testing should be taken into account in the overall limit setting and monitoring process;
           
            f.Credit limits should be reviewed regularly at least annually or more frequently if the borrower’s credit quality deteriorates;
           
            g.All requests of increase in credit limits should be fully evaluated and substantiated.
           
          Banks should closely monitor their credit exposures against established limits and put in place adequate procedures for timely identification of any exceptions against the approved limits. There should also be well defined procedures to deal with any excesses over approved limits. Furthermore, all such instances of excesses over limits should be reported to the senior management along with the details of the corrective action taken. Exceptions to the approved limits should be approved at senior level by the authorized persons. In case of occurrence of frequent exceptions, the management or the board should review the limit structure and devise a strategy to ensure non-occurrence of such breaches. 
           

        • 5.3. Delegation of Authority

          Banks are required to establish responsibility for credit approvals and fully document any delegation of authority to approve credits or make changes in credit terms. In this regard, banks are required to take into account the following factors: 
           
            a.Board of Directors or its relevant sub-committee should approve the overall lending authority structure, and explicitly delegate credit sanctioning authority to senior management (by position/level of hierarchy) and/or the Credit Committee. The Senior Management may assign the delegated powers to specific individuals or positions down the line subject to adherence of the overall delegation of authority and the criteria laid down for this purpose by the Board or its relevant subcommittee;
           
            b.Lending authority assigned to different levels of hierarchy should be commensurate with the level, experience, ability and character of the person. For this purpose, banks may develop a risk-based authority structure whereby the lending authority is tied to the risk ratings of the obligor;
           
            c.There should be a clear segregation of duties between Relationship Managers, Credit Approvers, Operations processors and Risk Managers with regard to credit approvals or making any changes in credit terms. Any limitations on who should hold credit approval authority should also be clearly stated;
           
            d.The credit policy should spell out the escalation process to ensure appropriate reporting and approval of credit extension beyond prescribed limits or any other exceptions to credit policy;
           
            e.There should be a periodic review of lending authority assigned to different levels of hierarchy;
           
            f.There should be an appropriate system in place to detect any exceptions or misuse of delegated powers and reporting thereof to the senior management and/or the Board of Directors or its relevant sub-committee;
           

        • 5.4. Credit Administration

          Credit administration is an important element of the credit process that support and control extension and maintenance of credit. Banks should have in place a system for the ongoing administration of their various credit risk-bearing portfolios. Banks should also have separate units to perform credit administration function. A typical credit administration unit generally performs the following functions: 
           
            a.Credit Documentation: Ensuring completeness of documentation (loan agreements, guarantees, transfer of title of collaterals, etc.) in accordance with the approved terms and conditions of credit;
           
            b.Credit Disbursement: Ensuring that credit approval have been obtained from the competent authority and all other formalities have been completed before any loan disbursement is effected;
           
            c.Credit monitoring: This process starts after disbursement of credit and include keeping track of borrowers’ compliance with credit terms, identifying early signs of irregularity, conducting periodic valuation of collateral and monitoring timely repayments;
           
            d.Loan Repayment: The obligors should be communicated ahead of time as and when the principal and/or commission income becomes due. This may be done either by providing details of the due dates and repayable amounts for both commission and principal in the facility agreement or through a separate communication to the obligor before each due date of the principal and/or commission income or by adopting both these practices. Any delinquencies involving non-payment or late payment of principal or commission should be tagged and communicated to the management. Proper records and updates should also be made after receipt of overdue amount;
           
            e.Maintenance of Credit Files: All credit files should be properly maintained including all original correspondence with the borrower and necessary information to assess its financial health and repayment performance. The credit files should be maintained in a well organized way so that these are easily accessible to external / internal auditors or SAMA inspection team. Banks may resort to maintain electronic credit files only if permitted by relevant law(s) and subject to compliance of all relevant rules/regulations;
           
            f.Collateral and Security Documents: Ensuring that all collateral/security documents are kept in a secured way and under dual control. Proper record of all collateral/security documents should be maintained to keep track of their movement. Procedures should also be established to track and review relevant insurance coverage for facilities/collateral wherever required. Physical checks on collateral/security documents should also be conducted on a regular basis.
           
          Banks should ensure that the credit administration function should be independent of business origination and credit approval process. In developing their credit administration function, banks should ensure: 
           
            a.the efficiency and effectiveness of credit administration operations, including monitoring documentation, contractual requirements, legal covenants, collateral, etc.;
           
            b.the accuracy and timeliness of information provided to management information systems;
           
            c.adequate segregation of duties;
           
            d.the adequacy of controls over all “back office” procedures; and
           
            e.compliance with prescribed management policies and procedures as well as applicable laws and regulations.
           

        • 5.5. Credit Risk Measurement

          Banks should adopt elaborate techniques to measure credit risk which may include both qualitative and quantitative techniques. Banks should also establish and utilize an internal credit risk rating framework in managing credit risk. The internal credit risk rating is a summary indicator of a bank’s individual credit exposures and categorizes all credits into various classes on the basis of underlying credit quality. This rating framework may incorporate, inter alia, the business risk (including industry characteristics, competitive position e.g. marketing/technological edge, management capabilities, etc.) and financial risk (including financial condition, profitability, capital structure, present and future cash flows, etc.). The rating system should be consistent with the nature, size and complexity of a bank’s activities. 
           
          An internal rating framework would facilitate banks in a number of ways such as: 
           
            a.Credit selection;
           
            b.Amount of exposure;
           
            c.Tenure and price of facility;
           
            d.Frequency or intensity of monitoring;
           
            e.Analysis of migration of deteriorating credits and more accurate computation of future loan loss provisions;
           
            f.Deciding the level of approving authority of credit approval.
           
          It is not the intention of these guidelines to prescribe any particular rating system. Banks can choose a rating system which commensurate with the size, nature and complexity of their business as well their risk profile. However, banks are encouraged to take into account the following factors in designing and implementing an internal rating system; 
           
            a.The rating system should explicitly define each risk rating grade. The number of grades on rating scale should be neither too large nor too small. A large number of grades may increase the cost of obtaining and analyzing additional information and thus make the implementation of rating system expensive. On the other hand, if the number of rating grades is too small it may not permit accurate characterization of the underlying risk profile of a loan portfolio;
           
            b.The rating system should lay down an elaborate criteria for assigning a particular rating grade, as well as the circumstances under which deviations from criteria can take place;
           
            c.The operating flow of the rating process should be designed in a way that promotes the accuracy and consistency of the rating system while not unduly restricting the exercise of judgment;
           
            d.The operating design of a rating system should address all relevant issues including which exposures to rate; the division of responsibility for grading; the nature of ratings review; the formality of the process and specificity of formal rating definitions;
           
            e.The rating system should ideally aim at assigning a risk rating to all credit exposures of the bank. However, the banks may decide as to which exposures needs to be rated taking into account the cost benefit analysis. The decision to rate a particular credit exposure could be based on factors such as exposure amount, nature of exposure(i.e. corporate, commercial, retail, etc.) or both. Generally corporate and commercial exposures are subject to internal ratings whereas consumer / retail loans are subject to scoring models;
           
            f.Banks should take adequate measures to test and develop a risk rating system prior to adopting one. Adequate validation testing should be conducted during the design phase as well as over the life of the system to ascertain the applicability of the system to the bank’s portfolio. Furthermore, adequate training should be imparted to the staff to ensure uniformity in assignment of ratings;
           
            g.Banks should clearly spell out the roles and responsibilities of different parties for assigning risk rating. Ratings are generally assigned /reaffirmed at the time of origination of a loan or its renewal /enhancement. Generally loan origination function initiates a loan proposal and also allocates a specific rating. This proposal passes through the credit approval process and the rating is also approved or recalibrated simultaneously by approving authority. This may, however, vary from bank to bank;
           
            h.The rating process should take into account all relevant risk factors including borrower’s financial condition, size, industry and position in the industry; the reliability of financial statements of the borrower; quality of management; elements of transaction structure such as covenants, etc. before assigning a risk rating. The risk rating should reflect the overall risk profile of an exposure;
           
            i.Banks should also ensure that risk ratings are updated periodically and are also reviewed as and when any adverse events occur. There should also be a periodic independent review of the risk ratings by a separate function independent of loan origination to ensure consistency and accuracy of ratings.
           

        • 5.6. Credit Risk Monitoring

          Banks should put in place an effective credit monitoring system that enables them to monitor the quality of individual credit exposures as well as the overall credit portfolio and determine the adequacy of provisions. The monitoring system should also enable the bank to take remedial measures as and when any deterioration occurs in individual credits or the overall portfolio. An effective system of credit monitoring should ensure that: 
           
            a.the current financial condition of the borrower is fully understood and assessed by the bank;
           
            b.the overall risk profile of the borrower is within the risk tolerance limits established by the bank;
           
            c.all credits are in compliance with the applicable terms & conditions and regulatory requirements;
           
            d.usage of approved credit lines by borrowers is monitored by the bank;
           
            e.the projected cash flow of major credits meet debt servicing requirements;
           
            f.collateral held by the bank provides adequate coverage;
           
            g.all loans are being serviced as per facility terms & conditions;
           
            h.potential problem credits are identified and classified on a timely basis;
           
            i.provisions held by the bank against non-performing loans are adequate;
           
          The banks’ credit policy should explicitly provide procedural guidelines relating to credit risk monitoring covering, inter alia, the following points: 
           
            a.The roles and responsibilities of individuals responsible for credit risk monitoring;
           
            b.The assessment procedures and analysis techniques (for individual loans & overall portfolio). This may include, inter alia, the assessment procedures for assessing the financial position and business conditions of the borrower, monitoring his account activity/conduct, monitoring adherence to loan covenants and valuation of collaterals;
           
            c.The frequency of monitoring;
           
            d.The periodic examination of collaterals and loan covenants;
           
            e.The frequency of site visits;
           
            f.Renewal of existing loans and the circumstances under which renewal may be deferred;
           
            g.Restructuring or rescheduling of loans and other credit facilities;
           
            h.The identification of any deterioration in any loan and follow-up actions to be taken.
           

        • 5.7. Independent Credit Risk Review

          Banks should establish a mechanism of conducting an independent review of credit risk management process. Such a review should be conducted by staff involved in credit risk assessment, independent from business area. The placement of this function within the organization and its reporting lines can be determined by the banks themselves provided its independence from the business is ensured. The Credit Policy of the bank should contain provisions for conducting the credit risk review whereas the modalities of conducting such a review should be spelt out in the procedural documents. The purpose of such review is to independently assess the credit appraisal and administration process, the accuracy of credit risk ratings, level of risk, sufficiency of collaterals and overall quality of loan portfolio. Banks should take into account the following factors for conducting a credit risk review: 
           
            a.All facilities except those managed on a portfolio basis should be subjected to individual risk review at least once in a year. The review may be conducted more frequently for new borrowers as well as for classified and low rated accounts that have higher probability of default;
           
            b.The credit review should be conducted with updated information on the borrowers financial and business conditions, as well as conduct of account. Any exceptions noted in the credit monitoring process should also be evaluated for impact on the borrowers’ creditworthiness;
           
            c.The credit review should be conducted on a solo as well as consolidated group basis to factor in the business connections among entities in a borrowing group;
           
            d.The results of such review should be properly documented and reported directly to the board or its relevant sub-committee as well as to the senior management;
           
          The credit risk review will mainly focus on corporate and commercial loans. Banks may decide not to cover a particular loans products or categories e.g. consumer loans or retail loans under the risk review. However, they should closely monitor the quality of such loans and report any deterioration in their quality along with the results of credit reviews conducted on other loans. 
           

        • 5.8. Managing Problem Credits

          Banks should establish a system to identify problem loans ahead of time for taking appropriate remedial measures. Such a system should provide appropriate guidance to concerned staff on identifying and managing various types of problem loans including corporate, commercial and consumer loans. Once a loan is identified as a problem loan, it should be managed under a dedicated remedial process. In this regard, banks may take into account the following factors: 
           
            a.The credit policy should clearly set out how the bank will manage problem credits. The basic elements of managing problem credits may include, inter alia, negotiations and follow-up with the borrowers, working out remedial strategies e.g. restructuring of loan facility, enhancement in credit limits, reduction in commission rates, etc., review of collateral/security documents, and more frequent review and monitoring. Banks should provide detailed guidance in this regard in their systems and procedures for dealing with problem credits;
           
            b.The organizational structure and methods for dealing with problem credits may vary from bank to bank. Generally the responsibility for such credits may be assigned to the originating business function, a specialized workout section, or a combination of the two, depending upon the size and nature of the credit and the reason for its problems. When a bank has significant credit-related problems, it is important to segregate the workout function from the credit origination function;
           
            c.There should be an appropriate system for identification and reporting of problem credits along with the details of remedial measures on regular basis to the senior management and/or the Board of Directors or its relevant sub-committee;
           

      • 6. Stress Testing of Credit Risk

        Banks should take into consideration potential future changes in economic conditions when assessing individual credits and their credit portfolios, and should assess their credit risk exposures under stressful conditions. This will enable them to review their credit portfolio and assess its resilience under “worst case” scenario. For this purpose, banks should adopt robust stress testing techniques. The stress testing of credit portfolio will enable banks to proactively analyze any inherent potential risks in individual credits or the overall credit portfolio or any components thereof. This will also enable them to identify any possible events or future changes in economic conditions that have unfavorable effects on their credit exposures and assessing their ability to withstand such effects. Such detection of any potential events or risks which are likely to materialize in times of stress, will also enable the banks to take timely corrective actions before the situation may get out of control. 
         
        Some of the common sources of credit risk which should, inter alia, be analyzed by banks are mentioned hereunder for their guidance: 
         
         i.Credit concentrations are probably the single most important cause of major credit problems. Credit concentrations are viewed as any exposure where the potential losses are large relative to the bank’s capital, its total assets or the bank’s overall risk level. Credit concentrations can further be grouped roughly into two categories: (i) Conventional credit concentrations e.g. concentrations of credits to single borrowers or counterparties, a group of connected counterparties, and sectors or industries; (ii) Concentrations based on common or correlated risk factors reflecting subtler or more situation-specific factors e.g. correlations between market and credit risks, as well as between those risks and liquidity risk, etc.;
         
         ii.Weakness in the credit granting and monitoring processes including e.g. shortcomings in credit appraisal processes as well as in underwriting and management of market-related credit exposures;
         
         iii.Excessive reliance on name lending i.e. granting loans to persons with a reputation for strong financial condition or financial acumen, without conducting proper credit appraisal as done for other borrowers;
         
         iv.Credit to related parties which are affiliated, directly or indirectly, with the bank;
         
         v.Lack of an effective credit review process to provide appropriate checks and balances and independent judgment to ensure compliance of bank’s credit policy and prevent weak credits being granted;
         
         vi.Failure to monitor borrowers or collateral values to recognize and stem early signs of financial deterioration;
         
         vii.Failure to take sufficient account of business cycle effects whereby the credit analysis may incorporate overly optimistic assumptions relating to income prospects and asset values of the borrowers in the ascending portion of the business cycle;
         
         viii.Challenges posed by the market-sensitive and liquidity-sensitive exposures to the credit processes at banks. Market-sensitive exposures (e.g. foreign exchange and financial derivative contracts) require a careful analysis of the customer’s willingness and ability to pay. Liquidity-sensitive exposures (e.g. margin and collateral agreements with periodic margin calls, liquidity back-up lines, commitments and some letters of credit, etc.) require a careful analysis of the customer’s vulnerability to liquidity stresses, since the bank’s funded credit exposure can grow rapidly when customers are subject to such stresses. Market- and liquidity-sensitive instruments change in riskiness with changes in the underlying distribution of price changes and market conditions;
         
        Stress testing should involve identifying possible events or future changes in economic conditions that could have unfavorable effects on a bank’s credit exposures and assessing the bank’s ability to withstand such changes. Three areas that banks could usefully examine are: (i) economic or industry downturns; (ii) market-risk events; and (iii) liquidity conditions. Stress testing can range from relatively simple alterations in assumptions about one or more financial, structural or economic variables to the use of highly sophisticated financial models. Whatever the method of stress testing used, the output of the tests should be reviewed periodically by senior management and appropriate action taken in cases where the results exceed agreed tolerances. The output should also be incorporated into the process for assigning and updating policies and limits. 
         
        Detailed guidance on stress testing of credit risk has been provided in the SAMA Rules on Stress Testing issued on 23 November 2011. Banks are required to take into account the requirements of these SAMA Rules in stress testing of their credit portfolio. 
         

      • 7. Management Information System

        Banks should put in place effective management information system(MIS) to enable management to be aware, measure, monitor and control the credit risk inherent in the bank’s all on- and off-balance sheet activities. An accurate, informative and timely management information system is an important factor in the overall effectiveness of the risk management process. Banks should comply with the following guidelines in developing and strengthening the MIS for credit risk: 
         
         i.The system should be capable of compiling credit information both on solo and consolidated basis as well as across various credit categories and products (including off-balance sheet activities);
         
         ii.The system should be able to produce all the required information to enable the management to assess quickly and accurately the level of credit risk, ensure adherence to the risk tolerance levels and devise strategies to manage the credit risk effectively;
         
         iii.The system should be able to provide information on the composition of the portfolio, concentrations of credit risk, quality of the overall credit portfolio as well as various categories of the portfolio and rescheduled/restructured and “watchlist” accounts;
         
         iv.The reporting system should ensure that exposures approaching pre-defined maximum risk limits/thresholds set out for individual exposures are brought to the attention of management. All exposures should be included in a risk limit measurement system;
         
         v.The management information reports should be prepared by persons who are independent of the business unit(s);
         
        The credit risk management function should monitor and report its measures of risk to appropriate levels of management, the relevant Board committee and the Board. The board should be regularly briefed on the overall credit risk exposure (including off-balance sheet activities) of the bank. The board should be provided, inter alia, the following information for its review: 
         
         i.The amount of credit exposures undertaken with broken down by loans categories, types of exposures, products and level of credit grades, etc.;
         
         ii.A periodic report on the existing lending products, their target market, performance and credit quality as also the details of any planned new products;
         
         iii.Concentrations of credit to large exposures, groups of connected parties, specific industries, economic sectors or geographic regions, etc.;
         
         iv.A report on the overall quality of the credit portfolio. This may include, inter alia, details of problem loans including those on the watchlist, categories of their classification, potential loss to the bank on each significant problem loan, the level of existing and additional provisions required there against, etc.;
         
         v.Details of the actions taken and planned to recover the significant problem loans as well as the status of adherence to the terms and conditions of any significant rescheduled/restructured loans;
         
         vi.Such other information as may be required by the board or deemed appropriate by the management to bring to the attention of the board;
         
        Banks should regularly review their management information systems to ensure their adequacy and effectiveness, and introduce changes wherever required. 
         

      • 8. Internal Controls System

        Bank's disclosures regarding Risk Management (both quantitative and qualitative) should be subject to the internal controls outlined in this section.
        As part of their internal controls system, banks should introduce effective controls to manage credit risk. The internal audit function of the bank should independently assess the adequacy and effectiveness of internal controls relating to credit risk management. The internal audit should periodically evaluate the soundness of relevant internal controls covering, inter alia, the following: 
         
         i.Adequacy of internal controls for each stage of the credit process;
         
         ii.Appropriateness and effectiveness of internal controls in commensuration to the level of risks posed by the nature and scope of the bank’s lending activities;
         
         iii.Reliability and timeliness of information reported to the Board of Directors, its relevant committee(s) and senior management;
         
         iv.Effectiveness of organizational structure to promote checks and balances and to ensure existence of clear lines of authority and responsibilities for monitoring adherence to approved credit policies, procedures and limits;
         
         v.Adequacy of credit policies and procedures as well as adherence to such policies and procedures;
         
         vi.Compatibility of credit policies and procedures with legal and regulatory requirements as well as adherence to applicable laws/ regulations (this function can either be performed by internal audit or compliance);
         
         vii.An assessment of the alignment of remuneration incentive plans with the approved risk appetite and credit policies of the bank;
         
         viii.Identification of any weaknesses in the credit policies, procedures and related internal controls to enable the management and/or the Board to take timely corrective actions;
         
        The internal audit should report the findings on adequacy and effectiveness of internal controls relating to credit function independently to the senior management and the Board or its relevant committee. The internal audit reports should also provide an assessment of the adequacy of any corrective actions being taken to address the material weaknesses. 
         

    • loan Classification, Provisioning and Credit Review

      No: 241000000312 Date(g): 19/1/2004 | Date(h): 27/11/1424Status: In-Force
      In July 2002, SAMA had issued a draft Circular entitled ‘Credit Classification and Review.’ Subsequently, Saudi banks were required to provide comments on the circular and estimate the quantitative impact of these rules on their financial position. In 2003, all Saudi banks have submitted their comments to SAMA. 
       
      SAMA has also closely monitored international developments in this regard emanating from the Basel Committee on Banking Supervision and the International Accounting Standard Board. Currently there is considerable amount of work in progress which has relevance for this subject in these organizations. However, we have incorporated various relevant concepts from recent developments in this circular and also highlighted their implications over the next few years. 
       
      Consequently, the Central Bank has decided to implement the proposed rules as minimum standards, while Saudi banks are encouraged to develop more sophisticated and refined methodologies for loan classification and provisioning. The added incentive for the banks would be better alignment of their methodologies for provisioning and the Basel capital requirements under the IRB approaches. Consequently, an integrated system based on historical loss experience, on a portfolio based approach, may be desirable to enable banks for estimating their provision and capital requirements. 
       
       SAMA has also addressed specific issues raised by banks as follows:
       
       1.There are inevitable differences between Accounting Provisions and Supervisory Provisions. The annual difference between the two calculations should be adjusted to the accumulated retained earnings in the Supervisory Returns. No adjustment needs to be made to the published financial statements of the banks. Where a bank has no accumulated retained earnings, the adjustment could be made to a general reserve or to statutory reserve following approval by SAMA on a case by case basis.
       
       2.General Provisions will be 1% of loans in the ‘Standard’ and ‘Special Mention’ categories. All Saudi Government loans or claims fully backed by collateral of Saudi Government in form of securities or guarantees should be deducted before calculating general provisions.
       
       3.SAMA has specified automatic provisioning requirements related to Banks’ non-performing loan portfolios, based on the number of days past due. However, exceptions are permitted for individual loans where a bank has strong documentary evidence that a loan is performing despite being past due. It is expected that such exceptions will be used in limited number of cases. Saudi banks are required to maintain a list of such loans that have been treated under this exception and document the underlying reasons.
       
      SAMA requires all Saudi banks to provide the following information. These are to be provided by 15th of the month following the end of the quarter. 
       
       1.A quarterly report on the loan portfolios according to the proposed classification system - Annex 1.
       
       2.A quarterly report on Loan Provisions -Annex 2.
       
       3.A quarterly list of loans where exceptions have been made to the general rule of automatic classification - Annex 3.
       
       4.Guidance Notes-Annex 4.
       
      These rules are to be implemented from 1 January 2004, with the first Quarterly Reports due as of 31 March 2004. 
       

      • Section I. Loan Classification

        • 1.1 Introduction

          Realistic assessment of asset quality and prudent recognition of income and expenses lie at the heart of the assessment of financial soundness of any individual banking institution. Therefore, it is essential that banks in Saudi Arabia follow minimum standards for loan assessment and classification. 
           
          This regulation aims to provide a degree of uniformity and consistency by requiring Saudi banks to use the proposed principal categories for loan classifications. All Saudi banks will be required to provide supervisory data on the basis of these proposed classification grades for comparison and for consolidation on a banking system-wide basis. However, Saudi banks are encouraged to develop and use more sophisticated classification systems and methodologies as long as they are consistent with the principal classification categories defined in this regulation. 
           

        • 1.2 Scope

          The credit products covered by this regulation (collectively referred to as “loans”) include all types of consumer and corporate loans, advances, overdrafts, credit card balances, leasing, musharaka, murabaha, istisna, letters of guarantee and credit and any other commission and non-commission bearing credit-related instruments and arrangements. They also include loans to businesses, financial institutions, governments and their agencies, individuals, project finance, residential and commercial mortgages and direct financial leases. Off balance sheet items such as guarantees, letters of credits, and derivatives such as futures and forward contracts, etc. carry credit risk. These may turn into loans or receivables as a result of defaults and other events and should be classified in appropriate categories, when such credit risk crystallizes into a loan or receivable. 
           

        • 1.3 Objectives

          The main objectives of a system of Ioan classification are as follows: 
           
          •To highlight those loans that represent an above-normal credit risk;
           
          •To evaluate the degree of risk involved;
           
          •To develop a strategy or action plan for monitoring and follow-up on weak loans and for the recovery or liquidation of impaired loans and other such outstanding credits;
           
          •To provide essential information for the determination of adequate provisions for expected credit losses; and,
           
          •To bring a degree of uniformity and consistency in the method of classification of loans outstanding among Saudi banks.
           

        • 1.4 Assessment and Classification of Individual Loans

          1.4.1Large commercial loans to corporates, governments, private banking customers and others are often reviewed and assessed on an individual basis. Systematic measurement of impairment of individual loans must include the use of a classification system for assigning loans to risk categories. Such a system should segregate loans by the probability of risks associated with individual loans. Over time, banks should monitor and evaluate the levels and trends of risk in their commercial loan portfolios through an analysis of the classification categories. Banks should also target troubled loans for more frequent reviews and higher levels of scrutiny.
           
          1.4.2The assessment of each loan should be based upon its fundamentals, including as a minimum the following evaluation factors:
           
           •The obligor’s character and integrity.
           
           •The purpose of the loan and the sources of repayment.
           
           •The overall financial condition and resources of the obligor, including the current and future cash flows.
           
           •The credit and delinquency history of the obligor.
           
           •The probability of default on existing loan and any new Ioan being extended.
           
           •The types of secondary sources of repayment available, such as guarantor’s support and collateral values when they are not a primary sources of repayment. (Undue reliance on secondary sources of repayment should be questioned and the bank’s policy on such practice should be reviewed.)
           
          1.4.3While assessing a loan, banks should consider the extent of the shortfall in the operating results and cash flows of the obligor, the support provided by any pledged collateral, and/or the support provided by any third party.
           
          1.4.4In order to promote uniformity in the criteria used by Saudi Banks for assigning quality rating to loans, SAMA proposes the system of credit classifications described in the following paragraphs. It should be noted that banks may use classification systems that have more grades than those noted below, as long as they can demonstrate that their systems comply with and their data can be summarized in a manner consistent with the system proposed in these regulations.
           
          1.4.5Standard Category
           
           Loans in this category are performing and have sound fundamental characteristics such as borrower’s overall financial conditions, resources and cash flows, credit history and primary or secondary sources of repayment.
           
           A classification of standard should be given to all loans that exhibit neither actual nor potential weaknesses. Loans that exhibit potential weaknesses should be categorized as Special Mention. Standard and Special Mention loans are considered as “performing” credits.
           
          1.4.6Special Mention Category
           
           A ‘Special Mention’ loan is defined as having potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may, at some future date, result in the deterioration of the repayment prospects for the loan. These loans are normally current and up-to-date in terms of principal and commission/income payments but deserve management’s close attention. These potential weaknesses may include:
           
           •Declining profitability
           
           •Tightening liquidity or cash flow
           
           •Increasing leverage and/or weakening net worth
           
           •Weakened marketability and/or value of collateral
           
           •Industry-specific problems
           
           •Economic and/or other problems affecting the obligor’s performance
           
           •Concerns about the obligor’s management competence or depth
           
           •Material documentation problems
           
           •Inability to obtain current financial information
           
          1.4.7‘Special Mention’ loans would not expose an institution to sufficient risk to warrant a non-performing classification and would continue to accrue commission. ‘Special Mention’ loans would have characteristics, which corrective management actions could remedy. The ‘Special Mention’ category should also not be used to list loans that contain risks usually associated with that particular type of lending. Any lending involves certain risks, regardless of the collateral or the obligor’s capacity and willingness to repay the debt. But only where the risk has increased beyond that which existed at origination, should the loans be categorized as ‘Special Mention’. However, loans to businesses in certain industries (for example, those with declining revenues or reducing margins or which are subject to specific competitive issues) may be included.
           
          1.4.8Loans, which exhibit well-defined weaknesses and a distinct possibility of loss, should be assigned the following categories from less to most severe:
           
           •“Substandard”
           
           •“Doubtful”
           
           •“Loss”
           
           Loans in the ‘Substandard’, ‘Doubtful’ and ‘Loss’ categories would be collectively termed as “non-performing” credits.
           
          1.4.9‘Substandard’ Category
           
           Loans in this category have well-defined weaknesses, where the current financial soundness and paying capacity of the obligor is not assured. Orderly repayment of debt may be in jeopardy. A ‘Substandard’ loan is inadequately protected by future cash flows, the obligor’s current net worth or by the collateral pledge, if any. An important indicator is that any portion of commission/income or principal or both are more than 90 days past due or where there is insufficient credits for an overdraft. For corporate, government and private banking loans and other individually reviewed loans, the 90 days past due rule will also generally apply, unless a bank has strong documentary evidence to support a different classification.
           
          1.4.10‘Doubtful’ Category
           
           A loan classified as ‘Doubtful’ has all the weaknesses inherent in one classified ‘Substandard’ with the added characteristic that the weaknesses make collection or liquidation of the principal and contractual commission/income in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Classification as ‘loss’ is not warranted because of specific factors that generate additional cash flows other than from realization of existing collateral. Such factors include business cash flows, potential merger, acquisition, capital injection or additional collateral. In general a loan where the principal and commission are more than 180 days past due should be included in this classification, except where a bank has strong documentary evidence to support a different categorization such as ‘Sub-standard’ or ‘Special Mention’.
           
          1.4.11‘Loss’ Category
           
           A loan classified as ‘Loss’ is considered uncollectible in the normal course of business and recourse will have to be made to collateral. Loss category does not mean that the asset has absolutely no recovery or salvage value but rather that it is prudent to establish a provision for the entire loan not covered by collateral. For private banking loans and other individually reviewed loans where principal or commission/income are past due for more than 360 days should be included in this classification except where a bank has strong documentary evidence to support a different categorization.
           

        • 1.5 Split Classifications

          1.5.1Split classifications refer to the practice of assigning different classifications to different entities within the same group relationship, or to different loans extended to the same obligor, or to different portions of a single loan.
           
          1.5.2Split within a relationship. Loans extended to subsidiaries of a parent company on the basis of direct or implied support from the parent should generally not be classified at the higher level than the parent. On the other hand, loans extended to subsidiaries without direct or implied parent support may be classified at a lower level than the parent. An exception may be where there is tangible collateral or independent cash flow.
           
          1.5.3Split to same obligor. All loans extended to one borrower should generally be classified at the same level. However, certain loans to an obligor may be classified at a different level than other loans if they are secured by collateral or guarantees of unquestionable value. For example, a loan secured by properly hypothecated cash collateral would be less severely classified than other less well-secured loans to the same borrower.
           

        • 1.6 Assessing Classification and Impairment of a Group of Loans

          1.6.1Generally, it is impractical for a bank to analyze and provide for impairment losses for their smaller loans on an individual, Ioan by loan basis, e.g. consumer and credit card loans. For groups of small homogenous loans, the loss attributes should normally be based on available information such as past due status.
           
          1.6.2For retail and consumer loans, it is difficult or impractical to make an individual assessment, the banks should use the following classification system to classify outstandings on a grouped basis.
           
          1.6.3Standard Loans. Loans in this category are performing and have sound fundamental characteristic of credit history, cash flow and timely repayment. These are normally represented by current balances with no hint of default.
           
          1.6.4Special Mention. These loans exhibit potential weaknesses that at a future date may result in deterioration of repayment. These loans are current and up to date but deserve management’s close attention.
           
          1.6.5Substandard. Loans where any portion of commission income or principal are more than 90 days overdue.
           
          1.6.6Doubtful Category. Loans where any portion of commission income or principal are more than 180 days overdue.
           
          1.6.7Loss Category. Loans where any portion of commission income or principal are overdue by more than one year.
           
          1.6.8For banks that wish to use more sophisticated methodologies based on historical data, there is no single best method for quantifying loss attributes for groups of loans. Acceptable methods range from a simple average of bank’s historical loss experience over a period of years to more complex ‘migration’ analysis techniques. The specific method often depends on the sophistication of a bank’s information system.
           

        • 1.7 Recognition of Income

          1.7.1Notwithstanding the provisions made under Section II below, all commission/income accrued but not received on loans that become non-performing should not be recognized as income and should be transferred to a commission/income in suspense account. Similarly, commission/interest charged to a non-performing overdraft is not considered to have been received. The bank should set aside a specific provision for the full amount of the commission transferred to the suspense account. This provision would offset the commission income receivable included under assets. These transfers to a suspense account should be made without regard to collateral, if any, and the possibility of the ultimate collection of the overdue amounts.
           
          1.7.2When amounts are received from borrowers in repayment of overdue commission/income or overdue principal, such amounts should first be offset against the overdue commission. This should be followed until such time as the loan is regularized and can be classified as performing, i.e. Standard or Special Mention.
           

      • Section II Minimum Provisioning Requirements

        • 2.1 General Provisions

          Experience shows that loan portfolios often contain loans which are in fact impaired at that balance sheet date, but which will not be specifically identified as such until some time in the future. Generally, there will not be sufficient information on hand during the review of loans to be certain that all impaired loans have been identified or of the correctness of the estimated losses and the adequacy of the provision for loan losses. 
           

        • 2.2 Impaired Loans

          As a result, a general provision should be made to cover the impaired loans which will only be identified as such in the future. Unless otherwise prescribed by SAMA, this general provision should be a minimum of 1% of the outstanding balances of the Standard and Special Mention categories. All Saudi government loans or claims fully backed by collateral of Saudi government in form of securities or guarantees should be deducted before calculating general provision. 
           

        • 2.3 Historical Data

          In general, if a bank has at least 3 years of reliable historical data captured through a system validated and approved by SAMA, it could establish an appropriate general provision using such data adjusted for current observable conditions. Such banks may seek exemption from SAMA in relation to the requirements in paragraph 2.2 above. Saudi banks are also encouraged to develop and implement more sophisticated systems that capture historical data on loan defaults and loss experience that could be used for general provisioning purposes. Although historical loss experience provides a reasonable starting point for a bank analysis, these cannot be accepted without analysis of current conditions and future prospects. Banks must make an adjustment that should reflect management’s best estimate of the level of charge-offs or specific provision that will be recognized. Factors include: 
           
           •Change in national and international lending policies and procedures.
           
           •Change in local, national and international economic and business conditions.
           
           •Changes in trends, volumes and severity of past due loans, impaired loans and troubled debt restructuring.
           
           •Changes in experience, depth and ability of lending management and staff.
           
           •Changes in bank’s loan review system and the degree of oversight by the Board.
           
           •Existence and effect of any concentration of credit.
           
           •Effect of external factors, competition, legislation, regulatory requirement, etc.
           
           •Changes in the risk profile of the portfolio as a whole.
           
          Loans that have been individually analyzed and provided for with a provision should also be included in the group for determining a bank’s historical experience for such group. However, to avoid double counting, loans for which specific provision has already been made should be subtracted from the group before a historical loss factor is applied to the group to establish appropriate general provisions. 
           
          Saudi banks should use a period of at least 3 years to determine their average historical loss experience. However, banks should weigh recent experience more heavily to accurately estimate bank’s expected losses in the current economic climate. 
           

        • 2.4 Specific Provisions

          A specific provision should be made for incurred and expected losses for individually assessed corporate, government, private banking and other large loans to reduce the carrying value of impaired credits to their estimated net realizable amount. Retail loans that fall under the non-performing loan categories should also be covered by specific provisions. Unless otherwise prescribed by SAMA, the following minimum provisions should be made on the aggregate of individual net exposures for each classification category. Loans which have been individually assessed and on which specific provisions, in excess of the prescribed minimum, have been made should be excluded in computing the minimum provisions by each classification category. Minimum provisions are to be computed on the net exposure which represents the balance outstanding less a prudent estimate of the fair value of the perfected collateral. 
           
          CategoryMinimum Provision
           (% of net exposure)
          ‘Substandard’25%
          ‘Doubtful’50%
          ‘Loss’100%

        • 2.5 Treatment of Differences between Supervisory and Accounting Provisions

          Saudi banks are expected to apply the relevant Accounting Standards. For purposes of bank accounting and financial reporting, the computation of general and specific provisions for loan impairment is governed by these accounting standards. Consequently, these are likely to differ from the supervisory general and specific provisions provided in this circular. While the accounting provisions are to be used for all published financial statements of a Saudi bank, the supervisory provisions are to be used solely for the purpose of prudential reporting to SAMA. 
           
          The treatment of accumulated specific and general accounting and supervisory provisions will continue to be guided by the relevant accounting standards and relevant SAMA rules respectively. However, the difference in the annual charge between accounting and supervisory provisions must be reflected by an adjustment directly into the accumulated retained earnings of the bank on the supervisory returns. In case a bank has no retained earnings, the adjustment will be made to the general or statutory reserves after discussion with the Central Bank on a case by case basis. 
           

      • Section III. Other Matters

        • 3.1. Rescheduled Loans

          A restructured troubled loan arises when a bank, for economic or legal reasons related to the obligor’s financial difficulties, grants him a concession that it would not otherwise consider. A bank should measure a restructured troubled loan by reducing the recorded outstanding to net realizable value as required by the relevant accounting standards, taking into account the cost of all concessions at the date of restructuring. The reduction in the outstanding amount should be recorded as a charge to the income statement in the period in which the loan is restructured. 
           
          In cases where non-performing loans in particular are rescheduled, such loans should not be upwardly reclassified merely because of the existence of a rescheduling agreement. Upward reclassification should only be made if and when there is sufficient evidence of adherence to the terms of the rescheduling agreement. This evidence would include the establishment of a history for at least 12 months of timely repayments of both principal and commission/interest under the rescheduling agreement. 
           

        • 3.2. Overdrafts

          Formal procedures should be put into place to support the determination of the classification of an overdraft based on transactions within the overdraft and in particular the timeliness of repayments of commission/income. 
           
          As a minimum, these procedures should include: 
           
          •Periodic systematic comparison of the aggregate value of credits in the overdraft account with the repayments due and other debits in the account.
           
          •Understanding the nature and source of the credits in the account.
           
          •Review of the history of the account balance.
           

        • 3.3. Collateral

          Prudent and proper valuation of collateral is critical to the determination of provisions. Proper procedures should be put into place to value collateral on a periodic basis, at least once a year, using external appraisers or external reliable published information. In cases where judgment is used in the valuation of the collateral and where the collateral or the credit is significant, valuations should be carried out by more than one external appraiser. In general, collateral obtained for consumer credit and similar credits where large number of relatively small balances is outstanding would be excluded from such requirements. The valuations so obtained should be adjusted downwards by an appropriate percentage to reflect costs of disposal, fluctuations in market values and the inherent lack of accuracy in such valuations. 
           

        • 3.4. The Basel Capital Accord and Provisioning

          The Basel 2 Capital Accord provides incentives to internationally active banks to develop and implement sophisticated and advance system for measuring and capturing credit, market and operational risks. For credit risk, it encourages banks to develop and implement sophisticated internal ratings based approaches. As a minimum, it requires all credit risk on the bank’s banking book to be classified into a system that has as a minimum 7 grades for performing loans and one for non-performing loans. It also requires banks to gather data for a minimum of 3 years on their history of losses arising from loan defaults. Data gathered from such systems permits banks and supervisors to collect information on Probability of Default (PD), Loss Given Default (LGD), and Expected Amount at Default (EAD). Such data permits banks to compute a capital charge for capital ratio purposes, using the risk weighted assets models designed by Basel under the IRB approach. 
           
          SAMA encourages all Saudi banks to understand, develop and implement, where cost-justified and appropriate, IRB approaches for capital adequacy purposes. While the IRB systems are primarily aimed at computation of regulatory capital, it is understood that the information on historical loss experience may have relevance for a bank’s calculation of general provisions. Consequently, SAMA will encourage Saudi banks to look into ways of aligning their capital adequacy and provisioning methodologies. 
           

      • Section IV. Independent Credit Review System

        • 4.1. Introduction

          All Saudi banks are expected to establish a system of independent, ongoing credit review and results of such reviews should be communicated directly to senior management, the Board of Directors and the Audit Committee. While the determination of the impairment of an asset is made by banks based on their own internal credit review procedures, which can vary from one bank to another, this regulation is aimed at ensuring that banks’ own systems as a minimum meet the following requirements. 
           

        • 4.2. Objectives

          The principal objectives of an effective independent credit review system are as follows: 
           
          •To ensure the credits are appropriately classified;
           
          •To ensure that credits with potential or well-defined weaknesses are identified promptly and that timely action is taken to minimize credit losses;
           
          •To project relevant trends that affect the collectibility of the portfolio and to isolate potential problem areas;
           
          •To review the adequacy of the allowance for credit losses;
           
          •To assess the adequacy of and adherence to internal credit policies and administrative procedures and to monitor compliance with relevant laws and regulations;
           
          •To evaluate the activities of credit personnel;
           
          •To provide senior management, the Board of Directors and the Audit Committee with an objective and timely assessment of the overall quality of the credit portfolio; and,
           
          •To ensure that management is provided with accurate and timely information related to credit quality that can be used for financial and regulatory reporting purposes.
           
          For an effective achievement of the above objectives, financial institutions should operate an independent credit review system having regard to the size of the institution and the complexity of its operations. 
           

        • 4.3. Elements of an Independent Credit Review System

          An institution’s written policy on its independent credit review system should address the following elements: 
           
          •Qualifications of credit review personnel
           
          •Independence of credit review personnel
           
          •Frequency of reviews
           
          •Scope of reviews
           
          •Depth of reviews
           
          •Review of findings and follow-up
           
          •Workpaper and report distribution
           

        • 4.4. Qualifications of Credit Review Personnel

          Persons involved in the credit review function should be qualified based on level of education, experience, and extent of formal credit training and should be knowledgeable in both sound lending practices and the institution’s lending guidelines for the types of credits offered by the bank. In addition, these persons should be knowledgeable of all relevant laws and regulations affecting the bank’s lending activities. 
           

        • 4.5. Independence of Credit Review Personnel

          An effective credit review system utilizes both the initial identification of emerging problem credits by credit officers, and the review of credit by individuals independent of the credit approval decisions. An important element of an effective system is to place responsibility on credit officers for continuous portfolio analysis and prompt identification and reporting of problem credits. Because of their frequent contact with borrowers, credit officers can usually identify potential problems before they become apparent to others. However, financial institutions should be careful to avoid over-reliance upon credit officers for identification of problem credits. Financial institutions should ensure that credits are also reviewed by individuals who do not have control over the credits they review and are not part of, or influenced by anyone associated with, the credit approval process. 
           
          While larger financial institutions would typically establish a separate department (unit) staffed with credit review specialists, cost and volume considerations may not justify such a department in smaller financial institutions. In smaller financial institutions, an independent credit review officer or internal audit may fill this role. 
           

        • 4.6 Frequency of Reviews

          Optimally, the credit review function can be used to provide useful continual feedback on the effectiveness of the credit process in order to identify any emerging problems. For example, the frequency of independent review of significant credits could be at least annually, upon renewal, or more frequently for ‘Special Mention’ loans, or when internal or external factors indicate a potential for deteriorating credit quality in a particular type of credit or pool of credits. A system of on-going or periodic portfolio reviews is particularly important for the provisioning process, which is dependent on the accurate and timely identification of problem credits. 
           

        • 4.7. Scope of Reviews

          The review should cover all credits that are significant. Also, the review typically includes, in addition to all credits over a pre-determined size, a sample of small credits, past due, non-accrual, renewed credits, restructured credits, credits previously considered non-performing or designated as ‘Special Mention’, related party credits, and concentrations and other credits affected by common repayment factors. The sample for each type of facility/portfolio selected for review should provide reasonable assurance that the results of the reviews have identified the major problems in the portfolio and reflect its quality as a whole, Financial institutions’ management is required to document the scope and the process of its reviews. The scope of credit reviews should be approved by the financial institutions’ Board of Directors and its Audit Committee on an annual basis or when any significant changes to the scope of reviews are made. 
           

        • 4.8. Depth of the Reviews

          These reviews should analyze a number of important aspects of selected credits, including: 
           
          •Credit quality
           
          •Sufficiency of credit and collateral documentation
           
          •Proper lien perfection
           
          •Proper approvals
           
          •Adherence to any credit agreement covenants
           
          •Compliance with internal policies and procedures and laws and regulations
           
          •Appropriateness of the classification assigned to the credits
           
          •Adequacy of the provisions made against such credits
           
          Furthermore, these reviews should consider the appropriateness and timeliness of the identification of problem credits by credit officers and the adequacy of the overall level of provisions for the whole credit portfolio and for the nonperforming credits. 
           

        • 4.9. Review of Finding and Follow-Up

          Findings should be reviewed with appropriate credit officers, department managers, and members of senior management and any existing or planned corrective action should be clarified for all noted deficiencies and identified weaknesses, including the timeframes for correction. All noted deficiencies and identified weaknesses that remain unresolved beyond the assigned timeframes for correction should be promptly reported to senior management, the Board of Directors and the Audit Committee. 
           

        • 4.10. Workpaper and Report Distribution

          A list of credits reviewed, the date of the review and documentation (including summary analysis) to substantiate assigned classifications of credits should be prepared on all credits reviewed. A report that summarizes the results of the credit review should be submitted to the Board of Directors on at least a quarterly basis. In addition to reporting current credit quality findings, comparative trends can be presented to the Board of Directors that identify significant changes in the overall quality of the portfolio. Findings should also address the adequacy of and adherence to internal policies, practices and procedures, and compliance with laws and regulations so that any noted deficiencies can be remedied in a timely manner. 
           

      • Annex 1 SAMA Prudential Return Classification of Loans For the Quarter Ending

         Individually Assessed Loans Loans Assessed as a Group Total Loans
         (SR OOP's) (SR 000's) (SR OOP's)
         Current QTRPrevious QTRQTR in Previous Year Current QTRPrevious QTRQTR in Previous Year Current QTRPrevious QTRQTR in Previous Year
        Standard           
        Special Mention           
        Substandard           
        Doubtful           
        Loss                                                                                                     
        TOTAL                                                                                                     
                    

      • Annex 2 SAMA Prudential Return Supervisory Loan Provisioning For the Quarter Ending

          (SR 000's)
        Current Quarter        		  
          Gross Loan AmountInterest in SuspenseGeneral ProvisionSpecific ProvisionTotalTotal Previous QTRCurrent QTR Charge to Net Income
        1.Standard       
        2.Special Mention       
        3.Substandard       
        4.Doubtful       
        5.Loss                                                                             
        TOTAL                                                                             
        6.Provisions for Published Statements per IAS                                                         
         Retained Eaminqs:       
         • Retained Earnings on Supervisory Returns                 
        7.Cumulative Charge (Addition) to Accumulated Retained Earnings on Supervisory Return                 
        8.Supervisory Retained Earnings at end of the period                 

      • Annex 3 SAMA Prudential Return List of Individually Assessed Loans Where Exceptions Made to the 90, 180, 360 Day Rule for Classification For the Quarter Ending

        (SR 000's)

        I.Analysis of the Loan Portfolio:
         
         Performing LoansLoans 90 OverdueLoans 180 OverdueLoans 360 OverdueTotal
        Number of Loans     
        Amount     
        II.Analysis of Exceptions:
         
         Gross Amount(SR OOP's) Loans on Which Exceptions MadeImpact on Classification
          Number of LoansAmount(+ or -)
        Standard    
        Specific Mention    
        Substandard    
        Doubtful    
        Loss    
        TOTAL    
        III.List 10 Major Loans on which exceptions made:
         
        (SR OOP's)
        Name of CounterpartyAmountImpact on Classification (+ or -)

      • Annex 4 Guidance Notes for Prudential Returns For Loan Classification and Provisioning

        1.Annex 1 - Loan Classification
         
         •Columns 1, 4 and 7 - Total reflects gross loan amount before Provisions.
         
         •Columns 2, 5 and 8 - Previous quarter gross Loans.
         
         •Columns 3, 6 and 9 - Same Quarter previous year.
         
         •Totals in columns 7, 8 and 9 should agree with total for item 9 on the M-1 returns.
         
        2.Annex 2 - Loan Provisioning
         
         •Column 1 - Shows gross loan outstanding amounts before Provisions. This should agree with item 9 on M-1 Return.
         
         •Column 2 - Interest in suspense to agree with 27.2 on M-1 return.
         
         •Column 3 - Shows general provisions to agree with 27.13 on M-1.
         
         •Column 4 - Shows specific provisions to agree with 27.12 on M-1.
         
         •Column 5 - Total Provisions for columns 2, 3 and 4.
         
         •Column 6 - Total provisions for same Quarter in previous year
         
         •Column 7 - This should reflect the charge (or credit) to net income on supervisory returns for the current Quarter.
         
         •Item 6 - This line should reflect the most recent available Quarter (indicate date) for which Accounting provision information is available.
         
         •Item 7 - This should reflect the adjustment (charge or credit) to supervisory Accumulated Retained Earnings arising from the difference between supervisory and accounting provisions.
         
         •Item 8 - Supervisory retained earnings at the end of the Quarter.
         
        3.Annex 3 - Loan Classification Exceptions
         
         •Item I - This is a simple aging analysis of the loan portfolio of the bank in terms of the number of loans and the amounts (before any exceptions are made).
         
         •Item II - Analysis of Exceptions:
         
          •Column 1 - Shows gross amount of loans in each category - equals item 9 on M-1.
         
          •Column 2 - Shows # of loans on which exception is made
         
          •Column 3 - Shows Amount of Loans on which exception is made
         
          •Column 4 - Impact of the exception on proposed classifications - show + or i.e. net impact on classification grades.
         
         •Item III - Shows impact for top 10 loans on standard classifications.