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  • 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.