2.1 Early Warning Signals
| No: 41033343 | Date(g): 6/1/2020 | Date(h): 11/5/1441 | Status: In-Force |
Effective from Jul 01 2020 - Jun 30 2020
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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.