1. Identification:

Effective from Jan 06 2020 - Jun 30 2020
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Early warning signs are indicators that point to potential payment difficulties. These indicators could be alienated into five broad categories:
i.	Economic environment,
ii.	Financial indicators,
iii.	Behavioral indicators,
iv.	Third-party indicators, and
v.	Operational indicators.
The main aim of this list is to produce a comprehensive set of signals that provides the bank an opportunity to act before the borrower’s financial condition deteriorates to the point of default. Each of these categories has been explained below from sections “i to v”.
It is the responsibility of the unit/section assigned for managing EWS process to interpret the signals received from a borrower and determine whether that borrower should be included in the watch list (prepared on the basis of EWS) for further corrective action.
In most cases, such a decision will involve the identification of groups of signals that validate one another. Taken alone, individual indicators can be too ambiguous/inconclusive to predict financial distress, but when a holistic approach is adopted the unit/ section responsible for managing EWS, may decide that the combination of certain signs anticipates serious financial distress.
Determining what combination of signs, that will trigger the scenario to classify the borrower as watch list, requires adequate knowledge of the industry and will involve some subjective judgment as well. In most cases, the specialized unit will have to identify very subtle warning signs that reinforce others in arriving at a judgment. These subtle signs might be based also on personal contacts between the bank and the borrower, especially in the context of medium-size enterprises.
For example, a trigger for the transfer to the watch list could be a signal received from only one substantial indicator, such as Debt/ Earnings before interest, taxes, depreciation and amortization (EBITDA) to be above 5 (the aforementioned example has been included for clarity purposes only and; should not be viewed as SAMA’s interpretation of the given financial ratio). However, the transfer may also be triggered by the combination of less significant indicators, e.g., an increase in the general unemployment rate, increase in days of receivables outstanding, or frequent changes of suppliers. In addition, signals received from at least two less significant indicators could trigger a deeper review of the borrower’s financial health.
The bank may expand the list of substantial indicators based on the findings from the analysis of the historical data and backtesting results. For the purpose of simple EWS approach (using one or multiple indicators with specific thresholds), the bank should define trigger points for creating signals based on good practice and analysis of historical data. In case of availability, a differentiation between the thresholds for different economic sectors would be a good practice. The bank should apply a prudent approach when selecting specific thresholds for particular indicators.
Criteria for the inclusion in the watch list should be applied at the individual level or at a portfolio level. For example, if real estate prices fall by more than 5 percent on an annual basis, for the group of loans that have real estate as collateral a review should be performed to determine if the collateral value is adequate in the light of price adjustment or not. Collateral evaluation should be done in accordance with SAMA Guidelines. In cases the collateral is no longer sufficient, a bank should take corrective action to improve collateral coverage.
An additional factor that should be considered in managing EWS is the concept of materiality. For this reason, a bank may define a level of average loan size in the NPL portfolio, determine that all loans above this indicator are material, and require more attention from the bank. The main principle behind this concept is to give a higher level of attention, scrutiny, and resources to specified cases.
i.	Economic environment:
	Indicators of the overall economic environment are very important for the early identification of potential deterioration of the loan portfolio. Their importance stems from the fact that they can point to the likely economic downturn. As such, they are a powerful determinant of the future direction of loan quality (as per international practices, real gross domestic product (GDP) growth is the main driver of nonperforming loan ratios) influencing not only the individual borrower's ability to pay his obligations but also collateral valuations.
	Table 1 below provides major indicators that should be monitored to identify potential loan servicing difficulties early on. Data sources for these indicators should be a combination of the bank’s internal economic forecasts and (particularly, in case of smaller banks) forecasts of respected forecasting banks in the country or abroad. Indicators of economic environment are especially relevant for predicting the future payment ability of individual entrepreneurs and family business owners. Given the broad nature of these indicators, they should be monitored continuously using information collected on a monthly or quarterly basis. When a downturn is signaled, a more thorough review of those segments of the portfolio that are most likely to be affected should be undertaken.
Table 1: List of Potential Economic Environment Indicators

Indicator	Description
Economic sentiment indicators (early indicator on monthly basis) or GDP growth	Economic growth directly influences borrowers’ (company and individuals) ability to generate cash flows and service their loans. Major changes in economic sentiment indicators and consequently growth forecasts should serve as a key flag for certain loan groups (retail, real estate, agriculture, hospitality sector, etc.). In most cases, oil prices, government spending, and inflation along with GDP growth has a good correlation with the prices of real estate. In a forecasted economic contraction, horizontal adjustments to real estate valuations (all assets classes) should be made.
Inflation/deflation	Above-average inflation or deflation may change consumer behavior and collateral values.
Unemployment	For MSME, an increased unemployment rate indicates a potential adjustment in the purchasing power of households, thus influencing businesses’ ability to generate cash flows to service their outstanding liabilities. Non-elastic consumption components (e.g., food, medicine) will be less sensitive to this indicator than elastic ones (e.g., hotels, restaurants, purchase of secondary residence and vacationing).

	Note: The above has been outlined for illustrative purposes only,
ii.	Financial indicators:
	Financial indicators (Table 2) are a good source of information about the companies that issue financial reports. However, it is not sufficient to rely only on annual financial reports. To ensure that warning signals are generated in a timely manner, the bank may require more frequent interim financial reporting (e.g., quarterly for material loans and semi-annual for all others).
	Data sources for financial indicators may be either company financial statements received directly from the borrower. For example, an increase in debt/EBITDA ratio could be due to (i) an increasing loan level, or (ii) a decrease of EBITDA. In the first case, appropriate corrective action could be the pledge of additional collateral. In the second case, it could be a short term or permanent phenomena and corrective actions could range from light restructuring to a more comprehensive restructuring of the obligations as part of the workout process. Financial indicators should be monitored continuously based on quarterly financial statements for material loans and on a semi-annual basis for others.
Table 2: List of Potential Financial Indicators

Indicator	Description
Debt/EBITDA	The prudent ratio should be used for most companies with somewhat higher threshold possible for sectors with historically higher ratios.
Capital adequacy	Negative equity, insufficient proportion of equity, or rapid decline over a certain period of time.
Interest coverage - EBITDA/ interest and principal expenses	This ratio should be above a defined threshold.
Cash flow	Large decline during reporting period, or negative EBITDA.
Turnover (applicable for MSME)	A decrease in turnover, loss of substantial customer, expiry of patent.
Changes in working capital	Lengthening of days in sales outstanding and days in inventory.
Increase in credit loan to customers	Lengthening of days in receivables outstanding. Sales can be increased at the expense of deteriorating quality of customers.

	Note: The above has been outlined for illustrative purposes only.
	For the MSME portfolio, wherein the quality of financial statements is weak it may be feasible to develop financial ratios based on cash flow statements, Banks are therefore advised to require the respective borrower to disclose details of all its bank accounts maintained, so as to enable capturing the state of liquidity. However, the privacy of the borrowers has to be ensured and written consent needs to be taken in order to access their personal information.
iii.	Behavioral indicators:
	This group of indicators (Table 3) includes signals about potential problems with collateral adequacy or behavioral problems. Most of these signals should be monitored at a minimum on a quarterly basis with more frequent monitoring of occupancy rates and real estate indexes during downturns.
Table 3: List of potential behavioral indicators:

Indicator	Description
Loan to value (LTV)	LTV > 100 % indicates that the value of the collateral is less than the loan amount outstanding. Reasons for this could be that collateral has become obsolescent or economic conditions have caused a rapid decrease in value. To be prudent, the ratio should be below 80 %, to provide adequate cushion to cover the substantial cost associated with collateral enforcement.
Downgrade in internal credit risk category	An annual review of borrower's credit profile reveals shortcomings.
Breaches of contractual commitments	Breach of covenants (financial or non-financial) in the loan agreement with bank or other financial institutions.
Real estate indexes	The bank should monitor real estate indexes in adequate-granularity. Depending on the collateral type (commercial or individual real estate) the bank needs to establish reliable, timely, and accurate tracking of changes in respective values. Decline larger than 5 percent on annual basis (y/y) should create a flag for all loans that have similar collateral. At this stage, the bank should review if LTV with the new collateral value is adequate.
Credit card loans	Delay in settling credit card loans or increasing reliance on provided credit line (particularly for partnerships and individual entrepreneurs).

	Note: The above has been outlined for illustrative purposes only.
iv.	Third-party indicators:
	The bank should organize a reliable screening process for information provided by third parties (e.g. rating agencies, tax authorities, press, and courts) to identify signs that could lead to a borrower’s inability to service its outstanding liabilities. These should be monitored on a daily basis so that they can be acted on immediately upon receipt of the information.
Table 4: List of potential third party information indicators

Indicator	Description
Default / any negative information	SIMAH Report / Negative press coverage, reputational problems, doubtful ownership. and involvement in financial scandals.	SIMAH Report / Media
Insolvency proceedings for major supplier or customer	May have a negative impact on the borrower	Information from courts and other judicial institutions.
External rating assigned and trends	Any rating downgrade would have been an indicator deteriorating in the borrower profile	Rating Agencies

	Note: The above has been outlined for illustrative purposes only.
v.	Operational indicators:
	In order to capture potential changes in the company’s operations, close monitoring of frequent changes in management and suppliers should be arranged.

Indicator	Description
Frequent changes in senior management	Often rotation of senior management, particularly Chief Executive Officer (CEO), Chief Financial Officer (CFO), Chief Risk Officer (CRO), could indicate internal problems in the company.	Annual report and discussion with the company.
Qualified audit reports	At times, auditors raise concerns about the quality of financial statements by providing modified opinions such as qualification, adverse and even some times disclaimer.	Annual report
Change of the ownership	Changes in ownership or major shareholders (stakeholders or shareholders).	Public registries and media.
Major organizational change	Restructuring of organizational structure (e.g., subsidiaries, branches, new entities, etc.).	Public registries and media.
Management and shareholder contentiousness	Issues arising from the management and from the shareholders which would result in serious disputes.	Public registries and media.

It is important to note that the proposed categories and indicators presented above are not exhaustive. Each bank should work to create a solid internal database of these and other indicators, which should be, utilized for EWS purposes. The indicators from the database should be backtested in order to find out the indicators with the highest signaling power. For this purpose, indicators should be tested at different stages of an economic cycle.

Note: The above has been outlined for illustrative purposes only.

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