Circular Re. The Rules Governing Credit Risk Exposure Classification and Provisioning for Finance Companies

Rules Governing Credit Risk Exposure Classification and Provisioning

November 2020

Saudi Arabian Monetary Authority

Contents

1. GENERAL REQUIREMENTS .................................................................................................................... 3
2. GOVERNANCE ........................................................................................................................................ 8
3. CREDIT RISK CLASSIFICATION............................................................................................................ 10
4. EXPECTED CREDIT LOSS PROVISIONING............................................................................................ 14
5. INTEREST RECOGNITION...................................................................................................................... 14
6. MACROECONOMIC FACTORS ............................................................................................................. 15
7. RESTRUCTURING................................................................................................................................... 16
8. DEFAULT.................................................................................................................................................. 19
9. WRITE-OFF ............................................................................................................................................. 20
10. CREDIT RISK MANAGEMENT.............................................................................................................. 21
11. IMPLEMENTATION ............................................................................................................................... 22
12. ANNEXURES........................................................................................................................................... 23

Rules Governing Credit Risk Exposure Classification and Provisioning

1. General Requirements

1.1 Introduction

Saudi Arabian Monetary Authority (SAMA) issued these rules in exercise of the powers vested upon it under Finance Companies Control Law promulgated by the Royal Decree No. (M/51) on 13/08/1433H and in pursuance of the Implementing Regulation of Finance Companies Control Law promulgated by the resolution of the Governor No (2/M U T) dated 14/04/1434H.

In reference to Article no. 13 of Finance Companies Control Law “The finance company shall allocate a provision for contingent operation losses in accordance with the criteria specified under the Regulations,” and Article 62 of the Implementing Regulation of the Finance Companies Control Law “The finance company must set provisions for contingent losses and risks in accordance with international accounting standards. SAMA may require the finance company to make one or more additional provisions for such losses and risks.”

These Rules set out the minimum requirements on Credit Risk Exposure Classification and Provisioning. A finance company’s credit risk exposure classification and provisioning are components of its credit risk management framework. Credit Risk Management must be performed by finance companies through the use of appropriate policies, procedures, and controls that identify, measure, monitor, control and report the actual credit risk of the finance company. Finance companies will not be able to achieve compliance with these Rules unless there is an effective and robust Credit Risk Management Framework that is commensurate with the nature, size, complexity and level of their credit risk exposure. As a result, finance companies must first conduct an analysis of current risk management framework to determine what adjustments are necessary as a result of these Rules, and implement the necessary remediating actions to ensure full compliance by the effective date.

It should be noted that the Board of Directors and Management of the finance company are responsible to set adequate policies and procedures, maintaining sound asset quality, having an adequate level of provisions and general reserve for credit losses at all times, and having effective exposure approval management and classification procedures, as well as an appropriate framework for dealing with problem exposures.

1.2 Objective of the Rules

The main objectives of these Rules are to enable finance companies to:

i. Evaluate the degree of credit risk associated with exposures;
ii. Prudently value exposure portfolio;
iii. Determine and make adequate provisions for expected credit losses following robust governance; and
iv. Achieve uniformity and consistency in exposure classification and provisioning methodologies.

1.3 Scope of Implementation

These Rules shall be applicable to all finance companies licensed pursuant to Finance Companies 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:

SAMA: Saudi Arabian Monetary Authority
Rules: Rules Governing Credit Risk Exposure Classification and Provisioning Credit Exposure: As prescribed by IFRS 9, this include loans and advances and other types of on- and off-balance sheet credit exposure (financial guarantees, bid and unutilized un-cancellable commitments and others), accrued commission / income receivable, commitments and contingent liabilities and any other commission / non-commission bearing credit-related instruments and arrangements. This will also include investments in non-trading debt securities (long-term/held-to-maturity investments) e.g. certificates of deposit, commercial papers and other negotiable debt instruments. Restructured Exposure: Any exposure arrangement in which the original terms and conditions have been changed or modified. Normal annual renewal of exposures should not be categorized as restructured exposure. Restructuring may occur in the form of either forbearance or renegotiation. Forborne Exposure and Renegotiated Exposure are defined as below:

a. Forborne Exposure: Any exposure arrangement in which the original terms and conditions have been changed or modified such that the modified terms result in a concession to the borrower, and the modification, which would not have been otherwise granted, was granted as a result of the borrower’s financial difficulty. b. Renegotiated and/or Refinanced and/or Rescheduled Exposure: Any exposure arrangement in which the original terms and conditions have been modified. However, the modification does not necessarily results in a concession to the borrower and the modification was not granted as a result of the borrower’s financial difficulty. These 3 terms have the same interchangeable meanings and should be used accordingly, if needed. Any other new term should be discussed with SAMA before using in practice.

Probability of Default: Measures the estimated likelihood of default over a time horizon as prescribed by IFRS 9.
Exposure at Default: As prescribed by IFRS 9, it measures estimated risk exposure at the time of likely default taking into consideration any prepayments, repayments of principal and interest, and drawdowns. This includes both on and off-balance sheet exposure. No consideration is given to collateral when determining the exposure at default. Loss Given Default: Measures the estimated risk of loss as prescribed by IFRS 9 i.e. the risk exposure adjusted for collateral and other recovery proceeds, fluctuation in market value and realization costs. Eligible collateral as elaborated in Annexure 1 should be included in the Loss Given Default calculation. Financial Asset: As prescribed by IFRS 9, a financial asset is any asset that is cash, an equity instrument of another entity, a contractual right to receive cash or another financial asset from another entity or to exchange financial asset or financial liabilities with another entity under conditions that are potentially favorable to the entity. This includes derivative and non-derivative contracts. Expected credit loss: As prescribed by IFRS 9, the estimated credit losses expected to be incurred from the occurrence of a credit event, e.g. default. Lifetime expected credit loss: As prescribed by IFRS 9, the expected credit losses that result from all possible default events over the life of the financial asset. 12-month expected credit loss: As prescribed by IFRS 9, the expected credit losses that result from those default events on the financial asset that are possible within 12 months after the reporting date. Stage 1 Exposure: As prescribed by IFRS 9, any exposure for which there is no significant increase in credit risk since origination or otherwise are considered high quality (i.e. rated of investment grade) or exhibit indicators of low credit risk. This exposure can be mapped to “Regular” Loans regulatory category (for the naming convention only) given in SAMA previous circular on Provisions Guidelines issued on 27/04/1438H. Stage 2 Exposure: As prescribed by IFRS 9, any exposure for which there is a significant increase in credit risk since origination. This includes rebuttable presumption that the credit risk has increased significantly when contractual payments are more than 30 days past due. This exposure can be mapped to “Special Monitoring Accounts and Substandard” regulatory category (for the naming convention only keeping in view conservatism of

IFRS 9) given in SAMA previous circular on Provisions Guidelines issued on 27/04/1438H.
There are 2 categories in Stage 2 exposures as defined in these rules for regulatory reporting purposes only and not for accounting purposes, i.e. Stage 2A and Stage 2B. Stage 2A or Special Monitoring Account category represents lower levels of credit risk within the stage 2 allocation while Stage 2B or substandard category represents moderate levels of credit risk within the stage 2 allocation. Stage 3 Exposure: As prescribed by IFRS 9, any exposure which is assessed as impaired or otherwise is in default as determined in Section 8 of these Rules. This includes the fact that the credit risk has significantly increased when contractual payments are more than 90 days past due. This exposure can be mapped to “Doubtful and Loss” regulatory category (for the naming convention only keeping in view conservatism of IFRS 9) given in SAMA previous circular on Provisions Guidelines issued on 27/04/1438H. There are 2 categories in Stage 3 exposures as defined in these rules, for regulatory reporting purposes only and not for accounting purposes, i.e. Stage 3A and Stage 3B. Stage 3A or Doubtful category represents higher levels of credit risk leading to impairment within the stage 3 allocation and exposures currently in cure period while Stage 3B or Loss category represents impaired/defaulted exposures within the stage 3 allocation. Past due: As prescribed by IFRS 9, an exposure where any amount due under the contract (interest, principal, fee or other amount) has not been paid in full at the date when it was due. An exposure should be considered past due from the first day of missed payment (scheduled payment date as per original or modified contract), even when the amount of the exposure or the past-due amount, as applicable, is not considered material (materiality means greater than 5% of total exposure). Problem loans: Loans that display well-defined weaknesses or signs of potential problems. Problem loans should be classified by the company 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 financial obligations as they fall due.
Net realizable amount: It is the amount the finance company is expected to receive in the ordinary course of business less the estimated costs of recovery. This should follow the same requirements as given in the Accounting Standards and practically followed by the finance companies i.e., the outstanding amount less the actual collateral held and recovery related costs.

2. Governance

It is the responsibility of the board of directors of finance companies to maintain ECL provisions at an adequate level and to oversee that the company has adopted appropriate credit risk practices for the assessment and measurement of ECL provisions, in accordance with the company’s stated policies and procedures, the applicable accounting framework and relevant SAMA rules and guidance.

Establishing a strong governance and controls framework over ECL estimation and reporting, focusing on data integrity and model validation is a key focus area for those charged with governance. A robust framework for assessing credit risk and measuring the level of provisions should include, but not limited to the following:

i. Clearly define key terms related to the assessment and measurement of ECL (such as loss events or default, SICR, etc.);
ii. Identify and describe roles and responsibilities of functions and personnel involved;
iii. Include, for collectively evaluated exposures, a description of the basis for creating groups of portfolios of exposures with shared credit risk characteristics;
iv. Identify and document the ECL assessment and measurement methods (such as a loss rate method, probability of default (PD)/loss-given-default (LGD) method, or other) to be applied to each exposure or portfolio;
v. Document the inputs, data and assumptions used in the ECL estimation process (such as historical loss rates, PD/LGD estimates and economic forecasts), how the life of an exposure or portfolio is determined (including how expected prepayments have been considered), the historical time period over which loss experience is evaluated, and any qualitative adjustments. Examples of factors that may require qualitative adjustments are the existence of concentrations of credit risk and changes in the level of such concentrations, increased usage of exposure modifications, changes in expectations of macroeconomic trends and conditions, and/or the effects of changes in underwriting standards and lending policies;
vi. Include a process for evaluating the appropriateness of significant inputs and assumptions into the ECL measurement method chosen. It is expected that the basis for inputs and assumptions used in the estimation process will generally be consistent period to period. Where inputs and assumptions change, the rationale should be documented;
vii. Address how ECL rates are determined (e.g. historical loss rates or migration analysis as a starting point, adjusted for current conditions, forward-looking information and macroeconomic factors). A finance company should have a realistic view of its lending activities and consider forward-looking information that is reasonably available, macroeconomic factors, and the uncertainty and risks inherent in its lending activities when estimating ECL. To ensure alignment and consistency of macroeconomic factors used to

create ECL models, SAMA may require, at its discretion, finance companies to consider the possible effects of certain indexes and economic factors in a specific manner, from time to time.
viii. Consider the appropriateness of historical data/experience in relation to current conditions, forward-looking information and macroeconomic factors, and document how management’s experienced judgment is used to assess and measure ECL;
ix. Determine the extent to which the value of collateral and other credit risk mitigants incorporated in the lending agreements affect ECL;
x. Include criteria for restructurings/modifications of lending exposures and their impact on ECL;
xi. Outline the company’s policies and procedures on write-offs and recoveries;
xii. Document the methods used to validate models used for ECL measurement (e.g., back-tests) including model risk management;
xiii. Review, evaluate, update, and report on the adequacy of expected credit losses by Internal Auditors as a third line of defense on an annual basis. Where a finance company’s Internal Auditor is unable to perform such reviews, the company may engage an independent third party to provide assurance to the Board of Directors and Senior Management on the quality and effectiveness of the internal controls, risk management and governance systems and processes set up under the IFRS 9 framework;
xiv. Providing relevant, timely, accurate and useful disclosures on expected credit losses in accordance with internal, regulatory, and accounting requirements; and
xv. Establish key performance indicators (KPIs) relating to ECL estimation and processes for regular reporting of those KPIs. For example, staging assessment KPIs might include how many credit exposures moved directly from Stage 1 to Stage 3 and how many credit exposures are moved to Stage 2 only because they are 30 days past due (and not flagged by other transfer criteria prior to delinquency) or operational performance KPI may include input data completeness, exposure reconciled, etc.

The framework must be reviewed at least annually, or more frequently when the need arises especially when new information becomes available during the quarterly expected credit loss assessment process.

3. Credit Risk Classification

Finance companies will be required to classify exposures on an individual or collective basis in one of three stages or regulatory categories based on their original credit risk at origination and the change in credit risk at reporting date since origination. SAMA encourages finance companies to adopt General Approach for measuring expected credit losses (ECL).

SAMA has provided mapping of IFRS 9 stages to regulatory categories (for the naming convention only keeping in view conservatism of IFRS 9) i.e. Regular, Special Monitoring Accounts, Substandard, Doubtful and Loss categories. The definitions given in SAMA previous circular on Provisions Guidelines (Circular No. 381000046342 dated 27/04/1438H) for these regulatory categories should no longer be used while applying the requirements of this new circular.

3.1 Stage 1 or Regular category

Any exposure for which there is no significant increase in credit risk since origination (SICR) or otherwise are considered high quality or exhibit indicators of low credit risk. Indicators of low credit risk include, but are not limited to:

i. The borrower has a low risk of default;
ii. The payments are not past due by more than 30 days;
iii. The borrower has a strong capacity to meet contractual cash flow obligations in the near term; and
iv. Adverse changes in economic and business conditions in the longer term may, but will not necessarily, reduce the ability of the borrower to fulfil contractual cash flow obligations.

3.2 Stage 2 or Special Monitoring Accounts / Substandard category

Any exposure for which there is significant increase in credit risk since origination. Each finance company must clearly define what it considers to be significant increase in credit risk. Such indicators may include, but are not limited to:

i. The borrower has a moderate risk of default;
ii. The payments are past due by more than 30 days; this is rebuttable only for direct exposures to the Government, Government Agencies or Ministries (or equivalent entities including contractors working directly for a governmental entity in cases where the delay is not due to performance issues);
iii. The borrower has a weak or deficient capacity to meet its contractual cash flow obligations in the near term; and
iv. Adverse changes in economic and business conditions in the longer term are more likely than not to reduce the borrower’s ability to fulfil its obligations.

Finance companies should continuously monitor stage 2 exposures to identify improvements in credit quality and determine eligibility for re-staging stage 2 exposures to stage 1. Finance companies should document the minimum eligibility requirement for re-staging stage 2 exposures into stage 1 exposures, which should at least include the following conditions:

i. The borrower does not have any exposure more than 30 days past due;
ii. Exposure repayments have been made when due over a continuous repayment period (cure period excluding grace period, if any) of 90 days for those non-retail customers that have moved from stage 1 to stage 2 due to overdue principal and/or interest for more than 30 days (but less than 90 days) or extended due to credit risk reasons;
iii. The borrower’s situation has improved so that the full repayment of the exposure is likely (tested over 90 days as part of cure period), according to the original or modified terms and conditions;
iv. The indicators which has contributed to the significant increase in credit risk no longer existed (tested over 90 days as part of cure period) to threaten the full repayment of the exposure under the original or modified terms and conditions.
v. The cure period requirements as stated above (90 days) do not apply to retail customers. For retail customers that have moved from stage 1 to stage 2B (as detailed below), they should be allowed to be moved back to stage 1 after a cure period of 60 days.

SAMA recognizes the added value of having discrete tiers of credit risk exposures within Stage 2 allocation. As a result, SAMA is establishing, for regulatory reporting purposes only and not for accounting purposes, a bifurcation of Stage 2 totals to be reported in the quarterly prudential returns. It is expected that finance companies will have robust internal risk rating processes and mappings, which can identify and categorize discrete levels of borrower performance characteristics and the resulting credit risk.

Stage 2 exposures segregation into Stage 2A and Stage 2B categories are explained as follows:

Stage 2A or Special monitoring accounts category represents lower levels of credit risk within the stage 2 allocation. It represents borrowers with some or all of the following qualitative and quantitative indicators:

Qualitative indicators include, but are not limited to:

i. Lower but increasing levels of credit risk;
ii. Expected change in credit risk to remain low and currently manageable;
iii. Demonstrates current capacity to repay the financial commitment but this capacity is declining or diminishing from the original approval standards and warrants greater attention;
iv. Demonstrates periodic ability of addressing pas