Guideline 5.7: Loan Classification System

Guideline No. 5.7
(Attached return would not be scanned) Our Ref : CB/POL/41911 2 September 1994 The Chief Executive All authorized institutions Dear Sir/Madam, Loan Classification System In October 1993, the Hong Kong Monetary Authority ("HKMA") circulated to the two industry Associations a Consultation Paper setting out its proposals for a loan classification system for supervisory purposes. Under the proposed system, institutions would be required to report their loans and advances according to five categories (i.e. Performing, Special Mention, Substandard, Doubtful and Loss), provisions made against each category and the value of security held against the non-performing loans. The proposal would serve the important supervisory objectives of :
(a) continuous monitoring of individual institutions’ asset quality and the adequacy of their level of provisioning; (b) identifying the outliers through peer group analysis made possible by the common classification system; and (c) early detection of deterioration of asset quality in specific sectors through monitoring the aggregate level of provisioning of individual sectors. The industry Associations have indicated general support for the proposals. They emphasized the need for HKMA to discuss with individual

institutions on how to map their existing loan categories into those under HKMA's proposed system. Reservations were also expressed on the proposed inclusion of equities and debt securities held by institutions on the grounds that they are of a different nature to commercial lending. The HKMA has discussed with all authorised institutions their internal loan classification systems and the issue of mapping with HKMA's proposed system. The discussions revealed that institutions generally fall into three situations:
(a) a small number who have not hitherto established a formal loan classification system; (b) the majority who have already established a formal system which is generally compatible with the proposed system; and (c) only one institution whose loan classification system is substantially different from the one proposed. The HKMA expects institutions which have not yet established a formal loan classification system to adopt the proposed system. For those institutions which need to map their loan categories into the five proposed categories, the HKMA will adopt a flexible approach which aims to minimise as far as possible the need for changes to institutions' established systems or running two systems. For most institutions, it should be possible to fit the whole of their own categories, or the whole of particular classes of loans within those categories, into those on the HKMA's return without conducting a separate reclassification of individual loans. Where this is not possible because of major definitional differences, institutions should contact the HKMA well in advance of the submission of the first return to discuss the appropriate basis of reporting. To ensure consistency in reporting by individual institutions, all institutions which have existing systems of loan classification should provide the HKMA on or before 15 November a brief description of their systems, the method which they intend to use to map their loan categories onto the HKMA return and any significant differences in definitions and approach between the HKMA system and their own. The HKMA will confirm in writing in due course the agreed methodology for mapping.

As regards investments in equities and debt securities, we have decided not to include them for reporting at this stage. 'Me treatment of these items will be reviewed after the new loan classification system has settled down. A Policy Paper setting out the new loan classification framework is attached. Annex 1 of the Paper is a copy of the new return on “Quarterly analysis of loans and advances and provisions” which will replace the existing return on "Quarterly analysis of loans and advances for use in Hong Kong". Pursuant to section 63(2) of the Banking Ordinance, all authorized institutions are required to submit, on a quarterly basis, the new return to the Monetary Authority not later than fourteen days after the end of each quarter. The first return will cover the position of your institution at 31 December 1994. Printed copies of the return will be sent to authorized institutions when they are available. The HKMA does not intend to require auditors' certificate in respect of the new return at this stage. The need for this requirement will be reviewed after the new loan classification system has settled down. The new return covers the information on overdue and rescheduled assets which institutions are currently required to report under Form MA(BS)1C. As from the first reporting of the new return at end December 1994, institutions should stop reporting such information on Form MA(BS)1C. Printed copies of the revised Form MA(BS)1C will be sent to all authorized institutions in due course. The basis for reporting loans and advances by economic sectors under Part I of the new return has not changed (although property lending has been broken down into those for development and investment purposes). The reporting instructions have however been expanded in certain areas and this may lead some institutions to re-classify some of their existing loans. To ensure an orderly adjustment to HKMA's statistics, institutions are requested not to make any re-classifications until the first submission of the new return and to provide at the time of submission a written explanation of any re-classifications made and to provide the amount of the affected items on the old as well as the new basis so that the overall effect of any changes can be quantified. Should you have any queries regarding the Policy Paper and the reporting requirements, please feel free to contact Ms Brenda Tao (878 1622) or Ms Irene Sy (878 8210).

Yours faithfully,
D T R Carse
Deputy Chief Executive (Banking) c.c. The Chairman, HKAB The Chairman, DTC Association President, Hong Kong Society of Accountants Auditors of Authorised Institutions The Chairman, Securities & Futures Commission

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LOAN CLASSIFICATION SYSTEM

1. Introduction
   This paper sets out a system for the classification and reporting of loans and other specified exposures by authorized institutions. The system will be supplemented by regular reporting on provisions set aside for each category of classified assets and for different sectors in Hong Kong. With such information, the Hong Kong Monetary Authority (HKMA) will be able to monitor more closely the asset quality and adequacy of provisions of institutions.
2. Background
   2.1 Inferior asset quality is a major cause of bank failures. It may be
   caused by imprudent lending or by a downturn in the economy. Asset quality and adequacy of provisions are therefore the major areas to which banking supervisors should pay particular attention. They need to be fully aware of the asset quality of individual banks and to be satisfied that adequate provisions have been maintained for problem assets.
   2.2 Hitherto, statistics collected by the HKMA have not included
   information on the amount of non-performing assets of institutions. It is not therefore in a position fully to monitor asset quality and assess the adequacy of bad debt provisions off-site. This can be done only through periodic on-site examinations by its staff and through annual audits by the external auditors. While this is, and will remain, the principal means of assessing asset quality, a standard loan classification system will help provide the HKMA with a clearer picture on the asset quality of individual institutions on a regular basis. With such information, the HKMA will be able to act more swiftly on detection of any deterioration in the asset quality of an institution. The validity of institutions' loan classifications will be checked during the course of on-site examinations.
   2.3 Various banking regulatory bodies in the region such as Singapore,
   Malaysia, Korea, Philippines, Indonesia and Australia have adopted

some form of loan or asset classification system. Most of such systems are modelled after the system adopted by the supervisory authorities of the United States. The system outlined in this paper will bring Hong Kong in line with the practices adopted by the supervisory bodies of the countries mentioned above.
3. The loan classification framework
3.1 Under the system, loans and advances will be classified into the
following categories:-
(a) Performing - loans where borrowers are current in meeting commitments and full repayment of interest and principal is not in doubt. (b) Special Mention - loans where borrowers are experiencing difficulties which may threaten the institution's position. Ultimate loss is not expected at this stage, but could occur if adverse conditions persist. Such borrowers should be subject to special monitoring. (c) Substandard - loans where borrowers are displaying a definable weakness which is likely to jeopardise repayment. The institution is relying heavily on available security. Some loss is possible, particularly of interest. (d) Doubtful - collection of the loan in full is improbable and the institution expects to sustain a loss of principal and/or interest, taking into account the market value of collateral. (e) Loss - loans which are considered uncollectible after exhausting all collection efforts such as realisation of collateral and legal proceedings etc.
3.2 Details of the definitions and characteristics of each category of
loans are given in the completion instructions included in Annex 1. In addition to loans, balances due from banks, acceptances and bills of exchange held, as well as commitments and contingent liabilities which subject an institution to credit risk are also classified in the same way in order to give a better picture on asset quality.

3.3 Although some countries have gone one step further to stipulate the
loan loss provisioning level required for different category of loans, e.g. 25% for substandard loans, 50% for doubtful loans and 100% for loss loans, the HKMA does not propose to do so in Hong Kong. The objective of the framework is to help identify potential and problem assets that may have an adverse bearing on the financial position of an institution. That said, institutions are expected to have their own internal guidelines on the provisioning level appropriate to each category of loans. They should also develop action plans appropriate to each category of loans with a view to recovering as much as possible of the debts owed and reducing the possible loss to the minimum. The HKMA will wish to discuss with individual institutions their internal guidelines and action plans.
4. Sectoral provisioning
4.1 In addition to a loan classification system, information on provisions
against various sectors of loans for use in Hong Kong will give the HKMA a better knowledge about how the institutions view the condition of individual sectors and enable it to assess the adequacy of provisions set aside by individual institutions from another perspective. This would help to identify those institutions whose provisions against lending to a particular sector seemed to be out of line with their peers. Furthermore, if the level of provisions set aside by the banking industry as a whole for a particular sector is very high or is increasing, the HKMA would be able to issue warnings to the industry regarding the risk of lending to this sector.
4.2 Institutions are therefore required to provide information on
provisions against various sectors of loans for use in Hong Kong, trade financing and other loans.
5. The reporting structure
5.1 To facilitate the collection of the relevant statistics on the value of
classified assets, the amounts of provisions set aside against them and sectoral provisions, a new quarterly return on “Analysis of loans and advances and provisions (MA(BS)2A(Rev.94))” has been established to replace the existing quarterly return on “Analysis of loans and advances for use in Hong Kong (MA(BS)2A)”. A copy of

the new return and the completion instructions are attached in
Annex 1.
5.2 Apart from the inclusion of information on sectoral provisioning and
loan classification, the HKMA has taken this opportunity to split item C1 of Part I of the existing return into two separate items namely “Property development” and “Property investment”. In addition, further information on loans to companies which are property-developer-connected is also required. These changes to the existing return will enable the HKMA to better monitor property￾related lending.
5.3 Also included in Note (3) of the new return is information on
overdue and rescheduled assets of authorized institutions. Such information is presently required under the Return of Profit and Loss (MA(BS)IC) but it is considered more appropriate to include it in the new return instead. The Hong Kong Monetary Authority September 1994