Saudi Arabian Monetary Authority

Guidelines on Management of Problem Loans

January 2020

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Contents

1. Introduction ........................................................................................................................... 3
   1.1 Purpose of document ........................................................................................................ 3
   1.2 Scope of Implementation .................................................................................................. 3
2. Problem Loan Prevention & Identification ............................................................................ 4
   2.1 Early warning signals as a tool for preventing NPLs ....................................................... 4
   2.2 Scope of EWS process ...................................................................................................... 4
   2.3 Stages of EWS process ..................................................................................................... 5
   2.4 EWS structure and institutional arrangements ................................................................ 17
3. Non-performing Loans (NPLs) Strategy ................................................................................ 19
   3.1 Developing the NPL strategy ........................................................................................... 19
   3.2 Implementing the NPL strategy ....................................................................................... 30
4. Structuring the Workout Unit ................................................................................................ 32
   4.1 Staffing the Workout Unit ................................................................................................ 32
   4.2 Incorporating legal and support functions into Workout Unit ......................................... 33
   4.3 Performance management ................................................................................................ 33
   4.4 Developing a written policy manual ................................................................................ 35
5. Workout Plan .......................................................................................................................... 36
   5.1 Preparing for the workout process ................................................................................... 36
   5.2 Identifying the workout options ....................................................................................... 46
   5.3 Negotiating and documenting workout plan .................................................................... 56
   5.4 Monitoring the restructuring plan ................................................................................... 69
   Appendix 1: Samples of Early Warning Signals ......................................................................... 79
   Appendix 2: Loan Life Coverage Ratio ..................................................................................... 82
   Appendix 3: Restructuring Principles ........................................................................................ 83
   Appendix 4: Details of Relevant Agreements ............................................................................ 84
   Appendix 5: Glossary of Technical Terms ................................................................................. 88

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1. Introduction

1.1 Purpose of document

The purpose of this document is to support the Saudi banking sector in their ongoing efforts to accelerate the resolution of non-performing loans (NPLs) associated with large corporates, micro, small and medium-sized enterprise sector. This document seeks to reflect the local and international best practices on dealing with problem loans, these guidelines also seek to take into account the specifics of Kingdom of Saudi Arabia’s (KSA) economic and banking sector structure and the extensive experience accumulated by KSA banks in dealing with their corporate borrowers, as well as KSA’s existing legal, regulatory and institutional framework for resolution and does not identify the possible obstacles to efficient and timely problem loan management that might still exist in this broader framework, or to propose potential improvements which would be outside the banks’ sphere of control.

Bank loans can become “problem loan” because of problems with the borrower’s financial health, or inadequate processes within banks to restructure viable borrowers, or both. In ascertaining how to deal with a problem loan, it is important to distinguish between a borrower’s “ability to pay” and “willingness to pay,” Making this distinction is not always easy and requires effort. These guidelines should guide banks staff in dealing with problem loans including non-performing loans (NPLs) extended to corporate and Micro, Small and Medium Enterprises (MSMEs). It deals with both ad-hoc and systemic financial distress and delves into how borrower problems may have arisen in the first place. It provides guidance to banks staff responsible for handling individual problem loans and to senior managers responsible for organizing portfolio-wide asset resolution.

1.2 Scope of Implementation

These guidelines are applicable as better practices for all banks licensed under Banking Control Law, including Foreign Bank Branches. These guidelines should be read in conjunction with Mandatory Rules on the Management of Problem Loans and Rules on Credit Risk Classification and Provisioning issued by Saudi Arabian Monetary Authority (SAMA).

Whenever the requirements specified under these guidelines differ from existing laws, regulations and circulars issued by SAMA or other government organizations, the later shall take precedence over these guidelines.

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2. Problem Loan Prevention & Identification

2.1 Early warning signals as a tool for preventing NPLs

One of the keys to maintaining acceptable levels of Non-Performing Loans lies in the ability to identify potential payment difficulties of a borrower as early as possible. SAMA views instituting an effective framework within regulated entities as a mandatory requirement. The sooner the problem is identified, the easier it will be to remedy it. Early warning signals (EWS), fully integrated into the bank’s risk management system, is a crucial tool to identify and manage upcoming problems with a borrower’s ability to service his loan.

The purpose of the EWS is therefore twofold:

i. To produce an early signal of potential payment difficulties of the borrower; and
ii. To allow the opportunity to develop a corrective action plan at a very early stage.
iii. When the borrower exhibits early warning signals, the bank should proactively identify the driver and assess whether the borrower’ case should continue to be handled by the business / commercial unit or if the Workout Unit (whether involved in a shadow capacity at first or have full control of the case) should be involved.

Banks should ensure that proper training is provided to the business units on how to manage accounts with early signs of stress.

2.2 Scope of EWS process

The EWS process is organized in three stages: identification, action, and monitoring. Each of these stages is described in detail in the following sections. The timeline for implementing actions included in each of these stages is explained in section 2.3.

#	Area	Description
1	Signal Identification	• Responsibility for establishing parameters for signals and monitoring resides in a separate unit or function within risk management, middle or back office. ; • Upon identification of a signal, notification is sent to the respective relationship manager and his team leader that action is required to close the EWS breach.

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#	Area	Description
2	Action	• Relationship Manager contacts the borrower and identifies the source and magnitude of a potential payment difficulty. ; • After analysis and in consultation with risk management, a corrective action plan is put in place. ; • A loan is added to the watch list prepared on the basis of EWS for the purposes of further monitoring.
3	Monitoring	• Risk management approval required to remove the loan from watch list prepared on the basis of EWS. ; • A loan can remain on watch list for a time period specified by the bank. After that period, loan must be either returned to originating unit or transferred to Workout Unit. ; • While on the watch list, a loan should be classified with a lower risk rating compared to the one prior to moving to the watch list.

2.3 Stages of EWS process

1. Identification:

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 borrower should be included in the watch list (prepared on the basis of EWS) for further corrective action.

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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

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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

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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.

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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.

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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.

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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,	Annual report

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Indicator	Description
	adverse and even some times disclaimer.
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 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.

2. Corrective Action:

Once an early warning signal is identified, based on the criteria explained above, the unit responsible for managing EWS, needs to flag the potentially problematic loan to the relationship officer / respective portfolio manager in charge of the borrower’s relationship.

The cause and severity of the EWS is assessed and based on the assessment the borrowers can be categorized as ‘watch list’. Following are the two potential scenarios:

• Loans remain performing while on the watch list and will be brought back to regular loans after some time, and
• The credit quality of the loan continues to deteriorate and it is transferred to the bank’s Workout Unit (Remedial / Restructuring etc.).

Once the borrower is classified as watch list, the bank should decide, document and implement appropriate corrective actions (within the specified timeframe) in order to mitigate further worsening of loan’s credit quality.

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Corrective action might include:

i. Securing additional collateral or guarantee (if considered necessary).
ii. Performing more regular site visits.
iii. More frequent updates to the credit committee.
iv. Assessment of financial projections and forecast loan service capacity.

3. Monitoring:

Once increased credit risk is identified, it is crucial for the bank to follow up on the signal received as soon as possible, and develop a corrective action plan to pre-empt potential payment difficulties. The intensification of communication with the borrower is of utmost importance. The action plan may be as simple as collecting missing information such as an insurance policy or as complex as initiating discussions on a multi-bank restructuring of the borrower’s obligations.

While the borrower remains on the watch list, bank’s primary contact with the borrower remains the business officer/portfolio manager, although the head of business as well as risk management, are expected to take a more active involvement in the decision and action process for larger, more complex loans. While on the watch list, the borrower should be classified in a lower rating than “ordinary” borrowers.

All loans in the bank’s portfolio should be subject to the EWS described above. This applies to performing loans that never defaulted, but to restructured loans as well.

A. Timeline

For EWS to be effective, clear deadlines for actions should be in place, and consistently enforced (see an indicative timeline in Table below). The level and timing of the monitoring process should reflect the risk level of the loan. Large loans should be monitored closely and by the Risk department and respective Credit committees or any higher management committees.

Banks should also establish the criteria to monitor large corporate loans and at the same time importance to be provided to smaller loans, and the same should be followed by designated staff within the bank, with the results reported to the management.

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Indicator	Responsibility	Workout (once the trigger identified)	Description
Any triggers identified / or any Signal received	Relationship Manager (RM) / Portfolio Manager (PM).	Max 1 working day.	RM / PM starts analyzing the borrower details to investigate further.
Follow up with the borrower and report with analysis	Relationship Officer / Portfolio Manager.	Max 3 working days for a material loan and 5 working days for others.	RM / PM contacts borrower determines reasons, and provide analysis.
Decision on further actions	Relationship Manager & Head of Business; EWS manager.	Max 6 working days for material loan and 10 working days for others.	Decision for a loan to be: (i) put on watch list and potential request for corrective action; (ii) left without action measures; and (iii) transferred to Workout Unit.
Review of watch list	Relationship Manager & Head of Business, EWS manager and Credit Committee.	Every fortnight for material loans and 1 month for others, the list is reviewed and amended, if needed.	Risk manager/EWS manager (in consultation with Head of Business) monitors the performance of the borrower and agreed mitigation measures. If needed, based on the recommendation of Credit Committee or any other delegated committee takes decision to transfer to Workout Unit.

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Indicator	Responsibility	Workout (once the trigger identified)	Description
Final decision	Head of Business /Risk manager, EWS manager.	Banks as per their internal policy can specify the maximum time a borrower can remain on watch list.	Borrower can be on watch list only on a temporary basis. Banks should assess as how much time should be specified for which the borrower remains in watch list, once the specified time is completed a final decision should be taken, i.e., loan either removed from watch list (if problems are resolved), or transferred to Workout Unit.

B. Establishing criteria for transfer to Workout Unit:

Banks shall establish and document a policy with clear and objective time-bound criteria for the mandatory transfer of loans from Loan Originating Units to the Workout Unit along with the specification of relevant approvals required for such transfers. The policy should include details on areas where proper collaboration is required between the Workout Unit and Loan Originating Units especially in scenarios where the borrowers are showing signs of stress but still being managed by the Loan Originating Units.

While corrective actions should be taken as soon as a problem is identified, if the problem cannot be solved within a reasonably short period, the loan should be transferred to the Workout Unit (WU) for more intensive oversight and resolution. Allowing past-due loans to remain within the originating unit for a long time perpetuates the problem, leads to increased NPL levels within the bank, and ultimately results in a lower collection/recovery rate.

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C. Following are generally the key indicators for transferring to Workout Unit (not all-inclusive):

i. Days past due (DPD) based on internal thresholds and considering the nature of the borrower should be included as a mandatory trigger (For further guidance on this refer to SAMA rules on Credit Risk Classification and Provisioning).

ii. Debt to EBITDA ≥ Internally set threshold dependent on the nature and industry of the borrower (not applicable to an MSME, in cases wherein reliable financial information is not available),

iii. Net loss during any consecutive twelve-month period ≥ Internally set threshold dependent on the nature and industry of the borrower,

iv. A loan classification of “Watch list” if syndication is involved and/or reputational/legal issues are at stake;

v. Length of time on watch list (e.g., more than twelve months), or at least two unsuccessful prior restructurings;

vi. An indication of an imminent major default or materially adverse event, including government intervention or nationalization, notice of termination of operating license or concession, significant external rating downgrade of borrower or guarantor, sudden plant closure, etc.;

vii. Litigation, arbitration, mediation, or other dispute resolution mechanism involving or affecting the banks; or

viii. Evidence or strong suspicion of corruption or illegal activity involving the borrower or the borrower’s other stakeholders.

Note: Banks are encouraged to develop customized indicators for the MSME sector.

The decision to transfer a loan to the Workout Unit should be based on a refined judgment that the loan will not be repaid in time, in full and urgent action is needed in view of the borrower’s deteriorating situation. The above-mentioned criteria can give a clear signal that: (i) loan-level is unsustainable; (ii) equity of a company has been severely depleted; or (iii) previous restructurings were not successful, and more drastic measures should be applied.

Exceptions to this policy should be rare, well documented in writing, and require the approval of the Board of Directors or any other bank’s board designated committee.

Note: Banks should define clear and objective criteria in its internal documentation, for handing over a borrower to the workout and legal support unit, as well as the criteria for returning the borrower back to the

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commercial unit for regular management. The commercial unit and the workout and legal support unit must be completely separated in terms of functional, organizational and personnel issues.

The work out unit should seek to restructure the loan and maximize banks recovery for borrowers considered as viable. Borrower’s viability needs to be evaluated in light of comparing the losses that may transpire in case of restructuring versus foreclosure.

However, on the other hand, foreclosure proceedings may be initiated, if the bank after due process concludes that the case is ineligible for restructuring consideration either because of financial or qualitative issues.

2.4 EWS structure and institutional arrangements

Structure of EWS within the Bank

To ensure the independence of the process, and achieve a holistic approach to credit risk monitoring, and prevent conflicts of interest, the unit responsible for managing EWS should operate outside of the loan originating unit. Best practice indicates that the responsibilities to manage the EWS process should be assigned within the credit risk management department and fully incorporated into the bank’s regular risk management processes.

Since an effective EWS requires an operational IT system that draws all information available about a particular borrower, EWS benefit from being part of the bank’s internal credit rating system that already contains information about the borrower. The bank should allocate enough staff and financial resources to keep the system operational and effective.

The operation of the EWS should be governed by written policies and procedures, including time thresholds for required actions, approved by the Board of Directors of the bank. They should be subject to annual review and reapproved by the Senior Management Committee to incorporate:

i. Required changes identified during previous operational periods;
ii. Regulatory amendments; and
iii. Additionally, independent quality assurance (e.g., review of the process by an external expert or the Internal Audit function) should be considered.

Reporting:

All actions during the EWS process should be recorded in the IT system to provide a written record of decisions and actions taken. At a minimum, the system should record:

i. Time the action was taken;
ii. Name and department of those participating/approving the actions;

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iii. The reasons for actions taken; and
iv. The decision of the appropriate approval authority, if applicable.

The watch list should include, at a minimum, the following information:

i. Details of the loan;
ii. Is it part of a group or related party;
iii. Material or non-material loan;
iv. Date added to the list;
v. Reviews taken (including timestamps) and outcomes,
vi. Mitigation measures; and
vii. Reasons for inclusion in the watch list.

The watch list (or at least material loans on it) should be presented monthly to a designated management committee (Executive Committee or Risk Committee) only or in parallel with the credit committee for information purposes and potential action. For major cases, the bank’s Management Board must be included in the decision-making process. The Board should also receive monthly:

a) A detailed list of material loans for information; and b) Aggregate figures for the loans on the watch list. Information about the borrower/group in potential payment difficulties must be disseminated widely and promptly within the banking group, including branches and subsidiaries. (For details on samples of EWS refer to Appendix 1).

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3. Non-performing Loans (NPLs) Strategy

The bank’s goal in the resolution process should be to reduce non-performing assets as early as possible, in order to:

i. Free up coinage and capital for new lending;
ii. Reduce the bank’s losses, and return assets to earning status, if possible;
iii. Generate good habits and a payment culture among borrowers; and
iv. Help maintain a commercial relationship with the borrower by conducting a responsible resolution process. To ensure that the goal is met, each bank should have a comprehensive, written strategy for management of the overall NPL portfolio, supported by time-bound action plans for each significant asset class. The bank must also put in place and maintain adequate institutional arrangements for implementing the strategy.

3.1 Developing the NPL strategy

The NPL reduction strategy should layout in a clear, concise manner the bank’s approach and objectives (i.e., maximizing recoveries, minimizing losses) as well as establish, at a minimum, annual NPL reduction targets over a realistic but sufficiently ambitious timeframe (minimum 3 years). It also serves as a roadmap for guiding the internal organizational structure, the allocation of internal resources (human capital, information systems, and funding) and the design of proper controls (policies and procedures) to monitor interim performance and take corrective actions to ensure that the overall reduction goals are met.

The strategy development process is divided into the following two components:

1. Assessment; and
2. Design.

1. Assessment

In order to prepare the NPL strategy, Banks should conduct a comprehensive assessment of their internal operating environment, external climate for resolution, and the impact of various resolution strategies on the bank’s capital structure.

i. Internal Self-Assessment

The purpose of this self-assessment is to provide management with a full understanding of the severity of the problems together with the steps that are to be taken into consideration to correct the situation. Specific details are noted below:

a) Internal Operating Assessment:

A thorough and realistic self-assessment should be required and performed to determine the severity of the situation and the paces that need to be taken

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internally to address it, there are a number of key internal aspects that influence the bank’s need and ability to optimize its management of, and thus reduce, NPLs and foreclosed assets (where relevant).

b) Scale and drivers of the NPL issue:

• Size and evolution of its NPL portfolios on an appropriate level of granularity, which requires appropriate portfolio segmentation;
• The drivers of NPL in-flows and outflows, by portfolio where relevant;
• Other potential correlations and causations.

c) Outcomes of NPL actions taken in the past:

• Types and nature of actions implemented, including restructuring measures;
• The success of the implementation of those activities and related drivers, including the effectiveness of restructuring treatments.

d) Operational capacities:

Processes, tools, data quality, IT/automation, staff/expertise, decision-making, internal policies, and any other relevant area for the implementation of the strategy) for the different process steps involved, including but not limited to:

• early warning and detection/recognition of NPLs;
• restructuring;
• provisioning;
• collateral valuations;
• recovery/legal process/foreclosure;
• management of foreclosed assets (if relevant);
• reporting and monitoring of NPLs and the effectiveness of NPL workout solutions.

For each of the process steps involved, including those listed above, banks should perform a thorough self-assessment to determine strengths, significant gaps and any areas of improvement required for them to reach their NPL reduction targets. The resulting internal report should be prepared and the same to be maintained for the record purpose.

Banks should monitor and reassess or update relevant aspects of the self-assessment at least annually and regularly seek independent expert views on these aspects, if necessary.

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ii. Portfolio Segmentation

Purpose and principles of portfolio segmentation

Segmentation is the process of dividing a large heterogeneous group of Non-performing loans into smaller more homogeneous parts. It is the essential first step in developing a cost-effective and efficient approach to NPL resolution. Grouping borrowers with similar characteristics allow the bank to develop more focused resolution strategies for each group. Using basic indicators of viability and collateral values, the portfolio can be broken down at an early stage by proposed broad resolution strategies (hold/restructure, dispose, or legal enforcement). Identifying broad asset classes at an early stage of workout is also helpful for efficient set up of Workout Unit, including allocation of staffing and specialized expertise for a more in-depth analysis of borrower’s viability and design of final workout plan.

The segmentation, including initial viability assessment, should be done immediately after the non-performing loan is transferred to the Workout Unit, and before the loan is assigned to a specific workout officer. The exercise is normally performed by a dedicated team in the Workout Unit.

In order to deal with the stock of NPLs, the bank should follow the principles of proportionality and materiality. Proportionality means that adequate resources should be spent on specific segments of NPLs during the resolution process, taking into account the substantial internal costs of the workout process borne by the bank. Materiality means that more attention should be allocated to larger loans compared to smaller loans during the resolution process. These principles should guide the allocation of financial, time and human (in terms of numbers and seniority) resources in WU.

A well-developed management information system containing accurate data is an essential pre-condition for conducting effective segmentation. The exercise is expected to be performed on the basis of information already contained in the loan file when it is transferred from the originating unit to the WU.

Two-Stage segmentation process

It is recommended that the basic segmentation of the bank’s NPL portfolio is done in the following two stages. The main objective is to select a smaller pool of loans relating to potentially viable borrowers, which warrant the additional (substantial in case of material loans) follow-up from WU, including in-depth viability analysis and re-evaluation of collateral, in order to design an appropriate workout plan.

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Stage one – Segmentation by nature of business, past-due buckets, loan balance, and status of legal procedure

The bank’s portfolio, segmentation can be conducted by taking multiple borrowers’ characteristics into consideration. Segmentations should have a useful purpose, meaning that different segments should generally trigger different treatments by the NPL WUs or dedicated teams within those units. Following is the list of potential segmentation criteria that can be utilized by banks:

i. Nature of the business: Micro, Small and medium-sized enterprises (MSMEs), including sole traders/ partnerships and Corporates: (by asset class or sector).

ii. Legal status: for existing loans already in legal proceedings or legal action has already been taken.

iii. Arrears bucket/days past due (the higher level of arrears the narrower the range of possible solutions)
a) Early arrears (>1 dpd and ≤90 dpd) b) Late arrears of (>90 dpd) c) Loan Recovery Cases > 90 dpd or 180dpd)

iv. Loan balance: Banks may decide the threshold for segmentation based on the size of the outstanding loan and cases with multiple loans;

Stage two – initial viability assessment

Following the initial segmentation, NPLs which are currently not in legal procedure should be further screened according to two criteria: (i) financial ratios (or Cash flows based ratios in case of MSME); and (ii) loan-to-value (LTV) ratio. These ratios are generally available to the bank from the borrower’s latest financial statements in the loan file, and should ideally not require any additional information from the borrower.

LTV ratio provides a good indication of the level of collateral against the outstanding loan. It is seen as a readily available indicator that captures quantitative aspect of collateralization of the loan, which should be an integral part of initial viability assessment. However, banks should consider stressed value of collateral (i.e. forced sale value in case of liquidation) for computation of these ratios. The quality of the collateral should also be considered for further assessment during later stages of restructuring process.

Banks are expected to set up internal LTV ratios depending on the size segment (Corporate / MSME) and the nature of the industry in which it operates and annual refine/ assess parameters, with an aim to be able to compare the cost of restructuring vs the cost of foreclosure/ legal proceeding. Segmentation

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according to LTV at this early stage is helpful for starting to consider various workout strategies described in Chapter 6.

Banks may consider below indicative broad benchmarks for the viability parameters as a part of initial assessment, these are intended to be indicative rather than prescriptive (i.e. determining viable, marginally-viable and non-viable borrowers):

• Debt/EBITDA ratio is used as a proxy for initial viability assessment of the borrower and reflects how leveraged the company is. The company is considered highly leveraged post breaching a certain threshold and the risk of loan repayment in full and in time could be excessive.
• The loan service coverage ratio should be comparable to the sector average within the restructuring period in which the unit should become viable.
• Trends of the company based on historical data and future projections should be comparable with the industry. Thus, the behavior of past and future EBIDTA should be studied and compared with industry average.
• For project finance and other multi-year loans, Loan life coverage ratio (LLCR), as defined below should be 1.4, which would give a cushion of 40% to the amount of loan to be serviced. For the details on the computation of LLCR , refer to Appendix 2.

LLCR = (Present value of total available cash flow (ACF) during the loan life period (including interest and principal) + Cash Reserves) / Outstanding amount of loan

The selection of thresholds for these indicators used in the initial viability assessment should be based on general market indicators.

SAMA is cognizant that acceptable thresholds with regards to key financial and collateral coverage ratio would vary depending on the nature of the industry, its economic outlook over the life of the loan, and size of the loans, hence does not lay down prescriptive limits. However, Banks are expected to assess document the above, as part of its NPL portfolio segmentation exercise. No particular ratio should be considered in Isolation, whilst segmenting the borrower and banks are advised to develop (either expert-based or statistical) rationale.

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The following has been illustrated to provide indicative guidelines as to how a segmentation could be undertaken:

Figure 1: Stage two of segmentation based on LTV and EBITDA (the below ratios are indicative only)

Borrower Segmentation	Loan-to-Value (LTV) Ratio	Earnings before Interest, Tax, Depreciation and Amortization (EBITDA) Ratio
Viable borrower	≤ 80 or ≥ 80	Debt/EBITDA ≤ 5
Marginally viable borrower	≤ 80 or ≥ 80	Debt/EBITDA ≤ 8 ≥ 5
Non-viable borrower	≤ 80 or ≥ 80	Debt/EBITDA ≥ 8

Banks should identify loans that may be non-viable as a result of primary viability assessment at this stage of the segmentation. Segregating these loans at this stage would enable banks to save time and financial resources. Identified non-viable loans should be promptly referred to legal unit under Workout Unit or considered for foreclosures.

The remaining pool of loans, recognized as viable and marginally viable after the initial assessment, should be assigned to the Workout Unit for an in-depth viability assessment based on additional information to be collected from the borrower and collateral re-evaluation. The differentiation on the grounds of collateral value reflected in the LTV ratio at this early stage allows the Workout Unit to receive a workout file with more granular information. Following this analysis, a customized workout plan is selected based on comparison of Net Present Value (NPVs - is the difference between the present value of cash inflows and the present value of cash outflows over a period of time) of expected recoveries under various alternative options.

Potential additional segmentation criteria:

In addition to basic segmentation using loan size, financial or collateral-based loan ratios, banks may choose to further segment the NPL portfolio using additional borrower characteristics. These include:

i. Industry and subsector of industry (e.g., real estate can be treated as a separate category with office buildings, apartments, land development, construction as sub-categories);

ii. Number of days past due. Higher payment interruption period could indicate a higher predisposition to legal actions;

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iii. Loan purpose (e.g., working capital, purchase of the real estate, or tangible assets);

iv. Type of collateral (e.g., commercial or residential real estate, land plot, financial assets);

v. Location of collateral;

vi. Country of residence/incorporation ((a) residents, (b) non-residents); and

vii. Interest coverage (low ratio indicates problem with free cash flows).

If however, further segmentation into small groups is unlikely to lead to better results and may result in lost focus, banks are advised to document the rationale for SAMA’s comfort.

iii. External conditions and operational environment

Understanding the current and possible future external operating conditions/environment is fundamental to the establishment of an NPL strategy and associated NPL reduction targets, related developments should be closely followed by banks, which should update their NPL strategies as needed.

The following list of external factors should be taken into account by banks when setting their strategy, however, it should not be seen as exhaustive as other factors not listed below might play an important role in specific circumstances.

a) Macroeconomic conditions:

Macroeconomic conditions will play a key role in setting the NPL strategy. This also includes the dynamics of the real estate market and its specific relevant sub-segments. For banks with specific sector concentrations in their NPL portfolios (e.g. Building & Construction, Manufacturing, Wholesale and Retail Trade), a thorough and constant analysis of the sector dynamics should be performed, to inform the NPL strategy.

b) Market expectations:

Assessing the expectations of external stakeholders (including but not limited to rating agencies, market analysts, researchers, and borrowers) with regard to acceptable NPL levels and coverage will help to determine how far and how fast banks should reduce their portfolios. These stakeholders will often use national or international benchmarks and peer analysis.

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c) NPL investor demand:

Trends and dynamics of the domestic and international NPL market for portfolio sales will help banks make informed decisions regarding projections on the possible pricing of portfolio sales. However, investors ultimately price on a case-by-case basis and one of the determinants of pricing is the quality of documentation and loan data that banks can provide on their NPL portfolios.

d) NPL servicing:

Another factor that might influence the NPL strategy is the maturity of the NPL servicing industry. Specialized services can significantly reduce NPL maintenance and workout costs. However, such servicing agreements need to be well steered and well managed by the bank.

iv. Capital implications of the NPL strategy

Capital levels and their projected trends are important inputs to determining the scope of NPL reduction actions available to banks. Banks should be able to dynamically model the capital implications of the different elements to their NPL strategy, ideally, under different economic scenarios, those implications should also be considered in conjunction with the risk appetite framework (RAF) as well as the internal capital adequacy assessment process (ICAAP).

Where capital buffers are slim and profitability low, banks should include suitable actions in their capital planning which will enable a sustainable clean-up of NPLs from the balance sheet.

2. Design

The design phase should identify options to be used to resolve NPLs, establish specific targets for NPL reduction, together with performance indicators detailing how the NPL reduction strategy will be implemented over short, medium and long term periods. Following are key components of the design phase:

i. Strategy implementation options

Banks should review the range of NPL strategy implementation options available and their respective financial impact. Examples of implementation options, not being mutually exclusive, are:

• Hold/restructuring strategy: A hold strategy (A hold strategy is not to terminate the relationship with the troubled borrower) option is strongly linked to the operating model, restructuring and borrower assessment expertise, operational NPL management capabilities, outsourcing of servicing and write-off policies.

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• Active portfolio reductions: These can be achieved through either sales and/or writing off provisioned NPL loans that are deemed unrecoverable. This option is to be linked to provision adequacy, collateral valuations, quality loan data, and NPL investor demand.

• Change of loan type: This includes foreclosure, loan to equity swapping, loan to asset swapping, or collateral substitution.

• Legal options: This includes insolvency proceedings and foreclosure proceedings

• Out-of-court solutions: Out-of-court debt restructuring involves changing the composition and/or structure of assets and liabilities of borrowers in financial difficulty, without resorting to a full judicial intervention, and with the objective of promoting efficiency, restoring growth, and minimizing the costs associated with the borrower’s financial difficulties (for details on out of court solutions please refer to section 6.2.2.)

Banks should ensure that their NPL strategy includes not just a single strategic option but rather combinations of strategies/options to best achieve their objectives over the short, medium and long term and explore which options are advantageous for different portfolios or segments and under different conditions.

Banks should also identify medium and long-term strategic options for NPL reductions which might not be achievable immediately, e.g. a lack of immediate NPL investor demand might change in the medium to long term. Operational plans might need to foresee such changes, e.g. the need for enhancing the quality of NPL loan data in order to be ready for future investor transactions.

Where banks assess that the above-listed implementation options do not provide an efficient NPL reduction in the medium to long-term horizon for certain portfolios, segments or individual loans, this should be clearly reflected in an appropriate and timely provisioning approach. The bank should write off loans that are deemed to be uncollectable in a timely manner.

ii. Targets

Before commencing the short to medium-term target-setting process, banks should establish a clear view of what reasonable long-term NPL levels are, both on an overall basis but also on a portfolio-level basis. In spite of uncertainty around the time frame required to achieve these long-term goals, however, they are an important input to setting adequate short and medium-term targets.

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Banks should include, at a minimum, clearly defined quantitative targets in their NPL strategy (where relevant including foreclosed assets), which should be approved by the senior management committee. The combination of these targets should lead to a concrete reduction, gross and net (of provisions), of NPLs, at least in the medium term. While expectations about changes in macroeconomic conditions can play a role in determining target levels (if based on solid external forecasts), they should not be the sole driver for the established NPL reduction targets.

In determining, the targets banks should establish at least the following dimensions:

• by time horizons, i.e. short-term (indicative 1 year), medium-term (indicative 3 years) and possibly long-term;
• by main portfolios (e.g. retail mortgage, retail consumer, retail small businesses and professionals, MSME corporate, large corporate, commercial real estate);
• by implementation option chosen to drive the projected reduction, e.g. cash recoveries from hold strategy, collateral repossessions, recoveries from legal proceedings, revenues from the sale of NPLs or write-offs.

The NPL targets should at least include a projected absolute or percentage NPL reduction, both gross and net of provisions, not only on an overall basis but also for the main NPL portfolios.

Where foreclosed assets are material, a dedicated foreclosed assets strategy should be defined or, at least, foreclosed assets reduction targets should be included in the NPL strategy. It is acknowledged that a reduction in NPLs might involve an increase in foreclosed assets for the short term, pending the sale of these assets. However, this timeframe should be clearly limited as the aim of foreclosures is a timely sale of the assets concerned.

Targets shall be initially defined for all main portfolios on a quarterly basis for the first year. Each of these high-level targets is to be accompanied by a standard set of more granular monitoring items, e.g. non-performing loan ratio and coverage ratio, etc.

Below shows high-level quantitative targets as per better international practices.
Sustainable solutions-oriented operational target:

• Loans with long term modifications / NPL plus performing forborne loans with Long term Modifications.

Action-oriented operational targets:

• Active NPL MSMEs for which a viability analysis has been conducted in the last 12 months / Active NPL MSMEs.

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• MSME and Corporate NPL common borrowers for which a common restructuring solution has been implemented.
• Corporate NPLs for which the bank(s) have engaged a specialist for the implementation of a company restructuring plan.

Banks running the NPL strategy process for the first time should not solely focus on the short-term horizon. The aim here is to address the deficiencies identified during the self-assessment process and thus establish an effective and timely NPL management framework, which allows the successful implementation of the quantitative NPL targets approved for the medium to long-term horizon.

Note 1:
As an illustration, Banks which have internally calibrated (through the cycle) TTC PD’s against a validated rating system, should not aim to foreclose accounts, against which a viable restructuring could lead to an ECL output which is less than the internal (if the same has been internally computed) or regulatory loss given default, if legal proceeding were to be initiated against the borrower.

Hence, for instance, by forgiving 20% of the outstanding amount would lead to a risk classification into a grade, which has 16% PD, (ignoring the 12 month period, for which the restructured loan would be classified as NPL, provided performance is satisfactory) and assuming that the internally computed LGD is 36%, the ECL % expected to arise from such a transaction would be around 24.6%, (20% concession and ((100% - 20% concession) * .16 PD * 36% LGD) = 4.6%))) vs an expected LGD for foreclosure of say 43%.

The above is a simplified illustration, SAMA is cognizant that:

• Obligors granted a material concession in course of foreclosures are classified as NPL for provisioning purposes for at least a year, which should be taken into account whilst computing the cost of foreclosure to the bank and;
• Expert Level Judgement or rating system override with respect to grade classification may be warranted whilst making the above assessment

However, the purpose of outlining the above is to endorse a long term vision in terms of making a balanced decision with respect to restructuring a distressed borrower (i.e. determining the viability of a borrower) rather than seeking outright enforcement proceeding.

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3.2 Implementing the NPL strategy

Banks should ensure that significant emphasis is placed on communication of the components of the approved strategy to relevant stakeholders across the bank and proper monitoring protocols are established. Following are key components of implementing an NPL strategy:

i. Monitoring of Results

a. Banks should establish a proper monitoring mechanism for NPL strategy to ensure it is delivering the expected results. Where any variances are identified prompt corrective action is to be taken to ensure goals/targets are met.

b. The strategy to be reviewed at a minimum on an annual basis. Where collection targets and budgets will require substantial annual revisions, policies and procedures should be revised as necessary.

ii. Embedding the NPL strategy

As execution and delivery of the NPL strategy involve and depends on many different areas within the bank, it should be embedded in processes at all levels of an organization, including strategic, tactical and operational.

All banks should clearly define and document the roles, responsibilities and formal reporting lines for the implementation of the NPL strategy, including the operational plan.

Staff and management involved in NPL workout activities should be provided with clear individual (or team) goals and incentives geared towards reaching the targets agreed in the NPL strategy, including the operational plan.

All relevant components of the NPL strategy should be fully aligned with and integrated into the business plan and budget. This includes, for example, the costs associated with the implementation of the operational plan (e.g. resources, IT, etc.) but also potential losses stemming from NPL workout activities. NPL strategy should be closely monitored to ensure it is delivering the expected results, variances should be identified and prompt corrective action taken to ensure longer-term goals and targets are met.

iii. Operational plan

The NPL strategy of banks should be back by an operational plan (which is to be approved by the senior management committee). The operational plan should clearly define how the bank would operationally implement its NPL strategy over a time horizon of at least 1 to 3 years (depending on the type of operational measures required).

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The NPL operational plan should contain at a minimum:

• Clear time-bound objectives and goals;
• Activities to be delivered on a segmented portfolio basis;
• Governance arrangements including responsibilities and reporting mechanisms for defined activities and outcomes;
• Quality standards to ensure successful outcomes;
• Staffing and resource requirements;
• Required technical infrastructure enhancement plan;
• Granular and consolidated budget requirements for the implementation of the NPL strategy;
• Interaction and communication plan with internal and external stakeholders (e.g. for sales, servicing, efficiency initiatives, etc.).
• The operational plan should put a specific focus on internal factors that could present impediments to successful delivery of the NPL strategy.

Implementing the operational plan

The implementation of the NPL operational plans should rely on suitable policies and procedures, clear ownership and suitable governance structures (including escalation procedures). Any deviations from the plan should be highlighted and reported to the management.

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4. Structuring the Workout Unit

Effective management of NPL resolution requires that the bank establish a dedicated unit to handle workout cases. Such Workout Unit (WU) should be established as a permanent unit within the bank’s organizational structure reporting directly to the Risk Management function rather than the Business / Loan Originating Units.

The rationale for creating an independent unit for dealing with NPLs includes the elimination of potential conflicts of interest between the originating officer and the troubled borrower. The segregation of duties includes not only relationship management (negotiation of the restructuring plan, legal enforcement, etc.) but also the decision-making process along with support services (loan administration, loan and collateral files, appraisers, etc.) and technical IT resources.

The appropriate organizational structure of the Workout Unit varies greatly depending upon the circumstances each individual bank faces. Larger banks dealing with a significant number of NPLs are likely to establish separate Working Units or create sub-divisions within a single WU to handle different asset classes such as Large Corporates, Medium Corporates, Small and Micro loans. Smaller banks may have to follow a simpler structure where a single work unit may handle a wide variety of borrowers.

4.1 Staffing the Workout Unit

Skills Required

Banks should ensure that the managers of the WU, their team leaders and workout officers are highly qualified professionals, who would be able to discharge their functions effectively and in connection therewith, training needs should be assessed and proper training plans are to be registered accordingly. Within the individual NPL WUs, more specialization is often useful based on the different NPL workout approaches required per relevant borrower segment.

Such workout officers should have strong analytical and financial analysis skills, understand the depth of the restructuring process and have the ability to work well under pressure.

Remuneration

Compensation structures for workout staff need to be aligned with long term strategy of the bank. If compensation is based on cash recoveries, officers may choose to optimize their own short-term income at the expense of longer-term profit maximization for the bank. Conversely, basing compensation on a reduction in the volume of non- performing loans may lead to improper restructuring or the bankruptcy of otherwise viable companies as officers seek to reduce the numbers by the quickest means possible. The staff may also be reluctant to employ the full range of restructuring options (particularly with respect to loan forgiveness) without

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provisions to indemnify them for costs and provide legal counsel to defend them in case legal charges are brought against them.

Assigning workload

Banks should establish policies specifying timelines for assigning stressed accounts to Work Officers, once the account is marked to be stressed.

4.2 Incorporating legal and support functions into Workout Unit

Banks require legal advice on a variety of matters related to the origination, management, and restructuring of loans. This includes not only documenting loan and restructuring transactions but also overseeing the collection process for those defaulted loans. It is highly recommended that Banks should maintain a dedicated legal team (or legal experts) within the Workout Unit to:

i. Assist in the negotiation of the restructuring of those loans that need to be addressed; and
ii. To be responsible for those loans that require legal solutions to be collected (bankruptcy or foreclosure).

4.3 Performance management

For Workout Unit (WU) staff involved in the management of Nonperforming Loans (NPLs), proper performance metrics should be established which should cater not only to the individual’s performance but also assess the performance of the team as a whole. Further, the performance of the Workout Unit should be monitored and measured on a regular basis. For this purpose, an appraisal system tailored to the requirements of the NPL Workout Unit should be implemented in alignment with the overall NPL strategy and operational plan.

Further to quantitative elements linked to the bank’s NPL targets and milestones (probably with a strong focus on the effectiveness of workout activities), the appraisal system may include qualitative measurements such as level of negotiations competency, technical abilities relating to the analysis of the financial information and data received, structuring of proposals, quality of recommendations, or monitoring of restructured cases.

It should also ensure that the higher degree of commitment, usually required of NPL WU staff is inculcated in the agreed working conditions, remuneration policies, incentives, and performance management framework.

As part of the performance measurement framework, it is recommended that banks' management should include specific indicators linked to the targets defined in the NPL strategy and operational plan. The importance of the respective weight given to these indicators within the overall performance measurement frameworks should be proportionate to the severity of the NPL issues faced by the bank.

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Finally, given that the important role of efficient addressing of pre-arrears is a key driver for the reduction of NPL inflows, a strong commitment of relevant staff regarding the addressing of early warnings should also be fostered through the remuneration policy and incentives framework.

Technical resources

One of the key success factors for the successful implementation of any NPL strategy option is an adequate technical infrastructure. In this context, it is important that all NPL-related data is centrally stored in robust and secured IT systems. Data should be complete and up-to-date throughout the NPL workout process.

An adequate technical infrastructure should enable NPL WUs to:

i. Easily access all relevant data and documentation including:
a) current NPL and early arrears borrower information including automated notifications in the case of updates; b) loan and collateral/guarantee information linked to the borrower; or connected borrowers; c) monitoring/documentation tools with the IT capabilities to track restructuring performance and effectiveness; d) status of workout activities and borrower interaction, as well as details on restructuring measures, agreed, etc.; e) foreclosed (foreclosure is the repayment of the outstanding loans to the extent possible through, legal enforcement by a bank) assets (where relevant); and f) tracked cash flows of the loan and collateral.

ii. Efficiently process and monitor NPL workout activities including:
a) automated workflows throughout the entire NPL life cycle; b) automated monitoring process (“tracking system”) for the loan status ensuring a correct flagging of non-performing and forborne loans; c) industrialized borrower communication approaches, e.g. through call centers (including integrated card payment system software on all agent desktops) or internet (e.g. file sharing system); d) incorporated early warning signals (see also EWS section); e) automated reporting throughout the NPL workout lifecycle for NPL WU management, senior management, and other relevant managers as well as the regulator; f) performance analysis of workout activities by NPL WU, sub-team and expert (e.g. cure/success rate, rollover information, effectiveness of

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restructuring options offered, cash collection rate, vintage analysis of cure rates, promises kept rate at call center, etc.); and g) evolution monitoring of portfolio(s) / sub-portfolio(s) / cohorts / individual borrowers.

iii. Define, analyze and measure NPLs and related borrowers:
a) recognize NPLs and measure impairments; b) perform suitable NPL segmentation analysis and store outcomes for each borrower; c) support the assessment of the borrower’s personal data, financial position and repayment ability (borrower affordability assessment), at least for non-complex borrowers; and d) conduct calculations of (i) the net present value (NPV) and (ii) the impact on the capital position of the bank for each restructuring option and/or any likely restructuring plan under any relevant legislation (e.g. foreclosures law, insolvency laws) for each borrower.

The adequacy of technical infrastructure, including data quality, should be assessed by an independent function on a regular basis (for instance internal or external audit).

4.4 Developing a written policy manual

All the banks should have a documented Policy Manual, which evidently mentioned a clear standard timeline for NPL management and resolution. The longer a borrower remains past due, the less likely that the borrower is to repay the loan. A successful resolution, therefore, requires that the bank recognizes the problem early and adheres to a tight but realistic timetable to ensure that the loan is restructured, sold to a third party, or collected through legal proceedings - in the case of non-viable borrowers) in a timely manner.

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5. Workout Plan

5.1 Preparing for the workout process

As the first step after receiving a new NPL, the workout team should ensure collection of all relevant and necessary information on the borrower’s loan and financial details to enable the selection of an appropriate workout plan. The Corporate/MSME team should ensure that the file is transferred with all necessary documentation and a case update summary is attached. In the best-case scenario, the bank should aim at achieving a consensual solution that satisfies the interests of both parties and results in a successful restructuring. Adopting such perspective implies not only a self-assessment of the bank’s options and legal position but also an analysis of the existing options and situation for the borrower. A comprehensive approach requires a thorough preparation process on both sides, which, if done properly, will maximize the chances of achieving a successful and mutually beneficial solution. All work out exercises should adhere to principles of restructuring outlined in Appendix 3 of this document and abide by Section 5 of the “Rules on the Management of Problem Loans”.

On the bank’s side, a thorough preparation includes:

i. Gathering all relevant information available on the borrower;
ii. Perform a thorough review of the borrower’s historical financials, business viability, business plan and forecast loan service capacity.
iii. Accurately assessing the value of the collateral securing the loan; and
iv. Conducting a detailed analysis of the bank’s legal position.

These aspects are further explained in the sections below.

5.1.1 Gathering of information about the borrower

All borrowers and guarantors should be informed promptly (within 5 business days) that responsibility for their relationship has been transferred to the Workout Unit. This notification should be in writing and contain a complete and accurate description of all legal obligations outstanding with the bank, the amounts and dates of all past due amounts together with any fees or penalties which have been assessed. The Workout Unit should intimate the borrower with any violations and loan covenants or agreements observed at the time of information collection.

The borrower should be requested to submit the following information, preferably in electronic format:

i. Information on all loans and other obligations (including guarantees) outstanding.
ii. Detailed contact information (mail, telephone, e-mail), including representatives, if applicable.

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iii. Detailed latest financial statements of the company (balance sheet, income statement, cash flow statement, explanatory notes). MSME’s and financially less-sophisticated enterprises may submit only aggregate financial figures.
iv. Updated business plan and the proposal for repayment/restructuring of loan obligations.
v. Individual entrepreneurs (for example sole proprietors), should also submit information about the household. The two additional parameters for determining the loan servicing ability of such borrowers are: (i) the borrower’s family composition (number of children, number of earners in the family) to determine justified expenses; and (ii) total net earnings.

Updated financial information, together with a detailed listing of all guarantees outstanding, if any, should be also collected from the guarantors (natural or legal persons) of loans. In addition, the bank should exercise all legal efforts to acquire additional information from other sources to form an accurate, adequate, and complete view of the borrower’s loan servicing capability.

During the file review, the Workout Unit should pay close attention to identifying any other significant creditors. These may include other banks and financial institutions, Zakat/Tax authority, utilities, trade creditors and loans to shareholders, related parties, or employees.

For any missing key information identified during the file review, the Workout Unit should develop a corrective action plan to ensure collection of these documents with the help of the business team. Some of this information should be requested promptly from the borrower or third party sources such as Credit Bureaus.

5.1.2 Identifying non-cooperative borrowers:

The Workout Unit should define non-cooperative borrowers and carefully document their non-compliance. Useful criteria to be used to identify these borrowers are:

i. Borrowers who default on their loans while having the ability to pay (“strategic defaulters”) in hopes of receiving unwarranted concessions from the bank.
ii. Failure to respond either orally or in writing to two consecutive requests from the bank for a meeting or financial information within 15 calendar days of each request.
iii. Borrowers who deny access to their premises and/or books and records.
iv. Borrowers who do not engage constructively with the bank, including those that are generally unresponsive, consistently fail to keep promises, and/or reject restructuring proposals out of hand.

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Non-cooperative borrowers are more likely to be transferred to the legal team as it would be difficult to reach a consensual restructuring solution if the Borrowers are not willing to cooperate with the Banks.

However, banks would have to maintain an appropriate audit trail, documenting the rationale for classifying a borrower as “non-cooperative”

5.1.3 Determining the bank’s legal rights and remedies

The banks having reviewed and understood the borrower’s business plan, but before initiating restructuring negotiations with a borrower, must prepare for these negotiations and have a very clear understanding of its bargaining position from a legal standpoint.

The Workout Unit should perform a thorough review of all documents relating to the borrower, with special emphasis on the loan agreement and the security package that was formalized when the transaction took place. An accurate assessment of the bank’s rights will have a critical impact on determining the resolution strategy to be adopted.

The following are general indicators that a Workout Unit could pay attention to when reviewing the documentation:

i. Whether the parties to the loan were adequately described in the loan documentation;
ii. Whether all key documents were signed by the duly authorized persons under Saudi governing law;
iii. Whether the bank is in possession of all original documents;
iv. Whether the collateral has been duly perfected, including registration at the applicable registry
v. Whether the loan documentation included non-compliance with certain financial indicators as ‘events of default’, and whether these indicators have been breached;
vi. Historical financial position, driver of historical underperformance and to what extent this is expected to drive forecast performance:
a) Current market challenges and outlook: The Banks should form a view on how this has impacted the borrower’s historically and how is it expected to impact its forecast performance and ability to repay the loan; b) The capabilities of the borrower’s Management team and whether they are capable of turning around the business; c) Strategy and turnaround initiatives: Does the borrower have a clear strategy or plan to turnaround the business? Has this plan been clearly documented and communicated to banks?

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d) Business plan and financial projections: How is the borrower expected to perform of the medium to long-term? What are the borrower’s cash flow projections, which should provide an indication of his loan service capacity going forward? What is the level of sustainable versus unsustainable loan; e) Alignment with credit terms: To what extent are all of the above aligned with existing credit terms and repayment plan;

vii. Whether the loan documentation included a cross-default clause and whether there are other loans that may be considered breached and/or accelerated as a result of the breach of one single loan;
viii. Whether there was an obligation on the bank to notify the borrower or potential guarantors of major changes in the documentation or the terms of the loan, like changes in legislation, currency, interest rates, etc.

If the borrower is not fully equipped to provide such information or if the banks would like to independently review such information, they can seek to appoint a financial advisor to perform an independent business review and clarify the above.

Once the Banks have formed a good understanding of the above, it is expected to assist them in identifying sustainable and commercial restructuring options that could align the banks’ interest with that of the borrower and maximize recovery. Such options should be continuously evaluated as the WU engage in restructuring discussions and gather further information.

5.1.4 Ensuring collateral’s validity

The workout team should ensure that the collateral taken at the time of loan agreement/origination was formalized and is still valid and enforceable. The banks should complete timely validation of legal documents to evade probable disputes or delay at the time of negotiating restructuring proposal. Furthermore, the banks should establish procedures around periodic (e.g. yearly basis) valuation and monitoring of acquired collateral

The Bank is required to perform detailed collateral analysis for all the accounts referred to WU. The workout team should perform this analysis as detailed out in section 7 of the “Rules on Management of Problem Loans”

5.1.5 Financial viability analysis

Banks need to conduct a thorough financial and viability analysis of its borrowers especially MSME NPL borrowers to determine their ability to repay their obligations. In addition, it is important to obtain sufficient insight into the business plan and projected cash flows available with the borrower for loan service. This will entail determining the borrower’s forecasted loan service capacity and assessment needs to be performed by the banks to align this with the restructured credit terms.

This analysis serves as the foundation for making an informed decision on the appropriate resolution approach – restructuring, sale to a third party, change of loan

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type (loan-to-asset or loan-to-equity swap) or legal proceedings. This analysis is required to be conducted by WU not previously involved in the loan approval process.

A. Analysis of key financial ratios

Financial ratios, calculated from data provided in the balance sheet and income statement, provide an insight into a firm’s operations and are among the most readily available and easy to use indicators for determining the borrower’s viability. In case of MSME borrowers, in the absence of availability of audited and reliable financial information banks should focus on cash-flow based analysis and should also assess the reasonableness of financial information (where this information is available).

Below are four categories of financial ratios that banks may consider for their initial financial analysis (being illustrated below for indicative purposes and should not be considered prescriptive):

i. Liquidity ratios measure how easily a company can meet its short-term obligations within a short timeframe.
a. Current ratio (total current assets/total current liabilities) measures a company’s ability to pay current liabilities by using current assets. It must be recognized that the distressed borrower’s ratios will be considerably lower. The Workout Unit should assess how the borrower can achieve