INSTRUCTION N° 002/2006-CSBF on Counterparty Risk Provisioning Rules for Credit Institutions

Follow us on: The Banking and Financial Supervision Commission (CSBF) of the Republic of MADAGASCAR,

Having regard to Law No. 95-030 of February 22, 1996, on the activity and supervision of credit institutions, particularly Article 41, which empowers the CSBF to set management standards that credit institutions must respect in order to guarantee their liquidity, solvency, and the balance of their financial structure,

Having regard to the opinion formulated by the Professional Association of Banks pursuant to the last paragraph of Article 36 of the aforementioned Law No. 95-030,

DECIDES

Article 1. – Subject of the Instruction

The purpose of this instruction is to clarify the rules for classifying doubtful, disputed, or contentious claims, their reclassification into healthy claims, and the establishment of provisions intended to cover counterparty risks for credit institutions.

Counterparty risks concern client risks, interbank risks, and, more generally, risks related to asset items and off-balance sheet commitments involving third parties.

Specific provisions may be established by the CSBF depending on the category of credit institutions.

Article 2. – Principle of Establishment

Pursuant to the principle of prudence, provisions for impairment losses or charges must be established upon detection of the risk and, in any case, during the quarterly review of all counterparty risks.

These provisions must be estimated based on information available at the date of the file review.

Article 3. – Rules for Downgrading to Doubtful, Disputed, or Contentious Claims

3.1. For the application of this instruction, doubtful, disputed, or contentious claims are defined as claims of any nature, even if secured, meeting one of the following characteristics:

– Claims presenting a probable or certain risk of partial or total non-recovery. This risk exists when the situation of a counterparty presents such characteristics that, regardless of the existence of any default, it appears probable that the institution will not receive all or part of the sums due under the commitments undertaken by the counterparty in accordance with the initial contractual provisions, notwithstanding the existence of guarantees or sureties. This is notably the case when the institution is aware of the deteriorated financial situation of its counterparty resulting in a risk of non-recovery;

– Claims giving rise to disputed recovery, namely: dispute over the reality or extent of the claim;

– Claims having a contentious nature, namely: filing for bankruptcy of the debtor, opening of liquidation or judicial settlement proceedings against them, ongoing judicial recovery proceedings.

The doubtful, disputed, or contentious nature relates to the debtor themselves, which must lead to classifying all their debts vis-à-vis the institution as doubtful, disputed, or contentious claims, including the portion not yet due. This so-called "contagion" rule also applies to off-balance sheet commitments where the risk concerns a counterparty identified as doubtful, disputed, or contentious, unless the characteristics of these commitments make it unlikely that they will be drawn upon.

However, discounted and undue values – commercial instruments, mobilization of claims on foreign entities – accepted by the drawee and on which a payment incident appears improbable, may be maintained in healthy exposures.

3.2. In any case, loans and off-balance sheet commitments presenting the following characteristics must be classified as doubtful, disputed, or contentious claims:

– Amortizable credits whose due dates have remained unpaid for more than three months;

– Overdrafts whose rotation rate, determined over six months according to the modalities defined in Annex 1, exceeds 180 days;

– Defaults on discounted values (local commercial paper, mobilization of claims on foreign entities) that could not be charged to the remitter, due to insufficient provision, within a period of 60 days from the detection of the payment default;

– Off-balance sheet commitments as soon as the following two conditions are met:
o Regardless of the existence of any settlement made regarding this commitment, it appears probable or certain that it will be called by its beneficiary. This is notably the case:
- when the institution is aware that the commitment has a high chance of being called given the course of the operation that justified its issuance;
- or that the commitment has already been called but not yet settled;
o and that the situation of the counterparty on which the risk of the commitment rests presents such characteristics that it appears probable that the funds that would be called under the commitment could not be recovered from them. This is notably the case when the institution is aware of the deteriorated financial situation of the counterparty resulting in a risk of non-recovery of sums that might be disbursed under the commitment.

Derogation from these rules is only possible for loans presenting the above characteristics but for which the absence of doubtful, disputed, or contentious nature of the claim can be established with certainty.

3.3. In the event of concluding an agreement for rescheduling or consolidation of doubtful, disputed, or contentious claims, the claims in question can only be reclassified into healthy exposures under the following conditions:

– Prior repayment by the debtor from their own treasury of at least 10% of the claim finalized after negotiation or of the total of overdue interest included therein if it exceeds 10% of the claim thus finalized;

– Failing that, at the end of a probationary period of six months from the first due date of the consolidation credit, during which the debtor has honored the credit due dates punctually, if any.

3.4. Except for exposures of a negligible amount relative to the costs of procedures to be initiated or for claims subject to partial write-off within the framework of consolidation, the write-off of doubtful, disputed, or contentious claims by transfer off the books is subject to the prior exhaustion of all legal means available to the creditor institution. The inventory of written-off claims with an amount equal to or greater than 20 million ariary, including claims that have been subject to partial write-off, accompanied by a history of each file and the diligence carried out by the institution, must be sent to the General Secretariat of the CSBF within a period of one month before the accounting entry of the operation.

In all cases, the write-off must be effected according to the following accounting entries:

For client risks

Debit: 6411 "Losses on advances and loans – covered by provisions" [amount of provisions + reserved interest]

6412 "Losses on advances and loans – not covered by provisions" [amount of provisions – reserved interest]

Credit: 27 "Disputed, doubtful or contentious claims" [gross amount]

and

Debit: 29 "Impairment losses on advances and loans" [amount of provisions]

326 "Reserved Products"
[amount of reserved interest]

Credit: 7822 "Reversal of provisions – operations with customers" [amount of provisions + reserved interest]

For other counterparty risks

Debit: 649 "Various banking operating expenses" [amount of provisions + possibly reserved products]

Credit: 17 or 37 or 47 "Disputed, doubtful or contentious claims" [gross amount]

and

Debit: 19 or 39 or 49 "Impairment losses (cash accounts, other financial accounts, fixed asset value accounts)" [amount of provisions]

326 "Reserved Products"
[amount of reserved interest, if any]

Credit: 782x "Reversal of provisions (depending on the nature of the counterparty)" [amount of provisions + possibly reserved interest]

Article 4. – Provisioning of Doubtful, Disputed, or Contentious Claims

4.1 Doubtful, disputed, or contentious claims must be provisioned based on their real recovery value.

Real recovery value refers to the gross value of the claim – that is, the amount of capital as well as accrued and due interest – minus the probable or certain risk of loss and reserved interest. The evaluation must obviously take into account the real value of the guarantees, i.e., the realization value on the market, as well as their effective possibility of realization.

4.2 Subject to the provisions of Article 4.3, the amount of the provision is to be determined:

– on a case-by-case basis and based on file elements for loans exceeding a threshold set by the General Directorate, which reports to the General Secretariat of the CSBF. This threshold must be determined in such a way as to ensure an individual review of the essential commitments of the institution.

– by sampling, in the absence of a full review, for exposures below the threshold referred to in the previous paragraph; the result of the survey will be extrapolated for risks not examined.

In any case, due dates on amortizable credits unpaid for more than three months must be fully provisioned.

An evaluation sheet according to the model in Annex 2 must be included in the file of clients classified as doubtful, disputed, or contentious.

4.3 Overdrafts presenting the characteristics stated in Article 3.2 are provisioned, for the net exposure minus the value of any guarantees, according to the following quotas:

– at least 40% when the rotation period for the last semester is between 180 and 240 days, – at least 60% when this period exceeds 240 days without exceeding 365 days, – 100% when this period exceeds 365 days.

4.4 The value of guarantees taken into account to determine the final risk incurred on compromised claims is subject to the following deductions in the absence of realization of these guarantees:

– for real estate guarantees: 25% when they have not been realized within a period of 18 months following the downgrading of the claim to doubtful, disputed, or contentious claims, 50% when this period reaches 24 months, 100% when this period exceeds 36 months; – for other guarantees: 25% when they have not been realized within a period of 12 months following the downgrading of the claim to doubtful, disputed, or contentious claims, 50% when this period reaches 18 months, 100% when this period exceeds 24 months.

4.5. In application of the provisions of PCEC 2005, interest and commissions accrued as appropriate on doubtful, disputed, or contentious claims are credited to account "326 – Reserved Products". The accrued and undue fraction of interest and commissions related to these claims must not be recognized during the periodic closing of the institution's accounts.

Article 5. – Procedural Rules

Any derogations from the provisions of Articles 3.2, 4.3, and 4.4, the reclassification into healthy loans referred to in Article 3.3, and the write-offs of claims referred to in Article 3.4 are subject to a written and reasoned decision, signed by a person with the necessary powers, approved by the unit responsible for internal audit of commitments, and countersigned by the General Directorate.

Article 6. – Accounting for Provisions

6.1. The established provisions are accounted for in a credit account and are deducted from the corresponding asset accounts.

Entries to be made:

– Debit: 6821 to 6826 depending on the case "Provisions – impairment losses…" – Credit: 19 or 29 or 39 or 49 "Impairment losses -…"

At the end of each fiscal year, it is necessary to adjust the amount of the provision based on the evolution of the file situation, either by increasing it (see scheme above) or by decreasing it through a reversal of provision as follows:

– Debit: 19 or 29 or 39 or 49 "Impairment losses -…" – Credit: 7821 to 7826 depending on the case "Reversal of provisions – impairment losses…"

6.2 Off-balance sheet commitments identified as disputed, doubtful, or contentious are subject to provisioning on the liability side of the balance sheet "provisions for charges", up to the amount of the estimated loss risk. This risk is a function of the real recovery value of the claim in the event that the commitment is called.

– Debit: 6839 "Provisions – other provisions for charges" – Credit: 559 "Other provisions for charges – non-current liabilities"

In case of reversals:

– Debit: 559 "Other provisions for charges – non-current liabilities" – Credit: 7839 "Reversal – other provisions for charges"

Article 7. – Miscellaneous Provisions

7.1. "General Risk Provisions" established on healthy claims during previous fiscal years must be treated according to the "Guide for First Application of the General Accounting Plan 2005".

7.2. When counter-guarantees are not called or when they are called but without a response from the guarantor, the General Secretariat of the CSBF may refuse to take into account any guarantee issued by said guarantor when calculating prudential ratios.

7.3 Credit institutions that resort to procedures other than those provided for by this instruction for the downgrading and provisioning of overdrafts, and whose effectiveness is judged equivalent, may request authorization from the General Secretariat of the CSBF to continue using these procedures. The request must be supported by a precise description of the system implemented and all useful elements of appreciation.

7.4. Credit institutions where the implementation of these provisions would pose technical problems must submit to the General Secretariat of the CSBF the transitional measures envisaged to address these difficulties in an acceptable manner. Based on the justifications presented, the General Secretary may grant a deadline for the implementation of the provisions of the instruction.

7.5 This instruction cancels and replaces all previous and contrary provisions, notably Instruction No. 004/97-CSBF of June 2, 1997. It enters into force as of the quarterly review mentioned in Article 2, on December 31, 2006.

Done in Antananarivo, on October 13, 2006.

For the Banking and Financial Supervision Commission,

THE PRESIDENT,

Gaston RAVELOJAONA.

Annexes:

Annex I

Annex II

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