Recommendation A-SKOK on Good Practices for Managing Credit Exposure Risk in Cooperative Savings and Loan Associations

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Financial Supervision Commission
Recommendation A-SKOK concerning good practices for managing credit exposure risk in cooperative savings and loan associations Warsaw, June 2015

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Introduction
This document is issued pursuant to Article 62(2) of the Act of 5 November 2009 on cooperative savings and loan associations and constitutes a collection of good practices regarding the management of credit exposure risk for the cooperative savings and loan association sector. When adapting its activities to this Recommendation, the association shall take into account applicable laws, in particular the provisions of the Act of 12 May 2011 on consumer credit.

Proper management of credit risk is of fundamental importance for the safety and development of the cooperative savings and loan association sector, directly translating into the safety of members' deposits, the stable functioning of the associations, and the financial results of this sector.

The provisions of Recommendation A-SKOK are aimed at reducing the credit risk occurring in the activities of the associations and support their sustainable activity in the area of loans granted to members, while maintaining the necessary level of safety. The provisions of the Recommendation concern secured and unsecured loans and advances. In the case of secured credit exposures, the specificity of accepted collateral is taken into account, in particular the most popular forms of collateral in associations – namely guarantees and real estate mortgages.

In the opinion of the supervisor, if associations offer the same products as banks, the credit risk in this area is the same. Consequently, expectations in this regard – both qualitative and quantitative – should be similar. The application of a different, including more lenient, approach may concern mainly organizational issues of the associations themselves, rather than the products they offer. This means that the provisions of Recommendation A-SKOK in selected areas are analogous or similar to those specified for the banking sector. The provisions of the Recommendation result from irregularities in the activities of associations identified during inspection and analytical supervision processes. The financial situation of the associations and the quality of their loan portfolios were also taken into account. Therefore, in some cases, the provisions contained in the document are different or stricter than those specified for banks.

In preparing the provisions of the Recommendation, the supervisor relied on:

• Basel Committee on Banking Supervision standards, adapted to the specificity of the cooperative savings and loan association sector,
• guidelines developed by the World Council of Credit Unions (WOCCU),
• risks and irregularities in the activities of associations identified based on inspection results and ongoing analytical supervision conducted "from the desk".

Key Provisions of the Recommendation
Management Board and Supervisory Board and Organizational Expectations The Recommendation defines the mutual relations between the management board and the supervisory board of the association regarding key areas of credit risk management, at the stage of defining and implementing credit risk management policy, including the determination of key LTV and DtI parameters, assessment of creditworthiness, and conducting reviews of this policy and reporting on incurred credit risk.

The Recommendation indicates the necessity for all associations to have formalized rules for managing credit risk, consistent with the strategic goals and general assumptions of the associations regarding risk management in their activities.

In particular, it provides that the management board approves maximum levels of the DtI and LTV indicators, and subsequently informs the supervisory board and the National Cooperative Savings and Loan Association (Kasa Krajowa) of the adopted parameters. The Recommendation indicates the factors that should be taken into account when setting DtI and LTV parameters.

Taking into account the need to ensure the appropriate quality of the credit process, the Recommendation defines what should be included in the association's credit risk management policy. The credit risk management policy used by the association should be subject to an annual review.

The Recommendation also defines the role of the management board and the supervisory board in the credit risk management process. To enable the effective performance of its tasks by the supervisory board, the association should have an internal reporting system including, among other things, the level of risk incurred by the association and information on the status of implementation of the adopted credit risk management policy, with reporting taking place at least once a year for exposures secured by mortgage and at least every six months for other exposures.

The Recommendation recommends the division of tasks performed in the association to ensure the independence of the risk acceptance function from the sales function.

Minimum expectations regarding the approach to high-value exposures and mortgage-backed loans are also presented. With regard to high-value exposures, associations should exercise particular caution in assessing creditworthiness, monitoring loan repayment, monitoring the borrower's creditworthiness, and in accepting collateral. In the opinion of the supervisor, the possibility of obtaining a high-value loan should also be dependent on the length of the member's cooperation with the association.

Identification, Measurement, and Assessment of Credit Exposure Risk Statutory requirements imposed on cooperative savings and loan associations regarding the rules for assessing creditworthiness are the same as for banks (Article 36 of the Act of 5 November 2009 on cooperative savings and loan associations refers to the Act of 29 August 1997 – Banking Law). Therefore, provisions relating to the rules for assessing members' creditworthiness are similar to solutions functioning in the case of banks. The assessment of creditworthiness should be based on the evaluation of quantitative and qualitative criteria. The document indicates key elements of the creditworthiness assessment process, such as determining the actual size of income available to the applicant and taking into account the actual size of costs incurred by the applicant. In the case of assessing the borrower's creditworthiness, the analysis of qualitative features should include, among other things: analysis of the applicant's personal characteristics, analysis of the history of the member's cooperation with the association, analysis of their credit history based on information available in databases and, where possible, in economic databases.

The Recommendation provides for the possibility of applying simplified rules for assessing creditworthiness. However, when allowing simplified rules for assessing creditworthiness, the risk of rapid implementation by some associations of statistical methods, i.e., in the absence of sufficient experience in their use, should be minimized. The result of incorrectly parameterized statistical methods may be relying on false creditworthiness assessment results at the stage of making credit decisions. Consequently, a condition for allowing the use of simplified rules for assessing creditworthiness is having at least one year of experience in using these tools and obtaining results comparable to those of creditworthiness assessment based on standard rules.

The legislator, in Article 9 of the Act of 12 May 2011 on consumer credit, provided for lenders, including associations, to use databases in assessing creditworthiness. The Recommendation contains appropriate provisions in this regard. This allows information provided by borrowers to be effectively verified (including regarding their potential burden with other loans). The Recommendation contains appropriate provisions in this regard. The exception from the general rule to always use databases when assessing creditworthiness is conditional, among other things, on the length of membership tenure and the amount of the requested exposure.

Reference was also made to issues related to loan restructuring.

Tools Supporting the Process of Managing Credit Exposure Risk The Recommendation includes provisions regarding tools supporting the process of managing credit exposure risk that the association should use – internal information systems, databases, and analytical tools supporting the measurement of risk levels.

The document contains provisions regarding the conduct of stress tests, which are one of the tools for effective credit risk management. Their results can indeed be an important source of data regarding the potential situation of the association in the event of unfavorable phenomena, e.g., significant changes in interest rates. At the same time, taking into account the organizational and technical requirements related to their effective conduct, conducting stress tests is recommended for the largest associations.

The possibility of conducting tests with the support of the National Cooperative Savings and Loan Association (Kasa Krajowa) is also provided.

Expectations Regarding Accepted Collateral
In the context of collateral accepted by associations, the maximum amount of exposure to a member for which collateral is not required was indicated, i.e., the level of three times the average monthly salary in the enterprise sector announced by the Central Statistical Office (GUS).

Supervisory expectations regarding mortgage collateral are similar to the provisions of Recommendation S concerning good practices in managing mortgage-backed credit exposures. More lenient expectations are provided for in the case where the initial LTV does not exceed 40% and the credit exposure is secured on residential real estate.

Detailed Recommendation 20.7 specifies LTV indicator limits "in the case of credit exposures secured on residential real estate." Indicating the generally applicable limit levels (target and for subsequent years in the transitional period), the Recommendation provides for the possibility of taking into account their increased level, if the part of the exposure exceeding the generally specified limit "is appropriately insured, or the borrower has provided additional collateral in the form of a freeze of funds in a bank account or through a pledge on złoty-denominated debt securities of the State Treasury or NBP." For economic equivalence to a freeze of funds, provided that the interests of the association are properly secured, funds accumulated in IKE (Individual Retirement Accounts) or IKZE (Individual Pension Accounts) may be recognized, due to their nature, including the possibility of determining their value and creating a pledge in favor of the association. At the same time, given that the accumulation of funds by savers in IKE or IKZE serves a retirement purpose, it is indicated that the necessity exists for the association to include in the loan contract a clause allowing the borrower, upon meeting the conditions resulting from Article 34(1) and Article 34a(1) of the Act (regarding withdrawal), access to funds accumulated in the retirement account, on condition that funds from the IKE or IKZE encumbered by the pledge are used to repay the incurred loan.

It should also be noted that as a result of further payments to IKE or IKZE, as well as due to the allocation of funds after signing the loan contract, the value of funds in the IKE or IKZE account increases. For this reason, it is important to determine in the loan contract the value of the pledge in favor of the association, in the event of the necessity for the association to use this pledge to satisfy claims arising from the contract. The source for pursuing the association's claims arising from the borrower's failure to fulfill obligations should be the amount indicated in the loan contract. The remaining part of the funds accumulated in the IKE or IKZE account should be managed by the saver in the IKE or IKZE, deciding on a refund (in the case of lack of withdrawal rights) or withdrawal and potential repayment of obligations to the association.

It should simultaneously be emphasized that in the case of funds accumulated within IKE or IKZE, for the purpose of applying a higher LTV limit, the amount that will be actually paid out to the client should be taken into account, not the nominal value of the accumulated funds.

The Recommendation also contains provisions regarding collateral in the form of guarantees, including, among other things, provisions regarding conducting an assessment of the guarantor's creditworthiness analogously to the requirements for the borrower at the time of granting the loan and at the time of its potential restructuring.

Monitoring and Reporting of Credit Exposure Risk Credit monitoring is a system of current verification of the member's creditworthiness and legal collateral. An important aspect of monitoring is its protective function, consisting of preventive actions and eliminating the consequences of active credit risk. The provisions of Recommendation A-SKOK regarding reporting rules include defining the basic goals of the reporting system, its minimum scope, and the frequency of reporting.

Associations should have limits allowing them to control and reduce the risk of the entire portfolio of credit exposures, as well as portfolios of individual types of exposures. Limits should reflect the diversification of credit exposures and accepted collateral. Each product should have a specified maximum level of single exposure, taking into account the segmentation of members.

Taking into account that the main source of financing for the activities of associations are short-term (up to one year) deposits of members (primarily savings of individuals), the Recommendation indicates the necessity of conducting an in-depth analysis of funding sources, developing a plan for their acquisition (and subsequently monitoring its implementation), as well as having procedures for managing liquidity gaps and mismatch risk in the management of interest rate risk. In the case of loans granted for periods exceeding 15 years, the association should indicate liabilities funding these loans with an appropriate maturity period.

Internal Control
Pursuant to the Act of 5 November 2009 on cooperative savings and loan associations, internal control should function in the associations. To ensure the appropriate quality of internal control, it is necessary in the association to formalize its functioning by adopting written internal regulations by the management board of the association defining the rules and manner of exercising control. To strengthen control mechanisms, it was specified which elements of the credit process should be controlled in particular.

Relations with Association Members
The document also contains provisions relating to relations with members in connection with the conclusion of a loan contract. Before concluding a loan contract, members should receive appropriate information regarding the terms and costs of the loan. The provisions of the Recommendation define good practice regarding the requirements imposed on lenders under the Act of 12 May 2011 on consumer credit.

Scope of Application of the Recommendation and the Role of the National Cooperative Savings and Loan Association (Kasa Krajowa) Due to the significant diversity of associations regarding the scale of their activities (balance sheet total size, loan portfolio size, number of members, number of employees, etc.) and the associated risk, for the purpose of determining the scope of application of selected provisions of Recommendation A-SKOK, associations were divided into three groups:

• GROUP I - associations meeting both criteria: the association's balance sheet total is less than 50 million PLN and the number of members is lower than 10 thousand;
• GROUP II - associations with a balance sheet total of at least 50 million PLN but not more than 200 million PLN (regardless of the number of members) and associations with a balance sheet total below 50 million PLN and at least 10 thousand members;
• GROUP III - associations with a balance sheet total above 200 million PLN (regardless of the number of members).

Only the main recommendations (i.e., Recommendation 1, Recommendation 2, etc.) apply directly to the smallest associations (GROUP I), and in the area covered by detailed recommendations (i.e., recommendations 1.1, 1.2, etc.), associations may introduce their own solutions, having in mind, of course, that these solutions ensure the realization of goals specified in the respective recommendations.

In the case of the largest associations (GROUP III), the supervisor expects the implementation of the Recommendation in its full scope, i.e., main and detailed recommendations.

In the case of medium-sized associations (GROUP II), the supervisor also expects the implementation of main and detailed recommendations, although associations may decide not to apply Recommendation 12.4 concerning, among other things, procedures defining the manner of collecting and processing information about the association's cooperation with members, as well as the manner of controlling the completeness and reliability of this information.

Additionally, associations from GROUP I and GROUP II may decide not to apply Recommendation 15 concerning the conduct of stress tests.

Recommendations 19.6 and 19.7 regarding the use of real estate databases are primarily directed at associations for which the share of the portfolio of mortgage-backed credit exposures (valued at book value) constitutes more than 5% of the balance sheet total or more than 10% of the loan portfolio (valued at book value) of the given association.

The Recommendation addresses the issue of cooperation between associations and the National Cooperative Savings and Loan Association (Kasa Krajowa) in several areas, which results from the special role of the Kasa Krajowa in the SKOK sector. Taking into account the tasks of the Kasa Krajowa specified in Article 44(2) of the Act on cooperative savings and loan associations, in order to ensure the most efficient implementation of the provisions of the Recommendation by cooperative savings and loan associations and to reduce organizational burdens for associations related to this process, the supervisor expects the Kasa Krajowa to take an active part in this process. This should significantly facilitate (especially for smaller associations) adapting to the Recommendation, and on the other hand, promote the improvement of credit risk management standards.

It is proposed that the Kasa Krajowa support associations in the process of improving credit risk management and adapting to the provisions of the Recommendation also in other areas – as appropriate to the needs reported by individual associations (e.g., in the organization of individual processes, determination of limits reducing credit risk relating to the entire portfolio and individual types of credit exposures).

The term "borrower" used in the Recommendation means a member of the association applying for a loan or to whom the association has granted a loan. Whenever in individual recommendations mention is made of "borrower" or "loan", the provisions of these recommendations also apply to "advance takers" and "advances", unless otherwise specified or if the inability of the association to comply with a given provision results from the specificity of advances. Furthermore, for the purposes of the Recommendation, the terms "association member" and "borrower" are used interchangeably.

In some areas, in accordance with the provisions of the Recommendation, mention is made of the minimum period of cooperation between the association member and the association (at least 6 months or at least 12 months). The adopted approach (restriction) results from the higher risk associated with the issues raised in selected Recommendations.

The Financial Supervision Commission expects that the Recommendation concerning good practices for managing credit exposures in cooperative savings and loan associations, constituting an annex to Resolution No. .../2015 of the Financial Supervision Commission of 23 June 2015 (Journal of Laws of KNF pos. ...), will be implemented no later than by 31 March 2016, with the exception of:

• Recommendation 10 and
• Recommendation 13,
  which associations classified into GROUP II should implement by 30 September 2016.

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Glossary of Used Terms:

1. Risk Appetite – expressed in the form of quantitative indicators, determined by the association, the maximum permissible level of exposure to credit risk.
2. Database – standardized internal and external data sets, maintained for the purposes of credit risk assessment by associations, banks, and institutions referred to in Article 105(4) of the Act of 29 August 1997 – Banking Law.
3. Economic Database – standardized data sets maintained by economic information bureaus, referred to in the Act of 9 April 2010 on the provision of economic information and exchange of economic data.
4. Real Estate Market Database – an internal or independent of the association standardized system for collecting and processing data, in which data on the real estate market are collected systematically, including in particular characteristics of real estate and information regarding prices and values of real estate, enabling the conduct of analyses and monitoring of phenomena occurring in the real estate market. Data entered into the database may come from sources of associations and banks or reliable non-bank sources.
5. Retail Credit Exposure – credit exposure to an individual, granted for purposes unrelated to economic activity or running an agricultural household, excluding mortgage-backed credit exposure.
6. Credit Exposure – the association's claim arising from a loan and advance, debt limit (including from a credit and debit card), acquired receivable, check and bill of exchange, realized guarantee, other receivable of a similar nature, and granted off-balance sheet commitment.
7. Mortgage-Backed Credit Exposure – credit exposure related to real estate financing, in which a mortgage security has been established or a mortgage constitutes the target security. If the Recommendation mentions "credit exposure secured on real estate," this should be understood as "mortgage-backed credit exposure." In the case of credit exposures not related to real estate financing, mortgage-backed credit exposures are considered to be credit exposures in which:

1. the original maturity period is longer than three years and
2. the mortgage is or will be the dominant security.

8. Household – related or unrelated persons living together and maintaining themselves. Single persons maintaining themselves independently are single-person households.
9. National Cooperative Savings and Loan Association (Kasa Krajowa) – Krajowa Spółdzielcza Kasa Oszczędnościowo-Kredytowa, referred to in Article 1 of the Act of 5 November 2009 on cooperative savings and loan associations.
10. Monitoring of Real Estate Value – observation by the association of changes in the value of real estate.
11. Commercial Real Estate – real estate that is not residential real estate.
12. Residential Real Estate – real estate intended for residential purposes, which is or will be inhabited or intended for rent by the owner (excluding economic activity), i.e., a house or residential premises constituting a separate real estate together with auxiliary premises serving to satisfy residential needs, or used in accordance with their purpose for other than residential purposes (components of the premises, i.e., rooms, even if they do not directly adjoin it or are located within the boundaries of the land real estate outside the building in which the given premises were distinguished, and in particular: basement, attic, storage room, garage), a building plot or its part, intended for construction
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