Rules on Management of Problem Loans

Saudi Arabian Monetary Authority
Rules on Management of Problem Loans
January 2020

Contents

1. General Requirements ................................................................................................. 3
   1.1 Introduction ........................................................................................................ 3
   1.2 Objective of the Rules ........................................................................................ 3
   1.3 Scope of Implementation .................................................................................... 3
   1.4 Definitions .......................................................................................................... 3
2. Problem Loan Prevention and Identification ............................................................. 5
   2.1 Early Warning Signals ....................................................................................... 5
3. Non-performing loans (NPL) Strategy ...................................................................... 7
   3.1 Developing the NPL Strategy ............................................................................ 7
   3.2 Implementing the NPL Strategy ......................................................................... 7
4. Structuring the Workout Unit .................................................................................... 8
   4.1 Performance Management .................................................................................. 8
5. Approaching Restructuring Cases .............................................................................. 8
   5.1 Viability of restructuring ................................................................................... 8
   5.2 Code of Conduct ............................................................................................... 10
6. Workout Plan ............................................................................................................ 11
   6.1 Negotiating and Documenting Workout Plan ................................................... 11
   6.2 Monitoring the Workout Plan ........................................................................... 12
7. Collateral .................................................................................................................. 13
   7.1 Governance ....................................................................................................... 13
   7.2 Types of Collateral and Guarantees ................................................................. 13
   7.3 General Requirements for Collateral ................................................................ 14
   7.4 Specific Requirements for Each Type of Collateral and Guarantees ............. 15
   7.5 Valuation Frequency ......................................................................................... 18
   7.6 Specific Requirements for Valuers ................................................................... 18
8. Regulatory Reporting Requirements ......................................................................... 19
9. Effective Date ........................................................................................................... 19

Rules on Management of Problem Loans

1. General Requirements
   1.1 Introduction
   In exercise of the powers vested upon Saudi Arabian Monetary Authority (SAMA) under the charter issued by the Royal Decree no. 23 on 23-05-1377AH (15 December 1957G) and the Banking Control Law promulgated by Royal Decree no. M/5 dated 22/2/1386AH. SAMA is hereby issuing the enclosed Rules on the Management of Problem Loans aimed to develop the practices followed by banks while dealing with loans showing signs of stress along with the loans already specified as non-performing. These rules should be read in conjunction with SAMA rules on Credit Risk Classification and Provisioning. Also, SAMA issued the Guidelines on Management of Problem Loans as good practices to support banks in implementing these Rules.

1.2 Objective of the Rules
The objectives of these rules are as follows:
i. To ensure banks put in place a conceptual framework which would facilitate rehabilitation of viable borrower, thereby supporting economic activity.
ii. To ensure banks look into aspects of customer conduct and fair treatment whilst dealing with problem loans, especially in instances involving the MSMEs.
iii. To ensure banks have adequate controls over non-performing and problem loan management and restructuring processes, including documented policies and procedures.

1.3 Scope of Implementation
These rules are applicable for all banks licensed under Banking Control Law.

1.4 Definitions
The following terms and phrases, where used in these Rules, should have the corresponding meanings, unless the context requires otherwise:
Problem loans: Loans that display well-defined weaknesses or signs of potential problems. Problem loans should be classified by the banks in accordance with accounting standards, and consistent with relevant regulations, as one or more of:
a) non-performing; b) subject to restructuring on account of inability to service contractual payments; c) IFRS 9 Stages 2; and exhibiting signs of significant credit deterioration or Stage 3; d) under watch-list, early warning or enhanced monitoring measures; or e) where concerns exist over the future stability of the borrower or on its ability to meet its financial obligations as they fall due.

Non-performing loans: As stipulated in BCBS 403 “Guidelines – Prudential treatment of problem assets – definitions of non-performing exposures and forbearance” endorsed by SAMA through circular no. 381000099757 dated 23/09/1438AH.

Watch-list: Loans that have displayed characteristics of a recent increase in credit risk, and are subject to enhanced monitoring and review by the bank.

Early Warning Signals: Quantitative or qualitative indicators, based on liquidity, profitability, market, collateral and macroeconomic metrics.

Cooperating borrower: A borrower which is actively working with a bank to resolve their problem loan.

Viable borrower: Is that, wherein the loss of any concessions as a result of restructuring, is considered to be lower than the loss borne due to foreclosure.

Viability Assessment: An assessment of borrower’s ability to generate adequate cash flow in order to service outstanding loans.

Covenant: A Borrower’s commitment that certain activities will or will not be carried out.

Key performance indicators: Indicators through which bank management or supervisor can assess the institution’s performance.

Collateral: Are those, whose value can be considered whilst computing the recoverable amount for workout cases or foreclosed cases, on account of meeting the stipulated conditions laid out in these rules, as would be applicable based on the nature of the collateral.

Failed restructuring: Any restructuring case where the borrower failed to repay the revised contractual cash flows as agreed upon with the bank and has transitioned into default.

Further to the above, Banks should adopt all requirements relating to i) Restructuring, ii) Identification of forbearance; iii) Identification of financial difficulty; iv) Identification of concession; and v) Stage allocation for forborne loans, as stipulated under SAMA Rules on Credit Risk Classification and Provisioning.

2. Problem Loan Prevention and Identification
   2.1 Early Warning Signals
   Banks should develop a clear, robust and demonstrable set of policies, procedures, tools, and governance around the establishment of Early Warning Signals (EWS) which are fully integrated into the bank’s risk management system.
   The established EWS should be comprehensive and relevant to the specific portfolios of the Banks, and should enable Banks to proactively identify potential difficulties, investigate the drivers of the borrowers stress, and act before the borrower’s financial condition deteriorates to the point of default. Banks should organize their EWS process in the following three stages:
   i. Identification of EWS:
   Banks’ EWS should, at a minimum, take into account indicators that point to potential payment difficulties. Individual banks should undertake an internal assessment as to which EWS are suitable for each of their lending portfolios taking into account a combination of the following:
   a. Economic environment: Banks should monitor indicators of the overall economic environment, which are relevant for determining the future direction of loan quality, and not only the individual borrower’s ability to pay their obligations but also collateral valuations. Examples of economic indicators, based on the nature of the respective portfolios, can include GDP growth, Inflation/deflation, and unemployment, as well as indicators that may be specific to certain sectors/portfolios, e.g. commodity or real estate. b. Financial indicators: Banks should establish a process in order to get frequent interim financial reports (or cash-flow/ turnover details for MSME) from their borrowers (e.g., quarterly for material loans to listed entities and semi-annual for all others), to ensure that EWS are generated in a timely manner. Examples of financial indicators, based on the nature of the respective portfolios, can include Debt/EBITDA, Capital adequacy, Interest coverage – EBITDA/ interest and principal expenses, Cash flow, Turnover (applicable for MSME).
   c. Behavioral indicators: Banks should institute behavioral warning signals to assess the integrity and competency of key stakeholders of the borrower. These indicators will help in the assessment of how a borrower behaves in different situations.
   Examples of these indicators are: regular and consistent attempts at delaying financial reporting requirements; reluctance or unwillingness to respond to various communications, any attempt at deception or misrepresentation of facts, excessive delays in responding to a request for no valid reason. d. Third-party indicators: Banks should organize a reliable screening process for information provided by third parties (e.g. rating agencies, General Authority of Zakat and Tax, press, and courts) to identify signs that could lead to a borrower’s inability to service its outstanding liabilities. Example of these indicators are: Default at other financial institutions / any negative information, insolvency proceedings for major supplier or customer, downgrade in external rating assigned and trends with respect to external ratings. e. Operational indicators: Banks should establish a process where any changes in the borrower’s operations are flagged as soon as they occur. Examples of these indicators, based on the nature of the portfolio can include, frequent changes of suppliers, frequent changes of senior management, qualified audit reports, change of the ownership, major organizational change, management and shareholder contentiousness. Banks should establish a comprehensive set of EWS that provide banks with an opportunity to act before the borrower’s financial condition deteriorates to the point of default, and enable them to proactively identify and flag other loans that have similar characteristics, i.e. multiple loan facilities extended to the same borrower, or borrowers in same sector that may be affected by the overall economic environment, or loans with similar type of collateral.
   ii. Corrective action:
   Banks should have a proper written procedures to be followed in case any of the established EWS is triggered. The response procedure should clearly identify the roles and responsibilities of all the sections responsible for taking action on the triggered EWS, specific timelines for actions along with, identification of the cause and severity of the EWS.
   iii. Monitoring:
   Banks should have a robust monitoring mechanism for following up on the triggered EWS, in order to ensure that the corrective action plan has been executed to pre-empt potential payment difficulties of the borrowers. The level and timing of the monitoring process should reflect the risk level of the borrower.

3. Non-performing loans (NPL) Strategy
   3.1 Developing the NPL Strategy
   i. Banks should develop and implement an NPL strategy that is approved by the Board of Directors or its delegated authority.
   ii. The NPL strategy should layout in a clear, concise manner the bank’s approach and objectives, and establish annual quantitative targets over a realistic but sufficiently ambitious timeframe, divided into short, medium and long-term horizons. It should serve as a roadmap for guiding 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 goals are met.
   iii. The NPL strategy should consider all available options to deal with problem loans, where banks review the feasibility of such options and their respective financial impact. These include hold/restructuring strategies, active portfolio reductions through either sales and/or writing off provisioned NPLs that are deemed unrecoverable, taking collateral onto the balance sheet, legal options and out-of-court options.
   iv. Banks should follow the principle of proportionality and materiality, while designing the NPL strategy, where adequate resources should be exhausted on specific segments of NPLs during the resolution process, including MSME’s.

3.2 Implementing the NPL Strategy
i. Banks should ensure that the components of the NPL strategy are communicated to relevant stakeholders across the bank, and proper monitoring protocols are established, together with performance indicators.
ii. The NPL strategy should be backed by an operational plan detailing how the NPL strategy will be implemented. This should include clearly defining and documenting the roles, responsibilities, formal reporting lines and individual (or team) goals and incentives geared towards reaching the targets in the NPL strategy.
iii. Banks should put in place mechanisms for a regular review of the strategy and monitoring of its operational plan effectiveness and its integration into the bank’s risk management framework.

4. Structuring the Workout Unit
   i. Banks should establish a dedicated Workout Department/Section/or Unit to manage all workout related cases in order to effectively manage NPL resolution process. The Workout Department/Section/or Unit should be independent of the Business/Loan Originating Units to avoid any potential conflicts of interest.
   ii. Banks should ensure that, Workout Unit is properly staffed with resources having the required skill sets to manage workout situations, strong analytical, legal, financial analysis skills, and proper understanding of the workout process.

4.1 Performance Management
i. Banks should establish proper and well-defined performance matrices for Workout Unit staff that should not be based solely on the reduction in the volume of non-performing loans; An appraisal system and compensation structures tailored for the NPL Workout Unit should be implemented and in alignment with the overall NPL strategy, operational plan and the bank’s code of conduct.
ii. In addition to quantitative elements linked to the bank’s NPL targets and milestones (with a strong focus on the effectiveness of workout activities), the appraisal system should 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, and monitoring of restructured cases.
iii. The importance of the respective weight given to indicators within the overall performance measurement framework should be proportionate to the severity of the NPL issues faced by the bank.

5. Approaching Restructuring Cases
   5.1 Viability of restructuring
   Banks should implement a well-defined restructuring policy aligned with the concept of viability that recognizes in a timely manner those borrowers who are non-viable. The policy should ensure that only viable restructuring solutions are considered, which should contribute to reducing the borrower’s balance of credit facilities. Long-term restructuring measures should only be considered viable where the following conditions are met:
   i. The bank can demonstrate, based on reasonable documented financial information, that the borrower can realistically afford the restructuring solution.
   ii. Outstanding arrears are addressed as part of the restructured terms. That does not necessarily mean full repayment, and should not conflict with the potential reduction in the borrower’s balance in the medium to long-term that could be required to align with the borrower’s loan service capacity.
   iii. In cases, where there have been previous restructuring solutions granted in respect of a loan, the bank should ensure that additional internal controls and early warning signals are implemented, so that the restructuring treatment meets the viability criteria. These controls should include, at a minimum, approval of a designated Senior Management Committee.
   Short-term restructuring measures should only be considered viable where the following conditions are met:
   i. The bank can demonstrate, based on reasonable documented financial information, that the borrower can realistically afford the restructuring solution.
   ii. Short-term measures are to be applied temporarily where the bank has satisfied itself and is able to attest, based on reasonable financial information, that the borrower demonstrates the ability to repay the original or agreed modified amount on a full principal and interest basis commencing from the end of the short-term temporary arrangement.
   iii. The solution approved is not perceived to lead to multiple consecutive restructuring measures in the future.
   The bank’s assessment of viability should be based on the financial characteristics of the borrower and the restructuring measure to be granted at that time.
   Whilst evaluating borrower’s viability, due consideration need be made, that any increase in pricing (for instance, over and above driven by risk-based pricing principles) with respect to the borrower’s outstanding facilities, does not make the resultant installments, unserviceable. Banks should undertake the viability assessment irrespective of the source of restructuring, for instance, borrowers using restructuring clauses embedded in a contract, bilateral negotiation of restructuring between a borrower and the banks, public restructuring scheme extended to all borrowers in a specific situation.

5.2 Code of Conduct
Banks should develop a written Code of Conduct for managing problem loans, the Code of Conduct should define a robust problem loan resolution process to ensure that viable borrowers are provided a chance for reaching a workout solution, rather than invoking outright enforcement actions. The Code of Conduct should be based broadly on but not limited to following:
i. Communication with the borrower: Banks should establish a written procedure around initiating communication with the borrowers along with the content, format, and medium of communication that is aligned with relevant Laws and Regulations, in the event that a borrower fails to pay in part or in full the installments as per the agreed repayment schedule.
ii. Information-gathering: Banks should establish a written procedure with proper timelines to collect adequate, complete and accurate information on the borrower’s financial condition from all available sources, in addition to standardized submissions such as quarterly/year-end financial statements, business/ operating plans obtained/submitted by the borrowers.
iii. Financial assessment of the borrower: Banks should ensure that proper analysis is performed on the information gathered relating to the borrower, in order to assess the borrower’s current repayment capacity, the borrower’s credit record, and the borrower’s future repayment capacity over the proposed workout period. Banks should ensure that reasonable efforts are made to cooperate with the borrower throughout the assessment process with the objective of reaching a mutual agreement on an appropriate workout solution.
iv. Proposal of resolution/solutions: Based on the assessment performed for the borrowers, banks should provide borrowers who are classified as cooperating a proposal for one or more alternative restructuring solutions, or if none of such solutions is agreed upon, one or more resolution and closure solutions, without this being considered as a new service to the borrower.
In presenting the proposed solution or alternative solutions, banks should be open to comments and queries on the part of borrowers, providing them with standardized – to the extent possible – and comprehensive information to help them understand the proposed solution or, in the case where there is more than one proposed solution, the differences across the proposed alternatives.
v. An objection-handling process: Banks should establish a clear and objective process for handling objections raised by the borrowers, and the process should be communicated to the borrowers. The process should highlight the appropriate forums for appeals and the timeframe for their closure.
Banks should develop standardized forms to be used by borrowers in case they want to raise an appeal. The forms should specify the list of information and required documents necessary to review the appeal, along with timelines for the submission and review of appeals.
vi. Workout fee: Banks should establish clear policy and procedure relating to charging fee for workout solution reached with borrowers. Banks should ensure that the policy and practice provide for impact analysis of the fee on borrower cash-flows, i.e. that increased cost is not going to further deteriorate the financial condition of the borrower. The rationale for charged fees should be clearly documented and transparency must be ensured through proper and clear communication with the borrower on fees charged by the banks.
The Code of Conduct should be reflected in all pertinent internal documentation with reference to problem loan resolution and be effectively implemented.

6. Workout Plan
   i. Banks should develop a workout plan agreed between the viable borrower and the bank in order to return the non-performing borrower to a fully performing status in the shortest feasible time-frame, matching the borrower’s sustainable repayment capacity with the correct restructuring option(s).
   ii. The workout plan needs to be approved by a designated Management Committee based upon the viability assessment and should clearly outline the steps to be taken, the timeline for implementation, and the responsibilities of each party involved.
   iii. The workout plan should include specific milestones and key performance indicators to monitor progress.
   iv. Banks should ensure that the workout plan is documented and signed by both the bank and the borrower.

7. Collateral
   7.1 Governance
   Banks should establish a clear governance framework for the management of collateral, including the identification, valuation, and monitoring of collateral assets.

7.2 Types of Collateral and Guarantees
Banks should accept various types of collateral and guarantees, including but not limited to:
i. Real estate (residential, commercial, industrial)
ii. Movable assets (vehicles, machinery, equipment)
iii. Financial assets (shares, bonds, deposits)
iv. Guarantees from third parties

7.3 General Requirements for Collateral
Banks should ensure that:
i. Collateral is legally enforceable and free from prior encumbrances, or that such encumbrances are properly accounted for.
ii. Collateral is adequately insured.
iii. The bank has clear procedures for the realization of collateral in case of default.

7.4 Specific Requirements for Each Type of Collateral and Guarantees
Banks should establish specific requirements for each type of collateral, including:
i. Real Estate: Regular physical inspections, verification of title deeds, and assessment of market value.
ii. Movable Assets: Registration in appropriate registries, regular inspections, and assessment of depreciation.
iii. Financial Assets: Verification of ownership, assessment of liquidity, and monitoring of market value.
iv. Guarantees: Verification of the guarantor’s financial capacity and legal enforceability of the guarantee.

7.5 Valuation Frequency
Banks should establish a policy for the frequency of collateral valuation, taking into account the type of collateral, market conditions, and risk profile. Valuations should be performed at least annually, or more frequently if significant changes in market conditions or collateral value are observed.

7.6 Specific Requirements for Valuers
Banks should ensure that valuers are independent, qualified, and experienced. Banks should maintain a list of approved valuers and monitor their performance.

8. Regulatory Reporting Requirements
   Banks should report problem loans and NPLs to SAMA in accordance with the prescribed formats and timelines. Reports should include detailed information on the nature of the problem, the status of the workout plan, and the expected recovery amount.

9. Effective Date
   These Rules shall come into effect on 1 July 2020.