loan Classification, Provisioning and Credit Review

Introduction Realistic assessment of asset quality and prudent recognition of income and expenses lie at the heart of the assessment of financial soundness of any individual banking institution. Therefore, it is essential that banks in Saudi Arabia follow minimum standards for loan assessment and classification. This regulation aims to provide a degree of uniformity and consistency by requiring Saudi banks to use the proposed principal categories for loan classifications. All Saudi banks will be required to provide supervisory data on the basis of these proposed classification grades for comparison and for consolidation on a banking system-wide basis. However, Saudi banks are encouraged to develop and use more sophisticated classification systems and methodologies as long as they are consistent with the principal classification categories defined in this regulation. 1.2 Scope The credit products covered by this regulation (collectively referred to as “loans”) include all types of consumer and corporate loans, advances, overdrafts, credit card balances, leasing, musharaka, murabaha, istisna, letters of guarantee and credit and any other commission and non-commission bearing credit-related instruments and arrangements. They also include loans to businesses, financial institutions, governments and their agencies, individuals, project finance, residential and commercial mortgages and direct financial leases. Off balance sheet items such as guarantees, letters of credits, and derivatives such as futures and forward contracts, etc. carry credit risk. These may turn into loans or receivables as a result of defaults and other events and should be classified in appropriate categories, when such credit risk crystallizes into a loan or receivable. 1.3 Objectives The main objectives of a system of Ioan classification are as follows: • To highlight those loans that represent an above-normal credit risk; • To evaluate the degree of risk involved; • To develop a strategy or action plan for monitoring and follow-up on weak loans and for the recovery or liquidation of impaired loans and other such outstanding credits; • To provide essential information for the determination of adequate provisions for expected credit losses; and, • To bring a degree of uniformity and consistency in the method of classification of loans outstanding among Saudi banks. 1.4 Assessment and Classification of Individual Loans 1.4.1 Large commercial loans to corporates, governments, private banking customers and others are often reviewed and assessed on an individual basis. Systematic measurement of impairment of individual loans must include the use of a classification system for assigning loans to risk categories. Such a system should segregate loans by the probability of risks associated with individual loans. Over time, banks should monitor and evaluate the levels and trends of risk in their commercial loan portfolios through an analysis of the classification categories. Banks should also target troubled loans for more frequent reviews and higher levels of scrutiny. 1.4.2 The assessment of each loan should be based upon its fundamentals, including as a minimum the following evaluation factors: • The obligor’s character and integrity. • The purpose of the loan and the sources of repayment. • The overall financial condition and resources of the obligor, including the current and future cash flows. • The credit and delinquency history of the obligor. • The probability of default on existing loan and any new Ioan being extended. • The types of secondary sources of repayment available, such as guarantor’s support and collateral values when they are not a primary sources of repayment. (Undue reliance on secondary sources of repayment should be questioned and the bank’s policy on such practice should be reviewed.)