2. ©2000 Bank for International Settlements 1 F I N A N C I A L S T A B I L I T Y I N S T I T U T E BANK FOR INTERNATIONAL SETTLEMENTS Credit Risk Management Asset Grading & Classification FSI – CBSWCA Khartoum, Sudan 8 – 12 April 2002 Jason George – Financial Stability Institute

3. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 2 Agenda Classification of credits Assessment of credit quality Treatment of guarantees Role of collateral Key indicators of problem credits Classification categories

4. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 3 CLASSIFICATION OF CREDITS Classification of credits is according to the probability of repayment which estimates the amount of loss that will probably be suffered on deteriorating credits.

5. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 4 ASSESSMENT OF CREDIT QUALITY The overall financial condition and resources of the borrower, including the current and stabilized cash flow.

6. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 5 ASSESSMENT OF CREDIT QUALITY The credit history of the borrower

7. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 6 ASSESSMENT OF CREDIT QUALITY The borrower’s or principal’s character

8. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 7 ASSESSMENT OF CREDIT QUALITY The purpose of the credit relative to the source of repayment

9. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 8 ASSESSMENT OF CREDIT QUALITY The types of secondary sources of repayment available: –guarantor –collateral

10. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 9 TREATMENT OF GUARANTEES A guarantee should provide support for repayment of debt, in whole or in part, and be legally enforceable. It is predicated upon both the guarantor’s financial capacity and willingness to provide support for a debt.

11. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 10 TREATMENT OF GUARANTEES Degree to which guarantors have demonstrated their ability and willingness to fulfill previous guarantees Whether previous performance was voluntary or the result of legal action Economic incentives for guarantor performance Type of guarantee

12. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 11 ROLE OF COLLATERAL Primary focus on a credit review is the borrower’s ability to repay without liquidation of collateral. However, in troubled loans, the assessment of collateral value should be used to support the credit.

13. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 12 ROLE OF COLLATERAL Whether bank has a legal claim to the assets Whether the bank can easily identify the collateral pledged by the borrower Maintenance of insurance Current valuation performed by an independent party Collateral inspections

14. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 13 KEY INDICATORS TO PROBLEM CREDITS

15. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 14 PROFILE OF A TROUBLED COMPANY Stages of a Cash Crisis –Cash Concern –Cash Crunch –Cash Crisis

16. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 15 CASH CONCERN Expenses reduced; salaries cut or raises delayed; bonuses cut or eliminated; overhead controls initiated Account receivable collections efforts strengthened; inventory levels reduced Capital expenditures reduced Prices cut to move stale inventory

17. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 16 CASH CRUNCH Expenses further reduced Employee layoffs Morale declines Nonessential assets sold Company seeks additional borrowings Assets are refinanced Product quality suffers

18. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 17 CASH CRISES Additional assets sold Layoffs continue Key employee resign Plants closed Changes in top management Overdrawn accounts Loans past due

19. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 18 EARLY DETECTION Financial Nonfinancial Personal

20. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 19 FINANCIAL Performance compared with plans Performance compared with trends Performance compared with peer companies in the same industry Financial structure

21. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 20 NONFINANCIAL Change in product mix Change in market strategy Rapid expansion plans Management turnover or shuffling Change in accounting firms Change in structure of board of directors

22. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 21 PERSONAL Lifestyle Personal investments Personal behavior Relationship with banker Willingness to provide information

23. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 22 CLASSIFICATION CATEGORIES Substandard Doubtful Loss

24. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 23 SUBSTANDARD Substandard credits are inadequately protected by the current sound worth and paying capacity of the borrower or of the collateral pledged. Substandard credits have well defined weaknesses that jeopardize the liquidation of the debt. If not corrected, these weaknesses expose the bank to loss.

25. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 24 DOUBTFUL Have all the weaknesses of a substandard credit with the added characteristic that the liquidation in full, on the basis of existing facts, is highly questionable and improbable.

26. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 25 LOSS Loss credits are considered uncollectable and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the credit has no recovery or salvage value, but it is not practical to defer writing off the bank’s books.

27. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 26 SPECIAL MENTION Defined as a credit having potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may, at some future date, result in deterioration of repayment abilities.

28. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 27 SPECIAL MENTION SITUATIONS Lending officer may be unable to properly supervise the credit because of an inadequate loan agreement Questions exist over the condition/control of collateral Economic conditions may unfavorably affect the obligor

29. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 28 Financial Stability Institute Jason George jason.george@bis.org (41 61) 280 8054