Remaining Issues: Provisioning, Interest Rate Risk, and Stress Testing


Part 1. Approaches to the Classification of Assets and Provisioning. Introduction. Loan Classification and Review. Loan classification. Review practices. Standard regulatory prescriptions versus allowing internal bank evaluations. Classification of multiple loans. Collateral and guarantees. Classification of restructured troubled loans. Frequency of review. Provisioning. Do provisions relate to... (see full summary)


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1. The Guide provides guidance for the purpose of compiling and disseminating FSIs. Nonetheless, in the course of the discussions preparing the Guide, it became clear that on some issues related to the development of data for use in supporting macroprudential analysis, there was no international consensus or best practice to draw on. This appendix describes current practices and concepts on three such issues, (1) provisioning, (2) measuring interest rate risk, and (3) stress testing, with the objective of supporting national efforts to further develop this work.

Part 1 Approaches to the Classification of Assets and Provisioning

2. There is no international consensus on best provisioning practices, resulting in significant differences among countries in the reported financial statements of deposit takers. This undermines meaningful cross- country comparisons of FSI data. The BCBS and the IMF have published several papers to encourage best practices. 1 In this section, various approaches to provisioning are reviewed to help indicate a possible framework within which key decisions on provisioning policy could be addressed. 2 These approaches do not necessarily constitute international best practice. The Guide relies on national practice in identifying loan loss provisions.

3. In 2003, the World Bank undertook a study titled "Bank Loan Classification and Provisioning Practices in Selected Developed and Emerging Countries" (hereafter referred to as BLCP) that provides the best overall information on current practices. 3 This text is largely based on that study.

Loan Classification and Review

4. The BLCP found that authorities in all 29 countries surveyed require banks to establish loan review procedures to examine the quality of individual loans or portfolios of loans for classification and provisioning purposes. However, the practices adopted are diverse as is the frequency of review.

Loan classification

5. While the BLCP found a very wide range of philosophies and practices, in almost all the countries surveyed, the supervisor has the authority to issue prudential regulations regarding classification of loans. These classifications vary across countries, but an example is provided in the loan classification scheme proposed by the Institute for International Finance (IIF). 4 It has five categories:

- Standard. Credit is sound and all principal and interest payments are current. Repayment difficulties are not foreseen under current circumstances, and full repayment is expected.

- Watch (special mention). The credit is subject to conditions that, if left uncorrected, could raise concerns Page 257 about full repayment. Such credit requires more than normal attention by credit officers.

- Substandard. Full repayment is in doubt due to inadequate protection (for example, on account of diminished obligor net worth or collateral), and/or interest or principal or both are more than 90 days overdue. These assets show underlying, well- defined weaknesses that could lead to probable loss if not corrected.

- Doubtful. Assets for which collection/liquidation in full is determined by bank management to be improbable due to current conditions, and/or interest or principal or both are overdue more than 180 days. Assets in this category are considered impaired 5 but are not yet considered total losses because some pending factors may strengthen the asset's quality (merger, new financing, or capital injection).

- Loss (write-off). An asset is downgraded to loss when management considers it to be virtually uncollectible, and/or principal or interest or both are overdue more than one year.

6. As further examples, the loan classification schemes of the United States and Japan are provided in Boxes A6.1 and A6.2.

Review practices

7. Country practices differ on whether ex post or ex ante information should be used to assess loan classification. Ex post methods rely on specific observable evidence from past behavior (such as 90-day nonpayment of interest and/or principal) or from the current condition of the debtor. Ex ante methods assess future losses by considering forward-looking information and a wide range of factors that could affect the ability of the debtor to meet the loan conditions. Reliance on ex ante methods has been increasing with the shift toward more risk-focused supervision and the use of internal models to evaluate risk.

8. In addition, other differences among country practices are evident:

- Some countries follow standard regulatory prescriptions; others allow internal bank evaluations.

- Some countries evaluate the portfolio on an asset- by-asset basis; others require creditors to treat the entire portfolio of loans to a single borrower as impaired if any of the loans to that borrower are impaired.

- The degree to which collateral, guarantees, or other mitigating factors can be taken into consideration varies.

- The definition of restructured troubled assets and whether they are treated as impaired varies across countries.

Box A6.1. U.S. Loan Classification System (Commercial Bank Examination Manual)

- Standard assets. Loans in this category are performing and have sound fundamentals. (Fundamentals include the borrower's overall financial condition, resources and cash flow, credit history, and character. They also include the purpose of the loan and types of secondary sources of repayment.)

- Specially mentioned loans.

- Substandard loans. Loans in this category have well- defined weaknesses, where the current sound worth and paying capacity of the borrower is not assured. Orderly repayment of debt is in jeopardy.

- Doubtful loans. Doubtful loans exhibit all the characteristics of substandard loans, with the added characteristics that collection in full is highly questionable and improbable. Classification of "loss" is deferred because of specific pending factors that may strengthen the asset. Such factors include merger, acquisition, or liquidation procedures; capital injection; perfecting liens on additional collateral; and refinancing plans.

- Loss loans. These loans are considered uncollectible and of such little value that their continuance as bankable assets is not warranted.This classification does not mean that the asset has absolutely no recovery or salvage value but rather that it is not practical or desirable to defer full provision or writing off this basically worthless loan. Partial recovery may be effected in the future.

Box A6.2. Loan Classification System of Japanese Financial Supervisory Agency

- Category I. Assets with no problems in terms of collectability.

- Category II. Assets with higher collectability risk than normal because of difficulties in fulfilling contracted conditions, or due to concerns about the credit risk of the borrower (15% provisioning required).

- Category III. Assets with concerns over final collection of value. Losses are likely to be incurred, but it is difficult to make estimates of the timing and scale of losses (70% provisioning required).

- Category IV. Assets that are assessed as uncollectible or of no value.

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Standard regulatory prescriptions versus allowing internal bank evaluations

9. Some countries have prescriptive systems that specify definitions for classifying loans into different categories based on the likelihood of default. The BLCP suggests that countries with less sophisticated supervisory systems often opt for these more explicit systems because they can be easier to monitor, provide for greater comparability, create a more even playing field among banks, promote better public understanding, and facilitate the compiling of statistical measures for off-site supervision and dissemination. Although there seems to be some convergence among these prescriptive systems toward the use of the five categories of loan quality outlined above, numerous exceptions were found.

10. Some other countries have systems that stress management responsibility in classifying loans and setting the size of provisions, with supervisors and auditors focusing on the oversight of the adequacy of the banks' own internal evaluations and procedures and how well they are implemented. Depending on the country, banks may either be required to establish a classification system or be provided with a basic definition of what constitutes impaired assets, with little or no guidance regarding the appropriate size of provisions.

Classification of multiple loans

11. The BLCP shows that although just over half of the countries in its sample require the downgrading of all loans to a common debtor if any of these loans are classified as...

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