CCP Advanced-Advanced Credit Risk Management

About Course

UNIT DESCRIPTION

This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable him/her to evaluate and manage credit portfolio risk using the proven tools and methods and advise management regarding optimal credit portfolio and credit risk diversification.

LEARNING OUTCOMES

A candidate who passes this paper should be able to:

Apply the principles of credit portfolio risk management in identification, measurement and management of major credit portfolio risks
Relate firm risks to portfolio risks and capital adequacy.
Mitigate credit exposure using various securities in covering credit obligations exposure.
Advise the management regarding the optimal lending, product-wise, for a profitable credit portfolio (Credit portfolio risk vs. Return).
Employ risk diversification, trading of credit assets and credit derivatives in mitigating credit portfolio risk.
Establish and implement the organization’s overall credit risk management plan.

Course Content

1. Introduction to Credit Portfolio Management (CPM)
1.1 Credit portfolio vs. Equity portfolio (Criticality of Credit Portfolio Risks) 1.2 Benefits of credit portfolio management 1.3 Role of credit portfolio management: Credit department; - veto rights, advisory or profit Centre 1.4 Portfolio management strategies - Passive Vs Active CPM 1.5 Portfolio analysis 1.6 Challenges of implementation of Active Credit portfolio management 1.7 Credit portfolio risk vs. Return

Credit Portfolio Management & Major Portfolio Risk (One & Two)
Introduction to Credit Portfolio
Objectives of Portfolio Management

00:00

2. Major Portfolio Risks
2.1 Systematic Risks 2.2 diversifiable risks 2.3Concentration Risks 2.4Credit portfolio Beta 2.5 Measuring Credit portfolio Risk

3. Credit Risk in Working Capital
3.1 Working capital cycle (Lenders’ point of view) 3.2 Working capital vs. Fixed capital 3.3 Working capital financing 3.4 Working capital ratios 3.5 Working capital behavior 3.6 Working capital risks (Overtrading, diversion, inflation and contingencies) and their impact 3.7 Working capital risks mitigations

4. Credit Risk in Project Finance
4.1 Overview of project finance (features and types of project finance) 4.2 Phases of projects and risks 4.3 Project credit risks 4.4 Financial study (cash flow forecasts, economic worth and credit worthiness) 4.5 Mitigating project credit risks

5. Firm Risks to Portfolio Risks and Capital Adequacy
5.1 Obligor probability of default (PD) and portfolio probability of default 5.2 Default risk (Firm level defaults and portfolio defaults) 5.3 Loss given default (LGD) and expected loss (EL) 5.4 Provisioning (firm level and portfolio-level) 5.5 Credit loss distribution 5.6 Economic Capital (measurement and optimisation)

TOPIC 6. CREDIT RISK PRICING
6.1 Credit pricing factors 6.2 The pricing structure 6.3 Origination of credit risk 6.4 Credit risk pricing models 6.5 Prime lending rates (Base rate and KBRR) 6.6 Pricing methods (RORAC, NPV, RANPV)

7. Credit Risk Modelling
7.1 Introduction to Credit Portfolio Models. 7.2 Basic statistics for risk management: Volatility, correlation, VaR, Monte Carlo simulation, Copula functions in modelling default correlation. 7.3 Merton Model, Moody’s KMV, Credit Metrics, One-period Portfolio Models, Gaussian Models etc 7.4 Alternative modelling approaches: Default models and mark to market / multi-state models, Structural and reduced form models 7.5 Conditional and unconditional models 7.6 Scenario and sensitivity analysis in CPM

8. Credit Risk and the Basal Accords and Prudential Guidelines in Lending
8.1 Regulatory framework 8.2 Basal I and its criticism 8.3 Alternative approaches for credit risk in Basal II 8.4 Risk Weighted Assets and Capital adequacy (Basal vs. Prudential Guidelines) 8.5 Criticism of Basal II 8.6 Credit risk measurement and management under Basal III 8.7 Basal III and prevention of future financial/credit crises 8.8 Managing nonperforming assets/loans under prudential guidelines (CBK) 8.9 IFRS 9 and management of accounts receivables 8.10 Towards Basel IV: Rationale and Regulatory compliance enhancement proposals Introduction. On the basis of purely credit risk, Basel I was formulated by the Basel Committee on Banking Supervision (BCSBS), a committee of central banks representing all the G – 20 and other major economies in the world. Later versions of the accords have incorporated market risk, liquidity risk, leverage risk and concentration risk among others. However, credit risk still has paramount importance in the accords, being the most important of all risks faced by lenders. Major cause of serious banking problems and bad debt issues can be directly attributable to ineffective credit standards, weak risk measurement infrastructure, or lack of flexibility to react quickly to changes in the economic or other external circumstances that lead to deterioration of credit assets. After the failure of two high profile international banks in 1974 (Herstatt Bank in Germany and Franklin National Bank in the US), due to excessive risk taking which resulted in crippling losses, the central banks of major economies in the world recognized the need for a broad supervision of banking globally. The Basel Committee was thus formed to formulate broad supervisory standards and guidelines of best practice in banking supervision. The guidelines so issued are recommendatory in nature and it is the onus of the member countries to implement them. It had also been realized that banks were becoming global in their operations and there was need for a regime to ensure that all banks are adequately regulated and that they held sufficient capital to protect the global financial system as well as their depositors. Amongst other things, the Accords provide guidance on risk management and minimum capital ratios to be implemented in the banks and financial institutions. The Committee formulates broad supervisory standards and guidelines before recommending statements of best practice in banking supervision with an overriding objective to promote sound business and supervisory standards through comprehensive risk management. Since the committee does not have powers to enforce the recommendations, national laws and regulations are the ones used for the enforcement (the subscribers to the accords and some non-member countries tend to implement the recommendations without coercion. Basel I (1988) – First Basel Accord It established a uniform system of capital adequacy standards for banks which came into effect in 1993. The main principle stipulates a minimum of 8% of capital to support the value of the risk weighted assets of a bank. That is, Capital (Tier 1 + Tier 2) ÷ Risk Weighted Assets = Capital Ratio (8% at minimum) Capital; Tier 1 capital consists of paid-up share capital and disclosed reserves (less goodwill) and it should be at least 50% of the total capital while Tier 2 capital (a.k.a supplementary capital) is made up of undisclosed reserves, loan loss allowances/reserves, asset revaluation reserves, hybrid capital instruments (such as mandatory convertible debt, etc.) and subordinated debt. Risk Weighted Assets (RWA); balance assets and off-balance assets are converted into risk assets by assigning to the appropriate risk weights based on their inherent risk. Below are the weights adopted under Basel I: Weights for On Balance Sheet items Counterparty/Asset Risk Weighting Cash, Central Bank and Government Exposure 0% OECD Govt Debt/Claims guaranteed by the Central Banks 0% Multilateral Development Banks (ADB, IBRD, etc.) 20% Banks in OECD/Claims guaranteed by them 20% Residential Mortgage Backed Loans 50% Private Sector Entities 100% Weights for Off-Balance Sheet items Counterparty/Asset Risk Weighting Certain Commitments that are Cancellable Unconditionally 0% Letters of Credit, Collateralized by Underlying Shipments 20% Transaction Related Contingencies (Bid Bonds, etc. 50% Direct Credit Substitutes – Guarantee of Indebtedness 100% Basel I Criticisms  It considered only credit risk; other risks such as market risk, operational risk, liquidity risk and concentration risk were not factored into the risk weighting but in 1996, an amendment was done requiring the allocation of capital to cover market risk.  The approach was overly simplistic; the accord adopted a ‘one-size-fits-all’ method while prescribing the calculation of minimum regulatory capital requirements and didn’t consider many differences among banks in different countries, where the methods of measuring capital may differ.  Rigid weightings; the weighting rules were found to be too rigid and unrealistic in certain instances. For example, private counterparties would attract a 100% weighting regardless of their underlying strength (like an AAA rating). Both AAA and B rated counterparties suffered the same 100% weighting despite the AAA rated being less risky that B rated counterparty.  Regulatory Arbitrage; the different weighting provided scope for institutions to circumvent the rules by actually reducing the capital requirements without the corresponding reduction of risk (they could even add to their risk profile). The behavior of banks becoming more sophisticated in their operations and risk management and increasingly finding ways to circumvent the rules has been known as “regulatory arbitrage”.  Lack of encouragement for diversification; the rules did not discourage concentration risk and did not encourage risk management by diversification, an identical quantum of capital needs to be maintained in respect for one large loan and five similar loans to different borrowers, provides a further scope for dysfunctional behavior. Basel II (2006) – The Second Basel Accord The weaknesses of Basel I were becoming more evident and the credit derivatives market and securitizations experienced explosive growth with evidence to suggest that banks were taking advantage of shortfalls in Basel I’s simplistic weighting. This called for an improved version of the rues and in 1999, the Basel Committee decided to propose a new, more comprehensive capital adequacy accord which was formerly called “A revised Framework on International Convergence of Capital Measurement and Capital Standards” and informally “Basel II”. It presented a more sophisticated approach to the calculation of minimum regulatory capital and introduced a three-pillar structure that seeks to align regulatory capital with economic capital. The restriction to credit risk and market ended and Basel II introduced a comprehensive spectrum of credit risk approaches and, a requirement to set aside capital for operational risk. Pillar 1 - Minimum Capital Requirements; consist of a similar risk capital ratio as for Basel I, albeit with the incorporation of operational risk. The fundamental ratio for minimum capital requirement is: Tier 1 + Tier 2 Capital = Capital Ratio (8% at the minimum) RWA (Credit, Market & Operational) The framework allowed for an array of approaches for measurement of credit risk, market risk and operational risk in determining capital levels with banks having the flexibility to adopt approaches that best fit their size, activities, level of sophistication and risk profile. Pillar 2 – Supervisory Review; this is meant to capture risks not identified in pillar I, giving regulators the ability to adjust the capital requirements calculated under Pillar 1. It sets out specific oversight responsibilities for the board and other senior personnel, thus reinforcing the principle of internal control and sound corporate governance. The accord stresses the importance of bank management to develop robust Internal Capital Assessment Procedures with targets that correlate to their particular risk profile and control environment. This would be subject to supervisory review and intervention – supervisors may force banks to immediately raise capital should they believe that capital levels maintained are insufficient. It means that banks have the incentive to hold a buffer level of capital above the minimum levels. Pillar 3 – Market Discipline; this aims at promoting market discipline through enhanced disclosure by banks by setting out detailed disclosure requirements and recommendations in a number of areas. This includes disclosing how a bank calculates its capital adequacy and its risk assessment methods and therefore the accord is cognizant to the requirements of various national accounting standards. By providing timely and transparent information, it should be possible for the market to better understand the business and respective risk of the banks. Alternative Approaches for Credit Risk in Basel II Standardized Approach; This groups exposures into a series of categories like in Basel I but whilst previously each category carried a fixed risk weighting, under Basel II, three of the categories have risk weighting determined by the external credit rating assigned to the borrower. Risk Weights in Basel II Standardized Approach Assessment (Based on External Rating) Counterparty Unrated AAA-AA A+ to A- BBB+ to BBB- BB+ to B- Below B- Sovereigns 100% Banks 100% Corporates 100% Retail-Mortgage 35% Other Retail 75% 0% 20% 20% 20% 50% 100% 150% 50% 100% 100% 150% 50% 100% 100% 150% Another feature is that, under Basel I, 8% capital adequacy is prescribed but under Basel II, the capital adequacy ratio of the credit portfolio will range from 1.6% to 12%, depending upon the risk weight such that lower risk will attract lower weightage. Risk Weights 20% Weight 100% Weight 150% Weight Capital Adequacy 1.60% 8% 12% Internal Ratings-Based (IRB) Approach; allows banks to use their own internal estimates of risk to determine capital requirements, with the approval of their supervisors (Central Banks). The standardized approach is mandatory but with the approval of the supervisors, banks can choose IRB. IRB can be: a) IRB Foundation (IRB-F) – where banks are required to provide their own internal estimates of PD and use predetermined regulatory inputs for LGD, EAD and a factor for maturity. b) IRB Advanced (IRB-A) – where all inputs to risk weighted asset calculation – PD, LGD, EAD – are estimated by the bank itself subject to regulatory satisfaction. IRB therefore presupposes advanced and sophisticated risk management systems in the bank and its adoption requires empirical data. Under the approach, a bank estimates each borrower’s creditworthiness and the results are translated into estimates of future loss amount, which form the basis of minimum capital requirements, subject to strict methodological and disclosure standards. Under both foundation and advanced approaches, the range of risk weights is far more diverse than in Standardized Approach, resulting in greater risk sensitivity. If an institution can at least produce reliable PD empirically, it can adopt IRB beginning with the foundation approach. The expected credit loss from the exposure is the main driver for determining credit rating in IRB. LGD is dependent on the collateral while EAD is the amount of credit extended and these three interact ti give the expected loss as: Expected Loss (EL) = EAD x PD x LGD (Refer to earlier notes/discussion) Example Suppose three customers, P Ltd, Q Ltd and R Ltd approach a bank for a credit facility of sh. 150 million with a maturity of one year. Based on EIIF study, the bank assigns the following ratings on the three prospective borrowers: Customer Customer Rating P Ltd Q Ltd R Ltd AA BB CC The ratings AA, BB, CC are assigned probabilities of default of 0.5%, 2% and 75% respectively. LGD assigned to the facilities secured by real estate is 40% while fully cash secured facilities are assigned 0%. Whilst P Ltd doesn’t offer any collateral, Q Ltd offers real estate as collateral and R Ltd offers full cash security for the credit facility. Rank the customers and assign them credit ratings based on the expected loss. Solution Customer PD Collateral LGD Exposure (EAD) Expected Loss (EL) P Ltd 0.5% None 100% 150m 0.75m Q Ltd 2% Real Estate 40% 150m 1.20m R Ltd 75% Fully Cash 0% 150m 0 As per EL, the least risky credit will be the one extended to R Ltd, followed by P Ltd and then Q ltd. Risk Weighted Assets (RWA) and Capital Adequacy in Basal II Under SA, RWA calculation is more or less the same as under Basel I, however with more granularity in weights. For IRB-F/A, a computation of PD, LGD and EAD is done followed by their adjustment to the correlation and maturity of the portfolio and a calculation of the capital requirement (K) using this formula: Where: N = normal distribution variable R = correlation G (PD) = inverse of cumulative normal distribution variable for PD value G (0.999) = inverse of cumulative normal distribution variable for 99.9% statistical confidence (or 3.09). M = maturity or term of the credit asset b(PD) = maturity adjustment with PD Once K is obtained, RWA can be found by multiplying K with EAD and the reciprocal of the minimum capital ratio of 8%, i.e. by a factor of 12.5 RWA = 12.5 x K x EAD Criticisms of Basel II  Insufficient attention to liquidity risk; the provisions did not give the required adequate focus on liquidity standards to address short-term and long-term liquidity mismatches against the backdrop that weak liquidity profile of banks is among the important catalysts the 2008 global financial crisis. The measurement and management of liquidity risk was left to the management of each bank and financial institution often resulting in underestimation of this risk.  Increased pro-cyclicality and higher leverage; risk of credit assets varies of the business cycle and IRB systems tend to reflect this; banks will act in a way that is pro-cyclical to the business cycle. During cyclical peaks, the borrower ratings tend to be better and hence low risk weights are applied. This anomaly results in the banks setting aside less capital at the top of the cycle, effectively underestimating their risk. Basel II can thus be perceived as making banks less capitalized and hence more vulnerable to failure during downturn.  Questionable correlation assumptions; Basel II correlations are mostly static but in reality, correlations are dynamics since the underlying behavior of credit assets is impacted by several dynamic forces such as financial products innovation, shifts in the markets/economy, etc. In certain case, the accord assumes that correlations decrease as a function of PD, however, studies have proven that this need be true and correlations can be higher for higher PD borrowers, contrary to these assumptions. Applying the same correlation values for different geographies may not be appropriate.  Overreliance on external ratings; the accord brought in a more prominent role for external ratings and accordingly, their ratings had begun to impact capital adequacy. Sometimes credit decisions were primarily based on external ratings as it they enjoyed support from the accord but there were serious questions regarding the accuracy and value of the credit ratings that played such an integral part to Basel II. It was also a concern that the external credit rating agencies were not able to provide ratings which reflected the actual underlying risk and provided the market with warning indicators of financial difficulties.  Usage of questionable risk management systems; Basel II provided scope for less vigilant banks to systematically underestimate risk and loss allowances with a knock-on effect on capital adequacy. This enabled the banks to pursue risky growth ambitions. Allowing the use of models (based on normal distribution and other related models) to estimate the underlying risk in marketable credit instruments is one of the major reasons for inadequate risk management in banks and financial intermediaries.  Insufficient attention to the risks posed by securitization and derivatives. Basel III – The Third Basel Accord Lessons from the 2008 credit crisis indicate how large and sudden significant changes in assets value can quickly eradicate bank capital. Too-big-to-fail institutions took on too much risk which highlights a failure in the previous regulation. Basel III focuses overwhelmingly on initiatives to reduce the probability of future crises, although it cannot eradicate this risk. In order to enhance the banking and financial systems’ shock absorbing capacity, Basel III prescribes more liquidity measures and buffers along with tighter control on leverage. The regulations affect all banks but the impact may differ across types and sizes of banks. Its implementation has resulted in increase in quantity and quality of capital, liquidity and improved ratios, amended Pillar 2 and capital preservation. Basel III structure retains the three pillars approach of Basel II with Pillar 1 having several new features aimed at improving and strengthening the capital position of banks and FIs. Credit Risk Measurement in Basel III The approaches adopted in Basel II are employed but based on the experience of Basel II implementation, the following modifications have been incorporated in Basel III to close loopholes and make the risk measurement techniques more robust:  Introduction of Credit Value Adjustment (CVA); this is the adjustment to the value of derivative products to account for counterparty credit risk. Basel III requires banks to hold regulatory capital against their CVA position.  Use of stress-tested PD; PD estimates in IRB approach will continue to drive capital requirements but the estimates will be more conservative. The requirement will be arrived at by using PD estimates for the portfolios in downturn conditions.   Strengthened requirement for the capital against credit risk; an additional capital charge for possible losses associated with deterioration in the creditworthiness of obligors is needed. Tighter rules to capture on and off-balance sheet risks are proposed. Capital requirement for counterparty credit risk must be determined using stressed inputs so as to remove the pro-cyclicality that arises when using volatility based risk inputs.  Tighter controls on OTC derivatives; institutions will only qualify for zero risk weight for OTC counterparty risk exposure if they deal with centralized exchanges.  Identifying instances of wrong way risk within counterparties; wrong way risk is a situation when exposure to counterparty is adversely correlated and increases probability of default under exactly the conditions where it was supposed to be least expected.  Raising the quality, consistency and transparency of the capital base;  Tier 1 capital will consist of going concern capital in the form of common equity and Tier 2 capital is simplified and tightened up with Tier 3 capital (as allowed in Basel II) being abolished.  Additional capital is required in the form of a “capital buffer”, designed to encourage institutions to hold more capital than the minimum stipulated by the accord or the national regulator. This will allow the institution to meet severe credit losses during periods of stress or crisis because they can utilize the capital buffer. If the capital buffers get drawn down during the stressful period, the institutions must immediately rebuild them, or else restrictions will be imposed on dividends, staff bonuses, etc.  Counter-cyclical capital buffer is also required to put brakes on rapid credit growth as was evident in the run-up to the 2008 credit crisis. The accord provides that the national regulators, at their discretion, may include a provision requiring institutions to employ and additional buffer, above and beyond the capital conservation buffer, in economic boom times. This is at 2.5% of the risk weighted assets, although the final decision about the percentage belongs to the national regulators, based on the circumstances of each country’s economy.  Leverage Ratio; this ratio was introduced to prevent the build-up of excess leverage that can lead to the de-leveraging credit crunch situation.  Pro-cyclicality; modification of the calibration of the PD within risk models and promotion of forward-looking provisioning based on expected losses of existing portfolios. The stipulated buffer capital system may be used in a macro prudential framework to restrain credit growth and thus acting in a counter-cyclic manner,  Global minimum liquidity standard; for interracially active banks and FIs, 30-day Liquidity Coverage Ratio (LCR) is required underpinned by a loner term structural liquidity ratio known as Net Stable Funding Ratio (NSFR) LCR = highly liquid assets ÷ Net cash outflow over 30-day period NSFR = Available amount of stable funding ÷ required amount of stable funding PRUDENTIAL GUIDELINES IN LENDING (CBK2013) GUIDELINE ON CAPITAL ADEQUACY CBK (BANKING INSTITUTIONS) Definitions Commodity risk is the risk that on- or off-balance sheet positions will be adversely affected by movements in commodity prices. Commodities include agricultural products, minerals (including oil) and precious metals (excluding Gold). Commodity risk only has a general market risk component because commodity prices are not influenced by specific market risk. Commodity risk comprises of directional risk which is the most important risk, basis risk, interest rate risk and forward gap risk. Directional risk is the exposure to changes in spot prices arising from net open positions. Basis risk is the risk that the relationship between the prices of similar commodities changes over time. Forward gap and interest rate risk is the exposure to changes in forward prices arising from maturity mismatches. Core Capital (Tier 1) - Is the permanent shareholders’ equity (issued and fully paid-up ordinary shares and perpetual non-cumulative preference shares), disclosed reserves such as ordinary share capital and perpetual non-cumulative share premium, retained earnings and 50% un-audited after tax profits less:  Investments in subsidiaries conducting banking business,  Investment in equity instruments of other institutions,  Intangible assets (excluding computer software) and goodwill. The current year to date 50% un-audited after tax profits will qualify as part of core capital, if and only if, the institution has made adequate provisions for loans and advances, proposed dividends and other appropriations have been deducted. Capital Conservation Buffer - Is a ratio of extra capital to risk weighted assets over and above the set minimum capital ratios, required to be maintained by institutions as a buffer for losses during periods of financial and economic stress. Credit Risk - Is the current or prospective risk to earnings and capital arising from an obligor’s (borrower’s) failure to meet the terms of any contract with the bank or if an obligor otherwise fails to perform as agreed. Financial Instrument - Is any contract that gives to both parties a financial asset of one entity and a financial liability of another entity. Financial instruments include both primary financial instruments (and cash instruments) and derivative financial instruments. A financial asset is any asset that is cash, the right to receive cash or another financial asset; or the contractual right to exchange financial assets on potentially favorable terms. A financial liability is the contractual obligations to deliver cash or another financial asset or to exchange financial liabilities under conditions that are potentially unfavorable. Foreign Exchange Risk refers to the risk that the value of on- or off-balance sheet positions will be adversely affected by movements in exchange rates. Positions denoted in foreign currency may decline in value due to movements in exchange rates. Foreign exchange risk only has a general Market risk component because movements in exchange rates are not affected by issuer- or issuance-specific factors. General Market Risk is the risk of loss arising from changes in the general market behavior. It is the risk of a price change in the underlying instrument owing to:  A change in the level of interest rates (in the case of a traded loan-stock instrument or loan- stock derivative), or  A broad market movement unrelated to any specific attributes of the individual securities (in the case of a security or security derivative), or  A change in the yield curve in the case of a fixed income instrument. Interest Rate Risk is the potential for losses in on- or off-balance sheet positions from adverse changes in interest rates. Interest rate-dependent instruments can be affected by both general and specific market risk. Market Risk: This is defined as the risk of losses in on- and off-balance sheet positions arising from movements in market prices. These risks pertain to interest rate related instruments in the trading book, commodities risk though out the bank, equities risk and foreign exchange risk both in the trading and banking book of financial institutions. Market risks Qualifying Assets include interest rate risk assets in the trading book and foreign currency and commodities risk assets throughout the bank. Market Risk Weighted Equivalent: Capital charge emanating from the market risk calculation to a risk weighted equivalent. Operational Risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Positions Held with Trading Intent - are those held intentionally for short-term resale and/or with the intent of benefiting from actual or expected short-term price movements or to lock in arbitrage profits, and may include for example proprietary positions, positions arising from client servicing (e.g. matched principal broking) and market making. Specific Risk - Refers to potentially adverse movement in the price of an individual loan/debt owing to factors related to the individual issuers. It does not affect foreign exchange- and commodities-related instruments because changes in FX rates and commodities prices are completely dependent on general market movements. Supplementary Capital (Tier 2) comprises of 25% of asset revaluation reserves which have received prior Central Bank’s approval, subordinated debt, issued and paid-in hybrid (debt equity) capital instruments or any other capital instrument approved by Central Bank. Supplementary capital must not exceed 100% core capital. Subordinated Debt - includes issued and paid-in unsecured debt instruments (debt equity, lines of credit, bonds, commercial paper or loan capital) having an original maturity of at least five years. Principal should be repayable after at least five (5) years. It also includes issued and paid- in limited life redeemable preference shares and loan loss reserves held against future, presently unidentified losses. During the last 5 years to maturity, a cumulative discount (amortization) factor of 20% per annum will be applied to reflect the diminishing value of these instruments as a continuing source of strength. Since subordinated debt is not normally available to participate in losses, the amount included for capital adequacy calculations is limited to 50% of core capital. Trading Book: Consists of positions in financial instruments which are held with trading intent or in order to hedge other elements of the trading book and are free of any restrictive covenants on their tradability, frequently and accurately valued and are actively managed. Total Capital - means core capital plus supplementary capital (Tier 1 + Tier 2). Purpose of and responsibility for the guidelines Purpose These guidelines are intended to ensure that each institution maintains a level of capital that is adequate to protect its depositors and creditors, commensurate with the risk associated with activities and profile of the institution, and promotes public confidence in the institution. Responsibility The Board of directors of each institution shall be responsible for establishing and maintaining, at all times, an adequate level of capital. The capital standards herein are the minimum acceptable for institutions that are fundamentally sound, well-managed, and which have no material financial or operational weaknesses. Higher capital ratios may be required for individual institutions based on but not limited to any one or more of the following criteria: a) The institution has incurred or is expected to incur losses resulting in a capital deficiency. b) The institution has significant exposure to risk, whether credit, concentrations of credit, market, interest rate, liquidity, operational, or from other non-traditional activities. c) The institution has a high or particularly severe volume of poor quality assets. d) The institution is growing rapidly either internally or through acquisitions. e) The institution is adversely affected by the activities or condition of its holding company, associates or subsidiaries, or f) The institution has deficiencies in ownership or management (i.e. shareholding structure; composition or qualifications of directors or senior officers; risk management policies and procedures). Capital requirements Capital requirements for a specific institution may increase or decrease depending upon its risk profile. An institution’s minimum capital requirement (MCR) will be calculated by dividing its Core and Total Capital by the sum of the value of its Risk-Weighted Assets for Credit Risk, Market Risk and Operational Risk, to arrive at the minimum Tier One and Regulatory capital adequacy ratios respectively. Capital Charge for Credit Risk Credit risk arises from the possibility of losses associated with reduction of credit quality of borrowers or counterparties. In institutions’ portfolio, losses arise from outright default due to inability or unwillingness of an obligor to meet commitments in relation to lending, trading settlements, or any other financial transaction. Alternatively, losses occur from reduction in portfolio value due to deterioration in credit quality. The capital risk charge for credit risk is therefore the allocation of capital for the various risk assets by assigning them risk weights based on their category and risk profiles. Capital Charge for Market Risk Institutions are required to assess, measure, and apply capital charges in respect of their market risks in addition to their credit risk. The risks subject to this requirement are;  The risks pertaining to interest rate related instruments;  Foreign exchange risk and commodities risk throughout the bank. Basis for Capital Charge for Market Risk The basis and framework for Central Bank of Kenya to apply capital charges in respect to specific and general market risks will be done using the Standardized Measurement Approach. All the institutions will initially be required to use the Standardized Measurement Method (See forms C, C1, C2 & C3), from the effective date of this guideline. At such time to be determined by the Central Bank of Kenya, institutions that wish to use internal rating models may apply to Central Bank for approval to use such models in applying capital charge for market risk. Capital Charge for Operational Risk Generally there are three methods for calculating operational risk capital charges in a continuum of increasing complexity and risk sensitivity. These are; the a) Basic Indicator approach (a fixed percentage of gross income amount), b) Standardized approach (sum of a certain percentage of an institution’s income in each business line) and c) Internal Measurement approach (Statistical measure of an institution’s operational loss based on its historical loss data). For the purposes of this guideline, Basic Indicator Approach (BIA) shall be used for calculating the capital charge against operational risk. Institutions are encouraged to adopt more advanced approaches as they develop more sophisticated operational risk measurement systems and practices. However, the use of such models shall only be approved by CBK at such time to be determined. SPECIFIC REQUIREMENTS Minimum Capital Requirements Minimum Ratios Unless a higher minimum ratio has been set by the Central Bank of Kenya for an individual institution based on the set criteria, every institution shall, at all times, maintain: A core capital of not less than eight per cent of total risk weighted assets plus risk weighted off-balance sheet items; i. A core capital of not less than eight per cent of its total deposit liabilities; ii. A total capital of not less than twelve per cent of its total risk weighted assets plus risk weighted off-balance sheet items. The computation of total capital requirement is as shown below; Eligible Tier I and Tier II Capital The Institution’s Capital Adequacy = Ratio (Ratio must be at least 12% {(Credit Risk Weighted Assets” of which 8% is Core Capital) Assets Associated with market Risk) +Market Risk Qualifying Assets + Operational Risk Charge} Capital Conservation Buffer In addition to the above minimum capital adequacy ratios of 8% and 12%, institutions are required to hold a capital conservation buffer of 2.5% over and above these minimum ratios to enable the institutions withstand future periods of stress. This brings the minimum core capital to risk weighted assets and total capital to risk weighted assets requirements to 10.5% and 14.5%, respectively. The capital conservation buffer should be made up of high quality capital which should comprise mainly of common equity, premium reserves and retained earnings. Institutions that currently meet the minimum capital ratios of 8% and 12% but remain below the buffer-enhanced ratios of 10.5% and 14.5% (current minimums plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer within 24 months from the effective date of this guideline (1st January 2013). Core Capital (Tier1) to RWA Total Capital (Tier 2) to RWA Minimum Ratio 8.0% 12.0% Conservation Buffer 2.5% 2.5% Minimum plus Conservation Buffer 10.5% 14.5% The above ratios are subject to review and may be changed from time to time. Minimum Absolute Core Capital Requirement Minimum core capital for banks, mortgage finance companies and financial institutions is as stated below: (i) Banks and Mortgage Finance Companies: Kshs.1, 000 million (1 billion). (ii) Financial Institutions: Kshs.200 million. Institutions’ minimum core capital levels will be monitored on a continuous basis by the Central Bank of Kenya. These levels will apply to all institutions and may be reviewed from time to time. Capital Charge for Risk Weighted Assets Risk Weighted Assets for Credit Risk Risk based approach to capital adequacy measurement applies to both on and off-balance sheet items. The focus of this section is credit risk, namely the potential risk of counter party default. On-Balance Sheet Items This framework uses only four weights, i.e. 0%, 20%, 50% and 100%. Credit exposures are risk weighted and classified into the four categories according to their relative risk. a) Zero % Weight The on-balance sheet assets which have been assigned a 0% weight include: cash (both domestic and foreign); loans and advances secured by cash; balances with the Central Bank of Kenya (including repo purchase transactions); claims on the Kenya Government by way of Government securities; and loans duly guaranteed by the Government of Kenya. Such Government guarantees should have been approved by the appropriate authorities in accordance with applicable laws and Government procedures; and loans duly guaranteed by OECD1 Central Governments. However, the weight for loans guaranteed by an OECD Central Government whose credit rating has been downgraded will be enhanced based on the extent of the downgrade. b) 20% Weight The 20% weight will be assigned to deposits and balances due from commercial banks, financial institutions, mortgage finance companies and building societies in Kenya. They should also include securities issued by foreign governments and banks and balances due from foreign banks; loans duly guaranteed by other EAC member states2 approved by the appropriate authorities in accordance with applicable laws and government procedures; claims (loans and advances) guaranteed by the following Multi-Lateral Development Banks (MDBs):  The International Bank for Reconstruction and Development  The Inter-American Development Bank  The Asian Development Bank  The African Development Bank  The European Investment Bank  Other MDBs in which G10 countries (Belgium, Netherlands, Canada, Sweden, France, Switzerland, Germany, United Kingdom, Italy, United States and Japan) are shareholding members. c) 50% Weight Mortgage loans fully secured by first legal charge over residential properties located within cities and municipalities in the Republic of Kenya that are either occupied by the borrower or rented will attract risk weight of 50%. The 50% weight will not be applied to loans granted to companies engaged in speculative residential building or property development. The underlying security held must be perfected in all respects and its forced sale value (FSV) should cover in full the outstanding debt with at least 20% margin. Any portion of the loan in excess of 80% of the FSV of the residential property should attract a risk weight of 100%. The account should neither be in arrears nor exhibit any weakness. Rescheduled facilities shall carry a risk weight of 100%. d) 100% Weight The on-balance sheet items assigned the 100% weight are all other claims on the public and private sector which are not covered under the other categories, including deposits in institutions under statutory management, balances from other foreign entities other than banks, premises and other fixed assets, loans and advances, bills discounted and all other assets of the institution. Off-Balance Sheet Exposures Off balance sheet items shall be converted to credit risk equivalents by multiplying the nominal principal amounts by a credit conversion factor. The resulting amounts will then be weighted depending on the nature of counterparty. For example, if the counterparty is a local bank, then the resulting amount shall be multiplied by a risk weight of 20%. The credit conversion factors listed below shall apply for various categories of off-balance sheet items, except for interest rate and exchange rate related items. a) Zero % conversion factor Short-term commitments with an original maturity of up to one year and cancellable unconditionally at any time e.g. bills for collection and any other contingent liability fully secured by cash. b) 20% conversion factor Short-term self-liquidating trade related contingencies arising from the movement of goods e.g. documentary credit collateralized by underlying shipments, and guarantees by Multilateral Development Banks specified in 4.3.1.1 (b) c) 50% conversion factor Transactions related to contingent items and other commitments with an original maturity exceeding one year e.g. performance bonds, bid bonds and standby letters of credit relating to a particular transaction. d) 100% conversion factor These are off- balance sheet items, which are substitutes for loans, e.g. letters of guarantee, bank acceptances and standby letters of credit serving as financial guarantees for loans and securities. Foreign exchange and interest rate related contingencies Foreign exchange and interest rate related contracts need special treatment, as the banks are not exposed to credit risk for the full face value of their contracts but only to the cost of replacing the cash flow if the counterparty defaults. While computing the credit risk of these contracts, financial institutions shall use the original exposure method. Institutions will apply one of the two sets of the conversion factors to the original principal amounts of each instrument according to the nature of the instrument and its maturity. The resulting amounts will then be weighed against the risk weight associated with the counterparty. The conversion factors for interest rate and exchange rate contracts are to be based on residual maturity period as shown in the table below: Residual maturity Exchange rate contracts Interest rate contracts One year or less 0.5% 2.0% Over one year to two years 1.0% 5.0% For each additional year 1.0% 3.0% Capital Charge for Market Risk Purpose The purpose of this section is to ensure that institutions which have significant exposure to market risks maintain adequate capital to support that exposure, in addition to capital requirements for credit and operational risks. The section also sets out the CBK’s approach in determining the adequacy of capital to support potential losses arising from market risk. In the same way as for credit risk, the market risk capital requirement applies to all institutions under the supervision of the CBK. Institutions are required to report their market risk exposures on a monthly basis. Institutions are required to complete the templates on:  A solo basis, covering the market risk exposure positions of the institution on a monthly basis, and  A consolidated basis, covering the market risk exposure positions of the institution and its subsidiaries on an annual basis.  No netting or offsetting requirements is permitted. The subsidiaries of foreign banks operating in Kenya, where the CBK is not the lead/home supervisor, are subject to the market risk capital requirements on a solo basis. The financial instruments and transactions allocated to the regulatory trading book include:  Equity assets including forwards.  Bonds, notes obligations, Treasury bills bonds; similar financial instruments, rated or unrated, even forward acquisitions.  Short sales on (i) and (ii) above.  Derivatives on interest rate risk  Hedging derivatives.  Financial futures contracts (excluding equity futures).  Forward contracts including forward rate agreements.  Swaps, and options  Other similar capital market instruments (excluding equity related instruments). Measurement Methods Two common methods for the measurement of market risk are: Standardized approach For the purpose of this guideline, all institutions will be required to adopt the standardized approach in calculation of capital charge for market risk. Under this approach, market risk is measured by a standardized risk-weighting system in which the risk weights are based on the types of positions and financial instruments held by an institution. The approach will be used to measure and report interest rate risk, foreign exchange risk and commodity risk. (a) Internal Models Approach The internal models approach allows those institutions with the necessary systems to use their own internal risk management models to calculate market risk. The use of this approach will be considered subject to approval of CBK. (b) Interest Rate Risk under the standardized Approach The use of the standardized approach to calculate interest rate risk uses the ‘building-block’ approach for specific risk and general risk. The capital charges for interest rate related instruments will apply to the current market value of items in a banking institution’s trading book(s). Interest rate related instruments include all fixed- rate and floating-rate debt securities, interest rate derivatives and instruments that behave like them, including non-convertible preference shares and traded mortgage securities. Interest rate derivatives include all derivatives contracts and off-balance-sheet instruments which react to changes in interest rates, e.g. interest rate futures, forward rate agreements (FRAs), interest rate and cross currency swaps, interest rate options, forward foreign exchange positions, and mortgage derivative products. Convertible bonds, i.e. debt issues or preference shares that are convertible, at a stated price, into common shares of the issuer, will be treated as debt securities. GUIDELINE ON RISK CLASSIFICATION OF ASSETS, PROVISIONING AND LIMITATION ON INTEREST RECOVERABLE ON NON-PERFORMING LOANS Terms used in this Guideline are as defined in the Banking Act and as further defined below: Interest owing; the interest accrued in accordance with the contract between the debtor and the institution but not paid by the date the requirements for the limitation of interest recoverable on non-performing loans came into operation. Limitation of interest recoverable on non-performing loans; refers to the restrictions imposed by section 44A of the Banking Act. Loans and loans advances may be used inter-changeably to mean a financial asset resulting from the delivery of cash or other assets by a lender to a borrower in return for a promise to repay on a specified date or dates, or on demand, usually with interest. Loans comprise business and personal lending, overdrafts, credit card lending, Hire purchases, Residential and Commercial Mortgage, Project Finance, finance lease and other financing arrangement that are in substance loans. Gross loan in a loan or group of loans is the face or principal amount, taking into account payments applied to reduce principal, and adjusted to reflect accrued but uncollected interest, charge-offs, unamortized premium or discount (i.e., a difference between acquisition cost and principal) and unamortized loan fees and costs. Interest in Suspense is interest accrued on non-performing loans that is not recognized as income in institution’s income statements. Net Loan is gross loan less interest in suspense less provisions for loans Impaired loan is a loan which has deteriorated in the credit quality such that it is probable that the institution will be unable to collect, or there is no longer reasonable assurance that the institution will collect, all amounts due according to the contractual terms of the loan agreement(s). Non-performing loans and advances means:  In respect of loan accounts and other credit extensions having pre-established repayment programs, when any of the following conditions exist:  Principal or interest is due and unpaid for 90 days or more; or  Interest payments for 90 days or more have been re-financed, or rolled-over into a new loan.  In respect of current accounts (overdrafts) and other credit extensions not having pre- established repayment programs, when any of the following conditions exist:  Balance exceeds the customers approved limit for more than 90 consecutive days;  The customers borrowing line has expired for more than 90 days;  Interest is due and unpaid for more than 90 days;  In respect of off balance sheet items, when the off balance sheet items crystallize and the customer’s accounts are debited and the principal and interest is thereafter unpaid for 90 days or more. Off balance sheet items; an asset or a debt or a financing activity that does not appear on an institution’s balance sheet. Such items include guarantees, acceptances, performance bonds, letters of credit, and other off balance sheet items deemed to constitute credit risk by the Central Bank of Kenya. Provisions for loan or allowance for loan mean the amount that reduces the gross loan in a loan or a group of loans to the carrying amount on the balance sheet. It can be:  Specific provision ’is a provision that is established against a loss that is identified in an individual loan.  General provision’ is a provision that is established for latent losses that are known to exist, but cannot yet be ascribed to individual loans. Other Provisions; refers to provision other than provision for loans losses. Past due or overdue - means any loan for which:  Principal or interest is due and unpaid for more than 30 days; or  Interest payments equal to more than 30 days interest have been refinanced, or rolled-over. Current accounts (overdrafts) and other credit extensions are considered past due when any of the conditions below exist:  Balance exceeds the customers approved limit for more than 30 consecutive days;  The customers borrowing line has expired for more than 30 days;  Interest is due and unpaid for more than 30 days; or  The account has been inactive or credits are inadequate to meet the outstanding interest for more than 30 days. The balance outstanding (not just the amount of delinquent payments) is used in calculating the aggregate amount of past due loans. Principal owing refers to the loan and advance that is still outstanding or unpaid excluding interest accrued when the loan and advance becomes non-performing. Performing loans and advances means loans and advances which are otherwise not defined as non-performing under this guideline. Renegotiated loans and advances may be used interchangeably with restructured loans and advances to mean loans and advances where the lender, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. Restructured troubled loans and advances are loans and advances for which the lender has granted a concession to the borrower due to a deterioration of the borrower’s financial condition. The restructuring may include:  A modification of terms, e.g., a reduction in the interest from that originally agreed or a reduction in the principal amount.  The transfer from the borrower to the bank of real estate, receivables from third parties, other assets, or equity interest in the borrower in full or partial satisfaction of the loan. Fully secured loan means that a credit facility where collateral used to secure the facility has a value that is sufficient to cover the carrying amount of the loan. Such security is perfected in all respects and has no prior encumbrances that could impair its value or otherwise prevent obtaining clear title. Grouping of accounts means loans and advances to related companies and individuals are grouped together and recognized as a single borrowing in completing returns under this guideline; loans to a company or individual are to be grouped together with loans to their associated companies and individuals. An overdraft; refers to a loan which can be transacted without any specific repayment schedule but has a limit and an expiry date for repayment. SPECIFIC REQUIREMENTS FOR LOANS AND ADVANCES Loan Review Objectives of loan review Each institution’s loan review function shall ensure that:  The lending function conforms to a sound and written lending policy which has been adopted and approved by the board of directors  Management and the board of directors are adequately informed regarding portfolio risk  Problem accounts are properly identified on a timely manner and internally classified appropriately, in accordance with the classification criteria as given in this guideline as a minimum  Adequate level of provisions for potential loss are made and maintained at all times Frequency and Reporting The management of each institution shall ensure that a review of its loan portfolio is made at least on a monthly basis. Such reports shall provide sufficient information that will enable the board to deliberate and direct management to take timely and necessary remedial action within a specified time frame. Classification of Loans In the determination of the classification for loans and advances, performance will be the primary consideration. The performance will generally show the repayment capability of the borrower. An institution could develop and implement its own loan classification system based on internal risk rating methodologies, however at minimum loans shall be classified into the five categories using the criteria provided in this Guideline. Loans classified as sub-standard, doubtful and loss shall be considered as non-performing loans (NPLs).  Normal  Watch  Sub-standard  Doubtful  Loss Where an institution is using its own internal risk rating system there should be a proper process to map the internal rating to classification provided in this guideline. Adverse Classification A significant departure from the primary source of repayment may warrant adverse classification even when a loan is current or is supported by an underlying collateral value. Reclassification may also be warranted if a delinquency has been technically cured by modification of terms, refinancing, or additional advances. In cases where different classification grades may be assigned based on subjective criteria, the more severe classification should generally apply. Moreover, nothing contained in the classification definitions below shall preclude assigning a more severe grade when an analysis of a borrower’s financial condition, ability, and willingness to repay justifies a more severe classification. Central Bank’s Classification Upon completion of an on-site examination, the Central Bank of Kenya will provide a list of reclassified accounts, some of which will be downgraded from categories earlier classified by the institution. No account from this list will be upgraded by the institution without sufficient justification. It is a requirement that, before the quarterly and year-end accounts are finalized and published, institutions take into account the provisions recommended in the latest Central Bank inspection report. Where necessary; tripartite meetings may be held between the institution, Central Bank of Kenya and the external auditors. Classification Categories (a) Normal These are well-documented facilities granted to financially sound customers where no weaknesses exist. All such loans must be performing in accordance with the contractual terms and are expected to continue doing so. Loans in this category are normally fully protected by the current sound net worth and paying capacity of the borrower. A facility is said to be performing if for;  Term loans: The loan has up to date repayments.  Overdrafts: The overdraft operates within the limit and the account receives sufficient credits each month to cover interest.  Bills Discounted; the bill is not yet due  Off Balance Sheet items; the off balance sheet items that have not yet crystallized. (b) Watch Loans in this category may be currently protected and may not be past due but exhibit potential weaknesses which may, if not corrected, weaken the asset or inadequately protect the institution’s position at some future date. Examples of such weaknesses include, but are not limited to:  Inability to properly supervise the debt due to an inadequate loan agreement;  Deteriorating condition or control of collateral.  Deteriorating economic conditions or adverse trends in the borrower’s financial position which may, if not checked, jeopardize repayment capacity.  Risk potential is greater than when the loan was originally granted. This category should not be used as a compromise between Normal and Substandard an the following criteria is used for the classification;  Term Loans which display one or all of the following characteristics:  Principal or interest is due and unpaid for 30 to 90 days  Interest payments are outstanding for 30 to 90 days or have been refinanced, or rolled over.  For loans paid in installments:  For loans paid on a monthly basis; less than 3 months arrears  For loans paid on a quarterly basis; 1 installment is not paid within 3 months  For loans paid semi-annually; if 1 installment is not paid within 3 months  For loans paid annually once; if 1 installment is not paid within 3 months  Current accounts (overdrafts) Current accounts (overdrafts) and other credit extensions are considered ‚Watch‛ when any of the conditions below exist:  Overdraft exceeds the customers approved limit for more than 30 to 90 consecutive days.  The customer’s credit line has expired and has not been renewed for more than 30 to 90 days from the date of expiry.  Interest is due and unpaid for more than 30 to 90 days.  The account has been inactive for more than 30 to 90 days or credits are inadequate to meet all the outstanding interest during the period.  The customer’s credit line has been extended administratively in line with the institution’s documented policy for more than 90 days from the date of expiry, on condition that, during the period of extension, it is performing as per contract terms.  Bills Discounted are considered watch when they become overdue for more than 30 to 90 days.  Off Balance Sheet items are considered watch when they have crystallized and remain unpaid for up to 90 days. An off-balance sheet item is said to have crystallized after occurrence or non-occurrence of anticipated events leading to existence of an asset or liability which was previously uncertain. (c) Substandard Loans in this category are not adequately protected by the current sound net worth and paying capacity of the borrower. In essence, the primary sources of repayment are not sufficient to service the debt and the institution must look to secondary sources such as collateral, sale of fixed assets, refinancing or additional capital injections for repayment. Any loan, which is past due for more than 90 days but less than 180 days, shall be classified as Substandard, at a minimum under the following headings:  Term loans (Generally) are classified as substandard where:  Principal or interest is due and unpaid for more than 90 days to 180 days.  Interest payments for more than 90 days to 180 days have been re-financed, or rolled-over into a new loan. The specific frequencies for installments: -  Monthly if principal or interest is due and unpaid over 3 months to 6 months  Quarterly if principal or interest on 2 installments is due and not paid within 3 months  Semi-annually if principal or interest on 1 installment is due and not paid within 6 months  Annually if principal or interest on 1 installment is due and not paid within 6 months  Current accounts (overdrafts) Current accounts (overdrafts) and other credit extensions are considered Sub Standard when any of the following conditions exist:  Debt exceeds the customers approved limit for more than 90 days to 180 consecutive days.  The customer’s credit line has expired for more than 90 days to 180 days.  Interest is due and unpaid for more than 90 days to 180 days.  The account has been inactive for more than 90 days to 180 days and credits are insufficient to cover all the outstanding interest during the period.  Bills Discounted; a bill discounted is considered substandard when the bill is overdue and unpaid for over 90 days to 180 days.  Off Balance Sheet Items; crystallized off balance sheet items that remain outstanding for over 90 days to 180 days. (d) Doubtful Loans in this category have all the weaknesses inherent in a substandard loan plus the added characteristic that the loan is not well secured. These weaknesses make collection in full, on the basis of currently existing facts, conditions, and value, highly questionable and improbable. The possibility of loss is high, but because of important and reasonably specific pending mitigating factors, the actual amount of loss cannot be fully determined. If pending events do not occur within 360 days and repayment must again be deferred pending further developments, a loss classification is warranted upon realization of securities held. A loan that is past due for more than 360 days may however retain a ‚doubtful‛ classification if it is backed by realizable security. Any loan which is past due more than 180 days shall be classified as Doubtful at a minimum as under:  Term loan Principal or interest is due and unpaid for over 180 days. The specific payment modes are classified as per the respective conditions: Mode of payment Installments in Arrears Monthly Over 6 months but less than 12 months Quarterly 3 not paid within 3 months Semi-annually 2 not paid within 3 months Annually 1 not paid within 9 months  Current accounts (overdrafts) Current accounts (overdrafts) and other credit extensions are considered ‚Doubtful‛ when any of the following conditions exist:  Debt exceeds the customers approved limit for more than 180 days.  The customer’s credit line has expired for more than 180 days.  The account has been inactive for more than 180 days or credits are inadequate to meet all the outstanding interest during the period.  Interest is unpaid and due for more than 180 days.  Bills Discounted; a bill discounted is considered doubtful when the bill is overdue for more than 180 days but not more than 360 days.  Off Balance Sheet items; crystallized off balance sheet items that remain outstanding for over 180 days to 360 days. Any loan, which is under doubtful category where the security has either been sold or discounted to zero value, shall be classified as loss unless the debt is in the process of being collected e.g. in due course or through legal action or any other means expected to result in repayment of the debt or in its restoration to current status. (e)Loss Loans, which are considered uncollectible or of such little value that their continuance recognition as bankable assets is not warranted shall be, classified as Loss. Losses shall be taken in the period in which they are identified. Loan; where principal or interest is due and unpaid for over 360 days. Mode of payment Installments in Arrears Monthly 12 or more Quarterly 4 or more Semi-annually 2 not paid within 5 months Annually 1 not paid within 11 months  Current accounts (overdrafts) and other credit extensions are considered Loss when any of the following conditions exist:  Debt exceeds the customers approved limit for more than 360 days.  The customer’s credit line has expired for more than 360 days.  The account has been inactive for more than 360 days or credits are inadequate to meet all the outstanding interest during the period.  Interest is unpaid and due for more than 360 days.  Bills Discounted; a bill discounted is considered loss when the bill is overdue for more than 360 days.  Off Balance Sheet items are considered loss if they have crystallized and remain outstanding for more than 360 days. (b) Classification of Multiple facilities  If an institution has granted multiple facilities to a single borrower, and any one of them is non-performing, then the institution shall evaluate every other loan to that borrower and where necessary place such loans on non-performing status.  Provisions will be made against that facility to fairly state the bank’s financial position.  Apportionment of joint collateral should be prorated for purposes of provisioning based on current exposure, unless the institution has formulated an alternative acceptable allocation mechanism of the collateral value to the individual non performing facility. Re-classification of Non-Performing Loans and Advances  A facility in the Substandard category will normally continue to be classified Substandard unless all past due principal and interest is repaid in full, in which case it may be upgraded to ‘Watch’ classification.  A facility in the Doubtful category will normally continue to be classified Doubtful unless all past due principal and interest is repaid in full, in which case it may revert to ‘Watch’ classification.  A facility which meets the above condition and has been classified as Watch may be reclassified Normal if a sustained record of performance is maintained for a period of six (6) Months.  No provisions for non-performing loans may be written back unless the accounts have been upgraded strictly on the basis of the criteria above. Classification of Renegotiated Loans and advances  Renegotiated loan and advance in the normal and watch categories will normally continue to be classified as normal or watch as the case may be unless the loans have exhibited weaknesses which may weaken the assets or inadequately protect the institution’s position at some future date. Examples of such weaknesses include, but are not limited to:  Inability to properly supervise the debt due to an inadequate loan agreement.  Deteriorating condition or control of collateral.  Deteriorating economic conditions or adverse trends in the borrower’s financial position which may, if not checked, jeopardize repayment capacity, and  Risk potential is greater than when the loan was originally granted. For normal and watch loan categories to be renegotiated, the customer must provide sufficient justification and evidence that he/she has enough income to support the new repayment schedule. In reviewing the terms and conditions of the facility, an institution must guard against granting ‘evergreen’ facilities which may be used as conduits to hide non-performing facilities.  A renegotiated loan and advance in the Substandard category will normally continue to be classified substandard unless:  All past due principal and interest is repaid in full at the time of renegotiation, in which case it may revert to ‘Watch’ classification or  A sustained record of performance under a realistic repayment program has been maintained. A sustained record of performance means that all principal and interest payments are made according to the modified repayment schedule. Note: A renegotiated loan which meets the first condition above (renegotiated substandard) may be reclassified as Normal if a sustained record of performance is maintained for six (6) months from the date of renegotiation. A renegotiated loan in the Sub-standard category, which meets the second condition above, may be classified as ‘Watch’ if the sustained record is maintained for at least six (6) months from the date of renegotiated date. It may however qualify for ‘Normal’ classification if the sustained record is maintained for at least twelve (12) months from the renegotiated date. If after a formal restructuring a loan deteriorates, it must revert to a non-performing classification status and be classified accordingly.  A renegotiated loan in the Doubtful category will normally continue to be classified Doubtful unless:  All past due principal and interest is repaid in full at the time of renegotiation, in which case it may revert to ‘Watch’ classification or  A sustained record of performance under a realistic repayment program has been maintained. Note: A renegotiated loan which meets the first condition above (renegotiated doubtful) may be reclassified Normal if a sustained record of performance is maintained for a period of six (6) months from the date of renegotiation. A renegotiated loan in the ‘Doubtful’ category, which meets the second condition above can be classified as ‘Watch’ if the sustained record of performance is maintained for at least twelve (12) months from the date of renegotiation. It may however qualify for ‘Normal’ classification if the sustained record of performance is maintained for at least eighteen (18) months from the renegotiated date. If after a formal restructuring, a loan deteriorates it must revert to a non-performing classification status and be classified accordingly. Provisioning Requirements (a) Suspension of Interest When a loan is classified to non-performing category, an institution should either cease the accrual of interest or continue to accrue interest suspended in accordance with the criteria set out in this guideline and should not be treated as income. Interest in suspense shall be taken into account in the computation of provisions for non-performing loans. (b) Minimum provisioning allocations. In determining the amount of potential loss in specific loans or in the aggregate loan portfolio, all relevant factors shall be considered including, but not limited to:  Historical loan loss experience,  Current economic conditions,  Delinquency trends,  The effectiveness of the institution’s lending policies and collection procedures, and  The timeliness and accuracy of its loan review function. The following minimum percentage amounts for provisioning are to be maintained according to assigned classifications. Where reliable information suggests that losses are likely to be more than these minimum amounts, larger provisions shall be made:  For loans classified Normal 1%  For loans classified Watch 3%  For loans classified Substandard 20%  For loans classified Doubtful 100%  For loans classified Loss 100% In the case of the first two categories the above percentages shall be applied against the gross balance of a loan regardless of whether the loan is analyzed individually or as part of a pool of loans. For nonperforming categories the percentages will be applied to the net balances after deduction of realizable value of security and interest in suspense. (c) Accounting treatment for provisions for loan losses If impairment charges computed under International Financial Reporting Standards (IFRSs) are lower than provisions required under this guideline, the excess provisions shall be treated as an appropriation of retained earnings and not expenses in determining profit and loss. Similarly any credits resulting from the reduction of such amounts results in an increase in retained earnings and are not included in the determination of profits or loss. Where the impairment charges computed under IFRSs are higher than provisions required under this guideline, the impairment charges will be considered adequate for purposes of this guideline. Treatment of Collateral General Classification ratings of loans do not depend on the amount or quality of collateral pledged. Collateral is regarded as a secondary source of repayment, and therefore is only used in assessing the amount of loan loss provision required for non-performing loans. This is especially true where the validity, value and ability to realize collateral are subject to significant doubt. Perfection of Securities Where securities are obtained, they should be perfected in all respects, namely:  Duly charged and registered.  Adequately insured.  Valued by a registered valuer.  Perfected in all other areas specified in the letter of offer. Valuation of Securities For the purpose of determining the value of security in accounts, security should be valued by a registered valuer on a reasonable and regular basis. This should be clearly stated in the institutions credit policy. Examiners may discount the value of securities depending on the prevailing circumstances of each case. If the Central Bank of Kenya deems it necessary, it may require the institution to have a valuation carried out by another valuer registered by the Institution of Surveyors of Kenya, at the institution’s expense. For the purpose of this guideline the value of chattels mortgage and guarantees that are not supported by tangible assets will not be considered, while debentures will be considered at 50% of the realisable market value based on the latest valuation or the book values as per the latest audited financial statements. Examiners may discount the value of securities further depending on the circumstances of each case. Discounting of Securities For the non-performing loans, the discounted value of collaterals shall be deducted from the loan balance before making provisions. The period allowable for deductions of discounted value of collaterals shall be for a maximum of five years from the period the loan becomes non-performing. Institutions will be expected to progressively discount the forced sale value of securities over the five-year period at a discount rate of 20% p.a. However, for the purpose of reporting to Central Bank, institutions will be required to discount their securities at a rate of 5% every quarter. For purposes of discounting, the security value will be based on the forced sale value when the loan becomes non-performing and any future appreciation in value should not affect the discount amount. For all forms of collaterals, the discounted value of securities may be deducted if transferability of title is certain and an active market exists. An active market here means that a bona fide sale (willing buyer/willing seller) can be achieved within a reasonable period. The effective date for starting discounting of securities shall be the date on which the underlying loan becoming non-performing. Examiner’s review The board of directors shall maintain adequate records supporting its evaluation of potential loan losses and the entries made to ensure adequacy of the provision for loan losses. Such records shall be available for examiners to assess management’s loss estimation procedures, the reliability of the information on which estimates are based, and the adequacy of the provision for loan losses. If the provision for loan losses is determined to be inadequate, adjusting entries will be required. Write-Off of Loan/Advances An institution should write off a loan or a portion of a loan from its balance sheet when the institution loses control of the contractual rights over the loan or when all or part of a loan is deemed uncollectible or there is no realistic prospect of recovery. This is normally evident at a stage where:  The institution loses control of the contractual rights that comprise the loan or part of the loan as determined by a court of law.  All forms of securities or collateral have been called, realized, but proceeds failed to cover the entire facility outstanding.  The institution is not able to collect or there is no longer reasonable assurance that the institution will collect all amounts due according to the contractual terms of the loan/advances agreement.  The borrower becomes bankrupt  Where efforts to collect debt are abandoned for any other reason. Write off of facilities classified as loss should be done within 180 days of their being classified as loss if there are no recoveries within this period. All credit policies should adequately detail the write-off procedures in order to minimize potential abuse. The ultimate authority for approval of write-offs rests with the board of directors and the memorandum accounts should be periodically audited. OTHER ASSETS Apart from the loans and advances portfolio, institutions may have other assets such as deposits with institutions under statutory management and liquidation, investments in associates, subsidiaries and joint ventures and sundry debtors which may be subject to loss or diminution in value. Institutions should regularly review the other assets and make necessary provisions as need arises. Provisions should be made where an actual loss of an asset occurs or when the recoverable amount of the asset is less than its carrying value. Provisions so made should not be lumped together with provisions for loans and advances but should be included under other provisions. REQUIREMENTS ON LIMITATION OF INTEREST RECOVERABLE ON NON - PERFORMING LOANS AND ADVANCES An institution shall be limited in what it may recover from a debtor with respect to a non- performing loan to the maximum amount of the sum of:  The principal owing when the loan become non-performing  Interest, in accordance with the contract between the debtor and the institution, not exceeding the principal owing when the loan becomes non-performing; and  Expenses incurred in the recovery of any amount owed by the debtor. If a loan becomes non-performing and then the debtor resumes payments on the loan and then the loan becomes non-performing again, the limitation under paragraphs the first and second clauses above shall be determined with respect to the time the loan last became non-performing. GUIDELINES ON PROHIBITED BUSINESS Definition of terms Insider - means any officer, director, employee or shareholder, or their associates. However, for public quoted companies holders of 5% or more of shares are considered as insiders. Reckless means 1. Transacting business beyond the limits set under the Banking Act or Central Bank of Kenya Act; Offering facilities contrary to any guidelines or regulations issued by the Central Bank; 2. Failing to observe the institution’s own policies as approved by the Board of Directors; or 3. Misuse of position or facilities of the institution for personal gain. Fraudulent means intentional deception, false and material representation, concealment or non- disclosure of a material fact or misleading conduct, device or contrivance that result in loss and injury to the institution with an intended gain to the officer of the institution or to a customer of the institution. Large exposure (for the purpose of this guideline) means all credit facilities granted to a person and his associates above 10% of an institution’s core capital. Restrictions on Facilities to Insiders (Banking Act Section 11) General Restrictions Sub-Sections 11(1) (a), (b), (c) and (d) of the Banking Act prohibit an institution from granting or permitting to be outstanding: 1. Any advance or credit facility against the security of its own shares 2. Any advance or credit facility or give any financial guarantee or incur any other liability to or in favour of, or on behalf of any company (other than another institution) in which the institution holds, directly or indirectly, or otherwise has a beneficial interest in more than 25% of the share capital of that company. 3. Any unsecured advances in respect of any of its employees or their associates. However, facilities granted to staff members within schemes approved by the board, and are serviced by salary through a check-off system are allowed. 4. Any advances, loan or credit facilities, which are unsecured, or advances, loans or credit facilities, which are not fully secured to: 1. Any of its officers or their associates. 2. Any person of whom or of which any of its officers has an interest as an agent, director, manager or shareholder. 3. Any person of whom or of which any of its officers is a guarantor. 5. For purposes of this section, where facilities to insiders are secured by guarantees, these guarantees should be supported by tangible or other securities with proven market value that are duly charged and registered in favour of the institution. Restrictions on Granting Facilities to Insiders on Preferential Terms 1. Sub-section 11(1)(e) of the Banking Act prohibits institutions from granting or from permitting to be outstanding any advance or credit facility to any of its directors or other person participating in the general management of the institution unless such advance, loan or credit facility: 1. Is approved by the full board of directors of the institution upon being satisfied that it is viable. An institution must ensure that all members of the Board are made aware of the facility before it is disbursed. 2. Is made in the normal course of business and on terms similar to those offered to ordinary customers of the institution. The institution shall notify the Central Bank of every approval given pursuant to this provision, within seven days of such approval. 2. Loan facilities to Executive Directors and Chief Executives are to be treated and reported as insider lending facilities. 3. Review of overdraft and re-scheduling of existing credit facilities should be treated as new facilities in compliance with the first provision above (Subsection 11 (1) (e). 4. Loans and other facilities to staff members should be within schemes approved by the Board. Restrictions on Aggregate Credit Limits to Insiders Sub-Sections 11(1) (f) and (g) of the Banking Act prohibit an institution from granting or permitting to be outstanding: 1. Any advance or credit facility or financial guarantee or incurring any other liability to, or in favor of, or on behalf of, any one insider in excess of 20% of core capital of the institution. 2. Any advance or credit facility or financial guarantee or any other liability to, or in favor of, or on behalf of all insiders amounting in aggregate to more than 100% of core capital of the institution. Prohibition on Reckless and Fraudulent Activities 1. Sub-section 11(1) (h) of the Banking Act prohibits an institution from granting, advancing or from permitting to be outstanding any advance or credit facility or giving a guarantee or incurring any liability or entering into any contract or transaction or conducting its business or part thereof in a fraudulent or reckless manner or otherwise than in compliance with the provisions of the Banking Act. 2. The above prohibitions (contained under section 11 of the Banking Act) are applicable whether or not the advance, loan or credit facility in question is granted to any person alone or with others.

9. Credit Portfolio Risk Mitigation
9.1 Credit risk diversification (traditional and modern diversification) 9.2 Trading of credit assets 9.3 Credit derivatives 9.4 Credit Insurance 9.6 Best practices and principles of credit portfolio management as per the International Association of Credit Portfolio Managers (IACPM) framework

10. Collateral Management
10.1 Security basics overview (need, attributes, types and pricing) 10.2 Methods of taking security and perfection of securities 10.3 Covenants (financial and nonfinancial) 10.4 Realising security 10.5 Credit risk management planning and strategy

11. Credit Portfolio Management and Credit Crisis
11.1 Road to credit crisis (role of banks, formation of credit bubbles, credit bubble explosion) 11.2 2008 Credit crisis (causes and consequences) 11.3 Lessons of the 2008 credit crisis

12. Analysis of Case Studies
12.1 Practical business scenarios on credit exposure management - entity level exposures and portfolio credit exposures and credit risk management planning

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Tumaini Institute

About Course

What Will You Learn?

Course Content

Credit Portfolio Management & Major Portfolio Risk (One & Two)

Introduction to Credit Portfolio

Objectives of Portfolio Management

2. Major Portfolio Risks 2.1 Systematic Risks 2.2 diversifiable risks 2.3Concentration Risks 2.4Credit portfolio Beta 2.5 Measuring Credit portfolio Risk

Major Portfolio Risks

Major Portfolio

Credit Risk in working Capital

Working Capital Exercise

4. Credit Risk in Project Finance 4.1 Overview of project finance (features and types of project finance) 4.2 Phases of projects and risks 4.3 Project credit risks 4.4 Financial study (cash flow forecasts, economic worth and credit worthiness) 4.5 Mitigating project credit risks

Credit Risk in Project Finance

Common features of project finance transactions

Risk Assessment Methods with Project Finance Models

Credit Risks in Project Financing

Firm Risks to Portfolio Risks and Capital Adequacy

Firms Risks to Portfolio Risks

TOPIC 6. CREDIT RISK PRICING 6.1 Credit pricing factors 6.2 The pricing structure 6.3 Origination of credit risk 6.4 Credit risk pricing models 6.5 Prime lending rates (Base rate and KBRR) 6.6 Pricing methods (RORAC, NPV, RANPV)

Credit Risk Pricing

Concepts Risk Based Pricing

Credit Risk Modelling

Credit Risk Modelling

Prudential Guidelines in Lending (CBK 2013)

Basel I -III

Portifolio Risk Mitigation

10. Collateral Management 10.1 Security basics overview (need, attributes, types and pricing) 10.2 Methods of taking security and perfection of securities 10.3 Covenants (financial and nonfinancial) 10.4 Realising security 10.5 Credit risk management planning and strategy

Collateral Management

11. Credit Portfolio Management and Credit Crisis 11.1 Road to credit crisis (role of banks, formation of credit bubbles, credit bubble explosion) 11.2 2008 Credit crisis (causes and consequences) 11.3 Lessons of the 2008 credit crisis

Credit Crunch

Credit Portfolio Management

12. Analysis of Case Studies 12.1 Practical business scenarios on credit exposure management - entity level exposures and portfolio credit exposures and credit risk management planning

Case Studies Analysis

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Dec 2021 Exam

Pilot Paper

APRIL 2022

August 2022