BANKING BUSINESS THEMED EXAMINATION PROGRAMME CREDIT RISK PROVISIONS SUMMARY FINDINGS DOCUMENT OVERVIEW

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1 BANKING BUSINESS THEMED EXAMINATION PROGRAMME CREDIT RISK PROVISIONS SUMMARY FINDINGS DOCUMENT OVERVIEW 1 Introduction Scope Preliminary observations Areas requiring consideration... 3 Corporate governance...3 Management information for board of directors...3 Timeliness...4 Property valuation...4 Large Exposures Conclusion Introduction 1.1 The Jersey Financial Services Commission (the Commission ) undertakes, on a regular basis, a series of on-site examinations on specific themes to assess the extent to which regulated entities are operating in accordance with their regulatory obligations under respective Laws, Orders and Codes of Practice. These examinations focus on identifying instances where depositors, customers or the registered entity may be at risk or where standards and practices required by the regulatory regime are not being observed. 1.2 During 2009, the Commission continued its themed assessments of risk management and control in relation to anti-money laundering and combating the financing of terrorism but also, partly in response to recommendations included in the IMF assessment of 2008, initiated a second series of themed examinations concerning credit risk provisions, which concluded early in All registered deposit takers were requested to complete a self-assessment questionnaire covering various aspects of policy and procedures relating to the identification and assessment of credit risk provisions. 1.4 Following analysis of the responses, a number of entities were selected to be visited. Six examinations were conducted, commencing in the second half of Issued: May 2010 Page 1 of 5

2 1.5 The purpose of this paper is to provide the banking sector with a summary of the key findings of the exercise. It is not intended to comprehensively describe all risks that may be associated with non-adherence to regulatory obligations and not all Jersey banks face the issues described below. However, the observations made reflect areas of potential risk and are provided for general guidance. 2 Scope 2.1 The Commission s on-site examination programme is designed to: Assess the risks faced by the entity and review the controls, procedures, policies and processes in place to mitigate those risks; Obtain a greater understanding of the entity s activities, thereby enabling the Commission to focus attention on higher risk areas; and Take into account existing relevant information, review the resolution of any previous examination issues and obtain assurance on any deficiencies highlighted through off-site supervision. 2.2 Commission officers reviewed, on a sample basis, the records, files and written procedures maintained by various banks and held discussions with management and staff involved in strategic, operational and compliance matters. Where appropriate, specific areas for improvement were identified with individual institutions and plans for remediation put into effect. The on-site examinations encompassed an inspection of systems and controls relating to credit risk provisions, by reviewing: Current policies and procedures for managing credit risk provisions; A selected sample of lending files; Governance in respect of provisions; Exposures against which a provision has been raised; The process for recovery of bad debts, with specific focus on the release of provisions and taking into profit interest held in suspense; and Policies and procedures in respect of the completion and control of security and the ongoing monitoring of its underlying value. 3 Preliminary observations 3.1 In 2004, the Commission carried out a themed examination programme which covered a much broader range of credit risk issues. These examinations indicated that credit risk levels in Jersey banks were modest and generally well managed, with a high percentage of deposits on-lent to parent/group. The 2009 examinations found nothing to alter this basic perception. 3.2 The current themed examination programme concentrated on provisions in respect of the customer loan book. In the early stages of the recent crisis, the Commission addressed Page 2 of 5 Issued: May 2010

3 with banks issues relating to their investment portfolios and monitored the progress of valuations over time. Therefore this element of asset valuation was deemed to be already covered. 3.3 About two thirds of total loans were concentrated in just a few of the larger banks in Jersey. In the smaller institutions, mortgages on high value residential property (often in the UK) and investment portfolios predominated. 3.4 Against the background of the debt problems that have emerged in other jurisdictions, the loan books of Jersey banks have proved remarkably resilient. Given the modest total level of loans and relatively prudent collateral requirements, notably in respect of loan to value ratios, only low levels of provisions have been required. These have been consistently managed within available financial resources. 3.5 The relatively low incidence of loan loss provisions limited opportunities to test key elements of the practical implementation of related policies and procedures. 4 Areas requiring consideration 4.1 In general, standards in respect of provisioning were found to be satisfactory. A number of specific issues were identified, which have been addressed with the banks concerned. 4.2 However, a small number of issues were identified that were of more general concern and these are detailed below. Corporate governance 4.3 Most banks in Jersey rely to some extent upon the policies and procedures relating to credit developed by their parent group. For most purposes, this has resulted in relatively high quality policies in respect of provisioning. 4.4 However, the boards of directors of Jersey incorporated subsidiaries need to formally adopt such policies and, where necessary, tailor them to the local market. In some cases there was only limited evidence that policies and procedures had been formally considered and adopted by the board of the Jersey subsidiary. Management information for board of directors 4.5 As might be expected, many banks in Jersey proved to be reliant upon group information technology support for the provision of management information, including that relating to problem loans and the identification of loan loss provisions. 4.6 The Commission observed instances of portfolio reporting which relied upon Excel spreadsheets. Although such ad hoc arrangements appeared to deliver adequate information, they involve manual re-input of data and may therefore increase the risk of errors in reporting and divert valuable staff time. 4.7 Should a Jersey board identify the need for additional or amended reports, there is a risk that a more urgent group priority may determine the speed with which development support can be made available. Issued: May 2010 Page 3 of 5

4 4.8 Some banks use portfolio management information to monitor delinquency behaviour and loss experience on a Channel Islands/Isle of Man or whole UK basis, particularly in respect of retail lending and residential mortgages. 4.9 The Commission acknowledges that Jersey based loan portfolios may not be large enough to produce statistically significant results on a standalone basis to support estimates of default levels and losses However, patterns of loss experienced in Jersey loan portfolios may not follow trends derived from, for example, whole UK experience. Therefore, there is a risk that loan loss provisions may not be maintained at appropriate levels The boards of Jersey banks should factor consideration of these issues into their policy deliberations. Timeliness 4.12 Some banks also rely upon group specialist problem loan management units. The Commission recognises that this makes available a higher level of expertise in the management of problem loans than could be provided on a standalone basis in Jersey banks. This is particularly relevant where the loan involves syndicated lending or UK property collateral However, there is a risk that, given that exposures of significance to a Jersey balance sheet may not be of first importance on a group wide basis, there may be delay in identifying and making appropriate loan loss provisions Although banks are careful to ensure that provisions recommended by such central units are duly authorised by their Jersey boards, there is less evidence that Jersey boards proactively seek loan loss provisions before they have been recommended by head office. Property valuation 4.15 It was encouraging to see that most banks had taken measures to review their property secured advances and security values during the recent extended market turmoil. The Commission observed a variety of approaches, including whole portfolio reviews based upon professional re-valuations, or the use of published property indices. For the most part, these exercises indicated that Jersey banks had portfolios that continued to exhibit relatively low loan to value ratios Nevertheless, despite the fact that most banks had a policy to revalue real estate collateral periodically, instances were observed where this requirement had been waived, even during the recent adverse trends in UK property values, and perhaps because of them. Large Exposures 4.17 In the course of this themed work, the Commission identified groups of exposures that the bank in question considered to be single groups of customers in the credit review process but the aggregated positions had not been reported to the Commission as Large Exposures. These related to property investment exposures through special purpose vehicles and included related, but separate, trusts. The linkage between these exposures Page 4 of 5 Issued: May 2010

5 was based upon commonality of ultimate beneficial owner and/or property portfolio manager. The decision not to report these as Large Exposures was based upon the lack of financial interdependence between the special purpose vehicles Although the structures were clearly established to isolate each company from the potential for contagion from the other related companies, the Commission noted that, in some instances, support had been provided from one company to another, or the ultimate beneficial owner had arranged to support collateral shortfalls Each structure identified has been individually addressed with the bank concerned. Banks should be aware of the possibility that common links, such as a single party selecting and advising on property investments, can result in failure across a number of exposures or the loss of significant income if the connection decides to change bank. This may involve assessing a group of loans as a single Large Exposure or taking the concentration of risk into account in the preparation of a bank s internal capital adequacy assessment process. 5 Conclusion 5.1 Following the completion of the themed programme, the Commission is content that banks in Jersey correctly identify problem loans and that appropriate levels of loan loss provisions are maintained. 5.2 The foregoing is not intended as formal regulatory guidance, nor should it be taken to cover all aspects of the subjects touched upon. 5.3 The Commission would welcome comments on any of the contents of this paper and would also be happy to address any concerns or questions that the reader may have in this respect. Any such communications should be addressed to the relevant Supervision manager or, where this does not apply, to: Mark Sumner Director, Banking & Insurance Jersey Financial Services Commission PO Box Castle Street St Helier Jersey JE4 8TP Telephone: Fax: m.sumner@jerseyfsc.org Issued: May 2010 Page 5 of 5