PART I - TITLE, SCOPE, APPLICABILITY AND DEFINITIONS

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1 DIRECTIVE ISSUED TO CREDIT INSTITUTIONS ON LOAN IMPAIRMENT AND PROVISIONING PROCEDURES THE BUSINESS OF CREDIT INSTITUTIONS LAWS OF 1997 TO (No.4) OF 2013 [66(I)/1997, 74(I)/1999, 94(Ι)/2000, 119(Ι)/2003, 4(Ι)/2004, 151(Ι)/2004, 231(Ι)/2004, 235(Ι)/2004, 20(Ι)/2005, 80(Ι)/2008, 100(I)/2009, 123(I)/2009, 27(I)/2011, 104(I)/2011, 107(I)/2012, 14(I)/2013, 87(Ι) 2013,102(I) 2013,141(Ι)2013] Directive under section 41 66(I) of (I) of (Ι) of (Ι) of (Ι) of (Ι) of (Ι) of (Ι) of (Ι) of (Ι) of (I) of (I) of (I) of (I) of (I) of (I) of (Ι) of (I) of (Ι) of 2013 The Central Bank of Cyprus, by virtue of the powers vested on it by section 41 of the Business of Credit Institutions Laws of 1997 to (No.4) of 2013, issues this Directive to Authorised Credit Institutions and credit institutions that operate in the Republic under section 10A of the above Law. PART I - TITLE, SCOPE, APPLICABILITY AND DEFINITIONS Short title 1. This Directive shall be referred to as the Directive on Loan Impairment and Provisioning Procedures of Applicability 2. The provisions of this Directive are applicable to all Authorised Credit Institutions and credit institutions that operate in the Republic under section 10A of the Law. 1

2 Scope 3. (1) The purpose of this Directive is: (a) To ensure prudent application of the International Financial Reporting Standards (IFRS) in the preparation of the financial statements of the ACIs. (b) to determine the procedures to be applied in the identification, assessment and measurement of loan impairments and the disclosure requirements of policies, valuation methods and analyses of the loan portfolio of the ACI. (2) In particular, and without prejudice to the context of subparagraph 1, the present Directive aims at ensuring that: (a) ACIs have in place adequate provisioning policies and procedures. (b) all credit facilities requiring provision are correctly and timely identified and adequate provisions are recognized. (c) in the case of collective impairment process, credit facilities are provided for using appropriate probabilities of default and loss given default levels. (d) ACIs make appropriate and relevant disclosures in their financial statements to reflect the quality of their loan portfolio and their provisioning policies and levels. Definitions 4. (1) Without prejudice to the definitions included in the Business of Credit Institutions Laws of 1997 to (No 4) 2013, for the purposes of the present Directive the following definitions are applicable : Authorised Credit Institutions or ACIs include Authorised Credit Institutions and credit institutions that operate in the Republic under section 10A of the Business of Credit Institutions Laws of 1997 to (No.4) of connected persons means persons who constitute a group of connected persons as provided in subsection (3) of section 11 of the 2

3 Business of Credit Institutions Laws of 1997 to (No.4) of 2013 and group of connected clients as defined in the Regulation (EU) no. 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012. credit facility in respect of a person means any loan, advance or overdraft granted to such a person, or the granting of any financial leasing including hire purchase financing, or the discount of any bill of which the person is either acceptor, or drawer or endorser, or the granting of any financial guarantee or the undertaking of any other financial liability or obligation on behalf of this person or the investment in securities issued by that person, or the undertaking of any commitment to grant any of the above, and includes any of the above in respect of another person secured by the guarantee of this person; it also includes any other on balance sheet asset item or off-balance sheet asset item of a bank, funded or unfunded, in respect of that person. original effective rate in respect of a credit facility means the interest rate agreed with the borrower at the origination of the loan. In the case of credit facilities with variable rate, the original effective rate shall be calculated by reference to the original spread and the current variable rate. (2) When referring to an ACI in this Directive, the term includes credit institutions that operate in the Republic under Section 10A of the Business of Credit Institutions Laws of 1997 to (No 4) PART II - PROVISIONING POLICIES AND PROCEDURES Provisioning policies and procedures 5. (1) ACIs shall have in place clearly defined provisioning policies and procedures suitable to the complexity and nature of the operations of the ACI and in accordance with the provisions of this Directive. 3

4 (2) Provisioning policies are established based on conservative assumptions and shall be approved and regularly reviewed by the ACI s Management Body. Provisioning policies and procedures shall reflect the expected losses from borrowers with uncertain repayment ability and shall be designed in such a way that the macroeconomic conditions of the markets the ACI operates are reflected in the measurement of impairments. (3) The provisioning procedures shall be clearly defined by the ACI's Senior Management and shall ensure compliance with the provisioning policy approved by the ACI s Management Body and the provisions of this Directive. (4) The ACI s Internal Audit Unit shall assess the compliance of the ACI with the provisions of this Directive and shall include its findings in the annual report submitted to the Management Body in accordance with the provisions of the Directive on a Framework of Principles of Operation and Criteria of Assessment of Banks Organisational Structure, Internal Governance and Internal Control Systems of 2006 to PART III - ASSESSMENT OF CREDIT FACILITIES FOR IMPAIRMENT Credit facilities impairment assessment 6. In accordance with the requirements of the International Accounting Standard 39 (IAS 39), an assessment shall be made at the end of each reporting period in order to identify whether there is any objective evidence that a financial asset or group of financial assets is impaired. The ACIs shall perform this assessment at least on a half-yearly basis. Impairment losses are incurred where there is objective evidence of impairment that results from one or more events that occurred after the initial recognition of the value of the asset. Such events (hereinafter referred to as trigger events ) must have an impact on the 4

5 estimated future cash flows of the credit facilities that can be reliably measured. Trigger events 7. (1) In order to identify whether objective evidence of impairment exists, ACIs shall define the trigger events that are considered as evidence of impairment. The trigger events shall be conservative and appropriate to each class of credit facilities and shall be regularly reviewed and updated in order to reflect current conditions and to ensure that impairment is identified as early as possible. (2) The following events may be considered as evidence of impairment: (a) Credit facilities that are classified as non-performing in accordance with the provisions of the Directive on the Definitions of Nonperforming and Restructured Credit Facilities of (b) restructured credit facilities included in performing credit facilities according to the above Directive. (c) material and persistent decrease in the borrowers income / future cash flows. (d) evident deterioration in the borrower s debt servicing capacity. (e) sizeable decrease in the value of collateral. (f) credit facilities already partially provided for. (g) credit facilities partially written-off. (h) credit facilities with internal credit rating representing high credit risk. (i) credit facilities with a significant decline in the internal credit rating. (j) credit facilities are overdue for review, in breach of the provisions of the ACI s credit risk policy. 5

6 A single event may not constitute, on its own, evidence of impairment and the absence of a trigger event does not preclude the occurrence of an impairment loss. (3) (a) In addition to the trigger events referred to in sub-paragraph (2), ACIs shall assess whether macroeconomic triggers exist, which may affect the future estimated cash flows of the borrowers. (b) These macroeconomic triggers include: (i) Current economic conditions which may adversely affect the estimated future cash flows of the borrower with consequent adverse impact on the borrower s repayment ability. (ii) increase in the unemployment rate (iii) decrease in property prices that may adversely affect the repayment ability of certain borrowers operating in particular sectors, such as developers, and the collateral value of mortgaged properties of all classes of borrowers. (iv) other adverse changes in the conditions of the economy in general. (4) ACIs shall define additional trigger events relating to each class of credit facilities as considered appropriate to each ACI. Indicatively, ACIs may define mortgage portfolio triggers or commercial real estate portfolio triggers, which may include decline in demand, signs of oversupply and / or price decreases. Credit facilities with a trigger event 8. (1) ACIs shall have in place adequate procedures to ensure that all credit facilities that meet the criteria for impairment assessment are correctly identified and timely assessed. (2) ACIs shall determine a threshold above which all borrowers, including their connected persons, which are subject to impairment review, are individually assessed for measurement and recognition of 6

7 impairment. The level of the threshold must be commensurate to the adequacy and robustness of the model for collective impairment measurement. In the absence of a robust model, a low threshold for individual assessment is expected to be set. Moreover, a low threshold for individual impairment assessment is expected to be defined in the initial stages of implementation of the model which may be increased as the model proves more robust. (3) Credit facilities to borrowers, including their connected persons, which are below the threshold defined in sub-paragraph (2), and which are subject to an impairment review, shall be assessed for measurement and recognition of impairment on a collective basis in a pool of credit facilities with similar credit risk characteristics. ACIs shall create pools of credit facilities in accordance to the credit risk characteristics of the borrowers. Restructuring of credit facilities 9. ACIs shall thoroughly assess credit facilities where the trigger event is the existence of a restructuring decision and especially credit facilities classified as non-performing / restructured in accordance with the Directive on the Definitions of Non-Performing and Restructured Facilities These credit facilities shall be examined for impairment and the projected future cash flows adopted by the ACI shall be adequately justified. Those credit facilities for which no impairment is recognized shall be included in the appropriate pool for collective assessment as per paragraph 10.(2). Credit facilities assessed on a collective basis 10. (1) ACIs are expected to break down credit facilities that have not been individually assessed into separate pools based on similar credit risk characteristics and which shall be assessed for measurement and recognition on a collective basis. The following may be taken into consideration for the purposes of classifying the credit facilities into the various pools : 7

8 (a) Credit facility type. (b) collateral type. (c) loan to value ratio. (d) employment status. (e) days in arrears. (f) economic sector. (g) restructured credit facilities. (h) cured credit facilities. (2) All credit facilities which were assessed on an individual basis but for which no impairment was recognized shall be included in a pool of credit facilities with similar credit risk characteristics for collective assessment. Material credit facilities and credit facilities to related parties 11. Irrespective of the provisions of paragraphs 7 and 8 of this Directive, the following credit facilities shall be reviewed for impairment on an individual basis: (a) All credit facilities to groups of connected persons which exceed 3% of the ACI s share capital and reserves. (b) all credit facilities to: (i) Shareholders with holdings in excess of 10% of the ACIs share capital and their connected persons. (ii) members of the Management Body of the ACI and their connected persons. (iii) managers of the ACI and their connected persons. Where the review of the credit facilities to the individuals referred to in this paragraph reveals unlikeness to pay, the provisions of paragraphs shall be applied for the measurement of impairment. 8

9 PART IV - MEASUREMENT OF IMPAIRMENT Measurement of impairment 12. The amount of impairment shall be measured as the difference between the carrying amount of the credit facility and the present value of estimated future cash flows, discounted at the credit facility s original effective interest rate. The estimated future cash flows shall include any expected cash flows from the borrowers operations, any other sources of funds and the expected proceeds from the liquidation of collateral, where applicable. In addition, the cash flows shall take into account any expected cash outflows resulting from existing offbalance sheet commitments. The timing of these cash flows shall be conservatively estimated by the ACI. Property collateral 13. (1) Where the future expected cash flows relate to realisation of the property collateral, the expected amount to be received at the point of liquidation shall be estimated taking into account the projected property prices at the time of liquidation, net of any selling, taxes and other expenses and any additional maintenance costs to be incurred by the ACI in relation to the repossession and the disposal of the collateral. (2) For each individually assessed credit facility, the ACIs shall determine the assumed timing of disposal based on reasonable assumptions, and taking into consideration the prevailing market conditions. (3) The market value of mortgaged properties shall be updated at regular intervals in order to reflect current market conditions. As a minimum requirement, ACIs shall revalue property collateral as prescribed in article 208 of the Regulation (EU) no. 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/

10 (4) In order to facilitate the estimation of proceeds at the time of property collateral disposal, ACIs shall use property price projections for each class of property held as collateral. These projections may be produced internally by appropriately qualified personnel of the ACI or provided by external experts. The properties shall be broken down into different categories in accordance to type, use and location. Price projections of each class of property shall be regularly updated taking into consideration transactions executed, macroeconomic conditions, input from professional valuers and the historical property price indices produced by the Central Bank. The property price projections produced by the ACI shall form the basis for ascertaining the realisable value of the property for the measurement of impairment. (5) In estimating cash flows from property collateral liquidation, ACIs shall use conservative assumptions and pay particular attention to the requirements of IFRS 13 on fair value measurements. In particular, ACIs shall: (a) Estimate the realistic time of collateral liquidation taking into account current and expected market conditions as well as the underlying legal framework of the disposal of mortgaged properties. (b) ensure that the estimated market value of property collateral at the point of liquidation is not higher than the current market value of the property. (c) ensure that income from property collateral is not assumed to increase from the current levels unless there is an existing contractual arrangement for such increase. Moreover, current income from property shall be adjusted when calculating the projected cash flows in order to reflect the expected economic conditions. For example, it may not be appropriate to project a flat rental income in a recessionary environment where vacant properties are increasing putting downward pressure on rent levels. (d) ensure that properties are valued based on existing use. Any future 10

11 prospects for redevelopment / alternative use and any possible increase in value thereby should be ignored. Measurement of impairment for individually assessed credit facilities 14. (1) ACIs shall maintain all supporting documentation for each individually assessed credit facility. A summary analysis of the resulting amount of impairment is expected to be prepared, which shall include the following: (a) The type of trigger event. (b) the value assigned on the collateral (based on the relevant property price projections in the case of property collateral) less selling expenses. (c) the assumed time of disposal (d) the discounting factors used. (e) the assumptions used in the cash flow forecasts. (f) amounts and timing of other cash flows assumed. (2) All proposals to provide or not for individually assessed credit facilities shall be initiated by the responsible officer in charge of the monitoring of the borrower who shall adequately justify the cash flows assumed. The proposals shall be submitted to the Risk Management Unit of the ACI which shall be fully responsible and accountable for the process and outcome of the provisioning review. The provisioning proposals shall be submitted by the Risk Management Unit to a provisioning committee consisting of the Chief Executive Officer and other members of the senior management of the ACI for their approval and then be forwarded to the Management Body for final approval. (3) The amount of impairment for an individually assessed credit facility shall be clearly justified on the basis of expected cash flows and supporting documentation kept in record for reference. Credit facilities for which no impairment is recognized shall form part of the 11

12 assessment for collective impairment. Collective impairment 15. (1) The amount of future cash flows for a pool of credit facilities is estimated on the basis of historical loss experience of credit facilities with similar credit risk characteristics. In accordance to IAS 39, ACIs shall calculate probabilities of default (PD) for each pool of credit facilities, taking into consideration the recent historical loss experience of each pool of credit facilities adjusted for current conditions. (2) ACIs shall apply appropriate models for the calculation of probability of default for each pool of credit facilities, which will form the basis for the calculation of the collective impairment. The model shall be based on conservative and supportable assumptions. (3) ACIs shall have in place appropriate models to calculate the loss given default (LGD) on the basis of the type of collateral, the length of time taken for disposal and the time of all available cash flows. In the absence of a robust model to calculate LGD, ACIs may use, for each pool of credit facilities, the LGD used for credit facilities of similar characteristics which were individually assessed. The ACIs shall assess the applicability of this LGD to each pool of credit facilities through a sample test of credit facilities in each pool. (4) Νon-performing credit facilities, excluding restructured credit facilities with arrears up to 90 days, as defined in the Directive on the Definitions of Non-Performing and Restructured Credit Facilities, are considered to be impaired. ACIs shall include non-performing credit facilities that are not individually assessed in accordance with paragraphs 8 and 11, in a pool of credit facilities with similar credit risk characteristics in order to be provided for on a collective basis. The relevant LGDs shall be applied to each pool of credit facilities. In calculating LGDs for non-performing credit facilities, ACIs shall take into account the fact that the LGD on a non-performing credit facility is higher than the LGD for a performing credit facility. Therefore, the 12

13 LGDs applied to the pools of non-performing credit facilities shall reflect this. The LGDs to be used shall be reviewed at each regular assessment of the credit facilities for impairment. (5) ACIs shall further break down the pool of restructured credit facilities according to the type of restructuring and the degree of adherence to the new agreed repayment program. Relevant PDs and LGDs shall be applied to each of these sub-categories taking into consideration cure rates. (6) All credit facilities which are not subject to impairment review shall be provided for on a collective basis using appropriate PDs and LGDs. In particular, for credit facilities classified as performing nonrestructured, provision shall be estimated based on the probability of loans moving from the performing pool into the non-performing pool over a defined length of time ( emergence period ). The emergence period indicates, on a forward looking basis, approximately how long it takes for non-performance to be identified and as such the longer the emergence period the higher the provision required. ACIs shall document and evidence the rationale for the emergence period applied to each portfolio. In determining impairments, a suitably conservative emergence period is used. Emergence periods may differ by credit facility and shall be influenced by the frequency of the credit review cycle of the ACI. The Central Bank may require readjustments to be made on the emergence period, where necessary. (7) ACIs shall submit to the Central Bank upon the completion of each regular institution-wide assessment of credit facilities for impairment, the following information for each pool of credit facilities, which are subject to collective impairment: (a) The PDs adopted and a narrative description of the methodology applied for their calculation. (b) The LGDs adopted and a narrative description of the methodology 13

14 applied for their calculation. (c) The cure rates adopted and a narrative description of the methodology applied for their calculation. PART V - INCOME RECOGNITION ON IMPAIRED EXPOSURES Income recognition 16. As a minimum requirement, interest income shall be recognized on the unimpaired part of such a credit facility, using the original effective interest rate of the credit facility. This also applies to credit facilities assessed for impairment on a collective basis. PART VI - ASSETS REPOSSESSED IN SATISFACTION OF DEBTS Classification of assets repossessed in satisfaction of debts 17. The classification of assets repossessed in satisfaction of debts in the ordinary course of business of the ACI shall be considered on the basis of the provisions of the relevant IFRS (IFRS 5, IAS 2, IAS 40) and taking into account the provisions of article 12 of the Business of Credit Institutions Laws of 1997 to (No 4) of 2013, which requires disposal of repossessed property within three years. In case assets are classified as investment property under IAS 40, the cost method shall be applied. In estimating the value of the repossessed assets, ACIs shall use independent professional valuers who shall follow best international practices. PART VII ACCOUNTING WRITE-OFF OF CREDIT FACILITIES Credit facilities write-off policy 18. ACIs shall have in place a policy for the accounting write-off of credit facilities which must ensure the timely accounting write-off of facilities where there is no realistic prospect of recovery. In addition, adequate governance procedures shall be put in place to determine the authorisation levels for approving the accounting write-off of credit facilities. 14

15 19. The accounting write-off of a credit facility does not imply that the ACI discontinues its efforts to recover the outstanding debts, which may only be discontinued when the cost of pursuing the recovery exceeds the expected amount to be recovered. PART VIII - DISCLOSURES Disclosures in the financial statements 20. (1) In accordance with the provisions of IFRS 7, ACIs shall provide adequate disclosures in their financial statements that enable users to evaluate the nature and extent of the risks undertaken by the ACI and how the ACI manages these risks. (2) Notwithstanding the requirements of IFRS7 and of Part 8 of the Regulation (EU) no. 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, ACIs shall, as a minimum, disclose as part of their financial statements the following: (a) An analysis of their credit facilities portfolio according to performance status as per the attached Table A. This table shall also be published on the ACIs website on a semi annual basis. (b) a vintage analysis per Table B, analysing non-performing credit facilities and impairment amount by year of origination of credit facilities. (c) a detailed description of the ACIs policies regarding specific and collective impairment. The description shall include : (i) a list of trigger events recognised by ACIs as evidence of impairment. (ii) the procedure and threshold for assessment of credit facilities on an individual basis. (iii) the ACIs assumptions regarding the value assigned on property 15

16 collateral. (iv) the procedure for collective assessment, explaining the methodology for estimating the probabilities of default and the loss given default rates used for each separate pool of credit facilities. (d) the total book value of repossessed assets at the end of the reporting period compared with the corresponding amount at the end of the previous reporting period, indicating the amount of assets repossessed and the amount of assets disposed of in the period. PART IX - EFFECTIVE DATE Effective date 21. (1) This Directive enters into force from the date of its publication in the Official Gazette of the Republic of Cyprus. (2) The disclosure requirements of this Directive shall be complied with from the financial statements for (3) ACIs shall prepare and submit to the Central Bank, by the end of March 2014, a detailed action plan leading to full compliance with the provisions of this Directive in the financial statements for