Guidelines for Managing Credit Risk Arising from Placements to Households (Natural Persons)

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1 Guidelines for Managing Credit Risk Arising from Placements to Households (Natural Persons) CROATIAN NATIONAL BANK Prudential Regulation and Bank Supervision Area Zagreb, 6 October 2006

2 I N T R O D U C T I O N Implementation and maintenance of a comprehensive system of an on-going credit risk identification, measurement, monitoring and controlling are prescribed by banks in their by-laws. These by-laws should contain the criteria for identifying and monitoring creditworthiness of persons to whom a bank is exposed, as well as the procedures for credit risk management (credit policies and procedures). Banks develop their credit policies and procedures taking into account the characteristics of their loan portfolio. In view of the material significance and specific characteristics of the portfolio of loans approved to natural persons 1, banks should treat this type of credit risk in particular within their credit policies and procedures. The purpose of this document is to provide guidelines for banks for managing the segment of credit risk associated with placements to households (natural persons). On the basis of these Guidelines, the Croatian National Bank will evaluate the efficiency of methods used by individual banks for identifying, measuring, monitoring and controlling credit risk to which their placements to natural persons are exposed and will also assess the level of that risk in the bank's loan portfolio. The Guidelines point to common data and procedures to be used by banks for the purpose of assessing, evaluating and recording credit risk arising from placements to natural persons. The primary objective of the Guidelines is to stimulate banks to introduce or improve their own credit policies and procedures which will prescribe the establishment of creditworthiness of natural persons when granting loans. These Guidelines refer to all the placements to natural persons. 1 In terms of these Guidelines, natural persons imply only natural persons - households, excluding craftsmen and other self-employed professions. 2

3 Guidelines for Managing Credit Risk Arising from Placements to Households (Natural Persons) 1. STRATEGY A bank should adopt the strategy of credit operations, which should, among other things, determine the level of credit risk arising from placements to natural persons that a bank is willing to assume. The bank must establish a system of monitoring the implementation of the adopted strategy, concerning the targeted and realised credit risk level, arising from the placements to natural persons. 2. RESPONSIBILITY OF THE BANK'S MANAGEMENT BOARD The bank's management board should ensure the implementation of the adopted strategy and adequate assessment of credit risk arising from placements to natural persons, establishment of the effective internal controls, as well as the application of the appropriate accounting framework and the appropriate system of reporting to the management board and senior management on the status, quality and movement of these placements. A bank should have adequate credit policies and procedures in place in order to ensure the implementation of the set strategy and realisation of the targeted level of placements, i.e. credit risk arising from placements to natural persons. The bank's policy and the implemented by-laws related to the granting of loans and other placements to natural persons should regulate: credit risk management on a debtor-by-debtor basis (in terms of establishing creditworthiness) and at the level of the bank's portfolio of placements to natural persons, procedures for approving loans and other placements to natural persons (including the limits on individual approval level), terms and conditions and criteria for approving individual types of placements to natural persons, registers of collaterals for the granted loans, procedures and process of collecting past-due claims, and procedures and process of determining additional capital and provisions for losses arising from placements to natural persons. The adopted procedures and processes of approving loans and other placements to natural persons should be developed, which provide for 3

4 the realisation of the targeted structure of portfolio of placements to natural persons (targeted quality and targeted portfolio structure on a product-by-product basis). They should also ensure sufficiency of information concerning individual debtors, purpose and structure of the requested placements, as well as concerning the actual sources of placement recovery. The internal policies and procedures should also define ceiling on exposure to individual natural persons (as well as to a group of connected persons) which should be based on a risk profile of an individual natural person or a group of connected persons. When determining the ceiling on exposure to individual natural persons or a group of connected persons, a bank should also take into account possible changes in the economic environment which could adversely effect creditworthiness of individual natural persons or a group of connected persons, as well as sensitivity of individual customers to changes in individual economic factors (e.g. exchange rate, interest rate, seasonal fluctuations, etc.). The internal controls system for assessing the credit risk arising from placements to natural persons should, among other things: include the measures to ensure reliable and comprehensive information and compliance with the laws and other regulations, internal policies and procedures, ensure that the bank's financial and supervisory reports are prepared in accordance with the applicable accounting framework and the supervisory guidelines that are in effect, include the well-defined process of verification of the existing procedures and criteria in the loan approval procedure. 3. APPROVAL OF PLACEMENTS Banks should establish a reliable system of approval of loans and other placements, and should clearly define the criteria for their approval to natural persons. Banks should establish a clear process of approving loans and other placements to natural persons. The approval of individual placements must be compliant with the prescribed credit policies and authorisations. A bank should ensure a documented tracking system for each approved placement (from loan application processing to the final decision on the approval). A bank should ensure that loan applications are processed and creditworthiness assessed by the persons having adequate knowledge and experience. Any loan application should be subject to a thorough credit analysis by a qualified credit analyst, whose experience corresponds to the size and 4

5 complexity of the respective placement. A bank should prescribe, by its procedures, the minimum information which should be analysed and encompassed in processing any loan application: basic data on the customer's identity, in accordance with the bank's credit policies and procedures, customer's risk profile, and his/her indebtedness in particular (including the data obtained from the credit registry and other external data available), in the case of a customer who has already done business with the bank, the information concerning the customer's relation with the bank (late repayment, delivery of the requested documents, etc.), customer's sensitivity to a possible change in the economic and market conditions, particularly in view of a possible change in his/her social status (stability of employment of the customer or his/her spouse), and basic data concerning the requested placement (the amount of the requested loan, loan purpose, loan repayment period, collateral, etc.) In order to ensure a high quality of the received information, the bank should also prescribe by its credit policies the minimum documentation which a customer should provide along with the loan application, such as: documentation concerning the identity of a debtor and of other loan participants (co-debtors, guarantors) documentation concerning the amount of income: income certificate (e.g. ID form (Report on receipts from employment, tax, surtax and contributions) or DNR form (Records of income from employment), tax card or, if the customer holds a giro account, the giro account statement, documentation concerning the collateral quality: land registry certificate, certificate from the book of deposited contracts, offer, sales contract, cost estimate, building permit, certificate from the Registry of Judicial and Notarial Security of Creditors' Claims by Lien on Movable Property and Rights, Ship Registry certificate, etc., in accordance with the loan purpose, and other documentation which a bank may require. 4. DETERMINING THE CEILING ON INDIVIDUAL CUSTOMER'S LOAN INDEBTEDNESS When approving loans and other placements to natural persons, a ceiling on the customer's indebtedness should be determined. A debtor who is not creditworthy is a bank's debtor - natural person 5

6 whose average monthly income does not cover his/her average monthly credit obligations towards the bank and other banks, as well as the obligations arising from operating and finance lease and other similar obligations. If, in the course of processing the loan application, it has been established that the loan applicant is not creditworthy, the bank is not supposed to approve the requested loan to such a customer. In case a bank grants a loan to such a customer, it becomes exposed to an increased risk. Banks themselves determine the limit on customer's creditworthiness and are obliged to report it to the Croatian National Bank. 5. TREATMENT OF LOAN COLLATERALS Banks should determine, it their credit policies and procedures, the procedure for accepting (list of acceptable collaterals), recording and monitoring the value of collaterals, as well as the coverage of a placement by collateral, in the case of a certain type of placements. The appraised collateral value must never be considered a proxy for the assessment of the customer's creditworthiness. Nevertheless, in view of significance of the collateral as a secondary source of placement recovery, a bank should prescribe in its credit policies at least the following : list of acceptable collaterals (which must take into account the legal enforcebility of the accepted collateral), the method of systematic tracking of the contracted collateral, which will allow for a systematic matching of the accepted collateral to the respective placements, procedure of an on-going monitoring of the contracted collateral value. 6. PLACEMENTS' PRICE RELATIVE TO RISK When approving the housing loans (or non-purpose mortgage loans) to natural persons, where residential (or commercial) real estate is provided as a collateral, a bank should prescribe, by its by-laws, the coverage of placement by the appraised market value of the collateral, i.e. a loan-to-value ratio (LTV). The LTV should not exceed 75%. This implies that the value of the appraised market value of collateral should be at least 35% larger than the value of placement. Banks should manage adequately the price of loans granted to natural persons relative to the associated risk. 6

7 A bank should ensure by its own credit policies that the placement price reflects the associated risk. It would thus be reasonable for banks to include the information obtained from the credit registries, or the lack of the same, in their policy of setting the prices of loans and other placements relative to the associated risk and the level of bank's exposure. 7. COMPREHENSIVE AND ON-GOING MONITORING SYSTEM A bank should establish a comprehensive and on-going system of monitoring its exposure to natural persons and incorporate it into its credit policies and procedures, both at the level of an individual customer and at the level of an individual loan portfolio. A bank's own credit policy should ensure an adequate administration of the granted placements, which includes keeping of credit records up-to-date, collecting of up-to-date information on the customers, etc. In that context, the account should be taken of the allocation of tasks by means of separating the loan administration of the already approved loans from the loan sales; separate lines of reporting for these two functions should be ensured as well. A bank should develop and incorporate into its existing credit policy and procedures the elements of assessment of exposure to natural persons, as well as regular reporting on that exposure to the management board. In order to identify, in a timely manner, a possible overindebtedness which could lead to the debtors' inability to settle their due liabilities, banks should establish a system of an on-going monitoring of their exposure to an individual customer (including the customers acting as debtors, co-debtors or guarantors) and his/her connected persons (where immediate family members must also be considered connected persons). Banks should provide a possibility of systematic identification of all the placements to an individual customer by all types of products (housing loans, mortgage loans, car loans, credit card loans and other loans to natural persons). In that regard, banks should ensure an adequate system (primarily IT system) which would support this type of information and which would provide historical data on the changes in customers' liabilities and their ability to settle obligations. For the purpose of establishing the previously described monitoring system, a bank should define detailed procedures of: 7

8 establishing total exposure to individual customers on the basis of total approved loans (purpose and non-purpose loans), overdraft facilities, commercial and credit cards, etc., regular monitoring of collateral quality and value, especially in the case of long-term placements and larger exposure of the bank, and measuring potential effect of a sudden exchange rate change (in view of a common practice of granting loans indexed to foreign currency) on the probability of recovering loans and other placements, as well as on a potential loss that could be incurred. 8. ESTABLISHMENT OF RELIABLE LOAN CLASSIFICATION SYSTEM Banks should develop a reliable classification system of loans and other placements on the basis of the credit risk assessment. Banks should develop an internal classification system of loans and other placements, which would, on the basis of the current financial position and customer's payment capacity, as well as the current value and possibility of exercising collateral, classify placements to natural persons into risk categories reflecting the associated degree of risk. When assessing the customer's current financial position, a bank may use the internal rating system for a customer, provided that it has been developed, by distinguishing appropriately customers of different degree of risk. In the process of classification, a bank should define precisely the procedure of identifying potential problem customers and their more frequent and careful monitoring. An on-going system of reporting on customers who are late with the settlement of their liabilities for a large number of days or who violate another contractual obligation important for a bank should be established as a part of the above process. That reporting system should be separated from the business segment of loan sale. A bank should prescribe a transparent process of identification of customers, placements to whom must be impaired in the bank's books on account of loss identification, as well as the method of loss amount identification in accordance with the existing legal framework and the applied accounting standards. 9. USE OF DATA FROM CREDIT REGISTRIES Banks should establish and maintain a comprehensive system of an on-going monitoring and controlling of data obtained by a bank by using the credit registries when approving loans to natural persons. 8

9 On the basis of the existing regulations, banks should exchange information concerning the customers' creditworthiness for the purpose of credit risk protection. Banks should establish a system of using the credit registry data, in a manner which allows them to determine creditworthiness of a person to whom a loan (or some other placement) is being approved on the basis of the data obtained. Natural persons who have failed to grant their approval to a bank for delivering the data on the amount of their indebtedness to the credit registries, when taking out a loan, are also treated as customers who are not creditworthy. Natural persons who are customers of the banks which do not exchange data with other banks which are the founders of the credit registries, i.e. which are not included in the system of credit registries, are also treated as customers who are not creditworthy. 9

Decision on the classification of exposures into risk categories and the method of determining credit losses. Subject matter Article 1

Decision on the classification of exposures into risk categories and the method of determining credit losses. Subject matter Article 1 Pursuant to Article 101, paragraph (2), item (2) of the Credit Institutions Act (Official Gazette 159/2013, 19/2015 and 102/2015) and Article 43 paragraph (2), item (9) of the Act on the Croatian National