FKGK Provisioning Policy Version 1.0 1
Contents 1. Introduction... 3 2. The purpose and scope of the document... 3 3. Terminology and Definitions... 3 4. General Principles... 5 5. Responsibilities... 5 6. Impairment... 6 6.1. Classification of Loans... 6 6.2. Impairment Triggers... 7 6.3. Methodology of Provisioning... 8 6.4. Recognition and Measurement... 9 7. Income Recognition... 9 8. File Control... Error! Bookmark not defined. 2
1. Introduction This document sets the standards that Fondi Kosovar per Garanci Kreditore (herein FKGK) needs to apply, for timely identification and adequately impair all expected losses from credit guarantees. The impairment of credit guarantees shall reflect expected losses with uncertain repayment ability and its designed in such a way that will reflect the nature of the operations of FKGK. Besides provisioning policy, this document will be accompanied with application guidance which guides and disclose the impairment methods for credit guarantee in the FKGK. Provisioning policy, along with application guidance will be complementary to Credit Risk Guarantee Policy and Procedure and all together these documents will constitute the framework for managing Credit Guarantee Risk. Given its importance, the provisioning policy and application guidance will be subject of regular review. 2. The purpose and scope of the document The purpose of this policy is to ensure that FKGK has made adequately a loss provision for all expected and incurred credit loss from loans that are placed under guarantees. This way financial statements of FKGK will reflect the losses that can be reasonably expected from credit guarantees. The scope of this document is solely for loans that would be placed under guarantee; therefore, this policy is not a subject for other financial assets. 3. Terminology and Definitions For consistency, the following terminologies are applied: IFRS (International Financial Reporting Standards) - is a is a set of rules or standards for accounting set by the IASB (International Financial Standards Board) with the intention of those standards being capable of being applied on a globally consistent basis, thus providing users of financial statements the ability to compare the financial performance. CBK the Central Bank of the Republic of Kosovo as defined in the Law No.03/L- 209 on the Central Bank. DCA (Development Credit Authority) is a loan portfolio guarantee scheme that aims increasing access to credit for Kosovo s agriculture sector by providing a 50% risk guarantee to loans issued by participating banks. 3
RFI (Registered Financial Institution) a Financial Institution licensed and supervised by the CBK that has entered into a Guarantee Agreement with the FKGK and agreed between FKGK and the respective Registered Financial Institution. MD (Managing Director) - one executive manager of the FKGK appointed by the Board of Directors. ECL (Expected Credit Loss) is the loss that FKGK can expect to lose in the case of default of credits placed under guarantee; PD (Probability of Default) - is the probability that an obligor will default over a period of time. PD can range from 0% to 100%; LGD (Loss given default) - is the incurred credit loss if a borrower defaults. It is defined as the percentage exposure at risk that is not expected to be recovered in an event of default; EAD (Exposure at default) is the total value (gross exposure) that FKGK is exposed to, at the time of a loan s default. It is seen as an estimation of the extent to which a FKGK may be exposed to counterparty in the event of the counterparty s default. Generally, EAD will not be larger than the borrowing facility; RR (Recovery Rate) - is the proportion of a bad debt (claims in case of FKGK) that can be recovered; LLP (Loan Loss Provisioning) - is an amount put aside, to cover a future liability. A provisions main purpose is to allow a current year s balance to become more accurate; Loan Impairment is a reduction of the asset value (recoverable value) below its book value due to the increase in credit risk; Past due loans are loans that have not been paid on its due date; Delinquent - occurs as soon as a borrower misses a payment, it s loan is past due up to 90 days from the first day of default (includes all loan exposures that are classified in Standard, Watch & Substandard category). A delinquency rate is the percentage of loans within a loan portfolio that have delinquent payments; NPL (Non-Performing Loan) - occurs when a borrower fails to repay the due principal or interest over 90 days from the first day of default (includes all loan exposures that are classified in doubtful or loss category). A NPL rate is the percentage of loans within a loan portfolio that have defaulted in payments; Roll Rate - refers to the percentage of borrowers who "roll" from the 30-days late to the 60-days late category or from the 60-days late to 90-days late category, and so on. Under this methodology, loans are grouped into ranges according to the number of days past due and statistical analysis is used to estimate the likelihood that loans in each range will progress through the various stages of delinquency, and ultimately prove irrecoverable. 4
4. General Principles Provisioning policy will be fully compliant with IFRS 9 standards, which implies that impairment provisioning will be recognized under expected loss approach. Other provisioning practices which apply incurred loss approach (such as CBK rules for provisioning) will be not applied in FKGK. DCA Records will be used initial estimation of PD (probability of default) and LGD (Loss Given Default) and they will have only a one-year time horizon, until sufficient records are generated from internal experience. DCA records are considered as best available data for initial estimation, since it reflects the same activity as FKGK. From Risk Management team is required to exercise judgement in making assumptions and estimations when calculating loan impairment provisions on both individually and collectively assessed loans. The most significant judgmental area is the calculation of collective impairment provisions. However, in the application guidance there should be appropriate disclosure of judgements, estimates and assumptions. Impairment Provisioning will be implemented in Management Information Systems (MIS) for each individual loan. However, Risk Management team will perform collective assessment into pools of loan that have similar characteristics. 5. Responsibilities Credit risk management team is responsible to carry out the fundamental tasks in the context of loan impairment and loan loss provision (allowances). Role and responsibilities of Credit risk management are: Understanding and determining the nature and level of risk being undertaken by FKGK in its activity and how this risk might relate to the level of general and specific allowances; Monitoring and managing the loan quality, by creating and maintaining effective controls system for identifying, measuring, monitoring, and addressing loan quality problems in a timely manner; Review on regular bases, the loan classification status, and make the provisioning accordingly in timely manner. They must ensure that all defaulting loans are provisioned; Ensuring that all claimed loans are removed from guarantee, but afterwards followed by recovery process; 5
The MD should be informed in monthly bases for the quality of loan portfolio and impairment loss provision for all loans. 6. Impairment Taking into consideration that activity of FKGK is related with partial guarantee of loans that are originated from RFI, it must be accounted that some loan may default; therefore, FKGK needs to set aside certain reserves. By setting aside loan loss reserves, FKGK can ensure that is presenting an accurate assessment of their overall financial position. 6.1. Classification of Loans One factor that generally indicates that there has been a deterioration in the credit quality of a loan is that the borrower has defaulted in making interest or principal payments when due on the loan. Since FKGK has limited information regarding the borrowers and loan quality, FKGK will use loan classification (that would be submitted from RFI) as the key information for determining loan quality. Thus, loan classification would be key trigger for provisioning at FKGK. According to the CBK Regulation on the assessment of loan risk losses, Kosovo Banks classifies borrowers into five categories, from A to E, and they are as following: Category A - Standard Loans: This loan classification includes all loan exposure that are currently on delinquent, with less than 30 days overdue from the maturity date of payment; Category B - Special Attention (Watch) Loans: This loan classification is intended to identify potential weak relationship at an early stage, were paying capacity of the borrower is not assured. All loan exposure that are overdue more than 30 days, but less than 60 days, need to be classified in Special Attention category Category C - Substandard Loans: This loan classification is intended to identify all loan exposures that show well defined weaknesses that jeopardize repayment on normal course. All loan exposure that are overdue more than 60 days, but less than 90 days, need to be classified in Substandard category; Category D - Doubtful Loans: This loan classification includes all loan exposures that show strong probability that principal amount will not be paid. All loan exposure that are 6
overdue more than 90 days, but less than 180 days need to be classified in Doubtful category Category E - Loss Loans: This loan classification includes all loan that based upon evaluation is no longer justifiable for carrying on the active book. This loan classification includes loan exposure that have failed to repay for over 180 days As per CBK regulation the quality of the pledged collateral does not affect the loan classification, and loans, respectively borrowers with credit ratings D or E are nonperforming. 6.2. Impairment Triggers Intension of this policy is for recognize the loss event as early as possible. Since FKGK does not have relevant data about the loan and the borrower, loan classification will be the key element for starting impairment of loans. The guiding principle of IFRS 9 is that Expected Credit Loss (ECL) reflects the general pattern of deterioration or improvement in the credit quality. The amount of ECL recognized as a loss allowance or provision depends on the extent of credit deterioration since initial recognition. Under the general approach, there are two measurement bases: 12-month ECLs (Stage 1), which applies to all items (from initial recognition) as long as there is no significant deterioration in credit quality. Lifetime ECLs (Stages 2 and 3), which applies when a significant increase in credit risk has occurred on an individual or collective basis. Stage 1 - involves identifying financial instruments that have not deteriorated. For these instruments 12-month expected credit losses would be recognized. That is, an estimate would be made of the probability of a default occurring in the 12 months following the reporting date. That probability would be multiplied by the shortfall in lifetime cash flows (that is, the present value of the difference of all principal and interest contractually due and the amount the entity expects to receive) In essence, the 12 month expected credit losses represent a portion of the lifetime credit losses. Stage 2 - involves identifying financial instruments that have deteriorated significantly in credit quality since they were first recognized, and do not exhibit objective evidence of a credit loss event. For these instruments, lifetime expected credit losses would be recognized; interest revenue would still be calculated on the gross carrying amount for these instruments. In contrast to 12-month expected credit losses, lifetime expected 7
credit losses represent estimates based on the probability of a default event occurring at any time over the life of an instrument and is not only weighted by the likelihood of possible default events over the next 12 months. Stage 3 - is for those financial instruments that do show objective evidence of impairment at the reporting date. For such instruments, lifetime expected credit losses are recognized, but unlike for financial assets in Stages 1 or 2, the interest revenue on these assets is calculated on the net carrying amount (ie the gross carrying amount less the loss allowance for expected credit losses). 6.3. Methodology for Impairment and Provisioning Since FKGK is a new institution and does not have any historical records on which the model can be based, then until such records are gathered the model will rely on the past data from DCA. Calculation of provisioning will be as per following method: ECL = PD x LGD x EAD One of the major challenges in this model is determining the probability of default. The best model that could suit FKGK needs is Roll Rate model. Roll Rate model is one of the approaches that group the loans as per their delinquency status. This model measures the percentage of loans that roll from one loan classification into another. The second concern in the model is calculation of LGD, which will be calculated by the following formula LGD = 1 RR (recovery rate) Exposure at default (EAD) is defined as exposure expected to be outstanding in case of default in next 1 year. The ECL model requires the entity to determine at each reporting date whether there is significant increase in credit risk in order to determine whether to apply 12-month PD or life time PD. 12-month PD is the possibility that within 12 months after the reporting date the loan will default. 12-month PD are just the portion of the life time expected credit losses. Long Time PD is the possibility of possible default over the life of the loan. 8
6.4. Recognition and Measurement FKGK should identify and recognize impairment in all guaranteed loan that are originated from RFI, but are likely uncollectable, or there is no longer reasonable assurance that the RFI will collect, all amounts due according to the contractual terms of the loan agreement. Although RFI should recognize impairment for all delinquent or defaulted loans (even for loans that are placed under guarantee), still FKGK has commitments for all loan placed under guarantee, therefore impairment must be made. When FKGK determines that loss is likely, impairment need to be made that must be accounted as a liability in the financial statement in the period in which the impairment occurs. 7. Income Recognition The incomes and expenses will be recognized from FKGK on accrual bases. This accounting rule applies to all guaranteed loans, regardless on which stage it belongs or percentage of impairment. Exception for this rule, are all loans that are claimed and payed out to RFI, then FKGK should cease accruing interest. DISCLAIMER: "This is an unofficial, non-normative translation of the Provisioning Policy provided by FKGK which does not constitute the official version drafted in Albanian language. If any text of this translated policy is inconsistent with the official version, the official version in Albanian language shall prevail. FKGK does not assume responsibility for any inaccuracy contained herein. 9