Credit Administration, Measurement

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Supervisory Policy ManualCRG3 Credit Administration, Measurement V. 1 -19.01.01and Monitoring

This module should be read in conjunction with the Introduction and with theGlossary, which contains an explanation of abbreviations and other termsused in this Manual. If reading on-line, click on blue underlined headings toactivate hyperlinks to the relevant module.

PurposeTo specify the components of systems that Als should have toadminister, measure and monitor their credit portfolios

ClassificationA statutory guideline issued by the MA under the Banking Ordinance,7(3}

Previous guidelines supersededThis is a new guideline.

ApplicationTo all Als

Structure1.

2.

3.

Credit administration1.1 Main functionsCredit measurement2.1 Accounting policies2.2 Credit risk measurement2.3 Internal risk rating systemsCredit monitoring3.1 Monitoring systems and procedures3.2 Management information systems3.3 Stress-testing
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1. Credit administration1.1 Main functions

1.1.1 Als should have a designated department dealing withthe administration of their various credit risk bearingportfolios.1.1.2 In addition to delivering customer services such as thedisbursement of loans, settlement of transactions,advising customers of interest rate fixing and sending outrenewal notices, the Credit Administration Departmentalso performs the following important control and riskmanagement functions:

ensuring that new credit applications have beenproperly approved; entering facility limits promptly and accurately intothe computer system; preparing loan documentation (loan agreements,guarantees, transfers of title to collateral to the AI,etc.); arranging for the safe custody of important legaldocumentation; verifying customers' authority to borrow; conducting valuation of collateral; effecting liens on deposits; checking whether drawdowns have beenapproved; arranging funding and coordinating with theTreasury function to fix interest rates for loandisbursements; keeping track of customers' compliance withcredit terms; monitoring the receipt of repayments; identifying early signs of delinquency orirregularity; obtaining customers' current financial information;

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V. 1 -19.01.01and Monitoring

keeping credit files complete and up to date; and producing management information on the creditportfolio.

1.1.3 Als should ensure that the Credit AdministrationDepartment carries out its functions effectively throughregular independent audits.1.1.4 The custody of key documents, the disbursement offunds and the entering of limits into the computerdatabase should be kept independent of the creditinitiation, approval and review functions.

2. Credit measurement2.1 Accounting policies

2.1.1 Credit exposures should be accounted for in accordancewith generally accepted accounting principles in HongKong (Hong Kong GAAP) and subject to the reportingand regulatory requirements, e.g. on provisioning, of theHKMA. Details of Hong Kong GAAP to be applied arebeyond the scope of this Manual. Als should consulttheir external auditors in case of doubt.

2.2 Credit risk measurement2.2.1 An AI's senior management should develop, with thesupport of its risk management function, policies,methodologies and procedures, subject to approval bythe Board of Directors, for the measurement of creditrisk. The approach adopted should align with the nature,size and complexity of an AI's activities.2.2.2 For monitoring to be effective the approach should coverall credit exposures. Als should therefore develop asystem or methodology, such as the calculation of creditequivalent amounts, for quantifying the credit risk of allon- and off-balance sheet products, includingderivatives, on a consistent basis.2.2.3 In most cases, credit risk equates to the nominal amountof a loan. The methodology should also, however, cover

the case of facilities with uncertain drawdowns or where

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the amount of risk varies over time in line with marketconditions.2.2.4 The approach should take into consideration maturities.In the case, for example, of two loans equal in all otherrespects (same borrower, amount, etc.) but with differingmaturity dates, the longer-term loan should beconsidered riskier.2.2.5 Where appropriate, exposures may be netted so that theamount of risk is not overstated, provided that this issupported by legally enforceable netting agreements.Similarly, account may be taken of any credit riskenhancement methods which have been utilised (seesubsection 6.3 of CR-G-1 "General Principles of CreditRisk Management" on risk mitigation) to avoidoverstating exposure.2.2.6 The methodology should permit the AI to measureexposure by counterparty groups, by industry, by country

and by other meaningful aggregations.2.2.7 Als should make use of internal credit ratings tomeasure counterparty risk. Subsection 2.3 discussesthis in more detail. It is recommended that Als developexpected default rates, aligned to their internal risk ratingcategories and derived from their historical experience,to quantify the likelihood of default. These can then befactored into their calculation of net return on facilities toproduce the risk-adjusted return.2.2.8 As regards off-balance sheet exposures, credit risk

measurement should take account of current exposure,potential future exposure (discussed below), presettlement and settlement risk.2.2.9 Potential future exposure means the estimated futurecost of replacing transactions with positive value to thelender, Le. what the loss might be if an obligor defaultsat any stage of a transaction's life. Simulations orscenario analysis can be used for this, taking intoaccount market volatility and portfolio effects.Alternatively, pre-determined credit conversion factors(as used for the purposes of completing the Return of

Capital Adequacy Ratio) may be used to provide a roughapproximation of future credit exposure.4
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2.2.10 Risk measurement of portfolios should take account of: types of facility; terms (repayment schedules, interest rates, etc.); the portfolio's maturity profile; the degree to which exposures are secured and

the type of collateral; internal credit ratings; potential changes in internal credit rating over thelife of individual loans in the portfolio; and outstandings against limits.

2.3 Internal risk rating systems2.3.1 Als are encouraged to develop and use an internal riskrating system for managing credit risk.2.3.2 Credit risk rating assigned to customers should cover allon- and off-balance sheet credit exposures of the AI tothe relevant customers. For facilities managed on aportfolio basis such as consumer loans, mortgages andcredit cards, it is acceptable to employ an automaticrating system based on a pre-determined set of objectiverating criteria, e.g. past account performance.2.3.3 Credit risk rating should in general be based on theunderlying credit-worthiness of the borrower, taking intoaccount the financial strength of the guarantor(s),collateral pledged and the risks of specific transactions.2.3.4 There are many variants of internal risk rating systems.The HKMA does not propose to prescribe any standardsat this stage. Als are, however, encouraged to adopt asystem which can map with, but is more sophisticatedthan, the 5-grade loan classification system currentlyemployed for regulatory reporting. In particular, Als arerecommended to adopt multiple grades for credits thatare not yet irregular and to be able to track the migrationof individual credits through the various grades. This willfacilitate the early identification of deteriorating credits so

that corrective actions can be taken to minimise creditlosses.5


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2.3.5 Properly developed internal risk rating systems can alsofacilitate internal capital allocation, determination of riskadjusted return on the portfolio, risk-adjusted pricing,migration analysis and stress-testing.2.3.6 There should be arrangements for a periodic review ofthe appropriateness of the internal risk rating system andthe validity of grading criteria by the middle office andthe Credit Committee.

3. Credit monitoring3.1 Monitoring systems and procedures

3.1 1 As compared with periodic credit reviews, creditmonitoring refers to the day-to-day monitoring of theperformance of individual credits and of the overallportfolio. This process is carried out at different levels.Individual account monitoring is performed by themarketing or account officers in the front office while themiddle or back office units are involved with more highlevel monitoring of the credit portfolio. See para. 2.1 ofCR-G-1 "General Principles of Credit Risk Management"on this allocation of responsibilities.

3.1.2 Als should have documented systems, procedures andprocesses for monitoring regularly the performance,quality and condition of individual credits and of theoverall portfolio.3.1.3 The objectives of monitoring are to ensure that:

credits are being serviced in compliance withfacility terms, including meeting contractualrequirements such as observing covenants andmaintaining collateral; early signs of delinquency are detected tofacilitate prompt remedial action and thus tominimise losses; management reports are made of any form ofdefault, breach of covenant or irregularity and ofthe effectiveness of remedial actions already

taken;

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Supervisory Policy ManualCRG3 Credit Administration, Measurement V.1 - 19.01.01and Monitoring

facilities granted to individual customers, groupsof related customers and at the total portfoliolevel, including various types of concentrationrisks, are within the limits and parameters set bythe credit risk strategy and policy; regulatory limits are complied with; provisions are realistically determined; and the Credit Committee or senior management isable to monitor the overall quality of the totalcredit portfolio, identify trends and reassess theappropriateness of the credit risk strategy andpolicy.

3.1.4 The system should define criteria for identifying andreporting credits whose internal credit rating might needto be downgraded or upgraded.3.1.5 There should be standard monitoring procedures whichprovide guidance on:

which officers are responsible for monitoring.Where front-line monitoring is carried out by theaccount officers their work should be checkedperiodically by independent parties, e.g. InternalAudit, to ensure there is adequate segregation ofduties and sufficient checks and balances; the frequency of monitoring. The frequency willdepend on the nature of the exposure. Someexposures (e.g. share margin financing) should be

monitored daily, others less frequently; the periodic checking of collateral valuations (inparticular, the current value of properties andshares); the frequency of site visits; and the identification of any changes in the borrower'scapacity to repay.

3.1.6 Als should establish monitoring systems appropriate totheir organisation structure and the volume andcomplexity of their credit activities. The following is a list

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of recommended monitoring procedures that they maywish to consider:ProceduresAt Individual facility level:Keeping regular contact withcustomers (including site visitsand meetings)Following up documentationdeficienciesReviewing exceptions andoverdue accountsMonitoring compliance withcredit facility termsMonitoring compliance withinternal and regulatory limitsIdentifying and following upoutstanding credit reviews andexpired facilitiesPerforming collateralrevaluationstocks and sharesreal estate (classifiedaccounts)Reviewing adequacy ofprovision for individualaccountsMonitoring performance oflarge exposuresFollowing up customers forlate paymentsTaking remedial action forloan recoveryAt portfolio level:Performing portfolio analysisand risk assessment by:- type, sector and internalcredit rating

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ProposedFrequencyOn-going

DailyDailyOn-goingDaily

Weekly

DailyQuarterlyMonthly

On-goingDailyOn-going

Monthly

Performed byFront office

Back officeMiddle officeMiddle office I BackofficeMiddle office ICompliance unitBack office

Back officeBack officeMiddle office I Seniormanagement I CreditCommitteeMiddle officeFront office I BackofficeFront office (lessserious) I Middle office

Middle office


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Performing trend and ratio MonthlyanalysesConducting loan migration Monthlyanalysis or stress-testReviewing risk concentrations Monthly Quarterly

Reviewing asset quality and Monthly -adequacy of provision for the QuarterlyportfolioMonitoring compliance with Dailyinternal and regulatory limitsMonitoring connected lending Monthly""-Quarterly

Middle officeMiddle officeMiddle office I Seniormanagement I CreditCommittee I Board ofDirectorsMiddle office I Seniormanagement I CreditCommittee I Board ofDirectorsMiddle office ICompliance unitCredit Committee IBoard of Directors

The frequency of monitoring should be increased, ifappropriate (e.g. weaknesses have been identified orfacilities are approaching the limit). Exceptions shouldbe promptly reported to senior management.

3.1.7 Where early signs of delinquency or other irregularsymptoms are detected in any accounts, they maywarrant a more detailed review of the credit-worthinessand the repayment ability of the customers concerned.In these cases, management should appoint someoneindependent of the officer who previously approved thefacilities to carry out the review. Remedial actionsshould then be recommended and, if approved,instituted to protect the interests of the AI. Theresponsible officer should subsequently report to theCredit Committee or senior management on the resultsof the remedial actions.

3.2 Management information systems3.2.1 Als' management information systems should becapable of quantifying periodically and efficiently thecredit risk of individual customers as well as that of theoverall portfolio. To achieve this, the systems should be

versatile and flexible enough to aggregate information in

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various meaningful ways in order to facilitate differenttypes of analysis and to highlight risk concentrations.3.2.2 Senior management should be provided with up-to-datemanagement information to enable them to direct an AI'scredit activities and control the associated risks. Theinformation would normally cover the following:

aggregate exposure versus portfolio limit byindustry, country, product and type ofcounterparty (e.g. banks, non-bank financialinstitutions, corporates, retail customers, etc.); total portfolio by internal credit rating and trend; total exposures to groups of relatedcounterparties; large exposures; connected lending; asset-based lending with loan-to-value ratiosexceeding pre-set limits (e.g. mortgages withloan-to-value ratios exceeding 70%); overdue accounts with ageing analysis (Le.amounts overdue one, three, six months etc.); credit downgrades and loans rescheduled duringthe period; interest suspended; adequacy of provisions; facilities expiring soon; undrawn commitment ratio (i.e. undrawn facilityamounts as a percentage of total facilities); loan-to-deposit ratio; and results of stress-tests (see subsection 3.3 below).

3.2.3 Data used for reporting should be complete, accurateand reliable.3.2.4 Management information reports should be user-friendly,

accurate and timely. Ideally, certain information such asconcentration risk limits and facilities approved should10


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be provided on an on-line, real-time basis if the totalcredits granted are approaching pre-set limits.3.2.5 The accuracy and appropriateness of reporting should

be periodically verified by Internal Audit.3.2.6 Based on periodic reports to the Board of Directors andsenior management on the AI's credit portfolio, its credit

strategy should be re-appraised and if necessaryadjusted.3.3 Stress-testing

3.3.1 Stress-testing should be employed to predict how aportfolio might respond to different eventualities, inparticular unfavourable developments. Tests should beconducted on the basis of realistic scenarios, with fullconsideration of the correlation of various risks and thevulnerability of credits. Typical scenarios would includedownturns in an industry or the overall economy, liquiditysqueezes and adverse market developments or interestrate trends.

3.3.2 Reports of the outcomes should be reviewed at anappropriately senior level and any necessary actiontaken, e.g.: policy or limit amendments; hedging; exposure reduction (e.g. through asset sales,securitisation, etc.); and contingency planning for actions to be takenshould a particular scenario happen.

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Credit Administration, Measurement

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