No. FINANCIAL SUPERVISION GUIDELINE 105.13 J. No. 1/339/96 Issued on 30 January 1996 Valid from 1 April 1996 To credit institutions until further notice 1(8) General guideline on credit risk management By virtue of section 4, point 2, of the Act on the Financial Supervision Authority, the Financial Supervision Authority issues the following general guideline on credit risk management. set out in this guideline are intended to ensure that credit institutions manage risk in accordance with sound and prudent management principles. The aim of the guideline is to cover the key CONTENTS principles of credit risk management as widely as possible. The contents of these principles 1 Purpose of the guideline have also been explained in detail to enable 2 General principles of credit risk credit institutions to use the guideline in the management assessment of the efficiency of their internal 3 Ranking and monitoring of borrowers monitoring systems and in the further develop- 4 Credit analysis ment of such systems. 5 Exposure decision 6 Flow of information and monitoring Credit institutions differ from each other in regard to the volume of their operations, their organizations, the range and complexity of the 1 Purpose of the guideline financial products they offer and the profiles of their clientele. Therefore, in the application of This guideline sets out the views of the Finan- this general guideline on credit risk managecial Supervision Authority on certain key ment, the credit institution should aim at achievprinciples of credit risk management that ing an appropriate level of risk management in should, in its opinion, be taken into consider- conformity with the nature and scope of the ation in view of compliance with the provi- institution's activities. sions on risk management laid down in section 68 of the Credit Institutions Act. The purpose Credit institutions may apply a variety of practiof the guideline is to enhance the efficiency of cal approaches to credit risk management. The credit risk management by credit institutions Financial Supervision Authority will review the and companies belonging to their consolida- application of this guideline in connection with tion groups. The bodies responsible for its on-site inspections. arranging credit risk management in the senior management of a credit institution are the This guideline applies to all activities which may supervisory board and the board of directors or expose a credit institution to credit risk. the board of management. In the following, the term 'Board' applies both to boards of directors and boards of management. The principles
2(8) Lending means bank credit and all other types of financing granted under the terms of borrowed capital, as well as various debt securities. This guideline also applies to guarantees, stand-by credit facilities, overdraft facilities, derivative contracts and other contracts with potentially associated credit risk. Borrowers means all individual and corporate customers to whom the credit institution has granted a loan or issued a guarantee or provided a stand-by credit facility or an overdraft facility. Borrowers also include counterparties to derivative contracts and other commitments that expose a credit institution to credit risk. A group of connected borrowers refers to borrowers who belong to the same group as the borrower or who otherwise share a common financial interest with the borrower. Credit risk describes the risk that a borrower may not perform the obligations of his credit relationship to the credit institution and such that the collateral deposited or pledged by the borrower is insufficient to cover the claims of the credit institution. The guideline first sets out the general principles of credit risk management (section 2). It then sets out the key principles of ranking and monitoring of customers (section 3), credit analysis (section 4) and exposure decisions (section 5). 2 General principles of credit risk management The credit institution should maintain a written credit policy including a credit risk strategy, jointly approved by the Board and the supervisory board, for their credit institution. This written policy should apply to the credit institution as well as companies belonging to its consolidation group. The credit policy and the credit risk strategy should be consistent with the credit institution's broader business strategies. The policy should be reviewed on a regular basis and updated whenever necessary. The credit institution's credit risk strategy and the rules based thereon should be drawn up so that it is in conformity with the nature and scope of the credit institution's activities as nearly as possible. Special attention should be paid to the following matters: a) Credit policy targets. In setting credit policy targets, the credit institution should take into consideration its broader business goals and strategies as well as its business concept, corporate culture and code of ethics. The credit policy targets should reflect the expertise of the credit institution. They may relate to, for instance, profitability or products and markets (types of credit, lines of business, borrower groups, areas, countries). b) The main principle in risk selection. The main principle is that credit should be granted primarily on the basis of the profitability of the project for which financing is applied and the borrower's ability to repay. c) Risk selection criteria. The purpose of the risk selection criteria is to regulate, together with credit policy targets, the structure and size of the credit institution's credit and contracts portfolio. All functions that expose a credit institution to credit risk should be identified and subjected to credit risk monitoring. The risk selection criteria should specify the type and degrees of risk exposure the credit institution is prepared to assume in its lending operations, and how risk taking is to be limited. A comprehensive system of limits, including country,
3(8) business line, borrower and productspecific limits, are essential items to identify beforehand when limiting risks. The risk selection criteria should also define the principles to be applied in spreading risks, hedging risks, swapping 1 risks and discharging credit risk exposures. d) Risk-assessment criteria. These criteria define how credit risks inherent in the credit institution's credit and contract portfolio are assessed, and they form the basis of credit risk monitoring. The main criterion should be that the credit institution will not assume credit risk exposure unless the risks can be assessed in a sufficiently reliable and prudent manner. The credit institution should have adequate methods, consistent with the size of its operations, for calculating the credit risks generated by various types of credits, guarantees, derivative contracts and other commitments. When assessing its aggregate credit risk exposure, the credit institution should take into account such factors as changes in the financial standing of borrowers, developments in market prices, considering their impact on the value of the credit portfolio and assets placed as collateral. The assessment of the aggregate credit risk exposure should also include a loan loss estimate for the entire credit portfolio. Borrower-specific credit risk estimates should be updated on a regular basis as long as the credit relationship continues. 1 The swapping of risks means, for example, that a credit risk or a large risk exposure is reduced by increasing interest rate risk or by swapping assets. Credit risk is swapped against investment risk for instance when the credit institution acquires temporary ownership of shares in a corporate borrower or when they otherwise pass into its ownership. institution to credit risk. Credit institutions should take special care when introducing new products, especially when they involve unfamiliar aspects in terms of relevant markets, pricing, contract law, risk management or accounting principles. Before introducing any new products, the credit institution should establish their compatibility with the credit policy. f) Credit-granting powers. The credit risk strategy should define the credit-granting powers to be applied at the different levels of the credit institution's organization. The credit-granting powers should specify the decision-making procedure to be applied in different situations. Credit-granting powers should be updated and re-evaluated at regular intervals. They should enable the credit institution to ensure that its lending operations are within the specified credit policy targets and aggregate limits. g) Rating of borrowers and pricing of risk. The credit institution should have rating principles to be applied to borrowers and credits. The confirmed rating principles should also be applied to the companies belonging to the consolidated group of the credit institution. It should be possible for the credit institution to use the rating principles to classify its credit portfolio, on a borrower-by-borrower basis and on the basis of groups of connected borrowers, according to risk categories defined by the institution itself, and, if possible, also according to ratings applied by public rating agencies. h) Overcollateralization, collateral assessment and special terms. The credit policy should also include principles concerning overcollateralization, collateral valuation and the use of special e) Principles concerning the introduction of new products that expose the credit
4(8) terms. The credit institution should not grant uncollateralized credit unless it has agreed in advance on principles concerning the granting of such credit. i) Organization of decision-making and risk management. The credit policy should include the principles according to which exposure decisions are prepared, made and monitored within the credit institution. Special attention should be paid to the separation of these functions and their independence from each other. j) Monitoring systems. The internal monitoring system of the credit institution should be devised so that it enables the Board to monitor the credit institution's compliance with the confirmed credit policy and credit risk strategy. Risk monitoring should cover all functions that may expose a credit institution to credit risk. The internal monitoring system should be complemented by internal audits performed on a regular basis. k) Staff. The credit institution should have in its employ a sufficient number of expert employees to perform the duties connected with the preparation and making of exposure decisions and with the monitoring and control of exposures. 3 Rating and monitoring of borrowers The Board should confirm a rating and monitoring system to be used by the credit institution and by companies belonging to its consolidation group. The rating system should specify which borrowers are to be rated and which borrowers are to remain outside the rating system. The rating system should cover all the credit institution's major borrowers. Rating should be based on the financial standing of the borrower or a group of connected borrowers, and estimated developments therein. A monitoring system should provide information on borrower-specific credit risk exposure and the aggregate credit risk exposure of the credit institution, as well as on any changes in these exposures. In rating and monitoring, special attention should be paid to the following matters: a) Rating frequency. The credit institution should, as a matter of principle, assure that new borrowers are rated and the ratings of old borrowers are routinely re-evaluated. Each new major borrower should be rated before credit is granted for the first time. The ratings of corporate borrowers should be re-evaluated at regular intervals, at least once a year. b) Borrower's operating environment. In rating a borrower, the credit institution should take into account the country in which the borrower is situated, his business environment and the nature of the business and the group of connected borrowers he belongs to. c) Monitoring of borrowers. The credit institution should have an early-warning system that reacts whenever a borrower deviates from his commitment to the credit institution or when the borrower's business activities clearly take a turn for the worse. The credit institution's borrower-monitoring policy should also include the procedures to be applied in monitoring problem borrowers. If special terms, or covenants, are applied in lending operations, the credit institution should be prepared for the borrower monitoring required by the use of such covenants. The principles and rules concerning borrower monitoring should include the following:
5(8) - in which cases ratings will be based on regular monitoring of a borrower's 4 Credit analysis financial standing and in Each exposure decision should be based on a which cases on a one-off evaluation; credit analysis. The credit analysis should give a sufficiently accurate picture of the borrower - in which case the credit institution applying for credit and of the project to be will perform a corporate analysis, financed. The credit institution's credit policy analysis of the financial statements and its credit risk strategy should include rules or some other corresponding analysis on the contents and scope of the credit analysis. of a borrower; The rules should specify the extent of the credit analysis to be performed depending on the type - how the monitoring will be carried of the borrowers and the different types and out between annual or interim ac- sizes of loans. counts, eg cash flow analysis; In a credit analysis, special attention should be - how often the credit institution will paid to the following matters: check and update the correctness of data concerning groups of connected borrowers or the total amount of credit, guarantees and other commitments issued to each borrower and the amounts and values of collateral; - at which point, when the solvency of a borrower is deteriorating, the credit institution should intensify borrower monitoring and the measures to be taken in that connection. d) Calculation of maximum potential loss. The credit institution should estimate the maximum potential loss that could arise to the credit institution from each group of connected borrowers in the event of bankruptcy, at least in the risk categories where the risk exposure is greatest ("stress scenario"). e) Responsibility for borrower relationship. The credit institution should have principles concerning the precise assignment of borrower responsibility. The basic principle should be that at least for each major borrower or group of connected borrowers, the credit institution should designate only one person or unit to be responsible for the rating and monitoring of the borrower. a) Information on the applicant. Particularly where corporate borrowers are concerned, the credit analysis should indicate the group of connected borrowers to which the borrower may belong, the ownership and structure of the company and any parties that exercise de facto control in the company. b) The credit institution's outstanding credit, guarantees, credit limits and derivative contracts with respect to the borrower, and the collateral related to these. Where familiar borrowers are concerned, the analysis should also indicate the borrower's current rating and the findings made in connection with borrower monitoring. c) Analysis of a corporate borrower. The credit analysis of a corporate borrower should also contain information on
6(8) - developments in the financial standing of the company over at least the last three years, as evidenced by historical financial statements and other data, and developments since the latest financial statement, as evidenced, for instance, by actual cash flows; - the country and field of business of the company. Special attention should be paid to the situation as regards competition and capacity in the field of business and the sensitivity of the field of business to economic conditions; - an evaluation of the competence and expertise of the company's management. d) Forecast of developments in the borrower's financial standing. This provides the credit institution with a basis for assessing the borrower's ability to repay the debt concerned. It is expedient to make the forecasts using cash flow analysis so that one cash flow analysis is based on a realistic evaluation of developments in the borrower's business and another on a pessimistic one. g) Sources of repayment funds. When making an exposure decision, the credit institution should verify the funds out of which the borrower intends to repay. The sources of repayment funds include wage and salary income, funds generated by the corporate borrower's business operations, as well as refinancing and realization of assets. When evaluating alternative sources of funds, the credit institution should ascertain that the sources are not interdependent. h) Major risks. The most important financial risks should be identified for any project. These risks may include cyclicality or structural margin erosion in the prices of the goods the company sells, dependence of the project on the success of another project of the borrower, losses generated by other activities, entry of viable competitors on the market, government measures or drying up of wage and salary income. i) Summary of the strengths and weaknesses of the borrower and the project to be financed and a justified credit proposal. 5 Exposure decision A documented exposure decision in writing should be made regarding each credit. In addie) Purpose of credit. By ascertaining the tion to the exposure decision, all loans granted purpose for which financing is intended, by the credit institution should be documented the credit institution ensures that the by a credit application, a credit analysis and a credit conforms with its credit policy. credit proposal, to the extent confirmed by the Board. f) Overcollateralization and own financing. The own funding provided by the borrower for the project concerned should be verified and evaluated in relation Regarding the principles to be applied in decision-making, special attention should be paid to the following matters: to the credit institution's credit pol- icy. In the same connection, the credit institution should specify how the overall financing for the project has been arranged. a) Power of decision. Only persons or units so authorized may make exposure decisions. Such decisions must be within the limits of their authorization.
7(8) b) Separation of the preparatory and decision-making functions. The preparation of exposure decisions and decision-making should be separated. Only in special cases defined by the Board may the person who makes an exposure decision be the same person who prepares the credit proposal. c) Pricing of credit. The credit institution should have credit pricing principles indicating, for instance, how the financial standing of the borrower, the risk, collateral requirement and other matters are to be taken into account in the price of the credit. d) Collateral. In valuing the collateral, the credit institution should take into account the dependence of the value of the collateral on developments in the financial position of the borrower or the project to be financed. The special nature of personal guarantees should be taken into account in assessing the quality of collateral. In the case of physical assets offered as collateral, attention should be paid to the market value and productive value of the collateral item and the estimated developments in these values over the maturity of the credit. If the credit analysis of a borrower indicates that he is not able to repay the credit except by the proceeds from the realization of the collateral, the credit institution should simply refrain from granting credit as a matter of principle. If the repayment of the credit is based on the realization of collateral, special attention should be paid to verifying that the productive value or the market value of the collateral is sufficient to guarantee the repayment of the credit for as long as the credit relationship continues. e) Contents of the exposure decision. The exposure decision or the documents attached to it should include detailed information on the contents of the decision and the grounds for granting the credit. The decision should include the following information: - the amount, maturity and repayment schedule of the credit; - interest rate and interest linkage, service charges and commissions; - amount of overcollateralization; - amount and quality of collateral; and - other terms. Covenants may be applied in accordance with principles confirmed by the Board concerning their use and monitoring. Covenants and changes in them should be documented. Moderation, from the borrower's point of view, should be observed in the application of covenants. f) Exceptional exposure decisions. The credit institution should have principles according to which an exceptional credit risk exposure may be taken. These principles should also include the procedure to be applied to credit applications made by problem borrowers regarding, for instance, the lowering of the interest rates on the credits or the reorganization of loans or collateral. g) Disbursement of credit to a borrower. The credit institution should not disburse credit to a borrower until it has received all the necessary documents to the extent defined by the internal rules of the credit institution. This principle also applies, where applicable, to the issuing of a guarantee or other commitment or to the making of a derivative contract.
8(8) h) Documentation. The credit documents should contain data on the different stages of the decision-making process and the names of the persons who participated in the preparation and decisionmaking. Credit documents should be filed in an orderly and thorough manner and kept for as long as the credit risk exposure exists, which at minimum would be as long as the debt is outstanding. 6 Flow of information and monitoring of compliance The Board should see to it that the staff is aware of the credit risk strategy adopted by the Board and the rules based thereon. The Board should monitor their compliance by means of an internal monitoring system and a unit responsible for internal audit.