Basel Committee on Banking Supervision

One of the lessons learnt from the great financial crisis is that supervisors and investors could not always understand and compare information about credit categorisation presented in banks’ financial statements. Banks used different (and often undisclosed or insufficiently disclosed) methodologies and assumptions for valuations, provisioning and risk weightings, increasing opacity and reducing comparability for end users. This inconsistency increased uncertainty at the height of the crisis and frustrated supervisors and investors who tried to compare and assess banks’ performance and risk.

Credit risk categorisation is a supervisory and bank management tool used to assess the solvency and the riskiness of banks’ credit risk exposures. It helps identify credit risk-related issues that require management or supervisory action. Differences across jurisdictions in credit categorisation and practices are detrimental in several ways:

1. At a bank level, they can make it difficult to properly assess credit risk and can delay early detection of an increase in credit risk (deterioration of asset quality) and its consequences, particularly when supervising a cross-border bank with activities in jurisdictions using different credit categorisation schemes.
2. At a system-wide level, they make international comparisons very challenging for supervisors, multilateral public bodies and market analysts. They can also raise questions about the comparability of common indicators used to benchmark asset quality at the global level.
3. At the international standards level, they can influence the implementation and assessment of compliance, eg with the Basel Core Principles, as different credit risk categorisation requirements and practices create different incentives to act early on problem assets, and initiate supervisor responses, which can ultimately lead to an unlevel playing field.

Enhanced comparability of terminology and the resulting harmonisation of practice enables supervisors and market participants to better understand asset quality issues, including on a cross- border basis and relative to other jurisdictions. Common definitions help set a consistent basis for supervisors to understand levels of problem loans as they discuss and consider supervisory responses.

The following terms are used throughout this chapter and have the meaning given below:

1. Categorisation: is used in the context of this chapter to avoid confusion with the concept of classification (eg “classified loans” or “adversely classified” loans) used in some jurisdictions as a supervisory tool and in the accounting framework.
2. Concessions: are special contractual terms and conditions provided by a lender to a counterparty facing financial difficulty so that the counterparty can sufficiently service its debt. The main characteristic of these concessions is that a lender would not extend loans or grant commitments to the counterparty, or purchase its debt securities, on such terms and conditions under normal market conditions.
3. Counterparty: is a natural or legal person to which a bank has exposure.
4. Material exposure: an exposure breaching the materiality threshold established in the relevant jurisdiction by the supervisor. The materiality threshold is defined by reference to a bank’s aggregated exposure to a counterparty or an amount past-due related to the counterparty’s debt.
5. Past due exposure: an exposure where any amount due under the contract (interest, principal, fee or other amount) has not been paid in full at the date when it was due. An exposure should be considered past due from the first day of missed payment, even when the amount of the exposure or the past-due amount, as applicable, is not considered material.
6. Problem assets: is an asset for which there is reason to believe that all amounts due, including the principal and interest, may not be collected in accordance with the contractual terms of the agreement with the counterparty (see BCP40.41).
7. Unlikely full repayment: an exposure where full repayment of principal and/or interest by the counterparty is unlikely without relying on the bank’s realisation of collateral or risk mitigants, even when it is not past due or has been past due for less than 90 days. For these exposures, CRE36.69 sets out indicators of unlikeliness to pay.

This chapter sets out guidelines for the definitions for “non-performing exposures” and “forbearance”, providing a consistent international standard for categorising problem assets. The definitions were built on commonalities in the existing definitions of many countries. These guidelines are intended to complement the existing accounting and regulatory frameworks in relation to asset categorisation. They harmonise the scope, recognition criteria, and level of application of the terms.

Interactions with other credit quality concepts under the Basel and accounting frameworks

The definitions form a consistent supervisory basis for the identification of problem loans, regardless of the risk of loss. They are not designed to: (i) undermine standards that are focused on the accuracy of impairments and provisions disclosed in financial statements and reflect the risk of loss; or (ii) replace the existing definitions of default used in the IRB approach or the standardised approach for credit risk. Instead, the definition of non-performing exposures is intended to complement the current category of “defaulted exposures” in the Basel Framework (CRE20.104 to CRE20.105 and CRE36.68 to CRE36.71). There are certain obstacles for effectively using the definition of default for a common understanding of problem loans:

1. it leaves to banks the specific recategorisation criteria from a defaulted category to a non-defaulted category;
2. it covers only cases of distressed restructuring that inflict a loss on a bank; and
3. it is open to various interpretations (eg there can be different interpretations about an exposure’s default status when it is impaired, especially for non-significant exposures when impairment may be recognised on a portfolio basis).

These two important elements of the definition of default – restructuring and impaired status – are specified by national guidance.

The definition of non-performing exposures builds on the definition of default but is broader than that definition in the following ways:

1. it is based on a standard 90 days past due (DPD) threshold, while the default definition used in the IRB approach allows for the use of a 180 DPD threshold for retail and public sector exposures;
2. it offers more harmonised recategorisation criteria than those currently existing under the definition of default; and
3. it offers more specific guidance regarding the interaction of forbearance measures and non-performing status.

The definition of non-performing exposures is designed to uniformly apply to all jurisdictions regardless of the regulatory approach applied to credit exposures. It is designed to be used alongside the definition of forbearance, which can be categorised as either performing or non-performing based on the outlined criteria.

The definitions in this chapter are intended to be used in the following contexts:

1. Supervisory asset quality monitoring, including so that supervisory colleges can obtain a more consistent basis for comparison across jurisdictions;
2. Banks‘ internal credit categorisation systems for credit risk management purposes (see BCP40.42);
3. Pillar 3 disclosure on asset quality (see DIS40, Table CRB-A); and
4. Dissemination of data for asset quality indicators.

Definition of non-performing exposures

Identification of non-performing exposures

Non-performing exposures should always be categorised for the whole exposure, including when non-performance relates to only a part of the exposure, for instance, unpaid interest. For off-balance sheet exposures, such as loan commitments or financial guarantees, the whole exposure is the entire uncancellable nominal amount.

The following exposures are considered as non-performing:

1. all exposures that are “defaulted” under the Basel framework, ie CRE20.104 to CRE20.105 or CRE36.68 to CRE36.71; or
2. all exposures that are credit-impaired (in the meaning of exposures having experienced a downward adjustment to their valuation due to deterioration of their creditworthiness) according to the applicable accounting framework;1 or
3. all other exposures that are not defaulted or impaired but nevertheless:
   1. are material exposures that are more than 90 days past due; or
   2. where there is evidence that full repayment based on the contractual terms, original or, when applicable, modified (eg repayment of principal and interest) is unlikely without the bank’s realisation of collateral, whether or not the exposure is current and regardless of the number of days the exposure is past due.

The identification of an exposure as non-performing is not intended to affect its categorisation as impaired for accounting purposes or as defaulted in accordance with the regulatory framework.2

Forborne exposures should be identified as non-performing when they meet the specific criteria provided for in this definition.

Collateralisation or received guarantees should have no direct influence on the categorisation of an exposure as non-performing. However, the bank may consider the collateral when assessing a borrower’s economic incentive (both positive and negative) to repay under the unlikeliness to repay criteria. Any recourse by the bank shall not be considered in this judgment. The collateralisation or guarantee status does not influence the past-due status, including the counting of past-due days and the determination of the exposure as non-performing, once the materiality and overdue days threshold have been met. When the relevant criteria are met, an exposure should be categorised as non- performing even if the collateral value exceeds the amount of the past-due exposure.

When a material exposure to a counterparty is categorised as non-performing, all exposures to that counterparty should be categorised as non-performing. However, for retail exposures as defined in the Basel Framework (CRE20.63 to CRE20.68 and CRE30.19 to CRE30.25), exposures can be categorised as non-performing on a transaction-by-transaction basis. In these cases, banks should consider the categorisation status of other exposures to the same counterparty, except in the rare circumstances when this information is not available.

When applied, the debtor approach applies at the level of a single counterparty. When a counterparty belongs to a group, designating an exposure to one entity belonging to a group as non-performing does not mandatorily lead to designating all exposures to the other entities from the same group as such. However, designating the exposure to one of the group entities as non-performing should be one of the inputs, along with the respective financial situation of other entities from the same group, when assessing the creditworthiness and determining the performing or non-performing status of exposures to the other entities in the group.

The likelihood of repayment could also be assessed through a comprehensive analysis of the financial situation of the counterparty, using all inputs available, including but not limited to:

1. patterns of payment behaviours in past circumstances;
2. new facts that change the counterparty’s situation; and
3. financial analysis.

Financial analysis may include, as appropriate:

1. For non-retail counterparties the following ratios: leverage ratio; debt/EBITDA ratio; interest coverage ratio; current liquidity ratio; or ratio of (operating cash flow + interest expenses)/interest expenses; loan-to-value ratio; and any other relevant indicators.
2. For retail counterparties, consideration of debt service coverage ratio, loan-to-value ratio, credit scores and any other relevant indicators.
3. For debt securities, a situation of partially or totally missed payment for more than 30 days will trigger a specific assessment of the counterparty’s creditworthiness. When the assessment evidences a situation where the full repayment of the security is unlikely, the security will be considered as non-performing regardless of the number of days it is past due.

When applying the criterion of unlikely full repayment to an exposure, the contractual features of the exposure (eg an interest-only mortgage loan, or a loan in which the repossession of collateral for repayment is contractually provided for, or a retained first-loss tranche in a securitisation transaction) should not automatically result in its categorisation as non- performing without analysis of payment behaviours or the financial situation of the counterparty. However, regardless of its contractual features, an exposure is categorised as non-performing when it is more than 90 days past due and meets the materiality threshold.

An exposure ceases to be non-performing and can be recategorised as performing when all the following criteria are simultaneously met:

1. the counterparty does not have any material exposure more than 90 days past due;
2. repayments have been made when due over a continuous repayment period as specified by the supervisor of at least three months.3 A longer repayment period can be required for non-performing forborne exposures;
3. the counterparty’s situation has improved so that the full repayment of the exposure is likely, according to the original or, when applicable, modified conditions; and
4. the exposure is not “defaulted” according to the Basel Framework or “impaired” according to the applicable accounting framework.

The following situations will not lead to the recategorisation of a non-performing exposure as performing:

1. partial write-off of an existing non-performing exposure, (ie when a bank writes off part of a non-performing exposure that it deems to be uncollectible);
2. repossession of collateral on a non-performing exposure, until the collateral is actually disposed of and the bank realises the proceeds (when the exposure is kept on balance sheet, it is deemed non-performing); or
3. extension or granting of forbearance measures to an exposure that is already identified as non- performing subject to the relevant exit criteria for non-performing exposures.

The recategorisation of a non-performing exposure as performing should be made on the same level (ie debtor or transaction approach) as when the exposure was originally categorised as non-performing.

Banks should be able to provide information on the amount of existing non-performing exposures for both the gross carrying amount and the carrying amount net of value adjustments and provisions. These value adjustments and provisions refer to both the allowance for credit losses and direct reductions of the outstanding of an exposure to reflect a decline in the counterparty’s creditworthiness.

In some jurisdictions, repossessed collateral is reported as a non-performing exposure. Such exposures should be identified separately from other non-performing exposures.

When banks are required under the applicable accounting standards to recognise interest income on non-performing exposures, they should be able to provide information about the amount of income recognised on non-performing exposures, as well as any adjustment to this income that they are required to implement, such as provisions or the establishment of reserves (post-tax appropriation of profits).

Forbearance occurs when:

1. a counterparty is experiencing financial difficulty in meeting its financial commitments; and
2. a bank grants a concession that it would not otherwise consider whether or not the concession is at the discretion of the bank and/or the counterparty. A concession is at the discretion of the counterparty (debtor) when the initial contract allows the counterparty (debtor) to change the terms of the contract in its own favour (embedded forbearance clauses) due to financial difficulty.

The identification of an exposure as forborne does not automatically affect its categorisation as impaired for accounting purposes or as defaulted in accordance with the regulatory framework.4

Forbearance includes concessions that are granted due to the counterparty’s financial difficulty on any exposure in the form of a loan, a debt security or an off-balance sheet item (eg loan commitments or financial guarantees), regardless of the measurement method for accounting purposes.

Forbearance is identified at the individual exposure level to which concessions are granted due to financial difficulty of the counterparty.

To identify cases of forbearance, banks should first determine if the counterparty is experiencing financial difficulty at the time when the forbearance is granted. The following list provides examples of possible indicators of financial difficulty, but is not intended to constitute an exhaustive enumeration of financial difficulty indicators with respect to forbearance. In particular, financial difficulty can be identified even in the absence of arrears on an exposure:

1. A counterparty is currently past due on any of its material exposures.
2. A counterparty is not currently past due, but it is probable that the counterparty will be past due on any of its material exposures in the foreseeable future without the concession, for instance, when there has been a pattern of delinquency in payments on its material exposures.
3. A counterparty’s outstanding securities have been delisted, are in the process of being delisted, or are under threat of being delisted from an exchange due to non- compliance with the listing requirements or for financial reasons.
4. On the basis of actual performance, estimates and projections that encompass the counterparty’s current capabilities, the bank forecasts that all the counterparty’s committed/available cash flows will be insufficient to service all of its loans or debt securities (both interest and principal) in accordance with the contractual terms of the existing agreement for the foreseeable future.
5. A counterparty’s existing exposures are categorised as exposures that have already evidenced difficulty in the counterparty’s ability to repay in accordance with the supervisory categorisation scheme in force or the credit categorisation scheme within a bank’s internal credit rating system.
6. A counterparty is in non-performing status or would be categorised as non- performing without the concessions.
7. The counterparty cannot obtain funds from sources other than the existing banks at an effective interest rate equal to the current market interest rate for similar loans or debt securities for a non-troubled counterparty.

Supervisors may set specific materiality thresholds for what constitutes a concession.

Concessions can be triggered by:

1. changes in the conditions of the existing contract, giving considerably more favourable terms for the counterparty;
2. a supplementary agreement, or a new contract to refinance the current transaction; or
3. the exercise of clauses embedded in the contract that enable the counterparty to change the terms and conditions of its contract or to take on additional loans, debt securities or off-balance sheet items at its own discretion. These actions should only be treated as concessions if the bank assesses that the counterparty is in financial difficulty.

There are many types of concession granted by lenders, or exercised by counterparties in existing contracts, that could be considered as forbearance. Not all concessions lead to a reduction in the net present value of the loan, and therefore a concession does not necessarily lead to the recognition of a loss by the lender. There is no concession when the borrower is not in financial difficulty. When a borrower is assessed as experiencing financial difficulty, examples of potential concessions are:

1. extending the loan term;
2. rescheduling the dates of principal or interest payments;
3. granting new or additional periods of non-payment (grace period);
4. reducing the interest rate, resulting in an effective interest rate below the current interest rate that counterparties with similar risk characteristics could obtain from the same or other institutions in the market;
5. capitalising arrears;
6. forgiving, deferring or postponing principal, interest or relevant fees;
7. changing an amortising loan to an interest payment only;
8. releasing collateral or accepting lower levels of collateralisation;
9. allowing the conversion of debt to equity of the counterparty;
10. deferring recovery/collection actions for extended periods of time; and
11. easing of covenants.

Refinancing an existing exposure with a new contract due to the financial difficulty of a counterparty could qualify as a concession, even if the terms of the new contract are no more favourable for the counterparty than those of the existing transaction.

A forborne exposure will be identified as such until it meets both of the following exit criteria:

1. When all payments, as per the revised contractual terms, have been made in a timely manner over a continuous repayment period of not less than one year (probation period for reporting). The starting date of the probation period should be the scheduled start of payments under the revised terms, regardless of the performing or non-performing status of the exposure at the time that forbearance was granted; and
2. The counterparty has resolved its financial difficulty.

Forbearance may be granted on performing or non-performing exposures. When forbearance is applied to a non-performing exposure, the exposure should remain non-performing. When forbearance is applied to a performing exposure, the bank then needs to assess whether the exposure meets the non-performing criteria, even if the forbearance resulted in a new exposure. When the original exposure would have been categorised as non-performing at the time of granting forbearance, had the forbearance not been granted, the new exposure should be categorised as non-performing.

Banks should pay particular attention to the appropriate categorisation of exposures on which forbearance has been granted more than once. When a forborne exposure under the probation period is granted new forbearance, this should trigger a re-start of the probation period, and banks should consider whether the exposure should be categorised as non-performing.

The continuous repayment period for non-performing and the probation period for forbearance can run concurrently. All non-performing forborne exposures should remain non-performing until they meet the criteria in paragraph PAP10.20. Thereafter, the remaining probation period for forbearance exit in paragraph PAP10.35 shall apply and the exposure should be identified as a performing forborne exposure.

When a forborne exposure becomes non-performing during the 12-month probation period, the probation period starts again.