Review the considerations that feed into classifying credit assets.
The idea
Credit asset classification sorts loans by how likely they are to be repaid in full, so provisioning, pricing, management attention and reporting follow risk. A common ladder runs pass, special mention, substandard, doubtful and loss, the last three being classified. The considerations are the borrower's repayment capacity from cash flow, the payment record with 90 days past due a common non-performing threshold, and financial trends. They also include the adequacy and realisable value of collateral, documentation and covenant compliance, industry conditions, and whether the loan was restructured because of difficulty. Classification should be forward looking, not driven by arrears or collateral alone. A well-secured loan whose borrower cannot service it is still weak, and a restructured loan that is current is not automatically cured.
A practice question
In a typical credit asset classification scheme, which order runs from the least severe to the most severe category?
- Pass, substandard, special mention, doubtful, loss.Why not: Places substandard ahead of special mention; special mention is the weakest non-classified grade.
- Special mention, pass, doubtful, substandard, loss.Why not: Reverses pass and special mention and swaps doubtful with substandard.
- Pass, special mention, substandard, doubtful, loss. - correct
- Pass, special mention, doubtful, substandard, loss.Why not: Swaps substandard and doubtful; doubtful implies a worse collection outlook.
The usual ladder moves from pass (fully performing) through special mention (watch) to the classified categories substandard, doubtful and loss, where loss means the asset is considered uncollectible.
A harder one
A retailer's loan is current on all payments and collateral covers 150 percent of the balance. Over two years its EBITDA has fallen 40 percent and its debt service coverage is now 0.9. Which classification is most appropriate?
- Pass, because payments are current and collateral exceeds the loan.Why not: Relies on payment record and collateral and ignores deteriorating capacity.
- Substandard: cash flow no longer covers debt service, so repayment relies on collateral or refinancing. - correct
- Loss, because coverage is below 1.0.Why not: Weak coverage with ample collateral does not mean the loan is uncollectible.
- Doubtful, because arrears have occurred and full collection of the balance is highly improbable on current facts.Why not: Facts state there are no arrears and collateral is ample, so collection is not doubtful.
Classification looks at repayment capacity, not just arrears or collateral. DSCR below 1.0 shows the borrower cannot service debt from operations, which is a classic substandard characteristic.
The hardest tier
A bank provisions by classification at these rates: pass 1 percent, special mention 5 percent, substandard 20 percent, doubtful 50 percent and loss 100 percent. Balances in USD million are 800, 120, 50, 20 and 10 respectively. USD 40 million of the special mention balance is downgraded to substandard. Required provisions after the downgrade are:
- USD 52 millionWhy not: Adds 20 percent on the 40 but forgets to release the 5 percent already held on it.
- USD 62 millionWhy not: Moves the 40 to doubtful (50 percent) instead of substandard.
- USD 44 millionWhy not: Ignores the downgrade; provisions rise when balances move to a worse class.
- USD 50 million - correct
Before: 8 + 6 + 10 + 10 + 10 = 44. The downgrade changes the rate on 40 from 5% to 20%, an extra 40 x 15% = 6. Total = 50.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Credit Risk Management
- Outline the main building blocks of a sound lending or financing policy.
- Show why exposure and concentration limits matter and what makes them hard to set.
- Outline how the scope and allocation of a bank's credit facility are handled, and the bank-level policies and steps used to cut credit risk.
- Set out what loan loss provisions and loan loss reserves are and how they work.
- Break expected loss into its components, then show how it differs from unexpected loss.
- Account for what IFRS 9 requires when expected loss is estimated.
- Outline a workout procedure for loss assets, and weigh the approach of keeping loss assets on the books against that of writing them off.
- Account for the elements that make up credit risk analysis.
- Lay out what makes up a bank's capacity to manage credit risk, and list the questions its board of directors should be asking.