General Principles of Credit Risk

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Supervisory Policy ManualCR-G-1 General Principles of Credit Risk V.1 -19.01.01Management

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 summarise the main principles which Als are expected to follow inmanaging credit risk.Specific risk controls and systems that should be established arecovered in the other modules within the Credit Management section.

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

Previous guidelines supersededCircular "Principles Underlying Prudent Credit Control by AuthorizedInstitutions" dated 14.02.00

ApplicationTo all Als

Structure1.2.3.

IntroductionOverview of the credit processAn appropriate credit risk environment3.1 Credit risk strategy and policy3.2 Risk tolerance and portfolio limits3.3 Risk concentrations3.4 New products3.5 Delegated credit authority
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3.6 Accountability3.7 Staff competence

4. Prudent procedures for approving credits4.1 Major principles

5. Effective systems for credit administration, measurement andmonitoring5.1 Credit administration5.2 Measurement and monitoring of credit risk5.3 Loan classification5.4 Loan provisioning

6. Adequate controls over credit risk6.1 Segregation of duties6.2 Exception reporting6.3 Risk mitigation6.4 Managing problem credits6.5 Independent audits

1. Introduction1.1 The HKMA expects all Als to have comprehensive credit riskmanagement systems appropriate to their type, scope,sophistication and scale of operations. These systems should

enable Als to identify, quantify, monitor and control credit riskand to ensure that adequate capital resources are available tocover the risk assumed.1.2 Credit risk is the risk that a borrower or counterparty fails tomeet its obligations. It exists in both the banking book and thetrading book, and both on and off the balance sheet of an AI.Obviously, credit risk arises from loans but there are othersources of credit risk such as.

trade finance and acceptances; interbank transactions; commitments and guarantees;

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interest rate, foreign exchange and credit derivatives(including swaps, options, forward rate agreements andfinancial futures); bond and equity holdings; and settlement of transactions 1.

1.3 Every AI should hold sufficient capital to cover credit risk andseek to strike an appropriate balance between risk and reward.This can be done not by avoiding credit risk exposure but bymanaging the risk the AI has chosen to take so that potentialcredit losses are minimised.1.4 Als which do not manage credit risk properly are likely to runinto serious problems. Such problems normally arise from:

lax credit standards for borrowers and counterparties; poor portfolio risk management; and failure to identify in good time changes in economic or

other conditions that may impair the financial strength ofborrowers and counterparties.It is therefore imperative that Als maintain effective systems tomanage credit risk.

2. Overview of the credit process2.1 The credit process, which underlies the management of an AI'scredit risk exposures, normally includes the following functions

and components: Credit strategy and policy - The Board of Directors isultimately responsible for approving an AI's credit riskstrategies and policies and ensuring that these areappropriate to the business and observed within theorganisation. It may delegate all or part of its credit

1 In the settlement of, say, a foreign exchange transaction, there is a risk that one party maysettle late, or not at all. If one party settles late, the other party may need to borrow thecurrency required from the market and incur interest cost until the former settles. If one partydefaults after receiving payment (e.g. due to differences in time zones), the other party losesthe whole principal (the potential loss could be larger than the principal if there is an adverseprice movement between the agreed rate and the market rate for replacing the contract).

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authority to the Credit Committee2 or senior managementwithin the AI but will remain responsible for overseeingcredit risk management. The Credit Committee or seniormanagement is responsible for translating the Board'scredit strategy into actual business and for ensuring thatnecessary credit risk management policies andprocedures are established to carry out such business.Risk management - Als are recommended to maintainan independent risk management function within themiddle office3 to assist the Board in managing credit risk.The risk management function, which is directlyaccountable to the Board, the Credit Committee or seniormanagement, is responsible for formulating credit riskmanagement methodologies and strategies and the dayto-day measurement, monitoring and evaluation of creditrisk within the AI.Credit initiation - This function is typically performed bythe front office3. The account officers solicit creditbusiness within laid-down policies and manage therelationship with customers. They may also beresponsible for preparing credit appraisals for new creditfacilities and for the renewal of existing facilities.Credit evaluation, approval and review - This involvesindependent evaluation of credit appraisals by the middleoffice, e.g. credit control or risk management unit, and theapproval of facilities by designated credit officers, theCredit Committee or the Board of Directors in accordancewith their credit authority. The process covers bothextension of new credits and renewal of eXisting credits.The latter is embodied in the credit review process inwhich the credit-worthiness of existing borrowers isperiodically updated and evaluated.Credit administration - The back office3 undertakes theoverall administration of the credit portfolio. It carries outsuch responsibilities as checking of credit approval and

2 Please see para. 2.1.2 and footnote 1 of CR-G-2 "Credit Approval, Review and Records" fora description of the key roles and functions of the Credit Committee.3 Please see Diagram 1 of this module for an illustration of the typical functions performed bythe front, middle and back offices.

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documentation, lien perfection, loan disbursement,collateral valuation, maintenance of credit files andcompilation of management information reports. Credit measurement and monitoring - These functionsare performed at different levels. The Board or the CreditCommittee oversees credit monitoring on a portfolio basisand may take part in reviewing large or connected

exposures. The front office monitors individual accountson a day-to-day basis and recommends changes ininternal credit rating and provisions where necessary.The middle office monitors limits and other riskparameters set down by the Board, reviews exceptionreports and checks that problem accounts are properlygraded and provided against. It also performs periodicreviews and analyses the quality of the credit portfoliousing stress-tests or other techniques. The back officeprovides support to the process through themeasurement and reporting of credit risk exposures formanagement information.

Problem loan management - This function ensures thatproblem loans are handled effectively to minimiseultimate credit losses. While less serious cases arefollowed up by the front office, it is recommended that themore serious accounts be transferred to a dedicatedwork-out unit for collection within the middle office. TheCredit Committee or senior management is responsiblefor overseeing the collection process on large nonperforming credits and determining the level of provisionsfor problem accounts. Independent audits - There should be independentparties, e.g. Internal Audit and Compliance, to conductregular independent credit and compliance audits on Als.These should have a direct reporting line to the Board orthe Audit Committee.

2.2 It is open to Als precisely how they structure the credit processwithin their organisations. Nevertheless the key functions andcomponents as mentioned above should be present, howevernamed, and kept separate. In particular, the credit initiationfunction should be independent of the credit approval andreview functions to avoid any potential conflict of interest. In

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cases where an AI finds it necessary to delegate small lendinglimits to staff in the front office for operational needs, thereshould be adequate safeguards, e.g. independent review ofcredits granted, to prevent abuse.2.3 The way in which an AI may structure its credit managementfunctions is shown in Diagram 1. It should be emphasised thatthis structure is illustrative only. Als have discretion as to the

precise organisational structure they adopt, provided that thegeneral principles of credit risk management set out in thisguideline are observed.2.4 The quality of an AI's credit risk exposures is determined to alarge extent by the effectiveness of its systems and controls formanaging credit risk. The principal elements of a sound creditrisk management process include:

establishing an appropriate credit risk environment; enforcing prudent procedures for approving credits; maintaining effective systems for credit administration,measurement and monitoring; and ensuring adequate controls over credit risk.The basic principles and requirements pertaining to theseelements are set out in the sections that follow.

3. An appropriate credit risk environment3.1 Credit risk strategy and policy

3.1.1 Each AI should have a written statement of its credit riskstrategy and policy which should be consistent with itsdegree of risk tolerance, level of capital available forcredit activities and credit management expertise.

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piagram 1; Organisation of credit fynctionsBOARD OF DIRECTORS

Approving credit strategy and policiesCredit approval and monitoring (for large or connected

transactions)Delegation of credit authorityOversight of credit risk managementI

CREDIT COMMITTEE I SENIOR MANAGEMENTCredit policy review

Implementing credit strategy and policiesEstablishing credit policies and manuals

Credit approval and monitoring (within delegated limits)Approving internal credit rating and provisions

Overseeing loan recovery progress

IFRONTOFFICE

Credit initiation/appraisalCredit approval(small limits)Recommendinginternal creditratings andprovisions

On-goingmonitoring ofindividualaccounts

IMIDDLE OFFICERecommending risk managementmethodologies

Limit/exceptions monitoringIndependent creditevaluation/review

Credit approval (Within delegatedlimits)Independent review of internal creditratings and provisions

Portfolio review and analysisStress-testing

Problem loan work-out

IBACK OFFICE

Checking creditapproval anddocumentationLien perfection

Fund disbursementCredit filemaintenance

Measurement andreporting of creditrisk exposuresCollateral valuation

INTERNAL AUDIT4and COMPLIANCECredit audit

Compliance audit

4 Internal Audit should report directly to the Board of Directors or the Audit Committee.

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3.1.2 The credit risk strategy and policy (including the criteriato be used in approving credit applications) should beapproved by the Board of Directors. The Board shouldalso review the strategy and policy periodically (at leastannually) in the light of the AI's financial results, marketconditions and trends and its capital resources.3.1.3 The credit risk strategy should encompass the need to

maintain sound credit quality, profits and businessgrowth. Als are in business to be profitable. Theytherefore have to decide on what risk/reward relationshipis acceptable for their business, after taking into accountresource and capital costs.3.1.4 The credit risk strategy should allow for economic cyclesand their effects on the credit portfolio during differentstages of an economic cycle. For example, it shouldcater for a higher incidence of defaults in the personalloan and credit card portfolios in times of economicrecession.3.1.5 The credit risk policy should follow the principles ofprudence. It should be enforced and appliedconsistently. It should ensure that credit facilities areonly granted to credit-worthy customers and that riskconcentrations are avoided. It guides management onhow business is to be developed.3.1.6 The credit risk policy should not be relaxed because ofcompetitive pressures. Any changes to the policy shouldbe approved by the Board of Directors and should notexpose the AI to excessive risk.3.1.7 Locally incorporated Als with overseas branches shouldestablish credit risk policies adapted to local conditions.3.1.8 Als granting credit to obligors in other countries shouldcater for the fact that in so doing they incur additionalrisks - country risk and transfer risk. They shouldtherefore take account of the environment - economicand political - in those countries, the potential effect ofchanges thereto on the obligors' ability to service thecredit and the contagion effects in regions whereeconomies are closely related.

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3.1.9 The Credit Committee or senior management should beresponsible for carrying out the strategy laid down by theBoard and for establishing procedures to identify,quantify, monitor and control the credit risk inherent inthe AI's activities and at the level of both the overallportfolio and individual borrowers/counterparties.3.1.10 The credit risk strategy and policy need to be clearly

disseminated to, and understood by, all relevant staff,and should be applied, where appropriate, on aconsolidated basis and at the level of individualsubsidiaries.3.2 Risk tolerance and portfolio limits

3.2.1 Als should be very clear about their credit risk tolerance,including how much, and what types of, risk they areprepared to undertake. Risk tolerance should becompatible with Als' strategic objectives.3.2.2 The credit risk policy should specify, among other things: types of facilities to be offered, along with ceilings,pricing, profitability, maximum maturities andmaximum debt-servicing ratios for each type oflending;

a ceiling for the total loan portfolio, in terms, forexample, of the loan-to-deposit ratio, undrawncommitment ratio, a maximum dollar amount or apercentage of capital base; portfolio limits for maximum aggregate exposures

by country, industry, category ofborrower/counterparty (e.g. banks, non-bankfinancial institutions, corporates and retail),product (e.g. property lending), groups of relatedparties and single borrowers; limits, terms and conditions, approval and reviewprocedures and records kept for connectedlending - all Als should have a formal policystatement, endorsed by the Board of Directors, onsuch lending covering these matters; types of acceptable collateral, loan-to-value ratiosand the criteria for accepting guarantees; and

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the minimum information required from loanapplicants.3.3 Risk concentrations

3.3.1 Als should establish a policy, endorsed by the Board ofDirectors, to control and monitor large exposures andother risk concentrations.3.3.2 Als should carefully manage and avoid excessive riskconcentrations of various kinds. These include exposureto:

individual borrowers (in particular exposureexceeding 10% of the AI's capital base); groups of borrowers with similar characteristics,economic and geographical sectors; and types of lending with similar characteristics (e.g.those based on assets with similar price

behaviour).3.3.3 Als should analyse their portfolios intelligently to identifyinter-dependencies. The importance can be illustratedby the contagion effects that a substantial decline inproperty or stock prices may have on the default rate ofthose commercial and industrial loans which rely heavilyon such types of collateral.3.3.4 Notwithstanding the 25% limit on large exposures under81 of the Banking Ordinance, Als should exerciseparticular care in relation to facilities exceeding 10% of

capital base.3.3.5 Als should beware of fads. For example, business withcompanies in the internet sector should be based onsound banking principles and Als should not be swayedby what is fashionable.3.3.6 Als should guard against over-extension of credit toasset-dependent sectors such as the property and stockmarkets and to other speculative investments. Such riskconcentrations can leave Als unduly exposed to acollapse in asset prices with consequent increaseddefaults by debtors.

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3.3.7 Where long-term domestic lending is financed by shortterm external borroWing, a reversal of capital flows canlead to a liquidity squeeze and exposure to possibleadverse exchange rate movements. Als shouldestablish prudent mismatch limits to control such risks.3.4 New products

3.4.1 Als should recognise and control the credit risk arisingfrom their services and activities, including the risks fromnew products.3.4.2 Before Als enter into new types of products andactivities, they should ensure that they understand therisks fully and have established appropriate credit riskpolicies, procedures and controls, which should beapproved by the Board of Directors or its appropriatedelegated committee. A formal risk assessment of newproducts and activities should also be performed anddocumented.

3.5 Delegated credit author ity3.5.1 Credit authority should be clearly delegated by an AI'sBoard of Directors.3.5.2 Credit authority should be appropriate for the products orportfolios assigned to the Credit Committee or individualcredit officers and should be commensurate with theircredit experience and expertise. As an example, anofficer approving personal loans should not have thesame limits as one approving corporate loans to property

developers. An officer's credit authority may, however,be increased as he or she develops an acceptable trackrecord3.5.3 Als should ensure that credit authority is required for alltypes of credit exposures, including the use of creditderivatives for hedging or income generation.3.5.4 Credit authority delegated to the Credit Committee andeach credit officer should be subject to regular review toensure that it remains appropriate to current marketconditions and the level of their performance.

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3.6.1 All staff should comply with laid-down credit policies andprocedures and be held accountable, ultimately to theBoard of Directors through their reporting officers, fortheir decisions when discharging their responsibilities.Thus, for example, if a credit goes into default and oninvestigation it transpires that an approval by an officerdid not comply with policies or procedures, the officerconcerned should be counselled, re-trained ordisciplined, as appropriate.

3.6.2 An AI's remuneration policies should be consistent withits credit risk strategy_ The policies should notencourage officers to generate short-term profits bytaking an unacceptably high level of risk.3.6.3 Where the account officer for a credit (or customerrelationship manager, branch manager or similar) moveson, the incoming officer should carry out a take-overreview. The review should cover inter alia the creditworthiness of the borrowers, the adequacy of thedocumentation, compliance with covenants,performance of each loan and the existence and valueof any collateral.

3.7 Staff competence3.7.1 Als should ensure that staff involved in any creditactivities are competent and fully understand their AI'sstrategic direction, policies, tolerance of risk and limits.3.7.2 The staff concerned should have appropriateprofessional qualifications, technical/managerial skills

and experience for their duties. Thus: senior management should be capable ofmanaging credit activities; account officers and credit officers should have asolid understanding of the credit risk associatedwith the products and customers they deal with; risk management staff should possess sufficientknowledge in credit risk management; work-out staff should have adequate experience in

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operations staff should be fully familiar with theprocedures and processes for carrying out allcredit administration tasks; and internal auditors should fully understand each ofthe credit management functions and the risks ineach of them.

3.7.3 Als should ensure that staffing levels are sufficient tohandle present and expected workloads.3.7.4 Als should encourage their staff and facilitate theiracquisition of the qualifications referred to in para. 3.7.2above. This can be achieved by in-house training orthrough courses for banking staff run by universities orunder the auspices of professional bodies such as theHong Kong Institute of Bankers and the CharteredInstitute of Bankers of the United Kingdom or otherprofessional bodies of similar standing.3.7.5 Als should also maintain a continuing credit trainingprogramme for staff to update their knowledge of creditrelated issues and risks imposed by changing marketcircumstances. The programme may consist of in-housedeveloped courses, seminars run by professionalassociations or both.

4. Prudent procedures for approving credits4.1 Major principles

4.1.1 Als should have a written statement (credit manual)setting out the criteria and procedures for granting newcredits, for approving extensions of existing credits andexceptions, for conducting periodic and independentreviews of credits granted and for maintaining therecords for credits granted.

4.1.2 The statement should lay down sound, well-definedcriteria for granting credit, including a thoroughunderstanding of the borrower or counterparty, thepurpose and structure of the credit and its source ofrepayment. The same criteria should be applied to bothadvised and unadvised facilities.

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4.1.3 Als should adhere closely to the "Know Your Customer"principle and should not lend purely on name andrelationship without a firm understanding of theborrower.4.1.4 Credit decisions should be supported by adequateevaluation of the borrower's repayment ability based onreliable information. Sufficient and up-to-date

information should continue to be available to enableeffective monitoring of the account.4 1.5 All credits should be granted on an arm's length basis.Credits to related borrowers should be monitoredcarefully and steps taken to control or reduce the risks ofconnected lending.4.1.6 Als should not over-rely on collateral or guarantees.While these can provide secondary protection to thelender if the borrower defaults, the primary considerationshould be the borrower's debt-servicing capacity.4.1.7 Als should be wary of rapid expansion of particular typesof lending. This may indicate a relaxation of creditstandards and increased focus on more marginalborrowers.4.1.8 Als should ensure through periodic independent auditsthat the credit approval function is being properlymanaged and that credit exposures comply withprudential standards and internal limits. The results ofsuch audits should be reported directly to the Board, theCredit Committee or senior management as appropriate.4.1.9 Detailed guidance on credit approval is available in .c.B:.G:.2. "Credit Approval, Review and Records".

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5. Effective systems for creditmeasurement and monitoring administration,5.1 Credit administration

5.1.1 Als should have systems for administering their creditportfolios, including keeping the credit files current,getting up-to-date financial information on borrowers andother counterparties, funds transfer and safe-keeping ofimportant documents.

5.2 Measurement and monitoring of credit risk5.2.1 Als should maintain comprehensive procedures andadequate information systems for measuring credit risk(including measuring credit risk of off-balance sheetproducts such as derivatives in credit equivalent terms)

and for monitoring the condition of individual credits tofacilitate identification of problem credits anddetermination of the adequacy of provisions andreserves. How elaborate credit risk measurement toolsneed to be depends on the complexity and degree of theinherent risks of the products involved.

5.2.2 Als should have information systems and analyticaltechniques that provide sufficient information on the riskprofile and structure of the credit portfolio. These shouldbe flexible to help Als to identify risk concentrations. Toachieve this, an AI's system should be capable ofanalysing its credit portfolio by the followingcharacteristics: size of exposure; exposure to groups of related borrowers; products; sectors, e.g. geographic, industrial; borrowers' demographic profile for consumercredits, e.g. age or income group, if appropriate; account performance;

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internal credit ratings5; outstandings versus commitments; and types and coverage of collateral.

5.2.3 Als should have in place a system for monitoring theoverall quality of their credit risk exposures under normaland stressful conditions.

5.2.4 There should also be a reporting system which alertsmanagement to aggregate exposures approachingvarious pre-set portfolio limits of the type set out insubsection 3.2 above.5.2.5 Als should be conscious of business and economiccycles and regularly stress-test their portfolios againstadverse market scenarios.5.2.6 Adequate contingency planning should be developed inconjunction with stress-testing to cater for situationswhere crises develop unexpectedly fast.

5.3 Loan classification5.3.1 Als should ensure that the loan portfolio is properlyclassified and have an effective early-warning system forproblem loans.5.3.2 As internal ratings are an increasingly importantmanagement and supervisory tool, Als are encouragedto develop and use internal risk rating systems inmanaging credit risk. The rating system should beconsistent with the nature, size and complexity of the

AI's activities.5.3.3 In using internal risk ratings, Als are recommended toseek to improve the sophistication of their loanclassification system beyond the 5-grade systemcurrently employed for regulatory reporting. In particular,Als are advised to adopt multiple grades for loans thatare not yet irregular and to develop the ability to track themigration of individual loans through the various internalcredit ratings.5 This term will hereafter be used inter-changeably throughout this Manual with "internal riskratings".

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5.4 Loan provisioning5.4.1 Als should establish policies on provIsioning whichensure that loans are prudently provided for on a timelybasis.5.4.2 Provisions should ideally be assessed on a loan-by-Ioanbasis with full provision being made for the likely loss.

The level of provisions is normally a matter for an AI todetermine in consultation with its external auditors butthe HKMA reserves the discretion to intervene where inits opinion the AI is being insufficiently prudent in itsapproach or is seriously out of line with the provisioningpolicy of its peers.5.4.3 If it is not possible to estimate the loss reliably, thefollowing provisioning benchmarks may be adopted:

Substandard: 20% - 25% of unsecured portion; Doubtful: 50% - 75% of unsecured portion; and Loss: 100% of unsecured portion.

5.4.4 Provisions will comprise specific and general provisions.Als should provide specifically for credits where lossesare certain or likely. The percentage to be provided willdepend on the particular circumstances. Over andabove this Als should maintain general provisions basedon historical loss experience and their assessment offuture economic trends in the markets in which theyoperate.

5.4.5 Further guidance on the above subjects is given in .cR:G.:a "Credit Administration, Measurement andMonitoring".

6. Adequate controls over credit risk6.1 Segregation of duties

6.1.1 Als should keep the functions of credit initiation,approval, review, administration and work-out asseparate as possible. See also section 2 on how thecredit functions may generally be structured.6.2 Exception reporting

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6.2.1 Als should establish and enforce internal controls andpractices so that deviations from policies, procedures,limits and prudential guidelines are promptly reported tothe appropriate level of management. This applies interalia to the approval of excesses under delegatedauthority.6.2.2 The above should be supported by a managementreporting system whereby relevant reports on the creditportfolio are generated to various levels of managementon a timely basis.

6.3 Risk mitigation6.3.1 In controlling credit risk, Als can utilise certain mitigationtechniques. Normally, they include:

accepting collateral, standby letters of credit andguarantees; entering into netting arrangements; setting strict loan covenants; and using credit derivatives and other hedginginstruments.

6.3.2 In determining which types of credit mitigationtechniques should be used, Als should consider: their own knowledge and experience in using suchtechniques; cost-effectiveness; type and financial strength of the counterparties orissuers; correlation with the underlying credits; availability, liquidity and realisability of the creditmitigation instruments; the extent to which legally recogniseddocumentation, e.g. ISDA Master Agreement, canbe adopted; and the degree of supervisory recognition of the

mitigation technique.

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6.3.3 While mitigation through collateral and guarantees isusually dealt with at the time of granting of credits, creditderivatives and netting are often employed after thecredit is in place, or used to manage the overall portfoliorisk.6.3.4 When the mitigation arrangements are in place theyshould then be controlled. Als should have written

policies, procedures and controls for the use of creditmitigation techniques. They should also ensureadequate systems are in place to manage theseactivities.6.3.5 Als should revalue their collateral and mitigationinstruments on a regular basis. The method andfrequency of revaluation depends on the nature of thehedge and the products involved.

6.4 Managing problem credits6.4.1 It is recommended that Als establish a dedicated unit tohandle the recovery and work-out of problem loans andput in place policies for the referral of loans to this unit.

6.5 Independent audits6.5.1 Als should establish a system of regular independentcredit and compliance audits. These audits should beperformed by independent parties, e.g. Internal Audit

and Compliance, which report to the Board or the AuditCommittee.6.5.2 Credit audits should be conducted to assess individualcredits on a sampling basis and the overall quality of thecredit portfolio. Such audits are useful for evaluating theperformance of account officers and the effectiveness ofthe credit process. They can also enable Als to takeearly measures to protect their loans.6.5.3 Compliance audits should be performed to testcompliance with established credit policies andprocedures, in particular credit approval, internal creditrating, the appropriateness of pricing, adequacy ofprovisioning and adherence to limits, statutoryrestrictions and operating procedures. Such auditsshould also be used to identify credit control or process

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weaknesses, irregularities and exceptions and to testwhether the reporting of credits to senior management isaccurate as regards composition, credit quality and valueof the portfolio.

6.5.4 The findings of these audits should be reported to theBoard or the Audit Committee on a timely basis, andappropriate remedial actions should be taken to addressany concerns and weaknesses raised.

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General Principles of Credit Risk

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