Early Warning Indicators for Credit Risk
Definition
Early Warning Indicators for Credit Risk (EWI) are any Early Warning Indicators that are used specifically for the anticipation of Credit Risk events.
EWI's can be quantitative or qualitative indicators, based on asset quality, capital, liquidity, profitability, market and macroeconomic metrics. In the context of the risk control framework, an institution can use progressive metrics (“traffic light approach”) or EWI to inform the institution’s management that a stress situation (“red triggers”) could potentially be reached.[1]
EBA Requirements[2]
As part of their monitoring framework, institutions should develop, maintain and regularly evaluate relevant quantitative and qualitative EWIs that are supported by an appropriate IT and data infrastructure that would allow the timely detection of increased credit risk in their aggregate portfolio as well as in portfolios, sub-portfolios, industries, geographies and individual exposures.
The EWIs should have defined trigger levels set with regard to the levels specified in credit risk appetite, strategy and credit risk policies, and have assigned escalation procedures, including assigned responsibilities for the follow-up actions. These escalation procedures should also include choosing exposures or borrowers for special monitoring — a watch list.
The EWI framework should contain a description of the relevance of the indicators in relation to the characteristics of transactions and borrower types, or for homogeneous groups of portfolios, when appropriate.
On identifying a triggered EWI event at the level of an individual exposure, portfolio, sub- portfolio or borrower group, institutions should apply more frequent monitoring and, when necessary, consider placing them on a watch list and undertaking predefined measures and mitigation actions. Monitoring this watch list should lead to specific reports being regularly reviewed by the head of the risk management function, the heads of functions involved in credit granting and the management body.
When the actions include interaction with the borrower, institutions should have regard to their individual circumstances. The level of contact and communication with the borrower during payment difficulties should be commensurate to the information requirements, as defined in the EBA Guidelines on arrears and foreclosure.
As part of their ongoing monitoring of credit risk, institutions should consider the following credit quality deterioration signals:
- negative macroeconomic events (including but not limited to economic development, changes in legislation and technological threats to an industry) affecting the future profitability of an industry, a geographical segment, a group of borrowers or an individual corporate borrower, as well as the increased risk of unemployment for groups of individuals;
- known adverse changes in the financial position of borrowers, such as a significant increase in debt levels or significant increases in debt service ratios;
- a significant drop in turnover or, in general, in recurring cash flow (including the loss of a major contract/client/tenant);
- significant narrowing of operating margins or income;
- a significant deviation in actual earnings from the forecast or a significant delay in the business plan of a project or an investment;
- changes in the credit risk of a transaction that would cause the terms and conditions to be significantly different if the transaction were newly originated or issued at the reporting date (such as increased amounts of required collateral or guarantees, or a higher recurring income coverage of the borrower);
- an actual or expected significant decrease in the main transaction’s external credit rating, or in other external market indicators of credit risk for a particular transaction or similar transaction with the same expected life;
- changes in the conditions of access to markets, a worsening in financing conditions or known reductions in financial support provided by third parties to the borrower;
- a slowdown in the business or adverse tendencies in the operations of the borrower that may cause a significant change in the borrower’s ability to meet its debt obligations; significant increase in economic or market volatility that may have a negative impact on the borrower;
- for transactions secured with collateral, a significant worsening of the ratio of their amount to the value of the collateral due to unfavourable developments in the value of the collateral, or no change or an increase in the outstanding amount due to the payment terms established (such as extended principal payment grace periods, rising or flexible instalments, extended terms);
- a significant increase in credit risk on other transactions of the same borrower or significant changes in the expected payment behaviour of the borrower, when known; m. a significant increase in credit risk due to an increase in the difficulties of the group to which the borrower belongs, such as residents of a specific geographical area, or significant unfavourable developments in the performance of the borrower’s sector of economic activity or increased difficulties in the group of related borrowers to which the borrower belongs;
- known legal action that may significantly affect the borrower’s financial position;
- the late delivery of a certificate of adherence, a waiver request or a breach with respect to the covenants, at least regarding the financial covenants, if applicable;
- negative institution-internal credit grade/risk class migrations in the aggregate credit portfolio or in specific portfolios/segments;
- an actual or expected internal credit rating/risk classification downgrade for the transaction or borrower or a decrease in behavioural scoring used to assess credit risk internally;
- concerns raised in the reports by the external auditors of the institution or borrower;
- one or more borrower-related facilities 30 days past due.
