1) COUNTRY RISKOther Transfer Risk Problems (OTRP) -- This category applies when:
1. A country is not complying with its external debt service obligations, as
evidenced by arrearages, forced restructuring, or rollovers; however, the country
is taking positive actions to restore debt service through economic adjustment
measures, generally as part of an International Monetary Fund (IMF) program; or
2. A country is meeting its debt obligations, but noncompliance appears imminent;
or
3. Exposures to a country have been classified previously, but recent debt service
performance indicates classification no longer is warranted (e.g., the country is
complying with the terms of IMF and rescheduling programs). However,
sustained resumption of orderly debt service needs to be demonstrated.Substandard -- This category applies when:
1. A country is not complying with its external service obligations as evidenced by
arrearages, forced restructuring, or rollovers; and
2. The country is not in the process of adopting an IMF or other suitable economic
adjustment program, or is not adequately adhering to such a program; or
3. The country and its bank creditors have not negotiated a viable rescheduling and
are unlikely to do so in the near future.
Value Impaired -- This category applies when a country has protracted arrearages, as
indicated by more than one of the following:
1. The country has not fully paid its interest for six months.
2. The country has not complied with IMF programs (and there is no immediate
prospect for compliance).
3. The country has not met rescheduling terms for more than one year.
4. The country shows no definite prospects for an orderly restoration of debt service
in the near future.
Loss -- This category applies when the loan is considered uncollectible and of such little
value that its continuance as a bankable asset is not warranted. An example would be an
outright repudiation by a country of its obligations to banks, the IMF, or other lenders.
As discussed in more detail in a later section of this guide, exposures rated as “Value
Impaired” are generally subject to an ATRR requirement. In addition, the volume of
less severely rated foreign exposures, including those rated “Moderately Strong,”
“ Weak,” “OTRP,” and “Substandard” are relevant to any assessment of possible
concentrations of risk, and should certainly be factored into the evaluation of the
adequacy of the bank’s capital and allowance for loan and lease losses.
2) COMMERCIAL LOAN RISK
Commercial Bank Examination Manual, 2060.1
Extensions of credit that exhibit well-defined credit weaknesses may warrant classification
based on the description of the following three classification categories:
Substandard—A substandard credit is inadequately
protected by the current sound worth
and paying capacity of the obligor or of the
collateral pledged, if any. Credits so classified
must have a well-defined weakness or weaknesses
that jeopardize the repayment of the debt.
They are characterized by the distinct possibility
that the bank will sustain some loss if the
deficiencies are not corrected. Loss potential,
while existing in the aggregate amount of substandard
credits, does not have to exist in
individual credits classified substandard.Doubtful—A credit classified doubtful has all
the weaknesses inherent in one classified substandard
with the added characteristic that the
weaknesses make collection or repayment in
full, on the basis of currently existing facts,
conditions, and values, highly questionable and
improbable. The possibility of loss is extremely
high but because of certain important and reasonably
specific pending factors, which may
work to the advantage and strengthening of the
credit, its classification as an estimated loss is
deferred until its more exact status may be
determined. Pending factors include proposed
merger, acquisition, or liquidation procedures;
capital injection; perfecting liens on additional
collateral; and refinancing plans.
Examiners should avoid classifying an entire
credit doubtful when collection of a specific
portion seems highly probable. An example of
proper utilization of the doubtful category is the
case of a company being liquidated, where the
trustee-in-bankruptcy has indicated a minimum
disbursement of 40 percent and a maximum of
65 percent to unsecured creditors, including the
bank. In that situation, estimates are based on
liquidation value appraisals, with asset values
yet to be realized. By definition, the only portion
of the credit that is doubtful is the 25 percent
difference between 40 and 65 percent. A proper
classification of such a credit would show 40 percent
substandard, 25 percent doubtful and 35 percent
loss.
Examiners should avoid repeating a doubtful
classification at subsequent examinations. The
time between examinations should be sufficient
to resolve pending factors. That is not to say that
situations do not occur to necessitate continuation
of the doubtful classification. However, the
examiner should avoid undue continuation if
repeatedly, over the course of time, pending
events do not occur and repayment is again
deferred awaiting new developments.Loss—Assets classified loss are considered
uncollectible and of such little value that their
continuance as bankable assets is not warranted.
This classification does not mean that the asset
has absolutely no recovery or salvage value but
rather it is not practical or desirable to defer
writing off this basically worthless asset even
though partial recovery may be effected in the
future. Writing off a loss asset or the portion of
an asset identified as loss ensures that the value
of the bank’s assets are properly reflected on
its Report of Assets and Liabilities. A loss asset
should not remain on the bank’s books while it
attempts a long-term recovery. Rather, losses
should be taken in the period in which they
surface as being uncollectible.
Bank management should maintain a record
of all loss assets or the portion of assets identi-
fied as loss that have been written off for
regulatory reporting purposes or for which a
specific reserve has been established. Bank
records should also demonstrate that these loss
assets have been fully reported to the head
office. For further information on the treatment
of loss assets, examiners should refer to their
respective agency’s policy.
3) NONACCRUAL LOANSCommercial Bank Examination Manual, 2040.1
Loans and lease-financing receivables are to be
placed on nonaccrual status if (1) principal or
interest has been in default for 90 days or more,
unless the loan is both well secured and in the
process of collection; (2) payment in full of
principal or interest is not expected; or (3) they
are maintained on a cash basis because the
financial condition of the borrower has
deteriorated.Definition of ‘‘well secured’’ and ‘‘in the process
of collection’’—A debt is ‘‘well secured’’ if it is
secured (1) by collateral in the form of liens on
or pledges of real or personal property, including
securities, that have a realizable value suf-
ficient to discharge the debt (including accrued
interest) in full or (2) by the guarantee of a
financially responsible party. A debt is ‘‘in the
process of collection’’ if collection of the asset is
proceeding in due course either (1) through legal
action, including judgment enforcement procedures,
or (2) through collection efforts (not
involving legal action) that are reasonably
expected to result in repayment of the debt or in
its restoration to a current status in the near
future. Statutory bad debt, ‘‘A paper,’’ is defined
in section 5204 of the U.S. Revised Statutes
(12 USC 56) as all debts to a bank on which
interest is past due and unpaid for six months,
unless the same is well secured and in the
process of collection. Delinquent loans that are
not covered under the definition of statutory bad
debt are designated ‘‘B paper.’’Exceptions—A loan does not need to be placed
on nonaccrual status if (1) the criteria for amortization
specified in AICPA Practice Bulletin
No. 6 are met with respect to a loan acquired
at a discount from an unaffiliated third party,
including those that the seller has maintained
on nonaccrual status, or (2) the loan is a consumer
loan or secured by a one- to four-family
residential property. However, the bank may
elect to carry these loans on a nonaccrual status.
Also, if a bank has a significant consumer or
residential mortgage loan portfolio in relation
to its total loans and tier 1 capital, a thorough
review of the delinquency status should be
performed to ensure that the bank has not
materially misstated its financial condition and
earnings.
Treatment of Cash Payments and Criteria for
the Cash-Basis Treatment of Income—When a
bank places a loan on nonaccrual status, it must
consider how to account for subsequent payments.
When the collectibility of the remaining
book balance of a loan on nonaccrual status is
uncertain, any payments received must be
applied to reduce principal to the extent necessary
to eliminate such doubt. Placing an asset on
nonaccrual status does not require a charge-off,
in whole or in part, of the asset’s principal.
However, any identified loss must be charged
off.
When a loan is on nonaccrual status, some
or all of the cash interest payments received
may be treated as interest income on a cash
basis, as long as the remaining book balance
of the asset after the charge-off, if any, is
deemed fully collectible. A bank’s determination
of the collectibility of an asset’s remaining
book balance must be supported by a current,
well-documented credit evaluation of the borrower’s
financial condition and repayment
prospects.
When recognition of interest income on a
cash basis is appropriate, the amount of income
recognized should be limited to what would
have been accrued on the loan’s remaining book
balance at the contractual rate. Any cash interest
payments received over this limit (and not
applied to reduce the loan’s remaining book
balance) should be recorded as recoveries of
prior charge-offs until these charge-offs have
been fully recovered. (A bank should have a
well-defined policy governing the treatment of
interest income and the charge-off of accrued
interest receivables.)Treatment of Previously Accrued But Uncollected
Interest—When a bank places a loan on
nonaccrual status, its policy should address an
appropriate treatment of previously accrued but
uncollected interest. One acceptable method is
to reverse all previously accrued but uncollected
interest against appropriate income and balancesheet
accounts. For interest accrued in the current
accounting period, the entry is made directly
against the interest income account. For prior
accounting periods, if accrued-interest provisions
to the ALLL were not made, the amount of
accrued but uncollected interest should be
charged against current earnings. Also for prior
accounting periods when provisions to the ALLL
for possible loss of interest had been made, the
bank generally reverses the accrued but uncollected
interest by charging the ALLL to the
extent of those specific provisions. Generally
accepted accounting principles do not require
the write-off of previously accrued interest if
principal and interest are ultimately protected
by sound collateral values. A bank is expected
to have a well-defined policy, subject to examiner
review, governing the write-off of accrued
interest.
Treatment of Multiple Extensions of Credit to
One Borrower—As a general rule, nonaccrual
status for an asset should be determined by
assessing its collectibility, repayment ability,
and performance. Thus, when one loan to a
borrower is placed in nonaccrual status, a bank
does not automatically have to place all of that
borrower’s other extensions of credit in nonaccrual
status. The bank should evaluate its
other extensions of credit to that borrower to
determine if one or more of them also should be
placed in nonaccrual status.Restoration to Accrual Status—As a general
rule, a nonaccrual loan may be restored to
accrual status when (1) its principal and interest
are no longer past due and unpaid, and the bank
expects repayment of the remaining principal
and interest, or (2) when it otherwise becomes
well secured and in the process of collection.
Before restoring a loan to accrual status, the
bank should consider the borrower’s prospects
for continuing future contractual payments. If
reasonable doubt exists, reinstatement may not
be appropriate.
To meet the first test, the bank must have
received payment of the past-due principal and
interest, unless the loan has been formally
restructured and qualifies for accrual status under
the restructured terms, or the asset has been
acquired at a discount from an unaffiliated third
party due to uncertainty about the amounts
or timing of future cash flows and meets the
amortization criteria (that is, accretion of discount)
specified in AICPA Practice Bulletin
No. 6.
A nonaccrual loan is considered in the process
of collection if the borrower has resumed
paying contractual interest and principal payments,
even if the past-due amount has not been
brought totally current. These loans may be
returned to accrual status provided two criteria
are met: All principal and interest amounts due
(including arrearages) are reasonably assured of
repayment within a reasonable period, and the
borrower has a sustained period of performance
(generally a minimum of six months) in accordance
with the contractual terms.
Until the loan is restored to accrual status,
cash payments received must be treated according
to the criteria stated above. In addition, after
a formal restructuring, if the loan that has been
returned to accrual status later meets the criteria
for placement in nonaccrual status (as a result of
past-due status based on its modified terms or
for any other reason), the asset must be placed
on nonaccrual status.Treatment of Nonaccrual Loans with Partial
Charge-Offs—GAAP and regulatory reporting
requirements do not explicitly address whether
partial charge-offs associated with a nonaccrual
loan (that has not been formally restructured)
must be fully recovered before a loan can be
restored to accrual status.
According to call report instructions, restoration
to accrual status is permitted when (1) the
loan has been brought fully current with respect
to principal and interest and (2) the bank expects
the loan’s full contractual balance (including
any amounts charged off), plus interest, will be
fully collectible under the terms of the loan.
Thus, to return a partially charged-off loan that
has been brought fully current to accrual status,
the bank should determine if it expects to
receive the full amount of principal and interest
called for by the loan’s terms.
When the contractual principal and interest of
a loan have been brought fully current, and the
borrower’s financial condition and repayment
prospects have improved so that the full contractual
principal (including any amounts charged
off) and interest is expected to be repaid, the
loan may be restored to accrual status without
having to first recover the charge-off.
Conversely, this treatment would be inappropriate
when the charge-off indicates continuing
doubt about the collectibility of principal or
interest.
The reasons for restoring a partially chargedoff
loan to accrual status must be documented.
These actions should be supported by a current,
well-documented credit evaluation of the borrower’s
financial condition and prospects for
full repayment of contractual principal (including
any amounts charged off) and interest. This
documentation will be subject to review by
examiners.