Transcript The 3 rd African SACCO Regulators’ Roundtable Crossroads

A
Presentation on
On-site Assessment of Credit Union
Assets Quality and Adequacy of the
Loan
Loss Reserves
By
Joseph William Kitandwe
Assistant Commissioner for Cooperative
Development
Ministry of Tourism Trade and Industry
Kampala, Uganda
[email protected]
www.mtti.go.ug
Outline of the Presentation
1. Introduction
2. Credit Union Asset Quality
3. Adequacy of Loan Loss Reserves
4. Challenges of Asset Quality and Loan Loss
Reserve Assessment
INTRODUCTION
a.
Credit Union (CU) or Savings and Credit
Cooperative Society Ltd.
A Credit Union is a financial cooperative society that is
operated for the purpose of promoting savings,
providing credit and other financial services to its
members.
INTRODUCTION
b. Assets
Things that are capable of being
owned or controlled to produce
value or held to have positive
economic value.
 Are economic resources
 Are valuable possessions
 Represent future benefits
INTRODUCTION
Assets (Cont)
Represent:
 Stored
purchasing power (cash)
 Money claims (receivables, stock
etc)
 Ownership of value that can be
converted into cash.
INTRODUCTION
Tangible Assets:
Have a physical substance and can be
touched.
Land, buildings, vehicles, inventories, plant
and equipment, currencies and precious
metals.
INTRODUCTION
 Current Assets:
Cash and other assets expected to be converted to
cash, sold, or consumed either in a year or in the
operating cycle (whichever is longer), without
disturbing the normal operations of a business.
 5 major items:


Cash and cash equivalents
Short-term investments
Receivables
INTRODUCTION
 Current Assets (Cont.)
 Inventory:
 Prepaid expenses and accrued incomes
 Liquid Assets: cash, debt stock, finished goods etc.
INTRODUCTION
 Fixed Assets (capital assets)
 PPE (property, plant, and equipment): Purchased
for continued and long-term use in earning profit
in a business.
Land, buildings, machinery, fittings and fixtures,
furniture, stock, tools and certain wasting
resources e.g. minerals. They are written off
against profits over their anticipated life by
charging depreciation expenses (with exception of
land assets).
INTRODUCTION
Intangible Assets
 Intangible assets lack physical substance but have value
to a firm.
 They include:
goodwill
 intellectual property rights: copyrights,
trademarks, patents,
 computer programs
 financial assets: accounts receivable,
bonds and stocks.

INTRODUCTION
 Long-term investments (investments)
Held for many years, for use in the business and not
for sale or intended to be disposed of in the near
future.
 Types of investments:



Securities such as bonds, common stock, or
long-term notes.
Fixed assets not used in operations like land
held for sale.
Special funds such as pension funds.
INTRODUCTION
 Other Assets

Information asset:
 With regard to information technology, especially
in information security, this relates to data needed
to conduct the organization business and the
technical equipment to manage (input, store, and
display, print) are called information assets.
 Can cause disruptions if unavailable
 Confidential information disclosure can represent
a huge liability.
Credit Union Asset Quality
 Loans to the members major assets
 Loans very critical to the existence and
survival of any CU.
 Asset Quality:
One of the critical elements of CU
operations
Credit Union Asset Quality
Mainly focuses on the CU’s loans. It is the
main variable that affects profitability. For
instance, an excess of defaulted or delayed
repayment of loans and high percentage of
other non-earning assets have negative
effects on credit union earnings since these
assets are not earning income.
 Delinquency therefore is an important
factor in determining asset quality.
Credit Union Asset Quality
 Credit Unions must also monitor the ratio of non-earning
assets to total assets and ensure that these non–earning
assets are not financed by savings deposits or external
credit but by those assets with no cost capital such as CU’s
capital or reserves.
 Managing liquidity is another important aspect of
administering a Credit Union.
 Asset quality is a function of the present conditions and the
likelihood of future deterioration or improvement based on
economic conditions, current practices and trends.
Asset Quality Assessment-Objectives
Aims at evaluating the Credit Union’s safety and
soundness focusing on the current and anticipated
asset quality problems.
Other objectives:
 Asset quality and the level of portfolio risk
determined.
 Confirming the existence of written lending and
investment policies and procedures. Whether they are
followed and are conducive to safe and sound
operations.
Asset Quality Assessment
 The trend of the portfolio performance,
whether negative or positive, established
 The quality of loan underwriting and
documentation established.
 The quality of investment controls and
monitoring established
Asset Quality Assessment
 Appraisal of the quality of Board and the
management team
 Identifying the areas where corrective action
is required to strengthen the CU
 Evaluation of the credit union’s policies,
systems of management, internal operations
and control
Asset Quality Assessment
 Review and ensure compliance with laws and
regulations as well as supervisory guidance conveyed
on specific policies.
 Evaluation of the adequacy and effectiveness of the
internal control system
 Adherence to adequate policies, practices and
procedures for evaluating the quality of assets and the
adequacy of loan loss reserves
Basis of On site Asset Quality Assessments
Either
 The CAMELS (Capital adequacy, Asset quality,
Management, Earning, Liquidity and Systems and
controls) model
or
 The PEARLS (Protection, Effective financial structure,
Asset quality, Rates of return and Costs, Liquidity
and Signs of Growth) model.
When to Conduct Asset Quality Assessment
 Annual basis
 The frequency can be can be increased / reduced
depending on the financial position, methods of
operation and compliance record of the credit union.
 On site assessments are supplemented by quarterly
off-site monitoring and surveillance.
Conducting Asset Quality Assessment
Comprises of:
 Review of pre-inspection feedback from other stake
holders about specific aspects to be looked into and
the off-site surveillance reports and audit reports of
the credit union.
 Examination of the adequacy of policies, procedures
and practices ,classification of assets, loan loss
provisioning for loans, concentration risk, and loan
review functions and, compliance with laws and
regulations.
Conducting Asset Quality Assessment
 Review of the operational guidelines based on the
policy framework for day-to-day management of the
portfolios.
 Examination of the primary records of the credit union
 Evaluation of the policies and procedures related to
the granting of loans, making investments and the
on-going management of the loan and investment
portfolios
Conducting Asset Quality Assessment
 Assessment of the policies regarding the periodic
review of individual credits, asset classification and
provisioning.
 Ascertaining that the policies are being reviewed
regularly and implemented consistently. And ensure
that credit unions have a process in place for
overseeing problem credits and collecting past due
loans.
Conducting Asset Quality Assessment
 According to the CAMELS rating system,
“management is a key determinant of the credit
union’s ability to correctly identify and respond to
financial problems. Hence the assessment covers the
board of directors ability to:
 Identify, measure, monitor, and control the risks of the
credit unions activities
 Ensure it is safe and sound operation
 Ensure compliance with applicable laws and regulation
Conducting Asset Quality Assessment
 The assessment of the management is also based on:

Strategic plan and business plan

Information systems and technology
 The System of Internal controls:

Effective internal controls enhance the safeguards
against system malfunction, errors in judgment
and fraud.
Conducting Asset Quality Assessment

Facilitate management to identify and track its
exposure to risk

Enable management to ensure the operating units
are acting within parameters established by the
board of directors and senior management.
Conducting Asset Quality Assessment
 Other important aspects of management relate to:
Information systems
 Segregation of Duties
 Audit program
 Record Keeping
 Protection of Physical Assets
 Education of Staff
 Succession Planning

Conducting Asset Quality Assessment
 Additional Management Issues:


Adequacy of the policies and procedures covering
each area of the credit unions operation (written,
board approved, followed)
Budget performance compared against actual
performance
Conducting Asset Quality Assessment
 Effectiveness of systems that measure and
monitor risk
 Integration of risk management with planning
and decision –making
 Responsiveness to examination and audit
suggestions, recommendations or
requirements
Conducting Asset Quality Assessment
 Compliance with laws and regulations
 Adequacy of the allowance for loan account
and other valuation reserves
 Appropriateness of the products and
services offered in relation to the credit
unions size and management experience
Conducting Asset Quality Assessment
 Loan to savings ratio trends and history
 Cost/benefit analysis of major service products
Conducting Asset Quality Assessment
 The board of directors and management have a
fiduciary responsibility to the members to maintain
very high standards of professional conduct. This
should be assessed to ascertain:
 Compliance with all laws and regulations
 Whether management adheres to the policy of
non discrimination
 The appropriateness of compensation policies and
practices for senior management.
Conducting Asset Quality Assessment
 That management contracts favorable to the CU.
Existence of performance standards for the CEO
/Manager and senior management and that the
evaluation process is well documented and effective.
 Avoidance of conflict of interest: An appropriate
policy and procedures for avoidance of conflict of
interest and management of potential conflicts of
interests should be put in place
Conducting Asset Quality Assessment
 Professional ethics and behavior:
Not to use the credit union for unauthorized or
inappropriate personal gain. Credit union property should
not be used for anything other than authorized activities.
Management should act ethically and impartially in
carrying out appropriate credit union policies and
procedures.
 When guarantees or collateral are provided, the credit
union should have a mechanism for continually assessing
the strength of these guarantees and appraising the worth
of the collateral.”(NCUA, 2003).
Conducting Asset Quality Assessment
 Table 1 below shows the PEARLS indicators of the
standards of excellence .Standards A1 and A2 relate to
asset quality
Table 1: Key PEARLS indicators of the standards of excellence
P1
P2
Some of the Key
PEARLS Indicators
Allowance for Loan
Losses/Delinquency >
12 months
Net Allowance for Loan
Losses / Delinquency
of 1-12 months
Standards of
Excellence
100%
35%
Conducting Asset Quality Assessment
P3
P4
A1
A2
A3
L1
Total Write- offs/Average Loan 100%
Portfolio> 12 months
Annual Loan Write-offs/Average Loan Minimal
Portfolio
Total Loan Delinquency /Gross Loan <=5%
Portfolio
Non- Earning Assets/ Total Assets
<=5%
Net Zero Cost Funds( Net Institutional >200%
& Transitory Capital + Non Interest
Bearing Liabilities)/Non-earning Assets
ST Investments+ Liquid Assets – ST Minimum 15%
Payables /Savings Deposits
Conducting Asset Quality Assessment
Some of the Key
PEARLS Indicators
L2
L3
Source: WOCCU
Standards of
Excellence
Liquidity
10%
Reserve/Savings
Deposits
Non –earning Liquid <1%
Assets/Total Assets
Conducting Asset Quality Assessment
 The quality and trends of all major assets and any
other assets that could adversely impact a credit
unions financial position are also considered.
 When conducting the assessment the examiner
reviews the credit union’s management of credit risk.
 It also evaluates the impact of other risks such as
interest rate, liquidity etc.
Conducting Asset Quality Assessment
 The liquidity position of the CU depends on the quality of
the debtors. The ratios to judge the quality or liquidity of
debtors include:
 Debtors Turnover:
This indicates the number of times debtors turnover
each year. Generally, the higher the value of debtor’s
turnover, the more efficient is the management of
credit.
 Debtors Turnover = Total Loans portfolio to average loan
portfolio
 Collection Period (Average Collection Period)
This indicates the number of days for which loans
remain outstanding.
 Average Collection Period (ACP) = 12 months (or 360
days) to Debtors Turnover
Conducting Asset Quality Assessment
Ageing Schedule
 The ACP measures the quality of debtors in an
aggregative way. Examiners can have a detailed idea of
the quality of the asset (debtors) through the ageing
schedule. This breaks down debtors according to the
length of time for which they have been outstanding.
This schedule helps to establish the percentage of debt
overdue, reveals the accounts where the CU has a
serious collection problem and spots the slow paying
debtors.
Conducting Asset Quality Assessment
Non –current Loans to Gross Loans
 This ration reflects the percentage of loans that are 90
days or more past due, or are no longer accruing
interest.
Others
 On site findings and areas of concern are discussed with
top management of the CU and corrective steps taken by
the CU are followed up by the supervisor/examiners.
 Requiring the credit union to strengthen lending practices,
credit-granting standards, and overall financial strength
when level of problem credits gets out of hand.
Conducting Asset Quality Assessment
Replacement of an Existing Asset
Management should follow a replacement policy based
on economic considerations and decide when to
replace. The sound policy is to make an analysis
whenever an alternative is available. This is most
important with regard to the non earning assets.
Adequacy of Loan Loss Reserves
 Loan Loss Reserves (LLR)
The LLR refer to the valuation allowance indicating
management’s estimate of potential loan losses that
may occur in the collection of outstanding loans and
loan derived assets. The estimate includes a historical
reserve amount based on the past history of
experienced loan losses, as well as the individual
classification of delinquent or other problem loans.
Importance of Loan Loss Reserves
The provision for loan losses is the first line
of defense against unexpected losses to the
CU since delinquency signals that loans are
at risk, thus the CU must set aside earning
to cover those possible losses so that
member–client savings remain protected.
 LLR is necessary to ensure that:
 Asset values are not inflated
Importance of Loan Loss Reserves

Reported net income is not overstated

Provisions for loans losses are made

Member savings are secure and

Dividends are neither overstated nor
erroneously paid out
Importance of Loan Loss Reserves
 An adequate LLR is, maintained at a level
that is adequate to absorb the estimated
amount of probable losses in the Credit
Unions loan portfolio at the date of the
financial statements, a major factor in the
evaluation of its ability to absorb credit
losses, the fairness and accuracy of its
financial statements and its safety and
soundness.
Importance of Loan Loss Reserves
 In addition, an adequate LLR will be the one
that is “directionally consistent”. That is one
that has an increasing provision expense
during a period when the qualitative and
environmental factors such as collateral
values falling, rising collection problems
and growing member bankruptcies.
Importance of Loan Loss Reserves
 On the other hand the collection expense
will decline when pool qualitative and
environmental factors support more
favorable condition such as better loan
approval procedures, declining delinquency
and collection problem loans and favorable
member employment.
On site Assessment of the LLRs
The on site assessment of the LLRs is intended to
determine the reasonableness of Credit Union’s
recorded reserves by ascertaining that the
methodology is logical, appropriate, consistently
applied and meets accepted accounting standards.
Objectives of the Assessment
 Determine if the Board provides effective oversight
and policy direction over the LLR process
 Determine if the CU’s methodology considers all risk
factors and is logical, appropriate, consistently applied
and meets the legal and industry requirements.
 Determine the reasonableness of the credit union’s
recorded LLR
Objectives of the Assessment
 Ensure that there is a comprehensive approach to LLR
determination by taking into consideration all areas
which may provide information on loss exposure and
the adequacy of the LLRs. E.g. lending policies, loan
portfolio management, internal credit review
processes and business planning.
Nothing is Ignored!
Objectives of the Assessment
Conclude on the adequacy of the LLR and the LLR
process. If the assessment concludes that the LLR level
is not appropriate or determines that the evaluation
process is based in the results of an unreliable loan
review systems, recommendations for correcting these
deficiencies, are noted in the report of examination
and likely is an unsafe and unsound condition.
Assessment Procedures
 Ensuring sufficient work is done to conclude on the
adequacy of the LLR amount and the processes used
by management to determine the amount.
 Determining the appropriateness of the LLR in
particular the effectiveness of the board oversight of
the LLR process as well as the quality of the
institutions loan review system, the effectiveness of
management in identifying, monitoring and
addressing asset quality problems.
Assessment Procedures
Emphasis is placed on:
 Testing Compliance to the credit policy and standards.
 Making a direct comparison of the relative size of the
loan loss reserve and the loan portfolio.
 Assessment of the credit quality of the loan portfolio is
critical to the loan loss adequacy determination.
Assessment Procedures
 Consideration of loan losses that can be specifically
identified and those that are anticipated but which
can't be specifically identified at the review date.
 Evaluate the mechanism for continually assessing the
strength of collateral and guarantees and appraising
the worth of the collateral.
When to Conduct Loan Loss Reserves Assessment
The adequacy of provisions for loan losses should be
assessed as regularly as possible in order to determine
the collectability of all loans in its portfolio and
maintain an LLR at an appropriate level to cover
estimated probable loan losses that exist at the date of
the financial statements
Challenges of Asset Quality and Loan Loss Reserve Assessment
 Inadequate financial resources, manpower and skills to
undertake the assessments on a sustainable basis
 The quality of the records kept by the CU:
 Inadequate data to support proper analysis of the loan
portfolio
Challenges of Asset Quality and Loan Loss Reserve Assessment
 Inability to interpret the economic and other
situations in order to come up with an appropriate
LLR
 Un cooperative Credit Union officials
 Laws and regulations
THANK YOU