How to Determine Local Efficient Lending Standards

1. How to Determine Local Efficient Lending Standards Otar Nadaraia Deputy Governor of NBG* Tbilisi, 2014 *The views expressed are those of the author and do not necessarily represent those of the NBG

2. Open Questions • What is a role of micro level data for financial stability? • What are benefits and limits expressing lending standards in ratios? • What are the key ratios? • What could be their ranges across sectors? • Should financial ratios incorporate risks like interest and exchange rate risks or should be left to the pricing? • Are debt sustainability ratios comparable internationally? What are the factors to be taken into account? (level of interest rates? Country risks?) • How market influences debt sustainability ratios? • What should be left to markets and competition and what should be determined by commonly agreed standards? • Data challenges – reliability/comparability across countries.

3. Financial depth doesn't tell whole story Source: BIS (2011), World Bank Databank (Latest Available), NBG Calc. (based on retail sample - PTI. Date does not takes in to account maturity)

4. Additional Room for Credit Growth * Assuming constant Income and PTI

5. Corporate ratios in Developed Countries Source: IMF, GFSR

6. Corporate ratios A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC- Possible effect of monetary easing Signs of financial vulnerability Source: IMF, GFSR

7. Corporate ratios in Emerging Markets *CEEMEA - Central Eastern Europe Middle East & Africa Source: IMF, GFSR

8. Retail ratiosInternational overview Canada vs. USA (2004) Canada vs. USA (2001) Source: Bank of Canada

9. Income level and credit standards • As development and income level rise debt service limits tend to become less strict. • For example in USA in the 1970s was PTI was around 25%. In the following decades these limits gradually climbed higher. • Based on current observed practice banks have increasing PTI requirements in income. This could be reflection of higher portion of expenses on essentials as well as high income variability in low income ranges. • In US prior to financial distress very high limits became common for loans. This largely helped to fuel real estate bubble.

10. Local practicesCorporate portfolio Source: IMF, NBG (based on corporate sample) Sound Borrowers

11. IFRS Provisioning and ICR *IFRS provision takes into account net working capital. Source: NBG calc. (based on a sample of corporate borrowers)

12. Local practicesRetail portfolio • PTI tends to be increasing in income. • FX risk is partially addressed by tighter PTI ratios. • Interest rate risk for floating interest rate loans is not addressed by PTI standards. Source: NBG calc. (based on a sample of banks’ mortgage procedures).

13. Financial ratios and stress tests • Use of debt service ratios during stress tests can make it more forward looking. • This is particularly relevant when historical data has low quality and/or structural changes make estimated parameters misleading. • Standard Loans Classification implies mild transaction level test: • A loan shall be classified as "Standard" if it is paying principal and interest in a timely manner and is supported by the sound capital and paying capability of the borrower. This classification is proper where the borrower is financially strong and has sufficient room to cushion unforeseen adverse impacts, is within its profit targets and produces cash flows sufficient to satisfy in a timely fashion all liabilities.

14. An example of Transaction Level stress test on a corporate borrower • Scenario: Following stress test is used: 5% decline of the GDP; foreign exchange rate decline by 20%; and real estate price decline by 20%. • Basic facts about Company: • Fish Products (local producing / Import / Re-Export); • Sector has low correlation with economic cycle; • Strong Market Position; • Industry in mature stage; • This scenario affects the income in the following way: • Local production – Despite of the GDP decline, because of substitution effect (Imported goods - more expensive than local goods) sales on locally produced goods do not fall; • The sale of imported products was reduced by 15%. Cost of goods sold was adjusted the same way, but since the company buys in foreign currency, FX rate reduction of 20% resulted increase of cost by 20%. The company is able to increase price only by 10%. As result the gross margin on imported goods has decreases from 20%to 13%.Re-export – As the stress test is conducted for domestic market we assume that sales amount and gross margin from re-export would have been the same. • Expenses – Expenses were divided into fixed costs and variable costs. Variable costs were corrected the same way as sales, but fixed costs remained unchanged. Fixed expense is in local currency and FX rate change has no effect on it. • Liabilities – Since company’s liabilities are completely in foreign currency, FX rate reduction immediately caused increase of both interest expense and principal by 20%.After stress, the company’s profitability indicators were reduced. EBIT/Interest was reduced from 4.64 to 3.11. LTV Ratio also increased from 67% to 98%. Regardless of profitability indicator reductions, the company has maintained its ability to meet its existing obligations. After materialization of stress tests scenario there is no requirement for additional provisioning in the future, no additional capital is needed as part of Basel II/III Countercyclical and or Conservation buffer and or ICAAP Framework.

15. Retail Credit Risk Stress Test

16. Lending standards, market conduct and responsible lending • There are many synergies between credit risk management and debt sustainability issues. To avoid consumer defaults and foreclosures, it is important to not to stretch debt service ratios. • Along with disclosure of risks, consumer financial education focusing on importance of debt sustainability ratios and debt limits could an important tool to advance consumer protection, as well as mitigate credit risk (subprime lending could be an example of this issue).

17. Concluding Remarks • Micro level credit quality ratios • Early warning indicator to detect micro as well as macro level vulnerability. • Has potential as a Macroprudential tool. • Can improve forward-looking quality of stress tests. • Need to agree on acceptable range of credit standards. • Competition should focus on price and other attributes of credit, rather than relaxing credit standards. • Along with good lending standard practices consumer education is a key to keep leverage at sustainable level and avoid debt overhang.

18. Thank you and I hope these points will help to open the floor for further discussions.