Early warning, watchlists and workout · RiskAtoms Academy

By the end you will be able to

1Score early-warning signals and decide which borrowers go on the watchlist.
2Update a borrower's PD on a warning signal, and say what a watchlist is for.
3Apply the definitions of default, non-performing exposure and forbearance, with their 90-day, 30-day, one-year and two-year rules.
4Compare restructuring with enforcement by present value, and test a restructuring against the 1% diminished-obligation threshold.

Why it matters

Graybeck Plastics Ltd has paid every instalment on time. Yet its revolver is almost fully drawn, its covenant certificate is late and has failed, two directors have left, and it is two grades weaker than when the bank lent to it. By the time a borrower misses a payment, most of the chances to protect the loan have gone. The work of the next few months decides how much of the £11.5m comes back.

Core explanation

From the first warning to the workout unit

Illustrative dataRiskAtoms Bank plc's credit book

The module's lending book: twelve invented corporate borrowers (exposure at default £587m, expected loss £2.81m), retail mortgages, personal loans and cards, a ten-grade master scale, personal-loan vintages and twenty past workouts. Every firm and figure is made up for teaching, in pounds, at one date; none is real data.

The grades and exposures are the book's. Each borrower's grade at approval, days past due, covenant headroom and qualitative signals are extras shared with L3.3.18: Provisioning basics. The early-warning flag's hit and false-alarm rates are those of M-C12: Conditional probability and Bayes' rule.

Early-warning signals

L3.3.01: The credit lifecycle placed monitoring between approval and collections. Its raw material is early-warning signals, the credit version of the key risk indicators of L2.4.06: Key risk indicators: a downgrade since approval, a revolver drawn to the limit, payments a few days late, thin covenant headroom, late accounts, managers leaving, a sector under stress, a share price or CDS spread falling away from peers (L3.3.16: Market-implied default risk). RiskAtoms Bank scores them: 2 points for a hard signal, 1 for a softer one. 2 or 3 points means closer monitoring; 4 or more puts the borrower on the watchlist.

Early-warning board (click a borrower)

- Down 2 grades since approval+2
- Revolver 96% drawn+1
- Covenant breached+2
- Accounts or covenant certificate late+1
- Key managers left+1

4 borrowers are on the watchlist (Graybeck Plastics Ltd, Hastemoor Construction Ltd, Larkhollow Freight Ltd, Mirefield Care Homes Ltd), with £109.5m of EAD, and 2 more are under closer monitoring. A watchlist review sets an action plan for each: ask for monthly management accounts, cut or freeze undrawn limits, take more security, reset covenants in return for a fee or tighter terms, and agree a date to decide whether to pass the case to the workout unit.

How much is a signal worth?

Suppose the bank's early-warning flag catches 60% of the borrowers that default within a year, and wrongly flags 5% of the others. Bayes' rule (M-C12: Conditional probability and Bayes' rule) turns that into an updated PD. For Mirefield Care Homes Ltd, grade 6, it goes from 1.13% to 12.1%: a big change, but most flagged borrowers of that grade still repay. For Graybeck Plastics Ltd, grade 9, the flag lifts 11.3% to 60.5%, and a covenant breach on top (caught in 50% of defaults and 4% of non-defaults) to 95.0%. The same signal means much more for a weak borrower than for a strong one, which is why the board weights signals and grades together.

Default, non-performing and forborne

Three definitions drive what happens next, and they are not the same thing:

Default (EU and UK capital rules): more than 90 days past due on a material obligation, or unlikely to pay. In the EU a past-due amount is material above both an absolute threshold (at most €100 for retail and €500 for other exposures) and a relative one (normally 1% of the exposure). Unlikely-to-pay signs include stopping interest accrual, a specific provision, a distressed restructuring and bankruptcy.
Non-performing exposure (EBA reporting): the same two legs, 90 days past due or unlikely to pay. Defaulted and impaired exposures are always NPE.
Forbearance: a concession to a borrower in financial difficulty. A forborne exposure can be performing or non-performing. Leaving non-performing takes at least a one-year cure period; the forborne flag then stays for a two-year probation period.

Sort itClassify each exposure

A retailer is 45 days late on a payment; no concession has been granted and the bank expects it to catch up.
A haulier in difficulty gets a six-month interest holiday; the loss in present value is 0.6%, and it pays on time otherwise.
A manufacturer is 95 days past due on a material amount.
A care home group's debt is cut by 15% and its term extended because it could not pay.
A forborne loan in its probation period becomes 35 days past due.

The workout unit

When a borrower is in default or close to it, the case moves from the relationship team to the workout unit, a separate team whose only aim is to maximise recovery. Its options run from gentle to final:

ExploreA workout, step by step

Click each box.

Standstill

Lenders agree not to enforce while the facts are gathered: independent business review, cash-flow forecast, valuation of the assets.

The formal version

Let a loan of principal $P_0$ pay coupon $c_0$ for $n_0$ years, and the restructured loan pay $c_1$ on $P_1$ for $n_1$ years. Both are discounted at the original effective interest rate $r$ (here 10.1%):

\begin{aligned} \text{NPV}_k &= \sum_{t=1}^{n_k} \frac{c_k P_k}{(1+r)^t} + \frac{P_k}{(1+r)^{n_k}}, \qquad k = 0, 1 \\ \text{DO} &= \frac{\text{NPV}_0 - \text{NPV}_1}{\text{NPV}_0} \qquad (\text{default if } \text{DO} > 1\%) \\ V_{\text{restructure}} &= p\,\text{NPV}_1 + (1-p)\,V_{\text{fail}}, \qquad V_{\text{enforce}} = (1 - \text{LGD})\,P_0 \\ p^{*} &= \frac{V_{\text{enforce}} - V_{\text{fail}}}{\text{NPV}_1 - V_{\text{fail}}} \qquad (\text{restructure if } p > p^{*}) \end{aligned}

The updated PD on a signal $S$ with hit rate $h$ and false-alarm rate $f$ is Bayes' rule from M-C12: Conditional probability and Bayes' rule:

P(D \mid S) = \frac{h\,\text{PD}}{h\,\text{PD} + f\,(1-\text{PD})} = \frac{0.60\times0.0113}{0.60\times0.0113 + 0.05\times0.9887} = 12.1\%

Conventions: annual payments, bullet repayment; DO as in the EBA guidelines on the definition of default, which compare net present values at the original effective rate. Recovery on enforcement uses the book's average workout LGD for subordinated loans, 79.7%, already discounted to the default date.

Try it

The proposal on the table writes off £2.0m, cuts the rate to 5% and extends the loan to 6 years. Try to design a restructuring that is not a default (a DO of 1% or less): you will find it gives the borrower almost no relief. Then lower the chance of success until enforcing becomes the better option.

Try itRestructure or enforce?

Principal written off£2.0m of £11.5m

New interest rate5.0%

New term6 years

Chance the plan works70%

PV of new terms at the original EIR£7.40m

PV if the plan fails£1.23m

Expected PV of restructuring£5.55m

PV of enforcing now£2.33m

Better optionrestructure

Break-even chance of success18%

Diminished financial obligation35.7%

Above the 1% threshold?default

Present values at Graybeck's original effective interest rate. Enforcing recovers the book's average subordinated workout recovery; a failed plan pays one year of interest, then recovers half that rate a year later.

Worked example

Graybeck Plastics Ltd: two years in the life of a problem loan

TimelineGraybeck Plastics Ltd, £11.5m subordinated loan

1 / 5

Month 0

Watchlist

Seven points on the board: down two grades, revolver 96% drawn, covenant breached, accounts late, managers gone. Undrawn line frozen; monthly reporting required. Performing, but IFRS 9 stage 2 (L3.3.18: Provisioning basics).

The numbers behind the month-6 decision

Step 1 of 5

1
Value of the old loan
£11.5m at 10.1% for 3 years, discounted at the same 10.1%: NPV = £11.50m, exactly its principal.

What the workout unit writes

Recommend restructuring: expected value £5.55m against £2.33m on enforcement. Classify as defaulted, non-performing forborne from signing; loss of £4.10m in present value recognised through the provision.

Regulatory lens

The definition of default is in Article 178 of the Capital Requirements Regulation, which the UK kept after leaving the EU. The EBA's guidelines on its application (EBA/GL/2016/07, applying from 1 January 2021) set out how to count days past due, the unlikely-to-pay indicators, the 1% threshold for a distressed restructuring and the minimum three-month (one year after a distressed restructuring) probation before a borrower leaves default; the EBA's technical standards set the materiality thresholds, and national supervisors set their own within them (the PRA chose zero for retail exposures, and €500 in sterling and 1% for others, from 31 December 2020). Non-performing and forborne exposures were defined for EBA supervisory reporting in 2013–14, with the one-year cure period, the two-year probation and the rule that if more than 20% of a debtor's on-balance sheet exposures are over 90 days past due, all its exposures are non-performing. The ECB's 2017 guidance on non-performing loans asks banks with many NPEs for reduction strategies and dedicated workout units. How default feeds capital is in M4.2: Credit risk capital; how it feeds provisions in L3.3.18: Provisioning basics and M4.7: Accounting for risk.

Spark Atoms

Spark AtomThe London Approach

When a UK company with many bank lenders got into trouble, the banks were encouraged by the Bank of England to follow the “London Approach”: a voluntary, collective way of deciding, on shared information, whether to call in receivers or support a workout. Pen Kent, the Bank's Director for Finance and Industry, said in 1993 that over the previous three years it had helped many businesses survive that might otherwise have closed.

Spark AtomOne bad loan can make them all bad

In EU reporting, if more than 20% of a company's on-balance sheet exposures to a bank are more than 90 days past due, every exposure the bank has to that company counts as non-performing, including loans being paid on time. For companies, the capital rules apply default to the obligor, not the loan.

Key takeaways

Early-warning signals (downgrades, high utilisation, late payments, covenant headroom, late accounts, market signals) feed a watchlist with an action plan per borrower.
A signal updates the PD by Bayes' rule; the same flag means far more for a weak borrower than for a strong one.
Default: 90 days past due on a material amount, or unlikely to pay. NPE uses the same two legs; defaulted and impaired exposures are always NPE.
Forbearance is a concession to a borrower in difficulty: one year to cure from non-performing, then two years' probation, back to NPE if more than 30 days past due.
A restructuring whose diminished obligation exceeds 1% is a default; the workout unit restructures when its expected value beats enforcement.

Reaction

Check what stuck

Glossary

Early-warning signal: Early-warning signal: a sign, before any missed payment, that a borrower may be heading for trouble.
Watchlist: A list of borrowers under closer watch: reviewed more often, with an action plan, usually no new lending without senior approval.
Days past due: Days past due: how many days a payment of interest, principal or fees has been overdue.
Unlikely to pay: Unlikely to pay: the bank judges that the borrower will not pay in full without the bank selling collateral, whatever the days past due.
Default: Under the EU and UK rules (CRR Article 178): the obligor is more than 90 days past due on a material obligation, or is unlikely to pay.
Non-performing exposure: Non-performing exposure: a material exposure more than 90 days past due, or one whose debtor is unlikely to pay in full without collateral being realised. Defaulted and impaired exposures are always NPE.
Forbearance: A concession (lower rate, longer term, payment holiday, write-off) granted to a borrower facing financial difficulty.
Cure period: The period a non-performing forborne exposure must perform for before it can return to performing: at least one year.
Probation period: The period a forborne exposure stays flagged after returning to performing: at least two years, ending only with regular payments and nothing more than 30 days past due.
Workout unit: The bank's specialist unit for borrowers in serious difficulty: it restructures, sells or enforces.
Diminished financial obligation: Diminished financial obligation: the fall in the present value of what the borrower owes, at the original effective rate, caused by a restructuring.
Standstill: An agreement among lenders not to demand repayment or enforce for a period while a rescue plan is worked out.
Enforcement: Using the bank's legal rights: demanding repayment, appointing administrators, selling the collateral.

Deep Dives & Origins

Deep Dives

European Central Bank, Guidance to banks on non-performing loans, March 2017. Intermediate.
P. Kent, “The London Approach”, Bank of England Quarterly Bulletin, 1993 Q1. Introductory.

Origins

European Banking Authority, Guidelines on the application of the definition of default under Article 178 of Regulation (EU) No 575/2013 (EBA/GL/2016/07), September 2016.
European Banking Authority, Final draft RTS on the materiality threshold for credit obligations past due (EBA/RTS/2016/06), 2016.
European Banking Authority, Final draft Implementing Technical Standards on supervisory reporting on forbearance and non-performing exposures (EBA/ITS/2013/03), 2013.
Regulation (EU) No 575/2013 (Capital Requirements Regulation), Article 178.

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