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How do TMRACs work in Credit Risk?

Date: February 16, 2016 Author: Ramzi Watfa
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Under the Basel and IFRS 9 guidelines, TMRACs will become critical tools to manage the credit risk portfolio on an ongoing basis. However not many banks understand what they are and how they work. I provided some reference to them in an earlier article, and here’s a little bit more on this issue.


Target Market and Risk Acceptance Criteria (TMRACs for short) At 6 Sigma Group, we created a system of measuring credit risk that accounts for 177 different criteria, the largest of any system available in the market. These criteria cover both financial and non financial attributes, and are based on four major pillars: numerical data, and assessments of management, industry and the environment (economic and political).

Recently we introduced another layer of assessment that takes credit risk assessment to another height altogether. This is with the introduction of Target Market and Risk Acceptance Criteria or TMRACs for short. These are a set of assessments that are both numerical and non numerical in nature that are unique to individual obligors. These are specific to the obligor’s sector (eg contracting), business (SMEs), facility type, pricing and share of wallet (RACs), and adherence to covenants. By adding this extra level of assessment, and assessing the number of deviations from the set norm, the system would be able to:

  1. Reject credit proposals if the number of deviations are above a certain threshold;
  2. Increase the obligor risk rating by a pre-set increment; and/or
  3. Increase the level of approval of the credit.

Use of TMRACs The 177 criteria used in risk rating obligors in our Credit Risk System or CRS (versus Moody’s 108, S&P’s 89 etc) are generic criteria that apply to all clients across board; and in general they are very sufficient (at least in CRS’ case) as they are cash flow centric, and forward looking. However there are some extra characteristics that define specific types of risks relating to obligors, their businesses and the products being offered to them. For example contractors, real estate, SMEs and the like have particular characteristics that may redefine their risk ratings to some extent depending on whether these obligors are in line with what the bank perceives to be the norm in their industries (what is referred to as Key Success Factors), products, type etc. So clients that fall within these categories have to be assessed against additional criteria; and if there were many deviations to their specific criteria, then their risk ratings are normally overridden. These criteria we call TMRACs and are defined in Industry Studies and Product Programs as called for in Principle 3 of the Basel Accords.

In addition, the bank should have General TMRACs that apply to all clients. This helps highlight existing flaws in the credit portfolio or red flags for new clients that do not fit the strategic makeup of the portfolio as defined in the Target Market Study of the bank (Principal 3 again). The Target Market Study that banks are supposed to produce on an annual basis is the one that protects the quality of the portfolio in line with the bank’s strategy to improve its Portfolio Risk Rating (PRR). Again the number of deviations from these will play a role in overriding the risk ratings.

All this was essential in managing the credit portfolio under Basel. Now it is imperative in controlling provisions under the forthcoming IFRS 9.

How Do You Decide on TMRACs By conducting Industry Studies and Product Programs, you have to create what is known as mandatory criteria for accepting obligors into the portfolio. One such basic criterion for example is that the Obligor Risk Rating (ORR) should not exceed 6; another Management rating not to be more than 5 etc… The criteria chosen depend entirely on the study you are conducting, which we actively sell to banks. Once the criteria is chosen, the only remaining issue is how many deviations one needs to set against each criterion that will ultimately impact the overall risk rating of each obligor. The number of deviations will increase the ORR by certain notches to allow the bank to (a) control the approving authority for that obligor in the credit flow process, (b) set sufficient provisions or capital against the exposure in anticipation of changes in the obligor’s future performance based on the number of deviations to a set of criteria, and (c) in the extreme, to limit approvals of obligors altogether in case their number of deviations exceed an acceptable threshold. The number of deviations to these criteria will determine by how much the risk rating will be increased (all determined by the bank) and hence the PRR, capital adequacy, etc etc.

To enable the bank to create a rule linking deviations to criteria, we recommend that each bank create 3 sets of criteria for each TMRAC list:

1. Critical Criteria: for which any deviation will halt the processing of a credit altogether. An example is the PRR > 6 criteria (PRR measuring the portfolio of facilities for each obligor). For these the bank would allocate the maximum allowable number of deviations per set (the equivalent of a weighting of 100%) sufficient enough to not pass the credit in the credit workflow (the maximum number is also set by the bank).

2. Allowable to a Point: these criteria would normally carry say double the number of deviations for each criteria and help push the overall result higher. An example of this would be the number of positive checking from other banks.

3. Acceptable Criteria: which carry single deviations, and are summed up along with all other similar deviations to a total sum at the end.

The total number of deviations across all the criteria is what will determine how much the risk rating will be overridden.

How Do You Measure Deviations The number of deviations are cumulative, that is they are added up across all the various TMRACs layers. For an SME that would be General + SME. For those without financials, that would be General+SME+No Financials criteria. The number of criteria, the number of layers, the number of deviations are all set by the bank. If you wish not to use TMRACs, then rely solely on the ORR generated by the risk rating system. If you want to be sophisticated, in line with Principal 3 of Basel and manage IFRS9 expectations, then you have to spend the effort and time to create them. Some data is at the Obligor Information Level (location, checkings, number of suppliers, number of clients etc), some financial specific (ratios etc), some are produce specific (excessive exposure levels), and some are pricing related (RAROC) etc.

Specific Questions Below is a useful set of Q&As with some banks relating to the subject which may answer some of yours:

  • Total Credit and Debit Amounts in Account criteria is the total credits that are captured in the SME’s current account with the bank (or all banks). This is a general criteria banks use in assessing whether SMEs are channeling all their cash flows into the bank, and/or reporting their sales and costs accurately. For accounts that do not provide financials, this is also a mandatory field to try and amass financial information on the account (Total Credit need to be higher than Total Debits for example).
  • The Maximum Average Borrowing (MAB) Amount is the average the client borrows from the bank over a year. This criterion is useful in calculating how much of the facility is being used, shares of wallet from all facilities at all other banks, and if there is a core borrowing observed in the account. MAB to Credit is a ratio of turnover of an overdraft facility. Again you define if and how you are going to use this information in assessing the criteria for your TMRACs.
  • General and SME criteria and cumulative capturing of deviations (example years in business being 3 for General and 10 for SMEs). If for example the bank decided it only wants to deal with companies that have at least 3 years in business then it sets this rule under the General Settings. So any client that has less than 3 years in business will have a deviation in this criterion. You may elect to allocate 10 deviations to this criteria out of a total of say 15 because you really do not want to deal with start-ups (GOD forbid!), so that the rating override takes the ORR beyond 7 and thus making the transaction non-bankable. In addition, and for SMEs in particular, you may decide not to deal with any that have less than 10 years of existence (because you came to the sensible conclusion that they need to have witnessed and overcome a business cycle to be a worthy credit for example). So for the SME TMRACs you set the criterion for years in business to 10. So the next time an SME that has 5 years of business is evaluated, it will pass the General Rule with no deviations, but fails the SME rule, and depending on the number of deviations you allocate to the SME rule, the risk rating override will increase accordingly. You may even elect not to do business with it given it is an SME with only 5 years of existence.
  • You have the ability to use any criterion that we have established as an API in the system for your rules. You are also able to establish a set of multiple criteria with And/Or logic.
  • Technically, the TMRACs can be used for both increasing and decreasing the risk rating (left open for the bank to decide). Specifically for obligors that do not provide financials where the CRS assigns a rating of 7.5, if there were no deviations to the no-financials TMRACs, you can improve this to say 6 (again you define by how much). For all else, the TMRACs are not there to substitute 177 criteria used in the risk ratings. They are to complement, and as such should be used to worsen the rating.

In addition, your risk rating methodology should be designed to carry 3 different ratings by obligor:

  1. The ORR from the risk rating based on the 177 criteria
  2. A PRR based on the facilities for each obligor
  3. An Overridden ORR using TMRACs (OORR)

You can then decide which one of these to use in your credit approvals, PRR calculations, Capital Adequacy and IFRS9 compliance.

If our current automated credit proposal helps reduce decision making from weeks to hours, then this added level of assessment will streamline the process tremendously beyond all that is available in the market. We encourage you to check what is offered today, and keep in tune for future developments. A demo of the system is available on our website.

© 2016 6 Sigma Group

While the information contained herein is believed to be accurate, neither 6 Sigma nor any of its affiliates or subsidiaries or its employees makes any representation or warranty, express or implied, as to the accuracy or completeness of the information set out in this document or that it will remain unchanged after the date of issue of this document, and accordingly neither 6 Sigma nor any of their respective affiliates or subsidiaries or employees has any responsibility for such information. This document is not intended by 6 Sigma to provide the sole basis of any credit decision or other evaluation and should not be considered as a recommendation by 6 Sigma that any recipient of this document should purchase an equity stake in, provide credit facilities to, or conduct any business with any company(ies) listed in this document. Each recipient should determine its interest in the information provided herein upon such independent investigations as it deems necessary and appropriate for such purpose without reliance upon 6 Sigma.

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