In credit risk management, the classification of loans under the IFRS 9 accounting standard plays a central role for both banks and investors. In this context, Stage 2 loans refer to exposures that have experienced a significant increase in credit risk since initial recognition but are not yet classified as impaired.

This intermediate category is characterised by the fact that, although the probability of default has increased, debtors are still meeting their payment obligations. However, the higher level of uncertainty associated with these loans requires financial institutions to make higher provisions, which in turn impacts their capital position and overall profitability.

Key features of Stage 2 exposures

Stage 2 exposures fall between performing and impaired exposures. Although they are still considered performing, they have experienced a deterioration in credit quality. This may be due to macroeconomic factors, sector-specific challenges or issues affecting the individual borrower, such as reduced cash generation or increased leverage.

A relevant aspect is that banks must calculate expected credit losses over the entire life of the loan, rather than over a 12-month period as is the case for Stage 1 loans. This accounting treatment reflects the increased risk and ensures a more prudent approach to managing such exposures.

Another distinguishing aspect is the need for constant monitoring of these loans. Depending on how the borrower's situation evolves, the exposure may be reclassified to Stage 1 if the situation improves, or escalated to Stage 3 if signs of default emerge.

Stage 2 loans: classification criteria

The transition from Stage 1 to Stage 2 occurs when there is a significant increase in credit risk, based on a series of indicators. The main ones include a deterioration in the borrower's credit rating, a breach of certain payment delay thresholds (typically more than 30 days) and an analysis of the economic outlook for the borrower's sector.

Banks use advanced models to assess changes in credit risk, combining quantitative and qualitative data to identify early warning signs of deteriorating credit quality. This approach allows corrective action to be taken before a loan becomes non-performing, thereby reducing potential losses.

It is important to note that a Stage 2 classification does not necessarily imply a future transition to Stage 3. Careful credit management and the implementation of restructuring strategies may even support a return to Stage 1.

Differences between Stage 1, Stage 2 and Stage 3 loans

Below are the specific characteristics of each credit category under the IFRS 9 framework:

●       Stage 1 loans: These include all exposures that have not experienced a significant increase in credit risk since initial recognition. For these positions, expected credit losses are calculated over a 12-month period as the risk of default is considered low.

●       Stage 2 loans: these exposures show a deterioration in credit quality, although they are not yet in default. The key difference compared to Stage 1 is that expected credit losses are assessed over the entire remaining lifetime of the loan.

●        Stage 3 loans: these are impaired exposures where the borrower is no longer able to meet its contractual obligations. In this case, the bank must recognise actual losses and implement recovery strategies, which may include the sale or restructuring of the loan.

The impact on banks' financial statements

An increase in loans classified as Stage 2 has a significant impact on banks' financial statements, as it results in higher provisions for expected credit losses. This loss coverage mechanism reduces available capital, which affects the institution's ability to originate new loans and impacts overall profitability.

Banks must therefore implement effective strategies to limit the migration of loans into Stage 2, by constantly monitoring their portfolios and taking prompt action on at-risk exposures. In addition, active management of these loans - including derisking - can help mitigate the negative impact on capital.

ARECneprix's role in managing Stage 2 loans

The complexity of managing Stage 2 loans makes the support of specialised credit collection and asset management providers essential. Companies such as ARECneprix offer advanced solutions to manage and optimise these exposures, helping to improve banks' balance sheets and reduce the associated risks.

ARECneprix's expertise in structuring financial transactions and managing credit and real estate portfolios makes it a strategic partner for financial institutions seeking tailor-made solutions. For more information on the capabilities of ARECneprix, please visit the ARECneprix website.

Stage 2 loans therefore represent a critical category in credit risk management, as they indicate a deterioration in portfolio quality without being non-performing. Proper classification and treatment of these exposures allows banks to implement effective mitigation strategies and avoid further asset deterioration.