PROJECT REPORT

ON

“CREDIT RISK MANAGEMENT IN BANKS”

A Project Submitted to

University of Mumbai for Partial Completion of the Degree of

Master’s in commerce

Under the Faculty of Commerce

BY:

ASHIKA ASHOK SHINGOTE

ROLLNO: 1962114

UNDER THE GUIDANCE OF

PROF.MADHU TIRTHANI

SHRI SIDH THAKURNATH COLLEGE OF ARTS & COMMERCE

ULHASNAGAR-421004.

UNIVERSITYOFMUMBAI

2019-20
 PROJECT REPORT

ON

“CREDIT RISK MANAGEMENT IN BANKS”

A Project Submitted to

University of Mumbai for Partial Completion of the Degree of

Master’s in commerce

Under the Faculty of Commerce

BY:

ASHIKA ASHOK SHINGOTE

ROLLNO:1962114

UNDER THE GUIDANCE OF

PROF.MADHU TIRTHANI

SHRI SIDH THAKURNATH COLLEGE OF ARTS & COMMERCE

ULHASNAGAR-421004.

UNIVERSITY OF MUMBAI

2019-20
COLLEGE CERTIFICATE
 DECLARTION

The Undersigned Miss/ Mr. ASHIKA ASHOK SHINGOTE here

by, declare that the work embodied in this project work titled “Credit
Risk management in Banks” forms my own contribution the research
work carried out under the guidance of PROF.MADHU TIRTHANI Is a
result of my own research work and has not been previously submitted to
any other University for any other Degree/ Diploma to this or any other
University.

Wherever reference has been made to previous works of others, it

has been clearly indicated as such and included in the bibliography.

ASHIKA ASHOK SHINGOTE

 ACKNOWLEDGEMNET
To list who all helped me is difficult because they are so numerous and the depth is so
enormous.

I would like to acknowledge the following as being idealistic channels and fresh
dimensions in the completion of this project.

I take this opportunity to thank the University Of Mumbai for giving me chance to do
this project.

I would like to thank my Principal, Dr. J. C. Purswani for providing the necessary
facilities required for completion of this project.

I take this opportunity to thank our Co-ordinator – Ms. Varsha Sawlani for her moral
support and guidance.

I would also like to express my sincere gratitude towards my Project Guide Prof.
Madhu Tirthani whose guidance and care made the project successful.

I would like to thank my College Library, for having provided various reference
books and magazines related to my project.

Lastly, I would to thank each and every person who directly or indirectly helped me in
the completion of the project especially My Parents and Peers who supported me
throughout my project.
 INDEX
Sr. Particular Page no
No.
1 Introduction to Credit Risk Management 9-22
1.1 Introduction
1.2 Importance Of Credit Risk
1.3 Statement Of The Problem
1.4 Types Of Credit Risk
1.5 Mitigation Of The Credit Risk
2 A Conceptual Framework Of Credit Risk 23-41
Management
2.1 Introduction
2.2 Concepts Of Credit
2.3 Credit Definition
2.4 Characteristics Of Credit
2.5 Research Design
2.6 Scope Of the Study
2.7 Objectives Of the study
2.8 Difficulties face to Credit Risk
Management
2.9 Challenges for Credit Risk Management
2.10 Significance Of Risk Management In
Banks
2.11 Aspects Of Credit Risk Management
2.12 Prudential Norms for Income
Recognition, Asset Classification and
Provisioning (IRAC) Norms
2.13 Management of NPA
2.14 Capital Adequacy Norms
2.15 Recovery Measures
2.16 Conclusion
3 Principles And Regulation Of Credit Risk 42-58
Management
3.1 Introduction
3.2 Concept of Credit Risk
3.3 Principles Of Credit Risk
3.4 Establishing an Appropriate Credit risk
Management
3.5 Operating Under a Sound Credit Granting
Process
3.6 Maintaining an appropriate Credit
Administration, Measurement and Monitoring
Process
3.7 Ensuring adequate controls over credit risk
3.8 Role of supervisor of the banking system
4 Analysis & Interpretations 59-67
4.1 To Review the Existing Practices of Risk
Management in Indian Banks
4.2 To Find Out Recurring Common Risk
incidents & The Causes For The Same
4.3 Analysis Relating To First Objective
4.4 Analysis Relating To Second Objective
4.5 Analysis Relating To Third Objective
4.6 Analysis Relating To Fourth Objective
4.7 Analysis Relating To Fifth Objective

5 Suggestions & Conclusion 68-75

 CHAPTER-I

INTRODUCTION TO CREDIT RISK MANAGEMENT

1.1 Introduction

1.2 Importance of Credit Risk

1.3 Statement of the Problem

1.4 Types of credit risk

1.4.1 Credit Default Risk

1.4.2 Concentration Risk

1.4.3 Country Risk

1.4.4 Market Risk

1.4.5 Operational Risk

1.4.6 Liquidity Risk

1.4.7 Reputational Risk

1.4.8 Business Risk

1.4.9 Systematic Risk

1.4.10 Moral Hazard

1.5 Mitigation of the Credit Risk

 CHAPTER – I

INTRODUCTION TO CREDIT RISK MANAGEMENT

1.1 INTRODUCTION

The world has experienced remarkable number of banking and financial crises during
the last few decades. Though most of those were experienced in the developing
countries, the majority of the crises coincided with the deregulatory measures that led
to excessively rapid credit extension. In the long run, continuous increases in asset
prices created bubble. At some point, the bubble burst and the asset markets
experienced a dramatic fall in asset prices coupled with disruption. Finally,
widespread bankruptcies accompanied by Non Performing Loans, Credit losses and
acute banking crises were observed. Subsequently, the global financial market is
going through a turbulent situation. This has necessitated a close examination of the
numerous issues related to the operation of financial markets to identify the root of the
problem. Various issues such as the capital adequacy levels in the banking system, the
role of rating agencies in financial regulation and the fair value assessment of banking
assets are the most debated ones. In response to the banking crises, significant
reformations have been carried out in the banking regulatory system.

In new economic policy in 1991, the financial (particularly banking) sectors received
special attention in improving their financial strength and functional efficiency and
thereby bring them to international standards.

The modern banking operations have greater impact on the economic development of
our country. The financial institutions are important constituents of financial system in
an economy. The banking industry is operating in a liberalized and global
environment, which is highly competitive and uncertain. Banks are offering
innovative products and initiating steps to computerize their offices to improve the
speed of their operations and provide prompt services to their customers, who are
becoming highly demanding. The foreign exchange business and cross-border
activities are increasing at a fast pace. The above developments have caused various
types of banking risks, which can be broadly related to market environment and their
business control functions. This risk may include credit risk, interest rate risk,
liquidity risk, foreign exchange risk, group risk, technology risks etc.
1.2 IMPORTANCE OF CREDIT RISK

The importance of credit risk has been presented in the following paragraph;

Risks are the uncertainties that can make the banks lose and become bankrupt.
According to the Basel Accord, risks can be classified as credit risk, market risk and
operational risk. Credit risk is the risk of loss due to an obligator’snon payment of an
obligation in terms of a loan or other lines of credit.

Credit risk is defined as “the risk of loss arising from outright default due to inability
or unwillingness of the customer or counter party to meet commitments in relation to
lending, trading, hedging, settlement and other financial transaction of the customer of
counter party to meet commitments”.

Credit risk is refers to the possibility that a borrower or counter-party will fail to meet
its obligations in accordance with agreed terms. It is the probability of loss from a
credit transaction

1.2.1 Forms of credit risk

Forms of credit risk are:

 Non-repayment of the principal of the loan and/ or the interest on it.

 Contingent liability like letters of credit or guarantees issued by the bank on

behalfof the client and upon crystallization – amount not deposited by the
customer.

 In the case of treasury operations, default by the counter-parties in meeting

theobligations. For example, in case of derivatives dealing, on the due date the
contract is not settled.
 In the case of security trading, settlement not taking place when it is due.
Forexample, due to non-availability of funds or due to short selling, on the due
date the claim is not settled.
 In the case of cross-border obligations, any default arising from the flow of
foreign exchange due to restrictions imposed on remittances out of the
country. For example, the counter party might have made the payment but the
country in which the counter party is residing does not allow the settlement.

The Reserve Bank of India came out with its first set of guidelines on risk
management during 1999. In these guidelines, it has been suggested that the banks
should put in place proper credit risk management system. Some banks initiated the
process of formulating credit risk policies in the year 2000 and have implemented
these policies while a few are still in the process of developing such policies. It has
been emphasized in credit risk management guidelines that while the credit risk
strategy of a bank should give recognition to the goals of credit quality, earnings and
growth, it is also essential that the lender must determine the acceptable risk/ reward
trade off for its activities, factoring in the cost of capital.

The Bank for International Settlements (BIS) says that “Granting Credit involves
accepting risk as well as producing profits”. The credit operations in banks, by nature
involve an element of credit risk. But if such risks are within predetermined ceilings,
properly assessed and calculated ones, loan loss to the bank can be restricted.

1.2.2 Sources of risk of loss under Credit Risk

The risk of loss arises from three sources. They are;

 Borrowers/ counterparty defaults –Bank loses both the principal and

theinterest.
 Deterioration in borrowers‟ credit quality – bank takes a hit if loan is
notrepriced for the higher risk.
 Improvement in borrowers‟ credit quality- borrower can refinance his loan at
a lower rate. In simple words, it means that they may close the accounts to
benefit from the lower interest rate in offer.

1.2.3 Credit Risk Management Indicators

In response to recent corporate and financial disasters, regulators have increased their
examination and enforcement standards. In banking sector, Basel II has established a
direct linkage between minimum regulatory capital and underlying credit risk, market
risk and corporate risk exposure of banks. This step gives an indication that Capital
management is an important stage in risk mitigation and management. However,
development of effective key risk indicators and their management pose significant
challenge. Some readily available sources such as policies and regulations can provide
useful direction in deriving key risk indicators and compliance with the regulatory
requirement can be expressed as risk management indicators. Amore comprehensive
capital management framework enables a bank to improve profitability by making
better risk-based product pricing and resource allocation.

The purpose of Basel II is to create an international standard about how much capital
banks need to put aside to guard against the types of risk banks face. In practice, Basel
II tries to achieve this by setting up meticulous risk and capital requirements aimed at
ensuring that a bank holds capital reserves appropriate to the risk the bank exposes
itself to. These rules imply that the greater the risk a bank is exposed to, the greater
the amount of capital a bank needs to hold to safeguard its solvency. The soundness of
the banking system is important because it limits economic downturn related to the
financial anxiety. Prudential regulation is expected to protect the banking system from
these problems by persuading banks to invest prudently. The introduction of capital
adequacy regulations strengthen bank and therefore, enhance the resilience of negative
shocks. However, these rules may cause a shift of providing loans from private sector
to public sector. Banks can comply with capital requirement ratios either by
decreasing their risk weighted assets or by increasing their capital.

1.2.4 Non Performing Loans/Assets

Nonperforming loans occurs due to poor risk management and plain bad luck because
of external independent factors. The inflation, deregulation and special market
conditions can lead to poor credit lending decision which in turn leads to
nonperforming loans.

Ongoing financial crises suggest that Non Performing Loans amount is an indicator of
increasing threat of insolvency and failure. However, the financial markets with high
Non Performing Loans have to diversify their risk and create portfolio with NPLs
along with performing loans, which are widely traded in the financial markets. Non
Performing Loan Ratios act as a strong economic indicator. Efficient credit risk
management supports the fact that lower Non Performing Loan Ratio (NPLR) is
associated with lower risk and deposits rate. However it also implies that in the long
run, relatively high deposit rate increases the deposit base in order to fund relatively
high risk, loans and consequently increases possibility of Non Performing Loan Ratio
(NPLR). Therefore, the allocation of the available fund and its risk management
heavily depend on how the credit risk is handled and diversified the NPL amount.

Nonperforming loans/assets is a probability of loss that requires provision. Provision

amount is “accounting amount” which can be further, if the necessity rises, deducted
from the profit. Therefore, high NPLs amount increases the provision which in turn
reduces the profit. It proves that Non Performing Loan Ratio and Capital Adequacy
Ratio are reasonably considered as credit risk management indicators.

1.2.5 Credit Risk Management in Banks

Bank loan is a debt, which entails the redistribution of the financial assets between the
lender and the borrower. The bank loan is commonly referred to the borrower who got
an amount of money from the lender, and need to pay back, known as the principal. In
addition, the bank normally charges a fee from the borrower, which is the interest on
the debt. The risk associated with loans is credit risk.
Credit risk is perhaps the most significant of all risks in terms of size of potential
losses. Credit risk can be divided into three risks; default risk, exposure risk and
recovery risk. As extension of credit has always been at the core of banking
operations, the focus of banks‟ risk management has been credit risk management. It
applied both to the bank loan and investment portfolio. Credit risk management
incorporates decision making process before the credit decision is made; follow up of
credit commitments including all monitoring and reporting process. The credit
decision is based on the financial data and judgmental assessment of the market
outlook, borrower, management and shareholders. The follow up is carried out
through periodic reporting reviews of the bank commitments by customer.
Accordingly, warning systems signal the deterioration of the condition of the
borrowers before default whenever possible. Loans that are in default or close to being
default become NPLs. The terms of the default rate in loans are defined by each 23
bank. Usually, loan becomes non performing after being default for three months but
this can depend on contract terms. NPLR shows the proportion of the default or near
to default loans to the actual performing loans. It indicates the efficiency of the credit
risk management employed in the bank. Therefore, the less the ratio the more
effective the credit risk management.

Capital is needed to cover the risks of such losses. Banks have an incentive to
minimize capital they hold since reducing capital frees up economic resources that can
be directed to profitable investment. In contrast, the less capital a bank holds, the
greater is the likelihood that it will not be able to meet its own debt obligations, that is,
the losses in a given year will not be covered by profit plus available capital , and that
the bank will become insolvent. Accordingly, banks must carefully balance the risks
and rewards of holding capital. A number of approaches exist to determine how much
capital a bank should hold.

The IRB approach adopted by Basel II focuses on the frequency of bank insolvencies
arising from credit losses that supervisors are willing to accept. Through IRB
approach, the Basel Committee intended to develop a framework which is credible,
prudentially sound and reflect healthy risk management practices. Banks have made
use of internal rating system for very long time as a means of categorizing their
exposure into broad, qualitatively differentiated layers of risk.

1.2.6 Increased trust on Banking Supervision and Risk Management

To strengthen banking supervision, an independent Board for Financial Supervision

(BFS) under the RBI was constituted in November 1994. The board is empowered to
exercise integrated supervision overall credit institutions in the financial system,
including select Development Financial Institutions (DFIs) and Non Banking
Financial Companies (NBFCs) relating to credit management, prudential norms and
treasury operations.

A comprehensive rating system based on the Capital adequacy, Asset quality,

Management, Earnings, Liquidity, Systems and Control (CAMELS) methodology has
also been instituted for domestic banks , for foreign banks the rating system is based
on Capital adequacy, Asset quality, Liquidity, Compliance and System (CALCS).
This rating system has been supplemented by a technology enabled quarterly off-site
surveillance system.

To strengthen the Credit Risk Management process in banks, in line with proposed
Basel I and Basel II accord, the RBI has issued guidelines for managing the various
types of risks that banks are exposed to make Credit Risk Management an integral
part of the Indian banking system, the RBI has also issued guidelines for Risk Based
Supervision (RBS) and Risk Based Internal Audit (RBIA).

These reform initiatives are expected to encourage banks to allocate funds across
various lines of business on the basis of their risk adjusted return on capital. These
measures would also help banks be in line with the global best practice of risk
management and enhance their competitiveness. The Indian Banking industry has
come along way since the nationalization of banks in 1969. The industry has
witnessed great progress, especially over the past 12 years and is today a dynamic
sector. Reforms in the banking sector have enabled banks explore new business
opportunities rather than remaining confined to generating revenues from
conventional systems. A wider portfolio, besides the growing emphasis in consumer
satisfaction, had led to the Indian banking sector reporting robust growth during past
few years.

1.3 STATEMENT OF THE PROBLEM

The Indian financial system consists of Financial Institutions, Financial Markets,

Financial Instruments and Financial Services. The Commercial Banks are the major
constituents of the Indian Financial System, Which plays a major role by transacting
the money from the surplus units to deficit units. The Commercial banks are
functioning in the competitive environment where one bank competes with another for
its survival and its success. The survival of the Financial Institution in general and
banks in particular is largely depending upon their performance and the profit earning
capacity. The profit earning capacity of banking business is influenced by a number of
factors; one of the important factors which have a bearing on the profitability of the
banks is Credit risk.

A strong banking sector is important for a flourishing economy. The failure of the
banking sector may have an adverse impact on other sectors also. Credit Risk is the
inability of the borrowers to meet their dues or commitments, which is one of the
major concerns for banks in India. Credit Risk is one of the major issues for banking
sector.

Granting Credit for economic activities is the prime duty of banking apart from raising
resources through fresh deposits , borrowing and recycling of funds received back
from borrowers constitute a major part of funding credit dispensation activity.
Lending is generally encouraged because it has the effect of funds being transferred
from the system to productive purposes, which results in economic growth. However,
lending also carries a risk called Credit Risk, which arises from the failure of
borrower.

The risks to which banks are exposed broadly classified as credit risk, liquidity risk,
interest risk, market risk, operational risk and management/ownership risk. While
each of these risks contributes to the total risk to which a bank is exposed, it is
perhaps the credit risk which stands-out as the most dreaded one. The nature and
extent of credit risk therefore, depend on the quality of loan assets and soundness of
investments.

Generally the day to day operations of the banking units are subject to a number of
risks. The total amount of risks faced by the banking units can be classified into two
types; controllable and uncontrollable. The banks have proper mechanism to identify,
measure and control the risk factors. The availability of proper risk monitoring and
controlling system helps the banking units to manage the risk factors in an efficient
manner and helps the bank to reduce their level of Non Performing Assets

Non Performing Assets reflect the performance of banks. A high level of Non
Performing Assets suggests high probability of a large number of credit defaults that
affect the profitability and net worth of banks and also erodes the value of assets. The
large volume of Non Performing Assets growth involves the necessity of provisions
which reduce the overall profits and shareholders’ value.

The magnitude of Non Performing Assets has a direct impact on the profitability of
banks as legally they are not allowed to book income on such assets as per the RBI
guidelines. Credit risk management system to oversee the management of Non
Performing Assets is an important parameter in the analysis of financial performance
of banks.

Risk management as a discipline is being taken seriously now a days. Nevertheless,

the financial storm teaches several key lessons which can assist to improve the risk
management in future. As a result, risk has become a very challenging area of studies.
This motivated the researcher to take up research on Credit Risk Management in
Commercial Banks.

Non recovery of loans along with interest forms a major hurdle in the process of credit
cycle. Thus, these loan losses/assets affect the bank’s profitability on a large scale.
NPAs have emerged since over a decade as an alarming threat to the banking industry
in India sending distressing signals on the sustainability and endurability of the banks
affected.

Despite various correctional steps administered to solve and end this problem,
concrete results are eluding. It is a sweeping and all pervasive virus that has
confronted universally the banking and financial institutions.

The non performing assets make a drastic impact on working of the banks. The
efficiency of a bank is not always reflected only by the size of its balance sheet by the
level of return on its assets. Non Performing Assets do not generate interest income
for the banks, but at the same time banks are required to make provisions for such
Non Performing Assets from their current profits.It is to be noted that the stock of
Non Performing Assets does not add to the income of the bank while at the same time,
additional cost is incurred for keeping them on the books.

To help the banking sector in clearing the old stock of chronic Non Performing
Assets, RBI has announced onetime on discretionary and non discriminatory
compromise settlement schemes in 2000 and 2001. Though many banks tried to settle
the old Non Performing Assets through this transport route, the response was not to
the extent anticipated as the banks had been bogged down by the usual fear psychosis
of being averse to settling dues where security was available.

Loan loss provisioning and write off go to reduce the capital available for further asset
creation. Gross NPAs do not, however disclose the entire picture of the over dues
from borrowers. These exclude unpaid interest including any penal interest accursed
on NPAs and as a prudential measure not recognized as income in the bank’s financial
statements.

A write-off of the Non Performing Assets involves foregoing of the accrued interest.
Hence, the magnitude of such interest dues assumes importance in accessing the likely
losses, a bank may suffer because of Non Performing Assets.

The tightened RBI norms for reckoning assets as Non Performing Assets and for non
recognition of income from such assets (by reducing the minimum period of debt
servicing default from 12 months to 90 days ), effective from the quarter ended march
2004, would presumably have resulted in significant additions to Non Performing
Assets during the financial year 2004.

The high level of Non Performing Assets in banks is a matter of grave concern to the
Public as well as to the Government. Since the bank credit is a catalyst to the
economic development of the country and any bottleneck in the smooth flow of credit
due to the mounting Non Performing Assets is bound to create an adverse
repercussion for the Economy of the Country.

Credit Risk Management has emerged as a big challenge for the Indian banking
system. Therefore, it is attempted to make a study of Credit Risk Management in
Commercial Banks to evaluate the credit efficiency by analyzing Credit deposit ratio,
Capital adequacy ratio, Management of Non Performing Loans/Assets and branch
managers‟ perception of Credit Risk Management System to oversee the management
of nonperforming loans/assets of sample branches.

It is in this context, the researcher has undertaken a study of Credit Risk Management
in Commercial Banks.

1.4 TYPES OF CREDIT RISK

1.4.1 Credit Default Risk

The risk of loss which arises from the debtor being unlikely to repay the amount in
full or when the debtor is more than 90 days past is the due date of credit payment, it
gives rise to credit default risk. The Credit default risk impacts all the sensitive
transactions which are based on credit like loans, derivatives or securities. Credit
default risk is also checked by banks before approving any credit cards or personal
loan.

1.4.2 Concentration Risk

This is the type of credit risk which is associated with exposure of any single or group
with the potential to produce large losses to threaten the core operations of a bank. It
may arise in the single form of single name concentration even industry concentration.
1.4.3 Country Risk

The risk which arises from a sovereign state when it freezes the payments for foreign
currency overnight defaults or its obligation which is termed as sovereign risk.
Country risk is exclusively associated with the performance of macroeconomics of a
country and is also closely related to the political stability in the country. Sudden
instability, which tends to happen during the elections, results in high country risk.

1.4.4 Market risk

McKinsey defines market risk as the risk of losses in the bank’s trading book due to
changes in equity prices, interest rates, credit spreads, foreign-exchange rates,
commodity prices, and other indicators whose values are set in a public market. Bank
for International Settlements (BIS) defines market risk as the risk of losses in on- or
off-balance sheet positions that arise from movement in market prices. Market risk is
prevalent mostly amongst banks who are into investment banking since they are active
in capital markets. Investment banks include Goldman Sachs, Bank of America,
JPMorgan, Morgan Stanley and many others.

Market risk can be better understood by dividing it into 4 types depending on the
potential cause of the risk:

Interest rate risk: Potential losses due to fluctuations in interest rate

Equity risk: Potential losses due to fluctuations in stock price

Currency risk: Potential losses due to international currency exchange rates (closely
associated with settlement risk)

Commodity risk: Potential losses due to fluctuations in prices of agricultural,

industrial and energy commodities like wheat, copper and natural gas respectively.

1.4.5 Operational risk

According to the Bank for International Settlements (BIS), operational risk is defined
as the risk of loss resulting from inadequate or failed internal processes, people and
systems or from external events. This definition includes legal risk, but excludes
strategic and reputation risk. Operational risk can widely occur in banks due to human
errors or mistakes. Examples of operational risk may be incorrect information filled in
during clearing a check or confidential information leaked due to system failure.

Operational risk can be categorized in the following way for a better understanding:

Human risk: Potential losses due to a human error, done willingly or unconsciously
IT/System risk: Potential losses due to system failures and programming errors

Processes risk: Potential losses due to improper information processing,

leaking or hacking of information and inaccuracy of data processing

Operational risk may not sound as bad but it is. Operational risk caused the
decline of Britain’s oldest banks, Barings in 1995. Since banks are becoming more
and more digital and shifting towards information technology to automate their
processes, operational risk is an important risk to be taken into consideration by the
banks.

Security breaches in which data is compromised could be classified as an

operational risk, and recent instances in this area have underlined the need for
constant technology investments to mitigate the exposure to such attacks.

1.4.6 Liquidity risk

It defines liquidity risk as the risk stemming from the lack of marketability of
an investment that cannot be bought or sold quickly enough to prevent or minimize a
loss. However if you find this definition complex, the term ‘liquidity risk’ speaks for
itself. It is the risk that may disable a bank from carrying out day-to-day cash
transactions.

Look at this risk like person A going to a bank to withdraw money. Imagine
the bank saying that it doesn’t have cash temporarily! That is the liquidity risk a bank
has to save itself from. And this is not just a theoretical example. A small bank in
Northern England and Ireland was taken over by the government because of its
inability to repay the investors during the 2007-08 global crisis.

1.4.7 Reputational risk

The Financial Times Lexicon defines reputation risk as the possible loss of
the organisation’s reputational capital. The Federal Reserve Board in the US defines
reputational risk as the potential loss in reputational capital based on either real or
perceived losses in reputational capital. Just like any other institution or brand, a bank
faces reputational risk which may be triggered by bank’s activities, rumors about the
bank, willing or unconscious non-compliance with regulations, data manipulation, bad
customer service, bad customer experience inside bank branches and decisions taken
by banks during critical situations. Every step taken by a bank is judged by its
customers, investors, opinion leaders and other stakeholders who mould a bank’s
brand image.
1.4.8 Business risk

In general, it defines business risk as the possibility that a company will have
lower than anticipated profits, or that it will experience a loss rather than a profit. In
the context of a bank, business risk is the risk associated with the failure of a bank’s
long term strategy, estimated forecasts of revenue and number of other things related
to profitability. To be avoided, business risk demands flexibility and adaptability to
market conditions. Long term strategies are good for banks but they should be subject
to change. The entire banking industry is unpredictable. Long term strategies must
have backup plans to avoid business risks. During the 2007-08 global crisis, many
banks collapsed while many made way out it. The ones that collapsed didn’t have a
business risk management strategy.

Systemic risk and moral hazard are two types of risks faced by banks that do not
causes losses quite often. But if they cause losses, they can cause the downfall of the
entire financial system in a country or globally.

1.4.9 Systemic risk

The global crisis of 2008 is the best example of a loss to all the financial institutions
that occurred due to systemic risk. Systemic risk is the risk that doesn’t affect a single
bank or financial institution but it affects the whole industry. Systemic risks are
associated with cascading failures where the failure of a big entity can cause the
failure of all the others in the industry.

1.4.10 Moral hazard

Moral hazard is a risk that occurs when a big bank or large financial institution takes
risks, knowing that someone else will have to face the burden of those risks.
Economist Paul Krugman described moral hazard as "any situation in which one
person makes the decision about how much risk to take, while someone else bears the
cost if things go badly. Economist Mark Zandi of Moody's Analytics described moral
hazard as a root cause of the subprime mortgage crisis of 2008-09
1.5 Mitigation of Credit Risk

There are multiple ways to mitigate the credit risk which are as follows:

A) Risk-Based Pricing

The lenders usually charge a higher rate of interest to borrowers who are defaulters.
This practice is known as risk-based pricing. The lenders take into consideration the
factors such as on purpose credit rating and loan to value ratio.

B) Credit insurance and credit derivatives

Bondholders hedge the risk by purchasing credit derivatives or credit insurances.

These contacts ensure the transference of the risk from the gender to the server against
a specific amount of payment. Credit default swap is the most common form of credit
derivative used in the market.

C) Covenants

Stipulations may be written by lenders to the borrowers which are called covenants.
These are usually written into loan agreements such as a periodic report about the
financial condition, refrain from paying dividends or further borrowing of amount or
any other specific action that affect the company’s financial position in a negative way
or repayment of the full loan at the request of the gender in events such as borrower
changes or changes in debt to equity ratio or change in interest coverage ratio.

D) Diversification

Lenders diversify their borrower pools and reduce the risk.

E] Deposit insurance

Governments may establish deposit insurance to guarantee bank deposits in the event
of insolvency and to encourage consumers to hold their savings in the banking system
instead of in cash.

F] Tightening

Lenders can reduce credit risk by reducing the amount of credit extended, either in
total or to certain borrowers. For example, a distributor selling its products to a
troubled retailer may attempt to lessen credit risk by reducing payment terms from net
30 to net 15.
 CHAPTER –II

A CONCEPTUAL FRAME WORK OF CREDIT RISK

MANAGEMENT

2.1 Introduction

2.2 Concept Of credit

2.3 Credit Definitions

2.4 Characteristics of credit

2.5 Research design

2.6 Scope of the study

2.7 Objectives of the study

2.8 Difficulties face to credit risk management

2.9 Challenges for credit risk management

2.10 Significance of Risk Management in Banks

2.11 Aspects of Credit Risk Management

2.12 Prudential Norms for Income Recognition, Asset Classification and Provisioning
(IRAC) Norms

2.13 Management of Non-Performing Assets

2.14 Capital Adequacy Norms

2.15 Recovery Measures

2.16 Conclusion
 CHAPTER – II

A CONCEPTUAL FRAME WORK OF CREDIT RISK

MANAGEMENT

2.1 INTRODUCTION

In this chapter an attempt has been made to highlight the Basel norms with
regards to Credit Risk Management in detail and the conceptual frame work of Non-
Performing 45 Assets (NPAs) and the salient features of Prudential relating to
management of NPAs. The Strategies adopted by the Central Government and RBI to
reduce the level of NPAs have also been discussed in this chapter.

2.2 CONCEPT OF CREDIT:

The word „credit‟ has been derived from the Latin word „credo‟ which means „I
believe‟ or „I trust‟, which signifies a trust or confidence reposed in another person.
The term credit means, reposing trust or confidence in somebody. In economics, it is
interpreted to mean, in the same sense, trusting in the solvency of a person or making
a payment to a person to receive it back after some time or lending of money and
receiving of deposits etc.3 In other words, the meaning of credit can be explained as,
A contractual agreement in which, a borrower receives something of value now and
agrees to repay the lender at some later date. The borrowing capacity provided to an
individual by the banking system, in the form of credit or a loan. The total bank credit
the individual has is the sum of the borrowing capacity each lender bank provides to
the individual.

2.3 CREDIT DEFINITIONS:

1. Prof. Kinley: “By credit, we mean the power which one person has to induce
another to put economic goods at his deposal for a time on promise or future payment.
Credit is thus an attribute of power of the borrower.”

2. Prof. Gide: “It is an exchange which is complete after the expiry of a certain period
of time”.

3. Prof. Cole: “Credit is purchasing power not derived from income but created by
financial institutions either as on offset to idle income held by depositors in the bank
or as a net addition to the total amount or purchasing power.”

4. Prof. Thomas: “The term credit is now applied to that belief in a man‟s probability
and solvency which will permit of his being entrusted with something of value
belonging to another whether that something consists, of money, goods, services or
even credit itself as and when one may entrust the use of his good name and
reputation.” On the basis of above definitions, it can be said that credit is the exchange
function in which, creditor gives some goods or money to the debtor with a belief that
after sometime he will return it. In other words, Trust‟is the „Credit‟.

5. Vasant Desai: “To give or allow the use of temporarily on the condition that some
or its equivalent will be returned.”

2.4 CHARACTERISTICS OF CREDIT:

Some characteristics of credit are of prime importance while extending credit to an

individual or to a business enterprise.

1. Confidence:

Confidence is very important for granting or extending any credit. The person or
authority must have confidence on debtor.

2. Capacity:

Capacity of the borrower to repay the debt is also very crucial thing to be considered.
Before granting or extending any advance, creditor should evaluate the borrower’s
capacity.

3. Security:

Banks are the main source of credit. Before extending credit, bank ensures properly
about the debtor’s security. The availability of credit depends upon property or assets
possessed by the borrower.

4. Goodwill:
If the borrower has good reputation of repaying outstanding in time, borrower may be
able to obtain credit without any difficulty.

5. Size of credit:

Generally small amount of credit is easily available than the larger one. Again it also
depends on above factors.

6. Period of credit:

Normally, long term credit cannot easily be obtained because more risk elements are
involved in its security and repayments.

2.5 RESEARCH DESIGN

The main task is to find the causes and to say to what extent they lead to such effects
i.e. it is to explain the causal relationship between variables. So explanatory research
design is used to find the cause and effect relationship between the various indicators
of credit risk and the indicator of profitability.

2.6 SCOPE OF THE STUDY

The Scheduled Commercial Banks command control over two thirds of the total assets
of the financial sector with a network of more than 80,000 branches across the country
and constitute the most significant segment of the financial sector. Hence, the present
study is confined to SCBs coming under Public Sector, Private Sector and Foreign
Banks. The study has excluded the Regional Rural Banks (RRBs) which forms a part
of the Indian Scheduled Commercial Banks. The banks‟ credit efficiency can be
measured by Credit risk management system employed by the banks. The areas
covered under the study are the proportion of credits with deposits, measure of capital
base through Capital adequacy ratio, Credit Risk Management System to see the
Management of Non Performing Assets in different bank groups, such as levels of
Non Performing Assets of different bank groups, assets quality of different bank
groups, recovery of Non Performing Assets of these banks through various measures,
and perceptions of branch managers on issues related to Non Performing Assets
management. All the above issues have been identified by the researcher for detailed
analysis and interpretations.

2.7 OBJECTIVES OF THE STUDY

The present study has the following objectives;

1. To study the practices of Credit Risk Management System in the Indian Banking
Sector with regard to Basel Accord,

2. To study the concept of Non Performing Assets and Prudential norms regarding
management of NPAs and Risk Weighted Assets,

3. To appraise the Credit Risk Management System employed by SCBs,

4. To examine Credit Deposit Ratio, Capital Adequacy Ratio, Gross NPAs to Gross
Advances Ratio, Net NPAs to Net Advances in measuring credit efficiency of banks,

5. To study the perceptions of branch managers of the study units towards Credit Risk
Management System and

6. To offer summary of findings, suggestions and conclusion of the study.

2.8 DIFFICULTIES FACE TO CREDIT RISK MANAGEMNET

Banks in emerging markets like India face intense challenges in managing Credit
Risk. These may be determined by factors external/internal to the bank. The external
factors include:

• Delay in production schedules/production difficulties o f borrowers

• Frequent instability in the business environment

• Wide swings in commodity/equity prices, foreign exchange rates and interest rates

• Legal framework less supportive of debt recovery

• Financial restrictions

• Government policies and controls

• Economic sanctions

• Natural disasters, etc

These may be aggravated by internal factors / deficiencies in the management of

credit risk within the bank like:

 Deficiencies in loan policies / administration

 Lack of portfolio concentration limits
 Excessive centralization or decentralization of lending authority
 Deficiencies in appraisal of financial position of the borrowers
 Poor industry analysis
 Excessive reliance on collateral
 Inadequate risk pricing
  Poor controls on loan documentation
 Infrequent customer contact
 Inadequate post-sanction surveillance
 Lack of articulated loan review mechanism
 Failure to improve collateral position as credits deteriorate
 Absence of stringent asset classification and loan loss provisioning standards
 Inadequate checks and balances in the credit process
 Failure to control and audit the credit process effectively.

These deficiencies can lead to loan portfolio weaknesses, including over concentration
of loans in one industry or sector, large portfolios of non-performing loans and credit
losses.These may further lead to miss liquidity and ultimately insolvency. The fact
that the banks operate in an economic environment that poses objective difficulties for
good credit management gives all the more reason to strengthen their credit risk
management practices

2.9 CHALLENGES FOR CREDIT RISK MANAGEMENT

With the global financial crisis still recent, credit risk management is still the focus of
intense regulatory scrutiny. While stricter credit requirements as a “top-down”
approach have helped mitigate some economic risk, it has left many companies
struggling to overhaul their approach to credit risk assessment.
In the scramble to implement risk strategies to improve overall performance and
secure a competitive advantage, a company must overcome significant credit risk
management challenges, such as:

1. Inefficient Data Management

Credit risk management solutions require the ability to securely store, categorize and
search data based on a variety of criteria. Any database needs to be updated in real
time to avoid potentially outdated information, as well as be keyword optimized to
ensure easy location of information.

2. Limited Group-Wide Risk Modeling Infrastructure

Sometimes it’s not enough to examine the risk qualities posed by a single entity—
a broad, comprehensive view of all risk measures as seen from above is key to
understanding the risk posed by a new borrower to the group. Robust stress-testing
capabilities and model management that spans the entire modeling life cycle is key to
ensuring accurate risk assessment.
3. Lacking Risk Tools
Identifying portfolio concentrations or re-grade portfolios is essential to ensuring
you’re seeing the big picture. A comprehensive risk assessment scorecard should be
able to quickly and clearly identify strengths and weaknesses associated with a loan.

4. Less-than-intuitive Reporting and Visualization

Forget cumbersome spreadsheet-based processes—to glean the most valuable insights,
data and analysis must be presented in an intuitive, clean and clearly visualized way.
Stripping away irrelevant data that overburdens analysts and IT can help zero in on
the most pertinent information.
The credit risk management software offered by GDS Link is state of the art and
provides the most accurate assessment of risk possible. Contact us today to find out
how we can add value and security to your investments.

2.10 SIGNIFICANCE OF RISK MANAGEMENT IN BANKS

The concept of Credit Risk Management under Basel norms has been
discussed in the following paragraphs Evolution of risk management in banks is driven
by market forces on the one hand and development in banking supervisions on the
other, each side operating in a complementary and mutually reinforcing ways. Rapid
pace of change in the banking activities as well as sophistication of technology and
increasing exposures to a diverse set of markets, have made management of risk a core
function within banks. Simultaneously supervisors also have an obvious interest in
promoting strong risk management in banking organizations because a safe and sound
banking system is critical to economic growth and stability of financial markets.

2.10.1 Risk

The risk, risk management and the importance of credit risk management has
been presented in the following paragraph; Risk is the threat that an event or action will
adversely affect an organization’s ability to achieve its objectives and successfully
execute its strategies. 1 Integrated Risk Management Development Wing/ Hand book
on “Risk Management and Basel II norms”, Canara Bank, June 2008, p.3-10. 46 Risk is
the probability of the unexpected happening – the probability of suffering loss. Risk can
be a potential loss and also can be a potential opportunity. As a bank, normally leverage
the potential opportunities by managing the inherent risk.

2.10.2 Risk Management

 Risk management is a planned method of dealing with the potential loss or
damage. It is an ongoing process of risk appraisal through various methods and tools
which continuously take care of the following functions;

 Assess what could go wrong

 Determine which risks are important to deal with

Implement strategies to deal with those risks

2.10.3 Elements of Sound Risk Management

The key elements of sound risk management are: Adoption of comprehensive

interest controls.

 Consistent formulation and application of policies and procedures

 Use of appropriate risk management techniques and reporting.

 Good Corporate Governance that is oversight by the board and

seniormanagement.

2.10.4 Advantages of Risk Management in Banks

Main management of sound risk management practices in banks are:

 Competitive advantages by way of lower regulatory capital charge

 Maintaining robust financial health.
 Increasing internal efficiency.
 Helps in effective decisions making.
 Proper pricing of services/products.
 Ensure adequate provisioning.
 Sound reputations and confidence in the market.
 Optimum contributions to stakeholders.

2.11 ASPECTS OF CREDIT RISK MANAGEMENT

The explanatory variables include the five main aspects of credit risk management.
These variables are as follows:

a. Understanding Credit Risk and Credit Risk Management.

b. Credit Risk Identification

c. Credit Risk Assessment and Analysis

d. Credit Risk Monitoring

e. Credit Risk Analysis

2.12 PRUDENTIAL NORMS FOR INCOME RECOGNITION, ASSET

CLASSIFICATION AND PROVISIONING (IRAC) NORMS

The major issues arising in the case of non- performing assets are the
recognition of income and determination of the quality of the assets followed by
adequate provisioning56. In its Annual Report, 1991-92, RBI has stated that “if the
balance sheet of a bank is to reflect actual financial health of that bank, there has to be a
proper system of recognition of income, classification of assets and provisioning for
bad debts on a prudential norm.

Consequently, RBI introduced a new set of prudential norms on income

recognition, asset classification, and provisioning known as IRAC norms in the year
1992-93 based on the recommendations of Narasimham Committee- I (Committee on
Financial System) with a view to enhance operational efficiency, productivity and with
the aim of imparting strength to the banking system as well as ensuring safety and
soundness through greater transparency accountability and public credibility.

The prudential norms for Commercial banks recommended by the

Narasimham Committee can be broadly classified into four categories:

a. Income recognition.

b. Classification of assets.

c. Provisioning for bad and doubtful debt and

d. Capital adequacy norms.

The salient features of the prudential norms are discussed below:

2.12.1 Income Recognition

Income recognition refers to accounting of interest income, commission and

other income at branch level for various advances and other services. In May 1989, the
RBI had issued another circular no. DBOB.BP. BC. 133/C469-89 dated 26.05.1989
stating that:

 Banks should not take into their income account, interest on loan classified
underhealth code classification 6, 7, 8 from the quarter in which the individual
accounts are classified under these categories.
  As regards advances are classified under health code nos. 4 and 5, application
ofinterest will depend on availability of adequate security, at the discretion of the
bank taking into account the prospects of reliability of the security,

RBI issued fresh guidelines in respect of recognition of interest as income

effective from the financial year 1992-93. In terms of these directives, in those loan
accounts which have been identified as non-performing interest recognized based on
the record of recovery rather than accrual of interest i.e. interest is not recognized as an
income till it is realized; thus, for the purpose of recognition of income, banks are
required to classify their loan accounts into two categories: a) Performing assets (PAs)
b) Non- performing assets (NPAs) If the asset is “Performing”, income can be
recognized even on accrual basis. If the asset is “Non Performing”, interest there on can
be recognized only on cash basis i.e. when it is actually realized.

2.12.2 Asset Classification

For the purposes of provisioning, the Narasimham Committee I recommended

that bank and financial institution should classify their assets by compressing the eight
health codes to form broad groups, viz. standard, substandard, doubtful and loss assets.
According to the new prudential norms, the advances are broadly classified into
performing and non- performing assets. Performing assets are standard assets and Non
performing assets are further classified into substandard, doubtful and loss assets.

2.12.2.1 Performing Assets – Standard Assets

Performing assets are standard assets which do not disclose any problem and
do not carry more than normal risk attached to the business. The performing asset is
one, which generates income for the bank. An account is considered to be a standard
asset when it is in order or where the over due amount is within a period of 90 days and
in respect of direct agricultural advances if the amount overdue is less than 2 harvest
seasons but for a period not exceeding 2 half years.

2.12.2.2 Non Performing Assets

Banks are required to classify non-performing assets further into the following
three categories based on the period for which the assets has remained non-performing

1. Sub-standard assets

2. Doubtful assets

3. Loss assets
1. Sub-Standard Assets

In respect of loan accounts if any amount is overdue for a period of more than
90 days from the due date, the account should be classified as substandard asset
provided it is covered by adequate securities i.e. where erosion in securities is less than
50 percent of the value of securities. Such NPAs account can remain in substandard
category for a maximum period of 18 months with effect from 31st March 2005; this
period of 18 months is reduced to 12 months. In other words, if an asset is identified as
NPAs w.e.f. 31.3.2005 it would become doubtful, if not upgraded to standard category
within a period of 12 months from the date it became NPA.

In cases where the loan was granted as a clean or unsecured loan, the account
on becoming NPA for the first time should be treated as substandard only. However in
case of serious credit impairment or where the realisibility of dues is considered remote,
it may be treated as loss asset.

2. Doubtful Assets

The following account should be classified as doubtful assets,

a. An account which has completed 12 months in substandard category and which is

covered by security ECGC cover.

b. A non-performing asset where the erosion in securities is more than 50 percent of the
value and value of securities available is more than 10 percent of the outstanding
liability.

3. Loss Assets

A loss asset is one where the loss has been identified by the bank or internal or
external auditor or the RBI inspectors, but the amount has not been written off wholly
or partly. In other words, such as asset is considered uncollectible with little salvage or
recovery value.

Further if the realizable value of security as assessed by the bank or approved

valuer or RBI is less than 10 % of the outstanding in the borrowal accounts, such
accounts should be classified as loss assets. However, this is applicable only in cases
where there is erosion in the value of existing securities and not in the case of accounts
where the loan was granted as clean or unsecured.

Types of NPAs

The Non-Performing Assets are of two types;

a) Gross NPAs and

b) Net NPAs

a) GROSS NPAs

Gross NPAs are the sum total of all loan assets that are classified as NPAs as
per RBI guidelines as on balance sheet date. Gross NPAs reflect the quality of the loans
made by banks. It consists of all the non-standard assets like substandard, doubtful and
loss assets.

b) NET NPAs

Net NPAs are those type of NPAs in which the banks have deducted the
provision regarding NPAs. Net NPAs shows the actual burden of banks. Since in India,
bank balance sheet contains a huge amount of NPAs and the process of recovery and
write off of loans is very time consuming. The provisions the banks have to make
against the NPAs according to the central bank guidelines are quite significant.

The following are deducted from gross NPAs to arrive at net NPAs;

a) Balance in interest suspense account if applicable.

b) Deposit Insurance Guarantee Corporation, Export Credit Guarantee Corporation

claim received and pending adjustment.

c) Part payment received and kept in suspense account.

Total provisions held excluding technical write off made at head office and
provision of standard assets.

2.12.3.4Provision for Loss Assets

The entire assets should be written off. If the assets are permitted to remain in
the books for any reasons, 100 percent of the outstanding should be provided for.

To sum up, provisions are made for NPAs as per the guidelines prescribed by
the regularity authorities, subject to minimum provisions as prescribed below by the
RBI:

Substandard Assets

1. A general provision of 10%

2. Additional provision of 10% for exposures which are unsecured ab-initio (where
realizable value of security is not more than 10 percent ab-initio)
Doubtful Assets

1. Secured portion.

a) Up to one year – 20%

b) One to three years – 30%

c) More than three years – 100% 77

2. Unsecured portion 100%

Loss Assets- 100%

In respect of foreign bank, provisions for non performing advances are made
as per the local regulations or as per the norms of RBI, whichever is higher.

The sale of NPAs is accounted as per guidelines prescribed by the RBI, which
requires provision to be made for any deficit (where sale price is lower than the net
book value), while surplus (where sale price is higher than the net book value) is
ignored. Net book value is outstanding as reduced by specific provisions held and
ECGC claims received.

For restructured / rescheduled assets, provisions are made in accordance with

the guidelines issued by RBI, which requires that the present value of future interest
due as per the original loan agreement compared with the present value of the interest
expected to be earned under the restricting package be provided in addition to provision
for NPAs. The provision for interest sacrifice arising out of the above is reduced from
advances.

In addition to the specific provision on NPAs, general provisions are also made
for standard assets as per the extent prescribed by the RBI guidelines. The provisions
on standard assets are not reckoned for arriving at net NPAs. These provisions are
reflected in Schedule 5 of the balance sheet under the head “other liabilities and
provisions – others”.

2.13 MANAGEMENT OF NON-PERFORMING ASSETS

With the introduction of International norms of Income Recognition, Assets

Classification and Provisioning Norms (IRAC norms) in Indian banking sector, the
management of NPAs has emerged as one of the major challenges facing the Indian
Banks. The success of banking Industry depends mostly upon its ability to maintain the
level of its NPAs at minimum. Therefore, the Credit risk management system to
oversee the management of NPAs has assumed a significant and vital role. The
effective NPAs management is the top priority for any banking company for its
survival.

Generally, the objectives of NPAs management are to make the amount of

provision requirements. These objectives can be achieved by adopting the following
strategies:

1. Preventing slippage of performing assets into the one ofNon Performing Assets.

2. Upgrading non-performing assets into performing assets.

3. Liquidating non-performing assets through effective recovery of bad loans.

2.13.1 Strategies for NPAs Management

The NPAs management strategy has certain objectives. The most important
objectives are as followers;

Improving the quality of loan assets with a view to transferring them from
nonperforming status. As a result of such improvement in quality, income of such
assets can be recognized.

Upgrading the status of loan assets with a view to reducing the amount of
provisions to be made on such loan assets.

Cleaning the balance sheet loan assets and portion of doubtful assets thereby
achieving an improvement in capital adequacy ratio.

2.13.2 Preventive Measures

A study at the behest the Board for Financial Supervision (BFS) was
conducted by the Reserve Bank by scanning relevant information/ data obtained from a
select group of banks, as also by holding discussion with bank officials, who manage
NPAs at the policy level as well as those who look after actual recovery, rehabilitation/
revival, restructuring of accounts at the implementing level. On the basis of the study,
the RBI had suggested a frame work of recommendation for preventing slippage of
NPAs accounts from sub- standard to doubtful/ loss category. The following are some
of the recommendations for accounts.

2.13.3 Recognize the Problem Early

Invariables, by the time banks start their efforts to get involved in a revival
process; it is too late to retrieve the situation – both in terms of rehabilitation of the
project and recovery of banks dues. Identification of weakness in the very beginning
(i.e., when the account starts showing first signs of weakness regardless of the fact that
it may not have become NPA) is imperative. Assessment of the potential of revival may
be done on viability study. Restricting should be attempted where, after an objective
assessment of the viability and promoter‟s intention (and his stake), banks are
convinced of a turnaround within a scheduled timeframe. In respect of totally unviable
units as decided by the bank/ consortium, it is better to facilitate winding up/ selling of
the business unit early, so as to recover whatever is possible through legal means before
the security position becomes worse.

2.13.4 Special Mention Accounts

A system of early recognition with timely and adequate interventions may

form the focus of approach in dealing with slippage of NPAs. In this context, RBI had
issued guidelines in 2003 where under banks have been advised to introduce a new
asset category “ Special Mention Accounts”, in between “Standard” and “Sub-
standard” categories for their internal monitoring and following up.

2.13.5 Early Alert System

The strategy of management of NPAs may be governed by the circumstances

connected to each individual case. Generally, the NPAs is more likely to be resolved in
terms of recovery if the company is in operation. For this to be effective there must be a
system of identifying the weakness in accounts at an early stage. Banks may put in
place 80 an “early alert” system that captures early warning signals in respect of
accounts showing first signs of weakness. This system may be an integral part of the
risk management process of the bank. Internationally, there is a similar system of
“special mention accounts”. Depending upon the identified weakness, one may go back
(rather than with reference to current period) to a prior earlier period in determining the
rehabilitation response.

2.13.6 Prompt Corrective Action (PCA)

A scheme of prompt corrective action based on certain triggers had been

introduced in December 2002 as a supervisory tool on an experimental basis. The
trigger points are Capital Adequacy Ratio (CAR), Net NPAs and Return on Assets
(ROA). The scheme is aimed at talking action at an early stage, when banks show
incipient sign of weaknesses. For every trigger point, certain structured and mandatory
actions have been laid down.

2.14 CAPITAL ADEQUACY NORMS

A system of capital adequacy was implemented on the model suggestion by

bank committee on capital convergence. The capital to risk weighted assets ratio
(CRAR) is the most widely employed to measure the soundness of a bank. The CRAR
of the bank reflects its ability to withstand shocks in the event of adverse developments.
The global range for capital adequacy ratio lies between 8.8% to 37.1%. Taking in to
consideration the substantial off Balance sheet exposures of banks, the Narashimham
Committee (1997) had recommended enhancement of CAR from the present stipulation
of 8% to 10% by 2002. Endorsing this decision, the union budget 1998-99 announced
raising ratio to 9 % by March 31, 2000 and to 10% as early as possible thereafter. 81
Further, according to RBI guidelines banks are eligible to declare dividends without the
RBI approval if they have a CAR of at least 11% for the preceding two years and the
fiscal year for which they propose to declare dividend.

2.15 RECOVERY MEASURES

The Central Government and RBI have also taken several steps to reduce the
NPAs in the banking system. Some of the important measures for recovery of NPAs are
described below;

2.15.1 Compromise Settlement Scheme (CSS)

The broad framework for compromise or negotiated settlement of NPAs

advised by RBI in July 1995 continues to be in place. Banks are free to design and
implement their own policies for recovery and write-off, incorporating compromise and
negotiated settlement with the approval of their boards, particularly for old and
unresolved cases falling under the NPA category. The policy framework suggested by
RBI provides for setting up an independent Settlement Advisory Committee headed by
a retired judge of the high court to scrutinize and recommend compromise proposal.

2.15.2 One-Time Settlement Scheme (OTS)

One-Time Settlement Scheme (OTS) was launched for the first time in May
1999. Specific guidelines were issued to Public Sector Banks (PSBs) for onetime
nondiscretionary and non-discriminatory settlement of NPAs of small sectors. It was
again introduced in July 2000. In May 2003, the time limit for processing of
applications received under the revised guidelines for Compromise Settlement of
chronic NPAs of PSBs up to Rs 10crore was extended to December 2003. Based on the
requests received for extending the time limit for operation of the guidelines and in
consultation with the government of India, the time limit for receiving application was
extended up to July 31, 2004. The guidelines are applicable to cases in which the banks
have initiated action under the SARFAESI Act 2002 and also cases pending before
courts (DRTs), subject to consent decree being obtained from the courts/ DRTs.

2.15.3 Lokadalats

One of the initiatives taken by the DRTs for recovery of NPAs is that DRTs
have started holding “Lokadalats”. The concept of Lokadalats was introduced by the
Chief Justice of India, Shri.P.N.Bhagwati in the year 1982 as a part of legal aid. By
now, it has become a usual feature of the legal system for effecting mediation and
conciliation between the parties and to reduce burden on the Courts/ DRTs especially
for small loans.

As for as recovery of smaller loans is concerned, the Lokadalats have proved a

very good agency for quick justice and settlement of dues. With the enactment of Legal
Services Authority Act, 1987, Lokadalats were conferred a judicial status and have
since emerged as a convenient method for settlement of disputes between banks and
small borrowers.

The RBI has issued guidelines to Commercial Banks and Financial Institutions
to enable them to make increasing the use of Lokadalats convened by various DRTs/
Debt Recovery Appellate Tribunals (DRATs) for resolving cases involving Rs.10lakhs
and above to reduce the stock of NPAs. The government has in August 2004, revised
the monetary ceiling of cases referred to Lokadalats organized by Civil Courts. As a
result, the scope of the Lokadalats is now expanded to cover both suit filed and non-suit
filed cases for recovery of dues in accounts failing in „Doubtful‟ and „Loss‟ categories
with outstanding balance up to Rs.20lakhs, by way of Compromise Settlement.

2.15.4 Debt Recovery Tribunals (DRTs)

The recovery of debts due to Banks and Financial Institutions Act, 1993 was
enacted on 24thAugust 1993 to provide for the establishment of Debt Recovery
Tribunals (DRTs) for expeditious adjudication and recovery of debts due to Banks and
Financial Institutions and the matters connected there with and incidental thereto. At
present, there are 29 DRTs set up at major centers in the country with 5 Debt Recovery
Appellate Tribunals (DRATs) located in five centers viz. Allahabad, Mumbai, Delhi,
Calcutta and Chennai. The Act was amended in the year 2000.

On the recommendation of the Reserve Bank, the Government of India set up a

working group under the Chairmanship of Shri.S.N.Aggarwal in July 2004 to review
the existing provisions of the said Act and improve the functioning of DRTs. The
working group was expected to examine issues and recommend appropriate measures
regarding;

1. The need to extend the provisions of the recovery of debt due to Banks and Financial
Institution act to cases of less than Rs.10lakh.

2. Redistribution of the jurisdictions of the various DRTs.

3. Modification in the existing strength of the DRTs/ Debt Recovery Appellate

Tribunals (DRATs).

4. Legal and institutional provisions.

 The working group suggested amendments to the Act and Rules framed
thereunder. The government has substantially amended the Debts Recovery Tribunals
(procedures) Rules, 2003 to facilitate better administration of the act including plural
remedies for banks.

2.15.5 Corporate Debt Restructuring (CDR)

One of the methods suggested for the reduction of non-performing assets is

Corporate Debt Restructuring (CDR). The process is primarily rescheduling the debt
portfolio of the borrowing among is creditors to help the borrowers in the revival of
projects, reduction in existing debt burden and establishment of new credit lines with
implied consumption that the lender would prefer reduction in risk to optimization of
returns. The object of the CDR is to ensure a timely and transparent mechanism for
restructuring of the corporate debts of viable corporate entities affected by internal and
external factors, outside the purview of BIFR, DRT or other legal proceedings, for the
benefit of all concerned. It is applicable to standard and sub-standard accounts with
potential cases of NPAs getting a priority. The scheme of Corporate Debt Restructuring
(CDR) was developed in India based on international experience and detailed
guidelines on the same were issued to banks and financial institutions in 2002 for
implementation. The scheme was future fine-tuned in February 2003 based on the
recommendations made 62http:/www.Ficci.com/Ficci/Surveys/Survers-banking.html.
63http:/www.The Hindu Business Line.com/2005/04/11stories. 88 by a working group
under Shri.Vepakamesam. It has three tire structures namely CDR standing forum,
CDR empowered group and CDR cell.

2.15.6 Circulation of Information on Defaulters

Periodical circulation of debts of willful defaulters of banks and financial

institutions by RBI is also suggested as a measure for reduction of NPAs. Now, RBI
has published a list of borrowers (with outstanding aggregate Rs.1crore and above)
against whom suits have been filed by banks and financial institution as on 31st march
every year.

2.15.7 National Company Law Tribunal (NCLT)

A revised framework of constituting the National Company Law Tribunal

(NCLT) and the National Law Appellate Tribunal (NCLT) has been provided for in the
Companies Act through the companies (Secondary Amendment) Act, 2002 to replace
the Board for Industrial and Financial Reconstruction (BIFR) besides looking at revival
and rehabilitation of sick companies and the liquidation process, the NCLT will also
handle the work of the Company Law Board.
2.15.8 Write – Off

Write- off is the last resort of NPAs management techniques. The bad debts
which are unrecoverable have to be written off from the banks sheet. It is an internal
mechanism of the banks to clear up the unproductive assets from the balance sheet, but
it, no other way, prevents the banks to recover the dues from the borrowers.

With regard to write off of bad loans by banks, the Supreme Court, in its recent
judgment has held that Commercial banks in consultation with the RBI are empowered
to write off non-performing assets running to crores. One cannot draw an adverse
inference of mismanagement against the bank concerned for doing so.

CONCLUSION

In any business, an element of bad debt is inevitable. Banking is a business

and therefore, NPAs are inevitable/. In a banking system like that of India, while
miracles cannot be expected from banks with different ownership, patterns, cultures and
client bases, it could be said that a fair degree of improvement of NPAs can be ensured.
The key drives of the banking sector would be competition, consolidation and
convergence. Therefore, there is a need to treat reduction of NPAs in banking sector as
a national priority item to make strong, resilient and geared up banking system to meet
the challenges of globalization.
 CHAPTER III
PRINCIPLES AND REGULATIONS OF CREDIT
RISK MANAGEMENT

3.1 Introduction
3.2 Concept of credit risk
3.3 Principles of Credit Risk Management
3.4 Establishing an appropriate credit risk management
3.5 Operating under a sound credit risk granting process
3.6 Maintaining an appropriate credit administration, measurement and monitoring
process
3.7 Ensuring adeaquate controls over credit risk
3.8 Role of supervisor of the banking system
 CHAPTER III
PRINCIPLES AND REGULATIONS OF CREDIT RISK
MANAGEMENT

3.1 INTRODUCTION
Banks have faced difficulties, which sometimes have led to bank failures also for various
reasons. The main cause of any serious banking problems appears to emanate from the
credit portfolio of the bank. An enquiry into many bank failures or bank's poor financial
soundness has always indicated that such difficulties are directly related to lax credit
standards of lending and poor credit risk management. Not understanding changes in
economy or other factors or not taking corrective steps can lead to deterioration in the credit
quality and financial standing of the banks. This experience is common in both developed
and underdeveloped nations.

3.2 CONCEPT OF CREDIT RISK

Credit risk in its simplest definition would mean as the potential that a bank borrower or
counterparty will fail to meet his obligations in accordance with agreed terms. While the
failure of a counter party could also happen in other areas of banking like investment,
foreign exchange, guarantee transactions, the major source of credit risk for the banks
originate from loans and advances. In fact, credit risk is existing through all the activities of
the bank. Managing the credit risk is essential to improve the profitability of the bank by
maximizing bank's risk adjusted return (i.e., after providing for any loan losses). This
involves managing the credit risk both in micro as well as macro situations. The bank must
manage the credit risk of individual transactions and also, the portfolio. Managing credit
risk also means managing other related risks such as liquidity risk, interest rate risk, legal
risk etc., In fact risk management is enterprise wide and credit risk is a critical component of
the system and a comprehensive and balanced approach is needed to achieve the long-term
goals of the bank.
Credit risk is inherent in every transaction of every bank world- wide. While this is almost
axiomatic and bank managements ought to have learnt lessons from past experiences, the
frequent bank failures in various countries from time to time and, the financial crisis and
melt down of US banks and other European bank even in the recent past indicate that risk
management still needs improvement.

Banks should have keen understanding and awareness of the various dimensions of the
risks. They should be able to identify measure, monitor and control risks. In case risk
occurs, to protect the financial integrity of the bank should have adequate capital. The risk
management practices followed by banks may from bank to bank depend upon various
factors. The nature of credit extended, the complexities of transaction, the organizational set
up of the bank, legal environment in which the bank operate, the public policies of the
government, the nature and economic conditions of the country in which they operate are
some of the variables which affect the credit risk management practices.

3.3 PRINCIPLES OF CREDIT RISK MANAGEMENT

Realizing the need to improve and strengthen the system of risk management, Basel
Committee on Banking Supervision enunciated sound principles and practices of lending
and managing credit risk. These fundamental principles and practices are to be followed
along with the existing practices related to assessment of asset quality, the adequacy of
provisions and reserves. These general principles have global application in all transactions
where credit risk is inherent. However, on-site and off-site supervisory techniques used by
the bank and the degree to which external auditors are trained in bank evaluation
supervisory functions, the management expectations, on credit risk management also play a
role in effective implementation of risk management practices. The main purpose is that that
the credit risk management approach used is enough for the activities of the bank a
sufficient risk-return discipline is established in credit risk management processes of the
bank.

The sound principles set out by Basel Committee on Banking Supervision (BCBS) cover
five major areas namely

1. Establishing an appropriate credit risk environment;

2. Operating under a sound credit-granting process

3.Maintaining an appropriate credit administration, measurement and

monitoring process;
4. Ensuring adequate controls over credit risk

5. Role of supervisor of the banking system (central bank)

Principles and practices covered in each of the broad areas identified by Basel Committee
on Banking Supervision are discussed below.

3.4 ESTABLISHING AN APPROPRIATE CREDIT RISK ENVIRONMENT

This area deals with the role of management and their responsibilities in creating a bank
wide and an appropriate credit risk environment to ensure a sound credit risk management
system.
A. Responsibility of the Board of Directors of the Bank:
It is the responsibility of the board of directors of the bank to approve and periodically
review the strategy of credit risk management. The directors should ensure that all
significant risk policies of the bank reflect the level of risk tolerance and expected
profitability based on the risk appetite of the bank. They have an important role to play in
credit approval and in overseeing of credit risk management functions as in other areas of
bank management. Every banks board should develop a risk strategy or plan recognizing
that the policies should cover many activities of the bank in which credit risk significant and
policies and procedures for conducting such activities.
The Board should ensure that the strategic plan developed clearly spells out the policy of the
bank's willingness to lend. The credit policy should list out types of credit (for example,
commercial, consumer, real estate), economic sector (agriculture, manufacturing service
mining etc), geographical location, ( domestic or overseas , specific regions for specific
credit types) currency (lending in Rupees or US dollars), maturity (minimum and maximum
periods for loans) and anticipated profitability (Minimum interest rate chargeable or base
rate and add on spread for different types of loan)). It should also cover the identification of
target markets (small and medium industries, exports of agricultural products,
pharmaceuticals, automobiles, consumer loans and retail loans like housing finance etc.).
The policy should also specify the overall parameters ( minimum portfolio return of certain
%) and characteristics (e.g. 80% of the portfolio should be secured loans, the average
maximum maturity period of the portfolio to be less than 5 years ) that the bank would want
to achieve in its credit portfolio including levels of diversification and concentration
tolerances( e.g. overall sectoral credit to mining sector should not exceed 3% of over all
credit of the bank). Every bank, regardless of size, or business mix is in business to make
profits. The credit policy should therefore specify the base rate (minimum rate below which
the bank will not lend to any borrower) taking into account the cost of capital. The board
should ensure that credit risk strategy determines the acceptable risk/reward trade-off,
recognizing credit quality, growth and earnings and should provide methods for selecting
risks and maximizing profits.
It is to be understood that credit policy is dynamic document and should be periodically
reviewed based on the financial results of the bank. Any changes needed due to changes in
economic factors, loan concentrations or problem loans, interest rate changes or regulatory
directions, then necessary changes must be made to the strategy. Since capital is the bulwark
against losses in protecting the banks soundness and financial viability, the board must also
determine the level of bank's capital which is adequate for risks assumed throughout the
entire bank.
A joint stock bank is a juristic person with perpetual existence. Therefore, in drawing the
credit risk strategy the board of directors of any bank should provide continuity in approach.
The strategy should consider cyclical aspects of business and economy and provide for
resultant changes and shifts in the composition and quality of credit portfolio. The policy
should be periodically assessed and if needed amended, to make it viable in the long-run
and through various economic cycles. It is an imperative that the credit risk strategy and
policies enunciated by the board of directors should be effectively communicated
throughout the bank. Everyone who assesses, approves, monitors or reports credit risk
should clearly understand the bank's priorities, approach and expectations in granting loans.
It should be the general policy of the bank that relevant personnel should be held
accountable for complying with established policies and procedures.
Since day to day operations are not supervised by the board, it is important that the board
should ensure that senior management is fully capable of managing the credit risk and
implement the risk strategy, policies and prudential limits approved by the board. For this
purpose, the board should see to that competent persons handle the credit portfolio and
provide for recruitment and training of such persons either with in credit policy parameters
or otherwise.
To enable the senior management to discharge their functions effectively, the board
of directors should approve (either within the credit risk strategy or by a separate statement
of credit policy), the bank's credit approval criteria including terms and conditions, the way
in which the bank will structure its credit risk management functions ( approving and
reporting lines of hierarchy) and the process of independent review of ( auditing) credit
function and overall credit portfolio.
The incentive for the senior management and other functionaries is the reward they get
when they perform well. There must also a feeling that deviant behavior will result in
punishment if the system must function efficiently and smoothly. To achieve these twin
goals the board of directors should ensure that the bank's remuneration policies do not
reward unacceptable behavior which weaken the banks credit risk strategy like exceeding
established limits, not obtaining securities or non-reporting or mis reporting of exception
transactions.
It is recognized well world over that outside directors, can be important sources of new
business for the bank. But specific policy must be in place to ensure whether directors can
get loans and if so how much and at what terms credit is granted. For avoiding conflicts of
interest, it is essential that board members do not override the credit approval and
monitoring processes of the bank. It is generally accepted that an interested director is not
allowed to be a party to the decision and excuse himself while other directors decide.

B. Role of senior management

While board of directors approves strategy and broad polices, the senior management of the
bank should be responsible for developing policies and procedures for identifying,
measuring, monitoring and controlling credit risk. Such policies and procedures should
address credit risk in all the bank's activities and at both the individual credit and portfolio
levels and implement the same.
The responsibility of the senior management includes ensuring that the bank's
credit approval process is carried out according to the established strategy. For this purpose,
they should ensure that written procedures are designed, developed and implemented for
each credit activity. To evaluate the success of implementation and make midcourse
corrections they must undertake a periodic independent assessment of the bank's credit risk
functions. Loan approval and review responsibilities are clearly defined and properly
assigned.
The design of written policy must include policies and procedures related to identifying,
measuring, monitoring and controlling credit risk. The policy must establish the framework
for lending and guide operating officials in approving credit applications and also address
issues relating to the following
✓ maintain sound credit approving standards;
✓ monitor and control of credit risk both individual and portfolio
✓ evaluate new business opportunities and inherent risk in them
✓ identifying non-performing loans and recovery of the same
This should naturally result in laying down clearly defined, guidelines consistent with
prudent banking practices and in conformity with relevant regulatory requirements with
regard to Target markets, portfolio mix, price and non-price terms, the structure of limits,
approval authorities, exception reporting, etc.,
The policies should also be adequate for the types and complex nature of the bank's business
mix and should be framed in the context of internal factors like staff capabilities, technology
constraints and external factors such as the bank's market position, area of operation, etc. In
drafting the policies and procedures the senior managers should make sure that that the
credit portfolio is adequately diversified given the bank's target markets and overall credit
strategy. The policy should be framed keeping in line with the target mix the bank wants to
achieve without compromising the individual and group exposure limits of their own
internal guidelines but also of the central bank. Specific industries, economic sectors,
geographic regions and specific products which reduce risk and improve returns must
be incorporated in the policy.
To be effective credit policies must be communicated throughout the organization, and this
becomes one of the major responsibilities of the senior management. Issue of internal
circulars, conducting special training programs, addressing group of officers responsible in
meetings are different ways by which the policies can be made known throughout the
organization in a short time.
Where a bank encourages international trade financing and grants credit for the same, in
addition to standard credit risk, risk associated with conditions in the home country, other
risks like default risk of the foreign borrower, country risk or sovereign risk, risks arising
out of economic, political and social environment of that foreign country should also be
taken into to account by the senior managers. The transfer risk, translation risk and the
effect of financial markets globalization risk (by way of imbalance of trade within a block)
of and the potential for spillover effects for the host country and contagion effects for an
entire region. The credit policy on international trade or foreign exchange business must be
specific in these aspects.
C. Proactive risk management

It is important that the risk management should be proactive. All procedures and controls
must be decided in advance before introduction or undertaking to reduce or eliminate the
risk inherent in credit products and activities. The identification and risk mitigation
measures and controls need to be approved by the board in advance or any appropriate
committee or authority entrusted with the responsibility. The senior managers have an
important role to play in the identification of existing and potential risks inherent in any
product or activity. Therefore, they should be able to banks identify all credit risk inherent
in the products the bank offers and the activities in which the bank is engaged. It is true that
such identification is possible only from a careful review of the credit risk characteristics of
the product or activity and that's where the role of the senior manager assumes importance.

In order to expand business banks, need to enter into new areas of business. Banks must
develop a clear understanding of the credit risks involved in complex credit activities (for
example, loans to oil exploration, satellite communications new drug research and
development ) asset securitization, customer-written options, advance credit derivatives,
etc.,) only because the credit risk involved, may be less obvious and demand more careful
analysis than the risk of traditional credit risk. It may also involve more complex credit
approval steps and may require tailored procedures and controls, which may require the
board approval, may be needed even though the basic principles of credit risk management
will still apply. In short if the venture if new or nontraditional, banks need to plan
significantly and careful oversight to ensure that risks are appropriately identified and the
process to manage them are put in place and appropriate approvals are obtained in advance.

While loaded with onerous responsibilities, the senior management also has adequate
powers to execute the same. It is senior management who determine who are all will be staff
involved in any activity where there is credit risk, on an activity which is established or
new, basic or more complex. This is a must since if the risk is not fully managed by capable
and competent staff to the highest standards and in compliance with the bank's policies and
procedures the entire exercise of credit management will crumble.

3.5 OPERATING UNDER A SOUND CREDIT GRANTING PROCESS

Banks must establish well defined credit criteria for approval of credit. This criteria must
incorporate clear understanding of the borrower ( his constitution), business risks the
borrower is undertaking, ( nature of activity like agriculture, manufacturing, trading or
export etc) the purpose of borrowing (like to start , to expand , to diversify business but not
for speculation), structure of credit ( like term loans, overdrafts, bills discounting or
guarantees etc) and source of repayment.
In designing well defined credit criteria, which is essential for sound risk management, the
following factors should be considered.
 Who is eligible for credit?
 How much credit borrower is eligible for?
 What types of credit are available for the borrower?
 Under what terms and conditions, the credits should be granted.
In order to determine the above four questions banks must receive enough information to
make a comprehensive analysis of the risk profile of the borrower and assessment of his
needs. It is important that the information leading to the decision is documented in
approving credit. One could easily relate such information to the age-old wisdom of lending
namely the Five Cs – character, credit, capacity, capital and collateral.
A. Know your customer
Banks should understand to whom they are lending. This has significance for different
purposes also. Eradication of black money and Anti-money laundering assuming global
importance, in an era of terrorist funding, a banker must know his customer better and
should become familiar with the borrower and be confident that they are dealing with an
individual or organization of sound repute and creditworthiness. This confidence he must
gain prior to entering into any new credit relationship. Therefore, a bank must put in place
strict policies for customer identification and antecedent verification with a view to avoid
association with individuals involved in fraudulent activities and other crimes. Asking for
references, verification through trade associations, checking their personal references and
financial condition through rating agencies are some of the steps a bank can initiate in this
regard.
The integrity and reputation of the borrower is the first line of defense for a banker. This has
to be analyzed with referenced to the repayment history. This indicates his willingness to
repay the borrowed sums.

B. Lending process

Before lending the purpose of the credit should be analyzed. Where a borrowing is for the
purpose of business, there is a possibility that it would be productively employed and
generate resources to repay. The current risk profile of the borrower and his business (its
sensitivity to economic and market developments) should be studied to understand the risk
undertaken by the bank in lending and to estimate the probability of default. How much loan
is sought and whether the banks' assessment supports his requirement.

It is always prudent to lend the amount required because under financing would harm the
business but excess lending also ruins the business equally. Banks must verify the source of
repayments and ensure that repayment is made out of profits and not out of sale of assets or
by further borrowings.

Banks should clearly specify the proposed terms and conditions of the credit, including
covenants designed to restrict adverse changes in the future risk profile of the borrower
While granting credit to a borrower, the bank should also consider where it is appropriate to
classify related parties as a single borrower. A related party or connected party or a group
has to be defined whether corporate or non-corporate, as an entity which is under a common
ownership or control or with strong connecting links like common management, familial
ties. Procedures to identify situations of related parties and appropriate steps to classify a
groups and aggregating exposures to groups accounts and across business activates must be
established.

Once criteria for granting credit are established the bank should ensure sufficient
information is received as per criteria to make proper credit-granting decisions. Bank's
should realize that all and adequate information on the credit criteria would serve as the
basis for rating the credit under the bank's internal rating system.Even when banks
participate in loan syndications or consortium lending fully relying on the credit risk
analysis done by the lead underwriter or on commercial loan credit ratings should be
avoided. Each member of the syndicate should perform their own independent credit risk
analysis in the same manner as other loans and review syndicate terms before committing to
the syndication. Granting loans results in accepting risks for earning profits. The risk/return
relationship and overall profitability of the account relationship should be considered before
establishing the relationship. The fundamental principle of pricing loans is that pricing
should recover all of the imbedded costs and compensate the bank for the risks incurred. In
analyzing risks banks should also consider adverse scenarios and their possible impact on
borrowers. Even at the time of granting the advance banks have to recognize that provisions
for expected losses need to be made and adequate risk weighted capital is needed to absorb
unexpected losses.

C. Repayment and recovery of loan

Equally important is the ability to repay as mere willing to repay still will not avoid risk, an
analysis of the current and future capacity of the borrower to repay based on various
scenarios and also based on historical and projected financial trends and cash flows should
be made. It should be verified that borrower has the legal capacity to borrow or assume the
liability. In the absence of such a capacity, banks may not be able enforce their claim and
recover the loans. Where the banks extend credit for commercial purposes, the borrower's
business expertise and the standing of the borrower in that business sector should be
checked.

D. Borrower's stake
One of the important factors which bank has to consider is the amount of money
the borrower has invested as his stake in the business. Higher the stake of the borrower,
higher will be his motivation to run the business profitably leading to timely repayment.

E. Collateral
Acceptance collateral is only a fall back for the banker to recover his dues or to ensure that
the credit risk mitigated. A banker would not like to encash his collateral for repayment and
would prefer always that his loan is repaid out of business income. Collateral cannot be a
substitute for comprehensive assessment of the borrower , nor can replace need for
sufficient information. But as risk management measure where applicable bank should
obtain collaterals and the adequacy and enforceability of collateral or guarantees, must be
ensured under various scenarios. It should be recognized that any recovery by enforcement
actions like foreclosure of mortgages will diminish the profit margin on the transaction.
Banks should evolve policies and procedures covering the acceptability of various forms of
collateral, ongoing valuation of such collateral, and a process to enforce the collateral.

F. Limit Exposures on credit

Banks should establish overall credit limits for individual borrowers as well as groups
of connected counterparties. Such limits must aggregate in a realistic manner and compare
and consolidate different types of exposures, both funded (like loans overdrafts etc) or non
funded (guarantees and letters of credit or acceptances) in the banking and trading book and
should include off the balance sheet exposure also. These exposure guidelines can be linked
to internal credit ratings also. The actual loan balance should be checked with exposure
limits and monitored for taking appropriate action if the limits are breached. Exposure
guidelines should also cover industries and economic sectors (for example 5% of bank's net
credit to housing sector), geographic regions (2% of export credit to Nepal) or specific
products (1% of incremental advances to reverse mortgage scheme loans or 18% of
advances to direct agriculture). As credit risk is inherent in all banking transactions it is
better to set limits on exposure for all such transactions and instruments.
Considering economic cycles, interest rate movements, liquidity and other market
conditions, banks should test the limits using stress testing methods and revise limits
accordingly and periodically.

G. Established procedures for credit approval

Banks must establish processes which clearly guide the officers as to the eligibility
of bankable activities and borrowers, information needed to evaluate the risk, different
tiers of approving authorities depending upon the loan size, risk mitigation measures like
obtaining securities verification of title to the securities, valuation of securities, and turn
around time to indicate approval and periodicity of review of the health of the accounts.
This process must be established not only for approving new credits but also for renewal
and extension of existing credits.
Sanction or approval of a loan involves many persons. Persons from marketing who
originate the business, persons from credit appraisal or analysis and persons who approve
the loan are all involved in granting the credit. The responsibilities of each of the
functionaries could be differently defined and assigned by the bank. It is therefore necessary
for the bank to establish procedures that coordinate the efforts of all of the various personnel
from different functional areas to ensure that sound credit decisions are made.
Information could be interpreted by individuals differently. In order to have uniformity and
continuity of processing the information uniformly and to maintain a sound credit portfolio,
a bank must have an established formal written evaluation and approval process for the
granting loans and other credits. Approval of loans should be made only in accordance with
such written guidelines.
It is not expected that every body will know every thing. Therefore banks, should establish
specialist credit oriented groups to analyze and approve loans related to specific product
lines, types of loans or industrial sectors. (For example a specialist in leather technology
could assess the loan request of a borrower relating to leather tanning and manufacture or
electrical engineer the requirements of power plant).
Banks can vest with authority, to grant loans and credit or approve changes in credit terms
to different levels of management personal in a hierarchy. Normally such delegation of
authority is given using a combination of individual signature authority, joint authorizations,
and credit approval committees, depending upon the size and nature and complexity of the
credit. In granting such authority, necessary expertise and experience of the individuals
involved should be ensured. The grant of loans should be with in such delegated authority
limits.
Authority with out responsibility is anathema to management. Therefore bank should
establish clear lines of accountability for decisions taken at different stages of credit
approval process In order to ensure that the laid down guidelines are followed, there should
be clear documentation of the approval process identifying the persons or committee which
analyzed the credit request, provided the inputs to the approving authority and the approving
authority that made the credit decision. This will form an audit trail and help to find out
deviations, if any, made in the credit approval process.
Banks should invest in adequate credit decision making resources like recruitment of
specialist officers, special training for credit functions, supportive mechanisms like
memberships in industrial associations, obtaining periodic industrial surveys, to learn about
industry trends, employing external agencies for credit rating or verification of borrowers to
enable sound credit decisions consistent with their credit risk management strategy to
competitively manage time delays and pressures on credit processing.
Each credit proposal should be analyzed carefully by a credit analyst with a background of
knowledge and expertise and experience, commensurate with the size and complexity of the
transaction. For this purpose Banks must develop and train a group of experienced officers
who should be responsible to exercise prudent judgment in taking credit risks.

H. Arm’s length Relationship

Every loan granted and renewal of such credit should be made subject to the criteria and
processes established and approved by Board of directors. The reason behind well designed
guidelines is that they create a system of checks and balances and promote sound credit
decisions and risk management. Therefore, every stake holder of the bank namely directors,
senior management and shareholders should respect them and not attempt to circumvent or
override the established policies and procedure for approval and monitoring of loans.
One of the cardinal principles that banks must ensure is that any extensions of credit must
be made on an arm's-length basis, where credit is extending to individuals and to their
related companies. Such credits must be monitored with particular care and other
appropriate steps taken to control or mitigate the risks of connected lending.
To ensure that an arm's length relationship is maintained in related accounts and controls are
implemented, the bank's credit criteria should not be altered to accommodate related
companies and individuals. It is necessary to stipulate that the related loans are not approved
on more favorable terms and conditions of than that of non-related borrowers under similar
circumstances. Imposing strict exposure limits on loans to related accounts and public
disclosure of the terms of credits granted to related parties are other methods of ensuring the
distance. Any significant or major transaction should be brought to the notice of the board
of directors and approval obtained prior to execution of such transaction. To avoid conflict
of interest, any interested board member should not be a party to the decision. In the cases
where large loan are given to a major shareholder in addition to the board the central
banking supervisory authorities must be informed.

3.6 MAINTAINING AN APPROPRIATE CREDIT ADMINISTRATION,

MEASUREMENT AND MONITORING PROCESS

Granting of loan or a facility is the beginning of assumption of risk. To successfully

mitigate and control the risk continuous monitoring of the credit is a must. There should be
a system in place to ensure ongoing administration of their various credit risk bearing
portfolios. The system should include monitoring the condition of individual
loans, including determining the adequacy of provisions and reserves. Banks should manage
the credit risk by developing and utilizing internal risk rating systems and such risk rating
should be consistent with the nature, size and complexity of a bank's business. There should
be a well designed management information systems (MIS) and easy, comprehensive and
well tested analytical techniques that enable management to measure the credit risk in on-
and off-balance sheet items of credit and to provide information on the composition of the
credit portfolio, and any concentrations of risk for monitoring the overall composition and
quality of the credit portfolio. The Risk management system should consider potential
future changes in economic conditions also when assessing individual credits and credit
portfolios. Bank should test under stressful conditions and assess their credit risk exposures
to ensure that losses and provisions are minimized.

A. Credit administration and monitoring

Credit administration plays a critical role in maintaining the safety and soundness of credit
portfolio of the bank. Once a loan is granted, credit is undertaken and then to maintain,
monitor and manage the risk becomes the function of credit administration, The main
functions of the credit administration can be summarized as under:
 Preparing various documents such as loan agreements
 Obtaining and custody of loan documents
 Monitoring documentation, contractual requirements, and legal covenants,
 Entering limits into the computer database
 Wiring out funds
 Recording day to day operations in overdraft account including issue of cheques etc.
 Obtaining current financial information, and Keeping the credit file up to date
 Sending out renewal notices
 Periodic valuation of collateral securities given and ensure that, where applicable,
collateral provides adequate coverage to the loan given
 Ensuring that securities are insured and insurance is kept valid
 Provide accurate and timely information to management information systems
 Ensure compliance with credit policies and procedures as well as applicable laws and
regulations
 Monitor the use of approved credit lines by customers
 Monitoring projected cash flows on major loans are realized to debt servicing
 Identifying and classifying potential problem credits on a timely basis.
Due to the multiple responsibilities the organizational structure of credit administration
function, varies with the size and sophistication of the bank. If a few individuals handle
several of the functions it should be ensured that they report to authorities independent of
credit marketing or approval functions. As in the case of loan approval process the entire
functions should be clearly defined and written policies must be put in place.

The loan review function is part of the credit administration and should determine that the
credit files are complete and that all loan approvals and other necessary documents have
been obtained (current financial statements, financial analyses and internal ratings, internal
memoranda, reference letters, and appraisals etc.). The loan review should use defined
procedures and criteria for identifying and reporting potential problem credits and other
exception transactions. Such transaction must be monitored more frequently and as possible
corrective action, classification and/or provisioning should be initiated.
It is essential that senior management understand and demonstrate that the importance of
credit administration in monitoring and controlling credit risk is recognized. Similarly
specific functions of ensuring credit quality and monitoring must be assigned to specific
individuals and for nonperformance accountability must be ensured.

B. Measuring risk by Internal risk rating of borrowers:

Banks must make you of an internal rating system to assess the quality of the risk. Banks
should develop the rating system consistent with their size and complexities of their loan
portfolio. Risk rating is an important tool to differentiate the degree of credit risk and
measure not only the individual loans to borrowers, but also to measure the credit portfolio
as a whole. Risk rating helps the bank in monitoring and controlling credit risk by
facilitating early identification of deterioration in credit quality. A well-designed rating
system can rate the riskiness of the borrower or the risks associated with a specific
transaction, or both and will help the bank to accurately determine the
1. Overall characteristics of the credit portfolio
2. Loan concentrations in borrower groups or sectors
3. Relative credit risk of the borrower or the activity
4. Problem credits and non-performing loans
5. Adequacy of loan loss provisioning
6. Capital requirements and internal allocation
7. Pricing of loans
8. Profitability of transactions and relationship.
9. Changes to credit strategy if necessary
Banks should review the ratings periodically and rate afresh the borrowers and transactions
in the light of changes in conditions and availability of latest inputs like financial statements
policy changes, economic conditions. Etc. In order to maintain consistent and accurate
reflection the quality of loans and portfolio, the ratings must be done loan review persons
who are independent of credit marketing and credit appraisal. They also need to be
confirmed again if credit approving persons assign the ratings or by higher authorities in the
credit approval chain.
Banks must establish Management Information systems to capture data on risk and use
analytical tools to interpret the same. The information on risk must cover both funded and
non-funded (on balance sheet and off-balance sheet transactions). Management Information
systems on risk should be capable of forewarn the quality deterioration of loans.
Banks must have specific methodologies to measure risk. Risk measurement should be
periodic, data based and validated appropriately. While measuring the credit quality loans to
individuals or portfolio banks must consider
1. Specific nature of the credit (loan, derivative, facility, etc
2. Contractual and financial conditions (maturity, reference rate, etc.
3. Exposure levels and changes in exposures
4. Existence of collateral
5. Internal risk rating
Banks normally monitor individual loans more closely. But to manage the overall credit
portfolio banks must put in place systems to measure and monitor composition and quality
of various loan types as portfolios in a consolidated way.
C. Concentrating on concentrations of risk
One of the major causes for problems in management of credit risk is the credit
concentration. Concentration is set occur when high proportion of the credit portfolio or
significant number of loans similar risk characteristics. This happens when direct (fund
based) or indirect (non fund based) credit is given to either a single borrower or a single
group or a single industry or sector of the economy or to a single region or a foreign country
or a group of countries with related economies. Concentration can also happen due to
lending a particular type of credit facility or of accepting a particular security for loans or
due to loans with same maturity.
To illustrate, if the bank's overall credit portfolio contains more loans to real estate sector,
say 10% of portfolio, then there is sectoral concentration. If the bank has extended loans say
around 5% of its total lending either to single company or a group of companies then there
is concentration of credit.
If the bank has issued maximum number of guarantees for imports from say Argentina or
extended loans for export to Argentina, then there is a geographic concentration.
Concentrations pose a serious risk to the stability of the bank in times of adverse changes in
the areas in which credit is concentrated. If there is a slump in the real estate sector then in
our example 10% of the loan portfolio will be under stress and become risky. Banks many
times allow certain level of concentration in their portfolio for reasons like
1. Bank's business thrust (say house finance bank)
2. Geographic location of branches (all branches situated with in a single state)
3. Lack of access to economically diverse borrowers
4. Expertise in a particular industry or economic sector.
5. Lack of expertise in different types of credit
While banks need to diversify their portfolio, they can not also miss out on sound credit
opportunities. Therefore banks should constantly review their portfolio and stipulate
acceptable concentration levels and introduce measures like higher pricing for the additional
risk, increasing capital, using mechanisms such as loan sales, credit derivatives,
securitization programs. Banks should have clearly defined policies and procedures, as well
as adequate controls, in place to manage concentration risk.

D. Portfolio testing
Risk means uncertainty. In managing risk this fact shall be kept in mind. A sound credit risk
management system should analyze what could potentially go wrong with either individual
loans or various credit portfolios. This information should be factored into any analysis
regarding adequacy of capital and provisions. Scenario analysis “What if' and stress testing
exercises will help to identify potential credit risk exposures problems and correlation of
various risks, especially credit, market risk and liquidity. Economic or industry down turns,
market related events including regulatory changes and liquidity constraints are main areas
of such testing. The testing results must be reviewed and if necessary, policy changes must
be initiated by the bank and contingency plans for risk mitigation drawn.

3.7 ENSURING ADEQUATE CONTROLS OVER CREDIT RISK

Internal Controls must be established to ensure that approval of credit is being properly
managed and that credit exposures are within approved levels and consistent with prudential
standards and internal limits laid down by the board. The internal controls must facilitate
enforcement of credit policy and detect any exceptions to policies, procedures and limits.
There shall be a proper reporting system in a timely manner to the appropriate level of
management.
The strength of a chain is the strength of its weakest link. However elaborate and
comprehensive guidelines are put in place, the desired result would be achieved only when
they are implemented both in letter and spirit. If the implementer of a process is the same
person who monitors the implementation also, then very purpose of monitoring will be lost.
Similarly, if a laxity comes to light very late to the notice of the bank, it may be too late to
remedy or control the risk arising out of it. Therefore, banks should establish a system of
independent, ongoing credit review. The findings of the review and any action taken on the
review should be communicated directly senior management and, if need be, to the board of
directors.
Despite all assessment, control and monitoring there will be some loans which will prove
difficult of recovery for various reasons in banking. Banks must have a system in place for
managing problem loans credits and various other workout situations like compromise, debt
restructuring and settlements. Here again the board should lay down detailed guidelines,
control mechanism and authority levels for granting such concession to account which are
difficult to recover.
Banks have branches and different levels of controlling organizational structures
like regional office, zonal office and Head office. Therefore, many persons have the
authority to grant loans. Because of this, an efficient internal review and reporting system is
needed to effectively manage the bank's various portfolios and also at different locations.
Status of the credit portfolio and performance of account officers should be made known to
the senior management and board of directors for evaluation.
The system should provide sufficient information for evaluation. Internal credit reviews
should be conducted by persons who are not involved in credit marketing or appraisal. Such
an independent review will provide an accurate assessment of quality of loans, compliance
with guidelines, accuracy of internal risk ratings and monitoring effectiveness and help to
evaluate the overall credit administration process. The reporting line for the internal review
would be senior management without lending authority, audit committee and board of
directors.
Internal audits of the credit risk processes should be conducted on a periodic basis. The
purpose of such audits would be to determine that credit risk management system functions
in compliance with bank's credit policies and procedures and within the guidelines
established. Audits also help to identify any weakness in the credit administration process,
policies and procedures and any exceptions to policies, procedures and limits.
As problem credits are a natural fall out of granting credit, the risk management system
should provide guidelines for handling problem credits and various other workout situations
by way of early identification of weakness and options available for improving the credit.
The functional set up to handle problem loans must be clearly defined as to who will
manage the stressed loans. Additional resources, expertise, and focused efforts will
normally improve collection results.

3.8 ROLE OF SUPERVISOR OF THE BANKING SYSTEM

Basel Committee on Banking Supervision emphasizes that role of the supervisor (I.e.,
Central Bank of the country) is vital for success of risk management in banks. According to
BCBS Central banks should insist that banks under their control install and have an
effective system in place to identify measure, monitor and control credit risk. They should
also set prudential limits of loan exposure to borrowers and their related companies in the
group restricting bank funds to avoid loss for bank as whole, on failure of any individual or
group. Central banks should conduct an independent evaluation of bank's strategies,
policies, practices and procedures related to the granting of credit and the ongoing
management of the portfolio. Central bank should set prudential limits to restrict over
enthusiastic lending by banks.
Central banks should assess the systems in place for to identify, measure, monitor and
control credit risk in each bank. Such assessment should include measurement tools (such as
internal risk ratings and credit risk models) used by the banks and the role of board of
directors in overseeing the risk management system. The assessment by the central bank to
evaluate the quality of credit risk management systems of banks will include
1. Testing the soundness of asset valuation procedures
2. Conducting a review of the quality of a sample of individual loans
3. Examining the Internal reviews and bank's own validation process
4. Examining any reviews conducted by the bank's external auditors, where available.
5. Verifying whether the bank recognizes problem credits at an early stage and takes the
appropriate actions
6. Independently assessing whether the capital of the bank, in addition to its provisions
and reserves, is adequate to the level of credit risk undertaken by the bank
7. Imposing certain reporting requirements for credits of a particular type or exceeding
certain established levels
8. Setting prudential limits for individual and groups and sectors

It is the board of directors and the senior management of a bank who are solely responsible
for the effective system of credit risk management and quality of credit portfolio of the
bank. Still the Central bank as the banking authority of the country has a moral duty to
ensure that the banking system is protected and managed well. After evaluating the credit
risk management system of a bank, the central bank supervisors should discuss with the
management of the bank any weaknesses detected in the system, excess concentrations, the
classification of problem loans and any additional provisions required and its impact on
bank's profitability. They should also ensure that the bank takes appropriate actions to
improve its credit risk management system by remedying the shortcomings noticed by the
central bank.
 CHAPTER IV

ANALYSIS & INTERPRETATIONS

4.1 To review the existing practices of risk management in Indian Banks

4.2 To find out recurring common risk incidents & the causes for the same

4.2.1 Credit appraisal

4.2.2 Sanctions & Approvals of risk

4.2.3 Disbursement

4.2.4 Review/ Monitoring/ Supervision

4.3 Analysis Relating to First Objective

4.4 Analysis Relating to Second Objective

4.5 Analysis Relating to Third Objective

4.6 Analysis Relating to Four Objective

4.7 Analysis Relating to Fifth Objective

 Chapter IV
Analysis & Interpretations

4.1 Objective 1: to review the existing practices of risk management in Indian banks
The present scenario of credit risk management practices in banks in India
A comprehensive processes, systems and practices followed at present by Indian banks in credit risk
management in respect of assessment, sanction, disbursement monitoring and recovery of loans will
be helpful in understanding the issues and problems currently faced by the industry and finding
solutions for the same.
The lending process is the beginning of the credit risk management function. The various stages of
the lending processes, task involved and the risk mitigation practices
followed by the banks are summarized below:
Credit Request acceptance:
Tasks involved Risk management practices followed

1. Obtaining KYC norms independently for

Verification of customer identity / business
entity loans and independent verification by bank
Verification of the credit history of the 2.CIBIL reports Obtaining and reporting
borrower
3. checking of list of RBI defaulters/ ECGC
defaulters/ Banned organizations list/
vanishing companies list of Ministry of
company affairs
4. Verification of address/ tracking through
postal dept/ employer of the wheweabuts of
the customer periodically
 5. Obtaining introduction in addintion to
KYC documents
6. Not engaging consultants for getting
business

Credit risk analysis- facility

Risk management practices followed
Tasks involved

Verification of customer requirements 1) Comparison with industry standards

Analysis of the nature and type of credit 2) Comparing past actual with projects/
transaction - (cash credit/ bill discounting/ requirements
term loan )
3) Verification of eligibility for schematic
lending
Appropriateness of the limit to borrower's
business. 4) Verification technical / feasibility
Facility risk including unique features of the
type of facility ( interest rate risk interm reports
loans)

4.2 Objective 2:
To find out recurring common risk incidents and the causes for the same
Common repeated lapses, regularities and defects in monitoring that occur generally year after
year:
Banks in India have well designed application forms. The application form calls for various
information about the borrower, his business, financial standing and the purpose of the loan etc.
Banks use structured formats for appraisal of credit proposals. Similarly recommendation to
approving authorities is also on pre approved formats. The terms of sanction of facilities are mostly
codified facility wise and are part of the sanction / approval letters. Documentation has been
standardized across the branches all over the country. Reporting lines have been clearly specified and
the reporting form for sanction, disbursement etc is periodically obtained from branches by the
controlling authority. All these forms are pre printed with necessary blanks for filling up the details
and do not give room for error or omission of important information. Banks also issue detailed
guidelines and circulars on each of the aspects of lending.
Still statutory auditors, Reserve Bank of India inspectors and even the internal auditors of the banks
during their inspections/ audits have found that many lapses recur despite the same being pointed out
in earlier reports and banks instructing the operating functionaries to initiate necessary action to
rectify the lapses and to prevent such irregularities not being repeated in future. A perusal of the RBI
inspection reports, statutory auditors comments and the internal inspection observations over a
period of five years from 2006 – 2010 has revealed a large number of lapses/ irregularities and
documentation defects that have occurred repeatedly. Some banks have also issued specific circulars
listing the repeated lapses for the guidance of their staff. It was observed that in all the banks chosen
for the study similar situation prevailed.

4.2.1 Credit appraisal:

1. Factors like inter- firm comparisons, financials of associates are not being built into proposals and
if done they are very cursory.
2. Unrealistic projections being accepted - The assumptions for projections are not fully explained
3. No assessment of non fund based limits are undertaken
4. In extending packing credit , no attempt is made to fix the tenor and the facility in conjunctionwith
the production cycle
5. While stipulating conditions for bringing in funds, no efforts are made to know their sources
6. No follow up is made to ensure that the funds have been actually brought in
7. Industrial and market scenarios are not analyses in depth
8. Proposal from branches lack vital information like operating experience, changes in local
conditions etc., limit utilization
9. Renewal require qualitative improvement
10. Renewal appraisal is not comprehensive , qualitative analysis of comments / qualifications in the
auditor report and review of pending claims are not done
11. Contingent liabilities of borrowers are not taken note of while assessing the financial risks
12. Confidential opinions from other existing bankers, financial institutions are not periodically
obtained in case of borrowers or guarantors
13. Copy of process notes are not filed properly in borrowers files in few cases.

4.2.2 Sanctions and approvals:

1. Certain sanctions are beyond delegated powers of authorities authorized them and immediate
approval from the appropriate authority is not obtained for exceeding the powers/ deviations
2. Value of securities mentioned in the sanction letter differs with actual value
3. Regularizing through post facto confirmation of excesses was routinely done with out using it as
an exception tool.
4. Instances of non –reporting / delayed reporting of excess seen
4.2.3 Disbursements:

1. Facilities are released before completion of documentation formalities

2.Some of the stipulations of sanction are not carried out
3. Appropriate documents are not obtained from guarantor
4. Charge is not created in some cases
5.Non availability on file / not obtaining of certificate of registration of charge Search report
6. Absence of latest encumbrance certificate
7.Copies indicating change in directorship is not obtained (available on file in respect of limited
companies.
8.While partnership deed is obtained, form A from Registrar of Firms not obtained
for records.
9. Insurance policies taken as securities are not assigned in favour of the bank.
10. Latest encumbrance certificate is not obtained and kept on file

4.2.4 Review / Monitoring/Supervision

1. Stock statements are received with few details

2. Stock statements are received with considerable delay
3. Unpaid stocks are not excluded while computing drawing power
4. Considerable delay in review and inspection of stock after receiving stock statements resulting in
excess finance beyond approved limits
5. Limits have expired and steps have not been taken for renewal of limits
6. Furnishing of financials is largely by way of provisional accounts for renewal of
limits
7.Large variations in provisional accounts and subsequent audited accounts are not enquired into or
satisfactorily explained. This results in excess finance.
8. Branches have no information on the performance of non- corporate borrowers except at year end.
Only in respected of listed companies quarterly reports are available.
9. Verification of end use of funds is not done in many cases by post disbursement visit
10. Unit visits are not conducted on monthly basis

4.3 Analysis relating to First objective

The first objective was to review the existing practices of credit risk management that is followed in
the banks. These practices were analysed in three different headings namely

1. Awareness and Risk Identification

2. Risk Policies and Risk Procedures
3. Risk Control Systems.
Responses were sought from the respondents in each of these areas. Analysis relating to Awareness
& risk identification covered the role of credit risk department, functions of credit risk department,
role of RBI, risk appreciation, risk rating, causes for increase in risk assets, sectoral delinquencies
leading to bad loans and poor risk management and the status of credit appraisal. The commitment of
the top management with regard to risk management was also analyzed.

4.4 Analysis relating to Second objective

The second objective was to review the recurring common risk incidents and the causes for such
recurrences. These recurring incidents are lapse or failure of either systems or people. These lapses
are analysed and responses were sought to know whether the officers agree to the recurrence of such
lapses in the areas of credit appraisal, loan disbursement and monitoring.

4.4.1 Recurring Lapses in credit appraisal

The researcher has reviewed national and international literature on the subject. He has studied the
existing systems in the chosen banks and perused the audit reports of internal auditors, statutory
auditors and Reserve bank of India. Based on these he has identified certain lapse which frequently
occurred in credit appraisal and also commented upon in the audit / inspection reports. The identified
lapses which occur repeatedly on appraisal are mentioned below.
1. Non obtaining ITAO/WTAO/SATO
2.Not making pre sanction unit visit
3.Not verifying IT returns independently / sources of repayment
4. Noncompliance KYC norms for borrowers on Introduction accounts
5. Not obtaining audited financial
6. Accepting inflated projections
7. Not obtaining bankers credit opinion
Respondent were asked to express whether they agree that the identified lapses are recurring lapses.

4.4.2 Recurring Lapses in credit disbursement

The researcher has reviewed national and international literature on the subject. He has studies the
existing systems in the chosen banks and perused the audit reports of internal auditors, statutory
auditors and Reserve bank of India. Based on these he has identified certain lapse which frequently
occurred in credit disbursement and also commented upon in the audit / inspection reports.
1. Incomplete documentation
2. Not making progress linked stage disbursements
3.Non verification of end use
4.Not obtaining EC four months after disbursement
5.Permitting frequent excess / over drawings in the account
6. Engagement of consultants for credit marketing
Respondent were asked to express whether they agree that the identified lapses are recurring lapses.

4.4.3 Recurring Lapses in credit monitoring

The researcher has reviewed national and international literature on the subject. He has studies the
existing systems in the chosen banks and perused the audit reports of internal auditors, statutory
auditors and Reserve bank of India. Based on these he has identified certain lapse which frequently
occurred in credit monitoring and also commented upon in the audit / inspection reports. The
following lapses were identified by the researcher.
1. Not obtaining valuation report once in 2/3 years
2. Not conducting periodic inspection of securities
3. Not obtaining copies renewal of license etc
4. Not obtaining monthly stock statements & verification of the same
5. Not conducting surprise checks at borrowers place
6. Non renewal of insurance
7. Not obtaining Acknowledge of debts
8. Non verification of borrowers address periodically
9. Non review of dormant / inoperative accounts
10. Not reporting of monthly sanctions in time
11. Not reporting excess permitted / exception made
12. Not obtaining confirmation of excesses in writing
13. Not reviewing accounts periodically
14. Accepting third party securities
15. Not obtaining balance confirmation in the accounts
Respondent were asked to express whether they agree that the identified lapses are recurring lapses.

4.5 Analysis relating to Third objective

The third objective was to find out the various constraints in implementing effective risk
management system. The researcher identified certain variables Constraints in implementing
effective risk management systems and sought the opinion of the bank officers for parametric
analysis. The variable identified and the analyses are presented below: Variables:
1. HR policies on promotion, placement affect efficient credit risk management
2. Present training given for Credit Risk Management is adequate
3. Delay in obtaining information, sanction and communicating changes in process, procedures and
policies create avoidable risk.

4.6 Analysis relating to fourth objective

The fourth objective was to find out the importance of human factor in building credit risk
management system. The importance of previous work experience in credit department the extent to
which professional qualification help in efficient in credit department the usefulness of training given
the type of training given and whether the training is helpful to make better credit analysis where
the considered by the researcher and he sought the opinion of the bank officers for parametric
analysis.

4.6.1 Type of training

Banks recruit officers with general bachelors / masters degrees. Their placement in .different
departments is based on vacancies and not based on any specialized qualifications. Positions in
Credit, risk and audit departments are not treated as specialized position but general position. Banks
have a system of periodic transfers and promotions. These things result in a situation that any
employee in a particular scale
can be posted to any position suitable for that scale. This results in a situation where any officer can
be posted to handle any position subject to his scale. Therefore the ability of the officer to function
effectively depends upon the training. The respondents were requested to indicate the type of training
needed to handle risk / credit department.

4.6.2 Human factors

The researcher wanted to find out about the importance human factor and their proper training in
building credit risk management system. For this purpose he designed certain variable in Likerts 5
point scale and sought responses. The variables and analysis are as under:
1. Previous experience in Credit department is necessary to work in Risk Management Department
2. Professional qualifications help to function efficiently in Credit / Risk Management department
3. Training given is useful to function in the credit /risk department efficiently
4. Training helps to makes better credit analysis

4.5.1 Analysis relating to fifth objective

The fifth objective was to find out the impact of adoption of risk management systems in banks. The
impact has been measured by finding out the response of officers in four different aspects. Namely –
1. Overall better credit management.

2. Significant improvement in functional areas.

3. Significant gain by the bank

4. Areas that need further improvement

4.5.2Better credit management due to adoption of risk management system

The officers were asked to respond in Likert's 5 point scale as to whether they agree that adoption of
risk management system as per base of recommendations and RBI regulations and guidelines has
resulted in better credit risk management. The results of this non-parametric analysis are presented
below.

4.5.3 Areas improved due to credit risk management.

The researcher has reviewed national and international literature on the subject. He has studied the
existing systems in the chosen banks and perused the audit reports of internal auditors, statutory
auditors and Reserve bank of India. He has also discussed the issue with the higher officials of the
management of the banks. Based on these he has identified certain areas critical for sound credit
functioning and better financial health of the bank. The researcher wanted to know whether any
improvement has been made in these areas after introduction of credit risk management. Respondent
were asked to express their opinion on the order of importance of the areas which has improved by
assigning ranks giving the highest rank for the most significantly improve area and the lower rank for
least significantly improved area.

4.5.4 Most felt Benefit by banks on adoption of credit risk management.

The researcher discussed the issue with the higher officials of the management of the banks. Based
on these he has identified certain benefits which banks managements have felt as gained by them
after introduction of credit risk management. Respondent were asked to express their opinion on the
order of importance of the areas which has the
mist beneficial effect by assigning ranks giving the highest rank for the most significant benefit
realized and the lower rank for least significant benefit.

4.5.5Areas of credit risk management system that needs further improvement.

The researcher has identified certain areas as critical for sound credit functioning and better financial
health of the bank. The researcher wanted to know whether any improvement has been made in these
areas after introduction of credit risk management and obtained responses. After analyzing the
responses certain conclusions were drawn. As a follow up the researcher wanted to know whether
those areas identified as improved need further improvement. Respondent were asked to express
their opinion on the order of importance of the areas which need further improvement by assigning
ranks giving the highest rank for the area where more room for further improvement is possible and
the lower rank for area where least room for further improvement is

CHAPETR V
SUGGESTIONS & CONCLUSION

5.1.1 Existing scenario of credit risk management department in banks

5.1.2Recurrence of common lapses in credit risk management
5.1.3 Profile of officers working in credit risk management department
5.1.4 Awareness about risk management
5.1.5 Risk policies and procedures
5.1.6 Risk control systems
5.1.7 Lapses that recur and causes for Causes for recurring
5.1.8 Constraints in implementation
5.1.9 Human factor in building credit risk management system
5.1.10 Impact of adoption of risk management system in banks
5.2.1 Credit Risk Management Practices
5.2.2 Lapses that recur and causes for Causes for recurring
5.2.3 Constraints in implementation
5.2.4 Impact of adoption of risk management system in banks
5.3 Conclusions
5.4 Scope for further research
 CHAPETR V
SUGGESTIONS & CONCLUSION

5.1.1 Existing scenario of credit risk management department in banks

Banks in India have well designed application forms for loans. The application form
calls for various information about the borrower, his business, financial standing and
the purpose of the loan etc. Banks use structured formats for appraisal of credit
proposals. Barks also rate the borrower internally using financial, managerial,
economic and technical parameters. Banks generally follow the Credit Monitoring
Arrangement formats suggested for Balance sheet analysis. Similarly recommendation
to approving authorities is also on pre approved formats. The terms of sanction of
facilities are mostly codified facility wise and are part of the sanction / approval
letters. Documentation has been standardized across the branches all over the country.
Reporting lines have been clearly specified and the reporting form for sanction,
disbursement etc is periodically obtained from branches by the controlling authority.
All these forms are pre printed with necessary blanks for filling up the details and
do not give room for error or omission of important information. Banks also issue
detailed guidelines and circulars on each of the aspects of lending.

5.1.2Recurrence of common lapses in credit risk management

Despite the various risk identification techniques and mitigation strategies, banks keep
accumulating non performing assets. A review of the internal audit reports,
observations made by RBI during their inspections on the credit portfolio and the
views of statutory auditors reveal that during their inspections/ audits have found that
many lapses recur despite the same being pointed out in earlier reports and banks
instructing the operating functionaries to initiate necessary action to rectify the lapses
and also to prevent such irregularities not being repeated in future.
5.1.3 Profile of officers working in credit risk management department
The survey revealed that credit risk management department is dominated by male
offices. 77.4% of the respondents (271) are male bank officers and the remaining
22.6% (79) are female bank officers. Younger officers are predominantly employed
and managements prefer matured but not old people to work in risk management
areas. (60% of all officers are less than 40 year of age, and 63.4% of the officers are
aged between 30-50) The majority of the officers working in the risk departments is
graduates and constitutes 62.6% (219) of the sample. Scale II & Scale III officers
(88.6%) are mainly managing the credit risk management departments with a total
service 10 years and up to 30 years. Majority of the officers (72.3%) have worked
more than 10-20 years in the credit risk related areas.

5.1.4 Awareness about risk management

Bank officers are well aware of the role of credit risk management. They agree that
the most important role of the risk department is to maintain quality. They also agree
that the most important function of the risk department is reconfirmation of rating of
borrowers and the second most function is to suggesting risk based pricing, followed
by security & mitigation measures. Bank executives strongly agree that Risk
management policies and procedures are set by RBI and merely followed by banks
and that Risk appreciation is not uniform at all levels of credit granting chain.
According to the officers surveyed Risk rating is more subjective and credit appraisal
is the weakest link in the credit approval system. Officers working in risk related areas
opine that non compliance with terms of sanction (like obtaining securities, insurance,
ensuring end use of funds etc.) is the major cause of risk assets. Poor credit appraisal
and poor monitoring are the second and third important causes. Political interference
and corruption are not mentioned as major causes for increase in risk assets. It
emerges from the study that corporate sector loans are the most contributing loan
sector to delinquency resulting in non performing assets. SME loans and Agricultural
loan are ranked as second and third most contributors to delinquency, Majority of the
officers working in risk management areas (68%) have answered that the top
management commitment is not absolute.

5.1.5 Risk polices and procedures:

On the issue of risk polices and procedure bank officers agree but not strongly that
banks on their own also initiate risk management policies and procedures. Similarly
they do not strongly support the notion that centralization of sanctions results in credit
risk mitigation. According to them Risk Management training is more in the nature of
credit appraisal and the tools for risk analysis like track record verification, pre
sanction audit, system for early detection of delinquency, information exchange
between banks are weak or not effectively used.

5.1.6 Risk control systems:

There is a strong agreement among offices working in credit risk management that
there is a conflict of interest between Credit Management department and Risk
Management department. They also strongly agree that Computerization has helped in
better credit risk monitoring. While they agree that Committee approach to credit
sanction really mitigates risk and verification of borrower identity, accounts, stock,
valuation security, legal opinion for title etc by external agencies results in no
accountability to employees and is a major weakness in the credit risk management
system. , they do not strongly advocate them. Similarly they agree but not strongly
that Delegation of powers of sanction may improve service quality but impairs credit
quality. However they strongly agree that Risk management tools help judge
borrower's ability, but not his willingness to pay strongly agree

5.1.7 Lapses that recur and causes for Causes for recurring
Most of the officers, (98%) agreed that there are recurring lapses in credit appraisal,
credit disbursement and credit monitoring. According to them ignorance about the
procedure / the reason for the procedure is the most important cause for recurring
lapses. Similarly trust on the borrower (that he will not default) and the perception that
omissions may not pose any risk are the reasons why lapses repeatedly take place.
They do not agree that compliance is tedious or lack of cooperation as the reason for
recurring lapses. Similarly they do not give importance to promotions, transfer or job
rotations or pressure of business or lack of incentive for compliance as major reasons
for recurring lapses. Majority of the officers (86%) said that audit department should
close the audit repots.

5.1.8 Constraints in implementation;

Officers accepted that delay in obtaining information, sanction and communicating
changes in process, procedures and policies create avoidable risk. But they rejected
the notion that HR policies on promotion, placement affect efficient credit risk
management and present training given for Credit Risk Management is adequate

5.1.9 Human factor in building credit risk management system

Majority of (70 %) of officers stated that combined training (training on procedures,
financial assessment and legal issues) is needed to handle credit / risk department.
They have strongly agreed that professional qualifications help to function efficiently
in Credit / Risk Management department and training helps to makes better
credit analysis. But have agreed only moderately that Previous experience in Credit
department is necessary to work in Risk Management Department

5.1.10 Impact of adoption of risk management system in banks

The officers working in credit risk management system strongly agreed that adoption
of credit risk management system in banks as per Basel committee recommendations
and RBI guidelines has resulted in better credit management. According to them,
Credit appraisal, pricing of loans and credit administration are areas that have
improved most respectively in the order of improvement. The most important benefit
the banks have gained are listed as Improvement in quality of loans Early detection of
problems accounts Less provisioning and capital allocation. While expressing their
opinion on further improvement of the risk management system, officers have
accorded priority for improvement to Credit administration and Pricing of loans in
that order. The perceptions of the bank officers do not have any association with the
gender, age, education levels, their scales, or experience in credit related areas. This
means that officers irrespective of these variations ( both male and female, young or
elder, no graduate or post graduate or professional, scale II or scale VI, well
experience in credit related areas or not) perceive the same type of notions. However
total experience in service has an association with perceptions of the bank officers,
Credit risk management system of banks in India is mostly influenced by risk
policies and procedures, recurring common mistake and human factor.

5.2.1 Credit Risk Management Practices

The existing credit risk management policies practices are mostly designed by
Reserve Bank of India and the banks in India merely follow the same. However the
practices and policies are adequate to manage the credit risk in the Indian context. It is
suggested that banks should also strive to supplement these policies and procedure by
using their expertise and experience gained over the years, calling for suggestions
from employees and customers and industry associations like Indian Bank
Association, confederation of Indian Industry and Indian Chartered Accountant
Institute etc., There is enough awareness about risk management among the officers of
the bank. However risk perception is not uniform at all levels of the credit granting
chain. Therefore banks must ensure that every person involved in the granting of
credit appreciates the risks fully and in a similar way. This could be achieved by
structured training programmes to officers. It is felt by the officers that the rating
process is subjective. While it may not be possible to have a totally objective rating
system due to judgmental elements in credit rating, the factors considered for rating
may be redesigned and more variables incorporated to make the rating more objective
and less subjective. The study found that non compliance with terms of sanction is the
major cause of risk assets. To over come this lacunae a pre release check should be
conducted by an independent officer before release. Poor monitoring continues to be
an important factor in creating risk assets. Under the present system of branch
banking, it the manager who is responsible for the entire credit risk management. It is
suggested that a separate centralized department for credit administration is created to
look after obtaining securities, insurance charge creating etc, Poor credit appraisal
despite improvement is another important factor. This can be remedied by creating a
data base of customer information for appraisal and computerizing the same. Training
intervention is also another measure to be undertaken for improving appraisal skills.
Corporate sector dominates as the major contributor to risky loans. While corporate
loans are an essential part of the credit portfolio of any banking institution both
for profitability concerns and national economic reasons, stringent measures to avoid
risk assets must be taken. A few such measures are suggested here under: If a
company defaults to the bank, companies in which the directors of the defaulting
company are holding office should be restricted for credit. Obtaining personal
guarantees of directors of all directors is another way of curbing corporate misuse of
bank funds. Every director must be individually credit rated along with the corporate
before loans are given to corporates. In each Board of directors of bank assisted
companies there shall be an independent observer appointed by the bank (not a
nominee director who participates and becomes responsible for decisions) who reports
the proceeding of the board meeting to the bank directly. SME loans contribute for
risk assets only next to corporate loans. Though there are laws to ensure that SME's a
paid with in 120 days many corporates do not pay the SME's in time which leads to
blocking of working capital and the loan becomes bad. To void banks must
incorporate a suitable loan covenant in their loan agreement to corporates sand
monitor compliance.
Agricultural loans are basic necessity of the economy and government's policy is
involved. Banks must closely interact with governments to ensure a health portfolio of
agricultural loans. Payment of any subsidy or government purchases must be made
directly to the bank which has financed. Since agriculture is monsoon dependent,
Comprehensive Agricultural Insurance must be compulsory like motor vehicles
insurance and government should discourage write offs and waivers etc to
inculcate better credit culture.
The officers indicted that Risk Management training is more in the nature of credit
appraisal. The training must be oriented towards risk identification, risk avoidance,
risk mitigation measures etc as separate course. The officers also indicted that the
tools for risk analysis like track record verification, pre sanction audit, system for
early detection of delinquency, information exchange between banks are weak or not
effectively used. Banks can put in place suitable procedures to ensure effective risk
management.
The top management commitment is not absolute is another finding. This is a policy
matter and the board of directors, reserve bank of India and Government of India are
the competent persons to remedy this malady. Possibly when persons of impeccable
integrity and competence are appointed to the board this could be addressed. There is
a strong agreement among offices working in credit risk management that there is a
conflict of interest between Credit Management department and Risk Management
department. This can be resolved only by properly defining the role of each
department and fixing the functional responsibility. Officers strongly agree that Risk
management tools help judge borrower's ability, but not his willingness to pay. Banks
can introduce with the help if experts, some physiological profiling for borrower's
values and beliefs systems and views on repayment of loans and tests as part of
deciding the willingness of the borrower to pay in addition to his track record and
references currently relied up on.

5.2.2 Lapses that recur and causes for Causes for recurring
Since most of the officers, agreed that there are recurring lapses in credit appraisal,
credit disbursement and credit monitoring the bank management should immediately
take steps to address this problem. Giving clear guidelines, better monitoring,
sensitizing and training the offices are the ways to go solve this problem. Majority of
the officers said that audit department should close the audit repots. The present
system prevailing in banks is that audit department only closes the report. But we
suggest that the closure of report shall be made after the same has been recommended
by the credit and risk departments to avoid repeat of lapses and to introduce an
element of accountability.

5.2.3 Constraints in implementation:

Officers state that delays in obtaining information, sanction and communicating
changes in process, procedures and policies create avoidable risk. There is system of
time norms in banks specifying time frames for each activity. A time frame of 45
days has been the norm for considering a credit application and sanction of loans.
Bank cans exposure ways to reduce this time frame. Possibly as earlier suggested,
creating a data base of customer information for appraisal computerization of
borrower track record could help to reduce the time. Officers opined that present
training given for Credit Risk Management is not adequate and combined training
(training on procedures, financial assessment and legal issues) is needed to handle
credit / risk department. The banks have to redesign training programmes so that it is
comprehensive for credit skills and risk management.

5.2.4 Impact of adoption of risk management system in banks

Credit risk management system of banks in India is mostly influenced by risk policies
and procedures, recurring common mistake and human factor. Officers have accorded
priority for further improvement in Credit administration and Pricing of loans. It is
suggested that bank according to their risk profile desired should initiate steps to
address all the above areas and better training could be a starting point.

5.3 Conclusions
After detailed study and analysis the researcher has reached the following
conclusions. Reserve Bank of India plays a major role in the guiding and directing
banks to establish and maintain a credit risk management system to international
standards. Banks in India have well designed systems and procedures in place to
handle credit risk management. Adoption of credit risk management system in banks
as per Basel committee recommendations and RBI guidelines has resulted in better
credit management. Despite the various risk mitigation strategies, banks still strive to
control the problem of non performing loans. There are recurring lapses which
aggravate the problem. The uses of recurring lapses are ignorance about the
procedures or the reason for the procedure and a sense of complacency that nothing
can go wrong in my watch. Delays in decisions in approving loans or recovery
contribute to risk assets. Indian banking has not been afflicted by the influence of
political interference or corruption to any significant extent and it is good sign of
sensible banking. Effectiveness of credit risk management system is mostly influenced
by risk policies and procedures, recurring common mistake and human factor.
Training emerges as an important intervention to remedy the lapses and shortcomings
and improve the credit risk management system. The top managements of banks has
to fully commit themselves for better credit risk management systems and
appointment of persons of impeccable integrity and competence to the boards of the
banks is a must to ensure such commitment.

5.4 Scope for further research:

The research has concluded that in Indian banking effectiveness of credit risk
management system is mostly influenced by risk policies and procedures, recurring
common mistake and human factor. Training emerges as an important intervention to
remedy the lapses and shortcomings and improve the credit risk management system.
The research has shown that Risk Management training is more in the nature of credit
appraisal. The training must be oriented towards risk identification, risk avoidance,
risk mitigation measures etc as separate course. Therefore there is a lot of scope for
research in the area of training for risk management.
There is scope for research in the area of top management role and commitment.
Causes for absence of full commitment in credit risk management systems, how
commitment of top management can be improved are emerging areas of interest for
research. This is important as major banks in India have sizable government
ownership and government relies on the banks for policy intervention.
The research reveals that Risk management tools help judge borrower's ability, but not
his willingness to pay. The researcher has suggested that banks can introduce with the
help of experts, some physiological profiling for borrower's values and beliefs systems
and views on repayment of loans and tests as part of deciding the willingness of the
borrower to pay in addition to his track record and references currently relied up on.
This is another very interesting and important area of research that can be undertaken.
Banking and risk management are dynamic processes and scope for further research
enormous in the areas of risk policies and procedures, recurring common mistake and
methods to control them.
QUESTIONNAIRE

Personal Details:

Respondent’s Name:

Gender:

o Male
o Female

Age:

o Below 20
o 20-30
o 30-40
o 40-50
o Above 50

Education:

o Below Graduate
o Graduate
o Post Graduate
o Professional
o Others

Experience:

o Below 5 years
o 05-10 Years
o 10-15 Years
o 15-20 Years
o Above 20 years
Q.1 Do you thinks the legal machinery for loan related process is
stringent enough?

o Highly yes
o Yes
o Can’t say
o No
o Highly no

Q.2 Do you think Non-Performing assets is an appropriate tool for

defining the financial health of banks?

o Highly yes
o Yes
o Can’t say
o No
o Highly no

Q.3 Do you think it is difficult for proven defaulter to get loan

sanctioned?

o Highly yes
o Yes
o Can’t say
o No
o Highly no

Q.4 Do you think the elements considered for maintaining sound Non-
Performing Assets management system is efficient?

o Highly yes
o Yes
o Can’t say
o No
o Highly no
Q.5 Do You thinks the monitoring of loans effectively would reduce bad
debts problems?

o Highly yes
o Yes
o Can’t say
o No
o Highly no

Q.6 Do you think the measurement of Non-performing asset management

is the only tool for ranking individual banks for their overall efficiency?

o Highly yes
o Yes
o Can’t say
o No
o Highly no

Q.7 Do you think the government has empowered the banks to take
adequate measures for recovery from defaulters?

o Highly yes
o Yes
o Can’t say
o No
o Highly no