Loan Policy- Credit Risk

Management

N.Gopal
Deputy General Manager/MOF
CAB Pune
RBI CAB Pune

July 5, 2010

RBI CAB Pune

July 5, 2010

Loan policy- Genesis, Importance- Credit

risk Management
Need for loan policy
Ingredients of a good loan policy
Loan Policy and risk Management
Prudential ceilings and loan policy
Final Analysis

RBI CAB Pune

July 5, 2010

RBI CAB Pune

July 5, 2010

RBI CAB Pune

July 5, 2010

Credit sanctioning guidelines, and the written

documentation setting forth standards as
determined by a bank's senior management.
A bank's loan policy also establishes minimum
credit standards for taking on loans.
It sets policies and procedures in treatment of
delinquent loans, and the type of customer a
bank wants as a borrower.

RBI CAB Pune

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RBI CAB Pune

July 5, 2010

1980s
The world and the way of banking changed
American banking history witnessed several credit
induced bank disasters
E.g. Continental, Sea First and Texan Banks
1990s Credit freeze due to East Asian Crisis
2000 GTBs credit induced problems
Lessons
The common triggers of crisis Aggressive and
unplanned lending
Credit concentration failure to diversify,
Risky practices, inadequate monitoring

Result

Poor credit culture

Credit culture is largely dependent on the

loan policies pursued by a bank
RBI CAB Pune

July 5, 2010

 First

six years of the millennium saw

paradigms shifts in bank lending
India became more closely
integrated to the global economy
Interest rates moved both ways
Traditional avenues for lending slowed
down
Competition

Policies responses had to become

dynamic outward and forward looking to
meet challenges

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RBI CAB Pune

1.
2.
3.
4.
5.
6.

7.

Board & Management Oversight

Portfolio Management
Management Information Systems
Market Analysis
Credit Underwriting Standards
Portfolio Stress Testing & Sensitivity
Analysis
Credit Risk Review Function

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 Theory

Broadly defining the credit culture

Broadly laying out the external-internal environment
Lookups

Statutory issues & Regulatory

Market, present environment
Studies

Industry, survey etc

Setting

up Risk Appetite

Fixation of internal norms & prudential ceilings

Deciding on risk rating
Implementation

Laying out procedures, appraisal standards,

schematic issues
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Credit Culture This is the way we

handle credit
Establish Business
Priorities

Choose Credit
Culture

Strategies

Credit Policy determines the credit

culture

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 Based on Corporate priorities

Credit Culture could be one of four
types
CORPORATE PRIORITY

CULTURE

Emphasis on asset quality , long

term growth

Values Driven
(Conservative, Prudent)

Short term gains

Earnings Driven
(Regardless of risk)

Market share, Size

Volume Driven
/Aggressive

No clear priorities

Unfocussed

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Overriding objective of credit policy

Healthy Balance between
Credit Volumes, Earnings & Asset Quality
Within the framework of
Regulatory prescriptions,
Corporate goals - social responsibilities

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 Credit

expansion

Steady expansion, sustained, continuous &

prudent growth
Steady rise in profits but emphasis on
Quality Assets
Profitable Relationships
Statutory

and Regulatory line

This philosophy seeks to instill a value driven

credit culture
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RBIs Guidelines on Risk Management Systems in Banks

require a typical Credit Policy to cover:
Standards of presentation of credit proposals, financial
covenants
Rating standards and benchmarks
Prudential limits on large credits and asset
concentrations
Standards for Loan collateral, Loan Review Mechanism
Pricing of loans, risk monitoring and evaluation
Legal and regulatory compliances
Delegation of credit sanctioning powers
Prohibition on lending

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 No

ambiguity in postulations- chance for

different understanding interpretations
Loan policy must clearly mark the boundaries
Government
RBI
Bank

Loan

policy should ideally list out restrictions

that credit grantors can refer
Loan policy must provide for exceptions- list
out if possible
Loan policy must also lay down the levels of
authority for certain credit decisions
Regulatory reviews, inspections also provide
opportunities for aligning loan policy to regulatory
thinking
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Sector specific guidelines should also contain

Dos and Donts based on present environment,
statutory and regulatory guidelines
e.g.
Financing Real Estate, Capital Markets, bill
discounting, NBFC lending etc
Ban on lending to units producing ozone
depleting substances is an instance of statutory
restriction

While assessing the adequacy of a loan policy

these Dos and Donts should be weighed by the
credit grantor

Deterrents to non compliance to these dos and

donts
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Target markets, industry and business sectors are

identified
Sectoral study
Trends in consumption, impact on a sector
Growth potential, capital investment,
Delinquencies

Conclusions

Translating experiences into policy

Industry Study
Products, Capital investment, Sunrise/sunset
Turnover, Labour, locational concentration
Market, fashion trends etc
Seasonality
Regulatory environment

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Policy not to stop with managing transaction risks

Has to address intrinsic risk also

Portfolio perspective
The risk inherent in certain lines of business is
known through industry analysis

Industry analysis to look at three vital factors

Historic elements
Predictive elements
Lending elements

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 Historic Risk Elements should look at:

Financials: capital, cash flows, w.c. cycle
Stability: demand, growth
Longevity of the industry: demand, trend need etc
Predictive Risk Elements would include:
Structure: constitution
Diversity: concentration
Entry barriers- political, financial, feasibility
Product Life cycle- ever in demand, seasonal etc
Economic Vulnerability, Political
/ Regulatory risks,
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 Lending

elements

Collaterals-availability, acceptability
Security- legal issues,
Valuation
Delivery Loan or an advance

Industry study should be periodically reviewed and

factored into the policy

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In real life policy setting industry analysis may or

may not be documented on these rigorous lines
In any case a careful consideration of all three risk
elements go into the industry limits fixed by each
bank
This is based on the lending experience and
business expectations that the bank has
It is intrinsic risks in sectors like real estate and
capital markets that explains the regulatory concern
about build up of asset concentrations in these areas
Inspection and Audit to help verification/validation
whether the intrinsic risk in industries with higher
exposure limits have been assessed by the bank

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Identify focus areas

broad confines of strategy,
study, restrictions etc.

Identify
macro economic trends,
regulatory stance
banks own experience
core competencies
Retail for instance became a focus area for banks
after the interest rate deregulation and the slow
down in corporate borrowings
SMEs, Agriculture and Micro Finance are today
perceived to be major business opportunities

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 Each

bank has its strong points and core

competencies
Public sector banks have a strong rural and
semi urban presence and a history of
success in agricultural and rural credit
Banks in Western India have a predominant
presence in sugar sector
Credit Policy to draw on such strengths
It should also leverage on sector specific
regulatory incentives and relaxations
extended from time to time
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Prudential limits
limiting magnitude of credit risk
Dispersion of credit risk- prevents concentration
DeterminantsCredit culture
Risk appetite
Regulatory dictates
Prevailing Industry and Economic Conditions
Loan policy should articulate the rationale behind the
limits, for better appreciation and understanding
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Financial Limits

Single & Group

Substantial
Exposure

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Maximum limit
Aggregate limit
Industry wise
Sector specific
Individual
Corporate
Partnership
Proprietorship
Aggregate linked to
capital funds
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 Financial

benchmarks with conditions under

which deviations can be permitted

Single and Group borrower limits not exceeding

what is prescribed by RBI- permissible deviations

Substantial Exposure limit (10% borrowers <

600% of capital)

Industry and sector wise ceilings

Limits on sensitive sectors subject to asset price
volatility

High risk and low priority sectors

Maturity profile of the loan book

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Limit setting is unique to each bank

It has to balance risk control against growth

imperatives
The limits set should reflect the legacy issues in
the portfolio
There should be higher limits for areas where Bank
has a natural advantage
Lower limits and ban in sectors where the Banks
prior experience has been adverse
Limit setting is dynamic and on-going
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 Tool

for the measurement of credit risk

To enable an informed and considered credit
decision as good or bad
To appropriately price loan products
BCBS defines credit rating as summary
indicator of risk inherent in individual credit
signifying the risk of loss due to default of a
counterparty by considering qualitative and
quantitative information

Policy should provide for rating of all loan accountsvery little exceptions
The rating should consist of 8-9 parameters (minimum)
Policy to specify minimum entry rating i.e. Hurdle Rate

Policy to lay down exceptions to Hurdle rate

Policy to lay down procedures to handle accounts which fall
below hurdle rating

Annual review of ratings- Quarterly, half yearly updates

Study of Rating migration
Pricing linked to Rating
Mapping of external ratings to internal ratings

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good loan policy to provide leeway for

It

should balance the risk and returns on the

retail front

Schematic

Lending
Directed credit flow to certain sectors

Housing, farming, SME, retail, personal loans,

special tie-ups etc
Retail loans under various products and
schemes designed by the Bank

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 Returns

from
retail/schematic
lending
commensurate with risks?
Schemes to match customer expectations?
Standard of Due Diligence and KYC?
Outsourcing risks adequately addressed?
Delinquencies
under control in specific
product categories?
What is the growth in terms of size, earnings
and quality?

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 Take

over route to grow business

Policy to clearly lay down ground rules
What type of borrower accounts
What level of exposures
Take over from whom
Take over standards
Pricing

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Profitability,
Customer Friendliness/service,
Compliance
Capital Conversation

Challenges arise when what the customer needs are

not provided for in the policy
Trade off business considerations, social
responsibility,
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 Area

of potential conflict in perceptions

differences between regulator and banks

Every

policy has to provide for exceptions

RBI the regulator also recognizes this

But question is how far and how much

Deviations/

needs

exceptions dictated by business

Extent

of their impact on risk profile to be

Within

the overall credit culture of the bank

seen

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 Credit

Policy serves a Gate Keeping function

Defines thrust areas in relation to credit
culture, profit objectives and regulatory
directions
Defines acceptable levels of risk by identifying
industry segments for fresh exposures
Prevents risk concentrations and ensures
diversification by setting limits on sectors and
individual transactions
It provides pricing strategies through the use
of Credit Risk Rating framework

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 Knowledge is the most potent of risk

mitigant
Does the policy provide for dissemination of
knowledge on credit?
Is the policy in itself, - Comprehensive,
Articulate, accurate and
User friendly?

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An ideal loan policy should

Create right for business growth
Maintain quality of assets
Provide platform for good procedures/process
Ensure regulatory and statutory compliances
Be the platform for Credit Risk Management

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