Loan Policy- Credit Risk Management

N.Gopal Deputy General Manager/MOF CAB Pune

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RBI CAB Pune

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 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

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RBI CAB Pune

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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.

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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

Credit culture is largely dependent on the loan policies pursued by a bank

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Poor credit culture

Result

 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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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 Short term gains Market share, Size No clear priorities

Values Driven (Conservative, Prudent) Earnings Driven (Regardless of risk) Volume Driven /Aggressive 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
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Economic Vulnerability, Political / Regulatory risks, RBI CAB Pune Environmental issues and Covariance factors

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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

Maximum limit Aggregate limit Industry wise Sector specific

Single & Group

Individual Corporate Partnership Proprietorship

Aggregate linked to capital funds
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Substantial Exposure

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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 accounts- very 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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A It

good loan policy to provide leeway for

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

RBI the regulator also recognizes this But question is how far and how much

Every

policy has to provide for exceptions

Deviations/ Extent Within

exceptions dictated by business needs

of their impact on risk profile to be seen the overall credit culture of the bank

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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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