loan policy - credit risk management

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

Loan Policy- Credit Risk Management

N.Gopal Deputy General Manager/MOF

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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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 GTB’s 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

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 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

1. Board & Management Oversight

2. Portfolio Management

3. Management Information Systems

4. Market Analysis

5. Credit Underwriting Standards

6. Portfolio Stress Testing & Sensitivity Analysis

7. Credit Risk Review Function

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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

Strategies

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Credit Policy determines the credit culture

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 Based on Corporate priorities

 Credit Culture could be one of four types

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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RBI’s 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

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 Do’s and

Don’ts 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 Do’s and Don’ts should be weighed by the credit grantor

 Deterrents to non compliance to these do’s and don’ts

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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

 Portfolio perspective

 The risk inherent in certain lines of business is known

through industry analysis

 Historic Risk Elements should look at:

 Financials: capital, cash flows, w.c cycle

Stability: demand, growth

Longevity of the industry: demand, trend need etc

 Structure: constitution

Diversity: concentration

Entry barriers- political, financial, feasibility

Product Life cycle- ever in demand, seasonal etc

Economic Vulnerability, Political / Regulatory risks,

Environmental issues and Covariance factors

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.

 SMEs, Agriculture and Micro Finance are today perceived to

be major business opportunities

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

Determinants-

Credit culture

Risk appetite

Regulatory dictates

Prevailing Industry and Economic Conditions

Loan policy should articulate the rationale behind the

limits, for better appreciation and understanding

 Financial benchmarks with conditions under which

deviations can be permitted

what is prescribed by RBI- permissible deviations

of capital)

volatility

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 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 Bank’s 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 good loan policy to provide leeway for

front

tie-ups etc

designed by the Bank

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/ exceptions dictated by business

needs

Extent of their impact on risk profile to be seen

Within 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

 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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July 5, 2010 55 RBI CAB Pune