Credit Credit ManagementManagement

Credit Credit ManagementManagement

Jyoti Kumar PandeyDeputy General Manager &

MOFCAB, Pune

Credit Opportunity Credit Creation

Credit Management

Credit Completion

Credit Life Cycle TheoryCredit Life Cycle Theory

AgendaAgenda

• Basics of credit management• Introduction of credit risk management• Other issues

IntroductionIntroduction

• Credit refers to Short Term Loans & Advances Medium / Long Term Loans Off-Balance Sheet Transactions

• Management refers to Pre-sanction appraisal Documentation Disbursement and Disbursal Post-lending supervision and control

Credit ManagementCredit Management

• Credit Management now includes Capital adequacy norms Risk Management including ALM Exposure Norms Pricing policy and credit risk rating IRAC norms Appraisal, credit-decision making and loan review

mechanism

Approach for safety of loansApproach for safety of loans

• Safety of loans is directly related to the basis on which decision to lend is taken Type and quantum of credit to be provided Terms and conditions of the loan

Approach for safety of loans Approach for safety of loans (Contd.)(Contd.)

• Two-pronged approach Pre-Sanction appraisal

To determine the ‘bankability’ of each loan proposal Post-Sanction control

To ensure proper documentation, follow-up and supervision

Pre-Sanction appraisalPre-Sanction appraisal

• Concerned with measurement of risk(iness) of a loan proposal Requirements are:

Financial data of past and projected working results Detailed credit report is compiled on the borrower / surety Market reports Final / audited accounts Income tax and other tax returns / assessments Confidential reports from other banks and financial

institutions Credit Report (CR) needs to be regularly updated

• Appraisal should reveal whether a loan proposal is a fair banking risk

Post-Sanction appraisalPost-Sanction appraisal

• Depends to large extent upon findings of pre-sanction appraisal Requirements are:

Documentation of the facility and ‘after care’ follow- up Supervision through monitoring of transactions in loan

amount Scrutiny of periodical statements submitted by the

borrower Physical inspection of securities and books of accounts of

the borrower Periodical reviews etc.

Bankers’ Credit ReportBankers’ Credit Report

• Includes seeking information including other banks – (writing or over telephone etc.)

• Sharing of information could be a sensitive issue Advisable to take an undertaking from customers Make the condition as part of account opening form or

loan application

Types of loans and Types of loans and advancesadvances

• Working Capital Finance Extended to meet day-to-day short term operational

requirements (sales & purchase of commodities, purchase of raw materials etc.)

• Loan for setting up new project, expansion and diversification of existing project etc. Short term or medium term

Loans and Advances Loans and Advances (Contd.)(Contd.)

• Difference between Loans and Advances Loans are extended in accounts in which no drawings

are permitted to the borrowers Generally there is one debit to principal amount to loan

account – though disbursal in stages is possible depending on the need of the borrower

For operational purposes loan can be credited to a special account where withdrawal from time to time can be done by the party depending upon his requirements

In case of advances, the sanctioned limit is placed at the disposal of the borrower, subject to terms of sanction, in running accounts which can be drawn upon by cheques by the borrower

Loans and Advances Loans and Advances (Contd.)(Contd.)

• Working capital finance in form of loan is also known as demand loan

• As an advance it is commonly known as cash credit facility

• Banks apart from working capital and medium term and long term finance may also extend casual overdrafts to approved customers In current accounts Loans against security of shares, FDs, housing loans etc.

Securities for lending Securities for lending

• Section 5 of B. R. Act defines secured and unsecured loans Secured – Loans and advances made on security of

assets the market value of which is not at any time less than the amount of the loan or advances

Unsecured – Means a loans or advance not so secured

• Security taken as an insurance against unwarranted situations

Securities for lending Securities for lending

• Two types: Primary and Collateral Primary Security – Generally from a viable and

professionally managed enterprise Personal

– Created by a duly executed promissory note, acceptance or endorsement of bill of exchange etc.

– Gives bank the right of action to proceed against the borrower personally in the event of default

Impersonal – Created by way of a charge (pledge, hypothecation, mortgage,

assignment etc.)

Securities for lending Securities for lending

Collateral Security – Meaning running parallel or together

Taken as additional and separate security Could be secured / unsecured guarantees, pledge of shares

and other securities, deposits of title deeds etc. Used to reinforce the primary security (for e.g. plantation

advances are not considered fully secured until crop is harvested)

Preconditions of loansPreconditions of loans

• Willingness or intention to repay as per agreement Relatively easier to assess Determined by good track record of payments and debt

servicing Uncertain / uncontrollable events could affect the

judgment

• Purpose for which loan is sought Should be documented carefully

Type of loan applied for - Working capital loan, term loan, personal loan etc.

• Conditions which can set the trend of future

Conditions determining Conditions determining future trendsfuture trends

• Three factors which can undergo changes: Prospects Future risk profile Repayment capacity

Tools for determining Tools for determining future trendsfuture trends

• Financial Analysis – past and projected• Credit rating• Assessment of credit needs• Terms of sanction• Documentation and creation of security interest• Post-lending supervision – 3 stages

Regular surprise verification of security Stock audit Obtaining and scrutiny of control statement (stock

statements, financial statements)

• Repayment and / or rollover

Risks in Bank LendingRisks in Bank Lending

• Credit Risk• Market Risk• Operational Risk

Credit RiskCredit Risk

• RBI defines credit risk as: the possibility of losses associated with diminution in the

credit quality of borrowers or counterparties. In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality.

Credit Risk ManagementCredit Risk Management

• Credit risk is defined, “as the potential 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

Credit Risk Management Credit Risk Management

• According to Reserve Bank of India, the following are the forms of credit risk: Non-repayment of the principal of the loan and/or the

interest on it Contingent liabilities like letters of credit/guarantees

issued by the bank on behalf of the client and upon crystallization amount not deposited by the customer

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

In the case of securities trading, settlement not taking place when it is due

In the case of cross-border obligations, any default arising from the flow of foreign exchange and/or due to restrictions imposed on remittances out of the country

Principles of sound credit Principles of sound credit risk managementrisk management

• BOD should have responsibility for approving and periodically reviewing credit risk strategy

• Senior management should have the responsibility to implement the credit risk strategy

• Bank should identify and manage credit risk inherent in all product and activities

Prudential Norms for Prudential Norms for appropriate Credit Risk appropriate Credit Risk

environmentenvironment• Norms for Capital Adequacy• Exposure Norms

Credit Exposure and Investment Exposure Norms to individual and group borrowers

Capital Market Exposures Banks-specific internal exposure limits

• IRAC norms• Credit rating system and risk pricing policy• ALM• Norms for setting up loan policy

Framework for Credit Risk Framework for Credit Risk ManagementManagement

• CRM framework includes: Policy framework: requires the following distinct building

blocks: (1) Strategy and policy, (2) organization, and (3) operations/systems

Credit risk rating framework Credit risk limits Credit risk modeling RAROC pricing Risk mitigants Loan review mechanism/credit audit

Policy FrameworkPolicy Framework

• Strategy and Policy: Credit policies and procedures of banks should

necessarily have the following elements: Written policies defining target markets, risk acceptance

criteria, credit approval authority, credit origination and maintenance procedures and guidelines for portfolio management and remedial management

Systems to manage problem loans to ensure appropriate restructuring schemes

A conservative policy for the provisioning of non-performing advances should be followed

Policy Framework Policy Framework (Contd.)(Contd.)

• Strategy and Policy: Credit policies and procedures of banks should

necessarily have the following elements: Consistent approach towards early problem recognition,

classification of problem exposures, and remedial action Maintain a diversified portfolio of risk assets in line with the

capital desired to support such a portfolio Procedures and systems, which allow for monitoring

financial performance of customers and for controlling outstanding within limits

Policy Framework Policy Framework (Contd.)(Contd.)

• Organizational Structure Banks should have an independent group responsible for

the CRM Responsibilities to include formulation of credit policies,

procedures and controls extending to all of its credit risk arising from corporate banking, treasury, credit cards, personal banking, trade finance, securities processing, payments and settlement systems

Board of Directors should have the overall responsibility for management of risks

Policy Framework Policy Framework (Contd.)(Contd.)

• Organizational Structure The Board should decide the risk management policy of

the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks

Risk Management Committee will be a Board level Sub committee including CEO and heads of Credit, Market and Operational Risk Management Committees. It will devise the policy and strategy for integrated risk management containing various risk exposures of the bank including the credit risk

RMC should effectively coordinate between the Credit Risk Management Committee (CRMC), the Asset Liability Management Committee and other risk committees of the bank, if any

Policy Framework Policy Framework (Contd.)(Contd.)

• Operations / Systems Credit process typically involves the following phases:

Relationship management phase, that is, business development

Transaction management phase to cover risk assessment, pricing, structuring of the facilities, obtaining internal approvals, documentation, loan administration and routine monitoring and measurement, and

Portfolio management phase to entail the monitoring of portfolio at a macro level and the management of problem loans.

Credit Risk Rating Credit Risk Rating FrameworkFramework

• Use of credit rating models and credit rating analysts

• Loans to individuals or small businesses, credit quality is assessed through credit scoring which is based on a standard formulae which incorporates party’s information viz. annual income, existing debts, other details such as homes (rented or owned) etc.

Credit Risk LimitsCredit Risk Limits

• Bank generally sets an exposure credit limit for each counterparty to which it has credit exposure

• Depending on the assessment of the borrower (commercial as well as retail) a credit exposure limit is decided for the customer, however, within the framework of a total credit limit for the individual divisions and for the company as a whole

Credit Risk LimitsCredit Risk Limits

• Also within the limit as per RBI, i.e. not more than 15% of capital to individual borrower and not more than 40% of capital to a group borrower

• Threshold limits are set which are dependent upon Credit rating of the borrower Past financial records Willingness and ability to repay Borrower’s future cash flow projections

Risk MitigantsRisk Mitigants

• Credit risk mitigation means reduction of credit risk in an exposure by a safety net of tangible and realisable securities including third-party approved guarantees/insurance

• Various risk mitigants are: Collateral (tangible, marketable) securities Guarantees Credit derivatives On-balance-sheet netting

Risk Mitigants Risk Mitigants (Contd.)(Contd.)

• Conditions for use of credit risk mitigants All documentation used in collateralized transactions

must be binding on all parties and must be legally enforceable in all relevant jurisdictions

Banks must have properly reviewed all the documents and should have appropriate legal opinions to verify such, and ensure its enforceability

Loan Review Mechanism / Loan Review Mechanism / Credit AuditCredit Audit

• Credit audit examines the compliance with extant sanction and post-sanction processes and procedures laid down by the bank from time to time

• The objectives of credit audit are: Improvement in the quality of credit portfolio Review of sanction process and compliance status of

large loans Feedback on regulatory compliance Independent review of credit risk assessment Pick-up of early warning signals and suggest remedial

measures, and Recommend corrective actions to improve credit quality, credit

administration, and credit skills of staff

RBI Guidelines on Credit RBI Guidelines on Credit Exposure and ManagementExposure and Management

• Credit exposure to an individual borrowers not to exceed 15% of capital funds

• Group borrowers exposure not to exceed 40% of capital funds

• Aggregate ceiling in unsecured advances should not exceed 15 % of total DTL of the bank from earlier 33.33%

RBI Guidelines on Credit RBI Guidelines on Credit Exposure and Management Exposure and Management

(Contd.)(Contd.)

• Bank cannot grant loans against security of its own shares

• Prohibition on remission of debts for UCBs without prior approval of RBI

• Restrictions on loans and advances to Directors and their relatives

• Ceiling on advances to Nominal Members – With deposits up to Rs. 50 crore (Rs. 50,000/- per borrower) and RS. 1,00,000/- for above Rs. 50 crore

RBI Guidelines on RBI Guidelines on Credit Exposure and Credit Exposure and

ManagementManagement• Prohibition on UCBs for bridge loans including

that against capital / debentures issues• Loan and advances against shares, debentures

UCBs are prohibited from permitted to extend any facilities to stock brokers

Margin of 40 per cent to be maintained on all such advances

• Restriction on advances to real estate sector – only for genuine constriction and not for speculative purposes

Components of Credit RiskComponents of Credit Risk

• Default Risk – Risk that a borrower or counterparty is unable to meet its commitment

• Portfolio Risk – Risk which arises from the composition / concentration of bank’s exposure to various sectors

• Two factors affect credit risk Internal Factors – Bank specific External factors – State of economy, size of fiscal deficit

etc.

Managing Internal FactorsManaging Internal Factors

• Adopting proactive loan policy• Good quality credit analysis• Loan monitoring• Sound credit culture

Managing External FactorsManaging External Factors

• Well diversified loan portfolio• Scientific credit appraisal for assessing financial

and commercial viability of loan proposal• Norms for single and group borrowers• Norms for sectoral deployment of funds• Strong monitoring and internal control systems• Delegation and accounatbility

Credit Risk Management as Credit Risk Management as per RBIper RBI

• Measurement of risk through credit scoring• Quantifying risk through estimating loan losses• Risk pricing – Prime lending rate which also

accounts for risk• Risk control through effective Loan Review

Mechanism and Portfolio Management

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