Loan Policy- Credit Risk Management
N.Gopal
Deputy General Manager/MOF
CAB Pune
RBI CAB Pune
July 5, 2010
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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
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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
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
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 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
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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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
bank’s 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
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
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
Financial Limits

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Single & Group

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

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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

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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 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
 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/
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
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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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