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Loan Policy - Credit Risk Management


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									Loan Policy- Credit Risk Management

       Deputy General Manager/MOF
                CAB Pune

                          RBI CAB Pune   July 5, 2010   1
RBI CAB Pune   July 5, 2010   2
 Loan  policy- Genesis, Importance- Credit risk
 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

                                   RBI CAB Pune   July 5, 2010   6
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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
   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   8
 Firstsix 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.   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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 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
                                       RBI CAB Pune   July 5, 2010   16
     Credit Culture “This is the way we handle

Establish Business     Choose Credit                  Strategies
    Priorities            Culture

    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   Values Driven (Conservative,
growth                                  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

                                         RBI CAB Pune   July 5, 2010   20
 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

                                    RBI CAB Pune   July 5, 2010   21
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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

                                              RBI CAB Pune   July 5, 2010   23
 No ambiguity in postulations- chance for different
  understanding interpretations
 Loan policy must clearly mark the boundaries
    RBI
    Bank
 Loan  policy should ideally list out restrictions that
  credit grantors can refer
 Loan policy must provide for exceptions- list out if
 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
    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
 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
  Regulatory environment

                                     RBI CAB Pune   July 5, 2010   27
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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
 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
     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
 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

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Prudential limits
    limiting magnitude of credit risk
    Dispersion of credit risk- prevents concentration
    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

 July 5, 2010                             RBI CAB Pune       36
    Financial Limits          Maximum limit
                               Aggregate limit
                               Industry wise
                               Sector specific

                               Individual
    Single & Group
                               Corporate
                               Partnership
                               Proprietorship

                               Aggregate linked to
    Substantial Exposure       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
   Industry and sector wise ceilings
   Limits on sensitive sectors subject to asset price
   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

 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
 What is the growth in terms of size, earnings and

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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

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    Customer Friendliness/service,
    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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     of potential conflict in perceptions differences
 Area
 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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