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Loan Policy - Credit Risk Management

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					Loan Policy- Credit Risk Management


                 N.Gopal
       Deputy General Manager/MOF
                CAB Pune

                          RBI CAB Pune   July 5, 2010   1
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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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 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
  issues
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     Credit Culture “This is the way we handle
                      credit”


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




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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
 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          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
    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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     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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