Loan Policy- Credit Risk Management N.Gopal Deputy General Manager/MOF CAB Pune

1. Loan Policy- Credit Risk Management N.Gopal Deputy General Manager/MOF CAB Pune RBI CAB Pune

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3. Presentation Objectives • 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 RBI CAB Pune

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6. What is it • 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. RBI CAB Pune

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8. Genesis – Importance of Policy • 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 RBI CAB Pune

9. The Need for Policy Making • 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 RBI CAB Pune

10. Ingredients of a good loan policy • Board & Management Oversight • Portfolio Management • Management Information Systems • Market Analysis • Credit Underwriting Standards • Portfolio Stress Testing & Sensitivity Analysis • Credit Risk Review Function RBI CAB Pune

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13. Loan policy formulation in a bank RBI CAB Pune

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16. Typical loan policy • 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 RBI CAB Pune

17. Process Credit Culture “This is the way we handle credit” Establish Business Priorities Choose Credit Culture Strategies Credit Policy determines the credit culture RBI CAB Pune

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19. Determines Credit Culture of Bank • Based on Corporate priorities • Credit Culture could be one of four types RBI CAB Pune

20. A Delicate Balancing Act • 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

21. Healthy Balance • 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

22. Regulatory and Statutory issues in Loan Policy formulation RBI CAB Pune

23. Regulatory requirements • 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

24. Credit Policy and Regulatory guidelines • 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 RBI CAB Pune

25. Policy -interspersed with Do’s and Don’ts • 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 RBI CAB Pune

26. Studies prior to formulating a policy RBI CAB Pune

27. Sector Watch and Industry Studies • 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 RBI CAB Pune

28. Industry Issues in Policy RBI CAB Pune

29. Industry Analysis – A key tool • 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 RBI CAB Pune

30. A Closer Look at 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 • 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, Environmental issues and Covariance factors RBI CAB Pune

31. A Closer Look at Industry Analysis • 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 RBI CAB Pune

32. Industry Analysis in Actual Practice • 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 RBI CAB Pune

33. Business prospecting through policy • 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 RBI CAB Pune

34. Core competencies- influence on policy • 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 RBI CAB Pune

35. Fixation of internal prudential ceiling norms RBI CAB Pune

36. Internal Prudential Limits – A Potent Instrument of Credit Risk Management- through Loan policy • 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 RBI CAB Pune

37. Prudential exposure ceilings • Financial Limits • Single & Group • Substantial Exposure • Maximum limit • Aggregate limit • Industry wise • Sector specific • Individual • Corporate • Partnership • Proprietorship • Aggregate linked to capital funds RBI CAB Pune

38. Some issues in limits • 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 RBI CAB Pune

39. Setting Prudential Limits – Specific to Each Bank • 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 RBI CAB Pune

40. Credit Rating & Loan policy RBI CAB Pune

41. Credit Rating • 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

42. Credit rating & Loan Policy • 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 RBI CAB Pune

43. Schematic Lending Policy RBI CAB Pune

44. Schematic Lending- Loan Policy • 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 RBI CAB Pune

45. Risk Vs Return- Retail Lending • 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? RBI CAB Pune

46. Taking over Loan Accounts RBI CAB Pune

47. Policy of take over • 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 RBI CAB Pune

48. Implementation Issues RBI CAB Pune

49. Challenge • 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, RBI CAB Pune

50. Policy Deviations –French Windows? • 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 RBI CAB Pune