Loan Policy- Credit Risk Management

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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

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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.

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Genesis – Importance of Policy1980s

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 problemsLessons

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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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

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Ingredients of a good loan policy1. 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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Loan policy formulation in a bank

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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

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Process

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Credit Culture “This is the way we handle credit”

Establish BusinessEstablish Business Priorities Priorities

Choose Credit Choose Credit Culture Culture

StrategiesStrategies

Credit Policy determines the credit culture

Determines Credit Culture of Bank

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Based on Corporate prioritiesBased on Corporate priorities

Credit Culture could be one of four Credit Culture could be one of four typestypes

CORPORATE PRIORITY CORPORATE PRIORITY CULTURECULTURE

Emphasis on asset quality , long term Emphasis on asset quality , long term growthgrowth

Values Driven (Conservative, Values Driven (Conservative, Prudent)Prudent)

Short term gains Short term gains Earnings Driven (Regardless Earnings Driven (Regardless of risk)of risk)

Market share, Size Market share, Size Volume Driven /AggressiveVolume Driven /Aggressive

No clear priorities No clear priorities UnfocussedUnfocussed

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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

Healthy Balance

Credit expansionSteady expansion, sustained, continuous & prudent

growthSteady 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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Regulatory and Statutory issues in Loan Policy formulation

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Regulatory requirements

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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

Credit Policy and Regulatory guidelinesNo ambiguity in postulations- chance for different

understanding interpretationsLoan 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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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

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Studies prior to formulating a policy

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Industry Issues in Policy

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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

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A Closer Look at Industry Analysis

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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, Environment issues

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

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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

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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 23

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

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Fixation of internal prudential ceiling norms

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Internal Prudential Limits – A Potent Instrument of Credit Risk Management- through Loan policy

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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

Prudential exposure ceilings

• Financial Limits

• Single & Group

• Substantial Exposure

Maximum limitAggregate limit Industry wise Sector specific

IndividualCorporatePartnershipProprietorship

Aggregate linked to capital funds

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Some issues in limitsFinancial 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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Setting Prudential Limits – Specific to Each Bank

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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

Credit Rating & Loan policy

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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

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

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Schematic Lending Policy

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Schematic Lending- Loan Policy

A good loan policy to provide leeway for

It should balance the risk and returns on the retail front

Schematic LendingDirected 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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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?

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Taking over Loan Accounts

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Policy of take over

Take over route to grow businessPolicy to clearly lay down ground rules

What type of borrower accountsWhat level of exposuresTake over from whomTake over standardsPricing

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Implementation Issues

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ChallengeProfitability, Customer Friendliness/service, ComplianceCapital 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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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

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In the Final Analysis

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Credit Policy As a Risk Management Tool

Credit Policy serves a ‘Gate Keeping’ function Defines thrust areas in relation to credit culture,

profit objectives and regulatory directionsDefines 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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Policy -Widen Knowledge Base

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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?

Loan Policy risk, growth, profits

An ideal loan policy should Create right for business growthMaintain quality of assets Provide platform for good procedures/processEnsure regulatory and statutory compliances Be the platform for Credit Risk Management

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