Credit ManagementJyoti Kumar PandeyDeputy General Manager &MOFCAB, Pune

College of Agricultural Banking, RBI, PUNE

Credit OpportunityCredit CreationCredit ManagementCredit CompletionCredit Life Cycle Theory

AgendaBasics of credit managementIntroduction of credit risk managementOther issues

IntroductionCredit refers to Short Term Loans & AdvancesMedium / Long Term LoansOff-Balance Sheet TransactionsManagement refers to Pre-sanction appraisalDocumentationDisbursement and DisbursalPost-lending supervision and control

Credit ManagementCredit Management now includesCapital adequacy normsRisk Management including ALMExposure NormsPricing policy and credit risk ratingIRAC normsAppraisal, credit-decision making and loan review mechanism

Approach for safety of loansSafety of loans is directly related to the basis on which decision to lend is takenType and quantum of credit to be providedTerms and conditions of the loan

Approach for safety of loans (Contd.)Two-pronged approachPre-Sanction appraisalTo determine the bankability of each loan proposalPost-Sanction controlTo ensure proper documentation, follow-up and supervision

Pre-Sanction appraisalConcerned with measurement of risk(iness) of a loan proposalRequirements are:Financial data of past and projected working resultsDetailed credit report is compiled on the borrower / suretyMarket reportsFinal / audited accountsIncome tax and other tax returns / assessmentsConfidential reports from other banks and financial institutionsCredit Report (CR) needs to be regularly updatedAppraisal should reveal whether a loan proposal is a fair banking risk

Post-Sanction appraisalDepends to large extent upon findings of pre-sanction appraisalRequirements are:Documentation of the facility and after care follow- upSupervision through monitoring of transactions in loan amountScrutiny of periodical statements submitted by the borrowerPhysical inspection of securities and books of accounts of the borrowerPeriodical reviews etc.

Bankers Credit ReportIncludes seeking information including other banks (writing or over telephone etc.)Sharing of information could be a sensitive issueAdvisable to take an undertaking from customers Make the condition as part of account opening form or loan application

Types of loans and advancesWorking Capital FinanceExtended to meet day-to-day short term operational requirements (sales & purchase of commodities, purchase of raw materials etc.)Loan for setting up new project, expansion and diversification of existing project etc.Short term or medium term

Loans and Advances (Contd.)Difference between Loans and AdvancesLoans are extended in accounts in which no drawings are permitted to the borrowersGenerally there is one debit to principal amount to loan account though disbursal in stages is possible depending on the need of the borrowerFor operational purposes loan can be credited to a special account where withdrawal from time to time can be done by the party depending upon his requirementsIn case of advances, the sanctioned limit is placed at the disposal of the borrower, subject to terms of sanction, in running accounts which can be drawn upon by cheques by the borrower

Loans and Advances (Contd.)Working capital finance in form of loan is also known as demand loanAs an advance it is commonly known as cash credit facilityBanks apart from working capital and medium term and long term finance may also extend casual overdrafts to approved customersIn current accountsLoans against security of shares, FDs, housing loans etc.

Securities for lending Section 5 of B. R. Act defines secured and unsecured loansSecured Loans and advances made on security of assets the market value of which is not at any time less than the amount of the loan or advancesUnsecured Means a loans or advance not so securedSecurity taken as an insurance against unwarranted situations

Securities for lending Two types: Primary and CollateralPrimary Security Generally from a viable and professionally managed enterprisePersonal Created by a duly executed promissory note, acceptance or endorsement of bill of exchange etc.Gives bank the right of action to proceed against the borrower personally in the event of defaultImpersonal Created by way of a charge (pledge, hypothecation, mortgage, assignment etc.)

Securities for lending Collateral Security Meaning running parallel or togetherTaken as additional and separate securityCould be secured / unsecured guarantees, pledge of shares and other securities, deposits of title deeds etc.Used to reinforce the primary security (for e.g. plantation advances are not considered fully secured until crop is harvested)

Preconditions of loansWillingness or intention to repay as per agreementRelatively easier to assessDetermined by good track record of payments and debt servicingUncertain / uncontrollable events could affect the judgmentPurpose for which loan is soughtShould be documented carefullyType of loan applied for - Working capital loan, term loan, personal loan etc.Conditions which can set the trend of future

Conditions determining future trendsThree factors which can undergo changes:ProspectsFuture risk profileRepayment capacity

Tools for determining future trendsFinancial Analysis past and projectedCredit ratingAssessment of credit needsTerms of sanctionDocumentation and creation of security interestPost-lending supervision 3 stagesRegular surprise verification of security Stock auditObtaining and scrutiny of control statement (stock statements, financial statements)Repayment and / or rollover

Risks in Bank LendingCredit RiskMarket RiskOperational Risk

Credit RiskRBI defines credit risk as:the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a banks portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality.

Credit Risk ManagementCredit risk is defined, as the potential that a borrower or counter-party will fail to meet its obligations in accordance with agreed termsIt is the probability of loss from a credit transaction

Credit Risk Management According to Reserve Bank of India, the following are the forms of credit risk:Non-repayment of the principal of the loan and/or the interest on itContingent liabilities like letters of credit/guarantees issued by the bank on behalf of the client and upon crystallization amount not deposited by the customerIn the case of treasury operations, default by the counter-parties in meeting the obligationsIn the case of securities trading, settlement not taking place when it is dueIn the case of cross-border obligations, any default arising from the flow of foreign exchange and/or due to restrictions imposed on remittances out of the country

Principles of sound credit risk managementBOD should have responsibility for approving and periodically reviewing credit risk strategySenior management should have the responsibility to implement the credit risk strategyBank should identify and manage credit risk inherent in all product and activities

Prudential Norms for appropriate Credit Risk environmentNorms for Capital AdequacyExposure Norms Credit Exposure and Investment Exposure Norms to individual and group borrowersCapital Market ExposuresBanks-specific internal exposure limitsIRAC normsCredit rating system and risk pricing policyALMNorms for setting up loan policy

Framework for Credit Risk ManagementCRM framework includes:Policy framework: requires the following distinct building blocks: (1) Strategy and policy, (2) organization, and (3) operations/systemsCredit risk rating frameworkCredit risk limitsCredit risk modelingRAROC pricingRisk mitigantsLoan review mechanism/credit audit

Policy FrameworkStrategy and Policy:Credit policies and procedures of banks should necessarily have the following elements:Written policies defining target markets, risk acceptance criteria, credit approval authority, credit origination and maintenance procedures and guidelines for portfolio management and remedial management Systems to manage problem loans to ensure appropriate restructuring schemes A conservative policy for the provisioning of non-performing advances should be followed

Policy Framework (Contd.)Strategy and Policy:Credit policies and procedures of banks should necessarily have the following elements:Consistent approach towards early problem recognition, classification of problem exposures, and remedial action Maintain a diversified portfolio of risk assets in line with the capital desired to support such a portfolio Procedures and systems, which allow for monitoring financial performance of customers and for controlling outstanding within limits

Policy Framework (Contd.)Organizational StructureBanks should have an independent group responsible for the CRMResponsibilities to include formulation of credit policies, procedures and controls extending to all of its credit risk arising from corporate banking, treasury, credit cards, personal banking, trade finance, securities processing, payments and settlement systemsBoard of Directors should have the overall responsibility for management of risks

Policy Framework (Contd.)Organizational StructureThe Board should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risksRisk Management Committee will be a Board level Sub committee including CEO and heads of Credit, Market and Operational Risk Management Committees. It will devise the policy and strategy for integrated risk management containing various risk exposures of the bank including the credit riskRMC should effectively coordinate between the Credit Risk Management Committee (CRMC), the Asset Liability Management Committee and other risk committees of the bank, if any

Policy Framework (Contd.)Operations / SystemsCredit process typically involves the following phases:Relationship management phase, that is, business developmentTransaction management phase to cover risk assessment, pricing, structuring of the facilities, obtaining internal approvals, documentation, loan administration and routine monitoring and measurement, andPortfolio management phase to entail the monitoring of portfolio at a macro level and the management of problem loans.

Credit Risk Rating FrameworkUse of credit rating models and credit rating analystsLoans to individuals or small businesses, credit quality is assessed through credit scoring which is based on a standard formulae which incorporates partys information viz. annual income, existing debts, other details such as homes (rented or owned) etc.

Credit Risk LimitsBank generally sets an exposure credit limit for each counterparty to which it has credit exposureDepending on the assessment of the borrower (commercial as well as retail) a credit exposure limit is decided for the customer, however, within the framework of a total credit limit for the individual divisions and for the company as a whole

Credit Risk LimitsAlso within the limit as per RBI, i.e. not more than 15% of capital to individual borrower and not more than 40% of capital to a group borrowerThreshold limits are set which are dependent upon Credit rating of the borrowerPast financial recordsWillingness and ability to repayBorrowers future cash flow projections

Credit Risk ModelingCredit risk models used by banks are (1) Altmans Z score model, (2) Credit metrics model, (3) Value at risk model, (4) KMV Model

Altmans Z Score Model95 % accuracy of prediction of bankruptcy up to two years prior to failure on non-manufacturing firms as well

Altmans Z Score ModelAltman Z-Score variables influencing the financial strength of a firm are: current assets, total assets, net sales, interest, total liability, current liabilities, market value of equity, earnings before taxes and retained earningsZ = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 + 0.999X5Where,X1 = working capital/Total assetsX2 = Retained earnings/Total assetsX3 = Earnings before interest and taxes/Total assetsX4 = Market value of equity/Book value of total liabilitiesX5 = Sales/Total assetsZ score of the firm is 3 or more Safe Below 1.8 Highly likely headed for bankruptcy2.8 to 3 Probably safe1.8 to 2.7 Likely to be bankrupt within 2 years

Credit Metrics ModelTool for assessing portfolio risk due to changes in debt value caused by changes in obligor credit qualityCredit Metrics has the following applications:Reduce the portfolio riskLimit settingIdentifying the correlations across the portfolio so that the potential concentration may be reduced and the portfolio is adequately diversified across the uncorrelated constituents Concentration may lead to an undue accumulation of risk at one point

Value at Risk ModelDefined as an estimate of potential loss in asset / portfolio over a given holding period at a given level of certaintyValue at risk is calculated by constructing a probability distribution of the portfolio values over a given time horizonThe values may be calculated on the daily, weekly or monthly basis

KMV ModelDeveloped by KMV Corporation based on Mertons (1973) analytical modelFirm would default only if its asset value falls below certain level (default point), which is a function of its liabilityEstimates the asset value of the firm and its asset volatility from the market value of equity and the debt structure in the opinion theoretic frameworkA metric (distance from default or DFD) is constructed that represents the number of standard deviation that the firms asset value is away from the default pointFinally, a mapping is done between the default values and actual default rate, based on historical default experience to give Expected Default Frequency (EDF)Estimation of asset value and asset volatility from equity value and volatility of equity return,Calculation of DFDDFD = (Asset value Default point) / (Asset value * Asset volatility)Calculation of expected default frequency

Risk Adjusted Return on CapitalBased on a mark-to-market conceptAllocates a capital charge to a transaction or a line of business at an amount equal to the maximum expected loss (at a 99 percent confidence level)The four basic steps in the process are:Determine basic risk categories interest rate risk, credit risk, operational risk, forex risk etc. Quantify the risk in each categoryRAROC risk factor = 2.33 * weekly volatility * square root of 52 * (I tax rate)2.33 gives the volatility (expressed as per cent) at the 99% confidence level52 converts the weekly price movement into an amount movement(I tax rate) converts the calculated value to an after-tax basisCompute the capital required for each category by multiplying the risk factor by the size of the position

Risk MitigantsCredit risk mitigation means reduction of credit risk in an exposure by a safety net of tangible and realisable securities including third-party approved guarantees/insuranceVarious risk mitigants are:Collateral (tangible, marketable) securitiesGuaranteesCredit derivativesOn-balance-sheet netting

Risk Mitigants (Contd.)Conditions for use of credit risk mitigantsAll documentation used in collateralized transactions must be binding on all parties and must be legally enforceable in all relevant jurisdictionsBanks must have properly reviewed all the documents and should have appropriate legal opinions to verify such, and ensure its enforceability

Loan Review Mechanism / Credit AuditCredit audit examines the compliance with extant sanction and post-sanction processes and procedures laid down by the bank from time to timeThe objectives of credit audit are:Improvement in the quality of credit portfolioReview of sanction process and compliance status of large loansFeedback on regulatory complianceIndependent review of credit risk assessmentPick-up of early warning signals and suggest remedial measures, andRecommend corrective actions to improve credit quality, credit administration, and credit skills of staff

RBI Guidelines on Credit Exposure and ManagementCredit exposure to an individual borrowers not to exceed 15% of capital fundsGroup borrowers exposure not to exceed 40% of capital fundsAggregate ceiling in unsecured advances should not exceed 15 % of total DTL of the bank from earlier 33.33%

- Capital Funds comprise of:a. Paid-up Capitalb. Free Reserves as per audited accountsc. Amount held under 'Building Fund' - Credit Exposure includesa. Funded and Non Funded credit limitsb. Facilities extended by way of equipment leasing and hire purchase financingc. ad hoc limits sanctioned to the borrowers to meet contingencies

RBI Guidelines on Credit Exposure and Management (Contd.)Bank cannot grant loans against security of its own sharesProhibition on remission of debts for UCBs without prior approval of RBIRestrictions on loans and advances to Directors and their relatives Ceiling on advances to Nominal Members With deposits up to Rs. 50 crore (Rs. 50,000/- per borrower) and RS. 1,00,000/- for above Rs. 50 crore

- Capital Funds comprise of:a. Paid-up Capitalb. Free Reserves as per audited accountsc. Amount held under 'Building Fund' - Credit Exposure includesa. Funded and Non Funded credit limitsb. Facilities extended by way of equipment leasing and hire purchase financingc. ad hoc limits sanctioned to the borrowers to meet contingencies

RBI Guidelines on Credit Exposure and ManagementProhibition on UCBs for bridge loans including that against capital / debentures issuesLoan and advances against shares, debenturesUCBs are prohibited from permitted to extend any facilities to stock brokersMargin of 40 per cent to be maintained on all such advancesRestriction on advances to real estate sector only for genuine constriction and not for speculative purposes

Components of Credit RiskDefault Risk Risk that a borrower or counterparty is unable to meet its commitmentPortfolio Risk Risk which arises from the composition / concentration of banks exposure to various sectorsTwo factors affect credit riskInternal Factors Bank specificExternal factors State of economy, size of fiscal deficit etc.

Managing Internal FactorsAdopting proactive loan policyGood quality credit analysisLoan monitoringSound credit culture

Managing External FactorsWell diversified loan portfolioScientific credit appraisal for assessing financial and commercial viability of loan proposalNorms for single and group borrowersNorms for sectoral deployment of fundsStrong monitoring and internal control systemsDelegation and accounatbility

Credit Risk Management as per RBIMeasurement of risk through credit scoringQuantifying risk through estimating loan lossesRisk pricing Prime lending rate which also accounts for riskRisk control through effective Loan Review Mechanism and Portfolio Management

Thank You

College of Agricultural Banking, RBI, PUNE