Credit Management

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Credit Management

• Jyoti Kumar Pandey
• Deputy General Manager
• MOF
• CAB, Pune

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(No Transcript)
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Credit Life Cycle Theory
Credit Opportunity
Credit Creation
Credit Completion
Credit Management
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Agenda

• Basics of credit management
• Introduction of credit risk management
• Other issues

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Introduction

• Credit refers to
• Short Term Loans Advances
• Medium / Long Term Loans
• Off-Balance Sheet Transactions
• Management refers to
• Pre-sanction appraisal
• Documentation
• Disbursement and Disbursal
• Post-lending supervision and control

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Credit Management

• Credit Management now includes
• Capital adequacy norms
• Risk Management including ALM
• Exposure Norms
• Pricing policy and credit risk rating
• IRAC norms
• Appraisal, credit-decision making and loan review
  mechanism

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Approach for safety of loans

• Safety of loans is directly related
• to the basis on which decision to lend is taken
• Type and quantum of credit to be provided
• Terms and conditions of the loan

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Approach for safety of loans (Contd.)

• Two-pronged approach
• Pre-Sanction appraisal
• To determine the bankability of each loan
  proposal
• Post-Sanction control
• To ensure proper documentation, follow-up and
  supervision

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Pre-Sanction appraisal

• Concerned with measurement of risk(iness) of a
  loan proposal
• Requirements are
• Financial data of past and projected working
  results
• Detailed credit report is compiled on the
  borrower / surety
• Market reports
• Final / audited accounts
• Income tax and other tax returns / assessments
• Confidential reports from other banks and
  financial institutions
• Credit Report (CR) needs to be regularly updated
• Appraisal should reveal whether a loan proposal
  is a fair banking risk

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Post-Sanction appraisal

• Depends to large extent upon findings of
  pre-sanction appraisal
• Requirements are
• Documentation of the facility and after care
  follow- up
• Supervision through monitoring of transactions in
  loan amount
• Scrutiny of periodical statements submitted by
  the borrower
• Physical inspection of securities and books of
  accounts of the borrower
• Periodical reviews etc.

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Bankers Credit Report

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

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Types of loans and advances

• Working Capital Finance
• Extended 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

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Loans and Advances (Contd.)

• Difference between Loans and Advances
• Loans are extended in accounts in which no
  drawings are permitted to the borrowers
• Generally there is one debit to principal amount
  to loan account though disbursal in stages is
  possible depending on the need of the borrower
• For 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
  requirements
• In 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

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Loans and Advances (Contd.)

• Working capital finance in form of loan is also
  known as demand loan
• As an advance it is commonly known as cash credit
  facility
• Banks apart from working capital and medium term
  and long term finance may also extend casual
  overdrafts to approved customers
• In current accounts
• Loans against security of shares, FDs, housing
  loans etc.

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Securities for lending

• Section 5 of B. R. Act defines secured and
  unsecured loans
• Secured 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 advances
• Unsecured Means a loans or advance not so
  secured
• Security taken as an insurance against
  unwarranted situations

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Securities for lending

• Two types Primary and Collateral
• Primary Security Generally from a viable and
  professionally managed enterprise
• Personal
• 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 default
• Impersonal
• Created by way of a charge (pledge,
  hypothecation, mortgage, assignment etc.)

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Securities for lending

• Collateral Security Meaning running parallel or
  together
• Taken as additional and separate security
• Could 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)

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Preconditions of loans

• Willingness or intention to repay as per
  agreement
• Relatively easier to assess
• Determined by good track record of payments and
  debt servicing
• Uncertain / uncontrollable events could affect
  the judgment
• Purpose for which loan is sought
• Should be documented carefully
• Type of loan applied for - Working capital loan,
  term loan, personal loan etc.
• Conditions which can set the trend of future

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Conditions determining future trends

• Three factors which can undergo changes
• Prospects
• Future risk profile
• Repayment capacity

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Tools for determining future trends

• Financial Analysis past and projected
• Credit rating
• Assessment of credit needs
• Terms of sanction
• Documentation and creation of security interest
• Post-lending supervision 3 stages
• Regular surprise verification of security
• Stock audit
• Obtaining and scrutiny of control statement
  (stock statements, financial statements)
• Repayment and / or rollover

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Risks in Bank Lending

• Credit Risk
• Market Risk
• Operational Risk

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Credit Risk

• RBI 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.

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Credit Risk Management

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

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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 it
• Contingent liabilities like letters of
  credit/guarantees issued by the bank on behalf of
  the client and upon crystallization amount not
  deposited by the customer
• In the case of treasury operations, default by
  the counter-parties in meeting the obligations
• In the case of securities trading, settlement not
  taking place when it is due
• In 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

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Principles of sound credit risk management

• BOD should have responsibility for approving and
  periodically reviewing credit risk strategy
• Senior management should have the responsibility
  to implement the credit risk strategy
• Bank should identify and manage credit risk
  inherent in all product and activities

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Prudential Norms for appropriate Credit Risk
environment

• Norms for Capital Adequacy
• Exposure Norms
• Credit Exposure and Investment Exposure Norms to
  individual and group borrowers
• Capital Market Exposures
• Banks-specific internal exposure limits
• IRAC norms
• Credit rating system and risk pricing policy
• ALM
• Norms for setting up loan policy

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Framework for Credit Risk Management

• CRM framework includes
• Policy framework requires the following distinct
  building blocks (1) Strategy and policy, (2)
  organization, and (3) operations/systems
• Credit risk rating framework
• Credit risk limits
• Credit risk modeling
• RAROC pricing
• Risk mitigants
• Loan review mechanism/credit audit

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Policy Framework

• Strategy 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

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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

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Policy Framework (Contd.)

• Organizational Structure
• Banks should have an independent group
  responsible for the CRM
• Responsibilities 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 systems
• Board of Directors should have the overall
  responsibility for management of risks

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Policy Framework (Contd.)

• Organizational Structure
• The Board should decide the risk management
  policy of the bank and set limits for liquidity,
  interest rate, foreign exchange and equity price
  risks
• Risk 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 risk
• RMC should effectively coordinate between the
  Credit Risk Management Committee (CRMC), the
  Asset Liability Management Committee and other
  risk committees of the bank, if any

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Policy Framework (Contd.)

• Operations / Systems
• Credit process typically involves the following
  phases
• Relationship management phase, that is, business
  development
• Transaction management phase to cover risk
  assessment, pricing, structuring of the
  facilities, obtaining internal approvals,
  documentation, loan administration and routine
  monitoring and measurement, and
• Portfolio management phase to entail the
  monitoring of portfolio at a macro level and the
  management of problem loans.

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Credit Risk Rating Framework

• Use of credit rating models and credit rating
  analysts
• Loans 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.

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Credit Risk Limits

• Bank generally sets an exposure credit limit for
  each counterparty to which it has credit exposure
• Depending 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

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Credit Risk Limits

• Also 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 borrower
• Threshold limits are set which are dependent upon
  
• Credit rating of the borrower
• Past financial records
• Willingness and ability to repay
• Borrowers future cash flow projections

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Credit Risk Modeling

• Credit 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 Model
• 95 accuracy of prediction of bankruptcy up to
  two years prior to failure on non-manufacturing
  firms as well

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Altmans Z Score Model

• Altman 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
  earnings
• Z 0.012X1 0.014X2 0.033X3 0.006X4
  0.999X5
• Where,
• X1 working capital/Total assets
• X2 Retained earnings/Total assets
• X3 Earnings before interest and taxes/Total
  assets
• X4 Market value of equity/Book value of total
  liabilities
• X5 Sales/Total assets
• Z score of the firm is
• 3 or more Safe
• Below 1.8 Highly likely headed for bankruptcy
• 2.8 to 3 Probably safe
• 1.8 to 2.7 Likely to be bankrupt within 2 years

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Credit Metrics Model

• Tool for assessing portfolio risk due to changes
  in debt value caused by changes in obligor credit
  quality
• Credit Metrics has the following applications
• Reduce the portfolio risk
• Limit setting
• Identifying 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

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Value at Risk Model

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

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KMV Model

• Developed by KMV Corporation based on Mertons
  (1973) analytical model
• Firm would default only if its asset value falls
  below certain level (default point), which is a
  function of its liability
• Estimates the asset value of the firm and its
  asset volatility from the market value of equity
  and the debt structure in the opinion theoretic
  framework
• A 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 point
• Finally, 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 DFD
• DFD (Asset value Default point) / (Asset
  value Asset volatility)
• Calculation of expected default frequency

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Risk Adjusted Return on Capital

• Based on a mark-to-market concept
• Allocates 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 category
• RAROC 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 level
• 52 converts the weekly price movement into an
  amount movement
• (I tax rate) converts the calculated value to
  an after-tax basis
• Compute the capital required for each category by
  multiplying the risk factor by the size of the
  position

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Risk Mitigants

• Credit risk mitigation means reduction of credit
  risk in an exposure by a safety net of tangible
  and realisable securities including third-party
  approved guarantees/insurance
• Various risk mitigants are
• Collateral (tangible, marketable) securities
• Guarantees
• Credit derivatives
• On-balance-sheet netting

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Risk Mitigants (Contd.)

• Conditions for use of credit risk mitigants
• All documentation used in collateralized
  transactions must be binding on all parties and
  must be legally enforceable in all relevant
  jurisdictions
• Banks must have properly reviewed all the
  documents and should have appropriate legal
  opinions to verify such, and ensure its
  enforceability

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Loan Review Mechanism / Credit Audit

• Credit audit examines the compliance with extant
  sanction and post-sanction processes and
  procedures laid down by the bank from time to
  time
• The objectives of credit audit are
• Improvement in the quality of credit portfolio
• Review of sanction process and compliance status
  of large loans
• Feedback on regulatory compliance
• Independent review of credit risk assessment
• Pick-up of early warning signals and suggest
  remedial measures, and
• Recommend corrective actions to improve credit
  quality, credit administration, and credit skills
  of staff

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RBI Guidelines on Credit Exposure and Management

• Credit exposure to an individual borrowers not to
  exceed 15 of capital funds
• Group borrowers exposure not to exceed 40 of
  capital funds
• Aggregate ceiling in unsecured advances should
  not exceed 15 of total DTL of the bank from
  earlier 33.33

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RBI Guidelines on Credit Exposure and Management
(Contd.)

• Bank cannot grant loans against security of its
  own shares
• Prohibition on remission of debts for UCBs
  without prior approval of RBI
• Restrictions 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

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RBI Guidelines on Credit Exposure and Management

• Prohibition on UCBs for bridge loans including
  that against capital / debentures issues
• Loan and advances against shares, debentures
• UCBs are prohibited from permitted to extend any
  facilities to stock brokers
• Margin of 40 per cent to be maintained on all
  such advances
• Restriction on advances to real estate sector
  only for genuine constriction and not for
  speculative purposes

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Components of Credit Risk

• Default Risk Risk that a borrower or
  counterparty is unable to meet its commitment
• Portfolio Risk Risk which arises from the
  composition / concentration of banks exposure to
  various sectors
• Two factors affect credit risk
• Internal Factors Bank specific
• External factors State of economy, size of
  fiscal deficit etc.

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Managing Internal Factors

• Adopting proactive loan policy
• Good quality credit analysis
• Loan monitoring
• Sound credit culture

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Managing External Factors

• Well diversified loan portfolio
• Scientific credit appraisal for assessing
  financial and commercial viability of loan
  proposal
• Norms for single and group borrowers
• Norms for sectoral deployment of funds
• Strong monitoring and internal control systems
• Delegation and accounatbility

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Credit Risk Management as per RBI

• Measurement of risk through credit scoring
• Quantifying risk through estimating loan losses
• Risk pricing Prime lending rate which also
  accounts for risk
• Risk control through effective Loan Review
  Mechanism and Portfolio Management

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Thank You