Jyoti Kumar Pandey Deputy General Manager & MOF CAB, Pune Credit Management Jyoti Kumar Pandey Deputy General Manager & MOF CAB, Pune

Credit Life Cycle Theory Credit Opportunity Credit Creation Credit Completion Credit Management

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

Introduction Credit refers to Management 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

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

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

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

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

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.

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

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

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

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.

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

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.)

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)

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

Conditions determining future trends Three factors which can undergo changes: Prospects Future risk profile Repayment capacity

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

Risks in Bank Lending Credit Risk Market Risk Operational Risk

Credit Risk RBI defines credit risk as: the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a bank’s 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 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

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

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

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

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

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

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 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

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

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.

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 party’s information viz. annual income, existing debts, other details such as homes (rented or owned) etc.

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

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 Borrower’s future cash flow projections

Credit Risk Modeling Credit risk models used by banks are (1) Altman’s Z score model, (2) Credit metrics model, (3) Value at risk model, (4) KMV Model Altman’s Z Score Model 95 % accuracy of prediction of bankruptcy up to two years prior to failure on non-manufacturing firms as well

Altman’s 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

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

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

KMV Model Developed by KMV Corporation based on Merton’s (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 firm’s 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

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

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

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

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

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%

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

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

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 bank’s exposure to various sectors Two factors affect credit risk Internal Factors – Bank specific External factors – State of economy, size of fiscal deficit etc.

Managing Internal Factors Adopting proactive loan policy Good quality credit analysis Loan monitoring Sound credit culture

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

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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