Credit Policy

Credit PolicyCredit Policy

Need for Credit Policy Need for Credit Policy

Components of Credit Policy Components of Credit Policy

Credit Policy Pursued by the Credit Policy Pursued by the Government Government

Credit CultureCredit Culture

Lending is an indispensable aspect of Lending is an indispensable aspect of banking, and a banker earns bulk of his banking, and a banker earns bulk of his income through lending. income through lending.

The other major reason of the lending The other major reason of the lending function is to add value to the bank. By function is to add value to the bank. By lending the funds mobilized, a bank will be lending the funds mobilized, a bank will be in a position to earn spreads to sustain in a position to earn spreads to sustain profitability profitability

Credit policyCredit policy

The lending decisions of a bank are guided The lending decisions of a bank are guided by its loan policy or credit policy. by its loan policy or credit policy.

The credit policy outlines the crucial lending The credit policy outlines the crucial lending decisions of a bank. It lays down the rules decisions of a bank. It lays down the rules and regulations that guide the sanctioning of and regulations that guide the sanctioning of loans. loans.

Credit Execution and AdministrationCredit Execution and Administration

Loan DecisionLoan Decision Loan agreementLoan agreement Terms of loanTerms of loan Repayment scheduleRepayment schedule Collateral requiredCollateral required Other conditionsOther conditions

However, to sustain profitability, prudent decisions However, to sustain profitability, prudent decisions need to be taken both prior to and after need to be taken both prior to and after sanctioning the credit. sanctioning the credit.

These rules generally relate to the amount of These rules generally relate to the amount of credit to be extended during a financial year, the credit to be extended during a financial year, the industries to focus on, the geographical spread, industries to focus on, the geographical spread, the type of credit to offer, the type of proposals to the type of credit to offer, the type of proposals to finance, the disbursal mechanism, the collateral finance, the disbursal mechanism, the collateral value, the method of pricing, the repayment value, the method of pricing, the repayment schedule, the monitoring process, etc. schedule, the monitoring process, etc.

These macro and micro level considerations These macro and micro level considerations of the lending activity contribute to the of the lending activity contribute to the achievement of the bank’s objectives. achievement of the bank’s objectives.

The bank’s management should thus, The bank’s management should thus, ensure that lending decisions fall in line with ensure that lending decisions fall in line with the bank’s overall objectives. the bank’s overall objectives.

The policy is laid down by the top management and The policy is laid down by the top management and deals with the following:deals with the following:

Exposure levelsExposure levels Credit risk assessmentCredit risk assessment Credit appraisal standardsCredit appraisal standards Documentation standardsDocumentation standards Delegation of powersDelegation of powers PricingPricing Review and renewal of advancesReview and renewal of advances Takeover of advances Takeover of advances


The policy also discusses different kinds of The policy also discusses different kinds of advances such as advances such as

personal loans, export credit, advances to personal loans, export credit, advances to priority sector and maturity period of bank’s priority sector and maturity period of bank’s advances.advances.

In the final pages, the policy details the In the final pages, the policy details the strengths, weaknesses and the prospects of strengths, weaknesses and the prospects of the bank.the bank.

NEED FOR CREDIT POLICYNEED FOR CREDIT POLICY The credit policy document is a document which carefully The credit policy document is a document which carefully

specifies the do’s and don'ts while sanctioning the loan specifies the do’s and don'ts while sanctioning the loan proposals.proposals.

As loan proposals differ widely from each other, there As loan proposals differ widely from each other, there cannot be a strict methodology for accepting or rejecting cannot be a strict methodology for accepting or rejecting the proposalsthe proposals

Instead, guidelines can be given within the credit policy for Instead, guidelines can be given within the credit policy for the decision makers to enable them to screen out loans, the decision makers to enable them to screen out loans, which can be out rightly rejected.which can be out rightly rejected.

Loans that can be sanctioned without any reference to the Loans that can be sanctioned without any reference to the top management and proposals that require a certain top management and proposals that require a certain amount of top-level decision-making.amount of top-level decision-making.

The credit policy of a bank consists of five major The credit policy of a bank consists of five major componentscomponents


a.a. General policiesGeneral policies b.b. Specific loan categoriesSpecific loan categories c.c. Miscellaneous loan policiesMiscellaneous loan policies d.d. Quality controlQuality control e.e. Other specific issues.Other specific issues.


The process of appraisal remains the same The process of appraisal remains the same with regard to any proposal – analyzing, with regard to any proposal – analyzing, selecting, sanctioning and monitoring. selecting, sanctioning and monitoring.

The top management sets the exposure The top management sets the exposure limits for individual/company/industry, credit limits for individual/company/industry, credit quality of the borrowers, lending rate, and quality of the borrowers, lending rate, and risk level, etc., and enable decentralized risk level, etc., and enable decentralized decision-making by the lower level decision-making by the lower level functionaries functionaries

COMPONENTS OF CREDIT COMPONENTS OF CREDIT POLICYPOLICY

VOLUME AND MIX OF LOANSVOLUME AND MIX OF LOANS GEOGRAPHICAL SPREADGEOGRAPHICAL SPREAD LOAN EVALUATION PROCEDURESLOAN EVALUATION PROCEDURES MANAGEMENT EVALUATIONMANAGEMENT EVALUATION FUNDAMENTAL ANALYSISFUNDAMENTAL ANALYSIS

CREDIT POLICY PURSUED BY CREDIT POLICY PURSUED BY THE GOVERNMENTTHE GOVERNMENT

The governments in different countries frame their lending The governments in different countries frame their lending structure so as to be consistent with their credit policy. structure so as to be consistent with their credit policy.

They decide as to what extent bank credit is to be They decide as to what extent bank credit is to be deployed. Every country has a different policy in this deployed. Every country has a different policy in this regard. In case of “socialist” economies such as China and regard. In case of “socialist” economies such as China and Vietnam, the state banks are forced to lend to the state Vietnam, the state banks are forced to lend to the state owned institutions that many a times are in a position to owned institutions that many a times are in a position to repay the loan.repay the loan.

This sort of directed lending within an economy amounts This sort of directed lending within an economy amounts to a subsidy, whereby the state, which owns all relevant to a subsidy, whereby the state, which owns all relevant financial institutions, is moving funds from one institution to financial institutions, is moving funds from one institution to another another


. In case of countries like India and Sri Lanka, . In case of countries like India and Sri Lanka, subsidy is given in the form of loans to the subsidy is given in the form of loans to the farmers, which remain uncollected. farmers, which remain uncollected.

The policy lending is imposed not only on the state The policy lending is imposed not only on the state owned banks but also on the private commercial owned banks but also on the private commercial banks to a considerable extent.banks to a considerable extent.

In countries like United States, certain laws In countries like United States, certain laws require banks to engage in lending in poorer areas require banks to engage in lending in poorer areas from which they take deposits. from which they take deposits.

Need “administrative guidance” to lend to certain Need “administrative guidance” to lend to certain companies or sectors favored by the government.companies or sectors favored by the government.


In India, the National Credit Council that was established in In India, the National Credit Council that was established in 1968 initially emphasized that commercial banks should 1968 initially emphasized that commercial banks should extend credit to the two priority areas, i.e. Agriculture and extend credit to the two priority areas, i.e. Agriculture and Small Scale Industries (SSIs). Small Scale Industries (SSIs).

RBI issued guidelines to commercial banks and the RBI issued guidelines to commercial banks and the lending policy also came in to focus on dispensing credit to lending policy also came in to focus on dispensing credit to agriculture, SSIs and transport operators.agriculture, SSIs and transport operators.

Nationalization of 14 banks in July 1969 (and six in 1980), Nationalization of 14 banks in July 1969 (and six in 1980), institutionalization of the policy objective of providing institutionalization of the policy objective of providing assured financial support to the Priority Sector, as the assured financial support to the Priority Sector, as the above activities came to be known, was formalized. above activities came to be known, was formalized.


The formal definition of Priority Sector came into The formal definition of Priority Sector came into existence. existence.

Retail trade, small business, professional and self-Retail trade, small business, professional and self-employed persons and educational loans were employed persons and educational loans were also included under priority sector. This was in also included under priority sector. This was in addition to SSIs, Agriculture and allied activities addition to SSIs, Agriculture and allied activities and Transport Operators.and Transport Operators.

Loans to housing and software sector have been Loans to housing and software sector have been brought under the priority sector.brought under the priority sector.

RBI GuidelinesRBI Guidelines

As per RBI’s guidelines at least 40% of the net bank credit As per RBI’s guidelines at least 40% of the net bank credit should be given to the priority sector, of which 18% would should be given to the priority sector, of which 18% would be for Agriculture and 10% to the weaker sections of the be for Agriculture and 10% to the weaker sections of the society.society.

RBI, NABARD and State Level Bankers Committee RBI, NABARD and State Level Bankers Committee (SLBC) govern the credit policy and procedures with (SLBC) govern the credit policy and procedures with respect to agricultural sector. respect to agricultural sector.

Depending on the segments, the policies and procedures Depending on the segments, the policies and procedures could differ substantially. could differ substantially.

The introduction of Service Area Approach in 1989 The introduction of Service Area Approach in 1989 prompted each bank’s branch to prepare its own Service prompted each bank’s branch to prepare its own Service Area Plan based on the village profile, skills and available Area Plan based on the village profile, skills and available resources. Such Service Area Plans would then be resources. Such Service Area Plans would then be integrated with the annual growth plan of a bank’s branch. integrated with the annual growth plan of a bank’s branch.

RBI guidelinesRBI guidelines

As per RBI’s guidelines at least 40% of the As per RBI’s guidelines at least 40% of the net bank credit should be given to the net bank credit should be given to the priority sector, of which 18% would be for priority sector, of which 18% would be for Agriculture and 10% to the weaker sections Agriculture and 10% to the weaker sections of the society. RBI, NABARD and State of the society. RBI, NABARD and State Level Bankers Committee (SLBC) govern Level Bankers Committee (SLBC) govern the credit policy and procedures with the credit policy and procedures with respect to agricultural sector. respect to agricultural sector.

Rating Criteria for BanksRating Criteria for Banks

The criteria for rating the bank are normally based The criteria for rating the bank are normally based on the assets, equity, profits, etc.on the assets, equity, profits, etc.

If the criteria for rating a bank were Return on If the criteria for rating a bank were Return on Equity (ROE) then the bank would easily Equity (ROE) then the bank would easily compromise profitability for safety.compromise profitability for safety.

If the criterion is total assets then it is of less If the criterion is total assets then it is of less significance as it tells very little about either significance as it tells very little about either profitability or creditworthiness.profitability or creditworthiness.

If the criterion is equity, then only the well-If the criterion is equity, then only the well-capitalized banks may be safe, but they may not capitalized banks may be safe, but they may not be profitable. be profitable.

Credit ratingCredit rating

The major drawback in case of these ratings The major drawback in case of these ratings is that they do not take into consideration is that they do not take into consideration the environment in which the banks operate. the environment in which the banks operate. The analysis of the banks should not be in a The analysis of the banks should not be in a vacuum. Their favorable financial ratios are vacuum. Their favorable financial ratios are to be looked upon and the environment in to be looked upon and the environment in which they operate should not be which they operate should not be overlooked. overlooked.

CREDIT RATINGCREDIT RATING

Credit rating is the main tool, which helps in measuring the Credit rating is the main tool, which helps in measuring the credit risk and facilitates pricing of a loan.credit risk and facilitates pricing of a loan.

It gives vital indications of weaknesses in a borrower’s It gives vital indications of weaknesses in a borrower’s profile.profile.

It also gives triggers for portfolio management at corporate It also gives triggers for portfolio management at corporate level.level.

Banks should realize the importance of developing and Banks should realize the importance of developing and implementing effective internal credit rating systems, and implementing effective internal credit rating systems, and also recognize the role such systems play in credit risk also recognize the role such systems play in credit risk management. management.

It involves evaluating and assessing an institution’s risk It involves evaluating and assessing an institution’s risk management, capital adequacy, and asset quality.management, capital adequacy, and asset quality.

Credit RiskCredit Risk

For the ongoing administration of their various For the ongoing administration of their various credit risk-bearing portfolios, credit risk-bearing portfolios, (a) Banks must have in place a system for (a) Banks must have in place a system for monitoring the condition of individual credits, monitoring the condition of individual credits, including determining the adequacy of provisions including determining the adequacy of provisions and reserves, (b) Banks should develop and utilize and reserves, (b) Banks should develop and utilize an internal risk rating system in managing credit an internal risk rating system in managing credit risk. The rating system should be consistent with risk. The rating system should be consistent with the nature, size and complexity of a bank’s the nature, size and complexity of a bank’s activities, activities,

CREDIT MISCREDIT MIS

c) Banks must have information systems and c) Banks must have information systems and analytical techniques that enable management to analytical techniques that enable management to measure the credit risk inherent in all on- and off-measure the credit risk inherent in all on- and off-balance sheet activities.balance sheet activities.

The management information system should The management information system should provide adequate information on the composition provide adequate information on the composition of the credit portfolio, including identification of any of the credit portfolio, including identification of any concentrations of risk, and (d) Banks must have in concentrations of risk, and (d) Banks must have in place a system for monitoring the overall place a system for monitoring the overall composition and quality of the credit portfolio. composition and quality of the credit portfolio.

Credit ratingCredit rating

The rating should consider the banking system of the The rating should consider the banking system of the country in which a bank operates – along with the degree country in which a bank operates – along with the degree of systemic risk implicit in the banking system – and the of systemic risk implicit in the banking system – and the level of sovereign risk in that country.level of sovereign risk in that country.

This is crucial to fully evaluate the creditworthiness of a This is crucial to fully evaluate the creditworthiness of a given bank. To assess the creditworthiness of banks in a given bank. To assess the creditworthiness of banks in a particular country, the analyst must therefore have an particular country, the analyst must therefore have an understanding of the understanding of the

Economic and political conditions prevailing in the country;Economic and political conditions prevailing in the country; Regulatory regime; and Regulatory regime; and Credit culture of the banks.Credit culture of the banks.

Different countries have different banking Different countries have different banking structures. The banking structure plays a vital role structures. The banking structure plays a vital role in the development of the banking system and this in the development of the banking system and this provides easy credit to all the sectors. For provides easy credit to all the sectors. For instance, a banking system which is highly instance, a banking system which is highly fragmented and in which banks draw deposits and fragmented and in which banks draw deposits and lend within small geographic areas has more lend within small geographic areas has more chances of bank failure than a system in which chances of bank failure than a system in which there are a comparatively small number of large, there are a comparatively small number of large, well capitalized banks with nationwide distribution. well capitalized banks with nationwide distribution.

CREDIT advantagesCREDIT advantages

Credit culture refers to the fundamental Credit culture refers to the fundamental principles that drive lending activity and how principles that drive lending activity and how management analyzes risk. management analyzes risk.

Credit culture encourages the management Credit culture encourages the management to maintain asset quality even under to maintain asset quality even under pressures to chase bad deals.pressures to chase bad deals.

The credit culture in the economy also The credit culture in the economy also affects the health of the banking system. affects the health of the banking system.

Documents

Credit Policy