CREDIT RISK MANAGEMENT POLICY IN INDIAN

BANKING BUSINESS
1 INTRODUCION

The latest buzz word is to manage Risk for endurance. After the Liberalization and
Globalization the focus is on measuring and strategically managing credit. Banks operating
credit in a risky environment are under increasing pressure to improve their performance while
meeting the demands of regulators. Although the element of credit risk has been always present
in the banking business, managing the same is gaining prominence as a recent phenomenon. On
the other hand, bad loans, mounting Non-Performing Assets (NPAs), thinning margin, entry of
private and Co-operative banks are changing the face of the Indian banking sector.

Banking sector were guided by the same norms risk taking, pricing and monitoring the credit.
Further, the investment market was not very active and hence banks earned larger spreads while
leading, which constituted a major source of income. In the present scenario, when spreads are
shrinking a competition is acute taking risk has become very crucial. At the same time, risk
taking has become an incentive as investment avenues are become attractive. Even with banking
operations becoming increasingly sophisticated, lending and deposit-taking remained the base of
most commercial bank. Many of these have diversified into derivatives trading, corporate
advisory services, securities underwriting and consumer retail market. With more increasingly
sophisticated technologies, bank are venturing into online electronic banking, providing ATM
center, tele banking and related bill presentation and payment services. Due to huge competition
in the industry and availability of credit to the corporate, quality borrowers were able to access
the debt market directly without going through the bank route. Thus, the credit route is now more
open to lesser mortals as banks need to deploy funds by extending the loans in the wake of
competition. With the low spreads, margins going down, banks were unable to absorb the loan
losses. When we glimpse at the risks faced by banks they may be numerous, however they fall
into four segments broadly. Four significant risks that confront banks are credit risk, interest risk,
liquidity risk and legal risk. However, of all the risk, credit risk is the oldest and biggest risk that
a bank, by virtue of its very nature of business inherits. It is off- late attracting a lot of attention
due to mounting non performing assets (NPA). NPAs not only reduce interest income but also
result in assets liability mismatch also reduced standard assets, increased loss of interest
implies loss of profit. Here, an attempt is made to examine credit risk, identify risk management
policy.

The risk management policy is framed recognizing the need to effectively identify
measure and manage the risk. These risks impact should not be adversely affected on banking
business, financial soundness. The document is drafted in view of with RBIs guidelines based
on Risk Management systems. In Indian banking industries is face to challenge of the managing
variety of financial and non financial risks..

1. credit risk
 2. liquidity risk

3. interest risk

4. legal or recovery risk

5. operational risk

Above top five risks are primary responsibility to understand and managing the risks faced by
banks.

2 OBJECTIVE OF THE RISK MANGAEMENT POLICY

To identify the risk profile of the bank and manage the risks faced by banks.

To establish risk procedures and system and setup of prudential limits, assignment of risk
limits.

To set standards for evaluation of risk faced by bank.

To provide a support system for managing the risk through addressing training operation
in monitoring information system integration, strength in the bank.

3. RISK MANAGEMENT FUNCTION AND ORGANIZATION

To identify monitor and measure the risk profile and develop risk policies procedures and
practices of the bank.

To monitor compliance of various risk parameters by operating department.

To formulate the credit policy, investment policy, recovery mechanism, loan policy, loan
pricing and risk management policy.

Delegation of powers for loan, loan recovery, standard loan quality, provision and legal
compliance.

To assign risk limited standards e.g. credit risk, earning risk, value at risk.

To NPA management of the bank therefore fresh NPA.

4. CREDIT RISK MANGEMENT

Credit risk management would be addressed by the RMP (Risk Management Policy) to cover to
the credit and investments. The banks lending portfolio would be governed by as laid down in
the lending policy. It would be reviewed as on going basis. The following instruments of credit
risk management would be put to use by bank.

4.1 CREDIT APPROVING AUTORITIES

The bank has a system of delegation of powers. The present delegation of powers shall be given
credit hub as well as risk management committee. The functions of approval are as under.

1. Branch should be referred the Rs 25 Lakhs and above credit proposal to RMC for
preliminary clearance in perspective of risk.

2. After preliminary clearance from RMC branch will referred full pledges proposal to
advances and loan department.

3. New proposals falling under the activity of promoters and builders and educational
institutions above Rs 2 Lakhs without permission of RMC should not submit for sanction.

4. Clean loan above Rs 50 Thousand clean T O D above 25 Lakhs. Clean bank guarantee
L.C. and D P Gs proposals above 25 Lakhs.

The bank shall established benchmark ratio such as Current Ratio, Debt equity, profitability debt
service coverage ratios until established the above ratio, present practice shall be continue till.

4.2 CREDIT RISK RATING AND RISK PRICING

The bank shall place credit rating scale model which are help to serve to determine the risk
perception of a borrower account facilitating a proper risk pricing and rating. Credit rating
weighed average score model is an important individual parameters in the entire portfolio. Risk
rating has to be done under three objective risk assessment personal factors, financial factors and
security factors. Specific weights have been prescribed for each parameter. Relevant factors
under three parameters are given in the rating format. Scores for each factor along with different
criteria have been suggested applicable criterion and score have to be extended to the outer
columns for each factor. Whenever more than on options allowed be souring a parameter, the
scourer is expected to use his discretion judiciously, e.g. under personal factors for period to stay
at the personal address, for more than five years, the score range is 6 to 5, if the period of the stay
fairly along, say 10 year and above, 6 marks can be given and if the period of stay is between 10
and 5 years, 5 marks be awarded. The score for each parameter has be added, average found out
and then multiplied with the prescribed weight to find out the average weighted score for each
parameter. Average weighted scores of all the three parameters should be averaged further to find
out the final weighed average score.

Table No 1: Table Showing Rating Scale Model

Weighted Average Score Rating Category

6.00 5.25 A Highest safety
5.24 4.75 B High safety
4.74 4.25 C Adequate safety
3.25 3.75 D Moderate safety
3.74 3.25 F Marginal safety
3.24 1.00 G Default and loss

Credit monitoring is a very crucial activity in recovery risk management. It is function of the
manager and credit management department at the branch level, and bank should develop and
implement procedures and reporting time to time. A well laid out system procedures for
effective post sanction monitoring of the borrower account. An effective credit monitoring
system will help in;

1. Understating the financial position of the borrower

2. Confirming credit in compliance with the sanction terms.

3. Ensuing that there are no deviations in the end use of fund, and use for the sanctioned
purpose.

4. Identifying potential problem loan account well time, help the bank to initiate corrective
action.

5. Continuous monitoring of day to day activity in all the account.

6. Obtaining stock statement regularly and fixing drawing power.

7. Reporting

8. To controlling branch and regional office, at least monthly bad loan are classified, such
loan requiring special attention loan renewal and restructured loan.

4.3 PRUDENTAIL NORMS

The bank shall established benchmark ratio such as Current Ratio, Debt equity, Profitability debt
service coverage ratios, until established the above ratio.

4.4 RISK RATING AND RISK PRICING

The bank shall place a credit rating system and risk rating model which are help to serve to
determine the risk perception of a borrower account facilitating a proper risk pricing and rating
taking into account following points

Market forced and competition

Value of collaterals
Value of the accounts

Strategic reasons such as additional business potential.

It has become necessary to adopt a portfolio approach to the total credit portfolio and credit
portfolio remains in order as a quality credit. Therefore at branch level monitor the post sanction
supervision and half yearly accountwise reviewed of Rs 25 Lakhs and above account should be
submitted to Head office and credit department will monitor the whole credit portfolio and
submitted the report to RMC on half yearly basis.

4.5 INVESTMENT CREDIT RISK

Investment committee shall assess the credit Risk of investment portfolio as per RBI guideline
and banks policy.

4.5.1 OFF BALANCE SHEET EXPOSURES

Off Balance sheet exposures essentially cover the following instruments and papers.

Letter of Guarantees

Letter of Credit

DPG

Stand by letters of Credit

Money Guarantees

4.5.2 MEDUIM RISK

Medium risk off balance sheet exposures shall be taken for counter parties considering credit
worthiness as envinced from credit appraisal and following point shall be taken in to account.

Primary or collateral security to the extent of full cover.

Guarantee cover is available

Period of instrument not exceeding 36 months

Minimum 25% cash margin of the value of the instrument is placed

4.5.3 MONITORING
Off Balance Sheet exposures shall monitored an quarterly basis and above Rs 70 Lakhs
exposures shall be monitored on monthly basis. Devolvement of off balance sheet be reported to
Head Office.

5 LIQUDITY RISK

Liquidity risk is depends on fluctuation in deposit and other liability as well as to fund loan
grouch and possible off balance sheet claims. Liquidity management is a mechanism which can
help to reduce the losses on forced sales of assets. Liquidity risk arises essentially farm funding
loan term assets by short term liability. Liquidity risk to be ensured frame following points.

1. Funding risk need to replace net outflows.

2. Time risk- need to compensate for non receipts of expected inflows.

3. Call risk due to crystallization of contingent liabilities.

Bank shall ensured while the liquidity management, planning from following aspects.

Identification of liquidity risk

Quantification of liquidity risk

Strategies for liquidity risk

Contingency plan

While carrying out liquidity risk management following limits to be considered

Call borrowing should not exceeds as per RBI norms.

Core deposits shall be direct proportion to core assets with a variance of 15%.

Increasing and decreasing interest rates positive on base rate.

Total limit sanctioned for off balance sheet exposures shall not exceed the amount of total
advances and investment of the bank.

6 INTEREST RATE RISK

Interest rate risk management is critical to market risk. It is market risk management especially
in a deregulated environment which has exposed the banking system to the adverse impacts of
interest rate risk
 Gap mismatch risk due to holding of assets / liability off balance sheet items with
different principal amount / maturity dates.

2) Basis risk due to possibility of interest rate of different assets and liabilities, off balance
sheet items in different magnitude.

3) Option risk prepayment of loan and premature enactment of deposits shall be impact on
banks liquidity risk.

7 DEFAULT RISK OR BAD DEBTS RISK

It is the probability of the event of bad debts, i.e. missing a payment obligation breaking an
agreement or economic default. A payment default is declared when a scheduled payment is not
made within 90 days from the due date. In other words, bad debts risk means an amount which
remains unpaid beyond the due date. According to the RBI circulars Any amount due to the
bank (interest and principle) under any credit facility is overdue, if it is not paid on the due date
fixed by the bank.

Bad loans are inevitable part of the banking business because in every loan there is an element of
risk involved and a possibility of loan not repaid. But in the last two decades we find that taking
huge loan from the banks and making its as NPA has been perfected as an exquisite art by the
big and corporate borrowers. Taking loans from the banks, deliberately not repaying it and
getting away from it through write-off has become an industry by itself. But as bank employees
we know that this is nothing by daylight robbery and open loot of public money because loans
are given by the Banks from the saving of the general public. That is way our slogan is Peoples
money for peoples welfare and not for private corporate loot.

The above Table No 2 showing that bad loan in the banks have been alarmingly increasing over
the last seven year, Gross NPAs and Bad loans in the Public Sector Banks have increased from
Rs 39, 030 crores as on 31March2008 to Rs 2, 50,000 crores.

7.1 INCREASES IN PROVISION FOR BAD LOANS

The provision being made from the earned profit of the banks is another serious challenge faced
by the banking industry today, such provision are based on Gross NPAs and reduce Net Profit of
every year.

However, lower provisions should not give one the impression that the banks have finally
got a grip on their bad loans. In fact, their bad loans have been on the rise. Before we
discuss that, lets take a look at the banks net interest income, an outcome of their bread-and-
butter business of giving loans. Forty listed banks net interest income in June has grown close to
11%, from Rs.58,351 crore to Rs.64,719 crore. The quarter-on-quarter rise, however, has been
less than 1%. The rise in net interest income has, to some extent, been nullified by a sharp drop
in fee income. So-called other income, which largely consists of fees and commission, has
dropped 10.24% in the June quarter to Rs.23,828 crore. Because the cost incurred to minimize
NPA and increase recovery of defaulted advances made to the borrower through legal
mechanism. This cost consists of cost of insurance, legal fees and other incidental charges.

In practice these expenses are transferred to the borrowers which results into increment in NPA
therefore the expenses incurred to net NPA ratios are computed. Lower ratio/percentage indicates
better banking practice. In most of the cases it is less than 1% of net NPA.

7.2 FRESH BAD LOANS ON THE INCREASE

Bad loans in the banks used to be explained as legacy issues, money stuck up in some old
accounts, etc. But, year after year, fresh bad loans are being added in the banks. There is clearly a
nexus between borrowers, bank and political administration.

There seems to be no respite from rising bad loans. The gross non-performing assets (NPAs) of
40 listed banks in the June quarter has grown some 21% in absolute terms. According to RBI, the
banks have added Rs 4,94,836 crores to their bad loans between 2007 to 2013.

8 RECOVERY RISK

Recovery risk depends on, amount of NPA with the type of defaulters and availability of
collaterals, third party guarantees and legal issue. Recovery of loan consist of all effect made by
the bank and the necessary measures adopted by bank for recovering their overdue loan amount.

8.1 MEANING OF RECOVERY RISK

Recovery risk management plays a vital role in the way banks perform i.e. it reflects the
profitability, liquidity, and reduced Non Performing Assets. The goal of recovery risk
management is to maximize a banks risk adjusted rate of return by maintaining loan recovery
policy and different parameter. Bank need to deal with recovery risk inherent in the entire
General Mechanism as well as Legal Mechanism recovery risk.

GENERAL MECHANISM

All the selected banks operated general mechanism of recovery of NPA, means all primary
measures to persuade the defaulting borrowers to repay their over dues like writing letters and
sending representatives of the banks to the borrowers for personal visits.

LEGAL MECHANISM

In case of legal mechanism it is observed that all the selected banks operated this mechanism to
the maximum extent involving Debt Recovery Tribunals (DRT), Lok Adalat, Securitization Act,
and Compromises (OTS), Write off, Up-gradation and Cash recovery. The banks should adopt
new recovery policy and different schemes for example interest rebate, cut of interest with
specific period, loan mela, and resettlement package etc. and they should also evaluation of NPA
scoring with interest rate for loan recovery. This will minimize NPAs.

SARFAESI ACT

Stringent action against wilful defaulters in terms of attachment of properties under SARFAESI
Act (Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest
Act), change in management and other legal action against the promoters are being considered to
be included in the draft Bill, the sources added. In order to prepare the draft Bill, the Department
of Financial Services has set up a panel for suggesting changes in the existing laws to make debt
recovery more effective and frame a statute with harsh penal provisions for wilful defaulters.

DEBT RCOVERY

Members of the panel entrusted to revisit the existing debt recovery laws include Former law
Secretary V K Bhasin, representatives of DRT, RBI, IBA and bar associations. The panel was set
up to plug the loopholes in the current legal framework for debt recovery. The committee
constituted would suggest amendments in SARFAESI Act and RDDB Act (Recovery of Debts
Due to Banks and Financial Institutions). Recently, United Bank of India has declared Kingfisher
Airlines, its promoter Vijay Mallya and three other directors as wilful defaulters citing alleged
diversion of funds. IDBI Bank is also considering similar action and is serving out a 15-day
notice period on non-payment of dues.

Noting that the rising non-performing assets (NPAs) of public sector banks is a matter of concern
for the government, Finance Minister Arun Jaitley in the Budget speech had announced setting
up of six new debt recovery tribunals at Chandigarh, Bangalore, Ernakulum, Dehradun, Siliguri
and Hyderabad. Government will work out effective means for revival of other stressed assets,
he had said. There are over 40,000 cases worth Rs. 1.73 lakh crore pending before various courts
and debt recovery tribunals. In March 2014, the gross non-performing assets in banking system
went up to 4.4 per cent from 3.8 per cent of the total assets in the previous fiscal. Gross NPA of
public sector banks jumped by 39 per cent to Rs. 2.16 lakh crore at the end of March 2014
from Rs. 1.55 lakh crore in the previous fiscal. However, gross NPAs in the case of private sector
banks rose 13.76 per cent to Rs. 22,744 crore compared to Rs. 19,992 crore at the end of March
2013. During 2013-14, public sector banks recovered Rs. 33,486 crore against the written-off
amount of Rs.34,620 crore.

RESTRUCTURING OF LOANS & SALE OF BAD LOANS/NPAs:

Already we know that a lot of concessions are being given to bad loan accounts like interest
waiver, one time settlement, provisioning from profits, write off, etc. Then started the re-
structuring of corporate debts.

Out of this Rs. 251,611 crores, 82 % of the loans are given to private corporate companies in the
following sectors. Recently our Hon. Finance Minister made the statement We cannot have an
affluent promoter and a sick company, promoter must bring in money. We wish banks take
firm steps to recovery NPAs increasing write off the amount of write offs towards bad loans is
also on the rise in the Banks. According to RBI, the bad loan worth Rs 1,41,295 Crores were
written off during the period 2007 to 2013. And most of these write off were in favour of the big
defaulters and corporate borrowers.

Table No 6:- Table Showing Private Corporate Companies

LOANS GIVEN

Sr. No. Industry (Rs. Crore)

1 Infrastructure 57,906
2 Iron & Steel 40,783
3 Textiles 21,990
4 Power 20,253
5 Ship-Breaking/Ship Building 16,792
6 Construction 16,062
7 Telecom 10,785
8 Pharmaceuticals 9,249
9 NBFC 6,976
10 Engineering 5,668
Total Loans restructured under CDR in above 10 sectors 2,06,464

Sources: RBI Reports

As though this is not enough, of late, sale of bad loans to private ARCs is on the increase. Last
year alone, more than Rs. 50,000 crores of bad loans have been sold away to Asset
Reconstruction Companies (ARC). There are proposals to set up bigger ARCs so that there can
be wholesale sale of NPAs. Sale of NPAs is another fraud mechanism. It is a device to take out
the NPAs from the books of the Banks. It is nothing but a camouflage. Recently, for example, in
one Bank, NPAs worth Rs. 938 crores were sold to an ARC for Rs. 600 crores. Thus there is a
direct loss of Rs 338 crores. That is not all. Out of the Rs. 600 crores purchase consideration,
the ARC paid Rs.30 crores, i.e 5 % of the sale price in cash. Balance 95 % i.e. Rs. 570 crores was
agreed to be paid as deferred bond after 10 years subject to realisation from the Assets. Thus,
with Rs. 30 crores, the whole NPA amounting to Rs. 938 crores was removed from the list of
NPAs of the Bank. This is the pattern. This is the method. This is the mechanism. But in the
process, the Bank has lost, the country has lost and the people have lost.

8.2 HOW DOES RECOVERY RISK MANAGEMENT HELP

Banks are likely to use four mantra for recovery risk management to be affected by banks profit.

To improve relationship between bank and barrowers.

First fund out potential NPAs and recovery attempts be made carefully.

To use short term legal mechanism like Compromise, OTS, Write off, Up-gradation and
Cash recovery.

To use long term legal mechanism like Debt Recovery Tribunals (DRT), Securitization
Act, filling suit.

8.3 SUGGESTIVE MODEL FOR PROVISION OF NPAs

Bank, while formulating the recovery risk policy guidelines need to take a fore- view of
the market with a focus on economic and fiscal policies of the state. It also needs to view its
impact on the banks i.e. balance sheet, profitably and liquidity risk. The suggestive model for
provision of NPAs use for recovery definitely increasing profit and decreasing loss of the
banking sector. The banks should adopt the following policy to solve the NPA problem at bank
level by making provisions on the principal outstanding loan-

1. a) No provision requirement on standard assets.

2. b) Banks have to make the additional provision over one year period under the head sub-
standard additional provision with minimum of 20 percent each year.

3. c) Assets classification and provision for non performing advances as under-

Outstanding / Irregular
Provision
Assets Classification
Installment Requirement

Standard Assets Regular installment paid or due

for not more than 90days.
 No provision

a) 3 months to 12 month 10% and .20%

depend upon value of
b) 13 months to 36 month security

I ) 12 months
Sub- standard Assets
Secured loan 75%
unsecured loan 100%
ii) 12 months
Secured loan 25%
unsecured loan 100%

36 months treated loss assets

has been identified by the bank
internal or by the external or by Secured loan 100%
Loss Assets
co-operative department or by unsecured loan 100%
the amount has not written- off
wholly and partly

It is clear that in the model NPAs total provision period is considered for 30 months instead of 60
months. Here only three step assets classification and provision on the principal outstanding have
been suggested. In this way banks have to make minimum provision of NPAs and higher level of
profit.

9 OPERATIONAL RISK MANAGEMENT

Operational risk is defied as any risk is not categorized as market or credit risk or the risk of loss
arising frame various types of human or technological errors. If arises in situations involving
settlement or payment risk or business interruption administrative and legal risk. The most
serious operational risk arises whether a breakdown in interest controls is.

9.1 INDENTIFICATION

Identification of operational risk is crucial to the management aspects following arrears

operational risk is perceived.

1. Lack of control over security items and stationery.

2. Unrestricted access to server room, cash cabin, strong room, and locker

room in bank premises.

 1. Sharing of confidential information with customer and third parties.

2. Lack of inquiry of customers.

3. Not proper information submitted by customers with related data report.

4. Incorrect, improper and delayed handling of transaction.

5. Defining of responsibility and accountability of various functionaries segregation of

duties adequate operation procedure.

10) CONCLSION

Recovery risk is changes in the regulators policies, Credit rating weighed average score model is
an important individual parameters in the entire portfolio. Risk rating has to be done under three
objective risk assessment personal factors, financial factors and security factors. Bank, while
formulating the recovery risk policy guidelines need to take a fore- view of the market with a
focus on economic and fiscal policies of the state. It also needs to view its impact on the banks
i.e. balance sheet, profitably and liquidity risk. It can be observed from historical background of
borrowers than collected internally rating scale, evaluation of NPA Scoring with interest rate etc.
recovery credit risk is real activity that should be managed to generate profitability by keeping
the three cardinal principles of banking in mind profitability, liquidity and solvency with the
thinning of spreads in the deregulated and liberalized economy. Recovery risk and profits have a
direct relationship though not proportionate, hence concept of no risk on gain applies to
banking industry as well.