CHAPTER VIII

SUPERVISION AND MONITORING

• Loan Review Mechanism (LRM).
Three Pillars of the Basel Accord II are:
• Pillar I: Minimum Capital Requirement
• Pillar II: Supervisory Review Process
• Pillar III: Market Disciplines

Think of Pillar II which requires -

Supervisory review process not only to ensure that banks
have adequate capital but also to encourage banks to adopt
better risk management techniques.

This was further elaborated in the following principles: 1

 Loan Review Mechanism (LRM )

Operating under a Sound Credit Granting Process:

Principle 4: Banks must operate within sound, well defined
crediting criteria. These criteria should include a clear indication of
the bank’s target market and a through understanding of the
borrower or counterparty, as well as the purpose and structure of
the credit, and its source of repayment.
Principle 6: Banks should have a clearly – established process in
place for approving new credits as well as the amendment, renewal
and refinancing of existing credits.
Principle 7: All extensions of credit must be made on an arm’s
length basis. In particular, credits to related companies and
individuals must be authorized on an exception basis, monitored
with particular care and other appropriate steps taken to control or
mitigate the risks of non-arms length lending.

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 Loan Review Mechanism

Maintaining an Appropriate credit Administration,

Measurement and Monitoring Process:

Principle 8: Banks should have in place a system for the on going

administration of their various credit risk bearing portfolios.
Principle 9: Banks must have in place a system for monitoring the
conditions of individual credits, including determining adequacy of
provisions and reserves.
Ensuring Adequate Controls over Credit Risk
Principle 14: Banks must establish a system of independent,
on-going assessment of the bank’s credit risk management
process and the results of such reviews should be communicated
directly to the board of directors and senior management. Because
various appointed individuals through out a bank have the authority to
grant credit, the bank should have an efficient internal review and reporting
system in order to manage effectively the bank’s various portfolios.
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 Loan Review Mechanism

The internal credit reviews conducted by individuals independent from the

business function provide an important assessment of individual
credits and the overall quality of the credit portfolio. The credit review
function must report directly to the Board of Directors, a committee with
audit responsibilities or a senior management without lending authority.
 
Ensuring Adequate Controls over Credit Risk
Principle 15: Banks must ensure that the credit-granting function is being
properly managed and that credit exposures are within levels consistent
with prudential standards and internal limits. Banks should establish and
enforce internal controls and other practices to ensure that exceptions to
policies, procedures and limits are reported in a timely manner to
appropriate level of management for action.
 
Principle 16: Banks must have a system in place for early remedial action on
deteriorating credits, managing problem credits and similar work out
situations.
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 Loan Review Mechanism

They were the elaborate guidelines that banks have received from BCBS.
RBI /India has accepted the recommendations.
Accordingly individual banks have laid out their credit policies and monitoring
their proper implementation. It is important to note that credit granting
functions and review functions are independent of each other and they are
to be monitored independently.
Loan Review Mechanism (LRM) is a comprehensive term which includes what
is traditionally known as functions of ‘supervision and control’ of bank
loan/advances granted to borrowers. Loan review Mechanism, in a broader
prospective includes-
1.Credit Audit, 2.Risk Based Internal Audit, 3.Physical Control through:
3.1 Physical verification through inventory control system, 3.2Stock Audit,
4.Financial control through
• Periodical statements such as stock statement, book debt statement,
quarterly information system, etc
• Regular reviews and renewals Review of credit rating of the borrower and
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his industry / sectorSpecial Audit
 Credit Audit
RBI in its paper entitled “Guidance Note on Credit Risk Management”
has suggested adoption of Credit Audit as in important tool of loan
review mechanism. It says:
Credit Audit examines compliance with extant sanction and post
sanction processes /procedures laid down by the bank from time to
time.

Objectives of Credit Audit

• Improvement in the quality of credit portfolio,
• Review sanction process and compliance status of large loans
• Feedback on regulatory compliance
• Independent review of credit risk assessment,
• Pick up early warning signals and suggest remedial measures
• Recommend corrective action to improve credit quality, credit
administration and credit skills of staff, etc
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