RBI Credit Policy also known as loan policy of the bank is instrumental in determining the money supply, the economy’s credit cost, and other national monetary matters. This credit policy is also important for distributing any credit among borrowers, lending rates and other key indicators
Credit Policy also known as loan policy of bank is instrumental in at accomplishing its mission commitment to excellence in customer service and stakeholder’s employee satisfaction. Bank board is generally the apex authority in formulating Credit Policy of the bank.
INTRODUCTION TO CREDIT RISK
Banks face various types of risks — credit, interest rate, foreign exchange, liquidity, equity price, legal, regulatory, operational, and more. Among them, credit risk is the most significant, referring to the inability or unwillingness of a borrower or counterparty to meet financial obligations.
Credit Risk = Transaction Risk + Default Risk + Portfolio Risk
Portfolio Risk includes:
Intrinsic Risk
Concentration Risk
Factors Influencing Credit Risk:
External: Economic conditions, commodity/equity price swings, exchange rates, interest rates, trade restrictions, government policies, sanctions.
Internal: Loan policy deficiencies, poor appraisal, excessive reliance on collateral, inadequate pricing, lack of post-sanction review, etc.
RBI Guidelines on Credit Risk Management
The RBI prescribes a comprehensive Credit Risk Management Framework, built on 4 pillars:
1. Measure Risk through Credit Rating/Scoring
Establish credit rating systems.
Use scores to assess borrower risk consistently.
2. Quantify Credit Risk
Estimate expected credit loss based on customer behavior
Determine unexpected loss from risk variations.
3. Price Risk Scientifically
Use RAROC (Risk-Adjusted Return on Capital) to set loan pricing.
Allocate capital based on loss likelihood.
4. Monitor and Control Risk
Identify weak credit accounts for proactive action.
Set exposure limits by rating.
Conduct regular portfolio reviews.
Ensure policy compliance and top management reporting.
Purpose and Role of Credit Rating
Definition: A credit rating is a grade given to a person, institution, or instrument to indicate ability to repay on time.
Purpose:
Reveals overall risk of lending.
Helps in loan pricing, approval, and portfolio management.
Enhances standardization in borrower assessment.
Assures credit-granting authorities of loan quality.
2.1 CREDIT POLICY (Loan Policy)
Definition: A Credit Policy is a comprehensive guideline document for all credit-related decisions in a bank.
Authority: Formulated by the Bank’s Board.
Objectives:
Ensure compliance with regulatory standards
Maintain internally set risk profiles
Protect the quality of the credit portfolio
Achieve bank profitability
Credit/Loan officers are responsible for implementing the policy
Credit Policy Objectives and Framework
Main Objective of Credit Policy
To maintain a:
Healthy balance between Credit Volumes, Earnings, and Asset Quality
Within the framework of:
Regulatory prescriptions
Corporate goals
Social responsibilities
This ensures that:
Credit expansion is steady, sustained, and prudent
Banks can earn good returns while maintaining high-quality assets
2.2 POLICY FRAMEWORK
The Credit Policy is a formal statement approved by the Bank’s Board
It incorporates regulatory guidelines and institutional goals
Purpose of Written Credit Policy
Ensure the bank operates within prescribed risk tolerances/limits
Provide clear risk tolerance guidelines to avoid inappropriate risk-taking
The Policy Should:
Specify roles of credit/loan officers
Define how to seek approvals for deviations
Detail the Credit Risk Committee/Sanctioning Authorities’ responsibilities
Be updated periodically to reflect new risks or regulatory changes
CONTENTS OF A CREDIT POLICY:
Purpose and Contents
A statement of:
What the policy seeks to achieve
A review of:
The economy
Regulatory concerns
Bank’s approach to performance
Objectives Statement
Details of the policy’s focus, including:
(a) Maintenance and improvement of asset quality
(b) Growth in assets consistent with risk management imperatives
(c) Maintaining reasonable risk-adjusted return on credit exposures
(d) Achieving or retaining market share aligned with the bank’s policy
(e) Lending to the priority sector
(f) Maintaining stipulated proportion between:
Fund-based assets
Non-fund-based assets
(g) Focus on sectors like:
Corporate, Mid Corporate, Retail
(h) Targets across:
Short-term, Medium-term, Long-term assets
Emphasis on fee-based income (LCs, BGs, etc.)
(i) Cut-off credit score below which assets won’t be booked
(j) Identification of undesirable or banned exposures
(k) Risk premium approach for pricing (MCLR, base rate
Lending Authority and Responsibilities
Defines:
Who approves loans
Powers of lending authorities
Process for approvals and confirmations
CREDIT POLICY
Controlling Authority
Sanctioning Authority must forward all sanctions to a higher authority (Controlling Authority) for review.
This is as per the hierarchy set for the specific segment or sector.
Typically, the Controlling Authority is one step above the Sanctioning Authority.
Role includes:
Recording sanctions/approvals.
Adding observations or conditions.
Ensuring operating officials comply or report actions taken.
Sign Off
After due diligence and credit appraisal:
A Designated Credit Officer signs off the credit proposal recommended by the Loan Department or Loan Marketing Officers.
This confirms:
Compliance with the Credit Policy.
Regulatory and internal policy adherence.
Credit acceptability.
Approvals for deviations, if any.
Officers may also confirm follow-through actions.
Credit Denial and Recording Procedure
Procedure for:
Rejecting credit requests
Maintaining records of rejections
Required to meet regulatory expectations on transparency.
Portfolio Composition, Credit Concentration, and Diversification Limits
Defines:
Sector-wise exposure limits
Geographical diversification
Limits are usually relative to the bank’s capital.
Referred internally as:
RDI (Risk Diversification Index)
Exposure Norm
Types of Loans
This section outlines how loans are sanctioned.
It includes the limits for loans, such as those in syndicated loans involving multiple banks.
It also mentions the types of borrowers eligible for loans, including employees, officers, and directors of the bank.
2. Appraisal Standards, Policy, Procedures, and Formats
Banks clearly define how loan appraisal is carried out.
Some banks have loan origination or marketing departments that find and bring in potential borrowers.
The process starts with a prior evaluation of the borrower’s financial strength.
If the borrower is considered strong, the loan is more likely to be approved.
If the borrower is unknown (e.g., a walk-in customer), the credit risk is harder to judge, and the loan may not be sanctioned.
Banks often use standardized formats to ensure every important risk or credit aspect is evaluated properly.
3. Appraisal Standards
These are a key part of a bank’s Credit Policy.
Banks have created and refined scientific methods for credit appraisal over time.
These methods are based on the experience of bankers and have stood the test of time.
Parameters used in appraisals can be grouped into two types:
Qualitative
Quantitative
4. Qualitative Appraisal (Explained in Detail)
Evaluates:
Viability of the loan request.
The bank’s risk exposure to the borrower’s group, sector, or industry.
The borrower’s past experience in the industry.
The borrower’s past dealings with the bank.
Quantitative Appraisal
This involves measurable financial parameters used to assess a borrower’s creditworthiness.
(a) Working Capital
1. Liquidity:
Current Ratio (CR) of 1.33 is generally used as a benchmark for liquidity.
This ratio indicates the ability of a borrower to meet short-term obligations.
However, this value is not strict; flexibility is allowed.
If a lower CR is projected, it doesn’t necessarily mean loan rejection.
The proposal may still be accepted if:
The reason for low CR is justified.
There is a plan to improve liquidity.
Additional terms may be applied:
The borrower might be required to bring in more long-term funds by a certain date if CR is low.
A mutually agreed timeframe is used to fulfill this requirement.
2. Net Working Capital (NWC):
NWC/TCA ratio is a further measure based on the Current Ratio.
It ensures there’s no mismatch between long-term sources and long-term uses.
If long-term funds are used for short-term needs, or vice versa, banks may find this unacceptable.
In such cases, banks may suggest corrective financial measures.
Financial Soundness
Depends on the promoter’s stake or leverage.
Different types of businesses (like manufacturing vs. leasing) have different benchmarks.
For industrial ventures, a Total Outside Liability / Adjusted Tangible Net Worth ratio of 3.0 is considered reasonable.
Some deviations may be allowed for valid reasons, at the bank’s discretion.
(iv) Turnover
Banks assess the trend in quantity and value-wise turnover.
Market share is also reviewed if data is available.
A steady or rising trend in turnover is preferred.
Variations can occur due to price changes, so volume-based trends are often more reliable.
(v) Profits
Net profit is the main measure.
However, cash accruals provide a better picture in some cases, especially due to:
Changes in depreciation or taxation over the years.
Non-operating income is excluded as it may be one-time or extraordinary.
Companies showing net losses for 2 or more years are monitored more closely, and exit options may be considered.
(vi) Credit Rating
In addition to the bank’s own Credit Risk Assessment, if the company is rated by an RBI-approved External Credit Rating Agency, that rating is also considered.
Ratings for instruments like Commercial Paper (CP) or Fixed Deposits (FD) are reviewed.
Banks do not insist on getting a new credit rating unless it already exists, as it involves extra cost.
Capital Markets
When a company’s shares are listed on stock exchanges, banks consider:
- Share price movement.
- Market value of the company’s shares vs. competitors.
- Investor response to public or rights issues.
- These factors indicate corporate reputation and investor confidence.
(b) Term Loans / DPGs (Deferred Payment Guarantees)
(i) Technical Feasibility
A project report is submitted by the borrower (either in-house or via consultants).
The bank vets the report for technical feasibility and economic viability.
If needed, a second opinion can be obtained from:
The bank’s Technical Consultancy cell or
External consultants.
(ii) Promoter’s Contribution
Normally, banks expect the promoter to contribute at least 20% of the total equity.
However, in large projects, this may vary.
The sanctioning authority can allow exceptions when justified.
(iii) Debt Service Coverage Ratios (DSCR – Net & Gross)
The Net DSCR should not fall below 2.0.
The Gross DSCR should not fall below 1.75.
These ratios help assess the borrower’s ability to repay loans through operating income.
(iv) Margin on Security
This relates to the Debt-Equity ratio of the project.
- Ideally, the ratio should be around 1.5:1.
- In any case, debt should not exceed 2 times the equity contribution.
- This ensures the project is not over-leveraged and has enough equity backing.
MIS and Review
Board Oversight: The Board should review the credit portfolio frequently.
Adherence to Policy:
Ensure that all covenants of the credit policy are being followed and assess whether the credit portfolio is contributing as expected to profits.Violation Analysis: If there are shortfalls or violations, the Board must investigate the reasons thoroughly.
Need for MIS: A well-structured MIS (Management Information System) is essential to facilitate these reviews.
Scope of Review: Focus should remain on credit performance and whether the credit policy has met its objectives.
Important policy parameters (like risk estimation, eligibility criteria, accounting standards) should not be changed frequently just for short-term profit.
Outcome: Reviews help ensure regulatory compliance and that policy adjustments, if any, are well-captured and justified.
Types of Borrowers and Types of Credit Facilties
Introduction – Types of Bank Customers and Legal Considerations
Essential Functions of a Bank:
Accept deposits from the public.
Lend or invest the money to earn profit.
Nature of Bank Customers:
Customers can be:
Individuals
Joint account holders
HUF (Hindu Undivided Family)
Trusts
Executors and Administrators
Agents, Attorneys
Firms, Clubs, Associations, Limited Companies
Responsibilities of the Banker:
Must ensure:
The person opening the account has legal capacity to do so.
There is clarity in the nature of the account relationship.
Legal Considerations:
The legal requirements for establishing a contractual relationship differ based on account type.
Transactions and obligations in an individual’s account differ significantly from those in a trust account.