Introduction to Credit Policy – Policy Framework | Credit Management | Financial Stability

A Credit Policy is a set of guidelines that a company establishes to manage the extension of credit to its customers. This policy outlines the criteria for extending credit, terms of repayment, and the procedures for handling past due accounts. The goal of a credit policy is to optimize a company’s sales while minimizing the risk of bad debts.

Table of Contents

1. Introduction
2. Policy Framework
3. Contents of a Credit Policy

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1. Introduction

The Credit Policy, also referred to as Loan Policy of a bank is generally aimed at accomplishing its mission commitment to excellence in customer service and shareholders’/stakeholders’ and employee satisfaction. Bank’s Board is generally the apex authority in formulating Credit Policy of a bank. Credit function of a bank encompasses all activities like sanctioning, issuing and collecting various types of loans and advances. In broad terms, credit includes different types of loans and advances such as cash credit, overdraft, demand loan, term loan, bills purchased/discounted, letter of credit, bank guarantees, co-acceptances, etc. Traditionally, branch is the main delivery unit of credit in a bank. However, these days other channels are also used for credit delivery. A bank’s customers could be individuals or partnerships, or companies owning business units of varied sizes and be situated in different geographies. Within the bank, a number of officials may handle credit functions. In order that all the officers and departments/branches follow appropriate guidelines and take correct decisions such that the bank is able to comply with

• regulatory standards,
• internally set risk profiles,
• maintain the quality of the credit portfolio and
• be profitable, banks must have a well-orchestrated and well-written Credit Policy.

A Credit Policy is a document which contains specific guidelines for all types of credit decisions and determines the composition of its overall portfolio. Credit/Loan officers (Credit/loan officers are persons who have been assigned the job of marketing and/or appraising of loans) and management of the bank will have to adhere to the credit policy.

The main objective of credit policy is to maintain a healthy balance between credit volumes, earnings and asset quality within the framework of regulatory prescriptions, corporate goals and social responsibilities. The policy will thus aim that the credit expansion should be steady, sustained and prudent. The policy should enable good earnings and a steady rise in profits while maintaining a close watch on Quality Assets.

It may be stated that the loan policy in quint essence is a bank’s approach to sanctioning, managing and monitoring credit risks aimed at effective systems and control. It is guided by the highest standards of commercial prudence and ethical business practices.

Credit Policy of a Bank is to include the following:

• Customer Acceptance Policy
• Know Your Customer Policy
• Retail and corporate lending guidelines
• Customer due diligence

2. Policy Framework

Credit Policy is a formal statement objective of a bank. This policy is approved by the banks’ Board and takes into account various regulatory guidelines. The main purpose of this written Credit Policy is to ensure that the bank operates within prescribed risk tolerances/limits. The policy should be clear in terms of risk tolerances; as the market is fiercely competitive, environment is challenging and in the absence of defined risk limits, the loan/credit officer might accept a risk exposure deviating from set instructions, which could impact the viability or profitability. The policy should specify the procedure and responsibility if the credit/loan officer wants to entertain a proposal outside the specified risk levels and how to seek specific approvals of such deviations/departures from the Credit Risk Committee/Sanctioning/Approving Authority. It will elaborate on the organization of the credit function within the bank and indicate the authorities and responsibilities attached to each functionary in the credit departments/branches. The policy will be explicit about risk management. This will ensure that where there are departures/deviations from the Policy or when new loan products are to be taken up, the Risk/Credit Committee or the Board reviews the issue/product and sets up procedures that the loan department might follow to protect the interests of the bank. Needless to say, Credit Policy must be periodically updated to include new products, respond to the changes in the risk environment, or adapt to new regulatory directives. The Credit Policy must reflect the realities faced by the operating staff handling lending function of the bank. An unrealistic policy may only be observed in its breaches. It may be noted that if a bank is having branches abroad, the same policy may not be applicable in foreign branches in its entirety. In such cases bank to follow the local laws and regulations of that country which shall be duly incorporated and brought out separately in the policy.

As per the RBI guidelines on Risk Management Systems in Banks, each bank should constitute a high level Credit Policy Committee, also called Credit Risk Management Committee or Credit Control Committee, etc. to deal with issues relating to credit policy and procedures and to analyse, manage and control credit risk on a bank wide basis. The Committee should be headed by the Chairman/CEO/ED, and should comprise heads of  Credit Department, Treasury, Credit Risk Management Department (CRMD) and the Chief Economist. The Committee should, inter alia, formulate clear policies on standards for presentation of credit proposals, financial covenants, rating standards and benchmarks, delegation of credit approving powers, prudential limits on large credit exposures, asset concentrations, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc.

Concurrently, each bank should also set up Credit Risk Management Department (CRMD), independent of the Credit Administration Department. The CRMD should enforce and monitor compliance of the risk parameters and prudential limits set by the CPC. The CRMD should also lay down risk assessment systems, monitor quality of loan portfolio, identify problems and correct deficiencies, develop MIS and undertake loan review/audit. Large banks may consider separate set up for loan review/audit. The CRMD should also be made accountable for protecting the quality of the entire loan portfolio. The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio.

3. Contents of a Credit Policy

The following is an indicative list of the contents of a good Credit Policy document:

• Purpose and contents: This is a statement of what the policy seeks to achieve and outlines its contents. Usually this would include a review of the economy, environment, regulatory concerns and the bank’s approach towards the business mix based on its performance, more particularly the previous years’ performance. Such a review would set the tone for the current year’s policy.
• Objectives Statement: This sets out the details of the policy. Some of the important objectives of the bank that will focus would be:

1. 1. maintenance and improvement of asset quality
   2. growth in assets consistent with risk management imperatives
   3. maintaining reasonable risk adjusted return on credit exposures
   4. achieving or retaining market share consistent with overall policy of the bank
   5. lending to priority sector
   6. maintaining stipulated proportion in share of fund based assets and non-fund based assets
   7. directions on focus areas like Corporate, Mid Corporate or retail to maximize yields or achieve better risk dispersal for the policy year
   8. targets for short-term, medium-term, long-term assets, emphasis on fee based income such as Letters of Credit (LCs) Bank Guarantees (BGs), acceptances, etc.
   9. cut off credit score below which the bank will not book assets.
   10. asset exposures that are undesirable and banned, assets that are considered of limited interest (restricted list) and would require specific approvals by Committees and
   11. approach on term premium and risk premium over the benchmark with reference to the pricing, etc.

• Lending authority and responsibilities: Lending Authority, apart from according sanctions, would be vested with powers to accord approvals and granting confirmation of action taken by lower authorities/operating functionaries. This segment will cover the issue of per occasion and over all powers or the authority of the Board of Directors, Credit Committee of the Board, Credit Committees at different levels, officers at different levels, etc. with regard to credit sanctions. This policy could be further detailed as board-approved document titled something like ’Delegation of Financial Powers’ or ‘Delegation of Authority’. This document will detail the approval authority for officers at different tiers in the hierarchy right up to the Board of Directors in respect of various types of borrowers. This will get updated whenever the bank revises the powers delegated to the functionaries of the bank.
• Controlling Authority: Sanctioning Authority shall have to put up for control, all the sanctions to an authority higher than the sanctioning authority, as per the hierarchy for the segment/sector-wise sanctioning/confirming authority decided by the bank, which would normally be at a one stage above a sanctioning authority. Controlling authority shall have powers to take on record, the sanctions/approvals confirmations accorded by a sanctioning authority, and convey its observation/conditions if any, and it will be the obligation of the operating functionaries to comply with the conditions, or report through the sanctioning authority, about the action taken if any. However, for board-level sanctions, there is no need for control submission as there is no authority above it.
• Sign off: Some banks require that after undertaking due diligence, assessment of credit facilities and appraisal of proposals, a screening committee or designated credit risk officer signs off the credit recommended by the processing department relationship officers. The Screening Committee/Designated Credit Risk Officer(s) sign(s) off evidencing that the loan proposal is in line with Risk Policy and Credit Policy of the bank, meets regulatory requirements, quality of credit is acceptable in terms of the lending practices of the bank etc., and acceptability of deviation(s) if any, sought for and confirmation of action taken (if  any) by the operating functionaries in anticipation of sanction/approval/confirmation of sanctioning/controlling authority.
• Credit denial and recording procedure: Bank’s policy will lay down the procedure to be followed when a credit request is turned down. Many regulators require that a written record be kept of each such refusal.
• Portfolio composition, credit concentration and diversification limits: The desired level of exposure to different sectors is spelt out under this head. Diversification of risk across sectors, geographical areas, etc. are also mentioned. Concentration limits in different sectors are defined relative to the capital of the bank and the asset levels obtaining in each sector. Generally, portfolio composition is defined based on the levels at the beginning of a credit period. Credit extensions to certain sectors may be considered desirable and certain other sectors may be avoided. These are specifically mentioned such that there is clarity for the loan/credit officers.
• Types of loans: The form in which loans may be sanctioned is elaborated in this section. The limits for participation in the loans syndicated by other banks are also specified. This covers the types of borrowers also. The policy on loans to employees, officers, directors, etc. are also mentioned here.
• Appraisal Standards, policy, procedures and formats: Banks usually spell out how the appraisal of a loan is done. Some banks have loan origination or loan marketing departments that actively source loans to be booked by the bank. The principle is that where the borrower is selected through a marketing effort, there is prior evaluation of the financial strength of the company and the credit risk is evaluated to be good or excellent. In such a case the addition of the loan asset to the books of the bank is considered desirable. As opposed to this, in the case of dealing with a walk in customer where the credit risk may or may not be acceptable. The effort put in evaluating such a credit may be a drain on the resource of the bank and may not produce a desirable result. In these cases, banks may stipulate higher threshold levels before appraisals. Banks have specific formats for loan appraisals to ensure that all aspects of credit quality and risks are evaluated and nothing is overlooked or ignored.

Appraisal Standards

Appraisal standards form an important part of a bank’s Credit Policy. Banks have, over the years, developed scientific credit appraisal methodologies which are being constantly honed in the light of the experiences gained by the bankers from time to time. Traditionally, appraisal methods include

• Security based,
• Balance Sheet based and
• Cash-flow based methods.

However, the basic standards for working capital facilities both fund based and non-fund based and term credit facilities have stood the test of time and are well understood. Certain basic parameters have, by and large, evolved over the years. These could broadly be classified as qualitative and quantitative.

(I) Qualitative
.
Each bank formulates its own loan policy and sanction of any credit proposal has to be within the framework of this policy. The formulation of loan policy is influenced by various factors like market conditions, policies of the competitors, bank’s own SWOT analysis and, of course, the RBI guidelines. The loan policy normally contains guidelines about the following aspects:

• Exposure limits for single counterparty and groups of connected counterparties.
• Exposure limits, fixed on the basis of risk perception the bank has on different sectors, for individual sectors like real estate, capital market, steel, cement, software, etc. This is under constant watch of the bank and if bank’s perception about any particular sector deteriorates, the exposure limit is reduced suitably and fresh sanctions of credit proposals, pertaining to that sector, are curtailed. In such cases, bank may even decide to exit some of the existing category accounts by formulating suitable exit strategies. The loan policy also covers the thrust areas, low priority areas, etc.
• Discretionary powers at various levels for sanctioning of credit proposals. Normally, the policy also lays down the powers of various authorities for allowing over drawings/ad hoc limits.

(II) Quantitative 

The credit facilities extended to a borrower are assessed based on the borrower’s need based credit requirements – be it working capital funds, non-fund based credit facilities, or term loans to meet the capital expenditure/other long-term funding requirements. Correct assessment of the required facilities and limits is considered vital, as short, or excess financing, may impact the business performance of the borrowing unit.

• Working Capital
  
  The basic quantitative parameters underpinning the bank’s credit appraisal are as follows:

1. 1. Liquidity: The Loan Policy of the bank should state which are the liquidity ratios it would examine while considering a credit proposition and also must clearly spell out what are the level of such ratios the bank is comfortable with for different sizes and sectors of borrowers, whether such levels are mandatory or indicative and also in case the actual, estimated or projected if such ratios are below such levels, whether such proposals should stand rejected or approval for deviation from the loan policy can be sought for or in case such shortfall need not be considered as a deviation warranting specific approval by sanctioning authority or any other authorities, what kind of treatment must be given, etc.
   2. Financial Soundness: The loan policy of a bank is expected to specify various desirable financial ratios so as to decide upon the acceptability of the same. Loan policy should also stipulate financial covenants and remedies for events of defaults in financial covenants so as to ensure continued financial soundness of the borrowers.
   3. Turnover: The trend in quantity and value wise turnover has to be carefully gone into and also market share wherever such data are available. The year on year increase should not be unreasonable and loan policy should stipulate what is reasonable rate of increase as what is more important is to establish a steady output if not a rising trend in quantitative terms. Because sales realization may be varying on account of price fluctuations. However, yardstick for y-o-y increase must be in value terms.
   4. Profits: Loan policy is expected to speak on the method of assessment of profitability. For the sake of proper assessment, treatment of the non-operating income has to be specified as these are usually one time or extraordinary income. Treatment of existing and prospective borrowers incurring net losses will be discussed unambiguously in the loan policy.
   5. Credit Rating: Apart from the bank’s Internal Credit Risk Assessment (ICRA), for most banks, it is mandatory to obtain External Credit Rating (ECR) from any of the RBI accredited External Credit Rating Agencies (ECRAs) of borrower for all exposures above a bank-specific threshold either from banking system or from the bank as decided in its loan policy as risk weight for capital adequacy calculation is based on ECR assigned. Normally, concessionary pricing may be extended to BBB-(‘Investment Grade’) and better rated borrowers as higher the rating, lesser is the risk weight. For the purpose of Capital Adequacy framework, banks can generally treat the validity of External Credit Rating as 15 months from the date of rating. Borrowers with 15-months-expired ECR shall be treated as unrated and Internal Credit Risk Assessment ICRA linked interest shall be charged. The ECR is also to be incorporated in the proposal.
   6. Capital Market Perception: Where the Company’s shares are listed on stock exchanges, the movement of the price of its share, the market value of shares vis-à-vis those of competitors in the same industry, response to public/rights issues are also kept in view as these are reflective of the corporate image in the eyes of the investors’ community. The loan policy should mention what is the treatment to be given at different scenarios, i.e., the shares of the borrower/applicant is outperforming/moving in tandem/underperforming the broader market.

• Term Loans/DPGs

1. 1. Technical feasibility: Loan policy should stipulate that in case of Term Loans and Deferred Payment Guarantees (DPGs), for what amount and above a project report is to be obtained from the customer and whether such report needs only to be compiled in-house or is to be compiled by a firm of expert-consultants/merchant bankers. Also, the loan policy should stipulate vetting of the technical feasibility and economic viability by external experts empaneled by the banks is necessary for what amount of exposure/project cost and above.
   2. Promoters’ Contribution: Loan policy should mention absolute or indicative maximum debt equity ratio. The promoter’s contribution may vary according to the size and nature of the project and hence, practically, there cannot be a definitive benchmark. The sanctioning authority/other appropriate authority should have the necessary discretion to permit deviations.
   3. Commercial Viability parameters: Desirable, indicative or mandatory minimum/maximum break even capacity utilization, debt service coverage ratio (both Gross DSCR and Net DSCR), fixed assets coverage ratio and security margin coverage ratio are to be specified in the loan policy.
   4. Other parameters: Other parameters governing working capital facilities, such as end use of funds, Credit Rating, triggers for interest rate reset, etc. would also be discussed in the loan policy that would govern the credit facilities, to the extent applicable.

• Lending to Non-Banking Financial Companies (NBFCs): Lending to Non- Banking Finance Companies is a separate game altogether as the RBI regulates NBFCs as it does banks and NBFCs are also into lending as banks do, though all the NBFCs do not accept deposits from public. The business model of NBFCs is quite distinct from all other models of business and has close resemblance to banks’ business model. Usual system of credit assessment will not suit NBFCs. Hence, the loan policy must spell out different aspects of financing NBFCs.
• Financing of infrastructure projects: In view of the national importance attached to infrastructure development, its criticality to economic development of the country, the potential for large volume business and the special skills required for credit appraisal/assessment, the banks have set up a separate Project Finance Division/Departments for financing infrastructure projects.

Infrastructure would include sectors such as power, roads, highways, bridges, ports, airports, rail system, water supply, irrigation, sanitation and sewerage system, telecommunication, housing, industrial park or any other public facility of a similar nature as may be notified by Ministry of Finance, (Department of Economic Affairs), (Infrastructure Policy & Programme Section) in the Gazette from time to time.

Loan policy of banks should crystalise its approach towards lending to infrastructure projects as to maximum amount and per cent of debt funding to be taken, debt equity ratio for different types of infrastructure, Parameters for establishing commercial viability of different types of infrastructure projects may also be told by the loan policy of a bank.

• Lease Finance: Bank’s loan policy on leasing finance has to, like any other lending, be aligned in lines of RBI instructions in this regard. Wherever RBI has permitted by the bank does not have appetite for the same or where more stringent stipulations are to be made, they must be incorporated in the loan policy.

• Letters of Credit, Guarantees and bills discounting: It should be enshrined in the loan policy with emphasis that the bank would open Letters of Credit (LCs), issue guarantees/acceptances and discount bills under LCs only in respect of genuine commercial and trade transactions of borrower constituents who have been sanctioned regular credit facilities by the Bank. RBI instructions from time to time on acceptances and guarantees need to be captured in a bank’s loan policy.

• Guarantees and co-acceptances favouring FIs/banks/other lending agencies: Loan policy must tell whether the bank may Extend Fund Based and Non-Fund Based (NFB) credit facilities against guarantees issued by other banks/FIs and also whether the banks may issue guarantees favouring FIs/other banks/other lending agencies for loans extended by them.

• Syndication of loans: The market for syndication of loans is expected to grow significantly, especially given the national thrust on infrastructure projects. When a corporate approaches the bank for funding its project cost and where the bank may not meet the entire financial needs of the borrower, the balance term loan/working capital finance would be syndicated. The loan policy must specify whether the bank would undertake syndication either on its own or jointly with other companies engaged in such activities.

• Hedging of forex risks: As mandated by RBI, the banks should have a separate Board Approved ‘Hedging Policy’. However, it is better that glimpses of the same have been captured at the appropriate places in the loan policy.

• Fair Practices Code (FPC) for lenders: Loan policy must be written keeping in mind that the banks would continuously attempt to introduce transparent and fair practices, as envisaged by RBI, in respect of acknowledging loan applications, their quick processing, appraisal and sanction, stipulation of terms and conditions, post disbursement supervision, changes in terms and conditions, recovery efforts, etc.

• Risk Policy: The accepted level of risk is mentioned here. Banks may indicate either the risk tolerance levels or if the bank has a separate risk policy cross references are mentioned here. The risk measurement tools are also mentioned in this part. The policy specifically mentions the banks approach to different industries. Generally, these are further elaborated in terms of specific percentage terms and/or numbers.

• Documentation responsibilities, waivers, waiver authority: The banks usually lay down in their loan policy that the loans may be disbursed only on completion of documentation, perfection of security and ensuring that the disbursements made/drawings are permitted to ensure end use of funds. Exceptions, e.g. when guarantee of directors is prescribed and one of them is travelling abroad, may be allowed only if loan policy so permits. The policy should prescribe that a record of exceptions indicating when the formality will be completed be kept. Depending upon the nature of the exception and the limit being sanctioned, it is usually stipulated that the authority for approving an exception is one level higher than the authority approving the limit. Some banks record exceptions in a separate register which is a record of specific approval for non-compliance of covenants or non-completion of a document or non-creation a charge. The policy will also specifically stipulate the MIS for outlier events such that the management/board is immediately seized of such events.

• Loan-file requirements/maintenance/administration: Under this head, banks indicate the need to maintain a loan register or record in the computer system with all details of the loan. If a copy of this needs to be kept in the loan file, that may be mentioned in the loan policy or in a separate executive order. Where there is a separate Loan administration department (somewhat in the nature of a back-office) its duties and responsibilities should be defined in the loan policy in brief though the detailed Standard Operating Procedure (SoP) will be separate. Sometimes, this kind of departments are also responsible for loan documentation, following up on loan waiver approvals generated by the loan marketing department, and for eventual rectification of documents. The Credit Policy will contain instructions on this aspect of loan administration.

• Loan loss provision policy: Normally, loan loss provisions are part of accounting disclosures. However, if there is no separate stressed assets policy, these aspects get mentioned in the Credit Policy. It lays down the loan loss recognition standards set by the bank, Income Recognition and Asset Classification norms, and loan loss provisions. Banks have little leeway in this area. Reserve Bank of India issues instructions in this regard that need to be followed.

With a view to ensure that banks have adequate provisions for loans and advances at all times, RBI has advised as under:

1. 1. Banks shall put in place a board–approved policy for making provisions for standard assets at rates higher than the regulatory minimum, based on evaluation of risk and stress in various sectors.
   2. The policy shall require a review, at least on a quarterly basis, of the performance of various sectors of the economy to which the bank has an exposure to evaluate the present and emerging risks and stress therein. The review may include quantitative and qualitative aspects like debt-equity ratio, interest coverage ratio, profit margins, ratings upgrade to downgrade ratio, sectoral non-performing assets/stressed assets, industry performance and outlook, legal/regulatory issues faced by the sector, etc. The reviews may also include sector specific parameters. After a careful review of each sector, banks consider making provisions for standard assets for that sector at higher rates so that necessary resilience is built in the balance sheets should the stress reflect on the quality of exposure to the sector at a future date. Besides, banks should also subject the exposure to those sectors to closer monitoring.

• Loan Grading/Credit Scoring: Every loan asset is graded/given a credit score based on defined parameters and the loan pricing is linked to such score. Credit policies indicate the accepted scores and rating for different types of loans and advances.

• Loan Review and Renewal Policy: In this head, policy on how and when a loan is reviewed is laid down. This will also incorporate regulatory instructions in this regard. Policy in respect of renewal of FB and NFB credit facilities in respect of various types of borrowers need to be in place. Instructions regarding renewal of credit facilities in the event of delay in Financial Statements also needs to be in place.