The meaning of credit risk in the business of lending is easy enough to understand and explain. Credit risk arises when a bank borrower or counter- party fails to meet his obligations according to specified schedule in terms of predetermined agreement either due to genuine problems or willful default.
Credit risk mitigation strategies in a bank taking place in two stages namely pre-sanction stage and post sanction stage of loans and advances. Pre-sanction process involves identification of borrower,the purpose of the loan, quantum of loan, period of loan, source of repayment, security for advance, profitability, pre-sanction unit inspection, appraisal of credit proposal, and sanctioning of the loan/limits. The post-sanction monitoring includes proper documentation for the loan/limits sanctioned, stamping, execution, execution of documents by special type of borrowers, attestation of documents, registration of mortgage/memorandum of the mortgage, registration with the Registrar of companies (ROC), post disbursement follow up/unit inspections etc.
Identification of the promoters
Since the safety of funds lent will be the main concern of a bank, the advance should be granted to a reliable borrower who can repay the loan in the ordinary course of business. While entertaining new proposals, as a matter of rule and without fail the caution advice and defaulter list of RBI/ECGC caution list/CIBIL and other credit information companies’ Reports/Reports from other banks are verified. Trade circle enquiry, information from Newspapers and magazines, may sometimes supply important information which is a matter of concern to the bank. Banks are advised by the Reserve Bank that they should desist from accepting credit appraisal notes prepared by outside consultants or in-house consultant of borrowing entity as the first step of risk mitigation measure. Preparation of appraisal note should be the responsibility of credit officer of the bank which should be in consonance with the Loan Policy of the bank. The credit officer has to correctly identify the directors of the company, through Director’s Identification Number (DIN) and Permanent Account Number (PAN) and find out that they are not in the list of defaulters/willful defaulters from the data available from RBI and credit information companies. In the case of doubts on identical names, they need to confirm the identity of such director/s through independent source instead of taking the declaration from the borrowing company.
Fraud Risk mitigation:
Essential aspects of credit appraisal:
The structure of credit risk management system provides essential prudential limits on various aspects of credit appraisal such as benchmark current ratio, debt-equity ratio, debt service coverage ratio (DSCR) or other ratios with flexibility for deviations as spelt out in their loan policy. The risk associated with any single borrower exposure or group of exposures (concentration risk) may result in ample loss to the bank. The lender must reduce this risk by diversifying the borrower pool. Hence, banks need to have a filtering apparatus to evaluate the exposure at regular intervals and to ensure that their exposure is within the threshold limit prescribed by Reserve Bank of India. Further, it’s necessary to stipulate a maximum exposure limit in cases of sensitive sectors (like equity shares and real estate business), other specific high-risk industries as perceived by the bank and also make sure of any excess exposure is fully covered by adequate collaterals or strategic considerations. The process of credit appraisal should also involve an evaluation of all available information about the borrower, including promoters’ past experience and competence to implement the existing/proposed business activity. Financial soundness and ability to service commitments even under adverse conditions; Business reputation and culture, compliance, complaints and outstanding or potential litigation; Security and internal control, audit coverage, reporting and monitoring the environment, business continuity management etc. It is also important for banks to ascertain the source and quality of equity capital and confirm that the debt of parent company is not infused as equity capital of the subsidiary/SPV to convince the banks of adequate capital in the business.
Covenants in sanction endorsement:
The terms and conditions of sanction endorsement duly acknowledged by the borrower/s and guarantor/s shall stipulate that (i) the borrower entity must periodically report its financial condition to the bank. (ii) Unsecured loans (appearing in the balance sheet) from friends and relatives of the promoters which are treated as quasi-equity for the purpose of debt equity measurement should not be withdrawn during the currency of bank loan and an undertaking on that effect should be taken from such unsecured lenders (iii) The company shall refrain from paying dividends, repurchasing shares; additional borrowing etc. which may adversely affects the company’s financial. (iv) The sanction should specify that the bank has the right to recall the advance in full or reduce the sanctioned limit in the events of negative change in debt equity ratio or interest coverage ratio.
The loan documents executed by the borrower should be sufficiently enforceable on their legal effect and flexible to allow banks to retain an appropriate level of control over the activities of the borrower. Documentation should also provide the lender, the right to intervene with appropriate measures to meet legal and regulatory obligations.
The precise credit risk management system differs from bank to bank depending upon the nature of their major flow of credits. Banks have to analyze overall credit risk at the individual customer and portfolio levels and decide to charge the higher rate of interest (credit spread) on debtors who are more likely to default. This practice of banks is called risk-based pricing. The risk-based pricing involves credit rating/scoring (external/internal) of customers upon evaluating the exposure to sensitive sectors like equity shares, real estate business and other high-risk industries as perceived by the bank, besides capability of the borrower on the basis of nature of business, credit ratings, financial soundness and ability to service commitments even under adverse conditions, availability of collateral security/credit guarantee from CGTMSE/ECGC etc.
Post disbursement Monitoring:
Financial institutions need to ensure the proper end-use of funds released to the borrower, inspection of borrower’s unit/site at regular interval is a vital and desired activity of banker to monitor the account. By conducting regular inspection of borrower’s unit /factory, bankers notice on many occasions, the irregularities like shortage of stock, stoppage of work in the factory, presence of other bank’s name board indicating financing by them on same security etc. Factory units/godown inspection also helps to identify the obsolete stock /rejected/returned goods being included in the stock register to calculate drawing power. Another important area of risk management is that the financiers have to be careful about diversion/siphoning of funds borrowed by the borrower. In terms of RBI guidelines, banks shall obtain an undertaking from the borrowers authorizing the banks to issue the discrete notice to the borrower’s auditors calling for a certificate in respect of diversion/siphoning of funds by the borrower. Generally, agreement of loan will have such clause to facilitate such certification by the auditors/borrowers. In addition to the above, bankers could engage their own auditors for such specific certification purpose without relying on certification provided by borrower’s auditors. However, such certificate cannot substitute bank’s basic minimum own diligence in the matter.
Loan Review Mechanism:
To check and control the slippage of advances from good to bad, banks use a tool called Loan Review Mechanism (LRM) system. The loan review mechanism is designed to evaluate the effectiveness of sanction process and status of post sanction position of the high-value loan accounts. As per RBI guidelines, at least 30-40% of the credit portfolio should be subjected to LRM in a year so as to ensure that all the major credit risks embedded in balance-sheet have been pursued.
Provisions to absorb losses:
The paramount duty of a bank is to monitor all its assets on a continuous basis, quantify the risk and make sufficient provisions to absorb any expected and unexpected losses. Quantifying the risk is done through estimating expected loan losses over a chosen time horizon is the most familiar risk metric. There is also an element of unexpected loan losses which are measured through statistical approaches. Banks make provisions for the possible loss values on both expected and unexpected loan losses estimated by them.
Under Basel standards which are the part of regulatory norms in India, banks are required to evaluate the potential value loss of assets held by them. The potential value losses of assets measured under the system are called Risk Weighted Asset (RWA). For example, RWA of Cash held by the bank is zero as it is an asset of the bank with zero risks, whereas other assets of the bank such as loans and advances, guarantees etc., are vulnerable to the risk of default. The loans and advances which are fully covered under the security of term deposits, NSCs, IVPs, KVP and Life policies of adequate surrender value or guarantees from ECGC, CGTSME etc., are treated as assets of lower risks. Under prudential norms assets are categorized as the standard account, substandard account, doubtful and loss accounts. Banks make proportionate provisions at different rates on the basis of the quality of advances classified under prudential norms to meet future unforeseen losses.
To make sufficient provisions to absorb any losses arising from the credit risks quantified under above methods, banks need to hold adequate capital. It is estimated that banks in India will need to raise around Rs.4.50 lakh Crore in tier I capital including Rs.2.40 lakh Crore in equity capital by March 2018 under Basel III norms.
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