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exposure within the Group and to assess the risk of losses associated with credit
extended to customers, financial investments and counter party risks with respect to
derivative instruments. Term loan refers to asset based loan payable in a fixed
number of equal installments over the term of the loan, usually for 1 to 5 years.
Credit Planning
A credit planning is to set out procedures for defining and measuring the credit-risk
exposure within the Group and to assess the risk of losses associated with credit
extended to customers, financial investments and counter party risks with respect to
derivative instruments.
The main aspects of a credit planning are-
1) the terms and conditions on credit,
2) customer qualification criteria,
3) procedure for making collections, and
4) steps to be taken in case of customer delinquency.
The Credit Authorisation Scheme (CAS) for bank advances was introduced by the Reserve Bank of
India in 1965.Under the Scheme, all scheduled commercial banks have to obtain prior
authorisation of the Reserve Bank before granting any fresh credit limit of Rs. 1 crore or more to
any single borrower. This limit was, however, raised to Rs. 2 crores in 1975.
The banks first scrutinise the proposals of the borrowers and then send them to the Reserve
Bank for approval.
The Reserve Bank goes through the proposal and if found suitable, then it may authorise the
concerned bank to sanction the loans asked for. The CAS is being reviewed by the Reserve
Bank from time to time and is progressively liberalised.
Recently, following the Vaghul Committee's Report on Money Market, certainchanges have
been introduced in the CAS for promoting the bill financing.
(i) From April 1, 1988, in the case of borrowers who enjoy aggregate working
capitalfacilities exceeding the cut-off point under the CAS, the limit sanctioned
against book debts should not be more than 75 per cent of aggregate limits
sanctioned to such a borrower for financing his inland credit sales.
(ii) (ii) Sanctioning of separate additional ad hoc inland bill limit is left to the
discretionof the banks.
(iii) All borrowers subject to the CAS have to attain a ratio of bill acceptances to total
inland credit purchases of 25 per cent.
Since the out-off point is raised from Rs. 4 crores to Rs. 6 crores from April, 1986, the
number of CAS parties covered under the scheme decreased from 843 in March 1986to
629 in March 1987. Total limits in force also dropped from Rs. 21,671 crores to
Rs.21,137 crores during this period.
The RBI received 749 applications for authorisation in 1986-87 of which 316 were
approved and Rs. 5,146 crores of loans was sanctioned.
Loan pricing
A bank acquires funds through deposits, borrowings, antiquity recognizing the costs of each
source and the resulting average cost of funds to the bank. The funds are allocated to assets,
creating an asset mix of earning assets such as loans and non-earning assets such as banks
premises.
The price that customers are charged for the use of an earning asset represents the sum of
the costs of the banks ’funds the administrative costs e.g salaries, compensation for non-
earning assets and other costs.
If pricing adequately compensates for these costs and customer to be fair .based on the
funds and service received.
The price of the loan is the interest rate the borrowers must pay to the bank, in addition to
the amount borrowed(principal).
The price/interest rate of a loan is determined by the true cost of the loan to the bank(base
rate)plus profit/risk premium for the bank’s services and acceptance of risk.
1. Interest expense,
3. Cost of capital
or
Cost of funds
The risk is the measurable possibility of losing or not gaining the value.
The primary risk of making a loan is repayment risk, which is the measurable possibility
that a borrower will not repay the obligation as an agreed.
Since past performance of a sector, industry or company is the strong indicator of future
performance, risk premiums are generally based on the historical quantifiable amount of
losses in that category.
Loan pricing is not an exact science- get adjusted by various qualitative as well as
qualitative variables affecting demand for and supply of funds. These are several methods
of calculating loan prices.
Fixed rate The loan is written at a fixed interest rate which is negotiated at an
origination. The rate remains fixed until maturity.
Variable rate The rate of interest changes basing on the minimum rate from time
to time depending on the demand for and supply of fund.
Prime rate Usually, relatively low rate offered to the highly honored clients for
a track record.
The rate for general This rate is applied for general borrowers’.This rate is usually
customer higher than the prime rate.
Caps and Floors For loans extended at variable rates, limits are placed on the extent
to which the rate may vary. A cap is an upper limit and a floor is the
lower limit.
Prime times This special rate is a number of times greater than the prime rate. If
the maturity of the loan is increased or decreased, this rate will also
be increased or decreased in a multiple.
Rates on another basis The interest rate can also be determined on the basis of the current
interest rate of debt instruments or the regional index of change of
interest/price.
This rate is similar to prime rate except that the base is different a
rate can be a bit lower or higher than the prime rate. Examples
include the regional index or other market interest rate such as the
CD rate.
Fees, charges etc. After sanctioning credit but before disbursing the amount to the
borrower, a charge is taken for this interim period. This charge
helps to prevent the loan taker from making unnecessary delay in
taking a loan.
Foreign Exchange Risk : Foreign exchange risk is present when a loan or portfolio of loans is
denominated in a foreign currency or is funded by borrowings in another currency. In some cases,
banks will enter into multi-currency credit commitments that permit borrowers to select the
currency they prefer to use in each rollover period. Foreign exchange risk can be intensified by
political, social, or economic developments. The consequences can be unfavorable if one of the
currencies involved becomes subject to stringent exchange controls or is subject to wide exchange-
rate fluctuations. Foreign exchange risk is discussed in more detail in “Foreign Exchange,” a
section of the Comptroller’s Handbook.
Transaction Risk: In the lending area, transaction risk is present primarily in the loan
disbursement and credit administration processes. The level of transaction risk depends on the
adequacy of information systems and controls, the quality of operating procedures, and the
capability and integrity of employees. Significant losses in loan and lease portfolios have resulted
from inadequate information systems, procedures, and controls. For example, banks have incurred
increased credit risk when information systems failed to provide adequate information to identify
concentrations, expired facilities, or stale financial statements. At times, banks have incurred losses
because they failed to perfect or renew collateral liens; to obtain proper signatures on loan
documents; or to disburse loan proceeds as required by the loan documents.
Compliance Risk: Lending activities encompass a broad range of compliance responsibilities and
risks. By law, a bank must observe limits on its loans to a single borrower, to insiders, and to
affiliates; limits on interest rates; and the array of consumer protection and Community
Reinvestment Act regulations. A bank’s lending activities may expose it to liability for the cleanup
of environmental hazards. A bank may also become the subject of borrower-initiated “lender
liability” lawsuits for damages attributed to its lending or collection practices. Supervisory
activities should include the review of the bank’s internal compliance process to ensure that
examiners identify and investigate compliance issues.
Strategic Risk :A primary objective of loan portfolio management is to control the strategic risk
associated with a bank’s lending activities. Inappropriate strategic or tactical decisions about
underwriting standards, loan portfolio growth, new loan products, or geographic and demographic
markets can compromise a bank’s future. Examiners should be particularly attentive to new
business and product ventures. These ventures require significant planning and careful oversight to
ensure the risks are appropriately identified and managed. For example, many banks are extending
their consumer loan activities to “sub- prime” borrowers. The product may be familiar, but the
borrowers’ behavior may differ considerably from the banks’ typical customer. Do they understand
the unique risks associated with this market, can they price for the increased risk, and do they have
the technology and MIS to service this market? Moreover, how will they compete with the nonbank
companies who dominate this market? Both bankers and examiners need to decide whether the
opportunities outweigh the strategic risks. If a bank is considering growing a loan product or
business in a market saturated with that product or business, it should make sure that it is not
overlooking other lending opportunities with more promise. During their evaluation of the loan
portfolio management process, examiners should ensure that bankers are realistically assessing
strategic risk.
Reputation Risk : When a bank experiences credit problems, its reputation with investors, the
community, and even individual customers usually suffers. Inefficient loan delivery systems, failure
to adequately meet the credit needs of the community, and lender-liability lawsuits are also
examples of how a bank’s reputation can be tarnished because of problems within its lending
division.
Reputation risk can damage a bank’s business in many ways. The value of the bank’s stock falls,
customers and community support is lost, and business opportunities evaporate. To protect their
reputations, banks often feel that they must do more than is legally required. For example, some
banks have repurchased loan participations when credit problems develop, even though these
problems were not apparent at the time of the underwriting.