CRDMGT Mod III CH 1 Documentation (1) - Merged

Course: Credit Management (Module III: Credit Management) NIBM, Pune
Module III: Credit Management
Chapter 1: Documentation
Dr R Bhaskaran
Objective
The objective of this chapter is to highlight the importance of documentation in the

credit function. The chapter explains all documents and security in detail and discuss
procedure of charges and relevant laws.
Structure
1. Introduction
2. The need for documentation
3. Important documents
3.1. Promissory note
3.2. Loan agreement
3.3. Other documents
4. Securities and creation of charge
4.1. Types of charges
4.2. Types of securities
4.3. Pledge
4.4. Hypothecation
4.5. Assignment
4.6. Mortgage
5. Insurance of securities
6. Stamping and registration
7. Limitation
7.1. Extension of period of limitation
8. Summary
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1. Introduction
Credit Departments of banks have three major responsibilities: (i) evaluation/appraisal

of an applicant’s credit worthiness and deciding on granting loan; and once the loan is
sanctioned (ii) disburse the loan as per sanction terms and conditions and (iii) follow up
conduct of the account to ensure that amounts are used as per sanction, repayments are
regular and account reviewed as per terms etc.
As regards the disbursement stage an item of work to be done very meticulously and
indeed most critical is documentation. Disbursement of loan cannot take place unless
documentation is complete. Documentation and disbursements are the two proofs of
loan without which banks cannot provide evidence for the loan given and establish their
rights to recover over the assets of the borrower in the event of recovery through legal
means. As such the competence of a credit officer in documentation plays a critical role
in the viability of loan. It should however be added that credit officers do not require a
law degree or specific drafting skills but should have a clear understanding of the set of
documents needed for each type of loan and important contents and provisions of the
documents. This will enable them to explain the importance of the document and be
trusted advisors to their customers at the same time safe guard the interests of the
bank.
Loan is a contract to lend money and repay as per terms. The steps in loan are as under
1. Applicant/Customer submits an application. The information in the application

is supported by various documents.
2. Bank considers the application and approves or sanctions the loan. The contents
of the application, discussions and acceptances through the appraisal process
and information contained in the documents submitted are essential part of the
process and hence contract. Letter of sanction issued by the bank is the offer for
the loan.
3. On receipt of the sanction letter customer accepts the same by signing the copy
of the letter. After that he executes necessary agreements after which
disbursements are made.
The entire process listed above involves documentation. The important points are
i. Application should be filled in full.

ii. Details in the official valid documents (OVD) for KYC should match with the
details in the application
iii. Documents about the financial details and other aspects of the applicant should
match or support the application.
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iv. Additional information asked by the bank should be listed in a separate paper
and kept with the other documents. Important points that emerge in the
discussion should be written and accepted by both parties.
v. Sanction letter should clearly state the terms and conditions. It should also list all
items that the applicant or bank has to do before the sanction becomes effective.
vi. The details of primary security or collateral security and method of charge
should be clearly mentioned in the sanction letter.
vii. Repayment terms should be indicated in the sanction letter. Loan agreement
should contain the schedule of repayment.
viii. If the amount sanctioned is more than the amount applied for, the reason for the
same should be written and accepted by the applicant/borrower.
The next stage is executing the agreements. Banks has developed detailed agreements
for every product. Content of agreement is discussed later in this chapter. Format and
content of agreement could differ slightly from bank to bank and among various types
of limit and security. Both customer and authorised bank official will have to sign every
page of the agreement and should ensure that it is filled up and nothing is left as blank.
In case a bank has to file a suit against the borrower and/or surety for recovery of dues
the above mentioned documents form the basis and evidence the loan. As indicated
above in respect of most loans banks have standard printed documents which are filled
in appropriate places. These loan documents have been prepared by banks with the
help of lawyers. As regards large value collaterals and in respect of project loans,
corporate loans and large value loans where the terms are more closely negotiated,
banks get the documents prepared and vetted by their approved lawyers before
effecting disbursement.
What is a Document
Section 3 of Indian Evidence Act, 1872 defines a document as:
– Anything in writing, words printed, words lithographed or Xeroxed or

photocopied or photographed,
– An inscription on a metal plate or stone ,
– A caricature or
– A plan,
2. Need for documentation
In normal business atmosphere, agreements and documents are drafted after

negotiation between the lender and the borrower. Given this documentation is done in
order to fulfil certain objectives of both the borrower and the lender.
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Documents should ensure that the objectives of borrower and the bank is well
expressed. The common expectations of a borrower will include:
 That sure that funds (under the loan) will be available as and when needed.
 That terms of credit such as interest and repayments are clearly mentioned
 The terms of penalties if any and conditions for prepayment of loans are
mentioned and
 The various information and details to be given to the bank and its periodicity is
clearly mentioned.
Through the documents lenders would like to
 Define conditions under which it is offering the loans

 Secure the loan as much closely as possible and
 Ensure that borrowers will provide necessary information as possible as also
allow monitoring the borrower’s financial conditions
From the above it will be clear that documents are necessary to
• identify both parties to the loan transaction

• understand and accept all the terms & conditions by both the lender and
borrower
• identify securities for the loan
• have written evidence of loans issued by the bank;
• ensure repayment of the loan by the borrower;
• enable the bank to, in case of need, seek recourse to legal course recovery of the
loan. It will be impossible to seek legal action in the absence of a document.
Documents help the bank to prove and establish before a court of law that the
amount was lent and the same has not been fully/partly repaid;
• create a legally enforceable charge on the securities in favour of the bank
• preclude creation of fresh charge on security given to the bank by other creditors
• determine and ensure that the loan does not suffer from period of limitation
3. Important Documents
3.1 Promissory Note:
This document is taken in the case of all Demand Loans, Cash Credits, Overdrafts, Bills
discounted and other similar limits. Promissory Note contains a promise to pay the
amount of loan and interest on demand. It specifies the terms of repayment, including
principal and interest, the length of the loan, late fees, and prepayment penalty if any.
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Promissory note itself or a support document will state the circumstances under which
the borrower may wind up in default, and what action bank may take the event of such a
default. The following is an example of a simple Promissory Note.
I/We……………………………………Jointly and severally ( Borrowers) promise to pay a

sum of Rs……………………………………….for value received to
…………………………………( name of the bank/lender together with interest thereon
at the rate of (rate of interest %) per annum.
It could be added that
If there is default in the above payment we promise to pay the lender all
reasonable costs to collection, penal interest @ ….. on the amount defaulted and
reasonable attorney and collection charges.
Promissory note will be supported by hypothecation, pledge or other document as per

the loan purpose and type.
3.2 Loan Agreement

Loans by commercial banks and other lending institutions are given under a contract
between the lender (debtor) and the borrower (creditor). As such, there is a need for a
written loan agreement between the two parties that will provide the details on the
rights and obligations of both the debtor and creditor with respect to the loan.
Key sections of loan agreement: Knowledge of the key sections and their contents is
important for credit and loan officers. The key sections of the agreement and its content
are as follows.
 Definitions and interpretations: This section will provide a list of terms used in
the agreement, their definitions and explanations if any. As these terms will
appear at several places in the agreement, credit officers should be familiar with
these terms and their interpretations.
 The Loan: The type/s of loans provided and the purpose for which the loans may
be used.
 Utilization of the Loans: This section will provide the details of when and how
will be the loans will be disbursed. For instance, at what stage of a project and
how much loan will be released by the bank or that the loan for house will be
released based on the demand raised by the builder on various stages of
completion as agreed in the purchase agreement. It will also specify in what
currency and in what form the loan will be made available.
 Terms and conditions. This will elaborate on various costs such as Rate of
interest, calculation of interest, and fees payable. Fees may include loan
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processing fee, cost of valuation, legal verification, commitment charges, costs of

inspection by the bank, etc.
 Security: This section will cover issues such as margin, primary security,
collateral security, hypothecation or pledge of material and the margin against it
for arriving drawing limit.
 Collateral/ surety and Guarantee: If the loan is secured by other collaterals or
guaranteed by another person or an entity the responsibilities and obligations of
the guarantor should be decided and the same will be included in this section.
Insurance conditions if any is also mentioned here.
 Representations and undertakings: This is the most critical section of the loan
agreement because this section contains all the obligations and responsibilities
of the borrower. The subsections of the section are as under.
o Representations: This section will contain the statements of the borrower

including who is he/it, the company is in good shape, it can enter into the
deal, the officers authorised to sign the deal, and the law governing the
deal.
o Undertakings: Covenants, credit triggers, etc will be mentioned in this
section.
o There will be clear statements about what the bank will deliver and what
it expects from the borrower in terms of statement, information etc.
 Default and other related issues.
o This section will contain definition of default and the responsibilities of
the borrower in the event of default and course of action that the bank
will take.
Agreement will have a number of schedules for (a) describing the borrower through ID
(PAN, Aadhaaretc), the place of business and (b) Rate of interest, (c) schedule of
properties and assets which are offered to secure the loan, (d) special terms and
conditions.
3.3 Other Documents
Beside the promissory note and loan agreement lenders may include any of the
following documents, depending on the nature of the financing and the credit
arrangements:
 Inter-creditor Agreement: An inter-creditor agreement is executed between one

or more creditors who have shared interests in a particular borrower say two
banks financing the same borrower. The agreement spells out aspects of their
relationship to each other and to the borrower so that, in the event a problem
emerges, there will be ground rules in place to handle the situation. The contents
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of an inter-creditor agreement would vary depending on the borrower, the type

of debt, and other factors, such as the presence of co-obligors.
 Security Agreement: A document that provides a lender a security interest in a
specified asset (other than mortgage) or property that is pledged as collateral. In
the event that the borrower defaults, the pledged collateral can be seized and
sold. A security agreement contain covenants that outline provisions for the
loaned funds such as repayment schedule or insurance requirements. The
borrower may also allow the lender to hold the collateral for the loan until
repayment. Security agreements may also pertain to intangible property, such as
patents or receivables.
 Mortgage Deed: This is executed if the loan is secured against mortgage of
property. This will mention the title, encumbrances etc.
 Disclosure and Authorizations: This is an agreement that permits the disclosure
of private information acquired during an insurance-related business. The
agreement will detail what the lender can disclose and what information will be
collected and who it will be shared with.
4. Securities and Creation of Charge
All security documents must be stamped as per the laws of respective state government.
In case of execution of documents by corporate or legal entity, common seal needs to be
affixed on documents creating charge. As regards security and collaterals, documents
evidencing ownership will be in the form of agreements, land records etc.
The security documents are valid for a period of 3 to 12 years from the date of execution
depending on the type of documents. A promissory note is valid for three years and a
term agreement for 12 years To extend the validity of the same lender/bank must
obtain a document of Acknowledgement of Debt and Security from the borrower and
guarantor on annual basis. The borrower / guarantor when they sign this document
acknowledge execution of banks security documents for the advance availed and also
confirm balance outstanding in the advance a/c as on particular date. This extends the
validity period by three years.
4.1 Types of Charges
• Fixed Charge: This is charge over specific asset of the company. Company cannot
sell the asset unless the dues are paid or unless permitted in writing by the
lender/bank. Floating Charge: This is an equitable charge created on certain
property of the company, which is continuously changing i.e. Stock in Trade,
receivables etc. The charge gets fixed the day the bank gives a notice for recovery
and specifies the assets covered
• PariPassu Charge: This charge is created in favour of several creditors with
priority. All parties with paripassu have equal right. This means that irrespective
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of the date of agreement or mortgage the parties to PP agreement enjoys a right

as if all of them entered into the agreement on the same day. The share however
will depend on the amount and will be proportional.
• Second charge: This means the person having second charge will get, in the event
of liquidation or sale of asset the balance after the person with first charge is
paid. If the first charge covers the entire value realized then the second charge
will get nothing.
4.2 Types of securities
• Primary Security: Hypothecation/pledge/assignment or mortgage of assets

created out of bank finance
• Collateral security: Mortgage of land, Third party guarantee, security by way of
deposits, assignment of policy etc.
4.3 Pledge
Pledge is the bailment of goods as a security for payment of a debt or performance of a

promise. Pledge means delivery of goods by the borrower to the lender (bailee) with
some purpose and with the condition that when the purpose is accomplished the goods
will be delivered back to the first person (bailor). Pledge can be only in respect of
movable goods like stocks.
Two types of pledge is practiced one where the goods pledged are in banks go down or
approved warehouse and the pledged goods are released or added as and when needed.
Drawing limit is arrived on the basis of value of pledged goods less margin. In the other
model the godown can be of the borrowed but the key will be with the banker. Banker
will collect the godown or warehouse rent as the case may be.
In the case of pledge, ownership remains with the borrower and only possession is
transferred to the banker. The bank as a bailee/pledgee must take good care of the
goods pledged, Bank can sell the pledged goods without intervention of the court in case
the borrower (bailor/pledger) fails to repay the bank loan. But the sale can be done only
after giving reasonable notice to the borrower. Bank as a pledgee has priority right over
the goods and Bank's right of sale under pledge cannot be extinguished even by lawful
seizure of goods pledged to it.
Pledge of godown if owned by the borrower will display a board announcing that goods
are pledged to the bank.
Gold loans are pledge loans. Here the pledged jewellery is kept in banks locker.
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4.4 Hypothecation
Hypothecation charge can be created on moveable things/property like stocks. In case

of hypothecation both ownership as well as possession remains with the borrower i.e.
neither ownership nor possession are transferred to the bank. In these cases, in the
event of default the bank has to freeze and possess the hypothecated goods. The charge
created in Hypothecation is a floating charge. When he invokes the hypothecation the
charge becomes fixed. Basic difference between pledge and hypothecation is one of
possession. In practice when bank creates a hypothecation charge on stocks etc. a board
or announcement to that effect is displayed in borrower’s business premises, more
particularly where the goods are kept. This can be a notice to public about bank’s
charge. In case of financing vehicles and fixed assets the name of Bank/Branch with
whom it is hypothecated is displayed by painting a notice to that effect on the backside
of the vehicle.
4.5 Assignment
Assignment is transfer of right or interest in an asset to recover the debt. Assignment is

practiced in the case of financial collaterals. The borrower (transferor) of claim is called
as the Assignor and the banker (transferee) is called the Assignee. Assignment can be
done in the case of Book Debts, Supply Bills, LIC policy, fixed deposit etc. Assignment
has to be recorded in writing. Assignment is required to be acknowledged by original
debtor say Insurance Company in the case of life insurance policy. Assignor cannot give
better title to the assignee than what assignor has.
In case of default, the assignee can recover the amount to the extent of value of
actionable claim from the original debtor without reference to assignor.
4.6 Mortgage
Mortgage is the transfer of interest in a specific immovable property, for the purpose of
securing an existing or future debt. The borrower is the person creating the mortgage
and is called as the mortgage. The bank in whose favour mortgage is created is called as
the mortgagee. Mortgage is created on immovable property like land and building.
There are six types of mortgages namely, (i)Simple Mortgage, (ii)Mortgage by

Conditional Sale (iii) Usufructuary Mortgage (iv)English Mortgage (v)Mortgage by
Deposit of title Deeds (Equitable Mortgage) and (vi)Anomalous Mortgage. Of these, all
mortgages except Equitable Mortgage require registration with the Registrar of
Assurances. In some states equitable mortgage has to be informed to the registrar in the
form of memorandum of information. The two most common type of mortgages in India
are as under:
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4.6.1 Registered Mortgage:
In the case of registered mortgage (also called legal mortgage) a mortgage deed is
written, which is stamped as per provisions of Stamp Act of the concerned state. The
deed is then executed in the presence of two witnesses. Thereafter, in terms of the
Indian Registration Act 1908, it is e registered with the Registrar of Assurances (Sub-
Registrar) within 4 months of the execution. Prudence demands that registration is
done immediately to ensure that if the property is mortgaged again the registration will
ensure first charge. A property could be mortgaged a number of times. In this
background, the first, second charge etc., over the property are decided on the basis of
date of registration.
4.6.2 Equitable Mortgage:
Equitable Mortgage is created by mere deposit of title deeds of property with intention
to create a charge there on. Title deeds may be deposited by the mortgagor himself or
his agent. In the case of a bank loan, the title deeds should be deposited with the bank
at any town notified by the State Government in this regard. Property may be situated
anywhere in India. For property located in Lucknow, title deeds can be deposited at
Chennai.
Since no special documentation is undertaken for creation of charge of equitable

mortgage, Bank maintains a register in which it records date, the name of person who
deposited the title deeds with details of property and purpose of deposit of title deed i.e.
creating a charge on said property offered as security for repayment of debt etc. It is
signed by official of the bank only. Borrower does not sign this register. This register is
admissible as evidence in court.
In no case the bank should part with the title deeds of equitable or registered mortgage
even for a short duration at the request of the mortgagor because if some other creditor
is induced to finance on the basis of title deeds, the bank may lose priority over the
mortgaged property.
Equitable Mortgage does not require registration with Registrar of Assurances. But in
case of a limited company charge in respect of equitable mortgage under Section 125 of
the Companies Act. 1956 must be registered with Registrar of Companies.
All mortgages in favour of bank require registration with CERSAI (established under
SARFAES1 Act) within 30 days.
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Table 1: Various kinds of charges over securities

Type of Security Type of Charge
Immovable Property like Land and Building Mortgage
Actionable claims like Book Debts, FDR, Assignment
NSC, Life Insurance Policies
Movable property / goods like Plant and Pledge or Hypothecation
Machinery, Stocks, Vehicle, Railway Receipt
Paper securities like shares, debentures, MF Lien
units, bonds
5. Insurance of security
Banks need to insure the assets financed for Fire/Natural Calamities/Floods/Theft/

War and other risks. It should be ensured that the name of borrower and address/es
where assets are located are correctly mentioned in policies. Bank Clause, which
mentions that bank has the first right over the claim amount settled by the insurance
company, must be mentioned in insurance policy. Original policy should be kept on
Bank record. In case of vehicles it should be 3 rd Party Insurance. All policies should be
renewed in time before due date.
6. Stamping and Registration
A document/agreement which has not been stamped as per the Indian Stamp Act is
invalid. There are certain documents on which stamp duty is prescribed by Central
Government and is uniform throughout India. These documents are Promissory Note,
Bill of Exchange, Receipt etc. Stamp duty on these documents will be same throughout
India except J & K. On all other documents, the ad valorem (based on value) stamp duty
rates are prescribed by the State Govt. Such documents are Power of Attorney,
Agreements, Guarantee Bond, Indemnity Bond etc.
7. Limitation
Documents executed by borrowers have limited life within which the banks are
supposed to exercise the rights conferred on them by the documents. In fact, the rights
are limited by the Limitation Act 1963. The Act limits the period within which a suit can
be filed against the borrower for recovery of loans. If the loans are not recovered and
the bank wants to proceed against the borrower it should do so before the expiry of
limitation period. Limitation period depends on the document. According to the Act the
period of limitation for different types of documents is as in the Table 2 below.
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Table 2: Loan account-wise limitation period
Type of Loan/Document Limitation
Demand loan: Promissory Three years from the date of loan

note
Temporary over draft : Three years from the date of loan
Promissory Note
Demand loan: Period 5 Three ears from the date of execution of document.
years: Promissory note
Term loan: Term agreement 12 years from the date of execution. In case of installments
or Mortgage 12years for each installment when it falls due
Cash credit Hypothecation: Three years from the date of documents
Promissory note
Cash credit pledge: Goods pledged has to be sold. For balance of loan if any
Promissory Note three years
Bill discounting Three years from the date of bill
Loan secured by mortgage 12 years from the date of mortgage
Bill purchasing Three years from the date of bill
7.1 Extension of period of limitation
According to Section 3 of Limitation Act, a suit cannot be filed for recovery on the
strength of a time barred document. Hence, if the documents are time barred, the bank’s
right of legal remedy for recovery is lost. Therefore, if a loan is not repaid within the
period of limitation the bank must get fresh document/s for extending the period of
limitation. However, according to Section 18 of the Act, when the borrower
acknowledges the debt in writing under the signature of the borrower or makes a part
payment under his/her signature before the expiry of period of limitation, then the
period of limitation is extended by one more period i.e. 3 years in case of promissory
note and 12 years in the case of mortgage or term loan from the date of such
acknowledgement document or such part payment.
8. Summary
Documentation is a very important stage in the lending process. Without relevant

documents banks cannot provide evidence for the loan given and hence cannot enforce
their rights over the borrower. Documents also fulfill certain objectives of the
borrowers including a confirmation that the bank will make the loan available and the
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terms and conditions for repayment of the loan. Important documents to be made and
executed are promissory note, loan agreement, inter-creditor agreement, security
agreement, mortgage deed, and disclosure and authentication forms. In addition,
adequate security for the loan should be obtained and charges on the securities must be
created. The bank should also ensure that securities are insured by the borrowers. The
documents should also be stamped as per the prevailing regulations after paying the
stamp duty. Though the documents provide certain rights to the banks for recovery of
loans the Limitation Act 1963 has limited the validity period of the documents.
Therefore, the banks must exercise their rights within the period of limitation or should
get fresh documents made.
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Chapter 2: Credit Monitoring and Early Warning Signs
Dr. M. Manickaraj
Objective:
The objective of this chapter is to make the readers understand and appreciate the
meaning and importance of credit monitoring, various tools for monitoring and to equip
them with various early warning signs and signs of fraud and what can they do to
safeguard the interests of the banks. The lesson will also make the readers to be aware
of the relevance and importance of automating credit monitoring.
Structure
1. Introduction
2. Objectives of credit monitoring
3. Instruments for credit monitoring
3.1. Stock audit
3.2. Quarterly reports
3.3. Annual reports
3.4. Annual review
3.5. Stock price movements
4. Early warning signs
4.1. Liquidity indicators
4.2. Financial indicators
4.3. Behavioural indicators
5. Signs of fraud
6. What should lenders do?
7. Automation of credit monitoring
8. Summary
1. Introduction
Credit Monitoring is an integral and an important part of credit management of banks

and lending institutions. Though loans might have been given after thorough due
diligence and credit analysis borrowers’ ability to repay loans may be influenced by
variety of factors. The factors could be both external as well as internal. It is possible
that even a best rated customer may end up with difficulty in generating sufficient cash
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flow to repay loans. Lending institutions therefore have to track the performance as
well the behaviour of borrowers in order to make sure that the loan given to them will
be repaid on time. In order to ensure this, loans should be monitored regularly using
appropriate tools and techniques. Moreover, lenders will have to look out for signs of
distress of borrowers so that timely action can be taken to avoid loans becoming non-
performing assets (NPA). Besides, borrowers may face temporary problems and lenders
may have to provide additional support.
2. Objectives of Credit Monitoring
Monitoring of the borrower accounts on an ongoing basis will facilitate foreseeing the
problems and taking corrective measures to meet the adverse impact. Effective credit
monitoring will also ensure proper usage of loan funds and reduce the loan losses which
will in turn maximize the returns to the banks.
Among others the following are the main objectives of credit monitoring:
 To check if the loans are used for the purpose for which they have been provided
 The borrowing firm’s performance is as expected and will be able to service the
loans
 The security offered for the loans are intact
If the above aspects are satisfactory the account will be regular and there will be no
concern about the asset quality. As such banks need to put in place a very sound and
effective credit monitoring system.
3. Instruments for credit monitoring
Most commonly used instruments for monitoring loans banks are as follows:
• Stock audit
• Inspection (onsite monitoring)
• Stock statement
• Quarterly reports
• Annual reports
• Annual review of loan account
• Stock price movements
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3.1 Stock Audit
Provision of working capital loan to business enterprises is a major business for

commercial banks. Inventory is one major item for which working capital is used.
Therefore, verification of stock is necessary to find out if the value of stock reflects the
loan utilised. Moreover, it will throw light on the level of activity of the borrowing firm.
It will also help find out if the firm is not able to sell the goods. Onsite as well as offsite
verification of stock can be done. Onsite verification (inspection) is nothing but visiting
the premises of the borrower firm and checking the stock and comparing it with the
stock statement submitted by the firm and also corroborating with the level of activity
in the business. Stock audit will also help verify if the borrower is maintaining a reliable
management information system and proper records are maintained.
Offsite stock verification is done by using a third party to verify and submit a statement
showing the details stock. In India, stock statements submitted periodically by
borrower firms are used for verification of stock and also to determine how much loan
should be released to the borrower. Normally, stock statements certified by an external
auditor should be submitted to banks every month or every quarter. The stock
statement will also show the details of receivables, payables and the amount of loan the
borrower is eligible. The eligible amount is called the Drawing Power. A typical stock
statement of manufacturing firms would like the table below.
Table: Stock Statement
Items Amount
Stock (A)
- Raw material
- Work in process
- Finished goods
Receivables (B)
Total current assets (A + B)
Trade credit (C )
Margin for working capital (D)
Drawing Power (A + B – C – D)
All these will ensure that the account is not misused. As the bank staff handle a larger
number of accounts there could be a tendency to ignore some of the above steps. At
times if the account is regular there could be laxity in the stock verification, both off site
and on site. This could encourage even the regular borrower to use the laxity to their
advantage. This must be avoided. Another issue is how fast the bank acts if something is
amiss or if the borrower is not regular in submitting statement or if the statement is
factually incorrect. Bank should immediately ask the borrower to set it right and ensure
the same. If the stock statement is delayed the bank should immediately get across to
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the borrower and if necessary freeze the limit. Immediate and prompt action will deter
the borrower from taking wrong steps. If the delay or defect in stock statement is
deliberate bank should treat it as an early warning. This also shows the borrowers
character in an adverse way.
3.2 Quarterly Reports
Another off site monitoring tool quarterly reports to be submitted by the borrowers.
The quarterly reports are submitted in the format prescribed by banks and are
popularly known as QIS (Quarterly Information System) reports. The quarterly reports
provide a summary of financial performance and the details of current assets of the
borrower. Certain guidelines for preparation and submission of QIS reports are as
follows:
(i) Information should be furnished for each line of activity / unit separately as
also for the company as a whole. In cases where the different activities / units
are financed by different banks, the concerned activity / unit wise data and
data relating to the company as a whole should be furnished to each financing
bank.
(ii) The valuation of current assets or current liabilities in these forms should be
on the same basis as adopted for the annual balance sheet and it should be
applied on a consistent basis.
(iii) The period should be shown in relation to the annual projection for the
relative item. If the levels of inventory / receivables are higher than the
stipulated norms, reasons therefor should be given.
(iv) If the canalized items form a significant part of raw materials inventory, these
may be shown separately.
(v) Amount of bills discounted with bankers should be indicated separately.
(vi) The classification of current assets or current liabilities should be made as
per the usually accepted approach of bankers and not as per definitions in the
Companies Act.
3.3 Annual Reports
Every business enterprise prepares its annual accounts and present the annual balance
sheet and profit and loss account to various stakeholders including the
owners/shareholders, government, lenders and the like. Public limited companies do
prepare a comprehensive annual report containing various reports including directors’
report, management discussion and analysis, report on corporate governance, auditors
report, and financial statements. These reports, if made available to lenders on time, will
provide data necessary for ascertaining the performance of the firm and to know the
repayment capacity of the firm.
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3.4 Annual Review
Every loan account will be subjected to a through and comprehensive review once every
year. The annual review is supposed to be done in a manner similar to credit analysis
and it will help the bank to evaluate the performance of the customer during the last
one year and to decide on continuing the loan relationship, credit risk rating of the firm,
revising the rate of interest, and to decide on the loan amount to be sanctioned.
3.5 Stock price movements
Companies listed in the stock exchanges are major borrowers of commercial banks. The
equity shares of listed companies are traded in the stock exchanges. The movement in
the stock prices of the companies in comparison with that of any share price index or
with that of competitor companies will provide indications regarding the performance
of the borrower company and it will also provide signals regarding the distress, if any,
in the company. Share price movements and the factors causing the movement are
monitored by a host of players including analysts, institutional investors, retail
investors, regulators, government, and so on. Therefore, stock prices can be considered
by lenders as reliable indicators of financial health of companies and also as an indicator
of early warning signal.
4. Early Warning Signs
One of the most important outcomes expected of monitoring is indications of

deterioration in the risk of loans. It would be or great use to lenders if the indicators
provide early warning signs. There are a number of early warning signals. These are
classified into
a. Liquidity indicators
b. Financial indicators
c. Behavioural indicators
4.1 Liquidity indicators
Liquidity indicators are the strongest and first apparent signs of trouble. Symptoms of
liquidity problems include:
• Increased credit enquiries about the customer from suppliers. This indicates
shortage of liquidity and that the borrower is seeking funds/goods from
many to overcome shortages.
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• Increase in the need for guarantees and LCs. This would indicate fall in the
credit worthiness of the borrower and hence the suppliers demand guarantee
from the banks.
• Return of cheques issued by the customer. This is a strong indication of

liquidity problem.
• Working capital loan limits fully utilised for extended periods without any
transactions and overdrawal from working capital loan account too
indicators of liquidity crisis of borrowers and significant rise in the credit risk
of the borrower.
• Increase in litigation against the client
• Third party claims like local bodies and tax authorities
• Delayed payment of salaries to employees

• Accelerated collection of bills by the customer or by the suppliers from the
customer
• Frequent and sudden request for enhancement of loan limits
• Breach of covenants related to working capital
• Full utilisation of loan limits inconsistent with sales
4.2 Financial Indicators
The following financial indicators too provide early warning signs of distress and can be
used by lenders for taking corrective steps:
• Working capital ratios: If current assets are more it could point excess
stock or poor collection efficiency. Similarly, a higher level of current
liabilities could show a higher credit period enjoyed or delays in settling
payables.
• Holding periods (inventory period, receivable period and payable period).

A longer holding period shows a poor turnover and hence a matter of
concern. Higher level of current assets, current liabilities and longer
operating cycle are indicators of inefficiency in operations and poor
performance. These will automatically lead to higher working capital
requirement.
• Profitability ratios and solvency ratios are good indicators of financial health and
the borrowers’ ability to service loans. However, if they can be calculated at
frequent intervals, say quarterly, they may provide early warning signs.
• Cash flow statement is a powerful tool to find out the liquidity position of
business firms.
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4.3 Behavioural Indicators
Behavioral indicators provide clues about customers’ integrity and competency.

Competence is implicit in the financial performance. Integrity is very difficult to
measure. However, there are indicators which point out to poor or doubtful integrity.
The following are indicators of borrowers’ integrity.
• Any deception, misrepresentation of facts or lie
• Delay in releasing financial statements and submission of reports/data to the

banks
• Reluctance or unwillingness to communicate
• Failure to respond to a specific question directly or entirely
• Providing evasive or unspecific information to a request
• Any indication that records have been misplaced or destroyed by the borrower
• Absence of key personnel from crucial meetings
5. Signs of Fraud
The points discussed above are indications of distress in the business and the
consequent difficulty in servicing loans by the borrower. However, there could be
borrowers who may like to defraud the lenders. The following are signs of fraud which
can be used by banks to protect their interests from such frauds.
• Sudden or rapid and significant decline in liquidity inconsistent with business

conditions or events
• Significant changes in accounting policies and methods
• Major change in accounting personnel
• Changing statutory auditors too often
• Engaging an auditing firm which doesn’t have the required skill and depth of
knowledge required for the business
• Excessive number of cheques issued to individuals other than employees
• Payroll inconsistent with the list of employees and/or volume of business
• Sale of assets without a sound business reason or at lower than fair value
• Lapping (misdirection of payments). Lapping is a fraudulent practice of

concealing theft of cash. Lapping occurs when a cashier or clerk steals cash from
one customer's payment and covers it up by stealing cash from the next
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customer's payment ... and so on. It is easier where cash handling and cash
recording duties are handled by the same person. Also called teeming and lading.
(Source: http://www.businessdictionary.com/definition/lapping.html)
• Use of shell entities to manipulate transactions
6. What Should Lenders Do?
Credit monitoring is a tool in the hands of banks. It is not an end itself. Unless the banks
take appropriate action credit monitoring will not achieve its objectives. Following is
the list of activities that bank can do enhance the effectiveness of credit monitoring.
• Know the customer – understanding customer is the first principle. Proper due
diligence before sanctioning loans will facilitate this.
• Sanctioning adequate amount and at reasonable terms is essential as failure to

do so will almost immediately result in credit quality issues ever before credit
monitoring begins.
• Bank should communicate with customers frequently. This helps bank to get
information from the customer some of which could indicate the shape of things
to come.
• Bank should meet key members of the accounting department and external
auditors of the borrowers.
• Obtain monthly statements on time and use the monthly information for
comparative analysis. Seek clarification if there is any deterioration in the
performance from the customer or from their accountants.
• Use plant/site/shop visits and monthly reports to identify behavioural signals.
• Stipulate a minimum number of but relevant covenants. Breach of such

covenants will provide action points for the banks.
• Heed to any warning signals particularly liquidity problems and frauds and
initiate appropriate action.
• Multiple warning signs are an indication of serious distress.
• Timely action is critical for good credit management. However, before any action
is taken, viability of the business should be studied.
7. Automation of credit monitoring
Advancement in information technology has enabled the banks and financial

institutions to automate various functions and operations. Automation in turn
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empowers the management of organisations to take right decisions and timely action.
Thanks to liberalisation and competition banks have become financial super markets
and offer variety of loan products to large number of customers. The variety and
number make it very difficult to monitor loans manually and hence there is a need for
monitoring of loans as well as loan portfolios. Automation of credit monitoring will
enable monitoring not only individual loan accounts but also loan portfolios. Loan
portfolios like overall portfolio, product portfolios, regional portfolios, portfolio of
various customer segments, and the like can be monitored effectively if automated.
Automation will also enable the banks to send reminders to customers regarding
payment of dues and also submission of reports. It will also provide triggers/signals to
the management of the bank at different levels which will enable timely action.
Ideally, an automated system should be put in place which takes care of the following:
• Identification of symptoms of sickness, weakness and deterioration of asset

quality well in time
• There should not be excessive reliance on securities in preference to viability

and cash flow. Collaterals do not ensure smooth running of loan accounts.
Collateral becomes critical once the account fails or defaulted. Whereas
monitoring happens before default and used to predict and prevent default. As
such there should not be excessive reliance on collateral.
• There should not be excessive lending to certain borrowers, industrial sectors,
and business groups.
• At the time of sanction of loans, there should not be over valuation of securities.
• The charges on securities should be properly created and on time.
• Stock statements, quarterly statements and annual reports should be submitted

in time by borrowers.
• All the covenants stipulated while sanctioning loan are adhered to.
• The interest and instalments are paid as per the agreed schedule.
8. Summary
One of the critical factors that will determine the quality and profitability of a bank’s
credit portfolio is the bank’s ability to detect problems early combined with prompt
action. Effective credit monitoring will also ensure proper usage of loan funds and
reduce the loan losses which will in turn maximize the returns to the banks. Banks use
variety of instruments for monitoring loans and major ones are: stock audit, inspection
(onsite monitoring), stock statement, quarterly reports, annual reports, annual review
of loan account, and stock price movements.
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Early warning signs will enable banks to initiate appropriate action. The early warning
signs are classified into three different types, namely, liquidity indicators, financial
indicators and behavioural indicators. In addition to the early warning signs banks shall
also look out for signs of frauds by the borrowers. The signs will enable banks to initiate
appropriate action at the right time.
Advancement in information technology enables automation of various functions of

banks and financial institutions. One big area where automation will provide substantial
results is credit monitoring. Automation of credit monitoring will help manage
individual loan accounts as well as loan portfolios efficiently.
Page 10 of 10
Chapter 3: Income Recognition and Asset Classification Norms
Dr.V. S. Kaveri
Structure
1. Introduction
2. Definitions
2.1. Stressed asset
2.2. Special mention account
2.3. Non-performing asset
3. Income recognition
4. Asset classification
5. Provisioning norms
6. Restructured advances
7. Conclusion
1. Introduction
If an account is NPA, bank cannot recognise interest income from that account. Further
depending on the age of NPA it will have to provision for loan losses. The non-recognition
of income impacts the NII and NIM and the provisioning reduces NPM and ROA. Given this
if the level of NPA in a bank’s portfolio is high its profitability will decline, capital will
eroding and its ability to honour its commitment to depositors will be affected.
Prior to the implementation of IRAC norms, different banks adopted different methods of
estimating loan losses, if at all and it was not clear if banks were financially stable. In view
of this, in line with the international practices and as per the recommendations of the
Committee on the Financial System1 , Reserve Bank of India ( RBI) introduced, prudential
norms for income recognition, asset classification and provisioning for advances /
investment for banks in India to be implemented in a phased manner. The essence of IRAC
is that the practice of income recognition should be based on record of recovery rather
than on any subjective considerations. Further, the classification of assets based on their
1
Chairman M Narasimham
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quality should follow uniform norms across the banking sector. Lastly, provisioning should
be based onthe asset classification and the period for which the asset has remained in the
concerned asset category and the availability of securities & value thereof.
In this background Banks are expected to (a) identify non performing assets (NPAs)
correctly and without any error, (b) not recognize income from NPAs and (c) make
provisions for various types of assets in terms of RBI guidelines. In this chapter, it is
attempted to provide a good understanding of Income Recognition and Asset Classification
(IRAC) as regulatory aspects of management of NPAs in simple words. The chapter is
arranged in terms of broad themes like
i. Definitions: Understanding what is NPA

ii. Income Recognition: Rules for not recognising income in NPA
iii. Provisioning: Provisioning for loan losses based on age of NPA and preventive
provision for standard assets
iv. Other issues
2. Definitions:
Assets, loans, advances and investments. This means that IRAC is concerned with earning
assets and not others. IRAC is further concerned with assets which are not performing as
per terms i.e. these assets have some issue regarding (i) payment of interest by the
borrower/issuer, (ii) repayment of principal by borrower/investor and (iii) adherence to
Terms of Credit in terms of margin on security, valuation, end use of credit etc.
Let’s start with a statement that if any of the above issues are found in an asset we can call
them stressed. Stress is the first point of the journey of an asset from being a standard or
performing asset to become an NPA.
i. Stressed Asset:Stressed Asset is defined as an account where principal and/or

interest remains overdue (not paid by the borrower) for more than 30 days. Not all
stressed accounts become NPA. Bank can proactively engage with the borrower and
ensure that an account does not slip into NPA. Stressed account is treated as
standard asset.
ii. Special Mention Account (SMA): SMA is the position between stressed account and
NPA. SMA is an asset which has potential weaknesses which if remains uncorrected
could lead to further deterioration of assets and as such deserves close management
attention so that it can be resolved through timely remedial action. All standard
borrowal accounts with impairment for 30 days or more besides other features
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causing a concern are classified as SMAs. Some of the points considered for
identification of SMAs indicated by RBI in its guidelines include :
a. Default in payment of interest / instalment due beyond 30 days
b. Persisting irregularities due to excess drawal beyond 30 days in Cash Credit
account
c. Shortfall in Drawing Power (DP) in Cash Credit account not regularized
within a week
d. Devolvement of Letter of Credit (LC)/ Deferred Payment Guarantee (DPG)
instalment and non-payment of the same beyond 15 days
e. Non-creation of charge on primary securities affecting the ultimate recovery
prospects in the account
f. Delayed / Non-submission of stock statements, other monthly information
data for 2 months continuously
g. No operations in the account during the reporting month
h. Decline in production activity below 60% of the accepted level.
i. Accounts remaining without review / renewal beyond 90 days from the due
date
j. Any other feature considered requiring attention of higher authorities
k. Continuous overdue in Bills facility beyond 10% of the outstanding balance
l. Bills Payable (BP) returned unpaid outstanding beyond 15 days, and
m. Non-payment of Defaulted Guarantees and Devolved LCs within 15 days.
The list is long and not all of them are related to interest and repayment. Some of the
issues are about non adherence to terms and conditions. Banks should use SMA as an early
warning and necessary steps to regularise these accounts as soon as possible and definitely
before they get classified as NPA.
i. Nonperforming Assets(Nonperforming Loans/Investments):An asset becomes

nonperforming when it ceases to generate income for the bank. A non-performing
asset (NPA) is a loan or an advance where;
a. interest and/ or installment of principal remains overdue for a period of more

than 90 days in respect of a term loan,
b. the account remains ‘out of order’, (amount outstanding in excess of drawing
limits) in respect of an Overdraft/Cash Credit (OD/CC) for a period of more than
90 days,
c. the bills account remains overdue for a period of more than 90 days in the case
of bills purchased and discounted,
d. the repayment of principal or interest thereon remains overdue for two crop
seasons for short duration crops and
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e. the installment of principal or interest thereon remains overdue for one crop
season for long duration crops,
Thus other than crop loan, irrespective of the amount of loan or type of business all
accounts should be classified as NPA if the account is overdue or out of order or unpaid for
90 days and more. As regards interest, the period of 90 days starts from the end of the
quarter in which the interest has been charged in the account and not from the date on
which the interest was charged. It can be added here that most banks charge interest only
in the last few days of the quarter.
In the case of CC and OD an account should be treated as 'out of order'if the outstanding
balance remains continuously in excess of the sanctioned limit/drawing power for 90 days.
Also where the outstanding balance in the main(principal) operating account is less than
the sanctioned limit/drawing power, but there are no credits continuously for 90 days and
sum of credits in the account are not enough to cover the interest debited during the same
period, these accounts should be treated as 'out of order'.
Further, any amount due to the bank under any credit facility will be treated as ‘overdue’ if
it is not paid on the due date fixed by the bank.
The above definition and understanding of NPA is important to comply with regulatory
prescriptions of income recognition and provisioning.
3. Income recognition:
Banks follow accrual basis of accounting. This means income and expenditure is recognised
on a accrued and due basis and not on actual receipt or payment. If the income is
recognised only on receipt it will be cash accounting. Banks follow double entry system of
accounting and if they have to treat NPA accounts differently the norms for the same
should be distinct. This would mean that inrespect of NPAs, income should be only on cash
basis whereas it could be accrual basis in respect of standard assets. Thus, in respect of
NPAs, uncollected interest will be held in Memorandum Account and must be included in
the ‘dues for collection’ when recoveries are made. This cash based income recognition is
also applicable to Government guaranteed accounts. However, interest on advances against
Term Deposits, National Savings Certificates (NSCs), Indira Vikas Patras (IVPs), Kisan Vikas
Patras (KVPs) and Life policies may be taken to income account on the due date, provided
adequate margin is available in the accounts. Fees and commissions earned by the banks as
a result of renegotiations or rescheduling of outstanding debts should be recognised on an
accrual basis over the period of time covered by the renegotiated or rescheduled extension
of credit.
There could be accounts where before it became NPA interest and other income were
recognized on accrual basis. As such the amount of NPA at the time of classification
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included amount of interest due as well. In such cases,any advance including bills
purchased and discounted, becomes NPA, the entire interest accrued and credited to
income account in the past periods, but not recovered should be reversed. This will apply
to Government guaranteed accounts also. Further in respect of NPAs, fees, commission and
other income that have accrued but not recovered and which are levied on a regular basis,
should cease to accrue in the current period and should be reversed with respect to past
periods, if uncollected.
Interest realized on NPAs may be taken to income account provided the credits in the
accounts towards interest are not out of fresh/ additional credit facilities sanctioned to the
borrower concerned. If the dues are on account of installment and interest but principal
due on a previous loan then recoveries should be first appropriated towards principal.
If an account turns into a NPA, banks should reverse the interest already charged and not
collected by debiting Profit and Loss account, and stop further application of interest.
However, banks may continue to record such accrued interest in the MemorandumAccount
in their books. Non recognition of income does not mean that the borrower need not pay
such interest or that his/her liability is reduced. They continue to owe the amount to the
bank.
How does non-recognition affect the banks income? Let see an example. A bank has
Sanctioned a CC limit of Rs 100 crore to a company at 7.5% rate of interest and a home loan
of Rs 50 lakh (outstanding Rs 40 lakh) to an individual at 8.4%. The company’sCC account
is overdrawn for more than 90 days and the Home loan borrower has defaulted 3 EMIs.
Normally the bank would have charged and taken to P/L account Rs1.75 crore interest
every quarter (Rs 7.5 crore every year) in the CC account. Interest on home loan is
calculated on monthly basis based on loan outstanding. However, as the loan is NPA the
bank cannot takethe interest due from the home loan borrower to P/L account which
would be Rs 31500 every month. At the end of the year bank’s income will be less by the
amount of interest.
4. Asset Classification:
Income recognition takes care on interest on NPA. But what about the amount of likely loan
losses? Some of the NPA accounts may not be realised and some could be partly realised.
Security in some accounts may not be sufficient to recover full amount. All these will
impact income and net worth. These aspects need to be factored.
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For this purpose all loan assets are classified into two categories viz., Performing /
Standard assets and Non-Performing Assets (NPAs). NPAs are further classified into Sub-
standard, Doubtful and Loss. As per the RBI guidelines, non-performing assets are
classified as under:
a. Sub-Standard - Accounts where there is likelihood of losses because the account has
(i) remained as NPA for a period of less than or equal to 12 months and, (ii) current
net worth or value of securities of the borrower/guarantor is inadequate to cover
bank dues
b. Doubtful Assets: - When a NPA account remains in the sub-standard category for a
period of 12 months & more it is classified as doubtful of recovery. This
classification is done for provisioning for the possibility that these amounts may not
be recovered at all. For this purpose Doubtful assets are further classified in to the
following three categories:
o D1 – when the accountremained as NPA in the bank’s book up to one year
o D2 - the account remained as NPA in the bank’s book for more than one year
period but less than three years
o D3- the account has remained as NPA in the bank’s book for more than three
years.
c. Loss Assets – An NPA is identified as loss asset for full value of asset if there is no
possibility of recovery in the account and the asset is non saleable though there
could be some salvage value, or to the extent of shortfall if the realisable value of
security is less than the outstanding amount.
There could be some disputes between the auditor and the bank regarding the
abovementioned issues. The following clarifications have been given in the guidelines
issued by RBI.
o In respect of accounts where there are potential threats for recovery on account of
erosion in the value of security or non-availability of security and existence of other
factors such as frauds committed by borrowers, it will not be prudent that such
accounts should go through various stages of asset classification but taken directly
as doubtful or loss.
o Erosion in the value of security can be reckoned as significant when the realizable
value of the security is less than 50 per cent to 90 per cent of the value assessed by
the bank or accepted by RBI at the time of last inspection, as the case may be. Such
NPAs may be straightaway classified under doubtful category.
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o If the realizable value of the security, as assessed by the bank/ approved valuers/
RBIinspector is less than 10 per cent of the outstanding in the borrowal account, the
existence of security should be ignored and the asset should be straightaway
classified as loss asset.
The above guidelines are general. RBI’s guidelines on NPA also cover many issues which
will clarify if an account is NPA or otherwise. These points are given below.
i. (Default of payment of interest and/or installment should be on continuous basis. In

other words, the asset should not be considered as NPA due to mere presence of
temporary irregularity.
ii. In cash credit account, it shouldbe ensured that drawings in the working capital
accounts are covered by adequate chargeable current assets such as stock and book
debts. These are the assets that can be quickly disposed of in the event of needing
liquidity. Further drawing power should be arrived at based on the stock statement
which is upto date. However it should not be more than 3 months old. The entire
outstanding in an accountwhich is based on drawing power calculated from stock
statements older than three months, would be deemed as irregular. Therefore,the
working capital borrowal account will become NPA if such irregular drawings are
permitted in the accounts for a continuous period of 90 days even though the unit
may be working or the borrower's financial position is satisfactory.
iii. In credit card accounts, the amount spent is billed to the card users through a
monthly statement with a definite due date for repayment. Banks give an option to
the card users to pay either the full amount or a fraction of it i.e., minimum amount
due on the due date and roll-over the balance amount to the subsequent months’
billing cycle. The credit card account will be treated as non-performing asset if there
is continued default in payment of the minimum amount due, as mentioned in the
statement, which is not paid fully within 90 days from the first month statement
date. Further, gap between two statements should not be more than a month.
iv. In the case of bank finance given for industrial projects or for agricultural
plantations etc. where moratorium is available for payment of interest, the payment
of interest becomes 'due' only after the moratorium or gestation period is over.
Therefore, such amounts of interest do not become overdue and, hence, do not
become NPA, with reference to the date of debit of interest. They become overdue
after due date for payment of interest, if uncollected.
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v. In the case of housing loan or similar advances granted to staff members where
interest is payable after recovery of principal, interest need not be considered as
overdue from the first quarter onwards. Such loans/advances should be classified as
NPA only when there is a default in repayment of instalment of principal or payment
of interest on the respective due dates. In such cases, loan account falls into NPA
category only when there is default in interest for more than 90 days from the
respective due date. This provision is also applied to loans provided to industries
or commercial concerns when repayment holiday is granted for certain period say,
6-12 months.
vi. Regular and ad hoc credit limits need to be reviewed/ regularised not later than
three months from the due date/date of ad hoc sanction. In case of constraints such
as non-availability of financial statements and other data from the borrowers, the
branch should furnish evidence to show that renewal/ review of credit limits is
already on and would be completed soon. In any case, delay beyond six months is
not considered desirable as a general discipline. Hence, an account where the
regular/ ad hoc credit limits have not been reviewed/ renewed within 180 days
from the due date/ date of ad hoc sanction will be treated as NPA.
vii. If all payments are made in respect of any NPA A/c , it becomes a standard asset
immediately. However, if only a few credits are recorded, that too just before the
balance sheet date and the advance becomes performing on that basis it calls for a
review by a supervisory authority
viii. It is difficult to envisage a situation when only one facility to a borrower becomes a
problem (non- performing) and not others. Therefore, all the facilities granted by a
bank to a borrower will have to be treated as NPA and not the particular facility or
part thereof which has become irregular.Accordingly, if one account becomes NPA,
all other accounts of a borrower are also treated as NPA .In other words, the asset
classification should be borrower-wise and not facility-wise, with an exception. to
agricultural advances as well as other advances to Primary Agriculture Cooperative
Societies (PACS) and Farmers Service Societies (FSS) for on-lending.
ix. Regarding Agriculture Advances, loans granted for short duration crops such paddy,
wheat etc., will be treated as NPA, if the installment of principal or interest thereon
remains overdue for two crop seasons. A loan granted for long duration crops,
which have a crop season of more than one year, such as sugar cane etc. will be
treated as NPA, if the installment of principal or interest thereon remains overdue
for one crop season. Depending upon the duration of crops raised by an
Page 8 of 21
agriculturist, the above NPA norms would also be made applicable to agricultural
term loans availed of by the farmer.
x. Where natural calamities impair the repaying capacity of agricultural borrowers,
banks may decide on their own as a relief measure by converting the short-term
production loan into a term loan or by re-schedulement of the repayment period;
and the sanctioning of fresh short-term loan, In such cases of conversion or re-
schedulement, the term loan as well as fresh short-term loan may be treated as
current dues and need not be classified as NPA.
xi. While fixing the repayment schedule in case of rural housing advances granted to
agriculturists under Indira AwasYojana and Golden Jubilee Rural Housing Finance
Scheme, banks should ensure that the interest/installment payable on such
advances are linked to crop cycles
xii. In respect of Advances under consortium, the asset classification should be done
independently by each member bank based on the record ofrecovery.
xiii. For the purposes of provisioningCentral Government (CG) guaranteed advances,

the advance becomes NPA only when the Central Government repudiates its
guarantee upon invocation of guarantee by banks. But the state government
guaranteed advances are treated at par with commercial advances. This rule is for
provisioning purposes and not for the purpose of recognition of income.
xiv. (Regarding time overrun in non-infrastructure projects under implementation, the

advance becomes sub-standard if the commencement of business does not take
place within six months from the original date of implementation or Date of
Commencement of Commercial operations (DCCO) as fixed by the bank, even
though the account may be regular as per the record of recovery. But in respect of
infrastructure projects, this period is two years from the DCCO as against six months
for non-infrastructure projects.
xv. There could be cases in respect of infrastructure and non-infrastructure projects
wherein sufficient time is needed for implementation. during which many
unhealthy developments may take place. Consequently, the advance may become
NPA, as per the record of recovery, even before commencement of commercial
operations unless it is restructured and becomes eligible for up-gradation in asset
classification as standard assets. Bank is permitted to sanction a fresh DCCO after
making a review of genuine reasons such as delays in obtaining clearance
certificates due to court cases or any other reason. If a fresh DCCO is issued due to
court cases or any other reason, the advance becomes NPA after another two years
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in respect of infrastructure projects. But for non- infrastructure projects, the period
is one year from the issuance of fresh DCCO.
xvi. Mere extension of DCCO is also same as Restructured Advance. But any change in
the repayment schedule due to increase in the project-outlay because of cost
escalation by more than 25 per cent, is not considered as restructured advance if it
takes place before the commercial operations of the project or before a fresh DCCO
is issued.
xvii. Provisions in respect of delayed implementation of the project should be as under :
a. Infrastructure projects - 0.40% till 2 years from DCCO and thereafter 1.0 %
for 3rd and 4th year.
b. Non infrastructure projects : 0.40 % up to 6 months from DCCO and 1.0%
for the next 6 months.
xviii. In case of Take-out debt the lending institution will reverse the provisions on take-
over of the debt and, the taking-over lending institution has to make provisions
treating as NPA from the actual date of the advance becoming NPA as per the record
of recovery.
xix. In respect of post shipment credit extended by banks to a borrower who is

exporting goods to those countries for which Export Credit Guarantee Corporation
(ECGC) cover is available, in the event of default, EXIM Bank guarantees to pay the
amount within 30 days from the date invoking the guarantee by the bank. To the
extent of the payment has been received from EXIM Bank, the advance may not be
treated as NPA for asset classification and provisioning purposes.
xx. In case of receipt of payments from the importer, sometimes it becomes difficult for
the importer’s bank abroad to remit money to India due to collapse of the payment
system due to genuine reasons such as war etc. In such instances, the asset
classification in the books of the exporter’s bank may be made after one year from
the date of amount deposited by the importer with his bank to remit to the
exporter’s bank.
xxi. In the case of sick Units, existing amount outstanding will be classified as sub-
standard/ doubtful based on the record of recovery. But for fresh sanctions offered
as part of rehabilitation package, theincome recognition and asset classification
(IRAC) and provisioning norms will apply after one year from the date of
disbursement of fresh loan.
5. Provisioning norms :
Page 10 of 21
Provisioning means a charge on the profit and loss account and creating a reserve for the
purpose of managing loan losses. Provisions should be made on the non-performing assets
on the basis of classification of assets into prescribed categories. Banks should make
provision for loan losses taking into account (a) the normal time lag between an account
becoming doubtful of recovery, its recognition as such,and the realization of the security
and (b) the possible erosion over time in the value of security charged to the bank. The
guidelines in this regard are discussed in the following.
Loss assets: Loss assets should be fully provisioned and written off. Write off is merely
from the books and does not extinguish borrowers liability to repay.
Doubtful assets:. These assets should be provisioned to the full extent to which the
advance is not covered by the realizable value of the security to which the bank has a valid
recourse and the realizable value is estimated on a realistic basis. In regard to the secured
portion and realisability has been estimated rationally and through a proper process,
provision may be made at the rates ranging from 25 percent to 100 percent of the secured
portion depending upon the period for which the asset has remained doubtful:
Period of NPA Loan loss provision

Up to 1 year 25%
One to three years 40%
More than 3 years 100%
Standard Assets: Generally, no provision is needed for standard assets. But regulators could
be extra cautious. Accordingly, for direct advances to Agriculture sector and Micro
Enterprises, 0.25 per cent provisioning on the loan outstanding is necessary. The
provisioning will be 0.40 per cent for other assets. In respect of commercial real estate
projects, the provisioning should be 1.0 per cent. Housing loans extended at teaser rates
are required to be provided at 2.0 per cent. Moreover for all fresh restructured advances,
5.0 percent provision has to be made. The provision on standard assets should not be
reckoned for arriving at net NPAs. Provisions towards standard assets need not be netted
from gross advances, but the same may be shown separately as 'Contingent Provisions
against Standard Assets' under 'Other Liabilities and Provisions’.
There are many related issues about how to arrive at NPA, how to provision etc. These are
in the form of clarifications to ensure that all banks adopt same norms and NPA is
calculated accurately and without any adjustment.
Page 11 of 21
 Stock audit is mandatory for high value advances (Rs 5 crores and above) on annual
basis. Similarly, immovable properties should be valued once in three years by an
approved valuer.
• Besides mandatory provisions, banks shall make Floating provisions out of profits.
These provisions should be held separately for advances and investments These are
not to be used for making specific provisions for NPAs or for standard advances but
they can be considered only for contingencies under extraordinary circumstances.
Under typical conditions, RBI may permit. These can be reckoned as part of Tier II
capital subject to overall ceiling of 1.25 per cent total risk weighted assets. Floating
provisions should be disclosed in the Annual Report of the bank.
• Along with Floating provisions, banks shall make Additional provisions at rates
which are higher than prescribed/mandatory rates. Such additional provisions for
NPAs may be netted off from gross NPAs to arrive at Net NPAs.
• For leased assets , the usual provisioning norms apply.
• Advances as against term deposits/NSC/IVP/LIC Policy are required to be provided
as per the asset classification status. They are treated as standard assets when
sufficient margin is available.
• Besides usual provision for the corresponding asset, the loss on revaluation of
foreign currencies, if any, should be booked in the P& L Account. If there is gain, it
should be adjusted against the provision amount
• As per the country risk assessed by ECGC, additional provisioning is required for the
country risk ranging from 0.25% to 100%. But total provisions are not to exceed the
loan amount.
• Usual provisions and floating provisions together should not be less than 70 per
cent of gross NPAs. This is called as Provisioning Coverage Ratio (PCR). Now a days,
banks are finding it difficult to fulfil this norm due to inadequate profits.
• In respect of provisions for the Diminution in the Fair Value (as part of
restructuring) for Standard assets and NPAs , such provisions should be netted
from the restructured loan asset.
• Sale of NPAs under SARFAESI Act: Banks can sell both standard and NPAs to Asset
Reconstruction Companies(ARCs). When sale-value is compared with book-value,
there could be shortfall or surplus. Shortfall, if any, should be debited to the Profit
and Loss account for that year. Excess amount , if any, will be utilized to meet
subsequent shortfall on account of sale of other financial assets in future.
• Regarding purchase/sale of NPAs outside the SARFAESI Act or under the SARFAESI
Act.
Page 12 of 21
• Purchase/sale should only be on ‘without recourse’ basis i.e. entire credit

risk should be transferred to purchasing bank. Subsequent to sale, there
should be no involvement w.r.t assets sold.
• Estimated cash flows should be realised within a period of 3 years.
• Non- performing assets should be held for at least two years in the books
of the selling bank and thereafter the same shall be sold.
• Retail NPAs can be bought/sold as a homogeneous pool, provided each
NPA of the pool is in the books for at least 2 years of the selling bank. The
pool of assets should be treated as a single asset in the purchasing bank’s
books.
• Sale of non-performing assets should be only on cash basis. The entire
sale consideration should be received upfront and only thereafter, assets
should be taken out of the books of the selling bank.
• Assets purchased should be held by the purchasing bank for at least 15
months before re-sale, if needed. And, these assets should not be sold
back to the same bank from which NPAs were purchased. The NPAs so
bought in may be classified as ‘standard’ in the books of the purchasing
bank for a period of 90 days from the date of purchase. Thereafter, the
asset classification status of the asset will be determined by the record of
recovery in the books of the purchasing bank with reference to cash flows
estimated while purchasing the asset.
• Where the purchase/ sale does not satisfy any of the prudential
requirements prescribed in these guidelines, the asset classification
status of the financial asset in the books of the purchasing bank at the
time of purchase, shall be the same as in the books of the selling bank.
Thereafter, the asset classification status will continue to be determined
with reference to the date when the asset became as NPA in the books of
the selling bank.
Provisions are required to be made for banks selling NPA and also banks purchasing
NPA. For Selling Bank, NPAs should be removed from books on transfer If sales
value is less than Book value , shortfall to be debited to P/L a/c. Similarly, if sales
value is more than Book value , excess should be utilized to meet shortfall/loss on
sale of other NPAs. Regarding Purchasing Bank, It should assign 100% credit risk
weights to the NPA assets purchased from other bank. If this is Investment,
additional capital charge for market risk is also called for. The Purchasing Bank
should comply with the exposure ceiling on account of the purchase. Disclosures in
respect of purchase and sale assets should be made in the Annual Report. of the
bank.
Page 13 of 21
• Bad and Doubtful Debts may be either fully provided for or written off to claim tax
benefits. But recovery from such written off accounts should continue even after the
write off
6. Restructured Advances:
A restructured account is one where the bank, for economic or legal reasons relating to the
borrower's financial difficulty, grants to the borrower concessions that the bank would not
otherwise consider. Restructuring would normally involve modification of terms of the
advances / securities, which would could be in the form of alteration of repayment period
/ repayable amount/ the amount of installments / rate of interest (due to reasons other
than competitive reasons). However, extension in repayment tenor of a floating rate loan
on reset of interest rate, so as to keep the EMI unchanged provided it is applied to a class of
accounts uniformly, will not render the account to be classified as ‘Restructured account’.
In other words, extension or deferment of EMIs to individual borrower as against to an
entire class, would render the accounts to be classified as 'restructured accounts’. In case of
roll-over of short term loans, where proper pre-sanction assessment has been made, and
the roll-over is allowed based on the actual requirement of the borrower and no concession
has been provided due to credit weakness of the borrower, then these might not be
considered as restructured accounts. However, if such accounts are rolled-over more than
two times, then third roll-over onwards the account would have to be treated as a
restructured account.
As per extant guidelines, thecut-off date when the package of debt restructuring proposal
is approved would decide the asset classification status. Accordingly, upon debt
restructuring, the standard asset as on the cut off date, will remain as sub-standard during
the restructuring period. Similarly, non performing asset (NPA) as on the cut off date will
continue to remain as NPA during the debt restructuring period and it shall fall into lower
asset classification category ( from sub-standard to doubtful). But there is a provision to
upgrade the asset classification status (from doubtful/sub-standard to standard) during
the restructuring period provided the project witnesses satisfactory performance in the
conduct of account for the specified period say, one year.
Additional finance may be provided as part of debt restructuring package. In that case,
Income Recognition and Asset classification (IRAC) guidelines are not applicable for
additional finance granted for a period of one year.
Debt restructuring scheme also includes repeat restructuring. Accordingly, a project may
be considered for repeat restructuring for a shorter period say, one year, but the asset
Page 14 of 21
classification as on the last date of the first debt restructuring will go undergo a change i.e.
standard asset to become sub-standard and, NPA will continue to remain as NPA and shall
fall into lower asset classification category depending upon the conduct of the account.
Banks may restructure the accounts classified under 'standard', 'sub- standard' and
'doubtful' categories. Normally, restructuring cannot take place unless alteration / changes
in the original loan agreement are made with the formal consent / application of the
debtor. However, the process of restructuring can be initiated by the bank in deserving
cases subject to customer agreeing to the terms and conditions.No account should l be
taken up for restructuring by the banks unless the financial viability is established and
there is a reasonable certainty of repayment from the borrower, as per the terms of
restructuring package.
Reduction in the rate of interest and / or reschedulement of the repayment of principal

amount, as part of the restructuring, will result in diminution in the fair value of the
advance. Such diminution in value is an economic loss for the bank and will have impact on
the bank's market value of equity. It is, therefore, necessary for banks to measure such
diminution in the fair value of the advance and make provisions for it by debit to Profit &
Loss Account. Such provision should be held in addition to the provisions as per existing
provisioning norms on NPA. For this purpose, the erosion in the fair value of the advance
should be computed as the difference between the fair value of the loan before and after
restructuring. Fair value of the loan before restructuring will be computed as the present
value of cash flows representing the interest at the existing rate charged on the advance
before restructuring and the principal, discounted at a rate equal to the existing (earlier)
interest rate as on the date of restructuring. Fair value of the loan after restructuring will
be computed as the present value of cash flows representing the interest at the rate
charged on the advance on restructuring and the principal, discounted at .a rate equal to
the actual interest rate charged to the borrower before restructuring .
7. Conclusion :
NPAs in Indian Banksare on the rise which is evident from the fact that gross NPAs of the
banking sector was as high as 9.0% as on June end, 2017. The amount of credit blocked in
these NPAs is more than Rs. 10 lakh crore.The increase in NPA has been more pronounced
since the year 2008.This unprecedented rise in the NPA level leads to high credit risk,
stress on profits, low credit growth, low bank rating,low reputation of a bank etc. Banks
will therefore need more capital to comply with current capital adequacy norms.
It is seen that, within the banking sector , public sector banks have a much higher level of
stressed advances whereas private sector banks and foreign banks have a somewhat lower
NPA and have been able to maintain a better quality loan assets. It is seen that industrial
Page 15 of 21
sectorhas experienced a very high level of stressed advances. Further, most of NPAs are
observed in a few sub-sectors such as steel, mining, cement , textile, infrastructure,
aviation etc. These sub-sectors claim a share of 24.2 percent in total advances of SCBs and
53.0 percent in total stressed advances of SCBs. Main reasons for high level of NPAs
include: global slow down, stress in certain industries in the country, low recovery from
restructured advances, wilful defaults etc.
In view of these adverse developments relating to NPAs, it is necessary to enhance the

overall effectiveness of NPA management. In this regard, one of the approaches is to
implement the IRAC guidelines in true spirit. For this, it calls for developing a good
understanding of IRAC guidelines on the part of officers in banks.
Page 16 of 21
Annexure
RBI observations on NPA in the latest report on trends and progress of banking
Excerpts from Report on Trends and Progress of Banking in India 2017 on Non-performing
Assets
The asset quality of banks deteriorated further during the year. Gross non-performing assets
(GNPA) ratio reached 9.3 per cent of total advances.
Table: Trends in Non-Performing Assets – Bank Group-wise. Rs Billion

Item PSBs* PVBs FBs All SCBs#
Gross NPAs
Opening Balance for 2016-17 5,400 562 158 6,120
Addition during the year 2016-17 3,275 814 66 4,157
Recovered during the year 2016-17 1,000 237 36 1,274
Written-off during the year 2016-17 827 207 51 1,085
Closing Balance for 2016-17 6,847 932 136 7,918
Gross NPAs as per cent of Gross Advances
2015-16 9.3 2.8 4.2 7.5
2016-17 11.7 4.1 4.0 9.3
Net NPAs
Net NPAs as per cent of Net Advances
2015-16 5.7 1.4 0.8 4.4
2016-17 6.9 2.2 0.6 5.3
In the recent time asset quality of banks deteriorated sharply. NPA accounts identified in the list
of one bank was found listed in other banks which has loan facilities extended to the same
borrower. These have been classified as NPAs. The share of doubtful and loss assets in total loan
assets of PSBs and PVBs increased during 2016-17, indicating an increase in the stickiness of
NPAs.
Large borrowers (exposure of ₹50 million or more) accounted for about 86.5 per cent of all NPAs,
while their share in total advances was only 56 per cent. Large borrowal loan accounts with some
sign of stress accounted for about 32 per cent of the total funded amount outstanding of PSBs as
against 17.4 per cent in the case of PVBs. This suggests persisting stress on the asset quality of
the banking system. This is corroborated by the high slippage ratio.
Page 17 of 21
Table Classification of Loan Assets – Bank Group-wise. March 16& 17. Rs Billion
Sub-Standard
Standard Assets Doubtful Assets Loss Assets
Bank Assets
Year
Group Per Per Per Per
Amount Amount Amount Amount
cent* cent* cent* cent*
PSBs 2016 52,875 90.7 2,005 3.4 3,232 5.5 163 0.3
2017 51,816 88.3 1,731 3.0 4,904 8.4 213 0.4
PVBs 2016 19,184 97.2 186 0.9 311 1.6 62 0.3
2017 21,748 95.9 310 1.4 519 2.3 90 0.4
FBs 2016 3,606 95.8 62 1.6 60 1.6 36 0.9
2017 3,304 96.0 40 1.2 83 2.4 14 0.4
All SCBs 2016 75,666 92.5 2,252 2.8 3,603 4.4 260 0.3
2017 76,868 90.7 2,081 2.5 5,505 6.5 316 0.4
Among industries, basic metals and products had the highest level of stress (GNPAs plus
restructured standard advances). Other industrial sectors with elevated levels of stress were
vehicle and transport equipment, cement, construction, textiles and engineering. In general,
PSBs’ exposure to industries in stress was much higher as compared to that of PVBs.
Table V.16: Sector-wise NPAs of Banks. March 16 & 17. Rs Billion

Of which
Non-
Priority Micro and
priority Total NPAs
Bank Sector Agriculture Small Others
Sector
Group Enterprises
Per Per Per Per Per Per
Amt. Amt. Amt. Amt. Amt. Amt.
cent# cent# cent# cent# cent# cent#
PSBs
2016 1,281 25.5 448 8.9 658 13.1 175 3.5 3,740 74.5 5,021 100.0
2017 1,543 24.1 548 8.5 757 11.8 238 3.7 4,868 75.9 6,411 100.0
PVBs
2016 101 21.0 40 8.2 47 9.6 15 3.1 382 79.0 484 100.0
2017 133 18.0 53 7.2 64 8.7 16 2.2 605 82.0 738 100.0
FBs
2016 23 14.3 0.4 0.3 4 2.3 19 11.7 135 85.7 158 100.0
2017 24 17.8 1 0.5 4 3.1 19 14.2 112 82.2 136 100.0
All SCBs
2016 1,405 24.8 488 8.6 708 12.5 208 3.7 4,257 75.2 5,662 100.0
2017 1,700 23.3 602 8.3 825 11.3 273 3.7 5,585 76.7 7,285 100.0
Page 18 of 21
Micro and small enterprises (MSEs) NPAs rose to reach 8.4 per cent in March 2017 while retail
loans and the real estate sectors continued to record moderate NPAs
There was an improvement in the provision coverage ratio (PCR) for the banking system as a
whole barring PVBs.
Prompt Corrective Action Framework
RBI had introduced the revised prompt corrective action (PCA) framework with effect from April
1, 2017 based on the financials of the banks for the year ended March 2017. Capital (CRAR/
common equity tier (CET) I ratio), asset quality (net non-performing assets (NNPA) ratio),
profitability (return on assets) and leverage (Tier I leverage ratio) are the key areas for
monitoring in the revised framework. Breach of any risk threshold will result in invocation of
PCA by the Reserve Bank. So far, seven PSBs have been put under PCA.
Table : Revised PCA Matrix – Indicators and Risk Thresholds

Indicator Risk Threshold 1 Risk Threshold 2 Risk Threshold 3
>=7.75% but
CRAR + applicable CCB* >=6.25% but <7.75% -
<10.25%
CET I Capital Ratio + >=5.125% but >=3.625% but
<3.625%
applicable CCB* <6.75% <5.125%
NNPA Ratio >=6.0% but <9.0% >=9.0% but <12.0% >=12.0%
Negative RoA for Negative RoA for Negative RoA for
RoA two consecutive three consecutive four consecutive
years years years
Tier I Leverage Ratio >=3.5% but <= 4.0% <3.5% -
Note: *: Applicable CCB is 1.25%, 1.875% and 2.5% as on March 31, 2017, March 31, 2018
and March 31, 2019, respectively.
Recovery of NPAs
Recovery of banks’ NPAs remains poor, having declined to 20.8 per cent by end-March 2017 from
61.8 per cent in 2009. During 2016- 17, Debt Recovery Tribunals (DRTs) made the highest
amount of recovery, followed by the Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Interest (SARFAESI) Act and LokAdalats. The significant improvement in
the case of DRTs was due to opening of new tribunals, strengthening existing infrastructure and
computerised processing of court cases.
An alternate option for banks is sale of NPAs to securitisation companies/reconstruction

companies (SCs/RCs) registered under the SARFAESI Act, 2002 with banks taking some haircut
on every sale. An analysis of purchase of NPAs by SCs / RCs indicates that acquisition cost as a
proportion of the book value of assets increased from 28.7 per cent in March 2014 to 36 per cent
Page 19 of 21
in March 2017, indicating that the banks had to incur lower haircuts on account of sale of NPAs.
Recent years have witnessed a sharp pick-up in the sale of stressed assets to SCs/RCs by PVBs
and FBs, however, sale of NPAs by PSBs remains lukewarm.
Table V.18: NPAs of SCBs Recovered through Various Channels. Rs Billion

2015-16 2016-17
Col.
Col.
(4)
Recovery No. of No. of (8) as
Amount Amount as % Amount Amount
Channel Cases Cases % of
Involved Recovered* of Involved Recovered*
Referred Referred Col.
Col.
(7)
(3)
i)
4,456,634 720 32 4.4 2,152,895 1,058 38 3.6
LokAdalats
ii) DRTs 24,537 693 64 9.2 28,902 671 164 24.4
iii)
SARFAESI 173,582 801 132 16.5 80,076 1,131 78 6.9
Act
Total 4,654,753 2,214 228 10.3 2,261,873 2,860 280 9.8
Notes: 1. *: Refers to amount recovered during the given year, which could be with reference to
cases referred during the given year as well as during the earlier years.
2. DRTs – Debt Recovery Tribunals.
References:
1. Master Circular on Income Recognition and Asset Classification, Reserve Bank of India,
July 01, 2016.
2. Report on Trend and Progress of Banking in India, Reserve Bank of India, 2015-16.
3.Financial Stability Report-June 2017., Reserve Bank of India.
4. Economic Survey of India, Ministry of Finance, GOI, 2016-17.
5Web-sites:
(i)Reserve Bank of India, Notification – Circulars on NPAs
(ii)Corporate Debt Restructuring ( CDR)
(iii)Board for Industrial Finance and Reconstruction (BIFR)
(iv)Asset Reconstruction Company of India Ltd (ARCIL)
(v) CRISIL, Study on NPAs
(vi) Ministry of Finance, GOI
Page 20 of 21
(vii) National Company Law Tribunal
Page 21 of 21
Chapter 4: Loan Recovery Measures
Dr V S Kaveri
Structure
1. Introduction
2. Traditional recovery measures
2.1. Sending reminders to a borrower
2.2. Visit to Borrower’s Business Premise/ Residence
2.3. Recovery Camp
2.4. Appointment of Professional Agencies for Recovery
2.5. Appropriation of Subsidy/ Exercising the Right to Sell-off
2.6. Recalling of Advances
2.7. Loan compromise
3. Legal measures
3.1. Recovery through Courts
3.2. Recovery through DRTs
3.3. Recovery under SARFAESI Act
3.4. Recovery through Lokadalat
3.5. Sale of assets to ARCs
4. NPA management initiatives
4.1. Debt restructuring
4.2. Write off
4.3. Rehabilitation of sick units
4.4. Circulation of list of defaulters
4.5. Management of Special Mention Accounts (SMAs)
4.6. Flexible Restructuring of Long Term Project (5/25) Scheme
4.7. Strategic Debt Restructuring (SDR)
4.8. Scheme for Sustainable Structuring of Stressed Assets (S4A)
4.9. Insolvency and Bankruptcy Code (IBC Code), 2016
4.10. Amendments in Debt Recovery Laws
4.11. Banking Regulation ( Amendment) Bill, 2017
5. Conclusion
Page 1 of 30
1. INTRODUCTION:
Non Performing Loans known as nonperforming assets is a major concern in the

banking industry today. RBI in its Financial Stability Report for half year ended
December 17 observes that “The overall risks to the banking sector remained elevated
due to asset quality concerns. Between March and September 2017, the gross non-
performing advances (GNPA) ratio of scheduled commercial banks (SCBs) increased
from 9.6 per cent to 10.2 per cent and the stressed advances ratio marginally increased
from 12.1 per cent to 12.2 per cent. Public sector banks (PSBs) registered GNPA ratio
at 13.5 per cent and stressed advances ratio at 16.2 per cent in September 2017.
The macro stress test for credit risk indicates that under the baseline macro scenario,
the GNPA ratio may increase to 10.8 per cent by March 2018 and further to 11.1 per
cent by September 2018”
The amount of Gross NPA as on March 17 was Rs 7917 Billion (Gross loans Rs81162
Billion) and net NPA was Rs 4331 Billion1. The following graph gives a view of the
movement of NPA during 16-17.
The increase in NPA is a phenomenon that has been observed since the global debt
crisis (2008) and European Government Bond Crisis (2009). The following graph
gives a picture of the growth of NPA vis a vis the growth of loan portfolio of banks.
1
Hand Book on Statistics of bank in India- MOVEMENT OF NON-PERFORMING ASSETS (NPAs) OF
SCHEDULED COMMERCIAL BANKS: RBI
Page 2 of 30
The above data and charts show us that

i. Both Gross and Net NPA are currently very high.
ii. Stressed Assets (we learnt in the previous lesson that stressed assets include
loans which are NPA as also overdue beyond 30 days) are at least 2 to 3 %
higher than NPAs
iii. There is a marked decline in the loan portfolio in the recent years. This is
mainly due to increased default by corporate borrowers. RBI in its latest
report on Trends and Progress in the banking system has observed that
“Large borrowers who have an exposure of ₹50 million or more accounted for
about 86.5 per cent of all NPAs, while their share in total advances was 56 per
cent by end-March 2017. All large borrowal loan accounts with any sign of
stress (including special mention account-0 (SMA-0), SMA-1, SMA-2, NPAs and
restructured loans) accounted for about 32 per cent of the total funded amount
outstanding of PSBs as against 17.4 per cent in the case of PVBs. This suggests
persisting stress on the asset quality of the banking system”
iv. The increase in Gross and Net NPA with the banking system has increased by
more that 140% during the year.
Clearly NPA management is the biggest challenge faced by the banks.
Page 3 of 30
NPA management has become critical because banks have to make provision for
NPA and this impacts the capital adequacy of banks.
It should be noted that nearly 91% of the accounts are regular and collection and
recovery in these cases is happening. Given this there are two broad methods of
collection and NPA management. We would like to discuss them in two broad heads
namely (a)traditional or in due course collection/recovery and (b) recovery once
the account has slipped into stressed asset and/or NPA. Various initiatives been
taken by Reserve Bank of India (RBI) and Government of India (GOI) in introducing
new loan recovery measures to bring down the level of non- performing assets
(NPAs) will form under the second method or approach.. As per the Report on Trend
and Progress of Banking in India 2015-16, the percentage of the amount recovered
from the loan amount outstanding through loan compromise, through Debt
Recovery Tribunals (DRTs) and under SARFAESI Act stood at 5.0 and 10.0 and 19.0
respectively. Though the percentage recovery through loan compromise is just 5.0,
it does help in reducing the large number of small borrowal accounts. RBI has also
issued guidelines on monitoring and follow up of NPA accounts. In this chapter, it is
attempted to make an overview of loan recovery measures.
Recovery should be thought of at the time of appraisal itself. If the cash flow of the
borrower is known and can be tied up recovery will be smooth. For example
i. in case of employees tie up with employers to recover from the salary,
ii. in case of farmers tie up with
(a) sugar factory which accepts sugar cane, or
(b) warehouses, market yards which accept grain for sale or
(c) dairy plant which accepts milk grain mandi,
iii. in case of MSME tie up
(a) with buyers of goods and services,
(b) merchant banks s who settle their POS payments,
(c) mother units if sme is an ancillary unit
Most business will have current account with the financing bank/branch and
recovery will be effected in those accounts. Normally this should work well. But if
the repayment is not regular then recovery measures come into play.
Recovery measures under traditional and new categories are listed as under:
Page 4 of 30
2. TRADITIONAL RECOVERY MEASURES:
2.1 Sending a Reminder:
Borrowers are expected to remember the amount to be paid and the due dates. Yet
sending reminders to borrowers when the amount is due, when the amount of
interest is charged to the account etc., could help in maintaining the account in
regular status. Banks should send a reminder to a borrower on monthly/quarterly
basis and as and when interest is charged and due. This will remind him/her or the
firm to pay interest/installment timely. As the facility of sending SMS is available
sending a reminder through that mode a day or two before the due date will prove
effective.
A borrower who is not able to pay on account of of genuine difficulties, may be

asked to approach the bank with a request to grant further time to pay the
interest/installment. This gives an opportunity to the bank to evaluate the financial
and stress and take appropriate decision.
When there is no response to the initial reminders, the bank must send letters
pointing out that bank may be constrained to initiate a stern action in case
interest/installment is not paid immediately. This exercise of sending reminders the
borrower will continue till all bank dues are recovered. The cost associated with the
reminder may be collected from a borrower. This task of sending the reminder
could be outsourced but enough care is needed to keep a check on the outsourcing
agency. It is important to note that this is the cheapest and most rewarding mode of
recovery particularly from the honest borrowers. Hence, banks depend on this
recovery measure very heavily.
2.2 Visit to Borrower’s Business Premise / Residence;
If Reminder through mail, sms and phone calls sod not succeed it is necessary to
follow up in person by visiting borrower’s business premise or residence. Branches
should maintain a record of the visits made and the amount collected every month.
During the monthly staff meeting, the branch manager should review visits made.
Frequent visits are called for in the case of borrowers defaulting for a long time.
These visits help not only in loan recovery but also in knowing about the overall
functioning of the business unit. It is possible that at the time of visit the firm is not
functioning or that stock is not moving or employees are less in number etc. These
are signs of stress in the business. Creditors not being paid, debtors being less than
normal volume etc., also point out stress. In these cases the loan officer or the
branch manager should discuss with the borrower, assess the situation and take
Page 5 of 30
action such as rephasement of installment, sanctioning additional credit etc. If the

stress is severe and could impact the security as well bank may like to call back the
loan. Similarly if the business is doing well and there is no stress but the borrower
has defaulted bank may decide to recall the loan.
2.3 Recovery Camps:
In respect of agricultural advances, large amount of small loans in a area visiting

every defaulter personally could be difficult. In these cases a meet with all the
borrowers or recovery camps will be useful. In case of agriculture loans such meets
should be organized immediately after harvest . These recovery camps need to be
properly planned and executed. It is advisable to take the help of local institutions
in the Government, Non-Government Organizations (NGOs) , It also calls for a
professional approach to give a wide publicity of the recovery camp to contact as
many farmers as possible and to motivate the staff to get involved earnestly in the
recovery drive. These recovery camps should be held along with routine banking
business..
2.4 Recovery through Agents.

Banks can use recovery agents for collecting dues. This is particularly useful in retail
loans like home loans, vehicle loans etc. This is not used in case of commercial
credit, project finance, MSME loans and agriculture loans. Retail loans are spread
across the city and it is difficult for the banker to visit all the defaulters personally.
Recovery agent is given a specific mandate. While this system is effective there are
attendant risks like using force for recovery, diverting recovered funds, postponing
recovery beyond 90 days so that higher recovery commission can be earned etc. It is
for this purpose RBI and IBA has mandated that recovery agent should undergo a
certification process with IIBF. Banks can work with agencies whose services shall
be utilized to ascertain the whereabouts of the borrowers, collect dues and take the
possession of assets charged to the bank upon serving a legal notice to the defaulter.
In rural areas, agents may be engaged also to contact the borrowers to remind them
to pay loan installments and collect cash recovery. Many banks employ recovery
agencies successfully. This of course increases the cost of credit delivery and gets
loaded on to honest borrowers as risk cost.
2.5 Appropriation of Subsidy / Exercising the Right to Sell-off:

In some of the sponsored schemes, the amount of subsidy is kept in deposit
accounts to be appropriated after a specified lock-in-period. In such cases, where
subsidy is available, and the account is likely to become NPA, the subsidy amount
could be appropriated (keeping in view the requirements of lock-in-period) in the
Page 6 of 30
loan account and necessary action should be initiated for recovery / write-off of the
balance amount. Keeping subsidy in deposit may not be a correct approach when
subsidy is intended to replace borrower’s capital and subsidy amount ensures the
viability of the borrowal account.
Where readily encashable securities such as Fixed Deposits, Life Insurance policies.
Government Securities, etc. of the borrowers are available with the bank and if
borrowers are not responding to the request for regularization of accounts, such
securities could be encashed after giving due notice to the borrower and guarantor,
if any.
2.6 Recalling of Advances

When rigorous follow-up of advances and close supervision efforts do not yield any
fruitful results in loan recovery from defaulters and, if the circumstances so warrant
that their loan amount is to be realized at once and/or facility to be terminated in
the interest of the bank, a final recall notice has to be served asking the party to
regularize the irregularity in the account/ pay unpaid loan installments
immediately. Wherever necessary, the borrower should also to be informed about
the bank’s intention to terminate the facility after a specified time limit. As far as
possible, number of legal notice should be restricted. . Especially in in case of small
advances, recall notice through advocate may be avoided unless the circumstances
require such a course of action. The Recall notice should be sent circumstances such
as the (i) borrower being a willful defaulter, (ii) bank dues being significantly
uncovered, (iii)death of the borrower, (iv) dissolution of a partnership firm, (v)
suspected siphoning of bank funds, (vi) borrower refusing to renew the credit limit,
etc. Before legal action, normal recovery efforts should be made to pursue the
borrower and the guarantor to repay the dues, which may include personal
contacts, persuasion, serving a demand notice, bringing local influence upon the
borrower to repay etc.
Proposal for legal action should be submitted to the appropriate sanctioning

authority at least six months before the expiry of limitation period. As per the
Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) ,
requirement of a recall notice to the borrower/ guarantor should be issued
providing therein a 30 days’ time for adjustment of the account. On getting the
approval of the higher authorities and after serving the recall notice, the account
should be transferred to a recalled-category to exercise utmost care for effecting
recovery, and to have special control over accounts.
Page 7 of 30
2.7 Loan Compromise:
Compromise in bank loan means - agreeing to a borrower’s request of accepting a

part of the outstanding dues in its books as full and final payment or allowing for the
non-compliance of certain terms of the loan after analyzing the alternative courses
of action, genuineness and capacity of the borrower to repay. It is also called as
voluntary debt reduction or scaling down of dues, mainly interest amount and bank
charges. In a situation, where the borrower’s ability/capacity to repay the bank’s
dues and the bank’s ability to recover the same by other means are limited, a
compromise proposal will l work well. Compromise proposals can be entertained at
a) pre-litigation stage, and b) post-litigation/decree stage. At the pre-litigation
stage, concessions are offered in the form of re schedulement / rephasement of
unpaid loan installments, debt restructuring, rehabilitation, etc. which would allow
some breathing period for loan repayment. This would in turn build/strengthen the
repayment capacity of the borrower. However, when such measures do not yield
any fruitful results and the borrower incurs heavy cash losses, bank may consider
compromise or scaling down the dues. Similarly, in other cases, where business loss
has crept in due to one or other genuine reasons and the borrower is not a willful
defaulter and requests for one or more concessions such as waiver of penal interest,
concession in interest rates, loan repayment in suitable installments etc. the request
may be accepted for compromise.
Compromise at post-litigation/decree stage, could also be considered so that the

borrower’s business activity is uninterrupted. In order to avoid cost, labour and
time involved in litigation matters and to have a better image in the market,
borrowers may offer to pay a lump-sum amount and request the bank to withdraw
the suits against them. At times, it becomes necessary to have settlement outside
the court through an amicable agreement as the antecedents of the defendants are
such that the court could take a sympathetic view and award a lenient decree
against them. Sometimes, after obtaining a decree, if a third party comes forward to
purchase the assets, the bank may consider the option of compromise. It is also
possible that the bank may go in for compromise when the decreed asset would not
fetch more than the claimed amount. In all cases, where suits have already been
filed, whatever compromise is to be made, must be sorted out through the court in
the form of a consent decree, so that it will be binding on all defendants.
Compromise has to be decided on the basis of merit of each case. Further, lot of
analysis has to be done by the bank before negotiating with the borrower. It is
necessary to carry out cost-benefit analysis to estimate the loss which may arise in
case compromise is accepted as against the benefit which may accrue if the money
Page 8 of 30
so recovered is invested profitably. Before negotiation, valuation of the assets and

collection of information about borrower and his personal assets should be
collected from the market. Branch manager should prepare a process note for loan
compromise in the light of the broad guidelines issued by the bank. The note should
contain, among other things, the amount covering the outstanding amount and
other charges, efforts already made for recovery, means or capacity of the party to
repay etc. The proposal recommended should be referred to the sanctioning
authority which would examine several factors such as fulfillment of terms and
conditions of loan compromise, post-disbursement supervision of the account, any
laxity in conduct, any act of commission or omission on the part of staff leading to
the debt proving irrecoverable, staff accountability, valuation of securities, interest
to be charged in respect of settlement through installments, etc., before arriving
finalizing the compromise terms Loan compromise should be considered as a last
resort of non- legal recovery measure. RBI has given autonomy to banks to come
forward with a Board approved compromise policy for different types of borrowers.
Decisions on compromise proposals should be taken by adopting a committee
approach. In this regard, banks have been advised to set up a Settlement Advisory
Committee which is given certain powers by the Board.
3 Legal Measures
3.1 Recovery through Courts:

Before taking a decision to file a suit, the branch manager should ensure that there
are sufficient securities available in the account and the borrowers or guarantors
are having adequate attachable personal assets to satisfy the decree against them.
The solution of obtaining a decree from the court serves the purpose only when it is
capable of being executed.
Enough care has to be taken at all stages of recovery through the court which in
chronological order include serving summons, submission of a written statement
recording the evidences, arguments, framing of issues, judgement and court order.
Regarding bank procedures, the branch has to first seek the permission from the
controlling office to file the suit. Thereafter, the approved advocate should be
contacted by the branch manager to file the suit. Before filing the suit, bank should
ensure that the documents are live, securities are properly charged to the bank,
fresh financial report on borrower/ guarantor is obtained, and a list of witnesses is
prepared. Before filing the suit, the branch manager should exercise the right to set-
off / appropriation, if available. The plaint prepared by the advocate should be
checked thoroughly as to the correctness of facts and figures. All parties and
guarantors are to be included in the suit. Names, addresses and securities should be
Page 9 of 30
stated properly and, suit should be filed in the court of the specified jurisdiction. A
notice of demand to the borrower and the guarantor should be issued before
commencing any legal action. In particular, the branch manager should contact the
advocate time and again to impress upon him to complete court formalities relating
to submission of statement, hearing, etc. The branch manager should brief the
advocate with regard to banking aspects.
After the decree is awarded, the details of the same should be read carefully. There
can be different kinds of decree, such as: (a) simple mortgage decree which is for the
realization of money charged on immovable property by sale (b) for recovery of
possession of land (c) for recovery of any property other than land or money (d) for
ordering to do some act other than payment of money or to stop from doing some
other acts, i.e. under this may be classified decrees for specific performance of
contracts, execution of documents, injunction etc. If it is a conditional decree, the
same must be fulfilled before execution. It must not be barred by limitation.
Execution of decree shall be in different forms such as delivery of property,
appointing a receiver or in such other manner as the nature of relief granted,
attachment and sale, or by arresting of Judgement Debtor (JD). Execution by arrest
is not available as a matter of right and arrest or detention cannot be ordered unless
it is proved to the satisfaction of the court that the borrower is unwilling to pay
despite having adequate means to pay. The burden of proving this is on the decree
holder. The court may refuse simultaneous execution against the person and
property of the debtor.
As soon as the accounts are decreed, it should be ensured whether the decree holder
is in conformity with the claims made by banks in the plaint. In case of any
discrepancy from bank’s normal claim, steps should be taken for revision/appeal
within a reasonable time, say one month from the date of decree. Execution petition
should be filed within three months of the date on which certified copies are made
available to the bank branch. In decreed accounts where certain agricultural land is
to be attached, the branch manager may participate in the auction for which
necessary permission from the competent authorities within the bank is needed. In
case securities are attached before judgement and/or after execution of decree and
kept in the bank’s custody, due care should be taken as to keep them intact. When a
case is decided partly or wholly against the bank, desirability of filling an appeal or
otherwise should be considered. The JD, who does not pay in terms of the decree,
alternative steps for execution, by attachment and sale of the properties and/or by
arrest of the JD as may be deemed for, should be taken promptly. Insolvency law
enables a creditor, who has obtained a decree to realize his debt by serving
insolvency notice of not less than a month. If the debtor fails to comply with the
Page 10 of 30
notice within the specified period, the bank can proceed against him for
adjudicating the same as an insolvent. If the property to be attached is situated
outside the jurisdiction of the court which has passed the decree, it should be got
transferred to the other concerned court in whose jurisdiction the property is
located. Quite often, banks have to proceed against their borrowers in the court of
law where no security is available. It takes a long time to obtain a decree like in
other cases, and then proceed for execution of the decree so obtained. In such case,
a quick remedy known as summary procedure suit is available which the bank can
use. Banks experience substantial delay in getting the decree and its execution.
3.2. Recovery through Debt Recovery Tribunals (DRTs)

There was considerable delays in the disposal of cases by the courts which
warranted exclusive courts for bank cases. DRTs are set-up under the Recovery of
Debts Due to Banks and Financial Institutions Act, 1993. Under the Act, two
Tribunals are set-up, i.e. Debt Recovery Tribunal (DRT) and Debt Recovery
Appellate Tribunal (DRAT). The DRTs are vested with competence to entertain cases
referred to them, by the banks and FIs for recovery of debts due to them. Each DRT
consists of a Presiding officer and DRAT is headed by a Chairperson. The order
passed by the DRT shall be appealable to the Appellate Tribunal but no appeal shall
be entertained by the DART unless the applicant deposits 75 per cent (now reduced
to 50 percent) of the amount due from him/it as determined by it. However, the
Appellate Tribunal may, for reasons to be received in writing, waive or reduce the
amount of such deposit. Any case involving debt exceeding Rs.10 lakhs can be
referred to Tribunal. Tribunal and the Appellate Tribunal shall not be bound by the
procedures laid down under Civil Procedures Code (CPC), 1908. But they will be
guided by the principles of ‘natural justice’. They make their own procedures,
including the places at which they shall have their sittings. An important power
conferred on the Tribunal is that of making an interim order (whether by way of
injunction or stay) against the defendant to debar him from transferring, alienating
or otherwise dealing with or disposing of any property and asset belonging to him
without prior permission of the Tribunal. This order can be passed even while the
claim is pending. After the claim is upheld by the Tribunal, it issues a Recovery
Certificate to the Recovery Officer who has powers for execution including
attachment, sale, arrest, appropriation as Receiver in the Court and power to
require the defendant (debtor) to remit the money to the Recovery Officer. The Act
provides the Tribunal and Appellate Tribunal the powers of a Civil Court in several
matters. These include summoning of witnesses, discovery and production of
documents, receiving evidence on affidavits and issuing commissions. The Act also
requires both tribunals to dispose of the applications or appeals within a period of 6
months
Page 11 of 30
Procedures to be followed under the Act are simple. To start with, the concerned
bank or FI is expected to make an application to the Tribunal within the specified
geographical limits. The application should be accompanied by such statements or
evidences and by the prescribed fees. On receipt of the application, the Tribunal
shall issue summons requiring the defendants should cause within 30 days of the
service of the summons or to stay the relief prayed for should not be granted. The
Tribunal after giving the applicant an opportunity of being heard passes such orders
on application as it thinks fit to meet ends of justice. The Tribunal may make an
interim order whether by injunction or stay debarring the defendant from sale or
transfer of assets. Thereafter, the Tribunal issues a recovery certificate and passes
on to the Recovery Officer for recovery of the amount of debts as specified therein.
The Recovery Officer sends a notice in writing and requiring the defendant or his
related parties to pay the amount within the specified period. On receipt of money, a
formal receipt will be issued. If the defendant fails to make the payment, the
Recovery Officer will then seize the property and arrange for its sale. He can even
arrest the defendant if the circumstances so warrant. The aggrieved party may make
an appeal within 45 days (now reduced to 30 days) from the date of the order to the
Appellate Tribunal which will then pass an order, confirming, modifying or
cancelling the order, appealed against. While DRTs are helping banks and FIs in
recovery of dues to the considerable extent, they are few in number (33 at present,
proposed to set up another six tribunals) in terms of steep rise in the number of
cases referred. In general, it is observed that the defendants approach the High
Court challenging the verdict of the Appellate Tribunal which leads to further delays
in recovery. There is shortage of the required number of recovery officers. Though
there are many initiatives taken to make stronger by assuring the required
infrastructure. setting targets to dispose of cases in a year, organizing Lokadalats to
dispose of small cases etc., banks continue to experience delays in loan recovery
through DRTs.
3.3. Recovery under SARFAESI Act,

Securitisation and Reconstruction of Financial Assets and Enforcement of Security
Interest (SARFAESI) Act provides for enforcement of security by banks/FIs without
the intervention of court/tribunal. For this, the borrowal accounts should have been
classified as NPA. Banks/FIs should issue a notice to the borrower asking to repay
the liabilities in full within 60 days from the date of receipt of the notice. (U/S 13/2).
Banks /FIs have to appoint an Authorized Officer (AO) to be appointed who should
not less than a Chief Manager in public sector banks/ FIs. The consent of 75 per cent
creditors in loan consortium is a must. (now, reduced to 60 per cent) for the
purposes of this Act. Advances should be secured advances and documents should
be valid for enforcement of security interest. The notice should be served properly -
Page 12 of 30
by a registered post with A.D., affixing the notice on the door, and publishing the
same in the local newspapers. If borrower is not available at the given address, the
notice should be pasted on the last known address, simultaneously publishing in the
local and national newspapers. Notice should be sent to all, if the number is more
than one. Banks /FIS have to inform the Court/DRT/Co-op Department, if the case is
pending before them and send a copy of the notice to them. Simultaneous action
may be taken against guarantors since the advance is recalled. If the full payment is
made during the notice period, no further action is called for. If the part payment is
made, the bank retains the right to seize the asset to claim the balance amount. Bank
can consider the case for compromise even during the notice period. If the borrower
makes payment with certain conditions, the concerned bank/s may accept or refuse
to accept. The bank is obliged to reply to any letter received from a borrower
seeking clarifications within fifteen days. But no stay shall be granted by DRT/ Court
just because; the borrower is not satisfied with the clarifications provided by the
bank.
On the expiry of the notice period, the secured creditor may take the following
actions [u/s 13(4)]. On default of repayment of bank dues as per the notice, the
Authorized Officer initiates certain steps in respect of moveable properties which
include:
(a) To take possession of movable properties in presence of two witnesses with

Panchanama drawn. Inform the Police personnel to take care of law-and-order, if a
need arises. On possession of assets / appointment of a manager, the matter should
be published in newspapers. Possession shall be physical or token i.e. merely
affixing a copy of the Panchanama on the asset.
(b) To prepare an Inventory of properties - one copy of the same shall be passed on
to the borrower. Since the bank holds the possession of the property as a deemed
owner, the AO should take sufficient care including insurance cover. The perishable
commodities should be arranged for sale on priority basis.
(c) To get valuation of the property in possession through the bank approved
valuer.
(d) Bank may try to sell the asset after serving a notice period of 30 days to the
borrower. he sale may be through public auction after publishing in the
local/national newspapers indicating the terms of sale, etc.
(e)If excess money is received over and above the banker's claim, the same should
be passed on to the borrower. If there are preferred creditors (workers' dues,
Page 13 of 30
statutory dues etc.) the payments should be paid to them first before the settlement
of bank dues. The asset should be sold above the minimum price as per the valuer's
certificate; otherwise the borrower's consent is a must. If the borrower agrees to
bring in a potential buyer who agrees to offer still a better price, preference should
be given to the borrower's choice. Sale of goods under pledge is similar to the
mortgaged asset.
(f) Certificate of Sale should be issued to the purchaser on receipt of full payment as
per the terms of sale. This shall be registered by the Banks. In this context, the
Government has set up Central Registry (CR) for registrations of transactions
relating securitization and reconstruction. The Registry is kept open for inspection
by anybody on payment of fees.
Procedures for sale of immovable secured assets are as per the usual practices.
Accordingly, the purchaser should pay a deposit of 25% of the amount of sale price
and the balance to be paid within the next 15 days of confirmation of sale. On default
of the payment by the purchaser within the specified period, the deposit paid earlier
should be forfeited and the property should be resold. Where the property is subject
to any encumbrances, the purchaser should deposit extra amount of discharge of
encumbrances. Board of Directors of banks may appoint a Manager in consultation
with the borrower to manage secured assets in their possession whose
salary/commission should be paid by the borrower. DRTs may be approached for
recovery of shortfall, if any, on sale of the secured assets by payment of the
prescribed fees. Any aggrieved borrower may approach DRT for which no fees have
to be paid. But he appeals to the Debt Recovery Appellate Authority (DRAT) within
30 days from the receipt of the order from DRT, fees are applicable. If DRT/DRAT is
in agreement with the borrower's charges of wrongful seizure etc., the secured
creditor is asked to restore the assets.
Regarding the eligibility criterions for enforcement of security interest debt should
be of Rs.1 lakh and above and overdue is more than 20% of principal amount and
interest thereof. Assets which will not be considered include agricultural and tools
of artisans, unsecured assets/clean loans/ un-drawn limits, unpaid stock, salary &
wages, lien on any goods, pledge of movables , sale or hire purchase/lease in which
security interest is not created etc. Wrongful seizure of assets should be avoided.
There are penalties for the same. There is no suit or prosecution against the secured
creditor for any action done in good faith . As per the recent amendment in the
SARFAESI Act, banks are now allowed to accept immoveable properties in full or
partial settlement of claims against defaulting borrowers., if no bidder comes to bid
or banks are not able to find a buyer for such assets. While recovery under the Act is
Page 14 of 30
good, there are several difficulties experienced by banks. In particular, DRTs are
found to be granting stay on the actions of the banks more frequently which
prevents banks in taking possessions of assets.
3.4. Recovery through Lokadalat:

The concept of Lokadalat was introduced in 1982 for providing quick and
convenient legal aid. Since then, a large number of Lokadalats have been organized
in different parts of the country from time to time and have got recognition and
patronage from every segment of the society. Based on the experiences of several
states, a Central Act, known as Legal Services Authorities Act, 1987 was passed for
providing legal basis for the Lokadalats and legal authority to the compromise
arrived at between the parties through such Lokadalats.
Today, Lokadalats are known for effecting mediation and counseling between the
parties i.e. bank and borrower and to reduce burden on the court, especially with
regard to small loans. Several aggrieved individuals and various social organizations
are also approaching Lokadalats. Lokadalats are generally presided over by two or
three senior persons including retired senior civil servants, defense personnel and
judicial officers. They take-up cases which are suitable for settlement of debt for
certain consideration. Parties are given a patient hearing while they explain their
legal position. They are then advised to reach to some settlement due to social
pressure of senior bureaucrats or judicial officers or social workers. If the
compromise is arrived at, the parties to the litigation sign a statement in presence of
authorities of the Lokadalat which is expected to be filed in the court to obtain a
consent decree. Normally, such settlements contain a clause - if the compromise is
not adhered to by the parties, the suits pending in the court will proceed in
accordance with the law and the bank will have the right to get a decree from the
court if the decision is in its favor.
In this context, certain guidelines have been formulated by banks in consultation

with the Indian Banks Association (IBA). Accordingly, bank-suits involving claims up
to Rs.20 lakhs may be brought before the Lokadalat. There should be a decree for
the interest claimed before suit. In respect of cases considered by Lokadalats, given
the small size of loan and other issues and to facilitate a reasonable compromise
with the party, banks may provide remission of interest. Now-a-days, even non-suit
filed cases in the doubtful and loss categories can be considered for settlement. Debt
Recovery Tribunals also organize Lokadalats. Thus, banks have taken maximum
benefit of Lokadalats and recovered the loan amount particularly from small
borrowers through settlements.
Page 15 of 30
3.5 Sale of Assets to ARCs

Under the SARFAESI Act, Asset Reconstruction Companies (ARCs) are permitted to
carry on securitization and reconstruction business as specified therein. Upon the
acquiring financial assets of a bank by an ARC, the same has to issue a notice to the
borrower to pay the dues to the ARC which is considered as a deemed lender to
enforce security interest. Any suit pending against the bank, the same shall be
continued in the name of ARC. ARC might also apply to one or more DRTs to transfer
the case filed by the bank against the borrower to the DRT of its jurisdiction. It might
continue to execute the Recovery Certificate issued to the bank. ARC issues Security
Receipts (SRs) to qualified Institutional Investors against financial assets acquired
which are held in the nature of a trust. SRs shall not require compulsory registration.
ARC is expected to bring in at least 5 percent of SRs (now, raised to 15 percent) and
the rest to be contributed by the qualified Institutional Investors Thus, ARCs are
regulated to protect the interest of all the concerned parties. Currently, 15 ARCs are
in operation. The problem is that ARCs have found it difficult to recover much from
the debtors. Hence, they have only been able to offer lower price to banks to accept.
It is disheartening to note that just half of the Security Receipts (SRs) issued were
redeemed completely by ARCs indicating their liquidity problems on account
mismatch in cash flows due to slow loan recovery.
RBI publishes information on the effectiveness of these methods in the Trends and
Progress of Banking Report. The following is produced from the report of 2017:
Rcent years have witnessed a sharp pick-up in the sale of stressed assets to SCs/RCs by PVBs and
FBs, however, sale of NPAs by PSBs remains lukewarm..
Table V.18: NPAs of SCBs Recovered through Various Channels

(Amount in ₹ billion)
2015-16 2016-17
Col. Col.
Recovery No. of (4) as No. of (8) as
Amount Amount Amount Amount
Channel Cases % of Cases % of
Involved Recovered* Involved Recovered*
Referred Col. Referred Col.
(3) (7)
1 2 3 4 5 6 7 8 9
i) Lok
4,456,634 720 32 4.4 2,152,895 1,058 38 3.6
Adalats
ii) DRTs 24,537 693 64 9.2 28,902 671 164 24.4
iii)
SARFAESI 173,582 801 132 16.5 80,076 1,131 78 6.9
Act
Total 4,654,753 2,214 228 10.3 2,261,873 2,860 280 9.8
Notes: 1. *: Refers to amount recovered during the given year, which could be with reference to
cases referred during the given year as well as during the earlier years.
2. DRTs – Debt Recovery Tribunals.
Page 16 of 30
Seller banks subscribed to more than 80 per cent of the total security receipts (SRs) issued (Table
V.19).
Table V.19: Details of Financial Assets Securitized by SCs / RCs
(Amount in ₹ billion)
Jun- Jun- Jun- Jun-
Item
14 15 16 17
1. Book Value of Assets Acquired 1598 1750 2377 2627
2. Security Receipts Issued by SCs / RCs 520 536 790 940
3. Security Receipts Subscribed to by
(a) Banks 429 441 651 777
(b) SCs / RCs 74 73 114 142
(c) FIIs 1 1 3 3
(d) Others (Qualified Institutional Buyers) 16 21 22 18
4. Amount of Security Receipts Completely
107 123 149 156
Redeemed
Source: Quarterly statement submitted by SCs / RCs.
Considering the amount of stressed assets the recovery these methods is not
impressive. If the ARC fails to pay the dues on security receipts it will become an NPA
which has been the reason for some big banks reporting higher provisions in the
recent years.
4. NPA Management Measures
4.1. Debt Restructuring:

Often it is seen that the borrower under stress and is in no position to repay dues
though business is running, and recall may add stress and result in closure of
business. There could be temporary volatility in business cash flows. For example a
Page 17 of 30
business could have met with a major fire accident, fire claim is not sufficient to
recoup all losses etc. In such cases Debt Restructuring could be pursued as a method
of managing stressed assets or NPAs.. As of now, there are two types of debt
restructuring: (i) Corporate Debt Restructuring (CDR), handled by a separate agency
or group of bankers established for this purpose and (ii) Debt Restructuring for
MSMEs which is done within the bank and not involving any outside agency.
Debt restructuring aims at making a project or finance , despite default , viable in the
near future provided the business is otherwise technically, commercially and
managerially viable and the borrower continues to be honest and cooperative. In
such cases of the terms of credit are reworked in the form of reduction in the rate of
interest, rephasement of unpaid loan installments, additional finance to be provided
though it is non-performing asset (NPA), conversion of debt into equity, lower
promoter’s contribution, financing of cash losses until the project breaks even etc.
To give effect to these changes/concessions to be offered as part of debt
restructuring, certain changes need to be made in the original loan agreement.
Hence, fresh loan agreements are entered into. There exists elaborate guidelines on
Debt restructuring issued by the RBI from time to time with reference to assessment
of viability restructuring period, promoter’s contribution, terms and conditions of
debt restructuring, loan agreements to be entered into, bank sacrifice etc.
Restructuring will help the customer but the bank will have to show the account s
NPA. Despite debt restructuring. Further additional provision of 100 per cent of
bank sacrifice has to be made. Bank sacrifice is determined as difference between
the present value of estimated cash receipts to the bank (interest, installments etc.,)
during the restructuring period in terms of original agreement and the present
value of estimated cash receipts to the bank (interest, installments etc.,) during the
restructuring period in terms of fresh agreement as under the debt restructuring. It
is mandatory to execute two agreements: Debtor- Creditors Agreement (DCA) and
Inter Creditors Agreement (ICA). Banks have agreed for many CDR but not all have
worked out well. Strangely corporates who got concessions during stress time did
not compensate the bank when they came out of stress. These corporates got the
best rating and best interest when they first took the loan. Ironically they also got
the benefit of concessions when they went into stress.
i. Corporate debt restructuring

In 2001, there was a slowdown in Indian economy. Many big corporates,
particularly steel plants, became NPA and, banks were not ready to provide further
finance to them. Therefore, RBI issued guidelines on Corporate Debt Restructuring
Page 18 of 30
(CDR) and asked banks to undertake debt restructuring for corporates. But there
was some hesitancy on the part of banks to implement the RBI guidelines on
corporate debt restructuring due to high credit risk. Hence, RBI decided to create a
separate agency, popularly known as CDR, to coordinate the corporate debt-
restructuring programme. The agency was promoted by IDBI Bank, State Bank of
India (SBI), Punjab National Bank (PNB), Bank of Baroda (BOB), Bank of India (BOI)
and ICICI Bank.
CDR is a three tier body consisting of Forum (Chiefs of banks, FIs and IBA),
Empowered Group ( Executive Director Level executives of banks/FIs participating
in debt restructuring of the concerned corporate and standing committee members
from IDBI Bank, SBI and ICICI Bank ) and CDR Cell (consisting of officers from
promoter banks on deputation). To assist the Forum in organizing the meeting etc.,
there is a Core Group consisting of one of the Chairmen of promoter banks.
While the Forum evolves broad policy-guidelines, the Empowered Group takes
decisions on the proposals recommended by the Cell. Initially, the borrower
approaches the Lead Bank with a request to restructure debt, which issues a written
consent. Alternatively, the borrower may approach the CDR Cell directly with the
written consent of at least two banks with minimum stake of 20 percent of total
bank dues. The borrower submits the proposal with the support of banks to the Cell.
The CDR covers only multiple banking corporates enjoying credit facilities
exceeding Rs.10 crores. Cases which come under Debt Recovery Tribunal (DRT),
and willful defaults are outside the purview of the CDR. Similarly, Board for
Industrial Finance and Reconstruction (BIFR) cases shall be considered if there is no
objection from it. The Cell considers all types of loan assets except Loss assets. But
in respect of Doubtful cases, CDR does not take the responsibility to arrange for
fresh loans. Decisions of the Group are based on the `super majority’ principle. i.e.
75 per cent of the secured creditors and 60 per cent of creditors in number should
agree for debt restructuring.
Immediately after receiving the proposal from a corporate, a flash report is

prepared by the CDR Cell which then obtains ‘in- principle sanction’ from the
Empowered Group to prepare debt restructuring package. Thereafter, CDR Cell
formulates the draft package in consultation with the stake holders. Draft package,
when gets ready, is submitted to the Empowered Group for sanction. After seeking
sanction, a Monitoring Committee is formed consisting of representatives from
Corporate, Cell and representatives of Creditors. This is responsible for
implementation of the package and monitoring the progress.
Page 19 of 30
The CDR is a voluntary system based on Debtor-Creditors Agreement (DCA) and

Inter-Creditors’ Agreement. (ICA). No banker/borrower can take a recourse to any
legal action during the `stand-still’ period of 90 or 180 days. There is a prescribed
time limit set for completing necessary formalities relating to initial scrutiny for
flash report (30 days), approval of the package (60-90 days), approval by creditors
(45 days) and implementation of the package (120 days). Nowadays, an ‘exit route’
is also available for any bank from CDR provided its share is taken by the other
members of loan consortium or by any new member is inducted to the Loan
Consortium. It is also possible to drop any case from the CDR in certain events such
as non-fulfillment of terms and conditions, package becoming unviable due to
sudden changes in the environment, merger with a strong company etc.
Initially CDR was found considered as a success story in terms of its success in
converting non-performing NPA corporates into Performing corporates due to
timely debt restructuring. Almost all banks in India availed of benefits of debt
restructuring of corporates in various industries. But during the recent past, there
are hardly any cases being referred to CDR because, the revival of CDR cases is
becoming difficult due to slow down in few industries such steel, cement, power,
mining, real estate etc., besides stricter RBI debt restructuring norms. In addition,
concessions which were provided to banks till recently by RBI are now being
withdrawn. Hence, banks now prefer to go in for debt restructuring of corporates
outside the CDR agency.
i. Debt restructuring for MSMEs:

In September 2005, RBI issued guidelines on Debt Restructuring for MSMEs. Based
on this each bank is expected to develop a debt restructuring policy duly approved
by the Board. MSME Debt restructuring policy refers to three types: (A) All MSMEs-
(Registered as under MSMED Act) – all bank dues to be considered for debt
restructuring (B) Corporate MSMEs (Registered under the Companies Act) – dealing
with a single bank - all bank dues to be considered for debt restructuring, and (C)
Corporate MSMEs- dealing with multiple banks – bank dues up to Rs.10 crores.
Further for taking up CDR – after CDR the project should become viable within a
period of 7 years. No debt restructuring is permitted beyond a period of 10 years.
Debt restructuring refers to only those loans and advances which are secured except
collateral free lending made in respect of small borrowers. Banks have to write off
any sacrifice made by them as part of debt restructuring on yearly basis. The
borrower is expected to submit a proposal for debt restructuring to the bank which
works out suitable internal procedures including the time limit, not exceeding 60
days to formulate debt restructuring package and approve. In case of multiple
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banks, the leader of the group/consortium is expected to complete all formalities

relating to debt restructuring. Review of the progress made in debt restructuring
should be made once in a year at the Board level and the relevant data should be
disclosed in the annual report.
CDR is a measure to nurse the stressed account back to health. It has tough
covenants and if the bank is not able to implement and make the borrower abide by
the covenants CDR will have no impact.
4.2. Loan Write-off:

If it is going to be non-remunerative either to file suit and/or continuing the account
in the bank’s books, it is advisable for the bank to waive off legal action and go in for
write-off outstanding dues. By waiver of legal action, banks may take a decision not
to pursue recovery through the court of law.
Such waiver of legal action is suggested when: (i) the means of the borrower are
negligible, (ii) borrowers are below the poverty- line, (iii) cost of recovery is higher,
(iv) the beneficiary is absconding, (v) it is difficult to obtain periodic balance
confirmation of debt-cum-acknowledgement of debt, (vi) securities are already sold
by the borrower, etc.
Similarly, write-off is proposed under certain circumstances such as : (i) borrowers

are adjudicated as insolvents and the bank has already realized part of the dues as a
secured creditor, (ii) revenue authorities under the State Public Recovery Act
(SPRA) have recovered some amount and there is no further chance of any
recovery, (iii) both borrower and guarantor are untraceable after selling their assets
and (iv) decrees remain unexecuted several times due to reasons beyond the control
of the bank.
Decisions to waive legal action or write-off are taken at controlling office on the
recommendation of the branch manager. If permission of the CGTMSE is required,
the same may be obtained. For write-off, various factors are considered which
include: (i) means or capacity of the borrower and guarantor, (ii) the amount to be
written off, (iii) efforts already put in for recovery and (iv)staff accountability.
Write-off is an internal exercise and the branch staff should keep the matter
confidential. Even after write-off, recovery efforts should continue.
4.3. Rehabilitation of Sick Units

At present, there are two types of sick units financed by banks and financial
institutions. These include :( i) Enterprises both in industrial and service related
activities in Micro, Small and Medium Enterprises (MSME) sector and (ii)
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Enterprises both in industrial and service related activities in the non- MSME sector
in which category, there are ‘weak’ and ‘sick’ companies. Weak companies do not fall
under the purviews of Sick Industrial Companies (Special Provisions) -SICA Act
,1985. Both sick MSMEs and Weak companies are rehabilitated based Reserve Bank
of India (RBI) guidelines..
(i) Rehabilitation of Sick MSMEs:

Micro or Small Enterprise (as defined in the MSMED Act 2006) may be said to have
become Sick, if (a) Any borrowal account of the enterprise remains Non- Performing
Asset (NPA) for three months or more or, (b) There is erosion in the net worth due
to accumulated losses to the extent of 50% of its net worth during the previous
accounting. Weak units are those whose accumulate losses exceed 50 per cent of
peak net worth during the last 5 years. Lastly, under section 3 (O) of the SICA, a
company is called as sick if it is a registered company, engaged in industrial/ service
related activities, and incurred losses which is more than peak net worth during the
last five years
Causes of Industrial sickness have to be viewed from the general background of

industrial economy. At any point of time, however problems of industries may not
be identical. Yet , causes of sickness can be divided into two categories: external and
internal. External causes are those over which the unit has no direct control, but
internal causes are those which are within the control of the management of the
unit. Sickness can originate at any time i.e. before implementation or during
commercial operations of the project. Normally, no account falls sick all of a sudden.
As these are already heavily debt burdened, any rehabilitation programme should be
based on an achievable and viable break-even point (BEP). It may necessary, once
rehabilitation is on, units should operate at much higher levels than before. Keeping
in view all the possible outcomes, risk involved and the extent of irregularity in the
account, bank decision should aim at sustaining the business activity and not the
borrower as an individual. The decision should be based on likelihood of possible
recovery. Finally, bank can support the borrower provided he has equal interest in
coming out of the sickness.
The rehab programme should be finalized after a detailed study of the sick unit and
understanding its problems and feasibility to revive. The following are important
aspects/ stages involved in preparation of the rehabilitation programme. (i) study
of the feasibility level of operation (ii)assessment of additional funds (iii)
determinants of sources of funds (iv) preparation of cash flow estimates (v)
arrangements with other creditors (vi) measures for sales promotion (vii) freezing
Page 22 of 30
of existing bank borrowings (viii) strategies for recovery of overdue debts and
disposal of unwanted assets (ix) additional financial arrangements with other
financial institutions and equity holders (x)arrangements for better management
performance.
Monitoring of Rehabilitation Programme: Having decided to rehabilitate the unit,

the bank has to undertake follow-up activities relating to implementation of the
programme and performance during the post implementation. The follow-up action
starts with the collection of necessary information from the borrower. Before
rehabilitating the sick unit, bank must indicate information required for follow-up
so that the borrower can develop his own information system. Bank monitoring
includes periodical stock inspection, study of periodical returns and statements
received from the borrower, forming a monitoring committee consisting the
borrower, the bank executive and the consultant holding meetings periodically,
annual factory inspection , study of annual financial statements, sending a nominee
of the bank on the board of the company etc.
Review the Performance at end of Rehabilitation Period: Bank will have to review
the performance of the borrower regularly, say, quarterly. Review of the account
should aim in examining whether there has been improvement in the overall
working of the unit. It should be ensured that there is not much variance between
the projected and actual figures of production and sales and, the funds are used as
agreed upon. If the cash budget system is introduced, business should generate as
much cash as expected. Review of the account should reveal the areas of weakness.
A detailed study of such areas would suggest the line of action to be taken.
There could be some small units, which have become sick on account of external
factors like lack of power supply, water, raw material, etc. Such units may be
referred to the State Level Coordination Committee, which has been set-up at the
State level with representatives of banks, term lending institutions, State
Governments, etc.
(ii) Rehabilitation of Sick Companies under the SICA:

SICA makes it mandatory for sick units to make reference to the Board for Industrial
and Financial Reconstruction – BIFR within 60 days of adoption of audited financial
statements in the Annual General Body meeting and determination of measures that
may be adopted. BIFR determines whether the company has become sick and then
registers the case. After registration, BIFR appoints an operating agency which
prepares a revival scheme/plan for revival. Once the scheme is prepared BIFR
consults all the stakeholders to seek suggestions on the same. Changes are made in
the draft scheme including financial assistance, fresh terms and conditions , if
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necessary. Thereafter, the legal formalities as stated under the relevant Acts (such
as Companies Act 1956, Foreign Exchange Management Act, Income Tax Act, etc.)
have to be completed by the company and other relevant parties. After the
formalities are completed, the scheme is sanctioned which then will be binding on
all the concerned parties. When the sanctioned scheme is implemented, BIFR may
call for any information from the company for assessing the progress and effects of
the scheme on overall performance of the company. Through enough arrangements
are made under the Act in terms of formulation of policy guidelines, rehabilitation
schemes, creation of sufficient number of institutions to look after revival of sick
units, the success rate is very low. Hardly, 5 per cent of the total sick units have
been fully revived. This is mainly due to lack of seriousness on the part of
entrepreneurs, lack of coordination between banks and financial institutions,
substantial delay in release of subsidies/ reliefs from the government, etc.
4.4. Circulation of List of Defaulters:

Reserve Bank of India has introduced the practice of circulating the list of defaulters
and also willful defaulters among Financial Institutions (FIs) and Banks. This
practice has been found useful in ensuring that defaulters do not avail of fresh loans.
For identification of willful defaulters, the RBI has provided broad parameters such
as diversion of funds, missing of primary security, etc. Auditors of companies have
also to mention in their certificate about diversion of funds, if any. In 2001, Credit
Information Bureau India Limited (CIBIL) was set-up to provide credit history of a
borrower as a critical input to credit institutions for arriving at credit decision.
CIBIL collects information from its members and makes the credit history available
to any credit institution on demand. Members are obliged to inform the CIBIL about
details of fresh sanctions / enhancement of credit limits on timely basis. On the line
of CIBIL, three y other credit information bureaus have also been set up. Due to
circulation of list of defaulters, it is possible to penalize defaulters which in turn
helps in creating a conducive environment for loan recovery.
4.5. Special Mention Accounts (SMAs)|:

Bank should not wait for the account to become an NPA before it starts taking action
for recovery. Rather it should review all the account for repayment and prevent
accounts from slipping into NPA. This will help in reducing the number of NPAs by
arresting the slippage in the loan asset quality. In the wake of increasing NPA, in
February 2014, RBI came out with a Framework to monitor such accounts (and
named them SMAs) more effectively. Under the Framework, Accounts which have
defaults within Standard Assets are classified into three categories: SMA-0, SMA-1
and SMA-2 based on the period of default of up to 30 days, 31-60 days and 61-90
Page 24 of 30
days respectively. And in respect of high value advances under this framework,
lenders are asked to form a Joint Lenders Forum (JLF) and prepare a Corrective
Action Plan (CAP) for SMA-2 accounts with a total debt of more than Rs. 100 crores.
For restructuring of debt of more than Rs. 500 crores, Technical Evaluation Viability
(TEV) study should be prepared by professional agencies identified by IBA and
approval by JLF creditors with super majority of more than 75 percent of value
(total debt)and 60 percent of creditors in number. This Framework has come to
stay and is found to be a useful tool for monitoring of SMAs. But high value NPAs
from corporates continued to remain in the books of banks due to difficulties in
resolving them through legal measures. Hence, it was felt necessary to introduce
new recovery measures during the last 203 years.
4.6. Flexible Restructuring of Long Term Project (5/25) Scheme:

This initiative leads to improve the position of loan recovery from infrastructure
projects which become non-performing more often in July 2014. RBI introduced
5/25scheme which involves flexible structuring of long term project loans to
infrastructure and core-sector industries. Under the scheme, banks can extend a
loan for a period of 20-25 years in such a way that it matches with the cash flows.
The term 5/25 is used since the loan would be subject to refinancing every five
years. However, both lenders and the borrowers have to adhere to certain
conditions which were found to be difficult to fulfil. Consequently, there is lack of
interest on the part of banks to associate with such long-term projects due to their
perception of high credit risk.
4.7. Strategic Debt Restructuring(SDR):

As a next step towards strengthening the NPA resolution, the RBI introduced SDR in
June 2015 to bypass legal hurdles faced by the banks while taking over a defaulting
company by converting part / full of its debt into equity to acquire management
control and finding a new buyer for equity holding within 18 months. However, if
the bank does not get a new buyer during the period, the asset has to be classified as
an NPA. After introduction of this scheme in few cases, very soon banks realized that
the period of 18 months was too short to comply with the requirements. Further, for
resolution of large borrowal accounts which are facing severe financial difficulties, it
also requires coordinated deep financial restructuring which calls for a substantial
write-down of debt and/or making large provisions towards bank sacrifice. Hence,
banks made a representation to RBI for allowing more time to write down the debt
and make the required provisions in cases of resolution of large accounts which was
not considered. As a result of this, while two dozen cases entered into negotiations
under SDR, only two cases have actually been concluded as of end-December 2016.
Page 25 of 30
4.8. Scheme for Sustainable Structuring of Stressed Assets (S4A):

Appreciating difficulties faced by banks in implementing the SDR with special
reference to acquiring management control, in June 2016 the RBI came out with
Scheme for Sustainable Structuring of Stressed Assets (s4a) to facilitate the
resolution of large accounts. For being eligible for resolution of large accounts
under the scheme, certain conditions need to be fulfilled which include : (i) The
project must have commenced commercial operations.(ii) The aggregate exposure
should be more than Rs.500 crores. (iii)The debt should meet the requirement of
test of sustainability of debt i.e. a portion of total debt can be serviced over the same
tenor as that of the existing facilities even if the future cash flows remain at their
current level. (iv) The sustainable debt should not be less than 50 percent of current
funded liabilities. Under the Resolution Plan, it is not necessary to change the
management. Regarding formalities, the Joint Lenders Forum (JLF) shall, after an
independent TEV, bifurcate the total bank debt of the borrower into two parts: Part
A debt (subordinated debt) and Part B debt i.e. total debt minus Part A debt. For
Part A debt, there will be no fresh moratorium granted on interest or principal
repayment and extension of the repayment schedule or reduction in the interest
rate. Part B debt shall be converted into equity/redeemable cumulative optionally
convertible preference shares, the fair value needs to be calculated by following the
prescribed methodologies. JLF shall engage the services of credible professional
agencies to conduct the TEV and prepare the resolution plan. The resolution plan
should be agreed upon by a minimum of 75 percent of lenders by value and 60
percent of lenders by number in the JLF meeting. At individual bank level, the
bifurcation into Part A debt and Part B debt shall be in the proportion of Part A debt
to Part B debt at the aggregate level. Overseeing Committees (OCs), comprising
eminent persons were also constituted by IBA in consultation with RBI. The
resolution plan shall be submitted to the OC by the JLF which will review the
processes involved in preparation of the resolution plan etc. for reasonableness and
adherence to the provisions of these guidelines and opine on it. Their success,
however, has been limited due to several reasons and one of them is delay in
decision making by JLF due to failure to fulfil the super majority criterions for
approval of Corrective Action Plan (CAP) by lenders. Hence, the RBI subsequently
reduced the minimum stake of creditors for super majority from 75 percent to 60
percent by value and from 60 percent to 50 percent by number. Under S4A, hardly
one case been cleared by National Company Law Tribunal (NCLT). Hence to
facilitate the process of NPA resolution, it was felt necessary to enact a new law to
avoid legal hurdles in the matters concerning insolvency and bankruptcy.
Page 26 of 30
4.9. Insolvency and Bankruptcy Code (IBC Code), 2016:

IBS Code was enacted since there was no single law that dealt with insolvency and
bankruptcy in India for individuals and corporates. Under this, secured creditors
with more than 75 percent share in total debt will be allowed to file an application
for the rescue of the company at a sufficiently early stage, rather than wait for the
same to have defaulted on 50 per cent of its outstanding debt, as currently provided
for in the Companies Act, 2013. Even unsecured creditors representing 25 per cent
of the total debt shall be allowed to initiate rescue proceedings against the debtor
company. Lastly, all existing laws that deal with insolvency of registered entities will
be removed and replaced by this single Code.
A timeline of 180 days which can be extended by another 90 days, in all 270 days, by
the adjudicating authority in exceptional cases, for dealing with applications of
insolvency resolution. The IBC envisages a competitive industry of insolvency
professionals, insolvency professional agencies and information utilities. These will
be regulated by an insolvency regulator namely, Insolvency and Bankruptcy Board
of India IIBBI), to regulate insolvency professionals and agencies.
As regards , during the insolvency resolution period of 180/270 days, the

management control will be passed on to a resolution professional who will come
up with an insolvency resolution plan which has to be approved by lenders with
super majority and also by the adjudicating authority. If rejected, the adjudicating
authority will order for liquidation. Under the Law, Debt Recovery Tribunal (DRT)
and National Company Law Tribunal (NCLT) are deployed as the adjudicating
authority. While NCLT will deal with rehabilitation and restructuring matters, DRT
will look after loan recovery if not feasible for rehabilitation and restructuring.
About the process to be adopted during the period of 180/270 days, the regulatory
authority appoints an administrator to take control of the assets and management of
the firm and prepare the resolution proposal. About information asymmetry
between creditors and debtors about the financial status of the company, the JLF
will approach an industry of information utilities so that decision on turnaround
strategy or bankruptcy shall be taken up quickly. It was also proposed to strengthen
DRTs since they are already overburdened with insolvency cases by increasing their
number.. As per information available in IBBI “After notification of relevant
provisions of the Insolvency and Bankruptcy Code 2016 on 01.12.2016, 2,434 fresh
cases have been filed before NCLT and 2,304 cases of winding up of companies have
been transferred from various High Courts. Out of these, a total number of 2,750
cases have been disposed of and 1,988 cases were pending as on 30.11.2017. As per
information received from Public Sector Banks (PSBs), as on 30.11.2017, an amount
Page 27 of 30
of Rs. 39.63 crore had been realized after filing of cases with NCLT, and an amount
of Rs. 2.89 crore had been borne by the banks as haircut”.2
4.10 Amendments in Debt Recovery Laws:

To facilitate effective NPA resolution, Government also thought of making
amendments in the existing Debt Recovery Laws which include: Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest (
SARFAESI) Act 2002, Recovery of Debts Due to Banks and Financial Institutions
(RDDBFI) Act- 1993, Indian Stamp Duty Act- 1899 and Depositories Act- 1996.
Accordingly, in May 2016, the Enforcement of Security Interest and Recovery of
Debt Laws and Miscellaneous Provisions (Amendment) Bill, 2016 was cleared by
the Parliament to amend Debt Recovery Laws. All these amendments would create a
conducive environment for recovery of bank due on a war footing.
4.11 Banking Regulation (Amendment) Act, 2017:

Despite several initiatives both by RBI and Government discussed above, banks have
continued to witness a very high level of stressed assets. The problem is that the
above initiatives like SDR, S4A and IBL are new, and financial restructuring
negotiations under these mechanisms inevitably take some time. But the country
cannot wait till then since over dues from the corporates are mounting. Hence, the
Government has enacted passed he Banking Regulation (Amendment) Act l, 2017 in
August 2017. It seeks to amend the Banking Regulation Act, 1949 to insert
provisions for handling cases related to stressed assets. The Act is aimed at tackling
the menace of massive stressed assets in the banking system granting more specific
powers to the RBI. Act also amends certain provisions of the Prevention of
Corruption Act (PCA),1988 to encourage bankers to take commercially bold
decisions, especially on haircuts on toxic assets, without fear of subsequent
prosecution. To state specific amendments to BR Act, while a new Section i.e. 35AA
is inserted as per the Ordinance to empower the government to authorize the RBI to
issue directions to banks as it deems fit to initiate insolvency process in case of a
default under the provisions of the IBC. Further, another section i.e. Section 35AB is
included in the Act to grant powers to the RBI to specify one or more authorities or
committees (called as Oversight Committees- OCs) to advise banks on resolution of
stressed assets. These OCs will be able to help banks in decision-making and also to
monitor the progress in resolving stressed assets (gross non-performing assets and
restructured standard advances). Thus, the central bank could monitor specific
cases, especially the more difficult ones, even when the resolution process under
2
This was stated by Shri P.P. Chaudhary, Minister of State for Law & Justice / Corporate Affairs in written
reply to a question in Rajya Sabha today i.e. 21/12/17
Page 28 of 30
IBL is under way. Bankers could also pursue the IBL mechanism more vigorously if
other mechanisms to deal with the NPA issue do not succeed.
The Reserve Bank issued a directive bringing certain changes to the existing
regulations on dealing with stressed assets With a view to facilitating decision
making in the JLF, the requirement of super majority which was necessary to initiate
procedure has been relaxed. Banks who were in the minority on the proposal
approved by the JLF are required to either exit by complying with the substitution
rules within the stipulated time or adhere to the decision of the JLF. Participating
banks have been mandated to implement the decision of JLF without any additional
conditionality Lastly, the Boards of banks were advised to empower their executives
to implement JLF decisions without further reference to them. The RBI has made
clear to the banks that non-adherence would invite enforcement actions. It was also
decided to reconstitute the OC under the aegis of the RBI and also enlarge it to
include more Members so that the OC can constitute requisite benches to deal with
the volume of cases referred to it. The RBI is planning to expand the scope of cases
to be referred to the OC beyond those under s4a as required currently. It is also
working on a framework to facilitate an objective and consistent decision-making
process with regard to cases that may be determined for reference for resolution
under the IBL. The RBI sought information on the current status of the large
stressed assets from the banks and constituted a Committee comprising majorly of
its independent Board Members to advise on the subject. RBI is also exploring the
feasibility of rating assignments being determined by itself by involving rating
agencies. Thus, with these initiatives from RBI, it is hoped that the Act would
produce the desired results.
5. CONCLUSION:
It is evident that NPAs cannot be avoided completely. Yet every bank should
attempt to keep the level of NPAs lower. Based on the discussion made above, few
learning could be summarized. Non-Legal measures are always preferred to legal
measures in terms of quick recovery and cost. But, a stern action is needed in
respect of wilful defaulters. For effective loan recovery, it calls for professional,
collective and timely action and maximum use of technology. Efforts of the
Government should be strengthened to develop a healthy climate for recovery by
seeking co-operation from all stakeholders. In addition, there should be an effective
coordination between banks and FIs in recovery aspects. It is also necessary to
ensure the adequate staff in the field to contact defaulters more frequently. Besides,
staff involvement in the recovery drive has be ensured by offering an incentive to
them. Further, judicial machinery has to become more efficient to dispose off the
cases pending before them early. In particular, DRTs have to gear-up to assist
Page 29 of 30
banks and FIs in their recovery effort. Lastly, banks to look into the recovery
matters more seriously. In other words, they should consider the loan recovery as a
continuous fight in which all of them have to participate more closely . In this
context, banks have a long way to go.
References:
1. Address by Dr K C Chakrabarty, Deputy Governor, Reserve Bank of India
titled “Corporate Debt Restructuring- Issues and Way Forward” at the
Corporate Debt Restructuring Conference 2012, Mumbai, dated 11 August
2012
2. CDR Web-site.
3. Report on Trend and Progress of Banking in India 2015-16Reserve Bank of
India.
4. Framework for Revitalizing Distressed Assets in the Economy, RBI Circular,
February 26, 2014.
5. Flexible Structuring of Long Term Project Loans to Infrastructure and Core
Industries, RBI Circular, July 15, 2014.
6 Strategic Debt Restructuring Scheme, RBI Circular, June 08, 2015.
7. Scheme for Sustainable Structuring of Stressed Assets, RBI Circular, June 13,
2016
8. Timelines for Stressed Assets Resolution, RBI Circular, May 05, 2017.
9. Insolvency and bankruptcy Bill, Tabled in Parliament on December 15, 2015
10. The Enforcement of Security Interest and Recovery of Debts Laws and
Miscellaneous Provisions (Amendment) Bill, Tabled in Parliament on May
11, 2016
11. RBI launches action plan upon introduction of Ordinance, RBI Press Release,
May (Amendment) Bill, Tabled in Parliament on May 11, 2016(Amendment)
Bill, Tabled in Parliament on May 11, 2016 22, 2017.
Page 30 of 30
Chapter 5: Credit Management and Credit Risk Management
Dr R. Bhaskaran
Objective: This chapter covers credit management and credit risk management. On
completing this chapter candidate will have good understanding of issues in credit
management, how to distinguish loss and risk and how credit risk is managed
Structure
1. Introduction
2. Risk management organization and systems
3. Major risks
4. Loan policy
5. Best practice in credit management
6. Understanding credit risk management
1. Introduction
Lets’ consider the following

i. A bank lends to a known defaulter and loses its money. Is this risk? Many will say
“No it is not a risk because bank lent to a known defaulter”. Others will say it is
“Credit Risk”. But if one looks closely it will be evident that banks credit appraisal
process, procedures and rules are such that it enables a bank to finance a defaulter
and thus there is a likelihood that this mistake will repeat. This is a credit loss and
operational risk.
ii. A bank invested in a AAA rated bond of blue chip company. After some time, the
blue-chip company went for unwanted diversification, faced huge liquidity issues
and the bond was downgraded to “D” rating. Bank had to provision for the likely
loss. This is clearly market risk as the bank had taken a right decision to invest but
the investment turned out poor.
iii. A banks normal level of NPA was 2% of its loans. It makes full provision for the
same. This year on account of increase in petroleum prices and the delay by the
government in releasing its due to its contractors many companies have defaulted
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or delayed resulting in spurt of NPA. The spurt in NPA will lead to some loss/haircut
etc., which are unexpected losses and is credit risk.
iv. A NBFC is Government owned and AAA rated. It is highly capitalized. All banks like
to invest in that company be it for shorter duration or long term. The company
issues long term loans to State Owned Corporations. Seeing the banks interest in
lending to it, the company started borrowing heavily in CP (90 days) and short term
(180 days) and used it for funding long term loans. At one point 60% of the NBFC
funds were short term, 20 % was equity and remaining long term loans. As the State
Owned Corporations were reeling indebt the Government brought a scheme to
rehabilitate them and asked them not to repay the debts till a new scheme is
brought out. The NBFC defaulted in its CP. The credit rating agency has obviously
erred in giving AAA. Banks have erred because at the time of investing they went by
AAA and did not do their own due diligence. Result is credit and market risk.
v. Recently one of the flamboyant airlines went burst and almost all banks had
exposure to the company. It was learnt that at one point of time all banks had
pursued eagerly with the airline for accepting a line of credit. Now all of them are
trying to catch hold of the airline baron. This is a case of combination of credit and
operation risk. Operation risk because for banks to lend to the airline at prime or
less than prime rate some procedures should have been bypassed.
Many more such examples of risks can be given. The intention is not to list all of them but
drive home a point that risk is inherent to banking and finance. In the pursuit of profit,
growth and need to be liquid banks could run into known and unknown losses.
Given this we can start this chapter with a statement that in the process of financial
intermediation, banks are confronted with various kinds of financial and non-financial
risks. Over the years the items included in the list of risks has been increasing. It appears
that the list will only increase. In view of this we can say that currently risks faced by banks
include credit risk, interest rate risk, foreign exchange rate risk, liquidity risk, equity price
risk, commodity price risk, legal risk, regulatory risk, reputational risk, operational risk,
compliance risk etc. These risks may happen independent of each other. But the above
examples show that generally these risks are highly interdependent and events that affect
one area of risk can impact a range of other risks.
Another issues that we must discuss before we go further is certain myths and perceptions
about risk.
Consider this statement

i. Higher the risk higher the reward.
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This statement justifies taking risk as higher rewards seem assured! It must be clarified
that it is not always so. Let us study this further. CIBIL credit score ranges from 300 to 900.
Anything above 750 is considered a good credit score. All banks /NBFCs usually look at the
credit score as one of the many things to check before advancing a loan. A banks base rate is
8.40. It lends to a customer with a CIBIL score of 750 and above at 8.6%. For every dip in
the score by 50 points bank adds 0.10% interest. It does not lend for scores less than 500.
What this means is that for a score of 500 the Rate of Interest will be 9.10%. One of the
main reason for a person having a low score could be his/her cash flows. Given this a
higher debt service will be pose more difficulty to the customer. From the banks angle if
the person were to default it means for a additional interest of 50bps it lost the entire 100
principals. High risk no doubt means high rewards but more importantly it means very
high losses. This kind of pricing works well in portfolio (home loan is a portfolio for a
bank) basis as the default is by a few people whereas everyone pays risk premium. Note
that for those who have high scores the bank charges premium on rate as well. Risk is
cross subsidised by regular borrowers in a bank. Thinking that a higher rate compensates
higher risk if the bank were to take very high exposures then a sub-prime disaster will
happen!
ii. Risk taking for profit.

Risk is uncertain. Therefore, if risk is taken there is a probability that the risk may
nothappen. Given this if the probability is known and the risk appetite is given it should be
possible to pursue some risky investments and credit and make high returns. This
argument is in fact an extension of the point given above about risk reward relationship. On
the other hand, if the risk happens then the bank will lose the entire credit and investment.
In view of this pursuing risk as an opportunity to make more profit cannot be the normal
course of business for the bank. Banks should confine themselves to managing risks that
they face in the normal course of business.
iii. Risk can be diversified.

Diversification reduces the impact of risk and does not eliminate the risk in a given
instrument or investment. Diversification ensures that impact of the risk is not heavy on
the bank. Diversification ensures that exposures are limited and hence the impact is
limited.
iv. Risk can be hedged.

True. Risk can be hedged in the market by appropriate instruments. Hedge has a cost.
Hedging does not mean that if the risk occurs the potential loss is fully covered by hedge.
Cost of hedge has to be well understood. Take the case of insurance. It is incurred every
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year whereas fire or other risks happen once in a while. Given this cost of hedge should be
carefully evaluated particularly when one resorts to exotic hedge instruments.
Another form of diversification is to resort to securitisation. Even in this a portion of the

costs remain with the issuing bank or company. As such risk cannot be fully hedged and
excessive hedge cost can bring down the organisations.
v. Risk culture and risk appetite

The Financial Stability Board defines risk culture as “the norms, attitudes and behaviors
related to risk awareness, risk taking and risk management.” Risk culture is effective when
it promotes sound risk-taking, addresses emerging risks (beyond risk appetite), and
ensures employees conduct business in a “legal and ethical manner.” This means that bank
should have well calibrated risk policy of do’s and don’ts, products, product selling and
services which reflect honest and ethical business. Risk appetite is therefore defined by
risk policy. Culture and appetite should be same in letter and spirit. Both these terms have
to be demonstrated by the management of the bank and Board. For example, Management
and CEO of the bank say KYC compliance should be 100% but at the branch or product
selling level the manager says KYC is discretionary then the risk culture is in paper and not
in practice. This dichotomy is often observed in selling third party products in bank which
could ultimately result in operational risk.
In the above paragraphs, a reasonable view of risk and risk management issues have been
given. It clearly shows that banks face many risks. It is also seen that it is difficult to predict
the timing of risk and management of risk is equally complicated. In view of this top
management of banks should attach considerable importance identifying, measuring,
monitoring and controlling risks in the organisation. For this purpose, managements
should establish a well empowered risk management department or function within the
bank. Such risk management function should encompass:
i) organisational structure;
ii) comprehensive approach to risk measurement
iii) appropriate risk management policies (Policies approved by the Board
consistent with the extant regulation, broader business strategies, capital
strength, management expertise, specifying overall risk culture and appetite).
iv) guidelines and other parameters used to govern risk in terms of business
mix and risk limits.
v) Risk monitoring and control frame work including MIS for reporting.
vi) Appropriate control system.
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This risk management framework should be independent of framework of each operational

departments and should have clear delineation of levels of responsibility for management
of risk. The entire framework and policies should be reviewed and evaluated periodically.
2. Risk management organisation and systems.
Risk management function in a bank should be based on its size, complexities and the
number of geographies in which it functions. Risk management function could be
centralised or decentralized. Availability of advanced technology and nearness to financial
markets are the reasons why banks choose centralised management structure. In a
centralised system information on various risk parameters and market information are
available on-line and real-time basis. It must be added that integrated treasury
management department is also centralised which is helpful in risk management functions.
Apart from this Banks should adopt risk management system suitable their size, business
mix, complexity of functions, the level of technical expertise and the quality of MIS
Further the Board of the bank should ensure that all risks are well understood and
managed by the bank by framing appropriate risk management policies, limits, procedures
and control. Board has the responsibility to ensure that the policy is implemented properly.
Risk limits should reflect banks risk bearing and risk management capacity.
At the organisational level, overall risk management should come under an independent
Risk Management Committee or Executive Committee of the top management executives.
The committee should report directly to the Board of Directors. This committee should be
an empowered group with full responsibility of evaluating overall risks faced by the bank
and determining appropriate levels of risks and take action best suited to the bank. The line
managements, however are fully accountable for the risks under their control. They should
manage and control risk.
Every bank should have a risk management policy. It will deal with The functions of Risk
Management Committee should be, as per policy statement of the bank
i. Identify, monitor and measure the risk profile of the bank.
ii. Develop, from time to time review risk policies and procedures and
recommend changes if any to the Board
iii. Verify the risk measurement models that are used for pricing complex
products
iv. Review the risk models as and when development takes place in the markets.
v. Quantify and specify prudential limits based on Board policies. on various
segments of banks’ operations. These limits could be in terms of portfolio
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standards or Credit at Risk (credit risk) and Earnings at Risk and Value at Risk
(market risk).
vi. Design stress test scenarios to measure the impact of unusual market
conditions and monitor variance between the actual volatility of portfolio
value and that predicted by the risk measures.
vii. Monitor compliance of various risk parameters by operating Departments.
It must be added here that robust MIS is a prerequisite for establishment of an effective risk
management system is the existence. Quality of MIS is also equally important.
In addition to risk management committee banks will have Asset - Liability Management
Committee (ALCO) which deals with different types of market risk and the Credit or Loan
Policy Committee (CPC) which stipulates and monitors credit /counterparty risk and
country risk in respect of the credit function. Generally, the policies and procedures for
market risk and liquidity are articulated in the ALM policies and credit risk is addressed in
Loan Policies and Procedures. As such RMC will function as a single Committee for
integrated management of credit, market risks and operational risk.
Generally, market variables are held constant for quantifying credit risk and credit
variables are held constant in estimating market risk. The past few financial crises have
however shown that most risks are interdependent and there exists a strong correlation
between unhedged market risk and credit risk. Un hedged Forex exposures with
corporates could increase the credit risk of banks who have financed them. The volatility in
the prices of collateral could also impact the quality of the loan book. In view of this RMC
should factor the views of ALCO and CPC and evaluate the impact of market and credit risks
on the financial stability/strength of banks.
3. Major Risks:
Banks face Credit risk, Market risk, Operations risk and liquidity risk. In this lesson we will
learn about credit risk
3.1 Credit Risk

Lending can result in a number of risks. Major risk among these is the risk of default which
is commonly known as credit risk. Credit risk is the probability that the borrower could
delay payment of interest or repayment of loan or completely defaults in the repayment of
loan. In view of this, every bank will carefully evaluate every proposal for risk in lending
and take decision on pricing of loan, security, collateral, debt service etc. based on specific
parameters which are focused on containing if not eliminating risk. In case of loans and
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investments, in addition to the risks related to creditworthiness of the counterparty, banks

are also exposed to interest rate, forex and country risks.
“Credit risk is most simply defined as the potential that a bank borrower or counterparty
will fail to meet its obligations in accordance with agreed terms” 1. Credit risk or default risk
is the probability of inability or unwillingness of a customer or counterparty to meet
commitments to the bank in relation to its borrowing from the bank. Credit Risk could be
transaction risk (default) or portfolio risk. Review of portfolio risk is getting increased
attention from banks in terms of measuring and managing the risk from credit exposures.
Portfolio risk of a bank depends on both external and internal factors. The external factors
include the state of the economy, volatility in (i) commodity/equity prices, (ii) foreign
exchange rates and (iii) interest rates, trade restrictions, economic sanctions, Government
policies, etc. The internal factors include deficiencies in loan policies/administration,
absence of prudential exposure limits which increases credit concentration, inadequately
defined lending powers for Loan Officers/Credit Committees, deficiencies in appraisal,
excessive dependence on collaterals, inadequate risk pricing, absence of effective loan
follow up, loan review mechanism etc.
Credit risk is nothing but counterparty risk. In a loan, the counterparty is the borrower. In
an investment, it is the issuer or issuing company. In the case of forex or other transactions,
it is the trading partners. The non-performance in a credit may arise from counterparty’s
refusal/inability to perform due to adverse price movements or from external constraints
that were not anticipated by the principal. It should however be seen that counterparty risk
is generally associated with financial risk associated with trading. As such risk of loan
default is called credit risk.
Lending is one of the major functions of the bank and credit is the largest asset in the
business of banks in India. For example, outstanding bank credit by commercial banks in
India on March 31, 2016 stood at Rs 78.96 lakh crore . This formed 60.3 % of total assets of
commercial banks as on that date. Given this a high default risk could have serious
implications for the banking system. In view of this credit risk should receive the top
management’s attention. Top management should consider risk prevention and risk
management. This can be achieved by
a) Adhering to high standards of credit appraisal including measurement of risk through

credit rating and credit scoring;
b) Adhering to industry and individual exposure limits
1
Principles for the management of credit risk: BIS: https://www.bis.org/publ/bcbsc125.pdf
Page 7 of 23
c) Appropriate risk pricing

d) Controlling loan losses through loan review mechanism
e) Participating in credit guarantee scheme (like CGTMSE) where applicable
Bank should periodically quantify credit risk through estimating expected loan losses and
unexpected loan losses.
Expected loss as the name indicates is the loss that a bank expects from a loan. Unexpected
loss is the loss that exceeds such expectations. Statistically expected loss is the average
credit loss that we would expect from an exposure or a portfolio over a given period of
time. Expected loss is the summation of expected losses of individual assets. This is
estimated based on past performance and statistical evaluation. Since the expected loss is
what a bank expects it is expected that it would have budgeted for it. Bank should not
normally find it difficult to manage known and expected losses.
Unexpected loss, is the average total loss over and above the mean loss (expected loss). It is
calculated as a standard deviation from the mean at a certain confidence level. It is also
referred to as Credit VaR. As per regulatory norms a bank will have to safeguard itself from
unexpected losses by allocating stipulated level of capital.
4. Loan Policy
3.1 Loan policy is a board approved document that details loan mix, products and pricing
of loans of a bank and general eligibility for the loans. Loan policies will specify standards
for approval of credit proposals, terms and conditions, internal and external rating
standards and benchmarks, delegation of sanction powers, prudential limits on large credit
exposures, limits on asset concentrations, types, quality and extent of loan collaterals,
portfolio management, loan review mechanism, risk concentrations, risk monitoring and
evaluation, pricing of loans, provisioning, compliance to legal and regulatory norms etc. As
such loan policy contains scope, rules, regulations, and procedures for credit function and
credit risk management.
All banks will have a Credit Policy Committee to deal with (a) issues relating to credit
policy and procedures and (b) to analyse, manage and control credit risk for the bank as a
whole. The Committee should review and recommend policy changes to the Board for its
approval. Another important committee is Credit Risk Management Department (CRMD).
The CRMD should ensure compliance to the risk parameters and prudential limits set by
the CPC. CRMD will also lay down risk assessment systems, monitor quality of loan
portfolio, identify problems and correct deficiencies if any, develop MIS and undertake loan
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review/audit. Large banks may consider separate set up for loan review/audit. CRMD is
vested with the responsibility of 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.
5. Best practices in Credit Risk Management
Credit Risk Management encompasses a host of management techniques, which help the
banks in mitigating the adverse impacts of credit risk.
5.1 Credit approval and authorization system
Delegation of powers for credit sanction will depend on the size and business mix of the
bank and its spread in geographies. Loans which are relatively riskier should be sanctioned
by higher levels in the credit hierarchy while loans with lower risk should be sanctioned at
lower levels. For example, powers for sanctioning gold loan and loan against FD should be
with the branch subject to certain business volumes or budget. At the same time big
corporate loans should be considered by specialised branches or central committee. Home
loans could be sanctioned by home loan branches which houses officials with special
knowledge and training. Thus, each bank should have a carefully formulated scheme of
delegation of powers.
In case of large volume loans banks should also evolve multi-tier credit approving system
where the loan proposals are approved by a ‘Committee’. Generally, credit facilities above a
specified limit may be approved by the ‘Committee’, which could include a member of
CRMD, who has no volume and profit targets and therefore will take a more impassionate
view of the proposal. Banks can also consider credit approving committees at various
operating levels i.e. large branches (where considered necessary), Regional Offices, Zonal
Offices, Head Offices, etc.
Given this it important that banks evolve suitable framework for reporting and evaluating
the quality of credit decisions taken by various officials/ groups. The quality of credit
decisions should be evaluated within a reasonable time, say 3 – 6 months, through a well-
defined Loan Review Mechanism.
5.2 Prudential Limits
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It is difficult to say no to a very good customer. At the same time banks should be vary of
risk of concentration. In view of this banks are expected to contain exposure to a single
party. For this purpose prudential limits should be laid down on various aspects of credit:
a) Appraisal Standards. Bank should stipulate threshold or acceptable financial
performance standards in terms current ratio (liquidity), debt equity ratio (financial
leverage) and PAT and EBIT (profitability) debt service coverage ratio ( ability to
pay) etc. Instead of stipulating this narrowly a bank could adopt a band or range for
these ratios. Similarly in case of retail credit it should specify LTV and FOIR. As these
ratios are stipulated for the bank as whole it should also specify permitted deviation
and the authority to approve deviations.
b) Exposure Limits: The idea behind exposure is to diversify risk. As banks have to
comply with limits prescribed by RBI it is preferable to keep these limits lower than
what RBI has indicated in its guidelines.
i. Single/group borrower limits: Generally, this is defined by various bench mark

that are mentioned in the paragraph above. The loan amount can be further
limited by stipulating an amount beyond which the bank will have exposure. For
example, it can be said that maximum amount for a home loan could be limited
at Rs 5 Crore. In respect of exposure to business bank may peg its limit to certain
multiples of owned funds of the borrower.
ii. Substantial exposure limit i.e. sum total of exposures assumed in respect of those
single borrowers enjoying credit facilities in excess of a threshold limit, say 10%
or 15% of capital funds of the bank. In these cases, the exposure limit may be a %
of capital funds depending upon the degree of concentration risk the bank is
exposed;
iii. Bank should also fixe maximum exposure limits to industry, sector, etc.
iv. There must also be systems in place to evaluate and review the exposures at
reasonable intervals. Where ever the particular sector or industry faces
slowdown or other sector/industry specific problem exposure limits should be
contained.
v. The exposure limits to sensitive sectors which are by nature subject to a high
degree of asset price volatility specific to industries and volatility due to
frequent business cycles namely advances against equity shares (market is
volatile) real estate (sector has its own ups and downs) should be limited.
Further if the bank feels some industries are high risk it may stipulate a lower
overall exposure.
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There will be occasions when the exposure limit may be breached like a borrower needing
temporary excess limits. There could be some strategic considerations for increase in
exposure. All such excess exposures should be fully backed by adequate collaterals.
In arriving at the exposure limits banks may keep in reckoning maturity profile of the loan
book, market risks inherent in the balance sheet, risk evaluation capability, liquidity, etc.
5.3 Risk Rating
Risk is not current or past. It is in future. Risk estimates are projections of past data with
statistical tools. The same set of past data and information can also be used to rate the
borrower for possible risks. Banks should use both internal and external rating system of
borrowers. Risk rating will serve an indicator of riskiness of the counterparty and for
taking credit decisions in a consistent manner. Risk rating of client loans (borrower or
facility rating) is based on borrower its antecedents, financial position, track record of
banking, profitability of current business etc. Bank collects information on these
parameters and assigns scores to each item. Bank compares the rating obtained by the
borrower to its threshold rating/score decide whether credit can be extended. External
rating is given by credit rating firms who collect information from the borrower, analyse
the same and arrive borrower’s credit rating. Internal credit rating would call for a score
card which is well developed and standardised across borrowers. The risk rating system
should be such that it reveals overall risk of lending and gives critical input for arriving at
terms of credit more importantly pricing.
Risk rating is also concerned with portfolio rating. This is an exercise of analysing the
banks loan book based on past performance and estimating the probability of risk and loan
losses. The risk rating, in short, should reflect the underlying credit risk of the loan book.
The rating exercise should also facilitate the credit granting authorities some comfort in its
knowledge of loan quality at any moment of time.
Rating symbols and its meaning
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The risk rating of borrowers should carried out in a well designed manner based on
financial analysis, projections and sensitivity, industrial and management risks. Banks will,
generally use a number of financial ratios and operational parameters that shows the credit
worthiness of the borrowers coupled with qualitative aspects of management and industry
characteristics that will impact the borrowers. Financial analysis will be taken up for the
immediate past few years. Rating method or information sought may not be the same for
all type of borrowers as large corporates, SME, small borrowers, traders, will have different
risk characteristics. Bank should prescribe the acceptable rating for each of its product and
type of customers which means a minimum rating below which no exposures would be
taken up. The loan policy should clearly state the procedure for any deviation in the laid
down criteria.
The credit risk assessment exercise should be repeated in regular periodicity, at least once
in a half year. This is independent of credit review. Having done the credit rating bank
should critically evaluate the rating migration of borrowers, portfolio, credit category etc.,
to understand the movement in the quality of its credit portfolio. Variations in the ratings
of borrowers over time indicate changes in credit quality and expected loan losses from the
credit portfolio. Thus, if the rating system is to be meaningful, the credit quality reports
should signal changes in expected loan losses. In order to ensure the consistency and
accuracy of internal ratings, the responsibility for setting or confirming such ratings should
vest with the Loan Review function and examined by an independent group of officials.
5.4 Risk Pricing
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Risk-return analysis and risk based pricing are fundamental aspects of risk management.
In a risk-return backdrop, borrowers with weak financial position are placed in high risk
category and hence the price of credit (ROI) is high. Given this, banks should evolve
appropriate metrics to price the loans. Risk based pricing could be portfolio pricing or
individual. Generally, banks add risk cost in arriving at the lending rates. Loan pricing could
be based on average cost or marginal cost. The pricing issues are critical and should be
done carefully and reviewed periodically.
Pricing of loans normally be based on risk rating or credit quality. Credit quality of
portfolio is decided on past behaviour of the loan portfolio, which is the function of loan
loss provisions and write offs in the past five years or so. Banks should build historical
database on the portfolio quality and provisioning etc., to enable them to price the risk. It
should be added here that value of collateral, competition, perceived value of accounts,
future business potential, portfolio/industry exposure and strategic reasons etc., play
important role in pricing. In this connection many banks use Risk Adjusted Return on
Capital (RAROC) framework for pricing of loans. This requires data on portfolio behaviour
and allocation of capital commensurate with credit risk inherent in loan proposals. Under
RAROC framework, lender charges an interest mark-up to cover the expected loss –
expected default rate of the rating category of the borrower. The lender then allocates
enough capital to the prospective loan to cover some amount of unexpected loss-
variability of default rates. It is a prudent practice to allocate enough capital so that the
expected loan loss reserve or provision plus allocated capital covers 99% of the probable
loan loss outcomes.
Competition, regulatory guidelines etc play an important role in pricing. Banks policy
should contain a clear direction on reckoning competition in pricing so that it avoids
adverse selection.
Marginal Cost based lending rate : MCLR

The Reserve Bank of India has changed the base rate system in April 2016 and introduced Marginal
Cost of Funds based Lending Rate (MCLR). Banks have to adopt MCLR as the internal benchmark
lending rates. Over and above MCLR banks will add a margin in accordance with the riskiness of the
borrower with reference to credit score or credit rating. RBI desires that MCLR should be revised
monthly by considering some new factors including the repo rate and other borrowing rates. It is
further stipulated that banks have to set five benchmark rates for different tenure or time periods
ranging from overnight (one day) rates to one year.
The new methodology uses the marginal cost or latest cost conditions reflected in the interest rate
given by the banks for obtaining funds (from deposits and while borrowing from RBI) while setting
their lending rate. This means that the interest rate given by a bank for deposits and the repo rate (for
Page 13 of 23
obtaining funds from the RBI) are the decisive factors in the calculation of MCLR.
Why MCLR ?
Prior to MCLR banks were seen slow to change their interest rate in accordance with rate change
signals given by RBI through monetary policy despite commercial banks depending to a significant
extent on RBI’s LAF repo for short term funds. MCLR has implications for monetary system and
ensures that rate signals given by RBI impact the market.
What is MCLR.
The word marginal is important to understand MCLR. In economics sense, marginal means the
additional or changed situation. Thus, marginal cost includes those costs that are currently incurred
and not the average cost of funds of the bank. While calculating MCLR, banks have to consider the
current market cost conditions i.e. the cost of raising incremental funds. This will include the interest
rate given to the fresh and renewal of deposits and other borrowings (often referred as cost for the
funds).
Components of MCLR.
1. Marginal cost of funds;

2. Negative carry on account of CRR;
3. Operating costs;
4. Tenor premium.
Marginal Cost of funds: The marginal cost of funds will include Marginal cost of borrowings and
return on networth. According to the RBI, the Marginal Cost should be charged on the basis of
following factors:
i. Interest rate given for various types of deposits- savings, current, term deposit, foreign
currency deposit
ii. Borrowings – Short term interest rate or the Repo rate etc., Long term rupee borrowing
rate
iii. Return on networth – in accordance with capital adequacy norms.
RBI has said that the marginal cost of borrowings shall have a weightage of 92% of Marginal Cost
of Funds while return on networth will have the balance weightage of 8%.
Negative carry on account of CRR: As RBI is not giving any interest on the CRR, negative cost is the
cost that the banks have to incur while keeping reserves with the RBI. For example if a bank gets
Rs.100 crore deposits at 5% and keeps 4% of funds as CRR then effective cost of deposit is 5% ÷ Rs 96
i.e. 5.21%. The negative cost is 0.21%.
Operating cost: is the operating expenses incurred by the banks. This includes cost of establishment
and operations.
Tenor premium: This is the premium for period. Generally the deposit rates are forward looking.
Therefore tenor premium will increase with increase in tenor. This means that bank will charge higher
interest rates on long term loans
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In essence, the MCLR is determined mainly marginal cost for funds and is essentially the
deposit rate and by the repo rate. Any change in repo rate brings changes in marginal cost and
hence the MCLR should also be changed.
Once MCLR is arrived actual lending rate will be MCLR plus risk premium.
Base rate
The base rate is calculated based on:
1. Cost for the funds (interest rate given for deposits),

2. Operating expenses,
3. Minimum rate of return (profit), and
4. Cost for the CRR ( negative carry)
Negative carry on CRR and operating expenses are common factors for both base rate and the MCLR.
Minimum rate of return is explicitly excluded under MCLR.
5.5 Credit Management
The objective of credit management is to (a) reasonable return on the portfolio, (b) and
keep the NPA minimum if not nil. For this, banks must have good appraisal, appropriate
eligibility norms and continuous follow up system for ensuring correct performance of
credit portfolio, precluding accounts from slipping into NPA and tracking the Non
Performing Loans. It should be clear that this is round the year exercise and not merely
around balance sheet dates. Many routine things such as (a) matching the stock turnover
to quarterly sales reported, (b) matching total sale (monthly/quarterly/annual etc) to
corresponding credit entries in the current account, (c) verifying invoices with the finished
goods sales etc will help in understanding disturbances or diversion if any. Verifying
whether or not the company/borrower pays the tax dues in time, if the physical stock
tallies with the stock statement and stock register, cash withdrawals are as per business
requirement etc will help maintain the quality of credit.
In case a company has subsidiaries or keen on expansion into new areas there is the
possibility of loan funds being used for expansion impacting the quality of credit. Only
effective monitoring and keeping close tab on fund cash movement among the companies
will help maintain asset quality. In case a company indulges is sharp practices its credit
quality will deplete. In view of this, credit department should evaluate the loan book
tracking the migration (upward or downward) of each segment of credit and major
borrowers from one rating scale to another. For this it is important that, in respect of
advances above a certain limit, borrower-wise ratings are updated at quarterly / half-
yearly intervals. Migration Data within grading categories would provide useful insights
into the nature and composition of risk in a loan book.
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To manage credit risk, banks may consider

 Stipulating quantitative ceiling on aggregate exposure in specified rating categories, i.e.
certain percentage of total advances should be in the rating category of 1 to 2 or 1 to 3,
2 to 4 or 4 to 5, etc.;
 Periodically evaluate the rating-wise distribution of borrowers in various industry,
business segments, etc., and evaluate the exposure to one industry/sector on the basis
of overall rating distribution of borrowers in the sector/group. This will help the bank
to take informed view on concentration by industry group. Also wherever a particular
industry is performing poorly bank should consider increasing due diligence and
quality standards for that specific industry;
 Targeting rating-wise volume of loans, defaults and provisioning requirements and
contain the actuals within the budget. If actual numbers show deviation/s from the
expected parameters, bank should consider restructuring of the portfolio.
 Undertaking rapid portfolio reviews, stress tests and scenario analysis when external
environment such as volatility in the forex market, economic sanctions, fiscal/monetary
policies, market risk, liquidity conditions, etc. undergo changes. The stress tests would
reveal undetected areas of potential credit risk exposure and linkages between different
categories of risk. It is possible that, there may be substantial correlation of various
risks, especially credit and market risks. The stress test results should be reviewed by
the Board and suitable changes made in prudential risk limits for protecting the quality.
Stress tests could also include contingency plans, detailing management responses to
stressful situations.
 introduce discriminatory time schedules for renewal of borrower limits. Lower rated
borrowers whose financials show signs of problems should be subjected to renewal
control twice or thrice an year.
Banks should evolve suitable framework for monitoring the market risks especially forex
risk exposure of corporates who have no natural hedges on a regular basis.
Banks may also use credit risk models which offer framework for examining credit risk
exposures, across geographical locations and product lines in a timely manner, centralising
data and analysing marginal and absolute contributions to risk. The models also provide
estimates of credit risk (unexpected loss) which reflect individual portfolio composition.
The Altman’s Z Score forecasts the probability of a company entering bankruptcy within a
12-month period. The model combines five financial ratios using reported accounting
information and equity values to produce an objective measure of borrower’s financial
health.
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5.6 Loan Review Mechanism (LRM)
Banks should use LRM which is an effective tool for constantly evaluating the quality of
loan book and to bring about qualitative improvements in credit administration. The main
objectives of LRM could be:
 to identify promptly loans which develop credit weaknesses and initiate timely
corrective action;
 to evaluate portfolio quality and isolate potential problem areas;
 to provide information for determining adequacy of loan loss provision;
 to assess the adequacy of and adherence to, loan policies and procedures, and to
monitor compliance with relevant laws and regulations; and
 to provide top management with information on credit administration, including credit
sanction process, risk evaluation and post-sanction follow-up.
Accurate and timely credit grading is one of the basic components of an effective LRM.
Credit grading involves assessment of credit quality, identification of problem loans, and
assignment of risk ratings. A proper Credit Grading System should support evaluating the
portfolio quality and establishing loan loss provisions. Given the importance and subjective
nature of credit rating, the credit ratings awarded by Credit Administration Department
should be subjected to review by Loan Review Officers who are independent of loan
administration.
Loan Reviews are designed to provide feedback on effectiveness of credit sanction and to
identify incipient deterioration in portfolio quality. Normally, Reviews of high value loans
should be undertaken within three months of sanction/renewal or more frequently when
factors indicate a potential for deterioration in the credit quality. The scope of the review
should cover all loans above a cut-off limit. In addition, banks should also target other
accounts that present elevated risk characteristics. At least 30-40% of the portfolio should
be subjected to LRM in a year to provide reasonable assurance that all the major credit
risks embedded in the balance sheet have been tracked.
The loan reviews should focus on:

 Approval process;
 Accuracy and timeliness of credit ratings assigned by loan officers;
 Adherence to internal policies and procedures, and applicable laws / regulations;
 Compliance with loan covenants;
 Post-sanction follow-up;
 Sufficiency of loan documentation;
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 Portfolio quality; and

 Recommendations for improving portfolio quality
The findings of Reviews should be discussed with line Managers and the corrective actions
should be elicited for all deficiencies. Deficiencies that remain unresolved should be
reported to top management.
5. Understanding credit risk management
The concept of credit risk management and the associated terms such as risk horizon,
rating migration, recovery rates, expected & unexpected loss and economic capital, which
find repeated mention in the RBI guidelines, can be better understood by means of an
example.
Given below is a case of a two-asset portfolio. This will help explain risk management.
Bank name “ No Risk Bank (NRB)”. As at the end of year it had a loan book with two loan
assets of borrower ABC Company and XYZ Company.
Client Industry/ Principal Interest Rte Residual Type of

Name Amount O/S (%) Maturity loan
sector
(Rs. Crores)
ABC Automobile 20.00 10.20% 3 years Secured
XYZ Textiles 10.00 10.50% 4 years Secured
Following detail are given.

a. Interest payment is half yearly with a bullet principal payment at the end of
3rd year and 4th year. Loans are floating rate linked to MCLR.
b. NRB wants to assess credit risk of its loan asset portfolio over a one-year risk
horizon i.e. estimate the probable credit loss behaviour of its existing loan
portfolio over the next 365 days.
c. Its internal credit rating scales are five starting from No risk (A) to Default
(E).
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Of the two assets NRB, ABC had “D” rating and XYZ had “C” rating. It is observed that the
credit rating of both the clients have moved (migrated) downwards from the initial rating
“B” given about two years back. As at the end of year it is observed that both companies are
closer to default rating (F). Now, the critical issue is will the clients default (migrate to
rating F) in the next one year? What are the chances?
NRB uses rating migration data of the past to estimate the probability of its borrowers
defaulting during the year. The rating migration matrix indicates the probability assets in
various risk rating scale migrating to default. The migration matrix of NRB for the current
year is given below.
Rating migration matrix (one year risk horizon)
Current Rating A B C D E
Probability of moving 0% 1% 5% 10% 16%
to Default (F)
From the migration matrix it can be inferred that there is no chance of “A” slipping into
default while there is 15% chance that “E” will slip into default. Based on this it can be said
that there is a 10% probability that ABC company could slip into default and 5%
probability that XYZ will slip into default.
In the event of default bank will have to depend on collateral for making recovery. Better
the quality of the collateral and collateral efficiency, higher will be the recovery. The
measure of extent of recovery from collateral is called the recovery rate. Generally, a fully
secured loan will exhibit a higher recovery rate than an unsecured loan. Based on past
behaviour (5 years), NRB has arrived at the following recovery rates.
Recovery Rates
Recovery Rate
Type of Loan Mean Standard Deviation
Secured Loan 45% 25%
Unsecured Loan 5% 15%
It must be added here that despite same quality of security the recovery rate can vary on a
case by case basis. This is on account of reasons such as demand for a particular security at
a particular point of time, legal processes if any etc. These aspects cannot be factored as
data on the same may not be consistent. It is for this reason that recovery rates are
captured in terms of mean and standard deviation. “Mean” indicates what can be expected,
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the variance while “standard deviation” gives the possibility of unexpected. In the case of
NRB the mean recovery rate from a secured loan is estimated to be 45% of the value of loan
in case of no default with a standard deviation of 25%.
Let’s now attempt to quantify the credit risk of its two-asset loan portfolio starting with the
estimation of the value of loan assets at the risk horizon (one year).
The value of the loan (consider loan to client ABC and XYZ ) can be studied in terms of :
 The value of loan in both non-default and default positions

 Probability of the loan migrating to default position
The value of loan in non-default state could be determined by discounting all the stipulated
cash flows. The discount rate would be the ROI stipulated for the account.
Loan asset ABC has a residual maturity of 3 years which means 6 half yearly interest
payment inflows and one final payment at the end of 3rd year. The cash flow will be as
under
ABC loan (Non-default) cash flow position

(Rs. crores)
No. of Interest Principal Discount Rate
half Payment Payment
years
1 1.02 - 10.2% Within risk
2 1.02 - Horizon i.e. one Year
3 1.02 -
4 1.02 - Beyond risk
5 1.02 - horizon
6 1.02 20.0
The value of Loan will be Rs 20 crore as the ROI is floating and it is presumed that there are
no credit rating changes. This is as per historical costing the way banks balance sheet is
made and not time adjusted. Thus, the value of the loan in non-default state will be Rs.20
crores.
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Similar to the above in the case of XYZ there will be there will be 8 half yearly interest
payments of Rs 0.525 Crore (two in the risk horizon) and the final repayment will be Rs 10
Crore.
The value of loan in default state is a function of the recovery rate. Since the mean recovery
rate for a secured loan is 45%, the value of loan under default would be Rs.9 crores (45% of
Rs.20 crores). Combining the two we have:
Value of loan ABC for risk estimates

(Rs. crores)
Loan A with current Non default Status Default Status

Rating of D
Value of loan (a) 20 9@
Probability (b) 90% 10%
Expected value (a *b) 18.0 0.90
Total Expected Value 18.0 + 0.90 = 18.90
Expected Loss 20.0 – 18.90 = 1.10.
@ value of loan * recovery rate
Based on migration rating matrix loan ABC has a 9% probability of default the expected
value of the loan at the risk horizon is Rs.18.90 crores which is Rs.1.10 crores less than the
value of loan in non-default state (Rs.20 crores). This difference between the value of loan
in non-default state and the expected value at risk horizon is termed as the expected loss.
Value of XYZ will be as under.

Loan A with current Non default Status Default Status
Rating of C
Value of loan (a) 10 4.5@
Probability (b) 95% 5%
Expected value (a *b) 9.5 0.225
Total Expected Value 9.5 + 0.225 = 9.725
Expected Loss 10 - 9.725 = 0.0275
Expected loss is the average credit loss that the bank can expect from portfolio of assets
over a period of time. The expected loss of portfolio is the summation of expected loss of
its assets. For the portfolio of NRB:
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(Rs. crores)
NRB portfolio Non-default value Expected value Expected loss
Loan ABC 20.00 18.90 1.10
Loan XYZ 10.00 9.725 0.275
Total 30.00 28.625 1.375
The expected loss for the NRB loan portfolio is Rs.1.375 crores. Expected loss is a measure
of the loan loss provisioning that the bank will have to make for managing the risk. Given
this expected loss is critical to risk pricing or loan pricing in a scientific manner using the
RAROC framework. Loans should be priced in such a way that the bank will have to cover
the expected loss over the risk horizon.
We have seen expected loss above. Another aspect of study is “unexpected loss”. As
explained, expected loss is the average loss that the bank can expect over a period of time.
This is estimated and can vary during the period for which the estimate is made. Such
fluctuation could happen on account of some of the parameters such as probabilities given
in the migration matrix, recovery rate or credit rating of assets varying during the period
and impacting the credit risk. Unexpected loss is the measure of this fluctuation/variance
in credit risk losses.
Let’s try and measure the unexpected loss from the portfolio so that NRB can (a) take
timely risk mitigating actions and (b) allocate sufficient capital (economic capital) to cover
the unexpected loss and prevent insolvency.
The unexpected loss of the portfolio is the function of the variation in the value of loan
assets in the portfolio at the risk horizon. Take the case of ABC Loan. The expected value of
the loan at the risk horizon is Rs.18.90 crores. This is the average value. Due to
uncertainty in the value of the recovery rate (measured by the standard deviation of
recovery rates) the loan value at the risk horizon has an uncertain portion. Since the
standard deviation of recovery rate of a secured loan is 25% the corresponding uncertain
portion of loan value of ABC is Rs.5 crores (25% of Rs.20 crores). This uncertain portion is
the primary contributor to the fluctuation in credit risk loss from the average and is
quantified using the standard deviation formula.
Loan Expected Loss Un expected Loss

Loan ABC 1.10 3.66
Loan XYZ 0.275 1.32
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It is worth noting that, though the value of loan ABC is only two times that of loan XYZ, the
unexpected loss could be three times. This is due to the lower credit rating of ABC.
Unexpected Loss (UL) calculation is illustrated as follows:
UL  LE  EDF   LGD
2
 LGD 2   EAD
2
Where,
LE = Loss Exposure
EDF = Expected Default Frequency
 LGD
2
= Variance of LGD
 EAD
2
= Variance of EAD
Loan ABC Loan XYZ

LE 20 10
EDF 10% 5%
Var (LGD) 0.0625 0.0625
LGD 55% 55%
Var(EDF) 9.0% 4.8%
UL (%) 18.30% 13.23%

UL 3.66 1.32
The standard deviation of the portfolio value is a measure of the unexpected credit loss
from a loan portfolio. Unexpected loss is assumed to be a ‘certain multiple’ of the standard
deviation of portfolio value. Banks are expected to allocate capital (known as economic
capital) to provide cushion for the portfolio unexpected loss. Generally the economic
capital is the same as the portfolio unexpected loss. The expected and unexpected losses
together capture (and help quantify) the credit risk of a portfolio of loan assets.
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Chapter 6: Credit Risk and Rating
Dr Richa Verma Bajaj
Objective
The objective of this chapter is to introduce the concept of credit risk and rating to readers.
Structure:
1. Introduction
2. NPAs Vs Credit Risk
3. Organizational Structure for Credit Risk Management
4. Ways to manage risk in Credit Portfolio
5. Components of Credit Risk
6. 1.6Identification and Assessment of Credit Risk
7. Is Credit Rating reflection of Credit Risk?
8. Rating Models
9. Regulatory Requirements
10. End Use of Rating
11. Credit Scoring Model for a Retail Credit
12. Parameters for Corporate Credit Risk Assessment Rating
13. Summary
1. Introduction
The principal activity of a bank is extending credit in the form of loans and advances. Credit
is said to perform efficiently if the fund is utilized for the intended purposes and when the
repayments are regular, and as per agreed terms. But this may not always be the case
because delay or default in repayment could happen for a number of genuine reasons.
There could be willful defaults as well. As such credit risk has been in existence since banks
came into being. It is the major risk to which the banks are exposed to. Loans are contracts
where the borrowers promise fixed repayments at regular interval in future. Credit risk
occurs when an expected repayment does not happen on the due date. It is nothing but
Page 1 of 25
default risk, resulting from the borrower’s failure to repay the bank dues consisting of
principal, interest, etc., in accordance with the agreed terms. In a bank’s portfolio, losses
could stem from default due to inability or unwillingness of a customer or counterparty to
meet commitments in relation to lending, trading, settlement and other financial
transactions. It is this possibility that bank tries to avoid by careful choice of customer
through calibrated appraisal. Aspects that are appraised before a loan is sanctioned include
capacity to pay and willingness to pay. In respect of a client who has some relationship with
banks or financial institutions, it is possible for a banker to judge the borrowers
willingness to pay through his past repayment history. But the same would be very
difficult for a new account. The ability of a borrower to pay is judged on the basis of the
information available in its (company’s) annual reports. This information is then fed into
the rating assessment sheet which helps the bank to arrive at a credit score or credit rating
of the applicant on which decision to lend or not to lend is based. This chapter focuses on
credit risk identification and assessment of credit risk by internal and external rating and
score cards. It is important at this point to understand risk management.
2. NPAs Vs Credit Risk

NPAs are ex-post, whereas risk is ex-ante. For reducing the level of rising NPAs in the
system, it is very important for banks to have proactive measures in place by setting up
strong credit risk management system. As the existing framework of tracking the Non-
Performing Loans around the balance sheet date does not signal the quality of the entire
loan book, banks should evolve proper systems for identification of credit weaknesses and
tackling the same well in advance. It is for this reason that banks adopt various portfolio
management techniques for gauging asset quality. They use many risk assessment models.
The credit risk models that have received global acceptance as benchmarks for measuring
stand-alone as well as portfolio credit risk are: Altman’s Z Score Model, Merton Model, KMV
Credit Monitor Model, Credit Metrics, Credit Risk+ and McKinsey Credit Portfolio View.
It is imperative that banks must have a robust credit risk management system which is
sensitive and responsive. The effective management of credit risk is a critical component of
comprehensive risk management and is essential for the long term viability of any banking
organization. Credit Risk Management encompasses a host of management techniques,
such as Credit Approving Mechanisms, Prudential Limits, Risk Rating, Risk Pricing,
Portfolio Management and Loan Review Mechanism.
Loan Review Mechanism (LRM) is an effective tool for constantly evaluating the quality of
loan book and to bring about qualitative improvements in credit administration and reduce
the level of NPAs. As there is strong linkage between credit management and credit risk
management activities of a bank.
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3. Organizational Structure for Credit Risk Management

A sound organizational structure is sine qua non for successful implementation of an
effective credit risk management system. The ‘Organizational Structure’ for credit risk
management as envisaged by RBI is depicted below:
Typical Organizational Structure for Credit Risk Management
Source- www.rbi.org.in
To manage credit risk properly, banks need to have in place an effective Credit Risk
Management Framework capable of identifying, measuring and managing credit risk. The
quest is for methods of credit risk measurement to make the transition from
subjective/qualitative based measurement to objective/quantitative based measurements
so as to improve the methods of pricing credit risk correctly and manage risk properly. The
Page 3 of 25
rising trend of fresh NPAs in India emphasizes this need (figure below). In recent years,
rising NPA levels have affected banks’ profitability and resulted in the decline of bank’s
capital adequacy ratio.
(Fresh accretion of NPAs during the year/Total standard assets at the beginning of the
year)*100
4. Ways to manage risk in Credit Portfolio

Banks have over the years learnt to manage credit risk. There exist a good appraisal and
due diligence system and collateral norms. Yet risk seems to grow unabated. The regulator
has therefore suggested.
 Approval Grid or Committee Approach: It has been suggested that each bank should
have a carefully formulated scheme of delegation of powers. The banks should also
evolve multi-tier credit approving system where the loan proposals are approved by an
‘Approval Grid’ or a ‘Committee’. Credit facilities above a specified limit may be
approved by the ‘Grid’ or ‘Committee’, comprising at least 3 or 4 officers and invariably
one officer should represent the Credit Risk Management Department (CRMD), who has
no volume and profit targets. Banks can also consider credit approving committees at
various operating levels i.e. large branches (where considered necessary), Regional
Offices, Zonal Offices, Head Offices, etc. Banks could consider delegating powers for
sanction of higher limits to the ‘Approval Grid’ or the ‘Committee’ for better
rated/quality customers.
 Setting of Prudential Limits: In order to limit the magnitude of credit risk, prudential
limits should be laid down on various aspects of credit, relating to various sectors or
Industry.
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 Risk Scoring or Rating System: Banks should have a comprehensive risk

scoring/rating system that serves as a single point indicator of diverse risk factors of
counterparty and for taking credit decisions in a consistent manner. To facilitate this, a
substantial degree of standardization is required in ratings across borrowers. The risk
rating system should be designed to reveal the overall risk of lending, critical input for
setting pricing and non-price terms of loans as also present meaningful information for
review and management of loan portfolio.
 Risk-return pricing Framework: RAROC or Risk Adjusted Return on Capital, is a
fundamental tenet of risk management. In a risk-return setting, borrowers with weak
financial position and hence placed in high credit risk category should be priced high.
Thus, banks should evolve scientific systems to price the credit risk, which should have
a bearing on the expected probability of default.
5. Components of Credit Risk

Broadly, credit risk is made up of Transaction risk and portfolio risk. Experience suggests
that rising NPAs (high credit risk) is the main risk to a bank’s earnings or capital base.
Default was traditionally managed through collaterals, covenants and proper selection of
obligors. Evidently there are situation where in collateral and other means fail to deliver. In
view of this and increasing NPAs, there has been substantial surge in interest in credit risk
management in the past decade or so. The reasons behind these are:
• Changing Profile of Banks Credit Portfolio

- Rising NPAs Level
- Concentration in Loan Portfolio
• Changing Regulatory Environment: (Basel Advanced approaches align regulatory
capital with economics capital i.e. risk based capital requirement)
• Expectation from shareholders to increase economic value: Risk Management
should focus on risk adjusted return on capital and Economic Value-Added Methods
6. Identification and Assessment of Credit Risk

In extending credit the banks have to make judgments about a borrower’s
creditworthiness. Credit risk arises when this creditworthiness gets change overtime.
Banks follow-up for the payments with the customer and more often end up in receiving
less than the amount that is due, resulting from deterioration in borrower credit quality.
The credit risk of a bank’s portfolio depends on various external and internal factors. The
external factors are the state of the economy, business uncertainty of borrowers,
instability in the business environment, wide swings in commodity/equity prices, foreign
exchange rates and interest rates, poor legal support for debt recovery, trade restrictions,
financial constraints, economic sanctions, Government policies, natural disasters etc. The
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internal factors are deficiencies in loan policies/administration, absence of prudential

credit concentration limits, inadequately defined lending limits for loan officers/credit
committees, deficiencies in appraisal of borrowers’ financial position, excessive
dependence on collaterals and inadequate risk pricing, absence of loan review mechanism
and post sanction surveillance, infrequent customer contact, failure to control and audit the
credit process effectively etc. These deficiencies will lead to loan portfolio weaknesses,
including over concentration of loans in one industry or sector, large portfolios of non-
performing loan and credit losses. These may further lead to liquidity and ultimately
insolvency. Thus, there is need for strong appraisal or assessment of a credit. The extent of
uncertainty from external and internal factors in bank’s credit portfolio from various
factors can be captured through rating.
Rating is an opinion of a banker on the inherent credit quality of a company and/or the
credit instrument. It judges the financial ability of an organization to honor payments of
principal and/or interest on a debt instrument, as and when they are due in future. It
indicates risk (default risk and recovery risk) associated with a credit exposure. Credit
rating is a forward looking process. It is about using observable information to predict
future outcomes of the credit granted. Credit Rating Framework in every bank is important
to avoid simplistic classification of loan into good or bad category.
Rating framework in the banks have evolved over the years from expert opinion
(judgment) based to statistical analysis based. Statistical models are credit scoring/rating
models for corporate and retail exposure. Some of these models are Altman Z score, models
based on equity data, discriminant analysis based rating etc., to mention a few. Banks have
started using these models for credit pricing.
7. Is Credit Rating reflection of Credit Risk?

Credit risk is the possibility of future credit loss. Losses in the credit portfolio of the banks
arise from reduction in portfolio value from actual and perceived deterioration in credit
quality due to unexpected changes. The probable unexpected changes in the credit quality of
borrower could be: diminution in the value of the assets (collateral) supporting the credit
exposure, diminution in the credit quality of the borrower or guarantor, changes in the
business climate such as deteriorating terms of trade, rising inflation, weaker exchange
rates or increased competition, which results in poor operational performance. Credit
rating is one measure which can be used to evaluate the risks in lending. The experience
(Figure below) suggest that borrower/obligor with low rating or low cash generation
capacity have high probability of non-repayment to bank and thus, higher credit risk.
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Credit rating is indicated in symbols ranging from AAA to CCC - C and D. Triple A (AAA) is
the highest rating indicating best credit or almost nil default and D shows default. The chart
above from Standard and poor shows the efficacy of rating in as much as the actual default
by AAA has been less than 10% in the three decades ending 2012. The default in the case of
others increases at an increasing rate as the rating grade deteriorates. Even as this shows
the importance of rating it also shows that even AAA rated instrument or borrower could
default. Evidently low rating grades are risky for the banks, though, depends upon industry
specific fundamentals. The chart also shows that default is more pronounced in the longer
end. We will discuss the characteristic features of rating later in this chapter. It should be
however said here that rating is not permanent for the entire period of bond or borrowing
as the rating agency will keep on reviewing the rating and downgrade it wherever needed.
8. Rating Models
8.1. One Dimensional Rating Model
Traditionally, the rating assessment was done considering 5 C’s of credit and these 5 C’s
were factored into banks internal rating model under five heads (as given in Table I). This
is called as one dimensional rating model, as collateral is a part of obligor’s rating model.
Page 7 of 25
Table I: One Dimensional Rating Model: Traditional Rating Methodology
5 C’s of Credit What it tells- Aspect

Assessed
Idiosyncratic/Borrower Character Management and attitude
specific/Internal/Controllable Capital towards credit
Factors Capacity Financial
Collateral strength/Operational
Efficiency
Efficiency of Business/
obligor
Collateral/Adequacy in case
of default
Systematic/External/Uncontrollable Condition Industrial performance
Factors
The main emphasis of this model is on collateral and capital. As such for new units and
green field ventures the model was inadequate.
8.2 Two-Dimensional Rating Model

Today, it is important for the banks to have in place two-dimensional internal rating system
for credit assessment, which focuses on mutually exclusive assessment of obligor and
facility. Thus, decision to lend or not to lend would depend on composite rating as shown
below in Table II and accordingly pricing/interest rate charges varies.
Table II: Two-Dimensional Rating Model

Obligor Rating is Obligor Rating is Bank will have to
Good Credit Good Good depend on repayment
Quality Facility Rating is Facility Rating is capacity of the
borrower
Strong Weak
Obligor Rating is Obligor Rating is Bank should In case

Bank will have Poor Poor of existing loan-
to depend on Chose EXIT
Facility Rating is Facility Rating is
good
performance of Strong Weak New loans - Avoid
the facility
Page 8 of 25
8.2.1. Parameters considered under Obligor Rating

Once the rating is done and it can be presented in terms of 2*2 matrix as above it is easy to
decide. The ratings Good, Poor and Strong and Weak are not based on a single factor but
the result of a number of factors about the obligor and facility.
In the absence of publicly available information on the quality of the borrower, the bank
will have to assemble information from private sources like credit and deposit files and
possibly purchase of information from credit rating agencies (external sources). This
information helps a manager in making an informed judgment on the probability of default
of the borrower and pricing of loan correctly. The banker’s credit decision is based upon
the following:
i. Borrower-specific Factors, which are idiosyncratic to the individual

borrowers. The commonly used borrower specific factors are:
Borrower Specific Factors Impact on Rating & Banker’s
Assessment
Reputation for prompt and timely repayment Positive
Large amount of Debt (Leverage) Negative. Possibility of default
Highly volatile earnings Negative Possibility of default and
delinquency
Sufficient collateral or assets backing the loan Positive
ii. Market Specific Factors, which have an impact on all borrowers at the time of
the credit decision. The commonly used market specific factors are:
Market Specific Factors Impact on Rating &

Banker’s Assessment
Business Cycle (Recession) Negative
Level of Interest Rates (High) Negative
Favorable Government Policy Positive
Better Industry Profitability Positive
The bank will weigh these factors objectively to come to an overall obligor rating and credit
decision. Because of certain subjectivity involved in these models, they are often called as
Expert systems.
Page 9 of 25
8.2.2. Facility Rating

Each credit must be supported by appropriate collateral. A poor credit can be mitigated
through high quality / liquid security. Financial and cash collaterals provides more comfort
to the lenders than any physical collateral. Higher the risk, greater the security required –
in quantity and quality to provide comfort to lenders. For unsecured credits, the facility
rating will be based on net worth of the obligor, the proportion of total funded debt by
senior unsecured debt, the level of subordination of the debt. For secured credits, the
presence of collateral and its quality and depth heavily affect the severity of facility rating.
The impact of various factors (Illustrative) on recovery rates are highlighted as below:
Factors Expected Impact on Recovery Caution points
Security/Collateral Secured : Positive Collateral value could
Value Unsecured : Negative fluctuate with economic
conditions
Seniority of the Senior Loan : Positive
Claim Subordinate -Negative
Safety, value and Physical Assets : Positive+ Assets will depreciate
existence of assets Higher Market Value Compared Age of marketable asset
to Book Value : Positive is important
Better Quality Assets: Positive+
Tangibility: Positive+
Earning: Positive+
Better Capacity Utilization :
Positive
Industry Utility industry: Positive Cash flow intensive
Characteristics Service (except high-tech and
telecom) :Positive - Could suffer from poor
collection
Macroeconomic GDP Growth : Positive+ Collateral such as real
conditions estate, shares and bonds
are more affected if GDP
growth is poor
Impact of Business Default Environment: Negative- Recession
Cycle
8.3. Composite Rating
Bank takes into the assessment of borrower on obligor and facility rating grade and arrives
at a composite rating. For this it will assign some number or mark to each of the issue that
Page 10 of 25
are listed in the tables above. The composite ratings give a better estimate of risk in
particular credit. The obligor with ‘Good’ obligor rating and ‘Strong’ facility risk rating will
be among the best customers of the bank. In contrast, borrower with ‘Poor’ rating at
obligor rating grade and ‘Weak’ facility rating grade are among the riskiest customers of
the bank. At this level, it is better for the bank to exit from existing account and avoid
accepting proposal in the case of new account. Following, is illustrative composite risk
rating matrix. It differentiates borrower with ‘1’ rating from borrower with ‘8’ rating and
accordingly price the customer separately depending on their rating and risk profile.
Composite Risk Rating Matrix
Facility Rating
Borrower A B C D E F
Rating Excelle Superi Above Avera Below Wea
nt or Average ge Average k
1- Minimal Risk 1 1 1 1 2 3
2 – Modest Risk 1 1 1 2 3 4
3 – Average 1 2 2 3 4 5
Risk
4 – Acceptable 2 2 3 4 5 6
Risk
5- Manageable 2 3 4 5 6 7
Risk
6- Watch 3 4 5 6 7 8
9. Regulatory Requirements
As per Basel norms, a bank must have a credible track record in the use of internal ratings
information. Accordingly banks are expected to develop their own internal risk estimates
of key parameters i.e. Probability of Default (PD) and Loss Given Default (LGD). A qualifying
Internal Risk Based (IRB) rating system must have two separate and distinct dimensions:
(i) the risk of borrower default (obligor rating), and (ii) transaction-specific factors (facility
rating). The transaction-specific factors are collateral, seniority, product type, etc. The
facility rating is based on the estimate of the expected loss for each facility and is calculated
as the product of PD indicated by obligor rating and LGD (and the usage in the event of
default for loan commitments) by facility rating. Recovery rate is simply 1-LGD. This rating
Page 11 of 25
can be expressed on a scale, say, 1-9, with each rating being mapped to a LGD bucket, say 0-
1%, 1-5%, 5-10% etc.
10. End Use of Rating

The purpose or objective of rating is that it should help in making good credit decisions and
as a result the credit portfolio should be very good. Rating helps in
• Individual Credit Selection: To accept or reject a particular credit
• Portfolio Level Analysis – To decide on how much concentration in particular rating
grades or industries – Correlation (within and across)
• Monitoring of loan portfolio: through migration analysis
• Aggregating the risk profile of bank – Expected losses (Provision) and Unexpected
Losses (Economic Capital)
• Loan Pricing: Risk adjusted performance measurement
11. Credit Scoring Model for Retail Credit
We have, in the foregoing, seen the use of rating in credit decisions and risk management.
Rating or credit score is arrived on the basis of number of variables. Scoring Models take
into account all the information known about a customer or applicant at the point of
application or behavior (relationship with the Bank). Thus, scoring models are categorized
on the basis of
- information from the application form,
- information from a credit bureau (if it exists),
- for existing customers applying for additional product, information about the way in
which the applicant has run his or her other accounts
Scoring models are of two types. Each is explained below:
(i) Application Scoring Systems
(ii) Behavioral Scoring Systems
11.1 Application Scoring Systems

It is considered as a means of assessing risk at the point of application for credit. The
features of application scoring system are:
- Usually applied at loan origination and initial sanction.
- Relies heavily on external data
- Used for credit risk determination, loan amount approval, limit setting, terms of
payment, pricing decision etc.
Typical fields used in application scorecard development are:
- Age
- Sex
- Educational Qualification
- Marital Status
- Residential Status (Home owner, living with parents etc.)
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- Length of time at current address

- Industry in which applicant works
- Job Position (eg, director, manager, team leader, team worker, etc.)
- Length of time in current job
- Current banking product holdings; and
- Length of time bank account held
11.2. Behavioral Scoring Systems

It assesses risk for existing customers through internal behavioral data. The features of
behavioral scoring models are:
- Enables the credit analysts to quickly and accurately evaluate the future payment
behavior of customer.
- Based on 3-4 years detailed customer attributes.
- Used for limit increase, renewals, reviews, cross selling, fraud detection etc.
Behavioural Scorecards data includes:
- Balance data
- Credit limit information (generally only including agreed limit, as the other limits
are beyond the customer control)
- Utilization information
- Transactions
Parameters for Housing Loan Portfolio are (Illustrative)
•Age
Personal details •Edcuational QUalification
•Marital Status
•Dependants
•- Percentage of Financing by Individual

Financial Details •Level of Income
•- Other Assets
•- Employment status
Employment Details •- Gross Monthly Income
•- No. of Years in Current Employment
•Designation
•Collateral
Security •Guarantor
Page 13 of 25
Important Indicators for a Retail Credit Scoring Models
Demographic Financial Indicators Employment Behavioral Indicators

Indicators Indicators
Age of Borrower Total Assets of the Type of Loans Outstanding

Marital Status of borrower Employment Credit Track Record -
Borrower Gross Income of the Designation Loan Defaulted or
Number of borrower Length of the delinquent
Dependents Gross Income of the current Service Number of Payments
Home Status Household Number of per year
Monthly Expenses of employments over Collateral/guarantee
Household the last few years Years of Banking
Ratios
- Loan to Value
Ratio
12. Parameters for Corporate Credit Risk Assessment Rating (Illustrative)
Corporates are risk rated on the basis of (a) business indicators (b) industry features and
performance (c) management quality, performance, and issues, (d) financial performance
and factors, (e) cash flow. Simultaneously facility rating is also made. In case of existing
borrowers compliance to sanction terms is also assessed. The details of items to be
considered in these issues are given in the following tables. The tables also show the
maximum and minimum score for each item. Finally all these scores are added up and the
score of the applicant or unit is compared with the risk rating range and threshold score
prescribed by the bank. (See table risk rating ranges). If the score is more than acceptable
level then the proposal is taken up for further scrutiny and eventually sanction of credit
facility.
In addition banks may also use external credit score or rating to reinforce their analysis
and finding.
A. Assessment of Business Risk
While the industry risk embodied in an exposure may be the same across all borrowers in
that industry, different borrowers in the same industry are in a position to hedge this risk
differently. The capacity of these units in mitigating the industry risks is measured by the
business risk assessment. The parameters selected for this purpose are the following:
Page 14 of 25
Risk Parameter Narration Remarks Score Score

Prescribed Obtained
Capacity Utilization: Good If the capacity utilization is more 2
Indicates the utilization than 90%
of the capacity Average Where capacity utilization is 1
between 50% - 90%
Poor Where capacity utilization is less 0
than 50%
Product Mix: Refers to Good Where the number of products 2
the number of products manufactured are 5 or more
manufactured or traded Average Where the number of products 1
in manufactured are more than 1
but less than 5
Poor Where only one product is 0
manufactured
Diversification among High Where the number of Buyers is 2
different consumer more than 5
segments/geographical Moderate Where the number of buyers is 1
spread more than 1 but less than 5
Low Where there is a single buyer 0
Adaptation to Good Where appropriate technology 2
Technology in and adequate measure of quality
changing environment control are in place
Average Where technology is proven with 1
no changes expected in the near
future
Satisfactory Outdated technology or 0
technology subjected to
obsolescence
Consistency in Quality Good The record of the company in 2
maintaining the quality of its
product is excellent. Sales
Rejections on account of poor
quality are almost non-existant
Average The record of the company in 1
maintaining the quality of its
products is good. There are only a
few cases of sales rejections.
There is no ISO certification
Page 15 of 25
Poor There is no consistency in quality 0

and there is no anxiety on the
part of management to rectify the
situation. Sales rejection on
account of poor quality are
common. There is no ISO
certification.
Distribution Network Good The company have adequate 2
distribution network for
marketing and sale of its product
Average The company have small 1
distribution network for
marketing and sale of its product
Poor A feeble distribution structure/no 0
structure of its own and sales
show a declining trend
B. Assessment of Industry Risk

The industry risk is assessed on the basis of current trends in industry, its overall
perception and future outlook.
Risk Narration Remarks Score Score

Parameter Prescribed Obtained
Competitive Excellent Turnover growth higher than the industry 3
Situation growth for the company
Good Turnover growth at par with the industry 2
growth
Neutral Static turnover growth in the company in 1
view of recession in the market
Unfavourable It would be difficult for the company to 0
compete in view of the declining turnover
growth
Regulatory Excellent Business Operations remain unaffected by 3
Risk Regulatory Risk
Good Effect of Regulatory Risk can be contained 2
Neutral Delicately balanced, Business Operations 1
can be affected if immediate steps not
taken
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Unfavourable Unable to cope with the situation 0

Industry Excellent Long term prospects of industry are 3
Outlook excellent
Good Outlook stable except for some critical 2
factors
Neutral Susceptible to unfavorable changes in the 1
economy
Unfavourable Industry in declining phase 0
Cyclicality of Excellent Not affected by cyclical fluctuations 2
Industry Good Favorable Industry cycle with long term 1
prospects
Unfavourable Susceptible to unfavourable changes in the 0
industry
Inputs/Raw High The availability, quality of key inputs/raw 2
Material Moderate materials have bearing on the quality and 1
availability Low price of final product/services. Consider 0
the following:
- Continuous availability of quality
input/raw materials
- Availability of substitutes for
input/raw materials
- Affordability of quality inputs/raw
material
Location Favourable Locational advantage might provide a 2
Issues Neutral borrower with a competitive advantage 1
Unfavourable vis-à-vis competitors like availability of 0
infrastructure, favourable government
policies, nearness to raw
materials/markets etc.
Market Good Assessment of the market/demand for the 2
Potential and Neutral product sold by the borrower in the area 1
Demand Unfavourable of operation. Compare Demand and Supply 0
Situation Scenario. Say supply more or less matches
demand, can be classified as ‘neutral’
scenario.
Page 17 of 25
C. Assessment of Management Risk
The quality of advance ultimately depends on the quality of management. Hence,

assessment of management risk is perhaps the most important area of risk assessment. The
bank has prescribed a set of value statements for various aspects of management risk.

Parameter Prescrib Obtained
ed
No. of Years of Very High; Where the borrower has an experience of 3
Experience in >5 years more than 5 years
Industry- High; Where the borrower has an experience of 2
Indicate the 2-5 years between 2- 5 years
Experience of Moderate; Where the borrower has an experience of 1
borrower in <2 years less than 2 years
that line of Absent; 0
activity 0 years
Management High The initiatives of the management to stay 2
Initiatives Moderate ahead of the competitors are a clear 1
Low indication of management quality. The 0
pointers are quality certification,
collaborations and marketing alliances,
awards etc.
Position of Increase Where the Net worth of the borrower 2
Net Worth- unit as on current Balance sheet date is
Indicate the greater than the net worth as on the
movement in previous Balance sheet date
net worth Stable Where the Net worth of the borrower 1
unit as on the current balance sheet date
is same as the net worth as on the
previous balance sheet date
Decrease Where the Net worth of the borrower 0
unit as on the current balance sheet date
is less than the net worth as on the
previous balance sheet date
Labour Excellent Where there have been no cases of 2
Relations – strike/lockouts since inception
Indicates Good Where there have been no cases of 1
Quality of strike/lockouts during the immediately
Management- preceding 2 years
Page 18 of 25
Labor Satisfactory Where there have been frequent cases of 0

Relations strikes and lockouts
Second Line Available Where second line is available 2
Management Not Where second line is not available 0
– Indicates Available
availability of
second line
management
Turnover of Rarely Where the key personnel has not changed 2
Key since last 5 years
Personnel – Occasionally Where the key personnel has not changed 1
Indicates the since last 2 years
retention of Frequently Where the key personnel has changed 0
key personnel during the year
Adherence to Honoured Consider the following to judge the 3
Financial on time payment of practices:
Discipline - Honoured Payment of Interest/Instalment, 2
Honouring but delayed Government dues like sales tax, creditors
Financial within velocity ratio
Commitments acceptable
on time period (say
10-15 days)
Honoured 1
but delayed
beyond
acceptable
period
(beyond 15
days)
Not 0
honoured
Team of Yes 2
Qualified
Professional
No 0
Page 19 of 25
D. Financial Risk (As per Last Audited Financial Statement)

Financial Risk is the risk apparent in the financial statements submitted by the borrower.
This risk can be quantitative which is measured using ratio analysis and qualitative which
is inherent in the off balance sheet liabilities and can be used in the auditors notes and
qualifications. A few select critical ratios have been identified for the purpose of calculating
the quantitative financial risk score.
Risk Parameter Range Remarks Score Score

Prescribed Obtained
TOL/TNW: TOL <1 The liability of the borrower should be 5
= Total Liabilities <2=>1 matched with the promoter’s stake. A 4
– Net Worth <3=>2 lower ratio indicates lower borrowing vis- 3
TNW= Net <4=>3 s-vis the tangible worth. Further, 2
Worth-Intangible <5=>4 investments in sister concerns, wherever 1
assets =>5 such investments do not generate any 0
business to the borrower account should
also be deducted from TNW for the
purpose of arriving at this ratio.
Interest =>3.5 Measures firm’s ability to pay interest. 5
Coverage Ratio: <3.5=>3.0 The servicing of loan obligation capacity 4
PBDIT/Interest, <3.0=>2.5 of the borrower is very crucial. This also 3
Here, interest <2.5=>2.0 indicates the number of times the gross 2
includes interest <2=>1.5 earnings cover the interest payable and is 1
paid on both term <1.5=>1.0 indicator of the measure of comfort 0
loans and <1.0 provided by the cash accruals from the -2
working capital operations
PAT/Net Sales =>9 This ratio reflects the ultimate accretion 5
(%) <9=>7 to the Net Worth of the borrower and is 4
<7=>5 an overall reflection of the profitability 3
<5=>3 2
<3=>1 1
<1 0
Return on =>8 This ratio is the measure of net profit on 5
Tangible Net <8=>7 the promoter’s stake. 4
Worth: <7=>6 3
Profit/TNW <6=>5 2
<5=>4 1
<4 0
ROCE: Net Profit 15% and This ratio is a measure of gross earnings 4
Page 20 of 25
after Tax/Total above which the assets in the business yields

Assets (%) 12% and 3
above
10% and 2
above
7% and 1
above
Less than 7% 0
Current Ratio =>1.33 Indicator of Liquidity. CR below 1 is 5
<1.33=>1.27 considered critical because it reflects the 4
<1.27=>1.22 non-availability of drawing power. 3
<1.22=>1.17 2
<1.17=>1.10 1
<1.10=>1.00 0
<1.00 -3
Net =>6 Reflects Current Assets Turnover. Lower 5
Sales/Inventory <6=>5 the figure, slower the turnover and higher 4
+ Receivables <5=>4 the risk of obsolescence and poor 3
(Times) <4=>3 realizations 2
<3=>2 1
<2 0
Net sales/Equity =>8 Reflects Long Term Liabilities Turnover. 5
+ Borrowings <8=>7 Lower the figure, slower the turnover and 4
(Times) <7=>6 higher the risk of default 3
<6=>5 2
<5=>4 1
<4 0
Debt Equity <0.50 Debt equity gearing is an important 5
Ratio= Long <1.00=>0.50 indicator for assessing risk in (term) 4
Term Debt/Net <1.50=>1.00 exposures 3
Worth <2.00=>1.50 2
<2.50=>2.00 1
=>2.50 0
Fixed =>3.0 Measures the liquidity position 5
Assets/Long <3.0=>2.5 4
Term Debts <2.5=>2.0 3
<2.0=>1.5 2
<1.5=>1.0 1
Page 21 of 25
<1.0 0
Growth in Net >20% 3
Sales (as >15%<20% 2
compared to >10%<15% 1
previous year) <10% 0
Growth in Net In excess of 3
Profit (as 20%
compared to In excess of 2
previous year) 15%<20%
In excess of 1
10%<15%
<10% 0
E. Parameters Based on Cash Flow Statement

Risk Parameters Range Score Score
Prescribed Obtained
Net Cash from Operations to >5 3
Sales >3% to 5% 2
0 – 3% 1
Negative 0
Net Cash from Operations to Above 40% 3
Long Term Debts Between 25% to 2
40%
Between 10% to 1
25%
Below 10% 0
12.1Facility Rating Model (Illustrative)
A. Risk Mitigation/Security Coverage
The Quality of Primary and Collateral Security is judged on the basis of: Marketability, Easy
Ascertainment of Value, Stability of Value, Storability and Efficient cost of supervision,
Transportability, Durability, Easy Ascertainment of Title, and Easy Transfer of Title.
Page 22 of 25
Risk Parameter Narration Remarks Score Score

Prescribed Obtained
Availability of Good More than 75% to 100% of the Total 2
Collateral Security Exposure
and Quality of Average Between 50% to 75% of the exposure 1
Collaterals* Poor Less than 50% of the exposure 0
No Collateral Security
Availability of Good Guarantee Available 2
Guarantee Average Guarantee not available 1
(Promoters-
Directors’
Guarantee/Third
Party Guarantee.
Means of the
Guarantor = Total
Exposure
(FB+NFB) taken
* Note: Marks to be allotted only if the formalities of documentation/creation of
securities are completed in all respect
B. Compliance of Sanction Terms

Parameter Prescribed Obtained
Compliance Excellent All sanction terms complied with including 3
of Sanction documentation/mortgage/ROC/second
Terms charge and legally enforceable
documentation held on records
Good All sanction terms complied except second 2
charge Only 2nd charge not registered
Neutral EM not completed 1
Unfavourable 0
Submission Excellent Timely Submission 3
of Stock Good Submitted within 30 days from due date 2
Statements Neutral Belated Submission beyond 30 days 1
Unfavourable 0
Submission Excellent Submitted within 5 months from the 3
of Audited closure of the account
Balance Good Submitted within a period of >5 months < 8 2
Page 23 of 25
sheet & months from the closure of the account

Profit & Loss Neutral Delay > 8 months 1
A/C & Unfavourable 0
Financial
Data in CMA
Forms
Repayment Excellent Upto 5 years 2
schedule for Good >5 years 1
Term Loans Unfavourable 0
only
Turnover in High Turnover Commensurate with sales 2
the account Moderate Turnover>70% to <90% 1
(Consider Low Turnover >60% to <70% 0
only Credit Turnover <60%
Turnover in
the Running
A/c facility
rating to
business-
Sales
Proceeds)
C. Operations in the Account
Operations in Favourable No Occasion of excess and return of 2

the account cheques
Satisfactory Rare occasions of excess and returns of
cheques
Average Occasional excesses and return of 1
cheques
Below Frequent excess and return of cheques 0
Average
Repayment of Favourable Timely Payment
Installment & Good Irregular/overdue upto one month from 2
Interest under due date
Term Loan and Neutral Irregular/overdue beyond one month 1
payment of upto 2 months
interest on cash Unfavourable Delayed beyond 2 months 0
credit/overdraft
Page 24 of 25
Margin given on >40%

Term loan 25% to <40%
20%<25%
<20%
Risk Rating Ranges (Illustrative)
Sl No. Aggregate Score - Range Rating Numeric Credit Quality

1 >90 A1 Lowest Risk
2 81 - 90 A2 Minimal Risk
3 71 - 80 A3 Moderate Risk
4 66 - 70 A4 Satisfactory Risk
5 61 - 65 A5 Acceptable Risk
6 56-60 A6 Watch List
7 51-55 A7 Risk Prone
8 <50 A8 High Risk
9 Default-NPA A9 Sub-Standard
10 - A10 Doubtful
11 - A11 Loss
1.13 Summary
Credit risk arises because in extending credit the banks have to make judgment about a
borrower’s creditworthiness. This creditworthiness may decline overtime due to poor
management or changes in the business climate. A bank can employ different models to
assess the risk of loans and bonds. These vary from relatively qualitative to the highly
quantitative models. . Every obligor and facility must be assigned a risk rating and loan will
be priced accordingly. The bank may use these models for credit pricing. Thus, it is
important that for proper credit risk management, the banks should have in place proper
system of appraisal before extending credit. In addition, there is need of separation of
credit risk management from credit sanction. The level of authority required to approve
credit will increase as amounts and transaction risks increase and as risk ratings worsen.
On the whole, it is important for the banks to have consistent standards for the origination,
documentation and maintenance of credit.
References
- Guidance Note on ‘Credit Risk Management’, October 12, 2002.
- Risk Management System in Banks, October 21, 1999 and January 29, 2003.
Page 25 of 25
Chapter 7: Regulatory Views and Guidelines on Credit Risk
Dr. Richa Verma Bajaj
Objective
This chapter is an attempt to make the readers understand all drivers of credit risk.
Structure
1. Introduction: Understanding Risk and Risk Terminologies
2. Credit Risk and Regulation
3. Extent of Credit Risk
4. Migration Analysis and Probability of Default Estimation (PD) or Default Risk
5. Exposure at Default (EAD) or Exposure Risk
6. Loss Given Default (LGD) or Recovery Risk
7. Correlation of Default
8. Conclusion
1. Introduction: Understanding Risk and Risk Terminologies
Business Dictionary defines risk in finance 1 as “The probability that an actual return on an
investment will be lower than the expected return. Financial risk is divided into the following
categories: Basic risk, Capital risk, Country risk, Default risk, Delivery risk, Economic risk,
Exchange rate risk, Interest rate risk, Liquidity risk, Operations risk, Payment system risk,
Political risk, Refinancing risk, Reinvestment risk, Settlement risk, Sovereign risk, and
underwriting risk etc”. Thus, anything the occurrence of which could result in reduces the
income to a bank can be termed as risk. It is also seen that there are a large number of risks
that a bank is exposed to.
As regards credit portfolio, risk could happen due to default, recovery, exposure etc. Banker
should be keen to know what these risks are, how they are measured, what their likely
impact is, how to reduce risk and how to manage risk. Table 1 below gives an over view of
these issues. The terms default risk and recovery risk, as also exposure risk and
concentration are linked to each other. If recovery is delayed or does not happen it is default
1
Read more: http://www.businessdictionary.com/definition/risk.html
Page 1 of 17
and if default leads to loss of interest and principal it is risk. Once default occurs rate of
recovery (poor recovery rate means high recovery risk) becomes important to arrive at LGD.
Exposure here means the amount of credit in a particular rating level or group or individual
who has defaulted.
Table 1: Risk terms and relationship

Terminology Terminology How to Impact of Risk Impact on Implication
used in Loan used in Reduce Bank of Basel
Policy Credit Risk these Accord on
document Policy Risks? Banks
document
Default Risk Probability of Through Rise in default
Increase Basel
Default (PD) Proper and recovery
Provisioning Accord,
Linking Appraisal risk with high nowhere
Recovery Credit Loss Given Through exposure to a
Decline in expect
Risk Management Default (LGD) timely particular Profitability banks to
with Credit Monitoring rating/industry/ change their
Exposure Risk Exposure at Through sector Decline in lending
Risk Management Default (EAD) quick results in high
Bank’s CAR practices,
Recovery credit loss whereas it
makes the
banks
Concentration in Portfolio results in Banks to Diversified understand
Correlation risk have Portfolio implication
diversified reduces Credit of the
portfolio Loss respective
lending
practice on
the bank’s
soundness
and
profitability
All these risks are interconnected. These risks can be avoided by proper appraisal, good
collateral policy, active and close monitoring of accounts and timely recovery and refinance.
The risk in all these four terms is commonly known as credit risk which is the probability of
loss of principal and interest due in the credit portfolio on account of default or other
reasons.
Page 2 of 17
Risk that has occurred is clearly measured by loss. But for risk management we must
measure future risks. This is measured based on past performance of the portfolio by taking
into account
(a) Probability of Default: which can be arrived at by statistically evaluating the past
default numbers
(b) Loss given default: This also can be arrived at based on past data of recovery rate in
respect of collaterals and other recovery and actual loss and statistical methods
(c) If the above two numbers are available for the bank as a whole as also for a given
business say retail, it should be possible to estimate exposure at Default or portfolio
at risk.
Risk will impact bank in terms of increased provisioning and write off. This will impact
profitability and the net worth of the banks. Banks need to be strong and stable and hence
need to provide additional capital to maintain the prescribed risk adjusted adequate level of
capital.
We have summarized the credit risk and how it warrants additional capital. The regulatory
oversight and requirement in this issue is focused on estimating risk and providing sufficient
capital that bank remains stable.
2. Credit Risk and Regulation
According to Basel II (2006), the amount of capital that a bank should hold against a given
exposure will be a function of the credit risk of that exposure. The accord requires
internationally active banks to use appropriate methods for calculating credit risk capital
requirement under Pillar I. The objective is to align regulatory capital with economic capital.
In this regard Basle committee introduced Internal Rating Based (IRB) Approach as a way
of estimating bank’s credit risk capital requirement, as distinct from the standardized
approach, which was regulator driven.
Under the standardized approach, the capital computation was based on the external
rating agency’s assessment of risk and risk weights are given by regulators. As against this
according to IRB approach four variables affect the credit risk capital requirement. These
are PD, LGD, EAD and maturity. For a given maturity, these parameters are used to estimate
two types of EL. Expected loss as amount is PD*LGD*EAD and EL as a percentage of EAD i.e.
EL% is PD%*LGD%. IRB requires banks to disclose PDs, LGDs and EADs within the portfolio
under Pillar-3.
Further the Basel Committee has prescribed two broad approaches: a foundation and an
advanced. Under the foundation approach, as a general rule, banks provide their own
Page 3 of 17
estimates of PD and rely on supervisory estimates for other risk components (i.e LGD, EAD
and Maturity). Under the advanced approach, banks provide their own estimates of PD, LGD
and EAD, and their own calculation of M, subject to meeting minimum standards. PD and LGD
are measured as decimals, and EAD is measured as currency (e.g. euros).
3. Extent of Credit Risk
Credit Risk is measured in terms of exposure, means that the amount of risk represented by
the outstanding balance at the date of default may differ from the ultimate loss in the event
of default because of potential recoveries (Recoveries depends upon Credit Risk Mitigants
like guarantees, either collateral or third-party guarantees, the capability of negotiating with
the borrower, funds available to repay debts). As mentioned in first chapter, credit risk is
made up of transaction risk or portfolio risk. The portfolio risk in turn comprises intrinsic
and concentration risk. The various component of credit risk are
Credit Risk
Transaction Risk Portfolio Risk
Default Risk
Concentration Risk Correlation Risk
Credit Spread Risk
Recovery Risk
Exposure Risk
Maturity
i. Transaction Risk: It is driven by the potential changes in the credit quality of a

borrower. It has following components i.e. Default Risk, Credit Spread (Down-
gradation) Risk, Recovery Risk, Exposure Risk and Maturity.
a) Default Risk: Obligors default only if they are unable or unwilling to service debt
obligation wholly or partly. On default, a portion or entire exposure is lost. Therefore,
Page 4 of 17
the default rate is an indicator or component of loss. Default risk is measured through
Default Probability (PD) estimation.
b) Credit Spread (Down-gradation Risk): after the credit is extended, change is
observed in borrower rating i.e. upgrade or downgrade in rating grades. If a borrower
does not default, there is still risk due to worsening in the credit quality. This results
in possible widening of the credit spread in each rating grade.
c) Loss Given Default (LGD): After default, attempts are made to recover the exposure.
The entire exposure may not be lost because recovery through collateral or other risk
mitigation mechanism may be available. LGD represents the fractional loss due to the
inability to recover the claim. It is nothing but, uncertain recovery post default. This
recovery risk is measured through Loss Given Default (LGD) estimation.
d) Exposure Risk: Exposure is the amount lent to the borrower. Many studies have
proved that before default, the obligor generally draws the unutilized credit to the
extent possible, resulting in an increase in the exposure at the time of default. Thus,
it the amount at risk in the event of default. It is measured through Exposure at Default
(EAD) estimation.
e) Maturity: It is the maturity period of the exposure. The maturity of the exposure also
contributes to risk. Longer maturity means exposure to the credit risk for a longer
time- higher average credit risk. The changes in the credit quality changes the credit
risk premium portion of the interest. Longer duration securities lose more value for
the same changes in the credit quality (interest rates) than shorter maturity
securities.
ii. Portfolio Risk
a) Correlation Risk (systemic): It is the most important contributor to credit risk.

Obligors are correlated with each other as suppliers, customers and competitors.
Macroeconomic variables (Economic, business and industry cycles) impact obligor
simultaneously. This results in an increase in credit loss. Correlation is extremely
difficult to measure, and it changes continuously with change in fundamentals. Thus,
concentration based on common risk factors may lead to simultaneous default.
b) Concentration Risk: It is nothing but over exposures to individual names as well as
to a single sector (geographic reason or industry) or to several highly correlated
sectors. Empirically, it is observed that obligors within the same sector are exposed
similarly to macro-economic environment and business cycle, resulting in
correlation. Concentration in bank’s portfolio are key drivers of correlation,
unexpected loss, portfolio risk and credit risk capital.
The above variables are detailed in this chapter through various sections:
Page 5 of 17
4. Migration Analysis and Probability of Default Estimation (PD) or Default Risk
The Basle accord clearly states that default risk is an important driver for credit risk
estimation in a bank. Probability of default (PD) is a quantitative measure of default risk. It
is measured in terms of credit ratings and there are many grades for rating. The PD increases,
or credit quality deteriorates when an obligor’s credit rating downgrades. The credit quality
of the borrower may not deteriorate suddenly, but it typically deteriorates over a period of
time and reached to the default state. In fact, Moody (1997) reported that sudden defaults
without preliminary downgrades are much rarer.
4.1 Regulatory Requirements
According to Basel, default probability gives the average percentage of obligors that default
in a rating grade in the course of one year (BIS, July 2005). Default is defined as, (i) Borrower
is unlikely to pay its debt obligation in full; (ii) the borrower is past due more than 90 days
on any credit obligation. The minimum requirement for PD estimation for regulatory
compliance includes- (i) it is often mapped to risk grade or risk rating of the borrower. It
should be estimated for each borrower’s industry-wise or rating class-wise; (ii) it must
represent a conservative view of a long-run average (pooled) PD for retail borrowers; (iii)
the bank must use historical observation period of at least five years; (iv) for Corporate or
Bank Exposure: PD is one year PD associated with the internal borrower’s grade to which
that exposure is assigned or 0.03% whichever is greater. This means that for PD estimation
for each rating grade and industry, it is important for bank to have in place 5 years of rating
data from the internal rating model of the bank.
4.2 Rating Transitions
Logically, default is one state into which debt issuer can transfer when their credit quality
changes. However, the rating can be upgraded, downgraded or remain unchanged. Changes
in the distribution of rating in a given year add to the changes in the credit quality of the
borrowers, this is mainly because of the parameters as stated in the previous Chapter. The
rating transition rates are considered as the representations of the historical behavior of
ratings. The probabilities associated with rating transition, in particular the default state, act
as an important input in credit risk models. The PD estimates, as per Basel accord, could be
derived from Transition Matrix. Last column of transition matrix represents PD. The
transition matrix is presented below:
Page 6 of 17
One Year Average Transition Matrix

AAA AA A BBB BB B C D
AAA 96.72 3.28 0.00 0.00 0.00 0.00 0.00 0.00
AA 2.28 91.50 5.39 0.60 0.00 0.12 0.00 0.12
A 0.00 3.68 83.92 7.36 2.45 0.41 0.68 1.50
BBB 0.00 1.03 5.82 71.23 11.30 2.05 3.42 5.14
BB 0.00 0.88 0.00 2.63 59.65 3.51 7.02 26.32
B 0.00 0.00 0.00 8.00 0.00 56.00 8.00 28.00
C 0.00 0.00 0.00 2.33 0.00 0.00 53.49 44.19
Reading the matrix: Let’s take AAA rated credit. The matrix shows that probability of AAA
becoming AA is 3.28% and remaining unchanged is 96.72. Similarly, AA moving to AAA is
2.28%. The probability of AAA become D is zero while probability of B moving to D is 28%.
This matrix prepared based on banks own past record. Given this the probability will change
every time the matrix is prepared.
Bank would have rated all its assets and can based on the matrix arrive at over all probability
of default and loss given default.
The matrix shows that as the assets go down from better rating grades to low rating grades,
the stability probability (as highlighted through diagonal) comes down and default
probability increases (D, last column of the matrix). The down gradation is more in non-
investment grades, which ultimately leads to higher defaults in these grades.
4.3 Decision Criteria for Rating grades and Industry
Following table depicts the historical rating transition frequencies and defaults rating
depending on whether a company’s rating was upgraded, downgraded or unchanged in the
previous years. The rating stability is higher in the higher rating grade (AAA or AA), although,
they have greater tendency to be downgraded than to be upgraded. Generally, PD increases,
or credit quality deteriorates as borrower’s credit rating downgrades.
Page 7 of 17
Migration Probabilities in various Rating Grades and Sectors

Default No change
Upgrade Downgrade (D) (excluding D)
Rating Grade-wise
AAA 0.00 2.66 0.00 97.34
AA 2.75 5.85 0.12 91.28
A 3.49 10.99 1.47 84.05
BBB 6.69 16.72 5.02 71.57
BB 4.24 10.17 25.42 60.17
B 8.00 8.00 28.00 56.00
C 2.33 0.00 44.19 53.49
D 1.70 0.00 0.00 98.30
Sector-wise
Textiles 1.32 7.93 16.74 74.01
Chemicals 3.45 7.04 11.49 78.02
Metal 6.09 9.68 27.24 56.99
Non-Metals 4.46 8.92 17.20 69.43
Machinery 1.82 8.39 20.07 69.71
Transport
Equipment 1.87 7.09 7.46 83.58
Food 2.44 6.50 27.64 63.41
Miss. Manu. 2.88 6.47 17.27 73.38
Diversified 1.67 10.00 24.17 64.17
Services 2.26 3.70 3.70 90.33
Source: own study
On sector–wise analysis, it is clear that the rating stability is higher in services sector
(90.33%) followed by Transport Equipment sectors (83.58%). In contrast, the rating
stability was observed lowest in Metal Sector (56.99%) followed in upside by Non-metal
sector (69.43%). However, the up-gradation and down-gradation probabilities were
observed higher in metal and non-metal sector.
Now, the question of interest to a credit officer is whether they should have more exposure
to Metal sector or services. Looking at the obligor rating probabilities, the bank will have
more comfort in lending to services, as default probabilities is low, and less to metal sector,
as there default probability is high. Whereas, from recovery point of view, Metal has more
recovery because of physical nature of assets and service sector face intangibility issue,
which leads to lower recovery. This is how advantages available in respective sector gets set
Page 8 of 17
off by their disadvantages. That is why; under Basel regime more importance is given to
composite ratings, which takes into account separate assessment of obligor and facility.
4.4. Importance of performing Migration Analysis for Banks
Banks should undertake and study migration data in regular periodicity for
• Timely Follow-up action, as and when down-gradation in rating grades occurs. In
addition, it gives early warning signals for corrective action.
• Identifying problem credit, the accounts moving towards default grade.
Thus, migration analysis helps the bank in identifying portfolio with high PD. It helps in
improving the bank’s credit portfolio quality by taking corrective action for management of
problem credit, so as to keep the default rate minimum.
We know that default depends upon common macroeconomic factors. Large and sudden
changes are affected by economic conditions and they occur infrequently. Economic
fluctuations have a strong influence on the tendency of rating results to improve or
deteriorate. In this background, it is clear that estimation of probability of default depends
upon rating of the borrower and migration in various rating grades. This in turn depends the
quality of appraisal system in the bank. Better the appraisal standards, lower will be the
migrations in rating grades and less defaults, assuming macroeconomic instability constant.
5. Exposure at Default (EAD) or Exposure Risk
EAD is the outstanding amount that is exposed to default risk and that would not be
recovered in the event of default. Before default, exposure is subject to default risk and after
default EAD is subject to recovery risk. Basel Committee (2006) define EAD as, “Expected
Gross exposure of the facility upon default of the obligor”. It is the only parameter which the
bank can influence in advance by pre-defined limits on credit approvals for certain PD/LGD
combinations. EAD depends a great deal on the bank’s own operational policies and
practices. Generally, the terms and conditions imposed by the bank with deterioration in
borrower credit quality are: reduction in limit, increase in margin/borrower’s contribution,
increase in collateral, change in price (increase in price with increase in risk) etc. Some of
these covenants can lower EAD, but this may come at the cost of higher PDs. Research
suggests that the draw-down of a credit line at default decreases with the borrower credit
quality. The rationale being that a bank is more likely to require covenants for lower credit
borrowers.
Page 9 of 17
5.1. How Exposure Amount Varies?
Expected outstanding amount varies depending upon a customer type and transaction
type. Thus, a bank must consider an estimate of the exposure amount (EAD) for each
Customer Type and Transaction (product/facility) Type in banks internal systems.
5.1.1 Customer types
The differentiation of customer types is relevant with regard to varying behavior in credit
line utilization. Bank may experience less dependence of large corporate accounts and
customers with better rating on its funding, as they have cheaper funds available in market
from alternative sources. Whereas, it’s difficult for Retail customers, small-medium sized
companies and low rated customers to raise the money from market and thus, they are much
more dependent upon bank’s funding to meet their requirements. In fact, they are more
likely to overdraw approved lines of credit. In this connection it has been observed that the
EAD for borrowers with whom the bank has agreed on covenants tends to decrease as the
borrower’s creditworthiness deteriorates.
5.1.2 Transaction (facility) type
Outstanding amount vary for specific products:

 Fixed Exposure – These are typically On Balance sheet. As such, EAD depends upon
actual outstanding or the amount currently drawn. They will be by definition fully
drawn (e.g. bullet or amortizing term loans) and have generally no chance to further
increase its exposure in excess of set transaction limit. In the event of default, the
exposure for such transactions is given by the current outstanding (i.e. book value of
the loan). As per Basel “for fixed exposures such as term loans and installment
loans, each loans’ EAD is no less than the principal balance outstanding”.
However, on balance sheet netting of loans and deposits of a bank to a corporate
counterparty will be permitted to reduce an estimate of EAD.
 Variable Exposure - Off Balance Sheet (Lending product with variable utilization):
The lines which are not fully used are treated as given contingencies and recorded as
off-balance-sheet. It is based on the outstanding and limit booked (commitment) or
an estimate of future drawdowns of available, but untapped credit. Committed lines
of credit allow the borrower to draw on those lines whenever he wants to, depending
upon his needs, and subject to a limit fixed by the bank. Thus, the bank must have a
measure in place of the line’s exposure at default (EAD). For certain facilities with un-
drawn commitments, EAD will include an estimate of future lending prior to default
(for revolving loans). EAD depends on how the relationship between banks and
clients evolves in adverse circumstances, when the client may decide to draw
Page 10 of 17
previously unused exposure. It can be expected that the counterparty close to

default tends to increase its utilization, while the bank will have to work against
this by reducing available limits. For off-balance sheet items, exposure is calculated
as the committed but undrawn amount multiplied by a CCF. The level of utilization
for off-balance-sheet transactions can range between 0 and 100% at the time of
default. The products like cash credit, overdraft, revolving line of credit (credit card)
and working capital loans are characterized by an external limit and an average of the
utilization of the month (outstanding) under consideration. Like, Project financing
implies uncertainty in the scheduling of the outflows and repayments.
5.2. Data requirement for EAD
EAD is estimated using empirical data by looking at the distribution of utilization levels of
credit lines prior to the moment of default. For EAD calculation for line of credit, the
customer behavior is estimated on the historical information. Information can be collected
on the defaulted companies/firms to study-
- how much they had drawn on the line by the time they defaulted
- how much they draw on the line, limit on the line, their credit rating before default
(one year before default)
EAD, will depend up on the actions of the counterparty (drawdown when default is
imminent) and the bank (withdrawal of limits, tighter covenants). Although there is the
possibility that current outstanding may be reduced prior to default, it is reasonable to hold
capital against all drawn exposures. In addition, a positive EAD is expected for all un-drawn
commitments and advised limits, including unconditionally and immediately cancelable
lines of credit. Banks must also have adequate systems and procedures in place to monitor
facility amounts, current outstanding against committed lines and changes in outstanding per
borrower and per grade. The bank must be able to monitor outstanding balances on a daily
basis.
Some relationship of credit line Utilization, obligor rating or default rates and economic cycle
etc., is give in the box below. This will help in understanding how to contain EAD.
Box: Study observations on un-drawn portion of loan commitments, rating or default

rates and the economic cycle.
It is important for banks to study the correlation between the use of un-drawn portion of
loan commitments, default rates and the economic cycle. As PD and EAD are likely to
grow in bad years, thus increase the unexpected losses of the bank. In this connection it
is seen that impact of Firms and Facility Characteristics reflects on credit line
Page 11 of 17
utilization and eventually on EAD: some observations from recently conducted

studies2 shows that
• Firm characteristics: lower quality borrowers draw less, suggesting banks
monitor these firms more closely
• Large credit lines have lower credit utilization
– This could be due to the fact that larger accounts/limits/lines are more
actively monitored by lenders
– Another reason could be that larger lines are granted to larger firms that
don’t need bank financing as much, even in default
• Credit lines with shorter maturities have higher credit line utilization
This could be due the fact longer maturities allow for closer and better monitoring
of the borrower. Further, longer the time to maturity, the larger the probability that
the credit quality will decrease.
• Collateralized credit lines have lower utilization
- Not surprising since a drawdown puts more collateral at risk to be seized by
the lender
• Macro-economic Conditions
- GDP growth: in recessions, credit line usage increases at any given time to default
• Bank characteristics:
- Bank NPL ratio: for a given time to default, credit lines by riskier banks are
drawn more, suggesting less bank monitoring
- Bank share: for a given time to default, credit lines by larger banks are drawn
more, suggesting less bank monitoring
6. Loss Given Default (LGD) or Recovery Risk
LGD is the credit loss that will be incurred if an obligor of the bank defaults. The measured
loss in the event of default and likewise the LGD (percentage of exposures), will clearly
depend upon the given definition of default. Many instances of defaults under the definition
may result in no loss incurred. For example, a firm may become “90 days past due” on a loan
payment and subsequently make good on all of its obligations. This event would count as a
default but would result in full recovery. A bank that ignores such events will under-estimate
recovery rates since the exposure and 100% recovery won’t be included in the bank’s loss
data. The bank’s model will consequently yield an overly pessimistic picture of loss given
default. However, recoveries tend to be different for various facility types issued by a bank.
They vary according to the value of the facility and the degree of stability of any collateral
2
https://www.fdic.gov/bank/analytical/cfr/bank-research-conference/.../jimenezg.ppt
Page 12 of 17
associated with the exposure. That is why, for in-house LGD estimation, the bank must have
sufficient data on corporate history.
6.1 Measures of LGD
Recovery in the event of default is not predictable. It depends upon factors such as
guarantees received from the borrower, type of such guarantees, collateral etc. Insufficient
recoveries to cover the bank’s exposure, gives rise to LGD. In other words, LGD is the
percentage of a defaulted exposure that the lending bank expects not to recover. It is
percentage/fraction of exposure amount (EAD), net of any recoveries, which will be lost
following a default event. Once a default event has occurred, loss given default includes three
types of losses, i.e. the loss of principal, the carrying costs of non-performing loans, e.g.
interest income foregone and workout expenses (collections, legal, etc.).
It is important that recoveries/LGD have to be assessed in economic sense rather than a

mere accounting perspective. Accounting LGD/Net Charge-off does not take into account
the length of the workout period and it does not include certain costs and payments which
banks actually incur. Simply, expressing the recovery amount as a percent of the loan balance
at default provides the recovery rate. The reciprocal of the recovery rate is the LGD, i.e. LGD=
(1-Recovery Rate). Accounting data is just a starting point for the computation of the true
loss rate or NPAs recovery. The efficiency level in terms of costs and time of the bank
workout department may affect LGD significantly. It must be reflected in the estimates used
to assess the recovery risk on future defaults. Workout/Economic LGD, takes care of all this
and it is after discounting recoveries from workout costs. Economic means that all related
costs have to be included and the discounting effects to be integrated. The Inputs required
for LGD estimation are: Exposure at Default, Recoveries, and Cost Incurred, Time of default
and Net Recoveries and Discount Rate.
Re cov eries  Costs

 (1  r ) t
LGD  1 
EAD
Thus, Economic LGD represents the net present value of the cash flow stream related to a
given exposure following the default event. Thus, LGD computation requires answers to
following question:
- How much is recovered and from where (Collateral liquidation)?
- How long did it take to recover?
- How much had to be spent in the recovery process (workout expenses)?
Page 13 of 17
How much the economic recovery rate differs from the cash recovery rate is driven by both
the amount of time it takes to collect on the defaulted loan and the discount rate applied.
Discounting each cash flow to the point of default provides the economic recovery on the
defaulted loan. The length of time to recover is critical important to understand the
significance of the discount rate. For products where recoveries are collected quickly, such
as credit cards, differences in discount rates will have little impact on the resulting LGD.
Where collection efforts may be protracted, such as large corporate bankruptcies, the
discount rate can have a significant impact on the calculated LGD.
6.2. Data Requirements for LGD
To complete this calculation, data on historical recovery rates must be collected. This
includes data on different components of recoveries recorded on defaulted exposures; for
instance, amount recovered, sources of recovery (collateral and guarantees, type of
liquidation and bankruptcy procedures), time period elapsed before the actual recovery and
administrative costs. For example, in a loan, LGD would include all collections made on the
loan, plus direct and indirect costs associated with collecting recoveries on the exposure. The
bank’s own workout and collection expertise significantly influences their recovery rates. A
bank using internal Loss Given Default estimates for capital purposes might be able to
differentiate Loss Given Default values on the basis of a wider set of transaction
characteristics (e.g. product type, wider range of collateral types) as well as borrower
characteristics. The Basel committee requires that LGD estimates produced by the banks
would be expected to represent a conservative view of long-run averages, accounting for the
possible correlation between recovery rates and default frequencies. LGD estimates must
reflect economic downturn conditions. A bank must satisfy the regulator that their internal
models are conceptually sound and historically consistent with their past experience
6.3 Importance of LGD Computation

- Development of a facility rating model which can be integrated with the borrower
rating model
- LGD estimates are key inputs for expected loss calculations for provisioning
- Regulatory Compliance
6.4. Determinants of LGD/Recovery Rate

- Borrower: Type, Country or region, Industry, Capital Structure, Rating of
counterparty (Initial and One year prior to default)
- Facility- Type (Working capital/term loans), Seniority Class, Debt Type,
Collateralization (LTV)
- Collateral: Type (Mortgage, Pledge, Hypothecation), Current book or Market Value,
Depreciation
Page 14 of 17
- Guarantee: Guarantor, Value, Risk Covered

- Bank Internal: Work out Strategy, Valuation Procedures, Collateralization Strategy,
Bank behavior in terms of debt negotiation
- Other Factors: Limit Sanctioned, Size of Loan Outstanding, Contractual Lending Rate,
Amount of Recoveries, Amount of Cost, Compromise amount, Year of Relationship
with the bank
LGD estimates must be based on historical recovery rates and not just on the collateral’s
estimated market value. It is important to note here that any improvement in the recovery
procedures leading to a reduction in the empirical LGDs may lead to lower capital
requirement for the subsequent years. In other words, speedy recovery results in lower LGD.
7. Correlation of Default
Portfolio credit risk measurement and management depends on

- Correlation: Credit portfolio correlation would mean number of times
companies/counterparties in a portfolio defaulted simultaneously
- Volatility: means rapid or unexpected changes which may be difficult to capture or
hold permanently
Correlation between assets with in portfolio results in portfolio risk. It is nothing, but,
Probability of default by two or more borrowers simultaneously. It is said that, higher the
correlation of default, greater is the concentration risk of the portfolio. Whereas, lower the
correlation of default, more diversified the portfolio is. In other words, it indicates low risk
in the portfolio. In general, credit correlation includes default correlation and credit
migration correlation, where, default correlation measures the extent to which the default
of one borrower is related to another borrower, while credit migration correlation measures
the joint credit quality changes short of default for the two borrowers. Both these
correlations are important for measuring and managing portfolio credit risk.
But the question here is - Why default events are correlated? To answer this or to
understand this it is necessary to explore the ways in which default events of two Firms are
linked. As this linkage would occur: (i) Between firms in same industry because of industry
specific economic conditions; (ii) Between companies in different industries that rely on
same production inputs and among companies that rely on the same geographical market;
(iii) May arise due to systemic or macroeconomic conditions in the national or international
market. In short, Macroeconomic fundamentals, industrial & geographic factors indicates the
extent of correlation among borrowers.
Page 15 of 17
Default Correlation ties the risk contribution of a risky asset to the totality of the portfolio.
The aggregation of risk contribution from several risky assets indicate the level of
concentration risk in the portfolio, as concentration based on the correlated risk factors
between borrowers may lead to simultaneous default. That is why while assessing the
totality of portfolio risk “Default Correlation/pair-wise correlation” between two assets is
very important. Because, higher the correlation of default, greater is the concentration risk
of the portfolio, vice-versa. For default correlation calculation, banks need to study the
profile of their entire credit portfolio and develop appropriate methodologies for estimation
of default dependencies. Default correlations estimates are highly relevant for the pricing,
portfolio management of loan portfolio and bank-wide risk management purposes.
7.1 Characteristics of default correlation
The important characteristics of default correlation are as follows:

(i) it increases with the level of credit risk in the economy, implying business cycle
effect on default correlation;
(ii) it increases with the credit risk of the firm. As credit quality worsens, PD increases
and thus, default correlation also increases;
(iii) Higher correlation can be observed within the same industry/rating grade
(concentration in textile); and
(iv) The across sector/industry correlation tend to be low and this gives opportunities
to banks to explore diversification strategies across industries and thereby
reducing the unexpected losses (UL).
The experience suggests that default probabilities are observed higher in low rating grade
issuers like BB, B and C. Studies have shown that the joint default frequencies move with
economic cycle, as the joint default frequencies within and across groups increases during
recession and reduce during boom. It is also observed that the default probabilities and
correlation estimates are cyclical in nature. These estimates vary with time, rating of the
issuer and economic activity of the issuer. The highest correlation is observed between
companies within the same rating grade and industry, because of borrower and industry
specific factors. In fact, the low value of the correlation among sectors and rating grades will
reduce the unexpected loss figure and provides the opportunity to banks to diversify their
portfolio and reduce the concentration risk.
8 Conclusion
Under Basel II, the amount of capital that a bank should hold against a credit exposure will
depends upon risk weight of that exposure. These risk weights are, thus, an indicator of risk
(unexpected loss) involved in a particular credit. In standardized approach, these risk
Page 16 of 17
weights are given by the regulator, whereas, under AIRB approach, the bank have to compute
these risk weights on the basis of its own data relating to Probabilities of Default (PD), Loss
Given Default (LGD), Exposure at Default (EAD) and Maturity. The experience suggests that
changes in default and recovery experience of the banks have reflection upon their credit
losses and, thus, credit risk capital charges. Therefore, the bank with high defaults and low
recovery (i.e. high LGD) needs to maintain more capital in IRB regime and vice-versa. Thus,
it is not sufficient on the part of the banks to merely focus on measuring only default
probability and loss given default when measuring portfolio credit risk. They must also look
into the correlation in defaulting borrowers and use as input in portfolio credit loss
estimation. The experience suggest that risk capital requirement differ for different rating
grades and industry depending on size of unexpected losses in the credit portfolio.
Page 17 of 17

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Course: Credit Management (Module III: Credit Management) NIBM, Pune

Module III: Credit Management

The objective of this chapter is to highlight the importance of documentation in the

Credit Departments of banks have three major responsibilities: (i) evaluation/appraisal

1. Applicant/Customer submits an application. The information in the application

i. Application should be filled in full.

– Anything in writing, words printed, words lithographed or Xeroxed or

2. Need for documentation

In normal business atmosphere, agreements and documents are drafted after

Through the documents lenders would like to

 Define conditions under which it is offering the loans

From the above it will be clear that documents are necessary to

• identify both parties to the loan transaction

3.1 Promissory Note:

I/We……………………………………Jointly and severally ( Borrowers) promise to pay a

It could be added that

Promissory note will be supported by hypothecation, pledge or other document as per

3.2 Loan Agreement

processing fee, cost of valuation, legal verification, commitment charges, costs of

o Representations: This section will contain the statements of the borrower

3.3 Other Documents

 Inter-creditor Agreement: An inter-creditor agreement is executed between one

of an inter-creditor agreement would vary depending on the borrower, the type

4. Securities and Creation of Charge

4.1 Types of Charges

of the date of agreement or mortgage the parties to PP agreement enjoys a right

4.2 Types of securities

• Primary Security: Hypothecation/pledge/assignment or mortgage of assets

Pledge is the bailment of goods as a security for payment of a debt or performance of a

Hypothecation charge can be created on moveable things/property like stocks. In case

Assignment is transfer of right or interest in an asset to recover the debt. Assignment is

There are six types of mortgages namely, (i)Simple Mortgage, (ii)Mortgage by

4.6.1 Registered Mortgage:

4.6.2 Equitable Mortgage:

Since no special documentation is undertaken for creation of charge of equitable

Table 1: Various kinds of charges over securities

Banks need to insure the assets financed for Fire/Natural Calamities/Floods/Theft/

6. Stamping and Registration

Table 2: Loan account-wise limitation period

Type of Loan/Document Limitation

Demand loan: Promissory Three years from the date of loan

Loan secured by mortgage 12 years from the date of mortgage

Bill purchasing Three years from the date of bill

7.1 Extension of period of limitation

Documentation is a very important stage in the lending process. Without relevant

Module III: Credit Management

Chapter 2: Credit Monitoring and Early Warning Signs

Credit Monitoring is an integral and an important part of credit management of banks

2. Objectives of Credit Monitoring

3. Instruments for credit monitoring

• Inspection (onsite monitoring)

• Annual review of loan account

• Stock price movements

3.1 Stock Audit

Provision of working capital loan to business enterprises is a major business for

Table: Stock Statement

3.2 Quarterly Reports

3.3 Annual Reports

3.4 Annual Review

3.5 Stock price movements

4. Early Warning Signs

One of the most important outcomes expected of monitoring is indications of

4.1 Liquidity indicators