Policies and Structure for Credit

Management
Unit II
Principles of Lending
Principles and regulation of lending; credit policies
and procedures; credit manuals;
organization of credit function; and credit committee.
Principle of lending
The business of lending, which is main business of the
banks, carry certain inherent risks and bank cannot
take more than calculated risk whenever it wants to
lend. Hence, lending activity has to necessarily hold on
to certain principles.
Lending principles can be conveniently divided into
two areas (i) activity, and (ii) individual.
 lending

Activity individual

6 ‘C’s
Security of the Process
safety of
liquidity diversit Appraisal borrowe
y stability profitability r Lending
 liquidity
Liquidity is an important principle of bank lending. Bank
lend for short period only because they lend public money
which can be withdrawn at any time by depositors.
They therefore advances loans on security of such assets
which are easily marketable and convertible into the cash at
short notice.
A bank chooses such securities in its investment portfolio
which possess sufficient liquidity. It is essential because if
the bank needs cash to meet the urgent requirement of its
customers, it should be in position to sell some of the
securities at a very short notice without disturbing their
market prices much.
 safety
The safety of funds lent is another principle of lending.
Safety means that the borrower should be able to repay the
loan and interest in time at regular intervals without default.
The repayment of the loan depend upon the nature of the
security, character of the borrower, his capacity to repay
and his financial standing.
diversity
In choosing its investment portfolio a commercial bank
should follow the principle of diversity.
It should not invest its surplus funds in a particular type of
securities. It should choose the shares and debentures of
different types of industries situated in different regions of
the country. The same principle should be followed in the
case of state govt. and local bodies.
Its aim at minimizing risk of the investment portfolio of a
bank. it also applies to the advancing of loans to varied
types of firms, industry, business and trades.
“ Do not keep all eggs in one basket ”
stability
Another important principle of bank’s investment policy
should be to invest in those stocks and securities which
possess a high degree of stability in their price.
The bank cannot afford any loss on the value of its
securities. It should therefore invest it funds in the shares of
reputed companies where the possibility of decline in their
prices is remote. Govt. bonds and debentures of companies
carry fixed rates of interest.
Their value change with change in the market rate of
interest. But the bank is forced to liquidate a portion of them
to meet its requirement of cash in cash of financial crisis.
 profitability
This is the fundamental principle for making investment by a
bank. Its must earn sufficient profits.
It should therefore invest in such securities which was sure a
fair and stable return on the funds invested.
The earning capacity of securities and share depends upon
the interest rate and the dividend rate and the tax benefits
they carry.
It is largely the govt. securities of the centre, state and local
bodies that largely carry the exemptions of their interest from
taxes.
The bank should invest more in such securities rather than in
the shares of new companies.
Regulation of Lending
According to Unified Directive No. 8, following are the rules/
provisions established for lending/ investment:
Implementation of Investment Policy and Procedures upon
Approval The licensed institutions shall implement the policies
and procedures regarding the investment in Government of
Nepal securities, Nepal Rastra Bank bonds, and other corporate
bodies' share and debentures only upon the approval of
investment policy and procedures by the Board of Directors.
Provision for Investment in Government of Nepal Securities
and Nepal Rastra Bank Bonds There shall be no restriction as
to investment by the licensed institutions in the securities of
Government of Nepal and Nepal Rastra Bank bonds.
Regulation of Lending
Provisions for Investment in Shares and Debenture
of Corporate Bodies (1) Licensed Institutions shall
invest only in the shares and debentures of
corporate bodies listed in the Nepal Stock
Exchange after the public issues of shares.
Licensed institutions may invest in shares and
securities of any one corporate body up to 10 percent
of its core capital and not exceeding the cumulative
amount of such investment in all the companies by
more than 30 percent of its core capital.
Regulation of Lending
According to Unified Directive No. 3 (Provisions
relating to Single Obligor and Limitation of the
Sectoral Credit and Facilities ), the following
provisions has been made:
Fixation of Limit on Credit and Facilities (1) For
"A", "B" and "C" Class licensed institutions Licensed
Institution may extend to a single borrower or group of
related borrowers the amount of fund-based/ non fund
based loans and advances up to 25 percent of its Core
capital fund
Having regard to aspects including production, employment,
the single borrower limit of the loans to be provided to
export sector, small and medium industries, pharmaceutical
industries, agricultural sector, tourism, cement industries,
iron industries and other production-oriented industries has
been fixed at 30 percent in the maximum.
2. Special Provisions Relating to Investment in
Hydropower Projects While investing in a hydropower
project, transmission line and cable car projects, the
following provisions shall be made:- a) The licensed
institutions may advance to the projects relating to
hydropower project the fund-based loan and non fund-based
facilities not exceeding an amount of 50 percent of its core
capital.
11. Provision Relating to Sectoral Credit-
(1) Licensed institution shall have adequate internal policies and systems in
place to monitor the concentration of sectoral exposures for controlling
risks.
The licensed institution shall separate sectoral exposures into two levels on
the basis of credit concentration and arrange for control, monitoring and
information system as follows (as formatted in Form)
(a) Level 1: Extension of Loans and Advances and Facilities from 50
percent to 100 percent of Core Capital into a single sector. The licensed
institution shall identify such loans and arrange monitoring mechanism and
information system by themselves and monitor at least on quarterly basis.
 (b) Level 2: With respect to extension of Loans and Advances and
Facilities exceeding 100 percent of Core Capital into a single sector such
loan shall be also be endorsed by the Board of Directors. The Board of
Director shall make a policy decision as to whether or not to maintain the
exposure limits exceeding 100 percent of the Core Capital on annual basis.
Provisions relating to Housing Land and Real Estate
Loans: (a) The amount of loan to be extended against
the security of real estate shall not be more than 50
percent of the fair market value of the real estate under
collateral security and 60% of FMV for
residentialhome loan
 (b) No licensed institution shall be allowed to advance
loan in real estate more than 25 percent of the total
loan and in real estate and residential housing both
more than 40 percent of the total loan.
Lending on Loan Against Shares shall be restricted to
50% of current market price or 180 days average price
whichever is low.
Laws Relating to Lending
Unified Directive 2 has made provision for Laws relating to
Lending.
 Entire loans and advances extended by a licensed institution
have to be classified as follows based on expiry of the
deadline of repayment of the principal and interest of such
loans/advances:- (a) Pass: Loans/advances which have not
overdue and which are overdue by a period up to three
months.
 (b)Watch List
(c) Sub-standard: Loans/advances which are overdue by a
period from three months to a maximum period of six moths.
(d) Doubtful: Loans/advances which are overdue by a
period from six-months to a maximum period of one
year.
(e) Loss: Loans/advances which are overdue by a
period of more than one year. The loans which are in
pass class and which have been
rescheduled/restructured are called as "the performing
loan, and the sub-standard, doubtful and loss
categories are called non-performing loans.
 Loan classification Minimum Provision
for loan loss

1 Pass Loan: no-default and within 3 1 percent

months of default
2 Watch List Loan: default for one month; non-
renewed; passive 5 percent
3 Sub-standard Loan: within 3 to 6 months 25 percent
of default
4 Doubtful: within 6 months to 12 months 50 percent
of default
5 Loss loan/the loan extended to blacklisted 100 percent
persons, firms, company or corporate body:
More than 12 months of default

21 Adv Hem Raj Pokhrel Upadhyaya, LL M 8/5/22

Provision to be maintained for loan
loss
Loan classification Minimum Provision for
loan loss
(a) Pass 1 percent
(b) Watch list 5 percent
(b) Sub-standard 25 percent
(c) Doubtful 50 percent
(d) Loss/ Bad loan 100 percent
Credit Strategy
Credit Strategy The primary purpose of bank’s credit strategy
is to determine the risk desire. Risk desire, at the organizational
level, is the amount of risk exposure, or potential adverse
impact from an event, that the bank is willing to accept. Once it
is determined, the bank shall develop a plan to optimize
return while keeping credit risk within predetermined
limits. The credit risk strategy thus should cover:
The bank’s plan to grant credit based on various client
segments and products, economic sectors, geographical
location, currency and maturity,
Target market within each lending segment and level of
diversification/concentration;
Pricing strategy.
Credit Strategy
Credit risk strategy should be developed on the basis of
bank's target market and its internal strength.
 The strategy should provide continuity in approach and take
into account cyclic aspect of country’s economy and the
resulting shifts in composition and quality of overall credit
portfolio.
 The credit procedures should aim to obtain a deep
understanding of the bank’s clients, their credentials and their
businesses in order to fully know their customers.
 These strategies should be reviewed periodically and
amended, as reason necessary; it should be viable in the long
run.
Credit Policies
Credit Policies: Every bank has to develop Credit Policies
Guidelines (CPG) that clearly outline the bank's view of business
development priorities and the terms and conditions that should be
stay to for loans to be approved.
The CPG should be updated at a regular interval to reflect changes
in the economic out look and the evolution of the bank’s loan
portfolio. To make it effective, policies should be communicated
timely and should be implemented by all levels of the bank through
appropriate procedures.
It should be distributed to all lending authorities and credit officers.
Credit policies establish framework for making investment and
lending decisions and reflect bank’s easiness for credit risk.
 Any significant deviation to these policies must be communicated
to the Senior Management/Board and corrective measures should be
taken.
Credit Policies
At a minimum, credit policies should include:
1. Areas of credit in which the bank plans to lend and
does not lend (acceptable and unacceptable lines of
credit). These areas can be on the basis of credit
facilities, type of collateral security, types of borrowers,
or geographic sectors on which the bank may focus;
2. Bank's formal credit approval process; detailed and
formalized credit evaluation/ appraisal process,
administration and documentation;
3. Credit approval authority at various levels;
Credit Policies
4. Clear guidelines for each of the various types of
credits, such as loans, overdrafts, mortgages, leases,
etc.
5. Concentration limits on single counter party and group
of connected counter parties, particular industries or
economic sectors, geographic regions and specific
products.
Banks can set their own strict internal exposure limits
comply with any prudential limits or restrictions set by
the Nepal Rastra Bank;
Credit Policies
5. Credit Pricing;
6. Roles and responsibilities of units/staff involved in
credit;
7. Guidelines on regular monitoring and reporting
system.
8. Guidelines on management of problem loans; and
9. Internal rating (Risk grading) systems including
definition of each risk grade and clear separation for
each risk grade.
Credit Policies
The credit policy should enchantment out the process
to ensure appropriate reporting and approval of credit
extension beyond prescribed limits. The policy should
also enchantment out approvals of disbursements of
excess over limits, and other exceptions to credit
policy.
In order to be effective, credit policies must be
communicated throughout the bank, implemented
through appropriate procedures, and periodically
revised to take into account changing internal and
external circumstances.
Credit Procedures
Credit Procedures The credit procedures should aim
to obtain a deep understanding of the bank’s clients
and their businesses in order to fully know their
customers.
Banks should develop procedures that adequately
capture most important issues regarding:
the borrower’s industry;
the purpose of credit;
Credit Procedures
source of repayment;
 track record and repayment history of the borrower;
repayment capacity of the borrower
the proposed terms and conditions and covenants;
adequacy and enforceability of collaterals; and
appropriate authorization for the loan.
Credit Limits
Credit Limits An important element of credit risk
management is to establish exposure limits for single
counter party and group of connected counter parties.
The objective of setting credit limit is to prevent banks
from relying excessively on a large borrower or group
of borrowers.
Banks are expected to develop their own stringent
limit structure while remaining within the exposure
limits set by the Nepal Rastra Bank.
Credit Limits
The size of the limits should be based on the credit
strength of the counterparty, purpose of credit,
economic conditions and the bank’s risk appetite.
Limits should also be set for respective products,
activities, specific industry, economic sectors and/or
geographic regions to avoid concentration risk. Credit
limits should be reviewed regularly at least annually or
more frequently if counter party’s credit quality
decline. All requests of increase in credit limits should
be validate.
Credit Manual
A book of instructions or handbook, especially for
providing loan
 Credit Committee

The Board of directors has a vital role in granting credit as

well as managing the credit risk of the bank. It is the overall
responsibility of a bank’s Board to approve credit risk
strategy and significant policies relating to credit risk and its
management which should be based on the overall business
strategy. Overall strategy as well as significant policies have
to be reviewed by the board regularly.
Each bank, depending upon its size, should constitute a
Credit Risk Management Committee (CRMC), ideally
comprising of head of credit department and treasury. This
committee should be empowered to oversee credit risk taking
activities and overall credit risk management function.
Credit Committee
 The CRMC should be mainly responsible for;
The implementation of the credit risk policy/strategy
approved by the Board.
Monitor credit risk and ensure compliance with limits
approved by the Board
Recommend to the Board, for its approval, clear
policies on standards for presentation of credit
proposals, financial agreement, rating standards and
benchmarks.
Credit Committee
Recommend handing over of credit approving powers,
limits on large credit exposures,
standards for loan collateral,
portfolio management,
loan review mechanism,
risk monitoring and evaluation,
pricing of loans,
regulatory/ legal compliance
Organization of Credit Function
A sound and well-defined criteria for new credits as
well as the expansion of existing credits is necessary
for credit risk management.
Before allowing a credit facility, the bank should make
an assessment of risk profile of the
customer/transaction. This may include:
• Credit assessment of the borrower (industry and firm
specific analysis)
 The purpose of credit and source of repayment.
 The track record / repayment history of borrower.
Organization of Credit Function
Repayment capacity and other sources of income of
the borrower.
• Terms, conditions for the credit agreement.
• Consistency in past history and future projections;
Expected future cash flow of the borrower.
• Adequacy and liquidity status of collaterals.
• Approval from appropriate authority
Organization of Credit Function
Banks have to make sure that the credit is used for the
purpose it was borrowed. Where the obligor has
utilized funds for purposes not shown in the original
proposal, banks should take steps to determine the
implications on creditworthiness.
Banks should classify such connected companies and
conduct credit assessment on group basis.
Banks utilize collateral and guarantees to help mitigate
risks inbuilt in individual credits but transactions
should be entered into primarily on the strength of the
borrower’s repayment capacity.
Organization of Credit Function
Banks should have policies covering
the acceptability of various forms of collateral,
procedures for the ongoing valuation of such collateral,
and a process to ensure that collateral is, and continues
to be.
 With regard to guarantees, banks should evaluate the
level of coverage being provided in relation to the credit-
quality and legal capacity of the guarantor.