CREDIT MANAGEMENT ABM FREE NOTES | MODULE D | CAIIB EXAM PREPARATION 2023

Overview Of Credit Management | ABM Free Notes

These credit management free notes will help you understand the types of credit and borrowers, the principle of lending, RBI’s role, and the insolvency resolution process and bankruptcy process.

Principles of credit

For lending operations, banks have developed certain basic principles. These principles greatly influence loan policies and other aspects of credit management. For instance, the safety of funds, purpose, profitability, liquidity, Security and risk spread.

Types of borrowers

The following can be categorised into borrowers:

1. A private individual: Governed by the Indian contract act, 1872
2. A sole trader: Unincorporated business having only 1 owner who pays personal income tax on profits earned from the business.
3. Partnership firms: Governed by the Indian partnership act, 1932
4. Joint ventures through special-purpose vehicles 
5. Clubs and association
6. Local authorities
7. Trusts 
8. Institutions
9. Government departments
10. Institutions 
11. Limited liability partnership: Governed by LLP act 2008
12. Private and public limited companies
13.  Statutory companies
14. Real estate investment trusts
15. Cooperative societies
16. Hindu undivided family: Treated as a person under Section 2(31) of the Indian tax Act, 1961
17. Person companies: that only has one person as a member under section 2(62) of the Companies Act, 2013
18. Companies
19. Statutory corporations
20. Trusts and cooperative Societies

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Types of credit

Bank credit can be fund-based or non-fund based.

Let’s understand this. 

In non-fund-based credit, there isn’t any transfer of money but the commitment by the bank on behalf of the client, which may result in a transfer of money to the beneficiary in the future.  

For example, a Bank guarantee issued in favour of government departments (or any other beneficiary) on the behalf of a contractor, who’s a bank’s customer. 

If the beneficiary invokes the guarantee, the bank will have to remit the amount to it and the client, for whom the guarantee was issued, will be liable to pay this amount to the bank.

Thus, a non-fund credit always has a possibility of getting converted into fund-based credit. 

Other than guarantees, the following are forms of non-fund Based credit:

1. Letter of credit 
2. Co-acceptance of bills 
3. Forward contract 
4. Derivatives 

Often, fund-based credit is classified based on:

1. Period (short-term or long-term)
2. Purpose (working capital finance, fixed asset, crop loan etc)
3. Types of customers (MSME, Corporate, agriculture, international, institutional credit etc)
4. Currency (rupee credit and foreign currency credit)

Credit management: Components

• Bank’s loan policy 

Based on the factors like market condition, SWOT (of its own), policies of competitors, sector’s exposure limits and RBI’s guidelines bank’s loan policy are formulated any credit proposal sanction has to be within the framework of this policy.

Generally, the following guidelines are contained in the loan policy:

1. The exposure limit for a single counterparty and a group of connected counterparties.
2. Fixing the exposure limit based on:

• Risk perception bank has on different sectors

1. Discretionary powers at various levels for sanctioning credit proposals.

• Appraisal 

The following are needed to be taken care of before lending money to a borrower:

1. Trustworthiness of borrower
2. Purpose of borrowing
3. Viability of the project/activity 
4. Risk Involved 
5. Amount 
6. Terms of repayment, Interest rate etc
7. Personal guarantee/collateral security 
8. Covenants prescription for effective monitoring 
9. Documents required for the enforcement of the claim in a court in case of default 
10. Charge to be created over the primary/collateral security 

Credit appraisal covers all these precautions under it.

The complexity of credit appraisal depends on various factors like the amount involved, the loan’s purpose and the borrower’s category.

• Delivery 

This relates to the legal aspects of documentation and the creation of charges over security. This also covers the method of delivery (like a loan or cash credit in case of working capital limits) and procedures for disbursal of a term loan.

• Control and monitoring 

To ensure the end use of the bank’s funds and safety monitoring is a must requirement. It’s also in favour of the borrower. In case an unforeseen difficulty arises that can be countered timely with efficient monitoring.

• Credit risk management

For the timely identification, measure and control of risk suitable policies has to be put in place.

• Rectification, reconstruction and recovery 

Credit default is possible even if all the components are properly imposed. 

Defaults can be wilful or due to genuine business problems. In case of unintentional default banks usually examine the feasibility of rectification of default (regularisation of account). 

After that rectification is beyond the reach of the borrower, the lender shall next examine the feasibility of reconstructing the account, so a long rope could be given to the borrower. 

Also, to make the project viable again repayment periods could be elongated, the margin for working capital could be reduced, and concession in pricing could be provided if required.

However, if reconstructing is not possible or the default is wilful, the bank needs to start the recovery process.

• Refinance

During times of tight liquidity position, refinancing comes into play. Norms to avail refinance from NABARD/SIDBI/RBI in respect of certain priority sector advances are elaborated, if a bank gets refinance advances the risk remains with the bank so it doesn’t impact the bank’s decision on a credit proposal.

RBI’s role in bank’s credit management 

The following guidelines have a direct influence on credit management in banks:

• The end use of funds 

There should be no diversion of working capital finance for the acquisition of fixed assets, investments in associate companies/subsidiaries, and acquisition of shares, debentures, units of mutual funds, and other investments in the capital market.

• Priority sector 

RBI decides which sector to include in the priority sector and the minimum percentage of the total credit of a bank to go for this sector. 

Banks are made to comply with the following guidelines:

1. The rate of interest will be as per directives issued by RBI’s department of the regulation (DoR) from time to time.
2. Loan-related and ad-hoc services charges/inspection charges are not allowed to be levied on priority sector loans up to Rs. 25,000. The In case of eligible priority sector loans to SHGs/JLGs, this limit will apply per member and not to the group as a whole.
3. A bank must maintain an electronic record of the date of receipt, sanction/rejection/disbursements with reasons and the record must be inspected (by inspecting agencies).
4. Banks must provide acknowledgement for loan applications received under Priority sector loans and bank boards should prescribe a time limit within which the bank communicates its decision in writing to the applicant.

• MSMED Act 2006

Here are some common guidelines for lending to the MSME sector:

1. Banks need to mandatorily acknowledge all loan applications (submitted manually or online) by their MSME borrowers.
2. Banks need to ensure a running serial number is recorded on the application form as well as the acknowledgement receipt. 
3. Banks are required to establish a system of Central registration of loan applications, online submission of loan applications and a system of e-tracking of MSE loan applications.
4. In case loans up to Rs 10 lakhs are extended to the MSE sector, banks are not allowed to accept the collateral security.
5. Under the PMEGP (Prime minister employment generation programme) which is administered by KVIC, banks are advised to extend collateral-free loans up to Rs. 10 lakhs to all the units. Based on a good track record and financial position, the limit to dispense with the collateral requirement for loans up to Rs. 25 lakhs (with approval of appropriate authority) can be increased.
6. A composite loan ceiling of Rs. 1 crore can be approved by banks to allow MSE enterprises to access their working capital and term credit requirements through a single window.
7. CLSS (Credit linked capital subsidy scheme) is aimed at facilitating technology upgradation by providing a 15% upfront subsidy up to a maximum cap of ₹15 lacks to MSE units.
8. Non-farm entrepreneurs individuals eligible for classification under the priority sector guidelines for GCC (general credit card) extended credit (working capital and term loan requirements of entrepreneurs GCC could be issued as a smart card/debit card.
9. To streamline the flow of credit to MSEs for timely and adequate facilitation of credit flow during their life cycle, RBI issued guidelines:

1. In case of loan terms, extend the standby credit facility 
2. To meet the emergent needs of MSE units, additional working capital is to be provided
3. Based on the actual sales of the previous year, the mid-term review of regular working capital limits is to be conducted.

• Credit exposure norms 

Following are some important credit exposure norms:

• For non-NBFCs: The exposure ceiling limit for a single counterparty (except for the board of banks which are allowed an additional 5%) is 20% (tier 1 capital) and for a group of interconnected counterparties, it’s 25% (tier 1 capital).

For NBFCs: The exposure ceiling limit for a single NBFC (except for the board of banks which are allowed an additional 5%) is 20% (tier 1 capital) and for a group of interconnected NBFCs, it’s 25% (tier 1 capital).

Based on risk perception, more stringent exposure limits could be applicable.

The forbearance of an additional 5% is not available to the exposure to NBFCs.

• After the publishing of the balance sheet date infusion of capital funds may also be taken into account to reckon Tier–1 capital.

Before reckoning the additions to the eligible capital base, banks must obtain an external auditor’s certificate on completion of augmentation of capital and submit the same to RBI.

In the case of collective investment undertakings, securitisation of vehicles and other structures determination of relevant counterparties look through approach has been made mandatory.

• Statutory and other restrictions on some credits 

Banks are required to observe certain statutory and regulatory prohibitions/restrictions concerning:

1. Advances to/against/investments in its shares
2. Directors and their relatives 
3. Entities in which directors and relatives have interest 
4. Directors of other banks 
5. Relative to senior officials
6. Sanctioning committee members of the bank
7. FDRs or other term deposits of other banks
8. India depository receipts, bullion and primary gold 
9. Gold ETF and MF 
10. Purchase of gold in any form 
11. Industries producing or consuming ozone-depleting substances
12. Units using chlorofluorocarbons in the manufacturing process 
13. Arbitrage operations 
14. Buyback stocks/securities
15. Sensitive commodities under selected credit control 
16. Financing promoter’s contribution  
17. Stock and commodity brokers
18. Market makers, shares, convertible debentures and bonds 
19. Units of equity-oriented mutual funds 
20. Certificate of deposits and buy back their CDs and all exposures to Venture capital funds (VCFs)

• Enhancing credit supply for large borrowers through the market mechanism

Additional provisions of 3% points over and above the applicable risk weight will be imposed on incremental exposure of the banking system to a specified borrower beyond NPLL.

• Loan system for delivery of bank credit 

Delivery of bank credit for borrowers having an aggregate fund-based working capital limit of ₹150 crores and above from the banking system and a minimum level of ‘loan account’ of 60% has been insisted upon.

• The interest rate on advances 

Internal benchmarks such as the Base rate/MCLR have not delivered effective transmission of monetary policy and it, therefore, recommended a switchover to an external benchmark-based lending rate system in a time-bound manner.

To price their advanced banks are mandated to consider the following guidelines:

1. Based on the terms and conditions specified in the RBI master directions, scheduled commercial banks shall charge interest on advances.
2. For duly advances approved by the board of directors or any committee of the board, a comprehensive policy on interest rates must have been prepared.
3. All the new floating rate personal or retail loans and floating rate loans extended to the MSME and ME shall be priced concerning the External benchmark-based lending rate (EBLR).
4. Except for the aforementioned, all rupee loans, sanctions and credit limits were renewed and will continue to be priced until the bank decided to switch over to EBLR.
5. Banks must have been allowed to offer all kinds of loans on fixated or floating interest rates.
6. Below a tenor of 3 years interest rates on fixed-rate loans shall not be less than the benchmark rate for a similar tenor.
7. Having regards to the total cost incurred to the bank in extending loans like personal loans and loans of a similar nature interest rate charged shall be justiciable if the extent of return could be reasonably expected from the transaction.
8. It should be on the banks to decide the interest rates on advances in foreign currency based on the market-determined external benchmark. Also, components of spread must be added to decide the lending rate.

Read about it in other

• Monetary and credit policy 

Banks adjust their loan policy and lending rates based on the content of the monetary and credit policy of the RBI.

• Methods of credit assessment 

RBI has mandated that banks have to grant working capital credit limits to MSEs, whose credit limit in individual cases is up to Rs. 5 crores. If the amount is higher, it’s computed based on a minimum of 20% of their projected annual turnover commonly known as the PAT method or Nayak committee method (opening cycle method).

• Income regulation and asset classification 

RBI prescribed banks to classify their assets depending on the conduct of each account.

• Irregularities and reporting of irregularities 

1. Keep the authority concerned informed of the position of irregular accounts at branch/operating units/processing cells at periodical intervals for control/monitoring.
2. To seek the confirmation, where required, of the appropriate authority in case irregularity in an individual account, is observed, accordingly with the requirements of delegation of financial powers enforceable at the material time.
3. To come up with a counter mechanism to regularise the irregularity observed in the account.

Special mention accounts

RBI introduced an asset category viz Special mention accounts (SMAs) which are further divided into the following:

1. Standard
2. Substandard

These show tendencies for possible defaults or delinquency.

SMAs don’t require provisioning since these are not classified as NPAs (Non-performance assets).

RBI guidelines on NPA about loans and advances including IRAC and Provision norms

In a phased manner, RBI introduced prudential norms in line with international practices and as per the financial system committee for income recognition, asset classification and provisioning for the advanced portfolio of the banks.

Banks need to ensure realistic repayment schedules may be fixed based on cash flow with borrowers while granting loans and advances.

Income recognition

Any asset that ceases to yield income for the bank, should be treated as NPA. Also, any income from such loan asset shouldn’t be booked as income until it’s recovered.

Provided that credits in accounts towards interest are not out of fresh/additional credit facilities sanctioned to the borrower concerned, Interest gained on the non-profit assets may be taken to the account.

For appropriation of recoveries in NPAs in the absence of agreement b/w the bank and the borrower, booking of interest on account of partial recovery in NPAs can be made as per a board-approved uniform policy adopted by the bank.

Asset classification

According to the RBI guidelines, all advances are required to be reviewed and classified into two principal categories at regular intervals.

Those principal categories are as follows:

• Performing assets or standard assets

Here are regular and temporarily irregular accounts, as identified by RBI from time to time. Based on actual realisation basis, advances are earning interest income.

Non-performing assets 

Here advances are not earning interest on the actual realisation basis.

Even a leased asset is considered a non-performing asset when it ceases to become generate income for the bank.

Mostly, irregular and sticky accounts with deep-seated irregularities are included in non-performing assets.

Banks are required to make a certain amount of provision on standard assets on fund based outstanding.

Modification in the extent of guarantee cover 

The extent of guarantee covers for credit facilities increased to 82% for ZED-certified MSEs, women, SC/STs, and units under the aspirational district.

Retail/wholesale trade guarantees aligned with other segments

With an exposure limit of up to Rs. 100 Lakhs retail/wholesale trade made an eligible activity under the Credit guarantee scheme.

Trading activities (MSE retail trade & wholesale trade) aligned with other activities of CGS-I.

The credit guarantee cover ceiling was raised from Rs 100 lakhs to Rs 200 lakhs.

The extent of guarantee coverage made at par with the other activities and the rate of annual guarantee fee with the other activities.

Transfer of borrower accounts from one bank to another 

Banks must set up a board-approved policy about taking over accounts from another bank. Before taking over an account, the transferee bank must obtain the necessary credit information from the transferor bank as per the format prescribed in the circular.

The policy may include:

 Norms relating to the nature of accounts that may be taken over

Authority levels of sanction of takeover 

Reporting of takeover to higher authorities 

Monitoring mechanism of taken-over accounts

Credit audit of taken-over accounts 

Examination of taken-over accounts at the Board/Board committee level 

Top management level 

Fair practices code 

Banks must disclose “all in cost” inclusive of all such charges involved in processing/sanctioning of loan applications transparently to enable the customer to compare the rates/charges with other sources of finance.

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