Page 154 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 11: Credit Derivatives

11.4.1 Credit Approving Authority Notes

Commercial bank usually adopts either a committee or sequential process of credit approval.
The former requires ultimate approval of a loan or credit facility by a committee that customarily
consists of members of senior management and the heads of the credit departments. The sequential
process involves an approval chain of individual loan officers with ascending levels of authority
to sanction credit. Most of the Indian banks, especially in the public sector, have adopted the
sequential system of loan sanction.
The proponents of the committee system believe that:

1. The committee has better decision making capabilities, by virtue of the combined experience
of its members and
2. There is greater transparency in the decision making process.

Advocates of the sequential system, however, argue that:
1. Majority of members may follow preferences of senior members of the committee.
2. The system may not always help in speedy decision making.

3. It may be difficult to fix accountability to generate more responsible decision-making.
4. Committee may hence be more risk-prone.
Ultimately, the size of the bank, scope of its operations and most important – its credit culture
will determine the type of credit approval process to be adopted by it. It may be mentioned that
RBI in its recent guidelines has reiterated its, earlier instruction to the banks to consider
establishment of the 'Committee' system of loan approval at the earliest.

11.4.2 Prudential Limits

In order to limit the magnitude of credit risk, banks may fix prudential limits on various aspects
of credit. The banks may establish:
1. Benchmark financial ratios, such as current ratio, debt equity ratio, profitability ratios,
debt service coverage ratio, etc. with flexibility for deviations (These will serve as minimum
entry level qualifications for a borrower to be eligible for credit granting).
2. Single/group borrower limits,
3. Substantial exposure limits i.e. sum total of exposures assumed in respect of those single
borrowers or group borrowers enjoying credit facilities in excess of a threshold limit,
4. Maximum exposure limits to industry, sector, geographic location etc.
The primary objective of fixing these limits is to avoid undue risk concentration, in any industry,
trade, group, business house, etc.
11.4.3 Risk Rating

An important tool in monitoring the quality of individual credits as well as the total portfolio,
is the use of an internal risk rating system. A well structured internal risk rating system is a good
means of differentiating the degree of credit risk indifferent credit exposures of a bank. This will
allow more accurate determination of the overall characteristics of the credit portfolio,
concentrations, problem credits and the adequacy of loan loss provisions, etc.

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