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Introduction:

Credit Policy
The word, "policy", can be a broad and frightening term. While most companies have
their own policies, procedures, and guidelines, it is unlikely that any two firms will
define them in a similar manner. Furthermore, while many individuals appreciate the
need for a workable set of regulations, "policy" carries some negative connotations
of bureaucracy and inflexibility. The word is derived from the same root as politics
and police, and the sentence, "It's not our policy," can infuriate customers.
Though most consumers expect to pay cash or use a credit card when making a
purchase, commercial customers typically want to be billed for any products and
services they buy. You need to decide how much credit you're willing to extend them
and under what circumstances. There's no one-size-fits-all credit policy--your policy
will be based on your particular business and cash-flow circumstances, industry
standards, current economic conditions, and the degree of risk involved.
As you create your policy, consider the link between credit and sales. Easy credit
terms can be an excellent way to boost sales, but they can also increase losses if
customers default. A typical credit policy will address the following points:

Credit limits. You'll establish dollar figures for the amount of credit you're
willing to extend and define the parameters or circumstances.

Credit terms. If you agree to bill a customer, you need to decide when the
payment will be due. Your terms may also include early-payment discounts
and late-payment penalties.

Deposits. You may require customers to pay a portion of the amount due in
advance.

Credit cards and personal checks. Your bank is a good resource for credit
card merchant status and for setting policies regarding the acceptance of
personal checks.

Customer information. This section should outline what you want to know
about a customer before making a credit decision. Typical points include
years in business, length of time at present location, financial data, credit
rating with other vendors and credit reporting agencies, information about the
individual principals of the company, and how much they expect to purchase
from you.

Documentation. This includes credit applications, sales agreements,


contracts, purchase orders, bills of lading, delivery receipts, invoices,
correspondence, and so on.
An often-overlooked element in setting a credit policy is the design of invoices
and statements. The invoice is the document that describes what the
customer is being billed for; the statement is the follow-up document that
indicates the status of the account.
One collection and creditor rights expert says that invoices and statements
that are clear, easy to read, and allow the customer to quickly identify what is
being billed are likely to be paid faster.

Here are several points to include on the invoice:

An invoice number
An invoice date
A customer number or other identifying code
A complete and clear description of the product or service and item numbers,
if appropriate. Avoid abbreviations your customer may not understand.
The customer's purchase order, job order or other reference information that
will make identifying the invoice easier
The total dollar amount due, clearly indicated
Payment terms and due date (and specify any early-payment incentives or
late-payment penalties).

OBJECTIVES OF A CREDIT POLICY


Five (5) objectives of a credit policy are listed as follows:

To ensure consistency in the processes and procedures used to manage all


credit aspects of an organization.

To ensure that the expectations of the management of an organization and


the credit department are aligned and met consistently.

To ensure that all customers are treated fairly when making credit decisions.

To provide for succession management and training if credit personnel leave


the business.

To evaluate credit decision making and adjust as circumstances warrant.

SETTING CREDIT POLICIES


Choosing the right balance in setting credit policies is a fine art. On the one hand, it
is important for your business to work with retailers to build sales but on the other
hand, if you are too free with credit, you may lose more on your sales than you will
make and that soon leads to financial disaster. So then, how do you juggle the
desire for higher sales with the need for rational credit decisions to strike the right
balance?
To answer this question, one of the most important things to look at is the size of
order. Obviously your credit standards should be more rigid on a large order than on
a small order. In most instances, if you're selling to small retailers and your opening
order requirements are not substantial, your typical first order will be in the $100$300 range.
If you're using typical mark-ups to get to that wholesale amount, your out-of-pocket
costs to produce the order will be in the $50-150 range. That being the case, your
sale is no larger than what someone may typically spend on a retail-shopping trip.
Sales of this nature are typically cash including credit cards and checks. The
dollar amount simply doesn't justify spending the time and money to do a full-blown
credit investigation so the terms are simple.
On your first sale to a retailer of this dollar amount, it is totally legitimate to request
that it ship COD. In some sectors, such as the handmade craft sector, this is the
norm. Their system is very simple and workable at both ends. The first order is
COD and subsequent orders are shipped Net 30 days, which means the retailer
pays by check 30 days after the order is shipped.
An invoice typically accompanies the package (as it should also with the COD
shipment), and the retailer processes it for payment according to terms. The logic is
that the supplier is guaranteed full payment on the first order and the fact that the
order was paid for indicates the store has the money to purchase additional
inventory.
In the rare event that the retailer defaults on payment of the second shipment
assuming it's of comparable size to the first the supplier only loses profit, since the
first COD payment would cover the cost of the second shipment.
You stand a pretty good chance that the third order will be paid for because you now
have two instances of good credit with the retailer. Theoretically, the most you can
lose on this credit system is your profit. Your costs are covered.
If a retailer balks at the COD terms, explain that you are a small start-up company
and you do not have the staff available to do credit checks. Asssure the retailer that
you will notify them of the COD amount the day the order ships so they can prepare
a check in advance and that subsequent orders will go open account.

Note: Do notify a customer of the COD amount whenever you make a shipment.
Many times the people working in the store are not authorized to write checks and
the shipment will have to be refused and reshipped the next day which is a hassle
for everyone involved.
Be wary of a retailer that gets too huffy at the COD terms on an initial small order.
All too often that is a danger sign that the retailer is not credit worthy.
If you ship an order COD, make sure you ship it "complete". As reasonable as COD
on a first order may be, it is unreasonable to expect a retailer to accept two or three
COD shipments simply to get the entire order. There is an add-on shipping fee for
CODs. If you ship in three increments, you are forcing the retailer to pay that COD
charge three times!
If you must make an initial partial shipment, either cancel out the balance of the
order or ship it out "open account" after getting the retailer's approval. Many
times the retailer would prefer not to get the straggling merchandise, preferring to
add it onto their re-order instead.
Even when you start a relationship on a COD basis, it is a good idea to provide a
credit application to the retailer for their submission. It gives you a good vehicle to
ensure you have the proper information for your records of the name, address, and
ownership of your customer. And it gives you a good way to store tax identification
numbers just in case you're sales-tax audited and need to prove you were selling
items for resale and not consumption.
Keep the form as simple as possible and ask for no more than one bank and three
vendor references. Make it look professional but not invasive. If you have time
you may want to follow-up with credit information requests to the vendors and bank
listed but since your first order is COD, you don't need to hold up any shipments
awaiting their response.
However you decide to handle credit, remember that the retailers are
yourcustomers. Treat them in a friendly albeit professional manner.

IMPORTANCE OF CREDIT POLICIES


Credit policies help govern the lending or credit activities of an organization. This
relates to goods or services extended to customers on a credit basis. There are
different types of credit polices which can affect the efficiency and cash flow of an
organization.

Identification
o

Credit policies represent the guidelines and rules established by top management to
govern or oversee the organization's credit department and it performance. This can
include credit or loan qualification requirements, loan amounts, types of customers,
collateral requirements and applicable interest rates.
Types

Credit policies can be based on the business industry. Automotive, home, academic,
retail, wholesale and credit card lending all may have different credit policies. Tight
credit policies refer to conservative or restrictive guidelines in the extension of credit.
Loose policies allow for more freedom or flexibility. A given business, for example,
may focus more on debt collection instead of credit investigations and analysis.
Significance

The significance of credit policies can be realized in the operational efficiency of


credit departments. This is due to a reduction of ambiguity over how to proceed in
their functions. Written guidelines allow for clarity and help to provide instruction.
Credit policies can also help improve a company's cash flow, depending on the
policy type. Tight credit polices can reduce instances of loan default and speed up
accounts receivable turnover, thus increasing cash flow.

WHY DO BANKS CREATE CREDIT?


Simply put, to collect interest.
People put their money into banks to generate interest and keep it safe.(could you
imagine the crime rate if everyone kept their life savings in cash at their own
house?).
Banks then loan that money out to other people or companies on the condition that
they'll pay back the money plus, say 10% more (called interest)--within an agreed
upon deadline. This person or company then makes good on their payment (plus
interest) and the bank gives some of the interest--say 1-2%--to the people that keep
their money at the bank.

The more money that people keep at the bank, the more money the bank can lend
out, thereby generating more money for them in the form of interest.
Credit cards, then, are a simplified process of lending the approved cardholder a preset amount of money (on which they have to pay interest) without the hassle of
dressing up, going to a bank, and convincing them that you will be successful in
paying them back. With credit cards, the longer it takes to pay them back, the more
you end up spending in interest, which is literally free money for the banks.
If everytime I give you $10 you give me $12 back, why WOULDN'T I create credit?

SIX ESSENTIAL ELEMENTS OF AN EFFECTIVE CREDIT


POLICY:

Receivables represent the largest single liquid asset of most companies.


On a good day, efficiently turning these accounts into cash flow is a tough
job. In the current business climate with reduced sales potential and the
threat of recession credit professionals are under increased pressure to
productively manage this key responsibility.
Whats the secret to successfully tackling this challenge? Consistent
operational processes.
Effectively managing accounts receivable is all about well -ordered
processes from beginning to end. Yet, surveys have shown that only a bout
half of all credit departments have a written credit policy in place and
only one-quarter of those regularly review that policy.
If youve been putting off drafting a credit and collections policy - or
havent updated yours in awhile this is an excellent time to do just that.
Following are six essential elements you should include to ensure youre
taking a consistent and structured approach to limiting bad debt and
improving the cash flow position of your company.

Elements of an Effective Credit and Collection Policy


1. Mission Statement
A thoughtfully designed mission statement is basic to a functional credit
and collection policy. The mission statement should define the purpose of
the credit department and express the long-range focus of the policy
within the framework of the organizations mission as a whole.

A key point to consider when developing the Mission Statement: the


primary purpose of every credit departme nt should be to maximize sales
within the framework of the organizations appe tite for risk.

2. Statement of Goals
Goals should track with current market conditions and the strategic
direction of your organization. In addition, they should function as drivers
to improve receivable management. Therefore, goals must be linked to
targets and monitored and measured against established metrics.
Many credit departments utilize the following metrics in establishing goals:

DSO Days Sales Outstanding


CEI Collection Effectiveness Index
Aging Bucket Performance
Percent Current
Bad Debt Write-off Percentage (see Accounting for Uncollectible
Accounts)

Benchmarking statistics by industry can be found in the Credit


Research Foundations Quarterly National Summary of Domestic Trade
Receivables.

3. Credit Department Organization


Including a section in the policy that spells out specific roles,
responsibilities and especially levels of authority of the various credit and
collections staff streamlines operations, prevents redundancy and
improves productivity.

4. Credit Evaluation and Approval Process


The most important function of this section of the policy should be to:
1. Define what your company considers an acceptable credit risk.
2. Outline a credit evaluation process that allows for quick, consistent
and objective decision making and, thus, delays as few orders as
possible.
3. Assign credit limits to every acceptable account to minimize the
need for manual intervention to release orders.

Items that should be covered:

Credit terms. Your terms may differ by product line and location of
the customer (domestic or international, country by country).
However, keep exceptions to the minimum and ensure they are
based on competitive practices and generate a satis factory return on
investment.

Credit evaluation process.


Do you require a signed credit application? (We
recommendalways, see Getting the Most Out of Your Credit
Applications.)
When do you require financials? What types of financial
statements are acceptable? (See Reliability of Financial
Statements on U.S. Firms) What ratios are used to analyze
financial information?
What third-party sources do you utilize: credit bureau reports,
credit references, bank references, public records, industry
credit group? (See, Getting Results with Industry Credit
Groups)
Do you use a credit scoring system? What and how?

Credit limits. How are credit limits calculated and assigned?

Substandard and unacceptable credit risks. Saying no to credit


should not negate the sale. Have a plan in place to: (1) notify the
customer and the sales department; (2) outline acceptable forms of
security or collateral; (3) offer alternative methods of payment; and
especially, (4) describe when you will reevaluate the account, and
how the customer can become creditworthy.

5. Credit Continuation Procedures


Granting, or withholding credit facilities should never be considered a one time decision. Today's business climate is erratic, to say the least.
Companies that appeared secure six months ago may now be on the
verge of collapse. Its essential to continually monito r your receivables
portfolio to ensure you are maintaining an overall appropriate level of risk.
Items to cover in this section:

Incentives for prompt payment. If you find your DSO (days sales
outstanding) isnt tracking where youd like, you might consider
discounting invoices for early payment, or charging interest on late
payment.
Frequency of and procedures for credit re -evaluation. Its good
practice to schedule all or a portion of your larger accounts (using
the80:20 rule) for routine review, so you can quickly revise limits
based on changing levels of creditworthiness.
Procedures for approving orders when a customer has reached
its credit limit.

6. Collection
Uncollected dollars nibble away at your companys cash flow and
profitability, and can ultimately threaten its very survival. A survey by the
Commercial Law League of America revealed that after three months, the
probability of collecting delinquent accounts drops to 73%. After 6 months,
collectability drops to 50%. And after 1 year, collectability is just 25%. Its
essential that you have a plan in place to follow up on every past due
account.

WHAT ARE THE 4 CS OF CREDIT?

Credit investigation could get intricate and dense. The information that is being
gathered could be getting strewn and scattered all over the place. The 4 Cs of Credit
helps in making the evaluation of credit risk systematic.
They provide a framework within which the information could be gathered,
segregated and analyzed. It binds the information collected into 4 broad categories
namelyCharacter; Capacity; Capital and Conditions.
No matter how many Cs we come up with, the fundamental question that remains to
be answered by the framework of our analysis is:
'Will I get paid on time?'
So let's discuss the structure of our credit analysis within the context of the 4 Cs of
Credit :

Character:
JP Morgan, a successful businessman once said that 'I will do business with anyone
as long as he/she is honest!'
In analyzing Consumer Credit one would consider the following:

Has the person declared bankruptcy in the past


Does the person have a good credit record
Does he/she have a stable job
What is the level of education/experience
What is the person earning and what is the earning potential
Stability at the place of residence, whether rented or owned.

In analyzing Commercial Credit one would consider the following:

The size of the operations


The number of years in business
The legal form of the business By this one means 'Retail', 'Wholesale',
'Service' or 'Manufacturing'. Typically the incidence of business failures is high
in the Retail and Service segments.
Is the business a Parent, Subsidiary or a division
Does the business have a Holding company?
" The structure of the business
Is the business a Sole Proprietor, Partnership or Corporation?
For Sole proprietor or Partnership type one would further seek personal
information on individual(s) running the business.
The number of employees
There are Industry specific Norms for 'Employees to Sales' ratio.
The management record of the company
The location of the company
Any previous evidence of fraud
Any previous Insolvency record?
Any Labor disputes or issues?
Are the products/service sold by the prospect complimenting products/service
to the ones that you may sell?
Is the business practice ethical?
Is the business seasonal/ non-seasonal
Is the business Local/ National or International.
o The economy of a business accordingly could depend upon local/ national
or international economy.
Is there a growing or a going market for this business or the business
redefining itself and what would be the impact of the internet on this business.
o See what computer downloads (free peer-to-peer file sharing (P2P) E.g.
Napster, Limewire) has done to the music industry
How willing is the prospect to share information?
How diligently does the prospect fill your Credit Agreement/Application?
What are the references saying?
Are there too many lay-offs especially of key personnel?
Are there any Law suits pending against the company?
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What does the website of the company say and look like?
Is there any recent media coverage about the company?
o Is it positive or negative
o Or are there any rumors floating?
If the company's stock is publicly traded then see how its stock is performing?
One can also check the indices for a particular type of Industry to see how in
general the Industry is doing. The collapse of the NASDAQ is a warning of the
debacle of the tech companies.

Capacity
What does one analyze under this segment?
Is it:

Capacity of the business to pay?


Capacity of the business in getting paid?
Capacity of the business to receive/absorb?
Capacity of the credit grantor to expose?

Sometime a business that you are analyzing might not have the required Capacity in
kind but the same could be latent and hidden in some other form. For example a
start-up business should have a good business blue-print of succeeding namely a
good business plan.
A contractor might have a good media advertising plan, say an Ad in the local
Yellow Pages. All this adds to the capacity of a business to carry on trade and
perhaps be successful.
Innovation, Education, Experience, Knowledge would be some other considerations.
Management should be able to foresee trends in the marketplace and blend
accordingly.
It should have plans both for good and bad turns in the economy. Adoption of sound
management techniques and computer-related technologies is important.
Companies must remain Relevant with their processes; products and operate with
Speed in today's Digital age.

Larger businesses should also have people that know how not just to manage the
company but also its main asset, its people.

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cash and only cash can pay bills


The capacity of a business to pay its bills would stem from good cash-flow. A
business could become cash strapped if it does not collect its accounts receivable on
time. You must have heard of DSO! What is DSO? Isn't it a measure of ones
capacity to pay? Say if a business has a DSO of 55 days. This means that at an
average this business gets paid by its customers in 55 days. The question then
arises that when will this business then pay its suppliers? In all probability the
answer is that its capacity to pay its suppliers will be after 55 days. In this event you
may want to evaluate its borrowing capacity to see if you can cajole this company to
pay you in time even if it means that this business borrows to pay you.
This would bring on the analysis of how the debt of the company is structured in
terms of secured and unsecured debt with an operating lender, generally the bank.
Short term borrowing could be calculated as a percentage of the inventory and A/R
on hand. One should look at the line of credit and see if there is capacity for more
borrowing. Also check for any negative occurrences as bad checks (cheques) or any
default against operating loans or covenants.
The capacity of your product to influence payment is also important. If your product
being sold is fiercely competitive then it may not have the capacity to influence timely
payment. If your product does not directly contribute to the COGS of the buyer then
again it might not have the capacity of influencing timely payment. Competition
definitely influences Capacity.
The Capacity to expose and increase your credit risk also depends upon your own
ability and resilience to getting hit with either slow payment or perhaps no payment!
Credit departments that have a lot of confidence in their collection ability and ability
to influence payment have a wider capacity to expose and absorb. Your productmargin will also influence this capacity.

Capital
Capital would refer to the financial resources obtained from financial records that a
company may have in order to deal with its debt. Many a time's credit analysts would
make this portion of the credit analysis the most important one. Weight is given on
Balance Sheet items and components like Working Capital , Net Worth and Cash
Flow.

One must know how to read financial statements and that too from the perspective of
a creditor. Short term liquidity is important if you are expecting to get paid in the short
term. You should be able to see whether this company has the ability to absorb more
debt and then where does your loan (selling on credit is a loan - isn't it?) fit in the
overall debt-framework of this business

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You should also evaluate to see if you can depend on the numbers whether they are
audited, unaudited or company prepared. If required speak with the firm or person
who has prepared the statements.

Leveraged borrowing depends on the equity/ net worth that a company has and it is
a good idea to see if the company is committed to improve its borrowing-power by
contributing to its Equity/Capital/Net Worth . One way of doing this is by retaining all
or portions of its earnings.

But all said, done and then undone Cash and ONLY Cash pays bills. Thus, keep an
eye of the company's cash-flow and cash-position.
But one must be cognizant of the fact that financial records are snapshots of the past
and credit analysis is trying to figure out the future. Thus all 4 Cs of credit are
important in the overall analysis of a company or an individual where you combine
elements of the past to make a futuristic prediction.

Conditions
This refers to the external conditions surrounding the business that you are
analyzing.
For example the construction industry might get influenced with the changes in the
government's wide range of policies on immigration, interest rates and taxation.
There might be likelihood that a company that you are evaluating deals in
international trade and a shift in the currency rates might have a detrimental or
beneficial effect on it.
Business with local economies would be prone to the social climate and their
influence on the local society. Torontonians must have heard of the flamboyant
discount retailer "Honest" Ed Mirvish who treats the local community to free turkeys
every Christmas.
On another note a lot of businesses became insolvent in the Ice Storm a few years
ago in eastern parts of the US and Canada that were totally dependant on the local
economy. If winter is very mild the businesses that depend on snow feel the crunch..
All of this can again influence the ability or intention of a customer to pay his/her
bills.Thus in evaluating the degree of risk of a customer, information revolving
around the 4Cs of credit would be normally necessary.

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WHY TO HAVE A WRITTEN CREDIT POLICY.?

First, the responsibility of managing receivables is a serious undertaking. It involves


limiting bad debts and improving cash flow. With outstanding receivables often being
a firm's major asset, it is obvious that a reasoned and structured approach to credit
management is necessary.
Second, a policy assures a degree of consistency among departments. By writing
down what is expected, the arms of your company (whether marketing, production,
or finance) will realize that they have a common set of goals. Conversely, a written
policy can delineate each department's functions so that duplication of effort and
needless friction are avoided.
Third, it provides for a consistent approach among customers. Decision making
becomes a logical function based on pre-determined parameters. This simplifies the
decision process and yields a sense of fairness that will only improve customer
relations.
Finally, it can provide some recognition of the credit department as a separate entity,
one which is worthy of providing input into the overall strategy of the firm. This allows
the department to be an important resource to upper management.
One can see that developing a policy is more than a necessity. It is an opportunity to
improve the efficiency of your entire organization.

4 WAYS TO CREATE A GOOD CREDIT POLICY


Every business owner knows the importance of cash flow. When you have a plan in
place to take care of the ebbs and flows of sales, most finance headaches
disappear. A business can be profitable but still have insufficient cash to manage its
everyday operations.
This occurs at times of seasonal changes to consumer behaviour and if you have not
put sufficient cash aside in the good times, your business can flounder when sales
drop. MYOB is a sophisticated accounting software package that can help you
predict the times when you need to rely upon accumulated cash rather than
continuing sales.
We have previously discussed how you can put plans in place to overcome these
fluctuations, by having an overdraft for example. Another way to ensure that your
cash flow fluctuations are minimised is to ensure that your debtors pay bills on time.
Attendees at MYOB courses will probably already have learned this.

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In fact, granting credit terms to a customer needs to be a carefully considered


practice, so let's take a look at some of the ways you can create a good credit policy
to ensure that you don't extend credit to customers who do not deserve it.

The aim of any good credit policy should be to identify which customers to trust.
Granting credit is a great way to maximise sales when it is done properly. Customers
feel a greater sense of loyalty when credit is extended to them and, provided this
process is properly managed, credit can become an important part of your business
development strategy.

Measuring the performance of debtors is an important part of credit policy. The more
information you gather about the ways in which your customers conduct their
accounts, the better position you will be in to manage the credit facilities you have
granted. Accounting packages like MYOB give you the capacity to analyse every
customer to ensure that they are keeping within their credit terms.

Developing a customer profile is also important. When you have a sophisticated


number of tools to measure the performance of every customer, you can not only
manage the terms under which they operate, but you will also know which customers
are likely to bring you further sales making it easier for you to offer them some more
attractive terms to encourage more sales.

Many businesses rely on the instinct, but a good credit policy is one that relies upon
actual measured performance. That's why it is necessary to have a good accounting
software package to keep a tab on every customer's performance. When granting
credit for the first time however, it may well be a pig in a poke type situation, but
business references

WHY POLICIES DIFFER


Credit policies differ in both length and content.
Concerning length, some are as short as several paragraphs, while others can go on
for many pages. As one might suspect, there are advantages and drawbacks to each
approach. In a positive sense, a detailed policy leaves little room for doubt.
Procedures are spelled out, and employees need only refer to their manual to know
how to perform. There will be no gray areas between departments, and consistency
will reign.
On the other hand, a long and excessively detailed policy can limit employee
creativity or empowerment. New ideas on how to work in a changing world will be
superseded by a set of omniscient regulations. Also, a huge volume of rules can be
overwhelming.
There is the story of a cartographer who wanted to map his country so perfectly that
he drew it on a scale of one to one. When completed, he found that he had nowhere
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to place the map. Similarly, too many written regulations can actually get in the way
of productivity.
The above arguments present a question of balance. As noted in our initial definition,
a policy must express a general course of action. It can be supplemented, however,
with some procedures that can guide daily functions. We will use this approach in
our later examples.
The question of companies having policies with differing contents is worth
mentioning. This can result from many factors which may include the
competitiveness of your industry, the location, profit margins, your company's goals
for market share, the company's own cash requirements, production needs, or the
size and culture of your firm. It is a truth that many policies can be designed, and
each one may be correct for a particular firm.
With this in mind, we will not try to provide a generic credit policy. Instead, we will
offer an approach for the development of your own policy and a format which may
prove effective.

WHY BANK CREDIT POLICIES FLUCTUATE

In a rational profit-maximizing world, banks should maintain a credit policy of lending


if and only if borrowers have positive net present value projects. Why then are
changes in credit policy seemingly correlated with changes in the condition of those
demanding credit?
This paper argues that rational bank managers with short horizons will set credit
policies that influence and are influenced by other banks and demand side
conditions. This leads to a theory of low frequency business cycles driven by bank
credit policies
. Evidence from the banking crisis in New England in the early 1990s is consistent
with the assumptions and predictions of the theory.

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THE NEED TO DEFINE CREDIT POLICY STANDARDS AND


PRACTICES
A new 501c3 research and education based non-profit focused on assuring that
banks, regulatory agencies, and policy makers have access to collaboratively
developed and empirically validated credit policy standards and best practices.

Introduction
Given that the primary reason identified in surveys, by regulators, and
researchers for the current, and past, credit crisis is a gradual decline in credit
standards, it seems it is time to try a different approach. The Credit Policy Institute is
the first 501c3 research and education based non-profit association focused on
working with a variety of financial, academic, and non-profit institutions to help
assure that banks, regulatory agencies, and policy makers have access to
collaboratively developed and empirically validated credit policy standards and best
practices.
The goal is to try and find a solution to what seem to be commonly agreed upon
issues that continue to be inadequately addressed at least in enough major
institutions to account for the vast majority of the historic and current losses.
To begin with, banking executives, as well as taxpayers, are concerned with keeping
financial institutions credit processes aligned with emerging market realities, as such
a key issue is understanding how to better manage and optimize regulatory capital
requirements while meeting borrower and investor requirements.
A critical success factor in this effort is the development and implementation of
effective credit policy and practices. However, while the Further Readings listed
below demonstrate that there has been a robust debate about various approaches,
to date there has been no empirical analysis of actual bank credit policy and
practices, only very high level surveys of bankers and regulators as to their views on
changes in lending standards without any examination of the actual standards. The
Institutes efforts are focused on helping banks and regulators finally justify the steps
necessary to mitigate future credit boom and bust cycles.
Consequently, the Institute's primary mission is to provide the infrastructure to help
the industry define, standardize, document, and share credit policy best practices,
and allow bankers and regulators to free up related resources for other purposes.
Without an empirical examination of actual credit policies and practices and there
potential related impact on loan portfolio performance, it is unclear how more
effective approaches can be identified and publicly supported.
To accomplish this mission, the Institute's first order of business is working with
senior credit executives to help securely collect and analyze a cross-section of the
industrys existing credit policies and practices. To date, the discussions reinforce
previous anecdotal indications that there is not uniform agreement as to what even
17

basic terms like credit policy or guideline mean, much less commonly agreed
standards or best practices.
The project is beginning with commercial real estate (CRE), the sector that seems to
be the most current concern and over time will expand to cover other credit products
such as Equipment Finance, SBA, and Asset Based Lending.
The Institute will incorporate evolving best practices and regulatory requirements
through on-going interaction with the appropriate stakeholders.

Current Management and Theoretical Discussion


There is an ongoing debate about the existence of generally accepted credit policy
standards and best practices, their impact on an individual banks competitive ability
and long term business survival, as well as on economy. There is even a robust
debate along the contingency theory front as to whether there is even such a thing
as 'best practices', and on the management front as to whether there is a tipping
point in size and risk complexity that is just too 'big to manage', let alone regulate.
In general, this topic relates to how industries identify and implement effective
operating standards and what, if any, role they play in corporate governance, in
particular risk management. Consequently, this article is meant to be an evolving
discussion of this topic, with the hope that practitioners and academics from around
the world will help inform and direct it.

Business Challenge this Discussion Aims to Address


In the financial institution sector there are espoused commercial credit policy
standards and generally recognized best practices; however, there are significant
loan portfolio performance differences between banks of similar size and serving
similar markets which raise a question about the adequacy of existing credit policies
and/or how the related practices are implemented.
To focus this discussion, I have chosen the commercial real estate (CRE) lending
segment because it has historically been a highly competitive and volatile market
subject to economically significant boom and bust cycles. Just after the last major
CRE related credit crisis in 1992 the regulators published a list of lessons learned
and related best practices, unfortunately they thought it was necessary to reissue
them 2006 and again in 2008.
What are they seeing or concerned about, and has the industry really learned from
the mistakes of the past?

18

Consequently, the specific research question, is whether there a way to improve


existing credit policy and practice, or its implementation, to help banks more
effectively manage through, or mitigate, these cycles? While it is assumed they play
a positive role, there is no research on whether the banking industry has defined and
accepted any CRE credit policy and practice standards, nor what, if any, specific role
standards may play in loan portfolio performance.
For example, there are surveys of whether a banks lending standards have
tightened or loosened, but no information on what those standards were before or
after the survey.

Specific Discussion Questions


Have banks agreed that there are credit policy and/or practice standards, and what,
if any, gaps exist and why ?
Is there any relationship between existing policies and/or supporting practices and
loan performance ?
Even though some 'prior' research indicates that regulatory assessments of credit
'standards' are effective as early warning systems, does recent experience really
support a continued reliance on those findings?

Broader Practical Application of This Discussion


As partially covered in the Further Readings listed below, there has been a rich
discussion about credit risk, principles versus rules based regulatory approaches
and the role of minimum capital requirements, organizational effectiveness,
behavioral economics, and implementation theory that has yet to be broadly applied
to existing credit policies and practices. Given recent experiences, there is the the
potential to create and justify new and innovative approaches that could save
billions, if not trillions, of dollars in future credit cycles.

IDBI BANK
The Industrial Development Bank of India Limited (IDBI) (BSE: 50011 ) is one
of India's leading public sector banks and 4th largest Bank in overall ratings. RBI
categorised IDBI as an "other public sector bank". It was established in 1964 by
an Act of Parliament to provide credit and other facilities for the development of the
fledgling Indian industry

19

It is currently 10th largest development bank in the world in terms of reach with 1455
ATMs, 883 branches including one overseas branch at DIFC, Dubai and 598 centers
including two overseas centres at Singapore & Beijing.
Some of the institutions built by IDBI are the National Stock Exchange of
India (NSE), the National Securities Depository Services Ltd (NSDL), the Stock
Holding Corporation of India (SHCIL), the Credit Analysis & Research Ltd,
the Export-Import Bank of India(Exim Bank), the Small Industries Development Bank
of India(SIDBI), the Entrepreneurship Development Institute of India, and IDBI
BANK, which is owned by the Indian Government.IDBI Bank is on a par with
nationalized banks and the SBI Group as far as government ownership is concerned
It is one among the 26 commercial banks owned by the Government of India.The
Bank has an aggregate balance sheet size of Rs. 2,53,378 crore as on March 31,
2011.
IDBI Bank, with which the parent IDBI was merged, was a new generation Bank. The
Pvt Bank was the fastest growing banking company in India. The bank was pioneer
in adapting to policy of first mover in tier 2 cities. The Bank has one of the highest
productivity per employee in Indian banking industry.
On 29 July 2004, the Board of Directors of IDBI and IDBI Bank accorded in principle
approval to the merger of IDBI Bank with the Industrial Development Bank of India
Ltd. to be formed incorporated under the Companies Act, 1956 pursuant to theIDB
(Transfer of Undertaking and Repeal) Act, 2003 (53 of 2003), subject to the approval
of shareholders and other regulatory and statutory approvals.
A mutually gainful proposition with positive implications for all stakeholders and
clients, the merger process is expected to be completed during the current financial
year ending 31 March 2005.
The immediate fall out of the merger of IDBI and IDBI Bank was the exit of
employees of IDBI bank. The cultures in the two organizations have taken its toll.
The IDBI Bank now is in a growing fold. With its retail banking arm expanding further
after the merger of United western Bank.

CREDIT POLICY OF IDBI BANK


Policy for micro, small & medium enterprises:
1. The Policy shall guide the Banks MSME Advances as defined by RBI from time to
time. The Policy shall also be applicable to the Banks MSME Advances as defined
by it from time to time. At present, the Advances to units with turnover upto Rs. 100

20

crore are treated as MSME Advances. Any parameter that is not detailed in this
policy, shall be guided by Banks Credit Policy from time to time.
2. Bank is committed to the Code of Conduct given by The Banking Codes and
Standards Board of India (BCSBI) for Micro & Small Enterprises, released on May
31,2008. The Code of Banks Commitment to Micro and Small Enterprises (MSE
Code) is a voluntary code, which sets minimum standards of banking practices for
banks to follow when they are dealing with Micro and Small Enterprises (MSEs) as
defined in the Micro Small and Medium Enterprises Development (MSMED) Act,
2006. It explains norms that banks are expected to follow while dealing with MSEs
for day-to-day operations and in times of financial difficulty.
3. The Bank would adopt cluster-based approach for financing MSME sector in line
with RBI guidelines.
4. The cases under the Government Sponsored Schemes shall be processed,
sanctioned, disbursed and monitored at the Branch level as per the extant
Delegation of Powers and the processes/procedures defined by the Bank from time
to time.
5. The Bank would comply with RBI guidelines issued from time to time in respect of
Rehabilitation of Sick MSME units and Debt Restructuring.MSME Credit Policy
6. The Bank has been actively engaged in providing a major thrust to financing of
MSMEs. With a view to improving the credit delivery mechanism and shorten the
Turn Around Time (TAT), the Bank has set up City MSME Centers (CSCs) at major
centers across the country. A number of products have been rolled out for the MSME
sector, which considerably expanded the Banks offerings to its MSME borrowers.
The sourcing of the business would primarily be at the designated MSME branches
and the CSCs (located in one of the identified branches in the city). A dedicated
Sales Force will be put in place in all potential centers to market MSME products.
Relationship Managers at the Branches would take care of the customer
requirements and do up-sell/cross-sell at the identified Branches.

7. MSME Finance Products


Asset Products:
a) Dealer Finance
b) Funding under Credit Gurantee Scheme for Mico & Small Enterprises
c) Direct Credit Scheme SIDBI
d) Preferred Customer Scheme- IDBI Bank/SIDBI
e) Vendor Financing Program

21

f) Lending against security of Future Credit Card Receivables


g) Working capital Finance for IT & ITEs
h) Finance to Medical Practitioner
i) Loans to Small Road & Water Transport Operators
j) IDBI Sulabh Vyapar Loan
k) Laghu Udyami Credit Card Scheme

8. Loans applications from MSME units are to be disposed off within a reasonable
time as per the below mentioned time norms, provided such applications are
completed in all respects provided and accompanied by a 'check list'.
i. Loans up to Rs.25000/- within two weeks from the date of receipt.
ii. Loans upto Rs.5 lakh, within four weeks from the date of receipt.
iii. Loans over Rs. 5 lakhs, within a maximum period of 8 weeks from the date of
receipt.

9. Security
No collateral security/ third party guarantee is insisted upon in respect of loans to
SEs (Erstwhile SSI) as under:
a. Upto Rs.10 lakhs
b. Upto Rs.25 lakhs in respect of units whose track record and financial positions are
good as per Bank records; and
c. Upto Rs.100 lakhs in respect of units whose borrowal accounts are covered under
the Scheme of Credit Guarantee Fund Trust for Micro & Small Enterprises
(CGTMSE). In respect of other SE and ME units, collateral security/ third party
guarantee may be stipulated by the bank.

10. ROI on Loans/Advances under MSME advances shall be linked to Base Rate
and priced at a spread, based upon:
The internal risk rating of client.
Tenor of loan
22

Competitive market rates of interest for client


Internal transfer pricing
Overall value of client relationship MSME Credit Policy

11. Rejection of credit proposals


i. Applications for credit facilities from SC/ ST customers shall not be rejected at the
Branch / CSCs level and such applications shall be referred to the next higher
authorities for their prior decisions/ permission;
ii. Whenever applications for loans under Govt sponsored schemes are rejected by
the CSCs/ Branches for valid reasons, a register is to be maintained to this effect,
which shall be examined by the controlling authorities during their visits;
iii. Rejection of MSME proposals shall be subject to concurrence of the next higher
authority;
iv. MSME proposals once rejected by a higher authority shall be placed before such
higher authority even through the subsequent proposals say, for lesser amount falls
within the powers of a lower authority;
v. Rejection of exports credit proposals under MSME shall be immediately reported
to Head-MSME; and
vi. Rejection of Credit proposals by the CSC level authorities shall be recorded in a
register maintained for this purpose, which shall be reviewed by the controlling
authorities visiting CSCs.
12. Bank is committed to address the Grievances of the Micro & Small Enterprises.
The aggrieved borrowers can address their grievances to the CSC Head/Regional
Head/Head MSME, whose address and telephone are provided with the branch/CSC
or may approach to Banking Ombudsman as per Banking Ombudsman Scheme,
2006 of the Reserve Bank of India.

ICICI BANK
ICICI Bank Limited (NSE: ICICIBANK, BSE: 532174, NYSE: IBN) is the second
largest financial services company in India. Headquartered in Mumbai, it offers a
wide range of banking products and financial services to corporate and retail
customers through a variety of delivery channels and through its specialised
subsidiaries in the areas of investment banking, life and non-life insurance, venture

23

capital and asset management. The Bank has a network of 2,533 branches and
6,800 ATMs in India, and has a presence in 19 countries, including India.
The bank has subsidiaries in the United Kingdom, Russia, and Canada; branches in
United States, Singapore, Bahrain, Hong Kong, Sri Lanka, Qatar and Dubai
International Finance Centre; and representative offices in United Arab Emirates,
China, South Africa, Bangladesh, Thailand, Malaysia and Indonesia. The company's
UK subsidiary has established branches in Belgium and Germany.
ICICI Bank's equity shares are listed in India on Bombay Stock Exchange and
the National Stock Exchange of India Limited and its American Depositary Receipts
(ADRs) are listed on the New York Stock Exchange (NYSE).
ICICI Bank was established in 1994 by the Industrial Credit and Investment
Corporation of India, an Indian financial institution, as a wholly owned subsidiary.
The parent company was formed in 1955 as a joint-venture of the World Bank,
India's public-sector banks and public-sector insurance companies to provide project
financing to Indian industry. The bank was initially known as the Industrial Credit and
Investment Corporation of India Bank, before it changed its name to the
abbreviated ICICI Bank. The parent company was later merged into ICICI Bank.
ICICI Bank launched internet banking operations in 1994.
ICICI's shareholding in ICICI Bank was reduced to 46 percent, through a public
offering of shares in India in 1998, followed by an equity offering in the form
of American Depositary Receipts on the NYSE in 2000. ICICI Bank acquired
the Bank of Madura Limited in an all-stock deal in 2001, and sold additional stakes to
institutional investors during 2001-02.
In the 1990s, ICICI transformed its business from a development financial institution
offering only project finance to a diversified financial services group, offering a wide
variety of products and services, both directly and through a number of subsidiaries
and affiliates like ICICI Bank. In 1999, ICICI become the first Indian company and the
first bank or financial institution from non-Japan Asia to be listed on the NYSE.
In 2000, ICICI Bank became the first Indian bank to list on the New York Stock
Exchange with its five million American depository shares issue generating a
demand book 13 times the offer size.
In October 2001, the Boards of Directors of ICICI and ICICI Bank approved the
merger of ICICI and two of its wholly owned retail finance subsidiaries, ICICI
Personal Financial Services Limited and ICICI Capital Services Limited, with ICICI
Bank. The merger was approved by shareholders of ICICI and ICICI Bank in January

24

2002, by the High Court of Gujarat at Ahmedabad in March 2002, and by the High
Court of Judicature at Mumbai and the Reserve Bank of India in April 2002.
In 2008, following the 2008 financial crisis, customers rushed to ATM's and branches
in some locations due to rumors of adverse financial position of ICICI Bank. The
Reserve Bank of India issued a clarification on the financial strength of ICICI Bank to
dispel the rumors.

Credit policy of icici bank


POLICY ON STEPPING UP CREDIT TO SMEs

1. Background
The Bank has proactively put in place a comprehensive strategy to cater to the
banking requirements of Small and Medium Enterprise (SME) sector in line with the
guidelines issued by Reserve Bank on India (RBI) for this sector from time to time.
The
extant
guidelines
are
issued
by
RBI
vide
its
circular
RPCD.PLNFS.BC.No.6/06.02.31/2007-08 dated July 2, 2007.
A separate business group viz Small Enterprises Group (SEG group) was set up to
cater to all banking requirements of SME sector.

2. Products and Services


At present, the SEG group covers customers through over 200 locations throughout
the country. SEG group has over 2000 professionals and has acquired over 9,00,000
customers. The products and services offered by SEG group is customized to the
business requirements of SME sector from time to time. This group, as on date
provides customized solution through three business subgroups, viz, Business
Banking Group, Cluster Banking Group and Corporate Linked Business.

2(a) Business Banking Group


This group offers a bouquet of customised products /services (secured and
unsecured) suited to the various requirements of the SME customer. These products
cater to the entire working capital cycle including trade finance products like LCs/
Bank Guarantees/ bills discounting facilities, export finance, term loans,
collection/payment accounts, anywhere banking current account services and other
25

financing requirements including forex risk management products in a simplified


manner to the SME sector.

2(b) Cluster Banking Group


The cluster banking group provides customized banking solutions to various clusters
like :

Life Sciences
Chemicals
Auto components
ECG (Emerging Corporate Group)
Construction
Wearing Apparel
Gems and Jewellery
Logistics
Electricals
IT and ITES (Information Technology)
EXIM (Export Import)
GLB(Govt. linked business)
SEZ (Special Economic Zone)
Special Projects

The above list would undergo modification depending on business requirement in


this sector from time to time.

2(c) Corporate Linked Business Group


The Corporate Linked Business Group provides comprehensive banking to the
supply chain partners who are associated with several large corporates in sectors
like petroleum, FMCG, commodities, engineering etc. The division has introduced
several innovative products like e-banking to these SMEs which combine financing
and help in seamless and real time fund transfer across locations.
The above structure is based on the business requirements of customers in SME
sector as on date, however, the same would undergo amendments depending on the
market requirement in this sector from time to time.

26

3. Other initiatives
The Bank also provides card based products like credit cards and debit cards aimed
exclusively at SMEs. Some of the innovative solutions to the SMEs include forex
services through the internet, mobile banking services and card to card fund transfer
etc.
The Bank has also taken a leading role in setting up a platform along with CNBC-TV
and CRISIL for recognising the spirit of entrepreneurship through Emerging India
Awards. The Bank has a regular feature in the mass media (including a magazine
devoted to SMEs) bringing recognition to highly successful SMEs and disseminating
information on issues of interest to SMEs in the respective sectors.

4. Customer categories
As on date, the SEG group acquires Sole Proprietorship Firms, Partnership Firms,
Private Limited and Public Limited company with net worth of up to Rs. 500.0 million
(mn), which is retained in the business group till the net worth reaches Rs. 900.0 mn.

5. Customer selection and credit process


Appreciating the SME customers need for simplified and reliable credit processes,
the Bank as on date offers pre-templated standardized products through easy
delivery mechanism thereby ensuring minimum turnaround time. The credit product
offered are broadly categorised as under:

5(a) Program Lending


The program lending involves a cluster-based approach wherein a lending program
is implemented for a homogeneous group of individuals / business entities, which
comply with certain laid down parameterised norms. Each program has a specific
scoring model that evaluates the borrower or its group entities. This scoring model
evaluates both quantitative and qualitative information of the borrower. A customer
become eligible for funds depending on minimum cut-off score stipulated in the
program and other conditioned as stipulated in the program from time to time.

5(b) Pre-approved limits


Further, in order to offer credit facilities to borrowers at short notice, the group also
offers a pre-approved limit, to certain borrowers (who have been selected based on
transaction history) to ensure faster turn around time when the actual need of the
27

borrower arises. These limits are mainly for working capital. The credit facilities are
primarily offered on unsecured basis.

5(c) Other lending


In addition to the above, credit facilities are also given to customers in this sector as
per the extant credit policy guidelines of the Bank. These facilities are approved by
authorities as per the Credit Approval Authorisation manual approved by Board from
time to time.
All above program/pre-approved limits are approved by Credit Risk Management
Group (CRMG) and SME Policy and Risk Group (SPRG) before being placed for
approval.
As indicated earlier, the product/service offerings to the customers (including delivery
mechanism) in this sector is customized to the business requirements from time to
time subject to adherence with extant guidelines issued from time to time.

6. Multichannel Servicing
In order to meet the SME customers requirements, as on date the Bank services
these customers through a combination of channels like the branch as well as a
relationship officer, internet, call centre services and ATMs. Most of our branches
work 12 hours a day and the ATMs, internet and the call centre provide 24X7 access
to the customer.

7. Monitoring
The Bank has a regular mechanism for monitoring and reporting of the portfolio
performance. The MIS reports on the exceptions to the defined norms as per the
product policies are being provided by the Credit Middle Office Group (CMOG).
Based on the reports furnished by CMOG, SEG group interacts with customers and
resolves the exceptions.
Further, the Banks Internal Audit Department conducts portfolio and branch audits
on regular basis. The CRMG and SPRG also conducts portfolio reviews to evaluate
and monitor the performance and quality of the portfolio.
Restructuring and Rehabilitation Policy at ICICI Bank

28

In the case of non-performing loans / stress cases where settlement or exit is not
possible immediately, handholding could be provided subject to long term viability of
the company and possibility to retain the loan as earning asset. The handholding
could include incremental exposure, wherever needed. However, such increase in
exposure should be covered, as far as possible, by collateral / corporate guarantees
of a good company / escrow or securitisation of cash flows.
Restructuring of the liabilities of the borrower by giving appropriate reliefs and
concessions such as reduction in interest rate, funding of interest, conversion of
interest / principal / other dues into equity / debentures or any other instruments,
reschedulement of principal, waiver of dues etc. under RBI guidelines, would be
used as a tool to improve the long-term viability of the borrower. Restructuring shall
however be used selectively and without diluting the Banks focus on collections. The
following aspects would be taken into account while preparing a restructuring
package:
1. The proposed restructuring would be based on the realistic projections for the
borrower including the estimated cash flows in the future.
2. As far as possible, efforts would be made to ensure commensurate sacrifices from
all the stakeholders including existing promoters.
3. Efforts would be made, wherever possible, to include the following covenants /
conditions in the restructuring package:

Enhancement in security package and payment security mechanisms e.g. Trust &
Retention (T&R) / escrow of cash flows of the borrower
Up-front trigger conditions, non-compliance of which would result into automatic
change of management
Personal guarantees of the promoters
Appointment of professionals on the Board or as executives to strengthen the
existing management
Mechanism to capture the upside potential consequent to restructuring through
equity, acceleration and recompense clauses
Appointment of concurrent auditors
In certain cases, where the Bank is already a part of the term lending consortium,
the Bank would endeavour to enter the working capital consortium as well. The
objective of this initiative would be to gain control of the borrowers cash flows. In
some cases ICICI Bank may give fresh credit facilities to the company to achieve

29

this. However the Credit Policy recognises the fact that actual entry might be a
gradual process

(a) Wherever considered necessary, the Bank would insist on


- change of management and/or
- pledge of promoters stake subject to extant regulatory stipulations

(b) Mechanism for monitoring the compliance of the conditions stipulated and the
performance of the company post restructuring would be put in place. Various
milestones would be worked out to monitor the implementation of the restructuring
package.
The restructuring package would be worked out within the existing regulatory
framework and in compliance with various prevailing guidelines.
The Bank would undertake the restructuring of the credit facilities to the Small and
Medium Enterprises (SME) borrowers taking into account the guidelines of RBI
issued from time to time. The guidelines require the restructuring to be undertaken
with reference to a set of criteria provided, which includes, eligible SMEs for
restructuring, viability criteria, prudential & asset classification norms etc. Further the
Bank would work out the restructuring package and implement the same in
accordance with the guidelines within a maximum period of 60 days from the date of
receipt of request from the eligible SME borrower.

Further, as the repaying capacity of the people affected by natural calamities gets
severely impaired due to the damage to the economic pursuits and loss of economic
assets, restructuring of existing loans of such borrowers would be undertaken in a
flexible manner as per the guidelines of RBI issued from time to time. The Bank
would ensure that the restructuring mechanism in such cases would synchronise
with the measures which are appropriate in a given situation

30

RESERVE BANK OF INDIA


The Reserve Bank of India (RBI) is the central banking institution of India and
controls the monetary policy of the rupee as well as US$300.21 billion
(2010) ofcurrency reserves. The institution was established on 1 April 1935 during
the British Raj in accordance with the provisions of the Reserve Bank of India Act,
1934. The share capital was divided into shares of Rs. 100 each fully paid which was
entirely owned by private shareholders in the beginning. Reserve Bank of India
plays an important part in the development strategy of the government.
It is a member bank of the Asian Clearing Union. Reserve Bank of India was
nationalised in the year 1949. The general superintendence and direction of the
Bank is entrusted to Central Board of Directors of 20 members, the Governor and
four Deputy Governors, one Government official from the Ministry of Finance, ten
nominated Directors by the Government to give representation to important elements
in the economic life of the country, and four nominated Directors by the Central
Government to represent the four local Boards with the headquarters at Mumbai,
Kolkata, Chennai and New Delhi. Local Boards consist of five members each Central
Government appointed for a term of four years to represent territorial and economic
interests and the interests of co-operative and indigenous banks.

Structure of RBI:
Central Board of Directors
The Central Board of Directors is the main committee of the central bank.
The Government of India appoints the directors for a four-year term. The Board
consists of a governor, four deputy governors, four directors to represent the regional
boards, and ten other directors from various fields.
Governors
The central bank till now was governed by 21 governors. The 22nd, Current
Governor of Reserve Bank of India is Dr Subbarao.
Supportive bodies
The Reserve Bank of India has four regional representations: North in New Delhi,
South in Chennai, East in Kolkata and West in Mumbai. The representations are
formed by five members, appointed for four years by the central government and
serve - beside the advice of the Central Board of Directors - as a forum for regional
banks and to deal with delegated tasks from the central board. The institution has 22
regional offices.

31

The Board of Financial Supervision (BFS), formed in November 1994, serves as a


CCBD committee to control the financial institutions. It has four members, appointed
for two years, and takes measures to strength the role of statutory auditors in the
financial sector, external monitoring and internal controlling systems.
The Tarapore committee was set up by the Reserve Bank of India under the
chairmanship of former RBI deputy governor S S Tarapore to "lay the road map"
to capital account convertibility. The five-member committee recommended a threeyear time frame for complete convertibility by 1999-2000.
On 1 July 2006, in an attempt to enhance the quality of customer service and
strengthen the grievance redressal mechanism, the Reserve Bank of India
constituted a new department Customer Service Department (CSD).
Offices and branches
The Reserve Bank of India has 4 regional offices,15 branches and 5 sub-offices. It
has 22 branch offices at most state capitals and at a few major cities in India. Few of
them arelocatedin Ahmedabad, Bangalore, Bhopal, Bhubaneswar,Chandigarh,
Chennai, Delhi, Guwahati, Hyderabad, Jaipur, Jammu, Kanpur, Kolkata, Lucknow,
Mumbai, Nagpur, Patna, and Thiruvananthapuram. Besides it has sub-offices
at Agartala, Dehradun, Gangtok, Kochi, Panaji, Raipur, Ranchi, Shimla andSrinagar.
The bank has also two training colleges for its officers, viz. Reserve Bank Staff
College at Chennai and College of Agricultural Banking at Pune. There are also
four Zonal Training Centres at Belapur, Chennai, Kolkata and New Delhi.

Bank Rate: RBI lends to the commercial banks through its discount window to help
the banks meet depositors demands and reserve requirements. The interest rate the
RBI charges the banks for this purpose is called bank rate. If the RBI wants to
increase the liquidity and money supply in the market, it will decrease the bank rate
and if it wants to reduce the liquidity and money supply in the system, it will increase
the bank rate. As of 5 May, 2011 the bank rate was 6%.

Cash Reserve Ratio (CRR): Every commercial bank has to keep certain minimum
cash reserves with RBI. RBI can vary this rate between 3% and 15%. RBI uses this
tool to increase or decrease the reserve requirement depending on whether it wants
to affect a decrease or an increase in the money supply. An increase in Cash
Reserve Ratio (CRR) will make it mandatory on the part of the banks to hold a large
proportion of their deposits in the form of deposits with the RBI. This will reduce the
32

size of their deposits and they will lend less. This will in turn decrease the money
supply. The current rate is 6%.

Statutory Liquidity Ratio (SLR): Apart from the CRR, banks are required to
maintain liquid assets in the form of gold, cash and approved securities. Higher
liquidity ratio forces commercial banks to maintain a larger proportion of their
resources in liquid form and thus reduces their capacity to grant loans and advances,
thus it is an anti-inflationary impact. A higher liquidity ratio diverts the bank funds
from loans and advances to investment in government and approved securities.
In well-developed economies, central banks use open market operations--buying
and selling of eligible securities by central bank in the money market--to influence
the volume of cash reserves with commercial banks and thus influence the volume of
loans and advances they can make to the commercial and industrial sectors. In the
open money market, government securities are traded at market related rates of
interest. The RBI is resorting more to open market operations in the more recent
years.
Generally RBI uses three kinds of selective credit controls:
1. Minimum margins for lending against specific securities.
2. Ceiling on the amounts of credit for certain purposes.
3. Discriminatory rate of interest charged on certain types of advances.
Direct credit controls in India are of three types:
1. Part of the interest rate structure i.e. on small savings and provident funds,
are administratively set.
2. Banks are mandatorily required to keep 24% of their deposits in the form of
government securities.
3. Banks are required to lend to the priority sectors to the extent of 40% of their
advances.

33

RBI RAISES REPO RATE BY 25 BPS:


The Reserve Bank of India (RBI) raised interest rates for the 12th time in 18 months
and signalled more was to come, confounding expectations that it was coming to the
end of its tightening cycle and putting it at odds with global peers focused on reviving
weak demand.
The RBI lifted its policy lending rate, the repo rate, by 25 basis points to 8.25
percent, in line with expectations, in a campaign that has done more to slow growth
than contain near double-digit inflation.

The central bank said it was too soon to ease back from its anti-inflationary bias.
Investors had expected one more rate increase before heading for a pause.
A Reuters poll after the policy statement showed economists now expect at least
one more rate rise this year.
"A premature change in the policy stance could harden inflationary expectations,
thereby diluting the impact of past policy actions. It is, therefore, imperative to persist
with the current anti-inflationary stance," it said in a statement.
The RBI's hawkishness, which saw it raise rates by an unexpectedly steep 50 basis
points in July, makes it an outlier as other central banks turn dovish on the back of a
festering global crisis.
The U.S. Federal Reserve has pledged to keep interest rates near zero for two
years, while emerging heavyweights Brazil and Indonesia have eased policy.
India's headline inflation for August rose to 9.78 percent, its highest in a year and
also highest among the BRIC contingent that includes Brazil, Russia and China.
Growth and demand, however, have cooled following the cumulative impact of
earlier rate increases and rising prices.
The benchmark 10-year bond yield rose 4 basis points to 8.36 percent after the
central bank kept up its hawkish tone, while the one-year swap rate surged 14 basis
points to 7.91 percent. Shares trimmed gains to rise 0.34 percent from 1.4 percent
earlier.

CREDIT POLICY OF RBI


where does rbi see indian economy heading?

In its mid-quarter credit policy announced today , RBI Governor, Duvvuri Subbarao
upped repo rate under the liquidity adjustment facility (LAF) by 25 basis points from
7.25% to 7.5% with immediate effect.
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Consequent to the above increase in the repo rate, the reverse repo rate under the
LAF will stand automatically adjusted to 6.5% and the marginal standing facility
(MSF) rate to 8.5% with immediate effect.
The RBI's statement on Credit Policy stated:
Since the Reserve Bank' Annual Policy Statement of May 3, the global environment
has changed for the worse, while domestic conditions are broadly consistent with the
Statement's projections. Growth expectations in advanced economies are visibly
moderating, even as inflationary pressures, primarily from commodity prices, have
increased. The capacity for conventional policy responses appears limited, with
many countries having already committed to fiscal consolidation amidst growing
sovereign debt risks. From our monetary policy perspective, global commodity prices
still remain the key external risk though some signs of moderation are becoming
visible.
Domestically, inflation persists at uncomfortable levels. Moreover, the headline
numbers understate the pressures because fuel prices have yet to reflect global
crude oil prices. On the growth front, even as signs of moderation are visible in some
sectors, broad indicators of activity 2010-11 fourth quarter profit growth and
margins and credit growth do not suggest a sharp or broad-based deceleration.
Going forward, notwithstanding both signs of moderation in commodity prices and
some deceleration in growth, domestic inflation risks remain high. Against this
backdrop, the monetary policy stance remains firmly anti-inflationary, recognising
that, in the current circumstances, some short-run deceleration in growth may be
unavoidable in bringing inflation under control.

Global economy
The global economy weakened in Q2 of 2011. Lead indicators suggest that growth
moderated in both advanced economies and emerging market economies (EMEs)
under the impact of high oil and other commodity prices, the spillover from the
Japanese natural disasters and monetary tightening in EMEs to contain inflationary
pressures. Uncertainty about the resolution of the sovereign debt problem in the euro
area has increased.
These developments increase downside risks to global growth prospects.
International commodity and oil prices showed signs of moderation on weak
economic data and unwinding of financial positions. However, on a year-on-year
(YoY) basis, commodity price inflation is still high. Consequently, headline inflation
rose in major advanced economies despite negative output gaps. As inflation in
EMEs remained elevated due both to high commodity prices and strong domestic
demand, many EMEs persisted with monetary tightening during Q2 of 2011 to
contain inflation.

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On domestic growth
The gross domestic product (GDP) growth decelerated to 7.8% in the fourth quarter
of 2010-11 from 8.3% in the previous quarter and 9.4% in the corresponding quarter
a year ago.
For the year as a whole, GDP growth in 2010-11 was 8.5%. While private
consumption was robust, investment activity moderated in Q4 of 2010-11.
During April-May 2011, both exports and imports increased sharply and the trade
deficit widened. The progress of south west monsoon 2011 has so far been
satisfactory, which augurs well for agricultural production.
Overall, even as there is deceleration in some important sectors, notably interestsensitive ones such as automobiles, there is no evidence of any sharp or broadbased slowdown.
Corporate earnings growth and profit margins in the fourth quarter of 2010-11 were
broadly in line with the performance over the past three quarters, suggesting that
demand remained steady, and in the face of sharp increases in input costs, pricing
power remained intact. Credit grew steadily (see below), while the composite
Purchasing Managers' Index (PMI) for May 2011 suggests reasonably good
conditions.

On inflation
The headline wholesale price index (WPI) inflation rate was 9.7% in March 2011. In
April 2011, it was 8.7% and rose to 9.1% in May 2011. The numbers for April and
May 2011 are as yet provisional and, given the recent pattern, these numbers are
likely to be revised upwards.
Thus, the headline WPI inflation rate remains elevated, consistent with the
projections made in the Annual Policy Statement of May 3 . The main drivers of WPI
inflation in April-May 2011 were non-food primary articles, fuel group and non-food
manufactured products. The consumer price inflation for industrial workers (CPI - IW)
rose from 8.8% in March 2011 to 9.4% in April 2011.
Non-food manufactured products inflation was 8.5% in March 2011. Provisional data
indicate that it increased from 6.3% in April to 7.3% in May 2011, numbers much
above its medium-term trend of 4%. This pattern in non-food manufactured
products inflation is a matter of particular concern. Besides reflecting high
commodity prices, it also suggests more generalised inflationary pressures; rising
wages and costs of service inputs are apparently being passed on by producers
along the entire supply chain.

Credit conditions
Year-on-year non-food credit growth moderated from 21.3% in March 2011 to 20.6%
in early June 2011, but remained above the indicative projection of 19%. The y-o-y
deposit growth increased to 18.2% in early June 2011 from 17% in March 2011.
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Consequently, the incremental non-food credit-deposit ratio moderated to 80.5% (yo-y) in early June 2011 from 95.3% in March 2011. The y-o-y increase in money
supply (M3) was at 17.3% in early June 2011 as compared with 16% in March 2011.
Monetary transmission has been quite strong with 45 scheduled commercial banks
raising their Base Rates by 25-100 basis points after the May 3 Policy Statement.
Cumulatively, 47 banks raised their Base Rates by 150-300 basis points during July
2010-May 2011. The higher cost of credit is restraining credit growth, but it still
remains fairly high, suggesting that economic activity is holding course.

Liquidity conditions
During the current fiscal year so far, liquidity conditions have remained consistent
with the anti-inflationary stance of monetary policy. The Governments cash balances
moved from a surplus of Rs 89,000 crore on an average during Q4 of 2010-11 to a
deficit of Rs 29,000 crore during Q1 of 2011-12 (up to June 15, 2011). Consequently,
net injection of liquidity through LAF repos declined from an average of Rs 84,000
crore during Q4 of 2010-11 to Rs 41,000 crore in 2011-12 (up to June 15, 2011). The
net liquidity injection by the Reserve Bank was higher at Rs 60,000 crore as on June
15, 2011. As articulated in the May 3 Policy Statement, the Reserve Bank will
continue to maintain liquidity conditions such that neither surplus liquidity dilutes the
monetary policy stance nor large deficit chokes off fund flows to productive sectors of
the economy.

Review on credit policy of RBI


The Reserve Bank of India (RBI) will review the credit policy on January 25. Last
year, the RBI started tightening the monetary policy, and raised the interest rates as
well as the cash reserve ratio ( CRR) many times. The RBI paused a further
tightening of the policy in the last review meeting in December, owing to cooling
inflation and moderation in economic growth.
However, the inflation rate is high again over the last few weeks and industrial
growth is showing signs of sluggishness due to the high interest rates. The RBI will
review the macroeconomic situation, and the various other short-term and long-term
parameters, during its forthcoming meeting.

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factors to be considered during the review:


Inflation
The Wholesale Price Index (WPI) based inflation rate which was on a downward
trajectory during the second half of last year surged again in December. The rise in
inflation was mainly triggered by a sharp rise in the prices of food articles and basic
commodities. In addition to the high prices of domestic food articles, the rising prices
of international commodities such as crude oil, metals etc are also weighing high on
the broader inflation as it went up to 8.43 percent last month from 7.48 percent in the
previous month.
It is expected that going forward, the rising domestic input costs for the
manufacturing sector along with demand pressures will further worsen the inflation
situation. Analysts believe the RBI will maintain its strong stance and may further
tighten the policy rates in the coming policy review.
Industrial growth
The Index of Industrial Production (IIP) numbers have started giving signals that the
industrial growth is slowing down due to the tight monetary policy regime since the
last three quarters. The IIP numbers grew by just 2.7 percent for the month of
November against 11.3 percent for the same month of the previous fiscal.
The impact on industrial growth is an important factor that will play a contradictory
role while deciding on further monetary tightening during the forthcoming policy
review meeting.
Fund inflows
The large global economies are still facing many problems and have not completely
come out of the slowdown. There is nervousness on the global front and emergency
measures are being taken. Easy monetary policies of large economies are also a
factor behind the high inflation rate in the emerging markets as a significant amount
of money is coming in.
The fund inflows will be another significant factor on the agenda.
Expected moves
High inflation and the tight liquidity situation are some of the top review parameters
for policymakers. The RBI is expected to maintain its tight monetary policy stand and
implement further tightening measures in small steps as it has done six times during
the last year.
Although the rates have already reached high levels and the liquidity situation is
tight, the pressure to check the rising inflation rate and bring it back to a downward
trajectory will play hard in the minds of policymakers. Analysts believe the RBI is
likely to increase the interest rates further in the forthcoming policy review and
maintain its tough stand against inflation.

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CONCLUSION
Indian banking industry faced many uncertainties during 2008-09 in the face of tight
market liquidity in the global financial markets. The RBIs prompt and relevant
measures ensured adequate domestic and foreign liquidity to Indian banking industry
so that the flow of credit to productive sectors would not suffer much. Yet, on
account of the severe global economic slowdown and its spillover effects on India,
growth of bank credit to commercial sector decelerated in 2008-09.
Bank credit to the commercial sector increased by 16.9% (y-o-y) in 2008-09 as
against 21.0% a year ago. Non-food credit growth of commercial banks picked up in
the first two quarters of 2008-09 on account of a sizeable increase in credit to
petroleum sector and also as a substitution for funds raised by the corpoates from
non-banking and external sources.
RBI decided to raise the rate at which the banks borrow from each other. The RBI
has also raised the rate of interest if banks borrow from the RBI. The cost on both
the ends, banks borrowing from RBI and interest that banks will recieve on
depositing money with the RBI, have increased in the same proportion -- 25 basis
points (one percentage points reflects one-hundredth of a percentage point).
The RBI stated "Increase the repo rate under the liquidity adjustment facility (LAF) by
25 basis points from 6.5 per cent to 6.75 per cent with immediate effect; and
increase the reverse repo rate under the LAF by 25 basis points from 5.5 per cent to
5.75 per cent with immediate effect."
This will force banks to slow down on giving out loans. A measure used by the RBI to
remove excess money supply in the economy, which in theory should lower
inflation.
The second cause of worry was the rise in prices of food and commodity. The central
bank said it was too early to assess the macroeconomic consequences of the natural
disaster in Japan. It was hopeful that as normalcy is restored, expenditure on
reconstruction may provide a boost to the economy. But RBI quipped that with the
nuclear disaster affecting the country, the new emphasis would be on thermal
powers which will in turn increase petroleum prices to further heights.
On the domestic economy, the bank resonated concerns similar to analyst
community like the continuing uncertainty about energy and commodity prices that
may dampen the investment climate. This will pose a threat to the current growth
rate of the country. The weak performance of capital goods in the IIP suggests that
investment momentum may be slowing down.
Inflation was a standard threat, and the RBI stated that the producers are unable to
pass on the cost to consumers. Oil prices too have played their role in this. It noted
that food prices are still and blamed the structural problems of demand and supply.

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BIBLIOGRAPHY

Primary sources:
Newspapers:

Hindustan times
Economic times
Times of india

Secondary source:
www.moneycontroll.com
www.investopedia.com
www.knowledgeleader.com
www.wikipedia.com

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