Empirical research shows that the banking sector across the globe consistently experiences a lower

percentage of default than other industry sectors. This finding, however, does not mean that banking
is a low-risk business. In fact, banking is inherently a high-risk business. Over the centuries,
countless banks have failed—and continue to do so today.

Banks can fail individually as a result of financial mismanagement or the misrepresentation of facts to
the regulator (the Reserve Bank of India, or RBI). An example of this type of failure is the 2004 fall
of Global Trust Bank, one of the leading private sector banks in India at the time. Banks can also fail
as a result of systemic events. Examples include the U.S. savings and loan crisis in the 1980s and the
U.S. subprime mortgage market crisis that triggered the 2007–08 global financial crisis.

Banks are susceptible to failure because they operate with very high leverage compared to
commercial and corporate entities. Typical capital ratios are around the 10 percent threshold,
although more recently, regulators have been forcing banks to increase their capital base. In the
case of significant loss, that capital buffer erodes easily.

The main cause of bank failure—and the single biggest risk most banks face—is credit risk. Credit risk
tends to be related to laxity in credit assessment, poor credit portfolio management, systemic crises
in the macroeconomy, or a combination of these factors.

By the end of this lesson, you should be able to:

 Explain credit risk, its basic components, and the importance of credit risk assessment.
 Outline the impact of credit risk on a bank’s financial performance.

What You Need to Know

The RBI guidelines provide a brief yet accurate definition of credit risk:
Credit risk is most simply defined as the potential that a bank’s borrower or counterparty may fail to
meet its obligations in accordance with agreed terms. It is the possibility of losses associated with
diminution in the credit quality of borrowers or counterparties. In a bank’s portfolio, losses stem from
outright default due to inability or unwillingness of a customer or a counterparty to meet
commitments in relation to lending, trading, settlement and other financial transactions.
(RBI/2011-12/311 DBOD.No.BP.BC.67/21.06.202/2011-12, 22 December 2011)

Apart from when the borrower defaults in paying dues, a second dimension to credit risk exists even

when the borrower continues to make regular interest and principal payments. Credit risk is also
defined as the loss in value of a credit exposure because of a deterioration in the
creditworthiness of the borrower, even if the borrower continues to service the debt and has not
yet defaulted.
 Example
Let’s say a borrower has availed a loan for a commercial property that is secured by
your bank. Although the repayments are made on time, the value of the property
secured by your bank may suddenly depreciate according to market trends. In this case,
a credit risk still exists because the value of the security has been eroded.
The Components of Credit Risk–

Credit risk is not a unitary concept. Credit risk can stem from risks related to the borrower (also
called obligor risk) and risks related to the facility, particular instrument, or security (which is
called facility risk).

A borrower’s default risk is driven by a combination of management risk, industry and business risk,
and financial risk. An assessment of credit risk analysis considers the following four areas:

 Financial risk: This concept refers to the risk that a borrower will fail either the
 liquidity or solvency test, or both, which may indicate a future failure to service the
debt. A complete financial risk assessment thoroughly analyses:
o Financial statement data and notes
o Financial ratios
o Cash flow
o Projections
 Management risk: This term describes when the borrower's management lacks
the ability or willingness to run the business in a way that generates sufficient cash
to service debt as initially agreed.

 Industry and business risk: This concept refers to the risk that the competitive
marketplace in which the borrower operates may lead to impacts that cannot be
readily managed or mitigated, increasing the likelihood of a failure to service debt.

 Facility risk: This term describes the risk that a credit exposure has not been
structured in an adequate manner, which adds unnecessary stress to the credit
relationship or fails to protect the lender if the borrower is unable to service the
debt.

One of the most important tasks for a banker is the estimation of credit losses. The key components
of measuring credit risk include:

Probability of Default (PD)

Borrower (or obligor) risk addresses the question “Who do you have exposure to?” and
refers to the probability that the borrower or counterparty will default on their
contractual debt obligations. This is called the probability of default (PD).

PD is the likelihood of a borrower defaulting in making full and timely repayment of

principal and/or interest as agreed. Banks use different individual models or
combinations of models to determine each borrower’s PD, including historical frequency
models and credit scoring or rating models. PD can range from zero percent to 100
percent.

For example, the bank gives Mr. Verma, the proprietor of M/s Verma Enterprises, a
business loan of Rs. 15.00 lacs to finance a property worth Rs. 9.00 lacs. The probability
of default is determined by analysing the financial performance and the PD for similar
borrowers. In this case, the PD is 5 percent, meaning the probability of M/s Verma
Enterprises defaulting on the loan is 5 percent.
Loss Given Default (LGD)
The term loss given default (LGD) refers to the amount a lender expects to lose
should a default actually take place. It is expressed as a percentage of the total
exposure. LGD is a function of the amount outstanding on the loan at the time of
default, called the exposure at default (EAD), and the amount recovered via security
(i.e., collateral and/or guarantees), called the recovery rate (RR).

Example
LGD = 1 – RR, where RR is the recovery rate.
The recovery rate is defined as the proportion of bad debt that can be recovered.
RR is calculated as follows:
RR = Value of Collateral / Value of Loan

In the example above, RR = (9/15) = 0.60.

LGD = 1 – 0.60 = 0.4, or 40%.
Hence, the LGD value in the above example is Rs. 6.00 lacs (40% of Rs. 15.00
lacs).

Exposure at Default (EAD)

The exposure amount at the time the borrower defaults may be different from the
exposure amount at the outset of the credit relationship. For a term loan, the exposure
amount is highest at the beginning, but is reduced over time and with each principal
repayment. A revolving credit facility may, at the outset, be undrawn. However, most
borrowers tend to draw down on all available credit facilities the deeper they fall into
financial difficulties. The result is typically a higher amount when the borrower
ultimately defaults. This concept is called the exposure at default (EAD).

EAD is the amount outstanding when the default occurs. It is the maximum loss a bank
may incur in case of default.

In the example above, the balance outstanding is Rs. 15.00 lacs at the time of default,
because we are not aware of any payments made to reduce the outstanding balance.
Hence, the EAD is Rs. 15.00 lacs.

Maturity
The second element of facility risk is related to the length, or maturity, of the credit
exposure. Long-term debt facilities are riskier than short-term facilities because many
more negative events can happen in the future term of a long-term facility.

In other words, maturity refers to the expected timeframe in which default is likely to
occur. In the example above, since the loan is a short-term loan, the maturity is one
year. Hence, maturity is 1.

Expected Loss (EL)

No one lends money without the expectation of being repaid. However, lending
experience teaches us that some loans will default. The amount we expect to default
and, ultimately, not recover gives rise to the concept called expected loss (EL).

EL is a function of the likelihood that a loan will default (PD) multiplied by the amount
that will be lost if the loan defaults (LGD) multiplied by the amount outstanding at the
time of default (EAD). Mathematically, EL is expressed as:

EL = PD x LGD x EAD
 Using the example of Mr. Verma’s loan, we calculate EL = 0.05 (PD) x 0.4 (LGD) x Rs.15
lacs (EAD). Hence the expected loss (EL) in this case equals Rs. 30,000.

The overall likelihood and the amount of loss must be factored into the credit and
pricing decision for this loan. Indeed, EL is factored into all loans.

Basel Norms
As mentioned, credit risk and the effect of credit losses can have a significant impact on
banks and their depositors. To address this risk, the Basel Committee on Banking
Supervision (BCBS) established a mechanism to cushion the banking sector from the
impact of such losses by way of allocating necessary cash reserves. This is commonly
called Basel norms.

The BCBS developed three sets of regulatory standards known as the Basel Accords (I,
II, and III), which stipulate guidelines for regulators and banks to allocate cash reserves
based on risk weights. Simply put, banks holding riskier assets need to hold more
capital.

Credit risk has to be measured by banks in order to provide the minimum regulatory
capital, which is called a capital-to-risk weighted assets ratio (CRAR). In India, the RBI
has prescribed the CRAR at 9 percent of the risk-weighted assets for credit risk.

Because credit risk is by far the largest risk most banks face, it requires the largest
capital allocation. Basel II distinguishes two distinct methodologies for assessing capital
adequacy:

1. The standardised approach

2. The internal ratings-based (IRB) approach

Basel II: The Standardised Approach to Capital Requirements for Credit Risk–

In the standardised approach, the local regulator (the RBI in India) stipulates specific risk-weighting
percentages for different grades of risk for providing capital.

In India, the RBI issued guidelines that stipulate specific risk weights for different loan types. For
these purposes, we will use two different loan types: corporate and non-corporate exposures.
For corporate exposures, the risk weight is determined by external credit ratings provided by
authorised rating agencies such as Moody’s. Based on the ratings given by these agencies, the risk
weight is finalised and the requisite capital is provided.

The Basel II framework distinguishes among different types of assets and credit products, including
exposure to corporations, governments, and other banks. It stipulates specific risk-weighting
percentages for different grades of risk. The tables below show the proposed risk-weighting for
corporate exposures based on external credit rating ranges. Similar tables and guidelines exist for
other credit products and customer segments. Separate risk-weighting rules also exist for past due
loans. (Image 1).

Evaluating Data

 The higher the risk weight, the more capital is provided by the bank, and vice
versa.
 The composition of different loans in a bank’s portfolio determines the overall
amount of regulatory capital required.
 If the portfolio consists of low-risk loans, the bank is in a position to have a larger
portfolio of healthy assets.
  Alternatively, if the bank has high-risk loans that carry high-risk weight, the bank is
required to allocate much more capital. This affects its loan growth potential.
 The composition of risk-weighted assets and the capital allocation for risk affects
almost all facets of bank performance.

Most of the banks in India are currently following the standardised approach.

Image 1

Internal Ratings-Based Approaches–

While the standardised approach involves a combination of external ratings (corporate exposures)
and regulator-prescribed capital allocation for non-corporate exposures, the internal ratings-based
(IRB) approach relies on a bank’s own assessment of its counterparties and exposures to determine
minimum capital requirements.

Typically, the IRB approach allows for greater granularity in calculating risk-weighted assets and
hence is likely to lead to a lower regulatory capital allocation. Only those banks meeting certain
minimum conditions, disclosure requirements, sophisticated risk-measurement practices and tools,
along with approval from their local regulator, are permitted to use the IRB approach. Few banks in
India meet these requirements and few use the IRB method.
Credit risk plays an important role in a bank’s profits and ability to grow. Since riskier assets and
borrowers require a higher capital allocation than less risky ones, a bank with higher credit-risk
assets consumes more capital because of the high risk-weighted assets on its balance sheet. Overall,
higher risk loans have higher expected losses, and higher expected losses require more regulatory
capital allocation. While this may be mitigated to some extent by pricing for risk, it is critically
important to understand and accurately underwrite credit risk.

What You Need to Do

As a credit analyst, your work has great value for the broader risk management—and ultimately the
safety and soundness—of your bank. Credit risk assessment should never be done in a mechanistic
way.

As a credit analyst, you should:

 Appreciate the importance of credit origination, the need for a thorough assessment of
the credit exposure at inception, and the assignment of the correct risk rating.
 Be cognisant of various components that drive credit risk and the factors that determine
those components.
 Be familiar with your bank’s credit policy, its processes, approval workflows and the
internal analytical tools used.

How This is Useful

As a lender in a small and medium enterprises (SME)–oriented branch, you are approached by two
prospective borrowers (Unit A and Unit B) seeking a working capital loan of Rs. 100.00 lacs. You find
that Unit A has a corporate credit rating of AAA with a risk weight of 20 percent and Unit B has a
credit rating of BB with a risk weight of 150 percent.

You now understand that Unit A carries less risk for the bank when compared with Unit B. You also
understand that for Unit A, the capital to be provided by the bank is Rs. 1.80 lacs (risk weight is 20
percent, which is Rs. 20.00 lacs; and the capital to be provided is at 9 percent of Rs. 20.00 lacs,
which is Rs. 1.80 lacs). For Unit B, the capital to be provided is Rs.13.50 lacs (risk weight is 150
percent, which is Rs. 150.00 lacs; and the capital to be provided is at 9 percent of 150 lacs, which is
Rs. 13.50 lacs).

You clearly understand that the quality of the loan is important not only from the risk point of view,
but also for the provision of capital, which affects your bank’s bottom line. With the same amount of
capital, your bank will be able to give loans to a large number of borrowers with lower risk weights as
compared with borrowers with higher risk weights, which affects your bank’s top line.

Questions You Should Ask

As a responsible credit professional, it is important that you understand the importance of credit risk,
its components and its impact on the bank. The following questions will further enhance your insight
into this critical aspect of lending:
Question 1
Select to flip
As you monitor and/or review your loans, have any key factors changed that may warrant a change
in the risk ratings?
Question 2
If you are aware that critical factors have changed, should you wait for the next formal review
meeting before you take any action?
Question 3
How can the credit terms and conditions be structured to adequately safeguard against credit
migration?

Answer

The key components of credit risk include probability of default, loss given default, and exposure at default.

Probability of default (PD) relates to the borrower/obligor. The factors affecting the likelihood of an obligor’s
default drive its PD. From a fundamental point of view, an obligor’s default risk is driven by the combination of
management risk, industry and business risk, and financial risk.

Credit risk has to be measured by banks in order to provide the minimum regulatory capital, which is called
a capital-to-risk weighted assets ratio (CRAR). In India, the RBI has prescribed the CRAR at 9 percent of the risk-
weighted assets for credit risk.

While the standardised approach involves a combination of external ratings (corporate exposures) and
regulator-prescribed capital allocation for non-corporate exposures, the internal ratings-based (IRB) approach
relies on a bank’s own assessment of its counterparties and exposures to determine minimum capital
requirements.

A bank’s profitability and capital conservation are significantly affected by credit risk. Therefore, it is crucial to
understand how credit risk is assessed and to adopt a structured framework to thoroughly assess it.

A structured credit risk analysis considers the following four areas:

1. Financial risk
2. Management risk
3. Industry and business risk
4. Facility risk

By the end of this lesson, you should be able to:

 Define the structured framework required to assess financial risk, management risk, industry and
business risk, and facility risk.
 Describe how these key components of risk framework help assess the main aspects of liquidity,
solvency, business sustainability, and repayment capability.

What You Need to Know

To get an overall idea of how credit risk is assessed, you need to understand its various components and how
each of these components contributes.
Financial Risk–
Financial risk is the potential uncertainty that the company’s cash flow will not be adequate to meet all future
obligations. Financial risk involves a deeper analysis of various financial statements. Please note that financial
reports in isolation may not present the entire analysis. Financial analysis integrated with qualitative analysis
(i.e., the business and management risk factors) becomes much more meaningful for credit analysis purposes.

Assessing Financial Risk Helps You to Evaluate the Default Risk

Default risk is the probability of a borrower failing to meet their loan obligations, including payments towards
principal and interest. Two types of analytical tests assess a borrower's financial risk: the liquidity test and
the solvency test.

1. The liquidity test determines whether the business is generating enough cash from normal
day-to-day operations to cover all normally occurring expenses, including interest and loan
repayments.

2. The solvency test determines whether there is enough cash from other sources—primarily
the liquidation of assets outside the operating cycle—to pay all debt principal and any
accrued interest.

A complete financial risk assessment consists of the thorough analysis of financial statement data and notes,
financial ratios, cash flow, and projections. It involves analysing the key cash drivers that affect the company’s
top- and bottom-line performance, and how management decisions influence the ability of the unit to deliver
consistent financial performance. The goal is to address the concerns of the lender from liquidity and solvency
perspectives.

Elements to Analyse:

 Balance sheet and income statements (profit and loss)

 Cash flow statement
 Business comparison with its peers
 The entity's overall financial performance

A key objective of financial analysis is to determine not only how a business performs but the reasons it
performs in that way.
Industry and Business Risk–

Business risk is the combination of a macro-level industrial risk and the individual business operating risk that
the company faces as part of its day-to-day operations. Business risk is influenced by numerous factors,
including sales volume, per-unit price, input costs, competition, overall economic climate, and government
regulations. Hence, business risk assessment includes analysis of the general business environment, industry
status, competition, and individual business vulnerability.

The Business Risk Assessment Process

This process includes two basic steps:

1. Determine the historical, current, and potential impact of macro-level factors on a business,
namely elements over which management has little or no control.
2. Consider how management anticipates and guides the business in the context of its external,
competitive environment.
The above forces have a direct impact on the financial performance of the business. As you can now see,
although financial risk and business risk are two different components of credit risk, they affect each other and
hence are always considered together when analyzing a proposal from a risk perspective.

Example: Business Risk Assessment

The recently introduced Goods and Services Tax (GST) is expected to make the interstate movement of goods
very easy, resulting in eliminating holdups at state borders, shortening the turnaround times for trucks, and
reducing fuel expenses. This new tax will positively affect trucking and logistic companies. However, the GST
may negatively affect truck manufacturing companies, because trucking companies may require fewer trucks
for the same level of transportation services. Similarly, regional warehousing industries may experience losses,
because manufacturing and distribution companies may move to a more central warehouse strategy in order to
reduce overall distribution costs.

A change in government, or in the political power in control, can result in significant regulatory change or
direction. Assessing industry risk involves understanding the risk factors associated with the borrower's
industry. Industry plays a major role in determining operating characteristics, including the structure of the asset
base, capital requirements, the timing and nature of cash flow, competition, and regulation.

An industry’s risk level also varies depending on the stage of the industry's life cycle. Emerging and declining
industries generally carry more risk, whereas growing and mature industries tend to be less risky.
Management Risk–

Management drives a business, sets its strategy, and makes operating and financing decisions, all within the
context of the industry and the broader external environment. Therefore, management determines—and is
responsible for—the company’s performance. Understanding management and performing a thorough
management risk assessment is one of the most critical components of any credit risk analysis.

It is management’s decisions and their implementation that ultimately lead to the generation of cash flow to
service the company’s debt.

This insight is reflected in the banker’s adage “Good management can weather a bad balance sheet, but a good
balance sheet cannot weather bad management.”

Management risk assessment is a judgmental process. As a credit professional, a credit analyst must assess
management’s behaviour, the decisions they have made in response to forces in the external environment, and
their past conduct.

The Impact of Management on Business Performance

 The risk in a business is linked directly to its management’s integrity, skill and execution,
and scope.
 All aspects of a business work together to contribute to a company’s success (or failure)—
from product offering to general operations to sales and distribution.
 However, if a company’s management is unskilled, dishonest, or inconsistent, this potential
may be wasted.

Conversely, a business that has a history of addressing customer needs poorly, is run inefficiently, and is headed
for demise can be turned around by high-quality executives who win the co-operation of workers, investors, and
clients.

If you are dealing with a new prospective credit customer, you will need to spend considerable time gathering
the necessary information. However, it will be time well spent. No bank wants to engage in a credit relationship
in which the willingness of the borrower to uphold the contract is in question. At the most basic level, if you are
not wholly comfortable with management’s willingness to repay debt, you should not enter into a credit
relationship with that entity.
Facility Risk–

Facility risk is the risk that credit has been structured inadequately, stressing the credit relationship and not
adequately protecting the lender in the case of non-performance by the borrower.

Appropriate structuring of credit facilities is an important element of sound credit underwriting practices. Credit
facilities should be structured in a manner such that they suitably match the cash flow requirements and
repayment sources of their customers.

Credit enhancements are to be adequately backed by collateral security to mitigate the loss in the event of
default.

The insights gained from the credit risk assessment will help include the necessary appropriate terms and
conditions for the credit agreement.

Structuring the loan is done for identification and minimisation of risks. If a credit is not structured properly, it
can result in non-payment or delayed payment of loans.

What You Need to Do

As a responsible credit professional, you must not only be familiar with the basic
components of credit risk, but also be confident about analysing the various risk factors
when you are underwriting the credit proposals.

The following actions should help you to achieve the desired results:

Financial Risk Analysis

Financial risk plays a key role in the overall credit risk assessment process. Keep the
following factors in mind:

 The overall credit decision process and the roles played by liquidity and solvency,
including how to interpret the results of the liquidity and solvency tests
 The four crucial assessments that are typically performed within the credit risk
analysis process aligned with the credit policy of the bank
 The specific elements involved in financial risk assessment
 The goal of credit risk assessment is to determine the likelihood that credit will be
repaid in full and on time

Industry and Business Risk Analysis

  Recognise that the competitive marketplace can, at times, be the most significant
area of risk affecting a business’s success.
 Understand the relationship between external market dynamics and overall credit
risk and how financial, industry and business, and management risks affect one
another.
 Understand how industry and business risk can affect a borrower's levels of
liquidity and solvency, both directly and indirectly.

Management Risk

 First and foremost, determine whether management is trustworthy and capable of

generating the cash needed to repay the debt.
 Identify the types of questions you need to ask management to assess the financial
outcomes reflected in the statements and the management actions that are in
play.
 Identify various sources you can use to obtain key management risk evaluation
information and analytical inference.

Facility Risk

 You need to ensure that the credit facility is properly structured so that it helps not
only identify, but also minimise, risks.
 You must realize that failure to structure a credit properly can result in default or
delayed repayment of loans.

How This is Useful

You receive a request from an existing customer, M/s Zenith Enterprises in Ambur, Tamil Nadu, for a term loan
and a working capital loan. While the term loan is for an investment in a plant and machinery worth Rs.150.00
lacs, the working capital limit is Rs. 30.00 lacs. Zenith Enterprises are engaged in exporting leather goods. Their
current account and past dealings with your institution are satisfactory. Based on the information provided in
this lesson, you will approach this request as follows:
 After confirming that the request falls within your institution's policy guidelines, you decide that a formal risk
assessment process is necessary. This includes evaluating the likelihood that Zenith will meet the standards for
liquidity and solvency to qualify for credit, in accordance with your institution’s policies.
 You undertake an overall macro review of the leather export industry.
 You understand that a business's financial performance is an important indicator of the risk in a credit
relationship.
 You take into account the demand and collection risks because Zenith mainly deals with export orders. Any
slowdown in the global economy or any adverse market conditions in the importing countries will affect cash
flow and thereby have an impact on the repayment obligations.
With this awareness, you begin the credit risk assessment process by focusing not only on how Zenith performs
financially, but also the reasons it performs this way in light of external market factors. The end result is an
opinion about Zenith’s industry and business risks and how those risks ultimately affect Zenith’s ability to
generate sufficient cash flow and pass the liquidity and solvency tests. This will lead to a decision about the
overall level of credit risk and whether or not that risk is acceptable to your institution.

Questions You Should Ask

Asking the right questions is a key part of successfully analysing the financial, business, and management risks

of a business. The following questions may be particularly helpful when you are looking into the risk aspects of

a credit proposal:

Question 1
Select to flip
How do the financial, business, and management risks affect liquidity and solvency for this prospective
borrower?
Question 2
How are these factors likely to change? What effect will this have on repayment risk?
Question 3
Do I understand the financial analysis—what happened—in relation to business and management impacts—
why it happened?

small and medium enterprise (SME) lending

reliable and effective credit underwriting approach is paramount to a bank’s small and medium enterprise
(SME) lending operations. It is also the basis for sound risk management.

The credit underwriting approach is documented as part of the bank’s credit policy and is generally approved by
the bank’s board of directors. It sets out the bank’s lending strategies, risk assessment criteria, facility
structuring guidelines, covenants and conditions, acceptable pricing, and rules for determining the approving
authority.

The foundation of a reliable and effective credit underwriting approach is governance that ensures that the right
people make the right decisions based on the right information. Hence, it is important that adequate controls are
applied within each stage of the approach.
 It is also important to continuously review the approach through processes that help provide feedback and drive
further improvements, such as the loan review mechanism (LRM).

By the end of this lesson, you should be able to:

 Outline the organisational structures for credit underwriting in India.
 Describe the two credit underwriting approaches: discretionary lending and program lending.
 Identify the key components of the credit assessment process.
 Explain the loan review mechanism (LRM).

What You Need to Know

Individual banks in India have different organisational structures for credit sourcing, underwriting,
and sanctioning. For SME credit underwriting, banks have four distinct organisational structures:

 A client sourcing and relationship management group

 A credit underwriting group, which is independent of the business group

 A centralised or regionalised sanctioning authority or committee: in most cases of SME

underwriting, the lending authority is delegated at an individual risk-approver level (a senior
credit underwriting officer with approved sign-off authority) and the credit risk component is
reviewed by a credit risk group.

 A credit operations group, usually a middle office, which supports data analysis, due diligence
checks, and post-sanction documentation and disbursement.

Organisational Units–

Development and Relationship Management

The business development and relationship management team sources potential credit opportunities
by considering the parameters of the bank’s overall credit strategy, including target markets and risk
acceptance criteria, as laid out in the credit underwriting standards. It gathers all the necessary
information from the client, carries out all the checks and due diligence, and draws up a proposal
note in a format prescribed by the bank.

The proposal is evaluated by the credit underwriting team in terms of credit policy and internal
guidelines. It is then transferred to the credit risk group, which independently evaluates the request
and assigns a credit rating.

The proposal is then presented to the sanctioning authority. Most public-sector banks follow a
committee system of sanction, in which the proposal is presented at a committee meeting of senior
executives, who decide on the proposal. In the case of private-sector banks, in most cases the
lending approval authority is delegated to an individual credit officer, but the approval limits decide
the required level of seniority for approvals.
The Credit Underwriting Approach

Banks use the appropriate credit underwriting approach based on the nature of the borrower
segment and risk profile. The credit underwriting approach involves the use of a structured credit risk
analysis to evaluate the borrower’s credit standing, repayment capacity, and the proposed facility
structure.

The focus of an effective credit analysis is to evaluate the risk that the credit extended will be repaid
in cash when due. The credit analysis approach considers three key aspects:

 Quantitative risk analysis: includes analysis of financial statements and other related financial
documents

 Qualitative risk analysis: includes evaluation of key industry, management, and business risks

 Lending facility structure analysis: includes evaluation of the loan structure that not only
meets the overall client needs but protects the bank as well. This evaluation also covers the
availability of collateral security, guarantees, and any government support such as the Credit
Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE).

Types of Credit Underwriting Approaches

The credit underwriting approach provides the operational methodology to make day-to-day lending
decisions using a structured credit analysis (as discussed above). Banks generally use two credit
underwriting approaches:

 Discretionary lending

 Program lending

Regardless of the underwriting approach, credit scoring is the basis used to grade all customers. A
credit grade (CG) is a numerical expression based on a standardised analysis of a client’s financial
and behavioural metrics to represent a borrower’s creditworthiness. The bank uses credit grades to
evaluate the potential risk posed by lending to a client and to mitigate losses due to bad debt. The
bank also uses credit scores to determine who qualifies for a loan, at what interest rate, and at what
credit limit.

Discretionary Lending

 Discretionary lending is widely used for sophisticated corporate and commercial borrowers.
Their borrowing requirements are complex and require expert-level credit judgement based on
specific industry and market insights.

 The availability of reliable and detailed financial and market information aids this type of
underwriting.
  The credit policy parameters and guidelines are kept at a broad advisory level in this type of
underwriting and hence offer a wider scope to apply discretionary judgement on a case-by-
case basis.

Program Lending

 For program lending, the credit evaluation is based on a rule-based approach. A set of
parameterised credit policy rules are established to ensure a quick and efficient way to
underwrite loan requests.

 The revenue and risks view are taken at a portfolio level rather than a case-by-case level,
hence the underwriting criteria.

 Program lending is best suited for evaluating small business lending decisions because:

o Small business customers require simplified and quick access to credit. A rule-based
underwriting approach supports this high-volume lending business by providing a fast,
uniform way to identify and mitigate key risks and make lending decisions.

o It drives standardisation and simplicity and reduces subjective evaluation. For example,
the predefined standardisation of acceptable collaterals, maximum unsecured exposure
norms, and loan-to-value benchmarks help both the front-line sales and credit
underwriting teams by providing a uniform understanding of key client acceptance
parameters.

o The use of surrogate financial documents, such as bank statements and tax records,
provides a strong comfort to drive financial risk.

o Analysis is applied in the absence of the availability of detailed and sophisticated

company financial statements.

Credit Decision Process–

The credit decision process starts with document collection and ends with a credit decision. Its
multiple steps are grouped in the following stages:

Stage 1: Prospecting stage

Stage 2: Login stage

Stage 3: Approval or rejection decision stage

(Image 1)

The Loan Review Mechanism (LRM)

The loan review mechanism (LRM) is an effective tool for the ongoing monitoring of the quality of the
credit portfolio. It also brings about qualitative improvements in credit administration. The LRM
includes all aspects of the credit underwriting process.

 Credit rating assignment

 Internal policies and procedures; applicable laws and regulations

 Compliance activities with loan covenants

 Sufficient loan documentation

 Post-sanction follow-up

 Assessment of portfolio quality

 Recommendations for improving portfolio quality

Types of Loans Taken Up for Review

 Loans above a predefined value

 Accounts that exhibit elevated credit risk

The review is usually undertaken within three to six months of the credit sanction or renewal.
Independent officers should undertake the review, and review findings must be reported directly to
the bank’s board or other designated committees.

Image 1
What You Need to Do
 Having a strong appreciation of the credit risk assessment approach is critical in your ability to identify the right
type of small business clients while being able to underwrite the credit request efficiently and effectively. To
enhance your skills in this area, you should:
 Familiarise yourself with your bank’s underwriting approach for the SME segment in order to apply the correct
underwriting approach as expertly as possible.
 Understand the crucial quantitative and qualitative assessments that are typically performed within the credit
analysis approach that help you identify and mitigate risk when reviewing credit requests.
 Familiarise yourself with the detailed step-by-step stages in the underwriting process in order to understand the
documentation and action steps you need to take to help the bank achieve a quick turnaround time in loan
disbursals.
 Use the loan review mechanism (LRM) as an effective tool for the ongoing monitoring of the quality of the
credit portfolio.

How This is Useful

You have received a loan request for establishing an oil processing unit in a semi-urban
industrial area. The applicant has been a client of yours for the past three years. The
applicant informs you that he is well experienced in the business and quite confident of
an assured market. The investment in machinery is Rs. 50.00 lacs and he is ready to offer
Rs. 10.00 lacs in addition to offering his residential property, worth Rs. 30.00 lacs, as a
mortgage. To process the request, you would take the following actions:

You know that certain analytical steps are typically followed to assess the credit risk. You
also know that the borrower has to meet prescribed benchmarks to establish his
repayment capacity and security sufficiency in order to qualify for credit at your bank.
Therefore, you feel you have a roadmap to follow when determining the loan decision.

You know that you must work through the following three-stage process and be well
prepared to improve your ability to process the loan quickly:

1. Prospecting stage: You will collect the documents relating to the applicant’s
business (trade licence, government approvals, business orders, Know Your
Customer (KYC) documents, etc.), screen the documents, and review the bank
statements.
2. Login stage: You will conduct spot inspection and due diligence, discuss (interview)
with the applicant, and conduct assessment and appraisal.
3. Approval or rejection stage: Based on your assessment, you will take the next steps
and either sanction or decline the proposal.
You will be able to collect the right set of documents from the applicant for evaluating his
financials under the program lending policy. You will also be able to review the available
qualitative and quantitative information upfront in order to conduct a well-guided
personal discussion with the applicant. You feel confident in participating in a process
that leads to a logical, defensible assessment of the likelihood that the loan will be repaid
in full and on time.

Questions You Should Ask

As a credit officer, whether you are new to your role or you are a seasoned credit officer, bear in mind the

following questions as you proceed through the credit assessment and decision process:

Question 1
Select to flip
Have I developed a thorough understanding of the bank’s credit policy for effectively underwriting various loan
products according to the underwriting norms?
Question 2
Am I ready with a checklist of documents that need to be gathered from the applicant?
Question 3
Have I prepared a checklist of items for when I visit the applicant’s site, and do I know how to check these
items?
Question 4
Am I ready with the type of questions to be asked when I interview the applicant? Do I have all the required
documents, data, and details to conduct the appraisal? Have I gone through the appraisal mechanism in order to
make a sound credit decision?
Question 5
Am I able to make a sound credit decision? For example, am I able to justify my decision with competent
authority?
Question 6
Am I able to communicate effectively with the applicant about credit approval or credit decline with due
justification? Am I in line with the post-disbursement review mechanism according to the prescribed
guidelines?

The Credit Lending Process

 Every bank has a predefined end-to-end lending process to reduce risk. It is very important for a lender to have
a detailed understanding of these steps in order to properly follow the bank’s lending procedures.

In this lesson, we will focus on the step-by-step activities within a typical SME loan sanctioning and monitoring
process: application, appraisal, sanction, disbursement, and monitoring. We will also focus on the need for a
sound credit process and sequential approach.

By the end of this lesson, you should be able to:

 Explain the end-to-end credit process adopted in SME lending.
 Identify the important actions and procedures adopted in each step of the credit process.
The objective of the credit appraisal process, or underwriting, is to enable the sanctioning authority to make a
sound credit decision. The end-to-end credit process involves a number of steps, including:
 The identification of a credit opportunity and contacting the prospective borrower
 The evaluation of the prospective borrower’s business and financial risks
 Enabling the sanctioning authority to take the credit decision
 The documentation and ensuring enforceability
 The release of the loan
 The monitoring of the advances and recovery according to the terms of the sanction
As part of the credit appraisal, banks have developed various models to review the proposed borrower’s
business and financial risks. The ultimate aim of the credit appraisal is to make an informed decision on the
risks involved in the particular advance.
End-to-End Lending Process–

A better understanding of the decision-making process will help the credit officer improve the quality of the
credit decision. The credit risk assessment comprises two parts.

First, the credit officer must assess the creditworthiness of the borrower, then rate the borrower and price the
product accordingly. Second, the credit officer must monitor the advances and recovery according to the terms
of the sanction. The various stages in the life cycle of a loan are illustrated below:
A traditional loan decision process (i.e., one that does not include automated risk rating inputs) may involve
several steps. These steps range from gathering data to determining policy compliance to structuring and pricing
the credit request.
The Steps of the Lending Decision Process–

The size of the loan or credit exposure may vary from a small amount to a fairly large amount. Hence, the
lending process differs based on loan size. Generally, the process is simplified for small loans in order to
guarantee a quicker turnaround time (TAT) than the TAT of larger loans.

Here are the steps of the lending decision process, with the critical activities generally followed.
Small Loans
Small loans usually follow the retail lending process, which involves only a few steps and is typically
scorecard-driven. Borrowers expect a simplified process, basic documentation, and quick decision-making.

Stage 1: Initial Verification Checks

What it involves: Collect Know Your Customer (KYC) documents and financial and non-financial data and
discuss with the applicant.
How this helps the banker: This step establishes the identity and ownership of the company and its promoters.
The banker will fully understand the details of the stakeholders and be able to procure the most recent financial
information.

Stage 2: Credit Bureau Checks

What it involves: Check for any adverse reports and discuss with the applicant.
How this helps the banker: This step establishes the credit quality and profile of the borrowing entities.

Stage 3: Internal Scorecard Generation

What it involves: The selection of personal, financial, and business performance information helps to generate a
credit scorecard, which in turn helps to arrive at a first-level "go or no-go" decision about the proposal.
How this helps the banker: This step helps determine whether the borrower meets the acceptable credit
standards according to the bank-approved credit policy.

Stage 4: Credit Approval or Decline

What it involves: The final informed decision takes into account various additional factors, such as the quantum
and tenor of the loan, pricing, and other terms and conditions as set out by the bank policy guidelines.
How this helps the banker: This step helps make a composite credit decision.

Large Loans
While some of the steps in the small loans decision process are common (initial verification checks, credit
bureau checks), the larger credit exposure loans have a much more detailed underwriting process.

 Form an initial assessment.

1. Screen against the credit policy: Determine whether the request falls within the
bank's policy guidelines.
2. Gather data: Collect all financial and non-financial data.
3. Undertake a detailed financial and business risk analysis.
 Interview the applicant.
1. Conduct management interviews: Prepare a list of questions for the business's
management team based on the analysis results.
 Evaluate risk through projections (for big-ticket term loans).
1. Build the analysis assumptions: Base these assumptions on both the analysis and the
management interviews.
2. Conduct the projections scenario analysis.
3. Determine and evaluate the projected risk.
 Structure and price the loan.
1. Obtain the appropriate security or guarantees to mitigate the impact of any losses.
2. Determine the pricing: Price the credit, taking into account established guidelines
and perceived credit quality. This is done through the SME rating of the prospective
borrower.
3. Grade the risk: Assign a risk grade according to the bank’s SME rating model.
Compare this rating with the rating from the SME Rating Agency (SMERA) of India
for any wide variation.
 As a credit officer, you need to be familiar with the credit policies and procedures of your banks in order to
properly apply all credit underwriting standards. You should be familiar with the bank’s credit scorecards and
its relation to pricing a loan. You should also be able to read the Credit Information Bureau India Ltd (CIBIL)
report and how they help to make credit decisions.

Moreover, you need to:

 Understand:
 The key documents and activities at the prospecting stage in order to improve the TAT of
loan decision-making
 The various components in a Credit Information Bureau India Ltd. (CIBIL) report and how
they can be used to make credit decisions
 The process of preparing credit scorecards
 The importance of obtaining adequate and appropriate securities or guarantees
 Develop:
 The skills to interview the client in order to gather the relevant information
 The skills to compare the bank’s scorecard rating with the SMERA rating and identify any
variations
 Price the Product:
 Price the loan product based on the bank’s scorecard rating.

You have been asked to process a business loan proposal for an automobile servicing unit ( an authorised
servicing agent for Maruthi Cars). It is seeking a working capital limit of Rs. 75.00 lacs. As one of your reputed
clients, it routes all its transactions through a current account in your branch. It also owns term deposits worth
Rs. 30.00 lacs. How will you handle this proposal?

By understanding the following key steps of the underwriting process, you will help to facilitate a quick
decision that will in turn delight the client:
 Capture the applicant’s business profile appropriately.
 Form an initial assessment based on gathered inputs (analyse eligibility and credit history).
 Visit the applicant’s site and discuss with the applicant the required matters.
 Obtain CIBIL or SMERA reports as applicable.
 Perform a credit appraisal according to the prescribed format and make a decision to sanction or to decline the
request.

As a lender, consider the following questions as you work through the credit assessment and decision process:

Question 1
Select to flip
Am I able to prepare an appropriate checklist in order to gather complete information from the applicant?
Question 2
Do I have the adequate knowledge to screen the documents before conducting the applicant interview?
Question 3
Have I developed the necessary interview skills to collect the relevant information to cross-verify the data
gathered either through documents or from information that is not available in the documents?
Question 4
 Am I up-to-date with the latest credit policy guidelines in order to relate the credit policy provisions while
appraising the proposals?
Question 5
Have I developed the judgement capabilities based on credit risk components either to sanction or to decline the
proposal? Am I able to justify either the sanction or the decline of the proposal on its merits and communicate
this decision convincingly?
Question 6
Am I familiar with the documentation process for a specific type of loan and disbursements thereof?

BORROWER DUE DILIGNECE

SME borrowers expect quicker turnaround time (TAT) because their needs are immediate. With SME
borrowers, banks face a challenge because relatively less financial information is available for financial analysis
and credit assessment. In such cases, banks have to depend on surrogate information and available documents in
order to make credit decisions. Therefore, initial due diligence plays a crucial role in financing SME borrowers.

Typically, SME borrowers with sizable loan requests maintain books and other financial statements. In such
instances, it is necessary for the lender to complete the entire credit process in order to arrive at a credit
decision. This takes considerable time and resources.

It is crucial that a lender be familiar with the pre-screening practices that filter the right quality of clients to the
next stage of credit appraisal. The qualitative and quantitative aspects of due diligence are important in each
step of the process. Improper screening results in a higher rate of rejection at later stages. This result not only
leads to poor customer experience but also consumes critical resources.

In this lesson, you will learn the importance of pre-screening practices to filter the right quality of clients to the
next stage of credit appraisal. We will also focus on the quantitative and qualitative aspects of due diligence.

The various credit verification methods adopted by banks are specifically designed to enhance analysis and
information accuracy while underwriting a loan request. In the case of small business lending, effective client
verification becomes crucial when one considers the limited availability of public information at an individual
borrower level.

By the end of this lesson, you should be able to:

 Explain the importance of pre-screening practices to filter the right quality of clients to the next stage of credit
appraisal.
 Describe the various credit verification methods to validate and complement the quantitative analysis.
 Outline the SME lending verification framework for credit and fraud risk evaluation.

What You Need to Know

The main objective of due diligence is to assist in making the right lending decision, which broadly comprises
the following two key areas:
 Ascertain borrower credentials from a financial and credit behaviour perspective
 Confirm the validity of borrower information
Due Diligence of Borrower Credentials–

The aim of evaluating a borrower’s repayment capability and overall credit behaviour is to gain a deeper
understanding of the financial transaction patterns and credit behaviours of the key individuals running the
business.

The most common types of verifications or analyses include:

 Analysing bank statement transactions

 Analysing tax (value added tax [VAT] or goods and services tax [GST]) statement trends
 Obtaining credit bureau checks

Bank Statement Analysis

Operating bank statements and overdraft statements are excellent indicators of a business’s financial health and
credit behaviour. Detailed analysis of these statements is a critical tool for the lender because it provides a
deeper understanding of both these factors.
The analysis of these statements can gather key information, including:

 Cash flow trends (e.g., monthly fluctuations, average balances, cash volatility, and turnover)
 Transactional or payment behaviour, such as:
o Customer-issued cheques being returned due to shortage of funds
o Third-party cheques deposited into the customer's account being returned
 Loan repayment history (regular equated monthly instalment [EMI] outflows and repayment
record)
 In the case of overdraft statements, the information on utilisation behaviour and hard usage
statistics

The Importance of Bank Statement Analysis

 A healthy and stable average balance reflects the business’s ability to pay for fixed
obligations and other business-related obligations while ensuring adequate cash on hand to
keep the business operations running smoothly.
 A high level of cash volatility, with instances of cash balances going into the negative or
over the limit, indicates poor cash management by the borrower.
 A high degree of quarterly fluctuations in credit turnover (the sum of all business-related
payment credits in the account) reflects a seasonal or non-steady business flow aspect of the
business and will require better analysis to understand the cash flow management by the
business owners to support such seasonal variability.
 “Large” transactions must be examined closely to assess trends or abnormalities.
 A high level of returns in the case of third-party cheques issued favouring the borrower will
need to be evaluated to identify the underlying reasons. This indicator signals a poor
collections discipline and reflects on the quality of the counterparties (buyers) the business
is dealing with.
  The return of cheques issued by the borrower is a more concerning issue, because it
indicates management’s poor commitment to honouring payments due and its inability to
meet its obligations.
 Frequent overdue or excess entries in overdraft statements alert the lender to poor operating
cycle management and cash flow issues that could potentially disrupt the business unless
adequately addressed.

Credit Bureau Analysis (TransUnion CIBIL)–

Credit bureau records offer an effective way to evaluate small business credit behaviour and repayment track
records at both a business and an individual level. Most banks use both to underwrite credit risk. This
information should be analysed for all key owners and managers. Credit records are available in the form of:

 A commercial credit report: When the borrowing entity is a company or non-individual

 A personal credit report: When the borrower is an individual who is the owner or one of the
main owners of the company

Verification of Borrower Information

 Credit bureaus collect factual information about commercial borrowers or individuals from
multiple sources (banks, credit card companies, collection agencies, blacklisted databases,
and various government agencies). This information usually includes:
o Basic borrower details: name, address, identification number, date of birth, date of
incorporation, and so on
o Borrower loan details: type and amount of credit facilities sanctioned, facility start
date, current outstanding and live status, and so on
o Past payment history and overdue information
o Bureau enquiries on the borrower during the past few months by various parties
o Information related to any bankruptcy, settlement, or legal suit against the borrower
 Credit bureaus do not provide information about the borrower’s income, revenue, or assets.

 Credit bureaus also provide a credit score. The credit score is a result of a mathematical
algorithm applied to a credit report and other available information to predict future
borrower delinquency.
 TransUnion CIBIL scorecards range between 300 and 900. Generally, banks in India insist
on a score of 750 and above for the sanction of a loan. The higher the score, the higher the
creditworthiness of the borrower and the higher the chances of sanction.

The Importance of Information Verification

 Verification provides detailed information about the various credit facilities in the name of
the borrowing entity and helps corroborate those details with the bank statements to identify
any missing information or additional information that the lender will require as part of due
diligence.
 Verification helps accurately establish the existing debt obligations and outstanding loan
amount, which in turn helps the assessment of a borrower’s debt repayment capacity.
 The repayment history provides excellent feedback about the borrower’s repayment
integrity and intention to service the debt. Records that reflect a high level of late payments
 (days past due) or non-payments, partial payments, or collection-induced repayments are a
good indicator of the potential risk in lending to the borrower.
 While the commercial bureau records of a company may show a good track record, the
individual credit bureau reports of the key owners are also critical because they tend to
reflect the management disposition towards repaying credit as well as any lack of integrity
and intent.

Verification of the Validity of Business and Borrower Information

The aim of this verification process is to validate the business and borrower-level information and therefore
help to mitigate potential adverse market information or fraud issues.

The most common types of verification or analysis conducted include:

 Site or office visits

 Personal discussions or tele-verification
 Residential verification
 Company search, Google search, defaulters search, or negative database search

Site or Office Verification

The bank-appointed verifier or a bank staff member conducts a physical visit to the borrower’s business or
operating unit premises. This type of verification is done:

 To assess the existence of the business and to corroborate the nature and size of the
operation with the information provided by the borrower
 To filter out potentially fraudulent applications and business entities with doubtful
operational premises and inaccessibility issues that may hamper future collections efforts in
the case of default

The Purpose of On-Site Verification

 To validate the address provided in the application form and to check whether the address is
easily accessible
 To confirm whether physical sign boards are in place and the relevant commercial operating
licences are properly displayed (e.g., shop and establishment certificate)
 To check the surrounding location of the business premises
 To observe the level of business activity and the number of employees seen at the business
premises
 To survey the neighbours of the borrowing entity and the owners and document any adverse
feedback
 To photograph the business premises

Personal Discussion or Management Interview–

The overall credit evaluation also includes a personal discussion or interview with the key promoters of the
borrowing entity. The aim of the interview is to better understand the borrower’s business profile and seek
clarifications on any discrepancies or observations that may be in variance with the policy or profile of the
borrower.

The interview is generally conducted by the credit manager or relationship manager (RM), either on-site and in-
person or by telephone, depending on the customer segment.
The Key Areas of the Personal Discussion or Management Interview

The interview will focus on understanding the reason for the loan, the business model and operating cycle of the
entity, cash flow, stability of income, and how the borrower will be able to repay the loan.

Typically, the following key topics are discussed:

 The real functional owner(s) operating the business and their background
 The nature of the business, industry type, products, success factors, risks, and the
competency of the key individuals to manage the business successfully
 Information about business continuity and succession risk
 The key suppliers and buyers and concentration risk-related issues
 Business consistency and operating cycle: turnover, profitability, profit margins, and
working capital cycle
 The reasons for funding and the details about the nature of use
 Any other transactional-related queries: post review of bank statements, credit reports, tax
statements, and so on

The Importance of the Personal Discussion or Management Interview

 Helps to gain first-person insight into the borrower and the business and establish overall
insight into the credibility of the borrower
 Helps to elicit more information from the borrower, which betters the lender’s overall
understanding
 Helps to evaluate the nature of the borrower’s activity. This evaluation will provide a fair
idea of the borrower’s intentions, which are not evident from the paperwork.
 Helps to identify the names of reference persons who are known to both the lender and the
borrower so that opinions can be obtained from these references later
 Clearly establishes the purpose of the loan request and the use of funds in order to make the
lending decision

Central Bank and Other Government Agencies Checks–

By conducting the central bank and other government agency checks, the lender can proactively use the
information to conduct a further investigation of the borrower’s veracity before making the final lending
decision.

The Purpose of the Central Bank and Other Government Agency Checks
These searches are conducted to identify any negative or adverse information that may have been recorded
against the borrowing entity or the key owners and to unearth potential adverse information that may affect the
business operation.

 The Reserve Bank of India (RBI) publishes a defaulters list to disseminate information
about wilful defaulters to other banks and financial institutions so that further financing will
not be provided to such borrowers. Wilful default is defined by the RBI as deliberate non-
payment of dues despite adequate cash flow and net worth, siphoning off funds, the selling
off of financed assets and the diversion of funds for activities other than the core business,
the misrepresentation of facts, or fraudulent transactions by the borrower.
 The Central Registry of Securitisation Asset Reconstruction and Security Interest of India
(CERSAI) provides a platform for filing the registration of transactions of securitisation,
 asset reconstruction, and security interest by banks and financial institutions. A CERSAI
database search will reveal any charges registered on immovable properties in favour of
financial institutions.
 The Export Credit Guarantee Corporation of India (ECGC) periodically publishes a caution
list of entities that have violated export-related rules. If the borrower’s name appears on this
list, details have to be examined and action initiated.

Information from the Central Bank and Other Government Agency Checks
This information includes

 Negative news flow or adverse media coverage about the borrowing entity or the key
owner(s)
 Information about any strictures or cases initiated by government agencies or litigation and
tax investigations; and
 Helps to identify any politically exposed person linked to the individual owner(s), which
may affect the bank’s reputation as a lender or generate adverse media or regulatory
implications

Anti-Fraud Verification Checks–

Fraud control checks provide for an independent verification of the borrower’s documents, credit initiation, and
vendor management process. These checks are generally performed by the bank’s in-house fraud control officer
or an agency deputed by the bank.

Fraud is likely to arise through first-party actions perpetuated by front-line sales staff, site inspectors, or bank
agencies. Key concerns include fraudulent income documents (e.g., tax returns or bank statements), fraudulent
transaction documents (e.g., invoices), inflated valuation reports to achieve higher loan eligibility, the issue of
fictitious properties, or multiple loans on the same property.

Anti-Fraud Verification

 Sample review of all customer-provided documents, including bank statements, tax

statements, and address and proof-of-identity documents
 Sample physical verification of documents to establish authenticity. Anti-fraud agents are
sent to the respective government agencies and banks to cross-check the accuracy of the
submitted loan documents. For bank statement verification, agents cross-check the sample
of entries (or salary credits) with the respective bank branch.
 Check the borrower’s signatures on the loan document and supporting documents to identify
any wrongful information or fraudulent signing on behalf of the borrower.

The Importance of Anti-Fraud Verification

  By authenticating the submitted loan documents, the bank is able to guarantee the accuracy
of the information upon which the lending review and analysis are conducted and to provide
the true financial health of the borrowing entity.
 The bank filters out any potential frauds perpetuated by in-house staff in collusion with the
borrower or with other bank-appointed agencies.
 The bank is safeguarded from reputational damage and adverse media publicity in case
fraudulent activities in loan decision-making are leaked into the public or regulator
domains.

What You Need to Do

Having detailed information about key verification checks helps you to gain a better appreciation while
undertaking borrower credit analysis and to make the right credit decisions. To enhance your skills in this area,
you should:
 Perform:
All required verification steps to make sure that you’re working with the highest quality
information possible.
 Understand:
 The key aspects of a bank statement analysis in order to effectively evaluate the borrower’s
financial health and creditworthiness.
 The credit bureau scorecards and how to analyse the various factors involved.
 Review:
The bureau records to ascertain key aspects of the borrower’s prior personal and business accounts
and credit facilities with various banks.
 Assess:
The level of repayment risk as evidenced by information in the credit bureau and from other
verification checks, and how it might affect the borrower’s ability and willingness to repay debt.
 Conduct:
Google searches to identify any adverse media information and reputational issues that the bank
may face if it advances a loan to a borrower with negative market information.

You have received a loan proposal from M/s Adharsha Enterprises, which is in the
electronics spare parts business. Adharsha is a regular supplier to M/s ABC Pvt. Limited,
which is a reputed corporate business group. You learned from a recent newspaper
article that ABC’s directors were investigated by the income tax authorities.
Although this has no direct impact on Adharsha’s loan proposal, the company may face
cash flow issues. Under these conditions, your due diligence plays a critical role in
safeguarding the interest of the bank.

You have also received an SME loan proposal from M/s Quality Springs for Rs. 50.00 lacs.
Quality Springs manufactures springs and supplies various automobile industries.
Currently, Quality Springs is dealing with another public-sector bank.

As part of your due diligence, you have obtained the bank account statements from
Quality Spring's existing bankers. While analysing the statements, you find that the credit
summation of the account from the past 12 months is approximately Rs. 30.00 lacs
against a sales turnover of Rs. 35.00 lacs showed in the books of accounts. Quality
Springs has projected sales of Rs. 50.00 lacs during the current year. The inputs provided
here will help you relate the credit summation to the sales and determine whether
Quality Springs’s dealings appear to be genuine.

Asking the right questions based on the verification inputs is key to ensuring the right loan decision is made.

Questions such as these can help ensure you are able to size up the information while making the loan decision:

Bank Statements:
Question 1
Select to flip
Are there EMIs in the current account statements that have not been declared by the borrower in its application
form when checked against the credit bureau live loan records?
Question 2
Are there repeated cheque returns from the same buyer? Is there a concern that the buyer is having cash flow
problems, especially if that buyer is a major customer? How will this affect your borrower in a worst-case
scenario?
Question 3
Do high-value, rounded credit and debit entries appear in the bank accounts? What do those entries represent?
Question 4
Is there a high degree of account volatility from month to month? If so, why?

Credit Bureaus:
Question 5
Select to flip
How has the business owner handled credit relationships in the past? If there have been issues, how have they
been resolved?
Question 6
Are there any adverse indications in the existing and past accounts and loan relationships with the bank?
Question 7
Are there any past payment problems that require explanation? If so, what are the explanations?
Question 8
Are there any recent loans availed past the credit bureau report date?

Personal Discussions or Office Verification:

Question 9
Select to flip
Who are the business's key suppliers and buyers? What are typical payment terms?
Question 10
Do the office reports provide an accurate representation of the business information as shared in the loan
application?
Question 11
What information does the Google check offer, and does it have any negative implications about the business’s
conduct?