Chapter 16

Lending Policies
and Procedures:
Managing Credit
Risk

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Introduction
 Credit is a broad term that has many different meanings in the financial
world. It is generally defined as a contractual agreement in which a
borrower receives something of value now and agrees to repay the
lender later—generally with interest.
 Lending to businesses, governments, and individuals is one of the
most important
services banks and their competitors provide, and it is also among the
riskiest as the recent global credit crisis has demonstrated.
Therefore, managing credit risk is an important topic for banks and
financial institutions.
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Types of Loans (By Purpose)

Bank loans may be divided into seven broad categories, explained by their purposes
1. Real estate loans are secured by real property-land, buildings, and : other structures and
include short-term loans for construction and land development and longer-term loans to finance
the purchase of farmland, homes, apartments, commercial structures, and foreign properties.
2. Financial institution loans include credit to banks, insurance companies, finance companies,
and other financial institutions.
3. Agricultural loans are extended to farms and ranches to assist in planting and harvesting
crops and supporting the feeding and care of livestock.
4. Commercial and industrial loans are granted to businesses to cover purchasing inventories,
paying taxes, and meeting payrolls.
5. Loans to individuals include credit to finance the purchase of automobiles, mobile homes,
appliances, and other retail goods, to repair and modernize homes, and to cover the cost of
medical care and other personal expenses and are either extended directly to individuals or
indirectly through retail dealers.
6. Miscellaneous Loans include all loans not listed above, including securities' loans.
7. Lease financing receivables, where the lender buys equipment or vehicles and leases them to
its customers. 3
Types of Loans (By Nature/Product)
Loans can be categorized into four types :

a) Continuous Loan: The loan accounts in which transactions may be made within certain
limit and have an expiry date for full adjustment will be treated as Continuous Loan.
Examples are: Cash Credit, Overdraft, etc.
b) Demand Loan: The loans that become repayable on demand by the bank will be treated
as Demand Loan. If any contingent or any other liabilities are turned to forced loan (i.e.
without any prior approval as regular loan) those too will be treated as Demand Loan.
Such as: Forced Loan against Imported Merchandise, Payment against Document,
Foreign Bill Purchased, and Inland Bill Purchased, etc.
c) Fixed Term Loan: The loans, which are repayable within a specific time period under a
specific repayment schedule, will be treated as Fixed Term Loan
d) Short-term Agricultural & Micro-Credit: Short-term Agricultural Credit will include the
short-term credits as listed under the Annual Credit Program issued by the Agricultural
Credit and Financial Inclusion Department (ACFID) of Bangladesh Bank.

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….Types of Loans (Cont’d)
Overall loans can be categorized into three categories:

Retail Loan Corporate loans S M E Loans

• Home loan Loan to specific corporate Cottage, Micro,

• Car Loan bodies. It can be new loan Small & Medium
• Personal loan or existing loan with Enterprise
• Credit cards renewal facilities.

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 Difference Between Loans & Advances
BASIS FOR
COMPARISON LOA N S ADVANCES

Meaning Funds borrowed by an Funds provided by the bank

entity from another entity, to an entity for a specific
repayable after a specific purpose, to be repayable
period carrying interest after a short duration is
rate is known as Loans. known as Advances.

What is it? Debt (EMI Nature) Credit Facility (Non-EMI

Nature)
Term Long Term Short Term
Legal formalities More Less
Security May or may not be secured Primary security, collateral
security and guarantees.
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 Factors Determining the Growth and
Mix of Loans
 Characteristics of the market area it serves.
 Lender size & its legal lending limit to a single borrower.
 The experience and expertise of management in making different types of loans.
 The expected yield that each loan offers compared to the yields on all
other
assets.

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 Steps in Lending Process
1. Finding Prospective Loan Customers
2. Evaluating a Prospective Customer's Character and Sincerity of Purpose
3. Making Site Visits and Evaluating a Prospective Customer's Credit Record
4. Evaluating a Prospective Customer's Financial Condition (Conducting ICRRS)
5. Assessing Possible Loan Collateral and Signing the Loan Agreement
6.Monitoring Compliance with the Loan Agreement and Other Customer Service
Needs

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 Is the Borrower Creditworthy?
5Cs of Credit
• Money lending is one of the main functions of a commercial bank. In the lending
process, selection of borrowers is the most crucial and vital job for a banker.
Before a customer enjoys credit facilities it is important that the applicant should
qualify for five Cs. The five Cs are:
1. Capital
2. Collateral
3. Characteristics of Borrower
4. Capacity to run the credit
5. Condition

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….5Cs (Cont’d)
 Character : Character refers to the client’s willingness and determination to meet
a loan obligation. Unlike the financial performance indicators that appear on the
balance sheet, character is an inner quality that is exhibited by such qualities as
integrity, stability, and honesty.
 Capacity: Loans are repaid from the cash generated during a company’s operating
cycle. Management’s ability to generate enough cash to satisfy all obligations is
defined as capacity.
 Capital: Capital refers to the funds available to operate a business, of which there
are two primary considerations: the amount of equity capital the owners have
invested in the business and how effectively the total capital in the business is
employed.

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….5Cs (Cont’d)

 Collateral: Collateral can help a borrower for securing loans.It gives the lender
the assurance that if the borrower defaults on the loan, the lender can repossess
the collateral.
 Conditions: This term refers to external variables such as the state of the
economy and the type of industry in which the client’s business is a part. For
example, a company that manufactures doorbells will be adversely affected when
nationwide housing starts are down.

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Types of Security
• Three types of security are considered :

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…….Types of Security(Cont’d)
 Primary security: Primary security is related to the purpose of the loan as under:
1. Consumer loan: The items/goods to be purchased.
2. Car loan: The car to be purchased
3. Home loan: The home to be purchased
4. Working capital loan:
➢ Trading: Items/ Stocks purchased for trading
➢ Manufacturing Industry: raw material, work in process, finished goods
➢ Service industry: Bills receivable, Sale proceeds
5. Work order loan: Bills receivable
6. Project Loan:
➢ Trading: Leasehold property/ Advance rent/Interior decoration
➢ Manufacturing Industry: Plant, machinery, Erection, Land, Land
vehicle, Building construction, License cost, Gas line/ electrical line cost/charge
development,
➢ Service industry: Cost of land, Development, Building Construction, Equipment cost,
Vehicle cost.
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 Charges On security
 Collateral Security:
Additional security for extra safety such as: Land, Building, Vehicle, FDRs/FI

Characteristics of Good Collateral:

 Tangible
 Genuineness/ Validity of title
 Proper demarcation
 Transferable/ negotiable/ easily marketable
 Price stability
 Storability and durability
 Location
 Easy accessibility

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 Charges On security
Basic Charge documents: to charge on the borrower for all types/ sizes of loans.
Demand promissory note, General loan agreement, letter of continuity, Letter of
revival are called basic charge documents.

Modes of Charge creation on securities:

1. Lien: To charge on F D R ( Cash collateral)

2. Pledge: To charge on the goods/stocks of the customer which are held under
control/Custody of the banker

3. Hypothecation: To charge on the goods/ stocks (movable) of the customer, which

are held under the control of the customer.

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 ….Charges On security(Cont’d)
4. Assignment: To charge on the bill’s receivable of the customer.
5. Mortgage: To charge on the immovable property of the customer.
6. Charge with R J S C (in case of limited company): H ypothecation charge( on
stock/movable property), Fixed and floating assets, Mortgage charge
7. Pari passu charge sharing:
➢ Creation of charge with R J S C +
➢ Pari passu charge sharing agreement with participating lenders.

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 Loan Review
While most lenders today use a variety of different loan review procedures, a few general
principles are followed by nearly all lending institutions. These include:
1.Carrying out reviews of all types of loans on a periodic basis-for example, routinely
examining the largest loans outstanding every 30, 60, or 90 days, along with a random
sample of smaller loans.
2.Structuring the loan review process carefully to make sure the most important features of
each loan are checked, including
a. The record of borrower payments to ensure the customer is not falling behind the planned
repayment schedule.
b. The quality and condition of any collateral pledged behind the loan.
c. L D C L : The completeness of loan documentation to make sure the lender has access to any
collateral pledged and possesses the full legal authority to take action against the
borrower in the courts if necessary.
d. An evaluation of whether the borrower's financial condition and forecasts have
changed, which may have increased or decreased the borrower's need for credit.
e. An assessment of whether the loan conforms to the lender's loan policies and to the
standards applied to its loan portfolio by examiners from the regulatory agencies.
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 …..Loan Review(Cont’d)
3.Reviewing the largest loans most frequently because the default on these
credit agreements could seriously affect the lender's own financial condition.
4. Conducting more frequent reviews of troubled loans, with the frequency of
review increasing as the problems surrounding any particular loan increase.
5.Accelerating the loan review schedule if the economy slows down or if the
industries in which the lending institution has made a substantial portion of its
loans develop significant problems ( e.g., the appearance of new competitors or
shifts in technology that will demand new products and delivery methods).

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 Regulation of Lending
 The quality of a loan portfolio and the soundness of its policies are the areas federal and
state regulators look at most closely when examining a lending institution. Any loans
made are subject to examination and review and many are restricted or even prohibited
by law.

 Under the Uniform Financial Institutions Rating System used by federal examiners, each
banking firm is assigned a numerical rating based on the quality of its asset portfolio,
including its loans. The examiner may assign one of these ratings:
1 = strong performance
2 = satisfactory performance
3 = fair performance
4 = marginal performance
5 = unsatisfactory
performance

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 ….Regulation of Lending(Cont’d)
•The quality of loans is a major component of asset quality but is only one dimension of a
lender's performance that is rated under the Uniform Financial Institutions Rating System.
Numerical ratings are assigned based on examiner judgment about six dimensions of
performance, referred to as the C A M E L S rating. The letters in C A M E L S are derived from
• C apital adequacy
• Asset quality
• M anagement quality
• E arnings record
• L iquidity position
• S ensitivity to market risk

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 ….Regulation of Lending(Cont’d)
• When an examiner finds loans that carry an immediate risk of not paying out as planned,
these credits are adversely classified. Typically, examiners will place adversely classified
loans into the following groupings according to BRPD Circular No.14 dated September 23, 2012,
BRPD Circular No. 19 dated December 27, 2012 and BRPD Circular No.08 dated August 02, 2015, BRPD
Circular No. 03 April 21, 2019
Classification Status
Loan Types SMA SS DF BL
Demand Loan ≥2 but <3 ≥3 but <9 ≥9 but <12 ≥ 12
Continuous Loan ≥2 but <3 ≥3 but <9 ≥9 but <12 ≥ 12
Fixed Term Loan ≥2 but <3 ≥3 but <9 ≥9 but <12 ≥ 12
Short term Agri Loan - ≥12 but <36 ≥36 but <60 ≥60

Where,
SMA= Special mention account
S S= Sub standard
D F= Doubtful
BL= Bad and Loss 21
 ….Regulation of Lending(Cont’d)
Loan Provisioning:
Base for provision:
(Total outstanding-Interest suspense-Value of eligible securities) or
(Total outstanding* 15%) whichever is higher.
General Provisioning:
Loan Classification
Un Classified Classified
UC SMA SS DF BL
1% 5% 20 50 100
% % %

B L Write Off

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 ….Regulation of Lending(Cont’d)
Once a loan becomes overdue, the bank tries to recover the repayments through
several procedures such as:
 Follow-up and persuasion over the phone.
 Sending reminder letters
 Single visit as well as group visit.
 Sending letters to guarantors.
 Warning on legal actions
 Loan rescheduling
 Loan restructuring
 Loan Write off
 Legal actions: Through N I Act 1881 or Artho Rin Adalat 2003

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Summary of Credit Process

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