If a bank were a superhero, credit risk would be its sneaky arch-nemesis — disguised in nice suits, smiling borrowers, and well-written business plans. But behind those smiles lies the ever-present threat: What if they don’t pay back?
Let’s unravel how banks protect themselves from this ever-lurking danger.
🎯 The Foundations of Lending: Why Policies Matter
Credit risk — the risk that a borrower delays or skips payments — is no small hiccup. It’s a 70% problem. That’s how much of a typical bank’s balance sheet is tied up in lending. So if borrowers flake out, the bank’s liquidity dries up faster than a puddle in the Sahara.
To tame this risk, banks create formal lending policies — essentially, their financial firewalls. These policies define:
- Who gets a loan
- How they’re vetted
- How loans are monitored
- What happens if things go wrong
Imagine running a massive restaurant. You’d need clear rules for chefs, waiters, deliveries, and hygiene. Lending policies are just that — a recipe book for safe banking.
And because the economy is like a fast-paced dance floor, policies must remain flexible. Risk managers need a clear path to the boardroom, in case something smells fishy.
🧱 Types of Credit Policies: Three Defense Layers
Lending policies typically fall into three layers of protection:
- Risk-limiting policies — How to avoid giving loans that smell like bad news.
- Asset classification policies — Sorting loans based on how likely they are to go sour.
- Loss provisioning policies — Preparing for when things do go sour.
But that’s just the start. You wouldn’t give all your savings to one friend, right? Neither should a bank.
🧯 Exposure & Concentration Limits: Don’t Put All Your Eggs in One Basket
Banks must avoid overexposure to:
- One borrower
- One industry
- One geographic area
This is like not stocking your entire menu with just pizza — what if the cheese market crashes?
To stay safe, banks set limits:
- A single customer usually gets no more than $10\%$–$25\%$ of the bank’s capital.
- Related-party lending $($think CEOs lending to their cousin’s startup$)$ is strictly limited.
- All exposures must be calculated without overvaluing collateral. That shiny car could lose value overnight.
Here’s where it gets tricky — defining a “single client.” If two companies are secretly controlled by the same boss, their combined loans count as one exposure. Like twins switching classes — they may look different, but they’re one risk to the system.
And speaking of related parties — favoritism is a big no-no. Regulators demand transparency, and when they don’t, banks should still hold their own ethical line.
So now that we’ve put some fences up…
📊 How Do Banks Decide Who Gets a Loan?
Think of a bank’s credit facility as a well-run kitchen:
- Ingredients $=$ Loan applications
- Recipes $=$ Lending rules
- Chef inspections $=$ Appraisals and monitoring
Let’s break down the key ingredients:
🧍 Lending Authority
Not every staffer can give out a large loan. Authority depends on experience. In big banks, lending power is distributed geographically or by product type.
🍽️ Types and Distribution of Loans
A balanced loan portfolio is crucial. Real estate loans, personal loans, business loans — each has a role. Overloading on one is like serving only one dish at a buffet.
🧐 Appraisal Process
Before the bank forks out funds, it must:
- Appraise the borrower’s financial health
- Re-appraise for renewals
- Limit the loan-to-value ratio
It’s like checking the expiry date on every ingredient.
💵 Loan Pricing
Loan rates must cover:
- Funding cost
- Supervision and admin cost
- Loss probability
- Reasonable profit
Pricing should also respond to market competition. No one wants to buy overpriced lemonade.
⏰ Maturities
Loans must have realistic repayment plans. Asking someone to repay a home loan in one year is like expecting a toddler to carry a refrigerator. Terms must match repayment capacity and collateral life.
🌎 Sector and Geographic Exposure
Banks need systems to monitor how much they’ve lent to particular regions or industries. If one sector collapses $($say tourism during a pandemic$)$, overexposure can break the bank.
📂 Financial Information
Rules must define:
- What documents are needed
- If audits are required
- Whether projections align with the loan duration
No surprises = safer lending.
⏳ Monitoring Collections
If a loan goes sour, the bank must:
- Report to the board
- Estimate expected losses
- Make recovery plans
Because ignoring a leak only floods the house later.
🧮 Total Loans Outstanding
Banks limit total lending based on:
- Capital
- Deposits
- Assets
They also factor in deposit volatility — because when cash in is unstable, cash out must be cautious.
💰 Margin Requirements
Banks set loan-to-collateral value limits, like giving a ₹70 loan against a ₹100 bond. Collateral values must also be periodically updated.
⚠️ Recognizing Impairments
A loan that smells rotten probably is. Policies should mandate identifying unrecoverable loans early. Delay only worsens the impact.
🔄 Renegotiated Debt
When borrowers struggle, banks may reduce interest/principal or swap debt for equity. But repeated restructuring = symptom of a bigger problem. Time to review the entire lending approach.
📜 Documented Guidelines
No “gentlemen’s agreements” here. Policies must be in writing. If it’s not on paper, it doesn’t exist.
🔍 Portfolio Reviews
Banks must regularly sample and inspect loans:
- 75% by loan amount
- 30% by loan count
- 50% of foreign loans
- 100% of loans $>$ 1-year maturity
Plus, they must flag:
- Loans to insiders or related parties
- Loans overdue by 30+ days
- Modified loan terms
- Any loans marked risky
🧾 Loan Loss Allowances
Banks need to set money aside for expected losses. Reviews must include:
- Current policy and risk factors
- Trends from the past
- Stress tests for what-if scenarios
Even off-balance-sheet commitments like guarantees and interbank deposits can carry credit risk. The shadow always counts.
But that leads us to the real question:
🔎 How Do Banks Label Risky Loans?
Enter Credit Asset Classification — the art of labeling loans from awesome to awful.
🟢 Standard
The gold standard. No issues. Fully secured. Payments on time. Chef’s kiss.
🟡 Specially Mentioned
Mild warning. Something smells fishy — maybe financials are slipping or revenues are unstable. Keep an eye out.
🟠 Substandard
Something’s broken. The borrower missed payments. Primary repayment has failed. Time to eye that collateral.
🔴 Doubtful
The borrower is in deep water. Payments overdue $>$ 180 days. Even collateral might not save the day.
⚫ Loss
No recovery expected. Delay = denial. It’s time to write it off and move on.
🚨 Understanding Nonperforming Loans
A loan is nonperforming when no payments are made for 90+ days. But it’s not just about delays. The borrower’s cash flows, intent, and ability to repay are all assessed.
Banks analyze:
- Age of delinquency $($30, 90, 180, 365 days$)$
- Reasons for default
- Each case individually, not just in bulk
- Provisioning needs, tailored to the bank’s risk appetite
🔚 Wrapping It All Up: The Bank’s Shield
From creating policies to reviewing risk, credit risk management is about building a shield, not a wall. The bank must stay open to borrowers, but protected from shocks.
It’s like walking a tightrope — balance, preparation, and constant checks keep the system standing.
And at the end of the day, a bank isn’t just lending money — it’s managing risk, trust, and survival.