Key Elements Of Effective Lending Policy

• Despite ongoing innovation in the financial sector, credit risk management typically constitutes over 70% of a bank’s balance sheet and remains the leading cause of bank failures. While credit risk management discussions often center on loan portfolios, the principles of assessing creditworthiness also extend to counterparties issuing financial instruments. Both financial
• analysts and bank supervisory agencies emphasize the significance of formal policies established by the board of directors and implemented by management.
• The key elements of an effective lending or financing policy can be summarized as follows:
  • Scope and Allocation: Clearly outline the extent and distribution of the bank’s credit facilities, along with the management approach for the credit portfolio, including origination, appraisal, supervision, and collection of investment and financing assets.
  • Flexibility and Adaptability: Ensure the policy is not overly restrictive, allowing for the presentation of proposals to the board that officers deem worthy of consideration, even if they fall outside written guidelines. Flexibility is crucial for rapid reaction and early adaptation to changing market conditions and asset mix.
  • Regulatory Compliance: Adhere to minimum standards prescribed by regulators for managing credit risk, covering identification of existing and potential risks, definition of risk management policies, and setting parameters for controlling credit risk.
  • Credit Risk Management: Limit or reduce credit risk, including concentration and large exposure policies, diversification strategies, guidelines for lending to connected parties, and managing overexposure.
  • Asset Classification and Evaluation: Assess credit risk exposure through asset classification, requiring periodic evaluation of the collectability of the credit instrument portfolio.
  • Provisioning and Allowances: Implement policies to make provisions for potential losses or allowances at a level adequate to absorb anticipated losses.
  • Tailored to Institution’s Needs: Reflect the size, complexity, and lending operations of the bank, tailoring the policy to its specific needs and characteristics. Allow for revisions as circumstances change, ensuring the policy remains flexible enough to accommodate new lending activities without major overhauls.
  • Detailed Guidelines: Include detailed guidelines for each lending department or function, such as real estate lending, appropriate to the size and scope of their operations.
  • Incorporation of Regulatory Standards: Integrate basic operational and managerial standards established by federal banking regulatory agencies for loan documentation and credit underwriting into the bank’s written loan policy.
  • Continuous Monitoring and Review: Implement robust monitoring and review mechanisms to assess the effectiveness of the lending policy, identify emerging risks, and make necessary adjustments.
• By incorporating these key elements into their lending or financing policy, banks can effectively manage risks, ensure regulatory compliance, and support sound lending practices.

Setting Exposure And Concentration Limits

• The importance of setting exposure and concentration limits lies in mitigating risks and ensuring the financial stability of banks. These limits serve to prevent overexposure to a single client, connected parties, or specific sectors, which could lead to significant losses in the event of default or economic downturn. By adhering to these limits, banks can diversify their lending portfolios, manage their risk exposure effectively, and maintain regulatory compliance, thereby safeguarding their operational health and sustainability. Regulators closely monitor three key issues to minimize or control exposures:
  • exposure to a single customer,
  • financing related to parties involved, and
  • excessive exposure to specific geographic areas or economic sectors.
• Large Exposures to a Single Customer or Connected Parties
  • Large-exposure and concentration limits set the maximum allowable exposure to individual clients, connected groups, or specific economic sectors. This is crucial for smaller, regionally focused, or specialized banks. Compliance with these limits is required by modern prudential regulations, which restrict investments or credit extensions exceeding a certain percentage of a bank’s capital and reserves. Adhering to regulatory standards boosts confidence among investors and customers, showcasing prudent risk management and maintaining the bank’s reputation and trustworthiness in the market. Most countries enforce single-customer exposure limits ranging from 10-25% of capital. Supervisory authorities require reporting on exposures exceeding a predetermined threshold, allowing for focused attention and precautionary measures to manage risk effectively.
  • Exposure limits help in effective liquidity management by preventing overconcentration, thus reducing the risk of liquidity strain from large exposures gone awry, which could impair the bank’s ability to fulfill short-term obligations.
  • Defining exposure presents challenges, particularly in determining which indirect credit forms should be included within exposure limits. Contingent liabilities and credit substitutes like guarantees, acceptances, and letters of credit should generally be included, although specific instruments may be treated differently.
  • Valuing collateral presents another difficulty, as its subjective nature can affect the determination of exposure size. It is prudent not to factor in collateral when assessing exposure size.
  • Moreover, defining the term “single client” can be contentious, especially when considering connected groups or individuals with mutual associations, control, or financial interdependence. Large exposures to specific clients signal a bank’s significant commitment, raising concerns about impartial risk assessment. Managing these exposures involves identifying common ownership, ensuring effective control, and relying on shared cash flows. Banks must monitor large clients closely, regardless of their current performance, and respond promptly to any concerns or external events. If there are indications of potential repayment difficulties, credit risk management should escalate the issue and develop contingency plans.
  • Banks should be flexible in adjusting exposure and concentration limits to align with evolving economic conditions, market dynamics, and risk appetite.
• Related-Party Financing
  • Dealing with related parties poses significant credit risk, as they often hold influence over a bank’s policies and decision-making, particularly in credit matters. Related parties typically include a bank’s parent, major shareholders, subsidiaries, directors, and executives. It is crucial for banks to identify and monitor credit extensions to insiders diligently. The concern arises from the possibility of credit decisions being made against the bank’s
    policies, with loan terms potentially more favorable for related parties compared to market standards.
  • To mitigate risks, most regulators establish limits on credit extended to related parties, typically as a percentage of Tier 1 or total qualifying capital. If regulatory limits are not in place, banks should establish their own limits as a board policy. Prudent banking practices necessitate board approval for all facilities extended to related parties.

Scope And Allocation Of Credit Facilities

• A lending policy should outline the scope and allocation of a bank’s credit facilities, as well as how the credit portfolio is managed, including loan origination, appraisal, supervision, and collection.

• Sound lending policies consist of multiple components. This figure illustrates these policies at FirstRand Bank in South Africa, organized according to the relevant stage of the credit risk identification and management process.

Bank-Specific Policies And Actions To Reduce Credit Risk

• Lending authority – This is typically determined by a bank’s size. Smaller banks usually have centralized authority, while larger ones decentralize based on geography, lending products, and customer types to expedite the lending process. A lending policy should set limits for all lending officers, which may exceed standard expectations based on individual experience and tenure. Group authority could also be employed, allowing a committee to approve larger loans. The policy should detail reporting procedures and the frequency of committee meetings.
  Type of loans and distribution by category – A lending policy should outline the types of loans and credit instruments the bank intends to offer, along with specific guidelines for each. These decisions should consider the expertise of lending officers, the bank’s deposit structure, and anticipated credit demand. Credit types associated with abnormal losses should be controlled or avoided entirely by senior management. Commonly, limitations are set based on aggregate percentages of total loans across different categories like commercial, real estate, and consumer loans. Policies regarding these limitations should permit deviations approved by the board.
• Appraisal process – A lending policy should specify the responsibility for appraisals and establish formal procedures for appraisals, including for renewals or extensions. It should define acceptable types and limits for appraisal amounts for each credit facility and describe circumstances requiring appraisals by qualified independent appraisers. Additionally, it should detail the loan-to-value ratio, valuation methods, differences among lending instruments, and include a schedule of down payment requirements, where relevant.
• Loan pricing – Pricing loans within a bank’s lending policy aims to strike a balance between the bank’s financial stability and its competitive positioning in the market. Loan pricing must cover costs of funds, supervision, administration, and potential losses while ensuring a reasonable profit margin. Loan rates should be periodically reviewed and adjusted to align with cost or competitive changes. Differential rates may be used to influence borrower behavior or attract specific types of borrowers. Pricing policies should include guidelines for determining fees on commitments or penalty interest rates.
• Maturities – A lending policy should set maximum loan terms and ensure realistic repayment schedules based on the expected source of repayment, loan purpose, and collateral lifespan.
• Exposure to geographic areas or economic sectors – Banks face concentration risk when heavily invested in a single industry or narrow geographic region, making them vulnerable to industry or regional weaknesses and simultaneous client failures. This concern is heightened for regional, specialized, or banks in small economies reliant on specific sectors. Assessing exposure to different sectors is challenging due to limited capability in banking systems to generate detailed sector-specific reports. Banks need robust monitoring systems to evaluate sector risks, mitigate adverse trends, and manage increased risk effectively. International lending introduces additional risks, notably country and transfer risks, including macroeconomic, political, and social factors affecting client performance, and difficulties in foreign exchange transactions. Banks must provision for these risks either on a loan-by-loan basis or through aggregate exposures to countries, setting aside special reserves accordingly.
• Insistence on availability of current financial information – Safe credit extension relies on accurate and complete borrower credit information, except in cases where loans are backed by readily marketable collateral. A lending policy should specify financial statement requirements for different borrowing levels, including guidelines for audited, unaudited, interim, and cash flow statements. It should mandate periodic external credit checks and, for loans exceeding one year maturity, require officers to prepare financial projections matching the loan’s duration. Clear assumptions for
  these projections should be outlined. All requirements should clearly flag any negative credit data as a violation of the bank’s lending policy.
• Collections monitoring – Effective collections monitoring is crucial within a bank’s lending policy. The policy should clearly define delinquent obligations for all loan types, ensuring a standard understanding of non-compliance or late payments. Also, the policy should specify the reports to be submitted to the board regarding delinquencies, providing comprehensive details
  for risk assessment and potential actions. Moreover, it must mandate a systematic and escalating collection procedure for managing delinquent loans, ensuring progressive steps in recovering overdue payments. Clear guidelines should ensure that all significant problem loans are reviewed
  by the board.
• Limit on total outstanding loans – A limit on the overall loan portfolio is typically based on deposits, capital, or total assets. This limit ensures that the bank’s lending exposure aligns with its risk capacity. Factors such as credit demand, deposit stability, and overall credit risk are considered when setting this limit.
• Maximum ratio of loan amount to the market value of pledged securities – A lending policy must specify margin requirements for accepted securities, aligned with their marketability.
  Additionally, it should define responsibility and schedule for regularly pricing collateral.
• Impairment recognition – A bank needs policies to consistently identify and acknowledge loan impairment when it is unlikely to collect amounts as per the loan agreement. Impairment is recognized by adjusting the loan’s carrying amount to its estimated realizable value through an existing allowance or by expensing it in the income statement when the impairment occurs.
• Renegotiated debt treatment – Renegotiated debt refers to loans that have been restructured due to the borrower’s financial decline, often involving reduced interest or principal payments. However, extending or renewing a loan with terms equivalent to new debt isn’t considered renegotiated debt. Restructuring may include transferring assets like real estate or receivables,
  debt-to-equity swaps, or adding new debtors. Approval by the board of directors is recommended before making concessions, and bank policies should ensure proper accounting and control. Restructured loans should be measured by reducing the recorded investment to a net realizable value, with the reduction recorded as a charge to the income statement. While significant renegotiated debt can signal bank problems, exceptions may arise in declining interest rate environments, benefiting both debtors and creditors.
• Written internal guidelines – A lending policy should include additional written guidelines for specific bank departments, referencing approved and enforced policies and procedures. The absence of such documentation is a significant deficiency and indicates a failure in the board of directors’ fiduciary responsibilities.
• Loan portfolio review – A bank’s loan portfolio reflects its market position, demand, business strategy, and credit capabilities. A comprehensive loan portfolio review typically includes a random sampling covering around 70% of the total loan amount and 30% of the number of loans. Additionally, it should encompass at least 75% of the total loan amount and 50% of the
  number of foreign currency loans and those with maturities over one year. Furthermore, a detailed credit portfolio review should cover loans to borrowers with exposure exceeding 5% of the bank’s capital, loans to shareholders and connected parties, loans with altered repayment terms, loans with overdue payments exceeding 30 days, and loans classified as substandard, doubtful, or loss.
• In each scenario, loan reviews should include borrower documentation and discussions with the responsible credit officer regarding the borrower’s business, prospects, and credit history. For loans exceeding 5% of a bank’s capital, analysis should consider the borrower’s future business plans and potential impacts on debt service capacity and principal repayment. Asset assessments should be systematic, consistent, and supported by documentation. While historical loan loss provisions have been somewhat subjective, management should exercise discretion in line with established policies and procedures. International Financial Reporting Standard 9 (IFRS 9) mandates a forward-looking approach to estimating loan losses and provisioning. Jurisdictions with prescriptive provisioning may face challenges aligning with Basel Accords and IFRS, risking credibility when reporting financial information to international entities like the IMF and the World Bank. Analysts dealing with systems where public sector authorities resist adaptation face difficulty as financial statements become unreliable for decision-making.
• An analysis of the overall allowance for losses should cover the following –
• A survey of the bank’s existing provisioning policy, including collateral valuation and enforceability.
• An overview of asset classification procedures and the review process, including the review timelines.
• Determination of factors likely to cause losses differing from historical experiences, such as economic conditions and changes in client profiles or bank procedures.
• A trend analysis over a longer period to help identify increases in overdue loans. An opinion on the adequacy of the current policy and additional provisions needed to align with IFRS standards.
• Interbank deposits – Interbank deposits are crucial assets for banks, especially in countries with restricted convertibility. They serve various purposes like facilitating fund transfers and settling securities transactions. Reviewing interbank lending involves assessing counterparty credit limits, provisions needed, reconciliation of accounts, pricing terms, and exposure concentration. It is vital to manage interbank deposits like any other credit risk, setting exposure limits and ensuring counterparties provide adequate collateral. Banks from well-regulated jurisdictions are generally considered lower risk compared to those from less-regulated countries.
• Off-balance-sheet commitments – Off-balance-sheet commitments with credit exposure require thorough review, including assessing risk analysis procedures and managing credit instruments like guarantees. This review should follow principles similar to those used for loan portfolio reviews,
  aiming to evaluate clients’ ability to meet financial commitments promptly.
• Overdue interest – To prevent income overstatement and ensure timely identification of nonperforming assets, bank policies should address uncollected interest. Two primary methods address interest suspension and non accrual.
• Firstly, when interest is suspended, it’s accrued or capitalized, with an offsetting entry for “interest in suspense”, preventing asset inflation.
• Secondly, when a loan is in nonaccrual status, uncollected interest is reversed against corresponding income and balance sheet accounts. Deductions for current period interest come from current interest income, while prior period deductions come from the reserve for possible loan losses or current earnings. Non-accruing loans are usually restored to accruing status after repayment of arrears or when future contractual payments are certain.
• In some jurisdictions, a bank may refrain from addressing interest arrears if the debt is well secured or the collection process is underway. A debt is well secured if backed by collateral, such as liens or pledges, with a realizable value enough to cover the debt fully. Debt is “in the process of collection” if it is undergoing legal action or collection efforts expected to
  lead to repayment or restoration to current status.

Asset Classification

• A bank’s loan portfolio undergoes reviews to gauge credit repayment likelihood and adequacy of loan classification. Factors considered include collateral quality and the borrower’s cash generation capability. Asset classification gradesassets based on credit risk, ensuring obligations are met as per contract terms. All risky assets, like advances, accounts receivable, investments, and contingent liabilities, should be classified. This process is crucial for credit risk management, involving origination classification and periodic reviews based on loan performance and economic factors. “Pass” or “watch” assets are typically reviewed semi-annually, while critical assets undergo quarterly assessment.

Traditional Classification Categories

• Banks establish classifications based on regulatory standards, typically divided into five categories reflecting debt service likelihood. However, with the adoption of IFRS 9, more intricate “expected loss” methods are being implemented, potentially reducing the significance of the traditional classification system over time. The following are the five standard asset classification categories –
  • Standard, or pass classification is used when debt service capacity is unequivocally assured. Typically, loans and assets fully secured by cash equivalents, such as bank certificates of deposit or treasury bills, are categorized as standard, irrespective of arrears or adverse credit indicators.
  • Assets classified as specially mentioned, or watch, denote those with potential weaknesses that, if unaddressed, could undermine the asset’s integrity or jeopardize the borrower’s ability to repay in the future. This includes instances of inadequate loan agreements, insufficient collateral control, or incomplete documentation. Additionally, loans extended
  • to borrowers facing adverse economic or market conditions are categorized here, as are those experiencing operational downturns or imbalanced balance sheet positions that haven’t yet threatened repayment.
  • Substandard assets signify clear credit weaknesses that endanger debt repayment capacity, especially when primary repayment sources are insufficient, requiring reliance on secondary sources like collateral, asset sales, refinancing, or fresh capital. These assets typically involve term credits to borrowers with inadequate cash flow to meet current debts or significantly undercapitalized borrowers. They may also include short-term loans where the inventory-to-cash cycle is inadequate for repayment. Assets overdue by at least 90 days, renegotiated loans, and those with delinquent interest payments from the borrower’s own funds are typically classified as substandard until consistent performance under a realistic repayment plan is achieved.
  • Doubtful assets share the weaknesses of substandard assets, but full collection is uncertain based on current information. Loss is possible, but certain factors may delay their classification as such until a clearer status is established. Assets overdue by at least 180 days are classified as doubtful unless sufficiently secured.
  • Loss classification denotes assets deemed uncollectible and of minimal value, warranting their removal from bankable assets. It doesn’t imply zero recovery but signifies that delaying their write-off isn’t practical or beneficial, although partial recovery might be feasible later. Assets overdue by at least one year are categorized as losses unless highly secured.
• Asset classification primarily focuses on a client’s ability and willingness to meet obligations using future cash flow. Some jurisdictions require all credit to a client to have the same risk classification, while others recommend assessing each asset individually. If subjective and objective criteria lead to different classifications, the more severe one usually applies. Banks must adjust classifications if regulators or auditors assign stricter ones. Advanced banking

Nonperforming Loans

• Nonperforming assets, typically loans, are those not generating income because principal or interest remains unpaid for a specified period, often 90 days or more. However, loan classification and provisioning involve more than just overdue amounts. The borrower’s ability to generate cash flow and repay the owed amounts is far more crucial than simply whether the loan is overdue. The aggregate level of provisions reflects a bank’s ability to manage credit risk effectively. Analysis of a nonperforming loan portfolio should include the following –
  • Age analysis of past-due loans, categorized by days overdue (30, 90, 180, and 360), should be conducted by customer type and economic activity branch to assess trends and equality of impact across all customers.
    Reasons for the decline in loan portfolio quality must be identified to explore potential corrective actions.
  • Individual assessment of nonperforming loans should be conducted, including detailed analysis to assess reversibility, improvement strategies for repayment capacity, and utilization of workout or collection plans.
  • Provision levels should be evaluated to gauge the bank’s resilience to loan defaults, considering their impact on profit and loss accounts to understand the effect of asset quality deterioration.

Loan Loss Provisioning

• Asset classification is crucial for determining the appropriate level of provisions to cover potential loan losses. Such provisions, along with general loss reserves that are typically counted as Tier 2 capital, are not assigned to specific assets. They form the basis for establishing a bank’s capacity to absorb losses.
• When establishing the reserve, it is essential to consider various significant factors impacting the collectibility of the loan portfolio. These factors encompass the effectiveness of credit policies and procedures, past loss incidents, loan portfolio expansion, management quality in lending operations, practices related to loan collection and recovery, shifts in national and local economic conditions, as well as broader economic trends.

Expected Loss And Unexpected Loss

• The expected loss calculation factors in the following:
  • Borrower risk: the likelihood of default based on the borrower’s profile.
  • Credit product risk: the potential loss in case of default based on the type of product lent.
  • Time since loan initiation: the exposure at default based on the duration of repayment.
• Definition of Risk Measures-
  • Probability of default (PD) represents the likelihood that a borrower will fail to make full and timely payments on their financial obligations within a specified timeframe. PD is determined for individual clients or portfolios with similar risk profiles based on historical data. Methods for calculating PD include historical default databases, credit default swap prices, bond prices, and data from external ratings agencies. Loss given default (LGD) measures the percentage risk of loss in the event of default based on past recovery experiences.
  • Exposure at default (EAD) estimates the bank’s exposure to a counterparty at the time of default, considering potential credit line utilization.
  • Expected loss (EL) is the amount the bank expects to lose from a counterparty’s default, forming the basis for book provisions.

Expected Loss And Unexpected Loss

• Expected Loss is calculated as: \(EL = PD \times EAD \times LGD\)

• Unexpected loss (UL) refers to the losses experienced in the financial statement currency during a severe stress scenario. It is usually recognized as an extreme point in the tail of a credit loss distribution, such as at the 99th percentile.

Expected Loss Under IFRS 9

• Starting from financial years commencing on January 1, 2018, IFRS 9 shifted accounting standards away from the incurred loss model of International Accounting Standard 39 (IAS) to an expected loss model, aligning them more closely with sound credit risk management practices. IFRS 9 mandates the division of expected losses into three stages –
  • Stage 1: Provisions for all performing assets (not in arrears) should be calculated based on a 12-month expected loss methodology, including effective interest on the gross amount.
  • Stage 2: Assets in arrears or affected by significant changes in the credit environment, such as changes in interest rates impacting a client’s debt servicing ability, should be provisioned based on lifetime expected losses, still including effective interest on the gross amount.
  • Stage 3: Nonperforming assets should carry provisions based on lifetime expected losses, including effective interest on the net amount.

Workout Procedures For Loss Assets

• Workout procedures are important for managing credit risk. Without timely action on problem loans, a bank risks missing opportunities to strengthen or collect on poor-quality assets, leading to losses that endanger a bank’s solvency. Evaluating workout procedures involves assessing the organizational structure, reviewing recovery attempts and successes, and analyzing the average time for recovery. Each loan and borrower should be assessed individually during the workout process. Common workout strategies include the following –
  • Minimizing the bank’s credit risk exposure, like requiring the borrower to contribute additional capital, funds, collateral, or guarantees.
  • Collaborating with the borrower to identify and address issues to enhance loan servicing and repayment capacity, such as providing guidance, implementing cost-saving measures, selling assets, restructuring debt, or adjusting loan terms.
  • Facilitating acquisition by a more creditworthy party or establishing joint ventures.
  • Resolving exposure through legal means, like out-of-court settlements, invoking guarantees, foreclosure, or liquidating collateral.
• Two approaches exist for dealing with loss assets –
  • The first approach, retaining loss assets, involves keeping them on the books until all collection efforts are exhausted. This approach is typical in banking systems with British tradition, resulting in larger loss reserves.
  • The second approach, writing off loss assets promptly against the reserve, is common in the U.S. tradition. It is more conservative, treating loss assets as nonbankable but potentially recoverable. Writing off loss assets immediately reduces the apparent size of the reserve relative to the outstanding loan portfolio.
• Evaluating provisions established by a bank requires understanding whether it is aggressively writing off losses or merely providing for them. The choice between these approaches often depends on taxation policies enforced by fiscal authorities.

Components Of Credit Risk Analysis

• The detailed breakdown of assets provides insight into a bank’s business profile, priorities, and risk appetite. An effective analysis should cover the types of loans, their recipients, and duration.
• Aggregate loan portfolio analysis should include:
  • Summary of major loan types, including customer count, average maturity, and interest rates
  • Distribution breakdown by currency, maturity (short-term vs. long-term), sectors, borrower types (state-owned vs. private), and corporate vs. retail lending.
  • Loans backed by government or other guarantees
  • Examination of loans by risk classification
  • Assessment of nonperforming loans, particularly analyzing loss experience over different periods to evaluate credit granting practices.
• Changes in a bank’s target customers directly impact the distribution of its lending products, while shifts in maturity structure can result from changes in customer preferences, product offerings, risk factors, or broader economic trends.

Credit Risk Management Capacity

• When overseeing a bank’s lending function, the board of directors must ensure it meets three key objectives: granting loans on a sound basis, profitable investment of funds, and satisfying the legitimate credit needs of clients. A risk management capacity review assesses the organization of the lending process, staffing adequacy, and the quality of available information.
• Lending process – The lending process relies on objective credit decisions to maintain an acceptable risk level relative to expected returns. A thorough review of this process involves analyzing credit manuals, assessing departmental performance, and examining procedures for origination, appraisal, approval, disbursement, monitoring, collection, and handling. Conducting interviews with middle-level managers and reviewing individual credit files are essential steps. Additionally, comparing appraised and approved credit applications over the past 6 or 12 months can indicate the quality of credit appraisal. Specific areas to review include:
  • Detailed credit analysis and approval procedures, including loan application forms and internal credit manuals.
  • Criteria for loan approval, pricing policy, lending limits, and branch network lending arrangements.
  • Collateral policies and practices, including revaluation methods.
  • Administration, monitoring, compliance, and control procedures.
  • Handling of exceptions.
• Staffing – This assessment should outline the roles and responsibilities of staff engaged in credit origination, appraisal, supervision, and risk monitoring. This includes identifying their quantity, hierarchical levels, tenure, expertise, and assigned duties. Evaluating staff organization, competencies, and qualifications in alignment with established policies and
  procedures is essential. Furthermore, ongoing training programs for credit staff must be reviewed to ensure adequacy. The quality and frequency of staff training often serve as reliable indicators of lending proficiency.
• Information flows – Efficient monitoring of adherence to established guidelines across an organization’s lending function is crucial. An internal review and reporting system are key tools for informing the directorate and senior management about policy implementation and loan portfolio status. Access to quality information at a reasonable cost is fundamental to credit
  management.Analyzing information availability, quality, and cost effectiveness is essential, especially regarding its dispersion within the bank. This analysis should closely intertwine with assessments of human resources, organizational structures, control mechanisms, and information technology. Additionally, the board of directors, often through a risk committee, should ensure a comprehensive understanding of credit risk management practices.
• The Board of Directors should regularly inquire to ensure the effectiveness of credit risk management. Key questions that the board should consider include:
  • Are our loan and deposit rates competitive?
  • How diverse are our interest income sources?
  • How secure is our income from loans? What’s the level of security?
  • Do our investment returns reflect the risks taken?
  • Is our liquidity position sustainable under stress?
  • What internal rating models do we utilize?
  • How accurate are our estimates for PD, LGD, and EAD?
  • What is our approach to problematic loans?
  • How frequently do we stress-test the portfolio?
  • Are all concentration risks disclosed?11. Do we have access to necessary information?
• Additionally, the board should review:
  • Total portfolio exposure and trends
  • Analysis by internal and external ratings, product types, and other relevant factors
  • Concentration trends
  • Provisioning for potential losses
  • Utilization of limits and any breaches
  • Profitability compared to budget
  • Impairment charges
  • Arrears and trends
  • Stress test results
  • Key risk indicators (KRIs)
  • Any other pertinent information management wishes to present