Credit policy sets the framework through which a financial institution originates, prices, administers, and monitors credit exposures to achieve portfolio-quality, profitability, and compliance objectives in a risk-controlled manner. In banking practice, it translates the Board-approved risk appetite into actionable standards for underwriting, concentration, pricing, collateralization, and remediation across the credit lifecycle.
Objectives
- Portfolio quality and resilience: Maintain low expected loss through prudent borrower selection, collateral coverage, covenants, and early warning systems, while limiting tail risk via diversification and concentration limits.
- Sustainable growth and returns: Align asset growth with capital, liquidity, and risk-adjusted return thresholds (RAROC/RoRWA), ensuring that pricing covers expected loss, cost of capital, and liquidity premiums.
- Regulatory and governance compliance: Ensure consistency with statutory norms, internal rating systems, provisioning frameworks, priority sector obligations, and internal delegations of power with auditability and accountability.
Theory and practice
- Risk–return trade-off: Credit policy operationalizes the theoretical relation between risk and expected return by setting hurdle rates and pricing grids conditional on Probability of Default, Loss Given Default, Exposure at Default, and maturity.
- Information and incentives: Asymmetric information is addressed through underwriting standards, KYC/AML, financial analysis, cash-flow–based appraisal, collateral valuation, and covenant design to mitigate adverse selection and moral hazard.
- Portfolio perspective: Single-name decisions are constrained by portfolio-level limits—industry, geography, rating buckets, single/connected obligor, and product—supported by stress testing, migration analysis, and concentration risk metrics.
- Procyclicality management: Countercyclical buffers, conservative through-the-cycle ratings, and dynamic provisioning anchor resilience; sectoral overlays and collateral haircuts adjust as risk signals deteriorate.
- Governance and accountability: Three lines of defense segregate origination, independent credit risk review/approval, and internal audit; deviations from policy require documented justification and escalation to credit committees.
Instruments
- Underwriting standards: Eligibility criteria, minimum financial ratios, cash-flow coverage thresholds, promoter contribution, end-use scrutiny, and due diligence requirements.
- Internal ratings and scoring: Obligor and facility ratings drive pricing, limits, collateral requirements, and approval levels; model governance covers validation, backtesting, and overrides.
- Collateral and covenants: Eligible collateral types, valuation frequency, margins/haircuts, perfection of security interest, financial/affirmative/negative covenants, and collateral top-up triggers.
- Limits architecture: Single/group borrower limits, sector caps, unsecured caps, tenor limits, LTV caps, and country limits; intraday and settlement exposure controls for trade products.
- Pricing framework: Risk-based pricing grids linking spreads to ratings, tenor, collateral, and product; floors to cover funding, liquidity, capital, operating costs, and expected loss; repricing/step-up clauses.
- Portfolio controls: Sectoral exposure “traffic lights,” watchlists, early warning indicators (EWI) dashboards, and action playbooks for remediation or exit.
- Monitoring and remediation: Covenants testing cadence, account conduct reviews, stock and receivables audits, borrower information covenants, restructuring criteria, and special mention/NPA cure pathways.
- Documentation standards: Standardized term sheets, security documentation, guarantee formats, conditions precedent/subsequent, and enforceability checks.
- Collections and recovery: Dunning strategies, settlement guidelines, collateral realization procedures, insolvency/IBC pathways, and write-off/waiver governance.
- Compliance overlays: Priority sector targets, exposure norms, related-party restrictions, and macroprudential directives; periodic policy reviews to incorporate regulatory changes.
Practical implementation notes
- Lifecycle coverage: Policy should span origination, approval, disbursement, monitoring, renewal, restructuring, and exit, with quantitative thresholds and exception handling.
- Data and MI: Define data lineage for risk metrics, automate EWI triggers, and institute monthly portfolio risk reviews with heat maps and exception reports for committees.
- Stress testing: Calibrate sectoral and macro scenarios to assess capital absorption, migration, and loss distributions; align contingency actions with results.
- Sector playbooks: Maintain sector-specific underwriting notes (e.g., real estate, infrastructure, MSME, agriculture, retail unsecured) with benchmark metrics and red flags.
- Climate and ESG: Integrate ESG risk factors, sector exclusions, and enhanced due diligence for high-risk industries; reflect in pricing and limits as relevant.
- Digital and retail credit: Define scorecard cut-offs, alternative data use, model drift monitoring, and caps on automated approvals; ensure explainability and fairness controls.
- Securitization and distribution: Eligibility and reps & warranties for originate-to-distribute models; retention and performance triggers to avoid misaligned incentives.
- Operational safeguards: Segregate duties, mandate maker–checker controls, and implement robust limit-checking systems to prevent breach at booking.
Linkages with monetary and macroprudential policy
- Transmission interface: Bank credit policy mediates policy-rate and liquidity changes into loan pricing, underwriting stringency, and credit availability.
- Countercyclical tools: Sectoral risk weights, provisioning buffers, and LTV/DTI caps complement internal limits to manage systemic risk without over-reliance on price instruments.
- Liquidity and capital constraints: Credit expansion aligns with internal funds transfer pricing (FTP), NSFR/LCR implications, and capital consumption under standardized/IRB approaches.
Common pitfalls and mitigants
- Over-reliance on collateral: Mitigate by prioritizing cash-flow viability and sensitivity analysis; impose conservative collateral haircuts and revaluation frequency.
- Model complacency: Institute strong override governance, challenger models, and periodic recalibration, especially after structural breaks.
- Concentration creep: Enforce pre-deal portfolio checks and dynamic sector caps tied to stress outcomes; trigger automatic exposure throttles.
- Weak monitoring cadence: Codify review frequencies, covenant testing calendars, and EWI triggers; automate alerts and require action logs.
Governance and review
- Board oversight: Approves risk appetite, key limits, and policy; receives periodic portfolio risk reports and stress-test outcomes.
- Credit committees: Decide large exposures, policy exceptions, restructurings, and sectoral strategies with documented rationales.
- Policy maintenance: Annual comprehensive review or ad hoc revisions upon regulatory or market changes; version control and staff training to ensure adoption.
CAIIB –Central banking (elective)- Model C -related articles
