Asset Quality Management in Bank
Asset Quality Management in Bank
Asset Quality Management in Bank
Introduction
Asset quality is one of the most critical areas in determining the overall
condition of a bank. The primary factor effecting overall asset quality is the
quality of the loan portfolio and the credit administration program. Loans are
usually the largest of the asset items and can also carry the greatest amount of
potential risk to the bank's capital account. Securities can often be a large
portion of the assets and also have identifiable risks. Other items which impact a
comprehensive review of asset quality are other real estate, other assets, off-
balance sheet items and, to a lesser extent, cash and due from accounts, and
premises and fixed assets.
Management often expends significant time, energy, and resources on their asset
portfolio, particularly the loan portfolio. Problems within this portfolio can
detract from their ability to successfully and profitably manage other areas of
the institution. Examiners need to be diligent and focused in their review of the
various asset quality areas, as they have an important impact on all other facets
of bank operations.
Evaluation of Asset Quality
The asset quality rating reflects the quantity of existing and potential credit
risk associated with the loan and investment portfolios, other real estate owned,
and other assets, as well as off-balance sheet transactions. The ability of
management to identify, measure, monitor, and control credit risk is also
reflected here. The evaluation of asset quality should consider the adequacy of
the Allowance for Loan and Lease Losses (ALLL) and weigh the exposure to counter-
party, issuer, or borrower default under actual or implied contractual agreements.
All other risks that may affect the value or marketability of an institution's
assets, including, but not limited to, operating, market, reputation, strategic,
or compliance risks, should also be considered.
Loan Policy
The Loan Policy does not establish prudent guidelines for loan concentrations and
provides inadequate guidance for commercial real estate and construction lending.
As a result, loan concentrations are excessive and are not being properly
monitored or controlled. Additionally, asset quality has deteriorated due to weak
loan underwriting and credit administration practices. The Loan Policy is again
criticized for its lack of sufficient guidance for underwriting commercial real
estate and construction loans. The policy does not:
• Establish prudent credit concentration guidelines
• Establish effective concentration monitoring and reporting procedures
• Require comprehensive analysis of cash flow and repayment ability
• Specify the type of financial information and other documentation necessary for
each loan type
• Require property inspections on commercial real estate and construction loans
Loan Underwriting Weaknesses
• Credit memos do not provide a clear assessment of repayment capacity - many real
estate credits are approved based olely on collateral values with no cash flow
analysis performed
• Loan documentation weaknesses are again noted at this examination – an excessive
62% of the credits reviewed contained documentation exceptions
• Property inspections are not being prepared for all commercial properties
Credit Administration Weaknesses
• Ongoing loan documentation is poor as updated financial statements are not being
acquired
• Management’s internal credit review is based solely on delinquency
• The watch list is inadequate - many of the credits classified in this
examination were not classified internally
Allowance for Loan and Lease Losses (ALLL)
The ALLL methodology is inadequate and a provision of at least $500M is needed to
replenish the ALLL following the credit losses identified during the examination.
The methodology needs to be revised to include the following items from the
Interagency Policy Statement on ALLL Methodologies and Documentation:
• The performing portion of the loan portfolio should be stratified into groups
with similar characteristics
• Reserves should be assigned based on the risk present in each group
• Factors such as changes in economic trends, underwriting standards, and
portfolio growth should be considered in determining an adequate reserve level.
Discussion Points – Asset Quality
The examination identified a number of significant weaknesses with regard to the
bank’s rapid expansion. Some of the more significant concerns related to asset
quality include the following:
• The volume and severity of adversely classified items rose substantially to 37%
of Tier 1 Capital and the ALLL
• Deterioration in asset quality is a result of more liberal credit practices and
lax loan documentation
• Credit approval memos do not provide a clear assessment of the borrowers’
repayment ability
• Loan documentation exceptions were noted in 62% of the loans reviewed
• The internal loan review and watch list process are inadequate
• The methodology for determining an appropriate Allowance for Loan and Lease
Losses is insufficient
• Management and the board are not adequately monitoring significant
concentrations of credit
• The loan policy is inadequate with regard to concentrations, commercial real
estate lending, and construction lending the problems cited above signify failures
with regard to management and board oversight. As a board member, what are some of
the actions that you would take to address these concerns? We have detailed
potential solutions below, and in a normal .
• Revise the Loan Policy to require more stringent credit practices and loan
documentation standards
• Revise the Loan Policy to provide more guidance over commercial real estate and
construction lending
• Revise the Loan Policy to establish more prudent limits for concentrations and
require more rigid monitoring and reporting processes for concentrations
• Enforce the Loan Policy and require exceptions to be reported to, and approved
by, the board
• Require more detailed credit approval memos from the loan officers
• Stop/slow loan growth until management has properly addressed underwriting and
administration weaknesses
• Determine if the experience and abilities of the lending staff are sufficient
relative to the portfolio and portfolio growth
• Improve the internal loan review and grading function
Salient feature:
Both crop production and investment credit met. Consumption / house hold /
miscellaneous agricultural expenditure / working capital needs for allied
activities also considered. Repetitive documentation avoided. Stamped receipts not
needed for purchase of manure, fertilisers, animal feeds and other inputs.
Advances recoveries could be withdrawn to meet unforeseen expenditure. Cardholders
eligible for personal accident insurance scheme upto Rs.50000; annual premium of
Rs.15/= per cardholder is shared by the bank and the borrower at 2:1 ratio. Built-
in incentive for prompt repayers. On credit balance in the short term / crop
loans, SB interest rates paid.
Eligibility:
All farmers, such as owner / tenant cultivators and share croppers are eligible.
Farmers cultivating on authorized leased lands are also eligible. Should not be a
defaulter to any financial institution.
Crop loan limits based on scale of finance and area under cultivation. Consumption
/ household expenses, post harvest and miscellaneous agricultural expenditure
considered. Working capital requirement for dairy and poultry for one month’s feed
cost met. Total limits as mentioned above are the operational limit. 20%
contingency is added on to the operational limit to fix the overall card limit.
Overall card limit is meant to avoid repetitive documentation and to take care of
increase in scale of finance in future. Term loan projects with a repayment period
of upto 5 years only are considered under VKV. Term loan limit is assessed based
on Unit Cost and the Activity undertaken based on viability of the project.
Lending norms:
Margin No margin for crop loans. For term loans and other short term loans,
margin is as follows
For loans upto Rs.50000 : No margin
For loans above Rs.50000 : 15 to 25% margin
Security For loans upto Rs.50000: only hypothecation of crops / assets purchased
out of bank loan
For loans above Rs.50000: hypothecation of crops / assets created and
mortgage of land / third party guarantee at bank’s discretion
Repayment Repayment for crop loans based on the crop period and reasonable period
for harvesting / marketing of produce
For term loans, as per the repayment period suggested by NABARD or on the
basis of income generation of the project; need based gestation period also
considered
Eligibility
If you are an Indian citizen and have obtained admission to a reputed university
or course either in India or abroad, you can approach the nearest bank — of
course, go to your bank first — and apply for a loan. Most banks give preference
to existing customers, as that would limit the procedures, and thus reduce the
time taken to sanction the loan. The amount sanctioned and the collateral are
often decided on a case-to-case basis, after evaluation of your credentials.
Work out your need
You must first ascertain the total cost of education including, usually, the
tuition fees, the library charges, boarding and lodging, books, hostel and exam
fees, equipment, project costs and so on. In the case of studies abroad, the
airfare can be included in the loan. Once you have estimated the cost, decide on
what you can put together and the loan amount you would require.
Margin
The margin money (your contribution towards the total cost) depends on the quantum
of loan and on the location of the institution. If the loan sought is below Rs 4
lakh, banks usually finance the full cost of education; that is, you do not put up
any margin money. But if the loan amount exceeds Rs 4 lakh, only 95 per cent would
be financed in case of studies in India. If you are going abroad, the bank will
finance up to 85 per cent of the loan. Once decide on the loan amount, you should
approach the bank with all the necessary certificates and documents. You will be
asked to come for a discussion so that the bank can ascertain your capability and
the financial back ground. The documents required could include certificates of
examination cleared, proof of address, income statement of the co-applicant, and
where some collateral security is required, the asset document. For loans below Rs
4 lakh, you may not have to offer any collateral security. These loans are granted
based on the financial soundness of the borrower, future earning capacity and
personal guarantee. Canara Bank for instance, insist on a guarantor and also ask
for his financial details. If the bank is satisfied with the documents, it may
take 15-20 days to sanction the loan.
Facts you should know
The terms and conditions of most banks are similar. The maximum amount of loan
granted is Rs 7.50 lakh for studies in India and Rs 15 lakh for studies abroad and
the repayment period could be up to seven years after completion of the course.
The amount is disbursed as and when required, and directly to the university or
institute. During the period of the study, only simple interest on the outstanding
loan is charged at quarterly rests. The loan repayment usually commences one year
after completion of the course or immediately after you get a job, whichever is
earlier. You have the flexibility to choose the repayment period and the size of
the equated monthly instalment. The EMI is the total loan amount and the interest
thereon (compounded quarterly after commencement of repayment) divided by the
repayment period (in months). You can also accelerate your repayment. No penalty
is charged for pre-payments.
Cost of the loan
The interest rate is by and large the only parameter for deciding which bank to
take the loan from. Interest rates again depend on the quantum of loan. Up to Rs 4
lakh, interest is charged at the prime lending rate (PLR) or medium term lending
rate (MTLR). For loans above Rs 4 lakh, interest is one per cent higher. At
present, the interest rates vary between 11.75 per cent and 14 per cent. Canara
Bank offers the best deal at 11.75 per cent for loans up to Rs 4 lakh. HDFC's loan
is much more expensive at around 14 per cent. Interest rate is subject to change
from time to time. There is usually no processing fee, or maximum of 1 per cent of
the loan amount. An educational loan appears to be a convenient and cost effective
means of making your dreams come true. But the success of the scheme depends on
how many people genuinely make the effort to repay the loans. If all borrowers
repay promptly, more students would benefit.
Risks borne by banks:
• Liquidity Risk
Liquidity risk is the potential inability of a bank to generate sufficient cash to
meet its normal operating requirements (cash expenses and repayment of
liabilities). A mismatch in the assets and liabilities causes a bank to have a
liquidity risk. A bank often promises greater liquidity in its liabilities than
its assets can provide directly. To deal with such contingencies, a bank must have
sources of liquidity - ways it can lay its hands on cash whenever it needs it.
However, excess liquidity is also costly for the bank because idle cash carries a
cost as the bank pays interest on its deposits. So, banks seek to achieve a
reasonable trade-off between overtly liquid and relatively illiquid.
MUMBAI, DEC 8: International credit rating agency Standard & Poor's (S&P) has
assigned BB ratings to Bank of India, Canara Bank, Union Bank of India and Central
Bank of India. However, S&P has cautioned the banking industry saying that the
asset quality of banks is poor.
All the four banks will be challenged to maintain profitability and asset quality
at current levels, given a weaker economic environment and the implementation of
more stringent prudential standards, an S&P release said on Tuesday.
"Rising impaired loans, a weak industrial sector and an economy that is less
robust than in the past, could be problematic for the industry in the near term.
These pressures are expected to have a negative impact on the profitability and
internal capital-generating capacity of all Indian financial intermediaries, at a
time when the Reserve bank of India has announced that it will progressively
strengthen capital requirements and asset classification and provisioning
standards, in the next two years," said S&P.
Implementation of these guidelines may necessitate additional capital infusions by
government or possibly a reassessment of the government required minimum
shareholding of 51 per cent in the state-owned banks that dominate the sector.
The ratings on all the four state-run banks are supported by their sound market
positions as key depository institutions, with each bank enjoying a strong funding
base. Creditworthness is also supported by majority government ownership and the
significant role the banks play in fulfilling social policy objectives.
These strengths are, however, moderated by asset quality that is poor by
international standards, weak underlying profitability and the challenging and
somewhat volatile and deregulating operating environment.
Central Bank's capital base is impaired by accumulated losses that are carried on-
balance sheet. Accordingly, the bank has relatively less financial flexibility
than other banks in the same category.
S&P has noted that the Indian financial sectorhas progressively reformed since
1991 and while the risk profile of the industry has improved significantly
following the introduction of tighter prudential controls on asset classification,
provisioning and capitalisation, the sector remains highly regulated and
relatively inefficient by international standards.
The almost complete deregulation of interest rates and the dismantling of the
standardised bank lending guidelines have introduced a range of new risks and
challenges and have necessitated the development of improved credit disciplines
and more sophisticated techniques for the management of liquidity and interest
rate risks. These are areas that have previously received little management
attention.
CRISIL rates HDFC BANK's
CRISIL has assigned a rating of AAA / Stable to HDFC Bank Limited's (HDFC Bank's)
Upper Tier II bonds issue. The rating reflects the bank's strong asset quality,
good capitalisation levels, and a healthy earnings profile. HDFC Bank's good
resource profile and strong market position across segments in the financial
services sector also support the rating.
HDFC Bank's strong asset quality is reflected in its low gross non-performing
assets (NPA) of 1.43 per cent (as a proportion of gross advances) as on March 31,
2006; the bank has a strong presence in the retail finance space, which has
traditionally been a low-risk business. A strong asset quality, along with a
healthy net worth base of Rs53 billion (as on March 31, 2006), has resulted in
strong coverage levels; as on March 31, 2006, the bank's net worth coverage for
net NPAs stood at a high of 34.2 times.
HDFC Bank's good capitalisation levels also reflect in its high Tier I capital
adequacy ratio and overall capacity adequacy ratio, each as a proportion of risk-
weighted assets, at 8.55 per cent and 11.41 per cent respectively. CRISIL expects
the bank's capitalisation levels to remain strong over the medium term, backed by
its healthy asset quality.
CRISIL's rating on HDFC Bank's debt instrument also derives strength from its
strong and stable earnings profile. This is reflected in the bank's high return on
assets of 1.4 per cent over the last four years. A high core fee income also
supports the bank's profitability levels: in 2005-06 (refers to financial year,
April 1 to March 31), HDFC Bank reported a core fee income of 1.9 per cent (as a
proportion of average funds deployed), as against the system average around 1 per
cent.
A high proportion of current and savings accounts - 55.4 per cent of the bank's
deposits as on March 31, 2006 - has also shored up its resource profile. This has
translated into low cost of deposits (3.38 per cent in 2005-06), supporting the
bank's profitability levels. The rating is also supported by HDFC Bank's strong
market position in the retail finance space; the bank is among the top three banks
in India, with disbursements of Rs. 142 billion in 2005-06.
Outlook: CRISIL expects HFDC Bank to maintain its healthy capital position,
supported by its strong asset quality levels in its fast-growing retail portfolio.
These factors will enable the bank to maintain its good earnings profile. The
rating is also based on CRISIL's expectation that HDFC Bank will maintain capital
adequacy at levels higher than the regulatory requirement throughout the tenure of
the instrument.
About the bank: HDFC Bank commenced operations in January 1995. The bank offers a
wide range of banking services, covering both commercial and investment banking on
the wholesale side and transactional and branch banking on the retail side. HDFC
Bank is India's largest private sector bank, active in the retail finance business
with a thrust on car finance, personal loans, commercial vehicle finance, two-
wheeler finance, and credit cards. The bank's retail advances, as a proportion of
total advances, stood at 61 per cent as on March 31, 2006. HDFC Bank had an asset
base of Rs735.06 billion as on March 31, 2006. It reported a profit after tax
(PAT) of Rs8.71 billion in 2005-06 (Rs6.66 billion in 2004-05).