Introduction to Credit Risk
Credit risk refers to the potential that a borrower will fail to meet their obligations in accordance with agreed terms. This type of risk is inherent to various forms of lending and financial transactions, and managing it effectively is crucial for the stability of financial institutions.
Components of Credit Risk
Credit products include various types of loans and advances provided by financial institutions, such as housing loans, lending against securities, and digital lending. Each product has specific regulatory guidelines regarding limits, loan-to-value (LTV) ratios, and conditions for approval.
- Housing Finance: Financial institutions have set limits on the amount and LTV ratios for housing loans to mitigate risks associated with property value fluctuations.
- Lending Against Securities: Loans against securities like shares, bonds, and mutual funds have predefined limits and LTV ratios to ensure that the lending is backed by adequate collateral.
- Digital Lending: The guidelines for digital lending include provisions for default loss guarantees and prudential norms to maintain the integrity of the lending process.
Effective management of credit risk involves assessing the borrower's creditworthiness, setting appropriate interest rates on advances, and ensuring that loans are adequately secured.
- Interest Rate on Advances: Institutions are free to offer advances on fixed or floating interest rates, with guidelines to ensure that the rates reflect the risk associated with the borrower.
- Loans and Advances: Regulations stipulate statutory restrictions and prudential exposure limits to prevent over-concentration of credit and ensure a diverse and stable loan portfolio.3. Income Recognition and Asset Classification
3. Income Recognition and Asset Classification
The correct recognition of income and classification of assets is essential for transparency and accuracy in financial reporting.
- IRACP Norms: The Income Recognition, Asset Classification, and Provisioning norms are critical for categorizing loans based on their performance and potential risk. These norms help in identifying Special Mention Accounts (SMA) and Non-Performing Assets (NPA), ensuring timely intervention and provisioning for potential losses.
- Provisioning Rates: Different categories of loans and advances have specific provisioning rates to cover potential losses. For example, sub-standard assets, doubtful assets, and loss assets have defined provisioning requirements based on the security coverage and aging profile.
The transfer and distribution of credit risk through mechanisms such as securitization and loan transfers allow financial institutions to manage and mitigate their exposure.
- Securitization of Standard Assets: Financial institutions can securitize standard assets to free up capital and distribute risk. The guidelines include minimum retention requirements and risk weights to ensure that the originating institution retains a portion of the risk.
- Transfer of Stressed Loans: The transfer of stressed loans to entities like Asset Reconstruction Companies (ARCs) helps in the resolution of bad debts and recovery of funds. These transfers are subject to regulatory guidelines to ensure that the process is transparent and fair.
