Agriculture Lending

Credit needs in Agriculture:

Agricultural credit is one of the most crucial inputs in all agricultural development programmes. For a
long time, the major source of agricultural credit was private moneylenders. But this source of credit was
inadequate, highly expensive and exploitative. To curtail this, a multi-agency approach consisting of
cooperatives, commercial banks ands regional rural banks credit has been adopted to provide cheaper,
timely and adequate credit to farmers.
The financial requirements of the farmers are for,
1. Buying agricultural inputs like seeds, fertilizers, plant protection chemicals, feed
and fodder for cattle etc.
2. Supporting their families in those years when the crops have not been good.
3. Buying additional land, to make improvements on the existing land, to clear old
debt and purchase costly agricultural machinery.
4. Increasing the farm efficiency as against limiting resources i.e. hiring of
irrigation water lifting devices, labor and machinery.
Credit is broadly classified based on various criteria

: 1. Based on time: This classification is based on the repayment period of the loan. It is
sub-divided in to 3 types
Short–term loans: These loans are to be repaid within a period of 6 to 18
months. All crop loans are said to be short–term loans, but the length of the
repayment period varies according to the duration of crop. The farmers require
this type of credit to meet the expenses of the ongoing agricultural operations on
the farm like sowing, fertilizer application, plant protection measures, payment of
wages to casual labourers etc. The borrower is supposed to repay the loan from
the sale proceeds of the crops raised.
Medium – term loans: Here the repayment period varies from 18 months to 5
years. These loans are required by the farmers for bringing about some
improvements on his farm by way of purchasing implements, electric motors,
milch cattle, sheep and goat, etc. The relatively longer period of repayment of
these loans is due to their partially-liquidating nature.
Long – term loans: These loans fall due for repayment over a long time ranging
from 5 years to more than 20 years or even more. These loans together with
medium terms loans are called investment loans or term loans. These loans are
meant for permanent improvements like levelling and reclamation of land,
construction of farm buildings, purchase of tractors, raising of orchards ,etc. Since
these activities require large capital, a longer period is required to repay these
loans due to their non - liquidating nature.

Based on Purpose: Based on purpose, credit is sub-divided in to 4 types.

Production loans: These loans refer to the credit given to the farmers for crop
production and are intended to increase the production of crops. They are also
called as seasonal agricultural operations (SAO) loans or short – term loans or
crop loans. These loans are repayable with in a period ranging from 6 to 18
months in lumpsum.
Investment loans: These are loans given for purchase of equipment the
productivity of which is distributed over more than one year. Loans given for
tractors, pumpsets, tube wells, etc.
Marketing loans: These loans are meant to help the farmers in overcoming the
distress sales and to market the produce in a better way. Regulated markets and

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commercial banks, based on the warehouse receipt are lending in the form of
marketing loans by advancing 75 per cent of the value of the produce. These
loans help the farmers to clear off their debts and dispose the produce at
remunerative prices.
Consumption loans: Any loan advanced for some purpose other than production
is broadly categorized as consumption loan. These loans seem to be unproductive
but indirectly assist in more productive use of the crop loans i.e. with out
diverting then to other purposes. Consumption loans are not very widely
advanced and restricted to the areas which are hit by natural calamities. These
loams are extended based on group guarantee basis with a maximum of three
members. The loan is to be repaid with in 5 crop seasons or 2.5 years whichever
is less. The branch manager is vested with the discretionary power of sanctioning

Borrower’s classification: The credit is also classified on the basis of type of

borrower. This classification has equity considerations.
Based on the business activity like farmers, dairy farmers, poultry farmers,
Borrower’s classification: The credit is also classified on the basis of type of
borrower. This classification has equity considerations.
Based on the business activity like farmers, dairy farmers, poultry farmers,
pisiculture farmers, rural artisans etc.
Based on size of the farm: agricultural labourers, marginal farmers, small
farmers , medium farmers , large farmers ,
Based on location hill farmers (or) tribal farmers.

Method of Appraising Farm Advance

Returns from the Investment
This is an important measure in credit analysis. The banker needs to have an idea about the extent of
likely returns from the proposed investment. The farmer’s request for credit can be accepted only if he
can be able to generate returns that enable him to meet the costs. Returns obtained by the farmer depend
upon the decisions like,
What to grow? How to grow? How much to grow? When to sell? Where to sell?
Therefore the main concern here is that the farmers should be able to generate higherl returns that should
cover the additional costs incurred with borrowed funds.
Risk Bearing Ability
It is the ability of the farmer to withstand the risk that arises due to financial loss. Risk can be quantified
by statistical techniques like coefficient of variation (CV), standard deviation (SD) and programming
models. The words risk and uncertainty are synonymously used.
Some sources / types of risk
1. Production/ physical risk.
2. Technological risk.
3. Personal risk
4. Institutional risk
5. Weather uncertainty.
6. Price risk

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pisiculture farmers, rural artisans etc.
Based on size of the farm: agricultural labourers, marginal farmers, small
farmers , medium farmers , large farmers ,
Based on location hill farmers (or) tribal farmers.

Repayment Capacity: Repayment capacity is nothing but the ability of the farmer to repay the loan
obtained for the productive purpose with in a stipulated time period as fixed by the lending agency. At
times the loan may be productive enough to generate additional income but may not be productive
enough to repay the loan amount. Hence the necessary condition
here is that the loan amount should not only profitable but also have potential for repayment of the loan
amount. Under such conditions only the farmer will get the loan amount.
The repayment capacity not only depends on returns, but also on several other quantitative and qualitative
factors as given below.

7 Ps of farm credit/ principles of farm finance

The increased role of financial institutions due to technological changes on agricultural front necessitated
the evolving of principles of farm finance, which are expected to bring not only the commercial gains to
the bankers but also social benefits. The principles so evolved by the institutional financial agencies are
expected to have universal validity. These principles are popularly called as 7 Ps of farm credit and they
are
1. Principle of productive purpose.
2. Principle of personality.
3. Principle of productivity.
4. Principle of phased disbursement.
5. Principle of proper utilization.
6. Principle of payment and
7. Principle of protection.
1. Principle of productive purpose

This principle refers that the loan amount given to a farmer - borrower should be capable of generating
additional income. Based on the level of the owned capital available with the farmer, the credit needs
vary. The requirement of capital is visible on all farms but more pronounced on marginal and small farms.
The farmers of these small and tiny holdings do need another type of credit i.e. consumption credit, so as
to use the crop loans productively (without diverting them for unproductive purposes). Inspite of knowing
this, the consumption credit is not given due importance by the institutional financial agencies.
This principle conveys that crop loanss of the small and marginal farmers are to
be supported with income generating assets acquired through term loans. The additional
incomes generated from these productive assets add to the income obtained from the
farming and there by increases the productivity of crop loans taken by small and marginal
farmers.
The examples relevant here are loans for dairy animals, sheep and goat, poultry
birds, installation of pumpsets on group action, etc.
2. Principle of personality:
The 3Rs of credit are sound indicators of credit worthiness of the farmers. Over the
years of experiences in lending, the bankers have identified an important factor in credit
transactions i.e. trustworthiness of the borrower. It has relevance with the personality of
the individual.
When a farmer borrower fails to repay the loan due to the crop failure caused by
natural calamities, he will not be considered as willful – defaulter, whereas a large farmer
who is using the loan amount profitably but fails to repay the loan, is considered as
willful - defaulter. This character of the big farmer is considered as dishonesty.

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Therefore the safety element of the loan is not totally depends up on the security
offered but also on the personality (credit character) of the borrower. Moreover the
growth and progress of the lending institutions have dependence on this major
influencing factor i.e. personality. Hence the personality of the borrower and the growth
of the financial institutions are positively correlated.
3. Principle of productivity:
This principle underlines that the credit which is not just meant for increasing
production from that enterprise alone but also it should be able to increase the
productivity of other factors employed in that enterprise. For example the use of high
yielding varieties (HYVs) in crops and superior breeds of animals not only increases the
productivity of the enterprises, but also should increase the productivity of other
complementary factors employed in the respective production activities. Hence this
principle emphasizes on making the resources as productive as possible by the selection
of most appropriate enterprises.
4. Principle of phased disbursement:
This principle underlines that the loan amount needs to be distributed in phases, so
as to make it productive and at the same time banker can also be sure about the proper

end use of the borrowed funds. Ex: loan for digging wells
The phased disbursement of loan amount fits for taking up of cultivation of perennial crops and
investment activities to overcome the diversion of funds for unproductive purposes. But one disadvantage
here is that it will make the cost of credit higher. That’s why the interest rates are higher for term loans
when compared to the crop loans.
5. Principle of proper utilization:
Proper utilization implies that the borrowed funds are to be utilized for the
purpose for which the amount has been lent. It depends upon the situation prevailing in
the rural areas viz., the resources like seeds, fertilizers, pesticides etc., are free from
adulteration, whether infrastructural facilities like storage, transportation, marketing etc.,
are available. Therefore proper utilization of funds is possible, if there exists suitable
conditions for investment.
6. Principle of payment:
This principle deals with the fixing of repayment schedules of the loans advanced
by the institutional financial agencies. For investment credit advanced to irrigation
structures, tractors, etc the annual repayments are fixed over a number of years based on
the incremental returns that are supposed to be obtained after deducting the consumption
needs of the farmers. With reference to crop loans, the loan is to be repaid in lumpsum
because the farmer will realize the output only once. A grace period of 2-3 months will
be allowed after the harvest of crop to enable the farmer to realize reasonable price for his
produce. Otherwise the farmer will resort to distress sales. When the crops fail due to
unfavourable weather conditions, the repayment is not insisted upon immediately. Under
such conditions the repayment period is extended besides assisting the farmer with
another fresh loan to enable him to carry on the farm business.
7. Principle of Protection:
Because of unforeseen natural calamities striking farming more often, institutional financial agencies can
not keep away themselves from extending loans to the farmers. Therefore they resort to safety measures
while advancing loans like
Insurance coverage
Linking credit with marketing
Providing finance on production of warehouse receipt
Taking sureties: Banks advance loans either by hypothecation or mortgage
of assets

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Credit guarantee: When banks fail to recover loans advanced to the weaker
sections, Deposit Insurance Credit Guarantee Corporation of India (DICGC)
reimburses the loans to the lending agencies on behalf of the borrowers.

Methods and Mechanics of Processing Loan Application

____________________________________________________________________
Procedure to be followed while sanctioning farm loan:
The financing bank is vested with the full powers either to accept or reject
the loan application of a farmer. This is nothing but the appraisal of farm credit
proposals or procedures and formalities followed in the processing of loans.
The processing procedure of a loan application can be dealt under following
ten sub-heads or steps.
1. Interview with the farmer
2. Submission of loan application by the farmer
3. Scrutiny of records.
4. Visit to the farmer’s field before sanction of loan
5. Criteria for loan eligibility
6. Sanction of loan
7. Submission of requisite documents
8. Disbursement of loan
9. Post-credit follow-up measures , and
10. Recovery of loan.
1. Interview with the farmer:
A banker has a good scope to assess the credit characteristics like honesty,
integrity, frankness, progressive thinking, indebtedness, repayment capacity etc, of a
farmer-borrower while interviewing. During the interview, the banker explains the terms
and conditions under which the loan is going to be sanctioned. Interview also helps the
banker to understand the genuine credit needs of farmer. Therefore an interview is not a
formality, but it facilitates the banker to study a farmer in detail and assess his actual
credit requirements.
2. Submission of loan application by the farmer:
The banker gives a loan application to the farmer borrower after getting
satisfied with his credentials. The farmer has to fill the details like the location of the
farm, purpose of the loan, cost of the scheme, credit requirements, farm budgets, financial
statements etc.
The items like 10 -1 (indicating the ownership of land or title deeds) and
adangal ( statement showing the cropping pattern adopted by the farmer-borrower ), farm
map, no-objection certificate from the co-operatives, non-encumbrance certificate from
Sub-Registrar of land assurances, affidavit from the borrower regarding his non-mortgage
of land elsewhere are to be appended to the loan application. A passport size photograph
of farmer is also to be affixed on the loan application form.
3. Scrutiny of records:
The relevant certificates indicating the ownership of land and extent of land are to
be verified by the bank officials with village karnam or village revenue official.

4. Visit to the farmer’s field before sanction of loan:

After verifying the records at village level, the field officer of the bank pays a
visit to the farm to verify the particulars given by the farmer. The pre-sanction visit is
expected to help the banker in identifying the farmer and guarantor, to locate the
boundaries of land as per the map, assess the managerial capacity of the farmer in
farming and allied enterprises and the farmer’s attitude towards latest technology. Details

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on economics of crop and livestock enterprises, economic feasibilities of proposed
projects and farmer’s loan position with the non- institutional sources are ascertained in
the pre -sanction visit. Hence, the pre-sanction visit of the bank officials is very important
to verify credit-worthiness and trust-worthiness of the farmer - borrower.
While appraising different types of loans, different aspects should be verified. For
advancing loan for well digging, the location of proposed well, availability of ground
water, rainfall, area to be covered (command area of the well) and distance from the
nearby well etc, are verified in the pre-sanction visit. In the same way, for other loans,
the relevant aspects are verified. All these aspects are included in the report submitted to
the branch manager for taking the final decision in sanctioning of the loan amount.
5. Criteria for loan eligibility:
The following aspects are to be considered while judging the eligibility of a farmer
- borrower to obtain loan.
He should have good credit character and financial integrity.
His financial transactions with friends, neighbours and financial institutions must
be proper (i.e. he should not be a wilful defaulter in the past)
He must have progressive outlook and receptive to adopt modern technology.
He should have firm commitment to implement the proposed plan.
The security provided by the farmer towards the loan must be free from any sort
of encumbrance and litigation.
6. Sanction of loan:
The branch manager takes a decision whether to sanction the loan (or) not,
after carefully examining all the aspects presented in the pre-sanction farm
inspection report submitted by the field officer. Before sanctioning, the branch
manager considers the technical feasibility, economic viability and bankability of
proposed projects including repayment capacity, risk-bearing ability and sureties
offered by the borrower.
If the loan amount is beyond the sanctioning power of branch manager, he
will forward it to regional manager (or) head office of bank, incorporating his
recommendations. The office examines the proposed projects and take final
decision and communicate their decision to the branch manager for further action.
7. Submission of requisite documents:
After the loan has been sanctioned, the following documents are to be obtained
by the bank from the farmer- borrower.
Demand promissory note
Deed of hypothecation – movable property
Deed of mortgage (for immovable property)
Guarantee letter

Instalment letter
An authorisation letter regarding the repayment of loan from the
marketing agencies.
Title deeds are to be examined by the bank’s legal officer. Simple mortgage is
followed in the case of ancestral property and equitable mortgage in respect of selfacquired
property.
8. Disbursement of loan:
Immediately after the submission of requisite documents, the loan amount is
credited to the borrower’s account. The sanctioned loan amount is disbursed in a phased
manner, after ensuring that the loan is properly used by the farmer- borrower. Based on
the flow of income of the proposed project a realistic repayment plan is prepared and
given to the farmer.

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9. Post-credit follow-up measures:
To ascertain the proper use of the sanctioned loan the branch manager or field
officer pays a visit to the farmer’s field. Apart from this, farmer can get the technical
advice if any needed from the field officer for the implementation of the proposed
project. These visits are helpful for developing a close rapport between the farmers and
the banker. And these visits are more informal than formal. These visits also help in
assessing any further requirement of supplementary credit to complete the scheme.
10. Recovery of loan:
Well in advance the bank reminds the farmer- borrower about the due date of
loan repayment. Some appropriate measures like organising recovery camps, special
drives, village meetings etc, are to be organised by banks to recover the loan in time. In
case of default, the reasons are to be ascertained as to whether he is a wilful defaulter or
not. If he founds to be a non-wilful defaulter, he is helped further by extending fresh
financial assistance for increased farm production. In the case of wilful defaulter, the
bank officials initiate stringent measures to recover loan through court of law. In some
possible cases banks make some tie-up arrangements i.e. the recovery of the loan is
linked with marketing. In respect of justifiable cases re-phasing of repayment plan is
allowed.

Causes for the poor repayment capacity of Kenya farmer

1. Small size of the farm holdings due to fragmentation of the land.
2. Low production and productivity of the crops.
3. High family consumption expenditure.
4. Low prices and rapid fluctuations in prices of agricultural commodities.
5. Using credit for unproductive purposes
6. Low farmer’s equity/ net worth.
7. Lack of adoption of improved technology.
8. Poor management of limited farm resources, etc
Measures for strengthening the repayment capacity
1. Increasing the net income by proper organization and operation of the farm business.
2. Adopting the potential technology for increasing the production and reducing the
expenses on the farm.
3. Removing the imbalances in the resource availability.
4. Making the schedule of loan repayment plan as per the flow of income.
5. Improving the net worth of the farm households.
6. Diversification of the farm enterprises.
7. Adoption of risk management strategies like insurance of crops, animals and
machinery and hedging to control price variations ,etc.,

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Risks Analysis In Banking Lending

What is Risk Analysis

Risk analysis is the process of assessing the likelihood of an adverse event occurring within the
corporate, government, or environmental sector. Risk analysis is the study of the underlying
uncertainty of a given course of action and refers to the uncertainty of forecasted cash flow
streams, variance of portfolio/stock returns, the probability of a project's success or failure, and
possible future economic states. Risk analysts often work in tandem with forecasting
professionals to minimize future negative unforeseen effects.

Risk analysis is the study of the underlying uncertainty of a given course of action and refers to
the uncertainty of forecasted cash flow streams, variance of portfolio/stock returns, the
probability of a project's success or failure, and possible future economic states.

Risks Associated with Banking Lending

The banking industry has awakened to risk management, especially since the global crisis during
2007-08. But what are the day to day risks and the long term risks faced by banks? Why do
dedicated risk management practices at companies like FIS Global even exist? Which risks are
their risk management products and services meant for? Here’s the list of 8 risks faced by banks:

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Credit risk According to the Bank for International Settlements (BIS), credit risk is defined as
the potential that a bank borrower or counterparty will fail to meet its obligations in accordance
with agreed terms. Credit risk is most likely caused by loans, acceptances, interbank transactions,
trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options,
and in the extension of commitments and guarantees, and the settlement of transactions. In
simple words, if person A borrows loan from a bank and is not able to repay the loan because of
inadequate income, loss in business, death, unwillingness or any other reasons, the bank faces
credit risk. Similarly, if you do not pay your credit card bill, the bank faces a credit risk.

Hence, to minimize the credit risk on the bank’s end, the rate of interest will be higher for
borrowers if they are associated with high credit risk. Factors like unsteady income, low credit
score, employment type, collateral assets and others determine the credit risk associated with a
borrower. As stated earlier, credit risk can be associated with interbank transactions, foreign
transactions and other types of transactions happening outside the bank. If the transaction at one
end is successful but unsuccessful at the other end, loss occurs. If the transaction at one end is
settled but there are delays in settlement at the other end, there might be lost investment
opportunities.

Look at it like person A sending US dollars to his family in India at the rate of 60 INR (Indian
Rupee) per dollar. The person B, who is the recipient however receives the payment late and
doesn’t get the exchange rate of 60 INR. Instead he receives the money at the exchange rate of
58 INR. This means they incurred a loss in the transaction. Similar situations occur during big
transactions in banks. If the bank is not able to settle a transaction at an expected time or during
an expected time duration, they may incur a credit risk. However, this kind of risk is called
“Settlement Risk” and it is closely associated with credit risk. It depends on the timing of the
exchange of value, payment/settlement finality and the role of intermediaries and clearing
houses.

While some credit risk is a result of macro forces affecting the economy or specific markets or
even specific individuals, there is another important risk that can be classified under credit risk:
this is the risk of deliberate fraud that is usually borne by the banks who issue credit products
such as credit cards.

Market risk

McKinsey defines market risk as the risk of losses in the bank’s trading book due to changes in
equity prices, interest rates, credit spreads, foreign-exchange rates, commodity prices, and other
indicators whose values are set in a public market. Bank for International Settlements (BIS)
defines market risk as the risk of losses in on- or off-balance sheet positions that arise from
movement in market prices. Market risk is prevalent mostly amongst banks who are into
investment banking since they are active in capital markets. Investment banks include Goldman
Sachs, Bank of America, JPMorgan, Morgan Stanley and many others.

Market risk can be better understood by dividing it into 4 types depending on the potential cause
of the risk:

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  Interest rate risk: Potential losses due to fluctuations in interest rate
 Equity risk: Potential losses due to fluctuations in stock price
 Currency risk: Potential losses due to international currency exchange rates (closely
associated with settlement risk)
 Commodity risk: Potential losses due to fluctuations in prices of agricultural, industrial
and energy commodities like wheat, copper and natural gas respectively

Operational risk

According to the Bank for International Settlements (BIS), operational risk is defined as the risk
of loss resulting from inadequate or failed internal processes, people and systems or from
external events. This definition includes legal risk, but excludes strategic and reputation risk.
Operational risk can widely occur in banks due to human errors or mistakes. Examples of
operational risk may be incorrect information filled in during clearing a check or confidential
information leaked due to system failure.

Operational risk can be categorized in the following way for a better understanding:

 Human risk: Potential losses due to a human error, done willingly or unconsciously
 IT/System risk: Potential losses due to system failures and programming errors
 Processes risk: Potential losses due to improper information processing, leaking or
hacking of information and inaccuracy of data processing

Operational risk may not sound as bad but it is. Operational risk caused the decline of Britain’s
oldest banks, Barings in 1995. Since banks are becoming more and more digital and shifting
towards information technology to automate their processes, operational risk is an important risk
to be taken into consideration by the banks.

Security breaches in which data is compromised could be classified as an operational risk, and
recent instances in this area have underlined the need for constant technology investments to
mitigate the exposure to such attacks.

Liquidity risk

Investopedia defines liquidity risk as the risk stemming from the lack of marketability of an
investment that cannot be bought or sold quickly enough to prevent or minimize a loss. However
if you find this definition complex, the term ‘liquidity risk’ speaks for itself. It is the risk that
may disable a bank from carrying out day-to-day cash transactions.

Look at this risk like person A going to a bank to withdraw money. Imagine the bank saying that
it doesn’t have cash temporarily! That is the liquidity risk a bank has to save itself from. And this
is not just a theoretical example. A small bank in Northern England and Ireland was taken over
by the government because of its inability to repay the investors during the 2007-08 global crisis.

Reputational risk

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The Financial Times Lexicon defines reputation risk as the possible loss of the organisation’s
reputational capital. The Federal Reserve Board in the US defines reputational risk as the
potential loss in reputational capital based on either real or perceived losses in reputational
capital. Just like any other institution or brand, a bank faces reputational risk which may be
triggered by bank’s activities, rumors about the bank, willing or unconscious non-compliance
with regulations, data manipulation, bad customer service, bad customer experience inside bank
branches and decisions taken by banks during critical situations. Every step taken by a bank is
judged by its customers, investors, opinion leaders and other stakeholders who mould a bank’s
brand image.

Business risk

In general, Investopedia defines business risk as the possibility that a company will have lower
than anticipated profits, or that it will experience a loss rather than a profit. In the context of a
bank, business risk is the risk associated with the failure of a bank’s long term strategy, estimated
forecasts of revenue and number of other things related to profitability. To be avoided, business
risk demands flexibility and adaptability to market conditions. Long term strategies are good for
banks but they should be subject to change. The entire banking industry is unpredictable. Long
term strategies must have backup plans to avoid business risks. During the 2007-08 global crisis,
many banks collapsed while many made way out it. The ones that collapsed didn’t have a
business risk management strategy.

Systemic risk and moral hazard are two types of risks faced by banks that do not causes losses
quite often. But if they cause losses, they can cause the downfall of the entire financial system in
a country or globally.

Systemic risk

The global crisis of 2008 is the best example of a loss to all the financial institutions that
occurred due to systemic risk. Systemic risk is the risk that doesn’t affect a single bank or
financial institution but it affects the whole industry. Systemic risks are associated with
cascading failures where the failure of a big entity can cause the failure of all the others in the
industry.

Moral hazard

Moral hazard is a risk that occurs when a big bank or large financial institution takes risks,
knowing thatsomeone else will have to face the burden of those risks. Economist Paul Krugman
described moral hazard as "any situation in which one person makes the decision about how
much risk to take, while someone else bears the cost if things go badly. Economist Mark Zandi
of Moody's Analytics described moral hazard as a root cause of the subprime mortgage crisis of
2008-09

Steps to Mitigate Your Bank’s Credit Risk

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Loan portfolios typically have the largest impact on the overall risk profile and earnings of
community banks.  A strong credit culture provides a platform for the Bank to compete
successfully in its market.   Although credit risk is inevitable, banks can mitigate the risk by
taking steps to strengthen its lending program.  The following steps can help assist in providing a
framework for a sound lending program:

 Written Credit Policies-A well-written and descriptive credit policy is the cornerstone of sound
lending.  Credit policies should address the inherent and residual risks in lending.
 Standardized Credit packages-Documented credit request packages should be uniform.  Most
credit packages will consist of a request, required supporting documentation, and an
analysis/financial review.
 Experienced Underwriting/Decision Making-Underwriters should effectively apply the Bank’s
credit policy and risk guidelines to determine the degree of risk involved in the credit request. 
Too many exceptions to policy may suggest that current underwriting guidelines may not be in
line with the Bank’s priorities or financial goals.  It is important to gather as much information as
possible, both internally and externally in order to make informed decisions on credit requests.
 Loan Approval Authority-The Bank should document loan approval authorities which are
approved by the Board of Directors.  In order to maintain a balance between credit quality and
profitable loan portfolio growth, appropriate lending authority controls must exist.  Each loan
file should contain documentation of proper approval.
 Well-Managed Credit Risk Rating System-Well- managed credit risk rating systems promote
bank safety and soundness by facilitating informed decision making.  The Bank’s risk rating
system should form the foundation for credit risk measurement, monitoring and reporting and
should support the board’s objectives.
 Accuracy of Loan Documentation-Properly executed loan documentation is necessary to ensure
the bank has an enforceable claim for repayment, including liquidation of collateral or the right
to demand payment.  Documentation must be properly drafted, completed, executed, filed and
stamped. A secondary review of this documentation should be in place.
 Monitoring/Reporting Loan Performance-It is important to identify trends within the loan
portfolio and isolate potential problem areas.  Reports to senior management should provide
sufficient information for an independent evaluation of risk and trends.
 Problem Asset Management-When collection problems persist and risk ratings deteriorate,
many banks find it beneficial to transfer problem loans to an independent work-out team.
 Adequate Loan Loss Reserve-The ALLL exists to cover any losses in the loan (and lease) portfolio
of all banks.  Adequate management of the allowance is an integral part of managing credit risk.
 Independent Loan Review and audit-Periodic objective reviews of credit risk levels and risk
management processes, as well as independent audits are essential to effective portfolio
management.

Methods Of Minimizing Risk

Lenders mitigate credit risk in a number of ways, including:

 Risk-based pricing – Lenders may charge a higher interest rate to borrowers who are
more likely to default, a practice called risk-based pricing. Lenders consider factors
relating to the loan such as loan purpose, credit rating, and loan-to-value ratio and
estimates the effect on yield (credit spread).

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 Covenants – Lenders may write stipulations on the borrower, called covenants, into loan
agreements, such as:[21]
o Periodically report its financial condition,
o Refrain from paying dividends, repurchasing shares, borrowing further, or other
specific, voluntary actions that negatively affect the company's financial position,
and
o Repay the loan in full, at the lender's request, in certain events such as changes in
the borrower's debt-to-equity ratio or interest coverage ratio.
 Credit insurance and credit derivatives – Lenders and bond holders may hedge their
credit risk by purchasing credit insurance or credit derivatives. These contracts transfer
the risk from the lender to the seller (insurer) in exchange for payment. The most
common credit derivative is the credit default swap.
 Tightening – Lenders can reduce credit risk by reducing the amount of credit extended,
either in total or to certain borrowers. For example, a distributor selling its products to a
troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30
to net 15.
 Diversification – Lenders to a small number of borrowers (or kinds of borrower) face a
high degree of unsystematic credit risk, called concentration risk.[22] Lenders reduce this
risk by diversifying the borrower pool.
 Deposit insurance – Governments may establish deposit insurance to guarantee bank
deposits in the event of insolvency and to encourage consumers to hold their savings in
the banking system instead of in cash.

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