A study of credit risk management in commercial banks

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A STUDY OF
CREDIT RISK
MANAGEMENT
IN
COMMERCIAL
BANKS

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CHAPTER-I INTRODUCTION AND DESIGN OF THE STUDY 1.1
Introduction 1.2 Importance of Credit Risk 1.3 Statement of the Problem
1.4 Review of Literature 1.5 Scope of the Study 1.6 Objectives of the Study
1.7 Methodologyof Research 1.7.1 Sources of Data 1.7.2 Sampling Design
1.7.3 Tools and Techniques 1.7.4 Framework of analysis 1.7.5 Processingof
Data 1.8 Period of Study 1.9 Chapter Scheme

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CHAPTER - I INTRODUCTION AND DESIGN OF THE
STUDY 1.1 INTRODUCTION The world has experienced remarkable number
of banking and financial crises during the last few decades. Though most of those were
experienced in the developing countries, the majority of the crises coincided with the
deregulatory measures that led to excessively rapid credit extension. In the long run,
continuous increases in asset prices created bubble. At some point, the bubble burst and
the asset markets experienced a dramatic fall in asset prices coupled with disruption.
Finally, widespread bankruptcies accompanied by Non Performing Loans, Credit losses
and acute banking crises were observed1
. Subsequently, the global financial market is
going through a turbulent situation. This has necessitated a close examination of the
numerous issues related to the operation of financial markets to identify the root of the
problem. Various issues such as the capital adequacy levels in the banking system, the
role of rating agencies in financial regulation and the fair value assessment of banking
assets are the most debated ones. In response to the banking crises, significant
reformations have been carried out in the banking regulatory system. In new economic
policy in 1991, the financial (particularly banking) sectors received special attention in
improving their financial strength and functional efficiency and thereby bring them to
international standards. 1Englund P. (1999), “The Swedish Banking crisis: Roots and
Consequences”, Oxford Review of Economic Policy, Vol.15,p 80-83. 17

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The modern banking operations have greater impact on the economic development of
our country. The financial institutions are important constituents of financial system in an
economy. The banking industry is operating in a liberalized and global environment,
which is highly competitive and uncertain. Banks are offering innovative products and
initiating steps to computerize their offices to improve the speed of their operations and
provide prompt services to their customers, who are becoming highly demanding. The
foreign exchange business and cross-border activities are increasing at a fast pace. The
above developments have caused various types of banking risks, which can be broadly
related to market environment and their business control functions. This risk may include
credit risk, interest rate risk, liquidity risk, foreign exchange risk, group risk, technology
risks etc. 1.2 IMPORTANCE OF CREDIT RISK The importance of credit risk has
been presented in the following paragraph; Risks are the uncertainties that can make
the banks lose and become bankrupt. According to the Basel Accord, risks can be
classified as credit risk, market risk and operational risk. Credit risk is the risk of loss due
to an obligator‟s non payment of an obligation in terms of a loan or other lines of credit2
.
Credit risk is defined as “the risk of loss arising from outright default due to inability or
unwillingness of the customer or counter party to meet commitments in relation to
lending, trading, hedging, settlement and other financial transaction of the customer of
counter party to meet commitments”3
. 2
Basel II (2006) International Convergence of
Capital Measurement and Capital Standards, A Revised Frame work Comprehensive Version.P.25.
3
Integrated Risk Management Development, -Hand Book on “Risk Management and Basel II norms”,
Canara Bank, June 2008, p.30. 18

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Credit risk is refers to the possibility that a borrower or counter-party will fail to meet its
obligations in accordance with agreed terms. It is the probability of loss from a credit
transaction 1.2.1 Forms ofcredit risk Forms of credit risk are: Non-repayment of the
principal of the loan and/ or the interest on it.Contingent liability like letters of credit
or guarantees issued by the bank on behalf of the client and upon crystallization – amount
not deposited by the customer.In the case of treasury operations, default by the
counter-parties in meeting the obligations. For example, in case of derivatives dealing, on
the due date the contract is not settled.In the case of security trading, settlement not
taking place when it is due. For example, due to non-availability of funds or due to short
selling, on the due date the claim is not settled.In the case of cross-border obligations,
any default arising from the flow of foreign exchange due to restrictions imposed on
remittances out of the country. For example, the counter party might have made the
payment but the country in which the counter party is residing does not allow the
settlement. The Reserve Bank of India came out with its first set of guidelines on risk
management during 1999. In these guidelines, it has been suggested that the banks should
put in place proper credit risk management system. Some banks initiated the process of
formulating credit risk policies in the year 2000 and have implemented these policies
while a few are still in the process of developing such policies. It has been emphasized in
credit risk management guidelines that while the credit risk strategy of a bank should give
recognition to the goals of credit quality, earnings and growth, it is also essential that the
lender must determine the acceptable risk/ reward trade off for its activities, factoring in
the cost of capital. 19

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The Bank for International Settlements (BIS) says that “Granting Credit involves
accepting risk as well as producing profits”. The credit operations in banks, by nature
involve an element of credit risk. But if such risks are within predetermined ceilings,
properly assessed and calculated ones, loan loss to the bank can be restricted. 1.2.2
Sources of risk of loss under Credit Risk The risk of loss arises from three sources.
They are; Borrowers/ counterparty defaults –Bank loses both the principal and the
interest.Deterioration in borrowers‟ credit quality – bank takes a hit if loan is not
repriced for the higher risk.Improvement in borrowers‟ credit quality- borrower can
refinance his loan at a lower rate. In simple words, it means that they may close the
accounts to benefit from the lower interest rate in offer. 1.2.3 Credit Risk Management
Indicators In response to recent corporate and financial disasters, regulators have
increased their examination and enforcement standards. In banking sector, Basel II has
established a direct linkage between minimum regulatory capital and underlying credit risk,
market risk and corporate risk exposure of banks. This step gives an indication that Capital
management is an important stage in risk mitigation and management. However,
development of effective key risk indicators and their management pose significant
challenge. Some readily available sources such as policies and regulations can provide
useful direction in deriving key risk indicators and compliance with the regulatory
requirement can be expressed as risk management indicators. Amore comprehensive capital
management framework enables a bank to improve profitability by making better risk-
based product pricing and resource allocation. 20

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The purpose of Basel II is to create an international standard about how much capital
banks need to put aside to guard against the types of risk banks face. In practice, Basel II
tries to achieve this by setting up meticulous risk and capital requirements aimed at
ensuring that a bank holds capital reserves appropriate to the risk the bank exposes itself
to. These rules imply that the greater the risk a bank is exposed to, the greater the amount
of capital a bank needs to hold to safeguard its solvency. The soundness of the banking
system is important because it limits economic downturn related to the financial anxiety.
Prudential regulation is expected to protect the banking system from these problems by
persuading banks to invest prudently. The introduction of capital adequacy regulations
strengthen bank and therefore, enhance the resilience of negative shocks. However, these
rules may cause a shift of providing loans from private sector to public sector. Banks can
comply with capital requirement ratios either by decreasing their risk weighted assets or
by increasing their capital. 1.2.4 Non Performing Loans/Assets Nonperforming
loans occurs due to poor risk management and plain bad luck because of external
independent factors. The inflation, deregulation and special market conditions can lead to
poor credit lending decision which in turn leads to nonperforming loans4
. Ongoing
financial crises suggest that Non Performing Loans amount is an indicator of increasing
threat of insolvency and failure. However, the financial markets with high Non
Performing Loans have to diversify their risk and create portfolio with NPLs along with
performing loans, which are widely traded in the financial markets. Non Performing Loan
Ratios act as a strong economic indicator. Efficient credit risk management supports the
fact that lower Non Performing Loan Ratio (NPLR) is associated with lower risk and
deposits rate. However it also implies that in the long run, relatively high deposit rate
increases the deposit base in order to fund relatively high risk 4
World Bank Policy,
Research working paper3769, November 2005. 21

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loans and consequently increases possibility of Non Performing Loan Ratio (NPLR).
Therefore, the allocation of the available fund and its risk management heavily depend on
how the credit risk is handled and diversified the NPL amount. Nonperforming
loans/assets is a probability of loss that requires provision. Provision amount is
“accounting amount” which can be further, if the necessity rises, deducted from the
profit. Therefore, high NPLs amount increases the provision which in turn reduces the
profit. It proves that Non Performing Loan Ratio and Capital Adequacy Ratio are
reasonably considered as credit risk management indicators. 1.2.5 Credit Risk
Management in Banks Bank loan is a debt, which entails the redistribution of the
financial assets between the lender and the borrower. The bank loan is commonly
referred to the borrower who got an amount of money from the lender, and need to pay
back, known as the principal. In addition, the bank normally charges a fee from the
borrower, which is the interest on the debt. The risk associated with loans is credit risk.
Credit risk is perhaps the most significant of all risks in terms of size of potential losses.
Credit risk can be divided into three risks; default risk, exposure risk and recovery risk.
As extension of credit has always been at the core of banking operations, the focus of
banks‟ risk management has been credit risk management. It applied both to the bank
loan and investment portfolio. Credit risk management incorporates decision making
process before the credit decision is made, follow up of credit commitments including all
monitoring and reporting process. The credit decision is based on the financial data and
judgmental assessment of the market outlook, borrower, management and shareholders.
The follow up is carried out through periodic reporting reviews of the bank commitments
by customer. Accordingly, warning systems signal the deterioration of the condition of
the borrowers before default whenever possible. Loans that are in default or close to
being default become NPLs. The terms of the default rate in loans are defined by each
22

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bank. Usually, loan becomes non performing after being default for three months but
this can depend on contract terms. NPLR shows the proportion of the default or near to
default loans to the actual performing loans. It indicates the efficiency of the credit risk
management employed in the bank. Therefore, the less the ratio the more effective the
credit risk management5
. Capital is needed to cover the risks of such losses. Banks have
an incentive to minimize capital they hold since reducing capital frees up economic
resources that can be directed to profitable investment. In contrast, the less capital a bank
holds, the greater is the likelihood that it will not be able to meet its own debt obligations,
that is, the losses in a given year will not be covered by profit plus available capital , and
that the bank will become insolvent6
. Accordingly, banks must carefully balance the risks
and rewards of holding capital. A number of approaches exist to determine how much
capital a bank should hold. The IRB approach adopted by Basel II focuses on the
frequency of bank insolvencies arising from credit losses that supervisors are willing to
accept. Through IRB approach, the Basel Committee intended to develop a framework
which is credible, prudentially sound and reflect healthy risk management practices.
Banks have made use of internal rating system for very long time as a means of
categorizing their exposure into broad, qualitatively differentiated layers of risk7
. 1.2.6
Increased trust on Banking Supervision and Risk Management To strengthen
banking supervision, an independent Board for Financial Supervision (BFS) under the
RBI was constituted in November 1994. The board is empowered to exercise integrated
supervision overall credit institutions in the financial system, including select
Development Financial Institutions (DFIs) and Non Banking 5
Special term dictionary for
investors: www.investo pedia.com. 6
Basel II IRB Risk weight functions:
http://www.bis.org/bcbs/irbriskweight. 7Internal Rating Based Approach: http:// www.bis.org. 23

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Financial Companies (NBFCs) relating to credit management, prudential norms and
treasury operations. A comprehensive rating system based on the Capital adequacy,
Asset quality, Management, Earnings, Liquidity, Systems and Control (CAMELS)
methodology has also been instituted for domestic banks , for foreign banks the rating
system is based on Capital adequacy, Asset quality, Liquidity, Compliance and System
(CALCS). This rating system has been supplemented by a technology enabled quarterly
off-site surveillance system. To strengthen the Credit Risk Management process in
banks, in line with proposed Basel I and Basel II accord, the RBI has issued guidelines
for managing the various types of risks that banks are exposed to make Credit Risk
Management an integral part of the Indian banking system, the RBI has also issued
guidelines for Risk Based Supervision (RBS) and Risk Based Internal Audit (RBIA).
These reform initiatives are expected to encourage banks to allocate funds across various
lines of business on the basis of their risk adjusted return on capital. These measures
would also help banks be in line with the global best practice of risk management and
enhance their competitiveness. The Indian Banking industry has come along way since
the nationalization of banks in 1969. The industry has witnessed great progress,
especially over the past 12 years and is today a dynamic sector. Reforms in the banking
sector have enabled banks explore new business opportunities rather than remaining
confined to generating revenues from conventional systems. A wider portfolio, besides
the growing emphasis in consumer 24

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satisfaction, had led to the Indian banking sector reporting robust growth during past
few years. 1.3 STATEMENT OF THE PROBLEM The Indian financial system
consists of Financial Institutions, Financial Markets, Financial Instruments and Financial
Services. The Commercial Banks are the major constituents of the Indian Financial
System, Which plays a major role by transacting the money from the surplus units to
deficit units. The Commercial banks are functioning in the competitive environment
where one bank competes with another for its survival and its success. The survival of the
Financial Institution in general and banks in particular is largely depending upon their
performance and the profit earning capacity. The profit earning capacity of banking
business is influenced by a number of factors; one of the important factors which have a
bearing on the profitability of the banks is Credit risk. A strong banking sector is
important for a flourishing economy. The failure of the banking sector may have an
adverse impact on other sectors also. Credit Risk is the inability of the borrowers to meet
their dues or commitments, which is one of the major concerns for banks in India. Credit
Risk is one of the major issues for banking sector. Granting Credit for economic
activities is the prime duty of banking apart from raising resources through fresh deposits
, borrowing and recycling of funds received back from borrowers constitute a major part
of funding credit dispensation activity. Lending is generally encouraged because it has
the effect of funds being transferred from the system to productive purposes, which
results in economic growth. However, lending also carries a risk called Credit Risk,
which arises from the failure of borrower. The risks to which banks are exposed
broadly classified as credit risk, liquidity risk, interest risk, market risk, operational risk
and management/ownership risk. While each of these risks contributes to the total risk to
which a bank is exposed, it is perhaps 25

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the credit risk which stands-out as the most dreaded one. The nature and extent of credit
risk therefore, depend on the quality of loan assets and soundness of investments8
.
Generally the day to day operations of the banking units are subject to a number of risks.
The total amount of risks faced by the banking units can be classified into two types;
controllable and uncontrollable. The banks have proper mechanism to identify, measure
and control the risk factors. The availability of proper risk monitoring and controlling
system helps the banking units to manage the risk factors in an efficient manner and helps
the bank to reduce their level of Non Performing Assets Non Performing Assets
reflect the performance of banks. A high level of Non Performing Assets suggests high
probability of a large number of credit defaults that affect the profitability and net worth
of banks and also erodes the value of assets. The large volume of Non Performing Assets
growth involves the necessity of provisions which reduce the overall profits and
shareholders value. The magnitude of Non Performing Assets has a direct impact on
the profitability of banks as legally they are not allowed to book income on such assets as
per the RBI guidelines. Credit risk management system to oversee the management of
Non Performing Assets is an important parameter in the analysis of financial performance
of banks9
. Risk management as a discipline is being taken seriously now a days.
Nevertheless, the financial storm teaches several key lessons which can assist to improve
the risk management in future. As a result, risk has become a very challenging area of
8AnantharamIyer, T.N., “Bank Supervision and the Management of Non Performing Advances” ,The
Journal of the Indian Institute of Bankers, Vol70.2(1991):7. 9http://www.Articlesbase.com/banking
articles/problem-and-recovery. 26

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studies10
. This motivated the researcher to takeup research on Credit Risk Management
in Commercial Banks. Non recovery of loans along with interest forms a major hurdle
in the process of credit cycle. Thus, these loan losses/assets affect the banks profitability
on a large scale. NPAs have emerged since over a decade as an alarming threat to the
banking industry in India sending distressing signals on the sustainability and
endurability of the banks affected. Despite various correctional steps administered to
solve and end this problem, concrete results are eluding. It is a sweeping and all
pervasive virus that has confronted universally the banking and financial institutions11
.
The non performing assets make a drastic impact on working of the banks. The efficiency
of a bank is not always reflected only by the size of its balance sheet by the level of
return on its assets. Non Performing Assets do not generate interest income for the banks,
but at the same time banks are required to make provisions for such Non Performing
Assets from their current profits.It is to be noted that the stock of Non Performing Assets
does not add to the income of the bank while at the same time, additional cost is incurred
for keeping them on the books. To help the banking sector in clearing the old stock of
chronic Non Performing Assets, RBI has announced one time non discretionary and non
discriminatory compromise settlement schemes in 2000 and 2001. Though many banks
tried to settle the old Non Performing Assets through this transport route, the response
was not to the extent anticipated as the banks had been bogged down by the usual fear
psychosis of being averse to settling dues where security was available.
10
http://www.aefeldman.com 11http:// www.scribd.com/doc/1857573/non performing assets 27

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Loan loss provisioning and write off go to reduce the capital available for further asset
creation. Gross NPAs do not, however disclose the entire picture of the over dues from
borrowers. These exclude unpaid interest including any penal interest accursed on NPAs
and as a prudential measure not recognized as income in the banks financial statements.
A write-off of the Non Performing Assets involves foregoing of the accrued interest.
Hence, the magnitude of such interest dues assumes importance in accessing the likely
losses, a bank may suffer because of Non Performing Assets. The tightened RBI
norms for reckoning assets as Non Performing Assets and for non recognition of income
from such assets (by reducing the minimum period of debt servicing default from 12
months to 90 days ), effective from the quarter ended march 2004, would presumably
have resulted in significant additions to Non Performing Assets during the financial year
2004. The high level of Non Performing Assets in banks is a matter of grave concern
to the Public as well as to the Government. Since the bank credit is a catalyst to the
economic development of the country and any bottleneck in the smooth flow of credit
due to the mounting Non Performing Assets is bound to create an adverse repercussion
for the Economy of the Country. Credit Risk Management has emerged as a big
challenge for the Indian banking system. Therefore, it is attempted to make a study of
Credit Risk Management in Commercial Banks to evaluate the credit efficiency by
analyzing Credit deposit ratio, Capital adequacy ratio, Management of Non Performing
Loans/Assets and branch managers‟ perception of Credit Risk Management System to
oversee the management of non performing loans/assets of sample branches. 28

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It is in this context, the researcher has undertaken a study of Credit Risk Management
in Commercial Banks. 1.4 REVIEW OF LITERATURE In view of the
seriousness of the problem of Non Performing Assets in banks and financial institutions
regarding Credit Risk Management System, a number of research studies have been
conducted earlier by researchers and research organizations in India and abroad on
different issues relating to the Non Performing Assets of bank. Similarly, a number of
research papers have been published by academicians and practioners in India and abroad
highlighting the credit risk due to problem of non performing assets in the banking sector.
It is also noted that, a large number of research projects / studies have also been
undertaken in this area by the National Institute of Bank Management, Pune, Indian
Banks Association, Mumbai and RBI. Besides, a number of papers have been presented
on the topic under study by the eminent academicians and practicing bankers in the
Conferences, National and International seminars. In this way, an attempt has been
made to review a few of the above studies and papers as a starting point for the present
study. V.S.Kaveri and K.V.Patel (1997) have concluded that improper selection of
borrowers, under-financing/ delays in financing, social political pressure for financing,
lack of income generation due to natural calamities, mismanagement of fund, lack of
proper follow up, willful defaults etc., are responsible for an account becoming Non
Performing Assets12
. 12
Kaveri, V.S and Patel, K.V., “Strategies for recovery of NPAs in Priority
Sector –A Study”,NIBM, Pune, 1997. 29

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Joel Bessis (1998) in his research paper “Risk Management in Banking” points out the
fact that credit risk is perhaps the most significant of all risks in terms of size of potential
losses. Credit risk can be divided into three; default risk, exposure risk and recovery risk.
As extension of credit has always been at the core of banking operation, the focus of
banks‟ risk management has been credit risk management. It applies both to the bank
loan and investment portfolio. Credit risk management incorporates decision making
process before the credit decision is made, follow up of credit commitments including all
monitoring and reporting process13
. In a study conducted by RBI(1999) by analyzing
800 top NPAs accounts in 17 banks, it reveals that “the higher proportion of NPAs in
Priority Sector Advances was attributed to the directed and pre-approved nature of loans
sanctioned under sponsored programmes, absence of any security, lack of effective
follow-up due to large number of accounts, ineffective legal recovery measures, vitiation
of repayment culture consequent to loan waiver schemes, etc14
. Usha Arora (2000) has
observed that more and more borrowers are turning to be willful defaulters taking the
benefit of mainly inherent deficiencies in our legal system. The problem of recovery has
been further aggravated by the external factors like the Government loan waiver
scheme15
. Taori (2000) has suggested that the surest way of containing Non
Performing Assets is to prevent their occurrence through introduction of proper risk
management system and effective credit monitoring16
. 13
Joel Bessis, (1998) “Risk
Management in Banking”,University of Gothenburg, Sweden. 14
Siddiqui,A.Q.,“Some Aspects and
Issues relating to NPAs in Commercial Banks”, RBI Bulletin, July 1999:930. 15UshaArora, “NPA
Management in the Indian Environment”, The Banker,Vol47.2(2000):28. 16
Taori, K.J., “Management of NPAs in
Public Sector Banks”, Banking Finance,Vol13.8 (2000):11. 30

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Bhattacharya (2001) rightly pointed to the
fact that in an increasing rate regime, quality
borrowers would switch over to other
avenues such as capital markets, internal
accruals for their requirements of funds.
Under such circumstances, banks would have
no option but to dilute the quality of
borrowers and thereby increasing the
probability of generation of Non Performing
Assets17
. Prashant K.Reddy (2002) in his
research paper “A comparative study of Non-
Performing Assets in India in the global
context-similarities, dissimilarities and
remedial measures” has stressedthe
importance of a sound understanding of the
macro economic variables and systematic
issues pertaining to banks and the economic
for solving the Non Performing Asset
problem along with the criticalityof a strong
legal frame work and legislative frame
work18. Muniappan (2002) has identified
that NPAs have two components: the
overhang component and the incremental
component. The overhang component arises
due to infirmities in structural and
institutional environment while the
incremental component arises from factors
internal to banks‟ management and credit
culture19. Misra (2003) has emphasized
that the high rise in Gross Net NPAs of the
banking sector in recent past is at an
exponential rate giving an indication that the
present ongoing recessionis taking a heavy
toll on corporate credit discipline and is
further supported by recovery climate, legal
system, approach of the lenders towards
lending and many other factors20
.
17
Bhattacharya,H.,“Banking Strategy, Credit
appraisal and Sending deviations”, Oxford
University press,New Delhi, 2001. 18
Prashant
K.Reddy., “A Comparative study of Non-Performing
Assets in India in the global context-similarities,

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dissimilarities and remedial measures”,26th June
(2006)
<http://papers.ssrn.com/so13/papers.CFM?abstract-
id=361822>. 19
Muniappan,G., “The NPAs
Overhang, Magnitude, Solutions and Legal reforms”,
RBI Bulletin,May 2002. 20Misra,T.P.,“Managing
of NPAs- A professional Approach”, IBA
Bulletin,Vol25.1(2003):18. 31

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Malydri and Sirisha (2003) have observed that, loan assets constitute a real economic cost
since they reflect the application of scare capital and credit funds for unproductive use21
.
In a similar manner, largely from lender‟s perspective, Das and Ghosh (2003) empirically
examines non-performing loans of India‟s Public Sector Banks in terms of various
indicators such as asset size, credit growth and macro economic condition, and operating
efficiency indicators and suggested that besides supporting policy environment, banks have
to devise appropriate lending terms taking into account the cost of credit, cost of funds,
maturity of loans and credit orientation among other factors so as to induce lower defaults
on borrowers 22
. Rajan & Dhal (2003) have dealt with the various reasons behind assets
turning Non Performing and have also analyzed their macro economic implications23
.
Due to accumulation of NPAs in banks, they not only lose their income but also incur
heavy expenditure to maintain such poor quality assets in their books. Apart from the
internal and external complexities, increase in NPAs directly affect banks‟ profitability,
sometimes even their existence24. Valasmma Antony (2004) has argued that willful
default must be treated as a criminal offence and is to be dealt with seriously. She has also
suggested that arrangements should be made for the exchange of credit information with
respect to 21
Malyadri, ParelSirisha.S, “Non Performing Assets in Commercial Banks- An overview”,
Banking Finance,Vol16.1 (2003):9. 22
Das,A,&Ghosh,S., “Determinants of Credit Risk”, paper presented
at the Conference on Money, Risk and Investment held at Nottingham Trent University, November 2003.
23
Rajan, Rajiv and Saratchandra Dhal (2003), “Nonperforming loans and terms of credit of Public Sector
Banks in India: An empirical assessment”, Reserve Bank of India occasional papers, Vol 24, no.3 winter
2003. 24Ramakrishna Reddy, G and Sree Bhargavi,T., “An Appraisal of Indian Banking from NPAs
Perspective”, The Journal of Accounting and Finance, Vol.18.1(2004): 53. 32

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defaulting customers amongst the banks so
that further NPAs with other banks can be
averted25. Muninarayanappa and Nirmala
(2004) outlined the concept of Credit Risk
Management in banks. They highlighted the
objectives and factors that determine the
direction of banks polices on credit risk
management. The challenges related to
internal and external factors in credit risk
management are also highlighted. They
concluded that success of credit risk
management requires maintenance of proper
credit risk environment, credit strategy and
policies. Thus the ultimate aim should be to
protect and improve the loan quality26
.
There is a considered view that the lending
policy of banks could have crucial influence
on Non Performing Loans (Reddy, 2004). He
critically examines various issues pertaining
the terms of credit of Indian banks and argues
that “the element of power has no bearing on
the illegal activity. A default is not entirely
an irrational decision rather a defaulter takes
in to the account probabilistic assessment of
various costs and benefits of his decision”.
He raises various initial issues pertaining to
credit delivery mechanisms of the Indian
banking sector. The study focuses on the
terms of credit such as interest rate charged to
various productive activities and borrowers,
the approach to risk management and
portfolio management in general27
.
Arunkumar, Rekha and Kotreshwar.G
(2005), in their 9th
capital market conference
paper “Risk Management in Commercial
Banks -A case study of Public and Private
Sector Banks” submitted to the Indian
Institute of Capital Markets has examined
and compared the trends in Non Performing
Assets level, CRM practices of Commercial
Banks, the response to reforms under Basel

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Accord II and Risk Based Supervision as
25Valasmma Antony, “A menace to the Banking
Industry,” Southern Economist 42.17 (2004): 23.
26
Muninarayanappa and Nirmala, “Credit Risk
Management in banks-Key issues”, Journal of
Accounting and Finance,Vol 18.1,p.94-98.
Reddy,Y.V., “Credit Policy Systems and Culture”,
RBI Bulletin,March 2004. 33

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between Public Sector Banks and Private Sector Banks. The study found a strong
relationship between NPAs level and Credit portfolio diversification28
. Non Performing
Loans occurs due to poor risk management and plain bad luck because of external
independent factors. The inflation, deregulation and special market conditions can lead to
poor credit lending decision which in turn leads to nonperforming loans29
. Charanjit Singh
and Mohammad Farook Khan (2005) have observed that DRTs are effective in recovery of
bank dues albeit to a certain extent and concluded that the passing of DRT Act and
establishment of DRTs has brought definite changes in recovery suits of banks30
. Non
Performing Loan Ratio (NPLR)act as a strong economic indicator. Efficient Credit Risk
Management supports the fact that lower NPLR is associated with lower risk and deposit
rate. However it also implies that in the long run, relatively high deposit rate increases the
deposit base in order to fund relatively high risk loans and consequently increases possibility
of Non Performing Loan Ratio(NPLR). Therefore, the allocation of the available fund and its
risk management heavily depend on how the credit risk is handled and diversified the Non
Performing Loan amount31
. Janardhan G Naik (2006) has observed that going by Basel II
norms and other international best practices in our banks are expected to manage NPAs quite
efficiently. 28
http://papers.ssrn.com/so13/papers.CFM?abstract-id=877812. World Bank Policy,
Research Working paper3769, November 2005. 30
Charanjit Singh and Mohammad Farook Khan.,
“Effectiveness of DRTs in recovery of Banks Dues”,IBA Bulletin, Vol 27.10(2005):30. 31
Ernst
&Young,“Global Non Performing Loan Report”, 2006. 34

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Surely the reforms in the legal system in the recent years such as SARFAESI Act, 2002 will
help in faster recovery of NPAs32
. Annual Survey on the “Status of Indian Banking
Industry: Progress and Agenda Ahead-2005” report that substantial progress made by banks
in cleaning up the NPAs from their balance sheet, was largely attributed to SARFAESI Act
and increases provisioning on Doubtful debts by majority of survey respondents. Absence of
secondary market for the trading of security receipt issued by ARCs was identified as one of
the major problem in Indian model of NPA management. Majority of the survey respondents
recommend separate NPA norms for the farm and SME sectors33
. B.M.Mishra and
SaratDhal (2008) have made an analysis of pro-cyclicality of bank indicators with a focus on
the Non-performing loans of Public Sector Banks in India. The empirical analysis
demonstrates that banks‟ Non Performing Assets are influenced by three major sets of
factors, i.e., terms of credit, bank specific indicators relating to asset size, credit orientation,
financial innovations (non interest income), and regulatory capital requirement and the
business cycle shocks. Using panel regression model, the study found that the terms of credit
variables such as interest rate, maturity and collateral and bank specific variables had
significant effect on the banks on performing loans in presence of macro economic shocks.
The empirical findings support the policy approach to the banking in the Indian context34.
M.Karunakar, K.Vasuki and S.Saravanan (2008) have made an analysis “Are non-
performing assets gloomy or greedy from Indian perspective” points out that the Non
Performing Assets have a deleterious effect on the return on assets in several ways. The
32
Janardhan G Naik., “NPAs management Challenges before Banking Sector”, The Management
Accountant, Vol 41.5 (2006):360. 33
FICCI Report of Annual Survey on the “Status of Indian Banking
Industry: Progress and Agenda Ahead-2005”, May 2006 <http://www.ficci/ surveys/ banking.pdf.
34
http://www.bis.org/repoffice pub/asp research 201003.08.pdf?no 35

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following are to cite a few such effects: the interest income of banks will fall and it is to
be accounted only on receipt basis; Bank‟s profitability is affected adversely because of
the providing of doubtful debts and consequent to writing it off as bad debts; Return on
Investment (ROI) is reduced; the Capital adequacy ratio is disturbed as Non Performing
Assets are entering into its calculation; the cost of capital will go up, the Assets-Liability
mismatch will widen; the Economic Value Addition (EVA) by banks gets upset because
EVA is equal to the net operating profit minus cost of capital; Non Performing Assets
require provisioning requirements affecting profits and accretion to capital funds and
capacity to increase good quality risk assets influence and It limits recycling of funds; set
in asset liability mismatches etc. Though RBI has taken a number of measures to reduce
the level of Non Performing Assets, the result is not up to the expectations35
. Dong
(2008), in his paper resolving “Non Performing Assets of the Indian Banking System”
submitted to the International Monetary Fund had reviewed the nature of Non Performing
Assets in the Indian Banking System and discussed the key design features that would be
important for the Assets Reconstruction Companies to play an effective role in resolving
Non Performing Assets. The analysis draws upon recent regional and cross-country
experiences in dealing with impaired assets during periods of financial crises36
.
R.K.Uppal (2009) clearly indicates that “Non Performing Assets were more in Public
Sector Bank groups while the least was in Foreign Bank groups, because advances by
Public Sector Bank groups to the priority sector advances were also high. Non
Performing Assets in the Public and Private Sector Bank groups were high mainly due to
increase in NPAs in the agricultural sector37
. 35
M.Karunakar, K.vasuki and S.Saravanan.,
“Are Non-Performing Assets gloomy or greedy from Indian Perspective”, Research Journal of Social
Sciences, INSINET Publication, Vol 13, 2008, pp-6-7. 36
http://mpra.ub.unit-muenchen.de/9758/1/mpra-
paper-9758.pdf. 37
R.K. Uppal., “Priority Sector Advance-trends, issues and strategies”, Journal of
Accounting and Taxation, Vol.1 (d) December 2009, P.86. 36

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Muniswaran.S (2010) rightly points out that, the profitability and viability of banks are
directly affected by quality and performance of advances. A sound NPAs management
system is used for quick identification of Non Performing advances, their containment at
minimum level and ensuring that their impingement on the financials is minimal38
.
The researcher has analyzed the various studies relating to the risk management in banks.
In such studies the policy aspects of risk management in general and management of non
performing assets in particular are only discussed. So far no study has been conducted on
the Credit Risk Management in Commercial Banks. Hence, the study has been
undertaken to evaluate the credit efficiency of Commercial Banks in India through Credit
Deposit Ratio, Capital Adequacy of banks to manage credit risk and the management of
Non Performing Assets-a component of Credit Risk Management in Commercial Banks.
1.5 SCOPE OF THE STUDY The Scheduled Commercial Banks command control
over two thirds of the total assets of the financial sector with a network of more than
80,000 branches across the country and constitute the most significant segment of the
financial sector. Hence, the present study is confined to SCBs coming under Public
Sector, Private Sector and Foreign Banks. The study has excluded the Regional Rural
Banks (RRBs) which forms a part of the Indian Scheduled Commercial Banks. The
banks‟ credit efficiency can be measured by Credit risk management system employed
by the banks. The areas covered under the study are the proportion of credits with
deposits, measure of capital base through Capital adequacy ratio, Credit Risk
Management System to see the Management 38
Muniswaran,S., 2010, “Non Performing Assets
Management of State Bank Groups”, MKU,P.273. 37

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of Non Performing Assets in different bank groups, such as levels of Non Performing
Assets of different bank groups, assets quality of different bank groups, recovery of Non
Performing Assets of these banks through various measures, and perceptions of branch
managers on issues related to Non Performing Assets management. All the above issues
have been identified by the researcher for detailed analysis and interpretations.
1.6 OBJECTIVES OF THE STUDY The present study has the following objectives;
To study the practices of Credit Risk Management System in the Indian Banking Sector
with regard to Basel Accord, To study the concept of Non Performing Assets and
Prudential norms regarding management of NPAs and Risk Weighted Assets, To
appraise the Credit Risk Management System employed by SCBs, To examine Credit
Deposit Ratio, Capital Adequacy Ratio, Gross NPAs to Gross Advances Ratio, Net NPAs
to Net Advances in measuring credit efficiency of banks, To study the perceptions of
branch managers of the study units towards Credit Risk Management System and 38

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6. To offer summary of findings, suggestions and conclusion of the study. 1.7
METHODOLOGYOF RESEARCH The present study is based on both analytical
and descriptive in methods. The study is primarily analytical in the sense that it analyses
various financial variables based on secondary data. It also adopts descriptive
methodology in order to ascertain the views of bankers to know their opinion on the
Credit Risk Management system adopted to evaluate loan assets quality and ensure the
profitability in their respective banks. For this, it was considered important to under take
a detailed study of Credit Risk Management System based on primary data collected
through field survey of branch managers of both Public and Private Sector Bank groups
and make an in-depth analysis of data to arrive at feasible solutions for the problem. In
this respect, it is considered a descriptive study. The methodology adopted for the study
is presented in the following paragraphs. 1.7.1 Sources of Data The required data
for the present study are collected from both primary and secondary sources. Primary
data are collected with the help of structured interview schedule questionnaire designed
for bank managers. The secondary data relevant to the study have been gathered from
published sources like the RBI publications such as reports on trends and progress of
banking in India, statistical tasks relating to banking in India, RBI Annual Report, RBI
Bulletins and Report on Currency and Finance, besides Books, Annual Reports of
Commercial Banks, Reports of various Committees appointed by RBI and articles
published in various Standard textbooks, Journals and Magazines. The papers presented
by experts in various conferences have also been reviewed for the purpose of analysis and
suggestions. 39

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1.7.2 Sampling design The present study attempts to analyze the Credit Risk
Management practices followed by selected SCBs functioning in the major cities of
Tamilnadu namely, Chennai, Trichy, Madurai, Coimbatore and Salem. The present study
has employed the judgement sampling techniques. The criteria considered for selecting
the sample units include more population, industrial cities, the number of branches, loan
extended, credit deposit ratio and the like. A sample of 50 bank branch managers i.e. ten
from each district has been selected. All the branch managers have been interviewed
personally with the help of structured interview schedule. In order to collect the
required data from the sample respondents, a structured interview schedule was
developed by reviewing the research works carried on the present topic. A pilot study
was conducted among the ten bank executives and finally the interview schedule was
modified based on the feedback received from the respondents. Further, a number of
discussions were made with the top executives of some of the banks in order to make
suitable corrections in the interview schedule. 1.7.3 Tools and Techniques The data
are analyzed by using appropriate statistical tools and techniques like; Percentages and
averages

Tables

Weighted Average Method

Ratio analysis

„t‟
Test

„f‟ Test

Chi-square Test

Correlation

Compound growth rate

40

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Diagrams

All the analyses have been done by using SPSS for windows
release 20 statistical packages. 1.7.4 Frame work of analysis In the present study,
some mathematical and statistical tools have been applied in order to realize the
objectives of the study. The tools applied and the relevance of its application is described
below: The technique of ratio analysis has been used to study the magnitude and trend
of Credit deposit ratio, Capital adequacy ratio and Non-performing assets of banks during
the study period. Correlation analysis has been used to establish the relationship
between macro economic variables as well as micro economic variables Regression
analysis has been used to examine the influence of Non Performing Assets variables on
other macro economic and micro economic banking variables. „t‟ test, „f‟ test, Chi
square test have been applied to test the significance of differences between the bank
groups, branch locations with regard to perceptions of branch managers on the various
aspects of Management of Credit Risk on Non Performing Assets. Compound Growth
Rate (CGR) for Gross NPAs, Net NPAs, Standard Assets, Substandard Assets, Doubtful
Assets and Loss Assets of different bank groups have been computed on the basis of the
semi log or exponential functions with the help of SPSS packages.

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1.7.5 Processing of data All the data have been classified, tabulated for better
comprehension and analysis. The data have been analyzed with the help of computers.
Simple mathematical tools like high level ratios, percentages and averages and statistical
tools such as correlation analysis, Chi-square test, „f‟ test,„t‟ test, Compound growth rate
have been applied for analysis of data. All the analyses have been done by using SPSS
for windows release 20 statistical packages. 1.8 PERIOD OF STUDY The study has
attempted to analyze the Credit Risk Management practices of the Indian SCBs in general
and that of the SCBs‟ financing in the major cities of Tamilnadu in particular. For the
purpose of analyzing the Credit Risk Management practices, the study has considered a
number of variables which are very essential to understand the Credit Risk Management
System. The required data regarding all those variables have been collected from the
secondary sources for a period of 10 years i.e. from 2001-02 to 2010-11. The primary
data required for the present study have been collected from the study area during the
year 2010. 1.9 CHAPTER SCHEME The present study has been organized in to
five Chapters. A sincere attempt has been made to arrange the chapters in a structured
manner from the point of content developments. They are; The introduction chapter
deals with the introduction and design of the study. It presents the statements of problem,
scope of the study, objectives of the study, review of 42

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earlier studies and literature, methodology, sources of data, tools and techniques of
analysis and division of chapters. The second chapter relates to the conceptual frame
work of Credit Risk Management with regard to Basel I and Basel II and Management of
Non Performing Assets, recommendations of various committees dealing with the
problem of Non Performing Assets, prudential norms of RBI and Government for
resolution of NPAs. The third chapter examines the magnitude of Credit deposit ratio,
Capital Adequacy Ratio, Credit Risk and Non Performing Assets of SCBs, Sector-wise
NPAs and Loan asset quality of different bank groups and recovery of Non Performing
Assets by SCBs in India The fourth chapter analyses the perceptions of branch
managers on the various issues relating to Credit Risk Management on Management of
Non Performing Assets at branch level and the recovery of Non Performing Assets by
SCBs in India. The fifth chapter summarizes the major findings of the study and offers
suggestions for effective management of credit risk.
CHAPTER -II A
CONCEPTUAL FRAME WORK OFCREDIT RISK MANAGEMENT 2.1
Introduction 2.2 Significance of RiskManagement in Banks 2.3 Basel Basel
I Accord Basel II Accord 43
SUMMARY OF FINDINGS AND CONCLUSION
5.1 Introduction Summary of findings 5.2 Magnitudeof CreditDepositRatio
5.3 Magnitudeof Capital Adequacy Ratio 5.4 Magnitudeof NPAsof Banks 5.5
Analysisof loan asset quality of Banks 5.6 Analysisof sector-wise NPAsof
Bank groups 5.7 Recovery of Non PerformingAssetsby Banks 5.8
Perceptionsof BranchManagerson the CreditRisk ManagementSystem to
oversee the Managementof NPAs 5.8.1 Generalopinion of BranchManagers
5.8.2 Opinion on causesof NPAs 5.8.3 Opinion on impactof Non Performing
Assets 5.8.4 Opinion on effectivenessof variousrecovery measures 5.8.5
Opinion on supportfrom variousagencies regarding recovery of NPAs 5.8.6
Opinion on issues on managementof NPAs 5.8.7 Opinion on suggestionsfor
effective measuresto avoid/minimizethe level of NPAs 5.8.8 Opinion on the
reasonsfor declinein the level of NPAs since 2002 5.8.9Opinion on general
commentsand suggestions 5.9Suggestions 5.9.1 Suggestionsto Government

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of Indiaand RBI 5.9.2 Suggestionsto the Bankers 233 5.9.3 Suggestionsto
the Borrowers 5.10 Conclusion CHAPTER-V SUMMARY OFFINDINGSAND
CONCLUSION 5.1 INTRODUCTION The major activities of a bank are to deal
with money and people. Since the money and peopleare highly sensitive, they
are to be handled carefully with moreskills and knowledge. Today the non
performingassets are posinga session‟s threat to the banking industry. The
financial health of the banks is greatly affected by the NPAs. The high level of
NPAsis the greatest impedimentto the economicgrowth of the country and
any bottleneck in the smooth flow of credit is bound to create adverse
repercussionsof NPAs which has emerged as oneof the major challenges for
the banks. The presentstudy has analyzed the Credit Risk Management
System employed to oversee the magnitudeof NPAsof four bank groupsin
Indianamely, Public Sector Bank groups, Old PrivateSector Bank groups,
New Private Sector Bank groupsand Foreign Bank groups; examined the
CreditRisk ManagementSystem regardingrecovery of NPAsby SCBsthrough
variousmeasuresrecommended by RBIand studied the implication of NPAs
on selected macro economicand micro bankingvariables. The effectiveness
of NPAsmanagementby SCBshas also been studied through scaling
technique using secondary data. In addition, the perceptionsof branch
managerson the variousaspects relating to CreditRisk ManagementSystem
on treatment of NPAsat branch level have been studied based on primary
data collected through field survey. The summary of major findingsof the
presentstudy and suggestion for effective managementof NPAsand
reduction of credit risks associated with NPAsare presented in the following
paragraphs. 234 SUMMARY OFFINDINGS 5.2 MAGNITUDEOFCREDIT
DEPOSITRATIO 5.2.1 The percentageof Creditdeposit ratio of SCBshas
increasing trend and it also prevailsabove the standard ratio of 60 percent.
5.2.2 Thepercentage of Creditdeposit ratio of PublicSector Bank groupshas
an increasing trend and the banks have a strong credit disbursement
network. 5.2.3 TheCredit depositratio of Old PrivateSector Bank groupshas
an increasing trend and CompoundGrowthRateof credits is morethan the
deposits. 5.2.4 The Creditdeposit ratio of New Private Sector Bank groupshas

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a remarkable increase of morethan 83 percent and the Compound Growth
Rate of depositsand credits has increased proportionately by each other.
5.2.5 TheCredit depositratio of Foreign Bank groupshas an increasing trend
from 71.42 percenton 2001-02to 81.24 percenton 2010-11and the
CompoundGrowthRateof deposits (18.2percent)and credits(18.6 percent)
has also increased proportionately. Foreign Bank groupshave a strong credit
disbursementnetwork. 5.3 MAGNITUDE OFCAPITALADEQUACY RATIO The
Capital Adequacy Ratio of all Scheduled CommercialBanksi.e. all bank groups
has an increasing trend duringthe study period. 235 Thestandard capital
adequacy ratio is 11 percent. From 2001-02to 2010-11, the Capital adequacy
ratio has increased and it is shown as follows; Public Sector Bank groupsfrom
12.5 percentto 17.7percent, New PrivateSector Bank groupswith 12.3
percentto 14.2 percent, Foreign Bank groupshas 12.9 percentto 14.2
percent. All the bank groupsin Indiahave maintained their capital adequacy
ratio above the standard ratio. Therefore, banks are having a strong capital
base to meet the time liability and other risks such as credit risk, operational
risk etc. 5.4 MAGNITUDE OFNPAsOFBANKS 5.4.1 The share of PSB groups
in the gross advancesof SCBs is high (i.e.) more than75 percentof the total
advancesof bank groupsin Indiaprovided by PSB groups followed by New
Private Sector Bank groups(14.4 percent), Foreign Bank groups(5.7 percent)
and Old PrivateSector Bank groups(4.83 percent)ason 31stMarch2011.
5.4.2 Theshare of PSB groupsin the gross NPAsof SCBsis high 75.9 percent
followed by New PrivateSector Bank groupswith 13.02 percent, Old Private
Sector Banksgroupswith 5.59 percentand closely followed by Foreign Bank
groups with 5.49 percent. 5.4.3 Thegrowth rate on gross NPAsin respect of
all the bank groupsremains positive except Old PrivateSector Bank groups
duringthe study period .New PrivateSector Bank groupsand Foreign Banks
groupshave a remarkable growth of 11.9 percentand 11 percent
respectively. The gross NPAsof Old Private Sector Bank groupshavereduced
considerably by 4.5 percent. 5.4.4 Thegross NPAsratio of SCBs has declined
from 10.4 percentin 2001-02 to 2.25 percentin 2010-11and that of PSB
groupshas declin 236 percent, Foreign Bank groupshas declined from5.4

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percentto 2.54percentduringthe study period. 5.4.5 Thenegative growth
rate of gross NPAsratio for all bank groupsduring the study period arefound
to be significant. 5.4.6 TheCompound GrowthRateof gross problem assets
ratio for all bank groups have negative growth of SCBs by14.2 percent, PSB
groupsby15.1 percent, Old PrivateSector Banksgroupsby16.3 percent, New
Private Sector Bank groupsby10 percentand Foreign Bank groupsby
8.2percentand it found to significant duringthe study period. 5.4.7 TheNet
Advancesof SCBsin India, the share of PSB groupshas morethan 75 percent
of total netadvancesof amongfour bank groupsin Indiafollowed by New
Private Sector Bank groups(14.43 percent), Foreign Bank groups(5.7
percent) and Old Private Sector Bank groups(4.82 percent). 5.4.8 The
CompoundGrowthRateof Net advancesof all bank groupsis positiveand
significant duringthe study period. 5.4.9 TheNet NPAsin respect all four
bank groupshave shown a decreasing trend till the year 2005-06and then it
increased gradually in the subsequentyearsof the study period dueto change
in assets classification normsfrom 180 daysto 90 dayson 31st March 2005.
5.4.10TheCompoundGrowthRateof net NPAsare negative as a whole for
New Private Sector Bank groups(18.3 percent), Old PrivateSector Banks
groups (17.9 percent), PublicSector Bank groups(15.3 percent)and Foreign
Bank groups(5.9 percent)and significant duringthe study period. 237
5.4.11 Allthe four bank groupshave witnessed a declining trend in their net
NPAsratio duringthe study period. The CompoundGrowthRateof net NPAs
ratio of all four bank groupsis negative and significant. 5.4.12 TheNet
Problem Assets ratio of SCBsas a whole the PSB groups, Old Private Sector
Bank groups, New PrivateSector Bank groupsand Foreign Bank groupsis
less than onepresentfrom 2005-06 onwardsduringthestudy period. 5.4.13
The CompoundGrowthRateof Net Problem Assets ratio of all the four bank
groupsis negative and significant duringthe period of study. 5.5 ANALYSIS
OF LOAN ASSET QUALITY OF BANKS 5.5.1 The proportion of Standard Assets
(PerformingAssets) in the total loan assets of SCBs has been increasing
duringthe study period which may be attributed to both increased recovery
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in the share of doubtfulassets, substandard assets and loss assets in the total
advancesof SCBstill the year 2007-08, thereafter it has an increasing trend in
the composition of all loan assets for the remaining period of study. 5.5.2 The
proportion of Standard Assets in the total advancesof all the four bank
groupsnamely PublicSector Bank groups, Old Private Sector Bank groups,
New Private Sector Bank groupsand Foreign Bank groupshas been
increasing duringthe period of study. Thereis significant declinein the share
of doubtfulassets, substandard assets and loss assets in the total advancesof
all the four bank groupstill the period of 2007-08 thereafter, it has an
increasing trend in the composition of all loan assets for the remainingperiod
of study. 5.5.3 Thesubstandard asset ratio of SCBs, PublicSector Bank
groups, Old Private Sector Bank groups, New PrivateSector Bank groupsand
Foreign Bank groups 238 aredecliningsignificantly till the period of 2005-
06 indicating upgradation of PerformingAssets. Thereafter the substandard
ratio has increasing trend during the remainingperiod of study which shows
the high degradation of performing assetswhich leads to increase the level of
NPAs. 5.5.4 TheCompound GrowthRateof Substandard Asset ratio shows a
positive growth of 7.7 percentfor PSB groups, 2.9 percentfor Old Private
Sector Bank groups, 1.7 percentfor New Private Sector Bank groups, 8.4
percentof Foreign Bank groupsand 7.4 percentof SCBs as a whole duringthe
study period. 5.5.5 TheDoubtfulAssetratio for all four bank groupshas
decreasing trend except in the year 2004 -05 and 2010-11. TheCompound
GrowthRate of doubtfulassets ratio of all bank groupsare negative and
significant duringthe study period. 5.5.6 Thegrowth rates of Loss Asset ratio
of all the four bank groupsare negative except Private Sector Bank groups(
Old and New)and significant except PrivateSector Bank groupsduringthe
study period 5.6 ANALYSISOF SECTOR-WISE NPAsOF BANK GROUPS 5.6.1
While the share of priority sector in GrossNPAsof PSB groupshas increased
from 44.49 percenton 2001-02to 63.62 percentason 2007-08, theshare of
Public Sector has declined from 1.97 percentto 0.4 percentduringthe study
period and Non priority sector has also decreased significantly from 53.54
percentto 35.63 percenton 2007-08and to 41 percenton 2010-

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11.TheCompoundGrowthRateof sector-wise NPAshas a negative growth.
239 5.6.2 Theshare of SSIs in the total NPAsunder priority sector advancesof
PSB groups declined from 18.73 percentason 2001-02 to 14.6 percentason
2007-08and it has increased to 20.2 percenton 2010-11 and theshare of
agriculturehas increased from 13.84 percentason 2001-02to 20.4 percent
as on 2010-11. TheCompound GrowthRateof priority sector advances, NPAs
under advancesto others sector has increased by 62.9 percentfollowed by
agriculturewith 7.3 percent. 5.6.3 Theshare of non priority sector in Gross
NPAsof Old PrivateSector Bank groups has declined from 60.46 percentason
31stMarch 2002 to 54.45 percentason 31st March 2011 and that of Public
Sector has declined from 0.18 percentto 0.03 percentas on 2005-06.In the
year 2006-10, thereareno NPAsin PublicSector and in the year 2010-11,itis
4 percent. Butthe share of Priority sector has increasing trend from39.35
percentas on 2001-02to 52.34 percentason 2007-08 and ithas decreased to
41.57 percentduringtheremainingperiod of study. It has negative
CompoundGrowthRatein publicsector (35.6percent), non priority sector
(8.1percent)and priority sector (3percent). 5.6.4 Whilethe share of SSIs in
the total NPAsunder Priority sector Advancesof Old Private Sector Bank
groupshas declined from 21.15 percentas on 2001-02to 14.33 percenton
2010-11,theshareof Agriculturehas increased from 6.06 percentto 10.84
percentduringthe study period. Theshare of others under priority sector has
increased from 12.14 percentto 28.83 percentas on 2007-08and it
decreased to 16.41 percentduringthe study period. 5.6.5. Whilethe share of
Priority sector in the GrossNPAsof New PrivateSector Bank groupshas
increased marginally from 9.35 percentto 22.6 percentduringthe 240 study
period, the share of Non priority sector has declined from 90.32 percentto
77.4 percentduringthe study period. 5.6.6.Theshare of SSI in the total NPAs
under Priority sector advancesof New Private Sector Bank groupshas
declined from 6.74 percentto 2.6 percentduringthe study period. 5.7
RECOVERY OF NON PERFORMING ASSETSOF BANK GROUPS 5.7.1 The
percentage of recovery of NPAsby SCBsthrough Lokadalats has lies between
14.02 percentason 2003-04 to 14percentason 2006-07. Itis considered as

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better recovery channelnext to the SARFAESIAct 2002.Butin the year 2007-
08 onwardsit has decreasing trend of recovery from 8.2 percentto 2.87
percenton 2010- 11. 5.7.2Thepercentage of NPAsrecovery by SCBsthrough
DRTshas increased from 17.2 percentin 2003-04 to 81 percentason 2008-
09 and thereafter it has declined to 27.89 percent. Butin the year 2008-09it
has a remarkablerecovery rate of NPAsof 81 percent, it indicates the better
recovery performanceof DRTs. 5.7.3 Thepercentage of NPAsrecovery by
SCBsthrough enforcementof security interest under SARFAESIActhas
increased from 14.73 percentin 2003-04to 61 percentin the year 2007-
08.TheSARFAESIAct is considered as most importantchannel for recovery
NPAsin India. Thereafter, the recovery rate of NPAs through SARFAESI Act
has declined to 37.78 percenton 2010-11. 5.7.4Thepercentage of recovery of
NPAsby SCBsthrough One Time Settlement and CompromiseSettlement
Scheme has increased from 40.86 percentin 2003-04 to 78.76 percentin the
year 2005.06. 241 5.7.5During2004-2005, severalbanksand certain
financial institutionssold their NPAsto the ARCILto the extent of Rs.15,
343crores. Thesetting up of the Asset Reconstruction Corporation of India
Ltd (ARCIL)has provided amajor boost to banks‟ efforts to recover their
NPAs. 5.7.5.1 In theyear 2005-2006, ARCILacquired Rs.21, 126crores of
NPAsof banks. The portfolio of assets acquired by ARCILwasdiversified
across major industry segments, which weregenerally performingwellin the
stock market. 5.7.5.2Attheend of June2007, thebook valueof total amount
of assets acquired by SCs/RCsregistration with the RBI stood at Rs.28,
544crores. The security receipts subscribed to by banksamounted to Rs.6,
894crores. The security receipts redeemed amounted Rs.660crores. 5.7.5.3At
the end June2008, thebook valueof total amountof assets acquired by
SCs/RCsregistered with the RBI wasat Rs.41, 414crores, showingan increase
of 45.1percentduringtheyear July 2007 to June2008. While security receipts
subscribed to by banksamounted to Rs.8, 319crores, security receipts
redeemed amounted toRs.1, 299crores. 5.7.5.4In theyear 2009, asat end June
2009, thebook valueof total amountof assets acquired by SCs/RCsregistered
with the RBIwas Rs.51, 542crores, showingan increaseof 24.5percent

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duringthe year July 2008 to June2009. Whilesecurity receipts subscribed to
by banksamounted to Rs.9, 570crores, security receiptsredeemed amounted
to Rs.2, 792crores. 5.7.5.5 Of the total amountof assets securitized by these
companiesat the end June2010; thelargest amountofRs.10,314croreswas
subscribed to by bank. However, there was a steady declinein the percentage
share of banks in total value of securitized assets in the recent years. 242
5.7.5.6 In 2010-2011, thebook valueof assets acquired by SCs/RCsgrew at
19percent(74,088crores)over the previousyear. Outof the total security
receipts issued by SCs/RCsin 2010-11,71percent (11,233crores)was
subscribed by banking sector. 5.8 PERCEPTIONSOFBRANCH MANAGERSON
THE CREDITRISK MANAGEMENTSYSTEM TOOVERSEE THE MANAGEMENT
OF NPAs 5.8.1 GENERALOPINION OFBRANCH MANAGERS 5.8.1.1Amongall
financeactivities, most of the samplebranches are providingfinancing
assignment to businessactivities followed by personalsegment and
agricultural activities. 5.8.1.2 Majority (92 percent)of the sample
respondentsareaccepting land and buildingas securities to sanction credits.
5.8.1.3 Majority (64 percent)respondentsaregetting financial details of
borrowers through CRISIL followed by personalasking with neighbouring
banks followed by getting information from CreditCell and only 28 percentof
the branches are having internal risk rating system. 243 5.8.1.4A majority
(84percent)of the respondentscollect the information to assess the
creditworthiness of the borrowersby previousloan transaction in the same
branch followed by getting information from neighboringbanks. 5.8.1.5 Most
of the respondents(88 percent)haveidentified the sourceof repaymentof
borrowersthrough income or salary statement followed by assessment of
balance sheet (84 percent)and income tax assessment order (48percent)
5.8.1.6 A majority (76 percent)of the respondentshaveopined that, the
repaymentof credit is promptand the balance 24 percentof respondents
have opined that the repaymentof credit is irregular which turnsinto
nonperformingassets 5.8.1.7 Mostof the respondents(80 percent)have
reasoned that difficulty to realize the securities is dueto deterioration,
maintenanceetc., accompanied by market fluctuation (76 percent)and only

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16 percentof the respondentshaveopined that the fake securities are the
reasonsfor the failureto realize the desired return. 5.8.1.8 Amongsample
respondents, 84 percentof the respondentshaveopined that the non
paymentof loan arises from willfulborrowers, followed by from first time
borrowers(44percent). 5.8.1.9Thelevel of NPAsin business activities has
been ranked as first because most of the samplebranches are providingmore
amountsof its credits to business activities followed by personalsegmentand
agricultural activities. 5.8.2 OPINION ON CAUSES OF NPAs 5.8.2.1 Willful
defaulthas been ranked asthe most importantreason for NPAs followed by
Diversion of funds, Businessfailure. Selection of inappropriate technology
and Inflation has been given the least rank. 244 5.8.2.2Thereare no
significant differencesbetween the bank groupsin rankingof factors
influencingNPAsby their branch managers except diversion of funds, under
financing, willfuldefault, improper selection of borrowers, lack of proper post
supervision and follow up and loan to priority sector advances 5.8.2.3 There
are no significant differencesbetween the branch locations in rankingof
factors influencingNPAsby the branch managers except in respect of factors
namely diversion of funds, selection of in appropriatetechnology, accidents
and naturalcalamities, loan waiver and wrongguidancegiven by political
parties. 5.8.3 OPINION ON IMPACTOF NON PERFORMING ASSETS 5.8.3.1In
the opinion of managers, the impact of NPAsis felt mostly on profit (i.e.)
reduction in profit followed by increase in the operatingexpenses, decrease in
return on assets, liquidity of the bank, capital adequacy ratio and considerable
reduction in advancesof the banks. However, the impact of NPAson
borrowingcapacity of bank and repaymentof deposits and recycling of funds
has been ranked low. 5.8.3.2 Whilethereare significant differencesbetween
the bank groupsin their opinion on the level of impact of NPAson the
borrowingcapacity of the bank, solvency liquidity of the bank, ability of
financeto other profitable ventures and increasingthe operating cost of the
bank, there are no significant differences between bank groupsin their
opinion on the level of impact on their performance variables. 5.8.3.3 There
are no significant differencesamongthe branch location in the opinion on the

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level of impactof NPAson the selected performancesvariableexcept
repaymentof deposits, capital adequacy ratio, ability of finance to other
profitable venturesand considerablereduction in advancesof banks. 245
5.8.4 OPINION ON EFFECTIVENESS OF VARIOUS RECOVERY MEASURES
5.8.4.1 Allthe given recovery channels are used by the branch managers
regarding recovery of NPAsbut Bankadalatthe recently introduced channel
by the RBIfor recovery of NPAshas been used only by 24 percentof sample
branch managers. 5.8.4.2 In the opinion of the bank managers, for effective
recovery of NPAs, CompromiseSettlement Scheme ranked as first followed by
enforcementof security interest under SARFAESIAct, then by other means in
the followingorder: by visit to borrowers‟ premises, Recovery camp and One
Time Settlements(OTS) 5.8.4.3 Thereareno significant differencesbetween
bank groupsin the perceptions of their branch managerson the effectiveness
of recovery measuresrecommended by RBIand GovernmentexceptCivil
Court, Visit to borrowers‟ premisesand Sale through ARCs 5.8.4.4 Thereare
significant differencesamongthe branch locations, namely Metro, Urban,
Semi-urban and Ruralbranch in their opinion on effectivenessof NPAs
recovery measuresregardingCompromiseSettlement, Recovery camp and
Civil Courts. 5.8.5 OPINION ON SUPPORTFROM VARIOUS AGENCIES
REGARDING RECOVERY OFNPAs 5.8.5.1 Themajority (84 percent)of branch
managershave the supportfrom Head office in the recovery of NPAsfollowed
by Co-bankers(72percent), Government agencies(64 percent) and Trade
associations and other agencies (48 percent) 5.8.5.2 Themajority (72
percent) of branch managers have the supportfrom Cobankers in the
recovery of NPAs and such a supportor lock of it has no significant 246
association with the bank groupsand there is a significant association
between opinion on supportfrom co- bankersand branch locations. 5.8.5.3
The majority (84 percent)of branch managers have the supportof head office
in the recovery of NPAsand such a supportor lack of it has no significant
association with the bank groupsin which they work and their areas of
operations. 5.8.5.4Themajority (64 percent)of branch managers have the
supportof Government agenciesin the recovery of NPAsand such a support

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or lack of it has no significant association with the bank groupsand there is a
significant association between opinion on supportfrom government
agencies and branch locations. 5.8.5.5 Themajority (52 percent)of branch
managersdo not have the supportof Trade associations in the recovery of
NPAsand such a supportor lack of it has no significant associations with the
bank groupsin which they work and their areas of operations. 5.8.6 OPINION
ON ISSUES ON MANAGEMENTOFNPAs In the opinion of the branch
managersregarding the management of NPAs, provision of the SARFAESIAct,
waiver of loan to be abolished, analysis of financial statement of borrowers,
appraisalof the amountand timing of cash flowsare given highest ranking
and the agriculturalloans below Rs. 1lakhand unsecured loanswhich are out
side the purview of SARFAESIAct has been ranked as low. 247 5.8.7 OPINION
ON SUGGESTIONS FOR EFFECTIVE MEASURESTO AVOID/MINIMIZE THE
LEVEL OF NPAs 5.8.7.1In theopinion of branch managers regarding,
maintainingcontinuousrapport or relationship with borrowers, compromise
settlement Scheme, regular monitoring of loan accounts, inspection of the
businessunits, case by case analysis, publishing the list of willfuldefaulters
through CIBILare given highest rankingas far as the effective measuresto
avoid/minimizeNPAsare concerned. However, the lowest rankingis given to
moretransparenciesin the granting of loans and reduction of priority sector
lending. 5.8.7.2Whilethereare significant differencesbetween the bank
groupsin their opinion on suggestions for effective measuresto avoid/
minimizethe level of NPAssuch as maintainingcontinuousrapport/
relationship with borrowers, makingthe bank staffs moreresponsible,
effective CorporateGovernanceand reduction of priority sector lending,
there are no significant differencesamongthe bank groupsin their opinion
with regard to all other suggestions for effective measuresto reducethe level
of NPAsat branch level. 5.8.7.3 Thereis significant differencesamongbranch
locations in their opinion on reconstruction of advances, case by case
analysis, publishing the list of willful defaultersthrough CIBIL, avoiding
political interferencein the granting of loans, making the borrowersmore
responsibleand accountable, proper pre-sanction appraisaland effective

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corporate governance, butthere are no significant differencesamongthe
branch locations in their opinion on all other suggestions for effective
measuresto reducethe level of NPAsat branch level. 5.8.8 OPINION ON THE
REASONS FOR DECLINE IN THE LEVEL OF NPAsSINCE 2002 248
Improvementin quality of advancesin the recovery of non performingassets
has been accorded the highest importancefollowed by improvementin credit
appraisalmade by Credit Risk ManagementSystem in the banks as the
second most importantreason, legal measuresand personaleffort of
managersand staffs in the recovery of NPAsare considered asthe other
importantreasonsfor decline in the level of non performingassets of banks,
write-off of non performingassets has been given the least rank. 5.8.9
OPINION ON GENERALCOMMENTSAND SUGGESTIONS The branch
managershave agreed to the largest extent with the statement like „loans
sanctioned under governmentsponsored schemesturn into NPAsthan other
categories‟ followed by „the banking reformshavehelped in improving
productivity and efficiency of the economy and increasingthe
competitivenessof banks‟ and „NPAs cannotbe eliminated totally. Similarly,
the managersare in the least favourableto reducingthe NPAsnormsfrom
90daysto 60daysso as to increase the quality of advances. 5.8.10.
SUGGESTIONS Based on the major findingsof the study, the following
suggestions are offered to have effective credit risk management system to
control the NPAsand increase the profitability and productivity of the banks.
5.8.10.1. SUGGESTIONSTOTHE GOVERNMENTOFINDIA AND RBI
5.8.10.1.1A highpowered committee on the credit risk managementsystem to
oversee the management of NPAs comprisingof legal expertsand a peer team
who have wideknowledgein the field of global financial sector should be
setup. The proposed committeeshould also addressthe effective CreditRisk
Management System to overseethe Credit depositRatio, Capital Adequacy
Ratio and the NPAs related issues especially on unsecured advances, priority
sector lending, micro financing, secured advancesand the likes. 249
5.8.10.1.2Managementof NPAsrequiresspecialized skill and knowledge,
most of the Foreign Banksare engaging professionalagencies right from the

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stage of identification of genuineborrowerstill the recovery of advances.
However, banksin Indiaare not permitted at presentto engage such
agencies. If they are permitted to use such agencies in the effective
managementof credit risk, it would reducethe cost of managingsuch funds
and thus to enhance competitiveness in financing. International experiences
also show a positive sign on the engagement of professionalagencies by the
banks. 5.8.10.1.3Theconceptof securitization is at presentgetting
momentum world wide. Itgives mutualbenefits to the lendersand borrowers
on the effective utilization of funds. Hence, RBIshould formulatean ideal
framework, keeping in mind the global scenario for securitization of stressed
assets of banking sector advancesto reducethe levelof NPAsat minimum
possible level. 5.8.10.1.4TheRBIinsists that all banks be subjected to
assessment and accreditation by a special rating agency approved by RBI. The
NPAslevel should be oneof the criteria for evaluatingthe performanceof the
banks. Based on this, banks would be given grades by the rating agencies.
This will improvethe image and ultimately help the stakeholders of the
banking industry. 5.8.10.1.5Thesharingof credit information is vital for
banks. Hence, the functioning of CIBILshould be strengthened to facilitate
smooth flow of credit information among the banks and guidelinesshould be
sent to all the bankscompulsorily, credit information about their borrowers
should be supplied to CIBIL. 5.8.10.1.6TheARCILhas been playinga critical
role in the sale of NPAsof the banks. Hence, permission should be given for
setting up morenumbersof ARCs 250 and banksmustbe encouraged to sell
this stressed asset to ARCs. This will also reducethe burden of bank
employeeswho are engaged in the recovery process. 5.8.10.1.7 Atthe
present, the percentage of recovery of NPAsthrough Civil Courts is highly
time consuming, more DRTsshould be setup to speed up the recovery of
NPAs. Existing DRTsshould be strengthened in terms of infrastructure, staff
and expertise. 5.8.10.2SUGGESTIONSTOTHE BANKERS 5.8.10.2.1The
borrowersshould be educated that repaymentof loansis their social
responsibility. For this purpose, an association of borrowersat branch level
should be organized to inculcate the accountability of borrowersto repay the

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loans promptly. Theproposed association should also addressgrievancesand
inconvenienceof the borrowersin the repaymentof loans. Besides, it should
also act as supplier of information to the borrowers. 5.8.10.2.2Thebank
should formulatea comprehensivecredit insurancescheme especially for
priority sector lendingand governmentsponsored schemein order to make
good the losses on account of NPAs. For this there should be a proper
coordination between bank and the governmentagencies to solveproblems
associated with the NPAs. Besides, a separate CreditRisk ManagementSystem
should be established in every branch to monitor the stressed loan accounts
under priority sector and governmentsponsored scheme. 5.8.10.2.3Incase
the borrower‟sability to repay the duesand banker‟s ability to recover the
same are limited, it would be better to organize moreRecovery camps,
CompromiseSettlements Scheme and Lokadalats. The Bankersshould take
adequate measuresto strengthen banker‟s customer relationship. The branch
manager should be given sufficient powersto accept the compromise
proposals 251 worked outat the Lokadalats within the broad policies and
guidelinesof each individualbank at ruraland semi-urban areas. 5.8.10.2.4
The SARFAESIAct has given the required power to fight the menaceof the
NPAsfor effective recovery of NPAs; the banksshould initiate the legal action
under this act where there is no room for CompromiseSettlement.
5.8.10.2.5Thequality of loan assets ensuresthe profitability and
competitivenessof the bank. Hence, bank should be very cautious in
identifyinggenuineborrowersand ask them to providecompleteinformation
to be stored in a database and monitor the loan accountsclosely to prevent
slippage of loan accounts into NPAscategory. 5.8.10.2.6Eachbank should set
up separate ARCsto take over the bad and doubtful debts at a discountso
that the responsibility of managingNPAscan be minimized. 5.8.10.2.7In the
case of loan accounts whererecovery is affected by temporary problemsor
naturalcauses, necessary steps should be taken by the branch managersfor
reschedulingor restructuringof such loan accounts before they slip into
NPAscategory. Slippages from standard assets to NPAscategory should be
regularly monitored and recovery measuresshould be intensified to prevent

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such slippages in future. 5.8.10.2.8Know Your Customer (KYC)normsshould
be implemented very strictly by every bank, since the decision regarding
sanctioning of loans dependsupon the information available about the
integrity of character, capacity, family background, knowledge, technical
competence, managerial capabilities, initiative and market standingof the
borrowers, the banksshould maintain a proper information system usingthe
information technology. 252 5.8.10.2.9Theexperiencesof branch covered in
the presentstudy indicate the recovery of NPAsis possible if adequate care is
taken by the bank officials. Hence, there should be pragmatic approach,
sincerity and involvementon the part of the branch officials. They should
shoulder the responsibility of recovery more enthusiastically and
confidentially. 5.8.10.2.10Thebank should makevigorouseffort to strengthen
the internalcontrol and risk managementsystem and set up early warning
signals to detect the NPAsat the early stage and initiate necessary actions.
5.8.10 .3 SUGGESTIONSTOTHE BORROWERS Willfuldefaultsand diversion
of fundsarethe major reasonsfor chronic NPAs. To avoid this, a quality circle
should be formed amongborrowersin consultation with bankers. Defaulters
should be prompted by fellow borrowersin regulating their loan accounts.
The quality circle should be created for healthy practices among the
borrowers in the repaymentof loans. A self controlmechanism as a partof
quality circle should be evolved to avoid willfuldefaultand diversion of
funds. CONCLUSION In the presentstudy, a sincere attempt has been made to
analyzethe parametersof CreditRisk ManagementSystemsto overseethe
managementof NPAsby banksand together the experiences of branch
managersof both Public and PrivateSector Bank groupsin metro, urban,
semi-urban and ruralareas which suggest that recovery of NPAs 253 willbe
moreeffective if proper care is taken by bank officials in shoulderingthe
recovery drivemoreenthusiastically and confidently. TheSARFAESI Act has
significant positive implication in the recovery of NPAsby banks. With the
passage of the Enforcementof Security Interest and Recovery of Debt Laws
(Amendment)billon 7th December 2004 by the CentralGovernment, the
recovery of NPAs has improved significantly. The success of credit risk

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managementrequires maintenanceof proper credit risk environment, credit
strategy and policies to manage the credit risk. Thus the ultimate aim is to
protect and improvethe loan quality to reducethe level of NPAs.

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