Risk Identification and Assessment of Limits
Credit Risk in non-fund based business of banks need to be assessed in a manner similar to the assessment of fund based business since it has the potential to become a funded liability in case the customer is not able to meet his commitments. Financial guarantees are generally long term in nature, and assessment of these requirements should be similar to the evaluation of requests for term loans. As contracts are generally for a term of 2-3 years, banks must obtain cash flows over this time horizon, arising from the specific contract they intend to support, and determine the viability of financing the contract.
Risk Monitoring and Control
For reducing credit risk on account of such off balance sheet exposures, banks may adopt a variety of measures some of which are indicated below:
- Banks must ensure that the security, which is available to the funded lines, also covers the LC lines and the guarantee facilities. On some occasions, it will be appropriate to take a charge over the fixed assets as well, especially in the case of long-term guarantees.
- In the case of guarantees covering contracts, banks must ensure that the clients have the requisite technical skills and experience to execute the contracts. The value of the contracts must be determined on a case-by-case basis, and separate limits should be set up for each contract. The progress vis-à-vis physical and financial indicators should be monitored regularly, and any slippages should be highlighted in the credit review.
- The strategy to sanction non-fund facilities with a view to increase earnings should be properly balanced vis-à-vis the risk involved and extended only after a thorough assessment of credit risk is undertaken.