Formulation of Credit Policy, Meaning

Credit Policy refers to the guidelines and rules framed by a business to regulate the granting and management of credit to customers. It decides who should be given credit, how much credit can be allowed, and the time period for repayment. A well-defined credit policy helps balance sales growth and risk control. In India, where delayed payments are common, credit policy plays an important role in controlling bad debts and maintaining cash flow. It includes terms of credit, credit standards, collection procedures, and credit control measures. An effective credit policy ensures financial stability, improves customer discipline, and supports smooth business operations.

Formulation of Credit Policy:

1. Credit Standards

Credit standards define the minimum requirements a customer must meet to receive credit. They include checking the customer’s financial position, payment history, creditworthiness, and market reputation. In India, businesses often face delayed payments, so strict credit standards help reduce risk of bad debts. Too strict standards may reduce sales, while too liberal standards may increase defaults. Proper credit standards balance sales growth and risk. They help decide whether to grant credit or demand advance payment. Well-framed standards protect the company’s cash flow and ensure safe extension of credit to reliable customers.

2. Credit Terms

Credit terms specify the conditions under which credit is given. They include the credit period, cash discount, and penalties for late payment. For example, offering a discount for early payment encourages customers to pay on time. In India, clear credit terms reduce disputes and improve collections. Flexible terms may increase sales, while strict terms reduce risk. While formulating credit terms, businesses consider industry practices, customer capacity, and competitive conditions. Proper credit terms help maintain liquidity, reduce overdue accounts, and ensure timely inflow of cash.

3. Credit Limit

Credit limit refers to the maximum amount of credit allowed to a customer. It is fixed based on the customer’s financial strength, past payment record, and business volume. In India, fixing suitable credit limits is essential to control exposure to risk. A high credit limit may increase sales but also raises the risk of default. A low limit controls risk but may affect customer satisfaction. Proper credit limits help businesses manage receivables effectively, avoid over-crediting customers, and ensure better control over outstanding dues.

4. Collection Policy

Collection policy determines how and when the firm will collect dues from customers. It includes reminder notices, follow-up calls, personal visits, and legal action in case of non-payment. In India, a systematic collection policy is important due to frequent delays in payments. A polite but firm approach helps maintain customer relations while ensuring recovery of dues. Efficient collection policy improves cash flow, reduces bad debts, and shortens the collection period. It also provides clarity to staff on actions to be taken for overdue accounts.

5. Credit Control and Review

Credit control and review involve continuous monitoring of customer accounts and reviewing their credit performance. It includes checking overdue balances, revising credit limits, and identifying slow payers. In India, regular review helps detect early warning signs of default. Based on performance, credit terms can be tightened or relaxed. Effective control ensures timely action on problem accounts, reduces financial risk, and maintains liquidity. Periodic review also helps in improving credit policy and adapting it to changing market and economic conditions.

Perquisites of good Credit Policy:

1. Clear Objectives & Risk Appetite Framework

A sound policy begins with defined objectives aligned with the bank’s business strategy—whether targeting growth, stability, or niche segments. It must establish a formal Risk Appetite Framework, quantifying how much risk (sectoral, borrower-wise, product-wise) the institution is willing to take. This includes setting exposure limits for single borrowers, groups, and industries. Clear objectives prevent ad-hoc lending and ensure every credit decision supports the bank’s long-term health and regulatory compliance, balancing opportunity with prudent risk containment.

2. Robust Credit Appraisal & Due Diligence

The policy must mandate a structured, multi-layered appraisal process. This includes thorough analysis of the 5 Cs of Credit (Character, Capacity, Capital, Collateral, Conditions), verified through financial statements, bank records, credit bureaus (CIBIL), and site visits. For retail loans, automated underwriting can be used with manual overrides. Rigorous due diligence minimizes information asymmetry, ensures loans are given based on repayment capacity rather than collateral alone, and forms the first line of defense against future NPAs.

3. Defined Pricing & Loan Structuring Guidelines

Credit pricing must reflect risk. The policy should provide a transparent pricing model that factors in the borrower’s risk profile (credit score), cost of funds, operational costs, and tenor. It must outline rules for loan structuring: appropriate tenure, repayment schedule (bullet, EMIs), and collateral requirements. Guidelines should specify conditions for offering floating vs. fixed rates, moratorium periods, and covenants. This ensures profitability, fair treatment of borrowers, and reduces disputes.

4. Comprehensive Documentation & Legal Compliance

A strict documentation protocol is non-negotiable. The policy must list all mandatory legal and security documents (agreements, charge creation, guarantees) for each loan type, ensuring enforceability. It must incorporate regulatory compliance from RBI, SEBI, and other relevant bodies—including KYC/AML norms, PSL targets, and reporting standards. This protects the bank in case of default, minimizes legal challenges, and avoids regulatory penalties that can damage reputation and finances.

5. Proactive Monitoring & Review Mechanisms

The policy must mandate continuous monitoring, not just annual reviews. This includes tracking financial covenants, end-use of funds, and early warning signals (EWS) like delayed payments or falling sales. It should define portfolio review frequency and triggers for moving an account to a “watch list.” Early detection of stress allows for timely restructuring, preventing accounts from slipping into NPA. Effective monitoring is dynamic and data-driven.

6. Well-Defined Recovery & NPA Management

The policy must have a clear, graded recovery process—from gentle reminders and restructuring options to legal action under SARFAESI. It should outline the NPA identification timeline (90+ days overdue), provisioning requirements, and the roles of recovery teams. Including guidelines for one-time settlements and write-offs ensures consistency and limits discretion. A strong recovery framework maximizes recoveries, cleans the balance sheet, and deters willful default.

7. Roles, Responsibilities & Governance

A clear governance structure assigns credit approval authority at various levels (officer, committee, board) based on loan size and risk. It defines the roles of the Credit Department, Risk Management, and Internal Audit. A Credit Policy Committee should regularly review and update the policy. This ensures accountability, prevents concentration of power, and embeds a culture of responsible lending throughout the organization.