Principles of Credit: Theory and Application

INTRODUCTION: CREDIT AS AN INDEPENDENT DISCIPLINE

Credit is not a mechanical extension of finance, accounting, or banking operations. It is an independent professional discipline grounded in judgment, prudence, and ethical responsibility. While finance focuses on optimization of returns and accounting emphasizes measurement and reporting, credit concerns itself primarily with preservation of capital and certainty of repayment. A credit manager deals with uncertainty, asymmetry of information, and human behavior, making credit appraisal a complex decision-making process rather than a formula-driven exercise. The history of banking crises in India and abroad establishes that failures have primarily arisen from dilution of credit discipline rather than shortage of liquidity. A credit manager therefore acts as a trustee of public funds and must approach every proposal with caution, skepticism, and independence. This responsibility assumes greater significance in a regulated banking environment where systemic stability is paramount.

Credit decisions involve long-term commitments, often extending over economic cycles, regulatory changes, and business transformations. The task of a credit manager is complicated by pressure for business growth, competition, and internal targets. Assuming the role of a credit manager without understanding its fiduciary nature leads to compromised asset quality. Therefore, credit must be approached as a separate body of knowledge with its own principles, tools, jurisprudence, and ethical foundations.

CONCEPT AND NATURE OF CREDIT

Credit is defined as the contractual provision of funds with the expectation of future repayment along with compensation for time value and risk. The two fundamental pillars of credit are willingness and ability to repay. Credit risk arises when either of these pillars weakens. Unlike market risk, credit risk is borrower-specific and cannot be fully diversified away. In Indian banking, credit risk constitutes the largest component of risk-weighted assets and directly impacts capital adequacy.

Credit risk management involves identification, measurement, mitigation, monitoring, and control of borrower-related risk. RBI guidelines on prudential norms emphasize early recognition of stress and prompt corrective action. Chartered accountants play a vital role in this ecosystem through financial analysis, certification, audit, and advisory functions.

THE FIVE CORE PRINCIPLES OF CREDIT

1. PRINCIPLE OF CHARACTER

Character represents the moral integrity, honesty, and intention of the borrower to repay obligations. It addresses the fundamental question: whether the borrower will repay, even if capable. Character assessment is qualitative and judgmental, yet it is the most critical element of credit appraisal. RBI’s Master Circular on Wilful Defaulters underscores that intentional non-payment despite capacity reflects serious character deficiencies.

Tools used to assess character include credit information reports from CIBIL, Experian, Equifax, and CRIF High Mark. Past repayment history, frequency of defaults, restructuring behavior, and settlement patterns reveal borrower intent. Bank account conduct analysis, including cheque returns and overdraft behavior, provides additional insight. Legal searches, litigation history, and regulatory compliance record further supplement character assessment.

Indian jurisprudence recognizes the primacy of borrower intent. In Central Bank of India vs Ravindra (2002), the Supreme Court emphasized equitable conduct in credit relationships. In State Bank of India vs Jah Developers (2019), principles of natural justice were emphasized in classifying borrowers as wilful defaulters. These rulings reinforce that character assessment must be fair, evidence-based, and documented.

A real-life example involves a promoter-controlled group where multiple entities defaulted sequentially after fund diversion. Despite adequate security, repeated defaults revealed systemic character failure, validating the maxim that bad character can destroy even well-secured loans.

2. PRINCIPLE OF CAPACITY (REPAYMENT ABILITY)

Capacity refers to the borrower’s ability to generate sufficient and sustainable cash flows to service debt. Capacity assessment transforms accounting data into forward-looking credit judgment. It is evaluated through income stability, cash flow adequacy, and sensitivity to adverse conditions.

For salaried borrowers, tools include salary slips, Form 16, bank statements, and employer profile. Fixed obligation to income ratio (FOIR) is used to determine repayment comfort. For business borrowers, audited financial statements, income tax returns, GST returns, and projected cash flows are analyzed. Key ratios include Debt Service Coverage Ratio (DSCR), Interest Coverage Ratio, and EBITDA margins.

Numerical Illustration:
A manufacturing firm reports EBITDA of ₹80 lakh, interest obligation of ₹30 lakh, and principal repayment of ₹20 lakh. DSCR = 80 / 50 = 1.6, indicating adequate capacity. However, a 25% decline in revenue reduces EBITDA to ₹60 lakh, reducing DSCR to 1.2. This sensitivity highlights vulnerability during downturns.

RBI guidelines require banks to assess repayment capacity based on realistic cash flows and not merely on collateral value. Failure to do so has been a recurring cause of NPAs.

3. PRINCIPLE OF CAPITAL

Capital represents the borrower’s financial stake and risk absorption capacity. It reflects the extent to which the borrower shares risk with the lender. Higher capital contribution indicates commitment and alignment of interest.

Capital is assessed through net worth statements, balance sheet analysis, and capital structure evaluation. Debt-equity ratio, tangible net worth, and promoter contribution norms are critical appraisal parameters. RBI project finance guidelines mandate minimum promoter contribution to ensure skin in the game.

Case Study:
Two infrastructure firms with identical cash flows approach banks for funding. Firm A has debt-equity of 1:1, while Firm B has 3:1. Despite similar profitability, Firm B is more vulnerable to stress due to thin capital cushion. Historical NPA analysis confirms that over-leveraged entities fail earlier during downturns.

4. PRINCIPLE OF COLLATERAL / SECURITY

Collateral provides a secondary source of repayment and mitigates loss severity, not default probability. Security includes tangible assets such as land, building, plant, and machinery, and intangible support such as guarantees.

Security assessment involves valuation, legal due diligence, enforceability, and liquidity analysis. RBI cautions against overreliance on collateral without cash flow support. The SARFAESI Act, 2002 provides enforcement mechanism, but realization delays and value erosion limit effectiveness.

In Transcore vs Union of India (2008), the Supreme Court clarified the complementary nature of SARFAESI and DRT mechanisms. In practice, however, collateral realization often takes years, reinforcing the primacy of capacity over security.

5. PRINCIPLE OF CONDITIONS

Conditions refer to external factors affecting repayment, including economic cycles, industry trends, regulatory changes, and technological disruptions. Credit appraisal must incorporate macroeconomic and sectoral analysis.

For example, lending to real estate developers post-RERA requires understanding regulatory compliance risk. RBI’s sector-specific exposure norms and stress testing guidelines address condition-related risks.

The COVID-19 pandemic demonstrated how external shocks can impair otherwise healthy borrowers. Moratorium schemes and restructuring frameworks highlighted the importance of condition analysis in credit decisions.

ADDITIONAL PRINCIPLES: CONSISTENCY AND CONDUCT

Consistency in income, operations, and behavior enhances credit confidence. Frequent restructuring, volatility in earnings, and unstable business models indicate elevated risk. Bank statement analysis reveals liquidity discipline and operational behavior.

TOOLS AND TECHNIQUES IN CREDIT APPRAISAL

Credit appraisal employs quantitative and qualitative tools. Credit rating models convert multiple parameters into risk scores. Financial analysis includes trend, ratio, and cash flow analysis. Site visits, stock inspections, and third-party verifications validate information.

Post-disbursement monitoring tools include covenants, periodic financial reporting, SMA classification, and Early Warning Signals (EWS). RBI’s Framework for Resolution of Stressed Assets emphasizes timely identification and resolution.

NPA JURISPRUDENCE AND REGULATORY FRAMEWORK

Indian NPA jurisprudence has evolved through RBI circulars and judicial pronouncements. The Asset Quality Review (AQR) initiated by RBI in 2015 reinforced transparent recognition of stress. Insolvency and Bankruptcy Code (IBC), 2016 transformed credit recovery by shifting focus from borrower protection to creditor rights.

In Swiss Ribbons vs Union of India (2019), the Supreme Court upheld the constitutional validity of IBC, recognizing its role in credit discipline. The Essar Steel judgment reinforced primacy of commercial wisdom of creditors.

ROLE OF CHARTERED ACCOUNTANTS IN CREDIT ECOSYSTEM

Chartered accountants contribute through credit appraisal, forensic audits, concurrent audits, and resolution advisory. Their expertise enhances objectivity, compliance, and analytical rigor in credit decisions.

CONCLUSION

The principles of credit are timeless and universal, yet their application requires contextual understanding, regulatory awareness, and ethical grounding. Dilution of any single principle can jeopardize asset quality. For chartered accountants and bankers alike, mastering credit principles is essential for safeguarding institutional stability and public trust.

Addendum: Expanded Regulatory and Jurisprudential Analysis

EXPANDED SECTION: EVOLUTION OF RBI CIRCULARS ON CREDIT DISCIPLINE

The regulatory framework governing credit in India has evolved progressively through a series of Reserve Bank of India circulars, master directions, and supervisory interventions. In the early phase of banking regulation, credit appraisal was largely institution-driven with limited standardisation. However, rising non-performing assets compelled RBI to introduce prudential norms on income recognition, asset classification, and provisioning in the early 1990s. These norms fundamentally altered credit behaviour by mandating objective recognition of stress rather than subjective managerial discretion. Subsequent circulars on exposure norms, group borrower limits, and sectoral caps further institutionalised risk containment.

The introduction of Special Mention Accounts (SMA) and Early Warning Signals (EWS) marked a paradigm shift from reactive to proactive credit management. RBI required banks to identify incipient stress even before default, thereby reinforcing the principle that credit risk begins much earlier than non-payment. Circulars on restructuring frameworks, including CDR, JLF, and later the June 7, 2019 Prudential Framework for Resolution of Stressed Assets, emphasised time-bound resolution and disallowed regulatory forbearance. These regulatory measures directly embedded credit principles into enforceable supervisory architecture.

EXPANDED SECTION: IBC JURISPRUDENCE AND CREDIT BEHAVIOUR

The Insolvency and Bankruptcy Code, 2016 represents a watershed moment in Indian credit jurisprudence. Prior to IBC, credit enforcement was fragmented across SARFAESI, DRTs, and civil courts, resulting in delays and value erosion. IBC introduced a creditor-in-control model, fundamentally altering borrower behaviour and credit pricing. Judicial pronouncements under IBC have consistently reinforced commercial wisdom of creditors, thereby strengthening credit discipline.

In Swiss Ribbons v. Union of India, the Supreme Court recognised that timely resolution maximises asset value and improves credit culture. In Committee of Creditors of Essar Steel v. Satish Kumar Gupta, the Court affirmed that courts should not interfere with commercial decisions of lenders. These rulings embolden credit managers to enforce discipline without fear of judicial second-guessing. IBC has thus operationalised the principle of consequences, making character and intent legally enforceable rather than merely moral constructs.

EXPANDED SECTION: CREDIT RATING MODELS AND INTERNAL RISK GRADING

Credit rating models translate qualitative credit principles into quantifiable risk metrics. Indian banks employ internal rating based approaches (IRB) aligned with Basel norms. These models incorporate borrower financial strength, industry risk, management quality, and conduct indicators. Weightages assigned to character, capacity, capital, and conditions reflect institutional risk appetite. Credit ratings influence pricing, exposure limits, and capital allocation.

For example, a borrower rated BBB may attract higher risk premium and closer monitoring compared to an A-rated borrower. Migration analysis tracks deterioration or improvement in credit quality over time. However, overreliance on models without judgment has proven dangerous. RBI supervisory reviews have repeatedly cautioned that models must supplement, not replace, human appraisal. Thus, credit rating systems are tools of discipline, not substitutes for professional skepticism.