CREDIT RISK MANAGEMENT

BY
SUJIR PRABHAKAR
VISITING PROFESSOR
 INTRODUCTION
Credit risk management involves assessing risk by
evolving suitable and effective systems.
This includes evolving credit policy, credit risk
policy and procedures for credit dispensation.
Credit risk is defined as the possibility of loss
associated with diminution in the credit quality of
borrowers/counterparty.
Under this portfolio losses arise from default due
to inability or unwillingness of a borrower or
counter party to fulfil his commitment.
 INTRODUCTION
Such defaults are possible in lending, trading,
settlement and other financial transactions.
Credit risk may emanate from a banks
dealings with individual, corporate, bank,
financial institution or a sovereign.
Credit risk manifests when there is a decline
in the credit standing of an issuer of bond or
debenture.
 INTRODUCTION
Credit risk will not crystallize immediately but
sent strong signals of probability of default.
Such decline often increases the expected
returns and thereby decline in price and liquidity.
The treatment of credit risk is different for a loan
or an investment.
Defaults leads to total or partial loss of amount
involved. Delay in payment also results in loss of
income on account of possible delay in
reinvestment plan.
 CREDIT RISK MANAGEMENT
Credit risk management has two categories
preventive steps and risk management steps.
Preventive steps are due diligence, thorough
appraisal.
Bank should have appropriate appraisal
process to avoid credit risk.
Miss-selling often results in poor credit
performance.
 CREDIT RISK MANAGEMENT
Concentration risk is another major risk area
that can result in default.
To mitigate this types of credit risk, banks
must have appropriate exposure norms.
Exposure norms are fixed for individuals,
groups and industry wise.
Collaterals are one of the risk management
tools.
 CREDIT RISK MANAGEMENT
collateral and collateral efficiency play a
crucial role.
Insurance cover is another risk mitigation tool.
Now a days credit insurance plays a major
role in covering credit default risk in banks.
Among other things appropriate interest rate
also plays a crucial role in credit risk
management.
 CREDIT RISK MANAGEMENT
Well defined Income Recognition and asset
classification policy is the core component of
credit risk management.
This not only helps bank to maximise its profits
by effective and efficient recovery techniques but
also helps bank to avoid slippages in NPA status
of assets.
Credit risk management comprises identification,
measurement, monitoring and mitigation of risk
exposures.
 OBJECTIVES
To evolve an integrated framework for charting/
categorizing various types of loans and advances
to determine quality of credit risk.
Draw up suitable strategies at the top level to
attain prescribed level/quality of exposure and
issue guidelines to strategic Business Units (SBUs)
Review the exposures and performances
periodically.
Devise suitable control and monitoring
mechanism.
 OBJECTIVES
Evolve and refine analytical tools to assess
risk profiles for ensuring healthy portfolios
and guarding against sickness.
IMPORTANT REQUIREMENTS AT MACRO
LEVEL:
Preparation of sound credit policy and
procedures.
Development and implementation of risk
assessment systems.
 OBJECTIVES
Monitoring concentrations
Portfolio management
Implementation of system.
REGULATORS EXPECTATION FROM BANKS:
Policy frame work.
Credit rating frame work.
Portfolio management and risk limits.
Managing credit risk in inter bank exposure.
 REGULATORS EXPECTATIONS
Credit risk in off balance sheet exposure.
Country risk.
Loan review mechanism/credit audit.
ROROC pricing/economic profit.
Basel II accord implications for credit risk
management.
Appropriate structures/systems.
 CREDIT RATING FRAME WORK
External credit rating agencies like CRISIL,
CARE,ICRA,Etc provide ratings to high ticket
credits, issue of bonds by companies and
banks.
This is a particular type of rating and takes in
to account performance of issuer in a given
context and the ability of issuer to manage a
change.
 CREDIT RATING FRAME WORK
The success of credit rating will depend upon
Critical evaluation of credit appraisal, follow up
and risk management system.
ensuring risk management system is oriented
towards their requirements dictated by the size
and complexity of business, risk philosophy,
market perception and expected level of capital.
Initiating necessary steps with the approval of
their board to eliminate gaps if any in compliance.
 ROLE OF TOP MANAGEMENT
Setting policies for assuming and managing
credit risk.
Review of credit appraisal systems, credit
policy manual and credit policy and
procedures and approving changes.
Approving policies for compromises, write
offs and management of NPAs and review of
portfolio periodically.
 ROLE OF TOP MANAGEMENT
Dealing with issues relating to delegation of
financial powers to various officials of a bank
but with in the overall parameters approved
by the banks board.
Setting parameters for credit portfolio in
terms of exposure limits for industry, regions
and groups.
Setting prudential norms for individual
borrowers.
 ROLE OF TOP MANAGEMENT
Deciding prudential limits for large credit
exposures, standards for collaterals, pricing,
provisioning, etc.
Setting parameters/guidelines for new credit
products and modifications.
Developing appropriate MIS and standards
for presentation of credit proposals, financial
covenants, rating standards and bench marks.
 BALANCE SHEET AND OFF BALANCE
SHEET EXPOSURES
Greater focus is given for financial stability of
banks and banking system.
The efforts in risk management is to bring in a
method so as to measure exposures in a
uniform way.
The risk weights formed the basis of arriving
at the capital required to manage credit risk.
Under Basel II banks are expected to maintain
capital against risk weighted assets.
 BALANCE SHEET AND OFF BALANCE
SHEET EXPOSURES
Banks exposure is categorized in to two major
heads balance sheet and off balance sheet
exposures.
Balance sheet items related to fund based assets
and off balance sheet items are non fund based
assets.
Off balance sheet exposures are those in the
form of financial commitments will become
liabilities to bank remains contingent upon future
events.
 BALANCE SHEET AND OFF BALANCE
SHEET EXPOSURES
Such future contingencies have high credit risk on
account of their uncertainty.
It was recommended in Basel II accord for
provision of capital for off balance sheet items
also.
Every asset appearing in the banks balance sheet
has to be assigned risk weight.
The risk weight enables banks for estimation of
capital requirement for specific identified
exposure of banks.
 ASSIGNMENT OF BALANCE SHEET
EXPOSURES
Under standardized approach for calculating
risk weights, 13 types of sectors are identified.
Sovereign exposure government of a country
Non government public sector entities (PSEs)
Multi development banks (MDBs)
Banks
Securities firms
Corporate
Retail portfolios
ASSIGNEMENT OR BALANCE SHEET
EXPOSURES
Residential properties
Commercial real estate
Non performing loans
High risk categories
Other assets
Off balance sheet exposures (LCs, BGs) to be
converted in to credit conversion factors.
 RISK RATING AND RISK PRICING
RBI desires all banks to have their own credit
rating system and a credit pricing system
based on such rating.
Banks have already internalized credit rating
system by developing their own modules or
by introducing rating modules developed by
rating agencies like CRISIL, FITCH, ICRA, CARE
and other authorized rating agencies by the
RBI.
 RISK RATING AND RISK PRICING
All the banks are expected to have a
comprehensive risk scoring/rating system that
serves as a single point indicator of diverse risk
factors of counter party to take credit decisions.
Standardization is required to be developed and
adopted by banks in rating of borrowers.
The risk rating system should be designed to
reveal overall risk of lending, critical inputs for
pricing and non pricing terms of loans and
information for review and management of loan
portfolio.
 RISK PRICING
Risk pricing is a fundamental tenet of risk
management.
Borrowers with weak financial position are
place in high risk category and priced high.
Banks have evolved proper and scientific
systems to price the risk by introducing risk
rating modules for various category of
borrowers.
 RISK PRICING
Probability of default (PD) is derived from the
past behaviour of the loan portfolio measured in
terms of loss provision/write offs for the past 5
years.
Banks have to build historical data base on the
portfolio quality and provisioning/write offs to
price the risks.
Pricing is also done on the basis of value of
collateral, market forces, perceived value of the
account, future business potential, portfolio/
industry exposure and other reasons.
 RISK PRICING
Risk pricing means the cost of possible default is
factored.
The pricing has a direct bearing on the risk rating
of a borrower.
Risk rating is also called credit rating. These
ratings influence price and demand for certain
securities like bonds.
Lower the credit rating riskier is the investment
and higher the expectation on the yield.
 RISK PRICING
Lower ratings do not always result in default.
They only indicate higher risk associated with
an investment.
There is more potential for default possibly
ensure higher returns.
Speculators prefer such type of high risk
investments to increase the return on their
investments.
 RISK ADJUSTED RETURN ON
CAPITAL(RAROC)
RAROC frame work for pricing loans is based
on
Data on portfolio behaviour
Allocation of capital commensurate with credit
risk inherent in loan proposals
Charging an interest mark up to cover expected
loss
Allocating enough capital to the prospective loan
to cover unexpected loss
 PORTFOLIO MANAGEMENT
Bank should be in a position to identify the
strength and weaknesses of products and
group of credit so that over all portfolio can
be managed efficiently to maintain quality.
Different credit risk models are to adopted
for this purpose.
Credit portfolio is classified in to various risk
categories following credit rating principles.
 PORTFOLIO MANAGEMENT
Banks should have adequate data on borrowers
credit status and behaviour of the account in
regard to repayment and compliance of other
terms and conditions.
banks should have an effective system for
identification of credit impairment/weakness
well in advance.
Risk management department should be
entrusted with the responsibilities of periodic
monitoring of all credit portfolios.
 PORTFOLIO MANAGEMENT
One of the methods of evaluating credit rating is
assignment of symbols vogue in the market.
Data can be aggregated for review of different
portfolios like retail, agriculture, industrial, etc
for follow up action.
The process serves the purpose if borrower wise
ratings are updated periodically.
Up to date data gives useful insight in to the
nature and composition of loan book and
compare the changes on year on year basis.
 PORTFOLIO MANAGEMENT
In order to maintain the portfolio quality,
banks are expected to take the following:
Stipulate quantitative ceiling on aggregate
exposure in specific rating category.
Evaluate rating wise distribution of borrowers in
various industry/business segments.
Exposure to one type of industry/sector should
be evaluated on the basis of overall rating
distribution of borrowers in sector/group.
 PORTFOLIO MANAGEMENT
Banks should weigh the pros and the cons of
concentration by industry/group.
Whether portfolio exposure to any single industry
is not performing well, the banks may review the
same and consider the quality standards.
As a prudent planning measure, banks may have
targets for rating wise volume of loans, probable
defaults and provisioning requirements.
Banks, in an adverse economic situation,
undertake rapid portfolio reviews, stress tests.
 PORTFOLIO MANAGEMENT
Credit risk models should be put in place to
evaluate credit portfolio.
The credit risk models through the availability
of centralized data, should develop a frame
work for examining credit risk exposures.
The models are also to provide estimates of
credit risk capital required to be maintained
by banks.
 PORTFOLIO MANAGEMENT
Credit risk models also provide insight in to
the trend/direction of the risk of the bank
which could be used for corrective action pro
actively.
Loan review mechanism (LRM) is an effective
tool for evaluating the quality of banks loan
book.
It also brings about qualitative improvement
in credit administration.
 PORTFOLIO MANAGEMENT
OBJECTIVES OF LOAN REIVIEW MECHANISM:
Promptly identify the loans which develop credit weakness
for corrective action.
Evaluate portfolio quality/isolate potential problem areas.
Provide information for loan loss provision.
Assess the adequacy of and adherence to loan policies and
procedures.
Monitor compliance with the relevant laws/regulations.
Provide top management with information on credit
sanction process, risk evaluation and post sanction follow
up.
 PRUDENTIAL EXPOSURE LIMITS
OBJECTIVES:
Formation of credit policy committee (CPC) or
Credit Risk Management Committee (CRMC)
Loan policy and documentation
Principles of loan policy
Each bank is mandated to have a high
powered committee for taking decision in
credit area.
 PRUDENTIAL EXPOSURE NORMS
STRUCTURE OF THE COMMITTEE:
The committee should be headed by the
chairman/CEO/Executive Director/s.
The committee should comprise of the heads
of credit department, credit risk department,
treasury department and chief economist.
The committee has to deal with issues
relating to credit policy and procedures.
 PRUDENTIAL EXPOSURE LIMITS
To analyse, manage and control credit
formation of clear policies relating to credit.
PRUDENTIAL LIMITS:
Stipulate benchmark ratios with flexibility for
deviations.
Single group borrower limit
Substantial exposure limit
Maximum exposure limits to industry, sector,etc
 PRUDENTIAL NORMS
Maturity profile of loan books may also be
considered keeping in view the maturity risk.
LOAN POLICY AND ITS DOCUMENTATION:
Every bank should have a loan policy in place. The
policy should have the approval of the board. It
cover the following:
Standards for appraisal and presentation of credit
proposal, financial covenants, rating standards and
bench marks.
Delegation of credit approving powers.
 PRUDENTIAL EXPOSURE
Prudential limits on large credit exposure.
Asset concentration, standards for loan
collaterals, credit approving systems.
Portfolio management
Loan review mechanism.
Methodologies for measurement, monitoring and
control of credit risk.
 CAPITAL REQUIREMENT
Basel II has laid down the method of
calculating the minimum capital
requirements under its pillar I that covers
credit, market and operational risks.
Regulatory capital is the minimum capital
required by the regulator.
Capital should cover all the three risks
mentioned above.
 CAPITAL REQUIREMENT
Banks capital has two major heads Tier I and
Tier II.
Tier I capital is share holders equity and Tier II
capital consists of undisclosed reserves,
revaluation reserves, general provisions/general
loan loss reserve and subordinated debt.
Banks may at the discretion of the RBI raise Tier
III capital for sole purpose of meeting market risk.
Tier III capital limited to 250% of Tier I capital.
 CAPITAL REQUIREMENT
Capital under Basel II calculated as follows:
Total capital = 9% in India
credit risk + market risk + operational risk
Credit risk is calculated by banks through
- standardized approach
- Internal Rating base Approach (IRB)
- Advanced IRB Approach
 CAPITAL REQUIREMENT
Market risk is for trading book and the market
risk is calculated by the following methods:
standard (using standard percent for each exposure)
Mark to market or mark to model (valuation of
trading assets in addition to providing for standard
percentages for each exposure)
Capital for operational risk
The level of sophistication is required by banks for
adopting different approaches to cover operational
risk.
 CAPITAL REQUIREMENT
There are three approaches for finding capital
requirement for operational risk.
Basic indicator approach
Standardized approach
Advanced approach
Banks are permitted to adopt advanced
approaches with the prior permission of the
RBI.
 CAPITAL REQUIREMENT
Adopting to the advanced approaches to cover all
the three major risks, banks need lesser capital.
Banks have to provide evidence that it is fully
equipped to adopt the advanced approaches.
This involves significant investment in data
management and personal skills.
Statistical analysis and modelling techniques are
essential to assess the risk and able to estimate
capital requirements on an on going basis.
 CAPITAL REQUIREMENT
STEPS REQUIRED TO ADOPT THE ADVANCED
APPROACHES UNDER BASEL II:
Gap analysis data and business gaps
Implementation architecture
Internal rating systems
Data management infrastructure
Data analytics
Testing
RBI approval/certification
 CREDIT RISK- STANDARDIZED
APPROACH
Out of the two approaches for maintaining
regulatory capital, the standardized approach
applies to majority of banks in India.
The requirements under the standardized
approach
All the exposures of a bank will have to be rated.
The credit rating has to be done by External
credit assessment institution (ECAI) known as
credit rating agency.
 CREDIT RISK STANDARDIZED
APPROACH
Classifying the credit exposures of a bank in to
individual claims. These weights have to be risk
weighted.
The risk weights of an individual claim is to be
arrived at based on regulators guidelines.
Credit risk mitigation collateral securities
EXTERNAL CREDIT RATING AGENCIES:
International (ECAI): Standard&Poors, Moodys and
Fitch. Internal Agencies: CRISIL, ICRA, FITCH India
and CARE.
 CREDIT RISK-STANDARDIZED
APPROACH
Credit rating agencies have to be recognized by
the RBI.
Selection of credit rating agencies is on the basis
of the following:
Objectivity
Independence
International access/transparency
Disclosure
Resources
credibility