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Supervised by
Name of the supervisor Prof. Siddhartha Chattopadhay
Name of the college The Bhawanipur Education Society College
Signature:
I hereby declare that the Project Work with the title (in block letters) .............................
...............................................................................................................
submitted by me for the partial fulfilment of the degree of B.Com. Honours in Accounting &
Finance / Marketing / Taxation / Computer Applications in Business under the University of
Calcutta is my original work and has not been submitted earlier to any other University
/Institution for the fulfilment of the requirement for any course of study.
I also declare that no chapter of this manuscript in whole or in part has been incorporated in
this report from any earlier work done by others or by me. However, extracts of any literature
which has been used for this report has been duly acknowledged providing details of such
literature in the references.
Signature
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I take this opportunity to express my profound gratitude and deep regards to my
guide Prof. Siddhartha Chattopadhaya
for his exemplary guidance, monitoring and constant encouragement throughout
the course of this thesis. The blessing, help and guidance given by him time to time
shall carry me a long way in the journey of life on which I am about to embark.
I also take this opportunity to express a deep sense of gratitude for his cordial
support, valuable information and guidance, which helped me in completing this
task through various stages.
I am obliged to my entire friend circle for valuable information provided by them. I
am grateful for their cooperation during the period of my assignment.
Lastly, I thank the almighty, my parents, sisters and friends for their constant
encouragement without which this assignment would not possible.
TABLE OF CONTENTS
CHAPTER NO.
TOPIC PAGE
NO.
I. INTRODUCTION
II. REVIEW OF LITERATURE
III. RESEARCH METHODOLOGY
IV. RESULTS AND DISCUSSION
V. SUMMARY
REFERENCES
CHAPTER ONE
1. INTRODUCTION
It is difficult to imagine another sector of the economy where as many risks are
managed jointly as in banking. By its very nature, banking is an attempt to
manage multiple and seemingly opposing needs. While risk-managing banks do
have less risk and more profit than banks engaged in similar activities that do not
manage credit risk via the loan sales market, the risk managing banks do not have
lower risk than other banks unconditionally.
This chapter contains information about credit risk, its types, various techniques
required etc.
All these are covered under the following heads:
1.1 Origin
1.2 Types of risks
1.3 Instruments and Tools
1.4 Credit Risk Menu
1.5 How are these are managed?
1.6 Need for the present Study
1.1 ORIGIN
The etymology of the word “Risk” can be traced to the Latin word “Rescum”
meaning Risk at Sea or that which cuts. Risk is associated with uncertainty and
reflected by way of charge on the fundamental/ basic i.e. in the case of business it
is the Capital, which is the cushion that protects the liability holders of an
institution. These risks are inter-dependent and events affecting one area of risk
can have ramifications and penetrations for a range of other categories of risks.
The foremost thing is to understand the risks run by the bank and to ensure that
the risks are properly confronted. Effectively controlled and rightly managed.
Each transaction that the bank undertakes changes the risk profile of the bank.
The extent of calculations that need to be performed to understand the impact of
each such risk on the transactions of the bank makes it nearly impossible to
continuously update the risk calculations. Hence, providing real time risk
information is one of the key challenges of risk management exercise. Thus,
Credit risk emanates from a bank’s dealings with an individual, corporate, bank,
financial institution or a sovereign. Commonly also referred to as default risk,
Credit risk events include bankruptcy, failure to pay, loan restructuring, loan
moratorium, accelerated loan payments. For banks, credit risk typically resides in
the assets in its banking book. The past decade has seen dramatic losses in the
banking industry. Firms that had been performing well suddenly announced large
losses due to credit exposures that turned sour, interest rate positions taken, or
derivative exposures that may or may not have been assumed to hedge balance
sheet risk. In response to this, commercial banks have almost universally
embarked upon an upgrading of their risk management and control systems.
Risks and uncertainties form an integral part of banking which by nature entails
taking risks. Business grows mainly by taking risk. Greater the risk, higher the
profit and hence the business unit must strike a tradeoff between the two. The
essential functions of risk management are to identify measure and more
importantly monitor the profile of the bank. While Non-Performing Assets are the
legacy of the past in the present, Risk Management system is the pro-active
action in the present for the future. Risk management is a constant challenge to
all financial institutions. Banks need to consistently develop and improve their
operational and technical practices. Credit Risk Management is assuming greater
importance in the current environment. With the implementation of the Basel
Accord, banks are increasingly moving towards quantitative risk evaluation of
their loan portfolios. The areas of market risk have long been under the
quantitative risk management scrutiny but credit risk has gradually emerged as an
area for the quantitative risk management. This area has a unique set of
challenges and opportunities for the quantitative risk managers.
1.2 TYPES OF RISKS
Risk is intrinsic to banking and it is as old as banking itself. Credit risk is most
simply defined as the potential that a bank’s borrower or counterparty may fail to
meet its obligations in accordance with agreed terms. It is the possibility of losses
associated with diminution in the credit quality of borrowers or counterparties. In
a bank’s portfolio, losses stem from outright default due to inability or
unwillingness of a customer or a counterparty to meet commitments in relation
to lending, trading, settlement and other financial transactions. Alternatively,
losses result from reduction in portfolio arising from actual or perceived
deterioration in credit quality. Managing risk is nothing but managing the change
before the risk manages. When we use the term “Risk”, we all mean financial risk
or uncertainty of financial loss. If we consider risk in terms of probability of
occurrence frequently, we measure risk on a scale, with certainty of occurrence at
one end and certainty of non-occurrence at the other end. Risk is the greatest
where the probability of occurrence or non-occurrence is equal. As per the
Reserve Bank of India guidelines issued in October 1999, there are three major
types of risks encountered by the banks and these are Credit Risk, Market Risk &
Operational Risk. As observed by RBI, Credit Risk is the major component of risk
management system and this should receive special attention of the Top
Management of a bank. Credit risk is the important dimension of various risks
inherent in a credit proposal, as it involves default of the principal itself. Credit
risk may arise due to internal -meaning faulty appraisal, inadequate monitoring,
unwillingness on the part of borrower to honor commitments despite being
capable or external factors such as government policies, industry related changes.
For most banks, loans are the largest and the most obvious source of credit risk;
however, other sources of credit risk exist throughout the activities of a bank,
including in the banking book and in the trading book, and both on and off
balance sheet. Banks increasingly face credit risk (or counterparty risk) in various
financial instruments other than loans, including acceptances, inter-bank
transactions, trade financing, foreign exchange transactions, financial futures,
swaps, bonds, equities, options and in guarantees and settlement of transactions.
For the sector as a whole, however the risks can be broken into six generic types:
systematic or market risk, credit risk, counterpartrisk, liquidityrisk, operational
risk, and legal risks. The banking industry has long viewed the problem of risk
management as the need to control their risk exposure, viz, credit, interest rate,
foreign exchange and liquidity risk. While they recognize counterparty and legal
risks, they view them as less central to their concerns, where counterparty risk is
significant, it is evaluated using standard credit risk procedures, and often within
the credit department itself. Likewise, most bankers would view legal risks as
arising from their credit decisions or, more likely, proper process not employed in
financial contracting. Thus, risk is considered as standardized, measurable and
manageable.
The five “C’s” of Credit includes Capital, Capacity, Conditions, Collateral, and
Character. Conventional credit risk arises through the possibility of default on a
debt, an investment, or even an invoice. When a financial obligation is not fully
discharged, a loss results. The amount of the loss may be the full amount that is
owed, or a portion thereof. The goal of credit risk management is to maximize a
bank’s risk-adjusted rate of return by maintaining credit risk exposure within
acceptable parameters. Banks need to manage the credit risk inherent in the
entire portfolio, as well as, the risk in the individual credits or transactions. Banks
should have a keen awareness of the need to identify measure, monitor and
control credit risk, as well as, to determine that they hold adequate capital
against these risks and they are adequately compensated for risks incurred.
Credit risk consists of primarily two components, viz. Quantity of risk, which is
nothing but the outstanding loan balance as on the date of default and the
Quality of risk, which is the severity of loss defined by Probability of Default as
reduced by the recoveries that could be made in the event of default. Thus, credit
risk is a combined outcome of Default Risk and Exposure Risk. The elements of
Credit Risk are Portfolio risk comprising Concentration Risk as well as Intrinsic Risk
and Transaction Risk comprising migration/down gradation risk as well as Default
Risk. At the transaction level, credit ratings are useful measures of evaluating
credit risk that is prevalent across the entire organization where treasury and
credit functions are handled. Measurement of credit risk is crucial if the banks
have to appropriately price their loan products, set suitable limits on amount of
credit to be extended as well as the loss exposure it accepts from any particular
counter party. Portfolio analysis help in identifying concentration of credit risk,
default/migration statistics, recovery data, etc. Off-balance sheet exposures such
as foreign exchange forward contracts, swaps, options etc are classified into three
broad categories such as Full Risk, Medium Risk and Low Risk and then translated
into risk weighted assets through a conversion factor and summed up. Thus the
management of credit risk includes: (a) measurement through credit
rating/scoring, (b) quantification through estimate of expected loan losses, (c)
Pricing on a scientific basis and (d) Controlling through effective Loan Review
Mechanism and Portfolio Management.
1.3 INSTRUMENTS AND TOOLS
The instruments and tools, through which credit risk management is carried out,
are detailed below: a) Exposure Ceilings: Prudential Limit is linked to Capital
Funds -say 20 per cent for individual borrower entity, 45 per cent for a group with
additional 5 per cent/10 per cent for infrastructure projects, subject to approval
of the Board of Directors, Threshold limit is fixed at a level lower than Prudential
Exposure; Substantial Exposure, which is the sum total of the exposures beyond
threshold limit should not exceed 600 per cent to 800 per cent of the Capital
Funds of the bank (i.e. 6 to 8 times). b) Review/Renewal: Multi-tier Credit
Approving Authority, constitution wise delegation of powers, sanctioning
authority’s higher delegation of powers for better-rated customers,
discriminatory time schedule for review / renewal, Hurdle rates and Bench marks
for fresh exposures and periodicity for renewal based on risk rating, etc c) Risk
Rating Model: Set up comprehensive risk scoring system on a six to nine point
scale. Clearly define rating thresholds and review the ratings periodically
preferably at half yearly intervals, to be graduated to quarterly so as to capture
risk without delay. Rating migration is to be mapped to estimate the expected
loss. d) Risk based scientific pricing: Link loan pricing to expected loss. High-risk
category borrowers are to be priced high. Build historical data on default losses.
Allocate capital to absorb the unexpected loss. Adopt the RAROC framework. e)
Portfolio Management: The need for credit portfolio management emanates from
the necessity to optimize the benefits associated with diversification and to
reduce the potential adverse impact of concentration’ of exposures to a particular
borrower, sector or industry. Portfolio management shall cover bank-wide
exposures on account of lending, investment, other financial services activities
spread over a wide spectrum of region, industry, size of operation, technology
adoption, etc. f) Credit Audit/Loan Review Mechanism: This should be done
independent of credit operations, covering review of sanction process,
compliance status, review of risk rating, pick up of warning signals and
recommendation for corrective action with the objective of improving credit
quality. The focus of the credit audit needs to be broadened from account level to
overall portfolio level. Regular, proper & prompt reporting to Top Management
should be ensured. Keeping in view the seriousness of credit risk and need to
manage the same appropriately, RBI issued guidelines on Credit Risk Management
on October 12, 2002. These guidelines focused that the banks should give credit
risk prime attention and should put in place a loan policy to be cleared by their
boards that covers the methodology for measurement, monitoring and control of
credit risk. Basel Committee has proposed Standardized Approaches, Foundation
Internal Rating Based Approach and Advanced Internal Rating Based Approach for
credit risk capital charge calculations.
Coyle (2000) defined credit risk as losses from the refusal or inability of credit
customers to pay what is owed in full and on time. The main sources of credit risk
include, limited institutional capacity, inappropriate credit policies, volatile
interest rates, poor management, inappropriate laws, low capital and liquidity
levels, directed lending, massive licensing of banks, poor loan underwriting,
reckless lending, poor credit assessment, no nonexecutive directors, poor loan
underwriting, laxity in credit assessment, poor lending practices, government
interference and inadequate supervision by the central bank. To minimize these
risks, it was necessary for the financial system to have well-capitalized banks,
service to a wide range of customers, sharing of information about borrowers,
stabilization of interest rates, reduction in non-performing loans, increased bank
deposits and increased credit extended to borrowers. Loan defaults and
nonperforming loans need to be reduced.
Bagchi (2003) examined the credit risk management in banks, risk identification,
risk measurement, risk monitoring, risk control and risk audit as a basic
consideration for credit risk management and concluded that proper credit risk
architecture, policies and framework of credit risk management, credit rating
system, monitoring and control contributes in the success of credit risk
management system.
Muninarayanappa and Nirmala (2004) outlined the concept of credit risk
management in banks. They highlighted the objectives and factors that determine
the direction of bank’s policies on credit risk management. The challenges related
to internal and external factors in credit risk management were also highlighted.
They concluded that success of credit risk management required maintenance of
proper credit risk environment, credit strategy and policies. Thus the ultimate aim
should be to protect and improve the loan quality.
Rajeev (2004) outlined the concept of Basel II-issues and constraints. The study
discussed the major risk elements and various approaches in respect of broad risk
areas. The study concluded that in order to qualify for use of the standardized or
advanced measurement approaches (AMA), a bank must satisfy its supervisors
that the minimum qualifying general and specific standards are attained and
maintained.
Kuosmanen (2005) addressed the issue to accurately define tools for monitoring
bank performance that integrate endogenous risk (i.e. credit risk) in the efficiency
analyses. As a baseline the specification of the models- desirable and undesirable
outputs when assuming variable returns to scale was used. This was further
adapted to define the real banking technology. Particularly, undesirable outputs,
NPL, were strictly linked only to that dimension of the output set that refers to
credit (i.e. loan portfolio). The rest of outputs, such as investment portfolio or
service fees, did not have a link with NPL.
Raghavan (2008) outlined the concept of Basel II Norms for Indian banks. The
study explained the three pillar approaches of Basel II Norms, implication of Basel
II in the banking sector, challenges for the banks on implementation of Basel II
Norms. The study concluded that Basel II principles be viewed more from the
angle of fine tuning one’s risk management capabilities through constant mind
searching rather than as regulatory guidelines to be compiled with.
Fethi and Pasiouras (2010) analysed bank efficiency from multiple angles. Among
these, a largely preferred approach relied on non-parametric efficiency frontier
techniques. These methods, best known as Data Envelopment Analysis (DEA) was
more suitable when multiple inputs were employed to obtain multiple outputs.
Even if parametric models allowed for stochastic errors, they have strong
assumptions on functional distributions (which was not needed in non-parametric
contexts) and did not allowed for multiple objectives to be pursued or desirable
and undesirable outputs to be jointly produced. The flexible nature of DEA was
especially appealing for applications based on diverse management and
accounting frameworks.
Banerjee (2011) outlined the introduction to the commercial banking in Indian
scenario and further tried to locate risk management areas in banking sector. The
study also highlighted increasing role of Cost and Management Accountants
(CMAs) in commercial banks in India to contribute towards risk management
functions to increase its efficiency and growth.
Where, i = 1 to 7
Wi = Weight attached
Fn = associated frequency
n = number of respondents
If the mean score was more than midpoint of scale i.e. 3, it was concluded that
respondents by and large tend to agree with the statement. Chi-square test was
applied to test the significance of observed association between rows and
columns of contingency tables. Chi-square was calculated using the
formula:
Where,
O = Observed frequencies
E = Expected frequencies
If the calculated value of chi-square is less than the table value, then the null
hypothesis may be accepted. Standard deviation was applied to test the
deviations from the arithmetic mean and to use this value in computation of t-
test. Standard deviation was calculated using the formula:
Where,
X = individual observations
n = number of observations
T-test was applied to test the null hypothesis that the sample has been drawn
from the normal population. T-value is computed using the following formula:
Where,
X = mean of the sample
u = population mean
s = sample estimate of standard deviation
If, on comparing, the calculated value of t is greater than the table value, the null
hypothesis is rejected. Otherwise, it may be accepted at the level of significance
adopted, indicating that there is a significant difference among the rows and
columns.
3.5 Limitations of the study
Following are the limitations of this study:
1. Due to time and resource constraint, respondents of only Ludhiana City were
considered for survey. A large sample from different cities may be included in
further studies.
2. As face to face interviews were conducted, many of respondents were not
much aware of the terms used in the questionnaire.
3. The information provided by respondents may not be fully accurate due to
unavoidable biases.
4. Relationship between government supplier and willingness to be aware of
credit risk management practices may be studied in detail.
RESULTS AND DISCUSSION
This chapter presents the analysis of primary data collected from the respondents
as well as the secondary data collected. The study was conducted to understand
and analyze the Credit Risk Management Framework and Practices adopted by
State bank of India and Punjab National Bank. This Chapter has been divided into
three sections. The first section reveals the demographic profile of the
respondents. The second section highlights the credit risk framework of State
Bank of India and Punjab National Bank. The third section reveals the comparison
of risk management practices of State Bank of India and Punjab National Bank.
4.1 Profile of Respondents
Chi-square 4.57
AGE OF RESPONDENTS
19-30
8 (26.70) 4 (13.33)
31-45
20 (66.7) 21 (70.00)
45-58
20 (6.70) 5 (16.67)
Chi-square 0.63
Figures in parentheses are %ages of total no. of respondents Table Value of chi-
square is 3.84, d.f. =1 at 5 per cent level of significance .
5.2.1 Conclusion
The survey has, thus, brought out that irrespective of sector and size of bank,
Credit Risk Management framework in India is on the right track and it is fully
based on the RBI’s guidelines issued in this regard. While ‘risk rating’ is the most
important instrument, the others proper credit administration, prudential limits
and loan review are used as very highly important instruments of credit risk
management. Most banks have their credit approving authority at ‘Head Office
Level’. Borrower limits and exposure limits are major prudential limits for credit
risk management. Risk pricing is a modern tool for pricing credit risk in banks.
However, both the banks was enthusiastic to use derivatives products as risk
hedging tools. The risk managers were of the opinion that the implementation of
credit risk related guidelines was not a problem for them, but lack of the
understanding of the methodologies / instruments was a cumbersome task for
many of them. They needed to undergo some training/education program in this
regard. Hence, the concerned banks as well as RBI should take appropriate steps
to organize high training programs on risk management at some institute of high
credibility.
5.3 Recommendations of the study
Majority of respondents were not aware about the credit risk management
practices and framework to be followed and adopted in SBI residential branches.
Therefore, steps needed to be taken to create awareness among SBI employees
about credit risk management. SBI employees and certain PNB employees found
certain terms technical to respond to. They need to be aware of these terms by
reading newspapers, through T.V etc. From 2014, Advanced Internal Rating Based
Approach will be implemented for measuring capital charges. Thus, employees
should gather various such information from the higher level to get updated on
daily basis. Also, banks should take help from other branches to collect the
information. There should be an efficient auditing of banks and securities firms
with respect to their exposure to risk and their internal controls. Besides capital
requirements and other quantitative requisites, regulators should set forth and
enforce qualitative requirements for internal controls; financial institutions (and
broker-dealers) should be required to have written risk control policies.
ANNEXURE
Q1. Please indicate the level of Credit Risk being faced by your bank on the
following transactions. (On a scale of 0 to 6, where 0 = no risk; 1 = very low risk;
and 6 = very high risk)
Q2. Who is responsible for approval of Credit Risk Policy in your bank? (Please tick
the appropriate)
A. Board of Directors ( )
B. Senior Management ( )
C. Credit Policy Committee ( )
D. Any other, please specify
_______________________________________________
Q3. Which technique/instrument, do you prefer the most for Credit Risk
Management in your bank? (Please rank in ascending order)
A. Credit Approval Authority ( )
B. Prudential Limits ( )
C. Risk Ratings ( )
D. Risk Pricing or Risk Adjusted Return on Capital (RAROC) ( )
E. Portfolio Management ( )
F. Loan Review Policy ( )
G. Any other, please specify
_______________________________________________
Q4. What is the credit limit for seeking approval from Credit Approval Committee
in your bank? (Please tick the appropriate)
A. Below 50 lacs ( )
B. 50 Lacss - 1 crore ( )
C. 1 crore - 4 crore ( )
D. Above 4 crore ( )
Q5. What activities you most prefer for Credit Risk Management? (Rank from High
To Low)
A. Industries Studies\Profiles ( )
B. Periodic Credit Calls ( )
C. Periodic Visits of Plants ( )
D. Develop MIS ( )
E. Credit Risk Rating/Risk Scoring ( )
F. Annual Review of Accounts ( )
G. Any other Modern Technique ___________________________________
Q6. At what interval the Credit Risk assessment is repeated in your bank?
A. Monthly ( )
B. Quarterly ( )
C. Bi-annually ( )
D. Annually ( )
Q7. Do you prepare ‘Credit Quality Reports’ for signaling loan loss in any
portfolio?
Yes ( ) No ( )
Q8. Please indicate, the relative importance of the following factors you consider
for pricing Credit Risk (on a scale of 1 to 7, where 1 = not used, 2 = unimportant; 7
= very important)
not used 1 2 3 4 5 6 7 V imp
A. Portfolio Quality ( ) ( ) ( ) ( ) ( ) ( ) ( )
B. Value of Collateral ( ) ( ) ( ) ( ) ( ) ( ) ( )
C. Market forces ( ) ( ) ( ) ( ) ( ) ( ) ( )
D. Perceived value of accounts ( ) ( ) ( ) ( ) ( ) ( ) ( )
E. Future business potential ( ) ( ) ( ) ( ) ( ) ( ) ( )
F. Portfolio Industry Exposure ( ) ( ) ( ) ( ) ( ) ( ) ( )
G. Strategic Reasons ( ) ( ) ( ) ( ) ( ) ( ) ( )
H. Any other, please specify ___________________________________________
Q10. Who review the ‘Loan Policy’ in your bank? (Tick the appropriate)
A. Board of Directors ( )
B. Credit Administration Department ( )
C. Loan Review Officer ( )
D. Any other, please specify ( )
Q11. How frequently you define exposure for managing off-balance sheet
exposure?
(A) Always (B) Often (C) Sometimes (D) Rarely (E) Never
Q12. Please indicate the relative importance of the following aspects that you
consider for evaluating bank-wise exposures (on a scale of 1 to 7, where 1 = not
used, 2 = unimportant; 7 = very important)
1 2 3 4 5 6 7
A. Study of Financial Performance ( ) ( ) ( ) ( ) ( ) ( ) ( )
B. Operating Efficiency ( ) ( ) ( ) ( ) ( ) ( ) ( )
C. Management Quality ( ) ( ) ( ) ( ) ( ) ( ) ( )
D. Past Experience ( ) ( ) ( ) ( ) ( ) ( ) ( )
E. Bank rating on Credit Quality ( ) ( ) ( ) ( ) ( ) ( ) ( )
F. Internal Matrix for studying ( ) ( ) ( ) ( ) ( ) ( ) ( )
counterparty or country risk
Q14. If yes, Which derivatives your bank use? (Tick the appropriate one)
(A) Forwards (B) Futures (C) Options (D) Warrants (E) Swaps (F) Swaptions
Q15. Which approach you prefer the most for measuring capital requirement for
Credit
Risk? (Please tick the appropriate)
A. Standardized Approach ( )
B. Foundation Internal Rating Based Approach ( )
C. Advanced Internal Rating Based Approach ( )
D. Any other ________________________________________
Q18. What does your bank most want to improve in credit risk management
function?
(Give Rating)
A. Organizational structure ( )
B. Credit administration ( )
C. Credit approval process ( )
D. Early warning system ( )
E. Bad debt management ( )
F. Risk modeling ( )
G. Special IT support for risk management ( )
H. Others (specify)
________________________________________________________
Respondent Profile:
Name of Respondent:
________________________________________________________
Designation:___________________
Gender: Male [ ] Female [ ]