DEPARTMENT OF MANAGEMENT STUDIES

PONDICHERRY UNIVERSITY

BANK FINANCIAL MANAGEMENT

ASSIGNMENT ON

CREDIT RISK MANAGEMENT STRUCTURE

SUBMITTED TO

DR.B.CHARUMATHI

SUBMITTED BY

SARANYA VASUDEVAN

2ND YEAR MBA, SEC A

 CREDIT RISK MANAGEMENT

Over the years, banks have been involved in a process of upgrading their risk management
capabilities. In doing so, the most important part of upgrading has been the development of the
methodologies, with introduction of more rigorous control practices, in measuring and managing
risk. However, the by far the biggest risk faced by the banks today, remains to be the credit risk,
a risk evolved through the dealings of the banks with their customers or counterparties. To site
few examples, between the late 1980's and early 1990's, banks in Australia have had aggregate
loan losses of $25 billion. In 1992, the banking sector experienced the first ever negative return
on equity, which this has never happened before. There have been many other banks in the
industrial countries, where losses reached unprecedented levels.

The analysis of credit risk was limited to reviews of individual loans, which the banks kept in
their books to maturity. The banks have stride hard to manage credit risk until early 1990s. The
credit risk management today, involves both, loan reviews and portfolio analysis. With the
advent of new technologies for buying and selling risks, the banks have taken a course away
from the traditional book-and-hold lending practice. This has been done in favour of a wider and
active strategy that requires the banks to analyse the risk in the best mix of assets in the existing
credit environment, market conditions, and business opportunities. The banks have now found an
opportunity to manage portfolio concentrations, maturities, and loan sizes, eliminating handling
of the problem assets before they start making losses.

With the increased availability of financial instruments and activities, such as, loan syndications,
loan trading, credit derivatives, and creating securities, backed by pools of assets (securitisation),
the banks, importantly, can be more active in management of risk. As an example, activities on
trading in credit derivatives (example - credit default swap) has grown exceptionally over the last
ten years, and presently stands at $18 trillion, in notional terns. As it stands now, the notional
value of the credit default swap (a swap designed to transfer the credit exposure of fixed income
products between parties) on many established corporate, exceeds the value of trading in the
primary debt securities, received from the same corporate. Loan syndications grew from $700
billion to more than $2.5 trillion between 1990 and 2005, and the same period saw a growth of
loan trading, which grew from less than $10 billion to more than $160 billion. For the banks,
securities pooled and reconstituted from loans or other credit exposures (asset-backed
securitisation), provided the means to reduce credit risk in their portfolios. This could be made
possible by the sale of loans in the capital market. This became especially viable in case of loans
on homes and commercial real estate.

The banks are now more equipped in handling credit risk, in the allocation of its on-going credit
allocation activities. Some of the banks use a more comprehensive credit risk management
system, by critically analyzing the credits, considering both, the probability of default and the
expected loss in the possibility of a default. More sophisticated banks use the criteria given in
Basel II accord in determining credit risk. In here the banks take credit decisions by increased
expert judgment, using quantitative, model-based techniques. Banks, which used to sanction
credits to individuals relying mainly on the personal judgment of the loan sanctioning officers,
now use a more advanced method of scrutinization, applying the statistical model to data, such as
credit scores of that individual. The lending activity of a bank has its credit risk invariably
embedded, as one finds in the market risk. It all such cases, banks need to monitor risks by
managing it efficiently, absorbing the risk involved.

Pricings of relevant risks are needed when-ever a bank moves in a lending contract with a
corporate borrower. New analytical tools now enable banking organizations to quantify lending
risks more precisely. Through these tools, banks can estimate the measure of risk that it is taking
on the fund, in order to earn its risk-adjusted return on capital. This allows the bank to price the
risk before originating the loan. Banks often use internal debt rating, or third party systems, that
uses market data to evaluate the measure of risk involved, when lending to corporate issuing
stocks.

The financial Pundits of the banking sector have discussed diverse range of subjects and issues,
and have arrived on four main themes for a better credit risk management.

The first theme is concerned with a rapid evolution of techniques to manage credit risk. This
evolution of techniques have been greatly supported by the technological advancement made,
with low cost computing being made available, making analyzing, measuring, and controlling
credit risk in a far better way. This has allowed introducing a more rigorous credit risk
management system. However, despite the thoughts of the utilization of the techniques evolved,
implementation of these practices still has a long way to go for the bulk of the banks. However, it
is expected that the pace at which the changes are required to be introduced, will soon accelerate.
With competition growing in the provision of financial services, there is a need for the banking
and financial institutions to identify new and profitable business opportunities, and as such, it is
inevitable that the policies on credit management have to change.

The second theme considered that, the ability to measure, control, and manage credit risk, is
likely to be the criteria as to how the banking sector grows in the future. Widespread cross-
subsidization has introduced significant negative impact on the net interest margin of all the
banks, with a profitable business supporting the cause of otherwise non-profitable activities. The
matter of cross-subsidization has been an intentional business decision by the management of the
institutions. However, this has introduced problems in cash flow, with the inability to accurately
measure risk and return. With the banks getting on to improve on their ability to measure risk
and return on the activities, it is inevitable that the characteristic of the internal subsidies will
become clearer.

The third theme considered the interaction between the management and the improved credit risk
measurement. The theme also looked into the possibility of using alternative risk measurement
techniques within the regulatory environment. There were certain issues that emerged.

1. The role of the supervision of a bank or a financial institution, in a more competitive and a
much more advanced financial environment.

2. At what extent are the banks' risk supervisory efforts and their relevant policies, keeping pace
with the initiatives and developments taking place in the market.

3. The urgent need to align the supervisory methodologies conceived, with the newly emerging
risk measurement practices. In this issue, a general sense of optimism exists, where the
alignment between the banking sector and the regulatory authority, regarding the approached
towards the risk management practices, would happen over time. However, there is an obstacle
in meeting the objective. The banks need to demonstrate with confidence, that they have in place
well defined, and well tested rigorous risk management models, which are completely integrated
into their operational system.

The fourth and the last theme that evolved, was the need to have a firm commitment from the
banking sector, relating to the management of risks in all its forms, and the need to have a strong
orientation of the credit management policy embedded within the culture of banking. Without
such a firm commitment coming from the higher levels in the banking sector, the alignment
between the regulatory authorities and the banking institution, relating to strong credit
management principles, is hard to achieve. It needs to be mentioned here that, today, unless
banking institutions do not take a firm committed step towards a viable credit management
system, and integrate the policies within their operational culture, it will be difficult for the
sector to meet any broader objective, which importantly includes improved shareholder returns.

In the matter to be better aligned, there is a necessity of accurate measure of the credit risk
involved in any transaction that the bank makes, and such a measure is bound to alter the risk-
taking behavior, both, at the individual and at the institutional levels within the bank. So long we
have been talking about the state-of-the-art technology and its use in rigorous credit risk
modeling. With this, it should be borne in mind that, improved measurement techniques are not
automatically evolved without the application of proper judgment and experience; where-ever
credit or other forms of risks are involved.

RISK MANAGEMENT STRUCTURE

A major issue in establishing an appropriate risk management organization structure is choosing

between a centralized and decentralized structure. The global trend is towards centralizing risk
management with integrated treasury management function to benefit from information on
aggregate exposure, natural netting of exposures, economies of scale and easier reporting to top
management.
The primary responsibility of understanding the risks run by the bank and ensuring that the risks
are appropriately managed should clearly be vested with the Board of Directors. The Board
should set risk limits by assessing the bank’s risk and risk-bearing capacity.
At organizational level, overall risk management should be assigned to an independent Risk
Management Committee or Executive Committee of the top Executives that reports directly to
the Board of Directors. The purpose of this top level committee is to empower one group with
full responsibility of evaluating overall risks faced by the bank and determining the level of risks
which will be in the best interest of the bank.
The function of Risk Management Committee should essentially be to identify, monitor and
measure the risk profile of the bank. The Committee should also develop policies and
procedures, verify the models that are used for pricing complex products, review the risk models
a development takes place in the markets and also identify new risks.
Internationally, the trend is towards assigning risk limits in terms of portfolio standards or Credit
at Risk (credit risk) and Earnings at Risk and Value at Risk (market risk).
A prerequisite for establishment of an effective risk management system is the existence of a
robust Management Information System (MIS), consistent in quality. The existing MIS,
however, requires substantial up gradation and strengthening of the data collection machinery to
ensure the integrity and reliability of data.
The risk management is a complex function and it requires specialized skills and expertise.
Banks have been moving towards the use of sophisticated models for measuring and managing
risks. Large banks and those operating in international markets should develop internal risk
management models to be able to compete effectively with their competitors.
As the domestic market integrates with the international markets, the banks should have
necessary expertise and skill in managing various types of risks in a scientific manner. At a more
sophisticated level, the core staff at Head Offices should be trained in risk modeling and
analytical tools. It should, therefore, be the endeavor of all banks to upgrade the skills of staffs.
Given the diversity of balance sheet profile, it is difficult to adopt a uniform framework for
management of risks in India. The design of risk management functions should be bank specific,
dictated by the size, complexity of functions, the level of technical expertise and the quality of
MIS. The proposed guidelines only provide broad parameters and each bank may evolve their
own systems compatible to their risk management architecture and expertise.
Internationally, a committee approach to risk management is being adopted. While the Asset-
Liability Management Committee (ALCO) deals with different types of market risk, the
Credit Policy Committee (CPC) oversees the credit/counterparty risk and country risk.
Banks could also set up a single Committee for integrated management of credit and market
risks. Generally, the policies and procedures for market risk are articulated in the ALM policies
and credit risk is addressed in Loan Policies and procedures.
Currently, while market variables are held constant for qualifying credit risk, credit variables are
held constant in estimating market risk. The economic crises in some of the countries have
revealed a strong correlation between unhedged market risk and credit. Forex exposures,
assumed by corporate whi have no natural hedges, will increase the credit risk which banks run
vis-à-vis their counterparties. The volatility in the prices of collateral also significantly affects
the quality of the loan book. Thus, there is a need for integration of the activities of both the
ALCO and the CPC and consultation process be established to evaluate the impact of market and
credit risks on the financial strength of banks. Banks may also consider integrating market risk
elements into their credit risk assessment process.