Credit Risk Management of Loan

Portfolios by Indian Banks:

Some Empirical Evidence
Jayanta Kishore Nandi* and Navin Kumar Choudhary**

The basic functions of most of the banks are the acceptance of deposits from public and
lending funds to public, corporate, etc. This business of lending has brought trouble to
individual banks as well as to the entire banking system, thus giving rise to credit risk,
which is the risk of default. The present paper is designed to develop an internal credit
rating model for banks which improves their current predictive power of financial risk
factors. It also studies how banks assess the creditworthiness of their borrowers and
how can they identify the potential defaulters so as to improve their credit evaluation.
To achieve the above-mentioned objective, a research has been conducted considering
the data for the last six years. Altman Z-Score model is used to arrive at an equation of
the Z-Score, which helps the banks to predict future defaulters and take necessary action
accordingly. The model, which has been developed, is an application of multivariate
discriminant analysis in credit risk modeling.

Introduction
Indian banking has come a long way from being a slow and lazy business institution to a highly
proactive, energetic and dynamic entity. This transformation is due to liberalization and economic
reforms that have facilitated banks to explore new business opportunities. As banks move into
a new high powered world of financial operations and trading, with new risks, there is a need
for more sophisticated and versatile instruments for risk assessment, monitoring and controlling
risk exposures.
Credit risk exists because an expected payment might not occur. Credit risk can be
defined as the probability of losses associated with diminution in the credit quality of
borrowers/counterparties or potential losses resulting from the refusal or inability of a
customer to pay what is owed in full and on time. It remains the most important risk to
manage till date (Bodla and Verma, 2009). In other words, it can be said that credit risk is
the potential that a bank borrower or counterparty will not succeed to meet up its obligations
in harmony with agreed upon terms and conditions. Credit risk arises when the borrower is
* Associate Dean, IBS Pune, Plot # 5, Equity Tower, Sanghvi Nagar Road, Aundh, Pune 411007, India; and is
the corresponding author. E-mail: jknandi@rediffmail.com
** Branch Manager, Super Religare Laboratories Limited, Apollo Towers, Sevoke Road, Siliguri 734401, India.
E-mail: navinkc202@gmail.com
2011 IUP. All Rights Reserved.
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The IUP Journal of Bank Management, Vol. X, No. 2, 2011

unable to repay the loan or when the credit rating deteriorates. The power of credit risk is
even reflected in the composition of economic capital, which the banks are required to
keep aside (70%) in order to protect themselves from various risks. The remaining is shared
between the other two primary risks, viz., market risk and operational risk. So, it has
become essential for banks to check the credit risk and keep the risk under control which
would otherwise lead to an increase in Non-Performing Assets (NPAs) which ultimately
lead to bankruptcy. Non-performing asset is a loan or a lease which does not meet its
stated principal and interest payments. Normally, any commercial loan, which is more
than 90 days in arrears, and any consumer loan, which is more than 180 days in arrears,
is considered as an NPA. In other words, NPA is a debt obligation where the borrower has
not paid any formerly agreed upon interest and principal repayments to the chosen lender
for an extended period of time. Differently, the asset which is not generating any income to
the bank is called an NPA.
Against this background, the present study is an attempt to address how banks can assess
the creditworthiness of their borrowers. For this purpose, Altman Z-Score model and Multivariate
Discriminant Analysis (MDA) have been used.

Literature Review
The financial sector is very crucial for growing economies and any variation in its performance
can affect the economy in either way. Many researchers have revealed the fact that the financial
development of a country contributes to its economic growth. Rajagopal (cited by Bodla and
Verma, 2009) made an attempt to overview the banks risk management and suggested a
model for pricing the products based on credit risk assessment of the borrowers.
He concluded that good risk management is good banking, which ultimately leads to profitable
survival of the institution.
Altman (2000) used Altman Z-Score model to examine the unique characteristics of business
failure in order to specify and quantify the variables which are effective indicators and predictors
of corporate distress.
Mitchell and Roy (2007) have used Altman Z-Score model in ranking the firms and
in the design of internal rating systems. They have also investigated whether some
models are better in differentiating defaulting and non-defaulting firms, the extent to
which different failure prediction models may yield significantly different rankings for
the same firm.
Since exposure to credit risk continues to be the leading source of problems in banks
worldwide, banks and their supervisors should be able to portray valuable lessons from past
experiences. Therefore, in this paper, an attempt is made to understand how banks assess
the creditworthiness of borrowers. We realize that banks consider, among other factors, the
current and prospective profitability, the borrowers past performance, its industrial sector
and how the borrower is placed in it. For this purpose, Altman Z-Score model is used
(in Indian context).
Credit Risk Management of Loan Portfolios by Indian Banks: Some Empirical Evidence

33

Objectives and Methodology of the Study

The present study has been undertaken primarily to examine the framework of credit risk
management of Scheduled Commercial Banks (SCBs) in India. Scheduled commercial banks
are those banks which are included in the Second Schedule of Reserve Bank of India (RBI)
Act, 1934. RBI, vide its order, includes only those banks in this schedule which satisfy the
criteria laid down vide Section 42 (6) (a) of the Act. As of June 30, 1999, there were 300
scheduled banks in India. In this paper, an attempt has been made to facilitate the banks to
predict future defaulters and to improve the current predicting power of financial risk factors of
banks, thereby reducing the NPAs.
As the objectives are clearly established, the present study is descriptive in nature. The study
being comprehensive, covers all the three sectors (public, private and foreign) of the Indian
banking industry. The required data for the study have been collected from the secondary
sources such as internet, database, books and periodicals, published reports and various research
papers. Statistical Package for Social Studies (SPSS) has been used for the analysis of the
collected data.
For the purpose of the study, a total of 45 Indian banks are considered. Out of which,
40 banks are divided into two groups of 20 each, both having equal number of companies.
These are used to develop the coefficient for the discriminant analysis, to develop the model for
predicting the defaulters and to test the accuracy of the model. The remaining five banks are
used to verify the developed model.

Credit Risk Management Model Description and Results

This section deals with the risk modeling technique that can be used for Credit Risk Management
in Indian banks. Various sectors are customers of banks. The developed model is for banking
sector. For developing the model, Altman Z-Score and discriminant analysis have been used.
A brief description of each model is discussed below:

Altman Z-Score Model

Altman Z-Score model is used to classify companies into good or bad, according to their
financial health. It is an application of MDA in credit risk modeling. Financial ratios measuring
probability, liquidity and solvency appeared to have significant discriminating power to separate
the firm that fails to service its debt from the firms that do not. These ratios are weighted to
produce a measure (credit risk score) that can be used as a metric to differentiate the bad firms
from the good ones. The variables considered for this model are classified into five standard
ratio categories: liquidity, profitability, leverage, solvency, and activity.
Z

= 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5

where,
X1 = Working capital/Total assets
X2 = Retained earnings/Total assets
X3 = Earnings before interest and taxes/Total assets
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The IUP Journal of Bank Management, Vol. X, No. 2, 2011

X4 = Market capitalization/Book value of total liabilities

X5 = Sales/Total assets
Z

= Overall index

The Altman Z-Score breaks down firms into three zones:

1. > 2.99: Not likely to go bankrupt
2. 1.8-2.99: Gray area
3. < 1.8: Likely to go bankrupt in the next two years

Multivariate Discriminant Analysis

Multivariate discriminant analysis is a statistical technique used to classify an observation into
one of several groupings dependent upon the observations individual characteristics. Mainly, it
is used to classify and/or make predictions in problems where the dependent variable appears
in qualitative form, e.g., male-female, bankrupt-non-bankrupt, etc. Therefore, the first step is
to establish explicit group classifications. After the groups are established, data are collected
for the objects in the groups and then a linear combination of these characteristics is derived
which clearly discriminates between the groups.

Analysis of the Data Through Discriminant Analysis

First, the 40 banks are divided into two groups, based on their financial health, as good or bad,
using Altman Z-Score model. Then, using the five ratios mentioned above as the input for the
discriminant analysis, we arrive at an equation, which is developed by the output of the
discriminant analysis and can be used to determine the defaulters.
The discriminant function that has been developed has incorporated all the five factors in it.
The eigenvalue (1.023) is greater than 1. It shows the ratio between group sum of squares
and within group sum of squares. Higher the value, the better it is. The eigenvalues table
provides information about the relative efficacy of each discriminant function.
The canonical correlation explains the correlation between the groups and the discriminant
scores. This also seems to be pretty reasonable at 0.711 (Table 1).
Table 1: Eigenvalue and Canonical Correlation
Function

Eigenvalue

Variance (%)

Cumulative (%)

Canonical
Correlation

1.023(a)

100.0

100.0

0.711

Wilks Lambda shows that proportion of variation in discriminant scores is not explained by
the differences among groups. So, lower the value, the better it is. Generally, it should be lesser
than 0.5. In our model, it comes out to be 0.494 (Table 2).
Credit Risk Management of Loan Portfolios by Indian Banks: Some Empirical Evidence

35

Table 2: Wilks Lambda

Test of
Function(s)

Wilks Lambda

Chi-Square

Degrees of
Freedom

Sig.

0.494

25.006

0.000

The hit ratio which shows the efficiency of the model in correctly predicting the groups is also
fairly high and it is 92.5%. Therefore, the model or the discriminant function is finally accepted.
The standardized coefficients allow us to compare variables measured on different scales.
Coefficients with large absolute values correspond to variables with greater discriminating ability.
It indicates the importance of the independent variables in predicting the dependent variables.
Table 3 downgrades the importance of leverage and activity ratio, but the order is otherwise the
same.
Table 3: Standardized Canonical Discriminant Function Coefficients
Function

Variables

Liquidity

1.195

Leverage

0.220

Profitability

0.615

Solvency

0.959

Activity

0.068

Canonical Discriminant Function Coefficients

The coefficients given in Table 4 are used to develop the actual equation used for predicting
and help to classify new variables.
Table 4: Canonical Discriminant Function Coefficients
Variables

Function
1

Liquidity

38.258

Leverage

28.835

Profitability

59.104

Solvency
Activity
(Constant)

8.190
108.495
9.033

The discriminant equation is given below which gives the discriminant score of the borrower:
Discriminant Score = 9.033 + 38.258 * X1 + 28.835 * X2 + 59.104 * X3 + 8.19 * X4
+ 108.495 * X5
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The IUP Journal of Bank Management, Vol. X, No. 2, 2011

The next step is deciding the range which categorizes the company as good or bad with
regard to financial health based on the discriminant score. This is arrived at by taking the
mean of group centroids (critical value). The group centroids help to determine the cut-off
point for classification (Table 5). This is used to group the variables into two: defaulters and
non-defaulters in banks.
Table 5: Functions at Group Centroids
Functions at Group Centroids
Original Group

Function
Critical Value

Needs significant improvement

in (bad) financial health
Good financial health

0.986
0.986

Note: Unstandardized canonical discriminant functions evaluated at group means.

The range comes out to be:

Needs significant improvement in (bad) financial health company < 0 < good health
financial company.
Thus, the new mean for Group 1 (non-performing banks) is 0.986 and for
Group 2 (performing banks) is 0.986 (Table 5). This means that the midpoint of these two is
zero. This is clear when the two means are plotted on a straight line, and their midpoints are
located as shown below:

0.986

+0.986

Mean of Group 1

Mean of Group 2

(Defaulters)

(Non-Defaulters)

Therefore, any positive value (greater than zero) of the discriminant score leads to classification
as non-defaulters, and any negative value (less than zero) of the discriminant score leads to
classification as defaulters.
Further, in future, when we want to predict whether a company has a bad or good health,
we can simply use the discriminant equation to calculate the discriminant scores and predict
the group membership.
The model developed using discriminant analysis is 92.5% accurate compared to the earlier
classification based on Altman Z-Score. Discriminant analysis has classified 23 companies as
having bad financial health compared to 20 in Altman Z-Score model. The result is accurate
and it shows that the discriminant model is bit stringent in evaluating the health. The discriminant
output is given in Table 6.
Credit Risk Management of Loan Portfolios by Indian Banks: Some Empirical Evidence

37

Table 6: Classification Results*

Predicted Group Members
Needs Significant
Improvement
(Bad) in Financial
Health

Financial Health

Original counts of needs

significant improvement (bad)
in financial health
Good financial health
Percentage of needs significant
improvement (bad) in financial health
Percentage of good financial health

Good Financial
Health

Total

20

20

17

20

100

100

15

85

100

Note: * 92.5% of original grouped cases correctly classified.

Verification of the Model

Various companies have been classified as having good or bad financial health based on the
calculated Altman Z-Score (Table 7). 40 out of 45 companies were divided into two groups
with 20 companies each having good financial health and bad financial health. These are then
used as inputs for the discriminant analysis to develop the credit risk management model. The
last five companies of Table 7 have been used to verify the model.
Table 7: Classification of Companies Based on Altman Z-Score
Name of the Bank

38

Altman
Z-Score

Financial
Health

Current
Ratio

Interpretation

ICICI Bank

3.70

Good

0.10

Needs significant
improvement

Kotak Mahindra Bank

3.75

Good

1.42

Needs significant
improvement

City Union Bank Ltd.

3.16

Good

2.54

Good

State Bank of Mysore

2.40

Needs significant
improvement

1.54

Needs significant
improvement

Bank of India

2.80

Needs significant
improvement

3.31

Good

Andhra Bank

3.21

Good

2.75

Good

Canara Bank

2.86

Needs significant
improvement

3.02

Good

Corporation Bank

3.39

Good

2.39

Good

The IUP Journal of Bank Management, Vol. X, No. 2, 2011

Table 7 (cont.)
Altman
Z-Score

Financial
Health

Current
Ratio

Indian Bank

2.36

Needs significant
improvement

2.09

Good

Oriental Bank of
Commerce

3.41

Good

3.94

Good

State Bank of India

3.01

Good

1.43

Needs significant
improvement

UCO Bank

2.49

Needs significant
improvement

3.39

Good

United Bank of India

2.45

Needs significant
improvement

2.96

Good

ING Vysya Bank

2.82

Needs significant
improvement

2.41

Good

Catholic Syrian Bank Ltd.

2.40

Needs significant
improvement

4.18

Good

Federal Bank Ltd.

3.32

Good

5.63

Good

Karur Vysya Bank

3.50

Good

2.85

Good

Ratnakar Bank Ltd.

3.34

Good

4.25

Good

Axis Bank

4.44

Good

5.24

Good

IndusInd Bank

3.61

Good

4.6

Good

Bank of Rajasthan

3.95

Good

5.16

Good

State Bank of Patiala

2.11

Needs significant
improvement

2.13

Good

South Indian Bank

2.80

Needs significant
improvement

3.36

Good

Lakshmi Vilas Bank

3.03

Good

3.81

Good

J&K Bank Ltd.

3.33

Good

4.48

Good

Dhanlaxmi Bank Ltd.

3.37

Good

4.33

Good

Tamilnad Mercantile
Bank Ltd.

2.49

Needs significant
improvement

3.51

Good

Development Credit Bank

3.32

Good

3.54

Good

Vijaya Bank

2.84

Needs significant
improvement

2.97

Good

Union Bank of India

2.74

Needs significant
improvement

2.78

Good

Syndicate Bank

2.71

Needs significant
improvement

2.95

Good

Punjab National Bank

3.06

Good

2.59

Good

Name of the Bank

Interpretation

Credit Risk Management of Loan Portfolios by Indian Banks: Some Empirical Evidence

39

Table 7 (cont.)
Name of the Bank

Altman
Z-Score

Financial
Health

Current
Ratio

Interpretation

Indian Overseas Bank

3.03

Good

2.30

Good

IDBI Bank

2.25

Needs significant
improvement

1.87

Needs significant
improvement

Dena Bank

1.83

Needs significant
improvement

2.23

Good

Central Bank of India

2.39

Needs significant
improvement

3.39

Good

Bank of Maharashtra

2.68

Needs significant
improvement

2.84

Good

Bank of Baroda

2.31

Needs significant
improvement

3.59

Good

Allahabad Bank

2.34

Needs significant
improvement

3.63

Good

State Bank of Travancore

1.47

Needs significant
improvement

1.14

Needs significant
improvement

American Express

3.30

Good

2.49

Good

Centurion Bank
of Punjab Ltd.

3.40

Good

2.45

Good

Karnataka Bank Ltd.

2.82

Needs significant
improvement

4.01

Good

State Bank of Bikaner

& Jaipur

1.86

Needs significant
improvement

1.58

Needs significant
improvement

Bharat Cooperative Bank

3.80

Good

5.04

Good

Current ratio is one of the most important financial variables. It does indicate about the
financial health of any company, but it cannot be taken as the sole criteria to judge the health
of any organization. From the above data, it is observed that on the basis of current ratio
(taking current ratio equal to two as the benchmark), many companies have been categorized
as good, but on the basis of our model more companies fall under the category, needs significant
improvement.
According to the developed model, the health of any company can be ascertained by
calculating the discriminant score and then comparing it with the critical value that distinguishes
the two groups. For calculating the score, we need the data of the five ratios of any particular
company. In our case, the data of the five companies that have been used to verify the model
is given in Table 8.
The Discriminant Equation
Discriminant Score = 9.033 + 38.258 * X1 + 28.835 * X2 + 59.104 * X3+ 8.19 * X4
+108.495 * X5
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The IUP Journal of Bank Management, Vol. X, No. 2, 2011

Putting the values of X1 to X5 in the above equation, we get the following scores (Table 8):
Table 8: Model Verification
Company Name

Altman
Z-Score

Financial
Health

Discriminant
Score

Financial
Health

American Express

3.30

Good

0.180423

Good

Centurion Bank of
Punjab Ltd.

3.40

Good

0.223316

Good

Karnataka Bank Ltd.

2.82

Needs significant
improvement

0.957890

Needs significant
improvement

State Bank of Bikaner

& Jaipur

1.86

Needs significant
improvement

3.437810

Needs significant
improvement

Bharat Cooperative Bank

3.80

Good

1.632715

Good

From Table 8, it is evident that the developed model yields the same result as the Altman
Z-Score. Hence, we can say that the developed model is valid and reliable.

Conclusion
In this paper, an attempt has been made to study the Credit Risk Management Framework of
scheduled commercial banks operating in India and also to arrive at a model that can help
Indian banks manage their credit risk in a better way.
The paper mainly adopts discriminant model to compare the performance of a number of
simple credit risk management techniques. This kind of simple and innovative technique can
provide a new standard for predicting the defaulters with accuracy. This study also helps in improving
the current predicting power of financial risk factors of banks thereby reducing their NPAs.
While risk rating is the most important instrument, other instruments of credit risk
management such as credit administration, prudential limits and loan review are used extensively
by the banks. If these instruments are united by simple models of credit risk management, as
discussed in this paper, it can help the banks in a big way. But the developed model should be
verified and should meet all the prudential norms, otherwise it can give misleading results.H

References
1. Altman E (2000), Predicting Financial Distress of Companies: Revisiting the Z-Score and
Zeta Models, pp. 2-5, available at http://pages.stern.nyu.edu/~ealtman/Zscores.pdf.
Accessed on November 15, 2009.
2. Bodla B S and Verma R (2009), Credit Risk Management Framework at Banks in India,
The IUP Journal of Bank Management, Vol. VIII, No. 1, pp. 47-49.
3. Mitchell J and Roy V P (2007), Failure Prediction Models: Performance, Disagreements,
and Internal Rating Systems, pp. 3-5, NBB Working Paper No. 23, available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1073862. Accessed on November
15, 2009.
Credit Risk Management of Loan Portfolios by Indian Banks: Some Empirical Evidence

41

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Publishing House Pvt. Ltd., Mumbai.
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Reference # 10J-2011-05-02-01

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The IUP Journal of Bank Management, Vol. X, No. 2, 2011

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