RISK

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What is Risk?
The variability or volatility of unexpected
outcome

Why to Take Risk?

Risk creates value and profits come from
taking Risks

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 BANKS ARE IN BUSINESS OF TAKING RISK
But
Excessive risks Bankruptcy
Avoiding all risk Stagnancy
BASEL-II: MORE RISK MORE CAPITAL
SOLUTION
MANAGE RISK

(A structured approach for evaluating and managing the uncertainties)

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 Credit Risk
 Market Risk
oLiquidity
oInterest rate
oForeign exchange
oCommodities and Equity
 Operational Risk

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CREDIT RISK

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Inability
or unwillingness of the borrower to either
repay amount due towards him/her or delayed
repayment of amount due towards him/her

In banking possibly the most important in terms

of potential losses

Exist throughout the activities of a bank

1) Banking book
2) On and off the balance sheet
3) Trading book

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Credit risk can thus be said to constitute
three elements:

Default risk- missing a payment obligation or

breaking a covenant

Exposure risk- uncertainty associated with

due towards customer at time of default

Recovery risk- The unpredictability

associated with recoveries with the advent of
default

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CREDIT RISK MANAGEMENT

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Risk Management-Credit 11/22/2010 10
 Risk Management Guidelines by SBP
 Directives for implementing Basel-II
 Prudential Regulations for
oCorporate/Commercial
oSME
oAgriculture
oConsumer
 SECP regulations
 Laws of the country
 International laws regarding settlement-UCP
600

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 Need for maximizing shareholders’ value
 Adopting policies/procedures which make
institution compliant with risk management
framework put forward by State Bank of
Pakistan
 Need to control rising NPLs of the Bank
 Introduction
of Basel-II has resulted in closer
alignment of regulatory capital and economic
risks
 Changes in global and local economic
scenario can cause a counterparty to default

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TOOLS FOR CREDIT RISK
MANAGEMENT

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External limits set on the maximum loan size
to an individual borrower or group
Uneven distribution of credit can generating
losses large enough to jeopardize an
institution’s solvency
Exposure limits will be set for the following:
oIndustry Exposures
oBusiness Segments/Products
oMaximum exposure under various risk classes
oCounterparties (i.e. individual/Group)

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 Credit assessment of the borrower’s industry,
and macro economic factors.
 The purpose of credit and source of repayment.
 The track record / repayment history of
borrower.
 Assess/evaluate the repayment capacity of the
borrower.
 The Proposed terms and conditions and
covenants.
 Adequacy and enforceability of collaterals.
 Approval from appropriate authority

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 Set up comprehensive risk rating system
(Architecture of Rating Model discussed in later
part)
 Clearly define rating thresholds
 Review the ratings periodically
 Rating migration is to be mapped to estimate
the expected loss

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 Priced into the product (risk-based pricing)

Covered by capital
reserves (economic capital)
Probability

Expected (EL) Unexpected (UL)

Loss (L)

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Risk Management-Credit 11/22/2010 18
 Defining a Portfolio mix as per strategy
guidelines provided by management
 Standardize risk measures for maintaining
asset quality
 Manage concentrations
 Establish objectives for credit quality and
measure quality of asset portfolio in line the
objectives set thereon
 Rebalance the portfolio to achieve strategic
objectives

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Risk Management-Credit 11/22/2010 20
Review of loans to decide whether a change in
the exposure strategy is necessary
The following are taken into account:
structuring of the facilities
Yield of the account
Repayment behaviour & capacity of the
borrower
Adherence to covenants
Current dynamics of industry
Economic conditions

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 Pre-disbursement audit custodian
 Custodian of charge documents/securities
 Maintenance of Credit file
 Monitoring of adherence to the terms and
condition of approval
 Sending ticklers
 Calculation drawing power will

 periodic reassessment of the security value

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 Negotiation and follow up- implement remedial
plans
 Workout remedial strategies- such as of loan
facility, enhancement in credit limits or reduction
in interest rates help improve obligor’s repayment
capacity
 Review of collateral and security document- To
ascertain the loan recoverable amount and
enforceability of contracts and
collateral/guarantee.
 Status Report and Review- development of the loan
accounts and progress of the remedial plans

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Risk Management-Credit 11/22/2010 24
Risk Management-Credit 11/22/2010 25
CREDIT RISK MEASUREMENT

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How is Credit Risk measured?
By estimating the amount that can potentially
be lost if a borrower defaults

Why to measure Credit Risk?

 Basel
Basel--II Requirement = Capital to be allocate
against credit risk taken

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 ADVANCED Banks use internal
estimations of PD,
INTERNAL RATING loss given default
BASED APPROACH (LGD) and exposure at
default (EAD) to
INCREASED SOPHISTICATION

calculate risk weights

for exposure classes
FOUNDATION Banks use internal estimations
of probability of default (PD)
INTERNAL RATING to calculate risk weights for
BASED APPROACH exposure classes. Other risk
components are standardized.
Risk weights are assigned in slabs
STANDARDISED according to the asset class or are based
on assessment by external credit
APPROACH assessment institutions

REDUCED CAPITAL REQUIREMENT

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Risk Management-Credit 11/22/2010 29
 CREDIT RISK MEASUREMENT
Obligor Risk

Industry Risk Business Risk Management Risk Financial Risk

Industry Market Position Track Record Existing Fin. Position

Characteristics

Industry Financials Operating Credibility Future Financial

Efficiency Position

Payment Record Financial Flexibility

Others Accounting Quality

•External factors
•Scored centrally once
in a year
•Internal factors
•Scored for each borrowing entity by the concerned credit
officer

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 FRR

Loan Structure Term Structure

a. Nature and a. Nature

purpose b. Quality
b. Product type c. Liquidity
d. Priority of rights in d. Market value
case of bankruptcy e. f. Quality of the charge
e. Degree of g. Legal status of rights
collateralization h. Legal enforceability
f. Composition of i. Time required to dispose
collateral off

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High probability of default on the borrower
≠ a high expected loss always
Collateral supporting such a facility = low
expected loss

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 Internal
Quantitative Qualitative Reporting to
Obligor
Evaluation Evaluation the Board
Rating

Financial Data
Migration Matrix
Probability of Default Stress Testing Portfolio
(PD Monitoring
Risk Components

Provisioning

Unexpected Loss (UL)

Loss Given Default

Calculation of Credit

Expected Loss (EL)

(LGD)

Risk Amount
Pricing

Exposure at Default Profit

(EAD) Management

Capital
Correlation Allocation

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CREDIT RISK IN TRADING BOOKS

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Institution’s exposures in financial instruments
and commodities
Held with the intention of trading
Heldfor hedging one or more of the other
exposures
free of any restrictive covenants on tradability
 Can be completely hedged
Frequently and accurately valued

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Default Risk:
The possibility that a issuer of an financial
instrument will fail to repay principal and
interest in a timely manner.

Settlement Risk:
The risk that one party will fail to deliver the
terms of a contract with another party at the
time of settlement

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