ABSTRACT:

“Banks are in the business of managing risk, not avoiding it…………………..”

Risk is the fundamental element that drives financial behavior. Without risk, the financial system
would be vastly simplified. However, risk is omnipresent in the real world. Financial Institutions,
therefore, should manage the risk efficiently to survive in this highly uncertain world. The future
of banking will undoubtedly rest on risk management dynamics. Only those banks that have
efficient risk management system will survive in the market in the long run. The effective
management of credit risk is a critical component of comprehensive risk management essential
for long-term success of a banking institution.

Credit risk is the oldest and biggest risk that bank, by virtue of its very nature of business,
inherits. This has however, acquired a greater significance in the recent past for various reasons.
Foremost among them is the wind of economic liberalization that is blowing across the globe.
India is no exception to this swing towards market driven economy. Better credit portfolio
diversification enhances the prospects of the reduced concentration credit risk as empirically
evidenced by direct relationship between concentration credit risk profile and NPAs of public
sector banks.

“……………………A bank’s success lies in its ability to assume and

Aggregate risk within tolerable and manageable limits”.

1. PREAMBLE:

1.1 Risk Management:

The future of banking will undoubtedly rest on risk management dynamics. Only those banks
that have efficient risk management system will survive in the market in the long run. The
effective management of credit risk is a critical component of comprehensive risk management
essential for long-term success of a banking institution. Credit risk is the oldest and biggest risk
that bank, by virtue of its very nature of business, inherits. This has however, acquired a greater
significance in the recent past for various reasons.
Foremost among them is the wind of economic liberalization that is blowing across the globe.
India is no exception to this swing towards market driven economy. Competition from within
and outside the country has intensified. This has resulted in multiplicity of risks both in number
and volume resulting in volatile markets. A precursor to successful management of credit risk is
a clear understanding about risks involved in lending, quantifications of risks within each item of
the portfolio and reaching a conclusion as to the likely composite credit risk profile of a bank.

The corner stone of credit risk management is the establishment of a framework that defines
corporate priorities, loan approval process, credit risk rating system, risk-adjusted pricing
system, loan-review mechanism and comprehensive reporting system.

1.2 Significance of the study:

The fundamental business of lending has brought trouble to individual banks and entire banking
system. It is, therefore, imperative that the banks are adequate systems for credit assessment of
individual projects and evaluating risk associated therewith as well as the industry as a whole.
Generally, Banks in India evaluate a proposal through the traditional tools of project financing,
computing maximum permissible limits, assessing management capabilities and prescribing a
ceiling for an industry exposure. As banks move in to a new high powered world of financial
operations and trading, with new risks, the need is felt for more sophisticated and versatile
instruments for risk assessment, monitoring and controlling risk exposures. It is, therefore, time
that banks managements equip themselves fully to grapple with the demands of creating tools
and systems capable of assessing, monitoring and controlling risk exposures in a more scientific
manner.

Credit Risk, that is, default by the borrower to repay lent money, remains the most important risk
to manage till date. The predominance of credit risk is even reflected in the composition of
economic capital, which banks are required to keep a side for protection against various risks.
According to one estimate, Credit Risk takes about 70% and 30% remaining is shared between
the other two primary risks, namely Market risk (change in the market price and operational risk
i.e., failure of internal controls, etc.). Quality borrowers (Tier-I borrowers) were able to access
the capital market directly without going through the debt route. Hence, the credit route is now
more open to lesser mortals (Tier-II borrowers). With margin levels going down, banks are
unable to absorb the level of loan losses. There has been very little effort to develop a method
where risks could be identified and measured. Most of the banks have developed internal rating
systems for their borrowers, but there has 3 been very little study to compare such ratings with
the final asset classification and also to fine-tune the rating system. Also risks peculiar to each
industry are not identified and evaluated openly. Data collection is regular driven. Data on
industry-wise, region-wise lending, industry-wise rehabilitated loan, can provide an insight into
the future course to be adopted.

Better and effective strategic credit risk management process is a better way to manage portfolio
credit risk. The process provides a framework to ensure consistency between strategy and
implementation that reduces potential volatility in earnings and maximize shareholders wealth.
Beyond and over riding the specifics of risk modeling issues, the challenge is moving towards
improved credit risk management lies in addressing banks’ readiness and openness to accept
change to a more transparent system, to rapidly metamorphosing markets, to more effective and
efficient ways of operating and to meet market requirements and increased answerability to stake
holders.

There is a need for Strategic approach to Credit Risk Management (CRM) in Indian Commercial
Banks, particularly in view of;

1. Higher NPAs level in comparison with global benchmark

2. RBI’ s stipulation about dividend distribution by the banks
3. Revised NPAs level and CAR norms
4. New Basel Capital Accord (Basel –II) revolution

1.3 Credit Risk Management (CRM) dynamics:

The world over, credit risk has proved to be the most critical of all risks faced by a banking
institution. A study of bank failures in New England found that, of the 62 banks in existence
before 1984, which failed from 1989 to 1992, in 58 cases it was observed that loans and
advances were not being repaid in time 5. This signifies the role of credit risk management and
therefore it forms the basis of present research analysis.

Researchers and risk management practitioners have constantly tried to improve on current
techniques and in recent years, enormous strides have been made in the art and science of credit
risk measurement and management. Much of the progress in this field has resulted from the
limitations of traditional approaches to credit risk management and with the current Bank for
International Settlement’ (BIS) regulatory model. Even in banks which regularly fine-tune credit
policies and streamline credit processes, it is a real challenge for credit risk managers to correctly
identify pockets of risk concentration, quantify extent of risk carried, identify opportunities for
diversification and balance the risk-return trade-off in their credit portfolio.

The two distinct dimensions of credit risk management can readily be identified as preventive
measures and curative measures. Preventive measures include risk assessment, risk measurement
and risk pricing, early warning system to pick early signals of future defaults and better credit
portfolio diversification. The curative measures, on the other hand, aim at minimizing post-
sanction loan losses through such steps as securitization, derivative trading, risk sharing, legal
enforcement etc. It is widely believed that an ounce of prevention is worth a pound of cure.
Therefore, the focus of the study is on preventive measures in tune with the norms prescribed by
New Basel Capital Accord.

The study also intends to throw some light on the two most significant developments impacting
the fundamentals of credit risk management practices of banking industry – New Basel Capital
Accord and Risk Based Supervision. Apart from highlighting the salient features of credit risk
management prescriptions under New Basel Accord, attempts are made to codify the response of
Indian banking professionals to various proposals under the accord. Similarly, RBI proposed
Risk Based Supervision (RBS) is examined to capture its direction and implementation
problems.

2. THE PROBLEM OF NON-PERFORMING ASSETS

2.1 Introduction:

Liberalization and Globalization ushered in by the government in the early 90s have thrown open
many challenges to the Indian financial sector. Banks, amongst other things, were set on a path
to align their accounting standards with the International standards and by global players. They
had to have a fresh look into their balance sheet and analyze them critically in the light of the
prudential norms of income recognition and provisioning that were stipulated by the regulator,
based on Narasimhan Committee recommendations.
Loans and Advances as assets of the bank play an important part in gross earnings and net profits
of banks. The share of advances in the total assets of the banks forms more than 60 percent7 and
as such it is the backbone of banking structure.

Bank lending is very crucial for it make possible the financing of agricultural, industrial and
commercial activities of the country. The strength and soundness of the banking system
primarily depends upon health of the advances. In other words, improvement in assets quality is
fundamental to strengthening working of banks and improving their financial viability.

3. MANAGEMENT OF CREDIT RISK - A PROACTIVE APPROACH

3.1 Introduction:

Risk is the potentiality that both the expected and unexpected events may have an adverse impact
on the bank’s capital or earnings. The expected loss is to be borne by the borrower and hence is
taken care by adequately pricing the products through risk premium and reserves created out of
the earnings. It is the amount expected to be lost due to changes in credit quality resulting in
default. Whereas, the unexpected loss on account of individual exposure and the whole portfolio
is entirely is to be borne by the bank itself and hence is to be taken care by the capital.

Banks are confronted with various kinds of financial and non-financial risks viz., credit, market,
interest rate, foreign exchange, liquidity, equity price, legal, regulatory, reputation, operational
etc. These risks are highly interdependent and events that affect one area of risk can have
ramifications for a range of other risk categories. Thus, top management of banks should attach
considerable importance to improve the ability to identify measure, monitor and control the
overall level of risks undertaken.

3.2 Credit Risk:

The major risk banks face is credit risk. It follows that the major risk banks must measure,
manage and accept is credit or default risk. It is the uncertainty associated with borrower’s loan
repayment. For most people in commercial banking, lending represents the heart of the Industry.
Loans dominate asset holding at most banks and generate the largest share of operating income.
Loans are the dominant asset in most banks’ portfolios, comprising from 50 to 70 percent of total
assets17.
Credit Analysis assigns some probability to the likelihood of default based on quantitative and
qualitative factors. Some risks can be measured with historical and projected financial data.
Other risks, such as those associated with the borrower’s character & willingness to repay a loan,
are not directly measurable. The bank ultimately compares these risks with the potential benefits
when deciding whether or not to approve a loan.

3.3 Components of credit risk:

The credit risk in a bank’s loan portfolio consists of three components

1. Transaction Risk
2. Intrinsic Risk
3. Concentration Risk
1. Transaction Risk: Transaction risk focuses on the volatility in credit quality and earnings
resulting from how the bank underwrites individual loan transactions. Transaction risk has
three dimensions: selection, underwriting and operations.
2. Intrinsic Risk: It focuses on the risk inherent in certain lines of business and loans to certain
industries. Commercial real estate construction loans are inherently more risky than
consumer loans. Intrinsic risk addresses the susceptibility to historic, predictive, and lending
risk factors that characterize an industry or line of business. Historic elements address prior
performance and stability of the industry or line of business. Predictive elements focus on
characteristics that are subject to change and could positively or negatively affect future
performance. Lending elements focus on how the collateral and terms offered in the industry
or line of business affect the intrinsic risk.
3. Concentration Risk: Concentration risk is the aggregation of transaction and intrinsic risk
within the portfolio and may result from loans to one borrower or one industry, geographic
area, or lines of business. Bank must define acceptable portfolio concentrations for each of
these aggregations. Portfolio diversify achieves an important objective. It allows a bank to
avoid disaster. Concentrations within a portfolio will determine the magnitude of problems a
bank will experience under adverse conditions.
3.4 Strategic credit risk management:

The post liberalization years have seen significant pressure on banks in India, some of them
repeatedly showing signs of distress. One of the primary reasons for this has been the lack of
effective and strategic credit risk management system. Risk selection, as part of a comprehensive
risk strategy that grows and supports from corporate priorities, is the foundation for future risk
management. This is the underlying premise of an integrated proactive approach to risk
management and entails a four step process:

Step 1. Establishing corporate priorities

Step 2. Choosing the credit culture.

Step 3. Determining credit risk strategy

Step 4. Implementing risk controls

These steps (strategies) focus on reducing the volatility in portfolio credit quality and bank
earning’s performance. Strategic CRM will provide all bank personnel a clear understanding of
the bank’s credit culture and of the risk acceptable in the loan portfolio. Senior management then
manages the process and the portfolio to align them with corporate priorities.

5. Credit Risk Management Practices in Commercial Banks – an evaluation

5.1 Introduction:

The objective of this chapter is to evaluate the credit risk management practices in public sector
banks vis-à-vis private sector banks based on primary data. Primary data have been collected
from the credit department executives serving in public and private sector banks at head office
level and regional office level in Karnataka with the help of predesigned questionnaires. In this
case, direct interview method has been followed for data accuracy and to get first-hand
information from respondents about credit risk management practices.

5.2 Sample data:

The study has analyzed the credit portfolio risk management policies and practices of 21 Banks
of which 12 are public sector banks and 9 private sector banks. Though it was originally aimed to
cover 20 percent of over 800 credit department executives in the selected banks, it was possible
to get the response of only about 10 percent of the number. Credit department executives were
not easily accessible. They were found either closeted in a meeting or busy otherwise. Therefore,
the generalizations formulated here are based on the opinions of this small number

5.3 Conclusion:

Based on these findings it can be concluded that; 1. “Credit risk management practices of
commercial banks in India do not meet the standards set out under the New Basel Capital
Accord”. 2. “There exists no marked difference between public sector banks and private sector
banks as regards their credit risk management performance”.

The reputation of a bank is very important for corporate clients. A corporation seeks to develop
relationship with a reputable banking entity with a proven track record of high quality service
and demonstrated history of safety and sound practices. Therefore, it is imperative to adopt the
advanced Basel-II methodology for credit risk. The Basel Committee has acknowledged that the
current uniform capital standards are not sensitive and suggested a Risk Based Capital approach.
Reserve Bank of India’ s Risk Based Supervision reforms are a fore-runner to the Basel Capital
Accord-II. For banks in India with the ‘ emerging markets’ tag attached to them going down the
Basel-II path could be an effective strategy to compete in very complex global banking
environment. Indian banks need to prepare themselves to be competed among the world’s largest
banks. As our large banks consolidate their balance sheets size and peruse aspirations of large
international presence, it is only expected that they adopt the international best practices in credit
risk management.

“……………A bank’s success lies in its ability to assume and

aggregate risk within tolerable and manageable limits”.

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