Credit Risk Measurement and

Management
• What is Credit?
• Amount of money that will be paid later in
exchange of some goods and services received
earlier.
• What is credit risk/ counterparty risk?
• Non- banking and banking business.
 Risk return trade off
• How much credit risk should be accepted in
return of increase in sale or business in case of
banking?
• How much compensation should be added
while pricing the product?
• Placing of credit cap or limit for each
customer.
• Acceptance or rejection of customer’s request.
 Components of Credit Risk
• Default risk
– Principal+ interest
– Measured by probability of default
– Depends on credit worthiness of the borrower

• Exposure risk:
– Uncertainty associated with future level or amount of risk
– Income lost…prepayment of loan, request for refund of deposit, off balance
sheet items

• Recovery risk (quality of guarantee provided by the borrower)

– Collateral risk…holds good only if sold at significant value
• Uncertainty related to access
• Uncertainty related to realizable value
– Third part guarantee risk
 Measurement of Credit Risk in Banking Transactions
and Factors Affecting the Credit Risk

• Measurement of Credit Risk

– D%xAx(1-r%)

• Factors Affecting the Credit Risk

– Internal Factors (controllable)
• Excessive lending to particular industry
• Ignoring the purpose for which loan was sought
• Poor quality or liberal credit appraisal
• Absence of efficient recovery mechanism
– External Factors (uncontrollable)
• Beyond the control of the bank
– Impact profitability of borrower
– Change in govt. policies
– Fluctuations in interest rates
– Change in political environment of own country
– In case of foreign project…change in country risk profile
 Types of Credit Facilities
• Retail Financing
– Consumer oriented services offered by banks to individuals
– Personal loans, debit cards
– B2C type of funding

• Wholesale financing
– Offered by banks to organizations
– Term loans, working capital loans
– B2B
• Fund Based Facilities
– Personal loan
• Personal financial need
• High interest rate
• Usually unsecured
• Advanced on the basis of credit history of borrower and his ability to repay from personal
income
– Mortgage loan/ Home loan
– Working capital loan
• Maximum Permissible Banking Finance
– MPBF= 75% of (Current Assets- Current Liabilities other than bank borrowings)
– MPBF= (75% of Current Assets)- Current liabilities other than bank borrowings
– MPBF= 75% of (Current Assets- Core Current Assets)- Current liabilities other than
bank borrowings
• Types of working capital loans
– Overdraft
– Cash credit
– Bill discounting
– Packing Credit
– Factoring
 – Demand loan
– Term loan
– Project/ Infrastructure loan
• Project finance refers to the funding of long-term projects, such as public
infrastructure or services, industrial projects, and others through a specific financial
structure.
• The structure of project financing relies on future cash flows for repayment of the
project finances. The assets or rights held under the project act as collateral for the
finance.
• Governments or companies prefer project finance for long gestation projects or for
joint venture arrangements or collaboration arrangements.
• SPV
– Micro finance loans
– Real estate construction loans
– Agriculture and Allied services loans

• Non Fund Facilities (nature of promise)

– Bank Guarantee
– Letter of Credit
 Classification of Assets
• Standard Assets

• Sub-Standard Assets
– An asset which has remained NPA for a period less than or equal
to 12 months

• Doubtful Assets
– An asset which has remained NPA for a period exceeding 12
months

• Loss Assets
– Where loss has been identified by the bank or internal or
external auditors but the amount has not been written off
wholly.
 Evaluating Credit Risk
• Making customer understand the reality
– Making him aware of all the charges and fee
– Implicit and explicit costs
• Check the credibility
• Ask and check the references
• Due diligence
• Recovery (Collateral)
• Nature of business
 Mitigating Credit Risk
• Identify credit risk
– Borrower's profile, regularity in payments, source of income,
operations
– Foreign exchange risk, derivatives
– Traditional- Credit, market, liquidity
– Modern approach- Stress testing

• How credit risk is mitigated

– Basel II has suggested two broad categories of risk mitigation:
– Funded risk mitigation
– Where the bank has a recourse to cash or buyer’s assets
• On balance sheet netting
• Collateral (Gold, Corporate debt securities, Equity, Mutual fund schemes etc.)
– Non-funded risk mitigation
• Guarantee by the third party (Govt., Banks)
 Other Techniques of Credit Risk
Mitigation
• Risk-based pricing
• Credit insurance (Credit Default Swaps)
• Tightening
• Diversification
• Covenants
– Periodic review
– Independent audit
– Repayment
 Qualitative Techniques of Credit Risk
Management
• Borrower/ Transaction specific risk management
– Capacity
– Capital (Debt to equity ratio)
– Character
– Collateral
– End use of loans
– Due diligence
• For retail financing
– Scorecard driven (Farm loan)
• For wholesale financing
– Case by case analysis
• Assessment of project sponsor/ borrower
• Reputation of the borrower
• Track record in the relevant sector (dividend, dynamic)
• Sector perspective
• Technical feasibility
• Commercial and economic viability
• Debt serving capability
• Reference from existing lenders
• Credit reference checks from credit bureaus
• Cash flows from the project
• Nature of security
• Director- not defaulted on payment
• Adherence to KYC
• Interaction with key management personnel
• Site visits- Risk identification and mitigation
• Put/call options
• Ability to infuse capital by promoters
• Covenants to be stipulated
 Qualitative Techniques of Credit Risk
Management (Cont…)
• Credit rating scales
– Rating provided by external agencies
– Credit Rating Information Services of India Limited
(CRISIL)
– Investment Information and Credit Rating Agency
of India Ltd. (ICRA)
– Credit Analysis and Research Ltd. (CARE)
– Fitch Ratings India Private Ltd. (Fitch)
• Portfolio risk management
– Once funds are disbursed, periodic reviews on the
portfolio/borrowers/assets are conducted.
– Some portfolios may develop weakness
– Mechanisms for monitoring and identifying early warning signals
(EWS) should be in place
– EWS in Retail Financing
• Infant/ early delinquencies
• Scorecard parameter reviews

– EWS in Wholesale Financing

• Deviation in operational performance (Budget)
• Site visit reports
• Progress report of the project
• Security margin cover
• Downward revision in rating
• Covenant monitoring
• Credit concentration risk analysis
• Special mention account (SMA) classification
– SMA-0 (not more than 30 days)
– SMA-1 (31-60)
– SMA-2 (61-180)
• Credit loss estimation
– Provides a consistent and common scale for
measurement of risk in terms of

– PD (Probability of default)
• Pooling method (Historical data)
• Statistical method (Characteristics of obligors- financial
statements, type of loan, size of loan, industry of the
company-logistic regression)

– LGD (Loss given default)

• Loss of principal and interest

– EAD (Exposure at default)

• Interest on deposit
• Credit default swaps
– Is a financial swap agreement that the seller of the
CDS compensate the buyer (usually the creditor of
the reference loan) in the event of a loan default
(by the debtor) or other credit event.
– The buyer makes a series of payments (the CDS
“fee” or “spread”) to the seller.
 Other Qualitative Techniques
• Stipulation of covenants
– Maximum debt to equity ratio, minimum debt service coverage ratio
– Periodical review

• Structuring of the transaction

– So that complete recourse is available to the lender in case of default
by the borrower.
• Direct control over cashflows
• Ring fencing of cashflows
• Cashflows carved out for loan repayment
• Board representation
• Priority of repayments
• Pari-Passu charge on the security with other lenders

• Syndication/Securitization
Quantitative Techniques of Credit Risk
Management

• Altman Z Score
– For predicting bankruptcy
– Used to predict probability that a firm will go into bankruptcy within two years
– Uses income and balance sheet values to measure the financial health of a
company
– Is a linear combination of 4 to 5 business ratios weighted by coefficients.
– Earlier tested for public manufacturing companies later extended to non
manufacturing and service companies.
– Z=1.2X1+1.4X2+3.3X3+0.6X4+1.0X5
• X1=working capital/total assets
• X2=retained earnings/total assets
• X3=EBIT/total assets
• X4=market value of equity/book value of total liabilities
• X5=sales/total assets
• Z>2.99 Safe zone
• Z 1.8 1 to 2.99 Grey zone
• Z<1.81 Distress zone
• Risk Adjusted Returns
– Refines an investment’s return by measuring how
much risk is involved in producing that return.
– Alpha
– Beta
– Sharpe ratio
Ret-RFR/SD= excess return generated per unit of risk
taken
• Mutual Fund A (12%-3%)/10%= 0.9
• Mutual Fund B (10%-3%)/7%= 1
– R Squared
• Value at Risk (VaR)
• Ratios and Financial Assessment
– Financial Statement Analysis
– Cash Flow Analysis
– Working Capital Analysis
 Credit Scoring Models
• Credit score is a statistical analysis performed
by lenders and financial institutions to access
a person’s credit worthiness.
• Lenders use credit scoring, among other
things, to arrive at a decision on whether to
extend credit.
• The methods used to arrive at the credit score
are called credit scoring models.
 Use of Credit Models
• Risk selection
• Translating the risk of default into appropriate
pricing
• Managing credit losses
• Evaluating new loan programs
• Reducing loan approval processing time
 Types of Credit Scoring Model
• FICO Score (Fair Isaac Corporation)

– California based analytics software firm

– Develop credit scores that lenders and creditors can use to evaluate applicants
and manage customers' accounts
– Scores are calculated based in the following parameters
• 35%- Payment history
• 30%- Amount of Debt or credit
• 15%- Length of the credit history
• 10%- New credit-No. of recently opened accounts
• 10%- Type of credit used
– Credit score ranges from 300-850 points
• 800&+: 1% chance of default
• 740-799: 2% chance of default
• 670-639: 8% chance of default
• 580-669: 28% chance of default
• 570&-: 61% chance of default
• Vantage Score
– The Vantage Score credit scoring model first emerged in 2006 and was started
by three credit bureaus namely, Experian, Equifax and TransUnion.
– The latest edition of the scoring method was introduced in March 2013, called
the Vantage Score 3.0.
– Credit scores range between 300- 850
– Based on
• Payment History
• Depth of Credit i.e. Age And Type of Credit
• Credit Utilisation
• Recent credit (Hard Enquiry, Soft Enquiry)
• Available Credit

– Level of credit scores follows similar brackets as that of FICO. However, rating
is based on A to F alphabets.
– Can be calculated based on one month credit history of the consumer (new
consumers)
• PLUS Score
– Developed by Experian credit reporting agency
– Credit score ranges from 330 to 830
– The score is compared with other consumers
across the segment
– Score will be ranked based on the percentile
– For example, if your score is noted in the 87th
percentile, it means that your score is better than
87% of the public
• Experian National Equivalency Score (ENES)
– Owned by Experian
– Score ranges from 360- 840
– Experian claims it to be similar to the FICO scoring
model
– Exact basis of calculation not publicized
– The score is available free of cost, hence, not used
by the lending organization
• Equifax
– Credit score ranges from 280- 850
– Equifax reports are detailed and easy to read.
– If a borrower who five years ago paid his or her
credit card bill late applies for a loan, a lender
reviewing his or her Equifax report can pinpoint
the exact month of the late payment.
– The report also indicates debts owned by
collection agencies and liens against the
borrower's assets.