Credit Risk Management in Banks

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• Management of Risk is the Primary activity of a
Bank and is also its uniqueness / strength.

• Unlike other business, Growth in Credit

Portfolio is directly linked to capital of the
Bank.

• Cost of poor risk management very high and

directly felt
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 Risk Management : Objectives

• Survival of organisation / Bank

• Efficiency in operations ,profit protection
• Identifying and achieving acceptable levels of Risk,
Earning stability
• Uninterrupted operations
• Continued growth
• Preservation of reputation

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Risk Control
• Avoid exposure

• Reduce the impact by reducing frequency of severity

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• Avoid concentration in risk area

• Transfer risk to another

• Employ risk management instruments to cover risk

Comparative advantage for Bank as a Financial
Intermediary

• Risk Assessment, Containment & Management Skills

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Credit Risk
• Possibility of losses associated with diminution in the quality of
borrowers
Loss
• Arising out of a perceived deterioration in credit quality
• Owing to Out-right default due to inability / unwillingness of
borrower to pay.
Costs to Bank
• Loss of income, provisioning / write off, capital adequacy
issues.

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 Capital Adequacy Issues
BASEL – I (1988)
• 8% on Risk weighted Assets
• RBI’s Bench Mark – 9%

BASEL – II - Risk Sensitivity of Capital Requirement

• Minimum Capital requirements for loans (Shift from regulatory
capital to economic capital)
• Supervisory Review (Review of Risk Management processes)
• Market Discipline (Core Principle – Mandatory disclosure; –
Supplementary Principle/Institution specific)
Minimum capital requirements to be determined by
• Standardised Approach
• Internal Rating based Approach

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 Corporate credit analysis
• Structured process of investigation and
assessment
• Prime focus --- assessment of customer's
liquidity
• Use of credit scoring, computer sensitivity
models, cash flow analysis

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 Principles of good lending
• C character
• A ability, can the borrower enter into a valid
contract
• M means, technical, managerial, financial
• P purpose, is it acceptable to lender
• A amount, consistent with purpose
&sufficient
• R repayment
• I insurance, safety net, security taken
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 What else does a banker look for

• I interest income

• C commissions

• E extras
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 credit risk
• What is credit risk ?????
• Is it identifiable ??????
• What factors contribute to credit risk ???
• Can we list them ?????
• Is it possible to quantify, classify credit risk
• Does credit risk make itself amenable to
statistical modeling ??????
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 Factors which affect credit quality
• Activity

• Person

• Financial

• Environment
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 Business Nature of Assets and
Cash flows existing debts
Environemnt customers Profits
business

Financial
Liquidity security
Business
and
strength
financial strength

Ability
to repay

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 Credit Risk Models

• Can we have a system which quantifies risk across

customer segments, industry, activity so that the risk
identified for a given risk level , is same

• Increasing shift towards quantitative treatment of

credit risk
• Securitisation / loan sales market - improving the
marketability
• Fine tuning capital requirements.

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 Model for Retail
- Non discretionary

Model for Commercial Credit

- Rating based, with independent approval

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 Non discretionary model
• Used for small value, large number
• Mainly for Retail segment,
Individuals ,Trade, rural etc.
• Identify the factors which go into designing a
credit rating model

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Credit Rating Framework (CRF)
• Each borrower to have a rating
• Graded classification of risks instead of Performing / Non
Performing Assets
• 6-9 grades for Performing Assets and at least 2 for NPA’s
• Standardize each grade
• Uniformity in approach
• Tool for credit selection, pricing
• Portfolio level analysis, surveillance, Monitoring
• Greater disclosures of the rating process, risk factors,
validation etc.

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 CRA Model
• Internal Factors
• External Factors
• Time Frame – Short Term / Long Term
• Objective Aspects – Quantitative
• Subjective Aspects - Qualitative

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Credit Risk Models

• Symbols, numbers, alphabets

• No ambiguities
• Lower the credit risk, lower the number in CRA scale
Acid Test
Grades developed should reflect similar risk traits for
corresponding grades developed by others for similar
exposures.

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 Rating Scale

xx1/xxTL1>=90
xx2/xxTL2>=75
xx3/xxTL3>=65
xx4/xxTL4>=50
xx5/xxTL5>=45
xx6/xxTL6>=35
xx7/xxTL7>=25
xx8/xxTL8< 25

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 Significance of Credit rating
• Basel II
• Requires rating to truly reflect risk
• Rating needs to be accepted by market
• If too lax , we add risk to portfolio
• If too strict we loose business to others
• Literally on the razor’s edge

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 What is measured in credit risk
• The person
• The activity
• The financing package
• The environment

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 Facets of Risk

Weightage
For Working For Term
Capital Loan
Financial 47 25
Business 20 25
Industry 8 10
Management 25 40
100 100

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 Financial risk
• Static Vs Dynamic
• Static
Liquidity,
Profitability,
Leveraging,
Inventory management
Trends---- What else
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 Financial risk
• Dynamic issues
– Future financial strength
– Probability of achieving projections
Risk Mitigation
Availability of collateral

Concept of negative marking

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 Financial risk parameters
• Static ratios
Current ratio, TOL/TNW,PAT/Net Sales,
PBDIT/INTT, ROCE, Inventory and receivable
ratios, performance trends
• Future prospects
• Projections, Non achievement of past
projections
• Risk Mitigation, Collateral etc

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 Financial Risk

(1) Static Ratios 38

(2) Future Prospects 03

Risk Mitigation / Securities /
(3) Financial Standing 06

Total 47

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 Business Risk
• Technology
• Capacity Utilisation
• Compliance with environment regulations
• User / Product Profile
• Consistency in Quality
• Distribution Network
• Consistency of Cash Flows

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 Industry Risk
• Competition
• Cyclicality / Industry outlook
• Regulatory Risk
• Contemporary issues like WTO etc.

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 Management Risk

• Evaluation of risk is qualitative

Difference between--
Individual and corporation
Relevance of Corporate governance
Dynamics of the situation

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 Management Risk
Integrity : Credibility – Sales
Projection
Track Record : Credibility – Profit
Projection
Managerial Competence/ : Payment Record
Commitment
Expertise : Strategic initiative
Length of relationship
Structure & Systems : -
Experience in Industry : -
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 Basic/hurdle requirements
• If score is ZERO under management risk-
-Integrity/Corporate governance or track
record or managerial competence DECLINE
• New unit, to secure full marks under
Environment compliance parameter.
-In case of existing unit if score is less try and
exit
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 Minimum scores for core parameters

• Financial WC 20/47 for existing,11/25 new

• Business WC 11/20 for existing, 10/25 new
• Industry WC 4/8 for existing, 5/10 new
• Management
WC 15/25 for existing, 24/40 new

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 Summing up
• It is both qualitative and quantitative
• It is dynamic
• It is highly subjective
• Still, it needs to be objective
• Need to balance cost of rating exercise with
benefits

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 Organisational Structure for Commercial Credit

• Relationship Management – business development

• Transaction Management (Pre Sanction, Post Sanction)
• Portfolio Management

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