CREDIT RISK

AND
RISK
MANAGEMENT
IN BANKS
1
 CREDIT RISK
• Inherent in banking.
• Risks that banks take must be-
reasonable, controlled, within their
financial resources and competence
• Covers- all risks related to a borrower
not fulfilling his obligations on time
• Magnitude of risk dependant on -
likelihood of default by counter party,
potential value of outstanding contracts,
legally enforceable netting arrangements
allowing offsetting contracts, collateral
security 2
 6C`S OF CREDIT
• Character (borrower's personal
character – honesty, willingness
and commitment to pay debts)
• Capacity
• Capital (financial condition)
• Condition (economic)
• Compliance

3
 OBTSTACLES IN CREDIT RISK
MANAGEMENT
• Governmental control
• Asymmetric and unreliable Information
• Legal framework
• Political pressures
• Production difficulties
• Financial restrictions
• Market disruptions
• Delays in production
• Instability in business environment 4
 CREDIT RISK MANAGEMENT -
OVERVIEW
• Origin – Client request, Prospect discovery,
Outside referral
• Evaluation – Purpose, Business, Management
• Negotiation – Tenor, Repayment, Covenants,
Security
• Approval
• Documentation – Legal drafting, Collateral
• Disbursement
• Administration – Repayment, Unforeseen
events, Compliance of terms and conditions
• Reviews – early recognition, Recovery Strategy
5
• Repayment
METHODS - REDUCTION OF CREDIT
RISKS
• Raising credit standards to reject
• Obtain collateral and Guarantees
• Ensure compliance with loan
agreement
• Transfer credit risk by selling
standardized loans
• Transfer risk of changing interest by
Hedging, financial futures, options
• Opt for loan syndication
6
 CREDIT DERIVATIVES
• Unbundling of credit risk - Off-balance sheet
financial instruments that permit one party to transfer
credit risk of a reference asset, which it owns, to
another party without actually selling the asset
• It is a bilateral contract between a protection buyer
(Lending bank) and a protection seller (Credit Risk
Buyer or Guarantor )
• Upon happening of credit event – Protection Seller
will make contingent payment (difference between full
face value and current resale value of a particular
bank loan)
• Condition that trigger payout – payment default,
insolvency, rating downgrading [ 8 different types of
credit events stipulated by International Swaps and
Derivatives Association]
• Protection buyer will pay - periodic fee to protection7
seller
 CREDIT RISK IN INDIA AND
SARFAESI ACT 2002
• Credit Risk: The risk of non-payment of principal
and/or interest to investors can be at two levels:
a) SPV; and
b) underlying assets.
• SPV is normally structured to have no other activity
apart from the asset pool sold by the originator
• Credit risk principally lies with the underlying asset
pool.
• A careful analysis of the underlying credit quality of
the Obligors and the correlation between the obligors
needs to be carried out to ascertain the probability of
default of the asset pool.
• A well diversified asset portfolio can significantly
8
reduce the simultaneous occurrence of default
 PROCESS OF SECURITIZATION
ANCILLARY SERVICE PROVIDERS

OBLIGOR
(Borrower) ISSUE OF SECURITIES
SALE OF ASSETS

INVESTORS
ORIGINATOR SPV (QIBs)
(Banker)

CREDIT RATING OF SECURITIES

CREDIT RATING AGENCY

BANKER 9
RISKS IN COMMERCIAL BANKING
Credit Risk Management & Internal
Controls
Interest Rate Risk
Foreign Exchange Lending Operations
Risk
Liquidity Risk
Operation Risk Market Operations, ALM
EDP Risk
Systemic Risk Business Operations
Management Risk 10
 CROSS BORDER MONEY FLOWS
AND REGULATIONS
• Growth of cross-border money flows highlighted lack
of efficient banking supervision on an international
level
• National banking supervisory authorities regulate
domestic banks and domestic activities of
international banks
• Failure of some US Banks prompted G10 central bank
Governors to set up Basel Committee on Banking
Supervision
• Committee issued Basel Capital Accord, credit risk
measurement framework for internationally active
banks, became a globally accepted standard (Basel I)
• Revised by Basel II- to achieve a better transparent
measurement of various risks incurred by
internationally active banks, limiting possibility of 11
contagion in case of a crisis
 BASEL ACCORD AND
BASEL II NORMS
• Basel accord - regulations for banks set by
Basel Committee, to protect interest of
depositors in a Bank.
• Basel- I accord was accountable for two
risks viz, Credit Risk and Market Risk
• Basel II uses a "three pillars" concept –
(1) minimum capital requirements
(2) supervisory review and
(3) market discipline – to promote greater
stability in the financial system
• The Basel I accord dealt with only parts of
each of these pillars 12
 ASSET LIABILITY MANAGEMENT
• Asset-Liability Management [ALM] models
enable institutions to
 measure and monitor risk, and
 provide suitable strategies for their
management
• Even in the absence of a formal ALM program,
understanding of these concepts is of value
to an institution as it provides a truer picture
of risk/ reward trade-off in which institution
is engaged
• The various aspects of B/S management deal
with planning as well as direction and control
of levels, changes and mixes of assets,
liabilities, and capital 13
 ALM STRUCTURE

GENERAL

ASSET, LIABILITY & CAPITAL MANAGEMENT

SPECIFIIC

LIBILITY MANGEMENT ASSET MANAGEMENT

FINANCIAL

BALANCE SHEET INCOME & EXPENDITURE

MANAGEMENT MANAGEMENT 14
 ALM process
a) Liquidity Risk Management – process to measure
liquidity positions of bank on an ongoing basis and
also to examine how liquidity requirements are likely
to evolve under crisis scenarios - assuring bank's
ability to meet its liabilities as they become due
b) Currency Risk - banks are free to set gap limits with
RBI's approval by adopting Value at Risk (VaR)
approach to measure risk associated with forward
exposures.
• Gap - difference between Rate Sensitive Assets and
Rate Sensitive Liabilities for each time bucket.
c) Interest Rate Risk - risk where changes in market
interest rates might adversely affect a bank's
financial condition
• Risk from earnings perspective can be measured as
changes in Net Interest Income (NII) or Net Interest
Margin (NIM) 15
 CAPITAL ADEQUACY RATIO
• Objectives : to strengthen soundness and stability of
banking system; Standardised Approach for credit
risk and Basic Indicator Approach for operational risk
• Effective date of migration – 31st March 2009.
• Capital Adequacy Ratio (CAR or CRAR) : ratio of
Eligible total capital funds
Credit Risk RWA + Market Risk RWA + Operational
Risk RWA
• Capital Fund has two tiers –
Tier I capital - PUC, Free Reserves
Tier II capital - Revaluation Reserves and other
non free reserves
• Reckoning of Tier 2 capital – reckoned as capital
funds up to a maximum of 100 % of Tier 1 capital,
after making necessary deductions/ adjustments
• Minimum requirements of capital fund - 9 % on an
ongoing basis 16
 Capital Adequacy Ratio (Contd.)
Risk Weighted Assets –
Fund Based : cash, loans, investments and
other assets.
Non Fund Based -The credit risk exposure
attached to off-balance sheet items
• Risk factors considered by RBI
effectiveness of bank’s risk management
systems in identifying, assessing /
measuring, monitoring and managing
various risks including interest rate risk,
liquidity risk, concentration risk and
residual risk 17
 INTEREST RATE RISK
• Determinant of banks` profitability - difference
between interest income and interest expense (called
Net Interest Income)
• Why Risk - mismatch of Assets and Liabilities gives
rise to interest rate risk ;may arise due to higher
borrowing charges and preferences of its constituents
• Objective of Risk Management – to insulate Net
Interest Income
• Methods of risk analysis – by Maturity; Funding
Gap Analysis, duration analysis and value at risk
• Risk Management Tool – transacting in derivative
instruments provide flexibility to banks; Forward
Rage Agreements; Interest Rate Swap
18