CREDIT RISK MANAGEMENT IN BANKS WITH REFERENCE TO

CANARA BANK LTD.

NATURE OF BANKING BUSINESS

Whether it's operating capital or financing loans that are ' term' in nature the ability to access
'OPM' (other people's money) remains a constant challenge for the business owner and
financial manager. You don't necessarily need a business plan when it comes to sourcing
financing, but you do require what we could simply call a clean loan package when it comes
to accessing chartered bank capital. We spend a lot of time with clients on the subject of
choosing the right bank. Invariably we think they have got it wrong. They're focusing on a
logo as opposed to choosing the best business banker that suits their needs. Truth be told the
owner/manager has an easier ob than our counterparts searching for the right business
finance solutions. Our system has it narrowed down to a handful of chartered banks and
occasionally a Credit Union or Non Schedule a bank. In the myriad of banks within their
system make it challenging - they have to rationalize ' money center banks ', 'Savings and
Loans ', 'Regional Banks ', Community Banks,' etc.

There's a tremendous difference between retain banking and commercial banking. It's
important to focus on the services of commercial bankers, as the lines can easily blur in the
SME sector around how business financing is collateralized. We constantly stress to clients
that it's important to separate their personal and business finances when it comes to operating
and growth capital. We meet many owners who tell us they have a business line of credit.
They're quite surprised when we demonstrate to them that the ' business financing ' that they
have in place is essentially lending based on their personal assets and personal credit history.
There are some key factors in choosing bank business loans and financing. Focus on the
relationship, not the fees. Revolving lines of credit are key to any growing firm's success.
They help balance out the investment you make in A/R, receivables, equipment, etc. One of
the truest maxims in business banking is that banks only lend generously when your firm
needs the funds the least. So here the concept of putting revolving credit facilities in place
when you might not necessarily need them is critical. The 4 C's of credit remain a true

constant in lending. They are especially true in the SME sector, and they are character,
capacity, credit, and collateral.

The field of economics can provide some insights for all of us when it comes to determining
the impact of recent banking problems on our overall economy and society at large.
However finding practical business solutions by using economics might prove to be more
elusive because of government and political barriers which effectively prevent the economy
from operating in a natural manner. For example, when businesses other than banks fail in
one way or another, they must typically stop operating and liquidate their companies via
bankruptcy or other legal processes. In contrast banks in the United States are not permitted
to be "normal businesses" in this regard and are kept afloat by a variety of artificial
government financial supports.

Banking problems are certain to produce a continuing drag on the economy. The recent crisis
involving banks has impacted other economic sectors such as real estate and automobile
manufacturing, and there are very few possibilities for a healthy economy while banks
continue to be as unhealthy as reflected in the above statistics. Meanwhile business owners
and managers are required to find ways to conduct "business as usual" in the face of bank
problems that make it difficult to do so. Some of these problems will cause a continuing
erosion of the overall economy if they remain unsolved.

Bankers worldwide recognized the risks associated with lending from the early days of
banking operations. They were able to manage the credit risks by their personal involvement
since the operations were limited and restricted with huge expansion with different products
introduced in the banks it is beyond the control of Individual personal to mitigate the risks
involved in credit. No scientific Risk Management processes were evolved for managing the
risks. However, the later half of 20th century and more particularly in the late 90s banking
operations witnessed significant changes such as advances in technology, closer interrelations among economies of various countries.

COMMON RISK FACED BY BANKS

There are certain risks involved in every business and these can often be detrimental to the
success of that business. That is why it is important to determine such difficulties well in
advance. Risk management refers to the approach or the logical process of eliminating or
minimizing the difficulties that are involved with the various business operations. The
process is designed to identify any situation that may damage the companys resources
including funds, staff and so on. Once the problems are figured out, professionals would
have to take measures to get rid of them. To simplify, risk management is the process where
various business difficulties are identified, assessed and prioritized. Once this awkwardness
has been identified, the managers will create a plan for minimizing or eliminating the impact
that various negative events can have on the business. Different businesses have different
kinds of hazards associated with them and depending on the particular business and the
specific hazards, risk management strategies are created. Certain standards are followed
when creating these strategies. There is a certain level of uncertainty within every business
organization and the strategies focus on managing the uncertainties. In order to create
effective strategies, managers will have to evaluate the ways the companys resources are
being used presently. In this step, they will have to thoroughly understand the process of
production and how it is related to the manufacture of services and goods for the customers.
Once they get a clear picture of how the organization works, they will be able to move
forward and refine the process so that the uncertainty factor can be managed. A business
may involve different kinds of difficulties that need to be mitigated. Effective risk
management strategies can help an organization achieve this goal. Some of the common
difficulty factors include workplace accidents, fires, earthquakes, tornados and other natural
disasters. There may also be some legal problems involved. There may be other related to
the business practices. These include uncertainty in the financial markets, credit risks,
failures in projects, difficulties related to storage and security of data records.

The primary goal of risk management is to protect the company from being vulnerable. For
many businesses, risk management strategies focus on reducing financial imminence and
keeping the business viable. However, these strategies also aim at protecting customers,
employees and the general public from events such as acts of terrorism and fires. Imminence
management strategies may also include practices that preserve data, records, physical

facilities, and physical assets that the company uses or owns. If you are thinking of
becoming a risk manager and want to help companies reach their business objectives by
reducing bad situations, you would need to decide which sector of the professional field you
want to work in. Managers may be required in various fields such as IT, insurance,
healthcare, investment banking and finance.

When more than 70% companies, fail to meet the requirements of the clients, at we not only
provide assurance to you but also incorporate Synergy in it that makes it much more
customize for the client to use it. In times of Risk, banks due its strong understanding of
ERM approaches governance framework were we are well positioned to support
organizations in putting a business focused Risk and Governance framework in place. Thus,
by making use of the Risk framework we support clients in developing and implementing an
integrated Risk management approach which involves three steps:

Risk Evaluation that is to analyze the Risks which possibly could affect the business and
trying to study the risk in detail so that the perfect solution can be formed.
Risk Response that includes forming the solution to the Risk in order to avoid it not only
while it is affecting but also for the future possibilities.
Risk Governance which means, even after proper measure have been taken up to address
and respond to the risk effectively, it is necessary to govern over the fact that it does not
crop up again to pose as a threat in the future.

CREDIT RISK FACED BY BANKS

Every bank employs a proper system for rating the credit risk related to the industrial and
institutional loans. Lenders use risk-rating assessments in approving credit, portfolio
observation, evaluation and profit analysis, setting loan-loss reserves and allocating capital.
Information of a firm's risk rating will give house owners and managers. Internal business
loan risk rating systems are getting a progressively necessary part of huge industrial banks
activity and management of the credit risk of each individual exposures and portfolios. we
have a tendency to use the range of current apply to illuminate the relationships between
uses of ratings, totally different choices for scoring system style, and also the effectiveness
of internal rating systems. Growing stresses on rating systems build an understanding of
such relationships necessary for each banks and regulators. In the past few years, there are
many developments within the field of modeling the credit risk in banks' business loan
portfolio management. Credit risk is actually the chance that a bank's loan portfolio can lose
price if its borrowers become unable to pay back their debts. Arguably, credit risk is that the
largest risk round-faced by industrial banks, since loans and alternative debt instruments
represent the majority of their assets.

Credit Risk management methods ought to mirror the character and complexness of the
institution's participation in retail payment systems, together with any support they provide
to clearing and settlement systems. Management ought to develop risk management
processes that capture not solely operational risks, however additionally credit, strategic,
liquidity, legal, and reputational, compliance risks, notably as they have interaction in new
retail payment merchandise and systems. Management ought to additionally develop an
enterprise wide read of retail payment activities because of cross-channel risk. These risk
management processes ought to take into account the risks display by third-party service
suppliers. For portfolio risk management, an application service supplier delivered platform,
permits you to deal with the general risks and opportunities among your loan portfolio
management. Get a whole read of the credit and operational risk related to a credit
relationship or a portfolio phase. Monitor and track unjust steps by investing each internal
and external knowledge.

CREDIT RISK MANAGEMENT PRACTICES

The position of a business in the market both locally and globally will to some extent depend
on how efficient the owner's business risk management practices are; managing business
credit will have its effects felt in the overall running of the business. Hence, good credit risk
management can otherwise be seen as a process that undergoes a phase by phase course. The
management should really focus on how to handle or mitigate business credit risk in a
systematic manner, taking time to evaluate things in each phase. One can decide to place all
the phase into one screening process and though this will give results, they may not
necessarily be the ideal results to capitalize on when dealing with credit risk. Hence, the
need to break down each phase and handle issues that pertain to it effectively before moving
to the next. The basic principal is that the phase will have a lead role, where the first lead in
the second, and the second to the third and last phase of effective risk management.
Collection of important data or information that pertains to credit is always the first thing all
credit handlers demand for; however, many managers will only look at this from just one
angle. They will scrutinize the information to see if it checks out, failing to consider other
factors such as the source of the information. Sometimes manager fail to see the importance
of recognizing the various elements of importance when handling a customer's credit file or
previous reports that may also be relevant information. Hence, recognition of the relevance
of information or credit data is an important first phase of effective business credit risk
management. Evaluation is the next phase of risk management in which the credit date
collected is carefully evaluated to identify the risk. Not only just that, but evaluation of
information will also measure the severity of the risk enabling the management to know with
mitigation measures to deploy. Evaluation of credit and related risks will also help the
management know how to deal with the subsequent results of the steps taken when
addressing the noted risks. This also makes it easier to give the business a proper footing by
being able to know how to capitalize on some risk, especially those that are considered
inevitable; in so doing lowering their negative impact. In fact, the various measures take to
mitigate, or capitalize on some of the notable risks will be the final phase of effective
business risk management. In this stage the management should be careful as some measure
may be effective when dealing with all risks while some risks need specific mitigation
measures.

Today if you want to maintain and improve long-term financial health of your company, you
need to satisfy your customers, make prudent investments, keep growing further while
controlling costs. The truth is, all customers aren't the same and the key to success is
acquiring profitable, high-value customers and partners as well as making them stay. In this
respect, credit risk management has always been important as it helps understand measure
and mitigate the risk that a company isn't paid back by its customers. How can you assess the
risk and what is the most powerful solution to manage it? Often solutions that manage credit
risk include qualified professionals, information technologies and relevant software. But
company credit reports are the simplest and the most effective way to check the economic
health of new or existing customers. There are a lot of websites which offer these as part of
credit risk management programs. Some of these websites require registration and the
purchase of a pre-paid package whereas others offer their services for a one-off simple
payment. The information as well as the quality of the data used in company reports varies
considerably across the world. Reading and understanding a company credit report is
important for determining a relationship with future clients and suppliers. The common data
used to analyze a company includes the history of filing, court judgments, auditors
qualifications and financial measurements. All this data is important for effective credit risk
management as well as generating credit scores. The credit score is calculated daily and is
entirely automated. There's no manual calculation required to manipulate or adjust credit
scores. Scores are updated on a real-time basis. As soon as a company submits its latest
accounts, they're analyzed within forty eight hours and then updated on the database.

Company credit reports are indispensable for credit risk management as they help compile
an opinion on a company's status. They give you all of the information you need in one easyto-read report: statutory information, risk information, ownership, balance sheet, cash flow
ratios, growth rates and many others. It's the only way to verify if a company is good to do
business with and make a decision based on the facts and risk assessment supplied in the
report. If there's no credit report available then the company may not have filed accounts and
it's important to exercise caution.

ARTICLE REVIEW
The significant transformation of the banking industry in India is clearly evident from the
changes that have occurred in the financial markets, institutions and products. While
deregulation has opened up new vistas for banks to augment revenues, it has entailed greater
competition and consequently greater risks. Cross-border flows and entry of new products,
particularly derivative instruments, have impacted significantly on the domestic banking
sector, forcing banks to adjust the product mix, as also to effect rapid changes in their
processes and operations in order to remain competitive to the globalised environment. These
developments have facilitated greater choice for consumers, who have become more
discerning and demanding compelling banks to offer a broader range of products through
diverse distribution channels. The traditional face of banks as mere financial intermediaries
has since altered and risk management has emerged as their defining attribute. The
information contained in bank financial statements on the risk management capabilities of
banks and then ascertains the sensitivity of bank stocks to risk management. The paper
interprets the selected accounting ratios as risk management variables and attempts to gauge
the overall risk management capability of banks by summarizing these accounting ratios as
scores through the application of multivariate statistical techniques. Returns on the banks'
stocks appear to be sensitive to risk management capability of banks. The expected coverage
of banking assets and the approach adopted for operational risk capital computation is
compared broadly with the position of the banking system in Asia, Africa and the Middle
East1. A survey conducted on twenty two Indian banks indicates insufficient internal data,
difficulties in collection of external loss data and modeling complexities as significant
impediments in the implementation of operational risk management framework in banks in
India. The reforms have led to the increase in resource productivity, increasing level of
deposits, credits and profitability and decrease in non-performing assets. However, the
profitability, which is an important criteria to measure the performance of banks in addition
to productivity, financial and operational efficiency, has come under pressure because of
changing environment of banking. An efficient management of banking operations aimed at
ensuring growth in profits and efficiency requires up-to-date knowledge of all those factors

Rudra Sensarma, M. Jayadev / 2009 / Are bank stocks sensitive to risk management? / Emerald Group
Publishing Limited.

on which the bank's profit depends. Accordingly, in this paper we have made an attempt to
identify the key determinants of profitability of Public Sector Banks in India. The critical
analytics of performance divulges that these markets although are yet to achieve minimum
critical liquidity, almost all the commodities throw an evidence of co-integration in both spot
and future prices, presaging that these markets are marching in the right direction of
achieving improved operational efficiency, albeit, at a slower pace. In the case of some
commodities, however, the volatility in the future price has been substantially lowers than the
spot price indicating an inefficient utilization of information. Several commodities also
appear to attract wide speculative trading. There is increasing concern about the vulnerability
of poor and near-poor rural households, who have limited capabilities to manage risk and
often resort to strategies that can lead to a vicious cycle of poverty. Household-related risk is
usually considered individual or private, but measures to manage risk are actually social or
public in nature2. Furthermore, various externality issues are associated with householdrelated risk, such as its links to economic development, poverty reduction, social cohesion,
and environmental quality. An asset-based approach to social risk management is presented,
which provides an integrated approach to considering household, community, and extracommunity assets and risk-management strategies. The concept repositions the traditional
areas of Social Protection in a framework that includes three strategies to deal with risk, three
levels of formality of risk management and many actors against the background of
asymmetric information and different types of risk. This expanded view of Social Protection
emphasizes the double role of risk management instruments protecting basic livelihood as
well as promoting risk taking. The risks associated with outsourcing have been the principal
limitation on the growth of business process outsourcing, especially cross-border outsourcing.
In addition to technological improvements in risk management, it is possible to reduce the
risk of opportunistic behavior faced by the buyer by redesigning work flows and dividing
work among multiple vendors, increasing the range of tasks that are now appropriate
candidates for outsourcing. We provide taxonomy of risks associated with the outsourcing of
business processes. We focus on strategic risks and identify the components of this risk and
the means by which it can be mitigated. The role of risk in determining the cost efficiency of
international banks in eight emerging Asian countries. Researchers consider three distinct risk
aspects under a total of eight risk measures: credit risk, operational risk, and market risk. This
analyzes the marginal effects of all risk measures on the inefficiency effect in order to
2

Richa Verma / 2006 / Determinants of Profitability of Banks in India / Journal of Services Research /
Vol. 6, No. 2.

explore a more detailed relationship between risks and efficiency3. A main cause of the crisis
of 20072009 is the various ways through which banks have transferred credit risk in the
financial system. We study the systematic risk of banks before the crisis, using two samples
of banks respectively trading Credit Default Swaps

and issuing Collateralized Loan

Obligations. After their first usage of either risk transfer method, the share price beta of these
banks increases significantly. This suggests the market anticipated the risks arising from
these methods, long before the crisis. We additionally separate this beta effect into volatility
and a market correlation component. Quite strikingly, this decomposition shows that the
increase in the beta is solely due to an increase in banks correlations. Thus, while banks may
have shed their individual credit risk, they actually posed greater systemic risk. This creates a
challenge for financial regulation, which has typically focused on individual institutions.
Internal credit risk rating systems are becoming an increasingly important element of large
commercial banks measurement and management of the credit risk of both individual
exposures and portfolios. This describes the internal rating systems presently in use at the 50
largest US banking organizations. We use the diversity of current practice to illuminate the
relationships between uses of ratings, different options for rating system design, and the
effectiveness of internal rating systems. Growing stresses on rating systems make an
understanding of such relationships important for both banks and regulators. We develop a
framework for analyzing the capital allocation and capital structure decisions facing financial
institutions. This incorporates two key features: (i) value-maximizing banks have a wellfounded concern with risk management; and (ii) not all the risks they face can be frictionless
hedged in the capital market4. This approach allows us to show how bank-level risk
management considerations should factor into the pricing of those risks that cannot be easily
hedged. We examine several applications, including: the evaluation of proprietary trading
operations, and the pricing of unchangeable derivatives positions.

We test how active

management of bank credit risk exposure through the loan sales market affects capital
structure, lending, profits, and risk. We find that banks that rebalance their loan portfolio
exposures by both buying and selling loans that is, banks that use the loan sales market for
risk management purposes rather than to alter their holdings of loans hold less capital than
other banks; they also make more risky loans as a percentage of total assets than other banks.
3

Robert Holzmann / 2001 / Social Risk Management: A New Conceptual Framework for Social
Protection / Kluwer Academic Publishers.
4

Dr. Y.V. Reddy / 2005 / Banking Sector Reforms in India / Emerald Group Publishing Limited.

Holding size, leverage and lending activities constant, banks active in the loan sales market
have lower risk and higher profits than other banks. Our results suggest that banks that
improve their ability to manage credit risk may operate with greater leverage and may lend
more of their assets to risky borrowers. Thus, the benefits of advances in risk management in
banking may be greater credit availability, rather than reduced risk in the banking system.
The role of information's processing in bank intermediation is a crucial input. The bank has
access to different types of information in order to manage risk through capital allocation for
Value at Risk coverage. Hard information, contained in balance sheet data and produced
with credit scoring, is quantitative and verifiable. Soft information, produced within a bank
relationship, is qualitative and non verifiable, therefore manipulable, but produces more
precise estimation of the debtor's quality. In this article, we investigate the impact of the
information's type on credit risk management in a principal agent framework with moral
hazard with hidden information5. The results show that access to soft information allows the
banker to decrease the capital allocation for Value at risk coverage. We also show the
existence of an incentive of the credit officer to manipulate the signal based on soft
information that he produces. Therefore, we propose to implement an adequate incentive
salary package which unable this manipulation. The comparison of the results from the two
frameworks using simulations confirms that soft information gives an advantage to the
banker but requires particular organizational modifications within the bank, as it allows
reducing capital allocation for Value at risk coverage. The world financial system
experienced a period of severe crisis during 20072009. Many of the factors that have
contributed to the turmoil, such as loose monetary policy or intense competition, have also
been central in previous crises. Key novel elements in the current crisis, however, are the
various ways through which banks have transferred credit risk in the financial system. Banks
traditionally shed only few risks from their balance sheets, such as through loan sales or
credit guarantees. This shedding was mainly limited to credits that were informational less
sensitive, such as consumer credit. In recent years, however, banks have dramatically
increased their risk transfer activities. For one, they have done this through the use of credit
derivatives, and mostly in the form of Credit Default Swaps6. These instruments allow banks
to trade credit risks on a variety of exposures. The markets for credit default swaps have
5

Alwang Jeffrey / 1999 / An asset-based approach to social risk management / The World Bank in its
series Social Protection Discussion Papers.
6

Rajiv Ranjan and Sarat Chandra Dhal / 2003 / Non-Performing Loans and Terms of Credit of Public
Sector Banks in India / Reserve Bank of India Occasional Papers / Vol. 24, No. 3.

grown tremendously since their inception in 1996, with outstanding volumes estimated at
around US $ 10 trillion before the start of the crisis. Spurred by new financial innovations,
banks have also significantly increased their securitization of assets. Particularly noteworthy
are the Collateralized Loan Obligations through which banks transfer pools of loans from
their balance sheet. While banks have frequently used loan sales to reduce risk in the past,
this new technique allowed banks to shed commercial loans on a large scale. The severity and
the widespread nature of the current crisis indicate that these risk transfer activities have
increased the risks in at least some parts of the financial system. A central question, however,
is how this credit risk transfer has affected the banks that used it to transfer away risk. After
all, the main rationale behind credit risk transfer is that it allows fragile financial institutions
to move risks to less fragile institutions and to diversify away concentrated exposures. It was
mainly for these reasons why regulators initially endorsed these activities. If even these
institutions did not benefit, there are important implications for the overall stability
assessment of the new credit risk transfer activities. In a static sense, a properly done transfer
of risk should of course reduce the banks risks. However, banks are likely to respond to any
reduction in their risk. This may be through various methods, such as by increasing their
lending, by reducing their monitoring and screening efforts or by leveraging up their capital
structure. Banks responses may also go beyond a pure offsetting of the risk that they have
shed. This may be, for example, because the new credit risk transfer methods provide banks
with effective risk management techniques7. Better risk management generally allows banks
to operate with riskier balance sheets. Additionally, these new instruments may make banks
less averse to crisis situations. This may further encourage risk-taking at banks. Banks may
also end up being riskier because they fail to effectively transfer the risk. This may be
because a bank keeps the riskiest tranche in a securitization or because of guarantees given to
securitization vehicles. credit risk transfer may also increase bank risk in a systemic sense,
even if banks individual risk does not increase. This is because securitization allows banks to
shed idiosyncratic exposures, such as the specific risk associated with their area of lending.
The idiosyncratic share in a banks risk may also be lowered because banks may hedge any
undiversified exposures they may have by buying protection using credit default swaps, while
simultaneously buying other credit risk by selling protection in the credit default swaps
market. Banks may thus end up being more correlated with each other. This may amplify the
risk of systemic crisis in the financial system, since it increases the likelihood that banks

R.S. Raghavan / 2003 / Risk Management in Banks / Chartered Accountant.

incur losses jointly. Securitization typically also exposes banks to greater funding risk. Such
risks are mostly systemic in nature, as current events have shown, since the markets for
securitized assets and the markets for funding those assets may collapse. For example, the
problems for securitization vehicles to refinance themselves during 2008 forced banks to
provide liquidity lines to these vehicles or take assets back on their balance sheet. Banks
additionally suffered because, due to the breakdown of the securitization market, they were
no longer able to sell the assets they had originated for securitization purposes. Effectively,
banks found risks they transferred away flowing back to their balance sheets. we explore
some of the aspects of the relationship between credit risk transfer activities and the riskiness
of banks. For this we focus on bank risk as perceived by the market through bank share
prices. We analyze a sample of banks that started trading Credit Default Swaps and a sample
of banks that issued Collateralized Loan Obligations between 1997 and 200688. As a possible
explanation of this risk increase, found that a bank increases its loan-to-asset ratio subsequent
to the first issuance of a collateralized loan obligations. Conclude that bank loan growth leads
to higher bank risk, including a worsening of the risk-return structure and decreasing bank
solvency. Shows that US banks which purchase protection using credit derivatives raise their
supply of loans. Provide evidence that banks increased their risk in response to securitization
by increasing their leverage. Presents evidence that the excess equity return effect of
announcing a new bank loan is mitigated when the lending bank actively trades in credit
derivatives. This suggests lower bank monitoring and hence higher risk-taking. Securitized
assets have a higher probability of default than assets with comparable characteristics that are
not securitized, consistent with lower screening efforts by banks. In a more general
setting, that off-balance sheet activities increase banks systemic risk. Our findings
complement the results of the abovementioned studies, as the identified changes in bank
behavior may also contribute to higher systemic risk.

S.M. Lokare / 2007 / Commodity Derivatives and Price Risk Management / Reserve Bank of India
Occasional Papers / Vol. 28, No. 2.