Credit Risk Management

Credit Risk

RBI definition of credit risk

Possibility of losses associated with decline in the credit

quality of borrowers or counterparties.

Default due to inability or unwillingness of a customer or

counterparty to meet commitments in relation to lending,
trading, settlement and other financial transactions.

Loss from reduction in portfolio value (actual or

perceived).
 Credit Risk

RBI definition of credit risk

Possibility that a borrowers may not meet their obligation

in terms of the loan agreed terms and conditions.

Probability of loss from a credit transaction.

 Forms of Credit Risk
Non-repayment of the interest on loan or loan principal.
Inability to meet contingent liabilities such as letters of
credit, guarantees issued by the bank on behalf of the
client.
Default by the counterparties in meeting the obligations
in terms of treasury operations.
Not meeting settlement in terms of security trading when
it is due.
Default from the flow of foreign exchange in terms of
cross-border obligations.
Default due to restrictions imposed on remittances out of
the country.
 Components of Credit Risk

Default risk Risk that a borrower or counterparty is

unable to meet its commitment.

Portfolio risk Risk which arises from the composition or

concentration of banks exposure to various sectors.

Two factors affect credit risk

Internal factors Bank specific.

External factors State of economy, size of fiscal

deficit etc.
 Managing Internal Factors

Adopting proactive loan policy.

Good quality credit analysis.

Loan monitoring.

Sound credit culture.

 Managing External Factors

Diversified loan portfolio.

Scientific credit appraisal for assessing financial and

commercial viability of loan proposal.

Norms for single and group borrowers.

Norms for sectoral deployment of funds.

Strong monitoring and internal control systems.

Delegation and accountability.

 Credit Risk Management as per RBI

Measurement of risk through credit scoring.

Quantifying risk through estimating loan losses.

Risk pricing Prime lending rate which also accounts for

risk.

Risk control through effective Loan Review Mechanism

and Portfolio Management.

 Principles of Credit Risk Management

Board of directors of a bank has to take responsibility for

approving and periodically reviewing credit risk strategy.

Senior management has to take the responsibility to

implement the credit risk strategy.

Bank has to identify and manage credit risk of all banking

products and activities.
 Prudential Norms for Credit Risk
Capital adequacy norms.
Exposure norms
Credit exposure and investment exposure norms to
borrowers (individuals and group)
Capital market exposures
Individual banks internal exposure limits
Banks internal risk assessment committee norms.
Credit rating system and risk pricing policy.
Asset liability management requirements.
Banks loan policy norms.
 Framework for Credit Risk Management
Credit risk management framework
Policy framework
strategy and policy
organization structure
operations / systems support
Credit risk rating framework
Credit risk limits
Credit risk modeling
Credit risk pricing
Risk mitigation
Loan review mechanism
Credit audit
 Policy Framework
Strategy and Policy
Documented policy specifying target markets.
Statement of risk acceptance criteria.
Credit approval authority.
Credit follow up procedures.
Guidelines for portfolio management.
Systems of loan restructuring to manage problem
loans.
Follow up procedures and provisioning of non-
performing loans and advances.
 Policy Framework

Strategy and Policy

Consistent approach towards early problem

recognition.

Classification of exposures in problem loans.

Maintain a diversified portfolio of loans in line with the

desired capital.

Procedures and systems for monitoring financial

performance of customers.

Controlling outstanding loan performance so that the

non-performance is within limits.
 Policy Framework
Organizational Structure
Independent group responsible for credit risk
management.
Formulation of credit policies.
Procedures and controls of all credit risk functions
corporate banking
treasury function
credit cards
personal banking
portfolio finance
securities finance
payment and settlement systems
Credit management team responsibility for overall credit risk
 Policy Framework
Organizational Structure
Board is in charge of the overall risk management
policy of the bank
credit
liquidity
interest rate
foreign exchange
price risk
 Policy Framework

Credit risk management committee

Integration of credit risk management committee with
market risk management committee, operations risk
management committee and asset liability
management committee
 Policy Framework
Operations / Systems support
- Phases of credit process
Relationship management phase
Business development
Product development
System development
 Policy Framework
Operations / Systems support
- Phases of credit process
Transaction management phase
Risk assessment
Pricing
Structuring of the credit operations
Internal approvals
Documentation
Loan administration
Credit monitoring and measurement
 Policy Framework
Operations / Systems support
- Phases of credit process
Portfolio management phase
Monitoring of portfolio
Management of problem loans
 Credit Risk Rating Framework

Credit rating models.

Credit rating analysts.

Loans to individuals or small businesses.

Credit quality assessed through credit scoring.

Annual income.

Existing debt.

Asset ownership details.

Family status.
 Credit Risk Limits

Credit limit exposure for each client (borrowers and

counterparties).

Total credit limit exposure for a firm.

Total credit limit exposure for an industry.

Total credit limit exposure for a region / division.

Total credit limit exposure for the bank.

 Credit Risk Limits
Reserve Bank of India Guidelines
not more than 15% of capital to individual borrower
not more than 40% of capital to a group borrower
Aggregate ceiling in unsecured advances not to exceed
15% of total demand and time liability (DTL) of the bank
Threshold limits
Credit rating of the borrower
Past financial records
Willingness and ability to repay
Borrowers future cash flow projections
 Credit Risk Modelling

Altmans Z score model

Credit metrics model

Value at risk model

Merton model
 Altmans Z Score Model
Altman Z-Score variables developed to measure the
financial strength of a firm
Z Score = a1 x V1 + a2 x V2 + a3 x V3 + a4 x V4 + a5 x V5
Where,
V1 = Working capital / Total assets
V2 = Retained earnings / Total assets
V3 = Earnings before interest and taxes / Total
assets
V4 = Market value of equity / Book value of total
liabilities
V5 = Sales / Total assets
a1 to a5 are the model constants identified
through statistical analysis (discriminate analysis)
 Altmans Z Score Model
Usage of Z score of the firm
Z1 or more Excellent firm
Z2 to Z1 Safe
Z3 to Z2 Doubtful performance
Below Z3 Expected to become bankrupt

Where: Z1 > Z2 > Z3

 Credit Metrics Model
Assessment of portfolio risk due to changes in debt value
caused by changes in credit quality
Applications
Reduces portfolio risk
Sets exposure limits
Identify correlations across portfolio
Reduce potential risk concentration
Results in diversified portfolio
Reduction of total risk
 Value-at-Risk Model

Estimate of potential loss in loan portfolio over a given

holding period at a given level of confidence.

Probability distribution of a loan portfolio value reducing

by an estimated amount over a given time horizon.

Time horizon estimate is over a daily, weekly or monthly

basis.
 Merton Model

Bank would default only if its asset value falls

below certain level (default point), which is a
function of its liability.
Estimates the asset value of the bank and its
asset volatility from the market value and the
debt structure in the option theoretic framework.
A measurement that represents the number of
standard deviation that the banks asset value
would be away from the default point.
(Mertons (1973))
 Merton Model
Historical default experience to compute Expected Default
Frequency (EDF)
Distance from Default (DFD) is the estimation of asset value and
asset volatility and volatility of equity return
DFD = (Expected asset value Default point) / (Asset value x
Asset volatility)
Expected default frequency (EDF) is arrived at from historical data
in terms of number of banks that have DFD values similar to the
banks DFD in relation to the total number of banks considered for
evaluation.

Model Efficiency
Difference between the estimated default values and actual
default rate
 Merton Model (Example)

Expected asset value (1 year hence) 200 billion

Default point (DP) 140 billion
Volatility of asset value 12%
Asset value 250 billion
E (Vt ) DP 200 140
DFD 2.00
v V 0.12 250

If from historical observation the number of banks

among 80 banks that have a default point of 2.00 are 12,
then EDF = 12/80 =15%
 Merton Model (Example)

Relationship between DFD and EDF

EDF

15%

2.0 DFD
 Risk Adjusted Rate of Capital for Banks

Mark-to-market concept
Allocates capital to a transaction at an amount equal to
the maximum expected loss (at a 99 percent confidence
level)
Basic risk categories
interest rate risk
credit risk
operational risk
foreign exchange risk
 Risk Adjusted Return on Capital

Quantify the risk in each category

Risk factor = 2.33 x weekly volatility x square root of

52 x (1 tax rate)

2.33 gives the volatility at 99% confidence level

52 weekly price movement is annualized

(1 tax rate) converts this to an after-tax basis

Capital required for each category

Multiplying the risk factor by the size of the position

 Credit Risk Mitigation
Credit risk mitigation reduces exposure of credit risk
Safety net of tangible assets
Safety from realizable (marketable) securities
Reduces exposure of risk from counterparty dealings
in guarantees and insurance
Risk mitigation measures
Collateral securities
Guarantees
Credit derivatives
Balance sheet netting
 Risk Mitigation
Needed procedures
Documentation made for all credit related
transactions
Collateralized transactions monitored regularly
Legally binding terms for the credit transaction
Review of borrower performance profile
Alternate options in terms of loan restructure to
changed scenarios
 Credit Audit

Compliance with pre sanction and post-sanction

processes set by the external and internal audit
committee

Special compliance requirement by the credit risk

management committee of the Board of Directors of the
bank
 Credit Audit
Bank credit audit
Quality of credit portfolio
Review of loan process
Compliance status of large loans

Report on regulatory compliance

Independent audit of credit risk measurement
Identification of loan distress signals
Review of loan restructuring decisions in terms of
distress loans
Review of credit quality
Review of credit administration
Review of employee credit skills
 RBI Guidelines on Credit Exposure and Management
Bank cannot grant loans against security of its own
shares
Prohibition on remission of debts for Urban Cooperative
Banks (UCBs) without prior approval of RBI
Restrictions on loans and advances to Directors and their
relatives
Ceiling on advances to Nominal Members With
deposits up to ` 50 crore (` 50,000/- per borrower) and
` 1,00,000/- for above ` 50 crore
 RBI Guidelines on Credit Exposure and Management
Prohibition on Urban Cooperative Banks (UCBs) for
bridge loans including that against capital / debenture
issues
Loans and advances against shares, debentures
UCBs are prohibited to extend any facilities to stock
brokers
Margin of 40 per cent to be maintained on all such
advances
Restriction on advances to real estate sector
Genuine construction and not for speculative
purposes