Course: Credit Management (Module III: Credit Management) NIBM, Pune

Module III: Credit Management

Chapter 6: Credit Risk and Rating

Dr Richa Verma Bajaj

Objective

The objective of this chapter is to introduce the concept of credit risk and rating to readers.

Structure:

1. Introduction
2. NPAs Vs Credit Risk
3. Organizational Structure for Credit Risk Management
4. Ways to manage risk in Credit Portfolio
5. Components of Credit Risk
6. 1.6Identification and Assessment of Credit Risk
7. Is Credit Rating reflection of Credit Risk?
8. Rating Models
9. Regulatory Requirements
10. End Use of Rating
11. Credit Scoring Model for a Retail Credit
12. Parameters for Corporate Credit Risk Assessment Rating
13. Summary

1. Introduction

The principal activity of a bank is extending credit in the form of loans and advances. Credit
is said to perform efficiently if the fund is utilized for the intended purposes and when the
repayments are regular, and as per agreed terms. But this may not always be the case
because delay or default in repayment could happen for a number of genuine reasons.
There could be willful defaults as well. As such credit risk has been in existence since banks
came into being. It is the major risk to which the banks are exposed to. Loans are contracts
where the borrowers promise fixed repayments at regular interval in future. Credit risk
occurs when an expected repayment does not happen on the due date. It is nothing but

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default risk, resulting from the borrower’s failure to repay the bank dues consisting of
principal, interest, etc., in accordance with the agreed terms. In a bank’s portfolio, losses
could stem from default due to inability or unwillingness of a customer or counterparty to
meet commitments in relation to lending, trading, settlement and other financial
transactions. It is this possibility that bank tries to avoid by careful choice of customer
through calibrated appraisal. Aspects that are appraised before a loan is sanctioned include
capacity to pay and willingness to pay. In respect of a client who has some relationship with
banks or financial institutions, it is possible for a banker to judge the borrowers
willingness to pay through his past repayment history. But the same would be very
difficult for a new account. The ability of a borrower to pay is judged on the basis of the
information available in its (company’s) annual reports. This information is then fed into
the rating assessment sheet which helps the bank to arrive at a credit score or credit rating
of the applicant on which decision to lend or not to lend is based. This chapter focuses on
credit risk identification and assessment of credit risk by internal and external rating and
score cards. It is important at this point to understand risk management.

2. NPAs Vs Credit Risk

NPAs are ex-post, whereas risk is ex-ante. For reducing the level of rising NPAs in the
system, it is very important for banks to have proactive measures in place by setting up
strong credit risk management system. As the existing framework of tracking the Non-
Performing Loans around the balance sheet date does not signal the quality of the entire
loan book, banks should evolve proper systems for identification of credit weaknesses and
tackling the same well in advance. It is for this reason that banks adopt various portfolio
management techniques for gauging asset quality. They use many risk assessment models.
The credit risk models that have received global acceptance as benchmarks for measuring
stand-alone as well as portfolio credit risk are: Altman’s Z Score Model, Merton Model, KMV
Credit Monitor Model, Credit Metrics, Credit Risk+ and McKinsey Credit Portfolio View.

It is imperative that banks must have a robust credit risk management system which is
sensitive and responsive. The effective management of credit risk is a critical component of
comprehensive risk management and is essential for the long term viability of any banking
organization. Credit Risk Management encompasses a host of management techniques,
such as Credit Approving Mechanisms, Prudential Limits, Risk Rating, Risk Pricing,
Portfolio Management and Loan Review Mechanism.

Loan Review Mechanism (LRM) is an effective tool for constantly evaluating the quality of
loan book and to bring about qualitative improvements in credit administration and reduce
the level of NPAs. As there is strong linkage between credit management and credit risk
management activities of a bank.

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3. Organizational Structure for Credit Risk Management

A sound organizational structure is sine qua non for successful implementation of an
effective credit risk management system. The ‘Organizational Structure’ for credit risk
management as envisaged by RBI is depicted below:

Typical Organizational Structure for Credit Risk Management

Source- www.rbi.org.in

To manage credit risk properly, banks need to have in place an effective Credit Risk
Management Framework capable of identifying, measuring and managing credit risk. The
quest is for methods of credit risk measurement to make the transition from
subjective/qualitative based measurement to objective/quantitative based measurements
so as to improve the methods of pricing credit risk correctly and manage risk properly. The

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Course: Credit Management (Module III: Credit Management) NIBM, Pune

rising trend of fresh NPAs in India emphasizes this need (figure below). In recent years,
rising NPA levels have affected banks’ profitability and resulted in the decline of bank’s
capital adequacy ratio.

(Fresh accretion of NPAs during the year/Total standard assets at the beginning of the
year)*100

4. Ways to manage risk in Credit Portfolio

Banks have over the years learnt to manage credit risk. There exist a good appraisal and
due diligence system and collateral norms. Yet risk seems to grow unabated. The regulator
has therefore suggested.

 Approval Grid or Committee Approach: It has been suggested that each bank should
have a carefully formulated scheme of delegation of powers. The banks should also
evolve multi-tier credit approving system where the loan proposals are approved by an
‘Approval Grid’ or a ‘Committee’. Credit facilities above a specified limit may be
approved by the ‘Grid’ or ‘Committee’, comprising at least 3 or 4 officers and invariably
one officer should represent the Credit Risk Management Department (CRMD), who has
no volume and profit targets. Banks can also consider credit approving committees at
various operating levels i.e. large branches (where considered necessary), Regional
Offices, Zonal Offices, Head Offices, etc. Banks could consider delegating powers for
sanction of higher limits to the ‘Approval Grid’ or the ‘Committee’ for better
rated/quality customers.
 Setting of Prudential Limits: In order to limit the magnitude of credit risk, prudential
limits should be laid down on various aspects of credit, relating to various sectors or
Industry.

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 Risk Scoring or Rating System: Banks should have a comprehensive risk

scoring/rating system that serves as a single point indicator of diverse risk factors of
counterparty and for taking credit decisions in a consistent manner. To facilitate this, a
substantial degree of standardization is required in ratings across borrowers. The risk
rating system should be designed to reveal the overall risk of lending, critical input for
setting pricing and non-price terms of loans as also present meaningful information for
review and management of loan portfolio.
 Risk-return pricing Framework: RAROC or Risk Adjusted Return on Capital, is a
fundamental tenet of risk management. In a risk-return setting, borrowers with weak
financial position and hence placed in high credit risk category should be priced high.
Thus, banks should evolve scientific systems to price the credit risk, which should have
a bearing on the expected probability of default.

5. Components of Credit Risk

Broadly, credit risk is made up of Transaction risk and portfolio risk. Experience suggests
that rising NPAs (high credit risk) is the main risk to a bank’s earnings or capital base.
Default was traditionally managed through collaterals, covenants and proper selection of
obligors. Evidently there are situation where in collateral and other means fail to deliver. In
view of this and increasing NPAs, there has been substantial surge in interest in credit risk
management in the past decade or so. The reasons behind these are:

• Changing Profile of Banks Credit Portfolio

- Rising NPAs Level
- Concentration in Loan Portfolio
• Changing Regulatory Environment: (Basel Advanced approaches align regulatory
capital with economics capital i.e. risk based capital requirement)
• Expectation from shareholders to increase economic value: Risk Management
should focus on risk adjusted return on capital and Economic Value-Added Methods

6. Identification and Assessment of Credit Risk

In extending credit the banks have to make judgments about a borrower’s
creditworthiness. Credit risk arises when this creditworthiness gets change overtime.
Banks follow-up for the payments with the customer and more often end up in receiving
less than the amount that is due, resulting from deterioration in borrower credit quality.
The credit risk of a bank’s portfolio depends on various external and internal factors. The
external factors are the state of the economy, business uncertainty of borrowers,
instability in the business environment, wide swings in commodity/equity prices, foreign
exchange rates and interest rates, poor legal support for debt recovery, trade restrictions,
financial constraints, economic sanctions, Government policies, natural disasters etc. The

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internal factors are deficiencies in loan policies/administration, absence of prudential

credit concentration limits, inadequately defined lending limits for loan officers/credit
committees, deficiencies in appraisal of borrowers’ financial position, excessive
dependence on collaterals and inadequate risk pricing, absence of loan review mechanism
and post sanction surveillance, infrequent customer contact, failure to control and audit the
credit process effectively etc. These deficiencies will lead to loan portfolio weaknesses,
including over concentration of loans in one industry or sector, large portfolios of non-
performing loan and credit losses. These may further lead to liquidity and ultimately
insolvency. Thus, there is need for strong appraisal or assessment of a credit. The extent of
uncertainty from external and internal factors in bank’s credit portfolio from various
factors can be captured through rating.

Rating is an opinion of a banker on the inherent credit quality of a company and/or the
credit instrument. It judges the financial ability of an organization to honor payments of
principal and/or interest on a debt instrument, as and when they are due in future. It
indicates risk (default risk and recovery risk) associated with a credit exposure. Credit
rating is a forward looking process. It is about using observable information to predict
future outcomes of the credit granted. Credit Rating Framework in every bank is important
to avoid simplistic classification of loan into good or bad category.

Rating framework in the banks have evolved over the years from expert opinion
(judgment) based to statistical analysis based. Statistical models are credit scoring/rating
models for corporate and retail exposure. Some of these models are Altman Z score, models
based on equity data, discriminant analysis based rating etc., to mention a few. Banks have
started using these models for credit pricing.

7. Is Credit Rating reflection of Credit Risk?

Credit risk is the possibility of future credit loss. Losses in the credit portfolio of the banks
arise from reduction in portfolio value from actual and perceived deterioration in credit
quality due to unexpected changes. The probable unexpected changes in the credit quality of
borrower could be: diminution in the value of the assets (collateral) supporting the credit
exposure, diminution in the credit quality of the borrower or guarantor, changes in the
business climate such as deteriorating terms of trade, rising inflation, weaker exchange
rates or increased competition, which results in poor operational performance. Credit
rating is one measure which can be used to evaluate the risks in lending. The experience
(Figure below) suggest that borrower/obligor with low rating or low cash generation
capacity have high probability of non-repayment to bank and thus, higher credit risk.

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Credit rating is indicated in symbols ranging from AAA to CCC - C and D. Triple A (AAA) is
the highest rating indicating best credit or almost nil default and D shows default. The chart
above from Standard and poor shows the efficacy of rating in as much as the actual default
by AAA has been less than 10% in the three decades ending 2012. The default in the case of
others increases at an increasing rate as the rating grade deteriorates. Even as this shows
the importance of rating it also shows that even AAA rated instrument or borrower could
default. Evidently low rating grades are risky for the banks, though, depends upon industry
specific fundamentals. The chart also shows that default is more pronounced in the longer
end. We will discuss the characteristic features of rating later in this chapter. It should be
however said here that rating is not permanent for the entire period of bond or borrowing
as the rating agency will keep on reviewing the rating and downgrade it wherever needed.

8. Rating Models
8.1. One Dimensional Rating Model
Traditionally, the rating assessment was done considering 5 C’s of credit and these 5 C’s
were factored into banks internal rating model under five heads (as given in Table I). This
is called as one dimensional rating model, as collateral is a part of obligor’s rating model.

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Table I: One Dimensional Rating Model: Traditional Rating Methodology

5 C’s of Credit What it tells- Aspect

Assessed
Idiosyncratic/Borrower Character Management and attitude
specific/Internal/Controllable Capital towards credit
Factors Capacity Financial
Collateral strength/Operational
Efficiency
Efficiency of Business/
obligor
Collateral/Adequacy in case
of default
Systematic/External/Uncontrollable Condition Industrial performance
Factors

The main emphasis of this model is on collateral and capital. As such for new units and
green field ventures the model was inadequate.

8.2 Two-Dimensional Rating Model

Today, it is important for the banks to have in place two-dimensional internal rating system
for credit assessment, which focuses on mutually exclusive assessment of obligor and
facility. Thus, decision to lend or not to lend would depend on composite rating as shown
below in Table II and accordingly pricing/interest rate charges varies.

Table II: Two-Dimensional Rating Model

Obligor Rating is Obligor Rating is Bank will have to
Good Credit Good Good depend on repayment
Quality Facility Rating is Facility Rating is capacity of the
borrower
Strong Weak

Obligor Rating is Obligor Rating is Bank should In case

Bank will have Poor Poor of existing loan-
to depend on Chose EXIT
Facility Rating is Facility Rating is
good
performance of Strong Weak New loans - Avoid
the facility

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8.2.1. Parameters considered under Obligor Rating

Once the rating is done and it can be presented in terms of 2*2 matrix as above it is easy to
decide. The ratings Good, Poor and Strong and Weak are not based on a single factor but
the result of a number of factors about the obligor and facility.

In the absence of publicly available information on the quality of the borrower, the bank
will have to assemble information from private sources like credit and deposit files and
possibly purchase of information from credit rating agencies (external sources). This
information helps a manager in making an informed judgment on the probability of default
of the borrower and pricing of loan correctly. The banker’s credit decision is based upon
the following:

i. Borrower-specific Factors, which are idiosyncratic to the individual

borrowers. The commonly used borrower specific factors are:
Borrower Specific Factors Impact on Rating & Banker’s
Assessment
Reputation for prompt and timely repayment Positive
Large amount of Debt (Leverage) Negative. Possibility of default
Highly volatile earnings Negative Possibility of default and
delinquency
Sufficient collateral or assets backing the loan Positive

ii. Market Specific Factors, which have an impact on all borrowers at the time of
the credit decision. The commonly used market specific factors are:

Market Specific Factors Impact on Rating &

Banker’s Assessment
Business Cycle (Recession) Negative
Level of Interest Rates (High) Negative
Favorable Government Policy Positive
Better Industry Profitability Positive

The bank will weigh these factors objectively to come to an overall obligor rating and credit
decision. Because of certain subjectivity involved in these models, they are often called as
Expert systems.

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8.2.2. Facility Rating

Each credit must be supported by appropriate collateral. A poor credit can be mitigated
through high quality / liquid security. Financial and cash collaterals provides more comfort
to the lenders than any physical collateral. Higher the risk, greater the security required –
in quantity and quality to provide comfort to lenders. For unsecured credits, the facility
rating will be based on net worth of the obligor, the proportion of total funded debt by
senior unsecured debt, the level of subordination of the debt. For secured credits, the
presence of collateral and its quality and depth heavily affect the severity of facility rating.

The impact of various factors (Illustrative) on recovery rates are highlighted as below:
Factors Expected Impact on Recovery Caution points
Security/Collateral Secured : Positive Collateral value could
Value Unsecured : Negative fluctuate with economic
conditions
Seniority of the Senior Loan : Positive
Claim Subordinate -Negative
Safety, value and Physical Assets : Positive+ Assets will depreciate
existence of assets Higher Market Value Compared Age of marketable asset
to Book Value : Positive is important
Better Quality Assets: Positive+
Tangibility: Positive+
Earning: Positive+
Better Capacity Utilization :
Positive
Industry Utility industry: Positive Cash flow intensive
Characteristics Service (except high-tech and
telecom) :Positive - Could suffer from poor
collection
Macroeconomic GDP Growth : Positive+ Collateral such as real
conditions estate, shares and bonds
are more affected if GDP
growth is poor
Impact of Business Default Environment: Negative- Recession
Cycle

8.3. Composite Rating

Bank takes into the assessment of borrower on obligor and facility rating grade and arrives
at a composite rating. For this it will assign some number or mark to each of the issue that

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are listed in the tables above. The composite ratings give a better estimate of risk in
particular credit. The obligor with ‘Good’ obligor rating and ‘Strong’ facility risk rating will
be among the best customers of the bank. In contrast, borrower with ‘Poor’ rating at
obligor rating grade and ‘Weak’ facility rating grade are among the riskiest customers of
the bank. At this level, it is better for the bank to exit from existing account and avoid
accepting proposal in the case of new account. Following, is illustrative composite risk
rating matrix. It differentiates borrower with ‘1’ rating from borrower with ‘8’ rating and
accordingly price the customer separately depending on their rating and risk profile.

Composite Risk Rating Matrix

Facility Rating

Borrower A B C D E F
Rating Excelle Superi Above Avera Below Wea
nt or Average ge Average k

1- Minimal Risk 1 1 1 1 2 3

2 – Modest Risk 1 1 1 2 3 4

3 – Average 1 2 2 3 4 5
Risk

4 – Acceptable 2 2 3 4 5 6
Risk

5- Manageable 2 3 4 5 6 7
Risk

6- Watch 3 4 5 6 7 8

9. Regulatory Requirements
As per Basel norms, a bank must have a credible track record in the use of internal ratings
information. Accordingly banks are expected to develop their own internal risk estimates
of key parameters i.e. Probability of Default (PD) and Loss Given Default (LGD). A qualifying
Internal Risk Based (IRB) rating system must have two separate and distinct dimensions:
(i) the risk of borrower default (obligor rating), and (ii) transaction-specific factors (facility
rating). The transaction-specific factors are collateral, seniority, product type, etc. The
facility rating is based on the estimate of the expected loss for each facility and is calculated
as the product of PD indicated by obligor rating and LGD (and the usage in the event of
default for loan commitments) by facility rating. Recovery rate is simply 1-LGD. This rating

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can be expressed on a scale, say, 1-9, with each rating being mapped to a LGD bucket, say 0-
1%, 1-5%, 5-10% etc.

10. End Use of Rating

The purpose or objective of rating is that it should help in making good credit decisions and
as a result the credit portfolio should be very good. Rating helps in
• Individual Credit Selection: To accept or reject a particular credit
• Portfolio Level Analysis – To decide on how much concentration in particular rating
grades or industries – Correlation (within and across)
• Monitoring of loan portfolio: through migration analysis
• Aggregating the risk profile of bank – Expected losses (Provision) and Unexpected
Losses (Economic Capital)
• Loan Pricing: Risk adjusted performance measurement
11. Credit Scoring Model for Retail Credit
We have, in the foregoing, seen the use of rating in credit decisions and risk management.
Rating or credit score is arrived on the basis of number of variables. Scoring Models take
into account all the information known about a customer or applicant at the point of
application or behavior (relationship with the Bank). Thus, scoring models are categorized
on the basis of
- information from the application form,
- information from a credit bureau (if it exists),
- for existing customers applying for additional product, information about the way in
which the applicant has run his or her other accounts
Scoring models are of two types. Each is explained below:
(i) Application Scoring Systems
(ii) Behavioral Scoring Systems

11.1 Application Scoring Systems

It is considered as a means of assessing risk at the point of application for credit. The
features of application scoring system are:
- Usually applied at loan origination and initial sanction.
- Relies heavily on external data
- Used for credit risk determination, loan amount approval, limit setting, terms of
payment, pricing decision etc.
Typical fields used in application scorecard development are:
- Age
- Sex
- Educational Qualification
- Marital Status
- Residential Status (Home owner, living with parents etc.)

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- Length of time at current address

- Industry in which applicant works
- Job Position (eg, director, manager, team leader, team worker, etc.)
- Length of time in current job
- Current banking product holdings; and
- Length of time bank account held

11.2. Behavioral Scoring Systems

It assesses risk for existing customers through internal behavioral data. The features of
behavioral scoring models are:
- Enables the credit analysts to quickly and accurately evaluate the future payment
behavior of customer.
- Based on 3-4 years detailed customer attributes.
- Used for limit increase, renewals, reviews, cross selling, fraud detection etc.
Behavioural Scorecards data includes:
- Balance data
- Credit limit information (generally only including agreed limit, as the other limits
are beyond the customer control)
- Utilization information
- Transactions

Parameters for Housing Loan Portfolio are (Illustrative)

•Age
Personal details •Edcuational QUalification
•Marital Status
•Dependants

•- Percentage of Financing by Individual

Financial Details •Level of Income
•- Other Assets

•- Employment status
Employment Details •- Gross Monthly Income
•- No. of Years in Current Employment
•Designation

•Collateral
Security •Guarantor

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Important Indicators for a Retail Credit Scoring Models

Demographic Financial Indicators Employment Behavioral Indicators

Indicators Indicators

Age of Borrower Total Assets of the Type of Loans Outstanding

Marital Status of borrower Employment Credit Track Record -
Borrower Gross Income of the Designation Loan Defaulted or
Number of borrower Length of the delinquent
Dependents Gross Income of the current Service Number of Payments
Home Status Household Number of per year
Monthly Expenses of employments over Collateral/guarantee
Household the last few years Years of Banking
Ratios
- Loan to Value
Ratio

12. Parameters for Corporate Credit Risk Assessment Rating (Illustrative)

Corporates are risk rated on the basis of (a) business indicators (b) industry features and
performance (c) management quality, performance, and issues, (d) financial performance
and factors, (e) cash flow. Simultaneously facility rating is also made. In case of existing
borrowers compliance to sanction terms is also assessed. The details of items to be
considered in these issues are given in the following tables. The tables also show the
maximum and minimum score for each item. Finally all these scores are added up and the
score of the applicant or unit is compared with the risk rating range and threshold score
prescribed by the bank. (See table risk rating ranges). If the score is more than acceptable
level then the proposal is taken up for further scrutiny and eventually sanction of credit
facility.
In addition banks may also use external credit score or rating to reinforce their analysis
and finding.
A. Assessment of Business Risk

While the industry risk embodied in an exposure may be the same across all borrowers in
that industry, different borrowers in the same industry are in a position to hedge this risk
differently. The capacity of these units in mitigating the industry risks is measured by the
business risk assessment. The parameters selected for this purpose are the following:

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Risk Parameter Narration Remarks Score Score

Prescribed Obtained
Capacity Utilization: Good If the capacity utilization is more 2
Indicates the utilization than 90%
of the capacity Average Where capacity utilization is 1
between 50% - 90%
Poor Where capacity utilization is less 0
than 50%
Product Mix: Refers to Good Where the number of products 2
the number of products manufactured are 5 or more
manufactured or traded Average Where the number of products 1
in manufactured are more than 1
but less than 5
Poor Where only one product is 0
manufactured
Diversification among High Where the number of Buyers is 2
different consumer more than 5
segments/geographical Moderate Where the number of buyers is 1
spread more than 1 but less than 5
Low Where there is a single buyer 0
Adaptation to Good Where appropriate technology 2
Technology in and adequate measure of quality
changing environment control are in place
Average Where technology is proven with 1
no changes expected in the near
future
Satisfactory Outdated technology or 0
technology subjected to
obsolescence
Consistency in Quality Good The record of the company in 2
maintaining the quality of its
product is excellent. Sales
Rejections on account of poor
quality are almost non-existant
Average The record of the company in 1
maintaining the quality of its
products is good. There are only a
few cases of sales rejections.
There is no ISO certification

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Poor There is no consistency in quality 0

and there is no anxiety on the
part of management to rectify the
situation. Sales rejection on
account of poor quality are
common. There is no ISO
certification.
Distribution Network Good The company have adequate 2
distribution network for
marketing and sale of its product
Average The company have small 1
distribution network for
marketing and sale of its product
Poor A feeble distribution structure/no 0
structure of its own and sales
show a declining trend

B. Assessment of Industry Risk

The industry risk is assessed on the basis of current trends in industry, its overall
perception and future outlook.

Risk Narration Remarks Score Score

Parameter Prescribed Obtained
Competitive Excellent Turnover growth higher than the industry 3
Situation growth for the company
Good Turnover growth at par with the industry 2
growth
Neutral Static turnover growth in the company in 1
view of recession in the market
Unfavourable It would be difficult for the company to 0
compete in view of the declining turnover
growth
Regulatory Excellent Business Operations remain unaffected by 3
Risk Regulatory Risk
Good Effect of Regulatory Risk can be contained 2
Neutral Delicately balanced, Business Operations 1
can be affected if immediate steps not
taken

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Unfavourable Unable to cope with the situation 0

Industry Excellent Long term prospects of industry are 3
Outlook excellent
Good Outlook stable except for some critical 2
factors
Neutral Susceptible to unfavorable changes in the 1
economy
Unfavourable Industry in declining phase 0
Cyclicality of Excellent Not affected by cyclical fluctuations 2
Industry Good Favorable Industry cycle with long term 1
prospects
Unfavourable Susceptible to unfavourable changes in the 0
industry
Inputs/Raw High The availability, quality of key inputs/raw 2
Material Moderate materials have bearing on the quality and 1
availability Low price of final product/services. Consider 0
the following:
- Continuous availability of quality
input/raw materials
- Availability of substitutes for
input/raw materials
- Affordability of quality inputs/raw
material
Location Favourable Locational advantage might provide a 2
Issues Neutral borrower with a competitive advantage 1
Unfavourable vis-à-vis competitors like availability of 0
infrastructure, favourable government
policies, nearness to raw
materials/markets etc.
Market Good Assessment of the market/demand for the 2
Potential and Neutral product sold by the borrower in the area 1
Demand Unfavourable of operation. Compare Demand and Supply 0
Situation Scenario. Say supply more or less matches
demand, can be classified as ‘neutral’
scenario.

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C. Assessment of Management Risk

The quality of advance ultimately depends on the quality of management. Hence,

assessment of management risk is perhaps the most important area of risk assessment. The
bank has prescribed a set of value statements for various aspects of management risk.

Risk Narration Remarks Score Score

Parameter Prescrib Obtained
ed
No. of Years of Very High; Where the borrower has an experience of 3
Experience in >5 years more than 5 years
Industry- High; Where the borrower has an experience of 2
Indicate the 2-5 years between 2- 5 years
Experience of Moderate; Where the borrower has an experience of 1
borrower in <2 years less than 2 years
that line of Absent; 0
activity 0 years
Management High The initiatives of the management to stay 2
Initiatives Moderate ahead of the competitors are a clear 1
Low indication of management quality. The 0
pointers are quality certification,
collaborations and marketing alliances,
awards etc.
Position of Increase Where the Net worth of the borrower 2
Net Worth- unit as on current Balance sheet date is
Indicate the greater than the net worth as on the
movement in previous Balance sheet date
net worth Stable Where the Net worth of the borrower 1
unit as on the current balance sheet date
is same as the net worth as on the
previous balance sheet date
Decrease Where the Net worth of the borrower 0
unit as on the current balance sheet date
is less than the net worth as on the
previous balance sheet date
Labour Excellent Where there have been no cases of 2
Relations – strike/lockouts since inception
Indicates Good Where there have been no cases of 1
Quality of strike/lockouts during the immediately
Management- preceding 2 years

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Labor Satisfactory Where there have been frequent cases of 0

Relations strikes and lockouts
Second Line Available Where second line is available 2
Management Not Where second line is not available 0
– Indicates Available
availability of
second line
management
Turnover of Rarely Where the key personnel has not changed 2
Key since last 5 years
Personnel – Occasionally Where the key personnel has not changed 1
Indicates the since last 2 years
retention of Frequently Where the key personnel has changed 0
key personnel during the year
Adherence to Honoured Consider the following to judge the 3
Financial on time payment of practices:
Discipline - Honoured Payment of Interest/Instalment, 2
Honouring but delayed Government dues like sales tax, creditors
Financial within velocity ratio
Commitments acceptable
on time period (say
10-15 days)
Honoured 1
but delayed
beyond
acceptable
period
(beyond 15
days)
Not 0
honoured
Team of Yes 2
Qualified
Professional
No 0

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 Course: Credit Management (Module III: Credit Management) NIBM, Pune

D. Financial Risk (As per Last Audited Financial Statement)

Financial Risk is the risk apparent in the financial statements submitted by the borrower.
This risk can be quantitative which is measured using ratio analysis and qualitative which
is inherent in the off balance sheet liabilities and can be used in the auditors notes and
qualifications. A few select critical ratios have been identified for the purpose of calculating
the quantitative financial risk score.

Risk Parameter Range Remarks Score Score

Prescribed Obtained
TOL/TNW: TOL <1 The liability of the borrower should be 5
= Total Liabilities <2=>1 matched with the promoter’s stake. A 4
– Net Worth <3=>2 lower ratio indicates lower borrowing vis- 3
TNW= Net <4=>3 s-vis the tangible worth. Further, 2
Worth-Intangible <5=>4 investments in sister concerns, wherever 1
assets =>5 such investments do not generate any 0
business to the borrower account should
also be deducted from TNW for the
purpose of arriving at this ratio.
Interest =>3.5 Measures firm’s ability to pay interest. 5
Coverage Ratio: <3.5=>3.0 The servicing of loan obligation capacity 4
PBDIT/Interest, <3.0=>2.5 of the borrower is very crucial. This also 3
Here, interest <2.5=>2.0 indicates the number of times the gross 2
includes interest <2=>1.5 earnings cover the interest payable and is 1
paid on both term <1.5=>1.0 indicator of the measure of comfort 0
loans and <1.0 provided by the cash accruals from the -2
working capital operations
PAT/Net Sales =>9 This ratio reflects the ultimate accretion 5
(%) <9=>7 to the Net Worth of the borrower and is 4
<7=>5 an overall reflection of the profitability 3
<5=>3 2
<3=>1 1
<1 0
Return on =>8 This ratio is the measure of net profit on 5
Tangible Net <8=>7 the promoter’s stake. 4
Worth: <7=>6 3
Profit/TNW <6=>5 2
<5=>4 1
<4 0
ROCE: Net Profit 15% and This ratio is a measure of gross earnings 4

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 Course: Credit Management (Module III: Credit Management) NIBM, Pune

after Tax/Total above which the assets in the business yields

Assets (%) 12% and 3
above
10% and 2
above
7% and 1
above
Less than 7% 0
Current Ratio =>1.33 Indicator of Liquidity. CR below 1 is 5
<1.33=>1.27 considered critical because it reflects the 4
<1.27=>1.22 non-availability of drawing power. 3
<1.22=>1.17 2
<1.17=>1.10 1
<1.10=>1.00 0
<1.00 -3
Net =>6 Reflects Current Assets Turnover. Lower 5
Sales/Inventory <6=>5 the figure, slower the turnover and higher 4
+ Receivables <5=>4 the risk of obsolescence and poor 3
(Times) <4=>3 realizations 2
<3=>2 1
<2 0
Net sales/Equity =>8 Reflects Long Term Liabilities Turnover. 5
+ Borrowings <8=>7 Lower the figure, slower the turnover and 4
(Times) <7=>6 higher the risk of default 3
<6=>5 2
<5=>4 1
<4 0
Debt Equity <0.50 Debt equity gearing is an important 5
Ratio= Long <1.00=>0.50 indicator for assessing risk in (term) 4
Term Debt/Net <1.50=>1.00 exposures 3
Worth <2.00=>1.50 2
<2.50=>2.00 1
=>2.50 0
Fixed =>3.0 Measures the liquidity position 5
Assets/Long <3.0=>2.5 4
Term Debts <2.5=>2.0 3
<2.0=>1.5 2
<1.5=>1.0 1

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 Course: Credit Management (Module III: Credit Management) NIBM, Pune

<1.0 0
Growth in Net >20% 3
Sales (as >15%<20% 2
compared to >10%<15% 1
previous year) <10% 0
Growth in Net In excess of 3
Profit (as 20%
compared to In excess of 2
previous year) 15%<20%
In excess of 1
10%<15%
<10% 0

E. Parameters Based on Cash Flow Statement

Risk Parameters Range Score Score
Prescribed Obtained
Net Cash from Operations to >5 3
Sales >3% to 5% 2
0 – 3% 1
Negative 0
Net Cash from Operations to Above 40% 3
Long Term Debts Between 25% to 2
40%
Between 10% to 1
25%
Below 10% 0

12.1Facility Rating Model (Illustrative)

A. Risk Mitigation/Security Coverage

The Quality of Primary and Collateral Security is judged on the basis of: Marketability, Easy
Ascertainment of Value, Stability of Value, Storability and Efficient cost of supervision,
Transportability, Durability, Easy Ascertainment of Title, and Easy Transfer of Title.

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 Course: Credit Management (Module III: Credit Management) NIBM, Pune

Risk Parameter Narration Remarks Score Score

Prescribed Obtained
Availability of Good More than 75% to 100% of the Total 2
Collateral Security Exposure
and Quality of Average Between 50% to 75% of the exposure 1
Collaterals* Poor Less than 50% of the exposure 0
No Collateral Security
Availability of Good Guarantee Available 2
Guarantee Average Guarantee not available 1
(Promoters-
Directors’
Guarantee/Third
Party Guarantee.
Means of the
Guarantor = Total
Exposure
(FB+NFB) taken
* Note: Marks to be allotted only if the formalities of documentation/creation of
securities are completed in all respect

B. Compliance of Sanction Terms

Risk Narration Remarks Score Score
Parameter Prescribed Obtained
Compliance Excellent All sanction terms complied with including 3
of Sanction documentation/mortgage/ROC/second
Terms charge and legally enforceable
documentation held on records
Good All sanction terms complied except second 2
charge Only 2nd charge not registered
Neutral EM not completed 1
Unfavourable 0
Submission Excellent Timely Submission 3
of Stock Good Submitted within 30 days from due date 2
Statements Neutral Belated Submission beyond 30 days 1
Unfavourable 0
Submission Excellent Submitted within 5 months from the 3
of Audited closure of the account
Balance Good Submitted within a period of >5 months < 8 2

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 Course: Credit Management (Module III: Credit Management) NIBM, Pune

sheet & months from the closure of the account

Profit & Loss Neutral Delay > 8 months 1
A/C & Unfavourable 0
Financial
Data in CMA
Forms
Repayment Excellent Upto 5 years 2
schedule for Good >5 years 1
Term Loans Unfavourable 0
only
Turnover in High Turnover Commensurate with sales 2
the account Moderate Turnover>70% to <90% 1
(Consider Low Turnover >60% to <70% 0
only Credit Turnover <60%
Turnover in
the Running
A/c facility
rating to
business-
Sales
Proceeds)

C. Operations in the Account

Operations in Favourable No Occasion of excess and return of 2

the account cheques
Satisfactory Rare occasions of excess and returns of
cheques
Average Occasional excesses and return of 1
cheques
Below Frequent excess and return of cheques 0
Average
Repayment of Favourable Timely Payment
Installment & Good Irregular/overdue upto one month from 2
Interest under due date
Term Loan and Neutral Irregular/overdue beyond one month 1
payment of upto 2 months
interest on cash Unfavourable Delayed beyond 2 months 0
credit/overdraft

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 Course: Credit Management (Module III: Credit Management) NIBM, Pune

Margin given on >40%

Term loan 25% to <40%
20%<25%
<20%

Risk Rating Ranges (Illustrative)

Sl No. Aggregate Score - Range Rating Numeric Credit Quality

1 >90 A1 Lowest Risk
2 81 - 90 A2 Minimal Risk
3 71 - 80 A3 Moderate Risk
4 66 - 70 A4 Satisfactory Risk
5 61 - 65 A5 Acceptable Risk
6 56-60 A6 Watch List
7 51-55 A7 Risk Prone
8 <50 A8 High Risk
9 Default-NPA A9 Sub-Standard
10 - A10 Doubtful
11 - A11 Loss

1.13 Summary
Credit risk arises because in extending credit the banks have to make judgment about a
borrower’s creditworthiness. This creditworthiness may decline overtime due to poor
management or changes in the business climate. A bank can employ different models to
assess the risk of loans and bonds. These vary from relatively qualitative to the highly
quantitative models. . Every obligor and facility must be assigned a risk rating and loan will
be priced accordingly. The bank may use these models for credit pricing. Thus, it is
important that for proper credit risk management, the banks should have in place proper
system of appraisal before extending credit. In addition, there is need of separation of
credit risk management from credit sanction. The level of authority required to approve
credit will increase as amounts and transaction risks increase and as risk ratings worsen.
On the whole, it is important for the banks to have consistent standards for the origination,
documentation and maintenance of credit.

References
- Guidance Note on ‘Credit Risk Management’, October 12, 2002.

- Risk Management System in Banks, October 21, 1999 and January 29, 2003.

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