Credit Risk Assessment

Group 6
Ankur Jain (09FN-014)
Gaurav gagan (09FN-038)
Imran Khan (09FN-042)
Dhruv Mohan (09FN-057)
Prasanna Tadimeti (09FN-127)
Kalpana Joshi (09FN-128)
 INTRODUCTION
 Credit risk is the oldest risk among the various types of risks in the financial
system, especially in banks and financial institutions due to the process of
intermediation.

 Growth in the markets, disintermediation, and the introduction of a number of

innovative products and practices have changed the way credit risk is measured
and managed in today’s environment.

 Studies carried out on bank failures in the U.S show that credit risk alone has
accounted for 71% of large bank failures in the period from 1980 to 2004 (Peter
Nakada, 2004).

 Significant resources are spent worldwide both by regulators and managements

of banks and financial institutions on understanding and managing credit risk.
 DEFINITION AND SCOPE
 Simon Hills (2004) of the British Bankers Association defines credit risk

“is the risk to a bank’s earnings or capital base arising from a borrower’s failure to
meet the terms of any contractual or other agreement it has with the bank. Credit
risk arises from all activities where success depends on counterparty, issuer or
borrower performance”.

 Thus, credit risk arises from many banking Credit Risk Management activities
apart from traditional lending activity

 Credit risk can be segmented into two major segments viz. intrinsic and portfolio
(or concentration) credit risks.

 The focus of the intrinsic risk is measurement of risk at individual loan level. This
is carried out at lending unit level.

 Portfolio credit risk arises as a result of concentration of the portfolio to a particular

sector, geographic area, industry, type of facility, type of borrowers, similar rating,
etc. Concentration risk is managed at the bank level as it is more relevant at that
level.
 SIGNIFICANCE OF CREDIT RISK
MANAGEMENT
 Increase in Bankruptcies: Compared to the past, bankruptcies have increased.
 Deregulation: Innovation stimulated by deregulation has led to new entrants into the
markets to provide services
 Disintermediation: As large institutions with strong credit quality are less dependent
on bank funds, banks are left to serve institutions with weaker credit quality
 Shrinking Margins on Loans :The increasing competition in the market is cited as
the major reason for this
 Growth of off-Balance Sheet Risks: The phenomenal expansion of the Over-the-
Counter (OTC) derivative products.
 Volatility in the Value of Collateral: It has been observed that predicting the market
value of collateral held against loan is very difficult.
 Advances in Finance Theory and Computer Technology: These advances have
paved the way for banks to test very sophisticated credit risk models.
 Risk-based Capital Regulations: The development of risk based capital
requirements pronounced by the Basle Committee has been one of the important
drivers of credit risk initiatives.
 APPROACHES TO CREDIT RISK

MEASUREMENT: INTRINSIC RISK
Expert Systems
 Credit Rating
 Credit Scoring

Expert Systems: In an expert system, the decision to lend is taken by the lending
officer who is expected to possess expert knowledge of assessing the credit worthiness of
the customer. Accordingly the success or failure very much depends on the expertise,
judgment and the ability to consider relevant factors in the decision to lend.
One of the most common expert systems is the five “Cs” of credit.
 Character: Measure of reputation of the firm, willingness to repay & repayment
history.
 Capital: The adequacy of equity capital of the owners so that the owner’s interest
remains in the business.
 Capacity: The ability to repay is measured by the expected volatility in the sources of
funds intended to be used by the borrower for the repayment of loan along with
interest. Higher the volatility of this source, higher the risk and vice versa.
 Collateral: Availability of collateral is important for mitigating credit risk.
 Cycle or (economic) Conditions: The state of the business cycle
 PROBLEMS (ES)
 The expert view on the above would finally influence the decision to lend or
not. Although many banks still use expert systems as part of their credit
decision process, these systems face two main problems (Saunders, 1999):

 Consistency: There may not be a consistent approach followed for different

types of borrowers and industries. Thereby the system would be person-
dependent

 Subjectivity: As weights applied to different factors are subjective,

comparability across time may not be possible.
 CREDIT RATINGS
 Process by which an alphabetic or numerical rating is assigned to a credit facility
extended by a bank to a borrower based on a detailed analysis of his character
and matching it with the characteristics of facility that is extended to him.

 The only difference is that while the rating by the external agency (CRISIL,
ICRA) is available in the public domain for any one to use, the internal ratings
carried out by a bank is confidential and is used for specific purpose only.

 CRISIL may apply “+” (plus) or “–” (minus) signs for ratings from AA to D to
reflect comparative standing within the category.

 CRISIL may assign rating outlooks for ratings from ‘AAA’ to ‘B. It indicates the
direction in which a rating may move over a medium term horizon of 1 to 2 years.
A rating outlook can be ‘Positive’, ‘Stable’ or ‘Negative’.

 Preference share rating symbols are identical to debenture rating symbols except
that the letters “pf” are prefixed to the debenture rating symbols, e.g. pf AAA (“pf
Triple A”).
 CREDIT RATINGS
HIGH INVESTMENT GRADES
AAA ( Tripple A ) Highest Safety

AA (Double safety) High Safety

INVESTMENT GRADES

A Adequate safety

BBB Moderate safety

Investment Grades:
SPECULATIVE GRADES

BB Inadequate
(Double B) Safety

B High Risk

C Substantial
Risk

D In Default
 RISK MANAGEMENT
Risk Management A number of financial ratios are used to ascertain the financial
strength and position.
 Operating performance
 Debt service
 Financial leverage
 Liquidity
 Receivables
Credit Scoring:
A major disadvantage of a rating model is the subjectivity of weight to be applied to
different segments in the rating exercise.
This drawback can be avoided in a scoring model which is based on rigorous
statistical techniques. This approach combines a number of ratios into a single
numerical score which is used to determine the credit quality or default.
The basic assumption of the method is that combination of a number of ratios
explains the success (no default) or failure (default) of a facility extended to a
borrower.
Starting with the historical data with known outcome of success or failure, a set of
ratios that differentiate the successful cases from the failed ones along with the
weights to be applied for each ratio is arrived at by multiple discriminant analysis
 CREDIT SCORING
The most popular among the models is the one by Altman’s (1968) Z-score model, which is a
classificatory model for corporate borrowers. Based on a matched sample (by year, size and
industry) of failed and solvent firms, and using linear discriminant analysis, the best fitting
scoring model for commercial loans took the following form: (Saunders, 1999)
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6X4 + 0.999X5
Where
 Z = Altman’s Z score of a commercial loan
 X1 = working capital/total assets ratio
 X2 = retained earnings/total assets ratio
 X3 = earnings before interest and taxes/total assets ratio
 X4 = market value of equity/book value of total liabilities
 X5 = Sales/total assets ratio

Each one of the ratios in the equation is weighted by weight empirically arrived at on the basis
of past experience with similar type of loans
The major advantage of the approach is that the score once arrived at can be used to classify
any new loan of the same category into good or bad.
The model is linear while the relationship between the score and the ratios can be non linear
 APPROACHES FOR PORTFOLIO/
CONCENTRATION RISK
Concentration risk refers to additional portfolio risk resulting from increased exposure to
one obligor or groups of correlated obligors. Concentration risk was generally addressed
by limiting the size of exposures to individual borrowers

a) To systematically address concentration risk.

b) The traditionally used exposure based fixed concentration limits do not recognize the
relationship between risk and return.
c) The portfolio approach would create a framework within which to consider
concentrations along almost any dimension (industry, sector, country, instrument
type, etc.).
d) To more rationally and accountably address portfolio diversification in terms of
addition to overall risk of the portfolio by deciding to take on higher exposure.
e) By capturing portfolio effects (diversification benefits and concentration risks) and
recognizing that risk accelerates with declining credit quality, a portfolio credit risk
methodology can be the foundation for a rational risk-based capital location process.
 CONCENTRATION RISK
Nobel Laureate Harry Markowitz’s Modern Portfolio Theory (MPT) is one of the
cornerstones of research in Finance. Markowitz defined for the first time, the meanings
of expected return and risk in an investment portfolio and pioneered the techniques to
measure them.

Even though the concepts of MPT were defined and originally applied for an equity
investment portfolio, the philosophy of MPT can be extended to any basket of assets.

The MPT stressed the need for looking at the interrelationships between the assets
before combining them into a portfolio. The interrelationship between assets is
measured by correlation or covariance in portfolio analysis. An efficient portfolio can be
constructed by using the interrelationship.

If two assets which are perfectly positively correlated with each other are combined in
the form of a portfolio, both the assets tend to go down or go up together in value. In
such a case, there is no possibility of reducing the risk of the portfolio and the objective
of holding a portfolio of assets as opposed to a single asset will be lost.
 MPT (cont…)
If two assets which are perfectly negatively correlated with each other are combined in the form of a
portfolio, if one asset goes up, the other asset will come down in value. In this case, the loss in the value
of one asset will be compensated by the increase in the value of the other

Using the concepts of MPT, it can be mathematically proved that if the correlation between the asset
returns is -1, at least one portfolio can be constructed such that the risk of the portfolio is zero

In loan portfolio, several individual credit exposures often share characteristics that can result in
concurrent losses. Excessive concentrations in certain geographical areas, industries and loan types
present risks that banks should consider in planning their credit portfolio.

By spreading the loan portfolio, a fully diversified, least risky portfolio which is not affected by unique
problems or happenings in a specific geographic area or industry or to a type of loan can be constructed

With the future course of economic events always uncertain, loan portfolio diversification is necessary to
safeguard lending performance.

Indian banks and financial institutions, with a huge lending portfolio can also fall victim to industry
risks if their loan portfolios contain concentrations in industries which are affected by the same
economic condition.
 BUILDING BLOCKS OF CREDIT RISK
MANAGEMENT
RBI’s Guidance note on credit risk management:
An effective credit risk management framework would comprise of the
following distinct building blocks:
 a) Policy and Strategy
 b) Organizational Structure
 c) Operations/Systems

a) Policy and Strategy

The Board of Directors of each bank shall be responsible for approving and
periodically reviewing the credit risk strategy and significant credit risk
policies
 BUILDING BLOCKS OF CREDIT RISK
MANAGEMENT
Credit Risk Policy
 Every bank should have a credit risk policy document approved by the Board.
The document should include risk identification, risk measurement, risk
grading/aggregation techniques, reporting and risk control/mitigation
techniques, documentation, legal issues and management of problem loans.
 Credit risk policies should also define target markets, risk acceptance criteria,
credit approval authority, credit origination/ maintenance procedures and
guidelines for portfolio management.
 The credit risk policies approved by the Board should be communicated to
branches/controlling offices. All dealing officials should clearly understand
the bank’s approach for credit sanction and should be held accountable for
complying with established policies and procedures.
 Senior management of a bank shall be responsible for implementing the credit
risk policy approved by the Board
 BUILDING BLOCKS OF CREDIT RISK
MANAGEMENT
Credit Risk Strategy
 Each bank should develop, with the approval of its Board, its own credit risk strategy
or plan that establishes the objectives guiding the bank’s credit-granting activities and
adopt necessary policies/procedures for conducting such activities. This strategy
should spell out clearly the organization's credit appetite and the acceptable level of
risk-reward trade-off for its activities.
 The strategy would, therefore, include a statement of the bank’s willingness to grant
loans based on the type of economic activity, geographical location,
currency, market, maturity and anticipated profitability. This would necessarily
translate into the identification of target markets and business sectors, preferred levels
of diversification and concentration, the cost of capital in granting credit and the cost
of bad debts.
 The credit risk strategy should provide continuity in approach as also take into account
the cyclical aspects of the economy and the resulting shifts in the composition/ quality
of the overall credit portfolio. This strategy should be viable in the long run and
through various credit cycles.
 Senior management of a bank shall be responsible for implementing the credit risk
strategy approved by the Board.
 BUILDING BLOCKS OF CREDIT RISK
MANAGEMENT
b) Organizational Structure
 The Board of Directors should have the overall responsibility for management of
risks. The Board should decide the risk management policy of the bank and set
limits for liquidity, interest rate, foreign exchange and equity price risks..
 The Risk Management Committee will be a Board level Sub committee including
CEO and heads of Credit, Market and Operational Risk Management Committees. It
will devise the policy and strategy for integrated risk management containing
various risk exposures of the bank including the credit risk
 It effectively coordinates between the Credit Risk Management
Committee (CRMC), the Asset Liability Management Committee and other risk
committees.
 It is imperative that the independence of this Committee is preserved. In the event
of the Board not accepting any recommendation of this Committee, systems should
be put in place to spell out the rationale for such an action and should be properly
documented. The credit risk strategy and policies adopted by the committee should
be effectively communicated throughout the organization.
 BUILDING BLOCKS OF CREDIT RISK
MANAGEMENT
c) Operations/Systems
Credit administration process:
 Relationship management phase i.e. business development.
 Transaction management phase covers risk assessment, loan pricing, structuring the
facilities, internal approvals, documentation, loan administration, on going
monitoring and risk measurement
 Portfolio management phase entails monitoring of the portfolio at a macro level and
the management of problem loans

Credit risk measurement and monitoring procedures:

 Banks should establish proactive credit risk management practices like annual /
half yearly industry studies and individual obligor reviews, periodic credit calls
that are documented, periodic visits of plant and business site, and at least quarterly
management reviews of troubled exposures/weak credits
 BUILDING BLOCKS OF CREDIT RISK
MANAGEMENT
 Banks should have a system of checks and balances in place for extension
of credit.
 The level of authority required to approve credit will increase as amounts
and transaction risks increase and as risk ratings worsen.
 Every obligor and facility must be assigned a risk rating.
 Mechanism to price facilities depending on the risk grading of the customer
 Banks should maintain a diversified portfolio of risk assets; have a system
to conduct regular analysis of the portfolio and to ensure on-going control
of risk concentrations.
 Credit risk limits include, obligor limits and concentration limits by
industry or geography.
 In order to ensure transparency of risks taken, it is the responsibility of
banks to accurately, completely and in a timely fashion, report the
comprehensive set of credit risk data into the independent risk system.
BUILDING BLOCKS OF CREDIT RISK
MANAGEMENT
 Banks should have systems and procedures for monitoring financial performance of
customers and for controlling outstanding within limits.
 A conservative policy for provisioning in respect of non-performing advances may be
adopted.
 Successful credit management requires experience, judgment and commitment to
technical development. Banks should have a clear, well-documented scheme of
delegation of powers for credit sanction.
 Banks should have a clear, well-documented scheme of delegation of powers for credit
sanction
 Banks must have a Management Information System (MIS), which should enable them
to manage and measure the credit risk inherent in all on- and off-balance sheet activities
 The MIS should provide adequate information on the composition of the credit
portfolio, including identification of any concentration of risk
 Banks should price their loans according to the risk profile of the borrower and the risks
associated with the loans
 Typical Organizational Structure for Risk
Management
Board of Directors

Risk Management Committee

(Board Sub-committee Including CEO and Heads of Credit, Market and Operational Risk
Management Committees)
Core Function: Policy and Strategy for Integrated Risk Management

Credit Risk Management Committee Alco/Market Operational

(Committee of Top Executives Including Risk Risk
CEO, Heads of Credit and Treasury, and Management Management
Chief Economist) Committee Committee

Credit Risk Management Credit Administration

Department (CRMD) Department (CAD)

Risk Planning Risk Assessment Risk Analytics Credit Risk – Systems

- Definition of and Monitoring - Credit Risk and - Integration of Risk
Procedures - Sector Review Pricing Models’ Procedures with
- Design of - Credit Rating Design and Credit Systems
Credit - Review of Credit Maintenance - Design and
Processes Proposals (new) - Portfolio Development of
Processes - Asset Review Analysis Support Systems for
(existing) and Reporting Risk Assessment and
Monitoring
 Credit Rating Framework (CRF)
CRF gives ratings to the risks associated with a credit exposure
This rating framework is the basic module for developing a credit risk
management system and all advanced models/approaches are based on this
structure
Use of Credit Ratings made on the CRF
•Individual credit selection, wherein either a borrower or a particular
exposure/facility is rated on the CRF
•Pricing (credit spread) and specific features of the loan facility. This would
largely constitute transaction-level analysis
•Portfolio-level analysis
•Surveillance, monitoring and internal MIS
•Assessing the aggregate risk profile of bank/ lender. These would be relevant
for portfolio-level analysis. For instance, the spread of credit exposures across
various CRF categories, the mean and the standard deviation of losses
occurring in each CRF category and the overall migration of exposures would
highlight the aggregated credit-risk for the entire portfolio of the bank
 Credit Rating Framework (CRF)
Basic Architecture of CRFs
1. Grading System for Calibration of Credit Risk
1.1 Nature of grading system
1.2 Number of grades used
1.3 Key outputs of CRF
2. Operating Design of CRF
2.1 Which exposures are rated?
2.2 The risk rating process
2.3 Assigning and monitoring risk ratings
2.4 The mechanism of arriving at risk ratings
2.5 Standardization and benchmark for risk ratings
2.6 Written communications and formality of procedures
3. CRFs and Portfolio Credit Risk
3.1 Portfolio surveillance and reporting
3.2 Adequate levels of provisioning for credit events
3.3 Guidelines for asset build up, aggregate profitability and pricing
3.4 Interaction with external credit assessment institutions
 Credit Rating Framework (CRF)

1. Grading System for Calibration of Credit Risk

 The grades (symbols, numbers, alphabets, descriptive terms)

used in the internal credit-risk grading system should represent,
without any ambiguity, the default risks associated with an
exposure
 The grading system should enable comparisons of risks for
purposes of analysis and top management decision-making
 It should reflect regulatory requirements of the supervisor on
asset classification (e.g. the RBI asset classification)
 Credit Rating Framework (CRF)

1.1 Nature of Grading System for the CRF

The grading system adopted in a CRF could be an alphabetic or numeric or an alphanumeric scale

The number of grades for the “acceptable” and the “unacceptable” credit risk categories would
depend on the finesse of risk gradation.

Normally, numeric scales developed for CRFs are such that the lower the credit-risk, the lower is
the calibration on the scale

The scale, starting from “1” (which would represent lowest level credit risk and highest level of
safety/ comfort) and ending at “9” (which would represent the highest level of credit risk and
lowest level of safety/ comfort), could be deployed to calibrate, benchmark, compare and monitor
credit risk associated with the bank’s exposures and give indicative guidelines for credit risk
management activities

Each bank may consider adopting suitable alphabetic prefix to their rating scales, which would
make their individual ratings scale distinct and unique
 Credit Rating Framework (CRF)
1.2 Number of Grades used in the CRF
 The number of grades used in the CRF depends on the anticipated
spread in credit quality of the exposures taken by the bank.
 This, in turn, is dependent on the present and the future business
profile of the bank and the anticipated level of specialization/
diversification in the credit portfolio
 CRFs with a large number of levels/grades on the rating scale are, as
evident, more expensive to operate as the costs of additional
information for (very) fine gradation of credit-quality increase
sharply
 A bank can initiate the risk-grading activity on a relative
smaller/narrower scale and introduce new categories as the risk-
gradation improves
 Credit Rating Framework (CRF)
1.3 Key Results of CRF
 The calibration on the rating scale is expected to define the pricing and related terms and
conditions for the accepted credit exposures. Broad price bands can be defined and
further refinement in the pricing proposal would be done based on the elements of the
loan proposal and the relationship of the bank with the borrower
 The calibration on the rating scale would allow prescription of limits on the maximum
quantum of exposure permissible for any credit proposal. The quantum would depend on
the credit-score on the CRF. These limits could be linked to an internal parameter or an
external parameter
 The rating scale could also be used for deciding on the tenure of the proposed assistance
 The rating scale could also be used to decide on the frequency/ intensity of monitoring of
the exposure. Banks may also use the rating scale to keep a close track of deteriorating
credit quality and decide on the remedial measures which the deterioration may warrant
 Though loss-provisions are often specified by the regulator (e.g. the RBI provisioning
norms), banks should develop their own internal norms and maintain certain level of
“reasonable over-provisioning” as a best practice
 Credit Rating Framework (CRF)
2. Operating Design of the CRF

2.1 Which Exposures are rated

 There may be a case for size-based classification of exposures and linking
the risk-rating process to these size-based categories
 The shortcoming of this arrangement is that though significant credit
migration/deterioration occurs in the smaller sized exposures, these are not
captured by the CRF
 In addition, the size-criteria are also linked with the tenure-criteria for an
exposure
 Given this apparent lack of clarity, a policy of ‘all exposures are to be
rated’ should be followed
 Credit Rating Framework (CRF)
2.2 The Risk Rating Process
 The CRF may be designed in such a way that the risk rating has certain linkages with the
amount, tenure and pricing of exposure
 The risk rating assigned to each credit proposal would thus directly lead into the related
decisions of acceptance (or rejection), amount, tenure and pricing of the (accepted) proposal
 The risk-rating process would be equally relevant in the credit-monitoring/ surveillance stage
 All changes in the underlying credit-quality are calibrated on the risk-scale and corresponding
remedial actions are initiated

2.3 Assigning and Monitoring Risk Ratings

• Responsibilities for calibration on the risk-rating scale are divided between the
“relationship” and the “credit” groups
• All large sized exposures (above a limit) are appraised independently by the
“credit” group
• The activities of assigning and approving risk-ratings need to be segregated
• Though the conventional relationship staff can assign the risk-ratings, the
responsibilities of final approval and monitoring should be vested with a separate
credit staff
 Credit Rating Framework (CRF)
2.4 Mechanism of arriving at Risk Ratings
 The following step-wise activities outline the indicative process for
arriving at risk-ratings:
Step 1 Identify all the principal business and financial risk
elements
Step 2 Allocate weights to principal risk components
Step 3 Compare with weights given in similar sectors and
check for consistency
Step 4 Establish the key parameters (sub-components of
the principal risk elements)
Step 5 Assign weights to each of the key parameters
Step 6 Rank the key parameters on the specified scale
Step 7 Arrive at the credit-risk rating on the CRF
Step 8 Compare with previous risk-ratings of similar
exposures and check for consistency
Step 9 Conclude the credit-risk calibration on the CRF
 Credit Rating Framework (CRF)
2.5 Standardization and Benchmarks for Risk Ratings
 The standards usually consist of financial ratios and credit-migration statistics, which capture
the financial risks faced by the potential borrower and also the Business risk is captured
 The next step would be to assign weights to these risk-parameters. In an industrial credit
environment, the CRF may place higher weights on size (as captured in gross revenues),
profitability of operations (operating margins), financial leverage (debt : equity) and debt-
servicing ability (interest cover). Similarly, the business and the management risk of the
proposed exposure are assessed and an overall/ comprehensive risk rating is assigned
 The CRF may also use qualitative/ subjective factors in the credit decisions. Such factors are
both internal and external to the company

2.6 Written Communications and Formality of Procedure

•The two critical aspects of the formality of procedure in the risk-rating process are
The process-flow through which a credit-transaction would flow across various units
The written communication on the risk-ratings assigned to a particular proposal
•The process-flow required for the credit appraisal exercise, may be explicitly drafted
and communicated
•It may clearly identify the transactions and linkages between various operating units of
the bank
 Credit Rating Framework (CRF)
3. CRFs and Aggregation of Credit-Risk
3.1 Portfolio Surveillance and Reporting
 The conventional internal MIS of a bank would identify the problem-loans in the
asset portfolio, as per the guidelines given by the regulator
 The CRF can be used for informing the top management on the frequency distribution
of assets across risk-rating scale, the extent of migration in the past and the
anticipated developments in the aggregated credit portfolio
3.2 Adequate levels of Provisioning for Credit Events
• The spread of the asset portfolio across the risk-rating scale and the trends in
rating
migration would allow the bank management to determine the level of provisioning
required, in addition to the regulatory minimum
• The extent of provisioning required could be estimated from the Expected Loss on
Default (which is a product of the Probability of Default (PD) and Loss Given
Default (LGD)
• An alternative would be to adopt a policy of allocating/provisioning an amount
which may be a proportion of the aggregate exposures in the
risk-rating scale which reflect the likelihood of the assets slipping into the NPA
category
 Credit Rating Framework (CRF)
3.3 Guidelines for Asset Build-up, Aggregate Profitability
and Pricing

 A clear analysis of the prevailing risk-posture of the bank, facilitated by the CRF,
would give strong recommendations for future asset build-up and business
development activities
 The extent of provisioning would be based on actual and anticipated erosion in
credit quality and would define the “cost” of maintaining an exposure in the bank’s
credit portfolio
 A similar analysis could be undertaken for a specific credit-product and the risk-
adjusted return can be assessed
 This will involve an analysis of the pricing-decisions, provisioning requirements,
loss on default and the incremental impact on bank’s profitability
 Credit Rating Framework (CRF)
3.4 Interaction with External Credit Assessment Institutions
(ECAI)
 The benefits of such a CRF system, in addition to those described above, could include a more
amenable interaction with rating agencies and regulatory bodies
As per the guidelines laid down by RBI:
 The proposals for investments should also be subjected to the same degree of credit risk
analysis, as any loan proposals
 The proposals should be subjected to detailed appraisal and rating framework that factors in
financial and non-financial parameters of issuers, sensitivity to external developments, etc
 The maximum exposure to a customer should be bank-wide and include all exposures assumed
by the Credit and Treasury Departments
 The coupon on non-sovereign papers should be commensurate with their risk profile
 The banks should exercise due caution, particularly in investment proposals, which are not
rated and should ensure comprehensive risk evaluation
 There should be greater interaction between Credit and Treasury Departments and the portfolio
analysis should also cover the total exposures, including investments
 The rating migration of the issuers and the consequent diminution in the portfolio quality
should also be tracked at periodic intervals
Credit Risk Models
A Credit Risk model determines the present value of a given loan or
fixed income security, given our past experience and assumptions
about the future
The increasing importance of credit risk modeling should be seen as
the consequence of the following three factors:
 Banks are becoming increasingly quantitative in their treatment of credit
risk
 New markets are emerging in credit derivatives and the marketability of
existing loans is increasing through securitization/ loan sales market
 Regulators are concerned to improve the current system of bank capital
requirements especially as it relates to credit risk
The credit risk models are intended to aid banks in quantifying,
aggregating and managing risk across geographical and product lines
Credit risk modeling may result in better internal risk management and
may have the potential to be used in the supervisory oversight of
banking organizations
 Techniques
1. Econometric Techniques such as linear and multiple discriminant analysis,
multiple regression, logic analysis and probability of default, etc.

2. Neural Networks : computer-based systems that use the same data employed in
the econometric techniques but arrive at the decision model using alternative
implementations of a trial and error method.

3. Optimization Models are mathematical programming techniques that discover

the optimum weights for borrower and loan attributes that minimize lender error
and maximize profits.

4. Rule-based or Expert Systems : characterized by a set of decision rules, a

knowledge base consisting of data such as industry financial ratios, and a
structured inquiry process to be used by the analyst in obtaining the data on a
particular borrower.

5. Hybrid Systems : In these systems simulation are driven in part by a direct causal
relationship, the parameters of which are determined through estimation
techniques.
 Credit Risk Models
Four Models are available for measuring credit risk:

Credit Risk
Models
 Credit Risk Models

Z-score Model:
 Application of multivariate discriminant analysis
 Five Ratios found significant.
Working Capital/ Total Assets
Retained Earnings/Total Assets
Earnings Before Interest and Taxes/Total Assets
Market Value of Equity/Book Value of Total Liabilities
Sales/Total Assets

KMV Model:
 Uses information on stocks prices and the capital structure of
the firm
 predicts the expected default frequency (EDF) of the firms
 Credit Risk Models
Credit Metrics:
Method for estimating the distribution of value of assets in a
portfolio subject to changes in the credit quality of individual
borrower.
Credit Risk+ Model:
 Model for default risk
 Used to obtain probability generating function for losses
 Losses are entirely determined by exposure and recovery rate
 These models should be used with modifications according to
country risk environment to fine tune the CRM process
 Success of Credit risk models depends upon historical loan loss
rate and other model variables spanning across multiple credit
cycles so banks should start using credit risk modeling only after
some period of time.
Credit Approval
Domain of Application
Used on a stand alone basis or in conjunction with a judgemental override system for approving
credit in the consumer lending business.
Used to include small business lending.
They are generally not used in approving large corporate loans

Credit rating Determination

Quantitative models used in deriving ‘shadow bond rating’ for unrated securities and commercial
loans.
Ratings influence portfolio limits and other lending limits used by the institution.

Credit risk models

Used to suggest risk premiathat should be charged in probability of loss and the size of the loss
given default.
Using a mark-to-market model, an institution may evaluate the costs and benefits of holding a
financial asset.
Unexpected losses implied by a credit model may be used to set the capital charge in pricing.

Early Warning
Credit models are used to flag potential problems in the portfolio to facilitate early corrective
action.
Common Credit Language
Credit models used to select assets from a pool to construct a portfolio acceptable to investors at
the time of asset securitization
Collection Strategies
Credit models may be used in deciding on the best collection or workout strategy to pursue.
 Credit Risk Models: Approaches
There are two approaches to credit risk measurement:
 First Approach :
 Development of statistical models through analysis of historical data.
 It tries to rate the firms on a discrete or continuous scale.
 Altman introduced the Z-score Model, separates defaulting firms from non-
defaulting ones on the basis of certain financial ratios.
 Altman, Hartzell, and Peck have modified the original Z-score model to develop
the Emerging Market Scoring (EMS) model.
 Second Approach :
 Captures distribution of the firm’s asset-value over a period of time based on the
expected default frequency (EDF) model.
 It calculates the asset value of a firm from the market value of its equity using an
option pricing based.
 It tries to estimate the asset value path of the firm over a time horizon.
 The default risk is the probability of the estimated asset value falling below a pre-
specified default point.
 Managing Credit Risk in Inter-bank
Exposure
 Key financial parameters to be evaluated for any bank are:
1. Capital Adequacy
 Capital adequacy needs to be appropriate to the size and structure of the balance sheet as
it represents the buffer to absorb losses during difficult times.
 The Basel standards require banks to have a capital adequacy ratio of 8% with Tier I ratio
not less than 4%. The RBI requirement is 9%.
2. Asset Quality
 Some issues to be considered are sectoral exposure limits, exposure in risky countries,
Net NPA level, impact of mark-to-market values of treasury transactions.
3. Liquidity
 Key ratios to be analysed are :
 Total Liquid Assets to Total Assets ratio
 Total Liquid Assets to Total Deposits ratio Loans to Deposits ratio
 Inter-bank deposits to total deposits ratio.

4. Profitability
 Key ratios to be analysed are :
 Return on Average Assets
 Return on Equity
 Net Interest Margin
 Operating Expenses to Net Revenue ratio
 Other Key Parameters
1. Ownership
 The spread and nature of the ownership structure is important.
 Support from a large body of shareholders is difficult to obtain if the bank’s performance is adverse.
 A smaller shareholder base constrains the ability to garner funds.
2. Management Ability
 Frequent changes in senior management, change in a key figure, and the lack of succession planning
need to be viewed with suspicion.
 Risk management is a key indicator of the management’s ability as it is integral to the health of any
institution.
3. Peer Comparison/ Market Perception
 It is appropriate to assess a bank’s financial statements against those of its comparable peers.
 Market sentiment is highly important to a bank’s ability to maintain an adequate funding base, but is
not necessarily reflective of published information.
4. Country of Incorporation/ Regulatory Environment
 Country risk needs to be evaluated since a bank which is financially strong may not be permitted to
meet its commitments in view of the regulatory environment or the financial state of the country in
which it is operating in.
5. Facilities can be classified into three categories:
1. On balance sheet items such as cash advances, bond holdings and investments, and off-balance sheet
items which are not subject to market fluctuation risk such as guarantees, acceptances and letters of
credit.
2. Facilities which are off-balance sheet and subject to market fluctuation risk such as foreign exchange
and derivative products.
3. Settlement facilities: These cover risks arising through payment systems or through settlement of
treasury and securities transactions.
 Country Risk
 Country Risk is the possibility that a country will be unable to service or repay its debts to foreign
lenders in a timely manner. In banking, this risk arises on account of cross border lending and
investment.
 Country risk comprises of the following risks :
1. Transfer Risk
 The core risk, on account of the possibility of losses due to restrictions on external remittances
 An obligor may be able to pay in local currency, but may not be able to pay in foreign currency.
2. Sovereign Risk
 Associated with lending to government of a sovereign nation or to taking government guarantees.
 Sovereign entities may claim immunity from legal process or might not abide by a judgment.
 Ordinarily, it is assumed that there will be no default by a sovereign.
3. Non-Sovereign or Political
 Risk arises when political environment or legislative process of a country leads to Government taking over the
assets of the financial entity (e.g. nationalization) and preventing discharge of its liabilities in a manner that had
been agreed to.
4. Cross Border Risk
 Arises on account of the borrower being a resident of a country other than the country where the cross border
asset is booked, and includes exposures to local residents denominated in currencies other than the local
currency.
5. Currency Risk
 Possibility that exchange rate changes will alter the expected amount of principal and return of the lending or
investment.
6. Macro-economic and Structural Fragility Risk
 In these crises firms could purchase foreign exchange to service foreign debt but collapse of exchange rates and
surge in interest rates due to severe government restrictions.
 Loan Review Mechanism/Credit Audit
Credit Audit examines compliance with sanction and post-sanction
procedures laid down by the bank.
Objectives of Credit Audit:
 Improvement in the quality of credit portfolio
 Review sanction process and compliance status of large loans
 Feedback on regulatory compliance
 Independent review of Credit Risk Assessment
 Pick-up early warning signals and suggest remedial measures
 Recommend corrective action to improve credit quality, credit administration and
credit skills of staff, etc.
Procedure to be followed for Credit Audit:
 Credit Audit is conducted on site, i.e. at the branch which has appraised the
advance and where the main operative credit limits are made available.
 Report on conduct of accounts of allocated limits are to be called from the
corresponding branches.
 Credit auditors are not required to visit borrowers’ factory/ office premises.
 BASAL || Norms for Credit Risk
New Capital Accord: Implications for
Credit Risk Management

 The Basel Committee on Banking Supervision had released in June 1999 the
first Consultative Paper on a New Capital Adequacy Framework with the
intention of replacing the current broad-brush 1988 Accord.

 The Basel Committee has released a Second Consultative Document in January

2001, which contains refined proposals for the three pillars of the New Accord –
Minimum Capital Requirements, Supervisory Review, and Market Discipline.
 Approaches for estimating Regulatory
Capital
Standardized Approach
Foundation IRB Approach
Advanced IRB Approach

Standardized Approach
• This approach follows Basel I by grouping exposures into a
series of risk categories
• However under Basel II three of the categories (loans to
sovereigns, corporate and banks) have risk weights determined
by the external credit ratings assigned to the borrower
 Foundation IRB Approach
•Internal measures of credit risk are based on assessments of the risk
characteristics of both the borrower and the specific type of
transaction
•Probability of default (PD) of a borrower or group of borrowers is the
central
•measurable concept
•Banks should also seek to measure how much they will lose should a
borrower default on an obligation. This is done through:
The magnitude of likely loss on the exposure: this is termed the
Loss Given Default (LGD), and is expressed as a percentage of the
exposure.
Secondly, the loss is contingent upon the amount to which the
bank was exposed to the borrower at the time of default,
commonly expressed as Exposure at Default (EAD)
•The maturity (M) of exposures is also considered.
•These components (PD, LGD, EAD, M) form the basic inputs to the
IRB approach, and consequently the capital requirements derived
from it
Foundation IRB Vs Advanced IRB
Data Input Foundation IRB Advanced IRB

Probability of Default Provided by bank based on Provided by bank based on

own estimates own estimates

Loss given default Supervisory values set by the Provided by bank based on
Committee own estimates

Exposure at default Supervisory values set by the Provided by bank based on

Committee own estimates

Maturity Supervisory values set by the Provided by bank based on

Committee own estimates
Or
At national discretion,
provided by bank based on
own estimates
 Principles for the Assessment of Banks’
Management of Credit Risk
Establishing an appropriate credit risk environment

Operating under a sound credit granting process

Maintaining an appropriate credit administration,

measurement and monitoring process

Ensuring adequate controls over credit risk

The role of supervisors

 A. Establishing an appropriate credit
risk environment
 Principle 1: The board of directors should have responsibility for approving and periodically
reviewing the credit risk strategy and significant credit risk policies of the bank. The strategy
should reflect the bank’s tolerance for risk and the level of profitability the bank expects to
achieve for incurring various credit risks.

 Principle 2: Senior management should have responsibility for implementing the credit risk
strategy approved by the board of directors and for developing policies and procedures for
identifying, measuring, monitoring and controlling credit risk. Such policies and procedures
should address credit risk in all of the bank’s activities and at both the individual credit and
portfolio levels.

 Principle 3: Banks should identify and manage credit risk inherent in all products and activities.
Banks should ensure that the risks of products and activities new to them are subject to adequate
procedures and controls before being introduced or undertaken, and approved in advance by the
board of directors or its appropriate committee.
 B. Operating under a sound credit
granting process
 Principle 4: Banks must operate under sound, well-defined credit-granting criteria. These
criteria should include a thorough understanding of the borrower or counterparty, as well
as the purpose and structure of the credit, and its source of repayment.

 Principle 5: Banks should establish overall credit limits at the level of individual
borrowers and counterparties, and groups of connected counterparties that aggregate in a
comparable and meaningful manner different types of exposures, both in the banking
and trading book and on and off the balance sheet.

 Principle 6: Banks should have a clearly-established process in place for approving new
credits as well as the extension of existing credits.

 Principle 7: All extensions of credit must be made on an arm’s-length basis. In particular,

credits to related companies and individuals must be monitored with particular care and
other appropriate steps taken to control or mitigate the risks of connected lending.
 C. Maintaining an appropriate credit
administration, measurement and monitoring
process
 Principle 8: Banks should have in place a system for the ongoing administration of
their
various credit risk-bearing portfolios.

 Principle 9: Banks must have in place a system for monitoring the condition of
individual credits, including determining the adequacy of provisions and reserves.

 Principle 10: Banks should develop and utilize internal risk rating systems in
managing credit risk. The rating system should be consistent with the nature, size
and complexity of a bank’s activities.

 Principle 11: Banks must have information systems and analytical techniques that
enable management to measure the credit risk inherent in all on- and off-balance
sheet activities. The management information system should provide adequate
information on the composition of the credit portfolio, including identification of
any concentrations of risk.
 C. Maintaining an appropriate credit
administration, measurement and monitoring
process

 Principle 12: Banks must have in place a system for monitoring the overall
composition and quality of the credit portfolio.

 Principle 13: Banks should take into consideration potential future changes in
economic conditions when assessing individual credits and their credit
portfolios, and should assess their credit risk exposures under stressful
conditions.
 D. Ensuring adequate controls over credit
risk
 Principle 14: Banks should establish a system of independent, ongoing credit
review and the results of such reviews should be communicated directly to the
board of directors and senior management

 Principle 15: Banks must ensure that the credit-granting function is being
properly managed and that credit exposures are within levels consistent with
prudential standards and internal limits. Banks should establish and enforce
internal controls and other practices to ensure that exceptions to policies,
procedures and limits are reported in a timely manner to the appropriate level
of management.

 Principle 16: Banks must have a system in place for managing problem credits
and various other workout situations.
 E. The role of supervisors
 Principle 17: Supervisors should require that banks have an effective system
in place to identify, measure, monitor and control credit risk as part of an
overall approach to risk management. Supervisors should conduct an
independent evaluation of a bank’s strategies, policies, practices and
procedures related to the granting of credit and the ongoing management
of the portfolio. Supervisors should consider setting prudential limits to
restrict bank exposures to single borrowers or groups of connected
counterparties.
THANK YOU