CREDIT RISK

What Does Credit Risk Mean?

 The risk of loss of principal or loss of a financial reward stemming

from a borrower's failure to repay a loan or otherwise meet a
contractual obligation.

 Credit risk arises whenever a borrower is expecting to use future

cash flows to pay a current debt. Investors are compensated for
assuming credit risk by way of interest payments from the borrower
or issuer of a debt obligation.
 Credit risk is closely tied to the potential return of an investment,
the most notable being that the yields on bonds correlate strongly to
their perceived credit risk
 The higher the perceived credit risk, the higher
the rate of interest that investors will demand
for lending their capital. Credit risks are
calculated based on the borrowers' overall
ability to repay. This calculation includes the
borrowers' collateral assets, revenue-
generating ability and taxing authority (such as
for government and municipal bonds).
 Credit risks are a vital component of
fixed-income investing, which is why
ratings agencies such as S&P, Moody's
and Fitch evaluate the credit risks of
thousands of corporate issuers and
municipalities on an ongoing basis. 
The Basel Committee has defined risk as “the
probability of the unexpected happenings – the
probability of suffering a loss”
Risk Vs Uncertainty
Risk perception involves studying “which event”
is likely to happen as opposed to uncertainty,
where the focus is on “what” could take place.
In a business situation, any decision could be
affected by a host of events, e.g. an abnormal
rise in interest rates, fall in bond prices,
growing incidence of defaults by debtors, and
so on.
A compact risk management system has to
consider all these as any of them could happen
at a future date, though the possibility may be
low.
Summary
Credit Risk Components
 Credit growth in the organization and
composition of the credit portfolio in terms of
sectors, centers, and size of borrowing
activities so as to assess the extent of credit
concentration
 Credit quality in terms of standard, sub-
standard, doubtful, and loss making assets
 Extent of the provisions made towards poor
quality credits
 Volume of off- balance sheet exposures having
a bearing on the credit portfolio
On the other hand, if the outcome is beyond
reasonable evaluation, it will be uncertainty as
opposed to pure risk, e.g. revolution in
electronics industry affects the medical
pathology areas.
Types of Risks
 Credit Risks
 Market Risks
 Organizational Risks
The Risk Management Process:
Four Processes –
(i) Risk Identification

(ii) Risk Measurement

(iii) Risk Monitoring

(iv) Risk Control

 Risk Identification
All types of risks (existing and potential)
must be identified, e.g. likely effect of
increase in the interest on the bank and the
borrowers in the next six months / one year
(short run)
 The magnitude of each risk segment may
vary from organization to organization
 Risk is also related to the geographical area
 To identify risks, we should scan both the
Balance Sheet items as well as the Off-
Balance Sheet items.
 Risk Measurement
 It means weighing the contents and/or value,
intensity and magnitude
Risk Monitoring
Keeping close track of risk identification and
measurement activities in the light of the risk, principles
and policies.
Risk Control
There must be an appropriate mechanism to regulate or
guide the operation of the risk management system in
the entire organization through a set of control
devices. These can be achieved through a host of
management processes.
Summary: Credit Risk Components
 Credit growth in the organization and composition of the
credit folio in terms of sectors, centers, and size of borrowing
activities so as to assess the extent of credit concentration.
 Credit quality in terms of standard, sub-standard, doubtful, and
loss-making assets.
 Extent of the provisions made towards poor quality credits
 Volume of off-balance sheet exposures having a bearing on
the credit portfolio.
Forms of Credit Risk
Credit involves not only funds outgo by way of
loans and advances and investments, but also
contingent liabilities. Therefore, credit risk
should cover the entire gamut of an
organization’s operations whose ultimate “loss
factor” is quantifiable in terms of money.
RBI has laid down the following forms of Credit Risk:
1. Non-repayment of the principal amount of loan and/or the
interest on it.
2. Contingent liabilities like LC / Guarantees issued by the
bank on behalf of the client and upon crystallization –
amount deposited by the customer
3. In the case of treasury operations, default by the
counterparties in meeting the obligations.
4. In case of securities trading, settlement not taking place
when it is due.
5. In the case of cross border obligations, any default arising
from the flow of foreign exchange and /or due to restrictions
imposed on remittances out of the country.
Common Causes of Credit Risk Situations
In banking related activities, losses from credit risk are
usually very severe and not infrequent. It is therefore,
necessary to look into the causes of credit risk
vulnerability.
Broadly, there are three sets of causes:
 Credit concentration
 Credit granting and /or monitoring process
 Credit exposure in the market and liquidity sensitive
sectors
1. Credit concentration
Any kind of concentration has its limitations.
Concentrating credit on any one obligor/group
or type of industry/trade can pose a threat to
the lender’s well-being.
In the case of banking or allied functions, the
extent of concentration is to be judged
according to the following criteria:
 The institution’s capital base (Paid up + Reserves and Surplus, etc.)
 The institution’s total tangible assets
 The institution’s prevailing risk level
The alarming consequence of concentration is the likelihood of large
losses at one time or in succession without an opportunity to absorb the
shock. Credit concentrations may take any or both of the following
forms:
(i) Conventional: in a single borrower/group or in a particular sector like
steel, petroleum etc.
(ii) Common/correlated concentration:
For example, exchange rate devaluation and its effect on foreign
exchange derivative counter-parties
 CREDIT CONCENTRATION
2. Ineffective Credit Granting and/or Monitoring Process:
A strong appraisal system and pre-sanction care are the basic
requisites in the credit delivery system. Prompt post-
disbursement supervision and follow-up system is necessary.
3. Credit exposures in the market and liquidity-sensitive sectors:
Foreign Exchange and Derivative contracts, Letters of Credit,
and Liquidity Break-up lines and so on are remunerative, but
they create sudden changes in the organization’s financial
base. To guard against these, organizations should have a
Compact Analytical System to check the customer’s exposure
to liquidity problems. According to Basel Committee, Market
and liquidity-sensitive exposures should be correlated to the
creditworthiness of the borrower.
 CONFLICTS IN CREDIT RISK
MANAGEMENT
An organization dedicated to optimally manage
credit risk faces conflicts, particularly while
meeting the requirements of the business
sector. Its customers expect the organization
(e.g. bank) to extend high quality lender
service with efficiency and responsiveness,
while the organization which is cautious about
risks may go for shorter credit and shorter
duration.
 BUILDING BLOCKS OF CREDIT
RISK MANAGEMENT
1. Formulation of credit risk policy and strategy:
Risk strategy which is a functional element
involving the implementation of risk policy is
concerned more with safe and profitable credit
operations. It takes into account the types of
economic / business activity to which credit is to be
extended, its geographical location and suitability,
scope of diversification, cyclical aspects of the
economy and ways and means to control when the
risks become too high.
2. Credit Risk Organization Structure
Depending upon each organization’s nature of
activity and its risk philosophy and risk
appetite, a separate organizational chart may
be constructed, combining both the junior and
senior management.
 RBI GUIDELINES FOR BANKS
 The Board of Directors would be at the higheat level
with a role in overall risk policy formulation and
overseeing.
 Board level sub-committee – called the Risk
Management Committee (RMC) – concerned with
integrated risk management, i.e. framing policy issues
and implementation strategies. The RMC comprises the
CEO, Heads of Credit Risk Management, and Market
and Operational Risk Management Committees.
 Credit Risk Management Committee (CRMC) should
function under the supervision of the RMC
 FUNCTIONS OF CRMC
 Implementation of Credit Risk Policy
 Monitoring Credit Risk on the basis of the risk limits fixed by
the board and ensuring compliance on an ongoing basis.
 Seeking the board’s approval for standards for entertaining
credit/investment proposals and fixing benchmarks and
financial covenants.
 Micromanagement of credit exposures for example risk
concentration/diversification, pricing, collaterals.
RBI has advised each bank to set up a Credit Risk Management
Department (CRMD) whose functions have been prescribed
by the RBI.
 FUNCTIONS OF CMRD
 Measuring, controlling, and managing credit risk on a
bank-wide basis within the limits set by the
board/CRMC
 Enforce compliance with the risk parameters and
prudential limits set by the board/CRMC
 Lay down risk assessment systems, develop an MIS,
monitor the quality of the loan / investment portfolio,
identify problems, correct deficiencies, and undertake
loan review/audit.
 Be accountable for protecting the quality of the entire
loan / investment portfolio.