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Credit Risk Management

WHAT IS CREDIT RISK?
“Probability of loss from a credit transaction “is the plain vanilla definition of credit risk.
According to the Basel Committee, “Credit Risk is most simply defined as the potential that a
borrower or counter-party will fail to meet its obligations in accordance with agreed terms”.
The Reserve Bank of India (RBI) has defined credit risk as “the probability of losses associated
with diminution in the credit quality of borrowers or counter-parties”. Though credit risk is
closely related with the business of lending (that is BANKS) it is Infact applicable to all
activities of where credit is involved (for example, manufactures /traders sell their goods on
credit to their customers).the first record of credit risk is reported to have been in 1800 B.C.

CREDIT RISK MANGEMENT----FUNCTIONALITY
The credit risk architecture provides the broad canvas and infrastructure to effectively identify,
measure, manage and control credit risk --- both at portfolio and individual levels--- in
accordance with a banks risk principles, risk policies, risk process and risk appetite as a
continuous feature. It aims to strengthen and increase the efficacy of the organization, while
maintaining consistency and transparency. Beginning with the Basel Capital Accord-I in 1988
and the subsequent Barings episode in1995 and the Asian Financial Crisis in1997, the credit risk
management function has become the centre of gravity , especially in a financially in services
industry like banking.

DISTINCTION BETWEEN CREDIT MANGEMENT AND CREDIT RISK
MANAGEMENT
Although credit risk management is analogous to credit management, there is a subtle difference
between the two. Here are some of the following:

CREDIT MANAGEMENT CREDIT RISK MANAGEMENT
1. It involves selecting and identifying the 1. It involves identifying and analyzing
borrower/counter party. risk in a credit transaction.
2. It revolves around examining the three 2. It revolves around measuring, managing

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principles and policies. It is forward looking in its assessment. 3. 4.) 3. Risk Monitoring. It is then followed by post- sanction supervision and a follow-up mechanism (e. Credit appraisal and analysis do not 4. etc. Risk Identification. 2. purpose organization’s credit philosophy and credit (especially if the project/purpose is viable or appetite. probability of default. inspection of securities. an exist route remains a usual option sanction. borrower’s capital. borrower/counterparty. It is predominantly concerned with the 3. accounting ratios. for instance. assessment. protection (security offered. through the sale of assets/securitization. The process is in fact the last of the four wings in the entire risk management edifice – the other three being organizational structure.). The risk management process has four components: 1. cash flow statement simulation techniques. Statistical tools like VaR (Value at Risk). etc.P’s of borrowing: people (character and and controlling credit risk in the context of an capacity of the borrower/guarantor). It is more backward-looking in its 6. 6. In effect it is the vehicle to implement a bank’s risk principles and policies aided by banks organizational structure. duration and sheet/income statement. Depending on the risk manifestations of an usually provide an exit feature at the time of exposure. Risk Measurement. etc. The standard financial tools of assessment 5. with the sole objective of creating and maintaining a healthy risk culture in the bank. 5. form the core of coupled with computation of specific credit risk management. It is predominantly concerned with probability of repayment. in terms of studying the looking. THE CREDIT RISK MANAGEMENT PROCESS The word `process’ connotes a continuing activity or function towards a particular result. for credit management are balance CVaR (Credit Value at Risk). 2 . at a likely scenario of an antecedents/performance of the adverse outcome in the business.g. not).

RISK MEASUREMENT: MEASUREMENT means weighing the contents and/or value. even within a bank.  Taking appropriate initiatives in planning the organization’s future thrust areas and line of business and capital allocation.  The magnitude of each risk segment may vary from bank to bank. RISK MONITORING: Keeping close track of risk identification measurement activities in the light of the risk. RISK IDENTIFICATION: While identifying risks. magnitude of any object against a yardstick. A bank that has international operations may experience different intensity of credit risks in various countries when compared with a pure domestic bank.  Directing the efforts of the bank to mitigate the risks according to the vulnerability of a particular risk factor. without which identification would not serve any purpose. sophisticated methodological/statistical may be necessary in others for a quantitative value. Using quantitative techniques in a qualitative framework will facilitate the following objectives:  Finding out and understanding the exact degree of risk elements in each category in the operational environment. While a very simple qualitative assessment may be sufficient in some cases. For the success of the 3 . Risk Control. 4. principles and policies is a core function in a risk management system. the following points have to be kept in mind:  All types of risks (existing and potential) must be identified and their likely effect in the short run be understood. In risk measurement it is necessary to establish clear ways of evaluating various risk categories.  The geographical area covered by the bank may determine the coverage of its risk content. Also. risks will vary in it domestic operations and its overseas arms. intensity. The systems/techniques used to measure risk depend upon the nature and complexity of a risk factor.

must be analyzed and reported.  There must be an action plan to deal with major threat areas facing the bank in the future. steps to change them should be considered. Risk monitoring activity should ensure the following:  Each operating segment has clear lines of authority and responsibility.  Putting in place a well drawn-out-risk-focused audit system to provide inputs on restraint for operating personnel so that they do not take needless risks for short- term interests. It is evident. RISK CONTROL: There must be appropriate mechanism to regulate or guide the operation of the risk management system in the entire bank through a set of control devices.  Whenever the organizations principles and policies are breached.  In the course of risk monitoring. The importance of each wing depends upon the nature 4 . therefore. to the concerned authorities to aid in policy making. it is essential that the operating wings perform their activities within the broad contours of the organizations risk perception.  Tracking of risk migration is both upward and downward.system.  Analyzing internal and external audit feedback from the risk angle and using it to activate control mechanisms. even if they may be to its advantage. These can be achieved through a host of management processes such as:  Assessing risk profile techniques regularly to examine how far they are effective in mitigating risk factors in the bank.  The activities of both the business and reporting wings are monitored striking a balance at all points in time.  Segregating risk areas of major concern from other relatively insignificant areas and exercising more control over them. if it appears that it is in the banks interest to modify existing policies and procedures. that the risk management process through all its four wings facilitate an organization’s sustainability and growth.

of the organizations activity. default by the counter-parties in meeting the obligations. if a particular bank decides to lend only against its deposits.  Contingent liabilities like letters of credit/guarantees issued by the bank on behalf of the client and upon crystallization---. The importance of each of these will depend on the organizations nature of activities.  Transactions with sizeable risk content should be transferred to professional risk institutions.amount not deposited by the customer. 5 .  In the case of treasury operations. settlement not taking place when it’s due. etc. The basic techniques of an ideal credit risk management culture are:  Certain risks are not to be taken even though there is the likelihood of major gains or profit.  In the case of securities trading. since obviously takers for loans will be very and occasional. But it still remains a fact that the importance of the entire process is paramount. However the bank may also not be in a position to deploy all its lendable funds. capacity and above all its risk philosophy and risk appetite. CREDIT RISK MANGEMENT TECHNIQUES Risk –taking is an integral part of management in an enterprise. FORMS OF CREDIT RISK The RBI has laid down the following forms of credit risk:  Non-repayment of the principal of the loan and /or the interest on it. then its margins are bound to be very slender indeed. For example.  The other risks should be managed by the institution with proper risk management architecture. its size. size and objective. risk transfer and risk assumption. For example. Similarly. like speculative activities. advances to small scale industrial units and small borrowers should be covered by the Deposit & Credit Insurance Scheme in India. Thus credit management techniques are a mixture of risk avoidance. export finance should be covered by the Export Credit Guarantee Scheme.

exchange rate devaluation and its effect on foreign exchange derivative counter-parties. Broadly there are three sets of causes. COMMON CAUSES OF CREDIT RISK SITUATIONS For any organization. the extent of concentration is to be judged according to the following criteria:  The institution’s capital base (paid-up capital + reserves & surplus. losses from credit risk are usually very severe and non infrequent. especially one in banking-related activities. The alarming consequence of concentration is the likelihood of large losses at one time or in succession without an opportunity to absorb the shock.  In the case of cross – border obligations.  Common/ correlated concentration: for example. Concentrating credit on any one obligor /group or type of industry /trade can pose a threat to the lenders well being. which are as follows:  CREDIT CONCENTRATION  CREDIT GRANTING AND/OR MONITORING PROCESS  CREDIT EXPOSURE IN THEMARKET AND LIQUIDITY SENSITIVITY SECTORS. etc. 6 .  The institutions prevailing risk level. etc).  The institutions total tangible assets. CREDIT CONCENTRATION Any kind of concentration has its limitations. It is therefore necessary to look into the causes of credit risk vulnerability. Credit concentration may take any or both of the following forms:  Conventional: in a single borrower/group or in a particular sector like steel. The cardinal principle is that all eggs must not be put in the same basket. any default arising from the flow of foreign exchange and /or due to restrictions imposed on remittances out of the country. petroleum. In the case of banking.

because they are probabilistic. in accordance with RBI guidelines: 7 . the Basel Committee states that. can be correlated with credit-worthiness of the borrower”. The history of finance is replete with cases of default due to ineffective credit granting and/or monitoring systems and practices in an organization.sanction care are basic requisites in the credit delivery system. To guard against rude shock. Its customers expect the bank to extend high quality lender-service with efficiency and responsiveness. however effective.INEFFECTIVE CREDIT GRANTING AND / OR MONITORING PROCESS: A strong appraisal system and pre. longer tenors and lesser collateral. In this context. An articulate balancing of this conflict reflects the strength and soundness of risk management practices of the bank. create sudden hiccups in the organizations financial base. This again needs to be supplemented by an appropriate and prompt post-disbursement supervision and follow-up system. placing increasing demands in terms of higher amounts. the organization must have in place a Compact Analytical System to check for the customer’s vulnerability to liquidity problems. The organization on the other hand may have a limited credit risk appetite and like to reap the maximum benefits with lesser credit and of a shorter duration. while being remunerative. COMPONENTS (BUILDING BLOCKS) OF CREDIT RISK MANAGEMENT The entire credit risk management edifice in a bank rests upon the following three building blocks. “Market and liquidity-sensitive exposures. CONFLICTS IN CREDIT RISK MANGEMENT An organization dedicated to optimally manage its credit risk faces conflict. particularly while meeting the requirements of the business sector. CREDIT EXPOSURE IN THE MARKET AND LIQUIDITY-SENSITIVE SECTORS: Foreign exchange and derivates contracts. need to be subjected to improvement from time to time in the light of developments in the marketplace. letter of credit and liquidity back up lines etc.

FORMULATION OF CREDIT RISK POLICY AND STRATEGY: All banks cannot use the same policy and strategy.1. framing policy issues on the basis of the overall policy prescriptions of the Board and coming up with an implementation strategy. its geographical location and suitability. risk monitoring and risk control. This committee should be headed by the CEO/executive director and should include heads of credit. should comprise the chief executive officer and heads of the Credit Risk Management and Market and Operational Risk Management Committee. autonomy and accountability of operating officials. Risk strategy which is a functional element involving the implementation of risk policy is concerned more with safe and profitable credit operations. cyclical aspects of the economy and above all means and ways of existing when the risk become too high. monitoring and control. the Credit Risk Management Department (CRMD) and the chief economist. 2. 8 . entrusted with enterprise wide risk management. However one aspect that is common for any bank is that it must have an appropriate policy framework covering risk identification. the policy document must provide flexibility to make the best use of risk-reward opportunities.  There has to be a board-level sub-committee called the Risk Management Committee (RMC) concerned with integrated risk management. the organization structure is formed taking care of the core functions of risk identification. and above all its risk philosophy and risk appetite . even though they may be similar in many respects. This is because each bank has a different risk policy and risk appetite. with a role in the overall risk policy formulation and overseeing. The RBI has suggested the following guidelines for banks:  The Board of Directors would be in the superstructure. CREDIT RISK ORGANISATION STRUCTURE: Depending upon a banks nature of activity. treasury. it takes in to account types of economic / business activity to which credit is to be extended. This sub-committee. scope of diversification. In such a policy initiative. As a matter of fact.  A Credit Risk Management Committee (CRMC) should function under the supervision of the RMC. risk measurement. That is. measurement. there must be risk control/mitigation measures and also clear lines of authority.

portfolio review. 9 . monitor the quality of loan /investment portfolio. develop an MIS. CREDIT RISK OPERATION & SYSTEM FRAMEWORK: Measurement and monitoring. provisional/compliance aspects. etc. risks concentration/diversification. whose functions have been prescribed by the RBI. correct deficiencies and undertake loan review /audit. collaterals.  Be accountable for protecting the quality of the entire loan/investment portfolio. controlling and managing credit risk on a bank –wide basis within the limits set by the board/CRMC.  Micro-management of credit exposures.FUNCTIONS OF CRMC:  Implementation of Credit Risk Policy. in credit risk determine the vulnerability or otherwise of an organization while extending credit. identify problems. tenor and pricing and to document the same in conformity with statutory / regulatory guidelines. Besides setting up macro-level functionaries on a committee basis each bank is required to put in place a Credit Risk Management Department (CRMD). FUNCTIONS OF CRMD:  Measuring. pricing.  Seeking the board’s approval for standards for entertaining credit/investment proposals and fixing benchmarks and financial covenants.  Lay down risk assessment systems. this should involve three clear phases:  Relationship management with the clientele with an eye on business development. 3.  Enforce compliance with the risk parameters and prudential limits set by the Board/CRMC. for example. including deployment of funds in tradable securities. along with control aspects.  Monitoring credit risk on the basis of the risk limits fixed by the board and ensuring compliance on an ongoing basis. As per RBI guidelines.  Transaction management involving fixing the quantum.

It has to emphasize on the following aspects:  There should be periodic focused industry studies identifying. but operate flexibly.higher the risk.  There should be a clearly laid down process of risk reporting of data/information to the controlling / regulatory authorities.  An appropriate credit rating system to operate.  Credit appraisal and periodic reviews----.  Credit sanctioning authority and credit risk approving authority to be separate.  Installation of a credit audit system in–house or handed-out to a competent external organization. In the light of all the above three phases. a bank has to map its risk management activities (identification.  There should be a consistent approach (keeping in view prudential guidelines wherever existing) in the identification.together with enhancement when necessary--- should be uniform.25%------of standard assets).  Hands-on supervision of individual credit accounts through half-yearly/annual reviews of financial.  Portfolio management. not only as per regulatory requirements but also with some additional cushioning (some banks in India provide for a fixed percentage-----usually 0. stagnant and dying sectors.  A compact system to avoid excessive concentration of credit should operate with portfolio analysis. measurement. monitoring and control). signifying appraisal/evaluation on a portfolio basis rather than on an individual basis (which is covered by the two earlier points) with a special thrust on management of non-performing items. in particular. classification and recovery of non-performing accounts.  Pricing should be linked to the risk rating of an account --. 10 . higher the price.  A conservative long provisionary policy should be in place so that all non performing assets are provided for.  Level of credit sanctioning authority is to be higher in proportion to the amount of credit. position of collaterals and obligor’s internal and external business environment.

 There should be sound Management Information System. duties and responsibilities of officials dealing with credit.  It facilitates the measurement of credit risk in quantitative terms. covering both good borrowers and bad borrowers.  It would enable an organization to compute its regulatory capital requirement based on an internal ratings approach. UTILITY Banks may derive the following benefits if they install an appropriate credit risk model:  It will enable them to compute the present value of a loan asset of fixed income security.  An appropriate credit risk model will facilitate an impact study of credit derivatives and loan sales/securitization initiatives.  It facilitates the pricing of loans and provides a competitive edge to the players. 11 . As a matter of fact. and capital structuring/restructuring. A risk model is a mathematical model containing the loan applicants’ characteristics either to calculate a score representing the applicant’s probability of default or to sort borrowers into different default classes. taking into account the organizations past experience and assessment of future scenario.  There should be detailed delegation of powers. portfolio management. managing risk across the geographical and product segments of the enterprise. A model is considered effective if a suitable ‘validation’ process is also built in with adequate power and calibration. customer profitability analysis.  It helps the top management in an organization in financial planning. a model without the necessary and appropriate validation is only a hypothesis.  Regulatory authorities find it easier to evaluate banks that have suitable credit risk model in place. CREDIT RISK MODEL A credit risk model is a quantitative study of credit risk. especially in cases where promised cash flows may not materialize. These make it clear that operations/systems in credit risk management become really effective tools only when they are led by principles of consistency and transparency.

a credit risk model enables achieving the objectives of what to measure. V1 = Working capital / Total assets V2 = Retained earnings / Total assets V3 = Earnings before interest and taxes / Total assets V4 = Market value of equity / Book value of total liabilities V5 = Sales / Total assets a1 to a5 are the model constants identified through statistical analysis (discriminate analysis) Usage of Z score of the firm •Z1 or more – Excellent firm •Z2 to Z1 – Safe •Z3 to Z2 – Doubtful performance •Below Z3 – Expected to become bankrupt Where: Z1 > Z2 > Z3 Credit Metrics Model Assessment of portfolio risk due to changes in debt value caused by changes in credit quality Applications  Reduces portfolio risk  Sets exposure limits  Identify correlations across portfolio  Reduce potential risk concentration  Results in diversified portfolio  Reduction of total risk Value-at-Risk Model 12 . how to measure and how to interpret the results Credit Risk Modelling  Altman’s z score model  Credit metrics model  Value at risk  Merton Model Altman’s Z Score Model Altman Z-Score variables developed to measure the financial strength of a firm Z Score = a1 x V1 + a2 x V2 + a3 x V3 + a4 x V4 + a5 x V5 Where.  Above all.

Model Efficiency Difference between the estimated default values and actual default rate Merton Model (Example) Expected asset value (1 year hence) 200 billion Default point (DP) 140 billion Volatility of asset value 12% Asset value 250 billion If from historical observation the number of banks among 80 banks that have a default point of 2. weekly or monthly basis. Probability distribution of a loan portfolio value reducing by an estimated amount over a given time horizon. A measurement that represents the number of standard deviation that the bank’s asset value would be away from the default point.00 are 12. Merton Model Bank would default only if its asset value falls below certain level (default point).Estimate of potential loss in loan portfolio over a given holding period at a given level of confidence.0 DFD Mark-to-market concept Allocates capital to a transaction at an amount equal to the maximum expected loss (at a 99 percent confidence level) 13 .12250tvEVDPDFDVMerton Model (Example) Relationship between DFD and EDF EDF 15% 2.000. Estimates the asset value of the bank and its asset volatility from the market value and the debt structure in the option theoretic framework.Merton Model Historical default experience to compute Expected Default Frequency (EDF) Distance from Default (DFD) is the estimation of asset value and asset volatility and volatility of equity return DFD = (Expected asset value – Default point) / (Asset value x Asset volatility) Expected default frequency (EDF) is arrived at from historical data in terms of number of banks that have DFD values similar to the bank’s DFD in relation to the total number of banks considered for evaluation. Time horizon estimate is over a daily. then EDF = 12/80 =15% ()2001402. which is a function of its liability.

etc. In credit risk modeling. RARUC model. Financial Ratio and Credit Risk Financial ratios play two roles in credit analysis  They help quantify the borrower’s credit risk before the loan is granted. linear discriminant model. Broadly the following range is available to an organization going in for a credit risk model:  Econometric technique: Statistical models such as linear probability and logit model.e. i. the aim is essentially to compute the probability of default of an asset/loan.  Optimization model: Mathematical process of identifying optimum weights of borrower and loan assets.CREDIT RISK MANAGEMENT TECHNIQUES Techniques are methods to accomplish a desired aim. they serve as an early warning device for increased credit risk Liquidity  Liquidity refers to the ability of a firm to meet its short-term financial obligations when they fall due  Quick ratio and Current ratio are commonly used liquidity measures  Both ratios contain the assets in the numerator to include items that potentially can be converted into cash  The higher both the ratios.  Neural networks: Computer based systems using economic techniques on an alternative implementation basis. the higher the liquidity position of the firm Current ratio  Frequently used measure of liquidity  Assumes that current assets have a liquidation value. the firm could sell all its current assets to pay back its current liabilities.  Hybrid system: simulation by direct casual relationship of the parameters.  Once granted. if it runs out its business  CURRENT RATIO=CURRENT ASSETS /CURRENT LIABILITIES Some guidelines to asses the level of Current ratio: CR > 2 Good 14 .

1<= CR <=2 Satisfactory CR < 1 Weak Quick ratio  Another frequently used measure of liquidity  Assumes that inventories do not necessarily have any liquidation value. a firm must meet all its obligations • when they are due • Frequently used ratios o Account receivables turnover rate o Account payables turnover rate o Inventory turnover rate Account receivables turnover rate • How quickly (or slowly…) the firm receives its receivables from sales • ACCOUNT RECEIVABLES TURNOVER = SALES/ ACCOUNT RECEIVABLES 15 .=CURRENT ASSETS−CURRENT LIABILITIES  Net working capital ratio is calculated as follows:  NET WORKING CAPITAL= NET WORKING CAPITAL/SALES Turnover ratios • These ratios measure how effectively a firm uses the • components of net working capital • A firm should minimize the amount of working capital Reduces invested capital. and hence.5 <= QR <= 1 Satisfactory  QR < 0.5 Weak Net working capital ratio  Measures the difference between current assets and current liabilities  NET WORKING CAP. if they are sold  QUICK RATIO=CURRENT ASSETS –INVENTORIES/CURRENT LIABILITIES  •Some guidelines to asses the level of Quick ratio:  QR > 1 Good  0. increases EVA • On the other hand.

Account payable turnover rate • How quickly (or slowly…) the firm pays its bills • ACCOUNT PAYABLE TURNOVER = PURCHASES/ACCOUNT PAYABLES Inventory per sales-% • How effectively inventory management works • INVENTORY PER SALES−% =INVENTORY/SALES Financial ratios and credit risk Financial ratios predict • Profitability: Weakened earnings may launch the process that leads firms into financial distress (early warning signs) • Financial leverage: All too much debt is a signal of already existing financial troubles (mid-term warning signs) • Liquidity and working capital: Liquidity straits are a strong signal of anticipated distress (final warning signs) • Main questions are – How to use financial rations in distress prediction? – Can we improve their prediction power by using other information? 16 .