A Project on

CREDIT RISK MANAGEMENT IN

BANKS
PROJECT REPORT

By

Anurag Ghosh
And
Harsh Raj

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 Methodology
We focused on different sets of data, facts and figures. The insights that you can get from data is
more than enough. We focused on both sets of data basically primary and secondary sets of data
which we have gathered from different sources like RBI, All Banking Solution etc. We have
analyzed and studied the data closely. Apart from this we have checked on different sources of
data from different banking sites. We have rigorously analyzed the NPA’s of different banks and
came to know the about the burgeoning problem of NPA’s that the banks are dealing with. This
problem basically indicates towards the credit risks. We focused on proper financial data and
used different statistical techniques like regression and correlation for further data analaysis.We
have considered the NPA and checked the balance sheets of top 5 banks of India. Looked into
their total loans and advances and burgeoning NPA’s.

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 INDEX
TOPIC PAGE

OVERVIEW ABOUT BANKING IN INDIA 6

RECENT GLOBAL ECONOMIC SCENARIO IN TERMS OF LOANS 7

AND ADVANCES
SCENARIO OF LOANS AND ADVANCES IN INDIAN BANK 8
CREDIT POLICY IN INDIA BANKS 9
DATA ANALYSIS ON INDIAN BANK’S NPA AND ITS CREDIT RISK 10-11
BUSINESS RISK 12
WHY CREDIT RISK MANAGEMENT AND WHY MANAGE RISK? 13
PRIMARY CAUSES OF CREDIT RISK 14
APPRAISAL OR ASSESSING THE CREDIT RISK 15-16
VALUE AT RISK (VAR) 17
CREDIT RISK MATRIX 18-19
BASEL AND IT’S IMPACT ON CREDIT RISK MANAGEMENT 20
CREDIT RISK MANAGEMENT IN BANKS AFTER GLOBAL 21
FINANCIAL CRISIS
MANAGING AND MITIGATING CREDIT RISK BY DIFFERENT 22-23
TECHNIQUES OF CREDIT RISK MANAGEMENT
CREDIT RISK MEASUREMENT 24
CREDIT RATING PROCESS 25
ASSET LIABILITY MANAGEMENT(ALM) 26
USE OF TECHNOLOGY TO AVOID CREDIT RISK TO 27
EFFECTIVELY MANAGE CREDIT RISK
CHALLENEGES TO PROPER CREDIT RISK MANAGEMENT 28
RECOMMENDATION FOR MANAGING CREDIT RISK IN A 29
BETTER WAY
CONCLUSION 30
BIBLIOGRAPHY 31

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OVERVIEW ABOUT BANKING IN INDIA
Indian banking is the lifeline of the nation and its people. Banking has helped in developing the
vital sectors of the economy. This banking sector has lived up to the hopes of millions of Indians
and fulfilled many dreams. But to do so, it has to traverse a long way, suffer the indignities of
foreign rule. Today, Indian banks can confidently compete with modern banks of the world and
Indian banking is looked out for all over the world. The Reserve Bank of India is a very pioneer
institution which controls the whole banking sector in a very proper and well organized way.
There have been many downturns in the economy and in the recent past the global economy has
undergone a huge turmoil situation but then also Indian Banking sector has been able to hold its
same position. Basically the way the banking is conducted in Indian bank is the thing to look out
for; the rules and regulation RBI lays on are very much game changer in its own way.

The definition of bank is ‘A bank is a financial institution that accepts deposits from the public
and creates credit.’

The main business of any bank across the globe is dependent on credit or loan. The main revenue
generation of the bank is from this operational sector which some people even call as Advance.
The banks generate revenue by giving credits or loans on a specific interest rate. The bank has
been the trusted institution for getting loans, as they are backed by the government support. In
fact the bank is the only financial institution where all types of persons from any segments of the
society are entertained and given loans. If we go through the banking history we can see many
person and companies are helped by this financial support by the banks. There has been a
symbiotic relation between the clients who take the loan from the bank and the bank itself. Both
have grown organically and this significantly has added to the countries’ economy. Indian
Banking sector is not an exception, Indian Banking sector has contributed substantially to the
growth of Indian economy.

Loans and advances is forte of any bank and bank so Indian banks also are trying to increase
their loans and advances by increasing lending and tapping more and more consumers. It will not
only generate more revenue for the bank at the same time it will encourage business and
development all over India. It will contribute to India’s GDP and attract all the foreign investors
too. This kind of lending will encourage the rural economy too, that is why government is
focusing on priority sector lending at the same time. All the Indian banks are backed by RBI on
this regard and RBI has been encouraging the banks to give more loans by cutting the repo rate
by .25 percent.

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 RECENT GLOBAL ECONOMIC
SCENARIO IN TERMS OF LOANS AND
ADVANCES
The global economic scenario is not in a good shape at all. The banking sector is in a very bad
shape after the US subprime crisis and the fall of Lehman brothers; after that crisis banking
sector worldwide has not been able to get out of this shockwave. It is a ray of hope that in this
turmoil situation also Indian Banks have been doing well. The failure to somewhat extent is due
to failure of the most important leg of the bank that is the credit section. The subprime crisis also
took place due to the very same reason, the failure of the borrowers to repay the loans. A
situation starting in 2008 affecting the mortgage industry due to borrowers being approved for
loans they could not afford. As a result, a significant rise in foreclosures led to the collapse of
many lending institutions and hedge funds. And this is not only the case in USA banks in Japan
and all over Europe has been facing the same scenario.

Total economic growth is also slowing down due as a result lending from banks are also slowing.
The banks are turning into risk averse, and are very careful while giving loans. This both the
scenario has impacted both the global banks and worlds economic growth directly as there has
been a symbiotic relation.

All the pioneer global banks are working on the same to curb the crisis by implementing
different norms and following different best practices, certain conventions are being devised.

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 SCENARIO OF LOANS AND ADVANCES
IN INDIAN BANKS
As per the Reserve Bank of India (RBI), India’s banking sector is sufficiently capitalized and
well-regulated. The financial and economic conditions in the country are far superior to any
other country in the world. Credit, market and liquidity risk studies suggest that Indian banks are
generally resilient and have withstood the global downturn well. The Indian banking system
consists of 26 public sector banks, 25 private sector banks, 43 foreign banks, 56 regional rural
banks, 1,589 urban cooperative banks and 93,550 rural cooperative banks, in addition to
cooperative credit institutions. Still, Public-sector banks control nearly 80 percent of the market,
thereby leaving comparatively much smaller shares for its private peers. Since 1992, the banking
sector reforms were introduced which faced new challenges in the ever changing scenario. The
challenges were many amongst them vital challenges were “4 Cs” i.e. Credit, Customer,
Computer, and Capital Restructuring. In the changing scenario, the banks are under tremendous
pressure to redefine their priorities, in order to manage these challenges effectively for their
survival and growth. The incidence of Non- performing assets (NPAs) is affecting the
performance of the credit institutions both financially and psychologically. Nonperforming assets
(NPA) is not only non – performing but also makes the banker and the bank non-performing as it

1. Prevents or delays recycling of funds.

2. Denies income from the assets by way of interest
3. Making profit by way of provision.

NPA is a disorder resulting in non –performance of a portion of loan portfolio leading to no

recovery or less recovery/income to the lender.NPA represent the quantified “Credit Risk”. It
also plays havoc on the mental make-up of the banker where in the banker tries to go slow on
lending, fearing future NPAs, it may lead to delay and denial of credit resulting in low off – take
of lendable funds.

Indian banks now have close to Rs 6, 00,000 crore bad loans. As a point of comparison, that’s
the total asset size of a big lender like Bank of India.

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 Credit Policy in Indian Banks
The main aim of the credit policy is Indian Bank is to provide adequate credit flow to the
productive sectors of the economy and cater to them for their betterment. The main aim is to
manage the growth momentum and capital flows. This not only adds value to the country’s GDP
but also add value to the country. The RBI governs this policy and hence RBI is very much
active and devices new monetary policy whenever there is a need for it. RBI is very much
focused on providing credits to each and every sector apart from this it focuses on priority sector
lending. Macroeconomic tools like the tools of monetary policy are used to achieve the objective
of this policy. This policy is very much important as it adds liquidity to the economy which is
very much needed for growth. The bank rate, the base rate, CRR , Repo Rate is the parameters
which the RBI uses to control the liquidity in the market. When there is a chance of growth
government wants the people to take more and more loans; it want to infuse liquidity in the
market. Then these rates are being varied and credit policy also changes according to them. But
when the country’s economy is not doing well and there is crisis the credit policy is also changed
accordingly. Take the case of the recent scenario of Indian Banking sector which is incurring
huge losses as credits given to corporate houses are turning bad due which banks are changing
their credit policy accordingly. The Indian banking sector is much more vigilant while giving out
any loan better to say they are focusing more on giving quality loans than quantity of loans. So it
can be very well inferred that the credit policy of banks changes with time to time depending on
the country’s economic scenario.

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 Data Analysis on Indian Bank NPA’s and its
Credit Risk
We have taken into consideration the top 5 banks of India for understanding the scenario and its
analysis

NPA(Crores) Loans & Advances(Crores)

Bank of Baroda 40,521.04 383,770.18
State Bank Of India 98,172.80 1,463,700.42
HDFC 4,392.83 464,593.96
ICICI 26,221.25 435263.94
PNB 55,818.33 412,325.80

On closer look on this data we found that with higher loans and advance NPA increases. We
have tried to analyze the same with different statistical approach like regression and correlation.

REGRESSION ANALYIS

NPA(Crores) Loans & Advances (Crores)

NPA(Crores) 1
Loans & Advances (Crores) 0.813978566 1

We found that there is strong correlation between loans and advances and NPA , So banks
should be very much cautious about lending out loans.

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 1,600,000.00
1,400,000.00 y = 0.0002x2 - 14.828x + 568039
A R² = 0.98
L
d 1,200,000.00
o
v 1,000,000.00
a
a
n 800,000.00
n Series1
s 600,000.00
c Poly. (Series1)
e 400,000.00
&
s
200,000.00
0.00
0.00 20,000.00 40,000.00 60,000.00 80,000.00 100,000.00 120,000.00
NPA

The above graph shows the parabolic relation between NPA and Loans and Advances, which
also signify more amount of loans and advances without proper security can expose a bank to
credit risk which results in more and more NPA

Therefore the credit policies are being considered while giving out loan; different protective
measures are taken on this regard.

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 Business Risk
Business risk is the possibilities a company will have lower than anticipated profits or
experience a loss rather than taking a profit. Basically risk is the somewhat a deviation from the
expected result.

There are many risks associated with a bank they are mainly:

∑ OPERATIONAL RISK
∑ CREDIT RISK
∑ MARKET RISK

Now the question arises that what is CREDIT RISK?

A credit risk is the risk of default on a debt that may arise from a borrower failing to make
required payments. In the first resort, the risk is that of the lender and includes lost principal and
interest, disruption to cash flows, and increased collection costs. Currently the risk that is
bothering all the banks the most is the Credit risk. The Indian banks has already incurred huge
losses for the same, almost there is a total bad loan of Rs.6 trillion according to a survey and the
banks are expecting to experience more on this regard, there has been an alert situation.

Now not only the RBI but also the government is coming up with solutions to curb this menace,
soaring NPA’s is hurting the Indian economy badly. The NPA’s are coming in huge numbers
more and more loans are turning bad day by day. The banks need sufficient amount of capital to
refill their coffers which the government is considering to provide at the same time banks are
devising out techniques to recover the NPA’s. But while doing a rigorous study we found out
that this will heal the wound temporarily but in order to uproot this problem the banks have to be
more cautious in the long run at the same time come up with new risk management techniques
and here comes the concept of CREDIT RISK MANAGEMENT and why should manage this
risk.The key strategy the bank is focusing on is to Identify, Measure, and Monitor and
Control the risk.

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 What is Credit Risk Management and why
manage risk?
Competition has become a reality in each and every sector so banks are also not immune to it.
And also with the advent of various technological innovations banks role has somewhat changed
and are forced to adapt to it.

Banks have to face strong competitive pressures both in selling of products and capital
procurement making them prone to risks which can significantly impact profitability.

Risk management is more of an offensive strategy than defensive one as it is really important for
strategic positioning of the bank.

It is also an efficient tool in managing utilization of capital, hence can serve as a critical
determinant of the profitability.

Credit Risk Contributors

∑ Credit Corporate Assets

∑ Retail Assets
∑ Non SLR Portfolio
∑ Trading book and banking book
∑ Interbank transactions
∑ Derivatives
∑ Settlement

What is Credit Risk Management?

It is the practice of mitigating losses by understanding bank’s capital adequacy and loan
loss reserves at any point in time. The major goal is to maximize risk adjusted rate of
return by maintaining credit risk exposure within acceptable parameters.

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 Now let’s focus on the primary causes of
Credit Risk
According to research and survey we found out the main causes for the credit risk are:-

¸ Asset (Loan) Quality

¸ Asset Liability Mismatch
¸ Fraud

Asset Loan Quality - It is found that if the quality of the loan is not good then can be
very risky for the bank. The loan is the asset for the bank, but the loan which is taken by
any people or organization is not repaid within due time this can result in NPA’s. This in
turn means that the loan which is your asset has turned bad. That is why banks checks the
credit worthiness of the person or organization before giving a loan/

Asset Liability Mismatch - Banks and financial institutions have assets and liabilities of
different maturities. This exposes them to interest rate risk and liquidity risk. This
mismatch can hit the bank badly if the banks trustable assets starts turning bad.

Fraud – Poor risk management process have also resulted in frauds in large institution.
One of the primary reasons for that is while giving a loan or a credit the bank sometimes
do not follow all the norms and accord that are laid down by RBI, sometimes the bankers
are also involved in this kind of unfair activities. Sometimes it is due to the lack of
foresight and lack of analysis e.g. the CIBIL score is not checked properly etc.

Backdated Credit Risk Management Policy – The banks has not upgraded them that
much with respect to the current market scenario. Many backdated techniques are being
followed crude process of giving loan are being followed around many banks in India.
This needs a serious upgradation.

To reduce all threats of credit risk all the banks of all over the world has laid down some
rules and a set of international banking regulation on bank supervision and this is
primarily termed as BASEL norms. BASEL has got certain pillars one of it laid down
different rules and regulation to control credit risk by certain credit risk management
techniques.

We will be discussing on BASEL briefly in this regard.

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 Appraisal or Assessing the Credit Risk
While giving out any loan the Bank’s needs to assess the credit risk in a proper way. It is very
important you do a proper decision making of the same before giving out the loan. This is
basically the part of decision making. Assessing credit risk requires us to model the probability
of a counterparty defaulting in full, or in part, on its obligation. We can picture the credit
decision in terms of the basic risk management model. This involves a decision either (A) to
extend credit, which provides a reward but entails a risk, or (B) to refuse credit. The situation
facing the credit manager is shown as a decision tree diagram. The requirement is to balance the
gain from taking the credit risk by extending credit against the potential loss. In the decision
problem the alternative is to refuse credit and not obtain any reward.

So once any of the decision is taken we need to analyze the total cost. We need to weigh and
evaluate the risk involved.

Three scenarios arises now

1) Extend credit and you get returns.

2) Extend credit but loan is not re-payed (loan turns bad)
3) Refuse credit
(1) + (2) can be clubbed to get the total cost which turns out to be

= (Revenue-cost) x (1-p) - cost x p [where cost is the cost of the loan]

=0 if the credit is refused. [ p is the credit defaulting probability]

Now it depends on bank’s discretion which way to go depending on the decision tree, if
extending credit yields a positive result then it should go with it. But if the result is negative the
bank should refuse the credit.

This totally depends on bank’s research and findings while giving out a loan.

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And here comes the concept of credit ratings which are provided by different rating agencies.
Apart from that a person’s credit worthiness can be checked by judging the CIBIL score.

On doing a proper regression analysis on the datasets the bank can forecast the probability of a
person defaulting a loan in near future. Probability p can be found out.

Taking some empirical data into consideration we are trying to forecast the probability of default
when a person takes a loan of rupees 960000.

Loans Taken Default Probability Repayment Probability

100000 0.1 0.9
3000000 0.4 0.6
50000 0 1
10000000 0.5 0.5
960000 0.1414 0.8586

With the help of regression we found out the default probability is .1414 and repayment
probability is .8586.

0.6

0.5
Default Probability

0.4

0.3

0.2

0.1

0
0 2000000 4000000 6000000 8000000 10000000 12000000
Loans Taken y = 4E-08x + 0.1039
R² = 0.7638

So now it depends on the bank’s discretion to give out the loan or not depending on certain
parameters. But as per best practices banks give loan to a person who has a less defaulting
probability.

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 Value at Risk ( VAR )
Value at Risk or VAR is used to calculate to find the level of financial risk within a firm in our
case it will be Bank for a certain period of time. This is basically a statistical technique that is
widely used by the banks to assess the total financial risk that it possesses. This approach uses
the statistical technique like covariance and variance. It helps the banks to find out the amount of
assets that are risk prone. So once the bank is aware of the same it can work on to secure those
doubtful debts.

If we plot the total loans given out and its trend line we can see that it follows a normal
distribution curve having a certain confidence level. This level of confidence signifies that the
loan will be recovered and the region apart from the level of confidence signifies that the loan is
prone to risk. In the below figure the red region signifies the region that is risk prone. So
basically the banks work on this area.

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 Credit Risk Matrix
It is a visual tool which tags a client’s account to the risk portfolio. When these individual risk
profiles are aggregated, we can get an overall idea of the credit risk profile of the receivables
portfolio. It brings up following advantages:

* Easily understandable

* compels development of risk mitigation plans appropriate for each of the risk profiles

* Tracks changes of receivables over time.

With Financial Position and Payment Habit as bases, the following credit risk matrix is

constructed:

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∑ Quadrant 1 (Exemplars) – Robust financial position being coupled with punctual

payment habit. This is an ideal credit risk profile. Clients who belong to this group are

not a lot, thus there is a need to exert utmost effort to keep the ones you already have.

∑ Quadrant 2 (Scrooges) – Robust financial position but with slow payment habits. One

can have trouble while collecting payment from this client and it isn’t because they don’t

have the means to do so. For this group, it is really important to understand their payment

processes and align collection process to theirs. Thus, having a good relationship with the

client is an added advantage..

∑ Quadrant 3 (Supporters) – Weak financial position but with punctual payment habit.

They may not have deep pockets, but they are very much eager to fulfil their obligations.

As their financial position is not strong, it’s important to keep tab of their operations and

detect signals (big or small) that indicate any deterioration to their financial position.

∑ Quadrant 4 (Toughies) – Weak financial position coupled with slow payment habit.

They’re not the best of clients credit wise so have to be carefully managed. Having a

bond or security in place is helpful, as does setting strict credit limits.

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BASEL and its impact on Credit Risk
Management
Basel 3 released in December 2010 is the third in series of Basel Accords. It basically deals with
risk management aspects of banking by focusing on capital adequacy, stress testing and market
liquidity risk.

Three Pillars of Basel 3:

ß Minimum regulatory risk requirement based on risk weighted assets.

ß Regulating frameworks in order to deal with main risks that bank faces.
ß Increasing bank’s transparency

Basel 3 norms are aimed at improving the bank’s ability to withstand economic and financial
stress situations. As per this norm, Indian banks have to raise Rs 6,00,000 crores by 2020 thus
making them capital sufficient and preventing them to go down at times of crisis.

With respect to credit risk management Basel 3 has put in some broad guidelines.

Some of them are:

¸ Establishing effective credit risk environment

¸ Sound credit granting process should be followed.

¸ Maintaining good credit administration, risk measurement and monitoring

processes.

¸ Banks supervisors should ensure they have effective system in place for
identification, measurement, monitoring and control of credit related risks.

The Basel committee has released a consultative document on Basel III which is aimed at
strengthening the capital levels of banks. It includes a proposal to strengthen the capital
requirements for credit exposures to counterparties when trading derivatives, creating repurchase
agreements, and performing securities financing activities.

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 Credit Risk Management in banks after the
Global Financial Crisis
Credit risk has always been a primary concern for financial services institutions but it is not
properly managed. With the advent of the financial crisis that started in 2007 exposed the
weaknesses of existing risk management systems and techniques in various financial institutions
especially banks. There always existed a shortcoming in the way the credit management
technique was existing and was managed in the banks. This was especially highlighted by
complex and innovative products like mortgage-backed securities and collateralized debt
obligations. Many firms were exposed to different sort of risk without being able to understand
the gravity of the same. This resulted in huge losses as the prices of their investments. It also had
an adverse effect as some of their counterparties, including large firms like Lehman Brothers,
filed for bankruptcy and became broke. Instruments such as over-the-counter derivatives
typically have long maturity periods, resulting in counterparties remaining exposed and at risk
for long periods of time. After the crisis started in 2007, firms started limiting their over-the-
counter exposure and asking for more collateral from brokers to protect against default and
hedge themselves from the same. Firms are now monitoring their credit risks more closely by
keenly monitoring their exposure to various counterparties. There is also a concern among
financial services executives that the global economy is still not stable, possibly caused by high
unemployment rates and improving but-still-low consumer confidence. Due to which business
governance has become a top priority in most of the organization. The result shows that the
senior executives in different financial firm are paying more importance to their credit risk more
than other kind of risk. According to a survey conducted 67% of the person said that credit risk is
their top priority.

To curb out this menace firms are observing the credit risk more minutely and cautiously, they
are carrying out rigorous credit analysis of different counterparties and various products. Special
teams are being set up to resolve existing credit disputes at the same time monitor the credit
quality of any loan and the credit worthiness of a borrower. Firms are trying to leverage this
credit risk with the help of different technologies. They mainly depend on different forecasting
techniques to calculate risk while giving a loan in this kind of stressed markets.

Norms and regulations of Basel III are being followed widely by the banks in order to manage
and mitigate risk. One of the main outcomes was of BASEL III is a significant rise in the
banking industry’s working capital requirement. Minimum capital requirement raised to 10.5%
from 8%.

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 Managing and Mitigating Credit Risk by
different Credit Risk Management
Techniques

Managing Credit Risk

Post financial crisis, banks, insurers and capital markets firms realized that traditional methods of
managing credit risk would not be sufficient. So they are now looking for more innovative
methods for approaching risk. Also, firms have understood the interdependencies between credit
and other types of risk hence are looking for enterprise wide risk management system. Some of
the ways of credit risk management are:

∑ Credit Portfolio Models-Differentiate credit risk based on different parameters like

industry, geography, credit grade etc. After that simulation is run generating large no of
scenarios and their resulting impact on credit portfolio value. Through this analysis,
portfolio managers can make decisions on ideal composition of portfolio based on their
risk appetite and performance targets.
∑ Internal ratings-It provides an estimate of creditworthiness of the entity and hence,
reflects entity’s ability to repay debt.
∑ Exposure limit-Firms monitor exposure to number of entities and categories such as
counterparts, bond issuers, issuer type, product type etc. Then some limits are assigned to
entities and whenever exposure crosses that mark, the entity is blocked until exposure
comes down. This is done for risk diversification i.e to avoid being overexposed to a
single entity.
∑ Stress Testing-It is done to overcome some of the drawbacks of old risk models by
testing based on combination of scenarios and is applied to firm wide portfolios so as to
capture risk along different lines of business.

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Mitigating Credit Risk

In addition to measurement and control of risks, some of the ways of mitigating risks that firms
undertake are:

∑ Risk based pricing-tool used to calculate interest rates on loans based on probability of
default or risk on loan.
∑ Covenants-They require the debtors to meet certain conditions such as maintaining
required capital level etc.
∑ Credit insurance-covers any losses resulting from unpaid receivables .Also covers
bankruptcies and late payments.
∑ Credit derivatives-Provide protection against credit risk of the underlying asset of
derivative.
∑ Collaterals-Counterparty holds the collateral of opposite counterparty till deal is done.

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 Credit Risk Measurement
So we get to see in order to do a proper credit risk management we need to do a proper credit
risk measurement as once we are aware of the intensity of the risk we can partition it to different
segments and take decisions accordingly and manage them.

There are certain traditional methods of credit risk measurement those are mainly:

ÿ Expert Systems ( The bank needs to rely on its credit analyst)

ÿ We need to check the credit worthiness by checking different internal and external
ratings of different rating agencies like Moody’s,S&P,Fitch etc.
In Indian context we need to check the ratings of CRISIL, ICRA, and CARE.

ÿ Maintaining a proper database which can be used time to time and following strict
SOPs.

CREDIT SCORING MODELS (ALTMAN Z SCORE MODEL)

Altman (1968) built a linear discriminant model based on financial ratios, matched sample (by
year, industry, size etc. )

X1=working capital/Total Assets

X2=Retained Earnings/Total Assets

X3=EBIT/Total Assets

X4=market value of equity/book value of total liability

X5=sales/total assets

Z=1.2X1+1.4X2+3.3X3+0.6X4+1.0X5

If Z<1.8 high probability of going bankrupt

If 1.8<Z<2.99 it lies in grey area

If Z>2.99 it indicates a healthy firm

So according to Z score we will be taking a call and this in turn helps in credit risk measurement.

We will be describing another inherent block without which credit risk management is
incomplete that is Credit Rating Process.

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 Credit Rating Process
Basic building block for any credit risk management model. It represents default probability. It
helps in taking decision accordingly. Followed widely in role sanction process. Banks get to
know about the risk appetite. It helps in proper analysis and reporting and administration. Loan
review monitoring and trigger actions accordingly if there is any scope of risk.

The underlying picture shows the credit rating process of CRISIL.

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 Asset Liability Management
It can be defined as the comprehensive and dynamic framework for measuring, monitoring and
managing financial risks related to: Interest rate, liquidity and foreign currency

It relates to managing structure of balance sheet (assets and liabilities) such a way that net
earnings from interest is maximized within the overall risk preference.

The strategies followed in ALM are:-

1) Spread Management – Maximizing the spread by reducing the exposure to cyclical rates
and stabilizing the income.

2) Gap Management – The Gap management focuses on balancing the GAP between the
interest sensitive asset and interest sensitive liability by distributing the asset and liability
into different time band according to their maturity period.

3) Interest sensitivity analysis – Understanding the impact of change of interest rates on

bank spread / net interest gain.

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Use of Technology to Effectively Manage
Credit Risk
During financial crisis, firms suffered since they had their risk systems and data
management systems working in silos. Later, they realized the issue and started focusing
on a holistic approach making credit risk an important part of enterprise risk linked to
other risk types example market risk. Financial firms started to spend more on their IT
risk and compliance systems, started going for a centralized data warehouse like
enterprise data warehouse and business intelligence model. Overall, there was significant
in IT spending in enterprise wide risk management in the financial world.
Some of the popular technological solutions used for credit risk management include-
SAS and Moody’s Analytics solutions, IFRS9 etc.
Most of the financial companies completely outsourced their IT risk and data
management to software & consulting giants like PWC, EY, Oracle Financial services,
TCS etc.

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 Challenges to Credit Risk Management
∑ Inefficient Data Management-Right data if not accessed properly can lead to delays.

∑ Non group wide risk management framework evades banks from generating complex,
meaningful risk measures.

∑ Constant rework-Model parameters can’t be changed easily resulting in effort

duplication and adversely affect bank’s efficiency ratio.

∑ Insufficient risk tools-Banks can’t identify portfolio concentrations or re-grade

portfolios effectively to manage risk.

∑ Inconvenient reporting-Manual spreadsheet based reporting overburden analysts and

IT.

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 Our Recommendations for Managing Credit
Risk
We believe that the most effective credit risk management solution focuses on process, culture,
people and organization. The Bank should be more proactive we have seen that already the banks
are in the same lines, but further enhancement is the key to success. If we take the case of Indian
Banking sector which was considered to be very safe and secured under the umbrella of RBI is
not that much safe and facing the threats of soaring NPA. The bank should focus on the inherent
quality of the loans given by them as basically they are the bank’s assets. The banking system
should be more robust. In this regard we suggest some recommendations.

ÿ The bank should follow the BASEL III norm widely

ÿ Analyzing the credit risk matrix properly before lending out any loan.
ÿ Proper Asset Liability Management (ALM).
ÿ Awareness and training is required to train the bankers about the credit risk and
they should be very much judicious while giving out any loan.
ÿ Better model management and better reporting process connecting all the
enterprises.
ÿ Enterprise wide risk management.
ÿ Proper usage of different decision support system while giving out loan.
ÿ Proper use of technology and analytical tools like R, SAS, SPSS which gives better
insights.
ÿ Usage of proper knowledge management database which can help with different sets
of useful data which can be analyzed while giving a loan.
ÿ Relying more on the credit analyst.
ÿ The banks should do a proper background check before lending out any loan this
can be done using better KYC. Apart from this CIBIL score must be checked along
with the credit ratings of different agencies.
ÿ Proper credit risk profile development.
ÿ Robust stress testing capabilities and usage of different data visualization
capabilities and business intelligence.

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 Conclusion
Better credit risk management presents an opportunity to greatly improve overall performance
and secure competitive advantage in this global economic scenario. Better credit risk
management reduces financial risk and in turn generates revenue for the Bank, which increases
the Bank’s profitability and once the bank is in a good shape the country’s economy is in a good
shape this in turn adds to the GDP of the country. So there is a symbiotic relation. Therefore
effective ways of risk management has gained importance. The chief goal of effective credit risk
management must be to maintain the key components of best practices that is followed
worldwide and adopted universally.

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 Bibliography and References
∑ www.capgemini.com/resource-file-
access/resource/pdf/Credit_Risk_Management__Trends_and_Opportunities.pdf
∑ http://www.allbankingsolutions.com/banking-tutor/basel-iii-accord-basel-3-norms.shtml
∑ http://www.firstpost.com/business/rs-600000-crore-npas-over-90-with-psbs-is-the-bad-
loan-story-turning-scary-2822560.html
∑ http://www.sas.com/en_us/insights/risk-management/credit-risk-management.html
∑ http://www.slideshare.net/sumant3063/credit-risk-management-presentation
∑ www.rbi.org.in
∑ www.investopedia.com
∑ Balance sheet of different banks
∑ www.moneycontrol.com
∑ www.linkedin.com

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