Credit Risk Management

Prof. Ashok Thampy

Indian Institute of Management Bangalore

All life is the management of risk,
not its elimination.

Walter Wriston
Former Chairman, Citicorp
 Categorisation of risk
• Risks that can be eliminated or avoided by
simple business practices,
• Risks that can be transferred to other
participants, and,
• Risks that must be actively managed at the
firm level.
 Risk avoidance practices
• Standardization of process, contracts and
procedures
• Construction of portfolios that benefit from
diversification across borrowers
• Implementation of incentive-compatible
contracts that hold management and
employees accountable.
 Risk transfer practices
• For several of the risks which are
understood by the market and for which
there exists a market, the bank can tranfer
risk through the buying and selling of
financial claims.
– Eg. Swaps, credit derivatives, securitization
 Risk absorbtion
• Risks that are too complex to be understood
and communicated to the market would
have to be absorbed by the bank.
– Credit risk arising from the lending activity of
the bank, particularly to small and medium
companies that are not tracked/monitored by
other market participants.
– Capital is an important component of the firm’s
ability to absorb risk
 Credit Risk: Definition
• Credit risk is the risk that the counterparty
to a transaction will fail to pay the amount it
owes to a creditor.
• Credit risk is also sometimes referred to as
default risk, that is the risk of a default on a
commitment to repay interest and/or
principal of a loan or bond issue.
 Credit Risk
• Credit risk arises most obviously in a
situation where a borrower may fail to repay
a loan, but it is also an issue in most
situations where a payment is due to be
made in the future.
• Eg. Interest payment on bonds, commercial
paper, certificates of deposit or swap
payments.
 Credit loss
• Credit risk leads to credit loss: the amount
of money owed to the bank by borrowers or
other counterparties (eg. Swap transactions)
but not repaid, plus any recovery costs
incurred.
• Credit loss is an inevitable part of the
business of lending and therefore affects
nearly every business unit of the bank.
NPA : Sector and bank
ownership breakup
 GDP and credit growth

Source: RBI
Gross Non-Performing Assets
Source: Report on trends and progress of banking in India 2017-19, RBI
NPAs : Some possible explanations
• S.H. Khan Committee (1998) :
recommended harmonising of roles of
Development Financial Institutions (DFIs)
and Commercial banks and that both evolve
towards Universal Banks.
• Commercial banks were mainly focussed on
working capital loans and DFIs were mostly
providing project finance. The committee
noted that this was blurring.
NPA: Some possible explanations
• Commercial banks – not well versed with project
finance and possibly lending more aggressively to
project finance.
• Corruption?
• Sectors such as infrastructure and steel have a high
proportion of NPAs.
– Infrastructure : Inadequate policy to ensure
linkages and approvals, example: Fuel linkages
to power projects not in place; Coal mine
allocation withdrawals following Supreme
Court order in the light of corruption cases.
– Steel : global steel cycle downturn; over
expansion funded with high debt
 Asset Quality Review by RBI
• RBI inspectors check banks book annually
• 2015-16 : RBI did a special inspection
which examined a larger sample of bank
loans. Most large accounts were checked.
• Identified ~200 accounts to be identified as
NPAs
• Banks were under reporting NPAs and
engaging in ever-greening (giving new
loans to enable old loans to be repaid.)
 Why AQR?
• “At the Reserve Bank, corporations and
banks come to us saying: ‘Give us some
forbearance. Don’t call our loans bad even
if it has not been paid for three years. Allow
us to postpone recognition.’ This is a wrong
way to go about it,”
Raghuram Rajan, RBI governor
https://www.thehindu.com/business/Industry/Asset-Quality-Review-and-its-impact-on-banks/article14494282.ece
 Univariate Comparison of firms banking with
Government owned banks and private banks in India
A: Firms with exclusive B: All remaining firms
relationships with (GOBE=0)
Government Owned
Banks
(GOBE=1)
Variable Mean Median Mean Median
Investments/Assets 5.4% 2.2% 6.4% 3%
Tobin’s Q 0.745 0.589 1.041 0.708
Cash flow/Assets 0.059 0.060 0.067 0.070
Leverage 30.6% 30.1% 26.5% 25.8%
ROE 0.9% 5.6% 6% 9.2%
ROA 2.3% 2.1% 4.2% 3.5%
Growth in sales 15.9% 10.6% 19.7% 13.4%
Total Assets 2336 507 9950 1899

Srinivasan, A., and Thampy, A., 2017, “The effects of relationships with Government Owned banks on Cash Flow Constraints: Evidence from
India”, Journal of Corporate Finance.
20
 Can GOB relationships mitigate cash flow
constraints?
Dependent Variable: Investment
(1) (2) (3) (4)

Qi,t-1 0.011*** 0.011*** 0.009*** 0.009***

Cash flowi,t 0.097*** 0.111*** 0.097*** 0.111***
Leveragei,t-1 -0.094*** -0.094*** -0.095*** -0.095***
Log Total Assetsi,t 0.032*** 0.032*** 0.033*** 0.033***
GOBEi,t -0.000 0.002 -0.003 -0.001
GOBEi,t * Qi,t-1 0.004* 0.004*
GOBEi,t * Cash flowi,t -0.033** -0.033**

N 23980 23980 23980 23980

Adjusted R-squared 0.191 0.191 0.191 0.191

Srinivasan, A., and Thampy, A., 2017, “The effects of relationships with Government Owned banks on Cash Flow
Constraints: Evidence from India”, Journal of Corporate Finance. 21
 GOB relationships mitigate cash flow
constraints for the larger firms
Firms with sales Firms with sales
< Rs. 1 billion > Rs. 1 billion

GOBEi,t -0.001 -0.001

(0.005) (0.008)
GOBEi,t*Qi,t-1 0.002 0.005
(0.005) (0.008)
GOBEi,t*Cashflowi,t -0.009 -0.071**
(0.026) (0.031)
N 11562 11664
R2 0.3583 0.3285
Adjusted R2 0.214 0.193
Srinivasan, A., and Thampy, A., 2017, “The effects of relationships with Government Owned banks on Cash Flow
Constraints: Evidence from India”, Journal of Corporate Finance.
 Do GOB’s cherry pick borrowers with lower credit
constraints? - 1
Dependent Variable: Dummy for exclusive GOB Relationship
Logistic Model
Leverage 1.017***
Profitability -0.797***
Tangibility 0.600***
Ln Total Assets -0.462***
EM Score -0.005***

N 29304
2 statistic 3336
Prob > 2 0.0000

Fixed Effects Industry-year

Srinivasan, A., and Thampy, A., 2017, “The effects of relationships with Government Owned banks on Cash Flow
Constraints: Evidence from India”, Journal of Corporate Finance.
23
 Can credit risk be eliminated?
• Credit risk cannot be eliminated for a bank
if it undertakes lending to non-sovereign
borrowers.
• Sub-sovereigns – states, municipalities
• Private borrowers

• The only way to eliminate credit risk is to

lend only to the central government in the
domestic currency. (This got challenged during the US debt
ceiling quagmire.)
Importance of Credit Risk for an
FI
• A major portion of the banks assets is loans
• For insurance companies, a significant part
of the premium income is invested in
market securities which is subject to credit
risk
• Fixed income mutual funds invest in market
securities that have credit risk
 Components of a CRM system
• Standards and reports
– Standardized processes and reports
• Position limits or rules
– Exposure norms to specific industries and
minimum standards for participation
• Investment guidelines or strategies
– Guidelines for the immediate future given the
firms overall position/ strategies for achieving
business goals.
• Incentive contracts and compensation
– Aligning the interest of the manager and bank
– Compensation tied to the level of risk taking
 Managing credit risk
• Managing credit risk means that credit
losses should be kept to acceptable limits.

• The objective of credit risk management is

to keep the credit losses within the
acceptable or tolerable limits for:
– profitability
– safety
 Basics of credit
5 Cs of Credit Analysis
• Character (honesty, willingness to pay)
• Capacity (cash flow, ability to pay)
• Capital ( real net worth, stake)
• Collateral (security, in case)
• Conditions ( vulnerability to economic
fluctuations)
 Inputs in retail credit analysis
• Annual gross income
• Monthly debt payment/Monthly net income
• Banking relationship-checking, term deposit
• Major credit cards
• Credit history
• Applicants age
• Residence - rent, buying, own
• Residence stability
• Job stability
 Commercial credit
• Detailed analysis and study required
• Decision: Yes or no
• If yes, interest rate depends on credit risk.
 3 Questions that a lender should
ask a borrower
• What do you want the loan for?
• How are you going to pay it back?
• What are you going to do to pay me back if
your theory doesn’t work?

– George Scott, of First National Bank (now Citigroup), quoted in Altman, E.I.,
Caouette, J.B., and Narayanan, P., Managing Credit Risk, 1998, page 85.
 Credit Analysis Process Flow
Repayment Motivation for Lenders credit
strategy Loan: Why? culture

Business and strategy

Review of borrower

Management analysis:
Financial Statement Analysis: Industry Analysis:
Competence, Integrity
Balance Sheet and cash flow -Position in industry
Depth
-Efficiency and costs -Market share
-Profitability -Cost efficiency
-Stability of earnings -Innovation trends
-Leverage
-Assumptions for projections

Risk rating
Financial Simulation
Qualitative arguments Covenants
Breakeven Pricing
Loan documentation
Stress Testing
Legal opinions

Loan Decision
 Credit risk measurement

• Credit risk, in order to be managed, it has to

be measured.

• For measurement, we need to apply

statistical tools and techniques.

• Capital, capacity, collateral and conditions

(sensitivity to the economy) are amenable to
statistical analysis.
 Commercial credit: Useful
accounting ratios
• Profitability -
– ROA = Net Profit/ Total Assets
– ROE = Net Profit/ Net worth
• Activity -
– Days cash = Cash/ Average daily sales(ADS)
– Days inventory outstanding =
Inventory/(COGS/365)
– Accounts receivable collection period =
accounts receivables/ ADS
– Days accounts payable outstanding = Accounts
payable/[(COGS+change in inventory)/365]
 Commercial credit:Useful
accounting ratios
• Liquidity
Current ratio = current assets/current liabilities
• Asset balance
current assets/total assets
• Cash position
cash/ total assets
 Commercial credit:Useful
accounting ratios
• Leverage ratios
• Debt to networth = Total liabilities/ Networth
• Times interest earned = EBIT/Interest expense
• EBIT = Earnings before taxes + Interest expenses
• DSCR = EBDIT / (Interest + 0.25 of total debt)
- Where DSCR is Debt Service Coverage Ratio
 S&P's Financial Ratios Across
Ratings
Leverage (%): Cash flow Coverage (multiplier)

Rating Total debt/Capital LT Debt/Capital EBITDA/Interest EBIT/Interest

AAA 23 13 26.5 21.4

AA 38 28 12.9 10.1

A 43 34 9.1 6.1

BBB 48 43 5.8 3.7

BB 63 57 3.4 2.1

B 75 70 1.8 0.8

CCC 88 69 1.3 0.1

 Credit scoring
• All banks have a credit scoring method for
finding out the credit risk of a borrower.

• The question is how good is your credit

scoring system.

• A good credit scoring model should have

the actual credit loss close to the expected
loss, ie., unexpected loss should be small.
 Credit exposure limits
• Credit exposure to different sectors to be
continually monitored.
• Understand the correlation of different
industry groups - ex. Real estate and
infrastructure sector has a significant impact
on the prospects of the cement and steel
industry, and therefore credit risk.
 Stress Testing
• Stress testing - provides early warning
regarding deterioration in loan , change loan
portfolio, indication about provisioning etc.

• Stress test can be done selectively. For

instance if Indian economy slows to 5%
growth rate, how would the loan and bond
portfolio in different sectors behave?
 Portfolio Approach
• Using the correlation in the credit risk of
different sectors, the optimal exposure to
different sectors can be found and
accordingly set exposure limits to different
industries.
 Get industry expertise

• Each business has its complications,

nuances and specific risks.
• Develop industry specific knowledge in
those specific sectors that the banks would
like to lend. ( Just like equity analysts
following a specific industry would have
knowledge on his industry).
• Benchmark firms within an industry with its
peers.
 Monitoring
• Credit requires continuous monitoring.
– Use the checking account as a way of
monitoring industrial borrowers
• Risk does not remain the same
– It needs to be periodically reviewed
• Business/economic situation changes
– Need to keep track of these and understand the
impact of these on specific sectors.
Why are banks in the credit risk business?
 Prudential Norms for Asset Classification,
Income Recognition and Provisioning

• When does an asset become an NPA?

– When interest and/or instalment of principal
remain “overdue” for a period of more than 90
days.
For agricultural loans:
- For short duration crops, the loan is treated as NPA if
installment of principal or interest thereon remains
overdue for two crop seasons.
- For long duration crops, the loan is treated as NPA if
installment of principal or interest remains overdue for
one crop season.
 NPA categories
• Sub-standard assets:
– Assets that have remained NPA for less than or
equal to 12 months
• Doubtful assets:
– Assets that have remained as sub-standard for
more than 12 months
• Loss assets:
– Loss asset is once which is considered
uncollectible.
 Provisioning norms
• Standard asset:
– 1% of loan portfolio
• Substandard asset:
– 10% on total outstanding with unsecured
portion requiring another 10% provisioning
• Doubtful assets:
– 100% to the extent the advance is not covered
by realisable value of security
 Calculating Return on a Loan

Expected return: 1 + E(r) = p(1+k)

where p equals probability of complete repayment
Note that realized and expected return may not be
equal

k is the contractually promised gross return on the

loan.
 Calculating Return on a Loan
Factors: Interest rate, fees, credit risk premium,
collateral, and other nonprice terms, such as
compensating balances and reserve requirements
Return = inflow/outflow
1 + k = 1 + (of + (BR + ø )) / (1 - b(1 - RR ))
Where:
of is the fees
BR is the base rate for loans
Φ is the credit risk premium
b is compensating balance
RR is reserve requirement
Numerator is the gross cash inflow to the FI
Denominator is the net amount lent by FI
 Expected Return from Loan &
Credit rationing
• Expected return from loan, E( R ) is given
by:
1 + E(r) = p (1+k) + (1-p)(1-LGD)
LGD depends on collateral availability and
quality of assets, p is the probability of
re-payment of loan, and k is the interest
rate on the loan
 Expected Return from Loan &
Credit rationing
• Expected return from loan, E( R ) is given
by:
1 + E(r) = p (1+k) + (1-p)(1-LGD)
If LGD = 1, then E(r)= p(1+k)-1
Now, if p decreases, can the expected return
be kept constant by increasing k?
 Drivers of Credit Risk
• Loss due to Credit Risk can be seen arising
from the following:
– Default – discrete state for the counterparty –
two states – default or no default. Probability of
default is PD.
– Credit Exposure (CE) or Exposure at Default
(EAD), which is the economic value of the
claim on the counterparty at the time of
default.
– Loss Given Default (LGD) – represents the loss
due to default = (1-Recovery Rate)
 Credit Loss
• Credit Loss in a two state world of default
and no-default is given by the following
expression:
• Loss Given Default,
Credit Loss = PD x EAD x LGD
– Where PD is the probability of default
– EAD is the exposure at default
– LGD = (1-R) where R is the recovery rate
 Expected Return from Loan &
Adverse selection and credit rationing
Expected Return,
As k increases, good/safe projects
E(R)
Will not come for financing but
Only the risky projects remain.

➔ Credit rationing

k
 Summary
• Credit risk cannot be avoided by a bank.
• Credit risk can be managed to keep credit risk
within acceptable limits - within expected loss.
• Unexpected loss should be very rare.
• Banks need to use the maximum information for
decision making and have a good risk
management system to reduce credit risk.
• Regulation plays an important role in accounting
for bad debts and providing for NPAs, thus
reducing the chance of an FI failing due to credit
risk.