To UNIVERSITY OF MUMBAI In partial fulfillment of the requirements For the award of the degree of MASTERS OF MANAGEMENT STUDIES (MMS) GURU NANAK INSTITUTE OF MANAGEMENT STUDIES Matunga, Mumbai.

Submitted By: HARJEET SINGH HUNDAL ROLL NO: 24 MMS 2009-2011

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I hereby declare that the project work entitled ³Management of credit risk in banks´ submitted to ³Guru Nanak Institute of Management Studies, ³is a record of an original work done by me under the guidance of ³Mr. Sameer Lakhani´ and this project work is submitted in partial fulfillment of the requirement for the award of the degree of Masters of Management Studies (MMS). The results embodied in this report have not been submitted to any other University or Institute for the award of any degree or diploma.


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I take this opportunity to sincerely thanks and express my gratitude to my project guide Mr. Sameer Lakhani for guiding me throughout my entire project. The experience and the knowledge acquired over the interactions with the guide have been invaluable to say the least and will help me a great deal in my future education and career. I would also like to thank my co-guide Mr. Sheela kathane for valuable input on coordination in my project. My project was completed in a very supportive and interactive environment and has been great learning experience. Last but not the least I would like to thanks friends for all the support they have provided me.


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In present scenario every company wants to be in the top line. For this they pressurize their departments to get more and more business. But because of very healthy competition also striving for success business gets divided among the competitors. Thus many companies find it difficult to achieve their targets. But some over achieve their targets with the help of proper utilization of available resources. One of the most important resources is MONEY. Basically money drives every business. If used sensitively a little money can generate huge amount of money.

This project is all about credit risk management. The main motive of this project is to understand it and how it is used in banking. The management of credit risk in today¶s banking business helps the bank to stable in the market. So that the bank running smoothly in the future by maintaining the credit risk and secure the bank from huge losses.

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3. 5. 1. 2. 8. Content Page No. Introduction Objective Research Methodology Risk Management Profile Analysis of Credit Risk Future Strategies Conclusion Bibliography 6 9 10 12 19 28 40 41 Page 5 . 6.INDEX S No. 7. 4.

The level of quality risk management policy and controls can make or break (literally) banks or financial institutions. a Wall Street casino.INTRODUCTION Risk Management Risk management is the analysis of risk coupled with the implementation of quality risk controls. to put it bluntly. derivative products that protect creditors against systemic risks in both the market and in the borrower. mortgages. instruments used by financial firms and institutions to make speculative and sometimes irresponsible bets on market movements.The unpredictability and inherent risks associated with the financial markets makes it vital for financial institutions and banks to implement risk management controls. A bank or a financial institution can protect itself from the potential risks and pitfalls of its asset portfolio by purchasing some Credit Default Swaps. receives a stream of premium payments (premiums Like the ones received by insurance companies). Risk management is needed for banks and financial institutions. There are dozens of types of risk management related derivative products. led to the credit derivative market degenerate into. coupled with poor understanding of complex and Byzantine instruments. Financial risk management products. loans) from the purchaser to the seller of said derivative. Credit Default Swaps are the most popular form of Credit Derivative. The underwriter of the swap. albeit good hedges for risk. Page 6 . are truly double edged swords. are derivative swaps that transfer exposure to fixed income assets (bonds.Lack of regulation. the most popular of them Credit Default Swaps. if coupled with wanton speculation and overleveraging. as well as a plethora of derivative securities. mainly because it insures a margin of safety that guarantees a levered financial firm's solvency. derivatives and other such contracts that help hedge and protect the downside. Credit Default Swaps. This evolved term covers a wider variety of responsibilities than insurance management ever did. include interest rate swaps. Risk management related credit derivative products such as Credit Default Swaps.The term "risk management" has evolved over the past twenty years from the term "insurance management".In recent years risk management products such as credit derivatives have evolved into vehicles of speculation. in return for agreeing to assume the risk of the underlying asset. foreign exchange swaps and contracts. the most popular kind of derivative. Credit Default Swaps are more or less an insurance policy taken out by a creditor that pays out if the borrower defaults. The most important part of risk management is the transferring of risk.

As long as banks and financial institutions use credit derivative products such as credit default swaps for hedging purposes only. Risk management. social and financial ramifications of credit derivative rules. There are too many arguments for and against regulation of credit derivative markets for there to be a concrete solution to the credit derivative problem. in no way is the credit default swap debate a black or white issue. leading to insolvency and systemic failure. The need for regulation. proper risk management can again be put into place. regulation and policy. Credit default swaps. If risk management products were used responsibly by banks and financial institutions. the whole financial calamity could have been minimized. Page 7 . the integrity of the risk management instruments will stay in place. however are a zero sum game. if done in a proper and responsible way. Once the damages of the financial crash are cleaned up and settled.There is simply too much nuance in the moral. The last thing a bank or a financial institution needs to do is exacerbate its risks by mixing gambling (speculation) with risk management. It is quite ironic that systems put into place to reduce risks ending up being the root of exacerbated risk. risks that are both inherent in today's global financial marketplace.The downturn in the housing markets has led this derivative house of cards to collapse upon itself. irresponsible speculation.For risk management to truly be risk management there should be zero tolerance for rampant. Some financial institutions have profited from correct bearish housing market bets. however. is an issue up for debate. The whole concept of risk management for banks and financial institutions is nullified by improper and risky speculative activities. instead of used to make levered bets. can effectively mitigate systemic and market risks.

The management of credit risk includes a) measurement through credit rating/ scoring. There is always scope for the borrower to default from his commitments for one or the other reason resulting in crystalisation of credit risk to the bank. recovery data. losses from changes in portfolio value arising from actual or perceived deterioration in credit quality that is short of default. In general. The elements of Credit Risk is Portfolio risk comprising Concentration Risk as well as Intrinsic Risk and Transaction Risk comprising migration/down gradation risk as well as Default Risk. more often than not.Credit Risk Credit Risk is the potential that a bank borrower/counter party fails to meet the obligations on agreed terms. Credit risk consists of primarily two components. The objective of credit risk management is to minimize the risk and maximize bank¶s risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters. default/migration statistics. Medium Risk and Low risk and then translated into risk Neighted assets through a conversion factor and summed up. viz. Off balance sheet exposures such as foreign exchange forward cantracks. which is nothing but the outstanding loan balance as on the date of default and the quality of risk. Portfolio analysis help in identifying concentration of credit risk. swaps options etc are classified in to three broad categories such as full Risk. At the transaction level. These losses could take the form outright default or alternatively. Default is not an abrupt process to happen suddenly and past experience dictates that. which is otherwise known as migration. c) Pricing on a scientific basis and d) Controlling through effective Loan Review Mechanism and Portfolio Management Page 8 . Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables. the severity of loss defined by both Probability of Default as reduced by the recoveries that could be made in the event of default. b) quantification through estimate of expected loan losses. borrower¶s credit worthiness and asset quality declines gradually. credit ratings are useful measures of evaluating credit risk that is prevalent across the entire organization where treasury and credit functions are handled. viz Quantity of risk. Default is an extreme event of credit migration. Thus credit risk is a combined outcome of Default Risk and Exposure Risk. etc.

To understand the policies and principles used by banks to sustain in market. ‡ ‡ ‡ ‡ To understand the concept and benefits of credit risk management in banks. To show that management of credit risk is very important in present scenario for every financial institution. To plan different strategies used in future to minimize the losses of banks. Page 9 .OBJECTIVES .

y y Page 10 . different strategies on the data of recession period to minimize the losses.RESEARCH METHODOLOGY Methodology of the project starts with: y y In the first phase we learned different things about credit risk management. I¶ve understood that banks were in losses because they were looking future¶s profit but not risk associated with that. Then after that we have applied. After that we have gone through the data related to banking industries to understand the main problem that they were facing during recession and due to that were not able to cope up with their losses.

Neglecting the market trend: .LIMITATIONS The various Limitations are:-y y y y Lack of awareness about counterparty: .Since the bank is not known before it takes lot of time to take initiative to manage credit risk management.Bank focus more on return from lending and neglecting the huge loss involved in. More focus on return: . Unable to track the credit risk: -The major problem for most banks is to unable to find the risk involved in this sector. y Page 11 . Too much lending on single sector: .As banks accepting the traditional method of lending and lend particular one section and unaware the risk arrived from that.Some respondents either do not have time or willing does not respond as they are quite annoyed with the adverse market conditions they faced so far.

Such outcomes could either result in a direct loss of earnings / capital or may result in imposition of constraints on bank¶s ability to meet its business objectives.Defining Risk For the purpose of these guidelines financial risk in a banking organization is possibility that the outcome of an action or event could bring up adverse impacts. Page 12 . Such constraints pose a risk as these could hinder a bank's ability to conduct its ongoing business or to take benefit of opportunities to enhance its business.

Risk Management Risk is inherent in any commercial activity and banking is no exception to this rule . Measurement of risk exposure is essential for implementing hedging strategies. Before overarching these risk categories.g. Traditional risk management techniques become obsolete with the growth of derivatives and off-balance sheet operations. Losses due to a sudden down turn in economy or falling interest rates). increasing deregulation. which had always existed in the system. coupled with diversifications. computation of risk-adjusted return on capital and active management of banks¶ risk portfolio.Regardless of the sophistication of the measures. banks often distinguish between expected and unexpected losses. The expansion in E-banking will lead to continuous vigilance and revisions of regulations. the expected default rate of corporate loan portfolio or credit card portfolio) and are typically reserved for in some manner. Operational. Page 13 .Rising global competition. effective risk managers will prosper and risk averse are likely to perish . The complex mathematical models programmed into risk engines would provide the foundation of limit management. it is believed that generally the banks face Credit. given below are some basics about risk Management and some guiding principles to manage risks in banking organization. Unexpected losses are those associated with unforeseen events (e.It can be said that risk takers will survive. losses experienced by banks in the aftermath of nuclear tests. introduction of innovative products and delivery channels have pushed risk management to the forefront of today¶s financial landscape. volume etc. While the types and degree of risks an organization may be exposed to depend upon a number of factors such as its size. we have to deal with a whole range of market related risks like exchange risks. Operational risk. complexity business activities. Ability to gauge the risks and take appropriate position will be the key to success .In the regulated banking environment. interest rate risk. Banks would find the need to develop technology based risk management tools. Market. etc. As we move into a perfect market economy. Compliance / legal /regulatory and reputation risks. Building up a proper risk management structure would be crucial for the banks in the future. risk analysis. Risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. Liquidity. Banks rely on their capital as a buffer to absorb such losses. Expected losses are those that the bank knows with reasonable certainty will occur (e. banks had to primarily deal with credit or default risk. would become more pronounced in the coming days as we have technology as a new factor in today¶s banking..g.

the risk awareness levels of line functionaries also will have to increase. The risk management process will be fully integrated into the business process. Risk management has to trickle down from the Corporate Office to branches or operating units. new risk management software. The bank of the future has to be a total-risk-enabled enterprise. More detailed and more frequent reporting of risk positions to banks¶ shareholders will be the order of the day. capital allocation will be based on the risk inherent in the asset. Risk management functions will be fully centralized and independent from the business profit centre¶s. As the audit and supervision shifts to a risk based approach rather than transaction orientation. risk advisory bureaus and risk reviewers. market and operational and so on will be combined. RAROC will be used to drive pricing. reported and managed on an integrated basis.External users of financial information will demand better inputs to make investment decisions. which addresses the concerns of various stakeholders¶ effectively. user interfaces etc. portfolio management and capital management. For some banks. All risks ± credit. performance measurement.. Page 14 . the review process will be more and more sophisticated Besides regulatory requirements. Innovative financial products implemented on computers. Banks will also have to deal with issues relating to Reputational Risk as they will need to maintain a high degree of public confidence for raising capital and other resources. with passage of time.Under Basel II accord. sustain and maximize shareholders¶ wealth. Advances in risk management (risk measurement) will lead to transformation in capital and balance sheet management. Risks to reputation could arise on account of operational lapses. this could offer the potential for realizing commercial gains through licensing. There will be an increase in the growth of consulting services such as data providers. Dynamic economic capital management will be a powerful competitive weapon. The implementation of Basel II accord will also strengthen the regulatory review process and. The demand for Risk Adjusted Returns on Capital (RAROC) based performance measures will increase. Risk return will be assessed for new business opportunities and incorporated into the designs of the new products. The legal environment is likely to be more complex in the years to come. Technology related risks will be another area where the operating staff will have to be more vigilant in the coming days. may become patentable. These reviews will be intended to provide comfort to the bank managements and regulators as to the soundness of internal risk management systems. capital allocation would also be determined by the market forces . The challenge will be to put all these capabilities together to create. opaqueness in operations and shortcomings in services. Systems and internal controls would be crucial to ensure that this risk is managed well.

it should be recognized that an institution need not engage in business in a manner that unnecessarily imposes risk upon it: nor it should absorb risk that can be transferred to other participants. Needless to add. the quality of assets in commercial banks will improve on the one hand and at the same time. Generally the risk management activities performed by middle management or units devoted to risk reviews fall into this category. Notwithstanding the fact that banks are in the business of taking risk. Common facilities could be considered for development of risk measurement and mitigation tools and also for training of staff at various levels. The risk management in those areas is confined to following operational procedures and guidelines set by management. measurement. For instance definition of risks. rather the goal of risk management is to optimize risk-reward trade -off. Page 15 . with the establishment of best risk management systems and implementation of prudential norms of accounting and asset classification. risk management activities broadly take place simultaneously at following different hierarchy levels. This is the risk management activities performed by individuals who take risk on organization¶s behalf such as front office and loan origination functions. monitoring and controlling risks to ensure that a) The individuals who take or manage risks clearly understand it.In every financial institution. Risk management as commonly perceived does not mean minimizing risk. b) The organization¶s Risk exposure is within the limits established by Board of Directors. . It involves identification.Risk management is an area the banks can gain by cooperation and sharing of experience among themselves. b) Macro Level: It encompasses risk management within a business area or across business lines. Rather it should accept those risks that are uniquely part of the array of bank¶s services. a) Strategic level: It encompasses risk management functions performed by senior management and BOD. As a result. f) Sufficient capital as a buffer is available to take risk The acceptance and management of financial risk is inherent to the business of banking and banks¶ roles as financial intermediaries. c) Micro Level: It involves µOn-the-line¶ risk management where risks are actually created. c) Risk taking Decisions are in line with the business strategy and objectives set by BOD. there will be adequate cover through provisioning for impaired loans. the NPA levels are expected to come down significantly. d) The expected payoffs compensate for the risks taken e) Risk taking decisions are explicit and clear. formulating strategy and policies for managing risks and establish adequate systems and controls to ensure that overall risk remain within acceptable level and the reward compensate for the risk taken. Risk Management is a discipline at the core of every financial institution and encompasses all the activities that affect its risk profile. ascertaining institutions risk appetite.

policies and procedures for risk management and procedure to adopt changes. compliance etc) should be independent from risk taking units and report directly to board or senior management who are also not involved in risk taking. size and complexity of institutions activities. A bank¶s ability to measure. Nevertheless. c) There should be an effective management information system that ensures flow of information from operational level to top management and a system to address any exceptions observed. there are some basic principles that apply to all financial institutions irrespective of their size and complexity of business and are reflective of the strength of an individual bank's risk management practices. in addition to risk management functions for various risk categories may institute a setup that supervises overall risk management at the bank. Such a setup could be in the form of a separate department or bank¶s Risk Management Committee (RMC) could perform such function*. monitoring. deregulation and globalization of financial activities emergence of new financial products and increased level of competition has necessitated a need for an effective and structured risk management in financial institutions. There should be an explicit procedure regarding measures to be taken to address such deviations. The individuals responsible for review function (Risk review. An effective risk management framework includes a) Clearly defined risk management policies and procedures covering risk identification. depends on the nature. A risk management framework encompasses the scope of risks to be managed. internal audit. The framework should be comprehensive enough to capture all risks a bank is exposed to and have flexibility to accommodate any change in business activities. and steer risks comprehensively is becoming a decisive parameter for its strategic positioning. monitor.Expanding business arenas. acceptance. and internal controls. Risk Management framework. The structure should be such that ensures effective monitoring and control over risks being taken. b) A well constituted organizational structure defining clearly roles and responsibilities of individuals involved in risk taking as well as managing it. used to manage risks. Page 16 . The risk management framework and sophistication of the process. d) The framework should have a mechanism to ensure an ongoing review of systems. the process/systems and procedures to manage risk and the roles and responsibilities of individuals involved in risk management. reporting and control. measurement. Banks.

This requires having a structure in place to look at risk interrelationships across the organization. Page 17 . Consequently the importance of staff having relevant knowledge and expertise cannot be undermined. Business Line Accountability. risk measurement should represent aggregate exposure of institution both risk type and business line and encompass short run as well as long run impact on institution. the rigor and robustness of its analytical methodologies. Whilst quantitative measurement systems support effective decision-making. such a lack of accountability can lead to problems. such as risk review. Finally any risk measurement framework. better measurement does not obviate the need for well-informed. however. In every banking organization there are people who are dedicated to risk management activities. Risk Evaluation/Measurement. is only as good as its underlying assumptions. internal audit etc. To the maximum possible extent institutions should establish systems / models that quantify their risk profile. Because line personnel. quantification is quite difficult and complex. understand the risks of the business. not only because a single transaction might have a number of risks but also one type of risk can trigger other risks. Since interaction of various risks could result in diminution or increase in risk. more than anyone e lse. While assessing and managing risk the management should have an overall view of risks the* A recent concept in this regard is Enterprise Risk Management (ERM) institution is exposed to. It must not be construed that risk management is something to be performed by a few individuals or a department. Until and unless risks are not assessed and measured it will not be possible to control risks. Wherever it is not possible to quantify risks. the risk management process should recognize and reflect risk interactions in all business activities as appropriate. To adequately capture institutions risk exposure. qualitative judgment.Integration of Risk Management Risks must not be viewed and assessed in isolation. especially those which employ quantitative techniques/model. Further a true assessment of risk gives management a clear view of institution¶s standing and helps in deciding future action plan. in some risk categories such as operational risk. Business lines are equally responsible for the risks they are taking. qualitative measures should be adopted to capture those risks. the controls surrounding data inputs and its appropriate application.

loans are the largest and most obvious source of credit risk. however. Alternatively losses may result from reduction in portfolio value due to actual or perceived deterioration in credit quality. The findings of their reviews should be reported to business units. public relations damage control.responding to regulatory criticism etc. Stress situations to which this principle applies include all risks of all types. This encompasses opportunity costs. Managing credit risk Credit risk arises from the potential that an obligor is either unwilling to perform on an obligation or its ability to perform such obligation is impaired resulting in economic loss to the bank. Credit risk emanates from a bank¶s dealing with individuals. corporate. For instance the default could be due to country in which there is exposure or problems in settlement of a transaction. litigation strategy . Contingency planning Institutions should have a mechanism to identify stress situations ahead of time and plans to deal with such unusual situations in a timely and effective manner. credit risk should be viewed in the context of economic exposures. trading. losses stem from outright default due to inability or unwillingness of a customer or counter party to meet commitments in relation to lending. credit risk could stem from activities both on and off balance sheet. settlement and other financial transactions. For instance contingency planning activities include disaster recovery planning. Credit risk can be further sub-categorized on the basis of reasons of default. Again the managerial structure and hierarchy of risk review function may vary across banks depending upon their size and nature of the business. Credit risk not necessarily occurs in isolation. Senior Management and. In a bank¶s portfolio. monitor and evaluate the risks. the Board. Contingency plans should be reviewed regularly to ensure they encompass reasonably probable events that could impact the organization . the key is independence. where appropriate. financial institutions or a sovereign. escalation and communication channels and the impact on other parts of the institution. transaction costs and expenses associated with a non-performing asset over and above the accounting loss.Plans should be tested as to the appropriateness of responses. To be effective the review functions should have sufficient authority. The same source that endangers credit risk for the Page 18 .Independent review One of the most important aspects in risk management philosophy is to make sure that those who take or accept risk on behalf of the institution are not the ones who measure. In addition to direct accounting loss. expertise and corporate stature so that the identification and reporting of their findings could be accomplished without any hindrance. For most banks.

b) Ensure that bank¶s overall credit risk exposure is maintained at prudent levels and consistent with the available capital c) Ensure that top management as well as individuals responsible for credit risk management possess sound expertise and knowledge to accomplish the risk management function d) Ensure that the bank implements sound fundamental principles that facilitate the identification. The responsibilities of the Board with regard to credit risk management shall. geographical location. preferably annually. Once it is determined the bank could develop a plan to optimize return while keeping credit risk within predetermined limits. Components of credit risk management A typical Credit risk management framework in a financial institution may be broadly categorized into following main components. For instance a bad portfolio may attract liquidity problem. The bank¶s credit risk strategy thus should spell out  The institution¶s plan to grant credit based on various client segments and products. monitoring and control risks. monitoring and control of credit risk. the overall strategy has to be reviewed by the board. e) Ensure that appropriate plans and procedures for credit risk management are in place. The very first purpose of bank¶s credit strategy is to determine the risk appetite of the bank. To keep it current. acceptance. interalia. preferred level of diversification/concentration. Page 19 . Board and Senior Management¶s Oversight It is the overall responsibility of bank¶s Board to approve bank¶s credit risk strategy and significant policies relating to credit risk and its management which should be based on the bank¶s overall business strategy. measurement. economic sectors. For the purpose of these guidelines the term Obligor means any party that has a direct or indirect obligation under a contract. a) Board and senior Management¶s Oversight b) Organizational structure c) Systems and procedures for identification. currency and maturity  Target market within each lending segment.  Pricing strategy. include: a) Delineate bank¶s overall risk tolerance in relation to credit risk.institution may also expose it to other risk. measurement.

The strategy should provide continuity in approach and take into account cyclic aspect of country¶s economy and the resulting shifts in composition and quality of overall credit portfolio. The CRMC should be mainly responsible for Page 20 . The credit procedures should aim to obtain an in depth understanding of the bank¶s clients. ideally comprising of head of credit risk management Department. should constitute a Credit Risk Management Committee (CRMC). Each bank. Organizational Structure To maintain bank¶s overall credit risk exposure within the parameters set by the board of directors. etc. g) Guidelines on management of problem loans. consumer. At minimum the policy should include a) Detailed and formalized credit evaluation/ appraisal process. It must facilitate effective management oversight and proper execution of credit risk management and control processes.It is essential that banks give due consideration to their target market while devising credit risk strategy. Such policies and procedures shall provide guidance to the staff on various types of lending including corporate. credit department and treasury. b) Credit approval authority at various hierarchy levels including authority for approving exceptions. depending upon its size. SME. It is the responsibility of senior management to ensure effective implementation of these policies. The senior management of the bank should develop and establish credit policies and credit administration procedures as a part of overall credit risk management framework and get those approved from board. as deemed necessary. measurement. Further any significant deviation/exception to these policies must be communicated to the top management/board and corrective measures should be taken. it should be viable in long term and through various economic cycles. In order to be effective these policies must be clear and communicated down the line. This committee reporting to bank¶s risk management committee should be empowered to oversee credit risk taking activities and overall credit risk management function. agriculture. monitoring and control d) Risk acceptance criteria e) Credit origination and credit administration and loan documentation procedures f) Roles and responsibilities of units/staff involved in origination and management of credit. the importance of a sound risk management structure is second to none. it is important that such structure should be commensurate with institution¶s size. While the strategy would be reviewed periodically and amended. complexity and diversification of its activities. While the banks may choose different structures. their credentials & their businesses in order to fully know their customers. c) Risk identification.

monitoring of credit exceptions / exposures and review /monitoring of documentation are functions that should be performed independently of the loan origination function. portfolio management. Further. The department would work out remedial measure when deficiencies/problems are identified  The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio. etc. provisioning. Notwithstanding the need for a separate or independent oversight. rating standards and benchmarks. standards for loan collateral. clear policies on standards for presentation of credit proposals. for its approval. b) Monitor credit risk on a bank-wide basis and ensure compliance with limits approved by the Board. Page 21 . Ideally. financial covenants. monitoring of loan / investment portfolio quality and early warning. regulatory/legal compliance. c) Recommend to the Board. the front office or loan origination function should be cognizant of credit risk.  The department also ensures that business lines comply with risk parameters and prudential limits established by the Board or CRMC. there should be adequate compensating measures to maintain credit discipline introduce adequate checks and balances and standards to address potential conflicts of interest.  Establish systems and procedures relating to risk identification.a) The implementation of the credit risk policy / strategy approved by the Board. risk monitoring and evaluation. For small banks where it might not be feasible to establish such structural hierarchy. pricing of loans. d) Decide delegation of credit approving powers. credit limit setting. Typical functions of CRMD include:  To follow a holistic approach in management of risks inherent in banks portfolio and ensure the risks remain within the boundaries established by the Board or Credit Risk Management Committee. risk concentrations. Management Information System. loan review mechanism. and maintain high level of credit discipline and standards in pursuit of business opportunities. the banks should institute a Credit Risk Management Department (CRMD). to maintain credit discipline and to enunciate credit risk management and control process there should be a separate function independent of loan origination function. Credit policy formulation. prudential limits on large credit exposures.

Where the obligor has utilized funds for purposes not shown in the original proposal.e. and macro economic factors. name lending should be discouraged. c) The track record / repayment history of borrower. f) Adequacy and enforceability of collaterals. a bank must not grant credit simply on the basis of the fact that the borrower is perceived to be highly reputable i. b) The purpose of credit and source of repayment. institutions should take steps to determine the implications on credit worthiness. Credits should be extended within the target markets and lending strategy of the institution. However. Institutions have to make sure that the credit is used for the purpose it was borrowed. e) The Proposed terms and conditions and covenants. It is utmost important that due consideration should be given to the risk reward trade ±off in granting a credit facility and credit should be priced to cover all embedded costs. g) Approval from appropriate authority In case of new relationships consideration should be given to the integrity and repute of the borrowers or counter party as well as its legal capacity to assume the liability.Systems and Procedures Credit Origination Banks must operate within a sound and well-defined criteria for new credits as well as the expansion of existing credits. Before allowing a credit facility. This may include a) Credit assessment of the borrower¶s industry. the bank must make an assessment of risk profile of the customer/transaction. While structuring credit facilities institutions should appraise the amount and timing of the cash flows as well as the financial position of the borrower and intended purpose of the funds. d) Assess/evaluate the repayment capacity of the borrower. Institutions should classify such connected companies and conduct credit assessment on consolidated/group basis. Prior to entering into any new credit relationship the banks must become familiar with the borrower or counter party and be confident that they are dealing with individual or organization of sound repute and credit worthiness. Page 22 . Relevant terms and conditions should be laid down to protect the institution¶s interest. In case of corporate loans where borrower own group of companies such diligence becomes more important.

Disbursement should be effected only after completion of covenants. Sometimes. A typical credit administration unit performs following functions: a. Institutions should review such arrangements and impose necessary limits if the transactions are frequent and significant Credit limits should be reviewed regularly at least annually or more frequently if obligor¶s credit quality deteriorates. Institutions may establish limits for a specific industry. All requests of increase in credit limits should be substantiated. yet these should be considered as a buffer providing protection in case of default. economic sector or geographic regions to avoid concentration risk. genuine requirement of credit. The credit administration function should ensure that the loan application has proper approval before entering facility limits into computer systems. Institutions are expected to develop their own limit structure while remaining within the exposure limits set by State Bank of Pakistan. generally most of the credit assessment and analysis is done by the lead institution.In loan syndication. It is the responsibility of credit administration to ensure completeness of documentation (loan agreements. Credit Administration Ongoing administration of the credit portfolio is an essential part of the credit process. Outstanding documents should be tracked and followed up to ensure execution and receipt. economic conditions and the institution¶s risk tolerance. While such information is important. Limit setting An important element of credit risk management is to establish exposure limits for single obligors and group of connected obligors. Credit Disbursement. Documentation. Credit administration function is basically a back office activity that support and control extension and maintenance of credit. Although the importance of collaterals held against loan is beyond any doubt. and receipt of collateral Page 23 . guarantees. primary focus should be on obligor¶s debt servicing ability and reputation in the market. b. All syndicate participants should perform their own independent analysis and review of syndicate terms Institution should not over rely on collaterals / covenant. institutions should not over rely on that. transfer of title of collaterals etc) in accordance with approved terms and conditions. Appropriate limits should be set for respective products and activities. The size of the limits should be based on the credit strength of the obligor. the obligor may want to share its facility limits with its related companies.

marketing/technological edge) y Management Page 24 . Among other things. Institutions should ensure that all security documents are kept in a fireproof safe under dual control.g. it is important that in such institutions individuals performing sensitive functions such as custody of key documents. entering limits into system. These include keeping track of borrowers¶ compliance with credit terms. Institutions should devise procedural guidelines and standards for maintenance of credit files. should report to managers who are independent of business origination and credit approval process. While in small Institutions it may not be cost effective to institute a separate credit administrative set-up. the rating framework may. Maintenance of Credit Files. Credit monitoring. wiring out funds. Registers for documents should be maintained to keep track of their movement. identifying early signs of irregularity. To start with. d. Proper records and updates should also be made after receipt. Physical checks on security documents should be conducted on a regular basis.. the loan should be continuously watched over. Loan Repayment. The obligors should be communicated ahead of time as and when the principal/markup installment becomes due. Procedures should also be established to track and review relevant insurance coverage for certain facilities/collateral. Collateral and Security Documents. Any exceptions such as non-payment or late payment should be tagged and communicated to the management. It need not mention that information should be filed in organized way so that external / internal auditors or SBP inspector could review it easily. c. In case of exceptions necessary approval should be obtained from competent authorities. etc. The credit files not only include all correspondence with the borrower but should also contain sufficient information necessary to assess financial health of the borrower and its repayment e. banks should establish a credit risk rating framework across all type of credit activities. f. Measuring credit risk The measurement of credit risk is of vital importance in credit risk management A number of qualitative and quantitative techniques to measure risk inherent in credit portfolio are evolving. incorporate: Business Risk y Industry Characteristics y Competitive Position (e. conducting periodic valuation of collateral and monitoring timely repayments. After the loan is approved and draw down allowed.

While a number of banks already have a system for rating individual credits in addition to the risk categories prescribed by SBP. The importance of internal credit rating framework becomes more eminent due to the fact that historically major losses to banks stemmed from default in loan portfolios.Financial Risk y Financial condition y Profitability y Capital Structure y Present and future Cash flows Internal Risk Rating Credit risk rating is summary indicator of a bank¶s individual credit exposure. An internal rating system categorizes all credits into various classes on the basis of underlying credit quality. An internal rating framework would facilitate banks in a number of ways such as a) Credit selection b) Amount of exposure c) Tenure and price of facility d) Frequency or intensity of monitoring e) Analysis of migration of deteriorating credits and more accurate computation of future loan loss provision f) Deciding the level of Approving authority of loan. A well-structured credit rating framework is an important tool for monitoring and controlling risk inherent in individual credits as well as in credit portfolios of a bank or a business line. all banks are encouraged to devise an internal rating framework. Page 25 . The Architecture of internal rating system The decision to deploy any risk rating architecture for credits depends upon two basic aspects: a) The Loss Concept and the number and meaning of grades on the rating continuum corresponding to each loss concept. b) Whether to rate a borrower on the basis of µpoint in time philosophy¶ or µthrough the cycle approach.

the nature of ratings review. the assignment of ratings always involve element of human judgment. the type of rating scale i. The banks may decide on their own which exposure needs to be rated. However. Page 26 . Banks thus design the operating flow of the rating process in a way that is aimed promoting the accuracy and consistency of the rating system while not unduly restricting the exercise of judgment. Generally corporate and commercial exposures are subject to internal ratings and banks use scoring models for consumer / retail loans. However the system should commensurate with the size. it is important that there should be sufficient gradations to permit accurate characterization of the under lying risk profile of a loan or a portfolio of loans. business line or both. Key issues relating to the operating design of a rating system include what exposures to rate. the formality of the process and specificity of formal rating definitions. A rating system with large number of grades on rating scale becomes more expensive due to the fact that the cost of obtaining and analyzing additional information for fine gradation increases sharply. alphabetical numerical or alpha-numeric etc.e. The operating Design of Rating System As with the decision to grant credit. Even sophisticated rating models do not replicate experience and judgment rather these techniques help and reinforce subjective judgment. the organization¶s division of responsibility for grading. it should be banks own choice. it might not be feasible for all banks to follow. the anticipated level of diversification and sophistication in lending activities. SBP does not advocate any particular credit risk rating system.Besides there are other issues such as whether to include statutory grades in the scale. What Exposures are rated? Ideally all the credit exposures of the bank should be assigned a risk rating. However given the element of cost. nature and complexity of their business as well as possess flexibility to accommodate present and future risk profile of the bank. The decision to rate a particular loan could be based on factors such as exposure amount.

c) The credit policy should also explicitly narrate the roles of different parties involved in the rating process. elements of transaction structure such as covenants etc. The former is specific to borrower while the later corresponds to the facility. Theoretically ratings are based upon the major risk factors and their intensity inherent in the business of the borrower as well as key parameters and their intensity to those risk factors. the credit policy should explicitly define each risk grade. quality of management. In addition the rating and loan analysis process while being separate are intertwined. the reliability of financial statements of the borrower. lay down criteria to be fulfilled while assigning a particular grade. size. as well as the circumstances under which deviations from criteria can take place. d) The institution must ensure that adequate training is imparted to staff to ensure uniform ratings e) Assigning a Rating is basically a judgmental exercise and the models . industry and position in the industry. manager or credit staff) * initiates a loan proposal and also allocates a specific rating. The analysis supporting the ratings is inseparable from that required for credit appraisal. The revision in the ratings can be used to upgrade the rating system and related guidelines. A more detail on the subject would be beyond the scope of these guidelines. Page 27 .The rating process in relation to credit approval and review Ratings are generally assigned /reaffirmed at the time of origination of a loan or its renewal /enhancement. Generally loan origination function (whether a relationship The credit risk exposure involves both the probability of Default (PD) and loss in the event of default or loss given default (LGD). The product of PD and LGD is the expected loss. ‚ Point in time means to grade a borrower according to its current condition while through the cycle approach grades a borrower under stress conditions. b) Since the rater and reviewer of rating should be following the same basic thought. Major risk factors include borrowers financial condition. The process of assigning a rating and its approval / confirmation goes along with the initiation of a credit proposal and its approval. This proposal passes through the credit approval process and the rating is also approved or recalibrated simultaneously by approving authority.external ratings and written guidelines/benchmarks serve as input. to ensure uniformity in the assignment and review of risk grades. How to arrive at ratings The assignment of a particular rating to an exposure is basically an abbreviation of its overall risk profile. however a few important aspects are a) Banks may vary somewhat in the particular factors they consider and the weight they give to each factor.

Page 28 . Ratings review The rating review can be two-fold: a) Continuous monitoring by those who assigned the rating. Institutions may establish limits for risk grades to highlight concentration in particular rating bands. In the event of any deterioration the ratings are immediately revised /reviewed.f) Institutions should take adequate measures to test and develop a risk rating system prior to adopting one. Even when such statistical models are found to be satisfactory. Adequate validation testing should be conducted during the design phase as well as over the life of the system to ascertain the applicability of the system to the institutions portfolio. review ratings as and when adverse events occur. institutions should not use the output of such models as the sole criteria for assigning ratings or determining the probabilities of default. It would be advisable to consider other relevant inputs as well. b) Secondly the risk review functions of the bank or business lines also conduct periodical review of ratings at the time of risk review of credit portfolio. It is important that the consistency and accuracy of ratings is examined periodically by a function such as an independent credit review group For consumer lending. A separate function independent of loan origination should review Risk ratings. Institutions that use sophisticated statistical models to assign ratings or to calculate probabilities of default. however. and updated at least annually. As part of portfolio monitoring. Adequate trend and migration analysis should also be conducted to identify any deterioration in credit quality. The Relationship Managers (RMs) generally have a close contact with the borrower and are expected to keep an eye on the financial stability of the borrower. Risk ratings should be assigned at the inception of lending. Where the model is relatively new. Institutions should. Institutions should apply the above principles in the management of scoring models. institutions should continue to subject credit applications to rigorous review until the model has stabilized. institutions should generate reports on credit exposure by risk grade. institutions may adopt credit-scoring models for processing loan applications and monitoring credit quality. must ascertain the applicability of these models to their portfolios.

the overall risk profile is within limits established by management and compliance of regulatory limits. The most important aspect about an obligor is its financial health. In case of existing obligor the operation in the account would give a fair idea about the quality of credit facility. For companies whose financial position is dependent on key management personnel and/or shareholders. as it would determine its repayment capacity. Consequently the management could fine tune or reassess its credit strategy /policy accordingly before encountering any major setback. regulations. At the minimum it should lay down procedure relating to: a) The roles and responsibilities of individuals responsible for credit risk monitoring b) The assessment procedures and analysis techniques (for individual loans & overall portfolio) c) The frequency of monitoring d) The periodic examination of collaterals and loan covenants e) The frequency of site visits f) The identification of any deterioration in any loan Given below are some key indicators that depict the credit quality of a loan: a. Consequently institutions need carefully watch financial standing of obligor. borrowers position within the industry and external factors such as economic condition. While making such analysis due consideration should be given to business/industry risk. in small and medium enterprises. Institutions should monitor the obligor¶s account activity. Page 29 . institutions should monitor cases of repeat extensions of due dates for trust receipts and bills. The banks credit policy should explicitly provide procedural guideline relating to credit risk monitoring. For trade financing. for example.Credit Risk Monitoring & Control Credit risk monitoring refers to incessant monitoring of individual credits inclusive of OffBalance sheet exposures to obligors as well as overall credit portfolio of the bank. Banks need to enunciate a system that enables them to monitor quality of the credit portfolio on day-to-day basis and take remedial measures as and when any deterioration occurs. b. Such a system would enable a bank to ascertain whether loans are being serviced as per facility terms. leverage and liquidity should be analyzed. The Key financial performance indicators on profitability. repayment history and instances of excesses over credit limits. the adequacy of provisions. government policies. equity. Establishing an efficient and effective credit monitoring system would help senior management to monitor the overall quality of the total credit portfolio and its trends. Conduct of Accounts. institutions would need to pay particular attention to the assessment of the capability and capacity of the management/shareholder(s). Financial Position and Business Conditions.

Page 30 .c. The obligor¶s ability to adhere to negative pledges and financial covenants stated in the loan agreement should be assessed. Collateral valuation. d. For consumer loans. External Rating and Market Price of securities such as TFCs purchased as a form of lending or long-term investment should be monitored for any deterioration in credit rating of the issuer. The results of such review should be properly documented and reported directly to board. electronic parts/equipments). additional precautionary measures should be taken. appropriate inspection should be conducted to verify the existence and valuation of the collateral. banks need to reassess value of collaterals on periodic basis. For instance loan granted against shares need revaluation on almost daily basis whereas if there is mortgage of a residential property the revaluation may not be necessary as frequently. Since the value of collateral could deteriorate resulting in unsecured lending. ongoing assessment of credit risk management process. or its subcommittee or senior management without lending authority. credit review should be performed on an annual basis. however more frequent review should be conducted for new accounts where institutions may not be familiar with the obligor. and for classified or adverse rated accounts that have higher probability of default. Exceptions noted in the credit monitoring process should also be evaluated for impact on the obligor¶s creditworthiness. Adverse changes should trigger additional effort to review the creditworthiness of the issuer. as well as large decline in market price. And if such goods are perishable or such that their value diminish rapidly (e. In case of credit facilities secured against inventory or goods at the obligor¶s premises. Risk review The institutions must establish a mechanism of independent. As stated earlier. Institutions should conduct credit review with updated information on the obligor¶s financial and business conditions. Loan Covenants. Credit review should also be conducted on a consolidated group basis to factor in the business connections among entities in a borrowing group. they should monitor and report credit exceptions and deterioration. However. the accuracy of credit rating and overall quality of loan portfolio independent of relationship with the obligor. The purpose of such reviews is to assess the credit administration process. and any breach detected should be addressed promptly. The frequency of such valuation is very subjective and depends upon nature of collaterals.g. institutions may dispense with the need to perform credit review for certain products. as well as conduct of account. All facilities except those managed on a portfolio basis should be subjected to individual risk review at least once in a year.

it should be managed under a dedicated remedial process. It would be better if institutions develop risk-based authority structure where lending power is tied to the risk ratings of the obligor. There should also be periodic review of lending authority assigned to officers.Delegation of Authority Banks are required to establish responsibility for credit sanctions and delegate authority to approve credits or changes in credit terms. ability and personal character. depending upon the size and nature of the credit and the reason for its problems. A bank¶s credit risk policies should clearly set out how the bank will manage problem credits. Often rigorous efforts made at an early stage prevent institutions from litigations and loan losses Page 31 . Lending authority assigned to officers should be commensurate with the experience. Once the loan is identified as problem. and explicitly delegate credit sanctioning authority to senior management and the credit committee. expertise and more concentrated focus of a specialized workout section normally improve collection results. by maintaining frequent contact and internal records of follow-up actions. Large banks may adopt multiple credit approvers for sanctioning such as credit ratings. risk approvals etc to institute a more effective system of check and balance. Negotiation and follow-up. A problem loan management process encompass following basic elements. Responsibility for such credits may be assigned to the originating business function. a specialized workout section. When a bank has significant credit-related problems. it is important to segregate the workout function from the credit origination function. The policy should also spell out authorities for unsecured credit (while remaining within SBP limits). The additional resources. It is the responsibility of banks board to approve the overall lending authority structure. The credit policy should spell out the escalation process to ensure appropriate reporting and approval of credit extension beyond prescribed limits. approvals of disbursements excess over limits and other exceptions to credit policy. Managing problem credit The institution should establish a system that helps identify problem loan ahead of time when there may be more options available for remedial measures. Banks differ on the methods and organization they use to manage problem credits. a. there should be compensating processes and measures to ensure adherence to lending standards. In cases where lending authority is assigned to the loan originating function. or a combination of the two. Proactive effort should be taken in dealing with obligors to implement remedial plans.

enhancement in credit limits or reduction in interest rates help improve obligor¶s repayment capacity. Review of collateral and security document. The institution¶s interest should be the primary consideration in case of such workout plans. While such remedial strategies often bring up positive results. before their implementation. Status Report and Review Problem credits should be subject to more frequent review and monitoring. should approve such workout plan. The review should update the status and development of the loan accounts and progress of the remedial plans. It needs not mention here that competent authority. the nature of problems being faced and most importantly obligor¶s commitment and willingness to repay the loan. institutions need to exercise great caution in adopting such measures and ensure that such a policy must not encourage obligors to default intentionally. However it depends upon business condition. Sometimes appropriate remedial strategies such as restructuring of loan facility.b. d. c. Page 32 . Institutions have to ascertain the loan recoverable amount by updating the values of available collateral with formal valuation. Progress made on problem loan should be reported to the senior management. Security documents should also be reviewed to ensure the completeness and enforceability of contracts and collateral/guarantee. Workout remedial strategies.

and the forward-looking banks would be in the process of placing their MIS for the collection of data required for the calculation of Probability of Default (PD). therefore management of risks in a proactive. the IT infrastructure and MIS at the banks need to be upgraded substantially if the banks want to migrate to the IRB Approach. Page 33 . exposure to one risk may lead to another risk. This would be adding depth and dimension to the banking risks. Also the personnel skills. Presently most Indian banks do not possess the data required for the calculation of their LGDs.Risk Management Scenario in the Future Risk management activities will be more pronounced in future banking because of liberalization. The standardized approach would be implemented by 31st March 2007. Exposure at Default (EAD) and Loss Given Default (LGD). efficient & integrated manner will be the strength of the successful banks. As the risks are correlated. The banks are expected to have at a minimum PD data for five years and LGD and EAD data for seven years. deregulation and global integration of financial markets.

Although many banks would be working towards the IRB Approach. Indian banks would be moving upward on the strategic continuum of risk scoring models as can be seen in the diagram on the previous page. Page 34 . the authors are of the opinion that RBI would have allowed a few banks to implement and follow the IRB Approach by the year 2015.

2. There was no coordination between Technical analyst (Assistant manager) and HR head. The employees had no knowledge about new product of the company. 4.Findings 1. 3. The lunch time was not proper and ignoring clients. There was no proper system to remind all the clients about the market at a time. Page 35 .

The skills of bank staff should be upgraded continuously through training. Banks will have to adopt global standards in capital adequacy. 4. in line with the requirements of a market-led integrated financial system Banks will have to adopt best global practices. wherever required. 5. income recognition and provisioning norms. Banks may have to evaluate on an ongoing basis. 8. Payment and settlement system will have to be strengthened to ensure transfer of funds on real time basis eliminating risks associated with transactions and settlement process. Page 36 . the need to effect structural changes in the organisation. 7. This will include capital restructuring through mergers / acquisitions and other measures in the best business interests. 2. 6. 3.Recommendations Improving Indian banking regulation Need to develop models for interest rate given ACTION POINTS ARISING OUT OF VISION REPORT 1. Benchmark standards could be evolved. In this regard. systems and procedures. the banks may have to relook at the existing training modules and effect necessary changes. Banks may enter into partnership among themselves for reaping maximum benefits. Seminars and conferences on all relevant and emerging issues should be encouraged. Regulatory set-up will have to be strengthened. internally. benefiting both the customer and the bank. IBA and NABARD may have to play a suitable role in this regard. There should be constant and continual upgradation of technology in the Banks. through consultations and coordination with reputed IT companies. Risk management setup in Banks will need to be strengthened.

Industry level initiatives will have to be taken. Page 37 . 10. so as to remain innovative. etc. for evolving better financial models. pilot projects. to speed up reform measures in legal and regulatory environment.9. Banks will have to set up Research and Market Intelligence units within the organization. may be at IBA level. Banks will have to interact constantly with the industry bodies. farming community. academic / research institutions and initiate studies. trade associations. to ensure customer satisfaction and to keep abreast of market developments.

Alternatively. Analyze the fundamental. reaches a certain level).g. options are useful as tools of risk management. The project is designed to upgrade investor¶s knowledge with the basics of how to make investment decisions in futures & options with reference to bear market. traders can use derivatives to hedge or mitigate risk. Page 38 . For many investors. Derivatives are extremely important and have a big impact on other financial market and the economy. technical and other factors for dealing in futures & options. Hedging is for minimizing risk not for maximizing the profit. stays in or out of a specified range.Conclusion Derivatives can be used by investors to speculate and make a profit if the value of the underlying moves the way they expect (e. moves in a given direction. Page 39 .ch/ 5) risk.moneycontrol.Bibliography 1) Management of banking and financial services (book) :by Padmalatha Suresh and Justin Paul 2) Economic Times 3) Business Standard 4) www.htm 6) www.

d) To keep these policies in line with significant changes in internal and external environment. in absence of any uneven circumstances it is expected that BOD re-evaluate these policies every year. any material exception to the risk management policies and tolerances should be reported to the senior management/board who in turn must trigger appropriate corrective measures. c) To ensure that risk taking remains within limits set by senior management/BOD. BOD is expected to review these policies and make appropriate changes as and when deemed necessary. To ensure that the policies are consistent with the risk tolerances of shareholders the same should be approved from board. Senior management has to ensure that these policies are embedded in the culture of organization.While the overall responsibility of risk management rests with the BOD. However not all risks are quantifiable.Extra Board and senior Management oversight. Risk tolerances relating to quantifiable risks are generally communicated as limits or sub-limits to those who accept risks on behalf of organization. b) The formulation of policies relating to risk management only would not solve the purpose unless these are clear and communicated down the is the duty of senior management to transform strategic direction set by board in the shape of policies and procedures and to institute an effective hierarchy to execute and implement those policies. a) To be effective. These exceptions also serve as an input to judge the appropriateness of systems and procedures relating to risk management. the concern and tone for risk management must start at the top. Qualitative risk measures could be communicated as guidelines and inferred from management business decisions. While a major change in internal or external factor may require frequent review. Page 40 .

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