Project Report

Submitted By:
Rupesh Zanzad
6/1/2020 MBA (B&FS)
Project title:
1. Research on Risk-based pricing and credit rating of borrowers. (Estimation & Prediction of Credit Risk)
2. RAROC based Capital Budgeting & Performance Evaluation of MSMEs Loans (Create Risk-Based
Pricing Model)
Objectives:
 Prepare Credit Rating Framework. Risk Assessment is the key objective hence the assessment revolves
around measures of risk for creditors.
 Assigning a numeric formula to arrive at a summary number or rating which aggregates all the risks of
default related to a particular borrower.
 Create Risk-based pricing model. Credit-scoring model and Risk based Pricing model are not limited to
predicting credit worthiness but also used in predicting potential default.

Brief description and background:

The effective management of credit risk is a critical component of comprehensive risk management and is
essential for the near- and long-term success of any banking organization. Setting Credit risk strategy/
appetite for the bank is one of the most important part in credit risk management. Risk appetite is important
because it sets the risk concentration limit, tolerance limit, and it also tells what could be the profit after
accepting the risk profile of the borrower. Policy and strategy are the building blocks of credit risk
management.

Policy and Strategy

On the basis of policy documents further risk measurement and mitigation process are devised. Policy
document clearly establishes the process for approving new credit, renewing or restructuring credit, etc.
Risks inherent to all the products and activities of the bank should be identified. The strategy would,
preferred levels of diversification and concentration, the cost of capital in granting credit, and the cost of bad
debts. The credit risk strategy should provide continuity in approach as it also considers the cyclical aspects
of the economy and the resulting shifts in the composition of the overall credit portfolio.

An independent audit and risk review function. Every obligor and facility must be assigned a risk rating. The
mechanism to price different facilities depend on the risk grading of the customer, and to attribute accurately
the associated risk weights to the facilities. According to the risk-based pricing model, banks should price
their loans according to the risk profile of the borrower and the risk associated with the loans.

Internal Credit Rating – Benefits

 Credit rating helps the investors in making investment decisions. Efficient decision making gives an idea
about the creditability of borrowers.
 Credit rating is an essential tool that helps in determining the risk attached to credit instruments and risk-
adjusted return expected.
 Encompasses identification, measurement, constant monitoring, quantify credit risk, and control of the
credit risk exposures.

Risk Based Pricing– Benefits

 Risk-based pricing analysis to include focus on profitability, sustainable growth and effective capital
management.
 It helps in making auditable decisions. Enables an institution to know early enough what kind of price
will satisfy its risk/return.
 Risk based pricing include efficient allocation of resources to borrowers with better prospects and
associated lower risk and less disruptive rationing of credit during economic downturns.
 Satisfies regulatory requirements that the risk inherent in the loan products and serves have been
adequately accounted for in the pricing.

Internal Credit Rating Framework

A credit-risk rating framework (CRF) helps financial institutions to avoid the limitations associated with a
broad classification of loans/exposures into “good borrowers” and “bad borrowers” category. An internal
rating system assists to manage and control credit risk incur through lending and other operations by
managing the creditworthiness of borrowers and the quality of credit transactions. The CRF deploys a rating
or number as a primary summary indicator of risks associated with credit exposure. The CRF assess credit
risk of transactions through the evaluation of various quantitative as well as qualitative factors. Such a rating
framework is the basic module for developing a robust credit risk management system and all advanced
credit scoring models are based on this structure. Internal credit scoring models are the tools that assist
banks in enhancing their quantifying, aggregating, managing and diversifying of risks. CRF enables the
financial institution to effectively manage the portfolio and cost of debt. This will lead to the optimal
utilization of resources.

Design of CRF

 The Risk rating process. Assigning and monitoring risk ratings.

 The mechanism of arriving at risk rating and benchmarking for risk ratings.

The calibration on the rating scale is expected to define the risk-based pricing and related terms and
conditions for the expected credit exposures. The rating scale could also be used for deciding on the tenure
of the proposed assistance. The frequency/ intensity of monitoring of the loans/exposure depends on rating
scale of borrowers. RBI proposed the following step-wise activities outline the indicative process for
arriving at credit risk-rating.
 Step I Identify all the principal business and financial risk elements
Step II Allocate weights to principal risk components

Step III Compare with weights given in similar sectors and check for consistency

Step IV Establish the key parameters (sub-components of the principal risk elements)

Step V Assign weights to each of the key parameters

Step VI Rank the key parameters on the specified scale
Step VII Arrive at the credit-risk rating on the CRF
Step VIII Compare with previous risk-ratings of similar exposures and check for consistency
Step IX Conclude the credit-risk calibration on the CRF

Internal Credit-Risk Rating Models

Credit Scoring models come in different shapes and sizes. Some generic, others are very specific (custom).
A model in which various variables are weighted in varying ways and result in a score. This score
subsequently forms the basis for a conclusion, decision or advice. Therefore, scoring models can relate to
quantitative assessment and improved decision makings in a consistent manner and answer a wide variety of
questions related to borrower creditworthiness. The credit risk models are intended to aid banks in
quantifying, aggregating and managing risk across different sector, geographical, and product lines. The
result of these models also plays increasingly important roles in bank risk management and performance
measurement process, customer profitability analysis, risk-based pricing, active portfolio management and
capital structure decisions.

Credit Rating Model Methodologies

Expert Judgment Based Rating Models

 Can include quantitative & qualitative factors, but qualitative factors must be expressed quantitatively.
Very flexible can incorporate different variables, based on situation.
 Scores and weights are constant and predefined.
 Rating are replicable once model is set. Rating grade is derived on the basis of weighted average score.

Statistical Rating Model

 Credit scoring system for Corporate, SMEs and Retail exposures. (Statistical: MDA, Logit, Probit, Tobit
type).
 Weighted average score is computed through statistical formula such as linear regression.

Hybrid Credit Scoring Model

 Mix of expert judgement and statistical methodologies

Artificial Neural Network Approach (ANN)

Credit Rating Models are divided into the following risk groups

Risk
Weigh
Risk Factors Factors Scales Scores weighted
t
Score
Weight *
Risk Score A B C
Scores
· Extent of Competition
· Industry Outlook
Industry · Industry Financials-e.g. Return on Capital
(External) Employed (ROCE) 15%
Risk · Earning Stability
· Cyclicality
· Technology risk
· Profitability-various ratios like ROA,
PBIT/TA, Turnover ratio (Sales/TA)
· Liquidity-NWC/TA, CR, Equity &
Reserves etc.
· Leverage: DSCR, D/E, TL/TNW, Interest
Financial coverage ratio etc.
45%
Risk · Solvency: RE/TA, QR etc.
· Financial Flexibility: Ability to raise
capital from market
· Financial Projection: 3-year projection
· Quality of Financial Statement
Management · Management Experiences 15%
Risk
· Group Support
· Management Succession
· Corporate Governance- ethics, disclosures
· Management Track record
· Strategic Initiatives, Achievements-sales,
profit, capital etc.
 · Relationship with the Bank

· Market share
· Price flexibility to adjust cost
· Raw material related risks
Business · Distribution set up
15%
Risk · Product diversity of markets
· Consistency with quality
· Advertising & Promotional activities
· R&D activities, Adoptions to patents
· Collateral Security Position
· Personal or Corporate Guarantee
Facility &
· Past Payment Record 10%
Project Risk
· Compliance with terms of sanction
· Operations of the account
· Asset coverage ratio, DSCR for the project
(in case of term loan)
Total 100%
Overall Rating

Each loan is evaluated under above five risk components. Scores used for risk ratings are based on an
evaluation of the relative strength or weakness of each consideration within given risk component. Various
scores are possible under each of the five risk components. These are based on relative strength or weakness
of both quantitative and qualitative factors. Under each risk component, there are a there are a number of
possible scores based on the selection of the most appropriate option. After completion of the evaluation
process, an overall score and risk rating is automatically determined.

Risk Rating and Attributes

There are six risk possible ratings. The risk rating for any particular loan facility is determined from the
overall score obtained from the risk evaluation process.

Table 2: Risk Ratings and Attributes

Sr. No Risk Rating Attributes Score
1 Very Low Risk Virtually no risk
Government borrower
Full cash security
Strongly capitalized
Outstanding management

2 Low Risk Minimal risk of any loss

Strong security position/capitalization
Strong management
Stable/strong industry
Excellent financial history /trend
 3 Moderate Risk Good Security Margin/ Strong LTV
Demonstrable debt service capacity
Sound management
Steady Financial trends
Steady Financial trends
Moderate capital level

4 Cautionary Lack of financials

Potentially security shortfall
Potential debt service shortfall
Significantly Adverse development of firm

5 Unsatisfactory Need for immediate action indicated

Security Shortfall/ Capital Crisis
Adverse Management change
Interest/principle dues
Partial suspension of operation

6 Unacceptable Bankruptcy
Definite loss evident
Disappearing assets/security
Fraud

Risk-Based Pricing
Risk-based pricing has been a topic of discussion since the 2008 financial crisis. Risk-based pricing
correctly assessing the risk within the framework of borrower credit provision. A simple loan pricing
framework that is reflective of the credit risk of the potential borrower as well as other risks that the lender
or bank adopts as a result of the transaction. Prudent identification, understanding and evaluation of risks
associated with lending as well as the pricing of those risks to ensure consistency with respect to the concept
of risk adjusted pricing. Risk-based pricing helps to determine whether or not to lend to the customer and the
affordability of the interest rate offered to the customer. Allows institutions to optimally price loans to cover
all costs as well as anticipated risks.

Risk-based pricing involves computing the minimum interest rate to be applied based on the trade-off
between transaction level risk adjusted return on capital (RAROC) and hurdle rate, which represents the
minimum RAROC that must be achieved from the loan. RAROC is a powerful risk measurement tool that
assists banks and financial institutions both in risk pricing and evaluating performance of different business
activities. Though RAROC concept is generally applied at firm level and it incorporates all kinds of the
Risks

RAROC is defined as the ratio of Net Risk Adjusted Return to Economic capital or RAROC is ratio of net
income to Risk Adjusted Capital. Net adjusted return is given by
Net Income = Operation Income + Non-Operating Income – Expected Loss – Operating Expense –
Cost of Funds.
For calculating economic capital, we require large amount of data. RAROC by using IRB capital as a proxy
to economic capital. IRB capital is calculated using Capital Requirement (k) and Exposure at Default (EAD)
as per given guidelines by the Reserve Bank of India (RBI).
Hurdle rate is calculated by taking the cost of equity and cost of debt. One of the aims of the project is to
compare RAROC with that of hurdle rate to determine performance of Corporate and SMEs accounts at both
bank level & business unit levels. In decision making RAROC may be applied as a thumb rule as
• If RAROC > Cost of capital, there is a value addition.
• If RAROC < Cost of capital, value is eroded.
• If RAROC = Cost of capital, value is maintained.
Risk Based-Pricing Components
Hurdle Rate
 It is the minimum required rate of return from each client with a provided credit exposure should achieve
in order for the economic cost to be covered and for the client to create an economic profit.
 The hurdle rate is calculated by taking into consideration the debt and equity component. The cost of
equity is calculated using Capital Asset Pricing Model (CAPM). Weighted Average Cost of Capital
(WACC) is usually considered as the hurdle rate.
 Ra = Rfr + [Ba x (Rm – Rfr)]
Ra=Expected return
Rfr=Risk-free rate
Ba=Beta of the security
Rm = Expected return on market
 WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
Where,
E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
Incremental Capital
 Incremental Capital is the additional capital which will be set aside for the loan.
 Credit Risk Weight Asset amount is considered as the incremental capital amount.
Cost of Funds (COF)
 COF can be computed at tenor level, product level and business unit level based on the structure and
policy of the institution.
 COF is derived using the Marginal COF computation.
Operating Cost
 Operating cost is the share of operating expenses which are associated with the sanctioned
loans/exposure. Operating cost can be computed at various unit level.
Expected Loss
 Expected loss is the amount of loss the institution may incur as a result of advancing a loan.
 It is the loss realized which can be estimated by Probability of Default (PD), Loss Given Default (LGD)
and EAD (Exposure at Default). Expected Loss = PD x LGD x EAD
 There are two main approaches for considering expected loss in the Risk-based pricing computation.
 Credit Risk- RB Expected Loss
 IFRS-9 Expected Credit Loss

Economic Capital (EC)

Economic Capital is the buffer against future unexpected losses brought through by credit, market and
operational risks, inherent in the business of lending money. It is the level of capital is needed in order to
remain solvent at a certain level of confidence and time horizon.
The economic capital is the amount of money which is needed to secure the survival in a worst-case
scenario, it is a buffer against unexpected shocks in market values.
Overview of Typical RAROC Model
Conclusion
Transition Matrix
Transition matrix act as indicators of the likely path of a given credit at a given sphere. Rating transition
matrix produce fundamental inputs that can be used by banks to measure and monitor credit risk in a loan
portfolio. They are useful indicators of historical behavior of ratings transition across the years. Clearly
distinguishable grades both in investment grade and non-investment grades are important for more
granularly measuring risk in a bank’s credit portfolio. Gini Co-efficient provides an evidence of good
discriminatory power of the rating system.
Risk Adjusted Return on Capital
RAROC as a measure tells the bank about profitability while acquiring any fresh account or while
monitoring existing one. RAROC is used as a tool to measure performance of a portfolio by comparing with
hurdle rate (cost of capital). It helps bank in taking business decisions.
As explained above, RAROC can also be used for pricing of loan by considering the risk associated with the
account.
RAROC needs to be approached carefully to ensure alignment between expectations about what its results
mean and the model’s inputs and assumptions—particularly with regard to how capital is calculated and
allocated, the bank’s rating philosophy, its risk appetite, and the nature of the bank’s portfolios. For
example, if banks simply apply generic RAROC models built for large corporate portfolios to calculate the
RAROC of SME portfolios, they are particularly likely to make improper decisions.
Despite these challenges, banks should start investing in RAROC. Developing the right RAROC tool will
help a bank factor risk into its investment, pricing, and compensation decisions throughout the economic
cycle. As well as creating long-term competitive advantage for individual institutions, RAROC may be one
of the best ways for the banking industry to avoid the boom-and-bust conditions prevailing in markets today.
Risk-Based Pricing
Risk-based pricing enables lenders to charge different interest rates to different borrowers based on their
risk. Risk-based pricing in credit products, driven by the credit profile of a potential borrower, is a tool that
compensates financiers for the credit risk assumed but also grow their lending business by expanding the
customer base through pricing based on credit quality.
Important points to consider when planning a RAROC Model Implementation

 Above, I have calculated RAROC using a bank specific hurdle rate (single hurdle rate). The
Banks/NBFCs can implement RAROC using portfolio specific hurdle rate i.e. different hurdle rate for
different business segments like Corporates, SME, Retail loans, etc.
 Many financial institutions use a single hurdle rate to assess the profitability for all its credit instruments.
It may be calculated using the capital asset pricing model (CAPM) and the beta estimated for the
financial institution as a whole. It therefore represents the systematic risk of the equity of the financial
institution. It can be shown theoretically that the use of a single hurdle rate is only appropriate under
very stringent distribution assumptions. Under more realistic market conditions, the use of a single
hurdle rate may result in the financial institution wrongfully accepting (rejecting) high-risk (low-risk)
projects and thus leading to a sub-optimal portfolio composition. The economic implications could be
significant given plausible parametric assumptions. To rectify this distortion, we need a methodology to
determine instrument-specific hurdle rates that can correctly capture the systematic risks of individual
debt instruments.
 The practice of using a single institution-wide hurdle rate is both theoretically and empirically an
approximation and presents empirical evidence that shareholders require different hurdle rates for
different lines of business (e.g., retail banking, investment banking, etc.) of a bank, even if these
businesses are capitalized to a common debt-rating standard. This is consistent with the fact that
different lines of business are subject to different amount of systematic risk. For example, a bank’s retail
banking business is expected to have a lower systematic risk than its investment banking business given
that the former is less subject to market-wide risk factors than the latter. Therefore, differentiated costs
of equity, and thus hurdle rates, are required to assess the profitability of individual lines of business.
 Banks and NBFCs can start working on developing a robust model by incorporating portfolio specific
hurdle rate and economic capital.