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Credit Risk

Various aspects of risk:


The risks associated with credit decisions Inter-relationship between the various credit related risks Quantification of such risks Theoretical framework of risks and the extent of their applicability in actual business decisions

Credit Risk

Principles and guidelines laid down both by BIS and RBI Various steps in the construction of credit risk assessment models: To enable us to prescribe benchmarks for the purpose of decision-making in dispensing credit

Credit Risk

Subjective and Objective Assessment of risk:


Importance of laying down a structured system of assessment and management of risks Being subjective, the lending bankers used to denote the risk content by using statements such as fair banking risk, high banking risk or acceptable banking risk etc.

Credit Risk

Necessary to set a limit for ourselves for absorption of risk which is called risk appetite
Can be fixed by quantification and aggregation of various elements of risk New age risk assessment process relies mainly on objective or quantified assessment of risks

Banker does not stop with his findings that a credit proposal is acceptable or fair banking risk Finds out the degree of acceptability of such risk elements

Credit Risk

If the degree of acceptability lies within his risk appetite limit, he may take a credit decision in favor of the proposal

Credit Risk Value of Collateral

Credit Risk BIS norms and RBI norms Sept 2001

Credit risk

Business-specific

Systemic Non-systemic

Management-specific

Systemic Risks: Recession or depression in the banking in the business, govt. regulations, political unrest, environmental issues etc. over which banking management have no control

Credit Risk BIS norms and RBI norms Sept 2001


These risks have been historically 25-30 percent of the risks 70-75 percent constitute the enterprise-specific risk elements

Statistical Techniques for Risk Management

NPV (Net present value) of projected cash-flows with a discount factor: Comparison between 2 projects can be made

Statistical Techniques for Risk Management

Standard Deviation

RBI Guidelines on Credit Risk Management Sept 2001

Credit Risk: An inability or unwillingness of a customer or a counterparty to meet commitments in relation to lending, trading, hedging, settlement and other financial transactions Credit risk constitutes transaction risk or default risk and portfolio risk

RBI Guidelines on Credit Risk Management Sept 2001


The portfolio risk in turn comprises of 2 components:
Intrinsic risk Concentration risk

RBI Guidelines on Credit Risk Management Sept 2001


External factors responsible for portfolio credit risk:
State of the economy Wide swings in commodity and equity prices Forex rates and interest rates Trade transactions Economic sanctions Govt. policies etc.

RBI Guidelines on Credit Risk Management Sept 2001


Internal factors:
Deficiencies in loan policies/administration Absence of prudential credit concentration limits Inadequately defined lending limits for loan officers/credit committees Deficiencies in appraisal of borrowers financial position Excessive dependence on collaterals and inadequate risk pricing Absence of loan review mechanism and postsanction surveillance etc.

RBI Guidelines on Credit Risk Management Sept 2001


Process of credit risk management:
The following steps are required to be articulated in the approved loan policy of the bank 1. Measurement of risk through credit rating/scoring 2. Quantification of risk through:
1. Estimating the expected loan loss over a chosen time horizon (Through tracking portfolio behaviour over 5 or more years) 2. Unexpected losses: the amount by which the actual losses exceed the expected loss (through statistical measurement tools like standard deviation of losses etc.)

RBI Guidelines on Credit Risk Management Sept 2001


Committee approach for credit approval at large branches, regional offices, zonal offices, head office etc. Setting up of prudential limits on various aspects of credit: This process may involve
1. Setting up benchmarks for liquidity ratios (viz., current ratio), gearing ratio (debt-equity ratio), profitability ratio, debt service coverage ratio or other ratios with flexibility for deviations which should be clearly spelt out

RBI Guidelines on Credit Risk Management Sept 2001


Setting up of prudential limits on various aspects of credit: This process may involve
2. Setting up of single group borrowing limits 3. Setting up of exposure limits may be fixed at 600 percent or 800 percent of the capital funds 4. Maximum exposure limits to industry 5. Evaluation of the maturity profile of the loan book of the bank

RBI Guidelines on Credit Risk Management Sept 2001 Risk rating


To facilitate taking credit decisions in a consistent manner
A single point indicator of diverse risk factors of a counterparty Also reflect the underlying credit risk of the loan book as well

Frequency of credit risk assessment exercises (bi-annually or in shorter periods) Risk Pricing

RBI Guidelines on Credit Risk Management Sept 2001 Risk rating


Portfolio management techniques for ascertaining asset quality of the entire loan book RBI guidelines prescribe the following measures:
Quantitative ceiling may be stipulated on aggregate exposure in specified rating categories 2. Evaluating rating-wise distribution of borrowers in various industries, business segments etc.
1.

RBI Guidelines on Credit Risk Management Sept 2001 Risk rating


RBI guidelines prescribe the following measures:
Evaluation of exposures to an industry/sector should be done on the basis of overall rating distribution of borrowers in the sector group 4. A prudent credit planning exercise may involve analysis of rating-wise: volume of loans, probable defaults and provisioning requirements in the respective credit portfolios
3.

RBI Guidelines on Credit Risk Management Sept 2001 Risk rating


RBI guidelines prescribe the following measures:
5.

Credit portfolio management involves rapid portfolio reviews, stress tests and scenario analysis especially when internal environment undergoes rapid changes (Ex. Volatility in the forex market, economic sanctions, changes in the physical/monetary policies, general slowdown of the economy, market risk events, extreme liquidity conditions etc.)

RBI Guidelines on Credit Risk Management Sept 2001 Risk rating


RBI guidelines prescribe the following measures:
6.

Introduction of discretionary time schedules for renewal of borrower limits (twice, thrice in a year)

RBI Guidelines on Credit Risk Management Sept 2001 Loan Review Mechanism
For large value accounts For continuous evaluation of the quality of loan book The main objectives of LRM include:
1. Prompt identification loans with credit weaknesses and initiation of timely corrective action 2. Evaluation of portfolio quality and isolating the problem areas 3. Providing information for determining adequacy of loan loss provision

RBI Guidelines on Credit Risk Management Sept 2001 Loan Review Mechanism
The main objectives of LRM include:
4. Assessment of the adequacy of and adherence to loan policies and procedures and monitoring of the compliance with relevant laws and regulations 5. Providing top management with information on credit administration, including credit sanction process, risk evaluation and post sanction followup

RBI Guidelines on Credit Risk Management Sept 2001 Loan Review Mechanism
Frequency and scope of reviews:
Review of high value loans should usually be undertaken within 3 months of sanction/renewal When signals indicating a potential for deterioration start emerging this may be done more frequently At least 30-40% of the portfolio should preferably be subjected to LRM in a year

RBI Guidelines on Credit Risk Management Sept 2001 Loan Review Mechanism
The loan reviews should focus on the following:
Approval process Accuracy and timeliness of credit ratings Adherence to internal policies and procedures Compliance with loan covenants Post-sanction follow-up Sufficiency of loan documentation Portfolio quality and recommendations for improving portfolio quality

RBI Guidelines on Credit Risk Management Sept 2001 Off-Balance Sheet Exposure

Full risk (credit substitutes): Standby letters of credit, money guarantees etc Medium risk (not direct credit substitutes): Bid bonds, LCs, indemnities and warranties Low risk: Reverse repos, currency swaps, options, futures etc

RBI Guidelines on Credit Risk Management Sept 2001 Risk Rating


Steps:
1. Identification of all principal business and financial risk elements 2. Allocation of weight-age to principal risk component 3. Comparison with weight-ages given in similar sectors and check for consistency 4. Establishing the key parameters (sub-components of the principal risk elements) 5. Assigning weight-ages to each of the key parameters

RBI Guidelines on Credit Risk Management Sept 2001 Risk Rating


Steps:
6. Ranking the key parameters on the specified scale 7. Arriving at the credit risk rating on the CRF (credit Rating Framework) 8. Comparison with previous risk ratings of similar exposures and verifying whether such ratings have been consistent 9. Final credit risk calibration on the CRF

RBI Guidelines on Credit Risk Management Sept 2001 Risk Rating


Identification of risk elements
Important external risk elements:
Intensity of competition Product substitution Entry Barriers Seasonality of the business Profile of the end users (high income, middle income etc.) Cyclic nature of the earnings

RBI Guidelines on Credit Risk Management Sept 2001 Risk Rating


Internal risk elements - Financial risk: RBI has identified certain areas for critical examination
Analysis of past financials (operating margins, interest cover, leverage, liquidity ratios, contingent liabilities etc.) Analysis of future cash-flows including projected profitability Flexibility to raise required resources Strength of the sponsor group Adequacy of debt service coverage Projected leverage

RBI Guidelines on Credit Risk Management Sept 2001 Risk Rating


Internal risk elements - Business risk:
Select suitable parameters by a lending bank Awarding score may be done by undertaking an inter-firm comparison of the relative strength of the enterprise vis--vis the strength of the competitors on the selected parameters. These parameters may be termed as Dynamic risk factors

RBI Guidelines on Credit Risk Management Sept 2001 Risk Rating


Internal risk elements - Management risk: Evaluation may involve assessment of management capability in terms of
Track-record of the management, Quality of the management personnel Payment record with banks Market standing/credibility Support from group companies Succession plan Capital market perception in respect of shares of the company

RBI Guidelines on Credit Risk Management Sept 2001 Risk Rating


Internal risk elements - Project risk: Evaluation would involve analysis and appraisal of the following:
Determination of size of the project in relation to the existing net worth of the enterprise Likelihood and extent of over-runs Assessment of project implementation risks Technology/stabilization risks Risks related to statutory clearances Assessment of funding risk

RBI Guidelines on Credit Risk Management Sept 2001 Risk Rating


Internal risk elements - Project risk: Evaluation would involve analysis and appraisal of the following:
Assessment of post-implementation risk. Ex. Future market potential, business positioning of the company vis--vis others, product acceptance etc.

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
The financial risk parameters are expressed in quantitative terms Gradation may not therefore pose a significant problem Quantification of the impact of other risk parameters viz., business risk, management risk etc. is a challenging proposition

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
Subjective values: 2 methods
Simple approach to calibrate the entire range of subjective perceptions into 3 or more categories. Ex.: Track record of management can be classified into 1) Excellent 2) Good 3) Satisfactory 4) Poor These categories may be assigned scores of 4, 3, 1, 0 respectively

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
Subjective values:

Negative scores are also assigned to the worst category of parameters Different patterns of classification depending on the nature of risk parameter. Ex. Parameter relating to payment record with banks.

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
Subjective values:
The different grades may be as
No record of default Payments received but sometimes with delay Payments received after much persuasion Default in payment

Scores may be given to these grades in the manner discussed above

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
To avoid, further subjectivity many institutions follow an improved method of quantification of subjective elements In this method no distinct categorization of the parameters is done

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
Instead the credit analysts perception of risk in various types of situations is given in the form of statements These statements are sorted, standardized and graded into various layers Each layer may accommodate more than 1 statement

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
The layers are then assigned with scores This method can be adopted by only those institutions which have a history of dealings with such activities

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
Setting the benchmarks and grades for financial risk parameters
Financial risk in broadly indicated by the level of the specific parameters i.e., current ratio, holding ratios etc. The ratios are culled out from an analysis of the financial statements

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
Setting the benchmarks and grades for financial risk parameters

These parameters may also be in the form of absolute financial quantity viz., sales etc. Once a decision to include a specific parameter in the model is taken, a benchmarking of the parameter has to be done

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
Setting the benchmarks and grades for financial risk parameters

The layering of the parameter may be done on the basis of this benchmark RBI has provided the following indicative guidelines regarding
Selection of the parameters Fixing the benchmark levels

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
Criteria If Gross revenues are between 800 to 1000 crores If Operating margin is 20% or more If ROCE is 25% or more Assignable Score 2 2 1

If Debt : Equity is between 0.6 and 0.8 If Interest cover is 3.50 or more If DSCR is 1.80 or more

2 1 1

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
An effective method of building the different layers in respect of a risk parameter is developed. This method applies the concept of Standard Deviation in the model development process.

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
In respect of 1138 companies in manufacturing sector on the basis of the information extracted from the database the current ratios range is 1 to 2 The minimum level has been selected as 1 below which the company has a negative NWC

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
A current ratio of 2 is high and has been considered as the higher limit
No. of observations = 1138 Mean (Average Current Ratio) = 1.415062 Standard Deviation of Current Ratio = .261854

Range Mean Two Std. Dev.

C.R .891353

Risk Range Less than 0.90

Risk Level

Score

High Risk/ 0 Not acceptable Caution Risk 1

Mean One Std. Dev. Mean

1.153207

0.90 to 1.14

1.415062

1.15 to 1.42

Acceptable Risk Desirable Risk Low Risk

Mean + One Std. Dev. Mean + Two Std. Dev.

1.676916

1.42 to 1.67

1.93877

More than 1.67

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
On the basis of the above method the range of other parameters can also be split into different layers of acceptability indicating different levels of financial risk

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk
The following parameters can be incorporated in the financial risk model: Ratio Category Selected Ratio
Liquidity ratios Gearing ratios Profitability ratios Return ratios Coverage ratios Inventory & Receivables holding ratios Current Ratio TOL/TNW PAT/Net Sales PBDIT/Total assets PBDIT/Interest (Inventory + Receivables) / Net Sales

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk

Final Gradation of the Credit Proposal

On the basis of aggregate scores in respect of all the individual macro credit risk parameters i.e., financial, business, management, project risk etc., lending institution may develop and use different credit risk models depending
A.

B.

The proposal relates to an existing unit or a new management Exposure is short term or long term etc.

RBI Guidelines on Credit Risk Management Sept 2001 Quantification and Aggregation of risk

Finally the different scores obtained are aggregated and the total normalized out of hundred The aggregate score is then measured against a pre-calibrated risk range table RBI suggested a scale consisting of 8 or 9 risk levels Illustrative table given by RBI

Risk Level
1 2 3 4 Low Risk Modest Risk

Description

Satisfactory Risk Fair Risk

5
6

Acceptable Risk
Watch List

7
8 9

Sub-Standard
Doubtful Loss