Credit Risk Management

FINANCIAL RISKS
 FINANCIAL RISKS
• Many businesses fail not because of lack of
business opportunities, but due to poor or
improper management of financial affairs.
• Financial risk refers to the chances of collapse
of a business due to wrong financing
polices/decisions/strategies such as lopsided
capital structure and asset-liability mismatch.
 Managing Credit Risks
• Financial analysis serves three main purposes:
• (a) It digs deep and brings out financial risks
• (b) It triggers questions that would lead to a
meaningful operating/business analysis. This
explains why financial details get prominence
among the information called for by credit
providers.
• (c) Thirdly, especially for financial intermediaries
such as banks, it is also useful to determine the
extent of financial support needed by the
prospective borrower.
 Credit Appraisal—Interpretation of
Financial Statements
• IMPORTANCE OF FINANCIAL STATEMENTS:
• Financial statements, the end product of
accounting, are viewed as proxies(the word proxy
is sometimes used in the meaning of ‘evidence’
or ‘indicator’.) of economic activities and
business performance.
• Analysis of financial statements enjoys a
prominent place in the assessment of the study
of credit risks, lending decisions and ongoing
monitoring of the lending portfolio.
 Continued…
• Financial statements, preferably audited, are
the major source of information to conduct
financial analysis because they contain data
related to land, building, machinery, vehicles,
stock, receivables, cash, bank deposits and
borrowings, capital, external creditors, tax
liabilities, sales, cost of sales, selling expenses,
other overheads, interest costs and cash
flows/funds flows, among others.
 FINANCIAL ANALYSIS
• While studying ten years financials is ideal, at
least five years’ financial data is needed for a
new credit prospect, unless the firm’s age is
lesser.
• Financial analysis should strive to recognize and
identify early warning signs and other financial
risks and suggest suitable defensive strategies
and practical solutions to mitigate risks and
protect the credit asset from potential problems
and credit losses.
 Credit-Worthiness???
• CRA (i.e. credit risk analyst) undertakes
financial analysis, primarily for ensuring the
creditworthiness of customers.
• It denotes checking whether the prospective
borrower is worthy to receive credit.
• It is similar to the term of ‘seaworthiness’ of
a ship, which is a normal clause in marine
insurance policies.
 Balance Sheet
• The balance sheet (B/S) shows the financial
position of a business as on a particular date,
at the end of a period—say a year, a quarter, a
month, etc.
• The balance sheet is a critical tool for an
effective credit evaluation.
• It answers a lot of questions an analyst has
while ascertaining creditworthiness, such as:
 Continued…

• 1. What is the capital structure of the business? Is it appropriate? Have

the owners of business put sufficient capital into the business?

• 2. What are the short-term and long-term liabilities of the business? Are
they properly structured? Is it possible to relate each source of finance
to a particular asset item?
 
• 3. How is credit provided by trade suppliers? Did the suppliers alter
trade terms?
 
• 4. What are the taxation and other statutory liabilities outstanding?
 
• 6. What is the quantum of fixed assets and are they put to optimum
use?
 Credit Executive assessment???
• credit executive is looking at things from an
entirely different angle, which calls for certain
adjustments to balance sheet items.
• Following are certain instances where the
analyst would have to recast the B/S,
sometimes through profit and loss (P&L)
account;
 Continued…
• 1. Intangibles: Sometimes the value of intangible
assets like ‘goodwill’ is part of net worth. The analyst
should deduct this from the net worth to arrive at
tangible net worth.
• 2. Unsubordinated shareholders’ loan: If included as
part of the equity or shareholders’ funds this item
should be excluded, especially in the case of limited
liability companies.
• 3. Dividends payable: In certain cases the dividends
payable may appear as part of the
equity/shareholders’ funds. These should be separated
and treated as current liability.
 Financial Appraisal for the Credit
Decision
• Though several qualitative factors play a role
in a credit decision, a major influencing factor
is the financial health of the borrower as
brought out by the financial appraisal.
• We will study as to how the credit officer uses
techniques such as ‘financial ratio analysis’,
‘cash flow analysis’ and ‘sensitivity analysis’ to
assess the credit worthiness of the borrowing
companies.
 FINANCIAL RATIO ANALYSIS
• Standard Ratios
• The relationship between items, or group of
items, appearing on the financial statements
can be expressed mathematically in the form
of Proportions, ratios, rates or percentages.
• Think of the combination of ASSETS &
LIABILITIES i.e. Is it the Current assets 2 times
the current liabilities or else!!!
 Important Points to Consider
• The necessity of expressing the relationship
between related items in the form of ratios or
percentages arises from the fact that absolute
Rupee data are incapable of revealing the
soundness or otherwise of a company's
financial position or performance.
• Net sales of Rs M may appear satisfactory, but
no positive conclusions can be drawn unless
they are compared with the total assets.
 Continued…
• Finding a ratio between the Net Sales and total
Assets used to achieve the sales shows the
efficiency of the company in utilizing the assets
and Industry comparison shows if the particular
enterprise is well managed or not as per industry
standards.
• A single ratio in itself is meaningless because it
does not provide a complete picture of a
company's financial position, What it exactly
reveals???
 Methods of Comparison
• Ratios and percentages have little significance
unless they can be compared with, or matched
against, appropriate standards.
• 1) Historical Comparison. Historical standards
are based on the record of the past financial and
operating performance of individual subject
business concern.
• Comparison of historical ratios throws more light
on the company’s performance than just one
year’s data.
 Continued…
• 2) Industry Comparison. Horizontal, Peer Group,
or Industry standards represent ratios and
percentages of selected competing companies,
especially the most progressive and successful
ones, or of the industry averages of which the
individual company is a member.
• Comparisons with Industry averages are most
valuable for judging the Financial health of a
Company.
 Continued…
• 3) Regulatory Requirements. Sometimes
Regulators lay down standards which must be
met before financing is allowed by
supervisors.
• State Bank Prudential regulations lay down
Minimum Current Ratio that should appear at
the time a finance is granted.
 Continued…
• 4) Budget Comparison. Budgeted standards, or "goal
ratios" as they are sometimes called. These are
developed by Senior Company Management and
monitored by them to judge the Company
Performance.
• Such ratios are based on past experience modified by
anticipated changes during the account period.
• Actual ratios are accomplishment of the anticipated
targets.
• Study of the Budgeted and Actual Ratios is also helpful
to the credit analyst.
 4-Broad Categories
• Most credit analysts use four broad categories of ratios
—liquidity, profitability, leverage, operating.
• Liquidity ratios indicate the borrower’s ability to meet
short-term obligations, continue operations and
remain solvent.
• Profitability ratios indicate the earnings potential and
its impact on shareholder returns.
• Leverage ratios indicate the financial risk in the firm as
evidenced by its capital structure, and the consequent
impact on earnings volatility.
• Operating ratios demonstrate how efficiently the
assets are being utilised to generate revenue.
 CASH FLOW ANALYSIS
• The profits of a company and the cash flows of a
company are two different things.
• The profits are important from the point of view
of long term sustainability of a company.
• However for a lending banker cash flows are
more important because the loans are repaid
from cash flows.
• Bank must make sure that the company is
managing its cash flows in a prudent manner.
 Continued…
• To get a clearer picture of the borrower’s capacity
to repay, the bank will have to convert the
income statement into a cash flow statement, or
call for a cash flow statement from the borrower.
• Typically, the statement of cash flows is divided
into four parts—
• cash from operating activities,
• cash from investing activities,
• cash from financing activities and
• cash.
 Points of Concern
• The intent is to distinguish between accounting profits
as measured by net income in the income statement,
and the firm’s various activities that affect cash flows,
but are not reported in the income statement.
• The vital analysis here is to determine how much cash
is generated from the firm’s activities, and whether it
is sufficient to cover loan repayments and interest
payments.
• How efficiently the firm is meeting its long-term and
short term obligations with the available sources ???
 Sensitivity Analysis
• It involves creating a mathematical model
generally on a spreadsheet of any business
results or other phenomena based on certain
assumptions say about prices or rates of
interest or government duties and then seeing
how any possible changes in the variables
affect the overall results in a positive or
negative manner.
 Credit Risk Assessment
• PURPOSE OF FACILITY / FINANCING:
• The purpose of advance firstly must be
satisfactory from the banker's view and
secondly there should not be any restraint
from government control, which makes a
particular advance impossible.
• Prudent financial institutions should always
avoid advances for speculative purposes.
 Continued…
• AMOUNT:
• It must be considered whether the proposed
amount is reasonable in relation to the
customer's own resources.
• Excessive Loan should be avoided but giving
less which does not fulfill the purpose of the
financing also increases credit risk.
 Continued…
• DURATION / TENOR :
• The general rule is that advances allowed by
financial institutions are repayable on demand
and they have to ensure that this fact should
be brought to the notice of the borrower in
every case.
• Giving a short term loan where the genuine
requirement is medium or long term also
raises risk.
 Continued…
• CREDIT INFORMATION REPORTS:
• It is important to ensure that past borrowing
record of the customer is clean and there are
no defaults against him.
• Think of the possibility if the said requirement
of facility is for “ re-financing” or else!!!
• Competence of Management:
• Think how important its relationship with the
safety of banks funds.
 Continued…
• PROFITABILITY FOR THE BANK:
• It has to be ensured that the rate of interest and other
Commissions and Fees agreed with the customer
provide a satisfactory return to the lending institution.
• The Internal Rate of Return (IRR) to the bank is
satisfactory.
• IMPORTANCE OF SECURITIES FOR MANAGING RISK:
• Securities for a proposed advance should normally be
required even though the borrower's financial position
appears to be sound.
 Continued…
• Some of the securities frequently offered to the financial institutions are:
• Lien on Customer’s own rupee and foreign currency accounts and fixed
deposits.
• Fully negotiable Stock Exchange Securities i.e. bearer bonds, scrips to
bearers and government promissory notes.
• Not negotiable securities, e.g. inscribed stocks or registered stocks and
shares.
• Goods and documents of title to goods.
• Life Insurance policies, debentures, book debts and ships
• Post office and National saving certificates.
• Gold or silver bullions and ornaments
• Mortgage of LANDED property INCLUDING INDUSTRIAL, COMMERCIAL
AND RESIDENTIAL BUILDINGS
• Plant and Machinery.
 Continued…
• The fact remains that, facility against a tangible
security duly perfected is the most important of
all the good lending principles as the lender's
interest may be safeguarded through the
realization of security in case of need.
• A prudent lending officer should always give due
importance to the security aspect of an advance
with proper documentation for perfection
thereof.
 EFFECTIVE CREDIT CONTROL
• Regional advances control plays a role
between branches and their head office as a
guideline and/or as an important link to see
that the credit policies are carried out in letter
and spirit.
• The salient features of an effective credit
control which are very essential to measure
success of a financial institution are as
follows:-
 Continued…
• A) APPROVAL OF CREDIT FACILITIES :
• In order to ensure the profitable use of funds the
credit facilities should be allowed at all
management levels after proper approval from
appropriate authority.
• B) DISCRETIONARY POWERS:
• Sufficient discretionary powers should be given
to the branch as well as regional management to
enable them to meet local requirements.
 Continued…
• C) FORMATION OF CREDIT COMMITTEES:
• Credit committees at various levels are important
in order to exercise effective control over
advances portfolio.
• D) RECORDS OF CUSTOMER'S CREDIT
FACILITIES:
• Proper record of all advances allowed from time
to time should be carefully kept for future
reference, examination, reviews and analysis.
 Continued…
• E) RECOVERIES OF DELINQUENT LOANS:
• Special Assets Management (SAM) i.e. recovery of
defaulted loans is a real challenge to the financial
institutions because of numerous difficulties faced
once the Obligor has become delinquent.
• All out constant vigorous efforts must be made
through negotiation, mediation, arbitration and
alternate dispute resolution for amicable settlement in
order to avoid cost and delay in recovery because of
litigation and court proceedings.
 PROPER AUDIT AND INSPECTION
ARRANGEMENTS:
• The Internal and External Audit in financial sector
is of paramount importance to manage RISKS TO
THE BANKS.
• Effective audit functions keep errors to the
minimum and act as deterrents to ROUGUE
officers and employees who may be looking for
opportunities to beat the systems evolved by the
banks to avoid frauds and forgeries which are
coming up as one of the increasingly important
causes of Portfolio Infection.
 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.
• To keep it current, the overall strategy has to
be reviewed by the board, preferably
annually.
 Continued…
• The responsibilities of the Board with regard to credit risk
management shall, include :

• a) Delineate bank’s overall risk tolerance in relation to credit risk.

• 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, measurement, monitoring and
control of credit risk.
• e) Ensure that appropriate plans and procedures for credit risk
management are in place.
 Risk Tolerance of Bank
• The very first purpose of bank’s credit strategy is to determine the
risk appetite of the bank. Once it is determined the bank could
develop a plan to optimize return while keeping credit risk within
predetermined limits. The bank’s credit risk strategy thus should
spell out:-

• a) The institution’s plan to grant credit based on various client

segments and products, economic sectors, geographical location,
currency and maturity ;

• b) Target market within each lending segment, preferred level of

diversification/concentration ;

• c) Pricing strategy ;
 Continued…
• The credit procedures should aim to obtain an in-
depth understanding of the bank’s clients, their
credentials & their businesses in order to fully know
their customers.
• 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 strategy would be reviewed periodically and
amended, as deemed necessary, it should be viable in
long term and through various economic cycles.
 Credit Policy’s Credibility
• The senior management of the bank should develop and establish
credit policies which shall provide guidance to the staff on various
types of lending including corporate, SME, consumer, agriculture,
etc. At minimum the policy should include :-
• a) Detailed and formalized credit evaluation/ appraisal process.
• b) Credit approval authority at various hierarchy levels including
authority for approving exceptions.
• c) Risk identification, measurement, 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.
• g) Guidelines on management of problem loans.
 Continued…
• To maintain bank’s overall credit risk exposure
within the parameters set by the board of
directors, the importance of a sound risk
management structure is second to none.
• While the banks may choose different structures,
it is important that such structure should be
commensurate with institution’s size, complexity
and diversification of its activities.
• It must facilitate effective management oversight
and proper execution of credit risk management
and control processes.
 CRMC???
• Each bank, depending upon its size, should constitute a Credit Risk
Management Committee (CRMC), ideally comprising of heads of credit
risk management Department, credit department and treasury.
• The CRMC should be mainly responsible for :-

• a) The implementation of the credit risk policy / strategy approved by the

Board.
• b) Monitor credit risk on a bank-wide basis and ensure compliance with
limits approved by the Board.
• c) Recommend to the Board, for its approval, clear policies on standards
for presentation of credit proposals, financial covenants, rating standards
and benchmarks.
• d) Decide delegation of credit approving powers, prudential limits on large
credit exposures, standards for loan collateral, portfolio management,
loan review mechanism, risk concentrations, risk monitoring and
evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc.
 CRMD???
• Ideally, the banks should institute a Credit Risk Management Department
(CRMD)
• Typical functions of CRMD include:

• a) 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.
• b) The department also ensures that business lines comply with risk
parameters and prudential limits established by the Board or CRMC.
• c)Establish systems and procedures relating to risk identification,
Management Information System, monitoring of loan / investment
portfolio quality and early warning. The department would work out
remedial measure when deficiencies/problems are identified.
• d) The Department should undertake portfolio evaluations and conduct
comprehensive studies on the environment to test the resilience of the
loan portfolio.
 Credit Origination???
• Credits should be extended within the target markets and lending
strategy of the institution.
• Before allowing a credit facility, the bank must make an assessment
of risk profile of the customer/transaction. This may include :-

• a) Credit assessment of the borrower’s industry, and macro

economic factors.
• b) The purpose of credit and source of repayment.
• c) The track record / repayment history of borrower.
• d) Assess/evaluate the repayment capacity of the borrower.
• e) The Proposed terms and conditions and covenants.
• f) Adequacy and enforceability of collaterals.
• g) Approval from appropriate authority
 Other Guidelines???

• 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.

• 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.

• However, a bank must not grant credit simply on the basis of

the fact that the borrower is perceived to be highly reputable
i.e. name lending should be discouraged.
 Continued…
• 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.
• 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.
• In case of corporate loans where borrower own group of
companies such diligence becomes more important.
• Institutions should classify such connected companies and
conduct credit assessment on consolidated/group basis.
 Continued…
• In loan syndication, generally most of the credit
assessment and analysis is done by the lead institution.
• All syndicate participants should perform their own
independent analysis and review of syndicate terms.
• Institution should not over rely on collaterals /
covenant.
• Although the importance of collaterals held against
loan is beyond any doubt, yet these should be
considered as a buffer providing protection in case of
default, primary focus should be on obligor’s debt
servicing ability and reputation in the market.