MBFI

Managing Credit Risk

N. R. BHUSNUR MATHProfessor

MDI Gurgaon

Credit Risk• Default Risk• Borrower may not pay on time or may not pay interest or may

not pay full amount or may not pay at all• Most important risk for banks as 50-65% of the assets are Loans

& Advances• NPA’s – defn

Once an NPA, interest is recognized only on receipt ie., switchover accounting for interest from “accrual” to “cash” basis

Banks have to “provide” for the NPA – according to the age of the NPA

Banks may have to write-off

Risk Management Process • Identifying & Measuring • Pricing Risk• Managing -Controlling,

Monitoring and Reviewing • Managing NPA’s

Credit Risk • Default by the borrower

Non willful Wilfull

• Deterioration of borrowers’ credit quality

Credit RiskRBI defines credit risk as:• the possibility of losses associated with diminution in

the credit quality of borrowers or counterparties. In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality.

Credit Risk Management According to RBI, the following are the forms of credit risk:• Non-repayment of the principal of the loan and/or the interest• Contingent liabilities like letters of credit/guarantees issued by

the bank on behalf of the client and upon crystallization amount not deposited by the customer

• In the case of treasury operations, default by the counter-parties in meeting the obligations

• In the case of securities trading, settlement not taking place when it is due

• In the case of cross-border obligations, any default arising from the flow of foreign exchange and/or due to restrictions imposed on remittances out of the country

Principles of sound credit risk management• BOD should have responsibility for

approving and periodically reviewing credit risk strategy

• Senior management should have the responsibility to implement the credit risk strategy

• Bank should identify and manage credit risk inherent in all product and activities

Credit Risk takes various forms

• Direct Lending:Loan amount (Principal as well as interest) will not be paid

• Guarantees/ Letter of Credit etc. Contingent Liability Funds may not be forthcoming upon

crystallization of liability

Credit Risks Include:• Loans• Trade financing• Guarantees , Acceptances, Letters of

credit• FX transactions• Interbank transactions• Corporate Bonds• Derivatives

Management of Credit Risk (loans)• Management refers to

Pre-sanction appraisal Due Diligence Documentation Disbursement and Disbursal Post-lending supervision and control

Pre-Sanction appraisal• Measurement of risk of a loan proposal

Financial data of past and projected working results

Detailed credit report is compiled on the borrower / surety

Market reports Final / audited accounts Income tax and other tax returns / assessments Confidential reports from other banks and financial

institutions

“Sound Credit” Granting Process• Thorough understanding of the borrower,

purpose/structure of credit and its source of repayment

• Use and abuse of credit scoring models• Have a clearly established process for approving

new credits/extension of existing credits.• Extension of credit must be made on an arm’s

length basis(?) – “Credit Processing Centres”• Establish overall credit limits at the level of

individual borrowers/connected counterparties

Post Sanction Monitoring• Documentation & Due-Diligence • Supervision through monitoring of transactions

in loan amount• Scrutiny of periodical statements submitted by

the borrower• Physical inspection of securities and books of

accounts of the borrower• Periodical reviews etc.

Securities for lending • Section 5 of B. R. Act defines secured and

unsecured loans Secured – Loans and advances made on

security of assets the market value of which is not at any time less than the amount of the loan or advances

Unsecured – Means a loans or advance not so secured

• Security taken as an insurance against unwarranted situations

Securities for lending Two types: Primary and Collateral• Primary Security

Personal Created by a duly executed promissory note,

acceptance or endorsement of bill of exchange etc.

Gives bank the right of action to proceed against the borrower personally in the event of default

Impersonal Created by way of a charge (pledge,

hypothecation, mortgage, assignment etc.)

Collateral Security Meaning running parallel or together

Taken as additional and separate security Could be secured / unsecured guarantees,

pledge of shares and other securities, deposits of title deeds etc.

Used to reinforce the primary security (for e.g. plantation advances are not considered fully secured until crop is harvested)

Credit Risk Management as per RBI

• Measurement of risk through credit scoring• Quantifying risk through estimating loan

losses• Risk pricing – Prime lending rate which also

accounts for risk• Risk control through effective Loan Review

Mechanism and Portfolio Management

RBI Guidelines on Credit Exposure and Management• Credit exposure to an individual

borrowers not to exceed 15% of capital funds

• Group borrowers exposure not to exceed 40% of capital funds

• Aggregate ceiling in unsecured advances should not exceed 15 % of total DTL of the bank from earlier 33.33%

RBI Guidelines on Credit Exposure and Management (Contd.)

• Bank cannot grant loans against security of its own shares

• Restrictions on loans and advances to Directors and their relatives

• Restriction on advances to real estate sector – only for genuine constriction and not for speculative purposes

Managing NPA’s• Built in pricing – the interest rate covers

expected losses (based on probability)• Declaration as “willful defaulter” – cannot

be on any corporate board• Legal Action• SARFESI Act• Debt Recovery Tribunals (DRT’s)• Corporate Debt Restructuring (CDR)

Asset Reconstruction Companies (ARC’s)• “Asset Recovery Fund” to take the NPAs off the

lender’s books at a discount.• Asset Reconstruction Company (Securitization

Company / Reconstruction Company) is a company registered under Section 3 of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SRFAESI) Act, 2002.

• A NBFC• ARC functions like an AMC within the guidelines

issued by RBI.College of Agricultural Banking, RBI,

PUNE

Functioning of ARC’s• Acquisition of financial assets • Change or takeover of Management / Sale or Lease of

Business of the Borrower• Rescheduling of Debts• Enforcement of Security Interest (as per section 13(4) of

SRFAESI Act, 2002)• Settlement of dues payable by the borrower• The ARC transfers the acquired assets to one or more

trusts (set up u/s 7(1) and 7(2) of SRFAESI Act, 2002)• Security Receipts are issues – similar to “units” of M

F’s

Quantitative Analysis – Expected & Unexpected Losses

• EL depends upon default probability(PD) Loss given default (LGD) &exposure at risk (EAD)

• EL = PD x LGD x EAD • Unexpected losses (UL) is the uncertainty

around EL and it is Standard deviation of EL

Expected Loss - Three Components

EXPECTED LOSS Rs. =

Probability of Default

(PD) %x

LossGiven Default

(Severity) %

Loan EquivalentExposure Rs

x

What is the probability of the counterparty defaulting?

If default occurs, how much of this do we expect to lose?

If default occurs, how much exposure do we expect to have?

Credit Risk Rating Framework• Use of credit rating models and credit

rating analysts• Loans to individuals or small businesses,

credit quality is assessed through credit scoring which is based on a standard formulae which incorporates party’s information viz. annual income, existing debts, other details such as homes (rented or owned) etc.

Components of Credit Risk• Default Risk – Risk that a borrower or

counterparty is unable to meet its commitment

• Portfolio Risk – Risk which arises from the composition / concentration of bank’s exposure to various sectors

• Two factors affect credit risk Internal Factors – Bank specific External factors – State of economy, size

of fiscal deficit etc.