Credit Risk Management in Banks

INDEX

INTRODUCTION

SIGNIFICANCE OF THE STUDY

OVERVIEW TO CREDIT RISK MANAGEMENT

OBJECTIVE

METHODOLOGY

CONCLUSION

RECOMMENDATIONS

10

LIMITATIONS

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REFERENCES

Credit Risk Management in Banks

INTRODUCTION
SIGNIFICANCE OF THE TOPIC

Over the last several years, two strands of view in the field of financial institutions have
received great amounts of attention. One strand investigates the issue of problem loans.
Virtually all research on the causes of bank and thrift failures find that failing institutions
have large proportions of nonperforming loans prior to failure and that asset quality is a
statistically significant predictor of insolvency. The other strand of research investigates
the productive efficiency of financial institutions.
Its said that almost always find that the average institution incurs high costs and generates
low profits relative to institutions on the best practice efficient frontier. Various studies
of mergers, agency problems, corporate governance, branching strategies, foreign
ownership, and etc. offer support for a number of explanations of this inefficiency.
On the surface, these two topics might appear to be largely unrelated, because operations
personnel typically do not participate in screening and monitoring loan customers, and
because loan officers and review personnel typically do not participate in overseeing
operations costs. Despite this apparent dichotomy, issues of problem loans and cost
efficiency are in fact related in several important ways.
First, its found that failing banks tend to be located far from the best practice frontier.
Thus, in addition to having high ratios of problem loans, banks approaching failure also
tend to have low cost efficiency.
Cost-inefficient banks may tend to have loan performance problems for a number of
reasons. For example, banks with poor senior management may have problems in
monitoring both their costs and their loan customers, with the losses of capital generated
by both these phenomena potentially leading to failure. Alternatively, loan quality
problems may be caused by events exogenous to the bank, such as regional economic
downturns, in which case extra expenses associated with the nonperforming loans (e.g.,
monitoring, negotiating workout arrangements, seizing and disposing of collateral,
diverted senior managerial focus) can create the appearance, if not the reality, of low cost
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Credit Risk Management in Banks

Moreover, the latter study found that banks management ratings were more strongly
related to their asset quality ratings than to any of their other examination ratings. A
relationship between asset quality and cost efficiency (via management quality) is
consistent with the failed bank data cited above, and suggests that the negative
relationship between problem loans and cost efficiency holds for the population of banks
as well as for the subset of failing banks.
Third, reports of bank efficiency have directly included measures of non-performing
loans in cost or production relationships. The stated purposes of this adjustment are to
control for the extra costs associated with nonperforming loans and/or to control for
underwriting and monitoring expenditures that influence loan quality.
The increasing bank crisis and the manifold increase in the NPA level has lead to the
increasing importance of the Credit Risk Management in banking sector. This paper
entails an in depth analysis of the credit risk management tools used by the banks and
the efficiency of these models in predicting the Default Rate

Credit Risk Management in Banks

AN OVERVIEW TO CREDIT RISK

MANAGEMENT
Risk management has assumed increased importance of regulatory compliance point
of view. Credit risk, being an important component of risk, has been adequately
focused upon. Credit risk management can be viewed at two levelsat the level of an
individual asset or exposure and at the portfolio level. Credit risk management tools,
therefore, have to work at both individual and portfolio levels.
Traditional tools of credit risk management include loan policies, standards for
presentation of credit proposals, delegation of loan approving powers, multi-tier credit
approving systems, prudential limits on credit exposures to companies and groups,
stipulation of financial covenants, standards for collaterals, limits on asset
concentrations and independent loan review mechanisms. Monitoring of nonperforming loans has, however, a focus on remedy rather than advance warning or
prevention. Banks assign internal ratings to borrowers, which will determine the
interest spread charged over PLR. These ratings are also used for monitoring of loans.
Some central banks like the RBI have suggested the use of rating models like
Altmans Z score models at individual loan/company level and risk models like Credit
Metrics and Credit Risk+ at the portfolio level. While evaluating credit and
monitoring, banks use a number of financial ratios. There have been studies of
predictive ability of various ratios.
Attempts at combining different ratios into a single measure by using the statistical
technique of "Multiple Discriminant Analysis" have also been made. Among these,
Altmans Z-Score is well known.
It forecasts the probability of a company entering bankruptcy. The model combines
five financial ratios into a single index. Practitioners, however, had difficulties in
using the model, as the classification error is high for more than one year in advance.

Credit Risk Management in Banks

Thus, by the time the model could be applied on published financial data, it would be
too late for any action to be taken.
Recently, significant advances have been made in credit risk modeling at the portfolio
level. The interest is not confined to academicians alone. Policy makers and
practitioners are also working on applying these models. Credit Metrics and Credit
Risk+ were released in 1997.
Credit Metrics was developed by JP Morgan and focuses on estimating the volatility
of asset values caused by variations in the quality of assets. To compute volatility, the
model tracks the "rating migration"the probability that a borrower of one risk rating
migrates to another risk rating. Credit Risk+ was developed by Credit Suisse
Financial Products. It is a statistical method for measuring and accounting for credit
risk. The model is based on actuarial calculation of expected default rates and
unexpected losses from default. The model is based on insurance industry models of
event risk. Under Credit Risk+, each individual obligor has a default probability. The
default probability is not constant over time but changes in response to background
economic factors.
To the extent that more than obligors are sensitive to the same background economic
factors, their default probabilities move together, which can lead to correlations in
defaults. Can banks go ahead and adopt models in their credit risk management
process? Which model to go for? A direct comparison of models is not simple, as
different models may be presented with rather different mathematical frameworks.
For example, given the same portfolio of credit exposures, the two models mentioned
above have been found to be, in general, yielding differing evaluations of credit risk.
The problem is not just that of selection of a model but that of validating the model
chosen. As credit risk models employ relatively longer time horizons (one year to
several years), their validation poses major difficulties in requiring many years of
historical data spanning multiple credit cycles for estimating key parameters
accurately. As a contrast, market risk models use a much shorter time horizon and
their "back testing" becomes simpler. Practitioners and researchers alike have reported
"data insufficiency" to be a key impediment to design and implementation. However,
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Credit Risk Management in Banks

it is critical that regulators are confident that models are conceptually sound and
empirically validated before they can be used in the process of supervisory process
and computation of capital requirements.
The task force has rightly recognized that data availability and model validation are
two hurdles to be crossed before the next step is taken. In fact, the recent revisions to
the 1988 Basel Accord, do not envisage permitting banks to set their capital
requirements solely on the basis of their own credit risk models.
Internationally, the degree to which models have been incorporated into the credit
management and economic capital allocation process varies greatly between banks.
Large-sized banks across the world have put in place risk adjusted return on capital
framework for pricing of loans. Banks have implemented different models for
corporate and retail businesses.
While only a small number of banks are currently using models for active credit risk
management, the internal applications are varied and include setting of concentration
and exposure limits, risk-based pricing, evaluation of risk-adjusted performance of
business lines or managers and customer profitability analysis. As discussed above,
credit risk models require, most importantly, historical loan loss data and other model
variables, spanning multiple credit cycles.
Banks must, therefore, as a first step, endeavor building adequate database for
implementing credit risk modeling over a period of time.
Most banks will need expert help in the preparatory and implementation phases
education and training, study of available models, building models depending on a
banks business profile, model validation, data sufficiency studies and building
systems for ongoing data build up.
To be able to move swiftly in this area, banks need to work from the sides of both the
business analytics and the supporting technology infrastructure. It is going to be some
significant investment, but considering that it is "risk management" that they are
going to spend on, it should be worthwhile.
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Credit Risk Management in Banks

OBJECTIVE OF THE STUDY

The objective of this research paper is to study the credit analysis process at Banks.
The study would provide for the in-depth understanding of credit analysis procedure
and credit decision-making in banks. It would also involve the study of various
scientific and statistical techniques available to the analyst to effect a credit decision.

In brief the objectives of the project are:

1. To study the credit analysis procedure at banks
2. Analyze the shortcomings of the credit risk management process followed
3. Analyze the various statistical techniques available to make a credit decision
4. Provide for a comprehensive credit risk management process to manage credit
risk.
5. To recommend improvements to the existing procedure.

Credit Risk Management in Banks

RESEARCH METHODOLOGY
The paper involves the study of the existing credit risk management in banks. Hence,
the methodology involves the process of
1. Gathering information on the existing system
2. Analyzing the process in detail
3. Identifying the shortcomings of the process
4. Studying the statistical techniques that could support and improve the existing
process
5. Making recommendations to improve the existing credit analysis process
The methodology thus is exploratory in nature.
Information for the purpose of the project has been gathered from

Primary and

Secondary sources

The secondary research included the study of the various research papers in the field
of credit risk management. The secondary research primarily dealt with the advanced
mathematical models used in risk management. The primary sources for secondary
data collection were the research papers, journals and newsletters.
The primary research was in the form of discussion with three banks. The discussion
was carried with help of an unstructured questionnaire, which gave an insight to my
research. The various issues covered in the discussion were:
the risk management tools used by the Banks; the cut off methodology; the industrial
trend; the implementation; the process; other complementary risk management tools
used; functioning of the current system.
The discussion was carried on with three banks:

Vivek Mathur,Director, finance department,American Express bank

Mr. T S Venkatraman, General Manager, Sundaram Finance

Vishaka Mulye, Manager, ICICI bank ltd

Credit Risk Management in Banks

CONCLUSION
Thus concluding the literature on cyclical effects on PD, LGD and EAD. Although
systematic risk factors have been incorporated into both academic and proprietary
models of PD, the same is not true for LGD and EAD. Moreover, systematic
correlation effects between PD and LGD, PD and EAD, and LGD and EAD have
been virtually ignored in the literature.
Clearly, a great deal of work needs to be done in these areas before regulators will be
convinced that bank internal models can accurately measure credit risk exposures,
especially in recessions.

Credit Risk Management in Banks

RECOMMENDATIONS
After in-depth analysis of the credit analysis process and the problems associated with
the Judgemental Approach the following recommendations have been made to
improve the effectiveness of the existing system.
The recommendations are:
1. The fundamentals of Credit analysis process have been outlined herewith to
provide for a guideline towards effective credit analysis procedure.
2. An asset liability management model has been provided to ensure adequate
cash flow generation from the investment, post lending period. This ensures
regular payment of lease rentals from the revenue generations of the asset.
3. The concept of credit scoring has been recommended to identify credit risk
associated with the individual credits. This helps in effectively classifying a
potential client into good or bad, depending on the predictive variables
employed. The development of a credit scorecard involves statistical techniques
and these have discussed in detail. The credit scorecard intends to remove
biasness and support the individual with vital information that enable credit
decision-making.
4. The Altman Z-Score model has also been recommended to identify or predict
the probabilities of default of a client based on Multi Discriminant Analysis
(MDA) at a 1-year or 4-year interval. Identification of probabilities of default is
imperative to any institution in the lending business.
5. A comprehensive Credit Risk Management process has been provided to cover
the entire credit cycle and to manage not only liquidity and interest rate risks
associated with Banks but also Credit risk arising from exposure. The CRM
process acts as a guideline to effective credit management.

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Credit Risk Management in Banks

LIMITATIONS
Sample size Limitations:

The research undertaken was limited to few banks. As the advanced risk all the
banks are not used management techniques and thus the information access
was limited.

The advanced models or the discriminant analysis is an complex process and

involves complicated calculations which couldnt be widely covered in the
paper.

The models are studied and found internationally which may not be as
applicable in the Indian Markets. The implication is dependent on the
efficiency of the markets

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Credit Risk Management in Banks

REFERENCES
Basel Committee on Banking Supervision, 1999, Credit Risk Modeling: Current
Practices and Applications,. Bank for International Settlements, June.
Carey, Mark and Michael Gordy, 2001, Systematic Risk in Recoveries on Defaulted
Debt, Unpublished Working Paper presented at the 2001, Financial Management
Association Meetings, Toronto, October 20.
Duffee, Gregory R., 1999, "Estimating the Price of Default Risk", Review of
Financial Studies, Spring, 12(1), 197-225.
Gordy, Michael, 2000a, A Comparative Anatomy of Credit Risk Models, Journal
of Banking and Finance, January, 119-149.
Gupton, Greg M., Christopher C. Finger and Mickey Bhatia, 1997, CreditMetrics
Technical Document, (New York, J.P.Morgan).
Gupton, Greg M., Daniel Gates and Lea V. Carty, 2000, Bank Loan Loss Given
Default, Moodys Investors Service, Global Credit Research, November.
Saunders, Anthony, 1999, Credit Risk Measurement: New Approaches to Value at
Risk and other Paradigms, John Wiley & Sons, New York.
Altman, E.I., 2000. Predicting financial distress of companies: Revising the Z-score
and ZETA_ Models. New York University, New York.
Altman, E.I., Haldeman, R., Narayanan, P., 1977. ZETA analysis, a new model for
Bankruptcy classification. Journal of Banking and Finance 1.
Altman, E.I., A. Resti and A. Sironi, Analyzing and Explaining Default Recovery
Rates, ISDA Resport, December 2001.
Bakshi, G., D. Madan, and F. Zhang, Investigating the Sources of Default Risk:
Lessons from Empirically Evaluating Credit Risk Models, University of Maryland
working paper, February 28, 2001.
Bangia, A., F.X. Diebold, T. Schuermann, Ratings Migration and the Business Cycle,
With Applications to Credit Portfolio Stress Testing. Wharton Financial Institutions
Center, Working Paper 26, April 2000.

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