Академический Документы
Профессиональный Документы
Культура Документы
Dr Arindam Bandyopadhyay
Objectives
Definition of Credit Risk and its major elements
Understand the major drivers of credit risk
Understand the importance of Credit Risk Management in FIs.
Explain the constituents of Credit Risk Management
Describe and evaluate the role of internal and external credit ratings.
Structure
1.1 Introduction
1.2 Credit Risk – Definition and causes
1.3 Key Drivers of Credit Risk
1.4 Mitigation of Credit Risk
1.5 Risk Rating-External vs. Internal Ratings
1.6 Credit Risk Drivers-PD, EAD, LGD
1.7 Credit Risk Management Framework
1.8 Role of Risk Management Department
1.9 Portfolio Risk Management
1.10 References
1.1 Introduction
The concept of credit risk is as old as lending as it has been the most important risk in
the banking book. Credit risk plays an important role in ensuring profitability,
soundness and stability of a financial institution. If a bank takes no risk it may have no
profit and at the same time if it takes too much risk and does not know how to manage it
may have no profit as well. It is well known fact that, globally, many financial
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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune
institutions have collapsed due to poor management of credit risk in their attempt to
grow portfolio volumes and improve earnings.
Taking a lending decision is discriminating between an affordable risk and non-
affordable risk and a need, therefore, arises to design a yardstick to accurately measure
risks. In recent years, credit risk has become universal and at the same time a lot of
progress has been made in the area of credit risk measurement. Basel regulations (Basel
II/III) have contributed a lot in this area. More importantly, the global credit and
sovereign debt crisis during 2007-09 and recent surge in non-performing loans of
public sector banks in India have shown that sound understanding of credit risk is
crucial for bank managers.
Management of credit risk begins at the loan appraisal stage itself. During the time of
appraisal, it is important to have clear perceptions of risks involved. Inadequate focus
on credit risk assessment may adversely affect the quality of the credit portfolio. The
effective management of credit risk is a necessity for long run success of a bank in a
more complex and competitive global market.
1.2 Credit Risk: Definition & Causes
Credit risk is the risk that an issuer of debt securities or a borrower may default on
repayment /contractual obligations. Default risk on a debt arises when the issuer fails to
pay the coupon or the repayment of bonds as per terms. In case of a borrower failure to
pay the interest and repayment of loan on agreed days is credit risk. The non fulfilment
of contractual obligations may arise due to unwillingness or inability of the
issuer/borrower or for any other reason. The risk is faced by the lender/investor and it
includes loss of principal and interest, disruption to cash flows and increased collection
costs.
A single borrower/obligor exposure is generally termed as obligor credit risk while the
credit exposure to a group of borrowers is called portfolio credit risk. Since banks
actually hold lot of assets in its books, they face portfolio credit risk due to clustered or
joint default incidents. Both obligor and portfolio credit risk are influenced by
systematic (industry specific or due to macroeconomic reasons like recession, fall in
commodity price etc.) and idiosyncratic risks (borrower specific problems-e.g.
management problems, poor financials etc.).
External forces that affect all business and borrowers in the country are called
systematic risks and this risk cannot be diversified. For instance, if the economy is
going through a recession, number of default incidents will increase that will trigger
higher credit losses.
The second type of credit risk is known as unsystematic (idiosyncratic to the individual
borrower) risk which can be diversified. Such risks are largely industry specific (e.g.
problems in Steel industry or Rubber industry) and or firm specific (dependent upon
typical character or nature of a firm).
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Banks obtain credit information report from credit bureaus like CIBIL to check the
credit history of the borrower which helps in avoiding credit risk by eliminating those
with poor credit score. A bank can diversify such risks by allocating credit to a range of
customers.
In extending credit, banks have to make judgments about a borrower’s
creditworthiness-its ability to pay principal and interest when due. Credit risk arises
because the creditworthiness of the borrower may decline over time due to change in
its financials, poor management by the borrower or changes in the business cycle such
as rising inflation, recession, weaker exchange rates or increased competition. Credit
risk of an issuer could change depending on the way the financial markets react to
deterioration in a company’s credit standing through higher interest rates on its debt
issues (like bonds), a decline in its share price, and/or a downgrading of the assessment
of its debt quality. Banks need to manage the credit risk inherent in the entire
investment and loans portfolio as well as the risk in individual credits or transactions.
1.3 Key Drivers of Credit Risk
Credit risk is the amount that can potentially be lost if a borrower defaults. It also
includes the cost of managing liquidity on account of default and delinquency. Credit
risk constitute three important elements: probability of default (PD), exposure at
default (EAD) and loss given default (LGD). Probability of default PD) measures the
default risk of a borrower. It is the likelihood that a borrower will default on loan in the
next year. The exposure uncertainty is measured by EAD. The loss given default (LGD)
captures the recovery risk.
1.4 Mitigation of Credit Risk
As risk is inherent in every form of lending, the management of risk involves scientific
management of the risk aimed at mitigating adverse effects. The Credit Risk
management would encompass:
Measurement of risk- Rating will enable the bank to measure the regulatory
(Basel II/III) as well as economic capital charge.
Risk based pricing-The interest rates on loan or expected coupon on a debt
could be fixed based on past experience, by quantifying the risk through
estimation by expected and unexpected loan losses. The resultant price will be
risk free price and risk charge or premium.
Risk based lending- through credit rating/scoring differentiate credit worthy
borrowers from those who could be risky and take informed credit decision.
Control of Risks- by following effective operational guidelines of Loan Policy
and Credit Risk Management Policy delineated by the risk management/credit
department in the central office.
Portfolio diversification-by grouping the borrowers in terms of similar risk
characteristics (sectoral pool, rating pool, loan to value ratio pool etc.) for
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Through the Cycle (TTC) Rating vs. Pont in Time (PIT) Rating-Rating agencies are
very clear about the fact that issuer credit ratings or long-term issue ratings should not
correspond to a mere snapshot of the present situation, but should focus on the long
term. This is why the agency ratings are less volatile and less sensitive to expected
changes in the business cycle. Rating agencies are therefore associated with “through-
the-cycle ratings. However, a point in time rating fluctuates with economic conditions
and is hence reacts more actively with business cycles.
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Generally rating agencies look at the permanent (long term) components of the balance
sheet and that is why the process is through the cycle rating (TTC). Following is the list
of rating agencies in India:
(a) Credit Analysis and Research Limited (CARE)
(b) CRISIL Limited (CRISIL of Standard and Poor)
(c) FITCH India (FITCH) and
(d) ICRA Limited (ICRA of Moody’s)
(e) Brickwork Ratings India Pvt., Ltd (BRICKWORK)
(f) SMERA (Small & Medium Enterprise Rating Agency)
In the case of sovereign, state, financial institutions, corporate credit rating agencies
(CRAs) publish, every year, average historical rating transition matrix that gives the
banks as well as investors a view about the default risk of across various rating grades.
This has been discussed in the later section of this chapter. Further banks, under the
Basel II/III, that use Standardized approach solicit specific rating by one or more of to
estimate their credit risk weighted assets (CRWA) and their capital to risk weighted
asset ratio (CRAR). This has been explained in great detail in the subsequent Basel
chapter.
B. Internal Ratings:
Every bank will have its own internal assessment or rating systems. These assessments
and ratings are taken up in the case of loan facilities sought or availed by the borrowers.
This type of rating framework is two dimensional in nature which is also termed as two
tier rating system. The purpose is to separate the default risk of the borrower from the
recovery risk associated with each facility. Internal rating system can be expert
judgment based or statistical analysis based process. The most extensively used type of
internal rating process is that in which the ratings are assigned using considerable
judgmental elements based on experienced credit officers’ opinion. These are based on
5 Cs principle: namely Character (borrower reputation), Capital (leverage), Capacity
(earnings volatility), Collateral and Conditions namely (business cycle or
macroeconomic conditions). Competition in the given business or industry and
compliance (KYC, Pollution etc.) are two more C’s that have gained importance in recent
years. In such a system, the relative importance given to each of risk category is not
formally defined. These assessment or rating model may be developed internally or by
vendors (e.g. risk assessment RAM model developed by CRISIL). Banks generally follow
point in time (PIT) rating methodology where they give highest importance to past
performance and the latest financial information.
Historically, banks have relied on internal systems to assess credit quality. The word
risk was not explicitly used in bank appraisal. Yet the focus was on four broad risk
categories namely Industry Risk, Financial Risk, Business Risk and Management Risk
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which focused on the and borrower (or Probability of Default, PD). Industry risk is
assessed by checking competitive position of the firm in the industry, industry outlook,
regulatory/environmental risk in the sector, industry financials etc. Financial risk
capture profitability, liquidity, leverage and cash flow volatility position of firms. There
are many financial ratios like operating profit to sales, networking capital to assets,
liabilities to assets, equity volatility etc. which give view or information on such risks.
Similarly, business risk is measured by contribution margin ratio= (sales-variable
expenses) ÷ sales, standard deviation of operating income ÷ mean of operating income
and sales variability ratio=standard deviation of sales÷ sales mean. Company’s capacity
utilization, R&D initiatives, market share, distribution network, consistency in quality
and compliance with regulation are also good indicators of business risk in a firm.
Correspondingly, collateral coverage ratio (appraised or approximate value of
collateral/loan balance) is used to evaluate the collateral.
In a two tier rating framework, the collateral risk is assessed separately. The collateral
risk explicitly measures loss given default (LGD). The rater would assign a facility to one
of several LGD grades based on the likely recovery rates associated with various types
of collateral, guarantees or other factors of the facility structure. It mainly considers the
marketability and value of the collateral in determining the prospective recovery rate.
Statistical scoring models, in contrast, are based on quantitative assessment of the
borrower that typically include both quantitative (e.g. financial ratios) and some
qualitative but standardized factors (e.g. payment history, industry affiliation,
management experience etc.). It can be applied to commercial credits as well as retail
loans. Statistical predictive analytic techniques can be used to determine risk level
involved on credits. Examples of such models include Altman Z score, Moody’s KMV,
Moody’s Risk Calc model etc. Statistically developed rating models have a more
prominent role in SMEs and smaller sized retail loans (e.g. Personal loans, Credit cards,
Mortgage loans, Auto loans etc.).
The statistical models select a set of risk factors (both quantitative as well as
qualitative) that characterize good (safe) borrowers from bad (risky) ones. The weight
given to each variable is statically derived which is also based on discriminatory and
predictive power. The final score can be used to discriminate between good and bad
credits. The statistical based approaches generally adopt logistic regression models in
predicting potential default risk of a borrower. The regression method produce
mathematical functions that provide scoring formula for predicting default risk levels.
Decision tree or neural network techniques are also used in developing predictive
models. Credit scoring is basically a numeric formula to arrive at a summary number
that aggregates all the risks of default related to a particular borrower. Credit score
basically measures the level of risk of being defaulted on loans. A scoring technique
quantifies risk’s links with borrower characteristics. It makes risk evaluation explicit,
systematic and transparent.
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Altman1 had developed the bankruptcy predictor discriminant scoring model for
publicly traded manufacturing firms in the United States. The indicator Z score is an
overall measure of default risk of a borrower. The weighted importance of these ratios
are based on the past observed experience of 33 defaulting vs. 33 similar set of non-
defaulting companies over many years. Altman’s statistically derived discriminant
function (Z-score credit classification model) takes the form of:
Z=1.2X1+1.4X2+3.3X3+0.6X4+0.999X5 Equation 1.1
Where X1=working capital/total assets; X2=Retained earnings/total
assets; X3=Earnings before interest & taxes/total assets; X 4=Market
value of equity/book value of total liabilities; and X 5=Sales/total assets.
Working capital is current assets minus current liabilities.
The higher the value of Z score, lower is the chance that a corporate will default. If
Z>2.99, borrower is considered safe. A borrower with Z score below 1.81 is classified as
risky. Hence, a bank should not sanction a loan to this borrower until it improves its
earnings. Note that the third variable, EBIT to total assets ratio has the highest
importance in the above Z score model.
Internal rating system often serves as a tool for credit policy in a bank. For example, a
bank may fix some minimum rating, such as investment grade or passing grade or BBB
or above, might be required for sanctioning a loan. Regardless of whether a rating
system relies on expert judgment or statistical models, one can think of a risk bucket as
a collection of obligors with similar Probability of Defaults (PDs). Normally, borrowers
are bucketed into seven or more grades (from safest risk category AAA to highest risk
category CCC). Internal ratings can be used for credit approval, loan loss reserving
(expected credit loss calculation), capital allocation (unexpected loss calculation), loan
pricing, limit setting, customer and business unit profitability analysis and portfolio
management. If rating is done and updated regularly, a credit officer will be able to
monitor the borrower and compare its risk vis-à-vis the industry trend. For this, banks
will have to keep the rating as well as default history. It is important to ensure that the
credit rating system not only a robust indicator of default probability but also that the
credit rating scales are granular enough for accurate measurement and pricing. It is
important to achieve a finer scale as the risk curve is typically very steep.
Internal rating is also basis of calculating the risk weighted assets (RWAs) under the
Basel Internal Rating Based (IRB) Approach. Whilst currently the Indian banks are
following the Standardized Approach (SA) as prescribed by the Reserve Bank of Indian
under the New Capital Adequacy Framework (NCAF), a bank can opt for IRB subject to
supervisory approval of the bank’s internal credit rating systems. This has been
explained in the later chapter.
1.6a. Credit Risk Driver 1: Default Risk
This is the most important driver of credit risk and is adequately measured by the
probability of default (PD). A bank can define default as missing a payment obligation,
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entering a legal procedure, a distressed exchange, or if the obligor is past due more than
90 days on any credit obligation or if the obligor has filed for bankruptcy or similar
protection from creditors. Credit rating agencies typically consider that default has
occurred when a contractual payment has been missed for at least three months.
Default does not necessarily imply losses, but may increase the chance of bankruptcy. In
accurately estimating the default risk, banks need a robust definition of default. The
market definition of default is related financial instruments (such as bonds). It
corresponds to principal or interest past due. The Basel definition considers a default
event has occurred if the loan is past due 90 days or if it has been provisioned. The legal
definition of default is linked with the bankruptcy of the firm. It may depend on the
legislation in various countries.
The probability of default (PD) is dependent on various firm specific factors like
company size, financials, and quality of management, competitive factors as well
systematic (or macroeconomic) factors. The probability of default (PD) of a borrower
can be measured by studying historical credit ratings migration towards defaults. There
is a statistically significant correlation between ratings and default probabilities. Table 1
illustrates this linkage based on Moody’s recent ratings.
Table 1 represents the one year historical average rating transition matrix for global
corporates. It is reporting the probabilities of migrating from a given rating to another
rating over one year. Moody’s 1 year transition matrix is shown in Table 1. It has eight
grades and in that the first rating category is Aaa while the eighth grade is Ca-C. Default
denotes defaulted cases and WR denotes the withdrawn ratings. The one year average
transition matrix has been constructed from the historical one year migration history of
bonds over many years (from 1970 to 2015). The first row tabulates first the
probability of remaining in Aaa, then of migrating from the Aaa rating to thee Aa, etc.
The second row reports the migration probabilities from the Aa class to all ratings
including default and so on. Similarly, the second column represents downgradation
probability from Aaa to Aa and from Aa to A and so on. Note that for each row, the
column sum should be equal to 100 percent.
Table 1: Moody’s Global Average One-Year Rating Migration Rates, 1970-2015
From/To Aaa Aa A Baa Ba B Caa Ca-C WR Default
Aaa 87.480 8.135 0.590 0.058 0.024 0.003 0.000 0.000 3.709 0.000
Aa 0.833 85.151 8.448 0.438 0.064 0.036 0.017 0.001 4.991 0.021
A 0.056 2.572 86.601 5.366 0.510 0.113 0.043 0.005 4.679 0.056
Baa 0.036 0.159 4.296 85.442 3.744 0.694 0.163 0.021 5.261 0.183
Ba 0.006 0.044 0.466 6.174 76.172 7.173 0.679 0.124 8.246 0.916
B 0.008 0.032 0.149 0.449 4.784 73.515 6.486 0.562 10.604 3.412
Caa 0.000 0.009 0.027 0.108 0.416 7.021 66.772 2.806 14.321 8.521
Ca-C 0.000 0.000 0.056 0.000 0.623 2.461 9.468 39.589 23.714 24.089
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The loss given default (LGD) is the proportion of exposure the bank might lose in case
the borrower defaults. The LGD ratio is defined as: 1-Recovery Rate (RR). It varies from
0% to 100%. The recovery rate (RR) is defined as the ratio of all value recovered in
terms of cash or securities net of the costs to the nominal value of unpaid principal and
interest. This recovery rate is again discounted using the original interest rate on the
facility to take into account the time value of money. The recovery rates is dependent
upon various factors such as a) purpose of the facility, b) product type, c) realizable
value of the collateral, d) seniority of the collateral charge ( 1 st charge or 2nd charge), e)
type of collateral (pledge, hypothecation, mortgage etc.), f) presence of guarantee, g)
industry factors and h) macroeconomic factors.
Under the Advanced IRB Approach (AIRB), all internally estimated inputs PD, EAD and
LGD are used for calculation of risk weighted assets subject to regulatory satisfaction.
Banks will have to keep LGD and EAD data across various facilities for at least 7 years.
Under IND AS (IFRS) 9, banks will have to estimate discounted LGDs for estimation of
expected credit loss (ECL) provisioning.
1.7. Credit Risk Management Framework
Credit risk management consists of a host of management techniques that help a bank
to mitigate the adverse impacts of credit risk. Credit risk management framework
should enable the top management of banks to know which, when and how much credit
risk to accept to strengthen bottom line. It constitutes of following aspects:
Identify the Risks: Data capturing and identify the key risk drivers (financial
risk, business risk etc.) through various rating models
Measure the Risks: Size (exposure effect), Timing (frequency-say quarterly or
yearly analysis), Probability of occurrence of such incidents (e.g. probability of
default) and estimation of expected and unexpected risks. For this, bank should
have proper systems and tools in place.
Manage / Control the Risks: Based on these measures, various reports
(regulatory as well as internal) can be generated that will help the management
in avoiding, mitigating, off-setting, diversifying the credit risks in various
portfolio segments
Monitor the Risks: Identify significant changes in risk profile or controls
The key tasks for the credit risk department are:
Segmentation of the credit portfolio (in terms of risk but not size)
Rating model requirements for risk assessments (corporate rating vs. retail
scoring)
Collect and store necessary data for measuring risks (financial as well as non-
financial information)
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Another aspect of credit risk management involves credit enhancement, which seeks to
reduce the amount of loss in the event of default through increasing the chance of
recovery rate. Covenants are designed to aid the active monitoring of risks and thus
trigger preventive actions when a borrower’s credit quality worsens. Covenants actually
create the incentive for the borrower to comply with specified conditions such as
containing the debt-to-equity ratio to a certain level or maintain certain level of
collateral.
Some internationally best practiced banks follow risk adjusted return approach to that
better suits with the bank’s risk appetite to manage the portfolio credit risk. Here, the
credit risk manager’s objective is to improve the bank’s returns on a risk adjusted basis.
In this context, risk adjusted return on economic capital (RAROC) metric is applied to
facilitate better decision. It allows the institution to compare the return with the size of
risk and its capital costs to take a better strategic decisions pertaining to pricing, credit
decision, capital allocation. This will be covered at a later stage in detail.
References
1. Altman, E. I. (1985), “Managing the Commercial Lending Process” in Handbook of
Banking Strategy, Eds. R C Aspinwall & R A Eisenbeis. NY: John Wiley & Sons, pp.
473-510.
2. BCBS (2006), “International Convergence of Capital Measurement and Capital
Standards: A Revised Framework”, Publication no. 128, Basel Committee on Banking
Supervision, Bank for International Settlements, Basel, June.
3. Saunders, A., and Cornett, M. M. (2013), “Financial Institutions Management-A Risk
Management Approach”, McGraw-Hill (Indian Edition-7e), Chapters: 11 & 12.
4. Bandyopadhyay, A. (2016), “Managing Portfolio Credit Risk in Banks”, Cambridge
University Press.
5. RBI (2007), “Guidelines for Implementation of the New Capital Adequacy
Framework”, April.
6. RBI (2015), “Master Circular-Prudential Guidelines on Capital Adequacy and Market
Discipline-New Capital Adequacy Framework (NCAF), 1 July.
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