Case Study Fuletron

IMB 587
FULLERTON: RISK ANALYTICS AND BUSINESS

STRATEGY
V RAVI ANSHUMAN AND SABY MITRA
V Ravi Anshuman, Professor of Finance & Accounting, and Saby Mitra, Senior Associate Dean and Professor, Scheller College
of Business, Georgia Tech, prepared this case for class discussion. This case is not intended to serve as an endorsement, source of
primary data, or to show effective or inefficient handling of decision or business processes.
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Fullerton: Risk Analytics and Business Strategy
In early April 2013, Shantanu Mitra, Chief Executive Officer of Fullerton India Credit Company Limited
(FICCL, or Fullerton), a non-banking Financial Company (NBFC) in India and a wholly owned
subsidiary of Singapore-based investment company Temasek, had just concluded a meeting with his
Chief Risk Officer, Anindo Mukherjee, Chief Financial Officer & Chief Operations Officer, Anand
Natarajan and Chief Analytics Officer, Bikramjit Ganguly. Fullerton provided loans to consumers and
small enterprises in urban and rural India. Typical loan size was small by developed country standards ($
750 for consumer loans and $ 1,500 for commercial loans) and many of its borrowers did not have their
credit history reported by the local credit bureaus. Owing to the nature of Fullerton’s customers, there was
significant risk in its lending business. However, Temasek had reason to be optimistic about the future of
Fullerton, given the credit issuance standards put in place in recent years, and the turnaround of the
company since the financial crisis in 2009.
Weak credit issuance standards had exposed the company to significant risk especially during the
financial downturn and had compelled its parent Temasek to inject new capital into the company to keep
it afloat. Credit policy and corporate governance changes, along with significant cost reduction initiatives
during the last few years, brought about a turnaround for the company. However, the highly competitive
nature of the Indian consumer and commercial loan markets required Fullerton to identify under-served
segments with acceptable risk-return characteristics, and also price its products appropriately to obtain the
risk-adjusted returns expected by Temasek. Mitra believed that using data and analytics would be critical
for his strategy in the future. His discussions with Mukherjee, Natarajan and Ganguly had focused on how
data analytics could form the basis of a strong credit issuance and loan pricing policy. Fullerton had
recently hired a team of highly trained data scientists to work with Ganguly.
Although the idea was intriguing, Mitra knew that there were many obstacles to the implementation of a
data analytics driven credit issuance and pricing policy. The loan data available to Fullerton and the
methods to analyze the data were not new, and while obtaining actionable insights from the data was not
trivial, it was clear to the team that translating these insights into actions on the ground would require
very difficult organizational, governance and incentive changes. Could Fullerton use data and analytics to
identify profitable segments and set interest rates that accurately accounted for the probability of default,
especially in high risk segments? Could data and analytics be used to create a loan portfolio that offered
acceptable returns during normal times as well as during recessions? Would the company be able to make
changes to its operations and decision making to take advantage of the insights from data and analytics?
Would important stakeholders such as its investors, board of directors, and regulators approve the actions
taken based on data and analytics?
THE INDIAN BANKING SECTOR
The Indian banking system has been regulated by the Reserve Bank of India (RBI). Public sector banks
(controlled by the Government of India) have historically dominated the retail lending sector. However, in
recent years, there has been a substantial increase in the presence of private sector banks and foreign
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banks in the Indian retail and commercial lending sectors. Companies such as Fullerton were classified as
non-banking financial companies (NBFCs).1 These companies, which are registered under the Indian
Companies Act of 1954, are regulated by the Reserve Bank of India. Although NBFCs do not hold a
banking license, they are typically involved in providing loans and advances, asset financing, insurance,
and the trading of financial instruments, thereby serving as alternatives to the regular public and private
sector banks. They increase competition and the availability of loans, spread risks during times of
financial distress, and complement the banking system to meet consumer and commercial credit needs.
Although NBFCs perform functions similar to that of banks,2 a key difference is that they cannot accept
demand deposits and are mostly dependent on funding from investors and financial institutions.3 Unlike
banks, NBFCs are less regulated and can be 100% foreign owned. Another important difference is that
NBFCs have to maintain a minimum capital adequacy ratio (CAR)4 of 15%, as compared to regular
banks, which require an 8% capital adequacy ratio.
COMPANY BACKGROUND AND HISTORY
Fullerton (FICCL) was a private limited company registered in India as a non-banking financial company
(NBFC) that did not accept deposits from consumers and provided consumer and commercial loans from
shareholder funds and borrowings from financial institutions.
After the launch of commercial operations in January 2007, Fullerton experienced an explosive growth in
loans, branches, and customers. In 2009, the company had over 800 branches in 450+ locations, over
650,000 customers, approximately $ 640 million in loans, and over 16,000 employees. The average loan
size was $ 750 for consumer loans and $ 1587 for commercial loans, and the average monthly payment
was $ 30 for consumer loans and $ 62 for commercial loans. Fullerton underwrote $ 43 million of new
loans every month and opened 28,000 new loan accounts every month in 2009. Over 95% of its
customers did not have any credit history reported by the local credit bureaus in 2009. Fullerton’s focus in
2009 was on lower income segments earning INR5 5,000–8,000 per month (i.e., $104–167 per month,
approximately) that did not have access to credit from banks and would have otherwise obtained credit
from moneylenders. In 2009, Fullerton’s product portfolio consisted of unsecured personal loans,
1
In March 2013, there were 12,355 NBFCs operating in the Indian markets, holding about INR 11 trillion in assets. In terms of market share,
NBFCs held 15%, as compared to public banks (61%), private banks (18%), and foreign banks (6%). The gross nonperforming assets (NPA) for
NBFCs was 2.2%, while that of public banks, private banks, and foreign banks was 4.1%, 2.0%, and 2.9%, respectively.
2
NBFCs are incorporated under the Companies Act, 1956. NBFCs can be classified into two broad categories, viz., (i) NBFCs accepting public
deposit (NBFCs-D) and (ii) NBFCs not accepting/holding public deposit (NBFCs-ND). Residuary non-banking companies (RNBCs) are another
category of NBFCs whose principal business is acceptance of deposits and investing in approved securities.
3
An NBFC must be registered with the Reserve Bank of India (RBI) and have authorization to accept deposits from the public. NBFCs can accept
deposits with maturity greater than 12 months. With deposit insurance, they can accept deposits (within regulated limits) for periods less than 12
months and periods more than 60 months. In general, NBFCs which accept deposits must have minimum investment grade credit ratings granted
by an approved credit rating agency. Although deposits in banks are insured by the Deposit Insurance and Credit Guarantee Corporation, deposit
insurance is not available to the depositors of NBFCs.
4
CAR is Tier I + Tier II capital as a percentage of risk weighted assets. Tier I capital for Fullerton includes shareholder funds. Risk weighted
assets are consumer and commercial loans that Fullerton provides adjusted for risk. Detailed CAR calculation guidelines are provided by central
banks.
5
INR is Indian Rupees. The exchange rate was around INR 48 to the USD ($) in 2009 and declined to INR 67 to the USD ($) by 2015.
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mortgage loans, loans to small and medium-sized enterprises (SME), and two-wheeler and commercial
vehicle loans.
In 2009, the impact of the financial crisis exposed the flaws in Fullerton loan underwriting standards.
After being on the company’s books for 10 months, loan delinquency rates (percentage of loans that are
30 days past due) were expected to stabilize between 10% and 15%. The high interest rate charged on
loans reflected the high rate of expected default and provided a substantial profit margin for Fullerton.
However, during the 2009 financial crisis, loan default rate for loans that had been 20 months-on-book
rose to approximately 35% and failed to stabilize.
Meanwhile, Fullerton had also started a rural lending program (microfinance) in 2008 with period end
receivables (net loans outstanding) reaching $ 34 million in 2009. Its rural business consisted of loans to
self-help groups, as well as secured two-wheeler and commercial vehicle loans. Although the default rate
(percentage of loans 30 days past due) for the rural portfolio was low and largely unaffected by the
financial crisis (2% in 2009), an act implemented by the government of Andhra Pradesh (one of the five
Indian states where Fullerton provided rural loans) in 2010 that restricted collection activities by financial
institutions resulted in a significantly increased default rate of 15% in 2010, as most borrowers realized
that Fullerton did not have the ability to effectively collect on debt.
Owing to large credit write-offs in its urban and rural businesses, Fullerton made losses of INR 2450
million ($49 million) in 2008 and INR 7170 million ($143 million) in 2010, while breaking even in 2009
(Exhibit 1). These losses required periodic capital infusion from Temasek to keep the company afloat ($
120 million in 2008 and $ 50 million in 2009, in addition to the original capital investments of $ 100
million in 2005 and $ 100 million in 2007). By 2009, Temasek had invested a total of $ 370 million in
Fullerton. In 2010, that investment was worth approximately $180 million owing to bad loans and losses.
In addition to shareholder capital, Fullerton also relied on loans from financial institutions to fund its
lending business. Its capital adequacy ratio (CAR) was 75% in March 2007 since it relied mainly on
shareholder capital to fund its operations at that time. With more loans from financial institutions over
time and write-offs in shareholder funds during the financial crisis, CAR decreased to 18% in December
2011 (Exhibit 2), still above its mandatory 15% level. Although greater leverage magnifies returns to
shareholders, it also increases solvency and liquidity risk during market downturns. Credit losses affected
the ability of Fullerton to borrow funds from financial institutions owing to the increased perceived risk in
its business model. With its business model in jeopardy, few financial institutions were willing to lend
any new funds to Fullerton. It was also unlikely that Temasek would invest new capital in the business. In
summary, Fullerton was struggling for survival after the financial downturn.
STRATEGIC SHIFT
In 2010, Mitra took over as CEO of Fullerton. He had over 30 years of consumer banking experience with
several international banks in India and Asia Pacific. Prior to Fullerton, he had held senior positions in
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credit and risk management at Citigroup and Standard Chartered Bank. His background in risk
management provided the expertise that Fullerton needed to make a shift in its lending operations.
Owing to the large losses during the financial downturn, Fullerton made several significant changes
during 2010-2012. The company reduced the number of branches from 850 to 340, reduced headcount
from 16,000 to 5,700, and reduced its presence from 450 towns in India to 250. In addition to cost-cutting
initiatives, Fullerton began targeting the under-served niche segments in its rural and urban businesses
between the segments served by the large private banks and the micro finance institutions. In particular, it
focused its urban businesses on the segment just below those covered by private and foreign banks
(Exhibit 3). Key competitors to Fullerton in this niche segment were public sector banks.
As a result of this change, Fullerton began focusing on relatively higher income earners (INR 400K–
1000K or $6,000–15,000 per annum) and the average loan size increased from INR 50,000 ($1,042) in
2009 to INR 180,000 ($3,529) in 2012. In the urban areas, it identified “aspirers” who were educated,
owned mid-sized businesses or held stable jobs, and had lifestyle aspirations. Its products were tailored to
customer needs across life stages – both personal and business.
The urban segment was catered through a branch network with a focus on smaller cities. The urban
business was further classified as retail and commercial (small and medium enterprises). The products
offered by its urban retail business were unsecured consumer loans (personal loans) and secured loans
(loans against property). Urban commercial loans included commercial vehicle finance, unsecured
business loans (for working capital requirements), and loans against property.
Fullerton’s rural business began to focus on households with annual income between INR 180K and INR
400K ($2,700–$6,000 per annum), which is relatively high for rural areas in India. Fullerton’s rural
products included personal and group loans, mortgages, and vehicle loans.
These changes led to significantly improved financial performance for the company. Following heavy
losses in 2010, after tax, quarterly profit increased to INR 6,578 million in 2011-2012, and to INR 7,587
million in 2012-2013. Exhibits 4 and 5 present the financials of Fullerton. Although the turnaround in
Fullerton was dramatic, the projected profits (as of mid-year) of approximately $ 21 million in 2012-2013
suggested a ballpark valuation of $210 million (using a P/E of 10 that is typical for banks).6 With an
investment of $370 million, Temasek expected a significantly higher valuation to ensure a reasonable
return on its investment.
6
Global growth turned weaker in 2012-2013. Compared to the previous year, downside risks appear reduced in Eurozone and the United States
but the risk of Chinese slowdown continued to weigh heavily on global recovery. The Indian economy remained sluggish with policy
uncertainties, governance concerns, and slacking external demand impacting the growth story adversely. GDP fell to a decade low of 5% owing
to a severe slowdown in the services sector and reduced government expenditure as part of a fiscal consolidation program. For the banking
industry, the net non-performing assets rose over the year from 1.24% to 1.73% while overall credit growth fell from 19% to 12%. On the
positive side, inflation was brought under control with the wholesale price index (WPI) falling below 6%. Domestic equity markets remained
resilient and registered 22% gains on strong FII inflows. The Reserve Bank of India infused INR 2.8 trillion of liquidity through bond purchases
and capital reserve requirement (CRR) reductions. The falling global commodity prices brought a temporary respite to the current account deficit.
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DATA ANALYTICS CENTERED DECISION MAKING
Fullerton’s niche focus on under-served market segments created opportunities for high profit margins
during normal business cycles, but also increased risk during economic downturns. Alert to this reality,
Mitra started an initiative to address unanticipated shifts in the economic environment. He believed that
the time was right to introduce a more scientific approach to lending in under-served market segments,
similar to the approach used by large foreign banks in more traditional segments. He believed that data
analytics could enable better targeting of customers, superior pricing of products, and more precise trade-
offs between risk and reward, so that Fullerton could earn good profits while taking reasonable risks. The
public sector banks that served similar market segments did not use data analytics in any significant way.
Mitra strongly believed that data analytics could increase business predictability for Fullerton, reduce loan
losses by allowing it to focus on the right segments of the market, and create a portfolio that quantified
and balanced risk and reward. Most importantly, Mitra believed that analytics would prove to be a
strategic asset, differentiating Fullerton from its competitors. In 2012, Mitra set up the risk analytics team
headed by Bikramjit Ganguly, who would report directly to the Chief Risk Officer, Anindo Mukherjee
(replaced by Rajesh Krishnamoorthy in late 2013 when Mukherjee moved to a different assignment). As
depicted in Exhibit 6, Mitra, Mukherjee as well as Krishnamoorthy wanted risk analytics to be an integral
part of: (i) market entry assessments, (ii) initial customer acquisition decisions, (iii) credit risk
management, (iv) distribution and channel management, and (v) employee and portfolio performance
analysis.
RISK ANALYTICS FRAMEWORK
A key motivation for adopting a data analytics approach was to ensure congruence between the risk
appetite of the firm and the risk exposure created by its credit granting decisions, and to make optimal use
of capital while meeting regulatory requirements. To properly assess risk exposure, financial firms have
to assess the inherent risk-return tradeoffs in normal economic times, and also measure the extent of
losses it may incur in a recession scenario. Although the former can be accounted for in the pricing of
loans, collateral requirements, and standard provisioning for bad loans, Fullerton needed to set aside
capital to account for risk during stress periods, in accordance with the Bank of International Settlements’
Basel norms.
Exhibit 7 describes the risk appetite framework at Fullerton. The Board of Directors approves the risk
appetite statement (RAS) that defines the metrics to assess performance at Fullerton (for e.g., risk
adjusted return, loss volatility, operational risk, solvency, liquidity, and reputation). The CEO is entrusted
with designing the firm’s strategy and business plan to meet the overall goals established by the Board of
Directors.
Two important outcomes of business planning are the capital implications and the risk-return
implications. The capital implications are measured by economic capital (EC) and risk adjusted return on
economic capital (RARoEC). The risk-return implications are measured by risk adjusted returns (RAR)
during normal economic times, and recession loss multiplier (RLM), which captures the vulnerability of
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the bank during stress periods. The latter is critical for financial firms because credit risk causes
significant adverse impact on a financial firm’s profits during stress periods. The capital and risk
implications are reconciled with the RAS, and the strategy and business plans are revised accordingly.
Exhibit 8 provides details of the risk assessment parameters at Fullerton, based on industry practices
prescribed by Basel II norms. Three key loss parameters capture the risk faced by Fullerton during normal
economic times. The probability of default (PD) measures the likelihood that an account becomes 90 days
past due during the next 12 months. The exposure at the time of default (EAD) is the outstanding balance
on the account at the time of expected default. The loss given default (LGD) is the percentage of the
outstanding balance that is expected to be lost (after incorporating the amount recovered and collection
costs) if there is default. Thus, the expected loss (EL) for an account is simply PD × LGD × EAD, and the
expected loss for the portfolio is aggregated from individual accounts.
Fullerton used various regression models to estimate PD, LGD, and EAD using historical loan and default
data that the company had stored internally or that it could obtain from the credit bureaus. For example, a
logistic regression was used to estimate the probability of default with predictor variables (such as annual
income, loan amount, and customer demographic variables) that the analytics team believed should
impact the likelihood of default and that were available in the historical data. Coefficient estimates for
these variables were obtained through regression analysis on historical data, and the coefficient estimates
were then used to forecast the PD, LGD, EAD, and EL for existing accounts.
These account-level values were aggregated to obtain the expected loss (EL) for the Fullerton portfolio.
The expected operating profit for the Fullerton portfolio was estimated by subtracting total expenses
(operating expenses plus cost of capital) from the pro-forma loan revenue (interest and fee income), while
the risk adjusted return (RAR %) of the portfolio is calculated by subtracting the expected loss (EL) from
the operating profits (expressed as a percentage of loan amount). Thus, risk adjusted return (RAR %) is a
metric of overall profitability of a business or segment after accounting for expected losses during normal
periods.
Although the above analysis is focused on normal economic times, Basel II norms also specify how stress
periods should be taken into account. At Fullerton, recession risk was captured in a measure termed as the
recession loss multiplier (RLM), which expresses stress period losses (or recession losses) as a multiple
of normal operating profits.7 RLM provides insights on the number of years of normal operating profit
that is wiped out by losses in a (rare) recession year. The recession loss is calculated by estimating the
recession probability of default (RPD) and the recession loss given default (RLGD) for each account in a
recession year, and then aggregating to the portfolio level. For the urban portfolio, the analytics team at
Fullerton used historical data from 2009 (recession year) and Basel prescribed methodologies to estimate
RPD and RLGD. For the rural portfolio, the team modeled customer behavior using historical data from
the Andhra Pradesh crisis in 2010 (described earlier) to estimate RPD and RLGD. To obtain a balance
7
In addition, loss absorption ability (LAA) is the loss coverage ratio (similar to RLM) that expresses normal operating profit as a percentage of
expected loss in a normal year.
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between profits in normal economic times and risk during stress periods, Fullerton wanted to maximize
profits (RAR) while keeping its vulnerability to stress periods (RLM) as low as possible.
CENTRALIZED CREDIT UNDERWRITING
One of the important decisions made by the company was to reorganize the credit underwriting process
from a decentralized approach (branch-based) to a centralized model that relied on validated internal and
credit bureau data. Credit approval and credit administration work were now managed by an independent
team to ensure demarcation of responsibilities for loan origination and credit approval functions.
Approval authority was governed through a carefully designed and periodically reviewed credit approval
authority matrix which required higher loan amounts and higher risk customers to be approved by more
senior approvers in the company.
The credit function was made an independent hierarchy reporting to the CEO (through the CRO) instead
of being part of the branch or regional hierarchy, so that credit decisions were made without considering
revenue targets. This separation of risk staff (who approved and administered credit) from the sales staff
(who originated credit) not only ensured independence of the risk management decisions, but also ensured
that the sales staffs’ incentives were more aligned with the bank’s overall objectives. In addition, by
relying on data and analytics, Fullerton would be shielded from judgement biases (of sales staff) that
affected the credit appraisal process.
Furthermore, by 2012, 75-80% of its customers had credit history reported by the local credit bureaus,
providing more data to the analytics team to refine its models. The availability of credit bureau data
facilitated a much more meaningful implementation of the risk analytics framework.
APPLICATION SCORECARD AND BEHAVIOR SCORECARD
The risk analytics team developed an automated application scorecard to evaluate new customers
(referred to as “risk grading” in the company). Using historical data, the team created a logistic regression
model based on customer information available from the application form and the credit bureaus.8
Depending on the applicant’s score (as determined by their models), the application was either directly
approved (green category) or rejected by the automated system (red category), with only a small sample
left for further manual analysis (amber category). The time taken to categorize applicants was only as
long as it took to feed in the personal data provided by the applicant.
The automated tool significantly reduced the average time required to reject or approve a loan application.
Furthermore, field agents used their experience with the software application system to focus on the
appropriate customer segments that were more likely to be approved. Ironically, they felt more
8
The comprehensive credit appraisal process involved individual customer salary verification, job stability and continuity verification, bank
balance and cash flow verification, loan repayment history, credit bureau score, income tax information, financial document verification,
residence and office verification, reference and contact detail checks, personal discussions, verification of contact information, and telephone
verification.
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empowered because the approval system was more predictable than the previous system, which was
subject to judgement biases of their managers. As a result, the loan approval rate also increased after the
introduction of the automated process.
For existing customers, the analytics team developed a behavioral scorecard to assess their risk of default.
The variables used in the logistic regression model included customer behavioral attributes on existing
loans with Fullerton as well as the customer’s performance on other loans with other banks (accessed
through the credit bureaus). This dynamic exercise (referred to as “scrubbing”) was helpful in estimating
an existing customer’s propensity to default such that preemptive actions could be triggered to mitigate
losses.
RISK-BASED PRICING
Mitra believed that the power of predictive analytics placed Fullerton in a superior position in identifying
good credit while avoiding bad credit. He also believed that analytics could be used in risk-based pricing,
that is, the interest rate on loans could be set according to analytics-based risk measures rather than
potentially biased subjective criteria. In addition, risk analytics would also allow Fullerton to price loans
differentially across market segments. For instance, loans sourced from lower income groups and from
smaller towns (Tier 4 cities in India) offered greater potential for margin because these loans were
precisely the ones that its competitors avoided for fear of adverse selection. Fullerton could use predictive
analytics to identify customers in such high margin segments with acceptable risk-return characteristics.
Fullerton began using a risk-based pricing approach that factored both the risk and the degree of
competition it faced in the market segment.
RISK MANAGEMENT IN OTHER AREAS
Fullerton also strengthened the overall risk management infrastructure in the company.9 Collections were
partially centralized with a mix of tele-collectors and field collectors, partially outsourced to third party
collection agencies, and segmented by product type for greater efficiency and effectiveness. Fraud
detection was also strengthened through neural network algorithms and comprehensive self-assessment
checklists for branches.
In addition to the above measures, Fullerton adopted conservative bad loan provisioning norms10 and
initiated write-off procedures that recognized losses early to ensure alignment of risk exposure with risk
9
Briefly, analytics is embedded in several places in Fullerton: customer retention/acquisition, collections, recovery, credit assessment, credit
information report, scrubbing, cross-selling (using propensity models on existing customers), etc.
10
To set aside loss reserves against accounts at different delinquency stages of the asset portfolio, the Reserve Bank of India (RBI) has specified
the logic for asset classification in terms of risk profile along with the provisioning norms for the different categories. Fullerton has asset
classification and provisioning policy which is stricter than that specified by the RBI. An asset is categorized as standard asset if there is no
default in principal and interest and does not disclose any problem nor carry more than normal risk. A provision of 0.4% of asset balance in urban
and 1% of asset balance in rural is kept in books. An asset is classified as a non-performing asset if interest overdue is greater than 90 days. On
classification of an asset as a NPA, no further income is accrued on an account and accrued income is reversed once it reaches 90 days past due
(dpd). Income accrual will restart only if the account comes back to current status.
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appetite. Fullerton’s provisioning policy for both secured and unsecured loans is more stringent than that
specified by the Reserve Bank of India for non-banking financial institutions. For example, for unsecured
products, Reserve Bank norms specify writing off a loan at 720 days past due, whereas Fullerton writes
off a loan at 120 days past due. For secured products, Reserve Bank norms specify 50% write-offs at
1,800 days past due, whereas Fullerton implements a 100% write-off policy at 720 days past due.
BUILDING AN ANALYTICS-DRIVEN ORGANIZATION
By early 2013, Fullerton had an experienced team and robust data analytic frameworks in place.
According to Mitra:
The expertise of the Fullerton data analytics team and their ability to model complex
tradeoffs in risk and return were unparalleled in the Indian banking sector. Very few other
banks had the ability to leverage data like Fullerton.
His focus was on how Fullerton could leverage these capabilities to build a data-driven organization
where strategy and decisions were guided by data and analytics. He identified the following areas of focus
for the analytics team.
BALANCING THE LOAN PORTFOLIO
Early in his tenure as CEO, Mitra had recognized that the Fullerton loan portfolio was skewed
unfavorably towards unsecured loans that inflated profits during normal periods but also led to larger
write-offs during stress periods. He initiated a process to change the mix towards secured loans and the
loan mix (portfolio shape) was gradually changed from an 80% unsecured or 20% secured composition in
2009 to a 69% unsecured or 31% secured composition in 2012. Although, the strategy made intuitive
sense, he was unable to precisely articulate the tradeoffs involved in such decisions to his board and
investors.
With the analytics team in place, one of the first tasks Mitra assigned to the team was to analyze and
quantify the effect of this strategic change. The team applied the risk models it had developed to estimate
the loss distribution for various values of the portfolio shape (mix of secured vs. unsecured loans in the
Fullerton loan portfolio). This information is captured in Exhibit 9 in terms of the credit risk parameters:
expected loss (EL), recession loss multiplier (RLM), loss absorption ability (LAA), risk adjusted return
(RAR), and economic capital (EC)11 estimated for four scenarios under consideration. Each scenario
11
The Basel II Advanced Internal ratings-Based (AIRB) framework establishes the minimum regulatory capital requirements for large banks.
Basel II recommends the Vasicek methodology to calculate capital requirement which involves estimating the loss distribution for a rare loss
event (probability of occurrence < 0.01%). It uses an asymptotic version of Vasicek’s portfolio credit loss model to get an estimate of the
distribution of loan losses for a given credit-rating category (Vasicek, O., Probability of Loss on Loan Portfolio, KMV Corporation, 1987).
Broadly speaking, the Vasicek methodology estimates the stress PD as a weighted average of the normal PD and the systemic/economic stress
factor. The weightage is based on “asset correlation” or correlation of defaults within an asset class and is defined by each asset class in Basel
notes.
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represents a potential evolution of the portfolio shape (mix of secured vs. unsecured loans) over time.
This data was used to determine a portfolio shape that would maximize profits while being consistent
with the board’s risk appetite. The board wanted an RLM of around 1.0 and was uncomfortable with
stress period credit risk above this level.
PRODUCT AND GEOGRAPHICAL MIX IN THE UNSECURED RETAIL SEGMENT
The analytics team also recognized that the advantage of predictive analytics would be much more
significant in analyzing urban unsecured retail loans as opposed to unsecured rural loans, because more
reliable internal and credit bureau data were available for urban customers. Data analytics would also
provide fewer insights on commercial loans because most of these loans were secured, and even when
unsecured, these loans were based on relationships. Further, the urban unsecured retail loan portfolio with
a large number of transactions offered the scale needed for performing risk analytics. In addition, shunned
by the traditional banking firms, this high-risk segment required a more scientific approach to pricing
credit risk. Also, the real value of analytics would come to the fore when evaluating unsecured loans
where information asymmetry is significant and there is no recourse to collateral. With risk analytics in
place, information asymmetry could be viewed as an opportunity for Fullerton to differentiate and
maintain a sustainable competitive advantage.12
The unsecured urban lending portfolio mainly consists of two types of personal loans: personal loans to
salaried customers and personal loans to self-employed customers. Exhibits 10 and 11 provide details of
the loan characteristics and historical delinquency rates of these loans, respectively. Both exhibits classify
the urban retail market segment into two product categories: personal loans to salaried customers (PL Sal)
and personal loans to self-employed customers (PL Self), who operate small businesses. These loans were
disbursed in Metro cities and Tier 1-4 (smaller cities and towns) areas, and were usually of low
denomination with a maturity that could extend up to 4 years. Personal loans to salaried customers were
on average half the size of personal loans to self-employed customers.
Exhibit 12 shows the details of personal loans for March 2013 and estimates for October 2013. Exhibit
12 also shows the risk analytics based estimates of the associated RAR and RLM. Mitra wanted the risk
analytics team to analyze this data to identify profitable segments of the market after accounting for risk
exposure.
DESIGNING INCENTIVES AND MANAGING THE IMPLEMENTATION
The incentive schemes at Fullerton for field agents encouraged volume, that is, field agents who sourced
unsecured loans were more concerned about closing deals than about the net margin that accrued to
Fullerton. On the other hand, incentives for the regional heads encouraged margin and the average interest
12
In March 2013, the loan portfolio of INR 48,234 million consisted of the following market segments: INR 37,141 million of urban retail loans,
INR 5,783 million of commercial loans, and INR 5,310 million of rural loans.
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rate on personal loans mattered to them. This created a dichotomy in incentives: field agents preferred
larger loan amounts, whereas the regional heads preferred loans with higher margins.
Thus, while risk analytics could provide insights to identify profitable segments and quantify the effect of
business actions, incentive alignment is also a key concern. Changing behavior of agents who sourced
loans would be critical for the success of the risk analytics driven strategy. Mitra believed that the
analytics team had deep insights on the changes that were needed and the precise tradeoffs involved.
Further, he believed that data could also provide insights on the root causes of the problems and the
design of incentive structures to address the root causes. He asked the analytics team to lead the
implementation and design appropriate incentives for field agents to induce “correct” behavior.
TASK FOR THE TEAM
Mitra had asked Ganguly and his team to come up with a business plan that defined the desired portfolio
shape (secured vs. unsecured debt), the desired product mix (PL Salaried vs. PL Self), and the desired
geographical mix (between Metro, Tier 1, 2, 3, and 4 cities) for the unsecured urban retail loan portfolio.
Specifically, he wanted the team to interpret the data that they had created for him (see Exhibits 9-12), to
develop actionable plans for Fullerton, and to justify the plans using the data. Ganguly and his core sub-
team comprising Raja Pal and Avinash Barnwal had to develop a top-down decision-making process to
first determine the desired portfolio shape (secured vs. unsecured debt). Then, within the unsecured retail
urban portfolio, the team had to identify the profitable market segments in terms of product categories
(PL Salaried vs. PL Self), as well as geographical locations (Metro, Tier 1–4 cities). In both these tasks, it
was important to maximize profits while maintaining acceptable risk exposure during stress periods.
Finally, the team had to re-design the incentive scheme for field agents to make it compatible with the
recently established risk analytics framework at Fullerton. Above all, Fullerton’s bet on risk analytics was
at stake. In the highly competitive Indian lending business, could data analytics be used to determine the
portfolio shape and also identify profitable product/geographical market segments to achieve a higher
valuation and a higher risk-adjusted return? Mitra wanted the analytics team to carefully consider the
risks of using analytics to drive business strategy.
Page 12 of 22
Exhibit 1
Trends in Net Income (INR million)
150
10 30
FY08 FY09 FY10 FY11 FY12
-2450
-7170
Source: Fullerton India Credit Company Limited
Exhibit 2
Capital Adequacy ratio
Capital Adequacy Ratio (CAR)

80.0%
74.8%
70.0%
60.0%
50.0%
40.0% 38.8% 33.3%

32.2% 31.4%
30.0%
21.3% 20.4%
20.0% 19.2% 18.1%
17.6%
10.0%
0.0%
Mar'07 Sep'07 Mar'08 Sep'08 Mar'09 Sep'09 Mar'10 Sep'10 Mar'11 Dec'11
Capital Adequacy ratio definition (CAR) is the amount of Tier I + Tier II capital as a percentage of risk weighted assets. Tier I capital for
Fullerton includes shareholder funds. Risk weighted assets are consumer and commercial loans that Fullerton provides adjusted for risk.
Page 13 of 22
Exhibit 3
Market Profile
Currency: INR: Indian Rupee. The exchange rate varied from INR 48 (2010) to INR 51 (2012) for 1 US $.
Currency units: Mio - millions
Source: Fullerton India Credit Company Limited (2010)
Page 14 of 22
Exhibit 4
Income Statement (2012-2013)
Profit and Loss Statement (in INR million)

FY 06-07 FY 07-08 FY 08-09 FY 09-10 FY 10-11 FY11-12 FY12-13
Interest Income 682 3,029 8,921 8,618 7,375 8,422 10,142
Interest Expense 192 662 2,619 2,860 2,680 3,323 4,259
Net Interest Income 490 2,367 6,302 5,759 4,696 5,099 5,883
Non Interest Income 14 477 1,956 737 1,079 1,478 1,704
- Fee Income 11 469 1,004 417 511 467 421
- Assignment Income - - - - 8 54 151
- Profit on Sale of Investment 1 4 15 53 132 105 265
- Other income 2 4 937 268 428 851 867
Operating Income 504 2,844 8,258 6,496 5,775 6,578 7,587
Operating Expense 970 5,080 6,163 6,354 4,945 4,784 4,812
Operating Profit (467) (2,236) 2,094 142 830 1,793 2,775
Provisions and Write-offs (net of write-backs) 8 175 2,037 7,312 804 1,302 1,259
Profit Before tax (475) (2,411) 57 (7,170) 26 492 1,517
Tax, including deferred tax 100 35 45 1 - (6) -
Profit After Tax (575) (2,446) 12 (7,171) 26 498 1,517
Exhibit 4 (Contd.)
Miscellaneous Financials
FY 06-07 FY 07-08 FY 08-09 FY 09-10 FY 10-11 FY11-12 FY12-13
Ending Net Receivables (ENR) 7,052 19,828 30,570 30,403 31,581 39,490 48,999
Average Net Receivables (ANR) 1,956 11,486 28,930 32,353 30,601 34,027 43,348
Net Income (NI) 504 2,844 8,258 6,496 5,775 6,578 7,587
Capital Adequacy Ratio (CAR) 74.8% 32.2% 33.3% 21.3% 20.4% 18.9% 24.7%
Page 15 of 22
Exhibit 5
Balance Sheet (March 2013)
Balance Sheet (in INR million)

FY 06-07 FY 07-08 FY 08-09 FY 09-10 FY 10-11 FY11-12 FY12-13
Asset
Cash and Bank Balances 1,072 1,117 5,126 2,400 731 4,158 3,065
Investments 120 500 2,375 2,732 4,333 3,610 3,672
- Government Securities - - - - - 51 1,011
- Certificate of Deposits / NCD's - - 1,000 - 2,198 2,662 2,224
- Equity / Preference investment - - 875 876 897 897 36
- Other investments 120 500 500 1,856 1,237 - 400
Advances 7,059 19,828 30,570 30,403 31,098 35,695 46,838
Fixed assets (including leased assets) 433 1,576 1,576 734 654 511 440
Other assets 262 1,212 1,974 1,830 1,538 1,986 2,179
Total assets 8,947 24,232 41,621 38,098 38,353 45,960 56,194
Liabilities
Equity Share Capital 6,547 10,643 14,668 17,087 17,087 17,087 18,587
Reserves (681) (3,127) (2,672) (9,843) (9,817) (9,319) (7,802)
Borrowings (excluding subordinated debt) 2,144 14,221 27,773 25,111 27,889 34,943 39,548
- Bank Loans - 4,901 12,600 11,382 10,578 14,485 10,235
- Non-Convertible Debentures - - 6,060 9,580 5,679 8,093 19,557
- Commercial Paper 2,144 9,320 9,113 4,149 11,632 12,364 9,756
Subordinated debt (included in Tier-2 capital) - - - - - - 2,000
- Non-Convertible Debentures - - - - - - 2,000
Other liabilities 936 2,495 1,852 5,743 3,194 3,249 3,861
Total liabilities 8,947 24,232 41,621 38,098 38,353 45,960 56,194
Page 16 of 22
Exhibit 6
Risk Analytics Value Chain
Page 17 of 22
Exhibit 7
Risk Appetite Framework
Board of Directors
Risk Appetite Statement (RAS)
Strategy
Alignment
Business Planning
Financial/
Risk
Capital
implication
implication
Exhibit 8
Fullerton Risk Appetite Assessment
Fullerton risk appetite assessment is founded on the approach recommended in the Basel II and III
guidelines for loss estimation. The expected loss calculation as per Basel II involves estimation of three
key parameters as follows.
Basel II loss parameters:
1. Probability of Default (PD)

Probability of default in next 12 months and default refers to an account becoming 90 days past due or
more at least once or in foreclosure, bankruptcy, charge off, repossession, and restructuring.
2. Loss Given Default (LGD)
LGD is defined as the net present value of loss net of collection and recovery cost as a percentage of
the exposure at the time of default.
Page 18 of 22
Exhibit 8 (Contd.)
3. Exposure at Default (EAD)

EAD is exposure of an account at the time of expected default. In the instance of installment-based
loans, EAD is conservatively estimated by current outstanding balance.
These three parameters are combined to estimate the expected loss, Expected Loss (EL) = PD × LGD ×
EAD.
An organization’s risk appetite is described by the following parameters:
1. Recession Loss (Stress Loss)

Recession Loss = Portfolio Size * Recession PD * Recession LGD. Recession loss concept is similar
in nature to expected loss defined above; however the parameters are modified to reflect the stress of a
recession (an event at lease as rare as once in 25 years) condition.
2. Recession Loss Multiplier (RLM)13
RLM = Recession loss/Average cycle operating profit. It is the number of years of average operating
profit (Revenue – Cost) expected to be lost in a recession year. RLM < 1 means the business generates
enough profit in an average year to compensate the loss from one recessionary year.
3. Loss Absorption Ability (LAA)
LAA = Operating profit of an average year/EL from an average year’s book. It provides an idea of the
return of a business in average cycle. (As per industry standards, a value greater than 2.5 is
acceptable.)
4. Risk Adjusted Return (RAR)14
RAR% = Revenue% – Cost% – Expected Loss% = [(Interest Income + Fee Income – Cost of Funds
(COF) – Operating Cost – Expected Loss) over lifecycle of accounts originated] expressed as a % of
disbursed amount. Risk adjusted return is a metric of overall profitability of a
business/segment/product.
5. Economic Capital (EC):
Economic capital covers unexpected losses, given by EC = Recession (Stress) Loss – Expected Loss
(EL).
6. Risk Adjusted Return on Economic Capital (RARoEC):
RARoEC = [Revenue – Cost – Expected Loss], expressed as a percentage of the economic capital
(EC).
13
An alternative measure is the revenue RLM, which is given by recession loss through account lifecycle, expressed as a fraction of the lifecycle
revenue.
14
An alternative measure is the risk adjusted yield (RAY), which is given by [Lifetime Interest Income + Fee Income – Cost of Funds (COF) –
Expected Loss] expressed as a % of disbursed amount, i.e., it excludes operating costs in evaluating the profitability of the business.
Page 19 of 22
Exhibit 9
Scenario Analysis of Portfolio Shape (secured–unsecured mix) for Urban Retail Segment
2013 2014 2015 2016 2017 2018

Sec 37% 35% 34% 32% 30% 30%
Unsec 63% 65% 66% 68% 70% 70%
RLM 1.6x 1.7x 1.6x 1.4x 1.3x 1.2x

Scenario 1
LAA 1.9x 2.0x 2.3x 2.6x 2.8x 3.0x
EL 3.2% 2.6% 2.3% 2.2% 2.2% 2.1%
RAR 3.3% 3.0% 3.5% 3.8% 4.2% 4.5%
EC 12% 11% 11% 11% 12% 12%
2013 2014 2015 2016 2017 2018

Sec 37% 40% 44% 47% 50% 50%
Unsec 63% 60% 56% 53% 50% 50%
RLM 1.6x 1.7x 1.5x 1.3x 1.1x 1.0x

Scenario 2
LAA 1.9x 2.0x 2.4x 2.9x 3.3x 3.5x
EL 3.2% 2.5% 2.1% 1.8% 1.7% 1.6%
RAR 3.3% 2.9% 3.3% 3.5% 3.9% 4.2%
EC 12% 11% 10% 10% 10% 10%
2013 2014 2015 2016 2017 2018

Sec 37% 43% 49% 54% 60% 60%
Unsec 63% 57% 51% 46% 40% 40%
RLM 1.6x 1.7x 1.5x 1.2x 1.0x 0.9x

Scenario 3
LAA 1.9x 2.1x 2.5x 3.0x 3.6x 3.8x
EL 3.2% 2.4% 2.0% 1.6% 1.4% 1.4%
RAR 3.3% 2.8% 3.1% 3.4% 3.8% 4.1%
EC 12% 11% 10% 9% 9% 9%
2013 2014 2015 2016 2017 2018

Sec 37% 45% 54% 62% 70% 70%
Unsec 63% 55% 46% 38% 30% 30%
RLM 1.6x 1.7x 1.4x 1.1x 0.9x 0.8x

Scenario 4
LAA 1.9x 2.1x 2.6x 3.2x 4.1x 4.3x
EL 3.2% 2.4% 1.8% 1.4% 1.2% 1.2%
RAR 3.3% 2.7% 3.0% 3.2% 3.6% 3.9%
EC 12% 10% 9% 8% 8% 8%
Terms defined in Exhibit 8
Page 20 of 22
Exhibit 10 Loan Characteristics of Personal Loans
Personal Loans (PL)

Salaried Customers Self Employed
Product
(PL Sal) Customers (PL Self)
Maturity : 12 – 48 Months Maturity : 12 – 48 Months
Maturity*
Repayment: PDC/ ECS Loan Repayment: PDC/ ECS Loan
65,000 for Metro & Tier 1 100,000 for Metro, Tier 1, Tier 2
Minimum Loan (INR)**
50,000 for Tier 2+ 50,000 for Tier 3 & 4
Maximum loan (INR) 1,500,000 2,000,000

Ticket Size (INR) 1,65,000 3,82,000
Fees 3.85% 2.60%
Pricing (Annual ROI) 34.90% 29.50%
Currency: INR
*PDC: Post-dated check, ECS: Electronic clearance system
** For PL Self loans, the minimum loan amount stated above reflects non-professional customers only. In the instance of professional customers,
the minimum loan amount is INR 100,000 across all geographies.
***DBR: Debt burden ratio given by monthly payments/monthly income
Monthly income and annual turnover numbers in INR
Exhibit 11
Trends in Personal Loans: Origination and Asset Quality
Personal Loans to Salaried Customers (PL Sal)
Account opened Loan Amt ENR_Mar13 Avg Tenor 30+%@ 90+%@ NCL
month (INR mio) (INR mio)a (in 12MOBb 18MOBc (INR mio) d
Pre Mar'11 30,116 2,607 36 5.10% 1.50% 5,104
Apr'11 - Mar'12 11,008 786 42 3.90% 1.20% 835
Apr'12 - Mar'13 9,730 1,387 43 2.80% 0.70% 662
Grand Total 50,854 4,780 37 4.40% 1.30% 6,601
Personal Loans to Self Employed Customers (PL Self)

Account opened Loan Amt ENR_Mar13 Avg Tenor 30+%@ 90+%@ NCL
month (INR mio) (INR mio) (in 12MOB 18MOB (INR mio)
Pre Mar'11 32,774 4,619 30 8.80% 2.30% 11,534
Apr'11 - Mar'12 6,329 324 35 2.20% 0.70% 358
Apr'12 - Mar'13 7,121 802 37 2.30% 0.50% 519
Grand Total 46,224 5,745 30 6.90% 1.80% 12,411
Notes:
a. ENR_Mar13 is the ending net receivable (loans outstanding in INR mio i.e., million) at the end of March 2013.
b. 30+%@12MOB is the percentage of delinquent loans (30 days past due) as a proportion of the ending net receivable at the end of 12
months on book.
c. 90+%@18MOB is the percentage of delinquent loans (90 days past due) as a proportion of the ending net receivable at the end of 18
months on book.
d. NCL is the net credit loss (including both provisions and write-offs net of recovery)
Page 21 of 22
Exhibit 12
Analysis of Product/Geographical Market Segments in Urban Retail Loans
Personal Loans (Salaried Customers)

Mar 2013 Oct 2013 (est.) RAR RLM
Metro 4,661 4,683 6% 1.0
Tier 1 3,410 3,367 6% 1.1
Tier 2 2,020 1,989 10% 0.9
Tier 3 1,747 1,743 11% 0.9
Tier 4 4,650 4,672 9% 0.8
Total 16,489 16,455
Personal Loans (Self Employed Customers)

Mar 2013 Oct 2013 (est.) RAR RLM
Metro 1,297 1,519 0% 2.8
Tier 1 2,432 2,725 6% 1.2
Tier 2 1,548 1,785 7% 1.2
Tier 3 1,411 1,552 8% 1.1
Tier 4 3,133 3,471 6% 1.3
Total 9,820 11,052
Page 22 of 22

Case Study Fuletron

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IMB 587

FULLERTON: RISK ANALYTICS AND BUSINESS

V RAVI ANSHUMAN AND SABY MITRA

THE INDIAN BANKING SECTOR

COMPANY BACKGROUND AND HISTORY

DATA ANALYTICS CENTERED DECISION MAKING

RISK ANALYTICS FRAMEWORK

CENTRALIZED CREDIT UNDERWRITING

APPLICATION SCORECARD AND BEHAVIOR SCORECARD

RISK MANAGEMENT IN OTHER AREAS

BUILDING AN ANALYTICS-DRIVEN ORGANIZATION

BALANCING THE LOAN PORTFOLIO

PRODUCT AND GEOGRAPHICAL MIX IN THE UNSECURED RETAIL SEGMENT

DESIGNING INCENTIVES AND MANAGING THE IMPLEMENTATION

TASK FOR THE TEAM

Source: Fullerton India Credit Company Limited

Capital Adequacy Ratio (CAR)

40.0% 38.8% 33.3%

Source: Fullerton India Credit Company Limited

Source: Fullerton India Credit Company Limited (2010)

Profit and Loss Statement (in INR million)

Source: Fullerton India Credit Company Limited

Balance Sheet (in INR million)

Source: Fullerton India Credit Company Limited

Source: Fullerton India Credit Company Limited

Risk Appetite Statement (RAS)

Source: Fullerton India Credit Company Limited

Basel II loss parameters:

1. Probability of Default (PD)

3. Exposure at Default (EAD)

An organization’s risk appetite is described by the following parameters:

1. Recession Loss (Stress Loss)

Source: Fullerton India Credit Company Limited

2013 2014 2015 2016 2017 2018

RLM 1.6x 1.7x 1.6x 1.4x 1.3x 1.2x

2013 2014 2015 2016 2017 2018

RLM 1.6x 1.7x 1.5x 1.3x 1.1x 1.0x

2013 2014 2015 2016 2017 2018

RLM 1.6x 1.7x 1.5x 1.2x 1.0x 0.9x

2013 2014 2015 2016 2017 2018

RLM 1.6x 1.7x 1.4x 1.1x 0.9x 0.8x

Terms defined in Exhibit 8

Source: Fullerton India Credit Company Limited

Exhibit 10 Loan Characteristics of Personal Loans

Personal Loans (PL)

Maximum loan (INR) 1,500,000 2,000,000

Source: Fullerton India Credit Company Limited

Personal Loans to Self Employed Customers (PL Self)

Personal Loans (Salaried Customers)

Personal Loans (Self Employed Customers)

Source: Fullerton India Credit Company Limited

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