Credit Assessment process

Management quality Business model Competitiveness Key success factors Credit Analysis Proposed activity & financing requirement Financial history, performance, capital usage and financing strategy Debt capacity , Cash Flow and Fund Flow analysis Industry cycles and business risk Internal Rating and probability of default Purpose of financing Determine type of financing - asset /receivable/cash flow financing/structured Risk mapping of transaction, is it bankruptcy remote the obligor ? Are there any risk sharing arrangements ? Co financing, Bank acceptances or Letter of credit backing etc. Transaction Is the transaction self financing ? i.e. commodity based lending analysis Extent of collateral risk-collateral value and market risk Is there a need to obtain additional collateral or balance sheet cash flow is adequate? Are there any contingent risks in the transaction which needs to be priced ? Transaction rating based upon credit support available and risk sharing Arrive at residual risks which are open in the transaction Think through the possibility of either sharing or pricing the residual risks Iterate the RAROC based pricing based on residual risk and transaction rating ( based upon additional structuring of credit support). In case of treasury based transaction , we can look at market credit support such as liquid collaterals . Arrive at the final pricing and transaction rating and residual risks which are open Specify the terms and conditions required to govern the transaction Put up the credit note for committee approval 1

Credit Structuring

Credit Assessment process

Obtain credit approval Communicate /negotiate with client on terms & financial covenants Carry out pre-disbursement checks-documentation and collateral execution Classify the credit exposure and profile the exposure details into the credit risk data base Monitor exposure regularly

Credit Approval

Life cycle monitoring

Carry credit reviews and rating watch both Internal & External rating migration Monitor collateral risk In case of structured transactions such as securitization track quality of asset pool, collection efficiency and default rates if any Revise rating in case of any downgrades or upgrades and review with Credit & Risk committees Follow classification as per asset classification norms Report and trigger action in case of any impairment
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Management -Industry strategy performance & business model

Promoter, Management quality & governance
Promoter background Past ventures Creditworthiness with banks/fin institutions

Industry/Competitive Advantage & Key Success factors

Five Force analysis of Industry competitiveness local/global Industrial policy environment Key success factors that drive performance Key Industry risks Past financial performance of Industry

Business Model

Product /service Fixed capital Intensive or working capital asset driven business Distribution driven/relationship driven Customer types Impact of competitive forces on business model Does the business model have the key Success Factors?
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Porters Five Forces

Financial strategy performance & earnings dynamics

Corporate Strategy

Product positioning, marketing supply chain & pricing strategy Competitive Advantage Operations strategy

Financial Strategy

Financing leverage Earnings model Cash flow management Fund Flow alignment Long term sustainability Asset creation for future growth Enterprise Value creation
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Financial strategy performance & earnings dynamics

Financial strategy -Capital structure Long debt /Tangible Net worth Total Debt/Tangible Net worth Short term debt / Operating Cash flow Contingent Liabilities /Operating cash flow

Capital efficiency ROCE ROE ROCE-Cost of Capital-=spread Stock Beta Enterprise Value

Benchmarking Bench financial ratios with mean of rating cohorts Benchmark financial performance strategy and earnings with industry peers

Working capital strategy Net working capital / Current assets Aging of debtors Aging of payables

Earnings and profitability Revenue-Core income Other income Earnings growth

Future plans and financial projections analysis Challenge assumptions for future financial projections

Profitability

Liquidity
Current Ratio Quick ratio Operating cash flow to sales

EBIDTA growth PAT PBT Operating margins

Debt repayment capacity DSCR for short term debt DSCR for long term debt Interest cover ratio

Liquidity and use of capital Fund flow analysis Cash flow analysis

Credit Risk evaluation & selection of MSME exposure-Using credit scoring model Qualitative factors
Credit Score
Conditioned on business management and other soft factors

Financial Factors credit Score

Conditioned more on financial factors

Willingness to pay

Ability to pay

More Accurate Model to predict probability of default

Use of credit scoring model is widely applied in MSME segments. For IRB approach, preparedness on this front is a must

Credit risk -Case study of an MSME unit

Credit risk evaluation of an MSME unit using the broad credit evaluation process & scoring model

The structure of the BASEL II&III Capital accord

Three Basic Pillars
Minimum capital requirements Supervisory Review Process Market Discipline

The structure of the BASEL II&III Capital accord

Three Basic Pillars Minimum capital requirements
Risk weighted assets

Supervisory review process

Market discipline

Definition of capital

Credit risk

Operational risk Basic Indicator Approach

Market risks Models Approach

Core Capital

Supplementary Capital

Standardised Internal Approach Ratings-based Approach

Standardised Advanced Standardised Approach Measurement Approach Approaches

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BASEL II & Indian Banks

RBI currently prescribes Standardised Approach for all Indian and foreign banks in India Indian Banks & Foreign Banks in India follow standardised approach for regulatory capital Credit Risk + Market Risk +Operational Risk=RWA Capital adequacy @9% of RWA Banks parallel run for IRB foundation targeted by 2012
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IRB ( Internal Ratings Based) Approach

IRB approach fundamentally has two sub approaches Foundation approach Advanced approach Both approaches are based upon a single factor default mode model The model is also called the asymptotic single risk factor model IRB is adapted from Merton & Vasciek single asset model to credit portfolios
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IRB Approach
IRB method of risk capital measurement is based upon Internal ratings of bank credit exposures Unexpected losses ( UL) Expected losses (EL) IRB Risk weight function equation or model produces capital for the UL Expected losses (EL) are to be treated separately Unexpected losses (UL) concept relies on the Value at Risk concept as its foundation
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Economic foundations of IRB model

Credit Loss rate over time normal business ( EL) & abnormal losses ( UL) The credit losses for a Bank over time vary depending upon the severity of loss rate irrespective of the portfolio to which the loans belong

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Economic foundations of IRB model

Loss distribution and Value at Risk. The potential losses at low frequency are higher in severity by historical experience. The IRB model targets in measuring credit risk capital for such potential unexpected losses. Expected losses are to be priced & provided for. In an extreme event, there is a likelihood of an UL of Rs 200 crs. 5% of the time (meaning 95% confidence level) over an horizon of one year. In other words likelihood that the bank will remain solvent over one year horizon is 95%

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Economic foundations of IRB model

The three basic parameters Probability of default ( PD) Loss Given Default (LGD) = (1-Recovery% on default) Exposure at Default (EAD) All the above three parameters are on default model only IRB analytical model is Portfolio invariant IRB analytical model in ratings based at individual loan asset level EL=PD*LGD*EAD EL is based upon average PD rates PD is expressed in %, LGD in % & EAD in value terms EL= 0.05%*35%*452 crs. =0.0791 crs.
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Asymptotic Single Risk Factor model (ASRF)-IRB

IRB analytical model is based upon the following postulates Portfolio invariance Law of large numbers Idiosyncratic risk cancel out each other & only systematic risk impact loss rates in large portfolios Granularity of portfolios is large Analytical model uses conditional PD and downturn LGD for estimation of UL For IRB framework target VAR =UL +EL=Capital +Provisions
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Risk Components: Drivers of Credit Risk

Driver of Credit Risk Obligor risk Transaction risk Likely size of exposure Maturity

Standardised Approach Credit assessment institutions Credit risk mitigation techniques Credit conversion factors Limited recognition

IRB Approach Probability of Default (PD) Loss Given Default (LGD) Exposure at Default (EAD) Maturity (M)

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Asymptotic Single Risk Factor model (ASRF)-IRB-Systematic risk factor

The IRB analytical model can be understood in its different components The model conditions the average default rate to arrive at the value of systematic risk factor that influences the credit loss

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Frequency 50 100 150 200 250 300 350 0 -3.84170562 -3.577063509 -3.312421398 -3.047779286 -2.783137175

-2.518495063
-2.253852952 -1.989210841 -1.724568729 -1.459926618 -1.195284507 -0.930642395 -0.666000284 -0.401358172 -0.136716061 0.12792605 0.392568162 0.657210273 0.921852384

Normal distribution of systematic risk factor values

Asymptotic Single Risk Factor model (ASRF)-IRB

continuous systematic risk factor values

1.186494496
1.451136607 1.715778719 1.98042083 2.245062941 2.509705053 2.774347164 3.038989275 3.303631387 3.568273498 3.832915609

Frequency

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LGD measures for the IRB model should be based either on supervisory estimates or internal bank historical data. Under foundation IRB method, downturn LGD will be provided by the regulator and in case of IRB advanced model, the same needs to be estimated by the Bank and used in the model

Asymptotic Single Risk Factor model (ASRF)-IRB LGD

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Asymptotic Single Risk Factor model (ASRF)-IRB Expected Loss

The IRB ASRF model computes the capital which is the entire figure from the origin to the VaR. However this also includes the loss during normal business conditions. Therefore Expected losses will need to be deducted in the IRB model to arrive at only the unexpected loss. The EL is defined as average PD *LGD

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Asymptotic Single Risk Factor model (ASRF)-IRB

For performing loans in IRB model, LGD is the downturn LGD which is higher than LGD during normal business condition In of non performing loans technically the terms N and PD would be 1 and the model output would be equal to 0. However still a capital charge to take care of uncertainty in recovery has to be made For default assets, best estimate of EL and LGD will be compared and the difference will be taken as Unexpected loss or capital charge
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Asymptotic Single Risk Factor model (ASRF)-IRB Asset correlations

Volatility of EL and UL over time is due strong correlation among individual exposures and correlation with a single systematic factor. The IRB model lays more stress on single systematic risk factor i.e. the state of global/national economy . In the IRB model asset correlation is the correlation of the asset default with the systematic risk factor. As all obligors are exposed to the single systematic risk factor, in aggregate the portfolio too is exposed to the single factor on portfolio defaults

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Asymptotic Single Risk Factor model (ASRF)-IRB asset correlations

Empirically & by intuition it is found... Increase in PD, the idiosyncratic risk of individual borrowers increases As PD ( default rates) among individual asset class increase, the correlation effects with other borrowers decrease Individual default rates depend less on systematic risk factor Correlations are effected by size of firms Higher the size of firm, higher the dependency on overall economy and hence correlation increases Example : present financial crisis, large banks default lead to contagion effect Asset correlations also increase by asset size There is a size adjustment in the IRB model

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Asset correlations and default rates are related through an exponential function within limiting limits of 0 to 100% default rates. For very high PD, correlation limits are 12% for very high PD and 24% for very low PD.

Asymptotic Single Risk Factor model (ASRF)-IRB asset correlations

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Asymptotic Single Risk Factor model (ASRF)-IRB asset correlations

Correlation adjustments in the IRB model .Correlation is an input provided in the model which has to be estimated for asset class The size adjustment for borrowers having annual sales between Rs 35 crs. to 350 Crs. ( taken at 1 Euro of Rs 70)

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Asymptotic Single Risk Factor model (ASRF)-IRB asset correlations

Correlation adjustments in the IRB model .Correlation is an input provided in the model which has to be estimated for asset class

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Asymptotic Single Risk Factor model (ASRF)-IRB Maturity factor

Empirical evidence states... Long term credits riskier than short term credits Exposures with higher maturity and low PD have greater rating /credit quality migration Risk Migration risk lower for exposures with high PD as there these exposures are closer to default MTM >given low PD , higher maturity MTM <given high PD, lower maturity Overall maturity effect dependent upon PD IRB for the above reasons includes maturity effect
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The maturity adjustment for the IRB equation is linear with a steep slope as at higher PD levels, the effect of maturity is lower . The factor B in the model is the regression slope of M with PD

Asymptotic Single Risk Factor model (ASRF)-IRB Maturity factor

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Asymptotic Single Risk Factor model (ASRF)-IRB Confidence Level

Confidence level in IRB foundation approach is a supervisory input Currently 99.99% i.e. 0.010% . The idea of BASEL II being that at least a solvent large bank would be of AA rating cohort

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Asymptotic Single Risk Factor model (ASRF)-IRB Risk Capital

Comprehensive view of the Capital Charge computation . RWA on every single exposure is arrived at by multiplying 12.5 * K * EAD. The scaling factor to give effect to UL is 12.5 and is arrived at by the reciprocal of 1/8 where 8% is BASEL minimum capital adequacy. Capital charge will then be 8% ( 9%) for India on the computed RWA

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Collateral effects-IRB capital charge

IRB recognizes credit risk mitigation
Collateral should be eligible as per regulatory requirement Eligibility of collateral same as standardised approach Effective LGD to be applied on Exposure after risk mitigation Minimum LGD as per foundation is 45% for unsecured senior corporate loans LGD for unsecured subordinated loans is 75%
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Collateral effects & Credit Risk Mitigation IRB approach

No correlation between credit quality of counterparty with collateral Where collateral is held by custodian ( in case of commodities, securities etc.) co mingling of assets to be avoided Provide haircuts on collateral value based upon market risk Internal estimates of collateral market risk or supervisory estimate of haircut can be used

Effective LGD= (E*/E) * LGD

E* = effective exposure calculated after considering credit risk mitigation E=exposure without considering collateral based risk reduction

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Collateral effects & Credit Risk Mitigation IRB approach

No correlation between collateral & counterparty Where collateral is held by custodian ( in case of commodities, securities etc..) co mingling of assets to be avoided

Provide haircuts on collateral value based upon market risk

Internal estimates of collateral market risk or supervisory estimate of haircut can be used

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Collateral effects & Credit Risk Mitigation IRB approach

In IRB approach the bank should estimate effective exposure E* = max(0,{E*(1+He)-C*(1-Hc-Hfx) He= Increment to exposure due to market movements Hc= Haircut to collateral due to market risk Hfx =Haircut to exposure due to foreign exchange movements Effective LGD= (E*/E) * LGD E* = effective exposure calculated after considering credit risk mitigation E=exposure without considering collateral based risk reduction

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Default Probability Model development

PD estimation requires a Internal rating and a quantitative approach to rating data Internal rating system must have two dimensions Risk of default =f(M,B,F,I)parameters Transaction specific risk factors ( facility rating) Risk default must me measured by assigning minimum rating grade distinctions to avoid risk concentrations + or signs within each grade can be used Rating grades and PD estimated should have an exponential relationship
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Facility rating or the transaction element must reflect the Loss severity consideration Facility rating should influence overall rating through effects of Seniority of the exposure Product type Collateral Collateral market risk Concentration risk through collateral Facility rating should enable estimate of LGD
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Internal ratings model

Internal ratings model

Banks should test for rating consistency Deviation of financial parameters/credit scores and PD ( actual default rates) or model PD rates across rating grades should be observed/minimised Banks should harvest minimum 5 year historical data on rating cohorts
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Credit Risk & Analysis Internal ratings

Source : Credit Risk Assessment guidelines-ONEB paper

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The Credit Management Process

Pre-Assessment Accept Internal Credit Rating PD LGD CR Measurement CR Management Pricing Provisioning Capital Allocn. Loan work outs
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Reject

EAD

Correlations

Traditional Approach to PDs

Focus on historical accounting data Purely empirical approach uses historical default rates of different credit ratings (e.g. Moodys and S&Ps) The traditional modeling approach attempts to identify the characteristics of defaulting firms First serious attempt usually attributed to Altman (late 60s) who used Discriminant analysis (Z scores) Scoring models have stood up well over time and are still used - especially in low-value, high-volume lending Later models have used Logit, Probit and ANNs

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Default probability models

MSME portfolios are generally granular

Relatively higher degree of homogeneity

Estimate of pool level PD can be used initially Credit scoring or logistic regression models suit better for PD estimation in MSME segment

Based on few financial ratios which are key risk indicators and easy to monitor
The above models are also easy to validate

Altman Z score model methodology is the basic foundation of such PD modeling

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ALTMAN Z SCORE MODELS

The Altman Z score Model uses the financial ratios of default & non default firms to estimate credit scores. Variant of Altman credit risk scoring models are based upon finer statistical regressions

The model construct

0.012 (X1)+0.041(X2)+0.033(X3)+0.006(X4)+0.999(X5)

X1=Net working capital/TOA X2=Retained Earnings/TOA X3=EBIDTA/TOA X4=Market Value of Equity/TOA X5=Sales/TOA Z=overall credit Index Interpretation of Z Index values for credit quality

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ALTMAN Z SCORE MODELS

The Altman Z score Model uses the financial ratios of default & non default firms to estimate credit scores. Variant of Altman credit risk scoring models are based upon finer statistical regressions

Z=overall credit Index Interpretation of Z Index values for credit quality Critical cutoff score is 1.81. Loans having credit score below 1.81 are in higher probability of default risk Loans between 1.81 to 2.50 are in the mid category Loan exposures more than 2.50 are in the strong credit quality class

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CRISIL PD estimates

CRISIL default study estimates PD for period 1998-2010

The method followed is static pool method year on year

PD estimated for both the Long term and short term debt issuances

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CRISIL PD estimates
CRISIL PD estimates are for one year transition as required by IRB foundation. The below estimates are for mix of mid size and large Corporate units

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CRISIL PD estimates
CRISIL PD estimates are for one year transition of short term issuances. The below estimates are for mix of mid size and large Corporate units

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CRISIL Industry wise default rates

Industry segment wise default rates worked out by CRISIL on its rated pool

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Credit Migrations-MTM approach

Concept of MTM approach probability credit migrations to default status. The MTM approach is continuous and not a discrete approach such as default mode

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Portfolio Credit Risk Modelling

While the term credit risk model is applied loosely to cover all forms of statistical analysis, including the estimation of PDs, credit risk modelling in the true sense of the term involves the portfolio assessment of credit risks and the use of the model as the framework for managing credit risk within the bank

There two fundamentally distinct portfolio modelling approaches :

Default mode modelling, and Mark-to-market modelling

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Mark-to-Market Modelling

MTM models define credit events to encompass both default and migration of credit ratings
By valuing every credit in every possible state and then probability weighting them, the MTM model effectively simulates the price at which any credit could be sold hence the MTM label

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Default Mode Modelling

Default mode accounts for default event only

The default no default event is statistically modelled as a binomial state DM method is based upon the binomial distribution and the assumption that the credit portfolio is granular

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Credit Risk portfolio level default mode

EAD ( exposure at default) = Principal committed + Accrued interest

EL( expected loss) =EAD * PD * LGD

LGD= (1-Recovery %)*EAD Unexpected Loss is the deviation about EL

UL

P (1 P ) LGDEAD

UL will be maximum for a portfolio of credit assets in case correlation is 1 Due to diversification UL reduces EL will be recovered through risk based pricing UL- EL = economic capital
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Framework of RBPM
Setting of Risk Appetite & Limits

Estimation of Risks
Integration of Risks Stress Testing

Capital Computation
Capital Allocation Estimation of Cost of Capital Allocation of financial Revenue & Expenses Allocation & apportionment of non-financial expenses Computation of Risk Based Performance
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Risk Adjusted Return on Capital

A RAROC model links Risk and Economic capital (Not regulatory capital)

Economic capital is the capital needed to absorb unexpected losses

Expected losses are priced into the transaction

So RAROC = Risk Adjusted Return over economic capital

Risk Adjusted Return= Return- Transaction costs ( variable & semi fixed + proportion of fixed cost allocated to product line) - Cost of Risk
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Risk Adjusted Return on Capital

Risk Costs = Expected loss

RAROC = Risk adjusted return ( RAR) / Economic capital in % terms

RAROC is similar to ROCE but with a risk adjustment in it

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Risk Adjusted Return on Capital

RAROC = Risk adjusted return ( RAR) / Economic capital in % terms

RAROC is similar to ROCE but with a risk adjustment in it

Overall spread = RAROC Cost of Capital (Tier I +Tier II)

Benchmark spread to peer groups

Compare RAROC across product lines /business verticals

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Risk Adjusted Return on Capital

Measurement of Economic Capital

Economic capital = Unexpected Losses

Credit VaR

Market RiskVaR

Operation al VaR

EC

In modelling Economic capital correlation is set to 1 for conservative basis or based on observed correlation data Stress tests can involve correlation inputs which observed under stressed
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RAROC MODEL INPUT COMPONENTS

Obligor Risk Rating Process Portfolio Capital Model PD & PD Migration Expected Loss individual exposure LGD [Loss Given Default] EC (Economic Capital) Correlation effects

Structure Asset Quality

Structure Term Loan Type

EA D [Expos Given Default]

Expected Losses -EL

UL [Unexpected Loss]

RAROC

Total Revenues Interest + fee income NIX (Non-Interest Expense)

LGD Amount PD -Overhead & other variable /semi fixed costs - Expected Loss

Net Income

- Income Tax & Capital Tax

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RAROC EQUATION

RAROC =
where,

Total Revenue Overhead - Expected Loss - Taxes Marginal Credit Capital

on Time Horizen = One year forward estimate of profitability

Total Revenue = Expected 1st yr Spread Revenue + Upfront Fees Overhead = Non-Interest Expense (fixed charge applied per segment) Expected Loss = Obligor PD * Facility LGD * Loan Exposure Taxes = Jurisdiction specific tax payable on loan income Marginal Credit Capital = 1st yr credit capital based on one factor VaR model (similiar to Basel II)

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IRB & RAROC Model-EXCEL examples

EXCEL based examples on the IRB credit Risk equation and RAROC pricing of MSME loan exposure will be practiced

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Other salient components and key assumptions of model: RAROC output compared to Hurdle Rate (cost of capital + risk premium) for all new/revised deals RAROC integral but not sole factor in lending decision, however, any deal falling below Hurdle requires level-up sign-off with rationale Data Inputs:
PD consistent with obligor RR; consistent with through the cycle outlook LGD facility specific and reflects average loss expected EAD based on expected utilization plus add-on factor Marginal Capital estimated using one factor model. Capital influenced by PD, LGD, and Term of deal. A Default/No Default model with loose assumptions on portfolio granularity and correlation/diversification 63

Foreign funding options for MSME

Methods of raising foreign funds
External Commercial Borrowing methods

Bank loans, Buyers credit, Suppliers credit

Securitized instruments (floating rate note, fixed rate notes, partially ,optionally convertible preference shares with a minimum maturity of 3 years)
Foreign Currency Convertible Bonds (FCCB) Foreign Currency Exchange Bond (FCEB)
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Foreign funding options for MSME

Basic compliance requirements & policy guidelines

The ECB bank borrowing methods will be guided by the ECB circular of RBI

The fund raising options such as FCCB, FCEB, Preference shares( partially/optionally convertible) are guided by FEMA and ECB guidelines and specific scheme guidelines issued by Ministry of Finance Govt of India.

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Thank You