Credit Risk

By Prof. Divya Gupta

Credit Risk
Credit Risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counter parties. Traditionally, the credit risk is thought of as having two components1) Liquidity 2) Solvency

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Credit risk management is not NPA Management

Need for credit risk in Indian Banks

Banks as intermediaries between Savers and investors accept deposits from public and lend the same to entrepreneurs to earn profits.? There is always a scope for the borrower to default from his commitment resulting in credit risk to a bank.

Credit risk may take the following forms:

In the case of direct lending- principal & interest amount may not be repaid In the case of guarantees and letter of credit In the case of treasury operations In the case of cross border exposure

Components of credit risk:

Quantity of risk Quality of risk

a) b) c)

Credit risk also includes three other risks: Counter party risk Portfolio risk Country risk

5 Cs of good and bad lending:

5 Cs of good lending Character Capacity Capital Collateral Conditions - economic 5 Cs of bad lending Complacency Carelessness Communication gap Contingencies-uncared Competition - unhealthy

Major sources of credit problems:

Concentrations Failure of due diligence in credit granting, review and monitoring process. Others sources of credit problems

Concentrations:
Credit concentrations are viewed as any exposure where the potential losses are large relative to the banks capital its total assets or where adequate measures exceed, the banks overall risk level. ---- why concentrations develop?

Concentrations:
Principles for management and control of risk concentrations RBI guidelines on exposure norms Techniques to check credit concentrations

Failure of due diligence in credit granting, review and monitoring process

Credit granting process Credit review process

Other sources of credit problems:

Absence of risk-sensitive pricing Lack of exercise of caution with leveraged credit arrangements Lending against non-financial assets Business cycle effects/absence of a thoughtful consideration of downside scenario.

Credit Risk Management Techniques:

Credit Appraisal and approval process Credit concentration and sectoral gap Credit scoring model and risk rating of loan Pricing of loans Loan review mechanism

Credit Risk Measurement Models

Default risk Model Credit Scoring Model Altmans Z Score Model RAROC Model

Altmans Z Score Model

Borrowers are categorized into two categorieshigh or low default risk, on the basis of past experience. The Z variable is an indicator of default risk classification of a commercial borrower. The variable depends upon the values of various financial ratios of the borrower. The weightage importance given to these ratios are fixed based on the intense research.

Altmans Z Score Model

Z =1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
where:
X1 = working capital/total asset ratio X2 = retained earning/total asset ratio X3 = EBIT/total asset ratio X4 = MVE/book value of long term debt ratio X5 = sales/total asset ratio

Analysis: Higher the value of Z , the lower is the default risk The value of Z less than 1.81 is considered as high default risk

Case:
The financial position of the ABC Ltd is as under: Particulars Amount (in lakhs) Working capital 400 Retained earnings 50 Total Assets 1000 Earning before Interest and Tax 100 Sales 1500 MVE to Long term debts 0.15 Calculate the Z score of this company using Altmans Z score model and take a decision regarding the credit risk of ABC Ltd.

Limitations of Z score Model

The model is based on two extreme events: default and no default The model is limited to financial ratios . The same model is to be applied for short term and long term loans.

RAROC Model
Risk adjusted return on capital (RAROC) model includes default risk in pricing of loan. RAROC = one year income on loan capital at risk or loan risk There are two methods for calculation of loan at risk.

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First Method:
Rupee capital risk exposure = Duration of loan x loan amount x expected change in credit premium L = DL X L X (R/1 + R)
The main feature of this method of to find out the maximum change in the credit risk premium on loan by next year. (based on rating)

Case:
Suppose a bank wants to calculate RAROC for a loan of Rs.100 crore earning net income including a fee of Rs.1.5crore, with duration of 3.2 years. The current market rate of interest for such loans is 12% and change in risk premium is 3.5%.

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Second Method: EL = PD * LGD * EAD EL= expected loss PD= probability of default LGD= loss given default EAD= exposure at default

On the basis of database the estimation is done.

Case
Sound Bank has given a loan of Rs.100 crore to a borrower. The chances of the borrower defaulting in a one year horizon is 2%. When the default occurs, the loss is likely to be 50%. Calculate the Expected Loss on this transaction.

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Unexpected loss: UL = PD * LGD * CAR

Where CAR = Credit at risk (maximum risk in worst situation)

Thank You!!!