MBFI

Managing Credit Risk

N. R. BHUSNUR MATH
Professor
MDI Gurgaon

Credit Risk

Default Risk

Borrower may not pay on time or may not pay interest or may
not pay full amount or may not pay at all

Most important risk for banks as 50-65% of the assets are Loans
& Advances

NPAs defn
Once an NPA, interest is recognized only on receipt ie.,
switchover accounting for interest from accrual to cash
basis

Banks have to provide for the NPA according to the age of

the NPA

Banks may have to write-of

Risk Management Process

Identifying & Measuring

Pricing Risk
Managing -Controlling,
Monitoring and Reviewing
Managing NPAs

Credit Risk
Default by the borrower
Non willful
Wilfull
Deterioration of borrowers
credit quality

Credit Risk
RBI defines credit risk as:
the possibility of losses associated with diminution in
the credit quality of borrowers or counterparties. In a
banks portfolio, losses stem from outright default
due to inability or unwillingness of a customer or
counterparty to meet commitments in relation to
lending, trading, settlement and other financial
transactions. Alternatively, losses result from
reduction in portfolio value arising from actual or
perceived deterioration in credit quality.

Credit Risk Management

According to RBI, the following are the forms of credit risk:

Non-repayment of the principal of the loan and/or the interest

Contingent liabilities like letters of credit/guarantees issued by

the bank on behalf of the client and upon crystallization amount
not deposited by the customer

In the case of treasury operations, default by the counterparties in meeting the obligations

In the case of securities trading, settlement not taking place

when it is due

In the case of cross-border obligations, any default arising from

the flow of foreign exchange and/or due to restrictions imposed
on remittances out of the country

Principles of sound credit risk management

BOD should have responsibility for
approving and periodically reviewing
credit risk strategy
Senior management should have the
responsibility to implement the credit
risk strategy
Bank should identify and manage credit
risk inherent in all product and activities

Credit Risk takes various forms

Direct Lending:Loan amount (Principal
as well as interest) will not be paid
Guarantees/ Letter of Credit etc.
Contingent Liability
Funds may not be forthcoming upon
crystallization of liability

Credit Risks Include:

Loans
Trade financing
Guarantees , Acceptances, Letters of
credit
FX transactions
Interbank transactions
Corporate Bonds
Derivatives

Management of Credit Risk (loans)

Management refers to
Pre-sanction appraisal
Due Diligence
Documentation
Disbursement and Disbursal
Post-lending supervision and control

Pre-Sanction appraisal
Measurement of risk of a loan proposal
Financial data of past and projected working
results
Detailed credit report is compiled on the
borrower / surety
Market reports
Final / audited accounts
Income tax and other tax returns / assessments
Confidential reports from other banks and financial
institutions

Sound Credit Granting Process

Thorough understanding of the borrower,
purpose/structure of credit and its source of
repayment
Use and abuse of credit scoring models
Have a clearly established process for approving
new credits/extension of existing credits.
Extension of credit must be made on an arms
length basis(?) Credit Processing Centres
Establish overall credit limits at the level of
individual borrowers/connected counterparties

Post Sanction Monitoring

Documentation & Due-Diligence
Supervision through monitoring of transactions
in loan amount
Scrutiny of periodical statements submitted by
the borrower
Physical inspection of securities and books of
accounts of the borrower
Periodical reviews etc.

Securities for lending

Section 5 of B. R. Act defines secured and
unsecured loans
Secured Loans and advances made on
security of assets the market value of which is
not at any time less than the amount of the
loan or advances
Unsecured Means a loans or advance not so
secured
Security taken as an insurance against
unwarranted situations

Securities for lending

Two types: Primary and Collateral
Primary Security
Personal
Created by a duly executed promissory note,
acceptance or endorsement of bill of exchange
etc.
Gives bank the right of action to proceed against
the borrower personally in the event of default
Impersonal
Created by way of a charge (pledge,
hypothecation, mortgage, assignment etc.)

Collateral Security
Meaning running parallel or together
Taken as additional and separate security
Could be secured / unsecured guarantees,
pledge of shares and other securities,
deposits of title deeds etc.
Used to reinforce the primary security (for
e.g. plantation advances are not
considered fully secured until crop is
harvested)

Credit Risk Management

as per RBI
Measurement of risk through credit scoring
Quantifying risk through estimating loan
losses
Risk pricing Prime lending rate which also
accounts for risk
Risk control through effective Loan Review
Mechanism and Portfolio Management

RBI Guidelines on Credit

Exposure and Management
Credit exposure to an individual
borrowers not to exceed 15% of capital
funds
Group borrowers exposure not to exceed
40% of capital funds
Aggregate ceiling in unsecured advances
should not exceed 15 % of total DTL of
the bank from earlier 33.33%

RBI Guidelines on Credit

Exposure and Management

(Contd.)

Bank cannot grant loans against security

of its own shares
Restrictions on loans and advances to
Directors and their relatives
Restriction on advances to real estate
sector only for genuine constriction
and not for speculative purposes

Managing NPAs
Built in pricing the interest rate covers
expected losses (based on probability)
Declaration as willful defaulter cannot
be on any corporate board
Legal Action
SARFESI Act
Debt Recovery Tribunals (DRTs)
Corporate Debt Restructuring (CDR)

Asset Reconstruction Companies (ARCs)

Asset Recovery Fund to take the NPAs off the
lenders books at a discount.
Asset Reconstruction Company (Securitization
Company / Reconstruction Company) is a
company registered under Section 3 of the
Securitization and Reconstruction of Financial
Assets and Enforcement of Security Interest
(SRFAESI) Act, 2002.
A NBFC
ARC functions like an AMC within the guidelines
issued by RBI.
College of Agricultural Banking, RBI,
PUNE

Functioning of ARCs
Acquisition of financial assets
Change or takeover of Management / Sale or Lease of
Business of the Borrower
Rescheduling of Debts
Enforcement ofSecurityInterest (as per section 13(4) of
SRFAESI Act, 2002)
Settlement of dues payable by the borrower
The ARC transfers the acquired assets to one or more
trusts (set up u/s 7(1) and 7(2) of SRFAESI Act, 2002)
Security Receipts are issues similar to units of M Fs

Quantitative Analysis
Expected & Unexpected Losses
EL depends upon
default probability(PD)
Loss given default (LGD) &
exposure at risk (EAD)
EL = PD x LGD x EAD
Unexpected losses (UL) is the uncertainty
around EL and it is Standard deviation of EL

Expected Loss - Three Components

EXPECTED
LOSS Rs.

Probability
of Default
(PD) %

Loss
x

Given
Default

Loan Equivalent
Exposure Rs

(Severity) %
What is the
probability of the
counterparty
defaulting?

If default occurs,
how much of this
do we expect to
lose?

If default occurs,
how much
exposure do we
expect to have?

Credit Risk Rating Framework

Use of credit rating models and credit
rating analysts
Loans to individuals or small businesses,
credit quality is assessed through credit
scoring which is based on a standard
formulae which incorporates partys
information viz. annual income, existing
debts, other details such as homes
(rented or owned) etc.

Components of Credit Risk

Default Risk Risk that a borrower or
counterparty is unable to meet its
commitment
Portfolio Risk Risk which arises from the
composition / concentration of banks
exposure to various sectors
Two factors affect credit risk
Internal Factors Bank specific
External factors State of economy, size
of fiscal deficit etc.