CREDIT

MANAGEMENT
P.K.Mishra
1
Executive Director (Retd.)
Reserve Bank of India
CREDIT LIFE CYCLE THEORY

Credit
Creation

Credit Credit
Opport CREDIT Manage
unity ment

Credit
Completion
2
 AGENDA
Basics of credit management
Introduction of credit risk
management
Other issues

3
 INTRODUCTION
 Credit refers to
 Short Term Loans & Advances
 Medium / Long Term Loans

 Off-Balance Sheet Transactions

 Management refers to
 Pre-sanction appraisal
 Documentation

 Disbursement and Disbursal

 Post-lending supervision and control

4
 CREDIT MANAGEMENT
Credit Management now
includes
„ Capital adequacy norms
„ Risk Management including ALM
„ Exposure Norms
„ Pricing policy and credit risk rating
„ IRAC norms (Income Recognition & Asset
Classificstion)
 „ Appraisal, credit-decision making and loan
review mechanism 5
 APPROACH FOR SAFETY OF LOANS
 Safety of loans is directly related
 „ To the basis on which decision to
lend is taken
„ Type and quantum of credit to be
provided
„ Terms and conditions of the loan

6
APPROACH FOR SAFETY OF LOANS
 The business of lending is not without certain
inherent risks, especially when the lending banks
depend largely on borrowed funds. The SIX
cardinal principles of lending are:
a) Safety

b) Liquidity

c) Profitability

d) Purpose

e) Diversification of Risks and

f) Security
7
APPROACH FOR SAFETY OF LOANS
a) Safety:
 Safety first is the most important principle of
good lending
 Safety of loans is directly related

„ To the basis on which decision to lend is

taken
„ Type and quantum of credit to be
provided
„ Terms and conditions of the loan

8
APPROACH FOR SAFETY OF LOANS
 The repayment of loans depend upon the
borrower’s
1) Capacity to pay

2) Willingness to pay and

3) Income generation

 The banker must, therefore, take utmost care in

ensuring that the enterprise or business for
which a loan is sought, is a sound one and the
borrower is capable of carrying it out
successfully.
9
APPROACH FOR SAFETY OF LOANS
b) Liquidity:
 It is to be seen that money lent is not going to be
locked up for a long time
 The money should return to the bank as per the
repayment schedule
 About 70% of the deposits collected are repayable
within a year, so funds advanced should be for
working capital and not for term loans of above
three years.

10
APPROACH FOR SAFETY OF LOANS
c) Profitability:
 A fair return on investment is essential so also in
the case of lending by banks.
 banks are commercial organisations and profit
earning is the motto of the banks to pay adequate
dividend to the shareholders.
 The interest margin of 3 to 4% between lending
and borrowing is essential to meet their
administrative expenses.
 There is a direct relationship between profit and
pricing of credit or service offered by a banker
11
APPROACH FOR SAFETY OF LOANS
d) Purpose:
 Loans for undesirable and speculative purposes
cannot be granted.
 Although the earnings on such business activities
may be higher, even then a bank cannot resort to
these loans
e) Diversification of Risks:
 It means that the banker should not grant
advances to only a few business houses,
undertakings, cities, industries and regions.
 It should be ensured that advances are 12
diversified in a good number of customers.
APPROACH FOR SAFETY OF LOANS
f) Security:
 The security offered against the loans may
consist of a large variety of items.
 It may be a plot of land, building, flat, shop,
ornaments. insurance policies, shares,
debentures etc.
 There may be cases where there is no security
except the personal security.
 The banker must realise that it is only a cushion
to fall back upon in case of need. The security
must be adequate and readily marketable, easy
13
to handle and free from encumbrances.
 APPROACH FOR SAFETY OF LOANS....
Two-pronged approach
 Pre-Sanction appraisal
 To determine the ‘bankability’ of each loan
proposal
 Post-Sanction control
 To ensure proper documentation, follow-up
and supervision

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 PRE-SANCTION APPRAISAL
 Concerned with measurement of risk(iness) of a
loan proposal
 Requirements are:
 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
 Credit Report (CR) needs to be regularly updated
 Appraisal should reveal whether a loan proposal
is a fair banking risk 15
 POST-SANCTION APPRAISAL
 Depends to large extent upon findings of
pre-sanction appraisal
 Requirements are:
 Documentation of the facility and ‘after care’ follow-
up
 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. 16
 BANKERS’ CREDIT REPORT
 Includes seeking information
including other banks – (writing or
over telephone etc.)
 Sharing of information could be a
sensitive issue
 Advisable to take an undertaking from
customers
 Make the condition as part of account
opening form or loan application 17
 TYPES OF LOANS AND ADVANCES
 Working Capital Finance
 Extended to meet day-to-day short term
operational requirements (sales &
purchase of commodities, purchase of
raw materials etc.)
 Loan for setting up new project, expansion
and diversification of existing project etc.
 Short term or medium term

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 LOANS AND ADVANCES.....
 Difference between Loans and Advances
 Loans are extended in accounts in which no drawings are
permitted to the borrowers
 Generally there is one debit to principal amount to loan
account –though disbursal in stages is possible depending
on the need of the borrower
 For operational purposes loan can be credited to a special
account where withdrawal from time to time can be done
by the party depending upon his requirements
 In case of advances, the sanctioned limit is placed at the
disposal of the borrower, subject to terms of sanction, in
running accounts which can be drawn upon by cheques by
the borrower 19
 LOANS AND ADVANCES.....
 Working capital finance in form of loan is
also known as demand loan
 As an advance it is commonly known as
cash credit facility
 Banks apart from working capital and
medium term and long term finance may
also extend casual overdrafts to approved
customers
 In current accounts
 Loans against security of shares, FDs, 20

housing loans etc.

TANDON COMMITTEE ON MPBF

 In 1974, a study group under the chairmanship of

Mr. P. L. Tandon was constituted for framing
guidelines for commercial banks for follow-up &
supervision of bank credit for ensuring proper
end-use of funds.
 The group submitted its report in August 1975,
which came to be popularly known as Tandon
Committee Report on Working Capital.
 Its main recommendations related to norms for
inventory and receivables, the approach to
lending, style of credit, follow ups & information
system. 21
TANDON COMMITTEE ON MPBF
 It was a landmark in the history of bank lending
in India. With acceptance of major
recommendations by Reserve Bank of India, a
new era of lending began in India.
 Tandon committee’s recommendations

 Breaking away from traditional methods of

security oriented lending, the committee
urged upon the banks to move towards need
based lending.
 The committee pointed out that the best security
of bank loan is a well functioning business
22
enterprise, not the collateral.
TANDON COMMITTEE ON MPBF
 Major recommendations of the Tandon
committee were as follows:
1. Assessment of need based credit of the borrower
on a rational basis on the basis of their business
plans.
2. Bank credit would only be supplementary to the
borrower’s resources and not replace them, i.e.
banks would not finance one hundred percent of
borrower’s working capital requirement.
3. Bank should ensure proper end use of bank
credit by keeping a closer watch on the borrower’s
business, and impose financial discipline on them. 23
TANDON COMMITTEE ON MPBF
4. Working capital finance would be available to
the borrowers on the basis of industry wise
norms (prescribed first by the Tandon
Committee and then by Reserve Bank of India)
for holding different current assets, viz.
 Raw materials including stores and others
items used in manufacturing process.
 Stock in Process.
 Finished goods.
 Accounts receivables.

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TANDON COMMITTEE ON MPBF
 Credit would be made available to the borrowers
in different components like cash credit; bills
purchased and discounted working capital, term
loan, etc., depending upon nature of holding of
various current assets.
 In order to facilitate a close watch under
operation of borrowers, bank would require them
to submit at regular intervals, data regarding
their business and financial operations, for both
the past and the future periods.

25
TANDON COMMITTEE ON MPBF
 The Norms
 Tandon committee had initially suggested norms
for holding various current assets for fifteen
different industries. Many of these norms were
revised and the least extended to cover almost all
major industries of the country.
 The norms for holding different current
assets were expressed as follows:
 Raw materials as so many months’ consumption.
They include stores and other items used in the
process of manufacture.
 Stock-in-process, as so many months’ cost of 26

production.
TANDON COMMITTEE ON MPBF
 Finished goods and accounts receivable as so many
months’ cost of sales and sales respectively. These
figures represent only the average levels. Individual
items of finished goods and receivables could be for
different periods which could exceed the indicated
norms so long as the overall average level of finished
goods and receivables does not exceed the amounts as
determined in terms of the norm.
 Stock of spares was not included in the norms. In
financial terms, these were considered to be a small
part of total operating expenditure. Banks were
expected to assess the requirement of spares on case-
by-case basis. However, they should keep a watchful 27
eye if spares exceed 5% of total inventories.
TANDON COMMITTEE ON MPBF
 The norms were based on average level of holding
of a particular current asset, not on the
individual items of a group.
 For example, if receivables holding norms of an
industry was two months and an unit had
satisfied this norm, calculated by dividing annual
sales with average receivables, then the unit
would not be asked to delete some of the accounts
receivable, which were being held for more than
two months.

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TANDON COMMITTEE ON MPBF
 The Tandon committee while laying down the norms
for holding various current assets made it very clear
that it was against any rigidity and straight
jacketing.
 On one hand, the committee said that norms were to
be regarded as the outer limits for holding different
current assets, but these were not to be considered to
be entitlements to hold current assets upto this level.
 If a borrower had managed with less in the past, he
should continue to do so. On the other hand, the
committee held that allowance must be made for some
flexibility under circumstances justifying a need for
re-examination. 29
TANDON COMMITTEE ON MPBF
 The committee itself visualized that there might
be deviations of norms in the following
circumstances.
1. Bunched receipt of raw materials including
imports.
2. Interruption of production due to power cuts,
strikes or other unavoidable circumstances.
3. Transport delays or bottlenecks.
4. Accumulation of finished goods due to non-
availability of shipping space for exports or other
disruption in sales.
30
TANDON COMMITTEE ON MPBF
5. Building up of stocks of finished goods, such as
machinery, due to failure on the part of the purchaser
for whom these were specifically designed and
manufactured.
6. Need to cover full or substantial requirement of raw
materials for specific export contract of short
duration.
 While allowing the above exceptions, the committee
observed that the deviations should be for known and
specific circumstances and situation, and allowed only
for a limited period to tide over the temporary
difficulty of a borrowing unit. Returns to norms would
be automatic when conditions return to normal. 31
TANDON COMMITTEE ON MPBF
 Methods of Lending
 The lending framework proposed by Tandon
Committee dominated commercial bank lending in
India for more than 20 years and its continues to do
so despite withdrawal of mandatory provision of
Reserve Bank of India in 1997.
 As indicated before, the essence of Tandon
Committee’s recommendations was to finance
only portion of borrowers working capital needs not
the whole of it. It was thought that gradually, the
borrower should depend less on banks to fund its
working capital needs 32
TANDON COMMITTEE ON MPBF
 From this point of view the committee recommended three
graduated methods of lending, which came to be known as
maximum permissible bank finance system or in short
MPBF system.
 For the purpose of calculating MPBF of a borrowing unit,
all the three methods adopted equation:
 Working Capital Gap = Gross Current Assets – Accounts
Payable
 …. as a basis which is translated arithmetically as follows:
 Gross Current Assets Rs. ………………
 Less: Current Liabilities
 other than bank borrowings Rs. ……………….
 Working Capital Gap Rs. ………………. 33
TANDON COMMITTEE ON MPBF
 First method of lending
 The contribution by the borrowing unit is fixed at a
minimum of 25% working capital gap from long-
term funds. In order to reduce the reliance of the
borrowers on bank borrowings by bringing in more
internal cash generation for the purpose, it would
be necessary to raise the share of the contribution
from 25% of the working capital gap to a higher
level.
 The remaining 75% of the working capital gap
would be financed by the bank. This method of
lending gives a current ratio of only 1:1. This is 34
obviously on the low side.
TANDON COMMITTEE ON MPBF
 Second method of lending
 In order to ensure that the borrowers do enhance
their contributions to working capital and to
improve their current ratio, it is necessary to
place them under the second method of lending
recommended by the Tandon committee which
would give a minimum current ratio of 1.33:1.
 The borrower will have to provide a minimum of
25% of total current assets from long-term funds.
However, total liabilities inclusive of bank
finance would never exceed 75% of gross current
assets. 35
TANDON COMMITTEE ON MPBF
 As many of the borrowers may not be immediately in
a position to work under the second method of
lending, the excess borrowing should be segregated
and treated as a working capital term loan which
should be made repayable in installments.
 To induce the borrowers to repay this loan, it should
be charged a higher rate of interest. For the present,
the group recommends that the additional interest
may be fixed at 2% per annum over the rate
applicable on the relative cash credit limits.
 This procedure should be made compulsory for all
borrowers (except sick units) having aggregate
working capital limits of Rs.10 lakhs and over. 36
TANDON COMMITTEE ON MPBF
 Third method of lending
 Under the third method, permissible bank
finance would be calculated in the same manner
as the second method but only after deducting
four current assets from the gross current assets.
 The borrower’s contribution from long-term funds
will be to the extent of the entire core current
assets, as defined, and a minimum of 25% of the
balance current assets, thus strengthening the
current ratio further. This method will provide
the largest multiplier of bank finance.
37
TANDON COMMITTEE ON MPBF
 Core portion current assets were presumed to be that
permanent level which would generally vary with the
level of the operation of the business.
 For example, in case of stocks of materials the core line
goes horizontally below the ordering level so that when
stocks are ordered materials are consumed down the
ordering level during the lead time and touch the core
level, but are not allowed to go down further.
 This core level provides a safety cushion against any
sudden shortage of materials in the market or
lengthening of delivery time. This core level is
considered to be equivalent to fixed assets and hence,
was recommended to be financed from long-term
38
sources.
TANDON COMMITTEE ON MPBF
 MPBF or Maximum Possible Bank Finance -
Tandon Committee
 Example :

 Let total Current Assets of a

company is Rs. 560 lakhs and total Current
Liability is also Rs. 560
lakh. The current liability includes short te
rm bank borrowings of Rs. 360 lakhs.
 Calculate MPBF using Tandon Committee
recommendations Method-I
 Calculate MPBF using Tandon Committee
39
recommendations Method-II
TANDON COMMITTEE ON MPBF
 Solution:
 Method 1

 Current assets, CA = 560

 Current Liability, CL = 560

 Current Liability excluding bank finance =

560–360 = 200
 So Working capital Gap (WCG) = 560 - 200
= 360

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TANDON COMMITTEE ON MPBF
 Method-II
 Margin = 25 % of WCG

 = 25% of 360 = 90

 MPBF = WCG –Margin = 360 –90 = 270

 Existing bank borrowing = 360

 Hence excess bank finance = 360 –270 =90

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 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
42
 SECURITIES FOR LENDING....
 Two types: Primary and Collateral
 Primary Security – Generally from a viable and
professionally managed enterprise
 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.

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 SECURITIES FOR LENDING....
 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)

44
 PRECONDITIONS OF LOANS
 Willingness or intention to repay as per
agreement
 Relatively easier to assess
 Determined by good track record of payments and
debt servicing
 Uncertain / uncontrollable events could affect the
judgment
 Purpose for which loan is sought
 Should be documented carefully
 Type of loan applied for - Working capital loan, term loan,
personal loan etc.
 Conditions which can set the trend of 45
future
 CONDITIONS DETERMINING
FUTURE TRENDS

Threefactors which can

undergo changes:
 Prospects
 Futurerisk profile
 Repayment capacity

46
 TOOLS FOR DETERMINING FUTURE
TRENDS

 Financial Analysis – past and projected

 Credit rating

 Assessment of credit needs

 Terms of sanction

 Documentation and creation of security interest

 Post-lending supervision – 3 stages

 Regular surprise verification of security
 Stock audit
 Obtaining and scrutiny of control statement (stock
statements, financial statements)
 Repayment and / or rollover 47
 RISKS IN BANK LENDING
CreditRisk
Market Risk
Operational Risk

48
 CREDIT RISK
 RESERVE BANK OF INDIA defines credit risk
as:
 „ the possibility of losses associated with
diminution in the credit quality of borrowers or
counterparties. In a bank’s 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. 49
 CREDIT RISK MANAGEMENT
Credit Risk is defined, “as the
potential that a borrower or
counter-party will fail to meet its
obligations in accordance with
agreed terms”
It is the probability of loss from
a credit transaction
50
 CREDIT RISK MANAGEMENT...
 According to Reserve Bank of India, the following
are the forms of credit risk:
 Non-repayment of the principal of the loan and/or
the interest on it
 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
counter-parties 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
51
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 products and activities

52
PRUDENTIAL NORMS FOR APPROPRIATE
CREDIT RISK ENVIRONMENT
 Norms for Capital Adequacy
 Exposure Norms
 Credit Exposure and Investment Exposure Norms to
individual and group borrowers
 Capital Market Exposures
 Banks-specific internal exposure limits

 IRAC norms
 Credit rating system and risk pricing policy

 ALM

 Norms for setting up loan policy

53
FRAMEWORK FOR CREDIT RISK
MANAGEMENT

 CRM framework includes:

 Policy framework: requires the following distinct
building blocks: (1) Strategy and policy, (2)
organization, and (3) operations/systems
 Credit risk rating framework
 Credit risk limits
 Credit risk modeling
 RAROC pricing (Risk-adjusted Return on Capital)
 Risk mitigants
 Loan review mechanism/credit audit

54
 POLICY FRAMEWORK
 Strategy and Policy:
 Credit policies and procedures of banks should
necessarily have the following elements:
 Written policies defining target markets, risk acceptance
criteria, credit approval authority, credit origination and
maintenance procedures and guidelines for portfolio
management and remedial management
 Systems to manage problem loans to ensure appropriate
restructuring schemes
 A conservative policy for the provisioning of non -performing
advances should be followed
 Consistent approach towards early problem recognition,
classification of problem exposures, and remedial action
 Maintain a diversified portfolio of risk assets in line with the
capital desired to support such a portfolio
 Procedures and systems, which allow for monitoring financial
55
performance of customers and for controlling outstanding
within limits
 POLICY FRAMEWORK...
 Organizational Structure
 Banks should have an independent group responsible
for the CRM
 Responsibilities to include formulation of credit policies,
procedures and controls extending to all of its credit risk
arising from corporate banking, treasury, credit cards,
personal banking, trade finance, securities processing,
payments and settlement systems
 Board of Directors should have the overall responsibility
for management of risks
 The Board should decide the risk management policy of
the bank and set limits for liquidity, interest rate,
foreign exchange and equity price risks
56
 POLICY FRAMEWORK...
 Risk Management Committee will be a Board level Sub
committee including CEO and heads of Credit, Market
and Operational Risk Management Committees. It will
devise the policy and strategy for integrated risk
management containing various risk exposures of the
bank including the credit risk
 RMC should effectively coordinate between the Credit
Risk Management Committee (CRMC), the Asset
Liability Management Committee and other risk
committees of the bank, if any

57
 POLICY FRAMEWORK...
 Operations / Systems
 Credit process typically involves the following
phases:
 Relationship management phase, that is, business
development
 Transaction management phase to cover risk
assessment, pricing, structuring of the facilities,
obtaining internal approvals, documentation, loan
administration and routine monitoring and
measurement, and
 Portfolio management phase to entail the monitoring
of portfolio at a macro level and the management of
problem loans.
58
 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 party’s
information viz. annual income, existing
debts, other details such as homes (rented
or owned) etc.
59
 CREDIT RISK LIMITS
 Bank generally sets an exposure credit limit for each
counterparty to which it has credit exposure
 Depending on the assessment of the borrower (commercial
as well as retail) a credit exposure limit is decided for the
customer, however, within the framework of a total credit
limit for the individual divisions and for the company as a
whole
 Also within the limit as per RBI, i.e. not more than 20% of
capital to individual borrower and not more than 40% (50%
for UCBs) of capital to a group borrower
 Threshold limits are set which are dependent upon
 Credit rating of the borrower
 Past financial records
 Willingness and ability to repay 60

 Borrower’s future cash flow projections

 CREDIT RISK MODELLING
 Credit risk models used by banks are (1)
Altman’s Z score model, (2) Credit metrics
model, (3) Value at risk model, (4) KMV
Model
 Altman’s Z Score Model
 95 % accuracy of prediction of bankruptcy up
to two years prior to failure on non-
manufacturing firms as well

61
 ALTMAN’S Z SCORE MODEL
 Altman (Edward I. Altman) Z-Score variables influencing the
financial strength of a firm are: current assets, total assets, net
sales, interest, total liability, current liabilities, market value of
equity, earnings before taxes and retained earnings
 Z = 0.012T1 + 0.014T2 + 0.033T3 + 0.006T4 + 0.999T5
 Where ,
 T1 = working capital / Total assets
 T2 = Retained earnings / Total assets
 T3 = Earnings before interest and taxes / Total assets
 T4 = Market value of equity / Book value of total liabilities
 T5 = Sales / Total assets
 Z score of the firm is
 3 or more – Safe
 2.8 to 3 – Probably safe
 1.8 to 2.7 – Likely to be bankrupt within 2 years
62
 Below 1.8 – Highly likely headed for bankruptcy
 CREDIT METRICS MODEL
 Tool for assessing portfolio risk due to changes in
debt value caused by changes in obligor credit
quality
 Credit Metrics has the following applications:
 Reduce the portfolio risk
 Limit setting
 Identifying the correlations across the portfolio so
that the potential concentration may be reduced and
the portfolio is adequately diversified across the
uncorrelated constituents
 Concentration may lead to an undue accumulation of risk
at one point
63
 VALUE AT RISK MODEL
 Defined as an estimate of potential loss in
asset / portfolio over a given holding
period at a given level of certainty
 Value at risk is calculated by constructing
a probability distribution of the portfolio
values over a given time horizon
 The values may be calculated on the daily,
weekly or monthly basis

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 KMV MODEL
 Developed by KMV Corporation based on Merton’s (1973)
analytical model
 Firm would default only if its asset value falls below certain level
(default point), which is a function of its liability
 Estimates the asset value of the firm and its asset volatility from
the market value of equity and the debt structure in the opinion
theoretic framework
 A metric (distance from default or DFD) is constructed that
represents the number of standard deviation that the firm’s asset
value is away from the default point
 Finally, a mapping is done between the default values and actual
default rate, based on historical default experience to give
Expected Default Frequency (EDF)
 Estimation of asset value and asset volatility from equity value and volatility of
equity return,
 Calculation of DFD
 DFD = (Asset value – Default point) / (Asset value x Asset volatility)
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 Calculation of expected default frequency
 RISK ADJUSTED RETURN ON CAPITAL
(RAROC)
 Based on a mark-to-market concept
 Allocates a capital charge to a transaction or a line of
business at an amount equal to the maximum expected loss
(at a 99 percent confidence level)
 The four basic steps in the process are:
 Determine basic risk categories – interest rate risk,
credit risk, operational risk, forex risk etc.
 Quantify the risk in each category
 RAROC risk factor = 2.33 x weekly volatility x square root of 52 x (I –
tax rate)
 2.33 gives the volatility (expressed as per cent) at the 99% confidence
level
 52 converts the weekly price movement into an amount movement
 (I – tax rate) converts the calculated value to an after - tax basis
Compute the capital required for each category by
multiplying the risk factor by the size of the position 66

RAROC – Risk-adjusted Return on Capital of Basel II

 RISK MITIGANTS
 Credit risk mitigation means reduction of credit risk in an
exposure by a safety net of tangible and realisable
securities including third-party approved
guarantees/insurance
 Various risk mitigants are:
 Collateral (tangible, marketable) securities
 Guarantees
 Credit derivatives
 On-balance-sheet netting

 Conditions for use of credit risk mitigants

 All documentation used in collateralized transactions must be
binding on all parties and must be legally enforceable in all
relevant jurisdictions
 Banks must have properly reviewed all the documents and 67
should have appropriate legal opinions to verify such, and
ensure its enforceability
 LOAN REVIEW MECHANISM/CREDIT
AUDIT
 Credit audit examines the compliance with
extant sanction and post-sanction processes and
procedures laid down by the bank from time to
time
 The objectives of credit audit are:
 Improvement in the quality of credit portfolio
 Review of sanction process and compliance status of
large loans
 Feedback on regulatory compliance
 Independent review of credit risk assessment
 Pick-up of early warning signals and suggest
remedial measures, and 68

 Recommend corrective actions to improve credit

quality, credit administration, and credit skills of
RBI GUIDELINES ON CREDIT EXPOSURE
& MANAGEMENT
 Credit exposure to an individual borrowers not to
exceed 20% of capital funds
 Group borrowers exposure not to exceed 50% of
capital funds
 Aggregate ceiling in unsecured advances should not
exceed 33.33 % of total DTL of the bank
 Bank cannot grant loans against security of its own
shares
 Restrictions on loans and advances to Directors and
their relatives
 Ceiling on advances to Nominal Members –With
deposits up to Rs. 50 crore (Rs. 50,000/- per borrower) 69
and RS. 1,00,000/- for above Rs. 50 crore
RBI GUIDELINES ON CREDIT EXPOSURE
& MANAGEMENT
 Prohibition on UCBs for bridge loans including
that against capital / debentures issues
 Loan and advances against shares, debentures
 UCBs are prohibited from permitted to extend any
facilities to stock brokers
 Margin of 40 per cent to be maintained on all such
advances
 Restriction on advances to real estate sector –
only for genuine construction and not for
speculative purposes

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 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 bank’s exposure to
various sectors
 Two factors affect credit risk
 Internal Factors – Bank specific
 External factors – State of economy, size of fiscal
deficit etc.

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 MANAGING INTERNAL FACTORS
 Adopting proactive loan policy
 Good quality credit analysis
 Loan monitoring
 Sound credit culture

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 MANAGING EXTERNAL FACTORS
 Well diversified loan portfolio
 Scientific credit appraisal for assessing
financial and commercial viability of loan
proposal
 Norms for single and group borrowers

 Norms for sectoral deployment of funds

 Strong monitoring and internal control

systems
 Delegation and Accounatbility
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 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
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THANK YOU

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 An adjustment to the return on
an investment that accounts for the element of
risk. Risk-adjusted return on capital
(RAROC) gives decision makers the ability to
compare the returns on several different projects
with varying risk levels. RAROC was popularized
by Bankers Trust in the 1980s as an adjustment
to simple return on capital (ROC).
Revenue-Expenses-Expected loss + income from capital

RAROC=

Capital
Value at Risk (VaR)
 In financial mathematics and financial risk
management, Value at Risk (VaR) is a widely used risk
measure of the risk of loss on a specific portfolio of financial
assets. For a given portfolio, probabilityand time horizon,
VaR is defined as a threshold value such that the
probability that the mark-to-marketloss on the portfolio
over the given time horizon exceeds this value (assuming
normal markets and no trading in the portfolio) is the given
probability level.
 For example, if a portfolio of stocks has a one-day 5% VaR
of Rs.1 million, there is a 0.05 probability that the portfolio
will fall in value by more than Rs.1 million over a one day
period if there is no trading. Informally, a loss of Rs.1
million or more on this portfolio is expected on 1 day in 20.
A loss which exceeds the VaR threshold is termed a “VaR
break.”