Crmdsm

Credit Risk Management & Debt Servicing Management (CRM &

DSM) by

Dinesh G. Mahabal

Agenda Anatomy of Risk What is Credit Risk Historical Perspective for Management of Cr

Risk at Indian Fin Institutions Why Credit Risk Management Task of Credit Risk Department Risk Management Process/ Cycle Building Blocks of Credit Risk Management

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Anatomy of Risk

What is Risk? Risk is the potential / probability for loss,

either directly through loss of earnings or capital or indirectly through the imposition of constrains on organization's ability to meet its business objectives.

RBI definition “Risk is defined as the probability of the

unexpected happenings- the probability of suffering a loss”. (Ref. RBI Guidance Note dated 12th October 2002)

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Anatomy of Risk

Banks during the process of financial intermediation are confronted with various kinds of financial and non-financial risks viz. credit, interest rate, foreign exchange rate, liquidity, equity price, commodity price, legal, regulatory, reputational, operational etc. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories.

Banks, therefore; attach considerable importance to improve the ability to implement the “Risk Cycle” functions consisting of four parameters i.e. identify, measure, monitor and control (IMMC) the overall level of risks undertaken.

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Anatomy of Risk

Lending function in particular involves a number of risks such as interest rate, forex and country risks in addition to the basic risk related to creditworthiness of the counterparty.

Credit risk or default risk involves inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, hedging, settlement and other financial transactions. The Credit Risk is generally made up of transaction risk or default risk and portfolio risk.

The portfolio risk in turn comprises intrinsic and concentration risk. The credit risk of a bank’s portfolio depends on both external and internal factors.

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Types of Risks for a Financial Company Market Risk: 1. Liquidity, 2. Interest Rate, 3. Currency/Forex, 4. Equity Price & 5. Commodity Price Operational Risk: The risk of loss resulting from inadequate or failed internal

processes, people and systems or from external events {includes legal risk but specifically excludes strategic (adverse business decisions) and reputational (risk of negative public opinion) risk}

People, Process, Management, Systems, Business and External Credit Risk: Transaction- Default, Delayed

Repayment, Downgrade Portfolio- Intrinsic, concentration

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Market Risk1. Liquidity is the ability to efficiently accommodate deposit and other liability decreases, as well as, fund growth in loan portfolio and the possible funding of off-balance sheet claimsThe liquidity risk manifests in three dimensions viz. a) Funding Risk – need to replace net outflows due to unanticipated withdrawals

/ non-renewal of depositsb) Time Risk – need to compensate for non-receipt of expected inflows of funds

i.e. performing assets turning into NPAc) Call Risk – due to crystallization of contingent liabilities and unable to

undertake profitable business opportunities when desired.

2. Interest Rate Risk: Risk arising due to the changes in the interest rates on assets and or liabilities which may be due to re-pricing, embedded options, basis risk or yield curve riskd) Gap or mismatch risk:- arises out of holding assets / liabilities and off-

balance sheet items with different principle amounts, maturity dates or repricing dates thereby causing exposures to unexpected changes in ROI

e) Basis risks arises when interest on assets and liability are fixed on different basis such as interest on loans is linked to LIBOR and rate on deposits is linked with bank rate or call money market rates

f) Re-pricing risk:- arises due to the changes in rate of interest on the date of maturity of an asset or liability. In such a case even if the period of re-pricing is the same, change in interest rate may be in different directions.

g) Embedded options are the options available to the depositors for repayment of deposits and borrowers to repay the loan before maturity

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Market Risk3. Currency/ Forex Risk :Three dimensional classification of

Currency Risk exposure covers: Transaction Exposure i.e. exposure on account of foreign

currency receipts (i.e. exports, etc.) or payments (i.e. imports, etc.). Adverse movements of concerned foreign currency against domestic currency involve loss of domestic funds. For example: depreciation of foreign currency against domestic currency in an export transaction and appreciation of foreign currency against domestic currency in an import transaction.

Translation Exposure / Accounting Exposure i.e. conversion of foreign currency into domestic currency periodically for the purpose of Statement of Accounts. Adverse movements will have their ultimate effect on bottom-line and/or Balance Sheet ‘footing’.

Economic Exposure i.e. adverse movements affecting competitive edge with eventual repercussions on the bottom-line of the organization.

4. Equity Risk arises out of exposure to capital market instruments. Banks directly invest as also extend credit facilities, both fund-based and non-funded, to their constituents (including Share Brokers) to enable them to participate in capital markets by way of purchase/sale transactions. In the process, Banks expose themselves through market risks associated with capital exposures

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Market Risk5. Commodity Price Risk:Any physical product such as agricultural products, metals, minerals, oil, gas, etc. available for trading in an organized market can be treated as ‘Commodity’ from risk management angle. Gold is treated as a foreign currency (under BASEL Committee guidelines) & hence the same is not classified under Commodity.Commodity of Trading is mainly prevalent in developed countries, with the availability of derivatives of hedge risk involved in commodity price fluctuations.However, Indian Banks hardly take up exposures in commodity trading. Commodity market often suffers from liquidity element. Commodity prices are very closely linked with seasonality in supply-demand position. Equilibrium prices are set up by inventory levels. Arising out of the aforesaid dominant aspects, following risk attributes are taken into

account in the evaluation of Commodity exposures: Risk of price movement in spot prices. Risk of price differential movement in the Commodities – different but related. Risk of change in cost o financing. Time spread risk and Option Risk.

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Operational Risk To understand what operational risk is, it is useful to consider the

standard “event types” provided by Basel and some actual losses (Impact) that have occurred in each Event Type & the cause/s thereof as follows:-

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Operational Risk

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Risk Profiles break up

6018

105 7

Risk Profiles of an Financial Organisation (%)

Credit Risk

Mkt. Risk

Liq. Risk

Op. Risk

Other Risks

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What is Credit Risk?As per RBI’s Guidance Note of Oct’02, “Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counterparties”..Thus, these losses, associated with changes in credit quality, could arise due to default (single or joint) or due to deterioration in credit quality.

– Default risk - obligor fails to service debt obligations– Recovery risk – recovery post default is uncertain– Spread risk – credit quality of obligor changes leading

to a fall in the value of the loan– Concentration risk – over exposure to a an individual

obligor, group or industry

– Correlation risk - concentration based on common risk factors between different borrowers, industries or sectors which may lead to simultaneous default.

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Identifying Elements of Credit Risk

Concentration Risk

Intrinsic/ Corelatio

n Risk

Portfolio Risk Individual Risk

Credit Risk

Downgrade Risk

Default Risk

Recovery Risk

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Credit Risk in Financial TransactionsDirect Lending: Interest / Installments not

repaid/ funds will not be availableGuarantees or Letters of Credit: funds will not

be forthcoming from the Guarantor upon crystallization of the liability

Treasury products: series of payments due from the counterparty cease or are not forthcoming

Trading: securities settlement is not effectedCross border exposure: free transfer of

currency is restricted or ceases

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Historical Perspective of Indian Practices in Credit Risk Management Traditional ratio analysis and post mortem of

balance sheet Collateral based lending – Often it is defensive

approach leading to a false sense of “security” Risk vs. return analysis – not fully adequate Credit limits on exposures - regulatory limits

insufficient Nepotism Risk vs. capacity to absorb risk in terms of

capital base and capital adequacy ratio

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Why should Banks be concerned with Credit Risk? Market Realities Structural increase in NPAs Concentrations in loan portfolios Capital market growth producing a “Winner’s Curse” effect i.e.

winner ending up with overpayment or getting less value for the spent.

Competitive margins despite decline in avg. quality of loans Declining and volatile values of Collateral Growth of Off-balance sheet derivatives and Securitization

products Changing Regulatory Environments RBI endorsement of Risk based Capital

Requirements as per BIS regulations Risk Based Supervision

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Importance of Credit Risk ManagementImproves Bank Competitiveness and

PerformanceShareholder Value Creation / Increase

( RAROC & Economic Capital concepts) Value Creation : transaction management & active portfolio managementValue Preservation : portfolio managementCapital Optimization

Thus, Improve Risk Adjusted Returns for all stakeholders

Regulatory Compliance (Basel II / III)

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Why should Banks be concerned with Credit Risk?

Skewed nature of loan returns Loan returns are highly asymmetric since there is

limited upside If borrower’s credit quality improves - no benefit to

lending bank since the borrower can refinance his loan at a lower rate

If borrower’s credit quality declines - bank is not compensated for taking the additional risk since loan price is not revised

If borrower defaults - accrued interest is reversed and any new payments are towards principal

If borrower becomes NPA - minimal recovery

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Why Credit Risk Management?Recent Complexities Emergence : Seven Reasons to follow best Credit Risk Management Practices as a consequence of LPG (Liberalization, Privatization & Globalization) phenomenon

1. Globalization:- Leading to opening up of the economy to the outside world, thus becoming vulnerable to economic problems in the countries across the world.

2. Deregulation:-Business area expansion. Banks introduced new products/ services

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Why Credit Risk Management?3. Severe Competition: pressure on

margins, competitive pricing is the need.

4. Sophistication of existing products and additions of new complex products.

5. Advances in Technology: increase in volume and speed.

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Why Credit Risk Management?6. Regulatory Developments:- New

Laws, Rules and Regulations, Capital Adequacy Norms, Basel –II Guidelines

7. Business Transformation:- Organizational changes, new activities, expansion in operations.

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Segmentation of the credit portfolio (in terms of risk but not size)

Model Requirements (for risk assessments) Data requirements Credit risk reporting requirements for regulatory /

control and decision-making purposes at various levels

Policy requirements for credit risk (credit process & practices, monitoring & portfolio management etc.)

Align Risk Strategy & Business Strategy

The Task for Credit Risk Department

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The Task for Credit Risk Department Take informed credit decisions;

Set provisioning and reserve requirements;

Establish minimum pricing levels at which credit exposures to an obligor may be undertaken / extended (Base Rate)

Price credit risky instruments and facilities (Credit Spread);

Measure the regulatory capital charge –Standardized and IRB Approaches;

Measure the economic capital;

Calculate risk adjusted performance measures such as RAROC (adopt it as a common language).

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Risk Management Process

It is imperative that banks have a robust credit risk management system which is sensitive and responsive to the factors present in banking transactions.

The effective management of credit risk is a critical component of comprehensive risk management and is essential for the long term success of any banking organisation.

Credit risk management encompasses identification, measurement, monitoring and control of the credit risk exposures

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• Identify the Risks: Name and Define

• Measure the Risks: Size, Timing, Probability

• Monitor the Risks: Identify significant changes in

risk profile or controls

• Manage / Control the Risks: Avoiding, Mitigating,

Off-setting, diversifying

• Again Go to Step 1


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Identify

Monitor

MeasureControl RISK

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Credit Approval & Risk Management ProcessThe whole Process can be divided in to

Four Parts: Risk Analysis (Identification) Risk Control Risk Management - Front Office - Back office - Credit Audit - Inspection & Audit

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Risk Analysis

Segmentation of Borrower (Retail, Corporate- Centralized/ Unit Level Processing)

Source of Cash Flow (Object Finance, Project Finance)

Credit Appraisal (Pre Sanction Inspection, Validation of Data/ Documents, Carry out Rating (Industry, Business, Financial, Management), Adherence to Financial Benchmark, Collateral Valuation and Risk Assessment)

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Risk Analysis

Credit Approval Committee (Based on Amount and Rating- Multi Tier Approval)

Sanction (Amount and Rating- Multi Tier Sanction , Pricing based on Risk Rating)

Post Sanction Review by Next Higher Authority

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Risk Control

Single/ Group Borrower Exposure Substantial Exposure Exposure to Term Loan ( 3 years and

above Residual Maturity) Industry/ Sector Exposure Limit Sensitive Sector Limit (Capital Market,

Real Estate, NBFC/Leasing & Hire Purchase)

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Risk Control

Unsecured Advance (including Unsecured Guarantees)

Exposure to Non Corporate & Private Limited Co.

Rating wise Borrower Rating wise Exposure Geography wise Exposure

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Risk Control

Rating wise Probability of Default Off balance sheet Exposure Country Wise Exposure Higher level prior approval for additional

exposure in sensitive sectors Each Approval Committee has to have

cap on account/amount per sitting.

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Risk Management

Front Office:KYC Norms, Defaulters ListApproval acceptance of offer letter Documentation and its validationPost Sanction InspectionApproval for DisbursementEnd use of FundsInsurance

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Risk Management

Periodical inspection (unit and collateral ), Stock and Book Debt Inspection by External Auditors

Transaction Monitoring (End use, DP limit, cash transaction, sales transaction)

Identifying potential weak accounts by early warning signals ( excess drawing, delayed payment of obligations, adverse signals in particular industry, return of cheques, inadequate transaction)

Monthly monitoring – multi tier Annual Review (Rating and Exposure wise) MIS maintenance

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Risk Management Back Office Generating/Updating Industry reports/scores (annually,

half yearly) Preparing trigger reports Independent rating validation Migration of rating and PD estimation (Measurement of

risk) Portfolio reviews Risk Control Monitoring Quality Assurance (Policy Reviews, Appraisal

Methodology) Training and Upgradation of Skills of Employees

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Risk ManagementCredit AuditRecommend corrective action to improve credit

qualityDone within 6 months of sanctionInspection & AuditExternalConcurrent Audit at Unit level at select branchesConcurrent Audit for specific accountsInternalRisk Based Internal AuditInspection by controlling office at non-concurrent

audit units.Dinesh Mahabal 37

OBJECIVES OF RISK MANAGEMENT SYSTEM

The three long term objectives :

1. To make use of CREDIT RATING as the tool for Credit Risk Management (e.g. decision making,pricing, Asset Quality).

2. Arriving at a single number VALUE at RISK figure for the bank and allocation of capital to the business units to arrive at RAROC and judge the performance of business units based on RAROC.

3. Risk Management should not be treated merely a compliance function but be used as a business opportunity. Dinesh Mahabal 38

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Risk Management Best Practices

Integrated

Best Risk

Management

Practices

Best

Practices

Infrastructure

Best

Practices

Policies

Best

Practices

Methodologies

Integrated Best Risk Management Practices

Limit Management (Monitor, Identify and Avoid)

Risk Analysis (Stress Testing, Scenario Analysis, Market VaR, Credit VaR)

RAROC ( Pricing, Capital Allocation)Active Portfolio Management

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Best Practices Infrastructure

People (Skills)OperationsAccurate DataTechnology

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Identification of Risk

Identification of various risk elements in the given process and define the same

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Measurement & Monitoring of Credit Risk Every obligor and facility must be assigned a risk

rating. Mechanism to price facilities depending on risk

grading. Banks should ensure consistent standards for

loan origination documentation etc. Banks should have a consistent approach towards

early problem recognition, classification of problem exposures and remedial action.

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Measurement & Monitoring of Credit Risk

Banks should maintain a diversified portfolio of risk assets

Banks should set Credit Risk limits like borrower limit industry limits etc.

Banks to report comprehensive set of credit risk data into independent risk system.

Systems to be put in place for monitoring financial performance of customers and for controlling outstanding within limits.

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Measurement & Monitoring of Credit Risk

Conservative provisioning policy for NPA advances.

Thus the following procedure is to be followed towards managing the risk involved in credit:-

Carefully formulated scheme of lending powers. Setting-up Prudential Limits Measurement of risk through credit rating

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Building Blocks of Credit Risk Management

An effective credit risk management framework comprises of the following distinct building blocks:

a) Policy and Strategyb) Organisational Structurec) Operations/ Systems

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Policy and StrategyThe Board of Directors/ Highest level

committee of each bank/ organisation should be responsible for approving and periodically reviewing the credit risk strategy and significant credit risk policies

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Building Blocks of Credit Risk Management Credit Risk Policy Every bank should have a credit risk policy

document approved by the Board. The document should include risk identification, risk measurement, risk grading/ aggregation techniques, reporting and risk control/ mitigation techniques, documentation, legal issues and management of problem loans.

Credit risk policies should also define target markets, risk acceptance criteria, credit approval authority, credit origination/ maintenance procedures and guidelines for portfolio management.

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Credit Risk Policy The credit risk policies approved by the Board

should be communicated to branches/controlling offices. All dealing officials should clearly understand the bank’s approach for credit sanction and should be held accountable for complying with established policies and procedures.

Senior management of a bank shall be responsible for implementing the credit risk policy approved by the Board.

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Building Blocks of Credit Risk Management Credit Risk Strategy Each bank should develop, with the approval of its Board,

its own credit risk strategy or plan that establishes the objectives guiding the bank’s credit-granting activities and adopt necessary policies/ procedures for conducting such activities. This strategy should spell out clearly the organisation’s credit appetite and the acceptable level of risk-reward trade-off for its activities.

The strategy would, therefore, include a statement of the bank’s willingness to grant loans based on the type of economic activity, geographical location, currency, market, maturity and anticipated profitability. This would necessarily translate into the identification of target markets and business sectors, preferred levels of diversification and concentration, the cost of capital in granting credit and the cost of bad debts

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Building Blocks of Credit Risk Management Credit Risk Strategy The credit risk strategy should provide continuity

in approach as also take into account the cyclical aspects of the economy and the resulting shifts in the composition/ quality of the overall credit portfolio. This strategy should be viable in the long run and through various credit cycles.

Senior management of a bank shall be responsible for implementing the credit risk strategy approved by the Board

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Building Blocks of Credit Risk ManagementOrganisational StructureSound organizational structure is sine qua

non for successful implementation of an effective credit risk management system.

The organizational structure for credit risk management should have the basic feature of Independence and arm’s length dealings within the organisation.

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Operations / Systems Banks should have in place an appropriate credit

administration, credit risk measurement and monitoring processes. The credit administration process typically involves the following phases:

Relationship management phase i.e. business development

Transaction management phase covers risk assessment, loan pricing, structuring the facilities, internal approvals, documentation, loan administration, on going monitoring and risk measurement.

Portfolio management phase entails monitoring of the portfolio at a macro level and the management of problem loans.

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Lessons Learned

Risk Appetite says

“Take risks: if you win, you will be happy;if you lose, you will be wise”

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Thank You…

[email protected]

Crmdsm

Economy & Finance

rate risk

portfolio risk

risk of loss

default risk

legal risk

funding risk

area of risk

mismatch risk