CHAPTER - VI

CHAPTER -VI

CREDIT RISK MANAGEMENT

■ INTRODUCTION
- PRINCIPLES OF ASSESSMENT OF CREDIT RISK
> APPROPRIATE CREDIT RISK ENVIRONMENT
> SOUND CREDIT GRANTING PROCESS
> APPROPRIATE CREDIT ADMINISTRATION, MEASUREMENT &
MONITORING PROCESS
> ADEQUATE CONTROLS OVER CREDIT RISK
> ROLE OF MANAGEMENT

■ MICRO LEVEL APPROACH

> EVALUATION OF PROPOSALS
> PRICING
> MONITORING

■ MACRO LEVEL APPROACH

> NPA MANAGEMENT
> MANAGEMENT OF CONTINGENT RISK

■ CONCLUSION

■ REFERENCES
CREDIT RISK MANAGEMENT

Introduction:
Banks in India under the FSR have been given freedom by RBI to formulate their own
policies & procedures. RBI has also implemented various international measures &
practices for banks in India to follow which include adoption of comprehensive system of
prudential accounting norms of assets classification, identification of NPAs and
providing provisioning there against, a system of capital adequacy etc. Banks are now
operating in global environment which is not only competitive but uncertain & risky too.
To be able to operate in complex and competitive international environment banks in
India are developing technology supported innovative and varied products & services so
as to provide better and faster comprehensive service to their corporate and individual
customers. Further, under the globalisation & deregulation policies banks are now faced
with different business related risks & control related risks. The business related risks are
linked with banks various operational activities i.e. credit risk & also dynamism of
prevalent market environment which include liquidity risk, Interest rate risk, foreign
exchange risk etc. On the other hand control related risk in banks arises out of
absence/lack of control & supervisory systems and norms.
Due to growing complexities in banking business leading to various risks it became
imperative for the banks to develop proper organisational setup, control mechanisms &
systems and appropriate risk management policies indicating the tolerance limits to
different business managers. In subsequent chapters we have examined various market
related risks in banking business. In this chapter we focus exclusively on credit risk
management in banks.
Credit risk is most simply defined as the potential that a bank borrower will fail to meet
its obligations in accordance with agreed terms. The goal here therefore is to maximise a
bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable
parameters. Banks arc increasingly facing credit risks and therefore, need to manage the
credit risk inherent in the entire portfolio as well as the risk in individual credits or
transactions. The loans and advances are the largest and most obvious source of credit

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risk. Therefore, effective management of credit risk is essential to the long-term success
of any banking organisation.
Since exposure to credit risk continues to be the leading source of problems in
banking business all over, bank management and their business managers should be able
to draw useful lessons from past experiences. Banks should now have a keen awareness
of the need to identify, measure, monitor and control credit risk as well as to determine
that they hold adequate capital against these risks and that they are adequately
compensated for risks incurred. There is urgent need for standardised sound practices that
specifically address the following areas:
(i) Establishing an appropriate credit risk environment,
(ii) Operating under a sound credit granting process,
(iii) Maintaining an appropriate credit administration, measurement and
monitoring processes, and, last but not the least,
(iv) Ensuring adequate controls over credit risk.
Credit risk management practices may differ from bank to bank depending
upon the nature and complexity of their credit activities. However, a comprehensive
credit risk management program should address the above four areas. These practices
should also be applied in conjunction with sound practices related to the assessment of
asset quality, the adequacy of provisions and reserves, and the disclosure of credit risk,
all of which have been addressed in recent Basel Committee documents as discussed in
Chapter II on Literature Survey. While the exact approach chosen by individual banks
will depend on a host of factors, including on-site and off-site supervisory techniques and
the degree to which external auditors are also used in the inspection and supervisory
function.
Any commercial bank can manage majority of its risks by implementing sound ALM
policy basically catering to its Liquidity & Interest rate risks. Even if the commercial
bank is able to check these risks it would be able to enhance its profitability along with
maintaining adequate liquidity. As discussed in earlier chapters, the profitability and
liquidity of a commercial bank is mainly dependent on the cash flows. Any delay in cash
inflows by way of default in loan repayments, etc, can lead to a chaos as all estimates
regarding the interest rate risk levels and liquidity may go for a toss .Cases of default of

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loans gives rise to low quality assets, leading to credit risk. This risk is inherent to any
commercial hank. As said earlier credit risk has an intricate linkage with interest rate risk
and liquidity risk making it all the more crucial for the commercial bank. Any error in
estimating the credit risk can lead to a situation wherein a commercial bank may have to
face severe liquidity crunch. Similarly, a highly volatile interest rate environment may
lead to deterioration in the quality of credit .Hence management of credit risk is an
essential part of ALM. In other words, the interest rate risk management and liquidity risk
management policies of a commercial bank must be supplemented by a well laid down
credit policy to manage the credit risk. Earlier, the credit policies of commercial banks
primarily focused on timely collection of dues. However, with market deregulation, there
has been an uncertainty in the operating environment of the commercial banks. Hence,
the credit risk management now involves evaluating and managing the growth and
diversification of loans/investments and establishing the tolerance limits for credit and
investment, i.e. the ratio of loan/investment loss allowance to total loans/investments.
The basic governing principles that have been recommended by the working committee
of the Group of ministers (GoM) of the G -10 countries and later endorsed by the Basel
committee are mentioned below:
Principles of the Assessment of Credit Risk1

A) Establishing an appropriate credit risk environment

B) Operating under a sound credit granting process
C) Maintaining an appropriate credit administration, measurement and
monitoring process
D) Ensuring adequate controls over credit risk
E) The role of bank management
A. Establishing an appropriate credit risk environment
1) The board of directors should have responsibility for approving and
periodically reviewing the credit risk strategy and significant credit risk policies of the
bank. The strategy should reflect the bank’s tolerance for risk and the level of
profitability the bank expects to achieve for incurring various credit risks.
2) Senior management should have responsibility for implementing the credit risk
strategy approved by the board of directors and for developing policies and procedures

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for identifying, measuring, monitoring and controlling credit risk. Such policies and
procedures should address credit risk in all of the bank’s activities and at both the
individual credit and portfolio levels.
3) Banks should identify and manage credit risk inherent in all products and activities.
Banks should ensure that the risks of products and activities new to them are subject to
adequate procedures and controls before being introduced or undertaken, and approved in
advance by the board of directors or its appropriate committee.
B. Operating under a sound credit granting process
1) Banks must operate under sound, well-defined credit-granting criteria. These criteria
should include a thorough understanding of the borrower or counterparty, as well as the
purpose and structure of the credit, and its source of repayment.
2) Banks should establish overall credit limits at the level of individual borrowers and
counterparties, and groups of connected counterparties that aggregate in a comparable
and meaningful manner different types of exposures, both in the banking and trading
book and on and off the balance sheet.
3) Banks should have a clearly-established process in place for approving new credits as
well as the extension of existing credits.
4) All extensions of credit must be made on an arm’s-length basis. In particular, credits to
related companies and individuals must be monitored with
particular care and other appropriate steps taken to control or mitigate the risks of
connected lending.
C. Maintaining an appropriate credit administration, measurement and
monitoring process
1) Banks should have in place a system for the ongoing administration of their various
credit risk-bearing portfolios.
2) Banks must have in place a system for monitoring the condition of
individual credits, including determining the adequacy of provisions and reserves.
3) Banks should develop and utilize internal risk rating systems in managing credit risk.
The rating system should be consistent with the nature, size and complexity of a bank’s
activities.
4) Banks must have information systems and analytical techniques that

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enable management to measure the credit risk inherent in all on- and off-balance sheet
activities. The management information system should provide adequate information on
the composition of the credit portfolio, including identification of any concentrations of
risk.
35)' Banks must have in place a system for monitoring the overall composition and quality
of the credit portfolio.
6) Banks should take into consideration potential future changes in economic conditions
when assessing individual credits and their credit portfolios, and should assess their credit
risk exposures under stressful conditions,

D. Ensuring adequate controls over credit risk

1) Banks should establish a system of independent, ongoing credit review and the results
of such reviews should be communicated directly to the board of directors and senior
management.
2) Banks must ensure that the credit-granting function is being properly
managed and that credit exposures are within levels consistent with prudential
standards and internal limits. Banks should establish and enforce internal controls and
other practices to ensure that exceptions to policies, procedures and limits are reported in
a timely manner to the appropriate level of management.
3) Banks must have a system in place for managing problem credits and
various other workout situations.

E. The role of bank management

1) Bank Management should ensure that there is an effective system in place to identify,
measure, monitor and control credit risk as part of an overall approach to risk
management. They should conduct an independent evaluation of a bank’s strategies,
policies, practices and procedures related to the granting of credit and the ongoing
management of the portfolio. Further, they should also consider setting a prudential limits
to restrict bank exposures to single borrower or groups of connected counterparties.

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The Credit risk management is managed at two levels. First is the micro-level and the
second being macro-level. The micro-level credit risk management concentrates on each
credit transaction of the bank, whereas the macro-level credit risk takes into account the
total credit exposure of the bank.
Micro-Level Approach
Effective management of credit risk involves the following key principles:
# Evaluation of proposals
# Pricing of the financial product
II Monitoring of the credit
Evaluation of Proposals
Evaluation involves selection of borrowers basis their creditworthiness in the market.
One more important aspect that must be considered by the bankers while evaluating a
credit proposal is the willingness of the person availing the loan to repay, In India a large
chunk of Non - Performing Assets (NPAs) of the commercial banks are on account of
willful defaulters. Accordingly, a number of variables need to be considered while
evaluating a loan proposal. Prominent among them are:
a) Operational Efficiency
b) Financial Feasibility
c) Future prospects of the Industry
d) Management Evaluation
Operational Efficiency
To assess the operational efficiency of the corporate client credit evaluation is conducted
at the corporate level. The critical aspects that are generally evaluated are:
> Business Stability
> Increase in market share
> Accessibility to key inputs
> Economies of scale & its advantages to the concern
> Operating margins
Financial Feasibility
Repayment capacity of the customer is a direct variable of its financial strength. Hence,
financial analysis becomes sine - qua -non for the analysis of credit risk. This includes:

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> Interest/principal coverage & Debt servicing aspects
> Management of Interest rate risk
> Capacity to raise funds
> Financial leverage
> Management of working capital
> Cost of capital
> Sensitivity analysis
> Management of Exchange risk
Future Prospects ofIndustry
An industry level credit analysis needs to be performed to study the prospects of the
industry
which basically includes:
> Analysis of the trade cycles prevailing in the Industry
> Analysis of consumer demand curves and their changes
> Analysis of different regulations governing the Industry
> Threat from substitute products & impact of cheap imports
Management Evaluation
The abovementioned factors assess the repaying ability of the customer, Management
evaluation is concerned with the willingness of the customer to repay. This evaluation
takes into account an in depth study on the performance of the promoters, group
companies/sister concerns & the top management. Another important aspect that needs
to be considered by the bank before sanctioning credit is the exposure limits. The bank
should ensure that it maintains proper exposure limits for its credit sanctions. This helps
in diversifying the credit risk,
It basically takes into consideration the following aspects:
# Market review of the individuals, company/group of companies and industry
# Loan Product being disbursed
# Quantum of money being lent for the different types of borrowers and for varying
categories of loans;
# Geographical concentration

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 The existing RBI norms2 prescribe exposure limits to individual borrowers and
corporate entities. Every commercial bank should in its own interest develop a policy
framework for determining such exposure limits based on its risk policy.
Pricing
Once the proposal is accepted based on the creditworthiness of a customer, the next step
is to quantify the risk involved in funding it. It becomes essential to arrive at the required
return for the identified risk level by using an appropriate pricing policy. Hence, it is a
widely acceptable credit risk management policy that, the rate at which the funds are
offered arc in conjunction with the creditworthiness of the customer. While performing
the financial appraisal for a proposal, the internal rate of return (IRR) is calculated. If the
payments are made regularly by borrowers, then the expected rate of return will be equal
to the contractual rate. However, there will always be some uncertainty attached to future
cash flows. This uncertainty relates mainly to the amount of cash inflows and the timing
of the cash flows. In such uncertain situations, the bank can arrive at the probability of
repayment/default and also the extent of recovery in case of a default. While the
probabilities can be assessed from past data, the recovery rate can be computed by
considering the guarantees and value of collaterals attached to the loan. Using these
probabilities and the recovery rates the expected return for the principal and the interest
component of the loan can be assessed as follows:3

Expected Return = Pi(r) + P2 [P(l+r)R/P - 1] ...Eq. (1)

Where,
Pi = Probability of repayment
P2 - Probability of default, (1 - Pi)
r = Contractual rate/interest rate
P = Principal component
R = Recovery rate
In the above formula Pi(r) gives the returns using the contractual rate and the
probability of total repayment of the loan in the normal course of payment while the
second part, i.e. P2 [P(l+r)R/P - 1] gives the returns using the recovery rate of the interest
and principal and the probability of default. The recovery rate refers to the percentage of

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the outstanding balance (principal and interest) that can be recovered by measures such as

enforcement securities, legal action, etc.

In case of a default, the bank may sometimes look for the recovery of the
principal component only. In such a case, the expected return can be calculated as

follows:
Expected Return = Pj(r) + P2(R - 1) .. ..Eq. (2)
In this case R, which is the recovery rate, will be the percentage of outstanding

principal that can be recovered.

ll can now be understood that while pricing a loan proposal, it is essential for a

bank to adjust the contractual rate so that it reflects the creditworthiness of the client. The
bank should, thus, build into its pricing mechanism the probabilities of default. Such an
exercise will, to a certain extent, reduce the loss due to defaults. From the above
equation, for a given contractual rate, the expected returns from the proposal were
assessed by considering the probability of the repayment/default, and the recovery rate.
Using this approach, it is, however, possible to decide the contractual rate to be offered
once the required rate is determined. The required rate, which includes the cost of funds,
transactions costs and the spreads, can be used as the expected rate.
Pricing sometimes also aims to tackle interest rate risk. For instance, most

commercial banks include an interest clause in the loan/hirc purchase/lease agreement to

protect themselves against rate fluctuations. Here the impact of risk is transferred to the
borrowers. This type of risk management is termed as passive risk management.

However, when a bank resorts to this, it has also to realize that there is a possibility of
transforming one risk into another. For instance, in the above mentioned case the interest

rate clause may minimize the interest rate exposure for the bank, but at the same time if
the customer is not in a position to sustain the rate fluctuations it might lead to credit risk
and liquidity risk. A Commercial Bank should be guarded against such risk
transformations.

Monitoring
Credit risk persists so long as the loan remains, which may be till the maturity period, or
sometimes even beyond that if there are delays/defaults. Hence, it is necessary to have a
periodic review of the credit risk involved with a disbursal. This necessitates a systematic

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data collection in credit management and a regular analysis of the borrowers is done, it
could improve the credit evaluation process of the commercial bank as a whole.
The above mentioned steps monitor the credit risk of the bank at the micro-level.
This approach does not, however, provide a holistic picture of the bank’s credit risk. To
obtain this, a macro-level approach needs to be adopted.
Macro-Level Approach;
To have a more broader outlook on the credit risk position, a macro-level approach can
be adopted using the Capital Adequacy Ratio (CAR). The capital adequacy of a bank,
which is the ratio of its capital to its risk weighted assets (RWAs), highlights on the
extent to which possible losses can be absorbed by the capital. Thus, the higher CAR the
better it is for the bank. Mathematically, the relationship between CAR and the risk
weighted assets can be expressed as follows:4

CAR = C/RWA ...Eq.(3)

Where,
C = Capital
RWAs = Risk weighted assets.
Since, the RWA is the product of the assets to its risk weights we can express Eq.
(3) as follows:
CAR = C/A x ARW .. .Eq. (4)
= C/A = 1/ARW ...Eq. (5)
Where,
ARW = Average risk weight.

The inverse relation between the CAR and risk weighted assets can be observed in
Equation 5. If a bank has more risky assets on its portfolio, then its capital adequacy will
be lower implying greater credit risk exposure. The converse holds true when a bank
adopts a more conservative approach in maintaining its asset portfolio. Along with this a
regular analysis of the business environment of the customer is also essential. A
commercial bank should take into account the probable affect on the customer’s business
in the event of certain situations, like rise in the interest rates, slowdown in industrial
growth, economic or political instability.

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This helps a commercial bank in understanding the impact of any change in the operating
environment of the business of the customer. This information enables the bank to take a
proactive approach as and when such situation arises. ,

Management of the Non Performing Assets:

Monitoring plays a significant role in controlling the level of the NPAs in the commercial
banks. This helps the bank in assessing the financial position of the customer and taking a
prompt action before the NPAs slip into the next category i.e. the bad assets. Sometimes,
in genuine cases, a bank with its diversified experience of various industries, can work
out certain revival packages relating to financial/management restructuring thereby
rescuing its customer by reviving its business. In the process, the commercial bank will
be able to control its NPAs. In worst cases of default one-time settlement d$als can be
made and, as a last resort, legal assistance may also be sought.
The CAR discussed above provides a benchmark for monitoring the risk level
considering the total assets of the bank. However, this does not make any distinction
between a performing asset and a non-performing asset both of which may have the same
risk weight. Despite the screening, most banks will have NPAs in their asset portfolio.
The bank can in fact quantify its credit risk based on the level of NPAs. Consider the
following expression which quantifies the credit risk:5

ENPA - (EBT/TA) / NPAs/TA ... .Eq.(6)

Where,
ENPA = Net NPA
EBT = Earnings Before Tax
TA = Total Assets
NPAs = Non-performing Assets
This expression quantifies the credit risk level of a bank. Credit risk can be
quantified in terms of the ratio of the percentage of earnings before tax as a proportion of
Net NPAs (ENPA). Here EBT is considered since there will be a tax exemption on the
loss assets that are written-off while a similar advantage is not available to provisions
(The proposal to provide tax shelter was introduced in the Union Budget 1999-2000).

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 The above given equation can also be expressed as follows:
ENPA = [(PAT/(1-T)]/TA / NPAs/TA ... .Eq. (7)
= PAT/(1-T)TA / NPAs/TA = PAT / (1-T) NPA
Hence, it can be said that their exists an inverse relationship between ENPA & Credit risk
i.e. higher the ENPA level lower is the credit risk. To achieve higher level of ENPA, a
commercial bank will have to increase its profitability and reduce its NPAs levels. In fact,
by assessing the ENPA for each product or region, greater insights can be obtained on the
credit exposure level of the bank. Monitoring this ratio over a period of time can enable
the bank to identify any trends.
Even after exercising much caution there are very high chances that NPAs may occur,
under such circumstances there are two alternatives available :
1) Provisioning against possible NPAs
2) Writing them off as Loss Assets (LA)
It is always beneficial for a commercial bank to write-off those NPAs where the
probability of repayments is very low. The benefit in choosing this option arises
from the tax shield that is available for the loss assets that are written-off.
Apart from the credit risk that arises due to the lending activity of banks, credit
risk may also arise due to the presence of other risks. For instance, due to interest
rate fluctuations, the floating rate of interest changed by the bank may to a certain
extent reduce its interest rate risk, but if the borrower is not in a position to bear
this increased interest burden, it may transform into a credit risk for the bank.
Similarly, credit risk also may result due to the presence of contingent liabilities
in the bank’s portfolio of liabilities.

Contingent Risk Management:

A Contingent liability arises when a commercial bank undertakes a liability on behalf of
its customer, consequent to happening or non-happening of an event. With this promise
its obligation to provide funds to a third party is contingent. Such a liability does not
appear on the balance sheet until the contingency .is realized. Contingent liabilities,
therefore, are referred to as off-balance sheet items. These off-balance sheet items can be
classified into the following different heads.

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Commitments
The bank has committed itself to advance funds and acquires a credit exposure at some
future date. These commitments include:
# Unused overdrafts and credit lines
# Revolving lines of credit
# Repurchase agreements (repos)
Guarantees
While issuing a bank guarantee on behalf of its customer a commercial bank underwrites

an obligation to the third party and extends guarantee for payment in case its client
defaults. In this case the commercial bank is exposed to risk only in the event of default
by its customer which can lead to a huge loss or result in it acquiring a sub-standard asset.
Examples of this type of contingent liabilities are:
Asset sales with recourse, Deferred payment guarantees, Financial guarantees
Performance guarantees, Commercial letters of credit etc.

Foreign exchange transactions

Foreign exchange rate agreements are binding on the customer and if the customer is
unable to exercise its obligation, the bank carries out its side of the contract. Examples of
this type of exposures include mostly the hedging instruments.

Investment Banking & Merchant Banking Operations:

When a bank is into investment banking and merchant banking operations, it also
generally performs the activity of underwriting securities. Here the bank offers to
subscribe to the unsubscribed part of a securities issue.
Hence it can be noted that the a commercial bank indirectly enhances its exposure to a
host of other risks by exposing itself to contingent risk. Even though the bank charges a
penal interest on crystallized liabilities, sometimes this may actually not be sufficient to
cover the losses incurred in the transaction.

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Conclusion:
Finally, just as for any other risk, for efficient credit risk and contingent risk management
the acceptable levels of risk should be clearly laid down. In the case of contingent risk
management, the acceptable levels of risk will have to be fixed considering the fact that it
may lead to risk transformation which may further enhance the levels of other risks. On
the other hand, credit risk management will be the thrust area for the bank since
inefficient risk management will deteriorate its asset quality. Thus, apart from setting
acceptable levels for credit risk, an improved review of each advances proposal for credit
approvals should also be generated, as sound credit risk management will always be a
competitive advantage to the bank.

References:
1) Basle Committee Recommendations (February 2000): Sound practices for
managing the Credit Risk in Banking Organisations.
2) For detailed Highlights of RBI guidelines on Credit Risk & its Evaluation please
refer credit risk management by S.N. Bidani & others (2004): Credit Risk
Management, Taxmann’s, Chapter 3 & 4. Page No. 8.
3) Fabozzi Frank J. & Astuo Konishi (1991) Asset - Liability Management, (Probs
Publishing Co.)
4) www.riskbook.com
5) Potluri Rao & Roger Le Roy Miller (1981): Applied Econometrics
(Prentice - Hall of India Private Limited)

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