Govind Gurnani, Former AGM, Reserve Bank of

India

Credit Risk Management In The Banking

Sector

Credit risk refers to the potential loss arising from a

bank borrower or counterparty failing to meet its
obligations in accordance with the agreed terms.
Credit risk analysis is the means of assessing the
probability that a customer will default on a payment
before you extend trade credit.

In simple terms, banks experience credit risk when

assets in a bank’s portfolio are threatened by loan
defaults. Credit risk is a sum of default risk and
portfolio risks.

Default risk happens due to the inability or

unwillingness of a borrower to return the promised
loan amount to the lender. Whereas, portfolio risks
depend upon several internal and external factors.

Internal factors can be bank policy, absence of

prudential limits on credit, lack of a loan review
mechanism within the company, and more. External
factors may include the state of the economy, forex
rates, trade restrictions, economic sanctions, and
more.

The presence of credit risk deteriorates the expected

returns and creates more than expected losses for
banks.

Key Factors In Credit Underwriting

▪ Credit Score
An important consideration in the underwriting
process, the credit score shows the borrower’s
creditworthiness based on their credit history,
payment history, and credit utilisation. A higher credit
score means a lesser credit risk, and vice versa.

▪ Credit History
Lenders examine a borrower’s credit history to gain
insight into their previous nancial behavior, which
includes loan repayments, credit card usage, and any
delinquencies. A good credit history increases the
chances of loan approval.

▪ Income and Employment Stability

The borrower’s income and employment history are
important considerations in underwriting. A
consistent and substantial revenue stream reassures
lenders of the borrower’s ability to repay loans on
schedule.
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▪ Debt-to-Income Ratio
The debt-to-income ratio (DTI) compares a borrower’s
monthly loan commitments to their monthly income.
A lower DTI ratio shows better debt management
capacity and increases loan approval prospects.

▪ Collateral
In case of secured loans, the lenders analyse the
value and condition of collateral given by the
borrower as a backup repayment source in the event
of secured loans.

Five C’s Criteria For Assessing Credit Risk

▪ Character : The credit history and credit score

(FICO) of the borrower and perceived trustworthiness.
▪ Capacity : The estimated likelihood of the
borrower being capable of meeting all interest
obligations and repaying the loan in-full at maturity,
which is determined using nancial ratios to estimate
the risk of default.
▪ Capital : The total amount of funds that the
borrower has on hand, including any capital the
borrower already put towards a potential investment.
▪ Collateral : The assets belonging to the borrower
that can be pledged as collateral to secure a loan.
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▪ Conditions : Conditions describe the contextual
details of the borrower and the current credit
environment in which the loan application is
considered.The conditions can consist of internal
factors including the purpose of the borrowing, or
external factors outside the control of the borrower,
such as the prevailing interest rates, current
economic conditions (or outlook), geopolitical risks,
and pending regulatory risks that could negatively
impact the borrower.

Credit Risk Assessment Models

◼ Credit Scoring Models

Credit scoring models are statistical tools that

evaluate creditworthiness and determine the
likelihood of default on credit obligations. These
models are used by credit bureaus & lenders to
assess the risk of lending money or extending credit
to individuals or businesses.

The credit scoring model evaluates various factors,

including payment history, credit utilisation, length of
credit history, types of credit accounts, & recent
credit inquiries. Each factor is assigned a weight, and
the model’s formula calculates a credit score based
on the evaluation.
A credit score typically ranges from 300 to 900, with a
higher score indicating a lower risk of default.
Lenders use credit scores to make decisions about
loan terms, including interest rates, repayment
periods, and loan amounts. A good credit score can
result in favorable loan terms, while a poor score can
lead to higher interest rates and less favorable terms.

◼ Credit Risk Models

Credit risk model is a method that uses statistical

techniques to evaluate a borrower's creditworthiness
and estimate the likelihood of them defaulting on their
payments.These models can range from simple
credit scoring models to complex models that
consider multiple factors, including:
▪ Financial statements
▪ Credit bureau data
▪ Alternate data

◼ Scenario Analysis

Scenario analysis involves generating hypothetical

scenarios that can negatively in uence the credit
portfolio. Typically, these involve economic
downturns, changes in regulatory requirements, and
natural disasters.
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 Financial institutions develop these scenarios based
on historical data and expert opinion. It helps in
understanding the following:
▪ E ect of changes in interest rates.
▪ Exchange rates or commodity prices.

For instance, nancial institutions can use scenario

analysis to determine the impact of a 1% rise in
interest rates on their credit portfolios. Scenario
analysis is simple to implement and understand and
provides a clear view of the possible impact of
individual risk factors under de ned conditions.

However, the scenarios usually are based on

historical data and hence may not be relevant in
forecasting future occurrences. Thus, it may not be
adequate in covering all the possible risks or real-
world scenarios.

◼ Sensitivity Analysis

Sensitivity analysis evaluates the changes in some

variables on the credit portfolio. It relies on single
variables, such as interest rates or unemployment,
that are incrementally changed to observe the
impacts and identify the consequences.

Sensitivity analysis allows for the identi cation of key

risk drivers and conducting a deep analysis of
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isolated variables. However, it relies on individual
variables—with no interplay among them —and
therefore, many systemic or interconnected risks can
remain undetected.

Types Of Credit Risks

1⃣ Credit Spread Risk: Credit spread risk is typically

caused by the changeability between interest and
risk-free return rates.

2⃣ Default Risk: When borrowers cannot make

contractual payments, default risk can occur.

3⃣ Downgrade Risk: Risk ratings of issuers can be

downgraded, thus resulting in downgrade risk.

4⃣ Concentration Risk or Industry Risk: When too

much exposure is placed to any industry or sector,
investors or nancial institutions can be at risk for
concentration risk.

5⃣ Institutional Risk: Banks may encounter

institutional risk if there is a breakdown in the legal
structure. Institutional risk may also occur if there is
an issue with an entity that oversees the contractual
agreement between a lender and a debtor.
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6⃣ Counterparty Credit Risk: Counterparty credit
risk is de ned as the risk that a counterparty defaults
before honoring its engagements.

7⃣ Credit Valuation Adjustment Risk: Credit

valuation adjustment (CVA) risk refers to the risk of
loss on OTC derivatives and securities nancing
transactions due to changes in counterparties 'credit
spread caused by a change in its creditworthiness. In
other words, CVA re ects the market value of the cost
of credit spread's volatility.

Stress Testing Methods For Assessment Of

Credit Risk

1⃣ Sensitivity Analysis
▪ Involves the impact of a large movement on single
factor or parameter of the model
▪ Used to assess model risk, e ectiveness of
potential hedging strategies, etc.

2⃣ Scenario Analysis
▪ Full representations of possible future situations to
which portfolio may be subjected
▪ Involves simultaneous, extreme moves of a set of
factors
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 ▪ Re ects individual e ects and interactions
between di erent risk factors, assuming a certain
cause for the combined adverse movements
▪ Used to assess particular scenarios (e.g., current
forecast, worst-case) to gain better.

3⃣ Event-driven Scenarios
Scenario is based solely on a speci c event
independent of the portfolio characteristics.
▪ Identify risk sources/events that cause changes in
market
▪ Identify e ects of these changes on the risk
parameters

4⃣ Portfolio-driven Scenarios
Scenario is directly linked to the portfolio:
▪ Identify risk parameters changes that result in a
portfolio change. Identify events that cause the
parameters to change
▪ May be drawn from expert analysis or quantitative
techniques

5⃣ Macroeconomic Scenarios
An shock to the entire economy that will a ect
industries to di erent degrees
▪ Occurs external to a rm and develops over time
e.g.changes in unemployment in a region, movement
towards a recession, etc.
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6⃣ Market Scenarios
A shock to the nancial and capital markets :
This shock may be historical or hypothetical, though
historic events help support the plausibility e.g. stock
market crash of early 2000s, change in interest rates,
shock to credit spreads in a sector.

7⃣ Worst Case/Catastrophe Scenarios

Events are exogenous to the markets or economy,
though impact arises through resulting changes.
Such events are often tied to speci c characteristics
of portfolio or exposures, e.g. terrorist attack on
major nancial center, change in regulations or
policies.

Factors A ecting Credit Risk Modeling

For lenders to minimise credit risk, credit risk

forecasting needs to be more precise. Here are some
factors to consider:

1⃣ Probability of default
Probability of default (PD) is the likelihood that a
borrower will fail to pay their loan obligations, and
lenders use it to assess the level of risk that comes
with loaning money. For individual borrowers, the PD
is typically based on two primary factors:
1. Credit score
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 2. Debt-to-income ratio

2⃣ Loss Given Default

Loss given default (LGD) refers to the amount of
money a lender is likely to lose if a borrower defaults
on a loan, helping them predict and manage their risk
exposure. LGD accounts for:
▪ Value of the collateral
▪ The type of loan
▪ The legal framework in which the lender operates

It helps lenders with credit risk management and

make informed decisions about loan pricing and
underwriting.

3⃣ Exposure At Default
Exposure at default refers to the amount of possible
loss a lender is exposed to at any point in time,
allowing them to better manage their risk. It considers
factors including:
▪ The outstanding principal balance
▪ Accrued interest
▪ Any fees or penalties associated with the loan

4⃣ Discount Factor
The discount factor is used to present value the future
cash ows (losses) back to the reporting date. 't'
represents the time in years until the cash ow occurs.
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 DF = 1 / (1 + Discount Rate)^t

Credit Risk Monitoring Techniques

1⃣ Robust Credit Policies and Procedures

Establish comprehensive credit policies and
procedures. Also, include clear guidelines for,
• Credit underwriting
• Loan origination
• Risk assessment

2⃣ Robust Underwriting Standards

Implement rigorous credit underwriting standards to
e ciently assess borrower creditworthiness and
mitigate default risk. This involves a thorough analysis
of:
• Borrowers’ nancials
• Collateral valuation

3⃣ Diversify Credit Portfolios

A well-diversi ed credit portfolio helps minimize
concentration risk. By spreading credit exposures
across various industries or sectors, and borrower
types, nancial institutions can reduce the impact of
adverse events and prevent potential losses.
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4⃣ Stress Testing and Scenario-Based Analysis
Conduct regular stress tests and scenario-based
analyses to assess the impact of adverse economic
conditions. This helps:
• Identify and detect vulnerabilities
• Evaluate capital adequacy ratio
• Develop risk mitigation strategies

5⃣ Risk Rating
Create a separate risk scoring or risk rating method
for internal purposes to ensure accurate assessment
and classi cation of the borrowers based on credit
quality. It can be designed with qualitative and
quantitative factors, such as nancial analysis, ratios,
etc. This improves
• Credit decision-making
• Detect high-risk borrowers for closer monitoring.

6⃣ Adequate Provision for Loan and Lease

Losses
Adequate allowance for loan and loan losses helps
analyse credit losses in the bank portfolio of loans
and leases. It ensures that banks have su cient
funds to cover potential credit losses. By maintaining
appropriate provision, banks and nancial institutions
can estimate and maintain adequate allowances.
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 7⃣ Skilled Credit Risk Management Team
Build a skilled credit risk management team with
diverse skill sets, including statistical modeling, risk
assessment, and data analysis. For this, banks and
nancial institutions can:
• Hire experienced credit o cers, loan
underwriters, analysts, etc., with strong analytical
and industry knowledge
• Identify skill gaps
• Focus on continuous workforce skilling and
upskilling.
• Assess expertise and capabilities.

Banks can leverage digital learning solutions to

provide a sustainable, e cient, and measurable way
to train the workforce in credit risk management.

8⃣ Use AI, ML, & Data Analytics

Use advanced technologies and intelligent digital
solutions to establish a robust reporting and analytics
framework. This helps banks gain insights into their:
• Credit risk exposures
• Portfolio performance
• Emerging trends
It also helps ensure accurate and timely reporting for
informed decision-making and e ective credit risk
mitigation.
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New Standards For Assessment Of Capital
For Credit Risk Under Basel Capital Accord

An analysis of Internal Rating Based approaches for

credit risk by the Basel Committee on Banking
Supervision highlighted a high degree of variability in
bank’s calculation of their risk weighted assets. It was
found that advanced internal risk models give banks
the most freedom to estimate their credit risk, often
yielding a much lower risk than the regulator’s
standard model. Basel 3.1 reforms for credit risk aims
to restore credibility in those calculations by
constraining banks’ use of internal risk models.

Revised Standardised Approach For Credit Risk

The new Standardised Approach framework for credit

risk explicitly requires banks to assess the risk of their
exposures at origination and on an annual basis.
Banks are also required to assess whether risk
weights applied are appropriate and prudent.

Exposure To Banks And Corporates

Risk weights have been modeled based on

underlying external ratings and due diligence to
ensure that the rating properly re ects underlying risk
of the exposure. It is to be assumed that 5 per cent of
total exposures fail the due diligence requirement and
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need to be backed by a higher risk weight. Corporate
SME exposure receives a risk weight of 85 percent.

Exposure To Sovereign

Risk weight for exposure to sovereign is to be applied

according to external rating of the country.

Regulatory Retail And Other Retail Exposures

i) Regulatory Retail : Qualifying revolving retail

exposure and other non-SME exposures receive a
risk weight of 75 percent.

ii) Other Retail : All other retail exposures are to be

risk weighted at 100 per cent.

Exposures Related To Equity And Subordinated

Debt

Risk weights for equity and subordinated debt

exposure are to be applied in the range of 150-250
per cent. It is assumed that average risk of
approximately 200 per cent is applied to these
exposures.

Exposure To Real Estate

There is increased sensitivity for exposures secured

by commercial and retail real estate, with greater
 emphasis placed on the loan to value ratio as the
driver of the risk weight. Under this, it is to be
assumed that 20 per cent of the exposures is highly
dependent on the cash ow of the underlying
property.

Determination Of Signi cant Increase In

Credit Risk

Signi cant increase in credit risk refers to a signi cant

change in the estimated default risk over the
remaining expected life of the nancial instrument at
each reporting date.

In determining whether there is a signi cant increase

in credit risk or not, following details to be analysed
relating to the asset/receivable account which is
under consideration for expected credit loss :

1. Changes In Internal Price Indicators

Signi cant changes in internal price indicators of

credit risk as a result of a change in credit risk since
inception, including, but not limited to, the credit
spread that would result if a particular nancial
instrument or similar nancial instrument with the
same terms and same counterparty were newly
originated or issued at the reporting date.
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 2. Changes In The Terms Of Existing Financial
Instrument

Other changes in the rates or terms of an existing

nancial instrument that would be signi cantly
di erent if the instrument was newly originated or
issued at the reporting date (such as more stringent
covenants, increased amounts of collateral or
guarantees, or higher income average) because of
changes in the credit risk of the nancial instrument
since initial recognition.

3. Changes In External Market Indicators Of Credit

Risk

Signi cant changes in external market indicators of

credit risk for a particular nancial instrument or
similar nancial instruments with the same expected
life. Changes in market indicators of credit risk
include to, but are not limited to :
(i) the credit spread;
(ii) the credit default swap prices for the borrower;
(iii) the length of time or the extent to which the fair
value of a nancial asset has been less than its
amortised cost; and
(iv) other market information related to the borrower,
such as changes in the price of a borrower’s debt
and equity instruments.
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 4. Signi cant Change In External Credit Rating

An actual or expected signi cant change in the

nancial instrument’s external credit rating.

5. Internal Credit Rating Downgrade Of The

Borrower

An actual or expected internal credit rating

downgrade for the borrower or decrease in
behavioural scoring used to assess credit risk
internally. Internal credit ratings and internal
behavioural scoring are more reliable when they are
mapped to external ratings or supported by default
studies.

6. Adverse Changes In Business, Financial Or

Economic Conditions

Existing or forecast adverse changes in business,

nancial or economic conditions that are expected to
cause a signi cant change in the borrower’s ability to
meet its debt obligations, such as an actual or
expected increase in interest rates or an actual or
expected signi cant increase in unemployment rates.

7. Signi cant Changes In The Operating Results

Of The Borrower
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 An actual or expected signi cant change in the
operating results of the borrower. Examples include
actual or expected declining revenues or margins,
increasing operating risks, working capital
de ciencies, decreasing asset quality, increased
balance sheet leverage, liquidity management
problems or changes in the scope of business or
organisational structure (such as discontinuance of a
segment of the business) that results in a signi cant
change in the borrower’s ability to meet its debt
obligations.

8. Signi cant Increase In Credit Risk On Other

Financial Instruments Of The Same Borrower

9. Signi cant Change In Regulatory, Economic Or

Tech Environment Of Borrower

An actual or expected signi cant adverse change in

t h e re g u l a t o r y, e c o n o m i c o r t e c h n o l o g i c a l
environment of the borrower that results in a
signi cant change in the borrower’s ability to meet its
debt obligations, such as a decline in the demand for
the borrower’s sales product because of a shift in
technology.

10. Signi cant Changes In The Value Of The

Collateral
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 Signi cant changes in the value of collateral
supporting the obligation or in the quality of third
party guarantees or credit enhancements, which are
expected to reduce the borrower’s economic
incentive to make scheduled contractual payments or
to otherwise have an e ect on the probability of a
default occurring. For example, if the value of
collateral declines because house prices decline,
borrowers in some jurisdictions have a greater
incentive to default on their mortgages.

11. Signi cant Changes In The Quality Of

Guarantee Provided By Shareholder

A signi cant change in the quality of guarantee

provided by a shareholder (or an individual’s parents)
if the shareholder (or parents) have an incentive and
nancial ability to prevent default by capital or cash
infusion.

12. Signi cant Changes In Financial Support From

A Parent Entity

Signi cant changes, such as reductions in nancial

support from a parent entity or other a liate or an
actual or expected signi cant change in the quality of
credit enhancement, that are expected to reduce the
borrower’s economic incentive to make scheduled
contractual payments. Credit quality enhancements
or support include the consideration of the nancial
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 condition of the guarantor and/or for interests issued
in securitisations, whether subordinated interests are
expected to be capable of absorbing expected credit
losses (for example, on the loans underlying the
security).

13. Expected Changes In Loan Documentation

Expected changes in the loan documentation

including an expected breach of contract that may
lead to covenant waivers or amendments, interest
payment holidays, interest rate step-ups, requiring
additional collateral or guarantees, or other changes
to the contractual framework of the instrument.

14. Signi cant Changes In Performance And

Behaviour Of Borrower

Signi cant changes in the expected performance and

behaviour of the borrower, including changes in the
payment status of borrowers in the group (for
example, an increase in the expected number or
extent of delayed contractual payments or signi cant
increase in the expected number of credit card
borrowers who are expected to approach or exceed
their credit limit or who are expected to be paying the
minimum monthly amount).

15. Changes In Credit Management Approach Of

Entity
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 Changes in the entity’s credit management approach
in relation to the nancial instrument, ie based on
emerging indicators of changes in the credit risk of
the nancial instrument, the entity’s credit risk
management practice is expected to become more
active or to be focused on managing the instrument,
including the instrument becoming more closely
monitored or controlled, or the entity speci cally
intervening with the borrower.

16. Past Due Information

In assessment of signi cant increase in credit risk,

there is a rebuttable presumption that the credit risk
on a nancial asset has increased signi cantly since
initial recognition when contractual payments are
more than 30 days past due. However, as per clause
5.5.11 of IFRS 9, when an entity determines that there
have been signi cant increases in credit risk before
contractual payments are more than 30 days past
due, the rebuttable presumption does not apply.

Conclusion
E ective Credit Risk Management is crucial for the
success and stability of any nancial institution. By
implementing robust processes, leveraging
appropriate technologies, and fostering a risk-aware
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culture, banks can navigate the complex landscape
of lending with con dence.

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