CREDIT RISK MANAGEMENT

Title
Date
Lifetime Learning Building Success Towards
Globalization

DECISION MAKING

Decision making process in general can

be of three types:
When the outcome of a particular decision can
be ascertained with certainty
When the outcome of the decision cannot be
ascertained with certainty
Decision making is called a risky situation when
the occurrence of an outcome can be assigned
some probability

2
01/30/16

Calculation of Z- Score

Total Current Assets - 72

Total Fixed Assets = 56
Total Liabilities = 61 mn
Current Assets= 67mn
Current Liabilities = 57mn
Retained Earnings = 76mn
Operating Income = 9 mn
Sales = 100mn
Current share price =2 AED
Number of shares = 10 mn shares

Capital required for a bank to sanction

credit limits
FACILITY

AMOUNT

Working Capital Loan

30

Term Loan

40

Letter of Credit (LC)

20

Bank Guarantee

10

Derivatives
Total Facilities

.External Rating of the company is BBB

5
105mn

What is Risk?
Risk, in traditional terms, is viewed as a 'negative'.
"exposing to danger or hazard".
hazard
The Chinese symbols for risk give a much better description of risk:
The first symbol is the symbol for danger,
danger while the second is the
symbol for opportunity,
opportunity making risk a mix of danger and opportunity.

Risk leads to the prospects of either loss, or gain.

The perception of risk is as old as human civilization.

Risk may be a source of hazards and perils and also an
opportunity to achieve success and prosperity.
Without risk, there is no opportunity.
opportunity
5

01/30/16

WHY TAKE RISK ?

WHAT HAPPENS IF BANKS

TAKE TOO MUCH RISK ?

A BREIF HISTORY ABOUT RISKS

IN BANKS

BANKING TILL GREAT DEPRESSION OF

1929
In the 19th Century, Banks became powerful
entities supported by the wave of industrialization
and development of large corporations.
The markets for securities and debt instruments
evolved significantly during this period, which
made Banks equally powerful.
This attack continued to gain significance till the
late 1920s which saw the famous crash of the
stock market bubble and the subsequent Great
Depression.

Stock Market Crash & Great

Depression
The stock markets crashed by nearly 50% in 1929.
The economic downturn that followed transformed
into a full scale recession across the globe, where
nearly 25% of workforce turn unemployed and
industrial productivity and national income halved.
Many Banks also collapsed during the crisis.
The crash of the markets and the recession was
largely attributed to the excessive level of
speculation, low level of regulation by the
Government of the Banks, power in the hands of
Banks and corporates and so on.
It is in this context, that the famous Glass-Steagall
Act was framed.

GLASS-STEAGALL ACT
This Act formed the cornerstone of the Banking
industry in the 20th Century.
This Act is also known as Banking Act of 1933.
The Act created the barriers between Commercial
Banking & Securities market industry.
This was enacted as at that time many blamed
the securities activities of the Banks as a major
reason for their collapse.

IMPACT OF GLASS-STEAGALL
ACT
The Act changed the landscape of Investment
Banking industry for the next 66 years.
The major commercial Banks closed down their
securities business.
This Act also led to the establishment of new
Securities firms.
The profitability of the Banks were severely impacted
as their most profitable business was closed
Many of the provisions were very harsh and led to a
situation where the growth of Banking industry was
significantly affected in the next two decades.

Watering Down of Glass Steagall

Act
The Act was affecting the growth of the Banking
industry.
Many subsequent legislations watered down the G-S
Act.
Significant among them was the decision to
deregulate the interest rates, permission given for
mergers between commercial and securities firms in
1980s, permission given to the Banks to create new
instruments like the mortgage based securities etc.
The Banking industry in Europe didnt face such
severe restrictions like US. This led to significant
growth in European Banking industry.

Finally the Act is Gone..

In 1999, the passage of Gramm-Leach-Bliley Act
by Bill Clinton Government removed all the major
barriers in the industry which was there for 66
years.
This Act formally dismantled the legal barriers for
the integration of financial services firms and
commercial banks.

What happened next. ?

Commercial banks are not supposed to be highrisk ventures; they are supposed to manage
other peoples money very conservatively.
Investment banks, on the other hand, have
traditionally managed money of people who can
take bigger risks in order to get bigger returns.
When
repeal
of
Glass-Steagall
brought
investment and commercial banks together, the
investment-bank culture came out on top. There
was a demand for the kind of high returns that
could be obtained only through high leverage
and big risk-taking.

Subsequently the crisis of

2008
Commercial banks traded in increasingly risky and
complex securities, continuing to buy and sell
mortgages, collateralized debt obligations and other
derivatives.
Because of the instruments complexity and institutions
vulnerable positions, many banks faced stark losses
during the 2008 financial crisis.
The crisis unfolded by the collapse of the Investment
Bank called
Lehman Brothers, which was the
largest ever bankruptcy in US.
Many Investment Banks and Commercial Banks
collapsed during the period and some survived because
of the large govt bailout during the crisis.

RISKS FACED BY BANKS

RISK MANAGEMENT

AN OVER VIEW TO RISKS

FACED BY BANKS

Risk
The word risk is derived from an Italian
word Risicare which means To Dare. In
this sense risk is a choice rather than fate.
Risk is uncertainty that an asset will earn an
expected rate of return, or that a loss may
occur.
Risk is volatility, where unexpected
changes; positive or negative are viewed
symmetrically.
The objective of risk management is not the
elimination of risk but to optimize it.

RISKS FACED BY BANKS

CREDIT RISK
MARKET RISK
LIQUIDITY RISK
OPERATIONAL RISK
LEGAL RISK
TECHNOLOGICAL RISK
REPUTATION RISK
OFF BALANCE SHEET RISK
CURRENCY RISK
DERIVATIVES RISK
COUNTRY RISKS
FORCE MAJURE RISK
REGULATORY RISK
24

01/30/16

Market risk
Market risk is caused due to changes in the
market variables having adverse impact on
earnings of a bank or on its capital.
Those variables are: interest rate, foreign
exchange, equity price, commodity price, and
liquidity.

Interest rate risk

Deregulation of interest rates has caused keen
competition and exposed banks to greater interest
rate risk.
Banks net interest income; difference between
interest received on its assets (loans/advances,
investment) and interest paid on its liabilities
(deposits) which is the major source of profitability
has been shrinking.
Mismatch risk or gap risk; short term deposits have
been used to finance long term investments.
Basis risk; changes in interest rate affect assets
and liabilities differently.
Price risk; value of investments affected by
changes in interest rate.

Liquidity risk
Mismatching in maturities of banks assets and
liabilities cause banks to finance liquidity at
unfavorable cost or forced to liquidated assets at
unfavorable prices.
Banks with surplus liquidity may also suffer due
to idling of funds.
Key ratios; loan to deposit ratio, liquid assets to
total assets, liquid assets to total deposits, interbank-deposits to total deposits.

Foreign exchange risk

Adverse exchange rate movements affect banks
foreign exposures when it is holding foreign
exchange assets or liabilities.
Translation risk; arises from the need to translate
foreign currency assets and liabilities into home
currency at end of accounting period.
Economic risk; change in future earning power
and cash flow as a result of adjustment of the
currencies.

Country risk
Cross border lending and investment, when
counterparty is unable service and repay the debt.
Currency transfer risk; borrower is able to repay in
local currency but there is shortage in foreign
currency.
Political risk; restrictions imposed
Sovereign risk; government involved but inability
to take legal action.
Cross border risk; borrower being resident of a
country other than where the cross border assets
are booked and exposure to currencies other than
local currencies.

Equity price risk

The risk that arises due to potential of a
bank to suffer losses on its exposure to
capital markets from adverse movements
in prices of equity.

Commodity price risk

Physical products that can be traded on a
secondary market are more volatile and complex.
Banks in developed markets use derivatives to
hedge commodity price risk.

Business environment risk

Arise when banks lending policies/strategies
particularly relating to identification of target
markets, products and customer base, without
proper planning and study of the business
environment.

Operational risk
Caused due to deficient and fast changing
internal
process/systems/procedures;
nonconducive work environment; de-motivated
untrained and incompetent staff or from external
events.
Legal risk
Technology risk
Outsourcing

Group risk
Arises
when
a
bank
has
other
domestic/overseas subsidiaries dealing in
various activities such as merchant banks,
mutual funds, insurance may not doing
well and incurring losses and in turn may
effect their profitability.

Credit Risk Frame work

Credit risk
The possibility of losses associated with diminution in the
credit quality of borrowers or counter parties.

In a banks credit portfolio, losses stem from outright

default due to inability or unwillingness of a customer or
counter party to meet their commitments in relation to
lending,
trading,
settlement
and
other
financial
transactions.

Alternatively, losses result from reduction in portfolio value

arising from actual or perceived deterioration in credit
quality.
Credit risk emanates from banks dealing with an individual,
corporate, bank, financial institution or a sovereign.

Forms of credit risk

1.
2.
3.
4.
5.

In the case of direct lending: principal and /or interest

amount may not be repaid.
In the case of guarantees or letter of credits: funds may
not
be
coming
from
the
constituents upon
crystallization of the liability.
In case of treasury operations: the payment or series of
payment due from the counter parties under the
respective contracts may not be forthcoming or ceases.
In case of security trading business: funds/securities
settlement may not be effected.
In case of cross-border exposure: the availability and
free transfer of foreign currency funds may either be
frozen or restrictions by the action of, or because of
political/economic conditions in the country where
borrower is located.

Credit Risk in Non-fund based

facilities
Banks should ensure that the security, which is
available to the funded lines, also covers the letter of
credits lines and the guarantee facilities. In case of
long term guarantee a charge over fixed assets will be
appropriate.
In case of guarantees covering contracts, banks must
ensure that the clients have the requisite technical
skills and experience to execute the contracts. Value of
contracts must be determined on a case by case basis
and separate limits should be set up for each contract.
The strategy to sanction non-fund facilities with a view
to increase earnings should be properly balanced with
the risk involved.

DISCUSSION

WHAT ARE THE MAJOR REASONS FOR

CREDIT RISK ?

FACTORS CAUSING CREDIT RISK

1.
2.
3.
4.
5.
6.
7.
8.

Deficiencies in appraisal of loan proposals and in

assessment of creditworthiness/ financial strength of
borrowers.
Inadequately defined lending policies and procedures.
High prudential exposure limits for individual and group
of borrowers.
Absence of credit concentration limits for various
industries/business segments.
Inadequate value of collaterals obtained by banks to
secure the loan facilities.
Over optimistic assessment of thrust/potential areas of
credit.
Liberal loan sanctioning powers for bank executives
without checks and balances.
Liberal sanctioning of non-fund based limits without
proper scrutiny of borrowers activity, financial strength,
cash flow.

Factors causing credit risk

1.
2.
3.
4.
5.
6.
7.
8.
9.

Lack of knowledge and skills of officials processing loan proposals and

subjectivity in credit decisions.
Lack of effective monitoring and consistent approach towards early
recognition of problem accounts and initiation of timely remedial actions.
Lack of information on functioning of various industries and performance of
economy.
Lack of proper coordination between various departments of banks looking
into credit functions.
Lack of well defined organizational structure and clarity with regard to
responsibilities, authorities and communication channels.
Lack of proper system of credit risk rating, quantifying and managing across
geographical and product lines.
Lack of effectiveness of existing credit inspection and audit system in
banks.
Lack of reliability and integrity of data being used for managing credit risks.
Staff accountability as result de-motivating the staff.

CREDIT RISK MANAGEMENT

PROCESS IN BANKS

Principles of Credit Risk Mgmt. in Banks

(per BASEL)

Banks must operate within sound, well-defined creditgranting criteria.

These criteria should include a clear indication of the banks target
market and a thorough understanding of the borrower or counterparty,
as well as the purpose and structure of the credit, and its source of
repayment.
Banks must receive sufficient information to enable a comprehensive
assessment ofthe true risk profile of the borrower or counterparty.
Depending on the type of credit exposure and the nature of the credit
relationship to date, the factors to be considered and documented in
approving credits include:

Establishing an appropriate credit risk environment

Operating under a sound credit granting process.
Maintaining an appropriate credit administration,
measurement and monitoring process.
Ensuring adequate controls over credit risks.

risk

CREDIT RISK MANAGEMENT

PROCESS
BUSINESS RISK ANALYSIS

FINANCIAL RISK ANALYSIS

SECURITY & COLLATERAL

MANAGEMENT

RISK MONITORING & MANAGEMENT

BUSINESS RISK

CASE STUDY-1
IDENTIFY THE KEY RISKS WITH THE
COMPANY.
ARABTEC
EMMAR PROPERTIES
EMMAR MALLS
DU
NAKHEEL

IDENTIFYING THE
FINANCIAL RISK

CASE STUDY-2
IDENTIFY THE KEY RISKS WITH THE
COMPANY.

FINANCIAL RISK ANALYSIS

RATIO & CASH FLOW ANALYSIS

SOME KEY FINANCIAL RATIOS

Debt : Equity
TNW
TOL/TNW
EBITDA
Net Profit Margin
Cash Accruals

LEVERAGE RATIOS

PROFITABILITY RATIOS

CASH FLOW ADEQUACY

DSCR

CAPITAL STRUCTURE - LEVERAGE

RATIOS AND PARAMETERS

DEBT: EQUITY RATIO

One of the most critical ratios in Project lending
This ratio indicates how many times the Own funds
has the company borrowed money

Project Debt/ Equity

WHAT IS THE ACCEPTABLE LEVEL OF D/E RATIO ?
The acceptable level of Debt : Equity ratio is
dependent on the type of project, industry etc.
But as a benchmark, we can consider a Debt: Equity
ratio in the range of 1.5- 2.0 times
The acceptable level could vary from Bank to Bank
depending on the Risk appetite.

Tangible Net worth

Tangible Net worth =
Share capital + Retained
Earnings+
Reserves(Intangibles)
-One has to careful on the Reserves part.
-Exclude Reserves like Fixed Assets Revaluation reserve which
It
the most
major measure
the not
companys
financial
strength. It
isisjust
a notional
item of
and
actual
reserves.
.shows the companys ability to meet the Liabilities

TOL/TNW
This ratio is a critical measure of solvency of the
company.
It shows how many times your Networth (own
funds) is the Outsiders liabilities.
The ratio =
Total Outsiders Liability
--------------------------------Networth
The benchmark ratio in this regard is a maximum
of 3 times.
The benchmark can vary from Bank to Bank
depending on their risk appetite.

DSCR
This is one of the most important ratio in Project
Finance.
This basically tests whether the internal
funding from the business is adequate to
meet the loan repayment obligations to the
Bank
Debt Service Coverage ratio, tests the ability of a
company to service the
Principal repayment
Interest servicing

DSCR

The acceptable range of DSCR in

Project Finance is 1.75 to 2 times.
Higher the DSCR, more comfortable is
the position of the lenders.

MAJOR PROFITABILITY &

OPERATING RATIOS

Net Profit Ratio

This ratio calculates the profit margin of a
company on the Net sales.
It is calculated as
= Profit After Tax
----------------------Net Sales
Profit before Tax also is analyzed as a percentage
of Net sales.

Cash Accruals
This refers to the Cash profits generated in the
business.
The Net Income (PAT) in the Financial statements
is after adjusting for non cash expenses like
depreciation.
Due to this the Reported Profits could differ from
the Cash Profits.
Cash Accruals = PAT+ Depreciation

EBITDA
(Earnings before Interest Tax, Depreciation &
Amortization)
The objective of this ratio is to calculate the
operating profits made by the company from the
core business operations.
The ratio calculates the operating profit margin
on the
Net sales made.
EBITDA
------------- X 100
sales of the Core Operating Performance of the
This isNet
an indicator
.company

5 Cs of CREDIT RISK

5CS

Character
Capacity
Capital
Collateral
Conditions

CREDIT RISK RATING

Credit risk rating objectives

1. Taking credit decision.
2. Pricing of loans.
3. Mitigation of risk. Customer
contribution.
4. Nature of facilities.
5. Delegation of sanction power.

Credit risk rating objectives

1.
2.
3.
4.
5.

Selective monitoring.
Ensuring quality.
Migration of credit. Higher to lower
Management of credit risk.
Identification of safe and risky
areas.

AN OVERVIEW OF A REAL LIFE CREDIT

RISK MODEL

CREDIT RISK SCORING

Z-SCORE MODEL

Z- score Model

Some financial ratios having

significant discriminating power to
separate healthy and weak units.
Z= B1X1+B2X2..+ BnXn
B = various discriminant coefficient
X = independent variables

 The Z-score formula for predicting bankruptcy

was published in 1968 by Edward I. Altman. The
formula may be used to predict the probability that
a firm will go into bankruptcy within two years.
Z-scores are used to predict corporate defaults and
an easy-to-calculate control measure for the financial
distress status of companies in academic studies.
The Z-score uses multiple corporate income and
balance sheet values to measure the financial
health of a company.

Z - score
Z= 1.2 X1+1.4 X2+ 3.3X3+ 0.6 X4+ 0.999 X5

Z- score model

1.

Greater than 2.675

Healthy units with low

probability of default

Between 1.81 and 2.675 Grey area with both

bankruptcy and non
bankruptcy possibilities.

Less than 1.81

Financial Distress High

chances of default

(Altman) Z-score
if (Z< 1.81) the firm will default. If Z (1.81:2.675),
the firm will either default or not. If (Z> 2.675),
the firm will not default.

CASE STUDY-2

Z-SCORING FRAMEWORK

PART-II

BASEL-II INSIGHTS
ON CREDIT RISK MANAGEMENT

Basel Committee on Banking Supervision-BCBS

A committee of central bankers/ bank supervisors from major

industrialized countries like Belgium, Canada, France, Germany,

Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden,
Switzerland, United Kingdom and United States.
BCBS has no formal supranational authority nor legal force
However IMF , World Bank, International Rating Agencies,
International Financial Institutions, etc use it as a benchmark for
assessment of the banks/ banking system

Basel Accord I (1988)

Portfolio Approach It focused primarily on credit risk and assets of

the banks were categorized into risk buckets with risk weights ranging
from 0% to 150%.

Particulars
Cash in hand, Balance with banks, Investment in
government securities etc
Money at call and short notices, Investment under
government guaranteed securities, Advances to
staff members etc
Claim guaranteed by DICGC/ECGE
Advance to public against Housing Finance
Advances to corporates, claim on PSUs, SME
and Retail exposure etc.
Advances under consumer credit
Advances covered under Commercial real estate

Risk We ight
0%
20%
50%
75%
100%
125%
150%

Minimum Capital Requirement 8% of risk weighted assets only for

credit risk.
Based on 1988 accord, central banks initiated various actions for the
banks like classification of assets, provision norms, classification of
asset class etc.

NEED FOR A NEW FRAME-WORK

Financial innovations viz derivatives and securitisation etc. and

growing complexity of transactions

Requirement of more flexible approaches as opposed to one
size fits all Approach
Requirement of Risk sensitivity as opposed to a broad- brush
Approach
In last 8-10 years banking sector worldwide has seen
catastrophic losses which led to failure of some established
banks like Bearing bank and Continental Illinois.

APPROACHES TO MEASURE DIFFERENT RISK UNDER

NEW ACCORD

Approaches
risk

to

measure

Standardized approach
Internal ratings based (IRB) approach
Foundation
Advanced
Approaches to measure Operational risk
Basic Indicator Approach
The Standardised Approach
Advanced Measurement Approach
Approaches to measure Market risk
Standardised method
Internal Model

Credit

Approaches to Credit Risk Management under

Basel II
INCREASED
SOPHISTICATION

Banks use internal

estimations of PD,
loss given
default
(LGD) and exposure at
default
(EAD)
to
calculate risk weights
for exposure classes
Banks use internal estimations
of probability of default (PD) to
calculate risk weights for
exposure classes. Other risk
components are standardized.

ADVANCED
INTERNAL RATING
BASED
APPROACH
FOUNDATION
INTERNAL
RATING BASED
APPROACH

STANDARDISE Risk weights are assigned in slabs

according to the asset class or are based
D
on assessment by external credit
APPROACH assessment institutions
REDUCED CAPITAL
REQUIREMENT

DISCUSSION
Why do all Banks run behind top rated
corporates to offer them loans at low rates
?
Why is very higher rate charged on
customers with average or weak financials
?
Why Residential Mortgage is a preferred
business for all UAE Banks ?

Why all Corporate Customers are not the same

for the Bank ?
The Bank has to set apart some capital when it lends
money as per the BASEL Norms which is adopted by all
the Banks of UAE.
The amount of capital set apart can vary from customer
to customer.
It depends on some key factors like the external rating of
the customer (by approved rating agencies like Moodys)
, type of facilities etc.
If customers with Higher Ratings are selected, it means
that the Bank has to set apart less capital. This in turn
leads to reduced risk and better profitability for the
Bank.
If Customers with poor rating/no rating is selected, it will
lead to higher capital requirement.

Credit Risk

Risk Weights for some Asset

classes

Off Balance Sheet Credit Risk

Credit Risk: Standardised

Approach
Risk weights are assigned in slabs of 0%, 20%, 50%,
100% & 150% on the basis of rating assigned by
ECAIs. For example -- Claims on Sovereigns (or
Central Bank) 0% to 150% risk weight on the basis
of country risk scores and at national discretion, a
lower risk weight may be applied.
Claims on Corporates will be risk weighted in the
range of 20-150% and unrated Corporates will be
assigned 100% risk weight.
UAE Central Bank has specified 12% Capital charge

Off Balance sheet items under Standardised

approach
The credit risk exposure attached to off-Balance Sheet items has to be
first calculated by multiplying the face value of each of the off-Balance
Sheet items by credit conversion factor (CCF). This will then have to be
again multiplied by the risk weights attributable to the relevant counterparty as specified in previous slide.

Sr.
No.
1

Instruments

Direct credit substitutes e.g. general guarantees of

indebtedness (including standby L/Cs serving as
financial guarantees for loans and securities) and
acceptances
(including
endorsements
with
the
character of acceptance).
Certain transaction-related contingent items (e.g.
performance bonds, bid bonds, warranties and
standby L/Cs related to particular transactions).
Short-term self-liquidating trade-related contingencies
(such as documentary credits collateralised by the
underlying shipments) for both issuing bank and
confirming bank.

*** Above list is not exhaustive.

Credit
Conversion
Factor (% )
100

50

20

Credit Risk Mitigants under Standardized

Approach
Eligible collaterals
Cash or deposit with bank, Gold
Securities issued by Central and State Governments
National Savings
Life insurance policies ( up to surrender value)
Debt securities rated by a recognised Credit Rating Agency
having at least BB rating when issued by public sector
entities and at least A rating when issued by other entities.
Debt securities not rated by a recognised Credit Rating
Agency
where these are issued by a bank, listed on a
recognised exchange and classified as senior debt
Equities included in main index.
Mutual funds having publicly quoted daily prices.

CORE OF BASEL II
CALCULATION OF CAPITAL CHARGE
Credit Facility

Amount

CASH CREDIT (WC)

50

TERM LOAN

40

LETTER OF CREDIT

30

BANK GUARANTEE

30

FORWARD CT/DERIVATIVE
LIMIT (CEL)

20

Cash margin on LC is at 10%

Cash margin on BG is at 10%
The company has an external rating of BBB by
Moodys
.Calculate
the capital charge for the Bank

CAPITAL CHARGE

Facility

Proposed Effective CCF

Limits Exposure (%)
(D) *
(E)

1. FBWC

50

2. TL-1

40

3 LC (Docum)

30

4 BG

30

5 CEL

20

Risk
Risk
Capital Charge
Weight Weighted (H = G * 12%)
(%) (F) Exposure
BBB (G = D*E*F)

Total
TRY THE SAME FOR COMPANIES WHICH ARE UNRATED & RATED AAA

CAPITAL CHARGE FOR DIFFERENT

TYPES OF EXPOSURES

VARIOUS ASSET CLASSES & RISK

WEIGHT
No

TYPE OF ASSET

RISK WEIGHT

CORPORATE EXPOSURES

Based on External rating (Covered

in earlier slide)

Public Sector Companies

In GCC if recognized as
public sector by local
regulator

0% if in local currency. Foreign

Currency loans @20%

Exposure on other Banks

Furnished in next slide

Exposure on Finance Cos

etc

Furnished in next slide

Retail (Comply with

Conditions)

75%

Residential Mortgage

35% ( If LTV less than 85% and

loan amount is less than 10mn)

Exposure on other Banks

Exposure on other Finance

Companies
If regulated like Banks, the treatment as above. If
not treated like corporate.

Retail Exposures

CREDIT RISK MANAGEMENT IN BANKS

CALCULATION OF TOTAL CAP. CHARGE. 1
READING MATERIAL -ADCB. 2

Four Key Risk Elements in IRB Approach

Probability of Default
(PD)
It measures the likelihood that
the borrower will default over a
given time-horizon.

Exposure at Default
(EAD)
It measures the amount of the
facility that is likely to be drawn
if a default occurs .

Loss Given Default

(LGD)
It measures the proportion of
the exposure that will be lost
if a default occurs.
Maturity
(M)
It measures the remaining
economic maturity of the
exposure .

Probability of Default (PD)

Probability of default measures the likelihood that the
borrower will default over a given time-horizon i.e.
What is the likelihood that the counterparty will
default on its obligation either over the life of the
obligation or over some specified horizon, such as an
year.
For estimation of PD, bank should already have Risk
Rating System in place for the last 5 years and the
history of default rates is being tracked since then .

Loss Given Default (LGD)

Loss Given Default is the credit loss incurred if an
obligor of the bank defaults.

LGD = 1 Recovery Rate

where, Recovery = Present Value of { Cash
flows received from borrower after the date of
default Costs incurred by the bank on
recovery }
Recovery rate = Recovery (as calculated above)/
Exposure on the date of default

Exposure at Default
(EAD)

EXPOSURE AT TIME OF DEFAULT (EAD) IS THE TOTAL BANK'S MONEY AT RISK

Maturity
(M)
It measures the remaining

economic maturity of the

exposure.
Determines framework for comparing different exposures.
Principal & outstanding balance
Opening Date of Loan
Contractual date of Maturity of Loan
Contractual and Discount Rate of Interest
Freq. of int. payment per annum
Tenor/Maturity (Years)
Time Period
Cash
Present Value of
in years
flow
Cash Flow
(A)
(B)
(c)
1
900
825.69
2
900
757.51
3
10900
8416.80
Total ------------------------>
10000.00
27591.11
Economic Maturity =
10000.00

10000
01/01/2003
31/12/2006
9.00%
1
3
(A) x (c)
825.69
1515.02
25250.40
27591.11
= 2.76