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DISSERTATION REPORT ON CREDIT RISK MANAGEMENT IN BANKS

FACULTY GUIDE: MRS. KIRANDEEP KAUR AMITY INTERNATIONAL BUSINESS SCHOOL

SUBMITTED BY: XYZ MBA-IB(2008-2010)

AMITY INTERNATIONAL BUSINESS SCHOOL NOIDA

AMITY UNIVERSITY UTTAR PRADESH


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DECLARATION
I XYZ, student of Master of Business Administration-International Business from Amity International Business School, Amity University Uttar Pradesh hereby declare that I have completed Dissertation on Credit Risk Management in Banks as part of the course requirement. I further declare that the information presented in this project is true and original to the best of my knowledge.

Signature XYZ Enroll.No. MBA(IB)-Finance

Amity International Business School


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CERTIFICATION
I, Mrs. ABC hereby certify that AXZ student of Master of Business AdministrationInternational Business from Amity International Business School, Amity University Uttar Pradeshhas completed dissertation on Credit Risk Management in Banks under my guidance.Ms. Suman Sharma was found to be sincere and hard working

Signature

Mrs.ABC Lecturer Amity International Business School

Amity International Business School


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ACKNOWLEDEGEMENT

Every endeavor in itself is an impression of the efforts of not only those who pursue it but of those as well who provide guidance and motivation towards its successful completion. Likewise, this project bears an imprint of all those who helped me at various stages and it would be unfair on my part not to thank them. I would like to express my gratitude to my research supervisor Mrs. ABC, Lecturer A.I.B.S. for her constant and sagacious guidance during the cource of this research.Without her scholarly advice and co-operation it would not have been possible for me to complete this project in the present form. Last, but not the least, I am really dearth of words to venerate my parents whose steady efforts and motivation helped me to accomplish this work successfully. I assure that all the information provided by me is original and authenticated.

XYZ

Amity International Business School


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Table of Content

S.No. 1 2 3 4 5 6 7

Chapter No. 1 2 3 4 5 6

Subject Introduction Review of Literature Research Methodology Data Analysis and Interpretation Case study analysis Conclusion and Recommendations Bibliography

Page No. 7 31 41 46 63 75 87

CREDIT RISK MANAGEMENT IN BANKS

Chapter-1. Introduction

Introduction
Success comes out of measuring because what cannot be measured cannot be managed. Banks have developed sophisticated systems to quantify and aggregate credit risk in an attempt to model the credit risk arising from important aspects of their business lines. Such models are intended to aid banks in quantifying, aggregating and managing risk across geographical locations and product lines. Banks credit exposures span across geographical locations and product lines. The use of credit risk models offer banks a framework for examining this risk in a timely manner, centralising data on global exposures and analysing marginal and absolute contributions to risk. These properties of models may contribute to an improvement in a banks overall ability to identify, measure and manage risk. The motivation for this particular study stemmed from the desire to provide more accurate and comprehensive base for the estimation of credit risk which will further aid the quantitative estimation of the amount of economic capital needed to support a banks risk-taking activities. As the outputs of credit risk models have assumed an increasingly large role in the risk management processes of large banking institutions, the issue of their applicability for supervisory and regulatory purposes has also gained prominence. Furthermore, a models-based approach may also bring capital requirements into closer alignment with the perceived riskiness of underlying assets, and may produce estimates of credit risk that better reflect the composition of each banks portfolio. However, before a portfolio modelling approach could be used in the formal process of setting regulatory capital requirements, it has to be ensured that the models are not only well integrated with banks day-to-day credit risk management, but are also conceptually sound, empirically validated, and produce capital requirements that are comparable across similar institutions. The etymology of the word Risk can be traced to the Latin word Rescum meaning Risk at Sea or that which cuts. Risk is associated with uncertainty and reflected by way of charge on the fundamental/ basic i.e. in the case of business it is the Capital, which is the cushion that protects the liability holders of an institution. These risks are inter-dependent and events affecting one area of risk can have ramifications and penetrations for a range of other categories of risks. Foremost thing is to understand the risks run by the bank and to ensure that the risks are properly confronted, effectively controlled and rightly managed. Each transaction that the bank undertakes changes the risk profile of the bank. The extent of calculations that need to be performed to understand the impact of each such risk on the transactions of the bank makes it nearly impossible to continuously update the risk calculations. Hence, providing real time risk information is one of the key challenges of risk management exercise. Till recently all the activities of banks were regulated and hence operational environment was not conducive to risk taking. Better insight, sharp intuition and longer experience were adequate to manage the limited risks. Business is the art of extracting money from others pocket, sans resorting to violence. But profiting in business without exposing to risk is like trying to live without being born. Every one knows that risk taking is failureprone as otherwise it would be treated as sure taking. Hence risk is inherent in any walk of life in general and in financial sectors in particular. Of late, banks have grown from being a financial intermediary into a risk intermediary at present. In the process of financial intermediation, the gap of which becomes thinner and thinner, banks are exposed to severe competition and hence are compelled to
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encounter various types of financial and non-financial risks. Risks and uncertainties form an integral part of banking which by nature entails taking risks. Business grows mainly by taking risk. Greater the risk, higher the profit and hence the business unit must strike a trade off between the two. The essential functions of risk management are to identify, measure and more importantly monitor the profile of the bank. While Non-Performing Assets are the legacy of the past in the present, Risk Management system is the pro-active action in the present for the future. Managing risk is nothing but managing the change before the risk manages. While new avenues for the bank has opened up they have brought with them new risks as well, which the banks will have to handle and overcome. When we use the term Risk, we all mean financial risk or uncertainty of financial loss. If we consider risk in terms of probability of occurrence frequently, we measure risk on a scale, with certainty of occurrence at one end and certainty of non-occurrence at the other end. Risk is the greatest where the probability of occurrence or non-occurrence is equal. As per the Reserve Bank of India guidelines issued in Oct. 1999, there are three major types of risks encountered by the banks and these are Credit Risk, Market Risk & Operational Risk. As we go along the article, we will see what are the components of these three major risks. In August 2001, a discussion paper on move towards Risk Based Supervision was published. Further after eliciting views of banks on the draft guidance note on Credit Risk Management and market risk management, the RBI has issued the final guidelines and advised some of the large PSU banks to implement so as to guage the impact. A discussion paper on Country Risk was also released in May 02. Risk is the potentiality that both the expected and unexpected events may have an adverse impact on the banks capital or earnings. The expected loss is to be borne by the borrower and hence is taken care of by adequately pricing the products through risk premium and reserves created out of the earnings. It is the amount expected to be lost due to changes in credit quality resulting in default. Where as, the unexpected loss on account of the individual exposure and the whole portfolio in entirely is to be borne by the bank itself and hence is to be taken care of by the capital. Thus, the expected losses are covered by reserves/provisions and the unexpected losses require capital allocation. Hence the need for sufficient Capital Adequacy Ratio is felt. Each type of risks is measured to determine both the expected and unexpected losses using VaR (Value at Risk) or worst-case type analytical model. Emergence of Risk management in Banks The banking environment consists of numerous risks that can impinge upon the profitability of the banks. These multiple sources of risk give rise to a range of different issues. In an environment where the aspect of the quantitative management of risks has become a major banking function, it is of lesser importance to speak of the generic concepts. The different types of risks needs to be carefully defined and such definitions provide a first basis for measuring risks on which the risk management can be implemented. There have been a number of factors that can be attributed to the stabilization of the banking environment in nineties. Prior to that period, the industry was heavily regulated. Commercial banking operations were basically restricted towards collecting resources and lending operations. The regulators were concerned by the safety of the industry and the control of its money creation power. The rules limited the scope of the operations of the various credit institutions and limited their risks as well. It was only during the nineties that banks experienced the first drastic waves
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of change in the industry. Among the main driving forces that played a crucial role in the changes were the inflating role of the financial markets, deregulation of the banking sector and the increase in the competition among the existing and emerging banks. On the foreign exchanges front, the floating exchanges rates accelerated the growth of uncertainty. Monetary policies favouring high levels of interest rates and stimulating their intermediation was by far the major channel of financing the economy, disintermediation increased at an accelerated pace. Those changes turned into new opportunities and threats for the players. These waves of changes generated risks. Risks increased because of new competition, product innovations, the shift from commercial banking to capital markets increased market volatility and the disappearance of old barriers which limited the scope of operations for the various financial institutions. There was a total and radical change in the banking industry. Here it is worth mentioning that this process has been a continuous 5 one and has taken place in an orderly manner. Thus it is no surprise that risk management emerged strongly at the time of these waves of transformation in the banking sector. Banks Risks As stated , risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. Risk measurement requires that both the uncertainty and its potential adverse effect on profitability be addressed. Let us now try to focus on the risk framework purely from the perspective of a bank Risk Framework The various risks associated with the banking may be defined as below and these definitions have the advantage of being readily recognizable to bankers. (i) Credit Risk : Risk of loss to the bank as a result of a default by an obligator. (ii) Solvancy Risk : Risk of total financial failure of a bank due to its chronic inability to meet obligations. (iii) Liquidity Risk : the risk arising out of a banks inability to meet the repayment requirements. (iv) Interest Rate Risk : Volatility in operationd of net interest income, or the present values of a portfolio, to changesin interest rates. (v) Price Risks : Risk of loss/gain in the value of assets, liabilities or derivative due to market price changes, notably volatility in exchange rate and share price movements. (vi) Operational Risk : Risks arising from out of failures in operations, supporting systems, human error, omissions, design fault, business interruption, frauds, sabotage, natural disaster etc. Credit Risk: Credit risk with respect to bank is most simply defined as the risk of a borrowers payment default on payment of interest and principal due to the borrowers unwillingness or inability to service the debt. The higher the credit risk an institution is exposed to, the 6 greater the losses may be. For banks and most other credit institutions, credit risk is considered to be the form of risk that can most significantly diminish earnings and financial strength. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organization. Banks should also consider the relationships between credit risk and other risks.

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Need to Manage Credit Risk For most banks loans are the largest and most obvious source of credit risk; Loans and advances constitute almost sixty per cent of the assests side of the balance sheet of any bank. As long as the borrower pays the interest and the principal on the due dates, a loan will be a performing asset. The problem however arises once the payments are delayed or defaulted and such situations are very common occurances in any bank. Delays/defaults in payments affect the cash forecasts made by the bank and further result in a changed risk profile, as the bank will now have to face an enhanced interest rate risk, liquidity risk and credit risk. Banks are increasingly facing credit risk in various financial instruments other than loans, which include interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions.

Traditional Credit Risk Measurement Approaches


It is hard to draw a clear line between traditional and new approaches, as many of the superior concepts of the 8 traditional models are used in the new models. One of the most widely used traditional credit risk measurement approaches is the Expert System. Expert Systems In an expert system, the credit decision is made by the local or branch credit officer. Implicitly, this persons expertise, skill set, subjective judgement and weighting of certain key factors are the most important determinants in the decision to grant credit. The potential factors and expert systems a credit officer could look at are infinite. However, one of the most common expert systems, the five Cc of credit will yield sufficient understanding. The expert analyzes these five key factors, subjectively weights them, and reaches a credit decision: -to-debt ratio (leverage) is viewed as a good predictor of bankruptcy probability. High leverage suggests greater suggests greater probability of bankruptcy than low leverage as a low level of equity reduces the ability of the business to survive losses of income. repayments on debt contracts prove to be a constant stream over time, but earnings are volatile (and thus have a high standard deviation ), its highly probable that the firms capacity to repay debt claims would be risk. y the borrower. The greater the propagation of this claim and the greater the market value of the underlying collateral, the lower the remaining exposure risk of the loan in t he case of a default. mining credit-risk exposure is the state of the business cycle, especially for cycle-dependent industries. For example, the infrastructure sectors (such as the metal industries, construction etc.) tend to be more cycle dependent than nondurable goods sectors, such as food, retail, and services. Similarly, industries that have exposure to international competitive conditions tend to be cycle sensitive. Taylor, in an analysis of Dun and Bradstreet bankruptcy data by industry (both means and standard deviations), 9 found some quite dramatic differences in US industry failure rates during the business cycle. history. In particular, it has been established empirically that the age factor of an organization is a good proxy for its repayment reputation. Another factor, not covered by the five Cs, is the
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interest rate. It is well known from economic theory that the relationship between the interestrate level and the expected return on a loan (loss probability) is highly non-linear. At low interest-rate levels, an increase in rates may lower the return on a loan, as the probability of loss would increased. This negative relationship between high loan rates and expected loan returns is due to two effects : i. Adverse selection ii. Risk shifting When loan rates rise beyond some point, good borrowers drop out of the loan market, preferring to self-finance their investment projects or to seek equity capital funding (adverse selection). The remaining borrowers, who have limited liability and limited equity at stake and thus lower rating have the incentive to shift into riskier projects (risk shifting). In upside economies and supporting conditions, they will be able to repay their their debts to the bank. If economic conditions weaken, they will have limited downside loss from a borrowers perspective. Although many financial institutions still use expert systems as part of their credit decision process, these systems face two main problems regarding the decision process: groups of borrowers? subjective weights applied to the five Cs derived by an expert can vary from borrower to borrower. This makes comparability of rankings and decisions across the loan portfolio very difficult for an individual attempting to monitor a personal 10 decision and for other experts in general. As a result, quite different processes and standards can be applied within a financial organization to similar types of borrowers. It can be argued that the supervising committees or multilayered signature authorities are key mechanisms in avoiding consistency problems and subjectivity, but it is unclear how effectively they impose common standards in practice. Management Information Systems Management of Credit Risk Banks must have information systems and analytical techniques that 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 concentration of risk. Banks should have methodologies that enable them to quantify the risk involved in exposures to individual borrowers. Banks should also be able to analyse credit risk at the product and portfolio level in order to identify any particular sensitivities or concentrations. The measurement of credit risk should take account of: i. The specific nature of the credit (loan, derivative, facility, etc.) and its contractual and financial conditions. ii. The exposure profile until maturity in relation to potential market movements iii. The existence of the collateral or guarantees iv. The potential for default based on the internal risk rating. The analysis of credit risk data should be undertaken at an appropriate frequency with the results reviewed against relevant limits. Banks should use measurement techniques that are appropriate to the complexity and level of the risks involved in their activities, based on robust data and subject to periodic validation.

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Credit Elements : Policy, Process, Behaviour Credit elements ultimately come together within the framework of credit policy, process, credit officers behaviour and audit. Policy is the credit cultures anchor and the banks credit conscience. Its role is to assist credit officers in balancing the volume and quality of credit. Process is the line-driven operational arm of credit and credit strategy. It makes the credit system work, defends its integrity through close supervision and built-in checks and balances and by anticipating problems, guards against surprises. Credit officers behaviour reflects the attitudes and patterns of behaviour of the CEO and supervisory management as well as institutional philosophies, traditions, priorities and standards. Audits role is more than being counting. It also evaluates such matters as conformity to policy, credit practices and procedures, portfolio quality, adherence to business plans, development and distribution of credit talent and the competence of individual credit officers. Credit behaviour ranges from defensive conservatism to irresponsible aggressiveness. There must be a balance, and this is what a bank expects of its credit officers: achieve earning objectives while meeting appropriate credit needs.

e taken. rollers when in trouble. The amount of the banks exposure should be related to the quality of the borrower. enters -folio objectives. RISK MANAGEMENT COMMITTEE Risk Management Committee was constituted on January 18, 2003. The functions of the Risk Management Committee include the following: To devise the policy and strategy for integrated risk management containing various risk exposures of the Bank including the Credit Risk. To co-ordinate between the Credit Risk Management Committee (CRMC), the Asset Liability Management Committee (ALMC) and Operational Risk Management Committee (ORMC) and other risk committees of the Bank. The responsibility of the Committee includes: Setting policies and guidelines for market risk measurement, management and reporting Ensuring that market risk management processes (including people, systems, operations, limits and controls) satisfy Banks policy Reviewing and approving market risk limits, including triggers or stop-losses for traded and accrual portfolios Appointment of qualifi ed and competent staff; ensuring posting of qualifi ed and competent staff and of independent market risk manager/s etc.

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Importance of Credit Risk Assessment


Effective credit risk assessment and loan accounting practices should be performed in a systematic way and in accordance with established policies and procedures. To be able to prudently value loans and to determine appropriate loan provisions, it is particularly important that banks have a system in place to reliably classify loans on the basis of credit risk. Larger loans should be classified on the basis of a credit risk grading system. Other, smaller loans, may be classified on the basis of either a credit risk grading system or payment delinquency status. Both accounting frameworks and Basel II recognise loan classification systems as tools in accurately assessing the full range of credit risk. Further, Basel II and accounting frameworks both recognise that all credit classifications, not only those reflecting severe credit deterioration, should be considered in assessing probability of default and loan impairment. A well-structured loan grading system is an important tool in differentiating the degree of credit risk in the various credit exposures of a bank. This allows a more accurate determination of the overall characteristics of the loan portfolio, probability of default and ultimately the adequacy of provisions for loan losses. In describing a loan grading system, a bank should address the definitions of each loan grade and the delineation of responsibilities for the design, implementation, operation and performance of a loan grading system. Credit risk grading processes typically take into account a borrowers current financial condition and paying capacity, the current value and realisability of collateral and other borrower and facility specific characteristics that affect the prospects for collection of principal and interest. Because these characteristics are not used solely for one purpose (e.g. credit risk or financial reporting), a bank may assign a single credit risk grade to a loan regardless of the purpose for which the grading is used. Both Basel II and accounting frameworks recognise the use of internal (or external) credit risk grading processes in determining groups of loans that would be collectively assessed for loan loss measurement. Thus, a bank may make a single determination of groups of loans for collective assessment under both Basel II and the applicable accounting framework. Credit Rating is the main tool to assess credit risk, which helps in measuring the credit risk and facilitates the pricing of the account. It gives the vital indications of weaknesses in the account. It also triggers portfolio management at the corporate level. Therefore, banks should realize the importance of developing and implementing effective internal credit risk management. It involves evaluating and assessing an institutions risk management, capital adequacy ,and asset quality. Risk ratings should be reviewed and updated whenever relevant new information is received. All credits should receive a periodic formal review (e.g. at least annually) to reasonably assure that credit risk grades are accurate and up-to-date. Credit risk grades for individually assessed loans that are either large, complex, higher risk or problem credits should be reviewed more frequently. To ensure the proper administration of their various credit risk-bearing portfolio the banks must have the following: a. A system for monitoring the condition of individual credits, and determining the adequacy of provisions and reserves, b. An internal risk rating system in managing credit risk. The rating system should be consistent with the nature, size and complexity of a banks activities,

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c. Information systems and analytical techniques that enable the 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, d. A system for monitoring the overall composition and quality of credit portfolio. In addition while approving loans, due consideration should be given to the integrity and reputation of the borrower or counterparty as well as their legal capacity to assume the liability. Once creditgranting criteria are established, it is essential for the bank to ensure that the information it receives is sufficient to make proper credit-granting decisions. This information will also serve as the basis for rating the credit under the banks internal rating system. Internal credit risk ratings are used by banks to identify gradations in credit risk among their business loans. For larger institutions, the number and geographic dispersion of their borrowers makes it increasingly difficult to manage their loan portfolio simply by remaining closely attuned to the performance of each borrower. To control credit risk, it is important to identify its gradations among business loans, and assign internal credit risk ratings to loans that correspond to these gradations. The use of such an internal rating process is appropriate and indeed necessary for sound risk management at large institutions. The long-term goal of this analysis is to encourage broader adoption of sound practices in the use of such ratings and to promote further innovation and enhancement by the industry in this area. Internal rating systems are primarily used to determine approval requirements and identify problem loans, while on the other end they are an integral element of credit portfolio monitoring and management, capital allocation, pricing of credit, profitability analysis, and detailed analysis to support loan loss reserving. Internal rating systems being used for the former purposes. As with all material bank activities, as sound risk management process should adequaltely illuminate the risks being taken and apply appropriate control allow the institution to balance risks against returns and the institutions overall appetite for risk, giving due consideration to the uncertainties faced by lenders and the long-term viability of the bank. Based on the historical data which is both financial and non-financial a score is arrived at. The borrower is then classified into different classes of credit rating based on the score which is used to determine the rate of interest to be charged. The borrowers credit rating method used above is only one such model. Based on the information available, a detailed and more comprehensive model can be developed by banks. Banking organizations should have strong risk rating systems. These systems should take proper account of the gradations in risk and overall composition of portfolios in originating new loans, assessing overall portfolio risks and concentrations, and reporting on risk profiles to directors and management. Moreover, such rating systems also should play an important role in establishing an appropriate level for the allowance for loan and lease losses, conducting internal bank analysis of loan and relationship profitability, assessing capital adequacy, and possibly performance-based compensation. Credit risk ratings are designed to reflect the quality of a loan or other credit exposure, and thus explicitly or implicitly- the loss characterstics of that loan or exposure.In addition, credit risk ratings may reflect not only the likelihood or severity of loss but also the variability of loss over time, particularly as this relates to the effect of the business cycle. Linkage to these measurable outcomes gives greater clarity to risk rating analysis and allows for more consistent evaluation of performance against relevant benchmarks, In documentation their credit administration procedure, institutions should clearly identify whether
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risk ratings reflect the risk of the borrower or the risk of the specific transaction. The rating scale chosen should meaningfully distinguish gradations of risk within the institutions portfolio, so that there is clear linkage to loan quality (and/or loss characterstics). To do so, the rating system should be designed to address the range of risks typically encountered in the underlying businesses of the institutions. Prompt and systematic tracking of credits in need of such attention is an element of managing credit risk. Risk ratings should be reviewed by independent credit risk management or loan review personnel both at the inception and also periodically over the life of the loan. In view of the diverse financial and non-financial risks confronted by banks in the wake of the financial sector deregulation, the risk management practices of the banks have to be upgraded by adopting sophisticated techniques like Value at Risk (VaR), Duration and simulation and adopting internal model- based approaches as also credit risk modeling techniques. When making credit rating decisions, banks review credit application and credit reports with respect to financial risk. Once lenders make a yes decision, they review the credit reports of their customers on a regular basis as they continue to manage their financial risk. This process scans credit reports for certain risk characterstics as defined by the lender. Some lenders, for example, monitor whether or not all of a consumers payments are on time. Others look at account balance in relation to the total credit limit. Some lenders review their accounts frequently. Others review accounts once a year. Account monitoring also allows lenders to manage the business risk of extending credit in a better way. Banks pool assets and loans, which have a possibility of default and yet provide the depositors with the assurance of the redemption at full face value. Credit risk, in terms of possibilities of loss to the bank , due to failure of borrowers/counterparties in meeting commitment to the depositors. Credit risk is the most significant risk, more so in the Indian scenario where the NPA level of the banking system is significantly high. The management of credit risk through an efficient credit administration is a prerequisite for long-term sustainability/ profitability of a bank. A proper credit administration reduces the incidence of credit risk. Credit risk depends on both internal and external factors. Some of the important external factors are state of economy, swings in commodity prices, foreign exchange rates and interest rates etc. The internal factors may be deficiencies in loan policies and administration of loan portfolio covering areas like prudential exposure limits to various categories, appraisal of borrowers financial position, excessive dependence on collaterals, mechanism of review and post-sanction surveillance, etc. The key issue in managing credit risk is to apply a consistent evaluation and rating system to all investment opportunities. Prudential limits need to be laid down on various aspects of credit viz., benchmarking current ratio, debt-equity ratio, profitability ratio, debt service coverage ratio, concentration limits for group/single borrower, maximum exposure limits to industries, provision for flexibilities to allow variation for very special features. Credit rating may be a single point indicator of diverse risk factors. Management of credit in a bank will require alertness on the part of the staff at all the stages of credit delivery and monitoring process. Lack of such standards in financial institution would increase the problem of increasing loan write-offs. How can an institution be sure that its collateral is totally protected in the event of bankruptcy by the borrower? The bank can ensure this through credit rating and loan documentation. Establishing Suitable Risk Position
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Since banks cannot de-link the credit risk from the lending activity, they can only attempt to reduce it to some extent by spreading their loans over a large group of borrowers, selling their services in a variety of markets with different economic characterstics. Banks can diversify their credit risk by maintaining proper exposure limits for its credit sanctions. Diversification can be attained by setting exposure limits in the following areas: -type term loan/CC etc); Though exposure norms are prescribed by the central banks from taking unlimited exposures, it will be in the in interest of the best to develop a policy framework from determining such exposure limits depending in its risk policy. Credit Risk Rating Basel Committee Norms Internal ratings based approach recommended by the basel committee would form the basis for a sophisticated risk management system for banks. A key element of the basel committees proposed new capital accord is the use of a banks internal credit risk ratings to calculate the minimum regulatory capital it would need to set aside for credit risk. Called the internal ratings based approach It links capital adequacy to the assets in a banks books. Compared to capital allocation based on the standardized approach (including the one-size fits all old version), the IRB regime is likely to make regulatory capital more consistent with economic capital (the capital required by a bank to cover unexpected losses, as an insurance against insolvency). This is likely to reduce the amount of regulatory capital banks will be required to set against credit risk inherent transactions and portfolios. Based on its risk assessment, a bank will slot the exposure within a given grade. There must be enough credit grades in a banks internal ratings system to achieve a fine distinction of the default risk of the various counter-parties. A risk rating system must have a minimum of six to nine grades for performing borrowers and a minimum of two grades for non-performing borrowers. More granularity can enhance a banks ability to analyse its portfolio risk position, more appropriately price low-risk borrowers in the highly competitive corporate lending market and importantly, prudently allocate risk capital to the non-investment grade assets where the range of default rates is of a large magnitude. The credit risk of an exposure over a given horizon involves the probability of default (PD) and the fraction of the exposure value that is likely to be lost in t he event of default or loss given default (LGD). While the PD is associated with the borrower, the LGD depends on the structure of the facility. The product of PD and LGD is the Expected Loss (EL). Risk tends to increase non-linearly default rates are low for the least risky grades but rise rapidly as the grade worsens an A grade corporate will have a less probability of defaulting within one year, while the next rated (BBB) borrower will have higher probability of defaulting, which may further be higher for a CCC rated borrower. The probability of default is what defines the objective risk characterstics of the rating. A banks rating system must have two dimensions. The first must be oriented to the risk of the borrower default. The second dimension will take into account transaction specific factors. This requirement may be taken care of by a facility rating which factors in borrower and transaction characterstics or by an explicit quantifiable LGD rating dimension. For the purpose, banks will need to estimate facility-specific LGD by capturing data on historical recoveries effected by them in the various assets that have default. The recoveries will have to be
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adjusted for all expenses incurred and discounted to the present value at the time the corporate default. Clarity and consistency in the implementation of the bank-wide rating system is integral to a bank to relate its credit scores to objective loss statistics and convince the regulator that its internal rating system is suitable for calculating regulatory capital. Human judgment is central to the assignment of a rating. Banks, therefore, should design the operating flow of the process towards promoting accuracy and consistency of ratings, without hindering the exercise of judgment. While designing the operating framework, banks should include the organizational division of responsibility of rating the nature of reviews to detect errors and inconsistencies, the location of ultimate authority over rating assignment, the role of models in the rating process and the specificity of rating definitions. Banks must have a mechanism of bank testing the rating system and the loss characterstics of their internal ratings. This is essential to evaluate the accuracy and consistency of the rating criteria, accurately price assets and analyse profitability and performance of the portfolio, monitor the structure and migration of the loan portfolio and provide an input to credit risk models and economic capital allocation process. The PD will allow the back testing of banks rating system by comparing the actual default performance of entities in a particular grade to the rate of default predicted by the bank rating. Back testing against internal data and benchmarking the performance of the internals ratings system against external rating systems will be a key part of the general verification process. There are certain limitations, however, in using such an external mapping. First, would be the significant difference in the quality and composition of the population of corporate rated by rating agencies and those in a banks portfolio. Second, would be the time lag in which the agencies would be putting out their data on default probabilities/migration frequencies with this time lag there is a likelihood that the adverse changes in default probabilities is factored into the rating system well after a recession in the economy. Third, there would be potential inconsistencies in mapping a point-in-time rating with a Through-the-cycle rating fourth, statistics available relate to developed markets and emerging markets and do not reflect representation of varying degree of economic reforms and globalization. Any improved internal risk internal rating system will need to have operational for some time before either the bank or the regulators can amass data needed to back test the system and gain confidence in it. The Basel paper on the IRB approach states that bank will be required to collect and store substantial historical data on borrower default, rating decisions, rating histories, rating migration, information used to assign the ratings, the model that assigned the ratings, PD histories, key borrower characterstics and facility information. Banks seeking eligibility for the IRB approach should move to develop and warehouse their own historical loss experience data. Although data constraints remain a challenge and data collection is costly, many banks have recognized its importance and have begun projects to build databases of loan characterstics and loss experience. The internal rating of a bank is not just a tool for judicious selection of credit at business unit level. Thanks to rapid developments taking place worldwide in a risk management practices, internal ratings are being put to uses that are more progressive. Internal ratings are used as a basis for economic capital allocation decision at the portfolio level and the individual asset level. Having allocated this capital and in vie of the average risk of default assumed by the bank, the bank needs to appropriately price the asset to compensate for the risk through a risk premium and also generate the required shareholder return on the economic capital at stake.
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Construction and validation of a robust internal credit risk rating system is just the first step toward sophisticated credit risk management. For an ambitious bank, the bank the IRB approach promoted by Basel will form the platform for the risk management measures that are more sophisticated such as rsik based performance measurement.

What is Credit risk?


Credit Risk is the potential that a bank borrower/counter party fails to meet the obligations on agreed terms. There is always scope for the borrower to default from his commitments for one or the other reason resulting in crystalisation of credit risk to the bank. These losses could take the form outright default or alternatively, losses from changes in portfolio value arising from actual or perceived deterioration in credit quality that is short of default. Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables. The objective of credit risk management is to minimize the risk and maximize banks risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters. Credit risk consists of primarily two components, viz Quantity of risk, which is nothing but the outstanding loan balance as on the date of default and the quality of risk, viz, the severity of loss defined by both Probability of Default as reduced by the recoveries that could be made in the event of default. Thus credit risk is a combined outcome of Default Risk and Exposure Risk. The elements of Credit Risk is Portfolio risk comprising Concentration Risk as well as Intrinsic Risk and Transaction Risk comprising migration/down gradation risk as well as Default Risk. At the transaction level, credit ratings are useful measures of evaluating credit risk that is prevalent across the entire organization where treasury and credit functions are handled. Portfolio analysis help in identifying concentration of credit risk, default/migration statistics, recovery data, etc. In general, Default is not an abrupt process to happen suddenly and past experience dictates that, more often than not, borrowers credit worthiness and asset quality declines gradually, which is otherwise known as migration. Default is an extreme event of credit migration. Off balance sheet exposures such as foreign exchange forward cantracks, swaps options etc are classified in to three broad categories such as full Risk, Medium Risk and Low risk and then translated into risk Neighted assets. Risk Management. Risk Management is a discipline at the core of every financial institution and encompasses all the activities that affect its risk profile. It involves identification, measurement, monitoring and controlling risks to ensure that a) The individuals who take or manage risks clearly understand it. b) The organizations Risk exposure is within the limits established by Board of Directors. c) Risk taking Decisions are in line with the business strategy and objectives set by BOD. d) The expected payoffs compensate for the risks taken e) Risk taking decisions are explicit and clear. f) Sufficient capital as a buffer is available to take risk The acceptance and management of financial risk is inherent to the business of banking and banks roles as financial intermediaries. Risk management as commonly perceived does not mean minimizing risk; rather the goal of risk management is to optimize risk-reward trade -off. Notwithstanding the fact that banks are in the business of taking risk, it should be recognized that an institution need not engage in business in a manner that unnecessarily imposes risk upon it:
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nor it should absorb risk that can be transferred to other participants. Rather it should accept those risks that are uniquely part of the array of banks services. In every financial institution, risk management activities broadly take place simultaneously at following different hierarchy levels. . a) Strategic level: It encompasses risk management functions performed by senior management and BOD. For instance definition of risks, ascertaining institutions risk appetite, formulating strategy and policies for managing risks and establish adequate systems and controls to ensure that overall risk remain within acceptable level and the reward compensate for the risk taken. b) Macro Level: It encompasses risk management within a business area or across business lines. Generally the risk management activities performed by middle management or units devoted to risk reviews fall into this category. c) Micro Level: It involves On-the-line risk management where risks are actually created. This is the risk management activities performed by individuals who take risk on organizations behalf such as front office and loan origination functions. The risk management in those areas is confined to following operational procedures and guidelines set by management. Expanding business arenas, deregulation and globalization of financial activities emergence of new financial products and increased level of competition has necessitated a need for an effective and structured risk management in financial institutions. A banks ability to measure, monitor, and steer risks comprehensively is becoming a decisive parameter for its strategic positioning. The risk management framework and sophistication of the process, and internal controls, used to manage risks, depends on the nature, size and complexity of institutions activities. Nevertheless, there are some basic principles that apply to all financial institutions irrespective of their size and complexity of business and are reflective of the strength of an individual bank's risk management practices.

Credit Risk Management Process

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Managing credit risk Credit risk arises from the potential that an obligor is either unwilling to perform on an obligation or its ability to perform such obligation is impaired resulting in economic loss to the bank. In a banks portfolio, losses stem from outright default due to inability or unwillingness of a customer or counter party to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively losses may result from reduction in portfolio value due to actual or perceived deterioration in credit quality. Credit risk emanates from a banks dealing with individuals, corporate, financial institutions or a sovereign. For most banks, loans are the largest and most obvious source of credit risk; however, credit risk could stem from activities both on and off balance sheet. In addition to direct accounting loss, credit risk should be viewed in the context of economic exposures. This encompasses opportunity costs, transaction costs and expenses associated with a non-performing asset over and above the accounting loss. Credit risk can be further sub categorized on the basis of reasons of default. For instance the default could be due to country in which there is exposure or problems in settlement of a transaction. Credit risk not necessarily occurs in isolation. The same source that endangers credit risk for the institution may also expose it to other risk. For instance a bad portfolio may attract liquidity problem. Components of credit risk management A typical Credit risk management framework in a financial institution may be broadly categorized into following main components. a) Board and senior Managements Oversight b) Organizational structure c) Systems and procedures for identification, acceptance, measurement, monitoring and control risks. Board and Senior Managements Oversight
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It is the overall responsibility of banks Board to approve banks credit risk strategy and significant policies relating to credit risk and its management which should be based on the banks overall business strategy. To keep it current, the overall strategy has to be reviewed by the board, preferably annually. The responsibilities of the Board with regard to credit risk management shall, interalia, include : a) Delineate banks overall risk tolerance in relation to credit risk.Ensure that banks overall credit risk exposure is maintained at prudent levels and consistent with the available capital c) Ensure that top management as well as individuals responsible for credit risk management possess sound expertise and knowledge to accomplish the risk management function d) Ensure that the bank implements sound fundamental principles that facilitate the identification, measurement, monitoring and control of credit risk. e) Ensure that appropriate plans and procedures for credit risk management are in place. The very first purpose of banks credit strategy is to determine the risk appetite of the bank. Once it is determined the bank could develop a plan to optimize return while keeping credit risk within predetermined limits. The banks credit risk strategy thus should spell out a) The institutions plan to grant credit based on various client segments and products, economic sectors, geographical location, currency and maturity b) Target market within each lending segment, preferred level of diversification/concentration. c) Pricing strategy. It is essential that banks give due consideration to their target market while devising credit risk strategy. The credit procedures should aim to obtain an indepth understanding of the banks clients, their credentials & their businesses in order to fully know their customers. The strategy should provide continuity in approach and take into account cyclic aspect of countrys economy and the resulting shifts in composition and quality of overall credit portfolio. While the strategy would be reviewed periodically and amended, as deemed necessary, it should be viable in long term and through various economic cycles. The senior management of the bank should develop and establish credit policies and credit administration procedures as a part of overall credit risk management framework and get those approved from board. Such policies and procedures shall provide guidance to the staff on various types of lending including corporate, SME, consumer, agriculture, etc. At minimum the policy should include a) Detailed and formalized credit evaluation/ appraisal process. b) Credit approval authority at various hierarchy levels including authority for approving exceptions. c) Risk identification, measurement, monitoring and control d) Risk acceptance criteria e) Credit origination and credit administration and loan documentation procedures f) Roles and responsibilities of units/staff involved in origination and management of credit. g) Guidelines on management of problem loans. In order to be effective these policies must be clear and communicated down the line. Further any significant deviation/exception to these policies must be communicated to the top management/board and corrective measures should be taken. It is the responsibility of senior management to ensure effective implementation of these policies. Organizational Structure.

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To maintain banks overall credit risk exposure within the parameters set by the board of directors, the importance of a sound risk management structure is second to none. While the banks may choose different structures, it is important that such structure should be commensurate with institutions size, complexity and diversification of its activities. It must facilitate effective management oversight and proper execution of credit risk management and control processes. Each bank, depending upon its size, should constitute a Credit Risk Management Committee (CRMC), ideally comprising of head of credit risk management Department, credit department and treasury. This committee reporting to banks risk management committee should be empowered to oversee credit risk taking activities and overall credi t risk management function. The CRMC should be mainly responsible for a) The implementation of the credit risk policy / strategy approved by the Board. b) Monitor credit risk on a bank-wide basis and ensure compliance with limits approved by the Board. c) Recommend to the Board, for its approval, clear policies on standards for presentation of credit proposals, financial covenants, rating standards and benchmarks. d) Decide delegation of credit approving powers, prudential limits on large credit exposures, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc. Further, to maintain credit discipline and to enunciate credit risk management and control process there should be a separate function independent of loan origination function. Credit policy formulation, credit limit setting, monitoring of credit exceptions / exposures and review /monitoring of documentation are functions that should be performed independently of the loan origination function. For small banks where it might not be feasible to establish such structural hierarchy, there should be adequate compensating measures to maintain credit discipline introduce adequate checks and balances and standards to address potential conflicts of interest. Ideally, the banks should institute a Credit Risk Management Department (CRMD). Typical functions of CRMD include: a) To follow a holistic approach in management of risks inherent in banks portfolio and ensure the risks remain within the boundaries established by the Board or Credit Risk Management Committee. b) The department also ensures that business lines comply with riskparameters and prudential limits established by the Board or CRMC. c) Establish systems and procedures relating to risk identification, Management Information System, monitoring of loan / investment portfolio quality and early warning. The department would work out remedial measure when deficiencies/problems are identified. The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio. Notwithstanding the need for a separate or independent oversight, the front office or loan origination function should be cognizant of credit risk, and maintain high level of credit discipline and standards in pursuit of business opportunities. Systems and Procedures Credit Origination. Banks must operate within a sound and well-defined criteria for new credits as well as the expansion of existing credits. Credits should be extended within the target markets and lending
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strategy of the institution. Before allowing a credit facility, the bank must make an assessment of risk profile of the customer/transaction. This may include a) Credit assessment of the borrowers industry, and macro economic factors. b) The purpose of credit and source of repayment. c) The track record / repayment history of borrower. d) Assess/evaluate the repayment capacity of the borrower. e) The Proposed terms and conditions and covenants. f) Adequacy and enforceability of collaterals. g) Approval from appropriate authority In case of new relationships consideration should be given to the integrity and repute of the borrowers or counter party as well as its legal capacity to assume the liability. Prior to entering into any new credit relationship the banks must become familiar with the borrower or counter party and be confident that they are dealing with individual or organization of sound repute and credit worthiness. However, a bank must not grant credit simply on the basis of the fact that the borrower is perceived to be highly reputable i.e. name lending should be discouraged. While structuring credit facilities institutions should appraise the amount and timing of the cash flows as well as the financial position of the borrower and intended purpose of the funds. It is utmost important that due consideration should be given to the risk reward trade off in granting a credit facility and credit should be priced to cover all embedded costs. Relevant terms and conditions should be laid down to protect the institutions interest. Institutions have to make sure that the credit is used for the purpose it was borrowed. Where the obligor has utilized funds for purposes not shown in the original proposal, institutions should take steps to determine the implications on creditworthiness. In case of corporate loans where borrower own group of companies such diligence becomes more important. Institutions should classify such connected companies and conduct credit assessment on consolidated/group basis. In loan syndication, generally most of the credit assessment and analysis is done by the lead institution. While such information is important, institutions should not over rely on that. All syndicate participants should perform their own independent analysis and review of syndicate terms. Institution should not over rely on collaterals / covenant. Although the importance of collaterals held against loan is beyond any doubt, yet these should be considered as a buffer providing protection in case of default, primary focus should be on obligors debt servicing ability and reputation in the market. Limit setting An important element of credit risk management is to establish exposure limits for single obligors and group of connected obligors. Institutions are expected to develop their own limit structure while remaining within the exposure limits set by State Bank of Pakistan. The size of the limits should be ba sed on the credit strength of the obligor, genuine requirement of credit, economic conditions and the institutions risk tolerance. Appropriate limits should be set for respective products and activities. Institutions may establish limits for a specific industry, economic sector or geographic regions to avoid concentration risk. Some times, the obligor may want to share its facility limits with its related companies. Institutions should review such arrangements and impose necessary limits if the transactions are frequent and significant
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Credit limits should be reviewed regularly at least annually or more frequently if obligors credit quality deteriorates. All requests of increase in credit limits should be substantiated. Credit Administration. Ongoing administration of the credit portfolio is an essential part of the credit process. Credit administration function is basically a back office activity that support and control extension and maintenance of credit. A typical credit administration unit performs following functions: a. Documentation. It is the responsibility of credit administration to ensure completeness of documentation (loan agreements, guarantees, transfer of title of collaterals etc) in accordance with approved terms and conditions. Outstanding documents should be tracked and followed up to ensure execution and receipt. b. Credit Disbursement. The credit administration function should ensure that the loan application has proper approval before entering facility limits into computer systems. Disbursement should be effected only after completion of covenants, and receipt of collateral holdings. In case of exceptions necessary approval should be obtained from competent authorities. c. Credit monitoring. After the loan is approved and draw down allowed, the loan should be continuously watched over. These include keeping track of borrowers compliance with credit terms, identifying early signs of irregularity, conducting periodic valuation of collateral and monitoring timely repayments. d. Loan Repayment. The obligors should be communicated ahead of time as and when the principal/markup installment becomes due. Any exceptions such as non-payment or late payment should be tagged and communicated to the management. Proper records and updates should also be made after receipt. e. Maintenance of Credit Files. Institutions should devise procedural guidelines and standards for maintenance of credit files. The credit files not only include all correspondence with the borrower but should also contain sufficient information necessary to assess financial health of the borrower and its repayment performance. It need not mention that information should be filed in organized way so that external / internal auditors or SBP inspector could review it easily. f. Collateral and Security Documents. Institutions should ensure that all security documents are kept in a fireproof safe under dual control. Registers for documents should be maintained to keep track of their movement. Procedures should also be established to track and review relevant insurance coverage for certain facilities/collateral. Physical checks on security documents should be conducted on a regular basis. While in small Institutions it may not be cost effective to institute a separate credit administrative set-up, it is important that in such institutions individuals performing sensitive functions such as custody of key documents, wiring out funds, entering limits into system, etc., should report to managers who are independent of business origination and credit approval process.

Measuring credit risk.


The measurement of credit risk is of vital importance in credit risk management. A number of qualitative and quantitative techniques to measure risk inherent in credit portfolio are evolving. To start with, banks should establish a credit riskrating framework across all type of credit activities. Among other things, the rating framework may, incorporate: Business Risk o Industry Characteristics
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o Competitive Position (e.g. marketing/technological edge) o Management Financial Risk o Financial condition o Profitability o Capital Structure o Present and future Cash flows Internal Risk Rating. Credit risk rating is summary indicator of a banks individual credit exposure. An internal rating system categorizes all credits into various classes on the basis of underlying credit quality. A well-structured credit rating framework is an important tool for monitoring and controlling risk inherent in individual credits as well as in credit portfolios of a bank or a business line. The importance of internal credit rating framework becomes more eminent due to the fact that historically major losses to banks stemmed from default in loan portfolios. While a number of banks already have a system for rating individual credits in addition to the risk categories prescribed by SBP, all banks are encouraged to devise an internal rating framework. An internal rating framework would facilitate banks in a number of ways such as a) Credit selection b) Amount of exposure c) Tenure and price of facility d) Frequency or intensity of monitoring e) Analysis of migration of deteriorating credits and more accurate computation of future loan loss provision f) Deciding the level of Approving authority of loan. The Architecture of internal rating system. The decision to deploy any risk rating architecture for credits depends upon two basic aspects a) The Loss Concept and the number and meaning of grades on the rating continuum corresponding to each loss concept*. b) Whether to rate a borrower on the basis of point in time philosophy or through the cycle approach. Besides there are other issues such as whether to include statutory grades in the scale, the type of rating scale i.e. alphabetical numerical or alpha-numeric etc. SBP does not advocate any particular credit risk rating system; it should be banks own choice. However the system should commensurate with the size, nature and complexity of their business as well as possess flexibility to accommodate present and future risk profile of the bank, the anticipated level of diversification and sophistication in lending activities. A rating system with large number of grades on rating scale becomes more expensive due to the fact that the cost of obtaining and analyzing additional information for fine gradation increase sharply. However, it is important that there should be sufficient gradations to permit accurate characterization of the under lying risk profile of a loan or a portfolio of loans The operating Design of Rating System. As with the decision to grant credit, the assignment of ratings always involve element of human judgment. Even sophisticated rating models do not replicate experience and judgment rather these techniques help and reinforce subjective judgment. Banks thus design the operating flow of
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the rating process in a way that is aimed promoting the accuracy and consistency of the rating system while not unduly restricting the exercise of judgment. Key issues relating to the operating design of a rating system include what exposures to rate; the organizations division of responsibility for grading; the nature of ratings review; the formality of the process and specificity of formal rating definitions. What Exposures are rated? Ideally all the credit exposures of the bank should be assigned a risk rating. However given the element of cost, it might not be feasible for all banks to follow. The banks may decide on their own which exposure needs to be rated. The decision to rate a particular loan could be based on factors such as exposure amount, business line or both. Generally corporate and commercial exposures are subject to internal ratings and banks use scoring models for consumer retail loans. The rating process in relation to credit approval and review. Ratings are generally assigned /reaffirmed at the time of origination of a loan or its renewal /enhancement. The analysis supporting the ratings is inseparable from that required for credit appraisal. In addition the rating and loan analysis process while being separate are intertwined. The process of assigning a rating and its approval / confirmation goes along with the initiation of a credit proposal and its approval. Generally loan origination function (whether a relationship manager or credit staff) * initiates a loan proposal and also allocates a specific rating. This proposal passes through the credit approval process and the rating is also approved or recalibrated simultaneously by approving authority. The revision in the ratings can be used to upgrade the rating system and related guidelines. How to arrive at ratings The assignment of a particular rating to an exposure is basically an abbreviation of its overall risk profile. Theoretically ratings are based upon the major risk factors and their intensity inherent in the business of the borrower as well as key parameters and their intensity to those risk factors. Major risk factors include borrowers financial condition, size, industry and position in the industry; the reliability of financial statements of the borrower; quality of management; elements of transaction structure such as covenants etc. A more detail on the subject would be beyond the scope of these guidelines, however a few important aspects are a) Banks may vary somewhat in the particular factors they consider and the weight they give to each factor. b) Since the rater and reviewer of rating should be following the same basic thought, to ensure uniformity in the assignment and review of risk grades, the credit policy should explicitly define each risk grade; lay down criteria to be fulfilled while assigning a particular grade, as well as the circumstances under which deviations from criteria can take place. c) The credit policy should also explicitly narrate the roles of different parties involved in the rating process. d) The institution must ensure that adequate training is imparted to staff to ensure uniform ratings e) Assigning a Rating is basically a judgmental exercise and the models, external ratings and written guidelines/benchmarks serve as input. f) Institutions should take adequate measures to test and de velop a risk rating system prior to adopting one. Adequate validation testing should be conducted during the design phase as well as over the life of the system to ascertain the applicability of the system to the institutions portfolio.
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Institutions that use sophisticated statistical models to assign ratings or to calculate probabilities of default, must ascertain the applicability of these models to their portfolios. Even when such statistical models are found to be satisfactory, institutions should not use the output of such models as the sole criteria for assigning ratings or determining the probabilities of default. It would be advisable to consider other relevant inputs as well. Ratings review The rating review can be two-fold: a) Continuous monitoring by those who assigned the rating. The Relationship Managers (RMs) generally have a close contact with the borrower and are expected to keep an eye on the financial stability of the borrower. In the event of any deterioration the ratings are immediately revised /reviewed. Secondly the risk review functions of the bank or business lines also conduct periodical review of ratings at the time of risk review of credit portfolio. Risk ratings should be assigned at the inception of lending, and updated at least annually. Institutions should, however, review ratings as and when adverse events occur. A separate function independent of loan origination should review Risk ratings. As part of portfolio monitoring, institutions should generate reports on credit exposure by risk grade. Adequate trend and migration analysis should also be conducted to identify any deterioration in credit quality. Institutions may establish limits for risk grades to highlight concentration in particular rating bands. It is important that the consistency and accuracy of ratings is examined periodically by a function such as an independent credit review group For consumer lending, institutions may adopt credit-scoring models for processing loan applications and monitoring credit quality. Institutions should apply the above principles in the management of scoring models. Where the model is relatively new, institutions should continue to subject credit applications to rigorous review until the model has stabilized. Credit Risk Monitoring & Control Credit risk monitoring refers to incessant monitoring of individual credits inclusive of OffBalance sheet exposures to obligors as well as overall credit portfolio of the bank. Banks need to enunciate a system that enables them to monitor quality of the credit portfolio on day-to-day basis and take remedial measures as and when any deterioration occurs. Such a system would enable a bank to ascertain whether loans are being serviced as per facility terms, the adequacy of provisions, the overall risk profile is within limits established by management and compliance of regulatory limits. Establishing an efficient and effective credit monitoring system would help senior management to monitor the overall quality of the total credit portfolio and its trends. Consequently the management could fine tune or reassess its credit strategy /policy accordingly before encountering any major setback. The banks credit policy should explicitly provide procedural guideline relating to credit risk monitoring. At the minimum it should lay down procedure relating to a) The roles and responsibilities of individuals responsible for credit risk monitoring b) The assessment procedures and analysis techniques (for individualloans & overall portfolio) c) The frequency of monitoring d) The periodic examination of collaterals and loan covenants e) The frequency of site visits f) The identification of any deterioration in any loan Given below are some key indicators that depict the credit quality of a loan:
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a. Financial Position and Business Conditions. The most important aspect about an obligor is its financial health, as it would determine its repayment capacity. Consequently institutions need carefully watch financial standing of obligor. The Key financial performance indicators on profitability, equity, leverage and liquidity should be analyzed. While making such analysis due consideration should be given to business/industry risk, borrowers position within the industry and external factors such as economic condition, government policies, regulations. For companies whose financial position is dependent on key management personnel and/or shareholders, for example, in small and medium enterprises, institutions would need to pay particular attention to the assessment of the capability and capacity of the management/shareholder(s). b. Conduct of Accounts. In case of existing obligor the operation in the account would give a fair idea about the quality of credit facility. Institutions should monitor the obligors account activity, repayment history and instances of excesses over credit limits. For trade financing, institutions should monitor cases of repeat extensions of due dates for trust receipts and bills. c. Loan Covenants. The obligors ability to adhere to negative pledges and financial covenants stated in the loan agreement should be assessed, and any breach detected should be addressed promptly. d. Collateral valuation. Since the value of collateral could deteriorate resulting in unsecured lending, banks need to reassess value of collaterals on periodic basis. The frequency of such valuation is very subjective and depends upon nature of collaterals. For instance loan granted against shares need revaluation on almost daily basis whereas if there is mortgage of a residential property the revaluation may not be necessary as frequently. In case of credit facilities secured against inventory or goods at the obligors premises, appropriate inspection should be conducted to verify the existence and valuation of the collateral. And if such goods are perishable or such that their value diminish rapidly (e.g. electronic parts/equipments), additional precautionary measures should be taken. External Rating and Market Price of securities such as TFCs purchased as a form of lending or long-term investment should be monitored for any deterioration in credit rating of the issuer, as well as large decline in market price. Adverse changes should trigger additional effort to review the creditworthiness of the issuer. Risk review The institutions must establish a mechanism of independent, ongoing assessment of credit risk management process. All facilities except those managed on a portfolio basis should be subjected to individual risk review at least once in a year. The results of such review should be properly documented and reported directly to board, or its sub committee or senior management without lending authority. The purpose of such reviews is to assess the credit administration process, the accuracy of credit rating and overall quality of loan portfolio independent of relationship with the obligor. Institutions should conduct credit review with updated information on the obligors financial and business conditions, as well as conduct of account. Exceptions noted in the credit monitoring process should also be evaluated for impact on the obligors creditworthiness. Credit review should also be conducted on a consolidated group basis to factor in the business connections among entities in a borrowing group.

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As stated earlier, credit review should be performed on an annual basis, however more frequent review should be conducted for new accounts where institutions may not be familiar with the obligor, and for classified or adverse rated accounts that have higher probability of default. For consumer loans, institutions may dispense with the need to perform credit review for certain products. However, they should monitor and report credit exceptions and deterioration. Delegation of Authority. Banks are required to establish responsibility for credit sanctions and delegate authority to approve credits or changes in credit terms. It is the responsibility of banks board to approve the overall lending authority structure, and explicitly delegate credit sanctioning authority to senior management and the credit committee. Lending authority assigned to officers should be commensurate with the experience, ability and personal character. It would be better if institutions develop risk-based authority structure where lending power is tied to the risk ratings of the obligor. Large banks may adopt multiple credit approvers for sanctioning such as credit ratings, risk approvals etc to institute a more effective system of check and balance. The credit policy should spell out the escalation process to ensure appropriate reporting and approval of credit extension beyond prescribed limits. The policy should also spell out authorities for unsecured credit (while remaining within SBP limits), approvals of disbursements excess over limits and other exceptions to credit policy. In cases where lending authority is assigned to the loan originating function, there should be compensating processes and measures to ensure adherence to lending standards. There should also be periodic review of lending authority assigned to officers. Managing problem credits The institution should establish a system that helps identify problem loan ahead of time when there may be more options available for remedial measures. Once the loan is identified as problem, it should be managed under a dedicated remedial process. A banks credit risk policies should clearly set out how the bank will manage problem credits. Banks differ on the methods and organization they use to manage problem credits. Responsibility for such credits may be assigned to the originating business function, a specialized workout section, or a combination of the two, depending upon the size and nature of the credit and the reason for its problems. When a bank has significant credit-related problems, it is important to segregate the workout function from the credit origination function. The additional resources, expertise and more concentrated focus of a specialized workout section normally improve collection results. A problem loan management process encompass following basic elements. a. Negotiation and follow-up. Proactive effort should be taken in dealing with obligors to implement remedial plans, by maintaining frequent contact and internal records of follow-up actions. Often rigorous efforts made at an early stage prevent institutions from litigations and loan losses b. Workout remedial strategies. Some times appropriate remedial strategies such as restructuring of loan facility, enhancement in credit limits or reduction in interest rates help improve obligors repayment capacity. However it depends upon business condition, the nature of problems being faced and most importantly obligors commitment and willingness to repay the loan. While such remedial strategies often bring up positive results, institutions need to exercise great caution in adopting such measures and ensure that such a policy must not encourage obligors to default intentionally. The institutions interest should be the primary
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consideration in case of such workout plans. It needs not mention here that competent authority, before their implementation, should approve such workout plan. c. Review of collateral and security document. Institutions have to ascertain the loan recoverable amount by updating the values of available collateral with formal valuation. Security documents should also be reviewed to ensure the completeness and enforceability of contracts and collateral/guarantee. d. Status Report and Review Problem credits should be subject to more frequent review and monitoring. The review should update the status and development of the loan accounts and progress of the remedial plans. Progress made on problem loan should be reported to the senior management

Chapter-2 Review of Literature

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Review of Literature
Until recently many researchers have shown interest in the field of credit risk management in banks . They have carried out numerous laboratory experiments and field observations to illuminate the darkness of this field. Their findings and suggestions are reviewed here.

Improving Banks' Credit Risk Management


by Xinzheng Huang and Cornelis W. Oosterlee Xinzheng Huang and Cornelis W. Oosterlee wrote about Improving Banks Credit Risk Managemnt. Talking about the recent credit crisis they have mentioned that Improving the practice of credit risk management by banks has thus become a top priority. Researchers Huang (Delft University of Technology) and Oosterlee (CWI) in the Netherlands focus on quantifying portfolio credit risk by advanced numerical techniques with an eye to active credit portfolio management. This work was sponsored by the Dutch Rabobank. According to them Credit risk is the risk of loss resulting from an obligor's inability to meet its obligations. Generally speaking, credit risk is the largest source of risk facing banking institutions. For these institutions, sound management involves measuring the credit risk at portfolio level to determine the amount of capital they need to hold as a cushion against potentially extreme losses. In practice, the portfolio risk is often measured by Value at Risk (VaR), which is simply the quantile of the distribution of portfolio loss for a given confidence level. With the Basel II accords (the recommendations on banking laws and regulations issued in 2004 by the Basel Committee on Banking Supervision), financial regulators aim to safeguard the banking institutions' solvency against such extreme losses.

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From a bank's perspective, a high level of credit risk management means more than simply meeting regulatory requirements: the aim is rather to enhance the risk/return performance of credit assets. To achieve this goal, it is essential to measure how much a single obligor in a portfolio contributes to the total risk, ie the risk contributions of single exposures. Risk contribution plays an integral role in risk-sensitive loan pricing and portfolio optimization. Extrapolation of credit risk from individual obligors to portfolio level involves specifying the dependence among obligors. Huang & Oosterlee have considered the Vasicek model.Widely adopted in the industry is the Vasicek model, on which is built the Basel II internal rating-based approach. It is a Gaussian one-factor model, with default events being driven by a single common factor that is assumed to follow the Gaussian distribution, and obligors being independent conditional on the common factor. Under certain homogeneity conditions, the Vasicek one-factor model leads to very simple analytic asymptotic approximations of the loss distribution, VaR and VaR Contribution. However, these analytic approximations can significantly underestimate risks in the presence of exposure concentrations, ie when the portfolio is dominated by a few obligors. In their research, Huang and Oosterlee showed that the saddle-point approximation with a conditional approach is an efficient tool for estimating the portfolio credit loss distribution in the Vasicek model and is well able to handle exposure concentration. The saddle-point approximation can be thought of as an improved version of the central limit theorem and usually leads to a small relative error, even for very small probabilities. Moreover, the saddle-point approximation is a flexible method which can be applied beyond the Vasicek model to more heavily tailed loss distributions which provide a better fit to current financial market data. The single factor in the Vasicek model represents generally the state of economy. More factors are necessary if one wishes to take into account the effects of different industries and geographical regions in credit portfolio loss modelling. For example, in the current crisis the financial industry is taking the hardest hit, while back in 1997 East Asian countries suffered most. Multiple factors can be used to incorporate these details, but they generally complicate the computational process, as high-dimensional integrals need to be computed. For this, the researchers proposed efficient algorithms of adaptive integration for the calculation of the tail probability, with either a deterministic multiple integration rule or a Monte Carlo type random rule. In the Vasicek model the loss given default (LGD) - the proportion of the exposure that will be lost if a default occurs - is assumed to be constant. However, extensive empirical evidence shows that it tends to go up in economic downturn. A heuristic justification is that the LGD is determined by the value of collateral (eg house prices in the case of mortgage loans), which is sensitive to the state of the economy. To account for this, Huang and Oosterlee proposed a new flexible framework for modelling systematic risk in LGD, in which the quantities have simple economic interpretation. The random LGD framework, combined with the fat-tailed models, further provides possibilities to replicate the spreads of the senior tranches of credit market indices (eg CDX), which have widened dramatically since the emergence of the credit crisis to a

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level that the industrial standard Gaussian one-factor model can not produce even with 100% correlation. This research provides useful tools to fulfill the needs of active credit portfolio management within banks. Banks can improve their insight into credit risk and take appropriate measures to maximize their risk/return profile. RISK MANAGEMENT IN BANKING COMPANIES "http://www.articlesbase.com/management-articles/risk-management-in-bankingcompanies-1838565.html" \t "_new" By:Risk Management In Banking Companies Risk Management in banking companies is also a group on internet that publishes related to Credit risk management. Its operations include risk identification, measurement and assessment, and its objective is to minimize negative effects risks can have on the financial result and capital of the bank. Banks are required to form a special organisational unit for the purpose of risk management. The risk to which the bank is particularly exposed in its operations are market risk(interest rate risk, foreign exchange risk, risk from change in market price of securities, financial and commodities), credit risk, liquidity risk, exposure risk, investment risk, operational risk, legal risk, strategic risk. These risks are highly inter-independent. Events that affect one area of risk can have ramifications for a range of other risk categories. In this article they have talked about the latest approaches of Credit risk management and the effect of Basal norms on it. CREDIT RISK MANAGEMENT They have defined Credit risk is as the potential that a bank borrower or counter party will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximise the banks risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherit in the entire portfolio as well as the risk in individual or credits or transactions. For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of the bank, including in the banking book and the trading book and both on and off the balance sheet. Banks are increasingly facing credit risk (or counter party risk) in various financial instruments other than loans including acceptances, inter bank transactions, trade financing, foreign exchange transactions swaps, bonds, equities, options and in the extension of commitments and guarantees, the settlement of transactions. BASAL II ON CREDIT RISK

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The basal community on banking supervision release a consultative document on New Capital Adequacy Framework with the view to replacing 1988 Accord. The document proposes three pillars for the new accord1. Minimum Capital Requirements, 2.Supervisory review 3.Market discipline A new accord continues with the minimum capital adequacy ratio of 8% of risk waited assets. Arrange of options to estimate capital as proposed in the document include a standardised approach. Under this approach, preferential risk weights in the range of 0%, 20%, 50%, 100%, and 150% are envisaged to be assigned on the basis of external credit assessments. Under foundation Internal Rating Based (IRB), community proposes certain minimum compliance.wiz.a comprehensive credit rating system with capability to quantify Probability of Default (PD) while assigning preferential risk weights, with the information supplied by national supervisor on loss given default (LGD) an exposure at default. Adoption a New Capital Accord by banks in the proposed state requires complete change in the existing risk management systems.

"Credit Risk Management: Policy Framework for Indian Banks"


By :CoolAvenues Knowledge Management Team CoolAvenues Knowledge Management Team, a knowledge management portal on various topics also have written about the credit risk management framework for Indian banks.According to them in this article, Risk is inherent in all aspects of a commercial operation and covers areas such as customer services, reputation, technology, security, human resources, market price, funding, legal, regulatory, fraud and strategy. However, for banks and financial institutions, credit risk is the most important factor to be managed. Credit risk is defined as the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk, therefore, arises from the banks' dealings with or lending to a corporate, individual, another bank, financial institution or a country. Credit risk may take various forms, such as:

in the case of direct lending, that funds will not be repaid; in the case of guarantees or letters of credit, that funds will not be forthcoming from the customer upon crystallization of the liability under the contract; in the case of treasury products, that the payment or series of payments due from the counterparty under the respective contracts is not forthcoming or ceases; in the case of securities trading businesses, that settlement will not be effected; in the case of cross-border exposure, that the availability and free transfer of currency is restricted or ceases.

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The more diversified a banking group is, the more intricate systems it would need, to protect itself from a wide variety of risks. These include the routine operational risks applicable to any commercial concern, the business risks to its commercial borrowers, the economic and political risks associated with the countries in which it operates, and the commercial and the reputational risks concomitant with a failure to comply with the increasingly stringent legislation and regulations surrounding financial services business in many territories. Comprehensive risk identification and assessment are therefore very essential to establishing the health of any counterparty. Credit risk management enables banks to identify, assess, manage proactively, and optimise their credit risk at an individual level or at an entity level or at the level of a country. Given the fast changing, dynamic world scenario experiencing the pressures of globalisation, liberalization, consolidation and disintermediation, it is important that banks have a robust credit risk management policies and procedures which is sensitive and responsive to these changes. The quality of the credit risk management function will be the key driver of the changes to the level of shareholder return. Industry analysts have demonstrated that the average shareholder return of the best credit performance US banks during 1989 - 1997 was 56% higher than their peers.

They have mentioned the Credit security on certain parameters.That areBuilding Blocks on Credit Risk In any bank, the corporate goals and credit culture are closely linked, and an effective credit risk management framework requires the following distinct building blocks: Strategy and Policy This covers issues such as the definition of the credit appetite, the development of credit guidelines and the identification and the assessment of the credit risk. Organisation This would entail the establishment of competencies and clear accountabilities for managing the credit risk. Operations/Systems MIS requirements of the senior and middle management, and the development of tools and techniques will come under this domain. Strategy and Policy It is essential that each bank develops its own credit risk strategy or enunciates a plan that defines the objectives for the credit-granting function. This strategy should spell out clearly the organizations credit appetite and the acceptable level of risk - reward trade-off at both the macro and the micro levels.

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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. The policy document should cover issues such as organizational responsibilities, risk measurement and aggregation techniques, prudential requirements, risk assessment and review, reporting requirements, risk grading, product guidelines, documentation, legal issues and management of problem loans. Loan policies apart from ensuring consistency in credit practices, should also provide a vital link to the other functions of the bank. It has been empirically proved that organisations with sound and well-articulated loan policies have been able to contain the loan losses arising from poor loan structuring and perfunctory risk assessments. The credit risk strategy should provide continuity in approach, and will need to take into account the cyclical aspects of any economy and the resulting shifts in the composition and quality of the overall credit portfolio. This strategy should be viable in the long run and through various credit cycles. An organisation's risk appetite depends on the level of capital and the quality of loan book and the magnitude of other risks embedded in the balance sheet. Based on its capital structure, a bank will be able to set its target returns to its shareholders and this will determine the level of capital available to the various business lines. Keeping in view the foregoing, a bank should have the following in place: 1. dedicated policies and procedures to control exposures to designated higher risk sectors such as capital markets, aviation, shipping, property development, defence equipment, highly leveraged transactions, bullion etc. 2. sound procedures to ensure that all risks associated with requested credit facilities are promptly and fully evaluated by the relevant lending and credit officers. 3. systems to assign a risk rating to each customer/borrower to whom credit facilities have been sanctioned. 4. a mechanism to price facilities depending on the risk grading of the customer, and to attribute accurately the associated risk weightings to the facilities. 5. efficient and effective credit approval process operating within the approval limits authorized by the Boards. 6. procedures and systems which allow for monitoring financial performance of customers and for controlling outstandings within limits. 7. systems to manage problem loans to ensure appropriate restructuring schemes. A conservative policy for the provisioning of non-performing advances should be followed. 8. a process to conduct regular analysis of the portfolio and to ensure on-going control of risk concentrations. Credit Policies and Procedures
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The credit policies and procedures should necessarily have the following elements:

Banks should have written credit policies that define target markets, risk acceptance criteria, credit approval authority, credit origination and maintenance procedures and guidelines for portfolio management and remedial management. Banks should establish proactive credit risk management practices like annual / half yearly industry studies and individual obligor reviews, periodic credit calls that are documented, periodic plant visits, and at least quarterly management reviews of troubled exposures/weak credits. Business managers in banks will be accountable for managing risk and in conjunction with credit risk management framework for establishing and maintaining appropriate risk limits and risk management procedures for their businesses. Banks should have a system of checks and balances in place around the extension of credit which are: o An independent credit risk management function o Multiple credit approvers o An independent audit and risk review function The Credit Approving Authority to extend or approve credit will be granted to individual credit officers based upon a consistent set of standards of experience, judgment and ability. The level of authority required to approve credit will increase as amounts and transaction risks increase and as risk ratings worsen. Every obligor and facility must be assigned a risk rating. Banks should ensure that there are consistent standards for the origination, documentation and maintenance for extensions of credit. Banks should have a consistent approach toward early problem recognition, the classification of problem exposures, and remedial action. Banks should maintain a diversified portfolio of risk assets in line with the capital desired to support such a portfolio. Credit risk limits include, but are not limited to, obligor limits and concentration limits by industry or geography. In order to ensure transparency of risks taken, it is the responsibility of banks to accurately, completely and in a timely fashion, report the comprehensive set of credit risk data into the independent risk system.

Organizational Structure A common feature of most successful banks is to establish an independent group responsible for credit risk management. This will ensure that decisions are made with sufficient emphasis on asset quality and will deploy specialised skills effectively. In some organisations, the credit risk management team is responsible for the management of problem accounts, and for credit operations as well. The responsibilities of this team are the formulation of credit policies, procedures and controls extending to all of its credit risks arising from corporate banking, treasury, credit cards, personal banking, trade finance, securities processing, payment and settlement systems, etc. This team should also have an overview of the loan portfolio trends and
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concentration risks across the bank and for individual lines of businesses, should provide input to the Asset - Liability Management Committee of the bank, and conduct industry and sectoral studies. Inputs should be provided for the strategic and annual operating plans. In addition, this team should review credit related processes and operating procedures periodically. It is imperative that the independence of the credit risk management team is preserved, and it is the responsibility of the Board to ensure that this is not allowed to be compromised at any time. Should the Board decide not to accept any recommendation of the credit risk management team and then systems should be in place to have the rationale for such an action to be properly documented. This document should be made available to both the internal and external auditors for their scrutiny and comments. The credit risk strategy and policies should be effectively communicated throughout the organisation. All lending officers should clearly understand the bank's approach to granting credit and should be held accountable for complying with the policies and procedures. Keeping in view the foregoing, each bank may, depending on the size of the organization or loan book, constitute a high level Credit Policy Committee also called Credit Risk Management Committee or Credit Control Committee, etc. to deal with issues relating to credit policy and procedures and to analyse, manage and control credit risk on a bank wide basis. The Committee should be headed by the Chairman/CEO/ED, and should comprise heads of Credit Department, Treasury, Credit Risk Management Department (CRMD) and the Chief Economist. The Committee should, inter alia, formulate clear policies on standards for presentation of credit proposals, financial covenants, rating standards and benchmarks, delegation of credit approving powers, prudential limits on large credit exposures, asset concentrations, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc. Concurrently, each bank may also set up Credit Risk Management Department (CRMD), independent of the Credit Administration Department. The CRMD should enforce and monitor compliance of the risk parameters and prudential limits set by the CPC. The CRMD should also lay down risk assessment systems, monitor quality of loan portfolio, identify problems and correct deficiencies, develop MIS and undertake loan review/audit. Large banks may consider separate set up for loan review/audit. The CRMD should also be made accountable for protecting the quality of the entire loan portfolio. The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio. Operations / Systems Banks should have in place an appropriate credit administration, measurement and monitoring process. The credit process typically involves the following phases: 1. Relationship management phase i.e. business development. 2. Transaction management phase: cover risk assessment, pricing, structuring of the facilities, obtaining internal approvals, documentation, loan administration and routine monitoring and measurement.
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3. Portfolio management phase: entail the monitoring of the portfolio at a macro level and the management of problem loans. Successful credit management requires experience, judgement and a commitment to technical development. Each bank should have a clear, well-documented scheme of delegation of limits. Authorities should be delegated to executives depending on their skill and experience levels. The banks should have systems in place for reporting and evaluating the quality of the credit decisions taken by the various officers. The credit approval process should aim at efficiency, responsiveness and accurate measurement of the risk. This will be achieved through a comprehensive analysis of the borrower's ability to repay, clear and consistent assessment systems, a process which ensures that renewal requests are analyzed as carefully and stringently as new loans and constant reinforcement of the credit culture by the top management team. Commitment to new systems and IT will also determine the quality of the analysis being conducted. There is a range of tools available to support the decision making process. These are:

Traditional techniques such as financial analysis. Decision support tools such as credit scoring and risk grading. Portfolio techniques such as portfolio correlation analysis.

The key is to identify the tools that are appropriate to the bank. 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 the bank's activities. Banks must have a MIS, which will enable them to manage and measure the credit risk inherent in all on- and off-balance sheet activities. The MIS should provide adequate information on the composition of the credit portfolio, including identification of any concentration of risk. Banks should price their loans according to the risk profile of the borrower and the risks associated with the loans

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Chapter-3 Research Methodology


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Research Methodology
Title-Credit Risk management in banks Research Questions1) Do the banks have a proper risk management system? 2) How the lenders can minimize their risk associated with lending? The purpose of this study is to test how active management of credit risk, as proxied by loan sales and purchases, affects a financial institution's capital structure, lending, profits, and risk. We estimate a series of cross-sectional, reduced form regressions that relate measures of capital structure, investments in risky loans, profits and risk to control variables (designed to capture the extent of a banks access to an internal capital market) to measures of the banks use of the loan sales market to foster risk management.

Scope of the StudyThis research covers all the aspects of credit risk management. It has a risk management framework that encompasses the scope of risks to be managed, the process/systems and procedures to manage risk and the roles and responsibilities of individuals involved in risk management. The framework is comprehensive enough to capture all risks a bank is exposed to and have flexibility to accommodate any change in business activities. This researchs risk management framework includes
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a) Clearly defined risk management policies and procedures covering risk identification, acceptance, measurement, monitoring, reporting and control. b) A well constituted organizational structure defining clearly roles and responsibilities of individuals involved in risk taking as well as managing it. Banks, in addition to risk management functions for various risk categories may institute a setup that supervises overall risk management at the bank. Such a setup could be in the form of a separate department or banks Risk Management Committee (RMC) could perform such function*. The structure is such that ensures effective monitoring and control over risks being taken c) It includes an effective management information system that ensures flow of information from operational level to top management and a system to address any exceptions observed. There is an explicit procedure regarding measures to be taken to address such deviations. d) The framework has a mechanism to ensure an ongoing review of systems, policies and procedures for risk management and procedure to adopt changes.

Significance of the StudyCredit risk management is a very important area for the banking sector and there are wide prospects of growth and other financial institutions also face problems which are financial in nature. Thats why Ive chosen this topic for my research. This research focuses on the importance of credit risk management for banking is tremendous. Banks and other financial institutions are often faced with risks that are mostly of financial nature. It talks about how these institutions can balance risks as well as returns. For a bank to have a large consumer base, it must offer loan products that are reasonable enough. However, if the interest rates in loan products are too low, the bank will suffer from losses. In terms of equity, a bank must have substantial amount of capital on its reserve, but not too much that it misses the investment revenue, and not too little that it leads itself to financial instability and to the risk of regulatory non-compliance. The study reveals the risks constantly faced by the banks. There are certain risks in the process of granting loans to certain clients. There can be more risks involved if the loan is extended to unworthy debtors. Certain risks may also come when banks offer securities and other forms of investments. The risk of losses that result in the default of payment of the debtors is a kind of risk that must be expected. Because of the exposure of banks to many risks, it is only reasonable for a bank to keep substantial amount of capital to protect its solvency and to maintain its economic stability. The study also have included the latest steps taken by the Besel commette with regard to the same.The second Basel Accords provides statements of its rules regarding the regulation of the bank's capital allocation in connection with the level of risks the bank is exposed to. The greater the bank is exposed to risks, the greater the amount of capital must be when it comes to its reserves, so as to maintain its solvency and stability. It talks about the practices, to determine the risks that come with lending and investment practices, how the banks can assess the risks. Credit risk management must play its role then to help banks be in compliance with Basel II Accord and other regulatory bodies.

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To manage and assess the risks faced by banks, it is important to make certain estimates, conduct monitoring, and perform reviews of the performance of the bank. However, because banks are into lending and investing practices, it is relevant to make reviews on loans and to scrutinize and analyse portfolios. Loan reviews and portfolio analysis are crucial then in determining the credit and investment risks. The complexity and emergence of various securities and derivatives is a factor banks must be active in managing the risks. The credit risk management system used by many banks today has complexity; however, it can help in the assessment of risks by analysing the credits and determining the probability of defaults and risks of losses. Credit risk management for banking is a very useful system, especially if the risks are in line with the survival of banks in the business world. Also, how banking professionals can maintain a balance between the risks and the returns, For a large customer base banks need to have a variety of loan products.If bank lowers the interest rates for the loans it offers, it will suffer In terms of equity, a bank must have substantial amount of capital on its reserve, but not too much that it misses the investment revenue, and not too little that it leads itself to financial instability and to the risk of regulatory non-compliance. Credit risk management is risk assessment that comes in an investment. Risk often comes in investing and in the allocation of capital. The risks must be assessed so as to derive a sound investment decision.And decisions should be made by balancing the risks and returns. Giving loans is a risky affair for bank sometimes and Certain risks may also come when banks offer securities and other forms of investments. The risk of losses that result in the default of payment of the debtors is a kind of risk that must be expected.A bank to keep substantial amount of capital to protect its solvency and to maintain its economic stability. The greater the bank is exposed to risks, the greater the amount of capital must be when it comes to its reserves, so as to maintain its solvency and stability. Credit risk management must play its role then to help banks be in compliance with Basel II Accord and other regulatory bodies. For assessing the risk, banks should plan certain estimates, conduct monitoring, and perform reviews of the performance of the bank. They should also do Loan reviews and portfolio analysis in order to determine risk involved. Banks must be active in managing the risks in various securities and derivatives. Still how progress has to be made for analyzing the credits and determining the probability of defaults and risks of losses, is included in this study.

Sample of the Research100 senior managers involved in risk management from the leading banks in India. Few banks are State Bank of India Punjab National Bank Bank of Baroda ICICI Allahabad Bank
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Oriental Bank of Commerce Bank of India

Sources of dataThe data used to prepare this report is secondary. The main sources are as follows Published reports Government statistics Scientific and technical Abstracts Company's financial statements Banks reports

Limitations of the Study


The information and data may not be accurate. The data may out of date-The data taken for this study is of yr 2008.The figures of analysis might have changed now. The data is generated through a questionnaire on Internet.Online surveys generally manipulates the answers.One cant tell exactly what the respondant wanted by his face expressions. Reliability is not guaranteed. Since it was an online survey we cant assure about the fact that it is filled by the same respondant from whom we wanted or by someone else. There may be missing information on some observations

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Chapter-4 Data Analysis & Interpretation

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Data Analysis & Interpretation


CREDIT RISK MANAGEMENT The Bank has put in place the Credit Risk Management Policy and the same has been circulated to all the branches. The main objective of the policy is to ensure that the operations are in line with the expectation of the management and the strategies of the top management are translated into meaningful directions to the operational level. The Policy stipulates prudential limits on large credit exposures, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, provisioning and regulatory / legal compliance. The Bank identifies the risks to which it is exposed and applies suitable techniques to measure, monitor and control these risks. While the Board / Risk Management Committee of the Board devises the policy and fixes various credit risk exposures, Credit Risk Management Committee implements these policies and strategies approved by the Board / RMC, monitors credit risks on a bank wide basis and ensures compliance of risk limits. The Bank studies the concentration risk by (a) fixing exposure limits for single and group borrowers (b) rating grade limits (c) industry wise exposure limits The Bank considers rating of a borrowal account as an important tool to manage the credit risk associated with any borrower and accordingly a two dimensional credit rating system was introduced in the Bank. Software driven rating / scoring models for different segments have been customized to suit the Banks requirements. Credit Rating 1. Obligor Rating Financial Parameters Managerial Parameters
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Industrial Parameters Operational Parameters 2. Facility Rating (Collateral Securities) AAA Lowest Risk AA Lower risk A Low Risk BBB Moderate risk Entry Level BB High risk B Higher risk C Highest risk MITIGATION OF CREDIT RISK Mitigation of credit risks and enhancing awareness on identification of appropriate collateral taking into account the spirit of Basel II / RBI guidelines and Optimizing the benefi t of credit risk mitigation in computation of capital charge as per approaches laid down in Basel II / RBI guidelines. The Bank generally relies on Risk Mitigation techniques like Loan participation, Ceiling on Exposures, Escrow mechanism, Forward cover, higher margins, loan covenants, Collateral and insurance cover. Valuation methodologies are detailed in the Credit Risk Management Policy. Bank accepts guarantees from individuals with considerable net worth and the Corporate. Only guarantees issued by entities with a lower risk weight than the counterparty shall be accepted to get the protection for the counterparty exposure. All types of securities eligible for mitigation are easily realizable financial securities. As such, presently no limit / ceiling has been prescribed to address the concentration risk in credit risk mitigates recognized by the Bank Credit Rating Frame Work (CRF) Credit Rating Framework (CRF) is one of the risk measurement technique the banks use to a great extent under risk management system. This is used primarily to standardise and uniformly communicate the judgement in credit selection procedure and not as a substitute to the vast lending experience accumulated by the Banks professional staff. In line with the guidelines of RBI, the Bank has proposed to bring in all the borrowal accounts (Standard accounts) with limits of Rs.2 lakh and above under the purview of credit risk rating. However, the rating model that will be applied varies according to the type / extent of exposure to suit the borrowers activities. The Bank is utilising their own internal Credit Rating Model for grading the borrowal accounts so far. The grades used in the internal credit risk grading system should represent without any ambiguity, the default risks associated with an exposure. This system shall also enable the Bank to undertake comparison of risk for the purpose of analysis and decision taking. Number of grades used in CRF depends on the anticipated spread in credit quality of the exposure of the Bank. The more the number of grades on the rating scale, the more the requirement of information. Hence, RBI suggest that the Bank can initiate the risk grading activity on a relatively smaller scale initially and introduce new categories as the risk gradation improves. As suggested by RBI the 9 level in the grading scale and the cut off level for Acceptable and unacceptable credit risk are: The calibration on the rating scale will allow prescription of limits on the maximum quantum of exposure permissible for any credit proposal. The quantum would depend on the credit score on

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the CRF. The Bank normally does not take any fresh exposure in the unacceptable level of scale of risk. Any takeover of fresh borrowers to comply with the following norms: 1) Minimum Current Ratio of 1.33 consistently for the last 3 years. 2) Minimum Current Ratio of 1.17 and 3) Current Ratio of at least 1.00 is stipulated for exceptional cases. As regards exit, the Banks Loan Policy permits for exit even when the account remains under Standard category if any warning signals are seen. The other mode available, if complete exit is felt impossible, by containing the exposure at the same level, risk participation and opt for recovery wherever warranted. The assignors of risk ratings utilize bench mark or pre specified standards for assessing the risk profile of the borrower, especially, the financial ratios, are directly compared with the specified bench marks. Further assignment of weightage is related to the level of the risk parameters which weigh more for altering the risk profile of the borrower.

In the run up to the credit crisis, banks risk governance, risk culture and incentive and remuneration policies were the three areas where the management of risk let them down the most.The majority of Chief Risk Officers (CROs), risk professionals and other senior managers
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taking part in the survey acknowledge that the industry as a whole had an inadequate framework for controlling risk. They also admit that the prevailing organizational culture did not stop excessive risk taking, fuelled by a system of profit-based rewards that failed to protect the needs of depositors. However, somewhat surprisingly, a majority (almost six out of ten) of banks still consider their own risk governance and culture to be effective, suggesting that some have yet to acknowledge their own role in the troubles that have embraced the sector.

Are banks taking sufficient action to improve risk management? The study indicates that many banks are taking positive steps to overcome these weaknesses; around half of those participating have already reviewed the way they manage risk, with most of the remaining respondents either involved in or about to start a review. However, only four out of ten have made or intend to make fundamental changes, which is perhaps lower than may have been expected and could indicate an unwillingness to take specific and decisive action in tackling the weaknesses that led to the credit crisis. Regardless of the degree of change anticipated, a majority of respondent banks are seeking to tighten up their overall risk management. Governance and culture are both high on the agenda as they attempt to put in place more effective policies, procedures and controls and make staff more aware of enterprise-wide risks when facing key business decisions. There is also considerable focus on improving the way that risk is reported and measured as well as the systems and data that underpin such analysis. This is recognition that managers across the business units did not have sufficiently robust data when making some of the decisions that led to the present troubles.

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Risk management has not been closely aligned with compensation policy Despite being cited in the survey as the single biggest contributor to the current crisis, less than half (46 percent) of the respondents are planning a significant increase in attention to this issue. There appears to be some uncertainty over the role of the risk management function in developing and managing compensation policy. This is not to say that respondents do not support reform to compensation: almost six out of ten favor greater use of long-term incentives; and a similar proportion want to expand the practice of risk-adjusted measures. Other proposals, such as longer deferral of bonuses and an increase in proportion of remuneration paid for divisional performance attract less interest. In a further twist, the risk professionals involved in this survey are also cautious about any external pressures on rewards and incentives, with just over a third (36 percent) agreeing that regulators should become more involved in the setting of remuneration in the banking industry.

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The survey suggests that although risk management is slowly starting to play a more central role in banks decision-making structures, many respondents feel that risk has still to shed its traditional image as a support function. The growing importance of the risk function in banking is reflected in our findings. Seven out of ten taking part believe that the risk function holds much greater influence than two years ago and eight out of ten see the way they manage risk as a source of competitive advantage (as opposed to merely providing checks and balances). Yet it seems that there is still a long way to go, with the vast majority concerned that risk management continues to be stigmatized as a back room function. Encouragingly, two of the areas where the CRO or equivalent is starting to exert considerably greater authority are strategy development and capital allocation. This is a logical development as banks seek to integrate risk and capital into their planning to ensure they do not over stretch their capacity in pursuit of profit. Six out of ten survey participants feel that the CRO should have even more influence over the development of strategy, although in light of recent events this figure could arguably be even higher. Overall it appears that the desire to manage risk at a strategic level has not fully filtered down to more practical issues. Although banks may be concerned about the apparent lack of involvement of the CRO in mergers and acquisitions, much of this is probably due to a relative lack of deals over the previous two years. However, the recent increase in activity in this area with the more stable institutions buying out their troubled compatriots calls for rigorous risk assessment of purchase targets.

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In a further reference to the often-marginalized role of risk professionals, half of those we surveyed believe that cultural change would be hastened by giving the function greater authority in the organization. Despite the fact that employee rewards are not high on the agenda of the CRO, there is at least some acknowledgement that the way staff are rewarded has a big impact on culture, with four out of ten arguing for incentives linked to effective risk management.

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Communicating with the rest of the organization When asked to list the factors that contributed to the current predicament in the industry, only two in ten banks(21 percent) feel that a lack communication across organizational silos played a part. However the respondents do recognize the need for improv ement, with better communication between the risk function and the business being seen as one of the most important ways to improve overall risk management, with a majority committed to making such changes. A more detailed look at communication and information sharing across the business reveals a number of inconsistencies that could affect the management of risk. The risk function claims to have developed much closer relationships with the senior executive team and the Risk Committee, suggesting that those involved in major strategic decisions are likely to consider the wider implications for the business. However, there is also evidence that such high-level risk management is not carried down to operational level; respondents admit that there is room for greater interaction with the lines of business and internal audit, and also between the risk committee and the audit committee. Such a weakness in communication enables business unit managers to take on large risks without consulting further up the management chain. Furthermore, with internal audit expected to play a greater role in risk management as the third line of defense, senior managers will want to see a closer relationship between the internal audit and risk functions.

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Where is pressure to change coming from? The biggest pressure on risk professionals appears to be coming from regulators and executive management, but not as might be expected from non-executive Board members. This may be at least partly down to the shortage of risk expertise of Board members and reinforces the suspicion that risk is viewed as a regulatory rather than a business issue, hence the lack of authority of the risk function. If banks are to avoid the problems that have plagued them in the past two years, non-executives will have a key role in providing an independent challenge to risk management.

56

While acknowledging the lack of risk experience and skills amongst senior executive and nonexecutive management, the banks taking part in the survey appear to have been slow to address this shortage. Only four out of ten respondents admit that insufficient risk expertise at Board level was a contributory factor in the credit crisis, and under half (45 percent) believe that their own organization lacks such know-how at the very top. Both these figures are considerably lower than may have been expected, given the risks that some banks may have taken in the lead up to the current troubles. When asked what would most improve risk management, the number one response (45 percent) was: Better in-house skills and experience, with over a third admitting that they need greater risk expertise at the very top. Interestingly, respondents from North America and Europe are considerably more confident in their in-house knowledge than their counterparts in other regions.
57

Are banks filling the skills gap? Despite this apparent awareness of their shortcomings, a significant minority of banks has no plans to appoint individuals with deep practical risk experience to senior positions. A third (33 percent) are not actively seeking such skills for the non-executive Board, which puts a question
58

mark over the extent of their commitment to truly independent risk assessment of strategic and commercial decisions. Surprisingly, less than three in ten (29 percent) of respondents feel that lack of skills and experience was a causative factor leading up to the current crisis. Regardless of this, across the organization as a whole, people, skills and training are considered to be by far the single biggest investment priority for banks.

Many banks in the survey recognize the limitations in the way they manage and report data and plan to focus more on stress testing and scenario analysis. However, there is a question mark
59

over whether any new approaches are flexible enough to make accurate predictions. The way that risk is reported and measured played a significant part in the credit crisis, according to those involved in the survey. Almost eight out of ten respondents (78 percent) are planning to pay more attention to this issue, with a similar proportion looking to improve risk systems and data quality. What is driving the change in approach to risk measurement? The survey shows that banks have been employing a wide variety of approaches to manage risk, although the use of Basel II credit risk models has been surprisingly low, given the regulatory pressure to take up such a tool.

60

In the future, respondents will be placing a stronger emphasis upon stress testing and scenario analysis to help measure and manage risk. This is an acknowledgement that recent analysis was not sufficiently robust to deal with the systemic risks in the market at the time. Arguably this increased focus on measurement may also be a precautionary move, given that some regulators are starting to insist on certain levels of stress testing as a minimum requirement in order to maintain capitalization and capital allocation levels. Will the use of economic capital reduce risk? The vast majority of survey participants uses or plans to use economic capital to estimate capital requirements, although in only a fifth of cases (21 percent) is this currently fully embedded. This trend, along with the substantial increase in reliance on Basel II models, creates a dilemma for banks: with a potential backlash against quantitative approaches that are based on static, historical data; can risk professionals develop more sophisticated, flexible models?

61

All the responses were gathered through online interviews of senior managers involved in risk management from leading banks around the world. The interviews, carried out by the Economist Intelligence Unit, covered a range of questions relating to risk management, with particular reference to the global credit crisis. Over half of the respondents work directly in the risk function for involved in organizations corporate, retail, investment and private banking, as well as asset management. Seven out of ten (72 percent) have a CRO or equivalent. Twenty percent had assets over US $500 billion and thirty fivepercent over US $250 billion.
62

Chapter-5 Case study Analysis

63

Case study
Assessment of permissible bank finance at PNB
Account: MIS XYZ Limited, New Delhi Asset classification: Standard Credit risk rating: BB as on 31.3.04 Consortium/multiple banking: Consortium Whether CMA: yes Lead bank: PNB PNB share %: Existing-48, Proposed-44 Whether SSl/Priority sector: NO Whether export oriented: yes Date of receipt of proposal at branch: 13.5.04 Date of receipt of proposal at HO: 18.8.04 Gist of the proposal: 1. Enhancement of fund based limits from Rs. 1550 lakhs (regular 1350 lakhs + adhoc 200 lakhs) to Rs. 1670 lakhs. 2. Enhancement of Non-fund based limits from Rs. 147 lakhs to Rs. 247 lakhs BANK'S COMMITMENT & MAXIMUM PERMISSIBLE EXPOSURE NORMS. (in lakhs) 1. Funds based W.C. limits 2. Term loan o/s 3. Investment in shares, debentures etc.; 4. Total of 1, 2, and 3: 5. Non-fund based: 6. Total of all exposures i.e. total of 4 & 5: 1670.00 745.00 nil 2415.00 247.00 2662.00

Total exposures to the company are within permissible exposure norms.

64

Financial data for the last 4 years (in lakhs) 31.3.2001 31.3.2002 31.3.2003 31.3.2004 Gross sales -domestic -export Other income Operating profit PBT PAT Cash profit Paid up capital 3934.77 2263.86 1670.91 14.86 267.74 282.62 256.60 509.02 1294.91 8082.81 4674.95 3407.86 44.76 316.84 361.60 339.60 812.82 1370.33 716.91 2.46 Nil 2084.80 1.51 1046.93 1.24 3.92% 11166.89 9088.19 2078.78 4.10 392.76 396.86 361.86 860.63 1425.27 1078.77 2.11 Nil 2501.93 1.45 1249.18 1.15 3.50% 12739.29 11643.55 1095.78 8.05 396.84 404.89 365.17 973.09 1425.27 1149.59 1.76 Nil 2573.10 1.35 1344.73 1.25 3.12%

Reserves and surplus (revaluation reserves) 377.31 Miscellaneous expenditure not written off Accumulated losses TNW Current ratio NWC DER Operating profit/gross sales 2.82 Nil 1166.40 1.37 557.71 1.18 6.80%

Key figures for quarter-ended 30.6.04 Sales Operating Profit 3381 109

65

Comments on financial indicators During the year ended 31.3.2004 gross sales have increased by 14.08%. The PBT has however increased only by 2.01%. Reasons have been attributed to higher depreciation during the year on account of expansion/modernization undertaken during the year. Cash profit (after tax) has increased by 12.89%. PAT will go down to Rs 263,73 lakhs after accounting for provision for deferred tax liability of Rs 101.45 lakhs Operating profit to gross sales ratio In 2002.04 is lower due to higher incidence of depreciation by Rs 103.78 lakhs. TNW In 2002'03 could not improve due to the provision of Rs. 294.35 lakhs for deferred tax liability (as per AS-22) Successive decline in export turnover: it is submitted that sales of the co. In the domestic market are only to the exporter leading to indirect exports. Ready made garments are quota items & quota is released by the Apparel Export Promotion Council on the basis of past performance, new investment and first come first serve basis. In the year 2002-04, Govt. of India, Ministry of textiles, imposed an embargo and hence the company could not achieve the export sales target, But the company took immediate steps to divert the finished stocks to domestic market so that overall sales targets are achieved, further the company is confident of achieving targeted export sales in the current year on the basis of quota in hand. Current ratio is satisfactory and has throughout been maintained above benchmark level of 1.33. Debt-equity ratio is satisfactory. As on 31.3.2004 investments in shares are Rs. 57.55 lakhs out of which Rs.21.07 lakhs has been invested in unlisted shares of associate concerns. The investment is made in due course of business and the quantum is insignificant in comparison to net worth/total capital deployed in the business.

Statutory liability: ESI & PF have been regularly deposited. Contingent liability: Bills discounted Bank guarantee 31.3.2003 212.74 34.00 31.3.2004 143.00 39.70

No adverse comments by the auditors As per auditors certificate there were no undisputed amount payable in respect of income tax, wealth tax, sales tax, custom duty and excise duty which are outstanding as at 31.3.2003 for more than 6 months from date they become Payable. In view of satisfactory net worth of the company vis a vis the amount of contingent liability and investments, no adverse impact is envisaged. 66

Brief history XYZ Limited is a closely held co. The co. is running a textile plant and is engaged in Dyeing & Processing of knitted fabrics, dyeing of yarn, printing and processing of woven fabrics, sewing thread and readymade garments. The A/C was taken over from another bank by sanctioning fund-based limit of Rs 800 lakhs & non-fund based limit of Rs 147 lakhs. The limits were enhanced to fund based Rs 1350 lakhs and non-fund based Rs 147 lakhs and term loan of Rs 745 lakhs. A consortium of banks is meeting the existing WC requirements of the co. Justification for working capital sanction (Rs in lakhs) Particulars For previous year 2002-2003 Projected sales Sales achievement % achievement % growth over previous year Projected profits Actual profits 11285.3 11166.89 98.95 35.71 2003-2004 12100.00 12347.00 102.04 10.57 25.54 Projection for current year 2004-2005 15500.00

516.8 396.86

431.98 404.89

454.10

The projected sales of Rs 155cr have been accepted by us for assessment in view of past trend as well as the expansion/modernization undertaken by the co. during the year 2002-03. Growth rate since inception is as under Year Gross turnover Growth

2000-2001 3949 2001-02 2002-03 2003-04 2004-05 8129 11167 12739 15500 105.84% 37.37% 14.00% 21.00%

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Justification for NFB facilities The co. is not seeking any enhancement In NFB limits from the consortium. However, with a view to rationalize the sharing for NFB limits among the consortium banks, our share is proposed to be increased to Rs' 247 lakhs.

Packing credit in foreign currency The company has requested for allowing packing. Credit in foreign currency (PCFC) and ZM has recommended for approval of the same subject to availability of foreign currency. However, we observe that no justification/terms and conditions including rate of interest has been proposed for PCFC. Also handling charges are to be levied for which borrower consent may be obtains. Further, availability of line of credit/foreign currency funds is to be ascertained from the foreign exchange office before allowing the facility. Thus, it has been advised by the branch/zonal office to- move for PCFC facility with proper justification and terms and conditions governing the PCFC Scheme in case of need. Rate of interest The co. has scored 95 marks out of 100 and is categorized as AA rated client. Rate of interest applicable is PLR+1.5% Existing Rate of interest PLR+2% i.e. 13% p.a. as applicable to A+ category Proposed rate of interest PLR+ 1.5% i.e. 12.5% p.a. as applicable to AA category. Rating parameter and scoring Parameter Maximum score 15 10 10 Co.s score

Current ratio Debt equity ratio Submission of QMS and other financial data Submission of data for renewal or review of account Achievement of sale projection

15 10 10

10

10

10 68

10

Achievement of profit projections Conduct of account Value of the account

10 25 10

10 20 10 The existing limits are fully availed and adequate yield is expected 95

total

100

Risk management department has rated the company BB. The details about this risk rating procedure being followed by the risk management department are explained later.

Assessment of permissible bank finance. Year ending Actual for 2003 11166.89 10880.91 35.71 Actual for 2004 (prov.) 12388.90 12388.90 13.86 Projection for 2005 15500.00 15000.00 21.08 Accepted for assessment 15500.00 15000.00 21.08

1. sales (gross) Sales (net) % of increase in net sales 2. basic data (value per month) a) sales (gross) -domestic

757.35 -exports 173.18 b) cost of production c) cost of sales d) raw materials -imported -indigenous e) other spares -imported Nil 797.85 791.83 596.27

942.2 90.2 921.85 925.80 683.49

1083.33 208.33 1133.85 1120.23 867.20

1083.33 208.33 1133.85 1120.23 867.20

Nil

Nil

Nil

69

-indigenous

3. Inventory holding levels: equivalent to raw materials, months consumption, stock in progress, months cost of production, finished goods, months cost of spares, months consumption (or %)

Particulars Raw materials -imported -indigenous

Past trend Actual for 2004 Projections for 2005 Accepted for assessment 1.48 1.38 1.50 1.50

Stock in progress 0.99 Finished goods Receivables -inland -exports Other spares 1.49 1.78 Nil 0.56

0.79 0.46

0.80 0.50

0.80 0.50

2.52 2.61 Nil

2.50 2.75 Nil

2.50 2.75 Nil

Justification 1. Raw material: The Company has projected inventory level for raw materials at 1.5 month against actual-level of 1.48 month and 1.38 month during financial year 2002-03 and 2003-04 respectively. It is informed that keeping in view the supply position of raw materials and nature of manufacturing process, the company is required to maintain average inventory level of raw material at 1.5 month. Justification given by the company is found acceptable by PNB. 2. Stock in process: the level of stock in process is in line with the past trend. 3. Domestic receivable: The level of domestic receivables is in line with the past trend. It is stated that since the market is becoming competitive, extending credit is one of the tools for marketing and maintaining the growth rate. The past trend of receivable level is as under. Year level in month 70

2001-02 2002-03 2003-04

1.99 1.49 2.49

4. Export debtors: The Company has projected export receivables at 2.75 month against actual level of 2.61 month during the previous year. The company has projected the increase taking into consideration the increase target for export set out by extending reasonable credit to the buyers. It is further informed that the export market is highly competitive and the company is required to extend average credit period of 2.75 month. 5. Finished goods: The Company has projected Inventory level of finished goods at 0.5 month against actual level of 0.56 and 0.43 month during financial year 2002-03 and 2003-04 respectively. On an average the company is required to maintain the finished goods level of 0.5 month to meet out the increased targeted turnover. The company has also informed that the level is in line with the Industry trend. We have accepted the level in view of the justification given by the company. 4. Chargeable current assets Particulars Past trend/actual for Projections for 2005 Accepted for assessment

2003 1. Imported raw materials 2. Indigenous raw materials 3. Stock in process 4. Finished goods 5. Other spares -imported -indigenous 6. Receivables -domestic -export Total 1131.14 307.89 3617.97 Nil

2004 Nil Nil Nil

880.21

942.48

1300.81

1300.81

792.34 444.09 62.30

726.80 396.73 121.94

907.08 560.12 135.00

907.08 560.12 135.00

2375.87 235.60 4799.42 71

2708.32 572.92 6184.25

2708.32 572.92 6184.25

The projected levels of receivables are in line with the holding levels in term of months sale and the absolute quantum is shown to increase in accordance with the increase in turnover.

5. Other current assets Particulars Past trend/actual for Projections for 2005 Accepted for assessment

2003 1. advances to suppliers for the raw materials and consumable stores/spares 2. advance payment of taxes 3. cash and bank balance 4. other current balance total 110.51

2004 122.05 130.00 130.00

68.55

73.44

90.00

90.00

12.56

26.74

40.00

40.00

211.16

142.85

195.00

195.00

402.78

365.08

455.00

455.00

Other current assets projected are in line with the past trend and in accordance with the increased level of operations and have therefore been accepted by us for assessment. 6. Other current liabilities Particulars Past trend/actual for Projections for 2005 Accepted for assessment

2003 1. creditors for purchase (months purchase) 2. advance from customers 565.69 (.095)

2004 566.80 (0.83) 693.76 (0.80) 693.76 (0.80)

51.20

22.00

30.00

30.00

72

3. other statutory liability 4. other current liability total

88.52

64.60

75.00

75.00

379.73

403.72

430.00

430.00

1085.14

1057.12

1228.76

1228.76

Other current liabilities projected are in line with the past trend and in accordance with the increased levels of operations and have therefore been accepted by us for assessment. 7. Net working capital Past trend/actual for Projections for 2005 Accepted for assessment

2003 1249.18

2004 1337.97 1630.00 1630.00

8. The CMA data and our assessment as above are based on the provisional figures given by the company for 2003-04 (the audited results as on 31/3/04). The audited figures have been compared with the estimated given by the company and it is observed that there is no major variation in the sales figures and profits are in line with the provisional figures. The comparative table of inventory holding is as under. Provisional Audited Projected Raw materials Work in process Finished Receivables 1.38 0.79 0.43 2.52 1.40 0.81 0.47 2.43 2.58 0.83 1.50 0.80 0.50 2.50 2.75 0.80

Export receivables 2.61 Creditors 0.83

As can be observed the holding level are compared with the provisional figures given by the company and hence the figures given by the company and hence the assessment of PBF is not effected.

Calculation of permissible bank finance

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Particulars a) chargeable current assets b) other current assets (no-5) c) total current assets (a +b) d) less other current liabilities (no-6) e) working capital gap (c-d) 6184.25 455.00 6639.25 1228.76 5410.49

f) minimum stipulated net working capital {25% of c export receivables } 1516.58 g) projected net working capital h) e-f i) e-g PBF (h or I whichever is less) 1630.00 3893.91 3780.49 3780.49

Summary of merits/justifications for considering the proposals 1. The promoters by virtue of their long association with the garments industry have requisite experience to carry out the manufacturing operations. They have got settled customer base also which will enable the co. to achieve its sales target. As informed, the co. has been able to secure the maximum amount of quota allocated in the northern region. 2. The required raw material is readily available. 3. The co. is situated at main Delhi Mathura road, hence accessibility of the exporters & the foreign buyers are very easy. As such the co. can provide better services. 4. The co. has full and composite facilities under one roof providing single window solution to their buyers. 5. The co. has full infrastructure like power, steam, and effluent treatment plant etc. to meet the requirement of the proposed expansion plan which will result in reduced capital cost viz a viz similar project being set up afresh. 6. the limits will be adequately covered by collateral security in the form of seconds pari passu charge on block assets (residual value Rs2395.30 lakhs as on 31.3.2002) and EM of property valued at Rs598.50 lakhs exclusively for PNB.

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Chapter-6
Conclusion and Recommendations
Risk management underscores the fact that the survival of an organization depends heavily on its capabilities to anticipate and prepare for the change rather than just waiting for the change and react to it. The objective of risk management is not to prohibit or prevent risk taking activity, but to ensure that the risks are consciously taken with full knowledge, clear purpose and understanding so that it can be measured and mitigated. It also prevents an institution from suffering unacceptable loss causing an institution to fail or materially damage its competitive position. Functions of risk management should actually be bank specific dictated by the size and quality of balance sheet, complexity of functions, technical/ professional manpower and the status of MIS in place in that bank. There may not be one-sizefits-all risk management module for all the banks to be made applicable uniformly. Balancing risk and return is not an easy task as risk is subjective and not quantifiable where as return is objective and measurable. If there exist a way of converting the subjectivity of the risk into a number then the balancing exercise would be meaningful and much easier. Banking is nothing but financial inter-mediation between the financial savers on the one hand and the funds seeking business entrepreneurs on the other hand. As such, in the process of providing financial services, commercial banks assume various kinds of risks both financial and non-financial. Therefore, banking practices, which continue to be deep routed in the philosophy of securities based lending and investment policies, need to change the approach and mindset, rather radically, to manage and mitigate the perceived risks, so as to ultimately improve the quality of the asset portfolio. As in the international practice, a committee approach may be adopted to manage various risks. Risk Management Committee, Credit Policy Committee, Asset Liability Committee, etc are such committees that handle the risk management aspects. While a centralized department may be made responsible for monitoring risk, risk control should actually take place at the functional departments as it is generally fragmented across Credit, Funds, Investment and Operational areas. Integration of systems that includes both transactions processing as well as risk systems is critical for implementation. In a scenario where majority of profits are derived from trade in the market, one can no longer afford to avoid measuring risk and managing its implications thereof. Crossing the chasm will involve systematic changes coupled with the characteristic uncertainty and also the pain it brings and it may be worth the effort. The engine of the change is obviously the evolution of the market economy abetted by unimaginable advances in technology, communication, transmission of related uncontainable flow of information, capital and commerce through out the world. Like a powerful river, the market economy is widening and breaking down barriers. Governments role is not to block that flow, but to acc ommodate it and yet keep it sufficiently under control so that it does not overflow its banks and drown us with the associated risks and undesirable side effects. To the extent the bank can take risk more consciously, anticipates adverse changes and hedges accordingly, it becomes a source of competitive advantage, as it can offer its products at a better price than its competitors. What can be measured can mitigation is more important than capital allocation against inadequate risk management system. Basel proposal provides proper starting point for forward-looking banks to start building process and systems attuned to risk management practice. Given the data-intensive nature of risk management process, Indian Banks have a long way to go before they comprehend and implement Basel II norms, in to-to. The effectiveness of risk measurement in banks depends on efficient Management Information System, computerization and net working of the branch activities. The data warehousing solution should effectively interface with the transaction systems like core banking solution and risk systems to collate data. An objective and reliable data base has to be built up for which bank has to analyze its own past performance data relating to loan defaults, trading losses, operational losses etc., and come out with bench marks so as to prepare themselves for the future risk management activities. 75

Any risk management model is as good as the data input. With the onslaught of globalization and liberalization from the last decade of the 20th Century in the Indian financial sectors in general and banking in particular, managing Transformation would be the biggest challenge, as transformation and change are the only certainties of the future. Here are some findings from the data collected-

1)Despite improving its profile, the risk function is still struggling to gain influence Seven out of ten respondents feel that risk departments are having a greater influence within banks, particularly at a strategic level. However their involvement in more day-to-day business decisions may be restricted by poor communication with the lines of business. More worryingly, a vast majority (76 percent) of those involved in managing risk still feel that, despite raising its profile, risk is stigmatized as a support function. 2)Banks are not addressing the lack of risk expertise at senior levels Under half (45 percent) of the banks in the survey acknowledge that their Boards are short of risk knowledge and experience a lower figure than may have been expected. It is of some concern that many are not even planning to address this issue particularly at the non-executive level where the need for expertise is most acute. With a quarter of respondents seeing no need for a Risk Committee, many organizations could be lacking a rigorous, independent challenge to the judgments being made in the businesses. 3)To change risk culture, banks should lead from the top The survey reveals the vast majority of those responsible for managing risk (77 percent) are dedicated to instilling a more robust risk culture in their organizations and feel that greater tone from the top, along with a more authoritative risk function, are two of the keys to such a transformation. Some respondents expressed concern that regulators rather than non-executive directors are driving change. This further supports the perception that in certain institutions risk may still be seen as a peripheral compliance issue, rather than an essential part of strategy. 4)76% of senior risk managers still feel risk is stigmatized as a support function 5)45% of the banks in the survey acknowledge that their Boards are short of risk knowledge and experience 6)Risk managers appear reluctant to tackle incentive and compensation issues Despite acknowledging that the rewards culture has had a big impact upon the current crisis, the majority of those responding are cautious about increasing the involvement of either regulators or the risk function itself in setting policy. This suggests that risk managers are uncertain of their role in this critical area. 7)Poor communication was not to blame for the credit crisis Only a fifth of respondents feel that a silo mentality contributed to the current turmoil in the industry, yet a majority acknowledge that communication between different parts of the business needs to improve. Banks are particularly concerned about improving links with the lines of business those on the front line who have to consider the risks they take on, whether its making trading decisions or developing new products. 8)Banks want to provide better information for decision making Almost eight out of ten respondents are seeking to improve the way that risk is measured and reported, a clear acknowledgement that previous models did not sufficiently measure potential risk exposure. Their emphasis will be on stress and scenario testing, along with Basel II credit
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models, but it remains to be seen whether such measures will be either flexible or sophisticated enough to fully capture the range of possible outcomes. 9)92% of those surveyed have carried out or are about to carry out a review of their risk management 10)36% of respondents feel that regulators should play a role in remuneration 11)52% of respondents say incentives and remuneration policies contributed to the credit crisis 12)42% of respondents have made or expect to make fundamental changes to risk management 13)The need for truly integrated risk management The credit crisis brings many banks overall risk governance into question, with some lacking the framework, the policies or the necessary capabilities to achieve a clear picture of the risks they are facing across the organization. In growing the business, executive teams should try to ensure that all employees are aware of and involved in managing risk, with senior management setting the overall strategic direction and embedding risk management philosophy across the business, ensuring that risk can be measured, reported and managed. They should also provide clear guidance reflected in explicit policies and procedures and a clear expectation of compliance with these. Strong performers tend to have clear lines of communication, with the risk management function integrated into the business, allowing insights and industry best practice to be shared. Risk management responsibilities should be streamlined so that risk can be owned and managed within the business unit, but quickly escalated through the risk management function and business units to the Board and its relevant committees where necessary. When they are working well, these three lines of defense give primary responsibility for risk management to the client facing areas of the business; support functions review and check that risks are accepted in line with the institutions policies and appetite; and finally internal audit provides assurance that the internal controls and risk management are operating as expected. Reliable quantitative and qualitative information should feed up from the business units to senior management and the Board and be delivered to decision makers in a timely fashion. 14)How should risk professionals influence compensation incentives? In an October 2008 letter to CEOs of leading financial companies, the UK Financial Services Authority (FSA) noted that firms possibly frequently gave incentives to staff to pursue risky policiesto the detriment of shareholders and other stakeholders. The FSA wants to see wider use of increased deferral of annual bonuses and the delivery of incentives in shares rather than cash, with performance measures linked to risk. The letter makes a case for the risk function to have a strong and independent role for setting compensation for the business areas. According to Kevin Blakely, President and CEO of The Risk Management Association, this means acting as an agitator rather than an administrator: Compensation is the responsibility of the Board, the compensation committee and the CEO, but the CRO should have a direct input into policy to ensure that risk is taken into consideration. In a separate report, the Institute of International Finance established a special Committee on Market Best Practices (CMBP), which also argues for compensation incentives to be based on performance and aligned with shareholder value and long term, organization wide profitability. It also suggests that compensation incentives should in no way induce risk taking in excess of the
77

organizations risk appetite and that the payout of bonuses should be closely related to the timing of risk adjusted profit. Although some of the casualties of the current crisis claim to have very long-term incentive plans that are directly linked to share price, this does not appear to be consistent across the industry. With many banks under partial or complete government ownership, banks are likely to be under considerable political pressure to show regulatory bodies that their compensation and incentive systems are risk based. 15)In many banks, the right hand side didnt know what the left hand was doing. Kevin Blakely, President and CEO, The Risk Management Association Developing a robust risk culture Banks should set realistic limits on risks that fit the culture and risk appetite of both the individual business lines and the overall institution. Senior managers have to strike a very delicate balance in matching the acceptable level of risk exposure to the culture in which that risk is being managed. In simple terms, they should have confidence in their own risk culture and the courage to be able to say: Although we are making a lot of money here, additional risk will not result in additional value being added to the business in the long term. The job then is to create a system of governance where risk can be managed and where every individual in the organization understands the appetite for risk and their part in mitigating it. This should help prevent those in the lines of business delegating responsibility for risk management. This appetite should be agreed upon at Board level and be the foundation for both the culture and the system of controls within the organization. Once this appetite is clear, potential decisions such as taking on loan portfolios can be assessed in the context of what risk is acceptable. The Risk Committee also has a vital role to play; yet a quarter of respondents in the survey have no plans to even form such a forum. Writing in the Financial Times in October 2008, Emilio Botn, Chairman, Banco Santander, noted that: Many are surprised to learn that the Banco Santander Boards Risk Committee meets for half a day twice a week and that the Boards 10 person executive committee meets every Monday for at least four hours, devoting a large portion of that time to reviewing risks and approving transactions. Not many banks do this. It consumes a lot of our directors time. But we find it essential and it is never too much. Botn also feels that: Risk is part of the daily conversation and viewed from an ente rprise-wide perspectiverisk management not only has a seat at the table, but is also an active participant in all key business decisions. Kevin Blakely, President and CEO, The Risk Management Association, also emphasizes the importance of the risk committee, which he believes should oversee the active acceptance of risk within the organization and make sure its mitigated, managed and priced for. He adds: The CRO should be a central part of the strategic planning process and be involved in any major decisions involving initiatives from the lines of business. I dont think this is happening sufficiently and is a major flaw in enterprise risk management in banks large and small. He goes on to say that: With such a weak information circulatory system, in many banks the right hand side didnt know what the left hand was doing and senior management did not know its overall exposure.

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16)Will risk be regulatory or internally driven? In the absence of a globally coordinated response from the banking industry, central banks and their regulators as lenders of last resort have taken the lead in rescuing and to some extent remolding the sector. Emerging regulatory changes will demand greater transparency, better risk management and stricter risk governance, with banks possibly having to augment their Boards with a relevant risk specialist. ...risk management not only has a seat at the table, but is also an active participant in all key business decisions. Emilio Botn, Chairman, Banco Santander Exactly how regulators will be involved in the management of risks in banks is unclear but they are likely to be more hands on. Governments in many countries have had to step into the breach to restore confidence and calm to their financial services markets. Such help comes at a price however, with numerous conditions that directly impact banks and have wider implications for the global economy. Since the recapitalization of many banks, the concept of the regulator as a key driver of change has become a reality with many institutions genuinely shocked at the capital levels they have been obliged to hold. Banks may not be able to resist calls of this sort unless they prove to regulators, policy makers and the public that they have taken the appropriate action to strengthen their own risk management procedures. Some risk management agendas and budgets in recent years appear to have been driven by the need to meet regulatory expectations set by such initiatives as Basel II, CSE, and SarbanesOxley. Such a compliance focus may possibly have distracted risk management resources from addressing wider organizational risks. 17)A significant minority of banks has no plans to appoint individuals with d eep practical risk experience to senior positions. 18)45% of respondents believe that their own organization lacks risk expertise at the very top 19)A need for greater knowledge and experience The industry as a whole is probably aware of the shortage of individuals with risk management skills and practical experience, particularly at a senior level. Much of this expertise appears to be concentrated in certain banks, yet even in these institutions, those with risk experience may not be fully involved in major strategic decisions. Those working in the risk function may also need to improve their skills and indeed raise the profile of the function by investing in people and training. With risk management clearly under the spotlight, it is no real surprise that people are to be the number one investment area. The Senior Supervisors Group (SSG) (comprising senior supervisors of major financial services firms from France, Germany, Switzerland, the United Kingdom, and the United States) report from March 20084 concludes that some of the executive leaders at firms that recorded larger losses did not have the same degree of experience in capital markets and did not advocate quick, strong, and disciplined responses. The report goes on to argue for the selection of executive leaders with expertise in a range of risks, given that it is very difficult to predict the source of the next disruption to the market.

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Senior management teams as a whole should try to maintain a risk profile consistent with the Board and senior managements tolerance for risk. Emilio Botn, Chairman, Banco Santander5 believes that: the Board must know and understand bankingThis is a complex industry, subject to constant change and innovation. What is needed are directors who know the business well. There is also a strong argument for more expertise across the organization. The three lines of defense model places the prime responsibility for risk management with the client fac ing areas of the business. Yet in a number of cases those working in the lines of business have not had sufficient accountability for their actions and have lacked awareness of the organizations overall risk appetite. This is probably down to the underlying organizational culture and something that can be addressed through training and improved communication. 20)61% of respondents will be placing more emphasis on stress testing and scenario analysis providing a true picture of changing levels of risk The credit crisis has highlighted some specific challenges in how banks manage risk, with perhaps the biggest concern being the apparent over reliance on quantitative models in decisionmaking. Even those that used more sophisticated models and testing were not always able to predict what was effectively a once in a lifetime set of circumstances. There appears to have been a lack of qualitative assessment of the risks and exposures being taken on. While quantitative techniques are likely to have an important role to play, these should be augmented by the judgment of those with extensive risk management and wider business experience. Measuring risk is clearly an integral part of effective risk management and the use of adaptive rather than static tools (such as Value at Risk) should provide more reliable indicators of future performance. In the lead up to the current crisis, many banks scenario planning was not sufficiently robust, leaving senior management unable to accurately stress test different options. Future scenarios should incorporate the views of experienced business and risk professionals, as well as those of regulators and other peers. The mandatory survival tests for capital levels set by the Federal Reserve, FSA and other authorities are likely to impact profitability and de-leverage the balance sheet. Such tests will almost certainly require greater use of stress and scenario analysis and consequently we are likely to see a new generation of models and a new alignment of risk management techniques. However, a model is only as good as its built-in assumptions and its input, which in many banks arrives in varying forms at different times from disparate sources around the organization. This was highlighted in the aftermath of the Lehman Brothers collapse, where some industry participants struggled to identify all their relevant exposures to Lehman across their group structures. In the future, banks should be aiming to consolidate their exposures into a single, consistent source of analysis of their potential risks. The Basel II capital framework currently used by the majority of banks can be strengthened, encouraging management to develop more forward-looking approaches to measuring risk. These would go beyond simply measuring capital and incorporate expert judgment on exposures, limits, reserves, liquidity and capital. To give it real teeth, economic capital should be tied into

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executive compensation so that rewards are based upon the economic value brought to the organization. According to the Senior Supervisors Group report6, those organizations that performed well through the crisis were distinguished by the orderly and timely flow of information. Many banks should consider reviewing their information circulatory system to overcome weaknesses such as: varying volumes and quality of information from different parts of the organization; timeliness of data; duplication of information as a consequence of having too many different sources; lack of understanding as to what information is needed, who should supply it and where it should be sent. Since the very first credit was extended, banks have amassed vast experience in managing risk, which makes the risk management weaknesses exposed by this crisis all the more surprising. These weaknesses have been compounded by the global nature of the banking system, with few parts of the world economy immune to the impact of the crisis. Moving forward, financial institutions should get back to basics through a renewed focus on understanding the risks that they take. By strengthening their risk governance regimes, they should help to make them more flexible to meet changing conditions. The findings from this survey point to a number of key improvements that banks should consider: 21)Improving governance and creating a risk culture By establishing an appropriate, enterprise-wide framework within which risk can be measured, reported and managed, banks can create a simpler system incorporating the three essential elements of an effective risk regime: governance, reporting and data, and processes and systems. Firm, visible leadership from the very top can help embed a risk philosophy and culture across the organization, with every employee fully aware of the organizations clearly articulated risk appetite and its impact on decision making. 22)Raising the profile of risk Those working in risk should seek to build stronger relationships with all levels of the organization, in particular the lines of business, Board, audit committee and internal audit. Improving risk expertise at senior levels As a matter of urgency, banks should be looking to acquire greater risk know-how within their senior executive and non-executive Boards, helping to provide a more robust and informed challenge to business decisions. 23)Risk models should support but not drive decision making Effective risk management is essentially about good judgment supported by appropriate quantitative data presented in a clear, simple format that the Board and other stakeholders can understand. Risk models should be less rooted in historic data and flexible enough to adapt to changing market conditions. 24)Addressing incentives head on Risk managers should play a role in promoting the principles of compensation policy (which would be developed by the compensation committee), with incentives based on performance and aligned with shareholder interest and long-term, organization-wide profitability. Such an approach should also help to reduce the intervention of the regulators.
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Future of Risk Management in Indian Banking Industry


The Indian Economy is booming on the back of strong economic policies and a healthy regulatory regime. The effects of this are far-reaching and have the potential to ultimately achieve the high growth rates that the country is yearning for. The banking system lies at the nucleus of a countrys development robust reforms are needed in Indias case to fulfill that. The BASEL II accord from the Bank of International Settlements attempts to put in place sound frameworks of measuring and quantifying the risks associated with banking operations. The paper seeks to showcase the changes that will emerge as a result of banks adopting the international norms. The structure of the paper is three-fold, where we begin by projecting the risk management scenario and its effects on internal operations of a bank, followed by the changes brought about in the banking sector of India and finally the macro effects on the economy. This enables one to discern the complete scenario that will emerge in the years ahead. The Risk Management scenario will strengthen owing to the liberalization, regulation and integration with global markets. Management of risks will be carried out proactively and quality of credit will improve, leading to a stronger financial sector. The calculation of risk will be done by credit scoring models such as Altmans Z Score Model & Merton Model but in a more sophisticated and developed manner. The management information systems (MIS) will be put in place and the level of efficiencies will increase more than proportionately. Risk based pricing will be used for all credit facilities extended by banks. The treasury departments of banks are poised to benefit from the BASEL II accord as would be showcased in the paper. The future will see a structural change in the banking sector marked by consolidation and a shake-out within the sector. The smaller banks would not have sufficient resources to withstand the intense competition of the sector. Banks would evolve to be a complete and pure financial services provider, catering to all the financial needs of the economy. Flow of capital will increase and setting up of bases in foreign countries will become commonplace. Finally, the economy will stand to benefit as the banking sector develops. Savings will be mobilized in the right direction and the required funds needed for the countrys development will be made available.

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Although many banks would be working towards the IRB Approach, the authors are of the opinion that RBI would have allowed a few banks to implement and follow the IRB Approach by the year 2015. Indian banks would be moving upward on the strategic continuum of risk scoring models as can be seen in the diagram on the previous page. BASEL II Effects on Internal Operations Once implemented, the BASEL II norms would greatly influence the internal operations of a bank the effects of which, would be clearly visible in 2015. In this section, we analyze the extent of change brought about by the norms. Risk Management Departments Role The Risk Department would gain prominence within the banks as they would be playing an extremely critical role in the management of the risks of the bank. Streamlining of information and data flow through the Risk Department would be essential in calculation and management of risks.

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Calculation of Risks & CAR Calculation of risk would be an essential requirement in the banks as they would be in the process of calculating not only the Credit Risk but also the Market Risk and the Operational Risks that the bank would be facing. The capital to be set off for advances made by the bank would depend largely upon the fair and accurate calculation of these risks. In 2005 five credit risk models have received global acceptance as benchmarks for measuring stand-alone as well as portfolio credit risk. They are: I. Altmans Z Score Model II. Merton Model III. KMV Model for measuring default risk IV. Credit Metrics V. Credit Risk+ These models would get more sophisticated and the banks would have more options as other models would gain acceptance. For Market Risks the banks would be employing other models such as VaR, Monte Carlo Simulation etc. As for the Operational Risks the banks would be following internal risk frameworks in assessing significant operational risks and their mitigation. Risk-Based Pricing Risk-based Pricing is the technique of charging different interest rates from two different customers on the same type of loans, depending on the risk attributed to each of them. Under this method credit scores are calculated for individuals, taking into consideration various factors which are assumed to represent the individuals willingness and capacity to repay the loan installments. As the banks would be in the process of moving toward the IRB Approach they would be armed with the knowledge of the risks associated with the various types of exposures. This knowledge would help the banks in passing on the charge arising from higher credit risk to the customers. The authors are of the opinion that Risk-Based Pricing would be the norm of the banking industry in another ten years. Technology (MIS) Indian banks would invest in development of Information Systems as MIS would play an essential role in the calculation of LGD, EAD and PD. As the banks are expected to integrate various financial services to provide a one-stop shop to the customers, MIS would be helpful to the banks in cross-selling and other marketing-related activities. The settings up of such systems are expected to reach completion by 2015 for most banks. Strengthening of Treasury Operations The spreads relating to core banking business of credit and deposit interest rates would narrow down. Also, if the bank enjoys low PD and LGD it would have larger amount of funds available to it, as its regulatory capital requirements would come down. The banks would have to search
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for alternative profit generating avenues in the form of float fund management, thereby strengthening their treasury operations, which will be a thrust area in the coming years. Human Resource Development More emphasis would be given to the human resources of the bank as Basel II would require banks to calculate and manage risks continuously. One of the key requirements of the new Accord is monitoring... the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems... The composition of skills required to perform in the new environment would undergo a change. This change will force banks to invest in educating its work force in various risk-scoring models and enabling them to acquire skills to tap the full potential that the market offers. The Operational Risk requirements of Basel II Accord extend deep into corporate procedures that may not seem obviously connected to financial risk management. HR systems, for example, must ensure that procedures and documents surrounding such tasks as staffing, education and system maintenance, are properly recorded and documented, and that organization charts and lines of responsibility can be tracked and reported as required. Banks would be required to address issues such as manpower planning, selection and deployment of staff and training them in Risk Management and Risk Audit. Hence, it is assumed that the banks that would have sound HR policies and practices in place. Emphasis on Corporate Governance In the future, there would be greater emphasis on corporate governance in banks because banking supervision cannot function as well if sound corporate governance is not in place and, consequently, banking supervisors have a strong interest in ensuring that there is effective corporate governance at every banking organization. Supervisory experience underscores the necessity of having the appropriate levels of accountability and checks balances within each bank. Increased Capital in the Market The authors are of the view that in the future the banks would follow the strategy of low defaults and narrower spreads. This would bring down their CAR requirements, freeing up more funds that could be invested in the economy. Another point to be noticed is that the banks would have in place more sophisticated credit scoring models and they would be able to invest in more profitable and less risky avenues thereby improving the efficiency of the capital markets. Systemic Risk Although the banks would benefit by having more free funds available, taking a macro view of the system we might see the systemic risk going down. The rationale behind this statement is that the banks risk models would have developed and become more sophisticated. They would not only take into account various characteristics of the borrower but also the future economic
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condition. The banks would become more robust and efficient thereby contributing to the reduction of systemic risk. International Scope With better utilization of capital, rollover of banks funds through securitization and efficiency in operations, Indian banks would become competitive in the international markets. The consolidation of banks would give them the requisite size and compliance with the Basel II Accord would give them greater efficiencies in management thereby making them competent for the international market. As per Indian Banks' Association report Banking Industry Vision 2010, there would be greater presence of international players in Indian financial system and some of the Indian banks would become global players in the coming years. So, one can envision Indian banks going global in search of new markets, customers and profits. The following points provide further insight on the expected banking scenario. Although, not direct consequences of the BASEL norms these structural changes will be a fall-out of the reforms in the banking sector. The implementation of the 2nd phase of the RBIs roadmap to reform in 2009, would al low foreign bank ownership of any local private bank, within an overall limit of 74%. These foreign banks would bring with them technological and management skills and improved efficiency. RBIs role in the banking industry RBI would be in the process of shifting to risk-based supervision (RBS) wherein the focus of its supervisory attention on the banks is in accordance with the risk each bank poses to itself and the system. The inceptions of RBS will require banks to reorient their original setup towards RBS and put in place an efficient Risk Management architecture, internal auditing focusing on risk, strengthening MIS and set up of compliance units. Slimming & Trimming of the Indian Banks Emphasis would be given to automation and outsourcing of different services would be done so as to enable the banks to tackle the increasing volumes of business effectively. Customer-Banker contact will be reduced to the bare minimum as it would be a paperless banking era, dominated by plastic money, electro-banking, and tele-banking.

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