CREDIT RISK

Introduction What is Credit Risk? Credit risk is defined as the risk of losses arising from the decrease in the credit quality of borrowers or counterparties. In the bank's portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to honor its commitments to lending, trading, settlement and other financial transactions. Otherwise, losses result from reduction in portfolio value arising from actual or perceived deterioration of credit quality. Credit risk arises from a banks who deals with an individual, corporate, bank, financial institution or a sovereign. In simple terms it is the probability of loss from a credit transaction. Loans are the largest and most obvious source of credit risk. Loans are given by banks in the form of corporate lending, sovereign lending, project financing and retail lending. The following forms may take place in credit risk:

In the case of direct loans: principal and or interest amount may not be repaid; In the case of guarantees or letters of credit: funds may not be forthcoming from the constituents upon crystallization of the liability;

In the case of treasury operations: the payment or series of payments due from the counter parties under the respective contracts may not be forthcoming or ceases;

In the case of trading securities businesses: funds or securities settlement may not be effected;

In the case of cross-border exposure: the availability and free transfer of funds of foreign currency funds may either cease or the sovereign may impose restrictions. Since, lending activities are usually spread across all branches and controlling offices of banks and lending activities typically command more than half of all risk taking activities of a bank, management of credit risk is very critical requirement of banks.

CREDIT RISK MANAGEMENT

Credit risk management encompasses of identification, measurement, monitoring and control of credit risk exposure. The effective management of credit risk is a critical

component of comprehensive risk management and essential for the long term success of a banking organization.

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. The management of credit risk includes: a) Measurement through credit rating/ scoring, b) Quantification through estimate of expected loan losses, c) Pricing on a scientific basis and d) Controlling through effective Loan Review Mechanism and Portfolio Management. Credit Risk Management Framework Banks need to manage credit risk inherent in the entire portfolio as well as risk in individual credits or transactions. The effective management of credit risk is a critical component of a comprehensive approach of risk management and essential to long term of any banking organization. Banks for this purpose incorporates proper framework for credit risk management (CRM), which includes, (a) Policy framework (b) Credit risk rating framework (c) Credit risk limits (d) Credit risk modeling (e) RAROC pricing (f) Risk mitigants (g) Loan review mechanism/credit audit A. Policy framework: Given the fast changing, dynamic world scenario experiencing the pressure of globalization, liberalization, consolidation and disintermediation, it is important that banks must have robust credit risk management policies (CRMPs) and procedures, which are sensitive and responsive to these changes. In any bank, the corporate goals and credit culture are closely linked and an effective CRM framework requires the following distinct building blocks: (1) Strategy and policy, (2) Organization, and (3) Operations/systems. 1. Strategy and policy: Strategy and policies includes defining credit limits, the development of credit guidelines and the identification and assessment of credit risk. Banks should develop its own credit risk strategy defining the objectives for the credit granting function. This strategy should spell out clearly the organisations credit limits and acceptable level of risk-reward trade-off at both macro and micro levels. The credit risk strategy should provide continuity in approach, and 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. Credit policies and procedures should necessarily have the following elements: Banks should have written policies that define target markets, risk acceptance criteria, credit approval authority, credit origination and maintenance procedures and guidelines for portfolio management and remedial management. Sound procedures to ensure that all risks associated with requested credit facilities are promptly and fully evaluated by the relevant lending and credit officers. Banks should establish proactive CRM 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. Procedures and systems, which allow for monitoring financial performance of customers and for controlling outstanding within limits. Systems to manage problem loans to ensure appropriate restructuring schemes. A conservative policy for the provisioning of non-performing advances should be followed. Banks should have a consistent approach towards early problem recognition, the classification of problem exposures, and remedial action and maintain a diversified portfolio of risk assets in line with the capital desired to support such a portfolio.

2. Organisational structure: Banks should have an independent group responsible for the CRM. The responsibilities of this team are the formulation of credit policies, procedures and controls extending to all of its credit risk arising from corporate banking, treasury, credit cards, personal banking, trade finance, securities processing, payments and settlement systems. 3. Operations/systems: Banks should have in place an appropriate credit administration, measurement and monitoring process. The credit process typically involves the following phases: Relationship management phase, that is, business development, Transaction management phase to cover risk assessment, pricing, structuring of the facilities, obtaining internal approvals, documentation, loan administration and routine monitoring and measurement, and Portfolio management phase to entail the monitoring of portfolio at a macro level and the management of problem loans.

The banks should have systems in place for reporting and evaluating the quality of the credit decisions taken by the various officers. Banks must have a MIS to enable them to manage and measure the credit risk inherent in all on and off-balance sheet activities. It should provide adequate information on the composition of the credit portfolio, including identification of any concentration of risk.

B. Credit risk-rating framework: A credit risk-rating framework deploys a number/alphabet/symbol as a primary summary indicator of risks associated with a credit exposure. These rating frameworks are logic-based, utilize responses made on a specified scale and promote the accuracy and consistency of the judgment exercised by the banks. For loans to individuals or small businesses, credit quality is typically assessed through a process of credit scoring. Prior to extending credit, a bank or other lender will obtain information about the party requesting a loan. In the case of a bank issuing credit cards, this might include the party's annual income, existing debts, whether they rent or own a home, etc. A standard formula is applied to the information to produce a number, which is called a credit score. Based upon the credit score, the lending institution decides whether or not to extend credit. The process is formulaic and highly standardized. Many forms of credit riskespecially those associated with larger institutional counterpartiesare complicated, unique or are of such a nature that that it is worth assessing them in a less formulaic manner. The term credit analysis is used to describe any process for assessing the credit quality of counterparty. While the term can encompass credit scoring, it is more commonly used to refer to processes that entail human judgement. One or more people, called credit analysts, review information about the counterparty. This might include its balance sheet, income statement, recent trends in its industry, the current economic environment, etc. They may also assess the exact nature of an obligation. For example, secured debt generally has higher credit quality than does subordinated debt of the same issuer. Based upon their analysis, they assign the counterparty (or the specific obligation) a credit rating, which can be used for making credit decisions. Many banks, investment managers and insurance companies hire their own credit analysts who prepare credit ratings for internal use. Other firmsincluding Standard & Poor's, Moody's and Fitchare in the business of developing credit ratings for use by investors or other third parties. Institutions that have publicly traded debt hire one or more of them to prepare credit ratings for their debt. In the United States, the National Association of Insurance Commissioners publishes credit ratings that are used for calculating capital charges for bond portfolios held by insurance companies. Rating AAA AA A Meaning Best credit quality: Extremely reliable with regard to financial obligations. Very good credit qualityVery reliable More susceptible to economic conditionsstill good credit quality Lowest rating in investment grade. Caution is necessaryBest sub-investment credit quality.

BBB BB

Vulnerable to changes in economic conditions Currently showing the ability to meet its financial obligations. Currently vulnerable to nonpayment Dependent on favorable economic condition. Highly vulnerable to a payment default. Close to or already bankruptpayment on the obligation currently continued Payment default on some financial obligation has actually occurred.

CCC CC C D

CREDIT RISK APPROACHES

Credit Risk

Standardized approach

Advanced Approach

Foundation IRB IRB

Advanced

Standardized approach: the Basel committee as well as RBI provides a simple methodology for risk assessment and calculating capital requirements for credit risk called Standardized approach. This approach is divided into the following broad topics for simpler and easier understanding 1. Assignment of Risk Weights: all the exposures are first classified into various customer types defined by Basel committee or RBI. Thereafter, assignment of standard risk weights is done, either on the basis of customer type or on basis of the asset quality as determined by rating of the asset, for calculating risk weighted assets.

2. External Credit Assessments: the regulator or RBI recognizes certain risk rating agencies and external credit assessment institutions (ECAIs) and rating assigned by these ECAIs, to the borrowers may be taken as a basis for assigning risk weights to the borrowers. Better rating means better quality of assets and lesser risk weights and hence lesser requirement of capital allocation.

3. Credit Risk Mitigation: Basel recognized Collaterals and Basel recognized Guarantees are two securities that banks obtain for loans / advances to cover credit risk, which are termed as Credit Risk Mitigants

Advanced Approach: Basel II framework also provides for advanced approaches to calculate capital requirement for credit risk. These approaches rely heavily on a banks internal assessment of its borrowers and exposures. These advanced approached are based on the internal ratings of the bank and are popularly known as Internal Rating Based (IRB) approaches. Under Advanced Approaches, the banks will have 2 options as under a) Foundation Internal Rating Based (FIRB) Approaches. b) Advanced Internal Rating Based (AIRB) Approaches. The differences between foundation IRB and advanced IRB have been captured in the following table: Table 2.9.1.1: The differences between foundation IRB and advanced IRB Data Input Probability of Default Foundation IRB Advanced IRB

Provided by bank based on Provided by bank based on own own estimates estimates

Loss Given Default

Supervisory values set by the Provided by bank based on own Committee estimates

Exposure at Default

Supervisory values set by the Provided by bank based on own Committee estimates

Effective Maturity

Supervisory values set by the Provided by bank based on own Committee estimates Or At the national discretion, provided by bank based on own estimates

Credit risk limits: For managing credit risk, a bank generally sets an exposure credit limit for each counterparty to which it has credit exposure. This is standard procedure in many contexts. It could be a corporate loan, individual loan or a derivative dealer transacting with counterparties. All entail credit risk. All are contexts where credit exposure limits are used. A bank may also use aggregate credit exposure limits. A bank might set credit exposure limits by industry. It might also set a total exposure credit limit for all its corporate lending activities. Exposures are calculated with the help of credit risk models. Depending on the assessment of the borrower (commercial as well as retail) a credit exposure limit is decided for the customer, however, within the framework of a total credit limit for the individual divisions and for the company as a whole. Also within the limit as per RBI, i.e. not more than 20% of capital to individual borrower and not more than 40% of capital to a group borrower. Threshold limit is set depending on the:

Credit rating of the borrower Past financial records Willingness and ability to repay Borrowers future cash flow projections.

Credit risk modeling: Credit risk models used by banks are (1) Altmans Z score model, (2) Credit metrics model, (3) Value at risk model, (4) KMV Model. 1. Altmans Z score Model Altman's Z score predicts whether or not a company is likely to enter into bankruptcy within one or two years. Edward Altman developed the "ALTMAN Z-SCORE" by examining 85 manufacturing companies in the year 1968. Later, additional "Z-Scores" were developed for private manufacturing companies (Z-Score - Model A) and another for general/service firms (Z-Score - Model B). The Z-Score Bankruptcy-Predictor combines several of the most significant variables in a statistically derived combination. It was originally developed on a sampling of manufacturing firms. However, the algorithm has been consistently reported to have a 95 % accuracy of prediction of bankruptcy up to two years prior to failure on non-manufacturing firms as well. There has been many other bankruptcy predictors developed and published. However, none has been so thoroughly tested and broadly accepted as the Altman Z-Score. The Altman Z-Score variables influencing the financial strength of a firm are: current assets, total assets, net sales, interest, total liability, current liabilities, market value of equity, earnings before taxes and retained earnings. Value of Z is as follows

Z = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 + 0.999X5 Where, X1 = working capital/Total assets X2 = Retained earnings/Total assets X3 = Earnings before interest and taxes/Total assets X4 = Market value of equity/Book value of total liabilities X5 = Sales/Total assets When Z score of the firm is: 3.0 Or more: Most likely safe based on the financial data. Mismanagement, fraud, economic downturns, and other factors may cause an unexpected reversal. 2.8 to 3.0: Probably safe to predict survival, but this is a portion of the gray area and is below the threshold of relative safety. 1.8 to 2.7: Likely to be bankrupt within two years. This is the lower portion of the gray area and dramatic action may be required. Below 1.8: Highly likely headed for bankruptcy. Rarely would a firm be expected to recover from a financial condition generating this or lower scores. 2. Credit Metrics Model Credit Metrics is a statistical model developed by J.P Morgan, the investment bank, in the year 1995 for internal use, but now its being used all around the world by hundreds of banks. This model works on the statistical concepts like probability, means, and standard deviation, correlation, and concentrations. This model was developed with 3 objectives in the forefront: To develop a Value at Risk (VAR) framework applicable to all the institutions worldwide those carry the credit risks in the course of their businesses. To develop a portfolio view showing the credit event correlation which can identify the costs of concentrations and the benefits of diversification in a mark to market framework? To apply it in making the following decisions: Investment decisions, risk mitigating actions, determining the risk based credit limits across the portfolio, and rational risk based capital allocations.

Credit Metrics is a tool for assessing portfolio risk due to changes in debt value caused by changes in obligor credit quality. This model includes the changes in value caused not only by possible default events, but also by upgrades and downgrades in credit quality, because the value of a particular credit varies with the corresponding credit quality. Credit Metrics also assess the Value- at risk (VAR) the volatility of value- not just the expected losses. The model assesses the risk within the full context of a portfolio addressing the correlation of

credit quality moves across obligors. This allows to directly calculating the diversification benefits or potential over concentrations across the portfolio. The transition table for the various categories of bonds is determined and then joint probability for both these under different combinations. Then the NPV of the portfolio is determined for all the combinations and a probability distribution is constructed. These probabilities are actually an analysis of past migrations and same is the case with default probability. In the case of default a recovery rate is taken as the portfolio value. This distribution gives us 2 measures of credit risk: standard deviation and percentile level. Credit Metrics has the following applications: Reduce the portfolio risk: There are 3 options available: reevaluate obligors having the largest absolute size arguing that a single default among these would have the greatest impact, reevaluate obligors having the highest percentage level of risk arguing that these are the most likely to contribute to portfolio losses, reevaluate obligors contributing the largest absolute amount of risk arguing that these are the single largest contributors to portfolio risk. The last categories are the "fallen angels" whose large exposures were created when their credit ratings were better, but who now have much higher percentage risk due to recent downgrades. Limit setting: Of course, what types of risk measure to use for limits, as well as what type of policy to take with regard to the limits are management decisions. A user might use the credit metrics for 2 different purposes namely what type of limit to set, which risk measure to use for the limits and what policy to employ with regard to the limits. These limits could be set in terms of percentage risk, exposure size and absolute risk.

Identifying the correlations across the portfolio so that the potential concentration may be reduced and the portfolio is adequately diversified across the uncorrelated constituents. Concentration may lead to an undue accumulation of risk at one point. This model has some limitations regarding the data availability but it doesnt require any changes as such for application in the Indian scenario. 3. Value at Risk Model This model is being used in some of the banks currently in India. Value at risk (VAR) is a statistical risk measure, which is used extensively for measuring the market risk of portfolios of assets and/or liabilities. Suppose a portfolios value at risk is 2Mn$ with a 95% confidence level, then it means that the portfolio is expected to loose a maximum of 2Mn$ 95% of the times. The Value at risk is calculated by constructing a probability distribution of the portfolio values over a given time horizon. The values may be calculated on the daily, weekly or monthly basis.

4. KMV Model This model was developed by KMV Corporation based on Mertons (1973) analytical model of firms value. This model uses stock prices and the capital structure of the firm to estimate its probability. The starting point of this model is the proposition that a firm would default only if its asset value falls below certain level (default point), which is a function of its liability. It estimates the asset value of the firm and its asset volatility from the market value of equity and the debt structure in the opinion theoretic framework. Using these two values, a metric (distance from default or DFD) is constructed that represents the number of standard deviation that the firms asset value is away from the default point. Finally, a mapping is done between the default values and actual default rate, based on historical default experience. The resultant probability is called Expected Default Frequency (EDF). Thus EDF is calculated in following three steps: I. Estimation of asset value and asset volatility from equity value and volatility of equity return, II. Calculation of DFD, DFD = (Asset value Default point) / (Asset value * Asset volatility) III. Calculation of expected default frequency. E. Risk Adjusted Return On Capital (RAROC): As it became clearer that banks needed to add an appropriate capital charge in the pricing process, the concept of risk adjusting the return or risk adjusting capital was born. RAROC is based on a mark-tomarket concept. As defined by Bankers Trust, RAROC allocates a capital charge to a transaction or a line of business at an amount equal to the maximum expected loss (at a 99 percent confidence level) over one year on an after-tax basis. As may be expected, the higher volatility of the returns, the more the capital allocated. The higher capital allocation means that the transaction has to generate cash flows larger enough to offset the volatility of returns, which results from the credit risk, material risk, and other risks taken. The RAROC process estimates the asset value that may prevail in the worst case scenario and then equates the capital cushion to be provided for the potential loss. There are four basic steps in this process: Analyse the activity or product and determine the basic risk categories that it contains, for example, interest rate (country, directional, basis, yield curve, optionality), foreign exchange, equity, commodity, and credit and operating risks. Quantify the risk in each category by a market proxy. Using the historical price movements of the market proxy over the past three years, compute a market risk factor, given by the following equation: RAROC risk factor = 2.33 * weekly volatility * square root of 52 * (I tax rate) In this equation, the multiplier 2.33 gives the volatility (expressed as per cent) at the 99 per

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cent confidence level. The term 52 converts the weekly price movement into an amount movement. The term (I tax rate) convert the calculated value to an after-tax basis. Compute the rupee amount of capital required for each category by multiplying the risk factor by the size of the position. Establishing the maximum expected loss in each product line and linking the capital to this loss makes it possible to compare products of different risk levels by stating the risk side of the risk-reward equation in a consistent manner. The risk-to-reward ratio becomes comparable.

The RAROC is an improvement over the traditional approach in that it allows one to compare two businesses with different risk (volatility of returns) profiles. Using a hurdle rate, a lender can also use the RAROC principle to set the target pricing on a relationship or a transaction. Although not all assets have market price distribution, RAROC is a first step towards examining an institutions entire balance sheet on a mark-to-market basis if only to understand the risk-return trade offs that have been made. F. Risk mitigants Credit risk mitigation means reduction of credit risk in an exposure by a safety net of tangible and realisable securities including third-party approved guarantees/insurance. Banks use a number of techniques to mitigate the credit risks to which they are exposed. Exposures may be collaterised by first priority claims, in whole or in part with cash or securities, a loan exposure may be guaranteed by a third-party, or a bank may buy a credit derivative to offset various forms of credit risk. Additionally banks may also net the loans owned to them against deposits from the same counter-party. The various credit risk mitigants laid down by Basel Committee are as follows: (Refer to page no.17 for detail information) 1. Collateral (tangible, marketable) securities 2. Guarantees 3. Credit derivatives 4. On-balance-sheet netting The extent to which a particular credit risk mitigant helps depends on the quantum of exposure, or the strength of the mitigant. There are certain conditions to be met for the use of credit risk mitigants, which are as follows: All documentation used in collateralized transactions and for documenting on-balancesheet netting, guarantees, and credit derivative must be binding on all parties and must be legally enforceable in all relevant jurisdictions. Banks must have properly reviewed all the documents and should have appropriate legal opinions to verify such, and ensure its enforceability.

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G. Loan review mechanism/credit audit Credit audit examines the compliance with extant sanction and post-sanction processes and procedures laid down by the bank from time to time. The objectives of credit audit are: Improvement in the quality of credit portfolio, Review of sanction process and compliance status of large loans, Feedback on regulatory compliance, Independent review of credit risk assessment, Pick-up of early warning signals and suggest remedial measures, and Recommend corrective actions to improve credit quality, credit administration, and credit skills of staff.

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 Types of Credit Rating Credit rating can be classified as: 1. External credit rating. 2. Internal credit rating

External credit rating: A credit rating is not, in general, an investment recommendation concerning a given security. In the words of S&P, A credit rating is S&P's opinion of the general creditworthiness of an obligor, or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation, based on relevant risk factors. In Moody's words, a rating is, an opinion on the future ability and legal obligation of an issuer to make timely payments of principal and interest on a specific fixed-income security. Since S&P and Moody's are considered to have expertise in credit rating and are regarded as unbiased evaluators, there ratings are widely accepted by market participants and regulatory agencies. Financial institutions, when required to hold investment grade bonds by their regulators use the rating of credit agencies such as S&P and Moody's to determine which bonds are of investment grade. The subject of credit rating might be a company issuing debt obligations. In the case of such issuer credit ratings the rating is an opinion on the obligors overall capacity to

meet its financial obligations. The opinion is not specific to any particular liability of the company, nor does it consider merits of having guarantors for some of the obligations. In the issuer credit rating categories are a) Counterparty ratings b) Corporate credit ratings

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c) Sovereign credit ratings The rating process includes quantitative, qualitative, and legal analyses. The quantitative analyses. The quantitative analysis is mainly financial analysis and is based on the firms financial reports. The qualitative analysis is concerned with the quality of management, and includes a through review of the firms competitiveness within its

industry as well as the expected growth of the industry and its vulnerability to technological changes, regulatory changes, and labor relations.

Internal credit rating: A typical risk rating system (RRS) will assign both an obligor rating to each borrower (or group of borrowers), and a facility rating to each available facility. A risk rating (RR) is designed to depict the risk of loss in a credit facility. A robust RRS should offer a carefully designed, structured, and documented series of steps for the assessment of each rating. The following are the steps for assessment of rating: a) Objectivity and Methodology: The goal is to generate accurate and consistent risk rating, yet also to allow professional judgment to significantly influence a rating where it is appropriate. The expected loss is the product of an exposure (say, Rs. 100) and the probability of default (say, 2%) of an obligor (or borrower) and the loss rate given default (say, 50%) in any specific credit facility. In this example, The expected loss = 100*.02*.50 = Rs. 1 A typical risk rating methodology (RRM) a. Initial assign an obligor rating that identifies the expected probability of default by that borrower (or group) in repaying its obligations in normal course of business. b. The RRS then identifies the risk loss (principle/interest) by assigning an RR to each individual credit facility granted to an obligor. The obligor rating represents the probability of default by a borrower in repaying its obligation in the normal course of business. The facility rating represents the expected loss of principal and/ or interest on any business credit facility. It combines the likelihood

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of default by a borrower and conditional severity of loss, should default occur, from the credit facilities available to the borrower.

Risk Rating Continuum (Prototype Risk Rating System)

RISK

RR

Corresponding Probable S&P or Moody's Rating

Sovereign Low

0 1 2 3 4 AAA AA A

Not Applicable

Investment Grade

BBB+/BBB BBBBB+/BB BBB+/B BCCC+/CCC CCIn Default Below Investment Grade

Average

5 6 7

High

8 9 10 11 12

The steps in the RRS (nine, in our prototype system) typically start with a financial assessment of the borrower (initial obligor rating), which sets a floor on the obligor rating (OR). A series of further steps (four) arrive at the final obligor rating. Each one of steps 2 to 5 may result in the downgrade of the initial rating attributed at step 1. These steps include analyzing the managerial capability of the borrower (step 2), examining the borrowers absolute and relative position within the industry (step 3), reviewing the quality of the financial information (step 4) and the country risk (step 5). The process ensures that all credits are objectively rated using a consistent process to arrive at the accurate rating.

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Additional steps (four, in our example) are associated with arriving at a final facility rating, which may be above OR below the final obligor rating. These steps include examining

third-party support (step 6), factoring in the maturity of the transaction (step 7), reviewing how strongly the transaction is structured. (step 8), and assessing the amount of collateral (step 9). b) Measurement of Default Probability and Recovery Rates. Credit rating systems can be compared to multivariate credit scoring systems to evaluate their ability to predict bankruptcy rates and also to provide estimates of the severity of losses. Altman and Saunders (1998) provide a detailed survey of credit risk management approaches. They compare four methodologies for credit scoring: 1. The linear probability model 2. The logit model 3. The probit model 4. The discriminant analysis model The logit model assumes that the default probability is logistically distributed, and applies a few accounting variables to predict the default probability. The linear probability model is based on a linear regression model, and makes use of a number of accounting variables to try to predict the probability of default. The multiple discriminant analysis (MDA), proposed and advocated by Aitman is based on finding a linear function of both accounting and market based variables that best discriminates between two groups: firms that actually defaulted and firms that did not default. The linear models are based on empirical procedures. They are not found in theory of the firm OR any theoretical stochastic processes for leveraged firms. Credit Risk Management In this backdrop, it is imperative that banks have a robust credit risk management system which is sensitive and responsive to these factors. The effective management of credit risk is a critical component of comprehensive risk management and is essential for the long term success of any banking organization. Credit risk management encompasses identification, measurement, monitoring and control of the credit risk exposures.

Building Blocks of Credit Risk Management:

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In a bank, an effective credit risk management framework would comprise of the following distinct building blocks:

Policy and Strategy Organizational Structure Operations/ Systems Policy and Strategy The Board of Directors of each bank shall be responsible for approving and

periodically reviewing the credit risk strategy and significant credit risk policies. Credit Risk Policy 1. Every bank should have a credit risk policy document approved by the Board. The document should include risk identification, risk measurement, risk grading/ aggregation techniques, reporting and risk control/ mitigation techniques,

documentation, legal issues and management of problem loans. 2. Credit risk policies should also define target markets, risk acceptance criteria, credit approval authority, credit origination/ maintenance procedures and guidelines for portfolio management. 3. The credit risk policies approved by the Board should be communicated to branches/controlling offices. All dealing officials should clearly understand the bank's approach for credit sanction and should be held accountable for complying with established policies and procedures. 4. Senior management of a bank shall be responsible for implementing the credit risk policy approved by the Board.</P< LI> Credit Risk Strategy 1. Each bank should develop, with the approval of its Board, its own credit risk strategy or plan that establishes the objectives guiding the bank's credit-granting activities and adopt necessary policies/ procedures for conducting such activities. This strategy should spell out clearly the organizations credit appetite and the acceptable level of risk-reward trade-off for its activities. 2. 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

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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. 3. The credit risk strategy should provide continuity in approach as also take into account the cyclical aspects of the economy and the resulting shifts in the composition/ quality of the overall credit portfolio. This strategy should be viable in the long run and through various credit cycles. 4. Senior management of a bank shall be responsible for implementing the credit risk strategy approved by the Board.

Organizational Structure Sound organizational structure is sine qua non for successful implementation of an effective credit risk management system. The organizational structure for credit risk management should have the following basic features: 1. The Board of Directors should have the overall responsibility for management of risks. The Board should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks. The Risk Management Committee will be a Board level Sub committee including CEO and heads of Credit, Market and Operational Risk Management Committees. It will devise the policy and strategy for integrated risk management containing various risk exposures of the bank including the credit risk. For this purpose, this Committee should effectively coordinate between the Credit Risk Management Committee (CRMC), the Asset Liability Management Committee and other risk committees of the bank, if any. It is imperative that the independence of this Committee is preserved. The Board should, therefore, ensure that this is not compromised at any cost. In the event of the Board not accepting any recommendation of this Committee, systems should be put in place to spell out the rationale for such an action and should be properly documented. This document should be made available to the internal and external auditors for their scrutiny and comments. The credit risk strategy and policies adopted by the committee should be effectively Operations / Systems

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Banks should have in place an appropriate credit administration, credit risk measurement and monitoring processes. The credit administration process typically involves the following phases: 1. Relationship management phase i.e. business development. 2. Transaction management phase covers risk assessment, loan pricing, structuring the facilities, internal approvals, documentation, loan administration, on going monitoring and risk measurement. 3. Portfolio management phase entails monitoring of the portfolio at a macro level and the management of problem loans 4. On the basis of the broad management framework stated above, the banks should have the following credit risk measurement and monitoring procedures: 5. 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 visits of plant and business site, and at least quarterly management reviews of troubled exposures/weak credits Credit Risk Models A credit risk model seeks to determine, directly or indirectly, the answer to the following question: Given our past experience and our assumptions about the future, what is the present value of a given loan or fixed income security? A credit risk model would also seek to determine the (quantifiable) risk that the promised cash flows will not be forthcoming. The techniques for measuring credit risk that have evolved over the last twenty years are prompted by these questions and dynamic changes in the loan market. The increasing importance of credit risk modeling should be seen as the consequence of the following three factors: 1. Banks are becoming increasingly quantitative in their treatment of credit risk. 2. New markets are emerging in credit derivatives and the marketability of existing loans is increasing through securitization/ loan sales market." 3. Regulators are concerned to improve the current system of bank capital requirements especially as it relates to credit risk.

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Importance of Credit Risk Models

Credit Risk Models have assumed importance because they provide the decision maker with insight or knowledge that would not otherwise be readily available or that could be marshalled at prohibitive cost. In a marketplace where margins are fast disappearing and the pressure to lower pricing is unrelenting, models give their users a competitive edge. The credit risk models are intended to aid banks in quantifying, aggregating and managing risk across geographical and product lines. The outputs of these models also play increasingly important roles in banks' risk management and performance measurement processes, customer profitability analysis, risk-based pricing, active portfolio management and capital structure decisions. Credit risk modeling may result in better internal risk management and may have the potential to be used in the supervisory oversight of banking organizations.

RBI Guidelines on Credit Risk New Capital Accord: Implications for Credit Risk Management The Basel Committee on Banking Supervision had released in June 1999 the first Consultative Paper on a New Capital Adequacy Framework with the intention of replacing the current broad-brush 1988 Accord. The Basel Committee has released a Second Consultative Document in January 2001, which contains refined proposals for the three pillars of the New Accord - Minimum Capital Requirements, Supervisory Review and Market Discipline. The Committee proposes two approaches, for estimating regulatory capital. viz., 1. Standardized and 2. Internal Rating Based (IRB) Under the standardized approach, the Committee desires neither to produce a net increase nor a net decrease, on an average, in minimum regulatory capital, even after accounting for operational risk. Under the Internal Rating Based (IRB) approach, the Committee's ultimate goals are to ensure that the overall level of regulatory capital is

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sufficient to address the underlying credit risks and also provides capital incentives relative to the standardized approach, i.e., a reduction in the risk weighted assets of 2% to 3% (foundation IRB approach) and 90% of the capital requirement under foundation approach for advanced IRB approach to encourage banks to adopt IRB approach for providing capital. The minimum capital adequacy ratio would continue to be 8% of the risk-weighted assets, which cover capital requirements for market (trading book), credit and operational risks. For credit risk, the range of options to estimate capital extends to include a standardized, a foundation IRB and an advanced IRB approaches.

RBI Guidelines for Credit Risk Management Credit Rating Framework

A Credit-risk Rating Framework (CRF) is necessary to avoid the limitations associated with a simplistic and broad classification of loans/exposures into a "good" or a "bad" category. The CRF deploys a number/ alphabet/ symbol as a primary summary indicator of risks associated with a credit exposure. Such a rating framework is the basic module for developing a credit risk management system and all advanced models/approaches are based on this structure. In spite of the advancement in risk management techniques, CRF is continued to be used to a great extent. These frameworks have been primarily driven by a need to standardize and uniformly communicate the "judgment" in credit selection procedures and are not a substitute to the vast lending experience accumulated by the banks' professional staff.

Broadly, CRF can be used for the following purposes: 1. Individual credit selection, wherein either a borrower or a particular exposure/ facility is rated on the CRF 2. Pricing (credit spread) and specific features of the loan facility. This would largely constitute transaction-level analysis. 3. Portfolio-level analysis.

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4. Surveillance, monitoring and internal MIS Assessing the aggregate risk profile of bank/ lender. These would be relevant for portfoliolevel analysis. For instance, the spread of credit exposures across various CRF categories, the mean and the standard deviation of losses occurring in each CRF category and the overall migration of exposures would highlight the aggregated credit-risk for the entire portfolio of the bank.

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. The management of credit risk includes a) Measurement through credit rating/ scoring, b) Quantification through estimate of expected loan losses, c) Pricing on a scientific basis and d) Controlling through effective Loan Review Mechanism and Portfolio Management. TOOLS OF CREDIT RISK MANAGEMENT. The instruments and tools, through which credit risk management is carried out, are detailed below: a) Exposure Ceilings: Prudential Limit is linked to Capital Funds say 15% for individual borrower entity, 40% for a group with additional 10% for infrastructure projects undertaken by the group, Threshold limit is fixed at a level lower than Prudential Exposure; Substantial Exposure, which is the sum total of the exposures beyond threshold limit should not exceed 600% to 800% of the Capital Funds of the bank (i.e. six to eight times). b) Review/Renewal: Multi-tier Credit Approving Authority, constitution wise delegation of powers, Higher delegated powers for better-rated customers; discriminatory time schedule for review/renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal based on risk rating, etc are formulated. c) Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point scale. Clearly define rating thresholds and review the ratings periodically preferably at half yearly intervals. Rating migration is to be mapped to estimate the expected loss. d) Risk based scientific pricing: Link loan pricing to expected loss. High-risk category borrowers are to be priced high. Build historical data on default losses. Allocate capital to absorb the unexpected loss. Adopt the RAROC framework. e) Portfolio Management The need for credit portfolio management emanates from the necessity to optimize the benefits associated with diversification and to reduce the potential adverse impact of concentration of exposures to a particular borrower, sector or industry. Stipulate quantitative ceiling on aggregate exposure on specific rating categories,

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distribution of borrowers in various industry, business group and conduct rapid portfolio reviews. f) Loan Review Mechanism This should be done independent of credit operations. It is also referred as Credit Audit covering review of sanction process, compliance status, review of risk rating, pickup of warning signals and recommendation of corrective action with the objective of improving credit quality. It should target all loans above certain cut-off limit ensuring that at least 30% to 40% of the portfolio is subjected to LRM in a year so as to ensure that all major credit risks embedded in the balance sheet have been tracked.

Risk Adjusted Rate of Return on Capital (RAROC) It gives an economic basis to measure all the relevant risks consistently and gives managers tools to make the efficient decisions regarding risk/return tradeoff in different assets. As economic capital protects financial institutions against unexpected losses, it is vital to allocate capital for various risks that these institutions face. Risk Adjusted Rate of Return on Capital (RAROC) analysis shows how much economic capital different products and businesses need and determines the total return on capital of a firm. Though Risk Adjusted Rate of Return can be used to estimate the capital requirements for market, credit and operational risks, it is used as an integrated risk management tool (Crouhy and Robert, 2001)

Credit risk arises from non-performance by a borrower. It may arise from either an inability or an unwillingness to perform in the pre-committed contracted manner. This can affect the lender holding the loan contract, as well as other lenders to the creditor. Therefore, the financial condition of the borrower as well as the current value of any underlying collateral is of considerable interest to its bank. The real risk from credit is the deviation of portfolio performance from its expected value. Accordingly, credit risk is diversifiable, but difficult to eliminate completely. This is because a portion of the default risk may, in fact, result from the systematic risk outlined above. In addition, the idiosyncratic nature of some portion of these losses remains a problem for creditors in spite of the beneficial effect of diversification on total uncertainty. This is particularly true for banks that lend in local markets and ones that take on highly illiquid assets. In such cases, the credit risk is not easily transferred, and accurate estimates of loss are difficult to obtain.

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

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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 through a conversion factor and summed up. The management of credit risk includes a) measurement through credit rating/ scoring, b) quantification through estimate of expected loan losses, c) Pricing on a scientific basis and d) Controlling through effective Loan Review Mechanism and Portfolio Management.

A) Tools of Credit Risk Management.

The instruments and tools, through which credit risk management is carried out, are detailed below: a) Exposure Ceilings: Prudential Limit is linked to Capital Funds say 15% for individual borrower entity, 40% for a group with additional 10% for infrastructure projects undertaken by the group, Threshold limit is fixed at a level lower than Prudential Exposure; Substantial Exposure, which is the sum total of the exposures beyond threshold limit should not exceed 600% to 800% of the Capital Funds of the bank (i.e. six to eight times). b) Review/Renewal: Multi-tier Credit Approving

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Authority, constitution wise delegation of powers, Higher delegated powers for better-rated customers; discriminatory time schedule for review/renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal based on risk rating, etc are formulated. c) Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point scale. Clearly define rating thresholds and review the ratings periodically preferably at half yearly intervals. Rating migration is to be mapped to estimate the expected loss. d) Risk based scientific pricing: Link loan pricing to expected loss. High-risk category borrowers are to be priced high. Build historical data on default losses. Allocate capital to absorb the unexpected loss. Adopt the RAROC framework. e) Portfolio Management The need for credit portfolio management emanates from the necessity to optimize the benefits associated with diversification and to reduce the potential adverse impact of concentration of exposures to a particular borrower, sector or industry. Stipulate quantitative ceiling on aggregate exposure on specific rating categories, distribution of borrowers in various industry, business group and conduct rapid portfolio reviews. The existing framework of tracking the non-performing loans around the balance sheet date does not signal the quality of the entire loan book. There should be a proper & regular on-going system for identification of credit weaknesses well in advance. Initiate steps to preserve the desired portfolio quality and integrate portfolio reviews with credit decision-making process. f) Loan Review Mechanism This should be done independent of credit operations. It is also referred as Credit Audit covering review of sanction process, compliance status, review of risk rating, pick up of warning signals and recommendation of corrective action with the objective of improving credit quality. It should target all loans above certain cut-off limit ensuring that at least 30% to 40% of the portfolio is subjected to LRM in a year so as to ensure that all major credit risks embedded in the balance sheet have been tracked. This is done to bring about qualitative improvement in credit administration. Identify loans with credit weakness. Determine adequacy of loan loss provisions. Ensure adherence to lending policies and procedures. The focus of the credit audit needs to be broadened from account level to overall portfolio level. Regular, proper & prompt reporting to Top Management should be ensured. Credit Audit is conducted on site, i.e. at the branch that has appraised the advance and where the main operative limits are made available. However, it is not required to visit borrowers factory/office premises.

B. Risk Rating Model

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Credit Audit is conduced on site, i.e. at the branch that has appraised the advance and where the main operative limits are made available. However, it is not required to risk borrowers factory/office premises. As observed by RBI, Credit Risk is the major
component of risk management system and this should receive special attention of the Top Management of the bank. The process of credit risk management needs analysis of uncertainty and analysis of the risks inherent in a credit proposal. The predictable risk should be contained through proper strategy and the unpredictable ones have to be faced and overcome. Therefore any lending decision should always be preceded by detailed analysis of risks and the outcome of analysis should be taken as a guide for the credit decision. As there is a significant co-relation between credit ratings and default frequencies, any derivation of probability from such historical data can be relied upon. The model may consist of minimum of six grades for performing and two grades for non-performing assets. The distribution of rating of assets should be such that not more than 30% of the advances are grouped under one rating. The need for the adoption of the credit risk-rating model is on account of the following aspects. Disciplined way of looking at Credit Risk. Reasonable estimation of the overall health status of an account captured under Portfolio approach as cont..

karavati Credit Risk Credit risk is considered as the most important of all risks. It is referred to the customers. inability or unwillingness to serve their debts, and constitutes a major source of loss not only on bank.s profitability but also on the initial asset; the loss could be as much partial as total of any amount lent to the counterparty. Not performing the obligations of a contract is usually appeared to loans, swaps, options, and during settlement. Securities firms are faced with credit risk whenever they enter into a loan agreement, an OTC contract, or extend credit. Credit risk is also the risk of a decline in the credit standing of an obligor of the issuer of a bond or stock. Such a possibility does not mean default, but it means that the probability of default increases because an upward move is needed of the required market yield to compensate the higher risk which brings a value decline. The real risk from credit is the deviation of portfolio performance from its expected value. Accordingly, credit risk is diversifiable, but difficult to eliminate completely and that because it depends on a number of borrower-specific factors and of systemic risk outlined above. Credit risk is not easily transferred, and

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accurate estimates of loss are difficult to obtain.

Credit Risk management One element that is widely affects the riskiness of credit in a bank is the asymmetric information or information asymmetry. It is defined as the situation where the one part of a transaction does not have the same or even has better information than the other and this may lead the transaction to fail. Asymmetric information generates two problems: adverse selection and moral hazard. Adverse selection in banking refers to a situation where individuals in a selection process have hidden economically undesirable characteristics and the final selection results in default and moral hazard describes the situation where one party to a contract takes a hidden action that benefits him or her but hurts the another party. It is obvious that solving asymmetric information problems in banking is a way to manage credit risk. The most usual methods is screening (collection of financial information about potential borrowers before the transaction), specialization (knowledge of particular credit markets and particular potential borrowers), monitoring the activities of the borrower, enforcing the covenants in the loan contract, having long term relationships, collaterals and compensating balances (ex. mortgages where home is collateral) and finally credit or loan rationing (refusal lending to borrowers even though they are willing to borrow). To continue with credit risk management tools, credit scoring and RAROC (risk-adjusted return on capital) method help to decide whether a loan is accepted, rejected or requires more attention. Credit scoring is a popular one, and is a technical method of assigning a score that classifies potential borrowers into risk classes according to their economic, or other, characteristics and RAROC is a technique that is used extensively as a management performance tool to evaluate the economic profit generated mainly from a loan. RAROC is compared with a benchmark rate in order the final decision to be made. Additionally, Creditmetrics model (JP Morgan.s CreditmetricsTM, 1997) which is based on a transition matrix of probabilities that measures the probability that the credit rating of a loan or any dept security will change over the term of the loan or maturity of credit instrument, is widely used. 32 Another approach to credit risk management is by credit risk mitigation tools. Securitization is one of the more visible forms and involves selling registered, rated securities in the capital markets. The aim is to transfer the credit risk which is involved in a specified loan portfolio to the institutional investors and insurance companies while bank is gaining liquidity (loans decrease by the same amount). An alternative to the process of securitization is to insure the bank asset by a credit default swap (CDS). The party buying credit protection pays a periodic fee to another party who agrees to reimburse the purchaser of credit protection in the event of failure to repay either the capital value of the debt or related interest within a specified time period. Proportionally, counterparty risk takes place. Ideally, every bank should institute a Credit Risk Management Department in order to monitor and implement all the appropriate functions that immune the organization from a daily and unavoidable risk like the credit risk.

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