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This document discusses credit risk management and debt servicing management. It begins with an agenda and overview of risk, credit risk, historical credit risk management practices in India, why credit risk management is important, and the tasks of a credit risk department. It then covers the risk management process/cycle and building blocks of credit risk management. Various types of risks for financial institutions are defined including market, operational, credit, and portfolio risks.

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Credit Risk Management & Debt Servicing Management (CRM & DSM) by Dinesh G. Mahabal
Agenda  Anatomy of Risk  What is Credit Risk  Historical Perspective for Management of Cr Risk at Indian Fin Institutions  Why Credit Risk Management  Task of Credit Risk Department  Risk Management Process/ Cycle  Building Blocks of Credit Risk Management Dinesh Mahabal 2
3 Anatomy of Risk  What is Risk?  Risk is the potential / probability for loss, either directly through loss of earnings or capital or indirectly through the imposition of constrains on organization's ability to meet its business objectives.  RBI definition  “Risk is defined as the probability of the unexpected happenings- the probability of suffering a loss”. (Ref. RBI Guidance Note dated 12th October 2002) Dinesh Mahabal
Anatomy of Risk  Banks during the process of financial intermediation are confronted with various kinds of financial and non-financial risks viz. credit, interest rate, foreign exchange rate, liquidity, equity price, commodity price, legal, regulatory, reputational, operational etc. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories.  Banks, therefore; attach considerable importance to improve the ability to implement the “Risk Cycle” functions consisting of four parameters i.e. identify, measure, monitor and control (IMMC) the overall level of risks undertaken. Dinesh Mahabal 4
Anatomy of Risk  Lending function in particular involves a number of risks such as interest rate, forex and country risks in addition to the basic risk related to creditworthiness of the counterparty.  Credit risk or default risk involves inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, hedging, settlement and other financial transactions. The Credit Risk is generally made up of transaction risk or default risk and portfolio risk.  The portfolio risk in turn comprises intrinsic and concentration risk. The credit risk of a bank’s portfolio depends on both external and internal factors. Dinesh Mahabal 5
Types of Risks for a Financial Company  Market Risk: 1. Liquidity, 2. Interest Rate, 3. Currency/Forex, 4. Equity Price & 5. Commodity Price  Operational Risk:  The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events {includes legal risk but specifically excludes strategic (adverse business decisions) and reputational (risk of negative public opinion) risk}  People, Process, Management, Systems, Business and External  Credit Risk: Transaction- Default, Delayed Repayment, Downgrade Portfolio- Intrinsic, concentration 6 Dinesh Mahabal
Market Risk 1. Liquidity is the ability to efficiently accommodate deposit and other liability decreases, as well as, fund growth in loan portfolio and the possible funding of off-balance sheet claimsThe liquidity risk manifests in three dimensions viz. a) Funding Risk – need to replace net outflows due to unanticipated withdrawals / non-renewal of deposits b) Time Risk – need to compensate for non-receipt of expected inflows of funds i.e. performing assets turning into NPA c) Call Risk – due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desired. 2. Interest Rate Risk: Risk arising due to the changes in the interest rates on assets and or liabilities which may be due to re-pricing, embedded options, basis risk or yield curve risk a) Gap or mismatch risk:- arises out of holding assets / liabilities and off-balance sheet items with different principle amounts, maturity dates or repricing dates thereby causing exposures to unexpected changes in ROI b) Basis risks arises when interest on assets and liability are fixed on different basis such as interest on loans is linked to LIBOR and rate on deposits is linked with bank rate or call money market rates c) Re-pricing risk:- arises due to the changes in rate of interest on the date of maturity of an asset or liability. In such a case even if the period of re-pricing is the same, change in interest rate may be in different directions. d) Embedded options are the options available to the depositors for repayment of deposits and borrowers to repay the loan before maturity Dinesh Mahabal 7
Market Risk 3. Currency/ Forex Risk :Three dimensional classification of Currency Risk exposure covers:  Transaction Exposure i.e. exposure on account of foreign currency receipts (i.e. exports, etc.) or payments (i.e. imports, etc.). Adverse movements of concerned foreign currency against domestic currency involve loss of domestic funds. For example: depreciation of foreign currency against domestic currency in an export transaction and appreciation of foreign currency against domestic currency in an import transaction.  Translation Exposure / Accounting Exposure i.e. conversion of foreign currency into domestic currency periodically for the purpose of Statement of Accounts. Adverse movements will have their ultimate effect on bottom-line and/or Balance Sheet ‘footing’.  Economic Exposure i.e. adverse movements affecting competitive edge with eventual repercussions on the bottom-line of the organization. 4. Equity Risk arises out of exposure to capital market instruments. Banks directly invest as also extend credit facilities, both fund-based and non-funded, to their constituents (including Share Brokers) to enable them to participate in capital markets by way of purchase/sale transactions. In the process, Banks expose themselves through market risks associated with capital exposures Dinesh Mahabal 8
Market Risk 5. Commodity Price Risk: Any physical product such as agricultural products, metals, minerals, oil, gas, etc. available for trading in an organized market can be treated as ‘Commodity’ from risk management angle. Gold is treated as a foreign currency (under BASEL Committee guidelines) & hence the same is not classified under Commodity. Commodity of Trading is mainly prevalent in developed countries, with the availability of derivatives of hedge risk involved in commodity price fluctuations.However, Indian Banks hardly take up exposures in commodity trading.  Commodity market often suffers from liquidity element.  Commodity prices are very closely linked with seasonality in supply-demand position.  Equilibrium prices are set up by inventory levels.  Arising out of the aforesaid dominant aspects, following risk attributes are taken into account in the evaluation of Commodity exposures:  Risk of price movement in spot prices.  Risk of price differential movement in the Commodities – different but related.  Risk of change in cost o financing.  Time spread risk and Option Risk. Dinesh Mahabal 9
Operational Risk  To understand what operational risk is, it is useful to consider the standard “event types” provided by Basel and some actual losses (Impact) that have occurred in each Event Type & the cause/s thereof as follows:- Dinesh Mahabal 10
Dinesh Mahabal 11 Operational Risk
12 Risk Profiles break up Risk Profiles of an Financial 10 Organisation (%) 5 7 18 60 Credit Risk Mkt. Risk Liq. Risk Op. Risk Other Risks Dinesh Mahabal
What is Credit Risk? As per RBI’s Guidance Note of Oct’02, “Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counterparties”..Thus, these losses, associated with changes in credit quality, could arise due to default (single or joint) or due to deterioration in credit quality. – Default risk - obligor fails to service debt obligations – Recovery risk – recovery post default is uncertain – Spread risk – credit quality of obligor changes leading to a fall in the value of the loan – Concentration risk – over exposure to a an individual obligor, group or industry – Correlation risk - concentration based on common risk factors between different borrowers, industries or sectors which may lead to simultaneous default. Dinesh Mahabal 13
14 Identifying Elements of Credit Risk Portfolio Risk Individual Risk Concentration Risk Intrinsic/ Corelation Risk Credit Risk Downgrade Risk Default Risk Recovery Risk Dinesh Mahabal
Credit Risk in Financial Transactions  Direct Lending: Interest / Installments not repaid/ 15 funds will not be available  Guarantees or Letters of Credit: funds will not be forthcoming from the Guarantor upon crystallization of the liability  Treasury products: series of payments due from the counterparty cease or are not forthcoming  Trading: securities settlement is not effected  Cross border exposure: free transfer of currency is restricted or ceases Dinesh Mahabal
16 Historical Perspective of Indian Practices in Credit Risk Management  Traditional ratio analysis and post mortem of balance sheet  Collateral based lending – Often it is defensive approach leading to a false sense of “security”  Risk vs. return analysis – not fully adequate  Credit limits on exposures - regulatory limits insufficient  Nepotism  Risk vs. capacity to absorb risk in terms of capital base and capital adequacy ratio Dinesh Mahabal
17 Why should Banks be concerned with Credit Risk?  Market Realities  Structural increase in NPAs  Concentrations in loan portfolios  Capital market growth producing a “Winner’s Curse” effect i.e. winner ending up with overpayment or getting less value for the spent.  Competitive margins despite decline in avg. quality of loans  Declining and volatile values of Collateral  Growth of Off-balance sheet derivatives and Securitization products  Changing Regulatory Environments  RBI endorsement of Risk based Capital Requirements as per BIS regulations  Risk Based Supervision Dinesh Mahabal
Importance of Credit Risk Management Improves Bank Competitiveness and Performance Shareholder Value Creation / Increase ( RAROC & Economic Capital concepts) Value Creation : transaction management & active portfolio management  Value Preservation : portfolio management  Capital Optimization  Thus, Improve Risk Adjusted Returns for all stakeholders Regulatory Compliance (Basel II / III) Dinesh Mahabal 18
19 Why should Banks be concerned with Credit Risk?  Skewed nature of loan returns  Loan returns are highly asymmetric since there is limited upside  If borrower’s credit quality improves - no benefit to lending bank since the borrower can refinance his loan at a lower rate  If borrower’s credit quality declines - bank is not compensated for taking the additional risk since loan price is not revised  If borrower defaults - accrued interest is reversed and any new payments are towards principal  If borrower becomes NPA - minimal recovery Dinesh Mahabal
Why Credit Risk Management? Recent Complexities Emergence : Seven Reasons to follow best Credit Risk Management Practices as a consequence of LPG (Liberalization, Privatization & Globalization) phenomenon 1. Globalization:- Leading to opening up of the economy to the outside world, thus becoming vulnerable to economic problems in the countries across the world. 2. Deregulation:-Business area expansion. Banks 20 introduced new products/ services Dinesh Mahabal
21 Why Credit Risk Management? 3. Severe Competition: pressure on margins, competitive pricing is the need. 4. Sophistication of existing products and additions of new complex products. 5. Advances in Technology: increase in volume and speed. Dinesh Mahabal
22 Why Credit Risk Management? 6. Regulatory Developments:- New Laws, Rules and Regulations, Capital Adequacy Norms, Basel –II Guidelines 7. Business Transformation:- Organizational changes, new activities, expansion in operations. Dinesh Mahabal
The Task for Credit Risk Department  Segmentation of the credit portfolio (in terms of risk but not size)  Model Requirements (for risk assessments)  Data requirements  Credit risk reporting requirements for regulatory / control and decision-making purposes at various levels  Policy requirements for credit risk (credit process & practices, monitoring & portfolio management etc.)  Align Risk Strategy & Business Strategy Dinesh Mahabal 23
The Task for Credit Risk Department  Take informed credit decisions;  Set provisioning and reserve requirements;  Establish minimum pricing levels at which credit exposures to an obligor may be undertaken / extended (Base Rate)  Price credit risky instruments and facilities (Credit Spread);  Measure the regulatory capital charge –Standardized and IRB Approaches;  Measure the economic capital;  Calculate risk adjusted performance measures such as RAROC (adopt it as a common language). Dinesh Mahabal 24
Risk Management Process  It is imperative that banks have a robust credit risk management system which is sensitive and responsive to the factors present in banking transactions.  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 organisation.  Credit risk management encompasses identification, measurement, monitoring and control of the credit risk exposures Dinesh Mahabal 25
Risk Management Process • Identify the Risks: Name and Define • Measure the Risks: Size, Timing, Probability • Monitor the Risks: Identify significant changes in risk profile or controls • Manage / Control the Risks: Avoiding, Mitigating, Off-setting, diversifying • Again Go to Step 1 Dinesh Mahabal 26
27 Risk Management Process Identify Monitor Measure Control RISK Dinesh Mahabal
Credit Approval & Risk Management Process The whole Process can be divided in to Four Parts:  Risk Analysis (Identification)  Risk Control  Risk Management  - Front Office  - Back office  - Credit Audit  - Inspection & Audit Dinesh Mahabal 28
Risk Analysis Segmentation of Borrower (Retail, Corporate- Centralized/ Unit Level Processing) Source of Cash Flow (Object Finance, Project Finance) Credit Appraisal (Pre Sanction Inspection, Validation of Data/ Documents, Carry out Rating (Industry, Business, Financial, Management), Adherence to Financial Benchmark, Collateral Valuation and Risk Assessment) Dinesh Mahabal 29
Risk Analysis  Credit Approval Committee (Based on Amount and Rating- Multi Tier Approval)  Sanction (Amount and Rating- Multi Tier Sanction , Pricing based on Risk Rating)  Post Sanction Review by Next Higher Authority Dinesh Mahabal 30
Risk Control  Single/ Group Borrower Exposure  Substantial Exposure  Exposure to Term Loan ( 3 years and above Residual Maturity)  Industry/ Sector Exposure Limit  Sensitive Sector Limit (Capital Market, Real Estate, NBFC/Leasing & Hire Purchase) Dinesh Mahabal 31
Risk Control  Unsecured Advance (including Unsecured Guarantees)  Exposure to Non Corporate & Private Limited Co.  Rating wise Borrower  Rating wise Exposure  Geography wise Exposure Dinesh Mahabal 32
Risk Control  Rating wise Probability of Default  Off balance sheet Exposure  Country Wise Exposure  Higher level prior approval for additional exposure in sensitive sectors  Each Approval Committee has to have cap on account/amount per sitting. Dinesh Mahabal 33
Risk Management Front Office: KYC Norms, Defaulters List Approval acceptance of offer letter Documentation and its validation Post Sanction Inspection Approval for Disbursement End use of Funds Insurance Dinesh Mahabal 34
Risk Management  Periodical inspection (unit and collateral ), Stock and Book Debt Inspection by External Auditors  Transaction Monitoring (End use, DP limit, cash transaction, sales transaction)  Identifying potential weak accounts by early warning signals ( excess drawing, delayed payment of obligations, adverse signals in particular industry, return of cheques, inadequate transaction)  Monthly monitoring – multi tier  Annual Review (Rating and Exposure wise)  MIS maintenance Dinesh Mahabal 35
Risk Management  Back Office  Generating/Updating Industry reports/scores (annually, half yearly)  Preparing trigger reports  Independent rating validation  Migration of rating and PD estimation (Measurement of risk)  Portfolio reviews  Risk Control Monitoring  Quality Assurance (Policy Reviews, Appraisal Methodology)  Training and Upgradation of Skills of Employees Dinesh Mahabal 36
Risk Management  Credit Audit  Recommend corrective action to improve credit quality  Done within 6 months of sanction  Inspection & Audit  External  Concurrent Audit at Unit level at select branches  Concurrent Audit for specific accounts  Internal  Risk Based Internal Audit  Inspection by controlling office at non-concurrent audit units. Dinesh Mahabal 37
OBJECIVES OF RISK MANAGEMENT SYSTEM The three long term objectives : 1. To make use of CREDIT RATING as the tool for Credit Risk Management (e.g. decision making,pricing, Asset Quality). 2. Arriving at a single number VALUE at RISK figure for the bank and allocation of capital to the business units to arrive at RAROC and judge the performance of business units based on RAROC. 3. Risk Management should not be treated merely a compliance function but be used as a business opDinpesho Mahrabtalunity. 38
Risk Management Best Practices Integrated Best Risk Management Practices Best Practices Infrastructure Best Practices Policies Best Practices Methodologies Dinesh Mahabal 39
Integrated Best Risk Management Practices Limit Management (Monitor, Identify and Avoid) Risk Analysis (Stress Testing, Scenario Analysis, Market VaR, Credit VaR) RAROC ( Pricing, Capital Allocation) Active Portfolio Management Dinesh Mahabal 40
Best Practices Infrastructure People (Skills) Operations Accurate Data Technology Dinesh Mahabal 41
Identification of Risk Identification of various risk elements in the given process and define the same Dinesh Mahabal 42
43 Measurement & Monitoring of Credit Risk  Every obligor and facility must be assigned a risk rating.  Mechanism to price facilities depending on risk grading.  Banks should ensure consistent standards for loan origination documentation etc.  Banks should have a consistent approach towards early problem recognition, classification of problem exposures and remedial action. Dinesh Mahabal
44 Measurement & Monitoring of Credit Risk  Banks should maintain a diversified portfolio of risk assets  Banks should set Credit Risk limits like borrower limit industry limits etc.  Banks to report comprehensive set of credit risk data into independent risk system.  Systems to be put in place for monitoring financial performance of customers and for controlling outstanding within limits. Dinesh Mahabal
45 Measurement & Monitoring of Credit Risk Conservative provisioning policy for NPA advances. Thus the following procedure is to be followed towards managing the risk involved in credit:-  Carefully formulated scheme of lending powers.  Setting-up Prudential Limits  Measurement of risk through credit rating Dinesh Mahabal
Building Blocks of Credit Risk Management An effective credit risk management framework comprises of the following distinct building blocks: a) Policy and Strategy b) Organisational Structure c) Operations/ Systems Dinesh Mahabal 46
Building Blocks of Credit Risk Management Policy and Strategy The Board of Directors/ Highest level committee of each bank/ organisation should be responsible for approving and periodically reviewing the credit risk strategy and significant credit risk policies Dinesh Mahabal 47
Building Blocks of Credit Risk Management  Credit Risk Policy  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.  Credit risk policies should also define target markets, risk acceptance criteria, credit approval authority, credit origination/ maintenance procedures and guidelines for portfolio management. Dinesh Mahabal 48
Building Blocks of Credit Risk Management  Credit Risk Policy  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.  Senior management of a bank shall be responsible for implementing the credit risk policy approved by the Board. Dinesh Mahabal 49
Building Blocks of Credit Risk Management  Credit Risk Strategy  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 organisation’s credit appetite and the acceptable level of risk-reward trade-off for its activities.  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 Dinesh Mahabal 50
Building Blocks of Credit Risk Management  Credit Risk Strategy  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.  Senior management of a bank shall be responsible for implementing the credit risk strategy approved by the Board Dinesh Mahabal 51
Building Blocks of Credit Risk Management  Organisational 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 basic feature of Independence and arm’s length dealings within the organisation. Dinesh Mahabal 52
Building Blocks of Credit Risk Management  Operations / Systems  Banks should have in place an appropriate credit administration, credit risk measurement and monitoring processes. The credit administration process typically involves the following phases:  Relationship management phase i.e. business development  Transaction management phase covers risk assessment, loan pricing, structuring the facilities, internal approvals, documentation, loan administration, on going monitoring and risk measurement.  Portfolio management phase entails monitoring of the portfolio at a macro level and the management of problem loans. Dinesh Mahabal 53
Lessons Learned Risk Appetite says “Take risks: if you win, you will be happy; if you lose, you will be wise” Dinesh Mahabal 54
Thank You… dmahabal1956@gmail.com Dinesh Mahabal 55

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Crmdsm

  • 1.
    Credit Risk Management& Debt Servicing Management (CRM & DSM) by Dinesh G. Mahabal
  • 2.
    Agenda  Anatomyof Risk  What is Credit Risk  Historical Perspective for Management of Cr Risk at Indian Fin Institutions  Why Credit Risk Management  Task of Credit Risk Department  Risk Management Process/ Cycle  Building Blocks of Credit Risk Management Dinesh Mahabal 2
  • 3.
    3 Anatomy ofRisk  What is Risk?  Risk is the potential / probability for loss, either directly through loss of earnings or capital or indirectly through the imposition of constrains on organization's ability to meet its business objectives.  RBI definition  “Risk is defined as the probability of the unexpected happenings- the probability of suffering a loss”. (Ref. RBI Guidance Note dated 12th October 2002) Dinesh Mahabal
  • 4.
    Anatomy of Risk  Banks during the process of financial intermediation are confronted with various kinds of financial and non-financial risks viz. credit, interest rate, foreign exchange rate, liquidity, equity price, commodity price, legal, regulatory, reputational, operational etc. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories.  Banks, therefore; attach considerable importance to improve the ability to implement the “Risk Cycle” functions consisting of four parameters i.e. identify, measure, monitor and control (IMMC) the overall level of risks undertaken. Dinesh Mahabal 4
  • 5.
    Anatomy of Risk  Lending function in particular involves a number of risks such as interest rate, forex and country risks in addition to the basic risk related to creditworthiness of the counterparty.  Credit risk or default risk involves inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, hedging, settlement and other financial transactions. The Credit Risk is generally made up of transaction risk or default risk and portfolio risk.  The portfolio risk in turn comprises intrinsic and concentration risk. The credit risk of a bank’s portfolio depends on both external and internal factors. Dinesh Mahabal 5
  • 6.
    Types of Risksfor a Financial Company  Market Risk: 1. Liquidity, 2. Interest Rate, 3. Currency/Forex, 4. Equity Price & 5. Commodity Price  Operational Risk:  The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events {includes legal risk but specifically excludes strategic (adverse business decisions) and reputational (risk of negative public opinion) risk}  People, Process, Management, Systems, Business and External  Credit Risk: Transaction- Default, Delayed Repayment, Downgrade Portfolio- Intrinsic, concentration 6 Dinesh Mahabal
  • 7.
    Market Risk 1.Liquidity is the ability to efficiently accommodate deposit and other liability decreases, as well as, fund growth in loan portfolio and the possible funding of off-balance sheet claimsThe liquidity risk manifests in three dimensions viz. a) Funding Risk – need to replace net outflows due to unanticipated withdrawals / non-renewal of deposits b) Time Risk – need to compensate for non-receipt of expected inflows of funds i.e. performing assets turning into NPA c) Call Risk – due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desired. 2. Interest Rate Risk: Risk arising due to the changes in the interest rates on assets and or liabilities which may be due to re-pricing, embedded options, basis risk or yield curve risk a) Gap or mismatch risk:- arises out of holding assets / liabilities and off-balance sheet items with different principle amounts, maturity dates or repricing dates thereby causing exposures to unexpected changes in ROI b) Basis risks arises when interest on assets and liability are fixed on different basis such as interest on loans is linked to LIBOR and rate on deposits is linked with bank rate or call money market rates c) Re-pricing risk:- arises due to the changes in rate of interest on the date of maturity of an asset or liability. In such a case even if the period of re-pricing is the same, change in interest rate may be in different directions. d) Embedded options are the options available to the depositors for repayment of deposits and borrowers to repay the loan before maturity Dinesh Mahabal 7
  • 8.
    Market Risk 3.Currency/ Forex Risk :Three dimensional classification of Currency Risk exposure covers:  Transaction Exposure i.e. exposure on account of foreign currency receipts (i.e. exports, etc.) or payments (i.e. imports, etc.). Adverse movements of concerned foreign currency against domestic currency involve loss of domestic funds. For example: depreciation of foreign currency against domestic currency in an export transaction and appreciation of foreign currency against domestic currency in an import transaction.  Translation Exposure / Accounting Exposure i.e. conversion of foreign currency into domestic currency periodically for the purpose of Statement of Accounts. Adverse movements will have their ultimate effect on bottom-line and/or Balance Sheet ‘footing’.  Economic Exposure i.e. adverse movements affecting competitive edge with eventual repercussions on the bottom-line of the organization. 4. Equity Risk arises out of exposure to capital market instruments. Banks directly invest as also extend credit facilities, both fund-based and non-funded, to their constituents (including Share Brokers) to enable them to participate in capital markets by way of purchase/sale transactions. In the process, Banks expose themselves through market risks associated with capital exposures Dinesh Mahabal 8
  • 9.
    Market Risk 5.Commodity Price Risk: Any physical product such as agricultural products, metals, minerals, oil, gas, etc. available for trading in an organized market can be treated as ‘Commodity’ from risk management angle. Gold is treated as a foreign currency (under BASEL Committee guidelines) & hence the same is not classified under Commodity. Commodity of Trading is mainly prevalent in developed countries, with the availability of derivatives of hedge risk involved in commodity price fluctuations.However, Indian Banks hardly take up exposures in commodity trading.  Commodity market often suffers from liquidity element.  Commodity prices are very closely linked with seasonality in supply-demand position.  Equilibrium prices are set up by inventory levels.  Arising out of the aforesaid dominant aspects, following risk attributes are taken into account in the evaluation of Commodity exposures:  Risk of price movement in spot prices.  Risk of price differential movement in the Commodities – different but related.  Risk of change in cost o financing.  Time spread risk and Option Risk. Dinesh Mahabal 9
  • 10.
    Operational Risk To understand what operational risk is, it is useful to consider the standard “event types” provided by Basel and some actual losses (Impact) that have occurred in each Event Type & the cause/s thereof as follows:- Dinesh Mahabal 10
  • 11.
    Dinesh Mahabal 11 Operational Risk
  • 12.
    12 Risk Profilesbreak up Risk Profiles of an Financial 10 Organisation (%) 5 7 18 60 Credit Risk Mkt. Risk Liq. Risk Op. Risk Other Risks Dinesh Mahabal
  • 13.
    What is CreditRisk? As per RBI’s Guidance Note of Oct’02, “Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counterparties”..Thus, these losses, associated with changes in credit quality, could arise due to default (single or joint) or due to deterioration in credit quality. – Default risk - obligor fails to service debt obligations – Recovery risk – recovery post default is uncertain – Spread risk – credit quality of obligor changes leading to a fall in the value of the loan – Concentration risk – over exposure to a an individual obligor, group or industry – Correlation risk - concentration based on common risk factors between different borrowers, industries or sectors which may lead to simultaneous default. Dinesh Mahabal 13
  • 14.
    14 Identifying Elementsof Credit Risk Portfolio Risk Individual Risk Concentration Risk Intrinsic/ Corelation Risk Credit Risk Downgrade Risk Default Risk Recovery Risk Dinesh Mahabal
  • 15.
    Credit Risk inFinancial Transactions  Direct Lending: Interest / Installments not repaid/ 15 funds will not be available  Guarantees or Letters of Credit: funds will not be forthcoming from the Guarantor upon crystallization of the liability  Treasury products: series of payments due from the counterparty cease or are not forthcoming  Trading: securities settlement is not effected  Cross border exposure: free transfer of currency is restricted or ceases Dinesh Mahabal
  • 16.
    16 Historical Perspectiveof Indian Practices in Credit Risk Management  Traditional ratio analysis and post mortem of balance sheet  Collateral based lending – Often it is defensive approach leading to a false sense of “security”  Risk vs. return analysis – not fully adequate  Credit limits on exposures - regulatory limits insufficient  Nepotism  Risk vs. capacity to absorb risk in terms of capital base and capital adequacy ratio Dinesh Mahabal
  • 17.
    17 Why shouldBanks be concerned with Credit Risk?  Market Realities  Structural increase in NPAs  Concentrations in loan portfolios  Capital market growth producing a “Winner’s Curse” effect i.e. winner ending up with overpayment or getting less value for the spent.  Competitive margins despite decline in avg. quality of loans  Declining and volatile values of Collateral  Growth of Off-balance sheet derivatives and Securitization products  Changing Regulatory Environments  RBI endorsement of Risk based Capital Requirements as per BIS regulations  Risk Based Supervision Dinesh Mahabal
  • 18.
    Importance of CreditRisk Management Improves Bank Competitiveness and Performance Shareholder Value Creation / Increase ( RAROC & Economic Capital concepts) Value Creation : transaction management & active portfolio management  Value Preservation : portfolio management  Capital Optimization  Thus, Improve Risk Adjusted Returns for all stakeholders Regulatory Compliance (Basel II / III) Dinesh Mahabal 18
  • 19.
    19 Why shouldBanks be concerned with Credit Risk?  Skewed nature of loan returns  Loan returns are highly asymmetric since there is limited upside  If borrower’s credit quality improves - no benefit to lending bank since the borrower can refinance his loan at a lower rate  If borrower’s credit quality declines - bank is not compensated for taking the additional risk since loan price is not revised  If borrower defaults - accrued interest is reversed and any new payments are towards principal  If borrower becomes NPA - minimal recovery Dinesh Mahabal
  • 20.
    Why Credit RiskManagement? Recent Complexities Emergence : Seven Reasons to follow best Credit Risk Management Practices as a consequence of LPG (Liberalization, Privatization & Globalization) phenomenon 1. Globalization:- Leading to opening up of the economy to the outside world, thus becoming vulnerable to economic problems in the countries across the world. 2. Deregulation:-Business area expansion. Banks 20 introduced new products/ services Dinesh Mahabal
  • 21.
    21 Why CreditRisk Management? 3. Severe Competition: pressure on margins, competitive pricing is the need. 4. Sophistication of existing products and additions of new complex products. 5. Advances in Technology: increase in volume and speed. Dinesh Mahabal
  • 22.
    22 Why CreditRisk Management? 6. Regulatory Developments:- New Laws, Rules and Regulations, Capital Adequacy Norms, Basel –II Guidelines 7. Business Transformation:- Organizational changes, new activities, expansion in operations. Dinesh Mahabal
  • 23.
    The Task forCredit Risk Department  Segmentation of the credit portfolio (in terms of risk but not size)  Model Requirements (for risk assessments)  Data requirements  Credit risk reporting requirements for regulatory / control and decision-making purposes at various levels  Policy requirements for credit risk (credit process & practices, monitoring & portfolio management etc.)  Align Risk Strategy & Business Strategy Dinesh Mahabal 23
  • 24.
    The Task forCredit Risk Department  Take informed credit decisions;  Set provisioning and reserve requirements;  Establish minimum pricing levels at which credit exposures to an obligor may be undertaken / extended (Base Rate)  Price credit risky instruments and facilities (Credit Spread);  Measure the regulatory capital charge –Standardized and IRB Approaches;  Measure the economic capital;  Calculate risk adjusted performance measures such as RAROC (adopt it as a common language). Dinesh Mahabal 24
  • 25.
    Risk Management Process  It is imperative that banks have a robust credit risk management system which is sensitive and responsive to the factors present in banking transactions.  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 organisation.  Credit risk management encompasses identification, measurement, monitoring and control of the credit risk exposures Dinesh Mahabal 25
  • 26.
    Risk Management Process • Identify the Risks: Name and Define • Measure the Risks: Size, Timing, Probability • Monitor the Risks: Identify significant changes in risk profile or controls • Manage / Control the Risks: Avoiding, Mitigating, Off-setting, diversifying • Again Go to Step 1 Dinesh Mahabal 26
  • 27.
    27 Risk ManagementProcess Identify Monitor Measure Control RISK Dinesh Mahabal
  • 28.
    Credit Approval &Risk Management Process The whole Process can be divided in to Four Parts:  Risk Analysis (Identification)  Risk Control  Risk Management  - Front Office  - Back office  - Credit Audit  - Inspection & Audit Dinesh Mahabal 28
  • 29.
    Risk Analysis Segmentationof Borrower (Retail, Corporate- Centralized/ Unit Level Processing) Source of Cash Flow (Object Finance, Project Finance) Credit Appraisal (Pre Sanction Inspection, Validation of Data/ Documents, Carry out Rating (Industry, Business, Financial, Management), Adherence to Financial Benchmark, Collateral Valuation and Risk Assessment) Dinesh Mahabal 29
  • 30.
    Risk Analysis Credit Approval Committee (Based on Amount and Rating- Multi Tier Approval)  Sanction (Amount and Rating- Multi Tier Sanction , Pricing based on Risk Rating)  Post Sanction Review by Next Higher Authority Dinesh Mahabal 30
  • 31.
    Risk Control Single/ Group Borrower Exposure  Substantial Exposure  Exposure to Term Loan ( 3 years and above Residual Maturity)  Industry/ Sector Exposure Limit  Sensitive Sector Limit (Capital Market, Real Estate, NBFC/Leasing & Hire Purchase) Dinesh Mahabal 31
  • 32.
    Risk Control Unsecured Advance (including Unsecured Guarantees)  Exposure to Non Corporate & Private Limited Co.  Rating wise Borrower  Rating wise Exposure  Geography wise Exposure Dinesh Mahabal 32
  • 33.
    Risk Control Rating wise Probability of Default  Off balance sheet Exposure  Country Wise Exposure  Higher level prior approval for additional exposure in sensitive sectors  Each Approval Committee has to have cap on account/amount per sitting. Dinesh Mahabal 33
  • 34.
    Risk Management FrontOffice: KYC Norms, Defaulters List Approval acceptance of offer letter Documentation and its validation Post Sanction Inspection Approval for Disbursement End use of Funds Insurance Dinesh Mahabal 34
  • 35.
    Risk Management Periodical inspection (unit and collateral ), Stock and Book Debt Inspection by External Auditors  Transaction Monitoring (End use, DP limit, cash transaction, sales transaction)  Identifying potential weak accounts by early warning signals ( excess drawing, delayed payment of obligations, adverse signals in particular industry, return of cheques, inadequate transaction)  Monthly monitoring – multi tier  Annual Review (Rating and Exposure wise)  MIS maintenance Dinesh Mahabal 35
  • 36.
    Risk Management Back Office  Generating/Updating Industry reports/scores (annually, half yearly)  Preparing trigger reports  Independent rating validation  Migration of rating and PD estimation (Measurement of risk)  Portfolio reviews  Risk Control Monitoring  Quality Assurance (Policy Reviews, Appraisal Methodology)  Training and Upgradation of Skills of Employees Dinesh Mahabal 36
  • 37.
    Risk Management Credit Audit  Recommend corrective action to improve credit quality  Done within 6 months of sanction  Inspection & Audit  External  Concurrent Audit at Unit level at select branches  Concurrent Audit for specific accounts  Internal  Risk Based Internal Audit  Inspection by controlling office at non-concurrent audit units. Dinesh Mahabal 37
  • 38.
    OBJECIVES OF RISKMANAGEMENT SYSTEM The three long term objectives : 1. To make use of CREDIT RATING as the tool for Credit Risk Management (e.g. decision making,pricing, Asset Quality). 2. Arriving at a single number VALUE at RISK figure for the bank and allocation of capital to the business units to arrive at RAROC and judge the performance of business units based on RAROC. 3. Risk Management should not be treated merely a compliance function but be used as a business opDinpesho Mahrabtalunity. 38
  • 39.
    Risk Management BestPractices Integrated Best Risk Management Practices Best Practices Infrastructure Best Practices Policies Best Practices Methodologies Dinesh Mahabal 39
  • 40.
    Integrated Best RiskManagement Practices Limit Management (Monitor, Identify and Avoid) Risk Analysis (Stress Testing, Scenario Analysis, Market VaR, Credit VaR) RAROC ( Pricing, Capital Allocation) Active Portfolio Management Dinesh Mahabal 40
  • 41.
    Best Practices Infrastructure People (Skills) Operations Accurate Data Technology Dinesh Mahabal 41
  • 42.
    Identification of Risk Identification of various risk elements in the given process and define the same Dinesh Mahabal 42
  • 43.
    43 Measurement &Monitoring of Credit Risk  Every obligor and facility must be assigned a risk rating.  Mechanism to price facilities depending on risk grading.  Banks should ensure consistent standards for loan origination documentation etc.  Banks should have a consistent approach towards early problem recognition, classification of problem exposures and remedial action. Dinesh Mahabal
  • 44.
    44 Measurement &Monitoring of Credit Risk  Banks should maintain a diversified portfolio of risk assets  Banks should set Credit Risk limits like borrower limit industry limits etc.  Banks to report comprehensive set of credit risk data into independent risk system.  Systems to be put in place for monitoring financial performance of customers and for controlling outstanding within limits. Dinesh Mahabal
  • 45.
    45 Measurement &Monitoring of Credit Risk Conservative provisioning policy for NPA advances. Thus the following procedure is to be followed towards managing the risk involved in credit:-  Carefully formulated scheme of lending powers.  Setting-up Prudential Limits  Measurement of risk through credit rating Dinesh Mahabal
  • 46.
    Building Blocks ofCredit Risk Management An effective credit risk management framework comprises of the following distinct building blocks: a) Policy and Strategy b) Organisational Structure c) Operations/ Systems Dinesh Mahabal 46
  • 47.
    Building Blocks ofCredit Risk Management Policy and Strategy The Board of Directors/ Highest level committee of each bank/ organisation should be responsible for approving and periodically reviewing the credit risk strategy and significant credit risk policies Dinesh Mahabal 47
  • 48.
    Building Blocks ofCredit Risk Management  Credit Risk Policy  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.  Credit risk policies should also define target markets, risk acceptance criteria, credit approval authority, credit origination/ maintenance procedures and guidelines for portfolio management. Dinesh Mahabal 48
  • 49.
    Building Blocks ofCredit Risk Management  Credit Risk Policy  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.  Senior management of a bank shall be responsible for implementing the credit risk policy approved by the Board. Dinesh Mahabal 49
  • 50.
    Building Blocks ofCredit Risk Management  Credit Risk Strategy  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 organisation’s credit appetite and the acceptable level of risk-reward trade-off for its activities.  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 Dinesh Mahabal 50
  • 51.
    Building Blocks ofCredit Risk Management  Credit Risk Strategy  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.  Senior management of a bank shall be responsible for implementing the credit risk strategy approved by the Board Dinesh Mahabal 51
  • 52.
    Building Blocks ofCredit Risk Management  Organisational 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 basic feature of Independence and arm’s length dealings within the organisation. Dinesh Mahabal 52
  • 53.
    Building Blocks ofCredit Risk Management  Operations / Systems  Banks should have in place an appropriate credit administration, credit risk measurement and monitoring processes. The credit administration process typically involves the following phases:  Relationship management phase i.e. business development  Transaction management phase covers risk assessment, loan pricing, structuring the facilities, internal approvals, documentation, loan administration, on going monitoring and risk measurement.  Portfolio management phase entails monitoring of the portfolio at a macro level and the management of problem loans. Dinesh Mahabal 53
  • 54.
    Lessons Learned RiskAppetite says “Take risks: if you win, you will be happy; if you lose, you will be wise” Dinesh Mahabal 54
  • 55.