Credit Risk Management & Debt Servicing Management

1. Credit Risk Management & Debt
Servicing Management (CRM & DSM)
by
Dinesh G. Mahabal

2. 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
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3. 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)
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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.
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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.
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6. 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
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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
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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
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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.
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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:-
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11. Dinesh Mahabal 11
Operational Risk

12. 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
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13. 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.
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14. 14
Identifying Elements of Credit Risk
Portfolio Risk Individual Risk
Concentration
Risk
Intrinsic/
Corelation
Risk
Credit Risk
Downgrade
Risk
Default
Risk
Recovery
Risk
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15. Credit Risk in Financial Transactions
 Direct Lending: Interest / Installments not repaid/
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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
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16. 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
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17. 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
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18. 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)
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19. 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
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20. 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
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introduced new products/ services
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21. 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.
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22. 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.
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23. 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
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24. 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).
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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
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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
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27. 27
Risk Management Process
Identify
Monitor
Measure
Control RISK
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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
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29. 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)
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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
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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)
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32. Risk Control
 Unsecured Advance (including
Unsecured Guarantees)
 Exposure to Non Corporate & Private
Limited Co.
 Rating wise Borrower
 Rating wise Exposure
 Geography wise Exposure
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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.
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34. 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
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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
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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
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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.
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38. 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

39. Risk Management Best Practices
Integrated
Best Risk
Management
Practices
Best
Practices
Infrastructure
Best
Practices
Policies
Best
Practices
Methodologies
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40. 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
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41. Best Practices Infrastructure
People (Skills)
Operations
Accurate Data
Technology
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42. Identification of Risk
Identification of various risk elements
in the given process and define the
same
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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.
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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.
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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
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46. 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
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47. 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
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48. 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.
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49. 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.
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50. 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
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51. 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
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52. 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.
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53. 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.
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54. Lessons Learned
Risk Appetite says
“Take risks: if you win, you will be happy;
if you lose, you will be wise”
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55. Thank You…
dmahabal1956@gmail.com
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