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  1. 1. THEME Credit as well as credit risk management in banks ank optimizes utilization liberated look. involved therein, appears to be aB of deposits by deploying Banks have grown funds for developmental from being aactivities and productive pur- financial interme- difficult proposition. There is an implicit understanding on the part of the planners that in the postposes through credit creation diary, in the past, nationalization era, banks will meetprocess. Deposit mobilization & to a risk interme- what is called social obligationsCredit deployment constitute the diary, at present. RS Raghavan through directed lending. Earlycore of banking activities and In credit, risks are co-related and stage of nationalization belongedsubstantial portion of expendi- exposure to one risk may lead to to security oriented approach; inture and income are associated another having deeper ramification the nineties it was the spread-ori-with them. In the case of deposits, and hence, the real mantra for pru- ented era and in the early 21st cen-baring few stray instances of oper- dent banking lies in successfully tury the focus is shifted to risk.ational risks linked to the system managing the risks in an integrated When the security orientedand human failure culminat-ing in fraud, forgeries & Even though Tandon Committee norms have been dumped to dust-loss, there may not be any- bins, alternative methods being practiced by the banks are yet tothing very alarming. But pass the test of time. While some banks adopt the method of justi-credit portfolio is the real fying the sanction of loan, others follow a combination of Turnoverdynamic activity thatrequires close monitoring Method, Cash Flow Method, Cash Budget Method, Projectedand continuous manage- Balance Sheet method, etc.ment. This article attemptsto focus on not only credit manage- and pro-active manner to optimize approach was followed, economicment but also credit risk manage- the exposure already taken or to be activities and banking productsment. assumed by the bank. Adherence to were simple and “instances of Till recently, all the activities standards of quick decision and frauds and forgeries were few andof banks were regulated and hence providing adequate and need based far in between.operational issues were not con- financial assistance on attractive It is very much essential to con-ducive to risk taking. The financial but safe terms, without losing the duct credit investigation beforesector, now, wears a relaxed and sight of the associated risks taking up a proposal for considera- tion. This preliminary study shouldThe author is the Senior Manager (Risk Management) at Vijaya Bank lead to valuable information onTHE CHARTERED ACCOUNTANT 996 FEBRUARY 2005
  2. 2. THEMEborrower’s integrity, honesty, reli- of the borrower is well establishedability, credit worthiness, manage- and the return to the bank by way ofment competency, expertise, asso- interest is examined. But the ques-ciate concern, guarantor, etc. A due tion is how to rely on the projecteddiligence report shall invariably cash flows. This can be overcomeaccompany the credit proposal by building up industry wise dataevaluation. Banks have to strictly and the financials of the borrower.adhere to the KYC (Know Your Information such as credit expo-Customer) norms to ensure sure in terms of sector, industry,bonafide identification of borrows security and region wise to all theand should also follow the pre- Second Method of lending. Proper credit appraisers in the institutionscribed Fair Practice Code on logistics should be built into the should be uniformly made avail-Lenders Liability, by evolving method of assessment -be it fund able with reasonable up-date so astheir own best practices to be fol- based or non-fund based require- to enable them to price, dispense,lowed by the field functionaries, so ment. What may be lacking is manage and monitor.as to avoid complaints from cus- assessment of credit with risk per- It is observed that extent oftomer at a later date. ception. credit dispensation power is not Banks have to structure the related to the credit skill acquiredLending methods assessed limits in the form of vari- by the authority , but linked to the Even though Tandon ous credit facilities, having regard position in the hierarchical ladderCommittee norms have been to the nature of activity, and, delegation has been based ondumped to dustbins, alternative process/business cycle, trade the credit size and not the creditmethods being practiced by the terms, availability of security, risk perceived in a proposal. Forbanks are yet to pass the test of operational convenience, etc. Loan this, discretionary powers shouldtime. While some banks adopt the System of Credit Delivery is one be linked to the risk rating of themethod of justifying the sanction such system, developed a few borrower. Banks are yet to fullyof loan, others follow a combina- years ago. This discipline in cash move from credit rating to the risktion of Turnover method, Cash flow management, on mutual rating of a borrower. When a bor-Flow Method, Cash Budget understanding between the bank rower secures 95% marks andMethod, Projected Balance Sheet and the borrower, should be rated AAA, what is implied ismethod, Net Owned Fund Method observed in respect of credit expo- credit rating is 95 (AAA) & the risk& the popular one-size fits all sures beyond a cut-off level of say rating is 5. The mindset should Rs 10 cr or so. In view of the change from credit rating to risk growing competition in the rating and proper system should be At present, due to lack of banking, take over of bor- put in place in this regard. credit appraisal skill at the rowal account is considered to Proposals of non fund based limits field level, manned by many be one of the major routes to should also be subjected to the generalist officials spread accelerate credit expansion. It same level of appraisal standards is just a shift of the lender, as adopted for appraising fund across the branch network, though there is no additional based limit so that the asset quality there is greater duplication of credit or asset creation activ- of the bank do not suffer any undue work at the sanctioning level ity. However, bankers should set back. Multiple analytical ratios at HO causing enormous and exercise due diligence and are to be worked out in the credit avoidable delay as papers caution while entertaining a appraisal duly discussing about the pass through more than a proposal for take over of an implications of these ratios. account from another lender. Detailed discussion on cash gener- dozen senior officials before When cash flow method is ation should compulsorily form they are placed before sanc- followed, repayment capacity part of credit appraisal. tioning authority. Based on the risk rating, theTHE CHARTERED ACCOUNTANT 997 FEBRUARY 2005
  3. 3. THEMEtype of security to be obtained and is an important function of credit some banks, in line with the expresscash margin to be insisted can be management and some of these RBI guidelines on credit risk man-decided. Care should be taken that aspects are discussed in brief: agement, follow the committeenon-fund based limit in exclusion Credit decisions do not get better, approach for credit sanction, inof fund based limit is not consid- all because more people review the reality the committee hardly meetsered by a bank and proportionate proposal. It can be improved only to share the broader range of skills,fund and non-fund based limits are when those who review it are expertise & knowledge. Gettingonly considered. Banks should put knowledgeable and carry with passed the proposal through circu-in place their own Security them requisite experience in credit lation is more often the rule than anStandards, Guarantee Standards, portfolio. Credit Department exception & one person’s decisionDocumentation standards & should be expertise-oriented rather gets the sanctity of committee. TheRenewal/review standards to suit than going by the scale and grade in committee approach is helping thetheir appetite and quality standards. the organization, as there are many bank in diffusing individual In big-ticket credit, analytical who climbed the organization lad- responsibility from the angle oftools will have to be used in various CVC.aspects of credit dispensation such A separate model for Non- At present, due to lack of creditas appraisal, delivery, monitoring, SLR securities should be appraisal skill at the field level,reporting, re-scheduling, restruc- manned by many generalist offi- evolved, covering the fea-turing, etc. As lenders feel that cials spread across the branch net-most of exposure ceiling / setting tures of instrument, com- work, there is greater duplication ofup limits, etc are regulator driven, it pany’s financials, etc. so work at the sanctioning level at HOis better to be pro- active in these as to capture the credit causing enormous and avoidableareas. Banks themselves should risk in securities. delay as the papers pass throughcompile separate list of sectors to Depending on the require- more than a dozen senior officials,guide the field functionaries in the ment, banks may think of before it is placed before the sanc-matter of credit deployment and tioning authority. Business Processsome of these are given below: evolving separate model Re-engineering and Core Banking❧ Indicative sectors where addi- for agricultural sector, Project may come to the rescue of tional / fresh exposures can be export/import business banks. considered without any prior etc. Exposure to sensitive sectors reference to higher authorities. such as Real Estate, Capital Market❧ List of activities where selec- der without being exposed to the & Commodities sector need to be tive approach is to be adopted requisite credit management. This kept under constant watch and ade- and fresh / additional exposures anomaly should be properly under- quately disclosed in the balance can be considered only with the stood by one and all. Typically, in sheet of banks; Monitoring of unse- prior approval of appropriate PSU banks, branch head has a cured exposures, both fund based authorities. three-year tenure in a particular and non-fund based, through inter-❧ Sectors / business segments branch. They are geared for asset nal ceilings prescribed by the Bank; where addi- based lending, disregard of lending Rating wise exposure ceilings i.e. tional/ fresh based on the forecast of cash flows. achieving not more than 30 % of exposure is Even in Asset Based Lending, gross exposures in anyone grade; prohibited for appraiser is bogged down in the Stipulation of exposure levels the time paper financial ratios rather than under some of the following head- being. cash flows which are vital in certain ings. type of industries like, hospitality, a) Sub-PLR lending. Credit construction, transport, hotel, etc b) Fixed Interest rate Monitoring where there are significant fluctua- c) Geographical region wise ceil- Credit tions in the cash flows. It requires ing. Monitoring totally different mindset. Though d) Maturity wise exposuresTHE CHARTERED ACCOUNTANT 998 FEBRUARY 2005
  4. 4. THEMEe) Precious Metals like gold, dia- amount of unity of direction in accomplish- mond credit to be ment of the corporate goals.f) Retail Lending. extended as Off-balance sheet exposuresg) Small & Medium Enterprise well as the such as foreign exchange forwardh) Large Borrowers beyond cut- loss expo- contracts, swaps, options etc are off level. sure it classified into three broad cate- accepts gories such as Full Risk, MediumCredit Risk from any Risk and Low Risk and then trans- As observed by RBI, Credit particular counter party. lated into risk weighted assetsRisk is the major component of risk Credit risk consists of primarily through a conversion factor andmanagement system and this should two components, viz. Quantity of summed up.receive special attention of the Top risk, which is nothing but the out- Thus the management of creditManagement of a bank. Credit risk standing loan balance as on the date risk includes: (a) measurementis the important dimension of vari- of default and the Quality of risk, through credit rating/scoring, (b)ous risks inherent in a credit pro- which is the severity of loss defined quantification through estimate ofposal, as it involves default of the by Probability of Default as reduced expected loan losses, (c) Pricing onprincipal itself. Credit risk may by the recoveries that could be made a scientific basis and (d)arise due to internal -meaning faulty in the event of default. Controlling through effective Loanappraisal, inadequate monitoring, Thus credit risk, is a combined Review Mechanism and Portfoliounwillingness on the part of bor- outcome of Default Risk and Management.rower to honour commitments Exposure Risk. The elements ofdespite being capable or external Credit Risk is Portfolio risk com- Tolls of credit risk managementfactors such as government poli- prising Concentration Risk as well The instruments and tools,cies, industry related changes. as Intrinsic Risk and Transaction through which credit risk manage- Credit Risk is the potential that a Risk comprising migration/down ment is carried out, are detailed below:bank borrower/counter party fails to gradation risk as well as Defaultmeet the obligations on agreed Risk. At the transaction level, credit a. Exposure Ceilings:terms. There is always a scope for ratings are useful measures of eval- Prudential Limit is linked tothe borrower to default from com- uating credit risk that is prevalent Capital Funds -say 20% for individ-mitments for one or the other reason across the entire organization ual borrower entity, 45% for aresulting in crystalisation of credit where treasury and credit functions group with additional 5%/10% forrisk to the bank. These losses could are handled. Portfolio analysis help infrastructure projects, subject totake the form of outright default or in identifying concentration of approval of the Board of Directors,alternatively, losses from changes in credit risk, default/migration statis- Threshold limit is fixed at a levelportfolio value arising from actual or tics, recovery data, etc. lower than Prudential Exposure;perceived deterioration in credit In general, Default is not an Substantial Exposure, which is thequality that is short of default. Credit abrupt process to happen suddenly sum total of the exposures beyondrisk is inherent to the business of and past experience indicates that, threshold limit should not exceedlending funds to the operations more often than not, borrower’s 600% to 800 % of the Capital Fundslinked closely to market risk vari- credit worthiness and asset quality of the bank (i.e. 6 to 8 times).ables. The objective of credit risk declines gradually, which is other-management is to minimize the risk wise known as migration. Default b. Review/Renewal:and maximize bank’s risk adjusted is an extreme event of credit migra- Multi-tier Credit Approvingreturn by assuming and maintaining tion. Managing default risk through Authority, constitution wise dele-credit exposure within the accept- efficient risk management system gation of powers, sancti6ningable parameters. Measurement of helps bank in building healthy authority’s higher delegation ofcredit risk is crucial if the banks have credit portfolio besides maximiz- powers for better-rated customers;to appropriately price their loan ing returns. Risk Management discriminatory time schedule forproducts, set suitable limits on System would help in providing review / renewal, Hurdle rates andTHE CHARTERED ACCOUNTANT 999 FEBRUARY 2005
  5. 5. THEMEBench marks for fresh exposures ness group. Rapid portfolio reviews Risk Rating Modelsand periodicity for renewal based are to be carried on with proper &on risk rating, etc regular on-going system for identi- The need for the adoption of the fication of credit weaknesses well credit risk-rating model is onc. Risk Rating Model: in advance. Steps are to be initiated account of the following aspects. Set up comprehensive risk to preserve the desired portfolio ● Disciplined way of looking atscoring system on a six to nine point quality and portfolio reviews Credit Risk.scale. Clearly define rating thresh- should be integrated with credit ● Reasonable estimation of theolds and review the ratings periodi- decision-making process. overall health status of ancally preferably at half yearly inter- account captured undervals, to be graduated to quarterly so f. Credit Audit/Loan Review Portfolio approach as contrastedas to capture risk without delay. Mechanism to stand-alone or asset basedRating migration is to be mapped to This should be done indepen- credit management.estimate the expected loss. dent of credit operations, covering ● Impact of a new loan asset on the review of sanction process, compli- portfolio can be assessed. Takingd. Risk based scientific pricing: ance status, review of risk rating, la fresh exposure to the sector in Link loan pricing to expected pick up of warning signals and rec- which there already exists siz-loss. High-risk category borrowers ommendation for corrective action able exposure may simplyare to be priced high. Build historical with the objective of improving increase the portfolio riskdata on default losses. Allocate cap- credit quality. It should target all although specific unit level riskital to absorb the unexpected loss. loans above certain cut-off limit is negligible/minimal.Adopt the RAROC framework. ensuring that at least 30% to 40% of ● The Co-relation or co-variance the portfolio is subjected to LRM in between different sectors ofe. Portfolio Management a year so as to ensure that all major portfolio measures the inter rela- The need for credit portfolio credit risks embedded in the bal- tionship between assets.management emanates from the ance sheet have been tracked and to ● Concentration risks are mea-necessity to optimize the benefits bring about qualitative improve- sured in terms of additional port-associated with diversification and ment in credit administration as folio risk arising on account ofto reduce the potential adverse well as Identify loans with credit increased exposure to a borrowerimpact of concentration’ of expo- weakness. Determine adequacy of / group or co-related borrowers.sures to a particular borrower, sec- loan loss provisions. Ensure adher- ● Need for Relationship Manager totor or industry. Portfolio manage- ence to lending policies and proce- capture, monitor and control thement shall cover bank-wide expo- dures. The focus of the credit audit over all exposure to high valuesures on account of lending, invest- needs to be broadened from customers on real time basis toment, other financial services activ- account level to overall portfolio focus attention on vital few so thatities spread over a wide spectrum of level. Regular, proper & prompt trivial many do not take much ofregion, industry, size of operation, reporting to Top Management valuable time and efforts.technology adoption, etc. There should be ensured. Credit Audit is ● Instead of passive approach ofshould be a quantitative ceiling on conducted on site, i.e. at the branch originating the loan and holdingaggregate exposure on specific rat- that has appraised the advance and it till maturity, active approaching categories, distribution of bor- where the main operative limits are of credit portfolio managementrowers in various industries & busi- made available. is adopted through securitisa-Under the New Basel II Accord, assessment of Credit Risk can be carried out in any of the threeapproaches viz. Standardised Approach, Foundation Internal Rating Based Approach andAdvanced Internal Rating Based Approach. At present, banks in India in general and PSU banksin particular, are ready to migrate to Basel II only at a conceptual and academic level.THE CHARTERED ACCOUNTANT 1000 FEBRUARY 2005
  6. 6. THEME tion/credit derivatives. nism for the off-balance sheet risk to Off-credit rating, may have to● Pricing of credit risk on a scien- exposure, maximum tenor of expo- be adopted. Currency risk is the pos- tific basis linking the loan price sure, etc in inter-bank transactions. sibility that exchange rate changes to the risk involved therein, The rating model shall take into will alter the expected amount of though the factor of business account both financial (capital ade- principal and return of lending or compulsion and competition is quacy, asset quality, profitability, investment. At times, banks may try always there. liquidity) and non-financial (coun- to cope with this specific risk on the● Rating can be used for the antic- try, ownership, management, mar- lending side by shifting the risk ipatory provisioning, certain ket perception) parameters. associated with exchange rate fluc- level of reasonable over-provi- Depending on the past exposure tuations to the borrowers. sioning as best practice. and dealings, in respect of various Given the past experience and rating categories of the counter Basel II requirementsassumptions about the future, the party banks, the maximum expo- Basel II, released by Baselcredit risk model seeks to deter- sure ceiling may be suitably fixed in Committee on Banking Super-mine the present value of a given relation to the Capital Funds posi- vision in June 2004, has proposedloan or fixed income security. It tion of the bank so as to assume and the adoption of a better risk sensi-also seeks to determine the quan- absorb the credit risk. tive and balanced portfolio frame-tifiable risk that the promised cash When a bank undertakes cross work for the calculation of capitalflows will not be forthcoming. border lending and investment to risk weight on credit exposure. ItThus, credit risk models are activities and finance is extended to is intended to bring the regulatoryintended to aid banks in quantify- its constituents under foreign trade capital requirement more in lineing, aggregating and managing risk transactions, it encounters country with the economic capital alloca-across geographical and product risk, comprising of Settlement risk, tion approach.lines. Credit models are used to flag Transfer risk, APPOINTMENTSpotential problems in the portfolio Sovereign Risk,to facilitate early corrective action. Non-Sovereign Risks, Cross Bor- der Risk, CurrencyCountry risk & inter-bank Risk, etc. Country ADexposure risk management During the course of their busi- involves aggrega-ness operations, banks invariably tion of countryassume inter-bank exposures of exposures andvarying degree arising from cus- monitoring thereoftomers trade transactions, place- against pre-ment of money as bank’s liquidity defined limits onmanagement, hedging, trading in the basis of ratingsecurities, transactional banking framework. Tillservices such as clearing, custodial such time banks& depository services, etc. As these evolve their owntransactions involve credit risk internal ratingproper evaluation of credit risk is mechanism, theessential wherever an exposure on country risk classi-other banks is assumed in any form. fication adopted In this regard, the bank shall put by ECGC Ltd -thein place proper credit rating models seven categoriesto evaluate the credit risk and rate classification ofthe counter party so as to fix suit- countries rangingable exposure limits and mecha- from Insignificant
  7. 7. THEME The expected loss / unexpected Advanced Internal Rating Based mation mechanism, high transac-loss methodology forces banks to Approach. At present, banks in tion cost, weak enforcement of col-adopt new Internal Ratings Based India in general and PSU banks in lateral, bankruptcy framework,approach to credit risk management particular, are ready to migrate to high NPA, directed credit issues,as proposed in the Capital Accord Basel II only at a conceptual and staff accountability concept, etc.II. Under the IRB approach (both academic level and they have to Laid back banking approach andFoundation and Advanced) banks travel a long distance when it comes related structural problems in thewill be allowed to use their own to organizational and technological banks needs to be addressed. Theinternal estimates to determine the readiness to go ahead with it to explosive growth in the markets forborrower’s credit worthiness to adopt the international practice. securitised assets and for creditassess the credit risk. In Standardised Approach, derivatives has offered bank new In to-days parlance, default bank allocates risk weight to each ways and means in managing asarises when a scheduled payment of the assets and off-balance sheet well as transferring credit risk.obligation is not met within 90 days items and produces a sum of Risk In many banks in India, partic-from the due date. Exposure risk is Weighted Asset Values (RW of ularly in the PSU sector, it isthe loss of amount outstanding at 100% may entail capital charge of 8 believed that loans are akin tothe time of default as reduced by the % and RW of 20% may entail capi- Indian marriages, where divorce isrecoverable amount. The loss in tal charge of 1.6%). The risk not feasible even when it is clearcase of default is D * X* (l-R) weights are to be refined by refer- that the relationship is incompati-where D is Default percentage, X is ence to a rating provided by an ble. Despite detailed technicalthe Exposure Value and R is the approved External Credit analysis that supports a credit deci-recovery rate. The extent of provi- Assessment Institution that meets sion, it is the credit officer whosioning required could be estimated certain strict standards. Under the decides on a proposal based on hisfrom the Expected Loss Given Foundation Internal Rating Based own judgment. However, when itDefault (which is the product of Approach, Bank rates the borrower comes to rating of a borrower, theProbability of Default, Loss Given and results are translated into esti- system and model in place shouldDefault & Exposure at Default). mates of a potential future loss be such that who ever in the bankThat is ELGD is equal to PD X amount that forms the basis of min- rates the borrower, the resultLGD X EaD. After knowing the imum capital requirement. Under should be same in at least 90% ofPD, it is necessary to calculate the Advanced Internal Rating Based the cases. Banks need both theproportion of loan loss on default. approach, the range of risk weights information and system to rate theA historical data of 5 to 10 years will be well diverse. level of risk in a credit proposal. Inmay be considered enough for esti- order to achieve this, credit offi-mating the proportion of loan loss Conclusion cers should work as a team andon default and the average may be Growth in the economy during share learning with an institutionaltabulated in respect of all the rating the last decade or so has been facil- commitment to develop capabili-grades, as under: itated the Non-Banking Financial ties through ongoing and well- Rating of a/c AAA AA A BBB BB B C D designed credit training. Bank should lend according to its PD appetite within the need-based LGD assessment of the credit require- ment of the borrower. Under the New Basel II Sectors and hence there is an urgent The ideal credit risk manage-Accord, assessment of Credit Risk need to focus on the need to inte- ment system should throw a singlecan be carried out in any of the three grate the financial market by lever- number as to how much a bankapproaches viz. Standardised aging on the strengths of NBFS. stands to lose on credit portfolioApproach, Foundation Internal Banks are risk averse to lending, and therefore how much capitalRating Based Approach and owing to lack of proper credit infor- they ought to hold. ■THE CHARTERED ACCOUNTANT 1002 FEBRUARY 2005