Bank Goals and Constraints Maximise Shareholder Wealth Amount of Cash Flow Timing of Cash Flow Risk of Cash Flow Constraints
Can we accurately predict the future?
The future is uncertain.
We can only predict with varying degrees of certainty the ability of various parties to honour their commitments.
Even with borrowers which have the highest credit quality (eg. AAA rated corporates) there will always be some uncertainty, especially in a long term relationship.
This uncertainty associated with timing & amount of cash flows is the risk.
The key strategy is to Identify, Measure, Monitor and Control the Risk.
Why Manage Risks ??
Increasing competition and technical progress have fundamentally changed the role of banks
Banks are exposed to strong competitive pressures in selling their products and procuring capital, exposing them to risks which can significantly impact profitability.
A bank’s ability to measure, monitor and mitigate risks comprehensively is important for its strategic positioning. It becomes a tool for offensive instead of defensive strategy.
Risk Management is an important tool towards optimum use of capital for generating profits and hence a critical determinant of bank’s profitability.
Key Banking Risks
Credit risk is the risk or potential of loss that may occur due to failure of borrower/ counterparty to meet the obligation on agreed terms and conditions of financial contract.
Market Risk is a possibility of loss to a bank caused by changes in the market variables which are external to the portfolio such as, macro economic factors like inflation, GDP growth, interest rates etc.
It is the risk of loss to future earnings, to fair values or to future cash flows that may result from changes in the price of financial instrument.
Market risk arises on account of
changes in interest rates
changes in foreign currency exchange rates
changes in commodity prices
changes in equity prices
Risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
Operational risks arise from variety of factors including
failure to obtain proper internal authorizations
improperly documented transactions
failure of operational and information security procedures
failure of computer systems, software or equipment
THE BASEL-II CAPITAL ACCORD Minimum Capital Requirements Supervisory Review Market Discipline Three Basic Pillars
Minimum Capital Requirement Provides for capital calculations for Credit, Market and Operational Risk
To ensure that Banks follow rigorous processes and measure their risk exposures correctly.
Disclosure norms of capital levels and risk exposures to help market participants to better assess the bank’s ability to remain solvent..
Standardized Approach Internal Rating based Approach
Credit Risk “ There is one big difference between selling a credit product and selling soap. The sale of money is not final, you expect it back with interest.”
Credit Risk basics …
Credit risk is the risk of loss that may occur from failure of the counter-party to make payments.
Reduction in the ability of counter-party to make payments.
Credit risk could be on account of :-
Obligor cannot service debt obligations.
Because of changes in credit quality of the obligor.
Anyone who is uncomfortable in drilling
holes in the middle of the North Sea probably
does not belong to the oil exploration business.
Likewise, anyone who is unprepared to take
credit risk should not be a banker.
Contributors to Credit Risk
Credit Corporate assets.
Non SLR portfolio
Trading book and banking book.
Inter bank transactions.
Liabilities of a Bank are very credit –sensitive as compared to that of a typical industrial firm.
Basel Committee on Banking Supervision has issued broad guidelines for best practices in credit risk management.
Establishing an appropriate credit risk environment.
Operating under a sound credit granting process.
Maintaining an appropriate credit administration, risk measurement and monitoring process.
Ensuring adequate controls over credit risk.
Role of bank supervisors in ensuring that banks have a effective system in place to identify, measure, monitor and control credit risk.
Broad Principles of Credit Risk Management in Banks
Important factors for Credit approval.
Traditional approaches to Credit Risk Measurement
Expert Systems (Your Credit analyst is best judge) .
Five Cs of Lending :-
Character, Capital, Capacity, Collateral and Cycle (economic conditions).
Credit Rating Systems (Internal / External)
Capture all relevant information about the borrower and assign a grade through a risk rating process.eg. CRISIL, ICRA rated Bonds / Debentures AAA, AA, A etc.
Prudential norms for single borrower/ group, rating linked exposures, industry level caps, delegation of powers
Some Quantitative techniques for Credit Risk Measurement
Credit scoring models (Altman Z Score model)
Altman (1968) built a linear discriminant model based only on financial ratios, matched sample (by year, industry, size)
Z = 1.2 X 1 + 1.4 X 2 + 3.3 X 3 +0.6 X 4 + 1.0 X 5
X 1 = working capital / total assets
X 2 = retained earnings / total assets
X 3 = earning before interest and taxes / total assets
X 4 = market value of equity / book value of total liabilities
X 5 = sales / total assets
Most credit scoring models use a combination of financial and non-financial factors
Financial Factors Non-financial Factors
Debt service coverage Size
Quantitative techniques for Credit Risk Measurement … contd
Academic belief is that default is driven by
market value of firm’s assets
level of firm’s obligations (or liabilities)
variability in future market value of assets
As the market value of firm’s assets approaches book value of liabilities, the default risk of firm increases
Default Point: The threshold value of firm’s assets (somewhere between total liabilities & current liabilities) at which the firm defaults
Relevant Networth = Mkt. Value of Assets - Default Pt.
Default: Relevant Networth = 0
Corporate Credit Risk models based on Stock Prices (KMV Model)
Some Credit Risk jargons
EXPECTED LOSS INR = Probability of Default (PD) % x Loss Severity Given Default (Severity) % Loan Equivalent Exposure (Exposure) INR x What is the probability of the counterparty defaulting? If default occurs, how much of this do we expect to lose? If default occurs, how much exposure do we expect to have? Borrower Risk Facility Risk Related
This relates to the volatility of the expected losses over a period of time
Amt of loss (Rs) Frequency of default Expected loss Unexpected loss Confidence interval (95%, 99.9%) Bank is required to keep Capital to absorb such losses.
Credit Rating Process
Basic building block for any Credit Risk Mgmt model.
Definition of rating
Represents default probability.
Role in sanction process
Risk appetite, minimum rating criterion.
Capital allocation, pricing.
Role in monitoring
Snap shot indicator of health of the asset.
Should be linked to asset review process.
Early warning system.
Credit Ratings helps in…..
Analysis & Reporting
Portfolio Reporting (Reporting of risk exposures to Senior Management)
Internal Credit Risk Rating process Credit Risk Industry Risk Business Risk Management Risk Financial Risk Industry Characteristics Industry Financials Market Position Operating Efficiency Track Record Credibility Payment Record Others Existing Fin. Position Future Financial Position Financial Flexibility Accounting Quality
Scored centrally once in a year
Scored for each borrowing entity by the concerned credit officer
Rating based pricing
Default rate, recovery rate
Expected loss charge, capital charge
Risk based exposure limits
Improved risk environment Time
But after all this, Institutions with best risk management systems failed…………….!!! What went wrong and learnings from these ???
Inherent quality of assets weak ( Subprime borrowers ).