An Overview of Credit Risk Management practices - A Banker’s perspective Sumant A. Palwankar Credit Risk Analyst 8 th October 2009.

What do Banks do for their Customers ??? Intermediation (Deposit & Lending function) Payment Systems (Retail, Corporates, Govt business) Other financial services . (Off-balance sheet activities, Insurance, Trust services)

Intermediation

(Deposit & Lending function)

Payment Systems

(Retail, Corporates, Govt business)

Other financial services .

(Off-balance sheet activities, Insurance, Trust services)

Bank Goals and Constraints Maximise Shareholder Wealth Amount of Cash Flow Timing of Cash Flow Risk of Cash Flow Constraints

Risk ???? Why Probability? 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 Probability?

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.

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 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 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 liquidity risk

Credit Risk

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

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

liquidity risk

Operational Risk 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 inadequate training and employee errors Fraud

Operational Risk

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

inadequate training and employee errors

Fraud

Kindly note that these are conceptually arrived numbers. Risk Grid-Institutional Players 20% 40% 40% Investment Banks 25% 60% 50% 25% Operational Risk 40% -do- 12% 30% ALM Risk 38% 10% Market Risk Depends on positions –proprietary trading Securities Broking 35% 35% Credit Risk Insurance Asset Management Banks Risk Category

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 Supervisory Review To ensure that Banks follow rigorous processes and measure their risk exposures correctly. Market Discipline 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

Supervisory Review

To ensure that Banks follow rigorous processes and measure their risk exposures correctly.

Market Discipline

Disclosure norms of capital levels and risk exposures to help market participants to better assess the bank’s ability to remain solvent..

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 :- Default risk Obligor cannot service debt obligations. Spread risk Because of changes in credit quality of the obligor.

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 :-

Default risk

Obligor cannot service debt obligations.

Spread risk

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.

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. Retail assets. Non SLR portfolio Trading book and banking book. Inter bank transactions. Derivatives. Settlement, etc. Liabilities of a Bank are very credit –sensitive as compared to that of a typical industrial firm.

Credit Corporate assets.

Retail assets.

Non SLR portfolio

Trading book and banking book.

Inter bank transactions.

Derivatives.

Settlement, etc.

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

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.

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. Limits Systems Prudential norms for single borrower/ group, rating linked exposures, industry level caps, delegation of powers

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.

Limits Systems

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 Leverage Industry Profitability Liquidity Net worth

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

Leverage Industry

Profitability

Liquidity

Net worth

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)

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

Some Credit Risk jargons Expected Losses 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

Expected Losses

Unexpected Losses 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.

Unexpected Losses

This relates to the volatility of the expected losses over a period of time

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.

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) Capture Asset quality migrations Product Pricing (Risk Return trade-offs) Capital Requirements. Administration Loan review /monitoring Trigger Actions (like planning exit strategy, reduction in exposures, credit enhancement)

Analysis & Reporting

Portfolio Reporting (Reporting of risk exposures to Senior Management)

Capture Asset quality migrations

Product Pricing (Risk Return trade-offs)

Capital Requirements.

Administration

Loan review /monitoring

Trigger Actions (like planning exit strategy, reduction in exposures, credit enhancement)

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 External factors Scored centrally once in a year Internal factors Scored for each borrowing entity by the concerned credit officer

External factors

Scored centrally once in a year

Internal factors

Scored for each borrowing entity by the concerned credit officer

Rating system Rating based pricing Default rate, recovery rate Expected loss charge, capital charge Portfolio management Scenario analysis Risk based exposure limits RAROC. Improved risk environment Time

Rating based pricing

Default rate, recovery rate

Expected loss charge, capital charge

Portfolio management

Scenario analysis

Risk based exposure limits

RAROC.

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 ). Complex transactions ( multi-tiered securisation ). Securitisation simply involves pooling of a set of credits or debt securities whose acquisition is financed by issuance of new debt securities. VaR measure as a risk metric for trading position (Assumption that assets can be sold or hedged quickly) UBS 2006 … It had never had a loss that exceeded its daily VaR UBS 2007…. It exceeded daily VaR by 29 times. UBS reported loss of $18.7 billion for year ended Dec07. Stress testing >>> regulatory camouflage.

Inherent quality of assets weak ( Subprime borrowers ).

Complex transactions ( multi-tiered securisation ).

Securitisation simply involves pooling of a set of credits or debt securities whose acquisition is financed by issuance of new debt securities.

VaR measure as a risk metric for trading position (Assumption that assets can be sold or hedged quickly)

UBS 2006 … It had never had a loss that exceeded its daily VaR

UBS 2007…. It exceeded daily VaR by 29 times.

UBS reported loss of $18.7 billion for year ended Dec07.

Stress testing >>> regulatory camouflage.

Some afterthoughts …. Effective management of funding liquidity, capital & balance sheet ( contingency plans). Informative and responsive risk measurement & management reporting and practices. Senior Mgmt role in understanding and acting on existing and emerging risks is extremely important.

Effective management of funding liquidity, capital & balance sheet ( contingency plans).

Informative and responsive risk measurement & management reporting and practices.

Senior Mgmt role in understanding and acting on existing and emerging risks is extremely important.

Case Study…. Drivers of credit risk. Risk mitigation strategies.

Drivers of credit risk.

Risk mitigation strategies.

Thanks for your attention . . .