RMPG Learning Series CRM Workshop Day 1 Session 1

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RMPG Learning Series CRM Workshop Handouts: File 1 of 9

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RMPG Learning Series CRM Workshop Day 1 Session 1

  1. 1. Agenda for Day 1 Introduction of Participants Introduction to Credit Risk Overview of Basel Guidelines Lunch Break Framework for Credit Risk Management Open Session/ Q&A IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 1
  2. 2. What is you Bank’s most important risk? Type of Business Biggest Risk Commercial Banking Credit Risk Investment Banking & Market Risk Trading Asset Management Operational Risk IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 2
  3. 3. Art of Credit - Managing Loan Losses“Credit Losses have, historically, been the single largest cause of bankfailures” - Economist“Bankers are in the business of taking and managing risk… that is thebusiness of banking.” - Walter Wriston, ex-Chairman, Citicorp“Volatility forms the link between risk and reward – the trick is for banks toreduce that observation to workable propositions.” - George Vojta, ViceChairman, Bankers Trust IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 3
  4. 4. What is at stake for banks who cannot balance therisk/reward relationship? Their own survival! - Illustrative Example % Net Interest Revenues 3.00 Plus: Other Income (Fee/FX) 1.00 Net Customer Revenues 4.00 Less: Direct + Allocated Costs -2.50 Net Margin Before Credit Costs 1.50 Less: Expected Credit Costs -1.25* Net Income 0.25 Required Return on Risk Adjusted Assets 1.60** Premium Shareholder Income/Loss -1.35 (* Based on assumed portfolio quality) (** Assumes 8% Risk Adjusted Capital allocation and required ROA (Return on Risk Adjusted assets) of 20%) IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 4
  5. 5. The Message A business must generate Premium Shareholder Income of at least 1.60% (i.e. a 20% ROA on 8% capital) in order not to erode Economic Value of Capital IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 5
  6. 6. How? To produce Premium Shareholder Income & long term shareholder value, banks must ensure Superior CREDIT RISK MANAGEMENT IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 6
  7. 7. How does your bank currently manage its Credit Risks? Is your focus on managing: > individual credit exposures? or > a portfolio of credit exposures? IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 7
  8. 8. There are 3 opposing forces that challenge credit riskmanagement ….. Greater Higher Risks Returns Credit risk management Regulators More Capital IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 8
  9. 9. Why is Credit Risk Management important for Banks? RoE for banks worldwide has been below 10% and declining after 1960 if one excludes non-interest income Suggests that loans have been “loss leaders” - inducing customers to buy into other products offered by banks 9 out of 10 banking failures attributable to poor credit risk management New forms of financial transactions emerging Asset backed securities Derivatives IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 9
  10. 10. Several factors are changing the face of the Banking industry across the globeHighly intense Liberalisation level Time 1990 2005 2010 Low Medium High Competition for Banks Capital Adequacy pressure Pressure on customers in the future 1990 2005 2010 Profits None Medium High Banks todayRelatively Competition for businessmanageable 1990 2005 2010 Low Medium High Medium Intense Pressures due to Capital adequacy norms IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 10
  11. 11. The Changing Marketplace for Credit New kinds of lenders / investors coming into the financial intermediation business Different approach to credit risk management Different investment horizons Different risk aptitudes and risk tolerances “Relationship based lending” changing from “art” to “science” IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 11
  12. 12. The different compartments of Financial Intermediationhave coalesced... Yesterday Liberalised Market “Must” capabilities for banks Banking Banking Implications Focus on well-defined target customer groups Term Term Lending Ability to offer a variety of Lending financial products (including new products) Insurance Insurance Sophisticated risk management Ability to use Technology as a competitive weapon NBFCs NBFCs IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 12
  13. 13. How are different banks preparing themselves to faceincreasing competition? • Move towards consolidation/ alliances • Banks are increasingly focusing on niche segments for growth • Technology is playing a key role in deciding the competitive position of banks • Introduction of new products & delivery mechanism to meet the customer requirements • Risk management has become “mantra” to the banking sector IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 13
  14. 14. The competition in the banking sector is getting intense Number of entities Large corporates Fiercely competitive SMEs Under served Intensifying competition Retail in select segments In USA, SMEs became of interest to banks after a recent focus on segmentation showed their profit contribution IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 14
  15. 15. Different credit segments generate different marketreturns - a key driver for portfolio managementU.S. Market Size and Profitability 800 Insurance Consumer 200 Finance Small Revenues Business ($BN) 100 Mortgages Credit 50 Cards Mutual Funds 5 10 15 20 25 30 35 40 ROE (%) Source: IFC Symposium, China IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 15
  16. 16. A bank should have a three-fold objective to implementCredit Risk Management systems Manage the credit risk inherent in individual credits or1 transactions as well as the risk in the entire portfolio Maximise the risk-adjusted return on capital by maintaining2 credit risk exposure within acceptable parameters3 Manage the relationship between credit risk and other risks IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 16
  17. 17. Conventional credit management practice - (Originateand Hold) Largely restricted to developing /procuring obligor assessment models and laying down loan policy Hold Till Maturity Monitoring Risk Management AA SS /Client Borrower Obligor Loan Origination / SS Management Credit Group EE /Servicing TT Recovery Obligor evaluation, /Recovery pricing, management & monitoring Involved post default IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 17
  18. 18. How Risk Builds in the Portfolio Ineffective monitoring due to incorrect risk perception (Tools/process Inadequate issue obligor risk assessment Monitoring Risk Management tools A S /Client Borrower Obligor Loan Origination / S Management Credit Group E /Servicing T Recovery /Recovery Imperfect Loan Structuring Correlation between assets. Asset displaying cyclical characteristics not tracked adequately IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 18
  19. 19. How Risk Builds in the Portfolio Fallen Angels Assets whose marginal risk contribution was low when the exposure was taken and risk on which has increased with passage of time but not tracked adequatelyRisk Exposure IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 19
  20. 20. So, what is driving banks to look at credit risk management? Maintain growth and improveIMPERATIVE profitability to sustain capital Need to grow adequacy Any growth strategy has Profits inherent risks •+ Need for striking a balance between growth, risks, and profits Understand the source of profits and risks Growth Risks Need the following : Understand risk Understand profits IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 20
  21. 21. Traditional Credit Analysis Credit analysis - the process of making inquiries prior to committing funds Based on two distinct issues: Willingness of borrower to repay Ability of borrower to repay To this day, banks are far ahead of other players in the core expertise of analysing credit risk Classic credit analysis remains the preserve of banks IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 21
  22. 22. Key Highlights of a Classic Credit Analysis Process Based on both subjective and objective elements Highly dependent on the quality of persons involved Usually a high variance in the quality of documentation of observations and analysis across time and persons It is rather expensive to maintain high standards (read consistency, objectivity, and accuracy of risk analysis) The final judgement is often determined by one or a few dominating parameters and / or officers IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 22
  23. 23. Drawbacks of Classic Credit Analysis Too expensive to maintain - training and retention costs of several experts getting out of hand The general approach was to hold loans to maturity - therefore, reasonable chance of loans going bad Increasing competition for lending has forced banks to duplicate skills and systems As banks become large, management of complex and subjective processes is extremely difficult Limitations of handling concentration risk IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 23
  24. 24. What is the Quantitative Approach to Credit Analysis? Use of a quantitative model for measuring credit risk of a particular account Use of a numerical scoring system to indicate degree of risk Components of overall risk may be broken down and separately captured Usually works best with objective data Advanced techniques used for capturing subjective data Amenable to further mathematical analysis for use in Trend analysis Default prediction Risk pricing Securitisation Leading banks moving towards increased use of quantitative models IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 24
  25. 25. Positives and Negatives of Quantitative Models Advantages Disadvantages High consistency - everyone speaks the Results are only as good as the same language of risk underlying algorithms High objectivity - result not influenced by individual persons Calibration and validation of model is essential to make it work - this Can capture trends indicating needs in-depth expertise deterioration or improvement in risk profile over time Users tend to substitute their judgements with such models - this is Gives insights into components of risk not the intended use of the models Can compare risks across different accounts more easily and objectively Can be used for pricing and portfolio management IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 25
  26. 26. Credit – Emerging Value Chain (Originate/Buy andManage) Risk Management Credit Secondary Market DerivativesIssuers/ PortfolioBorrowers Investment Product Loan Origination / Structuring / Client Management Securitisation Servicing IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 26
  27. 27. Migration Path for Credit Management Most banks are at the early stages of credit risk management Stage 1 Stage 2 Stage 3 Stage 4 Passive Active Semi- advanced Advanced traditionalists traditionalists practitioners practitioners Banks that Banks that manage Banks that manage Banks that use originate and their credit portfolio their credit portfolio very sophisticated typically hold to by RoE through finer pricing of models for maturity risks and have greater portfolio ability in managing management portfolio wide risk IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 27
  28. 28. Key Drivers of change in Credit Risk Practice Regulatory issues Capital adequacy Income recognition and provisioning norms Disclosure norms Increasing pressure to enhance shareholder returns Banking is also a commercial business that competes for equity Not amongst the top bracket growth sector businesses Emergence of markets for loans Securitisation Structured finance Derivatives IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 28
  29. 29. DISCUSSIONS IM aCS 2010 Printed 11-M ay-11For Classroom discussion only Page 29
  30. 30. All the contents of the presentation are confidential andshould not be published, reproduced or circulated without the written consent of IFC, Bangladesh Bank and IMaCS. IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 30

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