Credit risk refers to the risk of a counterparty defaulting on their obligations. It is defined as the possibility that a borrower may fail to meet their obligations in accordance with the agreed terms. There are several components of credit risk, including the amount of the loan, quality of the loan, default risk, exposure risk, and recovery risk. Credit risk management is important for banks due to new financial transactions, decreasing government support, and regulatory capital requirements. Banks traditionally evaluated credit risk using the 5 C's of credit analysis and now also utilize internal credit rating systems.

1. 1
What is Credit Risk?
The risk that a counterparty to a transaction will
fail to perform according to
the terms and conditions of the contract due
to
•Problems such as
•Bankruptcy
•Illiquidity ,etc.
Lenders, Depositors, Borrowers and Suppliers
- all face credit risk

2. 2
A More Formal Definition
Credit Risk is defined as the possibility
 that a borrower or counterparty will fail
to meet its obligations in accordance with
the agreed terms
Default triggers
a total or partial loss of any amount lent
to the counterparty

3. 3
Credit Risk Components
 “Quantity” of Risk
 Outstanding balance lent to the borrower
 “Quality” of Risk
 Dependant on

Chances that the default occurs

Guarantees that reduce the loss in the event of
default

4. 4
Credit Risk Components
Cont..
 Credit Risk or Loss Given Default (LGD)
Composed of
 Default Risk
 Exposure Risk
 Recovery Risk

5. 5
Default Risk
 Possible definitions
 Missing a payment obligation- usually three
months
 Breaking a covenant – financial ratios
bands
 Entering a legal procedure
 Economic default- market value of assets
drops below that of liabilities

6. 6
Exposure Risk
 Amortised debt- no exposure risk
 As repayment schedule known hence no
exposure risk
 Committed lines of credit like
 Overdraft
 All off balance sheet items like third party
guarantees
 Derivatives- if liquidation value is positive
then it remains if the counterparty defaults

7. 7
Recovery Risk
 Dependent upon
 Collateral security
 Third party guarantee
 Legal framework

8. 8
Credit Risk Management’s Importance
for Banks cont..
 New forms of financial transactions
emerging
 Securitisation
 Credit Derivatives
 CRAR( Capital to Risk-weighted Assets
Ratio) Framework
 Decreasing Govt. Support for bail outs

9. 9
Traditional Approach in
Credit Approval System
 5 “C” principles
 Character (of Borrower)
 Capital (Borrower’s risk-bearing
commitment)
 Capacity (to provide adequate cash flows)
 Collateral (Priority of charge and value)
 Condition- (of business of borrower and
industry he belongs to )
 Level of interest rates

10. 10
Evolution of Credit Risk Rating
Systems - India
 Position in India
 Regulatory Health-Code System (1980s)
 Internal Credit Rating Systems of banks
 In both cases , no explicit linkages with
capital requirements

11. 11
Five Eternal Principles of
Credit Risk Management
 Selection
 Limitation
 Diversification
 Provision
 Capitalisation
 Quantitative Approach attempts to
optimise all the above

12. 12
Credit Risk Management
 Limit systems and Credit screening
 Risk quality and ratings
 Credit enhancements
 Covenants- diversification, ratios
 Securitisation
 Guarantees
 Letters of credit

13. 13
Industry Ratings
-Risk Evaluation
 Cash Flows
 Debt Repayment Ability
 Time Horizon- 3 to 5 years
 Parameters
 Demand –Supply outlook
 Cost Structures
 Competition
 Govt Policies
 Financial performance-Historical
+Projected

14. 14
Company Ratings
 Industry Prospects
 Operating Efficiency
 Capacity utilisation levels
 Input-output norms
 Power consumption
 Gross margins
 Working capital management

15. 15
Company Ratings cont.
 Market Position
 Current and expected
 Likely growth rate for the company
 Current market share and its stability
 Barriers to entry
 Basis of competition
 Diversity of markets
 Product profile

16. 16
Company Ratings cont.
 Business Risk
 Accounting Quality
 Financial Performance

Past 3-5 years

Future 2-3 years

17. 17
Company Ratings cont.
 Financial Flexibility

Company’s need for funds

Ability to raise it through
 Debt
 Equity
 GDR’s, ADR’s
 Internal accruals
 Liquidation of marketable securities
 Support from group companies
 Financial Risk

Financial performance

Ability to fund capital commitments

Service debt obligations

18. 18
RBI Guidelines on Risk
Management
 RBI issued Guidelines to banks on Risk
Management in October, 1999.
 The Guidelines are aimed to make banks aware of
the risks and put in place proper risk
management system
 Emphasis placed on Board level overview and an
organisational structure and practices which
would enable proactive risk management
 Guidance Paper dated Sept.20, 2001 issued by
RBI on Credit Risk Management

19. 19
Integrated Management
Inter-relationships between risk
categories
Capital Adequacy Norms
Capital Adequacy for Market Risk
Basle Committee’s proposal to prescribe
explicit capital charge for Operational Risk
also

20. 20
Risk Management Structure
Risk Mgt. Committee
Credit Policy Committee
BOARD
*Asset-Liability Management Committee
ALCO *

21. 21
Organisational Scheme for Credit
Risk Management
R is k M a n a g e m e n t C o m m itte e
C re d it R is k M a n a g e m e n t
F u n c tio n
C re d it A d m in is tra tio n
F u n c tio n
L o a n R e vie w
F u n c tio n
C re d it P o lic y C o m m itte e

22. T.V.RAO
THANK YOU
22