Credit risk management in banks is a complex process that involves identifying, measuring, monitoring, and controlling risks associated with a bank's lending activities. The document discusses several key aspects of credit risk management: 1) It outlines various methods used by banks to assess credit risk when lending such as cash flow analysis, balance sheet analysis, and assessing repayment capacity. 2) It discusses the importance of proper credit appraisal, monitoring existing loans, and having standards for security, documentation, and loan renewals. 3) It notes that credit risk arises from both internal factors like faulty underwriting and external factors like changes in government policy or industry conditions. Managing this risk requires tools like exposure limits, risk ratings, and regular

1. THEME
Credit as well
as credit risk
management
in banks
ank optimizes utilization liberated look. involved therein, appears to be a
B of deposits by deploying Banks have grown
funds for developmental from being a
activities and productive pur- financial interme-
difficult proposition. There is an
implicit understanding on the part
of the planners that in the post
poses through credit creation diary, in the past, nationalization era, banks will meet
process. Deposit mobilization & to a risk interme- what is called social obligations
Credit deployment constitute the diary, at present. RS Raghavan through directed lending. Early
core of banking activities and In credit, risks are co-related and stage of nationalization belonged
substantial portion of expendi- exposure to one risk may lead to to security oriented approach; in
ture 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 oriented
and 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 to
thing 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 Turnover
dynamic activity that
requires close monitoring Method, Cash Flow Method, Cash Budget Method, Projected
and continuous manage- Balance Sheet method, etc.
ment. This article attempts
to focus on not only credit manage- and pro-active manner to optimize approach was followed, economic
ment but also credit risk manage- the exposure already taken or to be activities and banking products
ment. 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 and
of 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 before
sector, now, wears a relaxed and sight of the associated risks taking up a proposal for considera-
tion. This preliminary study should
The author is the Senior Manager (Risk Management) at Vijaya Bank lead to valuable information on
THE CHARTERED ACCOUNTANT 996 FEBRUARY 2005

2. THEME
borrower’s integrity, honesty, reli- of the borrower is well established
ability, credit worthiness, manage- and the return to the bank by way of
ment competency, expertise, asso- interest is examined. But the ques-
ciate concern, guarantor, etc. A due tion is how to rely on the projected
diligence report shall invariably cash flows. This can be overcome
accompany the credit proposal by building up industry wise data
evaluation. 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 the
and should also follow the pre- Second Method of lending. Proper credit appraisers in the institution
scribed 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 as
their 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 of
tomer at a later date. ception. credit dispensation power is not
Banks have to structure the related to the credit skill acquired
Lending 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 ladder
Committee norms have been to the nature of activity, and, delegation has been based on
dumped to dustbins, alternative process/business cycle, trade the credit size and not the credit
methods being practiced by the terms, availability of security, risk perceived in a proposal. For
banks are yet to pass the test of operational convenience, etc. Loan this, discretionary powers should
time. While some banks adopt the System of Credit Delivery is one be linked to the risk rating of the
method of justifying the sanction such system, developed a few borrower. Banks are yet to fully
of loan, others follow a combina- years ago. This discipline in cash move from credit rating to the risk
tion 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 and
Method, Projected Balance Sheet and the borrower, should be rated AAA, what is implied is
method, 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, the
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3. THEME
type of security to be obtained and is an important function of credit some banks, in line with the express
cash 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 committee
non-fund based limit in exclusion Credit decisions do not get better, approach for credit sanction, in
of fund based limit is not consid- all because more people review the reality the committee hardly meets
ered 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. Getting
only 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 an
Standards, Guarantee Standards, portfolio. Credit Department exception & one person’s decision
Documentation standards & should be expertise-oriented rather gets the sanctity of committee. The
Renewal/review standards to suit than going by the scale and grade in committee approach is helping the
their 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 of
tools will have to be used in various CVC.
aspects of credit dispensation such A separate model for Non- At present, due to lack of credit
as 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 of
up limits, etc are regulator driven, it pany’s financials, etc. so work at the sanctioning level at HO
is better to be pro- active in these as to capture the credit causing enormous and avoidable
areas. Banks themselves should risk in securities. delay as the papers pass through
compile 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 Process
some 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 exposures
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4. THEME
e) 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 exposures
g) Small & Medium Enterprise well as the such as foreign exchange forward
h) 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, Medium
Credit Risk from any Risk and Low Risk and then trans-
As observed by RBI, Credit particular counter party. lated into risk weighted assets
Risk is the major component of risk Credit risk consists of primarily through a conversion factor and
management 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 credit
Management of a bank. Credit risk standing loan balance as on the date risk includes: (a) measurement
is 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 of
posal, as it involves default of the by Probability of Default as reduced expected loan losses, (c) Pricing on
principal 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 Loan
appraisal, inadequate monitoring, Thus credit risk, is a combined Review Mechanism and Portfolio
unwillingness on the part of bor- outcome of Default Risk and Management.
rower to honour commitments Exposure Risk. The elements of
despite being capable or external Credit Risk is Portfolio risk com- Tolls of credit risk management
factors 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 Default
meet 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 to
the 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 a
resulting in crystalisation of credit where treasury and credit functions group with additional 5%/10% for
risk to the bank. These losses could are handled. Portfolio analysis help infrastructure projects, subject to
take 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 level
portfolio 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 the
quality that is short of default. Credit abrupt process to happen suddenly sum total of the exposures beyond
risk is inherent to the business of and past experience indicates that, threshold limit should not exceed
lending funds to the operations more often than not, borrower’s 600% to 800 % of the Capital Funds
linked 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 Approving
return 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, sancti6ning
able parameters. Measurement of helps bank in building healthy authority’s higher delegation of
credit 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 for
products, set suitable limits on System would help in providing review / renewal, Hurdle rates and
THE CHARTERED ACCOUNTANT 999 FEBRUARY 2005

5. THEME
Bench marks for fresh exposures ness group. Rapid portfolio reviews Risk Rating Models
and 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 on
c. 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 at
scoring 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 the
olds and review the ratings periodi- decision-making process. overall health status of an
cally preferably at half yearly inter- account captured under
vals, to be graduated to quarterly so f. Credit Audit/Loan Review Portfolio approach as contrasted
as to capture risk without delay. Mechanism to stand-alone or asset based
Rating 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. Taking
d. 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 simply
are to be priced high. Build historical with the objective of improving increase the portfolio risk
data on default losses. Allocate cap- credit quality. It should target all although specific unit level risk
ital 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 of
e. 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 of
to reduce the potential adverse well as Identify loans with credit increased exposure to a borrower
impact 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 to
tor or industry. Portfolio manage- ence to lending policies and proce- capture, monitor and control the
ment shall cover bank-wide expo- dures. The focus of the credit audit over all exposure to high value
sures on account of lending, invest- needs to be broadened from customers on real time basis to
ment, other financial services activ- account level to overall portfolio focus attention on vital few so that
ities spread over a wide spectrum of level. Regular, proper & prompt trivial many do not take much of
region, 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 of
should be a quantitative ceiling on conducted on site, i.e. at the branch originating the loan and holding
aggregate exposure on specific rat- that has appraised the advance and it till maturity, active approach
ing categories, distribution of bor- where the main operative limits are of credit portfolio management
rowers 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 three
approaches viz. Standardised Approach, Foundation Internal Rating Based Approach and
Advanced Internal Rating Based Approach. At present, banks in India in general and PSU banks
in particular, are ready to migrate to Basel II only at a conceptual and academic level.
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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 requirements
assumptions about the future, the party banks, the maximum expo- Basel II, released by Basel
credit 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 proposed
loan 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 capital
flows will not be forthcoming. border lending and investment to risk weight on credit exposure. It
Thus, credit risk models are activities and finance is extended to is intended to bring the regulatory
intended to aid banks in quantify- its constituents under foreign trade capital requirement more in line
ing, 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,
APPOINTMENTS
potential problems in the portfolio Sovereign Risk,
to facilitate early corrective action. Non-Sovereign
Risks, Cross Bor-
der Risk, Currency
Country risk & inter-bank Risk, etc. Country
AD
exposure risk management
During the course of their busi- involves aggrega-
ness operations, banks invariably tion of country
assume inter-bank exposures of exposures and
varying degree arising from cus- monitoring thereof
tomers trade transactions, place- against pre-
ment of money as bank’s liquidity defined limits on
management, hedging, trading in the basis of rating
securities, transactional banking framework. Till
services such as clearing, custodial such time banks
& depository services, etc. As these evolve their own
transactions involve credit risk internal rating
proper evaluation of credit risk is mechanism, the
essential 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 -the
in place proper credit rating models seven categories
to evaluate the credit risk and rate classification of
the counter party so as to fix suit- countries ranging
able exposure limits and mecha- from Insignificant

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 and
Foundation and Advanced) banks travel a long distance when it comes related structural problems in the
will be allowed to use their own to organizational and technological banks needs to be addressed. The
internal estimates to determine the readiness to go ahead with it to explosive growth in the markets for
borrower’s credit worthiness to adopt the international practice. securitised assets and for credit
assess 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 as
arises 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 is
the loss of amount outstanding at 100% may entail capital charge of 8
believed that loans are akin to
the time of default as reduced by the % and RW of 20% may entail capi-
Indian marriages, where divorce is
recoverable amount. The loss in tal charge of 1.6%). The risk
not feasible even when it is clear
case 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 technical
the 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 who
sioning required could be estimated certain strict standards. Under the
decides on a proposal based on his
from the Expected Loss Given Foundation Internal Rating Based
own judgment. However, when it
Default (which is the product of Approach, Bank rates the borrower
comes to rating of a borrower, the
Probability of Default, Loss Given and results are translated into esti-
system and model in place should
Default & Exposure at Default). mates of a potential future loss
be such that who ever in the bank
That is ELGD is equal to PD X amount that forms the basis of min-
rates the borrower, the result
LGD X EaD. After knowing the imum capital requirement. Under
should be same in at least 90% of
PD, it is necessary to calculate the Advanced Internal Rating Based
the cases. Banks need both the
proportion of loan loss on default. approach, the range of risk weights
information and system to rate the
A historical data of 5 to 10 years will be well diverse.
level of risk in a credit proposal. In
may be considered enough for esti-
order to achieve this, credit offi-
mating the proportion of loan loss Conclusion cers should work as a team and
on default and the average may be Growth in the economy during
share learning with an institutional
tabulated 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 single
can be carried out in any of the three grate the financial market by lever- number as to how much a bank
approaches viz. Standardised aging on the strengths of NBFS. stands to lose on credit portfolio
Approach, Foundation Internal Banks are risk averse to lending, and therefore how much capital
Rating Based Approach and owing to lack of proper credit infor- they ought to hold. ■
THE CHARTERED ACCOUNTANT 1002 FEBRUARY 2005