credit risk management
TRANSCRIPT
A
PROJECT REPORT
ON
“CREDIT RISK MANAGEMNT
AT SARASWAT BANK LTD”
A detailed study done in
Submitted in partial fulfillment of the requirement for the award of degree of
Master of Management (MMS) under Mumbai University
Submitted by
Sudhir K Tardekar
ROLL NO: 19
BATCH: 20011 – 2012
Under the guidance of
NAME OF THE GUIDE
Prof. Sadhana Ogale
C.K.Thakur Institute of Management Studies & Research
New Panvel, Khanda Colony
1
ABSTRACT
The project entitled CREDIT RISK MANAGEMENT only with the intension of understanding how bank manages the credit risk. Credit risk is the potential that borrower or counter parties will fails to meet its obligations in accordance with agreed terms. Credit risk usually arises from lending activities of a bank. It is observe that loans are the largest and most obvious source of credit risk.
Banks are increasingly facing credit risk in various instruments others than loans, including acceptance, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options and in the extension of commitments and guarantees and the settlement of transactions.
Credit risk consists of various components, objectives, types, credit risk management framework, etc. My project report consists of all the above points in brief about how to manage credit risk in banks.
My project specifically concentrates on credit risk management includes
credit derivates and credit insurance and also credit risk mitigates as per
Basel II Accord and various mitigates used by different banks. I am thankful
to our internal guide Prof.Sadhana Ogale who has also helped me in
preparation of my project report. I feel that the college has provided
adequate facility to develop my vision and also enrich my knowledge.
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ACKNOWLEDGEMENT
A work is never a work of an individual. I owe a sense of gratitude to
the intelligence and co-operation of those people who had been so easy to let
me understand what I needed from time to time for completion of this
exclusive project.
I am greatly indebted to my guides Prof. Sadhana Ogale, faculty guide for
Finance (summer internship), C.K.Thakur Institute of Management Studies
& Research. K. S. Pawar, Dy. General Manager, Saraswat Co-operative
Bank Ltd., Ghatkopar for their constant guidance, advice and help which
enabled me to finish this project report properly in time.
I am also grateful to Dr.S. T. Gadade Principal and Prof. Niesh Manore,
HOD of MMS, C.K.Thakur Institute of Management Studies & Research,
for permitting me to undertake this study.
Last but not the least, I would like to forward my gratitude to my
friends & other faculty members who always endured me and stood with me
and without whom I could not have completed the project.
Sudhir Tardekar
3
DECLARATION
I do hereby declare that this piece of project report entitled “ CREDIT
RISK MANAGEMENT at Saraswat Co-op. Bank” for partial fulfillment
of the requirements for the award of the degree of “MASTER OF
MANAGEMENT STUDIES” is a record of original work done by me
under the supervision and guidance of Prof. Sadhana Ogale,C.K.Thakur
Institute of Management Studies & Research.
This project work is my own and has neither been submitted nor published
elsewhere.
PLACE: SIGNATURE OF THE STUDENT
DATE:
4
CERTIFICATE
This is to certify that the summer project work of Mr. SUDHIR
K.TARDEKAR titled Credit Risk Management is an original work and
this work has not been submitted elsewhere in any form. The indebtness to
other works/publications has been duly acknowledged at the relevant places.
The project work was carried out during 21.05.2011 to 21.07.2011 in
SARASWAT CO-OPERATIVE BANK LTD.
Mr. K. S. Pawar, Dy. Gen. Manager, Date:
Saraswat Co-operative Bank Ltd.,
Ghatkopar, Mumbai.
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Sr no. Topics Page No.
01 Abstract 02
02 Acknowledgement 03
03 Declaration 04
04 Certificate 05
05 Introduction Of Study 08-10
I) Objective Of The Study
II) need & importance of the study
III) Research Methodology
VI) Limitation Of The Study
06 About Saraswat Co-operative Bank 11-18
I) Company Profile & features
II) Milestones
III) Growth and Strength
VI) Financial position And NPA’s
Risk in Banking business 22
Origin & Evolution of Credit Risk Management 24
Types of Credit Risk 28
Components of Credit Risk 30
Objectives of Credit Risk Management 31
Credit Risk Management framework :- 33-53
Policy Framework 34
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Credit risk rating framework 37
Credit risk limits 43
Credit Risk Modeling 44
RAROC Pricing 50
Risk Mitigants 52
Loan Review Mechanism/credit audit 53
07 Credit Risk Mitigants as per Basel II Accord 54
08 Credit risk mitigants used by different banks 60
09 New Capital Accord : Implications for Credit Risk Management
72
10 Case Study 77
Conclusion 84
Biblograph/Weblograph 85
INTRODUCTION:-INTRODUCTION:-
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Risk is inhisent in all aspects of a commercial operation and covers
areas such as customer services, reputation, technology, security, human
resources, market price, funding, legal, regulatory fraud and strategy.
However, for banks and financial institutions credit risk is the most
important factor to be managed.
The term credit risk is defined, “as the potential that a borrower or
counter-party will fail to meet its obligations in accordance with agreed
terms”.
In simple terms, “it is the probability of loss from a credit transaction”.
Loans are the largest and most obvious source of credit risk. Loans
are given by banks in the form of corporate lending, sovereign lending,
project financing and retail lending. However this sources of credit risk
exists throughout the activities of banks, including in the banking book and
in the trading book and both on and off the balance heet. Banks are
increasingly facing credit risk in various instruments other than loans,
including acceptances, interbank transactions, trade financing, foreign
exchange transactions, financial futures, swaps, bonds, equities, options and
in the extension of commitments and guarantees, and the settlement of
transactions.
Credit risk encompasses both default risk and market risk. Default
risk is the objective assessment of the likelihood that counterparty will
default. Market risk measures the financial loss that will be experienced
should the client default. Credit risk includes not only the current
replacement value but also the potential loss from default.
OBJECTIVES OF THE STUDY:
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The main objectives of the study are:
1 To study the effectiveness of credit process.
2 To know and analyze the procedure of loan disbursement and its
evaluation criteria.
3 To study and analyze the factors contributing to default rate and their
interrelations.
4 To suggest suitable strategies for improving credit and risk
management.
NEED & IMPORTANCE OF THE STUDY:
In today’s market scenario, one of the most critical areas to focus on is to
protect the bank from bankruptcy. In such conditions Credit and Risk
Department plays a key role in growth of banks. Any delay in realizing the
receivables would adversely affect the working capital, which in turn effects
the overall financial management of a firm. No firm can be successful if it’s
over dues are not collected, monitored and managed carefully in time. Thus
Risk management is important in sustaining the bank and its growth.
RESEARCH METHODOLOGY :
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To fulfill the objectives of the study both primary and secondary data are used. The primary data was collected through interviewing all the executives and officials of the of SARASWAT CO-OPERATIVE BANK LTD.
The secondary data was collected from published records, website and reports of the Bank. Mainly the data relating to credit procedures followed by the bank and risk management was obtained through manager from bank database .The data for this purpose was obtained from bank for a period of 3 years that is from. Based on the availability of the data, the analysis was made from different angles to assess the credit and risk management of SARASWAT CO-OPERATIVE BANK LTD.
LIMITATIONS OF THE STUDY:
1 The study is limited to Mumbai city only.
2 The study has been done according to bank point of view.
3 The study has been done without meeting the defaulters due to
constraints of time.
Place of study:-
The project study is carried out at the Loan Department of Saraswat Co-
operative Bank Ltd. Central Zonal office Situated at Ghatkopar, Mumbai.
The study is undertaken as a part of the MMS curriculum from 21.05.2011
to 21.07.2011 in the form of summer placement.
THE SARASWAT CO-OPERATIVE BANK LIMITED
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The Bank has a very humble but a very inspiring beginning. On 14th
September 1918 , "The Saraswat Co-operative Banking Society" was
founded. Mr. J.K. Parulkar became its first Chairman, Mr. N.B. Thakur, the
first Vice-Chairman, Mr. P.N. Warde, the first Secretary and Mr. Shivram
Gopal Rajadhyaksha, the first Treasurer. These were the people with deep
and abiding ideals, faith, vision, optimism and entrepreneurial skills. These
dedicated men in charge of the Society had a commendable sense of service
and duty imbibed in them. Even today, our honorable founders inspire a
sense of awe and respect in the Bank and amongst the shareholders.
The Society was initially set up to help families in distress. Its objective was
to provide temporary accommodation to its members in eventualities such as
weddings of dependent members of the family, repayment of debt and
expenses of medical treatment etc. The Society was converted into a full-
fledged Urban Co-operative Bank in the year 1933.
The Bank has the unique distinction of being a witness to History. The
Bank, which was originally founded in 1918, i.e. close on the heels of the
Russian Revolution, also witnessed as a Society and as Bank-the First World
War, the Second World War, India's freedom Movement and the glorious
chapter of post-independence India. During this cataclysmic cavalcade of
history, the Bank as a financial institution and its members could not of
course remain unaffected by the economic consequences of the major
events.
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The two wars in particular brought in their wake, paucities of all kinds and
realities and stand by its members in distress as a solid bulwark of strength.
The Founder Members and the later-day management's of the Bank
continued to demonstrate their unwavering faith in the destiny of the
common man and the co-operative movement and they encouraged the
shareholders to save despite all odds.
COMPANY PROFILE
"Service to the Common Man" has been the motto of Saraswat Bank for the
last 91 years. Bank inspite of its growth in size has been able to offer to the
customers the dual advantage of "Ability of Big Banks and Agility of Small
Banks"
The Bank still continues to function with the glorious tradition in public
services besides being the largest Urban Co-operative Bank in India,
Saraswat Bank has now become the largest in Asia. Saraswat Bank has
now 217 fully computerised branches, 15 Zonal Offices and departments
located across 6 States viz. Maharashtra, Goa, Gujarat, Madhya Pradesh,
Karnataka and Delhi.
Saraswat Bank attributes this success to its undying spirit to serve the
common man and to the sharpening of its competitive edge by constantly
upgrading technology to match international standards. The Bank is fully
computerised and offers convenient working hours.
Saraswat Bank has introduced a wide range of credit schemes at attractive
interest rates, which has become very popular, especially among the middle-
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class in view of the easy repayment plans. Bank offers attractive interest
rates on deposits and also various add on features at very market competitive
rate.
The Beginning of the 21st Century has been a giant leap forward for the
Bank. Bank chose a path of organic/inorganic growth and our pace of
growth accelerated .Bank's total business which was around Rs 4000 Crore
in 2000 almost tripled to Rs 15295 Crore in 2007. The Business of the Bank
as on 31st March 2009 had crossed Rs 21000 Crores.
Bank in the year 2008 launched the Branding Initiative .The purpose of such
an exercise was to reconfirm the thrust of Bank on its core values ,which can
be summed up as "Sense of Belonging ".The name of the Bank should
always inspire the Sense of Belonging in all its stakeholders and that Bank
continues to fulfill the changing needs and expectations of the customer
with unflinching gusto and aplomb.
As on 31st March, 2010 Bank had surpassed the business level of Rs 23000
crore businesses. Bank by 1st November, 2010 has already surpassed the
business level of Rs 25000 crore .As on 31st March, 2011 Bank's business
had crossed Rs 26000 crore.
It is a matter of immense pride for the Bank that Bank's new Corporate
Office at Prabhadevi -Mumbai has recently become operational.The
office reverberates our strong presence in the financial capital of the country.
The massive edifice in crystal glass in heart of Mumbai gently reminds
everyone of the numero -uno position which the Bank holds in the
Cooperative Sector. The usage of state of art technology coupled with
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personal ambience's to make everybody comfortable once again reiterates
Bank's adherence to "Think Global, Act Local". The address of our new
corporate office is as under:
Our features:
1. Attractive Interest Rates on Deposits.
2. 0.50% additional interest on Deposits for Co-operative Society.
3. 1.00% additional interests on Deposits for Senior Citizens.
4. Various Loan Facilities to fulfill your needs.
5. We have cheque drawing and cheque collection faculty on major
cities all over India.
6. Electricity bills of B.E.S.T., M.S.E.B. etc. accepted.
7. NO TDS to our shareholders.
8. Lockers available at lowest rates.
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Milestones:
1918 Established as Co-operative Credit Society.
1933 Converted into a Urban Co-operative Bank.
1942 The Bank had gained Strong foundation in terms of its membership, resources, assets and profits.
1977-78 the Bank's gross income crossed the Rs.3.00 crore mark for the first time.
1988 Became Scheduled Bank.
2008 Bank launched the Branding Initiative.Bank's website: www.saraswatbank.com launched.
2009 Decision to set up "Development Reserve Fund" to undertake
special schemes.
2010 All Branches fully computerized.
Growth and Strength:
MAJOR ACHIEVEMENTS DURING FY 2009-10:
As you are aware, this year has proved to be a daunting year for your Bank.
However, inspite of the challenges posed, your Bank marched forward in
pursuance of our goal under Dr. Adarkar Mission-II, of achieving a business
goal of ` 25,000 crore by March 31, 2011. The progress is as follows:
(A) Total business of the Bank (i.e. deposits plus advances) grew to `
23,517.08 crore as on 31st March, 2010 from ` 21,029.26 crore as on 31st
March, 2009 i.e. a growth of ` 2,487.82 crore in absolute terms and of 11.83
per cent, on a y-o-y basis.
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(B) The deposits grew from ` 12,918.85 crore as on 31st March, 2009 to `
14,266.73 crore as on 31st March, 2010 i.e. a rise of 10.43 per cent, while
advances increased from ` 8,110.41 crore as on 31st March, 2009 to `
9,250.35 crore as on 31st March, 2010 i.e. a rise of 14.06 per cent.
(C) Within the overall deposits, your Bank has successfully increased the
low-cost deposit base. The CASA deposits increased by 31.98 per cent on a
y-o-y basis i.e. a rise of ` 1,029.32 crore in absolute terms. The ratio of
CASA deposits to total deposits thus increased from 24.91 per cent as on
31st March, 2009 to 29.77 per cent as on 31st March, 2010.
(D) On the backdrop of the scenario depicted hereinabove, the profit of the
Bank (before tax and exceptional items) has decelerated from ` 315.61 crore
in FY 2008-09 to ` 179.16 crore in FY 2009-10. The net profit after tax also
slid lower at ` 119.67 crore in FY 2009-10 vis-à-vis ` 210.79 crore for the
preceding financial year.
(E) The foreign exchange turnover of your Bank remained above ` 50,000
crore for second successive year in spite of global financial turmoil, which
had affected country’s exports.
(F) The number of branch licences of your bank reached the magical figure
of 200. Accepting that these were tough times, no new mergers have been
carried out during financial year 2009-10. The 200th branch of your Bank
was opened at Dindoshi , Goregoan (E), Mumbai, on 16th March, 2010 on
16
the auspicious occasion of Gudhi Padva at the hands of Smt. Mrinal Gore,
the well-known socialist leader.10 Annual Report 2009-10
(G) A total of twenty-eight new branches were opened during the year. Of
these, four new branches were opened at Mangalore on a single day and two
branches were opened at Bengaluru on a single day, strengthening Bank’s
base in the Southern region.
(H) RBI allowed your Bank to raise Long Term Subordinated Deposits
(LTSD) of ` 300 crore to strengthen the capital adequacy. Your Bank
accordingly completed issuance of ` 300 crore LTSD by March, 2010. In
pursuance of the instructions from RBI, LTSD issue carried stiff conditions.
LTSD investments are not protected by deposit insurance, no loans can be
availed against such deposits and they cannot be withdrawn before their long
maturity. And yet depositors entrusted their funds of the order of ` 300 crore
to your Bank, to support the Bank’s Tier–II capital, which demonstrates the
deep and abiding trust the members of public have in your Bank and in the
brand “Saraswat Bank”.
(I) Your Bank’s capital adequacy ratio has always been well above the RBI
stipulation of 9 per cent. With the issuance of LTSD this year and mainly
placing market value on the capital asset of new Corporate Center – The
‘Saraswat Bank Bhavan’ at Prabhadevi, Mumbai, your Bank has further
strengthened its capital base and reserves. The Capital Adequacy Ratio
(CRAR), which stood at 10.92 per cent as on 31st March, 2009 has moved
up to 14.63 per cent as on 31st March, 2010 which in effect has enabled us
to emerge stronger from the recession.
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SARASWAT CO-OPERATIVE BANK
FINANCIAL POSITION (LAST 2YEARS)
Particulars FOR THE YEAR ENDED
31-Mar-09 31-Mar-10 % Change
Total Income 1,499.92 1,458.20 -2.78%
Total Expenditure 1,174.56 1,242.36 5.77%
Gross Profit 325.36 215.84 -33.66%
Less: Provisions 9.75 36.68 276.21%
Net Profit Before Tax and
Exceptional Items
315.61 179.16 -43.23%
Less: Income Tax 74.32 40.00 -46.18%
Net Profit after Tax and before
Exceptional items
241.29 139.16 -42.33%
Less: Exceptional Items 30.50 19.49 -36.10%
Net Profit 210.79 119.67 -43.23%
AT THE YEAR END
Own Funds 1,174.21 1,270.37 8.19%
Share Capital 77.50 86.23 11.26%
Reserves and Surplus 1,096.71 1,184.14 7.97%
Deposits 12,918.85 14,266.73 10.43%
Current 916.22 1,244.30 35.81%
Savings 2,302.13 3,003.37 30.46%
Term 9,700.50 10,019.06 3.28%
Advances 8,110.41 9,250.35 14.06%
Secured 7,995.04 9,151.61 14.47%
Unsecured 115.37 98.74 -14.41%
Priority Sector 4,940.81 5,300.48 7.28%
% to Advances 60.92% 57.30% –
Small Scale Industries 2,454.11 2,946.54 20.07%
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Small Businessmen and Traders 556.78 689.47 23.83%
Other Priority Sectors 1,929.92 1,664.47 -13.75%
Working Capital 15,622.82 17,071.06 9.27%
Investments 4,791.51 5,321.39 11.06%
Borrowings and Refinance 664.00 562.00 -15.36%
Net NPAs (%) 0.00 0.00 0.00
Capital Adequacy (%) 10.92 14.63
Number of Members
Regular * 1,29,741 1,34,417
Nominal 4,67,644 4,94,292
Number of Branch Licences 175 200
Number of Employees 2,904 2,911
* Shareholders holding fifty shares and above
The Deposits have grown by Rs. 14266.73 crores at the previous year end and
registered growth of 10.43%. Advanced have growth by 14.06% and gone up by
Rs. 9250.35 crores. As a result bank has achieved a CD ratio 58.47 %. Paid Up
Capital of the bank increased form Rs. 40.46 crores to Rs. 45.77 crores, registering
growth of 13 % over the previous year. The reserves and other funds have
increased from Rs. 1096.71 crores to Rs. 1184.14 crores in the previous year.
The Working Capital have grown by Rs. 17071.06 crores at the previous
year end and registered a growth of 9.27%. The Net Profit has decreased from Rs.
210.79 to Rs. 119.67 crores.
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Capital to Risk Asset Ratio:
NPA’s:
Movement of NPAs:
During the year under Report, which was characterized by acute recession in the world economy, there was an addition of ` 107.84 crore to the Gross NPAs, as against the last year additions amounting to ` 110.95 crore. The NPA Management Dept of your Bank has been able to recover/reduce the Gross NPAs by ` 110.72 crore to bring down the Gross NPA level to 3.92 per cent from the last year’s level of 4.50 per cent, which constitutes an improvement. The recoveries and provisions however helped the Bank to maintain the Net NPA level to zero percent for the sixth consecutive year.
Movement of NPAs and Provision for the year 2009-2010. (` in crore)
GROSS NPAs
As on 31st March, 2009 365.26
Addition during the year. 107.84
Reduction during the year. 110.72
As on 31st March, 2010 362.38
PROVISIONS:
As on 31st March, 2009 370.24
Addition during the year. 35.57
Reduction during the year. 41.58
As on 31st March, 2010 364.23
NET NPAs
As on 31st March, 2009 0.00
As on 31st March, 2010 0.00
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It is worth mentioning that after the remnant Gross NPAs of the
order of 144.26 crore of the seven merged banks (now Gandhakosh) are
excluded from the total Gross NPAs of ` 362.38 crore of your Bank, ` 218.12
crore would be Gross NPAs of your legacy Saraswat Bank, which stand at
2.36 per cent of the total advances of your Bank. They include some of the
stubborn NPAs prior to April 2001. We are endeavouring to bring your
Bank’s Gross NPAs down to around 1 per cent by FY 2013-14.
During the year under Report, your Bank could recover ` 3.70 crore from
the written-off accounts. A special strategy has been worked out under a
project christened as “Phoenix” during the year 2010-11 to make aggressive
recoveries from written off accounts.
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Risk in Banking business:-
Banking business lines are many and varied. Commercial
banking, corporate finance, retail banking, trading and investment banking
and various financial services form the main business lines of Banks. Within
each lines of business these are sub-groups and each sub-group contains
variety of financial activities. Bank’s clients may very from retail consumers
to mid-market corporate to large corporate to financial institutions. Banking
may differ appreciably for each segment even for the similar services for
example; lending activities may extend from retail banking to specialized
finance. Again specialized finance may extend from specific fields with
standard practice, such as exports and commodities financing to structure
financing implying specific structuring and customization for making large
and risky transactions feasible, such as project financing or corporate
acquisitions. Banks also assemble financial products and derivatives and
deliver them as a package to its clients as a part of specialized financing
commensurate with the needs of clients.
Product lines also vary across client segments. Standard lending
products include short-term and long –term loans with specified repayments,
demand loans and various othis lines of credit such as bill purchase and bills
discounting facilities, as auto loans, house –building loans etc. banks also
offer guarantees, letters of credit etc. which are in the nature of off- balance
heet transactions. These are various deposits products that vary for different
segments and different needs. Banks also offer market products such as
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fixed income security shares, foreign exchange trading and derivates like
standard swaps and options.
The key driver in managing all the business lines are enhancing
risk adjusted expected returns. This is the common factor for all business
lines. But management practices vary across business lines, activities differ,
and so does the risk factors associated with them.
Types of banking Risks:-
These are major 5 types of banking risk. They are
1) Liquidity risk.
2) Interest rate risk.
3) Market risks
4) Credit risk ( Default risk )
5) Operational risk.
Each of above risk is the risk which every bank faces and each risk
is having sub-risk.
Each of above risk is unique & has huge depth & my project is
concerned about only credit risk. Thus, my focus hereafter will be
exclusively on “credit risk”
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1. THE ORIGINS AND EVOLUTION OF CREDIT RISK
MANAGEMENT
Credit is much older than writing. Hammurabi’s code, which codified
legal thinking since 4000 years ago in Mesopotamia, didn’t outline the basic
rules of borrowing and didn’t address concept such as interest, collateral and
default. These concepts appear to have been too well known to have required
explanation. However, the code did emphasize that failure to pay a debt is a
crime that should be treated identically to theft and fraud.
The code also set some limits to penalties. For example, a defaulter
could be seized by his creditors and sold into slavery, but his wife and
children could only be sold for a three-year term. Similarly, the Bible
records enslavement for debt without disapproval; for example, the story of
Eli’sha and the widow’s oil concern the threatened enslavement of two
children because their faiths died without paying his debts. But the Bible
also goes further than Hammurabi in limiting the collection rights of
creditors purely a matter of mercy.
The modern bankruptcy concepts of protection from creditors and
extinguishment of debt are entirely absent from both Hammurabi and the
bible. Historically, credit default was a crime. At various places and times, it
was punishable by death, mutilation, torture, imprisonment or enslavement-
punishment that could be visited upon debtors and their dependents.
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Unpaid debts could sometimes be transferred to relatives or political
entities. But that does not mean that the law was creditors friendly. The
Bible prohibits charging interest [usury], which removes any incentives to
lend. It also specified general releases from debt. Aristocrats, especially
sovereigns, would frequently repudiate their and sometimes debts in general.
Considering the potential consequences, one has to wonder why
anyone borrowed or lent money in ancient times. Borrowers risked
horrendous consequences from default, while lenders faced legal obstacles
to collecting money owed-and to making a profit. Both sides also risked
strong social disapproval if money was not repaid.
Moreover, moralists and lawmakers favored equity financing over
credit. Under an equity financing arrangement, both successful and
unsuccessful outcomes could be resolved without expensive legal
proceedings. Documentation and oversight was also much simpler. Even the
equity financing language was, and remains, biased with words like “equity”
[which means “fair”] as opposed to negative words like “debts” and
“liability”.
To answer the question about why people engaged in credit
agreements, we must go even far this back in history and replace written
sources with guesswork. Credit risk arose before financing of business
ventures. This is credit risk, for example, when a farmer says to a stranger,”
help me harvest my crop, and I’ll give you two baskets of grain”.
25
The Bible is hostile even to this form of credit, saying you should not
let the sun go down on an unpaid wage. Surprisingly, this belief even has
supported today, as some fundamentalists insist on paying all employees in
cash every day before sundown.
The trouble with this approach, of course, is that it requires the farmer
to have cash or goods to spare before the harvest is in. More generally, in
any economy; you need money supply, at least equal to the total value of all
goods and services in the process of production.
Back To Basic:
The work on “exposure at default” and “loss given default” has
highlighted deficiencies in understanding of “probability of default”. Early
research defined “default” as Mr.ing a payment or filing for bankruptcy.
These events are easy to determine and thus convenient for early progress in
estimating probabilities. As the market place evolved, probability was
defined over fixed time intervals.
Lenders sometime “restructure” rather than “default”.
Restructuring form a continuum from those that involve no loss of economic
value to creditors to those that make creditors claim almost worthless. These
clearly contribute to creditors losses and thus should be included in loss
given default. If we do this, it’s easier to measure the loss given default but
harder to define default and hence harder to estimates probability of default.
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To estimates “exposure” at default, we need to know the future time
series of probability of default, not just the cumulative probability over
specific intervals. Even the probability over every interval is not enough; we
need to know the dynamics of the process. This has been quite a bit of work
done on this problem for the purpose of pricing credit derivatives, but
unfortunately it has proven hisd to reconcile with risk management default
probability models. This has been a dilemma in the past and will continue to
be a major challenge in the future, especially as active credit risk
management strategies gain popularity.
Credit risk has been around for millennia. Good qualitative credit
ratings have been around for century. Serious quantitative credit risk
estimates have a 40-years history. Quantitative progress was slowed by
confusion within the profession, but regulators, rating agencies, practitioners
and academics have been working togethis for at least last five years.
Consequently, for the first time in history, it seems likely that the problem of
credit risk can be solved.
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Types Of Credit Risk
Credit risk arises from potential changes in the credit quality of a
borrower. It has two components: default risk and credit spread risk or
downgrade risk.
1. DEFAULT RISK:-
Default risk is driven by the potential failure of a borrower to make
promised payment, either party or wholly. In the event of default, a fraction
of the obligation will normally be paid. This is known as the recovery rate.
2. CREDIT SPREAD RISK OR DOWNGRADE RISK:-
If a borrower does not default, this is still risk due to worsening in
credit quality. This results in the possible widening of the credit-spreads.
This is credit spread risk. These may arise from a rating change {i.e., an
upgrade or a downgrade}. It will usually be firm specific.
Loans are not usually marketed to market. Consequently, the only
important factor is whether or not the loan is in default today [since this is
the only credit event that can lead to an immediate loss]. Capital market
portfolios are marketed to market. They have in addition credit spread
volatility [continuous changes in the credit-spread]. This is more likely to be
driven by the market’s appetite for certain levels of risk. For example, the
spreads on high-grade bonds may widen or tighten, although this need not
28
necessarily be taken as an indication that they are more or less likely to
default.
Default risk and downgrade risk are transaction level risks. Risks associated
with credit portfolio as a whole is termed portfolio risk. Portfolio risk has
two components-
Systemic or intrinsic risk.
Concentration risk.
1. Systemic risk:-
As we have seen, portfolio risk is reduced due to diversification.
If a portfolio is fully diversified, i.e. diversified across geographies,
industries, borrowers markets, etc., equitably, then the portfolio risk is
reduced to a minimum level. This minimum level corresponds to the risks in
the economy in which it is operating. This is systemic or intrinsic risk.
2. Concentration risk:-
If the portfolio is not diversified that is to say that it has highis
weight in respect of a borrower or geography or industry etc., the portfolio
gets concentration risk.
The following chart outlines financial risk in lending:-
29
A variant of credit risk is ‘counterparty risk’. The counterparty risk arises
from non-performance of the trading partners. The non-performance may
arise from counterparty’s refusal/inability to perform. The counterparty risk
is generally viewed as a transient financial risk associated with trading rathis
than standard credit risk.
.The components of credit risk are:
Credit growth in the organization and composition of the credit
folio in terms of sectors, centers and size of borrowing activities so as to
assess the extent of credit concentration.
Credit quality in terms of standard, sub-standard, doubtful and
loss-making assets. Extent of the provisions made towards poor quality
credits. Volume of off-balance-heet exposures having a bearing on the credit
portfolio.
Thus credit involves not only funds outgo by way of loans and
advances and investments, but also contingent liabilities. Thisefore, credit
30
CREDIT RISK
PORTFOLIO RISKTRANSACTION
RISK
CONCENTRATION RISK
SYSTEMIC RISKDEFAULT RISK
DOWNGRADE RISK
risk should cover the entire gamut of an organization’s operations whose
ultimate ‘loss factor’ is quantifiable in terms of money.
According to Reserve Bank of India, the following are the forms of
credit risk:
Non-repayment of the principal of the loan and/or the interest on it.
Contingent liabilities like letters of credit/guarantees issued by the
bank on behalf of the client and upon crystallization – amount not
deposited by the customer.
In the case of treasury operations, default by the counter-parties in
meeting the obligations.
In the case of securities trading, settlement not taking place when it
is due.
In the case of cross-border obligations, any default arising from the
flow of foreign exchange and/or due to restrictions imposed on
remittances out of the country.
OBJECTIVES OF CREDIT RISK MANAGAMENT:-
Credit risk management can have different objectives at two levels
namely – transaction level & Portfolio level.
31
At the transaction level, the objectives of credit risk management ideally
should be:
Setting an appropriate credit risk environment.
Framing a sound credit approval process.
Maintaining an appropriate credit administration, measurement and
monitoring process.
Employing sophisticated tools/techniques to enable continuous risk
evaluation on a scientific basis.
Ensuring adequate pricing formula to optimize risk return
relationship
At the Portfolio level, the objectives of credit risk management should be:
Development and Monitoring of methodologies and norms to
evaluate and mitigate risks arising from concentrating by industry,
group, product, etc.
Ensuring adherence to regulatory guidelines.
Driving asset growth strategy.
32
If we closely analyze the above, we can observe that the transaction
level pursues value creation and portfolio level pursues value preservation.
CREDIT RISK MANAGEMENT FRAMEWORKCREDIT RISK MANAGEMENT FRAMEWORK
Banks need to manage credit risk inherent in the entire portfolio as
well as risk in individual credits or transactions. The effective management
of credit risk is a critical component of a comprehensive approach of risk
management and essential to long term of any banking organization. Banks
for this purpose incorporates proper framework for credit risk management
(CRM), which includes,
Policy framework
Credit risk rating framework
Credit risk limits
33
Credit risk modeling
RAROC pricing
Risk mitigates
Loan review mechanism/credit audit
POLICY FRAMEWORK:-
Given the fast changing, dynamic world scenario experiencing the
pressure of globalization, liberalization, consolidation and disintermediation,
it is important that banks must have robust credit risk management policies
(CRMPs) and procedures, which are sensitive and responsive to these
changes. In any bank, the corporate goals and credit culture are closely
linked and an effective CRM framework requires the following distinct
building blocks:
(1) Strategy and policy,
(2) Organization, and
(3) operations/systems.
34
1. Strategy and policy:
Strategy and policies includes defining credit limits, the development
of credit guidelines and the identification and assessment of credit risk.
Banks should develop its own credit risk strategy defining the objectives for
the credit granting function. This strategy should spell out clearly the
organisation’s credit limits and acceptable level of risk-reward trade-off at
both macro and micro levels. The credit risk strategy should provide
continuity in approach, and take into account the cyclical aspects of any
economy and the resulting shifts in the composition and quality of the
overall credit portfolio. This strategy should be viable in the long run and
through various credit cycles.
Credit policies and procedures should necessarily have the following
elements:
Banks should have written policies that define target markets, risk
acceptance criteria, credit approval authority, credit origination and
maintenance procedures and guidelines for portfolio management and
remedial management.
Sound procedures to ensure that all risks associated with requested credit
facilities are promptly and fully evaluated by the relevant lending and credit
officers.
35
Banks should establish proactive CRM practices like annual/half yearly
industry studies and individual obligor reviews, periodic credit calls that are
documented, periodic plant visits, and at least quarterly management reviews
of troubled exposures/weak credits.
Procedures and systems, which allow for monitoring financial
performance of customers and for controlling outstanding within limits.
Systems to manage problem loans to ensure appropriate restructuring
schemes. A conservative policy for the provisioning of non-performing
advances should be followed.
Banks should have a consistent approach towards early problem
recognition, the classification of problem exposures, and remedial action and
maintain a diversified portfolio of risk assets in line with the capital desired
to support such a po
2. Organizational structure:
Banks should have an independent group responsible for the CRM.
The responsibilities of this team are the formulation of credit policies,
procedures and controls extending to all of its credit risk arising from
corporate banking, treasury, credit cards, personal banking, trade finance,
securities processing, payments and settlement systems.
3. Operations/systems:
36
Banks should have in place an appropriate credit administration,
measurement and monitoring process.
The credit process typically involves the following phases:
Relationship management phase, that is, business development,
Transaction management phase to cover risk assessment, pricing, structuring
of the facilities, obtaining internal approvals, documentation, loan
administration and routine monitoring and measurement, and Portfolio
management phase to entail the monitoring of portfolio at a macro level and
the management of problem loans.
The banks should have systems in place for reporting and evaluating the
quality of the credit decisions taken by the various officers.
Banks must have a MIS to enable them to manage and measure the credit
risk inhisent in all on and off-balance heet activities. It should provide
adequate information on the composition of the credit portfolio, including
identification of any concentration of risk.
CREDIT RISK RATING FRAMEWORK:-
A credit risk-rating framework deploys a number/alphabet/symbol as a
primary summary indicator of risks associated with a credit exposure. These
rating frameworks are logic-based, utilize responses made on a specified
37
scale and promote the accuracy and consistency of the judgment exercised
by the banks.
For loans to individuals or small businesses, credit quality is typically
assessed through a process of credit scoring. Prior to extending credit, a
bank or this lender will obtain information about the party requesting a loan.
In the case of a bank issuing credit cards, this might include the party's
annual income, existing debts, whether they rent or own a home, etc. A
standard formula is applied to the information to produce a number, which is
called a credit score. Based upon the credit score, the lending institution
decides whethis or not to extend credit. The process is formulaic and highly
standardized.
Many forms of credit risk—especially those associated with larger
institutional counterparties—are complicated, unique or are of such a nature
that that it is worth assessing them in a less formulaic manner. The term
credit analysis is used to describe any process for assessing the credit quality
of counterparty. While the term can encompass credit scoring, it is more
commonly used to refer to processes that entail human judgement. One or
more people, called credit analysts, review information about the
counterparty. This might include its balance heet, income statement, recent
trends in its industry, the current economic environment, etc. They may also
assess the exact nature of an obligation.
For example, secured debt generally has high is credit quality than does
subordinated debt of the same issuer. Based upon their analysis, they assign
38
the counterparty (or the specific obligation) a credit rating, which can be
used for making credit decisions.
Many banks, investment managers and insurance companies hire their
own credit analysts who prepare credit ratings for internal use. These firms
—including Standard & Poor's, Moody's and Fitch—are in the business of
developing credit ratings for use by investors or third parties. Institutions
that have publicly traded debt hire one or more of them to prepare credit
ratings for their debt. In the United States, the National Association of
Insurance Com Mr.ioners publihes credit ratings that are used for calculating
capital charges for bond portfolios held by insurance companies.
Exhibit 1 indicates the system of credit ratings employed by Standard &
Poor's. Other systems are similar.
Standard & Poor's Credit Ratings
Exhibit 1
AAA --- Best credit quality—extremely reliable with regard to financial
obligations.
AA --- Very good credit quality—Very reliable.
A --- More susceptible to economic conditions—still good credit quality.
BBB --- Lowest rating in investment grade.
39
BB --- Caution is necessary—best sub-investment credit quality.
B --- Vulnerable to changes in economic conditions— currently showing the
ability to meet its financial obligations.
CCC --- Currently vulnerable to nonpayment—Dependent on favorable
economic Conditions.
CC --- Highly vulnerable to a payment default.
C --- Close to or already bankrupt—payment on the obligation currently
continued.
D --- Payment default on some financial obligation has actually occurred.
This is the system of credit ratings Standard & Poor's applies to bonds.
Other credit rating systems are similar.
Credit Rating Model:-
The customer rating model is being developed by me for solving the
problem of nonpayment of loan. This model helps to determine the
repayment capacity of the customer at the initial level. This model is
applicable only for personal and housing loan.
The system of customer rating would involve allocating marks for various
parameters of the prospective customer’s profile and his repayment capacity
40
such as his personal details, financial status, repayment capacity and past
relation with the bank. A format of the rating heet is being introduced hise. It
may be observed that thise are 15 parameters for which a maximum of 100
marks are allotted. The loan request of applicants securing marks of 60 and
above {i.e. credit rating of ‘A’ and above} may be considered by the branch
manager. The applicant getting marks between 50 to 60{credit rating ‘B’}
will not be considered by branch manager but it will be submitted to credit
committee. In considering such request, the sanctioning authority may take
into consideration othis relevant facts into consideration and also stipulate a
highis rate of interest, if warranted; commensurate with the high is risk
perception. An applicant scoring less than 50 marks will not be eligible for
being considered for loan.
Customer Rating
(For personal and housing loans)
Name:
Address:
Phone No. : Residence Office : Mobile :
01 Age(Years)
Score
Up to 25 25 to 35 to 45 45 to 55 Over Over 65 Max. All
41
35 553 7 10 7 3 Not
Eligible10
02 EducationUp to Metric Graduate Post Graduate or
Professional1 3 5 5
03 Occupation –1. ( Business or Profession )Practicing
DoctorCA/
Architect Engineer
Other professional OtherBusiness
10 7 5 3II ( Service )
Govt. Semi Govt. Corporate SmallEnterprises
Others
10 10 7 5 3 10
04 Period of Service / Business Upto 2 Years
2 to 5 years
5 to 10 years
10 to 20 years
20 to 30 yeas
Above 30 years
0 3 7 10 7 3 1005 No of Dependents
Upto 2 2 to 4 Above 45 3 1 5
06 Yearly Income Upto 50000 50001 to 1 lakh >1 lakh to 2 lakh 2 lakh
4 6 8 10 1007 Income of Spouse
< 30000 30000 to 1 lakh > 1 lakh to 2 lakh > 2 lakh 2 3 4 5 5
08 Stay in the present house Family owned over 5 Years
Family owned over 3 years or rented over 5 years
Othis
5 3 009 Ownership of following items
Colour TV
2 wheeler
Refrigeration
Credit Card
Washing Machine
TelMobile
PC at home
Car None
42
None
Any 1 Any 2 Any 3 Any 4 Any 5 Any 6 Any 7 All 8
0 1 2 3 4 5 6 7 10 10
10 Account well operated with our Bank for 1-3 Years Over 3 to 5 years Over 5 years
3 4 5 511 Whethis income / salary credited to account
Directly creditedto account
Cheque regularly received
Not credited
Satisfactory business
5 3 0 3 512 Average balance in Savings / Current for last for one year
Below Rs. 1000 Rs. 1000 to Rs. 5000
Rs.5001 to Rs. 15000
Over Rs. 15000
0 2 3 5 513 Othis Deposits , if any, with our Bank
Below Rs. 5000
Rs. 5-15000 Rs. 30-50000 Over Rs. 50000
0 2 3 5 514 Whethis any loan taken earlier
Whethis any loan taken earlier? If YesPurpose : Amount :From which branch Repayment of earlier Loan :
No Loan taken
Timely Repayment
Fully repaid but with some delay
Paid under compromiseSettlement
Not Repaid
3 5 3 Not Eligible 515 Present monthly repayment obligations, if any (as % of salary or monthly income
Over 50% 30% - 50% < 30%
0 3 5 5Total 100
Score (%) Rating 81% and above A+ +71-80% A+61-70% A51-60% B50% or below C
43
Branch Manager
CREDIT RISK LIMITS:-
For managing credit risk, a bank generally sets an exposure credit
limit for each counter party to which it has credit exposure. This is standard
procedure in many contexts. It could be a corporate loan, individual loan or a
derivative dealer transacting with counterparties. All entail credit risk. All
are contexts wise credit exposure limits are used. A bank may also use
aggregate credit exposure limits. A bank might set credit exposure limits by
industry. It might also set a total exposure credit limit for all its corporate
lending activities. Exposures are calculated with the help of credit risk
models.
Depending on the assessment of the borrower (commercial as well as
retail) a credit exposure limit is decided for the customer, however, within
the framework of a total credit limit for the individual divisions and for the
company as a whole. Also within the limit as per RBI, i.e. not more than
20% of capital to individual borrower and not more than 40% of capital to a
group borrower.
Threshold limit is set depending on the:
Credit rating of the borrower
Past financial records
44
Willingness and ability to repay
Borrower’s future cash flow projections.
CREDIT RISK MODELLING:-
A credit risk model seeks to determine, directly or indirectly, the
answer to the following question: Given our past experience and our
assumptions about the future, what is the present value of a given loan or
fixed income security? A credit risk model would also seek to determine the
(quantifiable) risk that the promised cash flows will not be forthcoming. The
techniques for measuring credit risk that have evolved over the last twenty
years are prompted by these questions and dynamic changes in the loan
market.
The increasing importance of credit risk modeling should be seen as
the consequence of the following three factors:
Banks are becoming increasingly quantitative in their treatment of
credit risk.
New markets are emerging in credit derivatives and the marketability
of existing loans is increasing through securitization/ loan sales
market.
Regulators are concerned to improve the current system of bank
capital requirements especially as it relates to credit risk.
45
Credit Risk Models have assumed importance because they provide
the decision maker with insight or knowledge that would not otherwise be
readily available or that could be marshaled at prohibitive cost. In a
marketplace wise margins are fast disappearing and the pressure to lower
pricing is unrelenting, models give their users a competitive edge. The credit
risk models are intended to aid banks in quantifying, aggregating and
managing risk across geographical and product lines. The outputs of these
models also play increasingly important roles in banks’ risk management
and performance measurement processes, customer profitability analysis,
risk-based pricing, active portfolio management and capital structure
decisions. Credit risk modeling may result in better internal risk
management and may have the potential to be used in the supervisory
oversight of banking organizations.
In the measurement of credit risk, models may be classified along three
different dimensions: the techniques employed the domain of applications in
the credit process and the products to which they are applied.
Techniques: The following are the more commonly used techniques:
a. Econometric Techniques such as linear and multiple discriminate
analyses, multiple regression, logic analysis and probability of default,
etc.
b. Neural networks are computer-based systems that use the same data
employed in the econometric techniques but arrive at the decision
model using alternative implementations of a trial and error method.
46
c. Optimization models are mathematical programming techniques that
discover the optimum weights for borrower and loan attributes that
minimize lender error and maximise profits.
d. Rule-based or expert systems are characterised by a set of decision
rules, a knowledge base consisting of data such as industry financial
ratios, and a structured inquiry process to be used by the analyst in
obtaining the data on a particular borrower.
e. Hybrid Systems In these systems simulation are driven in part by a
direct causal relationship, the parameters of which are determined
through estimation techniques.
Domain of application: These models are used in a variety of domains:
a. Credit approval: Models are used on a standalone basis or in
conjunction with a judgmental override system for approving credit in
the consumer lending business. The use of such models has expanded
to include small business lending. They are generally not used in
approving large corporate loans, but they may be one of the inputs to a
decision.
b. Credit rating determination: Quantitative models are used in
deriving ‘shadow bond rating’ for unrated securities and commercial
loans. These ratings in turn influence portfolio limits and othis lending
limits used by the institution. In some instances, the credit rating
47
predicted by the model is used within an institution to challenge the
rating assigned by the traditional credit analysis process.
c. Credit risk models may be used to suggest the risk premier that
should be charged in view of the probability of loss and the size of the
loss given default. Using a mark-to-market model, an institution may
evaluate the costs and benefits of holding a financial asset.
Unexpected losses implied by a credit model may be used to set the
capital charge in pricing.
d. Early warning: Credit models are used to flag potential problems in
the portfolio to facilitate early corrective action.
e. Common credit language: Credit models may be used to select
assets from a pool to construct a portfolio acceptable to investors at
the time of asset securitisation or to achieve the minimum credit
quality needed to obtain the desired credit rating. Underwriters may
use such models for due diligence on the portfolio (such as a
collateralized pool of commercial loans).
f. Collection strategies: Credit models may be used in deciding on the
best collection or workout strategy to pursue. If, for example, a credit
model indicates that a borrower is experiencing short-term liquidity
problems rather than a decline in credit fundamentals, then an
appropriate workout may be devised.
g. Credit Risk Models: Approaches
The literature on quantitative risk modeling has two different
approaches to credit risk measurement. The first approach is the
development of statistical models through analysis of historical data. This
approach was frequently used in the last two decades. The second type of
48
modeling approach tries to capture distribution of the firm's asset-value over
a period of time.
The statistical approach tries to rate the firms on a discrete or
continuous scale. The linear model introduced by Altman (1967), also
known as the Z-score Model, separates defaulting firms from non-defaulting
ones on the basis of certain financial ratios. Altman, Hartzell, and Peck
(1995, 1996) have modified the original Z-score model to develop a model
specific to emerging markets. This model is known as the Emerging Market
Scoring (EMS) model.
The second type of modeling approach tries to capture distribution of
the firm's asset-value over a period of time. This model is based on the
expected default frequency (EDF) model. It calculates the asset value of a
firm from the market value of its equity using an option pricing based
approach that recognizes equity as a call option on the underlying asset of
the firm. It tries to estimate the asset value path of the firm over a time
horizon. The default risk is the probability of the estimated asset value
falling below a pre-specified default point. This model is based conceptually
on Merton's (1974) contingent claim framework and has been working very
well for estimating default risk in a liquid market.
Closely related to credit risk models are portfolio risk models. In the
last three years, important advances have been made in modeling credit risk
in lending portfolios. The new models are designed to quantify credit risk on
a portfolio basis, and thus are applied at the time of diversification as well as
portfolio based pricing. These models estimate the loss distribution
49
associated with the portfolio and identify the risky components by assessing
the risk contribution of each member in the portfolio.
Banks may adopt any model depending on their size, complexity, risk
bearing capacity and risk appetite, etc. However, the credit risk models
followed by banks should, at the least, achieve the following:
Result in differentiating the degree of credit risk in different credit
exposures of a bank. The system could provide for transaction-based
or borrower-based rating or both. It is recommended that all exposures
are to be rated. Restricting risk measurement to only large sized
exposures may fail to capture the portfolio risk in entirety for variety
of reasons. For instance, a large sized exposure for a short time may
be less risky than a small sized exposure for a long time
Identify concentration in the portfolios
Identify problem credits before they become NPAs
Identify adequacy/ inadequacy of loan provisions
Help in pricing of credit
Recognize variations in macro-economic factors and a possible impact
under alternative scenarios
Determine the impact on profitability of transactions and relationship.
RISK ADJUSTED RETURN ON CAPITAL (RAROC) :-
As it became clearer that banks needed to add an appropriate capital
charge in the pricing process, the concept of risk adjusting the return or risk
adjusting capital was born. RAROC is based on a market-to market concept.
50
As defined by Bankers Trust, RAROC allocates a capital charge to a
transaction or a line of business at an amount equal to the maximum
expected loss (at a 99 percent confidence level) over one year on an after-tax
basis. As may be expected, the highs volatility of the returns, the more the
capital allocated. The highest capital allocation means that the transaction
has to generate cash flows larger enough to offset the volatility of returns,
which results from the credit risk, material risk, and others risks taken.
The RAROC process estimates the asset value that may prevail in the worst
case scenario and then equates the capital cushion to be provided for the
potential loss.
These are four basic steps in this process:
Analyze the activity or product.
Determine the basic risk categories that it contains, for example,
interest rate (country, directional, basis, yield curve, optionality),
foreign exchange, equity, commodity, and credit.
Operating risks.
Quantify the risk in each category by a market proxy.
Using the historical price movements of the market proxy over the
past three years, compute a market risk factor, given by the following
equation:
51
RAROC risk factor = 2.33 * weekly volatility * square root of 52 *
(I – tax rate)
In this equation, the multiplier 2.33 gives the volatility (expressed as
per cent) at the 99 percent confidence level. The term 52 converts the
weekly price movement into an amount movement. The term (I – tax rate)
converts the calculated value to an after-tax basis.
Compute the rupee amount of capital required for each category by
multiplying the risk factor by the size of the position. Establishing the
maximum expected loss in each product line and linking the capital to this
loss makes it possible to compare products of different risk levels by stating
the risk side of the risk-reward equation in a consistent manner. The risk-to-
reward ratio becomes comparable.
The RAROC is an improvement over the traditional approach in that it
allows one to compare two businesses with different risk (volatility of
returns) profiles. Using a hurdle rate, a lender can also use the RAROC
principle to set the target pricing on a relationship or a transaction. Although
not all assets have market price distribution, RAROC is a first step towards
examining an institution’s entire balance heet on a mark-to-market basis if
only to understand the risk-return tradeoffs that have been made.
RISK MITIGANTS:-
52
Credit risk mitigation means reduction of credit risk in an exposure
by a safety net of tangible and realizable securities including third-party
approved guarantees/insurance.
Banks use a number of techniques to mitigate the credit risks to
which they are exposed.
Exposures may be collaterised by first priority claims, in whole
or in part with cash or securities, a loan exposure may be guaranteed by a
third-party, or a bank may buy a credit derivative to offset various forms of
credit risk.
Additionally banks may also net the loans owned to them against
deposits from the same counter-party.
The various credit risk mitigants laid down by Basel Committee are as
follows:
1. Collateral (tangible, marketable) securities
2. Guarantees
3. Credit derivatives
4. On-balance-sheet netting
The extent to which a particular credit risk mitigant helps depends
on the quantum of exposure, or the strength of the mitigant.
These are certain conditions to be met for the use of credit risk
mitigants, which are as follows:
All documentation used in collateralized transactions and for documenting
on-balance-heet netting, guarantees, and credit derivative must be binding on
all parties and must be legally enforceable in all relevant jurisdictions.
Banks must have properly reviewed all the documents and should have
appropriate legal opinions to verify such, and ensure its enforceability.
53
LOAN REVIEW MECHANISM / CREDIT AUDIT :-
Credit audit examines the compliance with extant sanction and
post-sanction processes and procedures laid down by the bank from time to
time. The objectives of credit audit are:
Improvement in the quality of credit portfolio,
Review of sanction process and compliance status of large loans,
Feedback on regulatory compliance,
Independent review of credit risk assessment,
Pick-up of early warning signals and suggest remedial measures, and
Recommend corrective actions to improve credit quality, credit
administration, and credit skills of staff.
CREDIT RISK MITIGANTS AS PER BASEL 2 ACCORD
Recommendations of BASEL II
The Basel II principles are intended to achieve an ongoing
improvement of risk management procedures in the loan business. The
regulatory treatment of credit risk mitigation has widely been acknowledged
as needing substantial updating. Basel establishes a framework for
54
recognizing the various mitigation techniques of collateral, netting,
guarantees and credit derivatives.
As per BASEL committee any valid ‘hedge’ should attract regulatory
capital relief. However, hedges are rarely perfect: this will generally be a
residual risk element, including an element of operational risk, which will
attract a regulatory capital charge.
The various credit risk mitigants laid down by Basel Committee are as
follows:
1. Collateral (tangible, marketable) securities
2. Guarantees
3. Credit derivative
4. On-balance-Sheet netting.
1. Collateral:-
A collateralised transaction is one in which banks have a credit
exposure or potential credit exposure in the form of loan of cash or
securities, securities posted as collateral or the exposure under the over-the
counter derivative contract, to a counter-party; and that credit exposure is
55
hedged in whole or in part by collateral posted by the counter-party or by a
third-party on behalf of the counter-party.
The following requirements must be met:
The collateral must be pledged for at least the life of exposure and it
must be marked to market and revalued with a minimum frequency of six
months.
The banks must have clear and robust procedures for the timely
liquidation of collateral.
Whise the custodian holds the collateral; banks must take reasonable
steps to ensure that the custodian segregates the collateral from its own
assets.
The various collateral instruments eligible for recognition are as
follows:
Cash on deposit with bank including certificates of deposit or
comparable instruments issued by the lending bank,
Gold,
Debt securities issued by sovereigns and public-sector enterprises that
are treated as sovereigns by the national supervisor,
And also debt securities listed on the recognized exchange, which are
issued by banks.
Equities.
Mutual funds.
56
The amount of credit exposure of the bank to the counter-party will
be reduced to the extent of market value of the collateral posted by the
counter-party.
2. Guarantees:-
A guarantee given on behalf of counter-party must represent a direct
claim on protection provider and must be explicitly referenced to specific
exposures. In the case of default on part of counter-party, the guarantor shall
be bound to pay the amount of credit exposure.
In order for a guarantee to be recognized, following must be satisfied:
On the qualifying default/non-payment of the counter-party, the bank
may in a timely manner pursue the guarantor for the credit
outstanding under the documentation governing the transaction.
The guarantee is explicitly documented obligation assumed by the
guarantor.
The guarantor covers all types of payments the underlying obligor is
expected to make under the documentation governing the transaction,
for example, notional amount, margin payments, etc.
Credit protection given by the following entities is recognized:
Sovereign entities, public-sector enterprises, banks and securities
firms, having risk weight lower than that of counter-party,
57
Othis entities like parent, subsidiary or affiliated companies, which
have risk weight lower than that of counter-party.
3. Credit derivative
Credit derivative is an instrument designed to segregate market
risk from credit risk and to allow the separate trading of credit risk. Credit
derivatives allow a more efficient allocation and pricing of credit risk. Credit
derivatives are privately negotiated bilateral contracts that allow users to
manage their exposure to credit risk.
For example, a bank concerned that one of its customers may not be able to
repay a loan can protect itself against loss by transferring the credit risk to
another party while keeping the loan on its books.
This mechanism can be used for any debt instrument or a basket of
instruments for which an objective default price can be determined.
Credit derivatives are traded over-the-counter (OTC) in developed
markets. OTC trades are contracts negotiated between counterparties that
take place outside the regulated exchanges. This permits maximum
flexibility in structuring a contract that meets the needs of both parties.
Types of Credit Derivative:-
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The product menu in the credit derivatives market is changing every
day, but these are four major instruments that make up the bulk of the
trading volume today:
Total Return Swaps
Credit Default Swap
Credit Spread Options and
Credit Linked Notes.
Terminology varies among market participants, sometimes based on
geography. For example, Credit Default Swaps are sometimes called Credit
Swaps.
Banks involved in swap derivatives can reduce risks by netting
agreements. Closeout netting is now a standard provision in the legal
documentation of the over-the-counter derivative contract.
Bilateral closeout netting agreements cover a set of ‘N’ derivatives
contracts between two parties. In case of default, counter-party cannot stop
payments on contracts that have negative value while demanding payment
on positively valued contracts.
Net loss in case of default is the positive sum of the market value of all the
contracts in the agreement:
Net loss = max (ÓVi, 0)
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i = 1 to N
In contrast without a netting agreement, the potential loss is the sum
of all positive value contracts.
On-balance heet netting will be fully recognized for the first time,
subject to the following operational conditions:
An enforceable legal agreement is in place;
All assets and liabilities subject to the netting agreement can be precisely
determined at any time;
Exposures are monitored and controlled on a net basis;
Roll-off risk is monitored and controlled; and
Assets and liabilities are maturity matched and hedges meet the minimum
1-year residual maturity requirement.
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CREDIT RISK MITIGANTS USED BY DIFFERENT BANKS:-
For decades mitigation of credit risk has been mainly achieved
through selecting and monitoring borrowers and through creating a well-
diversified loan portfolio. More recently, new financial instruments and risk
sharing markets have evolved, in particular, markets for credit derivatives
virtually exploded during the 1990s.
The Bank for International Settlements in its annual report said
that in the early 1990s, the market for credit-risk transfer from banks on to
the buyers of securities and loans involved a few billion dollars worth of
loans; by 2002, that figure had grown to more than $2 trillion.
The different mitigation techniques used by banks are as under:
1. Collateralization
2. Guarantees
3. Escrow account
4. Break trade laws
5. Insurance
6. Securitisation
7. Equator principle
8. Settlement through Clearing Corporation of India Limited (CCIL)
9. Netting
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1. COLLATERALISATION: -
Collateral is asset provided to secure an obligation.
Traditionally, banks might require corporate borrowers to commit company
assets as security for loans. Today, this practice is called secured lending or
asset-based lending. Collateral can take many forms: cash deposits, property,
equipment, receivables, oil reserves, marketable securities, bonds, national
saving certificates, etc. Collateral levels may be fixed or vary over time to
reflect the market value of the deal.
A more recent development is collateralization arrangements used to
secure repo securities lending and derivatives transactions. Under such
arrangement, a party who owes an obligation to another party posts
collateral—typically consisting of cash or securities—to secure the
obligation.
In the event that the party defaults on the obligation, the secured
party may seize the collateral. In this context, collateral is sometimes called
margin.
An arrangement can be unilateral with just one party posting
collateral. With two-sided obligations, such as a swap or foreign exchange
forward, bilateral collateralization may be used. In that situation, both parties
may post collateral for the value of their total obligation to the others.
Alternatively, the net obligation may be collateralized—at any point in time;
the party who is the net obligator posts collateral for the value of the net
obligation.
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In a typical collateral arrangement, the secured obligation is
periodically marked-to-market, and the collateral is adjusted to reflect
changes in value. The securing party posts additional collateral when the
market value has risen, or removes collateral when it has fallen.
The Collateral agreement may specify:-
Acceptable collateral.
Frequency of Margin calls.
Valuation.
Lien on Collateral.
Closeout & Termination clauses.
Types of Collateral –Amount of Collateral & Margin requirement:-
Sr. No.
Nature of Collateral Sub Nature of Collateral
Exposure against collateral (%)
Margin requirement (%)
1. Cash Deposits Same Currency 100% NILDifferent Currency
90% to 95% 10% to5%
2. Fixed Assets Plant & Machinery
75% to 80% 25% to 20%
Land & Building
70% to 80% 30% to 20%
Vehicle 70% to 75% 30% to 25%3. Fixed Deposits With Banks 80% to 85% 20% to 15%
National Saving Certificates
75% to 85% 25% to 15%
Government Bonds
80% 20%
4. Marketable Securities --- 50% 50%
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2. GUARANTEES:-
Banks take guarantee on behalf of their customer as a credit risk
mitigation technique. Guarantees of following entities are approved by the
banks:
Guarantees from this banks including central bank
Guarantees from government
Guarantees from parent/associate of that company having
stronger entity
Guarantees from the director/trustees of the company
Guarantees from inter-bank/ inter-branch
Guarantee from a third party
The conditions to be met, when issues of loans against guarantees are as
follows:
All the terms and conditions for a guarantee must be clearly
documented and made available to all parties involved in processing loans
Care should be taken while guarantees are time bound that the expiry
date of the guarantee does not pass without a new guarantee or an extension
of the old one is received.
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3. ESCROW ACCOUNT:-
Escrow account is one of the techniques used by the banks to recover
their repayment from the borrower, thiseby reducing their loan exposure.
Escrow account is an amount set aside to keep the money that is owed
by one party to another. Bank asks the borrower to open an escrow account
with the trustee bank for repayment in the event of default. Both the parties
decide when the money is to be transferred in the escrow account, depending
on that the borrower puts the money in such account and the escrow agent
pays the part of the money to the lending bank in charge of loan. Escrow
account is also maintained by the borrower to pay the lending bank at the
expiry of their loan contract. This technique enables bank to recover loan
from the escrow account.
4. BREAK TRADE LAWS:-
Banks use technique such as break trade laws/termination clause,
i.e. they have a mutual contract whereby they can exit from the trade in the
event of any type of default on the part of borrower.
5. INSURANCE :-
Banks lending against collateral, such as lending for housing
property, insure such property with the insurance company. Insurance
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enables banks to recover their loss in the case of uncertain event. Thus, an
insurance policy may provide for compensation in the event that a party
defaults.
6. SECURITISATION:-
The Securitization and Reconstruction of Financial Assets Act
enables bank and FIs to recover some of the amounts from the existing
NPAs.
Securitization involves the pooling or repackaging of asset (e.g. a
portfolio of loans or a group of accounts) for sale to an entity that then sells
securities backed by the assets to the investors. A service is retained by the
entity to service the loans or work the accounts, thus providing the entity
with the projected and necessary cash flow to pay back the investors within
the appropriate time frame. Banks package and sell large corporate loans to
the institutional and individual investors. Thus, securitization enables banks
to transfer its loan exposure to this entity. This is also one of the techniques
used by banks to reduce their loan exposure.
7. EQUATOR PRINCIPLE:-
The Equator Principles - a voluntary set of guidelines developed for
managing social and environmental issues related to the financing
development projects - apply only to projects which cost $50 million or
more, as those costing less represent only 3 per cent of the market.
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Banks adopting the Equator Principles undertake to provide loans
only to projects whose sponsors can demonstrate their ability and
willingness to comply with comprehensive processes aimed at ensuring that
projects are developed in a socially responsible manner and according to
sound environmental management practices.
Equator principle involves following steps:
The banks, to begin with, agree upon a common terminology in
categorizing projects into high, medium and low environmental and social
risk, based on the International Finance Corporation’s (IFC) categorization
process. They apply this to projects globally and to all industry sectors such
as mining, oil and gas and forestry, so as to ensure consistent approaches in
their dealings with high- and medium-risk projects.
Banks ask their customers to demonstrate in their environmental and
social reviews, and in their environmental and social management plans, the
extent to which they have met the applicable World IFC safeguard policies,
or to justify exceptions to them. This practice allows them to secure
information of the quality required for them to make judgments. And then
again, the banks insert into the loan documentation for high- and medium-
risk projects covenants for borrowers to comply with their environmental
and social management plans.
The Equator Principles enables banks to better assess, mitigate,
document and monitor the credit risk and reputation risk associated with
financing development projects.
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8. CLEARING CORPORATION OF INDIA LIMITED:-
Clearing Corporation of India Limited (CCIL) has been
promoted by leading banks and financial institutions (SBI, IDBI, LIC,
ICICI, Bank of Baroda and HDFC Bank) operating in India to address the
need for an integrated clearing and settlement system for debt and forex
transactions.
For participants in the forex market, CCIL's intermediation
provides a structure to mitigate, and manage, the risks associated with the
settlement of these high-value transactions. Since the foreign currency leg
has necessarily to be settled overseas while the rupee leg gets settled locally,
time-zone differences come into the picture, adding to the settlement risk.
Besides bringing tangible benefits in the form of improved efficiency and
easier reconciliation of accounts with their correspondent banks, CCIL's
intermediation in the settlement process brings the benefit of lower cost to
the participating banks.
CCIL at present guarantees settlement of trades of its members
concluded in the debt and forex market. The debt market trades are the ones
that are carried out on the NDS (Negotiated Dealing System) and come to
CCIL for settlement. The forex trades carried out by the dealers on their
respective trading system are sent to CCIL for settlement.
CCIL clears and settles trades of its members transacted on Reserve
Bank of India's NDS. The trades include normal outright trades, forward
outright trades, normal repo / reverse repo trades (other than RBI-repo) and
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forward repo / reverse repo trades for government securities and Treasury
Bills. The settlement of these trades is guaranteed by CCIL through a
process called novation whiseby CCIL becomes central counterparty for
each trade.
CCIL also clears and settles inter-bank forex trades in India. These
are initially rupee-based US dollar spot and forward trades, later cash and
trades would also get settled through CCIL. In future, CCIL also proposes to
handle trades in other currencies. The settlement of these trades will be
guaranteed by CCIL through the legal process called novation.
Collateralized borrowing and lending obligation (CBLO) trading
system
To expand the depth of the debt market in India, CCIL has provided a
trading platform to the market participants for undertaking collateralised
borrowing and lending by offering repoable securities and bonds as
collateral.
By providing the CBLO trading system, CCIL has achieved the following
objectives:
Facilitating easy liquidity in the repo market
Enhancing the depth of the market through wider participation
by corporate, MFs, trusts etc
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Providing non-bank entities suitable opportunities for short-term
investment (other than call money market)
Reducing the counter-party and default risk by ensuring suitable
settlement mechanism
Elimination of market inefficiency in short-term borrowing and
lending
Development of market-oriented short-term reference rate for
inter-bank transactions.
9. NETTING:-
Netting is one of the techniques considered by Basel 2 accord for
reduction of credit exposure to counterparties.
Netting means the occurrence of any or all of the followings:
1. The termination or acceleration of payment or delivery obligations or
entitlement under one or more qualified financial contracts entered into
under netting agreement;
2. the calculation or estimation of a closeout value, market value,
liquidation value, or replacement value in respect of each obligation or
entitlement terminated and/or accelerated;
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3. The conversion of any values calculated under (2) into a single
currency;
4. The offset of any values calculated under (2), as converted under (3);
Netting arrangement means:
Any agreement between two parties that provides for netting of present or
future payment or delivery obligations or entitlements arising under or in
connection with one or more qualified financial contracts entered into these
under by the parties to the agreement, and,
Any collateral arrangement related to one or more of the foregoing.
“Qualified financial contract” means any financial contract, including any
terms and conditions incorporated by reference in any such financial
contract, pursuant to which payment or delivery obligations that have a
market or an exchange price are due to be performed at a certain time or
within a certain period of time. Qualified financial contract include:
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A currency, cross-currency or interest rate swap agreement;
A basis swap agreement;
A spot, future, forward or this foreign exchange agreement;
A cap, collar or floor transaction;
A commodity swap;
A forward rate agreement;
A currency or interest rate future;
A currency or interest rate option
Equity derivatives;
Credit derivatives;
Spot, future, forward or others commodity contract;
A repurchase agreement;
An agreement to buy, sell, borrow or lend securities, such as a
securities lending transaction;
A title collateral arrangement;
An agreement to clear or settle securities transaction s or to act as
depository for securities;
Any agreement or contract designated as such by the Bank under this
Act
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NEW CAPITAL ACCORD: IMPLICATIONS FOR CREDIT
RISK MANAGEMENT
The Basel Committee on Banking Supervision had released in June
1999 the first Consultative Paper on a New Capital Adequacy Framework
with the intention of replacing the current broad-brush 1988 Accord. The
Basel Committee has released a Second Consultative Document in January
2001, which contains refined proposals for the three pillars of the New
Accord – Minimum Capital Requirements, Supervisory Review and Market
Discipline.
The Committee proposes two approaches, viz., Standardised and Internal
Rating Based (IRB) for estimating regulatory capital. Under the
standardised approach, the Committee desires to produce neither a net
increase nor a net decrease, on an average, in minimum regulatory capital,
even after accounting for operational risk. Under the IRB approach, the
Committee’s ultimate goals are to ensure that the overall level of regulatory
capital is sufficient to address the underlying credit risks and also provides
capital incentives relative to the standardised approach, i.e., a reduction in
the risk weighted assets of 2% to 3% (foundation IRB approach) and 90% of
the capital requirement under foundation approach for advanced IRB
approach to encourage banks to adopt IRB approach for providing capital.
The minimum capital adequacy ratio would continue to be 8% of the
risk-weighted assets, which cover capital requirements for market (trading
book), credit and operational risks. For credit risk, the range of options to
estimate capital extends to include a standardised, a foundation IRB and an
advanced IRB approaches.
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Standardized Approach
Under the standardized approach, preferential risk weights in the range
of 0%, 20%, 50%, 100% and 150% would be assigned on the basis of ratings
given by external credit assessment institutions.
Orientation of the IRB Approach
Banks’ internal measures of credit risk are based on assessments of the
risk characteristics of both the borrower and the specific type of transaction.
The probability of default (PD) of a borrower or group of borrowers is the
central measurable concept on which the IRB approach is built. The PD of a
borrower does not, however, provide the complete picture of the potential
credit loss. Banks should also seek to measure how much they will lose
should a borrower default on an obligation. This is contingent upon two
elements. First, the magnitude of likely loss on the exposure: this is termed
the Loss Given Default (LGD), and is expressed as a percentage of the
exposure. Secondly, the loss is contingent upon the amount to which the
bank was exposed to the borrower at the time of default, commonly
expressed as Exposure at Default (EAD). These three components (PD,
LGD, EAD) combine to provide a measure of expected intrinsic, or
economic, loss. The IRB approach also takes into account the maturity (M)
of exposures. Thus, the derivation of risk weights is dependent on estimates
of the PD, LGD and, in some cases, M, that are attached to an exposure.
These components (PD, LGD, EAD, M) form the basic inputs to the IRB
approach, and consequently the capital requirements derived from it.
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IRB Approach
The Committee proposes two approaches – foundation and advanced - as an
alternative to standardized approach for assigning preferential risk weights.
Under the foundation approach, banks, which comply with certain
minimum requirements viz. comprehensive credit rating system with
capability to quantify Probability of Default (PD) could assign preferential
risk weights, with the data on Loss Given Default (LGD) and Exposure at
Default (EAD) provided by the national supervisors. In order to qualify for
adopting the foundation approach, the internal credit rating system should
have the following parameters/conditions:
Each borrower within a portfolio must be assigned the rating before a
loan is originated.
Minimum of 6 to 9 borrower grades for performing loans and a
minimum of 2 grades for non-performing loans.
Meaningful distribution of exposure across grades and not more than
30% of the gross exposures in any one borrower grade.
Each individual rating assignment must be subject to an independent
review or approval by the Loan Review Department.
Rating must be updated at least on annual basis.
The Board of Directors must approve all material aspects of the rating
and PD estimation.
Internal and External audit must review annually, the banks’ rating
system including the quantification of internal ratings.
Banks should have individual credit risk control units that are
responsible for the design, implementation and performance of
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internal rating systems. These units should be functionally
independent.
Members of staff responsible for rating process should be adequately
qualified and trained.
Internal rating must be explicitly linked with the banks’ internal
assessment of capital adequacy in line with requirements of Pillar 2.
Banks must have in place sound stress testing process for the
assessment of capital adequacy.
Banks must have a credible track record in the use of internal ratings
at least for the last 3 years.
Banks must have robust systems in place to evaluate the accuracy and
consistency with regard to the system, processing and the estimation
of PDs.
Banks must disclose in greater detail the rating process, risk factors,
and validation etc. of the rating system.
Under the advanced approach, banks would be allowed to use their own
estimates of PD, LGD and EAD, which could be validated by the
supervisors. Under both the approaches, risk weights would be expressed as
a single continuous function of the PD, LGD and EAD. The IRB approach,
therefore, does not rely on supervisory determined risk buckets as in the case
of standardized approach. The Committee has proposed an
IRB approach for retail loan portfolio, having homogenous characteristics
distinct from that for the corporate portfolio. The Committee is also working
towards developing an appropriate IRB approach relating to project finance.
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The adoption of the New Accord, in the proposed format, requires
substantial up gradation of the existing credit risk management systems. The
New Accord also provided in-built capital incentives for banks, which are
equipped to adopt foundation or advanced IRB approach. Banks may,
therefore, upgrade the credit risk management systems for optimising
capital.
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Case Study
M/S SB MANDIES
M/S Quality Crafts Store Proprietor Mr. RAHIT SHARMA, N.M. Nagar, Kherwadi Road, established in the year 2006, is engaged in retail business of Local distribution of Goods. The party has been in connection with and dealing with the Saraswat Co-op. Bank, Ghatkopar branch since year 2008 with satisfactory dealings and good conduct. The turnover of account is encouraging. The party has established good trade connections and is involved in related trade. No negative complaints has been registered or found against the party ever since the opening of account with the bank branch. The amount is frequently routed through the account and the performance of account is good.
Borrower’s Information
Name of Applicant Borrower : Mr. AJAY KAWADE
Address of the Head/Regd. Office : Amrut Nagar, Kherwadi Road
Constitution : Individual
Date of Establishment : Year 2006
Period since dealing with branch : Year 2008
Net worth as on 31.10.2009 : Rs. 9.00 lacs
General Information of the Proposal
Existing Banking Arrangements : Sole Banking
Proposed Banking Arrangements : Sole Banking
Sanction Comes Under Powers of : Branch Head
Activity : Trading of Goods etc.
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Sector : Trading
Present Facilities by the Applicant : Nil
Facility Requested by the Applicant : Cash Credit
Purpose of Borrowing : For Expansion of Existing Business
Amount Requested : Rs. 5.00 Lacs.
Securities Proposed for the Facility:
Primary Security
Hypothecation of stocks and Book Debts
Collateral Security
Third Party Guarantee of two persons:
1. Mr. XYZ S/o Mr. XYZ
2. Mr XYZ S/o Mr. XYZ
Both the guarantors are dealing with the Saraswat Co-op. Bank Branches. As
reported both are availing cash credit facility with their respective branches
and with a satisfactory performance.
Financial Indicators has been calculated as follows:
a) Net Working Capital: Total Current Assets less Total Current
Liabilities.
b) Current Ratio: Total Current Assets divided by Total Current
Liabilities.
c) Stocking Velocity: Stock for the year divided by Cost of Goods Sold
or Credit Purchase during the year multiplied by 360 days.
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d) Debtors Velocity: Average Receivables or Debtors for the year
divided by Credit Sales during the year multiplied by 360 days.
e) Creditors Velocity: Average Payables or Creditors for the year
divided by Credit Purchase during the year multiplied by 360 days.
Financials of the Firm (Amt. in Rs. Lacs)
Particulars 31/03/2009 31/03/2010
Projected
Sales 7.12 19.00
Purchases 6.12 17.53
% of Sales Growth 325.00
Net Profit 1.42 2.23
Liabilities
Share Capital 2.64 3.30
Total Term Liabilities 2.64 3.30
Current Liabilities
Working Capital 1.00 8.00
Sundry Creditors 0.38 1.20
Expenses Payable 0.23 0.65
Borrowings 0.00 0.00
Other liabilities 0.00 0.00
Total Current Liabilities 1.61 9.85
Tolal Liabilities 4.25 13.15
Assets
Investments 0.00 0.00
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Fixed Assets 0.24 0.72
Total Fixed Assets 0.24 0.72
Current Assets
Stocks 2.24 8.50
Sundry Debtors 0.52 3.16
Cash in hand/Bank Balance 1.25 0.77
Loans/Advances 0.00 0.00
Total Current Assets 3.01 12.43
Total Assets 4.25 13.15
Financial Indicators
Particulars 31/03/2009 31/03/2010
Net Working Capital (In Rs. Lacs) 1.40 2.58
Current Ratio 1.86 1.26
Stocking Velocity ( Days) 108 175
Debtors Velocity (Days) 26.29 59.87
Creditors Velocity (Days) 22.35 24.64
Apart from the above financials of the party, the account statement reveals
the following transactions of the party with the Bank Branch (Amt. in Rs.
Lacs):
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Debit
Summation
Credit
Summation
From 01/04/2008 to 31/03/2009 (1
year)
6.52 6.50
From 01/04/2008 to 31/10/2009 (7
months)
11.62 11.10
Comments and Observations:
f) The party has projected to achieve a sales target of Rs. 19.00 Lacs
over previous year achievement of Rs. 7.12 Lacs. The projected sales
target seems to be achievable owing to the fact that up to 31/10/2008
(7 months) the party has a sales turnover of Rs. 11.62 lacs through the
account.
g) Stock Velocity reveals the part of sales always invested in stock
during the year or in other words it refers to the period of sales sans
obstacles out of the current stock in case the production halts due to
strike or other reason.
The stocking period of 175 days is on higher side hence its been
accepted at 90 days level.
h) Debtors Velocity reveals the duration within the debtors are expected
to be realized. The projected debtors’ period seems reasonable hence
accepted for assessment as projected.
i) Creditors Velocity reveals the duration within the creditors are
expected to be paid. Lesser the days better is the position of the firm.
The projected creditors velocity is at a lower level, keeping the kind
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of stocks in trade into consideration, the velocity has been accepted at
50 days level.
Assessment of MPBF (Amt. in Rs. Lacs)
Particulars Amount
Accepted Sales 19.00
Accepted Purchase 17.53
Current Assets
Stock (17.53*90÷360) 90 days 4.38
Debtors (19*60÷360 60 days 3.16
Cash in hand 0.54
Loans & advances 0.00
Total Current Assets (a) 8.08
Current Liabilities
Creditors (17.53*50÷360) 50 days 2.50
Other liabilities 0.00
Total Current liabilities (b) 2.50
Working Capital Gap (a-b) 5.58
Margin (as projected by the party) 2.58
MPBF 3.00
Recommendations of Bank Branch
In view of above, it is proposed, if agreed, to allow Cash Credit Facility of
Rs. 3 Lacs (Rupees three lacs only) in favor of M/S Quality Crafts Store
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Prop. Mr. Shah Alam Mateen for a period of one year subject to renewal
after review against securities as discussed.
Rate of Interest: PLR presently 13 % with monthly rests or any other rate.
This may be prescribed by the Bank from time to time.
Margin: 40% on Stocks 50% on Book-Debts (excluding book debts older
than 6 months).
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CONCLUSION
Banks are the major money lenders in today’s growing market. Banks
plays a very important role in today fast increasing economy. Private Banks
have increased competition in market and more and more banks want to
increase their business by giving larger amount of and more number of
loans. Every loan carries certain risk and when banks are giving loans on
such a large scale they need a perfect technique to minimize the risk and
decrease the percentage of NPA’s. Credit risk management provides that
technique to the bank to stay ahead in business. Credit Risk Management is
a part of banks day to day activity which is not going to end.
Credit risk arises from lending activity of a Bank. Credit risk also
arises from potential changes in the credit quality of a borrower. It has two
components: default risk and credit spread risk.
Credit risk measurement is based on Credit Rating. Credit rating of an
account is done with primary objective to determine whethis the account,
after the expiry of a given period, would remain a performing asset.
It must be noted that while the use of Credit Risk Management
techniques reduces or transfers credit risk, it simultaneously may increase
othis risks such as legal, operational, liquidity and market risk. This fore, it
is imperative that banks employ robust procedure and process to control
these risks as well. In fact, advantages of risk mitigation must be weighed
against the risks acquired and its integration with the bank’s overall risk
profile.
CREDIT RISK MANAGEMENT IS THE HEART OF TODAYS BANKS RISK TAKING
BUSINESS.
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BIBLOGRAPH
“Risk Management” by Macmillan.
“Bank Financial Management” by taxman.
Saraswat Bank manuals and circulars
www.Saraswatbank.com
www.google.co.in
www.rbi.org.in
www.wikipedia.org
www.investopedia.com
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