introduction to credit risk management project

7/28/2019 introduction to credit risk management project

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CHAPTER I : INTRODUCTION

Indian economy today is in the process of becoming a world classeconomy. The Indianbanking industry is making great advancement in terms of quality,quantity, expansion anddiversification and is keeping up with the updated technology, ability;stability and thrust of a financial system, where the commercial banksplay a very important role emphasize the need of a strong effectivecontrol system with extra concern for the risk involved in the business.

The risk arises due to uncertainties, which in turn arise due to changestaking place in theeconomic, social and political environment and lack of non-availability

of informationconcerning such changes.

Risk means uncertainty/possibility of loss. In the financial arena,enterprise risks can be broadly categorized as credit risk, market risk,operational risk, strategic risk, funding risk,political and legal risk. Credit risk is the possibility that a borrower orcounter party will fail to meet agreed obligations. Globally more than50% of total risk elements in banks andfinancial institutions are credit risk alone. In banks, losses stem fromoutright default due to

inability or unwillingness of customer or counter party to meetcommitments in relation tolending, trading, settlement and other financial transactions. Thusmanaging credit risk forefficient management of a financial institution or bank has graduallybecome the most crucial task and this is the motivation for thisresearch.

GLOBAL SCENARIO

The period 2007-2012 underwent financial crisis, also known as the

Global Financial Crisis(GFC), or the Great Recession, is considered by many economists tobe the worst financial crisis since the great depression of the1930sThis resulted in the collapse of large financial institutions, thebailout of banks by national Governments, and downturns in stockmarkets around the world. Even the housing market suffered, resultingin evictions, foreclosures and prolonged unemployment contributing tothe failure of key businesses, declines in consumer wealth estimated


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in trillions of US dollars, and a significant decline in the economicactivity, leading to a severe 2008-2012 global recessions.

The bursting of the U.S. housing bubble, which peaked in 2007, causedthe values ofsecurities tied to U.S. real estate pricing to plummet, damagingfinancial institutions globally. The financial crisis was triggered by acomplex interplay of valuation and liquidity problems in the UnitedStates banking system in 2008. Securities in stock markets sufferedlarge losses during the 2008 and early 2009. Economies worldwideslowed down during this period, as credit tightened and internationaltrade declined. This financial crisis ended by around late 2008 andmid-2009.

The current European sovereign debt crisis is an ongoing financialcrisis that has made it difficult or impossible for some countries in theeuro area to re-finance their Governmentdebt without the assistance of third parties. From late 2009, fears of asovereign debt crisisdeveloped among investors as a result of the rising Government debtlevels around the world together with a wave of downgrading ofGovernment debt in some European states. Concerns intensified inearly 2010 and thereafter, leading Europes finance ministers on 9 May2010 approved a rescue package worth 750 billion to ensure financial

stability across Europe creating the European financial stability facility(EFSF).In October 2011 and February 2012, the Euro zone leaders agreed onmore measuresdesigned to prevent the collapse of member economies.

M & As ON THE RISE

The banking and capital market is readily transforming itself withincreased competition and globalization. Investment banking hasbounced back because merger and acquisition (M&A) has gathered

momentum. Hedge fund activity and increase of M&A activity are themain characteristics of globalised banking. M&As are usuallyhorizontal in banking sector as it is the same business. Ex: The Bankof Tokyo-Mitsubishi UFJ, which became the worlds largest bank, bymerging with Mitsubishi Tokyo Financial Group Inc. and UFJ holdingsInc. It created the bank of Tokyo-Mitsubishi, worlds largest financialgroup by assets at around $1.6 trillion, leaving behind; the U.S. basedCitigroup Inks $1.55 trillion.


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FUNDS CONTINUE TO FLOW TO EMERGING COUNTRIES

Emerging market continues to bring in more funds in the bankingsector. Lending toemerging markets rose. More and more funds continue to flow in theemerging markets like Latin American countries. Hedge fund activityhas also increased over time.

DOMESTIC SCENARIO

Indian banking industry has evolved over a long period of more than

two centuries. Despite the recent growth of private banks, the sector isdominated by Government-controlled banks that hold nearly three-fourths of total banks assets. Indian banking industry is considered tobe very stable with healthy balance sheets and low exposure to riskyassets. The global financial crises have not affected the Indian bankssignificantly. Internet, wireless technology and global straight-throughprocessing have created a paradigm shift in the banking industry. Thegrowing market is attracting more and more banks into the Indianterritories. In India, the most significant achievement of the financialsector reforms is the improvement in the financial health ofcommercial banks in terms of capital adequacy, profitability and asset

quality as well as greater attention to risk management. Later on, afteradopting the policy of deregulation, it opened the new opportunities forthe banks to increase revenues by diversifying into investmentbanking, insurance, credit cards, depository services, mortgagefinancing, securitization, etc. As now banks benchmark themselvesagainst global standards, they have increased the disclosures andtransparency in bank balance sheets, the banks also started focusingmore on corporate governance.


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1.1 About the study

Human beings have tried to manage risks faced in their everyday life.Keeping inflammable material away from fire, saving for possiblefuture needs, creation of a legal will are all examples of attempts atmanaging risk. Risk is the possibility of the actual outcome beingdifferent from the expected outcome. It includes both the downsideand upside potential. Downside potential is the possibility of the actualresults being adverse compared to the expected results. On the otherhand, upside potential is the possibility of the actual results beingbetter than the expected results.

1.1.1 Risk Management

Risk is derived from the Italian word Risicare meaning to dare. Risk isthe probability of the unexpected happening the probability ofsuffering a loss. Risk provides the basis for opportunity. The term riskand exposure have subtle differences in their meaning. Risk refers tothe probability of loss, while exposure is the possibility of loss althoughthey are often used interchangeably. Risk arises as a result ofexposure.


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Exposure to financial markets affects most organizations , eitherdirectly or indirectly. Financial markets help companies to gain, alsoexpose them to the possibility of loss. However, financial markets givestrategic benefits to the companies. Risk is the probable variability ofreturns. Since it is not always possible or desirable to eliminate risk,

understanding it is an important step in determining how to manage it.Identifying exposures and risks forms the basis for an appropriatefinancial risk management strategy.Financial risk arises through countless transactions of a financialnature, including sales and purchases, investments and loans, andvarious other business activities. When financial prices changedramatically, it can increase costs, reduce revenues, or otherwiseadversely impact the profitability of an organisation. Financialfluctuations make it more difficult to plan and budget, price goods andservices and allocate capital.

There are three main sources of financial risk:

Financial risks arising from an organisations exposure tochanges in marketprices, such as interest rates, exchange rates, and commodity

prices.

Financial risks arising from the actions of, and transactions with,other organizations such as vendors, customers, andcounterparties in derivatives transactions.

Financial risks resulting from internal actions or failures of theorganisation,

particularly people, processes and systems.

Financial risk management is a process to deal with uncertaintiesresulting from financial markets. It involves assessing the financialrisks facing an organization and developing management strategiesconsistent with internal priorities and policies. Addressing financialrisks proactively may provide an organisation with a competitiveadvantage. Organisations manage financial risk using a variety ofstrategies and products. It is important to understand how theseproducts and strategies work to reduce risk within the context of theorganizations risk tolerance and objectives.

1.1.2 Risk Management Process

The word process connotes a continuing activity or function towardsa particular result. The process is the vehicle to implement anorganizations risk principles and policies, aided by organizationalstructure. In general, the process can be summarized as follows:


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Risk identification.

Risk measurement.

Risk monitoring.

Risk control.

Risk management needs to be looked at as an organizationalapproach, as management of risks independently cannot have thedesired effect over the long term. This is especially necessary as risksresult from various activities in the firm and the personnel responsiblefor the activities do not always understand the risk attached to them.The steps in risk management process are as below:

Determining objectives: Determination of objectives is thefirst step and can be for protecting profits, or to developcompetitive advantage. The objectives are to be decided by themanagement and the risk manager will fulfill his responsibilities

in accordance with the objectives.

Identifying risks: Every organization faces risks, based on itseconomic, political, social and business factors, the features ofthe industry it operates in and other innumerable factors.

Risk evaluation: Once the risks are identified, they need to beevaluated for ascertaining their significance. The significance ofa particular risk depends On the size of the loss that it mayresult in, and the probability of the occurrence of such loss. Onthe basis of these factors, the various risks faced by thecorporate need to be classified as critical risks, important risksand not-so-important risks. Critical risks are those that mayresult in the bankruptcy of the firm. Important risks are thosewhich may not result in bankruptcy, but may cause severefinancial distress.

Development of policy: Risk management policy is developedbased on the risk tolerance level of the firm. For the policy to berelatively stable, the time frame should be long enough. Policydeclares how much risk to take.

Development of strategy: Policy dictates the riskmanagement strategy of the firm. Strategy specifies the natureof risk to be managed, timing, tools, techniques and instrumentsthat can be used to manage these risks. Strategy also deals withtax and legal problems and whether the company would makeprofits or stick to covering existing risks.


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Implementation: This is the operational part of riskmanagement. It includes finding the best deal in case of risktransfer, providing for contingencies in case of risk retention,designing and implementing risk control programs etc.

Review: The function of risk management needs to be reviewedperiodical depending on the costs involved. The factors thataffect risk management keeps changing, thus necessitating theneed to monitor the effectiveness of the decisions takenpreviously.

1.1.3 Financial Risk Management

Broadly speaking, risk management can be defined as a discipline forliving with the possibility that future events may cause adverseeffects. In the context of risk management in financial institutions

such as banks or insurance companies these adverse effects usuallycorrespond to large losses on a portfolio of assets. Specific examplesinclude: losses on a portfolio of market-traded securities such as stocksand bonds due to falling market prices (a so-called market risk event);losses on a pool of bonds or loans, caused by the default of someissuers or borrowers (credit risk); losses on a portfolio of insurancecontracts due to the occurrence of large claims (insurance orunderwriting risk). An additional risk category is operational risk, whichincludes losses resulting from inadequate or failed internal processes,fraud or litigation.In financial markets, there is in general no so-called free lunch or, in

other words, no profit without risk. This is the reason why financialinstitutions actively take on risks. The role of financial riskmanagement is to measure and manage these risks. Hence riskmanagement can be seen as a core competence of an insurancecompany or a bank: by using its expertise and its capital, a financialinstitution can take on risks and manage them by various techniquessuch as diversification, hedging, or repackaging risks, and transferringthem back to markets, etc.

TYPES OF RISKS

Risk faced by the bank can be segmented into three separable typesfrom the management perspective viz.

Risks that can be eliminated or avoided by simple businesspractices .


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Risks that can be transferred to other business participants (e.g.:insurancepolicy) and,

Risks that can be actively managed at the Bank level.

Risk is any real or potential event, action or omission, internal orexternal, which will have an adverse impact on the achievement ofbanks defined objectives. Risk is inherent in every business. Riskcannot be totally eliminated but is to be managed. Risks are to becategorized as high risk, medium risk and low risk and managed.Risks can be classified into three categories:

Credit risk

Market risk (interest rate risk, liquidity risk)

Operational risk

1.1.4.1 CREDIT RISK

Credit risk is the possibility of loss from a credit transaction. In abanks portfolio, losses stem from outright default due to inability orunwillingness of a customer or counterparty to meet commitments inrelation to lending trading, settlement and other financialtransactions. Credit risk emanates from banks dealings withindividuals, corporate, bank, financial institution or a sovereign. Creditrisk includes the following :Credit growth in the organization and composition of the credit folio interms of sectors, centers, and size of borrowing activities so as toassess the extent of credit concentration.

Credit quality in terms of standard, sub-standard, doubtful andloss-

making assets.

Extent of the provisions made towards poor quality credits.

Volume of off-balance-sheet exposures having a bearing on thecreditportfolio.

1.1.4.2 MARKET RISK

Market risk is the possibility of loss to a bank caused by changes in themarket variables. Market risk is the risk to the banks earnings andcapital due to changes in the market level of interest rates or prices ofsecurities, foreign exchange and equities, as well as the volatilities ofthose prices. Segments of market risk .


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Liquidity risk: Liquidity risk is the potential inability to meet thebanks liabilities as they become due. It arises when the banksare unable to generate cash to cope with a decline in deposits orincrease in assets. It originates from the mismatches of thematurity pattern of assets and liabilities.

Interest rate risk: Interest rate risk is the risk where changesin market interest rates might adversely affect a banks financialcondition. The immediate impact of changes in interest rates ison the net interest income.

Foreign exchange risk: Foreign exchange risk may be definedas the risk that a bank may suffer losses as a result of adverseexchange rate movements during a period in which it has anopen position, either spot or forward, or a combination of thetwo, in an individual foreign currency.

1.1.4.3 OPERATIONAL RISK

Operational risk is the risk of direct or indirect loss resulting frominadequate or failed internal processes, people, and systems or fromexternal events. Internal processes include activities relating toaccounting, reporting, operations, tax, legal, compliance, andpersonnel management etc.

Broadly the following can be grouped under operational risk:

Internal fraud

External fraud

Non adherence of systems and procedures

Poor documentation

Business disruption due to computer systems failure

Lack of succession planning

Failure of customer due diligence

1.2 OBJECTIVES

To study the credit risk faced by State Bank Of HyderabadBank.

To analyze the process of credit risk management and thepractices followed in State Bank of Hyderabad.

To analyze methods used by State Bank Of Hyderabad Bank tomitigate their risks.

To suggest ways to improve the credit risk management systemin State Bank of Hyderabad.


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1.3 RESEARCH METHODOLOGY

RESEARCH DESIGN :

This is a descriptive research explaining what the banks (State Bank

of Hyderabad) credit risk management practices are. An analysis isdone to understand their credit risk management status and suggestways to improve the same.

DATA COLLECTION METHODS AND SOURCES

This research is based on secondary data as primary data isconfidential to banks and is not available. The secondary data isderived from RBI website and various other related websites andbooks. The secondary data comprises of understanding credit riskmanagement as a subject and its parameters. These parameters

comprise of the various guidelines framed by RBI for all banks forbetter credit risk management.

3.3 SAMPLING TECHNIQUES

No sampling technique used.

TOOLS OF ANALYSISMS Excel 2007.

1.4 PROBLEM STATEMENT

To analyze the credit risk management practices of State BankOf Hyderabad Bank and suggest ways to improve them.

1.5 NEED AND SCOPE OF STUDY

NEEDIn the fast changing world, banks are continuously exposed to hugecredit risk which are due to the activities of the bank such as loans(constitute nearly 65% of the total assets of the scheduled commercialbanks in India at the end of any normal financial year), investment in

non-SLR instruments (7-9% of total assets at the end of any normalfinancial year), off balance sheet activities/items (6-7% of total assetsat the end of any normal financial year), CRR and SLR locks up 25-30%of banks cash. Change in political, social and market factors also havegreat impact on credits owned/owed by banks. Credit risk is the mainrisk faced by banks at any point in time. Hence it is important toconcentrate on the credit risk management of banks.


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SCOPE OF STUDY

Theoretical scope limited to analyzing the banks BASEL II disclosures,policydocuments and various documents on credit risk management.

1.6 LIMITATIONS OF STUDY

It is limited to State Bank Of Hyderabad Bank

It is based on documents availability.

Credit risk data is confidential to banks; hence primary dataavailability is

difficult.

It is based on data available in internet, books and researchpapers.


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LIRERATURE REVIEW :

Article 1

Title: Risk management in banks, 2003

Author: R. S. RaghavanAbout the Research:The author talks about the meaning of risk and the need for risk andrisk management initially. Different types of risks and losses as definedby RBI guidelines are explained in detail. It also measures each type ofrisk by using VaR (Value at risk) or worst case type analytical model todetermine both expected and unexpected losses. It also speaks aboutthe minimum capital requirement as per RBI guidelines. Credit risk andtools for management of credit risk is explained in detail. It is said thatcredit risk is measured through probability of default (POD), loss givendefault (LGD) and also through credit quality over time. Credit risk

management system should ideally show a single number to show howmuch a bank can lose on credit portfolio and how much capital theyought to hold. Market risk, tools to assess market risk and causes ofmarket risk are explained in detail. Operational, regulatory andenvironmental risks are also explained. The 1988 BASEL capital accordand its features are explained. Capital adequacy and measurement ofthe same is explained in detail. It is said that India has a long way togo before they comprehend and implement BASEL II norms.Article 2Title: An Empirical Analysis and Comparative Study of Credit RiskRatios between

Public and Private Sector Commercial Banks in India, 2011Author: Somanadevi Thiagarajan (Ph.D. Scholar, ManagementSciences, AnnaUniversity of Technology, Coimbatore, India Lecturer (on leave) FacultyofManagement, University of Belize, Belize), A. Ramachandran (Director,SNRInstitute of Management Sciences, SNR sons college, Coimbatore,India)About the Research:In this article, a study was carried out to measure the credit risk

component of the Indian Scheduled Commercial Banking Sector byusing data of ten years (2001-2010). It illustrates how credit risk ratioscan be used to measure the credit risk in the banking sector. Theresults of the study indicate a consistent increase in the total loans tototal assets ratio and the total loans to total deposits ratio for bothpublic and private sector during the period of study. There was agradual decrease in the ratio of nonperforming loans to total loans forboth public and private sector banks from 2001 to 2008 but there has


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been a gradual increase from 2009 to 2010 and this is significantlyhigher for private sector banks as compared to public sector banks.Also the study indicates a significantly drastic increase in the totalloans to total equity ratio in the public sector banks in the last fouryears. It also indicates that banks can have their own risk management

practices but has to be appropriately disclosed.Article 3Title: Risk management in Indian banks: Some emerging issues, 2010Author: Dr. Krishn A. Goyal, Convener & Head, ManagementDepartment, BhupalNobles (P.G.) College, Udaipur, Prof. Sunita Agrawal, Director, PacificBusinessSchool, Udaipur (Raj.)About the Research:The article speaks about the various types of risks the banks face inthe current scenario. It speaks about the need for risk management

and the process of risk management. The tools required for risk controlsuch as diversification of business, insurance and hedging, fixation ofexposure ceiling, and transfer of risk to another party on time, andsecuritisation and reconstruction are also mentioned. It also talksabout the structure of BASEL II. Capital ratio is defined as,

This is minimum capital requirement for banks to manage credit risk.It also talks about the implementation challenges faced by Indianbanks in light of risk management, such as implementation of new

framework which requires substantial resources, increase in capitalrequirements due to new norms, data intensiveness of riskmanagement, building models and forecasting, and trained and skilledmanpower.Article 4Title: BASEL II implementation retail credit risk mitigation, Banks andBankSystems, Volume 3, Issue 2, 2008Author: Marek Dohnal (Czech Republic)About the research:It introduces credit risk mitigation (CRM) as the methodology for the

recognition of collateral for retail lending which is BASEL II compliant.CRM technique reduces credit risk associated with an exposure orexposures which the credit institution continues to hold. CRM can beapplied in two approaches that BASEL II offers for the retail segment:standardized approach and internal rating based approach. The riskcomponents include measures of the probability of default (PD), lossgiven default (LGD), and the exposure at default (EAD) and serves as


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inputs to risk weight functions that have been developed for separateasset classes.Article 5Title: Credit as well as credit risk management in banks, February 2005Author: R S Raghavan

About the Research:Lending methods adopted by banks is a combination of turnovermethod, cash flow method, cash budget method, projected balancesheet method, net owned fund methodand the popular one-size fits all second method of lending. Creditmonitoring is an important function of credit management. Creditdepartment should be expertise oriented. Credit risk componentsinclude quantity and quality of risk. Exposure ceilings, review/renewal,risk rating model, risk based scientific pricing, portfolio management,credit audit/loan review mechanism are the tools of credit riskmanagement.

It concludes that banks should lend according to their risk appetitewithin the need based assessment of the credit requirement of theborrower. An ideal credit risk management system should show asingle number as to how much the bank would lose on credit portfolioand how much capital it ought to hold.Article 6Title: Real-time FX credit risk management: a sell-side challenge, June2007Author: A Client Knowledge insight paperAbout the research:The market practice for FX credit risk management varies widely.

Existent pre-trade checks are not always based on real timecalculation. It is most widely based only on settlement risk and thenthe post-trade market to market generally against the previousdays closing. Possession of legacy credit risk management systemsthat would require replacement in preference for newer systems thatcould accommodate multi-asset class risk assessment as well as fasterpre-deal checks based on real time calculations is emphasized for.Developing a front office credit solution that improves areas notedabove would be desirable but need to be addressed only afteraddressing the core credit system revision.

Article 7Title: BASEL II implementation retail credit risk mitigation, Banks andBankSystems, Volume 3, Issue 2, 2008Author: Marek Dohnal (Czech Republic)About the research:It introduces credit risk mitigation (CRM) as the methodology for therecognition of collateral for retail lending which is BASEL II compliant.


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CRM technique reduces credit risk associated with an exposure orexposures which the credit institution continues to hold. CRM can beapplied in two approaches that BASEL II offers for the retail segment:standardized approach and internal rating based approach. The riskcomponents include measures of the probability of default (PD), loss

given default (LGD), and the exposure at default (EAD) and serves asinputs to risk weight functions that have been developed for separateasset classes.

CONCLUSION

The above literature review helps us understand the basic definitionsof risk, credit risk, market risk, operational risk, risk management,credit risk management, credit risk mitigation, forex risk, probability ofdefault, loss given default, and exposure at default etc.The study clearly defines the need for credit risk management,

compliance with BASEL II norms, tools for credit monitoring, need forsafeguarding soft information, methods used for credit riskmanagement, and responsibilities of credit risk managementcommittee. It can be concluded that credit risk management is veryimportant in the fast growing world. Compliance with BASEL II helps inbetter policies and easier credit risk mitigation by bank.


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introduction to credit risk management project

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