An Overview of Credit Risk Management practices A Bankers perspective

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An Overview of Credit Risk Management practices-
A Bankers perspective

• Ravindra Gadiyar
• Vice President (Risk)
• Axis Bank Ltd
• 17th May, 2009

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What do Banks do for their Customers ???

• Intermediation
• (Deposit Lending function)
• Payment Systems
• (Retail, Corporates, Govt business)
• Other financial services.
• (Off-balance sheet activities, Insurance,
  Trust services)
  
  
  

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Bank Goals and Constraints
Maximise Shareholder Wealth
Amount of Cash Flow
Timing of Cash Flow
Risk of Cash Flow
Constraints
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Risk ????

• Why Probability?
• Can we accurately predict the future?
• The future is uncertain.
• We can only predict with varying degrees of
  certainty the ability of various parties to
  honour their commitments.
• Even with borrowers which have the highest credit
  quality (eg. AAA rated corporates) there will
  always be some uncertainty, especially in a long
  term relationship.
• This uncertainty associated with timing amount
  of cash flows is the risk.
• The key strategy is to Identify, Measure, Monitor
  and Control the Risk.

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Why Manage Risks ??

• Increasing competition and technical progress
  have fundamentally changed the role of banks
• Banks are exposed to strong competitive pressures
  in selling their products and procuring capital,
  exposing them to risks which can significantly
  impact profitability.
• A banks ability to measure, monitor and mitigate
  risks comprehensively is important for its
  strategic positioning. It becomes a tool for
  offensive instead of defensive strategy.
• Risk Management is an important tool towards
  optimum use of capital for generating profits and
  hence a critical determinant of banks
  profitability.

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Key Banking Risks

• Credit Risk
• Credit risk is the risk or potential of loss that
  may occur due to failure of borrower/
  counterparty to meet the obligation on agreed
  terms and conditions of financial contract.
• Market risk
• Market Risk is a possibility of loss to a
  bank caused by changes in the market variables
  which are external to the portfolio such as,
  macro economic factors like inflation, GDP
  growth, interest rates etc.
• It is the risk of loss to future earnings,
  to fair values or to future cash flows
  that may result from changes in the price of
  financial instrument.
• Market risk arises on account of
• changes in interest rates
• changes in foreign currency exchange rates
• changes in commodity prices
• changes in equity prices
• liquidity risk

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• Operational Risk
• Risk of loss resulting from inadequate or
  failed internal processes, people and systems or
  from external events.
• Operational risks arise from variety of factors
  including
• failure to obtain proper internal authorizations
• improperly documented transactions
• failure of operational and information security
  procedures
• failure of computer systems, software or
  equipment
• inadequate training and employee errors
• Fraud

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Risk Grid-Institutional Players
Kindly note that these are conceptually arrived
numbers.
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THE BASEL-II CAPITAL ACCORD
Three Basic Pillars
Minimum Capital Requirements
Supervisory Review
Market Discipline
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Minimum Capital RequirementProvides for capital
calculations for Credit, Market and Operational
Risk
Standardized Approach
Internal Rating based Approach

• Supervisory Review
• To ensure that Banks follow rigorous processes
  and measure their risk exposures correctly.

• Market Discipline
• Disclosure norms of capital levels and risk
  exposures to help market participants to better
  assess the banks ability to remain solvent..

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Credit Risk
There is one big difference between selling a
credit product and selling soap. The sale of
money is not final, you expect it back with
interest.
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Credit Risk basics

• Credit risk is the risk of loss that may occur
  from failure of the counter-party to make
  payments.
• Reduction in the ability of counter-party to make
  payments.
• Credit risk could be on account of -
• Default risk
• Obligor cannot service debt obligations.
• Spread risk
• Because of changes in credit quality of the
  obligor.

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• Anyone who is uncomfortable in drilling
• holes in the middle of the North Sea probably
• does not belong to the oil exploration business.
• Likewise, anyone who is unprepared to take
• credit risk should not be a banker.

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Contributors to Credit Risk

• Credit Corporate assets.
• Retail assets.
• Non SLR portfolio
• Trading book and banking book.
• Inter bank transactions.
• Derivatives.
• Settlement, etc.

Liabilities of a Bank are very credit sensitive
as compared to that of a typical industrial
firm.
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Broad Principles of Credit Risk Management in
Banks

• Basel Committee on Banking Supervision has
  issued broad guidelines for best practices in
  credit risk management.
• Establishing an appropriate credit risk
  environment.
• Operating under a sound credit granting process.
• Maintaining an appropriate credit
  administration, risk measurement and monitoring
  process.
• Ensuring adequate controls over credit risk.
• Role of bank supervisors in ensuring that banks
  have a effective system in place to identify,
  measure, monitor and control credit risk.

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Important factors for Credit approval.

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Traditional approaches to Credit Risk Measurement

• Expert Systems (Your Credit analyst is best
  judge).
• Five Cs of Lending -
• Character, Capital, Capacity, Collateral and
  Cycle (economic conditions).
• Credit Rating Systems (Internal / External)
• Capture all relevant information about the
  borrower and assign a grade through a risk rating
  process.eg. CRISIL, ICRA rated Bonds / Debentures
  AAA, AA, A etc.
• Limits Systems
• Prudential norms for single borrower/ group,
  rating linked exposures, industry level caps,
  delegation of powers

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Some Quantitative techniques for Credit Risk
Measurement

• Credit scoring models (Altman Z Score model)
• Altman (1968) built a linear discriminant model
  based only on financial ratios, matched sample
  (by year, industry, size)
• Z 1.2 X1 1.4 X2 3.3 X3 0.6 X4 1.0 X5
• X1 working capital / total assets
• X2 retained earnings / total assets
• X3 earning before interest and taxes / total
  assets
• X4 market value of equity / book value of total
  liabilities
• X5 sales / total assets
• Most credit scoring models use a combination of
  financial and non-financial factors
• Financial Factors Non-financial Factors
• Debt service coverage Size
• Leverage Industry
• Profitability
• Liquidity
• Net worth

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Quantitative techniques for Credit Risk
Measurement contd
Corporate Credit Risk models based on Stock
Prices (KMV Model)

• Academic belief is that default is driven by
• market value of firms assets
• level of firms obligations (or liabilities)
• variability in future market value of assets
• As the market value of firms assets approaches
  book value of liabilities, the default risk of
  firm increases
• Default Point The threshold value of firms
  assets (somewhere between total liabilities
  current liabilities) at which the firm defaults
• Relevant Networth Mkt. Value of Assets -
  Default Pt.
• Default Relevant Networth 0

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Some Credit Risk jargons

• Expected Losses

Borrower Risk
Facility Risk Related
EXPECTED LOSS INR
Probability of Default (PD)
Loss Severity Given Default (Severity)
Loan Equivalent Exposure (Exposure) INR
x
x

What is the probability of the counterparty
defaulting?
If default occurs, how much of this do we expect
to lose?
If default occurs, how much exposure do we expect
to have?
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• Unexpected Losses
• This relates to the volatility of the
  expected losses over a period of time

Expected loss
Bank is required to keep Capital to absorb such
losses.
Frequency of default
Unexpected loss
Confidence interval (95, 99.9)
Amt of loss (Rs)
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Credit Rating Process

• Basic building block for any Credit Risk Mgmt
  model.
• Definition of rating
• Represents default probability.
• Role in sanction process
• Risk appetite, minimum rating criterion.
• Capital allocation, pricing.
• Role in monitoring
• Snap shot indicator of health of the asset.
• Should be linked to asset review process.
• Early warning system.

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Credit Ratings helps in..

• Analysis Reporting
• Portfolio Reporting (Reporting of risk exposures
  to Senior Management)
• Capture Asset quality migrations
• Product Pricing (Risk Return trade-offs)
• Capital Requirements.
• Administration
• Loan review /monitoring
• Trigger Actions (like planning exit strategy,
  reduction in exposures, credit enhancement)

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Internal Credit Risk Rating process
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• Portfolio management
• Scenario analysis
• Risk based exposure limits
• RAROC.

• Rating based pricing
• Default rate, recovery rate
• Expected loss charge, capital charge

Rating system
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But after all this, Institutions with best risk
management systems failed.!!!What went
wrong and learnings from these ???
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• Inherent quality of assets weak (Subprime
  borrowers).
• Complex transactions (multi-tiered securisation).
  
• Securitisation simply involves pooling of a set
  of credits or debt securities whose acquisition
  is financed by issuance of new debt securities.
• VaR measure as a risk metric for trading position
  (Assumption that assets can be sold or hedged
  quickly)
• UBS 2006 It had never had a loss that
  exceeded its daily VaR
• UBS 2007. It exceeded daily VaR by 29 times.
• UBS reported loss of 18.7 billion for year
  ended Dec07.
• Stress testing gtgtgt regulatory camouflage.

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Some afterthoughts .

• Effective management of funding liquidity,
  capital balance sheet ( contingency plans).
• Informative and responsive risk measurement
  management reporting and practices.
• Senior Mgmt role in understanding and acting on
  existing and emerging risks is extremely
  important.

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Case Study.

• Drivers of credit risk.
• Risk mitigation strategies.

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Thanks for your attention . . .