CHAPTER 1.

INTRODUCTION OF BANKING SYSTEM

DEFINITION OF BANK:A financial institution that is licensed to deal with money and its substitutes by accepting time and demand deposits, making loans, and investing in securities. The bank generates profits from the difference in the interest rates charged and paid.

BANKING STRUCTURE IN INDIA:Todays dynamic world banks are inevitable for the development of a country. Banks play a pivotal role in enhancing each and every sector. They have helped bring a draw of development on the worlds horizon and developing country like India is no exception. Banks fulfills the role of a financial intermediary. This means that it acts as a vehicle for moving finance from those who have surplus money to (however temporarily) those who have deficit. In everyday branch terms the banks channel funds from depositors whose accounts are in credit to borrowers who are in debit. Without the intermediary of the banks both their depositors and their borrowers would have to contact each other directly. This can and does happen of course. This is what has lead to the very foundation of financial institution like banks. Before few decades there existed some influential people who used to land money. But a substantially high rate of interest was charged which made borrowing of money out of the reach of the majority of the people so there arose a need for a financial intermediate.

INDIAN BANKING SYSTEM:-

Reserve Bank of India

Schedule Banks

Non-Schedule Banks

State co-op Banks

Commercial Banks

Central co-op Banks and Primary Cr. Societies

Commercial Banks

Indian

Foreign

Public Sector Banks

Private Sector Banks

HDFC, ICICI etc.

State Bank of India and its Subsidiaries

Other Nationalized Banks

Regional Rural Banks

BROAD CLASSIFICATION OF BANKS IN INDIA:-

(1) The RBI: The RBI is the supreme monetary and banking authority in the country and has the responsibility to control the banking system in the country. It keeps the reserves of all scheduled banks and hence is known as the Reserve Bank. (2) Public Sector Banks: State Bank of India and its Associates (8) Nationalized Banks (19) Regional Rural Banks Sponsored by Public Sector Banks (196) (3) Private Sector Banks: Old Generation Private Banks (22) Foreign New Generation Private Banks (8) Banks in India (40) (4) Co-operative Sector Banks: State Co-operative Banks Central Co-operative Banks Primary Agricultural Credit Societies Land Development Banks State Land Development Banks (5) Development Banks: Development Banks mostly provide long term finance for setting up industries. They also provide short-term finance (for export and import activities) Industrial Finance Co-operation of India (IFCI) Industrial Development of India (IDBI)

 Industrial Investment Bank of India (IIBI) Small Industries Development Bank of India (SIDBI) National Bank for Agriculture and Rural Development (NABARD) Export-Import Bank of India

ROLE OF THE BANKS:-

Banks play a positive role in economic development of a country as repositories of communitys savings and as purveyors of credit. Indian Banking has aided the economic development during the last fifty years in an effective way. The banking sector has shown a remarkable responsiveness to the needs of planned economy. It has brought about a considerable progress in its efforts at deposit mobilization and has taken a number of measures in the recent past for accelerating the rate of growth of deposits. As recourse to this, the commercial banks opened branches in urban, semi-urban and rural areas and have introduced a number of attractive schemes to foster economic development. The activities of commercial banking have growth in multi-directional ways as well as multi-dimensional manner. Banks have been playing a catalytic role in area development, backward area development, extended assistance to rural development all along helping agriculture, industry, international trade in a significant manner. In a way, commercial banks have emerged as key financial agencies for rapid economic development. By pooling the savings together, banks can make available funds to specialized institutions which finance different sectors of the economy, needing capital for various purposes, risks and durations. By contributing to government securities, bonds and debentures of term-lending institutions in the fields of agriculture,

industries and now housing, banks are also providing these institutions with an access to the common pool of savings mobilized by them, to that extent relieving them of the responsibility of directly approaching the saver. This intermediation role of banks is particularly important in the early stages of economic development and financial specification. A country like India, with different regions at different stages of development, presents an interesting spectrum of the evolving role of banks, in the matter of inter-mediation and beyond. Mobilization of resources forms an integral part of the development process in India. In this process of mobilization, banks are at a great advantage, chiefly because of their network of branches in the country. And banks have to place considerable reliance on the mobilization of deposits from the public to finance development programmes. Further, deposit mobilization by banks in India acquired greater significance in their new role in economic development. Commercial banks provide short-term and medium-term financial assistance. The short-term credit facilities are granted for working capital requirements. The medium-term loans are for the acquisition of land, construction of factory premises and purchase of machinery and equipment. These loans are generally granted for periods ranging from five to seven years. They also establish letters of credit on behalf of their clients favoring suppliers of raw materials/machinery (both Indian and foreign) which extend the bankers assurance for payment and thus help their delivery. Certain transaction, particularly those in contracts of sale of Government Departments, may require guarantees being issued in lieu of security earnest money deposits for release of advance money, supply of raw materials for processing, full payment of bills on the assurance of the performance etc. Commercial banks issue such guarantees also.

CHAPTER 2. INTRODUCTION OF RISK MANAGEMENT

OBJECTIVES To study broad outline of management of credit, market and operational risks associated with banking sector . Though the risk management area is very wide and elaborated, still the project covers whole subject in concise manner. The study aims at learning the techniques involved to manage the various types of risks, various methodologies undertaken. The application of the techniques involves us to gain an insight into the following aspects: An overview of the risks in general. An insight of the various credit, market and operational risks attached to the banking sector The methodology related to the management of operational risk followed at PNB. Tools applied in for measurement and management of various types of risks. Having an insight into the practical aspects of the working of various departments.

INTRODUCTION The significant transformation of the banking industry in India is clearly evident from the changes that have occurred in the financial markets, institutions and products. While deregulation has opened up new vistas for banks to argument revenues, it has entailed greater competition and consequently greater risks. Crossborder flows and entry of new products, particularly derivative instruments, have impacted significantly on the domestic banking sector forcing banks to adjust the product mix, as also to effect rapid changes in their processes and operations in order to remain competitive to the globalized environment. These developments have facilitated greater choice for consumers, who have become more discerning and demanding compelling banks to offer a broader range of products through diverse distribution channels. The traditional face of banks as mere financial intermediaries has since altered and risk management has emerged as their defining attribute. Currently, the most important factor shaping the world is globalization. The benefits of globalization have been well documented and are being increasingly recognized. Integration of domestic markets with international financial markets has been facilitated by tremendous advancement in information and

communications technology. But, such an environment has also meant that a problem in one country can sometimes adversely impact one or more countries instantaneously, even if they are fundamentally strong. There is a growing realization that the ability of countries to conduct business across national borders and the ability to cope with the possible downside risks would depend, interalia, on the soundness of the financial system. This has consequently meant the adoption of a strong and transparent, prudential,

regulatory, supervisory, technological and institutional framework in the financial sector on par with international best practices. All this necessitates a transformation: a transformation in the mindset, a transformation in the business processes and finally, a transformation in knowledge management. This process is not a one shot affair; it needs to be appropriately phased in the least disruptive manner. The banking and financial crises in recent years in emerging economies have demonstrated that, when things go wrong with the financial system, they can result in a severe economic downturn. Furthermore, banking crises often impose substantial costs on the exchequer, the incidence of which is ultimately borne by the taxpayer. The World Bank Annual Report (2002) has observed that the loss of US $1 trillion in banking crisis in the 1980s and 1990s is equal to the total flow of official development assistance to developing countries from 1950s to the present date. As a consequence, the focus of financial market reform in many emerging economies has been towards increasing efficiency while at the same time ensuring stability in financial markets. From this perspective, financial sector reforms are essential in order to avoid such costs. It is, therefore, not surprising that financial market reform is at the forefront of public policy debate in recent years. The crucial role of sound financial markets in promoting rapid economic growth and ensuring financial stability. Financial sector reform, through the development of an efficient financial system, is thus perceived as a key element in raising countries out of their 'low level equilibrium trap'. As the World Bank Annual Report (2002) observes, a robust financial system is a precondition for a sound investment climate, growth and the reduction of poverty .

Financial sector reforms were initiated in India a decade ago with a view to improving efficiency in the process of financial intermediation, enhancing the effectiveness in the conduct of monetary policy and creating conditions for integration of the domestic financial sector with the global system. The first phase of reforms was guided by the recommendations of Narasimham Committee.

The approach was to ensure that the financial services industry operates on the basis of operational flexibility and functional autonomy with a view to enhancing efficiency, productivity and profitability'.

The second phase, guided by Narasimham Committee II, focused on strengthening the foundations of the banking system and bringing about structural improvements. Further intensive discussions are held on important issues related to corporate governance, reform of the capital structure, (in the context of Basel II norms), retail banking, risk management technology, and human resources development, among others. Since 1992, significant changes have been introduced in the Indian financial

system. These changes have infused an element of competition in the financial system, marking the gradual end of financial repression characterized by price and non-price controls in the process of financial intermediation. While financial markets have been fairly developed, there still remains a large extent of segmentation of markets and non-level playing field among participants, which contribute to volatility in asset prices. This volatility is exacerbated by the lack of liquidity in the secondary markets. The purpose of this paper is to highlight the need for the regulator and market participants to recognize the risks in the financial system, the products available to hedge risks and the instruments, including derivatives that are required to be developed/introduced in the Indian system.

The financial sector serves the economic function of intermediation by ensuring efficient allocation of resources in the economy. Financial intermediation is enabled through a four-pronged transformation mechanism consisting of liability-asset transformation, size transformation, maturity transformation and risk transformation. Risk is inherent in the very act of transformation. However, prior to reform of 1991-92, banks were not exposed to diverse financial risks mainly because interest rates were regulated, financial asset prices moved within a narrow band and the roles of different categories of intermediaries were clearly defined. Credit risk was the major risk for which banks adopted certain appraisal standards. Several structural changes have taken place in the financial sector since 1992. The operating environment has undergone a vast change bringing to fore the critical importance of managing a whole range of financial risks. The key elements of this transformation process have been:1. The deregulation of coupon rate on Government securities. 2. Substantial liberalization of bank deposit and lending rates. 3. A gradual trend towards disintermediation in the financial system in the wake of increased access of corporate to capital markets. 4. Blurring of distinction between activities of financial institutions. 5. Greater integration among the various segments of financial markets and their increased order of globalisation, diversification of ownership of public sector banks. 6. Emergence of new private sector banks and other financial institutions, and, 7. The rapid advancement of technology in the financial system.

CHAPTER 3. DEFINITION OF RISK

WHAT IS RISK?

"What is risk?" And what is a pragmatic definition of risk? Risk means different things to different people. For some it is "financial (exchange rate, interest-call money rates), mergers of competitors globally to form more powerful entities and not leveraging IT optimally" and for someone else "an event or commitment which has the potential to generate commercial liability or damage to the brand image". Since risk is accepted in business as a trade off between reward and threat, it does mean that taking risk bring forth benefits as well. In other words it is necessary to accept risks, if the desire is to reap the anticipated benefits. Risk in its pragmatic definition, therefore, includes both threats that can materialize and opportunities, which can be exploited. This definition of risk is very pertinent today as the current business environment offers both challenges and opportunities to organizations, and it is up to an organization to manage these to their competitive advantage.

 WHAT IS RISK MANAGEMENT - DOES IT ELIMINATE RISK?

Risk management is a discipline for dealing with the possibility that some future event will cause harm. It provides strategies, techniques, and an approach to recognizing and confronting any threat faced by an organization in fulfilling its mission. Risk management may be as uncomplicated as asking and answering three basic questions: 1. What can go wrong? 2. What will we do (both to prevent the harm from occurring and in the aftermath of an "incident")? 3. If something happens, how will we pay for it? Risk management does not aim at risk elimination, but enables the organization to bring their risks to manageable proportions while not severely affecting their income. This balancing act between the risk levels and profits needs to be well-planned. Apart from bringing the risks to manageable proportions, they should also ensure that one risk does not get transformed into any other undesirable risk. This transformation takes place due to the inter-linkage present among the various risks. Risk Management is a more mature subject in the western world. This is largely a result of lessons from major corporate failures, most telling and visible being the Barings collapse. In addition, regulatory requirements have been introduced, which expect organizations to have effective risk management practices. In India, whilst risk management is still in its infancy, there has been considerable debate on the need to introduce comprehensive risk management practices.

 OBJECTIVES OF RISK MANAGEMENT FUNCTION Two distinct viewpoints emerge One which is about managing risks, maximizing profitability and creating opportunity out of risks

And the other which is about minimizing risks/loss and protecting corporate assets. The management of an organization needs to consciously decide on whether

they want their risk management function to 'manage' or 'mitigate' Risks.

Managing risks essentially is about striking the right balance between risks and controls and taking informed management decisions on opportunities and threats facing an organization. Both situations, i.e. over or under controlling risks are highly undesirable as the former means higher costs and the latter means possible exposure to risk.

Mitigating or minimizing risks, on the other hand, means mitigating all risks even if the cost of minimizing a risk may be excessive and outweighs the cost-benefit analysis. Further, it may mean that the opportunities are not adequately exploited. In the context of the risk management function, identification and

management of Risk is more prominent for the financial services sector and less so for consumer products industry. What are the primary objectives of your risk management function? When specifically asked in a survey conducted, 33% of respondents stated that their risk management function is indeed expressly mandated to optimize risk.

 RISKS IN BANKING

Risks manifest themselves in many ways and the risks in banking are a result of many diverse activities, executed from many locations and by numerous people. As a financial intermediary, banks borrow funds and lend them as a part of their primary activity. This intermediation activity, of banks exposes them to a host of risks. The volatility in the operating environment of banks will aggravate the effect of the various risks. The case discusses the various risks that arise due to financial intermediation and by highlighting the need for asset-liability management; it discusses the Gap Model for risk management.

CHAPTER4. TYPOLOGY OF RISK EXPOSURE

Based on the origin and their nature, risks are classified into various categories. The most prominent financial risks to which the banks are exposed to taking into consideration practical issues including the limitations of models and theories, human factor, existence of frictions such as taxes and transaction cost and limitations on quality and quantity of information, as well as the cost of acquiring this information, and more.

 MARKET RISK Market risk is that risk that changes in financial market prices and rates will reduce the value of the banks positions. Market risk for a fund is often measured relative to a benchmark index or portfolio, is referred to as a risk of tracking error market risk also includes basis risk, a term used in risk management industry to describe the chance of a breakdown in the relationship between price of a product, on the one hand, and the price of the instrument used to hedge that price exposure on the other. The market-Var methodology attempts to capture multiple component of market such as directional risk, convexity risk, volatility risk, basis risk, etc. CREDIT RISK Credit risk is that risk that a change in the credit quality of a counterparty will affect the value of a banks position. Default, whereby a counterparty is unwilling or unable to fulfill its contractual obligations, is the extreme case; however banks are also exposed to the risk that the counterparty might downgraded by a rating agency.

LIQUIDITY RISK

Liquidity risk comprises both

Funding liquidity risk Trading-related liquidity risk. Funding liquidity risk relates to a financial institutions ability to raise the

necessary cash to roll over its debt, to meet the cash, margin, and collateral

requirements of counterparties, and (in the case of funds) to satisfy capital withdrawals. Funding liquidity risk is affected by various factors such as the maturities of the liabilities, the extent of reliance of secured sources of funding, the terms of financing, and the breadth of funding sources, including the ability to access public market such as commercial paper market. Funding can also be achieved through cash or cash equivalents, buying power , and available credit lines.

OPERATIONAL RISK It refers to potential losses resulting from inadequate systems, management failure, faulty control, fraud and human error. Many of the recent large losses related to derivatives are the direct consequences of operational failure. Derivative trading is more prone to operational risk than cash transactions because derivatives are, by heir nature, leveraged transactions. This means that a trader can make very large commitment on behalf of the bank, and generate huge exposure in to the future, using only small amount of cash. Very tight controls are an absolute necessary if the bank is to avoid huge losses.

LEGAL RISK Legal risk arises for a whole of variety of reasons. For example, counterparty might lack the legal or regulatory authority to engage in a transaction. Legal risks usually only become apparent when counterparty, or an investor, lose money on a transaction and decided to sue the bank to avoid meeting its obligations. Another aspect of regulatory risk is the potential impact of a change in tax law on the market value of a position.

 HUMAN FACTOR RISK Human factor risk is really a special form of operational risk. It relates to the losses that may result from human errors such as pushing the wrong button on a computer, inadvertently destroying files, or entering wrong value for the parameter input of a model.

CHAPTER 5. CREDIT RISK MANAGEMENT IN BANK

Although the effects of all risks types can cause negative consequences to the bank, credit risk has been pinpointed or identified as the key risk associated with negative consequences in terms of its influences on bank performance . This means if credit risk is not well managed, it can lead to failure. Thus, for any bank to succeed, its CRM must be handled with a lot of seriousness. This is because should a loss occur, the bank will have to extend its hands to get funds from other means to meet up or cover the losses. A clear reason why a correct management of credit risk is very important is because banks have a limited capacity to absorb loan losses and this looses can be covered only by using income generated by other profitable loans or by bank capital . If the income is used from these two sources to meet up for a loan that has not been paid, this action will go a long way to affect the capital adequacy of the bank, its liquidity and even its profitability. Looking at the consequences or effects of credit risk, it is important that before a bank gives out a loan, it should try as much as possible to have a concrete view of the borrower. (Greuning & Bratanovic, 2003, p. 136) says Because of the potentially dire effects of credit risk, it is important to p erform a comprehensive evaluation of a banks capacity to assess, administer, supervise, enforce and recover loans, advances, guarantees, and other credit instruments. The bank has to possess its capability of how to recover a loan from a customer while reviewing its credit risk management policies and practices as outlined by the board. This means that the credit risk management process has to be followed in order to ensure that granted loans can be recovered in time and if not, a good collateral can be got in replacement of the loan. Each bank obviously has to develop its own strategies so as to fight competitors in the same industry by being

successful. The bank has to assess the credit worthiness of the borrower and even after the loan is granted, interim monitoring is required until when the borrower has finished repaying the loan. This monitoring is very important because with the uncertainty in the future, any potential event that can cause a borrower to default payment can be fast identified or, a mechanism can be put in place on time to reduce the frequency and /or intensity of a loss should it occur. Early identification of borrowers at risk is good because it enables servicers to adequately staff collections departments, determine the most cost-effective type of customer outreach, and initiate repayment plans before a borrowers financial situation worsens to the point at which foreclosure is unavoidable.

 Credit Risk Management Policy/ philosophy

Banks like any other firm or corporation have formal laid down policies and principles that have been put in places by the board of directors on how to manage credits and this have to be carefully implemented by management. This restricts supervisors or managers on how to take action. They must do so by looking at the policies laid down to know if they are doing the right thing at the right time. Maness & Zietlow, 2005, p. 139 specifies that a credit policy has four major components which include; credit standards, credit terms, credit limits and collection procedures. - Credit standards- This is the profile of the minimally acceptable creditworthy customer - Credit terms- This is the credit period stipulating how long from the invoice the customer has to pay, and the cash discount (if any) . - Credit limit- This is the dollar amount that cumulative credit purchases can reach for a customer if credit is extended. - Collection procedures- These are detailed statements regarding when and how the company will carry out collection of past-due accounts. Despite the rules, it does not mean that the credit policies are stereotyped. A good lending policy is not overly restrictive, but allows for the presentation of loans to the board that officers believe are worthy of consideration but which do not fall within the parameters of written guidelines. (Greuning & Bratanovic, 2003, p. 137). Since the future is uncertain, flexibility must be allowed for easy adaption to changing condition (maybe internal or environmental).

Management policies have to constantly change with the changing activities of the banking environment since these activities may come with changing risks too. According to (Greuning & Bratanovic, 2003, p. 151), specific risk management measures include three kinds of policies; - Policies aimed to limit or reduce credit risk ( concentration and large exposures, adequate diversification, lending to connected parties, or over exposures) - Policies of asset classification (mandate periodic evaluation of collectability of the portfolio of loans and other credit instruments, including any accrued and unpaid interest, which exposes a bank to credit risk). - Policies of loss positioning (making of allowances at a level adequate to absorb anticipated loss). Credit Risk management Practices

As banks have different credit risk management policies / philosophies, same do the risk management practices differ from one financial institution to another despite the fact that they can be open to the same risk types. The practices differ according to their previously laid down policies and philosophies. Some or all of the banks may decide to use hedging strategies or insurance to influence their profits and / or to avoid the costs of variations but, the way they put it in practice or their way of going about this will be different. Another difference can also be seen in the level of risk tolerance. Each and every bank has their individual level of risk that they can decide to let go based on how it is outlined in their risk management policy. To summarize this, it is clear that the same theory can exit for firms in the same industry, but, the implementation in practice differs. Practice is not consistent

with theory. In most cases because of data limitation for most industries, it is difficult to describe which firms manage more risk than others or whether firms engage in dynamic risk management strategies and more importantly it cannot be reliably tested whether a firms risk management practices conform with existing theories . Credit risk management strategies.

The Macmillan English Dictionary defines a strategy as a plan (method) for achieving something, or the skill of planning how to achieve something. A strategy thus simply means a way to go about an activity. This thus goes that as banks have different credit risk policies /philosophies and different management practices, their strategies to attain their desired goals in the same way may differ. The idea to go about a particular activity can exist to the knowledge of the bankers but the strategy of how to implement so that desired goals can be attained and / or to make a difference will be different for each bank or company. Given the competitive environment in which banks operate, it is always good to have a strategy position. Credit culture

A bank as an entity can be likened to a community and thus has its own culture which acts as a mirror on how it carries out its own activities. Actions or behaviors out of this culture will be going against the roles or norms of the bank. A bank s credit culture is the policies, practices, philosophy and management style that are being put in place to act as a guide for the lending manager or personnel to carry out their credit management function. This spells out the lending environment and

points out the lending behavior that is acceptable to the bank. In a study made by Mckinley, (1990, cited in Boffey & Robson, 1995, p. 67), Credit culture is defined as a combination of factors that establish a lending environment that encourages certain lending behavior. It should include such things as managements communication of values and priorities, the indoctrination of lenders during training, and the banks lending philosophy and policy. Credit culture is thus good because it acts as a guideline for a good bank credit management, performance and maybe failure. Even if there is a wrong move in the credit risk management resulting to losses, the manager personally cannot be blamed if the decisions were taken based on its credit culture. The blame will go to the entire management or decision makers and adjustments can then be made. Credit Risk Management Process

The same way that banks have different credit culture, they also have different credit risk management processes. Credit risk management process is a set of outlined activities aimed at managing credit risk. These activities are just like the ones outlined above for the risk management process and will cover the range from credit granting to credit collection. They are risk identification, measurement, assessment, control and monitor. The first step is to identify the risk involved in the credit process. After identification, the risk is measured by evaluating the consequence if it is not well managed. After the evaluation phase, the risk is then assessed to know the impact, the likelihood of occurrence, and the possibility for it to be controlled. The control and monitoring phase then comes in. These phases are not distinct like the other three. In the control phase, measures which can be used to

avoid, reduce, prevent or eliminate the risk are put in place. The monitoring phase is used to make a constant check so that all processes or activities which have been put in place for the risk management process are well implemented for desired results to be gotten and in case of any distortions, corrections are then made. All this is done because credit risk is a very important and delicate risk that banks face and needs to be managed with great care / precaution because its consequences are always very detrimental to the bank. Despite the changes in the financial service sector, credit risk remains the major single cause of bank failure .

 Credit Risks effect on Profitability, liquidity and capital adequacy (solvency)

When banks desire to follow good credit risk management policies, practices, strategies or processes, it is all because they long or wish to make profits or create value. Profitability is the ability of a business entity to generate positive net income when cost is subtracted from revenue. For a bank to be profitable, liquidity and capital adequacy or solvency are essential. Liquidity is the availability of cash or the capacity to obtain it on demand, or the quality of being readily converted to cash. Solvency shows the companys after tax income and how likely it will continue to meet up with its debt obligations. A bank like any other enterprise has as one of its most important objective, profits or value creation. For this to be attained, she must always strive to strike a balance between profitability, liquidity and solvency (Gardener, 2007, p. 10). This is because the three are interrelated. The lack of good management of one probably affects the others and thus the banks value. Sustainable profitability is vital in maintaining the stability of the banking system. Even if solvency is high, poor profitability will in the long run weaken the capacity of a bank to absorb negative shocks and will eventually affect solvency again (Herrero, Gavila & Santabarbara, 2009, p. 2081). A bank receives savings from depositor (who are like lenders) and make it available to borrower in the form of loans. But, like any other FI, she determines among other factors, the efficient allocation of savings as well as the return of savings and investments (Herrero et al. 2009, p. 2080). This is strictly the banking business and for it to be profitable the bank must always have liquid cash (reserves) to meet up with the cash demands of the customers and also to meet up

with unpaid loans in case of default payments. So, good functioning of the bank revolves around these three elements which if poorly managed, the deficit of one goes along to affect the others and thus the bank value.

Problems:

When a bank fails to put in place a good credit risk management, she will find herself faced with a lot of problems and negative consequences associated to them. There may be many interrelated problems but the most basic ones which are so obvious and interrelated revolve around trying to be profitable, at the same time trying to be solvent and trying to be liquid: - Losses or no profitability: Profitability is the proof of an effective and well managed business. In this case, it is an indicator of the banks capacity to carry risk and / or to increase its capital by revealing indicator of its competitiveness in the banking markets and the quality of its management. The bank as a FI is into business like any other firm with the purpose of making a profit. For this to be attained, losses have to be minimized. Advising on losses suffered by banks is that the same basic causes tend to occur time and again so, it therefore makes sense that before reviewing office procedures, the causes of the different losses which have been incurred both within the bank and by competitors conducting similar business should be looked into (Richard & Simon, 2001, p. 17). The bank has to be sure about the capability of repayment of the borrower before granting any loans.

Capital inadequacy (insolvency): Capital adequacy means the financial capability of the bank to meet up with its financial obligations or uncertainties that may arise and thus will reduce the risk that it may face to some extent. An acceptable capital adequacy p osition is

equivalent to saying that a bank is not over exposed to risks (Garderner, 2007, p. 10)). This is because its primary role or main function is to absorb unexpected and exceptional losses that it might experience especially in situations of uncertainty. The more capital a bank has, the more are its creditors or the government insurance agency protected, and the greater is the capital loss that can be sustained without resulting in bankruptcy. (Shah, 1996, p. 279). This way, if by giving out credit, the bank does not carry out a good risk management, and the borrower fails to fulfill his or her payments, this will lead to a shortage in capital (given uncertainty) and increase in the risk because operationally speaking, the capital of a bank acts as an internal insurance fund against uncertainty.

Lack of liquidity: A more liquid bank will be more able to meet up with financial demands from its customers and thus create more value. Bank liquidity creation is positively correlated with bank value (Berger & Bouwman, 2009, p. 3779). Banks as FI have as main service, the creation of liquidity, but, this good can be destroyed by the behavior of individual financial institutions (Gaffney, 2009, p. 983) This being because when the monetization of the various types of collaterals (such as land or capital) turns over slowly, the bank s liquidity is lost. A loss in liquidity shows that they cannot meet up with demand if customers turn up and thus crisis can develop (Gaffney, 2009, p. 984). Given the foregoing problems amongst others which banks can encounter if they dont manage their credit risk well, the managers should see into it that while carrying out their operational function of risk assumption, a judicious balance between profitability, liquidity and capital adequacy must be stroked. In the past decades, rapid innovations in FMs and the internationalization of financial flow have changed the face of banking almost beyond recognition

(Greuning & Bratanovic, 2003, p 1).They have evolved greatly over a long time stemming from the late 1980s, from the traditional banking business to an increase in capital adequacy requirement, undergoing constant innovation today to improve liquidity and to meet up with their set goals or objectives. Credit Scoring

A credit granting process comes in place when a company which needs a loan from a bank or lending institution hands in an application demanding for a loan. This application then goes through some procedures or processing in the bank which evaluates the application using their individual evaluation method to determine the credit worthiness of the company. Some banks does the evaluation using numbers (credit scoring) while others does so using subjective evaluation like personal ID of the company or the owner. Credit scoring is a statistical technology that quantifies the credit risk posed by a prospective or current borrower and seeks to rank them so that those with poorer scores are expected to perform worse on their credit obligations than those with better scores (Aveny, Brevoort & Canner, 2009, p. 516). Credit scoring has an advantage in that it saves time, cost and believe to increase access to credit, promote competition and improve market efficiency. Credit scoring reduces subjective judgment and possible biases during the credit assessment process (Kraft, 2002, p. 6). This is to say no matter when or who is doing the evaluation, the result is always same because it is computerized. This shows that if a good credit scoring is taken by a bank before granting loans to customers, it can determine the ability of the customers to pay back the loans although in some cases it may not really be a guarantee since the future is uncertain. The way things or situations can be seen today may change tomorrow and obviously affect already taken decisions.

 The five Cs of Credit

Each bank has its analytical tools which it uses to minimize losses of money when giving out loans to customers. The bank always find itself in a situation where they can give a loan to a customer who will not be able to pay back or refuses to give to a customer who is good and has the potentials of meeting up with the repayment. To go about a good analysis of potential customers, the five C s of credit have been introduced as a guide for bankers of what criteria to use. This includes the gathering of both quantitative and qualitative information to assist the bankers in their screening process of bad and potential creditors. This information is gotten using the five Cs of credit as the standards tools. The five Cs include; character, capacity, capital, conditions and collateral (Dev, 2009, p. 34). The character of a company refers to the distinct capabilities about the company which the lenders see that inspires them with confidence that the loan will be repaid. This includes things like the business plan, cash flow, history, management, etc. The capacity of the company incorporates words like sufficiency, adequacy and perseverance. This means what the company as a customer has as assets and the value of those assets which shows that it can be able to repay its loans. Capital of the company means how much adequate funds she has to make her business operate efficiently in generating cash flow and efficiently within its competitive business environment. The condition of the company describes the economic and environmental influences on the companys financial condition and performance. Lastly, collateral refers to what the company is able to present to the lender which serves as the final source of repayment and protection against loan loss. The figure below shows a diagrammatic presentation of the loan knowledge structure involving the five Cs.

The Loan knowledge structure model as put forward by Beaulieu in the diagram above is to show how the bank incorporates the five Cs (character, capacity, capital, conditions and collateral) in their loan granting process of screening bad from potential creditors. When the loan officers receive the information (quantitative and qualitative) about the customer, they do their analysis not in isolation of each element but in relationship amongst the categories with

the customers character being the centre because it is the character that shows them the distinct capabilities about the customer whether they can pay the loan back or not. This is because a customer could as well show a good capacity, have enough capital, have a good economic / environmental influences on its financial condition and performance and have a good collateral but, if it has a bad character, it will not still act as an inspiration for the bank to grant the loan. On the other hand, if the character (business plan, cash flow, history, management, etc) showed by the customer in question is good, it will go ahead to assure them of the customer s repayment capability more. This will thus help the bank whether to grant the loan or not or it will determine the credit limit. This is because a customers character shows how their previous loan transactions were handled. If after the decision has been taken, whatever may arise in the future, the bank will always recall the decisions taken in the past given the structure they used for their analysis to see if they took the right decision or not.

 Credit granting When a customer demands for a credit, the bank cant just grant the loan because the demand has been made. The bank does so while looking at its policies on credit granting. This is important because the bank has to know the credit worthiness of the customer and its capability of repaying the loan. A credit granting decision is a very important and delicate issue to be handled by the bank. This is because banks need to examine and measure any activity which affects their risk profile and must closely monitor accompanying conditions. Loans are the main areas where banks make profits but are also the biggest area of risk. Thus for the bank to effectively carry out its risk management, it is always good to evaluate the credit profile of the transaction in question. This is to say the bank has to look at the purpose of the loan, how it is to be repaid, the repayment history of the borrower of previous loans, its capacity and even the collateral in order to be sure that it is equivalent to cover the loan in a case of default. Given the importance and implications of credit granting decisions, many research papers have been written based on it because a mistake in it can be very disastrous to the bank. The written works have almost the same elements that have to be considered before granting a loan to a customer. This is because when good decisions are taken, it is as if the loan is almost paid. For example, Maness & Zietlow, 2005, p. 165 said any decision on whether to grant a loan and how much credit to give is taken based on four steps; developing credit standards, gathering necessary information about the customer, applying credit standards, and setting limits . Developing credit standards refers to the minimum standards a customer has to fulfill before he or she can be extended credits. These standards should be set while looking at the customers character (i.e. morals, integrity, trustworthiness

and management quality, capital, capacity (i.e. its ability to repay debts when due), conditions (the general economy, the borrowers environment and the reasons for the loan request), and collateral (the asset which is given as a security to back up the loan). Gathering necessary information about the borrower is done so as to help the bank to evaluate the possibilities of the borrower repaying the loan or its credit worthiness. Applying credits standards is done after the necessary information has been gathered. From the information, it is analyzed if the customer has to be granted the loan. If so, how much is to be granted. In setting the limits of how a borrower can be approved of the loan, the bank can use credit scoring to choose those to whom the loan can be granted. This is done because it is often difficult for the bank as a lender to observe borrowers probability of default. Credit scoring is a model used by lending institutions to rank potential customers according to their default risk which can improve the allocation of resources from a better to a best position . Thus, it is important that each bank has a procedure or guideline on how to make its credit decision. An example is shown in the diagram below which illustrates how one corporation actually makes its credit decisions.

Explanation

When the bank has gathered necessary information about the borrower, the decision must be made whether a loan should be granted or not. If yes, how much? The borrowers risk classification is determined based on financial analysis and trade experience. The credit limit is set based on information on its previous purchasing patterns. When each new order is received the decision for approval is looked into based on its risk classification and credit limit. Based on the results if approved, the order is automatically filled and if not approved.

 Credit collection

There is no guarantee that when a bank has a good credit policy, its credit activity cannot encounter problem. There are probably some borrowers who will pass the due date and some may be delinquent. Credit collection procedures have to be implemented on how to collect the loans. It will become a problem if the credit collection procedures were not well formulated, or if the implementation is not well carried out, or if the credit policy was not well followed. This is because if the borrower repays late or defaults payment, the bank will obviously look for other means to meet up with this financial loophole. This can result to increased debts, which can lead to higher interest payments, reduced profits, reduced borrowing capacity, increased equity, reduced shareholders value, reduced future capital investments, limiting the banks long term business performance, or an increase in the length (thus amount) of trade credit taken from suppliers. (Maness & Zietlow, 2005, p. 206). So, it is a very important duty of the bank to accelerate it loan collection so as to avoid the above mentioned consequences. Even though the bank has to collect it loans, while collecting or using efforts to collect them, it has to make sure that it collects the amount owed as close to the credit terms as possible but must always try to preserve customers goodwill when doing so (Maness & Zietlow, 2005, p. 213). This is because some customers may fail to pay back their loans as a result of the fact that they may be experiencing temporary problems. If the banks personal efforts to collect these loans fail, they can then introduce a collection agency.

 Summary of theoretical framework

The theoretical framework has been basically to bring out theoretical concepts connected to my topic which will be used in conjunction with my empirical findings from my interviews in order to give me a good analysis, discussion and conclusion. It has been an elaborated work on the steps and activities that have to be followed if good results of credit management have to be obtained. This is from the inception of the risk when an analysis has to be done before deciding whether to give credit to a customer, through when the credit is given and to when it is collected. It might be difficult to bring out a model which incorporates all the concepts but if the theory is well understood and put into practice, good or better results of risk management can be attained. It should be noted that the concepts are not standard but change with the different banks and also influenced by the dynamic environment in which they operate. Summarily, when a customer (company in this case) demands for credit, the bank cant just go into granting the loan without first of all verifying if it is credit worthy or not. The bank goes through the process by using the criteria of the five Cs or credit scoring. If it finally arrives at a decision to grant the loan, it s no guarantee that the company will repay the money as predicted because the bank is operating in a very dynamic and unstable environment. This means that the banks has to have three options in mind; either the loan is repaid, there is a delayed payment or default. If it is repaid in time, then fine but if otherwise problems start arising especially to meet up with the demand of its customers / other financial obligations or even financial distress. This means risk management has to start from day one. If any risk is identified, continuation of the management process

continuous. It should be noted that monitoring takes place at all times to be sure the results are always as intended. This management is being done while following the policies, philosophy, practices, strategies and the credit culture of the bank. The bank is doing all this because its profitability, liquidity and solvency have to be guaranteed. Despite all these efforts by the banks, there are still failures at times or problems which can be attributed to different factors including information asymmetry (vital information which the customer hides from the bank).

CHAPTER 6 INSTRUMENTS OF CREDIT RISK MANAGEMENT Credit Risk Management encompasses a host of management techniques, which help the banks in mitigating the adverse impacts of credit risk. Credit Approving Authority

Each bank should have a carefully formulated scheme of delegation of powers. The banks should also evolve multi-tier credit approving system where the loan proposals are approved by an Approval Grid or a Committee. The credit facilities above a specified limit may be approved by the Grid or Committee, comprising at least 3 or 4 officers and invariably one officer should represent the CRMD, who has no volume and profit targets. Banks can also consider credit approving committees at various operating levels i.e. large branches (where considered necessary), Regional Offices, Zonal Offices, Head Offices, etc. Banks could consider delegating powers for sanction of higher limits to the Approval Grid or the Committee for better rated / quality customers. The spirit of the credit approving system may be that no credit proposals should be approved or recommended to higher authorities, if majority members of the Approval Grid or Committee do not agree on the creditworthiness of the borrower. In case of disagreement, the specific views of the dissenting member/s should be recorded. The banks should also evolve suitable framework for reporting and evaluating the quality of credit decisions taken by various functional groups. The quality of credit decisions should be evaluated within a reasonable time, say 3 6 months, through a well-defined Loan Review Mechanism.

 Prudential Limits

In order to limit the magnitude of credit risk, prudential limits should be laid down on various aspects of credit: stipulate benchmark current/debt equity and profitability ratios, debt service coverage ratio or other ratios, with flexibility for deviations. The conditions subject to which deviations are permitted and the authority therefor should also be clearly spelt out in the Loan Policy; single/group borrower limits, which may be lower than the limits prescribed by Reserve Bank to provide a filtering mechanism; substantial exposure limit i.e. sum total of exposures assumed in respect of those single borrowers enjoying credit facilities in excess of a threshold limit, say 10% or 15% of capital funds. The substantial exposure limit may be fixed at 600% or 800% of capital funds, depending upon the degree of concentration risk the bank is exposed; maximum exposure limits to industry, sector, etc. should be set up. There must also be systems in place to evaluate the exposures at reasonable intervals and the limits should be adjusted especially when a particular sector or industry faces slowdown or other sector/industry specific problems. The exposure limits to sensitive sectors, such as, advances against equity shares, real estate, etc., which are subject to a high degree of asset price volatility and to specific industries, which are subject to frequent business cycles, may necessarily be restricted. Similarly, high-risk industries, as perceived by the bank, should also be placed under lower portfolio limit. Any excess exposure should be fully backed by adequate collaterals or strategic considerations;

 banks may consider maturity profile of the loan book, keeping in view the market risksinherent in the balance sheet, risk evaluation capability, liquidity, etc. Risk Rating

Banks should have a comprehensive risk scoring / rating system that serves as a single point indicator of diverse risk factors of a counterparty and for taking credit decisions in a consistent manner. To facilitate this, a substantial degree of standardization is required in ratings across borrowers. The risk rating system should be designed to reveal the overall risk of lending, critical input for setting pricing and non-price terms of loans as also present meaningful information for review and management of loan portfolio. The risk rating, in short, should reflect the underlying credit risk of the loan book. The rating exercise should also facilitate the credit granting authorities some comfort in its knowledge of loan quality at any moment of time. The risk rating system should be drawn up in a structured manner, incorporating, inter alia, financial analysis, projections and sensitivity, industrial and management risks. The banks may use any number of financial ratios and operational parameters and collaterals as also qualitative aspects of management and industry characteristics that have bearings on the creditworthiness of borrowers. Banks can also weigh the ratios on the basis of the years to which they represent for giving importance to near term developments. Within the rating framework, banks can also prescribe certain level of standards or critical parameters, beyond which no proposals should be entertained. Banks may also consider separate rating framework for large corporate / small borrowers, traders, etc. that exhibit varying nature and degree of risk.

Forex exposures assumed by corporate who have no natural hedges have significantly altered the risk profile of banks. Banks should, therefore, factor the un hedged market risk exposures of borrowers also in the rating framework. The overall score for risk is to be placed on a numerical scale ranging between 1-6, 1-8, etc. on the basis of credit quality. For each numerical category, a quantitative definition of the borrower, the loans underlying quality, and an analytic representation of the underlying financials of the borrower should be presented. Further, as a prudent risk management policy, each bank should prescribe the minimum rating below which no exposures would be undertaken. Any flexibility in the minimum standards and conditions for relaxation and authority there for should be clearly articulated in the Loan Policy. The credit risk assessment exercise should be repeated biannually (or even at shorter intervals for low quality customers) and should be delinked invariably from the regular renewal exercise. The updating of the credit ratings should be undertaken normally at quarterly intervals or at least at half-yearly intervals, in order to gauge the quality of the portfolio at periodic intervals. Variations in the ratings of borrowers over time indicate changes in credit quality and expected loan losses from the credit portfolio. Thus, if the rating system is to be meaningful, the credit quality reports should signal changes in expected loan losses. In order to ensure the consistency and accuracy of internal ratings, the responsibility for setting or confirming such ratings should vest with the Loan Review function and examined by an independent Loan Review Group. The banks should undertake comprehensive study on migration (upward lower to higher and downward higher to lower) of borrowers in the ratings to add accuracy in expected loan loss calculations.

 Risk Pricing

Risk-return pricing is a fundamental tenet of risk management. In a risk-return setting, borrowers with weak financial position and hence placed in high credit risk category should be priced high. Thus, banks should evolve scientific systems to price the credit risk, which should have a bearing on the expected probability of default. The pricing of loans normally should be linked to risk rating or credit quality. The probability of default could be derived from the past behavior of the loan portfolio, which is the function of loan loss provision/charge offs for the last five years or so. Banks should build historical database on the portfolio quality and provisioning / charge off to equip themselves to price the risk. But value of collateral, market forces, perceived value of accounts, future business potential, portfolio/industry exposure and strategic reasons may also play important role in pricing. Flexibility should also be made for revising the price (risk premia) due to changes in rating / value of collaterals over time. Large sized banks across the world have already put in place Risk Adjusted Return on Capital (RAROC) framework for pricing of loans, which calls for data on portfolio behaviour and allocation of capital commensurate with credit risk inherent in loan proposals. Under RAROC framework, lender begins by charging an interest mark-up to cover the expected loss expected default rate of the rating category of the borrower. The lender then allocates enough capital to the prospective loan to cover some amount of unexpected loss- variability of default rates. Generally, international banks allocate enough capital so that the expected loan loss reserve or provision plus allocated capital covers 99% of the loan loss outcomes. There is, however, a need for comparing the prices quoted by competitors for borrowers perched on the same rating /quality. Thus, any attempt at price-cutting for market share would result in mispricing of risk and Adverse Selection.

 Portfolio Management

The existing framework of tracking the Non Performing Loans around the balance sheet date does not signal the quality of the entire Loan Book. Banks should evolve proper systems for identification of credit weaknesses well in advance. Most of international banks have adopted various portfolio management techniques for gauging asset quality. The CRMD, set up at Head Office should be assigned the responsibility of periodic monitoring of the portfolio. The portfolio quality could be evaluated by tracking the migration (upward or downward) of borrowers from one rating scale to another. This process would be meaningful only if the borrowerwise ratings are updated at quarterly / half-yearly intervals. Data on movements within grading categories provide a useful insight into the nature and composition of loan book. The banks could also consider the following measures to maintain the portfolio quality:-

1) stipulate quantitative ceiling on aggregate exposure in specified rating categories, i.e. certain percentage of total advances should be in the rating category of 1 to 2 or 1 to 3, 2 to 4 or 4 to 5, etc.;

2) evaluate the rating-wise distribution of borrowers in various industry, business segments, etc.;

3) exposure to one industry/sector should be evaluated on the basis of overall rating distribution of borrowers in the sector/group. In this context, banks should weigh the pros and cons of specialization and concentration by industry group. In cases where portfolio exposure to a single industry is

badly performing, the banks may increase the quality standards for that specific industry;

4) target rating-wise volume of loans, probable defaults and provisioning requirements as a prudent planning exercise. For any deviation/s from the expected parameters, an exercise for restructuring of the portfolio should immediately be undertaken and if necessary, the entry level criteria could be enhanced to insulate the portfolio from further deterioration;

5) undertake rapid portfolio reviews, stress tests and scenario analysis when external environment undergoes rapid changes (e.g. volatility in the forex market, economic sanctions, changes in the fiscal/monetary policies, general slowdown of the economy, market risk events, extreme liquidity conditions, etc.). The stress tests would reveal undetected areas of potential credit risk exposure and linkages between different categories of risk. In adverse circumstances, there may be substantial correlation of various risks, especially credit and market risks. Stress testing can range from relatively simple alterations in assumptions about one or more financial, structural or economic variables to the use of highly sophisticated models. The output of such portfolio-wide stress tests should be reviewed by the Board and suitable changes may be made in prudential risk limits for protecting the quality. Stress tests could also include contingency plans, detailing management responses to stressful situations.

6)introduce discriminatory time schedules for renewal of borrower limits. Lower rated borrowers whose financials show signs of problems should be subjected to renewal control twice/thrice an year.

 Loan Review Mechanism (LRM) LRM is an effective tool for constantly evaluating the quality of loan book and to bring about qualitative improvements in credit administration. Banks should, therefore, put in place proper Loan Review Mechanism for large value accounts with responsibilities assigned in various areas such as, evaluating the effectiveness of loan administration, maintaining the integrity of credit grading process, assessing the loan loss provision, portfolio quality, etc. The complexity and scope of LRM normally vary based on banks size, type of operations and management practices. It may be independent of the CRMD or even separate Department in large banks. The main objectives of LRM could be: to identify promptly loans which develop credit weaknesses and initiate timely corrective action; to evaluate portfolio quality and isolate potential problem areas; to provide information for determining adequacy of loan loss provision; to assess the adequacy of and adherence to, loan policies and procedures, and to monitor compliance with relevant laws and regulations; and to provide top

management with information on credit administration, including credit sanction process, risk evaluation and post-sanction follow-up. Accurate and timely credit grading is one of the basic components of an effective LRM. Credit grading involves assessment of credit quality, identification of problem loans, and assignment of risk ratings. A proper Credit Grading System should support evaluating the portfolio quality and establishing loan loss provisions. Given the importance and subjective nature of credit rating, the credit ratings awarded by Credit Administration Department should be subjected to review by Loan Review Officers who are independent of loan administration.

CHAPTER 5 TOOLS & MODELS OF CREDIT RISK MANAGEMENT

The instruments and tools, through which credit risk management is carried out, are detailed below:

1. Exposure Ceilings: Prudential Limit is linked to Capital Funds -say 20% for individual borrower entity, 45% for group with additional 5%/10% for infrastructure projects, subject to approval of the Board of Directors, Threshold limit is fixed at a level lower than Prudential Exposure; Substantial Exposure, which is the sum total of the exposures beyond threshold limit should not exceed 600% to 800 % of the Capital Funds of the bank (i.e. 6 to 8 times).

2. Review/Renewal:

Multi-tier Credit Approving Authority, constitution wise delegation of powers, sancti6ningauthoritys higher delegation of powers for better-rated customers; discriminatory time schedule for review / renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal based on risk rating, etc

3. Risk Rating Model:

Set up comprehensive risk scoring system on a six to nine point scale. Clearly define rating thresholds and review the ratings periodically preferably at half yearly intervals, to be graduated to quarterly soaps to capture risk without delay. Rating migration is to be mapped to estimate the expected loss.

4. Risk based scientific pricing:

Link loan pricing to expectedloss. High-risk category borrowersare to be priced high. Build historicaldata on default losses. Allocate capital to absorb the unexpected loss. Adopt the RAROC framework.

5. Portfolio Management

The need for credit portfolio management emanates from the necessity to optimize the benefits associated with diversification and to reduce the potential adverse impact of concentration of exposures to a particular borrower, sector or industry. Portfolio management shall cover bank-wide exposure son account of lending, investment, other financial services activities spread over a wide spectrum of region, industry, size of operation, technology adoption, etc. There should be a quantitative ceiling on aggregate exposure on specific rating categories, distribution of borrowers in various industries & business group. Rapid portfolio reviews are to be carried on with proper &regular on-going system for identification of credit weaknesses welling advance. Steps are to be initiated to preserve the desired portfolio quality and portfolio reviews should be integrated with credit decision-making processes. Credit Audit/Loan Review Mechanism This should be done independent of credit operations, covering view of sanction process, compliance status, review of risk rating, pick up of warning signals and recommendation for corrective action with the objective of improving credit quality. It should target all loans above certain cut-off limit ensuring that at least 30% to 40% of the portfolio is subjected to LRM in a year so as to ensure that all major credit risks embedded in the balance

sheet have been tracked and to bring about qualitative improvement in credit administration as well as Identify loans with credit weakness. Determine adequacy of loan loss provisions. Ensure adherence to lending policies and procedures. The focus of the credit audit needs to be broadened from account level to overall portfolio level. Regular, proper & prompt reporting to Top Management Should be ensured. Credit Audit is conducted on site, i.e. at the branch that has appraised the advance and where the main operative limits are made available.

Risk Rating Models The need for the adoption of the credit risk-rating model is on account of the following aspects. Disciplined way of looking at Credit Risk. Reasonable estimation of the overall health status of an account captured under Portfolio approach as contrasted to stand-alone or asset based credit management. Impact of a new loan asset on the portfolio can be assessed. Taking a fresh exposure to the sector in which there already exists sizable exposure may simply increase the portfolio risk although specific unit level risks negligible/minimal. The Co-relation or co-variance between different sectors of portfolio measures the inter relationship between assets. Concentration risks are measured in terms of additional portfolio risk arising on account of increased exposure to a borrower/ group or co-related borrowers. Need for Relationship Manager to capture, monitor and control the over all exposure to high value customers on real time basis to focus attention on vital few so that trivial many do not take much of valuable time and efforts.

 Instead of passive approach of originating the loan and holding it till maturity, active approach of credit portfolio management is adopted through securitisation/credit derivatives. Pricing of credit risk on a scientific basis linking the loan price to the risk involved therein, though the factor of business compulsion and competition is always there. Rating can be used for the anticipatory provisioning, certain level of reasonable over-provisioning as best practices. Given the past experience and assumptions about the future, the credit risk model seeks to determine the present value of a given loan or fixed income security. It also seeks to determine the quantifiable risk that the promised cash flows will not be forthcoming. Thus, credit risk models are intended to aid banks in quantifying, aggregating and managing risk across geographical and product lines. Credit models are used to flag potential problems in the portfolio to facilitate early corrective action.

CHAPTER 6 CREDIT RISK MANAGEMENT (CRM) IN LENDING DECISIONS

In this section I focused on knowing why the respondents think credit risk management is important because they all acknowledged their exposure to credit risk in their credit lending , why they involve it in their lending decisions if at all they do, the effectiveness of their lending decisions, what they think are the causes of defaults should they occur, what will be their contribution if lending decisions were concentrated in their hands without the banks policies and, the risk they think might arise from their decisions.

The role of credit risk management can never be undermined when carrying our lending decisions because the bank has to be sure to recover the money she is giving out especially as its continuous functioning depends on this. So, in this section on lending decisions, I tried to explore the degree of consciousness of the respondents of credit risk management in their lending decisions, the consequences of these decisions, their contribution if they were given the sole responsibility to handle lending decisions without policy guideline and the type of risks connected to lending decisions.

All the three respondents stressed the importance of credit risk management although they did so in different ways. Respondent A said it is important because it makes their decisions less risky, respondent B said it makes them to have a secure and trustful system and respondent C said it helps them to reduce losses. Respondents A and B said they involved CRM in their lending decisions because they often think of risk while respondent C talks of doing so because the

regulations of the bank says so. All three respondents admitted of seeing the effectiveness of their lending decisions although some cases of default may arise. This has not always been on the part of the bank but on the part of the customer resulting mainly from poor management although other causes may include; sickness, unemployment, instability in the global environment, etc.

CHAPTER 7 CONCLUSION

The results obtained from the project clearly support the assertion that poor credit risk management contributed to a greater extent to the bank failures in banking system. Therefore effective credit risk management is important in banks and allows them to improve their performance and prevent bank distress. The success of the systems depends critically upon a positive risk culture. Banks should have in place a comprehensive credit risk management process to identify, measure, monitor and control credit risk and all material risks and where appropriate, hold capital against these risks. Establishment of a comprehensive credit risk management system in banks should be a prerequisite as it contributes to the overall risk management system of the bank. There is also need for banks to adopt sound corporate governance practices, manage their risks in an integrated approach, focus on core banking activities and adhere to prudential banking practices.