CreditRisk

Bankoperationsinvolvesanctioningofloansandadvancestocustomersforvarietyofpurposes.
Theseloansmaybebusinessloansforshortorlongtermcommitmentsandconsumerfinancefor
purchaseofdurables,propertyandvehicles.Othertypesofloansprovidedbybanksaremicrocredit
forsmallborrowersandcontingentobligationsthatareoffbalancesheettransactions.

Theloansanctioningprocesscommenceswhenthebankreceivesaloanproposalfromthecustomer.
Theloanrequirementmaybeforequipmentpurchaseorforworkingcapitalfinancerequirements.If
itisforequipmentpurchasetheamountwillbepaiddirectlytothesupplier.Ifitisaworkingcapital
requirement,anoperationalbankaccountinthenameofthecustomerwillbeopenedand
permissionwillbegrantedtodrawtheamountasandwhenrequired.

Theloanproposalwillbeevaluatedusinganinternalratingsystemorthecreditratingofferedby
externalratingagencies.Aftertheloansanctionthebankneedstofollowupandmonitortheloan
accounts.Theloansanctionedmaybecomeadefaultorabadloaniftheoutstandingpayments
(eitherinterestorinstallmentoftheprincipleamount)areoverdueby90days.Thuscreditlifecycle
involvesfourstages,creditopportunity,creditassessment,creditmanagementandcredit
implication.

Creditworthinessoftheborrowerswillinfluenceloancommitmentbythebank.Theprerequisites
fortheloansanctioneddependsonthecreditworthinessoftheborrower.Therequirementofcredit
worthinessvariesdependingontypeofcreditandquantumofloanofferedtoborrowers.

Besidespersonalcreditworthinessthebankabilityoftheproposalistobeevaluatedintermsof
projectedcashflows,projectedinvestmentandpastperformanceoftheborrower.

Riskexposureforbanksiscomputedconsideringthreefactors.Thecriteriaarethedefault
percentage,exposurevalueforthebankandtheestimatedrecoveryrate.

Loss on default = D x E x (1-R)

WhereDisdefaultpercentage,EisexposurevalueandRisrecoveryrate.

Exampleofacreditevaluationprocessisgivenbelow.

CreditRiskEvaluationInformationRequirementbyBanks

DetailsofApplicants DetailsofApplicants
Nameoftheentity Accountnumber
Registeredofficeaddress Dateofaccountopening
Nameofthecontactperson Branchofapplicantaccount
Addressoffactory/establishment Whetherexistingborrowingcustomer
Addressforcorrespondence Lineofbusiness
Officecontractdetails Natureofproduct/serviceoffered
Dateofincorporation Typeofconstitutionofthebusiness
Datebusinesscommenced Existingactivityofthebusinessentity
Dateofformation Proposedactivityofthebusinessentity
Nameofparentcompanyifany



PurposeofLoan PurposeofLoan

Expectedsourceoffunds Exposureoftheborrowingentitywith
Businessowner otherbankgroups
Expectedaccountturnover Creditfacilityavailed
Returnoninvestment Creditfacilityapplied
Saleproceeds Typeoffacility
DetailsofDirector Amount
DetailsoftheBoard Purpose
Principalshareholdersofthecompany Tenor
andtheiraddress Primarysecurity
Collateralsecurity
Currencyofsecurity

DetailsofAssets InformationoneachtypeofAssets

Land Purposeofasset
Tools Imported/Indigenous
Electrical Supplier
Machinery Totalcost
Otherassets Promoterscontribution
Loanrequired

BusinessInformation ExistingCreditFacilityDetails

Detailsofcollateral Typesoffacility
Detailsofcustomersofbusiness Limits(value)
Currenciesinwhichbusinessis Outstandingasontheprevious
conducted accountingdate
Numberofemployees Namesofbankspresentlyworkingwith
Securitylodged
Rateofinterest
Repaymentterms

PastPerformance(Twoyears) FutureEstimate(Currentyearandnextyear)
NetSales NetSales
Netprofit Netprofit
Capital(networth) Capital(networth)
Totaldebt Totaldebt
Imports Imports
Exports Exports

BusinessandAgriculturalLoans

Theloanssanctionedbybanksforbusinessmaybebroadlyclassifiedintotwocategoriesnamely
workingcapitaladvancesandprojectloans.Loansanctionbybankscanbebasedonseveral
methods.Turnovermethodfocusesonprojectedsales,tradeterms,cashflowsandbusinesscycleof
theproposal.Basedontheassessmentacreditlimitwillbesanctioned.

Cashflowmethodwillconsiderindustrycapacity,sectorprojectionsandregionalperformanceof
theprojectindeterminingthecreditlimitsofthebusiness.Cashbudgetmethodusessalesforecast,
marketforecast,investmentforecast,loancommitmentexpenses,administrativecommitmentsand
projectexpenseestimates.

Projectedbalancesheetmethoddealswithtotalperformanceofthebusinessbyanalyzingasset
structure,investmentstructure,borrowingstructureandcapitalstructure.Projectsofthesebalance
sheetcriteriaintermsofliquidityandcashflowsidentifythecreditlimitforthebusiness.

Netownedfundmethodusesriskestimates,capitalcommitmentoftheborrower,security
requirements,guaranteerequirementsandthequalityofnetownedfundsoftheborrower.Onthe
basisoftheseestimatesadecisiononloanproposalwillbetakenbythebanks.

Whilesanctioningbusinessloans,abankfollowsastandardsetofprocedureswhichincludes
applicationofanalyticaltools,choiceofappraisalmethods,mannerofdeliveryofcredit,monitoring
ofaccountandschedulingofpayments.Similarlyforexportandimportloansaseparatesetof
standardproceduresarefollowed.

Additionalloanexposuresandloanrestructuringproposalsareconsideredbybanksonacaseto
casebasisconsideringspecificjustificationfortheproposal.

AgriculturalloansaresanctionedbybanksduringKharifandRabiseasons.Theseloansmaybefor
thepurchaseofequipment,forirrigationfacilities,forthepurchaseoffertilizersorseedsandother
purposessuchaslanddevelopment.

MicroFinance

Mr.MohammudYunusiscreditedwithmicrofinancemovementinBangladesh.Microfinanceaims
atdevelopingbankinghabitsamongpoorsectionsoftheeconomyandtoextendbankcreditto
sectionsthataretraditionallyneglectedasunbankable.

Microfinanceschemesprovidesmallloanswithoutcollateral.Itencouragessmallsavingsdeposits
fromtheborrowers.Microcreditisoftenassociatedwithagroupofborrowerssuchasselfhelp
groups.Microfinancealsoaimsatempoweringwomentoachieveselfreliance.

Thespecialfeaturesofmicrofinanceinclude(1)supplyleadingfinanceprinciplewhichmeansitis
thesupplierofmoneywhotakesinitiativetoidentifytheborrowerforlendingpurposes.(2)
Imperfectinformationparadigmwhichimpliesthattheborrowersareneglectedweakersectionsof
thesocietywhoselevelofeducationandawarenessarelow.(3)Informalcreditmarketswherein
sanctioningofloansisnotbasedontraditionalprudentialnormsbutonthebasisofborrower
welfare.(4)Encouragingsavingsofthepoorisanotherfundamentalmicrofinanceinitiative.

Microfinanceconcepthasbeenextendedtoadapttochangingneedsinchangingeconomies.Micro
financehasbeenextendedbycommercialbanksadoptinggrouplendingmethods.Loansare
sanctionedtoagroupofborrowerswhoregisterthemselvesasagroupforborrowingpurposes.The
borrowersareofsimilareconomicstatusandtheymayusethecreditbothforpersonaluseaswell
asaneconomicorbusinessactivity.Nocollateralsareinsistedwhilesanctioningloans.

Microfinanceisseenmoreasadevelopmentalinterventionthanatraditionalbanklendingactivity.

CreditEvaluation

Creditevaluationbeginswithsubmissionofloanproposalbytheborrower.Banksfollowa
comprehensiveapproachforcreditevaluation.Firsttheprojectforwhichloanissoughtwillbe
evaluatedintermsofcapitaladequacy,projectedcashflows,currentperformance,past
performanceoftheborrowerintermsofrepaymentsandadherencetobankingprocedures.

Besidesthesebanksfollowaninternalcreditratingsystembasedonpredeterminedcriteriaorthey
maydependonexternalcreditratingofferedbyreputedcreditratingagencies.Afterassessingthe
project,thenextissuewillbeevaluationofsecuritiesofferedascollateralfortheloan.

Nextintheassessmentwillbethehistoryoftheborrower,thepresentmanagementandits
competenceandotherqualitativeparametersobtainedthroughreportsfromvarioussourcessuch
asotherbankshavingbusinessrelationshipwiththeborrower,suppliersoftheborrowerandother
creditinformationagencies.

Oncealoandecisionhasbeenmade,thebankstaffwillhavetomonitorandtakeupnecessary
followupaction.Banksinsistonreceivingperiodicalreportsfromtheborrowerandalsoconduct
fieldvisitstothepremisesoftheborrowertoascertaintheprogressandutilizationofloanamount.

Banksusuallycomputecertainkeyratiosandanalyzethecashflowpositionoftheborrowerbesides
propervaluationofsecuritiesforaccessingthecreditworthinessoftheproposal.

ReserveBankofIndiahasprovidedguidelinesforloanappraisalandevaluationandinsistson
adoptionofKnowYourCustomerNorms(KYC)fromtheborrowers.

Someofthehindrancesinpropercreditevaluationinbanksincludetheadministrativeprocedures,
competenceofthestaffandnonintegrationofcreditsanctionandfollowupprocedures.Non
adherencetoprudentialnormssuggestedbyRBIisanotherdeterrentinthecreditevaluation
process.

HindrancesinCreditEvaluation

Focusonassetbasedlendingthancashflowbasedlending.
Industryspecificevaluationtoolsnotbeingused.
RBIguidelinesoncommitteeapprovalforcreditsanctionnotbeingfollowedfullysincethe
committeemembersdonotbeetfrequentlyasandwhenrequired.
Additionalevaluationsrequiredincaseofsensitivesectorssuchasfundingofcapitalmarket
securitiesorrealestateproposalsorcommoditymarkets.

Computationofcreditrisk

Creditriskisinherentinthebanklendingprocess.Thereforebankshavetometiculouslyplan,
understandandapplyriskmeasures.Allpersonnelanddepartmentsinvolvedincreditmanagement
musthaveathoroughunderstandingofcreditrisk.Banksfollowsystematicmethodsofrisk
computationandapplythemforloandecisions.Theydevelopandorganizecreditinformationfor
thispurpose.

Theinternalratingsystemfollowedbybanksrequiresbothfinancialaswellasqualitative
informationontheprojectandtheborrower.Certainkeyratiosandcashflowprojectionsarethe
basisforthequantitativemeasurementofrisk.Theriskmeasurescomputedbybankscouldbeaone
timemeasureforaborrowerorameasurethatismonitoredthroughouttheloanservicingperiod.
Thesemethodsareknownaspointintimemeasureandlifecyclemeasure.Anymethodormodel
adoptedbythebankneedstobeevaluatedastoitsreliability.Usuallypastborrowerdatawillbe
usedtoexaminethereliabilityofmodelsdevelopedforcreditriskanalysis.

Byconstantreviewandupdatingoftheerrorprobabilityofthesemodelsthatbankswillbeableto
reducerisksubstantiallyandmakethemdesirableforapplication.Besidesinternalratingsystem
banksalsodependoninformationprovidedbyratingagencies.Basedoncreditanalysistheloan
proposalswillberatedandgraded.Theseratingsandgradesmayundergochangeonaccountof
newdevelopmentsorchangesaffectingthebusinessoftheborrower.

Accordinglytheprobabilityofdefaultandtheprobabilityoflosswillhavetobekeptflexibleand
needsreviewperiodically.

Typeoffactor Examples

Sizeofoperation Amountofcapitalandnetassets
Safety Currentratio,capitaladequacyratio,andcurrent
accountbalanceratio
Profitability Returnonassets,operatingprofits,yearsrequiredto
paybackinterestbearingliabilities,andinterest
coverageratio
Others Rateofgrowthinsalesandprofits

Typeoffactor Examples

Industry Growthpotentialsizeofmarketfluctuations,andentry
barriers
Firm Ownershiprelationswithparentcompaniesoraffiliate
firms,themanagementsability,andexistenceofan
externalauditsystem

TypeofFactor RealEstatteFinance ProjectFinaance

Quantitaative Creditexttensionperio od,loanto
value(LTV V),anddebtservice
coverageratio(DSCR)
Qualitattive Characterristicsofrealestate,
e.g.,locattionsandoth her
conditionss,adequacyyofcash
flowsched dule,andrissks
attachedttosponsorsofthe
project
Creditextennsionperiod
dand
DSCR
Riskattache edtothepro oject,
e.g.,risksatttachedtospponsors
andoperato orsoftheprroject,
theriskofbbeingunableeto
completeth heproject,and
transferriskk

Creditriskmeasurem mentinvolveescomputatiionofprobabilityofdefaault,lossgiveendefaultan
nd
exposureatdefault.Theevaluattionprocessidentifiesexxpectedandunexpectedlossfromcreditrisk.
Whileexxpectedlossiseasilymeasurablethroughthecreeditriskmod dels,unexpecctedlossesaare
difficultsincethefreequencyofo
occurrenceofsucheventtsisless.Severalotherm measuresbessides
creditm
modelingsuch hasMonteCCarlosimulattionhavetobeappliedbbythebankstoestimatethe
unexpecctedloss.

 CreditRiskManagement

Foreffectivecreditriskmanagement,bankshavetoestablishanintegratedcreditriskmanagement
system.InthisexecutivesatBoardlevelaswellasbankstaffsdealingincreditriskatbranchlevel
aretobeinvolved.Properprocedures,documentation,methodsofappraisalandcreditauditareto
beincorporatedinthesystem.

Creditriskinvolvesprobabilityoflossofloansanctioned.Thislosscomprisesnonpaymentofinterest
orprinciple,counterpartyobligationsnotmet,settlementclaimsnotmet,defaultonaccountof
restrictionsimposed,foreignexchangeremittancesandinabilityoftheborrowertomeetcontingent
expenditures.

Creditriskisaffectedbybankspecificinternalfactorsorexternalfactorssuchaschangesinthe
economy.Internalriskfactorscanbemanagedbyadoptingasystematiccreditriskmanagement
policyandprocedure.Managingexternalfactorsinvolvesdiversificationofcreditamongdifferent
industrygroupsanddifferentborrowers.

Prudentialnormsforcreditriskmanagementcallsforacomprehensivepolicyframeworklaying
downstrategies,organizationalstructure,systemsupport,creditriskratingframework,creditrisk
limits,creditriskmodeling,creditriskpricing,riskmitigation,lowreviewmechanismandcreditaudit.

Bankshaveseveralchoicesregardingthemodelforcreditriskcomputation.Certainpopularmodels
inuseareAltmansmodel,creditmetricsmodel,valueatriskmodelandKMVmodel.Dependingon
thesuitabilityandtherequirementsofbanksamodelcanbechosenandadoptedforcreditrisk
measurement.

Themainaimofcreditriskmanagementisnotonlyquantifyingriskbutalsoreducingexposureof
creditriskbyadoptingsafetymeasuresthroughcollateralsecurities,guarantees,creditderivatives
andbalancesheetnetting.

RBIguidelinesoncreditexposureandmanagementcallforadoptionofprudentialnorms.This
specifiesbothquantitativeandqualitativerestrictionsonloansanctions.

Questions

1. What is credit risk? What factors influence credit risk?

2. Explain the procedure followed by banks for credit risk management.
3. Discuss the essential features of an integrated credit risk management system.
4. What is internal credit rating system?
5. Explain the methods of credit risk measurement.
6. Suggest an ideal policy framework for credit risk management in banks.
7. What are the models for credit risk computation? Briefly explain their features.
8. What is credit risk mitigation?
9. How do banks reduce losses on account of credit risk?
10. Explain the guidelines of RBI in terms of credit risk management.
11. What are the various types of business loans sanctioned by banks?
12. What is micro credit?
13. What are the objectives of micro credit institutions?
14. What are the methods of sanctioning business loans?
 15. Discuss the different approaches / models for micro credit.