unwillingness of the customer or counter party to meet commitments in relation to lending, hedging, settlement and other financial transactions. o Credit risk emanates when the counter party is unwilling or unable to meet or fulfill the contractual obligations/commitments thereby leading to defaults. Variants Credit Risk Transaction Risk Default Risk Down Grade Risk Port Folio Risk Concentration Risk Systemic Risk Default Risk Credit Default Risk Is the probability that the counter party will fail to meet his payment obligations as per agreement. Credit Risk of a bank depends upon several External and internal factors. These external or internal factors are related both to the borrower & the bank. Default Risk Internal factors Applicable to Banks: Deficient loan policies Inadequately defined powers for sanction of loans Absence of prudential credit concentration limits Absence of credit committees Deficiency in credit appraisal systems Excessive dependence on collaterals Inadequate/lack of risk pricing Absence of loan review mechanism Post sanction surveillance Default Risk External factors-Applicable to Borrowers: Inadequate technical know-how Locational disadvantages Outdated production process High input costs Break even point being very high Uneconomic size of plant Large investment in Fixed assets Over estimation of demand Wide swings in commodity or equity prices
Default Risk External Factors-Applicable both to the borrower and Banks: Credit worthiness of the counter party Interest rate risk Forex risk Country risk Economic scenario Government policies Trade restrictions.
Down Grade Risk Rating down grade risk This is the probability that the credit risk measure of the counter party as measured by a credit rating system ,worsens during the loan period and market value of the asset falls due to rating down grade. Status of the credit exposure may not remain the same. Quality of the credit exposure may improve on account of various factors. Quality of the credit exposure may deteriorate . Improvement in the credit quality indicated by the upward movement of the rating of the party is called upward migration. Deterioration in the quality of the credit exposure as indicated by the down ward movement of the credit rating is called down ward migration. Down Grade Risk When the quality of the exposure deteriorates as indicated by the down ward migration of the rating, the exposure needs more provision. Down grade risk also calls for more capital allocation Portfolio Risk At the portfolio level, the risk may be concentration risk or systemic risk. The concentration risk may be by way of: Industry/Activity Loan size Distribution in a region Security Loan Ratio Repayment period Interest rate Purpose Income level It would be prudent to set overall as also individual sub limits for each of the concentration classes Systemic Risk The portfolio quality may deteriorate in spite of proper diversification. This may be due to various factors beyond the control of the Borrower and the causes may be many and varied such as- Interest rate Exchange rate Government policy Inflation Etc