In Course of Banks Lending Involves a Number of Risks

8/4/2019 In Course of Banks Lending Involves a Number of Risks

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In course of banks lending involves a number of risks. In addition to the risks related to creditworthiness of the

counterparty, the banks are also exposed to interest rate, forex and country risks.

Unlike market risks, where the measurement, monitoring, control etc. are to a great extent centralized. Credit risks

management is a decentralized function or activity. This is to say that credit risk taking activity is spread across the

length and breadth of the network of branches, as lending is a decentralized function. Proper a sufficient care has to

be taken for appropriate management of credit risk.Credit risk or default risk involves inability or unwillingness of a customer or counterparty to meet commitments in

relation to lending, trading, hedging, settlement and other financial transactions. The objective of credit risk

management is to minimize the risk and maximize banks risk adjusted rate of return by assuming and maintaining

credit exposure within the acceptable parameters.

The Credit Risk is generally made up of transaction risk or default risk and portfolio risk. The portfolio risk in turn

comprises intrinsic and concentration risk. The credit risk of a banks portfolio depends on both external and internal

factors. The external factors are the state of the economy, rates and interest rates, trade restrictions, economic

sanctions, wide swings in commodity/equity prices, foreign exchange rates and interest rates, trade restrictions,

economic sanctions, Government policies, etc. The internal factors are deficiencies in loan policies/administration,

absence of prudential credit concentration limits, inadequately defined lending limits for Loan Officers/Credit

Committees, deficiencies in appraisal of borrowers financial position, excessive dependence on collaterals andinadequate risk pricing, absence of loan review mechanism and post sanction surveillance, etc.

Another variant of credit risk is counterparty risk. The counterparty risk arises from non-performance of the trading

partners. The non-performance may arise from counterpartys refusal/inability to perform due to adverse price

movements or from external constraints that were not anticipated by the principal. The counterparty risk is generally

viewed as a transient financial risk associated with trading rather than standard credit risk.

The management of credit risk should receive the top managements attention and the process should encompass:

Measurement of risk through credit rating/scoring:

(a) Quantifying the risk through estimating expected loan losses i.e. the amount of loan losses that bank would

experience over a chosen time horizon (through tracking portfolio behavior over 5 or more years) and unexpected

loss (through standard deviation of losses or the difference between expected loan losses and some selected target

credit loss quantile);(b) Risk pricing on a scientific basis; and

(c) Controlling the risk through effective Loan Review Mechanism and portfolio management.

The credit risk management process should be articulated in the banks Loan Policy, duly approved by the Board.

Each bank should constitute a high level Credit PolicyCommittee, also called Credit Risk Management Committee

or Credit Control Committee etc. to deal with issues relating to credit policy and procedures and to analyze, manage

and control credit risk on a bank wide basis.

The Committee should be headed by the Chairman/CEO/ED, and should comprise heads of Credit Department,

Treasury, Credit Risk Management Department (CRMD) and the Chief Economist.

The Committee should, inter alia, formulate clear policies on standards for presentation of credit proposals, financial

covenants, rating standards and benchmarks, delegation of credit approving powers, prudential limits on large credit

exposures, asset concentrations, standards for loan collateral, portfolio management, loan review mechanism, riskconcentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc.

Concurrently, each bank should also set up Credit Risk Management Department (CRMD), independent of the Credit

Administration Department. The CRMD should enforce and monitor compliance of the risk parameters and prudential

limits set by the CPC. The CRMD should also lay down risk assessment systems, monitor quality of loan portfolio,

identify problems and correct deficiencies, develop MIS and undertake loan review/audit.


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Large banks may consider separate set up for loan review/audit. The CRMD should also be made accountable for

protecting the quality of the entire loan portfolio. The Department should undertake portfolio evaluations and conduct

comprehensive studies on the environment to test the resilience of the loan portfolio.

Credit Risk may be defined as the risk of default on the part of the borrower. The lender always faces the risk of the

counter party not repaying the loan or not making the due payment in time. This uncertainty of repayment by the

borrower is also known as default risk.Some of the commonly used methods to measure credit risk are:

1. Ratio of non performing advances to total advances;

2. Ratio of loan losses to bad debt reserves;

3. Ratio of loan losses to capital and reserves;

4. Ratio of loan loss provisions to impaired credit;

5. Ratio of bad debt provision to total income; etc.

Managing credit risk has been a problem for the banks for centuries. As had been observed by John Medlin, 1985

issue of US banker.

Balancing the risk equation is one of the most difficult aspects of banking. If you lend too liberally, you get

into trouble. If you dont lend liberally you get criticized.Over the tears, bankers have developed various methods for containing credit risk. The credit policy of the banks

generally prescribes the criteria on which the bank extends credit and, inter alia, provides for standards.

Risk in business

Risk can be defined as any uncertainty about a future event that threatens theorganisation's ability to accomplish its mission. Business is a trade off between risk andreturn. There can be no risk-free or zero risk oriented business. Risk in its pragmaticsense, therefore, involves both threats that may be materialised and opportunities whichcan be exploited.

Credit Risk and Default

Credit Risk is the risk of loss to the Bank in the event ofDefault.

Default arises due to counterparty's inability and/or unwillingness to meet commitments inrelation to lending.

Credit risk is the potential loss that a bank borrower or counter party will fail tomeet its obligation in accordance with the agreed terms

TYPES OF THE CREDIT RISK

A) Transaction risk B) Portfolio riska) Grade risk a) concentration riskb) default risk b) intrinsic risk

1) non payment2) delayed payment

Credit risk may be in the following forms:


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* In case of the direct lending* In case of the guarantees and the letter of the credit* In case of the treasury operations* In case of the securities trading businesses* In case of the cross border exposure

Traditionally credit risk has 2 components

a) Solvency aspects of the credit risk-the risk borrower is unable to pay

b) Liquidity aspects of the risk-the risk that arise due to the delay in the repayment by theborrower leading to the cash flow problems for the leader

The need for Credit Risk Rating

The need for Credit Risk Rating has arisen due to the following:

1. With dismantling of State control, deregulation, globalisation and allowing things to shape

on the basis of market conditions, Indian Industry and Indian Banking face new risks andchallenges. Competition results in the survival of the fittest. It is therefore necessary toidentify these risks, measure them, monitor and control them.

2. It provides a basis for Credit Risk Pricing i.e. fixation of rate of interest on lending todifferent borrowers based on their credit risk rating thereby balancing Risk & Reward for theBank.

3. The Basel Accord and consequent Reserve Bank of India guidelines requires that the levelof capital required to be maintained by the Bank will be in proportion to the risk of the loanin Bank's Books for measurement of which proper Credit Risk Rating system is necessary.

4. The credit risk rating can be a Risk Management tool for prospecting fresh borrowers inaddition to monitoring the weaker parameters and taking remedial action.

The Credit Risk Rating method is used by Bank's Credit officers,

* To gather key information about risk areas of a borrower and* To arrive at a risk score that would reflect the borrower's creditworthiness/degree of risk.The types of Risks Captured in the Bank's Credit Risk Rating Model

The Credit Risk Rating Model provides a framework to evaluate the risk emanating fromfollowing main risk categorizes/risk areas:

* Industry risk* Business risk* Financial risk* Management risk* Facility risk* Project risk

The Overall Rating is assigned on a 'A++' to 'C' scale presented below along with itsmeaning:


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RatingGrade Description MeaningA++ Exceptionally high position of strength.

Very High degree of sustainability.Minimum Risk

A+ High degree of strength on a factoramong the peer group.High degree of sustainability.

Marginal RiskA Moderate degree of strength with positive outlook. Modest RiskB+ Moderate degree of strength with stable or marginally negative outlook. Average RiskB Weakness on a parameter in comparison to peers. Unstable outlook. Marginally Above Average RiskC A fundamental weakness with regard to the factor. Unlikely to improve

under normal circumstances. CautionD ** Default** "D" rating - This denotes default category for companies defaulting as per the NPA

guidelines. The underlying borrower or company being rated can be assigned a D rating only

in the Management/Facility Module.

Credit Risk is the potential that a bank borrower/counter party fails to meet the obligations

on agreed terms. There is always scope for the borrower to default from his commitmentsfor one or the other reason resulting in crystalisation of credit risk to the bank.These losses

could take the form outright default or alternatively,losses from changes in portfolio value

arising from actual or perceived deterioration in credit quality that is short of default. Credit

risk is inherent to the business of lending funds to the operations linked closely to market

risk variables. The objective of credit risk management is to minimize the risk and maximize

bank's risk adjusted rate of return by assuming and maintaining credit exposure within the

acceptable parameters.Credit risk consists of primarily two components, viz Quantity of risk,

which is nothing but the outstanding loan balance as on the date of default and the quality

of risk, viz, the severity of loss defined by both Probability of Default as reduced by the

recoveries that could be made in the event of default. Thus credit risk is a combined

outcome of Default Risk and Exposure Risk.

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In Course of Banks Lending Involves a Number of Risks