Bank Promotion Study

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Risk Management System in Banks: Credit Risk

 

The banks face mainly Credit Risk and Market Risk. Risk Management System of the bank evolves around managing these risks effectively. Different types of market risk are managed and looked after by Asset - Liability Management Committee (ALCO) whereas the credit /counterparty risk and country risk are managed through Credit Policy Committee (CPC).

Generally, the policies and procedures for measuring and containing market risk are articulated in the ALM policies and whereas credit risk is addressed in Loan Policies and Procedures. The market and credit risks are therefore managed in a parallel two-track approach in banks.


The other kind of risk that is being associated with Financial world is Operational Risk. A risk that cannot be categorized as Credit Risk or Market Risk is called Operational Risk. The example of operational risk is system breakdown, Staff related risks etc. Operational risks usually have a leading impact upon Credit or Market Risk. For example, if the selection of staff is not appropriate it can lead to Credit risk.




Credit Risk

Generally, Credit risk the risk that you owe when you lend money to somebody in the shape that money lent may not come back on given terms or on given time. If you have given funds to somebody on a specific term which may include rate of interest also, there are chances (or better call it risk) that borrower may not give you funds back as per agreed terms or he may not give it to you on time. This un-fulfilment of commitment from the borrower may paralyze your further plans and there are chances that effects of this delinquency will percolate and affect various other parties. So, it is imperative to measure and contain the 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 credit risk of a bank's portfolio depends on both external and internal factors. 

External factors are the state of the economy, wide swings in commodity/equity prices, foreign exchange rates and interest rates, trade restrictions, economic sanctions, Government policies, etc. 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 and inadequate risk pricing, absence of loan review mechanism and post sanction surveillance, etc.


Counterparty Risk

 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 counterparty's 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.


Management of Credit Risk

The Credit Management process should involve the following steps

a) Measurement of risk through credit rating/scoring;

b) Quantifying the risk through estimating expected loan losses and unexpected loan losses

c) Risk pricing on a scientific basis; and

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

CREDIT RISK MANAGEMENT COMMITTEE

Banks should constitute a high-level Credit Policy Committee, also called Credit Risk Management Committee or Credit Control Committee etc. 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 deal with issues relating to credit policy and procedures. It should further analyze, manage and control credit risk on a bank wide basis.

The Committee should, inter alia, formulate clear policies and specify standards like

i) Standards for presentation of credit proposals,

ii) Financial covenants

iii) Rating standards and benchmarks,

iv) Delegation of credit approving powers,

v) Prudential limits on large credit exposures, vi) Asset concentrations, vii) Loan Review Mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc.

Bank should have 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 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.


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 have 'Approval Grid' or a 'Committee', for sanctioning the loan proposals which should comprise of at least 3 or 4 officers and invariably one officer from CRMD. These committees are required to be formed at Large Branches, Regional Offices, Zonal Offices, Head Offices, etc. The credit decision should be taken by majority members of the 'Approval Grid' or 'Committee' and if they do not agree on the creditworthiness of the borrower, the specific views of the dissenting member/s should be recorded. The banks evaluate 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.


CONTROLLING AND MITIGATING CREDIT RISK:

Setting up of Prudential Limits

In order to limit the magnitude of credit risk, the banks should lay down the prudential limits:

a) The banks should stipulate benchmark current/debt equity and profitability ratios, debt service coverage ratio or other ratios, with flexibility for deviations.

b) The banks should specify the single/group borrower limits, which may be lower than the limits prescribed by Reserve Bank.

c) The banks should specify 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;

d) The banks should specify maximum exposure limits to industry, sector, etc. 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; and

e) The banks should consider maturity profile of the loan book, keeping in view the market risks inherent in the balance sheet, risk evaluation capability, liquidity, etc.


Risk Rating

Banks should have a comprehensive risk rating system that measures risk for taking credit decisions. It should possess following qualities/characteristics

i) The risk rating system should in-compass the overall risk of lending, by taking cognizance of critical inputs.

ii) The pricing and other terms of loan and advances should be fixed by considering rating of the credit proposal.

iii) The rating should further be meaningful to Management for review and managing the loan portfolio.

iv) The risk rating, in short, should reflect the underlying credit risk of the loan book. The risk rating system should be drawn up in a structured manner, incorporating, inter alia, financial analysis, projections and sensitivity, industrial and management risks.

v) Banks should have separate rating framework for large corporate / small borrowers, traders, etc. that exhibit varying nature and degree of risk.

Apart from other form of risk as mentioned above, banks face significant risk in form of Forex exposures. The banks forex exposure to corporate who do not have natural hedge consists significant risk factor. Therefore, the unhedged exposures of borrowers should also be taken care of in the rating framework.

The overall score for risk is placed on a numerical scale ranging between 1-6, 1-8, etc. on the basis of credit quality and the bank should prescribe the minimum rating below which no exposures would be undertaken.

Relaxation in stipulated norms and authority thereof has to be clearly articulated in the Loan Policy. The updating of the credit ratings is to be undertaken normally at quarterly intervals or at least at half yearly intervals.


Conclusion

The main function of Risk Management is to bring a balance between risk and return. 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. The pricing of loans normally is linked to risk rating or credit quality. if the pricing is well set to maintain balance between risk and return, then the banks will be able to mitigate the credit risk

 


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