DISSERTATION REPORT ON

CREDIT RISK MANAGEMENT IN BANKS

FACULTY GUIDE:
SUBMITTED BY:

MRS. KIRANDEEP KAUR

XYZ

AMITY INTERNATIONAL BUSINESS SCHOOL

MBA-IB(2008-2010)

AMITY INTERNATIONAL BUSINESS

SCHOOL

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 NOIDA

AMITY UNIVERSITY UTTAR PRADESH

DECLARATION
I XYZ, student of Master of Business Administration-International Business from Amity International
Business School, Amity University Uttar Pradesh hereby declare that I have completed Dissertation on
Credit Risk Management in Banks as part of the course requirement.

I further declare that the information presented in this project is true and original to the best of my
knowledge.

Signature

XYZ

Enroll.No.

MBA(IB)-Finance

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 Amity International Business School

CERTIFICATION
I, Mrs. ABC hereby certify that AXZ student of Master of Business Administration-
International Business from Amity International Business School, Amity University
Uttar Pradeshhas completed dissertation on Credit Risk Management in Banks under
my guidance.Ms. Suman Sharma was found to be sincere and hard working

Signature

Mrs.ABC

Lecturer

Amity International Business School

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 Amity International Business
School

ACKNOWLEDEGEMENT

Every endeavor in itself is an impression of the efforts of not only those who pursue it but of
those as well who provide guidance and motivation towards its successful completion. Likewise,
this project bears an imprint of all those who helped me at various stages and it would be unfair
on my part not to thank them.

I would like to express my gratitude to my research supervisor Mrs. ABC, Lecturer A.I.B.S. for
her constant and sagacious guidance during the cource of this research.Without her scholarly
advice and co-operation it would not have been possible for me to complete this project in the
present form.

Last, but not the least, I am really dearth of words to venerate my parents whose steady efforts
and motivation helped me to accomplish this work successfully.

I assure that all the information provided by me is original and authenticated.

XYZ

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Amity International Business School

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 Table of Content

S.No. Chapter No. Subject Page No.

1 1 Introduction 7
2 2 Review of Literature 31
3 3 Research Methodology 41
4 4 Data Analysis and Interpretation 46
5 5 Case study analysis 63
6 6 Conclusion and Recommendations 75
7 Bibliography 87

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CREDIT RISK MANAGEMENT IN BANKS

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 Chapter-1.
Introduction

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 Introduction
Success comes out of measuring because what cannot be measured cannot be managed. Banks
have developed sophisticated systems to quantify and aggregate credit risk in an attempt to
model the credit risk arising from important aspects of their business lines. Such models are
intended to aid banks in quantifying, aggregating and managing risk across geographical
locations and product lines. Banks credit exposures span across geographical locations and
product lines. The use of credit risk models offer banks a framework for examining this risk in a
timely manner, centralising data on global exposures and analysing marginal and absolute
contributions to risk. These properties of models may contribute to an improvement in a banks
overall ability to identify, measure and manage risk.
The motivation for this particular study stemmed from the desire to provide more accurate and
comprehensive base for the estimation of credit risk which will further aid the quantitative
estimation of the amount of economic capital needed to support a banks risk-taking activities.
As the outputs of credit risk models have assumed an increasingly large role in the risk
management processes of large banking institutions, the issue of their applicability for
supervisory and regulatory purposes has also gained prominence. Furthermore, a models-based
approach may also bring capital requirements into closer alignment with the perceived riskiness
of underlying assets, and may produce estimates of credit risk that better reflect the composition
of each banks portfolio. However, before a portfolio modelling approach could be used in the
formal process of setting regulatory capital requirements, it has to be ensured that the models are
not only well integrated with banks day-to-day credit risk management, but are also
conceptually sound, empirically validated, and produce capital requirements that are comparable
across similar institutions.

The etymology of the word Risk can be traced to the Latin word Rescum meaning Risk at
Sea or that which cuts. Risk is associated with uncertainty and reflected by way of charge on the
fundamental/ basic i.e. in the case of business it is the Capital, which is the cushion that protects
the liability holders of an institution. These risks are inter-dependent and events affecting one
area of risk can have ramifications and penetrations for a range of other categories of risks.
Foremost thing is to understand the risks run by the bank and to ensure that the risks are properly
confronted, effectively controlled and rightly managed. Each transaction that the bank undertakes
changes the risk profile of the bank. The extent of calculations that need to be performed to
understand the impact of each such risk on the transactions of the bank makes it nearly
impossible to continuously update the risk calculations. Hence, providing real time risk
information is one of the key challenges of risk management exercise.

Till recently all the activities of banks were regulated and hence operational environment was not
conducive to risk taking. Better insight, sharp intuition and longer experience were adequate to
manage the limited risks. Business is the art of extracting money from others pocket, sans
resorting to violence. But profiting in business without exposing to risk is like trying to live
without being born. Every one knows that risk taking is failureprone as otherwise it would be
treated as sure taking. Hence risk is inherent in any walk of life in general and in financial
sectors in particular. Of late, banks have grown from being a financial intermediary into a risk
intermediary at present. In the process of financial intermediation, the gap of which becomes

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thinner and thinner, banks are exposed to severe competition and hence are compelled to
encounter various types of financial and non-financial risks. Risks and uncertainties form an
integral part of banking which by nature entails taking risks. Business grows mainly by taking
risk. Greater the risk, higher the profit and hence the business unit must strike a trade off between
the two. The essential functions of risk management are to identify, measure and more
importantly monitor the profile of the bank. While Non-Performing Assets are the legacy of the
past in the present, Risk Management system is the pro-active action in the present for the future.
Managing risk is nothing but managing the change before the risk manages. While new avenues
for the bank has opened up they have brought with them new risks as well, which the banks will
have to handle and overcome.

When we use the term Risk, we all mean financial risk or uncertainty of financial loss. If we
consider risk in terms of probability of occurrence frequently, we measure risk on a scale, with
certainty of occurrence at one end and certainty of non-occurrence at the other end. Risk is the
greatest where the probability of occurrence or non-occurrence is equal. As per the Reserve Bank
of India guidelines issued in Oct. 1999, there are three major types of risks encountered by the
banks and these are Credit Risk, Market Risk & Operational Risk. As we go along the article, we
will see what are the components of these three major risks. In August 2001, a discussion paper
on move towards Risk Based Supervision was published. Further after eliciting views of banks
on the draft guidance note on Credit Risk Management and market risk management, the RBI
has issued the final guidelines and advised some of the large PSU banks to implement so as to
guage the impact. A discussion paper on Country Risk was also released in May 02. Risk is the
potentiality that both the expected and unexpected events may have an adverse impact on the
banks capital or earnings. The expected loss is to be borne by the borrower and hence is taken
care of by adequately pricing the products through risk premium and reserves created out of the
earnings. It is the amount expected to be lost due to changes in credit quality resulting in default.
Where as, the unexpected loss on account of the individual exposure and the whole portfolio in
entirely is to be borne by the bank itself and hence is to be taken care of by the capital. Thus, the
expected losses are covered by reserves/provisions and the unexpected losses require capital
allocation. Hence the need for sufficient Capital Adequacy Ratio is felt. Each type of risks is
measured to determine both the expected and unexpected losses using VaR (Value at Risk) or
worst-case type analytical model.

Emergence of Risk management in Banks

The banking environment consists of numerous risks that can impinge upon the profitability of
the banks. These multiple sources of risk give rise to a range of different issues. In an
environment where the aspect of the quantitative management of risks has become a major
banking function, it is of lesser importance to speak of the generic concepts. The different types
of risks needs to be carefully defined and such definitions provide a first basis for measuring
risks on which the risk management can be implemented.
There have been a number of factors that can be attributed to the stabilization of the banking
environment in nineties. Prior to that period, the industry was heavily regulated. Commercial
banking operations were basically restricted towards collecting resources and lending operations.
The regulators were concerned by the safety of the industry and the control of its money creation

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power. The rules limited the scope of the operations of the various credit institutions and limited
their risks as well. It was only during the nineties that banks experienced the first drastic waves
of change in the industry. Among the main driving forces that played a crucial role in the changes
were the inflating role of the financial markets, deregulation of the banking sector and the
increase in the competition among the existing and emerging banks.
On the foreign exchanges front, the floating exchanges rates accelerated the growth of
uncertainty. Monetary policies favouring high levels of interest rates and stimulating their
intermediation was by far the major channel of financing the economy, disintermediation
increased at an accelerated pace. Those changes turned into new opportunities and threats for the
players.
These waves of changes generated risks. Risks increased because of new competition, product
innovations, the shift from commercial banking to capital markets increased market volatility
and the disappearance of old barriers which limited the scope of operations for the various
financial institutions. There was a total and radical change in the banking industry. Here it is
worth mentioning that this process has been a continuous 5 one and has taken place in an orderly
manner. Thus it is no surprise that risk management emerged strongly at the time of these waves
of transformation in the banking sector.
Banks Risks
As stated , risks are usually defined by the adverse impact on profitability of several distinct
sources of uncertainty. Risk measurement requires that both the uncertainty and its potential
adverse effect on profitability be addressed. Let us now try to focus on the risk framework purely
from the perspective of a bank
Risk Framework
The various risks associated with the banking may be defined as below and these definitions
have the advantage of being readily recognizable to bankers.
(i) Credit Risk : Risk of loss to the bank as a result of a default by an obligator.
(ii) Solvancy Risk : Risk of total financial failure of a bank due to its chronic inability to meet
obligations.
(iii) Liquidity Risk : the risk arising out of a banks inability to meet the repayment
requirements.
(iv) Interest Rate Risk : Volatility in operationd of net interest income, or the present values of a
portfolio, to changesin interest rates.
(v) Price Risks : Risk of loss/gain in the value of assets, liabilities or derivative due to market
price changes, notably volatility in exchange rate and share price movements.
(vi) Operational Risk : Risks arising from out of failures in operations, supporting systems,
human error, omissions, design fault, business interruption, frauds, sabotage, natural disaster etc.
Credit Risk:
Credit risk with respect to bank is most simply defined as the risk of a borrowers payment
default on payment of interest and principal due to the borrowers unwillingness or inability to
service the debt. The higher the credit risk an institution is exposed to, the 6 greater the losses
may be. For banks and most other credit institutions, credit risk is considered to be the form of
risk that can most significantly diminish earnings and financial strength . The effective
management of credit risk is a critical component of a comprehensive approach to risk
management and essential to the long-term success of any banking organization. Banks should
also consider the relationships between credit risk and other risks.

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Need to Manage Credit Risk
For most banks loans are the largest and most obvious source of credit risk; Loans and advances
constitute almost sixty per cent of the assests side of the balance sheet of any bank. As long as
the borrower pays the interest and the principal on the due dates, a loan will be a performing
asset. The problem however arises once the payments are delayed or defaulted and such
situations are very common occurances in any bank. Delays/defaults in payments affect the cash
forecasts made by the bank and further result in a changed risk profile, as the bank will now have
to face an enhanced interest rate risk, liquidity risk and credit risk. Banks are increasingly facing
credit risk in various financial instruments other than loans, which include interbank transactions,
trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options,
and in the extension of commitments and guarantees, and the settlement of transactions.
Traditional Credit Risk Measurement Approaches
It is hard to draw a clear line between traditional and new approaches, as many of the superior
concepts of the 8 traditional models are used in the new models. One of the most widely used
traditional credit risk measurement approaches is the Expert System.

Expert Systems
In an expert system, the credit decision is made by the local or branch credit officer. Implicitly,
this persons expertise, skill set, subjective judgement and weighting of certain key factors are
the most important determinants in the decision to grant credit. The potential factors and expert
systems a credit officer could look at are infinite. However, one of the most common expert
systems, the five Cc of credit will yield sufficient understanding. The expert analyzes these
five key factors, subjectively weights them, and reaches a credit decision:
Capital Structure : The equity-to-debt ratio (leverage) is viewed as a good predictor of
bankruptcy probability. High leverage suggests greater suggests greater probability of
bankruptcy than low leverage as a low level of equity reduces the ability of the business to
survive losses of income.
Capacity : The ability to repay debts reflects the volatility of the borrowers earnings. If
repayments on debt contracts prove to be a constant stream over time, but earnings are volatile
(and thus have a high standard deviation ), its highly probable that the firms capacity to repay
debt claims would be risk.
Collateral : In event of a default a lender has claim on the collateral pledged by the borrower.
The greater the propagation of this claim and the greater the market value of the underlying
collateral, the lower the remaining exposure risk of the loan in t he case of a default.
Cycle/Economic Conditions : An important factor in determining credit-risk exposure is the
state of the business cycle, especially for cycle-dependent industries. For example, the
infrastructure sectors (such as the metal industries, construction etc.) tend to be more cycle
dependent than nondurable goods sectors, such as food, retail, and services. Similarly, industries
that have exposure to international competitive conditions tend to be cycle sensitive. Taylor, in
an analysis of Dun and Bradstreet bankruptcy data by industry (both means and standard
deviations), 9 found some quite dramatic differences in US industry failure rates during the
business cycle.

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Character : This is measure of the firms reputation, its willingness to repay, and its credit
history. In particular, it has been established empirically that the age factor of an organization is a
good proxy for its repayment reputation. Another factor, not covered by the five Cs, is the
interest rate. It is well known from economic theory that the relationship between the interest-
rate level and the expected return on a loan (loss probability) is highly non-linear. At low
interest-rate levels, an increase in rates may lower the return on a loan, as the probability of loss
would increased.
This negative relationship between high loan rates and expected loan returns is due to two
effects :
i. Adverse selection
ii. Risk shifting
When loan rates rise beyond some point, good borrowers drop out of the loan market, preferring
to self-finance their investment projects or to seek equity capital funding (adverse selection). The
remaining borrowers, who have limited liability and limited equity at stake and thus lower
rating have the incentive to shift into riskier projects (risk shifting). In upside economies and
supporting conditions, they will be able to repay their their debts to the bank. If economic
conditions weaken, they will have limited downside loss from a borrowers perspective.
Although many financial institutions still use expert systems as part of their credit decision
process, these systems face two main problems regarding the decision process:
Consistency : what are the important common factors to analyze across different types of
groups of borrowers?
Subjectivity : What are the optimal weights to apply to the factors chosen? In principle , the
subjective weights applied to the five Cs derived by an expert can vary from borrower to
borrower. This makes comparability of rankings and decisions across the loan portfolio very
difficult for an individual attempting to monitor a personal 10 decision and for other experts in
general. As a result, quite different processes and standards can be applied within a financial
organization to similar types of borrowers. It can be argued that the supervising committees or
multilayered signature authorities are key mechanisms in avoiding consistency problems and
subjectivity, but it is unclear how effectively they impose common standards in practice.
Management Information Systems Management of Credit Risk
Banks must have information systems and analytical techniques that enable management to
measure the credit risk inherent in all on- and off-balance sheet activities. The management
information system should provide adequate information on the composition of the credit
portfolio, including identification of any concentration of risk. Banks should have methodologies
that enable them to quantify the risk involved in exposures to individual borrowers. Banks
should also be able to analyse credit risk at the product and portfolio level in order to identify
any particular sensitivities or concentrations. The measurement of credit risk should take account
of:
i. The specific nature of the credit (loan, derivative, facility, etc.) and its contractual and financial
conditions.
ii. The exposure profile until maturity in relation to potential market movements
iii. The existence of the collateral or guarantees
iv. The potential for default based on the internal risk rating. The analysis of credit risk data
should be undertaken at an appropriate frequency with the results reviewed against relevant
limits. Banks should use measurement techniques that are appropriate to the complexity and

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level of the risks involved in their activities, based on robust data and subject to periodic
validation.

Credit Elements : Policy, Process, Behaviour

Credit elements ultimately come together within the framework of credit policy, process, credit
officers behaviour and audit. Policy is the credit cultures anchor and the banks credit
conscience. Its role is to assist credit officers in balancing the volume and quality of credit.
Process is the line-driven operational arm of credit and credit strategy. It makes the credit system
work, defends its integrity through close supervision and built-in checks and balances and by
anticipating problems, guards against surprises. Credit officers behaviour reflects the attitudes
and patterns of behaviour of the CEO and supervisory management as well as institutional
philosophies, traditions, priorities and standards.
Audits role is more than being counting. It also evaluates such matters as conformity to policy,
credit practices and procedures, portfolio quality, adherence to business plans, development and
distribution of credit talent and the competence of individual credit officers. Credit behaviour
ranges from defensive conservatism to irresponsible aggressiveness.
There must be a balance, and this is what a bank expects of its credit officers:
Understand each aspect of each credit proposal thoroughly.
Balance the quantity and quality of credit to achieve earning objectives while meeting
appropriate credit needs.
Always maintain acceptable credit standards.
Not be greedy and keep risks to reasonable limits.
Evaluate new business opportunities in a balanced way, avoiding risks that should not be
taken.
Not be mesmerized by house names or by size. Big borrowers can swing big and be high
rollers when in trouble. The amount of the banks exposure should be related to the quality of
the borrower.
Place the banks interest ahead of the profit centers
Be mindful of banks liquidity and loan port-folio objectives.

RISK MANAGEMENT COMMITTEE

Risk Management Committee was constituted on January 18, 2003. The functions of the Risk
Management Committee include the following:
To devise the policy and strategy for integrated risk management containing various
risk exposures of the Bank including the Credit Risk.
To co-ordinate between the Credit Risk Management Committee (CRMC), the Asset
Liability Management Committee (ALMC) and Operational Risk Management
Committee (ORMC) and other risk committees of the Bank.
The responsibility of the Committee includes:
Setting policies and guidelines for market risk measurement, management and reporting
Ensuring that market risk management processes (including people, systems, operations, limits
and controls) satisfy Banks policy
Reviewing and approving market risk limits, including triggers or stop-losses for traded
and accrual portfolios
Appointment of qualifi ed and competent staff; ensuring posting of qualifi ed and

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competent staff and of independent market risk manager/s etc.

Importance of Credit Risk Assessment

Effective credit risk assessment and loan accounting practices should be performed in a
systematic way and in accordance with established policies and procedures. To be able to
prudently value loans and to determine appropriate loan provisions, it is particularly important
that banks have a system in place to reliably classify loans on the basis of credit risk. Larger
loans should be classified on the basis of a credit risk grading system. Other, smaller loans, may
be classified on the basis of either a credit risk grading system or payment delinquency status.
Both accounting frameworks and Basel II recognise loan classification systems as tools in
accurately assessing the full range of credit risk. Further, Basel II and accounting frameworks
both recognise that all credit classifications, not only those reflecting severe credit deterioration,
should be considered in assessing probability of default and loan impairment.
A well-structured loan grading system is an important tool in differentiating the degree of credit
risk in the various credit exposures of a bank. This allows a more accurate determination of the
overall characteristics of the loan portfolio, probability of default and ultimately the adequacy of
provisions for loan losses. In describing a loan grading system, a bank should address the
definitions of each loan grade and the delineation of responsibilities for the design,
implementation, operation and performance of a loan grading system.
Credit risk grading processes typically take into account a borrowers current financial condition
and paying capacity, the current value and realisability of collateral and other borrower and
facility specific characteristics that affect the prospects for collection of principal and interest.
Because these characteristics are not used solely for one purpose (e.g. credit risk or financial
reporting), a bank may assign a single credit risk grade to a loan regardless of the purpose for
which the grading is used. Both Basel II and accounting frameworks recognise the use of internal
(or external) credit risk grading processes in determining groups of loans that would be
collectively assessed for loan loss measurement.

Thus, a bank may make a single determination of groups of loans for collective assessment under
both Basel II and the applicable accounting framework. Credit Rating is the main tool to assess
credit risk, which helps in measuring the credit risk and facilitates the pricing of the account. It
gives the vital indications of weaknesses in the account. It also triggers portfolio management at
the corporate level. Therefore, banks should realize the importance of developing and
implementing effective internal credit risk management. It involves evaluating and assessing an
institutions risk management, capital adequacy ,and asset quality. Risk ratings should be
reviewed and updated whenever relevant new information is received. All credits should receive
a periodic formal review (e.g. at least annually) to reasonably assure that credit risk grades are
accurate and up-to-date. Credit risk grades for individually assessed loans that are either large,
complex, higher risk or problem credits should be reviewed more frequently. To ensure the
proper administration of their various credit risk-bearing portfolio the banks must have the
following:

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a. A system for monitoring the condition of individual credits, and determining the adequacy of
provisions and reserves,
b. An internal risk rating system in managing credit risk. The rating system should be consistent
with the nature, size and complexity of a banks activities,
c. Information systems and analytical techniques that enable the management to measure the
credit risk inherent in all on- and off-balance sheet activities. The management information
system should provide adequate information on the composition of the credit portfolio, including
identification of any concentrations of risk,
d. A system for monitoring the overall composition and quality of credit portfolio. In addition
while approving loans, due consideration should be given to the integrity and reputation of the
borrower or counterparty as well as their legal capacity to assume the liability. Once credit-
granting criteria are established, it is essential for the bank to ensure that the information it
receives is sufficient to make proper credit-granting decisions. This information will also serve
as the basis for rating the credit under the banks internal rating system.
Internal credit risk ratings are used by banks to identify gradations in credit risk among their
business loans. For larger institutions, the number and geographic dispersion of their borrowers
makes it increasingly difficult to manage their loan portfolio simply by remaining closely attuned
to the performance of each borrower. To control credit risk, it is important to identify its
gradations among business loans, and assign internal credit risk ratings to loans that correspond
to these gradations. The use of such an internal rating process is appropriate and indeed
necessary for sound risk management at large institutions. The long-term goal of this analysis is
to encourage broader adoption of sound practices in the use of such ratings and to promote
further innovation and enhancement by the industry in this area. Internal rating systems are
primarily used to determine approval requirements and identify problem loans, while on the
other end they are an integral element of credit portfolio monitoring and management, capital
allocation, pricing of credit, profitability analysis, and detailed analysis to support loan loss
reserving. Internal rating systems being used for the former purposes. As with all material bank
activities, as sound risk management process should adequaltely illuminate the risks being taken
and apply appropriate control allow the institution to balance risks against returns and the
institutions overall appetite for risk, giving due consideration to the uncertainties faced
by lenders and the long-term viability of the bank.
Based on the historical data which is both financial and non-financial a score is arrived at.
The borrower is then classified into different classes of credit rating based on the score which is
used to determine the rate of interest to be charged. The borrowers credit rating method used
above is only one such model. Based on the information available, a detailed and more
comprehensive model can be developed by banks.
Banking organizations should have strong risk rating systems. These systems should take proper
account of the gradations in risk and overall composition of portfolios in originating new loans,
assessing overall portfolio risks and concentrations, and reporting on risk profiles to directors
and management. Moreover, such rating systems also should play an important role in
establishing an appropriate level for the allowance for loan and lease losses, conducting internal
bank analysis of loan and relationship profitability, assessing capital adequacy, and possibly
performance-based compensation. Credit risk ratings are designed to reflect the quality of a loan
or other credit exposure, and thus explicitly or implicitly- the loss characterstics of that loan or

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exposure.In addition, credit risk ratings may reflect not only the likelihood or severity of loss but
also the variability of loss over time, particularly as this relates to the effect of the business
cycle. Linkage to these measurable outcomes gives greater clarity to risk rating analysis and
allows for more consistent evaluation of performance against relevant benchmarks, In
documentation their credit administration procedure, institutions should clearly identify whether
risk ratings reflect the risk of the borrower or the risk of the specific transaction. The rating scale
chosen should meaningfully distinguish gradations of risk within the institutions portfolio, so
that there is clear linkage to loan quality (and/or loss characterstics). To do so, the rating system
should be designed to address the range of risks typically encountered in the underlying
businesses of the institutions. Prompt and systematic tracking of credits in need of such attention
is an element of managing credit risk. Risk ratings should be reviewed by independent credit risk
management or loan review personnel both at the inception and also periodically over the life of
the loan. In view of the diverse financial and non-financial risks confronted by banks in the wake
of the financial sector deregulation, the risk management practices of the banks have to be
upgraded by adopting sophisticated techniques like Value at Risk (VaR), Duration and simulation
and adopting internal model- based approaches as also credit risk modeling techniques.
When making credit rating decisions, banks review credit application and credit reports with
respect to financial risk. Once lenders make a yes decision, they review the credit reports of
their customers on a regular basis as they continue to manage their financial risk. This process
scans credit reports for certain risk characterstics as defined by the lender. Some lenders, for
example, monitor whether or not all of a consumers payments are on time. Others look at
account balance in relation to the total credit limit. Some lenders review their accounts
frequently. Others review accounts once a year. Account monitoring also allows lenders to
manage the business risk of extending credit in a better way.
Banks pool assets and loans, which have a possibility of default and yet provide the depositors
with the assurance of the redemption at full face value. Credit risk, in terms of possibilities of
loss to the bank , due to failure of borrowers/counterparties in meeting commitment to the
depositors. Credit risk is the most significant risk, more so in the Indian scenario where the NPA
level of the banking system is significantly high. The management of credit risk through an
efficient credit administration is a prerequisite for long-term sustainability/ profitability of a
bank. A proper credit administration reduces the incidence of credit risk.
Credit risk depends on both internal and external factors. Some of the important external factors
are state of economy, swings in commodity prices, foreign exchange rates and interest rates etc.
The internal factors may be deficiencies in loan policies and administration of loan portfolio
covering areas like prudential exposure limits to various categories, appraisal of borrowers
financial position, excessive dependence on collaterals, mechanism of review and post-sanction
surveillance, etc. The key issue in managing credit risk is to apply a consistent evaluation and
rating system to all investment opportunities. Prudential limits need to be laid down on various
aspects of credit viz., benchmarking current ratio, debt-equity ratio, profitability ratio, debt
service coverage ratio, concentration limits for group/single borrower, maximum exposure limits
to industries, provision for flexibilities to allow variation for very special features. Credit rating
may be a single point indicator of diverse risk factors. Management of credit in a bank will
require alertness on the part of the staff at all the stages of credit delivery and monitoring
process. Lack of such standards in financial institution would increase the problem of increasing
loan write-offs. How can an institution be sure that its collateral is totally protected in the event

17
of bankruptcy by the borrower? The bank can ensure this through credit rating and loan
documentation.

Establishing Suitable Risk Position

Since banks cannot de-link the credit risk from the lending activity, they can only attempt to
reduce it to some extent by spreading their loans over a large group of borrowers, selling their
services in a variety of markets with different economic characterstics. Banks can diversify their
credit risk by maintaining proper exposure limits for its credit sanctions. Diversification can be
attained by setting exposure limits in the following areas:
Types of individuals, company/group of companies and industry
Categories of loan (product-type term loan/CC etc);
Geographical concentration
Though exposure norms are prescribed by the central banks from taking unlimited exposures, it
will be in the in interest of the best to develop a policy framework from determining such
exposure limits depending in its risk policy.
Credit Risk Rating Basel Committee Norms
Internal ratings based approach recommended by the basel committee would form the basis for a
sophisticated risk management system for banks.
A key element of the basel committees proposed new capital accord is the use of a banks
internal credit risk ratings to calculate the minimum regulatory capital it would need to set aside
for credit risk. Called the internal ratings based approach It links capital adequacy to the assets in
a banks books. Compared to capital allocation based on the standardized approach (including
the one-size fits all old version), the IRB regime is likely to make regulatory capital more
consistent with economic capital (the capital required by a bank to cover unexpected losses, as an
insurance against insolvency).
This is likely to reduce the amount of regulatory capital banks will be required to set against
credit risk inherent transactions and portfolios. Based on its risk assessment, a bank will slot the
exposure within a given grade. There must be enough credit grades in a banks internal ratings
system to achieve a fine distinction of the default risk of the various counter-parties.
A risk rating system must have a minimum of six to nine grades for performing borrowers and a
minimum of two grades for non-performing borrowers. More granularity can enhance a banks
ability to analyse its portfolio risk position, more appropriately price low-risk borrowers in the
highly competitive corporate lending market and importantly, prudently allocate risk capital to
the non-investment grade assets where the range of default rates is of a large magnitude.
The credit risk of an exposure over a given horizon involves the probability of default (PD) and
the fraction of the exposure value that is likely to be lost in t he event of default or loss given
default (LGD). While the PD is associated with the borrower, the LGD depends on the structure
of the facility. The product of PD and LGD is the Expected Loss (EL).
Risk tends to increase non-linearly default rates are low for the least risky grades but rise
rapidly as the grade worsens an A grade corporate will have a less probability of defaulting
within one year, while the next rated (BBB) borrower will have higher probability of defaulting,
which may further be higher for a CCC rated borrower. The probability of default is what defines
the objective risk characterstics of the rating. A banks rating system must have two dimensions.
The first must be oriented to the risk of the borrower default. The second dimension will take
into account transaction specific factors. This requirement may be taken care of by a facility

18
rating which factors in borrower and transaction characterstics or by an explicit quantifiable
LGD rating dimension.
For the purpose, banks will need to estimate facility-specific LGD by capturing data on historical
recoveries effected by them in the various assets that have default. The recoveries will have to be
adjusted for all expenses incurred and discounted to the present value at the time the corporate
default. Clarity and consistency in the implementation of the bank-wide rating system is integral
to a bank to relate its credit scores to objective loss statistics and convince the regulator that its
internal rating system is suitable for calculating regulatory capital. Human judgment is central to
the assignment of a rating. Banks, therefore, should design the operating flow of the process
towards promoting accuracy and consistency of ratings, without hindering the exercise of
judgment. While designing the operating framework, banks should include the organizational
division of responsibility of rating the nature of reviews to detect errors and inconsistencies, the
location of ultimate authority over rating assignment, the role of models in the rating process and
the specificity of rating definitions. Banks must have a mechanism of bank testing the rating
system and the loss characterstics of their internal ratings. This is essential to evaluate the
accuracy and consistency of the rating criteria, accurately price assets and analyse profitability
and performance of the portfolio, monitor the structure and migration of the loan portfolio and
provide an input to credit risk models and economic capital allocation process. The PD will
allow the back testing of banks rating system by comparing the actual default performance of
entities in a particular grade to the rate of default predicted by the bank rating. Back testing
against internal data and benchmarking the performance of the internals ratings system against
external rating systems will be a key part of the general verification process.
There are certain limitations, however, in using such an external mapping. First, would be the
significant difference in the quality and composition of the population of corporate rated by
rating agencies and those in a banks portfolio. Second, would be the time lag in which the
agencies would be putting out their data on default probabilities/migration frequencies with
this time lag there is a likelihood that the adverse changes in default probabilities is factored into
the rating system well after a recession in the economy. Third, there would be potential
inconsistencies in mapping a point-in-time rating with a Through-the-cycle rating fourth,
statistics available relate to developed markets and emerging markets and do not reflect
representation of varying degree of economic reforms and globalization.
Any improved internal risk internal rating system will need to have operational for some time
before either the bank or the regulators can amass data needed to back test the system and gain
confidence in it. The Basel paper on the IRB approach states that bank will be required to collect
and store substantial historical data on borrower default, rating decisions, rating histories, rating
migration, information used to assign the ratings, the model that assigned the ratings, PD
histories, key borrower characterstics and facility information.

Banks seeking eligibility for the IRB approach should move to develop and warehouse their own
historical loss experience data. Although data constraints remain a challenge and data collection
is costly, many banks have recognized its importance and have begun projects to build databases
of loan characterstics and loss experience. The internal rating of a bank is not just a tool for
judicious selection of credit at business unit level. Thanks to rapid developments taking place
worldwide in a risk management practices, internal ratings are being put to uses that are more

19
progressive. Internal ratings are used as a basis for economic capital allocation decision at the
portfolio level and the individual asset level.
Having allocated this capital and in vie of the average risk of default assumed by the bank, the
bank needs to appropriately price the asset to compensate for the risk through a risk premium and
also generate the required shareholder return on the economic capital at stake.
Construction and validation of a robust internal credit risk rating system is just the first step
toward sophisticated credit risk management. For an ambitious bank, the bank the IRB approach
promoted by Basel will form the platform for the risk management measures that are more
sophisticated such as rsik based performance measurement.

What is Credit risk?

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 commitments for 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 banks 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. The
elements of Credit Risk is Portfolio risk comprising Concentration Risk as well as Intrinsic Risk
and Transaction Risk comprising migration/down gradation risk as well as Default Risk. At the
transaction level, credit ratings are useful measures of evaluating credit risk that is prevalent
across the entire organization where treasury and credit functions are handled. Portfolio analysis
help in identifying concentration of credit risk, default/migration statistics, recovery data, etc. In
general, Default is not an abrupt process to happen suddenly and past experience dictates that,
more often than not, borrowers credit worthiness and asset quality declines gradually, which is
otherwise known as migration. Default is an extreme event of credit migration. Off balance sheet
exposures such as foreign exchange forward cantracks, swaps options etc are classified in to
three broad categories such as full Risk, Medium Risk and Low risk and then translated into risk
Neighted assets.
Risk Management.
Risk Management is a discipline at the core of every financial institution and encompasses all the
activities that affect its risk profile. It involves identification, measurement, monitoring and
controlling risks to ensure that
a) The individuals who take or manage risks clearly understand it.
b) The organizations Risk exposure is within the limits established by Board of Directors.
c) Risk taking Decisions are in line with the business strategy and objectives set by BOD.
d) The expected payoffs compensate for the risks taken
e) Risk taking decisions are explicit and clear.
f) Sufficient capital as a buffer is available to take risk
20
The acceptance and management of financial risk is inherent to the business of banking and
banks roles as financial intermediaries. Risk management as commonly perceived does not
mean minimizing risk; rather the goal of risk management is to optimize risk-reward trade -off.
Notwithstanding the fact that banks are in the business of taking risk, it should be recognized that
an institution need not engage in business in a manner that unnecessarily imposes risk upon it:
nor it should absorb risk that can be transferred to other participants. Rather it should accept
those risks that are uniquely part of the array of banks services. In every financial institution,
risk management activities broadly take place simultaneously at following different hierarchy
levels.
.
a) Strategic level: It encompasses risk management functions performed by senior management
and BOD. For instance definition of risks, ascertaining institutions risk appetite, formulating
strategy and policies for managing risks and establish adequate systems and controls to ensure
that overall risk remain within acceptable level and the reward compensate for the risk taken.
b) Macro Level: It encompasses risk management within a business area or across business
lines. Generally the risk management activities performed by middle management or units
devoted to risk reviews fall into this category.
c) Micro Level: It involves On-the-line risk management where risks are actually created. This
is the risk management activities performed by individuals who take risk on organizations behalf
such as front office and loan origination functions. The risk management in those areas is
confined to following operational procedures and guidelines set by management. Expanding
business arenas, deregulation and globalization of financial activities emergence of new financial
products and increased level of competition has necessitated a need for an effective and
structured risk management in financial institutions. A banks ability to measure, monitor, and
steer risks comprehensively is becoming a decisive parameter for its strategic positioning. The
risk management framework and sophistication of the process, and internal controls, used to
manage risks, depends on the nature, size and complexity of institutions activities. Nevertheless,
there are some basic principles that apply to all financial institutions irrespective of their size and
complexity of business and are reflective of the strength of an individual bank's risk management
practices.

Credit Risk Management Process

21
Managing credit risk
Credit risk arises from the potential that an obligor is either unwilling to perform on an
obligation or its ability to perform such obligation is impaired resulting in economic loss to
the bank.
In a banks portfolio, losses stem from outright default due to inability or unwillingness of a
customer or counter party to meet commitments in relation to lending, trading, settlement and
other financial transactions. Alternatively losses may result from reduction in portfolio value due
to actual or perceived deterioration in credit quality. Credit risk emanates from a banks dealing
with individuals, corporate, financial institutions or a sovereign. For most banks, loans are the
largest and most obvious source of credit risk; however, credit risk could stem from activities
both on and off balance sheet.
In addition to direct accounting loss, credit risk should be viewed in the context of economic
exposures. This encompasses opportunity costs, transaction costs and expenses associated with a
non-performing asset over and above the accounting loss. Credit risk can be further sub
categorized on the basis of reasons of default. For instance the default could be due to country in
which there is exposure or problems in settlement of a transaction. Credit risk not necessarily
occurs in isolation. The same source that endangers credit risk for the institution may also expose
it to other risk. For instance a bad portfolio may attract liquidity problem.
Components of credit risk management
A typical Credit risk management framework in a financial institution may be broadly
categorized into following main components.
a) Board and senior Managements Oversight
b) Organizational structure
c) Systems and procedures for identification, acceptance, measurement, monitoring and control
risks.
Board and Senior Managements Oversight

22
It is the overall responsibility of banks Board to approve banks credit risk strategy and
significant policies relating to credit risk and its management which should be based on the
banks overall business strategy. To keep it current, the overall strategy has to be reviewed by the
board, preferably annually. The responsibilities of the Board with regard to credit risk
management shall, interalia, include :
a) Delineate banks overall risk tolerance in relation to credit risk.Ensure that banks overall
credit risk exposure is maintained at prudent levels and consistent with the available capital
c) Ensure that top management as well as individuals responsible for credit risk management
possess sound expertise and knowledge to accomplish the risk management function
d) Ensure that the bank implements sound fundamental principles that facilitate the
identification, measurement, monitoring and control of credit risk.
e) Ensure that appropriate plans and procedures for credit risk management are in place.
The very first purpose of banks credit strategy is to determine the risk appetite of the bank. Once
it is determined the bank could develop a plan to optimize return while keeping credit risk within
predetermined limits. The banks credit risk strategy thus should spell out
a) The institutions plan to grant credit based on various client segments and products, economic
sectors, geographical location, currency and maturity
b) Target market within each lending segment, preferred level of diversification/concentration.
c) Pricing strategy.
It is essential that banks give due consideration to their target market while devising credit risk
strategy. The credit procedures should aim to obtain an indepth understanding of the banks
clients, their credentials & their businesses in order to fully know their customers.
The strategy should provide continuity in approach and take into account cyclic aspect of
countrys economy and the resulting shifts in composition and quality of overall credit portfolio.
While the strategy would be reviewed periodically and amended, as deemed necessary, it should
be viable in long term and through various economic cycles.
The senior management of the bank should develop and establish credit policies and credit
administration procedures as a part of overall credit risk management framework and get those
approved from board. Such policies and procedures shall provide guidance to the staff on various
types of lending including corporate, SME, consumer, agriculture, etc. At minimum the policy
should include
a) Detailed and formalized credit evaluation/ appraisal process.
b) Credit approval authority at various hierarchy levels including authority for approving
exceptions.
c) Risk identification, measurement, monitoring and control
d) Risk acceptance criteria
e) Credit origination and credit administration and loan documentation procedures
f) Roles and responsibilities of units/staff involved in origination and management of credit.
g) Guidelines on management of problem loans.
In order to be effective these policies must be clear and communicated down the line. Further
any significant deviation/exception to these policies must be communicated to the top
management/board and corrective measures should be taken. It is the responsibility of senior
management to ensure effective implementation of these policies.
Organizational Structure.

23
 To maintain banks overall credit risk exposure within the parameters set by the board of
directors, the importance of a sound risk management structure is second to none. While the
banks may choose different structures, it is important that such structure should be
commensurate with institutions size, complexity and diversification of its activities. It must
facilitate effective management oversight and proper execution of credit risk management and
control processes.
Each bank, depending upon its size, should constitute a Credit Risk Management Committee
(CRMC), ideally comprising of head of credit risk management Department, credit department
and treasury. This committee reporting to banks risk management committee should be
empowered to oversee credit risk taking activities and overall credi t risk management function.
The CRMC should be mainly responsible for
a) The implementation of the credit risk policy / strategy approved by the Board.
b) Monitor credit risk on a bank-wide basis and ensure compliance with limits approved by the
Board.
c) Recommend to the Board, for its approval, clear policies on standards for presentation of
credit proposals, financial covenants, rating standards and benchmarks.
d) Decide delegation of credit approving powers, prudential limits on large credit exposures,
standards for loan collateral, portfolio management, loan review mechanism, risk concentrations,
risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc.
Further, to maintain credit discipline and to enunciate credit risk management and control
process there should be a separate function independent of loan origination function. Credit
policy formulation, credit limit setting, monitoring of credit exceptions / exposures and
review /monitoring of documentation are functions that should be performed independently of
the loan origination function. For small banks where it might not be feasible to establish such
structural hierarchy, there should be adequate compensating measures to maintain credit
discipline introduce adequate checks and balances and standards to address potential conflicts of
interest. Ideally, the banks should institute a Credit Risk Management Department (CRMD).
Typical functions of CRMD include:
a) To follow a holistic approach in management of risks inherent in banks portfolio and ensure
the risks remain within the boundaries established by the Board or Credit Risk Management
Committee.
b) The department also ensures that business lines comply with riskparameters and prudential
limits established by the Board or CRMC.
c) Establish systems and procedures relating to risk identification, Management Information
System, monitoring of loan / investment portfolio quality and early warning. The department
would work out remedial measure when deficiencies/problems are identified.
The Department should undertake portfolio evaluations and conduct comprehensive studies on
the environment to test the resilience of the loan portfolio.
Notwithstanding the need for a separate or independent oversight, the front office or loan
origination function should be cognizant of credit risk, and maintain high level of credit
discipline and standards in pursuit of business opportunities.
Systems and Procedures
Credit Origination.
Banks must operate within a sound and well-defined criteria for new credits as well as the
expansion of existing credits. Credits should be extended within the target markets and lending

24
strategy of the institution. Before allowing a credit facility, the bank must make an assessment of
risk profile of the customer/transaction. This may include
a) Credit assessment of the borrowers industry, and macro economic factors.
b) The purpose of credit and source of repayment.
c) The track record / repayment history of borrower.
d) Assess/evaluate the repayment capacity of the borrower.
e) The Proposed terms and conditions and covenants.
f) Adequacy and enforceability of collaterals.
g) Approval from appropriate authority
In case of new relationships consideration should be given to the integrity and repute of the
borrowers or counter party as well as its legal capacity to assume the liability. Prior to entering
into any new credit relationship the banks must become familiar with the borrower or counter
party and be confident that they are dealing with individual or organization of sound repute and
credit worthiness. However, a bank must not grant credit simply on the basis of the fact that the
borrower is perceived to be highly reputable i.e. name lending should be discouraged.

While structuring credit facilities institutions should appraise the amount and timing of the cash
flows as well as the financial position of the borrower and intended purpose of the funds. It is
utmost important that due consideration should be given to the risk reward trade off in granting
a credit facility and credit should be priced to cover all embedded costs. Relevant terms and
conditions should be laid down to protect the institutions interest.
Institutions have to make sure that the credit is used for the purpose it was borrowed. Where the
obligor has utilized funds for purposes not shown in the original proposal, institutions should
take steps to determine the implications on creditworthiness. In case of corporate loans where
borrower own group of companies such diligence becomes more important. Institutions should
classify such connected companies and conduct credit assessment on consolidated/group basis.
In loan syndication, generally most of the credit assessment and analysis is done by the lead
institution. While such information is important, institutions should not over rely on that. All
syndicate participants should perform their own independent analysis and review of syndicate
terms. Institution should not over rely on collaterals / covenant. Although the importance of
collaterals held against loan is beyond any doubt, yet these should be considered as a buffer
providing protection in case of default, primary focus should be on obligors debt servicing
ability and reputation in the market.

Limit setting
An important element of credit risk management is to establish exposure limits for single
obligors and group of connected obligors. Institutions are expected to develop their own limit
structure while remaining within the exposure limits set by State Bank of Pakistan. The size of
the limits should be ba sed on the credit strength of the obligor, genuine requirement of credit,
economic conditions and the institutions risk tolerance. Appropriate limits should be set for
respective products and activities. Institutions may establish limits for a specific industry,
economic sector or geographic regions to avoid concentration risk.
Some times, the obligor may want to share its facility limits with its related companies.
Institutions should review such arrangements and impose necessary limits if the transactions are
frequent and significant

25
 Credit limits should be reviewed regularly at least annually or more frequently if obligors credit
quality deteriorates. All requests of increase in credit limits should be substantiated.
Credit Administration.
Ongoing administration of the credit portfolio is an essential part of the credit process. Credit
administration function is basically a back office activity that support and control extension and
maintenance of credit. A typical credit administration unit performs following functions:
a. Documentation. It is the responsibility of credit administration to ensure completeness of
documentation (loan agreements, guarantees, transfer of title of collaterals etc) in accordance
with approved terms and conditions. Outstanding documents should be tracked and followed up
to ensure execution and receipt.
b. Credit Disbursement. The credit administration function should ensure that the loan
application has proper approval before entering facility limits into computer systems.
Disbursement should be effected only after completion of covenants, and receipt of collateral
holdings. In case of exceptions necessary approval should be obtained from competent
authorities.
c. Credit monitoring. After the loan is approved and draw down allowed, the loan should be
continuously watched over. These include keeping track of borrowers compliance with credit
terms, identifying early signs of irregularity, conducting periodic valuation of collateral and
monitoring timely repayments.
d. Loan Repayment. The obligors should be communicated ahead of time as and when the
principal/markup installment becomes due. Any exceptions such as non-payment or late payment
should be tagged and communicated to the management. Proper records and updates should also
be made after receipt.
e. Maintenance of Credit Files. Institutions should devise procedural guidelines and standards
for maintenance of credit files. The credit files not only include all correspondence with the
borrower but should also contain sufficient information necessary to assess financial health of the
borrower and its repayment performance. It need not mention that information should be filed in
organized way so that external / internal auditors or SBP inspector could review it easily.
f. Collateral and Security Documents. Institutions should ensure that all security documents
are kept in a fireproof safe under dual control. Registers for documents should be maintained to
keep track of their movement. Procedures should also be established to track and review relevant
insurance coverage for certain facilities/collateral. Physical checks on security documents should
be conducted on a regular basis.
While in small Institutions it may not be cost effective to institute a separate credit
administrative set-up, it is important that in such institutions individuals performing sensitive
functions such as custody of key documents, wiring out funds, entering limits into system, etc.,
should report to managers who are independent of business origination and credit approval
process.
Measuring credit risk.
The measurement of credit risk is of vital importance in credit risk management.
A number of qualitative and quantitative techniques to measure risk inherent in credit portfolio
are evolving. To start with, banks should establish a credit riskrating framework across all type of
credit activities. Among other things, the rating framework may, incorporate:
Business Risk

26
o Industry Characteristics
o Competitive Position (e.g. marketing/technological edge)
o Management
Financial Risk
o Financial condition
o Profitability
o Capital Structure
o Present and future Cash flows

Internal Risk Rating.

Credit risk rating is summary indicator of a banks individual credit exposure. An internal rating
system categorizes all credits into various classes on the basis of underlying credit quality. A
well-structured credit rating framework is an important tool for monitoring and controlling risk
inherent in individual credits as well as in credit portfolios of a bank or a business line. The
importance of internal credit rating framework becomes more eminent due to the fact that
historically major losses to banks stemmed from default in loan portfolios. While a number of
banks already have a system for rating individual credits in addition to the risk categories
prescribed by SBP, all banks are encouraged to devise an internal rating framework. An internal
rating framework would facilitate banks in a number of ways such as
a) Credit selection
b) Amount of exposure
c) Tenure and price of facility
d) Frequency or intensity of monitoring
e) Analysis of migration of deteriorating credits and more accurate computation of future loan
loss provision
f) Deciding the level of Approving authority of loan.
The Architecture of internal rating system.
The decision to deploy any risk rating architecture for credits depends upon two basic aspects
a) The Loss Concept and the number and meaning of grades on the rating continuum
corresponding to each loss concept*.
b) Whether to rate a borrower on the basis of point in time philosophy or through the cycle
approach.
Besides there are other issues such as whether to include statutory grades in the scale, the type of
rating scale i.e. alphabetical numerical or alpha-numeric etc. SBP does not advocate any
particular credit risk rating system; it should be banks own choice. However the system should
commensurate with the size, nature and complexity of their business as well as possess flexibility
to accommodate present and future risk profile of the bank, the anticipated level of
diversification and sophistication in lending activities.
A rating system with large number of grades on rating scale becomes more expensive due to the
fact that the cost of obtaining and analyzing additional information for fine gradation increase
sharply. However, it is important that there should be sufficient gradations to permit accurate
characterization of the under lying risk profile of a loan or a portfolio of loans
The operating Design of Rating System.
As with the decision to grant credit, the assignment of ratings always involve element of human
judgment. Even sophisticated rating models do not replicate experience and judgment rather

27
these techniques help and reinforce subjective judgment. Banks thus design the operating flow of
the rating process in a way that is aimed promoting the accuracy and consistency of the rating
system while not unduly restricting the exercise of judgment. Key issues relating to the operating
design of a rating system include what exposures to rate; the organizations division of
responsibility for grading; the nature of ratings review; the formality of the process and
specificity of formal rating definitions.
What Exposures are rated?
Ideally all the credit exposures of the bank should be assigned a risk rating. However given the
element of cost, it might not be feasible for all banks to follow. The banks may decide on their
own which exposure needs to be rated. The decision to rate a particular loan could be based on
factors such as exposure amount, business line or both. Generally corporate and commercial
exposures are subject to internal ratings and banks use scoring models for consumer retail loans.
The rating process in relation to credit approval and review.
Ratings are generally assigned /reaffirmed at the time of origination of a loan or its renewal
/enhancement. The analysis supporting the ratings is inseparable from that required for credit
appraisal. In addition the rating and loan analysis process while being separate are intertwined.
The process of assigning a rating and its approval / confirmation goes along with the initiation of
a credit proposal and its approval. Generally loan origination function (whether a relationship
manager or credit staff) * initiates a loan proposal and also allocates a specific rating. This
proposal passes through the credit approval process and the rating is also approved or
recalibrated simultaneously by approving authority. The revision in the ratings can be used to
upgrade the rating system and related guidelines.
How to arrive at ratings
The assignment of a particular rating to an exposure is basically an abbreviation of its overall
risk profile. Theoretically ratings are based upon the major risk factors and their intensity
inherent in the business of the borrower as well as key parameters and their intensity to those risk
factors. Major risk factors include borrowers financial condition, size, industry and position in
the industry; the reliability of financial statements of the borrower; quality of management;
elements of transaction structure such as covenants etc. A more detail on the subject would be
beyond the scope of these guidelines, however a few important aspects are
a) Banks may vary somewhat in the particular factors they consider and the weight they give to
each factor.
b) Since the rater and reviewer of rating should be following the same basic thought, to ensure
uniformity in the assignment and review of risk grades, the credit policy should explicitly define
each risk grade; lay down criteria to be fulfilled while assigning a particular grade, as well as
the circumstances under which deviations from criteria can take place.
c) The credit policy should also explicitly narrate the roles of different parties involved in the
rating process.
d) The institution must ensure that adequate training is imparted to staff to ensure uniform ratings
e) Assigning a Rating is basically a judgmental exercise and the models, external ratings and
written guidelines/benchmarks serve as input.
f) Institutions should take adequate measures to test and de velop a risk rating system prior to
adopting one. Adequate validation testing should be conducted during the design phase as well as
over the life of the system to ascertain the applicability of the system to the institutions
portfolio.

28
 Institutions that use sophisticated statistical models to assign ratings or to calculate probabilities
of default, must ascertain the applicability of these models to their portfolios. Even when such
statistical models are found to be satisfactory, institutions should not use the output of such
models as the sole criteria for assigning ratings or determining the probabilities of default. It
would be advisable to consider other relevant inputs as well.
Ratings review
The rating review can be two-fold:
a) Continuous monitoring by those who assigned the rating. The Relationship Managers (RMs)
generally have a close contact with the borrower and are expected to keep an eye on the financial
stability of the borrower. In the event of any deterioration the ratings are immediately revised
/reviewed.
Secondly the risk review functions of the bank or business lines also conduct periodical review
of ratings at the time of risk review of credit portfolio.
Risk ratings should be assigned at the inception of lending, and updated at least annually.
Institutions should, however, review ratings as and when adverse events occur. A separate
function independent of loan origination should review Risk ratings. As part of portfolio
monitoring, institutions should generate reports on credit exposure by risk grade. Adequate trend
and migration analysis should also be conducted to identify any deterioration in credit quality.
Institutions may establish limits for risk grades to highlight concentration in particular rating
bands. It is important that the consistency and accuracy of ratings is examined periodically by a
function such as an independent credit review group
For consumer lending, institutions may adopt credit-scoring models for processing loan
applications and monitoring credit quality. Institutions should apply the above principles in the
management of scoring models. Where the model is relatively new, institutions should continue
to subject credit applications to rigorous review until the model has stabilized.
Credit Risk Monitoring & Control
Credit risk monitoring refers to incessant monitoring of individual credits inclusive of Off-
Balance sheet exposures to obligors as well as overall credit portfolio of the bank. Banks need to
enunciate a system that enables them to monitor quality of the credit portfolio on day-to-day
basis and take remedial measures as and when any deterioration occurs. Such a system would
enable a bank to ascertain whether loans are being serviced as per facility terms, the adequacy of
provisions, the overall risk profile is within limits established by management and compliance of
regulatory limits. Establishing an efficient and effective credit monitoring system would help
senior management to monitor the overall quality of the total credit portfolio and its trends.
Consequently the management could fine tune or reassess its credit strategy /policy accordingly
before encountering any major setback. The banks credit policy should explicitly provide
procedural guideline relating to credit risk monitoring. At the minimum it should lay down
procedure relating to
a) The roles and responsibilities of individuals responsible for credit risk monitoring
b) The assessment procedures and analysis techniques (for individualloans & overall portfolio)
c) The frequency of monitoring
d) The periodic examination of collaterals and loan covenants
e) The frequency of site visits
f) The identification of any deterioration in any loan
Given below are some key indicators that depict the credit quality of a loan:

29
a. Financial Position and Business Conditions. The most important aspect about an obligor is
its financial health, as it would determine its repayment capacity. Consequently institutions need
carefully watch financial standing of obligor. The Key financial performance indicators on
profitability, equity, leverage and liquidity should be analyzed. While making such analysis due
consideration should be given to business/industry risk, borrowers position within the industry
and external factors such as economic condition, government policies, regulations. For
companies whose financial position is dependent on key management personnel and/or
shareholders, for example, in small and medium enterprises, institutions would need to pay
particular attention to the assessment of the capability and capacity of the
management/shareholder(s).
b. Conduct of Accounts. In case of existing obligor the operation in the account would give a
fair idea about the quality of credit facility. Institutions should monitor the obligors account
activity, repayment history and instances of excesses over credit limits. For trade financing,
institutions should monitor cases of repeat extensions of due dates for trust receipts and bills.
c. Loan Covenants. The obligors ability to adhere to negative pledges and financial covenants
stated in the loan agreement should be assessed, and any breach detected should be addressed
promptly.
d. Collateral valuation. Since the value of collateral could deteriorate resulting in unsecured
lending, banks need to reassess value of collaterals on periodic basis. The frequency of such
valuation is very subjective and depends upon nature of collaterals. For instance loan granted
against shares need revaluation on almost daily basis whereas if there is mortgage of a residential
property the revaluation may not be necessary as frequently. In case of credit facilities secured
against inventory or goods at the obligors premises, appropriate inspection should be conducted
to verify the existence and valuation of the collateral. And if such goods are perishable or such
that their value diminish rapidly (e.g. electronic parts/equipments), additional precautionary
measures should be taken.
External Rating and Market Price of securities such as TFCs purchased as a form of lending or
long-term investment should be monitored for any deterioration in credit rating of the issuer, as
well as large decline in market price. Adverse changes should trigger additional effort to review
the creditworthiness of the issuer.

Risk review
The institutions must establish a mechanism of independent, ongoing assessment of credit risk
management process. All facilities except those managed on a portfolio basis should be subjected
to individual risk review at least once in a year. The results of such review should be properly
documented and reported directly to board, or its sub committee or senior management without
lending authority. The purpose of such reviews is to assess the credit administration process, the
accuracy of credit rating and overall quality of loan portfolio independent of relationship with the
obligor.
Institutions should conduct credit review with updated information on the obligors financial and
business conditions, as well as conduct of account. Exceptions noted in the credit monitoring
process should also be evaluated for impact on the obligors creditworthiness. Credit review
should also be conducted on a consolidated group basis to factor in the business connections
among entities in a borrowing group.

30
As stated earlier, credit review should be performed on an annual basis, however more frequent
review should be conducted for new accounts where institutions may not be familiar with the
obligor, and for classified or adverse rated accounts that have higher probability of default.
For consumer loans, institutions may dispense with the need to perform credit review for certain
products. However, they should monitor and report credit exceptions and deterioration.
Delegation of Authority.
Banks are required to establish responsibility for credit sanctions and delegate authority to
approve credits or changes in credit terms. It is the responsibility of banks board to approve the
overall lending authority structure, and explicitly delegate credit sanctioning authority to senior
management and the credit committee. Lending authority assigned to officers should be
commensurate with the experience, ability and personal character. It would be better if
institutions develop risk-based authority structure where lending power is tied to the risk ratings
of the obligor. Large banks may adopt multiple credit approvers for sanctioning such as credit
ratings, risk approvals etc to institute a more effective system of check and balance. The credit
policy should spell out the escalation process to ensure appropriate reporting and approval of
credit extension beyond prescribed limits. The policy should also spell out authorities for
unsecured credit (while remaining within SBP limits), approvals of disbursements excess over
limits and other exceptions to credit policy.
In cases where lending authority is assigned to the loan originating function, there should be
compensating processes and measures to ensure adherence to lending standards. There should
also be periodic review of lending authority assigned to officers.
Managing problem credits
The institution should establish a system that helps identify problem loan ahead of time when
there may be more options available for remedial measures. Once the loan is identified as
problem, it should be managed under a dedicated remedial process.
A banks credit risk policies should clearly set out how the bank will manage problem credits.
Banks differ on the methods and organization they use to manage problem credits. Responsibility
for such credits may be assigned to the originating business function, a specialized workout
section, or a combination of the two, depending upon the size and nature of the credit and the
reason for its problems. When a bank has significant credit-related problems, it is important to
segregate the workout function from the credit origination function. The additional resources,
expertise and more concentrated focus of a specialized workout section normally improve
collection results.
A problem loan management process encompass following basic elements.
a. Negotiation and follow-up. Proactive effort should be taken in dealing with obligors to
implement remedial plans, by maintaining frequent contact and internal records of follow-up
actions. Often rigorous efforts made at an early stage prevent institutions from litigations and
loan losses
b. Workout remedial strategies. Some times appropriate remedial strategies such as
restructuring of loan facility, enhancement in credit limits or reduction in interest rates help
improve obligors repayment capacity. However it depends upon business condition, the nature
of problems being faced and most importantly obligors commitment and willingness to repay
the loan. While such remedial strategies often bring up positive results, institutions need to
exercise great caution in adopting such measures and ensure that such a policy must not
encourage obligors to default intentionally. The institutions interest should be the primary

31
consideration in case of such workout plans. It needs not mention here that competent authority,
before their implementation, should approve such workout plan.
c. Review of collateral and security document. Institutions have to ascertain the loan
recoverable amount by updating the values of available collateral with formal valuation. Security
documents should also be reviewed to ensure the completeness and enforceability of contracts
and collateral/guarantee.
d. Status Report and Review Problem credits should be subject to more frequent review and
monitoring. The review should update the status and development of the loan accounts and
progress of the remedial plans. Progress made on problem loan should be reported to the senior
management

Chapter-2
Review of Literature

32
 Review of Literature
Until recently many researchers have shown interest in the field of credit risk management in
banks . They have carried out numerous laboratory experiments and field observations to
illuminate the darkness of this field. Their findings and suggestions are reviewed here.

Improving Banks' Credit Risk Management

by Xinzheng Huang and Cornelis W. Oosterlee

Xinzheng Huang and Cornelis W. Oosterlee wrote about Improving Banks Credit Risk
Managemnt. Talking about the recent credit crisis they have mentioned that Improving the
practice of credit risk management by banks has thus become a top priority. Researchers Huang
(Delft University of Technology) and Oosterlee (CWI) in the Netherlands focus on quantifying
portfolio credit risk by advanced numerical techniques with an eye to active credit portfolio
management. This work was sponsored by the Dutch Rabobank.

According to them Credit risk is the risk of loss resulting from an obligor's inability to meet its
obligations. Generally speaking, credit risk is the largest source of risk facing banking
institutions. For these institutions, sound management involves measuring the credit risk at
portfolio level to determine the amount of capital they need to hold as a cushion against
potentially extreme losses. In practice, the portfolio risk is often measured by Value at Risk
(VaR), which is simply the quantile of the distribution of portfolio loss for a given confidence
level. With the Basel II accords (the recommendations on banking laws and regulations issued in

33
2004 by the Basel Committee on Banking Supervision), financial regulators aim to safeguard the
banking institutions' solvency against such extreme losses.

From a bank's perspective, a high level of credit risk management means more than simply
meeting regulatory requirements: the aim is rather to enhance the risk/return performance of
credit assets. To achieve this goal, it is essential to measure how much a single obligor in a
portfolio contributes to the total risk, ie the risk contributions of single exposures. Risk
contribution plays an integral role in risk-sensitive loan pricing and portfolio optimization.

Extrapolation of credit risk from individual obligors to portfolio level involves specifying the
dependence among obligors. Huang & Oosterlee have considered the Vasicek model.Widely
adopted in the industry is the Vasicek model, on which is built the Basel II internal rating-based
approach. It is a Gaussian one-factor model, with default events being driven by a single
common factor that is assumed to follow the Gaussian distribution, and obligors being
independent conditional on the common factor. Under certain homogeneity conditions, the
Vasicek one-factor model leads to very simple analytic asymptotic approximations of the loss
distribution, VaR and VaR Contribution. However, these analytic approximations can
significantly underestimate risks in the presence of exposure concentrations, ie when the
portfolio is dominated by a few obligors.

In their research, Huang and Oosterlee showed that the saddle-point approximation with a
conditional approach is an efficient tool for estimating the portfolio credit loss distribution in the
Vasicek model and is well able to handle exposure concentration. The saddle-point
approximation can be thought of as an improved version of the central limit theorem and usually
leads to a small relative error, even for very small probabilities. Moreover, the saddle-point
approximation is a flexible method which can be applied beyond the Vasicek model to more
heavily tailed loss distributions which provide a better fit to current financial market data.

The single factor in the Vasicek model represents generally the state of economy. More factors
are necessary if one wishes to take into account the effects of different industries and
geographical regions in credit portfolio loss modelling. For example, in the current crisis the
financial industry is taking the hardest hit, while back in 1997 East Asian countries suffered
most. Multiple factors can be used to incorporate these details, but they generally complicate the
computational process, as high-dimensional integrals need to be computed. For this, the
researchers proposed efficient algorithms of adaptive integration for the calculation of the tail
probability, with either a deterministic multiple integration rule or a Monte Carlo type random
rule.

In the Vasicek model the loss given default (LGD) - the proportion of the exposure that will be
lost if a default occurs - is assumed to be constant. However, extensive empirical evidence shows
that it tends to go up in economic downturn. A heuristic justification is that the LGD is
determined by the value of collateral (eg house prices in the case of mortgage loans), which is
sensitive to the state of the economy. To account for this, Huang and Oosterlee proposed a new
flexible framework for modelling systematic risk in LGD, in which the quantities have simple
economic interpretation. The random LGD framework, combined with the fat-tailed models,
34
further provides possibilities to replicate the spreads of the senior tranches of credit market
indices (eg CDX), which have widened dramatically since the emergence of the credit crisis to a
level that the industrial standard Gaussian one-factor model can not produce even with 100%
correlation.

This research provides useful tools to fulfill the needs of active credit portfolio management
within banks. Banks can improve their insight into credit risk and take appropriate measures to
maximize their risk/return profile.

RISK MANAGEMENT IN BANKING COMPANIES

"http://www.articlesbase.com/management-articles/risk-management-in-banking-
companies-1838565.html" \t "_new"

By:Risk Management In Banking Companies

Risk Management in banking companies is also a group on internet that publishes related to
Credit risk management. Its operations include risk identification, measurement and assessment,
and its objective is to minimize negative effects risks can have on the financial result and capital
of the bank. Banks are required to form a special organisational unit for the purpose of risk
management. The risk to which the bank is particularly exposed in its operations are market
risk(interest rate risk, foreign exchange risk, risk from change in market price of securities,
financial and commodities), credit risk, liquidity risk, exposure risk, investment risk, operational
risk, legal risk, strategic risk. These risks are highly inter-independent. Events that affect one area
of risk can have ramifications for a range of other risk categories. In this article they have talked
about the latest approaches of Credit risk management and the effect of Basal norms on it.
CREDIT RISK MANAGEMENT

They have defined Credit risk is as the potential that a bank borrower or counter party will fail to
meet its obligations in accordance with agreed terms. The goal of credit risk management is to
maximise the banks risk-adjusted rate of return by maintaining credit risk exposure within
acceptable parameters. Banks need to manage the credit risk inherit in the entire portfolio as well
as the risk in individual or credits or transactions.

For most banks, loans are the largest and most obvious source of credit risk; however, other
sources of credit risk exist throughout the activities of the bank, including in the banking book
and the trading book and both on and off the balance sheet. Banks are increasingly facing credit
risk (or counter party risk) in various financial instruments other than loans including
acceptances, inter bank transactions, trade financing, foreign exchange transactions swaps,
bonds, equities, options and in the extension of commitments and guarantees, the settlement of
transactions.

BASAL II ON CREDIT RISK

35
The basal community on banking supervision release a consultative document on New Capital
Adequacy Framework with the view to replacing 1988 Accord. The document proposes three
pillars for the new accord-

1. Minimum Capital Requirements, 2.Supervisory review 3.Market discipline

A new accord continues with the minimum capital adequacy ratio of 8% of risk waited assets.
Arrange of options to estimate capital as proposed in the document include a standardised
approach. Under this approach, preferential risk weights in the range of 0%, 20%, 50%, 100%,
and 150% are envisaged to be assigned on the basis of external credit assessments. Under
foundation Internal Rating Based (IRB), community proposes certain minimum
compliance.wiz.a comprehensive credit rating system with capability to quantify Probability of
Default (PD) while assigning preferential risk weights, with the information supplied by national
supervisor on loss given default (LGD) an exposure at default. Adoption a New Capital Accord
by banks in the proposed state requires complete change in the existing risk management
systems.

"Credit Risk Management: Policy Framework for Indian Banks"

By :CoolAvenues Knowledge Management Team

CoolAvenues Knowledge Management Team, a knowledge management portal on various topics

also have written about the credit risk management framework for Indian banks.According to
them in this article, Risk is inherent in all aspects of a commercial operation and covers areas
such as customer services, reputation, technology, security, human resources, market price,
funding, legal, regulatory, fraud and strategy. However, for banks and financial institutions,
credit risk is the most important factor to be managed. Credit risk is defined as the possibility
that a borrower or counterparty will fail to meet its obligations in accordance with agreed
terms. Credit risk, therefore, arises from the banks' dealings with or lending to a corporate,
individual, another bank, financial institution or a country. Credit risk may take various forms,
such as:

in the case of direct lending, that funds will not be repaid;

in the case of guarantees or letters of credit, that funds will not be forthcoming from the
customer upon crystallization of the liability under the contract;

in the case of treasury products, that the payment or series of payments due from the
counterparty under the respective contracts is not forthcoming or ceases;

36
 in the case of securities trading businesses, that settlement will not be effected;

in the case of cross-border exposure, that the availability and free transfer of currency is
restricted or ceases.

The more diversified a banking group is, the more intricate systems it would need, to
protect itself from a wide variety of risks. These include the routine operational risks
applicable to any commercial concern, the business risks to its commercial borrowers, the
economic and political risks associated with the countries in which it operates, and the
commercial and the reputational risks concomitant with a failure to comply with the
increasingly stringent legislation and regulations surrounding financial services business
in many territories. Comprehensive risk identification and assessment are therefore very
essential to establishing the health of any counterparty.
Credit risk management enables banks to identify, assess, manage proactively, and
optimise their credit risk at an individual level or at an entity level or at the level of a
country. Given the fast changing, dynamic world scenario experiencing the pressures of
globalisation, liberalization, consolidation and disintermediation, it is important that
banks have a robust credit risk management policies and procedures which is sensitive
and responsive to these changes.
The quality of the credit risk management function will be the key driver of the changes
to the level of shareholder return. Industry analysts have demonstrated that the average
shareholder return of the best credit performance US banks during 1989 - 1997 was
56% higher than their peers.

They have mentioned the Credit security on certain parameters.That are-

Building Blocks on Credit Risk

In any bank, the corporate goals and credit culture are closely linked, and an effective credit risk
management framework requires the following distinct building blocks: -
Strategy and Policy

This covers issues such as the definition of the credit appetite, the development of credit
guidelines and the identification and the assessment of the credit risk.
Organisation
This would entail the establishment of competencies and clear accountabilities for managing the
credit risk.
Operations/Systems
MIS requirements of the senior and middle management, and the development of tools and
techniques will come under this domain.

37
Strategy and Policy
It is essential that each bank develops its own credit risk strategy or enunciates a plan that
defines the objectives for the credit-granting function. This strategy should spell out clearly the
organizations credit appetite and the acceptable level of risk - reward trade-off at both the macro
and the micro levels.

The strategy would therefore, include a statement of the bank's willingness to grant loans based
on the type of economic activity, geographical location, currency, market, maturity and
anticipated profitability. This would necessarily translate into the identification of target markets
and business sectors, preferred levels of diversification and concentration, the cost of capital in
granting credit and the cost of bad debts.

The policy document should cover issues such as organizational responsibilities, risk
measurement and aggregation techniques, prudential requirements, risk assessment and review,
reporting requirements, risk grading, product guidelines, documentation, legal issues and
management of problem loans. Loan policies apart from ensuring consistency in credit practices,
should also provide a vital link to the other functions of the bank. It has been empirically proved
that organisations with sound and well-articulated loan policies have been able to contain the
loan losses arising from poor loan structuring and perfunctory risk assessments.

The credit risk strategy should provide continuity in approach, and will need to take into account
the cyclical aspects of any economy and the resulting shifts in the composition and quality of the
overall credit portfolio. This strategy should be viable in the long run and through various credit
cycles.

An organisation's risk appetite depends on the level of capital and the quality of loan book and
the magnitude of other risks embedded in the balance sheet. Based on its capital structure, a bank
will be able to set its target returns to its shareholders and this will determine the level of capital
available to the various business lines.

Keeping in view the foregoing, a bank should have the following in place: -

1. dedicated policies and procedures to control exposures to designated higher risk sectors
such as capital markets, aviation, shipping, property development, defence equipment,
highly leveraged transactions, bullion etc.

2. sound procedures to ensure that all risks associated with requested credit facilities are
promptly and fully evaluated by the relevant lending and credit officers.

3. systems to assign a risk rating to each customer/borrower to whom credit facilities have
been sanctioned.

4. a mechanism to price facilities depending on the risk grading of the customer, and to
attribute accurately the associated risk weightings to the facilities.

38
 5. efficient and effective credit approval process operating within the approval limits
authorized by the Boards.

6. procedures and systems which allow for monitoring financial performance of customers
and for controlling outstandings within limits.

7. systems to manage problem loans to ensure appropriate restructuring schemes. A

conservative policy for the provisioning of non-performing advances should be followed.

8. a process to conduct regular analysis of the portfolio and to ensure on-going control of
risk concentrations.

Credit Policies and Procedures

The credit policies and procedures should necessarily have the following elements: -

Banks should have written credit policies that define target markets, risk acceptance
criteria, credit approval authority, credit origination and maintenance procedures and
guidelines for portfolio management and remedial management.

Banks should establish proactive credit risk management practices like annual / half
yearly industry studies and individual obligor reviews, periodic credit calls that are
documented, periodic plant visits, and at least quarterly management reviews of troubled
exposures/weak credits.

Business managers in banks will be accountable for managing risk and in conjunction
with credit risk management framework for establishing and maintaining appropriate risk
limits and risk management procedures for their businesses.

Banks should have a system of checks and balances in place around the extension of
credit which are:

o An independent credit risk management function

o Multiple credit approvers

o An independent audit and risk review function

The Credit Approving Authority to extend or approve credit will be granted to individual
credit officers based upon a consistent set of standards of experience, judgment and
ability.

39
 The level of authority required to approve credit will increase as amounts and transaction
risks increase and as risk ratings worsen.

Every obligor and facility must be assigned a risk rating.

Banks should ensure that there are consistent standards for the origination, documentation
and maintenance for extensions of credit.

Banks should have a consistent approach toward early problem recognition, the
classification of problem exposures, and remedial action.

Banks should maintain a diversified portfolio of risk assets in line with the capital desired
to support such a portfolio.

Credit risk limits include, but are not limited to, obligor limits and concentration limits by
industry or geography.

In order to ensure transparency of risks taken, it is the responsibility of banks to

accurately, completely and in a timely fashion, report the comprehensive set of credit risk
data into the independent risk system.

Organizational Structure

A common feature of most successful banks is to establish an independent group responsible for
credit risk management. This will ensure that decisions are made with sufficient emphasis on
asset quality and will deploy specialised skills effectively. In some organisations, the credit risk
management team is responsible for the management of problem accounts, and for credit
operations as well. The responsibilities of this team are the formulation of credit policies,
procedures and controls extending to all of its credit risks arising from corporate banking,
treasury, credit cards, personal banking, trade finance, securities processing, payment and
settlement systems, etc. This team should also have an overview of the loan portfolio trends and
concentration risks across the bank and for individual lines of businesses, should provide input to
the Asset - Liability Management Committee of the bank, and conduct industry and sectoral
studies. Inputs should be provided for the strategic and annual operating plans. In addition, this
team should review credit related processes and operating procedures periodically.

It is imperative that the independence of the credit risk management team is preserved, and it is
the responsibility of the Board to ensure that this is not allowed to be compromised at any time.
Should the Board decide not to accept any recommendation of the credit risk management team
and then systems should be in place to have the rationale for such an action to be properly
documented. This document should be made available to both the internal and external auditors
for their scrutiny and comments.

40
The credit risk strategy and policies should be effectively communicated throughout the
organisation. All lending officers should clearly understand the bank's approach to granting credit
and should be held accountable for complying with the policies and procedures.

Keeping in view the foregoing, each bank may, depending on the size of the organization or loan
book, constitute a high level Credit Policy Committee also called Credit Risk Management
Committee or Credit Control Committee, etc. to deal with issues relating to credit policy and
procedures and to analyse, 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, risk concentrations, risk monitoring
and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc. Concurrently,
each bank may 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. 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.

Operations / Systems

Banks should have in place an appropriate credit administration, measurement and monitoring
process. The credit process typically involves the following phases: -

1. Relationship management phase i.e. business development.

2. Transaction management phase: cover risk assessment, pricing, structuring of the

facilities, obtaining internal approvals, documentation, loan administration and routine
monitoring and measurement.

3. Portfolio management phase: entail the monitoring of the portfolio at a macro level and
the management of problem loans.

Successful credit management requires experience, judgement and a commitment to technical

development. Each bank should have a clear, well-documented scheme of delegation of limits.
Authorities should be delegated to executives depending on their skill and experience levels. The
banks should have systems in place for reporting and evaluating the quality of the credit
decisions taken by the various officers. The credit approval process should aim at efficiency,
responsiveness and accurate measurement of the risk. This will be achieved through a
comprehensive analysis of the borrower's ability to repay, clear and consistent assessment
41
systems, a process which ensures that renewal requests are analyzed as carefully and stringently
as new loans and constant reinforcement of the credit culture by the top management team.

Commitment to new systems and IT will also determine the quality of the analysis being
conducted. There is a range of tools available to support the decision making process. These are:

Traditional techniques such as financial analysis.

Decision support tools such as credit scoring and risk grading.

Portfolio techniques such as portfolio correlation analysis.

The key is to identify the tools that are appropriate to the bank.

Banks should develop and utilize internal risk rating systems in managing credit risk. The rating
system should be consistent with the nature, size and complexity of the bank's activities.

Banks must have a MIS, which will enable them to manage and measure the credit risk inherent
in all on- and off-balance sheet activities. The MIS should provide adequate information on the
composition of the credit portfolio, including identification of any concentration of risk. Banks
should price their loans according to the risk profile of the borrower and the risks associated with
the loans

42
 Chapter-3
Research Methodology

43
 Research Methodology

Title-Credit Risk management in banks

Research Questions-
1) Do the banks have a proper risk management system?
2) How the lenders can minimize their risk associated with lending?

The purpose of this study is to test how active management of credit risk, as proxied by loan
sales and purchases, affects a financial institution's capital structure, lending, profits, and risk.
We estimate a series of cross-sectional, reduced form regressions that relate measures of capital
structure, investments in risky loans, profits and risk to control variables (designed to capture the
extent of a banks access to an internal capital market) to measures of the banks use of the loan
sales market to foster risk management.
Scope of the Study-
This research covers all the aspects of credit risk management. It has a risk management
framework that encompasses the scope of risks to be managed, the process/systems and
procedures to manage risk and the roles and responsibilities of individuals involved in risk
management. The framework is comprehensive enough to capture all risks a bank is exposed to
and have flexibility to accommodate any change in business activities. This researchs risk
management framework includes
a) Clearly defined risk management policies and procedures covering risk identification,
acceptance, measurement, monitoring, reporting and control.
b) A well constituted organizational structure defining clearly roles and responsibilities of
individuals involved in risk taking as well as managing it. Banks, in addition to risk management
functions for various risk categories may institute a setup that supervises overall risk

44
management at the bank. Such a setup could be in the form of a separate department or banks
Risk Management Committee (RMC) could perform such function*. The structure is such that
ensures effective monitoring and control over risks being taken
c) It includes an effective management information system that ensures flow of information from
operational level to top management and a system to address any exceptions observed. There is
an explicit procedure regarding measures to be taken to address such deviations.
d) The framework has a mechanism to ensure an ongoing review of systems, policies and
procedures for risk management and procedure to adopt changes.

Significance of the Study-

Credit risk management is a very important area for the banking sector and there are wide
prospects of growth and other financial institutions also face problems which are financial in
nature. Thats why Ive chosen this topic for my research.
This research focuses on the importance of credit risk management for banking is tremendous.
Banks and other financial institutions are often faced with risks that are mostly of financial
nature. It talks about how these institutions can balance risks as well as returns. For a bank to
have a large consumer base, it must offer loan products that are reasonable enough. However, if
the interest rates in loan products are too low, the bank will suffer from losses. In terms of equity,
a bank must have substantial amount of capital on its reserve, but not too much that it misses the
investment revenue, and not too little that it leads itself to financial instability and to the risk of
regulatory non-compliance.

The study reveals the risks constantly faced by the banks. There are certain risks in the process
of granting loans to certain clients. There can be more risks involved if the loan is extended to
unworthy debtors. Certain risks may also come when banks offer securities and other forms of
investments.

The risk of losses that result in the default of payment of the debtors is a kind of risk that must be
expected. Because of the exposure of banks to many risks, it is only reasonable for a bank to
keep substantial amount of capital to protect its solvency and to maintain its economic stability.
The study also have included the latest steps taken by the Besel commette with regard to the
same.The second Basel Accords provides statements of its rules regarding the regulation of the
bank's capital allocation in connection with the level of risks the bank is exposed to. The greater
the bank is exposed to risks, the greater the amount of capital must be when it comes to its
reserves, so as to maintain its solvency and stability. It talks about the practices, to determine the
risks that come with lending and investment practices, how the banks can assess the risks. Credit
risk management must play its role then to help banks be in compliance with Basel II Accord and
other regulatory bodies.

To manage and assess the risks faced by banks, it is important to make certain estimates, conduct
monitoring, and perform reviews of the performance of the bank. However, because banks are

45
into lending and investing practices, it is relevant to make reviews on loans and to scrutinize and
analyse portfolios. Loan reviews and portfolio analysis are crucial then in determining the credit
and investment risks.
The complexity and emergence of various securities and derivatives is a factor banks must be
active in managing the risks. The credit risk management system used by many banks today has
complexity; however, it can help in the assessment of risks by analysing the credits and
determining the probability of defaults and risks of losses.
Credit risk management for banking is a very useful system, especially if the risks are in line
with the survival of banks in the business world.

Also, how banking professionals can maintain a balance between the risks and the returns, For a
large customer base banks need to have a variety of loan products.If bank lowers the interest
rates for the loans it offers, it will suffer In terms of equity, a bank must have substantial amount
of capital on its reserve, but not too much that it misses the investment revenue, and not too little
that it leads itself to financial instability and to the risk of regulatory non-compliance.

Credit risk management is risk assessment that comes in an investment. Risk often comes in
investing and in the allocation of capital. The risks must be assessed so as to derive a sound
investment decision.And decisions should be made by balancing the risks and returns. Giving
loans is a risky affair for bank sometimes and Certain risks may also come when banks offer
securities and other forms of investments. The risk of losses that result in the default of payment
of the debtors is a kind of risk that must be expected.A bank to keep substantial amount of capital
to protect its solvency and to maintain its economic stability.

The greater the bank is exposed to risks, the greater the amount of capital must be when it comes
to its reserves, so as to maintain its solvency and stability. Credit risk management must play its
role then to help banks be in compliance with Basel II Accord and other regulatory bodies. For
assessing the risk, banks should plan certain estimates, conduct monitoring, and perform reviews
of the performance of the bank. They should also do Loan reviews and portfolio analysis in order
to determine risk involved.
Banks must be active in managing the risks in various securities and derivatives. Still how
progress has to be made for analyzing the credits and determining the probability of defaults and
risks of losses, is included in this study.

Sample of the Research-

100 senior managers involved in risk management from the leading banks in India. Few banks
are-
State Bank of India
Punjab National Bank
Bank of Baroda
ICICI
Allahabad Bank
Oriental Bank of Commerce

46
 Bank of India

Sources of data-
The data used to prepare this report is secondary. The main sources are as follows-
Published reports
Government statistics
Scientific and technical Abstracts
Company's financial statements
Banks reports

Limitations of the Study

The information and data may not be accurate.

The data may out of date-The data taken for this study is of yr 2008.The figures of
analysis might have changed now.

The data is generated through a questionnaire on Internet.Online surveys generally

manipulates the answers.One cant tell exactly what the respondant wanted by his face
expressions.

Reliability is not guaranteed.

Since it was an online survey we cant assure about the fact that it is filled by the same
respondant from whom we wanted or by someone else.
There may be missing information on some observations

47
Chapter-4

48
 Data Analysis & Interpretation

Data Analysis & Interpretation

CREDIT RISK MANAGEMENT
The Bank has put in place the Credit Risk Management Policy and the same has been circulated
to all the branches. The main objective of the policy is to ensure that the operations are in line
with the expectation of the management and the strategies of the top management are translated
into meaningful directions to the operational level. The Policy stipulates prudential limits on
large credit exposures, standards for loan collateral, portfolio management, loan review
mechanism, risk concentrations, risk monitoring and evaluation, provisioning and regulatory /
legal compliance.
The Bank identifies the risks to which it is exposed and applies suitable techniques to measure,
monitor and control these risks. While the Board / Risk Management Committee of the Board
devises the policy and fixes various credit risk exposures, Credit Risk Management Committee
implements these policies and strategies approved by the Board / RMC, monitors credit risks on
a bank wide basis and ensures compliance of risk limits.
The Bank studies the concentration risk by
(a) fixing exposure limits for single and group borrowers
(b) rating grade limits
(c) industry wise exposure limits

49
The Bank considers rating of a borrowal account as an important tool to manage the credit
risk associated with any borrower and accordingly a two dimensional credit rating system
was introduced in the Bank. Software driven rating / scoring models for different segments have
been customized to suit the Banks requirements.
Credit Rating
1. Obligor Rating
Financial Parameters
Managerial Parameters
Industrial Parameters
Operational Parameters
2. Facility Rating (Collateral Securities)
AAA Lowest Risk
AA Lower risk
A Low Risk
BBB Moderate risk Entry Level
BB High risk
B Higher risk
C Highest risk
MITIGATION OF CREDIT RISK
Mitigation of credit risks and enhancing awareness on identification of appropriate collateral
taking into account the spirit of Basel II / RBI guidelines and Optimizing the benefi t of credit
risk mitigation in computation of capital charge as per approaches laid down in Basel II / RBI
guidelines. The Bank generally relies on Risk Mitigation techniques like Loan participation,
Ceiling on Exposures, Escrow mechanism, Forward cover, higher margins, loan covenants,
Collateral and insurance cover. Valuation methodologies are detailed in the Credit Risk
Management Policy. Bank accepts guarantees from individuals with considerable net worth and
the Corporate. Only guarantees issued by entities with a lower risk weight than the counterparty
shall be accepted to get the protection for the counterparty exposure. All types of securities
eligible for mitigation are easily realizable financial securities. As such, presently no limit /
ceiling has been prescribed to address the concentration risk in credit risk mitigates recognized
by the Bank
Credit Rating Frame Work (CRF)
Credit Rating Framework (CRF) is one of the risk measurement technique the banks use to a
great extent under risk management system. This is used primarily to standardise and uniformly
communicate the judgement in credit selection procedure and not as a substitute to the vast
lending experience accumulated by the Banks professional staff. In line with the guidelines of
RBI, the Bank has proposed to bring in all the borrowal accounts (Standard accounts) with limits
of Rs.2 lakh and above under the purview of credit risk rating. However, the rating model that
will be applied varies according to the type / extent of exposure to suit the borrowers activities.
The Bank is utilising their own internal Credit Rating Model for grading the borrowal accounts
so far.
The grades used in the internal credit risk grading system should represent without any

50
ambiguity, the default risks associated with an exposure. This system shall also enable the Bank
to undertake comparison of risk for the purpose of analysis and decision taking. Number of
grades used in CRF depends on the anticipated spread in credit quality of the exposure of the
Bank. The more the number of grades on the rating scale, the more the requirement of
information. Hence, RBI suggest that the Bank can initiate the risk grading activity on a
relatively smaller scale initially and introduce new categories as the risk gradation improves. As
suggested by RBI the 9 level in the grading scale and the cut off level for Acceptable and
unacceptable credit risk are:
The calibration on the rating scale will allow prescription of limits on the maximum quantum of
exposure permissible for any credit proposal. The quantum would depend on the credit score on
the CRF. The Bank normally does not take any fresh exposure in the unacceptable level of scale
of risk. Any takeover of fresh borrowers to comply with the following norms:
1) Minimum Current Ratio of 1.33 consistently for the last 3 years.
2) Minimum Current Ratio of 1.17 and
3) Current Ratio of at least 1.00 is stipulated for exceptional cases.
As regards exit, the Banks Loan Policy permits for exit even when the account remains under
Standard category if any warning signals are seen. The other mode available, if complete exit is
felt impossible, by containing the exposure at the same level, risk participation and opt for
recovery wherever warranted. The assignors of risk ratings utilize bench mark or pre specified
standards for assessing the risk profile of the borrower, especially, the financial ratios, are
directly compared with the specified
bench marks. Further assignment of weightage is related to the level of the risk parameters which
weigh more for altering the risk profile of the borrower.

51
In the run up to the credit crisis, banks risk governance, risk culture and incentive and
remuneration policies were the three areas where the management of risk let them down the
most.The majority of Chief Risk Officers (CROs), risk professionals and other senior managers
taking part in the survey acknowledge that the industry as a whole had an inadequate framework
for controlling risk. They also admit that the prevailing organizational culture did not stop
excessive risk taking, fuelled by a system of profit-based rewards that failed to protect the needs
of depositors.
However, somewhat surprisingly, a majority (almost six out of ten) of banks still consider their
own risk governance and culture to be effective, suggesting that some have yet to acknowledge
their own role in the troubles that have embraced the sector.

52
Are banks taking sufficient action to improve risk management?
The study indicates that many banks are taking positive steps to overcome these weaknesses;
around half of those participating have already reviewed the way they manage risk, with most of
the remaining respondents either involved in or about to start a review. However, only four out of
ten have made or intend to make fundamental changes, which is perhaps lower than may have
been expected and could indicate an unwillingness to take specific and decisive action in tackling
the weaknesses that led to the credit crisis.
Regardless of the degree of change anticipated, a majority of respondent banks are seeking to
tighten up their overall risk management. Governance and culture are both high on the agenda as
they attempt to put in place more effective policies, procedures and controls and make staff more
aware of enterprise-wide risks when facing key business decisions. There is also considerable
focus on improving the way that risk is reported and measured as well as the systems and data
that underpin such analysis. This is recognition that managers across the business units did not
have sufficiently robust data when making some of the decisions that led to the present troubles.

53
54
Risk management has not been closely aligned with compensation policy
Despite being cited in the survey as the single biggest contributor to the current crisis, less than
half (46 percent) of the respondents are planning a significant increase in attention to this issue.
There appears to be some uncertainty over the role of the risk management function in
developing and managing compensation policy.
This is not to say that respondents do not support reform to compensation: almost six out of
ten favor greater use of long-term incentives; and a similar proportion want to expand the
practice of risk-adjusted measures. Other proposals, such as longer deferral of bonuses and an
increase in proportion of remuneration paid for divisional performance attract less interest.
In a further twist, the risk professionals involved in this survey are also cautious about any
external pressures on rewards and incentives, with just over a third (36 percent) agreeing that
regulators should become more involved in the setting of remuneration in the banking industry.

55
 The survey suggests that although risk management is slowly starting to play a more central
role in banks decision-making structures, many respondents feel that risk has still to shed its
traditional image as a support function. The growing importance of the risk function in banking
is reflected in our findings. Seven out of ten taking part believe that the risk function holds much
greater influence than two years ago
and eight out of ten see the way they manage risk as a source of competitive advantage (as
opposed to merely providing checks and balances). Yet it seems that there is still a long way to
go, with the vast majority concerned that risk management continues to be stigmatized as a back
room function.
Encouragingly, two of the areas where the CRO or equivalent is starting to exert considerably
greater authority are strategy development and capital allocation. This is a logical development
as banks seek to integrate risk and capital into their planning to ensure they do not over stretch
their capacity in pursuit of profit. Six out of ten survey participants feel that the CRO should
have even more influence over the development of strategy, although in light of recent events
this figure could arguably be even higher. Overall it appears that the desire to manage risk at a
strategic level has not fully filtered down to more practical issues.
Although banks may be concerned about the apparent lack of involvement of the CRO in
mergers and acquisitions, much of this is probably due to a relative lack of deals over the
previous two years. However, the recent increase in activity in this area with the more stable
institutions buying out their troubled compatriots calls for rigorous risk assessment of purchase
targets.

56
 In a further reference to the often-marginalized role of risk professionals, half of those we
surveyed believe that cultural change would be hastened by giving the function greater authority
in the organization. Despite the fact that employee rewards are not high on the agenda of the
CRO, there is at least some acknowledgement that the way staff are rewarded has a big impact
on culture, with four out of ten arguing for incentives linked to effective risk management.

57
Communicating with the rest of the organization
When asked to list the factors that contributed to the current predicament in the industry, only
two in ten banks(21 percent) feel that a lack communication across organizational silos played a
part. However the respondents do recognize the need for improvement, with better
communication between the risk function and the business being seen as one of the most
important ways to improve overall risk management, with a majority committed to making such
changes.
A more detailed look at communication and information sharing across the business reveals a
number of inconsistencies that could affect the management of risk. The risk function claims to
have developed much closer relationships with the senior executive team and the Risk
Committee, suggesting that those involved in major strategic decisions are likely to consider the
wider implications for the business.
However, there is also evidence that such high-level risk management is not carried down to
operational level; respondents admit that there is room for greater interaction with the lines of
business and internal audit, and also between the risk committee and the audit committee.
Such a weakness in communication enables business unit managers to take on large risks without
consulting further up the management chain. Furthermore, with internal audit expected to play a
greater role in risk management as the third line of defense, senior managers will want to see a
closer relationship between the internal audit and risk functions.

58
Where is pressure to change coming from?
The biggest pressure on risk professionals appears to be coming from regulators and executive
management, but not as might be expected from non-executive Board members. This may be
at least partly down to the shortage of risk expertise of Board members and reinforces the
suspicion that risk is viewed as a regulatory rather than a business issue, hence the lack of
authority of the risk function. If banks are to avoid the problems that have plagued them in the
past two years, non-executives will have a key role in providing an independent challenge to risk
management.

59
 While acknowledging the lack of risk experience and skills amongst senior executive and non-
executive management, the banks taking part in the survey appear to have been slow to address
this shortage. Only four out of ten respondents admit that insufficient risk expertise at Board
level was a contributory factor in the credit crisis, and under half (45 percent) believe that their
own organization lacks such know-how at the very top. Both these figures are considerably lower
than may have been
expected, given the risks that some banks may have taken in the lead up to the current troubles.
When asked what would most improve risk management, the number one response (45
percent) was: Better in-house skills and experience, with over a third admitting that they need
greater risk expertise at the very top. Interestingly, respondents from North America and Europe

60
are considerably more confident in their in-house knowledge than their counterparts in other
regions.

61
Are banks filling the skills gap?
Despite this apparent awareness of their shortcomings, a significant minority of banks has no
plans to appoint individuals with deep practical risk experience to senior positions. A third (33
percent) are not actively seeking such skills for the non-executive Board, which puts a question
mark over the extent of their commitment to truly independent risk assessment of strategic and
commercial decisions.
Surprisingly, less than three in ten (29 percent) of respondents feel that lack of skills and
experience was a causative factor leading up to the current crisis. Regardless of this, across the
organization as a whole, people, skills and training are considered to be by far the single biggest
investment priority for banks.

62
 Many banks in the survey recognize the limitations in the way they manage and report data
and plan to focus more on stress testing and scenario analysis. However, there is a question mark
over whether any new approaches are flexible enough to make accurate predictions. The way that
risk is reported and measured played a significant part in the credit crisis, according to those
involved in the survey. Almost eight out of ten respondents (78 percent) are planning to pay more
attention to this issue, with a similar proportion looking to improve risk systems and data quality.
What is driving the change in approach to risk measurement?
The survey shows that banks have been employing a wide variety of approaches to manage
risk, although the use of Basel II credit risk models has been surprisingly low, given the
regulatory pressure to take up such a tool.

63
64
 In the future, respondents will be placing a stronger emphasis upon stress testing and scenario
analysis to help measure and manage risk. This is an acknowledgement that recent analysis was
not sufficiently robust to deal with the systemic risks in the market at the time. Arguably this
increased focus on measurement may also be a precautionary move, given that some regulators
are starting to insist on certain levels of stress testing as a minimum requirement in order to
maintain capitalization and capital allocation levels.

Will the use of economic capital reduce risk?

The vast majority of survey participants uses or plans to use economic capital to estimate
capital requirements, although in only a fifth of cases (21 percent) is this currently fully
embedded. This trend, along with the substantial increase in reliance on Basel II models, creates
a dilemma for banks: with a potential backlash against quantitative approaches that are based on
static, historical data; can risk professionals develop more sophisticated, flexible models?

65
All the responses were gathered through online interviews of senior managers involved in risk
management from leading banks around the world. The interviews, carried out by the Economist
Intelligence Unit, covered a range of questions relating to risk management, with particular
reference to the global credit crisis.
Over half of the respondents work directly in the risk function for involved in organizations
corporate, retail, investment and private banking, as well as asset management. Seven out of ten

66
(72 percent) have a CRO or equivalent. Twenty percent had assets over US $500 billion and
thirty fivepercent over US $250 billion.

Chapter-5
Case study Analysis

67
 Case study
Assessment of permissible bank finance at PNB
Account: MIS XYZ Limited, New Delhi

Asset classification: Standard

Credit risk rating: BB as on 31.3.04

Consortium/multiple banking: Consortium

Whether CMA: yes

Lead bank: PNB

PNB share %: Existing-48, Proposed-44

Whether SSl/Priority sector: NO

Whether export oriented: yes

Date of receipt of proposal at branch: 13.5.04

Date of receipt of proposal at HO: 18.8.04

Gist of the proposal:

1. Enhancement of fund based limits from Rs. 1550 lakhs (regular 1350 lakhs + adhoc 200 lakhs) to Rs.
1670 lakhs.

2. Enhancement of Non-fund based limits from Rs. 147 lakhs to Rs. 247 lakhs

BANK'S COMMITMENT & MAXIMUM PERMISSIBLE EXPOSURE NORMS. (in lakhs)

1. Funds based W.C. limits 1670.00

2. Term loan o/s 745.00

3. Investment in shares, debentures etc.; nil

4. Total of 1, 2, and 3: 2415.00

5. Non-fund based: 247.00

6. Total of all exposures i.e. total of 4 & 5: 2662.00

Total exposures to the company are within permissible exposure norms.

68
Financial data for the last 4 years (in lakhs)

31.3.2001 31.3.2002 31.3.2003 31.3.2004

Gross sales 3934.77 8082.81 11166.89 12739.29

-domestic 2263.86 4674.95 9088.19 11643.55

-export 1670.91 3407.86 2078.78 1095.78

Other income 14.86 44.76 4.10 8.05

Operating profit 267.74 316.84 392.76 396.84

PBT 282.62 361.60 396.86 404.89

PAT 256.60 339.60 361.86 365.17

Cash profit 509.02 812.82 860.63 973.09

Paid up capital 1294.91 1370.33 1425.27 1425.27

Reserves and surplus (revaluation reserves) 377.31 716.91 1078.77 1149.59

Miscellaneous expenditure not written off 2.82 2.46 2.11 1.76

Accumulated losses Nil Nil Nil Nil

TNW 1166.40 2084.80 2501.93 2573.10

Current ratio 1.37 1.51 1.45 1.35

NWC 557.71 1046.93 1249.18 1344.73

DER 1.18 1.24 1.15 1.25

Operating profit/gross sales 6.80% 3.92% 3.50% 3.12%

Key figures for quarter-ended 30.6.04

Sales 3381

Operating Profit 109

69
Comments on financial indicators

During the year ended 31.3.2004 gross sales have increased by 14.08%. The PBT has however
increased only by 2.01%. Reasons have been attributed to higher depreciation during the year on
account of expansion/modernization undertaken during the year. Cash profit (after tax) has
increased by 12.89%.
PAT will go down to Rs 263,73 lakhs after accounting for provision for deferred tax liability of
Rs 101.45 lakhs
Operating profit to gross sales ratio In 2002.04 is lower due to higher incidence of depreciation
by Rs 103.78 lakhs. TNW In 2002'03 could not improve due to the provision of Rs. 294.35 lakhs
for deferred tax liability (as per AS-22)
Successive decline in export turnover: it is submitted that sales of the co. In the domestic market
are only to the exporter leading to indirect exports. Ready made garments are quota items &
quota is released by the Apparel Export Promotion Council on the basis of past performance, new
investment and first come first serve basis. In the year 2002-04, Govt. of India, Ministry of
textiles, imposed an embargo and hence the company could not achieve the export sales target,
But the company took immediate steps to divert the finished stocks to domestic market so that
overall sales targets are achieved, further the company is confident of achieving targeted export
sales in the current year on the basis of quota in hand.
Current ratio is satisfactory and has throughout been maintained above benchmark level of 1.33.
Debt-equity ratio is satisfactory.
As on 31.3.2004 investments in shares are Rs. 57.55 lakhs out of which Rs.21.07 lakhs has been invested
in unlisted shares of associate concerns. The investment is made in due course of business and the
quantum is insignificant in comparison to net worth/total capital deployed in the business.

Statutory liability:

ESI & PF have been regularly deposited.

Contingent liability: 31.3.2003 31.3.2004

Bills discounted 212.74 143.00

Bank guarantee 34.00 39.70

No adverse comments by the auditors

As per auditors certificate there were no undisputed amount payable in respect of income tax, wealth tax,
sales tax, custom duty and excise duty which are outstanding as at 31.3.2003 for more than 6 months from
date they become Payable.

70
In view of satisfactory net worth of the company vis a vis the amount of contingent liability and
investments, no adverse impact is envisaged.

Brief history

XYZ Limited is a closely held co. The co. is running a textile plant and is engaged in Dyeing &
Processing of knitted fabrics, dyeing of yarn, printing and processing of woven fabrics, sewing thread and
readymade garments. The A/C was taken over from another bank by sanctioning fund-based limit of Rs
800 lakhs & non-fund based limit of Rs 147 lakhs. The limits were enhanced to fund based Rs 1350 lakhs
and non-fund based Rs 147 lakhs and term loan of Rs 745 lakhs. A consortium of banks is meeting the
existing WC requirements of the co.

Justification for working capital sanction (Rs in lakhs)

Particulars For previous year Projection for current year

2002-2003 2003-2004 2004-2005

Projected sales 11285.3 12100.00 15500.00

Sales achievement 11166.89 12347.00

% achievement 98.95 102.04

% growth over 35.71 10.57 25.54

previous year

Projected profits 516.8 431.98 454.10

Actual profits 396.86 404.89

The projected sales of Rs 155cr have been accepted by us for assessment in view of past trend as well as
the expansion/modernization undertaken by the co. during the year 2002-03.

Growth rate since inception is as under

Year Gross turnover Growth

2000-2001 3949

2001-02 8129 105.84%

2002-03 11167 37.37%

2003-04 12739 14.00%

71
2004-05 15500 21.00%

Justification for NFB facilities

The co. is not seeking any enhancement In NFB limits from the consortium. However, with a view to
rationalize the sharing for NFB limits among the consortium banks, our share is proposed to be increased
to Rs' 247 lakhs.

Packing credit in foreign currency

The company has requested for allowing packing. Credit in foreign currency (PCFC) and ZM has
recommended for approval of the same subject to availability of foreign currency. However, we observe
that no justification/terms and conditions including rate of interest has been proposed for PCFC. Also
handling charges are to be levied for which borrower consent may be obtains. Further, availability of line
of credit/foreign currency funds is to be ascertained from the foreign exchange office before allowing the
facility. Thus, it has been advised by the branch/zonal office to- move for PCFC facility with proper
justification and terms and conditions governing the PCFC Scheme in case of need.

Rate of interest

The co. has scored 95 marks out of 100 and is categorized as AA rated client.

Rate of interest applicable is PLR+1.5%

Existing Rate of interest PLR+2% i.e. 13% p.a. as applicable to A+ category

Proposed rate of interest PLR+ 1.5% i.e. 12.5% p.a. as applicable to AA category.

Rating parameter and scoring

Parameter Maximum Co.s score

score

Current ratio 15 15

Debt equity ratio 10 10

Submission of QMS and other 10 10

financial data

Submission of data for renewal or 10 10

review of account

72
Achievement of sale projection 10 10

Achievement of profit projections 10 10

Conduct of account 25 20

Value of the account 10 10 The existing limits are fully availed and
adequate yield is expected

total 100 95

Risk management department has rated the company BB. The details about this risk rating procedure
being followed by the risk management department are explained later.

Assessment of permissible bank finance.

Year ending Actual for Actual for 2004 Projection for Accepted for
2003 (prov.) 2005 assessment

1. sales (gross) 11166.89 12388.90 15500.00 15500.00

Sales (net) 10880.91 12388.90 15000.00 15000.00

% of increase in net sales 35.71 13.86 21.08 21.08

2. basic data (value per

month)

a) sales (gross)
-domestic
757.35 942.2 1083.33 1083.33
-exports
173.18 90.2 208.33 208.33

b) cost of production 797.85 921.85 1133.85 1133.85

c) cost of sales 791.83 925.80 1120.23 1120.23

d) raw materials 596.27 683.49 867.20 867.20

-imported

-indigenous

e) other spares Nil Nil Nil Nil

73
 -imported

-indigenous

3. Inventory holding levels:

equivalent to raw materials, months consumption, stock in progress, months cost of production, finished
goods, months cost of spares, months consumption (or %)

Particulars Past trend Actual for 2004 Projections for 2005 Accepted for assessment

Raw materials 1.48 1.38 1.50 1.50

-imported

-indigenous

Stock in progress 0.99 0.79 0.80 0.80

Finished goods 0.56 0.46 0.50 0.50

Receivables

-inland 1.49 2.52 2.50 2.50

-exports 1.78 2.61 2.75 2.75

Other spares Nil Nil Nil Nil

Justification

1. Raw material: The Company has projected inventory level for raw materials at 1.5 month against
actual-level of 1.48 month and 1.38 month during financial year 2002-03 and 2003-04 respectively. It is
informed that keeping in view the supply position of raw materials and nature of manufacturing process,
the company is required to maintain average inventory level of raw material at 1.5 month. Justification
given by the company is found acceptable by PNB.

2. Stock in process: the level of stock in process is in line with the past trend.

3. Domestic receivable: The level of domestic receivables is in line with the past trend. It is stated that
since the market is becoming competitive, extending credit is one of the tools for marketing and
maintaining the growth rate. The past trend of receivable level is as under.

74
Year level in month

2001-02 1.99

2002-03 1.49

2003-04 2.49

4. Export debtors: The Company has projected export receivables at 2.75 month against actual level of
2.61 month during the previous year. The company has projected the increase taking into consideration
the increase target for export set out by extending reasonable credit to the buyers. It is further informed
that the export market is highly competitive and the company is required to extend average credit period
of 2.75 month.

5. Finished goods: The Company has projected Inventory level of finished goods at 0.5 month against
actual level of 0.56 and 0.43 month during financial year 2002-03 and 2003-04 respectively. On an
average the company is required to maintain the finished goods level of 0.5 month to meet out the
increased targeted turnover. The company has also informed that the level is in line with the Industry
trend. We have accepted the level in view of the justification given by the company.

4. Chargeable current assets

Particulars Past trend/actual for Projections for 2005 Accepted for

assessment

2003 2004

1. Imported raw Nil Nil Nil Nil

materials

2. Indigenous raw 880.21 942.48 1300.81 1300.81

materials

3. Stock in 792.34 726.80 907.08 907.08

process

4. Finished goods 444.09 396.73 560.12 560.12

5. Other spares 62.30 121.94 135.00 135.00

-imported

-indigenous

6. Receivables

-domestic 1131.14 2375.87 2708.32 2708.32

75
-export 307.89 235.60 572.92 572.92

Total 3617.97 4799.42 6184.25 6184.25

The projected levels of receivables are in line with the holding levels in term of months sale and the
absolute quantum is shown to increase in accordance with the increase in turnover.

5. Other current assets

Particulars Past trend/actual for Projections for 2005 Accepted for

assessment

2003 2004

1. advances to 110.51 122.05 130.00 130.00

suppliers for the
raw materials and
consumable
stores/spares

2. advance 68.55 73.44 90.00 90.00

payment of taxes

3. cash and bank 12.56 26.74 40.00 40.00

balance

4. other current 211.16 142.85 195.00 195.00

balance

total 402.78 365.08 455.00 455.00

Other current assets projected are in line with the past trend and in accordance with the increased level of
operations and have therefore been accepted by us for assessment.

6. Other current liabilities

Particulars Past trend/actual for Projections for 2005 Accepted for

assessment

2003 2004

1. creditors for 565.69 (.095) 566.80 (0.83) 693.76 (0.80) 693.76 (0.80)
purchase (months
purchase)

76
2. advance from 51.20 22.00 30.00 30.00
customers

3. other statutory 88.52 64.60 75.00 75.00

liability

4. other current 379.73 403.72 430.00 430.00

liability

total 1085.14 1057.12 1228.76 1228.76

Other current liabilities projected are in line with the past trend and in accordance with the increased
levels of operations and have therefore been accepted by us for assessment.

7. Net working capital

Past trend/actual for Projections for 2005 Accepted for

assessment

2003 2004

1249.18 1337.97 1630.00 1630.00

8. The CMA data and our assessment as above are based on the provisional figures given by the company
for 2003-04 (the audited results as on 31/3/04). The audited figures have been compared with the
estimated given by the company and it is observed that there is no major variation in the sales figures and
profits are in line with the provisional figures. The comparative table of inventory holding is as under.

Provisional Audited Projected

Raw materials 1.38 1.40 1.50

Work in process 0.79 0.81 0.80

Finished 0.43 0.47 0.50

Receivables 2.52 2.43 2.50

Export receivables 2.61 2.58 2.75

Creditors 0.83 0.83 0.80

As can be observed the holding level are compared with the provisional figures given by the company and
hence the figures given by the company and hence the assessment of PBF is not effected.

Calculation of permissible bank finance

77
Particulars

a) chargeable current assets 6184.25

b) other current assets (no-5) 455.00

c) total current assets (a +b) 6639.25

d) less other current liabilities (no-6) 1228.76

e) working capital gap (c-d) 5410.49

f) minimum stipulated net working capital {25% of c export receivables } 1516.58

g) projected net working capital 1630.00

h) e-f 3893.91

i) e-g 3780.49

PBF (h or I whichever is less) 3780.49

Summary of merits/justifications for considering the proposals

1. The promoters by virtue of their long association with the garments industry have requisite experience
to carry out the manufacturing operations. They have got settled customer base also which will enable the
co. to achieve its sales target. As informed, the co. has been able to secure the maximum amount of quota
allocated in the northern region.

2. The required raw material is readily available.

3. The co. is situated at main Delhi Mathura road, hence accessibility of the exporters & the foreign
buyers are very easy. As such the co. can provide better services.

4. The co. has full and composite facilities under one roof providing single window solution to their
buyers.

5. The co. has full infrastructure like power, steam, and effluent treatment plant etc. to meet the
requirement of the proposed expansion plan which will result in reduced capital cost viz a viz similar
project being set up afresh.

6. the limits will be adequately covered by collateral security in the form of seconds pari passu charge on
block assets (residual value Rs2395.30 lakhs as on 31.3.2002) and EM of property valued at Rs598.50
lakhs exclusively for PNB.

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 Chapter-6
Conclusion and Recommendations
Risk management underscores the fact that the survival of an organization depends heavily on its
capabilities to anticipate and prepare for the change rather than just waiting for the change and react to it.
The objective of risk management is not to prohibit or prevent risk taking activity, but to ensure that the
risks are consciously taken with full knowledge, clear purpose and understanding so that it can be
measured and mitigated. It also prevents an institution from suffering unacceptable loss causing an
institution to fail or materially damage its competitive position. Functions of risk management should
actually be bank specific dictated by the size and quality of balance sheet, complexity of functions,
technical/ professional manpower and the status of MIS in place in that bank. There may not be one-size-
fits-all risk management module for all the banks to be made applicable uniformly. Balancing risk and
return is not an easy task as risk is subjective and not quantifiable where as return is objective and
measurable. If there exist a way of converting the subjectivity of the risk into a number then the balancing
exercise would be meaningful and much easier. Banking is nothing but financial inter-mediation between
the financial savers on the one hand and the funds seeking business entrepreneurs on the other hand. As
such, in the process of providing financial services, commercial banks assume various kinds of risks both
financial and non-financial. Therefore, banking practices, which continue to be deep routed in the
philosophy of securities based lending and investment policies, need to change the approach and mindset,
rather radically, to manage and mitigate the perceived risks, so as to ultimately improve the quality of the
asset portfolio. As in the international practice, a committee approach may be adopted to manage various
risks. Risk Management Committee, Credit Policy Committee, Asset Liability Committee, etc are such
committees that handle the risk management aspects. While a centralized department may be made
responsible for monitoring risk, risk control should actually take place at the functional departments as it
is generally fragmented across Credit, Funds, Investment and Operational areas. Integration of systems
that includes both transactions processing as well as risk systems is critical for implementation. In a
scenario where majority of profits are derived from trade in the market, one can no longer afford to avoid
measuring risk and managing its implications thereof. Crossing the chasm will involve systematic
changes coupled with the characteristic uncertainty and also the pain it brings and it may be worth the
effort. The engine of the change is obviously the evolution of the market economy abetted by
unimaginable advances in technology, communication, transmission of related uncontainable flow of
information, capital and commerce through out the world. Like a powerful river, the market economy is
widening and breaking down barriers. Governments role is not to block that flow, but to accommodate it
and yet keep it sufficiently under control so that it does not overflow its banks and drown us with the
associated risks and undesirable side effects. To the extent the bank can take risk more consciously,
anticipates adverse changes and hedges accordingly, it becomes a source of competitive advantage, as it
can offer its products at a better price than its competitors. What can be measured can mitigation is more
important than capital allocation against inadequate risk management system. Basel proposal provides
proper starting point for forward-looking banks to start building process and systems attuned to risk
management practice. Given the data-intensive nature
of risk management process, Indian Banks have a long way to go before they comprehend and implement
Basel II norms, in to-to. The effectiveness of risk measurement in banks depends on efficient
Management Information System, computerization and net working of the branch activities. The data
warehousing solution should effectively interface with the transaction systems like core banking solution
and risk systems to collate data. An objective and reliable data base has to be built up for which bank has
to analyze its own past performance data relating to loan defaults, trading losses, operational losses etc.,

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and come out with bench marks so as to prepare themselves for the future risk management activities.
Any risk management model is as good as the data input. With the onslaught of globalization and
liberalization from the last decade of the 20th Century in the Indian financial sectors in general and
banking in particular, managing Transformation would be the biggest challenge, as transformation and
change are the only certainties of the future. Here are some findings from the data collected-

1)Despite improving its profile, the risk function is still struggling to gain influence
Seven out of ten respondents feel that risk departments are having a greater influence within
banks, particularly at a strategic level. However their involvement in more day-to-day business
decisions may be restricted by poor communication with the lines of business. More worryingly,
a vast majority (76 percent) of those involved in managing risk still feel that, despite raising its
profile, risk is stigmatized as a support function.
2)Banks are not addressing the lack of risk expertise at senior levels
Under half (45 percent) of the banks in the survey acknowledge that their Boards are short of risk
knowledge and experience a lower figure than may have been expected. It is of some concern
that many are not even planning to address this issue particularly at the non-executive level
where the need for expertise is most acute. With a quarter of respondents seeing no need for a
Risk Committee, many organizations could be lacking a rigorous, independent challenge to the
judgments being made in the businesses.
3)To change risk culture, banks should lead from the top
The survey reveals the vast majority of those responsible for managing risk (77 percent) are
dedicated to instilling a more robust risk culture in their organizations and feel that greater tone
from the top, along with a more authoritative risk function, are two of the keys to such a
transformation. Some respondents expressed concern that regulators rather than non-executive
directors are driving change. This further supports the perception that in certain institutions
risk may still be seen as a peripheral compliance issue, rather than an essential part of strategy.
4)76% of senior risk managers still feel risk is stigmatized as a support function
5)45% of the banks in the survey acknowledge that their Boards are short of risk knowledge
and experience
6)Risk managers appear reluctant to tackle incentive and compensation issues
Despite acknowledging that the rewards culture has had a big impact upon the current crisis, the
majority of those responding are cautious about increasing the involvement of either regulators
or the risk function itself in setting policy. This suggests that risk managers are uncertain of their
role in this critical area.
7)Poor communication was not to blame for the credit crisis
Only a fifth of respondents feel that a silo mentality contributed to the current turmoil in the
industry, yet a majority acknowledge that communication between different parts of the business
needs to improve. Banks are particularly concerned about improving links with the lines of
business those on the front line who have to consider the risks they take on, whether its
making trading decisions or developing new products.
8)Banks want to provide better information for decision making

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Almost eight out of ten respondents are seeking to improve the way that risk is measured and
reported, a clear acknowledgement that previous models did not sufficiently measure potential
risk exposure. Their emphasis will be on stress and scenario testing, along with Basel II credit
models, but it remains to be seen whether such measures will be either flexible or sophisticated
enough to fully capture the range of possible outcomes.
9)92% of those surveyed have carried out or are about to carry out a review of their risk
management
10)36% of respondents feel that regulators should play a role in remuneration
11)52% of respondents say incentives and remuneration policies contributed to the credit
crisis
12)42% of respondents have made or expect to make fundamental changes to risk
management
13)The need for truly integrated risk management
The credit crisis brings many banks overall risk governance into question, with some lacking the
framework, the policies or the necessary capabilities to achieve a clear picture of the risks they
are facing across the organization.
In growing the business, executive teams should try to ensure that all employees are aware of
and involved in managing risk, with senior management setting the overall strategic direction
and embedding risk management philosophy across the business, ensuring that risk can be
measured, reported and managed. They should also provide clear guidance reflected in explicit
policies and procedures and a clear expectation of compliance with these.
Strong performers tend to have clear lines of communication, with the risk management function
integrated into the business, allowing insights and industry best practice to be shared.
Risk management responsibilities should be streamlined so that risk can be owned and managed
within the business unit, but quickly escalated through the risk management function and
business units to the Board and its relevant committees where necessary. When they are working
well, these three lines of defense give primary responsibility for risk management to the client-
facing areas of the business; support functions review and check that risks are accepted in line
with the institutions policies and appetite; and finally internal audit provides assurance that the
internal controls and risk management are operating as expected.
Reliable quantitative and qualitative information should feed up from the business units to senior
management and the Board and be delivered to decision makers in a timely fashion.
14)How should risk professionals influence compensation incentives?
In an October 2008 letter to CEOs of leading financial companies, the UK Financial Services
Authority (FSA) noted that firms possibly frequently gave incentives to staff to pursue risky
policiesto the detriment of shareholders and other stakeholders.
The FSA wants to see wider use of increased deferral of annual bonuses and the delivery of
incentives in shares rather than cash, with performance measures linked to risk. The letter makes
a case for the risk function to have a strong and independent role for setting compensation for
the business areas.
According to Kevin Blakely, President and CEO of The Risk Management Association, this
means acting as an agitator rather than an administrator: Compensation is the responsibility of

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the Board, the compensation committee and the CEO, but the CRO should have a direct input
into policy to ensure that risk is taken into consideration.
In a separate report, the Institute of International Finance established a special Committee on
Market Best Practices (CMBP), which also argues for compensation incentives to be based on
performance and aligned with shareholder value and long term, organization wide profitability. It
also suggests that compensation incentives should in no way induce risk taking in excess of the
organizations risk appetite and that the payout of bonuses should be closely related to the timing
of risk adjusted profit.
Although some of the casualties of the current crisis claim to have very long-term incentive plans
that are directly linked to share price, this does not appear to be consistent across the industry.
With many banks under partial or complete government ownership, banks are likely to be under
considerable political pressure to show regulatory bodies that their compensation and incentive
systems are risk based.
15)In many banks, the right hand side didnt know what the left hand was doing.
Kevin Blakely, President and CEO, The Risk Management Association
Developing a robust risk culture
Banks should set realistic limits on risks that fit the culture and risk appetite of both the
individual business lines and the overall institution. Senior managers have to strike a very
delicate balance in matching the acceptable level of risk exposure to the culture in which that risk
is being managed.
In simple terms, they should have confidence in their own risk culture and the courage to be able
to say: Although we are making a lot of money here, additional risk will not result in additional
value being added to the business in the long term.
The job then is to create a system of governance where risk can be managed and where every
individual in the organization understands the appetite for risk and their part in mitigating it. This
should help prevent those in the lines of business delegating responsibility for risk management.
This appetite should be agreed upon at Board level and be the foundation for both the culture and
the system of controls within the organization. Once this appetite is clear, potential decisions
such as taking on loan portfolios can be assessed in the context of what risk is acceptable.
The Risk Committee also has a vital role to play; yet a quarter of respondents in the survey have
no plans to even form such a forum. Writing in the Financial Times in October 2008, Emilio
Botn, Chairman, Banco Santander, noted that: Many are surprised to learn that the Banco
Santander Boards Risk Committee meets for half a day twice a week and that the Boards 10-
person executive committee meets every Monday for at least four hours, devoting a large portion
of that time to reviewing risks and approving transactions. Not many banks do this. It consumes
a lot of our directors time. But we find it essential and it is never too much.
Botn also feels that: Risk is part of the daily conversation and viewed from an enterprise-wide
perspectiverisk management not only has a seat at the table, but is also an active participant in
all key business decisions.
Kevin Blakely, President and CEO, The Risk Management Association, also emphasizes the
importance of the risk committee, which he believes should oversee the active acceptance of
risk within the organization and make sure its mitigated, managed and priced for.

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He adds: The CRO should be a central part of the strategic planning process and be involved in
any major decisions involving initiatives from the lines of business. I dont think this is
happening sufficiently and is a major flaw in enterprise risk management in banks large and
small. He goes on to say that: With such a weak information circulatory system, in many banks
the right hand side didnt know what the left hand was doing and senior management did not
know its overall exposure.

16)Will risk be regulatory or internally driven?

In the absence of a globally coordinated response from the banking industry, central banks and
their regulators as lenders of last resort have taken the lead in rescuing and to some extent
remolding the sector. Emerging regulatory changes will demand greater transparency, better risk
management and stricter risk governance, with banks possibly having to augment their Boards
with a relevant risk specialist.
...risk management not only has a seat at the table, but is also an active participant in all key
business decisions.
Emilio Botn, Chairman, Banco Santander
Exactly how regulators will be involved in the management of risks in banks is unclear but they
are likely to be more hands on.
Governments in many countries have had to step into the breach to restore confidence and calm
to their financial services markets. Such help comes at a price however, with numerous
conditions that directly impact banks and have wider implications for the global economy.
Since the recapitalization of many banks, the concept of the regulator as a key driver of change
has become a reality with many institutions genuinely shocked at the capital levels they have
been obliged to hold. Banks may not be able to resist calls of this sort unless they prove to
regulators, policy makers and the public that they have taken the appropriate action to strengthen
their own risk management procedures.
Some risk management agendas and budgets in recent years appear to have been driven by the
need to meet regulatory expectations set by such initiatives as Basel II, CSE, and Sarbanes-
Oxley. Such a compliance focus may possibly have distracted risk management resources from
addressing wider organizational risks.
17)A significant minority of banks has no plans to appoint individuals with deep practical
risk experience to senior positions.
18)45% of respondents believe that their own organization lacks risk expertise at the very top
19)A need for greater knowledge and experience
The industry as a whole is probably aware of the shortage of individuals with risk management
skills and practical experience, particularly at a senior level. Much of this expertise appears to be
concentrated in certain banks, yet even in these institutions, those with risk experience may not
be fully involved in major strategic decisions.
Those working in the risk function may also need to improve their skills and indeed raise the
profile of the function by investing in people and training. With risk management clearly under
the spotlight, it is no real surprise that people are to be the number one investment area.

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The Senior Supervisors Group (SSG) (comprising senior supervisors of major financial services
firms from France, Germany, Switzerland, the United Kingdom, and the United States) report
from March 20084 concludes that some of the executive leaders at firms that recorded larger
losses did not have the same degree of experience in capital markets and did not advocate quick,
strong, and disciplined responses.
The report goes on to argue for the selection of executive leaders with expertise in a range of
risks, given that it is very difficult to predict the source of the next disruption to the market.
Senior management teams as a whole should try to maintain a risk profile consistent with the
Board and senior managements tolerance for risk.
Emilio Botn, Chairman, Banco Santander5 believes that: the Board must know and
understand bankingThis is a complex industry, subject to constant change and innovation.
What is needed are directors who know the business well.
There is also a strong argument for more expertise across the organization. The three lines of
defense model places the prime responsibility for risk management with the client facing areas
of the business. Yet in a number of cases those working in the lines of business have not had
sufficient accountability for their actions and have lacked awareness of the organizations overall
risk appetite. This is probably down to the underlying organizational culture and something that
can be addressed through training and improved communication.

20)61% of respondents will be placing more emphasis on stress testing and scenario analysis
providing a true picture of changing levels of risk
The credit crisis has highlighted some specific challenges in how banks manage risk, with
perhaps the biggest concern being the apparent over reliance on quantitative models in decision-
making. Even those that used more sophisticated models and testing were not always able to
predict what was effectively a once in a lifetime set of circumstances.
There appears to have been a lack of qualitative assessment of the risks and exposures being
taken on. While quantitative techniques are likely to have an important role to play, these should
be augmented by the judgment of those with extensive risk management and wider business
experience.
Measuring risk is clearly an integral part of effective risk management and the use of adaptive
rather than static tools (such as Value at Risk) should provide more reliable indicators of future
performance. In the lead up to the current crisis, many banks scenario planning was not
sufficiently robust, leaving senior management unable to accurately stress test different options.
Future scenarios should incorporate the views of experienced business and risk professionals, as
well as those of regulators and other peers.
The mandatory survival tests for capital levels set by the Federal Reserve, FSA and other
authorities are likely to impact profitability and de-leverage the balance sheet.
Such tests will almost certainly require greater use of stress and scenario analysis and
consequently we are likely to see a new generation of models and a new alignment of risk
management techniques.
However, a model is only as good as its built-in assumptions and its input, which in many banks
arrives in varying forms at different times from disparate sources around the organization. This
was highlighted in the aftermath of the Lehman Brothers collapse, where some industry

84
participants struggled to identify all their relevant exposures to Lehman across their group
structures. In the future, banks should be aiming to consolidate their exposures into a single,
consistent source of analysis of their potential risks.
The Basel II capital framework currently used by the majority of banks can be strengthened,
encouraging management to develop more forward-looking approaches to measuring risk. These
would go beyond simply measuring capital and incorporate expert judgment on exposures,
limits, reserves, liquidity and capital. To give it real teeth, economic capital should be tied into
executive compensation so that rewards are based upon the economic value brought to the
organization.
According to the Senior Supervisors Group report6, those organizations that performed well
through the crisis were distinguished by the orderly and timely flow of information. Many banks
should consider reviewing their information circulatory system to overcome weaknesses such
as: varying volumes and quality of information from different parts of the organization;
timeliness of data; duplication of information as a consequence of having too many different
sources; lack of understanding as to what information is needed, who should supply it and where
it should be sent.
Since the very first credit was extended, banks have amassed vast experience in managing risk,
which makes the risk management weaknesses exposed by this crisis all the more surprising.
These weaknesses have been compounded by the global nature of the banking system, with few
parts of the world economy immune to the impact of the crisis. Moving forward, financial
institutions should get back to basics through a renewed focus on understanding the risks that
they take. By strengthening their risk governance regimes, they should help to make them more
flexible to meet changing conditions.
The findings from this survey point to a number of key improvements that banks should
consider:
21)Improving governance and creating a risk culture
By establishing an appropriate, enterprise-wide framework within which risk can be measured,
reported and managed, banks can create a simpler system incorporating the three essential
elements of an effective risk regime: governance, reporting and data, and processes and systems.
Firm, visible leadership from the very top can help embed a risk philosophy and culture across
the organization, with every employee fully aware of the organizations clearly articulated risk
appetite and its impact on decision making.
22)Raising the profile of risk
Those working in risk should seek to build stronger relationships with all levels of the
organization, in particular the lines of business, Board, audit committee and internal audit.
Improving risk expertise at senior levels
As a matter of urgency, banks should be looking to acquire greater risk know-how within their
senior executive and non-executive Boards, helping to provide a more robust and informed
challenge to business decisions.
23)Risk models should support but not drive decision making

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Effective risk management is essentially about good judgment supported by appropriate
quantitative data presented in a clear, simple format that the Board and other stakeholders can
understand. Risk models should be less rooted in historic data and flexible enough to adapt to
changing market conditions.
24)Addressing incentives head on
Risk managers should play a role in promoting the principles of compensation policy (which
would be developed by the compensation committee), with incentives based on performance and
aligned with shareholder interest and long-term, organization-wide profitability. Such an
approach should also help to reduce the intervention of the regulators.

Future of Risk Management in Indian Banking Industry

The Indian Economy is booming on the back of strong economic policies and a healthy
regulatory regime. The effects of this are far-reaching and have the potential to ultimately
achieve the high growth rates that the country is yearning for. The banking system lies at the
nucleus of a countrys development robust reforms are needed in Indias case to fulfill that. The
BASEL II accord from the Bank of International Settlements attempts to put in place sound
frameworks of measuring and quantifying the risks associated with banking operations. The
paper seeks to showcase the changes that will emerge as a result of banks adopting the
international norms.

The structure of the paper is three-fold, where we begin by projecting the risk management
scenario and its effects on internal operations of a bank, followed by the changes brought about
in the banking sector of India and finally the macro effects on the economy. This enables one to
discern the complete scenario that will emerge in the years ahead.

The Risk Management scenario will strengthen owing to the liberalization, regulation and
integration with global markets. Management of risks will be carried out proactively and quality
of credit will improve, leading to a stronger financial sector.

The calculation of risk will be done by credit scoring models such as Altmans Z Score Model &
Merton Model but in a more sophisticated and developed manner. The management information
systems (MIS) will be put in place and the level of efficiencies will increase more than
proportionately. Risk based pricing will be used for all credit facilities extended by banks. The
treasury departments of banks are poised to benefit from the BASEL II accord as would be
showcased in the paper.

The future will see a structural change in the banking sector marked by consolidation and a
shake-out within the sector. The smaller banks would not have sufficient resources to withstand
the intense competition of the sector. Banks would evolve to be a complete and pure financial
services provider, catering to all the financial needs of the economy. Flow of capital will increase
and setting up of bases in foreign countries will become commonplace.

86
Finally, the economy will stand to benefit as the banking sector develops. Savings will be
mobilized in the right direction and the required funds needed for the countrys development will
be made available.

Although many banks would be working towards the IRB Approach, the authors are of the
opinion that RBI would have allowed a few banks to implement and follow the IRB Approach by
the year 2015. Indian banks would be moving upward on the strategic continuum of risk scoring
models as can be seen in the diagram on the previous page.

BASEL II Effects on Internal Operations

87
Once implemented, the BASEL II norms would greatly influence the internal operations of a
bank the effects of which, would be clearly visible in 2015. In this section, we analyze the extent
of change brought about by the norms.

Risk Management Departments Role

The Risk Department would gain prominence within the banks as they would be playing an
extremely critical role in the management of the risks of the bank. Streamlining of information
and data flow through the Risk Department would be essential in calculation and management of
risks.

Calculation of Risks & CAR

Calculation of risk would be an essential requirement in the banks as they would be in the
process of calculating not only the Credit Risk but also the Market Risk and the Operational
Risks that the bank would be facing. The capital to be set off for advances made by the bank
would depend largely upon the fair and accurate calculation of these risks. In 2005 five credit
risk models have received global acceptance as benchmarks for measuring stand-alone as well as
portfolio credit risk. They are: -

I. Altmans Z Score Model

II. Merton Model
III. KMV Model for measuring default risk
IV. Credit Metrics
V. Credit Risk+

These models would get more sophisticated and the banks would have more options as other
models would gain acceptance. For Market Risks the banks would be employing other models
such as VaR, Monte Carlo Simulation etc. As for the Operational Risks the banks would be
following internal risk frameworks in assessing significant operational risks and their mitigation.

Risk-Based Pricing

Risk-based Pricing is the technique of charging different interest rates from two different
customers on the same type of loans, depending on the risk attributed to each of them. Under this
method credit scores are calculated for individuals, taking into consideration various factors
which are assumed to represent the individuals willingness and capacity to repay the loan
installments. As the banks would be in the process of moving toward the IRB Approach they
would be armed with the knowledge of the risks associated with the various types of exposures.

88
This knowledge would help the banks in passing on the charge arising from higher credit risk to
the customers. The authors are of the opinion that Risk-Based Pricing would be the norm of the
banking industry in another ten years.

Technology (MIS)

Indian banks would invest in development of Information Systems as MIS would play an
essential role in the calculation of LGD, EAD and PD. As the banks are expected to integrate
various financial services to provide a one-stop shop to the customers, MIS would be helpful to
the banks in cross-selling and other marketing-related activities. The settings up of such systems
are expected to reach completion by 2015 for most banks.

Strengthening of Treasury Operations

The spreads relating to core banking business of credit and deposit interest rates would narrow
down. Also, if the bank enjoys low PD and LGD it would have larger amount of funds available
to it, as its regulatory capital requirements would come down. The banks would have to search
for alternative profit generating avenues in the form of float fund management, thereby
strengthening their treasury operations, which will be a thrust area in the coming years.

Human Resource Development

More emphasis would be given to the human resources of the bank as Basel II would require
banks to calculate and manage risks continuously. One of the key requirements of the new
Accord is monitoring... the risk of direct or indirect loss resulting from inadequate or failed
internal processes, people and systems... The composition of skills required to perform in the
new environment would undergo a change.

This change will force banks to invest in educating its work force in various risk-scoring models
and enabling them to acquire skills to tap the full potential that the market offers. The
Operational Risk requirements of Basel II Accord extend deep into corporate procedures that
may not seem obviously connected to financial risk management. HR systems, for example, must
ensure that procedures and documents surrounding such tasks as staffing, education and system
maintenance, are properly recorded and documented, and that organization charts and lines of
responsibility can be tracked and reported as required. Banks would be required to address issues
such as manpower planning, selection and deployment of staff and training them in Risk
Management and Risk Audit. Hence, it is assumed that the banks that would have sound HR
policies and practices in place.

Emphasis on Corporate Governance

In the future, there would be greater emphasis on corporate governance in banks because
banking supervision cannot function as well if sound corporate governance is not in place and,
consequently, banking supervisors have a strong interest in ensuring that there is effective

89
corporate governance at every banking organization. Supervisory experience underscores the
necessity of having the appropriate levels of accountability and checks balances within each
bank.

Increased Capital in the Market

The authors are of the view that in the future the banks would follow the strategy of low defaults
and narrower spreads. This would bring down their CAR requirements, freeing up more funds
that could be invested in the economy. Another point to be noticed is that the banks would have
in place more sophisticated credit scoring models and they would be able to invest in more
profitable and less risky avenues thereby improving the efficiency of the capital markets.

Systemic Risk

Although the banks would benefit by having more free funds available, taking a macro view of
the system we might see the systemic risk going down. The rationale behind this statement is that
the banks risk models would have developed and become more sophisticated. They would not
only take into account various characteristics of the borrower but also the future economic
condition. The banks would become more robust and efficient thereby contributing to the
reduction of systemic risk.

International Scope

With better utilization of capital, rollover of banks funds through securitization and efficiency in
operations, Indian banks would become competitive in the international markets. The
consolidation of banks would give them the requisite size and compliance with the Basel II
Accord would give them greater efficiencies in management thereby making them competent for
the international market. As per Indian Banks' Association report Banking Industry Vision
2010, there would be greater presence of international players in Indian financial system and
some of the Indian banks would become global players in the coming years. So, one can envision
Indian banks going global in search of new markets, customers and profits. The following points
provide further insight on the expected banking scenario. Although, not direct consequences of
the BASEL norms these structural changes will be a fall-out of the reforms in the banking sector.

The implementation of the 2nd phase of the RBIs roadmap to reform in 2009, would allow
foreign bank ownership of any local private bank, within an overall limit of 74%. These foreign
banks would bring with them technological and management skills and improved efficiency.

RBIs role in the banking industry

RBI would be in the process of shifting to risk-based supervision (RBS) wherein the focus of its
supervisory attention on the banks is in accordance with the risk each bank poses to itself and the
system. The inceptions of RBS will require banks to reorient their original setup towards RBS

90
and put in place an efficient Risk Management architecture, internal auditing focusing on risk,
strengthening MIS and set up of compliance units.

Slimming & Trimming of the Indian Banks

Emphasis would be given to automation and outsourcing of different services would be done so
as to enable the banks to tackle the increasing volumes of business effectively. Customer-Banker
contact will be reduced to the bare minimum as it would be a paperless banking era, dominated
by plastic money, electro-banking, and tele-banking.

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www.moodyskmv.com/research/whitepaper/Credit_Valuation.pdf.
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