Credit risk is the risk of customers defaulting or failing to comply with their obligation to

payback debt, triggering a total or partial loss. The primary cause of credit risk is poor credit
risk management. It is the risk that the interest or principal or both will not be paid as
promised.

Credit risk is borne by all lenders and will lead to serious problems, if excessive. For most
banks, loans are the largest and most obvious source of credit risk. It is the most significant
risk, more so in the Indian scenario where the NPA level of the banking system is
significantly high.

Credit Risk depends on both external and internal factors. The internal factors include –

1. Deficiency in credit policy and administration of loan portfolio.

2. Deficiency in appraising borrower’s financial position prior to lending.
3. Excessive dependence on collaterals.
4. Bank’s failure in post-sanction follow-up, etc.

The major external factors –

1. The state of economy

2. Swings in commodity price, foreign exchange rates and interest rates, etc.

Credit Risk can’t be avoided but has to be managed by applying various risk mitigating
processes –

1. Banks should assess the credit worthiness of the borrower before sanctioning loan i.e.,
credit rating of the borrower should be done beforehand

2. Banks should fix prudential limits on various aspects of credit – benchmarking

Current Ratio, Debt Equity Ratio, Debt Service Coverage Ratio, Profitability Ratio
etc.
3. There should be maximum limit exposure for single/ group borrower.
4. There should be provision for flexibility to allow variations for very special
circumstances.
5. Alertness on the part of operating staff at all stages of credit dispensation – appraisal,
disbursement, review/ renewal, post sanction follow-up can also be useful for
avoiding credit risk.
The article discusses about the various credit risk in scheduled banks and methodologies
followed by banks to reduce risks, these by creating a better understanding of credit risks in
Banking Sector.

For credit risk management most of the banks (if not all) are found performing several
activities like industry study, periodic credit calls, periodic plant visits , developing MIS, risk
scoring and annual review of accounts. However the banks in India are abstaining from the
use of derivatives products as risk hedging tools. A survey was conducted which showed that
irrespective of sector and size of bank, credit risk management framework in India is on the
right track and it is fully based on the RBI’s guidelines issued in this regard.

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;
 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.