Risks and risk management

Credit risk – what constitutes credit risk?

• Default Risk
• Borrower may not pay on time
• May not pay interest
• May not pay full amount
• May not pay at all
• Components of Credit Risk
• Default Risk – Risk that a borrower or counterparty is unable to meet its commitment
• Portfolio Risk – Risk which arises from the composition/ concentration of bank’s
exposure to various sectors
• Two factors affect credit risk – Internal factors (bank specific), External
factors (state of the economy, size of fiscal deficit etc.)
Credit risk – Risk of default
Implications
• Affects both investment and credit portfolio
• Gives rise to NPA and requires provisioning
• Resulting in reduced profits and capital erosion
Managing credit risk
• Can defaults be prevented? Can we lend to only those who will definitely pay?
Can we predict defaults? Can we identify willful defaulters?
• Before investing: Proper appraisal, due diligence and pricing
• After investing: Monitoring and eye out for early warning signals, action on
warning signals to prevent NPA
What to do if loans go bad?
• Recognition of NPAs: Provisioning
• Reconstruction, rescheduling, turnaround
• Recovery
• Costly litigation
• Security …do they have any value?
• Resolution
• Is it better to get something at least?
• Sale of NPAs
• To ARCs, to other banks (on a “without recourse”, cash-basis only)
• At what haircut?
• Write-off
• Metrics tracked: GNPA ratio, NNPA ratio
Income Recognition and Asset Classification
(IRAC) norms required by RBI
• Accounting norms – recognizing interest income, provisioning
Income recognition: Interest to be recognized only on receipt, not accrual basis, except where
advances are against term deposits, NSCs, etc.
Interest recognized but overdue in the past has to be reversed once an account becomes a NPA
• Asset classification – standard assets, NPAs, doubtful assets, loss assets, restructured
assets
• Standard assets – regular assets and stressed assets (Special Mention Assets SMA-
0,1,2); For CC accounts only SMA-1 and 2 apply. Why?
• Ind-AS and Basel III require banks to move from provisioning based on incurred losses
to prov. based on expected losses
Dynamic Loan Loss Provisioning Framework: Provisioning based on long-term average annual
expected loss based on probability of default (PD) x Loss given default (LGD) estimates
• Metric tracked: Provision Coverage Ratio (Expected to be at least 70%)
Minimum provisioning requirements as per
RBI
Definition Provision
I. Standard SMA-0 (overdue < 30 days); SMA-1 (OD for 31-60 0.25% - 1%; 2% on teasers
assets days); SMA-2 (OD for 61-90 days)
II. NPA Interest/ principal overdue > 90 days; outstanding balance in CC a/c > drawing power
continuously for 90 days
a. Sub-std An asset that has remained an NPA for less than or 15%; additional 10% for unsecured
equal to 12 months portion
b. Doubtful Asset that has remained in sub-standard category for 0-1 year-25%; 1-3Y-40%; >3Y-100% ;
12 months 100% for unsecured portion
c. Loss Asset identified by the bank/ auditors/ RBI on Write off
assets inspection as uncollectible

Provisions created for standard assets are kept outside of the balance sheet and do not reduce the book value
of gross loaned assets
In case an asset is put up for restructuring, it has to be immediately downgraded to an NPA (sub-std) in case it
has been so far classified as a standard asset
Liquidity risk
Arises due to
• defaults and non-payment of loans
• Prepayment of loans
• Need to sell investments at short notice when markets are illiquid or
freezing
Can be resolved by
• Securitization of loans (not so popular in India)
• Loan sales (good loans as well as distressed loans)
• Focus on short-term, safe, liquid investments – trading off returns
• Other liquidity management tools discussed separately
Interest rate risk (price risk & reinvestment risk)
• Defined as the vulnerability of a bank’s P/L and balance sheet to changes in market
interest rates
• Affects a bank’s core revenue stream and performance metric – NII and NIM respectively
• Interest rate movements affect the market value of IBA or Rate sensitive assets (RSA -
loans* and investments) and IBL (RSL - deposits and borrowings) –> price risk
• Interest rate movements affect the yield at which funds can be reinvested –
reinvestment risk
• Greater the mismatch in maturities of assets and liabilities, greater is the interest rate
risk
• Price risk and reinvestment risk counteract each other – This principle is used to
minimize overall interest rate risk impact
*In countries with an active securitization market, loans actually get re-priced while in
countries like India their PV changes though not the book value
Managing interest rate risk calls for comprehensive Asset-Liability Management (ALM)

• Gap Analysis to identify maturity mismatches in all RSA and RSL

components
• How do various items respond to an interest rate movement? How
should the bank management respond to an interest rate movement?
For e.g. if interest rates increase,
• Should the bank raise interest rates on loans and advances?
• Should the bank raise interest rates on deposits?
• Should the bank sell/ buy FI securities? Of what tenure, duration, type?
• When does the bank benefit?
• What happens to existing deposits?
• What happens to term loans? Fixed and floating rates of interest loans?
ALM instruments
• Managed by “playing the Yield curve”
• The shape and slope of the yield curve indicate the probable direction and expected rate of change in
yields in the future. All else constant, a rising YC signals falling security prices and hence, wisdom in
investing in shorter maturity investments
• Carry trade (can lead to liquidity and interest rate risk); riding-the-YC
• RBI conducted ‘Operation Twist’
• Duration/ Immunization techniques
• Duration is defined as the PV weighted measure of maturity of a security or a portfolio. While tenure
takes into account only the time factor to maturity, duration takes into account the cash flow pattern
over the remaining life of the security
• Duration is a strong measure of a security/portfolio’s sensitivity to interest rate changes; higher the
duration, higher is the price change to a change in rates
• Portfolio Immunization involves setting the weighted average duration of assets = wtd avg duration of
liabilities OR Duration of liabilities = Planned investment tenure OR duration of assets = Planned
payment tenure so that price risk and reinvestment rate risk cancel each other
• Derivatives like interest rate swaps
• Leave exposure unhedged!