The banks face mainly Credit Risk
and Market Risk. Risk Management System of the bank evolves around managing
these risks effectively. Different types of market risk are managed and looked
after by Asset – Liability Management Committee (ALCO) whereas the credit
/counterparty risk and country risk are managed through Credit Policy Committee
Generally, the policies and
procedures for measuring and containing market risk are articulated in the ALM
policies and whereas credit risk is addressed in Loan Policies and Procedures.
The market and credit risks are therefore managed in a parallel two-track
approach in banks.
The other kind of risk that is
being associated with Financial world is Operational Risk. A risk that cannot
be categorized as Credit Risk or Market Risk is called Operational Risk. The
example of operational risk is system breakdown, Staff related risks etc.
Operational risks usually have a leading impact upon Credit or Market Risk. For
example, if the selection of staff is not appropriate it can lead to Credit
Generally, Credit risk the risk
that you owe when you lend money to somebody in the shape that money lent may
not come back on given terms or on given time. If you have given funds to
somebody on a specific term which may include rate of interest also, there are
chances (or better call it risk) that borrower may not give you funds back as
per agreed terms or he may not give it to you on time. This un-fulfilment of
commitment from the borrower may paralyze your further plans and there are
chances that effects of this delinquency will percolate and affect various
other parties. So, it is imperative to measure and contain the risk.
Credit risk or default risk
involves inability or unwillingness of a customer or counterparty to meet
commitments in relation to lending, trading, hedging, settlement and other
financial transactions. The credit risk of a bank’s portfolio depends on both
external and internal factors.
External factors are the state of
the economy, wide swings in commodity/equity prices, foreign exchange rates and
interest rates, trade restrictions, economic sanctions, Government policies,
etc. Internal factors are deficiencies in loan policies/administration, absence
of prudential credit concentration limits, inadequately defined lending limits
for Loan Officers/Credit Committees, deficiencies in appraisal of borrowers’
financial position, excessive dependence on collaterals and inadequate risk
pricing, absence of loan review mechanism and post sanction surveillance, etc.
variant of credit risk is counterparty risk. The counterparty risk arises from non-performance
of the trading partners. The non-performance may arise from counterparty’s
refusal/inability to perform due to adverse price movements or from external
constraints that were not anticipated by the principal. The counterparty risk
is generally viewed as a transient financial risk associated with trading
rather than standard credit risk.
Management of Credit Risk
The Credit Management process
should involve the following steps
a) Measurement of risk through
b) Quantifying the risk through
estimating expected loan losses and unexpected loan losses
c) Risk pricing on a scientific
d) Controlling the risk through
effective Loan Review Mechanism and portfolio management.
CREDIT RISK MANAGEMENT
Banks should constitute a
high-level Credit Policy Committee, also called Credit Risk Management
Committee or Credit Control Committee etc. The Committee should be headed by
the Chairman/CEO/ED, and should comprise heads of Credit Department, Treasury,
Credit Risk Management Department (CRMD) and the Chief Economist.
The committee should deal with
issues relating to credit policy and procedures. It should further analyze,
manage and control credit risk on a bank wide basis.
The Committee should, inter alia,
formulate clear policies and specify standards like
i) Standards for presentation of
ii) Financial covenants
iii) Rating standards and
iv) Delegation of credit
v) Prudential limits on large
credit exposures, vi) Asset concentrations, vii) Loan Review Mechanism, risk
concentrations, risk monitoring and evaluation, pricing of loans, provisioning,
regulatory/legal compliance, etc.
Bank should have Credit Risk
Management Department (CRMD), independent of the Credit Administration
Department. The CRMD should enforce and monitor compliance of the risk
parameters and prudential limits set by the CPC. The CRMD should also be made
accountable for protecting the quality of the entire loan portfolio. The
Department should undertake portfolio evaluations and conduct comprehensive
studies on the environment to test the resilience of the loan portfolio.
Instruments of Credit Risk
Credit Risk Management
encompasses a host of management techniques, which help the banks in mitigating
the adverse impacts of credit risk. Credit Approving Authority
Each bank should have a carefully
formulated scheme of delegation of powers. The banks should also have ‘Approval
Grid’ or a ‘Committee’, for sanctioning the loan proposals which should
comprise of at least 3 or 4 officers and invariably one officer from CRMD.
These committees are required to be formed at Large Branches, Regional Offices,
Zonal Offices, Head Offices, etc. The credit decision should be taken by
majority members of the ‘Approval Grid’ or ‘Committee’ and if they do not agree
on the creditworthiness of the borrower, the specific views of the dissenting
member/s should be recorded. The banks evaluate the quality of credit decisions
taken by various functional groups. The quality of credit decisions should be
evaluated within a reasonable time, say 3 — 6 months, through a well-defined
Loan Review Mechanism.
CONTROLLING AND MITIGATING
Setting up of Prudential Limits
In order to limit the magnitude
of credit risk, the banks should lay down the prudential limits:
a) The banks should stipulate
benchmark current/debt equity and profitability ratios, debt service coverage
ratio or other ratios, with flexibility for deviations.
b) The banks should specify the
single/group borrower limits, which may be lower than the limits prescribed by
c) The banks should specify
substantial exposure limit i.e. sum total of exposures assumed in respect of
those single borrowers enjoying credit facilities in excess of a threshold
limit, say 10% or 15% of capital funds. The substantial exposure limit may be
fixed at 600% or 800% of capital funds, depending upon the degree of
concentration risk the bank is exposed;
d) The banks should specify
maximum exposure limits to industry, sector, etc. There must also be systems in
place to evaluate the exposures at reasonable intervals and the limits should
be adjusted especially when a particular sector or industry faces slowdown or
other sector/industry specific problems. The exposure limits to sensitive
sectors, such as, advances against equity shares, real estate, etc., which are
subject to a high degree of asset price volatility and to specific industries,
which are subject to frequent business cycles, may necessarily be restricted.
Similarly, high-risk industries, as perceived by the bank, should also be
placed under lower portfolio limit. Any excess exposure should be fully backed
by adequate collaterals or strategic considerations; and
e) The banks should consider maturity
profile of the loan book, keeping in view the market risks inherent in the
balance sheet, risk evaluation capability, liquidity, etc.
Banks should have a comprehensive
risk rating system that measures risk for taking credit decisions. It should
possess following qualities/characteristics
i) The risk rating system should
in-compass the overall risk of lending, by taking cognizance of critical
ii) The pricing and other terms
of loan and advances should be fixed by considering rating of the credit
iii) The rating should further be
meaningful to Management for review and managing the loan portfolio.
iv) The risk rating, in short,
should reflect the underlying credit risk of the loan book. The risk rating
system should be drawn up in a structured manner, incorporating, inter alia,
financial analysis, projections and sensitivity, industrial and management
v) Banks should have separate
rating framework for large corporate / small borrowers, traders, etc. that
exhibit varying nature and degree of risk.
Apart from other form of risk as
mentioned above, banks face significant risk in form of Forex exposures. The
banks forex exposure to corporate who do not have natural hedge consists
significant risk factor. Therefore, the unhedged exposures of borrowers should
also be taken care of in the rating framework.
The overall score for risk is
placed on a numerical scale ranging between 1-6, 1-8, etc. on the basis of
credit quality and the bank should prescribe the minimum rating below which no
exposures would be undertaken.
Relaxation in stipulated norms
and authority thereof has to be clearly articulated in the Loan Policy. The
updating of the credit ratings is to be undertaken normally at quarterly
intervals or at least at half yearly intervals.
The main function of Risk
Management is to bring a balance between risk and return. Risk-return pricing
is a fundamental tenet of risk management. In a risk-return setting, borrowers
with weak financial position and hence placed in high credit risk category
should be priced high. The pricing of loans normally is linked to risk rating
or credit quality. if the pricing is well set to maintain balance between risk
and return, then the banks will be able to mitigate the credit risk