credit risk in banking

7/30/2019 credit risk in banking

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Credit Risk

By Prof. Divya Gupta


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Credit Risk

Credit Risk is defined as the possibility of losses associated with diminution in thecredit quality of borrowers or counter parties.

Traditionally, the credit risk is thought of as having two components-

1) Liquidity2) Solvency


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Credit risk management is not NPAManagement


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Need for credit risk in Indian Banks

Banks as intermediaries between Saversand investors accept deposits from publicand lend the same to entrepreneurs toearn profits.?

There is always a scope for the borrower to default from his commitment resulting incredit risk to a bank.


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Credit risk may take the followingforms:

In the case of direct lending- principal &interest amount may not be repaid

In the case of guarantees and letter of credit

In the case of treasury operations

In the case of cross border exposure


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Components of credit risk:

Quantity of risk Quality of risk

Credit risk also includes three other risks:a) Counter party risk

b) Portfolio riskc) Country risk


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5 Cs of good and bad lending:

5 Cs of good lending 5 Cs of bad lending

Character ComplacencyCapacity CarelessnessCapital Communication gap

Collateral Contingencies- uncaredConditions - economic Competition - unhealthy


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Major sources of credit problems:

Concentrations

Failure of due diligence in credit granting,review and monitoring process.

Others sources of credit problems


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Concentrations:

Credit concentrations are viewed as anyexposure where the potential losses arelarge relative to the banks capital its totalassets or where adequate measuresexceed, the banks overall risk level.

---- why concentrations develop?


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Concentration s:

Principles for management and control of risk concentrations

RBI guidelines on exposure norms Techniques to check credit concentrations


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Failure of due diligence in credit granting,review and monitoring process

Credit granting process

Credit review process


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Other sources of credit problems:

Absence of risk-sensitive pricing Lack of exercise of caution with leveraged

credit arrangements Lending against non-financial assets Business cycle effects/absence of a

thoughtful consideration of downsidescenario.


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Credit Risk ManagementTechniques:

Credit Appraisal and approval process Credit concentration and sectoral gap

Credit scoring model and risk rating of loan Pricing of loans

Loan review mechanism


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Credit Risk Measurement Models

Default risk Model Credit Scoring Model

Altmans Z Score Model RAROC Model


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Altmans Z Score Model

Borrowers are categorized into two categories-high or low default risk, on the basis of pastexperience.

The Z variable is an indicator of default riskclassification of a commercial borrower.

The variable depends upon the values of variousfinancial ratios of the borrower.

The weightage importance given to these ratiosare fixed based on the intense research.


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Altmans Z Score Model

Z =1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5where:

X1 = working capital/total asset ratio

X2 = retained earning/total asset ratioX3 = EBIT/total asset ratioX4 = MVE/book value of long term debt ratioX5 = sales/total asset ratio

Analysis:Higher the value of Z , the lower is the default riskThe value of Z less than 1.81 is considered as high default risk


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Case:The financial position of the ABC Ltd is as under:

Particulars Amount (in lakhs)Working capital 400Retained earnings 50Total Assets 1000Earning before Interest and Tax 100Sales 1500MVE to Long term debts 0.15

Calculate the Z score of this company using Altmans Z score model

and take a decision regarding the credit risk of ABC Ltd.


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Limitations of Z score Model

The model is based on two extremeevents: default and no default

The model is limited to financial ratios . The same model is to be applied for short

term and long term loans.


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RAROC Model

Risk adjusted return on capital (RAROC)model includes default risk in pricing of loan.

RAROC = one year income on loancapital at risk or loan risk

There are two methods for calculation of loan at risk.


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First Method:Rupee capital risk exposure = Duration of loan x loanamount x expected change in credit premium

L = D L X L X (R/1 + R)

The main feature of this method of to find out the maximumchange in the credit risk premium on loan by next year.(based on rating)


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Case:

Suppose a bank wants to calculateRAROC for a loan of Rs.100 crore earningnet income including a fee of Rs.1.5crore,with duration of 3.2 years. The currentmarket rate of interest for such loans is12% and change in risk premium is 3.5%.


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Continue Second Method:EL = PD * LGD * EAD

EL= expected lossPD= probability of defaultLGD= loss given defaultEAD= exposure at default

On the basis of database the estimation isdone.


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Case

Sound Bank has given a loan of Rs.100crore to a borrower. The chances of theborrower defaulting in a one year horizonis 2%. When the default occurs, the loss islikely to be 50%. Calculate the ExpectedLoss on this transaction.


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Unexpected loss:UL = PD * LGD * CAR

Where CAR = Credit at risk (maximum riskin worst situation)


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Thank You!!!

credit risk in banking

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