Overview of Credit Risk Management practices in banksMarketing Report 1st Half 2009

Overview of Credit Risk Management practices –The banking perspective

SofiaDecember 2, 2010

Overview of Credit Risk Management practices in banks

Credit Risk is the current or prospective risk to earnings and capital, arising from an obligor’s failure to meet its obligations in accordance with the agreed terms

Goal of CRM: maximization of the bank’s risk adjusted rate of return by maintaining credit risk exposure within acceptable parameters

CRM refers to the credit risk in individual credits or transactions as well as the risk inherent in the entire portfolio

Consideration of the relationship between credit risk and other risks

The CRM approach used by individual banks should correspond to the scope and sophistication of the bank’s activities

Overview of Credit Risk Management practices in banks

Basic concepts of the credit risk management

Overview of Credit Risk Management practices in banks

Main principals for credit risk management

Lines of defence in the credit risk management process

• First line is considered Business origination units (business units). They are obliged to follow strictly the principles and rules defined in the Lending Rules and Credit Policy of the bank and to assess the credit risk in a manner of keeping the interests of the Bank.

• Second line is considered Credit Risk units (decision takers with credit approval competences). They are responsible for the precise and in depth assessment and approval of credit risks to different customer types of borrowers and the adherence to the approved Credit Policy of the bank.

• Third line is considered the Risk management unit. It is responsible for identification of treats against the overall credit portfolio, i.e. monitoring of existing credit risks within the portfolio and identification of potential credit risks that could evolve.

Overview of Credit Risk Management practices in banks

Credit risk process & credit risk management

Set objectives and

responsibilities

Set credit risk guidelines

Collect credit dataMeasure and

assess credit risk

Make credit decisions

Monitor credit performance

Allocate provisions;

capital charges

Overview of Credit Risk Management practices in banks

Broad principles of credit risk management in Banks

Best practices in credit risk management in the following areas

Establishing an appropriate credit risk environment

Operating under a sound credit granting process

Maintaining an appropriate credit administration, measurement and monitoring process

Ensuring adequate controls over credit risk

Role of bank supervisors in ensuring that banks have an effective system in place to identify, measure, monitor and control credit risk

Overview of Credit Risk Management practices in banks

Important factors for credit approval

Purpose of the credit and source of repayment;

Current risk profile (incl. the nature and aggregate amounts of risks) of the borrower or counterparty and its sensitivity to economic and market developments;

Borrower’s repayment history and current capacity to repay, based on the historical trends in its financials and future cash flow projections, under various scenarios; customer’s capacity to increase its level of indebtedness;

The proposed terms and conditions of the credit, including covenants designed to limit changes in the future risk profile of the borrower;

Proposed collateral types, LTV, adequacy and enforceability of collaterals or guarantees, under various scenarios;

Integrity and reputation of the borrower or counterparty.

Overview of Credit Risk Management practices in banks

Specific factors for credit approval for business customers

Internal factors

Financial risk

Assessment of the existing financial position

Assessment of the expected financial position

Accounting quality

Business risk

Market position

Operating Efficiency

Management risk

Management business expertise

Payment record

External factors

Conditions in the respective economic sector of activity

Economic trends in the industry of activity

Overview of Credit Risk Management practices in banks

Credit risk assessment tools

Expert judgment

Based on assessment of factors like: the features of the credit facility, the capital position (incl. capital structure) of the applicant, its repayment capacity, the collateralization, the economic conditions and the business cycle on the respective market

Credit rating systems

Capture all relevant information about the borrower and assign a grade through a risk rating process, by the consideration of financial and non-financial factors

Limits system

Prudential regulations for single borrowers/related parties, risk class/rating linked exposures, industry level caps, delegation of powers

Overview of Credit Risk Management practices in banks

Roles of Credit ratings

Rating represents the default probability

Role in approval process

depends on the risk appetite (minimum rating criterion)

capital allocation (pricing)

Role in monitoring, analysis and reporting

indicates the quality of the exposure at a given moment of time

should be linked to the periodicity of the asset review process

early warning system

capture asset quality migrations

product pricing (Risk Return trade-offs)

provisioning and capital requirements

Administration

Loan review/monitoring

Trigger Actions (i.e. planning credit enhancement, reduction in exposures, exit strategy)

Overview of Credit Risk Management practices in banks

Quantitative approach for credit risk measurement

Expected loss

=Probability of

default

(%)

XLoss given

default

X Exposure at default

Borrower risk Facility risk related

Overview of Credit Risk Management practices in banks

Portfolio Management

• scenario analysis

• risk based exposure limits

Usage of Credit Ratings

Rating based pricing

• default rate, recovery rate

• expected loss charge, capital charge

Rating system

Overview of Credit Risk Management practices in banks

Approaches to Credit Risk Management

Credit risks are managed at the level of the Obligor Group

Concentration Risk, as part of credit risk, includes:

large (connected) individual exposures and

significant exposures to groups of counterparties whose likelihood of

default is driven by common underlying factors, e.g. economic sector

(industry), geographical location, currency, credit risk mitigation techniques

(including, for example, risks associated with large indirect credit exposures

to a single collateral issuer)