Factors Affecting Credit Risk
- External Factors
These factors affect the business of a customer and reduce his capability to honour the terms of financial transaction with the bank. The main external factors affecting the overall quality of the credit portfolio of a bank are, exchange rate and interest rate fluctuations, Government policies, protectionist policies of other countries, political risks, etc. These factors look similar to market risk. But, whereas the market risks directly affect a bank, the factors mentioned here affect the business of the customers thus impairing the quality of the credit portfolio
- Internal Factors
These factors mainly relate to overexposure (concentration) of credit to a particular segment/geographical region, excessive lending to cyclical industries, ignoring purpose of loan, faulty loan and repayment structuring, deficiencies in the loan policy of the bank, low quality of credit appraisal and monitoring, and lack of an efficient recovery machinery
Steps taken to mitigate credit risks
The major objective of credit risk management is to limit the risk within acceptable level and maximize the risk adjusted rate of return on the credit portfolio. Following are the main steps taken by any bank in this direction:
At macro Level
- The risks to the overall credit portfolio of the bank are mitigated through frequent reviews of norms and fixinginternal limits for aggregate commitments to specific sectors of theindustry/business so that the exposures are evenly spread over various sectors and the likely loss is retained within tolerable limits.
- Bank also periodically reviews the loan policies relating to exposure norms to single and groupborrowers as also the structure of discretionary powers vested with various functionaries.
- Many banks classify their credit portfolio based on some parameters of quality and periodicallyreview this to avoid any rude shocks relating to credit losses.
- Normally, banks also formulate policies relating to rehabilitation, compromise,recovery and write off to get the best out of a worst case scenario.
At Micro level:
- This pertains to policies of the bank regarding appraisal standards, sanctioning and delivering process,monitoring and review of individual proposals/categories of proposals, obtention of collateral security etc.
- Credit ratings and credit scoring play important role in this area.
- For dispersion/ transfer of risk in large value accounts, bank can resort to consortium/ multiplebanking and use of derivatives like credit default swaps.
Credit Ratings
The level of credit risk involved in each loan proposal depends on the unique features of that proposal. Two similar projects, with different promoters, may be appraised by a bank as having different credit risks. Similarly, Two different projects, with same promoters, may also be appraised by the bank as having different credit risks. While appraising a credit proposal, the risk involved is also measured and often quantified by way of a rating.
Objective of Credit Rating
(a) To decide about accepting, rejecting or accepting with modifications/ special covenants
(b) To determine the pricing, i.e. the rate of interest to be charged
(c) To help in the macro evaluation of the total credit portfolio by classifying it on the ratings allotted to individual accounts. This is used for assessing the provisioning requirements, as also a decision making tool, by the management of the bank, for reviewing the loan policy of the bank.
Internal and External Ratings
Most of the bank’s in India have set up their own credit rating models. Some of the outside credit rating agencies are: CARE, ICRA, CRISIL and SMERA.
Methodology of Credit Rating
Based its on loan policies and risk perception, each bank has its own rating model. Common feature in all the risk models is that a score is given for different perceived risks by allotting different weightages. The sum of all these scores forms the basis for deciding on risk rating of a proposal. Normally, the broad categories of risk areas which are scored, are:
(a) Promoters/Management aspects and the securities available
(b) Financial aspects based on analysis of financial statements
(c) Business/project risks
In view of the dynamic market scenario, there is need to review the ratings of a borrower at regular intervals upgrade or downgrade or maintain it.
Use of Credit Derivatives for-Risk Management
- Credit derivatives are used to hedge the risks inherent in any credit asset without transferring theasset itself.
- The hedging is comparable to insurance and comes at a cost. Therefore, if the anticipated risk does notmaterialize, the return from the asset will be less than what it would have been without the hedging.
- While simple techniques for transferring credit-risk, such as financial guarantees, collateral and creditinsurance have been prevalent in the Indian banking industry for long, the recent innovative instruments incredit risk transfer (CRT) such as collateralized debt obligations (CDO), etc. are yet to gain significant currency.
- Credit Default Swaps (CDSs) finds use as the new hedging instrument.
Credit Default Swaps (CDSs):
- This is a bilateral contract in which the risk seller (lending bank) pays a premium to the buyer forprotection against credit default or any other specified credit event.
- Normally, CDS is a standardized instrument of ISDA (International Swaps and Derivatives Association).
- The credit events defined by ISDA are, bankruptcy, failure to pay, restructuring, obligationacceleration, obligation repudiation/ moratorium etc_
- As per RBI guidelines, only plain vanilla CDSs are allowed.
Credit Linked Notes (CLN):
In this, the risk seller gets risk protection by paying regular premium to the risk buyer, which is normally a SPV which issued notes linked to the underlying credit. These notes are purchased by the general investors and the money received from them is used by the SPV to buy high quality securities. The general investors get fixed or variable return on the note during its life. In maturity of the underlying credit, the securities purchased by SPV are sold and money returned to the investors. But, in case of default.in the underlying credit, these securities are used to pay to the risk seller.