Chapter 5 – Credit Risk

Risk identification

Credit Risk is the risk due to possible default by the borrower. It has two components i.e. (1) default risk (2) credit spread risk.

1. Default risk

It is driven by the potential failure of a borrower to make promised payments either partly or wholly. If a part payment is made, the obligation is reduced and this is called recovery rate.

2. Credit spread or downgrade risk:

If a borrower has not defaulted, there is still the possibility of risk due to deterioration in credit quality, which is called downgrade risk, as due to deterioration in credit quality, the credit rating may change.

Portfolio Risk : The risk associated with credit portfolio of the bank as a whole (total loans of the bank), is termed portfolio risk, which has two components i.e.Intrinsic Risk and Concentration Risk.

Intrinsic risk or systemic Risk — This is the risk which prevails in the industry in which the credit exposure has been taken by the bank, which means that risk to economy (industry/activity) is risk to bank also. This means if economy does not perform well as a whole, the performance of the credit portfolio of the bank will also be affected adversely.

Concentration risk : Where a bank does not diversify its portfolio i.e. it keeps on taking exposure in limited no. of companies or business segments or in geographical regions. In such circumstances there is concentration risk.

Risk Measurement

Risk measurement can be by way of

A credit rating

B Quantification through estimating expected loan losses.

Credit Risk Rating

A Credit-risk Rating Framework (CRF) is necessary to avoid the limitations associated with a simplistic and broad classification of loans/exposures into a “good” or a “bad” category. The CRF deploys a number/ alphabet/ symbol as a primary summary indicator of risks associated with a credit exposure. Such a rating framework is the basic module for developing a credit risk management system and all advanced models/approaches are based on this structure. In spite of the advancement in risk management techniques, CRF is continued to be used to a great extent. These frameworks have been primarily driven by a need to standardise and uniformly communicate the “judgement” in credit selection procedures and are not a substitute to the vast lending experience accumulated by the banks’ professional staff.

End Use of Risk-Ratings made on the CRF: Broadly, CRF can be used for the following purposes:

1. Individual credit selection, wherein either a borrower or a particular exposure/ facility is rated on the CRF.
2. Pricing (credit spread) and specific features of the loan facility. This would largely constitute transaction-level analysis.
3. Portfolio-level analysis.
4. Surveillance, monitoring and internal MIS
5. Assessing the aggregate risk profile of bank/ lender. These would be relevant for portfolio-level analysis. For instance, the spread of credit exposures across various CRF categories, the mean and the standard deviation of losses occurring in each CRF category and the overall migration of exposures would highlight the aggregated credit-risk for the entire portfolio of the bank.

Credit risk control & Monitoring (CRM)

The credit risk control and monitoring is directed both at the transaction level and portfolio level. The following points are important to be noted in this area:

• A comprehensive management information system and credit information system is important for an effective CRM.
• Existing MIS is required to be reviewed and updated regularly
• An elaborate and well communicated policy at transaction level is essential which must lay guidelines relating to procedures, risk taking
• A detailed MIS and CIS structure should be set up and enforced for future data requirements.

Credit risk policies and guidelines at Transaction Level

At transaction level the instruments of credit risk management include

• Credit appraisal process
• Risk analysis process
• Credit audit and loan review
• Monitoring process.

To ensure an effective credit risk management, the loan policy document approved by the Board of Directors of the bank should take care of following:

1. Delegation of powers (Credit approving authority)
2. Credit appraisal guidelines
3. Rating standards and benchmarks
4. Pricing strategy
5. Loan review mechanism

1. Delegation of powers: Banks should have policies in place for delegation of powers. The delegation can be multi-tier approving system where the proposals-are considered by Committee or Approval Grid, that may consist of 3-4 officers, one of which should be from CRMD. Only those proposals should be approved where majority of members agree.
2. Credit appraisal guidelines: These guidelines should take into account the borrower standards, procedures for analyzing credit requirements and risk factors. This brings uniformity of approach. These guidelines may relate to pricing policy, risk mitigation, risk monitoring and review at the transaction level.

Prudent limits : Credit risk can be limited by fixing prudent ceilings on various types of exposure. The prudent limits may be fixed on:

• Single party and group credit exposure
• Industry exposure
• Asset concentration
• Large exposure
• Maturity profile exposure
• Limits for financial and profitability ratios etc.

3. Rating Standards and benchmarks: Credit rating should be de-linked from the regular renewal exercise. The periodicity of risk assessment exercise may be determined on quarterly, half-yearly or yearly intervals as per risk policy of the bank.
4. Pricing of risk : Risk return pricing is a fundamental tenet of risk management. In a risk-return setting, the borrowers with weak financial position and hence placed in high credit risk category should be priced high. Thus banks should evolve scientific system to price the credit risk, which should have a bearing on the expected probability of default. The pricing of loans normally should be linked to risk rating or credit quality. The probability of default could be derived from the past behaviour of the loan portfolio, which is the function of loan loss provision / charge offs for the last, say five years or so. Banks should build historical database on the portfolio quality and provisioning / charge off to equip themselves to price the risk. But value of collateral, market forces, perceived value of accounts, future business potential, portfolio/industry exposure and strategic reasons may also play important role in pricing. Flexibility should also be made for revising the price (risk premia) due to changes in rating/value of collateral over a time period.

Credit risk control and monitoring at Portfolio Level

At portfolio level, the control and monitoring action take into account:

•  Risk of the given portfolio
•  Expected losses
•  Requirement of risk capital
•  Impact of changing the portfolio mix on risk
•  Expected losses and capital
•  Marginal and absolute risk contribution of a new position
•  Diversification benefits from change of mix

The activities to be undertaken for risk control and monitoring include:

•  Identification of weakness in the portfolio through risk migration method
•  Evaluation of exposure distribution over rating categories
•  Evaluation of rating wise distribution in various industries and set exposure limits
•  Move towards credit portfolio value at risk models
•  Fixation of quantitative ceiling on aggregate exposure in specified rating categories
•  Undertake rapid portfolio reviews, stress tests and scenario analysis

Portfolio Management

Important Management of portfolio has gained importance due to

• Less demand from companies for credit products due to disintermediation
• Different avenues available to companies leading to more supply
• Lowe returns and increased important of risk
• New opportunities for banks to invest such as pass through certificates, syndicated lending, project and structured finance
• Availability of new tools to manage credit portfolio such as securitization, secondary loan trading, credit derivatives.

Role of Loan Review Mechanism

Loan review mechanism can be used for constantly evaluating the quality of loans with a view to bring about qualitative improvements in credit administration.

An effective loan review mechanism should be capable

(a) to identify promptly, the loans which develop credit weaknesses and initiate timely corrective action,

(b) to evaluate portfolio quality and isolate potential problem areas,

(c) to provide information for determining adequacy of loan loss provisions,

(d) to assess the adequacy of and adherence to, loan policies and procedures, and

(e) to monitor compliance with relevant laws and regulations and

(f) to provide top management with information on credit administration, including credit sanction process, risk evaluation and post-sanction follow-up.

CREDIT DERIVATIVES

Banks undertake credit risk mitigation measures such as obtaining collaterals guarantees or covering themselves with credit derivatives. RBI had constituted a Working Group on Credit Derivatives and on its recommendations, issued the following guidelines:

Credit Derivatives : Credit derivatives are over-the counter financial contracts (“off-balance sheet” financial instruments), that permit the transferor to transfer credit risk (arising due to creation and owning of a financial asset) to another party without actually selling the asset. It can also be in the form of an on-balance sheet product In other words, it is a financial contract, which involves payments by one party to another on the basis of ‘performance” of a specified underlying credit asset.

Parties : There are two parties namely;

Protection Seller (or Credit Risk Buyer or Guarantor }: That receives premiums or interest — related payment, in return for assumption of the credit risk;

Protection Buyer (Credit Risk Seller or Beneficiary) : The bank that transfers the credit risk.

The protection seller makes the payment to protection buyer when the Credit Event happens, which usually includes bankruptcy, insolvency, merger, cross acceleration, cross default, failure to pay, repudiation, and restructuring, delinquency, price decline or rating downgrade of the underlying asset / issuer.

Types of Credit Derivatives: To start with, RBI has proposed to allow only the following 2 kinds of derivatives i.e.

• Credit Default Swap ( CDS),
• Credit Linked Note (CLN ).

Credit Default Swap (CDS) : The protection buyer pays a fee through the life of the contract, in return for a credit event payment by the protection seller following a credit event. In case the credit event does not occur: Protection Seller continues to receive the periodic payment and in case of occurring of a credit event, the Protection Buyer will receive a credit event payment.

If a Credit Event occurs and physical settlement applies : The transaction shall accelerate and Protection Buyer shall deliver the Deliverable Obligations to Protection Seller against payment of a pre-agreed amount If a Credit Event occurs and cash settlement applies, the transaction shall accelerate and Protection Seller shall pay to Protection Buyer the excess of the par value of the Deliverable Obligations on start date over the prevailing market value of Deliverable Obligations upon occurrence of Credit Event.

Credit Linked Note (CLN) It is a combination of a regular note and a credit option and an on-balance sheet equivalent of a credit default swap. Under this structure, the coupon or price of the note is linked to the performance of a reference asset. It offers lenders a hedge against credit risk; to investors, a higher yield for buying a credit exposure. CLNs arc generally created through a Special Purpose Vehicle (SPV), or trust, which is collateralized with highly rated securities. Investors buy the securities from the trust (or issuing bank) that pays a fixed or floating coupon during the life of the note. At maturity, the investors receive par value unless the referenced creditor defaultsor declares bankruptcy, in which case they receive an amount equal to the recovery rate. Here the investor is, in fact, selling credit protection in exchange for higher yield on the note.

Types of Credit Derivatives that are permitted Banks have been initially permitted to use credit derivatives only for the purpose of managing their credit risk, which includes:

• Buying protection on loans / investments to reduce credit risk
• Selling protection for the purpose of diversifying their credit risk and reducing credit concentrations and taking exposure in high quality assets,
• Market making activities by banks in credit derivatives are not envisaged for the present.

Risk Mitigation

The basic objective of risk identification or quantification is to take steps which help mitigation of the risk to the extent possible and desirable. The objective of risk mitigation is to transfer the risk to counter parties_

The risk mitigation process involves making use of various tools such as :

• Selection of Credit Risk Environment
• Diversified credit portfolio
• Risk sensitive credit granting process
• Audit trail in credit sanction process
• Appropriate exposure ceilings
• Borrower specific exposure ceiling
• Industry specific exposure ceiling
• Surveillance responsibilities

At transaction level, the banks mitigate the risk by obtaining collateral securities, cash margins, guarantees from 3rd parties. Recently the banks have started looking for instruments such as credit derivatives.

At portfolio level, the banks use asset securitization, credit derivatives etc. To mitigate credit risk.

SECURITISATION

Securitisation of assets is an additional channel for recycling of funds by business entities including banks.

Securitisation is a process through which the bank loan receivables (say instalment of a term loan due in future, sanctioned by the bank), are converted into debt instruments (such as pass through certificate, with a fixed rate of return) and then sold through SPV.

Special Purpose Vehicle(SPV) — A company normally promoted by a large institution that will purchase the loans for securitization. (usually, in the form of a trust). The loans and securities are held by the SPV (on behalf of investors of pass through certificate), to ensure that the investors’ interest is secure even if the originator goes bankrupt.

Pass through certificate (PTC) The debt instruments issued for securitization purposes (like bonds or debentures), are called pass-through certificate.

Originator : The bank which offers assets (i.e. loans) for securitisation to meet need of cash. The risk is transferred by the originator to the investor through PTC. A bank may invest in PTCs representing the loans of other banks