In course of banks lending involves a number of risks. In addition to the risks related to creditworthiness of the counterparty, the banks are also exposed to interest rate, forex and country risks.
Unlike market risks, where the measurement, monitoring, control etc. are to a great extent centralized. Credit risks management is a decentralized function or activity. This is to say that credit risk taking activity is spread across the length and breadth of the network of branches, as lending is a decentralized function. Proper a sufficient care has to be taken for appropriate management of credit 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 objective of credit risk management is to minimize the risk and maximize banks risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters.
The Credit Risk is generally made up of transaction risk or default risk and portfolio risk. The portfolio risk in turn comprises intrinsic and concentration risk. The credit risk of a banks portfolio depends on both external and internal factors. The external factors are the state of the economy, rates and interest rates, trade restrictions, economic sanctions, wide swings in commodity/equity prices, foreign exchange rates and interest rates, trade restrictions, economic sanctions, Government policies, etc. The 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.
Another 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.
The management of credit risk should receive the top management’s attention and the process should encompass:
Measurement of risk through credit rating/scoring:
(a) Quantifying the risk through estimating expected loan losses i.e. the amount of loan losses that bank would experience over a chosen time horizon (through tracking portfolio behavior over 5 or more years) and unexpected loss (through standard deviation of losses or the difference between expected loan losses and some selected target credit loss quantile);
(b) Risk pricing on a scientific basis; and
(c) Controlling the risk through effective Loan Review Mechanism and portfolio management.
The credit risk management process should be articulated in the bank’s Loan Policy, duly approved by the Board. Each bank should constitute a high level Credit Policy Committee, also called Credit Risk Management Committee or Credit Control Committee etc. to deal with issues relating to credit policy and procedures and to analyze, manage and control credit risk on a bank wide basis.
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, inter alia, formulate clear policies on standards for presentation of credit proposals, financial covenants, rating standards and benchmarks, delegation of credit approving powers, prudential limits on large credit exposures, asset concentrations, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc.
Concurrently, each bank should also set up 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 lay down risk assessment systems, monitor quality of loan portfolio, identify problems and correct deficiencies, develop MIS and undertake loan review/audit.
Large banks may consider separate set up for loan review/audit. 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.
Credit Risk may be defined as the risk of default on the part of the borrower. The lender always faces the risk of the counter party not repaying the loan or not making the due payment in time. This uncertainty of repayment by the borrower is also known as default risk.
Some of the commonly used methods to measure credit risk are:
- Ratio of non performing advances to total advances;
- Ratio of loan losses to bad debt reserves;
- Ratio of loan losses to capital and reserves;
- Ratio of loan loss provisions to impaired credit;
- Ratio of bad debt provision to total income; etc.
Managing credit risk has been a problem for the banks for centuries. As had been observed by John Medlin, 1985 issue of US banker.
“Balancing the risk equation is one of the most difficult aspects of banking. If you lend too liberally, you get into trouble. If you don’t lend liberally you get criticized”.
Over the tears, bankers have developed various methods for containing credit risk. The credit policy of the banks generally prescribes the criteria on which the bank extends credit and, inter alia, provides for standards.