Credit Management: ABM Module C | Advanced Bank Management
In this article, we’ll understand the various risks faced by banks, credit risk and factors affecting it, steps to mitigate credit risk and other important topics related to Risk management and Credit rating.
What’s A Credit Risk?
It can be defined as the possibility of loss or risk that a lender may not get the owed principal and interest that eventually leads to interruption of cash flows and increased cost of collection.
Five measures can indicate a credit risk which is as follows:
- Credit history
- Capacity to repay the
- The loan’s conditions
- Associated collateral
Operational risk: Operational risk may originate from frauds/disruption of business due to natural calamities.
Market risk: Adverse market movement such as interest rates, exchange rates etc. may lead to market risks.
Credit risk: Unwillingness/inability to repay leads to credit risk. These can be both funds based or non-fund based
Factors That Can Influence Credit Risks
External factors: Exchange/rate changes, govt policies, and political risks affect the business of a customer and impact negatively the capability to honour the terms of financial transactions with the bank.
Internal factors: Concentration of credit management to a particular segment or geographical region, ignoring the purpose of the loan, repayment structure, deficient loan policy, low-quality monitoring and credit appraisal are some internal factors that increase the possibility of credit risk.
|External Environment (Portfolio risk)
|Internal Environment (Transaction risk)
Credit Risks Mitigation Measures
The following measures can help limit the risk within the threshold level and maximise the risk-adjusted rate of return on the credit management portfolio.
Even expansion/spread of exposure and loss (within tolerable limits) over various sectors to fulfil the aggregate commitment to specific sectors can be achieved through frequent reviews of norms and fixing internal limits.
To overcome the possible worst-case scenarios banks, formulate policies to stress resolution, the policy is made such that it could efficiently work on rectification, restructuring, compromise, recovery and writing off etc.
Also, banks classify their credit portfolio based on quality and period to avoid any shocks related to credit losses.
The aforementioned can be performed at the macro level.
At the micro level, credit ratings and credit scoring play an important role in this area since policies about:
- Appraisal standards
- Sanctioning and delivering process
- Individual proposals/categories of proposals: Reviews and Monitoring
- Obtention of collateral security
- Personal guarantees
- Escrow mechanism
- Corporate guarantees of holding companies are formulated here.
Banks can use derivatives like credit default swaps or resort to consortium/multiple banking for the dispersion/transfer of the risk in large-value accounts.
Let’s study these mitigation measures in detail:
Unique features associated with each loan determine the level of credit risk.
With the following objectives risk involved is measured while appraising a credit proposal:
- Deciding on the accept/reject/accept with special covenants (modifications)
- Decide on the pricing (rate of interest to be charged)
- Macro evaluation of total credit portfolio based on the rating allotted (to individual accounts) classification to assess the provisioning requirements and review the loan policy of the bank.
External And Internal Rating
Banks are equipped with historical data and pragmatic expertise to move to the advanced internal rating-based approach.
RBI has mandated different risk weights to assets based on the external rating given by accredited rating agencies:
Methodology Of Credit Rating
Although each bank has its rating model which is based on loan policies and risk perceptions. Here are some common features in all risk models:
- A score is given for different perceived risks allotting different weights.
- A sum of all these scores forms the basis for deciding on the risk rating of the proposal.
- General areas of scores are:
- Promoters/Management aspects
- Securities available
- Based on the analysis of financial statements financial aspects
- Business/industry/project risks
Assigning the probability of default should be based on the borrower rating and assessing loss given default should be based on the facility rating.
ECR, BR and FR are meant to be reviewed periodically in a view of dynamic economic, political and market scenarios.
Use Of Credit Derivatives For Risk Management
Any risk inherent in any credit asset can be hedged using the credit derivates without even transferring the asset itself.
This process can be compared to insurance in terms of its utility and it comes at a cost.
For transferring credit, simple techniques like financial securities, collateral security and credit insurance have been prevalent in the Indian banking industry due to which the recent innovative instruments, such as CDO (credit default swaps) are yet to gain significant currency.
Let’s study in brief two credit management risk hedging derivatives below:
CDS (Credit default swaps)
It’s a bilateral contract in which the risk seller pays a premium to the buyer for protection against credit default or any other specified credit event.
The one seeking protection (holder of credit exposure) is the protection buyer and the one who underwrites the default is the protection seller.
It’s like insurance against the default of an underlying borrower or debt instrument, it transfers the credit exposure of fixed-income products.
It cannot be offered on conventional bank loans, but only on negotiable and publicly traded debt and not on conventional bank loans.
Default protection is limited to the principal and interest is not covered.
Reference entity: It’s the bond issuer on whom protection is offered.
Usually, CDS is a standardised instrument of ISDA (International swaps derivatives association).
The credit events that ISDA defines are bankruptcy, failure to pay, reconstruction, obligation repudiation/moratorium, etc.
Only plain vanilla CDSs are allowed as per RBI guidelines.
CLN (Credit linked notes)
This financial instrument (credit default swap is a financial derivative or contract) allows the issuer to transfer specific credit risks to credit investors.
It allows issuers of credit-linked notes to shift or “swap” their credit risk to another investor.
Here the risk seller gets protection by regularly paying the premium to the risk buyer.
These kinds of notes are sold to the general investors and the money collected from them is used by SPV to buy high-quality securities.
The general investor can get a fixed or variable return on the note during its life.
Once the maturity is reached, securities purchased by SPV are sold and money is returned to the investors but in case the default is underlying credit, these securities are used to pay the risk seller.
RBI’s Concern Over Derivatives
There is no apprehension if banks use derivatives to hedge their credit risk by way of purchasing risk protection. But when banks start selling credit protection to other lenders, that’s when the issue begins.
Since these instruments are so structured and complex and sometimes liability that arises in such cases is many times more than what is anticipated.
Due to this RBI doesn’t support the fast growth of derivates in the Indian financial market.
RBI Guidelines For Managing Credit Risk
- Lenders should never rely on credit evaluation reports created by internal or external consultants of the borrowing business; they should always conduct their own independent and unbiased credit appraisals.
- Banks must do sensitivity tests and scenario analysis, particularly for projects like infrastructure that must account for delays and cost overruns among other things.
- The lenders must ascertain the origins and calibre of the equity capital contributed by the promoters or shareholders.
- By Sections 153 to 158 of the Companies Act of 2013, each director must have a director identification number (DIN).
- The RBI for wilful defaulters notes that lenders may be able to need special certification from borrowers to monitor the end use of money. Banks and FIs will also need to ensure that relevant conditions in loan agreements are implemented to facilitate the granting of such a mandate by the lenders to the borrowers/auditors.
- Instead of relying on the borrower’s certification, lenders may choose to engage their auditors to ensure that funds are used appropriately and to prevent their syphoning or diversion.
- Bank boards should establish guidelines for timely reporting of credit information to CRILC (the Central Repository of Information on Large Credits) and access to information therefrom, as well as a method for correctly and promptly classifying borrowers as wilful defaulters.
Credit Information System
As a first step in credit risk management, the credit information system was created to halt the accumulation of new NPAs in the banking system through an effective system of credit information on borrowers.
Credit Information Companies (CICs)
The Credit Information Companies (Regulation) Act of 2005 authorised the creation of CIC to strengthen the legal framework for the collection, processing, and sharing of credit information on credit institution borrowers.
Credit Information Companies (CICS) gather publicly available information, credit transactions, and payment histories of people and businesses relating to loans and credit cards among other things.
CICS creates a score from a credit report based on the information gathered.
Before making a loan decision or providing a credit card, banks and non-banking financial institutions consult the CIC’s report and score.
Any score above 750 is regarded as an excellent score, which ranges from 350 to 850. The issues licence to CICs.
The well-known CICs in India are CIBIL, Equifax, Experian, and High Mark Credit Information Service.
A Central Repository Of Information On Large Credits (CRILC)
To collect, store and disseminate the credit data to the lender’s RBI set up CRILC.
Credit information, including classification of an account as SMA, on all the borrowers having aggregate fund-based and non-fund-based exposure of Rs. 5 crores and above.
In the case of crop loans aforementioned is not required but must continue to report their other agriculture loans.
Also, banks need to report their interbank exposure to CRILC including exposure to NABARD, SIDBI, EXIM bank and NHB.
Banks also report outstanding current amount balance of their customers (debit or credit) of Rs. 1 crore and above.
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