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This is being made available for Risk Management Practice Group on Linkedin. RMPG Learning Series CRM Workshop Handouts: File 1 of 9
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IMaCS 2010Printed 11-May-11
Page 1For Classroom discussion only
Agenda for Day 1
Introduction of Participants
Introduction to Credit Risk
Lunch Break
Framework for Credit Risk Management
Overview of Basel Guidelines
Open Session/ Q&A
IMaCS 2010Printed 11-May-11
Page 2For Classroom discussion only
What is you Bank’s most important risk?
Type of Business Biggest Risk
Commercial Banking Credit Risk
Investment Banking & Trading
Market Risk
Asset Management Operational Risk
IMaCS 2010Printed 11-May-11
Page 3For Classroom discussion only
Art of Credit - Managing Loan Losses
� “Credit Losses have, historically, been the single largest cause of bank
failures” - Economist
� “Bankers are in the business of taking and managing risk… that is the
business of banking.” - Walter Wriston, ex-Chairman, Citicorp
� “Volatility forms the link between risk and reward – the trick is for banks to
reduce that observation to workable propositions.” -George Vojta, Vice
Chairman, Bankers Trust
IMaCS 2010Printed 11-May-11
Page 4For Classroom discussion only
What is at stake for banks who cannot balance the risk/reward relationship?
Risk Adjusted assets) of 20%)
Their own survival! - Illustrative Example
%
Net Interest Revenues 3.00Plus: Other Income (Fee/FX) 1.00Net Customer Revenues 4.00Less: Direct + Allocated Costs -2.50Net Margin Before Credit Costs 1.50Less: Expected Credit Costs -1.25*Net Income 0.25
Required Return on Risk Adjusted Assets 1.60**Premium Shareholder Income/Loss -1.35
(* Based on assumed portfolio quality)(** Assumes 8% Risk Adjusted Capital allocation and required ROA (Return on
Risk Adjusted assets) of 20%)
IMaCS 2010Printed 11-May-11
Page 5For Classroom discussion only
The Message
A business must generate
Premium Shareholder Income
of at least1.60%
(i.e. a 20% ROA on 8% capital)
in order
not to erode
Economic Value of Capital
IMaCS 2010Printed 11-May-11
Page 6For Classroom discussion only
How?
To produce
Premium Shareholder Income
&
long term shareholder value,
banks mustensure
Superior
CREDIT RISK MANAGEMENT
IMaCS 2010Printed 11-May-11
Page 7For Classroom discussion only
How does your bank currently manage its Credit Risks?
Is your focus on managing:
> individual credit exposures?
or
> a portfolio of credit exposures?
IMaCS 2010Printed 11-May-11
Page 8For Classroom discussion only
There are 3 opposing forces that challenge credit risk management …..
Credit risk management
Regulators
Higher Returns
Greater Risks
More Capital
IMaCS 2010Printed 11-May-11
Page 9For Classroom discussion only
Why is Credit Risk Management important for Banks?
� RoE for banks worldwide has been below 10% and declining after 1960 if
one excludes non-interest income
� Suggests that loans have been “loss leaders” - inducing customers to buy into
other products offered by banks
� 9 out of 10 banking failures attributable to poor credit risk management
� New forms of financial transactions emerging
� Asset backed securities
� Derivatives
IMaCS 2010Printed 11-May-11
Page 10For Classroom discussion only
Banksin the future
Several factors are changing the face of the Banking industry across the globe
Intense
Highly intense
Pressures due toCapital adequacy norms
Medium
Com
peti
tion
for
cu
stom
ers
Relativelymanageable
Time
Banks today
1990 2005 2010
Liberalisation level
Low Medium High
1990 2005 2010
Capital Adequacy pressure
None Medium HighPre
ssur
e on
P
rofi
ts
1990 2005 2010
Competition for business
Medium HighLow
IMaCS 2010Printed 11-May-11
Page 11For Classroom discussion only
The Changing Marketplace for Credit
� New kinds of lenders / investors coming into the financial intermediation
business
� Different approach to credit risk management
� Different investment horizons
� Different risk aptitudes and risk tolerances
� “Relationship based lending” changing from “art” to “science”
IMaCS 2010Printed 11-May-11
Page 12For Classroom discussion only
The different compartments of Financial Intermediation have coalesced...
Yesterday
Banking
Insurance
NBFCs
Term Lending
Implications
Liberalised Market
Banking
Insurance
NBFCs
Term Lending
Focus on well-defined target customer groups
Ability to offer a variety of financial products (including new products)
Sophisticated risk management
Ability to use Technology as a competitive weapon
“Must” capabilities for banks
IMaCS 2010Printed 11-May-11
Page 13For Classroom discussion only
How are different banks preparing themselves to face increasing competition?
• Move towards consolidation/ alliances
• Banks are increasingly focusing on niche segments for growth
• Technology is playing a key role in deciding the competitive position of banks
• Risk management has become “mantra” to the banking sector
• Introduction of new products & delivery mechanism to meet the customer requirements
IMaCS 2010Printed 11-May-11
Page 14For Classroom discussion only
The competition in the banking sector is getting intense
Large corporates
SMEs
Retail
Fiercely competitive
Intensifying competition in select segments
Under served
In USA, SMEs became of interest to banks after a recent focus on segmentation showed their profit contribution
Number of entities
IMaCS 2010Printed 11-May-11
Page 15For Classroom discussion only
5 10 15 20 25 30 35 40
ROE (%)
Rev
enue
s($
BN
)
50
100
200
Small Business
Insurance800
Credit Cards
Mortgages
U.S. Market Size and Profitability
MutualFunds
ConsumerFinance
Source: IFC Symposium, China
Different credit segments generate different market returns - a key driver for portfolio management
IMaCS 2010Printed 11-May-11
Page 16For Classroom discussion only
A bank should have a three-fold objective to implement Credit Risk Management systems
Maximise the risk-adjusted return on capital by maintaining credit risk exposure within acceptable parameters
Manage the credit risk inherent in individual credits or transactions as well as the risk in the entire portfolio
Manage the relationship between credit risk and other risks
1
2
3
IMaCS 2010Printed 11-May-11
Page 17For Classroom discussion only
Hold Till Maturity
Conventional credit management practice - (Originate and Hold)
A
S
S
E
T
Obligor
Risk Management
Recovery
A
S
S
E
T
Borrower
Risk Management
Loan Origination / Credit Group
Recovery
Monitoring
/Client Management
/Servicing
/Recovery
Largely restricted to developing /procuring obligor assessment models and laying down loan policy
Obligor evaluation, pricing, management & monitoring Involved
post default
IMaCS 2010Printed 11-May-11
Page 18For Classroom discussion only
A
S
S
E
T
Obligor
Risk Management
Recovery
A
S
S
E
T
Borrower
Risk Management
Loan Origination / Credit Group
Recovery
Monitoring
/Client Management
/Servicing
/Recovery
How Risk Builds in the Portfolio
Inadequate obligor risk assessment tools
Ineffective monitoring due to incorrect risk perception(Tools/process issue
Correlation between assets. Asset displaying cyclical characteristics not tracked adequately
Imperfect Loan Structuring
IMaCS 2010Printed 11-May-11
Page 19For Classroom discussion only
How Risk Builds in the Portfolio
Fallen Angels
Assets whose marginal risk contribution was low when the exposure was taken and risk on which has increased with passage of time but not tracked adequately
Exposure
Ris
k
IMaCS 2010Printed 11-May-11
Page 20For Classroom discussion only
So, what is driving banks to look at credit risk management?
Profits
RisksGrowth
Maintain growth and improve profitability to sustain capital adequacy
Any growth strategy has inherent risks
Need for striking a balance between growth, risks, and profits
Understand the source of profits and risks
Need the following :� Understand risk� Understand profits
IMPERATIVE
•+
Need to grow
IMaCS 2010Printed 11-May-11
Page 21For Classroom discussion only
Traditional Credit Analysis
� Credit analysis - the process of making inquiries prior to committing funds
� Based on two distinct issues:
� Willingness of borrower to repay
� Ability of borrower to repay
� To this day, banks are far ahead of other players in the core expertise of
analysing credit risk
� Classic credit analysis remains the preserve of banks
IMaCS 2010Printed 11-May-11
Page 22For Classroom discussion only
Key Highlights of a Classic Credit Analysis Process
� Based on both subjective and objective elements
� Highly dependent on the quality of persons involved
� Usually a high variance in the quality of documentation of observations and
analysis across time and persons
� It is rather expensive to maintain high standards (read consistency, objectivity,
and accuracy of risk analysis)
� The final judgement is often determined by one or a few dominating parameters
and / or officers
IMaCS 2010Printed 11-May-11
Page 23For Classroom discussion only
Drawbacks of Classic Credit Analysis
� Too expensive to maintain - training and retention costs of several experts getting out of hand
� The general approach was to hold loans to maturity - therefore, reasonable chance of loans going bad
� Increasing competition for lending has forced banks to duplicate skills and systems
� As banks become large, management of complex and subjective processes is extremely difficult
� Limitations of handling concentration risk
IMaCS 2010Printed 11-May-11
Page 24For Classroom discussion only
What is the Quantitative Approach to Credit Analysis?
� Use of a quantitative model for measuring credit risk of a particular account
� Use of a numerical scoring system to indicate degree of risk � Components of overall risk may be broken down and separately captured
� Usually works best with objective data
� Advanced techniques used for capturing subjective data
� Amenable to further mathematical analysis for use in
� Trend analysis� Default prediction� Risk pricing� Securitisation
� Leading banks moving towards increased use of quantitative models
IMaCS 2010Printed 11-May-11
Page 25For Classroom discussion only
Positives and Negatives of Quantitative Models
Advantages
� High consistency - everyone speaks the same language of risk
� High objectivity - result not influenced by individual persons
� Can capture trends indicating deterioration or improvement in risk profile over time
� Gives insights into components of risk
� Can compare risks across different accounts more easily and objectively
� Can be used for pricing and portfolio management
Disadvantages
� Results are only as good as the underlying algorithms
� Calibration and validation of model is essential to make it work - this needs in-depth expertise
� Users tend to substitute their judgements with such models - this is not the intended use of the models
IMaCS 2010Printed 11-May-11
Page 26For Classroom discussion only
Credit – Emerging Value Chain (Originate/Buy and Manage)
Issuers/Borrowers
Risk Management
Loan Origination / Client Management
Portfolio
Investment
Credit Derivatives
Product Structuring / Securitisation
Secondary M
arket
Servicing
IMaCS 2010Printed 11-May-11
Page 27For Classroom discussion only
Migration Path for Credit Management
Passive traditionalistsBanks that
originate and typically hold to
maturity
Stage 1
Active traditionalists
Banks that manage their credit portfolio
by RoE
Active traditionalists
Banks that manage their credit portfolio
by RoE
Stage 2Stage 2
Semi- advanced practitioners
Banks that manage their credit portfolio
through finer pricing of risks and have greater
ability in managing portfolio wide risk
Semi- advanced practitioners
Banks that manage their credit portfolio
through finer pricing of risks and have greater
ability in managing portfolio wide risk
Stage 3Stage 3
Advanced practitioners
Banks that use very sophisticated
models for portfolio
management
Advanced practitioners
Banks that use very sophisticated
models for portfolio
management
Stage 4Stage 4
Most banks are at the early stages of credit risk management
IMaCS 2010Printed 11-May-11
Page 28For Classroom discussion only
Key Drivers of change in Credit Risk Practice
� Regulatory issues
� Capital adequacy
� Income recognition and provisioning norms
� Disclosure norms
� Increasing pressure to enhance shareholder returns
� Banking is also a commercial business that competes for equity
� Not amongst the top bracket growth sector businesses
� Emergence of markets for loans
� Securitisation
� Structured finance
� Derivatives
IMaCS 2010Printed 11-May-11
Page 29For Classroom discussion only
DISCUSSIONS
IMaCS 2010Printed 11-May-11
Page 30For Classroom discussion only
All the contents of the presentation are confidential and
should not be published, reproduced or circulated without the
written consent of IFC, Bangladesh Bank and IMaCS.
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