Financial Risk ManagementCIA 1Assignment onMeasurement and estimation of credit risk in retail loan portfolio of banks

Submitted By Rahul Jagwani1120305MBA F2

Measurement and estimation of credit risk in retail loan portfolio of banksCredit 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 Credit Risk is generally made up of transaction risk or default risk and portfolio risk.Retail loan portfolios are made up of individual small loans, and limited resources are devoted to analyzing the idiosyncratic risk of an individual borrower. To fully utilize economies of scale associated with risk assessment, statistical tools (credit scoring), and account management, retail loans are generally grouped into segments that have homogenous risk characteristics.In measuring the credit risk of loans and advances to customers the banks should reflect three components: (i)the probability of default by the counterparty on its contractual obligations; (ii) current exposures to the counterparty and their likely future development, from which the bank derives the exposure at default; and (iii) the likely loss ratio on the defaulted obligations (the loss given default).The following points briefly describe fundamental measuring frameworks for retail portfolios.Scorecard Models Scorecard model development is primarily used for rank-ordering purposes. Scorecards can include prediction of delinquency, default, bankruptcy, attrition, profitability, and account acquisition, as the data reflect portfolio risk characteristics. Scorecard development requires statistical techniques that include logistic/probit regression, decision tree methods, neural networks, and linear regression. Macroeconomic information is rarely considered in scorecard modeling, but with some adjustments, scorecards could be augmented with economic variables to address causal relationships.The information about ratings and scoring is widely used at the Bank for the purposes of credit risk management, the system of credit decision-making powers, determining the amounts above which independent credit assessment services are activated and in the credit risk assessment and reporting system.Risk Pricing - Risk-return pricing is a fundamental tenet of risk management. In a risk-return setting, borrowers with weak financial position and hence placed in high credit risk category should be priced high. Thus, banks should evolve scientific systems 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 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 collaterals over time. Large sized banks across the world have already put in place Risk Adjusted Return on Capital (RAROC) framework for pricing of loans, which calls for data on portfolio behaviour and allocation of capital commensurate with credit risk inherent in loan proposals. Under RAROC framework, lender begins by charging an interest mark-up to cover the expected loss expected default rate of the rating category of the borrower. The lender then allocates enough capital to the prospective loan to cover some amount of unexpected loss- variability of default rates. Generally, international banks allocate enough capital so that the expected loan loss reserve or provision plus allocated capital covers 99% of the loan loss outcomes.Loan Review Mechanism (LRM) - LRM is an effective tool for constantly evaluating the quality of loan book and to bring about qualitative improvements in credit administration. Banks should, therefore, put in place proper Loan Review Mechanism for large value accounts with responsibilities assigned in various areas such as, evaluating the effectiveness of loan administration, maintaining the integrity of credit grading process, assessing the loan loss provision, portfolio quality, etc. The complexity and scope of LRM normally vary based on banks size, type of operations and management practices.Roll Rate/Markov Chain Models - Roll rate models measure the percentage of accounts or dollars that "roll" from one stage of delinquency to the next until the accounts meet contractual default criteria. Individual accounts are not tracked in the model. The stages of delinquency reflect a pool of accounts at the segment or portfolio level.KMV portfolio Manager ModelIn KMVs Portfolio Manager all three key variablesreturns, risks, and correlationsare calculated. The return on loan is measured by All-in-spreads which is measured on the basis of fees paid on loan and spread on loan. The risk of loan reflects the volatility of loan default rate. On the basis of this unexpected loss is calculated. The expected return on loan and variances are calculated and then risk and return on the portfolio is calculated.

Estimation of credit risk in retail loan portfolio To estimate the credit risk in retail loan portfolio the bank may use following measures :- Stress Testing Approach - The use of stress testing for risk monitoring has increased considerably over the last decade. Stress testing a simulation technique used to assess the strength of a portfolio or a nancial institution under unusual economic conditions emerged as a powerful tool that was originally used in market risk. Its use has subsequently been extended into credit risk. To stress test a credit risk portfolio, practitioners focus on the key parameters that allow the risk of a credit portfolio to be assessed. These parameters, also known as Basel II parameters, are probability of default, loss given default, exposure at default and asset correlation.Internal Ratings Based Approach - Under theBasel IIguidelines, banks are allowed to use their own estimated risk parameters for the purpose of calculatingregulatory capital. This is known as theInternal Ratings-Based (IRB) Approachto capital requirements forcredit risk.The IRB approach relies on a bank's own assessment of its counterparties and exposures to calculate capital requirements for credit risk. TheBasel Committee on Banking Supervisionexplained the rationale for adopting this approach in a consultative paper issued in 2001. Such an approach has two primary objectives - Risk sensitivity - Capital requirements based on internal estimates are more sensitive to the credit risk in the bank's portfolio of assets Incentive compatibility - Banks must adopt better risk management techniques to control the credit risk in their portfolio to minimize regulatory capitalTo use this approach, a bank must take two major steps: Categorize their exposures into various asset classes as defined by theBasel IIaccord Estimate the risk parametersprobability of default (PD), loss given default (LGD), exposure at default (EAD), maturity (M)that are inputs to risk-weight functions designed for each asset class to arrive at the totalrisk weighted assets(RWA).

Sources http://www.risk.net/digital_assets/5118/jrmv_assouan_web.pdfhttp://2010.lloydsbankinggroup-annualreport.com/business-review/risk-management/Credit-risk.aspxhttp://www.phil.frb.org/bank-resources/publications/src-insights/2009/third-quarter/q3si1_09.cfm