PowerPoint Presentation

An Overview of Credit Risk ManagementGood Afternoon

Thank you opportunity & participation1What do Banks/NBFIs do for their Customers ???

Intermediation (Deposit & Lending function) Payment Systems (Retail, Corporates, Govt business) Other financial services (Off-balance sheet activities, Insurance, Trust services)

2Bank Goals and Constraints

Maximize Shareholder Wealth ConstraintsAmount of Cash FlowTiming of Cash FlowRisk of Cash FlowLiquidity riskCredit riskInterest rate riskFraud RiskSocialMarket CompetitionLegal/RegulatoryMain objective

we look at this from the blood line of the Financial business, which is the CASH which is the commodity that they buy and sell in their day to day business in order to make a profit

These financial institution need to manage these CFs properly bc earning a profit will depend on will how well they will manage the above three factors

Amongst other risks CR Risk is the main risk that threaten the CFs as normally in a Financial Institution 60%-80% will be lending assets

3Risk ????

This uncertainty associated with timing & amount of cash flows is the risk. The key strategy - is to Identify, Measure, Monitor and Control the Risk. Why Probability? The future is uncertain. We can only predict with varying degrees of certainty the ability of various parties to honor their commitments. Even with borrowers which have the highest credit quality (eg. AAA rated corporates) there will always be some uncertainty, especially in a long term relationship.

4Why Manage Risks ??

Increasing competition and technical progress have fundamentally changed the role of banks Banks are exposed to strong competitive pressures in selling their products and procuring capital, exposing them to risks which can significantly impact profitability. A banks ability to measure, monitor and mitigate risks comprehensively is important for its strategic positioning. It becomes a tool for offensive instead of defensive strategy. Risk Management is an important tool towards optimum use of capital for generating profits and hence a critical determinant of banks profitability.

Intense competition not like before many players trying to reach and grab the customer like never beforeVariety of products are coming out aiming the life style of the customer - with the development in the technology this has become very intenseNow the companies have become so successful in reversing the formula of catering for a needEarlier you have a need company catersNow they create the need and caters consumer has lost his power- ex : credit card offers you buy a tv bc you need a tv but today you buy the tv bc you have 40% with 12 months installments on credit cardso effectively you are buying the credit not the TV

From the banks side in a versatile environment like this where everyone is competing intensely now it is greatly important to have offensive strategies to manage risk rather than being defensive after it happens5Key Banking/NBFI Risks Credit Risk Credit risk is the risk or potential of loss that may occur due to failure of borrower/ counterparty to meet the obligation on agreed terms and conditions of financial contract. Market risk Operational Risk

6Credit Risk

There is one big difference between selling a credit product and selling soap. The sale of money is not final, you expect it back with interest.

Sell a bar of soap thats the end

But in credit you are expected to use the soap and give back the same soap with additional soap So there can be many things that can go wrongAnd banks has to keep a close eye on the consumer and his performance to ensure the safe return of the soapTo minimize the credit risk7Credit Risk basics Credit risk is the risk of loss that may occur from failure of the counter-party to make payments.Reduction in the ability of counter-party to make payments.Credit risk could be on account of :-default probability: What is the likelihood that the counterparty will default on its obligation either over the life of the obligation or over some specified horizon, such as a year credit exposure: In the event of a default, how large will the outstanding obligation be when the default occurs?recovery rate: In the event of a default, what fraction of the exposure may be recovered through bankruptcy proceedings or some other form of settlement?But this is a part and partial of the finance business you cant eliminate this if you do it you have no finance business

You can only try to minimize this 8Anyone who is uncomfortable in drilling holes in the middle of the North Sea probably does not belong to the oil exploration business.

Likewise, anyone who is unprepared to take credit risk should not be a banker.

9Factors Influencing the Level of Credit Risk Quantity of Credit RiskQuality of the Credit Risk ManagementNet RiskCredit Market and ProductRegulationsDirection of Credit RiskTesfaye BoruLelissa - Factors Influencing the Level of Credit Risk 10

11Approaches to Credit Risk ManagementExpert Systems (Your Credit analyst is best judge) .Five Cs of Lending :-Character, Capital, Capacity, Collateral and Conditions.Credit Rating Systems (Internal / External)Capture all relevant information about the borrower and assign a grade through a risk rating process.eg. AAA, AA, A etc.Limits SystemsPrudential norms for single borrower/ group, rating linked exposures, industry level caps, delegation of powers

12Proper Credit Risk Management helps in..

Analysis & ReportingPortfolio Reporting (Reporting of risk exposures to Senior Management/Regulators)Capture Asset quality migrationsProduct Pricing (Risk Return trade-offs)Capital Requirements.AdministrationLoan review /monitoringTrigger Actions (like planning exit strategy, reduction in exposures, credit enhancement)

13Broad Principles of Credit Risk Management in Banks

Basel Committee on Banking Supervision has issued broad guidelines for best practices in credit risk management.Establishing an appropriate credit risk environment.Operating under a sound credit granting process.Maintaining an appropriate credit administration, risk measurement and monitoring process.Ensuring adequate controls over credit risk.Role of bank supervisors in ensuring that banks have a effective system in place to identify, measure, monitor and control credit risk.

the major cause of serious banking problems continues to be directly related to lax credit standards for borrowers and counterparties

Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms

The goal of credit risk management is to maximize a banks risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters.

Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions.

Banks should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organisation.14Some points for FIs to mange the CR RISKEstablish a sound lending policy Flexibility in credit function to face market adversities Set Limit on total outstanding loansKeep an eye on Credit concentrationsEstablish appropriate maturity for each type of creditFocus on obtaining proper financial information from the borrowerEstablish sound appraisal processMaximum ratio of loan amount to the market value of pledged securities Set proper Lending authorities Appropriate Loan pricingEffective CollectionsProvisioning for NPAFinancial statement disclosure

15But after all this, Institutions with best risk management systems could fail.!!!

16What we learn from history is that people dont learn from history.

Warren Buffett17