RMPG Learning Series CRM Workshop Day 1 session 3

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



A loan creation planning process in a bank

Credit

StrategyLending Policy

Credit Policy

Focus Volume / Risk-Return / Client-base Norms/ Ratios

• Basis

• Corporate objectives

• Thrust areas

• Business targets

• Risk-return relationship

• Customer base

• Concentration Norms

• Characteristics of

preferred borrowers

The above aspects are captured in Business Plan,

Credit Policy, Manual of Instructions, Circulars



Credit Risk defined

Manifestation of Credit Risk

� Credit risk is the possibility that

payments would not happen as

per agreed terms – uncertainty in

amount and timeliness of

repayments� Inadequate repayments

� Untimely repayments

� Default risk is the risk that the

repayments stop all together

Likely Causes

� Inability to pay

� Short term cash flow or

liquidity problems

� Longer term solvency issues

� Delays in payment due to

operational issues with the

treasury function

� Unwillingness to pay



Sources of Credit Risk

• Repayment inability due to bad financial performance, point in the business cycle, poor management quality

• Unwillingness on part of obligor to make repayments on time

Asset Based lending

• Delays in completion

• Uncertain cash flows during operation due to lower PLFs, price risk, offtaker credit risk

• Sponsor and Technology risks

• Force Majeure

• Political risks

Cash flow based lending



Assessing and Managing Credit Risk

Effects of credit risk

• Potential inability of the organization to meet the liabilities as they become due

• Borrowing under unfavorable terms and conditions

• Distress asset sale• Reputational risk

Measurement of credit risk

• Appraisal and assessment.• Use of internal and

external rating

Management of credit risk

• Identification potential venerable credit

• Assessment of potential risk

• Monitoring and follow up• Control and mitigation

like collaterals.



Credit Risk Management Process has to be installed

� Identification of products (e.g. loan product, derivative, forex, guarantees), geographical locations (e.g. country risk), industry sectors (e.g. real estate, NBFCs) from where the credit risk is originating

� Analyse past credit trends, macro-economic factors and expected trends

Identification

� Measuring credit risk using validating scoring / rating models

� Estimating historical probability of default and recovery rates and loan loss rates to bank

� Linking risk scoring with quantification of risk

Measurement

� Limits on individual / group exposure, specific sectors like real estate, unsecured exposure etc.

� Eligible collaterals and their frequent valuations

� Loan Review Mechanism

Control



Credit risk management function at Bank

Credit Risk Management

Function

Policy OrganizationQuantification

ToolsManagement

ProcessesMonitoring and Control

The Board of Directors has the overall responsibility for the credit risk management and shall approve the

credit risk management policy, procedures and set prudential and other limits.

Quantification Tools

Management Processes



Policy Guidelines of Bank

1. Credit objectives

2A. Quality of asset base (Industry

Exposure)

2B. Quality of asset base (Selection

of Borrower)

3. Exposure norms

4. Tenure of credit

5. Credit acquisition

Structure of Credit guidelines of banks

6. Credit appraisal

7. Assessment of limits

8. Pricing

9. Credit monitoring

10. Delegation of authority

11. Recovery and exit policy

12. Internal Audit



Prudential limits for Individual and Group exposure

Prudential limits

� Individual Exposure� Lending

� Group exposure� Lending

Exposure ceiling

� Exposure of its owned fund� ≤ 35 %

� ≤ 35 %





Function


ToolsManagement








Organization structure

Board

RMC

Credit Officer

•Overall risk management

•Decide the risk management Policy

•Loan Sanction

•Setting up internal limit for portfolio management

•Preparation and presentation of appraisal note• Objective assessment of the credit risks involved• Ensuring the validity and accuracy of the data used for Credit decision

•Implementation of policy•Adherence to limits set by the Board• Recommendation of ceiling for various types of internal limits to the Board for effective portfolio management.

•Monitoring and reporting of risk levels•Review the risk based pricing• Review the appraisal note , results and trends



Comprehensive risk management structure

•Business units

RM

Department

RM interacts and functions with

business units

Risk Management Policy

Policies for

Risk

Management

unit

Policies for

management

of different

risks

Policies for

Different

operations

procedures

Policies

Different

business

units

Business Unit

Board of Directors

Risk Management Committee of Board


Committee (CRMC)

Asset Liability Management Committee (ALCO)

Operational Risk Management

Committee (ORMC)

Internal DocumentsOrganisation Structure



A Board level Risk Management Committee should be put in place to implement risk management across the bank

Reporting • Board of Directors

Supported By • Credit Risk Management Committee, Asset Liability Management Committee and Operational Risk Management Committee

• Devising policy and strategy for integrated risk management containing various risk exposures

• Providing guidance to various risk management committees operating under it

• Oversee the identification, measuring and monitoring the risk profile of the Bank

Desirable

Composition

• Managing Director / Chief Executive Officer, Executive Directors , Heads of Credit and Head of Risk.

Frequency • At minimum quarterly intervals

Roles



Bank should set up multiple risk management committees to create focus and handle different constituents of risk

Reporting

Supported By

Desirable

Composition

CRMC ALCO ORMC

Should be headed by Chairman/Executive Director/Chief Executive Officer (CEO) and comprises of heads of Credit and Risk Management Dept & Chief Economist

Should be headed by Chairman/ED/CEO and comprises of heads of Credit, Investment, Treasury, Resource and International Banking

Should be headed by Chairman/ED/CEO and comprises of heads of Credit, Information Technology, Human Resource and Risk Management

Risk Management Committee of Board

Credit Risk Management Department

ALCO Cell / Middle Office

Operational Risk Management Department



The committees should meet at frequent intervals to discuss tomonitor various aspects of risk

Frequency of

Meeting

Roles

CRMC ALCO ORMC

At Frequent Intervals (Minimum Monthly)

� Measure, Control and Manage Bank wide Credit Risk

� Compliance with lending and credit risk management policy

� Enforce compliance with prudential limits

� Measure, Control and Manage Bank wide risk on liquidity, interest rates and foreign exchange

� Product Pricing for Deposits & Advances

� Strategy for Resources Mobilisation

� Formulation of Bank wide Operational Risk Policy

� Act as agency for creating awareness on operational risk in the Bank

� Development of Operational Risk Management tools

Supported By Risk Management Department



Bank should install an independent risk management department housed in the Head Office

Location At Head Office / Corporate Office

Headed By An officer with a minimum rank of General Manager, having expert knowledge of banking business and credit, market and operational risk management

Supported By Minimum of 3/4 persons on current scale of operations and shall be increased with the enlargement of operations

Desired

Qualifications

Chartered Accountants, MBA, Cost Accountant, CFA, M. Sc. –Statistics and any other equivalent degree





Function


ToolsManagement




Quantification

Tools




The Policy would enable a structured assessment of risks, mitigants enabling credit and pricing decision

Portfolio Risk Management

Exposure Limits Monitoring, Oversight and Governance Structure

Monitoring, Oversight and Governance Structure

Credit Decision

Approve / Reject Additional collaterals, covenants, higher pricing

Additional collaterals, covenants, higher pricing

Assessment of mitigants on offer for the proposed transaction

Contractual arrangements in a project Financial collaterals, guarantees etc. for asset based lending

Financial collaterals, guarantees etc. for asset based lending

Assessment of risks

Financial Parameters Qualitative Parameters



Structure of rating model for balance sheet based lending

Financial Risk

Business Risk

Industry Risk

Management Risk

Borrower Risk Score

Account conduct

Credit rating model enables to view the borrowers with the risk perspective based on grades.

Project evaluation and status

+Final Borrower

Risk Score



Multiple components of model* and multiple parameters for each component

* Slide provides an outline of a rating model for Corporate Customers



Key Risks that need to be assessed for a project

Overall project

risk

Financial Risk

Sponsor Risk

Construction risk

Technology risk

Market / Revenue

Risk

O& M Risk

Fuel supply risk

DSCR, IRR

Best Case

Worst Case

Equity Contribution



Bank would need to finalise an approach for implementing robust risk rating models

Financial Risk Score

Management Risk Score

Industry Risk Score

Basic Borrower Risk Score

W 2

W 1

W 3

Conduct of account Risk

Score

Modified Score

PLUSTransaction Risk Score

Collateral Structuring

Calibration and Validation Robust & Acceptable

Risk Scoring Model



Estimation of Loss Given Default (LGD)

Market Value of security

Security Type

Loan Outstanding

at Default

LGD=(1 -RR)

Present Valueof Recovery Rate (RR)



Assessment of risks would also enable risk based pricing besides building a good quality portfolio

� Aligns the incentive to balance risk with return

� Pricing is a tool to maintain proactive provisioning

� Necessary for value creation and preservation

= + +

Price

(Interest

Rate and

fee income)

Cost of FundsCredit

Charge

Loan

Overhead &

Operating

Risk





Function


ToolsManagement





Management

Processes



Bank would need to install a three tier structure for Lending process loan management

. Front Office

Origination/Renew

al

Sales/Acquisition

Credit Risk Analysis

• Assessment

•Sanction

•Pre disbursement

formalities

•Disbursement

Post disbursement

•Monitoring

•Support to front and

mid office

•NPA Management

Bor

row

er

Risk Management Sanctioning Authority

Reg

ulat

ory

Rep

orti

ng

Evaluation

Collect and review data

Back OfficeMid Office

Audit and Control



Lending Process in Banks: Origination

Check for discrepancies and email the same to RM

RM/Branch

Front office checks whether all documents are in order and as per norms

CPU

Check MIS to know the status of the file and if declined, reasons for decline

Refer to CreditFile is processed by CPU as per policy

File is processed by CPU as per policy

Initiate Contact point verification (send details of the applicantcontaining customer number, residence address, residencetelephone no. , employer name ,office address, telephone no. etc.)and income document verification

Initiate contact point verification and income document verification

Prepare CAM (Credit Appraisal Memorandum) by leaving columnblank for remarks about Income document verification

Check whether file has been already logged Yes

NoYes

No

DSA/DMA convertprospective loanseekers into loanapplicant



Lending Process: Assessment , Risk Management and Sanction

Update (Credit

guarantor

Update the status of Income document verification, on receipt of the same in CAM (CreditAppraisal Memorandum) and MIS and complete the credit .Valuation andassessment ofguarantor will also be done based on prescribed guidelines

Credit officer adds the remarks on the basis ofdeviation observed and credit process checks

internalratingmodelfor quantificationof RiskCredit and Risk Department assesses the case based on score card /internal rating model for quantification of Risk

discussion

In case Personal discussion felt necessary conductthe same Note: Please refer to credit process checksand policy for requirement to conduct the personaldiscussion

Approved Hold Declined

Subject to conditions

Communicate to Br/RM

For want of signinging deviation

Communicate to Br/RM so that the customer can

be informedBr/RM collects PDC ,loan agreement and

other documents

Communicate to Br/RM so that the conditions can be

fulfilledInspection officer

Verifies Communicate approval

Communicate to Br/RM so that the conditions can be

fulfilledOperation for Disbursement/Post disbursal activities



Lending Process: Pre disbursement and disbursal

Review of security documents, execution of new set of prescribed loan document as advised by Legal department and entry of details

into document execution register.

Collection of Post Dated cheques (PDC)

YesCustomer will have to

open savings account and PDC will be issued

thereafter

Customer has bank account with cheque

book facility.No

Creation of

Charges

Creation of mortgage and

charges in Register of

Charges

Creation of account into CBS by following extant guidelines issued Creation of account into CBS by following extant guidelines issued with respect to KYC norms and setting up of limits

Update Drawing Power limit, Recovery of margin money and recovery of feesand charges ,if any . Creation of insurance on financed assets, issue of chequebook in the case of revolving credit,

Disbursal

Send copy of all executed document to CPU for disbursal clearance



Lending Process: Post disbursal

Post disbursal checks

Credit admin officer

regularly monitor

activities in loan account

Calculation of DP will be done at regular interval based on submitted stock and debtors statement and the

same will be allowed in CBS.

Loan Servicing

Revolving Credit

Monitoring of • Repayment• Penalties & charges• Change in interest rate• Revival of time bared

documents• Collection of required

additional PDC and extension of ECS mandate period

Loan account performance as per agreement

and pre decided terms

Triggers and early warning signals

• Closure of Account• Returned securities

documents and unused PDC

• All loan documents marked as cancelled and closed

No

Yes

Foreclosure and loan maturity

End





Function


Tools Management Processes

Monitoring and Control




Management

Processes



Lending Process: Monitoring ,Follow-up and NPA Management

If any of the defined triggers or weakness observed than CR Admin Officer

escalate the matter to it superior's

Review and decide to escalate further/keep in view

Credit Admin and Credit Officer to analyze unit

prepare recommendations

Credit officer and Admin to examine unit and prepare

recommendations

Credit Admin and its supervisor to review

unit on a monthly basis for next two months

If sign of deterioration persist

End

Performance improved by moratorium,deferment of interest pay,

re-assessment

Execute remedial solution and Credit

Admin to •Monitor to ensure

recommendations are implemented

•Prepare specific check points during inspections

Credit sanctioning authority will take final decision on

recommendation s put forth by Credit

Officer Escalation of a

case to Recovery/NPA cell

can happen only after review and final decision by

appropriate authority

End

NO

NO Yes

Yes

No

Keep in viewEscalate to

Credit admin

supervisor

Escalate to Head CPU Credit

officer needs to be assigned

Yes, Escalate to Head CPU

If unit

improves

If unit complying with the

condition and situation

improves



Risk monitoring and control

� Objectives of monitoring :-

• Improvement in the quality of credit portfolio

• Review of sanction process

• Compliance of due diligence process

• Feedback on regulatory compliance

• Picking-up early warning signals and suggesting remedial measures

• Recommending corrective action to improve credit quality, credit administration and

credit skills of staff etc.

� Phase wise monitoring :-

• During construction phase

• During operating phase



Risk mitigation

� Collateral securities can be broadly classified into two categories viz. Financial and Non-

financial

� Financial collaterals :-• Cash (including deposits),

• Gold,

• Securities issued by Central and State Government etc.

� Non-financial collaterals :-� Land and building,

� Raw materials, stock in trade, produce, and other goods

� Movable assets such as machineries.

� Documents of title to goods etc.

•The other forms of credit mitigation includes various form of guarantees and letter of comfort etc. Few

other mitigation arrangement includes escrow mechanism ,TRA and DSRA



Portfolio concentration needs to be minimised to manage Credit Risk at the portfolio level

Bank shall aim to diversify exposures through:

� Prudential limits for individual and group borrowers

� Rating-wise distribution of all the borrowers

� Exposure to particular sub-sector

� Geographical distribution of borrowers



The need for a more comprehensive risk assessment for cash flow based lending

� Limited recourse to the sponsors

� Limited tangible security from

the project till the assets are

created

� Highly capital intensive

� Due to long gestation period of

power projects repayment of

principals starts after quite some

time.

� Lack of diversification and there

is a single stream of revenue

� Extent of risks differ during different phases of

the project

� Need for specific assessment for each phase

Financial Closure

Commissioning

Steady state operations

Time

Ris

ks



Preliminary analysis would help banks optimise effort spent on detailed appraisal

Minimum information required for evaluation of credit request

� Status of land acquisition and statutory clearances

� Availability of construction infrastructure and status of fuel linkage.

� Status of all contracts e.g. EPC, Package contract and Shareholders agreement are in

place d) Proposed off take mechanism – through long term PPA or merchant sale.

� Cost of the project, Debt Equity ratio proposed.

� Proposed Shareholding pattern

� Promoters’ background and their capability to bring their share of contribution.

� Financial projections and ratios like IRR, DSCR of the project worked out by the

applicant.

� Principle business of the promoters and their ability to implement the current project.



Assessment of credit risks in cash flow (SPV) based lending…1

� Financial Parameters• Project IRR

• Average DSCR and Minimum DSCR for the base case.

• Sensitivity of DSCR and IRR to the project cost

o Change in Project Cost

o Change in PLF

o Change in Sale rate

o Change in Interest rate

o Change in fuel Cost

• CDM benefit

• Any other project specific critical risk



Assessment of credit risks in cash flow based (SPV) lending…2

� Qualitative parameters

• The promoters and Quality & expertise of management.

• Market size, growth prospects and business environment.

• Global market outlook.

• Govt. policies & economic situation.

� Risks could arise during the construction phase:

• Non completion of the project or various milestones.

• Time and cost overrun due to delay in completion.

• Cost overrun even though part of the project completed on time.

� Risks could arise during the operating phase:

• Fuel risk, Hydrological risk , Technology risk , Revenue risk , O & M risk ,Sponsor

risk and Supplier risk etc



Assessment of credit risks in balance sheet based lending…1

� Financial Parameters• Quantitative factors:

o Financials, ratios e.g. Sales growth , gearing , ROCE ,Quick ratio , Cash interest coverage ratio and retained earnings to equity etc.

o Sensitivity analysis.o Industry inter-firm comparison.

• Sensitivity analysis.• Industry inter-firm comparison.

� Qualitative parameters

• The promoters and Quality & expertise of management.• Market size, growth prospects and business environment.• Global market outlook.• Govt. policies & economic situation.



Assessment of credit risks in balance sheet based lending…2

� Risks could arise during the construction phase:

• Non completion of the project or various milestones.

• Time and cost overrun due to delay in completion.

• Cost overrun even though part of the project completed on time.

� Risks could arise during the operating phase:

• Fuel risk, Hydrological risk , Technology risk , Revenue risk , O & M risk

,Sponsor risk and Supplier risk etc

� Product fit & pricing.

� Credit rating.

� Review of account operation.

� Collateral offered.



DISCUSSIONS



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.

Economy & Finance

RMPG Learning Series CRM Workshop Day 1 session 3