Credit Risk Management - Bank Management - Lecture Slides, Slides of Banking and Finance

Download Credit Risk Management - Bank Management - Lecture Slides and more Slides Banking and Finance in PDF only on Docsity! Credit Risk Management Docsity.com Credit Risk RBI definition of credit risk • Possibility of losses associated with decline in the credit quality of borrowers or counterparties. • Default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. • Loss from reduction in portfolio value (actual or perceived). Docsity.com Components of Credit Risk • Default risk – Risk that a borrower or counterparty is unable to meet its commitment. • Portfolio risk – Risk which arises from the composition or concentration of bank’s exposure to various sectors. Two factors affect credit risk Internal factors – Bank specific. External factors – State of economy, size of fiscal deficit etc. Docsity.com Managing Internal Factors • Adopting proactive loan policy. • Good quality credit analysis. • Loan monitoring. • Sound credit culture. Docsity.com Managing External Factors • Diversified loan portfolio. • Scientific credit appraisal for assessing financial and commercial viability of loan proposal. • Norms for single and group borrowers. • Norms for sectoral deployment of funds. • Strong monitoring and internal control systems. • Delegation and accountability. Docsity.com Prudential Norms for Credit Risk • Capital adequacy norms. • Exposure norms  Credit exposure and investment exposure norms to borrowers (individuals and group)  Capital market exposures  Individual bank’s internal exposure limits • Bank’s internal risk assessment committee norms. • Credit rating system and risk pricing policy. • Asset liability management requirements. • Bank’s loan policy norms. Docsity.com Framework for Credit Risk Management  Credit risk management framework • Policy framework  strategy and policy  organization structure  operations / systems support • Credit risk rating framework • Credit risk limits • Credit risk modeling • Credit risk pricing • Risk mitigation • Loan review mechanism • Credit audit Docsity.com Policy Framework  Strategy and Policy • Documented policy specifying target markets. • Statement of risk acceptance criteria. • Credit approval authority. • Credit follow up procedures. • Guidelines for portfolio management. • Systems of loan restructuring to manage problem loans. • Follow up procedures and provisioning of non- performing loans and advances. Docsity.com Policy Framework • Organizational Structure  Board is in charge of the overall risk management policy of the bank  credit  liquidity  interest rate  foreign exchange  price risk Docsity.com Policy Framework  Credit risk management committee  Integration of credit risk management committee with market risk management committee, operations risk management committee and asset liability management committee Docsity.com Policy Framework  Operations / Systems support - Phases of credit process  Relationship management phase Business development Product development System development Docsity.com Credit Risk Rating Framework • Credit rating models. • Credit rating analysts. • Loans to individuals or small businesses. • Credit quality assessed through credit scoring.  Annual income.  Existing debt.  Asset ownership details.  Family status. Docsity.com Credit Risk Limits • Credit limit exposure for each client (borrowers and counterparties). • Total credit limit exposure for a firm. • Total credit limit exposure for an industry. • Total credit limit exposure for a region / division. • Total credit limit exposure for the bank. Docsity.com Credit Risk Limits • Reserve Bank of India Guidelines not more than 15% of capital to individual borrower not more than 40% of capital to a group borrower Aggregate ceiling in unsecured advances not to exceed 15% of total demand and time liability (DTL) of the bank • Threshold limits Credit rating of the borrower Past financial records Willingness and ability to repay Borrower’s future cash flow projections Docsity.com Altman’s Z Score Model Usage of Z score of the firm • Z1 or more – Excellent firm • Z2 to Z1 – Safe • Z3 to Z2 – Doubtful performance • Below Z3 – Expected to become bankrupt Where: Z1 > Z2 > Z3 Docsity.com Credit Metrics Model Assessment of portfolio risk due to changes in debt value caused by changes in credit quality Applications • Reduces portfolio risk • Sets exposure limits • Identify correlations across portfolio • Reduce potential risk concentration • Results in diversified portfolio • Reduction of total risk Docsity.com Value-at-Risk Model • Estimate of potential loss in loan portfolio over a given holding period at a given level of confidence. • Probability distribution of a loan portfolio value reducing by an estimated amount over a given time horizon. • Time horizon estimate is over a daily, weekly or monthly basis. Docsity.com Merton Model (Example) • Expected asset value (1 year hence) 200 billion • Default point (DP) 140 billion • Volatility of asset value 12% • Asset value 250 billion • If from historical observation the number of banks among 80 banks that have a default point of 2.00 are 12, then EDF = 12/80 =15% ( ) 200 140 2.00 0.12 250 t v E V DP DFD V Docsity.com Merton Model (Example) • Relationship between DFD and EDF EDF 15% 2.0 DFD Docsity.com • Mark-to-market concept • Allocates capital to a transaction at an amount equal to the maximum expected loss (at a 99 percent confidence level) • Basic risk categories • interest rate risk • credit risk • operational risk • foreign exchange risk Risk Adjusted Rate of Capital for Banks Docsity.com Risk Mitigation • Needed procedures Documentation made for all credit related transactions Collateralized transactions monitored regularly Legally binding terms for the credit transaction Review of borrower performance profile Alternate options in terms of loan restructure to changed scenarios Docsity.com Credit Audit • Compliance with pre sanction and post-sanction processes set by the external and internal audit committee • Special compliance requirement by the credit risk management committee of the Board of Directors of the bank Docsity.com Credit Audit • Bank credit audit Quality of credit portfolio Review of loan process Compliance status of large loans Report on regulatory compliance Independent audit of credit risk measurement Identification of loan distress signals Review of loan restructuring decisions in terms of distress loans Review of credit quality Review of credit administration Review of employee credit skills Docsity.com