1. MBIC Credit Risk Management
Hardik Semlani (08FT-079)
Malay Lakhani (08FT-084)
Niket Chheda (08FT-089)
Subhabrata De (08FT-110)
Sudarshan S (08FT-111)
Vaibhav Tambe (08FT-190)

2. Credit Risk Management
Credit risk is the risk of financial loss owing to the failure of the counterparty to perform its contractual obligations.
Lack of diversification of credit risk has been the primary reason for many bank failures.
Banks have a comparative advantage in making loans to entities with whom they have an ongoing relationship.
This creates excessive concentrations in geographic or industrial sectors. 2 2

3. Credit Risk Contd.
Credit risk is more difficult to quantify than market risk.
Default probabilities are difficult to assess because of the infrequency of defaults.
Credit risk has effectively three components. 3

4. Credit Risk
Credit risk: the chance that a debtor or financial instrument issuer will not be able to pay interest or repay the principal according to the terms specified in a credit agreement.
Credit risk means that payments may be delayed or ultimately not paid at all, which in turn cause cash flow problems and affects the bank’s liquidity.

5. Credit risk is the major single cause of bank failures because about 80% of a bank’s balance sheet relates to aspects of risk management.
Main types of credit risk are:
Personal or consumer risk
Corporate or company risk
Sovereign or country risk
An overall credit risk management review includes

6. The three components of Credit risk
Default risk – The risk of default by the counterparty and is measured by the probability of default.
Credit exposure risk – The risk of fluctuations in the market value of the claim on the counterparty.
At default, this is known as exposure at default.
Recovery risk – Uncertainty in the fraction of the claim recovered after default.
This depends on the seniority of debt, industry and the legal environment.
Thus Credit risk deals with the combined effect of market, default and recovery risks. 6

7. Main challenges
In addition to measuring individual default risk, we also need to measure the co movements of defaults.
We cannot observe occurrences of historical defaults on existing companies.
Defaults are also relatively scarce, especially for investment grade firms.
It is important to evaluate a bank’s capacity to assess, administer, enforce and recover credit instruments.
Credit risk management mainly focused on loan portfolio. 7

8. Enterprise-Wide Risks
Financial Risks
Market Risk
Liquidity Risk
Credit Risk
Credit Risk Associated with Investments
FX risk in a new foreign market
Financial Risk
Asset Liquidity
Derivatives documentation and counterparty risk
Business Risk
Operational Risk
Technology and operations outsourcing
Credit Risk Associated with Borrowers and Counterparties
Funding Liquidity

9. Credit Risk & Market Risk
Credit risk is different from market risk
Credit risk is more contextual.
The time horizon is usually longer for credit risk.
Legal issues are more important in case of credit risk.
If the counterparty defaults, while the contract has negative value, the solvent party typically cannot walk away from the contract.
But if the defaulting party goes bankrupt, while the contract has a positive value, only a fraction of the funds owed will be received. 9

10. Difference between Credit & Market Risk
Item
Market Risk
Credit Risk
Sources of Risk
Only Market Risk
Default Risk, Recovery Risk Also
Distributions
Mainly symmetric
Skewed, not symmetric
Time Horizon
Short term (days)
Long Term (Years)
Aggregation
Business/ Trading Unit
Whole firm vs Counterparty
Legal issues
Not Applicable
Very Important

11. Default Probability
Perhaps the biggest challenge in credit risk modeling consists of assessing the default probabilities.
There are broadly speaking two ways of doing this.
Actuarial methods forecast default probabilities by analyzing factors associated with historical default rates.
Altman Z – score and credit ratings fall in this category.
Credit risk can also be assessed from the price of traded assets whose value will be affect by default. 11

12. Credit Risk Management - Overview
Overview of Credit Risk
Drivers of Credit Risk
Settlement Risk
Pre-settlement Vs Settlement Risk
Measuring Credit Risk
Notional Amounts
Risk Weighted amounts
External/ Internal credit ratings
Internal portfolio credit models
Credit Risk Diversification
Credit Risk is Economic loss from the failure of a counterparty to fulfil its contractual Obligations
Measuring Credit Risks
Notional Amounts
Risk Weighted amounts
External/ Internal credit ratings
Internal portfolio credit models

13. Credit Portfolio Management
A lending policy should contain an outline of the scope and allocation of a bank’s credit facilities and the manner in which a credit portfolio is managed.
Flexibility is important for fast reaction and early adaptation to changing conditions in a bank’s asset mix and market environment.

14. Considerations for Sound Lending Policies
Limit on total outstanding loans: relative to deposits, capital or assets.
Geographic limits (usually a dilemma):
Geographic diversification may lead to bad loans if the bank lacks understanding of its diverse markets and/or doesn’t have quality management.
Strict geographic limits may create problems for markets with narrow economies.

15. Considerations contd.
Credit concentrations: lending policy should have diversified portfolio and balance between maximum yield and minimum risk. Concentration limits refer to the maximum permitted exposure to a single client, connected group and/or sector of economic activity.
Distribution by category: it is common to set limits based on aggregate percentages of total loans in real estate, consumer or other categories.

16. Considerations contd.
Type of Loans: lending policy should specify loan types, based on expertise of lending officers, deposit structure and anticipated credit demand.
Maturities: lending policy should establish the maximum maturity for each type of credit, and loans be granted with realistic repayment schedule.
Maturity should be related to the anticipated source of repayment, loan purpose and collateral useful life.

17. Considerations contd.
Loan pricing: rates on various loan types must be sufficient to cover costs of the funds, loan supervision, administrative costs and probable losses. Should provide reasonable profit margin.
Lending authority (determined by bank size): in small banks it is centralized , but decentralized in larger banks to avoid delays.
Limits should be set for lending officers according to experience. Committee authority allows approval of larger loans.

18. Considerations contd.
Appraisal Process: lending policy should outline where the appraisal responsibility lies and should define standard appraisal procedures.
Details should be provided regarding the ratio of the amount of the loan to the appraised value of both the project and collateral.
Maximum ratio of loan amount to the market value of pledged securities: lending policy should set forth margin requirements for securities accepted as collateral, related to the marketability of securities.

19. Considerations contd.
Financial statement disclosure: a bank should recognize a loan (original or purchased) in its balance sheet.
Impairment: a loan should be impaired (when it becomes difficult to be collected) to its estimated realizable value through an existing allowance.
Collections: reports should be submitted to the board with sufficient details to determine risk factor, loss potential, alternative courses of action and a follow up collection procedure.

20. Considerations contd.
Financial information: safe extension of credit depends on complete and accurate information on the borrower’s credit standing.
Lending policy should define financial statement requirements and external credit checks.
Long term loans require financial projections with horizons equivalent to the loan maturity.

21. Credit Portfolio Quality Review
Loan portfolio characteristics and quality are assessed through a review process.
The review includes a random sampling of loans to cover 70% of loans amount and 30% of the number of loans.

22. In addition, should include all of the following loans:
To borrowers if the loan accounts for more than 5% of the bank’s capital.
To shareholders and connected parties.
If interest or repayment terms have been rescheduled or changed.
If interest / principal is more than 30 days past due.
Classified as substandard, doubtful or loss.

23. Loan portfolio analysis should include:
A summary of major loan types (amount and number) including details on: number of borrowers, average maturity, average interest rate.
Loan distribution according to: currency, maturity, economic sector, public Vs. private borrowers, corporate Vs. retail borrowers.
Loans to government
Loan by risk classification
Nonperforming loans

24. Nonperforming Loan Portfolio (NPLP)
NPLP is a loan which is considered not performing (not generating income)
In commercial loans, where principal or interest on it is more than 90 days overdue
In consumer loans, where principal or interest on it is more than 180 days overdue
NPLP is an indication of the quality of the total loan portfolio and bank’s lending decisions.
Another indicator of portfolio quality is the bank’s collection ratio.

25. Single client lending
Single client: an individual / legal person or a connected group to which a bank is exposed.
Single clients present a singular risk to the bank if
financially interdependent and
share the same source of repayment.
Large exposure may be an indication of bank commitment to support specific clients.
Loan officer needs to frequently monitor events affecting large debtors and their performance.

26. Related party lending
Lending to connected parties is a dangerous form of credit exposure.
Related Parties: includes bank’s parent major shareholders, subsidiaries, affiliate companies, directors and executive officers.

27. Credit Risk Management Policies
Specific credit risk management measures typically include three kinds of policies:
Policies limit or reduce credit risk
Policies of asset classification
Policies of loan loss provisioning

28. Policies to Limit or Reduce Credit Risk
Traditionally, bank regulators pay closer attention to risk concentration to prevent excessive reliance on a large borrower.
Modern regulators stipulate that a bank not make investments or grant large loans in excess of a prescribed percentage of capital or reserves.
Basel imposes 25% single-customer to capital

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