Credit Risk

Meaning

Credit risk is defined as the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms.

The RBI’s guidance note on credit risk defines credit risk as the “possibility of losses associated with diminution of credit quality of borrowers or counterparties”.

Credit risk may take various forms, such asNature of Dealings Nature of Credit

Risk

Direct Lending Non-Repayment

Guarantee/Letter of credit

Non-Payment under Contract

Securities Trading Non-Settlement of Trade

Treasury Products Non-Payment of Dues from Contract

Reasons for Credit RiskMany credit problems reveal basic weaknesses in credit

granting and monitoring process: Lack of Credit Assessment: basic diligence is a

challenge for many banks Lack of testing and validation of new lending techniques Subjective Decision-making by Senior management Lack of effective Credit review process -Failure to monitor Borrower/Collateral values -Failure to detect Credit –related Fraud Neglecting Business Cycle effects in lending Non-use of risk sensitive pricing No caution on leveraged credit arrangements

Approaches to Credit Risk Measurement Four approaches

Expert Systems Credit Rating Financial Ratios Credit Scoring

Expert systems Expert Systems: In an expert system, the

decision to lend is taken by the lending

officer who is expected to possess expert knowledge of assessing the credit worthiness of the customer.

5C’s of credit are taken into consideration here.

1. Character 2. Capacity 3.Capital 4. Collateral and 5. Cycle or economic conditions

Credit Rating

A credit rating represents the agency’s opinion about the creditworthiness of an obligor with respect to a particular debt security or other financial obligation.

Credit agencies in India-CRISIL, ICRA, CARE, DCR India

International rating Agencies- Standard & Poor and Moody’s

Ratings awarded by major credit rating agencies AAA Highest Safety AA High Safety A Adequate safety BBB Moderate safety BB Sub Moderate safety B Inadequate safety C Substantial Risk D Default

Financial Ratios

Liquidity Ratios

Current Ratio =CA/CL

Quick Ratio = (CA – Inventories)/CL

Net working Capital = CA - CL

Profitability Ratios

Return on Equity = Net Income/Average Total equity

Return on Assets = Net Income/Average Total assets

Return on capital employed =EBIT/Average capital employed

Gross profit ratio = Net sales –COGS/Net sales Operating profit ratio = Gross profit –operating

expenses/Net sales

Leverage Ratios

Debt-Equity Ratio = Total outside liabilities/Net worth

Long term liabilities ratio = Long term debt/ Net worth

Interest coverage ratio = EBIT/ Interest expense Dividend payout = Cash dividends paid/Net

profit after tax

Credit scoring models:

Uses mathematical models to combine financial information of borrowers into a credit score.

The model developed by Altman(1968), called Z-score model is among the popular models. The model classifies borrowers based on a score derived from a linear combination of chosen financial ratios.

Formula for Z score:

Z = 1.2X1 + 1.4X2 +3.3X3 +0.6X4 +0.999X5

Where X1 = Working capital/Total assets X2 = Retained earnings/Total assets X3 = EBIT/Total assets X4 = Market value of equity to book

value of total liabilities X5 = Sales/Total assets

If Z score > 3 , the company is unlikely to default.

Between 2.7 AND 3.0, should be on alert Between 1.8 and 2.7, there is a good

chance of default. Less than 1.8, the probability of financial

default is very high

Example

Consider a company for which working capital is170,000 , total assets are 6,70,000, earnings before interest and taxes is 60,000,sales are 22,00,000, the market value of equity is 3,80,000, total liabilities 240000 and retained earnings is 3,00,000. Find the Z-score.

Z-Score

1.2*0.254+1.4*0.448+3.3*0.0896+0.6*1.583+0.999*3.284 =5.46

Indicates that the company is not in danger of defaulting in the near future.

Credit Risk Management

Credit risk can be monitored atMicro level – Non-performing AssetsMacro level – Capital Adequacy Ratio

NPA - ASSET CLASSIFICATION

NPAs are loans given by a bank or financial institution wherein the borrower defaults or delays interest or principal payments.

According to RBI norms, any interest or loan repayment delayed beyond 90 days has to be identified as a NPA.

SUB-STANDARD ASSETSThese are assets which come under the category of NPA for a period of less than 12 months.

DOUBTFUL ASSETSThese are NPA exceeding 12 months

LOSS ASSETS These NPA which are identified as unreliable by internal inspector of bank or auditors or by RBI.

Is considered uncollectible with so less value, even if there is any recovery value

Quantifying Credit Risk Classifying loans into performing and non-

performing will enable the banks to determine the amount of provisioning that is to be made. Loss assets -100% provision Doubtful asset- 100% to unsecured portion and20%

to 100% depending upon the period for which the asset has remained doubtful.

Period for which the asset has been considered as doubtful % of provision

Up to one year 20% One to three years 30% More than three years 100%

Substandard assets -10% provision

Macro level – Capital Adequacy Ratio

The capital adequacy of the bank which is the ratio of its capital to its risk weighted assets comments on the extent to which the possible losses can be absorbed by the capital.

CAR =C/RWA

Example1. Synergy Banking Services Ltd. has an

asset base of Rs.1000crore out of which 60 percent carry 100 percent risk weight, 30 percent carry 50 percent risk weight and the remaining zero percent risk weight. Compute the CAR if it has a capital of Rs.150 crore.

150

CAR = -------------------------------------------

600*1 + 300*0.5 +100*0

= 20%

The Basel II proposals for credit Risk Following approaches are mentioned by

Basel II. Standardized method Internal Rating Based( IRB) approach-

foundation Internal Rating Based( IRB) approach-

Advanced

Standardized method

Risk weights for different categories of assets are assigned for different categories of assets on the basis of external ratings by approved rating agencies.

Risk weights under standardized approach for credit risks

AAA

To

AA-

A+

To

A-

BBB+

To

BBB-

BB+

To

BB-

B+

To

B-

Below

B-

unrated

Country 0 20 50 100 100 150 100

Banks 20 50 50 100 100 150 50

Corporations

20 50 100 100 150 150 100

Suppose that the assets of a bank consist of Rs.100 million of loans to corporations rated A, Rs.10 million of government bonds rated AAA, and Rs.50 million of residential mortgage, Under Basel II standardized approach, what is the total risk weighted assets ?

0.5*100+0.0*10+0.35*50 =Rs. 67.5 million

Internal Rating based Approach

This approach allows banks to use their internal estimates of probability of default (PD), loss given default rate (LGD) and exposure at default (EAD).

PD -What is the probability of counterparty defaulting?

EAD -If the counterparty defaults what is our exposure?

LGD – How much of the exposure amount do we expect to loose?

In the foundation approach, the banks are allowed to estimate the PD while the supervisor will provide LGD and EAD.

In the advanced approach, banks would use their own estimates of PD, LGD and EAD.

Expected Loss (EL)= PD x EAD x LGDBanks may assume from experience:

1 % of loans to Default/year; 40 % of recovery rate

Expected Loss:For credit portfolio of Rs. 1000 crore,

EAD=1000cr,PD=1%, LGD=60%

EL= 1000*.01*.6 =6crore

Credit Granting Process

In India, RBI prescribed exposure limits for bank lending to individuals and groups. Credit limit for a single borrower is fixed at 15% of the

banks capital funds. For Group -40% of the bank’s capital funds Limit can be overshot up to 5% for individual and 10%

for gp borrowers in the case of lending for infrastructure projects.

These limits can be further extended by 5% with approval of BODs.