CREDIT RISK MANAGEMENT Lack of appropriate lending discipline and inadequate systems of control generally result in setback to banks.

Banks have also suffered from poor transactions management, incomplete credit information, poor documentation and gross inadequacy in pricing risks. For banks, credit risk is the foremost of all the risks, in terms of importance. Default risk, a major source of loss, is the risk that customer fail to comply with their obligation to service debt. Default triggers a total or partial loss of any amount lent to a counterparty. Decline in the credit standing of an obligor of the issuer of a bond or stock, is also a type of credit risk. Such deterioration does not imply default, but the probability of default increases. In the market, a deterioration of the credit standing of a borrower does materialize into a loss because it triggers an upward move of the required market yield to compensate the higher risk and triggers a value decline. The major credit risk are exposure, likelihood of default, or deterioration of the credit standing, and the recoveries under default. Scarcity of data makes the assessment of these components a challenge. Ratings are traditional measure of credit quality of the debts. Because ratings are ordinal measures of credit risk, they are not sufficient to value credit risk. Portfolio models show that portfolio risk varies across banks depending on the number of borrowers, the discrepancies in size between exposures and the extent of diversification among types of borrowers, industries and countries. There are various challenges of credit risk measurement, enumerated as under: Credit risk for traded instruments raises a number of conceptual and practical difficulties: a) What is the value subject to loss, or exposure, in future period? b) Does the current price embed already the credit risk, since the market prices normally anticipate future events and to what extent? c) Will it be easy to sell these instruments when signs of deterioration gets stronger? And d) Will the bank hold these instruments longer than under normal conditions?

Modelling default probability directly with credit risk models remains or major challenge. Another challenge of credit risk measurement is capturing portfolio effects. Due to scarcity of data, quantifying the diversification effect poses a great challenge.

Managing Credit Risk Use of covenants effectively as a pre-emptive device before credit standing deteriorates or losses occur. The rationale behind use of covenants is as under: They help to protect the banks from any significant deterioration in the risk profile of the borrower transactions without prior agreement. They allow banks to do restructuring of the loans in such instances. Covenants make it costlier for the borrower to default, because he loses the value of continuing operations. Covenants are incentives against moral hazard, since they restrict borrowers from taking additional risk that would increase banks risk. Collateralization in Credit Risk Mitigation A prudent collateralization practice can be effectively used to mitigate credit risk. Collaterals also act as an incentive for the borrower to fulfill debt obligations effectively. Collaterals may be in the form of real assets, securities, goods, receivables and margin borrowing the value of the collaterals vis--vis the loan amount, would depend upon the creditworthiness of the borrower and the level of risk associated with credit facility. In case the borrower fails to perform the debt obligations, the original credit risk turns into a recovery risk plus an asset value risk, which could be: a) Accessibility risk (difficulty to effectively seize the collateral), b) Integrity risk (the risk of damage to the collateral), c) Legal risk (risk of disputes arising from various laws in connection with asset seizure), and d) Valuation risk (the liquidation value of a collateral depends on the existence of secondary market and the price volatility of such a market). These uncovered through analysis. Overlooking the dangers in such situations results in susceptibility to concentration risk.

Capital Allocation and risk Contributions The risk management framework of the Indian banks needs to lay emphasis on prudent capital allocation system. Risk contributions are the foundation of the capital allocation system and of the risk-adjusted performance measurement system. Capital allocation defines meaningful keys for tracing back the overall risk to its sources. The capital allocation system allows us to break

down and aggregate risk contribution according to any criteria as long as individual transaction risk contribution are available. The capital allocation system provides the risk contributions for individual facilities for both credit risk and market risk. The goal of risk-bases pricing is to ensure a minimum target return on capital, in line with shareholders requirements. A hurdle rate serves as a benchmark for risk-based pricing and for calculating creation or destruction of value. Risk Return Optimization Aspects need to be examined while decidingon reducing risk, at a constant return, and The nature and extent of the collaterals. Increasing revenue , at the same time. Risk return optimization shows how to trade off risk across exposures to enhance the overall portfolio return. There is a potential for enhancement because income is proportional to size while risk is not. Portfolio optimization under global funding constraint means: Managing Concentrations Credit concentrations (as per the Basel Committee ) can be grouped into two categories: a) Conventional credit concentrations which include concentrations of credits to single borrowers or counterparties, a group of connected counterparties and sector or industries, or b) Concentrations based on common correlated risk factors to reflect subtler or more situation specific factors can only be Indian banks need to use models as these provide valuable insight for restructuring and expanding, or contracting, some portfolio segments or individual exposures. In fact, without such models there is no way to compare various what if scenarios and rank them in terms of their risk-return profiles. Further, Indian banks need to develop their own expertise and put sustained efforts for developing internal models, through focused approach, evidenced by internal research and developmental activities. These would help Indian banks to be Basel II compliant, in the very near future. Effective Use of Credit Risk Models Credit risk events, defaults and migrations result in changes in value of credit facilities. The Indian banks need to make effective use of various credit risk models, depending on the size of portfolio.

Progression Towards Stress Testing Stress tests make risks more transparent by estimating the potential losses on a portfolio in abnormal markets. They complement the internal models and management systems used by banks globally for capital allocation decisions. Simply speaking, stress testing is a way to produce alternative scenarios using sensitivity analysis. The New Basel Capital Accord uses more quantitative approaches methods where assumptions can be empirically evaluated. Stress testing should be able to link dramatic changes in the economic environment to the banks portfolio. There are, however, issues such as data availability, portfolio diversity and standardization of model inputs and outputs, which need to be addressed. Effective Use of Derivatives Derivatives help to customize the term structure of credit risk, independent of the underlying assets, bonds or loans. Credit derivatives allow better utilization of the current credit capacity, even though there are no cash deals meeting eligibility and maturity criteria. Securitization in Credit Risk Management The motivation for banks in securitization lies in the following potential benefits: Arbitraging the cost of funding in the market with funding on- balance sheet. Off-loading credit risk to free capital for new operations, and To modify the risk-return profile of the loan portfolio. The issue, when off-loading risks, is whether freeing up capital in this way is economically acceptable. The solution lies in finding out whether this makes the risk-return profile of the banking portfolio more efficient (higher return for the same risk or lower risk for the same return). Analyzing the economics of the securitization transaction requires reviewing all costs and benefits resulting from the specific values of each of the various parameters at the same time of securitization.

Conclusion The increasingly complex and competitive banking warrants sophisticated models for credits risk management. It is important to put in place an agile and dynamic Credit Risk Management

Systems, which addresses the challenges of contemporary banking scenario and strengthens them in their progression towards meeting global benchmarks.

Organizational structure for effective credit administration and risk management function

RBI has advised banks that for successful implementation of effective credit administration and risk management system, they should create a sound organizational structure. RBI has circulated an organizational chart for credit risk management and audit function which is available at Annexure II and have also issued some broad guidelines related to organizational set-up and on functional aspects which are briefly discussed below.

Function of Board and Credit risk Management committee (CRMC) Relating to Risk Management.

A banks Board of Directors should have the overall responsibility for management of credit and other risks. Bank may set up a Board-level sub-committee that should effectively coordinate amongst various committees, namely Credit Risk Management Cimmittee (CRMC). Asset Liability Management Committee (ALCO) and Operational Risk Management Committee (ORMC).

The banks Chairman/Chief Executive Officer (CEO) or Executive Director (ED) should head the Credit Risk Management Committee (CRMC) and the committee should compromise heads of Credit Administrative Deptt. (CAD), Credit risk management Department (CRMD), Treasury Department and Chief Econimist. The size of the committee may depend upon the size of the bank and its loan book.

RBI has also indicated that the Credit Risk Management Committee (CRMC) may undertake the following broad functions: Be responsible for implementation of Credit Risk Policy/stratedy approved bt the banks Board.

Monitor Credit Risk on a bank-wide basis and ensure compliance with prudential exposure limits approved by the board. Recommend to the board, for their approval, the policy on standards for presentation of credit proposals, financial convenants, rating standards and benchmarks. Decide on delegation of credit approving powers, prudential limits on large credit exposures, standards for loan collaterals, portfolio management, loan review mechanism, risk concentration, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliances etc.