Course: Credit Management (Module III: Credit Management) NIBM, Pune

Module III: Credit Management

Chapter 5: Credit Management and Credit Risk Management

Dr R. Bhaskaran

Objective: This chapter covers credit management and credit risk management. On
completing this chapter candidate will have good understanding of issues in credit
management, how to distinguish loss and risk and how credit risk is managed

Structure
1. Introduction
2. Risk management organization and systems
3. Major risks
4. Loan policy
5. Best practice in credit management
6. Understanding credit risk management

1. Introduction

Lets’ consider the following

i. A bank lends to a known defaulter and loses its money. Is this risk? Many will say
“No it is not a risk because bank lent to a known defaulter”. Others will say it is
“Credit Risk”. But if one looks closely it will be evident that banks credit appraisal
process, procedures and rules are such that it enables a bank to finance a defaulter
and thus there is a likelihood that this mistake will repeat. This is a credit loss and
operational risk.
ii. A bank invested in a AAA rated bond of blue chip company. After some time, the
blue-chip company went for unwanted diversification, faced huge liquidity issues
and the bond was downgraded to “D” rating. Bank had to provision for the likely
loss. This is clearly market risk as the bank had taken a right decision to invest but
the investment turned out poor.
iii. A banks normal level of NPA was 2% of its loans. It makes full provision for the
same. This year on account of increase in petroleum prices and the delay by the
government in releasing its due to its contractors many companies have defaulted

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or delayed resulting in spurt of NPA. The spurt in NPA will lead to some loss/haircut
etc., which are unexpected losses and is credit risk.
iv. A NBFC is Government owned and AAA rated. It is highly capitalized. All banks like
to invest in that company be it for shorter duration or long term. The company
issues long term loans to State Owned Corporations. Seeing the banks interest in
lending to it, the company started borrowing heavily in CP (90 days) and short term
(180 days) and used it for funding long term loans. At one point 60% of the NBFC
funds were short term, 20 % was equity and remaining long term loans. As the State
Owned Corporations were reeling indebt the Government brought a scheme to
rehabilitate them and asked them not to repay the debts till a new scheme is
brought out. The NBFC defaulted in its CP. The credit rating agency has obviously
erred in giving AAA. Banks have erred because at the time of investing they went by
AAA and did not do their own due diligence. Result is credit and market risk.
v. Recently one of the flamboyant airlines went burst and almost all banks had
exposure to the company. It was learnt that at one point of time all banks had
pursued eagerly with the airline for accepting a line of credit. Now all of them are
trying to catch hold of the airline baron. This is a case of combination of credit and
operation risk. Operation risk because for banks to lend to the airline at prime or
less than prime rate some procedures should have been bypassed.
Many more such examples of risks can be given. The intention is not to list all of them but
drive home a point that risk is inherent to banking and finance. In the pursuit of profit,
growth and need to be liquid banks could run into known and unknown losses.

Given this we can start this chapter with a statement that in the process of financial
intermediation, banks are confronted with various kinds of financial and non-financial
risks. Over the years the items included in the list of risks has been increasing. It appears
that the list will only increase. In view of this we can say that currently risks faced by banks
include credit risk, interest rate risk, foreign exchange rate risk, liquidity risk, equity price
risk, commodity price risk, legal risk, regulatory risk, reputational risk, operational risk,
compliance risk etc. These risks may happen independent of each other. But the above
examples show that generally these risks are highly interdependent and events that affect
one area of risk can impact a range of other risks.

Another issues that we must discuss before we go further is certain myths and perceptions
about risk.

Consider this statement

i. Higher the risk higher the reward.

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This statement justifies taking risk as higher rewards seem assured! It must be clarified
that it is not always so. Let us study this further. CIBIL credit score ranges from 300 to 900.
Anything above 750 is considered a good credit score. All banks /NBFCs usually look at the
credit score as one of the many things to check before advancing a loan. A banks base rate is
8.40. It lends to a customer with a CIBIL score of 750 and above at 8.6%. For every dip in
the score by 50 points bank adds 0.10% interest. It does not lend for scores less than 500.
What this means is that for a score of 500 the Rate of Interest will be 9.10%. One of the
main reason for a person having a low score could be his/her cash flows. Given this a
higher debt service will be pose more difficulty to the customer. From the banks angle if
the person were to default it means for a additional interest of 50bps it lost the entire 100
principals. High risk no doubt means high rewards but more importantly it means very
high losses. This kind of pricing works well in portfolio (home loan is a portfolio for a
bank) basis as the default is by a few people whereas everyone pays risk premium. Note
that for those who have high scores the bank charges premium on rate as well. Risk is
cross subsidised by regular borrowers in a bank. Thinking that a higher rate compensates
higher risk if the bank were to take very high exposures then a sub-prime disaster will
happen!

ii. Risk taking for profit.

Risk is uncertain. Therefore, if risk is taken there is a probability that the risk may
nothappen. Given this if the probability is known and the risk appetite is given it should be
possible to pursue some risky investments and credit and make high returns. This
argument is in fact an extension of the point given above about risk reward relationship. On
the other hand, if the risk happens then the bank will lose the entire credit and investment.
In view of this pursuing risk as an opportunity to make more profit cannot be the normal
course of business for the bank. Banks should confine themselves to managing risks that
they face in the normal course of business.

iii. Risk can be diversified.

Diversification reduces the impact of risk and does not eliminate the risk in a given
instrument or investment. Diversification ensures that impact of the risk is not heavy on
the bank. Diversification ensures that exposures are limited and hence the impact is
limited.

iv. Risk can be hedged.

True. Risk can be hedged in the market by appropriate instruments. Hedge has a cost.
Hedging does not mean that if the risk occurs the potential loss is fully covered by hedge.
Cost of hedge has to be well understood. Take the case of insurance. It is incurred every

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year whereas fire or other risks happen once in a while. Given this cost of hedge should be
carefully evaluated particularly when one resorts to exotic hedge instruments.

Another form of diversification is to resort to securitisation. Even in this a portion of the

costs remain with the issuing bank or company. As such risk cannot be fully hedged and
excessive hedge cost can bring down the organisations.

v. Risk culture and risk appetite

The Financial Stability Board defines risk culture as “the norms, attitudes and behaviors
related to risk awareness, risk taking and risk management.” Risk culture is effective when
it promotes sound risk-taking, addresses emerging risks (beyond risk appetite), and
ensures employees conduct business in a “legal and ethical manner.” This means that bank
should have well calibrated risk policy of do’s and don’ts, products, product selling and
services which reflect honest and ethical business. Risk appetite is therefore defined by
risk policy. Culture and appetite should be same in letter and spirit. Both these terms have
to be demonstrated by the management of the bank and Board. For example, Management
and CEO of the bank say KYC compliance should be 100% but at the branch or product
selling level the manager says KYC is discretionary then the risk culture is in paper and not
in practice. This dichotomy is often observed in selling third party products in bank which
could ultimately result in operational risk.

In the above paragraphs, a reasonable view of risk and risk management issues have been
given. It clearly shows that banks face many risks. It is also seen that it is difficult to predict
the timing of risk and management of risk is equally complicated. In view of this top
management of banks should attach considerable importance identifying, measuring,
monitoring and controlling risks in the organisation. For this purpose, managements
should establish a well empowered risk management department or function within the
bank. Such risk management function should encompass:
i) organisational structure;
ii) comprehensive approach to risk measurement
iii) appropriate risk management policies (Policies approved by the Board
consistent with the extant regulation, broader business strategies, capital
strength, management expertise, specifying overall risk culture and appetite).
iv) guidelines and other parameters used to govern risk in terms of business
mix and risk limits.
v) Risk monitoring and control frame work including MIS for reporting.
vi) Appropriate control system.

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This risk management framework should be independent of framework of each operational

departments and should have clear delineation of levels of responsibility for management
of risk. The entire framework and policies should be reviewed and evaluated periodically.

2. Risk management organisation and systems.

Risk management function in a bank should be based on its size, complexities and the
number of geographies in which it functions. Risk management function could be
centralised or decentralized. Availability of advanced technology and nearness to financial
markets are the reasons why banks choose centralised management structure. In a
centralised system information on various risk parameters and market information are
available on-line and real-time basis. It must be added that integrated treasury
management department is also centralised which is helpful in risk management functions.
Apart from this Banks should adopt risk management system suitable their size, business
mix, complexity of functions, the level of technical expertise and the quality of MIS

Further the Board of the bank should ensure that all risks are well understood and
managed by the bank by framing appropriate risk management policies, limits, procedures
and control. Board has the responsibility to ensure that the policy is implemented properly.
Risk limits should reflect banks risk bearing and risk management capacity.

At the organisational level, overall risk management should come under an independent
Risk Management Committee or Executive Committee of the top management executives.
The committee should report directly to the Board of Directors. This committee should be
an empowered group with full responsibility of evaluating overall risks faced by the bank
and determining appropriate levels of risks and take action best suited to the bank. The line
managements, however are fully accountable for the risks under their control. They should
manage and control risk.

Every bank should have a risk management policy. It will deal with The functions of Risk
Management Committee should be, as per policy statement of the bank
i. Identify, monitor and measure the risk profile of the bank.
ii. Develop, from time to time review risk policies and procedures and
recommend changes if any to the Board
iii. Verify the risk measurement models that are used for pricing complex
products
iv. Review the risk models as and when development takes place in the markets.
v. Quantify and specify prudential limits based on Board policies. on various
segments of banks’ operations. These limits could be in terms of portfolio

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standards or Credit at Risk (credit risk) and Earnings at Risk and Value at Risk
(market risk).
vi. Design stress test scenarios to measure the impact of unusual market
conditions and monitor variance between the actual volatility of portfolio
value and that predicted by the risk measures.
vii. Monitor compliance of various risk parameters by operating Departments.

It must be added here that robust MIS is a prerequisite for establishment of an effective risk
management system is the existence. Quality of MIS is also equally important.

In addition to risk management committee banks will have Asset - Liability Management
Committee (ALCO) which deals with different types of market risk and the Credit or Loan
Policy Committee (CPC) which stipulates and monitors credit /counterparty risk and
country risk in respect of the credit function. Generally, the policies and procedures for
market risk and liquidity are articulated in the ALM policies and credit risk is addressed in
Loan Policies and Procedures. As such RMC will function as a single Committee for
integrated management of credit, market risks and operational risk.

Generally, market variables are held constant for quantifying credit risk and credit
variables are held constant in estimating market risk. The past few financial crises have
however shown that most risks are interdependent and there exists a strong correlation
between unhedged market risk and credit risk. Un hedged Forex exposures with
corporates could increase the credit risk of banks who have financed them. The volatility in
the prices of collateral could also impact the quality of the loan book. In view of this RMC
should factor the views of ALCO and CPC and evaluate the impact of market and credit risks
on the financial stability/strength of banks.

3. Major Risks:
Banks face Credit risk, Market risk, Operations risk and liquidity risk. In this lesson we will
learn about credit risk

3.1 Credit Risk

Lending can result in a number of risks. Major risk among these is the risk of default which
is commonly known as credit risk. Credit risk is the probability that the borrower could
delay payment of interest or repayment of loan or completely defaults in the repayment of
loan. In view of this, every bank will carefully evaluate every proposal for risk in lending
and take decision on pricing of loan, security, collateral, debt service etc. based on specific
parameters which are focused on containing if not eliminating risk. In case of loans and

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investments, in addition to the risks related to creditworthiness of the counterparty, banks

are also exposed to interest rate, forex and country risks.

“Credit risk is most simply defined as the potential that a bank borrower or counterparty
will fail to meet its obligations in accordance with agreed terms” 1. Credit risk or default risk
is the probability of inability or unwillingness of a customer or counterparty to meet
commitments to the bank in relation to its borrowing from the bank. Credit Risk could be
transaction risk (default) or portfolio risk. Review of portfolio risk is getting increased
attention from banks in terms of measuring and managing the risk from credit exposures.
Portfolio risk of a bank depends on both external and internal factors. The external factors
include the state of the economy, volatility in (i) commodity/equity prices, (ii) foreign
exchange rates and (iii) interest rates, trade restrictions, economic sanctions, Government
policies, etc. The internal factors include deficiencies in loan policies/administration,
absence of prudential exposure limits which increases credit concentration, inadequately
defined lending powers for Loan Officers/Credit Committees, deficiencies in appraisal,
excessive dependence on collaterals, inadequate risk pricing, absence of effective loan
follow up, loan review mechanism etc.

Credit risk is nothing but counterparty risk. In a loan, the counterparty is the borrower. In
an investment, it is the issuer or issuing company. In the case of forex or other transactions,
it is the trading partners. The non-performance in a credit may arise from counterparty’s
refusal/inability to perform due to adverse price movements or from external constraints
that were not anticipated by the principal. It should however be seen that counterparty risk
is generally associated with financial risk associated with trading. As such risk of loan
default is called credit risk.

Lending is one of the major functions of the bank and credit is the largest asset in the
business of banks in India. For example, outstanding bank credit by commercial banks in
India on March 31, 2016 stood at Rs 78.96 lakh crore . This formed 60.3 % of total assets of
commercial banks as on that date. Given this a high default risk could have serious
implications for the banking system. In view of this credit risk should receive the top
management’s attention. Top management should consider risk prevention and risk
management. This can be achieved by

a) Adhering to high standards of credit appraisal including measurement of risk through

credit rating and credit scoring;
b) Adhering to industry and individual exposure limits

1
Principles for the management of credit risk: BIS: https://www.bis.org/publ/bcbsc125.pdf
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c) Appropriate risk pricing

d) Controlling loan losses through loan review mechanism
e) Participating in credit guarantee scheme (like CGTMSE) where applicable

Bank should periodically quantify credit risk through estimating expected loan losses and
unexpected loan losses.

Expected loss as the name indicates is the loss that a bank expects from a loan. Unexpected
loss is the loss that exceeds such expectations. Statistically expected loss is the average
credit loss that we would expect from an exposure or a portfolio over a given period of
time. Expected loss is the summation of expected losses of individual assets. This is
estimated based on past performance and statistical evaluation. Since the expected loss is
what a bank expects it is expected that it would have budgeted for it. Bank should not
normally find it difficult to manage known and expected losses.

Unexpected loss, is the average total loss over and above the mean loss (expected loss). It is
calculated as a standard deviation from the mean at a certain confidence level. It is also
referred to as Credit VaR. As per regulatory norms a bank will have to safeguard itself from
unexpected losses by allocating stipulated level of capital.

4. Loan Policy

3.1 Loan policy is a board approved document that details loan mix, products and pricing
of loans of a bank and general eligibility for the loans. Loan policies will specify standards
for approval of credit proposals, terms and conditions, internal and external rating
standards and benchmarks, delegation of sanction powers, prudential limits on large credit
exposures, limits on asset concentrations, types, quality and extent of loan collaterals,
portfolio management, loan review mechanism, risk concentrations, risk monitoring and
evaluation, pricing of loans, provisioning, compliance to legal and regulatory norms etc. As
such loan policy contains scope, rules, regulations, and procedures for credit function and
credit risk management.

All banks will have a Credit Policy Committee to deal with (a) issues relating to credit
policy and procedures and (b) to analyse, manage and control credit risk for the bank as a
whole. The Committee should review and recommend policy changes to the Board for its
approval. Another important committee is Credit Risk Management Department (CRMD).
The CRMD should ensure compliance to the risk parameters and prudential limits set by
the CPC. CRMD will also lay down risk assessment systems, monitor quality of loan
portfolio, identify problems and correct deficiencies if any, develop MIS and undertake loan

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review/audit. Large banks may consider separate set up for loan review/audit. CRMD is
vested with the responsibility of protecting the quality of the entire loan portfolio. The
Department should undertake portfolio evaluations and conduct comprehensive studies on
the environment to test the resilience of the loan portfolio.

5. Best practices in Credit Risk Management

Credit Risk Management encompasses a host of management techniques, which help the
banks in mitigating the adverse impacts of credit risk.

5.1 Credit approval and authorization system

Delegation of powers for credit sanction will depend on the size and business mix of the
bank and its spread in geographies. Loans which are relatively riskier should be sanctioned
by higher levels in the credit hierarchy while loans with lower risk should be sanctioned at
lower levels. For example, powers for sanctioning gold loan and loan against FD should be
with the branch subject to certain business volumes or budget. At the same time big
corporate loans should be considered by specialised branches or central committee. Home
loans could be sanctioned by home loan branches which houses officials with special
knowledge and training. Thus, each bank should have a carefully formulated scheme of
delegation of powers.

In case of large volume loans banks should also evolve multi-tier credit approving system
where the loan proposals are approved by a ‘Committee’. Generally, credit facilities above a
specified limit may be approved by the ‘Committee’, which could include a member of
CRMD, who has no volume and profit targets and therefore will take a more impassionate
view of the proposal. Banks can also consider credit approving committees at various
operating levels i.e. large branches (where considered necessary), Regional Offices, Zonal
Offices, Head Offices, etc.

Given this it important that banks evolve suitable framework for reporting and evaluating
the quality of credit decisions taken by various officials/ groups. The quality of credit
decisions should be evaluated within a reasonable time, say 3 – 6 months, through a well-
defined Loan Review Mechanism.

5.2 Prudential Limits

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It is difficult to say no to a very good customer. At the same time banks should be vary of
risk of concentration. In view of this banks are expected to contain exposure to a single
party. For this purpose prudential limits should be laid down on various aspects of credit:
a) Appraisal Standards. Bank should stipulate threshold or acceptable financial
performance standards in terms current ratio (liquidity), debt equity ratio (financial
leverage) and PAT and EBIT (profitability) debt service coverage ratio ( ability to
pay) etc. Instead of stipulating this narrowly a bank could adopt a band or range for
these ratios. Similarly in case of retail credit it should specify LTV and FOIR. As these
ratios are stipulated for the bank as whole it should also specify permitted deviation
and the authority to approve deviations.
b) Exposure Limits: The idea behind exposure is to diversify risk. As banks have to
comply with limits prescribed by RBI it is preferable to keep these limits lower than
what RBI has indicated in its guidelines.

i. Single/group borrower limits: Generally, this is defined by various bench mark

that are mentioned in the paragraph above. The loan amount can be further
limited by stipulating an amount beyond which the bank will have exposure. For
example, it can be said that maximum amount for a home loan could be limited
at Rs 5 Crore. In respect of exposure to business bank may peg its limit to certain
multiples of owned funds of the borrower.
ii. Substantial exposure limit i.e. sum total of exposures assumed in respect of those
single borrowers enjoying credit facilities in excess of a threshold limit, say 10%
or 15% of capital funds of the bank. In these cases, the exposure limit may be a %
of capital funds depending upon the degree of concentration risk the bank is
exposed;
iii. Bank should also fixe maximum exposure limits to industry, sector, etc.
iv. There must also be systems in place to evaluate and review the exposures at
reasonable intervals. Where ever the particular sector or industry faces
slowdown or other sector/industry specific problem exposure limits should be
contained.
v. The exposure limits to sensitive sectors which are by nature subject to a high
degree of asset price volatility specific to industries and volatility due to
frequent business cycles namely advances against equity shares (market is
volatile) real estate (sector has its own ups and downs) should be limited.
Further if the bank feels some industries are high risk it may stipulate a lower
overall exposure.

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There will be occasions when the exposure limit may be breached like a borrower needing
temporary excess limits. There could be some strategic considerations for increase in
exposure. All such excess exposures should be fully backed by adequate collaterals.
In arriving at the exposure limits banks may keep in reckoning maturity profile of the loan
book, market risks inherent in the balance sheet, risk evaluation capability, liquidity, etc.

5.3 Risk Rating

Risk is not current or past. It is in future. Risk estimates are projections of past data with
statistical tools. The same set of past data and information can also be used to rate the
borrower for possible risks. Banks should use both internal and external rating system of
borrowers. Risk rating will serve an indicator of riskiness of the counterparty and for
taking credit decisions in a consistent manner. Risk rating of client loans (borrower or
facility rating) is based on borrower its antecedents, financial position, track record of
banking, profitability of current business etc. Bank collects information on these
parameters and assigns scores to each item. Bank compares the rating obtained by the
borrower to its threshold rating/score decide whether credit can be extended. External
rating is given by credit rating firms who collect information from the borrower, analyse
the same and arrive borrower’s credit rating. Internal credit rating would call for a score
card which is well developed and standardised across borrowers. The risk rating system
should be such that it reveals overall risk of lending and gives critical input for arriving at
terms of credit more importantly pricing.

Risk rating is also concerned with portfolio rating. This is an exercise of analysing the
banks loan book based on past performance and estimating the probability of risk and loan
losses. The risk rating, in short, should reflect the underlying credit risk of the loan book.
The rating exercise should also facilitate the credit granting authorities some comfort in its
knowledge of loan quality at any moment of time.

Rating symbols and its meaning

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The risk rating of borrowers should carried out in a well designed manner based on
financial analysis, projections and sensitivity, industrial and management risks. Banks will,
generally use a number of financial ratios and operational parameters that shows the credit
worthiness of the borrowers coupled with qualitative aspects of management and industry
characteristics that will impact the borrowers. Financial analysis will be taken up for the
immediate past few years. Rating method or information sought may not be the same for
all type of borrowers as large corporates, SME, small borrowers, traders, will have different
risk characteristics. Bank should prescribe the acceptable rating for each of its product and
type of customers which means a minimum rating below which no exposures would be
taken up. The loan policy should clearly state the procedure for any deviation in the laid
down criteria.

The credit risk assessment exercise should be repeated in regular periodicity, at least once
in a half year. This is independent of credit review. Having done the credit rating bank
should critically evaluate the rating migration of borrowers, portfolio, credit category etc.,
to understand the movement in the quality of its credit portfolio. Variations in the ratings
of borrowers over time indicate changes in credit quality and expected loan losses from the
credit portfolio. Thus, if the rating system is to be meaningful, the credit quality reports
should signal changes in expected loan losses. In order to ensure the consistency and
accuracy of internal ratings, the responsibility for setting or confirming such ratings should
vest with the Loan Review function and examined by an independent group of officials.

5.4 Risk Pricing

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Risk-return analysis and risk based pricing are fundamental aspects of risk management.
In a risk-return backdrop, borrowers with weak financial position are placed in high risk
category and hence the price of credit (ROI) is high. Given this, banks should evolve
appropriate metrics to price the loans. Risk based pricing could be portfolio pricing or
individual. Generally, banks add risk cost in arriving at the lending rates. Loan pricing could
be based on average cost or marginal cost. The pricing issues are critical and should be
done carefully and reviewed periodically.

Pricing of loans normally be based on risk rating or credit quality. Credit quality of
portfolio is decided on past behaviour of the loan portfolio, which is the function of loan
loss provisions and write offs in the past five years or so. Banks should build historical
database on the portfolio quality and provisioning etc., to enable them to price the risk. It
should be added here that value of collateral, competition, perceived value of accounts,
future business potential, portfolio/industry exposure and strategic reasons etc., play
important role in pricing. In this connection many banks use Risk Adjusted Return on
Capital (RAROC) framework for pricing of loans. This requires data on portfolio behaviour
and allocation of capital commensurate with credit risk inherent in loan proposals. Under
RAROC framework, lender charges an interest mark-up to cover the expected loss –
expected default rate of the rating category of the borrower. The lender then allocates
enough capital to the prospective loan to cover some amount of unexpected loss-
variability of default rates. It is a prudent practice to allocate enough capital so that the
expected loan loss reserve or provision plus allocated capital covers 99% of the probable
loan loss outcomes.

Competition, regulatory guidelines etc play an important role in pricing. Banks policy
should contain a clear direction on reckoning competition in pricing so that it avoids
adverse selection.

Marginal Cost based lending rate : MCLR

The Reserve Bank of India has changed the base rate system in April 2016 and introduced Marginal
Cost of Funds based Lending Rate (MCLR). Banks have to adopt MCLR as the internal benchmark
lending rates. Over and above MCLR banks will add a margin in accordance with the riskiness of the
borrower with reference to credit score or credit rating. RBI desires that MCLR should be revised
monthly by considering some new factors including the repo rate and other borrowing rates. It is
further stipulated that banks have to set five benchmark rates for different tenure or time periods
ranging from overnight (one day) rates to one year.

The new methodology uses the marginal cost or latest cost conditions reflected in the interest rate
given by the banks for obtaining funds (from deposits and while borrowing from RBI) while setting
their lending rate. This means that the interest rate given by a bank for deposits and the repo rate (for

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obtaining funds from the RBI) are the decisive factors in the calculation of MCLR.

Why MCLR ?
Prior to MCLR banks were seen slow to change their interest rate in accordance with rate change
signals given by RBI through monetary policy despite commercial banks depending to a significant
extent on RBI’s LAF repo for short term funds. MCLR has implications for monetary system and
ensures that rate signals given by RBI impact the market.

What is MCLR.
The word marginal is important to understand MCLR. In economics sense, marginal means the
additional or changed situation. Thus, marginal cost includes those costs that are currently incurred
and not the average cost of funds of the bank. While calculating MCLR, banks have to consider the
current market cost conditions i.e. the cost of raising incremental funds. This will include the interest
rate given to the fresh and renewal of deposits and other borrowings (often referred as cost for the
funds).

Components of MCLR.

1. Marginal cost of funds;

2. Negative carry on account of CRR;
3. Operating costs;
4. Tenor premium.

Marginal Cost of funds: The marginal cost of funds will include Marginal cost of borrowings and
return on networth. According to the RBI, the Marginal Cost should be charged on the basis of
following factors:
i. Interest rate given for various types of deposits- savings, current, term deposit, foreign
currency deposit
ii. Borrowings – Short term interest rate or the Repo rate etc., Long term rupee borrowing
rate
iii. Return on networth – in accordance with capital adequacy norms.
RBI has said that the marginal cost of borrowings shall have a weightage of 92% of Marginal Cost
of Funds while return on networth will have the balance weightage of 8%.

Negative carry on account of CRR: As RBI is not giving any interest on the CRR, negative cost is the
cost that the banks have to incur while keeping reserves with the RBI. For example if a bank gets
Rs.100 crore deposits at 5% and keeps 4% of funds as CRR then effective cost of deposit is 5% ÷ Rs 96
i.e. 5.21%. The negative cost is 0.21%.

Operating cost: is the operating expenses incurred by the banks. This includes cost of establishment
and operations.

Tenor premium: This is the premium for period. Generally the deposit rates are forward looking.
Therefore tenor premium will increase with increase in tenor. This means that bank will charge higher
interest rates on long term loans

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In essence, the MCLR is determined mainly marginal cost for funds and is essentially the
deposit rate and by the repo rate. Any change in repo rate brings changes in marginal cost and
hence the MCLR should also be changed.
Once MCLR is arrived actual lending rate will be MCLR plus risk premium.

Base rate
The base rate is calculated based on:

1. Cost for the funds (interest rate given for deposits),

2. Operating expenses,
3. Minimum rate of return (profit), and
4. Cost for the CRR ( negative carry)
Negative carry on CRR and operating expenses are common factors for both base rate and the MCLR.
Minimum rate of return is explicitly excluded under MCLR.

5.5 Credit Management

The objective of credit management is to (a) reasonable return on the portfolio, (b) and
keep the NPA minimum if not nil. For this, banks must have good appraisal, appropriate
eligibility norms and continuous follow up system for ensuring correct performance of
credit portfolio, precluding accounts from slipping into NPA and tracking the Non
Performing Loans. It should be clear that this is round the year exercise and not merely
around balance sheet dates. Many routine things such as (a) matching the stock turnover
to quarterly sales reported, (b) matching total sale (monthly/quarterly/annual etc) to
corresponding credit entries in the current account, (c) verifying invoices with the finished
goods sales etc will help in understanding disturbances or diversion if any. Verifying
whether or not the company/borrower pays the tax dues in time, if the physical stock
tallies with the stock statement and stock register, cash withdrawals are as per business
requirement etc will help maintain the quality of credit.

In case a company has subsidiaries or keen on expansion into new areas there is the
possibility of loan funds being used for expansion impacting the quality of credit. Only
effective monitoring and keeping close tab on fund cash movement among the companies
will help maintain asset quality. In case a company indulges is sharp practices its credit
quality will deplete. In view of this, credit department should evaluate the loan book
tracking the migration (upward or downward) of each segment of credit and major
borrowers from one rating scale to another. For this it is important that, in respect of
advances above a certain limit, borrower-wise ratings are updated at quarterly / half-
yearly intervals. Migration Data within grading categories would provide useful insights
into the nature and composition of risk in a loan book.

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To manage credit risk, banks may consider

 Stipulating quantitative ceiling on aggregate exposure in specified rating categories, i.e.
certain percentage of total advances should be in the rating category of 1 to 2 or 1 to 3,
2 to 4 or 4 to 5, etc.;
 Periodically evaluate the rating-wise distribution of borrowers in various industry,
business segments, etc., and evaluate the exposure to one industry/sector on the basis
of overall rating distribution of borrowers in the sector/group. This will help the bank
to take informed view on concentration by industry group. Also wherever a particular
industry is performing poorly bank should consider increasing due diligence and
quality standards for that specific industry;
 Targeting rating-wise volume of loans, defaults and provisioning requirements and
contain the actuals within the budget. If actual numbers show deviation/s from the
expected parameters, bank should consider restructuring of the portfolio.
 Undertaking rapid portfolio reviews, stress tests and scenario analysis when external
environment such as volatility in the forex market, economic sanctions, fiscal/monetary
policies, market risk, liquidity conditions, etc. undergo changes. The stress tests would
reveal undetected areas of potential credit risk exposure and linkages between different
categories of risk. It is possible that, there may be substantial correlation of various
risks, especially credit and market risks. The stress test results should be reviewed by
the Board and suitable changes made in prudential risk limits for protecting the quality.
Stress tests could also include contingency plans, detailing management responses to
stressful situations.
 introduce discriminatory time schedules for renewal of borrower limits. Lower rated
borrowers whose financials show signs of problems should be subjected to renewal
control twice or thrice an year.

Banks should evolve suitable framework for monitoring the market risks especially forex
risk exposure of corporates who have no natural hedges on a regular basis.
Banks may also use credit risk models which offer framework for examining credit risk
exposures, across geographical locations and product lines in a timely manner, centralising
data and analysing marginal and absolute contributions to risk. The models also provide
estimates of credit risk (unexpected loss) which reflect individual portfolio composition.
The Altman’s Z Score forecasts the probability of a company entering bankruptcy within a
12-month period. The model combines five financial ratios using reported accounting
information and equity values to produce an objective measure of borrower’s financial
health.

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5.6 Loan Review Mechanism (LRM)

Banks should use LRM which is an effective tool for constantly evaluating the quality of
loan book and to bring about qualitative improvements in credit administration. The main
objectives of LRM could be:
 to identify promptly loans which develop credit weaknesses and initiate timely
corrective action;
 to evaluate portfolio quality and isolate potential problem areas;
 to provide information for determining adequacy of loan loss provision;
 to assess the adequacy of and adherence to, loan policies and procedures, and to
monitor compliance with relevant laws and regulations; and
 to provide top management with information on credit administration, including credit
sanction process, risk evaluation and post-sanction follow-up.

Accurate and timely credit grading is one of the basic components of an effective LRM.
Credit grading involves assessment of credit quality, identification of problem loans, and
assignment of risk ratings. A proper Credit Grading System should support evaluating the
portfolio quality and establishing loan loss provisions. Given the importance and subjective
nature of credit rating, the credit ratings awarded by Credit Administration Department
should be subjected to review by Loan Review Officers who are independent of loan
administration.

Loan Reviews are designed to provide feedback on effectiveness of credit sanction and to
identify incipient deterioration in portfolio quality. Normally, Reviews of high value loans
should be undertaken within three months of sanction/renewal or more frequently when
factors indicate a potential for deterioration in the credit quality. The scope of the review
should cover all loans above a cut-off limit. In addition, banks should also target other
accounts that present elevated risk characteristics. At least 30-40% of the portfolio should
be subjected to LRM in a year to provide reasonable assurance that all the major credit
risks embedded in the balance sheet have been tracked.

The loan reviews should focus on:

 Approval process;
 Accuracy and timeliness of credit ratings assigned by loan officers;
 Adherence to internal policies and procedures, and applicable laws / regulations;
 Compliance with loan covenants;
 Post-sanction follow-up;
 Sufficiency of loan documentation;

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 Portfolio quality; and

 Recommendations for improving portfolio quality

The findings of Reviews should be discussed with line Managers and the corrective actions
should be elicited for all deficiencies. Deficiencies that remain unresolved should be
reported to top management.

5. Understanding credit risk management

The concept of credit risk management and the associated terms such as risk horizon,
rating migration, recovery rates, expected & unexpected loss and economic capital, which
find repeated mention in the RBI guidelines, can be better understood by means of an
example.
Given below is a case of a two-asset portfolio. This will help explain risk management.

Bank name “ No Risk Bank (NRB)”. As at the end of year it had a loan book with two loan
assets of borrower ABC Company and XYZ Company.

Client Industry/ Principal Interest Rte Residual Type of

Name Amount O/S (%) Maturity loan
sector
(Rs. Crores)

ABC Automobile 20.00 10.20% 3 years Secured

XYZ Textiles 10.00 10.50% 4 years Secured

Following detail are given.

a. Interest payment is half yearly with a bullet principal payment at the end of
3rd year and 4th year. Loans are floating rate linked to MCLR.

b. NRB wants to assess credit risk of its loan asset portfolio over a one-year risk
horizon i.e. estimate the probable credit loss behaviour of its existing loan
portfolio over the next 365 days.

c. Its internal credit rating scales are five starting from No risk (A) to Default
(E).

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Of the two assets NRB, ABC had “D” rating and XYZ had “C” rating. It is observed that the
credit rating of both the clients have moved (migrated) downwards from the initial rating
“B” given about two years back. As at the end of year it is observed that both companies are
closer to default rating (F). Now, the critical issue is will the clients default (migrate to
rating F) in the next one year? What are the chances?

NRB uses rating migration data of the past to estimate the probability of its borrowers
defaulting during the year. The rating migration matrix indicates the probability assets in
various risk rating scale migrating to default. The migration matrix of NRB for the current
year is given below.

Rating migration matrix (one year risk horizon)

Current Rating A B C D E
Probability of moving 0% 1% 5% 10% 16%
to Default (F)

From the migration matrix it can be inferred that there is no chance of “A” slipping into
default while there is 15% chance that “E” will slip into default. Based on this it can be said
that there is a 10% probability that ABC company could slip into default and 5%
probability that XYZ will slip into default.

In the event of default bank will have to depend on collateral for making recovery. Better
the quality of the collateral and collateral efficiency, higher will be the recovery. The
measure of extent of recovery from collateral is called the recovery rate. Generally, a fully
secured loan will exhibit a higher recovery rate than an unsecured loan. Based on past
behaviour (5 years), NRB has arrived at the following recovery rates.

Recovery Rates
Recovery Rate
Type of Loan Mean Standard Deviation
Secured Loan 45% 25%
Unsecured Loan 5% 15%

It must be added here that despite same quality of security the recovery rate can vary on a
case by case basis. This is on account of reasons such as demand for a particular security at
a particular point of time, legal processes if any etc. These aspects cannot be factored as
data on the same may not be consistent. It is for this reason that recovery rates are
captured in terms of mean and standard deviation. “Mean” indicates what can be expected,
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the variance while “standard deviation” gives the possibility of unexpected. In the case of
NRB the mean recovery rate from a secured loan is estimated to be 45% of the value of loan
in case of no default with a standard deviation of 25%.

Let’s now attempt to quantify the credit risk of its two-asset loan portfolio starting with the
estimation of the value of loan assets at the risk horizon (one year).

The value of the loan (consider loan to client ABC and XYZ ) can be studied in terms of :

 The value of loan in both non-default and default positions

 Probability of the loan migrating to default position

The value of loan in non-default state could be determined by discounting all the stipulated
cash flows. The discount rate would be the ROI stipulated for the account.
Loan asset ABC has a residual maturity of 3 years which means 6 half yearly interest
payment inflows and one final payment at the end of 3rd year. The cash flow will be as
under

ABC loan (Non-default) cash flow position

(Rs. crores)
No. of Interest Principal Discount Rate
half Payment Payment
years
1 1.02 - 10.2% Within risk
2 1.02 - Horizon i.e. one Year
3 1.02 -
4 1.02 - Beyond risk
5 1.02 - horizon
6 1.02 20.0

The value of Loan will be Rs 20 crore as the ROI is floating and it is presumed that there are
no credit rating changes. This is as per historical costing the way banks balance sheet is
made and not time adjusted. Thus, the value of the loan in non-default state will be Rs.20
crores.

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Similar to the above in the case of XYZ there will be there will be 8 half yearly interest
payments of Rs 0.525 Crore (two in the risk horizon) and the final repayment will be Rs 10
Crore.

The value of loan in default state is a function of the recovery rate. Since the mean recovery
rate for a secured loan is 45%, the value of loan under default would be Rs.9 crores (45% of
Rs.20 crores). Combining the two we have:

Value of loan ABC for risk estimates

(Rs. crores)

Loan A with current Non default Status Default Status

Rating of D
Value of loan (a) 20 9@
Probability (b) 90% 10%
Expected value (a *b) 18.0 0.90
Total Expected Value 18.0 + 0.90 = 18.90
Expected Loss 20.0 – 18.90 = 1.10.
@ value of loan * recovery rate

Based on migration rating matrix loan ABC has a 9% probability of default the expected
value of the loan at the risk horizon is Rs.18.90 crores which is Rs.1.10 crores less than the
value of loan in non-default state (Rs.20 crores). This difference between the value of loan
in non-default state and the expected value at risk horizon is termed as the expected loss.

Value of XYZ will be as under.

Loan A with current Non default Status Default Status
Rating of C
Value of loan (a) 10 4.5@
Probability (b) 95% 5%
Expected value (a *b) 9.5 0.225
Total Expected Value 9.5 + 0.225 = 9.725
Expected Loss 10 - 9.725 = 0.0275

Expected loss is the average credit loss that the bank can expect from portfolio of assets
over a period of time. The expected loss of portfolio is the summation of expected loss of
its assets. For the portfolio of NRB:

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(Rs. crores)
NRB portfolio Non-default value Expected value Expected loss
Loan ABC 20.00 18.90 1.10
Loan XYZ 10.00 9.725 0.275
Total 30.00 28.625 1.375

The expected loss for the NRB loan portfolio is Rs.1.375 crores. Expected loss is a measure
of the loan loss provisioning that the bank will have to make for managing the risk. Given
this expected loss is critical to risk pricing or loan pricing in a scientific manner using the
RAROC framework. Loans should be priced in such a way that the bank will have to cover
the expected loss over the risk horizon.

We have seen expected loss above. Another aspect of study is “unexpected loss”. As
explained, expected loss is the average loss that the bank can expect over a period of time.
This is estimated and can vary during the period for which the estimate is made. Such
fluctuation could happen on account of some of the parameters such as probabilities given
in the migration matrix, recovery rate or credit rating of assets varying during the period
and impacting the credit risk. Unexpected loss is the measure of this fluctuation/variance
in credit risk losses.

Let’s try and measure the unexpected loss from the portfolio so that NRB can (a) take
timely risk mitigating actions and (b) allocate sufficient capital (economic capital) to cover
the unexpected loss and prevent insolvency.

The unexpected loss of the portfolio is the function of the variation in the value of loan
assets in the portfolio at the risk horizon. Take the case of ABC Loan. The expected value of
the loan at the risk horizon is Rs.18.90 crores. This is the average value. Due to
uncertainty in the value of the recovery rate (measured by the standard deviation of
recovery rates) the loan value at the risk horizon has an uncertain portion. Since the
standard deviation of recovery rate of a secured loan is 25% the corresponding uncertain
portion of loan value of ABC is Rs.5 crores (25% of Rs.20 crores). This uncertain portion is
the primary contributor to the fluctuation in credit risk loss from the average and is
quantified using the standard deviation formula.

Loan Expected Loss Un expected Loss

Loan ABC 1.10 3.66
Loan XYZ 0.275 1.32

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It is worth noting that, though the value of loan ABC is only two times that of loan XYZ, the
unexpected loss could be three times. This is due to the lower credit rating of ABC.
Unexpected Loss (UL) calculation is illustrated as follows:

UL  LE  EDF   LGD
2
 LGD 2   EAD
2

Where,
LE = Loss Exposure
EDF = Expected Default Frequency
 LGD
2
= Variance of LGD
 EAD
2
= Variance of EAD

Loan ABC Loan XYZ

LE 20 10
EDF 10% 5%
Var (LGD) 0.0625 0.0625
LGD 55% 55%
Var(EDF) 9.0% 4.8%

UL (%) 18.30% 13.23%

UL 3.66 1.32

The standard deviation of the portfolio value is a measure of the unexpected credit loss
from a loan portfolio. Unexpected loss is assumed to be a ‘certain multiple’ of the standard
deviation of portfolio value. Banks are expected to allocate capital (known as economic
capital) to provide cushion for the portfolio unexpected loss. Generally the economic
capital is the same as the portfolio unexpected loss. The expected and unexpected losses
together capture (and help quantify) the credit risk of a portfolio of loan assets.

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