17.Credit Risk Management in Commercial Banks p Rout 7

7/26/2019 17.Credit Risk Management in Commercial Banks p Rout 7

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CREDIT RISK MANAGEMENT IN COMMERCIAL BANKS:

AN INDIAN EXPERIENCE

Prafulla Kumar Rout*

ABSTRACT

Recent cases of bank failure across nations have been traced largely to rising toxic assets in

commercial banks loan portfolio..Risk is inherent part of banks business. Effective risk management is

critical to any bank for achieving financial soundness. Financial risk in a banking organization is

possibility that the outcome of an action or event could bring up adverse impacts. Such outcomes could

either result in a direct loss of earnings or capital or may result in imposition of constraints on banks

ability to meet its business obectives.

!his study evaluates the influence of credit risk management on financial performance of "ommercial

#anks in $ndia. %ligning risk management to banks organisational structure and business strategy has

become integral in banking business. "redit risk is the banks risk of loss arising from a borro&er &ho

does not make payments as promised. Such as event is called as default. "redit risk is the oldest and

biggest risk that a bank' by virtue of its very nature of business' inherits. !his has' ho&ever' ac(uired a

greater significance in the recent past for various reasons. Foremost among them is the &ind of

economic liberalization that is blo&ing across the globe. $ndia is no exception to this s&ing to&ards

market)driven economy. #etter credit portfolio diversification enhances the prospects of the reduced

concentration credit risk as empirically evidenced by direct relationship bet&een concentration credit

risk profile and *+%s of public sector banks.

Key wor!:" Cre#t r#!$% % Ba&$!% 're#t ma&a(eme&t% R#!$ #& fu&% fu& ma&a(eme&t %

______________________________________________________________________________

*Research Scholar, P.G.Dept. of Commerce, Utkal University, Vani Vihar, Bh!anes"ar.

INTROD)CTION1


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#he past $eca$e has seen $ramatic losses in the !ankin% in$stry. &irms that ha$ !een

performin% "ell s$$enly annonce$ lar%e losses $e to cre$it e'posres that trne$ sor, interest rate

positions taken, or $erivative e'posres that may or may not have !een assme$ to he$%e !alance sheet

risk. (n response to this, commercial !anks have almost niversally em!arke$ pon an p%ra$in% of

their risk mana%ement an$ control systems.

#he health of the financial system has important role in the contry as its failre can $isrpt

economic $evelopment of the contry. &inancial performance is company)s a!ility to %enerate ne"

resorces from $ay to $ay operation over a %iven perio$ of time an$ it is %a%e$ !y net income an$

cash from operation. #he financial performance measre can !e $ivi$e$ into tra$itional measres an$

market !ase$ measres. Drin% the +-)s an$ +)s "hen the financial an$ !ankin% crises !ecame

"orl$"i$e, ne" risk mana%ement !ankin% techni/es emer%e$. #o !e a!le to mana%e the $ifferent

types of risk one has to $efine them !efore on can mana%e them. #he risks that are most applica!le to

!anks risk are0 cre$it risk, interest rate risk, li/i$ity risk, market risk, forei%n e'chan%e risk an$

solvency risk. Risk mana%ement is the hman activity "hich inte%rates reco%nition of risk, risk

assessment, $evelopin% strate%ies to mana%e it, an$ miti%ation of risk sin% mana%erial resorces"hereas cre$it risk is the risk of loss $e to $e!tor)s nonpayment of a loan or other line of cre$it 1either

the principal or interest or !oth2. Defalt rate is the possi!ility that a !orro"er "ill $efalt, !y failin% to

repay principal an$ interest in a timely manner. 3 !ank is a commercial or state instittion that provi$es

financial services, incl$in% issin% money in varios forms, receivin% $eposits of money, len$in%

money an$ processin% transactions an$ the creatin% of cre$it.

Cre$it risk mana%ement is very important to !anks as it is an inte%ral part of the loan process. (t

ma'imi4es !ank risk, a$5ste$ risk rate of retrn !y maintainin% cre$it risk e'posre "ith vie" to

shiel$in% the !ank from the a$verse effects of cre$it risk. Bank is investin% a lot of fn$s in cre$it risk

mana%ement mo$elin%. Cre$it risk is the crrent an$ prospective risk earnin%s or capital arisin% froman o!li%or)s failre to meet the terms of any contract "ith the !ank or other"ise to perform as a%ree$.

Cre$it risk mana%ement is a strctre$ approach to mana%in% ncertainties thro%h risk assessment

$evelopin% strate%ies to mana%e it, an$ miti%ation of risk sin% mana%erial resorces. #he strate%ies

incl$e transferrin% to another party, avoi$in% the risk, re$cin% the ne%ative effects of the risk an$

acceptin% some or all of the conse/ences of a particlar risk. Cre$it risk mana%ement is very

important to !anks as it is an inte%ral part of the loan process. (t ma'imi4es !ank risk, a$5ste$ risk rate

of retrn !y maintainin% cre$it risk e'posre "ith vie" to shiel$in% the !ank from the a$verse effects

of cre$it risk.

6hen !anks %rant loans, they e'pect the cstomers to repay the principal an$ interest on an

a%ree$ $ate. 3 cre$it facility is sai$ to !e performin% if payment of !oth principal an$ interest are p to

$ate in accor$ance "ith a%ree$ repayment terms. #he non7performin% loans 18P9s2 represent cre$its

"hich the !anks perceive as possi!le loss of fn$s $e to loan $efalts. #hey are frther classifie$ into

s!stan$ar$, $o!tfl or lost. Bank cre$it in lost cate%ory hin$ers !ank from achievin% their set tar%et.

Cre$it risk in commercial !anks represents the most important type of risk. Banks !ear the

cre$it risk attache$ to !ank loans an$ for"ar$ contracts. #he risk of $efalts or protracte$ arrears on

otstan$in% loan is terme$ as cre$it risk . Cre$it Risk is the potential that a !ank !orro"er or conter2


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party fails to meet the o!li%ations on a%ree$ terms. (t mainly arises from the potential that a !orro"er

or conterparty "ill fail to perform on an o!li%ation.

L#terature Re#ew

Some of the relate$ literatre revie"s have !een critically e'amine$ in this paper relatin% to

the cre$it mana%ement an$ risk in !ankin% sector in (n$ia.

:acalay 1+--2 con$cte$ a srvey in the Unite$ States an$ fon$ cre$it risk mana%ement is

!est practice in !ank an$ a!ove ; of the !ank in contry have a$opte$ the !est practice. (na$e/ate

cre$it policies are still the main sorce of serios pro!lem in the !ankin% in$stry as reslt effective

cre$it risk mana%ement has %aine$ an increase$ focs in recent years. #he main role of an effective

cre$it risk mana%ement policy mst !e to ma'imi4e a !ank)s risk a$5ste$ rate of retrn !y maintainin%

cre$it e'posre "ithin accepta!le limits. :oreover, !anks nee$ to mana%e cre$it risk in the entire

portfolio as "ell as the risk in in$ivi$al cre$its transactions.

Boy$ 1+ar%i, 1@++2 st$ie$ that Cre$it risk mana%ement ma'imi4es !ank)s risk a$5ste$ rate of

retrn !y maintainin% cre$it risk e'posre "ithin accepta!le limit in or$er to provi$e frame"ork forn$erstan$in% the impact of cre$it risk mana%ement on !anks) profita!ility.

OB+ECTI,E O- T.E ST)D/

to make a st$y on the cre$it mana%ement in $ifferent commercial !anks

to s%%est the risk minimisation in cre$it mana%ement system in commercial !anks

R#!$ Ma&a(eme&t #& Commer'#al Ba&$!:

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Risk mana%ement is an essential element of corporate %overnance, nee$e$ to !alance risk an$

re"ar$7 threat an$ opportnity7 strate%y an$ operations. Son$ an$ effective risk mana%ement an$

controls promote !oth !ank an$ in$stry sta!ility makin% the investors an$ conterparties feel rather

confi$ent to involve in financial $eals. Banks have economic an$ commercial incentives to employ

stron% risk mana%ement internal control systems. 6ithot sch controls, a !ank is vlnera!le to risk.

#he importance of risk mana%ement an$ controls in protectin% a%ainst serios an$ nanticipate$ loss is

!est illstrate$ !y some recent cases "here risk mana%ement an$ controls !roke $o"n or "ere not

properly implemente$

(nitially, the (n$ian !anks have se$ risk control systems that kept pace "ith le%al environment

an$ (n$ian accontin% stan$ar$s. Bt "ith the %ro"in% pace of $ere%lation an$ associate$ chan%es in

the cstomer)s !ehavior, !anks are e'pose$ to mark7to7market accontin%. #herefore, the challen%e of

(n$ian !anks is to esta!lish a coherent frame"ork for measrin% an$ mana%in% risk consistent "ith

corporate %oals an$ responsive to the $evelopments in the market. 3s the market is $ynamic, !anks

shol$ maintain vi%il on the conver%ence of re%latory frame"orks in the contry, chan%es in the

international accontin% stan$ar$s an$ finally an$ most importantly chan%es in the clients) !sinesspractices. #herefore, the nee$ of the hor is to follo" certain risk mana%ement norms s%%este$ !y the

RB( an$ B(S.

#he Reserve Bank of (n$ia has !een sin% C3:A9S ratin% to evalate the financial son$ness

of the Banks. #he C3:A9S :o$el consists of si' components namely Capital 3$e/acy, 3sset

ality, :ana%ement, Aarnin%s ality, 9i/i$ity an$ Sensitivity to :arket risk. (n (n$ia, the focs of

the stattory re%lation of commercial !anks !y RB( ntil the early +s "as mainly on licensin%,

a$ministration of minimm capital re/irements, pricin% of services incl$in% a$ministration of

interest rates on $eposits as "ell as cre$it, reserves an$ li/i$ asset re/irements. (n these

circmstances, the spervision ha$ to focs essentially on solvency isses. 3fter the evoltion of theB(S pr$ential norms in +--, the RB( took a series of measres to reali%n its spervisory an$

re%latory stan$ar$s an$ !rin% it at par "ith international !est practices. 3t the same time, it also took

care to keep in vie" the socio7economic con$itions of the contry, the !siness practices, payment

systems prevalent in the contry an$ the pre$ominantly a%rarian natre of the economy, an$ ensre$

that the pr$ential norms "ere applie$ over the perio$ an$ across $ifferent se%ments of the financial

sector in a phase$ manner.

Cre#t R#!$ Ma&a(eme&t : A 'orrelat#e #m0a't

3 $eposit7!ankin% firm like most financial instittions ten$ to hol$ little o"ners capital relative

to the a%%re%ate vale of its assts. #he implication of this is that only a small percenta%e of total loans

nee$ to trn !a$ to psh the entire cre$it portfolio to the !rink of failre. 3ccor$in% to Peter an$ Sylvia

1@-2 the pro!a!ility that a $eposit !ankin% instittions cre$it portfolio $eclines in vale an$ perhaps

!ecome "orthless is kno"n as cre$it risk "hile varios attempts $esi%ne$ to control an$ protect !anks

a%ainst a$versities associate$ "ith these risk e'posre are referre$ to as cre$it risk mana%ement

processes.

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#he process of analy4in% cre$it risk, rankin% an$ /antifyin% them constitte a s!stantial

aspect of the frame"ork an$ %overnance strctres for most !ank mana%ement .3mon% the reasons

a$vance$ for Cre$it Risk :ana%ement incl$e mana%erial self7interest an$ appraisal %oal hi%h cost of

financial $istress an$ the e'istence of capital market imperfection. ther motivation for e'pen$in%

mana%erial resorces on Cre$it Risk :ana%ement accor$in% to :eyer 1@2, it is the nee$ for

insolvency avoi$ance, %iven the likelihoo$ of poor cre$it risk mana%ement sno"!allin% into financial

crisis.

Cre#t R#!$ Ma&a(eme&t #& Commer'#al Ba&$! :

#he first step in effective cre$it risk mana%ement is to %ain a complete n$erstan$in% of a

!ank)s overall cre$it risk !y vie"in% risk at the in$ivi$al, cstomer an$ portfolio levels.6hile !anks

strive for an inte%rate$ n$erstan$in% of their risk profiles, mch information is often scattere$ amon%

!siness nits. 6ithot a thoro%h risk assessment, !anks have no "ay of kno"in% if capital reserves

accrately reflect risks or if loan loss reserves a$e/ately cover potential short7term cre$it losses.

Vlnera!le !anks are tar%ets for close scrtiny !y re%lators an$ investors, as "ell as $e!ilitatin%

losses.

#he key to re$cin% loan losses an$ ensrin% that capital reserves appropriately reflect the risk profile

is to implement an inte%rate$, /antitative cre$it risk soltion. #his soltion shol$ %et !anks p an$

rnnin% /ickly "ith simple portfolio measres. (t shol$ also accommo$ate a path to more

sophisticate$ cre$it risk mana%ement measres as nee$s evolve. #he soltion shol$ incl$e0

Better mo$el mana%ement that spans the entire mo$elin% life cycle.

Real7time scorin% an$ limits monitorin%.

Ro!st stress7testin% capa!ilities. Data visali4ation capa!ilities an$ !siness intelli%ence tools that %et important information into

the han$s of those "ho nee$ it, "hen they nee$ it.

Cre#t R#!$ M#t#(at#&( 0ro'e!!e!

Banks assess the cre$it "orthiness of the !orro"er !efore sanctionin% loan i.e., cre$it ratin% of

the !orro"er !e $one !eforehan$. Cre$it ratin% is main tool of measrin% cre$it risk an$ it also

facilitates pricin% the loan.

By applyin% a re%lar evalation an$ ratin% system of all investment opportnities, !anks

re$ce its cre$it risk as it %et vital information of the inherent "eaknesses of the accont.

Banks fi' pr$ential limits on varios aspects of cre$it !enchmarkin% Crrent Ratio, De!t

A/ity Ratio, De!t Service Covera%e Ratio, Profita!ility Ratio etc.

#here is a ma'imm limit e'posre for sin%leE %rop !orro"er.

#here shol$ !e provision for fle'i!ility to allo" variations for very special circmstances.

3lertness on the part of operatin% staff at all sta%es of cre$it $ispensation appraisal,

$is!rsement, revie"E rene"al, post7sanction follo"7p can also !e sefl for avoi$in% cre$it

risk.

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C1alle&(e! to Su''e!!ful Cre#t R#!$ Ma&a(eme&t:

#he challen%es are many an$ some of the ma5or challen%es in cre$it risk have !een otline$ here as 0

I&eff#'#e&t ata ma&a(eme&t23n ina!ility to access the ri%ht $ata "hen it)s nee$e$ casespro!lematic $elays.

No (rou0w#e r#!$ moel#&( framewor$26ithot it, !anks can)t %enerate comple', meanin%fl

risk measres an$ %et a !i% pictre of %rop"i$e risk.

Co&!ta&t rewor$23nalysts can)t chan%e mo$el parameters easily, "hich reslts in too mch

$plication of effort an$ ne%atively affects a !ank)s efficiency ratio.

I&!uff#'#e&t r#!$ tool!26ithot a ro!st risk soltion, !anks can)t i$entify portfolio concentrations

or re7%ra$e portfolios often eno%h to effectively mana%e risk.

Cum3er!ome re0ort#&(2:anal, sprea$sheet7!ase$ reportin% processes over!r$en analysts an$

(#.

CONCL)SION

Risk is in$ispensa!le for !ankin% !siness, proper assessment of risk is an inte%ral part of a

!ank)s risk mana%ement system. Banks are focsin% on the ma%nit$e of their risk e'posre an$

formlatin% strate%ies to tackle those effectively. (n the conte't of risk mana%ement practices, the

intro$ction of norms an$ its s!se/ent a$option !y RB( is a si%nificant measre that promises to

promote son$ risk mana%ement practices.RB( enhance the risk sensitivity of capital re/irements,

promote a comprehensive covera%e of risks, offer a more fle'i!le approach thro%h a men of options,

an$ is inten$e$ to !e applie$ to !anks "orl$"i$e.

Cre$it Risk :ana%ement Policy of the !ank $ictates the Cre$it Risk Strate%y. #hese policies spell ot

the tar%et markets, risk acceptanceEavoi$ance levels, risk tolerance limits, prefer levels of

$iversification an$ concentration, cre$it risk measrement, monitorin% an$ controllin% mechanisms.

#he ever7improvin% risk mana%ement practices in the Bank "ill reslt in Bank emer%in% stron%er,

"hich in trn "ol$ confer competitive a$vanta%e in the market.

:oreover, the RB( has a$opte$ a series of steps to ensre that in$ivi$al !anks tackle risks

effectively !y settin% p risk mana%ement cells an$ also thro%h internal assessment of their riske'posre. 3part from this, RB( has opte$ for on7site an$ off7site srveillance metho$s for effective risk

mana%ement in the (n$ian Bankin% sector, so that systemic risk an$ financial trmoil can !e averte$ in

the contry.

RE-ERENCE

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3ltman, A., Caoette, F., = 8arayanan, P. 1+-2. Cre$it7risk :easrement an$ :ana%ement0

the ironic challen%e in the ne't $eca$e.Financial %nalysts ,ournal' -1+2, 7++.

Bene$ikt, G., (an, :., F$it, V. C., = 6olf, 6. 1@2. Bank Behavior "ith access to cre$it

risk transfer markets. Research $iscssion paper, Bank of &inlan$

Camp!ell, 3. 1@2. Bank insolvency an$ the pro!lem of nonperformin% loans. ,ournal of

#anking Regulation' /1+2, @H7IH.

Demir%JK7>nt, 3., = ?i4in%a, ?. 1+2. ?o" $oes forei%n entry affect $omestic !ankin%

marketsL.,ournal of #anking 0 Finance, 1-1H2, -+7++. Die%o0 Alsevier.

Gan$e, 3. 1@-2. Commercial Banks in (nvestment Bankin%. (n V. #. 3n5an = 6. 3. B.

3rno$ 1A$s.2,2andbook of Financial $ntermediation and #anking 1pp. +Malani, V. :. 1@2. Commercial Bankin% Crises in >enya0 cases an$

Reme$ies.%frican ,ournal of %ccounting' Economics' Finance 0 #anking Research, 1I2.

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17.Credit Risk Management in Commercial Banks p Rout 7

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Transcript of 17.Credit Risk Management in Commercial Banks p Rout 7