Credit Risk Management in Banks

Credit Risk Management In Banks Based On Case Studies Of ICICI AND SBI
EXECUTIVE SUMMARY
Finance is life of any business and banking sector is the major key player in
financing these businesses. Banks are in the business of risks and banking is
all about managing risk and return. Due to the highly volatile interest rate
environment, there is deterioration in credit quality and result in default
risks by borrowers, or a mismatch between assets and liabilities can lead to
liquidity risks and eventually lead to operational and reputation risks.
Although all the above risks are important and need to be suitably addressed
to, it is credit risk management that forms the core of commercial banking.
Credit is the primary basis on which a bank’s quality, performance and
reputation are determined. Proper credit management greatly influences
the success or failure of the financial institutions.
The main highlight of the project is on the risk faced by the banks and how
it is managed by them in the competitive scenario. Risk management has
become one of the most important concepts for carrying out any business.
The Risk Management system comprises policies, procedures,

organizational structure and control system for the identification,
measurement, monitoring, and management of various risks.
Bank is continuously upgrading and enhancing capabilities of its risk

management system in tune with guidelines and directions of RBI and is
well equipped to make transition to Basel II norms.
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• What Is Risk?
Risk may be defined as “exposure to uncertainty”. Leads to favourable or

unfavourable outcomes. Bankers are exposed to the vagaries of financial
markets and the outcome of this exposure may either be profit or loss.
Risk maybe defined “as the threat that an event or action will adversely
affect an organization’s ability to achieve its business objectives and execute
its strategies successfully”.
Risks manifest themselves in many ways and risks in banking are a result of
many diverse activities, executed from different locations and by numerous
people.
Banks can neither do without profits or risks. However, mere acceptance of

risks to remain profitable does not suffice. Apart from the losses that can be
incurred due to the risks, there is also an ultimate danger that the bank itself
may fail. Unlike other sectors, the problems in banking sector have
contagious effect on the entire financial system. The Asian crisis remains
fresh in the memory of the banking industry.
As bank failures are detrimental for the proper functioning of the financial
system, world over they are regulated more closely than any other sector. In
this process, the objective of the guidelines has been changing over the years
forcing the banks to move from reactive risk management practices to
proactive risk management practices.
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Till the seventies, guidelines of most economies shielded the banks from
competitive forces. Administered interest rates enabled the banks to lock
their spreads in a manner to cover their high operational costs. This was
the scene in most economies till the seventies. Regulations of this nature
invariably led to market imperfections, which in turn affected the
operational costs. This was the scene in most economies till the
seventies. Regulations of this nature invariably led to market
imperfections, which in turn affected the operational efficiency of the
banks. Later, during 1970s as the economies began to deregulate, with no
proper risk management practices in place, banks had to face the adverse
impact of the exposures taken by them.
Spreads narrowed as the volatility in the international interest rates

enhanced. In an attempt to shore up their earnings, banks adopted
aggressive strategies. The resultant mismatches in assets and liabilities
and rise in risk levels, led to the bankruptcy of some banks. Against this
background, evolved the concept of Asset-Liability Management.
The question that arises at this point is – what should the bank do in order
to take risk for greater returns and at the same time does not end up in
losses? Risk management is the solution to such situations.
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Introduction to Risk Management in Banks
For centuries, financial intermediaries – lenders, institutional, investors,

dealers, and insurers – have engaged in risk modeling. The model was in
their heads and was based on judgment and experience, but that model
involved categorizing and evaluating the proposed risk and reaching a series
of interrelated decisions. For example, in the context of bank lending for each
potential credit those decisions have included:
1) Whether or not to lend,
2) At what price to lend
3) What maturity should the loan have and
4) What collateral to accept and how to structure it
• What Is Risk Management???

Risk Management is a process consisting of well-defined steps, which
support better decision making by contributing to a greater insight into risks
and their impacts. It is as much as identifying opportunities as it is about
avoiding losses.
By adopting effective Risk management techniques, an organization can
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improve its safety, quality and business performance. Specifically, Risk

management is the process by which a bank identifies, measures, monitors
and controls its risk exposures to ensure that:
• There exists common understanding of risks across the
organisation.
• Risks are within tolerances established by the Board of Directors.
• Risk-taking decisions are consistent with strategic business objectives.
• Appropriate processes facilitate explicit and clear risk-taking
decisions.
• Expected return compensates for the risk taken.
• Capital Allocation is consistent with risk exposures.
• Performance incentives are aligned with risk tolerances.
What Have Been The Benefits Of The New Model-Based

Approach To Risk Measurement And Management?
The most important is that better risk measurement and management
contributes to more efficient resource allocation. When risk is better
evaluated, it can be more accurately priced; if it can be more accurately
priced, it can be more easily spread among a larger number of market
participants improving the risk bearing capacity of the market. Better risk
measurement and the consequent more efficient risk sharing improve the
markets’ ability to allocate resources to the most productive uses.
One example is the improvement in credit risk modeling that has led to the
development of new markets for credit risk transfer, such as credit risk
derivatives and Collateralized Debt Obligations (CDO). These new markets
have expanded the ways that market participants can share credit risk and
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have led to more-efficient pricing of that risk.
More accurate risk measurement and better management do not mean the
absence of loss. Improved risk management has meant that lenders and
investors can more thoroughly understand their risk exposure and
intentionally match it to the risk appetite and they can more easily hedge
unwanted risk.
• Risk Management Structure
As the Top management is ultimately responsible for the management of

various risks, the responsibility of designing and defining the structure of risk
management also rests with the top management.
CENTRAL RISK MANAGEMENT COMMITTEE
(CORPORATE LEVEL)
CEO / CMD
President
President President Business Dev
C Finance/CFO / CDO
r
A Risk management structure for a bank having a global presence would

be as follows:
The Central Risk Management Committee is constituted at the corporate
level headed by the Chief Executive Office (CEO) or the Chairman cum
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Managing Director of the Bank. The Chief Credit Officer (CCO) or

President of Credit Department, Chief Finance Officer (CFO) or President
of Finance and Accounts Department and Chief Development Officer
(CDO) or President Business Development are its members.
The CCO is responsible for managing credit risk.
The CFO who is handling the Finance and Accounting functions is

responsible for managing interest rate risks, foreign exchange risks and
country risks. He is responsible for overall asset liability management of
a bank.
The CDO of Business development is responsible for managing other
risks such as regulatory risks, technological risks, affiliation risks, etc.
The CCO, CFO and CDO report and put forward their respective
management plans to the Central Risk Management Committee and arrive
at a composite risk management policy and seek approval of the Board at
the same.
The Central Risk Management Committee, on the basis of the capital and
profit plan of the bank, decides the risk tolerance limits for each risk. The
CCO, CFO and CDO have to manage their respective portfolios within
the threshold risk limits. The field functionaries are informed clearly to
ensure that every person down the line is able to select the appropriate
risk and manage it effectively for risk return trade off.
The various divisions of the bank then formulate strategies to manage
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business operations from the varied risks. This ensures performance of

every individual in the organisation for selecting appropriate risks and
managing them within the threshold limits.
Various divisions working under the CCO, CFO and CDO, at frequent
intervals, aggregate the risk profile in their portfolio and report it to the
Central Risk Management Committee whish ensures that the volatility in
the portfolio is monitored effectively and contained within the risk
appetite of the bank.
• Basel Accord
 BASEL ACCORD I
A committee of central banks of G10 countries was formed to stabilize the
banking system and regulate it properly. It is called as Base Committee of
Banking Supervision (BCBS). The secretariat for this Committee is
provided by the BIS in Basel. The Basel Committee in Basel City,
Switzerland, published a set of minimal capital requirements for banks. This
is also known as the 1988 Basel Accord, and was enforced by law in the
Group of Ten (G-10) countries in 1922. The major drive for the 1988 Basel
Capital Accord was the concern of the Governors of the G10 central banks
that the capital of the world’s major banks had become dangerously low after
constant erosion through competition. Capital is necessary for banks as a
cushion against losses and it provides an incentive for the owners of the
business to manage it in a practical manner.
The 1988 Accord requires internationally active banks in the G10 countries
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to hold capital equal to at least 8% of a basket of assets measured in different

ways according to their risk. The definition of capital is set (broadly) in two
tiers, Tier I being shareholders’ equity and retained earnings and Tier II
being additional internal and external resources available to the bank. The
bank has to hold at least half of its measured capital in Tier I form. The two
principal purposes of the Accord were to ensure an adequate level of
capital in the international banking system and to create a “more level
playing field” in competitive terms so that banks could no longer build
business volume without adequate capital backing. These two objectives
have been achieved. The merits of the Accord were widely recognized and
during the 1990s the Accord became an accepted world standard, with well
over 100 countries applying the Basel framework to their banking system.
 BASEL ACCORD II
In January 2001 the Basel Committee on Banking Supervision issued a
proposal for a New Basel Capital Accord that, once finalized, will replace the
current 1988 Capital Accord. The proposal is based on three mutually
reinforcing pillars that allow banks and supervisors to evaluate properly
the various risks that banks face. The New Basel Capital Accord focuses
on:
a) Minimum capital requirements, which seek to refine the measurement
framework set out in the 1988Accord
b) Supervisory review of an institution’s capital adequacy and internal
assessment process
c) Market discipline through effective disclosure to encourage safe and
sound banking practices.
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The new accord is widely hailed for its comprehensive approach. Many
national supervisors have already begun to plan for the transition to Basel II
To assist in this process, the Committee has asked a group of supervisors
from around the world, with IMF and World Bank participation, to develop a
framework for assisting non-G10 supervisors and banks in the transition to
both the standardized and foundation IRB approaches of the New Accord.
The Committee believes that continued co-operation along these lines is
essential to ensuring a successful transition to the New Accord.
Gist of Basel II in A Nutshell
Threats posed by risk-prone assets held by the bank are to be

counterbalanced not only through holding prescribed minimum capital, but
also to be supplemented by effective supervisory review of capital adequacy
and acceptance of market discipline implying public disclosure to allow
market participants to assess key information about a bank’s risk profile and
level of capitalization. These constitute the three pillars under the second
accord. Thus the underlying implication of the new accord is greater risk
sensitivity. The new accord embodies the principles of “flexibility, menu of
approaches, and incentives for better risk management” as against the current
accord’s prescription of “one size fits all”.
Banks with advanced risk-management tools would be permitted to use their

own internal system for evaluating credit risk by the process of “internal
Ratings Based Approach” instead of the standard risk weight for each
category of assets. Such ratings under the standard Approach are done by
external credit rating agencies. The use of IRB approach will be subject to
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approval by the supervisors based on the standards established by the

Committee.
Towards extending the profile of risk-sensitivity, the new accord intends to

cover all types of risks to which the banks are exposed in addition to credit
risk. This category of market risks is grouped under “operational risks”.
Capital Adequacy:
The existing prudential Capital Adequacy norms (CRAR) will be completely
overhauled by the proposed Basel II norms in future. The new norms for
calculation of risk-weighted assets are aimed at improving the present system
of assessment of risk and to make them more meaningful.
Basel committee on Banking Supervision prescribed key principles for

effective banking supervision, some of them.
• Sound Capital assessment and comprehensive assessment of risks.
• On-site, off-site review/evaluation/surveillance and Stress Test for
banks.
• Excessive holding of capital over and above the requirement norms.
• Early intervention and prompt corrective action.
Supervisory Review :
The second pillar of the New Accord is based on a series of guiding
principles, all of which point to the need for banks to assess their capital
adequacy positions relative to their overall risks, and for supervisors to
review and take appropriate actions in response to those assessments. These
elements are increasingly seen as necessary for effective management of
banking organisations and for effective banking supervision respectively.
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Market Discipline:
The purpose of pillar three is to complement the minimum capital
requirements of pillar one and the supervisory review process addressed in
pillar two. The Committee has sought to encourage market discipline by
developing a set of disclosure requirements that allow market participants to
assess key information about a bank’s risk profile and level of capitalisation.
The Committee believes that public disclosure is particularly important with
respect to the New Accord where dependence on internal methodologies will
provide banks with greater discretion in determining their capital needs. By
bringing greater market discipline to bear through enhanced disclosures,
pillar three of the new capital framework can produce significant benefits in
helping banks and supervisors to manage risk and improve stability.
• Risk Management Process
Risk Management is a process, which involves

basically five steps, which are as follows:
 Risk Identification
Risk Identification involves establishing common
definition of risks across the organisation to ensure that there exists a
uniform understanding across top management, risk takers and risk
managers. Risk identification refers to the need for the organisation to
define and understand the nature of the risks, which it faces.
 Risk Measurement
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The primary objective of any risk management framework is to

enable an organisation to assess and manage the risk, which it faces on a
consistent basis. In order to do this, the organisation needs a
measurement methodology that allows comparison to be made across
different dimensions of risk and enables risk considerations to be factored
into performance measurement and capital allocation decisions
 Risk Monitoring
Risk monitoring is an operational process whereby the organisation would
ensure that it is operating within its defined risk policies and procedures.
 Risk Control
Risk control would be exercised through formal policies and risk profile
management techniques, which are reviewed and approved by the Board
on a regular basis. Risk control policies address aspects such as the scope
of authorised activities or procedures, quantitative guidelines for
managing the firm’s risk exposures, mechanisms for reviewing the
guidelines, etc.
 Risk Reporting
Risk reporting is closely linked to risk measurement. Risk reporting is a
process under which the organisation reports on risk internally through its
management information system as well as to its regulators and
shareholders. Risk management encompasses all the activities of the
organisation that affect its risk profile. These include decisions and
actions to avoid, mitigate, transfer, insure against, put limits on or
explicitly take risk.
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• Risk and Return Relationship
All the investments are risky, whether in stock and capital market or
banking and financial sector, real estate, bullion etc. The degree of risk
however varies on the basis of the features of the assets, investment
instrument, the mode of investment or the issuer of the security etc.
Investors have different motives for investing like regular income, capital
gains, hedge against inflation, and safety of funds, liquidity and
marketability. The first three motives of income, capital gains, and hedge
against inflation refer to the expected return and the last two motives lead
to the risks involved in the investments. Investors generally desire to
have the maximum return possible, as they like returns, but they dislike
the risk, and the extent of risk aversion varies from investor to investor.
But the return depends on the extent of risk that the investor takes.
TYPES OF RISKS FACED BY THE BANKS
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• Prominent Financial Risks

Risks manifest themselves in many ways and risks in banking are a result of
many diverse activities, executed from different locations and by numerous
people. The most PROMINENT FINANCIAL RISKS to which the banks
are exposed to are:
a) Credit Risk that arises due to the possibility of default or delay in
repayment obligation by the borrower of funds.

b) Interest Rate Risk that arises when the interest income or market
value of the bank is sensitive to interest rate fluctuations.
c) Foreign Exchange Risk that arises due to unanticipated changes in
exchange rates and becomes relevant due to the presence of multi
currency assets and/ or liabilities in the bank’s balance sheet.
d) Liquidity Risk that arises due to mismatch in the maturity patterns of
assets and liabilities, which may lead to a surplus/ deficit cash
situation.
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e) Contingency Risk is that arises due to presence of off-balance sheet

items such as guarantees letters of credit, underwriting commitments
etc.
f) Technology Risk is the risk that technological change will render
existing production and delivery systems obsolete and thereby impair a
Bank’s earning potential and capital.
g) Legal Risk arises from an organization inability to enforce it
contracts or collaterals. The risk usually arises from poorly drafted
legal or contractual documentation.
The risks faced by the bankers are fundamentally of three generic categories
viz. Credit Risk, Market Risk and Operational Risk.
CREDIT RISK:
Credit risk is the most fundamental of risks. Basel
Committee’s paper on Core Principles for management
of Credit Risk defines Credit Risk as “The potential
that a bank borrower or counterparty will fail to meet
its obligations in accordance with agreed terms.” In
other words, failure on the part of a borrower to either repay the loan
principal or to service the loan as per the terms of the loan agreement may be
defined as Credit Risk. The Basel Committee’s report adds “The goal of
Credit Risk Management is to maximize a bank’s risk-adjusted rate of return
by maintaining credit risk exposure within acceptable parameters. Banks
need to manage the credit risk inherent in the entire portfolio as well as the
risk in individual credits or transactions. Banks should also consider the
relationships credit risk and other risks. The effective management of credit
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risk is a critical component of a comprehensive approach to risk management

and essential to the long- term success of the banking organization.”
Credit risk may take various shapes. The guidelines issued recently by
Reserve Bank of India identify the following forms in which credit risk may
appear:
a) In case of direct lending, that the funds will not be repaid

b) In the case of guarantees or letters of credit, that funds will not be
forthcoming from the customer upon crystallization of his liability
under the contract with the banker
c) In the case of treasury products, that the payment or series of
payments due from the counterparty under the respective contracts is
not forthcoming or ceases
d) In the case of securities trading businesses, that settlement will not be
affected and
e) In the case of cross-border exposure, that the availability and free
transfer of currency is restricted or ceases
MARKET RISK:
Market Risk is defined as the losses in
on and off balance –sheet items arising
out from the movements in market
prices. There are basically four major
types of market risks that banks are exposed to viz. Interest Rate Risk,
Exchange Rate Risk, Commodity Price Risk and Equity Price Risk.
Management of Market Risk, in fact, is the major focus of Asset-Liability
Management in the banking system. The Basel Committee has also
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proposed a capital charge for market risk.
OPERATIONAL RISK:
It is too tempting to classify all those risks
that are not included in either the credit
risk or market brisk as Operational Risk.
The Basel Committee’s definition of
Operational Risk. The Basel Committee’s
definition of Operational Risk is “the risk
of direct or indirect loss resulting from inadequate or failed internal
processes, people and systems or from external events.” This definition
includes legal risk as well. The use of more highly automated technology,
the growth of e-commerce, large scale mergers and acquisitions that test
the viability of newly integrated systems, the emergence of banks as very
large-volume service providers, the increased prevalence of outsourcing
and the greater use of financing techniques that reduce credit and market
risk, but that create increased operational risk, all suggest that operational
risk exposures may be substantial and growing.
The Basel Committee Report on Operational Risk Management mentions

that a few international banks do have systems to measure operational
risk but they are yet to be classified as satisfactory or acceptable.
Experimental measures adopted by a few banks identified factors like
internal audit ratings, volume, turnover, error rates and income volatility
as indicators of the levels of operational risk. The management of
operational risk is more complicated and requires integration with the
other risk management strategies. Internal controls and internal audit
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are the two basic tools for controlling operational risks.
LIQUIDITY RISK:
Liquidity is the ease with which an
individual, business firm or a financial
institution can obtain cash by selling non-
cash bassets. Access to cash is important in
financial management of all business
enterprises as it helps in ensuing smooth
functioning of the enterprises.
Bank Liquidity may be defined as ability to raise a certain amount of
funds at a certain cost within a certain amount of time. Liquidity needs of
an individual bank are related to the demands made or likely to be made
by both the depositors and borrowers for funds over a period of time.
Liquidity Risk is the possibility that an institution may be unable to meet

its maturing commitments or any do so only by borrowing funds at
unaffordable costs or by disposing assets at rock bottom prices. It
originates from the mismatches in the maturity pattern of assets and
liabilities. Analysis of liquidity risk involves the measurement of not only
the liquidity position of the bank on an ongoing basis but also
examination of how funds requirements are likely to be affected under
crisis scenarios.
Various corrective measures that can be taken in order to avoid any

liquidity crisis may include following:
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1. If the bank is showing a rapid asset growth say in last 1 to 2 years

without corresponding increase in long-term funds it could trigger a
liquidity problem at a later stage. Banks in order to avoid this situation,
should fix prudential limit being the ratio of long-term assets to be
financed out of long-term liabilities. This may ensure that no
disproportionate growth in assets take place without corresponding
growth in long-term funding sources.
2. Banks, which have got high level of potential Non-Performing Assets,

are likely to be deprived of cash inflow and interest income from these
accounts. If NPA levels of the bank are higher than the industry
average, necessary strategies need to, be devised to speed up possible
recoveries.
3. In case of real or perceived negative publicity, bank may provide

necessary information to the public in proper perspective to reduce the
impact of adverse publicity.
4. If the bank is faces with a decline in earnings performance or

projections, it needs to take long-term view about the business
prospects and consider shift in target clientele, create niche market and
to improve on its operational efficiency. The impact of these events on
liquidity of the bank has to be assessed.
• Risks in Project Lending
What is project lending?
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Project lending is medium and long-term loans provided by specialized

financial institutions set up especially for this purpose. It also represents a
source of long-term finance generally repaid in more than 3 years but less
than 20 years. The purpose of the loan could be for the purchase of fixed
assets such as land, building, and machinery construction of factory,
expansion and modernization of Co., setting up a new project, etc.
Steps Involved In Project Lending

1. Projection
2. Loan application
3. Feasibility study
4. Detailed Project Appraisal
5. Issue of application letter
6. Acceptance of terms and conditions
7. Loan agreement
8. Disbursement of funds
9. Post-disbursement (check by bank)
RISKS INVOLVED IN PROJECT-LENDING

Project lending is a risky business as it involves risks capital. The various
risks in project lending are as under:
1. Operating Risk:
Once the projects starts, the bank will be concerned as to whether the
operations are taking place mentioned in the proposal (project-report).
The problem could arise if qualified personnel (employee) are not hired to
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run the project. The project should proceed as per schedule in order to run
successfully and ultimately make profits but in real life, project may not
run as per specifications in the proposal leading to operational risk.
2. Technology Risk:
Technology risk is a major concern for bankers and hence they do not like
to lend to new technologies and prefer tried and tested technology that has
been financed in the past. Also changes in technology might make the
existing machinery obsolete. Because of the fear of under performance of
technology, the banker may ask for additional guarantee from the
companies.
3. Construction Risk:
Non- completion, late completion and cost over-runs(excess cost0 on the
project never getting completed are the key construction risks. The loan
would be disbursed, cash spent but the project would incomplete. Without
completed project there is no cash flow and the loans will never be repaid.
4. Economic risks/ inflation risks.

They are economic viability / profitability factors used to judge a project.
As each project takes a lot of time to set up, start functioning and
ultimately start making profits, there is a difference between the input
price and the output price. The prices may increase to a great extent
making the project functioning difficult. Cross border transaction is also
difficult as each country has different inflation rate.
5. Environmental Risk:
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Environmental risk which was unheard of before is now an important

risk considered by all the banks. This is because, there are many examples
where the project has never started or stopped in between because it is
polluting the nature or harmful to the environment.
6. Political Risk:
Banks of developing countries are very concerned with regards to project
lending, because the rules and regulations in these countries keep
changing any Government action or inaction could affect the project. Also
any change in the Government could affect the project because of the
changes in the Government policies.
7. Foreign-Exchange Risk:
If the project is located abroad, if some portion of the funds is in foreign
currency loans, if plant and machinery is imported, or if any technician is
paid salary in foreign currency, then sudden and extreme changes in
currency values can have an adverse effect on the project.
8. Force-Majeur Risk: (Act of God)

It is also known as risk beyond anyone’s control. This risk could be
because of unforeseen circumstances like natural calamities, earthquakes,
draught, etc. this risk is inherent in all projects and cannot be controlled.
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Conclusion to the Project - Lending issue of the

banks:
Rate of flexibility in banking regulations has allowed banks to operate

better and ultimately serve the customers well and provide for more
capital for economic development.
• Introduction:
Credit Risk Management has
been practiced since
commencement of banking
activity but the discussions of
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risk management. The tools used in different risk management areas and the
resource deployed in terms of skills and technology has shown considerable
sophistication in recent years. The tone has been set by increasing
competition for loan business, declining spreads and the heightened risk
surrounding industrial and commercial activity.
The Basel Committee on banking supervision set by the Bank for

International Settlements (BIS) has issued some broad principles for
management of credit risk by banks. These are:
 Establishing an appropriate credit risk environment
 Operating under a sound credit granting process
 Maintaining an appropriate credit administration, risk measurement
and monitoring process
 Ensuring adequate controls over credit risk
 Role of bank supervisors (bank regulatory authorities) in ensuring that
banks have an effective system in place to identify, measure, monitor
and control risk
Credit risk management covers the decision-making process, before the

credit decision is made, the follow-up of credit facilities, plus all
monitoring and reporting processes. The decision making process covers
all the steps associated with a client’s credit application, from the original
account officer’s proposal to all credit officers who examine the credit
application, or to a credit committee which approves/reviews the
proposal. The decision is based on various credit evaluation parameters
based on financial data, plus judgmental assessment of the market
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outlook, of the borrower, of the management and of the shareholders. The

follow-up is done through periodic reporting reviews of the bank
commitments by customer, industry and country. In addition, “warning
systems” are put in place to signal the deterioration of the situation of the
borrower before default whenever possible. A work-out process, by which
all actions to minimize possible losses are considered and taken, can be
trigger if any default occurs.
• Credit Cards:
The concept of credit cards is simply “Buy
Now….Pay Later”. Through credit cards one
can buy with the card goods, consumable etc,
rather buying with ready cash. It is extremely
convenient as it avoids the risk of cashless in
transit. But it is not risk free alternate as far as bank is concerned. Thus all
the parties associated with the credit card transactions like the buyer, the
seller and the banker – face an element of risk.
• Credit Card Business in India

Andhra Bank and Central Bank introduced this business in 1981.Due to
the developing growth of Indian economy and rising the employment
opportunities, life style of Indian citizens has increased as a result of
which their buying capacity increased. The credit card business is
growing at 35% per year in India. At present there are 20 banks and 15
Non Banking Financial Corporations in combination of Indian and foreign
banks to promote the credit card business in India. At present India have 3
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million credit card holders. 68000 establishments have tied up with banks.
In spite of the growth of the credit business, it covers only 15% of total
earning population of the country.
• RBI Norms on Credit Cards (with effect from 2nd Nov 2005)
1. Issue of unwanted cards /credit facilities without the consent of

customer is prohibited. If Bank/NBFC violates the code then they need
to pay twice the amount to the customer.
2. The customers should be allowed to surrender the credit cards if the

terms of credit card agreement charges.
3. Banks/NBFC- should dispatch statement last week of each month and
should be careful in including bills. No wrong bill is permitted.
4. RBI has come out with following guidelines to protect the interest of
customers.
a. Method of calculation of the charges of interest has to be

disclosed to the customers on demand.
b. The following intermediaries are obliged to not to part any data

to any unauthorized persons:
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DNCR - Do Not Call Registry

DSA - Direct Selling Agent
DMA - Direct Marketing Agent
• Credit Risk Management- Importance

While financial institutions have faced difficulties over the years for a
huge number of reasons, the major cause of serious banking problems
continues to be directly related to lax credit standards for borrowers and
counter parties, poor portfolio risk management, or lack of attention to
changes in economic or other circumstances that can lead to a
deterioration in the credit standing of the bank’s counter parties.
For most of the banks, loans are the largest and obvious source of credit
risk. Banks are increasingly facing credit risk in various financial
instruments other than loans, including acceptances, interbank
transactions, trade financing, financial futures, and in extension of
commitments and guarantees, and the settlement of transactions.
The Goal of Credit Risk management is to maximize bank’s risk-adjusted

rate of return by maintaining credit risk exposure within acceptable
parameters. Banks need to manage credit risk inherent in the entire
portfolio as well as the risk in individual credits or transactions. Banks
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also have to consider the relationships between credit risk and other risks.
Since the exposure of credit risk continues to be the leading source of
problems, banks must have keen awareness in the need to identify,
measure, monitor and control credit risk as well as to determine that they
hold adequate capital against these risks and that they are adequately
compensated for the risks incurred.
Thus, an effective management of credit risk is a critical component of
a comprehensive approach to risk management and essential to the
long-term success of any banking organisation.
• Credit Risk Management Function
The functions performed by Credit Risk

Management are as follows:
• Formulation of desired credit risk management profile and

ensuring compliance with the lending policy of the bank.
• Designing loan approval process.
• Designing comprehensive Risk Rating models for various
categories of advances, and pricing policies.
• Evaluation of Policies for containing risks in various industries
and lines of business through industry studies.
29
• Setting systems for loan appraisal and review and evolving

management Information Systems (MIS) for construction and
periodical review of the credit profile of the bank.
• Migration analysis of the portfolio.
• Use of appropriate portfolio management tools on approval from
Risk Management Committee or Board of the bank.
• Assessing the training needs in the area of credit and designing
advanced programmer for human resource development for credit
risk management.
Evaluation of Credit Risk in a Borrowal Firm
Credit risk in a borrower firm depends on the following factors.

a) Strength of balance sheet from past operations and Projected data:
The strength of the balance sheet from past operations and projected data
can be found out with the help of the following financial ratios:
• Total outside liability to tangible net worth.
• Current ratio.
• Fixed asset turnover ratio.
• Inventory plus receivables to total sales ratio.
• Net profit to net sales ratio
• Profit before interest, depreciation and tax to interest payment.
• Net Sales Growth rate.
• Return on Capital Employed (ROCE)
b) Estimated asset and liability structure:
30
The financial ratios are the arithmetic relationship among various groups
of assets, liabilities and select indices from the revenue statement. These
do not depict the quality of such assets and liabilities. Apart from the
ratios, the following can be checked to assess the quality of the assets and
liabilities:
For liability structure

• A steady or adequate rise in the net worth over the years by infusion
of additional capital and plugging back of profits.
• A credit rating has been obtained from a reputed rating agency on the
debt instrument of the company and it has been remained unaffected.
• The commitments under term liabilities during the year have been
paid and whether such repayment was through the profitability
earned or by swapping it with a new liability.
• Percentage of accrued expenses in the current liabilities.
For Asset structure

• The firm has pursued any technological updating to survive
competition and avoid obsolescence.
• There are long-standing stocks and receivables, which are difficult
to be liquidated. A firm may show very high current ratio but if
the proportion of such stocks and debtors are high, then the current
ratio has to be reworked.
• The investment made in sister companies/ inter-corporate deposits
bearing adequate liquidity and/or helping forward/backward
integration. Whether the interest/ dividend earned on such
investment adequate and realized?
31
c) Risk of future business operations:

An operating cycle is a cycle of raw material being converted into finished
good and finally in sales revenue. Working capital represents an important
part of the employed capital of many companies. At every stage of this
cycle, certain risks are to be identified. Following points are to be
considered for evaluating the risk in future business operations:
d) Risk of future financial scenario:
Following points must be considered to ascertain as to whether the
strength of the existing balance sheet will change as a result of the
inflows and outflow of funds:
• Adequacy of long-term sources expected to be generated to finance
the proposed long-term uses
• Whether the proposed long term uses will help to increase its
production?
• Dividend policy of the firm.
• Adequate long-term surplus expected to be generated to provide
requisite margin for the additional investments in current assets
proposed.
e) Management Risk:
The quality and strength of management and evaluation of key
management traits has also to be considered for assessing the risk.
f) Industry Risk:
The performance of a firm is also affected by the changes in the industry,
to which the firm belongs. Analyzing and predicting the changes in the
32
industry level performance driven by macro-economic factors,

technology, and relationships among customers, suppliers and competitors
that constitute the business environment. The industry risk with respect to
borrowers’ relationship will depend on impact of macro-economic factors
on the performance of the firm.
g) Transaction Risk:
A particular transaction undertaken with a borrower (like issuance of
letter of credit, fully secured by deposit) will be virtually risk free or entail
minimum risk. But this cannot be avoided and must be taken into
consideration while taking credit decisions.
• Credit Risk Management Committee
CHIEF CREDIT OFFICER

(CCO )
Functional heads of Invitees from the

Risk Management Regional heads,
Departments 33
Reputed Credit Officers
A Credit Risk Management Committee is formed at the corporate level with

CCO/President Credit Department (Chief Credit Officer) as its Chairman
and the functional heads of risk management departments amongst its
members. The Committee also has invitees from the field, particularly the
Regional heads, and the expert Credit Officers. Such invitees participate in
the meetings on a rotational basis. The Committee meets once a month.
The main purpose of such a meeting would be to review the various
risk control measures, and for obtaining effective feedback of the field
functionaries for improvement in the Risk
Management techniques.
Traditionally, the credit policy of banks focused primarily on the timely
collection of dues. However, with the markets getting deregulated, there is
increased uncertainty in the operating environment. So, the credit risk
management now involves evaluation and management of growth and
diversification of loans/investment and establishment of the tolerance limits
for credit and investment.
Factors determining credit risk of bank’s portfolio can be divided into

external and internal factors. The bank does not have control on external
factors. These include factors across a wide spectrum ranging from the
state of the economy to the correlation among different segments of
industry. The risk arising out of external factors can be mitigated via
diversification of the credit portfolio across industries especially in light of
34
any expectations of adverse developments in the existing portfolio. As

banks have very little control over such external factors, the ban can
minimize the credit risk by managing the internal factors. The Banks loan
policies, appraisal processes, monitoring systems, know your Borrower at
entry level etc. This will improve the quality of credit decisions and
portfolio.
• Organizational Set Up For Credit Risk Management

A common feature of most successful banks
is to establish an independent group
responsible for credit risk management. This
will ensure that decisions are made with
sufficient emphasis on asset quality and will
deploy specialized skills effectively. In
some organizations, the credit risk
management team is responsible for the management of problem accounts
and for credit operations as well. It is imperative that the independence of the
credit risk management team is preserved, and it is the responsibility of the
Board to ensure that this is not allowed to be compromised at any time. The
credit risk strategy and policies should be effectively communicated
throughout the organization. All lending officers should clearly understand
the bank’s approach to granting credit and should be held accountable for
complying with the policies and procedures.
• Evaluation of Risk in Credit Portfolio of a Bank:

The amount of risk in the credit portfolio of a bank can be found from the
following:
35
Exposure risk
Exposure risk is the portfolio risk arising out of concentration of exposure to
a single borrower or a business group. Greater credit exposure to few
borrowers or a group, higher the risk in the portfolio, as the default on the
part of these borrowers to repay would affect liquidity of the bank. It is
essential to explore the possibilities for restructuring the exposure by way of
investment and lending where existroute is easier and returns are proportional
for risk return tradeoffs. Almost all the banks conform to the prudential
norms for exposure stipulated by the RBI. Majority of banks has designed
separate limits for restricting exposure within the order limit stipulated by
RBI.
Borrower risk
Borrower risk is the portfolio risk arising out of asset quality of individual
borrowers. Higher the asset quality of the individual loans, lesser the risk.
The asset quality of the borrower can be evaluated through a credit risk rating
system. Preference for asset quality should be emphasized through various
communications with the top management. More aggressive monitoring
should be introduced in respect of high-risk accounts.
Industry risk
Credit exposure of a bank also consists of accounts belonging to various
industries and other lines of business. Each Industry can be classified as a
low risk, moderate or high-risk industry. The below Industry matrix can
explain this:
From the matrix, the following observations can be made.
a) If the industry risk is low and even the exposure of the bank to that
36
particular industry is low, the bank can lend more in such an industry.
b) If the industry risk is low but the exposure of the bank to that particular
industry is high, the bank should strengthen its exposure to that industry so as
to protect itself from the competitors.
c) If the industry risk is high and the exposure of the bank is low, the lending
to such an industry should be discouraged.
d) If the industry risk as well as the exposure is high, the bank should stop
lending to such an industry and try to shed such accounts to improve the
industry risk profile. Most of the banks do carry out industry studies
normally undertaken by the Economic Intelligence Department or in large
Public/Private sector banks by Risk Management Department. The method
of conducting these studies may vary from bank to bank.
The large public/Private sector banks have their own database for analysing
spread of credit portfolio over various industries. Certain banks take
decisions on the basis of their experiences in a particular industry.
Geographic risk
Geographic risk is the risk arising out of the concentration of lending in a
particular geographical area. If the Bank’s credit were spread over different
activities in a particular geographical area, the geographical risk would be
less. Proper spread of credit to different activities is different geographical
risk.
Risk arising out of type of credit / nature of delivery
37
Term Loans, Overdrafts, cash credits and Bills purchased are included in the
credit basket. The term loans are the less liquid as compared to other types
of credit and so, the bank must take utmost care in this case. As the credit
period increases, the risk also increases. This compels the bank to limit its
exposure to term loans and increase the cost of borrowing as the credit period
increases. Pricing is generally linked to the bank’s medium term prime
lending rate (MTLR), the lowest in the industry. It is also beneficial for the
bank to finance those borrowers who have good track in repaying the loan.
Aggregation of the above mentioned risks would form a composite credit

profile in the entire credit portfolio of the bank.
• Instruments or Techniques of Credit Risk

Management
The credit risk management encompasses a host of management techniques,
which help the banks in mitigating the adverse impacts of credit risk. The
various credit risk management techniques are as follows:
a) Credit Approving Authority:
Credit approving authority is one of the instruments of assisting credit risk
management. The multi-tier credit approving system helps in approving the
loan proposals by an Approval Grid or a “Committee”, comprising of at least
3 to 4 officers invariably, one officer should represent the Credit Risk
Management department who has no volume or profit targets. The “Grid” or
“Committee” may approve the credit facilities above a specified limit. Banks
also consider credit-approving committees at various operating levels (large
branches, Regional offices, Zonal offices, Head offices etc.).
38
Banks could consider delegating power for sanction of higher limits to the
Committee for better related or quality customers. If the majority members
of the Committee do not agree on the creditworthiness of the borrower, no
credit proposals should be approved or recommended to the higher authority.
Specific views of dissenting member/s should be recorded in case of
disagreement.
b) Prudential Limits
In order to limit the magnitude of credit risk, prudential limits could be laid
down on various aspects of credit such as.
Benchmark
The bank should stipulate benchmark, current/debt equity and profitability
ratios, with flexibility for deviations. The conditions subject to which
deviations are permitted and the authority therefore should also be clearly
spelt out in the loan policy.
Borrower limits
The single/group borrower limits, whichever may be lower than the limits as
prescribed by the RBI to provide a filtering mechanism.
Substantial exposure limit

Substantial exposure limit which is 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 (Tier I & II). The
Substantial exposure limit may be fixed at 600% or 800% of capital fund,
39
depending upon the degree of concentration risk the bank is exposed.
Maximum exposure limit

Maximum exposure limit to industry or sector etc should be setup. There
must also be systems in place to evaluate the exposures at reasonable
intervals and the limits should be adjusted especially when a particular sector
or industry faces slow down or other specific problems. The exposure limits
to sensitive sectors, such as advances against equity shares, real estate, etc.,
which are subject to a high degree of asset price volatility and to specific
industry, which are subject to frequent business cycles, may necessarily be
restricted.
Similarly, high-risk industries, as perceived by the bank, should also be
placed under lower portfolio limit. Any excess exposure should be fully
backed by adequate collaterals or strategic considerations.
Maturity profile
Banks may consider maturity profile of the loan book, keeping in view the
market risks inherent in the balance sheet, risk evaluation capability,
liquidity, etc.
c) Risk rating:
Banks must have a comprehensive risk scoring/rating system that serves as a
single point indicator of diverse risk factors of a counter party and for taking
credit decisions in a consistent manner. To facilitate this, a substantial
degree of standardization is required in ratings across borrowers. The risk
rating system should be designed to reveal the overall risk of lending, critical
input for setting pricing and non-price terms of loans as also present
40
meaningful information for review and management of loan portfolio. The

risk rating in short should reflect the underline credit risk on the loan book
and should facilitate the credit granting authority, some comfort in its
knowledge of loan quality any time.
The risk rating system should be drawn up in a structured manner,
incorporating, financial analysis, projections and sensitivity, industrial and
management risks. Within the rating framework, banks can prescribe certain
level of standards, beyond which no proposals should be entertained. Banks
may consider separate rating framework for large corporate or small
borrowers, traders, (Retail-Small and Medium Enterprises) etc. Those
exhibit varying nature and degree of risk. The overall score for risk is to be
placed on a numerical scale ranging as per international standard such as
AAA, AA+, AA, A, BBB+, BBB, BB, B, C or range of (1-6) etc. on the
basis of credit quality. For each Alphabetic/ Numeric category, a
quantitative definition of the borrower, the loan’s underlying quality, pricing
and an analytic representation of the underlying financials of the borrower
should be presented As a prudent risk management policy, each bank should
prescribe the minimum rating below which no exposures would be
undertaken. Any flexibility in the minimum standards and conditions for
relaxation and authority therefore should be clearly articulated in the loan
policy.
d) Loan Review Mechanism

Loan review mechanism is an effective tool for constantly evaluating the
quality of loan book and to bring about qualitative improvements in credit
administration. Bank should, therefore, put in place proper Loan review
mechanism for large value accounts with responsibilities assigned in various
41
areas such as, evaluating effectiveness of loan administration, maintaining

the integrity of credit grading process, assessing the loan loss provision,
portfolio quality, etc. the complexity and scope of Loan review mechanism
normally vary based on bank’s size, type of operations and management
practices. It may be independent of the Credit Risk Management Department
or even a separate department in large banks.
The main objectives of Loan review mechanism could be:
To identify promptly loans which develop credit weaknesses and
initiate timely corrective action.
To evaluate the portfolio quality and isolate potential problem areas.
To provide information for determining adequacy of loan loss
provision.
To assess the adequacy of loan policies and procedures.
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 Loan review mechanism. 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 rating
awarded by Credit Administration Department should be subjected to
review by Loan Review Officers who are independent of loan
administration.
42
e) Risk pricing
Risk-return pricing is a fundamental principle of risk management in
which, the borrowers, with weak financial position, placed in the high
credit risk category, should be priced high, Scientific systems could be
evolved to price credit risks, which has a bearing on the expected
probability of defaults. The pricing of loans normally should be linked to
risk rating or credit quality. The probability of default could be derived
from the past behavior of the loan portfolio, which is the function of loan
loss provision/ charge offs for last five years or so.
Banks should build a historical database on the portfolio quality and

provisioning to equip themselves to price risk but the value of collateral,
market forces, perceived value of accounts, future business potential,
portfolio exposure and strategic reasons also play an important role in
pricing. Flexibility should be made for revising the price due to changes
in rating/ value of collaterals over time.
g) Portfolio management
The existing framework of tracking the Non Performing Assets around the
balance sheet does not signal the quality of entire loan book. Bank should
evolve proper systems for identification of credit weaknesses well in
advance. Most of the international banks have adopted various portfolio
management techniques for gauging asset quality. The Credit Risk
Management Department, set up at head office should be assigned the
responsibility of periodic monitoring of the portfolio. The portfolio
quality could be by tracking the migration (upward/downward) of
43
borrowers from one rating scale to another. This process would be

meaningful only if the borrower-wise rating are updated at half-
year/Yearly intervals. The following portfolio management tools could be
used.
Risk Adjusted Return on Capital (RAROC) is a sophisticated statistical

system, which measures the financial risks in any product, portfolio or
business for computing the amount of capital required to protect the bank
against the potential losses from each risk.
Migration analysis helps in tracing the degree of shift in loans from one risk
category to other and also provides foundation for deciding the adequacy of
loss provisions and for predicting effect on earnings.
Co variance analysis helps to evaluate positive or negative variance in the

fortunes of two industries or lines of business and its impact on the portfolio
risk.
Securitisation of loans creates the opportunity for national market for loans,
which significantly enhances an individual bank’s ability to manage portfolio
concentration risks. It is not very common in India so far. But the
introduction of Securitisation and Reconstruction of Financial Assets and
Enforcement Act, boost the very effective recovery measures.
Credit derivatives can be used as an effective portfolio risk management tool

to provide default protection in respect of a single specified credit sensitive
44
asset or a portfolio of assets.
• Why Credit Risk Management Is Crucial?

Basel II Accord conceived by the Basel Committee in June 1999 was
released practically after five years, in June 2004. During the series of
deliberants it became increasingly clear to the committee that in the most of
the countries of the world banks had been facing serious credit issue related
problems (besides market risks and operational risks) 90 to 95% of a bank’s
business stems credit operations mainly due to the following reasons.
 Lax credit standards for assessment of borrowers/ guarantors.
 Poor portfolio risk management.
 Lack of attention of changes in economics or other circumstances
leading to deterioration in credit quality.
There fore, they felt credit risk (comprising not only of loans and advances
but also investment in securities) management in banks need to be sharpened
and fine-tuned to focus on:
 Identification of risk elements.
 Measurement of risk as identified.
 Monitoring of risk based on appropriate credit rating system.
 Installation of ongoing control mechanisms in order that risk as
individual/portfolio does not attend any vulnerable position.
With a view to translating the aforesaid objectives into meaningful action in

each bank the committee first evolved broad principles of credit risk
management.
45
• Principles of Credit Risk Management

There are 16 principles of Credit Risk Management as per the Basel
Committee:
Basel committee has evolved principles covering establishment of credit risk
management environment, sound credit granting process, appropriate credit
administration, measurement, monitoring process and controls over credit
risk which are summarized as under:
1) Board of each bank has the responsibility of –

• Approving &
• Periodically reviewing credit risk policy and strategy reflecting risk
tolerance level, etc
2) Senior management (i.e. those below board) has the responsibility of

(a) Implementing credit risk policy
(b) Developing and maintaining procedure for identification,
measurement, monitoring and control of credit risk both at individual
credit level as also at portfolio level.
3) Before introducing any new credit, product inherent risk should be

thoroughly identify together with control procedure.
4) Credit granting criteria to include -

 Thorough understanding of the borrower/counter party.
 Purpose and structure of credits.
46
 Source of repayment.
5) Overall credit limits at the level of individual borrower/counter
party and group to be fixed.
6) To have a clearly established process for approving as well as

extending existing credits.
7) Risk of connected lending to be controlled /mitigated on an arm’s

length basis.
8) Credit risk-bearing portfolios to be under ongoing scrupulous

administration.
9) System of monitoring condition of individual or including determining

adequacy of proving must be in place in each bank.
10) Appropriate management information system must be installed

containing analytical techniques to measure credit risk including
concentration risk.
11) Overall composition and quality of credit portfolio must be

monitored regularly.
12) Potential future changes under stressful conditions, to be analyzed

while taking up credit risk.
47
13) To establish a system of independent, ongoing credit review and

reporting the outcome to board from time to time.
14) Credit exposures at any point of time are to be within levels
consistent with prudential standards and internal limits.
15) Appropriate system to be in place for managing problem credits.
16) Credit rating system in each bank should be consistent with the
nature, size and complexity of bank’s activities.
• Risk Management Systems- RBI

Guidelines
While managing credit risk the guidelines issued by

the RBI to banks I India are clearly defined and exhaustive. Broad spectrum
is as follows:
 Credit policies that define target markets, risk acceptance criteria,
credit approval authority, credit organization and maintenance
procedures and guidelines for portfolio management and remedial
management.
 Establish pro-active credit risk management practices like annual/half
yearly industry studies and individual obligor reviews, periodic credit
calls that are documented, periodic plant visits, and at least quarterly
management of troubled exposures/ weak credits.
 Business managers in banks in banks to be accountable for managing
risks and in conjunction with credit risk management framework for
48
establishing and maintaining appropriate risk limits and risk

management procedures for their businesses.
 Banks to have a system of checks and balances in place around the
extension of credit.
 An independent credit risk management function
 Multiple credit approvers.
 An independent audit risk review function
 The Credit Approving Authority to extend or approve credit will be
granted to individual credit officers based upon a consistent set of

standards of experience, judgment and ability.
 The level of authority required to approve credit will increase as
amounts and transaction risks increase and as risk rating worsen
 Every obligor and facility must be assigned a risk rating.
 Banks to ensure that there are consistent standards for the organization,
documentation and maintenance for extensions of credit.
 Banks to have a consistent approach toward early problem recognition,
the classification of problem exposures, and remedial action.
 Banks to maintain a diversified portfolio or risk assets in line with the
capital desired to support such a portfolio.
 Credit risk limits include, but are not limited to, obligor limits and
concentration limits by industry or geography.
 In order to ensure transparency of risks taken, it is now upon banks to
accurately, completely and in timely fashion, report the comprehensive

set of credit risk data into the independent risk system.
• Credit Risk Management – An Indian Perspective
49
Banks And Risk Management
Banks in the process of financial intermediation are

confronted with various kinds of financial and non-
financial risks viz. credit, interest rate, foreign
exchange rate, liquidity, equity price, commodity
price, legal, regulatory, reputational, operational,
etc. These risks are highly interdependent and events that affect one area of
risk can have ramifications for a range of other risk categories. Thus, top
management of banks should attach considerable importance to improve the
ability to identify measure, monitor and control the overall level of risks
undertaken.
• 21st Century Risk Management
Banking landscape in the 21st century will be bumpy and volatile. Invaded by
the forces of technological advancement in computers and communications
technology coupled with globalization of finance, financial services have
been commoditized. With commoditization comes the supremacy of the
customer. With customer dictating what is to be customized for delivery, the
forces of competition decide both the bank specific and systematic risks.
There is an entire “Galaxy of Risks” that comes in new forms, new shapes
50
and new combinations as follows:
Accounting Reputation
Risk Risk
Bankruptcy Spread Risk
Risk Systemic
Basis Risk Risk
Capital Risk Systems Risk
Catastrophic Tax Risk
Risk Time Lag
Contract Risk Risk
Credit Risk Technology
Currency Risk risk
Fraud Risk Volatility
Interest Rate Risk
Risk
Knowledge
Risk
Legal Risk
Limit Risk
Liquidity Risk
Market Risk
Personal Risk
Political Risk
Prepayment
Risk
Publicity Risk
Raw Data
Risk
Regulatory
Risk
51
With globalization, banks are exposed these risks in complicated
interdependencies. The many linkages between macro-economic
developments and the financial sector increase the systematic risks also for
the banking system. The technological advancement along with new cross-
border concentrations characterized by speed and volatility but also has made
them larger and more complex to analyze. New patterns of connectivity have
not only caused increased risk concentrations characterized by speed and
volatility, but also have made them larger and more complex to analyze. New
patterns of connectivity and speed occur. As a result, covariance across risk
categories increases in amount and in character. This heightened covariance
will cause chameleon like change in known risk categories to grow in
importance. Non-traditional risk areas such as reputation risk and legal risk
characterize the 21st century risk scenario. As a consequence, more and more
banks come to fall on these risks. Those banks who believe in risk
management as a mere regulatory requirement find their beliefs dashed to the
ground
Thus the changing nature of risks to banks will make risk management more
important today than ever before. The disaster that occurred in recent years
was not unfortunate and random events. They were the result of failure of
risk governance. Preventing such disasters in the future will heighten the
importance of putting in place improved risk governance mechanisms.
Management should not become entirely enraptured by their planned course
of action for financial parameters of performance such as assets growth,
growth of equity and return on assets only. Such undiluted devotion might
make, managements blind to the risks-in fact they are big boulders – of risks
on the road of intermediation. .
• Build the Risk Culture and it Manages All
There is need for cultural change when the environment is undergoing
fundamental change. Banks must be build and continue to portray an image
of safety and soundness. Bank managements must, therefore, determine
which beliefs and values need to be built as risk culture. Part of this culture
should be in the form of written responsibilities of committees, managers and
line management. The real culture supersedes all written policies.
• Written Responsibilities
Bank managements need to constitute risk policy committees with top
managements. These committees should set policies, guidelines and limits
for various risks assisted by technical advisory groups. The line
managements should be made responsible for ensuring that each department
has the right people with the right capabilities to meet the goals of risk
management. In addition, independent checks and balances need to be
maintained through, for ensuring the integrity of financial reporting. The
prime responsibilities of a risk manager include overseeing that all the
relevant policy procedures are properly applied and ensuring that all risk
limits accurately reflect both current and expected market conditions.
• The Risk Culture

Bank managements need also to create and sustain a strong and consistent
risk culture within their organizations. This culture – unwritten rules, beliefs,
values and responsibilities – supersedes all written policies. It sets the tone in
the bank as to how the line management and managers should think about
growth, business conditions and changing risks. If the culture is strong and
non contradictory, it helps the managers successfully adapt to change, the
future and the technology. All perceptions and decisions will automatically
be derived from this culture. Then only risk management becomes an
integrated business syndrome in banks.
ICICI Bank & its Credit Risk Management
Overview
ICICI Bank is India's second-largest bank with total assets of Rs. 3,446.58
billion (US$ 79 billion) at March 31, 2007 and profit after tax of Rs. 31.10
billion for fiscal 2007. ICICI Bank is the most valuable bank in India in
terms of market capitalization and is ranked third amongst all the companies
listed on the Indian stock exchanges in terms of free float market
capitalisation*. The Bank has a network of about 950 branches and 3,300
ATMs in India and presence in 17 countries. ICICI Bank offers a wide range
of banking products and financial services to corporate and retail customers
through a variety of delivery channels and through its specialised subsidiaries
and affiliates in the areas of investment banking, life and non-life insurance,
venture capital and asset management. The Bank currently has subsidiaries in
the United Kingdom, Russia and Canada, branches in Singapore, Bahrain,
Hong Kong, Sri Lanka and Dubai International Finance Centre and
representative offices in the United States, United Arab Emirates, China,
South Africa, Bangladesh, Thailand, Malaysia and Indonesia. Our UK
subsidiary has established a branch in Belgium.
ICICI Bank's equity shares are listed in India on Bombay Stock Exchange
and the National Stock Exchange of India Limited and its American
Depositary Receipts (ADRs) are listed on the New York Stock Exchange
(NYSE).
History
ICICI Bank was originally promoted in 1994 by ICICI Limited, an Indian

financial institution, and was its wholly-owned subsidiary. ICICI's
shareholding in ICICI Bank was reduced to 46% through a public offering of
shares in India in fiscal 1998, an equity offering in the form of ADRs listed
on the NYSE in fiscal 2000, ICICI Bank's acquisition of Bank of Madura
Limited in an all-stock amalgamation in fiscal 2001, and secondary market
sales by ICICI to institutional investors in fiscal 2001 and fiscal 2002. ICICI
was formed in 1955 at the initiative of the World Bank, the Government of
India and representatives of Indian industry. The principal objective was to
create a development financial institution for providing medium-term and
long-term project financing to Indian businesses. In the 1990s, ICICI
transformed its business from a development financial institution offering
only project finance to a diversified financial services group offering a wide
variety of products and services, both directly and through a number of
subsidiaries and affiliates like ICICI Bank. In 1999, ICICI become the first
Indian company and the first bank or financial institution from non-Japan
Asia to be listed on the NYSE.
After consideration of various corporate structuring alternatives in the

context of the emerging competitive scenario in the Indian banking industry,
and the move towards universal banking, the managements of ICICI and
ICICI Bank formed the view that the merger of ICICI with ICICI Bank
would be the optimal strategic alternative for both entities, and would create
the optimal legal structure for the ICICI group's universal banking strategy.
The merger would enhance value for ICICI shareholders through the merged
entity's access to low-cost deposits, greater opportunities for earning fee-
based income and the ability to participate in the payments system and
provide transaction-banking services. The merger would enhance value for
ICICI Bank shareholders through a large capital base and scale of operations,
seamless access to ICICI's strong corporate relationships built up over five
decades, entry into new business segments, higher market share in various
business segments, particularly fee-based services, and access to the vast
talent pool of ICICI and its subsidiaries. In October 2001, the Boards of
Directors of ICICI and ICICI Bank approved the merger of ICICI and two of
its wholly-owned retail finance subsidiaries, ICICI Personal Financial
Services Limited and ICICI Capital Services Limited, with ICICI Bank. The
merger was approved by shareholders of ICICI and ICICI Bank in January
2002, by the High Court of Gujarat at Ahmedabad in March 2002, and by the
High Court of Judicature at Mumbai and the Reserve Bank of India in April
2002. Consequent to the merger, the ICICI group's financing and banking
operations, both wholesale and retail, have been integrated in a single entity.
Credit Risk Management
Credit risk, the most significant risk faced by ICICI Bank, is managed by the
Credit Risk Compliance & Audit Department (CRC & AD) which
evaluates risk at the transaction level as well as in the portfolio context. The
industry analysts of the department monitor all major sectors and evolve a
sectoral outlook, which is an important input to the portfolio planning
process. The department has done detailed studies on default patterns of
loans and prediction of defaults in the Indian context. Risk-based pricing of
loans has been introduced.
The functions of this department include:

Review of Credit Origination & Monitoring
Credit rating of companies/structures
Default risk & loan pricing
Review of industry sectors
Review of large exposures in industries/ corporate groups/ companies
Ensure Monitoring and follow-up by building appropriate systems such as CAS
Design appropriate credit processes, operating policies & procedures
Portfolio monitoring
Methodology to measure portfolio risk
Credit Risk Information System (CRIS)
Focused attention to structured financing deals

Pricing, New Product Approval Policy, Monitoring
Monitor adherence to credit policies of RBI
During the year, the department has been instrumental in reorienting the
credit processes, including delegation of powers and creation of suitable
control points in the credit delivery process with the objective of improving
customer response time and enhancing the effectiveness of the asset creation
and monitoring activities.
Availability of information on a real time basis is an important requisite for
sound risk management. To aid its interaction with the strategic business
units, and provide real time information on credit risk, the CRC & AD has
implemented a sophisticated information system, namely the Credit Risk
Information System. In addition, the CRC & AD has designed a web-based
system to render information on various aspects of the credit portfolio of
ICICI Bank.
Conclusion
Risk is an inherent part of ICICI Bank’s business, and effective Risk

Compliance & Audit Group is critical to achieving financial soundness and
profitability. ICICI Bank has identified Risk Compliance & Audit Group as
one of the core competencies for the next millennium. The Risk Compliance
& Audit Group Group (RC & AG) at ICICI Bank benchmarks itself to
international best practices so as to optimise capital utilisation and maximise
shareholder value. With well defined policies and procedures in place, ICICI
Bank identifies, assesses, monitors and manages the principal risks:
The ability to implement analytical and statistical models is the true test of a
risk methodology. In addition to three departments within the Risk
Compliance & Audit Group handling the above risks, an Analytics Unit
develops quantitative techniques and models for risk measurement.
Primary Data on State Bank of India
About the Bank

The State Bank of India (SBI) is the only bank in India to be ranked among
the top banks in the world and also among the 20 banks in Asia in the annual
survey by “The Banker”. Its approach to business is being re-engineered
through change in processes, implementation of core banking and
recruitment of specialists.
The Report:
The researcher had a very good experience to interact with the bank manager
and know their experience in hand. The researcher was provided with very
good information on risk management in banks which summarization is done
below.
It was said that “High Risk High Return and Low Risk Low Return” is the
principle followed by the banks. As it is well known that banking is the
business of financial assets wherein many risks are involved. There are many
participants in this business like co-operative, nationalized banks etc. due to
this competitive scenario and as the economy is integrated to global level risk
management is very important. The Mr. S.N.Muthuswami spoke to the
researcher on the bank’s various risks faced, new plans for the bank and
his views on Risk Management.
The following is a part of the excerpt from an interview of the Chief Manager
of State Bank of India (Nepean Sea Road , Worli) , Mr. S.N.Muthuswami .
Views on the risks faced due to merging in banking which has

taken place recently with State Bank of Saurashtra-
Merging as a whole is a good concept because of the main reason of
expansion of the banking business of SBI. But the risks arte present in such a
consolidation. They are as follows:
• Convincing the employees become very difficult job as they are new to
the new policies, procedures, etc. to some extent.
• The work culture also changes.
• As far as the customers are concerned, they become new to the facilities
provided by the newly merged bank as they are used to the facilities
provided by the bank they deal with.
• The staff has had to face challenges of switching to a fully network
environment and replacing age-old processes with modern ones.
But to overcome this, SBI has created with the new system of banking
activity- the Core Banking Solution(CBS) where the customer can perform
transactions wherever they are across globe. The employers follow common
policies due to such a system. Thanks to the Australian software
application used for the CBS known as Banc 24.
The use of technology was another of the contributing factors to the

operational level of transaction and also in improving the service quality to
customer.
Plans on Card Business and thereby Credit Risk policies-

SBI credit card business, although, is in a good pace, but as far as the less
proportionate growth of Credit card selling is concerned, the reason behind
this would be the charge hired for the service the bank provides.
As per SBI’s policy on card selling, it avoids issuing credit card to some
group of people/professionals, like; Policemen, NRI, Advocates as they are
aware of the laws and can take advantage of this.
SBI attained impressive broad-based growth in credit. With the creation of a
group solely focused on mid-corporate, the bank augmented its portfolio of
new units and extension of credit significantly in this segment. The advances
grew substantially as a result of the setting up of Small Enterprises Credit
Cells (SECCs) across the country for uniform and speedy processing of loan
proposals.
While retail and consumer credit continue to expand and agriculture also
picked up, the biggest boost came from accelerating demand from medium
and large companies in manufacturing and infrastructure.
Express Credit which was introduced to provide pr-approved personal loans

to employees of leading PSUs and government gave good business. Kisan
Credit Card scheme target was surpassed by issuing near
10lakh cards.
The above are some of the credit facilities provided by the SBI.
Credit Risk Management:

A revised Credit Risk Assessment (CSA) System detailing a unified structure
certain segments like Small Scale Industries (SSI), was rolled out across the
whole Bank.
The Risk Management Committee of the Board (RMCB) oversees the policy
and strategy for integrated risk management relating to various risk
exposures of the Bank and the Credit Risk Management Committee (CRMC)
has been monitoring the Bank’s domestic credit portfolio.
SBI Branches Abroad, Opening New Branches Plans and the
risk faced during such an act-
The SBI had opened the branches abroad like in Sydney (Australia), Beijing
(China), Tokyo (Hong-Kong), etc. There are SBI representative offices like
State Bank of Canada, State Bank of Mauritius, State Bank of California, etc.
The Operational Risk Management Committee in the Bank oversees the

Operational Risks and the requisite control measures. An Operational Risk
Management Policy duly approved by Central Board of the Bank is in place.
The International Banking Group (IBG):

The Bank had a network of 54 overseas offices spread over nearing 28
countries covering all time zones. For efficient and extensive international
operations, the Bank maintains comprehensive Correspondent Relationship
with many international banks.
The risk that involves is the foreign risk wherein the sovereign risk element
appears as:
• Country policy may change in other nations.
• Local union/standing might create problem.
• The market condition like interest rate fluctuations in abroad
Conclusion:
The bank had witnessed an unparalleled growth in bank credit, with a
particularly sharp pick-up in the second half of the year. State Bank of India,
being a Public Sector Bank, has given full justice to the growth in the
economy of the country, to the customers as far as the services rendered are
concerned & the ultimate usage of technology has scored at its best level.
Indeed, it is rightly said,
State Bank of India…Pure Banking…Nothing else!!!
FINDINGS OF THE STUDY
Credit Risk Management System
1) The Lending Policy and the Credit Risk
Rating System are the basic tools, which can

help to contain the credit portfolio of the
banks .All the banks have specified in-house limits of finance to
certain industries or lines of business and to single borrower in order to
diversify the risk. Every bank has adopted Credit Rating system. The
banks in India, no longer content with traditional measures like
exposure limits and credit rating, are in the process of overhauling
their entire system of risk management. The banks will be moving
towards Risk-Adjusted Return on Capital frame work for appraising
of loans which calls for data on portfolio behavior and allocation of
capital commensurate with credit risk inherent in loan proposals.
2) Most of the banks have separate credit monitoring or recovery
departments dealing with resolution of Non -performing Assets. Most

of the banks do not have a formal credit risk management structure. In
some of the private sector banks, credit risk management department
has implemented sophisticated information system and also designed a
web-based system to render information on various aspects of credit
portfolio.
3) It is a very important that banks maintain a formal Credit Risk
Management Policy and ensure a devotion to the same under all

circumstances. However, while laying down the system, banks must
distinguish between the risk factor of the borrower and those
associated with specific transaction.
4) Non-Performing Assets: The percentage of the non-performing loans
in schedule commercial banks in India as compared to the other

nations is very high .This high percentage can also be attributed to the
severe asset classification norms, which the Indian banks follow.
As per the report published in DNA Money, dated 22nd August 2007,
“High – risk Loans begin to hurt Banks”, Indian Banks are paying
the price for riding on the high growth bandwagon in the last one year.
Rising retail borrowing costs for customers due to higher interest rates
has meant that NPAs of banks have risen in the first quarter of the
year. The banks that are facing the brunt of the rate fury are three of
the largest banks in the country.
The State Bank of India and Punjab National Bank in the
quarter ended June have seen their net NPAs rise by 6 basis points,
respectively, largely as higher interest rates meant more retail
borrowers were unable to repay the EMIs. The ICICI bank was the
worst hit because of the high proportion of the retail lending in its
portfolio. It’s net NPAs increased by 30 basis points in the period.
5) Unlike in other nations where the ill-liquid assets are classified into
loss category after they remain as due/doubtful for a considerable
period of time, the Indian banks classify all un-collectable assets
immediately into the loss assets category. While the Indians banks
make provisions even for the secured portion of the assets, in other
nations, the secured portion is deducted and provision is made on the
net doubtful assets. The provision that Indian banks make on the
unsecured portion is 100 percent, while it ranges between 50-75
percent in other nation. Thus, the norms that govern the Indian banks
are in several aspects more stringent than in other nations.
6) In most of the bank, sanctioning authorities are delegated as per

hierarchical positions and the amount, which is to be sanctioned,
depends upon the grade of the officer and the nature of the security
available for advance. Sanctioning powers in Indian banks are not
based on the agreeable risk grade of an account (i.e. if the risk is least,
the power to sanction the loan should be higher).
CONCLUSION
RBI’s Step
The Advisory Group constituted by the Reserve Bank of India has
recommended the bank boards should modify their approach towards internal
controls to have a firmer say in their maintenance and improvement in the
internal control systems. The Apex bank may consider issuing detailed
instructions requiring banks to have mechanisms in place for continually
assessing the strength of guarantees and appraising the worth of collateral.
The RBI may assist the banks in hastening introduction of scientific risk
management systems.
Conclusion
A clear distinction should be made between risk taking and risk
management. Risk management oversees and ensures the integrity of the
process with which risk are taken. To maintain objectivity, risk management
cannot be part of risk taking process. Individuals who manage risk need to be
completely independent from those responsible for risk taking. Enterprise
risk management is a complex and multifaceted process, which varies from
one organization to the other. It should be visualized and ensured to be an on-
going process, involving continual oversight, planning and modifications as
needs evolve.
RECOMMENDATIONS & SUGGESTIONS
How to Shield Yourself?

With globalization, banks are exposed to
many risks in complicated
interdependencies. Linkage between
macro-economic developments and the
financial sector increases the systemic
risks for the banking system. Effective
governance of these risks comprises several policies and procedures that can
take many different forms from bank to bank. The role of the Board of
Directors is crucial in effective risk management. The bank must know what
risks it faces and implement a system of measuring those risks. The benefits
of risk management are myriad in nature but accrue mainly in two ways: one
is the risk containment and the other is profit optimization. The New Capital
Accord has proposed a “three pillar” structure for supervision. These three
pillars are: minimum capital requirement, the supervisory oversight and the
judgment and market discipline. Bank management must create and sustain a
strong and consistent risk culture within their organizations.
Following are the recommendations:

 Credit risk should receive the prime attention of the top
management. The banks should put in place the loan policy, approved
by the board of directors covering the methodologies for measurement,
monitoring and control of credit risk.
 Banks should also evolve comprehensive risk rating system that
serves as a single point indicator of diverse risk of counter parties in

relation to credit and investment decisions.
 The banks should evaluate portfolio quality on an ongoing basis
rather than near about balance sheet date. The proposal for investment
should be subjected to the same degree of credit analysis as loan
proposals. The risk evaluation should also include balance sheet
exposure. The current potential credit exposures may be measured on a
daily basis.
 Implementation of integrated risk management could be assigned to
a risk management committee or a committee of top executives that

reports to the board. The banks should constitute a high level credit
policy committee to deal with issues pertaining to credit sanction,
disbursement and follow of procedures to manage and control credit
risk on a whole bank basis.
 The bank should concurrently set up an independent credit risk
management department to enforce and monitor compliance of risk

parameters and prudential limits set by the board/credit policy
committee.
 Due to diversity and varying size of balance sheet items between
banks, it may neither be possible nor it necessary to adopt uniform risk

management system. The design of risk management framework
should therefore be oriented towards the banks own requirement
dictated by the size and complexity of the business, risk philosophy,
market perception and the existing level of capital. In other words
banks can evolve their own systems compatible with the type and size
of operations as well as risk perception. While doing so banks may
critically evaluate their existing risk management system in the light of
guidelines issued by the Reserve bank and putting place a proper
system for covering the existing deficiencies and requisites up
gradation.
 In managing credit risk, the key issue is to recognize the need to apply
a consistent evaluation and rating scheme of all investment
opportunities. This is essential in order for credit decisions to be made
in a consistent manner. Prudential limits need to be laid down on
various aspects of credit namely benchmark current debt/ equity and
profitability ratios, debt service coverage ratios, concentration limits
for single/group borrowers, maximum exposure limits to industry etc.
there should be provision of some flexibility to allow for very special
features.
 The primary responsibility of understanding the risk run by the bank
and ensuring that such risk are appropriately addressed should be

vested with board of directors. At organizational level, overall risk
management needs to be vested with an independent risk management
committee or executive committee entrusted with the responsibility of
identifying, measuring and monitoring the risk profile of the bank that
reports directly to the board of directors and the committee should
develop policies and procedures, verify the models used for pricing
complex product and identify newer risk impacting the banks balance
sheets. The committee should also oversee the adherence to the risk
parameters of the various operating departments of the bank.
 As banks move more towards off balance sheet activities, the implied
risk of agency activities must be better integrated into overall risk

management and strategic decision making. Currently, they are
ignored when bank risk management is considered or are at a fairly
primitive stage.
 The autonomy risk management department as found in most of the
banks is limited as the ratings decided by then are not the final ratings
as these are subject to changes by top management and other
department. We strictly recommend risk rating should be the final
rating, which should not be subject to change at any cost. There should
strict confidentiality about the rating process and parameters else the
proposals will be window dressed for favorable rating. The rating
department should have time limit specified. If possible all banks
should have their risk department certified by the ISO 2002 norms.
BIBLIOGRAPHY & WEBLIOGRAPHY
BIBLIOGRAPHY
Banking Strategy (Vol: 2),
(ICFAI Publishers)
- Katuri Nageswara Rao
Bank Financial Management
(TAXMANN)
- Indian Institute of
Banking & Finance
Risk Management in Banks (ICFAI)
- K.Seethapathi
Bank Credit Redefining Priorities

Professional Banker (ICFAI University Press)
Newspapers referred:
• DNA Money
• HT Business & World
WEBLIOGRAPHY
www.rbi.org.in
www.sbi.co.in
www.icici.com

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Credit Risk Management in Banks

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Credit Risk Management In Banks Based On Case Studies Of ICICI AND SBI

The Risk Management system comprises policies, procedures,

Bank is continuously upgrading and enhancing capabilities of its risk

Risk may be defined as “exposure to uncertainty”. Leads to favourable or

Banks can neither do without profits or risks. However, mere acceptance of

Spreads narrowed as the volatility in the international interest rates

Introduction to Risk Management in Banks

For centuries, financial intermediaries – lenders, institutional, investors,

• What Is Risk Management???

improve its safety, quality and business performance. Specifically, Risk

What Have Been The Benefits Of The New Model-Based

have led to more-efficient pricing of that risk.

• Risk Management Structure

As the Top management is ultimately responsible for the management of

A Risk management structure for a bank having a global presence would

Managing Director of the Bank. The Chief Credit Officer (CCO) or

The CCO is responsible for managing credit risk.

The CFO who is handling the Finance and Accounting functions is

The various divisions of the bank then formulate strategies to manage

business operations from the varied risks. This ensures performance of

to hold capital equal to at least 8% of a basket of assets measured in different

Gist of Basel II in A Nutshell

Threats posed by risk-prone assets held by the bank are to be

Banks with advanced risk-management tools would be permitted to use their

approval by the supervisors based on the standards established by the

Towards extending the profile of risk-sensitivity, the new accord intends to

Basel committee on Banking Supervision prescribed key principles for

• Risk Management Process

Risk Management is a process, which involves

The primary objective of any risk management framework is to

• Risk and Return Relationship

TYPES OF RISKS FACED BY THE BANKS

• Prominent Financial Risks

a) Credit Risk that arises due to the possibility of default or delay in

repayment obligation by the borrower of funds.

e) Contingency Risk is that arises due to presence of off-balance sheet

risk is a critical component of a comprehensive approach to risk management

a) In case of direct lending, that the funds will not be repaid

proposed a capital charge for market risk.

The Basel Committee Report on Operational Risk Management mentions

are the two basic tools for controlling operational risks.

Liquidity Risk is the possibility that an institution may be unable to meet

Various corrective measures that can be taken in order to avoid any

1. If the bank is showing a rapid asset growth say in last 1 to 2 years

2. Banks, which have got high level of potential Non-Performing Assets,

3. In case of real or perceived negative publicity, bank may provide

4. If the bank is faces with a decline in earnings performance or

• Risks in Project Lending

What is project lending?

Project lending is medium and long-term loans provided by specialized

Steps Involved In Project Lending

RISKS INVOLVED IN PROJECT-LENDING

4. Economic risks/ inflation risks.

Environmental risk which was unheard of before is now an important

8. Force-Majeur Risk: (Act of God)

Conclusion to the Project - Lending issue of the

Rate of flexibility in banking regulations has allowed banks to operate

The Basel Committee on banking supervision set by the Bank for

Credit risk management covers the decision-making process, before the

outlook, of the borrower, of the management and of the shareholders. The

• Credit Card Business in India

1. Issue of unwanted cards /credit facilities without the consent of

2. The customers should be allowed to surrender the credit cards if the

a. Method of calculation of the charges of interest has to be