Credit Risk Management Framework at Banks in India

B S Bodla* and Richa Verma**

Credit risk emanates from a banks dealings with an individual, corporate, bank, financial institution or a sovereign. The present paper is designed to study the implementation of the Credit Risk Management Framework by Commercial Banks in India. To achieve the above mentioned objective a primary survey was conducted. The results show that the authority for approval of Credit Risk vests with Board of Directors in case of 94.4% and 62.5% of the public sector and private sector banks, respectively. This authority in the remaining banks, however, is with the Credit Policy Committee. For Credit Risk Management, most of the banks (if not all) are found performing several activities like industry study, periodic credit calls, periodic plant visits, developing MIS, risk scoring and annual review of accounts. However, the banks in India are abstaining from the use of derivatives products as risk hedging tool. The survey has brought out that irrespective of sector and size of bank, Credit Risk Management framework in India is on the right track and it is fully based on the RBIs guidelines issued in this regard.

Introduction
Credit Risk is intrinsic to banking and it is as old as banking itself. Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a banks portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality. Credit risk emanates from a banks dealings with an individual, corporate, bank, financial institution or a sovereign. In recent years, financial sector failures and banking sector weaknesses have induced policy makers to devise prudent risk management mechanism. Against this backdrop, Basel Capital Adequacy norms, originally conceived during 1988, brought about broad agreement among G-10 central banks for applying Common Minimum Capital Standards to their banking industries. Such standards are aimed at putting all banks on an equal footing with respect to capital adequacy so as to promote safety and soundness in banking. Keeping in view the seriousness of credit risk and need to manage the same appropriately, RBI issued guidelines on Credit Risk Management on October 12, 2002. These guidelines focused that the banks should give credit
* Professor, Depar tment of Management, Kurukshetra University, Kurukshetra 136119, India. E-mail: bsgju@yahoo.co.in ** Faculty Research Associate, National Institute of Bank Management, Pune 411048, India. E-mail: richverma@rediffmail.com 2009 TheManagement Framework at Banks in India Credit Risk Icfai University Press. All Rights Reserved. 47

risk prime attention and should put in place a loan policy to be cleared by their boards that covers the methodology for measurement, monitoring and control of credit risk. Basel Committee has proposed Standardized Approaches, Foundation Internal Rating Based Approach and Advanced Internal Rating Based Approach for credit risk capital charge calculations. Basel-I played a significant role in strengthening the financial system. It provided capital charge for credit risk only. It put strong and weak borrower at par and did not provide for difference between regulatory risk and banks actual risk. This led to the evolution of Basel-II capital accord, which considers estimation of minimum capital requirements for credit, market and operational risk. In Basel-II, credit risk has been elaborately defined and risk weights have been scientifically determined for strong and weak borrowers. The major issue before the banks presently is the implementation of this new framework as per RBI and Basel directives. In this backdrop, present study is an attempt to investigate the implementation of the Credit Risk Management Frame the work in commercial banks in India.

Review of Existing Literature

To formulate the problem and to design the survey instruments, a review of existing literature was made. Gist of these previous studies pertaining to Credit Risk Management is prescribed as follows: Rajagopal (1996) made an attempt to overview the banks risk management and suggests a model for pricing the products based on credit risk assessment of the borrowers. He concluded that good risk management is good banking, which ultimately leads to profitable survival of the institution. A proper approach to risk identification, measurement and control will safeguard the interests of banking institution in long run. Froot and Stein (1998) found that credit risk management through active loan purchase and sales activity affects banks investments in risky loans. Banks that purchase and sell loans hold more risky loans (Credit Risk and Loss loans and commercial real estate loans) as a percentage of the balance sheet than other banks. Again, these results are especially striking because banks that manage their credit risk (by buying and selling loans) hold more risky loans than banks that merely sell loans (but dont buy them) or banks that merely buy loans (but dont sell them). Treacy and Carey (1998) examined the credit risk rating mechanism at US Banks. The paper highlighted the architecture of Bank Internal Rating System and Operating Design of rating system and made a comparison of bank system relative to the rating agency system. They concluded that banks internal rating system helps in managing credit risk, profitability analysis and product pricing. Duffee and Zhou (1999) model the effects on banks due to the introduction of a market for credit derivatives; particularly, credit-default swaps. Their paper examined that a bank can use swaps to temporarily transfer credit risks of their loans to others, reducing the likelihood that defaulting loans trigger the banks financial distress. They concluded that the introduction of a credit derivatives market is not desirable because it can cause other markets for loan risk-sharing to break down.
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Ferguson (2001) analyzed the models and judgments related to credit risk management. The author concluded that proper risk modelling provides a formal systematic and disciplined way for firms to measure changes in the riskiness of their portfolio and help them in designing proper strategic framework for managing changes in their risk. Bagchi (2003) examined the credit risk management in banks. He examined risk identification, risk measurement, risk monitoring, risk control and risk audit as basic considerations for credit risk management. The author concluded that proper credit risk architecture, policies and framework of credit risk management, credit rating system, monitoring and control contributes in success of credit risk management system. Muninarayanappa and Nirmala (2004) outlined the concept of credit risk management in banks. They highlighted the objectives and factors that determine the direction of banks policies on credit risk management. The challenges related to internal and external factors in credit risk management are also highlighted. They concluded that success of credit risk management require maintenance of proper credit risk environment, credit strategy and policies. Thus the ultimate aim should be to protect and improve the loan quality. Louberge and Schlesinger (2005) aim to propose a new method for credit risk allocation among economic agents. Their paper considers a pool of bank loans subject to credit risk and develops a method for decomposing the credit risk into idiosyncratic and systematic components. The paper shows how financial contracts might be redesigned to allow for banks to manage the idiosyncratic component for their own account, while allowing systematic component to be retained, passed off to capital market or shared with borrower. Bandyopadhyay (2006) aims at developing an early warning signal model for predicting corporate default in emerging market economy like India. He also presented the method for directly estimating probability of default using financial and non-financial variable. For predicting corporate bond default multiple discriminant analysis is used and logistic regressions model is employed for estimating Probability of Default (PD). The author concluded that by using Z score model, banks and investors in emerging markets like India can get early warning signals about the firms solvency status and reassess the magnitude of default premium they require on low grade securities. The PD estimate from logistic analysis would help banks to estimate credit risk capital and set corporate pricing on a risk adjusted return basis. This model has high classification power of sample and high prediction power in terms of its ability to detect bad firm in sample. On making the review of the previously conducted studies, it is clear that majority of the studies that focus on credit risk management practices in banks provide conceptual framework. Hence, empirical studies on credit risk framework of banks in India are yet to be effected. Moreover, no study has made a size-wise and sector-wise comparison of the credit risk management among banks in India. The present study is an attempt to address the above issues pertaining to the credit risk management framework of banks in India.

Research Objective and Methodology

The present study is undertaken primarily to examine the credit risk management framework of Schedule Commercial Banks (SCBs) in India, which is followed in pursuance to Basel Accords
Credit Risk Management Framework at Banks in India 49

and RBI guidelines. An attempt is also made to examine the size and ownership effect on the credit risk management practices in banks. In sync with the above-mentioned objectives, the study intends to test the following null hypotheses: (i) There is no difference between credit risk management practices of large banks and small banks; and (ii) There is no difference in credit risk management practices of Public Sector Banks (PSBs) and Private sector Banks (PBs). As the concept of risk management in the emerging scenario is quite new, the present study is both exploratory as well as descriptive in nature. The study being comprehensive one covers all the three sectors (public, private and foreign) of Indian Banking Industry. To achieve the objectives of this study, we have resorted to sampling techniques and accordingly the data was collected through field survey using structured questionnaire (the questionnaire can be obtained from the authors on request) facilitating face-to-face interviews with banks officials and other persons connected with risk management operations. The genesis of the different questions incorporated in this questionnaire was to bring out and analyze the credit risk management practices adopted by the banks. This study is based on a sample of 26 SCBs comprising 18 PSBs, eight private sector banks and a foreign bank. This sample of 26 banks is made up of 19 small banks and seven large banks (Exhibit 1). For the purpose of the analysis foreign banks are included in the category of private sector banks. In order to measure the importance attached by the responding banks to risk management aspects, the response was obtained on seven-point scale ranging from 1 to 7. Here 1 means the lowest importance and 7 means the highest importance given to an item. For analysis purpose, mean score has been computed. To examine the significance of difference about the importance given to various items between PSBs and PBs as well as small and large banks t-test was applied. Chi-square test was applied to examine whether responses are independent of sector and size of the banks under study.

Credit Risk Management Survey Results

This section shows the survey results regarding Credit Risk Management practices of SCBs in India. The first question raised to bankers was about the relative importance of various transactions, which cause credit risk in their bank. The responses obtained according to sector and size in this regard are presented in Tables 1a and 1b respectively. The former table, which presents the sector-wise details of the responses obtained, indicates that direct lending (with mean score, 4.72) and guarantees or letter of credit (mean score, 3.72) contain the highest and second highest level of credit risk. In the case of private sector banks also the maximum credit risk is associated with direct lending activities (mean score, 4.75) followed by Cross Border Exposure (mean score, 3.75). The sector-wise comparison of the responses indicates that there is no significant difference between the PSBs and PBs in so far as the importance assigned to various transactions leading to credit risk is concerned. Bank size-wise data as given in Table 1b presents that in the case of large size banks, direct lending obtains the highest mean score (4.29) and hence it is the major source of credit risk. Guarantees or letter of credit and cross border exposure with mean score of 3.43 each
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Table 1a: Sector-Wise Level of Credit Risk on Various Transactions

Transactions Direct Lending Guarantees or Letter of Credit Cross Border Exposure Mean Score Public 4.72 3.72 3.56 Private 4.75 3.38 3.75 Standard Deviation Public 1.27 0.83 1.59 Mean Score Private Difference 1.28 1.30 1.75 0.35 0.19 Mean Score Difference 0.61 0.26 0.28 t Value Sig. Level 0.960 0.417 0.795 Sig. Level 0.280 0.567 0.710

2.78E-02 0.051 0.826 0.263 t Value 1.106 0.580 0.376

Table 1b: Size-Wise Level of Credit Risk on Various Transactions

Transactions Direct Lending Guarantees or Letter of Credit Cross Border Exposure Mean Score Large 4.29 3.43 3.43 Small 4.89 3.68 3.71 Standard Deviation Large 1.38 1.27 1.51 Small 1.20 0.89 1.69

are other two important factors causing credit risk. Similarly, direct lending activities (with mean score, 4.89) followed by cross border exposure (mean score, 3.71) are the major sources of credit risk in case of small size banks. The size-wise comparison shows that each of the sources of credit risk gets slightly higher score in case of the small size banks than that in case of large size banks. However, this difference is statistically insignificant and hence the size does not make a difference in the importance of various sources of credit risk for commercial banks in India. After examining the major sources of credit risk in the banks, the bankers were next asked about their views on the introduction of Securitization Ordinance Act, 2002, as a move towards effective management of credit risk in SCBs in India. According to this survey, 61.1% of PSBs and 37.5% of PBs are of the view that Securitization Ordinance is very important in credit risk management in banks (Table 2).
Table 2: Effectiveness of Securitization Ordinance Act, 2002 in Credit Risk Management
Sector-Wise Frequency Distribution Public Private ChiSector Sector Square Banks Banks Value (df) 11 (61.1) 6 (33.3) 1 (5.6) 18 8 3 (37.5) 4 (50) 1 (12.5) 7 3.138 (2) Size-Wise Frequency Distribution Large Small ChiBanks Banks Square Value (df) 2 (28.6) 5 (71.4) 12 (63.2) 5 (26.3) 1 1 (5.3) (5.3) 19 4.096 (2)

Levels of Effectiveness Very Much Some What Not at All No Response Total

Overall

14 (53.9) 10 (38.5) 1 (3.8) 1 (3.8) 26

Note: Figures in parentheses are the percentage of total.

Six (33.3%) PSBs are of the view that, the act will be of some what help in dealing with credit risk. The similar response is obtained in case of four (50%) PBs. Although, the response of one PB is negative towards the aforesaid ordinance, not even a single PSB have responded negatively to it. The table further indicates the response obtained from large and small size banks. Two (28.6%) large banks and 12 (63.2%) small size banks have responded favorably to
Credit Risk Management Framework at Banks in India 51

this question. They believe that Securitization Ordinance will be of great help to them in dealing with credit risk. But, five (71.4%) large and five (26.3%) small size banker are of view that it will be of some what help to them in dealing with risk. One small size bank did not respond to it and one responded negatively. We next asked the bankers, who is responsible for approval of credit risk policy in their bank. The response obtained in this regard is presented in Table 3. This table clearly indicates that Board of directors is responsible for approval of credit risk policy in as many as 17 (94.4%) PSBs and the Credit Policy Committee approve credit risk policy in one PSB out of 18 surveyed. In the case of private sector banks, the Board of Directors is responsible in case of five (62.5%) banks and the same task is performed by Credit Policy committee in three (37.5%) banks.
Table 3: Responsibility of Approval of Credit Risk Policy
Authority for Credit Risk Policy Board of Directors Senior Management Credit Policy Committee Total Overall Sector-Wise Frequency Distribution Public Sector Banks 17 (94.4) 1 (5.6) 18 Private Sector Banks 5 (62.5) 3 (37.5) 8 4.342**(1) ChiSquare Value (df) Size-Wise Frequency Distribution Large Banks 5 (71.4) 2 (28.6) 7 Small Banks 17 (89.5) 2 (10.5) 19 1.280 (1) ChiSquare Value (df)

22 (84.6) 4 (15.4) 26

Note: Figures in parentheses are the percentage of total. ** significant at 0.05 level.

The above analysis shows that the authority for credit risk policy depends on the ownership pattern of the banks. This is confirmed by the chi-square test which was applied to test the null hypothesis that the authority for effecting credit risk policy is independent of ownership pattern this hypothesis is rejected at 5% level of significance. The results clearly indicate that senior management is not given responsibility for credit risk management in even a single bank. Bank size-wise analysis indicates that in as many as five (71.4%) large banks and 17 (89.5%) small size banks, the Board of Directors is responsible for approval of credit risk policy and same task is performed by credit policy committee in two large (28.6%) and two small (10.5%) banks. The chi-square test value offers that the size effect on the decision regarding to whom to give the responsibility for credit risk management does not depend on size of the bank. That is size is not an important factor in taking decision about the authority for credit risk policy. Next, the bankers were asked a question about the instruments/techniques used by them for managing credit risk in their bank. Let me mention here that Credit Risk Management encompasses a host of management techniques, such as credit approving authority, prudential limits, risk ratings, risk pricing, portfolio management and loan review mechanism. As per RBI guidelines each bank should have a carefully formulated scheme of delegation of powers. The bank should also evolve multi-tier credit approving system where the loan proposals all approved by a committee comprising of at least 3 or 4 officers. The response obtained regarding the instruments of credit risk management used by the banks under survey is presented in Table 4. This table shows that, at the overall level, Risk Rating techniques is found in use by the
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maximum banks in India (i.e., 92.3%) followed by credit approval authority (88.5%), prudential limits and loan review policy (80.8%) and so on. It is also clear from the table that the banks are using more than one instrument/techniques for managing their risk. Further, the table clearly indicates that risk rating technique of managing credit risk is used by as many as 17 (94.4%) PSBs for managing credit risk. Prudential Limits, Credit Approval Committee and Loan Review Policy are used as credit risk management technique by 16 (88.9%), 15 (83.3%) and 14 (77.8%) banks respectively. Portfolio management is applied by twelve (66.7%) banks. Similarly, 10 (55.6%) banks are making use of RAROC. Only three (16.7%) of the sample PSBs are making use of other tools like collateral, credit audit and problem loan management as a tool of credit risk management in their bank.
Table 4: Instruments of Credit Risk Management
Sector-Wise Frequency Distribution Technique Overall Public Sector Banks 15 (83.3) 16 (88.9) 17 (94.4) 10 (55.6) 12 (66.7) 14 (77.8) 3 (16.7) 18 Private Sector Banks 8 (100) 5 (62.5) 7 (87.5) 4 (50) 5 (62.5) 7 (87.5) 3 (37.5) 8 ChiSquare Value (df) 1.507 (2) 2.483 (1) 0.376 (1) 0.069 (1) 0.042 (1) 0.337 (1) 1.354 (1) Size-Wise Frequency Distribution Large Banks Small Banks ChiSquare Value (df) 0.071 (1) 0.538 (1) 0.586 (1) 0.465 (1) 2.148 (1) 0.538 (1) 2.111 (1)

Credit Approval Authority Prudential Limits Risk Ratings Risk Pricing/ RAROC Portfolio Management Loan Review Policy Any Other Technique Total

23 (88.5) 21 (80.8) 24 (92.3) 14 (53.8) 17 (65.4) 21 (80.8) 6 (23.1) 26

6 (85.7) 5 (71.4) 6 (85.7) 3 (42.9) 3 (42.9) 5 (71.4) 3 (42.9) 7

17 (89.5) 16 (84.2) 18 (94.7) 11 (57.9) 14 (73.7) 16 (84.2) 3 (15.8) 19

Note: Figures in parentheses are the percentage of total.

Contrarily, 100% of the private sector banks favor Credit Approval Authority for credit risk management. Seven banks (87.5%) are making use of risk rating and loan review policy as a tool of risk management. Prudential limits and portfolio management exercise are performed by five (62.5%) among the sample private sector banks. The table further presents the response obtained from large and small size banks. Bank size-wise analysis of the responses about instruments of Credit Risk Management as given in Table 4 indicates that Credit Approval Authority and Risk Ratings are used as tools of credit risk management by 85.7% of the large size banks and 89.5% of the small banks. Five banks (71.4%) among the PSBs under study are making use of Prudential Limits and Loan Review Policy. The remaining instruments like RAROC, Portfolio management are used by three (42.9) banks. In the case of small size banks, as many as 18 (94.7%) banks are making use of Risk Rating for managing credit risk. Prudential Limits and Portfolio Management are used by 16 (84.2%) and 14 (73.7%) of the small banks under study. 57.9% of the small banks are making use of risk pricing technique for managing credit risk in their banks portfolio. Thus, the preceding analysis brings out that the choice for
Credit Risk Management Framework at Banks in India 53

instruments of Credit Risk Management is neither dependent on size nor on sector. The above is confirmed by the results of chi-square test applied for the purpose. We have observed from Table 4 that large majority of the sample banks have favored Credit Approval Authority for managing credit risk. Now, the next question arises about the limits at which the approval is required from the Credit Approval Authority. The responses obtained in this regard are presented in Table 5.
Table 5: Credit Limits for Seeking Approval from Credit Approval Committee
Sector-Wise Frequency Distribution Credit Limit Overall Public Sector Banks 1 (5.6) 2 (11.1) 13 (72.2) 2 (11.1) 18 Private Sector Banks 3 (37.5) 1 (12.5) 4 (50) 8 3.860 (2) ChiSquare Value (df) Size-Wise Frequency Distribution Large Banks 1 (14.3) 6 (85.7) 7 Small Banks 3 (15.8) 3 (15.8) 11 (57.9) 2 (10.5) 19 1.578 (2) ChiSquare Value (df)

Above 20 Lakhs Above 50 Lakhs Above 1 Crore No Response Total

4 (15.4) 3 (11.5) 17 (65.4) 2 (7.7) 26

Note: Figures in parentheses are the percentage of total.

The table clearly indicates that in 13 (72.2%) of the selected PSBs and four (50%) of the selected PBs, the approval of Credit Approval Committee is taken for the credit of above Rs. 1 cr. Two PSBs and one PB seek this approval when the credit limit is above Rs. 50 lakhs but less than Rs. 1 cr. For credit of above Rs. 20 lakhs and less than Rs. 50 lakhs, the approval is taken by one PSB and three PBs. The size-wise analysis indicates that majority of banks (i.e., 85.7% large size banks and 57.9% small size banks) seek the approval from the credit approval authorities, when the credit is above Rs. 1 cr. One large size banks seek approval when the amount of credit is above Rs. 20 lakhs but less than Rs. 50 lakhs. Three small banks (15.8%) perform the same exercise in the case of exposure of above Rs. 20 lakhs but less than Rs. 50 lakhs. Now, the question arises, at what level these committees are working in the banks. Banks can have credit approving committees at various operating levels, i.e., large branches levels, regional levels, zonal levels, head offices, etc. The survey results in regard to levels of credit approving committees are exhibited in Table 6. It is obvious from this table that majority of banks (76.9%) have their credit approval committee at Head Office Level. Sector-wise response reveals that in 15 (83.3%) PSBs and five (62.5%) PBs, the credit approval committees are working at Head Office level. In 12 (66.7%) PSBs, the approval committees are set up at Zonal Level and same is true in the case of one PB. These committees are working at Regional level in four PSBs and two PBs. Approval committees are set up at Branch level by only one PSB and two PBs. The above analysis brings out that the preference for head office level and Zonal level approval committee is more in PSBs than that of PBs. Size-wise analysis (Table 6) offers that the approval committees are set up at head office level in case of five (71.4%) large banks and 15 (78.9%) small banks. Four large PSBs and
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nine small PBs have set up the committees for credit approval at zonal level. While the committees are working at Branch Level in only one large bank and two small size banks, one large bank and five small banks have set up this committee at Regional Level.
Table 6: Level at which Approval Committees are Set-Up
Sector-Wise Frequency Distribution Level Overall Public Sector Banks 1 (5.6) 4 (22.2) 12 (66.7) 15 (83.3) 18 Private Sector Banks 2 (25.0) 2 (25.0) 1 (12.5) 5 (62.5) 8 ChiSquare Value (df) 1.883 (1) 0.006 (1) 7.354* (1) 2.252 (1) Size-Wise Frequency Distribution Large Banks 1 (14.3) 1 (14.3) 4 (57.1) 5 (71.4) 7 Small Banks 2 (10.5) 5 (26.3) 9 (47.4) 15 (78.9) 19 ChiSquare Value (df) 0.048 (1) 0.503 (1) 0.103 (1) 0.446 (1)

Branch Level Regional Level Zonal Level Head Office Level Total

3 (11.5) 6 (23.1) 13 (50.0) 20 (76.9) 26

Note: Figures in parentheses are the percentage of total. * significant at 0.01 level.

In order to limit the magnitude of credit risk, prudential limits should be laid down on various aspects of credit, such as benchmark for ratios, borrowers limits, exposure limits, maturity profile of loan book, etc. In view of this, a questionwhat aspects of credit banks generally consider for defining prudential limits was asked during the survey. The responses obtained in this regards are presented in Tables 7a and 7b after converting them in score from a seven-point scale.
Table 7a: Sector-Wise Response on the Aspects Considered for Defining Prudential Limits
Aspects Stipulate Benchmark for Ratios Single/Group Borrower Limits Exposure Limits Maximum Exposure to Industry Consideration of Maturity Profile of Loan Book Mean Score Public 5.22 5.50 5.56 5.39 4.89 Private 4.50 5.29 5.14 5.29 4.14 Standard Deviation Public 0.94 0.79 0.78 0.92 0.83 Mean t Score Value Private Difference 1.52 1.50 1.46 0.76 1.21 0.72 0.21 0.41 0.10 0.75 1.393 0.472 0.920 0.264 1.768 Sig. Level 0.178 0.642 0.367 0.794 0.090

Table 7b: Size-Wise Response on the Aspects Considered for Defining Prudential Limits
Aspects Stipulate Benchmark for Ratios Single/Group Borrower Limits Exposure Limits Maximum Exposure to Industry Consideration of Maturity Profile of Loan Book Mean Score Large 4.50 5.57 5.43 5.29 4.57 Small 5.22 5.39 5.44 5.39 4.72 Standard Deviation Large 1.97 1.13 1.13 1.11 1.40 Small 0.65 0.98 0.98 0.78 0.83 Mean t Score Value Difference 0.72 0.18 0.10 0.15 0.880 0.401 0.264 0.336 Sig. Level 0.416 0.692 0.973 0.794 0.740 55

1.59E-02 0.035

Credit Risk Management Framework at Banks in India

The former table indicates that exposure limits and single/group borrower limits with mean of 5.56 and 5.50, respectively are the most important and second most important aspects that are generally considered for defining prudential limits in PSBs. Maximum exposure to industry (mean, 5.39) and benchmarking for ratios gains the third and fourth position in terms of importance. In the case of private sector banks, single/group borrower limits and maximum exposure to industry with the mean score of 5.29 are the most important aspects for defining prudential limits. Exposure limits (mean, 5.14) and stipulate benchmark for ratios (mean score, 4.50) attain second and third position in terms of importance. The Consideration of Maturity Profile of Loan Books with the lowest mean of 4.89 in PSBs and 4.14 in PBs is the least important aspect for defining prudential limits. While making sector-wise analysis of the mean score, we observe that the score obtained by almost each aspect of prudential limits is more in PSBs in comparison to PBs. But, the same is not confirmed by the t-test as the t-values for various aspects are insignificant at 5% level. Table 7b presents size-wise statistical output of the information obtained from risk managers of banks. This table shows that in the large size banks, single/group borrower limits, exposure limits and maximum exposure to industry, consideration of maturity profile of loan book stood at first, second, third and fourth position with the mean score of 5.57, 5.43, 5.29 and 4.57 respectively. Stipulate benchmark for ratios with the lowest mean of 4.50 turns the least important aspect generally considered. In the case of small size banks, exposure limits with the mean score of 5.44 claimed the highest importance level in defining prudential limits. Single/group borrower limits and maximum exposure to industry with the mean score of 5.39 each shares the second position in terms of importance. Stipulate benchmark for ratios and consideration of maturity profile of loan book gains third and fourth position in terms of importance. Thus, the size-wise analysis reveals that all the aspects except one (single/group borrower limits) are considered slightly more important in case of small banks than in large banks. But, this difference in score is not found significant statistically. Besides defining the prudential limits, banks further go for different activities like industries studies, plant visits, risk rating, etc., for managing credit risk in their portfolio. In the present survey, an attempt was made to gather the information about the tendency of the commercial banks in India about various activities performed for credit risk management. The survey results are presented in Table 8. The survey brought out that Credit risk rating and annual review of accounts are performed by all PSBs. Development of MIS, industries studies and periodic visits of plants are performed by 94.4%, 88.9% and 83.3% banks, respectively. Thirteen (72%) PSBs make periodic credit calls for managing credit risk. All the PBs have favored annual review of accounts and remaining activities like industries studies, periodic credit calls, periodic visits of plants, development of MIS, credit risk rating are performed by as many as seven (87.5%) of private sector banks under survey. The table under reference also indicates the response obtained according to size of banks. It is found that all the large size banks perform each and every activity except industries studies for managing credit risk in their bank. Only six (85.7%) banks are found going for industries studies for credit risk management. Annual review of accounts is performed by each of the small banks and credit risk rating by 94.7% banks. 89.5% of the small banks perform Industries studies and have MIS for managing credit risk. Periodic visits of plants and periodic credit calls are performed by 15 (78.9%) and 13 (68.4%) banks, respectively. The above analysis provides that periodic credit calls is a
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more popular activity among the large banks than their counterpart small banks. The same is confirmed by chi-square test as its value was found significant at 10% level. However, the chi-square values are insignificant pertaining to the remaining activities. Thus, size of the bank does not affect the importance level of various activities necessary for credit risk management.
Table 8: Activities Performed for Credit Risk Management
Sector-Wise Frequency Distribution Activities Overall Public Sector Banks Private Sector Banks 7 (87.5) 7 (87.5) 7 (87.5) 7 (87.5) 7 (87.5) 8 (100) 8 ChiSquare Value (df) 0.845 (1) 0.728 (1) 0.074 (1) 0.376 (1) 2.340 (1) Size-Wise Frequency Distribution Large Banks Small Banks ChiSquare Value (df) 0.686 (1)

Industries Studies/ Profiles Periodic Visits of Plants Develop MIS Credit Risk Rating/ Risk Scoring Annual Review of Accounts Total

23 (88.5) 16 (88.9)

6 (85.7) 17 (89.5) 7 (100) 7 (100) 7 (100) 7 (100) 7 (100) 7 13 (68.4) 15 (78.9) 17 (89.5) 18 (94.7) 19(100) 19

Periodic Credit Calls 20 (76.9) 13 (72.2) 22 (84.6) 15 (83.3) 24 (92.3) 17 (94.4) 25 (96.1) 18(100) 26 (100) 26 18(100) 18

2.874** (1) 1.742 0.798 0.383 (1) (1) (1)

Note: Figures in parentheses are the percentage of total. * significant at 0.01 level.

The analysis of Table 8 has shown that Risk rating is given the maximum importance as a credit risk management activities amongst the commercial banks, irrespective of their sector or size. Now, the question arises. How the banks are presenting their ratings? Whether it is with the help of numbers or alphabets? The response obtained in this regard is presented in Table 9. This table clearly indicates that, at the overall level, the highest percentage of banks use alphabets (38.5%) followed by those uses numbers (34.6%) and alpha-numeric (30.8%). Only one bank
Table 9: Presentation of Banks Rating
Presentation of Rating Sector-Wise Frequency Distribution Overall Public Sector Banks 6 (33.3) 6 (33.3) 6 (33.3) 1 (5.6) 18 Private Sector Banks 3 (37.5) 4 (50.0) 2 (25.0) 1 (12.5) 2 (25.0) 8 ChiSquare Value (df) 0.042 (1) 0.650 (1) 0.181 (1) 2.340 (1) 2.052 (1) Size-Wise Frequency Distribution Large Banks 3 (42.9) 4 (57.1) 2 (28.6) 1 (14.3) 1 (14.3) 7 Small Banks 6 (31.6) 6 (31.6) 6 (31.6) 2 (10.5) 19 ChiSquare Value (df) 0.287 (1) 1.412 (1) 0.022 (1) 2.823* (1) 0.071 (1)

Numbers Alphabets Alpha-Numeric Symbol Descriptive Terms Total

9 (34.6) 10 (38.5) 8 (30.8) 1 (3.8)

3 (11.5) 26

Note: Figures in parentheses are the percentage of total. * significant at 0.01 level. Credit Risk Management Framework at Banks in India 57

was found using symbols. Sector-wise analysis reveals that use of numbers, alphabets, and alpha-numeric variables is equally practiced among PSBs. Only one PSB is making use of descriptive terms. In case of private sector banks alphabets are used by half of the sampled banks. Numbers are used by three private banks (37.5%) under study. Two (25%) private banks are making use of alpha-numeric variables and other two use descriptive terms. The size-wise pattern of frequency distribution regarding the way of presenting Banks Rating indicates that 57.1% large size banks make use of alphabets. Numbers and alpha-numeric variables are used by 42.9% and 28.6% of the large banks, respectively. However, in the case of small size bank, none is found making use of symbols. Each method, i.e., Numbers, alphabets and alpha-numeric characters are used by 31.6% banks. Only two small size banks are making use of descriptive terms. The next question asked pertain to the frequency with which the bankers assess the risk in their banking portfolio. The outcome of the processed data regarding the above question is presented through Table 10. This table exhibits that, on the whole, none of the sample banks assess the credit risk monthly. The majority of the banks perform annual assessment of credit risk. The above is true irrespective of sector as well as size of the bank. 11.1 PSBs and 25% PBs perform this exercise bi-annually. The quarterly credit risk assessment is done by three (16.7%) PSBs and one PB. In the case of large size banks, the highest percentage of banks assess credit risk annually followed by those do the same quarterly. The above also holds true in case of small size banks.
Table 10: Frequency of Credit Risk Assessments
Sector-Wise Frequency Distribution Public Private ChiSector Sector Square Banks Banks Value (df) 3 (16.7) 2 (11.1) 13 (72.2) 18 1 (12.5) 2 (25.0) 5 (62.5) 8 0.833 (2) Size-Wise Frequency Distribution Large Small ChiBanks Banks Square Value (df) 2 (28.6) 1 (14.3) 4 (57.1) 7 2 (10.5) 3 (15.8) 14 (73.7) 19 1.292 (2)

Frequency

Overall

Monthly Quarterly Bi-Annually Annually Total

4 (15.4) 4 (15.4) 18 (69.2) 26

Note: Figures in parentheses are the percentage of total.

The next question raised to bankers was about the preparation of credit quality report by them. Table 11 indicates that on the whole, more than half of the banks prepare credit quality reports.
Table 11: Preparation of Credit Quality Reports
Nature of Purpose Sector-Wise Frequency Distribution Overall Public Sector Banks 10 (55.6) 8 (44.4) 18 Private Sector Banks 5 (62.5) 3 (37.5) 8 ChiSquare Value (df) 0.109 (1) Size-Wise Frequency Distribution Large Banks 5 (71.4) 2 (28.6) 7 Small Banks 10 (52.6) 9 (47.4) 19 ChiSquare Value (df) 0.740 (1)

Yes No Total

15 (57.7) 11 (42.3) 26

Note: Figures in parentheses are the percentage of total. 58 The Icfai University Journal of Bank Management, Vol. VIII, No. 1, 2009

The above is true irrespective of ownership pattern and size of the bank. However, the percentage of those who do not prepare the credit quality reports is abnormally high, i.e., 42.3%, on the whole. Hence, both large as well as small banks in either of the sector need to consider this activity sincerely. Next question asked to the bankers is about RAROC, an important technique of credit risk management, which is gaining importance day by day. Bankers were asked: whether they have developed RAROC framework for risk pricing in their bank? The responses obtained in this regard are presented in Table 12. The table clearly indicates that at the overall level, only 38.5% of the banks have given positive response about the use of risk pricing framework named as RAROC. Sector-wise analysis reveals that 22.2% of the sample PSBs and 75% PBs have responded favorably to this question. The chi-square value is found significant at 0.01 levels; hence the proportion of users of RAROC framework is higher among PSBs than that of PBs. However, there is no such difference between the small and large size banks.
Table 12: Development of RAROC Framework for Risk Pricing
Sector-Wise Frequency Distribution Public Private ChiSector Sector Square Banks Banks Value (df) 4 (22.2) 14 (77.8) 18 6 (75.0) 1 (12.5) 1 (12.5) 8 8.466*(1) Size-Wise Frequency Distribution Large Small ChiBanks Banks Square Value (df) 3 (42.9) 4 (57.1) 7 7 (36.8) 11 (57.9) 1 (5.3) 19 0.033 (1)

Nature of Response Yes No No Response Total

Overall

10 (38.5) 15 (57.7) 1 (3.8) 26

Note: Figures in parentheses are the percentage of total. * significant at 0.01 level.

We further asked the bankers about the factors they generally consider for pricing risk in their bank. The responses obtained in this regard are presented in Table 13a and 13b. According to the statistics presented in the former table, future business potential and value of collateral with the mean score of 5.06 and 4.94 are the most important and second most important factors considered for pricing credit risk in PSBs. Market forces and portfolio quality with the mean score of 4.89 and perceived value of accounts with mean score of 4.88 have claimed third and fourth position respectively, in terms of their importance. Strategic reasons (score, 4.25) and portfolio industry exposure (scores, 4.00) have lowest position in terms of importance. Similarly, in case of PBs, future business potential (mean of 5.25) has greatest importance in pricing credit risk. Portfolio quality, value of collateral and portfolio industry exposure with mean of 5.13 shares the second position jointly. Perceived value of accounts, strategic reasons and market forces stood at third, fourth and fifth position in terms of importance in pricing credit risk in banks. On the sector-wise comparison, we find that all the factors except market forces and perceived value of accounts have obtained relatively higher score in private banks in comparison to PSBs. However, the same is not confirmed by the value of t-test, which gave the values 0.438, 0.570, 0.522, 2.631 and 0.607 in case of portfolio quality, value of collateral, future business potential, portfolio industry exposure and strategic reasons respectively. The t-values are judged as insignificant in case of each of the above factors. Table 13b presents
Credit Risk Management Framework at Banks in India 59

size-wise data. The table indicates that future business potential and strategic reasons with the mean score of 5.29 and 5.00 are the most important and second most important factors for pricing credit risk in large size banks. Value of collateral and market forces with the mean value of 4.86 shares the third position. Portfolio quality and perceived value of accounts with the mean of 4.71 and 4.67 stood at fourth and fifth position in terms of importance. Portfolio industry exposure with lowest mean of 4.17 stood at lower position as a factor for pricing credit risk. Portfolio quality, value of collateral and future business potential with the mean of 5.05 shares the first position in terms of importance in pricing credit risk amongst the small size banks. Perceived value of accounts, market forces and portfolio industry exposure stood at second, third and fourth position with mean score of 4.89, 4.68 and 4.42 respectively. On the size-wise analysis, we find that portfolio quality, value of collateral, perceived value of accounts, portfolio industry exposure with higher mean value are relatively more important factors considered for pricing credit risk in small banks in comparison to larger ones. However, the above-mentioned statement is not confirmed by the value of t-test.
Table 13a: Sector-Wise Response to Factors Considered for Pricing Credit Risk in Banks
Factors Portfolio Quality Value of Collateral Market Forces Perceived Value of Accounts Future Business Potential Portfolio Industry Exposure Strategic Reasons Mean Score Public 4.89 4.94 4.89 4.88 5.06 4.00 4.25 Private 5.13 5.13 4.38 4.75 5.25 5.13 4.57 Standard Deviation Public 1.32 0.94 0.76 1.17 0.94 1.12 1.29 Mean t Score Value Private Difference 1.13 0.64 1.30 1.04 0.71 0.64 0.79 0.24 0.18 0.51 0.13 0.19 1.13 0.32 0.438 0.570 1.273 0.274 0.522 2.631 0.607 Sig. Level 0.665 0.575 0.215 0.787 0.606 0.015 0.551

Table 13b: Size-Wise Response to Factors Considered for Pricing Credit Risk in Banks
Factors Portfolio Quality Value of Collateral Market Forces Perceived Value of Accounts Future Business Potential Portfolio Industry Exposure Strategic Reasons Mean Score Large 4.71 4.86 4.86 4.67 5.29 4.17 5.00 Small 5.05 5.05 4.68 4.89 5.05 4.42 4.17 Standard Deviation Large 1.98 1.07 1.46 1.97 0.95 1.47 1.00 Small 0.91 0.78 0.75 0.74 0.85 1.02 1.15 Mean t Score Value Difference 0.34 0.20 0.17 0.23 0.23 0.25 0.83 0.436 0.513 0.400 0.278 0.602 0.480 1.467 Sig. Level 0.676 0.612 0.693 0.791 0.553 0.636 0.157

Banks now-a-days are making use of various credit risk models for evaluating their credit portfolio. The important among these models include Altmans Z-score Model, Merton Model, KMV Credit Monitor Model, Credit Metrics, Credit Risk+, Mckinsey Credit Portfolio View, etc.
60 The Icfai University Journal of Bank Management, Vol. VIII, No. 1, 2009

Therefore, we next asked to bankers about the use of these models. The survey has brought out that (Table 14) 42.3% of the banks, at overall level, use the models other than that mentioned in the table. Only one private bank and one PSB is making use of Altmans Z-score model for credit evaluation. KMV Credit Monitor Model is used by another bank. No PSB is making use of Merton model and Mckinsey Credit Portfolio view. Credit Metrics is used by three banks (16.7%) and other three are making use of Credit Risk+ Nine (50%) of the PSBs are making use of other models like internally developed model or models developed by CRISIL. In the case of private sector banks, no bank is making use of KMV credit monitor model and Mckinsey Credit Portfolio view for evaluation of their credit portfolio. Altmans Z-score model is used by one PB and other make use of Merton model. Four (50%) PBs are making use of credit risk+ and other two (25%) use credit metrics. Two PBs are also making use of other models like risk assessment models for corporates and facility information like facility type, tenor, provisioning. Not even a single large bank is making use of KMV credit monitor model and Mckinsey credit portfolio view. Altman Z-score model, Merton model, credit metrics and credit risk+ are used by four large (21.1%) banks under study. The remaining three (42.9%) are making use of other models for credit evaluation purpose. Six small banks are making use of credit risk+ and credit metrics is used by four (21.1%). None of the small size bank is making use of Merton model and Mckinsey credit portfolio view. One small bank use Altmans Z-score model and KMV credit Monitor model is used by other. Other models like CRISIL and internally s developed models are used by eight (42.1%) small size banks.
Table 14: Use of Credit Risk Models for Credit Portfolio Evaluation
Sector-Wise Frequency Distribution Credit Risk Model Altmans Z-Score Model Merton Model KMV Credit Monitor Model Credit Metrics Credit Risk+ McKinesy Credit Portfolio View Any Other Total Overall Public Sector Banks 1 (5.6) 1 (5.6) 3 (16.7) 3 (16.7) 9 (50.0) 18 Private Sector Banks 1 (12.5) 1 (12.5) 2 (25.0) 4 (50.0) 2 (25.0) 8 ChiSquare Value (df) 0.376 (1) 2.340 (1) 0.462 (1) 0.248 (1) 3.128 (1) 1.418 (1) Size-Wise Frequency Distribution Large Banks Small Banks ChiSquare Value (df) 0.586 (1)

2 1 1

(7.7) (3.8) (3.8)

1 (14.3) 1 (14.3) 1 (14.3) 1 (14.3) 3 (42.9) 7

(5.3)

2.823** (1) 0.383 0.151 0.778 0.001 (1) (1) (1) (1)

(5.3)

5 (19.2) 7 (26.9) 11 (42.3) 26

4 (21.1) 6 (31.6) 8 (42.1) 19

Note: Figures in parentheses are the percentage of total. * significant at 0.10 level.

As discussed above Loan review (Table 4) plays a very important role in risk management activities of a bank and RBI guidelines on credit risk management require that the banks should review their loan policy regularly. Therefore, a question was also asked in this regard. The survey brought out that none of the sample banks review the loan policy monthly and quarterly (Table 15). This policy is reviewed annually by a large majority (88.5%) of the
Credit Risk Management Framework at Banks in India 61

commercial banks, at the overall level. The above pattern is found true irrespective of ownership pattern as well as size of bank. Infact, only one PSB and two PBs are found reviewing their loan policy bi-annually. Each of these three banks reviewing their loan policy bi-annually is of small size.
Table 15: Frequency of Review of Loan Policy
Sector-Wise Frequency Distribution Public Private ChiSector Sector Square Banks Banks Value (df) 1 (5.6) 17 (94.4) 18 2 (25) 6 (75) 8 2.052 (1) Size-Wise Frequency Distribution Large Small ChiBanks Banks Square Value (df) 7(100) 7 3 (15.8) 16 (84.2) 19 1.249 (1)

Interval for Review Monthly Quarterly Biannually Annually Total

Overall

3 (11.5) 23 (88.5) 26

Note: Figures in parentheses are the percentage of total.

Who is responsible for review of loan policy in the banks? This question also needs to be answered by the banks. The response obtained in this regard is presented in Table 16.
Table 16: Responsibility of Review of Loan Policy
Sector-Wise Frequency Distribution Risk Management Authority Board of Director Credit Administration Department Loan Review Officer Any Other Total Overall Public Sector Banks Private Sector Banks 5 (62.5) 3 (37.5) 2 (25.0) 8 ChiSquare Value (df) 2.483 (1) 4.342 (1) 2.052 (1) .462 (1) Size-Wise Frequency Distribution Large Banks Small Banks ChiSquare Value (df) 0.151 (1) 1.742 (1) 0.071 (1) 0.383 (1)

21 (80.8) 16 (88.9) 4 (15.4) 3 (11.5) 1 (3.8) 26 1 (5.6) 1 (5.6) 1 (5.6) 18

6 (85.7) 15 (78.9) 1 (14.3) 7 4 (21.1) 2 (10.5) 1 (5.3) 19

Note: Figures in parentheses are the percentage of total.

The table clearly indicates that on the whole, Board of directors is responsible for review of loan policy among as high as 80.8% of the banks. The pattern holds good in case of both PSBs and PBs irrespective of their size. Credit Administration Department is responsible for the same in case of only 21.1% of the small size banks. The loan policy is reviewed by loan review officer in one PSB and two PBs. Sometimes other individuals from management perform the review of loan policy. In the case of large size banks, the Board of directors reviews loan policy in six (85.7%) banks. Board of Directors is responsible for review in 15 (78.9%) small size banks. With the increasing off-balance sheet exposures in the banks, it is important to study this question. Do banks have defined any exposure to manage off-balance sheet exposure in their books? The responses in regard to this ratio are presented in Table 17. This table indicates that, at the overall level, 73.1% of the banks responded positively to the above-mentioned question.
62 The Icfai University Journal of Bank Management, Vol. VIII, No. 1, 2009

There is no difference both across the ownership pattern and size of the banks in so far as the response of this question is concerned. The table further indicates that 66.7% of PSBs and 87.5% of PBs have defined exposure for off-balance sheet exposure. But the response of five (27.8%) PSBs and one (12.5%) PB was negative towards it. One PSB has not responded to this question. Five (71.4%) large banks and 14 (73.7%) small banks have positively responded towards the definition of off-balance sheet exposure.
Table 17: Definition of Exposure for Managing Off-Balance Sheet Exposure
Nature of Purpose Sector-Wise Frequency Distribution Overall Public Sector Banks 12 (66.7) 5 (27.8) 1 (5.6) 18 Private Sector Banks 7 (87.5) 1 (12.5) 8 0.853 (1) ChiSquare Value (df) Size-Wise Frequency Distribution Large Banks 5 (71.4) 2 (28.6) 7 Small Banks 14 (73.7) 4 (21.1) 1 (5.3) 19 0.111 (1) ChiSquare Value (df)

Yes No No Response Total

19 (73.1) 6 (23.1) 1 (3.8) 26

Note: Figures in parentheses are the percentage of total.

The banks also need to develop a framework for studying inter-bank exposure. An attempt was made to know whether the bankers have this type of framework. The survey has brought out that (Table 18) 16 (88.9) PSBs and six (75%) PBs have responded favorably to it.
Table 18: Development of Framework for Studying Inter-Bank Exposure
Sector-Wise Frequency Distribution Response Overall Public Sector Banks 16 (88.9) 1 (5.6) 1 (5.6) 18 Private Sector Banks 6 (75) 2 (25) 8 1.883 (1) ChiSquare Value (df) Size-Wise Frequency Distribution Large Banks 7(100) 7 Small Banks 15 (78.9) 3 (15.8) 1 (5.3) 19 1.326 (1) ChiSquare Value (df)

Yes No No Response Total

22 (84.6) 3 (11.5) 1 (3.8) 26

Note: Figures in parentheses are the percentage of total.

Size-wise analysis reveals that seven large (100%) banks and fifteen (78.9%) small banks have developed system for studying inter-bank exposure. Thus, majority of the banks irrespective of their ownership pattern and size, have developed procedure for investigating inter-bank exposure. Further, we asked the bankers, what aspects they generally consider for evaluating bank-wise exposure. The responses obtained in this regard are presented in Tables 19a and 19b. The former table indicates that Study of Financial Performance is the most important factor (mean score, 5.67) followed by past experience (mean score, 5.44) and Management Quality (mean score, 5.38) in case of PSBs. Operating Efficiency and bank rating on credit quality with mean of 5.31 and 4.94 follow the above aspects in terms of importance.
Credit Risk Management Framework at Banks in India 63

In the case of private sector banks, past experience with mean score of 5.88 and study of financial performance and bank rating on credit quality with mean score of 5.63 are the most important and second most important aspects for managing bank-wise exposure. Management quality (mean, 5.13) and operating efficiency (mean, 4.75) stood at third and fourth position in terms of importance. Internal Matrix for studying counter party or country risk got the lowest mean score in PSBs (4.12) as well as in PBs (4.63) and hence this is the least important aspect considered for bank-wise exposure. The sector-wise analysis indicates that study of financial performance, operating efficiency and management quality are significantly important aspects considered in PSBs in comparison to PBs. All other objectives are found relatively more important in PBs in comparison to PSBs. The t-values, which were computed to test the significance of difference of the mean score obtained by various factors considered for evaluating bank exposure in case of small and large size banks are insignificant. Hence, size as well as ownership pattern do not affect the importance of various aspects.
Table 19a: Sector-Wise Importance Assigned to Aspects Considered for Evaluating Inter-Bank Exposures
Aspects Study of Financial Performance Operating Efficiency Management Quality Past Experience Bank Rating on Credit Quality Internal Matrix for Studying Counter Party or Country Risk Mean Score Public 5.67 5.31 5.38 5.44 4.94 4.12 Private 5.63 4.75 5.13 5.88 5.63 4.63 Standard Deviation Public 0.82 0.95 0.89 0.81 1.82 1.83 Mean t Score Value Private Difference 0.74 1.67 1.73 0.35 0.52 1.69 4.17E-02 0.120 0.56 0.25 0.44 0.68 0.51 1.062 0.474 1.832 1.432 0.661 Sig. Level 0.906 0.300 0.640 0.081 0.167 0.515

Table 19b: Size-Wise Importance Assigned to Aspects Considered for Evaluating Inter-Bank Exposures
Aspects Mean Score Large 5.50 4.17 4.67 5.50 5.57 4.71 Small 5.71 5.44 5.50 5.61 5.00 4.11 Standard Deviation Large Small 1.22 1.72 1.97 0.84 0.79 1.80 0.59 0.86 0.79 0.70 1.75 1.78 Mean t Score Value Difference 0.21 1.28 0.83 0.11 0.57 0.60 0.550 2.434 1.011 0.322 0.824 0.759 Sig. Level

Study of Financial Performance Operating Efficiency Management Quality Past Experience Bank Rating on Credit Quality Internal Matrix for Studying Counter Party or Country Risk

0.588 0.023 0.354 0.750 0.418 0.456

With the growing Derivatives Market, it was considered necessary to ask the bankers, whether they use derivatives for managing Credit Risk in their bank. The data obtained in this regard is presented in Table 20. This table clearly indicates that the majority of the bankers responded negatively about the use of derivatives. The above holds true irrespective of size of the banks and ownership pattern.
64 The Icfai University Journal of Bank Management, Vol. VIII, No. 1, 2009

Table 20: Use of Derivatives as a Tool of Credit Risk Management

Sector-Wise Frequency Distribution Public Private ChiSector Sector Square Banks Banks Value (df) 4 (22.2) 14 (77.8) 18 4 (50) 4 (50) 8 2.006 (1) Size-Wise Frequency Distribution Large Small ChiBanks Banks Square Value (df) 3 (42.9) 4 (57.1) 7 5 (26.3) 14 (73.7) 19 0.657 (1)

Response

Overall

Yes No Total

8 (30.8) 18 (69.2) 26

Note: Figures in parentheses are the percentage of total.

According to Basel-II accord, the banks may follow various approaches for capital charge calculations. These approaches are: standardized approach, foundation internal rating based approach, advanced internal rating based approach, etc. Besides having questions about the practices of credit risk management, the bankers were asked about the approaches they were using for capital charge calculations. The Table 21, contains the results of the above survey. It is clear from this table that 17 (94.4%) PSBs, five (62.5%) PBs, six (85.7%) large banks and 16 (84.2%) small banks were seen making use of Standardized approach for capital charge calculations. One (5.6%) PSB and one (5.3%) small size bank have responded in favor of Foundation Internal Rating Based Approach. No bank has responded in favor of Advanced Internal rating Based Approach. However, three (37.5%) PBs, one (14.3%) large size bank and two (10.5%) small size bank have not responded to this question.
Table 21: Approaches for Capital Charge Calculations
Sector-Wise Frequency Distribution Approaches Overall Public Sector Banks Private Sector Banks 5 (62.5) ChiSquare Value (df) 5.515**(2) Size-Wise Frequency Distribution Large Banks Small Banks ChiSquare Value (df) 1.280 (2)

Standardized Approach Foundation Internal Rating Based Approach Advanced Internal Rating Based Approach No Response Total

22 (84.6) 17 (94.4)

6 (85.7) 16 (84.2)

(3.8)

1 (5.6)

0.462 (1)

(5.3)

0.383

(1)

3 (11.5) 26

18 8

3 (37.5)

1 (14.3) 7

2 (10.5) 19

Note: Figures in parentheses are the percentage of total. * significant at 0.10 level.

Conclusion
In this paper, an attempt has been made to study the Credit Risk Management Framework of scheduled commercial banks operating in India. The survey based findings are presented below:

The risk managers are of the opinion that, the direct lending activities cause the
maximum level of credit risk in both PSBs and PBs. The same holds true irrespective of
Credit Risk Management Framework at Banks in India 65

size of the banks. In order to manage and control credit risk, the majority of banks have responded favorably to the enactment of Securitization Ordinance Act, 2002.

Regarding the authority for approval of the Credit Risk Policy, it was found that in
84.6% of the banks, the same is approved by Board of Directors. The authority of credit risk management is set up at Head Office level in most of the banks. The credit sanction of the authority is obtained from for exposures of more than Rs. 1 cr.

The survey indicated that more than 90% of the banks favor risk rating as an instrument
for Credit Risk Management. The other instruments such as proper credit administration in form of credit sanctions, prudential limits and loan review are also given very high importance by the banks.

For management of credit risk, RBI has suggested various prudential limits like clear
definition of exposure limits and single/group borrower limits. Amongst these limits, the former is favored more in public sector banks and the latter gains more importance in private banks. Size-wise analysis has revealed that the large size banks favor single/ group borrower limits, but exposure limits have more importance in small size banks.

The risk rating is the most important activity performed by banks for credit risk
management. For risk rating the design of MIS is considered as an important requirement for banks now-a-days. The survey brought out that more than 90% of banks perform risk rating exercise and they have started developing MIS. In most of the banks the rating is presented in the form of Alphabets.

Regarding frequency of the credit risk assessment exercise, it has been observed that the
bankers perform it annually. The other most important technique for credit risk management, as suggested by RBI, is Risk adjusted pricing of the portfolio. The survey has indicated that Risk pricing is favored by around 60% of the banks. The survey further exhibited that the Future Business Potential is the most important factor considered for pricing credit risk in banks.

Regarding model for evaluation of their credit portfolio, it came to light that most of the
banks favored CRISIL models and internally designed models. Around 90% of the s banks in India make the annual review of their loan policy and this exercise is performed by Board of Directors in more than 80% of banks.

The survey also brought out that 73.1% of the banks have clearly defined their
off-balance sheet exposure.

Study of Financial performance, operating efficiency and management quality are

assumed as more important aspects in PSBs in comparison to PBs for evaluating interbank exposure.

The use of derivatives in banks for credit risk management is almost negligible. For capital charge calculation, almost 85% of the banks have favored standardized
approach of credit risk.
66 The Icfai University Journal of Bank Management, Vol. VIII, No. 1, 2009

The survey has, thus, brought out that irrespective of sector and size of bank, Credit Risk Management framework in India is on the right track and it is fully based on the RBIs guidelines issued in this regard. While risk rating is the most important instrument, the others proper credit administration, prudential limits and loan review are used as very highly important instruments of credit risk management. Most banks have their credit approving authority at Head Office Level. Borrower limits and exposure limits are major prudential limits for credit risk management. Risk pricing is a modern tool for pricing credit risk in banks. However, the banks in India are not very enthusiastic to use derivatives products as risk hedging tools as till date they are not used in majority of the banks. The risk managers were of the opinion that the implementation of credit risk related guidelines was not a problem for them, but lack of the understanding of the methodologies/instruments was a cumbersome task for many of them. They needed to undergo some training/education program in this regard. Hence, the concerned banks as well as RBI should take appropriate steps to organize high training programs on risk management at some institute of high credibility. H

References
1. Bagchi S K (2003), Credit Risk Management A Panacea or Conundrum?, SBI Monthly Review, Vol. 42, No. 10, pp. 497-504. 2. Bandyopadhyay Arindam (2006), Predicting Probability of Default of Indian Corporate Bonds: Logistic and Z-Score Model Approaches, The Journal of Risk Finance, Vol. 7, No. 3, pp. 255-272. 3. Duffee Gregory R and Zhou Chunseng (1999), Credit Derivatives in Banking: Useful Tools for Managing Risk? Research Program in Finance 289, University of California, Berkeley. 4. Ferguson Roger W (2001), Credit Risk Management Models and Judgement, PNB Monthly Review, Vol. 23, No. 10, pp. 23-31. 5. Froot Kenneth A and Jeremy C Stein (1998), Risk Management, Capital Budgeting, and Capital Structure Policy for Financial Institutions: An Integrated Approach, Journal of Financial Economics, Vol. 47, pp. 55-82. 6. Guidance Note on Credit Risk Management, October 12, 2002, Department of Banking Operations and Development, Reserve Bank of India. 7. Louberge Henri and Schlesinger Hanis (2005), Coping with Credit Risk, The Journal of Risk Finance, Vol. 6, No. 2, pp. 118-134. 8. Muninarayanappa and Nirmala (2004), Credit Risk Management in Banks Key Issues, Journal of Accounting & Finance, Vol. 18, No. 1, pp. 94-98. 9. Rajagopal S (1996), Bank Risk Management A Risk Pricing Model, SBI Monthly Review, Vol. 35, No. 11, pp. 553-567. 10. Treacy William F and Carey Mark S (1998), Credit Risk Rating at Large US Banks, Federal Reserve Bulletin, November.
Credit Risk Management Framework at Banks in India 67

Exhibit 1: List of Respondents (Banks)

Size-Wise Large Banks Public Sector Banks Bank of Baroda (BOB) Canara Bank (CB) Punjab National Bank (PNB) State Bank of India (SBI) Private Sector Banks HDFC Bank Ltd. (HDFC) ICICI Bank Ltd. (ICICI) UTI Bank Ltd. (UTI) Small Banks Public Sector Banks Allahabad Bank (AlB) Andhra Bank (AB) Central Bank of India (CBI) Indian Bank (IB) Oriental Bank of Commerce (OBC) Syndicate Bank (SyB) UCO Bank (UCOB) Union Bank of India (UBI) Vijaya Bank (VB) State Bank of Hyderabad (SBH) State Bank of Indore (SBIn) State Bank of Patiala (SBP) State Bank of Saurashtra (SBS) State Bank of Travancore (SBT) Private Sector Banks IndusInd Bank Ltd. (INDUS) Bank of Rajasthan Ltd. (BoR) Kotak Mahindra Bank Ltd. (KMB) Karnataka Bank Ltd. (KB) Citibank N.A. (CITI)* Note: * Foreign Bank.
68 The Icfai University Journal of Bank Management, Vol. VIII, No. 1, 2009

Sector-Wise Public Sector Banks Allahabad Bank (AlB) Andhra Bank (AB) Bank of Baroda (BOB) Canara Bank (CB) Central Bank of India (CBI) Indian Bank (IB) Oriental Bank of Commerce (OBC) Punjab National Bank (PNB) Syndicate Bank (SyB) UCO Bank (UCOB) Union Bank of India (UBI) Vijaya Bank (VB) State Bank of Hyderabad (SBH) State Bank of India (SBI) State Bank of Indore (SBIn) State Bank of Patiala (SBP) State Bank of Saurashtra (SBS) State Bank of Travancore (SBT) Private Sector Banks Bank of Rajasthan Ltd. (BoR) Citibank N.A. (CITI)* HDFC Bank Ltd. (HDFC) ICICI Bank Ltd. (ICICI) IndusInd Bank Ltd. (INDUS) Karnataka Bank Ltd. (KB) Kotak Mahindra Bank Ltd. (KMB) UTI Bank Ltd. (UTI)

Questionnaire on Credit Risk Management

1) (a) Please indicate the level of Credit Risk being faced by your bank on the following transactions (on a scale of 1 to 7, where 1 = no risk; 2 = very low; and 7 = very high) 1 I. II. Direct Lending Guarantees or Letter of Credit 2 3 4 5 6 7

III. Cross Border Exposure (b) To what extent the Securitization Ordinance Act, 2002 is effective in Credit Risk Management for your bank? Very much ________ Some what ________ Not at all ________

2) (a) Who is responsible for approval of Credit Risk Policy in your bank? (Please tick) I. II. Board of Directors Senior Management

III. Credit Policy Committee IV. Any other, please specify (b) Which technique/instrument, do you use for Credit Risk Management in your bank? (Please tick) I. II. Credit Approval Authority Prudential Limits

III. Risk Ratings IV. Risk Pricing or Risk Adjusted Return on Capital (RAROC) V. Portfolio Management VI. Loan Review Policy VII. Any other, please specify 3) (a) What is the credit limit for seeking approval from Credit Approval Committee in your bank? (Please tick) I. II. Above 20 Lakhs Above 50 Lakhs

III. Above 1 Crore (b) At what level the Approval Committees are set up in your bank? (Please tick) I. II. Branch Level Regional Level

III. Zonal Level IV. Head Office Level

(Contd...) Credit Risk Management Framework at Banks in India 69

Questionnaire on Credit Risk Management

(...contd)

(c) Please indicate the relative importance of the following aspects of credit, you consider while defining prudential limits (on a scale of 1-7, where 1 = not used; 2 = unimportant; 7 = very important) 1 I. II. Stipulate Benchmark for ratios Single/Group borrower limits 2 3 4 5 6 7

III. Exposure limits IV. Maximum exposure limits to Industry V. Consideration of Maturity Profile of Loan Book (d) Does your bank perform the following activities for Credit Risk Management? (Please tick) I. II. Industries Studies\Profiles Periodic Credit Calls

III. Periodic Visits of Plants IV. Develop MIS V. Credit Risk Rating/Risk Scoring

VI. Annual Review of Accounts (e) Please tick, which of the following is applicable for rating in your bank? I. II. Number Alphabets

III. Alpha-Numeric IV. Symbol V. Descriptive Terms

4) (a) At what interval the Credit Risk assessment is repeated in your bank? Monthly Yes No Yes No
(Contd...) 70 The Icfai University Journal of Bank Management, Vol. VIII, No. 1, 2009

Quarterly

Bi-annually

Annually

(b) Do you prepare Credit Quality Reports for signaling loan loss in any portfolio? (c) Have you developed Risk Adjusted Return on Capital (RAROC) Framework for Risk Pricing in your bank?

Questionnaire on Credit Risk Management

(...contd)

5) (a) Please indicate, the relative importance of the following factors you consider for pricing Credit Risk (on a scale of 1 to 7, where 1 = not used, 2 = unimportant; 7 = very important) 1 I. II. Portfolio Quality Value of Collateral 2 3 4 5 6 7

III. Market forces IV. Perceived value of accounts V. Future business potential VI. Portfolio Industry Exposure VII. Strategic Reasons VIII. Any other, please specify _____________ (b) Please identify which of the following Credit Risk Model you use for evaluation of Credit Portfolio. I. II. Altmans Z-Score Model Merton Model

III. KMV Credit Monitor Model IV. Credit Metrics V. Credit Risk+

VI. McKinesy Credit Portfolio View VII. Any other, please specify 6) (a) At what interval the Loan Policy is reviewed? Monthly Quarterly Bi-annually Annually

(b) Who review the Loan Policy in your bank? (Tick the appropriate) I. II. Board of Directors Credit Administration Department

III. Loan Review Officer IV. Any other, please specify (c) Do you have defined exposure for managing off-balance sheet exposure? Yes No

7) (a) Have you developed any framework to study the inter-bank exposures? Yes No

(Contd...) Credit Risk Management Framework at Banks in India 71

Questionnaire on Credit Risk Management

(...contd)

(b) Please indicate the relative importance of the following aspects that you consider for evaluating bank-wise exposures (on a scale of 1 to 7, where 1 = not used, 2 = unimportant; 7 = very important) 1 I. II. Study of Financial Performance Operating Efficiency 2 3 4 5 6 7

III. Management Quality IV. Past Experience V. Bank rating on Credit Quality VI. Internal Matrix for studying counter party or country risk (c) Does your bank use Derivatives to manage Credit Risk? Yes No

8) Which approach you are using for measuring capital requirement for Credit Risk? I. II. Standardized Approach Foundation Internal Rating Based Approach

III. Advanced Internal Rating Based Approach

Reference # 10J-2009-02-03-01

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