Marketing Report 1st Half 2009

Credit Risk Management

Principles and Practices

Dr. Gregorio E. Baccay III

25 February 2017

GEBaccay
 Basic concepts of the credit risk management

Credit Risk is the current or prospective risk to earnings and capital, arising
from an obligors failure to meet its obligations in accordance with the agreed
terms

Goal of CRM: maximization of the financial institution's risk adjusted rate of

return by maintaining credit risk exposure within acceptable parameters

CRM refers to the credit risk in individual credits or transactions as well as

the risk inherent in the entire portfolio

Consideration of the relationship between credit risk and other risks

The CRM approach used by individual financial institution should correspond

to the scope and sophistication of the financial institution's activities

GEBaccay
 Main principals for credit risk management

Lines of defense in the credit risk management process

First line is considered Business origination units (business units). They are
obliged to follow strictly the principles and rules defined in the Lending Rules
and Credit Policy of the financial institution and to assess the credit risk in a
manner of keeping the interests of the institution.
Second line is considered Credit Risk units (decision takers with credit
approval competences). They are responsible for the precise and in depth
assessment and approval of credit risks to different customer types of
borrowers and the adherence to the approved Credit Policy of the institution.
Third line is considered the Risk management unit. It is responsible for
identification of treats against the overall credit portfolio, i.e. monitoring of
existing credit risks within the portfolio and identification of potential credit
risks that could evolve.

GEBaccay
 Credit risk process & credit risk management

Allocate Set objectives

provisions; and
capital charges responsibilities

Monitor credit
performance Set credit risk
guidelines

Make credit
decisions Collect credit
Measure and data
assess credit
risk

GEBaccay
 Broad principles of credit risk management in Banks

Best practices in credit risk management in the following areas

Establishing an appropriate credit risk environment

Operating under a sound credit granting process

Maintaining an appropriate credit administration, measurement and

monitoring process

Ensuring adequate controls over credit risk

Role of FI's managers/supervisors in ensuring that FI's have an

effective system in place to identify, measure, monitor and control credit
risk

GEBaccay
 Important factors for credit approval

Purpose of the credit and source of repayment;

Current risk profile (incl. the nature and aggregate amounts of risks)
of the borrower or counterparty and its sensitivity to economic and
market developments;

Borrowers repayment history and current capacity to repay,

based on the historical trends in its financials and future cash flow
projections, under various scenarios; customers capacity to increase
its level of indebtedness;

The proposed terms and conditions of the credit, including

covenants designed to limit changes in the future risk profile of the
borrower;

Proposed collateral types, Loan to Values (LTV), adequacy and

enforceability of collaterals or guarantees, under various scenarios;
GEBaccay Integrity and reputation of the borrower or counterparty.
 Specific factors for credit approval for business customers

Internal factors
Financial risk
Assessment of the existing financial position
Assessment of the expected financial position
Accounting quality
Business risk
Market position
Operating Efficiency
Management risk
Management business expertise
Payment record

External factors
Conditions in the respective economic sector of activity
Economic trends in the industry of activity
GEBaccay
 Credit risk assessment tools

Expert judgment

Based on assessment of factors like: the features of the credit

facility, the capital position (incl. capital structure) of the applicant,
its repayment capacity, the collateralization, the economic
conditions and the business cycle on the respective market

Credit rating systems

Capture all relevant information about the borrower and assign a

grade through a risk rating process, by the consideration of
financial and non-financial factors

Limits system

Prudential regulations for single borrowers/related parties, risk

class/rating linked exposures, industry level caps, delegation of
powers

GEBaccay
 Roles of Credit ratings

Rating represents the default probability

Role in approval process
depends on the risk appetite (minimum rating criterion)
capital allocation (pricing)
Role in monitoring, analysis and reporting
indicates the quality of the exposure at a given moment of time
should be linked to the periodicity of the asset review process
early warning system
capture asset quality migrations
product pricing (Risk Return trade-offs)
provisioning and capital requirements
Administration
Loan review/monitoring
Trigger Actions (i.e. planning credit enhancement, reduction in exposures, exit strategy)
GEBaccay
 Quantitative approach for credit risk measurement

Borrower risk Facility risk related

*Probability of **Loss ***Exposure at

Expected X X
= default given
loss default
(%) default

*Likelihood that a loan will not be repaid & will fall into default (from 0 to 100%)
**Fractional loss due to default (LGD=1 - Recovery Rate)
***The amount the borrowers owe to the FI at the time of default
****Is what an FI can expect to lose in the case the borower defaults

GEBaccay
 SCENARIO

Supposed Company X takes out a loan from FI A for P

10M (EAD). Company X pledges P 3M collateral
against this loan (for simplicity, let's say the collateral is
cash). The Company's PD is determined by analyzing
their credit risk aspects (evaluate the financial health of
the borrower, taking into account economic trends,
borriwer relationship with the FI, etc). For Company X
let's say PD is 0.99. This means the company is
extremely risky,the probability of them defaulting a loan
is 99%.
GEBaccay
 CALCULATION OF LGD

LGD = 1 - Recovery Rate (RR)

RR is defined as the proportion of a bad debt
that can be recovered.
RR = Value of Collateral Value/Value of the
Loan
RR = P3M/P10M = 30%
LGD = 1 - 0.30 = 0.70 or 70%
so LGD = P7M
GEBaccay
 CALCULATION OF EL

EL = PD x LGD x EAD
EL = 0.99 x 70% x P10M
EL = P6.93M

FI A can expect to lose P6.93M

GEBaccay
 7 PRINCIPLES
of Loan Portfolio
Management/Risk
Management
GEBaccay
 PRINCIPLE 1

Understand two major principles of risks:

a.) stuff happens
b.) You don't know what you don't know

GEBaccay
 PRINCIPLE 2

LPM is only one aspect of overall risk

management
look at all the risks your organization faces
how you manage ypur loan portfoloio depends on
how you manage your capital, amount of expected
earnings, economic outlook, etc

GEBaccay
 PRINCIPLE 3

Know your organization's risk position and

appetite for risk
Prepare a survey to identify major risks. Establish
atings for each identified risk along three
parameters:
Significance of risk. How much damage will be caused if
the event happens?
Likelihood of risk event occurring. What are the chances
that this event will happen?
Ability to manage the risk. Is the risk something that can
be easily anticipated and managed?
GEBaccay
 PRINCIPLE 4

Build risk management principles into your

strategic plan
Your strategic plan should be the foundation for
policies, goals, targets, and underwriting standards.
Run stress testing scenarios to better understand
what happens when things dont go according to
plan.

GEBaccay
 PRINCIPLE 5

Monitor key performance indicators and share

the results
Make sure everyone in the organization can see
how the organization is doing and progressing.
Develop an easy to understand dashboard to
highlight what is working well and what needs
improving.

GEBaccay
 PRINCIPLE 6

Have a rigorous, independent review process

Have an internal auditor/credit reviewer who reports
directly to the board and senior management.
You want to find problems early while they can still
be fixed. Never fool yourself. Also have an external
auditor/credit reviewer to check on the internal
processes.

GEBaccay
 PRINCIPLE 7

None of the actions or strategies above make

any difference unless there is a culture of trust
and respect
Make sure you have a culture of trust and respect.
Employ people who are competent, well-trained,
and have demonstrated a set of values that include
trust and respect.
Good people make loan portfolio and risk
management work. It is the foundation upon which
everything else rests.
GEBaccay
 FINAL THOUGHTS

Loan portfolio and risk management is not just

about avoiding risk. It is also about balancing
risk with reward, making sure you are seizing
opportunities in your marketplace and serving
your community well.
So, go for the opportunities while balancing your
risk management strategy with these seven
points. It can help make your organization even
more successful.
GEBaccay