Unit III

Credit Monitoring & Risk Management

Part I – Credit Monitoring

 Core functions of Banking

Accepting Deposits Lending loans

Credit Management

Pre-sanction Post-sanction

Credit review & Monitoring

 To check continuously if the loan policy is
being adhered to
 To identify problems in accounts, even at the
incipient stage
 To assess the bank’s exposure to credit risk
 To assess the bank’s future capital
requirements
 To obtain and scrutinize the financial
statements of the borrowers periodically
 To ensure compliance of covenants (sanction
terms) and notice violations immediately, if any
 To periodically ensure that the security coverage
for the loans granted doesn’t get diluted
 To notice payment defaults immediately
 To identify genuine problems of the potential
borrowers and institute timely remedial action
 Macro level
◦ Economic developments that may have an impact on the
industry
◦ Industry development that may have an impact on the
borrower
 Borrower’s level
◦ Financial health of the borrower – over/ under borrowed?
◦ Borrower’s repayment record
◦ Quality/ condition/ value of security offered – primary &
collateral
◦ Completeness of documentation as per legal
requirements
◦ Adherence to loan covenants
 Categories of sickness
◦ Sickness at birth
 Project itself becomes infeasible due to faulty
assumptions or change in environment
◦ Induced sickness
 Incompetence in management or willful default
◦ Genuine sickness
 Circumstances beyond the borrower’s control
 Happens in spite of the borrower’s sincere efforts to
avert the situation
 Effect of financial distress
◦ Prolonged period of lack of profitability
◦ Decay in cash flows – not able to meet the current
liabilities/ high level of unrealizable receivables
◦ Providing inadequate depreciation to the fixed assets –
assets losing market value not getting reflected in the
balance sheet
◦ Rates of return from investments drop below the cost of
capital
 Issues to be tackled
◦ What are the signals of financial distress?
◦ Can the banks detect the signs of distress early enough?
◦ Can financial distress be predicted?
Warning signs Endogenous(Originating) from the firm
 Management Related
◦ Lack of technical expertise
◦ Failure to control cost
◦ Fraud
◦ Poor capacity utilization
 Technology Related
◦ Wrong choice of technology
◦ Choice of obsolete process
 Product related
◦ Over estimating demand
◦ Demand for product fails
◦ Improper pricing
 Financial management related
◦ Underestimating the project cost
◦ Inadequate working capital
◦ Financial control are weak
Warning signs Exogenous(Originating Externally) to
the firm
1) At the project implementation stage
- Currency risk
- Upward revision of import duties or excise duty may
escalate the project cost
- Delay in the receipt of approval for the project from the
government
- Force major event
2) At the production stage
- Non availability of raw material
- Power cuts, transport bottlenecks
- technological changes
-force major events
Warning signs Exogenous(Originating Externally)
to the firm
3) At the sales/marketing stage
- reduction in demand
- withdrawal of degree of government protection
- price cutting by competitors
- availability of cheaper alternatives
- economic downturn
4) Financial Management
- Non availability of adequate credit from bank
- delay in release of adequate of funding by the
banks
 Continuous irregularities in Cash Credit/ Overdraft
accounts – inability to maintain margin/ frequent
drawings exceeding the sanctioned limits/ periodical
interest debited remaining unrealized
 Balance in CC account always at the maximum
 Default/ delay in payment of installments in Term loan
accounts
 Non-submission/ delay in submission / incorrect
submission of stock statements and other control
statements
 Attempts to divert sales proceeds through accounts of
other banks
 Downward trend in credit summations (sales turnover)
 Frequent return of cheques/ bills
 Decline in production/ sales/ profit
 Rising level of inventories – slow moving of
finished goods
 Large and longer outstanding in bills accounts
 Large and longer outstanding of credit
documents negotiated through bank and
frequent return of the same
 Failure to pay statutory liabilities
 Diverting the bank’s finance – utilizing the funds
for purpose other than running the business
 Non cooperation – not furnishing required
information/ delay in meeting payment
commitments etc.
 Statistical tools used to predict distress
◦ Regression Analysis – uses past data to forecast values of
dependant variables
◦ Discriminant Analysis – classifies data in to predetermined
groups by generating an index
 Popular model used by bankers
 Altman’s Z-score model
 Alternate Models
◦ ZETA score model
◦ Emerging Market Scoring (EMS) Model
◦ Logit analysis, Probit Analysis and Linear probability models
◦ Multinomial logit technique model
◦ ‘Gambler’s ruin’ approach model
◦ Neural networks model
 Discriminant function Z
Z = 1.2X1 + 1.4X2 +3.3X3 + 0.6X4 + 1.0X5
X1 = working capital/total assets (%)
X2 = retained earnings/total assets (%)
X3 = EBIT/total assets (%)
X4 = market value of equity/book value of debt (%)
X5 = sales/total assets (times)
◦ The firm is classified as financially sound if Z>2.99 and
financially distressed (bankrupt) if Z<1.81
 Model is based on two Important concepts of
corporate finance
◦ Operating leverage
◦ Asset utilization
 Explanation on significance of indicators
◦ When sales decline, EBIT falls (X3 falls)
◦ When EBIT falls, retained earnings fall (X2 falls)
◦ Fall in RE leads to fall in working capital as well as
market value of equity (X1 and X4 fall)
◦ Fall in market value leads to higher financial
leverage and hence higher risk and financial
distress
◦ The above chain of events lead to decline in Z score
 Assumptions/ Limitations of the model
◦ Firm’s equity is publically traded
◦ Firm is engaged in manufacturing activities
Altman’s ZETA Score
 Appraise companies outside the manufacturing
companies
 The score is reported to proved warning singanls 3-
5 years prior to bankruptcy
 It considers variables such as 1)ROA 2) earning
stability 3) debt service 4) cumulative profit 5)current
ratio 6) capitalization
Emerging Market Score(EMS)
 No model specific to emerging countries

 Developed by Altman, Hartzell & Peck

 It’s a modified Altman Z Score model

 Z=6.56x1+ 3.26x2+6.72x3+1.05x4+3.25x5
 Subsequent researcher used logit analysis,
probit analysis and linear probability model to
improve the accuracy of predicting distress
 Multinominal logit model is used to create
model to differentiate financial distress
company that survive and company that goes
for bankruptcy
 Gambler’s ruin approach combines net
liquidation(Total asset liquidation – total
liability) with net cashflow(Net cash inflow – net
cash outflow)
 Other models like neural network, genetic
programming & rough sets & multidimensional
scaling approach has been used
 Workout procedure to be adopted by the banks to
ensure high recovery rates
◦ Intensify the collection process through letters/ telephone
calls/ personal visits/ inspections
◦ Build an appropriate team from internal or external
resources to enforce an effective monitoring system, which
may involve legal action
◦ Assess available alternative solutions taking into account
the costs involved – whether to go in for restructuring or
loan sales or legal action or write off

 Banks basically have two choices for the workout

◦ Restructure the problem (Rehabilitation) for potentially
viable sick units within stipulated time frame – 3 to 6
months
◦ Liquidate the credit
 Broad parameters for grant of relief
Term Loans
◦ Waiver of penal interest and additional charges, if
any during the intervening period
◦ Interest on term loan may be reduced, if necessary;
reduced interest rates are prospective
◦ Unpaid interest may be segregated and funded;
repayment schedule for the same may be fixed
(within 3 years normally); no interest to be charged
on unpaid interest
◦ Fresh term loans may be sanctioned for revival –
repayment period to be fixed between 5 to 7 years
Cash Credit
◦ Waiver of penal interest and additional charges, if
any during the intervening period
◦ Unpaid interest in Cash Credit account may be
segregated and funded; this funded loan, which is a
clean loan, can be extended as a term loan (FITL)
without interest – to be repaid within 3 to 5 years
◦ A part of working capital loan may be unsecured
without any primary security; this portion may be
converted as ‘working capital term loan (WCTL)’ to
be repaid in installments; interest on this loan may
be at a concessional rate
Cash losses
 Even after rehabilitation, till the firm reaches the
break even period, the cash losses incurred by the
firm may be funded by banks
Additional loan assistance
 Additional working capital loan may be granted for
carrying on the operations at a concessional
interest (comparable to prime lending rate – PLR)
 Additional loan for meeting capital expenditure, if
any, may be granted as contingency assistance, at a
concessional rate
Start-up expenses & Margin for working capital
 The ailing firm tends to have liquidity problems and hence to
ensure uninterrupted operations, the bank can fund for
making payments to the pressing creditors/ statutory
liabilities and to provide margin for WC loans; such payments
may be treated as part of the term loans for start –up
Promoters’ contribution
 Fresh infusion of funds from the borrowers is required to
ensure their involvement – at least 20 to 30% of the total term
loan requirement should be contributed by the promoters
Concessions from other agencies
 State Government – SLIIC/ SFCs/ SIDBI
 Central Government – BIFR/ IDBI
 Rights of the rehabilitating bank
◦ Right of Review - to reassess the facilities offered - for
example, to revise the interest rate upwards etc.
◦ Right of Recompense – to recoup the interest and other
monetary sacrifices, once the firm generates adequate
positive cash flows
 Cases where rehabilitation should not be
considered
◦ If the firm’s sickness is due to the following, the bank
should not go in for rehabilitation but should take
efforts for recovery of the dues
 Mismanagement
 Willful default
 Unauthorized diversion of funds
 Dispute among partners/ promoters
 Unit III
Credit Monitoring & Risk Management

Part II – Risk Management

 Banks are subject to various inter dependant
risks, owing to the type of business they
transact
 The Risk management in banks is considered
very much essential as they occupy an
eminent role in the nation’s economy
 Risk management involves
◦ Risk identification
◦ Risk Measurement
◦ Risk monitoring
◦ Risk control
 Government
Monetary/Fiscal/
Industrial trade

Financial intermediaries/
policies

Other FIs/Banks
Risks

Banks
Lending/
Investment policies

Corporates
Business/ Trade/
Market
 Risks faced by
Banks

Asset- Portfolio Operational Solvency

Liability risks risks risks risks

Interest rate
risks Credit risks

Liquidity
risks
Market risks
Foreign
Exchange
risks
 Asset-Liability risks are risks arising from
the dissimilar characteristics of assets and
liabilities of the bank
 The dissimilar characteristics could be
related to
◦ Interest rate – mismatch in exposures to interest
rates of assets and liabilities
◦ liquidity – mismatch in maturity intermediation of
assets (inflows) and liabilities (outflows)
◦ Foreign exchange – mismatch between the foreign
exchange assets and liabilities
 Interest Interest
Spread
income costs

Variable in Variable in Variable in

long term short term short term

 Difference between the interest earnings and interest costs of

a bank is its ‘spread’
 Mismatch in reprising of assets and liabilities due to changes
in interest rates over a period of time exposes the spread of
banks to unexpected changes, giving rise to interest rate risk
 Interest rate risk for a bank is zero, if all assets and liabilities
have perfectly matched reprising
 Cash
Inflows Outflows Liquidity
reserves

Uncertainty Uncertainty Uncertainty Liquidity

in in in risk

 Maturity characteristics of the liabilities differ from

that of the assets
 Banks are vulnerable to liquidity risk owing to the
presence of demand liabilities on their books
 Demand liabilities are matched largely by liquid
assets in the form of loans and advances,
generating large possibilities of liquidity risk
 Short Long
Net position
position in position in
in currency A
currency A currency A

Exchange rate of currency A

versus reference currency
Net position
value in
reference
currency
 Changes in exchange rates of currency A (for
example $) against a reference currency (say
Rupee) cause changes in the value of net position
in reference currency terms
 Mismatch gives rise to foreign exchange risk
 Portfolio risks are risks connected with the
loan and investment portfolios of the banks
and they are viewed independent of the
liabilities
◦ Credit risk – It refers to the probability that a
borrower will fail to meet his obligations in
accordance with the agreed terms. In other words,
it is the possibility of losses associated with decline
of credit quality of the borrowers
◦ Market risk – It is the risk of losses in ‘on balance
sheet’ and ‘off balance sheet’ trading positions
arising out of movements in market prices of debt,
equity, foreign exchange and commodity markets
 Loss given
Exposure Probability default
 combined combined

at default with of default with rate

Credit risk

 It is the most important risk faced by a bank given the

importance of loans in its portfolio
 Probability of default is the most important source of this risk
 In case of default, the value that can be recovered from the
exposure becomes critical
 For example, in case the probability of default is high but the
loan is fully secured and can be recovered through sale of
securities, then credit risk is non- existent. This variable is
captured by ‘loss given default rate’
 Risk factors:
 affect Variable of resulting in
Interest rates, equity
interest: Market
prices, commodity
Value of trading risk
prices & foreign
portfolio
exchange rates

 Market risk is applicable to the trading portfolio

of a bank (both ‘on balance sheet ‘ and ‘off
balance sheet’)
 The focus is on changes in market prices of
trading instruments – interest rates, equity
prices, commodity prices and foreign exchange
rates
 Operational Risk
◦ It is the risk of loss resulting from inadequate or failed
internal processes, people, and systems or from external
events
◦ It is given lot of importance by the regulators (apart from
credit and market risks, operational risk also is included in
the New Basel Accord 2003 for the purposes of capital
adequacy)
 Solvency Risk
◦ It is a situation wherein losses are large enough to wipe out
the capital of a bank
◦ Since insolvency can arise from any of the aforementioned
risks faced by the banks, the management of capital
encompasses the management of all other risks
 Execution, Internal
delivery and fraud
process
management
External
fraud

Business Operational
disruptions risk
and systems Employee
practices
and
workplace
Damage to safety
physical Client,
assets product and
business
practices
 Level of interest Level of credit
rate risk assumed risk assumed

Chosen Level of market

Level of liquidity level of risk assumed
risk assumed solvency
risk
Level of
Level of foreign operational
exchange risk risk assumed
assumed Level of
capital
required
 The level of solvency risk chosen by a bank helps it to place limits on
the credit, liquidity, market, interest rate, foreign exchange and
operational risks it assumes
 The level of credit, liquidity, market, interest rate, foreign exchange
and operational risks assumed, in turn, determine the amount of
capital, bank needs in order to meet these risks
 Risk Measurement
 Risk measurement consists of three steps
1. Identification of the basic risk factors and indices
2. Identification of a target variable (variable the bank
wishes to protect from risk – it can be market value,
earnings or cash flows depending on what is critical or
important for the bank)
(For example, in case of Interest rate risk
 Risk factor – Interest rate
 Target variables can be
1. Earnings perspective – net interest income or spread
2. Economic value perspective – net worth of the bank)
 Once target variable is identified, the amount of
sensitivity of the target variable to the changes in the
basic factors is measured through an exposure map. The
exposure map will look like the following equation:
ΔVt = Delta × ΔPt
Where Vt is the value of the target variable at time t and
Pt is the value of risk factor at time t, and Delta is the
exposure of the target variable to the basic risk factor
3. Once the exposure map is ready, the next step involves
an assessment of the range and likelihood of possible
outcomes of the values of the basic risk factors and
thereby the values of target variables, which are the
estimates of risk
 Mitigation
 It is done by way of cost-benefit analysis
 Tools for analysis are carefully chosen after analyzing their
usefulness to the situation - for example, a derivative contract
can be purchased to hedge against adverse stock price
movements
 The analysis should accompany the strategy to
deal with the risk – no exposure, selective exposure or
magnified exposure
 once the strategy is implemented, it can be
subject to evaluation and back testing
 Performance evaluation feeds back into the risk
measurement process in order to improve the
efficiency of the process
Risk Measurement
• Enlisting basic risk factors and indices to measure them
• Determining exposure of target variables to risk factors
• Grasping range of likelihood of the possible outcomes

Tool Analysis
• Analyzing tools that can alter risk exposure and evaluating
risk-cost trade-off of each tool

Exposure measurement
• Selecting a strategy of no exposure, selective exposure or
magnified exposure

Performance evaluation
• Back testing the risk measurement model to evaluate its
performance
 A concrete step was taken by RBI to manage
credit risk in banks, in the year 1998, by way of
introducing ‘Prudential norms for Asset
Classification, Income Recognition and
Provisioning’– initiated from Narasimham
Committee Recommendations of 1991and 1998
on financial sector reforms
 RBI gave instructions to all banks to classify
assets (loans and advances) under certain
categories; it also includes leased assets
 Loans which do not generate income to the
bank are to be classified as ‘Non-performing
Assets’ (NPA)
 NPA is a loan where
◦ Interest and/or installment of principal remain overdue for a
period of more than 90 days in respect of term loans
◦ Account remains out of order in respect of overdraft/ cash
credit accounts for more than 90 days
◦ Bill remains overdue for a period of more than 90 days in
respect to bills purchased/ bills discounted accounts
◦ Interest and/or installment of principal remain overdue for two
crop seasons, in respect of crop loans granted for short
duration crops
◦ Interest and/or installment of principal remain overdue for one
crop season, in respect of crop loans granted for long duration
crops
◦ The amount of liquidity facility remains outstanding for more
than 90 days in respect of securitization transaction
◦ Derivative contracts, whose overdue receivables remain unpaid
for more than 90 days
 Income recognition – income from NPA is not to be
recognized on accrual basis but is booked as income only
when it is actually received; hence
◦ Banks should not charge interest on any NPA
◦ Unrealized interest, if any, should be reversed or
provided for
◦ Unrealized finance charge component of finance
income in case of leased assets should be reversed
or provided for
◦ Interest realized on NPAs may be taken to income
account provided the credits in the accounts
towards interest are not out of fresh/additional
credit sanctioned to the borrower
 Asset classification – NPAs are classified based on i)
period for which the asset has remained as NPA and ii) the
realizability of dues
 The following are classification norms with effect from
31.03.2005
◦ i) Sub-standard asset – an asset, which has remained
NPA for a period of less than or equal to 12 months
◦ ii) Doubtful asset – an asset, which has remained in
the sub-standard category for a period of 12 months
◦ Iii) Loss asset – an asset which is considered
uncollectable and hence continuance as a bank asset
is not warranted
 The assets, which are not classified as NPAs i.e. accounts which
are conducted well are called ‘Standard Assets’
 Provisioning norms – adequate provision has
to made by the banks for their NPA accounts
◦ Loss assets
 They have to be written-off or provision has to be
made for 100% of the outstanding amount
◦ Doubtful assets
 Provision of 100% to the extent of loan not covered by
realizable security (unsecured portion)
 Provision 25% to 100% for the portion of loans covered
by realizable security as under (secured portion)
 Up to 1 year – 25%
 1 to 3 years – 40%
 More than 3 years – 100%
 Provisioning norms
◦ Sub-standard assets
 General provision of 15% on the total outstanding should be
made ( without making any allowance for ECGC Guarantee
cover and securities available)
 The unsecured exposures would attract an additional
provision of 10% constituting to 25% of the outstanding
balance
◦ Standard assets
 Direct advances to Agriculture, Small & Micro enterprises
sectors – 0.25%
 Advances to commercial real estate sector – 1.00%
 Advances to commercial real estate residential housing
sector – 0.75%
 All other advances – 0.40%
 Managing risks in banks is uniquely important
because their capital base is small relative to their
assets and liabilities; small % changes in assets or
liabilities can translate in to large % changes in
capital
 ALM is concerned with management of risks
associated with the assets and liabilities of the bank
viz. interest rate risk, liquidity risk and foreign
exchange risk (currency risk)
 ALM has been gaining a lot of importance as the
banks focus on mitigating the balance sheet
weaknesses
 ALM techniques have been evolving over a period of
time
The ALM process rests on three pillars:
 ALM information system
◦ Management Information system
◦ Information availability, accuracy and expediency
 ALM Organization
◦ Structure and responsibilities
◦ Level of top management involvement
 ALM process
◦ Deals with Risk parameters, Risk identification, Risk
measurement, Risk management, Risk policies and
tolerance – RBI guidelines primarily addresses
liquidity and interest rate risks
 Information is the key to ALM process
 Getting information in time is a difficult process,
considering the large network of branches
 This problem can be addressed by following an
ABC approach i.e. analyzing the behaviour of asset
and liability products in top branches contributing
significant business to make rational assumptions
on other branches
 The data and assumptions can be refined over a
period of time; experience helps banks to conduct
business within the ALM framework
 Increased level of Computerization in banks is a
blessing in disguise in accessing data
 Banks typically have an ALM committee (ALCO)
comprising of bank’s senior management
including CEO entrusted with the responsibility of
ALM
 ALCO’s responsibility is to device strategies for
ALM, monitor and manage the interrelated risk
exposure on a daily basis
◦ Assess the probability of various liquidity shocks
◦ Assess the probability of various interest rate scenarios
and their impact on net income
◦ Position the bank to handle the above at minimum cost,
while achieving a reasonable profitability level
◦ Handle foreign exchange risks – derivatives market helps
 Liquidity is to be tracked through maturity or cash
flow mismatches – a maturity liability will be a cash
outflow and a maturity asset will be a cash inflow
 Use of a maturity ladder and calculation of cumulative
surplus or deficit of funds at selected maturity dates
is adopted as a standard tool
 Assets and liabilities are grouped in to different
maturity profiles (time buckets) and presented for
decision making (1-14 days, 15-28 days, 29 days to
3 months, 3-6 months, 6-12 months, 1-2 years, 2-5
years and over 5 years)
 Main focus should be on short-term mismatches (up
to 26 days). RBI’s instructions is to keep the
mismatches below 20% of the cash outflows in each
time bucket
 Interest rate risk can be measured either from
i) earnings perspective (net interest income) or
ii) economic value perspective (net worth)
 Methods used – Gap Analysis, Simulation and
Value at Risk
 Mismatch between rate sensitive liabilities and
rate sensitive assets is measured and gaps are
identified in various buckets (up to 1 month, 1-3
months, 3 to 6 months, 6-12 months, 1-3 years,
3-5 years, over 5 years, non-sensitive)
 The Gap reports indicate whether the institution
is in a position to benefit from rising interest
rates (positive Gap) or declining interest rate
(negative Gap)
 Floating exchange rates and increased capital
flows across free economies contributes to
increase in volume of foreign exchange
transactions and the associated risks
 If the liabilities in one currency exceed the
level of assets in the same currency mismatch
can add or erode value depending upon
currency movements
 Currency risk can be avoided by reducing the
mismatches by adopting suitable strategies