Credit Risk Management: Policy Framework for Indian Banks

 | June 08,2010 04:18 pm IST

1.1 Risk is inherent in all aspects of a commercial operation and covers areas such as customer services, reputation, technology, security, human resources, market price, funding, legal, regulatory, fraud and strategy.

However, for banks and financial institutions, credit risk is the most important factor to be managed. Credit risk is defined as the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk, therefore, arises from the banks' dealings with or lending to a corporate, individual, another bank, financial institution or a country. Credit risk may take various forms, such as:


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

In the case of guarantees or letters of credit, that funds will not be forthcoming from the customer upon crystallization of the liability under the contract;

In the case of treasury products, that the payment or series of payments due from the counterparty under the respective contracts is not forthcoming or ceases;

In the case of securities trading businesses, that settlement will not be effected;

In the case of cross-border exposure, that the availability and free transfer of currency is restricted or ceases.


1.1.2 The more diversified a banking group is, the more intricate systems it would need, to protect itself from a wide variety of risks. These include the routine operational risks applicable to any commercial concern, the business risks to its commercial borrowers, the economic and political risks associated with the countries in which it operates, and the commercial and the reputational risks concomitant with a failure to comply with the increasingly stringent legislation and regulations surrounding financial services business in many territories. Comprehensive risk identification and assessment are therefore very essential to establishing the health of any counterparty.


1.1.3 Credit risk management enables banks to identify, assess, manage proactively, and optimise their credit risk at an individual level or at an entity level or at the level of a country. Given the fast changing, dynamic world scenario experiencing the pressures of globalisation, liberalization, consolidation and disintermediation, it is important that banks have a robust credit risk management policies and procedures which is sensitive and responsive to these changes.


1.1.4 The quality of the credit risk management function will be the key driver of the changes to the level of shareholder return. Industry analysts have demonstrated that the average shareholder return of the best credit performance US banks during 1989 - 1997 was 56% higher than their peers. Low loan loss banks stage a quicker share price recovery than their peers, and in a credit downturn, the market rewards the banks with the best credit performance with a moderate price decline relative to their peers.


1.2 Building Blocks on Credit Risk
In any bank, the corporate goals and credit culture are closely linked, and an effective credit risk management framework requires the following distinct building blocks: -

1.2.1 Strategy and Policy
This covers issues such as the definition of the credit appetite, the development of credit guidelines and the identification and the assessment of the credit risk.


1.2.2 Organisation
This would entail the establishment of competencies and clear accountabilities for managing the credit risk.


1.2.3 Operations/Systems
MIS requirements of the senior and middle management, and the development of tools and techniques will come under this domain.


1.3 Strategy and Policy

1.3.1 It is essential that each bank develops its own credit risk strategy or enunciates a plan that defines the objectives for the credit-granting function. This strategy should spell out clearly the organisation's credit appetite and the acceptable level of risk - reward trade-off at both the macro and the micro levels.


1.3.2 The strategy would therefore, include a statement of the bank's willingness to grant loans based on the type of economic activity, geographical location, currency, market, maturity and anticipated profitability. This would necessarily translate into the identification of target markets and business sectors, preferred levels of diversification and concentration, the cost of capital in granting credit and the cost of bad debts.


1.3.3 The policy document should cover issues such as organizational responsibilities, risk measurement and aggregation techniques, prudential requirements, risk assessment and review, reporting requirements, risk grading, product guidelines, documentation, legal issues and management of problem loans. Loan policies apart from ensuring consistency in credit practices, should also provide a vital link to the other functions of the bank. It has been empirically proved that organisations with sound and well-articulated loan policies have been able to contain the loan losses arising from poor loan structuring and perfunctory risk assessments.




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pramod on 07/31/10 at 08:04 pm

its very helpful to me

paddy on 07/11/11 at 01:42 am

very good