IMaCS 2010Printed 11-May-11
Page 1For Classroom discussion only
Agenda for Day 1
Introduction of Participants
Introduction to Credit Risk
Lunch Break
Framework for Credit Risk Management
Overview of Basel Guidelines
Open Session/ Q&A
IMaCS 2010Printed 11-May-11
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A loan creation planning process in a bank
Credit
StrategyLending Policy
Credit Policy
Focus Volume / Risk-Return / Client-base Norms/ Ratios
• Basis
• Corporate objectives
• Thrust areas
• Business targets
• Risk-return relationship
• Customer base
• Concentration Norms
• Characteristics of
preferred borrowers
The above aspects are captured in Business Plan,
Credit Policy, Manual of Instructions, Circulars
IMaCS 2010Printed 11-May-11
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Credit Risk defined
Manifestation of Credit Risk
� Credit risk is the possibility that
payments would not happen as
per agreed terms – uncertainty in
amount and timeliness of
repayments� Inadequate repayments
� Untimely repayments
� Default risk is the risk that the
repayments stop all together
Likely Causes
� Inability to pay
� Short term cash flow or
liquidity problems
� Longer term solvency issues
� Delays in payment due to
operational issues with the
treasury function
� Unwillingness to pay
IMaCS 2010Printed 11-May-11
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Sources of Credit Risk
• Repayment inability due to bad financial performance, point in the business cycle, poor management quality
• Unwillingness on part of obligor to make repayments on time
Asset Based lending
• Delays in completion
• Uncertain cash flows during operation due to lower PLFs, price risk, offtaker credit risk
• Sponsor and Technology risks
• Force Majeure
• Political risks
Cash flow based lending
IMaCS 2010Printed 11-May-11
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Assessing and Managing Credit Risk
Effects of credit risk
• Potential inability of the organization to meet the liabilities as they become due
• Borrowing under unfavorable terms and conditions
• Distress asset sale• Reputational risk
Measurement of credit risk
• Appraisal and assessment.• Use of internal and
external rating
Management of credit risk
• Identification potential venerable credit
• Assessment of potential risk
• Monitoring and follow up• Control and mitigation
like collaterals.
IMaCS 2010Printed 11-May-11
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Credit Risk Management Process has to be installed
� Identification of products (e.g. loan product, derivative, forex, guarantees), geographical locations (e.g. country risk), industry sectors (e.g. real estate, NBFCs) from where the credit risk is originating
� Analyse past credit trends, macro-economic factors and expected trends
Identification
� Measuring credit risk using validating scoring / rating models
� Estimating historical probability of default and recovery rates and loan loss rates to bank
� Linking risk scoring with quantification of risk
Measurement
� Limits on individual / group exposure, specific sectors like real estate, unsecured exposure etc.
� Eligible collaterals and their frequent valuations
� Loan Review Mechanism
Control
IMaCS 2010Printed 11-May-11
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Credit risk management function at Bank
Credit Risk Management
Function
Policy OrganizationQuantification
ToolsManagement
ProcessesMonitoring and Control
The Board of Directors has the overall responsibility for the credit risk management and shall approve the
credit risk management policy, procedures and set prudential and other limits.
Quantification Tools
Management Processes
IMaCS 2010Printed 11-May-11
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Policy Guidelines of Bank
1. Credit objectives
2A. Quality of asset base (Industry
Exposure)
2B. Quality of asset base (Selection
of Borrower)
3. Exposure norms
4. Tenure of credit
5. Credit acquisition
Structure of Credit guidelines of banks
6. Credit appraisal
7. Assessment of limits
8. Pricing
9. Credit monitoring
10. Delegation of authority
11. Recovery and exit policy
12. Internal Audit
IMaCS 2010Printed 11-May-11
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Prudential limits for Individual and Group exposure
Prudential limits
� Individual Exposure� Lending
� Group exposure� Lending
Exposure ceiling
� Exposure of its owned fund� ≤ 35 %
� ≤ 35 %
IMaCS 2010Printed 11-May-11
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Credit risk management function at Bank
Credit Risk Management
Function
Policy OrganizationQuantification
ToolsManagement
ProcessesMonitoring and Control
The Board of Directors has the overall responsibility for the credit risk management and shall approve the
credit risk management policy, procedures and set prudential and other limits.
Quantification Tools
Management Processes
IMaCS 2010Printed 11-May-11
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Organization structure
Board
RMC
Credit Officer
•Overall risk management
•Decide the risk management Policy
•Loan Sanction
•Setting up internal limit for portfolio management
•Preparation and presentation of appraisal note• Objective assessment of the credit risks involved• Ensuring the validity and accuracy of the data used for Credit decision
•Implementation of policy•Adherence to limits set by the Board• Recommendation of ceiling for various types of internal limits to the Board for effective portfolio management.
•Monitoring and reporting of risk levels•Review the risk based pricing• Review the appraisal note , results and trends
IMaCS 2010Printed 11-May-11
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Comprehensive risk management structure
•Business units
RM
Department
RM interacts and functions with
business units
Risk Management Policy
Policies for
Risk
Management
unit
Policies for
management
of different
risks
Policies for
Different
operations
procedures
Policies
Different
business
units
Business Unit
Board of Directors
Risk Management Committee of Board
Credit Risk Management
Committee (CRMC)
Asset Liability Management Committee (ALCO)
Operational Risk Management
Committee (ORMC)
Internal DocumentsOrganisation Structure
IMaCS 2010Printed 11-May-11
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A Board level Risk Management Committee should be put in place to implement risk management across the bank
Reporting • Board of Directors
Supported By • Credit Risk Management Committee, Asset Liability Management Committee and Operational Risk Management Committee
• Devising policy and strategy for integrated risk management containing various risk exposures
• Providing guidance to various risk management committees operating under it
• Oversee the identification, measuring and monitoring the risk profile of the Bank
Desirable
Composition
• Managing Director / Chief Executive Officer, Executive Directors , Heads of Credit and Head of Risk.
Frequency • At minimum quarterly intervals
Roles
IMaCS 2010Printed 11-May-11
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Bank should set up multiple risk management committees to create focus and handle different constituents of risk
Reporting
Supported By
Desirable
Composition
CRMC ALCO ORMC
Should be headed by Chairman/Executive Director/Chief Executive Officer (CEO) and comprises of heads of Credit and Risk Management Dept & Chief Economist
Should be headed by Chairman/ED/CEO and comprises of heads of Credit, Investment, Treasury, Resource and International Banking
Should be headed by Chairman/ED/CEO and comprises of heads of Credit, Information Technology, Human Resource and Risk Management
Risk Management Committee of Board
Credit Risk Management Department
ALCO Cell / Middle Office
Operational Risk Management Department
IMaCS 2010Printed 11-May-11
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The committees should meet at frequent intervals to discuss tomonitor various aspects of risk
Frequency of
Meeting
Roles
CRMC ALCO ORMC
At Frequent Intervals (Minimum Monthly)
� Measure, Control and Manage Bank wide Credit Risk
� Compliance with lending and credit risk management policy
� Enforce compliance with prudential limits
� Measure, Control and Manage Bank wide risk on liquidity, interest rates and foreign exchange
� Product Pricing for Deposits & Advances
� Strategy for Resources Mobilisation
� Formulation of Bank wide Operational Risk Policy
� Act as agency for creating awareness on operational risk in the Bank
� Development of Operational Risk Management tools
Supported By Risk Management Department
IMaCS 2010Printed 11-May-11
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Bank should install an independent risk management department housed in the Head Office
Location At Head Office / Corporate Office
Headed By An officer with a minimum rank of General Manager, having expert knowledge of banking business and credit, market and operational risk management
Supported By Minimum of 3/4 persons on current scale of operations and shall be increased with the enlargement of operations
Desired
Qualifications
Chartered Accountants, MBA, Cost Accountant, CFA, M. Sc. –Statistics and any other equivalent degree
IMaCS 2010Printed 11-May-11
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Credit risk management function at Bank
Credit Risk Management
Function
Policy OrganizationQuantification
ToolsManagement
ProcessesMonitoring and Control
The Board of Directors has the overall responsibility for the credit risk management and shall approve the
credit risk management policy, procedures and set prudential and other limits.
Quantification
Tools
Management Processes
IMaCS 2010Printed 11-May-11
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The Policy would enable a structured assessment of risks, mitigants enabling credit and pricing decision
Portfolio Risk Management
Exposure Limits Monitoring, Oversight and Governance Structure
Monitoring, Oversight and Governance Structure
Credit Decision
Approve / Reject Additional collaterals, covenants, higher pricing
Additional collaterals, covenants, higher pricing
Assessment of mitigants on offer for the proposed transaction
Contractual arrangements in a project Financial collaterals, guarantees etc. for asset based lending
Financial collaterals, guarantees etc. for asset based lending
Assessment of risks
Financial Parameters Qualitative Parameters
IMaCS 2010Printed 11-May-11
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Structure of rating model for balance sheet based lending
Financial Risk
Business Risk
Industry Risk
Management Risk
Borrower Risk Score
Account conduct
Credit rating model enables to view the borrowers with the risk perspective based on grades.
Project evaluation and status
+Final Borrower
Risk Score
IMaCS 2010Printed 11-May-11
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Multiple components of model* and multiple parameters for each component
* Slide provides an outline of a rating model for Corporate Customers
IMaCS 2010Printed 11-May-11
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Key Risks that need to be assessed for a project
Overall project
risk
Financial Risk
Sponsor Risk
Construction risk
Technology risk
Market / Revenue
Risk
O& M Risk
Fuel supply risk
DSCR, IRR
Best Case
Worst Case
Equity Contribution
IMaCS 2010Printed 11-May-11
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Bank would need to finalise an approach for implementing robust risk rating models
Financial Risk Score
Management Risk Score
Industry Risk Score
Basic Borrower Risk Score
W 2
W 1
W 3
Conduct of account Risk
Score
Modified Score
PLUSTransaction Risk Score
Collateral Structuring
Calibration and Validation Robust & Acceptable
Risk Scoring Model
IMaCS 2010Printed 11-May-11
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Estimation of Loss Given Default (LGD)
Market Value of security
Security Type
Loan Outstanding
at Default
LGD=(1 -RR)
Present Valueof Recovery Rate (RR)
IMaCS 2010Printed 11-May-11
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Assessment of risks would also enable risk based pricing besides building a good quality portfolio
� Aligns the incentive to balance risk with return
� Pricing is a tool to maintain proactive provisioning
� Necessary for value creation and preservation
= + +
Price
(Interest
Rate and
fee income)
Cost of FundsCredit
Charge
Loan
Overhead &
Operating
Risk
IMaCS 2010Printed 11-May-11
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Credit risk management function at Bank
Credit Risk Management
Function
Policy OrganizationQuantification
ToolsManagement
ProcessesMonitoring and Control
The Board of Directors has the overall responsibility for the credit risk management and shall approve the
credit risk management policy, procedures and set prudential and other limits.
Quantification Tools
Management
Processes
IMaCS 2010Printed 11-May-11
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Bank would need to install a three tier structure for Lending process loan management
. Front Office
Origination/Renew
al
Sales/Acquisition
Credit Risk Analysis
• Assessment
•Sanction
•Pre disbursement
formalities
•Disbursement
Post disbursement
•Monitoring
•Support to front and
mid office
•NPA Management
Bor
row
er
Risk Management Sanctioning Authority
Reg
ulat
ory
Rep
orti
ng
Evaluation
Collect and review data
Back OfficeMid Office
Audit and Control
IMaCS 2010Printed 11-May-11
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Lending Process in Banks: Origination
Check for discrepancies and email the same to RM
RM/Branch
Front office checks whether all documents are in order and as per norms
CPU
Check MIS to know the status of the file and if declined, reasons for decline
Refer to CreditFile is processed by CPU as per policy
File is processed by CPU as per policy
Initiate Contact point verification (send details of the applicantcontaining customer number, residence address, residencetelephone no. , employer name ,office address, telephone no. etc.)and income document verification
Initiate contact point verification and income document verification
Prepare CAM (Credit Appraisal Memorandum) by leaving columnblank for remarks about Income document verification
Check whether file has been already logged Yes
NoYes
No
DSA/DMA convertprospective loanseekers into loanapplicant
IMaCS 2010Printed 11-May-11
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Lending Process: Assessment , Risk Management and Sanction
Update (Credit
guarantor
Update the status of Income document verification, on receipt of the same in CAM (CreditAppraisal Memorandum) and MIS and complete the credit .Valuation andassessment ofguarantor will also be done based on prescribed guidelines
Credit officer adds the remarks on the basis ofdeviation observed and credit process checks
internalratingmodelfor quantificationof RiskCredit and Risk Department assesses the case based on score card /internal rating model for quantification of Risk
discussion
In case Personal discussion felt necessary conductthe same Note: Please refer to credit process checksand policy for requirement to conduct the personaldiscussion
Approved Hold Declined
Subject to conditions
Communicate to Br/RM
For want of signinging deviation
Communicate to Br/RM so that the customer can
be informedBr/RM collects PDC ,loan agreement and
other documents
Communicate to Br/RM so that the conditions can be
fulfilledInspection officer
Verifies Communicate approval
Communicate to Br/RM so that the conditions can be
fulfilledOperation for Disbursement/Post disbursal activities
IMaCS 2010Printed 11-May-11
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Lending Process: Pre disbursement and disbursal
Review of security documents, execution of new set of prescribed loan document as advised by Legal department and entry of details
into document execution register.
Collection of Post Dated cheques (PDC)
YesCustomer will have to
open savings account and PDC will be issued
thereafter
Customer has bank account with cheque
book facility.No
Creation of
Charges
Creation of mortgage and
charges in Register of
Charges
Creation of account into CBS by following extant guidelines issued Creation of account into CBS by following extant guidelines issued with respect to KYC norms and setting up of limits
Update Drawing Power limit, Recovery of margin money and recovery of feesand charges ,if any . Creation of insurance on financed assets, issue of chequebook in the case of revolving credit,
Disbursal
Send copy of all executed document to CPU for disbursal clearance
IMaCS 2010Printed 11-May-11
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Lending Process: Post disbursal
Post disbursal checks
Credit admin officer
regularly monitor
activities in loan account
Calculation of DP will be done at regular interval based on submitted stock and debtors statement and the
same will be allowed in CBS.
Loan Servicing
Revolving Credit
Monitoring of • Repayment• Penalties & charges• Change in interest rate• Revival of time bared
documents• Collection of required
additional PDC and extension of ECS mandate period
Loan account performance as per agreement
and pre decided terms
Triggers and early warning signals
• Closure of Account• Returned securities
documents and unused PDC
• All loan documents marked as cancelled and closed
No
Yes
Foreclosure and loan maturity
End
IMaCS 2010Printed 11-May-11
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Credit risk management function at Bank
Credit Risk Management
Function
Policy OrganizationQuantification
Tools Management Processes
Monitoring and Control
The Board of Directors has the overall responsibility for the credit risk management and shall approve the
credit risk management policy, procedures and set prudential and other limits.
Quantification Tools
Management
Processes
IMaCS 2010Printed 11-May-11
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Lending Process: Monitoring ,Follow-up and NPA Management
If any of the defined triggers or weakness observed than CR Admin Officer
escalate the matter to it superior's
Review and decide to escalate further/keep in view
Credit Admin and Credit Officer to analyze unit
prepare recommendations
Credit officer and Admin to examine unit and prepare
recommendations
Credit Admin and its supervisor to review
unit on a monthly basis for next two months
If sign of deterioration persist
End
Performance improved by moratorium,deferment of interest pay,
re-assessment
Execute remedial solution and Credit
Admin to •Monitor to ensure
recommendations are implemented
•Prepare specific check points during inspections
Credit sanctioning authority will take final decision on
recommendation s put forth by Credit
Officer Escalation of a
case to Recovery/NPA cell
can happen only after review and final decision by
appropriate authority
End
NO
NO Yes
Yes
No
Keep in viewEscalate to
Credit admin
supervisor
Escalate to Head CPU Credit
officer needs to be assigned
Yes, Escalate to Head CPU
If unit
improves
If unit complying with the
condition and situation
improves
IMaCS 2010Printed 11-May-11
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Risk monitoring and control
� Objectives of monitoring :-
• Improvement in the quality of credit portfolio
• Review of sanction process
• Compliance of due diligence process
• Feedback on regulatory compliance
• Picking-up early warning signals and suggesting remedial measures
• Recommending corrective action to improve credit quality, credit administration and
credit skills of staff etc.
� Phase wise monitoring :-
• During construction phase
• During operating phase
IMaCS 2010Printed 11-May-11
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Risk mitigation
� Collateral securities can be broadly classified into two categories viz. Financial and Non-
financial
� Financial collaterals :-• Cash (including deposits),
• Gold,
• Securities issued by Central and State Government etc.
� Non-financial collaterals :-� Land and building,
� Raw materials, stock in trade, produce, and other goods
� Movable assets such as machineries.
� Documents of title to goods etc.
•The other forms of credit mitigation includes various form of guarantees and letter of comfort etc. Few
other mitigation arrangement includes escrow mechanism ,TRA and DSRA
IMaCS 2010Printed 11-May-11
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Portfolio concentration needs to be minimised to manage Credit Risk at the portfolio level
Bank shall aim to diversify exposures through:
� Prudential limits for individual and group borrowers
� Rating-wise distribution of all the borrowers
� Exposure to particular sub-sector
� Geographical distribution of borrowers
IMaCS 2010Printed 11-May-11
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The need for a more comprehensive risk assessment for cash flow based lending
� Limited recourse to the sponsors
� Limited tangible security from
the project till the assets are
created
� Highly capital intensive
� Due to long gestation period of
power projects repayment of
principals starts after quite some
time.
� Lack of diversification and there
is a single stream of revenue
� Extent of risks differ during different phases of
the project
� Need for specific assessment for each phase
Financial Closure
Commissioning
Steady state operations
Time
Ris
ks
IMaCS 2010Printed 11-May-11
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Preliminary analysis would help banks optimise effort spent on detailed appraisal
Minimum information required for evaluation of credit request
� Status of land acquisition and statutory clearances
� Availability of construction infrastructure and status of fuel linkage.
� Status of all contracts e.g. EPC, Package contract and Shareholders agreement are in
place d) Proposed off take mechanism – through long term PPA or merchant sale.
� Cost of the project, Debt Equity ratio proposed.
� Proposed Shareholding pattern
� Promoters’ background and their capability to bring their share of contribution.
� Financial projections and ratios like IRR, DSCR of the project worked out by the
applicant.
� Principle business of the promoters and their ability to implement the current project.
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Assessment of credit risks in cash flow (SPV) based lending…1
� Financial Parameters• Project IRR
• Average DSCR and Minimum DSCR for the base case.
• Sensitivity of DSCR and IRR to the project cost
o Change in Project Cost
o Change in PLF
o Change in Sale rate
o Change in Interest rate
o Change in fuel Cost
• CDM benefit
• Any other project specific critical risk
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Assessment of credit risks in cash flow based (SPV) lending…2
� Qualitative parameters
• The promoters and Quality & expertise of management.
• Market size, growth prospects and business environment.
• Global market outlook.
• Govt. policies & economic situation.
� Risks could arise during the construction phase:
• Non completion of the project or various milestones.
• Time and cost overrun due to delay in completion.
• Cost overrun even though part of the project completed on time.
� Risks could arise during the operating phase:
• Fuel risk, Hydrological risk , Technology risk , Revenue risk , O & M risk ,Sponsor
risk and Supplier risk etc
IMaCS 2010Printed 11-May-11
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Assessment of credit risks in balance sheet based lending…1
� Financial Parameters• Quantitative factors:
o Financials, ratios e.g. Sales growth , gearing , ROCE ,Quick ratio , Cash interest coverage ratio and retained earnings to equity etc.
o Sensitivity analysis.o Industry inter-firm comparison.
• Sensitivity analysis.• Industry inter-firm comparison.
� Qualitative parameters
• The promoters and Quality & expertise of management.• Market size, growth prospects and business environment.• Global market outlook.• Govt. policies & economic situation.
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Assessment of credit risks in balance sheet based lending…2
� Risks could arise during the construction phase:
• Non completion of the project or various milestones.
• Time and cost overrun due to delay in completion.
• Cost overrun even though part of the project completed on time.
� Risks could arise during the operating phase:
• Fuel risk, Hydrological risk , Technology risk , Revenue risk , O & M risk
,Sponsor risk and Supplier risk etc
� Product fit & pricing.
� Credit rating.
� Review of account operation.
� Collateral offered.
IMaCS 2010Printed 11-May-11
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DISCUSSIONS
IMaCS 2010Printed 11-May-11
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All the contents of the presentation are confidential and
should not be published, reproduced or circulated without the
written consent of IFC, Bangladesh Bank and IMaCS.
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