This chapter demonstrates the literature that is relevant to the research on Credit Risk Management in Banking. The author has enclosed literature on dynamics, models, model features, and Basel II regulatory process for credit risk. The author has also enveloped literature on credit risk management in banks. The author has also exhibited the literature on currently available approaches in calculating and managing the credit risk and it’s fit of with current banks in India. This chapter mainly focuses on the module and element available in credit risk with its fit with Indian banking sector. Many innovations have been brought in the financial services, in this the credit risk had been given the major importance to stop them from the failures and have a common goal: enhancing the risk-return profile of the bank portfolio. (Bessis 2002; Greuning and Bratanovic 2000) This chapter will form the basis for the arguments presented in preceding chapters.
In the world of rising competition and turbulent business environment, it has become essential to identify measure and manage the credit risk to improve economical capital over the period of time .To enhance the credit risk new strategies been evaluated (Lore and Borodovsky 2000). Over the period of decade there is a tremendous change in banking to manage the economic capital and more than 80 percent of bank’s balance sheet generally relates to aspect of risk management. It involves complete assessment of the banks in different aspects such as supervise, control, enforce and recover loan, advances, guarantees and other credit derivates and the overall assessment includes the banks credit risk management policies and practices of the bank and in vice versa it makes banks to identify, measure and manage credit risk according to the changes in global capital market. (Greuning and Bratanovic 2000; Bessis 2002).
2.1 Definition of Credit Risk
Credit Risk has been defined by many authors writing on this topic. Some of the definitions are as follows.
2.2 Credit Risk:
It is the risk which is associated third parties money borrowed and he is not able to pay. In first the organization determines the interest rate for the loan and the guarantee amount required to secure the loan to check the credit worthiness (Andrew 2002) Credit risk includes risks connected with upgrading or downgrading borrower’s credit worthiness. (Tapiero 2004) financial risks such as market risk, operational risk and credit risk decides the probabilities of future returns, extreme events and unknown defaults within an organization. Proposing credit risk combined with information leap decision theory, helps financial sectors balance regulatory requirements and revenue targets through loan and interest rates for secure credit risk group. (Web1).The external risks that are inaccessible from organization’s control but affected by its financial operations are the financial risk, which includes
2.2.1 TYPES OF CREDIT RISK:
Different authors had given different approach regarding credit risk types:
2.2.2 Five Main Factors Contributing the Level of Losses with Credit Risk Models:
2.3 CREDIT RISK POLICY:
According to (Coyle 2000) policy should be realistic and manageable and there several different ways to formulate the policies depends on the management. Credit risk policy of every bank have to determine: how much credit to be provided; for what time duration; types of clients and so on, the bank policy should also specify the degree of diversity in size and the concern is apparently in profitability and the risk of loan. Credit rating desired by banks should have tolerance for risk associated with their economic capital. In this case, credit risk can be diversified and other risks can be priced high. Management must indicate the tolerance level to its credit risk and bind the loan losses (in terms of probability). Authorities should set approval on the credit sizes and the risk exposure. Credit risk should be tracked and the exposure level reported systematically combined with information about creditors in it and (Crouhy Et al 2006) often the policy are insufficient or same type of other product makes the profit maximization (Mostafa 2000) policy should be employee knowledgeable and capable persons to control and manage risks, and reviewing reports from management to certify the adequacy of risk profile and controls. (Website 7)
2.3.1The Most Commonly Used Management Tools Include
The commonly used tools by the management in setting up the policy are:
2.4 Dynamics of Credit Risk
Variety of aspects factors in banks credit risk business; identifying and better understanding and gives a good opportunity in lending activities and maximise the return on the risk which banks has taken (Kudyba 2004)The importance measuring and identifying of credit risk makes both the possibility of default and loss incurred. According (Duffie and Singleton 2003; Culp 2001; Banks 2002; Kudyba 2004) they had given three dynamics influencing the credit risk are.
2.4.1 Identifying Credit Risk:
Different authors have different approaches in identifying the credit risk process, it provides with strong base for the better risk management process. The identifying activity determines the business at each for its capability (Glantz 2003) and impact of the current decision on the business (Basu and Rolfes 1995)the business at the individual level they are taken in the account but later it may be aggregated for the better management of risk, not only the current risk are identified r but also the emerging risk are taken into account and even those which doesn’t have impact with the business but it may have in the future and identifying, could provide with better constraint for the future in business in regards to credit risk (web 1). the credit risks at each level is studied and then a cumulative risk statement for the organization as a whole is formed, during this process the present risks as well as possible risks in the near future should be marked with the help of valid knowledge from risk officers, the credit risk identification process must proceed in a logical succession: beginning with the most common or essential and moving to the more complex or esoteric. Thus, the identification of risk must be broad and stand as basis for quantification and limit-setting phases. (Banks 2002; Bitner and Goddard 1992; Kudbya 2004).
2.4.2Measuring credit risk:
According to (Duffie and Singleton 2003) the measurement of credit risk presents some challenges in measuring, but credit risk is considered as a component of market risk. The measurement process requires a blend of theory and art (Figlewski and Levich 2002) thus measuring of credit risk is being done in different ways (anonyms).
The involvement of credit risk to market risk is difficult in providing the benefits to the counterparty from credit risk and limiting the interest towards credit risk by industry, geographic region and so on. Several complementary measures of credit risk have been exposed for the better understanding of credit risk and risk managers explored such measures (Duffie and Singleton 2003).
B) Market value of default loss:
Determining the Value of Debt and Market value of default loss are the same (Burner 2004). An approximate calculation of the influence of credit risk on market values helps to figure out the expenses and profits of marketing and in determining the strength of financial firm’s resources supporting credit risk. Determining of value of debt is same as (Duffie and Singleton 2003; Glantz 2003).
Accurate measure of exposure quantifies future measures (Schwartz and smith 1997) In case, new plans that attract customer’s attitude is introduced by a counterpart, the exposure measure is used by an organization to limit strategies and reward credits, exposure might be fruitless when the counterparty conceals essential information. (Duffie and Singleton 2003; Servigny and Renault 2004).
22.214.171.124 USES OF CREDIT RISK MEASUREMENT:
According to (Fma Report) though there is no standard protocol for measuring credit risk, a regular evaluation of credit risk is a must for a perfect financial management. The actual loan losses distributed are asymmetric so there could be small chances of big losses and big chances of small losses (Glantz 2003) Credit risk is calculated from possible losses in credit portfolio, the possible losses can divide into
2.4.3 Expected loss:
The loss which is expected from the borrower’s default probability and the exposure at default less the recovery data, i.e., all expected cash flows, especially from the realization of collateral. Under certain credit conditions all the expected losses should be accounted for income planning and included as standard risk costs. (FMA Report; Figlewski and Levich 2002
2.4.4 Unexpected loss:
The unexpected loss arises from the expected losses. They are taken into account indirectly via equity costs for income planning and setting up credit conditions. Risk coverage capital is used to secure the unexpected loss to compensate the expected looses. (FMA Report; Figlewski and Levich 2002)
2.4.5Expected loss vs. unexpected loss:
The expected loss and unexpected loss cannot be minimized through diversification. The yield from loan can be made profitable by covering directly the expected loss (it should be included related funding and operating costs) and by covering the unexpected loss indirectly (making profits from bank’s difficulty rate on the assigned capital cushion ). Exact measurements of Expected loss and unexpected losses are decisive for profitability measurement. Comparing pricing, resource allocation, or portfolio management is critical to find out the profitability and it is helpful only when there is constant measurement of expected loss and unexpected losses. The connection among Unexpected Loss and Concentration Risk, Correlation and Portfolio measures the uncertainty or variability of loss. The possible levels of unexpected losses in a portfolio of credit exposures are essential to the successful management of credit risk. Expected loss is subtracted from loss at the confidence interval usually done by all the banks. Credit pricing is used for recovering the expected loss. Therefore, capital is needed only to cover Unexpected Losses (“loss estimated at the confidence interval minus EL”). (Glantz 2003; Saunders and Allen 2002;Saita 2007; Website 3) figure 2. Explains correlation against the expected loss and unexpected loss.
(Adapted from website 3)
2.5 Calculation of Credit Risks:
For measuring the unexpected losses the two main methods used today:
The accuracy level and methods of calculation are totally different in both the methods .scenario techniques are the easy methods and used where the VaR IS not possible.
2.5.1Value at Risk (VAR) ANALYSIS:
According to (Fma report) Value at Risk:”the maximum loss will not exceed a certain probability at a given horizon” is used to measure, manage, assess and control in investment management (jorion 2004) While determining the value at risk, the confidence level exposes the probability of maximum losses which will not exceed the holding period and analysis can be done on the available historical data (Pilipovic 1998). VaR estimates the current value of portfolio and probability of changes in the future portfolio. (Marrison 2002) The level of accuracy is usually measured between 95% and 99.95%, which shows the highest loss possibility between 5% and 0.05%. In holding period, loss occurs due to liquidity of assets. Value at Risk analysis has the advantage of calculating risks with different portfolios and with different types of risks such as credit risk, market risk and operational risk. (Pearson 2003; Saunders and Allen 2002; Saita 2007)
126.96.36.199Computation of Value at Risk:
To calculate value at risk, for single assets is a bit uncomplicated (Caouette et al 1998) it is necessary to conclude the allocation of potential losses in credit portfolio. Assumptions are made at default rate and they developed for the future exposure default. Value fluctuations in the extreme market movement are calculated by using stress tests but insufficient historical data can restrict the calculation of credit risk. (Fallon 1996; Fma Report; Pearson 2003)
2.5.2 SCENARIO ANALYSIS:
Scenario analysis put up a multiple factors such as conceptual (verbal), relational (models) and numerical (data) can be organized in a logical manner (Website 9). The existing historical market data and/or internal bank data generates a scenario relating to the development for the default rate. It is mostly used in potential future losses and external losses (Rosengren 2006). In the Normal case scenarios, the developed loss is unspecified with certain historical period. In Worst case scenarios, occurrences of excessive losses are unspecified. It is used in determining the area of fluctuation in portfolio values. Higher feasible risks are calculated on the basis of scenario analysis. This techniques has a limited explanatory power will make only a few changes in parameters. The quality of result will be lower when compared to value at risk concept. From the given historical data and limited parameters, value at risk concept cannot be achieved. Banks using the results from scenario analysis have to accept less precise results than using value at risk concept. The additional cost or profit and additional benefit could be derived by implementing this method. (FMA report; website 10)
2.6 BANK FOR INTERNATIONAL SETTLEMENTS (BIS):
The Bank for International Settlements (BIS) was established on 17th may 1930, is the world’s oldest international financial organization and it acts as central banks for all the banks. It fosters international monetary and financial cooperation for all central banks. The head office is in Basel, Switzerland. The BIS customers are central banks and international organizations and it doesn’t anticipate any deposits or provide any financial services to private individuals or corporate entities and it strongly advises caution against fraudulent schemes. The BIS currently employs 557 staff from 48 countries. The Basel Based Committees supports in researching the economic, monetary, financial and legal activities. It shares the statistical information among the central banks, and it publishing statistics on global banking, securities, and foreign exchange and derivatives markets. The role of the BIS is dynamic to the global financial society and is also an emergency "funder" to nations in trouble; it aided the countries such as Mexico and Brazil during their debt crises in 1982 and 1998. It does race directly with other private financial institutions for global banking activities. BIS struggle to offer quality services in order to attract central banks as their clients to provide security; it also maintains abundant equity capital and reserves that are diversely invested following risk analysis. It works With International Monetary Fund (IMF) of all central banks .it cooperate in organizing and reviewing the technical assistance for all central banks. (Zulu et al., 1994 And Baker 2002)
The BIS fulfils this mandate by acting as:
a forum to promote discussion and policy analysis among central banks and within the international financial community
Main motto for implication of Basel II was to escape from “one-size fits all” from Basel I (Santos 2000) According to (Greuning and Bratanovic 2003) List of options for measuring credit, market and operational risk. The approaches set by Basel II balance themselves in terms of simplicity and accuracy. Basel committee considers three types of approaches to deal with credit risk are
2.6.2Three Pillars of Basel II:
Basel committee has developed three comprehensive pillars for sound capital regulation framework. The implementation of all the three pillars in a place makes adequate level of soundness. (Akkizidis and Vivianne 2006)
Minimum capital requirement: the main aim is to determine the capital required for portfolio in banks given the level of credit risk. (Williams 2007)
Supervisory review: it gives the supervisory approaches to the banks for their capital management .The aim here for the banks is to follow rigorous procedure in measuring the risk exposure and to have enough capital to cover their risk involved in it .Banks usually consider an internal process to demonstrate their risk profile, operations and strategy to enable the supervisors to intervene the bank’s capital. An approach for the identification and understanding of various situations such as the falling capital level can raise questions on the ability of a bank to withstand business shares. (Williams 2007)
188.8.131.52 Pillar 3
Market discipline: the new requirement has been introduced to reveal the risk information of equity and capital markets, so that the investor gets a better practised discipline regarding the bank behaviour. A cautioner notice can be available for the investor to find out the level of risk involved in it. (Servigny and Renault 2004, Crouhy Et al., 2006).In order to do business in a safe, sound and effective manner risk assessment mechanism is important. A perfect risk assessment makes a participant effective, reliable and timely in the market place. It gives transparency and disclosure in the capital adequacy issue. Figure 3 shows the picture of pillars formed by Basel II accord. (Williams 2007)
Calculation of credit risk in capital adequacy requirement includes a standardized approach and two versions of an Internal rating based model.
Adapated from (Akkizidis and Bouchereau 2006)
2.6.3CURRENT CREDIT RISK REGULATIONS:
(1988) BIS guidelines have set regulations for current credit risk which includes the minimum capital adequacy for credit risk, the definitions for the countable equity capital and strengthening the capital standards in large banks. The calculation approach was switched by BIS guidelines and set as indirect capital requirement method or minimum capital requirement. At first, Instance Balance sheets positions are weighted in accordance to the counterparty risk and later 8% of standard capital requirement is multiplied and to be maintained for all the credit portfolio issued by the banks. (Williams 2007; Saunders and Allen 2002).
Opportunities created in “Regulatory Capital Arbitrage” increases the risk based capital ratio through securitization and financial innovations, and many banks have lowered risk based capital considerably without decreasing the overall credit exposure. Therefore the stability is being created in the periods of disaster and insecurity. September 1997 Amendment in Basel Accord has given additional arbitrage opportunities in lower-risk based capital requirements. Grounding risk management and measuring with the available traditional data and formal quantitative techniques. (Fig. 3.1) (Effros 1998; Saunders and Allen 2002; Williams 2007).
2.6.1 Methods for Calculating Regulatory Credit Risk:
There are number of approaches for calculating regulatory credit risk are:
Risk weight of each firm’s assets are allocated in producing the sum of risk weighted assets value external credit assessment are used in determining the counterparty risk weight (FSA 2006)
Credit risk for small and limited licence firms which has incidental credit risk exposure .This might prove costly for the firms to calculate the regulatory capital calculations. In this case the firms are required to weight risk on whole exposures. If it is not possible the firms can use single risk weight to all exposures classes which might be unduly costly. (FSA 2006)
Here the internal assessment is established for the credit risk in their portfolios. The risk weighted in this approach will be more diverse than the standard approach. This approach risk sensitive. (FSA 2006)
2.6.2 DEFICIENCIES IN THE CURRENT REGULATIONS:
Counterparties are not differentiated in depth with the risk weighting factors and thus the risk is not represented in satisfactory and in perspective form. Correlation within the credit portfolio is not measured. The hedging of credit risk is not judged with the credit derivatives, net economical output has been supported with the capital to judge the credit risk. (Erisk 2005; Alexander et al. 2005).
2.6.3 Factors Challenging existing Regulations in Credit Risk Management:
The following factors challenge credit risk management are .Transactions and portfolio approaches are not differentiated in current practice. There are various contracts in commercial loans which are often complicated with our structural elements. Measuring risk adjusted profitability is difficult to accept due to lack of understanding in operating & economic capital cost: limited loan trading makes it hard to compare the value between loans and other traded asset classes (Gallati 2003).
2.7APPROACHES AND OPTIONS OF BASEL II:
Basel II regulatory has two alternative approaches for calculating the credit risk for their capital requirements they are Standardized approach and Internal Rating Based (IRB) approach. In standardized approach, credit risk is measured on the basis of External Credit Assessment Institutions (ECAI s). In IRB approach, banks use their own internal rating system to measure the determinants of credit risk and supervisory approval according to different versions- Under the foundation version, the Probability of Default (PD) is calculated on the basis of their own ratings, for the other determinants they rely on supervisors under the advanced version, and they have their own measures for all other determinants such as Loss Given Default (LGD) and Exposure At Default (EAD). (WEB 4)
2.7.1 MODELS OF CREDIT RISK:
A majority of mathematical researches has been dedicated to credit risk for modelling the default event occurrence. (Bielecki and Rutkowski 2002)
The main objective of these models is to support in pricing and hedging of financial contracts that are sensitive to credit risk. The pricing of credit risk is done in order to produce internal consistency in financial model. The two challenging methodologies emerged to model the default/migration times and the recovery rate, are structural approach and reduced-form approach. (Web 5)
The main concern in structural models is regarded with the modelling and pricing of credit risk that are specific to corporate obligation (a firm). The major framework of structural model is the evolution of firm’s value and the firm’s capital structure; hence it is also referred to as firm value approach. Value of firm structures the firm’s economical fundamentals. Structural framework has an alternate approach in postulating the bankruptcy decision and these results in specifying capital structure and strategic debt service. (Bielecki and Rutkowski 2002)
The value of firm’s assets and capital structure are not modelled in reduced-form model. It is only concerned with the modelling of default time and hence referred to as Intensity-based model, and with migration between credit rating classes are called as credit migration models .(Bielecki and Rutkowski 2002)
2.7.2CRITICAL FACTORS IN CREDIT RISK MODELINGS:
(Gallati 2003, 136)
2.7.3 Developing Approaches in Credit Risk Management:
The new generation with new technologies has emerged in engineering the credit risk topic. Eight most obvious reasons for this rapid rush in interest are,
The knowledge attained over the past decades on the basis of theoretical and academic research and also practical experiences has helped in realizing the importance of market risk modelling and in welcoming all new challenges on credit risk and operational risk. (Gallati 2003)
As the expanded capital market is a boon and has given accessibility to small and middle-market firms. The borrowers who are left behind from raising funds from the banks and financial institutions are smaller and have weaker credit ratings. A rapid growth in capital market has lead to “winner’s curse” and it resulted in credit portfolio structure of financial institutions. (Gallati 2003)
Despite the average quality, loans have turned down in respect to the margin spread, (due to disintermediation), whole sale loan markets has gone very thin, lending has gone worse in risk premium and tradeoffs. The important factor is that, it has improved competition for low quality borrowers (finance companies). It concentrates on higher risk rather than low quality at the end of the market. (Gallati 2003)
Considering the economic downsides in bankruptcy statistics, it has showed a considerable increase in bankruptcies due to global competition and sectoral changes worldwide. Technology and credit risk analysis plays a vital role now than the past and promisingly the most important part. (Gallati 2003)
The real estate value and asset value are hard to predict and are realized through liquidation process because of banking crisis has developed in different countries. In case of weaker rating, the collateral values risks lending. (Gallati 2003)
Counterparty risk and credit exposure has grown on the basis of derivative market and it has extended the need for credit analysis in loan book. The leading banks have created imaginary value for the off-balance-sheet exposure using Over-The-Counter (OTC) swaps and forwards which exceeds 10 times more than their portfolio. The off-balance-sheet credit risk was one of the reasons to introduce the risk based capital requirement in1993. (Gallati 2003)
In BIS systems, a minimum capital requirement was held on the basis of marked-to market current value of OTC derivatives contract added with the potential future exposure. (Gallati 2003)
Information technology has played a vital role in developing the historical information databases which has provided the banks to test the high powered modeling techniques. Modern Portfolio Theory’s (MPT) models and techniques have helped to analyze loan loss and value distribution in management of their portfolios. (Gallati 2003)
2.8Credit risk in banks:
In rising market, banks have a poor conception of bank credit risk. (Global Credit Research 1999) Banking works as a part of an internal system in which credit circulated around various economic sectors. Banks and financial institutions must regularly balance risks and rewards. Dramatic increase in the price of interest rate on loan products, lose the customer; too low the prices of loan a product makes starve the profit margin or take a loss. More liquidity of cash in reserve makes miss investment, less liquidity makes risk regulatory refusal and financial instability in the market to stand. It is be difficult for the banks to measure overall risk exposure and strike the right balance. Senior management decides the credit scoring proportion for loan based on the customer or a client. Every bank has individual sub units for the credit risk, approval and sanctioning. Credit risk policy differs from banks to banks in the credit risk management is set by the top management of banks. Banks have a variety of options in credit risk models, for identifying, measuring and managing the risk. (Jorion 2003; Coult 1990; Gup 1999)
Credit risk issues in the banks can be through consumer ,mortgage lending, bad debts, corporate consumers ,industry risk, settlement and delivery risk .(chartered institute of bankers 1988) The rapid evolution of credit risk management techniques speeds the advance of a response in the events in the banking and financial sector. Rising technological developments have played a supporting role in facilitating the adoption of most accurate credit risk management techniques. Even though advance in study and analysis in relation to credit risk, implementation of some new approaches has a long way to play for the large number of banks. Better measurement and management of credit risk in banks is likely to carry implications to develop in the future and it is reflected from the different activities of the banks. Certainly, as banks improve their ability to assess risk and return associated with their various activities internal subsidies will become more transparent. (Reserve Bank of Australia Bulletin 1997; Coult 1990; Gup 1999)
The figure portrays the risk appetite in Indian banking and the major parts of risk in banks are credit risk as it holds the major part of risk in the banks and major part of concentration is given to the credit risk as shown in the figure 1.
Fig 3. Risk appetite https://184.108.40.206/Kredito%20rizika/Rizikos%20valdymo%20sistema/krvaldymas2.pdf 2008
From the above discussions the researcher has understood that credit risk have been defined in several ways. True fact is different books and articles got different ways of approaches towards the same meaning. Credit risk is given critical importance in the banks as it plays the important role in banks and other financial institutions. Credit lending is one of the main objectives of the banks and other financial institution; it takes the major part of the business other than market and operational risk. All the rest functional activities are depending on it. Various approaches and practices are being followed for the risk management.
Different types of credit risk has been given by the various authors depends on the business and perception of the business. The different models and approaches show level of losses involved in credit risk. All the banks and other financial institution have their own credit risk policy depends on their size and nature of their business and mostly the management uses the common approaches to come out of it. The first step of banks could be identifying, as it works as the strong data base for the banks and the measuring, is to know the value of the business and later the managing, to protect from the future outcomes of risk in the business.
The possible losses can calculated from the expected and unexpected losses. Unexpected losses can be calculated with two approaches Value at Risk and scenario analysis. Value at Risk exposes the probability of maximum losses which enables to measure and manage the credit portfolio. The future portfolio exposure losses can be identified. Historical and available data are used to calculate the credit risk in Scenario analysis future and excessive losses can be identified.
Basel ll formed by Banks for international settlements (BIS) set for the central banks to manage their risk under the three pillars. The banks regulatory capital calculated under various approaches. Few options and approaches are set up for calculating the credit risk by the Basel committee .structural and reduced form method to validate the default loss in the current portfolio exposure .the eight most developing approaches reckoned in the credit risk management for the banks and other financial institutions.
Banks works as mutual between the depositor and lenders and its internal system in which credit is spread around various economic sectors. Modern banks have come with various techniques and software to make out the credit risk in their banking business. As credit risk is one of major problems for the banks in their banking business and new approaches gave the new modification for the banks to access, analysis and manage the credit risk in the banks.
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