Page 83 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes Credit risk is inherent to the business of lending funds to the operations linked closely to
market risk variables. The objective of credit risk management is to minimize the risk and
maximize bank’s risk adjusted rate of return by assuming and maintaining credit exposure
within the acceptable parameters. Credit risk consists of primarily two components, viz

Quantity of risk, which is nothing but the outstanding loan balance as on the date of
default and the quality of risk, viz, the severity of loss defined by both Probability of
Default as reduced by the recoveries that could be made in the event of default. Thus credit
risk is a combined outcome of Default Risk and Exposure Risk. The elements of Credit
Risk is Portfolio risk comprising Concentration Risk as well as Intrinsic Risk and

Transaction Risk comprising migration/down gradation risk as well as Default Risk. At
the transaction level, credit ratings are useful measures of evaluating credit risk that is
prevalent across the entire organization where treasury and credit functions are handled.
Portfolio analysis help in identifying concentration of credit risk, default/migration
statistics, recovery data, etc.
In general, Default is not an abrupt process to happen suddenly and past experience dictates that,
more often than not, borrower’s credit worthiness and asset quality declines gradually, which is
otherwise known as migration. Default is an extreme event of credit migration.
Off balance sheet exposures such as foreign exchange forward contracts, swaps options, etc are
classified in to three broad categories such as full Risk, Medium Risk and Low risk and then
translated into risk weighted assets through a conversion factor and summed up. The management
of credit risk includes (a) measurement through credit rating/scoring, (b) quantification through
estimate of expected loan losses, (c) Pricing on a scientific basis and (d) Controlling through
effective Loan Review Mechanism and Portfolio Management.

Self Assessment

State whether the following statements are true or false:
3. Credit risk arises from all activities where success depends on counterparty, issuer or
borrower performance.
4. Credit risk is a combined outcome of Default Risk and Exposure Risk.
5. Portfolio analysis help in identifying concentration of credit risk, default/migration
statistics, recovery data, etc.
6. The objective of credit risk management is to minimize the risk and maximize bank’s risk
adjusted rate of return by assuming and maintaining credit exposure within the acceptable
parameters.

5.3 Managing Credit Risk

Credit Risk Management covers the decision-making process, before the credit decision is made,
and the follow-up of credit commitments, plus all monitoring and reporting processes. Credit
risk arises from the potential that an obligor is either unwilling to perform on an obligation or
its ability to perform such obligation is impaired resulting in economic loss to the bank.
In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a
customer or counter party to meet commitments in relation to lending, trading, settlement and
other financial transactions. Alternatively losses may result from reduction in portfolio value
due to actual or perceived deterioration in credit quality. Credit risk emanates from a bank’s

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