Page 86 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 5: Credit Risk Management

of credit risk management needs analysis of uncertainty and analysis of the risks inherent in a Notes
credit proposal. The predictable risk should be contained through proper strategy and the
unpredictable ones have to be faced and overcome. Therefore any lending decision should
always be preceded by detailed analysis of risks and the outcome of analysis should be taken as
a guide for the credit decision. As there is a significant co-relation between credit ratings and
default frequencies, any derivation of probability from such historical data can be relied upon.
The model may consist of minimum of six grades for performing and two grades for non-
performing assets. The distribution of rating of assets should be such that not more than 30% of
the advances are grouped under one rating. The need for Credit Risk Rating has arisen due
dismantling of State control, deregulation, globalization and allowing things to shape on the
basis of market conditions; Indian Industry and Indian Banking face new risks and challenges.
Competition results in the survival of the fittest. It is therefore necessary to identify these risks,
measure them, monitor and control them. It provides a basis for Credit Risk Pricing i.e. fixation
of rate of interest on lending to different borrowers based on their credit risk rating thereby
balancing Risk & Reward for the Bank.
The need for the adoption of the credit risk-rating model is on account of the following aspects:
Disciplined way of looking at Credit Risk.

Reasonable estimation of the overall health status of an account captured under Portfolio
approach as contrasted to stand-alone or asset based credit management.
Impact of a new loan asset on the portfolio can be assessed. Taking a fresh exposure to the
sector in which there already exists sizable exposure may simply increase the portfolio
risk although specific unit level risk is negligible/minimal.

The co-relation or covariance between different sectors of portfolio measures the inter
relationship between assets. The benefits of diversification will be available so long as
there is no perfect positive correlation between the assets, otherwise impact on one would
affect the other.
Concentration risks are measured in terms of additional portfolio risk arising on account
of increased exposure to a borrower/group or co-related borrowers.
Need for Relationship Manager to capture, monitor and control the over all exposure to
high value customers on real time basis to focus attention on vital few so that trivial many
do not take much of valuable time and efforts.
Instead of passive approach of originating the loan and holding it till maturity, active
approach of credit portfolio management is adopted through securitisation/credit
derivatives.

Pricing of credit risk on a scientific basis linking the loan price to the risk involved
therein.
Rating can be used for the anticipatory provisioning. Certain level of reasonable over-
provisioning as best practice.
Given the past experience and assumptions about the future, the credit risk model seeks to
determine the present value of a given loan or fixed income security. It also seeks to determine
the quantifiable risk that the promised cash flows will not be forthcoming. Thus, credit risk
models are intended to aid banks in quantifying, aggregating and managing risk across
geographical and product lines. Credit models are used to flag potential problems in the portfolio
to facilitate early corrective action.

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