Page 157 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 5. A foreign country or a group of countries whose economies are strongly interrelated
6. A type of credit facility or security with the same maturity.
Concentrations can stem from more complex or subtle linkages among credits in the portfolio.
The concentration of risk does not only apply to the granting of loans but to the whole range of
banking activities that, by their nature, involve counterparty risk. A high level of concentration
in a few firms or industries or areas can expose the bank to avoidable risk in the area in which
the credits are concentrated.
Portfolio management balances and contains overall portfolio risk by anticipating, constantly
assessing and controlling exposure to each of the areas listed above. Portfolio management is
particularly relevant as banks diversify their operations. It is closely linked with a bank's
strategic planning process. Banks should, therefore, establish acceptable risk exposure limits
based on the expected returns in its various business activities.

Risk concentration limits may vary among banks and regions. In many instances, avoiding or
reducing concentrations may be extremely difficult. In addition, banks may want to capitalize
on their expertise in a particular industry or economic sector. A bank may also decide that it is
being adequately compensated for incurring certain concentrations of risk. Consequently, banks
may not necessarily stop financing in such areas solely on the basis of concentration. In such
cases, banks may adopt measures such as:
1. Pricing for additional risk

2. Increased holdings of capital to compensate for additional risks and
3. Making use of loan participation in order to reduce dependency on a particular sector of
the economy or group of related borrowers.

Now possibilities to manage credit concentrations and other portfolio issues viz. loan sales,
credit derivatives, securitisation, secondary loan markets etc., are still to evolve in the Indian
context.
With regard to portfolio management, RBI, in its risk management guidelines. has recommended
appointment of Portfolio Managers to watch the loan portfolio concentrations and exposure to
counterparties. It has also advised banks to consider appointment of Relationship Managers to
ensure that overall exposure to a single borrower is monitored, captured and controlled. The
Relationship Managers may service high value loans so that a substantial share of the loan
portfolio, which can alter the risk profile of the bank, would be under constant surveillance.

11.4.6 Loan Review Mechanism/Credit Review Function

Loan Review Mechanism (LRM) is an effective tool for constantly evaluating the quality of loan
book and to bring about qualitative improvements in credit administration. Because individuals
throughout the bank have the authority to grant credit, the bank should have an effective and
efficient internal review and reporting system in order to manage effectively the bank's loan
portfolio. Internal credit reviews conducted by individuals independent from the business
function provide an important assessment of individual credits and the overall quality of the
credit portfolio.

The main objectives of LRM as envisaged in the RBI document are to:
1. Assess adequacy of and adherence to loan policies and procedures, and to monitor
compliance with relevant laws and regulation;

2. Provide top management with information on credit administration, including credit
sanction process, risk evaluation and post-sanction follow-up;

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