Download - CREDIT RISK 1
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Credit Risk
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Meaning
Credit risk is defined as the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms.
The RBI’s guidance note on credit risk defines credit risk as the “possibility of losses associated with diminution of credit quality of borrowers or counterparties”.
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Credit risk may take various forms, such asNature of Dealings Nature of Credit
Risk
Direct Lending Non-Repayment
Guarantee/Letter of credit
Non-Payment under Contract
Securities Trading Non-Settlement of Trade
Treasury Products Non-Payment of Dues from Contract
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Reasons for Credit RiskMany credit problems reveal basic weaknesses in credit
granting and monitoring process: Lack of Credit Assessment: basic diligence is a
challenge for many banks Lack of testing and validation of new lending techniques Subjective Decision-making by Senior management Lack of effective Credit review process -Failure to monitor Borrower/Collateral values -Failure to detect Credit –related Fraud Neglecting Business Cycle effects in lending Non-use of risk sensitive pricing No caution on leveraged credit arrangements
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Approaches to Credit Risk Measurement Four approaches
Expert Systems Credit Rating Financial Ratios Credit Scoring
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Expert systems Expert Systems: In an expert system, the
decision to lend is taken by the lending
officer who is expected to possess expert knowledge of assessing the credit worthiness of the customer.
5C’s of credit are taken into consideration here.
1. Character 2. Capacity 3.Capital 4. Collateral and 5. Cycle or economic conditions
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Credit Rating
A credit rating represents the agency’s opinion about the creditworthiness of an obligor with respect to a particular debt security or other financial obligation.
Credit agencies in India-CRISIL, ICRA, CARE, DCR India
International rating Agencies- Standard & Poor and Moody’s
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Ratings awarded by major credit rating agencies AAA Highest Safety AA High Safety A Adequate safety BBB Moderate safety BB Sub Moderate safety B Inadequate safety C Substantial Risk D Default
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Financial Ratios
Liquidity Ratios
Current Ratio =CA/CL
Quick Ratio = (CA – Inventories)/CL
Net working Capital = CA - CL
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Profitability Ratios
Return on Equity = Net Income/Average Total equity
Return on Assets = Net Income/Average Total assets
Return on capital employed =EBIT/Average capital employed
Gross profit ratio = Net sales –COGS/Net sales Operating profit ratio = Gross profit –operating
expenses/Net sales
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Leverage Ratios
Debt-Equity Ratio = Total outside liabilities/Net worth
Long term liabilities ratio = Long term debt/ Net worth
Interest coverage ratio = EBIT/ Interest expense Dividend payout = Cash dividends paid/Net
profit after tax
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Credit scoring models:
Uses mathematical models to combine financial information of borrowers into a credit score.
The model developed by Altman(1968), called Z-score model is among the popular models. The model classifies borrowers based on a score derived from a linear combination of chosen financial ratios.
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Formula for Z score:
Z = 1.2X1 + 1.4X2 +3.3X3 +0.6X4 +0.999X5
Where X1 = Working capital/Total assets X2 = Retained earnings/Total assets X3 = EBIT/Total assets X4 = Market value of equity to book
value of total liabilities X5 = Sales/Total assets
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If Z score > 3 , the company is unlikely to default.
Between 2.7 AND 3.0, should be on alert Between 1.8 and 2.7, there is a good
chance of default. Less than 1.8, the probability of financial
default is very high
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Example
Consider a company for which working capital is170,000 , total assets are 6,70,000, earnings before interest and taxes is 60,000,sales are 22,00,000, the market value of equity is 3,80,000, total liabilities 240000 and retained earnings is 3,00,000. Find the Z-score.
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Z-Score
1.2*0.254+1.4*0.448+3.3*0.0896+0.6*1.583+0.999*3.284 =5.46
Indicates that the company is not in danger of defaulting in the near future.
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Credit Risk Management
Credit risk can be monitored atMicro level – Non-performing AssetsMacro level – Capital Adequacy Ratio
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NPA - ASSET CLASSIFICATION
NPAs are loans given by a bank or financial institution wherein the borrower defaults or delays interest or principal payments.
According to RBI norms, any interest or loan repayment delayed beyond 90 days has to be identified as a NPA.
SUB-STANDARD ASSETSThese are assets which come under the category of NPA for a period of less than 12 months.
DOUBTFUL ASSETSThese are NPA exceeding 12 months
LOSS ASSETS These NPA which are identified as unreliable by internal inspector of bank or auditors or by RBI.
Is considered uncollectible with so less value, even if there is any recovery value
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Quantifying Credit Risk Classifying loans into performing and non-
performing will enable the banks to determine the amount of provisioning that is to be made. Loss assets -100% provision Doubtful asset- 100% to unsecured portion and20%
to 100% depending upon the period for which the asset has remained doubtful.
Period for which the asset has been considered as doubtful % of provision
Up to one year 20% One to three years 30% More than three years 100%
Substandard assets -10% provision
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Macro level – Capital Adequacy Ratio
The capital adequacy of the bank which is the ratio of its capital to its risk weighted assets comments on the extent to which the possible losses can be absorbed by the capital.
CAR =C/RWA
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Example1. Synergy Banking Services Ltd. has an
asset base of Rs.1000crore out of which 60 percent carry 100 percent risk weight, 30 percent carry 50 percent risk weight and the remaining zero percent risk weight. Compute the CAR if it has a capital of Rs.150 crore.
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150
CAR = -------------------------------------------
600*1 + 300*0.5 +100*0
= 20%
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The Basel II proposals for credit Risk Following approaches are mentioned by
Basel II. Standardized method Internal Rating Based( IRB) approach-
foundation Internal Rating Based( IRB) approach-
Advanced
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Standardized method
Risk weights for different categories of assets are assigned for different categories of assets on the basis of external ratings by approved rating agencies.
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Risk weights under standardized approach for credit risks
AAA
To
AA-
A+
To
A-
BBB+
To
BBB-
BB+
To
BB-
B+
To
B-
Below
B-
unrated
Country 0 20 50 100 100 150 100
Banks 20 50 50 100 100 150 50
Corporations
20 50 100 100 150 150 100
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Suppose that the assets of a bank consist of Rs.100 million of loans to corporations rated A, Rs.10 million of government bonds rated AAA, and Rs.50 million of residential mortgage, Under Basel II standardized approach, what is the total risk weighted assets ?
0.5*100+0.0*10+0.35*50 =Rs. 67.5 million
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Internal Rating based Approach
This approach allows banks to use their internal estimates of probability of default (PD), loss given default rate (LGD) and exposure at default (EAD).
PD -What is the probability of counterparty defaulting?
EAD -If the counterparty defaults what is our exposure?
LGD – How much of the exposure amount do we expect to loose?
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In the foundation approach, the banks are allowed to estimate the PD while the supervisor will provide LGD and EAD.
In the advanced approach, banks would use their own estimates of PD, LGD and EAD.
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Expected Loss (EL)= PD x EAD x LGDBanks may assume from experience:
1 % of loans to Default/year; 40 % of recovery rate
Expected Loss:For credit portfolio of Rs. 1000 crore,
EAD=1000cr,PD=1%, LGD=60%
EL= 1000*.01*.6 =6crore
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Credit Granting Process
In India, RBI prescribed exposure limits for bank lending to individuals and groups. Credit limit for a single borrower is fixed at 15% of the
banks capital funds. For Group -40% of the bank’s capital funds Limit can be overshot up to 5% for individual and 10%
for gp borrowers in the case of lending for infrastructure projects.
These limits can be further extended by 5% with approval of BODs.