CREDIT RISK MANAGEMENT WITH REFERENCE OF STATE BANK OF INDIA

CREDIT RISK
MANAGEMENT WITH
REFERENCE OF STATE
BANK OF INDIA

CHAPTER I
INTRODUCTION AND RESEARCH
DESIGN

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1.1 Introduction:

1.2 Objectives of the study

1.3 Hypothesis of the study

1.4 Significance of the Study

1.5 Statement of the Problem

1.6 Scope of the study

1.7 Methods of Data collection

1.8. Methods of Data Analysis

1.9 Limitations

1.10 Conclusion

1.1. INTRODUCTION:-

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Definition-

Credit risk management is the practice of mitigating losses by understanding the adequacy of
a bank's capital and loan loss reserves at any given time – a process that has long been a
challenge for financial institutions.

Banks are regarded as the blood of the nation’s economy without them one cannot imagine
economy moving. Therefore banks should be operated very efficiently Advance is heart and
recovery is oxygen for the bank and to survive it is necessary to give advances and recover
the amount at the appropriate time. Through credit risk management we have tried to learn the
various aspects related to credit appraisal and credit policy of SBM. Credit Risk Management
covers all the areas right from the beginning like inquiry till the loan is paid up.
We are preparing comprehensive report on “Credit Risk Management at State Bank of State
Bank of India”.

The basic idea of project is to augment our knowledge about the industry in its totality and
appreciate the use of an integrated loom. This makes us more conscious about Industry and its
pose and makes us capable of analysing Industry’s position in the competitive market. This
may also enhance our logical abilities. There are various aspects, which have been studied in
detail in the project and have been added to this project report. Though credit management, a
very vast topic, we have tried to incorporate to the best of our capacity from all possible
aspects in this project.

Concept-

Credit risk refers to the probability of loss due to a borrower’s failure to make payments on
any type of debt. Credit risk management is the practice of mitigating losses by understanding
the adequacy of a bank’s capital and loan loss reserves at any given time – a process that has
long been a challenge for financial institutions. The global financial crisis – and the credit
crunch that followed – put credit risk management into the regulatory spotlight. As a result,
regulators began to demand more transparency. They wanted to know that a bank has
thorough knowledge of customers and their associated credit risk. And new Basel III
regulations will create an even bigger regulatory burden for banks. To comply with the more
stringent regulatory requirements and absorb the higher capital costs for credit risk, many
banks are overhauling their approaches to credit risk. But banks who view this as strictly a

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compliance exercise are being short-sighted. Better credit risk management also presents an
opportunity to greatly improve overall performance and secure a competition.

Meaning-

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or
meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive
the owed principal and interest, which results in an interruption of cash flows and increased
costs for collection. Excess cash flows may be written to provide additional cover for credit
risk. When a lender faces heightened credit risk, it can be mitigated via a higher coupon rate,
which provides for greater cash flows.

Although it's impossible to know exactly who will default on obligations, properly assessing
and managing credit risk can lessen the severity of a loss. Interest payments from the
borrower or issuer of a debt obligation are a lender's or investor's reward for assuming credit
risk.

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RISK MANAGEMENT STRUCTURE-

Nature-

2.1 A major issue in establishing an appropriate risk management organisation structure is

Board of Directors. The Board should set risk limits by assessing the bank’s risk and risk-
bearing capacity. At organisational level, overall risk management should be assigned to an
independent Risk Management Committee or Executive Committee of the top Executives that
reports directly to the Board of Directors. The purpose of this top level committee is to
empower one group with full responsibility of evaluating overall risks faced by the bank and
determining the level of risks which will be in the best interest of the bank. At the same time,
the Committee should hold the line management more accountable for the risks under their
control, and the performance of the bank in that area. The functions Risk Management
Committee should essentially be to identify, monitor and measure the risk profile of the bank.
The Committee should also develop policies and procedures, verify the models that are used
for pricing complex products, review the risk models as development takes place in the

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markets and also identify new risks. The risk policies should clearly spell out the quantitative
prudential limits on various segments of banks’ operations. Internationally, the trend is
towards assigning risk limits in terms of portfolio standards or Credit at Risk (credit risk) and
Earnings at Risk and Value at Risk (market risk). The Committee should design stress
scenarios to measure the impact of unusual market conditions and monitor variance between
the actual volatility of portfolio value and that predicted by the risk measures. The Committee
should also monitor compliance of various risk parameters by operating Departments.

2.2 A prerequisite for establishment of an effective risk management system is the existence
of a robust MIS, consistent in quality. The existing MIS, however, requires substantial up
gradation and strengthening of the data collection machinery to ensure the integrity and
reliability of data.
2.3 The risk management is a complex function and it requires specialised skills and
expertise. Banks have been moving towards the use of sophisticated models for measuring
and managing risks. Large banks and those operating in international markets should develop
internal risk management models to be able to compete effectively with their competitors. As
the domestic market integrates with the international markets, the banks should have
necessary expertise and skill in managing various types of risks in a scientific manner. At a
more sophisticated level, the core staff at Head Offices should be trained in risk modelling
and analytical tools. It should, therefore, be the endeavour of all banks to upgrade the skills of
staff. 2.4 Given the diversity of balance sheet profile, it is difficult to adopt a uniform
framework for management of risks in India. The design of risk management functions should
be bank specific, dictated by the size, complexity of functions, the level of technical expertise
and the quality of MIS. The proposed guidelines only provide broad parameters and each
bank may evolve their own systems compatible to their risk management architecture and
expertise.

2.5 Internationally, a committee approach to risk management is being adopted. While the
Asset - Liability Management Committee (ALCO) deal with different types of market risk,
the Credit Policy Committee (CPC) oversees the credit /counterparty risk and country risk.
Thus, market and credit risks are managed in a parallel two-track approach in banks. Banks
could also set-up a single Committee for integrated management of credit and market risks.
Generally, the policies and procedures for market risk are articulated in the ALM policies and
credit risk is addressed in Loan Policies and Procedures.

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2.6 Currently, while market variables are held constant for quantifying credit risk, credit
variables are held constant in estimating market risk. The economic crises in some of the
countries have revealed a strong correlation between unhedged market risk and credit risk.
Forex exposures, assumed by corporates who have no natural hedges, will increase the credit
risk which banks run vis-à-vis their counterparties. The volatility in the prices of collateral
also significantly affects the quality of the loan book. Thus, there is a need for integration of
the activities of both the ALCO and the CPC and consultation process should be established
to evaluate the impact of market and credit risks on the financial strength of banks. Banks
may also consider integrating market risk elements into their credit risk assessment process.

Scope of Credit Risk -

It can be understood from the above that credit risk arises from a whole lot of banking
activities apart from traditional lending activity such as trading in different markets
investment of funds, provision of portfolio management services, providing different type of
guarantees and opening of letters of credit in favour of customers etc. For example, even
though guarantee is viewed as a non-fund based product, the moment a guarantee is given, the
bank is exposed to the possibility of the non- funded commitment turning into a funded
position when the guarantee is invoked by the entity in whose favour the guarantee was
issued by the bank. This means that credit risk runs across different functions performed by a
bank and has to be viewed as such credit.

State Bank of India (SBI) came into existence by an act of Parliament as successor to the
Imperial Bank of India. Today, State Bank of India (SBI) has spread its arms around the
world and has a network of branches spanning all time zones. SBI's International Banking
Group delivers the full range of cross-border finance solutions through its four wings-the
Domestic division, the Foreign Offices division, the Foreign Department and the International
Services division.

Credit risk refers to the probability of loss due to a borrower’s failure to make payments on
any type of debt. Credit risk management is the practice of mitigating losses by understanding
the adequacy of a bank’s capital and loan loss reserves at any given time – a process that has
long been a challenge for financial institutions. The global financial crisis – and the credit
crunch that followed – put credit risk management into the regulatory spotlight. As a result,
regulators began to demand more transparency. They wanted to know that a bank has

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thorough knowledge of customers and their associated credit risk. And new Basel III
regulations will create an even bigger regulatory burden for banks. To comply with the more
stringent regulatory requirements and absorb the higher capital costs for credit risk, many
banks are overhauling their approaches to credit risk. But banks who view this as strictly a
compliance exercise are being short-sighted. Better credit risk management also presents an
opportunity to greatly improve overall performance and secure a competitive advantage.

Challenges to Successful Credit Risk Management

Inefficient data management. An inability to access the right data when it’s needed causes
problematic delays.

No group wide risk modelling framework. Without it, banks can’t generate complex,
meaningful risk measures and get a big picture of group wide risk.

Constant rework. Analysts can’t change model parameters easily, which results in too much

duplication of effort and negatively affects a bank’s efficiency ratio.

Insufficient risk tools. Without a robust risk solution, banks can’t identify portfolio
concentrations or re-grade portfolios often enough to effectively manage risk.

Cumbersome reporting. Manual, spread sheet-based reporting processes overburden

Best Practices in Credit Risk Management

The first step in effective credit risk management is to gain a complete understanding of a
bank’s overall credit risk by viewing risk at the individual, customer and portfolio levels.
While banks strive for an integrated understanding of their risk profiles, much information is
often scattered among business units. Without a thorough risk assessment, banks have no way
of knowing if capital reserves accurately reflect risks or if loan loss reserves adequately cover
potential short-term credit losses. Vulnerable banks are targets for close scrutiny by regulators
and investors, as well as debilitating losses. The key to reducing loan losses – and ensuring
that capital reserves appropriately reflect the risk profile – is to implement an integrated,
quantitative credit risk solution. This solution should get banks up and running quickly with

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simple portfolio measures. It should also accommodate a path to more sophisticated credit
risk management measures as needs evolve. The solution should include:

Better model management that spans the entire modeling life cycle.

Real-time scoring and limits monitoring.

Robust stress-testing capabilities.

Data visualization capabilities and business intelligence tools that get important
information into the hands of those who need it, when they need it.

Principles for the Management of Credit Risk - consultative document

1. While financial institutions have faced difficulties over the years for a multitude of
reasons, the major cause of serious banking problems continues to be directly related to lax
credit standards for borrowers and counterparties, poor portfolio risk management, or a lack
of attention to changes in economic or other circumstances that can lead to a deterioration in
the credit standing of a bank's counterparties. This experience is common in both G-10 and
nonG- 10 countries.

2. Credit risk is most simply defined as the potential that a bank borrower or
counterparty will fail to meet its obligations in accordance with agreed terms. The goal of
credit risk management

is to maximise a bank's risk-adjusted rate of return by maintaining credit risk exposure within
acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as
well as the risk in individual credits or transactions. Banks should also consider the
relationships between credit risk and other risks. The effective management of credit risk is a
critical component of a comprehensive approach to risk management and essential to the
longterm success of any banking organisation.

3. For most banks, loans are the largest and most obvious source of credit risk; however,
other sources of credit risk exist throughout the activities of a bank, including in the banking
book and in the trading book, and both on and off the balance sheet. Banks are increasingly
facing credit risk (or counterparty risk) in various financial instruments other than
loans, including acceptances, interbank transactions, trade financing, foreign exchange

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transactions, financial futures, swaps, bonds, equities, options, and in the extension of
commitments and guarantees, and the settlement of transactions.

4. Since exposure to credit risk continues to be the leading source of problems in banks
world-wide, banks and their supervisors should be able to draw useful lessons from past
experiences .Banks should now have a keen awareness of the need to identify, measure,
monitor and control credit risk as well as to determine that they hold adequate capital against
these risks and that they are adequately compensated for risks incurred. The Basel Committee
is issuing this document in order to encourage banking supervisors globally to promote sound
practices for managing credit risk. Although the principles contained in this paper are most
clearly applicable to the business of lending, they should be applied to all activities where
credit risk is present.

1.2- Objectives of the study-

1.To study the concept of credit risk management in banks.

2. To know the impact of consumer's satisfaction of credit risk management in banks.

3. To study the profitability and financial risk programmes.

4. To give proper suggestion for following study.

1.3 Hypothesis of the study-

Research Hypothesis The researcher expected with better credit risk management with
high return on asset (ROA) and lower non-performing asset (NPA).With the help of data
the study was established and tested the following hypothesis:

1 (H1): credit risk management had an effect on the bank performance.

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1.4 Significance of the study-

This study aims to provide a basis for guidance for the commercial banks of Baluchistan to
adopt long-term performance-improving risk management strategies (Campbell, 2007). The
model for the study shows the impact of risk management strategies, including hedging,
diversification, the capital adequacy ratio and corporate governance. The research will also
examine the impact of each risk management strategy individually in order to understand the
importance of each strategy. To the best of authors’ knowledge, there is no study on credit
risk management on Baluchistan using the described parameters. The findings of this study
are intended to contribute positively to society by demonstrating that the banks of Baluchistan
can develop effective strategies to improve their CRM. Additionally, policy makers can
identify and generate appropriate policies to govern bank behaviour in order to minimize risk.

The project helps in understanding the clear meaning of credit Risk Management in State
Bank of India. It explains about the credit risk scoring and Rating of the Bank. And also Study
of comparative study of Credit Policy with that of its competitor helps in understanding the
fair credit policy of the Bank and Credit Recovery management of the Banks and also its key
competitors.

1.5 Statement of the problem-

The problem of the study is to understand the impact of credit risk management for workers
in the Indian banking sector, by helping administrators to predict the extent of variation in
profits when managing bank credit risks, considering profits as an important base for decision
makers inside and outside commercial banking facilities, and since bank credit is one of the
most dangerous Functions of commercial banks on which the strength of assets and the health
of their financial position depends.

In order to face the failures that occurred in the economic markets, which were revealed by
the global financial crisis, the Basel III Committee has presented a set of basic reforms within
the international legislative frameworks, these reforms that would strengthen the level of
banking commitment, detailed prudential measures, and the necessary instructions, which In
turn, it will increase the flexibility of banking institutions in times of financial and economic
crises .Accordingly, the problem of the study is summarized about the extent to which there is
an impact of credit risk management on the Indian banking sector.

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1.6 Scope of the study-

Establishing appropriate credit risk environment.

Operating under sound credit granting process.

Maintaining an appropriate credit administration, measurement & Monitoring Ensuring

adequate control over credit risk.

Banks should have a credit risk strategy which in our case is communicated throughout the
organization through credit policy.

Two fundamental approaches to credit risk management:-

9.The internally oriented approach centres on estimating both the expected cost and volatility
of future credit losses based on the firm’s best assessment. Future credit losses on a given
loan are the product of the probability that the borrower will default and the portion of the
amount lent which will be lost in the event of default. The portion which will be lost in the
event of default is dependent not just on the borrower but on the type of loan (eg., some bonds
have greater rights of seniority than others in the event of default and will receive payment
before the more junior bonds).

To the extent that losses are predictable, expected losses should be factored into product
prices and covered as a normal and recurring cost of doing business. i.e., they should be direct
charges to the loan valuation. Volatility of loss rates around expected levels must be covered
through risk-adjusted returns. So total charge for credit losses on a single loan can be
represented by ([expected probability of default] * [expected percentage loss in event of
default]) + risk adjustment * the volatility of ([probability of default * percentage loss in the
event of default]).

Financial institutions are just beginning to realize the benefits of credit risk management
models. These models are designed to help the risk manager to project risk, ensure
profitability, and reveal new business opportunities. The model surveys the current state of
the art in credit risk management. It provides the tools to understand and evaluate alternative
approaches to modelling. This also describes what a credit risk management model should do,
and it analyses some of the popular models. 10

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The success of credit risk management models depends on sound design, intelligent
implementation, and responsible application of the model. While there has been significant
progress in credit risk management models, the industry must continue to advance the state of
the art. So far the most successful models have been custom designed to solve the specific
problems of particular institutions. A credit risk management model tells the credit risk
manager how to allocate scarce credit risk capital to various businesses so as to optimize the
risk and return characteristics of the firm. It is important or understand that optimize does not
mean minimize risk otherwise every firm would simply invest its capital in risk less assets. A
credit risk management model works by comparing the risk and return characteristics between
individual assets or businesses. One function is to quantify the diversification of risks. Being
well-diversified means that the firms have no concentrations of risk to say, one geographical
location or one counterparty.

1.7 Methods of data collection-

To fullfill the information about credit risk management in banks, the researcher had used
secondary data collection method:-

Secondary data is the data that has already been collected through primary sources and made
readily available for researchers to use for their own research. It is a type of data that has
already been collected in the past.

A researcher may have collected the data for a particular project, and then made it available to
be used by another researcher. The data may also have been collected for general use with no
specific research purpose like in the case of the national census.

Data classified as secondary for particular research may be said to be primary for another
research. This is the case when data is being reused; making it primary data for the first
research and secondary data for the second research it is being used for.

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Secondary data- secondary data was also useful to collect the information, the magazines
about the banking system in India, internet, text books, annual reports these secondary data
collection methods had been used to collect the information.

Sampling-

Sampling method used for the project report is the state bank of India.

The sampling method used for collecting data is convenient sampling, the information
selected by researcher conveniently with references and observations. State bank of India was
an example or reference for that, the branches of this bank observed by researcher and
provides information about credit risk management.

1.8 Methods of data analysis-

The data had been analysed, using SPSS, by calculating descriptive statistics like
percentages, mean score, standard deviation in large and small banks. One-way
analysis of variance (ANOVA) was conducted to examine the significance of differences
between perceptions of credit managers in large and small banks for each survey item
and F and p values obtained at 0.05 level of significance. The results show that on 15
out of 32 variables tested, the differences between the means of large and small banks
are highly significant (significance is less than or equal to 0.05) or the responses of credit
managers on various CRM problems and obstacles are statistically different. That means
there is a significant difference in perception of credit managers towards CRM
practices/problems of large and small public sector banks in the following areas:

1. The bank has a well-designed credit risk policy and strategy (Q 1): The mean score
for large banks is 4.60(S.D 0.568), and for small banks 4.47(S.D 0.579). F value 4.875
(do 1, 335) at p= 0.028 (Table 1) As such, credit managers in small banks do not
perceive credit policy of their banks as well-designed as in large banks. 2. The post
sanction loan monitoring in the bank is as strong as the loan approval process (Q 7): The
mean score for large banks, 4.05 (S.D 0.975) is higher than for small banks (3.67 with
S.D 1.191). F value 10.617 (do 1,335) at p=0.001 (Table 1). Large banks’ risk managers

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are more satisfied with their banks’ two fundamental CRM processes, loan approval and
is a significant difference in mean .

: Reduction in processing effort per loan application. F value 6.119 (do 1, 335) at p=0.014.
Regular rating reviews. F value 8.839 (do 1,335) at p=0.003. Reduction in subjectivity in
credit ratings. F value 3.994 (do 1,335) at p=0.046. Internal audits. F value 4.093 (do 336) at
p=0.044. Independence of loan review mechanism. F value 9.857 (do 1,335) at p=0.002. N
all the above five areas, mean scores for small PSBs are less than the large banks. In other
words, the small banks’ risk managers are feeling the need for improvement in these areas,
which are generally the source of various substantive and procedural errors in design and
execution of CRM systems and procedures (Oesterreichische, 2004). It may be concluded that
there are many critical CRM practices where there are significant differences in large and
small Indian public sector banks which require the attention of banks’ top management,
especially of small banks,

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Mitigate credit risk.

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1.9 LIMITATIONS OF STUDY-

There are quite a few things that have to be taken into account when dealing with credits. A
common misconception is the fact that there are downsides only for the debtor. In fact, credits
pose certain amounts of risk to the creditors as well, and that’s why credit risk management is
particularly essential. It’s worth nothing that CLB Solutions is a company that’s capable of
providing actionable and valuable advice when it comes to risk management as well as other
types of financial and accounting services. With this in mind, the term risk in this particular
situation represents the chance of incurring financial or non-financial damage as a result of
the inability of the debtor to make a payment for the credit under any circumstances. So, let’s
take a look at the disadvantages that stem from failing to implement proper credit risk
management strategies.

1. This study is only restricted to State Bank of India only.

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2. The result of the study may not be applicable to any other banks.

3. Since the part of the study is based on their perceptions, the findings may change over the
years in keeping with changes in environmental factor.

4. The present study does not ascertain the views from the borrowers who are not directly
concerned with management of non-performing assets.

5. The time constraint was a limiting factor, as more in depth analysis could not be carried.

.6. Some of the information is of confidential in nature that could not be divulged for the
study.

7. Employees were not co operative.

CONCLUSION:

The project undertaken has helped a lot in gaining knowledge of the “Credit Policy and Credit
Risk Management” in Nationalized Bank with special reference to State Bank of India. Cree
did Policy and Credit Risk Policy of the Bank has become very vital in the moot h operation
of the banking activities. Credit Policy of the Bank provides s the framework to determine (a)
whether or not to extend credit to a customer and d (b) how much credit to extend. The
Project work has certainly enriched the knowledge abo UT the effective management of
“Credit Policy” and “Credit Risk Management” in banking sector.

“Credit Policy” and “Credit Risk Management” is a vast subject and it is very difficult to cove
r all the aspects within a short period. However, every effort has been made to cover most of t
he important aspects, which have a direct bearing on improving the financial performance of
Banking Industry

To sum up, it would not be out of way to mention here that the State Bank of Indi a has given
special inputs on “Credit Policy” and “Credit Risk Management”. In pursuance of the instruct
ones and guidelines issued by the Reserve Bank of India, the State bank Of India is granting
and expand ding credit to all sectors.

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The concerted efforts put in by the Management and Staff of State Bank of India has helped
the Bank in achy vying remarkable progress in almost all the important parameters. The Bank
is marching ahead in the d direction of achieving the Number-1 position in the Banking Indus

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