Bank Management - 2

Project Report:
Evaluating Credit Risk of
Indian Banks

Submitted By: Group Kaushik -311151 Shabab

6 Chaudhary - 311163

Aakash Bansal -
311121 Ambuj
Pushkarna - 311130
Amit Murli Badlani -
311131 Pratyaksh
Submitted To: Prof.
Vandana Gupta
 Evaluating Credit Risk of Indian Banks

Credit Risk
Risk is inherent part of bank’s business. Effective risk management is critical to any bank for
achieving financial soundness. In view of this, aligning risk management to bank’s
organisational structure and business strategy has become integral in banking business.

Credit risk is the bank’s risk of loss arising from a borrower who does not make payments as
promised. Such as event is called as default. Another term for credit risk is default risk. The risk
of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a
loan or otherwise to meet a contractual obligation is termed as credit risk.

Components of Credit Risk:

Credit risk consists of primarily two components:

 Quantity of risk, which is nothing but the outstanding loan balance as on the date of
default and the quality of risk
 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.

Credit Risk Management:

Credit risk management is a complex process, and it ensures banks identify, assess, manage, and
optimize their credit risk at an individual level or at an entity level or at the portfolio level. Banks
should have sound and efficient credit risk management policies and procedures which are
responsive to the micro and macro-economic changes. The efficiency and quality of the credit
risk management will be the key challenge and driver for the asset quality and profitability of
banks.
The primary techniques of credit risk management are creating credit standards, developing
credit scores, analysis of credit worthiness of borrowers, proper risk rating, adequate
collaterals and risk- based pricing.

Primary Causes of Credit Risk in Banks:

The major causes of Credit risk are:

1. Asset Loan Quality:

 It is found that if the quality of the loan is not good then can be very risky for the
bank. The loan is the asset for the bank, but the loan which is taken by" any
people or organization is not repaid within due time this can result in NPA's.
 This in turn means that the loan which is your asset has turned bad. That is why
banks checks the credit worthiness of the person or organization before giving a
loan.

2. Asset Liability Mismatch:

 Banks and financial institutions have assets and liabilities of different maturities.
This exposes them to interest rate risk and liquidity risk.
 This mismatch can hit the bank badly if the banks trustable assets start turning bad.

3. Fraud:
 Poor risk management process have also resulted in frauds in large institution.
One of the primary reasons for that is while giving a loan or a credit the banks
sometimes do not follow all the norms and accord that are laid down by RBI,
sometimes the bankers are also involved in this kind of unfair activities.
 Sometimes it is due to the lack of foresight and lack of analysis e.g. the CIBIL
score is not checked properly etc.

Mitigation of Credit Risk by Banks:

Banks mitigate credit risk by using several methods:

1. Risk-based pricing: Lenders generally charge a high interest rate to borrowers who are
more likely to default, a practice called risk-based pricing. Lenders consider factors
relating to the loan such as loan purpose, credit rating and loan-to-value ratio and estimate
the effect on yield (credit spread).

2. Covenants: Lenders may write stipulations on the borrower, called covenants, into loan
agreements:
 Periodically report its financial condition
 Refrain from paying dividends, repurchasing shares, borrowing, further, or other
specific, voluntary actions that negatively affect the company’s financial position
 Repay the loan in the full, at the lender’s request, in certain events such as
changes in the borrower’s debt-to-equity ratio or interest coverage ratio.

3. Credit insurance and credit derivatives: Lenders and bond holders may hedge their
credit risk by purchasing credit insurance or credit derivatives. These contracts the
transfer risk from the lender to the seller (insurer) in exchange for payment. The most
common credit derivative is the credit default swap.

4. Tightening: Lenders can reduce credit risk by reducing the amount of credit extended,
either in total or to certain borrowers. For example, a distributor selling its products to a
troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30
to net 15.

5. Diversification: Lenders to a small number of borrowers (or kinds of borrower) face a

high degree of unsystematic credit risk, called concentration risk. Lenders reduce this risk
by diversifying the borrower pool.

6. Deposit insurance: Many governments establish deposit insurance to guarantee bank

deposits of insolvent banks. Such protection discourages consumers from withdrawing
 money (when a bank is becoming insolvent, to avoid a bank run), and encourages
consumers to holding their savings in the banking system instead of in cash.

Credit Risk Measurement

So we get to see in order to do a proper credit risk management we need to do a proper credit
risk measurement as once we are aware of the intensity of the risk we can partition it to different
segments and take decisions accordingly and manage them.

There are certain traditional methods of credit risk measurement those are mainly:

1. Expert Systems (The bank needs to rely on its credit analyst).

2. We need to check the credit worthiness by checking different internal and external
ratings of different rating agencies like Moody's, S&P, Fitch etc. Is Indian contest we
need to check the ratings of CRISIL, ICR and CARE.

3. Maintaining a proper database which can be used time to time and following strict
SOPs.

Credit Scoring Models (ALTMAN 7 SCORE MODEL):

Altman (1968) built a linear discriminant model based on financial ratios, matched sample (by
year, industry, size etc.) -

XI - Working capital/Total Assets

X2 - Retained Earnings/Total Assets

X3 - EBIT/Total Assets

X4 - Market value of equity/book value of total liability

X5 - Sales/total assets
 Z=1.2X1+1.4X2+3.3X3+0.6X4+1.0X5

 If Z<1.8 high probability of going bankrupt

 If 1.8<Z<2.99 it lies in grey area
 If Z>2.99 it indicates a healthy firm

So, according to Z score we will be taking a call and this in turn helps in credit risk
measurement.

Asset Liability Management:

It can be defined as the comprehensive and dynamic framework for measuring, monitoring and
managing financial risks related to: Interest rate, liquidity and foreign currency.

It relates to managing structure of balance sheet (assets and liabilities) such a way that net earnings
from interest is maximized within the overall risk preference.

The strategies followed in ALM are:

1. Spread Management: Maximizing the spread by reducing the exposure to cyclical and
stabilizing the income. rates

2. Gap Management: The Gap management focuses on balancing the GAP between the
interest sensitive asset and interest sensitive liability by distributing the asset and liability
into different time band according to their maturity period.

3. Interest sensitivity Analysis: Understanding the impact of change of interest rates on

bank spread net interest gain.
Comparison between ROA, NPAs and CAR of Public Sector
Banks (PSB)

Comparison between ROA, NPAs and CAR of

Private Sector Banks (PSB)
 Interpretation

This study shows that there was a significant relationship between bank performance (in terms of
return on asset) and credit risk management (in terms of nonperforming asset). Better credit risk
management results in better bank performance. Thus, it was of crucial importance that banks
practiced prudent credit risk management and safeguarding the assets of the banks and protected
the investors’ interests. The study also revealed banks with higher profit potentials could better
absorb credit losses whenever they cropped up and therefore recorded better performances.
Furthermore, the study showed that there was a direct but inverse relationship between return on
asset (ROA) and the ratio of non-performing asset (NPA). This had led us to accept our
hypothesis and conclusion that banks with higher interest income had lower non-performing
assets, hence good credit risk management strategies.

Recommendations

1. The public sector banks needed to effectively use technology to counter the challenges posed
by the private sector banks, especially in the retail business. Better customer services backed
by superior technology and the lack of legacy systems have enabled the private sector banks
to gain market share from the public sector banks.

2. Banks should initiate efforts on adopting the new technologies in order to improve their
customer service levels and provide new delivery platforms to them. The success of these
initiatives would have a bearing on their banks market position.

3. Banks should participate in portfolio planning and management.

4. Banks should provide training for the employee to enhance their capacity and reviewing the
adequacy of credit training across.

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