TYBBI Project
TYBBI Project
TYBBI Project
PROJECT ON
CREDIT RISK MANAGEMENT
BACHELOR OF COMMERCE
BANKING & INSURANCE
SEMESTER V
(2017-2018)
SUBMITTED
In partial Fulfillment of the requirement for the
Award of Degree of Bachelor of Commerce – Banking & Insurance.
SUBMITTED BY,
Rushikesh Dattatraya Bandekar
ROLL NO. - 07
UNDER GUIDANCE,
Asst. Prof. Kunal Soni
CERTIFICATE
Signature of student
Name of Student
Roll No.07.
ACKNOWLEDGEMENT
The college, the faculty, the classmates & the atmosphere, in the college
were all the favorable contributory factors right from the point when the
topic was to be selected till the final copy was prepared. It was a very
enriching experience throughout the contribution from the following
individuals in the form in which it appears today. We feel privileged to
take this opportunity to put on record my gratitude towards them.
PROF. KUNAL SONI made sure that the resource was made available
in time & also for immediate advice & guidance throughout making this
project. We are thankful to Mr. SANTOSH SHINDE associated with
administration part of Financial Markets & Banking & Insurance section
has been very helpful in making the infrastructure available for data
entry.
EXECUTIVE SUMMARY
The aim of credit risk management is to reduce the Probability of loss from a
credit transaction. Thus it is needed to meet the goals and objectives of the banks. It
aims to strengthen and increase the efficacy of the organization, while maintaining
consistency and transparency. It is predominantly concerned with probability of
default. It is forward looking in its assessment, looking, for instance, at a likely
scenario of an adverse outcome in the business. The management of credit risk must
be incorporated into the fiber of banks. Credit risk systems are currently experiencing
one of the highest grow financial services. There is a direct correlation between
market risk and credit risk and credit risk has an impact on the operational market.
CONTENTS
NO. OF CHAPTERS PAGE NUMBER
CHAPTERS
INTRODUCTION TO RISK MANAGEMENT AND CREDIT RISK 1-8
1 MANAGEMENT
IMPORTANCE OF RISK MANAGEMENT
PRINCLIPLES OF RISK MANAGEMENT
CREDIT AUDIT
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6 OBJECTIVE AND COMPONENT OF CREDIR AUDIT
HOW ARE CREDIT AUDIT CONDUCTED
STRUCTURE OF CREDIT AUDIT DEPARTMENT
Chapter-1
INTRODUCTION
With the advancing liberalization and globalization, credit risk management is
gaining a lot of importance. It is very important for banks today to understand and
manage credit risk. Banks today put in a lot of efforts in managing, modeling and
structuring credit risk.
Credit risk is defined as the potential that a borrower or counterparty will fail to
meet its obligation in accordance with agreed terms. RBI has been extremely
sensitive to the credit risk it faces on the domestic and international front.
Credit risk management is not just a process or procedure. It is a fundamental
component of the banking function. The management of credit risk must be
incorporated into the fiber of banks.
Any bank today needs to implement efficient risk adjusted return on capital
methodologies, and build cutting-edge portfolio credit risk management systems.
Credit Risk comes full circle. Traditionally the primary risk of financial institutions
has been credit risk arising through lending. As financial institutions entered new
markets and traded new products, other risks such as market risk began to compete
for management's attention. In the last few decades financial institutions have
developed tools and methodologies to manage market risk.
Recently the importance of managing credit risk has grabbed management's
attention .Once again; the biggest challenge facing financial institutions is credit risk.
In the last decade, business and trade have expanded rapidly both nationally and
globally. By expanding, banks have taken on new market risks and credit risks by
dealing with new clients and in some cases new governments also. Even banks that
do not enter into new markets are finding that the concentration of credit risk within
their existing market is a hindrance to growth.
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Any activity involves risk, touching all spheres of life, whether it is personal
or business. Any business situation involves risk. To sustain its operations, a business
has to earn revenue/profit and thus has to be involved in activities whose outcome
may be predictable or unpredictable. There may be an adverse outcome, affecting its
revenue, profit and/or capital. However, the dictum “No Risk, No Gain” hold good
here.
DEFINING RISK
The word RISK is derived from the Italian word Risicare meaning “to dare”.
There is no universally acceptable definition of risk. Prof. John Geiger has defined it
as “an expression of the danger that the effective future outcome will deviate from the
expected or planned outcome in a negative way”. The Basel Committee has defined
risk as “the probability of the unexpected happening – the probability of suffering a
loss”.
The four letters comprising of the word RISK define its features. R = Rare
(unexpected)
I = Incident (outcome)
S = Selection (identification)
K = Knocking (measuring, monitoring, controlling)
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TYPES OF RISKS:
The risk profile of an organization and in this case banks may be reviewed from the
following angles:
A. Business risks:
1.Capital risk
2.Credit risk
3.Market risk
4.Liquidity risk
5.Business strategy and environment
6.Operational risk
7.Group risk
B. Control risks:
I. Internal Controls
II. Organization
III. Management (including corporate governance)
IV. Compliance
Both these types of risk, however, are linked to the three omnibus risk
categories listed below:
1. Credit risk
2. Market risk
3. Organizational risk
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The Concern over risk management arose from the following developments:
In February 1995, the Barings Bank episode shook the markets and brought
about the downfall of the oldest merchant bank in the UK. Inadequate
regulation and the poor systems and practices of the bank were responsible
for the disaster. All components of risk management – market risk, credit risk
and operational risk – were thrown overboard. Shortly thereafter, in July
1997, there was the Asian financial crisis, brought about again by the poor
risk management systems in banks/financial institutions coupled with
perfunctory supervision by the regulatory authorities, such practices could
have severely damaged the monetary system of the various countries involved
and had international ramifications.
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Ideally, the risk management system in any organization/bank must codify its
risk philosophy and risk appetite in each functionally area of its business.
Risk philosophy: It involves developing and maintaining a healthy portfolio within
the boundary set by the legal and regulatory framework.
Risk appetite: Is governed by the objective of maximizing earnings within the
contours of risk perception.
Risk philosophy and risk appetite must go hand-in-hand to ensure that the bank has
strength and vitality.
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The risk element in various segments within an organization may vary
depending on the type of activities they are involved in. For example,
in bank the credit risk of loans to priority sectors may be perceived as
being of `high frequency but low value’. On the other hand, the
operational risk involved in
large deposit accounts may be seen as `low frequency but high value’.
The severity and magnitude of various types of risk in an organization
must be clearly documented. The checks and safeguards must be stated
in clear terms such that they operate consistently and effectively, and
allow the power of flexibility.
There should be clear times of responsibility and demarcation of duties
of people managing the organization.
Staff accountability must be clearly spelt out so that various risk
segments are handled by various officers with full understanding and
dedication, taking responsibility for their actions.
After identification of risk areas, it is absolutely essential that these are
measured, monitored and controlled as per the needs and operating
environment of the organization. Hence, like the internal audit of
financial accounts, there has to be a system of `internal risk audit’.
With regular risk audit feedback, the principles of risk management
may be laid down or changed.
operate in an integrated manner on an
All the risk segments should
enterprise-wide basis.
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Chapter-2
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It revolves around examining the three P,s It revolves around measuring, managing
of borrowing : People, Purpose, and and controlling credit in the context of an
Protection organizations credit philosophy and credit
appetite
It is predominantly concerned with the It is predominantly concerned with
probability of repayment probability of default
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The methodology and models or risk evaluation must be built into the
system. Action points of correcting deficiencies beyond tolerance
levels must be
provided for in the policy.
Risk policy documents need to be uniform for all types of risks and,
in fact, it may not be practicable. Therefore, separate policy
documents have to be made for each segment-like credit risk, market
risk or operational risk-within the framework of risk principles.
An appropriate MIS is a must for the smooth and successful
operation of risk management activities in the bank.
Data collection,
collation and updating must be accurate and prompt.
The organizational structure must be so designed as to fit its risk
philosophy and risk appetite. Functional powers and responsibilities
must be specified for the officials in charge of managing each risk
segment. A `back testing’ process-where the quality and accuracy of
the actual risk measurement is compared with the results generated
by the model and corrective actions taken-must be installed.
There should be periodical reviews- preferably on semiannual basis- of
the risk mitigating tools for each risk segment. Improvements must be
initiated where necessary in the light of experience gained.
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RISK IDENTIFICATION:
While identifying risks, the following points have to be kept in mind:
All types of risks (existing and potential) must be identified and their likely
effect in the short run be understood.
The magnitude of each risk segment may vary from bank to bank.
The geographical area covered by the bank may determine the coverage of its
risk content. A bank that has international operations may experience different
intensity of credit risks in various countries when compared with a pure
domestic bank. Also, even within a bank, risks will vary in it domestic
operations and its overseas arms
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RISK MEASUREMENT:
MEASUREMENT means weighing the contents and/or value, intensity,
magnitude of any object against a yardstick. In risk measurement it is necessary to
establish clear ways of evaluating various risk categories, without which
identification would not serve any purpose. Using quantitative techniques in a
qualitative framework will facilitate the following objectives:
Finding out and understanding the exact degree of risk elements in
each category in the operational environment.
Directing the efforts of the bank to mitigate the risks according to the
vulnerability of a particular risk factor.
Taking appropriate initiatives in planning the organization’s future
thrust areas and line of business and capital allocation. The
systems/techniques used to measure risk depend upon the nature and
complexity of a risk factor. While a very simple qualitative assessment may
be sufficient in some cases, sophisticated methodological/statistical may be
necessary in others for a quantitative value.
RISK MONITORING:
Keeping close track of risk identification measurement activities in the light
of the risk, principles and policies is a core function in a risk management system. For
the success of the system, it is essential that the operating wings perform their
activities within the broad contours of the organizations risk perception. Risk
monitoring activity should ensure the following:
Each operating segment has clear lines of authority and responsibility.
Whenever the organizations principles and policies are breached, even if
they may be to its advantage, must be analyzed and reported, to the
concerned authorities to aid in policy making.
In the course of risk monitoring, if it appears that it is in the bank's interest
to modify existing policies and procedures, steps to change them should be
considered.
Tracking of risk migration is both upward and downward.
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RISK CONTROL:
There must be appropriate mechanism to regulate or guide the operation
of the risk management system in the entire bank through a set of control
devices. These can be achieved through a host of management processes such
as:
Assessing risk profile techniques regularly to examine how far they are
effective in mitigating risk factors in the bank.
Analyzing internal and external audit feedback from the risk angle and
using it to activate control mechanisms.
Segregating risk areas of major concern from other relatively
insignificant areas and exercising more control over them.
Putting in place a well drawn-out-risk-focused audit system to provide
inputs on restraint for operating personnel so that they do not take
needless risks for short-term interests.
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Chapter-3
The international regulatory bodies felt that a clear and well laid risk
management system is the first prerequisite in ensuring the safety and stability
of the system. The following are the goals of credit risk management of any
bank/financial organization:
Maintaining risk-return discipline by keeping risk exposure within
acceptable parameters.
Fixing proper exposure limits keeping in view the risk philosophy and
risk appetite of the organization.
Handling credit risk both on an “entire portfolio” basis and on an
“individual credit or transaction” basis.
Maintaining an appropriate balance between credit risk and other risks –
like market risk, operational risk, etc.
Placing equal emphasis on “banking book credit risk” (for example,
loans and advances on the banks balance sheet/books), “trading book
risk” (securities/bonds) and “off-balance sheet risk” (derivatives,
guarantees, L/Cs, etc.)
Impartial and value-added control input from credit risk management to
protect capital.
Providing a timely response to business requirements efficiently.
Maintaining consistent quality and efficient credit process.
Creating and maintaining a respectable and credit risk management
culture to ensure quality credit portfolio.
Keeping “consistency and transparency “as the watchwords in credit
risk management.
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In the case of cross – border obligations, any default arising from the flow
of foreign exchange and /or due to restrictions imposed on remittances out
of the country.
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CREDIT CONCENTRATION
Any kind of concentration has its limitations. The cardinal principle is
that all eggs must not be put in the same basket. Concentrating credit on any one
obligor /group or type of industry /trade can pose a threat to the lenders well
being. In the case of banking, the extent of concentration is to be judged
according to the following criteria:
The institution’s capital base (paid-up capital+reserves & surplus, etc).
The institutions total tangible assets.
The institutions prevailing risk level.
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FUNCTIONS OF CRMC:
Implementation of Credit Risk Policy.
Monitoring credit risk on the basis of the risk limits fixed by the
board and ensuring compliance on an ongoing basis.
Seeking the board’s approval for standards for entertaining
credit/investment proposals and fixing benchmarks and financial
covenants.
Micro-management of credit exposures, for example, risks
concentration/diversification, pricing, collaterals, portfolio review,
provisional/compliance aspects, etc.
Besides setting up macro-level functionaries on a committee basis each bank
is required to put in place a Credit Risk Management Department (CRMD),
whose functions have been prescribed by the RBI.
FUNCTIONS OF CRMD:
Measuring, controlling and managing credit risk on a bank –
wide basis within the limits set by the board/CRMC.
Enforce compliance with the risk parameters and prudential
limits set by the Board/CRMC.
Lay down risk assessment systems, develop an MIS, monitor
the quality of loan /investment portfolio, identify problems,
correct deficiencies and undertake loan review /audit.
Be accountable for protecting the quality of the entire
loan/investment portfolio.
Enforce compliance with the risk parameters and prudential
limits set by the Board/CRMC.
Lay down risk assessment systems, develop an MIS, monitor
the quality of loan /investment portfolio, identify problems,
correct deficiencies and undertake loan review /audit.
Be accountable for protecting the quality of the entire
loan/investment portfolio.
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3. CREDIT RISK OPERATION & SYSTEM FRAMEWORK:
Measurement and monitoring, along with control aspects, in credit risk
determine the vulnerability or otherwise of an organization while extending
credit, including deployment of funds in tradable securities. As per RBI
guidelines, this should involve three clear phases:
Relationship management with the clientele with an eye on business
development.
Transaction management involving fixing the quantum, tenor and
pricing and to document the same in conformity with statutory /
regulatory guidelines.
Portfolio management, signifying appraisal/evaluation on a portfolio
basis rather than on an individual basis (which is covered by the two
earlier points) with a special thrust on management of non-performing
items.
In the light of all the above three phases, a bank has to map its
risk management activities (identification, measurement, monitoring
and control). It has to emphasize on the following aspects:
Hands-on supervision of individual credit accounts through half-
yearly/annual reviews of financial, position of collaterals and obligor’s
internal and external business environment.
Credit sanctioning authority and credit risk approving authority
to be separate.
Level of credit sanctioning authority is to be higher in
proportion to the amount of credit.
Installation of a credit audit system in–house or handed-out to
a competent external organization.
An appropriate credit rating system to operate.
Pricing should be linked to the risk rating of an account ---
higher the risk, higher the price.
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Chapter-4
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1. Through the cycle: In this method of credit rating, the condition of the
obligor and/or position of exposure are assessed assuming the “worst
point in business cycle”. There may be a strong element of subjectivity
on the evaluator’s part while grading a particular case. It is also
difficult to implement the method when the number of
borrowers/exposures is large and varied.
2. Point-in-time: A rating scheme based on the current condition of the
borrower/exposure. The inputs for this method are provided by
financial statements, current market position of the trade / business,
corporate governance, overall management expertise, etc. In India
banks usually adopt the point-in-time method because:
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COMPONENTS OF SCORES/GRADES:
Scores are mere numbers allotted for each quantitative and qualitative
parameter---out of the maximum allowable for each parameter as may be fixed by an
organization ---of an exposure. The issue of identification of specific parameters, its
overall marks and finally relating aggregate marks (for all quantitative and qualitative
parameters) to various grades is a matter of management policy and discretion----
there is no statutory or regulatory compulsion. However the management is usually
guided in its efforts by the following factors:
Size and complexity of operations.
Varieties of its credit products and speed.
The banks credit philosophy and credit appetite.
Commitment of the top management to assume risks on a calculated
basis without being risk-averse.
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A basic requirement in risk grading is that it should reflect a clear and fine
distinction between credit grades covering default risks and safe risks in the short
run. While there is no ideal number of grades that would facilitate achieving this
objective, it is expected that more granularity may serve the following purposes:
Objective analysis of portfolio risk.
Appropriate pricing of various risk grade borrower’s, with a focus on low-
risk borrowers in terms of lower pricing.
Allocation of risk capital for high risk graded exposures.
Achieving accuracy and consistency.
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Generally speaking credit rating is done for any type of exposure irrespective
of the nature of an obligor’s activity, status (government or non-government) etc.
Broadly, however, credit rating done on the following types of exposures.
Wholesale exposure: Exposed to the commercial and institutional
sector(C&I).
Retail exposure: Consumer lending, like housing finance, car finance, etc.
The parameters for rating the risks of wholesale and retail exposures are
different. Here are some of them:
In the wholesale sector, repayment is expected from the business for which the
finance is being extended. But in the case of the retail sector, repayment is
done from the monthly/periodical income of an individual from his salary/
occupation.
In the wholesale sector, apart from assets financed from bank funds, other
business assets/personal assets of the owner may be available as security. In
case of retail exposure, the assets that are financed generally constitute the
sole security.
Since wholesale exposure is for business purposes, enhancement lasts
(especially for working capital finance) as long as the business operates. In the
retail sector, however, exposure is limited to appoint of time agreed to at the
time of disbursement.
“Unit” exposure in the retail category is quite small generally compared to
that of wholesale exposure.
The frequency of credit rating in the case of wholesale exposure is generally
annual, except in cases where more frequent ( say half yearly ) rating is
warranted due to certain specific reasons ( for example, declining trend of
asset quality. However retail credit may be subjected to a lower frequency
(say once in two years) of rating as long as exposure continues to be under the
standard asset category.
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A. Wholesale exposure:
For wholesale exposures, which are generally meant for the business
activities of the obligor, the following parameters are usually important:
Quantitative factors as on the last date of borrower’s accounting year:
1. Growth in sales/main income.
2. Growth in operating profit and net profit.
3. Return on capital employed.
4. Total debt-equity ratio.
5. Current ratio.
6. Level of contingent liabilities.
7. Speed of debt collection.
8. Holding period of inventories/finished goods.
9. Speed of payment to trade creditors.
10. Debt-service coverage ratio (DSCR).
11. Cash flow DSCR.
12. Stress test ratio (variance of cash flow/DSCR compared with
the preceding year).
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B. Retail Exposure:
In undertaking credit rating for retail exposures----which consists
mainly of lending for consumer durables and housing finance, or any other form
of need based financial requirement of individuals/groups in the form of
educational loans—the two vital issues need to be addressed:
1. Borrower’s ability to service the loan.
2. Borrower’s willingness at any point of time to service the loan and /
or comply with the lenders requirement.
The parameters for rating retail exposures are an admixture of
quantitative and qualitative factors. In both situations, the evaluator’s objectivity
in assessment is considered crucial for judging the quality of exposure. The
parameters may be grouped into four categories:
1. PERSONAL DETAILS:
a. Age: Economic life, productive years of life.
2. EMPLOYMENT DETAILS:
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3. FINANCIAL DETAILS:
As per RBI guidelines, all exposure (without any cut off limit) are to be
rated.
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Chapter-5
CREDIT AUDIT
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OBJECTIVES
SCOPE
Credit audit must cover not only funded credit/loans --------including accounts
receivable------but also the investment portfolio, of both government and corporate
securities. It should also cover non-funded commitments (letter of credit, guarantees,
bid bonds, etc).individual account verification should be followed up by portfolio
verification (for example, loan/credit portfolio on the whole, sectoral position,
etc.)The scope and coverage of such an audit depends on the size and complexity of
operations of an organization and past trends (say a period of three-five years)
reflected in the individual / portfolio quality of accounts.
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Monitoring: The credit audit process ensures that the bank/financial institution
concerned follows necessary monitoring measures so that the asset quality
(loan/investment)remains at an acceptable level, and in cases of signs of deterioration,
necessary rectification measures are initiated. Monitoring is an ongoing mechanism
and in reality a safety valve for a bank/financial institution.
Therefore, a credit audit is complementary to the entire credit risk management
system.
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-To analyze credit audit findings and advise the departments/functionaries concerned.
-To follow up with the controlling machines.
-To apprise the top management.
-To process the responses received and arrange for the closure of the relative credit
audit reports.
-To maintain a database of advances subjected to credit audit.
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-Verifying compliance with the bank’s policies and regulatory compliance with
regard to sanction.
-Examining the adequacy of documentation.
-Conducting the credit risk assessment.
-Examining the conduct of account and follow-up looked at by line functionaries.
-Overseeing action taken by line functionaries on serious irregularities.
-Detecting early warning signals and suggesting remedial measures.
Frequency of review:
The frequency of review varies depending on the magnitude of risk (say, three
months for high risk accounts, and six months for average risk accounts, one year for
low-risk accounts).
-Feedback on general regulatory compliance.
-Examining adequacy of policies, procedures and practices.
-Reviewing the credit risk assessment methodology.
-Examining the reporting system and exceptions to them.
-Recommending corrective action for credit administration and credit skills of staff.
-Forecasting likely happenings in the near future.
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Chapter-6
CREDIT RISK MODEL
A credit risk model is a quantitative study of credit risk, covering both good
borrowers and bad borrowers. A risk model is a mathematical model containing the
loan applicants’ characteristics either to calculate a score representing the applicant’s
probability of default or to sort borrowers into different default classes. A model is
considered effective if a suitable ‘validation’ process is also built in with adequate
power and calibration. As a matter of fact, a model without the necessary and
appropriate validation is only a hypothesis.
UTILITY
Banks may derive the following benefits if they install an appropriate credit
risk model:
It will enable them to compute the present value of a loan asset of fixed
income security, taking into account the organizations past experience and
assessment of future scenario.
It facilitates the measurement of credit risk in quantitative terms, especially in
cases where promised cash flows may not materialize.
It would enable an organization to compute its regulatory capital requirement
based on an internal ratings approach.
An appropriate credit risk model will facilitate an impact study of credit
derivatives and loan sales/securitization initiatives.
It facilitates the pricing of loans and provides a competitive edge to the
players.
It helps the top management in an organization in financial planning, customer
profitability analysis, portfolio management, and capital
structuring/restructuring, managing risk across the geographical and product
segments of the enterprise.
Regulatory authorities find it easier to evaluate banks that have suitable credit
risk model in place.
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According to RBI, the following are the main reasons for nonpayment by
borrowers:
INTERNAL REASONS:
EXTERNAL REASONS:
a) Recession.
b) Non-payment by borrower’s customers ------both abroad and local.
c) Inputs/power shortage.
d) Price escalation (especially borrower’s product without the ability to pass on
full quantum of increase to their buyers.
e) Accidents and massive earthquakes.
f) Changes in government policies regarding excise duty/import duty/pollution
control orders.
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WILFUL DEFAULT:
So far there has been no standard definition of willful default. The RBI has
stated the following examples of willful default.
a) Default occurs when the unit has the capacity to honour its obligations.
b) When the unit has not used the funds for the specific purposes and diverted
them for other purposes.
c) The unit has siphoned off the funds in breach of the specific purposes of the
finance; the funds are not available with the unit in the form of other assets.
In essence, willful default may be defined as any nonpayment of
commitment by an obligatory ---even when there is no cash / asset crunch ----
with the sole intent of causing harm to a lender.
A willful default is generally the consequence of siphoning off funds
by means of misappropriation / fraud. Cases of willful default need stern
action including filing of a criminal suit when so advised.
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CONCLUSION
We can conclude that Credit risk management is not just a process or procedure. It is
a fundamental component of the banking function. In my opinion credit risk
management is an important function of banns today. All banks need to practice it in
some form or the other. They need to understand the importance of credit risk
management and think of it as a ladder to growth by reducing their NPA’s. Moreover
they must use it as a tool to succeed over their competition because credit risk
management practices reduce risk and improve return on capital with rates of any
systems area.
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BIBLIOGRAPHY
Books referred:
CREDIT RISK MANAGEMENT by S.K. Bagchi
Websites Visited:
www.icicibank.com
www.idbibank.com
www.google.com
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