While the Indian economy steeply recovered from the effects of the first lockdown, the second wave of the pandemic increased the risk in the credit profiles of borrowers – making credit risk management the need of the hour.
Moody’s, a US-based credit rating agency, commented upon the recovery of the economy:
“A severe second wave of the coronavirus has increased risks to the outlook with potential longer-term credit implications. Risks to India’s credit profile, including a persistent slowdown in growth, weak government finances, and rising financial sector risks, have been exacerbated by the shock.”
Rising credit risks also leads to an increase in interest rates that can further lead to a decline in credit growth in banks. Authors of a recent RBI study suggest that banks have accumulated high NPAs over the last few years. This increased risk can prompt banks to increase their interest rates, making it difficult for borrowers to procure loans.
Therefore, to resolve this challenge banks must develop flexible risk assessment and management processes.
In this article, we will discuss the nature of credit risk and different risk management tools and techniques to help banks curb risks and sell better.
What is credit risk?
RBI defines credit risk as: “The possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a bank’s portfolio, losses stem from outright default due to the inability or unwillingness of a customer or counterparty to meet commitments concerning lending, trading, settlement, and other financial transactions. Alternatively, losses result from a reduction in portfolio value arising from actual or perceived deterioration in credit quality.”
In simple terms, banks experience credit risk when assets in a bank’s portfolio (borrowed loans) are threatened by loan defaults. Credit risk is a sum of default risk and portfolio risks.
Default risk happens due to the inability or unwillingness of a borrower to return the promised loan amount to the lender. Whereas, portfolio risks depend upon several internal and external factors. Internal factors can be bank policy, absence of prudential limits on credit, lack of a loan review mechanism within the company, and more.
External factors may include the state of the economy, forex rates, trade restrictions, economic sanctions, and more.
The presence of credit risk deteriorates the expected returns and creates more than expected losses for banks.
What are some major types of credit risks?
Now, banks can experience five major types of credit risks:
- During the repayment period, i.e. when the borrower does not repay the amount.
- When selling off a secured asset does not yield expected returns.
- In case when a series of repayments stop due to some unexpected reasons.
- Credit risk due to loss of funds while settling acquired securities.
- Risks while payment to offshore organizations when they are under sovereign jurisdiction.
To offset such risks, banks must use various credit risk management tools and techniques. Let us look at some of those.
Techniques and Tools for Credit Risk Management
Credit Approving Authority
Banks can create a multi-tier credit approving system where officers review the loan before sanctioning it. It can help reduce the chances of any new credit risk. To maximize this benefit, banks can create a grid of officers, and they can operate on multiple levels of the organization i.e., regional offices, zonal offices, head offices, etc.
Additionally, the grid/committee could oversee the sanction of high-value loans by carefully assessing borrower creditworthiness. To ensure the best quality of credit decisions, banks must review them periodically.
Banks can also use new-age Lending CRMs like LeadSquared to conduct pre-screening checks and analyze credit profiles while onboarding prospective borrowers. Not only will this accelerate the screening process but will also maintain borrower credibility.
Banks can set up prudential limits on various KPIs such as debt-equity and profitability ratio, debt service coverage ratio, and other important ratios. Further, they must ensure that the loan policy mentions the most permissible deviation that can be allowed from these KPIs. Based on the concentration risk, banks can also reduce their credit exposures to individuals who enjoy credit facilities excess of their capital threshold.
Even while lending to industries, banks can set limits for every sector. Based on the stress on each segment, banks can adjust the exposure and lend with reduced risk. Banks can do this by limiting new advances against assets that can experience high price volatility and, hence credit risk. While lending to distressed sectors, banks must adequately back their credit by collaterals and strategic considerations. Prudential limits must be reviewed periodically. It will factor in other market-related issues and improve credit risk management.
Rating borrower creditworthiness is standard practice across all financial institutions. However, banks can also create a separate risk scoring/rating method for internal purposes. It will give loan officers a clear understanding of the risks involved as time passes on.
Risk rating will help banks understand individual credit behavior better and the overall risk within their portfolio. The rating can be designed on various quantitative and qualitative factors such as:
- Financial analysis
- Financial ratios; and
- Other operating parameters.
Banks can improve their rating mechanism by weighing these ratios based on years. It will give a higher degree of importance to near-term developments and make ratings more accurate. In addition to this, separate scales for rating can be devised for different borrowers to personalize risk assessment and improve the system’s flexibility. To ensure that these rating models remain relevant and consistent, they should be rechecked and revised. It will enable banks to identify variations that could cause any future credit losses and address them quickly.
Pricing your loan products based on risk categories of borrowers is important to curb credit risks. Generally, borrowers having less than average credit history or weak financials are categorized as high-risk individuals and subjected to high interest rates.
To ensure higher accuracy, banks should price credit risks based on the expected probability of default. Internationally, large banks have implemented the Risk-Adjusted Return On Capital (RAROC) framework, which adjusts the interest rates based on the expected loss on loans from the start itself. The banks then allocate some capital to cover up the losses incurred on the prospective loan.
The RAROC framework helps banks in effective credit risk management and provides better loan pricing to borrowers.
Analytics for Risk Detection and Control
Through AI and ML, banks can now analyze customer credit history to foresee changes in their credit behavior. Banks can detect any change in the risk profile of the customer and make effective credit decisions.
This real-time insight into customer behavior will allow banks to take proactive measures. It will help them design effective credit frameworks and install policies to reduce credit risks. Data analytics can also be applied to simulate stressful environments for lending processes and to find out credit weaknesses.
Appropriate risk rating/pricing can enable better portfolio management. Banks must identify patterns in the migration of borrowers based on the change in their credit quality. The data will provide banks the insights they need to identify the quality of their loan books and take corrective actions if necessary. Additionally, banks can also:
- Create credit ceilings based on borrower ratings to limit credit exposure.
- Understand the rating-wise distribution of borrowers in various industries.
- Limit exposure to segments based on the pros, cons, and current financial state. In case the industry is going through a period of stress, banks can increase the quality standards required to borrow from them.
- Design and undertake stress tests to identify weaknesses in their credit administration, policies, and tools to improve their credit risk management process.
Loan Review Mechanism
An LRM is a great tool to understand the quality of loan books and bring qualitative improvements in credit-related decision-making. LRM can help banks identify large value loans that can potentially develop credit weakness and create a proactive approach to credit risk management. Additionally, LRMs are also very helpful in:
- Identifying adequacy of and adherence to loan policies, procedures.
- Checking compliance with government laws.
- Supporting existing credit risk management infrastructure.
Effective credit risk management starts with assessing the borrower’s profile and continues till recovery and beyond. Banks must create agile lending processes equipped with relevant rating systems to identify creditworthiness and charge appropriate interest rates. This will help them cover up any potential loan defaults that may happen in the future. Banks must also allocate enough capital to cover up any major loan losses and remain afloat. Such practices are necessary to reduce higher default probabilities and improve the health of loan books.
LeadSquared’s new age Lending CRM is helping leading Indian banks identify creditworthy borrowers during the onboarding process and creating an additional layer of security for credit risk management.
1. What is risk management in the banking industry?
Risk management is a proactive process to identify any potential loan losses that may occur due to some reason and reduce the overall risk in your loan portfolio.
Banks can experience operational risk in the event of a breakdown of internal controls and corporate governance. It can lead to loss of finance through error, fraud, or the inability to perform required functions promptly.
The banks can manage operational risks by setting up risk monitoring systems to gauge the performance of operations, set up operational limits, create contingent systems, and design policies to offset such conditions which can cause risk. Lending CRM is also a helpful tool to assess the borrower’s profile and disburse loans faster.
Credit risk management is a process through which financial institutions (FIs) can cut/mitigate any possible credit risks in their loan portfolio. FIs can do it through several tools and techniques such as setting up credit approving authorities, risk rating, risk pricing, portfolio management, and loan review mechanisms.