Financial Standards and Codes: Report of Advisory Group on Banking Supervision

Management of Credit Risk

Introduction

Management of credit risk assumes great importance in environments where there is a predominance of lending in the overall asset portfolio and where credit histories on borrowers and other counterparties are not well documented and are unavailable. Effective management of credit risk is all the more critical in a scenario of increasing liberalisation and globalisation as a result of which the economic fortunes of banks’ clientele can and do undergo quick and substantial changes. The Group has tried to assess the quality of credit risk management in banks in India on the basis of the principles laid down in Principles for Management of Credit Risk (September 2000) brought out by the BCBS. Comments with regard to the related aspects of internal rating systems in banks and banks’ interactions with highly leveraged institutions are given below. Areas in which, in the opinion of the Group, gaps exist and wherein corrective action can be initiated, are summarised below.

With regard to measurement and monitoring of credit risks, the Group considers that the following aspects of risk management practices of Indian banks merit urgent review. The gap between these practices and the relative international benchmarks is noticeable and in the interests of the soundness and international credibility of the system, it would be desirable to bridge these at an early date.

1. Though banks in India monitor individual credits, the determination of provisions for loan losses are formulae-based. Such provisioning detracts attention from specific risks attendant to individual credits as also to specific sections of the total credit portfolio.

2. While most banks have information systems which enable them to measure credit and concentration risks in all on-balance sheet exposures, the information system is not being used to capture and keep in focus risks attached to off-balance sheet activities.

3. Although while assessing individual credit, banks generally take into consideration potential future changes in the economic scenario, the likely adverse impact of all such changes on the credit portfolio under conditions of stress is most often not examined. This denotes a certain degree of unpreparedness and lack of strategy on the part of the banks for managing such risks

Risk management on scientific basis is a recent phenomenon in Indian banks which have so far not focused hard enough on their strategies for credit risk management. While, therefore, most of them have defined loan policies duly approved by their Board of Directors, clearly stated strategies for risk management do not form part of most such policies. This reveals inadequacies of the risk management policies applied hitherto by banks in India as well as the limitations of the MIS on which these systems have been built. Banks in India have to pay attention to improving their MIS as well as the credit risk management systems and strategies within as short a timeframe as possible. In the absence of a clear strategy, shared and well understood throughout the organisation, credit risk management will remain patchy and lack uniformity of approach.

The core principles recommend and the Group agrees that banks must establish a system of independent, and ongoing assessment of their credit risk management processes. The results of such reviews should be communicated directly to the senior most management and the Board of Directors of the bank for any remedial action that may be necessary.

While no minimum standards or codes have been suggested so far in respect of internal rating systems for banks, probably in view of the country-specific requirements in this regard, the BCBS has published a study on the range of practices in the internal rating systems of banks (Range of Practice in Banks’ Internal Ratings Systems, January 2000). Since developments in this area will be vital for improving the competitiveness and long term stability of the Indian banking system, the Group thought it fit to assess the Indian position vis-à-vis these practices.

Use of internal rating systems in Indian banks is still not extensive as most banks are still in the process of putting in place sophisticated risk management practices. Lack of qualified personnel, absence of reliable high frequency historical data which can facilitate meaningful modelling and lack of proper appreciation of risk management concepts at the middle and senior management levels are important handicaps faced by Indian banks in their developing internal rating systems extensively.

Credit rating in India is mostly unidimensional, i.e., there is an overall rating given to the borrower and the same rating is applicable for all facilities extended by the bank to him. The credit rating systems as developed by banks in India are largely based on their experience and broadly take into account financial factors, industry specific factors and management factors. These factors are generally rated separately and due weights are assigned (which is again based on the experience of respective banks). To arrive at an overall risk rating, the above factors are aggregated and calibrated to obtain a single point indicator of risk associated with the client. A move towards multidimensional rating systems is overdue as there is no other reliable method of assessing risks where the activities of the clients themselves and the facilities enjoyed by them are multidimensional

The internal rating approach, as practised by most banks in India, measures risk in quantitative mode. Important inputs in risk rating systems of banks in India are financial analysis, projections and sensitivity and incidence of industrial and management risks. Systems of internal rating which include measurements of probability of default (PD), loss given default (LGD) and exposure at the time of default (EAD) are still not widely used. Banks should urgently adopt systems of internal rating which are more risk-oriented and can capture, inter alia, the above mentioned elements of risk

Rating systems could be put to various uses by banks. Internationally, these are used for management reporting, pricing, decisions on reserve levels, allocation of economic capital, compensation for relationship managers and for setting credit limits. Only a few banks are using the rating systems and that too for management reporting, setting credit limits and for pricing of loans. Use of these systems for internal ratings, decisions on reserve levels, or allocation of economic capital, is still rare.

It would be necessary to strengthen the MIS and data collection machinery in banks to ensure integrity and reliability of data. In view of the wide network of branches and the fact that most of the branches in semi-urban and rural areas have not been computerised, collection of reliable and relevant data will have to be ensured before statistical models can be used for drawing meaningful conclusions.

It will take another three to five years before the whole banking system can expect to come to the level of risk management envisaged in the BCBS paper. This presupposes extensive computerisation and the right kind of MIS. Banks shall have to build historical database on the portfolio quantity and provisioning/charge off to equip themselves for pricing risks properly. All banks cannot be expected to be able to do so in the very near future. However, the bigger banks must expedite the process of transition from elementary levels of risk management to levels of greater sophistication. They may be encouraged to engage, wherever considered necessary, external assistance, e.g., from consultants, so that the available in-house expertise gets duly supplemented.

Banks in India will have to formulate a medium term strategy to implement risk aggregation and capital allocation mechanism. Reserve Bank of India may consider guiding the banks to more sophisticated risk management concepts in a time bound manner. It may consider directing some more capable and better equipped banks to adopt more advanced and sophisticated practices without waiting for the whole banking system to attain the same level of proficiency in risk management. Such banks, acting as forerunners, could provide models for other banks to follow.

The near-failure of Long Term Capital Management, the high-profile US-based hedge fund, in 1998 had brought into focus the special care that needs to be taken by banks in dealing with Highly Leveraged Institutions (HLIs). The BCBS had, in this regard, brought out a set of principles titled Banks’ Interactions with Highly Leveraged Institutions (January 1999). HLIs have been defined for the purpose of the BCBS paper as those which are subject to little or no direct regulatory oversight, are required to make only limited disclosures and take on significant leverage.

In view of their high leverage, lack of adequate disclosure and the increase in their activities in recent years, HLIs represent a special type of counterparty risk to banks and to the financial system as a whole. Supervisory responses to the potential problems posed by HLIs would have to take into account the credit exposures arising out of transactions with HLIs, particularly the off-balance sheet exposures. The responses will have to include more stringent capital requirements for such exposures, and setting out of policies, procedures and documentation for taking on such exposures. These may further include, inter alia, established policies and procedures for information gathering, due diligence and credit analysis of HLIs’ activities, setting of overall credit limits for HLIs and close monitoring of credit exposures vis-à-vis HLIs.

While Indian banks do not generally have dealings with HLIs, with increasing globalisation, the possibility of such interactions taking place and on an increasing scale is quite on the cards. It is, therefore, felt necessary to have necessary guidelines in this regard in place. Such guidelines may also have to take care of situations where HLIs or highly leveraged individuals, by means of cross holdings disguised by intricate methods, may be able to camouflage their high leverage.

The boards of banks in India have responsibility for approving and periodically reviewing the loan policies of banks, which cover credit risk policy and strategy. Banks have sound and well-defined credit granting systems. The credit granting criteria include a clear indication of banks’ target markets and a thorough understanding of the borrower or counterparty. The purpose and structure of credit, and its source of repayment are also clearly identified.

Systems for monitoring overall composition and quality of credit portfolio and for monitoring individual credits and credit risk-bearing portfolios are in place. Banks ensure that the credit granting function is being properly managed and that credit exposures are within levels consistent with prudential standards and internal limits. Connected lending to their directors or to parties in which the directors are interested are statutorily prohibited. The regulator has also prescribed maximum exposure limits to individual and group borrowers. There are also systems in place to report exceptions to policies, procedures and limits to the appropriate authority. For credits where quality is deteriorating, banks have systems in place for early remedial action.

Through on- and off-site supervisory systems, RBI conducts independent evaluation of a banks’ strategies, policies, procedures and practices related to the granting of credit and the ongoing management of the portfolio. RBI has issued comprehensive risk management guidelines to banks. However, scientific credit risk management systems are yet to stabilise in Indian banks. Impact of changes in economic conditions on the credit portfolio is not analysed in a sophisticated manner. Further, while there are information systems to measure credit and concentration risks in all on-balance sheet exposures, the attention given to off-balance sheet activities is rather inadequate. Necessary guidelines for interactions with highly leveraged institutions also need to be put in place. It would, therefore, appear that management of credit risk in Indian banks admits of considerable improvement. The banks should be focussing far more on credit risk strategies in their loan policies. RBI may consider guiding banks to more sophisticated risk management concepts in a time bound manner.