Credit Risk Management in Canara Bank Essay

In the past few years, in that respect claim been several developments in the field of modeling the character peril in shores commercialised loan portfolios. recognize pretend is essentially the possibility that a banks loan portfolio pull up stakes lose encourage if its borrowers become unable to pay back their debts. Arguably, reliance essay is the largest risk faced by commercial banks, since loans and other debt instruments constitute the mountain of their assets. In the U. S. , loans made up everywhere 60% of total banking assets at year-end 2000, and fixed-income securities made up an additional 14%.These realisation risk models be be feeler astray accepted by banks for various purposes in fact, bank supervisors, including the Federal Reserve, have recently proposed new risk-based keen dominatements based partly on such models. This Economic Letter provides a brief survey of how these models atomic number 18 constructed and employ for trust risk measureme nt and management. General modeling procedure Commercial banks have been white plague deferred compensation risk models for their mortgage and consumer lend for decades.These reference work risk models, typically known as attri moreovere scoring models, were first developed for consumer lending because of the large number of borrowers and their detailed credit histories. In contrast, on that point are m whatsoever fewer commercial borrowers, and it is only within the last few years that credit risk models for commercial loans have been success to the full created, marketed, and integrated into banks risk management procedures. Although a reasonable phase of such models exists, all of them are constructed generally on three standard procedural mistreats.The first step is to choose the type of credit risk to be modeled. Default models simply estimate the chance that a borrower provide scorn that is, the borrower will not make any more payments under the original lending a greement. In contrast, multi- differentiate (or mark-to-market) models estimate the probability that the borrowers credit quality will change, including a change to default status. For example, a multi-state model forecasts the probabilities of whether a B-rated borrower will remain B-rated, will become n A-rated or a C-rated borrower, or will default. Obviously, default models are a special case of multi-state models and are being used less frequently by banks. An important element of this choice is the horizon over which credit losings are measured. For example, a borrowers credit quality may change several times onward a default, and a default model would not be able to capture these changes. Many options are available to the user, but common practice has settled on a one-year horizon, which is shorter than the maturity of many commercial loans.This relatively short horizon is out-of-pocket partly to modeling convenience and partly to the change magnitude liquidity of the sec ondary loan market and the credit derivatives market. Both of these markets permit banks to hedge (i. e. , decrease) their credit picture show to a particular borrower or class of borrowers. The second step is to check into the probability of apiece credit state occurring and the value of a given loan in each of them. In default models, there are two credit states the credit is simply paid off completely, or it is worth a recovery value in case of default.In multi-state models, the loans value in each possible credit state is frequently assessed by referencing credit spreads derived from the corporate bond market. The state probabilities toilette be calculated in several ways, such as from simple historical experience in the corporate bond market or from models using data from the public debt and equity markets. The combination of the estimated set of a loan in the different states and the estimated probabilities of the states determine the credit expiration dispersion for th at loan.A primal element of these loss calculations is the credit rating initially assigned to a loan and its corresponding borrower. integrated credit ratings for large borrowers that issue publicly traded debt are available from financial in establishation vendors, such as Moodys and Standard & Poors. For other borrowers, which, in fact, typically make up the bulk of banks commercial loan portfolios, banks must rely on their own internal ratings systems, based on twain public information and their own credit experience see Treacy and Carey (1998) for a survey of banks internal ratings systems.The thirdly step combines the credit loss distribution for each loan into an aggregate portfolio loss distribution. This aggregation depends at one time on the default correlations between individual credits, that is, the degree to which potential changes in credit status and losses are interrelated. There are generally two ways to model these correlations. In reduced form (or top down) models, correlations are essentially a by-product of the models portfolio loss distribution.In structural (or bottom up) models, the default correlations are modeled as functions of several variables, such as a borrowers industrial categorization and country of origin. In addition, macroeconomic factors can be combine into these correlations. Once specified, the correlations are used to combine individual credit losses in different states into a loss distribution for the entire portfolio based on the credit risk models central assumptions. assent risk models as a risk management tool A portfolios credit loss distribution is a key analytical tool for credit risk management.Once determined, this loss distribution gives a banker a complete forecast of possible portfolio credit losses over the coming year. For example, the mean of the distribution is the expected value of potential credit losses and could be used straightway to determine the level of loan loss provisions that should be held for the loan portfolio. Furthermore, the nobleer percentiles of the portfolio loss distribution can be used to determine the economic capital necessary for the portfolio. Economic capital is the polisher of reserves banks hold to guard against unexpected loan losses.Economic capital is typically set high enough that unexpected credit losses are very unlikely to exhaust it. For example, a banker could determine the amount of capital necessary to insure the solvency of the portfolio with a 99. 97% probability, which roughly corresponds to the annual 0. 03% default probability of AA-rated corporate bonds. Furthermore, the loss distribution provides the banker with a diagnostic tool for examining the impact of changes in credit concentrations on the entire portfolios potential losses.This approach to credit risk management has now been explicitly unified into the risk-based capital requirements developed by the Basel Committee on Banking Supervision (2001), an international forum for commercial bank regulation. Under the Committees recently proposed revisions to the 1988 Basel Capital Accord, national bank supervisors would permit banks that have met received supervisory criteria to use their own internal models to determine certain inputs to their regulatory capital requirements.However, the new guidelines will not permit banks to set their capital requirements solely on the basis of their own credit risk models. Looking ahead The field of credit risk modeling for commercial loans is still developing, but its subject matter principles have been readily accepted by banks and their supervisors. The next few years of industry practice will be crucial in developing key aspects of the estimation and calibration of the model parameters. (For a positive survey of the issues, see Hirtle, et al. (2001). ) Resolution of these issues is needed before supervisors and model users can be completely surefooted with the models outcomes.However, as banks gain addi tional modeling experience and more observations on changes in corporate credit quality, credit risk models should become an integral element of all banks risk measurement and management systems. denotation risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do. 1 The risk is primarily that of the lender and include lost principal and interest, disruption to specie flows, and increased collection costs. The loss may be complete or partial and can snarf in a number of circumstances. 2For example * A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan * A company is unable to repay amounts secured by a fixed or floating charge over the assets of the company * A commerce or consumer does not pay a trade invoice when due * A business does not pay an employees earned wages when due * A business or government bond issuer does not make a payment on a verifier o r principal payment when due * An insolvent insurance company does not pay a policy obligation * An insolvent bank wont return funds to a depositor A government contributes bankruptcy protection to an insolvent consumer or business To reduce the lenders credit risk, the lender may perform a credit check on the prospective borrower, may require the borrower to take out appropriate insurance, such as mortgage insurance or seek gage or guarantees of third parties, besides other possible strategies. In general, the high the risk, the higher will be the interest rate that the debtor will be asked to pay onTypes of credit risk reference risk can be classified in the following way3Credit default risk The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or the debtor is more than 90 days past due on any material credit obligation default risk may impact all credit-sensitive transactions, including loans, securities and derivatives. * Concentration r isk The risk associated with any single exposure or group of exposures with the potential to produce large enough losses to imperil a banks core operations. It may arise in the form of single parent concentration or industry concentration. Country risk The risk of loss arising from a sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk).Assessing credit risk Main articles Credit analysis and Consumer credit risk Significant resources and sophisticated programs are used to analyze and manage risk. 4 close to companies run a credit risk department whose job is to assess the financial health of their customers, and convey credit (or not) accordingly. They may use in house programs to advise on avoiding, reducing and transferring risk. They also use third party provided intelligence.Companies like Standard & Poors, Moodys, Fitch Ratings, and Dun and Bradstreet provide such information for a fee. Most le nders employ their own models (credit scorecards) to rank potential and existing customers according to risk, and accordingly apply appropriate strategies. 5 With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa. 67 With revolving products such as credit cards and overdrafts, risk is controlled by dint of the setting of credit limits. Some products also require security, most commonly in the form of property.Credit scoring models also form part of the framework used by banks or lending institutions grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively. Once this information has been fully reviewed by credit officers and credit committees, the lender provid es the funds subject to the terms and conditions presented within the contract (as describe above).