Credit Risk in Retail Loan Portfolio with Reference to South Indian Bank
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Risk is an integral part of the banking business and the Bank aims at delivering superior value to shareholders by achieving an appropriate trade-off between risk and return. Sound risk management and balancing risk-return trade-off are critical to a Bank’s success. Business and revenue growth have therefore to be weighed in the context of the risks embedded in the Bank’s business strategy. Of the various types of risks the Bank is exposed to, the most important are credit risk, market risk (which includes liquidity risk and price risk) and operational risk. The identification, measurement, monitoring and mitigation of risks, continued to be a key focus area for the Bank. The risk management strategy of the Bank is based on a clear understanding of various risks, disciplined risk assessment, risk measurement procedures and continuous monitoring for mitigation. The policies and procedures established for this purpose are continuously benchmarked with the best practices followed in the Industry. Credit risk is the risk due to the uncertainty in counterparty’s ability to meet its obligation. Because there are many types of counterparties from individuals to sovereign governments and many different types of obligations from auto loans to derivative transaction, credit risk takes many forms.
A bank or a financial institution enters into a large number of financial transactions. In these transactions, the bank is exposed to a risk linked to a risk linked to the financial strength of the counterparty. Credit risk originates from the point where FI has completed its transaction and the obligation of counterparty starts. The process of measuring the credit risk for a portfolio of credit assets is different from the one used for a single loan because of the correlated between loans in a portfolio. Correlation reflects the extent to which loans tend to default simultaneously. This may happen because of macroeconomic factors like recession or interrelationships between the various credit assets. The effect of correlation may result highly skewed loss distributions. Such results are hard t find and so some models are used for measuring the credit risk of a portfolio:-
* The Credit Risk+ Model
* The Credit Metrics Model
* The KMV Portfolio Manager Model
* The Modern Portfolio Theory
The South Indian Bank’s risk management structure is overseen by the Board of Directors. Appropriate policies to manage various types of risks are approved by Risk Management Committee (RMC), which provides strategic guidance while reviewing portfolio behavior. The senior level management committees like Credit Risk Management Committee (CRMC), Market Risk Management Committee (MRMC) and Operational Risk Management Committee (ORMC) develop the risk management policies and vet the risk limits. The Asset Liability Management Committee and Investment Committee ensure adherence to the implementation of the above risk management policies, develop Asset Liability Management Policy and Investment Policy within the above risk framework. Compliance with Basel II framework
The Bank has migrated to Basel II norms during Financial Year 2008-09. In tune with regulatory guidelines on Pillar I of Basel II norms, Bank has computed capital charge for credit risk as per the Standardized Approach, for market risk as per the Standardized Duration Method and for operational risk as per the Basic Indicator Approach. To address the issues of Pillar II, the Bank has implemented ICAAP (Internal Capital Adequacy Assessment Process) during the year integrating capital planning with budgetary planning and to capture residual risks which are not addressed in Pillar I like credit concentration risk, interest rate risk in the banking book, liquidity risk, earnings risk, strategic risk, reputation risk etc.
Bank has adopted a common framework for additional disclosures under Pillar III for adhering to market discipline of Basel II guidelines. This requires the Bank to disclose its risk exposures, risk assessment processes and its capital adequacy to the market in a more consistent and comprehensive manner. Apart from the Risk Management Committee of the Board at apex level, the Bank has a strong Bank-wide risk management structure with Credit Risk Management Committee, Market Risk Management Committee and Operational Risk Management Committee at senior management level, operational risk management specialists in all Regional Offices and dedicated mid-office at Treasury Department/International Banking Division at operational level. Standardized Approach
The term standardized approach (or standardized approach) refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk. In many countries this is the only approach the regulators are planning to approve in the initial phase of Basel II Implementation. The Basel Accord proposes to permit banks a choice between two broad methodologies for calculating their capital requirements for credit risk. The other alternative is based on internal ratings. There are some options in weighing risks for some claims, below are the summary as it might be likely to be implemented:- For some “unrated” risk weights, banks are encouraged to use their own internal-ratings system based on Foundation IRB and Advanced IRB in Internal-Ratings Based approach with a set of formulae provided by the Basel-II accord.
The term Foundation IRB or F-IRB is an abbreviation of foundation internal ratings-based approach and it refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Under this approach the banks are allowed to develop their own empirical model to estimate the PD (probability of default) for individual clients or groups of clients. Banks can use this approach only subject to approval from their local regulators. Under F-IRB banks are required to use regulator’s prescribed LGD (Loss Given Default) and other parameters required for calculating the RWA (Risk Weighted Assets). Then total required capital is calculated as a fixed percentage of the estimated RWA.
The term Advanced IRB or A-IRB is an abbreviation of advanced internal ratings-based approach and it refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Under this approach the banks are allowed to develop their own empirical model to quantify required capital for credit risk. Banks can use this approach only subject to approval from their local regulators. For more background on the types of models banks have applied, see the Jarrow-Turnbull model. Under A-IRB banks are supposed to use their own quantitative models to estimate PD (probability of default), EAD (exposure at default), LGD (loss given default) and other parameters required for calculating the RWA (risk-weighted asset). Then total required capital is calculated as a fixed percentage of the estimated RWA.
There exist several alternative weights for some of the following claim categories published in the original Framework text.
* Claims on sovereigns
Credit Assessment| AAA to AA-| A+ to A-| BBB+ to BBB-| BB+ to B-| Below B-| unrated| Risk Weight| 0%| 20%| 50%| 100%| 150%| 100%|
* Claims on the BIS, the IMF, the ECB, the EC and the MDBs Risk Weight: 0%
* Claims on banks and securities companies
Related to assessment of sovereign as banks and securities companies are regulated. Credit Assessment| AAA to AA-| A+ to A-| BBB+ to BBB-| BB+ to B-| Below B-| unrated| Risk Weight| 20%| 50%| 100%| 100%| 150%| 100%|
* Claims on corporates
Credit Assessment| AAA to AA-| A+ to A-| BBB+ to BB-| Below BB-| unrated| Risk Weight| 20%| 50%| 100%| 150%| 100%|
* Claims on retail products
This includes credit card, overdraft, auto loans, personal finance and small business. Risk weight: 75%
* Claims secured by residential property
Risk weight: 35%
* Claims secured by commercial real estate
Risk weight: 100%
* Overdue loans
more than 90 days other than residential mortgage loans.
150% for provisions that are less than 20% of the outstanding amount 100% for provisions that are between 20% – 49% of the outstanding amount 100% for provisions that are no less than 50% of the outstanding amount, but with supervisory discretion are reduced to 50% of the outstanding amount *
Risk weight: 100%
Risk weight: 0%
From 2009-10 South Indian Bank has been following this approach according to the Basel II norms and thus they are able to manage their credit risk to a large extend.
*http://www.southindianbank.com/userfiles/annualreport_2010_11.pdf * http://www.bis.org/publ/bcbsca.htm
* Financial Risk Management- Vivek, PN Asthana