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Credit Risk Identification & Measurement

Historically credit is good if used prudently. However, there are numerous instances where both lenders and borrowers and even global economics suffer because of credit. The main reason traceable is poor credit risk analysis and inadequate credit risk management. 

So it is important to understand first what is credit and then credit risk before we move to credit risk management.

What is Credit ?

Word “Credit'' is derived from Latin word “credere”  which means “to believe“. Therefore, Credit is the trust which allows one party (Lender) to provide money or resources to another party (Borrower)  with an intention to receive it back after some time.

As per Encyclopaedia Britannica, Credit is defined as “A transaction between two parties in which one (the creditor or Lender) supplies Money, Goods, Services or Securities in return for a promise of future payment by the other debtor or borrower. Such transactions normally include the payment of interest to the lender.”

Thus, risk in credit is default by the borrower or counterparty. Apart from default there are other signs of credit risk which are explained in the following paragraphs.

What is Credit Risk ?

As per Basel norms, Credit risk is the future possibility of net losses associated with worsening credit profile of borrowers or counterparties. These future losses are subject to the standalone default risk of the counterparty, the risk of exposure at the time of default, the risk of recovery against the defaulted amounts, and the risk of larger number of simultaneous defaults in concentrated portfolio exposures.

Therefore, Credit risk can be defined as ‘the potential that a contractual party will fail to meet its obligations in accordance with the agreed terms’. Credit risk is also variously referred to as default risk, performance risk or counterparty risk. These all fundamentally refer to the same thing: the impact of credit effects on a firm’s transactions.

Forms of Credit Risk 

Generally, there is not a definitive ‘YES’ or ‘NO’ answer to whether a borrower can and will pay back a loan.  As such, the lender must address the question of likelihood. i.e likelihood that the borrower will pay back the loan in accordance with the terms of the agreement.

Major Drivers of Credit Risk

Credit risk is the possibility of losses associated with changes in the credit profile of borrowers or  counterparties. These losses, associated with changes in portfolio value, could arise due to default (single or joint) or due to deterioration in credit quality. 

• Default risk - obligor fails to service debt obligations
•  Recovery risk – recovery post default is uncertain
• Spread risk – credit quality of obligor changes leading to a fall in the value of the loan
• Concentration risk – over exposure to a an individual obligor, group or industry
• Correlation risk - concentration based on common risk factors between different borrowers, industries or sectors which may lead to simultaneous default. 

Unsystematic Risk :-  These risks don’t affect the entire economy or all business enterprises  / households. These risks are mainly industry specific and/or firm specific. 

Credit risks are triggered by both systematic and unsystematic factors and are required  to be carefully handled.

Interest rate changes, inflation, recessions and wars all represent sources of Systematic Risk

Unsystematic Risk is a risk unique to the operation of an individual firm. Examples of this can include management risks, location risks and succession risks.

What is Credit Risk Analysis?

It is the study from the perspective of a supplier of credit of a present/prospective claim 

on another agent in the form of debt . Few Suppliers of Credit & their concerns are :-

Credit Risk Management

Credit Risk Management is the process of controlling the potential consequences of credit risk. The process follows a standard risk management framework: namely identification, measurement, monitoring and mitigation. That is, the cause of the risk has to be identified, the extent of the risk has to be evaluated and decisions have to be made as to how this risk is to be managed.

Extent of Risk  or How Much Risk ?

Quantification of risk is done through Credit Rating  which depicts the degree of credit risk associated with the borrower. Updating the grades is often the fundamental basis of the continued loan/credit risk review process in banks and financial institutions. A sound rating system is essential to generate accurate and consistent risk ratings for risk management and monitoring . 

Credit Rating Framework

Details of above parameter shall be discussed in detail in  level no. 2 program

External Credit Ratings  Agencies & Grades

As per RBI, Credit rating agencies recognised are CRISIL, CARE, ICRA, Brickwork Ratings India Ltd., India  Rating and Research Pvt. Ltd., SMERA  Ratings & Informatics Valuation and Ratings Pvt. Ltd.

Sample International Definition of various grades used by these agencies are:- 

AAA: Ratings denote the lowest expectation of default risk. They are assigned only in cases of exceptionally strong capacity for payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events.

AA: Ratings denote expectations of very low default risk. They indicate a very strong capacity for payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events.

A: Ratings denote expectations of low default risk. The capacity for payment of financial commitments is considered strong. This capacity may, nevertheless, be more vulnerable to adverse business or economic conditions than is the case for higher ratings.

BBB: Ratings indicate that expectations of default risk are currently low. The capacity for payment of financial commitments is considered adequate but adverse business or economic conditions are more likely to impair this capacity.

BB: Ratings indicate an elevated vulnerability to default risk, particularly in the event of adverse changes in business or economic conditions over time; however, business or financial flexibility exists which supports the servicing of financial commitments.

B: Highly Speculative. 'B' ratings indicate that material default risk is present, but a limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is vulnerable to deterioration in the business and economic environment.

C: Substantial credit risk. Default is a real possibility.

D : Default has occurred.

Banks are also having its own credit rating models known as internal rating models and they are having its own grades also.  

These models are based on the categories of borrowers  like Corporate, SME, Traders, NBFCs, Infrastructure Projects etc. With the help of these models banks are doing Obligor Rating and Facility rating.  

1. Obligor Risk Rating  refers to the probability of default by a borrower in repaying its obligation in the normal course of business.

As mentioned above in the credit risk rating framework, there are different grades of rating. After doing the borrower’s rating it is assigned a particular grade, say “A” .

Each of these grades are having a PD i.e. Probability of default which is calculated by dividing the total no. of defaults with the total number of rated borrowers under this category.  e.g. there are a total 1000 borrowers in a bank under ‘A' category at the end of  a particular year and total no. defaults under this category are 30 then PD is 30/1000= .03 % . 

All the borrowers falling under this category will carry .03  PD

2. Facility rating means that the security available to secure this facility. There are different securities available, eg, financial Instruments like FDRs, Insurance Policy, NSCs, Corporate bonds, Govt. Bonds, etc., commodities like Gold, Silver, tangible securities like Mortgages, Plant & Machinery, Vehicles, Stocks etc. or Intangible assets like Guarantee, Goodwill, brand value etc.

For facility rating also a grade system is formed according to the % of recovery and nature of securities. e.g. Financial securities are having the highest marks and unsecured loans carry least marks.

With the help of above, banks are able to calculate the Loss Given Default ( LGD).  LGD by the formula is :- 

LGD- ( 1-r) ; suppose, in any loan  account security has the potential to pay total exposure outstanding at default then value of ‘ r’ is 1  and LGD is 0.

EAD is Exposure at Default which means if at a particular time  (say after 1 year) default occurs than what shall be Outstanding in the various account of the borrower

With the help of above banks calculate the Expected loss and decide the credit premium to be charged from the borrower and keep the necessary provision.

EL = PD*LGD*EAD

With respect to Retail loans, Banks are using Credit Score Models; and PD & LGD is calculated at portfolio level.

Use of Credit Rating in Banks/FIs

• For Acquisition of new customers 
• For Pricing the Loan Products 
• For Capital Requirements 
• For Monitoring & Follow up 

Written by Mr Rajesh Mahajan, former General Manager (Risk Management), Bank of Baroda. The article is based upon the lecture delivered by Mr Rajesh Mahajan in Banking Quest' online training "Program on Risk Management in Banks and NBFCs" on June 27, 2021.