Govind Gurnani, Former AGM, RBI

Credit Risk Management In The Banking

Sector : Simpli ed

Credit risk refers to the potential loss arising from a

bank borrower or counterparty failing to meet its
obligations in accordance with the agreed terms.
Credit risk analysis is the means of assessing the
probability that a customer will default on a payment
before you extend trade credit.

In simple terms, banks experience credit risk when

assets in a bank’s portfolio 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
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rates, trade restrictions, economic sanctions, and
more.

The presence of credit risk deteriorates the expected

returns and creates more than expected losses for
banks.

In this article, following topics relating to credit risk

have been discussed :

1. Key factors in credit underwriting

2. Five C’s criteria for assessing credit risk
3. Credit risk assessment models
4. Types of credit risks
5. Stress testing methods for assessment of credit
risk
6. Factors a ecting credit risk modeling
7. Credit risk monitoring techniques

1. Key Factors In Credit Underwriting

▪ Credit Score
An important consideration in the underwriting
process, the credit score shows the borrower’s
creditworthiness based on their credit history,
payment history, and credit utilisation. A higher credit
score means a lesser credit risk, and vice versa.
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▪ Credit History
Lenders examine a borrower’s credit history to gain
insight into their previous nancial behavior, which
includes loan repayments, credit card usage, and any
delinquencies. A good credit history increases the
chances of loan approval.

▪ Income and Employment Stability

The borrower’s income and employment history are
important considerations in underwriting. A
consistent and substantial revenue stream reassures
lenders of the borrower’s ability to repay loans on
schedule.

▪ Debt-to-Income Ratio
The debt-to-income ratio (DTI) compares a borrower’s
monthly loan commitments to their monthly income.
A lower DTI ratio shows better debt management
capacity and increases loan approval prospects.

▪ Collateral
In case of secured loans, the lenders analyse the
value and condition of collateral given by the
borrower as a backup repayment source in the event
of secured loans.
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2. Five C’s Criteria For Assessing Credit
Risk

▪ Character : The credit history and credit score

(FICO) of the borrower and perceived trustworthiness.
▪ Capacity : The estimated likelihood of the
borrower being capable of meeting all interest
obligations and repaying the loan in-full at maturity,
which is determined using nancial ratios to estimate
the risk of default.
▪ Capital : The total amount of funds that the
borrower has on hand, including any capital the
borrower already put towards a potential investment.
▪ Collateral : The assets belonging to the borrower
that can be pledged as collateral to secure a loan.
▪ Conditions : Conditions describe the contextual
details of the borrower and the current credit
environment in which the loan application is
considered.The conditions can consist of internal
factors including the purpose of the borrowing, or
external factors outside the control of the borrower,
such as the prevailing interest rates, current
economic conditions (or outlook), geopolitical risks,
and pending regulatory risks that could negatively
impact the borrower.
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3. Credit Risk Assessment Models

◼ Credit Scoring Models

Credit scoring models are statistical tools that

evaluate creditworthiness and determine the
likelihood of default on credit obligations. These
models are used by credit bureaus & lenders to
assess the risk of lending money or extending credit
to individuals or businesses.

The credit scoring model evaluates various factors,

including payment history, credit utilisation, length of
credit history, types of credit accounts, & recent
credit inquiries. Each factor is assigned a weight, and
the model’s formula calculates a credit score based
on the evaluation.

A credit score typically ranges from 300 to 900, with a

higher score indicating a lower risk of default.
Lenders use credit scores to make decisions about
loan terms, including interest rates, repayment
periods, and loan amounts. A good credit score can
result in favorable loan terms, while a poor score can
lead to higher interest rates and less favorable terms.
 ◼ Credit Risk Models

Credit risk model is a method that uses statistical

techniques to evaluate a borrower's creditworthiness
and estimate the likelihood of them defaulting on their
payments.These models can range from simple
credit scoring models to complex models that
consider multiple factors, including:
▪ Financial statements
▪ Credit bureau data
▪ Alternate data

◼ Scenario Analysis

Scenario analysis involves generating hypothetical

scenarios that can negatively in uence the credit
portfolio. Typically, these involve economic
downturns, changes in regulatory requirements, and
natural disasters.

Financial institutions develop these scenarios based

on historical data and expert opinion. It helps in
understanding the following:
▪ E ect of changes in interest rates.
▪ Exchange rates or commodity prices.

For instance, nancial institutions can use scenario

analysis to determine the impact of a 1% rise in
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interest rates on their credit portfolios. Scenario
analysis is simple to implement and understand and
provides a clear view of the possible impact of
individual risk factors under de ned conditions.

However, the scenarios usually are based on

historical data and hence may not be relevant in
forecasting future occurrences. Thus, it may not be
adequate in covering all the possible risks or real-
world scenarios.

◼ Sensitivity Analysis

Sensitivity analysis evaluates the changes in some

variables on the credit portfolio. It relies on single
variables, such as interest rates or unemployment,
that are incrementally changed to observe the
impacts and identify the consequences.

Sensitivity analysis allows for the identi cation of key

risk drivers and conducting a deep analysis of
isolated variables. However, it relies on individual
variables—with no interplay among them —and
therefore, many systemic or interconnected risks can
remain undetected.
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4. Types Of Credit Risks

1⃣ Credit Spread Risk: Credit spread risk is typically

caused by the changeability between interest and
risk-free return rates.

2⃣ Default Risk: When borrowers cannot make

contractual payments, default risk can occur.

3⃣ Downgrade Risk: Risk ratings of issuers can be

downgraded, thus resulting in downgrade risk.

4⃣ Concentration Risk or Industry Risk: When too

much exposure is placed to any industry or sector,
investors or nancial institutions can be at risk for
concentration risk.

5⃣ Institutional Risk: Banks may encounter

institutional risk if there is a breakdown in the legal
structure. Institutional risk may also occur if there is
an issue with an entity that oversees the contractual
agreement between a lender and a debtor.

6⃣ Counterparty Credit Risk: Counterparty credit

risk is de ned as the risk that a counterparty defaults
before honoring its engagements.
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 7⃣ Credit Valuation Adjustment Risk: Credit
valuation adjustment (CVA) risk refers to the risk of
loss on OTC derivatives and securities nancing
transactions due to changes in counterparties 'credit
spread caused by a change in its creditworthiness. In
other words, CVA re ects the market value of the cost
of credit spread's volatility.

5. Stress Testing Methods For Assessment

Of Credit Risk

1⃣ Sensitivity Analysis
▪ Involves the impact of a large movement on single
factor or parameter of the model
▪ Used to assess model risk, e ectiveness of
potential hedging strategies, etc.

2⃣ Scenario Analysis
▪ Full representations of possible future situations to
which portfolio may be subjected
▪ Involves simultaneous, extreme moves of a set of
factors
▪ Re ects individual e ects and interactions
between di erent risk factors, assuming a certain
cause for the combined adverse movements
▪ Used to assess particular scenarios (e.g., current
forecast, worst-case) to gain better.
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3⃣ Event-driven Scenarios
Scenario is based solely on a speci c event
independent of the portfolio characteristics.
▪ Identify risk sources/events that cause changes in
market
▪ Identify e ects of these changes on the risk
parameters

4⃣ Portfolio-driven Scenarios
Scenario is directly linked to the portfolio:
▪ Identify risk parameters changes that result in a
portfolio change. Identify events that cause the
parameters to change
▪ May be drawn from expert analysis or quantitative
techniques

5⃣ Macroeconomic Scenarios
An shock to the entire economy that will a ect
industries to di erent degrees
▪ Occurs external to a rm and develops over time
e.g.changes in unemployment in a region, movement
towards a recession, etc.

6⃣ Market Scenarios
A shock to the nancial and capital markets :
This shock may be historical or hypothetical, though
historic events help support the plausibility e.g. stock
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market crash of early 2000s, change in interest rates,
shock to credit spreads in a sector.

7⃣ Worst Case/Catastrophe Scenarios

Events are exogenous to the markets or economy,
though impact arises through resulting changes.
Such events are often tied to speci c characteristics
of portfolio or exposures, e.g. terrorist attack on
major nancial center, change in regulations or
policies.

6. Factors A ecting Credit Risk Modeling

For lenders to minimise credit risk, credit risk

forecasting needs to be more precise. Here are some
factors to consider:

1⃣ Probability of default
Probability of default (PD) is the likelihood that a
borrower will fail to pay their loan obligations, and
lenders use it to assess the level of risk that comes
with loaning money. For individual borrowers, the PD
is typically based on two primary factors:
1. Credit score
2. Debt-to-income ratio

2⃣ Loss Given Default

Loss given default (LGD) refers to the amount of
money a lender is likely to lose if a borrower defaults
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 on a loan, helping them predict and manage their risk
exposure. LGD accounts for:
▪ Value of the collateral
▪ The type of loan
▪ The legal framework in which the lender operates

It helps lenders with credit risk management and

make informed decisions about loan pricing and
underwriting.

3⃣ Exposure At Default
Exposure at default refers to the amount of possible
loss a lender is exposed to at any point in time,
allowing them to better manage their risk. It considers
factors including:
▪ The outstanding principal balance
▪ Accrued interest
▪ Any fees or penalties associated with the loan

4⃣ Discount Factor
The discount factor is used to present value the future
cash ows (losses) back to the reporting date. 't'
represents the time in years until the cash ow occurs.
DF = 1 / (1 + Discount Rate)^t
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 7. Credit Risk Monitoring Techniques

1⃣ Robust Credit Policies and Procedures

Establish comprehensive credit policies and
procedures. Also, include clear guidelines for,
• Credit underwriting
• Loan origination
• Risk assessment

2⃣ Robust Underwriting Standards

Implement rigorous credit underwriting standards to
e ciently assess borrower creditworthiness and
mitigate default risk. This involves a thorough analysis
of:
• Borrowers’ nancials
• Collateral valuation

3⃣ Diversify Credit Portfolios

A well-diversi ed credit portfolio helps minimize
concentration risk. By spreading credit exposures
across various industries or sectors, and borrower
types, nancial institutions can reduce the impact of
adverse events and prevent potential losses.
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4⃣ Stress Testing and Scenario-Based Analysis
Conduct regular stress tests and scenario-based
analyses to assess the impact of adverse economic
conditions. This helps:
• Identify and detect vulnerabilities
• Evaluate capital adequacy ratio
• Develop risk mitigation strategies

5⃣ Risk Rating
Create a separate risk scoring or risk rating method
for internal purposes to ensure accurate assessment
and classi cation of the borrowers based on credit
quality. It can be designed with qualitative and
quantitative factors, such as nancial analysis, ratios,
etc. This improves
• Credit decision-making
• Detect high-risk borrowers for closer monitoring.

6⃣ Adequate Provision for Loan and Lease

Losses
Adequate allowance for loan and loan losses helps
analyse credit losses in the bank portfolio of loans
and leases. It ensures that banks have su cient
funds to cover potential credit losses. By maintaining
appropriate provision, banks and nancial institutions
can estimate and maintain adequate allowances.
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 7⃣ Skilled Credit Risk Management Team
Build a skilled credit risk management team with
diverse skill sets, including statistical modeling, risk
assessment, and data analysis. For this, banks and
nancial institutions can:
• Hire experienced credit o cers, loan
underwriters, analysts, etc., with strong analytical
and industry knowledge
• Identify skill gaps
• Focus on continuous workforce skilling and
upskilling.
• Assess expertise and capabilities.

Banks can leverage digital learning solutions to

provide a sustainable, e cient, and measurable way
to train the workforce in credit risk management.

8⃣ Use AI, ML, & Data Analytics

Use advanced technologies and intelligent digital
solutions to establish a robust reporting and analytics
framework. This helps banks gain insights into their:
• Credit risk exposures
• Portfolio performance
• Emerging trends
It also helps ensure accurate and timely reporting for
informed decision-making and e ective credit risk
mitigation.
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