Credit Risk Management


Priya Dhaulta
PGDBM 3rd Sem
Institute of Productivity & Management

"Ships are safe in harbour
but they are not meant for that
banking is business of taking
informed and calculated risk

The business of banking means
"accepting of deposit for the purpose of onward lending"

Risks in Business

Risk can be defined as any uncertainty about a future event that threatens the organisation's ability to accomplish its mission.  Business is a trade off between risk and return.  There can be no risk-free or zero risk oriented business.  Risk in its pragmatic sense, therefore, involves both threats that may be  materialised and opportunities which can be exploited.

Credit Risk and Default

Credit Risk
is the risk of loss to the Bank in the event of Default.

Default arises due to counterparty's inability and/or unwillingness to meet commitments in relation to lending.

Credit risk is the potential loss that a bank borrower or counter party will fail to meet its obligation in accordance with the agreed terms


A) Transaction risk                     B) Portfolio risk
a) Grade risk                              a) concentration risk
b) default risk                             b) intrinsic risk

1) non payment
2) delayed payment

Credit risk may be in the following forms:

* In case of the direct lending
* In case of the guarantees and the letter of the credit
* In case of the treasury operations
* In case of the securities trading businesses
* In case of the cross border exposure

Traditionally credit risk has 2 components

a) Solvency aspects of the credit risk-the risk borrower is unable to pay

b) Liquidity aspects of the risk-the risk that arise due to the delay in the repayment by the borrower leading to the cash flow problems for the leader

The need for Credit Risk Rating

The need for Credit Risk Rating has arisen due to the following:

1. With dismantling of State control, deregulation, globalisation and allowing things to shape on the basis of market conditions, Indian Industry and Indian Banking face new risks and challenges.  Competition results in the survival of the fittest. It is therefore necessary to identify these risks, measure them, monitor and control them.

2. It provides a basis for Credit Risk Pricing i.e. fixation of rate of interest on lending to different borrowers based on their credit risk rating thereby balancing Risk & Reward for the Bank.

3. The Basel Accord and consequent Reserve Bank of India guidelines requires that the level of capital required to be maintained by the Bank will be in proportion to the risk of the loan in Bank's Books for measurement of which proper Credit Risk Rating system is necessary.

4. The credit risk rating can be a Risk Management tool for prospecting fresh borrowers in addition to monitoring the weaker parameters and taking remedial action.

The Credit Risk Rating method is used by Bank's Credit officers,

* To gather key information about risk areas of a borrower and
* To arrive at a risk score that would reflect the borrower's creditworthiness/degree of risk.

The types of Risks Captured in the Bank's Credit Risk Rating Model

The Credit Risk Rating Model provides a framework to evaluate the risk emanating from following main risk categorizes/risk areas:

* Industry risk
* Business risk
* Financial risk
* Management risk
* Facility risk
* Project risk

The Overall Rating is assigned on a 'A++' to 'C' scale presented below along with its meaning:

Rating Grade




Exceptionally high position of strength.
Very High degree of sustainability. 

Minimum Risk


High degree of strength on a factor
among the peer group. 
High degree of sustainability.

Marginal Risk


Moderate degree of strength with positive outlook.

Modest Risk


Moderate degree of strength with stable or marginally negative outlook.

Average Risk


Weakness on a parameter in comparison to peers.  Unstable outlook.

Marginally Above Average Risk


A fundamental weakness with regard to the factor.  Unlikely to improve under normal circumstances.





** "D" rating - This denotes default category for companies defaulting as per the NPA guidelines. The underlying borrower or company being rated can be assigned a D rating only in the Management/Facility Module.

Credit Risk is the potential that a bank borrower/counter party fails to meet the obligations on agreed terms. There is always scope for the borrower to default from his commitments for one or the other reason resulting in crystalisation of credit risk to the bank.These losses could take the form outright default or alternatively,losses from changes in portfolio value arising from actual or perceived deterioration in credit quality that is short of default. Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables. The objective of credit risk management is to minimize the risk and maximize bank's risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters.Credit risk consists of primarily two components, viz Quantity of risk, which is nothing but the outstanding loan balance as on the date of default and the quality of risk, viz, the severity of loss defined by both Probability of Default as reduced by the recoveries that could be made in the event of default. Thus credit risk is a combined outcome of Default Risk and Exposure Risk.

Priya Dhaulta
PGDBM 3rd Sem
Institute of Productivity & Management

Source: E-mail June 18, 2007




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