Credit Risk Management: What is it and Why is it Important?

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Credit Risk-management

Credit Risk Management is certainly becoming an important aspect of all financial institutions. Akshay Gupta, a former GyanOne client, an ISB Alumni, and a thorough finance professional, shares detailed insight into this aspect of the finance industry.

Credit Risk Management (CRM): What is it?

A credit risk is the risk of borrower default. It is essential to measure credit risk as banks are expected to hold reserves against expected credit losses; its cost is included in cost of funds for the borrower.

In general, banks charge higher cost and higher security from less creditworthy counterparties as the credit risk of such counterparties is higher. Ultimately, the bank’s objective is also to earn money. It is vital to determine an acceptable level of risk so as to ensure adequate return to stakeholders.

CRM as a career option for Finance professionals

Credit Risk Management is the backbone of any bank or financial institution. This division is independent of front office and does not have any revenue or fees targets to ensure that the decisions are made without any undue influence.

Generally credit risk management has 3 areas- Credit Underwriters, Credit Analytics (develop models related to PD, ratings, EAD, LGD etc) and Credit Monitoring (review of existing exposure).

A successful credit officer not only has sound technical knowledge but also has soft skills such as being a keen observer, fast decision maker, good negotiator with front office, and a critical thinker with strong comprehension skills. The role also involved a high level of responsibility as any bad decisions will have serious repercussions on the bank’s resources.

Credit Risk-managementEstimating Credit Risk i.e Expected Credit Losses

Probability of default (PD): The likelihood that the borrower will fail to make full and timely repayment of its financial obligations.

Exposure at default (EAD): The expected value of the loan at default.

Loss given default (LGD): The amount of loss if there is a default.

Expected Loss (EL) = Probability of default (PD) x Loss given default (LGD)x Exposure at default (EAD)

PD is estimated by assigning credit rating to the borrower. It depicts what the probability of default (missed payment of debt obligations; irrespective of the amount) is for the borrower.

Globally, rating agencies and banks follow a 20 point rating scale ranging from AAA to D (AAA being the highest and D being the lowest rating). Assessing credit ratings involve analysis of following risks:

Business Risk: It involves assessment of industry in which borrower operates, its competitive market position (level of product differentiation and pricing leadership) and operational efficiencies (ability of borrower to produce goods at a competitive cost).

This will help to determine the sustainability and stability of borrower’s cash flows.

Financial Risk: It includes assessment of borrower’s past and future financial performance. This risk highlights how business strengths have helped the borrower to earn its cash flows to service its debt in past (in the event of crisis) and what the level of future cash flows will be to support the debt levels.

Borrower’s liquidity (level of buffer in terms of liquid investments, undrawn committed credit lines) and financial flexibility (ability to raise additional capital in event of crisis) is also factored.

Management Risk: Assessment of management’s integrity (willingness to pay), competence (ability to run or grow the business) and risk appetite (level of risk that the management is willing to take) is done

Project Risk: If borrower is undertaking a large project (greenfield or brownfield), then risks related to implementation, funding and sustainability are evaluated.

Default probabilities may be estimated from a historical data base of actual defaults using statistical techniques. External ratings agencies maintain data base of PDs across rating categories based on their historical default experience across various industries and geographies.

The PD of a borrower not only depends on the risk characteristics of that particular borrower but also the economic environment and the degree to which it affects the borrower.

That is, in the global context; generally the rating of the borrower is capped to the rating of its sovereign unless the borrower operates in multiple geographies.

EAD is estimation of bank’s exposure to the borrower at the time of borrower’s default. For fixed exposure such as term loan, EAD is equal to the loan outstanding.

For revolving exposure such as line of credit or derivatives, EAD is divided in 2 parts: committed exposure and non-committed exposure.

EAD is equal to the amount of facility for committed revolving exposure and for non-committed exposure, it is calculated using the conversion factors (depending upon the terms and conditions) as prescribed by the regulator.

LGD is estimation of loss to bank if borrower defaults. This depends upon the recovery done by bank post default and takes in to account the realisable value of security.

For unsecured borrowers, the recovery rate takes in to account the general recovery available to all unsecured creditors in event of liquidation of all borrowers’ assets (estimated to be low).

The banks mitigate credit risk through proper structuring via collateral and covenants. Adequate collateral reduces LGD of the borrower with high PD and thus EL is reduced.

The banks also structure the facilities of high PD borrowers with tighter covenants so as to reduce the EL and monitor such accounts very closely.

Sometimes the bank mitigates its risk of low rating borrowers through unfunded credit risk mitigation such as guarantee from better rated counterparty (partial or full), selling the first loss piece to other financial institution etc.

This would help to increase the PD of borrower. Generally, the banks earn high pricing from low rated borrower.

To summarise, 5 Cs lays the foundation of credit risk. These are: Condition (business and project risk), Capacity (financial and project risk), Collateral (LGD and EAD), Covenant (LGD and EAD) and Character (management risk).

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