This is being made available for Risk Management Practice Group on Linkedin. RMPG Learning Series CRM Workshop Handouts: File 1 of 9

1. Agenda for Day 1
Introduction of Participants
Introduction to Credit Risk
Overview of Basel Guidelines
Lunch Break
Framework for Credit Risk Management
Open Session/ Q&A
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 1

2. What is you Bank’s most important risk?
Type of Business Biggest Risk
Commercial Banking Credit Risk
Investment Banking & Market Risk
Trading
Asset Management Operational Risk
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3. Art of Credit - Managing Loan Losses
“Credit Losses have, historically, been the single largest cause of bank
failures” - Economist
“Bankers are in the business of taking and managing risk… that is the
business of banking.” - Walter Wriston, ex-Chairman, Citicorp
“Volatility forms the link between risk and reward – the trick is for banks to
reduce that observation to workable propositions.” - George Vojta, Vice
Chairman, Bankers Trust
IM aCS 2010
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4. What is at stake for banks who cannot balance the
risk/reward relationship?
Their own survival! - Illustrative Example
%
Net Interest Revenues 3.00
Plus: Other Income (Fee/FX) 1.00
Net Customer Revenues 4.00
Less: Direct + Allocated Costs -2.50
Net Margin Before Credit Costs 1.50
Less: Expected Credit Costs -1.25*
Net Income 0.25
Required Return on Risk Adjusted Assets 1.60**
Premium Shareholder Income/Loss -1.35
(* Based on assumed portfolio quality)
(** Assumes 8% Risk Adjusted Capital allocation and required ROA (Return on
Risk Adjusted assets) of 20%)
IM aCS 2010
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5. The Message
A business must generate
Premium Shareholder Income
of at least 1.60%
(i.e. a 20% ROA on 8% capital)
in order
not to erode
Economic Value of Capital
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6. How?
To produce
Premium Shareholder Income
&
long term shareholder value,
banks must ensure
Superior
CREDIT RISK MANAGEMENT
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For Classroom discussion only Page 6

7. How does your bank currently manage its Credit Risks?
Is your focus on managing:
> individual credit exposures?
or
> a portfolio of credit exposures?
IM aCS 2010
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For Classroom discussion only Page 7

8. There are 3 opposing forces that challenge credit risk
management …..
Greater
Higher Risks
Returns
Credit risk
management
Regulators
More Capital
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9. Why is Credit Risk Management important for Banks?
RoE for banks worldwide has been below 10% and declining after 1960 if
one excludes non-interest income
Suggests that loans have been “loss leaders” - inducing customers to buy into
other products offered by banks
9 out of 10 banking failures attributable to poor credit risk management
New forms of financial transactions emerging
Asset backed securities
Derivatives
IM aCS 2010
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For Classroom discussion only Page 9

10. Several factors are changing the face of the Banking
industry across the globe
Highly intense
Liberalisation level
Time 1990 2005 2010
Low Medium High
Competition for
Banks Capital Adequacy pressure
Pressure on
customers
in the future
1990 2005 2010
Profits
None Medium High
Banks today
Relatively Competition for business
manageable
1990 2005 2010
Low Medium High
Medium Intense
Pressures due to
Capital adequacy norms
IM aCS 2010
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For Classroom discussion only Page 10

11. The Changing Marketplace for Credit
New kinds of lenders / investors coming into the financial intermediation
business
Different approach to credit risk management
Different investment horizons
Different risk aptitudes and risk tolerances
“Relationship based lending” changing from “art” to “science”
IM aCS 2010
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12. The different compartments of Financial Intermediation
have coalesced...
Yesterday Liberalised Market “Must” capabilities for banks
Banking Banking Implications Focus on well-defined
target customer groups
Term
Term Lending Ability to offer a variety of
Lending financial products
(including new products)
Insurance Insurance Sophisticated risk
management
Ability to use Technology
as a competitive weapon
NBFCs NBFCs
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13. How are different banks preparing themselves to face
increasing competition?
• Move towards consolidation/ alliances
• Banks are increasingly focusing on niche segments for growth
• Technology is playing a key role in deciding the competitive position
of banks
• Introduction of new products & delivery mechanism to meet the
customer requirements
• Risk management has become “mantra” to the banking sector
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14. The competition in the banking sector is getting intense
Number of entities
Large corporates Fiercely competitive
SMEs Under served
Intensifying competition
Retail in select segments
In USA, SMEs became of interest to banks after a recent focus on
segmentation showed their profit contribution
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15. Different credit segments generate different market
returns - a key driver for portfolio management
U.S. Market Size and Profitability
800
Insurance
Consumer
200 Finance
Small
Revenues
Business
($BN)
100
Mortgages
Credit
50 Cards
Mutual
Funds
5 10 15 20 25 30 35 40
ROE (%)
Source: IFC Symposium, China
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16. A bank should have a three-fold objective to implement
Credit Risk Management systems
Manage the credit risk inherent in individual credits or
1
transactions as well as the risk in the entire portfolio
Maximise the risk-adjusted return on capital by maintaining
2
credit risk exposure within acceptable parameters
3 Manage the relationship between credit risk and other risks
IM aCS 2010
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For Classroom discussion only Page 16

17. Conventional credit management practice - (Originate
and Hold)
Largely restricted to developing
/procuring obligor assessment models
and laying down loan policy
Hold Till Maturity
Monitoring
Risk Management
AA
SS /Client
Borrower
Obligor Loan Origination / SS Management
Credit Group
EE
/Servicing
TT
Recovery
Obligor evaluation, /Recovery
pricing,
management &
monitoring Involved
post
default
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For Classroom discussion only Page 17

18. How Risk Builds in the Portfolio
Ineffective
monitoring due to
incorrect risk
perception
(Tools/process
Inadequate issue
obligor risk
assessment
Monitoring
Risk Management
tools
A
S /Client
Borrower
Obligor Loan Origination / S Management
Credit Group
E
/Servicing
T
Recovery
/Recovery
Imperfect Loan
Structuring
Correlation between
assets. Asset
displaying cyclical
characteristics not
tracked adequately
IM aCS 2010
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For Classroom discussion only Page 18

19. How Risk Builds in the Portfolio
Fallen Angels
Assets whose marginal risk
contribution was low when the
exposure was taken and risk
on which has increased with
passage of time but not
tracked adequately
Risk
Exposure
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20. So, what is driving banks to look at credit risk
management?
Maintain growth and improve
IMPERATIVE profitability to sustain capital Need to grow
adequacy
Any growth strategy has
Profits inherent risks
•+ Need for striking a
balance between growth,
risks, and profits
Understand the source of
profits and risks
Growth Risks
Need the following :
Understand risk
Understand profits
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21. Traditional Credit Analysis
Credit analysis - the process of making inquiries prior to committing funds
Based on two distinct issues:
Willingness of borrower to repay
Ability of borrower to repay
To this day, banks are far ahead of other players in the core expertise of
analysing credit risk
Classic credit analysis remains the preserve of banks
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22. Key Highlights of a Classic Credit Analysis Process
Based on both subjective and objective elements
Highly dependent on the quality of persons involved
Usually a high variance in the quality of documentation of observations and
analysis across time and persons
It is rather expensive to maintain high standards (read consistency, objectivity,
and accuracy of risk analysis)
The final judgement is often determined by one or a few dominating parameters
and / or officers
IM aCS 2010
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For Classroom discussion only Page 22

23. Drawbacks of Classic Credit Analysis
Too expensive to maintain - training and retention costs of several
experts getting out of hand
The general approach was to hold loans to maturity - therefore,
reasonable chance of loans going bad
Increasing competition for lending has forced banks to duplicate skills
and systems
As banks become large, management of complex and subjective
processes is extremely difficult
Limitations of handling concentration risk
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For Classroom discussion only Page 23

24. What is the Quantitative Approach to Credit Analysis?
Use of a quantitative model for measuring credit risk of a particular account
Use of a numerical scoring system to indicate degree of risk
Components of overall risk may be broken down and separately captured
Usually works best with objective data
Advanced techniques used for capturing subjective data
Amenable to further mathematical analysis for use in
Trend analysis
Default prediction
Risk pricing
Securitisation
Leading banks moving towards increased use of quantitative models
IM aCS 2010
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For Classroom discussion only Page 24

25. Positives and Negatives of Quantitative Models
Advantages Disadvantages
High consistency - everyone speaks the Results are only as good as the
same language of risk underlying algorithms
High objectivity - result not influenced
by individual persons Calibration and validation of model
is essential to make it work - this
Can capture trends indicating needs in-depth expertise
deterioration or improvement in risk
profile over time Users tend to substitute their
judgements with such models - this is
Gives insights into components of risk not the intended use of the models
Can compare risks across different
accounts more easily and objectively
Can be used for pricing and portfolio
management
IM aCS 2010
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For Classroom discussion only Page 25

26. Credit – Emerging Value Chain (Originate/Buy and
Manage)
Risk Management Credit
Secondary Market
Derivatives
Issuers/ Portfolio
Borrowers Investment
Product
Loan Origination / Structuring /
Client Management Securitisation
Servicing
IM aCS 2010
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For Classroom discussion only Page 26

27. Migration Path for Credit Management
Most banks are at the early stages of credit risk management
Stage 1 Stage 2 Stage 3 Stage 4
Passive Active Semi- advanced Advanced
traditionalists traditionalists practitioners practitioners
Banks that Banks that manage Banks that manage Banks that use
originate and their credit portfolio their credit portfolio very sophisticated
typically hold to by RoE through finer pricing of models for
maturity risks and have greater portfolio
ability in managing management
portfolio wide risk
IM aCS 2010
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For Classroom discussion only Page 27

28. Key Drivers of change in Credit Risk Practice
Regulatory issues
Capital adequacy
Income recognition and provisioning norms
Disclosure norms
Increasing pressure to enhance shareholder returns
Banking is also a commercial business that competes for equity
Not amongst the top bracket growth sector businesses
Emergence of markets for loans
Securitisation
Structured finance
Derivatives
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For Classroom discussion only Page 28

29. DISCUSSIONS
IM aCS 2010
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For Classroom discussion only Page 29

30. All the contents of the presentation are confidential and
should not be published, reproduced or circulated without the
written consent of IFC, Bangladesh Bank and IMaCS.
IM aCS 2010
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For Classroom discussion only Page 30