Changing credit risk profile in banks

Credit Risk Management (CRM), as is understood and practiced following its introduction in Basel I way back in 1988, is fast undergoing seminal changes more so after Global Financial Crisis (GFC) - 2008.

Both the perception of operational teams at the banks and entrepreneurs’ way of availing credit from banks have changed. The just in time inventory and quest to reduce holding cost of stocks in warehouses have changed credit needs of  entrepreneurs. Technology has narrowed the time gaps, communication is faster, markets are better integrated, and arbitrage opportunities are short lived.

Credit rating assessment, repayment history, operating business cycles and consumer preferences are fast changing. Accordingly the manufacturing units have realigned the production cycles to fine tune costs. These developments have a bearing on the risks that the entrepreneurs are taking which gets transmitted to banks. Understanding business of borrowers is significant to mitigate risks. The risk assessment and credit appraisal systems used in lending for projects and processes have to be realigned to make CRM a more robust device to mitigate risks.

Traditionally credit risk is defined as the risk that a counter-party may fail to perform fully or partially its financial obligations that can arise from multiple activities across sectors. For example, credit risk  could arise from the risk of default on a loan or bond obligation, or from the risk of a guarantor, credit enhancement provider or derivative counter-party failing to meet its obligations.

Even change in the operational intricacies of underlying borrowers can have a telling impact on heat map of credit risk and hence banks need to track the way business is done by constituents so that appropriate ring fencing is possible.

1: Increased credit risk sensitivity:
Propelled by the experience GFC-2008, regulators, banks, non-banks have improved their management of credit risk in areas such as governance and risk reporting. Risk aggregation has also become more sophisticated since the financial crisis. Regulatory requirements such as the Basel framework and stress testing have been the significant driver in improving modelling outcomes. Banks have highlighted increased reliance upon stress testing using their internal models based on data analytics.

Against this background, it is necessary for banks to be cautious and assess the extent of risk inherent in the new dispensation and realise that some CRM strategies or regulatory capital models could mask increased risk-taking.

In the current low interest rate environment, there is a ‘search for yield’ by some constituents across sectors. This manifests itself in an increase in their risk tolerance in a variety of different products such as auto lending by banks, increasingly risky assets in the investment portfolio for life insurers, and the syndicated leveraged loan market. Lower-quality assets with lower-rated counterparties could  generate more credit risk.

2: Diversification of credit deployment:
Wide ranging large size exposure to loan products tends to increase incipient risk that can manifest in a greater measure. Credit risk results from lending products such as traditional bank lending and direct lending by non-banks. Banks should take cognisance the most traditional product in the banking sector, loans to the corporate sector are one of the largest sources of credit risk. In loans to small and medium-sized enterprises, the risk concentration is dissipated and more so when it comes to retail lending.

With diversified lending products and due to competition, even the terms of sanction are aligned to the markets. Non funded facilities like letters of credit and guarantees have become more vulnerable to risks. In case of funded assets, only the portion of delinquent loan, if paid can upgrade the loan assets whereas in case of non-funded loans, the entire facility becomes due in one go. While pursuing product diversification, banks should be watchful in articulating asset mix in such a way that the risk is mitigated with best possible combination of loan products.

3: Credit valuation adjustment (CVA):
Looking to the change in riskiness of credit due to; (i) Changing product diversity, (ii) Demand for competitive pricing and finer terms of sanction of loans, (iii) Demand for lesser ‘skin in the game ’margins of borrowers, (iv) Enhanced concentration risk due to rise in group and single borrower exposures, and (v) Changing production/ business models of entrepreneurs is leading to seminal changes in CRM profile.

Taking these factors into account, Bank for International Settlement (BIS) has introduced the concept of Credit Valuation Adjustment (CVA) as an effective tool to mitigate credit risk in its Basel III  framework. CVA is known to be the arithmetical difference between default-free value of counter-party (net worth of borrower) and risk adjusted market value of counter-party (net worth of borrower) representing the probability of erosion in the ability of counter-party to honor bank’s commitments. Thus the concept of CVA as an additional risk measure can be used by banks to mitigate risks.

According to Basel III, ‘Banks will be subject to a capital charge for potential markto- market losses (i.e. CVA risk) associated with deterioration in the creditworthiness of a counter-party. While the Basel II standard covers the risk of a counter-party default, it does not address such CVA risk, which during
the financial crisis was a greater source of losses than those arising from outright defaults’. CVA risk is the risk of mark-tomarket losses due to a degradation of the credit spread of the counter-party.

Globally regulators and regulated entities (banks) identified the importance of taking CVA risk into account. As a consequence, banks have to actively manage CVA in general, and some have set up a dedicated CVA as a systemic control device to centralise the CRM operations with the help of CVA  determinant. This can prevent devolving counter-party risk on banks.

4: Risk Mitigation:
CVA needs a close monitoring of borrowers standing in the market. Once CVA factor of counter-party borrowers is captured, the next move of banks should be to align exposure by shedding part of it to keep risks well balanced but it may not practically be possible to do so. Alternatively more capital is needed to counter upside risk of CVA.

Hence, Basel regulations suggest increased use of margin as a tool for risk mitigation. Therefore CVA calls for a close monitoring of value of underlying collaterals so that the margin is able to absorb the increased risk represented by variations in the value of CVA. Margin should be the collateral used to de-risk against counterparty credit risk.

Assessment of CVA and margin values of counterparty needs robust market intelligence and data analytical tools to constantly tap the status of large value borrowers depending upon the size and composition of loan portfolio. Living up to the real time monitoring of borrower status both in terms of performance and change in net worth will be critical to improve quality and timeliness of CRM. 

Compromise in time or means of assessment of counterparty can impinge upon the risk management capability of banks. In this league, risk management strategies of borrower firms assumes equal significance.

Borrowers must be persuaded and monitored to keep their risks within manageable range so that banks can be assured of better CVA outcomes. Banks have to upgrade their CRM strategies by better fusion of technology and market intelligence to guard against devolvement of CRM.

(The author is the Director of National Institute of Banking Studies and
Corporate Management – NIBSCOM, Noida, India. The views are his own)