“CREDIT RISK MANAGEMENT IN BANKS WITH REFERENCE TO

CANARA BANK LTD.”

NATURE OF BANKING BUSINESS

Whether it's operating capital or financing loans that are ' term' in nature the ability to access

'OPM' (other people's money) remains a constant challenge for the business owner and

financial manager. You don't necessarily need a business plan when it comes to sourcing

financing, but you do require what we could simply call a clean loan package when it comes

to accessing chartered bank capital. We spend a lot of time with clients on the subject of

choosing the right bank. Invariably we think they have got it wrong. They're focusing on a

logo as opposed to choosing the best business banker that suits their needs. Truth be told the

owner/manager has an easier ob than our counterparts searching for the right business

finance solutions. Our system has it narrowed down to a handful of chartered banks and

occasionally a Credit Union or Non Schedule a bank. In the myriad of banks within their

system make it challenging - they have to rationalize ' money center banks ', 'Savings and

Loans ', 'Regional Banks ', Community Banks,' etc.

There's a tremendous difference between retain banking and commercial banking. It's

important to focus on the services of commercial bankers, as the lines can easily blur in the

SME sector around how business financing is collateralized. We constantly stress to clients

that it's important to separate their personal and business finances when it comes to operating

and growth capital. We meet many owners who tell us they have a business line of credit.

They're quite surprised when we demonstrate to them that the ' business financing ' that they

have in place is essentially lending based on their personal assets and personal credit history.

There are some key factors in choosing bank business loans and financing. Focus on the

relationship, not the fees. Revolving lines of credit are key to any growing firm's success.

They help balance out the investment you make in A/R, receivables, equipment, etc. One of

the truest maxims in business banking is that banks only lend generously when your firm

needs the funds the least. So here the concept of putting revolving credit facilities in place

when you might not necessarily need them is critical. The 4 C's of credit remain a true

constant in lending. They are especially true in the SME sector, and they are character,

capacity, credit, and collateral.

The field of economics can provide some insights for all of us when it comes to determining

the impact of recent banking problems on our overall economy and society at large.

However finding practical business solutions by using economics might prove to be more

elusive because of government and political barriers which effectively prevent the economy

from operating in a natural manner. For example, when businesses other than banks fail in

one way or another, they must typically stop operating and liquidate their companies via

bankruptcy or other legal processes. In contrast banks in the United States are not permitted

to be "normal businesses" in this regard and are kept afloat by a variety of artificial

government financial supports.

Banking problems are certain to produce a continuing drag on the economy. The recent crisis

involving banks has impacted other economic sectors such as real estate and automobile

manufacturing, and there are very few possibilities for a healthy economy while banks

continue to be as unhealthy as reflected in the above statistics. Meanwhile business owners

and managers are required to find ways to conduct "business as usual" in the face of bank

problems that make it difficult to do so. Some of these problems will cause a continuing

erosion of the overall economy if they remain unsolved.

Bankers worldwide recognized the risks associated with lending from the early days of

banking operations. They were able to manage the credit risks by their personal involvement

since the operations were limited and restricted with huge expansion with different products

introduced in the banks it is beyond the control of Individual personal to mitigate the risks

involved in credit. No scientific Risk Management processes were evolved for managing the

risks. However, the later half of 20th century and more particularly in the late 90s banking

operations witnessed significant changes such as advances in technology, closer inter-

relations among economies of various countries.

COMMON RISK FACED BY BANKS

There are certain risks involved in every business and these can often be detrimental to the

success of that business. That is why it is important to determine such difficulties well in

advance. Risk management refers to the approach or the logical process of eliminating or

minimizing the difficulties that are involved with the various business operations. The

process is designed to identify any situation that may damage the company’s resources

including funds, staff and so on. Once the problems are figured out, professionals would

have to take measures to get rid of them. To simplify, risk management is the process where

various business difficulties are identified, assessed and prioritized. Once this awkwardness

has been identified, the managers will create a plan for minimizing or eliminating the impact

that various negative events can have on the business. Different businesses have different

kinds of hazards associated with them and depending on the particular business and the

specific hazards, risk management strategies are created. Certain standards are followed

when creating these strategies. There is a certain level of uncertainty within every business

organization and the strategies focus on managing the uncertainties. In order to create

effective strategies, managers will have to evaluate the ways the company’s resources are

being used presently. In this step, they will have to thoroughly understand the process of

production and how it is related to the manufacture of services and goods for the customers.

Once they get a clear picture of how the organization works, they will be able to move

forward and refine the process so that the uncertainty factor can be managed. A business

may involve different kinds of difficulties that need to be mitigated. Effective risk

management strategies can help an organization achieve this goal. Some of the common

difficulty factors include workplace accidents, fires, earthquakes, tornados and other natural

disasters. There may also be some legal problems involved. There may be other related to

the business practices. These include uncertainty in the financial markets, credit risks,

failures in projects, difficulties related to storage and security of data records.

The primary goal of risk management is to protect the company from being vulnerable. For

many businesses, risk management strategies focus on reducing financial imminence and

keeping the business viable. However, these strategies also aim at protecting customers,

employees and the general public from events such as acts of terrorism and fires. Imminence

management strategies may also include practices that preserve data, records, physical

facilities, and physical assets that the company uses or owns. If you are thinking of

becoming a risk manager and want to help companies reach their business objectives by

reducing bad situations, you would need to decide which sector of the professional field you

want to work in. Managers may be required in various fields such as IT, insurance,

healthcare, investment banking and finance.

When more than 70% companies, fail to meet the requirements of the clients, at we not only

provide assurance to you but also incorporate Synergy in it that makes it much more

customize for the client to use it. In times of Risk, banks due its strong understanding of

ERM approaches governance framework were we are well positioned to support

organizations in putting a business focused Risk and Governance framework in place. Thus,

by making use of the Risk framework we support clients in developing and implementing an

integrated Risk management approach which involves three steps:

Risk Evaluation that is to analyze the Risks which possibly could affect the business and

trying to study the risk in detail so that the perfect solution can be formed.

Risk Response that includes forming the solution to the Risk in order to avoid it not only

while it is affecting but also for the future possibilities.

Risk Governance which means, even after proper measure have been taken up to address

and respond to the risk effectively, it is necessary to govern over the fact that it does not

crop up again to pose as a threat in the future.

CREDIT RISK FACED BY BANKS

Every bank employs a proper system for rating the credit risk related to the industrial and

institutional loans. Lenders use risk-rating assessments in approving credit, portfolio

observation, evaluation and profit analysis, setting loan-loss reserves and allocating capital.

Information of a firm's risk rating will give house owners and managers. Internal business

loan risk rating systems are getting a progressively necessary part of huge industrial banks

activity and management of the credit risk of each individual exposures and portfolios. we

have a tendency to use the range of current apply to illuminate the relationships between

uses of ratings, totally different choices for scoring system style, and also the effectiveness

of internal rating systems. Growing stresses on rating systems build an understanding of

such relationships necessary for each banks and regulators. In the past few years, there are

many developments within the field of modeling the credit risk in banks' business loan

portfolio management. Credit risk is actually the chance that a bank's loan portfolio can lose

price if its borrowers become unable to pay back their debts. Arguably, credit risk is that the

largest risk round-faced by industrial banks, since loans and alternative debt instruments

represent the majority of their assets.

Credit Risk management methods ought to mirror the character and complexness of the

institution's participation in retail payment systems, together with any support they provide

to clearing and settlement systems. Management ought to develop risk management

processes that capture not solely operational risks, however additionally credit, strategic,

liquidity, legal, and reputational, compliance risks, notably as they have interaction in new

retail payment merchandise and systems. Management ought to additionally develop an

enterprise wide read of retail payment activities because of cross-channel risk. These risk

management processes ought to take into account the risks display by third-party service

suppliers. For portfolio risk management, an application service supplier delivered platform,

permits you to deal with the general risks and opportunities among your loan portfolio

management. Get a whole read of the credit and operational risk related to a credit

relationship or a portfolio phase. Monitor and track unjust steps by investing each internal

and external knowledge.

CREDIT RISK MANAGEMENT PRACTICES

The position of a business in the market both locally and globally will to some extent depend

on how efficient the owner's business risk management practices are; managing business

credit will have its effects felt in the overall running of the business. Hence, good credit risk

management can otherwise be seen as a process that undergoes a phase by phase course. The

management should really focus on how to handle or mitigate business credit risk in a

systematic manner, taking time to evaluate things in each phase. One can decide to place all

the phase into one screening process and though this will give results, they may not

necessarily be the ideal results to capitalize on when dealing with credit risk. Hence, the

need to break down each phase and handle issues that pertain to it effectively before moving

to the next. The basic principal is that the phase will have a lead role, where the first lead in

the second, and the second to the third and last phase of effective risk management.

Collection of important data or information that pertains to credit is always the first thing all

credit handlers demand for; however, many managers will only look at this from just one

angle. They will scrutinize the information to see if it checks out, failing to consider other

factors such as the source of the information. Sometimes manager fail to see the importance

of recognizing the various elements of importance when handling a customer's credit file or

previous reports that may also be relevant information. Hence, recognition of the relevance

of information or credit data is an important first phase of effective business credit risk

management. Evaluation is the next phase of risk management in which the credit date

collected is carefully evaluated to identify the risk. Not only just that, but evaluation of

information will also measure the severity of the risk enabling the management to know with

mitigation measures to deploy. Evaluation of credit and related risks will also help the

management know how to deal with the subsequent results of the steps taken when

addressing the noted risks. This also makes it easier to give the business a proper footing by

being able to know how to capitalize on some risk, especially those that are considered

inevitable; in so doing lowering their negative impact. In fact, the various measures take to

mitigate, or capitalize on some of the notable risks will be the final phase of effective

business risk management. In this stage the management should be careful as some measure

may be effective when dealing with all risks while some risks need specific mitigation

measures.

Today if you want to maintain and improve long-term financial health of your company, you

need to satisfy your customers, make prudent investments, keep growing further while

controlling costs. The truth is, all customers aren't the same and the key to success is

acquiring profitable, high-value customers and partners as well as making them stay. In this

respect, credit risk management has always been important as it helps understand measure

and mitigate the risk that a company isn't paid back by its customers. How can you assess the

risk and what is the most powerful solution to manage it? Often solutions that manage credit

risk include qualified professionals, information technologies and relevant software. But

company credit reports are the simplest and the most effective way to check the economic

health of new or existing customers. There are a lot of websites which offer these as part of

credit risk management programs. Some of these websites require registration and the

purchase of a pre-paid package whereas others offer their services for a one-off simple

payment. The information as well as the quality of the data used in company reports varies

considerably across the world. Reading and understanding a company credit report is

important for determining a relationship with future clients and suppliers. The common data

used to analyze a company includes the history of filing, court judgments, auditor’s

qualifications and financial measurements. All this data is important for effective credit risk

management as well as generating credit scores. The credit score is calculated daily and is

entirely automated. There's no manual calculation required to manipulate or adjust credit

scores. Scores are updated on a real-time basis. As soon as a company submits its latest

accounts, they're analyzed within forty eight hours and then updated on the database.

Company credit reports are indispensable for credit risk management as they help compile

an opinion on a company's status. They give you all of the information you need in one easy-

to-read report: statutory information, risk information, ownership, balance sheet, cash flow

ratios, growth rates and many others. It's the only way to verify if a company is good to do

business with and make a decision based on the facts and risk assessment supplied in the

report. If there's no credit report available then the company may not have filed accounts and

it's important to exercise caution.

ARTICLE REVIEW

The significant transformation of the banking industry in India is clearly evident from the

changes that have occurred in the financial markets, institutions and products. While

deregulation has opened up new vistas for banks to augment revenues, it has entailed greater

competition and consequently greater risks. Cross-border flows and entry of new products,

particularly derivative instruments, have impacted significantly on the domestic banking

sector, forcing banks to adjust the product mix, as also to effect rapid changes in their

processes and operations in order to remain competitive to the globalised environment. These

developments have facilitated greater choice for consumers, who have become more

discerning and demanding compelling banks to offer a broader range of products through

diverse distribution channels. The traditional face of banks as mere financial intermediaries

has since altered and risk management has emerged as their defining attribute. The

information contained in bank financial statements on the risk management capabilities of

banks and then ascertains the sensitivity of bank stocks to risk management. The paper

interprets the selected accounting ratios as risk management variables and attempts to gauge

the overall risk management capability of banks by summarizing these accounting ratios as

scores through the application of multivariate statistical techniques. Returns on the banks'

stocks appear to be sensitive to risk management capability of banks. The expected coverage

of banking assets and the approach adopted for operational risk capital computation is

compared broadly with the position of the banking system in Asia, Africa and the Middle

East1. A survey conducted on twenty two Indian banks indicates insufficient internal data,

difficulties in collection of external loss data and modeling complexities as significant

impediments in the implementation of operational risk management framework in banks in

India. The reforms have led to the increase in resource productivity, increasing level of

deposits, credits and profitability and decrease in non-performing assets. However, the

profitability, which is an important criteria to measure the performance of banks in addition

to productivity, financial and operational efficiency, has come under pressure because of

changing environment of banking. An efficient management of banking operations aimed at

ensuring growth in profits and efficiency requires up-to-date knowledge of all those factors

on which the bank's profit depends. Accordingly, in this paper we have made an attempt to 1 Rudra Sensarma, M. Jayadev / 2009 / Are bank stocks sensitive to risk management? / Emerald Group Publishing Limited.

identify the key determinants of profitability of Public Sector Banks in India.  The critical

analytics of performance divulges that these markets although are yet to achieve minimum

critical liquidity, almost all the commodities throw an evidence of co-integration in both spot

and future prices, presaging that these markets are marching in the right direction of

achieving improved operational efficiency, albeit, at a slower pace. In the case of some

commodities, however, the volatility in the future price has been substantially lowers than the

spot price indicating an inefficient utilization of information. Several commodities also

appear to attract wide speculative trading. There is increasing concern about the vulnerability

of poor and near-poor rural households, who have limited capabilities to manage risk and

often resort to strategies that can lead to a vicious cycle of poverty. Household-related risk is

usually considered individual or private, but measures to manage risk are actually social or

public in nature2. Furthermore, various externality issues are associated with household-

related risk, such as its links to economic development, poverty reduction, social cohesion,

and environmental quality. An asset-based approach to social risk management is presented,

which provides an integrated approach to considering household, community, and extra-

community assets and risk-management strategies. The concept repositions the traditional

areas of Social Protection in a framework that includes three strategies to deal with risk, three

levels of formality of risk management and many actors against the background of

asymmetric information and different types of risk. This expanded view of Social Protection

emphasizes the double role of risk management instruments protecting basic livelihood as

well as promoting risk taking. The risks associated with outsourcing have been the principal

limitation on the growth of business process outsourcing, especially cross-border outsourcing.

In addition to technological improvements in risk management, it is possible to reduce the

risk of opportunistic behavior faced by the buyer by redesigning work flows and dividing

work among multiple vendors, increasing the range of tasks that are now appropriate

candidates for outsourcing. We provide taxonomy of risks associated with the outsourcing of

business processes. We focus on strategic risks and identify the components of this risk and

the means by which it can be mitigated. The role of risk in determining the cost efficiency of

international banks in eight emerging Asian countries. Researchers consider three distinct risk

aspects under a total of eight risk measures: credit risk, operational risk, and market risk. This

analyzes the marginal effects of all risk measures on the inefficiency effect in order to

2 Richa Verma / 2006 / Determinants of Profitability of Banks in India / Journal of Services Research / Vol. 6, No. 2.

explore a more detailed relationship between risks and efficiency3. A main cause of the crisis

of 2007–2009 is the various ways through which banks have transferred credit risk in the

financial system. We study the systematic risk of banks before the crisis, using two samples

of banks respectively trading Credit Default Swaps and issuing Collateralized Loan

Obligations. After their first usage of either risk transfer method, the share price beta of these

banks increases significantly. This suggests the market anticipated the risks arising from

these methods, long before the crisis. We additionally separate this beta effect into volatility

and a market correlation component. Quite strikingly, this decomposition shows that the

increase in the beta is solely due to an increase in banks’ correlations. Thus, while banks may

have shed their individual credit risk, they actually posed greater systemic risk. This creates a

challenge for financial regulation, which has typically focused on individual institutions.

Internal credit risk rating systems are becoming an increasingly important element of large

commercial banks’ measurement and management of the credit risk of both individual

exposures and portfolios. This describes the internal rating systems presently in use at the 50

largest US banking organizations. We use the diversity of current practice to illuminate the

relationships between uses of ratings, different options for rating system design, and the

effectiveness of internal rating systems. Growing stresses on rating systems make an

understanding of such relationships important for both banks and regulators. We develop a

framework for analyzing the capital allocation and capital structure decisions facing financial

institutions. This incorporates two key features: (i) value-maximizing banks have a well-

founded concern with risk management; and (ii) not all the risks they face can be frictionless

hedged in the capital market4. This approach allows us to show how bank-level risk

management considerations should factor into the pricing of those risks that cannot be easily

hedged. We examine several applications, including: the evaluation of proprietary trading

operations, and the pricing of unchangeable derivatives positions. We test how active

management of bank credit risk exposure through the loan sales market affects capital

structure, lending, profits, and risk. We find that banks that rebalance their loan portfolio

exposures by both buying and selling loans – that is, banks that use the loan sales market for

risk management purposes rather than to alter their holdings of loans – hold less capital than

other banks; they also make more risky loans as a percentage of total assets than other banks.

3 Robert Holzmann / 2001 / Social Risk Management: A New Conceptual Framework for Social Protection / Kluwer Academic Publishers.

4 Dr. Y.V. Reddy / 2005 / Banking Sector Reforms in India / Emerald Group Publishing Limited.

Holding size, leverage and lending activities constant, banks active in the loan sales market

have lower risk and higher profits than other banks. Our results suggest that banks that

improve their ability to manage credit risk may operate with greater leverage and may lend

more of their assets to risky borrowers. Thus, the benefits of advances in risk management in

banking may be greater credit availability, rather than reduced risk in the banking system.

The role of information's processing in bank intermediation is a crucial input. The bank has

access to different types of information in order to manage risk through capital allocation for

Value at Risk coverage. Hard information, contained in balance sheet data and produced

with credit scoring, is quantitative and verifiable. Soft information, produced within a bank

relationship, is qualitative and non verifiable, therefore manipulable, but produces more

precise estimation of the debtor's quality. In this article, we investigate the impact of the

information's type on credit risk management in a principal agent framework with moral

hazard with hidden information5. The results show that access to soft information allows the

banker to decrease the capital allocation for Value at risk coverage. We also show the

existence of an incentive of the credit officer to manipulate the signal based on soft

information that he produces. Therefore, we propose to implement an adequate incentive

salary package which unable this manipulation. The comparison of the results from the two

frameworks using simulations confirms that soft information gives an advantage to the

banker but requires particular organizational modifications within the bank, as it allows

reducing capital allocation for Value at risk coverage. The world financial system

experienced a period of severe crisis during 2007–2009. Many of the factors that have

contributed to the turmoil, such as loose monetary policy or intense competition, have also

been central in previous crises. Key novel elements in the current crisis, however, are the

various ways through which banks have transferred credit risk in the financial system. Banks

traditionally shed only few risks from their balance sheets, such as through loan sales or

credit guarantees. This shedding was mainly limited to credits that were informational less

sensitive, such as consumer credit. In recent years, however, banks have dramatically

increased their risk transfer activities. For one, they have done this through the use of credit

derivatives, and mostly in the form of Credit Default Swaps6. These instruments allow banks

to trade credit risks on a variety of exposures. The markets for credit default swaps have

5 Alwang Jeffrey / 1999 / An asset-based approach to social risk management / The World Bank in its series Social Protection Discussion Papers.

6 Rajiv Ranjan and Sarat Chandra Dhal / 2003 / Non-Performing Loans and Terms of Credit of Public Sector Banks in India / Reserve Bank of India Occasional Papers / Vol. 24, No. 3.

grown tremendously since their inception in 1996, with outstanding volumes estimated at

around US $ 10 trillion before the start of the crisis. Spurred by new financial innovations,

banks have also significantly increased their securitization of assets. Particularly noteworthy

are the Collateralized Loan Obligations through which banks transfer pools of loans from

their balance sheet. While banks have frequently used loan sales to reduce risk in the past,

this new technique allowed banks to shed commercial loans on a large scale. The severity and

the widespread nature of the current crisis indicate that these risk transfer activities have

increased the risks in at least some parts of the financial system. A central question, however,

is how this credit risk transfer has affected the banks that used it to transfer away risk. After

all, the main rationale behind credit risk transfer is that it allows fragile financial institutions

to move risks to less fragile institutions and to diversify away concentrated exposures. It was

mainly for these reasons why regulators initially endorsed these activities. If even these

institutions did not benefit, there are important implications for the overall stability

assessment of the new credit risk transfer activities. In a static sense, a properly done transfer

of risk should of course reduce the banks’ risks. However, banks are likely to respond to any

reduction in their risk. This may be through various methods, such as by increasing their

lending, by reducing their monitoring and screening efforts or by leveraging up their capital

structure. Banks’ responses may also go beyond a pure offsetting of the risk that they have

shed. This may be, for example, because the new credit risk transfer methods provide banks

with effective risk management techniques7. Better risk management generally allows banks

to operate with riskier balance sheets. Additionally, these new instruments may make banks

less averse to crisis situations. This may further encourage risk-taking at banks. Banks may

also end up being riskier because they fail to effectively transfer the risk. This may be

because a bank keeps the riskiest tranche in a securitization or because of guarantees given to

securitization vehicles. credit risk transfer may also increase bank risk in a systemic sense,

even if banks’ individual risk does not increase. This is because securitization allows banks to

shed idiosyncratic exposures, such as the specific risk associated with their area of lending.

The idiosyncratic share in a bank’s risk may also be lowered because banks may hedge any

undiversified exposures they may have by buying protection using credit default swaps, while

simultaneously buying other credit risk by selling protection in the credit default swaps

market. Banks may thus end up being more correlated with each other. This may amplify the

risk of systemic crisis in the financial system, since it increases the likelihood that banks

incur losses jointly. Securitization typically also exposes banks to greater funding risk. Such 7 R.S. Raghavan / 2003 / Risk Management in Banks / Chartered Accountant.

risks are mostly systemic in nature, as current events have shown, since the markets for

securitized assets and the markets for funding those assets may collapse. For example, the

problems for securitization vehicles to refinance themselves during 2008 forced banks to

provide liquidity lines to these vehicles or take assets back on their balance sheet. Banks

additionally suffered because, due to the breakdown of the securitization market, they were

no longer able to sell the assets they had originated for securitization purposes. Effectively,

banks found risks they transferred away flowing back to their balance sheets. we explore

some of the aspects of the relationship between credit risk transfer activities and the riskiness

of banks. For this we focus on bank risk as perceived by the market through bank share

prices. We analyze a sample of banks that started trading Credit Default Swaps and a sample

of banks that issued Collateralized Loan Obligations between 1997 and 200688. As a possible

explanation of this risk increase, found that a bank increases its loan-to-asset ratio subsequent

to the first issuance of a collateralized loan obligations. Conclude that bank loan growth leads

to higher bank risk, including a worsening of the risk-return structure and decreasing bank

solvency. Shows that US banks which purchase protection using credit derivatives raise their

supply of loans.  Provide evidence that banks increased their risk in response to securitization

by increasing their leverage. Presents evidence that the excess equity return effect of

announcing a new bank loan is mitigated when the lending bank actively trades in credit

derivatives. This suggests lower bank monitoring and hence higher risk-taking. Securitized

assets have a higher probability of default than assets with comparable characteristics that are

not securitized, consistent with lower screening efforts by banks. In a more general

setting, that off-balance sheet activities increase banks systemic risk. Our findings

complement the results of the abovementioned studies, as the identified changes in bank

behavior may also contribute to higher systemic risk.

8 S.M. Lokare / 2007 / Commodity Derivatives and Price Risk Management / Reserve Bank of India Occasional Papers / Vol. 28, No. 2.