rmpg learning series crm workshop day 1 session 1

IMaCS 2010Printed 11-May-11

For Classroom discussion only

Agenda for Day 1

Introduction of Participants

Introduction to Credit Risk

Lunch Break

Framework for Credit Risk Management

Overview of Basel Guidelines

Open Session/ Q&A



What is you Bank’s most important risk?

Type of Business Biggest Risk

Commercial Banking Credit Risk

Investment Banking & Trading

Market Risk

Asset Management Operational Risk



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



What is at stake for banks who cannot balance the risk/reward relationship?

Risk Adjusted assets) of 20%)

Their own survival! - Illustrative Example

%

Net Interest Revenues 3.00Plus: Other Income (Fee/FX) 1.00Net Customer Revenues 4.00Less: Direct + Allocated Costs -2.50Net Margin Before Credit Costs 1.50Less: 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%)



The Message

A business must generate

Premium Shareholder Income

of at least1.60%

(i.e. a 20% ROA on 8% capital)

in order

not to erode

Economic Value of Capital



How?

To produce

Premium Shareholder Income

&

long term shareholder value,

banks mustensure

Superior

CREDIT RISK MANAGEMENT



How does your bank currently manage its Credit Risks?

Is your focus on managing:

> individual credit exposures?

or

> a portfolio of credit exposures?



There are 3 opposing forces that challenge credit risk management …..

Credit risk management

Regulators

Higher Returns

Greater Risks

More Capital



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



Banksin the future

Several factors are changing the face of the Banking industry across the globe

Intense

Highly intense

Pressures due toCapital adequacy norms

Medium

Com

peti

tion

for

cu

stom

ers

Relativelymanageable

Time

Banks today

1990 2005 2010

Liberalisation level

Low Medium High

1990 2005 2010

Capital Adequacy pressure

None Medium HighPre

ssur

e on

P

rofi

ts

1990 2005 2010

Competition for business

Medium HighLow



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”



The different compartments of Financial Intermediation have coalesced...

Yesterday

Banking

Insurance

NBFCs

Term Lending

Implications

Liberalised Market

Banking

Insurance

NBFCs

Term Lending

Focus on well-defined target customer groups

Ability to offer a variety of financial products (including new products)

Sophisticated risk management

Ability to use Technology as a competitive weapon

“Must” capabilities for banks



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

• Risk management has become “mantra” to the banking sector

• Introduction of new products & delivery mechanism to meet the customer requirements



The competition in the banking sector is getting intense

Large corporates

SMEs

Retail

Fiercely competitive

Intensifying competition in select segments

Under served

In USA, SMEs became of interest to banks after a recent focus on segmentation showed their profit contribution

Number of entities



5 10 15 20 25 30 35 40

ROE (%)

Rev

enue

s($

BN

)

50

100

200

Small Business

Insurance800

Credit Cards

Mortgages

U.S. Market Size and Profitability

MutualFunds

ConsumerFinance

Source: IFC Symposium, China

Different credit segments generate different market returns - a key driver for portfolio management



A bank should have a three-fold objective to implement Credit Risk Management systems

Maximise the risk-adjusted return on capital by maintaining credit risk exposure within acceptable parameters

Manage the credit risk inherent in individual credits or transactions as well as the risk in the entire portfolio

Manage the relationship between credit risk and other risks

1

2

3



Hold Till Maturity

Conventional credit management practice - (Originate and Hold)

A

S

S

E

T

Obligor

Risk Management

Recovery

A

S

S

E

T

Borrower

Risk Management

Loan Origination / Credit Group

Recovery

Monitoring

/Client Management

/Servicing

/Recovery

Largely restricted to developing /procuring obligor assessment models and laying down loan policy

Obligor evaluation, pricing, management & monitoring Involved

post default



A

S

S

E

T

Obligor

Risk Management

Recovery

A

S

S

E

T

Borrower

Risk Management

Loan Origination / Credit Group

Recovery

Monitoring

/Client Management

/Servicing

/Recovery

How Risk Builds in the Portfolio

Inadequate obligor risk assessment tools

Ineffective monitoring due to incorrect risk perception(Tools/process issue

Correlation between assets. Asset displaying cyclical characteristics not tracked adequately

Imperfect Loan Structuring



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

Exposure

Ris

k



So, what is driving banks to look at credit risk management?

Profits

RisksGrowth

Maintain growth and improve profitability to sustain capital adequacy

Any growth strategy has inherent risks

Need for striking a balance between growth, risks, and profits

Understand the source of profits and risks

Need the following :� Understand risk� Understand profits

IMPERATIVE

•+

Need to grow



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



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



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



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



Positives and Negatives of Quantitative Models

Advantages

� High consistency - everyone speaks the same language of risk

� High objectivity - result not influenced by individual persons

� Can capture trends indicating deterioration or improvement in risk profile over time

� Gives insights into components of risk

� Can compare risks across different accounts more easily and objectively

� Can be used for pricing and portfolio management

Disadvantages

� Results are only as good as the underlying algorithms

� Calibration and validation of model is essential to make it work - this needs in-depth expertise

� Users tend to substitute their judgements with such models - this is not the intended use of the models



Credit – Emerging Value Chain (Originate/Buy and Manage)

Issuers/Borrowers

Risk Management

Loan Origination / Client Management

Portfolio

Investment

Credit Derivatives

Product Structuring / Securitisation

Secondary M

arket

Servicing



Migration Path for Credit Management

Passive traditionalistsBanks that

originate and typically hold to

maturity

Stage 1

Active traditionalists

Banks that manage their credit portfolio

by RoE

Active traditionalists


by RoE

Stage 2Stage 2

Semi- advanced practitioners


through finer pricing of risks and have greater

ability in managing portfolio wide risk

Semi- advanced practitioners


through finer pricing of risks and have greater

ability in managing portfolio wide risk

Stage 3Stage 3

Advanced practitioners

Banks that use very sophisticated

models for portfolio

management

Advanced practitioners

Banks that use very sophisticated

models for portfolio

management

Stage 4Stage 4

Most banks are at the early stages of credit risk management



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



DISCUSSIONS



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.

rmpg learning series crm workshop day 1 session 1

Economy & Finance