A Study On Credit Risk Assessment

Published Date: 02 Nov 2017

A Study on Credit Risk Assessment on SBI and its Improvements.

By

Name: Mayur Ashok Jain.

Enrolment No:12BSPHH010536.

IBS Hyderabad

A Report submitted in partial fulfilment of the requirements of MBA Program of IBS Hyderabad

Distribution List:

State Bank of India

(S.M.E Sector)

Date of submission

01/05/2013

ABSTRACT OF THE WORK TILL DATE:

At the initial stage I made myself clear about banks and banking industry:

A bank is a financial institution and a financial intermediary that accepts deposits and channels those deposits into lending activities, either directly or through capital markets bank connects customers that have capital deficits to customers with capital surpluses.

In general a Bank is "A firm which collects money from those who have spare and lends to those who needs it".

Section 5(b) of the Banking Regulation Act,1949 defines banking as "the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawal by cheque, draft, order, or otherwise".

Section 5(c) of the Banking Regulation Act, defines a banking company as "any company which transacts the business of banking in India."

BANKING INDUSTRY:

The Reserve Bank of India (RBI), being the central bank of the country closely monitors the various developments in the whole financial sectors.

A sound and effective banking system in India can lead to a healthy economy. For the past three decades India's banking system has several outstanding achievements to its credit. Extensive reach to its customers has been one of the most striking achievements. It has extended its arms to the remote places of the country apart from dominating in the metropolitans. The government's regular policy for Indian bank since 1969 has paid rich dividends with the nationalization of 14 major private banks of India. It was in 1786 when the first bank in India was established. Since its inception, banking system in India has undergone three distinct phases.

Early phase from 1786 to 1969 of Indian Banks

Nationalization of Indian Banks and up to 1991 prior to Indian banking sector Reforms.

New phase of Indian Banking System with the advent of Indian Financial & Banking Sector Reforms after 1991.

Phase I

In the year 1786 The General Bank of India was founded. After this Bank of Hindustan and Bengal Bank came into existence. The East India Company established three banks as independent units and called them Presidency Banks and they are: Bank of Bengal (1809), Bank of Bombay (1840) and Bank of Madras (1843). These three banks were amalgamated in 1920 and Imperial Bank of India was established which started as private shareholders banks, mostly Europeans shareholders. Allahabad Bank was set up in the year 1865. For the first time in the year 1894 Punjab National Bank Ltd. was set up by Indians with headquarters at Lahore. Bank of India, Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank of Mysore were found between 1906 and 1913. Reserve Bank of India came into existence in the year 1935. The banks experienced periodic failures between 1913 and 1948, so the first phase witnessed very slow growth. There were nearly 1100 banks. To streamline the functioning and activities of commercial banks, the Government of India came up with The Banking Companies Act, 1949 which was later changed to Banking Regulation Act 1949 as per amending Act of 1965 (Act No. 23 of 1965). Reserve Bank of India was given with extensive powers to supervise banking in India as the Central Banking Authority.

During those days people believed in savings facility with some amount of interest provided by the Postal department since they believed this to be comparatively safer. Public had lesser confidence in banks because more funds were given to traders than common people.

Phase II

Once India got independence government took major steps to reform Indian Banking Sector. In 1955, Imperial Bank of India was nationalized with extensive banking facilities on a large scale especially in rural and semi-urban areas. State Bank of India was established to act as the principal agent of RBI and to handle banking transactions of the Union and State Governments all over the country. Seven subsidiary banks of State Bank of India were nationalized in 1960 and on 19th July, 1969, major process of nationalization was carried out by then Prime Minister of India, Mrs. Indira Gandhi. Fourteen major commercial banks were nationalized. Second phase of nationalization Indian Banking Sector Reform was carried out in 1980 with seven more banks. This step brought 80% of the banking segment in India under Government ownership.

The following are the steps taken by the Government of India to Regulate Banking Institutions in the Country:

ï‚· 1949: Enactment of Banking Regulation Act.

ï‚· 1955: Nationalization of State Bank of India.

ï‚· 1959: Nationalization of SBI subsidiaries.

ï‚· 1961: Insurance cover extended to deposits.

ï‚· 1969: Nationalization of 14 major banks.

ï‚· 1971: Creation of credit guarantee corporation.

ï‚· 1975: Creation of regional rural banks.

ï‚· 1980: Nationalization of seven banks with deposits over 200 crore.

After the nationalization of banks, the branches of the public sector bank India rose to approximately 800% in deposits and advances took a huge jump by 11,000%.

Phase III

During this phase many more products and facilities in the banking sector were introduced in its reforms measure. In 1991, under the chairmanship of M Narasimham, a committee was set up by his name which worked for the liberalization of banking practices. Our country is full of foreign banks and their ATM stations so government has put efforts to satisfy customer’s needs. Phone banking and net banking is introduced. Now the entire system is swift and very convenient and now Time has more value than Money. The financial system of India has shown a great deal of resilience. It is sheltered from any crisis triggered by any external macroeconomics shock as other East Asian Countries suffered. This is all due to a flexible exchange rate regime, the foreign reserves are high, the capital account is not yet fully convertible, and banks and their customers have limited foreign exchange exposure.

Banking can be classified into three categories:

Public sector banks:

Public sector banks (PSBs) occupy approximately 80% of the business in banking industry. PSBs play major role in the banking business because of their extensive reach and availability, number of branches and their offerings. Being a public organization, government holds a lot of responsibility to encourage PSBs to be run on specialized lines to effectively serve its potential clients.

Private Sector Banks:

Post liberalization, RBI has given license to many private sector institutions to carry on banking activities in customer and retail segment. Since then private sector banks has grown manifold and occupies approximately 11 % of the banking business.

Foreign banks:

It has been decades since foreign banks have been operating in India. Operating in India for decades, RBI has issued license to many foreign banks to carry out its operation in India post liberalization. The enlarged presence of foreign banks has increased competition in the banking industry. There has been a phase of transformation in technology to meet the requirements of the customers which has even intensified the competition in the banking industry. Their presence in India has benefited large Indian companies by making foreign currency accessible.

Factors affecting banking industry

Indian economy:

Banking industry is related with the growth of the overall economy of the country. As growing banking industry is because of the growing economy, Economic growth is the major attribute in deciding the life of banking industry. India is one of the fastest growing economies in the world and is expected to grow at a faster pace due to rapid industrialization and diversified growth in services and agriculture industry. It will increase the credit requirements and hence will affect the banking industry. It will provide opportunities to the banking industry to look after the requirements of the corporate and growth opportunities.

Rising per capita income:

The rising per capita income is expected to increase the growth of retail credit. Due to increase in the net disposable income of the people, their willingness to spend is also increasing. Although Indians have traditional mindset towards credit except for housing and other necessities, their increasing per capita income and exposure to new products and changing lifestyle is expected to trigger willingness in taking credit. A study of the customer profiles of different types of banks reveals that foreign and private banks share of younger customers is over 60% whereas public banks have only 32% customers under the age of 40. Private Banks also have a much higher share of the more profitable mass affluent segment.

Financial Inclusion Program:

Rural market is one of the untapped markets and RBI is trying to capture this untapped market and the growth potential by volume growth for banks. Financial inclusion includes providing banking services to the vast untapped sections of the people at an affordable cost in order to attract potential customers. The RBI has taken many initiatives such as Financial Literacy Program, promoting effective use of development communication and using Information and Communication Technology (ICT) to spread general banking concepts to people in the areas who are not at all aware about the banking services. All these initiatives of promoting rural banking are taken with the help of mobile banking, self help groups, microfinance institutions, etc. Financial Inclusion, on the one side, helps corporate in fulfilling their social responsibilities and on the other side it is fuelling growth in other industries and so as a whole economy.

Increasing non-performing and restructured assets:

Slowdown in Indian economy for the past couple of years has affected the banking industry. Due to slowdown, many industries could not turn their business into a profit making activity. As a result, repayment of the credit is difficult. Aggressive lending policy has also turned many loans affecting the banking industry. . Restructuring of assets means loans whose duration has been increased or the interest rate has been decreased. It occurs when the company which has taken loan is unable to pay off its debt. Both of these have impacted the profitability of banks as they are required to have a higher provisioning amount which directly eats into the profitability. The key challenge going forward for banks is to increase loans and effectively manage NPAs while maintaining profitability.

Intensifying competition:

Post liberalization, RBI has given license to many private sector banks and foreign banks to carry on business in financial services, the entrance of these new sectors has intensified competency in banking sector. These days banks are providing many homogeneous services which has resulted in a large number of players in the banking industry and hence intensified competition. Recently, the RBI released the new Banking License Guidelines for NBFCs. As a result, the number of players in the industry is expected to increase in near future. This will intensify the competition in the banking industry.

After clearing the concepts of banking and banking industry I made myself clear to the concept of "Credit Risk Assessment"

In the Indian scenario, credit risk is such a type of risk which cannot be ignored or be avoided. Effective management of credit risk is all the more critical in increasing liberalization and globalization. It is necessary to understand, how credit risk management process works in modern business environment? A credit control system should include procedure for deciding how much credit to take as well as how much to give by setting up certain credit limit. Risk can arise from over exposure to particular bank, a company or a supplier. Credit risk is two ways risk which affects both the counter parties involved in any agreement.

Credit risk management enables the banks, companies, traders to understand the basic information and principle of evaluating and mitigating the credit risk viz. other related risks such as currency, country and political risk, so that it helps in negotiating or arranging credit terms, carrying out proper lending decisions and on line payment In order to minimize the level of bad debts and timely payments. Therefore a balance must be achieved between the risk and return particularly on marginal business.

Credit management is an ongoing cycle; where an organizations frame clear lending policies which play an important role. Credit cycle is the sequence of events from placing of an order by customer to the delivery of the goods or service. The most important factor is the need to keep cash coming into business and to maintain liquidity in order to have sufficient money to pay current expenditure. Speeding up the credit cycle can reduce the level of bad debts.

Organizations (company or bank) important role is to appoint well trained and motivated staff because it helps to establish a strong liaison between credit control staff and the sales force throughout the credit period. There are alternative methods of reducing credit risk to obtain security of payments in order to minimize the magnitude of credit risk i.e. secured methods of payment like paying in advance, letter of credit etc can be beneficial.

A loan or course of non repayment must be managed through adequate security or guarantee and insurance. Credit insurance protects the holder from non-payment by customer for goods supplied or services rendered.

Various credit risk models which have been developed over a period of years in order to measure or quantify the intensity of credit risk. A credit derivative is a financial instrument which is used to measure the creditworthiness of parties involved. A credit rating agency (CRA) measures the customer’s ability to pay back a loan, and interest rate applied to loans by assigning suitable credit scores by monitoring the risk. Various ratings ranging from AAA to D are assigned depending on the proportion of risk.

Thus these key elements provide a proper framework for managing credit risk and provide a base for understanding the related aspects of credit risk which surely cannot be ignored under any circumstances.

I studied the KYC i.e. Know Your Customer policy of SBI through which I will come to know if the company is operating legally and if it has been registered under various acts under which it needs to be registered. I will also see if the company has important registrations such as Unit Registration Certificate, Pan Card details, Service tax registration, Sales tax registration etc.

I also learned about the Entry Barriers which a company needs to clear before the request for loan is accepted. Entry Barriers comprises of two aspects namely "Compliance of Environmental Regulation" and "Integrity" depending on the nature of the company (Trading or Non-Trading) and its business models (Regular or Simplified) which is determined on the basis of business exposure i.e. exposure over Rs5 Cr = Regular Model and exposure between Rs0.25 Cr to 5Cr = Simplified Model.

Compliance of Environmental Regulations comprises if value statements such as-

Full Compliance of Environmental Regulations as per the Central/State laws.

At present partial Compliance but firm step initiated for full Compliance.

Utter disregard of Environmental Regulations.

Integrity comprises of value statements such as-

Character of Management.

Reliability of Management.

Rumors of Adverse Features.

Repots on conduct/stock audits/periodic inspection.

Corporate governance in place.

Corporate Governance needs fine tuning.

Company is not a defaulter.

Complacency in implementation of Corporate Governance Principles.

Disregard of Corporate Governance Systems.

All these value statements holds certain marks and only if the loan availing company is able to clear the minimum criteria of these barriers the proposal of the company for loan can be considered for Credit Risk Analysis.

I also analysed books of accounts of "Macnons Infratech Pvt.Ltd" this comprise of Income Statements and Balance Sheets of current year past 3 years and forecast of coming years for Credit Risk Analysis. After collection of data I audited the reports and checked if the reports given are true and fair and also check the transparency and adherence to Accounting Standards by the loan availing company. To qualify for the loan facility of SBI easily it has to get a minimum of SB-10 rating. In all there are 16-SB ratings from SB-1 to SB-16, The rating of different slabs of SB are given as follows:

CRA Models

CRA Rating

Comfort/Safety level

SB-1 – SB-3

Highest

SB-4 – SB-7

High

SB-8 – SB-10

Adequate

SB-11 – SB-15

Inadequate/Low

SB-16

Default

From SB-1 to SB-10 the project has a very bright chance to get qualified for loans from bank but sanction is very difficult if SB rating is from SB-11 to SB-15 and on SB-16 the company is not eligible for loan facility.

To calculate the SB rating I understood and calculated different ratios under different risks such as Financial Risk, Business Risk and Management Risk.

Financial Risk comprises ratios such as Total Outside liability/total Net Worth, Current ratio, Return on Capital Employed, Retained Profit/Total assets, Interest Coverage Ratio, PAT/Net Sales, Net Cash Accruals/Total Debt, Average Year to Year growth, Financial Flexibility, Group Risk, Foreign Risk, Future Prospects etc.

Business Risk comprises of aspects such as Competition, Line of Activity and Market Risk, Outlook/Cyclicality, Regularity Risk, Technology, Business Environment, Flexibility in Operations, Vulnerability to Macro-Environment, Distribution Network, Access to resources, User Product Profile, Capacity Utilization, Research and Development/Innovation, Compliance of Environmental Regulation etc.

Management Risk comprises of aspects such Integrity, Track Record/Conduct of Account/Payment Record, Managerial Competence/Commitment/Expertise, Structure and Systems, Experience in Industry, Strategic Initiatives, Length of Relationship with the Bank, Credibility, Ability to manage Change, Succession Plan/Key Person etc. Apart from all these ratios I also need to look in aspects such as Country risk, Industry risk, Political Risk, Economic risk, Currency Risk etc. All these ratios and risks are allotted certain marks which are converted into SB ratings which determine if the company can be given loan or not.

After getting the entire necessary information about SB rating I analysed and interpreted the ratios and also depicted important aspects in the form of table and charts.

NOTE: All the above mentioned details is just the abstract of the work I have done till date for "Macnons Infratech Pvt.Ltd", the actual calculations, analysis and interpretation for "Macnons Infratech Pvt.Ltd" is mentioned and shown in part of "MAIN TEXT" as it should contain detail progress of the project and discussion.

INTRODUCTION:

Risk Management

Risk management, in recent times, has become a home-world in the financial sector. Risk management is the human activity which integrates recognition of risk, risk assessment, developing strategies to manage it, and mitigation of risk using managerial resources. Risk management in banks/ financial institutions is no longer viewed only as a means of staying out of financial trouble, but also increasingly as a proactive competitive tool. The failure of several financial institutions in recent decades heightens the importance of internal risk management best practices and regulatory risk controls.

Credit Risk Management –An Overview

Management of credit risk assumes great importance in environments where there is a predominance of lending in the overall asset portfolio and where credit histories on borrowers and other counterparties are not well documented and are unavailable. Effective management of credit risk is all the more critical in a scenario of increasing liberalization and globalization as a result of which the economic fortunes of banks/financial ’ clientele can and do undergo quick and substantial changes.

Credit Risk Management will enable general bankers, companies, business staff, traders and credit analyst trainees to understand the basic information and principles underlying credit risk evaluation, and to use those underlying principles to undertake an analysis of non financial and financial risks when preparing a credit proposal.

In today's environment of intense competitive pressures, volatile economic conditions, rising bankruptcies, and increasing levels of consumer and commercial debt, an organization's ability to effectively monitor and manage its credit risk can mean the difference between success and survival. It aims to strengthen and increase the efficacy of the organization, while monitoring consistency and transparency.

Definition

"Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (i.e. either the principal or interest (coupon) or both)".

Credit Risk

Credit is both given (by the creditor) and taken (by the debtor). It represents an amount of money that will be paid at some future date, in return for benefits received earlier, such as goods purchased or loans or services obtained. Credit risk is the risk that arises when counterparty fails to perform on an obligation to the financial institutions. It involves both settlement and pre-settlement credit risk for customers across all the products spread across the country. On settlement day, the exposure to counterparty default may equal the full value of any cash flows or a security the institutions is to receive. Prior to settlement, credit risk is measured as sum of the replacements cost of the position, plus an estimate of the bank’s potential future exposure from the instrument as a result of market changes. The first record of credit risk is reported to have been in 1800 B. C .Credit risk mainly includes:

Direct Credit Risk

Counterparty default on on-balance –sheet products e.g. loans or issued debts where the exposure is full face value

Credit Equivalent Exposure

Counterparty default on unaltered off-balance sheet products, e.g. swaps or options, where the credit equivalent exposure is the function of the current market prices

Settlement Risk

Counterparty default on transactions in the process or being settled and where the value has been delivered to the counterparty but not yet received in return

Credit risk can be further extended to include the receiver of credit. For e.g., there could be risk to a buyer or a borrower from the refusal or inability of suppliers and bankers, principally for financial reasons, to supply goods, services or finance that business needs to continue operating. In assessing credit risk from a single counterparty, an institution must consider three issues:

Default probability: What is the likelihood that the counterparty will default on its obligation either over the life of the obligation or over some specified horizon, such as a year? Calculated for a one-year horizon, this may be called the expected default frequency.

Credit exposure: In the event of a default, how large will the outstanding obligation be when the default occurs?

Recovery rate: In the event of a default, what fraction of the exposure may be recovered through bankruptcy proceedings or some other form of settlement?

Two way nature of risk

Credit risk is a two way risk, affecting both counterparties i.e. lender as well as borrower (customer) to an agreement:

For a supplier there could be a risk concerning the customer’s ability to pay, and for the customer there could be some risk concerning the ability of the supplier to deliver in any business or trade

Similarly a lending bank accepts some risk of the customer’s inability to repay the loan. For the borrower, however, there could be a risk of the bank withdrawing its lending facility.

The Risk Reward Trade-Off

When a decision is taken to give credit, there has to be a trade-off between the credit risk and the reward for the lender or credit provider. If a company grants trade credit to a customer the risk of non payment or late payment will depend on the situation and character of the customer. In some or a supplier instances, a customer might take credit with dishonest intent of not paying in most instances, nonpayment or slow payment is caused by:

An inability to pay on time or in full or

A tendency of large corporate or institutional customers deliberately takes credit from small suppliers beyond the due payment date, or even though payment in full will be made eventually.

The proportion of risk is greater than a larger amount of credit risk granted, or when credit is granted for longer periods. The trade –off between risks and return calls for decisions about:

How much credit risk should be acceptable in order to achieve extra sales?

How much to add to the price of an order to compensate for a perceived credit risk?

What credit limits should be, both in total for the company and individually for each of the company’s customers and whether existing limits should be changed, up or down?

In some cases whether to accept or reject a customer’s order. The optimal credit decisions maximize total returns (income) net of the costs of bad debts and delayed payments.

A balance should be achieved between risk and return. When deciding about a proposed transaction, a manager should have an understanding of credit risk involved, comparing the potential losses if the risk is realized with the potential profits from the client transaction. Credit risk varies according to whether the business relationship is with the customer, a bank or a supplier.