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M. K. Nanjunda

Any book on risk management for banks lists risks to be managed by a bank by the dozen. However, the single most important risk to be managed was, is and will be the “credit risk”.

While there is unanimity in this assertion, systems and procedures for the appraisal, measurement and monitoring of credit risk have undergone radical changes in recent times. The advent of information technology has made a significant impact on the w ays of measuring credit risk by banks.

Consider a conventional, conservative banker who aims to make the right decision every time, based on acquired experience, analysis of repayment capability and personal knowledge of the customer. He assumes personal responsibility for the credit decisions.

On the other hand, today, bankers take a collective view at portfolio level on the aggregate credit risk/default levels acceptable and aim to charge a risk premium to cover probable losses indicated by credit scoring models.

With today’s dynamic credit scoring approach, lending decisions, , taken according to pre-set formula aiming to achieve estimated profit margin after providing cushion for default risk, remain impersonal. One can certainly say that this approach has caught on in the retail loans segment .

A credit risk measurement system which can be relied upon to generate pre-set level of exposures/profit margins will be attractive to bankers when other not easily predictable risks are clamouring for ttention.

For instance, market risk, operational , systems and reputation risks receive more attention as these risks are not amenable to be managed on formula-based approach. Hence if credit risk can be contained within predictable outcome, formula-based approach is likely to be favoured by both the regulator/regulated.

Basel – II advancement in credit risk measurement bears testimony to the above statement. The approach has now become distinctly more science-(or math) oriented. The advanced IRB approach is an example of the transformation in approach to credit risk measurement from subjective to objective, almost bereft of personal judgements.

Supervision/ regulation are also moving towards endorsing the science of credit risk measurement – using analysis of historical patterns on actuarial basis by using scientific technique previously unavailable.

In this scenario, what is the role of senior managers with traditional credit training with its essential element of personal judgement? To determine this, it is necessary to review the ground already covered by science and its future likely gains.

Looking to the retail segment, the portfolio, formula-based approach is in total control in advanced countries and gaining ground in India too, particularly in this decade.

Credit scoring techniques in the retail segment viz. retail loans, credit card business, etc. have enabled massive outreach by banks and cut costs on credit dispensation. The advent of IT has lowered entry barriers in the segment and competition has intensified.

New competitors have entered the market, based on scientifically calculable risk, using cheaper and flexible ways of attracting customer attention. Even constraints imposed by capital have been overcome by securitisation techniques. Thus the move to risk/reward, on a collective basis, as the driver of retail lending decisions is complete.

The natural progression would be to extend the techniques of credit scoring to the small and medium businesses. Nevertheless, progress towards scientific approach is already evident among large corporates.

This looks surprising in view of the complexity of such businesses and density of their published accounts which do not lend themselves readily to the simple common denominator approach which characterises retail personal segment loans.

Here (in the large corporate segment), rating agencies have established themselves as codifiers of credit risk. They succeed in reducing indigestible quantities of data to short-term, long-term credit rankings to enable lenders to take quick decisions.

The reluctance of rated corporates to accept restrictive covenants in loan agreements and their success in negotiating relaxations is an indicator of the power of ratings.

The area where credit rating/scoring is yet to make a significant impact is in the SME segment. SMEs look no further than the banks for their borrowing needs and would not be able to justify the expense of a rating agency’s ongoing analysis.

For the time being, it seems the traditional skills of experienced lending banker still provides the best guarantee of safe lending to this important sector. Serious efforts are on by rating agencies/banks to cover this segment as well.

However, traditionally constituents of this segment are loathe to provide detailed information which the rating exercise entails and it takes quite a while before rating becomes a “ norm” for these firms. Movement in this direction will strengthen, with rated units getting benefits in terms of lower interest rates.

The barriers of entry are the strongest in middle markets where “Know Your Customer” is the mantra for banks. Middle market business thrives on personal relationships and understanding of customers’ business by the banker.

Foreign banks and non-banking competitors have not been very successful in bringing down the dominance of domestic banks in this segment.

It is perhaps a good thing that the formula-based approach to credit risk segment is proving the least practical in this market segment which would prove most damaging for domestic banks when the barriers of entry are lowered.

In summary, credit scoring and advance of rating agencies will narrow the field for application of traditional credit skills.

Today’s banker must be at home with a combination of both approaches, using technology/database and formula for estimating risk/reward matrix and personal judgement for putting these in proper context.

More Stories on : Banking | Insight | Credit Market

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