Having reached a comfortable asset quality, the worrying factor is how to sustain it. Any deterioration in credit risk could be disruptive. Plans and appropriate strategies are needed to ensure sustained growth of good quality credit.

In assessing credit risk (CR) in business operations, banks normally tend to remain focused on factoring sectoral exposure, outstanding credit, and its risk weights.

However, the dimensions and intensity of credit risk will also depend upon (i) the cost of credit administration (CCA) and (ii) operational risks (OR). CR will depend upon the ticket size of the loan, the rating of the borrower, the tenor of the loan, risk-based pricing, liquidity conditions, etc. The CCA will depend upon the transaction costs in the running and maintenance of loan accounts.

Finally, OR will depend upon the efficiency of people, processes, technology, and systemic controls. The add-on implications of these three factors will ultimately determine the credit risk of the bank.

During the tenure of the loan, the composite CR will be based upon the added CCA varying with the conduct of the loan account, needs of post-sanction follow-up, dealing with the potential downgrade, if any, restructuring loan account (hand holding borrowers under stress) as and when needed and costs of impediments on way to maintaining the loan account.

Similarly, the lending operations will also depend upon the extent of added OR due to people’s decisions going wrong and systemic controls failing to retain the quality of assets. In the credit portfolio, if any loan account slips to the non-performing category, the CR increases. Thus, the CCA will include a host of such uncertain embedded costs difficult to decipher before the end of the lending contract. Therefore, in the given credit portfolio, the comprehensive CR needs to embed CCA and OR.

The composite risks in the lending activity will thus depend upon the ability of the bank to map the granular processes associated with the credit granting and recovery process. Now that the banks have started co-lending operations, the credit risk assessment becomes more vulnerable to many other interdependent factors for which different metrics are to be built.

Mapping credit process

The various borrowing sectors will have different intricate processes in augmenting lead generation, sanction, disbursement, follow-up, and recovery until the lending contract ends. Eventually, after studying the credit processes for some years, banks can arrive at an add-on factor comprising CCA and OR for each sector of exposure that can be loaded onto the risk-based pricing. It will then make credit risk reading complete and comprehensive.

The regulatory risk weights are common to all banks but exposure, lending schemes, features of loan products, target group of borrowers, processes and delivery methods, and conduct of loan accounts that build up the integrated risk of credit portfolio will be specific to banks.

It is up to the bank to carve out its comprehensive credit risk, set its risk appetite, and follow risk-based pricing products, and transaction costs.

Banks should therefore go beyond traditional credit risk assessment to precisely make it more comprehensive and inclusive, factoring CCA and OR emanating from the credit portfolio. Then banks can plan how to mitigate CR not only by exposure management but also by looking at the implications of ticket size, overheads, and operational risks.

Banks can align the ticket size of loans, sectoral exposure, and time of credit expansion with their own SWOT analysis fitting to their internal competencies.

In carving out a balanced credit portfolio, banks should plan to reduce the load of CCA and OR to bring about overall efficiency.

The writer is an Adjunct Professor, Institute of Insurance and Risk Management – IIRM Hyderabad. Views expressed are personal

comment COMMENT NOW