Managing bad loans

Written by Arindam Bandyopadhyay | Updated: Sep 3 2014, 14:56pm hrs
Indian banks are facing issues associated with risk management and capital adequacy due to structural increase in their non-performing assets (NPAs) resulting in write downs and losses. Credit risk is the largest element of risk in the books of most scheduled commercial banks (SCBs). Therefore, a robust credit risk management system must be established in banks that should enable the top management to know how much credit risk to accept for strengthening the bottom line. Banks should have a keen awareness of the need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred.

The internal rating-based (IRB) approach is one of the most innovative elements of the New Capital Adequacy Framework (NCAF) stipulated by RBI. It allows banks themselves to estimate certain key risk elements in the calculation of their capital requirements against credit risk.

Of the 17 SCBs that had applied for adopting the IRB standards, RBI has considered only four important nationalised banks and three leading private sectors banks to work together as parallel (in 2013-15). It has two stages: Foundation Internal Rating-Based Approach (FIRB) and Advanced Internal Rating-Based Approach (AIRB).

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Under FIRB, banks are allowed to develop their internal empirical model to estimate the PD (probability of default) for their obligors. Other factors like loss given default (LGD) and exposure at default (EAD) will be given by the regulator. Under AIRB, banks will have to use their own quantitative models to estimate all risk elements required for calculating the risk-weighted asset (RWA). Then total required capital is calculated after multiplying the estimated RWA by 9%.

Under the IRB approach, banks must categorise banking-book exposures into broad classes of assets with different underlying risk characteristics. The classes of assets are corporate, sovereign, bank, retail, and equity. Within the retail asset class, three sub-classes are separately identified. For every asset class, banks need to internally develop rating models that provide frequent updates and early warnings of changes in borrowers credit quality including default. The rating models must look at borrower character, capital structure, capacity to pay, collateral attached to the loan and business cycle conditions to predict future default risk. Internal ratings allow to measure credit risk and to manage consistently a banks credit portfolio. Robust data management process to develop internal rating models (corporate, SMEs, retail, etc), testing these models predictive power on a regular basis, incorporating model outputs in business decision-making are the prerequisite for adoption of the IRB approach.

The accompanying table documents the portfolio credit risk position of major SCBs. A sharp increase in NPAs and restructuring of loans has already alerted the SCBs to improve their credit risk management process. The unexpected default risk has gone up due to economic slowdown and poor management of credit risk. This effect has been clearly captured by default volatility and asset correlation metrics. The higher the value of default volatility and asset correlation, the greater the chance that credit portfolio of the bank is more prone to systematic risk.

A better credit appraisal method backed by a powerful credit scoring model and prudent monitoring and sound risk capital analysis would enable banks to better handle the crisis period. Recently, European regulators and analysts are using a traditional American bank metric called Texas Ratio (non-performing loans to cash and equity ratio, if it is greater than 100, then it is alarming) as a guide to check their capital problems due to bad loans. We have also estimated return on risk weighted assets (RORWA) for 15 SCBs in India. RORWA helps us determine if a financial entity has the right balance between capital, returns and risk. The higher the ratio, the better the banks ability to balance shareholders return as well as its tier 1 capital adequacy ratio. It is a powerful risk measurement metric that assist banks and FIs both in measuring solvency and evaluating performance of different lending activities. Risk-based pricing and alignment of capital will increase productivity in banks business through optimum and efficient decision-making.

Further, a survey of 10 banks was conducted at NIBM to understand the preparedness of Indian banks in implementing the IRB approach. The survey suggests that even though banks are eagerly planning for IRB implementation, the preparation level is skewed. Some banks still depend on external vendor provided models whereas few others have their own customised models. Moreover, data storage and pooling is another issue that needs to sort out internally by most banks. Many banks do not have rating-wise PD history even for five years. Unlike corporates, update of ratings of retail loans is not done regularly and banks do not study the credit behaviour of customers. Developing LGD and EAD prediction models and their usage in taking credit decisions, portfolio monitoring, loan limit setting, and risk-based pricing are also not commonly practised in public sector banks. However, top managements of few leading banks think that the major incentive for moving into the IRB process is rewarding, since increased sophistication in the risk assessment process will provide business advantages.

Some implementation challenges for adopting IRB capital rule as prescribed by RBI are data challenges (PD data at least for the last five years, exposure facility data and limit utilisation and LGD data for last seven years needs to be collected and maintained); model validation (banks must validate the accuracy and consistency of their internal models); developing skill sets (a big challenge is developing risk management infrastructure, systems, HR skills, etc); and involvement of top management (necessary for incorporating model outputs in business decision-making).

Integrated implementation of Basel II advanced approaches in banks with wide geographical coverage is a challenge. IRB seeks to differentiate risks on an asset-by-asset level (rating-wise, exposure-wise, industry-wise, region-wise). The risk differentiation will add more transparency to the decision-making process at many levels in the bank. Banks will also have to put in place early warning systems (studying the movement of NPAs, frequent rating updates, studying the credit line usage pattern) to prevent NPAs. Regulators, thus, expect that banks should view IRB compliance as an investment rather than mere compliance. This will also make them more resilient to any macroeconomic downturn. The IRB system, if adopted properly, will make the banks top management aware of the inherent risks in the business activities. They can use this knowledge to gain competitive advantage and enhance the shareholder value.

The author is associate professor, Finance, National Institute of

Bank Management (NIBM), Pune. Views are personal.