Financial Risk Management

CIA 1
Assignment on
Measurement and estimation of credit risk in retail loan portfolio of banks

Submitted By
Rahul Jagwani
1120305
MBA F2

Measurement and estimation of credit risk in retail loan portfolio of banks

Credit risk or default risk involves inability or unwillingness of a customer or counterparty to
meet commitments in relation to lending, trading, hedging, settlement and other financial
transactions. The Credit Risk is generally made up of transaction risk or default risk and portfolio
risk.
Retail loan portfolios are made up of individual small loans, and limited resources are devoted to
analyzing the idiosyncratic risk of an individual borrower. To fully utilize economies of scale
associated with risk assessment, statistical tools (credit scoring), and account management,
retail loans are generally grouped into segments that have homogenous risk characteristics.
In measuring the credit risk of loans and advances to customers the banks should reflect three
components: (i) the probability of default by the counterparty on its contractual obligations; (ii)
current exposures to the counterparty and their likely future development, from which the bank
derives the exposure at default; and (iii) the likely loss ratio on the defaulted obligations (the
loss given default).
The following points briefly describe fundamental measuring frameworks for retail portfolios.
Scorecard Models

Scorecard model development is primarily used for rank-ordering purposes. Scorecards

can include prediction of delinquency, default, bankruptcy, attrition, profitability, and
account acquisition, as the data reflect portfolio risk characteristics.

Scorecard development requires statistical techniques that include logistic/probit

regression, decision tree methods, neural networks, and linear regression.

Macroeconomic information is rarely considered in scorecard modeling, but with some

adjustments, scorecards could be augmented with economic variables to address causal
relationships.

The information about ratings and scoring is widely used at the Bank for the purposes of credit
risk management, the system of credit decision-making powers, determining the amounts above
which independent credit assessment services are activated and in the credit risk assessment
and reporting system.
Risk Pricing - Risk-return pricing is a fundamental tenet of risk management. In a risk-return
setting, borrowers with weak financial position and hence placed in high credit risk category
should be priced high. Thus, banks should evolve scientific systems to price the credit risk,
which should have a bearing on the expected probability of default. The pricing of loans
normally should be linked to risk rating or credit quality. The probability of default could be
derived from the past behaviour of the loan portfolio, which is the function of loan loss
provision/charge offs for the last five years or so. Banks should build historical database on the
portfolio quality and provisioning / charge off to equip themselves to price the risk. But value of
collateral, market forces, perceived value of accounts, future business potential,
portfolio/industry exposure and strategic reasons may also play important role in pricing.
Flexibility should also be made for revising the price (risk premia) due to changes in rating /

value of collaterals over time. Large sized banks across the world have already put in place
Risk Adjusted Return on Capital (RAROC) framework for pricing of loans, which calls for data on
portfolio behaviour and allocation of capital commensurate with credit risk inherent in loan
proposals. Under RAROC framework, lender begins by charging an interest mark-up to cover
the expected loss expected default rate of the rating category of the borrower. The lender then
allocates enough capital to the prospective loan to cover some amount of unexpected lossvariability of default rates. Generally, international banks allocate enough capital so that the
expected loan loss reserve or provision plus allocated capital covers 99% of the loan loss
outcomes.
Loan Review Mechanism (LRM) - LRM is an effective tool for constantly evaluating the quality
of loan book and to bring about qualitative improvements in credit administration. Banks should,
therefore, put in place proper Loan Review Mechanism for large value accounts with
responsibilities assigned in various areas such as, evaluating the effectiveness of loan
administration, maintaining the integrity of credit grading process, assessing the loan loss
provision, portfolio quality, etc. The complexity and scope of LRM normally vary based on
banks size, type of operations and management practices.
Roll Rate/Markov Chain Models - Roll rate models measure the percentage of accounts or
dollars that "roll" from one stage of delinquency to the next until the accounts meet contractual
default criteria. Individual accounts are not tracked in the model. The stages of delinquency
reflect a pool of accounts at the segment or portfolio level.
KMV portfolio Manager Model
In KMVs Portfolio Manager all three key variablesreturns, risks, and correlationsare
calculated. The return on loan is measured by All-in-spreads which is measured on the basis of
fees paid on loan and spread on loan. The risk of loan reflects the volatility of loan default rate.
On the basis of this unexpected loss is calculated. The expected return on loan and variances
are calculated and then risk and return on the portfolio is calculated.

Estimation of credit risk in retail loan portfolio To estimate the credit risk in retail loan portfolio
the bank may use following measures :Stress Testing Approach - The use of stress testing for risk monitoring has increased
considerably over the last decade. Stress testing a simulation technique used to assess the
strength of a portfolio or a nancial institution under unusual economic conditions emerged as
a powerful tool that was originally used in market risk. Its use has subsequently been extended
into credit risk. To stress test a credit risk portfolio, practitioners focus on the key parameters
that allow the risk of a credit portfolio to be assessed. These parameters, also known as Basel II
parameters, are probability of default, loss given default, exposure at default and asset
correlation.
Internal Ratings Based Approach - Under the Basel II guidelines, banks are allowed to use
their own estimated risk parameters for the purpose of calculating regulatory capital. This is
known as the Internal Ratings-Based (IRB) Approach to capital requirements for credit risk.
The IRB approach relies on a bank's own assessment of its counterparties and exposures to
calculate capital requirements for credit risk. The Basel Committee on Banking
Supervision explained the rationale for adopting this approach in a consultative paper issued in
2001. Such an approach has two primary objectives

Risk sensitivity - Capital requirements based on internal estimates are more sensitive to
the credit risk in the bank's portfolio of assets

Incentive compatibility - Banks must adopt better risk management techniques to control
the credit risk in their portfolio to minimize regulatory capital

To use this approach, a bank must take two major steps:

Categorize their exposures into various asset classes as defined by the Basel II accord
Estimate the risk parametersprobability of default (PD), loss given default (LGD),
exposure at default (EAD), maturity (M)that are inputs to risk-weight functions designed
for each asset class to arrive at the total risk weighted assets(RWA).

Sources
http://www.risk.net/digital_assets/5118/jrmv_assouan_web.pdf
http://2010.lloydsbankinggroup-annualreport.com/business-review/risk-management/Creditrisk.aspx
http://www.phil.frb.org/bank-resources/publications/src-insights/2009/third-quarter/q3si1_09.cfm