Project On

“CREDIT DELIVERY MECHANISM IN

INDIAN BANKS & SUGGESTION
FOR IMPROVEMNETS”

Project Guide
Prof. N Krishnamurthy

Submitted By
Kunal.H.Gosalia
MMS Finance
2008-2010
 Certificate

This is to certify that the study presented by Kunal.H.Gosalia to

Thakur Institute of Management Studies & Research in part
completion of MMS Course under “CREDIT DELIEVRY MECHANISM
IN INDIAN BANKS – SUGGESTION FOR IMPROVEMENTS” has been
done under my guidance in the year 2008-2010.

The Project is in the nature of original work that has not so far been
submitted for any other course in this institute or any other institute.
Reference of work and relative sources of information has been given
at the end of the project.

Signature of the Candidate

Forwarded through the Research Guide

Signature of the Guide

Prof. N. Krishnamurthy

2
 Acknowledgement

There are several claimants on my gratitude in the task of preparation

of this Project report on “Credit Delivery Mechanism in Indian
Banks & Suggestions for Improvements”. I would like to extend
my gratitude to my guide Prof. N.Krishnamurthy, without whose
continuous guidance and encouragement this project would not have
been possible.

I would also like to thank Prof. S.Ganga, our Course Coordinator, for
providing the necessary guidance and support, during the preparation
of the project. Also I would like to take this opportunity to thank all the
staff of Thakur Institute of Management Studies and Research
for providing the necessary infrastructure and facilities for helping to
take the project to fruition.

3
 Executive Summary

In India, our environment hitherto was totally regulated and

directed with reference to our industry, banking etc. High tariff walls
due to shortage of foreign exchange and forced restriction on imports,
protected indigenous Industries and created a suppliers' market, where
the consumer had no or very limited choice. Similarly Banks operated
in an atmosphere where everything was directed and controlled
externally (albeit either by RBI or Finance Ministry), the need for
studying risk was never felt. Lack of product-quality in Industry or poor
service and lack of efficiency in service-centers were never felt
seriously, as there was no competition and no alternative choice before
the consumer.

But with dismantling of State control over every sector of

economy, with deregulation (i.e. supply, demand and prices) to shape
on the basis of market forces, Indian Industry and Indian Banking have
now come to face a new challenge. Competition results in the survival
of the fittest. In the liberalized environment, competing with the high-
tech new generation Banks, the erstwhile commercial banks have to
re-orient themselves to the changed situation.

Lending which was the primary function of banking has gained

lot of importance as it determines the profitability of the bank. A bank
can lend successfully only when a borrower’s credit worthiness is
accurately assessed. The method of analysis required varies from
borrower to borrower. It also varies in function of the type of lending
being considered. The lending can differ in the way credit given to
retail customers or corporate customers, secured or unsecured, long
term or short term etc.

4
 For financing a project, bank would look at the funds generated
by the future cash flows to repay the loan, for asset secured lending,
bank would look at the assets and for an overdraft facility, it would look
at the way the account has been run over the past few years. In this
project the appropriate methods of analysis for lending to companies,
known as ‘corporate credit’ is being detailed.

This project is about the credit analysis in banks. The process of

lending, the various analysis involved in giving credit to a customer are
detailed. Focus is on financial ratio analysis, non financial analysis and
different models used by banks in the lending process.

5
 Contents

Sr. No Topic Pg. Nos.

1 Introduction 7 – 10
2 Overview of Credit Analysis 11 – 14
3 Lending Process 15 – 19
4 Financial Statement Analysis I 20 – 24
5 Financial Statement Analysis II 25 – 30
6 Non Financial Analysis 31 – 32
7 Credit Models 33 – 49
8 Conclusion 50-51
9 Bibliography 52

6
 1. Introduction

The significant transformation of the banking industry in India is

clearly evident from the changes that have occurred in the financial
markets, institutions and products. While deregulation has opened up
new vistas for banks to augment revenues, it has entailed greater

7
competition and consequently greater risks. Cross-border flows and
entry of new products, particularly derivative instruments, have
impacted significantly on the domestic banking sector forcing banks to
adjust the product mix, as also to effect rapid changes in their
processes and operations in order to remain competitive in the
globalize environment. These developments have facilitated greater
choice for consumers, who have become more discerning and
demanding compelling banks to offer a broader range of products
through diverse distribution channels. The traditional face of banks as
mere financial intermediaries has since altered and risk management
has emerged as their defining attribute.

Currently, the most important factor shaping the world is

globalization. Integration of domestic markets with international
financial markets has been facilitated by tremendous advancement in
information and communications technology. But, such an environment
has also meant that a problem in one country can sometimes
adversely impact one or more countries instantaneously, even if they
are fundamentally strong.

There is a growing realization that the ability of countries to

conduct business across national borders and the ability to cope with
the possible downside risks would depend, interalia, on the soundness
of the financial system. This has consequently meant the adoption of a
strong and transparent, prudential, regulatory, supervisory,
technological and institutional framework in the financial sector on par
with international best practices. All this necessitates a transformation:
a transformation in the mindset, in the business processes and finally,
in knowledge management. This process is not a one shot affair; it
needs to be appropriately phased in the least disruptive manner.

8
 The banking and financial crises in emerging economies have
demonstrated that, when things go wrong with the financial system,
they can result in a severe economic downturn. Furthermore, banking
crises often impose substantial costs on the exchequer, the incidence
of which is ultimately borne by the taxpayer. The World Bank
Annual Report (2002) has observed that the loss of US $1
trillion in banking crisis in the 1980s and 1990s is equal to the
total flow of official development assistance to developing
countries from 1950s to the present date. As a consequence, the
focus of financial market reform in many emerging economies has
been towards increasing efficiency while at the same time ensuring
stability in financial markets.

From this perspective, financial sector reforms are essential in

order to avoid such costs. It is, therefore, not surprising that financial
market reform is at the forefront of public policy debate in recent
years. Financial sector reform, through the development of an efficient
financial system, is thus perceived as a key element in raising
countries out of their 'low level equilibrium trap'. As the World Bank
Annual Report (2005) observes, ‘a robust financial system is a
precondition for a sound investment climate, growth and the
reduction of poverty ’.

Financial sector reforms were initiated in India two decade ago

with a view to improving efficiency in the process of financial
intermediation, enhancing the effectiveness in the conduct of
monetary policy and creating conditions for integration of the domestic
financial sector with the global system. The first phase of reforms was
guided by the recommendations of Narasimhan Committee.

• The approach was to ensure that ‘the financial services industry

operates on the basis of operational flexibility and functional

9
 autonomy with a view to enhancing efficiency, productivity and
profitability'.
• The second phase, guided by Narasimham Committee II,
focused on strengthening the foundations of the banking system
and bringing about structural improvements. Further intensive
discussions are held on important issues related to corporate
governance, reform of the capital structure, (in the context of
Basel II norms), retail banking, risk management technology, and
human resources development, among others.

Since 1992, significant changes have been introduced in the

Indian financial system. These changes have infused an element of
competition in the financial system, marking the gradual end of
financial repression characterized by price and non-price controls in
the process of financial intermediation. While financial markets have
been fairly developed, there still remains a large extent of
segmentation of markets and non-level playing field among
participants, which contribute to volatility in asset prices. This volatility
is exacerbated by the lack of liquidity in the secondary markets. The
purpose of this paper is to highlight the need for the regulator and
market participants to recognize the risks in the financial system, the
products available to hedge risks and the instruments, including
derivatives that are required to be developed in the Indian system.

The financial sector serves the economic function of

intermediation by ensuring efficient allocation of resources in the
economy. Financial intermediation is enabled through a four-pronged
transformation mechanism consisting of liability-asset transformation,
size transformation, maturity transformation and risk transformation.

10
 2. Overview of Credit
Analysis

2.1 Need for credit analysis

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 Credit analysis is done in order to lessen the credit risk faced by a
bank. Credit risk is defined as the possibility of losses associated with
diminution in the credit quality of borrowers or counterparties. In a
bank's portfolio, losses stem from outright default due to inability or
unwillingness of a customer or counterparty to meet commitments in
relation to lending, trading, settlement and other financial transactions.
Alternatively, losses result from reduction in portfolio value arising
from actual or perceived deterioration in credit quality. Credit risk
emanates from a bank's dealings with an individual, corporate, bank,
financial institution or a sovereign. Credit risk may take the following
forms

• In the case of direct lending: principal/and or interest amount

may not be repaid;
• In the case of guarantees or letters of credit: funds may not be
forthcoming from the constituents upon crystallization of the
liability;
• In the case of treasury operations: the payment or series of
payments due from the counter parties under the respective
contracts may not be forthcoming or ceases;
• In the case of securities trading businesses: funds/ securities
settlement may not be effected;
• In the case of cross-border exposure: the availability and free
transfer of foreign currency funds may either cease or the
sovereign may impose restrictions.

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2.2 Role of credit analysis
The extent of the credit analysis is determined by
 The size and nature of the enquiry,
 The potential future business with the company,
 The availability of security to support loans,
 The existing relationship with the customer.

The analysis determines whether the available information is adequate

for decision making purposes, of if additional information is required.
The analysis therefore covers a wide range of issues.
For evaluating a loan proposal for a company, it is necessary to
 Obtain credit and trade references,
 Examine the borrower’s financial condition,
 Consult with legal counsel regarding a particular aspect of the
draft loan agreement

2.3 Framework of Credit Analysis

Credit analysis includes financial and non-financial factors, and these

factors are all interrelated. These factors include:
 The environment
 The industry
 Competitive position of the firm
 Financial risks the company has
 Management/business risks
 Loan structure and documentation issues.

2.4 Overview of Credit Analysis Process

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 Identify purpose of
loan

Specify sources of
repayment
primary/secondary

Industry
evaluation
Quality of
Cash
management
Flow
forecast Environme
nt
evaluation

Historical
financial
analysis
Security
Key risks evaluation
and
mitigation

14
3. Lending Process

15
3.1 RBI Guidelines for Credit Risk Management Credit Rating
Framework

A Credit-risk Rating Framework (CRF) is necessary to avoid the

limitations associated with a simplistic and broad classification of
loans/exposures into a "good" or a "bad" category. The CRF deploys a
number/ alphabet/ symbol as a primary summary indicator of risks
associated with a credit exposure. Such a rating framework is the basic
module for developing a credit risk management system and all
advanced models/approaches are based on this structure. These
frameworks have been primarily driven by a need to standardize and
uniformly communicate the "judgment" in credit selection procedures
and are not a substitute to the vast lending experience accumulated by
the banks' professional staff.

Broadly, CRF can be used for the following purposes:

1. Individual credit selection, wherein either a borrower or a

particular exposure/ facility is rated on the CRF
2. Pricing (credit spread) and specific features of the loan facility.
This would largely constitute transaction-level analysis.
3. Portfolio-level analysis.
4. Surveillance, monitoring and internal MIS

These would be relevant for portfolio-level analysis. For instance, the

spread of credit exposures across various CRF categories, the mean
and the standard deviation of losses occurring in each CRF category
and the overall migration of exposures would highlight the aggregated
credit-risk for the entire portfolio of the bank.

16
3.2 Types of Credit Rating
Credit rating can be classified as:
3.2.1 External Credit Rating.
3.3.2 Internal Credit Rating.

3.2.1 External Credit Rating:

A credit rating is not, in general, an investment recommendation
concerning a given security. In the words of S&P,” A credit rating is
S&P's opinion of the general creditworthiness of an obligor, or the
creditworthiness of an obligor with respect to a particular debt security
or other financial obligation, based on relevant risk factors.” In Moody's
words, a rating is, “an opinion on the future ability and legal obligation
of an issuer to make timely payments of principal and interest on a
specific fixed-income security.”
Since S&P and Moody's are considered to have expertise in credit
rating and are regarded as unbiased evaluators, there ratings are
widely accepted by market participants and regulatory agencies.
Financial institutions, when required to hold investment grade bonds
by their regulators use the rating of credit agencies such as S&P and
Moody's to determine which bonds are of investment grade.
The subject of credit rating might be a company issuing debt
obligations. In the case of such “issuer credit ratings” the rating is an
opinion on the obligor’s overall capacity to meet its financial
obligations. The opinion is not specific to any particular liability of the
company, nor does it consider merits of having guarantors for some of
the obligations. In the issuer credit rating categories are
a) Counter party ratings
b) Corporate credit ratings
c) Sovereign credit ratings

17
 The rating process includes quantitative, qualitative, and legal
analyses. The quantitative analysis is mainly, financial analysis and is
based on the firm’s financial reports. The qualitative analysis is
concerned with the quality of management, and includes a through
review of the firm’s competitiveness within its industry as well as the
expected growth of the industry and its vulnerability to technological
changes, regulatory changes, and labor relations.

3.2.2 Internal Credit Rating:

A typical risk rating system (RRS) will assign both an obligor
rating to each borrower (or group of borrowers), and a facility rating to
each available facility. A risk rating (RR) is designed to depict the risk
of loss in a credit facility. A robust RRS should offer a carefully
designed, structured, and documented series of steps for the
assessment of each rating.
The following are the steps for assessment of rating:
Objectivity and Methodology: The goal is to generate accurate and
consistent risk rating, yet also to allow professional judgment to
significantly influence a rating where it is appropriate. The expected
loss is the product of an exposure (say, Rs. 100) and the probability of
default (say, 2%) of an obligor (or borrower) and the loss rate given
default (say, 50%) in any specific credit facility. In this example,
The expected loss = 100*.02*.50 = Rs. 1
A typical risk rating methodology (RRM)
o Initial assign an obligor rating that identifies the expected
probability of default by that borrower (or group) in repaying its
obligations in normal course of business.
o The RRS then identifies the risk loss (principle/interest) by
assigning an RR to each individual credit facility granted to an
obligor.

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The obligor rating represents the probability of default by a borrower in
repaying its obligation in the normal course of business. The facility
rating represents the expected loss of principal and/ or interest on any
business credit facility. It combines the likelihood of default by a
borrower and conditional severity of loss, should default occur, from
the credit facilities available to the borrower.

3.3 Documentation - Term Loan Agreement

The loan agreement is the legal document that defines the
relationship between the borrower and the lending bank or banks. The
loan agreement gives the bank the right to terminate the loan
agreement if any of the following events occur:
o Non payment of principal
o Non payment of interest
o Acceleration of other indebtedness (cross default)
o Voluntary or involuntary bankruptcy.
These events are known as ‘events of default’ and the mechanism in
the loan agreement used to control them are known as loan agreement
covenants.

19
4. Financial Statement
Analysis I

20
4.1 Ratio Analysis
Interpreting and analyzing financial statements enables to
discover what a company’s financial position is. Ratio analysis is a
device which is used to
• Compare the performance of a company this year with last year
• Compare the performance of a company with its competitors.
• Detect specific weaknesses
• Determine a company’s liquidity (ability to meet debts)
• Determine a company’s profitability
• Provide an indicator of trends.

Financial ratios can be divided into five categories

4.1.1. Liquidity ratios
4.1.2 Turnover ratios
4.1.3 Leverage ratios
4.1.4 Profitability ratios
4.1.5 Valuation ratios

4.1.1 Liquidity Ratios: Liquidity refers to the ability of a firm to meet

its obligations in the short-run, usually one year. Liquidity ratios are
generally based on the relationship between current assets (the
sources for meeting short-term obligations) and current liabilities. The
important liquidity ratios are:

• The Current Ratio: A simple measure that estimates whether

the business can pay debts due within one year from assets that
it expects to turn into cash within that year.

21
 • A ratio of less than one is often a cause for concern, particularly
if it persists for any length of time.
Current Ratio = Current Assets
Current Liabilities

• The Quick Ratio: Not all assets can be turned into cash quickly
or easily. Some - notably raw materials and other stocks - must
first be turned into final product, then sold and the cash collected
from debtors. The Quick Ratio therefore adjusts the Current Ratio
to eliminate all assets that are not already
Quick Ratio = Current Assets – Stock
Current Liabilities

4.1.2 Turnover Ratios: Turnover ratios, also referred to as activity

ratios or asset management ratios, measure how efficiently the assets
are employed by a firm. These ratios are based on the relationship
between the level of activity, represented by sales or cost of goods
sold, and levels of various assets. The important turnover ratios are:
inventory turnover, average collection period, receivable turnover,
fixed assets turnover, and total assets turnover.

• Stock Turnover Ratio: Stock turnover measures how fast the

inventory is moving through the firm and generating sales.
Inventory turnover reflects the efficiency of inventory
management.
Stock Turnover = Cost of Goods Sold
Average Inventory

• Debtor’s Turnover Ratio: This ratio shows how many times

sundry debtors (accounts receivable) turnover during the year.
Debtor’s Turnover = Net Credit Sales

22
 Average Sundry Debtors

• Average Collection Period: The average collection period

represents the number of days’ worth of credit sales that is
locked in sundry debtors.

Average Collection Period = Average Sundry Debtors

Average Daily Credit Sales

The average collection period and debtors’ are related as follows:

Average Collection Period = 365
Debtors’ Turnover

• Fixed Assets Turnover: this ratio measures sales per rupee of

investment in fixed assets.
Fixed Assets Turnover = Net Sales
Average Net Fixed Assets

• Total Assets Turnover: Akin to the output-capital ratio in

economic analysis, the total assets turnover is defined as:
Total Assets Turnover = Net Sales
Average Total Assets

4.1.3 Leverage Ratios: Leverage ratios help in assessing the risk

arising from the use of debt capital. Two types of ratios are commonly
used to analyze financial leverage: structural ratios and coverage
ratios. Structural ratios are based on the proportions of debt and equity
in the financial structure of the firm. The important structural ratios are
debt-equity ratio and debt-assets ratio. Coverage ratios show the
relationship between debt servicing commitments and the sources of
meeting these burdens. The important coverage ratios are interest

23
coverage ratio, fixed charges coverage ratio, and debt service
coverage ratio.

• Debt – Equity Ratio: the debt equity ratio shows the relative
contributions of creditors and owners.

Debt Equity Ratio = Debt

Equity
• Debt – Assets Ratio: the debt-asset ratio measures the extent
to which borrowed funds support the firm’s assets.
Debt – Assets Ratio = Debt
Assets

• Interest Coverage Ratio: Also called the times interest earned,

this ratio enables to know whether a firm can easily meet its
interest burden even if profit before interest and taxes suffer a
considerable decline or not.
Interest Coverage Ratio = Profit before Interest and Taxes
Interest

• Fixed Charges Coverage Ratio: This ratio shows how many

times the cash flow before interest and taxes covers all fixed
financing charges.
Fixed Charges Coverage Ratio =
Profit before Interest & Taxes + Depreciation
Debt Interest

• Debt Service Coverage Ratio: Used by banks in India, the

debt service coverage ratio is defined as:
Debt Service Coverage Ratio =

24
 Profit after Tax + Dep. + Non Cash Charges + Interest + Lease
Rental
Interest + Lease Rental +Repayment of Loan

4.1.4 Profitability Ratios: Profitability reflects the final result of

business operations. There are tow types of profitability ratios: profit
margins ratios and rate of return ratios. Profit margin ratios show the
relationship between profit and sales. The most popular profit margin
ratios are: gross profit margin ratio and net profit margin ratio. Rate of
return ratios reflect the relationship between profit and investment.
The important rate of return measures are: return on assets, earning
power return on capital employed and return on equity.

• Gross Profit Margin Ratio: This ratio tells us something about

the business's ability consistently to control its production costs
or to manage the margins its makes on products its buys and
sells.
Gross Profit Margin Ratio= Gross Profit
Net Sales

• Net Profit Margin Ratio: This ratio shows the earnings left for
shareholders as a percentage of net sales. It measures the
overall efficiency of production, administration, selling, financing
and pricing.
Net Profit Margin Ratio = Net Profit
Net Sales

• Return on Assets: ROA is an odd measure because its

numerator measures the return to shareholders whereas its
denominator represents the contribution of all investors.
Return on Assets = Profit after Tax

25
 Average Total Assets

• Earning Power: Earning power is a measure of business

performance which is not affected by interest charges and tax
burden. It abstracts away the effect of capital structure and tax
factor and focuses on operating performance.
Earning Power = Profit before Interest and Taxes
Average Total Assets

• Return on Capital Employed: ROCE is the post-tax version of

earning power. It considers the effect of taxation, but not the
capital structure. It is internally consistent.
Return on Capital Employed: Profit before Interest and Tax (1 –
Tax rate)
Average Total Assets

• Return on Equity: It measures the profitability of equity funds

invested in the firm. It’s very important measure because it
reflects the productivity of ownership (or risk) capital employed
in the firm.
Return on Equity = PAT – Preference Dividend
Equity Share Cap. + Reserves & Surplus

4.1.5 Valuation Ratios: Valuation ratios indicate how the equity

stock of the company is assessed in the capital market. Since the
market value of equity reflects the combined influence of risk and
return, valuation ratios are the most comprehensive measures of a
firm’s performance. The important valuation ratios are: price-earnings
ratio, yield, and market value to book value ratio.

26
 • Price Earnings Ratio: The price earnings ratio or the price
earnings multiple is a summary measure which primarily reflects
growth prospects, risk characteristics shareholder orientation,
corporate image and degree of liquidity
Price Earnings Ratio = Market Price per share
Earnings per share

• Yield: this is a measure of the rate of return earned by

shareholders.
Yield = Dividend + Price change
Initial Price
• Market Value to Book Value: This ratio reflects the
contribution of a firm to the wealth of society.
Market Value to Book Value = Market Value per share
Book Value per share

4.2 Historical and Peer Group Analysis

Useful information can be obtained by comparing ratios from the
same company over time (from historical data) or comparing the dame
ratios in similar companies (from industry studies from sources such as
ratings agencies)
The advantage of using historical ratio analysis from the same
company is that the information is easily obtained and directly
comparable. The disadvantage is results may have been influenced by
different economic conditions, different production methods, inflation,
or changes in accounting policies.
For peer group analysis, it is often difficult to find similar
companies with which to make a comparison. Typically a bank
compares the financial ratios calculated on the spreadsheet with
published data, such as lists of industry standard ratios. Another
approach is that banks use the data published by credit rating

27
agencies or financial databases available in the market which enables
the analysis of the company vis-à-vis its competitors.

5. Financial Statement
Analysis II

28
5.1 Cash Flows:
A firm basically generates cash and spends cash. It generates
cash when it issues securities, raises a bank loan, sells a product,
disposes an asset, etc. it spends cash when it redeems securities, pays
interest and dividends, purchases materials, acquires an asset etc. the
activities that generate cash are called sources of cash and activities
that absorb cash are called uses of cash.
Companies can be profitable with negative cash flows and loss
making with positive cash flows. A company can report a large profit
for a year in which the cash balance may have fallen, perhaps as a
result of heavy expenditure on fixed assets. Likewise, a company can
be losing money and generating cash via asset disposals. It is
important to understand that cash and profit are different.
The purpose of cash flow statement is, therefore, to report the
net change in the cash balance and to help explain how the surplus or
deficit in cash arose.

5.2 Components of Cash Flows

Cash Flow from Operating activities + Cash Flow from Investing
activities + Cash Flow from Financing activities = Net Cash Flow for the
period.

5.2.1 Cash Flow from Operating activities

Profit before interest and tax
+ Depreciation

29
 + Non cash charges
+ Changes in working capital
= Cash flow from operating activities

5.2.2 Cash flow from investing activities

Sale of assets
- Purchase of assets
= Cash flow from investing activities
5.2.3 Cash flow from Financing activities
Issue of shares
+ Issue of debentures
+ Raising of loan
- Redemption of debentures
- Repayment of loan
= Cash flow from financing activities

5.3 Summary of cash flow statement

o Reports the financial effect of all transactions during the
accounting period.
o Mixes capital and revenue transactions and is entirely backward
looking.

Cash flow statements are used to

o Assess the long term risks in a lending situation
o Test the assumptions of a given project
o Understand the parameters in a project in order to devise
appropriate security structures and financial ratio covenants in
the loan agreement.

30
6. Non Financial Analysis

31
6.1 Economy Analysis
It is important to do an economic analysis before lending. The
rates are which credit is offered is determined by the demand and
supply of funds in the market. Usually higher interest rates are charged
for loans when there is high inflation in the economy. It is also
important to know the growth rate of the economy because if the
economy grows at a faster rate, the companies also grow at a fast rate
and there is more need for funds.

6.2 Industry Analysis

The industry sector in which the borrower operates has a
significant impact upon the way the business is managed. It also
produces different financing and asset structures in the balance sheet
of the businesses. The terms of trade between the buyer and the seller
in the industry and the methods by which the contract of sale are
controlled will all have and e effect upon borrower’s activity in the
industry and a financial implication in its business.

6.3 Business Analysis

The nature of the market in which the customer operates or in
which its products are sold is important to understand. In investigating
the market the analyst is be able to establish a point of view of both
macro and micro- economic elements that may affect the future of the
debtor or obligor. The potential effectiveness of plans and strategies

32
can be achieved when comparing the obligor’s view of market
compared to independently sourced information. In business analysis,
specific analysis is done by understanding the product, the growth of
the business in which the firm is operating, its corporate strategy and
plans, its business plans and its management.

7. Credit Models

33
7.1 Credit Evaluation
Proper assessment of credit risks is an important element of
credit management. It helps in establishing credit limits. In assessing
credit risks, two types of errors occur:
• Type I error: A good customer is misclassified as a poor credit
risk.
• Type II error: A bad customer is misclassified as a good credit
risk.

Both the errors are costly. Type I error leads to loss on account of
failure to serve a particular client. Type II error results in creation of
Non Performing Asset (NPA) on account of loan given to a risky
customer.

While misclassification errors cannot be eliminated wholly, a

bank can mitigate these occurrences by doing proper credit evaluation.
Three broad approaches are used for credit evaluation, viz. traditional
credit analysis, numerical credit scoring, and discriminant analysis.

7.2. Credit Models

7.2.1 Traditional Credit Analysis
The traditional approach to credit analysis calls for assessing a
prospective customer in terms of “five C’s of credit”.

34
 • Character: The willingness of the customer to honor his
obligations. It reflects integrity, a moral attribute that is
considered very important by credit managers.
• Capacity: The ability of the customer to meet credit obligations
from the operating cash flows.
• Capital: The financial reserves of the customer. If the customer
has problems in meeting credit obligations from operating cash
flow, the focus shifts to its capital.
• Collateral: the security offered by the customer in the form of
pledged assets.
• Conditions: the general economic conditions that affect the
customer.
A bank can rely upon the following information to evaluate the credit
worthiness of a customer.
• Financial Statements: financial statements contain a wealth of
information. A searching analysis of the customer’s financial
statements can provide useful insights into the creditworthiness
of the customer. The following ratios are particularly helpful in
this context: current ratio, acid test ratio, debt equity ratio, EBIT
to total assets ratio, and return on equity.
• Bank references: The banker of the prospective customer is
another source of authentic information. To ensure a higher
degree of candour, the customer’s banker may be approached
indirectly by the bank of the firm granting credit.
• Previous experience: the previous experience of the bank with
the customer is very helpful in all further dealings of the bank.
Bank has all the details regarding the customer’s bank accounts,
his deposits, withdrawals etc.
• Prices and yields on securities: for listed companies, valuable
inferences can be derived from stock market data. Higher the

35
price-earnings multiple and lower the yield on bonds, other
things being equal, lower will be the credit risk.

Traditional Credit Analysis

36
7.2.2 Risk Classification Scheme

37
 On the basis of information and analysis in the credit
investigation process, customers are classified into various risk
categories. A simple risk classification scheme is shown below;
Risk Classification Scheme

Risk Description
Class
1 Customers with no risk of default
2 Customers with negligible risk of default (default rate less
than 2%)
3 Customers with little risk of default (default rate between 2%
& 5%)
4 Customers with some risk of default (default rate between 5%
& 10%)
5 Customers with significant risk of default (default rate in
excess of 10%)

7.2.3 Sequential Credit Analysis

Sequential credit analysis is an efficient method. In this analysis,
investigation is carried further if the benefit of such analysis outweighs
it cost. To illustrate, consider three stages of credit analysis: review of
the past payment record, detailed internal analysis, and credit
investigation by an external agency. The credit analyst proceeds from
stage one to stage two only if there is no past payment history and
hence a detailed internal credit analysis is warranted. Likewise, the
credit analyst goes from stage two to stage three only if internal credit
analysis suggests that the customer poses a medium risks and hence
there is a need for external credit analysis.

7.2.4 Discriminant Analysis

The technique of discriminant analysis is employed to construct a
better risk index than the one given above. The nature of this analysis
is discussed with the help of a simple example. A bank considers the

38
following financial ratios of its customers as the basic determinants of
creditworthiness: current ratio and return on net worth. The plot of its
customers on a graph of these two variables is shown below. X‘s
Represent customers who have paid their interest and installments on
time and O‘s represent customers who have defaulted on payment of
interest or installment or both.. the straight line seems to separate the
X’s from the O’s – while it may not be possible to completely separate
the X’s and O’s with the help of a straight line, the straight line does a
fairly good job of segregating the two groups. The equation of this
straight line is
Z = 1 Current Ratio + 0.1 Return on Equity
Since this is the line which discriminates between the good customers
(those who pay) and the bad customers (those who default), a
customer with a Z score of more than 3 is deemed creditworthy and a
customer with a Z score of less than 3 is considered not creditworthy.
The higher the Z score, the stronger the credit rating.
Discriminant Analysis

39
 Current
Ratio

Return on
Equity
7.2.5 Numerical Credit Scoring
In traditional credit analysis, customers are assigned to various
risk classes somewhat judgmentally on the basis of the five C’s of
credit. Credit analysts may, however, want to use a more systematic
numerical credit scoring system. Such a system may involve the
following steps:

• Identify factors relevant for credit evaluation.

• Assign weights to these factors that reflect their relative
importance.
• Rate the customer on various factors, using a suitable rating
scale (usually a 5-point scale or a 7-point scale is used.)
• For each factor, multiply the factor rating with the factor weight
to get the factor score.
• Add all the factor scores to get the overall customer rating index.
• Based on the rating index, classify the customer.

40
 Construction of a Credit Rating Index (based on a 5-point
rating scale)

Scoring applications:
It is estimated that as much as 80% of the “measurable and
controllable” risk is decided upon at the time of underwriting. Stated
another way, once the account or loan is approved, servicing and loss
mitigation techniques can control future losses only to a limited extent
relative to the control or loss avoidance offered by making the correct
decision in the first place. Because of this, an obvious area of scoring
application is that of evaluating new credit applicants.

For e.g. the use of mortgage score could have substantially

reduced the foreclosure rate. In this comparison, the approval rate for
the score based approach was set equal to that of manual
underwriting. Although this example comes from the mortgage
industry, the loss avoidance benefit due to scoring is believed to be
similar across all asset classes where there is meaningful data on
which to develop scores. The benefit of loss avoidance is only one of
many. Equally important is the benefit of fast, consistent, unbiased,
and defensible decision making. This is especially true in today’s

41
environment of pre-approvals, on-line banking, Internet Web sites, and
Fair Lending considerations.

Application scoring ranges in degree of scope from providing

supplemental information to the underwriter (who makes final
decision) to totally automated decision making independent of an
underwriter’s intervention. Thus scoring is used to determine the
“processing path” or degree of underwriting and level of
documentation required. Score-suggested declinations typically are
review by a human underwriter before a declination is issued.

Score based underwriting is typically the first application

explored when scoring technology is introduced to a new product type.
A natural extension of this is risk based or score based pricing.

7.2.6 Risk based pricing

Risk based pricing is used extensively. In mortgage industry, for
example, has offered different note rates for different levels of risk for
risk for decades, and for those who put less than 20% of the house’s
value into the down payment, the industry requires that mortgage
insurance premium be paid. The higher loan to value (LTV) ratio loans
has been demonstrated to be significantly higher risk. The mortgage
insurance industry itself uses risk based pricing, as evidenced by a
premium structure based on LTV, product type, and level of coverage.

In the card industry, the practice of different credit card annual

percentage rates (APR) for those of varying risk are commonplace. The
metrics used in risk based pricing structures are being replaced by
scoring technology. The score based pricing mechanism has been used
for some time at a somewhat coarse level in the card industry,
whereas it is only beginning to transform the mortgage industry.

42
 The basic premise is the same for score based and risk based
pricing-provide a more competitively priced product to the deserving
consumer by reducing the cross subsidization of losses and expenses,
while better stabilizing the return. Score based pricing algorithms more
accurately support multiple pricing tranche, each of which is
independently priced for the target return.

Many factors go into a score based pricing algorithm beyond the

expected loss level for the score tranche. The factors include, but are
not limited to, the volatility of performance of the score tranche, its
unique capital reserve requirement, specific servicing cost, cash flow,
and other product-specific characteristics differing by score trance,
such as attrition rate for the card product and prepayment rate for the
mortgage product. Basically the bank has to comprehensively consider
all the factors that will determine the future value of the asset.
Essentially, the bank is valuing each score tranche independently. An
optimal score based pricing algorithm should also fully integrate the
secondary market or “execution” price of the individual score tranche
in a real time fashion.

7.3 Pattern Classification Systems

A pattern classification system is a method for deciding to which
of several discrete classes an observation should be assigned, based
on measurements of the observation’s characteristics. For credit risk
pattern classification systems, the measurements are made on
variables that determine credit risk – characteristics like number of
previous delinquencies fro the borrower or loan-to-value ratio of a loan.
The important credit risk pattern classification systems having only two
classes are: acceptable risk and not acceptable risk. The two class

43
system will allow us to discuss all the types of choices that need to be
made in statistical modeling. Credit risk modeling can involve multiple
classifications. A hypothetical set of five classes might be high accept,
accept, low accept, refer to underwriter, and refer to a senior
underwriter, where different actions would be undertaken based on
class.

7.4 Credit risk modeling approaches

There are different approaches to credit risk modeling. The
essential difference between various credit risk modeling approaches –
regression, rules based systems, neural networks, and case based logic
is the form of the function that relates the measurements to the
classes, the inputs to outputs, the independent variables.

The four types of approaches to credit risk modeling are:

7.4.1 Rules based Systems
7.4.2 Linear Regression
7.4.3 Non linear Regression
7.4.4 Neural Networks

7.4.1 Rules based Systems

The simplest credit risk pattern recognition system is rules based
system with a single rule, such as a system for mortgage credit risk
based only on the loan-to-value ratio. (LTV)

Rule 1: If LTV is <= b percent, accept the loan, otherwise refer.

This very simple system qualifies as a pattern classification

system because it takes the value of a variable for a particular

44
observation (a loan application) and uses it to assign the observation to
a particular class (accept or refer). The adjustable parameter, b, set
the assignments.
For every pattern classification system there is an associated
diagram showing how the system assigns the observations to the
various classes, which is called the system’s class diagram. The class
diagram of a rules-based system with one adjustable parameter is a
line, divided into two regions, one for acceptance (all points to the left
of and including the value b) and one for referral (all points to the right
of ).

Rules Based System with One Adjustable Parameter

Rules Based System with Two Adjustable

Parameters

45
 Rule 2: if the LTV <= 80 percent and the DTI <= 36 percent,
accept; otherwise refer.
*DTI = Debt-to- income ratio
Rule 2 divides the space into two regions, accept and refer. The
accept region is the rectangle in the lower left hand area, bounded by
80 LTV on the horizontal axis and 36 DTI on the vertical axis. The refer
region is everything outside the accept region.
Rules based systems can be made much more flexible with more
variables and more complex rules. The variables can be continuous (a
credit score) or discrete (loan purpose, with such categories as
purchase, refinance with no cash out, or refinance with cash out). Each
variable adds a dimension to the class diagram. Adding a credit score
would require a three dimensional diagram, adding loan purpose a four
dimensional diagram, and so forth. With a two class system, however,
no matter how many dimensions, the class diagram will be divided into
two regions: accept and refer.

Rules Based System with Two Adjustable Parameters –

Compound Rules

46
 Rule 3: if the LTV <=80 percent and the DTI <=38 percent,
accept;
Otherwise: If the LTV <=85 percent and the DTI <=36 percent,
accept;
Otherwise: If the LTV <=90 percent and the DTI <=34 percent,
accept;
Otherwise refer.

This system embodies a tradeoff between the higher risk of

increased LTV and lower risk of lower DTI. In principle, it is possible to
build as elaborate a system of rules as required for any degree of
flexibility.

7.5.2 Linear Regression (Hypothetical)

Linear regression is an improvement over pure rules-based
systems. The linear regression shown in below figure has a single
independent variable, LTV, and a single dependent variable, the

47
proportion of losses in each LTV category. Because it does not separate
the data into discrete classes, the regression line by itself is not a
complete pattern recognition system. Rather it creates a function that
relates the probability of a loss to the LTV. This function can be
combined with a rule to create a pattern recognition system that
accepts or refers the loan.
The regression based system’s ability to handle trade off’s
among variables becomes apparent when we increase the number of
variables. The linear regression will generally create an acceptance
region that is triangular in shape, rather than a set of boxes. The
regression equation is also simple in form than compound rules.
The general form of regression equation is:
1. P = a + b * LTV + c * DTI
The fact that the acceptance region is a triangle show that there is a
risk trade-off between LTV and DTI. The boundary line is the set of all
DTI/LTV combinations that have a risk of 3.5 percent:
2. DTI = ((0.035 – a) – b * LTV)/c = (0.035 – a)/c - (b/c) * LTV
The lower of the DTI, the higher the LTV that can be accepted to
achieve the same level of risk.
Linear Regression (Hypothetical)
Probability of Loss vs. LTV
Probability of Loss

Accept if p<=0.03 Refer if p>0.03

48
 LTV
Linear Regression (Hypothetical)

7.5.3 Non Linear Regression

A non linear regression fits a curve rather than a line to a set of
observations. The curve may take virtually any form that can be
described by a function. The below given figure shows a power curve
fitted to the same set of points that was used for the linear regression,
probability of a loss versus LTV. When the power curve is fitted to the
previous LTV/DTI data, the accept-refer region again shows a trade-off
between LTV and DTI, but this time with an important difference. As
with the linear regression, the curve slopes downward, showing that
the higher the LTV, the lower must be the DTI in order to maintain a
constant probability of loss. But now the boundary line separating the
accept from the refer region is curved, bowed out, reflecting a more
complex relationship between DTI and LTV.
Non linear regression can take infinity of forms. One form used in
credit risk modeling is the logistic or sigmoid curve. Many applications

49
in credit risk consist of binary data; an event takes place or it does not
– foreclosure or no foreclosure, delinquency or no delinquency.
Generally, no curve will fit binary data close to perfectly, soothe
problem is how to fit a curve to the probability of the event. In this
case, it is desirable to have the curve be constrained to values
between 0 and 1, so that the estimated probability does not take o an
impossible value.
Power Function vs. Linear Regression (Hypothetical)
Probability of Loss vs. LTV
0.0
Loss
Probability of

6
0.0
5
0.0
4
0.0
3
0.0
2
0.0
1
0 20 40 60 80 100 120

LTV

Linear Regression Non linear

regression
Accept if p<=0.03 Refer if p>0.03

LTV

7.5.4 Neural Networks

50
 Neural networks are pattern classification systems whose
structures in suggested by the interconnection of neurons in the
human brain. The below given figure shows a single artificial neuron
that takes a weighted sum of the inputs and indexes it with a value
from 0 to 1, using a logistic function. In a neural network, there are one
or more layers of neurons with outputs from one layer forming the
inputs for the subsequent layer. Layers between the input and output
layers are considered hidden from general view. These interconnected
neurons form a system that can model highly non-linear processes with
complex interactions among the variables.

Artificial Neuron – 3 Inputs, Logistic Transfer

Function

Weights
a1
Input 1
a2
Logistic
Function
Input 2 Of Output
a3
Weighted
Average
Input 3 Of
Inputs
The simplest neural network system – a single neuron – is, in
fact, essentially a logistic regression with additive inputs. The flexibility
of neural network derives from combining inputs and outputs from
many logistic curves. The potential flexibility of regression derives from
the use of non-linear functional forms, transformed variables, and
interaction terms.
Neural Network – 3 Inputs, 1 Hidden Layer with 2 Neurons

51
52
 8. Conclusion

Lending which is the most important function in any bank

involves assessing the creditworthiness of a customer. It involves
financial and non financial analysis. Ratio analysis and cash flow
forecasting is a financial measure whereas non financial analysis
include economy analysis, industry analysis and business analysis.
Banks use different credit analysis models such as traditional
credit analysis, numerical scoring model, sequential credit analysis,
pattern recognition systems etc. Statistical tools like discriminant
analysis, regression analysis, linear and non linear regression are used
to a great extent for credit analysis.

53
 Bibliography

Reference Books & Articles

 Credit Risk Management – Andrew Fight
 Developing and Applying Credit Risk Models – Elizabeth Mays
 Financial Management Theory and Practice – Prasanna Chandra
 RBI guidelines

Papers
 The Economic Times of India

54
  Business Standard

World Wide Web

 www.rbi.org.in
 www.bankersacademy.com/riskmanagement.php
 www.iba.org.in
 www.bis.org
 www.financialinvestmentplanner.com/Economy_Microeconomics_Lending
-models.html
 www.gdrc.org/icm/model/1-credit-model.html
 http://www.frbsf.org/econrsrch/workingp/wp99-06.pdf
 www.gdrc.org/icm/model/1-credit-model.html

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