Principles for the Management of Credit Risk

July 1999

Introduction

1. While financial institutions have faced difficulties over the years for a multitude of reasons,
the major cause of serious banking problems continues to be directly related to lax credit
standards for borrowers and counterparties, poor portfolio risk management, or a lack of
attention to changes in economic or other circumstances that can lead to a deterioration in
the credit standing of a bank's counterparties. This experience is common in both G-10 and
non-G-10 countries.

2. Credit risk is most simply defined as the potential that a bank borrower or counterparty will
fail to meet its obligations in accordance with agreed terms. The goal of credit risk
management is to maximise a bank's risk-adjusted rate of return by maintaining credit risk
exposure within acceptable parameters. Banks need to manage the credit risk inherent in
the entire portfolio as well as the risk in individual credits or transactions. Banks should also
consider the relationships between credit risk and other risks. The effective management of
credit risk is a critical component of a comprehensive approach to risk management and
essential to the long-term success of any banking organisation.

3. For most banks, loans are the largest and most obvious source of credit risk; however,
other sources of credit risk exist throughout the activities of a bank, including in the banking
book and in the trading book, and both on and off the balance sheet. Banks are increasingly
facing credit risk (or counterparty risk) in various financial instruments other than loans,
including acceptances, interbank transactions, trade financing, foreign exchange
transactions, financial futures, swaps, bonds, equities, options, and in the extension of
commitments and guarantees, and the settlement of transactions.

4. Since exposure to credit risk continues to be the leading source of problems in banks
world-wide, banks and their supervisors should be able to draw useful lessons from past
experiences. Banks should now 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 Basel
Committee is issuing this document in order to encourage banking supervisors globally to
promote sound practices for managing credit risk. Although the principles contained in this
paper are most clearly applicable to the business of lending, they should be applied to all
activities where credit risk is present.

5. The sound practices set out in this document specifically address the following areas: (i)
establishing an appropriate credit risk environment; (ii) operating under a sound credit-
granting process; (iii) maintaining an appropriate credit administration, measurement and
monitoring process; and (iv) ensuring adequate controls over credit risk. Although specific
credit risk management practices may differ among banks depending upon the nature and
complexity of their credit activities, a comprehensive credit risk management program will
address these four areas. These practices should also be applied in conjunction with sound
practices related to the assessment of asset quality, the adequacy of provisions and
reserves, and the disclosure of credit risk, all of which have been addressed in other recent
Basel Committee documents.

6. While the exact approach chosen by individual supervisors will depend on a host of
factors, including their on-site and off-site supervisory techniques and the degree to which
external auditors are also used in the supervisory function, all members of the Basel
Committee agree that the principles set out in this paper should be used in evaluating a
bank's credit risk management system. Supervisory expectations for the credit risk
management approach used by individual banks should be commensurate with the scope
and sophistication of the bank's activities. For smaller or less sophisticated banks,
supervisors need to determine that the credit risk management approach used is sufficient
for their activities and that they have instilled sufficient risk-return discipline in their credit risk
management processes.

7. The Committee stipulates in Sections II through VI of the paper, principles for banking
supervisory authorities to apply in assessing bank's credit risk management systems. In
addition, the appendix provides an overview of credit problems commonly seen by
supervisors.

8. A further particular instance of credit risk relates to the process of settling financial
transactions. If one side of a transaction is settled but the other fails, a loss may be incurred
that is equal to the principal amount of the transaction. Even if one party is simply late in
settling, then the other party may incur a loss relating to missed investment opportunities.
Settlement risk (i.e. the risk that the completion or settlement of a financial transaction will
fail to take place as expected) thus includes elements of liquidity, market, operational and
reputational risk as well as credit risk. The level of risk is determined by the particular
arrangements for settlement. Factors in such arrangements that have a bearing on credit
risk include: the timing of the exchange of value; payment/settlement finality; and the role of
intermediaries and clearing houses.

Invitation to comment

The Basel Committee is issuing this paper for consultation. Comments should be submitted
no later than 30 November 1999. The Committee intends to release a final version of the
paper once all comments have been considered. Comments should be sent to:

Basel Committee on Banking Supervision

Attention: Mr William Coen
Bank for International Settlements

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1.0 Risk Management

1.1 Risk is inherent part of Bank’s business. Effective Risk Management is critical to any
Bank for achieving financial soundness. In view of this, aligning Risk Management to Bank’s
organizational structure and business strategy has become integral in banking business. Over
a period of year, Union Bank of India (UBI) has taken various initiatives for strengthening
risk management practices. Bank has an integrated approach for management of risk and in
tune with this, formulated policy documents taking into account the business requirements /
best international practices or as per the guidelines of the national supervisor. These policies
address the different risk classes viz., Credit Risk, Market Risk and Operational Risk.

1.2 The issues related to Credit Risk are addressed in the Policies stated below;

1.2.1 Loan Policy.

1.2.2 Credit Monitoring Policy.
1.2.3 Real Estate Policy.
1.2.4 Credit Risk Management Policy.
1.2.5 Collateral Risk Management Policy.
1.2.6 Recovery Policy.
1.2.7 Treasury Policy.

1.3 The Policies and procedures for Market Risks are articulated in the ALM Policy and
Treasury Policy.

1.4 The Operational Risk Management involves framework for management of operational
risks faced by the Bank. The issues related to this risk is addressed by;

1.4.1 Operational Risk Management Policy.

1.4.2 Business Continuity Policy.
1.4.3 Outsourcing Policy.
1.4.4 Disclosure Policy.

1.5 Besides, the above Board mandated Policies, Bank has detailed ‘Internal Control
Principles’ communicated to the business lines for ensuring adherence to various norms like
Anti-Money Laundering, Information Security, Customer complaints, Reconciliation of
accounts, Book-keeping etc.

2.0 Oversight Mechanism:

• 2.1 Our Board of Directors has the overall responsibility of ensuring that adequate
structures, policies and procedures are in place for risk management and that they are
properly implemented. Board approves our risk management policies and also sets
limits by assessing our risk appetite, skills available for managing risk and our risk
bearing capacity.

2.2 Board has delegated this responsibility to a sub-committee: the Supervisory

Committee of Directors on Risk Management & Asset Liability Management. This is
the Apex body / Committee is responsible for supervising the risk management
activities of the Bank.

2.3 Further, Bank has the following separate committees of top executives and
dedicated Risk Management Department:

2.3.1 Credit Risk Management Committee (CRMC): This Committee deals with
 issues relating to credit policies and procedure and manages the credit risk on a Bank-
wide basis.
2.3.2 Asset Liability Management Committee (ALCO): This Committee is the
decision-making unit responsible for balance sheet planning and management from
the angle of risk-return perspective including management of market risk.
2.3.3 Operational Risk Management Committee (ORMC): This Committee is
responsible for overseeing Bank’s operational risk management policy and process.
2.3.4 Risk Management Department of the Bank provides support functions to the risk
management committees mentioned above through analysis of risks and reporting of
risk positions and making recommendations as to the level and degree of risks to be
assumed. The department has the responsibility of identifying, measuring and
monitoring the various risk faced the bank, assist in developing the policies and
verifying the models that are used for risk measurement from time to time.

3.0 Credit Risk

• 3.1 Credit Risk Management Policy of the Bank dictates the Credit Risk Strategy.

3.2 These Polices spell out the target markets, risk acceptance / avoidance levels, risk
tolerance limits, preferred levels of diversification and concentration, credit risk
measurement, monitoring and controlling mechanisms.

3.3 Standardized Credit Approval Process with well-established methods of appraisal

and rating is the pivot of the credit management of the bank.

3.4 Bank has comprehensive credit rating / scoring models being applied in the
spheres of retail and non-retail portfolios of the bank.

3.5 The Credit rating system of the Bank has eight borrower grades for standard
accounts and three grades for defaulted borrowers.

3.6 Proactive credit risk management practices in the form of studies of rating-wise
distribution, rating migration, probability of defaults of borrowers, Portfolio Analysis
of retail lending assets, periodic industry review, Review of Country, Currency,
Counter-party and Group exposures are only some of the prudent measures, the bank
is engaged in mitigating risk exposures.

3.7 The current focus is on augmenting the bank’s abilities to quantify risk in a
consistent, reliable and valid fashion, which will ensure advanced level of
sophistication in the Credit Risk Measurement and Management in the years ahead.

4.0 Market Risk

• 4.1 Bank has well-established framework for Market Risk management with the Asset
Liability Management Policy and the Treasury Policy forming the fulcrum for
procedures, processes and structure. It has a major objective of protecting the bank’s
net interest income in the short run and market value of the equity in the long run for
enhancing shareholders wealth. The important aspect of the Market Risk includes
liquidity management, interest rate risk management and the pricing of assets and
liabilities. Further, Bank views the Asset Liability Management exercise as the total
 balance sheet management with regard to its size, quality and risk.

4.2 The ALCO is primarily entrusted with the task of market risk management. The
Committee decides on product pricing, mix of assets and liabilities, stipulates
liquidity and interest rate risk limits, monitors them, articulates Bank’s interest rate
view and determines the business strategy of the Bank.

4.3 Bank has put in place a structured ALM system with 100% coverage of data on
both assets and liabilities. To measure liquidity and interest rate risk, Bank prepares
various reports such as Structural Liquidity, Interest Rate Sensitivity, Fortnightly
Dynamic Statement etc. Besides RBI reporting many meaningful analytical reports
such as Duration Gap analysis, Contingency Funding Plan, Contractual Maturity
report etc. are generated at periodic intervals for ALCO, which meets regularly.
Statistical and mathematical models are used to analyze the core and volatile
components of assets and liabilities.

4.4 The objective of liquidity management is to ensure adequate liquidity without

affecting the profitability. In tune with this, Bank ensures adequate liquidity at all
times through systematic funds planning, maintenance of liquid investments and
focusing on more stable funding sources.

4.5 The Mid Office group positioned in treasury with independent reporting structure
on risk aspects ensure compliance in terms of exposure analysis, limits fixed and
calculation of risk sensitive parameters like VaR, PV01, Duration, Defeasance Period
etc. and their analysis.

5.0 Operational Risk

• 5.1 Operational Risk, which is intrinsic to the bank in all its material products,
activities, processes and systems, is emerging as an important component of the
enterprise-wide risk management system. Recognizing the importance of Operational
Risk Management, Bank has adopted a Comprehensive Operational Risk
Management Policy. This would entail the bank to move towards enhanced level of
sophistication in the years ahead and to capture qualitative and quantitative measures
of Operational Risk indicators in management of operational risk.

5.2 Bank has comprehensive system of internal controls, systems and procedures to
monitor and mitigate risk. Bank has also institutionalized new product approval
process to identify the risk inherent in the new product and activities.

5.3 The Internal audit function of the Bank and the Risk Based Internal Audit,
compliments the banks ability to control and mitigate risk.

6.0 Bank’s Preparedness to meet Basel II norms

• 6.1 Bank carried out a comprehensive Self-Assessment exercise spanning all the risk
areas and evolved a road map to move towards implementation of Basel II as per
RBI’s directions. The program in implementation of Risk Management,
Organizational Structure, Risk measures, risk data compilation and reporting etc. is as
per this laid down road map.
 6.2 The Polices framed and procedures / practices adopted are benchmarked to the
best in the industry on a continuous basis and the Bank has a clear intent to reach an
advanced level of sophistication in management of risks in the coming year.

6.3 The ever-improving risk management practices in the Bank will result in Bank
emerging stronger, which in turn would confer competitive advantage in the Market.

6.4 Bank will implement New Capital Accord w.e.f. 31/03/2008. The parallel run, till
implementation, is currently underway.

Risk Management in Credit Risk Portfolios with Correlated Assets

Author: Prof. Dr. Nicole Bäuerle (Institute for Mathematical Stochastics,

Universität Hannover, former visiting postdoctoral research fellow at
RiskLab)

Abstract: We consider a structural model of credit risk in the spirit of Merton

[Journal of Finance 29 (1974) 449], where a firm defaults when its
market value falls below the value of its debts or a certain given
threshold level. Models of this type have extensively been used for
valuing default-risky securities. Our research now focuses on the effect
which positive dependence between credit risks in a portfolio has on the
risk of the lending institute. In order to allow for unexpectedly defaults,
we suppose that the firm's asset value follows a geometric Lévy
process. The following two main results are obtained: a positive
dependence in terms of association between the credit risks always
leads to a higher risk for the lending institute than independent credit
risks, where the risk of the institute can be measured by any of the
following risk measures: variance, upper partial moments or risk
sensitive measure. In a second part we investigate the influence of the
portfolio structure. We suppose that a firm's asset value is influenced by
an idiosyncratic risk, a sector specific risk and a systematic risk. Sectors
can be defined, e.g., by the type of industry or geographic region. We
show that whenever a sector structure majorizes another, the risk for
the lending institute increases. This proves in particular a positive effect
of diversification.

Keywords Structural credit risk model, association, positive dependence,

: Lévy process

Date: March 1, 2001 (First version)

Type: Published paper

Projects: Combined Market and Credit Risk Stress Testing

 Dependence Modelling in Risk Management

Remark: The paper was initiated during the RiskLab visit.

Referenc
Insurance: Mathematics and Economics 30, no. 2 (2002) 187-198.
e: