RISK MANAGEMENT MODULE B QUIZ 1

Credit risk is the possibility that a borrower or counterparty will fail to meet contractual obligations. It can cause loss of principal, interest or replacement value. Credit risk management covers individual obligors as well as the overall portfolio.

Obligor- or borrower-level risk focuses on the creditworthiness of an individual borrower, including willingness and ability to repay. Portfolio risk considers the combined exposures, concentrations, correlations and loss distribution across many borrowers.

A comprehensive framework includes strategy and risk appetite, credit policies, underwriting standards, due diligence, approval authority, exposure limits, monitoring, problem-loan management, independent review and management information. No single control is sufficient on its own.

A sound credit culture promotes responsible lending, independent challenge, accurate documentation, timely escalation of deterioration and accountability for exceptions. It avoids incentives that reward loan growth without regard to risk-adjusted returns or asset quality.

Exceptions should be justified, documented, approved by an authorised independent level, monitored and reported for patterns. Uncontrolled exceptions can undermine policy and create adverse selection or excessive risk concentration.

Credit due diligence verifies the borrower, purpose, financial statements, cash-flow capacity, management, industry conditions, existing liabilities, security and relevant legal/regulatory information. It supports a reasoned credit decision rather than relying only on the application or collateral.

Sustainable cash flow from operations is generally the primary source of repayment. Collateral is a secondary source if repayment fails and can be difficult or costly to realise; lending should not depend solely on collateral appreciation.

Industry demand weakness is a business/operating risk driver. High leverage increases financial risk because debt service is fixed and leaves less room to absorb lower earnings. Business and financial risk interact: operating deterioration can magnify the chance of default when leverage is high.

Industry factors such as competition, regulation, input prices, technology, demand cycles and barriers to entry affect the borrower‘s revenue stability and margins. A strong company may still be vulnerable to a severe industry downturn, so entity analysis needs industry context.

An internal rating system consistently differentiates borrowers or facilities by credit risk. Ratings support approval, pricing, limits, monitoring, provisioning/capital processes where applicable, and portfolio analysis. They should be validated and governed rather than treated as infallible predictions.

Reliable rating assignment uses defined criteria, current verified information, trained assessors, documented rationale, appropriate approval and independent review. Override decisions should be controlled and monitored so ratings remain comparable across borrowers and time.

External ratings can provide an independent input, but a bank remains responsible for its own credit assessment, due diligence, exposure monitoring and compliance with applicable regulatory rules. Ratings may lag changes in a borrower‘s condition and are not guarantees against default.

Concentration risk arises when exposures are large to a single borrower/group, sector, geography, collateral type or common risk driver. Correlated losses can exceed what would be expected from examining each exposure independently.

Systematic credit risk comes from common macroeconomic or market factors that affect many borrowers, such as a recession or a broad rise in interest rates. Idiosyncratic risk is specific to an individual borrower and is more amenable to diversification.

PD estimates the likelihood that a borrower or obligor will default over a specified horizon under a defined default standard. It is distinct from Exposure at Default (EAD), the amount at risk when default occurs, and Loss Given Default (LGD), the proportion of exposure expected to be lost.

Exposure at Default (EAD) estimates the amount the bank may be exposed to when default occurs. For undrawn commitments, EAD may include an estimate of future drawdown, often using a credit conversion factor or other appropriate method.

Loss Given Default (LGD) is the proportion of exposure expected to be lost after considering recoveries and relevant costs, subject to the model‘s definitions. A simplified relationship is expected loss = PD × EAD × LGD.

Expected loss = 0.02 × ₹10 crore × 0.40 = ₹0.08 crore, i.e. ₹8 lakh. The calculation is a simplified credit-risk estimate; actual regulatory and accounting treatments may use additional rules, horizons and assumptions.

Credit risk models help estimate default likelihood, loss severity and exposure, support portfolio loss analysis, pricing, limits, capital and risk-adjusted performance measurement. They are decision-support tools and require validation, data quality and expert oversight.

Risk-based pricing links loan pricing to the risk of the borrower/facility and the resources required to support it, including expected loss, operating costs, funding costs and capital. It aims to achieve an appropriate risk-adjusted return, subject to competition and regulatory/fair-lending constraints.