Credit Risk Management

Credit Risk: Definition

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 restrictions may be imposed by the sovereign.

Building Blocks of Credit Risk Management

In a bank, an effective credit risk management framework would comprise of the following distinct building blocks:
a) Policy and Strategy
b) Organizational Structure
c) Operations/ Systems

Credit Risk Policy

1. Every bank should have a credit risk policy document approved by the Board. The document should
include risk identification, risk measurement, risk grading/ aggregation techniques, reporting and risk
control/ mitigation techniques, documentation, legal issues and management of problem loans.
2. Credit risk policies should also define target markets, risk acceptance criteria, credit approval authority,
credit origination/ maintenance procedures and guidelines for portfolio management.
3. The credit risk policies approved by the Board should be communicated to branches/controlling offices.
All dealing officials should clearly understand the bank’s approach for credit sanction and should be held
accountable for complying with established policies and procedures.
4. Senior management of a bank shall be responsible for implementing the credit risk policy approved by the
Board.

Credit Risk Strategy

1. Each bank should develop, with the approval of its Board, its own credit risk strategy or plan that
establishes the objectives guiding the bank’s credit-granting activities and adopt necessary policies/
procedures for conducting such activities. This strategy should spell out clearly the organization's credit
appetite and the acceptable level of risk-reward trade-off for its activities.
2. The strategy would, therefore, include a statement of the bank’s willingness to grant loans based on the
type of economic activity, geographical location, currency, market, maturity and anticipated profitability.
This would necessarily translate into the identification of target markets and business sectors, preferred
levels of diversification and concentration, the cost of capital in granting credit and the cost of bad debts.
3. The credit risk strategy should provide continuity in approach as also take into account the cyclical
aspects of the economy and the resulting shifts in the composition/ quality of the overall credit portfolio.
This strategy should be viable in the long run and through various credit cycles.
4. Senior management of a bank shall be responsible for implementing the credit risk strategy approved by
the Board.
Typical Organizational Structure for Risk Management

Credit Rating Framework

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
5. Assessing the aggregate risk profile of bank/ lender. 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.

Basic Architecture of CRFs

I. Grading system for calibration of credit risk

a. Nature of grading system
b. Number of grades used
c. Key outputs of CRF

II. Operating design of CRF

a. Which exposures are rated?
b. The risk rating process
c. Assigning and monitoring risk ratings
d. The mechanism of arriving at risk ratings
e. Standardization and benchmark for risk ratings
f. Written communications and formality of procedures

III. CRFs and Portfolio Credit Risk

a. Portfolio surveillance and reporting
b. Adequate levels of provisioning for credit events
c. Guidelines for asset build up, aggregate profitability and pricing
d. Interaction with external credit assessment institutions

IV. Nature of Grading System for the CRF

A rating scale could consist of 9 levels, of which levels 1 to 5 represent various grades of acceptable credit
risk and levels 6 to 9 represent various grades of unacceptable credit risk associated with an exposure.

V. Mechanism of Arriving at Risk-Ratings

 Step I Identify all the principal business and financial risk elements

Step II Allocate weights to principal risk components

Step III Compare with weights given in similar sectors and check for consistency
Step IV Establish the key parameters (sub-components of the principal risk elements)
Step V Assign weights to each of the key parameters
Step VI Rank the key parameters on the specified scale
Step VII Arrive at the credit-risk rating on the CRF
Step VIII Compare with previous risk-ratings of similar exposures and check for consistency
Step IX Conclude the credit-risk calibration on the CRF

VI. Standardization and Benchmarks for Risk-Ratings

The next step would be to assign weights to these risk parameters. In an industrial credit environment, the CRF may
place higher weights on size (as captured in gross revenues), profitability of operations (operating margins), financial
leverage (debt: equity) and debt-servicing ability (interest cover). Assume that the CRF assigns a 20% weightage to
each of these four parameters and the ROCE and DSCR are given a 10% weightage each. The weighted-average score
for the financial risk of the proposed exposure is 1.60, which would correspond with the extremely low risk/highest
safety level-category of the CRF (category 1). Similarly, the business and the management risk of the proposed
exposure are assessed and an overall/ comprehensive risk rating is assigned.

Illustration
The CRF may specify that for the risk-rating exercise:

If Gross Revenues are between Rs.800 to Rs.1000 crore assign a score of 2

If Operating Margin is 20% or more assign a score of 2
If Return on Capital Employed is 25% or more assign a score of 1
If Debt : Equity is between 0.60 and 0.80 assign a score of 2
If interest cover is 3.50 or more assign a score of 1
If Debt Service Coverage Ratio (DSCR) is 1.80 or more assign a score of 1

Credit Risk Models: Approaches

The literature on quantitative risk modelling has two different approaches to credit risk measurement;

 The first approach is the development of statistical models through analysis of historical data. This approach
was frequently used in the last two decades.
 The second type of modelling approach tries to capture distribution of the firm's asset-value over a period of
time.

The statistical approach tries to rate the firms on a discrete or continuous scale. The linear model introduced by
Altman (1967), also known as the Z-score Model, separates defaulting firms from non defaulting ones on the basis of
certain financial ratios. Altman, Hartzell, and Peck (1995,1996) have modified the original Z-score model to develop a
model specific to emerging markets. This model is known as the Emerging Market Scoring (EMS) model.

A. Linear Discriminant Models (Zeta Analysis)

While linear probability models estimate or project a value for the expected probability of default, should a loan be
made, discriminant models divide borrowers into high or low default risk classes contingent on their observed
characteristics (Xj).
For example, consider the discriminant analysis model developed by E. I. Altman for publicly traded manufacturing
firms in U S. The indicator variable Z is an overall measure of the default risk classification of the borrower. That, in
turn, depends on the values of various financial ratios of the borrower (Xj) and the weighted importance of these ratios
based on the past observed experience of defaulting versus non-defaulting borrowers derived from a discriminant
analysis model.

Altman’s discriminant function takes the form: 

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Where;
X1 = Working Capital/total assets ratio
X2 = Retained earnings/total assets ratio
X3 = Earnings before interest and taxes/total assets ratio
X4 = Market value of Equity/book value of long term debt ratio
X5 = Sales/total assets ratio

The higher the value of Z, the lower the default risks classification of the borrower. Thus, low or negative values of Z
may be evidence of the borrower being a member of a relatively high default risk class. 

Suppose that the financial ratios of a potential borrowing firm took the following values:

X1 = 0.2; X2 = 0; X3 = -0.2; X4 = 0.1; X5 = 2.0

The ratio X2 is zero and X3 is negative, indicating that the firm has had negative earnings or losses in recent periods.
Also, X4 indicates that the borrower is highly leveraged. However, the working capital ratio (X 1) and the sales/assets
ratio (X5) indicate the firm is reasonably liquid and is maintaining its sales volume. The Z score provides an overall
score or indicator of the borrower’s credit risk since it combines and weights these five factors according to there past
importance in explaining borrower default. For the borrower in question: 

Z = 1.2 (.2) + 1.4(0) + 3.3(-0.2) + 0.6(.10) + 1.0(2.0)

Z = 0.24 + 0 - .66 + 0.06 + 2.0
Z = 1.64

According to Altman’s credit scoring model, any firm with a Z score of less than 1.81 should be placed in the high
default risk region. Thus, the bank should not make a loan to this borrower until it improves its earnings.

– Z > 2.99 - “Safe” Zone

– 1.8 < Z < 2.99 - “Grey” Zone
– Z < 1.80 - “Distress” Zone

‘Z’ Score: Private Firm Model

Z’ = .717X1 + .847X2 + 3.107X3 + .420X4 + .998X5

X1 = Current Assets - Current Liabilities/ Total Assets

X2 = Retained Earnings/ Total Assets
X3 = Earnings Before Interest and Taxes/ Total Assets
X4 = Book Value of Equity/Total Liabilities
X5 = Sales/ Total Assets

– Z’ > 2.90 - “Safe” Zone

– 1.23 < Z’ < 2.90 - “Grey” Zone
– Z’ < 1.23 - “Distress” Zone

“Z’’ Score: Model for Manufacturers, Non-Manufacturer Industrials, & Emerging Market Credits

Z’’ = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4

 X1 = Current Assets - Current Liabilities/ Total Assets
X2 = Retained Earnings/ Total Assets
X3 = Earnings Before Interest and Taxes/ Total Assets
X4 = Book Value of Equity/ Total Liabilities

– Z’’ > 2.60 - “Safe” Zone

– < Z’’ < 2.60 - “Grey” Zone
– Z ” < 1.1 - “Distress” Zone

B. RAROC (Risk Adjusted Return on Capital) Model

A popular model to evaluate credit risk based on market data is the RAROC model. RAROC was pioneered by
Bankers Trust and has been adopted by many banks all over the world. The essential idea behind RAROC is that
rather than evaluating the actual or promised annual cash flow on a loan (such as net interest and fees), the lending
officer (credit manager) balances expected loan income against loan’s risk. Thus, rather than dividing loan income by
assets (ROA), it is divided by some measure of asset (loan) risk:

RAROC = [{One year income of a loan} / {Loan (asset) risk or risk capital}]

A loan is approved only if RAROC is sufficiently high relative to a benchmark cost of capital for the bank.
Alternatively, if the RAROC on an existing loan falls below a bank’s RAROC benchmark. The lending officer should
seek to adjust the loan’s terms to make it “profitable” again.

One problem in estimating RAROC is the measurement of loan risk (the denominator in the RAROC equation). Using
the popular equation used in Duration Analysis, where the percentage change in the market value of an asset such as a
loan DL/L is related to the duration of the loan and the size of the expected change in the credit risk factor on the loan
(DR/1 + R):

DL/L = -D ([DR/1 + R]), or, DL = -D [(DR/1 + R)]L

While the loan’s duration (say 3 years), the loan amount (say US $1,000, 000), the R is 10 percent and DR is 0.01
(expected decline in credit quality), then

DL = -3(1,000,000)(0.01/1.10)
= -27, 273

Thus, while the face value of the loan is US $1,000,000, the risk amount or change in the loan’s market value due to a
decline in its credit quality is US $27, 273. To determine the loan is worth making, the estimated loan risk is compared
to the loan’s income (spread over the Bank’s cost of funds plus fees on the loan). Suppose the projected spread plus
fees is as follows:

Spread = 0.002 X 1,000, 000 = US $2000

Fees = 0.001 X 1,000, 000 = US $1000
Total = US $3000

The loan’s RAROC is:

RAROC = [{One year income on loan}/{Loan risk (or capital risk)}] = 3000/ 27273= 11.7%

Note that this calculation can be either forward looking, comparing the projected income over the next year on the
loan with DL, or backward looking, comparing the actual income generated on the loan over the past year with DL. If
the 11.7% exceed the bank’s internal RAROC benchmark (based on its cost of funds), the loan will be approved. If it
is less, the loan will either be rejected outright or the borrower will be asked to pay higher fees and/or higher spread to
increase the RAROC to acceptable levels.
 C. A Loan Surveillance Model

Delton L Chesser developed a model to predict noncompliance with the customer’s original loan agreement, where
non-compliance is defined to include not only default but any workout that may have been arranged resulting in a
settlement of the loan less favourable to the lender than the original agreement. Chesser used data from four
commercial banks in three states over the years 1961 to 1971. His observation consisted of a paired sample of 37
satisfactory loans and 37 unsatisfactory (noncompliance) loans one year before noncompliance.

Chesser’s model, which was based on a technique called logit analysis, consisted of the following six variables:

X1 = (Cash + Marketable Securities)/Total Assets

X2 = Net Sales/ (Cash + Marketable Securities)
X3 = EBIT/ Total Assets
X4 = Total Debt/ Total Assets
X5 = Total Assets/ Net Worth 
X6 = Working Capital/ Net Sales

The estimated coefficients, including an intercept term, are

y = -2.0434 – 5.24X1 + 0.0053X2 – 6.6507X3 + 4.4009X4 – 0.0791X5 – 0.1020X6

The variable y, which is a linear combination of the independent variables, is used in the following formula to
determine the probability of noncompliance, P.

P = 1/(1 + e-y)

Where e = 2.71828. The estimated value can be viewed as an index of a borrower’s propensity for noncompliance, the
higher the value of y, the higher of noncompliance for a particular borrower. Chesser’s classification for P is, 

1.     If P > 0.50, assign to the noncompliance group

2.     If P < 0.50, assign to the compliance group

Using Chesser’s model it was possible to classify correctly roughly three out of every four loans one year before
noncompliance. To illustrate the use of Equations, consider the following ratios calculated from the 1980 Annual
report of General Motors. 

X1 = 0.1074, X2 = 15.5400
X3 = -0.0343 X4 = 0.4094
X5 = 0.8412 X6 = 0.0545

Plugging these values into the above equation, y = 0.5661. Plugging this value into the probability equation, P is
0.3621, indicating membership in the compliance group. Even though 1980 was a not good year for General Motors.,
which is reflected by its X 3 value of –0.0343, GM still was predicted to be a member of the compliance group on the
strength of its balance sheet. If GM’s 1978 EBIT figure of $6.485 billion had been earned in 1980, the value of X 3
would have been 0.1875. In this counterfactual situation, the new y and P values would have been –1.585 and 0.1701,
respectively. This example illustrates the importance of looking at more than one ratio to judge performance, and the
sensitivity of the logit function to a change in a particular variable.

Chesser’s “Credit – scoring” model, which is typical of the framework used to build either credit scoring or loan-
review models, can be used to monitor loan compliance.

Portfolio Risk: A Definition

Portfolio Credit Risk arises from an acceleration in the expected loss of a portfolio due to increased exposure to one
credit, or groups of highly co-related credits. Portfolio risk comprises of intrinsic n concentration risk. The credit risk
of a bank’s portfolio depends on both internal n external factors. The external factors are the state of economy, wide
swings in commodity/ equity prices, foreign exchange rates n interest rates, trade restrictions, economic sanctions,
government policies, etc.
The internal factors are deficiencies in loan policies/ administration, absence of prudential credit concentration limits,
inadequately defined lending limits for loan officers/ credit committees, deficiencies in appraisal of borrower’s
financial position, excessive dependence on collateral n inadequate risk pricing, absence of loan review mechanism n
post sanction surveillance, etc.

Portfolio Risk: Basel Committee Views

According to BCBS, concentrations are most probably the single most important cause of major credit problems.
Credit concentrations are viewed as any exposure where the potential losses are largely relative to the bank’s capital,
its total assets or, where adequate measures exist, the bank’s overall risk level.

Credit concentrations, according to the committee, can further be grouped into two categories; viz.; (a) conventional
credit concentration, which would include concentrations of credits to single borrowers or counterparties, a group of
connected counterparties, and sectors or industries, n (b) concentrations based on common or co-related risk factors to
reflect subtler or more situation specific factors.

Portfolio Risk Analysis

Portfolio credit risk analysis allows credit managers to quantify n test concentration risk along various dimensions as
under:
- Industry
- Rating Category
- Country or Geographic location
- Type of instrument

Owing to heightening competition, good customer relationships have often become synonymous with heavily
concentrated exposures. As a result corporate borrowers command larger commitments because of relationship with
banks. Banks are often caught in a paradoxical trap of their own making whereby customers with whom they have
developed the most valuable relationships are precisely the customers to whom they have least capacity to take
incremental risk. This gives fear to the banks that they are vulnerable to a turn for the worse in credit cycles.

Portfolio Risk: J P Morgan’s Credit Metrics

I. Concentration risk refers to additional portfolio risk resulting from increased exposure to one obligor or
groups of correlated obligors.
II. The traditionally used exposure based concentration limits do not recognize the relationship between risk
and return.
III. The portfolio approach would create a framework within which to consider concentrations along almost any
dimensions (industry, sector, country, instrument type, etc.).
IV. To more rationally and accountability address portfolio diversification in terms of addition to overall risk of
the portfolio by deciding to take on higher exposure. Some firms or industries may be individually risky, but
offer a relatively small marginal contribution to overall portfolio risk due to diversification benefits.
V. By capturing portfolio effects (diversification benefits and concentration risks) and recognizing that credit
quality, a portfolio credit risk methodology can be the foundation for a rational risk based capital allocation
process.

Portfolio Risk n Diversification benefits

The diversification principle suggests that lenders cannot assess the riskiness of individual loans in isolation; rather,
this riskiness must be evaluated with other loans in the portfolio. If the additional loan added to the portfolio is highly
correlated with existing loans (e.g. adding another real estate or drip irrigation loan to an already concentrated
portfolio of real estate or drip irrigation loans), then the lender is taking on more portfolio risk than if a less correlated
loan (financing to a wholesale dealer in textile goods) were added to the portfolio.

The are two simple models widely employed by bankers to measure credit risk concentration beyond the purely
subjective model of, ”we have already lent too much to this borrower.”

 The first is called migration analysis, where lending officers track the credit ratings of certain sectors
(provided by Credit Rating Agencies Standard & Poor, Moody’s, Dun & Bradstreet, etc. to name a few) - for
example, machine tools. If ratings of a number of firms in a sector decline, lending to that sector will be
 curtailed. The problem with this approach is that it amounts to “locking the stable door after the horse has
bolted.”
 A second model is for management to set some firm external limit on the maximum loans that can be made to
an individual borrower. For example, suppose management is unwilling to permit losses exceeding 10 percent
of a Bank’s capital to a particular sector. If it is estimated that the amount lost per Rupee of defaulted loans in
this sector is 25 paise, then the maximum loans to a single borrower as a percent of capital, defined as the
concentration limit, is: Concentration limit = Maximum loss as a percent capital x 1/Loss rate= 10% x
[1/0.25 ] = 40%

Sufficient loan volume data may be available to allow managers to analyze the overall concentration or credit risk
exposure of the bank. Such loan volume data include:

 Supervisory Authority’s reports on classification of loans given by commercial banks to different economic
sectors viz., real estate, agriculture, commercial and industrial, individuals, state and central governmental
agencies, and overseas.
 Shared national data on loans given different commercial banks to different sectors of the economy.

RBI Guidelines for Portfolio Risk Management

The portfolio quality could be evaluated by tracking the migration (upward or downward) of borrowers from one
rating scale to another. This process would be meaningful only if the borrower-wise ratings are updated at quarterly /
half-yearly intervals. Data on movements within grading categories provide a useful insight into the nature and
composition of loan book.

The banks could also consider the following measures to maintain the portfolio quality:

I. Stipulate quantitative ceiling on aggregate exposure in specified rating categories, i.e. Certain percentage of
total advances should be in the rating category of 1 to 2 or 1 to 3, 2 to 4 or 4 to 5, etc.;
II. Evaluate the rating-wise distribution of borrowers in various industry, business segments, etc.;
III. Exposure to one industry/sector should be evaluated on the basis of overall rating distribution of borrowers
in the sector/group. In this context, banks should weigh the pros and cons of specialisation and concentration
by industry group. In cases where portfolio exposure to a single industry is badly performing, the banks may
increase the quality standards for that specific industry;
IV. Target rating-wise volume of loans, probable defaults and provisioning requirements as a prudent planning
exercise. For any deviation/s from the expected parameters, an exercise for restructuring of the portfolio
should immediately be undertaken and if necessary, the entry level criteria could be enhanced to insulate the
portfolio from further deterioration;
V. Undertake rapid portfolio reviews, stress tests and scenario analysis when external environment undergoes
rapid changes (e.g. Volatility in the forex market, economic sanctions, changes in the fiscal/monetary
policies, general slowdown of the economy, market risk events, extreme liquidity conditions, etc.). The
stress tests would reveal undetected areas of potential credit risk exposure and linkages between different
categories of risk. In adverse circumstances, there may be substantial correlation of various risks, especially
credit and market risks. Stress testing can range from relatively simple alterations in assumptions about one
or more financial, structural or economic variables to the use of highly sophisticated models. The output of
such portfolio-wide stress tests should be reviewed by the board and suitable changes may be made in
prudential risk limits for protecting the quality. Stress tests could also include contingency plans, detailing
management responses to stressful situations.
VI. Introduce discriminatory time schedules for renewal of borrower limits. Lower rated borrowers whose
financials show signs of problems should be subjected to renewal control twice/thrice a year.

Sample SME Credit Scoring Model

Possible Criteria Attributes with Hypothetical Weights*

Credit History of Principal(s) Major Derogatory Minor Derogatory Satisfactory No Record:
Data: Consumer Credit (bankruptcy, (minor delinquencies) +15 pts 0 pts
Report collections) - 10pts
- 60pts
Unused Credit Data: 75% of Available 74%-33% of <33% of Available No Record:
Consumer Credit Report Available +20 pts 0 pts
 +40 pts +30 pts
Credit History of Business Major Derogatory Minor Derogatory Satisfactory No Record:
Data: Business Credit Report -40 pts -10 pts +15 pts 0 pts
Industry Type Data: Federal Group A Group B Group C Group D (high
SIC Code (manufacturing, with +40 pts +35 pts risk, e.g.,
hard assets) restaurant):
+50 pts +20 pts
Available Liquid Assets of <85K $6-10K $20-49K $50K & up
Business (e.g., bank balances) +18 pts +20 pts +40 pts +45 pts
Data: Loan Application
Net Worth of Principal(s) <$50K $50-100K $100-250K $250K & up
Data: Loan Application +10 pts +20 pts +30 pts +40 pts

Example: SME Applicant Evaluation

Judgment-Base
Criteria Underwriting Credit Scoring
Credit history of principal(s) + 15
Unused credit – 20
Credit history of business + 15
Industry type – 20
Available liquid assets of business + 45
Net worth of principals + 40
+ 155
Overall Decision
Accept Accept
Probability of repayment (based on the past ? 18:1
performance of the pooled borrowers) (18 out of 19 applicants with this score
will repay)

Predictive Factors Included in Scoring Models

Business Owner

Years in Business Age

Industry Marital Status

Years of Management Experience Residential Status

Total Assets Number of Years at Address

Company Credit Bureau File Personal Credit Bureau File

– Multi-year history of payment – Multi-year history of payment performance
performance
– Public record information such as – Public record information, such as bankruptcy
bankruptcy and tax liens and tax liens

Scoring models are most reliable when sufficient data exists to depict a borrower’s performance over a multi-year
period AND when sufficient data exists to depict other similar borrowers’ performance over a multi-year period.
 Total Application and Underwriting Costs

Consumer Loan SME Loan

(Assumes that consumer loans
are typically scored and SME

$30 – 50 Underwriting $300 – 500

$2 – 10 Administrative $25 – 100

loans are not)
Today

$10 – 20 Corporate Overhead $100 – 200

$1 – 5 Data Cost $25 – 100

$5 – 10 Miscellaneous $50 – 100

$48 – 95 TOTAL COST $500 – 1,000

Impact of Credit Scoring:

Note: Approximately 80% of costs are people costs.
Reduce Costs:
– Reduce losses by 10-30% while holding approval Increase Revenues:
rates constant
– Increase approval rate 10-30% while holding
– Reduce time and manual steps in processing each the loss rate constant
application
– Increase NII through risk-based pricing (A study
– Reduce number of applications requiring manual by the Federal Reserve Bank of Atlanta suggests that
review banks using SME Credit Scoring enjoy a 7 percent
higher loan premium than banks that do not use
– Reduce training time for new credit staff scoring)

Credit Rating Agency for MSMEs

A credit rating agency named Small and Medium Enterprises Rating Agency of India Ltd. SMERA is the country's
first Rating agency that focuses primarily on the Indian Micro, Small and Medium Enterprise (MSME) segment. It is
a joint initiative of SIDBI, Dun & Bradsheet, leading banks in India, and CIBIL. SMERA's primary objective is to
provide Ratings that are comprehensive, transparent and reliable. This would facilitate greater and easier flow of credit
from the banking sector to MSMEs.

Credit Rating is an estimate of the credit worthiness of an individual, corporation, or a country. It is an opinion made
by credit evaluators of a borrower’s potential to repay debt. Every rating grade comes with its probability of default,
which in turn assists investor/lender to take informed investment decision. Rating is arrived after considering various
financial, non-financial parameters, past credit history and future outlook. There are various types of ratings viz. Issuer
Rating/ Obligor Rating, Bank loan Rating, Issue based Ratings, Project Rating etc. Based on type of borrower/issuer,
Ratings can be classified as Individual Rating, Corporate Rating, Bank/Financial Institutions Rating, SME Rating,
MFI Rating etc.

SMERA offering

SMERA Credit Ratings provides a comprehensive and independent third-party evaluation of the overall condition of
the applicant. Currently, SMERA offers Obligor Ratings which takes into account the financial and non-financial
factors that have bearing on the credit worthiness of the applicant. At present, SMERA offers following products:
– MSME Rating
– Greenfield & Brownfield Grading
– Microfinance Institutions (MFI) Rating
– Green Rating
– Risk Management  Solutions
– Maritime Training Institutions (MTI) Rating

SMERA Rating endeavours to enhance the market standing of the applicant amongst lenders, trading partners and
prospective customers.
Rating Methodology (Manufacturing)

SMERA rating framework considers a number of financial and non financial parameters of the enterprise and the
impact of the macro economic factors like government policies, trade policies and regulations and the industry
specific dynamics. SMERA believes that the industry in which a SME operates has a direct bearing on the overall
performance of the SME and therefore rates SMEs based on industry benchmarks.  SMERA Rating is a
comprehensive assessment of the enterprise taking into considerations the overall financial and non financial
performance of the subject company vis-à-vis the other peers in the industry in the same line of business and size
criteria. Based on its assessment and understanding, SMERA has developed rating methodology framework which
mainly addresses the following areas

 Industry Risk
 Business Risk
– Market Risk
– Operating Efficiency
 Management Risk
 Financial Risk
 New Project Risk

A. Industry Risk

The industry in which an enterprise operates plays a crucial role in the credit risk assessment. It is a key determinant
of the level and volatility in earnings of any business.

B. Business Risk

Business risk is the possibility of a credit customers failing to pay because of circumstances connected with the
customer’s business activities and management.

a. Market Risk : Market risk is the exposure of the unit to the forward and backward linkage in the course of
conducting its business, and the risk of facing sustained periods of unfavorable trends in such factors as
product prices, raw material prices, single product dependence, pricing inflexibility, etc.

b. Operating Efficiency : In markets where competitiveness is largely determined by costs, the market position is
determined by the unit’s operational efficiency. The result of these factors is reflected in the ability of the unit
to maintain /improve its market share and command differential in pricing. In a competitive market, it is
critical for any business unit to control its costs at all levels. This assumes greater importance in commodity or
"me too " businesses, where low cost producers almost always have an edge. Cost of production to a large
extent is influenced by location of the production unit(s), access to raw materials, access to human resources,
scale of operations, technology, level of integration , experience and the ability of the unit to efficiently use its
resources.

C. Management Risk

Management risk refers to the instance of risk of non payment arising out of a business failure due to the perceived
inefficacies of the management. The elements in management risk are assessing the management quality judged on the
basis of the basic educational qualification, professional experience of the entrepreneur; and business attitude that is
related to the motivation of carrying out the business and pursuing business strategies.

Majority of the Indian SMEs are essentially managed by one or two key persons. In this scenario, the quality of
management personnel becomes critical. In assessing management quality three factors are critical:

– Character - relate to the willingness to pay. Apart from the characteristic disposition of honesty and
integrity, several aspects are judge in terms of Track record of previous borrowing and payment is an
indicator. Whether the owners/ directors have a financial interest in the business. Business premises given
the impression of a well-run unit.
– Ability - relates basically to the ability to pay. Credit worthiness of the buttoner/borrowing company is
assessed, including financial strength, and
– Capacity - refers to the borrower having technical, managerial and financial abilities in order to operate
profitably and succeed in business.
Quality of management would determine level of control, overall organizational capability, willingness to service
loan, etc. Absence or inadequate of presence of these factors would lead towards greater risks. Type of organizational
also adds to the management risk. Past experience of the management in handling similar business, performance of
group companies and their track record, vision and mission of the management, organisation structure, succession
issues, networth and corporate governance also plays an important role in assessing the management.

D. Financial Risk

Financial risk analysis involves thorough evaluation of the financials of the SMEs. Careful analysis of the audited
financials, observations of auditors in the auditors report and notes to accounts, consistent treatment of financials play
an important role. Key ratio analysis, trend ratios, financial disclosures and off Balance sheet items and their impact
on the profitability is studied and analysed in depth. Further the source of financial funding and their impact on the
capital employed structure needs to be analysed. Availability of liquid investments, unutilized lines of credit, financial
strength of group companies, market reputation, relationship with financial institutions and banks, enterprise
perceptions and experience of tapping funds from different sources also play an important role in financial analysis.
Past performance of the company, level of financial transparency i.e. quality of documents and future plans plays an
important role in the determination of rating.

While the focus of rating exercise is to evaluate the future cash flow adequacy for servicing debt obligations, a
detailed review of the past financial statements is critical for better understanding of the influence of all the business
and financial risk factors. Evaluation of the existing financial position is also important for determining the sources of
secondary cash flows and claims that may have to be serviced in future.

E. New Project risks:

The scale and nature of new projects can significantly influence the risk profile of any. Unrelated diversifications into
new products are invariably assessed in greater detail.

The main risks from the new projects are time and cost overruns, even non-completion in an extreme case, during
construction phase; financing tie-up; operational risks; and market risk. Besides clearly establishing the rationale of
new projects, the protective factors that are assessed include track record of the management in project
implementation, experience and quality of the project implementation team, experience and track record of technology
supplier, implementation schedule, status of the project, project cost comparisons, financing arrangements, tie-up of
raw material sources, composition of operations team and market outlook and plans.

SMERA Initial Public Offering (IPO) Scale

SMERA Initial Public Offering (IPO) grading is a five point grading scale. The issuers with strong fundamental
relative to its peers are assigned highest score "SMERA IPO Grade 5" and the issuers with poor fundamentals relative
to its peers are assigned lowest score i.e. "SMERA IPO Grade 1“

SMERA IPO Grade Evaluation

SMERA IPO Grade 5 Strong fundamentals

SMERA IPO Grade 4 Above Average Fundamentals
SMERA IPO Grade 3 Average Fundamentals
SMERA IPO Grade 2 Below Average Fundamentals
SMERA IPO Grade 1 Poor Fundamentals

SMERA’s MSME Rating Scale

SMERA's MSME rating scale consists of two parts, a composite appraisal/condition indicator and a size indicator.
SMERA Rating categorises MSMEs based on size, so as to enable fair evaluation of each MSME amongst its peers.
The SMERA’s MSME rating scale is specified below:
 SMERA Rating Rating Appraisal Indicator

MSME 1 Highest
MSME 2 High
MSME 3 Above Average
MSME 4 Average
MSME 5 Below Average
MSME 6 Inadequate
MSME 7 Low
MSME 8 Lowest

NSIC D&B SMERA Rating Scale

Rating Indicator

Financial Strength
High Moderate Low
Performance Highest SE1A SE1B SE1C
Capability
High SE2A SE2B SE2C
Moderate SE3A SE3B SE3C
Weak SE4A SE4B SE4C
Poor SE5A SE5B SE5C

Green Field Brown Field Rating Scale

Grading Scale Explanation

Pr1 The company has the strongest likelihood of  viable operations
Pr2 The company has very strong likelihood of  viable operations
Pr3 The company has strong likelihood of  viable operations
Pr4 The company has moderately strong likelihood of  viable operations
Pr5 The company has an average likelihood of  viable operations
Pr6 The company has low likelihood of  viable operations
Pr7 The company has very low likelihood of  viable operations
Pr8 The company has poor likelihood of  viable operations  
SMERA’s Default Study

A. Default Distribution

Rating Scale NPA Restructuring Total Default Total ratings Default%

1 0 0 0 38 0.00%
2 0 5 5 330 1.52%
3 14 25 39 1538 2.54%
4 16 47 63 1048 6.01%
5 13 44 57 703 8.11%
6 18 16 34 192 17.71%
7 11 6 17 41 41.46%
8 2 2 4 7 57.14%
Total 74 145 219 3897 5.62%

B. Default Distribution based on Industries:

Industry Per cent Industry Per cent

Auto Ancillary 11.4% Food & Agro 5.2%

Paper & Packaging 10.00% Pharmaceuticals & Chemicals 5.1%
Gems & Jwellery 9.7% Plastic & Rubber 4.6%
IT & ITES 8.6% Services 3.8%
Ceramic & Stone 8.6% Leather & Leather Goods 3.4%
Garments & Exports 8.1% Printing & Publishing 3.2%
Infrastructure 7.1% Others 3.1%
Metals & Metal Products 6.9% Electrical & Engineering Goods 2.3%
5.6%

C. SMERA’s Cumulative Default Rates (2006-10)

Rating Scale CDR 2006-08 CDR 2007-09 CDR 2008-10 5 year Average of 3
Year CDR

1 0.00% 0.00% 0.00% 0.00%

2 6.39% 4.44% 1.04% 3.96%
3 10.41% 10.00% 6.13% 8.85%
4 26.70% 24.36% 12.08% 21.05%
5 29.80% 24.51% 25.97% 26.46%
6 61.84% 66.13% 46.94% 58.30%
7 100.00% 100.00% 89.10% 96.37%
8 0.00% 33.33% 83.33% 38.89%
 D. Time to Default

Rating Scale Months to Default

1 No Default
2 26.17
3 22.07
4 14.66
5 7.32
6 8.74

E. FY 2007-11 Transition Matrix

Year 2

1 2 3 4 5 6 7
Year 1 1 100
2 16 48 31 5
3 16 55 23 6 1
4 3 24 52 18 3
5 34 52 10 3
6 8 8 17 50 17
Retail Scoring Model

Two types of credit decisions

 Judgemental
 Statastical

The credit decision

Scoring vs. judgmental

 Both methods
 Assume that the future will resemble the past
 Compare applicants to past experience
 Aim to grant credit only to acceptable risks

 Added value of scoring

 Defines degree of credit risk for each applicant

 Ranks risk relative to other applicants
 Allows decisions based on degree of risk
 Enables tracking of performance over time
 Permits known and measurable adjustments
 Permits decision automation

Evaluating the credit applicant

CHARACTERISTICS JUDGMENT CREDIT SCORING

Time at present address + 12

Time at present job + 20
Residential status - 5
Debt ratio + 21
Bank reference + 28
Age N/A 15
•
Income
•• - 5
• •
•• ••
# of Recent inquiries - -7
% of Balance to avail. lines + 10
# of Major derogatories. + 35
Overall + 212

Decision Accept Accept

Odds of repayment ? 11:1

Scorecard

Own/ Own/25 Rent/15 Other/1 NI/17

Rent 0

Years at <5/ .5-2.49/ 2.5- 6.5- >10.5/23 NI/14

address 12 10 6.49/15 10.49/19
Occupation Prof/ Semi-Prof/44 Mgr/31 Officer/28 Bill Coll/25 Retired/31 Others/22 NI/27
50
Years on Job <.5/2 .5-1.49/8 1.5- 2.5-5.49/25 5.5- 12.5/39 Retired/43 NI/20
2.49/19 12.49/30
Deptt None/0 Deptt St/11 Major Both/27 No NI/12
St/Major CC CC/16 Answer/10
Bank Ref Chk/5 Sav/10 Chk&S Other/10 NI/9
av/20
 Debt Ratio <15/22 15-25/15 26- 36-49/5 50+/0 NI/13
35/12
No of recent 0/3 1/11 2/3 3/-7 4/-7 5-9/20 No Record/
enquiries 0
Years in file <.5/0 1-2/5 3-4/15 5-7/30 8+/40
% Bal to 0- 16-30%/5 31- 41-50%/-10 >50%/-18
avail lines 15%/15 40%/-3
Worst No Any Dero/ Any 1 satis/17 2 satis/ 24 3 satis/29
Reference record/0 -29 slow/-
14

Interrelationships

Own / Rent
Age Time at
address
Time at
Source
Job
Specific creditor
 Custom scorecards
Other creditor / portfolio
 Borrowed scorecards
Multiple creditors
 Pooled data scorecards
Prior scorecard experience
 Launch scorecards

Managing Credit Risk in Inter-bank Exposure

The key financial parameters to be evaluated for any bank are:

a) Capital Adequacy
b) Asset Quality
c) Liquidity
d) Profitability

Capital Adequacy

 The Basel standards currently require banks to have a capital adequacy ratio of 8% with Tier I ratio not less
than 4%. The Reserve Bank of India requirement is 9%.

Asset Quality

The key ratios to be analysed are

 Gross NPAs to Gross Advances ratio,
 Net NPAs to Net Advances ratio
 Provisions Held to Gross Advances ratio and
 Provisions Held to Gross NPAs ratio.
Liquidity

The key ratios to be analysed are

 Total Liquid Assets to Total Assets ratio (the higher the ratio the more liquid the bank is),
 Total Liquid Assets to Total Deposits ratio (this measures the bank's ability to meet withdrawals),
 Loans to Deposits ratio and
 Inter-bank deposits to total deposits ratio.

Profitability

The key ratios to be analysed are:

 Return on Average Assets (measures a bank's growth/ decline in profits in comparison with its balance sheet
expansion/ contraction),
 Return on Equity (provides an indication of how well the bank is performing for its owners),
 Net Interest Margin (measures the difference between interest paid and interest earned, and therefore a bank's
ability to earn interest income) and
 Operating Expenses to Net Revenue ratio (the cost/income ratio of the bank).

In addition to the quantitative indices, other key parameters to be assessed are:

 Ownership
 Management ability
 Peer comparison/ Market perception
 Country of incorporation/ Regulatory environment
Country risk needs to be evaluated since a bank which is financially strong may not be permitted to meet its
commitments in view of the regulatory environment or the financial state of the country in which it is operating in.
Banks should be rated (called Bank Tierings) on the basis of the above factors. An indicative tiering scale is:1

Bank Tier Description

1 Low risk
2 Modest risk
3 Satisfactory risk
4 Fair Risk
5 Acceptable Risk
6 Watch List
7 Substandard
8 Doubtful
9 Loss

Loan Review Mechanism/ Credit Audit

Objectives of Credit Audit

 Improvement in the quality of credit portfolio

 Review sanction process and compliance status of large loans
 Feedback on regulatory compliance
 Independent review of Credit Risk Assessment
 Pick-up early warning signals and suggest remedial measures
 Recommend corrective action to improve credit quality, credit administration and credit skills of staff, etc.

Functions of Credit Audit Department

 To process Credit Audit Reports
 To analyse Credit Audit findings and advise the departments/ functionaries concerned
 To follow up with controlling authorities
 To apprise the Top Management
 To process the responses received and arrange for closure of the relative Credit Audit Reports
 To maintain database of advances subjected to Credit Audit
Portfolio Review: Examine the quality of Credit & Investment

 (Quasi Credit) Portfolio and suggest measures for improvement, including reduction of concentrations in
certain sectors to levels indicated in the Loan Policy and Prudential Limits suggested by RBI.

Loan Review: Review of the sanction process and status of post sanction processes/ procedures (not just restricted to
large accounts)

 all fresh proposals and proposals for renewal of limits (within 3 – 6 months from date of sanction)
 all existing accounts with sanction limits equal to or above a cut off depending upon the size of activity
 randomly selected ( say 5-10%) proposals from the rest of the portfolio · accounts of sister concerns/
group/associate concerns of above accounts, even if limit is less than the cut off.

Action Points for Review

 Verify compliance of bank's laid down policies and regulatory compliance with regard to sanction
 Examine adequacy of documentation
 Conduct the credit risk assessment
 Examine the conduct of account and follow up looked at by line functionaries
 Oversee action taken by line functionaries in respect of serious irregularities
 Detect early warning signals and suggest remedial measures thereof

Frequency of Review
 The frequency of review should vary depending on the magnitude of risk (say, for the high risk accounts - 3
months, for the average risk accounts- 6 months , for the low risk accounts- 1 year).
 Feedback on general regulatory compliance.
 Examine adequacy of policies, procedures and practices.
 Review the Credit Risk Assessment methodology.
 Examine reporting system and exceptions thereof.
 Recommend corrective action for credit administration and credit skills of staff. Forecast likely happenings in
the near future.