Business Essay - Credit Risk Management Banking

Credit Risk Management Banking

This chapter demonstrates the literature that is relevant to the research on Credit Risk Management in Banking. The author has enclosed literature on dynamics, models, model features, and Basel II regulatory process for credit risk. The author has also enveloped literature on credit risk management in banks. The author has also exhibited the literature on currently available approaches in calculating and managing the credit risk and it's fit of with current banks in India. This chapter mainly focuses on the module and element available in credit risk with its fit with Indian banking sector. Many innovations have been brought in the financial services, in this the credit risk had been given the major importance to stop them from the failures and have a common goal: enhancing the risk-return profile of the bank portfolio. (Bessis 2002; Greuning and Bratanovic 2000) This chapter will form the basis for the arguments presented in preceding chapters.

In the world of rising competition and turbulent business environment, it has become essential to identify measure and manage the credit risk to improve economical capital over the period of time .To enhance the credit risk new strategies been evaluated (Lore and Borodovsky 2000). Over the period of decade there is a tremendous change in banking to manage the economic capital and more than 80 percent of bank's balance sheet generally relates to aspect of risk management. It involves complete assessment of the banks in different aspects such as supervise, control, enforce and recover loan, advances, guarantees and other credit derivates and the overall assessment includes the banks credit risk management policies and practices of the bank and in vice versa it makes banks to identify, measure and manage credit risk according to the changes in global capital market. (Greuning and Bratanovic 2000; Bessis 2002).

2.1 Definition of Credit Risk

Credit Risk has been defined by many authors writing on this topic. Some of the definitions are as follows.

The risk of loss due to failure by counterparty to perform on a contractual obligation (Banks 2002)
The risk of changes in value associated with unexpected changes in credit quality (Duffie and Singleton 2003).
The risk that a borrower will be unable to repay (Coult 1990).
This is the risk that a counterpart defaults and the bank losses all its market position or that part which is irrecoverable (Andrew 2002).
Credit risk is the risk of loss due to a non-payment of a loan or credit. It can be either the principal amount or interest amount. It exists when payment is being expected from someone he fails to pay. Lending financial institution creates substantial provisions or write offs ( Brain 2000 )
The risk that counterparty will not settle an obligation for full value, either when due or at any time thereafter, in exchange for value systems, the risk is generally defined to include replacement risk and principal risk (Gallati 2003).
Credit risk can be defined as the economic loss suffered due to the default of a borrower or counterparty (Lam 2003).
Credit risk is commonly thought of as the probability of default (Barnhill et .al., 1999).
The possible loss (probability of default) that could occur for the ROP if the counterparties fail to meet their financial responsibilities, not only at the present time but also in the future (during the maturity of all outstanding transactions that result in credit risk). Settlement risk is explicitly excluded from the definition of credit risk (Blommertein 2005).

2.2 Credit Risk:

It is the risk which is associated third parties money borrowed and he is not able to pay. In first the organization determines the interest rate for the loan and the guarantee amount required to secure the loan to check the credit worthiness (Andrew 2002) Credit risk includes risks connected with upgrading or downgrading borrower's credit worthiness. (Tapiero 2004) financial risks such as market risk, operational risk and credit risk decides the probabilities of future returns, extreme events and unknown defaults within an organization. Proposing credit risk combined with information leap decision theory, helps financial sectors balance regulatory requirements and revenue targets through loan and interest rates for secure credit risk group. (Web1).The external risks that are inaccessible from organization's control but affected by its financial operations are the financial risk, which includes

Credit risk
Liquidity risk
Currency risk
Cash-flow risk(CIMA )

2.2.1 TYPES OF CREDIT RISK:

Different authors had given different approach regarding credit risk types:

Pre-settlement risk is a loss in advance before terminating a contract due to counterparty's default; this loss mainly depends on the alternate value of the contract at the time of default.
Settlement risk- is the loss realized, when the payments are not received according to the contract on the settlement date.( Aziz and Charupat2000)
Personal or consumer risk
Corporate or company risk
Sovereign or country risk (Greuning and Bratanovic 2000; 126)
Credit default risk
Credit spread risk (choudhry 2004; 2)

2.2.2 Five Main Factors Contributing the Level of Losses with Credit Risk Models:

Changes in loss rate given defaults.
Ratings migration.
Correlation among default and rating transaction.
Changes in credit spread.
Changes in exposure levels. (Gallati 2003, 136).

2.3 CREDIT RISK POLICY:

According to (Coyle 2000) policy should be realistic and manageable and there several different ways to formulate the policies depends on the management. Credit risk policy of every bank have to determine: how much credit to be provided; for what time duration; types of clients and so on, the bank policy should also specify the degree of diversity in size and the concern is apparently in profitability and the risk of loan. Credit rating desired by banks should have tolerance for risk associated with their economic capital. In this case, credit risk can be diversified and other risks can be priced high. Management must indicate the tolerance level to its credit risk and bind the loan losses (in terms of probability). Authorities should set approval on the credit sizes and the risk exposure. Credit risk should be tracked and the exposure level reported systematically combined with information about creditors in it and (Crouhy Et al 2006) often the policy are insufficient or same type of other product makes the profit maximization (Mostafa 2000) policy should be employee knowledgeable and capable persons to control and manage risks, and reviewing reports from management to certify the adequacy of risk profile and controls. (Website 7)

2.3.1The Most Commonly Used Management Tools Include

The commonly used tools by the management in setting up the policy are:

Pricing of loan transactions based on the risks involved in it.
Individual loans or portfolios are to setup with risk limits.
Applying as a tool for managing credit risk credit insurance, derivatives and guarantees
Securitization of risks.
Buying and selling of assets.(FMA Report 2005)

2.4 Dynamics of Credit Risk

Variety of aspects factors in banks credit risk business; identifying and better understanding and gives a good opportunity in lending activities and maximise the return on the risk which banks has taken (Kudyba 2004)The importance measuring and identifying of credit risk makes both the possibility of default and loss incurred. According (Duffie and Singleton 2003; Culp 2001; Banks 2002; Kudyba 2004) they had given three dynamics influencing the credit risk are.

2.4.1 Identifying Credit Risk:

Different authors have different approaches in identifying the credit risk process, it provides with strong base for the better risk management process. The identifying activity determines the business at each for its capability (Glantz 2003) and impact of the current decision on the business (Basu and Rolfes 1995)the business at the individual level they are taken in the account but later it may be aggregated for the better management of risk, not only the current risk are identified r but also the emerging risk are taken into account and even those which doesn't have impact with the business but it may have in the future and identifying, could provide with better constraint for the future in business in regards to credit risk (web 1). the credit risks at each level is studied and then a cumulative risk statement for the organization as a whole is formed, during this process the present risks as well as possible risks in the near future should be marked with the help of valid knowledge from risk officers, the credit risk identification process must proceed in a logical succession: beginning with the most common or essential and moving to the more complex or esoteric. Thus, the identification of risk must be broad and stand as basis for quantification and limit-setting phases. (Banks 2002; Bitner and Goddard 1992; Kudbya 2004).

Illustration:

Credit risks:

Fundamental
Unsecured loan / loan-equivalent default risk.
Derivative-equivalent default risk.
Marketable securities.
Deposit default risk.
Settlement / delivery risk.
Sovereign default risk.
Convertibility risk.
Collateral default risk.
Liquidity risk. (Banks 2002)
Esoteric
Cash flow mistakes risk (creating unsecured loan).
Contingent cash-flow risk (triggered by events).
Credit cliff risk (triggered by rating events).
Model risk (in credit analysis, pricing and valuation).(Banks 2002)

2.4.2Measuring credit risk:

According to (Duffie and Singleton 2003) the measurement of credit risk presents some challenges in measuring, but credit risk is considered as a component of market risk. The measurement process requires a blend of theory and art (Figlewski and Levich 2002) thus measuring of credit risk is being done in different ways (anonyms).

Specialized measures of credit risk

The involvement of credit risk to market risk is difficult in providing the benefits to the counterparty from credit risk and limiting the interest towards credit risk by industry, geographic region and so on. Several complementary measures of credit risk have been exposed for the better understanding of credit risk and risk managers explored such measures (Duffie and Singleton 2003).

B) Market value of default loss:

Determining the Value of Debt and Market value of default loss are the same (Burner 2004). An approximate calculation of the influence of credit risk on market values helps to figure out the expenses and profits of marketing and in determining the strength of financial firm's resources supporting credit risk. Determining of value of debt is same as (Duffie and Singleton 2003; Glantz 2003).

C) Exposure:

Accurate measure of exposure quantifies future measures (Schwartz and smith 1997) In case, new plans that attract customer's attitude is introduced by a counterpart, the exposure measure is used by an organization to limit strategies and reward credits, exposure might be fruitless when the counterparty conceals essential information. (Duffie and Singleton 2003; Servigny and Renault 2004).

2.4.2.1 USES OF CREDIT RISK MEASUREMENT:

Active portfolio management.
Setting of concentration and exposure limits.
Setting of hard targets on syndicated loans.
Risk bearing pricing.
Improving the risk return profiles of the portfolio,
Evaluation of risk-adjusted performance of business lines of managers using risk-adjusted return on capital.
Economic capital allocation.
Setting or validating loan loss reserves either for direct calculation or for validation process.(Website 3)

According to (Fma Report) though there is no standard protocol for measuring credit risk, a regular evaluation of credit risk is a must for a perfect financial management. The actual loan losses distributed are asymmetric so there could be small chances of big losses and big chances of small losses (Glantz 2003) Credit risk is calculated from possible losses in credit portfolio, the possible losses can divide into

Expected loss.
Unexpected loss.

2.4.3 Expected loss:

The loss which is expected from the borrower's default probability and the exposure at default less the recovery data, i.e., all expected cash flows, especially from the realization of collateral. Under certain credit conditions all the expected losses should be accounted for income planning and included as standard risk costs. (FMA Report; Figlewski and Levich 2002

2.4.4 Unexpected loss:

The unexpected loss arises from the expected losses. They are taken into account indirectly via equity costs for income planning and setting up credit conditions. Risk coverage capital is used to secure the unexpected loss to compensate the expected looses. (FMA Report; Figlewski and Levich 2002)

2.4.5Expected loss vs. unexpected loss:

The expected loss and unexpected loss cannot be minimized through diversification. The yield from loan can be made profitable by covering directly the expected loss (it should be included related funding and operating costs) and by covering the unexpected loss indirectly (making profits from bank's difficulty rate on the assigned capital cushion ). Exact measurements of Expected loss and unexpected losses are decisive for profitability measurement. Comparing pricing, resource allocation, or portfolio management is critical to find out the profitability and it is helpful only when there is constant measurement of expected loss and unexpected losses. The connection among Unexpected Loss and Concentration Risk, Correlation and Portfolio measures the uncertainty or variability of loss. The possible levels of unexpected losses in a portfolio of credit exposures are essential to the successful management of credit risk. Expected loss is subtracted from loss at the confidence interval usually done by all the banks. Credit pricing is used for recovering the expected loss. Therefore, capital is needed only to cover Unexpected Losses (“loss estimated at the confidence interval minus EL”). (Glantz 2003; Saunders and Allen 2002;Saita 2007; Website 3) figure 2. Explains correlation against the expected loss and unexpected loss.

2.5 Calculation of Credit Risks:

For measuring the unexpected losses the two main methods used today:

Value At Risk Analysis or
Scenario Techniques

The accuracy level and methods of calculation are totally different in both the methods .scenario techniques are the easy methods and used where the VaR IS not possible.

2.5.1Value at Risk (VAR) ANALYSIS:

According to (Fma report) Value at Risk:”the maximum loss will not exceed a certain probability at a given horizon” is used to measure, manage, assess and control in investment management (jorion 2004) While determining the value at risk, the confidence level exposes the probability of maximum losses which will not exceed the holding period and analysis can be done on the available historical data (Pilipovic 1998). VaR estimates the current value of portfolio and probability of changes in the future portfolio. (Marrison 2002) The level of accuracy is usually measured between 95% and 99.95%, which shows the highest loss possibility between 5% and 0.05%. In holding period, loss occurs due to liquidity of assets. Value at Risk analysis has the advantage of calculating risks with different portfolios and with different types of risks such as credit risk, market risk and operational risk. (Pearson 2003; Saunders and Allen 2002; Saita 2007)

2.5.1.1Computation of Value at Risk:

To calculate value at risk, for single assets is a bit uncomplicated (Caouette et al 1998) it is necessary to conclude the allocation of potential losses in credit portfolio. Assumptions are made at default rate and they developed for the future exposure default. Value fluctuations in the extreme market movement are calculated by using stress tests but insufficient historical data can restrict the calculation of credit risk. (Fallon 1996; Fma Report; Pearson 2003)

2.5.2 SCENARIO ANALYSIS:

Scenario analysis put up a multiple factors such as conceptual (verbal), relational (models) and numerical (data) can be organized in a logical manner (Website 9). The existing historical market data and/or internal bank data generates a scenario relating to the development for the default rate. It is mostly used in potential future losses and external losses (Rosengren 2006). In the Normal case scenarios, the developed loss is unspecified with certain historical period. In Worst case scenarios, occurrences of excessive losses are unspecified. It is used in determining the area of fluctuation in portfolio values. Higher feasible risks are calculated on the basis of scenario analysis. This techniques has a limited explanatory power will make only a few changes in parameters. The quality of result will be lower when compared to value at risk concept. From the given historical data and limited parameters, value at risk concept cannot be achieved. Banks using the results from scenario analysis have to accept less precise results than using value at risk concept. The additional cost or profit and additional benefit could be derived by implementing this method. (FMA report; website 10)

2.6 BANK FOR INTERNATIONAL SETTLEMENTS (BIS):

The Bank for International Settlements (BIS) was established on 17th may 1930, is the world's oldest international financial organization and it acts as central banks for all the banks. It fosters international monetary and financial cooperation for all central banks. The head office is in Basel, Switzerland. The BIS customers are central banks and international organizations and it doesn't anticipate any deposits or provide any financial services to private individuals or corporate entities and it strongly advises caution against fraudulent schemes. The BIS currently employs 557 staff from 48 countries. The Basel Based Committees supports in researching the economic, monetary, financial and legal activities. It shares the statistical information among the central banks, and it publishing statistics on global banking, securities, and foreign exchange and derivatives markets. The role of the BIS is dynamic to the global financial society and is also an emergency "funder" to nations in trouble; it aided the countries such as Mexico and Brazil during their debt crises in 1982 and 1998. It does race directly with other private financial institutions for global banking activities. BIS struggle to offer quality services in order to attract central banks as their clients to provide security; it also maintains abundant equity capital and reserves that are diversely invested following risk analysis. It works With International Monetary Fund (IMF) of all central banks .it cooperate in organizing and reviewing the technical assistance for all central banks. (Zulu et al., 1994 And Baker 2002)

The BIS fulfils this mandate by acting as:

a forum to promote discussion and policy analysis among central banks and within the international financial community
a centre for economic and monetary research
a prime counterparty for central banks in their financial transactions
Agent or trustee in connection with international financial operations.

http://www.bis.org/about/index.htm

http://www.investopedia.com/articles/03/120903.asp

2.6.1Basel II

Main motto for implication of Basel II was to escape from “one-size fits all” from Basel I (Santos 2000) According to (Greuning and Bratanovic 2003) List of options for measuring credit, market and operational risk. The approaches set by Basel II balance themselves in terms of simplicity and accuracy. Basel committee considers three types of approaches to deal with credit risk are

Internal ratings-based approaches
Full modes approach
Pre commitment approach(Servigny and Renault 2004, 393)

2.6.2Three Pillars of Basel II:

Basel committee has developed three comprehensive pillars for sound capital regulation framework. The implementation of all the three pillars in a place makes adequate level of soundness. (Akkizidis and Vivianne 2006)

2.6.2.1Pillar 1

Minimum capital requirement: the main aim is to determine the capital required for portfolio in banks given the level of credit risk. (Williams 2007)

2.6.2.2Pillar 2

Supervisory review: it gives the supervisory approaches to the banks for their capital management .The aim here for the banks is to follow rigorous procedure in measuring the risk exposure and to have enough capital to cover their risk involved in it .Banks usually consider an internal process to demonstrate their risk profile, operations and strategy to enable the supervisors to intervene the bank's capital. An approach for the identification and understanding of various situations such as the falling capital level can raise questions on the ability of a bank to withstand business shares. (Williams 2007)

2.6.2.3 Pillar 3

Market discipline: the new requirement has been introduced to reveal the risk information of equity and capital markets, so that the investor gets a better practised discipline regarding the bank behaviour. A cautioner notice can be available for the investor to find out the level of risk involved in it. (Servigny and Renault 2004, Crouhy Et al., 2006).In order to do business in a safe, sound and effective manner risk assessment mechanism is important. A perfect risk assessment makes a participant effective, reliable and timely in the market place. It gives transparency and disclosure in the capital adequacy issue. Figure 3 shows the picture of pillars formed by Basel II accord. (Williams 2007)

Calculation of credit risk in capital adequacy requirement includes a standardized approach and two versions of an Internal rating based model.

)

2.6.3CURRENT CREDIT RISK REGULATIONS:

(1988) BIS guidelines have set regulations for current credit risk which includes the minimum capital adequacy for credit risk, the definitions for the countable equity capital and strengthening the capital standards in large banks. The calculation approach was switched by BIS guidelines and set as indirect capital requirement method or minimum capital requirement. At first, Instance Balance sheets positions are weighted in accordance to the counterparty risk and later 8% of standard capital requirement is multiplied and to be maintained for all the credit portfolio issued by the banks. (Williams 2007; Saunders and Allen 2002).

Opportunities created in “Regulatory Capital Arbitrage” increases the risk based capital ratio through securitization and financial innovations, and many banks have lowered risk based capital considerably without decreasing the overall credit exposure. Therefore the stability is being created in the periods of disaster and insecurity. September 1997 Amendment in Basel Accord has given additional arbitrage opportunities in lower-risk based capital requirements. Grounding risk management and measuring with the available traditional data and formal quantitative techniques. (Fig. 3.1) (Effros 1998; Saunders and Allen 2002; Williams 2007).

2.6.1 Methods for Calculating Regulatory Credit Risk:

There are number of approaches for calculating regulatory credit risk are:

Standardised Approach:

Risk weight of each firm's assets are allocated in producing the sum of risk weighted assets value external credit assessment are used in determining the counterparty risk weight (FSA 2006)

Simplified Standard Approach:

Credit risk for small and limited licence firms which has incidental credit risk exposure .This might prove costly for the firms to calculate the regulatory capital calculations. In this case the firms are required to weight risk on whole exposures. If it is not possible the firms can use single risk weight to all exposures classes which might be unduly costly. (FSA 2006)

Internal Rating Based (IRB) Approach:

Here the internal assessment is established for the credit risk in their portfolios. The risk weighted in this approach will be more diverse than the standard approach. This approach risk sensitive. (FSA 2006)

2.6.2 DEFICIENCIES IN THE CURRENT REGULATIONS:

Counterparties are not differentiated in depth with the risk weighting factors and thus the risk is not represented in satisfactory and in perspective form. Correlation within the credit portfolio is not measured. The hedging of credit risk is not judged with the credit derivatives, net economical output has been supported with the capital to judge the credit risk. (Erisk 2005; Alexander et al. 2005).

2.6.3 Factors Challenging existing Regulations in Credit Risk Management:

The following factors challenge credit risk management are .Transactions and portfolio approaches are not differentiated in current practice. There are various contracts in commercial loans which are often complicated with our structural elements. Measuring risk adjusted profitability is difficult to accept due to lack of understanding in operating & economic capital cost: limited loan trading makes it hard to compare the value between loans and other traded asset classes (Gallati 2003).

2.7APPROACHES AND OPTIONS OF BASEL II:

Basel II regulatory has two alternative approaches for calculating the credit risk for their capital requirements they are Standardized approach and Internal Rating Based (IRB) approach. In standardized approach, credit risk is measured on the basis of External Credit Assessment Institutions (ECAI s). In IRB approach, banks use their own internal rating system to measure the determinants of credit risk and supervisory approval according to different versions- Under the foundation version, the Probability of Default (PD) is calculated on the basis of their own ratings, for the other determinants they rely on supervisors under the advanced version, and they have their own measures for all other determinants such as Loss Given Default (LGD) and Exposure At Default (EAD). (WEB 4)

2.7.1 MODELS OF CREDIT RISK:

A majority of mathematical researches has been dedicated to credit risk for modelling the default event occurrence. (Bielecki and Rutkowski 2002)

The main objective of these models is to support in pricing and hedging of financial contracts that are sensitive to credit risk. The pricing of credit risk is done in order to produce internal consistency in financial model. The two challenging methodologies emerged to model the default/migration times and the recovery rate, are structural approach and reduced-form approach. (Web 5)

STRUCTURAL MODEL:

The main concern in structural models is regarded with the modelling and pricing of credit risk that are specific to corporate obligation (a firm). The major framework of structural model is the evolution of firm's value and the firm's capital structure; hence it is also referred to as firm value approach. Value of firm structures the firm's economical fundamentals. Structural framework has an alternate approach in postulating the bankruptcy decision and these results in specifying capital structure and strategic debt service. (Bielecki and Rutkowski 2002)

REDUCED-FORM MODEL:

The value of firm's assets and capital structure are not modelled in reduced-form model. It is only concerned with the modelling of default time and hence referred to as Intensity-based model, and with migration between credit rating classes are called as credit migration models .(Bielecki and Rutkowski 2002)

INTESITY-BASED APPROACH: Random time of default is modeled under this approach and with that evaluation of risk natural probability with default time and cash flows, Random time of default can be defined jump time. Conditional expectation plays an important role in evaluating the default intensity process (saunders 1999; Bielecki and Rutkowski 2002)
CREDIT MIGRATION: It characterizes the expected changes in credit quality of obligor. The basic objective is asset pricing and risk management. The quality of credit migrates for each credit classes.( Bielecki and Rutkowski 2002; Ramaswamy 2003)
DEFAULTABLE TERM STRUCTURE: Interest rates are modeled under this approach, but there is no much difference with default-free term structure. Interest rates are modelled for overall credit rating classes under default able term structure. (Bielecki and Rutkowski 2002; Schmid 2004)

2.7.2CRITICAL FACTORS IN CREDIT RISK MODELINGS:

Probability density functions of credit loss.
Expected and unexpected credit loss.
Time horizon.
Default mode.
Conditional versus unconditional models.
Approaches to credit risk aggregation.
Correlation between credit events.

(Gallati 2003, 136)

2.7.3 Developing Approaches in Credit Risk Management:

The new generation with new technologies has emerged in engineering the credit risk topic. Eight most obvious reasons for this rapid rush in interest are,

Maturity market risk area:

The knowledge attained over the past decades on the basis of theoretical and academic research and also practical experiences has helped in realizing the importance of market risk modelling and in welcoming all new challenges on credit risk and operational risk. (Gallati 2003)

Disintermediation of borrowers:

As the expanded capital market is a boon and has given accessibility to small and middle-market firms. The borrowers who are left behind from raising funds from the banks and financial institutions are smaller and have weaker credit ratings. A rapid growth in capital market has lead to “winner's curse” and it resulted in credit portfolio structure of financial institutions. (Gallati 2003)

Competitive margin structure:

Despite the average quality, loans have turned down in respect to the margin spread, (due to disintermediation), whole sale loan markets has gone very thin, lending has gone worse in risk premium and tradeoffs. The important factor is that, it has improved competition for low quality borrowers (finance companies). It concentrates on higher risk rather than low quality at the end of the market. (Gallati 2003)

Structural changes in bankruptcies:

Considering the economic downsides in bankruptcy statistics, it has showed a considerable increase in bankruptcies due to global competition and sectoral changes worldwide. Technology and credit risk analysis plays a vital role now than the past and promisingly the most important part. (Gallati 2003)

Diminishing and volatile values of collaterals:

The real estate value and asset value are hard to predict and are realized through liquidation process because of banking crisis has developed in different countries. In case of weaker rating, the collateral values risks lending. (Gallati 2003)

Exposure from Off-Balance-Sheet derivative:

Counterparty risk and credit exposure has grown on the basis of derivative market and it has extended the need for credit analysis in loan book. The leading banks have created imaginary value for the off-balance-sheet exposure using Over-The-Counter (OTC) swaps and forwards which exceeds 10 times more than their portfolio. The off-balance-sheet credit risk was one of the reasons to introduce the risk based capital requirement in1993. (Gallati 2003)

Capital requirement:

In BIS systems, a minimum capital requirement was held on the basis of marked-to market current value of OTC derivatives contract added with the potential future exposure. (Gallati 2003)

Technological advancement:

Information technology has played a vital role in developing the historical information databases which has provided the banks to test the high powered modeling techniques. Modern Portfolio Theory's (MPT) models and techniques have helped to analyze loan loss and value distribution in management of their portfolios. (Gallati 2003)

2.8Credit risk in banks:

In rising market, banks have a poor conception of bank credit risk. (Global Credit Research 1999) Banking works as a part of an internal system in which credit circulated around various economic sectors. Banks and financial institutions must regularly balance risks and rewards. Dramatic increase in the price of interest rate on loan products, lose the customer; too low the prices of loan a product makes starve the profit margin or take a loss. More liquidity of cash in reserve makes miss investment, less liquidity makes risk regulatory refusal and financial instability in the market to stand. It is be difficult for the banks to measure overall risk exposure and strike the right balance. Senior management decides the credit scoring proportion for loan based on the customer or a client. Every bank has individual sub units for the credit risk, approval and sanctioning. Credit risk policy differs from banks to banks in the credit risk management is set by the top management of banks. Banks have a variety of options in credit risk models, for identifying, measuring and managing the risk. (Jorion 2003; Coult 1990; Gup 1999)

Credit risk issues in the banks can be through consumer ,mortgage lending, bad debts, corporate consumers ,industry risk, settlement and delivery risk .(chartered institute of bankers 1988) The rapid evolution of credit risk management techniques speeds the advance of a response in the events in the banking and financial sector. Rising technological developments have played a supporting role in facilitating the adoption of most accurate credit risk management techniques. Even though advance in study and analysis in relation to credit risk, implementation of some new approaches has a long way to play for the large number of banks. Better measurement and management of credit risk in banks is likely to carry implications to develop in the future and it is reflected from the different activities of the banks. Certainly, as banks improve their ability to assess risk and return associated with their various activities internal subsidies will become more transparent. (Reserve Bank of Australia Bulletin 1997; Coult 1990; Gup 1999)

The figure portrays the risk appetite in Indian banking and the major parts of risk in banks are credit risk as it holds the major part of risk in the banks and major part of concentration is given to the credit risk as shown in the figure 1.

2.9Summary:

From the above discussions the researcher has understood that credit risk have been defined in several ways. True fact is different books and articles got different ways of approaches towards the same meaning. Credit risk is given critical importance in the banks as it plays the important role in banks and other financial institutions. Credit lending is one of the main objectives of the banks and other financial institution; it takes the major part of the business other than market and operational risk. All the rest functional activities are depending on it. Various approaches and practices are being followed for the risk management.

Different types of credit risk has been given by the various authors depends on the business and perception of the business. The different models and approaches show level of losses involved in credit risk. All the banks and other financial institution have their own credit risk policy depends on their size and nature of their business and mostly the management uses the common approaches to come out of it. The first step of banks could be identifying, as it works as the strong data base for the banks and the measuring, is to know the value of the business and later the managing, to protect from the future outcomes of risk in the business.

The possible losses can calculated from the expected and unexpected losses. Unexpected losses can be calculated with two approaches Value at Risk and scenario analysis. Value at Risk exposes the probability of maximum losses which enables to measure and manage the credit portfolio. The future portfolio exposure losses can be identified. Historical and available data are used to calculate the credit risk in Scenario analysis future and excessive losses can be identified.

Basel ll formed by Banks for international settlements (BIS) set for the central banks to manage their risk under the three pillars. The banks regulatory capital calculated under various approaches. Few options and approaches are set up for calculating the credit risk by the Basel committee .structural and reduced form method to validate the default loss in the current portfolio exposure .the eight most developing approaches reckoned in the credit risk management for the banks and other financial institutions.

Banks works as mutual between the depositor and lenders and its internal system in which credit is spread around various economic sectors. Modern banks have come with various techniques and software to make out the credit risk in their banking business. As credit risk is one of major problems for the banks in their banking business and new approaches gave the new modification for the banks to access, analysis and manage the credit risk in the banks.

3. Research Methodology:

3.1introduction:

Research methodology is an idea which is associated with logical procedure of projects. It gives a methodical path to be followed which will convey in response to this research question. According to Clifford woody research is investigation of new fact in any branch of knowledge. Research involves defining and redefining problem, formulating hypothesis or suggested solution; collecting, organizing, evaluating data; making deductions and reaching conclusion, at last taking care of the conclusion with the aims and objective used for the theory. (Kothari 2005). Various methods are used to gather the information in order to meet the objectives as set in the introduction chapter of the dissertation. The most appropriate approaches, strategies and methods for the project to achieve the purpose of research have been chosen. (Smith, et. al., (2002) argues that each stage of the business research process is important because of its interdependent nature. However, how to choose them as Saunders (2003) states that methodology, firstly the author must make sure what kind of research philosophy should be adopted. This chapter provides an overview about different research methodologies for conducting a research study and then, the survey was conducted.

3.2 Research Strategy

Selecting an appropriate research approach mainly depends on the researcher. There are basically two types in it; they are deductive and inductive approach. The general purposes of the deductive approach are to enable the researcher to utilize stored up experience in order to predict and obtain new conclusion. Deductive approach is deducting of events or concepts which got relationship with the theory or hypothesis or which is a testable ratio between the 2 or more variables which are taken from the literature review and the main aim of the research. This refers to testing of the research which correlates with the hypothesis and refers to the gathering of quantitative data which is less confusing, hard facts, with large measurements, scope of data manipulation with measurements, scope for data with statistical representation, if necessitated the theory can be modified in search of the findings. In simple words it is testing theory .The collection of quantitative data cannot be done in this research as there are not many banks have implemented Basel II in India for their credit risk management in the bank.

Inductive approach states the purpose to get logic of what is going on, this makes the better understanding of the problem. It makes the task sensible for analysing the collected data and the result could be the formulation of theory. At the end we may end up the same theory or new theory can be formulated. Here it mainly focuses on the invention of a theory from the data. The theory deals with complexity not the generalised. It makes in depth of understanding of the theory, however it would be in the limits in setting a new highly structured research design (Saunders et. al, 1997;2003) and this has been done by conducting the Semi-structured interviews of the compatibility of the Basel II.

The three main reasons recommended by (Saunders et al. 1997; 2003) in which quantitative and qualitative data are differentiated with their strength and weakness, so that research design is set in accord to the theory. Quantitative data is based on meanings, of derived from numbers. The collection results are resulted in numerical and standardised data and the analysis can be conducted by the use of diagrams, histogram, pie-charts statistics and others (Saunders et al. 1997;2003) According to (smith et al. 2002) Qualitative data is used where the researcher aims to find why is the problem occurring, rather than quantitative data which is very specific in what is happening in set terms. In third it is found that the Qualitative data is used, where there is limited access to the data which navigate to less reliable data. Quantitative data is obtained from controlled observation, laboratory experiments, mass survey and no constraints which pilot to quality data. Other forms of research manipulations allows for longitudinal measures of following performance of research subjects. Some of these belong to deductive tradition, others to inductive approach. What really matters is not the label that has been attached to a strategy, but whether it is appropriate for the particular research and objectives. The research strategies used in this research are Survey and case study (Saunders et al. 1997; 2003).

3.2.1 Reliability

Reliability is one of the most critical elements in assessing the quality of the construct measures, and it is a necessary condition for scale validity. A statistically reliable scale provides consistent and stable measures of a construct. Composite reliability estimates are used to assess the inter-item reliability of the measures. Some items may be removed from the construct scales if their removal results in increases in the reliability estimate, however, care was taken to ensure that the content validity of the measures is not threatened by the removal of a key conceptual element (Robson C. 2002).

Reliability can be assessed by posing the following questions:

Will the measures yield the same results on other occasions?
Will similar observations be reached by other observers?
Is there transparency in how sense was made from the raw data? (Smith et al. 2002)

According to Robson (2002) there are four threats to reliability:

Participant bias
Participant error
Observer error
Observer bias (Robson. C, 2002)

3.2.2 Validity

Validity is concerned with whether the findings are really what they appear to be about (Saunders et al. 1997; 2003). The content validity of a questionnaire refers to the representative of item content domain. It is the manner by which the questionnaire and its items are built to ensure the reasonableness of the claim of content validity. The conceptualization of survey instrument constructs are based on preliminary literature review to form the initial items, the personal interviews with practitioners and experts used for scale purification suggest that the survey instrument has strong content validity. (Saunders et al. 1997;2003) Validity is established by showing that the instrument measures the construct it is intended to measure. Construct validity is evaluated by performing correlation and factor analysis. High correlations considered to indicate construct validity.

Robson (2002) identified threats to validity as:

History
Testing
Instrumentation
Mortality
Maturation
Ambiguity about causal direction (Robson, 2002)

Generalisability is sometimes referred as external validity. The biggest threat a researcher can have in mind is the extent to which the research results are generalisable that is whether the findings may be equally applicable to other research settings. The threat increases in magnitude when the researcher conducts case study on a particular organization (Saunders et, al., 1997; 2003). But this has been overcome by the researcher by collecting the valid data from the genuine personalities.

3.3 Survey method

Survey approaches are usually more specific in subject matters. These approaches are most commonly used the way of research in business and management studies. Data are usually collected through the use of questionnaires, although sometimes researchers directly interview subjects and soon (Denscombe, 1998) Questions can be complex or open-ended. Surveys can use qualitative or quantitative measures. The unique feature of the survey method is its combination of a commitment to a breadth of study, a focus on the picture at a given point in time, and a dependence on practical data. A survey is reliable, trustworthy, and explanatory and gives more control over the research process.

3.3.1 Advantages of Survey Method:

It is relatively inexpensive
Many questions can be asked about a given topic giving significant flexibility to the analysis.
It has enabled the researcher to collect practical data.
The data collected by this method is structured and therefore it needs less analysis.
It has enabled the researcher to frame generalizations depending on the size of the sample even though the sample size is very low. (Saunders et. al., 2003)

3.3.2 Disadvantages of Survey Method:

Data may not be correct due to partiality opinions of the respondents.
It takes much time in designing and piloting
The questions will be the same throughout the survey process
The researcher must ensure that a large number of the selected sample will reply.
The results depend largely on the participant motivation (Marshall, 1997, Saunders et al 1997; 2003).

3.4 Case study method

(Robson 2002 citing Saunders et al 2003) case study can be defined as a strategy for doing research on existing fact which involves the practical study, with its real life background of using multiple sources of evidence (Robson, 2002 citing Saunders et. al., 1997;2003). Case study method helped the author in gaining rich understanding of the context issue of the object or research and the processes being enacted experience or adds the strength to the research process said by (Morris and wood, 1991 citing Saunders et. al., 1997;2003). Case study method was used while doing inductive research and its worth while using for the existing theory in various disciplines. (Saunders et. al,1997; 2003).

Some benefits of case study methods are; this method generates the answer for the question `why`, `what`, `how`, and soon. Questions usually are concern of the survey strategy. It helped the researcher in providing understanding and solutions to the problem and the biggest advantage is that it enabled the researcher to challenge an existing theory and also provides a source of new hypotheses (Saunders et. al., 1997; 2003).

The author has used both Survey and Case study method in this research therefore this research can be called as Multi-method strategy. These approaches cannot exist in isolation and therefore it will be beneficial if we mix and match. This approach allows the researcher to take a broader, and often complimentary, view of the research problem and issue (Saunders et al.1997; 2003).

3.5 Collection of data

The most important part of the research process is collection of data. It identifies the problem to be investigated and at the same time describes the research design and how it will be implemented to carry out the investigation. In this part the researcher gets a sources of information on which his study is based (Saunders et al. 1997; 2003). The sources are categorized into primary and secondary resources. While collecting the data the researcher has to keep in mind the issues of reliability and validity to get the right answer to the research problem. Some disadvantages of case study methods are it lacks in validity, the generated hypothesis cannot be checked and lacks in generality.

3.5.1 Primary Research Methods

A qualitative research involves diverse nature of qualitative analysis approach, and it doesn't have any standardised approach as it is a resist to a quantitative approach, is used to collect and represent the research data with the different strategies to different data's (Dey 1993 citing Saunders et al. 1997; 2003). (Robson 2002) suggest that qualitative research is an approach to research lay down of techniques. They believe that the accuracy of qualitative research is imitation from the nature of the social experience that is being explored. The primary researches which a researcher can obtain are reports, thesis, emails, conference report, and company report and unpublished manuscript scores. Two methods are used to discover the answers for the criteria are Survey Questionnaires and semi-structured Interviews are the two methods used to determine the compatibility of Basel II in India banks. Interviews with the users specifically target the two criteria, which are user satisfaction and the post compatibility factors thus validating the acceptance level.

3.5.1.1 Interviews

A purposeful discussion between two or more people is interviews (Kahn and cannel, 1957 citing Saunders et al.1997; 2003) are a conversion of data into information and conclusion related to the subject (Gummesson 1991) a valid and reliable data are gathered to the research question. According to different authors there are different types of interviews are categorized such as structured, semi-structured and unstructured interviews (Saunders et al. 2003) standardised and non-standardised interviews (Healey and Rawlinson, 1993 citing Saunders et al. 1997) respondent and informant interviews (Robson 2002) interviews are in-depth surveys that attempt to obtain in-depth facts and data's from a relatively small number of informants. They believe that such an approach allows the researcher “to seek new insights” so that the phenomena can be explored whilst gathering explanatory and descriptive material. Interviews were carried out to identify the factors that have an impact on the use of the system.

Semi-structured interviews are used in qualitative research and quantitative research and it helps in order to understand the relationship between variables. It may be used to explore and explain the themes which have emerged from the use of questionnaire (Wass and Wells, 1994 citing Saunders et al. 2003) in this type of interview; the researcher would be able to know the specific information which can be compared to the information collected through other interviews. The researcher will use the semi structured interview in this research process.

The interview questions consisted of 3 open ended questions which were easy to answer and were supportive in collecting the required data. As they were simple in terms of understanding and they were clear-cut as aims of the research have been visibly directed. The topic of semi-structured interviews addresses the view of compatibility of Basel II and credit risk management in an Indian bank. Three staff from banks was interviewed about the process and their success factors which were again validated with the literature of secondary research. The interview questions are attached in Appendix-A.1.

3.5.1.2 Survey Questionnaires

Questionnaire in general term is the techniques used for the data collection and in which each person is asked to respond the same set of questions in regards to the subject (DeVaus 1991 citing Saunders et al. 2003)Data collected using questionnaires are called as survey questionnaires. It can play a part in the research project and provide advice on their design. Relevancy and accuracy are the two basic criteria to be met if the questionnaire is to achieve the researcher's purposes. A questionnaire is relevant when there is no unnecessary information is collected and if the information that is essential to solve the business problem is obtained. Accuracy of the questionnaire means that the information is reliable and valid.

The

In Appendix-A.2.

3.5.2 Secondary Research Methods

Secondary data is reanalyzing of the data that have already been collected for some other purposes. Secondary data includes both raw data and published summaries (Saunders et al. 1997) it includes both the quantitative and qualitative data and which can be used for both the descriptive and explanatory research. The researcher can obtain secondary data's from books, internet, newspapers, e-journals, journals and business reports to collect the relevant material. And this secondary data has been used to analyze the result from the findings of the primary research. The data which has already been published and while using this data the researcher has to keep in mind about the validity and reliability of the sources where this data is published. The researcher should try and use the recently published data as it will be more appropriate to the current day scenario. The level of detail in this data is less as compared to the primary data. According to (Kervin, 1999 citing Saunders et al. 2003) business research, in case study approach use complied data and pervious data. The major advantage of is that secondary data can be obtained in a less expensive than the primary data. In addition, secondary data can usually be obtained quickly, easily and less time consuming. (Saunders et al. 2003). The researcher has used books, electronic journals, websites, business reports, newspapers and the research journals to collect the relevant material.

3.6 Triangulation

(Mackey and Gass 2005, 181) defines triangulation as “independent method of obtaining data in a single investigation to arrive at the same research finding “. There are different types of triangulation such as theoretical, investigator and methodological triangulation (Yins 2003: 99 and Mackey and Gass 2005:181). Triangulation is using multiple independent methods to obtain data in the study of same subject (Yins 2003; Mackey and Gass 2005 and Saunders et al. 1997, 2003). The use triangulation can provide complete, holistic and contextual data and develops converging lines of inquiry in case study research (Yin 2003). It may also reveal unique variance which is not enclosed using single methods. According to (Smith et al. 2002) all individual methods of research have it own merits and demerits which can be balanced used triangulation. Researcher in this project has done data and methods triangulation to validate data of interview and other findings.

3.7 Summary

The writer has selected the inductive approach in this research for his research findings. The writer has used both primary data and secondary data for the research. Survey and Case study method has been used in this research; thus this research can be called as Multi-method strategy. To balance the drawback and benefits of different research methods writer has used triangulation of methods and data. A qualitative approach is been used by the writer in this research. Semi-structured interviews and survey questionnaires will provide through the data required for analysis leading to the answer of the research aim and objectives within the limitations of the research.

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