7.1. Credit Risk

Effective from Nov 23 2011 - Nov 22 2011
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Credit risk is historically the most significant risk faced by the banks. It is measured by estimating the actual or potential losses arising from the inability or unwillingness of the obligors to meet their credit obligations on time. Banks may choose to conduct stress tests either under Standardized Approach or Internal Rating Based (IRB) Approach of Basel-II. Furthermore, they may use a combination of risk parameters including Exposure at Default (EAD), Probability of Default (PD), Loss Given Default (LGD) and Maturity (M) to measure the credit risk.
Banks should conduct the stress tests on credit risk to estimate the impact of defined scenarios on their asset quality, profitability and capital. For this purpose, both on-balance sheet and off-balance sheet credit exposures should be covered. Some possible scenarios for conducting stress tests on credit risk are listed below:
	i.	Decrease in Oil Prices: Significant decrease in oil prices in the international market may affect the economic indicators of the country and possibly the credit portfolio of banks. The impact of significant reduction in oil prices on the asset quality, profitability and capital adequacy may be assessed;
	ii.	Economic Downturn: The adverse changes in major macro-economic variables may have implications for the quality of credit portfolio of banks. Banks may develop stress scenarios to assess the impact of adverse changes in economic variables like GDP, inflation, unemployment rate, etc. on their asset quality, profitability and capital adequacy. The unemployment rate and inflation may have direct impact on the quality of credit cards and personal loans.;
	iii.	Changes in LGDs and other Risk Parameters: Significant changes in LGDs, PDs, EAD, credit ratings, etc. of the obligors may heighten the credit risk of the bank. Banks may develop scenarios based on adverse changes in these credit risk parameters and assess the impact on their profitability and capital adequacy;
	iv.	Significant Increase in NPLs: Significant increase in non-performing loans (NPLs) due to multiple factors would adversely affect the asset quality and require additional provisioning. Such a scenario may involve increase in aggregate NPLs as well as downgrading all or part of the classified loans falling in various categories of classification by one notch. Banks may develop scenarios based on significant changes in the level of NPLs and their classification categories to assess the resultant impact on their provisioning requirements;
	v.	Slowdown in Credit Growth: Significant reduction in credit growth may adversely affect the income level and profitability. Banks may assess impact of marginal or negative growth in lending on their profitability and capital adequacy;
	vi.	Failure of Counterparties: Banks may have significant exposure to few counterparties or groups of related counterparties. Furthermore they might have significant exposure to few industrial sectors or geographic areas. Banks may develop scenarios to assess the impact of failure of their major counterparties or of increased default risk in a particular industry or geographic area on their profitability and capital adequacy.
Banks would develop their own scenarios taking into account the nature, size and mix of their credit portfolio. Furthermore, they should take into account the following factors while conducting stress tests on credit risk:
	i.	Stress tests may be conducted to cover the entire credit portfolio or selected credit areas like corporate lending, retail lending, consumer lending, etc. or a combination of both;
	ii.	Stress testing of corporate loans portfolio may involve the assessment of creditworthiness of individual borrowers and then aggregating the impact of risk factors on the portfolio level;
	iii.	Banks may use financial models to calculate the revised PDs and LGDs based on the selected scenarios and assess the impact thereof on the profitability and capital adequacy of the bank;
	iv.	Stress tests on consumer and retail loans may be conducted on portfolio level given the relatively large number and small value of such loans;
	v.	Banks having established internal credit rating systems may develop scenarios involving downgrading of the credit ratings of borrowers to assess the impact of identified risk factors on the quality of credit portfolio;
	vi.	The extreme but plausible events occurred over a business cycle may be taken into account in developing the relevant scenarios.