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Credit risk happens to be one of the most common risks that banks and corporates face. The probability of default generally depends on the credit rating of the borrower and an event of default may not always lead to a situation of total loss. There is always a possibility of recovery but again the quantum of recovery is unpredictable. In this scenario, the best technique, which the banks and corporates can do is to transfer their risks to another party. The instruments, which facilitate this process, are credit derivatives. These credit derivatives are basically over- the- counter (OTC) transactions, which banks and other corporates can use to mitigate their credit risks.
If we are defining Credit Risk as the losses in the event of default by the borrower or in determining the credit quality, we are undermining the quantum of inherent risk involved in the credit portfolio. Collaterals, guarantees by the third-parties, borrowers' willingness to repay all these help the bank to mitigate the quantum of credit risk. Occurrence of both default and recovery from default are unpredictable. Since the magnitude of credit risk may be phenomenal and emerges from different angles, it is desirable to view the credit risk evenly from three different angles: default risk, exposure risk and recovery risk.
A Bank disburses a loan or releases non-funded limits as per the requirement of the borrower after proper execution of documents. The loan document stipulates certain terms and conditions for repayment of the loan amount. If the borrower fails to adhere to the covenants of the agreement in repaying the interest component or the principal component it tantamounts to default. As per existing guidelines in the banking industry, if the interest and/or installment of principal remains unpaid for a period more than 180 days, the advance is to be classified as a non-performing asset. It has been proposed to adopt a 90-day norm for recognizing loans as non-performing from March 31, 2004. When the banks are not receiving the scheduled payments after the due date in the loans which are defined under NPA category, they are all in technical default. Certain persuasion and negotiation trigger repayment and convert NPAs into performing assets.
when the value of an asset goes below the value of an outstanding liability, the default is called an economic default. In such a scenario, the bank has two alternatives: one, insist for additional collaterals to cover the outstanding liabilities where the asset value had eroded, and second, initiate the recovery management depending upon the history of the loan account. The probability of default in credit is mostly dependent on credit rating of the borrower. The severity of losses is dependent on the quality of credit, which is again dependent on recoveries in case of default and probability of default. |
