Credit-Risk-Modelling - a banking and finance related project

Banking

Assets

In the BFSI world, assets are resources that a financial institution owns or controls, and which have economic value that can generate future benefits. Here are common types:

• Loans: Money lent to customers (individuals or companies) with the expectation of repayment plus interest. Loans are a major asset, as they generate revenue for the institution.
• Investments: Securities like stocks, bonds, or government treasuries purchased by the institution. These serve to generate income or potential capital gains.
• Cash and Cash Equivalents: Liquid assets like cash on hand, deposits with other banks, or highly liquid short-term investments. This ensures the bank has cash for daily operations.
• Property and Equipment: Physical assets like buildings, land, computers, and furniture owned by the institution.
• Intangible Assets: Non-physical assets like intellectual property (patents, trademarks), customer relationships, and goodwill.

Liabilities

Liabilities are a financial institution's obligations– money it owes to others. Here are the key types of liabilities in BFSI:

• Deposits: Money placed by customers into savings, checking, or other types of accounts. These are a major liability, as the institution must be able to repay customers on demand or per agreed terms.
• Borrowings: Funds borrowed by the institution from other banks, the central bank, or through issuing bonds. Used to fund lending activities or operations.
• Insurance Reserves: (Insurance specific) Funds set aside to cover potential future claims from policyholders.
• Accounts Payable: Money owed to suppliers, vendors, or for other operational expenses.

CASA stands for Current Account Savings Account in the Banking, Financial Services, and Insurance (BFSI) sector. It refers to the total deposits that a bank has in its current accounts and savings accounts.

1. Current Account: This type of account is typically used by businesses and individuals for frequent transactions. There are usually no restrictions on the number of transactions or withdrawals allowed, but they may not earn interest.

2. Savings Account: Savings accounts are designed for individuals to deposit their savings while earning a nominal interest rate. These accounts usually have limitations on the number of transactions allowed per month.

CASA is crucial for banks because it represents low-cost funds that they can use for lending and investment activities. Since savings accounts offer lower interest rates compared to fixed deposits, and current accounts often don't pay any interest, banks can use these funds to lend to borrowers at higher interest rates, thus generating profits. Higher CASA ratios indicate that a larger portion of a bank's deposits comes from current and savings accounts, which is generally preferred as it reduces the cost of funds for the bank. Banks often aim to increase their CASA ratio to improve their profitability and strengthen their balance sheets.

The Importance of Understanding Assets and Liabilities

Financial institutions carefully manage their assets and liabilities for several reasons:

• Profitability: The net interest margin (difference between interest earned on loans and interest paid on deposits) is a key driver of profitability.
• Liquidity: Maintaining enough liquid assets to meet withdrawal requests and financial obligations is critical to avoiding a liquidity crisis.
• Solvency: Ensuring that assets exceed liabilities so the institution remains financially viable in the long term.
• Regulatory Compliance: BFSI institutions are subject to regulations that often dictate limits or requirements for the composition of their balance sheets.

NPA stands for Non-Performing Asset. In the BFSI domain, particularly banking, it refers to loans or advances that are in default or arrears, meaning the borrower has failed to make their loan payments for a certain period of time. Here's a breakdown of NPAs:

Disbursed amount

The disbursed amount refers to the total sum of money that has been released or paid out to a borrower by a lender, typically in the context of loans or credit facilities. When a loan is approved, the disbursed amount is the actual money transferred to the borrower's account or paid out to them in another form, such as a cashier's check or direct payment to a vendor.

Examples of disbursed amounts include:

1. Personal Loans: If a bank approves a personal loan for $10,000, and the entire amount is transferred to the borrower's account, then the disbursed amount is $10,000.

2. Mortgages: When a mortgage loan is approved for the purchase of a house, the disbursed amount is the total loan amount transferred to the seller or their representative, typically through a wire transfer or a cashier's check.

3. Business Loans: If a business secures a loan of $50,000 to purchase new equipment, the disbursed amount is the full $50,000 provided to the business for that purpose.

4. Credit Cards: When a credit card issuer grants a credit limit to a cardholder, any transactions made using the card constitute disbursed amounts until they are repaid.

5. Student Loans: For student loans, the disbursed amount is the portion of the loan that is actually paid out to the educational institution to cover tuition, fees, and other approved expenses.

In summary, the disbursed amount represents the actual funds transferred from the lender to the borrower or the designated recipient as part of a loan or credit agreement.

Outstanding Principal

OSP, or Outstanding Principal, refers to the remaining amount of the original principal balance on a loan that has not yet been repaid. It represents the portion of the loan amount that the borrower still owes to the lender. As loan payments are made over time, the outstanding principal decreases.

Here are some examples of OSP:

1. Mortgage Loan: Suppose a borrower takes out a mortgage loan for $200,000 to purchase a house. After making regular monthly payments for several years, the outstanding principal might be $150,000. This means the borrower still owes $150,000 to the lender to fully repay the loan.

2. Car Loan: If someone finances the purchase of a car with a $20,000 loan and has been making monthly payments for some time, the outstanding principal would be the remaining balance on the loan. For example, if they have paid off $8,000 of the loan so far, the outstanding principal would be $12,000.

3. Student Loan: A student borrows $30,000 in student loans to finance their education. After graduation, they begin making monthly payments. The outstanding principal would be the remaining balance on the loan after each payment is made, reflecting the amount still owed to the lender.

4. Business Loan: A company borrows $100,000 to expand its operations. As they make payments on the loan, the outstanding principal decreases. For instance, if they have paid off $30,000 of the loan, the outstanding principal would be $70,000.

In summary, OSP, or Outstanding Principal, is the remaining amount of the original loan balance that the borrower still owes to the lender. It decreases over time as loan payments are made.

DPD, or Days Past Due, is a commonly used metric in the banking and financial sectors to measure the number of days a payment on a loan or credit obligation has been overdue. It helps lenders assess the timeliness of borrower payments and manage credit risk.

Here's how DPD works with some examples:

1. Example 1: Mortgage Payment Let's say a borrower has a monthly mortgage payment due on the 1st of each month. If the borrower fails to make the payment by the due date and still hasn't made the payment by the 10th of the month, the DPD for that payment would be 10.

2. Example 2: Credit Card Payment A credit card issuer typically sets a due date for monthly payments. If a cardholder misses the due date for their credit card bill by three days, the DPD for that payment would be 3.

3. Example 3: Loan Payment Consider a borrower with a car loan that requires monthly payments. If the borrower's payment is due on the 15th of the month and they fail to make the payment until the 20th, the DPD for that payment would be 5.

4. Example 4: Installment Loan Payment For installment loans with fixed monthly payments, such as personal loans, if a borrower misses their payment due on the 5th of the month and makes the payment on the 12th, the DPD would be 7.

Days Past Due

DPD is an important indicator for lenders to monitor because it helps them assess the risk of default by borrowers. Generally, the higher the DPD, the greater the risk of default. Lenders may use DPD information to determine whether to extend additional credit, modify existing credit terms, or take other actions to mitigate risk. Additionally, DPD can affect a borrower's credit score and overall creditworthiness, as late payments can be reported to credit bureaus.

Portfolio at Risk

PAR (Portfolio at Risk) is a metric used in the banking and financial sectors to assess the level of risk associated with a loan portfolio. It indicates the proportion of outstanding loan balances that are at risk of default or are already in arrears.

PAR is typically expressed as a percentage and is calculated by dividing the total outstanding loan balances that are past due by the total outstanding loan portfolio. Loans are considered past due if the borrower has failed to make scheduled payments within a specified time frame, usually expressed in days or months.

For example, if a bank has a total loan portfolio of $100 million, and $5 million of that portfolio is past due by 30 days or more, the PAR would be calculated as follows:

PAR = (Total past due loans / Total outstanding loan portfolio) * 100 = ($5,000,000 / $100,000,000) * 100 = 5%

This means that 5% of the bank's total loan portfolio is currently at risk of default due to late payments.

Examples of loans that contribute to PAR include:

1. Consumer Loans: Such as personal loans, auto loans, and credit card balances that have not been paid according to the agreed-upon terms.

2. Mortgages: Home loans where the borrower has missed one or more mortgage payments.

3. Business Loans: Loans provided to businesses for various purposes, such as working capital, expansion, or equipment purchases, where the borrower has defaulted on payments.

4. Microfinance Loans: Small loans provided to individuals or small businesses in developing countries, where borrowers may face challenges in meeting repayment obligations.

5. Student Loans: Educational loans that have not been repaid by borrowers within the specified grace period or after leaving school.

PAR is an important indicator for financial institutions as it helps them assess the credit quality of their loan portfolio and identify potential areas of risk. A high PAR may indicate weaknesses in the lending practices or economic challenges that could lead to increased loan defaults and financial losses. Banks and lenders use this information to implement strategies for managing and mitigating credit risk effectively.

How a Loan Becomes an NPA

Typically, a loan becomes an NPA if the principal or interest payment is overdue for a specific timeframe, which is usually 90 days as per Reserve Bank of India (RBI) guidelines. However, some banks may define a shorter or longer overdue period depending on their internal policies.

Why NPAs are a Problem for Banks

• Reduced Income: NPAs represent assets that are no longer generating income for the bank in the form of interest payments. This directly impacts the bank's profitability.
• Increased Risk: NPAs pose a higher risk of loss for the bank as the borrower may be unable to repay the loan in full. This can erode the bank's capital base and financial stability.
• Limited Lending Capacity: High NPA levels can restrict a bank's ability to lend new loans. Since a significant portion of their funds are tied up in unrecovered loans, they have less capacity to lend to new borrowers.
• Negative Impact on Market Confidence: High NPA levels can signal financial weakness and create a negative perception among investors and depositors, potentially leading to capital flight.

Classifications of NPAs

NPAs are further categorized based on the length of time they have been overdue, which reflects the increasing likelihood of the loan being unrecoverable. Here are the common classifications:

• Substandard Assets (12 months overdue): These are the least severe category, but they still indicate a higher risk of default compared to performing loans.
• Doubtful Debts (18 months overdue): There is significant doubt about the borrower's ability to repay the full amount.
• Loss Assets (beyond a certain period): These are considered highly unlikely to be recovered and are typically written off the bank's books.

Measures to Address NPAs

Banks employ various strategies to manage and reduce NPAs:

• Loan Restructuring: Modifying the loan terms (interest rate, repayment schedule) to make them more manageable for the borrower.
• Debt Recovery Actions: Legal proceedings to recover the outstanding amount, including asset seizure and sale.
• Provisioning: Setting aside funds to cover potential losses from NPAs.
• Stricter Credit Risk Assessment: Implementing more robust processes to assess a borrower's creditworthiness before granting a loan.

Conclusion

NPAs are a significant concern for banks and financial institutions, impacting their profitability, solvency, and lending capacity. Understanding and effectively managing NPAs is crucial for maintaining a healthy and stable financial system.

Loan Classification: From DPD (Days Past Due) to Written Off

In banking, loans are categorized based on their repayment status. This classification system helps banks assess the risk associated with each loan and take appropriate actions. Here's a breakdown of the key stages from a borrower's perspective, along with the bank's corresponding actions:

1. DPD (Days Past Due):

This is the initial stage of delinquency. It refers to the number of days a borrower has exceeded the due date for a loan payment. Most banks categorize DPDs in brackets, for example, (1-30) days, (31-60) days, and so on. The higher the DPD, the more severe the delinquency.

• Bank's Actions:
  • Upon a missed payment, banks typically initiate gentle reminders via email, SMS, or phone calls.
  • Depending on the bank's policy and the severity of the DPD, late fees or penalties might be applied.

2. Non-performing Asset (NPA):

A loan becomes an NPA if the borrower misses payments for a specific period, typically 90 days or more (depending on bank regulations). This signifies a higher risk of default for the bank.

• Bank's Actions:
  • Banks will intensify collection efforts, involving dedicated personnel and stricter follow-up procedures.
  • They might restructure the loan terms (e.g., extend the repayment period or reduce interest rates) to help the borrower recover.
  • The NPA status will be reflected in the borrower's credit report, negatively impacting their creditworthiness.

3. Special Mention Account (SMA):

While not a formal NPA yet, SMAs are identified by banks as loans with a high potential of turning into NPAs. These might include accounts with high DPDs, restructured loans, or borrowers facing financial difficulties.

• Bank's Actions:
  • Banks closely monitor SMAs and might impose stricter loan covenants or require additional security from the borrower.
  • They might offer credit counseling or loan modification options to prevent the account from slipping into NPA status.

4. Write-off:

If all recovery efforts fail and the bank deems the loan unrecoverable, it is written off. This means the bank removes the loan amount from its active accounts and recognizes it as a loss.

• Bank's Actions:
  • The bank may initiate legal proceedings against the borrower to recover the dues.
  • The write-off will be reported to credit bureaus, severely damaging the borrower's credit score for a significant period.

It's crucial to understand that these stages are progressive. Timely intervention and working with your bank to address delinquencies can prevent your loan from progressing towards write-off and minimize the negative impact on your creditworthiness.

DPD (Days Past Due)	Classification	Description
0 Days	Current	Loan payment is on time
1-30 Days	Delinquent	Loan payment is overdue
31-60 Days	Delinquent	Loan payment is significantly overdue
61-90 Days	Delinquent	Loan payment severely overdue, risk of default increases
90-180 Days	Substandard / NPA	Loan classified as Non-Performing Asset
180+ Days	Doubtful / NPA	High risk of default, significant recovery efforts required
NA	SMA (Special Mention Account)	Loan exhibits potential signs of stress and could slip into NPA category
NA	Written-Off	Loan deemed unrecoverable, removed from bank's balance sheet

Absolutely! Let's break down NNPA and GNPA, followed by a Markdown table explanation:

NNPA (Net Non-Performing Assets)

• Definition: This represents the portion of a bank's non-performing assets (NPAs) remaining after deducting provisions set aside for potential losses. Provisions are like reserve funds created by banks to anticipate losses on bad loans.
• Calculation: NNPA = Gross NPAs – Provisions
• Significance: NNPA is a more accurate measure of a bank's true financial health with regards to bad loans. It shows the actual potential losses the bank might face if borrowers completely default on their NPAs.

GNPA (Gross Non-Performing Assets)

• Definition: This represents the total value of a bank's non-performing assets (NPAs) before accounting for any provisions.
• Calculation: GNPA = Total value of all NPAs (Substandard, Doubtful, and Loss Assets)
• Significance: GNPA offers a broader picture of a bank's asset quality and the overall level of stressed loans on its books.

Markdown Table

Metric	Definition	Calculation	Significance
GNPA (Gross Non-Performing Assets)	Total value of NPAs before provisions	Total value of all NPAs (Substandard, Doubtful, Loss Assets)	Indicates overall level of stressed loans
NNPA (Net Non-Performing Assets)	Value of NPAs after deducting provisions	Gross NPAs - Provisions	Reveals potential losses if borrowers default, a better indicator of bank's financial health

Key Points

• Banks aim to keep both GNPA and NNPA ratios low.
• High GNPA and NNPA ratios signal potential financial distress for a bank.
• Investors and regulators closely track these metrics to assess a bank's stability.