Navigating the Financial Frontier: Inside the Strategy of Credit Risk Management and Provisioning through Expected Credit Loss | Part II

How important is Credit Risk in any financial Institution (FI)?

State Bank of India (SBI), the largest lender in India saw its earnings increase by 41% over the previous 3 years, making it the second-most profitable company behind Reliance Industries in FY23.

Profitability serves as a strong indicator of a robust business model, effectively demonstrating the company's ability to generate revenue in excess of its costs and expenses. It also underscores effective cost controls, highlighting the organization's competence in managing its operating expenses and optimizing resource allocation. This, in turn, can lead to enhanced margins and create a cushion against market volatility or unforeseen financial setbacks. Overall, strong profitability suggests that the company is not just capturing market share, but doing so in a financially sustainable manner.

For long-term, stable, progressive, risk-aware, and bullish investors, stability and resilience to risk events are paramount. It's in these areas that the balance sheet and risk profile of the company hold significance. As of March 2023, SBI's group-level Credit Risk Exposure stood at Rs. 38.4 Trillion after consolidating 53 Group Companies. This figure represents 65% of the total Balance Sheet size of Rs. 59.5 Trillion. The calculation of this risk exposure involves applying regulatory-provided risk weights to all the company's assets.

Liabilities, in financial terms, refer to the future obligations or payables that arise from the assets themselves. They are commitments that the company must fulfill over time, representing a claim against the company's resources.

On the other hand, Capital & Reserves, also known as Owner's Equity, are funds that stay invested in the company's assets. They form the foundation of a company's financial structure, serving as a source of funds for growth and expansion. Owner's equity reflects the ownership interest in the business and consists of contributions by the owners plus retained earnings or losses.

The provision is an essential aspect of financial planning and risk management. These are portions of profits that have not been booked or recognized and are intentionally set aside to absorb potential future losses. The practice of maintaining provisions ensures that the company has a financial cushion to fall back on in case of adverse financial events.

To ensure solvency, SBI's assets, amounting to Rs. 59.5 Trillion, must exceed its liabilities, which stand at Rs. 55.9 Trillion. The Capital and Reserves, totaling Rs. 3.6 Trillion, act as a backbone for financial stability, serving as Core Risk Capital (CET 1). Additionally, long-term debt instruments with loss-absorbing features, worth Rs. 1.25 Trillion, and other components like general reserves (AT1 & Tier II Capital Instruments) contribute to fortifying the financial structure, thereby enhancing the bank's resilience against potential financial uncertainties.

What is Credit Risk?

Possibility of losses associated with decline in the credit quality of borrowers or counterparties. Default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions.

From a regulatory standpoint, financial institutions (FIs) might face two principal categories of losses within their credit portfolio: expected losses and unexpected losses. Expected losses are managed by earmarking a portion of earnings for provisions to cover potential loan losses, along with implementing sound pricing strategies. On the other hand, to handle unexpected losses, FIs are guided to maintain sufficient capital, with both Economic Capital and Regulatory Capital acting as foundational measures to ensure financial stability.

We can categorize risk events into three main classes:

1. Expected Losses: In the simplest terms, these represent the mean losses that financial institutions (FIs) typically incur and can be seen as the first area in the chart, signaling high probability and significant impact. Known as Expected Credit Loss, they are the usual costs incurred in the lending business. FIs manage these by setting provisions from earnings before disbursing dividends or registering Net Profits in Reserves & Surplus. (SBI held NPA Provisions of 0.7 Trillion - 92% of GNPA)
2. Unexpected Losses: This category is depicted as the second part of area under the curve, representing lower probability but substantial effects, accounting for say 13.5% of the FI's losses empirically when realized. FIs are required to keep adequate regulatory capital to absorb these losses. A minimum Capital to Risk Weighted Assets Ratio (CRAR) is mandated by regulator to ensure resilience and macroeconomic stability. Such capital instruments are highly loss-absorbent. (SBI maintained a 14.68% CRAR as of Mar'23, equating to Rs. 4.1 Trillion of regulatory capital against its Total Risk-Weighted Assets).
3. Tail Risk: The risks extending beyond expected and unexpected losses are termed as tail risks. They're characterized by extremely low occurrence probabilities (e.g., 0.01% if calculated at 99.99% confidence level) but can have a massive impact if they do occur. The nuances and implications of tail risk could be a subject for further exploration in a separate article.

And therefore, Loan Loss Provisioning and Expected Credit Loss!

Economic Capital vs. Regulatory Capital: Distinct Concepts and Their Roles in Risk Management

"Economic Capital refers to the capital a financial institution reserves to secure its ongoing viability over a specific period, given a defined confidence level. Essentially a risk measure, it functions to offset potential losses, guided by the institution's risk management practices. These practices consider various risks such as credit risk, operational risk, market risk, and liquidity risk, among others.

Unlike external regulations, economic capital is an internal gauge tailored to the institution's unique risk profile. Its purpose is to maintain sufficient capital to survive unforeseen negative scenarios, thereby fostering stakeholder trust.

Regulatory Capital, in contrast, is the mandated minimum capital that banks and financial entities must maintain, as per regulatory authorities like the Basel Committee on Banking Supervision (BCBS), Federal Reserve, European Central Bank (ECB), etc. Computed according to specific standards and principles set by these bodies, with a focus on loss absorption, it seeks to enforce stability within the financial system and safeguard depositors' interests.

The key divergence between the two concepts centers on their purpose and governance. Regulatory capital, enforced by external authorities, aims to fortify the overall financial structure and protect depositors. Economic capital, an internally governed metric, helps financial institutions navigate their particular risks and remain resilient against potential losses. The economic capital held might fluctuate above or below the regulatory capital levels, reflecting the institution's risk tolerance and individualized risk evaluation."

Sources of SBI Info:

• Annual_Report_2023.pdf (sbi.co.in)
• Basel III Disclosures (sbi.co.in)