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Banking and Insurance - Laws and Practice · Risk Management in Banks and Basel Accords

Credit Risk Management in Banks: Appraisal, Rating and Mitigation

Updated 11 October 2026 · Fact-checked

Credit risk is the chance that a borrower or counterparty fails to pay a bank as agreed. Banks manage it through sound appraisal, internal and external credit rating, exposure limits, collateral and guarantees, monitoring and early stress recognition. In exams, answer by naming the risk, the control tool, how it works and its limit.

Understand Credit Risk Management

Credit risk is the risk of loss because a borrower or counterparty does not repay principal or interest on time, or at all. For most banks it is the largest risk, because lending is their core business. It also arises in off-balance sheet items such as guarantees, letters of credit and derivative contracts.

Banks control credit risk at three levels. At the portfolio level, the board approves a credit policy, risk appetite and limits on how much can go to one borrower, group, industry or sector. At the transaction level, the bank appraises each proposal, rates the borrower, fixes pricing and takes security. At the monitoring level, the bank tracks the account after disbursal and acts early when stress appears.

Credit appraisal examines the borrower's character, capacity to repay, cash flows, capital, collateral and the conditions of the business. The bank checks the purpose of the loan, the project or business viability, past conduct, and the legal title of any security. Good appraisal avoids bad loans at the start.

Credit rating converts this assessment into a grade. Banks use internal rating models and also use ratings from external credit rating agencies approved by RBI. Under the Basel standardised approach, the rating of an approved agency decides the risk weight on an exposure, and unrated exposures get a prescribed weight. Better rating means lower risk weight, lower capital need and usually lower pricing.

Exposure norms stop concentration. RBI sets limits on a bank's exposure to a single borrower and a group of connected borrowers as a percentage of the bank's capital funds, with a higher limit allowed in some cases such as infrastructure. Check the current RBI circular for exact percentages before quoting them. Credit risk mitigation reduces loss if default occurs, through collateral, guarantees, netting and credit derivatives. Mitigation lowers the loss, but it does not remove the default risk, and it brings its own risks such as legal, valuation and documentation risk.

Key rules to remember

Expected loss
EL = PD × LGD × EAD
PD is probability of default, LGD is loss given default, EAD is exposure at default. Provisions are meant to cover expected loss; capital covers unexpected loss.
Risk-weighted asset for credit risk
Credit RWA = Exposure × Risk weight
Exposure here is after any eligible credit risk mitigation. Capital required = RWA × minimum capital ratio.
Exposure ceiling
Maximum exposure = Ceiling % × Capital funds
Use the percentage in the current RBI exposure norms for single and group borrowers. Capital funds is as defined by RBI, so do not use total assets.
Loss given default
LGD = 1 − Recovery rate
Recovery rate is the share of exposure recovered after default, net of costs.
Net exposure after collateral (simple approach)
Net exposure = Exposure − Eligible collateral value (after haircut)
Eligible collateral is cut by a haircut for price volatility. Net exposure cannot be negative for capital purposes.

How to solve Credit Risk Management questions

Use this method for any descriptive or case question on credit risk.

  1. 1Define credit risk in one line and say where it arises in the case.
  2. 2Identify the stage involved: appraisal, rating, sanction, documentation, monitoring or recovery.
  3. 3State the relevant control: credit policy, rating, exposure norm, collateral, guarantee, covenant or early warning signal.
  4. 4Apply it to the facts, naming the borrower, amount, security and any concentration or rating issue.
  5. 5If numbers are given, compute exposure, risk weight, RWA or expected loss, showing each step.
  6. 6Mention the residual risk, such as collateral valuation, legal enforceability or concentration.
  7. 7Conclude with a clear recommendation or finding, and a compliance or board-level action if relevant.

Quickest way: Four-box answer frame

When to use it: Use when time is short or a theory question asks how banks manage credit risk.

  1. Box 1: Identify – appraisal and rating before sanction.
  2. Box 2: Limit – exposure norms and sectoral limits set by board and RBI.
  3. Box 3: Mitigate – collateral, guarantees, netting, covenants.
  4. Box 4: Monitor – early warning signals, review, stress recognition and recovery.
  5. Add one line on residual risk and close with the conclusion.

Common mistakes in Credit Risk Management

  • Treating credit risk mitigation as removal of credit risk.

    Students read security as a guarantee of repayment.

    Fix: Say mitigation reduces loss on default. Mention residual risks such as valuation, enforceability and documentation.

  • Confusing exposure norms with risk weights.

    Both involve percentages and capital.

    Fix: Exposure norms cap how much can be lent to a borrower or group. Risk weights decide how much capital is needed against an exposure.

  • Quoting exposure ceilings from memory without basing them on capital funds.

    Students recall percentages but forget the base or the current circular.

    Fix: State the ceiling as a percentage of capital funds and refer to the current RBI norms. Do not use total assets as the base.

  • Mixing expected and unexpected loss.

    Both appear in risk management and capital discussions.

    Fix: Expected loss is the average anticipated loss and is covered by pricing and provisions. Unexpected loss is the deviation above it and is covered by capital.

  • Ignoring collateral haircuts in numerical questions.

    Students subtract the full market value of collateral.

    Fix: Reduce collateral value by the haircut first, then subtract it from exposure.

  • Writing only theory in a case question.

    Students recall notes instead of reading the facts.

    Fix: Link every control to a fact in the case and finish with a conclusion.

Worked examples

Example 1

A bank has a corporate exposure of ₹50,00,000 to a borrower. PD is 4%, LGD is 45% and EAD equals the full exposure. Calculate the expected loss and explain how it should be treated.

Show the solution
  1. Use EL = PD × LGD × EAD.
  2. PD = 0.04, LGD = 0.45, EAD = ₹50,00,000.
  3. EL = 0.04 × 0.45 × 50,00,000.
  4. 0.04 × 0.45 = 0.018.
  5. 0.018 × 50,00,000 = ₹90,000.
  6. Expected loss is a normal cost of lending, so the bank should cover it through loan pricing and provisions, while capital is held for unexpected loss.

Answer: Expected loss is ₹90,000. It should be recovered through pricing and provisions; capital covers unexpected loss.

Example 2

A bank lends ₹80,00,000 to a firm against eligible financial collateral worth ₹30,00,000. The supervisory haircut on the collateral is 10%. The remaining exposure carries a risk weight of 100%. Compute the risk-weighted asset, ignoring any other adjustment, and state the effect of collateral.

Show the solution
  1. Apply the haircut: 10% of ₹30,00,000 = ₹3,00,000.
  2. Eligible collateral value = 30,00,000 − 3,00,000 = ₹27,00,000.
  3. Net exposure = 80,00,000 − 27,00,000 = ₹53,00,000.
  4. Credit RWA = 53,00,000 × 100% = ₹53,00,000.
  5. Without collateral, RWA would have been ₹80,00,000 at the same weight, so collateral cuts RWA by ₹27,00,000.
  6. The bank still carries default risk on ₹53,00,000 and legal and valuation risk on the collateral.

Answer: Credit RWA is ₹53,00,000, which is ₹27,00,000 lower than without collateral. Residual risk remains.

Exam tips

  • In case questions, use the sequence: appraisal, rating, limit, security, monitoring, conclusion.
  • Show every step in numerical parts, including the haircut and the base used for exposure ceilings.
  • Quote RBI exposure percentages only when sure of the current circular; otherwise say a percentage of capital funds as prescribed by RBI.
  • Keep one line each on expected versus unexpected loss; examiners like this distinction.
  • Link this topic to Basel capital adequacy and asset classification in your answer for extra marks.

Practice questions from Risk Management in Banks and Basel Accords

Credit Risk Management in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Credit Risk Management: frequently asked questions

What is credit risk in banks?

It is the risk that a borrower or counterparty fails to meet payment obligations to the bank. It covers loans, guarantees, letters of credit and derivative exposures. It is usually the largest risk a bank faces.

What are the main credit risk mitigation techniques?

Common techniques are collateral, guarantees, on-balance sheet netting and credit derivatives. They reduce the loss if default occurs. They do not remove the borrower's default risk and carry legal and valuation risk.

Why do banks have exposure norms?

Exposure norms prevent concentration of lending to one borrower, group or sector. A failure of a large borrower can then not wipe out a large part of the bank's capital. RBI sets the limits as a percentage of capital funds.

How does credit rating affect a bank's capital?

Under the standardised approach, the rating of an approved agency decides the risk weight on an exposure. A better rating gives a lower weight and so a lower capital requirement. Unrated exposures get a prescribed weight.