Credit Risk Management Practices and Their Influence on Banking Sector Stability

Abstract

Credit risk is the largest risk that most banks carry, and failures in managing it have been at the centre of many banking crises. This article examines how credit risk management practices influence the stability of the banking sector. It sets out a framework linking five groups of practices, namely identification, measurement, mitigation, monitoring, and provisioning and capital, to stability through four channels: lower formation of non-performing assets (NPAs), smaller losses in downturns, adequate loss-absorbing buffers and sustained confidence. It reviews the evolution of international standards from the Basel Accords to expected credit loss accounting, and the empirical literature on risk management and bank resilience. The Indian experience provides a striking illustration. The gross NPA ratio of scheduled commercial banks rose to 11.2 percent in March 2018 after a period of weak appraisal and delayed recognition, then fell to 2.1 percent by September 2025, a multi-decade low, following an asset quality review, the Insolvency and Bankruptcy Code, recapitalisation and stronger supervision. The Reserve Bank of India’s December 2025 stress tests projected that the capital adequacy ratio of 46 major banks would remain at 14.1 percent or above by March 2027 even under the most severe scenario. A simulation of three hypothetical banks with identical capital but different credit practices shows how practices translate into stability. The bank with weak practices had a 99.9th-percentile loss of 18.6 percent of its loan book and a 1.9 percent annual probability of exhausting its capital; the bank with strong practices had a 99.9th-percentile loss of 3.8 percent and no failures in 40,000 simulated years. The article concludes with recommendations for banks and regulators, including the transition to expected credit loss provisioning planned for April 2027.