Credit Risk Management Lecture

 Modern approach to assessing credit risk,  Risks associated with lending,  Credit culture and risk profile,  Risk tolerance,  Portfolio risk and return,  Loan policy issues,  Loa

 List of risks faced by banks,

 Definition of credit risk,

 Is credit risk important for a bank?

 What information are required for credit risk analysis?

 Modern approach to assessing credit risk,

 Risks associated with lending,

 Credit culture and risk profile,

 Risk tolerance,

 Portfolio risk and return,

 Loan policy issues,

 Loan portfolio objectives,

 Strategic planning for the loan portfolio,

 Credit risk management, and

 Closing remarks.

Financial transactions are becoming more and

more complex in the banking or financial services sector.

This is due to a number of factors such as;

(a) customers’ expectations,

(b) competition between the financial services

providers,

(c) changes in demography,

(d) changes in the financial services market, and (e) structural adjustments in the economy.

Financial transactions become more sophisticated

as the socio-technical systems and functions,

indispensable for every day living, are integrated

in various combinations.

While, customers demand greater benefits from

the level of services from their lenders on one side,

on the other hand, the lenders must balance the

risk/reward position.

Interest Rate Risk

Exchange Rate Risk

Definition of Credit

Risk

It is defined as the possibility that a borrower will fail to

repay his/her debt (s) to the bank/lender on the due date.

When the bank/lender is unable to collect the debt (s) from the borrower (s), the bank/lender will be short by the amount

of cash that the borrower has failed to repay.

Another terminology that can be used to describe such a

risk factor - “ Risk of Default ”.

As a bank or any financial services provider’s credit risk

increases over time, this institution is compelled to make

provision to write off the debt (s) in its books of account.

Loans written-off translates into an operating expenses.

A Typical Example of Credit Risk

Suppose, I take a loan of US$1,000 from Citibank at the interest rate of 5% per annum for a period of 5 years.

I start repaying for the first 6 months and then stop

servicing the loan on the 7 th Month because I have made other commitment elsewhere.

(a) What is the credit risk for the Citibank?

(b) How it would impact on the liquidity of the bank?

Microsoft Excel Worksheet

Is Credit Risk Important for a Bank?

For most banks, loans are the largest asset on the bank’s

Balance Sheet, and obviously the major source of credit risk.

Besides loans, there are other pockets of credit risk, both

on and off-balance sheet such as:

(a) investment portfolio,

(b) overdrafts,

(c) letters of credits (L/Cs), and

(d) guarantees.

If a bank or financial institution does not ensure that there

is a systematic credit appraisal system in place, then this

bank is likely to become heavily exposed to credit risk.

A bank’s first line of defense against excessive credit risk

is the initial credit-granting process involving:

(a) sound underwriting standards,

(b) an efficient and balanced approval process, and

(c) a competent lending staff.

Trading Risk

This type of risk originate when a bank sells or securitize its loan portfolio or other assets with counterparty.

The agreement based on the trading risk will consider

amongst other issues, the right of course by the purchaser

in the event that the data and information were not correctly calculated at the time of the transaction.

Trading risk may also arise in the case where a bank

engages into a swap of “floating interest rate” to a “fixed

interest rate” on a borrowing contract with another

counterparty.

Concentration risk of credit consists of direct, indirect,

or contingent obligations exceeding 25% of the bank’s capital structure.

Concentrations within, or dependent on, an industry are subject to the additional risk factors of external

economic conditions.

From a sound risk management perspective, a periodic review of the industry trends be made in order to assess its susceptibility to external factors.

Earnings at Risk (EaR)

The continued viability of a bank depends on its ability

to earn an appropriate return on its assets and capital.

Good earnings performance enables an institution to

fund expansion, remain competitive in the market place, and replenish, and/or, increase capital.

Earnings always represent a bank’s first line of defense against capital depletion due to credit losses, interest rate risk, and other operational risks.

Risk managers should extremely careful, when

assessing a bank’s risk exposure, to include Earnings at Risk as part of the risk profile.

Funding & Liquidity Risk

This type of risk is arises, when a bank or financial institution cannot be funded, and in turn, cannot discharge its financial obligations on due dates and cost effectively.

The nature of such risk demands prudent management at

all times.

Otherwise, the bank runs the risk of having to extend its

borrowings, selling its assets, issuing additional equity

capital, and to the extreme of even having to close down

the business – this bad news!

Liquid fund is like the life-blood for a bank It cannot afford

or fail to plan its liquidity requirement on a daily basis.

It is regarded as an important tool in the asset & liability

management for banks.

Value at Risk (VaR)

This is an estimation technique that measures the worst

Expected loss that a bank can suffer over a given time

Interval under normal market conditions at a given confidence

In short, it measure the volatility of a business assets at risk.

The more volatile the asset portfolio of the bank, the greater the risk of loss.

In view of the economic uncertainty over the last decade, VaR has become the standard framework for measuring and

reporting risk exposures in banks and other financial

institutions.

If the model is used productively, it can also help as warning signals.

Solvency Risk

Basel II introduces a far more sophisticated approach to bank solvency than Basel I – the prior international capital accord dating from 1988.

Earlier regime represented little more that a flat tax on

banks, which were required to hold capital equal to 8% of their assets.

New Accord differentiates among risks with far greater

Strategic Risk

In today’s commercial languages, there are many

definitions, which can be associated with strategic risk.

In the banking terminology, strategic risk is all about the degree of risk link to a bank’s inappropriate strategies,

which do not match the corporate goals.

In effect, the strategies may not fit the future ideals of the bank – in short there is a mis-match.

Such risk may originate from the fact that the bank may

have a good plan, but inadequate decision-making

processes or lacks a systematic implementation plan (e.g

a business strategy that is unclear, but financially viable,

or a business venture that is clear but financially

uneconomical).

Reputation Risk

Such risk is of significant negative public opinion that

results in a critical loss of funding or customers.

It may involve actions that create a lasting negative image

on the institution’s operation.

Service or product problems, mistakes, malfeasance, or fraud may cause reputational risk.

Reputation risk may not only affect the bank’s image but its affiliation with other institutions.

This risk is very damaging especially if the institution

operate in a very small market

Once the reputation is gone, so will be the eventual

demise of the bank.

Interest Rate Risk

This type of risk arises when there is a mis-match between assets & liabilities of the bank, which are subject to

interest rate adjustment within a specified period.

It is usually expected that a bank’s lending, funding, and Investment transactions are linked to changes in interest rates.

When the interest rates change, the immediate impact of such change usually affects the net interest income (NII).

The long-term impact would necessarily affects the bank’s net worth position.

It involves changes in the economic value of the bank’s

assets & liabilities including any off-balance sheet item.

Such risk originates for institutions dealing in foreign currency

transactions.

Financial institutions dealing with foreign counterparties

are subject to country risk as well to the extent that the

party or parties become unable or unwilling to fulfill their

obligations because of economic, social, or political factors.

Hence, it is important for a bank or financial institution to

monitor its net-off position (i.e offseting its foreign denominated

assets against its foreign denominated liabilities) and take measure to

hedge the exchange exposure.

Otherwise, the bank or financial institution can be heavily

Foreign Exchange Rate Risk

Legal & Regulatory Risk

This type of risk arises from violations or

non-compliance with the laws, rules, regulations or prescribed practices.

Legal risk may also arise when the legal rights & obligations or parties to a transaction are not well established.

The bank may face legal risks with respect to

customer disclosure & privacy protection.

Weather Risk

Over the years, the weather condition all over the world has changed drastically with untold consequences It is still

changing without much of early warning signs.

The risk of catastrophic losses originating from extreme

weather condition poses a much greater danger today than

in the last decade or so.

Credit risk specialists are now very much concern with the potential implication of this phenomenon, when assessing borrowers’ business plans.

Such a factor is quite prevalent in countries sitting on the earthquake zone Even the new Basel II takes into account that banks’ should make provision for such eventualities.

Act of Terrorism Risk

“Expect the Unexpected” – this quote is now a common

parlance in our every day life

What use to be a very far remote event can hit us any time, and at any place.

Terrorism is part of the world uncertainty and costs of doing business This is especially in the case of mega business

like banks & others.

Again, Basel II Accord foresees that banks must be ready to make necessary provisions in their books of accounts for the act of terrorism

It is now referred as “ External Event Risk” for banks.

Risk of Money Laundering

Through the offshore business activities, money laundering has become a major business.

Banks are heavily exposed to such illegal & criminal activities

If they do not have adequate internal controls to spot & deal with such transactions.

In consequence, the regulators demand that banks should

strengthened their internal control systems because most of the illegal transfer of funds finally get through the banking

system.

The introduction of Know Your Customer (KYC) is very

crucial for all banks to follow – otherwise, they are subject

to pay heavy penalties with the risk of closure, if they fail.

Retail Market

Mid Market

Corporate Market

Individuals

Medium-Size Businesses

Large Companies

•Capital (Economic, and Regulatory)

•Provision for Default

•Provision for Risk Sharing (e.g co-financing)

Credit Application

or Origination

Credit Management

Portfolio Valuation & Management

Capital

Market

Credit Capital

Credit Derivatives Credit Securitization Third Party Assets Sales

•Portfolio Assessment

• Portfolio Valuation

• Value-at-Risk (VaR)

• Portfolio Management

Credit Trading Book Credit Modeling

Portfolio Valuation Credit Evaluation

Credit Procedures

& I.T Systems

Credit Administration

& Monitoring Credit Modification

Capital Management

*Economic Capital

*Regulatory Capital MODERN CREDIT MANAGEMENT SETTING

Sound credit risk analysis would depend on a number of Critical piece of information such as;

 Purpose of the loan/credit,

 Amount required,

 Repayment capacity of the borrower,

 Duration of the loan/credit,

 Borrower’s contribution,

 Security aspects & insurance protection,

 Borrower’s character,

 Business plan & projections,

 Environmental considerations, and

 Other considerations.

Purpose of the Loan

This is one of the key information required from the borrower

in order for the banker to base his/her judgment as to whether

to proceed with further credit appraisal.

There is nothing wrong for a bank to finance the repayment

of another loan, if the new loan means sound refinancing

of the existing debt.

Banks would not certainly engage in the financing of loans or credits, which are outside its scope of business or finance

illegal business activities.

(e.g gambling, speculative transactions, drug trafficking,

environmentally unfriendly projects).

The purpose of the loan/credit must be clear from the outset once the borrower submits his/her application.

Amount of Finance Required

In as far as due consideration for the amount of the loan is concerned, the loans officer or executive must adhere to the principles of lending.

Banks normally set their loan policy in accordance with their financial resources

Too high an amount of the loan will be outside the bank’s mandate.

In the modern day banking environment, if a bank cannot finance a loan application on its own and the project is

economically feasible, it may act as the lead banker to call for a syndicate lending.

Repayment Capacity

This test would give the banker a fair idea on how to assess the repayment capacity of its borrowers.

The repayment schedule is calculated on the basis of a

projected financial statement over time.

If a borrower expects to make surplus cash from its activities then the source of repayment will come from the cash flow.

It is one of the key data required by any banker.

It must be noted that a bank does not lend money to a

customer on security only

The key priority for the banker is the ability for the customer

to service its loan/credit efficiently.

Duration of the Loan/Credit

The time it takes to service a loan/credit cannot exceed a Bank’s normal credit policy (e.g if a bank has a policy not to

lend beyond 5 years for a credit type, then it cannot lend beyond this specific time frame)

In addition, if a project has a life time of say 7 years, it is

expected that the project should be in a position to repay the bank in full within this time limit.

There can only be exception, when the bank would extend the duration of the loan, subject to satisfying that the

borrower will honour its commitment within the foreseeable risk.

The duration of a loan is always tied to the rate of interest.

Borrower’s Contribution

A borrower’s contribution towards the total borrowing

application is very vital for the banker to gauge the degree

of seriousness of the applicant.

A small or no contribution towards the total loan applied

represents to the bank that the borrower is very uncertain

or uncommitted towards the entire obligation.

It is one of the indicators that the banker would be mindful when due consideration is given to the application.

Even, when a customer makes a significant contribution

towards the whole project, there is no assurance that the project will succeed Nevertheless, it gives an indication as

to the strength of the entire business concept.

Security Aspects & Insurance Protection

Strictly, from a commercial lending viewpoint, the security aspects and insurance protection is the last resort.

It is considered as a back up position in the event that the customer defaults on his/her obligations to repay the loan.

It is important to note that a good banker should not lend the shareholders’ funds purely on the security offered by the borrowers.

If this is the case, then the bank is in the business of

substituting credit for asset purchases This approach to lending can be very dangerous for the bank and its group

of shareholders.

Lending should be based on the capacity to repay the loan.

Borrower’s Character

A very vital piece of information that will allow the banker to decide “to lend, or not to lend”.

A banker should not deal with a customer or potential

customer that he/she cannot trust

The business of banking is all about trust, confidentiality

& risk involved.

The principle of lending is also about knowing your customer

at all times, otherwise, the bank is likely to experience

serious problem of “bad debts” on its books of accounts.

Banks are not in the business of issuing credits for free It is the shareholders’ funds together with other suppliers of

capital, which are placed at risk.

Business Plan & Projections

Good banking practice is not about making a promise to repay the debt incurred by the borrower or debtor.

It must be focused on sound financial plan, which would allow the banker to identify the strength and weakness of the credit application at the time of its submission.

A business plan & its projections is equivalent to an

architect’s plan, which provides all the information about the proposed building to be constructed.

A customer, who fails to produce a projected financial plan

is a signal to bank that there is something wrong about the

whole business concept being asked to finance.

A sharp banker is most likely to turn down the application.

They are now having to behave like good corporate citizen

by refusing to lend to projects, which are not friendly to

the environment.

Other Lending Considerations

Banks are now also conscious to take into consideration

the likely impact on its borrowers’ obligations due to

changes in the weather conditions.

In the last decade, the world has witnessed the catastrophic events, which had had adverse impact on the level of

business risks, and eventually turning into default risk.

A number of businesses have had to re-style their business proposition in a manner that they are insured against the

scope of natural catastrophes.

Some businesses are also compelled to subscribe to the

“weather risk insurance” before they can be considered

eligible for financing by the banks or financial institutions.

Other Lending Considerations

Some banks would not be prepared to lend to their corporate customers, if they are not in possession of a rating from

either Standard & Poor's, or Moody’s.

Other consideration can also be linked to an assessment of the sector, which the business operates Is the sector in

growth stage, or decline?

The economic business cycle will also be one of the major considerations, that will be assessed before a final decision

is reached.

Banks restraint its credit expansion, when the economy is

suffering from a downturn as opposed to an economic boom.