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Welcome to this Morning's Presentation. Credit Risk Management in Banking Industry. Presented by : Dr. Peter Larose. Focus of this Presentation. What are the reasons for risks in banking industry? List of risks faced by banks, Definition of credit risk,

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Presentation Transcript
slide1

Welcome

to this Morning's

Presentation

Credit Risk Management

in

Banking Industry

Presented by : Dr. Peter Larose

slide2

Focus of this Presentation

  • What are the reasons for risks in banking industry?
  • 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.
slide3

Credit Risk Management in Banking Industry

The business of banking

is always tied to a

multitude of risks.

slide4

Credit Risk Management in Banking Industry

What Are the Reasons for Risks in the Banking Industry?

  • 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;
  • customers’ expectations,
  • competition between the financial services
  • providers,
  • (c) changes in demography,
  • (d) changes in the financial services market, and
  • (e) structural adjustments in the economy.
slide5

Credit Risk Management in Banking Industry

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.

slide6

Credit Risk Management in Banking Industry

List of Risks Faced By Banks

  • MARKET RISKS
  • Interest Rate Risk
  • Exchange Rate Risk
  • Legal/Regulatory Risk
  • OPERATIONAL RISKS
  • Credit Risk
  • Trading Risk
  • Concentration Risk
  • Earnings at Risk
  • Funding & Liquidity Risk
  • Value at Risk
  • Solvency Risk
  • Strategic Risk
  • Reputation Risk
  • OTHER RISKS
  • Weather Risk
  • Terrorist Risk
  • Money Laundering
slide7

Credit Risk Management in Banking Industry

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.

slide8

Credit Risk Management in Banking Industry

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 7th 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?

slide9

Credit Risk Management in Banking Industry

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:
  • investment portfolio,
  • overdrafts,
  • letters of credits (L/Cs), and
  • 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.
slide10

Credit Risk Management in Banking Industry

  • A bank’s first line of defense against excessive credit risk
  • is the initial credit-granting process involving:
  • sound underwriting standards,
  • an efficient and balanced approval process, and
  • a competent lending staff.
slide11

Credit Risk Management in Banking Industry

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.

slide12

Credit Risk Management in Banking Industry

Concentration Risk

This risk arises, when a bank or financial institution has

lent to a single borrower, a group of borrowers, or borrowers engaged in or dependent on one industry (say tourism sector).

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.

slide13

Credit Risk Management in Banking Industry

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.

slide14

Credit Risk Management in Banking Industry

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.

slide15

Credit Risk Management in Banking Industry

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.

slide16

Credit Risk Management in Banking Industry

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

precision.

In addition to introducing new requirements for rating of

credit risk, Basel II requires large, internationally active banks to calculate their operational risk capital from the

bottom up, using both internal & external loss data.

slide17

Credit Risk Management in Banking Industry

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).

slide18

Credit Risk Management in Banking Industry

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.

slide19

Credit Risk Management in Banking Industry

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.

slide20

Credit Risk Management in Banking Industry

Foreign Exchange Rate Risk

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

exposed, and loose a lot of shareholders’ fund.

slide21

Credit Risk Management in Banking Industry

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.

slide22

Credit Risk Management in Banking Industry

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.

slide23

Credit Risk Management in Banking Industry

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.

slide24

Credit Risk Management in Banking Industry

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.

slide25

Credit Risk Management in Banking Industry

Comparison of Cross-Section of Borrowers in the Banking Market

Large

Retail

Market

Individuals

Mid

Market

Medium-Size

Businesses

Borrowers

Large

Companies

Corporate

Market

Small

Credit Exposure

Low

High

slide26

Credit Risk Management in Banking Industry

Borrower

Submission

Approval/Rejection

Credit Application

or Origination

  • Capital * Capacity
  • Character * Collateral
  • * Consideration

Credit Analysis

& Assessment

  • Credit Policy
  • Credit Limit
  • Credit Pricing

*Credit Structuring

*Credit Sanctioning

Credit Management

& Administration

  • Capital (Economic, and Regulatory)
  • Provision for Default
  • Provision for Risk Sharing (e.g. co-financing)
slide27

Credit Risk Management in Banking Industry

Credit Risk Management in Banking Industry

Borrower

  • *Origination
  • Structuring
  • Pricing
  • Underwriting
  • Sanctioning
  • Monitoring

Credit Application

or Origination

Credit

Management

Portfolio Valuation & Management

  • Portfolio Assessment
  • Portfolio Valuation
  • Value-at-Risk (VaR)
  • Portfolio Management

Credit

Portfolio

Trading

Book

Credit Derivatives

Credit Securitization

Third Party Assets Sales

Credit

Capital

Capital

Market

slide28

Credit Risk Management in Banking Industry

MODERN CREDIT MANAGEMENT SETTING

Credit Modeling

Portfolio Valuation

Credit Trading Book

Credit Evaluation

Capital Management

*Economic Capital

*Regulatory Capital

Credit Administration

& Monitoring

Credit Procedures

& I.T. Systems

Credit Modification

slide29

Credit Risk Management in Banking Industry

What Information Are Required for Credit Risk Aanlysis?

  • 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.
slide30

Credit Risk Management in Banking Industry

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.

slide31

Credit Risk Management in Banking Industry

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.

slide32

Credit Risk Management in Banking Industry

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.

slide33

Credit Risk Management in Banking Industry

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.

slide34

Credit Risk Management in Banking Industry

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.

slide35

Credit Risk Management in Banking Industry

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.

slide36

Credit Risk Management in Banking Industry

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.

slide37

Credit Risk Management in Banking Industry

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.

slide38

Credit Risk Management in Banking Industry

Environmental Considerations

During the last decade or so, the conservation/protection of

the environment took centre stage in whatever business

decision is taken.

Banks have been accused of financing many projects at the

destruction of the environment. In fact, repeated threats

have been issued against the banks that engages into such

projects.

In order to avoid the bad publicity from the environmentalists

who are also bank customers, banks have had to re-assess

their lending policies.

They are now having to behave like good corporate citizen

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

the environment.

slide39

Credit Risk Management in Banking Industry

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.

slide40

Credit Risk Management in Banking Industry

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.

slide41

Credit Risk Management in Banking Industry

Modern Approach to Assessing Credit Risk

Credit risk assessment is no longer seen from the traditional

perspective that it should be considered in isolation.

The modern approach is to judge the credit risk from a total

risk model.

Such a model considers two categories of risks:

(a) Systematic, and

(b) Unsystematic.

This is due principally that a business is always subject

to the macro-economic environment that it operates in.

Within the macro-environment a business can simply

Inherit risk, which cannot be diversified.

slide42

Credit Risk Management in Banking Industry

  • Systematic Risk
  • This type of risk is also referred as “undiversifiable” risk or
  • market risk, and sometimes also known as macro-economic
  • risk.
  • The macro-economic risk can embody:
  • Interest rate,
  • exchange rate, and
  • inflation.
  • A business including banks cannot avoid such risk because
  • it affects all enterprises, which operates within a particular
  • jurisdiction.
  • That is, why the stocks have a tendency to move together.
  • Investors are also exposed to “ market uncertainties” no
  • matter how many stocks they hold in their portfolios.
slide43

Credit Risk Management in Banking Industry

  • Unsystematic Risk
  • This type of risk is sometimes referred as “unique risk”.
  • It is particularly tied to the business specifics and some to
  • Its immediate competitors.
  • Such risk can be avoided and minimized, if the management
  • of a business is able to diversify the company’s activities
  • having paid due regards to the specific problems relating to
  • the business.
  • Examples:
  • Company profit,
  • Products/services,
  • Geographical areas, the market where the company operates,
  • Management issues, and
  • Operating costs structure.
slide44

Credit Risk Management in Banking Industry

Total Risk Model

Total Risk = Systematic Risk + Unsystematic Risk

Company Specific Risk

Market Risk

  • Cash Flow
  • Borrowings
  • Portfolio

GDP

Interest Rate

Exchange Rate

Inflation

slide45

Credit Risk Management in Banking Industry

Considerations to Systematic & Unsystematic Risk

It is very vital that when banks consider the credit or loan

application for its customers, that an overall picture of the

status of the economic environment is assessed.

This is principally due to whatever commercial strategies

are applied by a business or individual earning a salary from

his/her employer is subject to systematic risk.

We live in an economic environment, whereby the Govt of

day dictates the policy and measures to be adopted and

followed nationally.

A business would fail or succeed depending on how the

strategies are applied in the context of macro-economic

fundamentals.

slide46

Credit Risk Management in Banking Industry

Credit Risk Analysis

In today’s current economic turbulence, the credit risk

analysis by banks must be seen in a very wide context.

It is not a matter for the bankers to focus on the figures

and the personality of the borrower, but also assess the

risk dimensions surrounding the proposition as a whole.

Example:

What would be the impact of the interest rate changes do

to the cost of servicing the loan/facilities?

Is the borrower’s business heavily exposed to exchange

rate risk?

What about the trends in the industry, which the business

operates?

What if the key personnel leaves the business?

slide47

Credit Risk Management in Banking Industry

Credit Risk Analysis

Other Examples:

What is the existing commitment of the borrower?

What is the likely impact of weather conditions on the

borrower’s ability to survive?

Has the borrower made a plan, which takes into account

the state of the economy?

How is the business cycle likely to affect the borrower’s

income generation?

Is there any likely possibility that that taxation rate will

increase?

What is the level of competition in the market?

Who are the new entrants in the market?

Is there any possible threats coming from aggressive

bidder to take over the borrower’s business?

slide48

Credit Risk Management in Banking Industry

Risks Associated with Lending

A key challenge in managing credit risk is the understanding

of the interrelationships of 9 risk factors:

Often risks will be either positively or negatively correlated

to one another.

Actions or events will affect correlated risks similarly.

(e.g. reducing the level of problem assets should reduce not only credit

risk, but also liquidity and reputation risk).

When two risks are negatively correlated, reducing one type

of risk may increase the other.

(e.g. a bank may reduce overall credit risk by expanding its holdings

of mortgage loans instead of commercial loans, only to see its interest

rate risk rise because of the interest rate sensitivity & option of

the mortgages).

slide49

Credit Risk Management in Banking Industry

Risks Associated with Lending

  • The NINE type of risk connected with lending can
  • described as:
  • Credit risk,
  • Interest rate risk,
  • Liquidity risk,
  • Price risk,
  • Foreign exchange rate risk,
  • Transaction risk,
  • Compliance risk,
  • Strategic risk, and
  • Reputation risk.
  • Each of this type of risk will be considered individually.
slide50

Credit Risk Management in Banking Industry

Risks Associated with Lending

Credit Risk

For most banks, loans are the largest and most obvious

source of credit risk.

There are also pockets of credit risk both on & off-balance

sheet of the banks (e.g. investment portfolio, overdrafts, & letters

of credit).

In addition products/services such as; derivatives, cash

management services, foreign exchange also expose a

bank to credit risk.

Here the risk of repayment i.e. possibility that an obligor

Will fail to perform as agreed, is either lessened or increased by a

bank’s credit risk management practices.

slide51

Credit Risk Management in Banking Industry

Risks Associated with Lending

Interest Rate Risk

The level of interest rate risk attributed to the bank’s

lending activities depends on the composition of its loan

portfolio and the degree to which the terms of its loans

(i.e. rate structure, maturity, embedded options) expose the bank’s

revenue stream to changes in rates.

It is important that pricing and portfolio maturity decisions

should be made with an eye to funding costs and maturities.

Banks frequently shift interest rate risk to their borrowers

by structuring loans with variable interest rates.

Borrowers with marginal repayment capacity may experience

financial difficulty if the interest rates on these loans increase

slide52

Credit Risk Management in Banking Industry

Risks Associated with Lending

Interest Rate Risk

The level of interest rate risk attributed to the bank’s

lending activities depends on the composition of its loan

portfolio and the degree to which the terms of its loans

(i.e. rate structure, maturity, embedded options) expose the bank’s

revenue stream to changes in rates.

It is important that pricing and portfolio maturity decisions

should be made with an eye to funding costs and maturities.

Banks frequently shift interest rate risk to their borrowers

by structuring loans with variable interest rates.

Borrowers with marginal repayment capacity may experience

financial difficulty if the interest rates on these loans increase

slide53

Credit Risk Management in Banking Industry

Risks Associated with Lending

Liquidity Risk

Because of the size of the loan portfolio, effective

management of liquidity risk requires that there be close ties

to and good information flow from the lending function.

Banks can use their loan portfolios as a source of funds by

reducing the total dollar volume of loans through sales,

securitization, and portfolio run-off.

Many larger banks have been expanding their underwriting

of loans for the loans syndicated market.

As part of the liquidity planning, bank’s overall liquidity

strategy should include loan portfolio segments that may be

easily converted into cash.

slide54

Credit Risk Management in Banking Industry

Risks Associated with Lending

Price Risk

Most of the developments that improve the loan portfolio’s

liquidity have implications for price risk.

Traditionally, the lending activities of most banks were not

affected by price risk. This is due that loans were held to

maturity, accounting doctrine required book value

accounting treatment.

As banks develop more active portfolio management practice

and the market for loans expands and deepens, loan

portfolios will become increasingly sensitive to price risk.

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Credit Risk Management in Banking Industry

Risks Associated with Lending

Foreign Exchange Rate Risk

This type of risk is present when a loan or portfolio of loans

is denominated in foreign currency or is funded by

borrowings in another currency.

In some cases, banks will enter into multi-currency credit

commitments that permit borrowers to select the currency

they prefer to use in each rollover period.

Foreign exchange rate risk can be intensified by political,

social, or economic developments. The consequences can

be unfavourable if one of the currencies involved becomes

subject to stringent exchange controls or is subject to wide

exchange-rate fluctuations.

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Credit Risk Management in Banking Industry

Risks Associated with Lending

Transaction Risk

In the business of lending, transaction risk is present

primarily in the loan disbursement and credit administration

processes.

The level of transaction risk depends on the adequacy of

Information systems and controls, the quality of operating

procedures, the capability and integrity of employees.

Banks have and continue to experience credit risk when

information systems failed to provide adequate information

to identify concentrations, expired facilities, or stale

financial statements.

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Credit Risk Management in Banking Industry

Risks Associated with Lending

Compliance Risk

Lending activities encompass a broad range of compliance

responsibilities and risks.

By law, a bank must observe limits on its loans to a single

borrower, connected person, affiliates, limits on interest

rates and other regulatory limits imposed by the Central

bank or monetary authority.

A bank may also become the subject of borrower initiated

“lender liability” lawsuit for damages attributed to its

lending or collection practices.

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Credit Risk Management in Banking Industry

Risks Associated with Lending

Strategic Risk

A primary objective of the loan portfolio management is to

control the strategic risk associated with a bank’s lending

activities.

Inappropriate strategic or tactical decisions about under-

writing standards, loan portfolio growth, new loan products,

geographic markets can compromise a bank’s future.

These strategies require significant planning and careful

oversight to ensure the risks are appropriately identified

and managed.

It is important for bankers to decide whether the benefits

outweigh the strategic risk.

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Credit Risk Management in Banking Industry

Risks Associated with Lending

Reputation Risk

When a bank experiences credit problems, its reputation with

investors, the community, and even individual customers

usually suffers.

Inefficient loan delivery systems, failure to adequately meet

the credit needs of the community, and lender-liability

lawsuits are also examples of how a bank’s reputation can

be tarnished because of problems with its lending division.

Reputation risk can damage a bank’s business in many ways.

(e.g. share price falls, customers & community support is lost, and

business opportunities evaporate).

To protect this reputation, they often have to do more than

is legally required.

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Credit Risk Management in Banking Industry

Credit Culture & Risk Profile

Understanding the credit culture and risk profile of a bank

Is central to successful loan portfolio management.

Because of the significance of a bank’s lending activities,

the influence of the credit culture frequently extends to

other banking activities.

It is important that staff members throughout the bank

should understand the bank’s credit culture and risk profile.

A bank’s credit culture is the sum of its credit values, beliefs

and behaviours. It is what is being done and how it is

accomplished. The credit culture exerts a strong influence

on a bank’s lending and credit risk management.

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Credit Risk Management in Banking Industry

Credit Culture & Risk Profile

Two banks with identical levels of classified loans can have

quite different profiles.

Bank A’s classified loans might be fully secured and made

to borrowers within the local market, while Bank B’s loans

are made out-of-market, unsecured loan participations.

Consider as well how much more the failure of a US$3m

loan would hurt a US$500m bank than a US$5b bank.

The risk profile will change over time as the portfolio

composition and internal and external conditions change.

Credit culture vary from bank to bank – it is not all the same!

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Credit Risk Management in Banking Industry

Risk Tolerance

In addition to establishing strategic objectives for the loan

portfolio, senior management and the Board of Directors

are responsible to set the risk limits on the bank’s

lending activities.

Risk limits should take into account, the bank’s historic

loss experience, its ability to absorb future losses, and

the bank’s desired rate of return.

Limits may be set in various ways, individually and in

combination. (e.g. applied to a characteristic of loans, volume of

a particular segment of the portfolio, and the composition of the entire

loan portfolio).

Limits on loans to certain industries or on certain segment

should be set in line with its impact on the whole portfolio.

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Credit Risk Management in Banking Industry

What if one of your customer is to present you with this scenario

for financing, which project would you finance?

These are 3 mutually exclusive projects with their respective costs to

Implement, expected net returns (net of the costs to implement), and

risk levels (all in present values).

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Credit Risk Management in Banking Industry

The most likely informed decision, which a risk manager will take

depending, of course his attitude towards risk:

*For a budget-constrained manager, the cheaper the project the better.

This will result him/her selecting Project X.

*The returns-driven manager will choose Project Y with the highest

returns, assuming that budget is not an issue.

Project Z will be chosen by the risk-averse manager as it provides

the least amount of risk while providing a positive net return.

What is interesting here is that with 3 different projects and 3 different managers, 3 different decisions will be made.

The typical question, which follows from this short overview drives us to ask.

Which manager is correct, and Why?

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Credit Risk Management in Banking Industry

Portfolio Risk & Return

Banking is both a risk-taking and profit-making business,

and bank loan portfolios should return profits which is

commensurate with their risk.

Although this concept is intellectually sound and almost

universally accepted by bankers, management have had

difficulty implementing it.

Over the years, volatility in banks’ earnings usually has

been linked to the loan portfolio.

While there are many contributing factors including market

forces, anxiety for income, poor risk management, a

common underlying factor has been banks’ tendency to

under-estimate or under price credit risk.

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Credit Risk Management in Banking Industry

Portfolio Risk & Return

The price (index rte, spread, and fees) charged for an individual

credit should cover funding costs, overhead costs,

administrative costs, required profit margin, and a premium

for risk.

Funding costs are relatively easy to measure and build

into loan pricing, but measuring overhead and administrative

costs is sometimes more complicated because traditionally

banks have not had sophisticated accounting systems.

Recent developments in credit and portfolio risk

measurement and modeling are improving banks’ ability

to measure and price more precisely and are facilitating

the management of capital and the allowance for loan

and lease losses.

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Credit Risk Management in Banking Industry

Loan Policy Issues

  • The loan policies vary from bank to bank. However, it is
  • generally understood that the underlying factors are
  • important considerations.
  • Loan authorities,
  • Limits on aggregate loans & commitments,
  • Portfolio distribution by loan category and product,
  • Geographic limits,
  • Desirable types of loans,
  • Underwriting criteria,
  • Financial information and analysis requirements,
  • Collateral and structure requirements,
  • Margin needed for profit per product,
  • Pricing guidelines,
  • Documentation standards, and
  • Collections & charge-offs guidelines.
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Credit Risk Management in Banking Industry

Loan Portfolio Objectives

  • Loan portfolio objectives establish specific, measurable
  • Goals for the portfolio. They are an out-grown of the credit
  • Culture and risk profile.
  • The Board of Directors must ensure that loans are made
  • With the following three basic objectives:
  • To grant loans on a sound and collectible basis,
  • 2) To invest the bank’s funds profitably for the benefit of the
  • shareholders and to protect the depositors’ funds, and
  • 3) To serve the legitimate credit needs for their communities.
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Credit Risk Management in Banking Industry

Strategic Planning for the Loan Portfolio

  • In drawing the strategic plan, and objectives, the senior
  • Management and the Board of Directors should consider:
  • Objectives for loan quality,
  • Loan product mix,
  • Targeted industries/businesses,
  • Targeted market share,
  • Customers needs and services,
  • How much the portfolio should contribute to the bank’s
  • Financial returns?
  • What proportion of the balance sheet assets will be
  • channel to loans,?
  • Objectives for portfolio diversification,
  • Product specialization, and
  • Loan growth targets (e.g. product, market, segment, areas).
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Credit Risk Management in Banking Industry

Credit Risk Management

  • The primary controls over a bank’s lending functions are
  • the credit risk management based on the following
  • principles
  • Independence,
  • Credit policy administration guidelines,
  • Loan review guidelines,
  • Audit of the transactions,
  • Administrative & documentation controls,
  • Use of external reporting (e.g. rating agencies, analysts,
  • Stock exchange reports, auditors report).
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Credit Risk Management in Banking Industry

Credit Risk Management

Independence

Independence is the ability to provide an objective report

of facts and to form impartial opinions.

Without independence, the effectiveness of control units

may be in jeopardy. It requires generally a separation of

duties and reporting lines.

Independence of the credit risk department of a bank

depends on the corporate culture and the promotion of

objective criticism within the bank so as to improve or

modernize the operations.

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Credit Risk Management in Banking Industry

Credit Risk Management

Credit Policy Administration Guidelines

The credit policy administration is responsible for the day-

to-day supervision of the loan policy.

If policy needs to be supplemented or modified, credit

policy administration drafts the changes for consideration

by the management and the Board of Directors.

Such a unit – if it exist, should establish a formal process

for developing, implementing and reviewing policy

directives from time to time.

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Credit Risk Management in Banking Industry

Credit Risk Management

Loan Review Guidelines

Loan review is a mainstay of internal control of the loan

portfolio.

Periodic reviews of credit risk levels and risk management

processes are essential to effective portfolio management.

To ensure the independence of loan review, the unit should

report administratively and functionally to the Board of

Directors or standing committee with audit responsibilities.

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Credit Risk Management in Banking Industry

Credit Risk Management

Audit of Transactions

Audit activities in lending departments usually focus on

the accounting controls in the administrative support

functions.

While loan review has primary responsibility for evaluating

credit risk management controls, audit will generally be

responsible for validating the lending-related models.

Audits should be done at least annually and whenever

models are revised or replaced.

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Credit Risk Management in Banking Industry

Credit Risk Management

Administration & Documentation Controls

Credit administration is the operations arm of the lending

function.

The responsibilities for credit risk administration vary from

bank to bank.

This is in line with the overall corporate objectives of the

bank in question.

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Credit Risk Management in Banking Industry

Credit Risk Management

Use of External Reports

The use of external reports is an invaluable tools for the

credit management department of a bank.

The report from a rating agency would indicate the degree

of risk, which the bank faces towards its clientele from

a macro-economic analysis viewpoint.

Likewise, reports from specialist analysts would indicate

the latest evaluation of a borrower’s performance.

The stock exchange should be able to indicate the latest

Share price and its forecast.

The auditors would alert the shareholders of the financial

standing of the borrower.

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Credit Risk Management in Banking Industry

Closing Remarks

Credit risk for banks is a wide subject and it is still evolving

in many aspects either through new models, management,

or research of new information about the customers,

markets, products, or even about the banks’ themselves.

It is an interesting subject, but at the same time, no body

including myself would be able to predict default risk with

accuracy. There will always be a margin of error.

If your prediction is right, then you are 100% lucky.

We still learning this trade in the 21st Century, and I hope

you have been able to learn something today from this

presentation.

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Credit Risk Management in Banking Industry

I wish you all,

good luck

in your studies.