CREDIT RISK MANAGEMENT IN A BANK UNDER A RAPID GROWTH

Part 1: a dynamic model for loan impairment provisioning

Ihor Voloshyn

May 2014

Version 1

Working paper

Ihor Voloshyn
PhD., senior scientist at Academy of Financial Management
of Ministry of Finances of Ukraine
38-44, Degtyarivska str.,
04119, Kyiv, Ukraine
Tel. +38 044 486 5214
vologor@i.ua

Electronic copy available at: http://ssrn.com/abstract=2433090

Abstract
The features of credit risk management under rapid growth of a bank are investigated.
The growth rate of loan portfolio is shown to be needed to take into account for
effective credit risk management. It is developed a dynamic model of provisioning
for impairment of loans. The proposed model takes into consideration the
requirements of sufficient liquidity, target profitability and covering credit risk.

Key words: dynamic model, bank, balance sheet, risk management, loan, deposit,
credit risk, provisions for impairment, interest rate, operating expenses, return on
equity (ROE), capital, liquidity, growth rate

JEL Classifications: G12, G21

Electronic copy available at: http://ssrn.com/abstract=2433090

1. INTRODUCTION

The banking system of Ukraine demonstrated very high growth rates of loan portfolio
from 2002 up to 2008 that achieved values from 30 to 80 annual percent. Now the
Ukrainian experts are expecting a new wave of lending that may begin from the end
of 2014 to the beginning of 2015, of course, after overcoming the current political
and financial crisis of 2013-2014. Note that the renewal of lending is strongly needed
for renovation of the social-economic development of Ukraine. And the banking
system and prudential supervision must prepare to renewal of lending in advance.
This paper is devoted to study features of credit risk management in a bank
under rapid growth. In the first part of the paper a dynamic model of provisioning
will be considered.

2. INFLUENCE OF RAPID GROWTH ON FINANCIAL POSITION OF

A BANK

Granting the new loans a bank must immediately (according Ukrainian national
accounting standards not later than on the first day of the following month) to make a
provisions for impairment of these loans. However, the new loans have not yet
brought to the bank an interest income which is sufficient to create these provisions.
In fact, the bank can make the provisions for impairment of the new loans only
through interest income on the existing loans. It particularly plays a significant role
under pro-cyclic provisioning. Emphasize that this is an important point to
understand the impact of growth rate on the ability of banks to cover credit risk
effectively. Then, the ability of the bank to make the provisions will depend on the
ratio between the new and the existing loans in the banks portfolio, i.e. the growth
rate of the loan portfolio. Thus, the growth rate of loan portfolio is needed to take into
account for effective credit risk management in a bank.

Note that renovation and expansion of lending affect complexly on financial

position of a bank on its liquidity, profitability and risk. So, the liquidity of the bank
depends from matching the growth rates of assets and liabilities. Profit and loss are
defined by net interest income, expense on provisions for loan impairment, operating
expenses and target profit. The expected credit losses are determined by exposure at
risk, default probability of borrower and recovery rate. Follow to mark that the rapid
growth of assets with growth rate higher than the one of capital reduces capital
adequacy, and further requires additional capitalization of the bank.
Consider in more detail the possible behavior of net interest income. On the
one hand, an increase of lending leads to a rise in interest income. On the other hand,
an increase in interest expense enlarges too due to a rise of deposits financed new
loans (Fig. 1). In Fig. 1 for simplification the influence of operating expenses and
target profit on a banks ability of provisioning is neglected. As a result of
competition for borrowers and depositors net interest spread tends to a decrease. So,
resulting influence of these factors on net interest income is uncertain.
But the growth of the loan portfolio requires uniquely enhancing amount of
provisions for impairment of loans.
There is a situation when the growth rate of loans will be so great that the
ability of a bank to create the provisions will decrease and it will be forced to tighten
lending standards: requirements to creditworthiness of borrowers, recovery rates, etc.
This, in turn, will lower demand for loans and thus may inhibit extension of lending.
After all, are there enough creditworthy borrowers for banks to lend to? This situation
may improve the government guarantees on loans for priority economic sectors,
innovation and investment projects, etc.
Thus, there is a system risk that the banks under rapid growth may not have
time to make the provisions needed to cover credit risk. It may lead to accumulation
of credit risk in the banking system and then to necessity of capitalization of state
banks and nationalization of private banks. Such a risk makes necessary to strengthen
the prudential standards.
4

To take into account all these factors it is needed to develop a dynamic model
of the banks activity.
Increase in
interest income

Increase in
loans

Change of
lending
standards

Change in
expense on
provisions

Change in net
interest income

Increase in
interest expense

Increase in
deposits

Figure 1. Mutual influence of loan and deposit growths on the banks ability to make
provisions for impairment of loans

3. A DYNAMIC MODEL OF PROVISIONING

FOR IMPAIRMENT OF LOANS

In order not to obscure the provisioning process by the details consider a bank that
grants loans and attracts deposits only. Assume that quality of existing loans keep on
initial level and the bank does not pay dividends. Without loss of generality let
demand for loans and supply of deposits are inelastic. The balance sheet of the bank
at time t has the following form (Fig. 2):
C(t) + L(t) - y(t) + FA = D(t) + E(t), (1)
where C(t) is the liquidity buffer, or the amount of highly liquid assets to maintain
liquidity and compliance with the National bank on required liquidity reserves, L(t) is
the gross amount of loans (before provisioning) or exposure at default, y(t) is the
amount of the provisions, FA is the value of fixed assets (is assumed to be constant);
D(t) is the amount of deposits, E(t) is capital. In this case:
C(t) = gD(t), (2)
5

where g is the liquidity ratio (is assumed to be constant).

Liquidity buffer
Deposits
Loans

Provisions
Capital
Fixed assets

Figure 2. A simplified balance sheet of the bank

Consider the banks activity in continuous time. Suppose that the banks capital
is changed only due to the current profit and loss. Then the rate of change in capital
(the first time derivative of capital) is the instantaneous profit (loss) of the bank:
E'(t) = (L(t) RL D(t) RD y'(t) OE(t)) (1 T), (3)
where '

d
is the first derivative respect to time t; RL and RD are interest rates on
dt

loans and deposits, correspondently; OE(t) is operating expenses, T is tax rate.

In this case:
OE(t) = (D(t)+E(t)). (4)
where is a ratio of operating expenses (operating expenses to total assets) [1].
The first and the second members of the right-hand side of the equation (3) are
interest income on loans and interest expense on deposits, the third is expense on
provisioning; the fourth is operating expenses.
Assume that the bank has a target profit and a planned increase of deposits that
provide a correspondent rise of loans. Then, substituting in the equation (3) the gross
amount of loans L(t) from the balance sheet equation (1) and formulas (2) and (4)
find the first order linear differential equation with respect to the unknown provisions
function y(t) with the initial condition y(0):
y'(t) RL y(t) = Q(t), (5)
where Q(t) is revenues directed on provisioning. In this case:
6

Q(t) = (1 - g) RL RD D(t ) FA RL ( RL ) E (t )

E (t )
. (6)
1 T

The differential equation (5) with respect to the unknown provisions function
y(t) with the initial condition y(0) has the following solution [2]:
t

y(t) = y (0) expRL t Q( z ) expRL (t z ) dz . (7)

0

The solution (7) shows that in the future time t the value y(t) of the provisions is
equal to the future value of an initial provisions y(0) and revenues Q(t) that are
accrued by the interest rate RL on loans.
The solution (7) demonstrates too how much provisions the bank can create or
describes the banks ability to make the provisions.
According to Basel the amount of provisions are computed as follows [3]:
y*(t)= L(t)PD(t)LGD(t), (8)
where y*(t) is the amount of provisions or expected credit losses;
PD(t) is probability of default (the average of all loans);
LGD(t) is the loss given default (the average of all loans) at time t.
The banks ability y(t) to make its provisions (equation (7)) must be balanced
with the required amount of provisions y*(t) (formula (8)), i.e.:
y(t) y*(t). (9)
Consider the following scenario of the banks activity. Dynamics of deposits
D(t) and target capital E(t) are subjected to the exponential laws, correspondently:
D(t) = D(0)exp(t), (10)
where is the planned growth rate of deposits that is constant, D(0) is the amount of
deposits at time t = 0;
E(t) = E(0)exp(ROEt), (11)
where ROE is the target return on equity or the growth rate of capital, E(0) is the
value of capital at time t = 0. Note that profitable activity of the bank, on the one
hand, improves in customer confidence to the bank and, on the other hand, provides

revenue of income tax to the state budget. Besides, it is required for top-management
and shareholders.
Further it will be needed the provisions ratio (t) calculated as follows:

(t )=

y(t)
, (12)
L(t)

where y(t) is the amount of the provisions, L(t) is the amount of loans at time t. It
describes the quality of loan portfolio.

4. SUMMARY

Renovation and expansion of lending affect complexly on financial position of a bank

on its liquidity, profitability and risk. Granting the new loans the bank must
immediately make provisions for impairment of these loans. However, the new loans
have not yet brought to the bank an interest income which is sufficient to create these
provisions. In fact, the bank can make the provisions only through interest income on
the existing loans. Then, the ability of the bank to cover credit risk will depend on the
ratio between the new and the existing loans in the portfolio, i.e. the growth rate of
the loan portfolio. Thus, the growth rate of loan portfolio is needed to take into
account for effective credit risk management in a bank.
To take into account all these factors it is helpful to use a dynamic model of
provisioning that allows estimating an impact of rapid growth on a banks ability to
make provisions and thus to achieve matching the provisioning ability of a bank and
required level of provisions.
There is a system risk that the banks under rapid growth may not have time to
create the provisions needed to cover credit risk. It may lead to accumulation of credit
risk in the banking system. Such a risk makes necessary to strengthen the prudential
standards.
In the second part of the paper results of calculation and actual behavior of
provisions ratio will be considered.
8

LITERATURE
1. Bessis J. Risk Management in Banking. West Sussex, England: Wiley &
Sons Inc., 1988. 430 p.
2. Keisler, H.J. (2006) The ebook Elementary Calculus: General Solution:
www.vias.org/calculus/14_differential_equations_03_007.html.
3. International Convergence of Capital Measurement and Capital Standard
(2004).

Revised

Framework.

Bank

for

International

Settlements:

http://www.bis.org/publ/bcbs107.pdf.