Chapter Six: Credit Risk Management

Enterprise-Wide Risks
FX risk in a new foreign market

Financial Risks

Credit Risk Associated with Investments

Financial Risk

Market Risk

Asset Liquidity

Business Risk

Operational Risk

Liquidity Risk

Credit Risk

Technology and operations outsourcing

Derivatives documentation and counterparty risk

Funding Liquidity

Credit Risk Associated with Borrowers and Counterparties

6.1 Components of Credit Risk

Definition: the chance that a debtor or financial instrument issuer will not be able to pay interest or repay the principal according to the terms specified in a credit agreement.

Credit risk means that payments may be delayed or ultimately not paid at all, which in turn cause cash flow problems and affects the banks liquidity.

Credit risk is the major single cause of bank failures because about 80% of a banks balance sheet relates to aspects of risk management. Main types of credit risk are: Personal or consumer risk Corporate or company risk Sovereign or country risk An overall credit risk management review includes

It is important to evaluate a banks capacity to assess, administer, enforce and recover credit instruments. Credit risk management mainly focused on loan portfolio.

6.2 Credit Portfolio Management A lending policy should contain an outline of the scope and allocation of a banks credit facilities and the manner in which a credit portfolio is managed. Flexibility is important for fast reaction and early adaptation to changing conditions in a banks asset mix and market environment.

Considerations for Sound Lending Policies

Limit on total outstanding loans: relative to deposits, capital or assets. Geographic limits (usually a dilemma): Geographic diversification may lead to bad loans if the bank lacks understanding of its diverse markets and/or doesnt have quality management. Strict geographic limits may create problems for markets with narrow economies.

Credit concentrations: lending policy should have diversified portfolio and balance between maximum yield and minimum risk. Definition: Concentration limits refer to the maximum permitted exposure to a single client, connected group and/or sector of economic activity. Distribution by category: it is common to set limits based on aggregate percentages of total loans in real estate, consumer or other categories.

Type of Loans: lending policy should specify loan types, based on expertise of lending officers, deposit structure and anticipated credit demand. Maturities: lending policy should establish the maximum maturity for each type of credit, and loans be granted with realistic repayment schedule. Maturity should be related to the anticipated source of repayment, loan purpose and collateral useful life.

Loan pricing: rates on various loan types must be sufficient to cover costs of the funds, loan supervision, administrative costs and probable losses. Should provide reasonable profit margin. Lending authority (determined by bank size): in small banks it is centralized , but decentralized in larger banks to avoid delays. Limits should be set for lending officers according to experience. Committee authority allows approval of larger loans.

Appraisal Process: lending policy should outline where the appraisal responsibility lies and should define standard appraisal procedures. Details should be provided regarding the ratio of the amount of the loan to the appraised value of both the project and collateral. Maximum ratio of loan amount to the market value of pledged securities: lending policy should set forth margin requirements for securities accepted as collateral, related to the marketability of securities.

Financial statement disclosure: a bank should recognize a loan (original or purchased) in its balance sheet. Impairment: a loan should be impaired (when it becomes difficult to be collected) to its estimated realizable value through an existing allowance. Collections: reports should be submitted to the board with sufficient details to determine risk factor, loss potential, alternative courses of action and a follow up collection procedure.

Financial information: safe extension of credit depends on complete and accurate information on the borrowers credit standing. Lending policy should define financial statement requirements and external credit checks. Long term loans require financial projections with horizons equivalent to the loan maturity.

6.3 Credit Portfolio Quality Review Loan portfolio characteristics and quality are assessed through a review process. The review includes a random sampling of loans to cover 70% of loans amount and 30% of the number of loans.

In addition, should include all of the following loans:

To borrowers if the loan accounts for more than 5% of the banks capital. To shareholders and connected parties. If interest or repayment terms have been rescheduled or changed. If interest / principal is more than 30 days past due. Classified as substandard, doubtful or loss.

Loan portfolio analysis should include:

A summary of major loan types (amount and number) including details on: number of borrowers, average maturity, average interest rate. Loan distribution according to: currency, maturity, economic sector, public Vs. private borrowers, corporate Vs. retail borrowers. Loans to government Loan by risk classification Nonperforming loans.

6.4 Nonperforming Loan Portfolio (NPLP) Definition: a loan is considered not performing when principal or interest on it is past due for 90 days or more!! NPLP is an indication of the quality of the total loan portfolio and banks lending decisions. Another indicator of portfolio quality is the banks collection ratio.

6.5 Credit Risk Management Policies

Specific credit risk management measures typically include three kinds of policies: Policies limit or reduce credit risk Policies of asset classification Policies of loan loss provisioning

6.6 Policies to Limit or Reduce Credit Risk

Large exposures: Traditionally, bank regulators pay closer attention to risk concentration to prevent excessive reliance on a large borrower. Modern regulators stipulate that a bank not make investments or grant large loans in excess of a prescribed percentage of capital or reserves. Basel imposes 25% single-customer to capital

Single client: an individual / legal person or a connected group to which a bank is exposed. Single clients present a singular risk to the bank if 1) financially interdependent and 2) share the same source of repayment. Large exposure may be an indication of bank commitment to support specific clients. Loan officer needs to frequently monitor events affecting large debtors and their performance.

 Related party lending

Lending to connected parties is a dangerous form of credit exposure. Related Parties: includes banks parent major shareholders, subsidiaries, affiliate companies, directors and executive officers.

6.7 Asset Classification

6.8 Loan Loss Provisioning Policy