Presented by : Dr. Peter Larose. What are the reasons for risks in banking industry? List of risks faced by banks, Definition of credit risk,

Presented by : Dr. Peter Larose

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.

Credit Risk Management in Banking Industry


Financial transactions are becoming more and more complex in the banking or financial servicessector.

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 sophisticatedas the socio-technical systems and functions,indispensable for every day living, are integratedin various combinations.

While, customers demand greater benefits fromthe level of services from their lenders on one side,on the other hand, the lenders must balance the risk/reward position.


OPERATIONAL RISKSCredit RiskTrading RiskConcentration RiskEarnings at RiskFunding & Liquidity RiskValue at RiskSolvency RiskStrategic RiskReputation Risk

MARKET RISKSInterest Rate RiskExchange Rate RiskLegal/Regulatory Risk

OTHER RISKSWeather RiskTerrorist RiskMoney Laundering


Definition of Credit RiskIt 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) fromthe borrower (s), the bank/lender will be short by the amountof cash that the borrower has failed to repay.

Another terminology that can be used to describe such arisk factor - “Risk of Default”.

As a bank or any financial services provider’s credit riskincreases over time, this institution is compelled to makeprovision to write off the debt (s) in its books of account.

Loans written-off translates into an operating expenses.


A Typical Example of Credit RiskSuppose, I take a loan of US$1,000 from Citibank at theinterest 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 madeother 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’sBalance Sheet, and obviously the major source of credit risk.

Besides loans, there are other pockets of credit risk, bothon 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 thereis a systematic credit appraisal system in place, then thisbank is likely to become heavily exposed to credit risk.


A bank’s first line of defense against excessive credit riskis 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 securitizeits loan portfolio or other assets with counterparty.

The agreement based on the trading risk will consideramongst other issues, the right of course by the purchaserin the event that the data and information were not correctlycalculated 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 “fixedinterest rate” on a borrowing contract with anothercounterparty.


Concentration RiskThis risk arises, when a bank or financial institution haslent 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 aresubject 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 defenseagainst 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 institutioncannot be funded, and in turn, cannot discharge its financialobligations on due dates and cost effectively.

The nature of such risk demands prudent management atall times.

Otherwise, the bank runs the risk of having to extend itsborrowings, selling its assets, issuing additional equitycapital, and to the extreme of even having to close downthe business – this bad news!

Liquid fund is like the life-blood for a bank. It cannot affordor fail to plan its liquidity requirement on a daily basis.

It is regarded as an important tool in the asset & liabilitymanagement for banks.


Value at Risk (VaR)

This is an estimation technique that measures the worstExpected loss that a bank can suffer over a given timeInterval 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 greaterthe risk of loss.

In view of the economic uncertainty over the last decade, VaRhas become the standard framework for measuring andreporting risk exposures in banks and other financialinstitutions.

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


Solvency RiskBasel 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 greaterprecision.

In addition to introducing new requirements for rating ofcredit risk, Basel II requires large, internationally active banks to calculate their operational risk capital from the bottom up, using both internal & external loss data.


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 thebank – 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 RiskSuch 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 RiskThis 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, andInvestment 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’snet 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 counterpartiesare subject to country risk as well to the extent that theparty or parties become unable or unwilling to fulfill theirobligations because of economic, social, or political factors.

Hence, it is important for a bank or financial institution tomonitor 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 heavilyexposed, and loose a lot of shareholders’ fund.

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 haschanged drastically with untold consequences. It is stillchanging without much of early warning signs.

The risk of catastrophic losses originating from extremeweather condition poses a much greater danger today thanin the last decade or so.

Credit risk specialists are now very much concern with thepotential implication of this phenomenon, when assessingborrowers’ business plans.

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


Act of Terrorism Risk

“Expect the Unexpected” – this quote is now a commonparlance 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 doingbusiness. This is especially in the case of mega businesslike banks & others.

Again, Basel II Accord foresees that banks must be ready tomake necessary provisions in their books of accounts forthe act of terrorism.

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


Risk of Money LaunderingThrough the offshore business activities, money launderinghas become a major business.

Banks are heavily exposed to such illegal & criminal activitiesIf they do not have adequate internal controls to spot & dealwith such transactions.

In consequence, the regulators demand that banks shouldstrengthened their internal control systems because most ofthe illegal transfer of funds finally get through the bankingsystem.

The introduction of Know Your Customer (KYC) is verycrucial for all banks to follow – otherwise, they are subjectto pay heavy penalties with the risk of closure, if they fail.


RetailMarket

MidMarket

CorporateMarket

Individuals

Medium-SizeBusinesses

Large Companies

Low High

Large

Credit Exposure

Bo

rro

wer

s

Small

Comparison of Cross-Section of Borrowers in the Banking Market


Borrower

Credit Applicationor Origination

Credit Management& Administration

Credit Analysis& Assessment

Submission Approval/Rejection

•Capital * Capacity•Character * Collateral * Consideration

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

•Credit Policy•Credit Limit•Credit Pricing

*Credit Structuring*Credit Sanctioning

Credit Risk Management in Banking IndustryCredit Risk Management in Banking Industry

Borrower

Credit Applicationor Origination

Credit Management

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

TradingBook

CreditPortfolio

Portfolio Valuation & Management

CapitalMarket

CreditCapital

Credit DerivativesCredit SecuritizationThird Party Assets Sales

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


Credit Trading Book Credit ModelingPortfolio 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 ofCritical 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 LoanThis is one of the key information required from the borrowerin order for the banker to base his/her judgment as to whetherto proceed with further credit appraisal.

There is nothing wrong for a bank to finance the repaymentof another loan, if the new loan means sound refinancingof the existing debt.

Banks would not certainly engage in the financing of loans orcredits, which are outside its scope of business or financeillegal business activities.(e.g. gambling, speculative transactions, drug trafficking,

environmentally unfriendly projects).

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


Amount of Finance RequiredIn as far as due consideration for the amount of the loan isconcerned, the loans officer or executive must adhere to theprinciples of lending.

Banks normally set their loan policy in accordance with theirfinancial 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 iseconomically feasible, it may act as the lead banker to callfor a syndicate lending.


Repayment CapacityThis test would give the banker a fair idea on how to assessthe repayment capacity of its borrowers.

The repayment schedule is calculated on the basis of aprojected financial statement over time.

If a borrower expects to make surplus cash from its activitiesthen 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 acustomer on security only.

The key priority for the banker is the ability for the customerto service its loan/credit efficiently.


Duration of the Loan/CreditThe time it takes to service a loan/credit cannot exceed aBank’s normal credit policy. (e.g. if a bank has a policy not tolend 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 isexpected that the project should be in a position to repaythe bank in full within this time limit.

There can only be exception, when the bank would extendthe duration of the loan, subject to satisfying that theborrower will honour its commitment within the foreseeablerisk.

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


Borrower’s ContributionA borrower’s contribution towards the total borrowingapplication is very vital for the banker to gauge the degreeof seriousness of the applicant.

A small or no contribution towards the total loan appliedrepresents to the bank that the borrower is very uncertainor uncommitted towards the entire obligation.

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

Even, when a customer makes a significant contributiontowards the whole project, there is no assurance that theproject will succeed. Nevertheless, it gives an indication as to the strength of the entire business concept.


Security Aspects & Insurance ProtectionStrictly, from a commercial lending viewpoint, the securityaspects and insurance protection is the last resort.

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

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

If this is the case, then the bank is in the business of substituting credit for asset purchases. This approach tolending can be very dangerous for the bank and its groupof shareholders.

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


Borrower’s CharacterA very vital piece of information that will allow the banker todecide “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 customerat 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 isthe shareholders’ funds together with other suppliers ofcapital, which are placed at risk.


Business Plan & ProjectionsGood banking practice is not about making a promise to repaythe debt incurred by the borrower or debtor.

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

A business plan & its projections is equivalent to an architect’s plan, which provides all the information about theproposed building to be constructed.

A customer, who fails to produce a projected financial planis a signal to bank that there is something wrong about thewhole business concept being asked to finance.

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


Environmental ConsiderationsDuring the last decade or so, the conservation/protection ofthe environment took centre stage in whatever businessdecision is taken.

Banks have been accused of financing many projects at thedestruction of the environment. In fact, repeated threatshave been issued against the banks that engages into suchprojects.

In order to avoid the bad publicity from the environmentalistswho are also bank customers, banks have had to re-assesstheir lending policies.

They are now having to behave like good corporate citizenby refusing to lend to projects, which are not friendly tothe environment.


Other Lending ConsiderationsBanks are now also conscious to take into considerationBanks are now also conscious to take into considerationthe likely impact on its borrowers’ obligations due to the likely impact on its borrowers’ obligations due to changes in the weather conditions.changes in the weather conditions.

In the last decade, the world has witnessed the catastrophicIn the last decade, the world has witnessed the catastrophicevents, which had had adverse impact on the level of events, which had had adverse impact on the level of business risks, and eventually turning into default risk.business risks, and eventually turning into default risk.

A number of businesses have had to re-style their businessA number of businesses have had to re-style their businessproposition in a manner that they are insured against theproposition in a manner that they are insured against thescope of natural catastrophes.scope of natural catastrophes.

Some businesses are also compelled to subscribe to theSome businesses are also compelled to subscribe to the““weather risk insurance” before they can be consideredweather risk insurance” before they can be consideredeligible for financing by the banks or financial institutions.eligible for financing by the banks or financial institutions.


Other Lending ConsiderationsSome banks would not be prepared to lend to their corporatecustomers, if they are not in possession of a rating fromeither Standard & Poor's, or Moody’s.

Other consideration can also be linked to an assessment ofthe sector, which the business operates. Is the sector ingrowth stage, or decline?

The economic business cycle will also be one of the majorconsiderations, that will be assessed before a final decisionis reached.

Banks restraint its credit expansion, when the economy issuffering from a downturn as opposed to an economic boom.


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 totalrisk model.

Such a model considers two categories of risks:(a) Systematic, and (b) Unsystematic.

This is due principally that a business is always subjectto the macro-economic environment that it operates in.

Within the macro-environment a business can simply Inherit risk, which cannot be diversified.


Systematic RiskThis type of risk is also referred as “undiversifiable” risk ormarket risk, and sometimes also known as macro-economicrisk.

The macro-economic risk can embody:(1) Interest rate,(2) exchange rate, and(3) inflation.

A business including banks cannot avoid such risk becauseit affects all enterprises, which operates within a particularjurisdiction.

That is, why the stocks have a tendency to move together.Investors are also exposed to “ market uncertainties” nomatter how many stocks they hold in their portfolios.


Unsystematic RiskThis type of risk is sometimes referred as “unique risk”.

It is particularly tied to the business specifics and some toIts immediate competitors.

Such risk can be avoided and minimized, if the managementof a business is able to diversify the company’s activitieshaving paid due regards to the specific problems relating tothe business.

Examples:• Company profit,• Products/services,• Geographical areas, the market where the company operates,• Management issues, and• Operating costs structure.


Total Risk = Systematic Risk + Unsystematic Risk

Market Risk Company Specific Risk

GDPInterest RateExchange RateInflation

• Cash Flow• Borrowings• Portfolio


Considerations to Systematic & Unsystematic RiskIt is very vital that when banks consider the credit or loanapplication for its customers, that an overall picture of thestatus of the economic environment is assessed.

This is principally due to whatever commercial strategiesare applied by a business or individual earning a salary fromhis/her employer is subject to systematic risk.

We live in an economic environment, whereby the Govt ofday dictates the policy and measures to be adopted andfollowed nationally.

A business would fail or succeed depending on how thestrategies are applied in the context of macro-economicfundamentals.


Credit Risk AnalysisIn today’s current economic turbulence, the credit riskanalysis by banks must be seen in a very wide context.

It is not a matter for the bankers to focus on the figuresand the personality of the borrower, but also assess therisk dimensions surrounding the proposition as a whole.

Example:What would be the impact of the interest rate changes doto the cost of servicing the loan/facilities?Is the borrower’s business heavily exposed to exchangerate risk?What about the trends in the industry, which the businessoperates?What if the key personnel leaves the business?


Credit Risk AnalysisOther Examples:What is the existing commitment of the borrower?What is the likely impact of weather conditions on theborrower’s ability to survive?Has the borrower made a plan, which takes into accountthe state of the economy?How is the business cycle likely to affect the borrower’sincome generation?Is there any likely possibility that that taxation rate willincrease?What is the level of competition in the market?Who are the new entrants in the market?Is there any possible threats coming from aggressivebidder to take over the borrower’s business?


A key challenge in managing credit risk is the understandingof the interrelationships of 9 risk factors:

Often risks will be either positively or negatively correlatedto one another.

Actions or events will affect correlated risks similarly.(e.g. reducing the level of problem assets should reduce not only creditrisk, but also liquidity and reputation risk).

When two risks are negatively correlated, reducing one typeof risk may increase the other.(e.g. a bank may reduce overall credit risk by expanding its holdingsof mortgage loans instead of commercial loans, only to see its interestrate risk rise because of the interest rate sensitivity & option of the mortgages).


The NINE type of risk connected with lending candescribed 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.


Credit RiskFor most banks, loans are the largest and most obvioussource of credit risk.

There are also pockets of credit risk both on & off-balancesheet of the banks (e.g. investment portfolio, overdrafts, & lettersof credit).

In addition products/services such as; derivatives, cashmanagement services, foreign exchange also expose abank to credit risk.

Here the risk of repayment i.e. possibility that an obligorWill fail to perform as agreed, is either lessened or increased by a

bank’s credit risk management practices.


Interest Rate RiskThe level of interest rate risk attributed to the bank’slending activities depends on the composition of its loanportfolio and the degree to which the terms of its loans(i.e. rate structure, maturity, embedded options) expose the bank’srevenue stream to changes in rates.

It is important that pricing and portfolio maturity decisionsshould be made with an eye to funding costs and maturities.

Banks frequently shift interest rate risk to their borrowersby structuring loans with variable interest rates.

Borrowers with marginal repayment capacity may experiencefinancial difficulty if the interest rates on these loans increase


Interest Rate RiskThe level of interest rate risk attributed to the bank’slending activities depends on the composition of its loanportfolio and the degree to which the terms of its loans(i.e. rate structure, maturity, embedded options) expose the bank’srevenue stream to changes in rates.

It is important that pricing and portfolio maturity decisionsshould be made with an eye to funding costs and maturities.

Banks frequently shift interest rate risk to their borrowersby structuring loans with variable interest rates.

Borrowers with marginal repayment capacity may experiencefinancial difficulty if the interest rates on these loans increase


Liquidity RiskBecause of the size of the loan portfolio, effective management of liquidity risk requires that there be close tiesto and good information flow from the lending function.

Banks can use their loan portfolios as a source of funds byreducing the total dollar volume of loans through sales,securitization, and portfolio run-off.

Many larger banks have been expanding their underwritingof loans for the loans syndicated market.

As part of the liquidity planning, bank’s overall liquiditystrategy should include loan portfolio segments that may beeasily converted into cash.


Price RiskMost of the developments that improve the loan portfolio’sliquidity have implications for price risk.

Traditionally, the lending activities of most banks were notaffected by price risk. This is due that loans were held tomaturity, accounting doctrine required book value accounting treatment.

As banks develop more active portfolio management practiceand the market for loans expands and deepens, loan portfolios will become increasingly sensitive to price risk.


Foreign Exchange Rate RiskThis type of risk is present when a loan or portfolio of loansis denominated in foreign currency or is funded by borrowings in another currency.

In some cases, banks will enter into multi-currency creditcommitments that permit borrowers to select the currencythey prefer to use in each rollover period.

Foreign exchange rate risk can be intensified by political,social, or economic developments. The consequences canbe unfavourable if one of the currencies involved becomessubject to stringent exchange controls or is subject to wideexchange-rate fluctuations.


Transaction RiskIn the business of lending, transaction risk is present primarily in the loan disbursement and credit administrationprocesses.

The level of transaction risk depends on the adequacy ofInformation systems and controls, the quality of operatingprocedures, the capability and integrity of employees.

Banks have and continue to experience credit risk wheninformation systems failed to provide adequate informationto identify concentrations, expired facilities, or stalefinancial statements.


Compliance RiskLending activities encompass a broad range of complianceresponsibilities and risks.

By law, a bank must observe limits on its loans to a singleborrower, connected person, affiliates, limits on interestrates and other regulatory limits imposed by the Centralbank 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.


Strategic RiskA primary objective of the loan portfolio management is tocontrol the strategic risk associated with a bank’s lendingactivities.

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 carefuloversight to ensure the risks are appropriately identifiedand managed.

It is important for bankers to decide whether the benefitsoutweigh the strategic risk.


Reputation RiskWhen a bank experiences credit problems, its reputation withinvestors, the community, and even individual customersusually suffers.

Inefficient loan delivery systems, failure to adequately meetthe credit needs of the community, and lender-liabilitylawsuits are also examples of how a bank’s reputation canbe 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 thanis legally required.


Understanding the credit culture and risk profile of a bankIs central to successful loan portfolio management.

Because of the significance of a bank’s lending activities,the influence of the credit culture frequently extends toother banking activities.

It is important that staff members throughout the bankshould understand the bank’s credit culture and risk profile.

A bank’s credit culture is the sum of its credit values, beliefsand behaviours. It is what is being done and how it isaccomplished. The credit culture exerts a strong influenceon a bank’s lending and credit risk management.


Two banks with identical levels of classified loans can havequite different profiles.

Bank A’s classified loans might be fully secured and madeto borrowers within the local market, while Bank B’s loansare made out-of-market, unsecured loan participations.

Consider as well how much more the failure of a US$3mloan would hurt a US$500m bank than a US$5b bank.

The risk profile will change over time as the portfoliocomposition and internal and external conditions change.

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


In addition to establishing strategic objectives for the loanportfolio, senior management and the Board of Directorsare responsible to set the risk limits on the bank’slending activities.

Risk limits should take into account, the bank’s historicloss experience, its ability to absorb future losses, and the bank’s desired rate of return.

Limits may be set in various ways, individually and incombination. (e.g. applied to a characteristic of loans, volume ofa particular segment of the portfolio, and the composition of the entireloan portfolio).

Limits on loans to certain industries or on certain segmentshould be set in line with its impact on the whole portfolio.


Name of Project Project Cost Financial Return Risk

Project X SR50,000 SR50,000 SR25,000

Project Y SR250,000 SR200,000 SR200,000

Project Z SR100,000 SR100,000 SR10,000

These are 3 mutually exclusive projects with their respective costs toImplement, expected net returns (net of the costs to implement), andrisk levels (all in present values).

What if one of your customer is to present you with this scenariofor financing, which project would you finance?


The most likely informed decision, which a risk manager will takedepending, 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?


Banking is both a risk-taking and profit-making business,and bank loan portfolios should return profits which iscommensurate with their risk.

Although this concept is intellectually sound and almostuniversally accepted by bankers, management have haddifficulty implementing it.

Over the years, volatility in banks’ earnings usually hasbeen linked to the loan portfolio.

While there are many contributing factors including marketforces, anxiety for income, poor risk management, acommon underlying factor has been banks’ tendency tounder-estimate or under price credit risk.


The price (index rte, spread, and fees) charged for an individualcredit should cover funding costs, overhead costs,administrative costs, required profit margin, and a premiumfor risk.

Funding costs are relatively easy to measure and buildinto loan pricing, but measuring overhead and administrativecosts is sometimes more complicated because traditionallybanks have not had sophisticated accounting systems.

Recent developments in credit and portfolio risk measurement and modeling are improving banks’ abilityto measure and price more precisely and are facilitatingthe management of capital and the allowance for loanand lease losses.


The loan policies vary from bank to bank. However, it isgenerally understood that the underlying factors areimportant considerations.1) Loan authorities,2) Limits on aggregate loans & commitments,3) Portfolio distribution by loan category and product,4) Geographic limits,5) Desirable types of loans,6) Underwriting criteria,7) Financial information and analysis requirements,8) Collateral and structure requirements,9) Margin needed for profit per product,10)Pricing guidelines,11)Documentation standards, and12)Collections & charge-offs guidelines.


Loan portfolio objectives establish specific, measurableGoals for the portfolio. They are an out-grown of the creditCulture and risk profile.

The Board of Directors must ensure that loans are madeWith the following three basic objectives:

1) 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.


In drawing the strategic plan, and objectives, the seniorManagement and the Board of Directors should consider:

I. Objectives for loan quality,II. Loan product mix,III. Targeted industries/businesses,IV. Targeted market share,V. Customers needs and services,VI. How much the portfolio should contribute to the bank’sVII.Financial returns?VIII.What proportion of the balance sheet assets will be IX. channel to loans,?X. Objectives for portfolio diversification,XI. Product specialization, andXII.Loan growth targets (e.g. product, market, segment, areas).


The primary controls over a bank’s lending functions arethe credit risk management based on the followingprinciples

A. Independence,B.Credit policy administration guidelines,C.Loan review guidelines,D.Audit of the transactions,E. Administrative & documentation controls,F. Use of external reporting (e.g. rating agencies, analysts,

Stock exchange reports, auditors report).


IndependenceIndependence is the ability to provide an objective reportof facts and to form impartial opinions.

Without independence, the effectiveness of control unitsmay be in jeopardy. It requires generally a separation ofduties and reporting lines.

Independence of the credit risk department of a bankdepends on the corporate culture and the promotion ofobjective criticism within the bank so as to improve ormodernize the operations.


Credit Policy Administration GuidelinesThe credit policy administration is responsible for the day-to-day supervision of the loan policy.

If policy needs to be supplemented or modified, creditpolicy administration drafts the changes for considerationby the management and the Board of Directors.

Such a unit – if it exist, should establish a formal processfor developing, implementing and reviewing policydirectives from time to time.


Loan Review GuidelinesLoan review is a mainstay of internal control of the loanportfolio.

Periodic reviews of credit risk levels and risk managementprocesses are essential to effective portfolio management.

To ensure the independence of loan review, the unit shouldreport administratively and functionally to the Board ofDirectors or standing committee with audit responsibilities.


Audit of TransactionsAudit activities in lending departments usually focus onthe accounting controls in the administrative supportfunctions.

While loan review has primary responsibility for evaluatingcredit risk management controls, audit will generally beresponsible for validating the lending-related models.

Audits should be done at least annually and whenever models are revised or replaced.


Administration & Documentation ControlsCredit administration is the operations arm of the lendingfunction.

The responsibilities for credit risk administration vary frombank to bank.

This is in line with the overall corporate objectives of the bank in question.


Use of External Reports

The use of external reports is an invaluable tools for thecredit management department of a bank.

The report from a rating agency would indicate the degreeof risk, which the bank faces towards its clientele froma macro-economic analysis viewpoint.

Likewise, reports from specialist analysts would indicatethe latest evaluation of a borrower’s performance.

The stock exchange should be able to indicate the latestShare price and its forecast.

The auditors would alert the shareholders of the financial standing of the borrower.


Credit risk for banks is a wide subject and it is still evolvingin 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 bodyincluding myself would be able to predict default risk withaccuracy. 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 hopeyou have been able to learn something today from thispresentation.


I wish you all, good luck

in your studies.



Documents

Presented by : Dr. Peter Larose. What are the reasons for risks in banking industry? List of risks faced by banks, Definition of credit risk,