Credit Risk Management

Credit Risk Management
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, 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.

The business of banking
Credit Risk Management in Banking Industry The business of banking is always tied to a multitude of risks.

What Are the Reasons for Risks in the Banking Industry?
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.

Financial transactions become more sophisticated
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.

List of Risks Faced By Banks
Credit Risk Management in Banking Industry List of Risks Faced By Banks OPERATIONAL RISKS Credit Risk Trading Risk Concentration Risk Earnings at Risk Funding & Liquidity Risk Value at Risk Solvency Risk Strategic Risk Reputation Risk MARKET RISKS Interest Rate Risk Exchange Rate Risk Legal/Regulatory Risk OTHER RISKS Weather Risk Terrorist Risk Money Laundering

Definition of Credit Risk
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.

A Typical Example of Credit Risk
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?

Is Credit Risk Important for a Bank?
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.

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

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.

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.

Earnings at Risk (EaR) The continued viability of a bank depends on its ability to earn an appropriate return on its assets and capital. Good earnings performance enables an institution to fund expansion, remain competitive in the market place, and replenish, and/or, increase capital. Earnings always represent a bank’s first line of defense against capital depletion due to credit losses, interest rate risk, and other operational risks. Risk managers should extremely careful, when assessing a bank’s risk exposure, to include Earnings at Risk as part of the risk profile.

Funding & Liquidity Risk
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.

Value at Risk (VaR) This is an estimation technique that measures the worst Expected loss that a bank can suffer over a given time Interval under normal market conditions at a given confidence In short, it measure the volatility of a business assets at risk. The more volatile the asset portfolio of the bank, the greater the risk of loss. In view of the economic uncertainty over the last decade, VaR has become the standard framework for measuring and reporting risk exposures in banks and other financial institutions. If the model is used productively, it can also help as warning signals.

Solvency Risk Basel II introduces a far more sophisticated approach to bank solvency than Basel I – the prior international capital accord dating from 1988. Earlier regime represented little more that a flat tax on banks, which were required to hold capital equal to 8% of their assets. New Accord differentiates among risks with far greater 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.

Strategic Risk In today’s commercial languages, there are many definitions, which can be associated with strategic risk. In the banking terminology, strategic risk is all about the degree of risk link to a bank’s inappropriate strategies, which do not match the corporate goals. In effect, the strategies may not fit the future ideals of the bank – in short there is a mis-match. Such risk may originate from the fact that the bank may have a good plan, but inadequate decision-making processes or lacks a systematic implementation plan. (e.g. a business strategy that is unclear, but financially viable, or a business venture that is clear but financially uneconomical).

Reputation Risk Such risk is of significant negative public opinion that results in a critical loss of funding or customers. It may involve actions that create a lasting negative image on the institution’s operation. Service or product problems, mistakes, malfeasance, or fraud may cause reputational risk. Reputation risk may not only affect the bank’s image but its affiliation with other institutions. This risk is very damaging especially if the institution operate in a very small market. Once the reputation is gone, so will be the eventual demise of the bank.

Interest Rate Risk This type of risk arises when there is a mis-match between assets & liabilities of the bank, which are subject to interest rate adjustment within a specified period. It is usually expected that a bank’s lending, funding, and Investment transactions are linked to changes in interest rates. When the interest rates change, the immediate impact of such change usually affects the net interest income (NII). The long-term impact would necessarily affects the bank’s net worth position. It involves changes in the economic value of the bank’s assets & liabilities including any off-balance sheet item.

Foreign Exchange Rate Risk
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.

Legal & Regulatory Risk
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.

Weather Risk Over the years, the weather condition all over the world has changed drastically with untold consequences. It is still changing without much of early warning signs. The risk of catastrophic losses originating from extreme weather condition poses a much greater danger today than in the last decade or so. Credit risk specialists are now very much concern with the potential implication of this phenomenon, when assessing borrowers’ business plans. Such a factor is quite prevalent in countries sitting on the earthquake zone. Even the new Basel II takes into account that banks’ should make provision for such eventualities.

Act of Terrorism Risk “Expect the Unexpected” – this quote is now a common parlance in our every day life. What use to be a very far remote event can hit us any time, and at any place. Terrorism is part of the world uncertainty and costs of doing business. This is especially in the case of mega business like banks & others. Again, Basel II Accord foresees that banks must be ready to make necessary provisions in their books of accounts for the act of terrorism. It is now referred as “ External Event Risk” for banks.

Risk of Money Laundering
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.

Retail Market Mid Market Corporate Market
Credit Risk Management in Banking Industry Comparison of Cross-Section of Borrowers in the Banking Market Large Retail Market Individuals Mid Market Borrowers Medium-Size Businesses Large Companies Corporate Market Small Low Credit Exposure High

Borrower Credit Application or Origination Credit Analysis
Credit Risk Management in Banking Industry Borrower Submission Approval/Rejection Credit Application or Origination Capital * Capacity Character * Collateral * Consideration Credit Analysis & Assessment *Credit Structuring *Credit Sanctioning Credit Policy Credit Limit Credit Pricing Credit Management & Administration Capital (Economic, and Regulatory) Provision for Default Provision for Risk Sharing (e.g. co-financing)

Borrower Credit Application or Origination Credit Management
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 Credit Portfolio Portfolio Assessment Portfolio Valuation Value-at-Risk (VaR) Portfolio Management Trading Book Credit Derivatives Credit Securitization Third Party Assets Sales Credit Capital Capital Market

Credit Administration
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

What Information Are Required for Credit Risk Aanlysis?
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.

Purpose of the Loan This is one of the key information required from the borrower in order for the banker to base his/her judgment as to whether to proceed with further credit appraisal. There is nothing wrong for a bank to finance the repayment of another loan, if the new loan means sound refinancing of the existing debt. Banks would not certainly engage in the financing of loans or credits, which are outside its scope of business or finance illegal business activities. (e.g. gambling, speculative transactions, drug trafficking, environmentally unfriendly projects). The purpose of the loan/credit must be clear from the outset once the borrower submits his/her application.

Amount of Finance Required
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.

Repayment Capacity This test would give the banker a fair idea on how to assess the repayment capacity of its borrowers. The repayment schedule is calculated on the basis of a projected financial statement over time. If a borrower expects to make surplus cash from its activities then the source of repayment will come from the cash flow. It is one of the key data required by any banker. It must be noted that a bank does not lend money to a customer on security only. The key priority for the banker is the ability for the customer to service its loan/credit efficiently.

Duration of the Loan/Credit
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.

Borrower’s Contribution
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.

Security Aspects & Insurance Protection
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.

Borrower’s Character A very vital piece of information that will allow the banker to decide “to lend, or not to lend”. A banker should not deal with a customer or potential customer that he/she cannot trust. The business of banking is all about trust, confidentiality & risk involved. The principle of lending is also about knowing your customer at all times, otherwise, the bank is likely to experience serious problem of “bad debts” on its books of accounts. Banks are not in the business of issuing credits for free. It is the shareholders’ funds together with other suppliers of capital, which are placed at risk.

Business Plan & Projections
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.

Environmental Considerations
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.

Other Lending Considerations
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.

Other Lending Considerations
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.

Modern Approach to Assessing Credit Risk
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.

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.

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.

Total Risk = Systematic Risk + Unsystematic Risk
Credit Risk Management in Banking Industry Total Risk Model Total Risk = Systematic Risk + Unsystematic Risk Company Specific Risk Market Risk GDP Interest Rate Exchange Rate Inflation Cash Flow Borrowings Portfolio

Considerations to Systematic & Unsystematic Risk
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.

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?

Credit Risk Analysis Other Examples:
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?

Risks Associated with Lending
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).

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.

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.

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

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.

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.

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.

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.

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.

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 underwriting 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.

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.

Credit Culture & Risk Profile
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.

Credit Culture & Risk Profile
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!

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.

What if one of your customer is to present you with this scenario
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? Name of Project Project Cost Financial Return Risk Project X SR50,000 SR25,000 Project Y SR250,000 SR200,000 Project Z SR100,000 SR10,000 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).

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

Portfolio Risk & Return
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.

Portfolio Risk & Return
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.

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.

Loan Portfolio Objectives
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.

Strategic Planning for the Loan Portfolio
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).

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).

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.

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.

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.

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.

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.

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.

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.

I wish you all, good luck in your studies.
Credit Risk Management in Banking Industry I wish you all, good luck in your studies.

Thank You for Your Attention
Credit Risk Management in Banking Industry Thank You for Your Attention

The End

Credit Risk Management

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