Chapter Six: Credit Risk Management

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Chapter Six Credit Risk Management
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Enterprise-Wide Risks
FinancialRisk
Business Risk
OperationalRisk
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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.

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• 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

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

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• 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.

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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.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.

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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.

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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.

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• 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.

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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

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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

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• 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.

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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.

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6.7 Asset Classification
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6.8 Loan Loss Provisioning Policy