Credit Risk in Banking Finance Essay

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Credit in bank is a contractual agreement in which a borrower receives something of value now and agrees to repay the lender at some later date (Joan Selorm Tsorhe p.6). However, credit risk arises whenever a lender is exposed to loss from a borrower, counterparty, or an obligor who fails to honor their debt obligation as they have agreed or contracted (Colquitt 2007, 1).

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Credit risk implies that payments may be delayed or ultimately not paid at all, which can in turn cause cash flow problems and affects a bank’s liquidity. Despite innovation in the financial services sector, credit risk is still the "major cause of bank’s failures" (Greuning & Bratanovic 2009, 135).

Credit risk is faced by banks when a borrower (customer) cannot honoring its debt obligations on due date or at maturity. This risk which is also called ‘counterparty risk’ is capable of putting the bank in distress if not adequately dealt with. There is always the possibility for a borrower to default from his commitments for one or the other reason; therefore a sound credit risk management framework is indispensable to a healthy and profitable banking institution.

2.2 Credit risk management in banking

Banks generate their profit from the spread between the interest rate they charge to borrowers and the interest rate they pay to depositors. The major function of banks has always consisted of lending activities and assessing the credit worthiness of a borrower has always been of utmost importance (Andrew Fight, 2004). In order to generate profit, banks make loan with the aim that the latter will be fully repaid as per the agreement.

Therefore banks must ensure that borrowers will be able to repay back their obligations on due date in order to maximize the value of the bank. Banks have to manage credit risk effectively, for them to be profitable and to ensure their survival. Banks can reduce their exposure to credit risk by adopting robust credit risk management methods.

Credit risk management is basically the procedures adopted by banks with the aim of reducing or avoiding credit risk. It involves tools, procedures and mechanisms that banks rely on to monitor their lending activities. It involves the identification of potential risks, the measurement of these risks, the appropriate treatment, and the actual implementation of risk models.

2.2.1 Credit risk management strategies

The methods for hedging credit risk include (as identified by T. Funso, 2012, pp31-38) but not limited to these:

1. Compliance to Basel Accord: Being able to identify, generate, track and report on risk-related data in an integrated manner, with full auditability and transparency and creates the opportunity to improve the risk management processes of banks. The New Basel Capital Accord places explicitly the responsibility on banks to adopt sound internal credit risk management practices to assess their capital adequacy requirements.

2. Adoption of a sound internal lending policy: Strict adherence to the lending policy is by far the cheapest and easiest method of credit risk management. The lending policy should be in line with the overall bank strategy and the factors considered in designing a lending policy should include; the existing credit policy, industry norms, general economic conditions of the country and the prevailing economic climate.

3. Credit Derivatives: This provides banks with an approach which does not require them to adjust their loan portfolio. Credit derivatives provide banks with a new source of fee income and offer banks the opportunity to reduce their regulatory capital. The commonest type of credit derivative is credit default swap whereby a seller agrees to shift the credit risk of a loan to the protection buyer. Frank Partnoy and David Skeel in Financial Times of 17 July, 2006 said that "credit derivatives encourage banks to lend more than they would, at lower rates, to riskier borrowers". Recent innovations in credit derivatives markets have improved lenders’ abilities to transfer credit risk to other institutions while maintaining relationship with borrowers.

4. Credit Securitization: It is the transfer of credit risk to a factor or insurance firm and this relieves the bank from monitoring the borrower and fear of the hazardous effect of classified assets. This approach insures the lending activity of banks. The growing popularity of credit risk securitization can be put down to the fact that banks typically use the instrument of securitization to diversify concentrated credit risk exposures and to explore an alternative source of funding by realizing regulatory arbitrage and liquidity improvements when selling securitization transactions. A cash collateralized loan obligation is a form of securitization in which assets (bank loans) are removed from a bank’s balance sheet and packaged (tranched) into marketable securities that are sold on to investors via a special purpose vehicle.

5. Credit Bureau: This is an institution which compiles information and sells this information to banks as regards the lending profile of a borrower. The bureau awards credit score called statistical odd to the borrower which makes it easy for banks to make instantaneous lending decision. An example of credit bureau in Mauritius is the Mauritius Credit Information Bureau.

Traditional methods of controlling credit risk

1. Screening and monitoring: Adverse selection in loan market requires the lenders screen out the bad credit from the good ones so that loans are profitable to them. Once a loan has been made, the bank’s has to monitor or follow up the borrowers’ activities.

2. Long-term Customer Relationship: if the borrower has borrowed previously from the bank, the bank has a record of the loan payments. This reduces the costs of information collection and makes it easier to screen out bad credit risks. Long-term relationship enables banks to deal with even unanticipated moral hazard contingencies.

3. Collateral Requirements: is an important credit risk management tool. Collateral, which is properly promised to the lender as compensation if the borrower defaults, it lesser the lender’s losses in the case of a loan default.

4. Credit Rationing: is one way of credit risk management that refers refusing to make loans even though borrowers are willing to pay the stated interest rate or even a higher rate.

5.Know Your Customer principle: A refers toA due diligence activities thatA financial institutionsA and other regulatedA companiesA must perform to ascertain relevant information from their clients for the purpose of doing business with them. Banks must be fully aware of the repaying capacity of borrowers.

2.3 Basel II framework in Mauritius

Basel Accords is the most famous international legislation worldwide. Basle II is implemented in Mauritius since end March 2008 with the Bank of Mauritius having issued several Guidelines in line with the principles set up by the Basel Committee on Banking Supervision (BCBS). Its objective is to maintain an adequate level of Capital Adequacy Ratio, and to improve quantitative risk measurement and risk management across banks (Mauritius Bankers Association Limited, 2008).

This international standard helps to ensure proper capital regulations in all banks and make provisions for enhanced risk management practices, which is of great help for banks.

Basel II is comprised of three pillars as illustrated in Figure 1 below.

Source: (BCBS)

Generally, banks can expect to experience losses and these are:

Expected Losses (EL): perceived as cost of business undertaking by financial institutions;

Unexpected Losses (UL): losses above expected level when banks anticipate their occurrence though the timing and severity cannot be known beforehand. A few portions of unexpected losses might be absorbed by the interest rate charged on credit exposure although market will not support adequate prices to cover all unexpected losses.

Loss Given Default (LGD): the amount of fund that bank can lose when the borrower defaults on a loan (BCBS, 2006).

In order to cover the risks of these losses, banks need to hold enough capital.

Basel II distinguishes between two methods to measure credit risk:

The Standardised Approach and the Internal Rating Based (IRB) Approach. The latter can be further divided into two approaches namely the Foundation Internal Rating Based Approach and the Advanced Internal Rating Based Approach. The Internal Rating Based Approach is more sophisticated than the Standardised Approach while the Advanced Internal Rating Based Approach is the most sophisticated Approach within the IRB methods.

2.4 Banking credit risk management guidelines in Mauritius

The Bank of Mauritius recognizes that credit constitutes by far the largest part of a financial institution’s business in Mauritius and its mismanagement can pose a serious threat to the institution’s continued existence, with resulting impacts on the interests of depositors and other stakeholders. Therefore it imposes guidelines which banks in Mauritius must abide with.

2.4.1 Establishment of a credit risk policy

Banks have the obligation to establish a written policy that includes principles and objectives governing their willingness to accept credit risk, establish the areas of credit in which they are willing to engage and those in which they are refusing to engage. The policy must define the levels of authority to approve credits, establish prudent limits on the financial institution’s exposure to credit risk and on the concentration of credit risk in different areas of the institution’s credit portfolio; and defines the accountabilities of the chief executive officer to the board of directors.

2.4.2 Responsibilities and Accountabilities of the Board of Directors

The board of directors is responsible for reviewing and approving a bank’s credit risk strategy and policies. Each bank should develop a strategy that sets the objectives of its credit-granting activities and adopt the necessary policies and procedures for conducting such activities.

2.4.3 Responsibilities and Accountabilities of Chief Executive Officer

The chief executive officer shall develop a soundly based credit risk management policy for approval by the board of directors. The latter must ensure clearly documented delegation of credit approval authority of management personnel and committees, and also ensure that the board approved credit risk management policy is implemented in its true spirit, using strictly and exclusively prudential credit appraisal criteria and considerations and not influenced by any extraneous factors. Also it must install adequate internal controls, covering the entire credit spectrum, ensure implementation of an effective internal inspection/audit function.

2.4.4 Conduct Review and Risk Policy Committee

The function of the committee would be to assist the board in discharging its responsibilities in the area of credit risk management.

2.4.5 Credit Risk Management Process

Credit risk management process should cover the entire credit cycle starting from the origination of the credit in a financial institution’s books to the point the credit is extinguished from the books. It should provide for sound practices in:

Credit Processing/Appraisal: it is the stage where detailed and authentic information from application forms on credit, is gathered and screened in order to determine the types of credit that are acceptable. Then banks assess customers’ ability to meet its obligations and this usually includes assessing their collaterals and guarantees.

Credit-approval/Sanction: approval authorities will cover new credit approvals, renewals of existing credits, and changes in terms and conditions of previously approved credits, particularly credit restructuring, all of which should be fully documented and recorded.

Credit Documentation: documentation is an essential part of the credit process and is required for each phase of the credit cycle, including credit application, credit analysis, credit approval, credit monitoring, collateral valuation, impairment recognition, foreclosure of impaired loan and realization of security. The format of credit files must be standardized and files neatly maintained with an appropriate system of cross-indexing to facilitate review and follow-up.

Credit Administration: financial institutions must ensure that their credit portfolio is properly administered, that is, loan agreements are duly prepared, renewal notices are sent systematically and credit files are regularly updated.

Disbursement: when the credit is approved, the customer should be advised of the terms and conditions of the credit by way of a letter of offer. The duplicate of this letter should be duly signed and returned to the institution by the customer. The facility disbursement process should start only upon receipt of this letter and should involve, inter alia, the completion of formalities regarding documentation, the registration of collateral, insurance cover in the institution’s favour and the vetting of documents by a legal expert. Under no circumstances shall funds be released prior to compliance with pre-disbursement conditions and approval by the relevant authorities in the financial institution.

Monitoring and Control of Individual Credits: A proper credit monitoring system provide the basis for taking prompt corrective actions when warning signs point to a deterioration in the financial health of the borrower. Examples of such warning signs include unauthorised drawings, arrears in capital and interest and a deterioration in the borrower’s operating environment. Financial institutions must have a system in place to formally review the status of the credit and the financial health of the borrower. It must also include a review of up-to-date information of the borrower.

Monitoring the Overall Credit Portfolio (Stress Testing): it is the analysis of what could potentially go wrong with individual credits and the overall credit portfolio if conditions/environment in which borrowers operate change significantly. The results of this analysis should then be factored into the assessment of the adequacy of provisioning and capital of the institution. Such stress analysis can reveal previously undetected areas of potential credit risk exposure that could arise in times of crisis. The results must serve as an important input into a review of credit risk management framework and setting limits and provisioning levels.

Classification of credit: Credit classification process grades individual credits in terms of the expected degree of recoverability. Banks must have in place the processes and controls to implement the board approved policies, which will, in turn, be in accord with the proposed guideline. They should have appropriate criteria for credit provisioning and write off. Up until the time the proposed guideline comes into effect, the existing guideline on credit classification will continue to apply.

Managing Problem Credits/Recovery: A bank’s credit risk policy should clearly set out how problem credits are to be managed. It involves following all aspects of the problem credit, including rehabilitation of the borrower, restructuring of credit, monitoring the value of applicable collateral, scrutiny of legal documents, and dealing with receiver/manager until the recovery matters are finalized. Banks must put in place systems to ensure that management is kept advised on a regular basis on all developments in the recovery process.

Management Information Systems: The feasibility and effectiveness of the various requirements of the credit risk management framework depend, in large measure, on the adequacy of management information systems in a financial institution. The information generated by management information systems enables the board and management to fulfill their respective oversight roles, including the adequate level of capital that the institution should be carrying. The quality, detail and timeliness of information respecting the composition and soundness of credit portfolio, are critical to credit risk management. A well functioning information system would permit credit exposures approaching risk limits to be identified and brought to the timely attention of management and the board. Also, the system’s design can throw out information on concentration of risks within the credit portfolio, including concentration in maturity streams, enabling management to take remedial action in a timely manner.

2.5 Capital Adequacy Ratio

Ebhodaghe (1991) defines capital adequacy as a situation where the adjusted capital is sufficient to absorb all losses and cover fixed assets of the bank leaving a comfortable surplus for the current operation and future expansion.

Capital adequacy ratio (CAR) is a ratio of a bank’s capital to its risk.

The presence of capital adequacy regulations ensures that banks will hold enough capital so that it can act as a cushion in case of losses, to ensure survival of banks. Therefore, banks in Mauritius compute composite Capital adequacy Ratio, encompassing both credit risk and operational risk. They are required to maintain a minimum composite Capital Adequacy Ratio of 10 per cent which is above the minimum 8 per cent prescribed by BCBS.

For the purpose of calculating the CAR, the capital of a bank is divided into two tiers (levels): Core Capital (Tier 1) and Supplementary Capital (Tier 2).

mbox{CAR} = cfrac{mbox{Tier 1 capital + Tier 2 capital}}{mbox{Risk weighted assets}}

(Source: Wikipedia)

2.6 Nonperforming loan

A loan is nonperforming when it is not earning income and, full payment of principal and interest is no longer anticipated, principal or interest is 90 days or more delinquent, or the maturity date has passed and payment in full has not been made.

The problem of non-performing loans (NPLs) has gained increasing importance because large amount of NPLs can lead to bank failure. Dermirgue-Kunt(1989) found that failing banking institutions always have high level of NPLs prior to failure.

Brewer et al. (2006) use NPLR as a strong economic indicator. Efficient credit risk management supports the fact that lower NPLR is associated with lower risk and lower deposit rate. However it also implies that in long run, relatively high deposit rate increases the deposit base in order to fund relatively high risk loans and consequently increases possibility of NPLR. Therefore, the allocation of the available fund and its risk management heavily depend on how the credit risk is handled and diversified to decrease the NPL amount. NPL is a probability of loss that requires provision. Provision amount is "accounting amount" which can be further, if the necessity rises, deducted from the profit. Therefore, high NPL amount increases the provision amount which in turn reduces the profit.

NPLs lead to unprofitable banks. The eradication of NPLs is important to improve bank performance.

Non Performing Loan Ratio (NPLR) is defined as NPLs divided by Total Loans (TLs).

2.6 Banks profitability and its measurement

Like all businesses, banks generate their profit by earning more money than they spend in their expenses. Banks generate the major portion of their profit from the fees they charge for their services and the interest they earn on their assets. Their major expense is the interest they pay for their liabilities (deposits). The major assets of a bank are its loans to individuals, businesses, and other organizations and the securities it holds, while its major liabilities are its deposits and the money that it borrows, either from other banks or by selling commercial paper in the money market. And the profitability of any business can be measured through return on assets (ROA) and return on equity (ROE).

At the beginning, many banks used a purely accounting-driven approach and focused on the measurement of NI, for example, the calculation of ROA. However, this approach does not consider the risks related to the referred assets, for instance, the underling risks of the transactions, and also with the growth of off-balance sheet activities. Thus the riskiness of underlying assets becomes more and more important. Gradually, the banks notice that equity has become the scarce resource. Thereby, banks turn to focus on the ROE to measure the net profit to the book equity in order to find out the most profitable business and to do the investment (Gerhard.S, 2002).

Mostly ROE is used to measure the profitability of banks. The efficiency of the banks can be evaluated by applying ROE, since it shows that banks reinvest its earnings to generate future profit.

The growth of ROE may also depend on the capitalization of the banks and operating profit margin. If a bank is highly capitalized through the risk-weighted capital adequacy ratio (RWCAR) or Tier 1 capital adequacy ratio (CAR), the expansion of ROE will be retarded. However, the increase of the operating margin can smoothly enhance the ROE45. ROE also hinges on the capital management activities. If the banks use capital more efficiently, they will have a better financial leverage and consequently a higher ROE. Because a higher financial leverage multiplier indicates that banks can leverage on a smaller base of stakeholder’s fund and produce higher interest bearing assets leading to the optimization of the earnings.46 On the contrary, a rise in ROE can also reflect increased risks because high risk might bring more profits. This means ROE does not only go up by increasing returns or profit but also grows by taking more debt which brings more risk. Thus, positive ROE does not only represent the financial strength. Risk management becomes more and more significant in order to ensure sustainable profits in banks (R. Alton Gilbert and David C. Wheelock, 2007).

2.7 Relationship between credit risk management and bank performance

As per different researchers and authors, Credit risk is the most significant of all risks in terms of size of potential losses. As the extension of credit has always been at the core of banking operation, the focus of banks’ risk management has been credit risk management. When banks manage their risk better, they will get advantage to increase their performance (return). Better risk management indicates that banks operate their activities at lower relative risk and at lower conflict of interests between parties. (Anthony M. Santomero, 1997)

The advantages of implementing better risk management lead to better banks performance. Better bank performance increases their reputation and image from public or market point of view. The banks also get more opportunities to increase the productive assets, leading to higher bank profitability, liquidity, and solvency. Therefore, Effective credit risk management should be a critical component of a bank’s overall risk management strategy and is essential to the long-term success of any banking organization. It becomes more and more significant in order to ensure sustainable profits in banks.

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Credit Risk In Banking Finance Essay. (2017, Jun 26). Retrieved October 4, 2022 , from

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