Risk is Present Everywhere Finance Essay

Risk is present everywhere. It is an important player in any financial system. As such, the banking institution should manage their risk efficiently in order to survive in this highly uncertain world. . It can be said that "Banks are in the business of managing risk, not avoiding risks" or "a bank's success lies in its ability to assume and aggregate risk within tolerable and manageable limits." First author Prof RekhaArunkumar and second Author Dr. G. Kotreshwar. Only those banks that have an efficient risk management system will survive in the long run and the effective management of credit risk is a critical component. Credit risk is the oldest and biggest risk that bank, by virtue of its very nature of business, inherits. This has however, acquired a greater significance in the recent past for various reasons. Foremost among them is the wind of economic liberalization that is blowing across the globe. (Rekha A., 2004). In this literature review, the researcher explain the how credit risk arises and some ideal principle of credit risk management. The research covers theories and previous studies on the equivalent title.

Definition of bank

In order to have a better understanding of the different type of risk arises from the banking sector. Let define a bank itself. A bank is considered as a financial intermediary who make surplus unit meet deposit unit. More precisely, the bank accepts deposit from surplus unit and gives loan to deficit unit or through capital markets. As, bank are cornerstone of every countries economy, therefore, it is highly regulated. Banks main revenue comes from lending loan. They use an ideology call the fractional reserve banking, that is, they keep 10% of their deposit and lend 90% of it in order to make profits (Wikipedia). The banks have also a minimum capital requirement which has been initiated from 1988. These requirements are regulated by the Basel framework. This framework is regulated internationally. There are also other definitions of banks but generally it contained the same message. According to Crowther," A bank is a firm which collects money from those who have it spare. It lends money to those who require it." According to Mr Parking, "A bank is a firm that takes deposits from households and firms and makes loans to other households and firms.

Core function of banks

The main business of banks is to grant loan and accept deposit. Loan is a debt, which entails the redistribution of the financial assets between the lender and the borrower. Another core function of the banks is to accept deposit. The bank therefore, make the deficit unit (person needing the loans) meets the surplus units (person accepting the loans). According to Kelly Kendrick (the basics of Business bank loans), there are two basic types of loan mainly consumer loans and commercial loans. Commercial loans are mostly granted to businesses. These loans are granted to finance, financing equipment, financing an office building or construction loan. Consumers loans are made to individuals are used for personal reasons or financing home. The terms of the loan include the payment plan, payback period (or amortization period) and the interest rate. Granting loan is the main source of income for any income for any commercial banks. They give loan to their clients and in return charge an interest rate to the client. The most important income of banks is to accept deposits from its clients. The bank has to accept money from various types of income earners. The bank has to accept the society as a whole; therefore it has to response to all kind of deposits from low income earners to businessmen. For the fixed income earners, their main objective is to keep their money in a safe place and think about their future plans while for business, they deposit their saving mainly as a mode of payments.

Relationship between Deposits and Credit risk

Banks earn the core amount of their income from the spread between the interest rate they charge to borrowers and the interest rate they pay to depositors. The main reason for lenders and borrowers to enter into relationship is to be able to reduce, the amount of asymmetric information and agency costs. Agency cost refers to cost which are attributed to the transactions, where a banks acts in the form of agents and representatives of their clients and the latter should consent to the particular tasks. Agency costs also mean that bankers require the bank to back its lending with a minimum amount of its own capital ( Over Rein Hetland (May 25, 2011)) also and asymmetric information refers to a situation where the banks are unaware of some information that only the borrowers know. According to an analysis made by Wharton 1999 (Deposits and relationship lendings) , A durable lending relationship, in which the bank gains information about the borrowing firm, has been shown to be valuable both to small firms (Petersen and Rajan, 1994, and Berger and Udell, 1995) and to large firms (Lummer and McConnell, 1989, and Slovin, Sushka, and Polonchek, 1993). In particular, continuing relationships are associated with lower loan rates, less stringent collateral requirements, and a lower likelihood of credit rationing. From another regression works by, Over Rein Hetland(May 25, 2011), We see that the existence of a positive deposit account balance increases interest rate margins paid by the firm, but it also increases credit granted which would automatically increase the credit risk of the bank. From the same regression works, Over Rein Hetland also pointed out that, firm borrowers with deposit accounts are more likely to remain borrowers at a bank when the bank faces high loan losses, relative to other borrowers not holding deposits at that bank. In my future analysis, I would like to analyze if the banking sector in Mauritius has been able to cope with the credit risk arises with the amount of deposit and agency cost.

Relationship between Loans and Credit risk

The main risk which arises form loan is credit risk. The researchers have characterized loans components and see if, there is any correlation with credit risk. The main components are: Collateral, maturity, size of the loan, type of lender and relationship between customer and bank. Collateral can be defined as the property or other assets that a borrower offers to a lender to secure a loan. Collateral has been classified as a complex debate from various authors. (Stiglilz and Weiss 1981), Bester (1985), Chan and Kanatas (1985) said that, lower risk borrowers are willing to pledge more and better collateral, given that their lower risk means they are less likely to lose it. It can be said it more simpler words that collateral may help to control the problem of moral hazard and asymmetric information. Freixas and Rochet (1997) concluded that high risk borrowers do not need to post collateral whereas low risk ones do, in exchange for lower interest rates. It can be assumed that the collateral create a situation where both parties make the same effort in order to make the project works. However, the empirical evidence shows that the bankers normally associates collateral to with greater risk borrower. (Orgler 1970), (Hester 1979). There are also some arguments which compromised the relationship explained above, Saunders (1997) claims that the best lenders do not need to post collateral as their credit risk is small. (Manove and Padilla (1999, 2001)) said that, the probability that more collateral entails more non-performing loans or greater probability of default. In my future analysis I would like to analyze if, the Mauritian Banking sector has a positive or negative relationship between loans and collaterals. Maturity In our modern era, the longer maturity date, the more likely, the borrower's would have trouble to repay back the loan. Due, to the volatility of the economies we are currently living in. According to (Jackson and Perraudin (1999), the longer the maturity, ceteris paribus, the greater the risk of the borrower's encountering problems. Flannery (1986) had concluded also that, the maturity is an alternative mechanism for solving the problems of adverse selection and moral hazard in credit relationships. However, this assumption is highly criticized, because in other words, due to the facts that it considered that lower risk borrowers would therefore choose short term finance, the shorter the maturity, the lower the risk. It can be noted that this argument cannot be considered right. As such, the empirical evidence, shows that credit risk and maturity have a negatively relationship (Berger and Udell (1990)), and even no relationship (booth (1992)). In my analysis, I would like to test whether; the maturity has a positive impact on the credit risk. Size of the loan According to Gabriel Jimenez and Jesus Saurina (2002), size of loan is directly related to the size of the borrower, the age of the company and the length of the bank-borrower relationship. They consider those attributes to be an indicator of credit risk. The smaller the loan, it is related to newly created companies which involve greater credit risk, therefore, greater rates of default. Large loan to large companies are considered to be less risky as the big companies has greater financial stability. It can also be noted that large loan are scrutinize in more detail which result in lower rate of default. The empirical evidence from (Berger and Udell (1990) and Booth (1992) agreed with this statement. (Berger and Udell (1995), Leeth and Scott (1989) and Harhoff and Korting (1997) have noted that small companies are more opaque in information terms than large ones, as such they provide more collateral to secure loans. As such, it creates a positive empirical relationship between collateral and credit risk and a negative relationship between size and default. (Gabriel Jimenez and Jesus Saurina (2002). Relationship between type of lender and relationship between customer and bank on credit risk According to Gabriel Jimenez and Jesus Saurina (2002), a close relationship between the bank and the borrower enables bank to obtain extremely valuable information about the latter's economic and financial institution. According to (Sharpe (1990) and Rajan (1992)), this close relationship may produce informational rents for the bank which would enable them to exercise a certain degree of market power in the future. Therefore, banks may be prepared to finance riskier borrowers if they can subsequently offset this high default rate by applying higher interest rates to the surviving companies. (Petersen and Rajan (1995)) I would like to test whether the bonding between banks and customers do have a positive impact on the credit risk. Customer satisfaction has become an important issue nowadays. (According to Ernst & Young February 2010).

How macroeconomics affect credit risk in the banking sector?

Macroeconomic views In general credit risk refers to a situation where, a loan not being paid to the lender. (Vitor Castro (2011/2012)). An analyse of credit risk is vital because it signals that a financial sector has becomes more vulnerable to shocks. (Vitor Castro (2011/2012)). This can help the regulatory authorities to take measures to prevent a possible crisis (Agnello and Sousa, 2011; Agnello et al., 2011) and the analyse is important because many banks' bankruptcies are related to the huge ratio of nonperforming loans to the total loans. (Heffernan (2005)). The aim of this literature is to find the distinct economic factors that affect the credit risk in the banking sector. There are factors which influence everyone in the economic as such; it is named credit systematic risk. (Vitor Castro (2011/2012)). The main macroeconomic factors are: Employment rate movements, growth in gross domestic product, stock index, inflation rate and exchange rate movements. These are the main macroeconomic policies which surely affect a borrower's repaying rate. There are also factors which are limited only to the borrowers and the financial institution. In other word, the unsystematic credit risk (Vitor Castro (2011/2012)): In the case of individual, we have different traits and personality, their financial position and their particular credit insurance (Vitor Castro (2011/2012)) To the companies, management, financial position, sources of funds and financial reporting and their ability to pay the loan and specific factors of the industry sector. (Vitor Castro (2011/2012)) According to many other researches, Aver (2008), Bohachova (2008), Bonfim (2009), Kattai (2010) and Nkuzu (2011) have pointed out that these factors considerable influence on the changes of credit risk. Aver (2008) shows that the credit risk of the Slovenian banking loan portfolio depends especially on the economic environment (employment and unemployment), long-term interest rates and on the value of the stock exchange index. According to other research, Kattai (2010) Fainstein and Novikov (2011) the latters have arrived for the same conclusion basing their study for three countries mainly, Estonia, Latvia and Lithuania). These results have indicated the importance of interest rate and economic growth in the good running of the banking system. The researchers have also pointed out the impact of macroeconomic factors on credit default. Many researchers have concluded that, the macroeconomic have an impact on credit default. Ali and Daly (2010) had compared Australian data and Us data for the period 1995-2009 and they found that, the level of economic activity, interest rates and total debt provide meaningful indicators for aggregate default. According to Pesola (2005) regression model an analyses of the macroeconomic determinants of banking sector distresses in comparison of some industrial countries for the period 1980-2002, the author has concluded that high customer indebtedness combined with adverse macroeconomic surprise shocks to income and real interest rates contributed to the distress in banking sector. More precisely, Pesola (2005), Jimenez and Saurina (2006), Bohachova (2008) and bonfim (2009) they concluded by saying that the result of wrong decisions of financing will become apparent only during the period of recession of the economy and this will cause the growth of non-performing loans and loan losses. In other survey, made by Louzis et al. (2012), an analysis of nine greek banks over the period 2003-2009, the author have concluded that GDP growth rate, unemployment rate and also the lending rates have a deep impact on the level of nonperforming loans. Following these analyses of the researchers, I would like to analyse the effect of the macroeconomics on the credit risk and acknowledge whether they are correlated. There are also some analyse work on the credit unsystematic risk. Jimenes and Saurina (2004) and Ahmad and Ariff (2007) had concluded that collateralized loans have higher probability of default and that loans granted by savings banks are riskier and that a close bank borrower relationship increases the willingness for banks taking more risk. It is important to understand the macroeconomic views in order to have an adequate understanding of the impact credit risk on the banking sector. By underlying the basis macroeconomic views, it would be easier to understand the dilemma the bankers are in.

Credit Risk in banking

According to the Basel Accords, the main risks the banks are facing are credit risk, market risk and operational risk. In the Basel Accords words, credit risk is the risk of loss due to an obligator's non-payment of an obligation in terms of a loan or other lines of credit. According to (Joan Selorm Tsorhe p.6) and (R.S. Raghavan, 2003) credit risk is the potential that a bank borrower/counter party fails to meet the obligations on agreed terms. According to Prof Rekha Arunkumar, credit risk occurs when a borrower default to repay the lent money and remain the most important risk to manage till date. The banks cannot have any guarantee that the borrower's would fulfill its obligation. The borrower's may incur any kind of difficulties in a foreseeable future which would result in the crystallization of credit risk to the bank. As such, it is considered as one of the most important and complex risk, the bank may have to deal with. According to Prof Rekha Arunkumar, Credit risk is the oldest and biggest risk that a bank can faced and by virtue of its very nature of the business inherits.

Component of Credit risk

According to Wikipedia, Credit risk Consist of type of risk mainly: Credit default risk Concentration risk Country risk Credit default risk refers to the risk of loss arising from a debtor being unlikely to pay its loan obligations in full or the debtor is more than 90 days past due on any material credit obligation; default risk may impact all credit-sensitive transactions, including loans, securities and derivatives. Secondly we have concentration risk; it is associated with any single exposure or group of exposures with the potential to produce large enough losses to threaten a bank's core operations. It may arise in the form of single name concentration or industry concentration. Finally, we have country risk which is associated with the loss arising from a sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk). Our next section, we would look at how the different banks manage credit risk. This is the core idea of this study.

Credit risk Management in the Banking Sector

Banks earn the core of their income from the differences in the interest rate they set for deposits and loans. As such, lending has always been an integral function for banks. In order to set the appropriate rate, the banks have to assess the credit worthiness of the borrowers. (Andrew Fight, 2004). The banks are in an obligation to set appropriate rate to be able to compensate for the default amount in order to maximize its profit. In order to be competitive, the banks have to conduct an adequate credit risk management framework. This particular framework would help them be in a better position to cope with the difference problems attached to credit risk. According to a search, credit risk takes about 70% and 30% remaining is shared between the other two primary, that is, Market risk and operational risk. Banks can reduce their credit exposure by applying to the following credit risk management principles. The following principles are identified by Fredrick S. Mishkin: Screening and Monitoring: It mainly refers to adverse selection which occurs when a bank cannot differentiate between good payers and bad payers. The banks should have some background works on the client and if the loan has been approved, the bank should monitor the borrowers' activities. According to Diamond (1984, 1991, 1996), screening and monitoring of loan takers are important functions to banks. According to Dell'Ariccia, Igan and Laeven (2008), before the financial crisis of 2007-2009, banks had reduced their strictness on their monitoring and screening standard. Keys, Mukherjee, Seru and Vig (2010) and Milan and Sufi (2009) have indicated that securitization has somehome reduced the incentives of US mortgage lenders to properly screen borrowers. It can be noted in the beginning of the financial crisis that, banks have improve their screening and monitoring standards, improving their retention rates( according to Wikipedia, retention rates is the ratio of the number of retained customers to the number at risk). Long term Customer Relationship: If the particular client have previously deal with the banks, the banks would be in a better position know whether the client is a good or bad credit. This would definitely reduce the cost of information. According to TIBEBU TEFERA (June 2011), long- term relationship enables banks to deal with even unanticipated moral hazard contingencies. According to Galbreath and Rogers (1999), "CRM can be described as activities a business performs to identify, qualify, acquire, develop and retain increasingly loyal and profitable customers by delivering the right product or service, to the right customer, through the right channel, at the right time and the right cost. . (according to Ernst & Young February 2010). According to a survey in France, 35% of customer has changed banks due to bad services. (Ernst & Young February 2010). In another survey, 46% of current level of personal relationship as either bad or limited. Uk 12 per cent, Italy 13% and 40% Spanish customers. (Ernst & Young February 2010). According to Ivana Domazet, Jovan Zubovic and Marko Jelocnik (2010) has indicated that the two main determinants of the success in the investment banking sector are: customer satisfaction and product quality. As, the customers in the banking sector are well educated about the market, therefore, they are not loyal about any particular brand. Collateral Requirements: According to investopedia, collateral is a property or other assets that a borrower offers a lender to securing a loan. If the borrower stops payment, the lender can seize the collateral to recoup its losses. As such, it can be considered an important tool as it pressures the borrower to meet the demand of the loan contracts. According to J. Peltoniemi (2007), good borrowers' quality is associated with higher collateral requirements. In European countries, Davydenko and Franks (2004) concluded that 75.7% of firm loans in France, 88.5% in Germany are secured and Gonas et al (2004) argued that 73% loans are secured in US firm loans. According to GreenBaunm and Thakor (1995), "First, collateral allows a reduction of the loan loss for the bank in the event of the default of the loan and secondly, collateral helps to solve the problem of adverse selection borne by the bank when lending, as it constitutes a signalling instrument providing some valuable information to the bank. I would like to analyse these particular relationship in my future analysis. Credit Rationing According to (Frederick S.Mishkin, 2004, pp 217-220) it 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. Diamond (1984), Williamson (1986) and Krasa and Vilamil (1992) concluded that banks success lied in their ability to analyse economies of scope in performing monitoring of borrowers on behalf of lenders. For Thilo Pausch (February 2005), banks have a well-diversified loan portfolio which help them reduced the credit risk. It can be noted that credit rationing is can be considered an important tools for credit management. According to the various researchers mention above, if a bank is able to understand all these concepts, they would be in a better place to control credit risk. Some other principles are listed below:

Credit rating agencies

Many debt securities are assigned by credit rating agencies. The most common credit agencies S& P's and Moody's. This categorization would obviously facilitate the institution to judge the securities but they should also carry their own classification. Example of classification by moody's are as follows:

Moody's

S & P's

Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 INVESTMENT GRADE AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa Caa3 Ca C HIGH YIELD BB+ BB BB- B+ B B- CCC+ CCC CCC- CC C D Banks use credit ratings as proxies for the quality of collateral. (Jens Hilscher and Mungo Wilson January 2012). The main idea behind these classifications according to Jens Hilscher and Mungo Wilson is that, the credit ratings are thought to provide information about the likelihood of default and other forms of corporate failure. It can be noted that, credit rating in the banking sector are considered an important tools. According to Fitch IBCA views, a company's performance and financial stability, the risks to its operations and the degree of any external support is summarized in a given rating.

Loan loss provision

The institution should have provided a specific amount of reserve for the obvious losses based on their analysis of the borrower's creditworthiness. The provision which concerned mainly the loan is considered as specific loan (Hong kong Monetary Authority May 1999). As such, the bank would be able to bear the loss of certain loan losses. The bank should also provide a provision for the unexpected losses. These provisions are categories as general provision. Generally, all banks consist of a system of establishment of proper provision. All establishments have their own ways of establishing their own institution provision scheme. According to a Hong Kong Monetary Authority May 1999, the loan provision should be based on the assessment of the recoverability of individual loans or portfolios of loan with similar characteristics. Therefore, it is essential to hedge against credit risk.

Risk Processing

According to STANDARD & POOR'S the appropriate step should be as follows: Set Credit Objectives and responsibilities Set credit risk Guidelines Collect credit Data Measure Credit Risk Make credit Decisions Monitor Credit Performance Allocate Credit Capital It be noted that the formula for calculation of expected loss are: Expected loss = Probability of default * loss given default (Bank of international settlement 2001) According to Standard & poor's if any institution follows these criteria they would be in a better place to understand credit risk management. Credit risk processing takes into consideration many internal and external factors of an organization. ( Oesterreichische Nationalbank (OeNB, 2004). This thorough assessment would help the bank to anticipate credit risk more adequately.

Credit Culture

According to Thomas H.McManus, Senior Examiner (SRC insights: first quarter 2004), a credit culture is "the sum of all the characteristics of an organization's unique behaviour in its extension of credit. Another definition can be "Credit culture embraces all the factors that bear on credit extension, credit quality and recurrent cyclical patterns and sequences. (Mueller 1995, pp.41). The credit culture of banks also has implications for the smooth transmission of monetary policy as its effectiveness in manipulating movements in lending rates may be diluted if the credit cultures of banks are not driven by prices. (Anthony Birchwood, University of the westIndies, stAuugustine Campus). According to Dam Dan Luy (2010), credit culture encompasses " attitudes, perception, behaviours, styles and beliefs that are conducted and practiced throughout the credit organization as a result of management attitudes towards credit risks". As such, credit culture can be considered as an important aspect of credit risk management. Credit culture is considered as the cement that fixes the credit process and forms the foundation for credit discipline.

Credit Culture at Goldman Sachs (Risk Management and credit Lending by Prof Albert Ip, December 15 2011)

Sophisticated, detailed understanding of risks by senior management Culture of over communication Escalation, Escalation, Escalation Co-option of business unit professionals into risk Management Accountability Long history of Promoting risk Managers Intolerant of lack of control focus Learn from past mistakes To conclude, it can be noted that, there are a variety of risk management framework even though it is impossible to completely eradicate credit risk from the banking sector. In my future research work, I would like to test, if in our local banking system, does the banks have any particular type of credit risk management framework and whether it helps to reduce the credit risk and increase the profitability of the bank.

Basel Framework

History The first Capital Accord was introduced in 1988. The capital accord was created from the Basel Committee on Banking Supervision. It was a committee of banking supervisory authorities of the G-10 countries. Their main objectives were to establish a framework for bank supervision with a view to strengthen the stability of financial institutions in general and banks in particular. According to the Bank for international settlements (Aug 2009), the committee provides a forum for regular cooperation between its member countries on banking supervisory matters. It seek to achieve these objectives via 3 ways, mainly, by exchanging information on national supervisory arrangements, by improving the effectiveness of techniques for supervising international banking business and by setting minimum supervisory standard in areas where they are considered desirable. (Bank for international settlements (Aug 2009)). The main aspect of the Basel accord 1988 was the minimum capital ratio of capital to risk-weighted assets of 8 per cent by end-1992. The framework has reached practically all countries with an international active bank. The accord was built to be continuously improved to the demand of the world economy. In November 1991, it was amended to give a greater precision to the definition of those general provisions or general loan-loss reserves which could be included in capital for purposes of calculating capital adequacy. (Bank for international settlements (Aug 2009)). There was another amendment taking effect at the end of 1995, to recognise the effects of bilateral netting of banks' credit exposures in derivative products and to expand the matric of add on factors. In 1996, there was a amendment concerning market risk. In 1999, there was a new proposal for a new capital adequacy framework to replace the 1988 accord and released in 26 June 2004. It contains three important aspects mainly: minimum capital requirements, supervisory review of an institution's capital adequacy and internal assessment process and effective use of disclosure as a lever to strengthen market discipline and encourage safe and sound banking practices. (Bank for international settlements (Aug 2009)). In July 2009, the Basel committee has decided to create the Basel 3 in order to face the changing business industry we live in.

How to manage Credit risk under the Basel Framework?

Basel framework has pointed out four specific steps in order to manage credit risk (Basel Committee on Banking Supervision September 2000): Establishing an appropriate credit environment Operating under a sound credit granting process Maintaining an appropriate Credit administration, measurement and monitoring process Ensuring adequate controls over credit risk. Establishing an appropriate credit risk environment Principle 1: The board of directors should have responsibility for approving and periodically (at least annually) reviewing the credit risk strategy and significant credit risk policies of the bank. The strategy should reflect the bank's tolerance for risk and the level of profitability the bank expects to achieve for incurring various credit risks. Principle 2: Senior management should have responsibility for implementing the credit risk strategy approved by the board of directors and for developing policies and procedures for identifying, measuring, monitoring and controlling credit risk. Such policies and procedures should address credit risk in all of the bank's activities and at both the individual credit and portfolio levels. Principle 3: Banks should identify and manage credit risk inherent in all products and activities. Banks should ensure that the risks of products and activities new to them are subject to adequate risk management procedures and controls before being introduced or undertaken, and approved in advance by the board of directors or its appropriate committee. Operating under a sound credit granting process Principle 4: Banks must operate within sound, well-defined credit-granting criteria. These criteria should include a clear indication of the bank's target market and a thorough understanding of the borrower or counterparty, as well as the purpose and structure of the credit, and its source of repayment. Principle 5: Banks should establish overall credit limits at the level of individual borrowers and counterparties, and groups of connected counterparties that aggregate in a comparable and meaningful manner different types of exposures, both in the banking and trading book and on and off the balance sheet. Principle 6: Banks should have a clearly-established process in place for approving new credits as well as the amendment, renewal and re-financing of existing credits. Principle 7: All extensions of credit must be made on an arm's-length basis. In particular, credits to related companies and individuals must be authorized on an exception basis, monitored with particular care and other appropriate steps taken to control or mitigate the risks of non-arm's length lending. Maintaining an appropriate credit administration, measurement and monitoring process Principle 8: Banks should have in place a system for the ongoing administration of their various credit risk-bearing portfolios. Principle 9: Banks must have in place a system for monitoring the condition of individual credits, including determining the adequacy of provisions and reserves. Principle 10: Banks are encouraged to develop and utilise an internal risk rating system in managing credit risk. The rating system should be consistent with the nature, size and complexity of a bank's activities. Principle 11: Banks must have information systems and analytical techniques that enable management to measure the credit risk inherent in all on- and off-balance sheet activities. The management information system should provide adequate information on the composition of the credit portfolio, including identification of any concentrations of risk. Principle 12: Banks must have in place a system for monitoring the overall composition and quality of the credit portfolio. Principle 13: Banks should take into consideration potential future changes in economic conditions when assessing individual credits and their credit portfolios, and should assess their credit risk exposures under stressful conditions. Ensuring adequate controls over credit risk Principle 14: Banks must establish a system of independent, ongoing assessment of the bank's credit risk management processes and the results of such reviews should be communicated directly to the board of directors and senior management. Principle 15: Banks must ensure that the credit-granting function is being properly managed and that credit exposures are within levels consistent with prudential standards and internal limits. Banks should establish and enforce internal controls and other practices to ensure that exceptions to policies, procedures and limits are reported in a timely manner to the appropriate level of management for action. Principle 16: Banks must have a system in place for early remedial action on deteriorating credits, managing problem credits and similar workout situations. The role of supervisors Principle 17: Supervisors should require that banks have an effective system in place to identify measure, monitor and control credit risk as part of an overall approach to risk management. Supervisors should conduct an independent evaluation of a bank's strategies, policies, procedures and practices related to the granting of credit and the ongoing management of the portfolio. Supervisors should consider setting prudential limits to restrict bank exposures to single borrowers or groups of connected counterparties.

Guideline on Credit risk Management according to Bank of Mauritius

The Guideline was issued by the bank of Mauritius for two main purposes. Firstly, it set out the responsibilities and accountabilities of the board of directors and management in credit management and secondly, it outlines the processes to be used in Managing the credit activity in a financial institution. Establishment credit risk policy Ensure credit risk policy is accepted by the board of directors Ensure credit risk policy is accepted by chief executive officer Conduct review and risk policy Committee Credit processing/Appraisal Credit Approval/Sanction Credit Documentation Credit Administration Disbursement Monitoring and control of individual credits Monitoring the overall credit portfolio (stress testing) Credit Classification Managing problem credits/recovery

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