The Credit Risk of Banks Finance Essay

The aim of the study is to assess the credit risk management of major banks in Mauritius. This chapter presents the review of related research of the component credit risk management. Banks main activities and operations are based on the management of wide range of equity capital, assets and liabilities. Greuning, H.V and Bratanovic, S.B (2003) pointed out that Adequate risk management is therefore a must and forms part of effective banking operation. Common cited risks include; operational risk, liquidity risk, interest rate risk and credit risk. All these risks arise while banks perform their most fundamental and traditional role of lending and borrowing. According to the consultative paper issued by the Basel committee on bank supervisions (1999), credit risk continues to remain one of the biggest sources of risk for banking institutions throughout the world. This is due to the fact that loan portfolio of banks is the largest asset and the main source of revenue. Also, credit risk is associated with potential fluctuations of the stream of cash flows of an asset. It is often pointed to be responsible for bank failure. Hence, to improve their credit risk management, monitoring and assessment, banks have been using a number of tools and methods over the past 20 years. Improving actual systems and implementing new systems to evaluate certain types of loan more efficiently, objectively and accurately to better mitigate credit risk and improve portfolio performance is an ongoing process in the banking sector of Mauritius. (John B 2011) said that credit risk is one of the oldest and most major forms of risk faced by banks as financial intermediaries. Since this particular risk has the power of wiping out enough of a bank's capital to force it into bankruptcy, managing this kind of risk has always been one of the predominant challenges in running a bank smoothly. (Broll, Pausch and Welzel, 2002).

2.1 The Credit Risk of Banks

2.1.1 Another Definition

The Monetary Authority of Singapore (2006) defined credit risk as the "risk derived from the doubtfulness of an obligor's capability to perform its contractual obligations", where the term obligator refers to any party that has a direct or indirect obligation under a contract. It also state that credit risk could rise from both on and off balance sheet transactions. Moreover, financial instruments like; options, futures, swaps, foreign exchange, guarantee and others also contribute to credit exposure of banks. (Blommertein 2005) defined credit risk as the possible loss, known as probability of default, that could arise if the counterparties fail to meet their financial obligations, not only in present time but in future time also. Credit risk is also known as default risk or counter party risk. According to the BCBS (2001), it is defined as the possibility of losing the outstanding loan partially or totally, due to credit events. Credit risk therefore measures the portion of the loan that is exposed to default risk (Basu, 1997, 2002a). (Andrew 2002) add that credit risk is the risk that a counterpart defaults and the bank losses all its market position or that part which is irrecoverable. 2.1.2 Categories of Credit Risk To gain a better understanding on the nature of credit risk, it is necessary to introduce the types of credit risk involved in financial activities before any further discussion. Concerning the categorizing of credit risk, different authors have expressed various criteria. Horcher (2005), who defines six types of credit risk, including default risk, counterparty pre-settlement risk, counterparty settlement risk, legal risk, country or sovereign risk and concentration risk. However, since legal risk is more likely to be considered as independent or belonging to operational risk nowadays (see HSBC 2006 annual report, Casu, Girardone and Molyneux 2006, etc) and concentration risk, together with adverse selection as well as moral hazard, is more reasonably to be thought of as an important issue in managing credit risk rather than a type of the risk itself (see Duffie and Singleton 2003), in the following illustration, only the rest four kinds of credit risk mentioned by Horcher (2005) will be touched upon. Default Risk According to Horcher (2005), traditional credit risk relates to the default on a payment, especially lending or sales. And a likelihood of the default is called the probability of default. When a default occurs, the amount at risk may be as much as the whole liability, which can be recovered later, depending on factors like the creditors' legal status. However, later collections are generally difficult or even impossible in that huge outstanding obligations or losses are usually the reasons why organizations fail. Counter Party Pre-Settlement Risk Pre-settlement risk arises from the possibility that the counterparty will default once a contract has been entered into but a settlement still does not occur. During this period, a contract has unrealized gains, which indicates the risk. The potential loss to the organization depends on how market rates have changed since the establishment of the original contract, which can be evaluated in terms of current and potential exposure to the organization (Horcher 2005). Counter Party Settlement Risk According to Casu, Girardone and Molyneux (2006), settlement risk is a risk typically faced in the interbank market and it refers to the situation where one party to a contract fails to pay money or deliver assets to another party at the settlement time, which can be associated with any timing differences in settlement. Horcher (2005) points out that the risk is often related with foreign exchange trading, where "payments in different money centers are not made simultaneously and volumes are huge". The case of the small German bank Bankhaus Herstatt, which received payments from its foreign exchange counterparties but had yet to make payments to counterparty financial institutions on the shutting down date, can serve as a typical example for the failure caused by settlement risk (Heffernan 1996). Country or Sovereign Risk Country risk arises due to the impact of deteriorating foreign economic, social and political conditions on overseas transactions and sovereign risk refers to the possibility that governments may enforce their authority to declare debt to external lenders void or modify the movements of profits, interest and capital under some economic or political pressure (Casu, Girardone and Molyneux 2006). Then as Horcher (2005) has concluded, since evidence shows that countries and governments have temporarily or permanently imposed controls on capital, prevented cross-border payments and suspended debt repayments etc, problems arise for issuers to fulfill obligations in such environment. Also financial crisis may precipitate sometimes.

2.1.3 Identifying Credit Risk Exposures in Banks

Generally, credit risk is related to the traditional bank lending activities, while it also comes from holding bonds and other securities. Basel (1999a) reports that for most banks, loans are the largest and most obvious source of credit risk; however, throughout the activities of a bank, which include in the banking book as well as in the trading book, and both on and off the balance sheet, there are also other sources of credit risk. Various financial instruments including acceptances, interbank transactions, financial futures, guarantees, etc increase banks' credit risk. Therefore, it is indispensable to identify all the credit exposures-- the possible sources of credit risk for most banks, which can also serve as a starting point for the following parts of this work. A. On-Balance Sheet Exposures Loans According to Saunders and Cornett (2006), the major types of bank loans are commercial and industrial (C&I), real estate, consumer and others. Commercial and industrial loans can be made for periods from a few weeks to several years for financing firms' working capital needs or credit needs respectively. Real estate loans are primarily mortgage loans whose size, price and maturity differ widely from C&I loans. Consumer loans refer to those such as personal and auto loans while the so called other loans include a wide variety of borrowers such as other banks, nonblank financial institutions and so on. Credit risk is the predominant risk in bank loans. Over the decades the credit quality of many banks' lending has attracted a large amount of attention. The only change is on the focus of the problems from bank loans to less developed countries and commercial real estate loans to auto loans as well as credit cards, which is an American example. Since the default risk is usually present to some degrees in all loans (Saunders and Cornett 2006), the individual loan and loan portfolio management is undoubtedly crucial in banks' credit risk management. Nonperforming Loan Portfolio According to Hennie (2003), nonperforming loans are those not generating income, and loans are often treated as nonperforming when principal or interest is due and left unpaid for 90 days or more. Thus the nonperforming loan portfolio is a very important indication of the bank's credit risk exposure and lending decisions quality. Debt Securities Besides lending, credit risk also exists in banks' traditional area of debt securities investing. Debt securities are debt instruments in the form of bonds, notes, certificates of deposits, etc, which are issued by governments, quasi-government bodies or large corporations to raise capital.1 In general, the issuer promises to pay coupon on regular basis through the life of the instrument and the stated principal will be repaid at maturity time. However, the likelihood that the issuer will default always exists, resulting in the loss of interest or even the principal to banks, which can be a damaging impact. B. Off-Balance Sheet Exposures Since the 1980s, off-balance sheet commitments have grown rapidly in major banks, among which there are swaps, forward rate agreements, bankers' acceptances, revolving underwriting facilities, etc. (Hull 1989). Those commitments give rise to new types of credit risk from the possibility of default by the counterparty. In this section, some of the off-balance sheet credit exposures will be introduced, among which the first one is related to derivative contracts. Derivatives Contracts According to Saunders and Cornett (2006), banks can be dealers of derivatives that act as counterparties in trades with customers for a fee. Contingent credit risk is quite likely to be present when banks expand their positions in derivative contracts. Since the counterparty may default on payment obligations to truncate current and future losses, risk will arise, which leaves the banks unhedged and having to substitute the contract at today's interest rates and prices. This is also more likely to happen when the banks are in the money and the counterparty is losing heavily on the contract. Comparatively, the type of credit (default) risk is more serious for forward contracts and swap contracts, which are nonstandard ones entered into bilaterally by negotiating parties. While trading in options, futures or other similar contracts may expose banks to lower credit risk since contracts are held directly with the exchange and there are margining requirements. However, the credit risk is also not negligible. Guarantees and Acceptances Bank Guarantee is an undertaking from the bank which ensures that the liabilities of a debtor will be met, while a bankers' acceptance is an obligation by a bank to pay the face value of a bill of exchange on maturity (Basel 1986). It is mentioned by Basel (1986) that since guarantees and acceptances are obligations to stand behind a third party, they should be treated as direct credit substitutes, whose credit risk is equivalent to that of a loan to the ultimate borrower or to the drawer of the instrument. In this sense, it is clear that there is a full risk exposure in these off balance sheet activities. Interbank Transactions Banks send the bulk of the wholesale dollar payments through wire transfer systems such as the Clearing House Interbank Payments System (CHIPS). The funds or payments messages sent on the CHIPS network within the day are provisional, which are only settled at the end of the day. Therefore, when a major fraud is discovered in a bank's book during the day, which may cause an immediate shutting down, its counterparty bank will not receive the promised payments and may not be able to meet the payment commitments to other banks, leaving a serious plight. As pointed out by Saunders and Cornett (2006), the essential feature of the above kind of settlement risk in interbank transactions is that, "banks are exposed to a within-day, or intraday, credit risk that does not appear on its balance sheet", which needs to be carefully dealt with. Loan Commitments A loan commitment is a formal offer by a lending bank with the explicit terms under which it agrees to lend to a firm a certain maximum amount at given interest rate over a certain period of time. In this activity, contingent credit risk exists in setting the interest or formula rate on a loan commitment. According to Saunders and Cornett (2006), banks often add a risk premium based on its current assessment of the creditworthiness of the borrower, and then in the case that the borrowing firm gets into difficulty during the commitment period, the bank will be exposed to dramatic declines in borrower creditworthiness, since the premium is preset before the downgrade.

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