Credit risk management in major British Banks

CREDIT RISK MANAGEMENT
STRATEGIES OF MAJOR BRITISH BANKS
Research Question: How do banks currently implement their credit
risk management strategy, and how they mitigate/transfer the
exposure of credit risk?
Supervisor Name: Jonathan Knowles
Master of Business Administration (Finance)
Programme Code: PGBM0073
By: Muhammad Saqib Islam Qureshi
Student ID: 139177952
Academic Year 2014-2015
University of Sunderland London Campus
Copyright University of Sunderland London Campus, No part of this publication may be
reproduced without the prior written permission of the copy right owner

DISSERTATION (PGBM73) DECLARATION
Statement of Originality and Authenticity
I confirm that the dissertation I am submitting is an original and authentic piece of work
written by myself that satisfies the University rules and regulations with respect to Plagiarism
and Collusion. I further confirm that I have fully referenced and acknowledged all material
incorporated as secondary resources in accordance with the Harvard system.
I also certify that I have taken a copy of the dissertation, which I will retain until after the
Board of Examiners has published the results, and which I will make available on request in
pursuance of any appropriate aspect of the marking and moderation of the work within the
University Regulations.
Name: Saqib Islam Qureshi
Registration Number: 139177952
Programme: MBA (Finance)
Study Centre: University of Sunderland London Campus
Date: 03-03-2015

Acknowledgment
First of all I would like to thank ALLAH Almighty, Who gave me the strength
and encouragement to do this Master Degree from one of the leading
Universities.
I would like to express my special thanks to my supervisor Mr Jonathan
Knowles for his support and expert guidance throughout the whole research.
I am also so grateful to my parents for their support and encouragement during
this education period.
I am also thankful to all my friends and colleagues for their support and help
during the whole academic period which raised my confidence in completing
this dissertation.

List of Contents
Executive Summary.…………………………………………………………………………..
Chapter 1 Introduction………………………………………………………………………..
1.1 Introduction of credit risk…………………………………………………………...
1.2 Research objectives and motivation………………………………………………...
1.3 Project Background…………………………………………………………………
Chapter 2 Critical Literature Review………………………………………………………..
2.1 Credit Risk in Banking Industry…………………………………………………….
2.1.1 Definition…………………………………………………………………
2.1.2 Credit Risk Classification…………………………………………………
2.1.3 Exposure of Credit Risk in Banks………………………………………...
2.2 General Principles of Sound Credit Risk Management in Banks…………………..
2.3 Credit Risk Measurement…………………………………………………………...
2.3.1 Fundamentals of Credit Risk Management……………………………….
2.3.2 Credit Risk Rating………………………………………………………...
2.3.3 Credit Scoring Systems…………………………………………………...
2.3.4 Credit Risk Modelling…………………………………………………….
2.4 Methods of Credit Risk Mitigation/Transfer………………………………………..
2.4.1 Traditional Methods………………………………………………………

2.4.2 New Methods……………………………………………………………..
2.5 Credit Risk Concentration…………………………………………………………..
Chapter 3 Research Methodology……………………………………………………………
3.1 Research objectives…………………………………………………………………
3.2 Research design……………………………………………………………………..
3.3 Research Sample and data…………………………………………………………..
3.3.1 Research Sample Banks…………………………………………………..
3.3.2 Research Data……………………………………………………………..
3.4 Limitations………………………………………………………………………….
3.4.1 Limitation on Sampling…………………………………………………...
3.4.2 Limitation on Research Approach………………………………………...
3.4.3 Limitation on Ratio and Data Availability………………………………..
Chapter 4 Research Findings…………………………………………………………………
4.1 Credit Exposure and quality of UK Banks………………………………………….
4.2 Credit Risk Management Practices and Techniques at Barclays, RBS and Lloyds...
4.2.1 Introduction and overview………………………………………………...
4.2.2 Credit Risk Management Practices and Techniques……………………...
4.2.2 (A) Governance of Credit Risk Management…………………......
4.2.2 (B) Loan/Credit Granting Process………………..……………….

4.2.2 (C) Models for Credit Risk Management………………………..
4.2.2 (D) Credit Risk Exposure Management………………………….
4.2.2 (E) Credit Quality Management………………………………….
4.2.2 (F) Mitigation Techniques……………………………………….
4.3 Comparison with Basel Requirements……………………………………………...
4.3.1 Credit Risk Environment…………………………………………………
4.3.2 Credit Granting Process…………………………………………………..
4.3.3 Monitoring and Measurement Process……………………………………
4.3.4 Control over Credit Risk………………………………………………….
4.3.5 Credit Risk Mitigation………………………………………………….....
Table of Comparison…………………………………………………………………………..
Chapter 5 Conclusion and Recommendations……………………………………………….
Personal Development………………………………………………………………………...
References………………………………………………………………………………………

Executive Summary
The main theme of the research is Credit risk management practices and techniques of major
selected UK Banks. The first part is about introduction of the Research Topic. In introduction
part the background of the research is discussed together with its strategic importance in
banking industry is discussed as well. The main research objectives are discussed in the
introduction part as well and rationale of the project. In second chapter, a brief discussion of
the research Topic is undertaken taking into account the. An introduction of credit risk is
discussed in detail in this chapter together with credit exposure in the banks and general
principals are discussed for sound credit risk management. Basel requirements of sound
credit risk management are the main discussion in this part. Following the principles, a brief
discussion of measurement methodologies and techniques for credit risk exposure are
discussed. Different models used by banks in measuring the exposure of credit risk are
discussed and general parameters used by banks to develop the models and to assign the
scores to the borrower or counterparties are also discussed. Main parameters like probability
of default, exposure at default and loss given default are discussed in detail in this chapter.
Different banks use different approaches to measure the credit risk like the use of external
credit agencies, internally developed credit risk model and risk awareness culture awareness
in the organization. The other main area of literature is transferring and mitigation techniques
adopted by banks in order to reduced or completely remove the credit risk in the books of
banks. Some of the rational techniques are discussed like credit limits, accurate loan pricing,
netting agreements and diversification. New methods are asset securitization and use of
derivatives is discussed in brief as well. 3rd
Chapter is about the research methodologies
which covers the research types design and data used for findings purpose. 4th
chapter is
about discussion on three selected banks (Barclays, RBS and Lloyds) and at the end a

comparison is made of three banks of different techniques and strategy adopted for credit risk
management.

1. Introduction
In this chapter, the reason for choosing this research issue in the light of background study
will be discussed. The motivation and rationale behind the research will be discussed. This
discussion will follow with the brief explanation of objectives and overview of the project.
1.1 Introduction of Credit Risk
Credit risk is one of the most important and significant risk in the banking industry. Most of
the crises arise because of huge portfolio of bad lending (Bleim, D. O; 2001). There is
essentially the need to manage and restrain this risk. If the different risks are measured in the
banking sector, credit risk is the most important risk. Different approaches, tools, models are
available for credit risk management (CRM) (Caoutte, J. B., Altman E. I., Narayanan, P.
1998).
Many Scientist states that the Credit Risk is the chance of defaulting, if the borrower is
unable to repay his/her debt due to some circumstances. Chances of risk occur, when the
debtor is unable to pay loan due to some reason (Bleim, D. O; 2001). Basel (1999a) Defines
Credit Risk as where the potential counter party fails to meet its obligation accordance with
agreed terms (Basel Committee 19999a). Credit risk arises through different sources like
lending, investing, credit granting activities and concerns the return of borrowed money. It
also arises through contractual agreements such as derivatives. When an organization owes
many counter parties and creditors failed or has financial difficulties, credit risk arises. Credit
risk is common in every business but its importance is more for banks and lending
institutions, where lending is the main and core activity of their operations. Credit risk is also
known as counterparty risk. Banks are increasingly facing this risk in the form other than loan
as well like, trade financing, swaps, bonds, equities, options and futures (Basel 1999a).

1.2 Research objectives.
The main objective and aim of this research is to critically analyse and explore the strategies
and practices adopted by major UK banks for management of credit risk. Different techniques
are adopted according to the nature of the risk and lending and different approaches can be
utilised to assess risk of default. The main objectives are:
1. To examine the credit risk management policies/practices and techniques of banks.
2. To critically examine the measurement methodologies, credit risk modelling and scoring.
3. To critically evaluate the risk arises through credit and ways to transfer /mitigate the risk
exposure.
1.3 Project Background.
Credit risk management (CRM) have always been an important part of the banking activities.
This term is important in long term stability of the bank and they need to make sure that they
have large form of capital against any credit risk to be tackle adequately. More attention is
always given to the credit risk management by the senior managements especially in the
banking industry. Event after the major financial crises of 2007-08, its importance and need
to make more effective strategy and manage the credit exposure has been increased. Some
research and work has been done on bank credit risk management like Wakasagi, Sasaki
(1998). However more of these searches focus on part of the credit risk management and
more focus is on US banks searches, may be due to availability of data, while the focus on
UK banks is seldom discussed. This dissertation will be focus on the major UK banks and an
overall review of the credit risk management process, techniques and strategy.
Credit risk is the most oldest and important issue for the banking industry and if it is not
managed properly can cause major issues like bankruptcy and may drag the bank into great

trouble. Managing credit risk is not an easy task for banks since comprehensive and through
consideration and practices are needed to identifying, measuring, controlling, minimize and
transferring the risk. Poor Credit risk management caused one of the main reasons of Major
event of global crises of 2007-08 (The Economist, 2013). According to the U.S Senate’s
Levin-Coburn Report “the crises was the result of high risk complex financial product, the
failure of regulators and credit rating agencies”. Financial inquiry commission concluded the
failure was due to poo corporate governance and risk management. Collapse of mortgage-
lending standards and deregulation of credit derivatives and failure of credit rating agencies
to correctly price risk ware the main causes of global crises (The Economist, 2013). Poor
Credit risk management led most of the financial institutions and banks to be collapsed and
default globally. Many of the banks faced hard times, some collapsed, some were
nationalised and by the end of September 2008, 284 banks and lenders were collapsed (The
Economist, 2013). This emphasise the importance of credit risk management and for banks
and financial institutions to be operate securely, their credit risk management strategy plays a
vital role.
Credit risk management provides both challenges and opportunities for the banks. Different
type of challenges banks encounter on the way to credit risk management. Credit complexity
is the main issue now a day as single business is targeted by various lines in the business. A
variety of approaches are available for mitigating/transferring the credit risk. Traditional
approaches are generally focused on loan underwriting and risk diversification, while new
ways refer to asset securitizing and hedging with credit derivatives.

2. Critical Literature Review
2.1 Credit Risk in Banking Industry
2.1.1 Definition
Credit Risk in the risk of possibilities that borrower and counterparties may default.
According to Basel, Credit risk is the potential that the counterparties and borrowers fail to
meet their contractual obligations in accordance with the agreed terms (Basel 2000).
According to Duffie and Singleton (2003), Credit risk in the risk of default caused by the
changes in the credit quality of the counterparty or issuer. The fundamental objective and aim
of credit risk management is to maintain the credit risk exposure within acceptable
parameters and maximising the risk adjusted rate of return. Banks should manage both the
individual risk and an entire portfolio of credit risk. Credit risk is the largest element of the
risk in the books of banks and if not managed properly, can weaken the individual banks or
even can impact on the whole banking system (Jackson and Perraudin 1999).
2.1.2 Credit Risk Classification
Generally banks face different types of credit risk, that can be categorise in different
categories. For better understanding of the idea of credit risk management it is necessary to
understand the different types of credit risk. Different authors have defined different credit
risk. For example Hennie (2003) identifies three types of main credit risk as consumer risk,
corporate risk and sovereign risk. In other book by Horcher (2005) defines six main types of
credit risk as default risk, counter party settlement risk, pre-settlement counterparty risk, legal
risk, country risk and concentration risk.
A. Default Risk

Default risk a traditional credit risk and arises due to default of payment especially in the case
of lending and sales. It is the simple form of credit risk and the probability of default can
either be the full amount of liability. The default amount can be recovered later depending on
the legal status of the borrower. Sometimes it is impossible to get the defaulted amount later
and eventually is the main reason for the failure of the organization (Horcher 2005).
B. Pre-settlement Risk
This is risk that counterparty may default before the contract final maturity. Pre-settlement
risk arises if either the counterparty defaults before the payment is due or financial
intermediary responsible for the settlement declares bankruptcy before the transaction is
settled. The risk of unrealised gain arises during this period and the potential loss to the
organization depends upon the fluctuation of the rate in the open market (Horcher 2005).
C. Settlement Risk
This is the risk faced most by the banks in daily inter-bank market. During the last several
years, it has become the most high profile risk facing by the participating in financial markets
and contributes to the global credit crises (Navneet Arora, Priyanka Gandhi, Francis
Longstaff 2012). It refers to a situation where one party to a contract fails to make settlement
at the settlement time and it is associated with any timing differences. This situation is mostly
finding in the case of foreign exchange trading and where amounts are huge (Horcher 2005).
The best example of this risk can be more clarified by the failure of German bank Herstatt in
1974. Bank had taken the receipt, but had not made the payment before the market closed
down making substantial losses (Anonymouse 2014).
D. Country/ Sovereign Risk

Sovereign risk arises due to the deteriorating foreign economy. This risk arises if government
enforce their authorities to declare debts, change the interest rates under political pressure.
Horcher concluded that government put restriction and controls on capital and foreign
payments or may cease debt payments etc. can lead to issues and complexities for the issuer
to practice in this environment. Sometimes financial crises may also contribute to the country
risk.
2.1.3 Exposure of Credit Risk in Banks
Traditionally Credit risk arises from lending activities; however it also comes in the form of
holding bonds, securities derivatives contracts. Basel (1999a) identifies that though loans are
the biggest source of credit risk, some off balance sheet exposure also contribute to the credit
risk like futures. Guarantees, interbank transactions, so it is absolutely necessary to identify
all the credit risk exposure for the bank. Exposure of credit risk can mainly be classified into
main categories as on balance sheet and off balance sheet exposure.
A. On-Balance sheet exposure.
Loans: there are different types of loan like commercial and industrial loans, real estate loans
like mortgages and loans to consumer etc. commercial and industrial loans have the length
from few weeks to several years depends upon the business requirements. In contrast to the
commercial and industrial loans, estate loans differ largely in size price and terms of
maturity. Consumer and other loans are loans refer as personal loans and auto loans etc.
(Saunders, Cornet 2010). Credit risk present in large amount in loans. Over the period banks
focus on loans is more concerned about loans in less developed countries and from
commercial and estate loans to auto loans and credit cards as well. Credit risk management is
crucial in all types of loans as default risk is somehow present in all loans. In managing credit
risk, both individual loan and loan portfolio management is important.

Non-performing loans: Hennie (2003) defines the non-performing loans as when the principal
amount and the interest due is not paid for 90 days or more, the loan is then considered to be
non-performing loan. It is the initial indicator of bad lending decision quality and risk
exposure as bank might have to think about the credit quality controls as well.
Debt Securities: Debt securities are financial instruments issued by government bodies or big
corporations in order to raise capital. They can be in the form of bonds, notes, certificates etc.
The issuer of security bonds pays the coupon amount throughout the life of the certificate and
the principal amount will be paid at maturity. Credit risk is also exists in debt securities as
there is always the chance exist that the issuer will default which can be a damaging impact.
B. Off-Balance sheet exposure.
Since the off-balance sheet commitments have grown rapidly, these types of commitments
are subject to create new credit risk by chances of default of counterparty. According to Hull
(1989) traditionally ratios had been measured to check the capital adequacy of the banks. As
the growth of off-balance sheet commitments, the measurement is now moving towards
weighting scheme (Hull 1989). This section covers some of the exposures relating to the off-
balance sheet exposure.
Derivatives: These are bilateral contracts, the payment of which is linked with the occurrence
of default of bankruptcy of counterparty. Banks can use credit derivatives to transfer some of
their risk of loans to third party. Although credit derivatives cannot eliminate credit risk but
it can be used to transfer the risk to third party. Derivatives are tools used to manage the
credit risk portfolio more efficiently. Statistics shows the increasing use of credit derivatives
(Bernadette A. Minton, René Stulz, and Rohan Williamson 2006). Forward risk is exposed to
a greater degree of risk than futures and options as forward contract is not tradable in market
and. However credit risk is not negligible in any case.

Bank Guarantee: Bank guarantee is a type of agreement as a part of a bank to provide the
payment in the event of default of original party. It is a kind of surety by bank to payment if
the party fails to pay (WiseGreek 2015). According to Basel committee, this should be
considered as a direct full risk as bank has an obligation to stand behind the third party (Basel
Committee 1986). So in the case of guarantees and acceptances there is a full risk exposure as
off balance sheet activity.
Banks transfer money through online wire transfer system to different banks, if the payment
is not made or transferred within the same day the counter-party bank may not receive the
payment and eventually failed to pay to other banks leaving serious losses.
2.2 General Principles of Sound Credit Risk Management in Banks
According to Hennie (2003) Credit risk is still the main cause of bank failures as about 80%
of the banks statements relates to credit risk management. Basel also point out the major
banking problems as poor portfolio management, poor credit standards for creditors and
counterparties, etc. All of these prove the vital role of credit risk management in banking
industry. This section will discuss the main aim and goal of credit risk management and
sound practices bank should adopt for credit risk management. This section is based on
principles of sound credit risk management issued by Basel committee.
The main goal and aim of sound credit risk management is to develop a strong mechanism
that support the increase in shareholders’ value and maintain the risk exposure within
acceptable parameters to maximise the risk adjusted rate of return. As stated by the Basel
committee (1999a), both the risk arises as a result of individual creditor and transaction and
the whole portfolio of risk should be managed and the relationship of risk with others must be
considered as well.

By reviewing the general principles of Credit Risk management, can provide a scenario of
how banks carry out the practices. Despite the specific approaches may be differ by bank to
bank, Basel (1999a) identified the practice of credit risk management and these are discussed
below:
Establishing an appropriate Risk Environment
Significant credit risk policies should be reviewed and approved periodically by the board of
directors. Strategy should reflect the bank’s tolerance level and also the level of profitability
that the management is expecting. Credit risk strategy should be reflect in all bank’s activities
either individual or portfolio level. Strategy should be based on exposure type that bank have
to face. Board must also identify the capital adequacy level. Strategy should be viable and
through various economic cycles. Board should ensure the strategy is communicated
throughout the organisation and senior management is capable of managing the credit
activities. Credit policies should not contradict the remuneration policies and bank other
policies as well that make the bank credit process weak. Senior management should be
responsible to develop the procedures for identifying, measuring, monitoring and controlling
the credit risk. Banks should also make sure that all the products and activities are subject to
the adequate risk management process and all controls are being performed and approved by
the board of directors or committee.
Operating under a sound credit granting procedure
Banks criteria for granting credit should be clearly defined with terms and conditions, types
of credit and target market etc. Sufficient information should be assed of borrower profile
like history, repayments and guarantees if any. Granting process involves risk as well as it is
a source of profit. Bank should asses risk/reward relation in any credit granting and
established the provision for known losses and must hold adequate capital for unexpected

losses. There should be predetermined credit limits and should recognised the risk associated
with it. There should be clear established process for new and existing credit as well.
Maintain an appropriate administration, measurement and monitoring process
Credit administration is important in maintaining the safety and soundness of a bank. Credit
team should have the responsibility to keep the credit files of each borrower up-to-date
through obtaining latest financial information and communication regarding renewal and
payments. Bank should make sure the documentation is up-to-date and legal requirements are
fulfilled. Management should be responsible for monitoring the credit quality. Internal rating
system should be encouraged as well to assess the accurate exposure of risk. Risk should be
assessed through information system and by the use of analytical techniques.
Adequate Credit Risk Controls
Credit management process should be monitored independently and proper internal controls
and procedures should be in place to ensure exceptions to policies, procedures should be
reported and action upon as well.
2.3 Credit Risk Measurement
Measuring risk has always been an important part of credit risk management process. In
recent years, revolution has been brewing in the risk as it is both managed and measured. It is
hard to contrast the traditional and new approaches as most of the new approaches best ideas
are taken from the old traditional approaches (Saunders Anthony, Allen Linda, 2002). With
the development in the technology, credit risk management evolves greatly during recent
years. In this section the fundamentals of credit risk measurement and three general methods
to measure the credit risk will be discussed.
2.3.1 Fundamentals of Credit Risk Measurement

Banks measure risk in order to get idea about the possible future outcomes. According to
Lowe (2002), the credit risk should be measured taking into account of size and scope of the
exposure. Lowe (2002) defines that all kind of measurement methodologies comprises of four
common blocks, these are probability of borrowers defaulting (PD’s), the correlation of PD’s,
the possible loss in the event of default (LGD’s) and correlation between PD’s and LGD’s.
2.3.2 Credit Risk Rating System
The Ratings provides the measure of the credit worthiness of the entity, taking into account of
factors such as financial history, assets and liabilities of the subject. Risk rating applies to all
kind of loans except personal and mortgage loans. Risk rating assist in underwriting loans
and assist in portfolio management. Credit risk rating reflects the severity of loss as well as it
predicts the variability of loss over time. https://www.dico.com/design/Publications/En/By-
law5-CommercialLendingPractices-May2005-UpdatedMay2008/CreditRiskRatings.pdf.
Banks use internal as well as external rating in their risk management.
External Credit Ratings
Credit rating agencies (CRA’s) provide a measure of creditworthiness and financial strength
of a company. These measure the ability of a company to meet their debt servicing
obligations. These generally focus on the long term prospective of a company. The role of
credit rating has been increasing over times. Banks, pension funds, trustees and bondholders
have used the credit agencies and as a result their role has increasingly growing in the market
over the recent years (Fernando Gonzalez, François Haas, Ronald, Mattias Persson…2004).
Credit agencies base their calculation on the financial statements, franchise value,
management quality and competitive position in the industry. More focus is on the long term
ability of the company to meet its debts. The process also involves the private information of
the company that companies agree to share with CRA’s. These opinions are used to assess the

credit risk by banks and financial institutions to make decisions. Ratings help medium size
companies and banks who lack the resources, with portfolio governance. However, some
criticism are discussed on the credit rating agencies, still its use seemed to be increasing in
recent years. Below table shows the rating symbols of some famous credit rating agencies:
Internal Credit Ratings
According to Basel Committee (2001) the internal rating based approach consists of risk
associated with borrower and transaction both. Some of the main components that banks use
for internal rating are the probability of default (PD), loss given default (LGD) and exposure
at default (EAD). These components help banks in deriving capital requirements. Consistent

and meaningful approach to internal rating can help banks in assessing credit risk in loans
and other sources of credit exposures as well. Since the recommendations by Basel (1999) for
banks to incorporate internal rating system, its important has been increasing in large banks.
In many banks internal ratings are essential part that allows banks to monitor the credit risk
closely and it serves as calculation of building loan loss reserves and is key component of
bank internal rating systems.
2.3.3 Credit Scoring System
Credit scoring has the same concept as credit rating and used with all types of analysis. It
distinguishes good and bad applicants.it is a very important application in statistical
modelling and main goal is to determine the probability of default (PD). In this task, bank
follows the predictive model and assigns scores according to the model (Thomas Verbraken,
Cristián Bravo, Richard Weber, Bart Baesens 2014). Different evaluation systems are
defined by Dr. Edward I. Altman. Some of the approaches are qualitative uni-variant and
multi-variant where market and accounting measures are considered. Some other models are
options/ a contingent claim model where future payoff is depends on the value of another
asset. Ratio/market value model is one of the approaches adopted by banks as a modern
technique http://people.stern.nyu.edu/ealtman/3-%20CopCrScoringModels.pdf.
2.3.4 Credit Risk Modelling
Over the year, the world largest banks have tried to develop models to manage the credit risk
across geographic lines. The output of these models play important role in bank’s
performance measurement and risk management process, customer profitability analysis,
active portfolio management and capital structure decisions. These models allow tailored
approach to risk management. They are influenced by credit quality, economic environment
and reflect concentration risk within a portfolio. These contribute to an improved credit

culture in overall banking activities (Basel Committee on Banking Supervision 1999). Below
figure shows how the credit risk models are categorise into groups and their results as well:
Source: http://vddb.library.lt/fedora/get/LT-eLABa-0001:J.04~2012~ISSN_1392-
3110.N_2_27.PG_71-77/DS.002.1.01.ARTIC
The models of probability of default calculate the probability of default of a party. Scoring is
use of financial reports of the company. Market information of assets and obligations are
used to calculate probability of default. Models of credit position used to evaluate the
probability of credit default level. Models of portfolio loss are a result of two above discussed
models. PD is the probability of default that debtor will not meet its obligation. LGD is loss
given default and calculates the loss in the case of default of a particular loan or under
Group of Models Models Result of Models
Models of
Probability of
Defaults
Models of Credit
Position
Models of
Portfolio Loss
Actuary
Option
Scoring
Credit Margin
Credit Equivalent
Position
Loss Given
Default
Market Value
Probability of
Default
PD
EAD
LGD
EL=PD*LGD*EAD
UL=Var(EL)

particular circumstances. EAD is the amount of loss in the case if default. EL shows the
evaluated level of default of the whole group (Diana Cibulskiene, Reda Rumbauskaitè 2012)
Different Approaches are adopted by banks to calculate the PD, LGD and EAD. Some of the
main and general techniques adopted by banks in their credit risk modelling are discussed
below.
Structural approach
The concept of structural models is used to assess the probability of default (PD) based on the
value of corporate’s assets and liabilities. General idea behind this approach is that the
company would be considered as default if the value of its assets falls below the value of its
liabilities. As this approach relates to the firms valuation it is also known as “Firm value
model”. The first structural model was suggested by Merton in 1974 and based on Merton
model new models have been developed like Moody’s KMV for assessing the PD
http://www.crisil.com/pdf/global-offshoring/Credit_Risk_Estimation_Techniques.pdf. In
Merton model the probability of the value of the assets at T time is developed with the
assumption that asset follow lognormal distribution. KMV model uses the Merton model to
assess the term “Distance-to-Default” with the use of market value of assets. The model
derives the actual probability of default. Below figure is the Merton Model for calculation of
PD

Statistical approach
Numerous statistical techniques and data can be used to determine the PD for defined time
horizon. Data on the characteristics of the obligor can be used to determine and predict the
probability of default. These models define the relationship between the data inputs and the
outcomes. Different techniques like regression analysis, hazard models and decision trees can
be used in this approach. One of the most recommended techniques is the use of logistic
regression. It is the most and widely used technique to estimate PD for small and medium
size organization and retail obligors as well http://www.crisil.com/pdf/global-
offshoring/Credit_Risk_Estimation_Techniques.pdf. The first step in the process is to define
the dependant variable and then to select the relevant predictive variable and correlation
within variables and in the last stage involves the calculation of probabilities. Another famous
model is known as Credit Risk+. It uses the information relating to the quality and systematic
risk of the party and size and maturity of an exposure and this model is widely used in the
insurance companies (First Boston Credit Suisse 1997)
Rating Based model
One of the most commonly used models based on rating is Credit Metrics of JP Morgan.
Credit Metrics is the extension of Merton’s Model with the assumption that value of assets of
company also determines the probability of firm’s migration to other credit rating. Change in
the credit quality of a firm is an indicator of fall in return within certain threshold (D. Diaz G.
Gemmill 2002)
2.4 Methods of Credit Risk Mitigation/Transfer
A lot of variety and approaches are available to transfer or mitigate the risk. Banks adopt
different methods to transfer or mitigate the exposure of risk in order to avoid or reduce

losses. Old and traditional methods mainly focus on diversification and underwriting process
while new methods refer to hedging and asset securitizing methods. In the past few years the
range of transfer instruments has increased considerably. In this section main methods will be
discussed.
2.4.1 Traditional Methods
Credit Limits
If credit limits should be carefully applied to products, they can help and assist in credit
management about counterparty selection. Credit limit should be performed to different
products, activities and different industries as well.
Credit Rationing
Credit rationing is the most common technique that banks adopt in the credit risk
management. Banks favour the loan most that is most profitable to them in the sense of risk
to return trade off. Credit rationing can takes two forms. Either bank refuses to grant a loan to
a borrower in-spite of borrower willing to pay higher rate of interest or bank can restrict the
limit of credit lesser than the borrower want.
Accurate Loan Pricing
Loan pricing is one of the obvious ways to reduce or minimize the risk. Bank should make
sure that the price of the loan exceeds the risk adjusted rate. It should include any
administration cost plus any charges associated to loan. Normally the risk premium is high
for riskier parties and banks should keep changing the interest rate with the profile of the
loan. On the other hands higher risk is involve in high loan rates as the probability of default
is high in high premium loans as well.

Collateral/Asset based lending
Collateral has been using by banks for long times as a support of various lending agreements.
Collateral is defined as the bank requires any asset as a security for an obligation or loan
(http://riskencyclopedia.com/articles/collateral/). It applies to other transactions like as an
initial margin. Sometimes collateral are useless for banks especially if the amount of
collateral diminishes so quickly and sometimes collateral does not provide enough cash flow
to fulfil the default amount as well. So the matter is that the banks should make sure that they
have enough cash in the event when needed.
Diversification
Diversification is the very common and old technique used by banks to offset the risky loans
against the overall loan portfolio. Through these banks main objective is to minimise the un-
systematic risk. Un-systematic risk is the risk of credit takers default in specific industry or
region. The risk of sudden decline in the industry or economy cannot be overviewed.
Diversification can take place in the categories like geographically, industry wise etc.
volatility of risk in the specific industry, customers or area can be offset or diversified to the
other industry or to the low riskier customers and by this the overall risk portfolio can be
reduced to the acceptable (Csongor, Curtis Dionne 2005).
Netting
It is a mean of reducing the exposure of credit risk of counterparties. Normally it is common
in banks in interbank transactions. Two types of netting are commonly used in the derivative
markets as payment netting and closeout netting. In payment netting multiple cashflows are
net into one payment per currency by the counterparty. It not only reduces the settlement risk
but also a way to streamline the process. Another form is closeout netting. In closeout netting

counterparties agree to net the multiple obligations as swaps and derivatives. In the event of
any counterparty default the outstanding amounts are cancelled and this helps in reducing the
pre- settlement risk (Hendricks, Darryll).
2.4.2 New Methods
Asset Securitization
In securitization, assets are pooled and securities are issued against the assets pooled. In
typical asset securitization the asset is transferred to the Special purpose entity (SPE) in
exchange of cash or interest (Barth, Mary, Ormazabal, Gaizka, Taylor, Daniel 2012). In
banks assets securitization takes a form where banks sell securities against the bunch of
income earning assets. Different types of assets can be used for asset securitization like
mortgages, loans and trade receivables as well. It helps banks to improve the credit risk
management and diversify he risk (Rose, Hudgins 2008)
Loan sales
Loan sales have existed for many years as a source of managing credit risk. Ni loan sales
bank have the advantage that the risk is transferred to the new investors but bank still earn the
fee from loan. Bank loan sales occurs when bank make a loan and sells it o outside buyer.
Two types of loan sales are famous as participation and assignment. More common type is
participation where the contract between the borrower and the bank remains same.
Credit Derivatives
Credit derivatives are designed to transfer the credit risk to another party. They allow banks
to manage their credit risk more efficiently. This is a form of financial instrument that
transfer credit risk related to underlying entity from one party to another party. The reason of

high acceptance of credit derivatives is that they transfer the unwanted risk of parties to the
wanted one foe some fee. It takes many forms. The basic forms are discussed below:
Credit Default Swap: This is the most common type of credit derivatives. In this the buyer of
the swap makes periodic payments either over the maturity of the agreement or the
occurrence of the specific event. In credit default swap (CDS), bank enters into an agreement
where banks pay the specific amount over the life of the agreement or the occurrence of an
event like default or failure to pay. Through CDS banks transfer the riskier entities off from
the balance sheet. (http://www.fincad.com/resources/resource-library/wiki/types-credit-
derivatives.)
Credit Linked Note: credit link note is a kind of debt instrument and suitable to hedge for
credit risk. It is a bundle with an embedded credit derivative. In this investor accept the
exposure of default or credit event and in exchange of higher yield or fee.
(http://riskencyclopedia.com/articles/credit_derivative/).
Credit Options: It is financial contract derivative in which buyer pays the premium amount to
the seller in exchange of the contingent payment if the credit spread changes from the certain
level http://www.investopedia.com/terms/c/credit-spread-option.asp.
Basel Capital Requirement
Basel has defined the principle formula to calculate the minimum requirement of capital for
credit risk. This helps in regulating the whole banking activities safely. In order to protect the
credit and operational risk of banks Basel required banks to have its capital ratio not less than
8% and by following the Basel requirements, banks can maintain the adequate requirement
and operate safely as well (Basel Committee on banking supervision 2006) .
2.5 Credit Risk Concentration

Concentrations are one of the main reasons of banks credit problems. It is one of the most
common reasons of bank to undergo losses and crises appeared because of inappropriate
control on concentration risk (Basel committee on banking supervision, 1, 2006).
Concentration risk is the risk by single or group of exposures where the losses are large
enough as compare to the capital, wealth or income of a bank, so that the whole activities of
the bank are disturbed (Diane Reynolds, 2009). According to T. Adams concentration is
related to possessing large amount of loan portfolio in the bank. There are different reasons of
concentration risk like specialization of banks as some banks are specialized in certain
geographical or industrial areas in order to be convenient to collect information and benefit
from more knowledge but banks should bear in mind about the cost of charge-off as well
(Rita Skridulyte, Eduardas Freitakas, 2012).

3 Research Methodology
3.1 Research Objectives/Philosophy
The main focus in this research has been on the current credit risk management practices of
major banks in UK. The traditional and modern methods applied by banks in their credit risk
management strategies and policies and measurement methodologies of credit risk are
discussed in this research. The research focus can be divided into following main questions:
A. The current credit risk management policies and strategies adopted by major UK
banks. Bank’s lending decision quality and exposure to the credit risk as well.
B. Techniques adopted by banks in identification of credit risk, their measurement
methodologies and modelling and scoring techniques.
C. Basel requirements on credit risk management and disclosure.
D. Recommendations for improvements in credit risk management.
3.2 Research Design
A combined research methodology will be used due to the objectives of the research. The use
of both qualitative and quantitative research will be applied. Most of the research will be
qualitative as due to the research objectives. In qualitative research, descriptive, non-
numerical and non- quantified data is collected. According to White (2003), in qualitative
research the results are mostly descriptive and rather than numerical data i.e. the results are
not derived by statistical methods (Saunders, Thornhill 2012). Quantitative research will only
be used to calculate the ratios as from the research objectives it can be seen that the main
focus is on analysing the credit risk management techniques and practices so the quantitative
research will be only the calculation of ratios to make the whole dissertation a little bit more

comprehensive. Unlike qualitative research, in quantitative research results include series of
numerical and statistical calculations and presentations. To get general understanding of the
lending process and credit exposure, ratio analysis method will be adopted and this will not
be complicated analysis of ratios.
As already discussed, the qualitative part of the research will be discussed more. In these
techniques the comparison method and textual methods will be adopted. These methods are believed
to be suitable for research objectives as by analysing the bank performance reports and relevant
information, which provides the general information on the bank’s credit risk management practices.
Those outcomes and results will be used to compare the different techniques and measurement
methodologies of banks and through these recommendations and conclusions will be made and any
improvements in the bank’s credit risk management will be suggested.
3.3 Research Sample and Data
3.3.1 Research Sample Banks
In the UK the investment banking industry is dominated by European and US banks while the
retail industry is most dominates by British banks together with the building societies as well.
The major banks in UK according to capital are HSBC, Barclays and RBS etc. these will be
the focus of the research and as a sample three major banks data will be used to achieve the
research objectives
Information from the published reports, case study will be used for research findings and for
quantitative data as well. Lloyds Group, Barclays and RBS will be used for both qualitative
and quantitative research. Information from financial reports, published relative information
will be used to assess the standard practices and techniques for credit risk management. To
collect the primary data for the research purpose, a questionnaire has been made to get the
idea of general practices adopted by banks in credit risk management, their measurement

techniques and models adopted by banks and mitigation and transfer techniques adopted. The
result of questionnaire will be used to assess the techniques adopted by bank in assessing the
credit risk and measurement methodologies adopted. This questionnaire has details about the
latest techniques and models used by banks and general techniques to assess the exposure.
3.3.2 Research Data
A. Quantitative
The quantitative data is obtained from the previous work by Xiuzhu Zhao (2007) and Basel
(1998) ratios recommended. Following six ratios have been selected to for the research and
description of these is as follows:
1. Problem loans to gross loan ratio (NPLGL) = Impaired loans/Gross loans
This ratio calculates the quality of the banks loans and measures as banks doubtful loans in
the banking credit portfolio. Doubtful loans are loans which are not expected to pay within 90
days of their due date and this may differ bank to bank. This is a measure of quality of banks
and indicates the performance of bank. Higher the ratio is, worse the credit performance of
the bank will be (http://www.investopedia.com/terms/n/nonperformingloan.asp).
2. Net Charges off to gross loan ratio (NCOGL) = write off loans excluding recoveries/
Gross loan
This is the measure of loans write off from the books of banks. Net charge off is the amount
owed to company but unlikely to be paid. Poor bad debts and loans are regularly checked and
write off by banks on monthly or quarterly basis. Less percentage shows the less amount of
charge off of non-performing loans. Negative amount indicates the more recoveries than
charge off in certain period (http://www.investopedia.com/terms/n/net-charge-off-nco.asp)

3. Loan Loss Reserve to gross loans ratio = loan loss reserve/ gross loan
It measures the percentage of loan portfolio that has been set aside for future adverse events.
Since the financial crises prompted many banks are keeping money aside for future losses.
This is known as the asset quality ratio of the bank and determines the quality of the loans
held by the banks http://www.investopedia.com/terms/l/loanlossprovision.asp.
4. Total Capital ratio = Total Capital/ Risk adjusted Assets
This is one of the Basel requirements (1998). The higher ratio indicates the better quality of
asset. The more high in ratio is; the better will be the asset quality.
5. Tier 1 Capital = Tier1 Capital/ Risk adjusted asset
Tier 1 Capital is also known as core equity capital and it measure the Bank’s financial
strength on the basis of its equity capital and reserves. Banks risk adjusted assets include all
the assets that are systematically weighted for credit risk. According to Basel (1998), the
minimum level required is 8%. It is used to grade the bank’s capital adequacy
(http://www.investopedia.com/terms/t/tier-1-capital-ratio.asp)
These ratios will obtain from online publications of Fitch ratings, Moody’s investor services,
banks management accounts and press releases as well.
B. Qualitative
The qualitative data mainly picked from the chosen banks annual reports and management
accounts. Some of the data is also picked from credit reports from credit agencies and its
evaluation on banks performance. Almost all the banks have independent sections on credit
risk management. Those reports and publications highlight the credit risk management
policies adopted by banks, disclosure requirements and any comply with regulatory bodies as

well. The governance credit risk structure and strategy can also be found in the reports and
how the risk is measured and different models for assessing risk exposure is also available on
websites in shape of reports and management accounts together with relevant figures. Thus
these are the basis of whole research and comparison of chosen bank and difference in any
techniques and procedure are also discussed in the research. Besides these reports, Basel
requirements (1999 and 2000) will serve as a key role for research requirements as well.
These reports show the basic principles of credit risk management. Below is the brief
description of papers issued by Basel in (2000) on principles of credit risk management:
Basel Practice for Credit Risk Disclosure: Basel issued papers in 2000 that provides the basic
guideline about information to better understanding of banks credit risk profile. Main
recommendation on credit risk disclosure, recommendation on credit quality and risk
management are the aspects discussed in the papers.
Research Questionnaire
A research questionnaire has been designed for the collection of primary data. The data
collected is used in the qualitative research findings. The questionnaire was meant to be sent
to all three selected banks. No response from RBS and Lloyds had been received instead of
contacting several times. This might be due to banks complex procedures and due to over
protection culture of the banking systems. After several attempts and contact, I only managed
to get informal feed-back of questionnaire from Barclays. The most of the qualitative
research findings are based on the Annual reports and secondary data because the primary
data is very limited.
The research questionnaire and findings results from Barclays are as below:
Questionnaire:

Credit Risk Management Governance
How and by whom strategies, plans and directions are set? Is it done at group level or divisional
level?
Answer: The Risk Committee Board is responsible for all risk appetite and the a brief approach of
risk exposure is set through the ERFM
Credit Risk Measurement:
1. Credit Ratings
a. Internal Credit Ratings
(Details)
Rating scale from lowest probability of default to 21as highest is used.
Ratings are based on borrower quality and reviewed regularly.
b. External Credit Ratings
(Details)
In some cases external credit agencies ratings are also used but the use is limited,
and internal scoring and ratings are used mostly.
2. Credit Scoring
Factors to be considered and benchmarks used?
Credit quality of the borrower
Paying ability of the customer
Securities value
Credit Risk modelling
1. Structural models (Merton based models like a firm is considered to be default if
its assets fall below the liabilities)
2. Rating Based models ( Changes in debt value caused by changes in credit
quality of obligor)
3. Actuarial models
4. Microeconomic model
Others (please specify)
In retail portfolio the use of regression models are used to determine the value of PD, EAD
and LGD.
Different measures are used like interest rate, GDP, credit quality of borrower, market
values of assets held etc.
Mostly cases are measured through internally generated models.
Credit Risk mitigation and transfer strategy of bank.
(Details)
The use of different techniques are applied I n different cases. The use of Credit limits,
derivatives, collateral, netting agreements are widely used in different risk portfolios.

3.4 Limitations on Research Methodology
3.4.1 Limitation on Sampling.
The issue of sampling in qualitative research is a big issue due to lack of availability of
information, restrictions and over protective environment in banking industry. For the
sampling only three banks are selected that is really a small sample size. The research criteria
could have been wider by choosing and making different groups of banks by their size and
then comparing the credit risk management practices of small group of banks and with big
group of banks. But due to the insufficient information and restrictions to disclose the
information not enough information is available either in secondary data or through primary
data sources.
3.4.2 Limitation on Research approach
The main area of this research as discussed before is depends upon the qualitative research.
But the quantitative approach will not be ignored as some of the area is about the bank’s
performance and calculation of ratios. Quantitative research is adopted only for the ratio
analysis and much of the research is based on generalization and best practices so comparing
the ratios would not be significant. On the other hand comparing the ratios doesn’t make
much more sense as the sample size is too small to compare the ratios.
3.4.3 Limitation on Ratio and Data Availability
In-spite of choosing the ratios it is difficult to find out how many ratios will be fine for the
comparison and which ratio is more important or related the management of credit risk and
above all not all the ratios are available for targeted banks. Every bank has slightly different
ways to calculate the ratios.

4. Research Findings
4.1 Credit Exposure and Quality of UK Banks
Ratio Analysis and comparison has been made in order to assess the credit risk level and
quality selected banks (Barclays, RBS, Lloyds). Five ratios have been collected from online
Fitch Rating analysis for two years 2013 and 2013. The analysis of these ratios will be made
in order to assess the changing in the bank’s credit risk quality and level for two years and
then these can be critically analyse with other banks ratios well.
Source: Fitch Ratings Banks Full Rating Reports (Fitch Ratings 2014)

The first ratio is Non-performing loan to gross loan ratios. Non-performing loans are loans
which are 90 days older than their maturity dates. This ratio calculates the quality of loans in
a bank’s portfolio. Table below shows the percentage of ratios of selected banks for 2012-13:
NPLGL = Impaired Loans/ Gross Loan
The Decrease in the ratio shows the improved control over the non-performing loans and
better loan quality as well. The lowest ratio of Barclays shows its sound credit management
and loan granting process as compared to RBS and Lloyds. Lloyd’s ratio has improved a lot
in 2013 and shoes a decrease of 2.4 % that is a good indicator and better loan management
(http://www.lloydsbankinggroup.com/globalassets/documents/investors/2014/fitch_lbg_29ap
r2014.pdf). In contrast with Lloyds and Barclays, the NPLGL ratio has risen of RBS for
almost 0.94 % that indicates the bad loan management or may be due to clean-up of the
books (http://www.investors.rbs.com/~/media/Files/R/RBS-IR/credit-ratings/fitch/2014-10-
24-fitch-on-rbs-full-report.pdf). Barclays has the strongest ratio as compare to other banks.
5.74 % in 2013 as compared to 5.66 % in 2012. This is almost the same and shows the
continued sound management of loans and credit risk management as well.
(http://www.barclays.com/content/dam/barclayspublic/docs/InvestorRelations/Credit-
ratings/fitch-credit-opinion-09092014.pdf).
The second ratio is Net charge of to gross loans ratio. It indicates the loans that have been
written off from the impaired loans.
NCOGL = Write off Loans/ Gross Loans
Barclays NCOGL ratio indicates a slightly improved signal and drop down from 0.74 % in
2012 to 0.67 % in 2013. It is an indicator of less write off of impaired loans and might shows
the recoveries of impaired loans in 2013. Decrease in ratio shows active recovery

management.
(http://www.barclays.com/content/dam/barclayspublic/docs/InvestorRelations/Credit-
ratings/fitch-credit-opinion-09092014.pdf). On the other hand RBS ratio shows a slight
increase in 2013 as 0.93 % as compare to 0.8 % in 2012
(http://www.investors.rbs.com/~/media/Files/R/RBS-IR/credit-ratings/fitch/2014-10-24-fitch-
on-rbs-full-report.pdf). Lloyds shows a significant decrease of write off loans in 2013 as 0.5
% as compared to 1.0 % in 2012
(https://www.lloyds.com/~/media/files/lloyds/investor%20relations/ratings/2014/fitch%20rep
ort%20august%202014.pdf).
Loss loan reserves indicate the amount of reserves separated by bank for loan losses and any
adverse events. It is measure by dividing Loan Loss Reserves or allowance to gross loans.
RBS in this regard has the highest amount of reserves ratio. This might be due to poor loan
quality or might be over protection of bank as well. RBS Reserve ratio is 6.05 % in 2013 as
compared to 4.63 % in 2012. The reserve ratio is not available for Lloyds as this might be due
to not disclosed by bank as it is not available online for the required two years. Barclays has
reserve ratio of 1.81 % in 2013 and 1.66 % in 2012.
Total Capital and Tier_1 Ratios are one of the recommended ratios by Basel. It is calculate as
dividing the adjusted capital to Risk adjusted Assets of bank. The higher ratio is a good
indicator. Risk Adjusted Assets are assets weighted for credit risk. Basel Recommendation of
Tier_1 Ratio is not less than 8 %. Barclays has the ratio in 2013 of 13.2 % and RBS has 10.9
% in 2013 and Lloyds has 14 % in 2013. Lloyds has the highest ratio as compare to other
two. It is the ratio that indicates the capital adequacy of bank in case of any default by the
major borrower.
4.2 Credit Risk Management Practices and Techniques at Barclays, BS and Lloyds.

The general idea of how banks manage their credit risk has been discussed in the literature
chapter of the dissertation. In this chapter focus is on three selected banks and their credit risk
management techniques and strategies. The general idea will be gained of how Barclays,
RBS and Lloyds manage their credit exposure recently.
4.2.1 Introduction and Overview
Barclays bank has 48 Million customers and clients with over 300 years of history and
expertise in banking. It was incorporated in 1690. According to Relbanks statistics, Barclays
stands 10 in world ranking banks according to total assets. The total assets of Barclays were
amount to 2,266 US$ Billion in 2014 (Relbank 2014). Barclays is a global financial service
group with operations across Europe, Africa, America and Asia. It operates in around 50
countries and rank as second largest bank in UK in terms of assets.
Royal Bank of Scotland is founded in 1727 with its headquarters in Edinburgh, Scotland. It
provides financial and insurance services worldwide. The total assets for 2014 was 1,704
US$ Billion and ranked third largest bank in the UK (Relbank 2014). Its main subsidiaries are
National Westminster, Ulster bank and Coutts.
Lloyds Bank with total assets valued at 1402 US$ Billion in 2014 ranked as third largest bank
according to Relbank statistics (Relbank 2014). It is a major British financial institution with
the history begins in1765 with founding of Lloyds Bank. It is also the 4th
oldest bank in the
UK.
4.2.2 Credit Risk Management Practices and Techniques
A. Credit Risk Management Governance
In Barclays there are four board level committees that manage and monitor the risk across the
group. These are the Board, the Board Enterprise wide risk committee (BEWRC), the Board

Financial Risk Committee (BFRC) and the Board Conduct, Reputational and operational Risk
Committee (BCROR). The Board is responsible of overall group risk appetite while BEWRC
works on behalf of Board and recommend and review the design and completeness of overall
risk profile. The BFRC committee monitor the risk appetite and make sure the actual
performance does not differ with expected. The board audit committee reviews the
impairment allowances and all control issues. In Barclays, the responsibility of risk
management lies from top board through the organisation Framework (ERMF) that set out
the responsibility of each member in the risk management. It is a brief approach for all of the
risk in Barclays and set out the tools techniques and approaches applicable to the whole bank
(Barclays 2013 Annual Report: http://reports.barclays.com/ar13/)
While in RBS the Group Board Risk Committee consist of three Non- Executive Directors, is
responsible and act as a committee of group board and bank board as well. The main
responsibility of the committee is to promote risk awareness culture in the group and making
of risk strategies and policies. It also makes risk appetite framework and limits for the group
and also for the divisional risk committees. At divisional level, Divisional committees are in
charge of establishing and maintaining the Credit risk management framework that should
comply with group objectives as well. The divisional heads are responsible to both divisional
CEO through the Chief Risk Office (CRO) and to the Group Head as well.
(http://rbs.live.hemscottir.com/download/report/Terms_of_Reference_for_Board_Risk_Com
mittee.pdf)
In Lloyds bank the Group Risk Committee takes responsibility in regards to Group risk
appetite and risk management frame-work and overview the Group risk divisions as well. As
same in RBS Lloyds division committee is responsible at division level (Lloyds Banking
Group, 2015 http://www.lloydsbankinggroup.com/our-group/corporate-governance/risk-
committee/.) The below figure shows the structure of Lloyds Risk Governance:

(http://www.lloydsbankinggroup.com/our-group/corporate-governance/risk-committee/)
B. Loan/ Credit Granting Process
The credit approval criteria are same in almost all the banks. Prior to the approval the
customer credit facilities is checked. Factors such as the present ability to pay, any contract
for loans, security against loan and any loan restriction to determine are assessed. Banks also
check the credit attribute and loss on default and other attributes are considered as well like
economic part, geographical place and projected turnover etc. all of these procedures are
necessary and almost adopted by all the banks in the same manner
(http://www.writtenessays.net/operating-under-a-sound-credit-granting-process-of-barclays-
bank/). While approving different customer s are subject to different credit process as some
of them are corporate borrowers and some of them are for personal business. So the expertise
in the field is applied by bank to make sure the sound and effective approval process.
C. Models for Credit Risk Management
Credit models are adopted by banks for credit granting, monitoring and for the portfolio
analysis. Models are developed for different types of borrowers and in Barclays, RBS and

Lloyds, slightly different approaches are used. Generally as discussed in the literature chapter
four types are common as PD (Probability of Default), LGD (Loss given Default) and EAD
(Exposure at Default) Models.
Barclays uses the regression models to predict the value of PD in retail portfolio. In order to
predict the Probability of default Barclays use the macroeconomic measure like interest rates,
GDP and inflation rates are used as well. For counterparty risk assessment, it uses the market
value of assets. Each customer is allocated an estimated PD, LGD and EAD. PD is calculated
on TTC Basis that shows the default frequency of past 12 month or predicted default
frequency of next 12 months. Credit quality of the borrower is checked as well (Barclays Plc.
2013…page 114 to 119). While in RBS different models are designed for Retail and
wholesale Assessment of PD, LGD and EAD. Bank Use different credit grading models in
order to assess the risk characteristics of customer and different models are produce for
different model type, that are based on customer account data and data from credit bureaux as
well (RBS 2013...page 20-23). In Lloyds numbers of factors are considered as economic
factors and changes in risk portfolio in order to calculate the model drivers.
Exposure Measurement
Three parameters (PD, LGD, and EAD) are widely used by Barclays bank in order to assess
variety of applications. These parameters are used in different process and stages of credit
risk as at stage of credit grading, approval and at risk reward and pricing stages as well.
These parameters are helpful in pricing and in calculation of impairment as well. Different
internally build models are used by Barclays are Statistical Model, Structural models and
expert lender models. Structural models are used for default distance calculations. These rely
upon time series data and with combing internal and external rating agencies data as well.
Expert lenders models are used where there is insufficient data is available to assess the risk

and these rely on credit expert knowledge and expertise. Statistical models are used for high
volume portfolios (Barclays Plc. 2013… Page 119-120).
RBS uses models in credit risk management, approval and reporting and monitoring process.
Different models are based on three general parameters as PD, LGD and EAD and these
models are then categorising in wholesale and retail. In PD Models each customer is assigned
a PD. In EAD models internal and historical data is used to predict EAD of customer. LGD
models assess the borrower characteristics, cost of collection etc. (RBS 2013…page20-21).
Lloyds use PD models in commercial portfolio and segment customers into number of rating
grades with assigned probabilities. EAD and LGD are used in retail portfolio and developed
internally and where necessary use external data and use statistical analysis (Lloyds Banking
Group 2013 …page 36).
Internal Credit Rating System
RBS, Barclays and Lloyds all use internally developed models and ratings to assess borrower
quality that are based on PD calculations. All customers are assigned credit rating and band
according to their characteristics and quality assessment. RBS use a master grading scale
with10 AQ Bands. Lloyds baking group use the PD Grades from 1 to 23 to assess the
borrower. At Barclays internal credit rating scale is utilised from lowest PD to 21 as highest
PD rate.
D. Credit Risk Exposure Management
Barclay’s net group credit risk exposure has reduced to 8% to £ 709.8 bn. in December 2013.
Concentration issue is given particular importance in Barclays and according to the annual
reports published the geographical concentration of group assets was stable in 203 as
compared to 2012. Main Geographical segments for Barclays are UK, Europe and America

where 37% of the Exposure related to UK, 24 % in Europe and in America it was 29 % in
2013. Concentration as already discussed in the literature as concentration exist when the
majority of the parties and customers/borrower are related to the same industry, geographical
location or have similar economic characteristics (Barclays 2014).
RBS has devised the credit risk assets as a measure of group’s exposure to its customers. It
includes advances, loans leases securities and other instruments. RBS has provided ion the
reports the distribution of its credit risk on the basis of industry, geography and customer
types as well. It helps in assessing and identifying the potential risky areas. RBS Use two
principal classifications to assess the exposure named as Sector cluster to identify the
industry exposure and exposure class. For example geographical exposure is divided into UK,
Europe, US and ROW (Rest of World). Exposure are allocated to sector clusters are
Sovereign, Financial institutions, Corporates and personal (RBS 2013…Page 22-25).
While Barclay’s practices are similar to as RBS, Barclays include maturity analysis to its
credit exposure as well.
E. Credit Quality Management
As Already mentioned Barclays, RBS and Lloyds mostly use internal credit rating and
models to assess the quality of borrower. All banks have developed internal models to
measure the key parameters. With the help of internal and external resources, these banks
calculate the PD, LGD and EAD for each exposure and manage the credit risk and maintain
the credit quality of the Credit Assets. Below is the figure from the Barclays Annual Report
2012 of the PD ratios that fall under Strong, Satisfactory and higher risky.

(http://reports.barclays.com/ar12/riskmanagement/creditriskmanagement/assetcreditquality.html)
Loan Impairments and Allowances
In Barclays Loans are categorise as, neither past due nor impaired, past due but not impaired,
impaired and restructured loans. Past due loans are loans where borrower failed to pay the
amount under the terms of the contract. Impairment allowance is financial assets that have
been impaired. The loans are subject to internal rating that shows the level of risk. In
Barclays loan portfolio 85% of home loans are categorise as strong and this is due to
improvement in overall UK portfolio and other loans as cards retail lending are satisfactory as
well. The overall portfolio has improved in Barclays according to the annual reports 2013
(Barclays 2014).
Lloyds group use the similar approach and wording as Barclays in their financial statements.
According to the December 2013 results, Lloyds past due but not impaired loans were
amounted to £ 13.7bn as compared to £ 15.3bn which shows and decrease of around 10.4 %.
Impaired loans for the period were amounted at £ 32.3bn.
F. Mitigation Techniques
Barclays Annual Report 2012
Internal measures of credit quality
Retail
lending
Wholesale
lending
Credit quality description
Probability
of default
Probability
of default
Default
grade
Strong 0.0-0.60% 0.0-0.05%
0.05-0.15%
0.15-0.30%
0.30-0.60%
1-3
4-5
6-8
9-11
Satisfactory 0.60-10.00% 0.60-2.15%
2.15-11.35%
12-14
15-19
Higher risk +1000.000% +1135.000% 20-21

Banks always try to reduce the risk through various techniques and by implementing sound
credit management models and assessing techniques. Now days almost all the banks transfer
of mitigate the whole or part of their risk either to third party or reduced it by securities and
guarantees. Its importance has increased since the credit crunch of 2008.
Barclays bank uses different techniques to mitigate the exposure of credit risk. Barclays deals
in buying and selling of financial instruments includes interest footers and swaps. It also buys
instruments that are traded over the counter. These are ranged from derivatives that are
tailored for the requirements of bank and form a master agreement. Barclays employ verity of
strategies and techniques in order to mitigate the credit risk and currently it is divided in three
main types and used in different areas of the group are Set-off, Collateral and Risk Transfer.
It also makes sure that all the policies and procedures are recorded properly. It consider
number of things in recognition of credit risk like legal effectiveness and valuation issues of
collateral. Mitigation techniques are largely applied in case of derivatives and Barclays enter
in to master agreements (e.g. ISDA and support annex CSA). The group can exercise
collateral in case of default by the counter party. Different types of collateral are acquire like
property, motor vehicles and other physical assets. Collateral value is affected by the changes
in property values (Barclays Plc. 2013).
There is not much information available on RBS regarding the mitigation and transferring
techniques of credit risk exposure. Some of the general on limited information is available
online and through this information it can be judged that RBS uses the same techniques and
strategies to reduce of transfer the credit risk. Credit limits are set by the group’s credit risk
management framework and based on the credit quality and appetite of risk exposure. In
terms of collateral RBS continuously monitor the rating of the borrower and it requires more
collateral if the credit rating of the borrower downgraded by one or two notches. RBS Buys
derivatives as well to avoid the counterparty credit risk.

In Lloyds bank, the credit risk division set out the policies and procedures for the
management of credit risk. Another team called risk oversight team that controls the
performance trends in credit. Credit limits are set in accordance with the agreed
methodology. Lloyds bank held collateral for mortgage customers and business guarantees.
Collateral is reviewed on regular basis by the group’s appropriate and qualified sources.
Residential mortgages are reviewed on open market value and may require additional
collateral in case of any loss of value decrease. The use of master netting agreements is
adopted by banks in credit derivatives agreements. Bank uses export credit agencies for the
mitigation of political and country risk. These agencies provide commercial and political
mitigation and enable customers by offering finance on favourable terms and promote the
country’s exports and imports. Bank also uses credit derivatives, swaps and credit linked
notes (Lloyds Banking Group Plc. 2013).
4.3 Comparison with Basel Requirement
Credit risk management strategies and practices have been discussed in the above section of
Barclays, RBS and Lloyds. This section involves the comparison of practices of these banks
with the Basel 1999 and 2000 regulations. The general idea is obtained to compare the banks
management practices with Basel Requirements. These principles are already discussed in the
literature chapter now here the comparison with selected banks will be discussed.
4.3.1 Credit Risk Environment
Barclays and RBS have clear defined responsibilities for credit risk all over the group from
executive committee to risk officials. The risk culture is embedded in the organisational
structure. As discussed earlier, Barclays have five steps for credit risk management as
identify, assess, control, report and manage and challenge. Established lines for
communication between lending managers and credit team enable the smooth running of the

operations and sound credit risk environment
(http://www.barclays.com/content/dam/barclayspublic/docs/Citizenship/Policy-
Positions/environmental-and-social-risk-assesment-in-lending.pdf).
RBS group risk management is integrated as all the policies and procedures are controlled
centrally besides the legal regulatory requirements. Lloyd’s group has a conservative model
for awareness and risk culture and senior management is responsible for the implementation
of the risk practices and strategy throughout the group.
4.3.2 Credit Granting Process
Almost in all selected banks, credit granting criteria follow the Basel general requirements.
As mentioned earlier with all banks credit limits are assigned through professional experts
and while assigning the limits, the quality of the borrower is assessed as well. These limits
are reviewed regularly to determine any change in the credit quality of the borrower may
affect the credit limits as well.
4.3.3 Monitoring and Measurement Process
Barclays, RBS and Lloyds all use the internal rating models for the measurement of credit
exposure. Barclays have the internal credit ratings ranging from 1 to 21 and RBS uses the 10
AQ bands for internal credit ratings, while Lloyds have the rating from 1 to 23. Internal
models are widely used by all three banks in assessing the PD, EAD and LGD parameters.
These parameters are based on different information as quality of borrower and external and
internal rating as well.
4.3.4 Controls over Credit Risk
Different functions and committee are assigned who regularly review the policies and
procedures for credit risk management by these banks as already mentioned in the section.

4.3.5 Credit Risk Mitigation
Already discussed in the section, different techniques are adopted by these banks to mitigate
the risk of credit. The policies and practices are almost same in the all three banks in order to
mitigate of transfer the credit risk. To mitigate the credit risk, the use of credit limits,
derivatives collateral and netting agreement is wide and used in different areas of the loans
and advances.
Table of Comparison
At the end the comparison of all the three banks is presented in the table form for better
understanding of differentiation and similarities in the practices and techniques adopted by
major three UK banks.
Barclays
ROYAL BANK OF
SCOTLAND
LLOYDS
Credit Risk
Management
Governance
Four board level
committee: the board,
BEWRC board
enterprises wide risk
committee, BFRC,
board financial risk
committee, BCROR
board conduct,
reputational/operational
committee.
Group board risk
committee at group
level and divisional
level committee
reporting to group
risk committee
Group risk
committee is
established for the
overall group risk
exposure.

Credit Granting Before approval
customer credit quality
check is done. Creditor
ability to pay, securities
agt. loan
Customer credit
quality check is
required. Creditor’s
ability to pay and
securities agt. loan
Same as first two
banks is done.
Creditor ability to
pay, securities agt.
loan
Credit Risk
Measurement
Internal models are
used to calculate the
parameters like PD,
EAD and LGD.
Ratings are assigned to
each customer. Ratings
range from 1 to 21
Internally generated
models are used.
Internally generated
Ratings are used to
assess the quality of
borrower.
Use of external and
internal ratings to
assess the credit
quality of the
borrower
Credit Quality
Management
Quality statistics has
been made. Different
credit concentration is
used on geographical
and other basis.
Same as Barclays,
concentration are
used to assess the
exposure
Not much different
than first two banks.
Credit Risk
Mitigation
Different techniques
like, credit limits,
derivative. Netting
agreement, guarantees
and collateral use.
Credit limits,
guarantees, netting
agreement and
derivatives are used
Same as first two
banks. All the
methods are used in
order to mitigate the
exposure of credit
risk.

5 Conclusion and Recommendations.
Through research on articles and books on bank management, it is concluded that credit risk
is declared as big and significant risk as compared to other risks in banking industry. After
the credit crunch of 2007-2008, its importance has been increased and banks are considering
the credit risk exposure as a major risk in the overall portfolio. The failure of most of the
banks and financial institutions in 2007-2008 crises was the poor lending procedure and
management of credit risk. Though banks can never know the quality and intentions of
borrowers and counterparties, but better credit risk management can minimise the risk
exposure.
In this dissertation, the credit risk management techniques and practices of major UK Banks
are analysed and discussed. Through various sources and annual reports of banks, various
findings have been achieved. The findings are shown in the form of ratio analysis and show
the overall same levels of exposure and quality and smooth and steady performance on credit
management. Five major ratios are obtained from the Piller 3 annual reports of selected
banks. The analysis shows the satisfactory requirements are fulfilled with the Basel
Requirements as to capital and tier-1 ratios and improvements can be seen throughout the
year. The room for the improvement is still there and improvements for future still to be
made. By assessing the practices and strategies, it can be said that major British banks follow
the Basel guidelines. Different banks adopt slightly different techniques and practices to
follow the standard procedures. Most of the British major banks adopt the internal
measurement methodology to measure the credit risk exposure. As already discussed in the
research findings area Barclays, RBS and Lloyds mostly rely on internal ratings and
internally generated models to assess the credit exposure of the borrowers while Lloyds uses
the external help some-how as well. As regard with the mitigation and transfer management

of credit exposure, almost they use the same techniques and methods for mitigation of risk
exposure. The use of collateral and derivatives is widely used in mitigation of risk especially
in the cases of counterparty risk. Credit limits and netting agreements are also imposed on
loans and advances. The important ratios and Basel requirements on capital requirements are
also followed by banks and the ratios are seemed to be satisfactory and banks are having
adequate capital ratios as well. Most of the information is not available in the published
reports that can lead to misjudge the bank’s risk management of not comprehensive findings.
As mentioned, this dissertation is focused on specific areas and limited areas of credit risk are
discussed, it could have been more discussion on other areas like asset securitization, stress
testing and impact of accounting rules. These areas could be discussed in more depth as well
to have better understanding of credit risk management practices and techniques of major UK
Banks.
Recommendations
The joint forum was established in 1996 with collaboration with Basel committee on Banking
supervision and other regulatory organisations. They took a survey in 2013 of banking
supervisors and other securities and insurance institutions to understand the current situation
of credit risk management since the credit crises of 2008 (Bank of International Settlement
2015). The survey was aimed to asking the supervisors about the changes in new credit risk
tools, challenges in internal controls and governance of credit risk, changes in collateral risk,
any developments in the use of models and key operation changes as well. Based on the
results and suggestions by the supervisors and discussions with different firms and
organisations, the forum emerged some theme and suggested some recommendations to the
supervisors for better management of credit risk. Some of the findings are discussed below
and suggestions by the forum for better management of credit risk.

Forum concludes that since the crises, it seems betterment in the credit risk governance,
reporting and risk aggregation. There is more reliance on stress testing and using the firm’s
internal models though some supervisors said that some regulatory models encourage risk
taking as well. Forum suggested on the basis of the survey that supervisors should not rely
too much on the internal and regulatory models and simple measure could be evaluated where
appropriated (Bank of International Settlement 2015).In the current low risk environment
some of the firms are looking for yield. Forum suggested to supervisors to be cautious of this
risk taking behaviour (Bank of International Settlement 2015). Forum also suggested to the
firms about derivatives as it the significant source of risk I the credit risk management. There
is a need for high quality collateral and forum committees are seeking for the availability of
liquid collateral and considering lowering the systematic risk. Forum also recommended the
organisations that they are accurately measuring the exposure of counterparties.
Some of the best practices are also suggested that banks should deploy technology into the
credit risk management in order. New technology especially cloud computing services has
made the credit risk management more transparent and proactive. It is an online service that
allows the data to be stored on remote servers and the information about the customer and
ratings is available at real time and these type of IT solutions helped in strategy making and
easy assessment of credit risk exposure. Surveys says that by June 2014, 78 % of the
institutions ware using the cloud based services indicates and annual increase of 20 % overall
in the UK (http://www.cio.co.uk/cmsdata/whitepapers/3580544/white-paper-tinubu-
square_FINAL_1.pdf).
Adoption of new techniques and principle regulatory body’s requirements is a good sign.
Since the credit crunch there are a lot of improvements and requirements can be seen by the
Basel regulatory and other regulatory authorities. In order to avoid the big crunches like
2007-08 regulatory bodies and banks both have regularly assess and monitor the models and

practices adopted and any further developments should be adopted in order for better credit
risk management.

Personal Development
By starting the MBA Programme, opened a lot of opportunities and possibilities for personal
development. The beginning of the programme was the transitional point for my career and
was a good time to review and stock my existing skills and experience to ascertain my current
position and to make a plan for future. Now at the completion stage of MBA, I have achieved
necessary skills and attributes that should be achieved by the graduates. Although there is a
lot of room for development and I am looking forward; lot of challenges ahead in my
professional life, but the MBA programme has developed me in all the necessary skills and
qualification to market myself with confidence and progress in the career. Some of the
qualities I would like to share that I think I have achieved fully or partly while studying in the
one of the leading and esteemed university:
I have gained subject knowledge and skills through current research and professional
practice. I have also achieved the entrepreneur approach to the issues solving and flexibility
and creativity skills have been developed through learning and teaching methods adopted in
the university. These skills are achieved mainly through programs and subjects offered in the
MBA. It also developed me in self-confidence, ethical leadership, global citizenship and
commitment to life learning. Professional and employability skills have also been developed
through these modules learning structure as well. These skills are developed through
assessment methods adopted and through different short development workshops offered by
the university. Different visiting speaker’s presentations and opportunity to share information
with them and through different workshops were very useful in building self-confidence,
professionalism and employability as well. Communication skills and effective team working
skills are developed through presentations and critical discussion and analysis at workshops

Regarding the PGBM073 Dissertation module, it can be said that, it has bring lot of
knowledge and self-confidence in the field of research. The learning outcomes I have
achieved through this research are deeper knowledge of the field. It also developed the skills
to critically and independently deal with complex issues and enhance my problem solving
skills as well. It also helps me to be organised and systematically integrate the knowledge
within the time framework and consciousness of the ethical aspects of the work as well.
Some of the challenges that I believe have to face in to the professional life are being labelled
as inexperienced and difficulty in getting the job and competition in the market. There is lack
of real world experience as well. I have to realise the fact that this is a critical stage of
transition and in order to adjust smoothly in to the professional culture, there is lot to do. It is
also the hard decision whether to start the job or go for further studies. Most of the time the
pressure and excitement of choosing between careers is more crucial for fresh graduates. As a
fresh graduate, the issue with dealing with success or failure in job is one of the main issues
as well.
At the end the MBA programme has developed my in the basic necessary skills so I can be a
good professional in the future either I start an job or go for further studies, though there is
always a room for improvements.

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