Credit risk management lecture

Presented by : Dr. Peter Larose

 What are the reasons for risks in banking industry?
 List of risks faced by banks,
 Definition of credit risk,
 Is credit risk important for a bank?
 What information are required for credit risk analysis?
 Modern approach to assessing credit risk,
 Risks associated with lending,
 Credit culture and risk profile,
 Risk tolerance,
 Portfolio risk and return,
 Loan policy issues,
 Loan portfolio objectives,
 Strategic planning for the loan portfolio,
 Credit risk management, and
 Closing remarks.

Credit Risk Management in Banking Industry

Financial transactions are becoming more and
more complex in the banking or financial services
sector.
This is due to a number of factors such as;
(a) customers’ expectations,
(b) competition between the financial services
providers,
(c) changes in demography,
(d) changes in the financial services market, and
(e) structural adjustments in the economy.

Financial transactions become more sophisticated
as the socio-technical systems and functions,
indispensable for every day living, are integrated
in various combinations.
While, customers demand greater benefits from
the level of services from their lenders on one side,
on the other hand, the lenders must balance the
risk/reward position.

OPERATIONAL RISKS
Credit Risk
Trading Risk
Concentration Risk
Earnings at Risk
Funding & Liquidity Risk
Value at Risk
Solvency Risk
Strategic Risk
Reputation Risk
MARKET RISKS
Interest Rate Risk
Exchange Rate Risk
Legal/Regulatory Risk
OTHER RISKS
Weather Risk
Terrorist Risk
Money Laundering

Definition of Credit
RiskIt is defined as the possibility that a borrower will fail to
repay his/her debt (s) to the bank/lender on the due date.
When the bank/lender is unable to collect the debt (s) from
the borrower (s), the bank/lender will be short by the amount
of cash that the borrower has failed to repay.
Another terminology that can be used to describe such a
risk factor - “Risk of Default”.
As a bank or any financial services provider’s credit risk
increases over time, this institution is compelled to make
provision to write off the debt (s) in its books of account.
Loans written-off translates into an operating expenses.

A Typical Example of Credit Risk
Suppose, I take a loan of US$1,000 from Citibank at the
interest rate of 5% per annum for a period of 5 years.
I start repaying for the first 6 months and then stop
servicing the loan on the 7th
Month because I have made
other commitment elsewhere.
(a) What is the credit risk for the Citibank?
(b) How it would impact on the liquidity of the bank?
Microsoft Excel
Worksheet

Is Credit Risk Important for a Bank?
For most banks, loans are the largest asset on the bank’s
Balance Sheet, and obviously the major source of credit risk.
Besides loans, there are other pockets of credit risk, both
on and off-balance sheet such as:
(a) investment portfolio,
(b) overdrafts,
(c) letters of credits (L/Cs), and
(d) guarantees.
If a bank or financial institution does not ensure that there
is a systematic credit appraisal system in place, then this
bank is likely to become heavily exposed to credit risk.

A bank’s first line of defense against excessive credit risk
s the initial credit-granting process involving:
a) sound underwriting standards,
b) an efficient and balanced approval process, and
c) a competent lending staff.

Trading Risk
This type of risk originate when a bank sells or securitize
its loan portfolio or other assets with counterparty.
The agreement based on the trading risk will consider
amongst other issues, the right of course by the purchaser
in the event that the data and information were not correctly
calculated at the time of the transaction.
Trading risk may also arise in the case where a bank
engages into a swap of “floating interest rate” to a “fixed
interest rate” on a borrowing contract with another
counterparty.

Concentration Risk
This risk arises, when a bank or financial institution has
lent to a single borrower, a group of borrowers, or
borrowers engaged in or dependent on one industry (say
tourism sector).
Concentration risk of credit consists of direct, indirect,
or contingent obligations exceeding 25% of the bank’s
capital structure.
Concentrations within, or dependent on, an industry are
subject to the additional risk factors of external
economic conditions.
From a sound risk management perspective, a periodic
review of the industry trends be made in order to assess
its susceptibility to external factors.

Earnings at Risk (EaR)
The continued viability of a bank depends on its ability
to earn an appropriate return on its assets and capital.
Good earnings performance enables an institution to
fund expansion, remain competitive in the market place,
and replenish, and/or, increase capital.
Earnings always represent a bank’s first line of defense
against capital depletion due to credit losses, interest
rate risk, and other operational risks.
Risk managers should extremely careful, when
assessing a bank’s risk exposure, to include Earnings at
Risk as part of the risk profile.

Funding & Liquidity Risk
This type of risk is arises, when a bank or financial institution
cannot be funded, and in turn, cannot discharge its financial
obligations on due dates and cost effectively.
The nature of such risk demands prudent management at
all times.
Otherwise, the bank runs the risk of having to extend its
borrowings, selling its assets, issuing additional equity
capital, and to the extreme of even having to close down
the business – this bad news!
Liquid fund is like the life-blood for a bank. It cannot afford
or fail to plan its liquidity requirement on a daily basis.
It is regarded as an important tool in the asset & liability
management for banks.

Value at Risk (VaR)
This is an estimation technique that measures the worst
Expected loss that a bank can suffer over a given time
Interval under normal market conditions at a given confidence
In short, it measure the volatility of a business assets at risk.
The more volatile the asset portfolio of the bank, the greater
the risk of loss.
In view of the economic uncertainty over the last decade, VaR
has become the standard framework for measuring and
reporting risk exposures in banks and other financial
institutions.
If the model is used productively, it can also help as warning
signals.

Solvency Risk
Basel II introduces a far more sophisticated approach to
bank solvency than Basel I – the prior international capital
accord dating from 1988.
Earlier regime represented little more that a flat tax on
banks, which were required to hold capital equal to 8% of
their assets.
New Accord differentiates among risks with far greater
precision.
In addition to introducing new requirements for rating of
credit risk, Basel II requires large, internationally active
banks to calculate their operational risk capital from the
bottom up, using both internal & external loss data.

Strategic Risk
In today’s commercial languages, there are many
definitions, which can be associated with strategic risk.
In the banking terminology, strategic risk is all about the
degree of risk link to a bank’s inappropriate strategies,
which do not match the corporate goals.
In effect, the strategies may not fit the future ideals of the
bank – in short there is a mis-match.
Such risk may originate from the fact that the bank may
have a good plan, but inadequate decision-making
processes or lacks a systematic implementation plan. (e.g.
a business strategy that is unclear, but financially viable,
or a business venture that is clear but financially
uneconomical).

Reputation Risk
Such risk is of significant negative public opinion that
results in a critical loss of funding or customers.
It may involve actions that create a lasting negative image
on the institution’s operation.
Service or product problems, mistakes, malfeasance, or
fraud may cause reputational risk.
Reputation risk may not only affect the bank’s image but
its affiliation with other institutions.
This risk is very damaging especially if the institution
operate in a very small market.
Once the reputation is gone, so will be the eventual
demise of the bank.

Interest Rate Risk
This type of risk arises when there is a mis-match between
assets & liabilities of the bank, which are subject to
interest rate adjustment within a specified period.
It is usually expected that a bank’s lending, funding, and
Investment transactions are linked to changes in interest
rates.
When the interest rates change, the immediate impact of
such change usually affects the net interest income (NII).
The long-term impact would necessarily affects the bank’s
net worth position.
It involves changes in the economic value of the bank’s
assets & liabilities including any off-balance sheet item.

Such risk originates for institutions dealing in foreign currency
transactions.
Financial institutions dealing with foreign counterparties
are subject to country risk as well to the extent that the
party or parties become unable or unwilling to fulfill their
obligations because of economic, social, or political factors.
Hence, it is important for a bank or financial institution to
monitor its net-off position (i.e. offseting its foreign denominated
assets against its foreign denominated liabilities) and take measure to
hedge the exchange exposure.
Otherwise, the bank or financial institution can be heavily
exposed, and loose a lot of shareholders’ fund.
Foreign Exchange Rate Risk

Legal & Regulatory Risk
This type of risk arises from violations or non-
compliance with the laws, rules, regulations or
prescribed practices.
Legal risk may also arise when the legal rights &
obligations or parties to a transaction are not well
established.
The bank may face legal risks with respect to
customer disclosure & privacy protection.

Weather Risk
Over the years, the weather condition all over the world has
changed drastically with untold consequences. It is still
changing without much of early warning signs.
The risk of catastrophic losses originating from extreme
weather condition poses a much greater danger today than
in the last decade or so.
Credit risk specialists are now very much concern with the
potential implication of this phenomenon, when assessing
borrowers’ business plans.
Such a factor is quite prevalent in countries sitting on the
earthquake zone. Even the new Basel II takes into account
that banks’ should make provision for such eventualities.

Act of Terrorism Risk
“Expect the Unexpected” – this quote is now a common
parlance in our every day life.
What use to be a very far remote event can hit us any time,
and at any place.
Terrorism is part of the world uncertainty and costs of doing
business. This is especially in the case of mega business
like banks & others.
Again, Basel II Accord foresees that banks must be ready to
make necessary provisions in their books of accounts for
the act of terrorism.
It is now referred as “ External Event Risk” for banks.

Risk of Money Laundering
Through the offshore business activities, money laundering
has become a major business.
Banks are heavily exposed to such illegal & criminal activities
If they do not have adequate internal controls to spot & deal
with such transactions.
In consequence, the regulators demand that banks should
strengthened their internal control systems because most of
the illegal transfer of funds finally get through the banking
system.
The introduction of Know Your Customer (KYC) is very
crucial for all banks to follow – otherwise, they are subject
to pay heavy penalties with the risk of closure, if they fail.

Retail
Market
Mid
Market
Corporate
Market
Individuals
Medium-Size
Businesses
Large
Companies
Low High
Large
Credit Exposure
Borrowers
Small
Comparison of Cross-Section of Borrowers in the Banking Market

Borrower
Credit Application
or Origination
Credit Management
& Administration
Credit Analysis
& Assessment
Submission Approval/Rejection
•Capital * Capacity
•Character * Collateral
* Consideration
•Capital (Economic, and Regulatory)
•Provision for Default
•Provision for Risk Sharing (e.g. co-financing)
•Credit Policy
•Credit Limit
•Credit Pricing
*Credit Structuring
*Credit Sanctioning

Credit Risk Management in Banking IndustryCredit Risk Management in Banking Industry
Borrower
Credit Application
or Origination
Credit
Management
*Origination
•Structuring
•Pricing
•Underwritin
g
•Sanctioning
•Monitoring
Trading
Book
Credit
Portfolio
Portfolio Valuation & Management
Capital
Market
Credit
Capital
Credit Derivatives
Credit Securitization
Third Party Assets Sales
•Portfolio Assessment
• Portfolio Valuation
• Value-at-Risk (VaR)
• Portfolio Management

Credit Trading Book Credit Modeling
Portfolio Valuation
Credit Evaluation
Credit Procedures
& I.T. Systems
Credit Administration
& Monitoring
Credit Modification
Capital Management
*Economic Capital
*Regulatory Capital
MODERN CREDIT MANAGEMENT SETTING

Sound credit risk analysis would depend on a number of
Critical piece of information such as;
 Purpose of the loan/credit,
 Amount required,
 Repayment capacity of the borrower,
 Duration of the loan/credit,
 Borrower’s contribution,
 Security aspects & insurance protection,
 Borrower’s character,
 Business plan & projections,
 Environmental considerations, and
 Other considerations.

Purpose of the Loan
This is one of the key information required from the borrower
in order for the banker to base his/her judgment as to whether
to proceed with further credit appraisal.
There is nothing wrong for a bank to finance the repayment
of another loan, if the new loan means sound refinancing
of the existing debt.
Banks would not certainly engage in the financing of loans or
credits, which are outside its scope of business or finance
illegal business activities.
(e.g. gambling, speculative transactions, drug trafficking,
environmentally unfriendly projects).
The purpose of the loan/credit must be clear from the outset
once the borrower submits his/her application.

Amount of Finance Required
In as far as due consideration for the amount of the loan is
concerned, the loans officer or executive must adhere to the
principles of lending.
Banks normally set their loan policy in accordance with their
financial resources.
Too high an amount of the loan will be outside the bank’s
mandate.
In the modern day banking environment, if a bank cannot
finance a loan application on its own and the project is
economically feasible, it may act as the lead banker to call
for a syndicate lending.

Repayment Capacity
This test would give the banker a fair idea on how to assess
the repayment capacity of its borrowers.
The repayment schedule is calculated on the basis of a
projected financial statement over time.
If a borrower expects to make surplus cash from its activities
then the source of repayment will come from the cash flow.
It is one of the key data required by any banker.
It must be noted that a bank does not lend money to a
customer on security only.
The key priority for the banker is the ability for the customer
to service its loan/credit efficiently.

Duration of the Loan/Credit
The time it takes to service a loan/credit cannot exceed a
Bank’s normal credit policy. (e.g. if a bank has a policy not to
lend beyond 5 years for a credit type, then it cannot lend beyond this
specific time frame).
In addition, if a project has a life time of say 7 years, it is
expected that the project should be in a position to repay
the bank in full within this time limit.
There can only be exception, when the bank would extend
the duration of the loan, subject to satisfying that the
borrower will honour its commitment within the foreseeable
risk.
The duration of a loan is always tied to the rate of interest.

Borrower’s Contribution
A borrower’s contribution towards the total borrowing
application is very vital for the banker to gauge the degree
of seriousness of the applicant.
A small or no contribution towards the total loan applied
represents to the bank that the borrower is very uncertain
or uncommitted towards the entire obligation.
It is one of the indicators that the banker would be mindful
when due consideration is given to the application.
Even, when a customer makes a significant contribution
towards the whole project, there is no assurance that the
project will succeed. Nevertheless, it gives an indication as
to the strength of the entire business concept.

Security Aspects & Insurance Protection
Strictly, from a commercial lending viewpoint, the security
aspects and insurance protection is the last resort.
It is considered as a back up position in the event that the
customer defaults on his/her obligations to repay the loan.
It is important to note that a good banker should not lend
the shareholders’ funds purely on the security offered by
the borrowers.
If this is the case, then the bank is in the business of
substituting credit for asset purchases. This approach to
lending can be very dangerous for the bank and its group
of shareholders.
Lending should be based on the capacity to repay the loan.

Borrower’s Character
A very vital piece of information that will allow the banker to
decide “to lend, or not to lend”.
A banker should not deal with a customer or potential
customer that he/she cannot trust.
The business of banking is all about trust, confidentiality
& risk involved.
The principle of lending is also about knowing your customer
at all times, otherwise, the bank is likely to experience
serious problem of “bad debts” on its books of accounts.
Banks are not in the business of issuing credits for free. It is
the shareholders’ funds together with other suppliers of
capital, which are placed at risk.

Business Plan & Projections
Good banking practice is not about making a promise to repay
the debt incurred by the borrower or debtor.
It must be focused on sound financial plan, which would allow
the banker to identify the strength and weakness of the credit
application at the time of its submission.
A business plan & its projections is equivalent to an
architect’s plan, which provides all the information about the
proposed building to be constructed.
A customer, who fails to produce a projected financial plan
is a signal to bank that there is something wrong about the
whole business concept being asked to finance.
A sharp banker is most likely to turn down the application.

Environmental Considerations
During the last decade or so, the conservation/protection of
the environment took centre stage in whatever business
decision is taken.
Banks have been accused of financing many projects at the
destruction of the environment. In fact, repeated threats
have been issued against the banks that engages into such
projects.
In order to avoid the bad publicity from the environmentalists
who are also bank customers, banks have had to re-assess
their lending policies.
They are now having to behave like good corporate citizen
by refusing to lend to projects, which are not friendly to
the environment.

Other Lending Considerations
Banks are now also conscious to take into considerationBanks are now also conscious to take into consideration
the likely impact on its borrowers’ obligations due tothe likely impact on its borrowers’ obligations due to
changes in the weather conditions.changes in the weather conditions.
In the last decade, the world has witnessed the catastrophicIn the last decade, the world has witnessed the catastrophic
events, which had had adverse impact on the level ofevents, which had had adverse impact on the level of
business risks, and eventually turning into default risk.business risks, and eventually turning into default risk.
A number of businesses have had to re-style their businessA number of businesses have had to re-style their business
proposition in a manner that they are insured against theproposition in a manner that they are insured against the
scope of natural catastrophes.scope of natural catastrophes.
Some businesses are also compelled to subscribe to theSome businesses are also compelled to subscribe to the
““weather risk insurance” before they can be consideredweather risk insurance” before they can be considered
eligible for financing by the banks or financial institutions.eligible for financing by the banks or financial institutions.

Other Lending Considerations
Some banks would not be prepared to lend to their corporate
customers, if they are not in possession of a rating from
either Standard & Poor's, or Moody’s.
Other consideration can also be linked to an assessment of
the sector, which the business operates. Is the sector in
growth stage, or decline?
The economic business cycle will also be one of the major
considerations, that will be assessed before a final decision
is reached.
Banks restraint its credit expansion, when the economy is
suffering from a downturn as opposed to an economic boom.

Credit risk assessment is no longer seen from the traditional
perspective that it should be considered in isolation.
The modern approach is to judge the credit risk from a total
risk model.
Such a model considers two categories of risks:
a) Systematic, and
b) Unsystematic.
This is due principally that a business is always subject
o the macro-economic environment that it operates in.
Within the macro-environment a business can simply
nherit risk, which cannot be diversified.

Systematic Risk
This type of risk is also referred as “undiversifiable” risk or
market risk, and sometimes also known as macro-economic
risk.
The macro-economic risk can embody:
1) Interest rate,
2) exchange rate, and
3) inflation.
A business including banks cannot avoid such risk because
t affects all enterprises, which operates within a particular
urisdiction.
That is, why the stocks have a tendency to move together.
nvestors are also exposed to “ market uncertainties” no
matter how many stocks they hold in their portfolios.

Unsystematic Risk
This type of risk is sometimes referred as “unique risk”.
It is particularly tied to the business specifics and some to
Its immediate competitors.
Such risk can be avoided and minimized, if the management
of a business is able to diversify the company’s activities
having paid due regards to the specific problems relating to
the business.
Examples:
• Company profit,
• Products/services,
• Geographical areas, the market where the company operates,
• Management issues, and
• Operating costs structure.

Total Risk = Systematic Risk + Unsystematic Risk
Market Risk
Company Specific Risk
GDP
Interest Rate
Exchange Rate
Inflation
• Cash Flow
• Borrowings
• Portfolio

Considerations to Systematic & Unsystematic Risk
It is very vital that when banks consider the credit or loan
application for its customers, that an overall picture of the
status of the economic environment is assessed.
This is principally due to whatever commercial strategies
are applied by a business or individual earning a salary from
his/her employer is subject to systematic risk.
We live in an economic environment, whereby the Govt of
day dictates the policy and measures to be adopted and
followed nationally.
A business would fail or succeed depending on how the
strategies are applied in the context of macro-economic
fundamentals.

Credit Risk Analysis
In today’s current economic turbulence, the credit risk
analysis by banks must be seen in a very wide context.
It is not a matter for the bankers to focus on the figures
and the personality of the borrower, but also assess the
risk dimensions surrounding the proposition as a whole.
Example:
What would be the impact of the interest rate changes do
to the cost of servicing the loan/facilities?
Is the borrower’s business heavily exposed to exchange
rate risk?
What about the trends in the industry, which the business
operates?
What if the key personnel leaves the business?

Credit Risk Analysis
Other Examples:
What is the existing commitment of the borrower?
What is the likely impact of weather conditions on the
borrower’s ability to survive?
Has the borrower made a plan, which takes into account
the state of the economy?
How is the business cycle likely to affect the borrower’s
income generation?
Is there any likely possibility that that taxation rate will
increase?
What is the level of competition in the market?
Who are the new entrants in the market?
Is there any possible threats coming from aggressive
bidder to take over the borrower’s business?

A key challenge in managing credit risk is the understanding
of the interrelationships of 9 risk factors:
Often risks will be either positively or negatively correlated
to one another.
Actions or events will affect correlated risks similarly.
(e.g. reducing the level of problem assets should reduce not only credit
risk, but also liquidity and reputation risk).
When two risks are negatively correlated, reducing one type
of risk may increase the other.
(e.g. a bank may reduce overall credit risk by expanding its holdings
of mortgage loans instead of commercial loans, only to see its interest
rate risk rise because of the interest rate sensitivity & option of
the mortgages).

The NINE type of risk connected with lending can
described as:
Credit risk,
Interest rate risk,
Liquidity risk,
Price risk,
Foreign exchange rate risk,
Transaction risk,
Compliance risk,
Strategic risk, and
Reputation risk.
Each of this type of risk will be considered individually.

Credit Risk
For most banks, loans are the largest and most obvious
source of credit risk.
There are also pockets of credit risk both on & off-balance
sheet of the banks (e.g. investment portfolio, overdrafts, & letters
of credit).
In addition products/services such as; derivatives, cash
management services, foreign exchange also expose a
bank to credit risk.
Here the risk of repayment i.e. possibility that an obligor
Will fail to perform as agreed, is either lessened or increased by a
bank’s credit risk management practices.

Interest Rate Risk
The level of interest rate risk attributed to the bank’s
lending activities depends on the composition of its loan
portfolio and the degree to which the terms of its loans
(i.e. rate structure, maturity, embedded options) expose the bank’s
revenue stream to changes in rates.
It is important that pricing and portfolio maturity decisions
should be made with an eye to funding costs and maturities.
Banks frequently shift interest rate risk to their borrowers
by structuring loans with variable interest rates.
Borrowers with marginal repayment capacity may experience
financial difficulty if the interest rates on these loans increase

Liquidity Risk
Because of the size of the loan portfolio, effective
management of liquidity risk requires that there be close ties
to and good information flow from the lending function.
Banks can use their loan portfolios as a source of funds by
reducing the total dollar volume of loans through sales,
securitization, and portfolio run-off.
Many larger banks have been expanding their underwriting
of loans for the loans syndicated market.
As part of the liquidity planning, bank’s overall liquidity
strategy should include loan portfolio segments that may be
easily converted into cash.

Price Risk
Most of the developments that improve the loan portfolio’s
liquidity have implications for price risk.
Traditionally, the lending activities of most banks were not
affected by price risk. This is due that loans were held to
maturity, accounting doctrine required book value
accounting treatment.
As banks develop more active portfolio management practice
and the market for loans expands and deepens, loan
portfolios will become increasingly sensitive to price risk.

Foreign Exchange Rate Risk
This type of risk is present when a loan or portfolio of loans
is denominated in foreign currency or is funded by
borrowings in another currency.
In some cases, banks will enter into multi-currency credit
commitments that permit borrowers to select the currency
they prefer to use in each rollover period.
Foreign exchange rate risk can be intensified by political,
social, or economic developments. The consequences can
be unfavourable if one of the currencies involved becomes
subject to stringent exchange controls or is subject to wide
exchange-rate fluctuations.

Transaction Risk
In the business of lending, transaction risk is present
primarily in the loan disbursement and credit administration
processes.
The level of transaction risk depends on the adequacy of
Information systems and controls, the quality of operating
procedures, the capability and integrity of employees.
Banks have and continue to experience credit risk when
information systems failed to provide adequate information
to identify concentrations, expired facilities, or stale
financial statements.

Compliance Risk
Lending activities encompass a broad range of compliance
responsibilities and risks.
By law, a bank must observe limits on its loans to a single
borrower, connected person, affiliates, limits on interest
rates and other regulatory limits imposed by the Central
bank or monetary authority.
A bank may also become the subject of borrower initiated
“lender liability” lawsuit for damages attributed to its
lending or collection practices.

Strategic Risk
A primary objective of the loan portfolio management is to
control the strategic risk associated with a bank’s lending
activities.
Inappropriate strategic or tactical decisions about under-
writing standards, loan portfolio growth, new loan products,
geographic markets can compromise a bank’s future.
These strategies require significant planning and careful
oversight to ensure the risks are appropriately identified
and managed.
It is important for bankers to decide whether the benefits
outweigh the strategic risk.

Reputation Risk
When a bank experiences credit problems, its reputation with
investors, the community, and even individual customers
usually suffers.
Inefficient loan delivery systems, failure to adequately meet
the credit needs of the community, and lender-liability
lawsuits are also examples of how a bank’s reputation can
be tarnished because of problems with its lending division.
Reputation risk can damage a bank’s business in many ways.
(e.g. share price falls, customers & community support is lost, and
business opportunities evaporate).
To protect this reputation, they often have to do more than
is legally required.

Understanding the credit culture and risk profile of a bank
Is central to successful loan portfolio management.
Because of the significance of a bank’s lending activities,
the influence of the credit culture frequently extends to
other banking activities.
It is important that staff members throughout the bank
should understand the bank’s credit culture and risk profile.
A bank’s credit culture is the sum of its credit values, beliefs
and behaviours. It is what is being done and how it is
accomplished. The credit culture exerts a strong influence
on a bank’s lending and credit risk management.

Two banks with identical levels of classified loans can have
quite different profiles.
Bank A’s classified loans might be fully secured and made
to borrowers within the local market, while Bank B’s loans
are made out-of-market, unsecured loan participations.
Consider as well how much more the failure of a US$3m
loan would hurt a US$500m bank than a US$5b bank.
The risk profile will change over time as the portfolio
composition and internal and external conditions change.
Credit culture vary from bank to bank – it is not all the same!

In addition to establishing strategic objectives for the loan
portfolio, senior management and the Board of Directors
are responsible to set the risk limits on the bank’s
lending activities.
Risk limits should take into account, the bank’s historic
loss experience, its ability to absorb future losses, and
the bank’s desired rate of return.
Limits may be set in various ways, individually and in
combination. (e.g. applied to a characteristic of loans, volume of
a particular segment of the portfolio, and the composition of the entire
loan portfolio).
Limits on loans to certain industries or on certain segment
should be set in line with its impact on the whole portfolio.

Name of Project Project Cost Financial Return Risk
Project X SR50,000 SR50,000 SR25,000
Project Y SR250,000 SR200,000 SR200,000
Project Z SR100,000 SR100,000 SR10,000
These are 3 mutually exclusive projects with their respective costs to
Implement, expected net returns (net of the costs to implement), and
risk levels (all in present values).
What if one of your customer is to present you with this scenario
for financing, which project would you finance?

The most likely informed decision, which a risk manager will take
depending, of course his attitude towards risk:
*For a budget-constrained manager, the cheaper the project the
better.
This will result him/her selecting Project X.
*The returns-driven manager will choose Project Y with the highest
returns, assuming that budget is not an issue.
Project Z will be chosen by the risk-averse manager as it provides
the least amount of risk while providing a positive net return.
What is interesting here is that with 3 different projects and 3
different managers, 3 different decisions will be made.
The typical question, which follows from this short overview drives
us to ask.
Which manager is correct, and Why?

Banking is both a risk-taking and profit-making business,
and bank loan portfolios should return profits which is
commensurate with their risk.
Although this concept is intellectually sound and almost
universally accepted by bankers, management have had
difficulty implementing it.
Over the years, volatility in banks’ earnings usually has
been linked to the loan portfolio.
While there are many contributing factors including market
forces, anxiety for income, poor risk management, a
common underlying factor has been banks’ tendency to
under-estimate or under price credit risk.

The price (index rte, spread, and fees) charged for an individual
credit should cover funding costs, overhead costs,
administrative costs, required profit margin, and a premium
for risk.
Funding costs are relatively easy to measure and build
into loan pricing, but measuring overhead and administrative
costs is sometimes more complicated because traditionally
banks have not had sophisticated accounting systems.
Recent developments in credit and portfolio risk
measurement and modeling are improving banks’ ability
to measure and price more precisely and are facilitating
the management of capital and the allowance for loan
and lease losses.

The loan policies vary from bank to bank. However, it is
generally understood that the underlying factors are
important considerations.
1) Loan authorities,
2) Limits on aggregate loans & commitments,
3) Portfolio distribution by loan category and product,
4) Geographic limits,
5) Desirable types of loans,
6) Underwriting criteria,
7) Financial information and analysis requirements,
8) Collateral and structure requirements,
9) Margin needed for profit per product,
10)Pricing guidelines,
11)Documentation standards, and
12)Collections & charge-offs guidelines.

Loan portfolio objectives establish specific, measurable
Goals for the portfolio. They are an out-grown of the credit
Culture and risk profile.
The Board of Directors must ensure that loans are made
With the following three basic objectives:
1) To grant loans on a sound and collectible basis,
2) To invest the bank’s funds profitably for the benefit of the
shareholders and to protect the depositors’ funds, and
3) To serve the legitimate credit needs for their communities.

n drawing the strategic plan, and objectives, the senior
Management and the Board of Directors should consider:
. Objectives for loan quality,
I. Loan product mix,
II. Targeted industries/businesses,
V. Targeted market share,
V. Customers needs and services,
VI. How much the portfolio should contribute to the bank’s
VII.Financial returns?
VIII.What proportion of the balance sheet assets will be
X. channel to loans,?
X. Objectives for portfolio diversification,
XI. Product specialization, and
XII.Loan growth targets (e.g. product, market, segment, areas).

The primary controls over a bank’s lending functions are
the credit risk management based on the following
principles
A.Independence,
B.Credit policy administration guidelines,
C.Loan review guidelines,
D.Audit of the transactions,
E. Administrative & documentation controls,
F. Use of external reporting (e.g. rating agencies, analysts,
Stock exchange reports, auditors report).

Independence
Independence is the ability to provide an objective report
of facts and to form impartial opinions.
Without independence, the effectiveness of control units
may be in jeopardy. It requires generally a separation of
duties and reporting lines.
Independence of the credit risk department of a bank
depends on the corporate culture and the promotion of
objective criticism within the bank so as to improve or
modernize the operations.

Credit Policy Administration Guidelines
The credit policy administration is responsible for the day-
o-day supervision of the loan policy.
f policy needs to be supplemented or modified, credit
policy administration drafts the changes for consideration
by the management and the Board of Directors.
Such a unit – if it exist, should establish a formal process
or developing, implementing and reviewing policy
directives from time to time.

Loan Review Guidelines
Loan review is a mainstay of internal control of the loan
portfolio.
Periodic reviews of credit risk levels and risk management
processes are essential to effective portfolio management.
To ensure the independence of loan review, the unit should
report administratively and functionally to the Board of
Directors or standing committee with audit responsibilities.

Audit of Transactions
Audit activities in lending departments usually focus on
he accounting controls in the administrative support
unctions.
While loan review has primary responsibility for evaluating
credit risk management controls, audit will generally be
responsible for validating the lending-related models.
Audits should be done at least annually and whenever
models are revised or replaced.

Administration & Documentation Controls
Credit administration is the operations arm of the lending
unction.
The responsibilities for credit risk administration vary from
bank to bank.
This is in line with the overall corporate objectives of the
bank in question.

Use of External Reports
The use of external reports is an invaluable tools for the
credit management department of a bank.
The report from a rating agency would indicate the degree
of risk, which the bank faces towards its clientele from
a macro-economic analysis viewpoint.
Likewise, reports from specialist analysts would indicate
the latest evaluation of a borrower’s performance.
The stock exchange should be able to indicate the latest
Share price and its forecast.
The auditors would alert the shareholders of the financial
standing of the borrower.

Credit risk for banks is a wide subject and it is still evolving
in many aspects either through new models, management,
or research of new information about the customers,
markets, products, or even about the banks’ themselves.
It is an interesting subject, but at the same time, no body
including myself would be able to predict default risk with
accuracy. There will always be a margin of error.
If your prediction is right, then you are 100% lucky.
We still learning this trade in the 21st
Century, and I hope
you have been able to learn something today from this
presentation.

I wish you all,
good luck
in your studies.

Credit risk management lecture

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