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 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 Credit Risk Management in Banking Industry 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 Credit Risk Management in Banking Industry 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 Credit Risk Management in Banking Industry Definition of Credit ItRisk 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 Credit Risk Management in Banking Industry 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 years I start repaying for the first 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 Works heet Credit Risk Management in Banking Industry 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 Credit Risk Management in Banking Industry 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 Credit Risk Management in Banking Industry 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 Credit Risk Management in Banking Industry 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 Credit Risk Management in Banking Industry 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 Credit Risk Management in Banking Industry 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) Credit Risk Management in Banking Industry 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) Credit Risk Management in Banking Industry 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 Risk Management in Banking Industry Credit Policy Administration Guidelines The credit policy administration is responsible for the dayto-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 for developing, implementing and reviewing policy directives from time to time Credit Risk Management in Banking Industry 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 Credit Risk Management in Banking Industry Audit of Transactions Audit activities in lending departments usually focus on the accounting controls in the administrative support functions 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 Credit Risk Management in Banking Industry Administration & Documentation Controls Credit administration is the operations arm of the lending function 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 Credit Risk Management in Banking Industry 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 Management in Banking Industry 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 Credit Risk Management in Banking Industry I wish you all, good luck in your studies Credit Risk Management in Banking Industry Credit Risk Management in Banking Industry ... 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 Credit Risk Management. .. the risk/ reward position Credit Risk Management in Banking Industry OPERATIONAL RISKS Credit Risk Trading Risk Concentration Risk Earnings at Risk Funding & Liquidity Risk Value at Risk. .. Valuation • Value-at -Risk (VaR) • Portfolio Management Credit Risk Management in Banking Industry MODERN CREDIT MANAGEMENT SETTING Credit Trading Book Credit Modeling Portfolio Valuation Credit Evaluation