CHAPTER 2 THEORITICAL FOUNDATIONS Definition of Risk

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1 CHAPTER 2 THEORITICAL FOUNDATIONS 2.1. Definition of Risk Risk has the variety definition each person; there will be vary to other. According to Gallati (2003, h.7) risk define as a condition in which there are exist an exposure to adversity. According to Bessis (2002; 11) risk define as uncertainties resulting in adverse variations of probability or in losses. It is mean that risk is probability and uncertain, it will result on the gain but also result on losses. According to Workbook level 1 Global Association of Risk Professionals Badan Sertifikasi Manajemen Risiko (2005:A.4) risk define as chance of a bad outcome. In finance, credit is the granting of a loan and the creation of debt. Any movement of financial capital is normally quite dependent on credit, which in turn is dependent on the reputation or creditworthiness of the entity which takes responsibility for the funds Credit Definition of Credit Definition of credit may vary one to other. There are some of the definition of credit by some of the people listed in Credit Management Handbook Veithzal Rivai and Andria Permata Rivai (2006; 4). There are: Credit may be defined as the right to receive payment or the obligation to make payment on demand or at some future time on account of an immediate transfer of goods (Raymond P. Kent, 1961). Credit in economics and finance, refers to the faith that creditor (lender) places in a debtor (borrower) by extending him loan (encyclopedia Americana, 1980). 5

2 The word credit has many meanings, but in economics it usually refers to the ability to obtain something of value in the present in return for a promise to pay for it at some future time, combining the elements of a promise and of time (Charles L. Prather, 1961). credit may be appropriately described as the transmittal of economic value now, on faith, in return for an expected equivalent economic value in the future. (National Association of Credit Management, 1965) Credit in general is the ability to obtain goods, service, or money now in exchange for promise of payment in the future, (Christine Ammer and Dean S. Ammerm 1979). Credit and its opposite, debt, are transactions in which command over resources is obtained in the present in exchange for a promise to repay in the future, normally with a payment of interest as compensation to the lender (encyclopedia of Economics, 1982) Differences of Credit According to the Veithzal Rivai and Andria Permata Rivai (2006;11-41) there are several types of credit defining by purpose, term of credit, the institution that accept the credit, economic sector, characteristic, shape, resource fund, collateral, the person and the place Credit Risk In the Pedoman Standar Penerapan Manajemen Risiko bagi Bank Umum from Bank Indonesia, credit risk defined as the risk result from the failure of the counterparty to fulfill their duty or liability. Credit risk can be comes from the functional activities bank such as funding, treasury and investment, and trading expenditure, which recorded in banking book or even trading book. 6

3 2.4. Customer Loan Request Process The customer loan request process first come by obtaining the credit information of the customer. Here the customers ask to fulfill their background about his/her demography and financial condition. After the bank have the credit information of the customer, the credit officer do his/her job by analyze the credit application from the credit information given. Then the credit decision result from the credit analysis by the credit officer. There will be two possible outputs there, revise terms of credit or directly convey decision to borrower. When the output is revised terms of credit, it means that the customer must revise its terms of credit that it back again to the credit analysis step. When the output is convey decision to the borrower, there will be two decisions that are accept or reject its credit application. Revise Terms Obtain Credit Information Credit Analysis Credit Decision Convey Decision to Borrower Figure 2.1 Customer Loan Request Process (Hempel, Coleman and Simonson (1986; 415)) 2.5. Quality Of Credit (Collectability) Figure 2.1 Collectability Term 7

4 The quality of credit intuitively based on the probability of risk arise concerning of bank because of the condition and compliance of customer in term of their duty to pay their interest loan, annually pay their loan until it paid completely to the bank. There are qualifications in determining the quality of the credit. Table 2.1 Collectability Description Collectability Score Term Description 1 Pass Pay its annual payment and its interest on time. Have the active account in the bank Some of the credit use cash for the collateral Special Mention Sub Standard Doubtful Loss Do not pay its annual payment and its interest for less than 90 days. Have the relatively active account in the bank Rare happen the violation of the contract Support by new credit applied Do not pay its annual payment and its interest for more than 90 days until 180 days. Have the relatively low active account in the bank There is violation happen of the contract for more than 90 days There are indications of customer s financial problems Weak on the credit documentation Do not pay its annual payment and its interest for more than 180 days until 270 days. Interest capitalization There is violation happen of the contract for more than 180 days Weak on the credit documentation Do not pay its annual payment and its interest for more than 270 days. Operational loss fulfill by the new credit applied From the side of law and market, the collateral cannot be sold in the appropriate price 8

5 2.6. Type On Credit Analysis According to Hempel, Coleman and Simonson (1986; ) there are two types of credit analysis, that are judgmental credit analysis and empirical credit analysis. Judgmental Credit Analysis The judgmental system of consumer credit analysis relies on the consumer loan officer s experience and insight when appraising a borrower s ability and willingness to repay. This evaluation is similar to the evaluation of a business loan at perhaps a lower level sophistication. As in commercial lending, the consumer loan officer also must assess the applicant s character, use of fund, primary source of repayment, and any secondary or collateral sources of repayment. In the judgmental method credit analysis, character can be evaluated from the applicant s credit history and from the degree of dependability demonstrated through length and consistency of employment, length and type of residency, apparent sincerity, and other factor. The applicant s income is almost always the primary source of the repayment of the consumer loans. Income, of course, must be adequate in relation to the borrower s debts and other financial obligations. The loan officer must also evaluate secondary sources of repayment and establish the present and probable future value of collateral offered. Empirical Credit Analysis Empirical consumer credit analysis, also known as credit scoring, assigns point values to various applicant characteristics. The points are added to award the applicant a numerical score, which is then compared with a predetermined accept reject score, and credit is denied those whose scores are below this. 9

6 Unlike judgmental systems, empirical systems of analysis can consider age, but only as a positive factor. The objective of credit scoring is to predict whether a borrower is a good (creditworthy) or bad (not creditworthy) risk, based on certain characteristics. In Pedoman Standar Penerapan Manajemen Risiko bagi Bank Umum from Bank Indonesia (2003), bank in Indonesia can use system and statistic or probabilistic methodology to measure risk related to certain type from the credit risk transaction. In the use of the system, bank must control and annually recheck the model accuracy and assumption that used to predict the loss and adapt the assumption with the internal and external changes. From International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version, June 2006 by the Basel Committee on Banking Supervision, it apply to statistical models and other mechanical methods used to assign borrower or facilities ratings or in estimation of the loss. Credit scoring models and other mechanical rating procedures generally use only a subset of available information. Although mechanical rating procedures may sometimes avoid some of the idiosyncratic errors made by rating systems in which human judgment plays a large role, mechanical use of limited information also is a source of rating errors. Credit scoring models and other mechanical procedures are permissible as the primary or partial basis of rating assignments, and may play a role in the estimation of loss characteristics. Sufficient human judgment and human oversight is necessary to ensure that all relevant and material information. Including that, which is outside the scope of the model, is also taken into consideration, and that the model is used appropriately. The burden is on the bank to satisfy its supervisor that a model or procedure has good predictive power and that regulatory capital requirements will not be distorted as a result of its use. The variables that are input to the model must from a reasonable set of predictors. 10

7 The model must be accurate on average across the range of borrowers or facilities to which the bank is exposed and there must be known material biases. The bank must have in place a process for vetting data inputs into a statistical default or loss prediction model which includes an assessment of the accuracy, completeness and appropriateness of the data specific to the assignment of an approved rating. The bank must demonstrate that the data used to build the model are representative of the population of the bank s actual borrowers or facilities. When combining model results with human judgment, the credit officer must take into account of all relevant and material information not considered by the model. The bank must have written guidance describing how human judgment and model result are to be combined. The bank must have procedures for human review of model-based rating assignments. Such procedures should focus on finding and limiting errors associated with known model weaknesses and must also include credible ongoing effort to improve the model s performance. The bank must have a regular cycle of model validation that includes monitoring of model performance and stability; review of model relationships; and testing of model outputs against outcomes Personal Credit Risk According to Masyhud Ali (2006: ), if the financial information availability about customer s account has spread widely in the bank it will easier the bank to give the banking service for the customer (even though it can be used in the developed countries). The easier have result the competition each bank in limited consumer credit market that push the development of using the credit scoring models. Besides, the characteristic of retail banking business as identified by Basel Committee push the need of credit scoring models applied. The characteristic as the homogeneous portfolio result the application of the credit scoring models is become relevant and represent as the analysis tool for personal loan proposal. 11

8 2.8. Özlem Özdemir s Paper The paper done by Özlem Özdemir explores the relationship between consumer credit clients payment performance. More specifically, this study aims to examine the relationship between the consumer credit clients payment performance and some demographic variables (such as marital status, sex, age, residential status, occupation) and some financial variables (such as income, loan size, interest rate, maturity, credit category). Data to examine this relationship is obtained from the customer records of a private bank in Turkey. A logistic binary regression is used to evaluate the data The Model Özlem Özdemir constructed a conceptual model to explain the relationship between consumer credit clients payment performance and credit category, interest rate, sex, age, marital status, income, loan size, maturity, residential status and occupation. The equation of the model is as follows: Payment performance = β0 + β1 Credit Type + β2 Interest + β3 Sex + β4 Age+ β5 Marital Status +β6 Income +β7 Principal + β8 Number of Payments + β9 Residential Status + β10 Occupation + E The Result The result from the Özlem Özdemir research is financial variables rather than the demographic characteristics of clients have a significant influence on customers pay back performance. Thus, the longer the maturity time, the higher the interest rate, and the higher the credit default risks. This suggests bankers apply appropriate adjustments to financial variables in order to minimize credit default risk. 12