BBK3253 Risk Management Prepared by Dr Khairul Anuar L6 - Managing Credit Risk 23-0
Content 1. Credit risk definition 2. Credit risk in the banking sector 3. Credit Risk vs. Market Risk 4. Credit Products Loans vs. Bonds 5. Understanding Credit Risk A Simple Loan 6. Managing Credit Risk 23-1
1. Credit risk definition The potential for loss due to failure of a borrower to meet its contractual obligation to repay a debt in accordance with the agreed terms Example: A homeowner stops making mortgage payments Commonly also referred to as default risk Credit events include bankruptcy, failure to pay, loan restructuring, loan moratorium, accelerated loan payments For banks, credit risk typically resides in the assets in its banking book (loans and bonds held to maturity) Credit risk can arise in the trading book as counterparty credit risk 23-2
1. Credit risk definition Credit risk refers to the probability of loss due to a borrower s failure to make payments on any type of debt. Credit risk management, meanwhile, is the practice of mitigating those losses by understanding the adequacy of both a bank s capital and loan loss reserves at any given time a process that has long been a challenge for financial institutions. 23-3
2. Credit risk in the banking sector Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximise a bank's riskadjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Banks should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organisation. 23-4
2. Credit risk in the banking sector For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off the balance sheet. The banking book is an accounting term that refers to assets on a bank's balance sheet that are expected to be held to maturity. Banks are not required to mark these to market. Unless there is reason to believe that the counter-party will default on its obligation, they are held at historical cost. The trading book is also an accounting term that refers to assets held by a bank that are regularly traded. The trading book is required under Basel II and III to be marked to market daily. 23-5
2. Credit risk in the banking sector Banks are increasingly facing credit risk (or counterparty risk) in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions. Since exposure to credit risk continues to be the leading source of problems in banks world-wide, banks and their supervisors should be able to draw useful lessons from past experiences. 23-6
3. Credit Risk vs. Market Risk Market risk is the potential loss due to changes in market prices or values Assessment time horizon: typically one day Credit risk is the potential loss due to the non-performance of a financial contract, or financial aspects of non-performance in any contract Assessment time horizon: typically one year Credit risk is generally more important than market risk for banks 23-7
3. Credit Risk vs. Market Risk Many credit risk drivers relate to market risk drivers, such as the impact of market conditions on default probabilities. Differs from market risk due to obligor behaviour considerations The five C s of Credit Capital, Capacity, Conditions, Collateral, and Character 23-8
Steps in the Lending Process 1. Finding prospective loan customers 2. Evaluating a customer s character and sincerity of purpose 3. Making site visits and evaluating a customer s credit Record 4. Evaluating a prospective customer s financial condition 5. Assessing possible loan collateral and signing the loan Agreement 6. Monitoring compliance with the loan agreement and other customer service needs 23-9
Credit Analysis: What Makes a Good Loan? Is the Borrower Creditworthy? The Cs of Credit: Character - Specific purpose of loan and serious intent to repay the loan Capacity - Legal authority to sign binding contract Cash - Ability to generate enough cash to repay loan Collateral - Adequate assets to support the loan Conditions - Economic conditions faced by borrower Control - Does loan meet written loan policy and how would loan be affected by changing laws and regulations 23-10
4. Credit Products Loans vs. Bonds Loans A contractual agreement that outlines the payment obligation from the borrower to the bank May be secured with either collateral or payment guarantees to ensure a reliable source of secondary repayment in case the borrower defaults Often written with covenants that require the loan to be repaid immediately if certain adverse conditions exist, such as a drop in income or capital Generally reside in the bank s banking book or credit portfolio Although banks may sell loans another bank or entity investing in loans 23-11
4. Credit Products Loans vs. Bonds Bonds A publicly traded loan an agreement between the issuer and the purchasers Collateral support, payment guarantees, or secondary sources of repayment may all support certain types of bonds Structuring characteristics that determine a bond investor s potential recovery in default Generally reside in the bank s trading book 23-12
5. Understanding Credit Risk A Simple Loan Contractually, how a loan should work: 23-13
5. Understanding Credit Risk A Simple Loan Credit risk arises because there is the possibility that the borrower will not repay the loan as obligated 23-14
6. Managing Credit Risk The following 2 concepts will provide a framework to understand the principles financial managers must follow to minimize credit risk, yet make successful loans: adverse selection and moral hazard 23-15
6. Managing Credit Risk Adverse selection - refers to a market process in which undesired results occur when buyers and sellers have asymmetric information (access to different information); the "bad" products or services are more likely to be selected. A moral hazard is a situation in which a party is more likely to take risks because the costs that could result will not be borne by the party taking the risk. In other words, it is a tendency to be more willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place. Information asymmetry there is always a gap what insiders and outsiders know about a company. Since outsiders don t know as much about a company as insiders, a good reputation alleviates and allow customers to make a choice. More important in a period of rapid changes, globalization, internet blogs, activism, mass media. 23-16
6. Managing Credit Risk Solving Asymmetric Information Problems: 1. Screening and Monitoring: collecting reliable information about prospective borrowers. This has also lead some institutions to specialize in regions or industries, gaining expertise in evaluating particular firms also involves requiring certain actions, or prohibiting others, and then periodically verifying that the borrower is complying with the terms of the loan contract. 23-17
6. Managing Credit Risk Specialization in Lending helps in screening. It is easier to collect data on local firms and firms in specific industries. It allows them to better predict problems by having better industry and location knowledge. 23-18
6. Managing Credit Risk Monitoring and Enforcement also helps. Financial institutions write protective covenants into loans contracts and actively manage them to ensure that borrowers are not taking risks at their expense. 23-19
6. Managing Credit Risk 2. Long-term Customer Relationships: past information contained in checking accounts, savings accounts, and previous loans provides valuable information to more easily determine credit worthiness. 23-20
6. Managing Credit Risk 3. Loan Commitments: arrangements where the bank agrees to provide a loan up to a fixed amount, whenever the firm requests the loan. 4. Collateral: a pledge of property or other assets that must be surrendered if the terms of the loan are not met ( the loans are called secured loans). 23-21
6. Managing Credit Risk 5. Compensating Balances: reserves that a borrower must maintain in an account that act as collateral should the borrower default. 6. Credit Rationing: lenders will refuse to lend to some borrowers, regardless of how much interest they are willing to pay, or lenders will only finance part of a project, requiring that the remaining part come from equity financing. 23-22