credit risk management in banking: a case for credit friendliness
Post on 06-Apr-2017
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FAC IL ITATOR: Sam OMOLE
CREDIT RISK MANAGEMENT
IN
BANKINGA CASE FOR CREDIT FRIENDLINESS
A SHORT COURSE
This document contains confidential and proprietary information. It is furnished for evaluation purpose only. Except with the prior written permission this document and the information contained herein may not be published, disclosed, or used for any other purpose.
T H E B U S I N E SS O FB A N K I N G I S A LW AY S T I E D T O A M U LT I T U D E O F R I S K S .
W I S E P L A N N E R C O N S U LT I N G
COURSE FOCUS
• Risks In Banking: New Matters Arising
• Why Is Credit Risk Important?
• Credit Risk Analysis
• Credit Risk Management
R I S K S I N B A N K I N G : N E W M AT T E R S A R I S I N G .
W I S E P L A N N E R C O N S U LT I N G
Banking transactions are becoming more complex due to these factors:
customers’ expectations,
competition between the financial services
providers,
changes in demography,
changes in the financial services market, and
structural adjustments in the economy.
CUSTOMERS: Want more benefits
BANKS: Must balance risk/reward
R I S K S FA C E D BY B A N K S .
W I S E P L A N N E R C O N S U LT I N G
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
W H AT I S C R E D I T R I S K ?
W I S E P L A N N E R C O N S U LT I N G
• 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.
A TYPICAL EXAMPLE OF CREDIT RISKSuppose, I take a loan of NGN100,000 from SKYE bank at the interest rate of 5% per annum for a period of 2 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 SKYE bank?
b) How it would impact on the liquidity of the bank?
W H Y I S C R E D I T R I S K I M P O RTA N T ?
W I S E P L A N N E R C O N S U LT I N G
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:
• INVESTMENT PORTFOLIO,
• OVERDRAFTS,
• LETTERS OF CREDITS (L/CS), AND
• GUARANTEES.
Without systematic credit appraisal system in place, the bank is likely to become heavily exposed to credit risk.
F I R S T L I N E O F D E F E N C E A G A I N S T C R E D I T R I S K
W I S E P L A N N E R C O N S U LT I N G
A bank’s first line of defence against excessive credit
risk
is the initial credit-granting process involving:
1) sound underwriting standards,
2) an efficient and balanced approval process, and
3) a competent lending staff.
C R E D I T R I S K A N A LY S I S
W I S E P L A N N E R C O N S U LT I N G
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.
C R E D I T R I S K A N A LY S I S :P U R P O S E O F T H E L O A N / C R E D I T
W I S E P L A N N E R C O N S U LT I N G
• 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.
• 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,).
• The purpose of the loan/credit must be clear from the
outset once the borrower submits his/her application.
C R E D I T R I S K A N A LY S I S :A M O U N T R E Q U I R E D
W I S E P L A N N E R C O N S U LT I N G
• 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.
C R E D I T R I S K A N A LY S I S :R E PAY M E N T C A PA C I T Y O F T H E B O R R O W E R
W I S E P L A N N E R C O N S U LT I N G
• 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.
C R E D I T R I S K A N A LY S I S :D U R AT I O N O F T H E L O A N / C R E D I T
W I S E P L A N N E R C O N S U LT I N G
• The time it takes to service a loan/credit cannot
exceed a Bank’s normal credit policy.
• 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.
C R E D I T R I S K A N A LY S I S :B O R R O W E R ’ S C O N T R I B U T I O N
W I S E P L A N N E R C O N S U LT I N G
• 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. It is also an indication as to the strength
of the entire business concept.
C R E D I T R I S K A N A LY S I S :S E C U R I T Y A S P E C T S & I N S U R A N C E P R O T E C T I O N
W I S E P L A N N E R C O N S U LT I N G
• 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.
C R E D I T R I S K A N A LY S I S :B O R R O W E R ’ S C H A R A C T E R
W I S E P L A N N E R C O N S U LT I N G
• This is 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.
C R E D I T R I S K A N A LY S I S :B U S I N E SS P L A N S & P R O J E C T I O N S
W I S E P L A N N E R C O N S U LT I N G
• 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.
C R E D I T R I S K A N A LY S I S :E N V I R O N M E N TA L C O N S I D E R AT I O N S
W I S E P L A N N E R C O N S U LT I N G
The last decade saw the conservation/protection of the
environment taking centre stage in business decisions.
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 act like good corporate citizen
by refusing to lend to projects, which are not friendly
to the environment.
C R E D I T R I S K A N A LY S I S :O T H E R C O N S I D E R AT I O N S
W I S E P L A N N E R C O N S U LT I N G
• Some banks would not be prepared to lend to their
corporate customers, if they are not in possession of
a good credit rating from a rating agency.
• 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.
C R E D I T R I S K A N A LY S I S :T H E Q U E S T I O N S
W I S E P L A N N E R C O N S U LT I N G
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.
EXAMPLES
1. What would be the impact of the interest rate
changes do to the cost of servicing the loan/facilities?
2. Is the borrower’s business heavily exposed to
exchange rate risk?
3. What about the trends in the industry, which the
business operates?
4. What if the key personnel leaves the business?
C R E D I T R I S K A N A LY S I S :T H E Q U E S T I O N S ( 2 )
W I S E P L A N N E R C O N S U LT I N G
EXAMPLES contd.
5. What is the existing commitment of the borrower?
6. What is the likely impact of weather conditions on the
borrower’s ability to survive?
7. Has the borrower made a plan, which takes into
account the state of the economy?
8. How is the business cycle likely to affect the
borrower’s income generation?
9. Is there any likely possibility that that taxation rate
will increase?
10. What is the level of competition in the market?
11. Who are the new entrants in the market?
12. Is there any possible threats coming from aggressive
bidder to take over the borrower’s business?
W I S E P L A N N E R C O N S U LT I N G
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. The NINE type of risk connected with lending
can described as:
1) Credit risk,
2) Interest rate risk,
3) Liquidity risk,
4) Price risk,
5) Foreign exchange rate risk,
6) Transaction risk,
7) Compliance risk,
8) Strategic risk, and
9) Reputation risk.
R I S K A SS O C I AT E D W I T H L E N D I N G : T H E 9 R I S K S FA C T O R S
W I S E P L A N N E R C O N S U LT I N G
The primary controls over a bank’s lending functions are
the credit risk management based on the following
principles
1. Independence,
2. Credit policy administration guidelines,
3. Loan review guidelines,
4. Audit of the transactions,
5. Administrative & documentation controls,
6. Use of external reporting (e.g. rating agencies,
analysts, Stock exchange reports, auditors
report).
C R E D I T R I S K M A N A G E M E N T: T H E P R I M A RY C O N T R O L
W I S E P L A N N E R C O N S U LT I N G
• 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.
C R E D I T R I S K M A N A G E M E N T: T H E P R I M A RY C O N T R O L ( I N D E P E N D E N C E )
W I S E P L A N N E R C O N S U LT I N G
• The credit policy administration is responsible for the
day- to-day supervision of the loan policy.
• If 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.
C R E D I T R I S K M A N A G E M E N T: T H E P R I M A RY C O N T R O L ( C R E D I T P O L I C Y A D M I N I S T R AT I O N G U I D E L I N E S )
W I S E P L A N N E R C O N S U LT I N G
• 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.
C R E D I T R I S K M A N A G E M E N T: T H E P R I M A RY C O N T R O L ( L O A N R E V I E W G U I D E L I N E S )
W I S E P L A N N E R C O N S U LT I N G
• 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.
C R E D I T R I S K M A N A G E M E N T: T H E P R I M A RY C O N T R O L ( A U D I T O F T H E T R A N S A C T I O N S )
W I S E P L A N N E R C O N S U LT I N G
• 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.
C R E D I T R I S K M A N A G E M E N T: T H E P R I M A RY C O N T R O L ( A D M I N I S T R AT I V E & D O C U M E N TAT I O N C O N T R O L S )
W I S E P L A N N E R C O N S U LT I N G
• 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.
C R E D I T R I S K M A N A G E M E N T: T H E P R I M A RY C O N T R O L ( USE OF EXTERNAL REPORTING )
Wise Planner Consulting43, AfriBank Street,
Victoria Island,Lagos, Nigeria.
M: +234 (0)70 406 03344E: info@wiseplannerconsulting.com W: www.wise-plannerconsulting.com
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