7- credit risk

7/31/2019 7- Credit Risk

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Credit Risk


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Asset Management(ie. Credit Risk Management)

What are the assets of a Bank?

Credit risk of liquid assets is typically not that

important. Why?Credit risk of fixed assets is typically notrelevant

Credit risk in lending is the key issue

Are there any other sources of credit risk?


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Credit Risk And The CARArrangements

A very simplistic approach to credit risk

Different categories of business areweighted according to credit risk

What are the categories and what are the

weighting's?

Some changes currently being considered


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How Important Is TheManagement Of Credit Risk?

In comparison to the management of other risks

As a factor in Bank failure

As a factor influencing Bank performance


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Basic Faults in Lending

Procedures1) Inattention to loan policies2) Overly generous loan terms and lack of clearstandards

3) Disregard of banks own policies 4) Unsafe concentration of credit5) Poor control over loan personnel6) Loan growth beyond the banks ability tocontrol quality7) Poor systems for detecting loan problems8) Lack of understanding of borrowers creditneeds9) Out-of-market lendings


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Basel on Credit Risk

Credit Risk the risk of counterpartydefault usually represents the single

largest risk facing an Bank. The presenceof a well-functioning credit risk management system is, therefore,fundamental to the safety and soundness of

an Bank. Credit risk management systemis the responsibility of the top managementand must include methodologies tomonitor and measure credit risk.


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The Management Of Credit Risk (Compared To Other Risks)

Inherently more difficult than managingother risks

The example of managing

liquidity risk

capital risk


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Credit Risk Management

A Banks loan portfolio is the product of largenumbers of individual lending decisions

These decisions involve a large number of different lending officers


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Credit Risk Management

Therefore, coordination is crucial

Without coordination, a Bank cannotcontrol its level of credit risk (or its risk-return tradeoff)


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A Management System ForControlling Credit Risk

Credit philosophy and culture

What are the characteristics of a good creditculture?

Organisation of lending

Loan policy and procedures formulation


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Credit Philosophy and Culture

The credit philosophy (thinking) and loanpolicy must be supported by andcommunicated through an appropriatecredit culture.The credit philosophy of an organizationwill be largely dependent on the profitexpectations of owners and shareholders.An effective credit culture exists when thebehavior of every individual in the loanorganization is closely aligned withmanagements priorities.


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Organisation of lending

Board ofDirectors

ExecutiveManagement

Directors Loan

Committee

Directors audit

Committee

Audit

Department

Loan

Review

Credit

Department

Officers Loan

Committee

Senior loanOfficer

CreditAnalysis Securities

ConsumerLendingDivision

CorporateServices

OtherLendingDivision

InternationalDivision

CommercialLendingDivision


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Cash Flows For Loan Repayment -Three Potential Sources

What are they?They are expected future cash flows andthey can come from the following

sourcesCash Flow from operations (ie. P/L)Cash Flow from sale of an asset. (ie.B/S - asset)Cash Flow from other financing (ie. B/S- liability)


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First Way Out Versus Second WayOut

Cash flow from operations is typicallyregarded as the first way out for anyloan

Cash flow from sale of an asset istypically regarded as the second way outfor any loan


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Why Should Cash Flow FromOperations Be Regarded As TheFirst Way Out?

Relates to the underlying logic behinda loanThat is, an individual borrows $400k now to buy a printing businessThe business will generate cash flowinto the future which will be used torepay the $400k loanThis is a simple exercise inredistributing cash flows through time


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Why Should Cash Flow FromOperations Be Regarded As The

First Way Out (contd)? Berry et.al. (p.10) refers to this as thegoing concern approach to lending What are the alternatives?Security-based lending!

Note that cash flow from other

funding is often unattractive becauseit is frequently a case of sendinggood money after bad


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What Is The Logic BehindSecurity-Based Lending?

You can have $400k to buy thisprinting businessBut our assessment is that there isno way that the expected cash flowsgenerated by the business will besufficient to repay the loanIn any case we are not at risk because when you default we willsell your house to repay the debt


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Flaws In Security-Based Lending -1. The Courts Reaction

Not surprisingly, the courts take avery poor view of this style of lendingFrequently results in court decisionsagainst the lenderParticularly where the security isthird party guarantee security (eg.parents house as security for theson/daughter to borrow the $400K)


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Flaws In Security-Based Lending -2. The Lenders Reaction

Security-based lending is frequentlyunprofitable for the lender

There are substantial costs involvedin realising on security


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Flaws In Security-Based Lending -3. The Customers Reaction

Not conducive to a long termprofitable relationship

Inevitably creates ill-will with thecustomer

Can lead to damaging publicity


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Taking Stock - Four Reasons WhyCash Flow From Operations Is

Regarded As The First Way Out?

The logic of lending

Costs of realising on security

The courts reaction

The customers reaction


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Why Is Security RegardedAs The Second Way Out?

Acts as a form of insurance

Reduces the level of certaintyrequired with the first way out

The idea of belt and braces lending

Ideally the second way out should beindependent of the first way out


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Some Key Accounting Concepts

Bad and doubtful debts

P&L charge (expense) to provide fordoubtful debts

B/S provisions for doubtful debts

General Specific


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Specific Provisions

When a doubtful debt is identified, aspecific provision equal to its amount is

created

When it is identified as bad, it is

written off against this provision


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General Provisions

Covers bad debts inherent in the loanportfolio but not yet specificallyidentified and provided for

No bad debts are written off against this

general provision


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Doubtful Debt Expense In P&L

Includes charges for general provisions

and specific provisions


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Non-Accrual Items

Applies to those facilities on whichincome may no longer be accrued aheadof its receiptKey element - any facility where there isreasonable doubt about the collectabilityof P&I

Can involve a specific provision beingraised


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Restructured Items

Where the original contractual terms havebeen modified to provide for concessions

of P or I related to the financialdifficulties of the customer

Examples


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Assets Acquired Through SecurityEnforcement

Where an asset has been acquired throughsecurity enforcement, or

Where a Bank assumes ownership of anasset in settlement of all or part of a debt

Why should these assets be included aspart of impaired assets?

7- credit risk

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