skye bank

FA C I L I TAT O R : S a m O M O L E

CREDIT RISK MANAGEMENT

IN

BANKING

A C A S E F O R C R E D I T F R I E N D L I N E S S

A SHORT COURSE

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T H E B U S I N E S S O FB A N K I N G I S A L W A Y 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 L T 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 A T T E R S A R I S 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 F A C E D B Y B A N K S .


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 A T I S C R E D I T R I S K ?


• 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 RISK

Suppose, 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 R T A N T ?


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


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


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


• 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


• 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 P A Y M E N T C A P A C I T Y O F T H E B O R R O W E R


• 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 A T I O N O F T H E L O A N / C R E D I T


• 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


• 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


• 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


• 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 S S P L A N S & P R O J E C T I O N S


• 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 T A L C O N S I D E R A T I O N S


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 A T I O N S


• 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


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 )


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?


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 S S O C I A T E D W I T H L E N D I N G : T H E 9 R I S K S F A C T O R S


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 R Y C O N T R O L


• 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 R Y C O N T R O L ( I N D E P E N D E N C E )


• 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 R Y 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 A T I O N G U I D E L I N E S )


• 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 R Y 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 )


• 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 R Y 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 )


• 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 R Y C O N T R O L ( A D M I N I S T R A T I V E & D O C U M E N T A T I O N C O N T R O L S )


• 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 R Y 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: [email protected]

W: www.wise-plannerconsulting.com

THANK YOU

skye bank

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