credit risk management in banking: a case for credit friendliness

FAC IL ITATOR: Sam OMOLE

CREDIT RISK MANAGEMENT

IN

BANKINGA CASE FOR CREDIT FRIENDLINESS

A SHORT COURSE

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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 .


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 .


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 ?


• 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 ?


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 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


• 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


• 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 SS 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 TA L C O N S I D E R AT 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 AT 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 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


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


• 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 )


• 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 )


• 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 )


• 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 )


• 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 )


• 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: [email protected] W: www.wise-plannerconsulting.com

THANK YOU

credit risk management in banking: a case for credit friendliness

Economy & Finance