Credit Risk Credit Risk Dr Said Abu JalalaDr Said Abu Jalala

IntroductionIntroduction

Financial institutions have faced difficulties over Financial institutions have faced difficulties over the years for a multitude of reasonsthe years for a multitude of reasons

The major cause of serious banking problems The major cause of serious banking problems continues to be directly related to low credit continues to be directly related to low credit standards for borrowers and counterparties, standards for borrowers and counterparties, poor portfolio risk management, or a lack of poor portfolio risk management, or a lack of attention to changes in economic or other attention to changes in economic or other circumstances that can lead to a deterioration circumstances that can lead to a deterioration in the credit standing of a bank's counterpartiesin the credit standing of a bank's counterparties

Definitions

Credit riskCredit risk is the risk of loss due to a debtor's is the risk of loss due to a debtor's non-payment of a loan or other line of credit non-payment of a loan or other line of credit (either the principal or interest or both).(either the principal or interest or both).

Credit risk is most simply defined as the Credit risk is most simply defined as the potential that a bank borrower or potential that a bank borrower or counterparty will fail to meet its counterparty will fail to meet its obligations in accordance with agreed obligations in accordance with agreed termsterms. .

Sources of Credit RisksSources of Credit Risks

Exposure to credit risk continues to be the leading Exposure to credit risk continues to be the leading source of problems in banks worldsource of problems in banks world--wide, banks and wide, banks and their supervisors should be able to draw useful their supervisors should be able to draw useful lessons from past experienceslessons from past experiences. .

Banks should now have a keen awareness of the Banks should now have a keen awareness of the need to identify, measure, monitor and control credit need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate risk as well as to determine that they hold adequate capital against these risks and that they are capital against these risks and that they are adequately compensated for risks incurredadequately compensated for risks incurred..

Risks faced by lenders to consumersRisks faced by lenders to consumersMost lenders employ their own (Credit Scorecards) Most lenders employ their own (Credit Scorecards) models to rank potential and existing customers models to rank potential and existing customers according to risk, and then apply appropriate according to risk, and then apply appropriate strategies. strategies.

With products such as unsecured personal loans or With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher mortgages, lenders charge a higher price for higher risk customers and vice versa.risk customers and vice versa.

With revolving products such as credit cards and With revolving products such as credit cards and overdrafts, risk is controlled through careful setting of overdrafts, risk is controlled through careful setting of credit limits. credit limits.

Some products also require security, most commonly Some products also require security, most commonly in the form of property.in the form of property.

Risk faced by lenders to businessRisk faced by lenders to business Lenders will trade off the cost/benefits of a loan Lenders will trade off the cost/benefits of a loan according to its risks and the interest charged. But according to its risks and the interest charged. But interest rates are not the only method to compensate interest rates are not the only method to compensate for risk. Protective covenants are written into loan for risk. Protective covenants are written into loan agreements that allow the lender some controls. These agreements that allow the lender some controls. These covenants may:covenants may:

- limit the borrower's ability to weaken his balance - limit the borrower's ability to weaken his balance sheet voluntarily e.g., by buying back shares, or paying sheet voluntarily e.g., by buying back shares, or paying dividends, or borrowing further. dividends, or borrowing further.

- allow for monitoring the debt by requiring audits, and - allow for monitoring the debt by requiring audits, and monthly reports.monthly reports.

- allow the lender to decide when he can recall the loan - allow the lender to decide when he can recall the loan based on specific events or interest coverage based on specific events or interest coverage deteriorate.deteriorate.

Risks faced by lenders to businessRisks faced by lenders to business

A recent innovation to protect lenders A recent innovation to protect lenders from the danger of default are credit from the danger of default are credit derivatives, most commonly in the form derivatives, most commonly in the form of a credit default swap. These financial of a credit default swap. These financial contracts allow companies to buy contracts allow companies to buy protection against defaults from a third protection against defaults from a third party, the protection seller. The party, the protection seller. The protection seller receives a periodic fee protection seller receives a periodic fee (the credit spread) as compensation for (the credit spread) as compensation for the risk it takes, and in return it agrees to the risk it takes, and in return it agrees to buy the debt should a credit event buy the debt should a credit event ("default") occur.("default") occur.

Risks faced by business Companies carry Companies carry credit riskcredit risk when, for example, they when, for example, they do not demand up-front cash payment for products or do not demand up-front cash payment for products or services.services.

By delivering the product or service first and billing the By delivering the product or service first and billing the customer later - if it's a business customer - the customer later - if it's a business customer - the company is carrying a risk between the delivery and company is carrying a risk between the delivery and payment.payment.

Significant resources and sophisticated programs are Significant resources and sophisticated programs are used to analyze and manage risk.used to analyze and manage risk.

Risks faced by businessRisks faced by business

Some companies run a credit risk department whose Some companies run a credit risk department whose job is to assess the financial health of their customers, job is to assess the financial health of their customers, and extend credit (or not) accordingly. and extend credit (or not) accordingly.

They may use in house programs to advise on They may use in house programs to advise on avoiding, reducing and transferring risk.avoiding, reducing and transferring risk.

They also use third party to provide such information They also use third party to provide such information for a fee.for a fee.

Risks faced by businessRisks faced by business

Example:Example:

A distributor selling its products to a troubled retailer A distributor selling its products to a troubled retailer may attempt to:may attempt to:

- lessen credit risk by tightening payment terms, or - lessen credit risk by tightening payment terms, or

- by actually selling fewer products on credit to the - by actually selling fewer products on credit to the retailer, or retailer, or

- even cutting off credit entirely, and demanding - even cutting off credit entirely, and demanding payment in advance. payment in advance.

Such strategies impact on sales volume but reduce Such strategies impact on sales volume but reduce exposure to credit risk and subsequent payment exposure to credit risk and subsequent payment defaults.defaults.

Risks faced by businessRisks faced by business

Credit risk is not really manageable for very Credit risk is not really manageable for very small companies (i.e., those with only one or small companies (i.e., those with only one or two customers). This makes these companies two customers). This makes these companies very vulnerable to defaults, or even payment very vulnerable to defaults, or even payment delays by their customers.delays by their customers.

The use of a collection company is not really a The use of a collection company is not really a tool to manage credit risk; rather, it is an tool to manage credit risk; rather, it is an extreme measure closer to a write down in that extreme measure closer to a write down in that the creditor expects a below-agreed return after the creditor expects a below-agreed return after the collection agency takes its share (if it is able the collection agency takes its share (if it is able to get anything at all).to get anything at all).

Credit risk related to the process of settling financial transactions

If one side of a transaction is settled but the other fails, a loss If one side of a transaction is settled but the other fails, a loss may be incurred that is equal to the principal amount of the may be incurred that is equal to the principal amount of the transactiontransaction. . Even if one party is simply late in settling, then the Even if one party is simply late in settling, then the other party may incur a loss relating to missed investment other party may incur a loss relating to missed investment opportunitiesopportunities..

Settlement riskSettlement risk ((ii..ee. . the risk that the completion or settlement of the risk that the completion or settlement of a financial transaction will fail to take place as expecteda financial transaction will fail to take place as expected) ) thus thus includes elements of liquidity, market, operational and includes elements of liquidity, market, operational and reputational risk as well as credit riskreputational risk as well as credit risk..

The level of risk is determined by the particular arrangements The level of risk is determined by the particular arrangements for settlementfor settlement. . Factors in such arrangements that have a Factors in such arrangements that have a bearing on credit risk includebearing on credit risk include: : the timing of the exchange of the timing of the exchange of value and the role of intermediaries.value and the role of intermediaries.

Credit risk management

The goal of credit risk management is to of credit risk management is to maximize a bank's riskmaximize a bank's risk--adjusted rate of adjusted rate of return by maintaining credit risk exposure return by maintaining credit risk exposure within acceptable parameterswithin acceptable parameters. .

Banks need to manage the credit risk need to manage the credit risk inherent in the entire portfolio as well as inherent in the entire portfolio as well as the risk in individual credits or the risk in individual credits or transactionstransactions. .

Credit risk managementCredit risk management

Banks should also consider the Banks should also consider the relationships between credit risk and relationships between credit risk and other risksother risks. .

The effective management of credit risk The effective management of credit risk is a critical component of a is a critical component of a comprehensive approach to risk comprehensive approach to risk management and essential to the longmanagement and essential to the long--term success of any banking term success of any banking organizationorganization..

Credit risk management practices

Establishing an appropriate credit risk environment; Establishing an appropriate credit risk environment;

Operating under a sound creditOperating under a sound credit--granting process;granting process;

Maintaining an appropriate credit administration, Maintaining an appropriate credit administration, measurement and monitoring process; and measurement and monitoring process; and

Ensuring adequate controls over credit riskEnsuring adequate controls over credit risk. .

Although specific credit risk management practices Although specific credit risk management practices may differ among banks depending upon the nature may differ among banks depending upon the nature and complexity of their credit activities, a and complexity of their credit activities, a comprehensive credit risk management program will comprehensive credit risk management program will address these four areasaddress these four areas..