Posted in Finance Articles, Total Reads: 5536
, Published on 21 May 2012
Credit is the main revenue generator for banks. It shows the ability of banks in mobilization of the deposits. Credit deployment comes into picture when banks want to utilize the amount in their depository accounts. A depository account bears operational risk, technological risk and human risk in terms of fraud, but the extent of loss is not that significant. When it comes to Credit, a huge amount of risk can be seen and that’s where Credit Monitoring and Credit Management are needed. And this makes banks more cautious, when it comes to lending money.
Credit is raised by two types of borrowers, individual borrowers and corporate borrowers. Retail loans consisting of individual borrowers follow less stringent processes to verify credibility of the borrower but when it comes to corporate borrowers banks follow various methods and Credit Agency’s rating to find out the credibility of the corporate.
Banks are pretty cautious when they employ various lending methods; most popular of these lending methods are Cash Flow Method, Cash Budget Method and Projected Balance Sheet Method. In additions to this, various methods of assessment are employed for fund based and non fund based requirement which should be met by borrowers.
Credit risk in terms of the Bank of International Settlements is defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with the agreed terms. The largest source of risk faced by financial institutions is the Credit Risk. Exposure to credit risk has been a major problem faced by banks in the recent past. In the bank's portfolio, losses stem from outside default due to inability or unwillingness of the customer or the counter party to meet the commitments; losses may also result from reduction in the portfolio value arising from actual or perceived deterioration in credit quality.
Banks need to evaluate the credit risk inherent in the entire portfolio and also at the individual level. The correlation between credit risk and other types of the risk have to be taken into consideration since it leads to a cascading effect. It is essential for the top management to take active interest in managing the credit risk exposure of the bank.
Measuring Credit Risk
Loans turn out to be the major source of credit risk to banks, however other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off balance sheet. Banks increasingly face credit risk in various financial instruments other than loans, including acceptances, inter-bank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options and in guarantees and settlement of transactions.
The goal of credit risk management is to maximize a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks should have a keen awareness of the need to identify measure, monitor and control credit risk, as well as, to determine that they hold adequate capital against these risks and they are adequately compensated for risks incurred.
Senior Management Oversight
It is the imperative for the senior management to monitor the overall credit risk exposure. The senior management of the bank should develop and establish credit policies and credit administration procedures as a part of overall credit risk management framework and get these approved from the board. Such policies and procedures shall provide guidance to the staff on various types of lending including corporate, SME, consumer, agriculture, etc. In order to be effective these policies must be clear and communicated down the line. Further any significant deviation to these policies must be communicated to the top management and corrective measures should be taken. It is the responsibility of senior management to ensure effective implementation of these policies.
Credit Risk Management Tools
The Central bank of India has instructed the banks to strictly comply with the credit exposure ceiling of 15 per cent and 40 per cent of capital funds to single and group borrower, respectively. Credit exposure to a single borrower may exceed the exposure norm of 15 percent of the bank's capital funds by an additional 5 percent and by an additional 10 percent for group borrower provided the additional credit exposure is on account of extension of credit to infrastructure projects. A prudential measure has to be taken to reduce their exposure to specific industry or sectors.
Risk based pricing
The banks need to price the products based on the risk associated with the borrower. High risk category borrowers are to be priced higher. Capital has to be allocated to mitigate the risk of unexpected loses.
The need for credit portfolio management emanates from the necessity to optimize the benefits associated with diversification and to reduce the potential adverse impact of concentration’ of exposures to a particular borrower, sector or industry. The effect of correlation and volatility among the assets of the portfolio has to be studied in detail. High correlation between the asset classes might impact the portfolio quality under stress conditions.
Loan Review Mechanism
LRM is an effective tool for constantly evaluating the quality of loan book and to bring qualitative improvements in credit administration. Banks should, therefore, put in place proper Loan Review Mechanism for large value accounts with responsibilities assigned in various areas such as, evaluating the effectiveness of loan administration, maintaining the integrity of credit grading process, assessing the loan loss provision, portfolio quality, etc. The complexity and scope of LRM normally vary based on banks’ size, type of operations and management practices.
Credit Risk - After the Crisis
During the 2008 financial crisis, where big organizations were jolted, credit remains to be the main source of financing for companies and individuals. Also it will remain a core driver of banks revenues and profits. The three pillars of Credit economics which were driving the system before the financial crisis remains the same even after the financial crisis. Those pillars are efficiency (operational cost), effectiveness (risk premium) in combination with pricing (revenues). In essence the only change is the strategies implemented by the banks. Thus banks are involved in redesigning of the credit underwriting process. The following steps are involved:
1. Start with a clear risk strategy
Clear risk strategy is to identify your own risk appetite. Banks should be aware of their own risk appetite and according to that they should be involved in the lending. This risk appetite is going to identify the risk return characteristics of the banks.
2. Make risk assessment a balance of past and future
The statistical methods involved in risk assessment are mostly based on historical data. However for the proper assessment, banks have to keep in mind the historical trend and extrapolate the curve to next few years to anticipate future scenario.
3. Strengthen end-to-end risk mindset
The risk assessment should be done in proper coordination between the sales team and the processing team. Thus proper communication between various teams should be done for risk assessment and all of them should be involved in decision making.
4. Boost effectiveness through improvement in efficiency
To increase speed and reduce cost of credit underwriting decisions efficiency has to be increased. Increased efficiency will lead to fewer mistakes, more stability in lending process and thus improve effectiveness.
Change in Regulatory Scenario
Basel III is the new regulatory framework designed to correct the deficiencies in regulation that led to the global financial crisis of 2008. It is to be noted that in the wake of financial crisis, the Basel Committee on Banking Supervision (BCBS) has initiated several post-crisis reform measures, mainly in terms of building on the Basel II capital adequacy framework.
The proposed Basel III guidelines seek to improve the ability of banks to withstand periods of economic and financial stress by prescribing more stringent capital and liquidity requirements for them. The suggested capital requirement is a positive for banks as it raises the minimum core capital stipulation, introduces counter-cyclical measures, and enhances banks’ ability to conserve core capital in the event of stress through a conservation capital buffer.
The prescribed liquidity requirements, on the other hand, are aimed at bringing in uniformity in the liquidity standards followed by banks globally. The proposed changes are to be phased in gradually, starting in January 2013 to January 2015, while the creation of a conservation buffer could be set up by banks during the period January 2016 to 2019.
Credit will continue to remain one of the strongest pillars of revenue generation for Financial Intermediaries. Credit Risk, in turn, can shake any financial intermediary if not properly taken care of. Proper management of Credit Risk is very important for banks. Management starts from measurement of risk and continues till constant monitoring of the risk. Various methods are employed by banks to measure the credit risk in order to make a right decision.
Though these methods were present before the 2008 financial crisis, the event has changed the mindset of people managing credit all over the world. The bottom line made clear after the crisis is that the methods still remain the same, it is the strategies employed by organizations to implement them that should be changed. Taking cognizance of these issues even the regulatory framework is being updated, as can be seen in the new Basel III norms (given by the Bank of International Settlements) which have stricter regulations on lending.
These activities are making one phrase true – "All roads lead to Rome". Be it credit analysis methods, or organizations that are changing the methods of implementation of their credit analysis or be it Bank of International Settlements which came up with Basel III norms, the objectives of all are the same; credit analysis should be more stringent so that a similar financial crisis is not repeated in future.