A critical study of credit risk management in the First Bank of Nigeria PLC - Dissertation Example

?A CRITICAL STUDY OF CREDIT RISK MANAGEMENT IN THE FIRST BANK OF NIGERIA PLC. Literature Review: Credit risk management contains some key principles that are: a clear structure should be established, accountability and responsibility should be allocated, prioritize the processes, clear communication of assigned responsibilities and answerability assigned thereto (Lindergren, 1987). Credit risk management has an overwhelming concern on a bank. First one is reaction against bank losses from the Newton, it is realized that losses are unbearable after the losses have occurred. The second aspect is that that bank has been pushed by the recent progress in the area of financing securitization, commercial paper and competition with other non-banks to find possible loan borrowers (Demirguc and Huzinga, 1999). Big and stable companies have been seen to shift in the open market sources like those in bond markets of finance. The degree of risk of assumed losses can be minimized by organizing and managing the lending criteria with professionalism and also with active approach. Credit risk management issues can be measured if bank could tap progressively refined measuring technique (Gill, 1989). The adoption of more rigorous credit risk has been facilitated by the technological developments, predominantly the growing availability of low cost computing power and communication. A lot of banks still have a long way to go in the implementation of such new approaches. Competition in the provision of financial services is increasing probable due to the acceleration of change in credit risk management in the banks which is viewed as an unavoidable response to an environment and, thus need to classify new and gainful business prospects and appropriately measure the related risk is mounting for the banks and other financial institutions (Lardy, 1998; Roels et. al. 1990). The nature and relative sizes of the implicit internal subsidiaries will become more apparent as banks develop their aptitude to assess risk and return related with their various activities. It is observed that credit risk arise before business ventures are financed (Brown and Manassee, 2004). Credit risk management can be defined as the identification of risk, its measurement, monitoring of risk and even the control of risk that could arise in case of default in loan payment (Early, 1996; Coyle, 2000). When banks extend their credit considering that borrowers will pay back their loan amounts then the extended credit to the borrowers may be at the risk of default, banks income decreases due to the necessity for the provision for the loans as some borrowers usually default. Commercial banks are exposed to an additional risk of variability as they do not have a clue of what proportion of loan borrowers will default. As a matter of fact almost all the financial institutions bear a certain degree of risk when these institutions lend to consumers and to the businesses, hence when certain borrowers fail to repay the loan amount, they experience some loan losses. Credit risk face by a bank has a possibility of loss arising in case of non-repayment of interest or principal or both. Payment delays and the credit risk among procedures can be transferred by the banks and other financial intermediaries (Demirguc-kunt and Huzinga, 2000). Certain techniques are developed for the measurement of the credit risk which can be linked with pace of evolution (Laker, 2007; McDonough, 1998; Couhy, 2005; Brown, 2004). Different banks are differentiated with their adoption of different credit risk management policies. A bank having assets that constitutes of loans in their portfolio are relatively illiquid and exhibits the highest credit risk (Koch and MacDonald, 2000). According to the asymmetric information, good borrowers and bad borrowers are might be impossible to distinguish, which can result into an adverse selection and moral hazards problems (Auronen, 2003). Due to the adverse selection and moral hazards banks are led to substantial accumulation of non-performing accounts. Following are the processes of risk identification, measurement, assessment, monitoring and control that are followed by the management of credit risk in a bank. This process involves identification of possible risk causes, evaluation of their consequences, monitor actions exposed to the recognized risk features and put in place control measure to avoid or minimize the unwanted effects. According to IAI (2003), “Effective system that ensures repayment of loans by borrowers is critical in dealing with asymmetric information problems and in reducing the level of loan losses, thus the long-term success of any banking organization.” An effective credit risk management involves establishment of suitable credit risk atmosphere, operations under sound credit granting process, sustaining suitable credit administration that encompasses monitoring procedure as well as adequate control over credit risk (Greuning and Bratanovic, 2003). According to Greuning and Bratanovic (2003), “Considerations that form the basis for sound CRM system include: policy and strategies that clearly outline the scope and allocation of a bank credit facilities and the manner in which credit portfolio is managed, i.e. how loans are originated, appraised, supervised and collected”. It has also been detected that high class credit risk management staffs are critical for the assurance of the required knowledge and judgment, thus managing the credit risk successfully (Wyman, 1999). Marphatia and Tiwari (2004) have discussed that credit risk management predominantly is about individuals, how individuals ponder and they intermingle with each other. According to Grauwe (2007) central bank should only provide liquidity against assets of good nature and those banks which have given loans of massive amounts of money to evade funds should be given punishment. Otherwise if a careless bank gets away with it on the cheap then they will be encouraged to take such actions again in future. Hence, ethical hazard at this point may be a dilemma, in which a bank may have to make a decision considering both present and future of the financial stability. According to the Basel (1999a), credit risk is defined as “the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed term”. Whereas Monetary Authority of Singapore (2006) has defined it to be the “risk arising from the uncertainty of an obligor’s ability to perform its contractual obligations”, in which the term “obligor” denotes to any party that has direct or indirect compulsions under the contract. Concerning the significance of this kind of financial risk, Kaminsky and Reinhart, as cited by Jackson and Perraudin (1999), thinks that financial risk is the largest component of risk in the books of most banks and if managed improperly, can weaken a single bank or even can impact on the financial destabilization of the whole banking system. Thus credit risk is undeniably an inherent and critical part of the banking system. It is essential to familiarize with the types of credit risk involved in the financial undertakings before any additional discussion so that a better understanding on the nature of credit risk should be gained. Different authors have articulated various criteria, regarding the categorizing of credit risk. According to Hennie (2003), consumer risk, corporate risk and country risk are the three main credit risks, while Culp and Neves (1998) believe that there are two types of risks that are default risk and resale risk. What is assumed here is part of 3 views from Horcher (2005), who has defined 6 categories of credit risk. These 6 categories of credit risk includes “default risk, counter party settlement risk, counterparty pre-settlement risk, legal risk, country or sovereign risk and concentration risk”. Nowadays Legal risk is considered as independent or more likely belongs to the operational risk and concentration risk (Duffie and Singleton 2003). Default on a payment is related to the traditional credit risk, particularly lending or sales Horcher (2005). A probability of default is known as the probability of default. When a default arises, relying on factors like creditors legal status, the amount at risk may be as much as the whole liability, which could be recovered later on. Though collections later on are usually difficult or even unmanageable in that huge outstanding compulsion or losses are generally the causes why an organization fails. In case of a pre-settlement risk, it arises if the counterparty will default while it has entered into a contract but settlement still does not occur. Throughout this period, risk is indicated by the unrealized gains in a contract. Since the establishment of the original contract, the possible loss to the business depends on how market rates have changed. Current and possible exposures to the business are ways in which it can be evaluated (Horcher 2005). When one party in a contract fails to pay money or deliver assets to the other party at the time of settlement, this situation refers to the settlement risk which is a risk normally faced in the interbank market and it can be related with any timing difference in settlement (Casu, Girardone and Molyneux, 2006). Horche (2005) figures out that the risk is frequently related with the foreign exchange trading, where “payments in different money centers are not made simultaneously and volumes are huge”. Considering the case of a small German Bank Bankhaus Herstatt, can serve as a classic example of a failure which was caused by the settlement risk in which the German bank received payments from its counterparties of foregin exchange but it had yet to make payments to the financial intermediaries on the last date (Heffernan 1996). The strategies and the policies both should be planned and executed well; so that both should be able to conduct credit granting activities and also they should be able to establish a valuable credit atmosphere. Furthermore, the formation of a good credit culture inside a bank results into the establishment of an appropriate credit environment (Strischek 2002). The main objective presented by Basel (1999a) of credit risk management is to make best use of the bank’s risk adjusted rate of return by sustaining the credit risk exposure within suitable parameters. It is demanded that both the credit risk rising from the individual creditor and the risk of the entire portfolio should be managed, being consistent with the principles of managing portfolio, the relationship between credit risk and others must be considered as well. Country risk takes place due to the impact of declining foreign economic conditions, social form and political situation on abroad transactions (Casu, Girardone and Molyneux 2006). The types of credit offered by the bank and its target markets as well as the necessary characteristics of its credit portfolio should be clearly stated in a credit risk strategy. While the parameters within which credit risk is to be controlled as well as the banks credit risk management philosophy are expressed in the credit risk policies (Hennie 2003). According to Fabozzi (2006), to measure a risk is always a critical part in credit risk management process, quantify a credit risk is a complicated process as it lacks enough historical data, involvement of diversified borrowers and the diversity in default causes. During the last 20 years credit risk management evolved greatly due to the dramatic development of technology. In many cases a borrower knows more than the bank in a lending process about its own credit risk and the bank, as the with lack of information, the bank may attempt to increase the interest rate of borrower for the compensation of an unknown credit risk. The issue is that the greater interest rate prevents those borrowers which have less possibility of defaulting rather than preventing those riskier borrowers which may default, and it is recommended that it the most effective way that can limit the access the credit. Nonetheless, quantitative credit revelation limits should also be given care consideration which is a noticeable thing. The choice of an optimal limit is an important task for banks, since a smaller limit reduces lending volumes as well as profits whereas a larger one encourages borrowers with low credit quality (Xiuzhu Zhao 2007). Nowadays the term Credit Risk Management CRM is very famous amongst the banks and the financial institutions. The focus of credit risk management is to minimize and reduce non-performing loans of the bank or a financial institution which came from the customers. The flow of the financial assets gets a strong impact from the banks and their associates through their processes and procedures. Financial status can become wobbly through uncertainties in various economic factors, factors including international markets or even financial constraints. Apart from the financial deficiencies, there are also other factors that can cause a financial constraint. These factors include lack in capability of aggressive debt collection, no external help is provided by the financial market to the needy consumer and also there is capability issue regarding the collection of information from the consumer. Financial resources will definitely become too much stagnant with non-performing loans. The credibility of the consumers that have taken loan should be assessed by the banks and other financial institutions so that credit risk management should be provided effectively. Considering an enterprise, the credit portfolio assessment should be enough to deliver a system in which the competence of the business enterprise to pay and revising the risks is promoted continuously. It is very common that the occurrence of the risk during a transaction is limited in a banking process. To anticipate the risk of the future, managers of the bank should also bank on the usefulness of the obligatory regulations. Internal process and the actions of the people make dependent the position of the institutions on the market failure from the different financial indicators. Cash flow approach in bank’s lending under the economic theory in the banking that encompasses the income theory and interest rate (Akperan, 2005). To produce satisfactory level of return and curtail the damages to its shareholders, credit risk management needs to have a strong and robust process to manage the loan portfolios by enabling the bank to manage proactively. Banks recognizes the credit risk management’s importance as banks can establish the process standards, duties segregation and responsibilities included in the policies and procedures that are endorsed by the banks (Focus Group, 2007). Due to the overwhelming of uncertainties in the financial system, credit risks are appearing in the banking institutions. The country then faces a major challenge in the shape of uncertainties. Banks have used major approaches, continuous efforts on close monitoring and research, are amongst them. The key sources of uncertainties, that are believed by the banks are monitoring as well as research, like the treasury and data gathering institutions (Uchendu, 2009). The market structure in banking sector is important as it stimulates the effectiveness of the banking sector and companies to access to funding or credit investment. The development of the banking system and its structure is affected by the economic growth. Two factors are considered as the part of the development, firstly the vast knowledge in risk assessment and secondly the managerial approach. Since the banks and its processes are vastly regulated, the assessment of the effect of credit risk management in the financial sources and banks become very useful (Gonzalez, 2009). The Nigerian banks are in the pre-consolidation era because they almost lost their basic in playing strategically. Most of the banks during the post consolidation era needed to accelerate growth of their revenues and profitability through strategic repositioning and restructuring. To achieve the banking omnipotence in this event, there is a great struggle and competition. All the adversities of the banking and the financial sector should be an addition of the sharp deviation to strengthen the operation. Variety of methods has been employed by the financial sector of the Nigeria so that banks could achieve their performance under the analysis of the behavior of the banks. Most of the banks applied the discounted cash flow method in the post consolidation, to measure the nature of the dividend policy in the banking sector. The evaluation method includes the price book value model, price to earning model, economic profit model and PGE model (Meristem, 2008). The structure of the markets and the assets were the reason that shows poor performance in the operations of the Nigerian banks. As the interest rates get affected, it will also have an impact on the values of the assets and rates of prices will increase suddenly. Capabilities in operations and profitability tend to lose in the banking segment because of the changes in the environment of the financial sectors. The chances to get potentials by providing the sound and suitable management to the banks are extremely high. With the introduction of the strategies, the amounts in profitability are settled. It will help in assessing the techniques and procedures in order to monitor the risks that might embroil. The policy of credit risk is expected to be linked with the control on market risk, exchange risk and interest rate risks if paid exceptional devotion to the credit risk and its policies. Adequate controls should be ensured for the new product and activities of the bank to identify the risks. In this way the related risks are exposed with the assistance of the accounting and management information systems (CenBank, 2000). According to Jimenez and Saurina (2004), credit risk determinants that demonstration collateralized loans have greater probability of getting default. The banks which have probability of loan getting default is protected by collateral, have less incentives to assume suitable screening and credit valuation at the time of loan approval. Category of loan is also an important factor of credit risk where Loan given by the saving banks are uncertain and are inclined to default. It is found that the relationship between close banks to borrower is significantly positively related to credit risk, with the increase in this relationship banks becomes more willing to take credit risk by lending to the riskier firms. Berger and De Young (1997) found lagged capital for different types of banks which showed mixed results. The coefficient of lagged capital is considerably adversely associated to credit risk in the case of thinly capitalized banks. Thinly capitalized banks take more risky loans on an average, which hypothetically could lead to greater problematic loans; supported by the moral hazard hypothesis. Banks may increase the capital in advance to afford cushion against potential loan loss arising from NPL increases; a conceivable reason suggested by the researchers. Same results were proposed by Shrieves and Dahl (1992). An inverse relationship between capital asset ratio and credit risk was discovered by Cummins and Sommer (1995). The findings of their research suggested that the banks that are sufficiently capitalized take more risk than other banks. Angbazo (1997) discovered additional indication of the impact of credit risk on the performance of the banks. To reimburse the great risk of default, banks with a greater risky loan portfolio seem to oblige higher net interest margin. The results of this study clearly suggest that the significance of the association amongst net interest margin and credit risk is high. The earlier findings are supported, that size and diversification are adversely associated with each other, with the finding of the study of Hassan, et al. (1994). Brewer et al. (1996) found out that loan sectors had a significant relationship with credit risk. Fixed rate mortgage loans, investments made in corporations of services and loans of real estates showed a clear and significantly negative relationship with that of credit risk. Hence there is a significant and positive relation between non-fixed rate mortgage loan and credit risk. Froot and Stein (1998), found that banks investment in risky loans is affected by credit risk management through active loan purchase and sales activities. As a percentage of the balance sheet, banks that purchase and sell loans that hold more risky loans than other banks. Other than the banks that merely sell loans or banks that just buy loans, the banks which manage their credit risk by the buying and selling of loans have holding of more risky loans which makes these results striking. Ferguson (2001), analysis of the model and the judgments that were associated to the credit risk management were made. It was concluded by the researcher that to measure alterations in the riskiness of a portfolio and in designing a proper strategic framework, a proper risk model is required for managing changes in their risk. Bagchi (2003) has studied banks for the purpose of their credit risk management system. Following factors were studied as basic consideration like risk management, risk measurement, risk monitoring, risk control and risk audit for credit risk management. The researcher has concluded some factors to have a successful credit risk management, policies and framework of the credit risk management, the credit rating system, it’s monitoring and control. Methodology: Research design: The research design of the present study will be mixed research design that involves the mixing of quantitative and qualitative methods or paradigm characteristics. The study will be comprised of two phases i.e. Phase I and Phase II PHASE- I OF THE STUDY: The Phase I of the study will be qualitative .The present study will be conducted to Evaluate the credit risk management practice of the First Bank of Nigeria Plc. Suggesting a broad outline of measures for improving credit risk management practices of the First Bank of Nigeria Plc., Profiling and analysis of concentration of risk in the First Bank of Nigeria Plc., Reviewing the New Basel Capital Accord norms and their likely impact on credit risk management practices of First Bank Nigeria Plc., Examining the role of Risk Based Supervision in strengthening credit risk management practices of First Bank of Nigeria Plc. To review the techniques used by the First Bank of Nigeria Plc. as regards CRM procedure. Find out the challenges being encountered by First Bank of Plc. with regard to CRM and suggest measures to address such challenges and To assess the effectiveness with which the First Bank has managed its portfolio. Why Qualitative Research? Qualitative Research is an inquiry process of understanding based on distinct methodological traditions of inquiry that explores a social or human problem. The researcher builds a complex, holistic picture, analyzes words, reports detailed views of informants, and conducts the study in a natural setting (Creswell,1998). Phenomenological Study This study is a Phenomenological study, aiming of exploring the lived experiences of employees and customers in order to evaluate the Credit Risk Management Strategies. Selection of the Participants The sample will be taken through Purposive Sampling technique that involves selecting respondents primarily on the basis of meeting inclusion criteria, their availability and willingness to participate in the research (Shaughnessy; Zechmeister & Zechmeister; 2003). Inclusion criteria: 1. Employees belonging to profession of Banking. 2. Employees aged 30 -40 years 3. Employees should have at least one year work experience in that work place. Sample Five employees who would give their consent will be made a part of the research study. The Qualitative method of In-Depth Interviews will be used in order to get data. In-Depth Interview In-Depth Semi Structured Interview is an interview technique which employs open ended questions with additional probes where required. In depth Interview will be devised by the researcher containing different questions regarding Credit Risk Management. It will also contain information related to demographic characteristics. Inquiry Question The basic inquiry question of the present research is: 1. What are the credit risk management (CRM) procedures that are in existence in the First bank of Nigeria Plc.? 2. How effective are the credit risk management (CRM) system procedures of First Bank of Nigeria Plc.? 3. How adequate are the existing credit risk management system of First Bank of Nigeria Plc.? Data Analysis Strategy Phenomenological Data Analysis will be used to analyze the transcribed data through which researcher will identify themes. It will tell us about the effective and risk factors of the Credit Risk Management. It will also facilitate to make new amendments in the existing strategies in order to remove risks. Verification Criteria Different verification methods will be used to evaluate the credibility of the research findings. PHASE II OF THE STUDY: The Phase II of the study will be quantitative in order to investigate the Research Hypothesis. This study phase will use a correlational Research Design. It is a method of quantitative research in which there are two or more quantitative variables and they need to be studied in relation with each other. The researcher wants to develop a relationship between the variables. All the variables had been existing before the study is conducted and the researcher just measures the relationships by using different quantitative measures (Bajpai & Singh, 2008). Sampling strategy: The sample will consist of employees of different Banks. The sampling strategy will be Purposive in nature. A purposive sample is defined as such a sample that the researcher chooses based on who they think would be appropriate for the respective study. The employees will be selected on the basis of their representation of the socio-economic statuses. The data will be gathered from those employees via using Demographic sheet and questions regarding Credit Risk Management of first Bank of Nigeria. Inclusion Criteria a) Age range of the employees will be from 30-40 years. b) Work experience of the employees should be more than one year in the same Bank. Sample size: The sample size will be 200 employees. Demographical Sheet The demographic sheet will include age, gender, education, total monthly income, other sources of income, religion, religiosity rating, no of siblings, birth order, family type, number of family members, years of experience in work place, experience of dealing with customer, understanding of the procedure, satisfaction with the job, satisfaction with the work environment, satisfaction with the procedures of Credit Risk Management, questions regarding efficacy of procedures and limitations and risks of the procedures using in the bank, to get more detailed information about the participants and their views regarding the Credit Risk Management. Statistical analysis: The data collected from all the employees on all the research variables will be then fed in a statistical software program and was statistically analyzed by using 19th version of Statistical Package for Social Sciences (SPSS-19). To analyze demographic information descriptive statistical procedures will be used while to test the hypotheses that have been put forth, Pearson Product Correlation analysis will be used. Procedure: PHASE I: In the first phase the data will be collected from different employees who will be having much time for interview. The permission to collect data will be taken from the respective authorities of the Banks. The authorities and participants will be informed about the purpose of the research study. The data will be collected by contacting each participant individually for in depth interview at the respective places. A total of five employees will be interviewed. The participants will be ensured about the confidentiality to make them comfortable in expressing their views. Responses will be later developed in to expanded notes. PHASE II In the phase II of the research, the sample will be taken from purposively selected Banks of Nigeria. The administrative resource person of respective Banks will be contacted for the permission of data collection. The administrative persons and participants will be informed about the purpose of the research. Group administration will be done in which the employees will self-administered the questionnaires. The participants will also be briefed regarding ethical considerations like about their right to withdraw at any point, confidentiality of the information provided etc., and they were made to sign a consent form. Questionnaires will be binded together in booklets which then will be distributed among all participants and they will be asked to fill them in. Relevant instructions will be delivered before the participants could start filling in. The researcher will supervise the administrations so that the queries of participants could be answered. Read More