Corporate Risk Managemenet - Assignment Example

Credit Risk Management: Introduction: Risk management refers to the identification, prioritizationand assessment of risks, and this is followed by economical and coordinated use of resources meant to control, monitor and minimize the probability of the unfortunate event occurring. The purpose of risk management is to also increase the various opportunities that the organization might experience. There are many areas that risks can emanate from; and this includes legal liabilities, uncertainty in financial markets, credit risks, and natural disasters (Stone, 33). This paper seeks to provide an explanation on how to manage risk in a financial industry. Specifically, this paper provides an explanation on how to manage risks of a banking sector, and this is in regard to the taking of an insurance policy. In the banking sector, Risk management practices focuses on the operational risks, liquidity risks, credit risks, market risk and interest rate risk. This paper focuses mostly on the Credit risk of my hypothetical banking organization. The hypothetical name of my bank is the Bank of Venus. This is a bank, with a presence all over the country, and has more than 300 employees. This bank specializes in offering all manner of banking services, and this includes issuance of loans, safe keeping of precious commodities, money transfer and forex exchange. All these areas have their own risks. Credit risk refers to a situation where a borrower may fail to pay a debt, in which he or she is obligated to pay (Olson and Desheng, 51). The risks involved in this situation include a loss on the interest, and the principal amount given as a loan. Occurrence of this risk also causes a disruption in the cash flow of the bank, and an increase the costs of collecting the debts owed to the bank. Effectively reducing the occurrence of these risks, results to the success of the banking institution. This is because the bank’s main source of income emanates from interests it charges on the loans issued (Mehta, 28). To achieve success therefore, the Bank of Venus took an insurance policy to safeguard and protect itself from negative experience in case there was the emergence of risks associated with issuance of credit. However, the insurance company seeks to increase the following year’s premium. This will increase the operational costs of the banking organization; as a result, there will be a reduction of profits. This paper therefore seeks to identify and explain alternative courses of risk management practices that the bank can initiate. This paper also seeks to explain the various thought processes and analysis that the bank should take for purposes of choosing the alternative course of action. Alternative Risk Management Course of Action in Managing Credit Risk: The first alternative method of managing credit risks is referred to as risk based pricing. This is a method in which the bank will charge a very high interest rate to individuals who are most likely to default. Under this method, the bank will look into the credit rating of the individual, the purpose of the loan, and the loan to value ratio (Hopkin, 31). Other factors that the bank will look at before issuing the loan and calculating interests are the employment status of the borrower, the amount of loan under consideration, and the levels of documentation involved during the process of applying for a loan (Hull, 22). Under this method of risk management, the bank will calculate the rate of interest by analyzing the time value of the money, and also estimating the probability of the borrowing defaulting on the loan. However, this form of managing credit risk has come under a lot of criticisms. One of the major criticism of this strategy emanates from consumers who are of the view that initiating this type of policy in managing credit risk makes it difficult for shopper to locate affordable interest rates from lenders/ banking organizations (Tarantino and Deborah, 12). This is because it is difficult for shoppers to identify at first glance at what interest rate they qualify to get a loan. This strategy makes it difficult for the poor to access credit, and it also increases the percentage of default. Another method of managing credit risk in the banking organization is the use of covenants. Covenants are written down stipulations by the lenders, on a borrower. These covenants constitute specific loan agreements, such as the requirement that the borrower will constantly notify the bank on his or her financial condition (Bellalah, 37). These agreements will also ask the borrower to repay the full amount of loan, at a specific date, and on the request of the bank. This is in case changes are depicted on the borrower’s debt to equity ratio. If a borrower violates the conditions set up by the covenant, then it means that he or she is defaulting on the repayments of the loan under consideration. On this basis therefore, the bank has an option of accelerating the repayment of the loan under consideration. The main purpose of a covenant is to ensure that the credit risk that is attached to the issued loan does not mature. This is by providing an early warning system on the capability of the borrower to pay the loan, or on his/ her intentions to default on the loan. The bank can also waive the covenant, either on a permanent basis, or on a temporary basis. Proponents of this form of risk management argue that covenants help to create a channel of communication between the borrower and the lender (Bielecki, Damiano and Fredrick, 17). However, critics of this form on managing credit risk argue that covenants do not create a free environment to the borrower to effectively use the amount of loans for purposes of developing himself. This is because covenants place a lot of restrictions on how the borrower will use the loan. Another method of managing the credit risk is the diversification of the borrower’s pool (Christoffersen, 31). Under this method of credit risk management, the bank will diversify the portfolio of its borrowers. The bank will not concentrate on issuing loans in one sector, and neglecting other sectors. For example, the bank might decide to issue 5% of loan applicants to individuals, another 5% of loan applicants to corporations, another 5% to government agencies, etc. By taking this action, the bank will manage to reduce the rates of defaults in relation to the loans that it issued. This is because if one sector defaults, the other sector will most definitely pay the loan. This process will be advantageous to the bank because it’s credit risk is spread over a wider pool of borrowers, and therefore in case of a default, the bank will not lose much of its principal amount and interests that ensure from this principal amount (Clark, 27). However, it is disadvantageous because this policy is always developed out of assumptions. The assumption that this principle is developed under is the notion that not all types of borrowers will default on the loans issued. Another method of managing the credit risk of the bank is to reduce the amount of loans that the organization issues (Malz, 61). This move is referred to as tightening of credit. The bank has the option of reducing the general amount it issues as a loan, or the amount of loan it issues to specific individuals or sectors of the economy. However, this move is disadvantageous if the main source of revenue for a banking organization emanates from the interests derived from the loans. Thought Process and Analysis for Purposes of Choosing an Alternative Course of Action: There are five main steps that the bank needs to undertake for purposes of choosing an alternative course of action. The first step in this process is the identification of the risk under consideration. This is an important step in this process, and this is because the management cannot develop a plan on how to manage the risk under consideration unless they know what type of risk they are faced with. In our circumstance above, the bank has to develop an alternative policy in managing credit risk. This is because of an increase in the premium rates of their insurance policy (Abrahams and Mingyuan, 51). The following are the main methods of identifying the risks under consideration, namely brainstorming, interviews, surveys, working group, experiential and documented knowledge. The process of risk identification emanates from the origin of the problem. For example, under credit risk identification program, policy makers will have to identify the reasons as to why people can default on the loans issued by the bank. In this scenario, the origin of the risk under consideration is the inability of loan holders to effectively repay back their loans. The second step in this thought process and analysis is measuring or analyzing the risk under consideration. Risk analysis refers to the identification of the impact that the risk under consideration will cause in case of an occurrence (Fraser and Betty, 26). This process includes analyzing the risk under consideration, and thereafter measuring the impact of the risk to the business organization. For example, in the management of credit risk, this process will involve analyzing the various credit risks that the organization faces, and thereafter determining what will happen to the organization in case the risk materializes. For example, if an organization suffers from risks associated with issuance of credit, chances are that this will affect the cash flow of the bank. It will also increase the operational costs of the bank that is costs of recovering the debts. It will also affect the profitability of the business organization, because the bank will not be able to make profits in terms of interests from the loan. Risk analysis can either be quantitative or qualitative. The numerical determination of the risk under consideration is referred to as quantitative analysis. For instance, under the quantitative analysis of credit risk, policy holders would determine how much in losses will the bank suffer in case borrowers default on the loans issued (Hubbert, 27). Qualitative analysis involves determination of the extent of the various vulnerabilities that the risk under consideration poses, and developing counter measures in mitigating the risk under consideration. The third step in this thought process and analysis is referred to as the risk control process. This process involves devising measures that are meant to control the risk under consideration. It is during this process that the management of the bank will have to analyze the various alternative courses apart from insurance that can help to prevent the occurrences that emanate from credit risks (Jorda?o, 41). This stage involves the creation of policies, systems, and procedures by an organization for purposes of managing and controlling the credit risk. For instance, the Bank of Venus will analyze all the mentioned alternative courses of action in mitigating the credit risk. After this analysis, the bank will choose the best method that in their opinion will replace the insurance policy that it had undertaken. It is only if the internal methods of controlling the risk under consideration fail, that the bank might resort to the use of other external methods of controlling risks. The fourth step involves the transfer of the risk under consideration. The organization will only pass through this step in case its internal machineries are unable to control and mitigate the risk under consideration (Abrahams and Mingyuan, 51). Transfer of risks involves the issuance of the risk to a third party. This is where insurance agencies came in. In the case of the Bank of Venus, it is prudent that they will not pass through this process. This is because this process involves dealing with third parties like insurance agencies, and it is this insurance agency that the bank wants to stop dealing with them. This is because of an increase in the premium of their insurance policies. The fifth and the final step involve the review of the risk under consideration. This is the evaluation of the first four procedures of developing a course of action in credit risk management. Under this process, the management conducts an audit on the efficiency and effectiveness of the credit risk management policy taken, and whether it aligns with the goals of the organization (Jorda?o, 41). The review needs to be done on a continuous basis, and this is because then needs of the borrowers and the banks are always changing. This process aims at identifying if the steps taken to manage the credit risk are working, and if they are not effective, then this process aims to identify where the problem is, so that the bank can take adequate measures for purposes of correcting the situation. Conclusion: In conclusion, this paper manages to identify the various alternative processes of managing credit risk apart from the use of an insurance policy. The methods that this paper identifies are, the use of covenants, risk based pricing, diversification of the borrowers pool and reduction of the number of loans offered. This paper clearly explains these strategies, and it outlines their advantages and disadvantages. This paper has also managed to identify the process in which the bank under consideration will have to follow in order to choose a strategy that will better manage their credit risks, the process are five, and it starts with risk identification, risk analysis, risk control, transfer of risk, and finally, a review of the risk management process. From this paper, we can learn that it is important for the banking organization to initiate measures that will help in managing their credit risks, and this is because it will protect them from suffering losses that emanate from defaulting of loans. This paper also denotes that credit risk management will also help in improving the cash flow of the bank under consideration. Works Cited: Abrahams, Clark R., and Mingyuan Zhang. Fair lending compliance intelligence and implications for credit risk management. Hoboken, N.J.: Wiley, 2008. Print. 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