Credit Risk Management in the Banking Sector - Research Paper Example

1.0 Introduction The drive by countries to improve the efficiency and resilience of their financial systems through deregulation, the development of domestic capital markets, the privatisation of state-owned financial entities and the encouragement of foreign bank entry are all measures adopted of late by governments to encourage efficiency into the banking system (BIS Paper No 33,2005). Today, bankers are increasingly becoming conscious about recent developments in their respective markets and have resorted into various method of managing credit risk. Risk management appears to have improved in most regions as a result of the introduction of new approaches to the allocation of credit as well as better measurement and pricing of the various risks (BIS Paper No 33, 2005). Credit risk management appears to have improved during the past decades due to greater reliance on market determined prices. Credit risk today is managed through the creation of an in-house risk management unit. In addition, efficient credit risk valuation methods are being employed today by banks. Banks have also resorted into more advanced methods of credit risk management and quantification such as value at risk, stress testing, credit scoring. 1.1 Overview of Financial Market Risk According to BIS paper No.33, financial markets are subject to various sources of risk: credit, market, liquidity, operational and legal risks. These risks tend to be more pronounced in the developing world than in developed countries due to a lower level of economic, financial and institutional development. Credit risk tends to be more acute as a result of a lack of highly rated counterparties. Market and liquidity risks are higher due to thinly traded markets (IMF BIS Paper No. 33). Operational risks may also be exacerbated because of inadequate human resources or the failure of manual, mechanical or electronic systems to process payments. Finally, legal risk may also be part of the environment (for instance, due to the inability to foreclose on collateral). The next section discusses credit risk and some of its components and how it can be managed. 1.2 Credit Risk According to the International Monetary Fund Business Paper No. 33, credit risk is the risk that a debt issuer will default is known as credit risk; this is typically the most important form of risk for commercial banks (Shapiro, 2003; Buckley, 1996; Muller and Verschoor, 2005; Solt and Wayne, 2001).Solt & Wayne (2001) argues that, in assessing credit risk, an institution needs to consider three issues: default probabilities over the horizon of the obligation, credit exposure (ie how large the obligation is when the default occurs) and the recovery rate (ie what part of the exposure may be recovered through bankruptcy proceedings or some other form of settlement) (Solt and Wayne, 2001). Credit risk is often difficult to assess due to the lack of information on the credit history and financial position of borrowers, inadequate accounting practices and standards that make it difficult to evaluate credit exposures, macroeconomic volatility and deficiencies in the institutional environment (e.g., political instability) (BIS Paper No.33, 2005). Weak enforcement of creditor rights may also contribute to uncertainty regarding recovery rates. Although many of these factors have been improving in recent years, progress in some cases is slow (Mohanty et al., 2006). Moreno (2006) highlights two key issues related to credit risk that are relevant for emerging market economies (EMEs). First, the distinct increase in the share of credit to the household sector that has been observed in a number of countries could lower credit risk if the concentration of bank assets fell, if consumer credit diversifies risk among a larger number of borrowers. Moreno (2006), further states that, credit risk could rise if banks are lending in new market segments. Second, there is significant credit risk associated with the effects of asset price fluctuations on banking books. One concern in this case is the volatility associated with property prices, a phenomenon that appears to be quite generalized in the world financial system (Mohanty et al., (2006). Another concern is exchange rate volatility, which can lead to credit risk in financially dollarised economies. 2.0 Management of Credit Risk In management of credit risk, I will focus only on the currency risk exposure aspect of credit risk. That is in a situation where credit is offered in multiple denominations of currency. Currency risk or foreign exchange exposure or better still foreign exchange risk refers to the risk that a company's cash flows, transactions and future business operations may be affected by changes in exchange rates. (Shapiro, 2003; Buckley, 1996; Muller and Verschoor, 2005; Solt and Wayne, 2001). Foreign-currency-denominated assets and liabilities as well as expected foreign-currency-denominated future cash flow streams are therefore clearly exposed to exchange rate risk. (Buckley, 1996; Shapiro, 2003). Buckley (1996) also notes that home-currency-denominated expected future cash flows may also be exposed to foreign exchange risk. For example, a home based bank accepting deposit and offering credit in foreign countries through subsidiaries or international lending, as such its expected future cash flows will be affected by exchange rate movements between the home and the foreign currency. (Buckley, 1996). Exposure to foreign exchange risk is classified into three types including transaction exposure, translation exposure and economic or operating exposure. (Buckley, 1996; Shapiro, 2003 Transaction Exposure Here, I have considered transaction exposure, with the exposure of a firm's foreign currency-denominated balance sheet items (asset and liabilities) to changes in exchange rate changes due to credit being offered in foreign currency. Transaction exposure is therefore a measure of the change in the asset or liability's value that occurs as a result of an exchange rate change. (Shapiro, 2003; Muller and Verschoor, 2005). Here credit risk is the risk that, the value of the credit will be less than the initial value of the credit granted due to currency translation. Here, when preparing a consolidated financial statement for the entity credit dominated in foreign currency needs to be converted to the local currency. The is a risk of foreign exchange losses, where the value of the foreign currency has depreciated with respect to the local currency. . Translation Exposure Translation exposure is the exposure a firm faces in relation to changes in its foreign currency-denominated cash flows owing to a change in the exchange rate. Translation exposure is principally concerned with the firm's accounts receivables and payables that are denominated in foreign currency. (Shapiro, 2003). Translation exposure affects both balance sheet and income statement items of the firm as well as cash flow items. Both translation and transaction exposure constitutes accounting exposure, that is, exposure that is based on the changes of balance sheet and income statement items that occur as a result of an exchange rate change. (Buckley, 1996; Shapiro, 2003). Economic Exposure Economic, operating, or competitive exposure is the exposure that a firm faces owing to the fact that its competitive position may change as a result of changes in exchange rates. It is exposure that the firm faces in relation to its future transactions. Unlike translation and transaction exposure, economic exposure does not deal with changes in already existing income statement and cash flow statement. Rather, it considers how changes in exchange rates may affect the firm's future position competitive position in relation to transactions that have not yet been entered into the balance sheet although contracts might have been established. (Buckley, 1996; Shapiro, 2003; Muller and Verschoor, 2005). While it is possible to eliminate transaction and translation exposure through the use of hedging instruments such as forwards, futures, options as well as other hedging strategies such as exposure netting it is not possible to hedge against economic exposure. (Shapiro, 2003; Faff and Irio, 2001; Solt and Wayne, 2001). Managing Foreign Exchange Exposure. The United Kingdom and French banks can mange its currency exposures arising from credit through hedging. By so doing it will take a position such as acquiring a cash flow or an asset or a contract that will rise or fall in value and offset the fall or rise in value of an existing position. (Moffet et al, 1995). Shapiro (2003, pp 329) states that hedging a particular currency refers to establishing an offsetting position so that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Banks can further use currency futures, currency swaps, currency forwards and currency options to hedge its expected future exposure to exchange rates. Translation and transaction exposure can be managed using the following hedging strategies: Forward market Hedge If a bank or credit company is expecting to receive a future stream of cash flows in a foreign-currency, she can sell the stream of cash flows in a forward market to lock in a minimum value of the cash flows in terms of the home currency. No matter what happens, with the exchange rate, the company will still receive its guaranteed amount of home currency cash flows. (Shapiro, 2003). The only expenditure that will be incurred will be the price paid for establishing the hedge position. On the other hand if the company has foreign-currency-denominated liabilities, it can minimize the risk by buying a forward contract to hedge against an appreciation of the foreign currency. (Shapiro, 2003).Therefore a company that is long in a foreign currency will sell the foreign currency forward while a company that is short in a foreign currency will buy the currency forward. (Shapiro, 2003). However, by establishing this hedging strategy, the company also foregoes any benefits that may accrue if on the other hand the foreign currency appreciates relative to the local currency. Therefore downside risk is protected at the expense of upside potential. (Shapiro, 2003). Options Market Hedge Instead of establishing the hedge with a forward contract the company could hedge its receivables by buying a put option. By using this technique she will be able to speculate on the appreciation of the foreign and domestic currency as well, while limiting downside potential. (Shapiro, 2003). A currency put option gives the holder the right but not the obligation to deliver a currency at a specified price known as the exercise price at the expiry date. (Moffett et al, 1995; Shapiro, 2003). Thus if we assume that instead of the forward contract, there is a put option on the local currency, then the company can purchase this contract and lock in a minimum value of the local currency. In this case she protects herself against downside risk but upside potential is unlimited. As can be seen downside risk is limited while upside potential is unlimited. The minimum loss that can be made will be the premium paid for the put option to establish the hedge. This type of hedge is analogous to establishing a protective put position in the case of hedging against stock price that serves as collateral to a credit decreases. (Bodie et al, 2002). Swap Hedging. A currency swap contract is a contract between two counter-parties (Parties to the contract) where one counter-party exchanges a stream of cash flows (debt-service obligations) in one currency for a stream of cash flows in another currency. By so doing both counter-parties can achieve their desired currencies. (Shapiro, 2003). By entering a currency swap contract, the company can also manage its currency exposure. In this way for example, the company which has borrowed, ZAR at a fixed interest rate can transform its ZAR debt into a fully hedge pound liability by exchanging cash flows with another counter-party who desires to have a fully hedged ZAR liability. The two loans comprising the currency swap have parallel interest and principal repayment schedules. At each payment date, the company will pay a fixed interest rate in pounds and receive a fixed rate in ZAR. The counter parties also exchange principal amounts at the start and end of the swap arrangement. (Shapiro, 2003). In a nutshell, the company can engage in a currency swap by borrowing a foreign currency and converting its proceeds to pounds, while simultaneously arranging for the other counter-party to make requisite foreign currency payments at each period. In return for this foreign currency payment, the company pays an agreed-upon amount of pounds to the counter-party. Given the fixed nature of the periodic exchanges of currencies, the currency swap is equivalent to a package of forward contracts of currencies. (Shapiro, 2003). Futures Hedging Currency futures contracts are contracts for specified quantities of a given currency, in which the exchange rate is fixed at the date of the contract. (Shapiro, 2003). For contracts traded on the International Monetary Market (IMM), the delivery date of the contract is determined by the board of directors of the IMM. Like forwards and options, Futures contracts can be used to eliminate credit risk arising from currency fluctuations. (Shapiro, 2003). Currency futures contracts are currently available for the Australian dollar, Brazilian real, British pound, Canadian dollar, euro, Japanese yen, Mexican Peso, New Zealand dollar, Russian rubble, South African rand, and Swiss Franc. (Shapiro, 2003: p. 267). However, these contracts have limited delivery dates and are traded only in small quantities. Thus designing a hedging strategy using futures contracts can be very difficult. (Shapiro, 2003). Conclusions and Recommendations Based on the analysis above, we can conclude that there are a number of different forms of credit risk faced by banks. These risks require that the firm to adopt a global strategy as well as a series of risk management strategies to hedge against risk as examined above. Today with domestic and foreign banks operating side by side risk management in the banking system is getting efficient. By employing better risk management practices, foreign banks are likely to improve risk and return trade-offs. Studies further claim that foreign banks may reduce the volatility of credit. Indeed, foreign banks may stabilise local credit in periods of stress given their ability to spread risk, retain local deposits and gain ready access to external funds (IMF 2005). Some evidence further indicates that foreign banks may reduce the likelihood of banking crises by inducing stronger and less volatile loan growth than that generated by domestic banks (IMF, 2005) References Buckley A. (1996). Multinational Finance. Third Edition. Prentice Hall. Moreno, R (2006): "The changing nature of risks facing banks", BIS Papers, No. 28, August. Mohanty, M, G Schnabel and P Garcia-Luna (2006): "Banks and aggregate credit: what is new'" BIS Paper No. 28, August. Shapiro A.C. (2003). Multinational Financial Management. Seventh Edition. Wiley and Sons Inc. Solt M. E., Wayne L. Y. (2001). Economic exposure and hysteresis Evidence from German, Japanese, and U.S. stock returns Global Finance Journal. Pp 217-235 Vachani S. (2005). Problems of foreign subsidiaries of SMEs compared with large companies. International Business Review, vol. 14, pp. 415-439. Muller A., Verschoor W. F.C. (2005) Foreign exchange risk exposure: Survey and suggestions. Journal of Multinational Financial Managemen. Read More