Bank Lending - Principles for the Management of Credit Risk - Coursework Example

Bank Lending Principles for the management of Credit Risks Word Count: 2346 {Introduction to Conclusion} Contents of the Report Introduction What is Credit Risk? Risk Management Structure Risk Mitigation: Secure Environment to grant Credit: Abbey National plc Conclusion References Introduction Credit Risk Management is an activity of paramount importance to any financial institution. It is essential to the long term success of any banking organization. Sound credit risk management principles increase the stakeholder value by providing for ‘value creation’, ‘value preservation’ and ‘capital optimization’. Most of the serious banking problems can be traced to poor credit standards for counterparties and poor portfolio risk management. Risk Management Group of the Basel Committee on Banking Supervision defines credit risk as “potential that a borrower or counterparty of a financial institution will fail to meet the obligations in accordance with the agreed terms” (bcbs54, 1999). Such deviations from the obligations result in market distortions and cause several woes to both; the bank and the counterparty. Although the risks involved with sanction of a credit is to a large extent intangible; banks can; and in fact to a large extent have been successful in mitigating the risks involved. Effective risk mitigation requires the establishment of appropriate credit risk environment, which can facilitate the creditors to analyze the risks involved in granting credit to counterparty, in nearly tangible format. Most importantly, banks must follow clear guidelines in granting credit to borrowers inclusive of granting new credit, renewal or amendments to existing credit and termination of credit. What is Credit Risk? Credit risk is considered to be one of the oldest forms of risk experienced in the financial markets. Several dominant banking players in Europe such as Bardi, Peruzzi and the Acciaimlli, during the medieval periods have had reported collapse due to over extension of credit (Mukherjee, 2003). Although credit risk has remained to be the most dominant of all the risks in banks across the globe, several new types of financial risks have arisen as a consequence to the globalization of the economy. Bhargava (Bhargava, 2000) presents an insightful pie chart describing the main financial risks that are prevalent in the banking industry. Figure: Pie Chart showing the proportion of Financial Risks (Bhargava, 2000) It can be clearly seen that Credit Risks occupy a major portion of the pie and a bane for most bankers across the world. Credit Risk The degree of credit risk is the probability that a loan lent to a counterparty by a bank may not be repaid. For example assume that £ 100 has been lent to a borrower with a stipulation that the loan should be repaid in full at the end of one year with 20% service charge. It consequently means that the borrower has to pay back £ 120. However assume that the borrower paid back the service charge of £ 20 at year end; and also repaid a principal amount of £ 60. Further assume that the borrower repays another installment of the principal component of £ 30. The borrower does not pay the remaining principal amount of £ 10. Now the actual loss sustained by the bank can be computed as follows (Smith, 2003): The Lender’s Expectations at Year End = £ 100 + £ 20 = £ 120. The Borrower Returns: £ 60 + £ 20 = £ 80 (1st year end), and £ 30 (2nd year end) The value of £ 30 paid after one year of the due date = £ 30 X discount factor for 1 year at 20% per annum = £ 30 X 0.8333 = £ 25. Therefore value of total repayment to the lender = £ 80 + £ 25 = £ 105. Thus the loss to the lender vis-à-vis expectation = £ 120 - £ 105 = £ 15 = 12.5% of £ 120. If the bank had initially anticipated this risk beforehand and loaded the premium onto the normal price. Then the bank would have gained despite the non payment of a part of the sum by the borrower. Risk Management Structure Unarguably, effective credit risk management is one of the most crucial aspects that must be taken into account by any bank. The crucial elements that make up an effective risk management structure include the following: The Board: The Board of any bank performs the all important task of setting the limits for any credit. The Risk Management Committee: This committee performs a number of functions such as, ‘Identifying, Measuring and Monitoring Risks’, ‘Develop Policies and Procedures’, ‘Verifying Pricing Models’, ‘Review Risk Models’ and ‘Identify New Risks’ (fsa.uk, 2005). The Risk Management Committee can further be divided into two departments that work mutually: Asset Liability Management Committee: This committee deals with analyzing the current trends and forecasting future trends of market risk policies and procedures. Credit Policy Committee: This committee deals with constant updates of the bank’s credit policies and procedures. This committee bases its decision on the inputs provided by the Asset Liability Management Committee. An industry survey was carried out by Lepus, a U.K.-based investment banking management consultancy, to identify the key issues of effective credit risk management. The following points were the results of the survey: Robust Technology and Business Process: Robust Technological advancements such as those brought about by BASEL Committee, assist managers to analyze credit risks. Policies: Comprehensive and Strategic policies are necessary to provide a solid framework for the bank to operate in. Policies must be current and reflect the latest trends of the market. Exposures: This incorporates the ability of the management committees in banks to forecast and measure the risks. Robust Analytics: Banks must invest in robust credit risk analysis techniques to avoid any problems. Risk Mitigation: Secure Environment to grant Credit: Abbey National plc Abbey National plc Abbey National plc is one of UK’s leading personal finances companies that provide a range of services including mortgages, credit cards, loans, long term investments and insurance cover. With over 18 million customers Abbey National plc is a reputed organization with well established clientele. The following sections identify the steps that Abbey National plc may take in order to establish a secure environment to grant credit. BASEL Committee Guidelines The BASEL Committee has been constantly providing with guidelines to help banks across the world to draft sound banking principles, with these guidelines as the back drop. The BASEL Committee’s Article number 75, released in September 2000 provides a set of principles under various domains to help banks in establishing a sound credit risk environment. The following steps that are suggested for Abbey National plc, is based on the guidelines provided by BASEL Committee’s Article. Secure Credit Granting Steps The following sections identify the various parameters that must be carefully taken into account by a bank (Abbey Bank), to arrive at a decision whether to sanction or reject credit to a borrower. Management Risk Parameters Integrity: Integrity of the borrower is the single-most important aspect in any decision to grant or deny credit. Numerous features amalgamate in judging the overall integrity of any borrower. Most importantly the bank must assess the track record of the borrower in the past. The bank must take into account the type of relationship had with other banks prior to approaching the current bank. The assets of the borrower must be ascertained and checked to see if any part of the assets is having any negative standing by law. The borrower must be checked for judicial clean chit. Lack of integrity nullifies all other risk mitigation processes. Regardless of any positives the borrower may possess, insufficient integrity is sufficient for the bank to deny any credit to the borrower. Financial Statements: Before making any decisions, the bank should check the financial statement of the counterparty. If the credit to be sanctioned is for a firm, the financial reports of the past few years are analyzed. These financial reports must be checked to determine the trends in progress within the firm. Presence of an inclination in the company’s profits is considered positive. Prospective Projections: If the company is newly established, the future projections laid out by the company must be taken into account. In such cases, the integrity of the firm or its stakeholders assumes a very high level of importance due to the lack of availability of financial numbers. Comparisons: If all the tests enumerated yield a positive result, the bank must; as a final check, compare the financial data obtained from the borrower with other established borrowers of the bank of similar nature. This provides the bank with an idea about the prospective growth of the borrower based on which the bank may decide to grant or deny the credit. Market/Industry Risk Parameters Market Analysis: The industry or the market, in which the interested counterparty is located in, serves as a major indicator to the bank in assessing the level of risk involved in issuing credit. The concerned officials at the bank must consider the prevalent market trends and outlook to determine the prospective scope of the company and their products in the market. A demand analysis reveals important information that can be used by the bank. Government Policies: The risks that are needed to be analyzed in this phase have a correlation with respective government policies. For example, if the government encourages funding for infrastructure in UK, consequently there will be a sudden inclination in the steel, cement and related construction equipment industry. In such a scenario, if a company that deals with manufacturing of tractors seeks credit from the bank, it must be considered positively. Competition: Another important aspect that must be measured here is the level of competition being faced by the company seeking credit and its standing amidst its competitors. Contemporary Issues: Another area that might lead to a risk is the contemporary issues faced by the borrower. The bank must not see only the scenario prevailing in UK but also examine the external factors that might affect company’s production/sales. For example, suppose a pharmaceutical company of UK, needs a credit from Abbey International plc. The pharmaceutical company intends to export its goods to USA. In such a scenario, the company should possess the necessary approval from US (US FD Approval) for exporting their goods. Therefore Abbey bank must check whether the company has the necessary approval for selling goods at US. Business Risk Parameters Technology: Technology being used in a company plays an important role in the decision making process of the lending bank. If the company uses obsolete technology, there is a good possibility that it may not be able to meet the international standards and quality may suffer. This will affect the sales and profits of the company and in turn affect the repayment capacity of the company to the bank. Hence the bank should examine and satisfy itself, whether the technology used by the company is appropriate. Distribution Network: The bank must check whether the company enjoys a good distribution network. A good network ensures that the company’s product can be marketed without any hassles. Cash flow Consistency: The bank is a profit making organization and its main motive is to get back the amount lent with interest. Hence the bank has to analyze and satisfy itself about the company’s cash flows. That is, they should verify whether the cash generated by the company is sufficient to take care of the bank’s interest. Financial Risk Parameters The bank needs to see certain financial aspects of the borrower before sanctioning any credit. The parameters to be analyzed include: Current Ratio: this is the most important ratio indicative of the liquidity position of the enterprise. It is used to analyze the liquidity enjoyed by a company. This is worked out taking into account the short term assets of the company with its short term liabilities. Current Ratio (CR) = Current Assets / Current Liability. TOL / TNW: The requirement of the company is broadly funded by (a) Own Funds or Tangible Net Worth, (b) Short Term Credit and (c) Long Term Credit. The (b) and (c) are external sources of funding, therefore known as Total Outside Liability (TOL). This ratio provides information about the position about own funds (TNW) compared to long term funds (TOL). PAT / Net Sales (%): It indicates the profit earning ratio of a company in relation to sales. PBDIT / Interest (Times): This is another profitability ratio, which helps the banks to determine whether the income generated is sufficient to meet the interest payment for the loan taken. PBDIT denotes to Profit Before Deprecation, Interest and Tax (Operating Profit). ROCE (%): Any organization takes up the business mainly to generate income out of capital employed. Return On Capital Employed (ROCE) ratio suggests the ability of the company to generate sufficient income on its employed capital. Ratings After taking all the above mentioned parameters the bank must arrive at the credit risk rating for the company. Risk rating is a deliberate action in the process of financial decision making. The action results from an optimal choice made by the decision maker, which in turn emanates from systematic analysis of the various alternatives. UK banks adopt certain parameters to arrive at credit risk rating. After rating, three brad classifications can be made. AAA/AA: If a bank arrives at this rating for a borrower, it indicates highest safety. A/BBB: This rating indicates moderate safety. < BBB: This rating indicates High Risk. Conclusion Credit Risk Management has been and will remain to be a major challenge to all banking organizations. It is utmost crucial for all banks to equip themselves with modern policies and principles of establishing a sound credit risk management framework. Credit lending is the initial and most important aspect of credit risk management. It is an intangible aspect, and requires insight and foresight on part of the manager to determine whether to grant or reject a loan. Definitive parameters must be set and rated to determine the final assessment of the counterparty. Banks must be aware of the latest drivers that provide good analysis of risk management such as BASEL II. Incorporating all these measures into the decision making will result in results favorable and positive to the bank and will enhance their image in the banking industry. References Basil Committee on Banking Supervision (2000), “Principles for the management of credit risk”, Article 54. Basil Committee on Banking Supervision (2000), “Principles for the management of credit risk”, Article 75. Mukherjee (2003), “Credit Appraisal, Risk Analysis and Decision Making”, Snow White Publications, Pg 727. Bhargava (2000), “Credit Risk Management Systems in Banks”, ICICI Bank Publications. Andrew Smith (2003), “What is Risk Management”, HBOS Publications. Financial Services Authority (2005), “Financial Risk Outlook”, found at: http://www.fsa.gov.uk/pubs/plan/financial_risk_outlook_2005.pdf Read More