Influence of Credit Risk on Financial Institutions - Research Proposal Example

?The Influence of Credit Risk in Financial s Table of Contents Table of Contents 2 3 Introduction 3 Aim of the Study & Specificationof Objectives 4 Literature Review 5 Methodology & Data 8 Critical Reflection 10 Conclusion 11 Time Schedule 11 Limitations 11 References 13 Title The title of the research proposal is “The influence of credit risk in financial institutions”. Introduction The research study is related to the risk management issues that are associated with financial institutions. The purpose of the study is to identify and analyse the influence of credit risk in financial institutions. Credit risk has been defined by various financial institutions as the prospective reduction in the value of the on-balance-sheet and off-balance-sheet related assets owing to deterioration in the credit related profile of the clients of an institution (International Finance Corporation, 2010). Financial institutions primarily play a role of assisting the flow of funds from various ‘individual surplus units’ to ‘deficit units’. Financial institutions comprise of commercial banks, finance companies, savings institutions, credit unions, money market funds, mutual funds, pension funds and insurance companies (Madura, 2008). Adequate management of the credit risk in the financial institutions is a critical aspect for the growth and survival of the institutions. If a financial institution fails to control risks like that of credit risk then it can lead to insolvency (Wenner & Et. Al., 2007). The recent financial crisis had a major impact on the worldwide financial system. Managing risk and capital requirements in the various financial institutions have turned out to be an utmost necessity. Financial institutions generally have a quite complex structure related to liability. Credit risk of a financial institution is considered as a function of market valuations of the institution’s asset portfolio and its leverage (Chen & Et. Al., 2009). Thereby, the study aims to critically discuss the influence that the credit risk generally has on financial institutions. Aim of the Study & Specification of Objectives The aim of the study is to recognise the significant and influential capabilities of credit risk in financial institutions. The relevance of the study can be judged from the fact that in terms of financial risks that a financial institution face, the credit risk or default risk is considered to be one of the most significant and critical risk factors that every financial institution endeavours to mitigate to protect the financial institution and its consumers from insolvency. Objective of the study is to analyse and identify influence of different credit risks on financial institutions such as default risk; credit spread risk, sovereign risk, downgrade risk and counterparty risk. Therefore, a few questions that can be considered are: What is the credit risk? What is the influence of credit risks on financial institutions such as commercial banks, insurance companies, savings institutions and others? What are the ways by which credit risks are being mitigated by financial institutions? In order to find answers to these questions scholarly articles, books, journals and others will be observed and used to identify the relevant aspects related to the study. Literature Review According to Investopedia (2011), credit risk can be identified as a risk if an individual or a company will be incapable to pay the principal or contractual interest on its debt obligations. This type of risk is mainly concerned with the investors who generally hold bonds within their portfolio. Government bonds, primarily issued by the federal government, are considered to have the slightest amount of default risks as well as lowest amount of returns. Corporate bonds have a tendency to have the highest level of default risks but it also provides higher level of interest rates. Bonds that hold higher chances of being default are measured to be junk bonds, whereas, bonds that have lower chance of default are generally considered as investment grade (Investopedia ULC, 2011). According to Landschoot and Vennet (2002), banks can incur considerable losses at times when the ‘credit quality’ of the borrowers of the banks generally deteriorates. The credit risk driven shocks that leads to the distress of the banks can be caused by both domestic as well as foreign undesirable economic events (Landschoot & Vennet, 2002). As observed by Rahman and Shahimi (2010), credit risks in financial institutions such as banks generally arise due to unwillingness or inability of the borrowers towards repayment of monthly instalments in a timely manner and with full agreement to the decided terms. Credit risk can be observed to be diversified, but the risk can’t be entirely eliminated as a part of it can occur as consequence of systematic risk (Rahman & Shahimi, 2010). As observed by banque-credit (2011), from the perspective of the financial institutions the credit risk basically emanates from the ‘uncertainty of losses’. It has been also observed that the credit risk has certainly a severe consequence for any organisation as each debt that is unpaid can be considered economically to be a dead loss that the creditor has to bear. In terms of evaluating the credit risk, the solvability related question of a financial institution is a prime factor. The solvability aspect mainly depends upon the pure internal elements that a financial institution has within itself. The outside contextual aspects such as global economic scenario, geographical localisation and the forecasts of sectoral evolution can also play a major role in case mitigating credit risk by a financial institution (banque-credit, 2011). According to the Basel Committee (2000), credit risk has been observed to be the chief source of difficulties in case of banking institutions all through the world (Basel Committee on Banking Supervision, 2000). According to International Monetary Fund (2006), there has been an increasing acknowledgment that the dispersion related to credit risk by different banks to a wider as well as more varied group of investors, instead of warehousing such type of risk on the balance sheet of the banks, has aided in making banking as well as in general financial system, even more resilient. Credit derivatives as well as structured credit based markets have developed quite rapidly in the recent few years (International Monetary Fund, 2006). As observed by Wilson (1998), financial institutions are increasingly managing and measuring the credit risk related exposures at the ‘portfolio level’ along with the transaction level. In order to mitigate credit risks at the portfolio level, financial institutions have recognised the fact the all credits can turn out to be “bad” credit due to certain economic scenario. Managements of the financial institutions at present possess increasing scope to manage exposure to credit risks proactively by using syndicated lending, credit derivatives and also third party guarantees (Wilson, 1998). As observed by Financial Services Agency (2011), in case insurance companies credit risk has a significant influence and they can incur major losses due to the deterioration or reduction of the value of an asset of the financial standing of the credit granted company (Financial Services Agency, 2011). According to Barry (1991), credit risk can be considered as arguably the major risk faced by insurance companies with regard to their huge liabilities that support their investment-oriented products (Barry, 1991). As observed by Bloomfield (1997), credit risks can be mitigated by a financial institution by using collateral or by structuring a special function intermediary and by effectively controlling a portfolio of derivatives (Bloomfield, 1997) According to Bindseil and Papadia (2006), collateral frameworks can provide financial institutions such as banks desired level of protection from credit risk (Bindseil & Papadia, 2006). According to Basel Committee (2000), collateral as well as guarantee are considered to be the most extensively used forms related to credit risk mitigation. Apart from these stringent covenants, third-party guarantees, on-balance sheet netting and credit derivatives have been used to mitigate credit risks in financial institutions (Basel Committee on Banking Supervision, 2000). Therefore, it can be observed that credit risk plays a critical role in case of ensuring stability of a financial institution. Thus, financial institutions require not only preparing mitigation techniques to prevent occurrence of debacle from defaulters but they also need to identify borrowers who can likely to become defaulters in order to prevent such event from occurring. Methodology & Data The research will be conducted by using both quantitative and qualitative analysis. Quantitative research analysis will be used for measuring and analysing the causal relationships that exists between variables. For this research quantitative research will allow to collect facts through data collection method from respondents. The data for this research will be collected from 100 respondents which will be the sample size. The respondents will be general employees and managerial level employees of 20 different financial institutions such as commercial banks, savings institutions, finance companies, insurance companies, and others. The 100 respondents will be selected from these financial institutions by using random sampling. The respondents will be provided with a set of question through a questionnaire and it will be mailed to them comprising questions related to the credit risk, how significant they consider credit risk to be among the various other financial risks that are present, influence of credit risk on their financial institution and the various mitigating measures they are using to prevent their organisation from facing insolvency and other critical scenario due to credit risk. The respondents will also be asked to provide their recommendations related to their views and other methods that can be used to prevent credit risks from occurring. These findings will be represented by using graphical methods such bar chart, tables, pie-chart and also t-test will used to analyse the findings from the respondents (Golafshani, 2003). In order to get a thorough understanding of the research problem related to certain intangible information that could not be represented through quantitative analysis, qualitative analysis will be conducted by using case study and literature review method. Through the case study method various findings from financial institutions can be gathered related to their credit risk scenario. Literatures can be observed to identify what different financial institutions consider regarding influence of credit risk to operations and various mitigation techniques can also be identified. Thus, by using these methods an in-depth analysis of the research problems can be performed to get to core of the research topic. These methods can provide certain difficulties such as availability of adequate respondents, biasness of the responses from the respondents. Critical Reflection It can be observed that the proposed research is quite significant in relation to the existing global economic scenario. The recent economic meltdown has highlighted the significance of maintaining proper credit ratio in the financial institutions as well as has brought into light the significance of mitigation techniques and the constant endeavour of various financial institutions to prepare adequate techniques to prevent any credit risk. It can be also seen that occurrence of credit risk at times can give rise to downgrading of borrowers and recessionary scenario (The Telegraph, 2008). Therefore, credit risk has a major influence on the financial institutions globally. Thus, the proposed research can be seen as an extremely crucial study and can enlighten the reader with several valuable findings. The proposed research create certain potential difficulties such as in terms of research data findings through selecting appropriate respondents, appropriate use analytical tools to analyse research data, finding appropriate literature and case study to use for the research. These limitations can be mitigated by using appropriate research tools and selecting respondents according to the requirements. Conclusion Literature review on the research topic has highlighted the significance of the study in light of the existing economic scenario. Therefore, the research topic will provide a valuable insight into the research topic by employing quantitative and qualitative research methods. The case studies and existing literatures will provide with recent occurrences in relation to the research topic. Thus, the research study can be an extremely value adding factor for the readers. Time Schedule April 12th to April 25th Collection and re-organisation of relevant literatures. April 26th to May 5th Preparation of questionnaire and mailing it to the respondents. May 6th to May 25th Data collection and sorting to finalise relevant information for analysis May 26th to June 15th Analysis of data, finding appropriate solution to the research problem and preparing the final draft. Limitations In the process of completing this research there are certain limitations present which can create difficulties in reaching a proper conclusion. In this research the data is intended to be collected from respondents of various financial institutions. Therefore, respondents’ bias can create a difficulty in finding actual relation between credit risk and its influence in financial institutions. The availability of response within specific time period can create hindrance as the questionnaire to the respondents will be mailed; therefore there can be a scenario where all the respondents might not reply back with the filled up questionnaire within the provided time period. These aspects have to be taken care of in the research to complete it within proper timeframe. References Basel Committee on Banking Supervision, 2000. Industry Views on Credit Risk Mitigation. Bank for International Settlements. [Online] Available at: http://www.bis.org/publ/bcbs67.pdf [Accessed April 05, 2011]. Barry, G., 1991. Credit Risk Research Private Placement Bonds and Commercial Mortgage Loans. Brighton. [Online] Available at: http://www.actuaries.org/AFIR/colloquia/Brighton/Barry.pdf [Accessed April 05, 2011]. Bloomfield, P., 1997. Statistics of Credit Risk Management in Financial Derivatives. North Carolina State University. [Online] Available at: http://www4.stat.ncsu.edu/~bloomfld/talks/TriangleSlides.pdf [Accessed April 05, 2011]. Bindseil, U. & Papadia, F., 2006. Credit Risk Mitigation in Central Bank Operations and its Effects on Financial Markets: The Case of the Eurosystem. European Central Bank, Occasional Paper Series, No. 49. banque-credit, 2011. The Credit Risk. Banks. [Online] Available at: http://www.banque-credit.org/EN/banks/insolvency-risk.html [Accessed April 05, 2011]. Chen, R. R. & Et. Al., 2009. Financial Institutions In Crisis: Modeling The Endogeneity Between Default Risk And Capital Requirements. Indian School of Business. [Online] Available at: http://www.isb.edu/Faculty/upload/Doc2220101455.pdf [Accessed April 05, 2011]. Financial Services Agency, 2011. Credit Risk Management System Checklist and Manual. Manual. [Online] Available at: http://www.fsa.go.jp/en/refer/manual/hoken_e/h12.pdf [Accessed April 05, 2011]. Golafshani, N., 2003. Understanding Reliability and Validity in Qualitative Research. Nova Southeastern University. [Online] Available at: http://www.nova.edu/ssss/QR/QR8-4/golafshani.pdf [Accessed April 05, 2011]. International Finance Corporation, 2010. Challenges and Opportunities. Climate Risk and Financial Institutions. [Online] Available at: http://www.scribd.com/doc/39820870/IFC-Publishes-Report-on-Climate-Risk-and-Financial-Institutions [Accessed April 05, 2011]. Investopedia ULC, 2011. Credit or Default Risk. Risk and Diversification: Different Types of Risk. [Online] Available at: http://www.investopedia.com/university/risk/risk2.asp [Accessed April 05, 2011]. International Monetary Fund, 2006. Global Financial Stability Report. International Monetary Fund. Landschoot, A. V. & Vennet, R. V., 2002. How Does a Banks' Risk Profile Influence the Effect of Credit Risk? Evidence from Bank Stock Market Returns. Social Science Electronic Publishing, Inc. [Online] Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=302453&http://www.google.co.in/url?sa=t&source=web&cd=2&ved=0CCUQFjAB&url=http%3A%2F%2Fpapers.ssrn.com%2Fsol3%2FDelivery.cfm%2FSSRN_ID302453_code020301590.pdf%3Fabstractid%3D302453&rct=j&q=influence%20of%20credit%20risks%20%2B%20commericial%20banks&ei=X7WaTdnfC8XIrQfM8MXuBg&usg=AFQjCNFxOY4HewByTP2q80SM7NMpJ3RaAQ&sig2=zx_iPFK46YLqlghUICJfFw [Accessed April 05, 2011]. Madura, J., 2008. Financial Markets and Institutions. Cengage Learning. Rahman, A. A. & Shahimi, S., 2010. Credit Risk and Financing Structure of Malaysian Islamic Banks. Journal of Economic Cooperation and Development, 31, 3, pp. 83-105. The Telegraph, 2008. Overhaul 'Increases Risk Of Recession'. Banks and Finance. [Online] Available at: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/2781906/Overhaul-increases-risk-of-recession.html [Accessed April 05, 2011]. Wenner, M. & Et. Al., 2007. Managing Credit Risk in Rural Financial Institutions in Latin America. IADB. [Online] Available at: http://idbdocs.iadb.org/wsdocs/getdocument.aspx?docnum=1442364 [Accessed April 05, 2011]. Wilson, T. C., 1998. Portfolio Credit Risk. FRBNY Economic Policy Review. Read More