The Management of Credit Risk in a Bank - Essay Example

Running head: Information systems management Student name: Student number: Course title: Lecturer: Date: Information Systems Management Most managers in an organization fail to realise that project planning is key to a successful project. Most of these managers ignore this important step in favour of getting the work done. By ignoring this step they overlook risk management yet it is the most important part of the project planning. It is always advisable to know all the risk which might interfere with the project and be prepared in case of any unusually happening on the project. According to Saunders (2010, p.125) risk management can be defined as a discipline at the central part of a bank and it comprises of various factors that can interfere with the risk profile. It entails identification of risk, measuring of risk, monitoring and controlling risk so as to avoid huge losses in the bank. This paper will analyze the management of credit risk in a bank. Most banking institutions face problems of customers failing to complete their obligations as per the contract which they had entered with the bank. These customers may fail to repay loan because of various reasons. Some of the reasons might be inability to repay because of bankruptcy, or the customer is not willing to repay. In other cases, the borrower may be depending on his debtors who may delay or fail completely. These bank risks arise when the banks are dealing with the individual, a sovereign, or corporate. Mostly, loans are the main source of credit risk in bank or financial institutions. Furthermore, the credit risk might arise from balance sheet activities. Other factors causing credit risk are the economic exposures which consist of the expenses incurred on non performing assets, opportunity costs and cost of transactions in the bank. These risks can be managed through various components. These components are categorised as follows. Firstly, the risk can be managed through board and senior management oversights, secondly is by using of advanced systems and processes for recognising the signs of risk, acknowledging, measuring, monitoring and controlling of those risks and finally is by using organizational structure. Board and senior management’s oversight To avoid risk within the banking organization, the board must approve various banks’ credit risk procedures and other policies which will minimise these risks. They also need to approve the management which design the overall strategy of the bank on how to carryout its business. These measures need to be approved in yearly basis to ensure that it is not obsolete because of changing business environment. Some of the main responsibilities of the board are the issues of controlling credit risk which is comprised of the following. First, they should maintain the exposure limit and banking standards so that the bank is not exposed to credit risk at any given moment. Secondly, ensure that the top managers who are responsible for the credit risk management are qualified in that field and ensure that they are trained so that they know the system used by the bank. Different banks have their own way of managing credit risk though the exposure limits are normally set by the international banking act. Also they should ensure that the bank has adopted effective fundamental principles which can help in risk identification, measurement of credit risk, monitoring and controlling of credit risk and lastly, ensure that the bank has adopted relevant measures of handling the credit risk in the company (Doherty, 2010. pp 88-92) Since the main business of the bank is keeping and lending money, they should developed a credit strategy which aimed at maximising the return and at the same time maintaining credit risk within the limits set. This risk strategy should give the proper way of lending and the principles which should be observed strictly while granting loan. It also should clearly state the bank’s plan on lending and the sectors in which the bank should lend. It is important to categorise this basing on the segments and products, locality of the customer, duration of the loan, interest charged and the economic situation in the country. Other important factors include the preferred level of diversification i.e. segmenting the market so as to identify the reliable customers who are willing to pay premium prices for the loan. These customers can be identified effectively if the bank develops a credit risk strategy that aims at understanding the customer in terms of character, financial stability, and the repayment ability. Top managers in the bank should developed a policy that will govern the lending procedure as part of credit risk management framework and ensure that such policy is approved by the board of directors. Such policy should be used by the employees in the bank who are vetting loan application forms and when making decision in lending to various customers such as farmers, corporate, consumers and SME (Saunders, 2010. p 124). They should ensured that this policies is addressing important factors such as appraisal process, the authority which is responsible for approving exceptional cases, how to identify signs of risk, measurement of the risk and the expected measures. Other issues which might be reflected in this policy are the risk acceptance criteria, administration of credit, and guidelines on management of non performing loans. These policies should be communicated down the line clearly and be written in concise and clear language to avoid confusion. It is the responsibility of top management to ensure that the policy is implemented. Organization Structure Banks have different structures, it is therefore essential for these structures to be set in accordance with the size of the bank, complexity and diversification of its daily work. Furthermore, the bank should compose a credit risk management committee. This committee should be represented by the managers from different departments such as the credit risk management department, loan department, and treasury. The main function of this committee in the bank should comprise of the following. Ensure that credit risk policy is implemented and be followed whenever a loan application form is received. Assess the customer who has borrowed loan to ensure that he or she has made a minimum requirement as per the policy. Recommend to the board of directors on policies and standards that should be approved which should cover the credit proposals, the minimum standards of the loans and benchmarks. Decides on important issues such as delegation of powers to approve loans in the bank, the minimum exposure limits on credits, nature of the loan security, loan review mechanism, monitoring on application of loan, pricing of the loans and the expected legal compliances etc. To ensure that credit risk is control effectively in the bank, there should be a clear function of some departments. For example the bank managers should ensure that policies governing loans, setting of minimum and maximum amount of loans which the bank can lend, monitoring of loans are the things which should be done separately from the functions of loan originations. This will ensure that every factor before lending of funds is considered in details (Ramos, 2009. pp 212-214) Every bank irregardless of it size have a credit risk management department so as to handle the following issues in the bank. Ensure that the set standards governing the lending in bank are maintained and also ensure that exposure limits are within the boundaries before lending. Ensure that the rules and regulation of credit risk are observed as established by the board or credit risk management committee. Institute systems of detecting signs of risk, management information system, warning signs of non-performing loans, and ways of monitoring loans. The department should develop measures to be followed in case of problems on money advanced. Systems and procedures Credit origination Before the bank lends to its customers, it must consider several factors such as lending strategy and their target market. The bank managers should research on the customer who is applying for loan to find out the following. They should establish the purpose of the loan and the means of repayment. By knowing the means of repayment the managers will be in a position to establish the nature of the business and use their expertise knowledge to forecast the future of the business. It is also important to follow the history of the borrower i.e. on how he has been handling his obligations such as repayment of the loans (Ramos, 2009. p 221). From this, it will be simple for the managers and the lending authority to propose terms and conditions which will govern the loan contract between the borrower and the bank. Lastly, they have to consider the nature of the collateral, is it realisable? Some collaterals may not be easily realised because of its nature while some might deteriorate in value thus exposing bank position into risk. When all these procedures are through, the loan is approved by the relevant authority. Many banks have been faced with the risk of loan default by new borrowers. This has resulted because of negligence in the side of the bank. This happens on the basis of assuming that the customer or the borrower is highly reputable. Whenever a bank is approached by the new customer for loan, the bank should ensure that the customer is well known. The bank should ensure that the customers is creditworthy and is capable of repaying the banks loan. While structuring the loan facility the bank should ensure that all the lending principles are considered to avoid risk of non payment. Such principles include appraising the amount and liquidity of the customer, his financial status and the purpose of the loan. The bank has to make sure that the loan is used in the initial project. There have been tendencies where customers borrow loans for a project but they end up using those funds in a different project that they had not planned for. In case the borrower has used the funds in a project not shown in the initial proposal, the bank managers should visit the borrower to find out the financial status of the borrower. In case of corporate loans, the company should show the relationship between them with the projects they have invested the money in. In most cases parent companies have used its subsidiary company to borrow loans; this might be against the bank policy though other banks acknowledge the act. Bank should not rely on collateral provided because their major aim is to find out whether the borrower is in a position to repay the loan and not to collect the collateral which will be sold, collaterals should only be collected for formalization process (Saunders, 2010. p 125) Limit setting Banks should set their own exposure limit to ensure that the bank remain liquid all the time. The bank should set different exposure limit depending on the nature of the customers. Exposure limit for corporate customers should be higher than that of individual customers but this should be based on the repayment ability. This exposure limits should be reviewed annually for necessary changes. Credit Administration Banks should establish a credit administration to handle the following functions. First, credit administration should ensure that the loan application form is correctly completed and the details of the customer in the form match with those in the identification documents. Some of the important documents at this phase are the guarantees and transfers of security to the bank custody. Secondly, credit administration should ensure that the disbursement is made after proper approval of the loan application and after the facility limits have been saved in the system of the computer. The third function is the credit monitoring. Credit administration function should ensure that the borrower is performing his obligation in terms of repayment. Another function is keeping proper records for the repayment. The borrower needs to be communicated to before the date of repayments is reached. This is very important because it act as a reminder especially if the customer is very busy with other management or business issues. Lastly, credit administration should ensure that the documents such as collateral are kept in a safe place to avoid risk which might be caused by the fire (Resti, 2009. p 234) Credit risk monitoring and control This is an act of monitoring the borrower’s credit with his books of accounts such as balance sheet, profit and loss account cash flows statements etc. The bank should monitor the borrowers account so as to identify the way account is being conducted. Banks needs to develop a system which will monitor customers’ account so that they can detect any sign of deterioration in early stages. This will help the bank to determine whether the loan is been used in the right project or not. The monitoring system will enable the top managers to monitor the total credit portfolio and its trends in the bank. The banks credit policy should unambiguously provide the steps of monitoring and the means of realising the funds in the account. In most cases the customer should provide the evidence that certain amount withdraw will be used in various fields as per the original project. This policy should also lay down procedure that describe the roles and tasks of the borrower on the risk which might occur, the criteria used when analysing individual loans & overall portfolio in the bank, regularity of monitoring the loans, evaluations of collaterals and loan securities, and detection of risk on loan due to poor management (Saunders, 2010. p 127) Banks should also establish key indicators that portray the credit quality of a loan. These comprised of business condition in terms of performance and the liquidity position of the business. Another important indicator is the way obligor is conducting the accounts i.e. number of withdrawals against the deposits made and lastly is the value of collateral in relation to the loan. The bank should ensure that the value of collateral is higher than the value of loan. However, the bank should pay close attention when accepting shares and stock as collateral. This is because share can easily fall in value. Other collateral such as the life insurance should also be accepted with caution because the borrower can fail or stop paying the premiums to insurance company making the collateral to loose value. Managing problem credit Banks should develop some system which will help in detecting risk before it is too late to be corrected. It is important for a bank to establish a system which can identify the signs of risk so that the bank can take the necessary precautions before it is too late. Credit risk policy of any bank contained the procedures of handling the risk which might occur before the customer complete its obligation of servicing the loan. Such procedures differ from one bank to another. Problem loan management process takes in various elements such as negotiation and follow-up. The bank should continuously communicate with the customer and follow up in case of default. In case a risk has been identified such as loss of business the bank can decide to restructure loan facility i.e. if it was overdraft the bank can consider turning it into a loan so that the terms of repayment can be changed for the benefit of the borrower and the bank. Other important step which can be taken by the bank in the efforts of obtaining back their funds is through enhancement of credit limits. Banks can also decide to reduce amount of the interest rates so that the borrower can be in a position to pay (Resti, 2009. p 232). However, the borrower’s condition may also make all these efforts not to bare any fruit. In some cases the borrower may be depending on the business which might be in a critical condition. An example of such situation is when the company is under receivership. Under such condition, the most important thing is the borrowers willingness to repay the loan through other means such as realising is own estates or his own assets. Although such counteractive strategies frequently raise ways of recovering the funds, banks needs to put into effect a lot of concern in accepting such measures and that the borrower should not fail to repay intentionally. It is for this reason that the bank needs to evaluate carefully the collateral before accepting it. Another method of evaluating the ability of the customer to repay loan is through credit scoring. The bank can undertake this so that it can find out how the customer has been behaving when delivering his obligation of repaying debts. Review of the customers account might be helpful also because the bank will get to analyze the number of withdrawals and deposit. The bank will also be in a position to know whether the account is ever in credit or not. Such indication can reflect the true nature of the borrower when it comes to servicing of loans. From the above analysis of the credit risk in the bank, it is evident that risk management is an essential part of project planning. But in the most case the plan does not work because of poor planning and the act of negligence by the top managers in the bank. Managers should understand that the business environment is changing as time goes and therefore the traditional way of doing things should be changed (Doherty, 2010. p 114). The second factor which is causing risk management to fail is the issue of management in the bank. Some of the managers in the banks fail to take all the precaution seriously because they think they can handle all the issues by themselves. This is mostly contributed by the system of the management being practiced in the organization. Psychologist such as Taylor had pointed out that organization structure is the key determinant of the success of an organization. For this reason, the bank should ensure that they established the right structure which will enable the organization to succeed. In conclusion, risk management is an important part of project planning and every manager should ensure that a lot of attention is put on this part while carryout a project plan. Banks managers should ensure that experts are involved on this so that the proper Bibliography Doherty, N. 2010. Integrated risk management: techniques and strategies for managing corporate risk. Journal of Financial Services Research vol.12, no. 3, pp. 83-115 Ramos, S 2009, Financial risk management: a practical approach for emerging markets. Journal of bank Issues and Practices, vol. 45, no. 2, pp. 207-226 Resti, A. 2009. Risk management and shareholders' value in banking: from risk measurement models to capital allocation policies. John Wiley and Sons. 4th edn. Pp 229-235 Saunders, A. 2010. Credit Risk Management in and Out of the Financial Crisis: New Approaches to Value at Risk and Other Paradigms. John Wiley and Sons. 3rd edn. Pp 124-129 Read More