Credit risk
Category: Corporate Governance
Credit risk. The risk arising from an debtor’s failure to meet the terms of any contract with the bank or otherwise fail to perform as agreed. Credit risk is found in all activities where success depends on counterparty, issuer, or borrower performance.
Issues to be considered by the Council:
Level of risk tolerance — eagerness to assume more risk and consequently to receive a higher return;
Parameters of the risk portfolio — Many banks create their several risk portfolios by market direction rather than by setting a model portfolio. Portfolios usually included are the credit/lending portfolio, the currency trading account and the Bank’s securities portfolio. The primary portfolio is the credit/loan portfolio. Bank Supervisory Council and Management Board members must monitor the pro-activeness of this portfolio, preferably managing toward a target portfolio — which, itself, must be revised from time to time according to market conditions.
Credit risk parameters — In order to advise Supervisory Council on activities within the loan portfolio, the Supervisory Council and Management Board members must be apprised in a timely fashion of the risk methodology and its changes; deterioration of large credit exposures and loosening and tightening of risk parameters due to market or portfolio conditions.
Insidertransactions — Bank Supervisory Council and Management Board members must be vigilant to monitor and encourage to prevent the lending portfolio from containing loans or contracts which are not transparently arrived-at and do not benefit the Bank.
Directed lending — In a similar manner, the Supervisory Council and Management Board members must monitor that undue influence is not placed on a bank to make a loan at the request of a superior without the facts independently supporting such a decision; lending instructions from above or outside the Bank unduly influencing the immediate decision-maker. So-called «paper trails» on decision making are important in this context.
Sectoral concentrations — Unless the Bank specializes in financing one or several industries, there should be an avoidance of concentrations in sectoral lending. The exceptions might be a Bank entering into a market development/penetration campaign during which it will be expected to take on larger concentrations of borrowers in a given sector. A further comment could be made that a Bank should consciously select the peer groups it feels most comfortable in undertaking the risk financing in a sector. For example, the largest, best performing companies, the second quartile of performance, etc.
Concentrations by product or duration of exposure -Increasingly bankers are looking at the risk involved in concentrations by product — long term lending, for example, or consumer loans. Currency exposures would be another example.
Concentrations by customer relationship — It is incumbent on the Bank to learn their customer affiliations, particularly for borrowing relationships, so that a concentration of risk exposure does not build up without the Bank’s awareness of the true exposure. Examples of Banking practice in this regard include prohibiting so-called parent — daughter flow of financing by writing special covenants in the loan agreements that prohibit these arrangements.
Managing non-performing assets — One of the functions of lending is the management of non-performing loans and how pro-active a bank is in this matter. Restructuring of non-performing loans can bring them back into the category that does not require provisioning. Follow-through with loan workout and collection and ongoing loan review are essential to maintain proper control over the portfolio and keep the interest income at its maximum. However, banks’ goal should be issuing loans that will not result in restructuring or workout.
Currently, NBU requires banks to follow certain credit risk normatives as defined by the Instruction No. 386 from 28 August 2001 «On regulation of activity of commercial banks in Ukraine». Main provisions are: single borrower exposure (limit — 25% of capital); large credit exposures (limit — 12.5% of regulatory capital); single insider exposure (limit — 5% of capital); aggregate insider lending (limit — 40% of capital).
In its risk framework NBU will be assessing the following credit risk components: asset portfolio composition, collateral management procedures, loan policies, exposures to unfunded credit commitments, adequacy of provisions, credit administration, management reporting, accounting issues, internal control mechanisms.
Example:
The credit risk is the main risk factor that bankers should watch for. The biggest bank failures were mostly attributable to the poor credit risk management.
In December 1998, the Japanese Government refused any stay of execution for the ailing Nippon Credit Bank (NCB) — one of the world’s leading banks — and put it under state control. The move came as bad debts rose towards $27bn. Officials said the bank had failed to come up with a satisfactory plan to recover bad loans. Bad loans reached ¥3.2 trillion ($27 bn), about one-third of its total lending. NCB was among the world’s top 50 banks in 1997, according to Fortune magazine, with assets totaling ¥12.3 trillion ($106bn).