Credit Risk
Category: Bank Management
Definition
This one is the most dangerous and common risk a bank has to face; this happens every time a customer does not respect his financial commitments with the bank; most of the time, this is the reimbursement of a loan.
There are many reasons to this:
dishonesty
cause beyond control
economic failure: unemployment for private customers or insolvency for a commercial or an industrial firm.
Measuring credit risks
The agreement for a loan and the delivery of funds do not put an end to a credit operation, for, during the entire life time of the loan, the risk remains.
The portfolio of a bank has to be diversified so that the failure of a customer, or a group of customers, of an economic sector or a geographical area does not put its existence in jeopardy.
a) Measuring customers risks
The amount of the credits granted to one customer should not exceed a percentage of the capital stock of the bank; this limit can be fixed by Public Authorities.
b) Measuring the risks on groups of customers
This means that a limitation should be decided upon for credits granted to customers benefiting from amounts exceeding a fixed percentage of the capital stock.
So, a credit institution, with a capital stock of: 100 million USD, could decide on the following limits:
40 million for one customer
800 million for the group of customers benefiting from credit lines between 15 and 40 million.
c) Measuring the risk in every economic sector
The bank has to measure the risks related to each economic sector and to diversify its range of sectors if possible.
d) Measuring the risks on the different kinds of customers
The amount and the type of risk can vary a gread deal depending of the segment of the market: private customers, commercial or industrial firms, regional, national or international companies, etc..
e) Measuring the risks according to the various credits granted
This has to be measured because various over drafts, discounts, guarantees, short term or long term credits and so on do not carry the same risk.
f) Measuring the risks in every geographical area
The economic difficulties in a region, or in a country can have an effect on the solvency of a bank deeply committed in this area.
Managing credit risk
a) Risk Diversification
Referring to point 3.1.4.2, the management of any Bank has to spread the risk on the a wide range of customers, credits and countries, etc.
b) Clearly stated objectives
The general Management of a Bank has to conceive a clear Credit strategy with well defined objectives.
commercial objectives: qualitative and quantitative objectives for every category of customers depending on the potential market and the forecast profitability
objectives on the quality of the risks: a system of rating can be set up; it gives a rating to every customer, depending on its financial situation, its management and its economic environment. This quotation will fix the maximum limits and the categories of credit to be granted.
profitability objectives: a good balance must be found between.
risky credits with a good margin and low risk credits with a low margin.
c) A clear delegation scale
For efficiency reasons, credits cannot be authorised by only one person or one committee; so the authorisation process must be decentralised.
In most banks, limits are set on a quantitative basis depending on the position of the operator.
| COMMERCIAL BANK | ||
|
Branch Manager General Manager Credit Committee |
overdraft
50 000 100 000 over |
discount
100 000 1 000 000 |
This system can be completed by a system of qualitative limits (Property loans-International credits, medium and long term credits)
d) Good quality analysis
The decision of granting, increasing, reducing or refusing a credit is taken from a document which must hold the necessary information (financial, economic, managerial).
Many banks have standardised documents to make the connection of information efficient.
e) A strict follow-up
Here are the four basic elements of credit management.
every customer has to be monitored up by one person.
all necessary information on all the credits granted to the customer must be transmitted to the person in charge.
very anomaly should be detected in real time and analysed; an over utilisation of a credit line can be due to a bad evaluation of the financial needs, or an increase of the needs due to developing activity, or current needs or losses.
f) Guarantee follow up
The bank has to be aware that the value of a guarantee in support of a credit can change during the life of the credit. If so, new guarantees might have to be taken.
g) An efficient legal department
It is inevitable that some credits will fail to be repaid, but limiting losses depends on the efficiency of the legal department: (respect of the legal time, new guarantees if possible, strict monitoring.