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Credit Risk

Asset Management (ie. Credit Risk Management)

What are the assets of a Bank?

Credit risk of liquid assets is typically not that

important. Why?
Credit risk of fixed assets is typically not

Credit risk in lending is the key issue

Are there any other sources of credit risk?

Credit Risk And The CAR Arrangements

A very simplistic approach to credit risk

Different categories of business are

weighted according to credit risk

What are the categories and what are the

Some changes currently being considered

How Important Is The Management Of Credit Risk?

In comparison to the management of

other risks
As a factor in Bank failure
As a factor influencing Bank performance

Basic Faults in Lending Procedures

1) Inattention to loan policies 2) Overly generous loan terms and lack of clear

standards 3) Disregard of banks own policies 4) Unsafe concentration of credit 5) Poor control over loan personnel 6) Loan growth beyond the banks ability to control quality 7) Poor systems for detecting loan problems 8) Lack of understanding of borrowers credit needs 9) Out-of-market lendings

Basel on Credit Risk

Credit Risk the risk of counterparty

default usually represents the single largest risk facing an Bank. The presence of a well-functioning credit risk management system is, therefore, fundamental to the safety and soundness of an Bank. Credit risk management system is the responsibility of the top management and must include methodologies to monitor and measure credit risk.

The Management Of Credit Risk (Compared To Other Risks)

Inherently more difficult than managing

other risks
The example of managing
liquidity risk

capital risk

Credit Risk Management

A Banks loan portfolio is the product of large

numbers of individual lending decisions

These decisions involve a large number of

different lending officers

Credit Risk Management

Therefore, coordination is crucial Without coordination, a Bank cannot

control its level of credit risk (or its riskreturn tradeoff)

A Management System For Controlling Credit Risk

Credit philosophy and culture
What are the characteristics of a good credit culture?

Organisation of lending

Loan policy and procedures formulation

Credit Philosophy and Culture

The credit philosophy (thinking) and loan

policy must be supported by and communicated through an appropriate credit culture. The credit philosophy of an organization will be largely dependent on the profit expectations of owners and shareholders. An effective credit culture exists when the behavior of every individual in the loan organization is closely aligned with managements priorities.

Organisation of lending
Board of Directors

Directors audit Committee

Executive Management

Directors Loan Committee

Audit Department

Credit Department

Senior loan Officer

Officers Loan Committee

Loan Review

Credit Analysis


Consumer Lending Division

Commercial Lending Division

International Division

Other Lending Division

Corporate Services

Cash Flows For Loan Repayment Three Potential Sources

What are they? They are expected future cash flows and

they can come from the following sources Cash Flow from operations (ie. P/L) Cash Flow from sale of an asset. (ie. B/S - asset) Cash Flow from other financing (ie. B/S - liability)

First Way Out Versus Second Way Out

Cash flow from operations is typically

regarded as the first way out for any loan

Cash flow from sale of an asset is

typically regarded as the second way out for any loan

Why Should Cash Flow From Operations Be Regarded As The First Way Out?
Relates to the underlying logic behind

a loan That is, an individual borrows $400k now to buy a printing business The business will generate cash flow into the future which will be used to repay the $400k loan This is a simple exercise in redistributing cash flows through time

Why Should Cash Flow From Operations Be Regarded As The First Way Out (contd)?
Berry (p.10) refers to this as the

going concern approach to lending What are the alternatives? Security-based lending! Note that cash flow from other funding is often unattractive because it is frequently a case of sending good money after bad

What Is The Logic Behind Security-Based Lending?

You can have $400k to buy this

printing business But our assessment is that there is no way that the expected cash flows generated by the business will be sufficient to repay the loan In any case we are not at risk because when you default we will sell your house to repay the debt

Flaws In Security-Based Lending 1. The Courts Reaction

Not surprisingly, the courts take a

very poor view of this style of lending Frequently results in court decisions against the lender Particularly where the security is third party guarantee security (eg. parents house as security for the son/daughter to borrow the $400K)

Flaws In Security-Based Lending 2. The Lenders Reaction

Security-based lending is frequently

unprofitable for the lender

There are substantial costs involved

in realising on security

Flaws In Security-Based Lending 3. The Customers Reaction

Not conducive to a long term

profitable relationship
Inevitably creates ill-will with the

Can lead to damaging publicity

Taking Stock - Four Reasons Why Cash Flow From Operations Is Regarded As The First Way Out?
The logic of lending Costs of realising on security The courts reaction

The customers reaction

Why Is Security Regarded As The Second Way Out?

Acts as a form of insurance
Reduces the level of certainty

required with the first way out

The idea of belt and braces lending Ideally the second way out should be

independent of the first way out

Some Key Accounting Concepts

Bad and doubtful debts
P&L charge (expense) to provide for

doubtful debts
B/S provisions for doubtful debts
General Specific

Specific Provisions
When a doubtful debt is identified, a

specific provision equal to its amount is created

When it is identified as bad, it is

written off against this provision

General Provisions
Covers bad debts inherent in the loan

portfolio but not yet specifically identified and provided for

No bad debts are written off against this

general provision

Doubtful Debt Expense In P&L

Includes charges for general provisions

and specific provisions

Non-Accrual Items
Applies to those facilities on which

income may no longer be accrued ahead of its receipt Key element - any facility where there is reasonable doubt about the collectability of P&I Can involve a specific provision being raised

Restructured Items
Where the original contractual terms have

been modified to provide for concessions of P or I related to the financial difficulties of the customer

Assets Acquired Through Security Enforcement

Where an asset has been acquired through

security enforcement, or
Where a Bank assumes ownership of an

asset in settlement of all or part of a debt

Why should these assets be included as

part of impaired assets?