Credit Risk Management

What are the reasons for risks in banking industry?
List of risks faced by banks,

Definition of credit risk,
Is credit risk important for a bank?
What information are required for credit risk analysis?
Modern approach to assessing credit risk,
Risks associated with lending,
Credit culture and risk profile,
Risk tolerance,
Portfolio risk and return,
Loan policy issues,
Loan portfolio objectives,
Strategic planning for the loan portfolio,
Credit risk management, and
Closing remarks.
Credit Risk Management in Banking Industry
Financial transactions are becoming more and

more complex in the banking or financial services
sector.
This is due to a number of factors such as;

(a) customers expectations,
(b) competition between the financial services
providers,
(c) changes in demography,
(d) changes in the financial services market, and
(e) structural adjustments in the economy.
Financial transactions become more sophisticated

as the socio-technical systems and functions,
indispensable for every day living, are integrated
in various combinations.
While, customers demand greater benefits from

the level of services from their lenders on one side,
on the other hand, the lenders must balance the
risk/reward position.
OPERATIONAL RISKS MARKET RISKS

Credit Risk Interest Rate Risk
Trading Risk Exchange Rate Risk
Concentration Risk Legal/Regulatory Risk
Earnings at Risk
Funding & Liquidity Risk
Value at Risk OTHER RISKS
Solvency Risk Weather Risk
Strategic Risk Terrorist Risk
Reputation Risk Money Laundering
Definition of Credit
ItRisk
is defined as the possibility that a borrower will fail to
repay his/her debt (s) to the bank/lender on the due date.
When the bank/lender is unable to collect the debt (s) from

the borrower (s), the bank/lender will be short by the amount
of cash that the borrower has failed to repay.
Another terminology that can be used to describe such a

risk factor - Risk of Default.
As a bank or any financial services providers credit risk

increases over time, this institution is compelled to make
provision to write off the debt (s) in its books of account.
Loans written-off translates into an operating expenses.

A Typical Example of Credit Risk

Suppose, I take a loan of US$1,000 from Citibank at the
interest rate of 5% per annum for a period of 5 years.
I start repaying for the first 6 months and then stop

servicing the loan on the 7th Month because I have made
other commitment elsewhere.
(a) What is the credit risk for the Citibank?
(b) How it would impact on the liquidity of the bank?
Micros oft Excel

Works heet
Is Credit Risk Important for a Bank?

For most banks, loans are the largest asset on the banks
Balance Sheet, and obviously the major source of credit risk.
Besides loans, there are other pockets of credit risk, both

on and off-balance sheet such as:
(a) investment portfolio,

(b) overdrafts,
(c) letters of credits (L/Cs), and
(d) guarantees.
If a bank or financial institution does not ensure that there

is a systematic credit appraisal system in place, then this
bank is likely to become heavily exposed to credit risk.
A banks first line of defense against excessive credit risk

is the initial credit-granting process involving:
(a) sound underwriting standards,
(b) an efficient and balanced approval process, and
(c) a competent lending staff.
Trading Risk
This type of risk originate when a bank sells or securitize
its loan portfolio or other assets with counterparty.
The agreement based on the trading risk will consider

amongst other issues, the right of course by the purchaser
in the event that the data and information were not correctly
calculated at the time of the transaction.
Trading risk may also arise in the case where a bank

engages into a swap of floating interest rate to a fixed
interest rate on a borrowing contract with another
counterparty.
Concentration Risk
This risk arises, when a bank or financial institution has
lent to a single borrower, a group of borrowers, or
borrowers engaged in or dependent on one industry (say
tourism sector).
Concentration risk of credit consists of direct, indirect,

or contingent obligations exceeding 25% of the banks
capital structure.
Concentrations within, or dependent on, an industry are

subject to the additional risk factors of external
economic conditions.
From a sound risk management perspective, a periodic

review of the industry trends be made in order to assess
its susceptibility to external factors.
Earnings at Risk (EaR)

The continued viability of a bank depends on its ability
to earn an appropriate return on its assets and capital.
Good earnings performance enables an institution to

fund expansion, remain competitive in the market place,
and replenish, and/or, increase capital.
Earnings always represent a banks first line of defense

against capital depletion due to credit losses, interest
rate risk, and other operational risks.
Risk managers should extremely careful, when

assessing a banks risk exposure, to include Earnings at
Risk as part of the risk profile.
Funding & Liquidity Risk

This type of risk is arises, when a bank or financial institution
cannot be funded, and in turn, cannot discharge its financial
obligations on due dates and cost effectively.
The nature of such risk demands prudent management at

all times.
Otherwise, the bank runs the risk of having to extend its

borrowings, selling its assets, issuing additional equity
capital, and to the extreme of even having to close down
the business this bad news!
Liquid fund is like the life-blood for a bank. It cannot afford

or fail to plan its liquidity requirement on a daily basis.
It is regarded as an important tool in the asset & liability

management for banks.
Value at Risk (VaR)

This is an estimation technique that measures the worst
Expected loss that a bank can suffer over a given time
Interval under normal market conditions at a given confidence
In short, it measure the volatility of a business assets at risk.
The more volatile the asset portfolio of the bank, the greater
the risk of loss.
In view of the economic uncertainty over the last decade, VaR

has become the standard framework for measuring and
reporting risk exposures in banks and other financial
institutions.
If the model is used productively, it can also help as warning

signals.
Solvency Risk
Basel II introduces a far more sophisticated approach to
bank solvency than Basel I the prior international capital
accord dating from 1988.
Earlier regime represented little more that a flat tax on

banks, which were required to hold capital equal to 8% of
their assets.
New Accord differentiates among risks with far greater

precision.
In addition to introducing new requirements for rating of

credit risk, Basel II requires large, internationally active
banks to calculate their operational risk capital from the
bottom up, using both internal & external loss data.
Strategic Risk
In todays commercial languages, there are many
definitions, which can be associated with strategic risk.
In the banking terminology, strategic risk is all about the

degree of risk link to a banks inappropriate strategies,
which do not match the corporate goals.
In effect, the strategies may not fit the future ideals of the
bank in short there is a mis-match.
Such risk may originate from the fact that the bank may
have a good plan, but inadequate decision-making
processes or lacks a systematic implementation plan. (e.g.
a business strategy that is unclear, but financially viable,
or a business venture that is clear but financially
uneconomical).
Reputation Risk
Such risk is of significant negative public opinion that
results in a critical loss of funding or customers.
It may involve actions that create a lasting negative image

on the institutions operation.
Service or product problems, mistakes, malfeasance, or

fraud may cause reputational risk.
Reputation risk may not only affect the banks image but
its affiliation with other institutions.
This risk is very damaging especially if the institution

operate in a very small market.
Once the reputation is gone, so will be the eventual
demise of the bank.
Interest Rate Risk
This type of risk arises when there is a mis-match between
assets & liabilities of the bank, which are subject to
interest rate adjustment within a specified period.
It is usually expected that a banks lending, funding, and

Investment transactions are linked to changes in interest
rates.
When the interest rates change, the immediate impact of

such change usually affects the net interest income (NII).
The long-term impact would necessarily affects the banks

net worth position.
It involves changes in the economic value of the banks

assets & liabilities including any off-balance sheet item.
Foreign Exchange Rate Risk

Such risk originates for institutions dealing in foreign currency
transactions.
Financial institutions dealing with foreign counterparties

are subject to country risk as well to the extent that the
party or parties become unable or unwilling to fulfill their
obligations because of economic, social, or political factors.
Hence, it is important for a bank or financial institution to

monitor its net-off position (i.e. offseting its foreign denominated
assets against its foreign denominated liabilities) and take measure to
hedge the exchange exposure.
Otherwise, the bank or financial institution can be heavily

exposed, and loose a lot of shareholders fund.
Legal & Regulatory Risk

This type of risk arises from violations or non-
compliance with the laws, rules, regulations or
prescribed practices.
Legal risk may also arise when the legal rights &
obligations or parties to a transaction are not well
established.
The bank may face legal risks with respect to

customer disclosure & privacy protection.
Weather Risk
Over the years, the weather condition all over the world has
changed drastically with untold consequences. It is still
changing without much of early warning signs.
The risk of catastrophic losses originating from extreme

weather condition poses a much greater danger today than
in the last decade or so.
Credit risk specialists are now very much concern with the
potential implication of this phenomenon, when assessing
borrowers business plans.
Such a factor is quite prevalent in countries sitting on the

earthquake zone. Even the new Basel II takes into account
that banks should make provision for such eventualities.
Act of Terrorism Risk

Expect the Unexpected this quote is now a common
parlance in our every day life.
What use to be a very far remote event can hit us any time,
and at any place.
Terrorism is part of the world uncertainty and costs of doing

business. This is especially in the case of mega business
like banks & others.
Again, Basel II Accord foresees that banks must be ready to

make necessary provisions in their books of accounts for
the act of terrorism.
It is now referred as External Event Risk for banks.

Risk of Money Laundering

Through the offshore business activities, money laundering
has become a major business.
Banks are heavily exposed to such illegal & criminal activities

If they do not have adequate internal controls to spot & deal
with such transactions.
In consequence, the regulators demand that banks should

strengthened their internal control systems because most of
the illegal transfer of funds finally get through the banking
system.
The introduction of Know Your Customer (KYC) is very

crucial for all banks to follow otherwise, they are subject
to pay heavy penalties with the risk of closure, if they fail.
Comparison of Cross-Section of Borrowers in the Banking Market

Large
Retail Individuals
Market
Borrowers
Mid Medium-Size
Market Businesses
Large Corporate
Companies Market
Small
Low Credit Exposure High
Borrower
Submission Approval/Rejection
Credit Application
or Origination
Capital * Capacity
Character * Collateral
* Consideration
Credit Analysis
& Assessment
*Credit Structuring Credit Policy
*Credit Sanctioning Credit Limit
Credit Pricing
Credit Management
& Administration
Capital (Economic, and Regulatory)
Provision for Default
Provision for Risk Sharing (e.g. co-financing)
Borrower
*Origination
Structuring
Pricing
Credit Application Underwritin
or Origination g
Sanctioning
Monitoring
Credit
Management
Portfolio Valuation & Management Portfolio Assessment

Trading Credit Portfolio Valuation
Credit Derivatives Portfolio Value-at-Risk (VaR)
Book Credit Securitization Portfolio Management
Third Party Assets Sales
Capital Credit
Market Capital
MODERN CREDIT MANAGEMENT

SETTING
Credit Trading Book Credit Modeling Credit Evaluation

Portfolio Valuation
Capital Management
*Economic Capital
*Regulatory Capital
Credit Modification Credit Administration Credit Procedures

& Monitoring & I.T. Systems
Sound credit risk analysis would depend on a number of

Critical piece of information such as;
Purpose of the loan/credit,

Amount required,
Repayment capacity of the borrower,
Duration of the loan/credit,
Borrowers contribution,
Security aspects & insurance protection,
Borrowers character,
Business plan & projections,
Environmental considerations, and
Other considerations.
Purpose of the Loan

This is one of the key information required from the borrower
in order for the banker to base his/her judgment as to whether
to proceed with further credit appraisal.
There is nothing wrong for a bank to finance the repayment

of another loan, if the new loan means sound refinancing
of the existing debt.
Banks would not certainly engage in the financing of loans or

credits, which are outside its scope of business or finance
illegal business activities.
(e.g. gambling, speculative transactions, drug trafficking,
environmentally unfriendly projects).
The purpose of the loan/credit must be clear from the outset

once the borrower submits his/her application.
Amount of Finance Required

In as far as due consideration for the amount of the loan is
concerned, the loans officer or executive must adhere to the
principles of lending.
Banks normally set their loan policy in accordance with their

financial resources.
Too high an amount of the loan will be outside the banks

mandate.
In the modern day banking environment, if a bank cannot

finance a loan application on its own and the project is
economically feasible, it may act as the lead banker to call
for a syndicate lending.
Repayment Capacity
This test would give the banker a fair idea on how to assess
the repayment capacity of its borrowers.
The repayment schedule is calculated on the basis of a

projected financial statement over time.
If a borrower expects to make surplus cash from its activities

then the source of repayment will come from the cash flow.
It is one of the key data required by any banker.
It must be noted that a bank does not lend money to a

customer on security only.
The key priority for the banker is the ability for the customer
to service its loan/credit efficiently.
Duration of the Loan/Credit

The time it takes to service a loan/credit cannot exceed a
Banks normal credit policy. (e.g. if a bank has a policy not to
lend beyond 5 years for a credit type, then it cannot lend beyond this
specific time frame).
In addition, if a project has a life time of say 7 years, it is

expected that the project should be in a position to repay
the bank in full within this time limit.
There can only be exception, when the bank would extend

the duration of the loan, subject to satisfying that the
borrower will honour its commitment within the foreseeable
risk.
The duration of a loan is always tied to the rate of interest.

Borrowers Contribution
A borrowers contribution towards the total borrowing
application is very vital for the banker to gauge the degree
of seriousness of the applicant.
A small or no contribution towards the total loan applied

represents to the bank that the borrower is very uncertain
or uncommitted towards the entire obligation.
It is one of the indicators that the banker would be mindful

when due consideration is given to the application.
Even, when a customer makes a significant contribution

towards the whole project, there is no assurance that the
project will succeed. Nevertheless, it gives an indication as
to the strength of the entire business concept.
Security Aspects & Insurance Protection

Strictly, from a commercial lending viewpoint, the security
aspects and insurance protection is the last resort.
It is considered as a back up position in the event that the

customer defaults on his/her obligations to repay the loan.
It is important to note that a good banker should not lend

the shareholders funds purely on the security offered by
the borrowers.
If this is the case, then the bank is in the business of

substituting credit for asset purchases. This approach to
lending can be very dangerous for the bank and its group
of shareholders.
Lending should be based on the capacity to repay the loan.

Borrowers Character
A very vital piece of information that will allow the banker to
decide to lend, or not to lend.
A banker should not deal with a customer or potential

customer that he/she cannot trust.
The business of banking is all about trust, confidentiality

& risk involved.
The principle of lending is also about knowing your customer

at all times, otherwise, the bank is likely to experience
serious problem of bad debts on its books of accounts.
Banks are not in the business of issuing credits for free. It is

the shareholders funds together with other suppliers of
capital, which are placed at risk.
Business Plan & Projections

Good banking practice is not about making a promise to repay
the debt incurred by the borrower or debtor.
It must be focused on sound financial plan, which would allow

the banker to identify the strength and weakness of the credit
application at the time of its submission.
A business plan & its projections is equivalent to an

architects plan, which provides all the information about the
proposed building to be constructed.
A customer, who fails to produce a projected financial plan

is a signal to bank that there is something wrong about the
whole business concept being asked to finance.
A sharp banker is most likely to turn down the application.

Environmental Considerations
During the last decade or so, the conservation/protection of
the environment took centre stage in whatever business
decision is taken.
Banks have been accused of financing many projects at the

destruction of the environment. In fact, repeated threats
have been issued against the banks that engages into such
projects.
In order to avoid the bad publicity from the environmentalists

who are also bank customers, banks have had to re-assess
their lending policies.
They are now having to behave like good corporate citizen

by refusing to lend to projects, which are not friendly to
the environment.
Other Lending Considerations

Banks are now also conscious to take into consideration
the likely impact on its borrowers obligations due to
changes in the weather conditions.
In the last decade, the world has witnessed the catastrophic

events, which had had adverse impact on the level of
business risks, and eventually turning into default risk.
A number of businesses have had to re-style their business

proposition in a manner that they are insured against the
scope of natural catastrophes.
Some businesses are also compelled to subscribe to the

weather risk insurance before they can be considered
eligible for financing by the banks or financial institutions.
Other Lending Considerations

Some banks would not be prepared to lend to their corporate
customers, if they are not in possession of a rating from
either Standard & Poor's, or Moodys.
Other consideration can also be linked to an assessment of

the sector, which the business operates. Is the sector in
growth stage, or decline?
The economic business cycle will also be one of the major

considerations, that will be assessed before a final decision
is reached.
Banks restraint its credit expansion, when the economy is

suffering from a downturn as opposed to an economic boom.
Credit risk assessment is no longer seen from the traditional

perspective that it should be considered in isolation.
The modern approach is to judge the credit risk from a total

risk model.
Such a model considers two categories of risks:

(a) Systematic, and
(b) Unsystematic.
This is due principally that a business is always subject

to the macro-economic environment that it operates in.
Within the macro-environment a business can simply

Inherit risk, which cannot be diversified.
Systematic Risk
This type of risk is also referred as undiversifiable risk or
market risk, and sometimes also known as macro-economic
risk.
The macro-economic risk can embody:

(1) Interest rate,
(2) exchange rate, and
(3) inflation.
A business including banks cannot avoid such risk because

it affects all enterprises, which operates within a particular
jurisdiction.
That is, why the stocks have a tendency to move together.

Investors are also exposed to market uncertainties no
matter how many stocks they hold in their portfolios.
Unsystematic Risk
This type of risk is sometimes referred as unique risk.
It is particularly tied to the business specifics and some to

Its immediate competitors.
Such risk can be avoided and minimized, if the management

of a business is able to diversify the companys activities
having paid due regards to the specific problems relating to
the business.
Examples:
Company profit,
Products/services,
Geographical areas, the market where the company operates,
Management issues, and
Operating costs structure.
Total Risk = Systematic Risk + Unsystematic Risk

Company Specific Risk
Market Risk
GDP Cash Flow

Interest Rate Borrowings
Exchange Rate Portfolio
Inflation
Considerations to Systematic & Unsystematic Risk

It is very vital that when banks consider the credit or loan
application for its customers, that an overall picture of the
status of the economic environment is assessed.
This is principally due to whatever commercial strategies

are applied by a business or individual earning a salary from
his/her employer is subject to systematic risk.
We live in an economic environment, whereby the Govt of

day dictates the policy and measures to be adopted and
followed nationally.
A business would fail or succeed depending on how the

strategies are applied in the context of macro-economic
fundamentals.
Credit Risk Analysis

In todays current economic turbulence, the credit risk
analysis by banks must be seen in a very wide context.
It is not a matter for the bankers to focus on the figures

and the personality of the borrower, but also assess the
risk dimensions surrounding the proposition as a whole.
Example:
What would be the impact of the interest rate changes do
to the cost of servicing the loan/facilities?
Is the borrowers business heavily exposed to exchange
rate risk?
What about the trends in the industry, which the business
operates?
What if the key personnel leaves the business?
Credit Risk Analysis

Other Examples:
What is the existing commitment of the borrower?
What is the likely impact of weather conditions on the
borrowers ability to survive?
Has the borrower made a plan, which takes into account
the state of the economy?
How is the business cycle likely to affect the borrowers
income generation?
Is there any likely possibility that that taxation rate will
increase?
What is the level of competition in the market?
Who are the new entrants in the market?
Is there any possible threats coming from aggressive
bidder to take over the borrowers business?
A key challenge in managing credit risk is the understanding

of the interrelationships of 9 risk factors:
Often risks will be either positively or negatively correlated

to one another.
Actions or events will affect correlated risks similarly.

(e.g. reducing the level of problem assets should reduce not only credit
risk, but also liquidity and reputation risk).
When two risks are negatively correlated, reducing one type

of risk may increase the other.
(e.g. a bank may reduce overall credit risk by expanding its holdings
of mortgage loans instead of commercial loans, only to see its interest
rate risk rise because of the interest rate sensitivity & option of
the mortgages).
The NINE type of risk connected with lending can

described as:
Credit risk,
Interest rate risk,
Liquidity risk,
Price risk,
Foreign exchange rate risk,
Transaction risk,
Compliance risk,
Strategic risk, and
Reputation risk.
Each of this type of risk will be considered individually.

Credit Risk
For most banks, loans are the largest and most obvious
source of credit risk.
There are also pockets of credit risk both on & off-balance

sheet of the banks (e.g. investment portfolio, overdrafts, & letters
of credit).
In addition products/services such as; derivatives, cash

management services, foreign exchange also expose a
bank to credit risk.
Here the risk of repayment i.e. possibility that an obligor

Will fail to perform as agreed, is either lessened or increased by a
banks credit risk management practices.
Interest Rate Risk

The level of interest rate risk attributed to the banks
lending activities depends on the composition of its loan
portfolio and the degree to which the terms of its loans
(i.e. rate structure, maturity, embedded options) expose the banks
revenue stream to changes in rates.
It is important that pricing and portfolio maturity decisions

should be made with an eye to funding costs and maturities.
Banks frequently shift interest rate risk to their borrowers

by structuring loans with variable interest rates.
Borrowers with marginal repayment capacity may experience

financial difficulty if the interest rates on these loans increase
Interest Rate Risk

The level of interest rate risk attributed to the banks
lending activities depends on the composition of its loan
portfolio and the degree to which the terms of its loans
(i.e. rate structure, maturity, embedded options) expose the banks
revenue stream to changes in rates.
It is important that pricing and portfolio maturity decisions

should be made with an eye to funding costs and maturities.
Banks frequently shift interest rate risk to their borrowers

by structuring loans with variable interest rates.
Borrowers with marginal repayment capacity may experience

financial difficulty if the interest rates on these loans increase
Liquidity Risk
Because of the size of the loan portfolio, effective
management of liquidity risk requires that there be close ties
to and good information flow from the lending function.
Banks can use their loan portfolios as a source of funds by

reducing the total dollar volume of loans through sales,
securitization, and portfolio run-off.
Many larger banks have been expanding their underwriting

of loans for the loans syndicated market.
As part of the liquidity planning, banks overall liquidity

strategy should include loan portfolio segments that may be
easily converted into cash.
Price Risk
Most of the developments that improve the loan portfolios
liquidity have implications for price risk.
Traditionally, the lending activities of most banks were not

affected by price risk. This is due that loans were held to
maturity, accounting doctrine required book value
accounting treatment.
As banks develop more active portfolio management practice

and the market for loans expands and deepens, loan
portfolios will become increasingly sensitive to price risk.
Foreign Exchange Rate Risk

This type of risk is present when a loan or portfolio of loans
is denominated in foreign currency or is funded by
borrowings in another currency.
In some cases, banks will enter into multi-currency credit

commitments that permit borrowers to select the currency
they prefer to use in each rollover period.
Foreign exchange rate risk can be intensified by political,

social, or economic developments. The consequences can
be unfavourable if one of the currencies involved becomes
subject to stringent exchange controls or is subject to wide
exchange-rate fluctuations.
Transaction Risk
In the business of lending, transaction risk is present
primarily in the loan disbursement and credit administration
processes.
The level of transaction risk depends on the adequacy of

Information systems and controls, the quality of operating
procedures, the capability and integrity of employees.
Banks have and continue to experience credit risk when

information systems failed to provide adequate information
to identify concentrations, expired facilities, or stale
financial statements.
Compliance Risk
Lending activities encompass a broad range of compliance
responsibilities and risks.
By law, a bank must observe limits on its loans to a single

borrower, connected person, affiliates, limits on interest
rates and other regulatory limits imposed by the Central
bank or monetary authority.
A bank may also become the subject of borrower initiated

lender liability lawsuit for damages attributed to its
lending or collection practices.
Strategic Risk
A primary objective of the loan portfolio management is to
control the strategic risk associated with a banks lending
activities.
Inappropriate strategic or tactical decisions about under-

writing standards, loan portfolio growth, new loan products,
geographic markets can compromise a banks future.
These strategies require significant planning and careful

oversight to ensure the risks are appropriately identified
and managed.
It is important for bankers to decide whether the benefits

outweigh the strategic risk.
Reputation Risk
When a bank experiences credit problems, its reputation with
investors, the community, and even individual customers
usually suffers.
Inefficient loan delivery systems, failure to adequately meet

the credit needs of the community, and lender-liability
lawsuits are also examples of how a banks reputation can
be tarnished because of problems with its lending division.
Reputation risk can damage a banks business in many ways.

(e.g. share price falls, customers & community support is lost, and
business opportunities evaporate).
To protect this reputation, they often have to do more than

is legally required.
Understanding the credit culture and risk profile of a bank

Is central to successful loan portfolio management.
Because of the significance of a banks lending activities,

the influence of the credit culture frequently extends to
other banking activities.
It is important that staff members throughout the bank

should understand the banks credit culture and risk profile.
A banks credit culture is the sum of its credit values, beliefs

and behaviours. It is what is being done and how it is
accomplished. The credit culture exerts a strong influence
on a banks lending and credit risk management.
Two banks with identical levels of classified loans can have

quite different profiles.
Bank As classified loans might be fully secured and made

to borrowers within the local market, while Bank Bs loans
are made out-of-market, unsecured loan participations.
Consider as well how much more the failure of a US$3m

loan would hurt a US$500m bank than a US$5b bank.
The risk profile will change over time as the portfolio

composition and internal and external conditions change.
Credit culture vary from bank to bank it is not all the same!
In addition to establishing strategic objectives for the loan

portfolio, senior management and the Board of Directors
are responsible to set the risk limits on the banks
lending activities.
Risk limits should take into account, the banks historic

loss experience, its ability to absorb future losses, and
the banks desired rate of return.
Limits may be set in various ways, individually and in

combination. (e.g. applied to a characteristic of loans, volume of
a particular segment of the portfolio, and the composition of the entire
loan portfolio).
Limits on loans to certain industries or on certain segment

should be set in line with its impact on the whole portfolio.
What if one of your customer is to present you with this scenario

for financing, which project would you finance?
Name of Project Project Cost Financial Return Risk
Project X SR50,000 SR50,000 SR25,000
Project Y SR250,000 SR200,000 SR200,000
Project Z SR100,000 SR100,000 SR10,000
These are 3 mutually exclusive projects with their respective costs to

Implement, expected net returns (net of the costs to implement), and
risk levels (all in present values).
The most likely informed decision, which a risk manager will take
depending, of course his attitude towards risk:
*For a budget-constrained manager, the cheaper the project the

better.
This will result him/her selecting Project X.
*The returns-driven manager will choose Project Y with the highest

returns, assuming that budget is not an issue.
Project Z will be chosen by the risk-averse manager as it provides

the least amount of risk while providing a positive net return.
What is interesting here is that with 3 different projects and 3

different managers, 3 different decisions will be made.
The typical question, which follows from this short overview drives
us to ask.
Which manager is correct, and Why?
Banking is both a risk-taking and profit-making business,

and bank loan portfolios should return profits which is
commensurate with their risk.
Although this concept is intellectually sound and almost

universally accepted by bankers, management have had
difficulty implementing it.
Over the years, volatility in banks earnings usually has

been linked to the loan portfolio.
While there are many contributing factors including market

forces, anxiety for income, poor risk management, a
common underlying factor has been banks tendency to
under-estimate or under price credit risk.
The price (index rte, spread, and fees) charged for an individual
credit should cover funding costs, overhead costs,
administrative costs, required profit margin, and a premium
for risk.
Funding costs are relatively easy to measure and build

into loan pricing, but measuring overhead and administrative
costs is sometimes more complicated because traditionally
banks have not had sophisticated accounting systems.
Recent developments in credit and portfolio risk

measurement and modeling are improving banks ability
to measure and price more precisely and are facilitating
the management of capital and the allowance for loan
and lease losses.
The loan policies vary from bank to bank. However, it is

generally understood that the underlying factors are
important considerations.
1) Loan authorities,
2) Limits on aggregate loans & commitments,
3) Portfolio distribution by loan category and product,
4) Geographic limits,
5) Desirable types of loans,
6) Underwriting criteria,
7) Financial information and analysis requirements,
8) Collateral and structure requirements,
9) Margin needed for profit per product,
10)Pricing guidelines,
11)Documentation standards, and
12)Collections & charge-offs guidelines.
Loan portfolio objectives establish specific, measurable

Goals for the portfolio. They are an out-grown of the credit
Culture and risk profile.
The Board of Directors must ensure that loans are made

With the following three basic objectives:
1) To grant loans on a sound and collectible basis,
2) To invest the banks funds profitably for the benefit of the

shareholders and to protect the depositors funds, and
3) To serve the legitimate credit needs for their communities.

In drawing the strategic plan, and objectives, the senior

Management and the Board of Directors should consider:
I. Objectives for loan quality,

II. Loan product mix,
III. Targeted industries/businesses,
IV. Targeted market share,
V. Customers needs and services,
VI. How much the portfolio should contribute to the banks
VII.Financial returns?
VIII.What proportion of the balance sheet assets will be
IX. channel to loans,?
X. Objectives for portfolio diversification,
XI. Product specialization, and
XII.Loan growth targets (e.g. product, market, segment, areas).
The primary controls over a banks lending functions are

the credit risk management based on the following
principles
A. Independence,
B. Credit policy administration guidelines,
C. Loan review guidelines,
D. Audit of the transactions,
E. Administrative & documentation controls,
F. Use of external reporting (e.g. rating agencies, analysts,
Stock exchange reports, auditors report).
Independence
Independence is the ability to provide an objective report
of facts and to form impartial opinions.
Without independence, the effectiveness of control units

may be in jeopardy. It requires generally a separation of
duties and reporting lines.
Independence of the credit risk department of a bank

depends on the corporate culture and the promotion of
objective criticism within the bank so as to improve or
modernize the operations.
Credit Policy Administration Guidelines

The credit policy administration is responsible for the day-
to-day supervision of the loan policy.
If policy needs to be supplemented or modified, credit

policy administration drafts the changes for consideration
by the management and the Board of Directors.
Such a unit if it exist, should establish a formal process

for developing, implementing and reviewing policy
directives from time to time.
Loan Review Guidelines

Loan review is a mainstay of internal control of the loan
portfolio.
Periodic reviews of credit risk levels and risk management

processes are essential to effective portfolio management.
To ensure the independence of loan review, the unit should

report administratively and functionally to the Board of
Directors or standing committee with audit responsibilities.
Audit of Transactions
Audit activities in lending departments usually focus on
the accounting controls in the administrative support
functions.
While loan review has primary responsibility for evaluating

credit risk management controls, audit will generally be
responsible for validating the lending-related models.
Audits should be done at least annually and whenever

models are revised or replaced.
Administration & Documentation Controls

Credit administration is the operations arm of the lending
function.
The responsibilities for credit risk administration vary from

bank to bank.
This is in line with the overall corporate objectives of the

bank in question.
Use of External Reports

The use of external reports is an invaluable tools for the
credit management department of a bank.
The report from a rating agency would indicate the degree

of risk, which the bank faces towards its clientele from
a macro-economic analysis viewpoint.
Likewise, reports from specialist analysts would indicate

the latest evaluation of a borrowers performance.
The stock exchange should be able to indicate the latest

Share price and its forecast.
The auditors would alert the shareholders of the financial

standing of the borrower.
Credit risk for banks is a wide subject and it is still evolving

in many aspects either through new models, management,
or research of new information about the customers,
markets, products, or even about the banks themselves.
It is an interesting subject, but at the same time, no body

including myself would be able to predict default risk with
accuracy. There will always be a margin of error.
If your prediction is right, then you are 100% lucky.
We still learning this trade in the 21st Century, and I hope

you have been able to learn something today from this
presentation.

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What are the reasons for risks in banking industry?

List of risks faced by banks,

Financial transactions are becoming more and

This is due to a number of factors such as;

Financial transactions become more sophisticated

While, customers demand greater benefits from

OPERATIONAL RISKS MARKET RISKS

When the bank/lender is unable to collect the debt (s) from

Another terminology that can be used to describe such a

As a bank or any financial services providers credit risk

Loans written-off translates into an operating expenses.

A Typical Example of Credit Risk

I start repaying for the first 6 months and then stop

(a) What is the credit risk for the Citibank?

(b) How it would impact on the liquidity of the bank?

Micros oft Excel

Is Credit Risk Important for a Bank?

Besides loans, there are other pockets of credit risk, both

(a) investment portfolio,

If a bank or financial institution does not ensure that there

A banks first line of defense against excessive credit risk

The agreement based on the trading risk will consider

Trading risk may also arise in the case where a bank

Concentration risk of credit consists of direct, indirect,

Concentrations within, or dependent on, an industry are

From a sound risk management perspective, a periodic

Earnings at Risk (EaR)

Good earnings performance enables an institution to

Earnings always represent a banks first line of defense

Risk managers should extremely careful, when

Funding & Liquidity Risk

The nature of such risk demands prudent management at

Otherwise, the bank runs the risk of having to extend its

Liquid fund is like the life-blood for a bank. It cannot afford

It is regarded as an important tool in the asset & liability

Value at Risk (VaR)

In short, it measure the volatility of a business assets at risk.

In view of the economic uncertainty over the last decade, VaR

If the model is used productively, it can also help as warning

Earlier regime represented little more that a flat tax on

New Accord differentiates among risks with far greater

In addition to introducing new requirements for rating of

In the banking terminology, strategic risk is all about the

It may involve actions that create a lasting negative image

Service or product problems, mistakes, malfeasance, or

This risk is very damaging especially if the institution

It is usually expected that a banks lending, funding, and

When the interest rates change, the immediate impact of

The long-term impact would necessarily affects the banks

It involves changes in the economic value of the banks

Foreign Exchange Rate Risk

Financial institutions dealing with foreign counterparties

Hence, it is important for a bank or financial institution to

Otherwise, the bank or financial institution can be heavily

Legal & Regulatory Risk

The bank may face legal risks with respect to

The risk of catastrophic losses originating from extreme

Such a factor is quite prevalent in countries sitting on the

Act of Terrorism Risk

Terrorism is part of the world uncertainty and costs of doing

Again, Basel II Accord foresees that banks must be ready to

It is now referred as External Event Risk for banks.

Risk of Money Laundering

Banks are heavily exposed to such illegal & criminal activities