Welcome to this Morning's Presentation

1. Welcome to this Morning's Presentation Credit Risk Management in Banking Industry Presented by : Dr. Peter Larose

2. Focus of this Presentation • 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.

3. Credit Risk Management in Banking Industry The business of banking is always tied to a multitude of risks.

4. Credit Risk Management in Banking Industry What Are the Reasons for Risks in the 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; • customers’ expectations, • competition between the financial services • providers, • (c) changes in demography, • (d) changes in the financial services market, and • (e) structural adjustments in the economy.

5. Credit Risk Management in Banking Industry 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.

6. Credit Risk Management in Banking Industry List of Risks Faced By Banks • MARKET RISKS • Interest Rate Risk • Exchange Rate Risk • Legal/Regulatory Risk • OPERATIONAL RISKS • Credit Risk • Trading Risk • Concentration Risk • Earnings at Risk • Funding & Liquidity Risk • Value at Risk • Solvency Risk • Strategic Risk • Reputation Risk • OTHER RISKS • Weather Risk • Terrorist Risk • Money Laundering

7. Credit Risk Management in Banking Industry Definition of Credit Risk It 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 provider’s 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.

8. Credit Risk Management in Banking Industry 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?

9. Credit Risk Management in Banking Industry Is Credit Risk Important for a Bank? • For most banks, loans are the largest asset on the bank’s • 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: • investment portfolio, • overdrafts, • letters of credits (L/Cs), and • 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.

10. Credit Risk Management in Banking Industry • A bank’s first line of defense against excessive credit risk • is the initial credit-granting process involving: • sound underwriting standards, • an efficient and balanced approval process, and • a competent lending staff.

11. Credit Risk Management in Banking Industry 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.

12. Credit Risk Management in Banking Industry 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 bank’s 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.

13. Credit Risk Management in Banking Industry 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 bank’s 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 bank’s risk exposure, to include Earnings at Risk as part of the risk profile.

14. Credit Risk Management in Banking Industry 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.

15. Credit Risk Management in Banking Industry 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.

16. Credit Risk Management in Banking Industry 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.

17. Credit Risk Management in Banking Industry Strategic Risk In today’s 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 bank’s 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).

18. Credit Risk Management in Banking Industry 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 institution’s operation. Service or product problems, mistakes, malfeasance, or fraud may cause reputational risk. Reputation risk may not only affect the bank’s 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.

19. Credit Risk Management in Banking Industry 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 bank’s 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 bank’s net worth position. It involves changes in the economic value of the bank’s assets & liabilities including any off-balance sheet item.

20. Credit Risk Management in Banking Industry 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.

21. Credit Risk Management in Banking Industry 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.

22. Credit Risk Management in Banking Industry 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.

23. Credit Risk Management in Banking Industry 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.

24. Credit Risk Management in Banking Industry 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.

25. Credit Risk Management in Banking Industry Comparison of Cross-Section of Borrowers in the Banking Market Large Retail Market Individuals Mid Market Medium-Size Businesses Borrowers Large Companies Corporate Market Small Credit Exposure Low High

26. Credit Risk Management in Banking Industry Borrower Submission Approval/Rejection Credit Application or Origination • Capital * Capacity • Character * Collateral • * Consideration Credit Analysis & Assessment • Credit Policy • Credit Limit • Credit Pricing *Credit Structuring *Credit Sanctioning Credit Management & Administration • Capital (Economic, and Regulatory) • Provision for Default • Provision for Risk Sharing (e.g. co-financing)

27. Credit Risk Management in Banking Industry Credit Risk Management in Banking Industry Borrower • *Origination • Structuring • Pricing • Underwriting • Sanctioning • Monitoring Credit Application or Origination Credit Management Portfolio Valuation & Management • Portfolio Assessment • Portfolio Valuation • Value-at-Risk (VaR) • Portfolio Management Credit Portfolio Trading Book Credit Derivatives Credit Securitization Third Party Assets Sales Credit Capital Capital Market

28. Credit Risk Management in Banking Industry MODERN CREDIT MANAGEMENT SETTING Credit Modeling Portfolio Valuation Credit Trading Book Credit Evaluation Capital Management *Economic Capital *Regulatory Capital Credit Administration & Monitoring Credit Procedures & I.T. Systems Credit Modification

29. Credit Risk Management in Banking Industry What Information Are Required for Credit Risk Aanlysis? • 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, • Borrower’s contribution, • Security aspects & insurance protection, • Borrower’s character, • Business plan & projections, • Environmental considerations, and • Other considerations.

30. Credit Risk Management in Banking Industry 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.

31. Credit Risk Management in Banking Industry 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 bank’s 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.

32. Credit Risk Management in Banking Industry 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.

33. Credit Risk Management in Banking Industry Duration of the Loan/Credit The time it takes to service a loan/credit cannot exceed a Bank’s 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.

34. Credit Risk Management in Banking Industry Borrower’s Contribution A borrower’s 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.

35. Credit Risk Management in Banking Industry 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.

36. Credit Risk Management in Banking Industry Borrower’s 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.

37. Credit Risk Management in Banking Industry 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 architect’s 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.

38. Credit Risk Management in Banking Industry 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.

39. Credit Risk Management in Banking Industry 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.

40. Credit Risk Management in Banking Industry 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 Moody’s. 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.

41. Credit Risk Management in Banking Industry Modern Approach to Assessing Credit Risk 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.

42. Credit Risk Management in Banking Industry • 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: • Interest rate, • exchange rate, and • 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.

43. Credit Risk Management in Banking Industry • 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 company’s 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.

44. Credit Risk Management in Banking Industry Total Risk Model Total Risk = Systematic Risk + Unsystematic Risk Company Specific Risk Market Risk • Cash Flow • Borrowings • Portfolio GDP Interest Rate Exchange Rate Inflation

45. Credit Risk Management in Banking Industry 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.

46. Credit Risk Management in Banking Industry Credit Risk Analysis In today’s 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 borrower’s 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?

47. Credit Risk Management in Banking Industry Credit Risk Analysis Other Examples: What is the existing commitment of the borrower? What is the likely impact of weather conditions on the borrower’s 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 borrower’s 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 borrower’s business?

48. Credit Risk Management in Banking Industry Risks Associated with Lending 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).

49. Credit Risk Management in Banking Industry Risks Associated with Lending • 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.

50. Credit Risk Management in Banking Industry Risks Associated with Lending 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 bank’s credit risk management practices.