Chapter Six: Credit Risk Management
Enterprise-Wide Risks
Financial Risks
FX risk in a new
foreign market
Financial
Risk
Business
Risk
Technology and
operations
outsourcing
Operational
Risk
Derivatives
documentation and
counterparty risk
Market
Risk
Liquidity
Risk
Funding Liquidity
Credit Risk
Associated with
Investments
Asset Liquidity
Credit
Risk
Credit Risk
Associated with
Borrowers and
Counterparties
6.1 Components of Credit Risk
Definition: the chance that a debtor or financial
instrument issuer will not be able to pay
interest or repay the principal according to the
terms specified in a credit agreement.
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Credit risk means that payments may be
delayed or ultimately not paid at all, which in
turn cause cash flow problems and affects the
bank’s liquidity.
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Credit risk is the major single cause of bank
failures because about 80% of a bank’s
balance sheet relates to aspects of risk
management.
Main types of credit risk are:
Personal or consumer risk
Corporate or company risk
Sovereign or country risk
An overall credit risk management review
includes
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It is important to evaluate a bank’s capacity to
assess, administer, enforce and recover credit
instruments.
Credit risk management mainly focused on
loan portfolio.
6.2 Credit Portfolio Management
 A lending policy should contain an outline of
the scope and allocation of a bank’s credit
facilities and the manner in which a credit
portfolio is managed.
 Flexibility is important for fast reaction and
early adaptation to changing conditions in a
bank’s asset mix and market environment.
Considerations for Sound Lending
Policies
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Limit on total outstanding loans: relative to
deposits, capital or assets.
Geographic limits (usually a dilemma):
Geographic diversification may lead to bad
loans if the bank lacks understanding of its
diverse markets and/or doesn’t have quality
management.
Strict geographic limits may create problems
for markets with narrow economies.
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Credit concentrations: lending policy should
have diversified portfolio and balance between
maximum yield and minimum risk.
Definition:
Concentration limits refer to the maximum
permitted exposure to a single client, connected
group and/or sector of economic activity.
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Distribution by category: it is common to set
limits based on aggregate percentages of total
loans in real estate, consumer or other
categories.
Type of Loans: lending policy should specify
loan types, based on expertise of lending
officers, deposit structure and anticipated
credit demand.
 Maturities: lending policy should establish the
maximum maturity for each type of credit, and
loans be granted with realistic repayment
schedule.
Maturity should be related to the anticipated
source of repayment, loan purpose and
collateral useful life.
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Loan pricing: rates on various loan types must
be sufficient to cover costs of the funds, loan
supervision, administrative costs and probable
losses. Should provide reasonable profit
margin.
Lending authority (determined by bank size):
in small banks it is centralized , but
decentralized in larger banks to avoid delays.
Limits should be set for lending officers
according to experience. Committee authority
allows approval of larger loans.
Appraisal Process: lending policy should
outline where the appraisal responsibility lies
and should define standard appraisal
procedures.
Details should be provided regarding the ratio
of the amount of the loan to the appraised
value of both the project and collateral.
 Maximum ratio of loan amount to the market
value of pledged securities: lending policy
should set forth margin requirements for
securities accepted as collateral, related to the
marketability of securities.
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Financial statement disclosure: a bank should
recognize a loan (original or purchased) in its
balance sheet.
Impairment: a loan should be impaired (when
it becomes difficult to be collected) to its
estimated realizable value through an existing
allowance.
Collections: reports should be submitted to the
board with sufficient details to determine risk
factor, loss potential, alternative courses of
action and a follow up collection procedure.
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Financial information: safe extension of credit
depends on complete and accurate information
on the borrower’s credit standing.
Lending policy should define financial
statement requirements and external credit
checks.
Long term loans require financial projections
with horizons equivalent to the loan maturity.
6.3 Credit Portfolio Quality Review
 Loan portfolio characteristics and quality are
assessed through a review process.
 The review includes a random sampling of
loans to cover 70% of loans amount and 30%
of the number of loans.
In addition, should include all of the
following loans:
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To borrowers if the loan accounts for more
than 5% of the bank’s capital.
To shareholders and connected parties.
If interest or repayment terms have been
rescheduled or changed.
If interest / principal is more than 30 days past
due.
Classified as substandard, doubtful or loss.
Loan portfolio analysis should include:
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A summary of major loan types (amount and
number) including details on: number of
borrowers, average maturity, average interest
rate.
Loan distribution according to: currency,
maturity, economic sector, public Vs. private
borrowers, corporate Vs. retail borrowers.
Loans to government
Loan by risk classification
Nonperforming loans.
6.4 Nonperforming Loan Portfolio (NPLP)
 Definition: a loan is considered not performing
when principal or interest on it is past due for 90
days or more!!
 NPLP is an indication of the quality of the total
loan portfolio and bank’s lending decisions.
 Another indicator of portfolio quality is the bank’s
collection ratio.
6.5 Credit Risk Management Policies
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Specific credit risk management measures
typically include three kinds of policies:
Policies limit or reduce credit risk
Policies of asset classification
Policies of loan loss provisioning
6.6 Policies to Limit or Reduce Credit
Risk
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Large exposures:
Traditionally, bank regulators pay closer
attention to risk concentration to prevent
excessive reliance on a large borrower.
Modern regulators stipulate that a bank not
make investments or grant large loans in
excess of a prescribed percentage of capital or
reserves.
Basel imposes 25% single-customer to capital
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Single client: an individual / legal person or a
connected group to which a bank is exposed.
Single clients present a singular risk to the
bank if 1) financially interdependent and
2) share the same source of repayment.
Large exposure may be an indication of bank
commitment to support specific clients.
Loan officer needs to frequently monitor
events affecting large debtors and their
performance.
 Related party lending
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Lending to connected parties is a dangerous
form of credit exposure.
Related Parties: includes bank’s parent major
shareholders, subsidiaries, affiliate companies,
directors and executive officers.
6.7 Asset Classification
6.8 Loan Loss Provisioning Policy