Managing Credit Risk in Banking

Chapter 2

Literature Review

2.1 Introduction

As discussed in chapter one, the main objective of this research is to portray the contemporary practices of managing credit risk in banking industry and comparing the practices between banks in UK and Bangladesh. To achieve the prime objective the research will also critically investigate the nature of credit risk for banks and evaluate the risk as a cause of major bank failures in history. The study will also explore various methods of bank credit risk management especially the Basel framework. Finally the research will try to formulate a set of best practices for credit risk management in Bangladeshi and British banks. This section of the study contains the relevant literatures and review of previous works on bank credit risk management which are present as following.

2.2 An Overview of Risks in Banking Business

Risk denotes uncertainty that might trigger losses. As our financial system is market based, it requires an effective risk management framework. Risks in financial markets have changed in the past three decades reflecting the changing nature of financial intermediation (Machiraju, 2008). A modern bank has to deal with various types of risks. These major categories of risks are credit risk, interest rate risk, foreign exchange risk, liquidity risk, operational risk and systematic risk. A brief discussion on these risks are presented below –

2.2.1 Credit Risk

Credit risk is the risk of losing money when loans default (Machiraju, 2008). When the borrowers fail to repay the loan or interest it becomes bad. Bad loans are one of the prime reasons of bank losses. Credit risk is the largest element of risk in the books of most banks which if not managed in a wiser way, may break down individual banks or may cause widespread financial instability by endangering the whole banking system (Jackson and Perraudin, 1999). For this reason in banking industry credit risk is a critical issue and needs careful management.

2.2.2 Interest Rate Risk

Interest rate risk management may be approached either by on balance adjustment or off-balance sheet adjustment or a combination of both. On-balance sheet adjustment involves changes in banks portfolio of assets and liabilities as interest rates change. When medium or long-term loans are funded by short-term deposits, a rise in the rate of interest will increase the cost of funds but the earnings on the assets will not, thereby reducing the margin or spread on the assets.

2.2.3 Liquidity Risk

Liquidity risk refers to the bank’s ability to meet its cash obligations to depositors and borrowers. A liability sensitive position than to assets of interest rates reduces the liquidity position of a bank. The mismatch between short-term liabilities and long-term assets creates a severe funding problem as the liabilities mature. Again if the duration of assets exceeds the duration of liabilities the ability to realize liquidity from the assets of the bank is reduced. Liquidity needs are increasingly met by deposit and non-deposit sources of funds paying market rates of interest (Machiraju, 2008).

2.2.4 Operational Risk

Operational risk is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems from external events. Operational risks -include – information technology risk, human resources risk, loss to assets risk and relationship risk (Balthazar, 2006).

2.2.5 Foreign Exchange Risk

Foreign exchange risk arises out of the fluctuations in value of assets, liabilities, income or expenditure when unanticipated changes in exchange rates occur. An open foreign exchange position implies a foreign exchange risk.

2.3 Credit Risk and its Categories

Credit risk, as discussed above, is defined as the probability that borrower of a bank or counterparty debtor will fail to meet its obligations in accordance with agreed term (Bessel, 1999). It may also be defined as the risk arising from the uncertainty of an obligor’s capability and willingness to carry out its contractual obligations. Here obligors are any party that has direct or indirect financial obligations inside the contract. Following are major categories of credit risk –

2.3.1 Risk of Default

Traditional credit risk is involved with default on a repayment of loans. And a likelihood of the default is called the probability of default. When a default occurs, the amount at risk may be as much as the whole liability, which can be recovered later, depending on factors like the creditors’ legal status. However, later collections are generally difficult or even impossible in that huge outstanding obligations or losses are usually the reasons why organizations fail.

2.3.2 Pre-settlement Risk

The possibility that the counterparty may default once a contract has been entered into but a settlement is still to occur is called pre-settlement risk. Through this period, the contract will have unrealized gains. This signifies the risk. The probable loss to the bank is dependent on the magnitude of change in market rates after the origination of the original contract. Such risk can be assessed in terms of existing and probable exposure to the organization (Horcher, 2005).

2.3.3 Risk of Counterparty Settlement

Settlement risk is common the interbank market and the risk arise when one party to a contract fails to pay funds or deliver assets to other one during the time of settlement. Such risk can be associated with any timing differences in settlement (Casu et al, 2006). Counterparty settlement risk is usually associated with foreign exchange trading, where “payments in different money centers are not made simultaneously and volumes are huge”. German bank Herstatt failure in 1974 created similar scenario as it received payments from its foreign exchange counterparties but never made payments to counterparty financial institutions as it ceased to operate before that.

2.3.4 Sovereign Risk

Sovereign risks are borne from the impact of crises in economic and/or socio-political situation in foreign severing nations. Such risk is prevalence on transactions with overseas nations and refers to the uncertainty when governments for some reason declares debt to foreign lenders void or adjust the profit, interest and capital movement (Casu et al, 2006). Evidence demonstrates that sovereign governments have both temporarily and permanently exercised controls on capital, stopped cross-border payments and cancelled debt repayments.

2.4 Fundamental Risk Management Practices in Banks

Banking industry has its own methods of managing different types of risk. A brief summary of each risk management practice is given below –

Risks in Banking Business

Standard Risk Management Practices

Credit Risk

Raising credit standards

Using guarantees and collateral

Monitoring the borrower behaviour after loan made

Transferring credit risk by selling standardised loans

Diversifying credit portfolio

Interest Rate Risk

Using adjustable interest rates on loan

Using various non-traditional financial instruments referred to as derivatives such as futures, options, swaps or creation of synthetic loans through use of futures.

Liquidity Risk

Liability management

Using mathematical model for matching asset and liability terms

Foreign Exchange Risk

Forward contracts

Money market alternative

Foreign currency futures

Currency swaps and

Foreign currency options etc.

Table 2.1: Standard Methods of Bank Risk Management

2.5 A Closure Look on Credit Risk Management Techniques

Hennie (2003) states that despite innovations in the financial services sector over the years, credit risk is still the major single cause of bank failures, for the reason that “more than 80 percent of a bank’s balance sheet generally relates to this aspect of risk management”. The consultative paper issued by Basel (1999a) also points out that the major cause of serious banking problems continues to be directly due to the loose credit standards for borrowers and counterparties, poor portfolio risk management and so on. All such evidence proves the extremely vital role credit risk management plays in the whole banking risk management approach as well as the sustainable success of the organization. In this section, the goal and principles of banking credit risk management will be summarized briefly, which together with the above part on the identification of the existing credit risk in banking activities, will provide a basic framework for the understanding and discussion of banks’ credit risk management practices. The standard credit risk management processes are discussed as following –

2.5.1 Developing and Using a Sound Credit Granting Process

A sound credit granting process requires the establishment of well-defined credit granting criteria as well as credit exposure limits in order to assess the creditworthiness of the obligors and to screen out the preferred ones. A bank’s credit criteria are designed to shape the types and characteristics of its preferred obligors, and they should set out who are eligible for the credit, the amount of the credit and the relative terms and conditions (Monetary Authority of Singapore 2006). These criteria, together with the credit exposure limits on single and groups of counterparties that usually base on internal credit rating, should help banks to generate sufficient information on credit risk profiles and instruct the safe credit approval process, which are applicable to credit extension activities as well.

2.5.2 Maintaining an Appropriate Credit Administration, Measurement and Monitoring Process

Credit administration can play a vital role in the success of a bank, since it is influential in building and maintaining a safe credit environment and usually saves the institution from lending sins. Therefore, banks should never neglect the effectiveness of their credit administration operations (Wesley, 1993). Then talking about credit risk measurement in banks, it is required that banks should adopt effective methodologies for assessing the credit risk inherent both in the exposures to individual borrowers and credit portfolios, and this will be explained in details later. The last focus in this area of principles is related to credit risk monitoring, which is definitely a must in banks’ risk management procedure. Banks should keep track on the borrowers’ current financial conditions and ensure their compliance with the covenants. Both cash flows and collateral adequacy should be ensured and the potential problem credits should be considered. In this way, banks are well in control of their credit qualities as well as all the related situations, and can react to any future changes timely and readily.

2.5.3 Transferring Credit Risk

Once loans are made Banks may use credit derivatives to transfer credit risks. There are different types of credit derivatives – credit default swap, credit linked note and total return swap. Other forms of risk transfers include trading loans, securitizations and bank or insurance guarantees. However there are regulatory concerns over these methods.

2.6 Bank Risk Exposure and Causes of Bank Failures

Generally, credit risk is related to the traditional bank lending activities, while it also comes from holding bonds and other securities. Basel (1999a) reports that for most banks, loans are the largest and most obvious source of credit risk; however, throughout the activities of a bank, which include in the banking book as well as in the trading book, and both on and off the balance sheet, there are also other sources of credit risk. Various financial instruments including acceptances, interbank transactions, financial futures, guarantees, etc increase banks’ credit risk. Therefore, it is indispensable to identify all the credit exposures– the possible sources of credit risk for most banks, which can also serve as a starting point for the following parts of this work.

2.6.1 On-balance Sheet Exposures

Commercial and industrial, real estate, consumer and others are the most common types of loans. Commercial and industrial loans can be made for periods from a few weeks to several years for financing firms’ working capital needs or credit needs respectively. Real estate loans are primarily mortgage loans whose size, price and maturity differ widely from C&I loans. Consumer loans refer to those such as personal and auto loans while the so called other loans include a wide variety of borrowers such as other banks, nonblank financial institutions and so on.

Credit risk is the predominant risk in bank loans. Over the decades the credit quality of many banks’ lending has attracted a large amount of attention. The only change is on the focus of the problems from bank loans to less developed countries and commercial real estate loans to auto loans as well as credit cards, which is an American example. Since the default risk is usually present to some degrees in all loans (Saunders and Cornett 2006), the individual loan and loan portfolio management is undoubtedly crucial in banks’ credit risk management.

Besides lending, credit risk also exists in banks’ traditional area of debt securities investing. Debt securities are debt instruments in the form of bonds, notes, certificates of deposits, etc, which are issued by governments, quasi-government bodies or large corporations to raise capital.1 In general, the issuer promises to pay coupon on regular basis through the life of the instrument and the stated principal will be repaid at maturity time. However, the likelihood that the issuer will default always exists, resulting in the loss of interest or even the principal to banks, which can be a damaging impact.

2.6.2 Off-Balance Sheet Exposures

Since the 1980s, off-balance sheet commitments have grown rapidly in major banks, among which there are swaps, forward rate agreements, bankers’ acceptances, revolving underwriting facilities, etc. (Hull 1989). Those commitments give rise to new types of credit risk from the possibility of default by the counterparty. In this section, some of the off-balance sheet credit exposures will be introduced, among which the first one is related to derivative contracts.

(a) Derivatives Contracts: According to Saunders and Cornett (2006), banks can be dealers of derivatives that act as counterparties in trades with customers for a fee. Contingent credit risk is quite likely to be present when banks expand their positions in derivative contracts. Since the counterparty may default on payment obligations to truncate current and future losses, risk will arise, which leaves the banks unhedged and having to substitute the contract at today’s interest rates and prices. This is also more likely to happen when the banks are in the money and the counterparty is losing heavily on the contract. Comparatively, the type of credit (default) risk is more serious for forward contracts and swap contracts, which are nonstandard ones entered into bilaterally by negotiating parties. While trading in options, futures or other similar contracts may expose banks to lower credit risk since contracts are held directly with the exchange and there are margining requirements. However, the credit risk is also not negligible.

(b) Guarantees and Acceptances: Bank Guarantee is an undertaking from the bank which ensures that the liabilities of a debtor will be met, while a bankers’ acceptance is an obligation by a bank to pay the face value of a bill of exchange on maturity (Basel 1986). It is mentioned by Basel (1986) that since guarantees and acceptances are obligations to stand behind a third party, they should be treated as direct credit substitutes, whose credit risk is equivalent to that of a loan to the ultimate borrower or to the drawer of the instrument. In this sense, it is clear that there is a full risk exposure in these off balance sheet activities.

(c)Interbank Transactions

Banks send the bulk of the wholesale dollar payments through wire transfer systems such as the Clearing House InterBank Payments System (CHIPS). The funds or payments messages sent on the CHIPS network within the day are provisional, which are only settled at the end of the day. Therefore, when a major fraud is discovered in a bank’s book during the day, which may cause an immediate shutting down, its counterparty bank will not receive the promised payments and may not be able to meet the payment commitments to other banks, leaving a serious plight. As pointed out by Saunders and Cornett (2006), the essential feature of the above kind of settlement risk in interbank transactions is that, “banks are exposed to a within-day, or intraday, credit risk that does not appear on its balance sheet”, which needs to be carefully dealt with.

(d) Loan Commitments

A loan commitment is a formal offer by a lending bank with the explicit terms under which it agrees to lend to a firm a certain maximum amount at given interest rate over a certain period of time. In this activity, contingent credit risk exists in setting the interest or formula rate on a loan commitment. According to Saunders and Cornett (2006), banks often add a risk premium based on its current assessment of the creditworthiness of the borrower, and then in the case that the borrowing firm gets into difficulty during the commitment period, the bank will be exposed to dramatic declines in borrower creditworthiness, since the premium is preset before the downgrade.

2.6.3 Causes of Bank Failures

Over the last century many banks failed and the reasons were also varying. In following sections major causes of bank failures are present with examples.

Cause of Bank Failures

How Fails

Example

Improper credit evaluation, poor selection of borrowers

If the credit evaluation is poor, loans are given to borrowers not having enough repayment capacity. As a result the volume of loans disbursed increases which may initially strengthen the asset portfolio of the bank. But at the same time it carries with itself the risk of Non Performing Assets. If there are no stringent regulations regarding specific provisioning of NPAs, provisioning made is insufficient. Hence the impact is that banks do not address the problem of NPAs until it is reached an alarming level.

Subprime Mortgage Crises – Mortgage borrower was not evaluated diligently

Excessive exposure to real estate industry

One of the types of securities banks accept is the Immovable Property. Once the property is mortgaged in the bank’s name, the bank enjoys an exclusive control over it in case the borrower defaults in repayment of the loan. But real estate in itself has limitations such as the liquidity problem and risk of decline in the prices. Banks tend to give more and more loans against real estate when the market is at boom. Over a period of time the market stabilizes, real estate prices fall thereby reducing the value of collaterals in bank’s commercial loan portfolios.

Subprime Mortgage Crises – Banks over-invested in Housing industry

Foreign Exchange Risk

Banks may get into trouble if they undertake large and risky foreign exchange business. Losses may result if the bank has incurred liability in terms of a foreign currency and there is an unanticipated appreciation in that specific currency. The risk is higher especially in the environment of floating exchange rates. If the transactions are entered into with a fixed currency exchange rate the future liability is known in advance.

Herstatt Bank failure in 1974

Management Frauds

Managerial personnel are in whole charge of the bank’s funds and are responsible for proper channelisation of the same. But in cases managers divert bank funds from banks to businesses owned by them or the main shareholders. Also in cases the latter acquires assets of the banks for less than true value or sells assets to banks at excessive prices. In addition finance extended by the banks is used for speculative real estate or industrial projects by the firms of the bank’s own groups.

Bank failures in Spain

Other causes of bank failures are –

Deterioration in bank’s capital position:

Although it is recognized that bank’s capital position should be improved, it is not always possible. The reasons are inadequate retained earnings, which actually should be the primary source for strengthening bank’s capital position a faulty dividend policy and insufficient provisioning for bad debts results into reduced retained earnings.

Heavy Expenditure on Bank’s Fixed Assets

Heavy expenditure on assets especially on the office building requires huge investment. This may endanger the liquidity of bank funds.

Huge Operating Costs

Sometimes banks open deposit counters which are a Cost Unit but not definitely a profit center. Due to excessive number of branches not only the time and demand liabilities of the bank but also operating costs like staff salaries and maintenance are pushed up.

Lack of Supervision

BCCI failure is a very good example of lack of supervision. In July 1991 the Bank of Credit and Commerce International failed because of wide spread fraud. BCCI had a very complex structure involving branches over 70 countries. Its complex group structure made it difficult to conduct effective supervision and audit. It is believed that BCCI’s financial statements had been falsified from its establishment in 1972. A scheme of deception was developed to conceal lending losses. To achieve this BCCI failed to record deposit liabilities and created fictitious loans that generated substantial but fictitious profits. Frauds also took place in BCCI’s treasury position.

Inadequate regulatory capital

The regulatory capital should be in line with the economic capital. It will help to strengthen the solvency of banks. The correct measurement of risk would enable it to be better managed. It is also important that capital requirements should cover operational risks including fraudulent operations. This risk is nearly always present in banking crisis of some size and its coverage with capital should help reduce it. The banks should be required to maintain sufficient control over the risks associated with their business such that their survival is not jeopardized.

2.7 Basel I and II: A Comprehensive Credit and Other Management Approach

Basel Committee of Banking Supervision (BCBS) in 1988 came out with idea of risk weighted capital adequacy standards. The standard is called Basel I. The main objectives of the accord were to bolster the soundness and stability of the international banking system and diminish the existing sources of competitive inequality among international banks (Blathazar, 2006). The accord has classified the bank capital in two tiers (See Table 1).

Tier 1

Paid-up Capital

Disclosed Reserves (Retained Profits, Legal Reserves)

Tier 2

Undisclosed Reserves

Asset revaluation reserves

General provisions

Hybrid instruments (must be unsecured, fully paid-up)

Subordinated debt (max. 50% Tier 1, min. 5 years – discount

factor for shorter maturities)

Deductions

Goodwill (from Tier 1)

Investments in Unconsolidated Subsidiaries (from Tier 1 and Tier 2)

Table 2.2: Classification of Bank Capital for Capital Adequacy Calculation

Source: Balthazar, L (2006). “Basel 1 to 3: The Integration of State-of-the-Art Risk Modeling in Banking Regulation, P-18

The rules under the accord were designed to define a minimum capital level. This capital level is to be compared with risk weighted assets (see table 2).

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%

Item

0

Cash

Claims on OECD central governments

Claims on other central governments if they are denominated and funded in the national currency. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20

Claims on OECD banks and multilateral development banks

Claims on banks outside OECD with residual maturity<1 year

Claims on public sector entities (PSE) of OECD countries

50

Mortgage Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

100

All other claims: claims on corporate, claims on banks outside

OECD with a maturity>1 year, fixed assets, all other assets

Table 2.3 : Risk Weights of Assets

Source: Balthazar, L (2006). “Basel 1 to 3: The Integration of State-of-the-Art Risk Modeling in Banking Regulation, P-18

The standard level of the capital adequacy ratio was set to 8% (See the equation below).

However sovereign regulators have the flexibility to implement stronger requirements. The Accord was primarily proposed for internationally active banks. But only nationally active banks are free to adopt the accord.

The major weakness of the Basel I was that its concentration on only credit risk. It also had the following limitations (Machiraju, 2008):

It was not risk sensitive as it did not take care for different magnitude of different corporations;

It kept an opportunity for banks to create artificial arbitrage because of unequal treatment of short-term and long-term loans;

It was applied to all portfolios in same way irrespective of the diversification in the portfolio.

In answer to these limitations BCBS introduced market risk in the accord in 1996. Market risk was defined as the risk of losses in on- and off balance sheet positions arising from movements in market prices (BCBS Document, 1996). Later in 2004 full proposal in name of Basel 2 was published which had three pillars –

Table 2.4: Three Pillars of Basel 2 Accord

Pillar One

Pillar Two

Pillar Three

Solvency Ratio, Capital:RWA where assets are weighted for credit, market and operational risks;

Supervisory Review and Internal Assessment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Market Discipline. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Basel 3 is in progress in response of the recent financial crises and widespread bankruptcies during 2008 and onward.

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2.7.1 Importance of Basel Capital Accord

The modern capital adequacy standard is a sensible regulation that is essential for maintaining harmony in international banking mechanisms in at least two ways –

Maintaining Soundness and Stability of International Banking System: Example of German bank Herstatt failure can be reviewed to better understand how new capital accord can maintain soundness and stability of international banking system. The 2 billion DEM asset bank Herstatt was involved in foreign exchange during post-Bretton Woods era when currency market was extremely volatile. In 1974, the bank speculated against the dollar and the speculation went wrong. To cover its losses the bank became involved in taking further positions. Eventually the bank ended up with open position of 2000 million DEM which was three times the bank’s capital. Finally when the regulators ordered the bank to close its position the bank’s losses were equal to four times its capital and it was declared bankrupt. The day when Herstatt was declared bankrupt, many other international banks had released payments in DEM that arrived at Herstatt in Frankfurt. However, because of time zone difference corresponding dollar amount was never sent to New York (Balthazar, 2006).

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Now let’s examine if Basel capital accord was in effect at that time what would happen –

Herstatt could not have entered into positions which would reduce the capital adequacy ratio;

If adequate capital was kept in accordance with Basel accord, the international banks those sent USD to Herstatt could have been paid after it went bankrupt;

Regulators would have been informed in time when the bank was taking excess risk putting the depositors’ funds in risk.

Thus capital adequacy standards can harmonize the international banking sector and helps avoiding losses of international banks in similar scenarios.

Diminish Existing Sources of Competitive Inequality: International banks compete in the same global business arena however regulated by the national regulators. As discussed earlier, regulations have a negative relationship with bank profitability. When a national regulator puts excess regulatory pressure on a nation’s internationally active banks, it may lose competitiveness in international banking arena if regulators in other countries are not doing the same thing. For example, Royal Bank of Scotland in UK and Bank of America in US both may compete in the same international market but regulated by separate authorities. The differences in regulations in two geographical locations are sources of competitive inequality. The internationally accepted capital adequacy standard is therefore essential for diminishing such inequality in competition.

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2.8 Managing Credit Risk: Differences between Bangladesh and United Kingdom

The major difference between the credit management techniques in banks in Bangladesh and United Kingdom can summarised as following:

Areas of Difference

Bangladesh

United Kingdom

Use of Credit Derivatives. . . . . . . . . . . . . . . . . .

The practice of credit derivatives is rare in Bangladeshi Banks

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Many British banks uses credit derivatives excessively in credit risk management

Use of Information Technology

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Use of technology like credit rating system, customer credit checking mechanisms are still impossible in Bangladesh

Banks in UK have long been using high-end information technology solu