Professional Documents
Culture Documents
The aim of credit risk management is to balance between risk and return to achieve optimum profitability and efficiency Taking and institutional view banks could minimise concentration risk Lending on a more scientific basis would help remove subjectivity
1
Introduction
Credit risk seeks following objectives:
a) achieve and appropriate balance between risk and return; b) avoid concentration risk; c) manage loans on a portfolio basis; and d) take a group of loans off the statement of financial position.
Loan Pricing
All loans provide a cost to the Statement of Financial Position
Statement of Financial Position Costs
Capital Cost: Capital that must be allocated to support default risk Liquidity: Lending activities must allow sufficient liquidity on Statement of financial position Cost of Funds: Returns must be achieved from loan including considering Return on Equity, Return on Liquidity, Market Cost of Deposits and Return on the Loan
5
Loan Pricing
Noncredit Risk Costs
Interest Rate Risk: Whether loan book has fixed/floating rate loans Pre-payment Risk: Risk that loans will be paid out earlier than specified term Origination Costs: Costs of marketing and monitoring securitised loans sold
Credit Costs
Expected Losses = Default Probability x (1 Recovery Rate) Unexpected Losses: Generally reflects volatility of Expected Losses
6
Capital Adequacy
Recent evidence shows poor credit decisions play a major part in bank failures Generally, banks required to allocate a minimum of 8% of a loans value from Capital As some loans riskier than others, risk weighting system adopted
8
Securitisation
Clean sale supply of assets:
Should be no beneficial interest in the sold assets and absolutely no obligation on institution Should be no recourse (including costs) to the institution and no obligation to repurchase loan asset
Securitisation
Amount paid for loans should be fixed and received at time asset is transferred from lending institution Any assets provided to the Special Purpose Vehicle (SPV) as a substitute or sold below book value do not relieve credit risk
10
Securitisation
Revolving Facilities:
Defined as assets with ongoing credit relationship such as credit cards and home loans Rights, details of cashflows and obligations of each party must be clearly specified As with normal securitisation, institution cannot supply additional assets to the pool
11
Securitisation
Liquidity shortfalls for the institution share must not exceed the interest receivable Institution retains right to cancel undrawn amounts Institution must have no obligation to repurchase
12
13
Introduction
When financial institutions make loans, returns generated mean accepting some default risk It is imperative that default risk is managed so that the solvency of the bank is not threatened Should the problem loan be foreclosed or actively managed?
14
Causes of Default
Default does not necessarily mean that all of the loan extended is lost. Default is defined here as a loan where repayments are overdue Better lending procedures can minimise, but not eliminate, the risk of default Harder to manage default risk as loan book becomes larger
15
Causes of Default
Likely causes of default
Lack of compliance with loan policies Lack of clear standards and excessively lax loan terms Inadequate controls over loan officers Over-concentration of bank lending Loan growth exceeding banks capabilities Inadequate problem loan identification Insufficient knowledge of customers finance Lending in unfamiliar markets
16
Boom:
Major asset inflation with business overconfidence and declining credit standards
Downturn:
Declining asset values and economic activity generally accompanied by increased defaults
18
19
20
Not all of the loan must have provisions made as lender may assess the likely losses from the asset.
22
Once the above steps are completed, the financial institution must write off the bad debt with asset valued at zero and a charge made against profits.
24
Dynamic Provisioning
The risk profile of the loan portfolio is sensitive to point in the economic cycle, e.g. greatest defaults occur at bottom of economic cycle Therefore:
Credit risk is not static but changes over time Bad debt should not come as a surprise as modelling should detect changes to probable default risk in portfolio segments
26
Dynamic Provisioning
Key principles in dynamic provisioning:
Classify loans into homogeneous groups Sub-classify groups by maturity length
Determine probability of loss for each group Determine likely severity of loss for each group
Use the historical loan-loss information to create predictive model incorporating economic conditions, interest rates, investment activity, etc. Apply model outcome to current provisions
27