Risk Management and Credit Risk Basics

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Questions and Answers

What does a Z-score lower than 1.8 indicate about a company?

The company is financially stable.

The company is likely to face bankruptcy. (correct)

The company is in a safe financial zone.

The company has a good credit rating.

A Z-score of 3 or above suggests a company is at high risk of filing for bankruptcy.

False

What is the market value of equity for Belta manufacturers?

$7,000,000

A Z-score between 1.8 and 3 means the company is in a __________ area.

grey Signup and view all the answers

Match the following Z-score ranges with their financial implications:

Lower than 1.8 = High probability of bankruptcy Between 1.8 and 3 = Moderate chance of bankruptcy 3 and above = Unlikely to file for bankruptcy Signup and view all the answers

What is the primary goal of credit risk management according to the Basel Committee?

Maximize the bank’s risk-adjusted rate of return Signup and view all the answers

Credit risk is easily quantified and managed by banks.

False Signup and view all the answers

What is the primary objective of a Bank Risk Manager?

Maximize shareholders' wealth Signup and view all the answers

Credit risk is the potential that a bank borrower will fail to meet ________ in accordance with agreed terms.

obligations Signup and view all the answers

Match the following terms with their definitions:

Credit Risk = Potential failure to meet obligations Risk Measurement = Qualifying exposures to risk Return on Equity (ROE) = Measure of financial performance Basel Committee = Global standard setter for banks Signup and view all the answers

Which of the following factors has increased competition in banking markets?

Deregulation Signup and view all the answers

Investors expect a higher rate of returns without taking on additional risks.

False Signup and view all the answers

What should banks estimate to ensure they hold adequate capital?

Expected losses and profitability of unexpected losses Signup and view all the answers

What are loans that are not repaid classified as?

Non-Performing Loans Signup and view all the answers

Consumer credit risk is associated with lending to individuals with poor credit ratings.

True Signup and view all the answers

What five factors does personal judgment consider in assessing a loan application?

Character, Capacity, Capital, Collateral, Conditions Signup and view all the answers

Altman’s Z-Score model predicts the chances of a business going _____ in the next two years.

bankrupt Signup and view all the answers

Match the following credit risk types with their descriptions:

Consumer Credit Risk = Risk associated with credit cards Business Credit Risk = Default by small and large businesses Diversity in Lending = Lend to many industries Credit Monitoring = Reduces moral hazards Signup and view all the answers

Which of the following methods is NOT a way to minimize credit risk?

Overextension Signup and view all the answers

Credit scoring involves asking several questions and weighting the answers to assess the borrower's creditworthiness.

True Signup and view all the answers

Who developed Altman’s Z-Score model?

Edward Altman Signup and view all the answers

Study Notes

Risk Management

Risk management is a critical tool to ensure bank soundness and profitability.
It is a complex and comprehensive process, involving creating a suitable environment, maintaining efficient risk measurement, monitoring risk-taking activities, and establishing internal controls.
Risk measurement involves qualifying risk exposures.
Risk management encompasses all processes a financial institution follows to define strategies, identify risks, quantify them, and manage their nature.

Credit Risk

Credit risk is the potential for a borrower to fail to meet obligations.
Borrowers can include other banks, companies, investors, and institutions.
Quantifying credit risk can be challenging.
Credit risk is essentially the same as default risk.

Basel Committee on Banking Supervision (BCBS)

The BCBS aims to maximize the bank's risk-adjusted rate of return through increasing credit risk exposure within acceptable parameters.
It is the primary global standard setter for banking supervision.
It fosters regular cooperation in banking supervisory matters.

Types of Credit Risk

Consumer credit risk: Lending to individuals with poor credit ratings, often through credit cards.
Business credit risk: Default by small or large businesses, including instances like Penn Square Bank's failure (1984).

Methods to Minimize Credit Risk

Screening: Assessing potential borrowers to ensure they are low-risk and don't have a history of debt.
Credit checking: Verifying applicant credit history for default records.
Credit scoring: Gathering and assessing information (employment history, business history, length of time with bank, etc.) from potential borrowers.

Personal Judgment

Credit decisions often involve personal judgment based on the five C's of credit (character, capacity, capital, collateral, and conditions).
Statistical programs compare borrower information to similar consumers' credit performance.
A credit score predicts the borrower's creditworthiness.

Monitoring

Monitoring reduces moral hazards by including covenants in loan contracts.
Covenants establish repayment requirements.
Long-term customer relationships can also mitigate such risks, which is not typical in short-term lending practices.

Credit Rationing

Credit rationing occurs when a bank limits the amount of loan available for a borrower, often to mitigate adverse selection, moral hazard, and manage overall risk.
This approach helps to moderate risk exposure.
This can be done by restricting who can borrow, or how much.

Collaterals

Loans with collateral requirements (secured loans) employ assets as security.
On loan defaults, the bank reclaims these assets.
Examples include compensating balances (minimum funds in an account) in commercial loans.

Diversification

Banks can diversify lending across industries, locations, and borrowers to reduce overall risk exposure.
Credit risk concentration is measured by migration risk factors and concentration limits.
Diversifying loan types reduces the impact of individual loan failures.

Altman's Z-Score Model

A numerical measure predicts a business's likelihood of bankruptcy within two years.
Developed by Edward Altman in 1968, it evaluates financial stability.
It uses multiple balance sheet and income statement values.
Higher Z-scores indicate lower bankruptcy risk.

External Credit Rating

External credit rating agencies (Moody's, S&P, Fitch) provide independent assessments of credit risk.
Their importance is rising due to regulatory pressures and the increasing complexity of cross-border lending.
Credit ratings influence a borrower's cost of borrowing, with higher ratings leading to lower costs.
Ratings are essentially opinions.

Credit Rating Categories

AAA, AA, and A—good credit rating
BBB and BB—average credit rating
B, C, and D—low credit rating

Value at Risk

Will be discussed in a later session.

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Description

Explore the fundamentals of risk management and credit risk in banking. This quiz covers essential concepts such as risk measurement, monitoring activities, and credit exposure strategies set by the Basel Committee on Banking Supervision. Test your understanding of these vital financial principles.