Credit Risk Management PDF

Chapter 4 Credit Risk Management Risk Management It is central tool to ensure banks soundness and profitability. Complex and comprehensive process: It include creating and appropriate environment, maintaining an efficient risk measurement structure, monitoring and mitigating risk...

Chapter 4 Credit Risk Management Risk Management It is central tool to ensure banks soundness and profitability. Complex and comprehensive process: It include creating and appropriate environment, maintaining an efficient risk measurement structure, monitoring and mitigating risk taking activities and establishing adequate framework of internal control. Risk measurement deals with the qualification of risk exposures, while management is over all process that a financial institution follows to define a business strategies to identify the risk to which is exposed, to quantify those risk, and to understand and control the nature of risk.  For each class of risk, banks need to estimate the expected losses and the profitability of unexpected loses, so that an appropriate amount of capital may be held. Bank Risk Manager objective is to maximize the shareholders wealth, hence must manage the trade of between risk and return carefully,. Must generate the returns greater than opportunity cost of capital (Cost of bank- raising equity) and keeping share holder happy. The aim of the Manager is Max ROE, hence they can do these calculations for all parts of the business, in oder to identify how capital is being used with in the bank and what parts are generating the best/worst returns  Investors can only expect a higher rate of returns by increasing the risk they are prepared to bear. Deregulations, globalization, and internationalization has increased the degree of competition in banking markets, therefore, banks need to take on mor risk, to achieve satisfactory returns. Credit Risk The potential a bank borrower will fail to meet obligations in accordance with agreed terms and conditions. Borrowers can be Other banks Companies Investors Institutions Credit risk is most difficult to quantify Credit risk is same is default risk  According to the basil committee, The goal of credit risk management is to maximize the bank’s risk adjusted rate of return, by increasing credit risk exposure within acceptable parameters. The Basel Committee on Banking Supervision (BCBS) is the primary global standard setter for the prudential regulation of banks and provides a forum for regular cooperation on banking supervisory matters. When loan/fixed income security fails to make a promised payment, de to debtor’s inability/unwillingness Debtor is financially unable to pay/not have the resources/unwilling to pay Loans that are not repaid is are classified as non-performing loans or bed debts, or loans losses. These NPLs are most frequent cause of the bank losses. Types of Credit Risk Consumer Credit Risk: Risk associated with credit cards-Lending to poor credit rating persons Business Credit Risk: Default by small business Default by large business PENN SQUARE BANK: US Bank Failure (1984) Aggressive lending to Energy Firm (Oil & Gas). It was sold to bank of America. Lending to poor credit rating businesses Methods to Minimize Credit Risk SCREENING: Helps to overcome adverse selection problem in loan markets Lender wants to minimize information asymmetry problems in retail loan market. They need to ensure that that potential borrowers are a good risk, and don’t have history of bed debts and unpaid loads They do this by:  Credit Checking: Checking credit default of potential applicant Credit history Default record against applicant Credit Scoring: Get information on potential borrower Ask several questions and weight answers Employment history Business History Lenth of time with bank Type of account held Length of time at present address  Personal judgment on behalf of the loan officer, based on 5 Cs Character Capacity Capital Collateral Conditions Using statistical programs, creditors compare the information to the credit performance of consumers with similar profiles A credit Score helps to predict how creditworthy the applicant is  MONITORING: Reduces moral Hazards  CREDIT RATIONAING: LOAN $500 instead of $1000  COLLETERALS  DIVERSIFICATION: LEND TO MANY INDUSTRIES Altman’s Z-Score Model Altman’s Z-Score model is a numerical measurement that is used to predict the chances of a business going bankrupt in the next two years. The model was developed by American finance professor Edward Altman in 1968 as a measure of the financial stability of companies. Altman’s Z-score model is considered an effective method of predicting the state of financial distress of any organization by using multiple balance sheet values and corporate income.  Usually, the lower the Z-score, the higher the odds that a company is heading for bankruptcy. A Z-score that is lower than 1.8 means that the company is in financial distress and with a high probability of going bankrupt. On the other hand, a score of 3 and above means that the company is in a safe zone and is unlikely to file for bankruptcy. A score of between 1.8 and 3 means that the company is in a grey area and with a moderate chance of filing for bankruptcy. Problem Belta manufacturers in China produce car engines. They have been in the business for almost 20 years. They have been profitable enough to employ more staff and increase their production. But with a recent loan taken to facilitate automation, investors want to know how the company is doing. Their total assets are worth $3,500,000 while they have a working capital of $4,200,000. Their liabilities stand at $5,000,000 while retained earnings amount to $800,000. Earnings Before Interest and Tax come to $6,500,000. Sales total $8,300,000 while the market value of equity is $7,000,000. Here is the calculation of Belta’s Altman z-score: External Credit Rating  AAA, AA, A – Good Credit Rating BBB, BB – Average Credit Rating B, C, D – Low Credit Rating Value at Risk Will be discussed in next class