AC959 Bank Strategy and Risk

1
AC959 Bank Strategy and Risk

• Lecture 5
• Credit risk

2
Aims of lecture

• Understand the principles underlying sound credit
  risk management
• Explain how banks manage the credit function

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Principles for sound credit risk management

• Establish an appropriate credit risk environment
• Operate a sound credit-granting process
• Maintain an appropriate credit administration
  process
• Ensure adequate controls over credit risk
• Basel Committee on Banking Supervision (2000)

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Credit environment

• Degree of risk aversion
• Loan policy/credit culture
• Aggressive or conservative growth?
• Particular business segments

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Credit granting process

• Retail versus commercial
• Pricing the loan
• Price market rates premium fees
• Credit limits
• Collateral
• Diversification

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Assessing credit risk of individual loans (1)

• Qualitative approach credit checking
• Past credit history
• Borrowers gearing
• Wealth of borrower
• Volatile earnings?
• Is there collateral?
• Employment history
• Length of time customer
• More than one credit card?

7
Assessing credit risk of individual loans (2)

• Quantitative approach
• credit scoring
• Altman Z-Score
• Working capital/total assets
• Retained earnings/total assets
• Earnings before interest and tax/total assets
• Market value of equity/book value of liabilities
• Sales/total assets

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Limitations of scoring models

• Type I and II errors
• Only as good as the specification
• Rely on historical data
• Require regular evaluation of the model

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Maintain an appropriate credit administration
process

• Monitor on-going quality of loan book
• Credit risk committee
• Require measurement techniques
• Both individual loan and portfolio levels
• Forward-looking
• Internal rating systems

10
Credit risk indicators

• Total loans/total assets
• Non-performing loans/total loans
• Loan losses/total loans
• Loan loss reserves/total assets
• Loan concentration
• Loan growth
• High lending rates
• Loan loss reserves/non-performing loans

11
Adequate controls over credit risk

• System for early remedial action
• Regular review of credit risk processes.