Types Of Risks Source Calan

Published Date: 02 Nov 2017

There is no single definition of risk, Economists, behavioral scientists; risk theorists, statisticians, and actuaries each have their own concept of risk. However, risk traditionally has been defined in terms of uncertainty. Based on this concept, risk is defined as uncertainty concerning the occurrence of a loss. (George, E.R., 2008). Risks may be defined as the possibility of events, or combinations of events, occurring which have an adverse impact on the economic value of an enterprise as well as the uncertainty over the outcome of past events (P.O.J. Kelliher, D. Wilmot, J. Vij, & P.J.M. Klumpes, 2012). The risk (risk in finance) can be basically classified in 2 main groups: Systematic risks and unsystematic risks (Gaurav Akrani, 2012).

Types of Risks: Source Calan City Life

Moreover, risks can also be classified into several distinct categories. In which, the most important categories are i) pure and speculative risk is defined as a situation in which there are only the possibilities of loss or no loss. Meanwhile, speculative is defined as a situation in which either profit or loss is possible, ii) fundamental risk and particular risk is risks that affects the entire economy or large numbers or persons or groups within the economy. In contrast, a particular risk is a risk that affects only individuals and not the entire community, and iii) enterprise risk is a term that encompasses all major risks faced by a business firm. Such risks include pure risk, speculative risk, strategic risk, operational risk and financial risk. (George, E. R, 2008). As risk is a burden not only to the individual but to society as well. Thus, it is important to examine some techniques for handling the problem of risk. There are five major methods of risk handling such as Avoidance, Loss Control, Retention, Non-insurance transfers, and Insurance. However, each business has its particular risk and the banking sector is not an exception. Risk in a banking organization refers to the possibility that the outcome of an action or event could bring adverse impacts on the institution’s capital, earnings or its viability. Such outcomes could either result in direct loss of earnings and erosion of capital or may result in imposition of constraints on a bank’s ability to meet its business objectives (Reserve bank of Malawi, 2007). Besides, each bank also has its particular risks to control up to its core business. As such, there is no single prescribed risk management system that works for all. To effectively manage the bank risk, each banking institution should tailor its risk management program to its needs and circumstances (Reserve bank of Malawi, 2007). The banks should do for its risk management such as Risk identification, Risk measurement, Risk monitoring, and Risk controlling. Meanwhile, according to Oester Reichische National Bank (OeNB), the main functions of credit risk management are i) Identification, ii) Measurement, iii) Aggregation, iv) Planning and management, and Monitoring.

Source: Guideline on Credit Risk Management - OeNB

According to David H. Pyle, some major risks could be identified included i) Market risk is the change in net asset value due to changes in underlying economic factors such as interest rates, exchange rates, and equity and commodity prices, ii) Credit risk is the change in net asset due to changes the perceived ability of counterparties to meet their contractual obligations, iii) Operational risk results from costs incurred through mistakes made in carrying out transactions such as settlement failures, failures to meet regulatory requirements, and untimely collections, Performance risk encompasses losses resulting from the failure to properly monitor employees or to use appropriate methods. (David H. Pyle, 1997). A major source of credit risk in financial markets arises from exposure to counterparties in financial derivatives such as swaps, forwards, and options. Over the years for most banking institutions, credit granting/loans are the largest and most obvious sources of bank risks (Basel, 2000). It is the banks’ credit risk. Credit risk is a factor in every business. It exists whenever payment or performance to a contractual agreement by another organization is expected, and it is the likelihood of a loss arising from default or failure of another organization (Horcher, 2005). Credit risk is defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed term (Basel, 2000). Credit risk is the risk of default or of reductions in market value caused by changes in the credit quality of issuers or counterparties (Duffie & Singleton, 2003). Credit risk arises from all transactions where actual, contingent or potential claims against any counterparty, borrower or obligator exist, including those claims that we plan to distribute (Deutsche Bank Annual Review, 2011)

In recent decades, many countries have experienced banking sector problems. Some studies shows at least two-thirds of International Monetary Fund (IMF) member countries have gone through banking crisis in the last twenty years. The major causes seem come mainly from the instability of the macroeconomic; lending booms and assets price bubbles; inadequate preparation for financial liberalization and after all, the non performing loans increase as a certainty result. The microeconomic factors also play important roles behind such banking crisis. The causes are mainly come from the problem of information asymmetry; frauds of management and risk exposure and risk management (Pavla Vodova, n.d.). Source of risks as referred by (Basel, 2000), except for the risk from loans, the bank are increasingly facing credit risk in various financial instruments including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swap, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions.

2.2 Credit risk is the risks due to the changes in net asset value due to changes perceived ability of counterparties to meet their contractual obligations (David H. Pyle, 1997). The Basel (2001) defined credit risk is the risk that a counterparty will fail to perform fully its financial obligations. It includes the risk of default on a loan, as well as the risk of a guarantor or derivative counterparty failing to meet its obligations. Credit risk has long been identified as the dominant risk for banking firms and is an inherent part of their core lending business. (Basel, 2001).

According to Hennie (2003), there are three main types of credit risk are consumer risk, corporate risk and sovereign or country risk. Culp & Neves (1998), consider realized default risk and resale risk to be the two types of credit risk. Horcher (2005), there are six types of credit risk, including i) default risk, ii) counterparty pre-settlement risk, iii) counterparty settlement risk, iv) legal risk, v) country or sovereign risk and vi) concentration risk and identifying Credit Risk Exposures. Default risk arises from money owed, either through lending or investment that the borrower is unable or unwilling to repay. The amount at risk is the defaulted amount. The likelihood of the default occurring is known as the probability of default (PD). Depending on the nature of the lending agreement, the amount at risk from a default may be as much as the entire liability. Poor economic conditions and high interest rates contribute to the likelihood of default for many organizations. The likelihood of recovery depends on several factors including the creditors’ legal status. However, the later collection may be difficult or impossible if the fails due to large losses or obligations. Counterparty pre-settlement risk or replacement risk arises from the possibility of counterparty default once a contract has been entered into but prior to settlement. The risk associated with the pre-settlement period is that a contract has unrealized gains; Counter party settlement risk is the risk that payment is made but not received, and it may result in large losses because the entire payment is potentially at risk during the settlement process. The size of the loss depends on the size of the payments. Settlement risk is often associated with foreign exchange trading, where payments in different money centers are not made simultaneously and volumes are huge and the payment systems of various countries and the financial institutions that participated in them; Legal risk is the risk that an organization is not legally permitted or able to enter into transactions, particularly derivatives transactions. It is necessary to assess the underlying legal entity with which a contractual agreement is undertaken. In international financial management, legal risk is closely related to sovereign risk, since the activities of the sovereign government may alter the legal rules under which transactions are undertaken; Country or Sovereign risk arises from legal, regulatory, and political exposures in international transactions. Sovereign risk arises when transactions in other countries expose an organization to the restrictions and regulations of foreign governments. From time to time, countries and governments have temporarily or permanently imposed controls on capital, prevented cross-border payments, suspended debt repayments, suspended convertibility of the currency, changed laws, and seized assets; Concentration risk is a source of credit risk that applies to organizations with credit exposure in concentrated sectors. Concentration risk affects organizations with exposure that is poorly diversified by region or sector. A bank with a large number of borrowers in a particular industry sector is vulnerable to industry concentration risk. Similarly, an investment portfolio may be subject to concentration risk if it specializes in a particular industry or sector.

Credit risk can be traced in part to the concerns of regulatory agencies and investors regarding the risk exposures of financial institutions through their large positions in Over the Counter (OTC) derivatives and to the rapidly developing markets for price- and credit-sensitive instruments that allow institutions and investors to trade these risks. At a conceptual level, market risk—the risk of changes in the market value of a firm’s portfolio of positions—includes the risk of default or fluctuation in the credit quality of one’s counterparties (Duffie & Singleton, 2003).

2.3 Credit risk management

Credit Risk is measured through Probability of Default (POD) and Loss Given Default (LGD), Expected loss (EL) and Unexpected Loss (UL). Bank should estimate the probability of default associated with borrowers in each of the rating grades. How much the bank would lose once such event occurs is what is known as Loss Given Default (R.S.Raghavan, 2003). The credit crisis has forced the banks to take a critical look at how they manage risk and has exposed some significant weakness in risk management across the financial industry. The collapse of several high profile banks, the emergency bailout of others, departure of CEOs, and CFOs, the hundreds of billions of dollars of writedowns, efforts by banks to raise fresh capital were all sign that something has gone very badly wrong (KPMG, 2009). According to Raghavan (2003), the management of credit risk includes i) Measurement through credit rating/ scoring; ii) Quantification through estimate of expected loan losses; iii) Pricing on a scientific basis and iv) Controlling through effective loan review mechanism and portfolio management. He also lists out the instruments and tools, through which credit risk management should be carried out i) the exposure ceilings, the prudential limit is linked to the capital fund. Based on that, threshold limit is fixed at a level lower than Prudential Exposure; Substantial Exposure, which is the sum total of the exposures beyond threshold limit should not exceed eight times of the Capital Funds of the bank, ii) Review/Renewal is to be formulated to early capture existing or fresh exposure of the existing credit profiles, iii) Risk Rating Model is responsible for setting up comprehensive risk scoring system on a six to nine point scale. Clearly define rating thresholds and review the ratings periodically preferably at half yearly intervals. Rating migration is to be mapped to estimate the expected loss, iv) Risk based scientific pricing, the linked loan pricing to expected loss. In line with it, high-risk category borrowers are to be priced high, vi) Portfolio Management, the need for credit portfolio management emanates from the necessity to optimize the benefits associated with diversification and to reduce the potential adverse impact of concentration of exposures to a particular borrower, sector or industry, vii) Loan Review Mechanism should be done independent of credit operations and referred to Credit Audit covering review of sanction process, compliance status, review of risk rating, pick up of warning signals and recommendation of corrective action with the objective of improving credit quality. According to Horcher (2005), the key credit risk management technique is to reduce the credit risk exposures. Credit exposure is the cost of replacing or hedging the contract at the time of default (Jeff Aziz & Narat Charupat, 1998). Managing credit exposure techniques used i) Formalize the credit risk function, ii) Consider opportunities for credit exposure diversification, iii) Require settlement and payment techniques that provide certainty, iv) Deal with high-quality counterparties, v) Use collateral where appropriate, vi) Use netting agreements where possible, vii) Monitor and limit market value of outstanding contracts.

2.4. Sound Credit Risk Management

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. The reason that "more than 80 percent of a bank’s balance sheet generally relates to this aspect of risk management" and the major cause of serious banking problems continues to be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank’s counterparties (Basel, 2000). We all known, the core function of banks are mobilization of fund and lending out at a higher rate for returns. However, giving loans the banks also engage in the risks of defaults which directly affect on the banks’ equity and the sustainability of the banking system also. Therefore, carefully portfolios assessment for prudent credit granting is known to be the heart of sound credit management system. The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision (Basel, 2001). The Committee encourages contacts and cooperation among its members and other banking supervisory authorities. It circulates to supervisors throughout the world both published and unpublished papers providing guidance on banking supervisory matters. Contacts have been further strengthened by an International Conference of Banking Supervisors (ICBS) which takes place every two years (About the Basel Committee, n.d.). Now, banks tend to standardize the internal risk management system based on relevant principles issued by Basel.

2.5 Principles for the management of credit risk.

2.5.1 The Goal of Credit Risk Management: the goal of credit risk management is to maintain the bank’s credit risk exposure within parameters set by the Board of Directors (Basel, 2000). Contemporary banking organizations are exposed to a diverse set of market and non-market risks, and the management of risk has accordingly become a core function within banks (Ben S. Bernanke, 2006). The goal of credit risk management is to maximize a bank’s risk adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Consistent with principles of managing portfolio, it is requested that both the credit risk arising from individual creditors or transactions and the risk of the entire portfolio should be managed, and the relationship between credit risk and others must be considered as well (Basel, 2000).

2.5.2 Function of Credit Risk Management

Since exposure to credit risk continues to be the leading source of problems in banks. For more effective management, Basel recommends to promote the sound practices for managing credit risk under the sound credit risk management i) establishing an appropriate credit risk environment; ii) operating under a sound credit granting process; iii) maintaining an appropriate credit administration, measurement and monitoring process; and iv) ensuring adequate controls over credit risk.

Establishing an Appropriate Credit Risk Environment: The banks are to ensure the risks from all products and activities to be identify and manage in term of credit risk management prior to being introduced or undertaken, and approved in advance by the board of directors or its appropriate committee. It also requires that approving and periodical (at least yearly) reviewing the credit risk strategy and bank’s credit risk policy are the responsibility of the bank’s Board of Director. The strategy reflects the bank’s tolerance for risk and the level of profitability the bank expects to achieve for incurring various credit risks (for example consumer, commercial, real estate). For effective management, the bank’s credit risk strategy should be conducted by senior risk management, responsible for developing policies and procedures for identifying, measuring, monitoring and controlling credit risks. The strategy needs to take into account the cyclical aspect of any economy and the resulting shifts in the composition and quality of the overall credit portfolios and is effectively communicated throughout the banking organization. All personals/staff involved in the credit activities should be held accountable for complying with established policies and procedures. It is critical that staff involved in any activities to the highest standards. To effectively manage risk, the cornerstone of safe and sound banking is the design of written policies, frameworks for lending and guide for the credit granting activities. Such policies should be clearly defined, consistent with prudent banking practices and relevant regulatory requirements and adequate for the nature and complexity of the bank’s activities. In term of discretionary power, the Board of Directors ensures that the bank’s remuneration policies do not contradict the credit risk policy.

Operating under a Sound Credit Granting Process, The principle requires the bank to clearly understand the borrowers or counterparties, the purposes of the credit and their source of repayment and creditworthiness, legal capacity etc. prior to granting credit. At any rates, the bank should not grant credit simply because the borrowers are familiar to the bank or are perceived to be highly reputable. Strictly complying policies helps to avoid association with individuals involved in fraudulent activities and crimes. For those, the bank is required to practice within sound banking operation which well-defined credit granting criteria for each target market. The criteria should be set out who is eligible for credit at what limits, what types of credit are available under what terms and conditions. To prevent the bank from seriously affected by defaulted credit of related customers, banks are to establish the credit limit at the level of individual borrowers, counterparties, and groups of related/connected customers. The bank should have a clearly established process in place for approving new credits as well as the amendment, renewal and re-financing of existing credits. Proposal should be subject to careful analysis by a qualified credit analyst with expertise commensurate. There should be policies regarding the information and documentation needed to approve new credits, renew existing credits etc. Bank must develop a corps of credit risk officers with experience, knowledge and background to exercise prudent judgment in assessing, approving and managing credit risks. Banks utilize a combination of individual signature authority, dual or joint authorities, and a credit approval group of committee. The arm’s – length basis (keep a certain distance avoiding intimacy) is to be made against all extension of credits. Particularly, credit to connected customers must be authorized on exception basis; monitor with particular care to mitigate the risks may have of non arm’s length lending.

Maintaining an Appropriate Credit Administration, Measurement and Monitoring Process Credit administration; After credit disbursement, maintaining credit portfolios plays an important role to ensure the return of the credit repayments. Therefore, Basel requires banks to have in place system for the ongoing administration of various credit risk bearing portfolios; have in place a system for monitoring the condition of credit, determining the adequacy of provision and reserves for proper maintenance of credit profiles. The bank is to build a range of credit administration function incompatible with the size of the bank. The internal risk rating systems should be established and under periodic review which support the effectiveness of management. The internal risk rating system should be responsive to indicators of potential or actual deterioration in credit risk. A management information system is also required for providing adequate information on the composition of the credit portfolios. The effectiveness of bank’s credit risk management system is highly dependent on the quality of management of information system. Therefore, quality, details and timeliness of information are critical. The analysis of credit historical data should be undertaken at appropriate frequency with the results review to find out the level of risks involves in their activities based on robust data. The market is changing all the times, when assessing the credit portfolios, potential future changes in economic conditions should be taken into consideration. Scenario analysis and stress testing are useful ways of assessing areas of potential problems and include contingency plans regarding actions management might take given certain scenarios.

Ensuring Adequate Controls over Credit Risk; At all time, banks must ensure the credit granting function is being properly managed and the credit exposures are within levels consistent with prudential standards and internal limits. Timely report manner is to be made for appropriate level of management for action. Internal credit review is to be conducted on independent basis and internal audit should be conducted on a periodic basis to determine that credit activities are in compliance and the reveal the weakness areas (in any). A system in place for early remedial action on deteriorating credits, managing problem credits and similar workout situation is to be established for in time actions.

The role of supervisors; Supervisors should conduct independent evaluation of a bank’s strategy, policy, procedure and practice related to the granting of credit and the ongoing management of the portfolios. After evaluation, the supervisors should address with management any weaknesses detected in the system, excess concentrations, the classification of problem credits and the estimation of any additional provision and the effect on the bank profitability of any suspension of interest accruals. For all, supervisor are to ensure the bank take appropriate techniques to manage the risks.

2.6 Risk identification in the banking risk management plays a crucial role. There are many kinds of risks impact on the banks/firms. Therefore, in order to effectively managing the risks, the banks are to identify what are the major risks of the system to focus. A bank’s risks have to be identified before they can be measured and managed (OeNB, n.d.). Banking institution should identify and assess the operational risk inherent in all material products, activities, processes and systems. Effective risk identification considers both internal factors (such as the banking institution’s structure, the nature of activities, and quality of the bank’s human resources, organizational changes and employee turnover) and external factors (such as changes in the industry and technological advances) that could adversely affect the achievement of the bank’s objectives. In addition to identifying the most potentially adverse risks, banking institutions should assess their vulnerability to these risks (Malawi risk management guideline, 2007). The analysis of historical data of the existing loans portfolios is another source of identifying risks. It helps to form the trend of the market which is good for management of the credit strategy. However, these factors are not, by themselves, the sufficient basis to determine the risks of the loans. Management should also consider any current factors that are likely to cause loans losses associated with the bank’s loans portfolios to differ from historical loss experience. The factors could be the changes in lending policy & procedure, or changes in experiences, ability, and depth of lending management and staff etc. (Basel, 2006). Besides the factors relating to the credit risk, the bank is also to identify the risks of the markets and the risks from the daily operations (operational risks), the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from externally events (The New Basel Capital Accord, 2001)

2.7. Credit risk measurement:

Financial Institutions engage in risks. Risk measurement is one component of risk management. Risk management involves identifying and measuring risk, followed by decisions about how best to manage it (Horcher, 2005). Over the last two decades, the academy and practitioners have developed new and more sophisticated credit-scoring/early-warning systems; moved away from only analyzing the credit risk of individual loans and securities towards developing measures of credit concentration risk where the assessment of credit risk plays a central role; developed new models to price credit risk (such as the risk adjusted return on capital models (RAROC)) and developed models to measure better the credit risk of the balance sheet instruments in responding the facts that the number of bankruptcies increased in the worldwide (A. Saunders & L. Allen, 2002).

Risk measurement is about trying to obtain some measures of the dispersion of possible future outcomes, and in practice, the focus is usually on the downside outcomes. Number of common building blocks include: i) a system for rating loans (generally based on some concept of the probability of the borrower defaulting); ii) assumptions about the correlation of default probabilities (PDs) across borrowers; iii) assumptions about the loss incurred in the case of default (commonly referred to as the LGD-Loss Given Default); and iv) assumptions regarding the correlation between the PD and the LGD (Basel, 2002). In practices, the focus of risk measurement is on downside outcomes, rather than upside outcomes, so that measure of risk tends to focus on the likelihood of losses, rather than characterizing the entire distribution of possible future outcomes. This focus is clearly evident in the increasing use of value-at-risk (VaR) based models to measure credit risk (Basel, 2002). VaR, Regulators and their constituent financial institutions have generally focused on a widely applied measure of market risk called VaR. In order to ensure effectiveness of the risk measurement system, the banks must have in place sound stress testing processes for evaluating their estimates of LGD. An independent unit must carry out stress tests, which must be conducted at least every six months. Stress testing must involve identifying possible events or future changes in economic conditions that could have unfavorable effects on banks. LGD estimates and the effect these might have on their overall capital adequacy. Three areas that banks might usefully examine are: (i) economic or industry downturns; (ii) market-risk events; and (iii) correlation in estimates of PD and LGD across exposures (New Basel Capital Accord, 2001)

2.8. Credit risk assessment

One of the elementary roles of credit department of the bank is the evaluation of credit applications and monitoring and evaluation of existing credits. Different types of borrowers are subject to different type of assessment. The aim of this procedure is to answer if the client is and will be able in the future to meet its obligation and repay its debt (Pavla Vodová, n.d). Historically, bankers have relied on the 5 C’s of expert systems to assess credit quality. They are character (reputation), capital (leverage), capacity (earnings volatility), collateral, and cycle (macroeconomic) conditions. Evaluation of the 5 C’s is performed by human experts, who may be inconsistent and subjective in their assessments. According to Basel, 2006 on banking supervision, the bank should operate under sound credit risk assessment and valuation of loans. Under principles there are two boards of categories: supervisory expectations concerning sound credit risk assessment and valuation for loans and supervision evaluation of credit risk assessment for loans, control and capital adequacy. The principles require the bank has a system in place for valuation of internal credit risk, classification of loans quality and tools to indentify loan loss and determine loan provisions in a timely model. The model should consider the impact of changes to borrowers and loan related variables such as probability of default, los given default, collateral values and internal rating system

2.9. Credit risk monitoring

According to DICO – Deposit Insurance Cooperatio of Otario, the loan portfolio should be monitored on an ongoing basis, to determine if performance meets the board's expectations, and the level of risk remains within acceptable limits. Additionally, senior management, the credit committee and the board of director should monitor for illegal loans and large loans that approach regulatory limits. The purpose of loan monitoring is to detect problem accounts early and to mitigate against probable losses either through loan restructuring or the termination of poor quality loans. Loan monitoring is a comprehensive process, which includes: routine review of borrowers; accounts (including lines of credit) to detect unusual activity; annual and interim review of commercial loans; interim review of problem mortgages; Use of exception reports recording loan irregularities; internal audit or league reviews of loan portfolio.

2.10. Credit risk rating

A credit rating is for assessing the creditworthiness of an individual or corporation to predict the probability of default, which is based on the financial history and current assets and liabilities of the subject. For certain defaulted instruments, an important indicator of credit quality is the credit rating of the counterparty. Credit ratings are provided by major independent rating agencies such as Moody’s and Standard & Poor’s (Duffie & Singleton, 2003). The original Basel accord, (1988) has been the standard for capital requirements for global banks. The basic idea of the accord is that banks must hold capital of at least 8% of total risk-weighted assets. Over the years, bankers have extended the Office of the Comptroller of the Currency (OCC) rating system by developing internal rating systems that more finely subdivide the pass/performing rating category. How a bank selects and manages its credit risk is critically important to its performance over time; indeed, capital depletion through loan losses has been the proximate cause of most institution failures. Identifying and rating credit risk is the essential first step in managing it effectively. Well-managed credit risk rating systems promote bank safety and soundness by facilitating informed decision making. Rating systems measure credit risk and differentiate individual credits and groups of credits by the risk they pose. This allows bank management and examiners to monitor changes and trends in risk levels. The process also allows bank management to manage risk to optimize returns (Office of Comptroller of Currency, 2012).

Moody’s and S&P debt rating range

2.11. Credit risk modeling

Over the last decade, a number of the world’s largest banks have developed sophisticated systems in an attempt to model the credit risk arising from important aspects of their business lines. The models are intended to better quantify, aggregate and manage risk across geographical and product lines. Credit risk modelling methodologies allow a tailored and flexible approach to price measurement and risk management. Models are, by design, both influenced by and responsive to shifts in business lines, credit quality, market variables and the economic environment. Furthermore, models allow banks to analyse marginal and absolute contributions to risk, and reflect concentration risk within a portfolio. These properties of models may contribute to an improvement in a bank’s overall credit culture (Basel 2 – Credit risk modeling, 1999).

2.12. Credit risk provision

In considering new credits, bank must recognize the necessity of establishing provisions for identified and expected losses and holding capital adequacy to absorb the losses (Basel, 2000).

2.13. Credit Risk Mitigation and Transfer

Mitigate and transfer the risk if to avoid or reduce losses. The traditional methods for reducing credit risk aims to the loan processing and diversification, while the new means refer to asset securitization and hedging with credit derivatives (Neal 1996). Credit risk can be moderated by enhancing the loan structure. Parties to a loan can arrange for mitigants such as collateral, guarantees, letters of credit, credit derivatives, and insurance during or after the loan is underwritten (Office of Comptroller of Currency, 2012).

2.14. Traditional Methods for Controlling Credit Risk

2.14.1 Accurate Loan Pricing

Banks should ensure the price of a loan exceed a risk adjusted rate, and include any loan administration costs (Heffernan, 1996) on the basis that the higher premium for riskier borrowers and the loan rate should keep changing with the alteration of the loan risk profile.

2.14.2. Credit Rationing

The tenet of credit rationing, as concluded by (Horcher, 2005), is that credit granting favors the most attractive risk-to-return tradeoff. Credit rationing takes two forms in a bank. The bank may either refuse to make a loan to a borrower regardless of his/her willingness to pay a higher interest rate, or restrict the quantity of the credit, which can be much less than what the borrower wants (Mishkin, 2004).

2.14.3. Credit Limits

The credit limits should be prepared for different products, activities as well as industries respectively based on customers’ real capital requirement. Limit should be established for group of related customers and for particular industries, economic sectors, geographic counterparty regions and specific products which ensure bank’s lending activities to be adequately diversified. The overall limit setting and monitoring process must be regularly placed under stress testing to evaluate the risk association reflection with the near term liquidation of positions in the event of counterparty default (Basel, 2000).

2.14.4. Collateral

The use of collateral to support various lending agreements for reducing credit risk has been adopted by banks for a long time already. It is applied not only to loans but also in other transactions such as derivative trading, where it works as an initial margin. However, the usefulness and importance of collateral use has actually been doubted. Wesley (1993) used to comment that collateral seldom provides a way out for a loan because when it matters most it has the least value. Collateral and guarantees helps to mitigate risks. Collateral cannot be the substitute for a comprehensive assessment of the borrowers. Banks should have policies covering acceptability of various form of collateral, procedure for valuation of such collateral and ensure the collateral is enforceable and realizable (Basel, 2000).

Collateral, the most common form of credit risk mitigation, is any asset that is pledged, hypothecated, or assigned to the lender and that the lender has the right to take possession of if the borrower defaults. Once the lender has taken possession of the collateral, loan losses can be reduced or eliminated through sale of the assets. The level of loss protection is a function of the assets’ value, liquidity, and marketability (Office of Comptroller of Currency, 2012).

2.14.5. Diversification

Diversification is a very common concept in the area of risk management. For minimizing credit risk, diversification can be used to offset the additional volatility created from an increase in the number of risky loans.

2.15. Newer Methods for Credit Risk Transfer: Asset Securitization; Loan Sales; Credit Derivatives. According to Neal (1996), credit derivatives can help banks to manage the credit risk by insuring against adverse movements in the credit quality of the borrowers, and the major types of credit derivatives are credit default swaps, credit options and credit-linked notes.

2.16. Issues in Credit Risk Management

2.16.1. Adverse Selection: It is often the case that in the lending process, a borrower knows more than the bank about his/her own credit risk. The problem is that the higher interest rate does not prevent riskier borrowers but those with less probability to default, and it is suggested that the more effective way be used to limit access to credit instead. However, what is likewise noticeable is that the quantitative credit exposure limits also deserves careful consideration.

2.16.2. Credit Risk Concentrations

Concentrations, as pointed out by Basel (2000), are probably the single most important cause of major credit problems. They are regarded as any exposure where the potential losses are large relative to the bank’s capital and are quite common in the banking sector. The reason is that banks usually cannot avoid specializing in certain industries or geographical areas due to the convenience for collecting information and the benefits of being more knowledgeable as well as better able to predict defaults of the targets they are familiar with. However, by doing this, banks should also bear the cost of charge-offs, nonperforming asset and strict reserve requirements.

3. Non-Performing loans (NPL)

According to Patersson & Wadman (2004), non- performing loans are defined as defaulted loans which banks are unable to profit from. Defaulted loans force banks to take certain measures in order to recover and securitize them in the best way (Ernst & Young, 2004). A non- performing loan is any loan in which interest and principal payments are more than 90 days overdue; or more than 90 days worth of interest has been refinanced (International Monetary Fund, 2009). Non-performing loans generally refer to loans which for a relatively long period of time do not generate income; that is the principal and/or interest on these loans has been left unpaid for at least 90 days (Fofac, 2009). Disclosure of the extent of these losses in its financial statements may lead to a loss of confidence in the bank’s management and a reduction in its credit ratings. This will in turn increase the bank’s cost of borrowing in the wholesale market and make it more expensive or more difficult to raise capital. In extreme cases, it can leads to a loss of deposits, the withdrawal of the bank’s authorization and ultimately insolvency (M.G. Taylor, 1993). NPLs have greater implication on the function of the banks as well as the overall financial sector development. Deterioration in banks’ loan quality is one of the major causes of financial fragility. The classification of a loan as bad or doubtful may result from a specific act by the borrower, for example, petitioning for bankruptcy, or from circumstances that have the potential to place the loan at risk. For example, the borrower may have defaulted on one or more of the terms of the loan, or a substantial part of its assets may be in an industrial sector or country that is suffering from an economic recession (M.G. Taylor, 1993). Macroeconomic instability would have consequences for the loan quality of banks in any country. High inflation increases the volatility of business profits because of its unpredictability, and because it normally entails a high degree of variability in the rates of increase of price of the particular goods and services which make up the overall price index. The probability that firms will make losses rise; as does the probability that they will earn windfall profits. Sinkey and Greenwalt (1991) indicated that there is significant positive relationship between the loan-loss rate and internal factors such as high interest rates, excessive lending, and volatile funds. Keeton (1999) also indicated a strong relationship between credit growth and impaired assets. Keeton (1999) shows that rapid credit growth, which was associated with lower credit standards. Salas and Saurina (2002) reveal that rapid credit expansion, bank size, capital ratio and market power explain variation in NPLs.