LDM | Risk Management

Background

Risk is the probability of incurring a loss or damage because of actual outcome being different from the expected outcome. This means that, broader the range of possible outcomes, the greater the risk. Risk is the major constraint on investment whilst return on investment is the major opportunity or benefit generated by it.

Risks are inherent in any kind of business. Risks and uncertainties form an integral part of banking industry which by nature entails taking risks. Therefore, risk management assumes more importance in banking industry as this industry exists for the purpose of taking risk.

Definition

Credit risk refers to the risk arising out of an individual counter party (a borrower or a lender) failing to meet or being prevented from meeting its obligations. In other words, this is a risk that a borrower of a bank makes defaults in his/her repayment (of principal and/or interest) obligations in accordance with agreed terms. There is always scope for the borrower to default from his commitments for one or the other reason resulting in crystallization of credit risk to the bank. Credit risk arises most obviously in the potential for default on the part of persons or institutions borrowing.

Tools for Management of Credit Risk

The instruments and tools used generally by the banks and financial institutions for the management of credit risk are detailed below:

Setting Individual or Group Exposure Limits

Management needs to establish limits to control the exposure of all risk-related activities. Banks generally link Prudential Limit with the Core Capital Fund. For Nepalese banks and financial institutions the limit is 25% of core capital for fund based credit and 50% of core capital for non-fund based credit.

Banks may be establish limit based on inter-day, overnight, revolving or term exposure. They implement limit as a result of risk exposure to customers, countries or market conditions. Banks initially establish limit at individual, department or branch level. Subsequently, Banks consolidate limits at head office level. In due course, value at risk limits may replace such limits.

Review/Renewal

Loan screening and appraisal are effective tools for ensuring good loans. Screening filters out those proposals that do not meet the lender’s criteria for eligibility. These criteria cover creditworthiness, borrower attributes and trade reputation and the nature of the business proposed. Banks should have multi-tier credit approving authority, constitution wise delegation of powers.

Setting Risk Rating Model

Banks should set up comprehensive risk scoring system on a six to nine point scale. Then they should define rating thresholds. Also, banks should review ratings periodically preferably at half yearly intervals. Rating migration is to be mapped to estimate the expected loss.

Risk Based Scientific Pricing

Banks price their loans at a level that will cover all costs as well as returns expected by investors. The costs include all costs incurred in operating the bank. On the other hand, investors’ expected return should be equal to a market return on shareholders’ investment. On top of this, they match any inflation during the period and provide capital to support planned growth. Loan pricing must be linked to expected loss and appropriate risk premium must be added to determine pricing for each customer risk category.  High-risk category borrowers are to be priced high.

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. For effective portfolio management, banks should stipulate quantitative ceiling on aggregate exposure on specific rating categories, distribution of borrowers in various industry, business group and conduct rapid portfolio reviews. The existing framework of tracking the non-performing loans around the balance sheet date does not signal the quality of the entire loan book. There should be a proper & regular on-going system for identification of credit weaknesses well in advance. Initiate steps to preserve the desired portfolio quality and integrate portfolio reviews with credit decision-making process. Credit portfolio should be under continuous review to improve risk positions.

Loan Review Mechanism

Review of credit facilities are done independent of credit operations. All credit application shall contain a review date, which should preferably be not more than 12 months from the date of credit appraisal report. Though the term loan is provided for longer period, review of such loans is to be made on annual basis until the repayment of final installment. Review of term loans (excluding retail loans) shall be supplemented by the site visit report and progress/review report.

It is essential that risk is reassessed on regular basis to ensure that the structure, size of facilities, terms and conditions, including securities and pricing on which these facilities are provided remain appropriate. It is a requirement not to have overdue reviews. Delay in completion of review may be indication of customer having problems.

Nepal Rastra Bank Directives and Credit Risk Management

Nepal Rastra Bank (NRB) has issued directive 5 to the banks and financial institutions for the management of risk. According to the provisions of the directive, banks and financial institutions must follow directive 2: loan classification and provisioning and directive 3: single obligor and sectoral limit.

NRB has issued Risk Management Guidelines for Banks and Financial Institutions 2018. This guideline required banks and financial institutions to have robust arrangements to manage and control credit risk. Also, appropriate governance, processes, and internal controls should exist for accepting, managing and monitoring credit risk, on a group and solo basis, in a manner commensurate with the nature, scale and complexity of the financial institution’s activities.

Basel II and Credit Risk Management

The banking industry has changed in many ways since introduction of Basel I in 1988. Vastly improved risk-management systems is one of the significant changes in this regard. However, for banks that operate on a global scale in virtually all financial markets, Basel I has become outdated. The capital regime recommended by Basel I has not kept pace with either the complex nature of the operations of the large banks or the substantial changes in both the concepts and technology of risk management. To address these issues, the Basel committee has developed more risk-sensitive regulatory framework that takes into account the recent developments in risk management techniques, i.e., the Basel II.

The Basel II seeks to fine- tune the basic content of the earlier Accord to create a degree of homogeneity among all banking systems in the world in terms of adherence to prudential norms. To enable this, it has drawn up three mutually reinforcing pillars, which together are to increase the safety and soundness of the financial system. The basic idea is to implement a more risk-sensitive and flexible approach to bank capital requirements (Pillar 1) which gives positive incentives for banks to pursue more sophisticated and effective risk management techniques. At the same time, the aim is to align supervisory review (Pillar 2) more closely with the way in which banks manage their risks, including encouraging the use, and further development, of internal risk and capital management systems. In this process the level of transparency and disclosures is to increase significantly (Pillar 3).

Capital Requirement

The Basel II revision provides for more elaborate calculation of the credit risk component of the capital requirement, allowing banks to use either a standardized approach (external ratings given by external credit rating agencies) or an internal rating-based (IRB) approach. The measurement of credit risk requires banks to dis-aggregate risk into individual components, i.e, probabilities of default, loss given default, exposure at default and correlation of defaults.

The probability of default is the likelihood of a customer going into “default” within the next 12 months. Exposure at default implies the expected amount of exposure at the point of “default”. Loss given default is the probable financial loss associated with the “default”, net of collections, recovery costs and realized security. The Basel accord intends to introduce a shift in the responsibility for measuring risk away from regulators towards banks. Such a shift would necessitate strengthening of oversight on banks’ risk measurement and management.

Internal Credit Rating

Credit risk has been tackled in a different way where banks are to develop their internal rating mechanisms which would have to be approved by their Boards and probably, ultimately also by the regulatory authority for the process of calculating capital requirements. Presently, capital charge is against a predefined set of weights laid down against the balance sheet items.

Difference may arise in the risk weights applied especially to the loan book based on individual credit risk rating assigned to individual companies in the portfolio. Therefore, introduction of these changes in the risk-based capital requirements effects banks, clients and the regulator.

Basel III

Basel III does not have additional specific provision for credit risk management. Basel II has prescribed minimum 3 key principles:

• Minimum Capital Requirements: minimum capital requirements for banks to 4.5% of common equity, as a percentage of the bank’s risk-weighted assets plus an additional 2.5% buffer capital requirement that brings the total minimum requirement to 7%.
• Leverage Ratio: Banks must hold a leverage ratio in excess of 3%.
• Basel III has introduced two new standards for liquidity: Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).

Basel Accord in Nepalese Perspective

Nepal Rastra Bank (NRB) issued Capital Adequacy Framework 2015 based on Basel III Accord but in simplified form.

Conclusion

Credit risk management is critical to the good health of a bank. As credit business covers major component of the bank’s business, management of credit risk gets utmost significance at the Bank. Therefore, banks must have a robust credit risk management system to preempt decisions and actions that will cause the bank loss and to minimize the cost of errors when these occur.