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Project Topic:

CREDIT RISK MANAGEMENT AND BANK PERFORMANCE

Project Information:

 Format: MS WORD ::   Chapters: 1 - 5 ::   Pages: 57 ::   Attributes: Questionnaire, Data Analysis, Abstract  ::   2,925 people found this useful

Project Department:

BANKING FINANCE UNDERGRADUATE PROJECT TOPICS, RESEARCH WORKS AND MATERIALS

Project Body:

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND TO THE STUDY

It is difficult to imagine another sector of the economy where as many risks are managed jointly as in Banking. Banks and banking activities have evolved significantly through time. With the introduction of money, financial services like acceptance of deposits, lending money, currency exchange and money transfers became important because of the central role of money, Banks had had and still have an important role in the economy. Like any other firm banks are exposed to classical operational risks like infrastructure breakdown, problems, environmental risks e.t.c. More typical and important for a bank re the financial risk it takes by the transformation and brokage function.

By its very nature, banking is an attempt to manage multiple and seemingly oozing needs. Bank stands ready to provide liquidity on demand to depositors through the checking account and to extend credit as well as liquidity to their borrowers through lines of credit (Kashyap, Rajan, and Stein 1999). Because of these fundamental roles, banks have always been concerned with both solvency and liquidity. Traditionally, Banks held capital as a buffer against insolvency and they held liquid assets like cash and securities to guard against unexpected withdrawals by depositors or draw downs by borrowers. Banks are germane to economic development through the financial services they provide. Their intermediation role can be said to be a catalyst for economic growth. In recent years, risk management at banks has come under increasing scrutiny. Banks have attempted to sell sophisticated credit risk management systems that account for borrowers risk

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and perhaps the risk reducing benefits of diversification across borrowers in a large portfolio. Banks that manage their credit risk (buy and sell loans) hold more risky loan than banks that merely sell loans or banks that merely buy loans. For banks, credit risk typically resides in the assets in its banking books (loans and bonds held to maturity). Credit risk refers to the risk that a borrower will default on any type of debt by failing to make required payments. The risk is primarily that of the lender and includes lost principal and interest, disruption to cash flows and increased collection costs. The loss may be complete partial and can rise in a number of circumstances for example consumer may fail to make a payment due on mortgage loan, credit card, or other loan. Traditionally, the five c‟s representing the borrowers characters, capacity, collateral and conditions have been recommended.

Credit management is the process of collecting payments from customers. This is the function within a bank or company to control credit policies that will improve revenues and reduce financial risks. Credit management is also the process for controlling and collecting payments from customers. A good credit management system will help you reduce the amount of capital tied up with debtors and minimise your exposure to bad debts. Credit management generally is usually regarded as assuring that buyers pay on time, credit costs are kept low and poor debts are managed in such a manner that payment is received without damaging the relationship with a customer. .A credit manager is a person employed by an organisation to manage the credit department and make decision concerning credit limits, acceptable level of risks and terms of payment to their customers. Credit risk is the potential loss due to failure of a borrower to meet its contractual obligation to repay a debt in accordance with the agreed terms. Credit risk management is undoubtedly among the most crucial issues in the field of financial

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risk management. Credit risk management is to maximise a banks readjusted rate of return by maintaining credit risk exposure.

More lenders employ their own models to rank potential and existing customers according to risk, and then apply appropriate strategies. With products such as unsecured personal loan or mortgages, lenders charge a higher price for a higher risk customer and vice versa. With revolving products such as credit cards and over drafts, risk is controlled through the setting of credit limits. Some products also require collateral in fact almost all products requires collateral in case anything happens to be able to prevent bad debt. For most banks loans are the largest and most obvious source of credit. However there are other sources of credit risk both on and off the balance sheet. Off balance sheet items includes letter of credit, unfunded loan commitments and lines of credit. Other products, activities and services that expose a bank to credit risks are credit derivatives foreign exchange and cash management services.

Credit scoring models also form an art of the framework used by banks or lending institution to grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of credit risk including, but not limited to, operating experience, management expertise, asset quality, leverage and liquidity ratio. Once this information has been fully reviewed by credit officers and credit committees, the lender provides the funds subject to the terms and conditions resented within the contract.

The strategies to manage threats typically include transferring the threat to another party, avoiding the threat, reducing the negative effect or probability of the threat or even accepting some or all of the potential or actual consequences of a particular threat, and the opposites for opportunities. Certain aspects of many of the risk management standards have come under criticism for having no measurable improvement on risk, wether the confidence in estimates and

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decisions seem to increase. In ideal risk management, a priotization process is followed whereby the risks with the greatest probability of occurrence are handled first, and risks with lower loss are handled in descending order. In practice, the process of assessing the overall risk can be difficult and balancing resources used to mitigate between risks with a high probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence can be often mis-handled.

The credit risk management needs to foster a climate for good banking where prices are in line with the risks taken..

If revenue is the energy that powers a company, credit management is the engine that keeps it flowing. The credit management engine acts as a power house, driving revenue and motivation to every art of an organisation. As the credit management engine becomes more refined and efficient, so any business becomes more productive and profitable. Credit allows for the expanded movement of products and for economic growth and prosperity. Without risk management functions, it is unlikely that the bank succeeds In achieving It‟s long term strategy and to remain solvent. A strong strategic risk management avoids important pitfalls like credit concentrations, lack of credit discipline, aggressive underwriting to high risk counterparts and products at inadequate prices.

BANK PERFORMANCE

The term „performance‟ means carrying into execution or achievement; or accomplishment of specific activities, or the performance of an undertaking of a duty. „Bank performance‟ may be defined as the reflection of the way in which the resources of a bank are used in a form which enables it to achieve its objectives.

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Furthermore, the term bank performance means the adoption of a set of indicators which are indicative of the bank‟s current status and the extent of its ability to achieve the desired objectives.

As the banking sector is considered a vital segment of a modern economy, its efficiency is of vital importance. In order to ensure a healthy financial system and an efficient economy, banks must be carefully evaluated and analysed.

While banks help business organisations by rendering a wide range of products and services, the products and services are more or less identical from one bank to another, and there is little scope for differentiating between them. Therefore, it is necessary to measure the banks‟ individual performance to determine their contribution to business development.

It is inevitable that banks continue to attract significant attention from the public and scrutiny by financial regulators as there is a growing need to evaluate banks in a more efficient manner. Not only supervising institutions, regulators and bank management bodies, but also clients of banks, are becoming increasingly concerned about the stability and sustainability of these financial institutions.

There are other reasons to evaluate the performance of banks to determine their operational results and their overall financial condition; measure their assets quality, management quality and efficiency, and achievement of their objectives; as well as ascertain their earning quality, liquidity, capital adequacy, and level of bank services.

According to the interdisciplinary journal of contemporary research business, the major cause of serious banking problems continues to be directly related to low credit standards for borrowers

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and counterparties, poor portfolio management, and lack of attention to changes in economic or other circumstances that can lead to deterioration in the credit standing of bank‟s counter parties. And it is clear that banks use high leverage to generate an acceptable level of profit. Credit risk management comes to maximize a bank‟s risk adjusted rate of return by maintaining credit risk exposure within acceptable limit in order to provide a framework of the understanding the impact of credit risk management on banks profitability. The excessively high level of non-performing loans in the banks can also be attributed to poor corporate governance practices, lax credit administration processes and the absence or non- adherence to credit risk management practices.

The health of the financial system has important role in the country (Das & Ghosh, 2007) as its failure can disrupt economic development of the country. Financial performance is company‟s ability to generate new resources, from day-to-day operation over a given period of time and it is gauged by net income and cash from operation. The financial performance measure can be divided into traditional measures and market based measures (Aktan & Bulut, 2008). During the 1980‟s and 1990‟s when the financial and banking crises became worldwide, new risk management banking techniques emerged. To be able to manage the different types of risk one has to define them before on can manage them. The risks that are most applicable to banks risk are: credit risk, interest rate risk, liquidity risk, market risk, foreign exchange risk and solvency risk.

Risk management is the human activity which integrates recognition of risk, risk assessment, developing strategies to manage it, and mitigation of risk using managerial resources (Appa, 1996) whereas credit risk is the risk of loss due to debtor‟s non-payment of a loan or other line of credit (either the principal or interest or both) (Campbell, 2007). Default rate is the possibility that a borrower will default, by

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