Chapter 3 Introduction to credit risk and factors affecting credit risk.docx

Chapter 3 Introduction to credit risk and factors affecting credit risk.docx

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Chapter3Introductiontocreditriskandfactorsaffectingcreditrisk

CHAPTER3

INTRODUCTIONTOCREDITRISKANDFACTORSAFFECTINGCREDITRISK

INTRODUCTIONTOCREDITRISKANDFACTORSAFFECTINGCREDITRISK2

3.1INTRODUCTION4

3.2DEFININGCREDIT4

3.3CREDIT:

PRIMARYACTIVITYOFBANKS4

3.4DEFININGCREDITRISK6

3.6BANKINTERNALFACTORSAFFECTINGCREDITRISK7

3.7EXTERNALFACTORSAFFECTINGCREDITRISK11

3.8SUMMARY52

TESTYOURKNOWLEDGE-THEORY55

ESSAYQUESTIONSANDCASESTUDIES:

CHAPTER3-CREDITRISK&FACTORSAFFECTINGCREDITRISK57

APPENDIX1–INFORMATIONRETRIEVEDDIRECTLYFROMTHEWEBSITEOFNEWZEALANDRESERVEBANKABOUTTHEBASELCAPITALADEQUACYREQUIREMENT63

CHAPTER3

INTRODUCTIONTOCREDITRISKANDFACTORSAFFECTINGCREDITRISK

AIM

Toprovidelearnerswithaclearunderstandingof:

∙creditandcreditrisk;

∙theprimaryclientclassificationofbanks;and

∙thefactorsaffectingcreditrisk.

KEYCONCEPTS

CreditCreditrisk

CreditpolicyDefaultrisk

CompetitionbetweenbanksIndividuals

SoleproprietorshipsPartnerships

CompaniesTrusts

MacroexternalvariablesEconomicenvironment

InternationalenvironmentPhysicalenvironment

InstitutionalenvironmentandlegislationTechnologicalenvironment

PoliticalenvironmentSocialenvironment

LEARNINGOUTCOMES

Oncompletionofthischapterlearnersshouldbeableto:

∙Brieflyexplainwhatcreditisandhowbankcreditdiffersfromcreditingeneral.

∙Definecreditrisk.

∙Explaintheinternalfactorsthataffectthecreditriskofbanksandanalysetheactualinformationofbankstoratetheirrelativeriskwithregardtoeachotheraswellasingeneral.

∙Analysetheexistingtrendincompetitionbetweenbanksandprovideinnovativesolutionsastohowbankscouldcompetesuccessfullywithoutincreasingcreditrisk.

∙Explainthedifferentborrowergroupsofbanksandthecreditriskspertainingtoeachofthegroupsthatbanksshouldconsiderduringcreditriskdecisions.

∙Comparetherelativecreditriskofclientsfromdifferentindustries/sectorsandproviderecommendationswithsubstantiatedreasonsformarketexpansioninthedifferentindustries.

∙Considerthedifferentimportantaspectsintheeconomicenvironmenttodeterminewhetherthecreditrisksofbanksareincreasingornotandtoproviderecommendationsaboutthecreditriskassessmentprecautionsthatmayberequired.

∙Evaluatethecreditriskeffectthataninternationaltransactionwhichaclientappliesforcanhaveonthebank.

∙Explainphysicalenvironmentalfactorsthatshouldbeconsideredbybanksandapplyinformationaboutthefactorstoactualriskassessmentprocesses.

∙ExplaintheBaselIIaccordasaregulationofcapitaladequacy,andindicatehowincreasesindifferentassettypeswillaffectit.

∙Explainthedifferenttypesofactionsthatcentralbankscanapplytochangethelendingactivitiesofbanks.

∙Discussthedifferentlegislativeaspectsregardinginsolvency,fullage,matrimonies,organisedlabour,andorganisedbusinessthatshouldbeconsideredandclarifyhowtheinformationwillbeobtained.

∙Assessthecreditriskofclientsbasedonthetechnologicalenvironmentthattheyareoperatinginandproviderecommendationsaboutthecreditriskacceptabilityofalendingtransactioninthisregard.

∙Assessthecreditriskoftransactionsintermsofpoliticalandsocialenvironmentalfactors.

3.1INTRODUCTION

Oneofthemostdifficultthingstodo,istopredicttheoutcomeofafutureeventwithcertainty.Allfinancialandbusinessdecisionsare,however,basedonfutureexpectationsandassuchcanonlybeprovedtoberightorwrongafterwards.Noteverydecisioncanberightasnopersoncanconsistentlymakepredictionswhicharecorrect.Tokeepthemarginoferroraslowaspossible,itisnecessarytoseekmethodstoincreasetheaccuracyofdecisionmaking.Allsuchmethodsrequireathoroughknowledgeoffactorswhichcaninfluencetheoutcomeofafutureeventinordertotakethesefactorsintoconsiderationduringthedecisionmakingprocess.

Inthismoduletheuncertaintywhichsurroundstheoutcomeofeventswillbediscussedwithspecialemphasisoncreditriskandfactorswhichinfluencecreditrisk.

3.2DEFININGCREDIT

ThewordcreditoriginatedfromtheLatinwordcredowhichmeans"Ibelieve"andreferstothefactthatapositionoftrustisestablishedwhenapurchaser/borrowerpresentshis/hercreditworthinessasmediumofexchangetoobtaincertaingoodsorservicesimmediatelyagainstdeferredfuturepayment.

Creditcanthusbedefinedas:

!

Thefacilitytoobtaingoodsorservicesimmediatelyagainstapromisedfuturecashpayment.

Theabovementioneddefinitionreferstocreditingeneral.Fromabankingviewpointcreditcanbedefinedas:

!

Anytransactionenteredintowithapersonorconcernwhichresultsinfundsbeinglent.

3.3CREDIT:

PRIMARYACTIVITYOFBANKS

Theoperationalactivitiesofbanksconsistsimplisticallystatedoftakingdepositsandlendingmoney.Itisthelatteractivitythatposestheriskofilliquidityoreveninsolvencytobanksifitisnotexecutedinascientificmanner.Thisstatementisprovenbythefactthattheprovisionforbaddebtsbybanksarenormally,accordingtotheirannualreports,0,75%oftotalassets,whilstthenetprofitbeforetaxationoflargebanksisapproximately2to2,5%.Badvariationsinbaddebtprovisioningwillthereforehaveasubstantialeffectonthenetprofitpercentage.

Wefurtherfindthatbankscanexperienceincreasingpressureonincomemarginsfrominteraliathefollowingcaseswhichcouldbeextensivecontributingfactors:

!

Firstlycontinuousandsubstantialchangesintheexchangeratesofthecurrenciesofcountriescanaffectdifferentsectorsoftheeconomyintermsoftheircreditrisk.Forexample:

Inthecaseofthecontinuousstrengtheningofacurrency,businessthatareprimarilyintheexportmarket,mayloosemarketshareduetotheirinabilitytocompetewellwithproductprices.Inthecaseoftheweakeningofexchangeratesitmayeffectbusinessesthatareexportingwell,butthissituationmayplaceaheavyburdenonbusinessesinrespectofthereinvestmentoffundsforreplacementofimportedmachineryandequipmentofcapitalassetnature.Itisespeciallythesurvivalofthesmallerbusinesseswhichisthreatenedbythis.Theresultisthattheriskofbanksincreaseswhentheyfinancethesebusinessesorindividualswhoaredependantonthesebusinessesforanincome.

!

Thephaseoftheeconomiccycleinacountrycanalsohaveasevereimplicationonthecreditriskofbanks.Thisisprovenbythefactthateconomicactivitywithanincreaseininflationandveryhighincreaseingrossmoneysupply,whichnormallyformpartoftheupwardpartoftheeconomiccycle,willresultininterestincreasesintermsofmonetaryauthoritydecisions.Governmentsgenerallyuseinterestratestocontroltheeconomy.Thisisachievedbyloweringinterestratestostimulatetheeconomyandincreasinginterestratestocooltheeconomydown.Theseregulatorymeasurescanseverelyinfluencetheliquidityandsolvencyofbusinessesandindividualswhomakeuseofinterestbearingdebtduringperiodsofincreasinginterestrates.

!

TheCentralBanksofcountriesalsoplacecertainrestrictionsonbankstocontroltheeconomybyinteraliachangingcashreserveandliquidassetrequirements.Thisgenerallyleadstobankslimitingtheirlendingduringperiodsinwhichhighercashreserveandliquidassetrequirementshavetobeconformedto.Thusthefinancialperformanceofbankscannormallynotbesustainedduringsuchperiods.

!

Floodsanddroughtsinthenaturalenvironmentcontributetothebaddebtsofbanks.

!

Thebankingsectorisdependentonexpensiveinformationtechnologyduetotheneedforextensivemanagementinformationandspeedyprocessingoftransactions.Banksthushavetomakelargecapitalinvestmentsinequipment.

!

Thecompetitionbetweendifferentbanksaswellasthecompetitionwithothertypesofbusiness（forexample,motorvehiclemanufacturersthatalsoprovidefinanceforvehiclesthattheysell）isintenseandhasanegativeinfluenceonthefinancialperformanceofbanksingeneral.

Itisevidentfromtheabovementionedfactorsthatbanksfindthemselvesinavolatileandeverchangingenvironment.Theyshouldthuscontinuallytrytoensurebetterfinancialperformancebyconcentratingontheprimaryactivitythroughwhichtheygeneratetheirprofits,namelycredit.Rememberbankers'breadandbutterbusinessdependsondealingincredit.

3.4DEFININGCREDITRISK

Fromabankingviewpointcreditriskcanbedefinedas:

Thechancethatapersonorconcerntowhichfundsarelentmayforwhateverreasonfailtohonourthecontractualcommitmentsenteredintowiththelendinginstitutionandthatthelendinginstitutionhasnotmadeadequateprovisionstocontrolthedamageorsecureanalternativemeansofpayment.

3.5OVERVIEWOFFACTORSAFFECTINGCREDITRISK

Thecreditenvironmentofabankcanbedescribedasthesumofallthevariableswhichhavearealorpotentialeffectontheriskwhichbankstakewhengrantingcredittoclients,andconsistofthefollowing:

!

Theinternalenvironmentwhichisthetotalityofinteractingvariables（factors）withinthebankwhichhavearealorpotentialeffectonthecreditriskofthebankandwhichmaybedirectlyorindirectlyinfluencedbybankmanagement.Themainvariablesinthisenvironmentare:

-creditpolicy;

-staff;

-systemsusedforthemanagement,monitoringandcontrolofadvances;

-products;and

-targetmarketchoice.

!

Theexternalenvironmentwhichisthetotalityofinteractingvariables（factors）