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

1、Chapter 3 Introduction to credit risk and factors affecting credit riskCHAPTER 3INTRODUCTION TO CREDIT RISK AND FACTORS AFFECTING CREDIT RISKINTRODUCTION TO CREDIT RISK AND FACTORS AFFECTING CREDIT RISK 23.1 INTRODUCTION 43.2 DEFINING CREDIT 43.3 CREDIT: PRIMARY ACTIVITY OF BANKS 43.4 DEFINING CREDI

2、T RISK 63.6 BANK INTERNAL FACTORS AFFECTING CREDIT RISK 73.7 EXTERNAL FACTORS AFFECTING CREDIT RISK 113.8 SUMMARY 52TEST YOUR KNOWLEDGE - THEORY 55ESSAY QUESTIONS AND CASE STUDIES: CHAPTER 3 - CREDIT RISK & FACTORS AFFECTING CREDIT RISK 57APPENDIX 1 INFORMATION RETRIEVED DIRECTLY FROM THE WEBSITE OF

3、 NEW ZEALAND RESERVE BANK ABOUT THE BASEL CAPITAL ADEQUACY REQUIREMENT 63CHAPTER 3INTRODUCTION TO CREDIT RISK AND FACTORS AFFECTING CREDIT RISKAIMTo provide learners with a clear understanding of: credit and credit risk; the primary client classification of banks; and the factors affecting credit ri

4、sk.KEY CONCEPTSCredit Credit riskCredit policy Default riskCompetition between banks IndividualsSole proprietorships Partnerships Companies Trusts Macro external variables Economic environmentInternational environment Physical environmentInstitutional environment and legislation Technological enviro

5、nmentPolitical environment Social environment LEARNING OUTCOMESOn completion of this chapter learners should be able to: Briefly explain what credit is and how bank credit differs from credit in general. Define credit risk. Explain the internal factors that affect the credit risk of banks and analys

6、e the actual information of banks to rate their relative risk with regard to each other as well as in general. Analyse the existing trend in competition between banks and provide innovative solutions as to how banks could compete successfully without increasing credit risk. Explain the different bor

7、rower groups of banks and the credit risks pertaining to each of the groups that banks should consider during credit risk decisions. Compare the relative credit risk of clients from different industries/sectors and provide recommendations with substantiated reasons for market expansion in the differ

8、ent industries. Consider the different important aspects in the economic environment to determine whether the credit risks of banks are increasing or not and to provide recommendations about the credit risk assessment precautions that may be required. Evaluate the credit risk effect that an internat

9、ional transaction which a client applies for can have on the bank. Explain physical environmental factors that should be considered by banks and apply information about the factors to actual risk assessment processes. Explain the Basel II accord as a regulation of capital adequacy, and indicate how

10、increases in different asset types will affect it. Explain the different types of actions that central banks can apply to change the lending activities of banks. Discuss the different legislative aspects regarding insolvency, full age, matrimonies, organised labour, and organised business that shoul

11、d be considered and clarify how the information will be obtained. Assess the credit risk of clients based on the technological environment that they are operating in and provide recommendations about the credit risk acceptability of a lending transaction in this regard. Assess the credit risk of tra

12、nsactions in terms of political and social environmental factors. 3.1 INTRODUCTIONOne of the most difficult things to do, is to predict the outcome of a future event with certainty. All financial and business decisions are, however, based on future expectations and as such can only be proved to be r

13、ight or wrong afterwards. Not every decision can be right as no person can consistently make predictions which are correct. To keep the margin of error as low as possible, it is necessary to seek methods to increase the accuracy of decision making. All such methods require a thorough knowledge of fa

14、ctors which can influence the outcome of a future event in order to take these factors into consideration during the decision making process.In this module the uncertainty which surrounds the outcome of events will be discussed with special emphasis on credit risk and factors which influence credit

15、risk.3.2 DEFINING CREDITThe word credit originated from the Latin word credo which means I believe and refers to the fact that a position of trust is established when a purchaser/borrower presents his/her creditworthiness as medium of exchange to obtain certain goods or services immediately against

16、deferred future payment.Credit can thus be defined as:! The facility to obtain goods or services immediately against a promised future cash payment.The above mentioned definition refers to credit in general. From a banking viewpoint credit can be defined as:! Any transaction entered into with a pers

17、on or concern which results in funds being lent.3.3 CREDIT: PRIMARY ACTIVITY OF BANKSThe operational activities of banks consist simplistically stated of taking deposits and lending money. It is the latter activity that poses the risk of illiquidity or even insolvency to banks if it is not executed

18、in a scientific manner. This statement is proven by the fact that the provision for bad debts by banks are normally, according to their annual reports, 0,75% of total assets, whilst the net profit before taxation of large banks is approximately 2 to 2,5%. Bad variations in bad debt provisioning will

19、 therefore have a substantial effect on the net profit percentage. We further find that banks can experience increasing pressure on income margins from inter alia the following cases which could be extensive contributing factors:! Firstly continuous and substantial changes in the exchange rates of t

20、he currencies of countries can affect different sectors of the economy in terms of their credit risk. For example: In the case of the continuous strengthening of a currency, business that are primarily in the export market, may loose market share due to their inability to compete well with product p

21、rices. In the case of the weakening of exchange rates it may effect businesses that are exporting well, but this situation may place a heavy burden on businesses in respect of the reinvestment of funds for replacement of imported machinery and equipment of capital asset nature. It is especially the

22、survival of the smaller businesses which is threatened by this. The result is that the risk of banks increases when they finance these businesses or individuals who are dependant on these businesses for an income.! The phase of the economic cycle in a country can also have a severe implication on th

23、e credit risk of banks. This is proven by the fact that economic activity with an increase in inflation and very high increase in gross money supply, which normally form part of the upward part of the economic cycle, will result in interest increases in terms of monetary authority decisions. Governm

24、ents generally use interest rates to control the economy. This is achieved by lowering interest rates to stimulate the economy and increasing interest rates to cool the economy down. These regulatory measures can severely influence the liquidity and solvency of businesses and individuals who make us

25、e of interest bearing debt during periods of increasing interest rates. ! The Central Banks of countries also place certain restrictions on banks to control the economy by inter alia changing cash reserve and liquid asset requirements. This generally leads to banks limiting their lending during peri

26、ods in which higher cash reserve and liquid asset requirements have to be conformed to. Thus the financial performance of banks can normally not be sustained during such periods.! Floods and droughts in the natural environment contribute to the bad debts of banks. ! The banking sector is dependent o

27、n expensive information technology due to the need for extensive management information and speedy processing of transactions. Banks thus have to make large capital investments in equipment.! The competition between different banks as well as the competition with other types of business (for example

28、, motor vehicle manufacturers that also provide finance for vehicles that they sell) is intense and has a negative influence on the financial performance of banks in general. It is evident from the above mentioned factors that banks find themselves in a volatile and ever changing environment. They s

29、hould thus continually try to ensure better financial performance by concentrating on the primary activity through which they generate their profits, namely credit. Remember bankers bread and butter business depends on dealing in credit.3.4 DEFINING CREDIT RISKFrom a banking viewpoint credit risk ca

30、n be defined as:The chance that a person or concern to which funds are lent may for whatever reason fail to honour the contractual commitments entered into with the lending institution and that the lending institution has not made adequate provisions to control the damage or secure an alternative me

31、ans of payment.3.5 OVERVIEW OF FACTORS AFFECTING CREDIT RISKThe credit environment of a bank can be described as the sum of all the variables which have a real or potential effect on the risk which banks take when granting credit to clients, and consist of the following: ! The internal environment w

32、hich is the totality of interacting variables (factors) within the bank which have a real or potential effect on the credit risk of the bank and which may be directly or indirectly influenced by bank management. The main variables in this environment are:- credit policy;- staff;- systems used for the management, monitoring and control of advances;- products; and- target market choice.! The external environment which is the totality of interacting variables (factors)

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