Credit Risk Management

Credit risk management is the process of identifying, assessing, and controlling the potential risks associated with lending money or extending credit to borrowers. This includes evaluating the creditworthiness of potential borrowers, setting appropriate credit limits, and monitoring the creditworthiness of existing borrowers to ensure that they are meeting their obligations. Credit risk management strategies are designed to minimize the potential losses that an organization may incur as a result of defaults or other problems with borrowers, and to maximize the potential returns from credit operations. This can include measures such as careful borrower selection, collateral requirements, and risk-based pricing.

Credit risk is the possibility that a counterparty or borrower won't fulfill their commitments in accordance with the terms set forth, causing a financial loss to the institution. Although loans are the main source of credit risk, there are other sources that can be found throughout a financial institution's operations, such as in the trading book and both on and off the balance sheet.

Strong measures to monitor and control this risk should be put in place given the credit risk's large weight in banks' and other credit institutions' risk profiles. A thorough risk management strategy must include the efficient handling of credit risk. For accepting, managing, and monitoring credit risk on a group or individual basis, in a way commensurate with the type, scale, and complexity of the financial institution's activities, appropriate governance, processes, and internal controls should exist. Consistent provisioning strategies are necessary for financial organizations to have reliable processes for assessing their credit exposures. They must consider the future in order to determine whether the safeguards now in place are sufficient to address any potential credit risk.

The organizational structure, credit strategies, policies, and procedures, limits and indicators, credit granting procedures, credit administration, measurement, and monitoring procedures, credit risk mitigation strategies, and controls of credit risk are the topics we'll cover in this section.

Appropriate Organizational Structure

The size, complexity, and diversification of the activities conducted by financial institutions influence organizational structures. What's important is that the structure supports efficient management oversight and proper implementation of credit risk management and control processes, regardless of the structure in place.

The numerous credit-related tasks, such as credit evaluation, analysis, approval, disbursement, administration, and monitoring, should be divided into separate categories. For large banks, distinct divisions need be set up to carry out each task. The structure should guarantee that conflicts of interest between these functions are identified and managed and that adequate checks and balances are in place even if they are within the same unit, especially in smaller banks where it may not be possible to adequately staff different units.

A credit risk management function that is separate from the risk-taking units should be present in the bank. Regarding the creation of the credit risk management framework, this credit risk management function should have the authority to object and, if necessary, escalate its concerns to higher management. The Chief Risk Officer, or a similar authority or person, must oversee this activity and keep it separate from other credit-related responsibilities (second line of defense).

Credit Risk Strategies, Policies and Procedures

The bank's appetite to accept credit risk should be stated for each activity type, product type (such as working capital, consumer loan, fixed-term, etc.), economic sector (such as real estate, construction, retail), geographic location, etc. in the credit risk strategy. The company should be made aware of the credit risk plan, and the board or management should review it on a regular basis.

Target markets and the overall qualities the bank wants to see in its credit portfolio, such as levels of diversity and concentration tolerances, should be identified as part of the credit strategy. The strategy should be established based on the organization's own strengths rather than just the target markets. The credit risk strategy should also reflect the country's economy's cyclical features and the ensuing changes in the composition and quality of the overall credit portfolio.

Policies governing the data and paperwork required for the approval of new loans, the renewal of current ones, and/or the modification of already granted credit should be in place.

For each type of loan, credit policies and procedures should define criteria for granting loans in a safe and sound manner including, but not limited to:

The purpose of the credit and the repayment source

Gathering pertinent data based on the various client risk profiles

Utilizing suitable instruments, such as internal or external scoring systems

Based on past financial trends and projected future cash flows, an analysis of the borrower's repayment history (including, if available, that in other banks), as well as their current and future repayment capacity,

For commercial loans, the borrower's business experience, the state of its industry, and its standing within that industry

Wealth of the personal guarantors and the borrower

The credit agreement's proposed terms, conditions, and stipulations

Sensitivity of collateral to market and economic trends

The sufficiency, enforceability, and liquidity state of the collaterals, as well as the operational factors of their mobilization

Credit risk management must be a priority in all bank operations, both on an individual and portfolio level. These guidelines must be specific, aligned with the bank's credit strategy, compliant with international standards and banking practices, and sufficient for the scope and complexity of its operations.

The actions the concerned staff of the various functions involved must take to evaluate and approve the credit proposals and monitor credit relationships should be clearly specified in policies and procedures for the various types of loans.

Credit policies must clearly state who has the authority to approve credit, as well as specify delegations, exceptions, and waivers. Authority must always be delegated with consideration for knowledge and experience.

A clearly defined collateral policy must be in place by the bank, outlining the types of collaterals that are acceptable, haircuts, and the maximum loan-to-value (LTV) for each category of products in relation to the collateral.

Credit Limits and Indicators

To ensure diversification of risks and limit concentration risk, limits on credit exposures should be set for all relevant activities. They may include:
Restrictions on exposure to particular activities or types of products, such as those that are off-balance-sheet
Restrictions on individual counterparties, groups of connected counterparties, other banks, and financial institutions—both domestic and international—that are associated
Restrictions on particular industries, economic sectors, or subsectors;
Limits on collateral types' exposure;
Restrictions on exposure to connected parties;
Restrictions on geographic exposures, including to other nations, and/or branches;
Restrictions on the amount of credit that approving managers may grant.

These restrictions should be periodically examined and updated, ideally once a year. Additionally, banks should take the results of the stress test into account when setting and monitoring their overall limit policy.

In addition to establishing limits, banks should use early warning indicators to identify instances of increased exposure to particular credit risk components, and they should respond to these indicators by determining whether they may be a sign of potential credit quality issues.

Credit Granting Processes
Granting of credit should follow predetermined processes:

Assessment: In accordance with the organizational and structural makeup of the bank, credit proposal assessments should be carried out at the appropriate level. According to their risk profiles, credit assessments should adhere to procedures, methodologies, and operating guidelines that describe the essential elements and scope of due diligence as well as the gathering of pertinent documentation and information.

Review: Before submitting loan ideas to the individual, unit, and/or committee that will approve them, the bank should have a person independent from the initial evaluation evaluate and analyze each loan request. In smaller businesses, any qualified official who is not involved in the credit evaluation and approval process may perform an independent review. While it is normally the responsibility of the credit risk management department or unit to organize such reviews, this is not always the case.

Approval: Based on the initial credit assessment, unbiased review, and analysis, the designated level of approving authority makes the approval decision, including the approval of specific terms and conditions.

Distribution: After the designated unit or person receives notice of the approval decision, disbursement is done in accordance with processes to ensure that all terms and conditions are confirmed and, if necessary, guarantees are taken.

Administration: The credit administration function is in charge of keeping track of and updating credit files as well as following up on essential actions (renewal notices, updating information, etc.).

Credit Risk Monitoring

The Credit Risk Management Function should oversee credit risk management independently from risk-taking units.

Banks need to have a system in place for properly classifying their credit risk at the bank, portfolio, and borrower levels. Quantitative and qualitative methods should be used to classify credit risk, qualitative criteria, a grading of the various inherent risk levels, and necessary actions in line with the recognized level of risk.

The use of internal rating systems (IRR), which assist the financial institution in differentiating between the various credit exposures in its portfolio, determining the portfolio's characteristics (concentration, problem loans, etc.), and confirming the accuracy of the provisions, is a useful tool in monitoring the quality of individual loans as well as the overall portfolio.

Banks should continuously assess the quality of their credit relationships and maintain current records of their credit portfolios, risk profiles, and borrower situations. This comprises the timely gathering and routine examination of financial data, including annually audited financial accounts.

On-site visits should be used to monitor business borrowers as well. Individual customers' repayment capacities should also be updated frequently to allow for early detection of any negative developments that might affect loan repayment.

Remedial actions

For the prompt implementation of corrective steps on deteriorating credits and management of issue loans, including determining the proper legal proceedings, banks should have efficient processes and procedures in place.

Without delay, appropriate corrective actions should be implemented, such as calling for more or stronger assurances.

Rearranging may be necessary. It entails altering loan terms, repayment plans, and interest rates and is typically to be agreed upon when the borrower's needs have changed but the loan is still performing. When used as a corrective action, it must adhere to a specific approval process that includes a justification for how the change will increase the likelihood that the loan will be repaid.

Restructuring encompasses all parts of rescheduling and taking a fresh look at the partnership, which calls for more paperwork and a new credit report. When employed as a corrective measure, it must go through a particular approval procedure.

Neither rescheduling nor restructuring should be used by way of forbearance.

Recovery process

Problem loans should be handled by a specialized recovery unit if rescheduling and restructuring are not possible or do not help the issue. In order to deal with problematic debtors, this unit should take proactive measures.

Banks should write off loans and sell collateral when all else fails to reduce costs.

Such a process needs to be closely watched, call for a certain level of approval, and provide the board and NRB with a certain amount of information.

Process of Provisioning

Banks should have a sound loss methodology that is documented, including policies, procedures, and controls for assessing credit risk, in order to quickly identify troubled exposures and determine the appropriate loss provisioning.

Reference: NRB

Credit Risk Management