What is Credit Risk in Banking?
Credit risk refers to the risk of default or non-payment or non-adherence to contractual obligations by a borrower. The revenue of banks comes primarily from interest on loans and accordingly loans form a major source of credit risk. Banks face credit risks from financial instruments such as acceptances, interbank transactions, trade financing, foreign exchange transactions, futures, swaps, bonds, options, settlement of transactions, and others.
As of May 2019, credit card losses in the USA outpaced other forms of individual loans. There has been a huge spike in lending to riskier borrowers which has resulted in larger charge offs by the banks.
Causes for Credit Risk Problems in Banks
Although credit risk is inherent in lending, various measures can be taken to ensure that the risk is minimized. Poor lending practices result in higher credit risk and related losses. The following are some banking practices which result in higher credit risk for the bank:
Cause #1 – Credit Concentration
Where a majority of the lending of the banks is concentrated on specific borrower/borrowers or specific sectors, it causes a credit concentration. The conventional form of credit concentration includes lending to single borrowers, a group of connected borrowers, a particular sector or industry.
Examples of Credit Concentration
Let us consider the following examples to understand credit concentration better
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- Example #1 – A major bank focuses on lending only to Company A and its group entities. In the event that the group incurs major losses, the bank would also stand to lose a major portion of its lending. Therefore, in order to minimize its risk, the bank should not restrict its lending to a particular group of companies alone.
- Example #2 – A bank lends only to borrowers in the real estate sector. In the event that the whole sector faces a slump, the bank would also automatically be at a loss as it will be unable to recover the monies lent. In this scenario, although the lending is not restricted to one company or related group of companies if all the borrowers are from a specific sector, there still exists a high level of credit risk.
Therefore, in order to ensure that the credit risk is kept at a lower rate, it is important that lending practices are distributed amongst a wide range of borrowers and sectors.
Cause #2 – Credit Issuing Process
This includes flaws in the banks’ credit granting and monitoring processes. Although credit risk is inherent in lending, it can be kept at a minimum with sound credit practices.
The following are instances wherein flaws in the credit processes of the bank results in major credit problems –
#1 – Incomplete Credit Assessment
In order to evaluate the creditworthiness of any borrower, the bank needs to check for (1) credit history of the borrower, (2) capacity to repay, (3) capital, (4) loan conditions, and (5) collateral. In the absence of any of the above information, the creditworthiness of the borrower cannot be evaluated accurately. In such a case, the bank must exercise caution while lending.
- For Example – Company X wants to borrow $100,000 but it does not furnish sufficient information to perform a thorough credit evaluation. Therefore it is a higher credit risk and will be eligible for a loan only at a higher interest rate as compared to companies which are a lower credit risk. In such a scenario, if a bank agrees to lend money to Company X with a view to earning higher interest, it stands to lose both interests as well as the principal as Company X poses a higher credit risk and it may default at any stage during repayment.
#2 – Subjective Decision Making
This is a common practice in many banks and other institutions wherein the senior management is given free rein in taking decisions. Where the senior management is allowed to make decisions independent of the company policies, which are not subject to any approvals, there could be instances where loans are granted to related parties with no credit evaluations being done and accordingly the risk of default also increases.
- For Example – In the absence of strict guidelines, Mr. K, a director of a major bank, will be more likely to advance loan to a company headed by his relative or close associate without performing adequate credit evaluations. If the loan had been advanced to a third party company with no associations to Mr. K, there would have been a thorough credit check and the credit risk would be lower. Therefore, it is essential that senior management is not given free rein in lending decisions.
#3 – Inadequate monitoring
Where the lending is for the long term, they are almost always secured against assets. However, the value of assets may deteriorate over time. Therefore, it is not only important to monitor the performance of the borrowers, but also monitor the value of assets. If there is any deterioration in their value, additional collateral may help reduce credit problems for the bank. Also, another issue could be the instances of fraud relating to collaterals. It is important for banks to verify the existence and value of collaterals prior to lending to minimize the risk of any fraud.
- Example A – Company P borrowed $250,000 from a bank against the value of its offices. If the bank regularly monitors the value of the asset, in the event of any diminution in its value, it would be in a position to ask for additional collateral from the Company. However, if there is no regular monitoring mechanism, where both the value of the asset decreases and company P defaults in its loan, the bank stands to lose which could have been avoided with a sound monitoring practice.
- Example B – Let us consider the same example – Company P borrowed $250,000 from a bank against the value of its offices. Prior to lending, it is important that the bank verifies the existence of the asset as well as its value and not go simply by the paperwork submitted. There could be instances of fraud wherein loans are taken against fictitious assets.
- Example C – Company P borrows $100,000 with no collateral based on its performance. Performing credit evaluation prior to lending is not sufficient. It is essential that the performance of Company P is regularly monitored by the Bank to ensure that it is in a position to repay the loan. In case of poor performance, the bank may request collateral to be provided and therefore reduce the credit risk impact.
Cause #3 – Cyclical Performances
Almost all industries go through a depression and a boom period. During the boom period, the evaluations may result in the good creditworthiness of the borrower. However, the cyclical performance of the industry must also be taken into account in order to arrive at the results of credit evaluations more accurately.
Example – Company Z obtains a loan of $500,000 from a bank. It is engaged in the business of real estate. If it borrows during a period of boom, the bank must also take into account its performance during any subsequent depression. The bank must not always go by current trends but must also provide for any future slumps in the industry performances.
Credit Risks in Banks are inherent to the lending function. They cannot be avoided wholly; however, their impact can be minimized with proper evaluation and controls. Banks are more prone to incur higher risks due to their high lending functions. It is important that they identify the causes for major credit problems and implement a sound risk management system so that they maximize their returns while minimizing the risks.
This has been a guide to Credit Risk in Bank. Here we discuss the top 3 causes of credit risk in banks – 1) Credit Concentration 2) Credit Issuing Process 3) Cyclical Performances along with its examples and detailed explanation. You can learn more about finance from the following articles –