PRINCIPLES OF CREDIT

WHY DO BANKS MONITOR AND CONTROL RISK?

Why do banks monitor and control risk?

The risk the bank takes can lead to losses. The credit risk team responsible for monitoring and controlling risk has to keep a close eye on different reports that reflect customer defaults, and should take into consideration multiple factors such as:

  • The rate of risk growth compared to what was planned
  • The different levels of risk and loan loss experienced in different client sectors and with different credit products
  • Aging, which is the duration of loans to each defaulting group.
  • The concentration of different customer segments. The bank needs to examine different industries like tourism, medical, etc. It should analyze defaulting customers ages, employment status and where they live.

The best way to avoid losses is not to take any risks. The second-best way is to take a controlled and studied risk. The risk team develops models to calculate both expected losses and unexpected losses. An expected loss is to be covered within the product pricing, while the bank can take precautions to minimize as much as possible unexpected losses.

Monitoring risk has to be an ongoing process to fine-tune the required corrective actions on a continual basis. 

Retail credit risk versus corporate credit risk

Corporate risk is the risk that a corporate or an establishment that fails to fulfill its payment obligation to the bank in full and on time. These losses could be in large amounts that the bank’s capital cannot absorb. The point with corporate risk is that one or more customers could negatively damage the profitability of a bank while for the retail risk, you need to have losses of a massive number of customers or “portfolio loss” in order to compare that with the corporate risk.

Expected risk versus Unexpected Risk

We need to differentiate between expected credit risk and unexpected credit risk:

Expected risk is the expected loss due to the expected risk of customers’ defaults in payment. The Expected loss considers the cost of doing business.The expected loss is the amount a bank can expect to lose on average over a predetermined period when extending credits to its own customers. Such losses would be clear from the bank’s accounts for the previous year, or even better by looking at an average of its performance over the previous three years.  Therefore, the risk control team in a bank can estimate the expected loss for the coming year based on the performance of last year or an average of the previous three years. With some models and formulae, the team will be able to assume and predict the expected loss for next year.

The known formula for calculation of Expected risk losses is:

Expected loss = Probability of defaults (PD) x Loss-given default (LGD) x Exposure at default (EAD)

Let us use an example where the probability of defaults in the previous year was 5% (based on figures obtained from the previous year’s performance), the loss-given defaults were 15%, and the exposure at default was $800 million. We then get the following results:

PD x LGD x EAD                     = Expected loss

5% x 15% x $800,000,000   = $6,000,000

This tells us that we may expect a loss of $6m next year based on the performance of the previous year.

The expected loss is the price the bank has to bear in order to be able to do business and exist in the market. The expected loss would be taken into consideration when loans are priced.

Unexpected risk lossis the risk of having losses that are beyond the bank’s expectation for credit risk losses. This type of risk represents the real risk for the bank since it is difficult to predict, unlike expected risk, which can be calculated – thereby allowing the bank to anticipate the expected risk and generate a provision in its financial statements.

Risk losses negatively affect banks’ profitability when they are above the expected loss, and when risk exposure is beyond the banks’ financial tolerance.  It is normal that banks expect risk to occur as it part of the price that is paid to do business and make a profit.

When the amount of risk exceeds expectations then that is the risk that the bank can be negatively affected. This must be avoided as much as possible.

There are ways to handle the unexpected risk which will be covered later in this chapter.