Book 2. Credit Risk

FRM Part 2

CR 3. Credit Risk Management

Presented by: Sudhanshu

Module 1. Credit Risk Policies and Credit Asset Classification

Module 2. Loan Loss Provisioning and Credit Risk Assessment

Module 1. Credit Risk Policies and Credit Asset Classification

Topic 1. Elements of an Effective Lending Policy

Topic 2. Settng Exposure and Concentration Limits

Topic 3. Credit Facility Allocation and Credit Risk Reduction

Topic 4. Credit Asset Classification

Topic 1. Elements of an Effective Lending Policy

• Credit Risk and Bank Failure

  • Credit risk, or counterparty risk, is the chance a borrower will be late on or completely miss payments.

  • This risk is a major cause of bank failures, linked to about 70% of a bank's balance sheet.

• Effective Lending Policy

  • A good lending policy should detail the bank's credit facilities and how risk is managed, including origination, appraisal, internal supervision, and collection procedures.

  • It's essential for policies to be flexible and adaptable to changing conditions.

  • Risk managers must have direct access to the board of directors for special issues.

Practice Questions: Q1

Q1. Within their credit risk management plan, banks are either required to include, or at least should strongly consider including, a:

A. classification of risks organized by collectability.

B. loan loss provisions equal to at least 8 % of their loan portfolio.

C. duration target for the bank's portfolio that is not higher than 10.

D. rigid set of policies designed to address every possible risk source.

Practice Questions: Q1 Answer

Explanation: A is correct.

All banks should have a well-developed series of policies to manage credit risk
exposures. Policies should include recognizing and managing known risks. They need to be flexible to adapt to changing conditions. While regulators like to see established loan loss provisions and risk parameters, the specific targets are at the discretion of each bank because risk exposures are unique.

Topic 2. Setting Exposure and Concentration Limits

• What are Concentration Limits?

  • Concentration limits are the maximum exposure a bank will have to a single client, economic sector, or geographic area.

  • These limits are often a percentage of the bank's reserves or capital.

  • For individual clients, many countries set limits between 10% and 25% of the bank's capital.

• Challenges and Considerations

  • Determining exposure is complex, especially with less-direct forms of credit like guarantees, letters of credit, and contingent liabilities.

  • Collateral should not be factored into sizing risk exposures.

  • "Single client" can include an individual, an entity, or a connected group.

  • Large exposures to a single client may bias risk appraisals, creating a vested interest in the client's success.

  • Related parties (e.g., parent companies, major shareholders) can influence credit decisions, leading to terms more favorable than market norms.

Practice Questions: Q2

Q2. A risk analyst is reviewing his bank's credit risk management policies. He notes that banks have limits on related-party financing decisions. His colleague agrees and correctly adds that:

A. the term single client only refers to a legal person.

B. all banks have a limit of 10 % of capital for a single client.

C. loan collateral should be included in exposure sizing using mark-to-market principles.

D. acceptances and letters of credit should be factored into the risk exposure of a single client.

Practice Questions: Q2 Answer

Explanation: D is correct.

Credit risk management should consider both related-party financing and concentration limits. The concern with a related-party transaction is either that a credit decision may be biased, or the loan terms may be more favorable than market norms. Concentration limits should be imposed to protect against overexposure to single client, region, or sector of the economy. Alternative credit  (e.g., acceptances, lines of credit, guarantees, etc.) should be factored in as well, but collateral should not be considered when sizing risk exposures.

Topic 3. Credit Facility Allocation and Credit Risk Reduction

• Scope and Allocation

  • A bank's credit facility scope should cover how loans are originated, appraised, supervised, and collected, with flexibility for changing market conditions.

  • Lending policies should include several risk-reduction factors:

    • Lending Authority: Set clear limits for lending officers, possibly with higher limits for more experienced staff.

    • Loan Types: Specify which credit instruments the bank will use, based on officer expertise and demand.

    • Appraisal Process: Formally define the appraisal process, including limits and requirements for independent appraisals.

    • Loan Pricing: Price loans based on the cost of funds, supervision, and a reasonable profit margin, factoring in the probability of loss.

    • Maturities: Establish maximum maturities and realistic repayment schedules for different loan types.

    • Concentration Exposure: Monitor and understand concentration risks by geographic region or economic sector.

• Financial Information: Specify required financial information for loans, including external credit checks and audited financials.

• Collections: Detail the process for dealing with delinquencies, including reporting to the Board and plans for potential losses.

• Limits on Loans Outstanding: Set policy limits relative to capital, deposits, or total assets, considering credit risks and deposit volatility.

• Pledged Securities: Establish clear margin requirements and a process for periodic re-pricing of collateral to reduce risk.

• Impairment Recognition: Systematically identify and address loans that are uncollectible.

• Renegotiated Debt: Define the process for restructured loans, noting that a high number of restructurings can signal a serious credit risk issue for the bank.

• Written Guidelines: All lending policies must be formally documented and not just informally understood.

Practice Questions: Q3

Q3. A regional bank wants to decrease risk in their lending practices. They are considering several lending policy changes. Which of the following items should be included in this new risk-reductionfocused direction?

A. All loans should have a maximum maturity schedule of 10 years.

B. The Board should approve all individual delinquency workout plans.

C. Financial projections from business clients should match the maturity of their loan.

D. Credit officers should have the flexibility to extend any type of credit that a customer needs as long as they find it to be a reasonable risk for the bank.

Practice Questions: Q3 Answer

Explanation: C is correct.

Some lending policy practices that reduce risk are matching the length of financial projections to loan maturities, only offering loans that match the bank’s targeted products, matching maturity to the type of loan and the source of funds for repayment, and having a formal delinquency workout policy. The Board should be aware of delinquency issues, but they do not need to approve each individual
workout plan when a solid policy is in place.

Topic 4. Credit Asset Classification

• The Classification Process

  • Asset classification is the process of assigning bank assets to credit risk grades based on their likelihood of repayment.

  • Assets should be classified at loan origination and then periodically reviewed and reclassified.

  • The review should consider the client's financial condition, loan performance, and economic trends.

  • Regulators use five categories for asset classification:

    1. Standard (Pass): Delinquency is not a concern, and loans secured by cash equivalents typically fall into this category.

    2. Specially Mentioned (Watch): Assets with potential weaknesses that could affect the borrower's ability to repay.

    3. Substandard: Loans with defined credit weaknesses that could jeopardize repayment. The primary source of repayment has often failed, and the bank is looking to secondary sources like collateral. Nonperforming loans over 90 days delinquent are typically in this category.

    4. Doubtful: These assets have the same concerns as substandard assets, but the expectation of loss is more significant. Nonperforming loans over 180 days delinquent are placed here unless they are well-secured.

5. Loss: Delinquency is considered highly probable, and the loan should be written off. Nonperforming loans over one year delinquent are categorized as a loss unless they are sufficiently secured.

Practice Questions: Q4

Q4. Three and a half months ago, XYZ Manufacturing lost their single largest customer, and the company stopped service of all debt payments to ABC Bank. The bank has seized some collateral, but they are working with XYZ as they form plans to find new customers and build a better future. For now, the loans to XYZ Manufacturing should most likely be classified as:

A. loss.

B. doubtful.

C. substandard.

D. specially mentioned.

Practice Questions: Q4 Answer

Explanation: C is correct.

XYZ Manufacturing is approximately 105 days delinquent on debt service payments. ABC Bank has begun to access secondary sources of capital (i.e., collateral), but XYZ has hope for repayment. There is a path for them to move forward. A renegotiation may be needed down the line, but for now, this loan should be classified as “substandard.” They are not as severe as “doubtful” or “loss,” and they are a bigger concern than merely being classified as “specially mentioned.”

Module 2. Loan Loss Provisioning and Credit Risk Assessment

Topic 1. Loan Loss Provisions and Reserves

Topic 2. Expected Loss vs. Unexpected Loss

Topic 3. Expected Loss Under IFRS 9

Topic 4. Managing Loss Assets

Topic 5. Credit Risk Analysis

Topic 6. Credit Risk Management Capacity

Topic 1. Loan Loss Provisions and Reserves

• Loan Loss Provisions: These are resources that a bank sets aside to cover potential future losses. The asset classification process helps banks determine these provisions.

• Loan Loss Reserves: These represent the accumulation of loan loss provisions over multiple years, and they are recorded on a bank's financial statements. Both loan loss provisions and reserves are typically counted as Tier 2 capital.

• Factors for Determining Reserves: Banks should consider several items when deciding on an appropriate reserve level, including:

  • Credit quality policies and procedures.

  • Previous loss exposures.

  • Growth in the bank's loan portfolio.

  • The quality of management in charge of lending.

  • Loan collection and recovery policies.

  • Changes in the economic environment and business conditions.

Practice Questions: Q1

Q1. Two senior credit managers are reviewing their bank's loan loss reserve procedures. Which of the following elements is most important when determining the appropriate level of reserves?

A. Current loan loss reserves.

B. The bank's experience with previous losses.

C. The current number of nonperforming loans in aggregate.

D. A list of all loans that are delinquent for more than 180 days.

Practice Questions: Q1 Answer

Explanation: B is correct.

It is important to include the bank’s previous experience with loan losses. Loss provisions should not be biased by the number of aggregate losses already on the books (i.e., reserves). Loss provisioning needs to consider the bank’s policies at a high level and not focus on classification issues (i.e., the number of days delinquent). If they did factor delinquency, then 180 days is too long.

Topic 2. Expected Loss Vs Unexpected Loss

• Expected Loss (EL): This is the anticipated dollar loss if a borrower defaults on a loan. EL is a quantitative measure of counterparty risk.

• Components of Expected Loss:

  • Probability of Default (PD): The likelihood that a borrower will fail to make timely payments.

  • Loss Given Default (LGD): The expected percentage loss of the amount borrowed in the event of a default.

  • Exposure at Default (EAD): An estimate of the dollar loss exposure for the bank when a borrower defaults.

• Formula: Expected loss is calculated as:

  $EL(\$)=PD(\%)\times LGD(\%)\times EAD(\$)$.

• Unexpected Loss: This is a loss not captured by the expected loss formula. It is typically considered a tail risk event, such as a 99th percentile event.

Practice Questions: Q2

Q2. Which of the following components of expected loss considers the product that was used for the loan?

A. Unexpected loss.

B. Loss given default.

C. Exposure at default.

D. Probability of default.

Practice Questions: Q2 Answer

Explanation: B is correct.

The component of expected loss that considers which loan product was used is loss given default (LGD). The probability of default (PD) considers which client is associated with the loan while the exposure at default (EAD) considers how long the loan has been outstanding.

Topic 3. Expected Loss Under IFRS 9

• IFRS 9 Model: Since January 1, 2018, IFRS 9 requires a three-stage expected loss model, replacing the incurred loss model of IAS 39.

• Stage 1: For all performing (non-delinquent) assets, provisions for expected loss are calculated using a 12-month expected loss methodology. This includes effective interest based on the gross amount.

• Stage 2: Assets with any level of delinquency require a lifetime expected loss model, also including effective interest based on the gross amount.

• Stage 3: Nonperforming assets also use a lifetime expected loss model, but the effective interest is based on the net (carrying) amount.

Practice Questions: Q3

Q3. A bank's loan asset is considered delinquent, but not yet nonperforming. There is a short-term macroeconomic event that is temporarily preventing repayment. According to IFRS 9, which "stage" is required for this specific loan?

A. Stage 1.

B. Stage 2.

C. Stage 3.

D. Stage 4.

Practice Questions: Q3 Answer

Explanation: B is correct.

IFRS 9 requires three stages of reporting. Stage 1 is for performing assets. They can apply a 12-month expected loss methodology using effective interest computed based on the gross amount. Stage 2 is for assets with some level of delinquency. They can apply a lifetime expected loss methodology using effective interest computed based on the gross amount. Stage 3 is for nonperforming assets. They can apply a lifetime expected loss methodology using effective interest computed based on the net amount.

Topic 4. Managing Loss Assets

• Loan Workout Procedure: This is a crucial process for reducing risk and involves reviewing historical collection attempts. A common procedure can include these four steps in any order:

  1. Reducing the bank's credit risk exposure by getting additional capital, collateral, or guarantees.

  2. Working with the borrower to identify areas for improvement, such as providing advice, developing a plan to cut costs and increase earnings, selling assets, or restructuring the loan.

  3. Introducing a third party as a potential joint venture partner or for a takeover.

  4. Liquidation through an out-of-court settlement, which may involve foreclosure or liquidating collateral.

• Approaches to Managing Loss Assets: From a balance sheet perspective, there are two ways to handle loss assets:

  1. Retention: Common in the British tradition, this method keeps loss assets on the balance sheet to allow time for collection attempts. This makes the loss reserve appear larger.

  2. Write-off: Common in the U.S. model, this method immediately writes off losses, which removes them from the loan loss reserves account. This makes the reserves appear smaller in relation to the loan portfolio size.

Practice Questions: Q4

Q4. A financial analyst for ABC Bank notices that loan loss reserves are fairly small relative to the size of the bank's loan portfolio. He tells his coworker that this is a red flag for him. However, his coworker tells him that there could be an easy explanation that could be cleared up by asking management. The coworker is suggesting that ABC Bank could be following the:

A. British model and using the retention model for addressing loss assets.

B. U.S. model and using the write-down model for addressing loss assets.

C. U.S. model and providing internal consulting to help the borrower enhance their ability to pay.

D. U.S. model and allowing more time for collection efforts or collateral enhancement to work out.

Practice Questions: Q4 Answer

Explanation: B is correct.

The U.S. model involves immediate write-down. This method allows for the option of repayment but treats it as unlikely. It will make the loan loss reserves appear smaller on the balance sheet. The British model uses retention of loss assets, which will make the loan loss reserves appear much larger on the balance sheet than the write-off model. While loss assets are retained on the balance sheet, managers give more attention to loss workout options.

Topic 5. Credit Risk Analysis

• Components: Credit risk analysis should evaluate the lending products used, the customer base, and the loan terms. Key components include:

  • A summary of major loan types, including details like average maturity and interest rates.

  • The distribution of the loan portfolio, segmented by currencies, maturities, and economic sectors. The category of the borrower (e.g., state-owned, private) should also be identified.

  • A list of all loans with guarantees from government bodies or other entities.

  • A thorough review of loans by their risk classification.

  • An analysis of nonperforming loans with reference to their vintage year (the year they were originated).

Practice Questions: Q5

Q5. Portfolio-level credit risk analysis should include:

A. customer segmentation data.

B. current macroeconomic conditions.

C. commentary from the credit risk officer.

D. details on the bank's interest rate hedging policy.

Practice Questions: Q5 Answer

Explanation: A is correct.

Portfolio-level credit risk analysis should include a summary of major loan types, customer segmentation data, a list of loans with guarantees, a review of loans by risk classification, and an analysis of nonperforming loans. Because this is a portfolio-level analysis, credit officer commentary is not needed.

Topic 6. Credit Risk Management Capacity

• The board of directors is ultimately responsible for the credit risk management capacity of a bank. Their main lending objectives are to make loans that are sound and collectible, profitable, and meet the legitimate lending needs of society.
• Key Components of Review: A review of a bank's credit risk management capacity should include:

  • Lending Process: This review should evaluate the origination, appraisal, approval, monitoring, and collection procedures. It should also cover the criteria for loan approval, lending limits at various management levels, and the collateral review process. The review should also consider the volume of credit applications appraised versus approved over the last 6-12 months.

  • Staffing: The review should list the staff involved in credit origination, appraisal, supervision, and risk monitoring. It should detail the number of staff, their experience, qualifications, and specific responsibilities. An essential part of this is detailing all staff training, including its frequency and adequacy.

  • Information Flows: The review needs to assess how lending information reaches senior managers, the board, and the risk committee in a timely manner.

• Key Questions for the Board of Directors: With respect to credit risk management, the board of directors should be asking a number of key questions, including:

  • Are the bank's loans and deposits priced competitively?

  • Are the sources of interest income well-diversified?

  • How secure is the income from the loan portfolio, and do investment returns reflect the level of risk taken?

  • Can the bank's liquidity position survive stressed scenarios?

  • Which internal rating models does the bank use? Are PD (Probability of Default), LGD (Loss Given Default), and EAD (Exposure at Default) estimates historically accurate?

  • How frequently is the loan portfolio stress-tested?

  • Are all concentration risks adequately disclosed?

  • Does the bank have the required information, such as exposure trends, concentration trends, loss provisions, and delinquency trends?

Practice Questions: Q6

Q6. The credit risk management capacity review process should include:

A. staff diversity metrics.

B. information available to credit loan officers.

C. a list of all loans denied in the last three months.

D. timeliness of information flows from loan officers to the Board.a

Practice Questions: Q6 Answer

Explanation: D is correct.

The credit risk management capacity review process should include the lending process, staffing, and information flow concerns. Census data should be gathered on staff including the number of people in the risk management function, their ages, their experience, and their specific responsibilities. Diversity metrics may be captured by human resources but not in this review. Within the lending process, it is useful to understand credit applications relative to approvals over the last 6–12 months. The key part of information flow analysis is to understand if accurate, timely, and cost-effective data is making its way to the senior managers and the Board.