Question

Loans can turn bad and increase banks’ impaired loan position (non-performing loan). The impaired loans would increase credit risk to the detriment of bank insolvency. Thoroughly discuss this issue.

Answer 1

Over the last few years, the financial services industry has faced challenges for a variety of reasons, but many of these challenges can be related to poor lending practices, inefficient practices for risk management, or lack of flexibility in responding to changing economic circumstances. Credit risk, in basic terms, is the danger of bad loans, in the event that the borrower fails to satisfy its obligations under the negotiated terms of the loan. The primary objective of credit risk management is to take measured exposures within specified parameters such that the overall process leads to optimization of the risk-adjusted rate of return for the banks. Loans are the main sources for credit risk for banks; however, there is presence of other sources of credit risk that exist in the banking operations, including the trading and banking books, and also on and off the balance sheet.

Banks should be well aware of the need to define, calculate, track and manage credit risk as well as to assess that they maintain sufficient capital against such risks and are compensated in an adequate manner for risks incurred. “The Basel Committee” has released established guidelines in this regard such as to enable supervisors of global banks to pursue sound credit management practices. The sound practices of credit management comprise the following:

· Establishment of a suitable environment for management of credit risks;

· Development of a sound and stringent process for disbursement of loans;

· Maintenance of an effective credit management, monitoring and measurement process;

· Ensure that there are adequate controls for credit risks.

While different credit risk management strategies can differ among banks depending on the complexity and nature of their credit operations, a comprehensive system of management of credit risks can address the above mentioned areas. The above practices should be implemented in conjunction with sound evaluation of the standard of underlying assets, the adequacy of reserves and provisions, and the credit risk disclosures, all of which have been provided for in the guidelines of “the Basel Committee”.

It is important that banks operate under well-defined credit requirements. Such parameters will clearly identify the target market of the bank, the credential requirements of the borrower, the intent and nature of the loan and the repayment source. Financial institutions must set an aggregate credit cap for all borrowers and relevant counterparties as set out in the credit policy. Banks must specifically describe their approval requirements for new loans, renewals, refinancing and early terminations. Deviation from the guidelines must not be entertained without any recommendation from the Board. This will reduce the probability of any loan turning bad and in the process reduce credit risks of banks.