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. 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. Banks’ revenue comes primarily from interest on loans; accordingly, loans form a major source of credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more.

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, resulting in larger bank charge offs.

Causes for Credit Risk Problems in Banks

Although credit risk is inherent in lending, various measures can be taken to minimize the risk. Poor lending practices result in higher credit risk and related losses. The following are some banking practices that result in higher credit risk for the bank:

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Cause #1 – Credit Concentration

Where a majority of the banks’ lending 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, or a particular sector or industry.

Let us consider the following examples to understand credit concentration better.

  • Example #1 – A major bank focuses on lending only to Company A and its group entities. If the group incurs major losses, the bank would also lose a major portion of its lending. Therefore, the bank should not restrict its lending to a particular group of companies alone to minimize risk.Example #2 – A bank lends only to borrowers in the real estate sector. If the whole sector faces a slump, the bank would automatically be at a loss as it cannot recover the monies lent. In this scenario, although the lending is not restricted to one company or a related group of companies if all the borrowers are from a specific sector, there still exists a high level of credit risk.

Therefore, to ensure that the credit risk is kept at a lower rate, lending practices must be 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 result in major credit problems –

To evaluate the creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more of any borrower, the bank needs to check for (1) the credit history of the borrower, (2) capacity to repay, (3) capital, (4) loan conditions, and (5) collateral. The borrower’s creditworthiness cannot be evaluated accurately without the above information. 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 than companies with lower credit risk. In such a scenario, if a bank agrees to lend money to Company X to earn 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.

This is a common practice in many banks and other institutions wherein the senior management is given free rein in making 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. 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 a 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 with Mr. K, there would have been a thorough credit check, and the credit risk would be lower. Therefore, senior management mustn’t be given free rein in lending decisions.

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 to 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 collateral. Banks need to verify the existence and value of collateral before 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. There could be instances of fraud wherein loans are taken against fictitious assets. Before lending, it is important that the bank verifies the existence of the asset and its value and not go simply by the paperwork submitted.Example C – Company P borrows $100,000 with no collateral based on its performance. Performing credit evaluation before lending is not sufficient. The Bank must regularly monitor the performance of Company P to ensure that it is in a position to repay the loan. In case of poor performance, the bank may request that collateral be provided, reducing 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 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. The bank must not always go by current trends but must also provide for any future slumps in the industry performance. If it borrows during a boom period, the bank must also consider its performance during any subsequent depression.

Conclusion

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 of major credit problems and implement a sound risk management system to maximize their returns while minimizing the risks.

This has been a guide to Credit Risk in Banks. Here we discuss the top 3 causes of credit risk in banks – 1) Credit Concentration, 2) Credit Issuing Process, and 3) Cyclical Performances along with their examples and detailed explanation. You can learn more about finance from the following articles –

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