3b. - Credit Risk in Banking

CHECK-IN CODE
UD
BU7056 Credit, Lending and Risk Management
Credit Risk in Banking
SESSION 12
Session 2: Objectives
• Understand what credit risk is?

• Explain the types of credit risk
• Identify the 5 C’s of credit
• Discuss the impact of credit risk
• Consider alternative approaches to strategy planning

Credit Risk
 Credit risk is the probability of a financial

loss resulting from a borrower's failure to
repay a loan.
 Essentially, credit risk refers to the risk that
a lender may not receive the owed principal
and interest, which results in an interruption
of cash flows and increased costs for
collection.
 Lenders can mitigate credit risk by analysing
factors about a borrower's creditworthiness,
such as their current debt load and income.
Introduction
BU7056 Credit,
to Banking
Lending and Risk Management
TYPES OF CREDIT RISKS

Default Risk
It is the probability that borrowers could
default on a commitment to pay their
promised dues.
This type of risk involves the situation

where the borrower fails to make the
repayment of principle or interest on loan
or any kind of debt instrument, as per the
terms and conditions of the contract.
Default can be due to the fall in credit

repayment capacity of the individual or
external disturbances like change in
market conditions or economic system.

• Banks often engage in transactions with
other parties such as banks and financial
institutions regarding deposits, derivative
contracts, interbank lending or any kind or
trade financing.
• During such cases also the parties may fail

to honour the contract and may default on
Video 1  A summary of Counterparty Risk
Video 2  The Counterparty Story
the repayment.

Concentration Risk
• Banks might heavily invest in a single industry,
geographic area or a borrower. Thus, concentration
of portfolio is very risky because if there are any
adverse conditions in that sector, region or the
individual borrower, the loan may not be repaid.
This will affect the credit quality of banks in a
negative way.
• A potential for a loss arising from a single exposure
(huge) or group of exposures by a bank relative to a
its capital, total assets, or overall risk level, and so
may be able to threaten a bank's health or ability to
maintain its core operations.

Sovereign Risk  Some banks purchase government bonds. They
may also have exposure to foreign governments.
 Those governments may default on repayment of
debt obligations due to political or economic
instability;
 This will lead to credit risks.
Sovereign risk is the potential that a nation's
government will default on its sovereign debt by
failing to meet its interest or principal payments.
Sovereign risk is typically low but can cause losses
for investors in bonds whose issuers are
experiencing economic woes leading to a sovereign
debt crisis.
Class Activity 1
During COVID, we had many companies shut down across various sectors.
However, banks had various loans still running in their portfolios. Consider
Bank A had more loans given to fast foods, coffee shops, airlines and night
clubs, and Bank B had a loan portfolio mix of airlines, pharmaceutical
companies, educational institutions and night clubs.
What can you say about the portfolio mix of the business sectors each of
the Banks chose to play in?
Which bank do you consider carrying a higher risk of bankruptcy?
What kinds of risks are inherent here?

Class Activity 2
After the pandemic, many companies witnessed losses and preferred to lay-
off staff to remain in business. Jack lost his job during this redundancy
process.
He owns a credit card and has had to rely on it to attend to his immediate
needs. The repayment time was due, and he has an obligation to make his
due payment, but no longer has the means to fulfil this obligation.
What kind of risk is inherent in this case?

IMPACT OF CREDIT RISKS

Rise in loan loss provision
• Banks need to put aside some fund in anticipation of credit default
from borrowers. If there is a heavy loan default, this provision will
increase, and it will bring down the profitability and capital available
for lending. Increase in provision will put restriction on the bank’s
ability to give loans.
Financial loss
• Default on loan will result in losses because the banks are not getting
the amount that they were supposed to get. This will affect their ability
to meet the regulatory requirements.

Strain on liquidity
• A large number or loan default will put a strain on the liquidity
available. This will result decrease of funds to meet short term
obligations and may trigger of the liquidity crisis.
Damage of reputation
• A heavy loan default, will definitely lead to loss of reputation, because
customer will feel that the management is not competent enough to
handle the business efficiently.
High borrowing cost
• High credit risk will lead to higher cost of borrowing for the banks from
interbank market because they will have to face more stringent term of
borrowing to compensate for the risk.

THE FIVE C’s
OF CREDIT

These are the criteria used as a framework used by financial institutions
and other non-bank lenders to evaluate the creditworthiness of a
borrower, as well as the strength of an overall borrowing request.

Cs of Credit
Capacity to pay: is also determined by analysing the number and amount of debt obligations the
borrower currently has outstanding, compared to the amount of income or revenue expected each month.
“Ability to pay”
Capital: for a business-loan application consists of personal investment into the firm, retained
earnings, and other assets controlled by the business owner.
Conditions of the loan: refer to the terms of the loan itself as well as any economic conditions
that might affect the borrower.
Character of the borrower: refers to a borrower's reputation or record regarding financial

matters. The old adage that past behaviour is the best predictor of future behaviour is one that lenders
devoutly subscribe to. “Willingness to pay”
Collateral: Personal assets pledged by a borrower as security for a loan are known as collateral. Business
borrowers may use equipment or accounts receivable to secure a loan, while individual debtors often pledge
savings, a vehicle, or a home as collateral.

Cs of Credit
Read more:
https://corporatefinanceinstitute.com/resources/c
ommercial-lending/5-cs-of-credit/


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CHECK-IN CODE

Credit Risk in Banking

• Understand what credit risk is?

BU7056 Credit, Lending and Risk Management

 Credit risk is the probability of a financial

BU7056 Credit, Lending and Risk Management

This type of risk involves the situation

Default can be due to the fall in credit

BU7056 Credit, Lending and Risk Management

• During such cases also the parties may fail

BU7056 Credit, Lending and Risk Management

BU7056 Credit, Lending and Risk Management

BU7056 Credit, Lending and Risk Management

BU7056 Credit, Lending and Risk Management

BU7056 Credit, Lending and Risk Management

BU7056 Credit, Lending and Risk Management

BU7056 Credit, Lending and Risk Management

BU7056 Credit, Lending and Risk Management

and other non-bank lenders to evaluate the creditworthiness of a

borrower, as well as the strength of an overall borrowing request.

BU7056 Credit, Lending and Risk Management

Character of the borrower: refers to a borrower's reputation or record regarding financial

BU7056 Credit, Lending and Risk Management

BU7056 Credit, Lending and Risk Management

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