Credit Risk

Management
OVERVIEW OF CREDIT RISK
MANAGEMENT
Learning Outcomes

§ Expose participants to the ‘what’ and ‘why’ of Credit

Risk Management: the risk landscape, key terms and
definitions, and the importance of sound credit risk
management.

§ Enhance participants’ understanding of their role as

officers to effectively mitigate the credit risk as it
impacts the Bank.

§ Expose participants to practical tools and strategies to

manage risks inherent in the Bank.
The Concept of Risk and Risk Management:

Risk
Life is all abound Do you
about everywhe agree?
risk! re in all
activities!
What is Risk & Enterprise Risk Management (ERM)?

§ Risk is the effect of uncertainty on objectives.

§ Risk is the expression of the likelihood and impact of an
event with the potential to influence the achievement of
an organization’s objectives.
§ Risk Management is the process of identifying, measuring,
prioritizing, monitoring and controlling risk, used in an
organization in developing strategies to achieve objectives.
§ It includes the prevention of potential problems, the early
detection of actual problems when they occur, and the
correction of the policies and procedures that permitted
the occurrence.
§ Enterprise risk management takes a holistic approach and
calls for management-level decision-making that may not
necessarily make sense for an individual business unit or
segment. Thus, instead of each business unit being
responsible for its own risk management, firm-wide
surveillance is given precedence.
Enterprise Risk Management Contd.

§ Enterprise risk management (ERM) is a methodology

that looks at risk management strategically from the
perspective of the entire firm or organization.

§ It is a top-down strategy that aims to identify, assess,

and prepare for potential losses, dangers, hazards, and
other potentials for harm that may interfere with an
organization's operations and objectives and/or lead
to losses.

§ It also often involves making the risk plan of action

available to all stakeholders as part of an annual
report. Industries as varied as aviation, construction,
public health, international development, energy,
finance, and insurance all have shifted to utilize ERM.
Potential Consequences of Unmanaged Risks

§ Poor Performance
§ Organizational decline
§ Inadequate Information
§ Significant Losses of Clients or Suppliers
§ Loss of Markets
§ Inefficient Use of resources
§ Loss of Morale
§ Obsolete or Unclear Strategies
§ Excessive Costs
Benefits of Risk Management

Better Protects the

Reassures
Service value of the
Stakeholders
Delivery banks assets

Improved Quick grasp

portfolio of new
quality Opportunities
Enterprise Risk Management: Different Perspectives

Regulatory • Compliance with prudential standards

• Capital Adequacy
Perspective • Qualitative Standards and Quantitative Standards

• Risk budgeting and risk based pricing

Strategic •
•
Risk appetite and risk limits
Management of volatility of earnings
Perspective • Achieve balance between capital efficiency and capital
adequacy

Best Practices • Global best practices

• Other regulatory practices
Perspective • Basel II, IFRS, COSO, and other global best practices
Three lines of Defence

First Line of • Functions that own and Manage risks: Operational

Management;

Defense • Day to day risk management, control and decision-making.

• Functions that oversee risks: Risk Management

Second Line Committees; Risk Management Department;

Compliance functions;

of Defense • Risk oversight, methodology review, policy formulation.

Assurance that risks are managed across the business
units.

Third Line of • Functions that provide independent assurance: Audit

Committee/Board; Internal Audit; External Audit;

Defense • Independent assurance on the effectiveness of the risk

management processes.

The different lines of defense involve all key stakeholders and thus focus on
creating a culture of placing risk management at the center of the organization
First Line of Defence

Operational Management

Management is responsible for:

§ Identifying risks within the day-to-day operations
§ Assessing the risks
§ Monitoring and ensuring controls put in place are enforced
§ Reporting risk indicators, effectiveness of controls

Front line staff should:

§ Understand their roles and responsibilities

§ Implement policies and procedures
§ Apply risk controls
Second Line of Defence

Risk Management and Compliance Functions: These functions operate

independently from operations and complement operations by:

§ Reviewing business units from a risk perspective

§ Monitoring to ensure compliance to controls

§ Participating in business units risk meetings

§ Analyzing risk reports

§ Combination of watchdog and trusted advisor

§ Enforce limits and actively challenge business

§ Develop methodologies and tools to monitor risk

§ Overarching “risk oversight unit” across all risk types

Third Line of Defence

Audit Committee, Internal Audit and External Audit These functions

provide independent assurance:

§ They regularly review the work of the first and second line of defense;
§ Internal audit provides assurance on the effectiveness of governance,
risk management, and internal controls, including the manner in which
the first and second lines of defense achieve risk management and
control objectives.
Risk Management Framework

Operational Market Risk

Risk
Fraud Liquidity
Credit
Personnel Interest
Risk Rate
Competition
Default /
Systems Foreign
Repayment
Concentration Political Exchange
Security Assets &
Regulatory Liabilities
Credit Risk

Risk of loss incurred

Failure of clients to
by any institution Due to:
repay their debts
that provides credit

An MFIs entire loan portfolio is exposed to Credit Risk.

Credit risk is more significant in microfinance due to
the following reasons;
§ Working with economically vulnerable segment of
population
§ Lack of conventional guarantees and client credit
history
§ Concentration of loan portfolio in certain sectors
§ High systemic or “contagious” risk
§ Main incentive to repay is access to the next loan
Credit Risk Management
Managing Credit Risk: Portfolio or Enterprise Level
Managing Credit Risk: Customer Level
Benefits of Credit Risk Assessments
Risk Treatment Response

Risk response planning is the process of developing options and determining actions to enhance opportunities
and reduce threats to the project`s objectives. It includes identification and assignment of individuals or parties
to take responsibility for each agreed risk response. This process ensures that identified risks are properly
addressed. The effectiveness of response planning will directly determine whether risk increases or decreases.
Risk response planning must be appropriate to the severity of the risk, cost effective in meeting the challenge,
timely to be successful, realistic within the project context, agreed upon by all parties involved, and owned by a
responsible person. Selecting the best risk response from several options is often required.All techniques to
manage risk fall into one or more of these four major categories:

§ Avoidance (eliminate): Means walking away from the risk. Not performing an activity that carry risk. This is
usually a costly option given the fact that investment has been made before reaching the point of the
decision.

§ Control (mitigate, reduction). Strategy to reduce the severity of the loss or the likelihood of the loss from
occurring e.g. product line diversification, operating an offsite IT location etc.

§ Acceptance (retention): This is the strategy of taking no action. E.g self insurance. Essentially, an
organization should look at a risk likelihood and impact in the light of its established risk tolerance and
then decide whether or not to accept that risk.

§ Transference (sharing, insure, outsourcing): Virtually, all organizations or individual regularly share some of
their risks by purchasing insurance to hedge or share their risks.
Credit Risk Monitoring & Reporting
There should be an effective management information system (MIS) to
monitor risk levels and facilitate timely review of risk positions and
exceptions.

§ The reports should be frequent, timely, accurate, and informative.

§ It should provide a good feedback system to elicit action.

§ The monitoring process should provide assurance that there are

appropriate controls in place for the organization’s activities and that
the procedures are understood and followed.
Questions
LOAN PORTFOLIO FUNDAMENTALS
Learning Outcomes

q Expose participants to the ‘what’ and ‘why’ of Loan

Portfolio Management

q Enhance participants’ understanding of their role as

Relationship Managers to effectively mitigate
portfolio/credit risk.

q Understand the rationale for Portfolio Monitoring

q Expose participants to practical tools and strategies to

manage loan portfolio effectively.
The Concept of Credit & Loan:

q Credit is defined as “the provision of or

commitment to provide funds on an
unsecured or a secured basis to a debtor
who is obliged to repay on demand OR at
a fixed or determinable future , the
amount borrowed together with fees
and/or interest payable.
Types of Credit/Loans

q Business Loans

q Overdraft

q Consumer Loans

q Payroll Lending

q Agricultural Loans

q Green Financing

q SME Financing
The Rationale for Portfolio Monitoring

q Why are arrears a problem?

q Why is it important to maintain a good level of quality of the portfolio?
q What are consequences of high Arrears?

q Bad loan portfolio can spell doom and trigger credit crisis in an institution.
q The current economic downturn coupled with dwindling market have significant
implications for credit quality resulting to some banks carrying bad loans in their
risk asset.
q Relationship Managers tend to underplay the importance of credit controls and
administration in their lending function as they are seen as restrictive.
q Passive approach by Relationship Managers towards lending.
q A customer not monitored can divert original loan to riskier ventures which has
impact on loan repayment and bad debts for the bank.
q Bad debts lead to increased provisioning, reduced profitability, higher capital
allocation, increased regulatory oversight and reputational risk for the bank.
Common Reasons for NPLs

At Origination: ‘’If the foundation is After Disbursement:

weak , what can the righteous do?’’ q Lack of Attention to Early
q Lack of analytical depth of Problems Recognition
business-family environment q Poor monitoring by Credit Staff
q Deficiencies in financial analysis q Poor Controls
q Hasty decisions without q Lack of adequate, relevant and
analytical foundation timely reports.
q Lack of independence of mind q Management influence
on loan proposal/appraisal q Po o r s t a f f p e r f o r m a n c e
q Incomplete documentation in management system
borrower's file
q Disregard of banks credit policy
q Loan payment terms
q D e s i re t o a c h i eve t a r ge t by
Relationship Officers
Early Warning Indicators-Liquidity

q Increased credit inquiries about the q Third-party claims such as those

client due to the government or health
q Increased need for guaranteed care providers
payment to creditors q Payroll delayed or missed (a very
q Poor Credit reports from Credit serious situation)
Bureau q Increased collection activity either
q Returned items (goods) from by or against the client
deposits made by their clients q Frequent and sudden requests for a
q Returned cheques drawn on the temporary bulge or loan
client’s account accommodation
q Operating loans fully utilized for q Operating loan covenants squeezed
extended periods or actually out of covenant
q Operating Loans over their limit q Any inappropriate trend relative to
q Increased litigation against the events, for example, a fully used
client operating loan inconsistent with
sales or credit policy
Early Warning Indicators-Profitability

Attention should be paid to the following:

q Account Receivables

q Account Payables

q Stock / Inventory
Strategic Approach to Portfolio Management

Constant Monitoring

“Carrots” “Sticks”

q Access to future loan q R e c ov e r y a c t i o n s b y

q Repayment Incentives Staff
q S i m p l e p r o c e s s f o r q Penalty Fees
repeat borrowers q Contract enforcement
through lawyer
The importance of Managing Client Relationship

q Relationship assures repayment

q Recurrent loans are easier and
thus cheaper
q Recurrent loans are more secure
q Satisfied clients are the best
promotion

q A good client relationship is

important even after a client
delays
q Loan officer work s t o h e l p a
c l i e n t m a i n t a i n g o o d c re d i t
history
RACI Chart-Responsibility Assignment Matrix

Responsibility for Scope of NPL Reporting

Defaulting Loans Operations
Credit Officer
Branch Manager
Recovery Officer
Risk Management
External Recovery

The Importance of An Arrears Committee;

q To uncover the weaknesses of loan analysis

q To determine the impact of delinquency of each loan
officer within institution’s portfolio
q To assess the effectiveness of the collection process
q To design actions for the recovery of the loan
Strategies on Loan Portfolio Management

q Regular review of financial statements

q Compliance with loan agreements-without close monitoring breach of loan

agreements (missed repayments) may be undetected which could
endanger the banks exposure

q Periodic on the spot assessment visits to the customer business

q Turnover trends

q Venture into new business and geographical regions

q Change in lifestyle of the customer

Strategies for Minimizing Arrears & Default

q Establish a target level acceptable arrears based on the cost and effects of
delinquency on lending
q Set realistic but demanding goals for reducing delinquency to acceptable levels
q Most arrears are not caused by bad borrowers, but by poorly implemented credit
methodology
q Create an image and philosophy of zero tolerance for arrears
q Weed out those with bad intentions/ reputation, and ensure that loan sizes and
terms do not make repayments difficult
q Benefits of on-time repayment & cost of late repayment from the borrowers’
perspective should far outweigh the benefit of late repayment and cost of on -time
repayment
q Develop MIS that enables timely & useful analysis of portfolio quality, determine
trends in the portfolio overtime, & identify possible causes of arrears.
q Avail Information that enables officers to conduct effective and timely follow-up of
the loans so as to manage their portfolios efficiently.
q Establish prudent loan loss reserve and write-off policies
Desired Institutional Culture

q High ethical standard q Evaluating the internal control of a

microfinance institution is the
q E n v i r o n m e n t b a s e d o n h o n e s t y, responsibility of everyone
accountability

q Compliance with policies

q Free flow of information

q Team working approach

q Learning philosophy

q Address possibility of fraud, not ignore

it
Ensuring Compliance

q Policies should be written

q Policies should be Simple/Clear

q Policies should be Available

q Policies should be Understood

q Policies should be Relevant

q Policies should be Up To Date

q Policies should be Implemented

q Reward for Compliance

q Sanction for non-compliant

What is (Automated Credit Scoring)

q Credit scoring (and its automation) is a systematic and trackable way to determine
the relative amount of risk a potential borrower. A credit score is a number that
rates the likelihood an individual will pay back a loan.
Uses of Credit Score

Loan application approval decision (fully automated or partially automated)

Behavioral tracking (using credit scores) for loan performance

Loan classification for risk management

Business development, e.g., cross selling

Loan pricing and automated limit adjustment

Advantages of Automated Credit Scoring

q Speed – loan application or loans can be evaluated in seconds.

q Productivity and efficiency - Large amount of information are handled easily to
allow the organization to be more productive and efficient.
q Consistency and accuracy – Human error is essentially eliminated, while
ensuring consistency and standardization of the credit analysis across the
organization
q Decide whether to extend credit, and how much credit to extend.
q Forecast the future behavior of a new credit applicant by predicting loan
default chances or poor repayment behaviors at the time the credit is granted
q Predict the future payment behavior of existing debtors in order to
identify/isolate bad customers to direct more attention and assistance to them
q Evaluates the recovery rate of severely delinquent or written off accounts and
can be used for pricing a portfolio
q Lower non-performing loans (NPLs) and reduced of collection cost
q Lower loss provisions and higher recovery rate
Example of Simplified Credit Scoring Solution
Questions
 Jacob Enamaye, Lisa Odiwe
08035271933, 08165485009
[email protected]