Concept of Credit
Credit is defined by the Economist Dictionary of Economics as “the
use or possession of goods or services without immediate payment” and
it “enables a producer to bridge the gap between the production and
sale of goods” and “virtually all exchange in manufacturing, industry
and services is conducted on credit”.(Colquitt 2007)
Consequently, credit generates debt that a party owes the other.
The former is called a debtor or borrower. The latter is a creditor or
lender. Certainly the debtor will have to pay an extra amount of money
for delaying the payment. In that circle, both debtor and creditor
expect a return which is worth their paying more and waiting,
respectively.
Debtor Creditor: Pays the creditor extra money earned from
reinvestments of the credit amount Gives the debtor time and takes back
a return for supplying the credit So now it is clear why credit exists
and how important it is to the economy. Firms or individuals that run
short of capital need credit to continue or expand their
businesses/investments. The ones that have excess money, on the other
hand, never want to keep it in the safes. As a result, all are growing
and making more money.
Demand and supply together exist but do they meet each other? Here
borne financial intermediaries who act as the bridge between credit
suppliers and clients.
Now in this innovative phase of the global financial-services
industry, numerous types of financial institutions have joined the
credit supplier group: insurance companies, mutual funds, investment
finance companies, etc. (Colquitt 2007, 2)
Nevertheless, banks are still the dominant source that both individuals and corporates seek credit from.
In banking specifically, two primary kinds of credit services
based on customer categories are offered: retail credit and wholesale
credit. Lending in retail or personal banking are subject to
individuals and may fall under: home mortgages, installment loans (e.g.
consumer loans, educational loans, auto loans…), credit card revolving
loans, revolving credits (e.g. overdrafts), etc. (Crouhy et al. 2006,
207-208). Wholesale lending, on the other hand, involves firms as the
borrowers and therefore is of much higher value, more complicated and
poses more threats to the banks.
Concept of Credit Risk
Quite often in the previous sections of this paper, credit risk
has been mentioned or even defined. However, it still needs to be
repeated from a deeper point of view. Basically, it is understandable
that credit risk occurs when the debtor cannot repay part or whole of
the debt to the creditor as agreed in the mutual contract. More
formally, “credit risk arises whenever a lender is exposed to loss from a
borrower, counterparty, or an obligor who fails to honor their debt
obligation as they have agreed or contracted”. This loss may derive
from deterioration in the counterparty’s credit quality, which
consequently leads to a loss to the value of the debt. (Colquitt 2007)
Or in the worst case, the borrower defaults when he/she is unwilling or
unable to fulfill the obligations (Crouhy et al. 2006).
Risks in Banks
Risks are the uncertainties that can make the banks to loose and
be bankrupt. According to the Basel Accords, risks the banks facing
contain credit risk, market risk and operational risk. Credit risk is
the risk of loss due to an obligator's non-payment of an obligation in
terms of a loan or other lines of credit. The Basel committee proposes
two methodologies for calculating the capital requirements for credit
risk, one is to measure the credit risk in a standardized manner and
the other is subject to the explicit approval of the bank’s supervisor
and allows banks to use the IRB approach. Market risk is defined as the
risk of losses in on and off-balance sheet positions arising from
movements in market prices. The capital treatment for market risk
addresses the interest rate risk and equity risk pertaining to financial
instruments, and the foreign exchange risk in the trading and banking
books. The value at risk (VaR) approach is the most preferred to be
used when the market risk is measured. Operational risk is defined as
the risk of direct or indirect loss resulting from inadequate or failed
internal processes, people and systems or from external events. There
are three approaches applied to the operational risk measurement: Basic
Indicator Approach (BIA), Standardized Approach (SA), and Advanced
Measurement Approach (AMA).
The banking business, compared to other types of business, is
substantially exposed to risks, especially in this ever-changing
competitive environment. Banks no longer simply receive deposits and
make loans. Instead, they are operating in a rapidly innovative
industry with a lot of profit pressure that urges them to create more
and more value-added services to offer to and better satisfy the
customers.
Risks are much more complex now since one single activity can
involve several risks. Risks are inside risks. Risks overlap risks.
Risks contain risks. Scholars and analysts in recent decades have been
trying to group banking risks into categories. The Basel Accords issued
by the Basel Committee on Bank Supervision mention three broadest risk
types in the first pillar: credit, market and operational risks. Then
the second pillar deals with all other risks. Anthony (2009) categories
risks into six generic kinds: systematic or market risk (interest rate
risk), credit risk, counterparty risk, liquidity risk, operational
risk, and legal risks. This categorization is based on types of
services offered by banks. (The Wharton Financial Institutions Center
2007) But the risks seem to be insufficient and some overlapping can be
found. Counterparty risk and credit risk are quite alike or the list
lacks country risks, for example.
Another classification that is quite comprehensive though not
particularly aims at banks only is introduced in “The Essentials of
Risk Management” (2006) by Michel Crouhy, Dan Galai and Robert Mark.
Risk Management in Banks
As mentioned above, “risk is always bad as a false assumption and
can mislead the way people deal with risks. Eliminating each and every
risk definitely is not the way because risk is an unavoidable element
of life. Moreover there is a special relationship between risk and
reward. If you want a higher rate of return, be willing to take risks
and be tolerant of risks is a must. “The greater the risk, the greater
the gain.” (Spanish Proverb). “He who doesn?t risk never gets to drink
champagne.” (Russian Proverb) (Book Rags 2010)
The point is people know how to cope with, or in other words how
to control risks properly, responsibly, and in a business context,
profitably, beneficially and sustainably. That is the question risk
management must answer. Ordinary people also manage risks in different
ways. Nevertheless, risk management in organizations is more concerned.
Like risk, risk management has been attempted to define in various
ways. It may take pages to list all the definitions from the
literature. But there is one definition from the International
Organization for Standardization (ISO) that is typical and covers most
of general issues: “Risk management is a central part of any
organization’s strategic management. It is the process whereby
organizations methodically address the risks attaching to their
activities with the goal of achieving sustained benefit within each
activity and across the portfolio of all activities.” (IRM, 2002: )
The three key phrases in the sentences above are in bold. First,
risk management’s primary mission is to bring benefits to the companies
and makes them sustainable. Second, risk management is at the heart of
any firm’s strategy. The significance of risk management in an
organization’s activities was surprisingly ignored for a long time. It
used to be regarded as no more than insurance. It only started to catch
attention from business top executives in the 1990s after the enormous
derivatives disasters triggered in the United States that shook
Barings Bank, Procter & Gamble, Gibson Greetings, government of
Orange County - California, BankAmerica Corp. and many other giants
with loss of billions of dollars. (Culp, 2001: ix; Markham, 2002:
198-201). Third, risk management is an ongoing and continuously
developing process.
The need for risk management in the banking sector is inherent in
the nature of the banking business. Poor asset quality and low levels
of liquidity are the two major causes of bank failures. During periods
of increased uncertainty, financial institutions may decide to
diversify their portfolios and/or raise their liquid holdings in order
to reduce their risk. In terms of credit risk management, the goal is
to maximize a bank’s risk-adjusted rate of return by maintaining credit
risk exposure within acceptable parameters and the maximization of
shareholder value. Banks need to manage the credit risk inherent in the
entire portfolio as well as the risk in individual credits or
transactions. Banks should also consider the relationship between credit
risk and other risks, for example, the relationship between credit
risk, interest risk, liquidity risk, and market risk. The effective
management on credit risk is a critical component of a comprehensive
approach to risk management and essential to long-term success of any
banking organization.
Undeniably banking risk management in the modern business world
takes place in such a great scale and unexpected manner. On the one
hand, the creation and development of a number of risk instruments
allow higher risk diversification, better prediction and more effective
solutions to the potential dangers in the global financial market. On
the other hand, growing interactions among financial institutions in
the world make room for a possible sequential effect if something goes
wrong. The consequences might be “far beyond the doors of the banks and
investors themselves”. (Utrecht University 2010)