1. Credit Risk Dr Said Abu Jalala

2. Introduction Financial institutions have faced difficulties over the years for a multitude of reasons The major cause of serious banking problems continues to be directly related to low credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank's counterparties The major cause of serious banking problems continues to be directly related to low credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank's counterparties

3. Definitions Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest or both). Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.

4. Sources of Credit Risks Exposure to credit risk continues to be the leading source of problems in banks world-wide, banks and their supervisors should be able to draw useful lessons from past experiences. Banks should now have a keen awareness of the need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred.

5. Risks faced by lenders to consumers Most lenders employ their own (Credit Scorecards) models to rank potential and existing customers according to risk, and then apply appropriate strategies. With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa. With revolving products such as credit cards and overdrafts, risk is controlled through careful setting of credit limits. Some products also require security, most commonly in the form of property.

6. Risk faced by lenders to business Lenders will trade off the cost/benefits of a loan according to its risks and the interest charged. But interest rates are not the only method to compensate for risk. Protective covenants are written into loan agreements that allow the lender some controls. These covenants may: - limit the borrower's ability to weaken his balance sheet voluntarily e.g., by buying back shares, or paying dividends, or borrowing further. - allow for monitoring the debt by requiring audits, and monthly reports. - allow the lender to decide when he can recall the loan based on specific events or interest coverage deteriorate.

7. Risks faced by lenders to business A recent innovation to protect lenders from the danger of default are credit derivatives, most commonly in the form of a credit default swap. These financial contracts allow companies to buy protection against defaults from a third party, the protection seller. The protection seller receives a periodic fee (the credit spread) as compensation for the risk it takes, and in return it agrees to buy the debt should a credit event ("default") occur.

8. Risks faced by business Companies carry credit risk when, for example, they do not demand up-front cash payment for products or services. By delivering the product or service first and billing the customer later - if it's a business customer - the company is carrying a risk between the delivery and payment. Significant resources and sophisticated programs are used to analyze and manage risk.

9. Risks faced by business Some companies run a credit risk department whose job is to assess the financial health of their customers, and extend credit (or not) accordingly. They may use in house programs to advise on avoiding, reducing and transferring risk. They also use third party to provide such information for a fee.

10. Risks faced by business Example: A distributor selling its products to a troubled retailer may attempt to: - lessen credit risk by tightening payment terms, or - by actually selling fewer products on credit to the retailer, or - even cutting off credit entirely, and demanding payment in advance. Such strategies impact on sales volume but reduce exposure to credit risk and subsequent payment defaults.

11. Risks faced by business Credit risk is not really manageable for very small companies (i.e., those with only one or two customers). This makes these companies very vulnerable to defaults, or even payment delays by their customers. The use of a collection company is not really a tool to manage credit risk; rather, it is an extreme measure closer to a write down in that the creditor expects a below-agreed return after the collection agency takes its share (if it is able to get anything at all).

12. Credit risk related to the process of settling financial transactions If one side of a transaction is settled but the other fails, a loss may be incurred that is equal to the principal amount of the transaction. Even if one party is simply late in settling, then the other party may incur a loss relating to missed investment opportunities. Settlement risk (i.e. the risk that the completion or settlement of a financial transaction will fail to take place as expected) thus includes elements of liquidity, market, operational and reputational risk as well as credit risk. The level of risk is determined by the particular arrangements for settlement. Factors in such arrangements that have a bearing on credit risk include: the timing of the exchange of value and the role of intermediaries.

13. Credit risk management of credit risk management is to maximize a bank's risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. The goal of credit risk management is to maximize a bank's risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions.

14. Credit risk management Banks should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long- term success of any banking organization.

15. Credit risk management practices Establishing an appropriate credit risk environment; Operating under a sound credit-granting process; Maintaining an appropriate credit administration, measurement and monitoring process; and Ensuring adequate controls over credit risk. Although specific credit risk management practices may differ among banks depending upon the nature and complexity of their credit activities, a comprehensive credit risk management program will address these four areas.