Ch05 Financial Advisers Credit Risk.docx

FINANCIAL ADVISERS & CREDIT RISK AND RISK IN OUR SOCIETY Meaning of Risk Risk: Uncertainty concerning the occurrence of a loss Objective Risk vs. Subjective Risk – Objective risk is defined as the relative variation of actual loss from expected loss It can be statistically calculated using a measure of dispersion, such as the standard deviation – Subjective risk is defined as uncertainty based on a person’s mental condition or state of mind Two persons in the same situation may have different perceptions of risk High subjective risk often results in conservative behavior Chance of loss: The probability that an event will occur Objective Probability vs. Subjective Probability – Objective probability refers to the long-run relative frequency of an event assuming an infinite number of observations and no change in the underlying conditions It can be determined by deductive or inductive reasoning – Subjective probability is the individual’s personal estimate of the chance of loss A person’s perception of the chance of loss may differ from the objective probability Peril and Hazard A peril is defined as the cause of the loss – In an auto accident, the collision is the peril A hazard is a condition that increases the chance of loss – Physical hazards are physical conditions that increase the chance of loss (icy roads, defective wiring) – Moral hazard is dishonesty or character defects in an individual, that increase the chance of loss (faking accidents, inflating claim amounts) – Morale Hazard is carelessness or indifference to a loss because of the existence of insurance (leaving keys in an unlocked car) – Legal Hazard refers to characteristics of the legal system or regulatory environment that increase the chance of loss (large damage awards in liability lawsuits) Basic Categories of Risk Pure and Speculative Risk – A pure risk is one in which there are only the possibilities of loss or no loss (earthquake) – A speculative risk is one in which both profit or loss are possible (gambling) Fundamental and Particular Risk – A fundamental risk affects the entire economy or large numbers of persons or groups (hurricane) – A particular risk affects only the individual (car theft) Enterprise Risk – Enterprise risk encompasses all major risks faced by a business firm, which include: pure risk, speculative risk, strategic risk, operational risk, and financial risk Types of Pure Risks Personal risks involve the possibility of a loss or reduction in income, extra expenses or depletion of financial assets: – Premature death of family head – Insufficient income during retirement Most workers are not saving enough for a comfortable retirement – Poor health (catastrophic medical bills and loss of earned income) – Involuntary unemployment Property risks involve the possibility of losses associated with the destruction or theft of property: – Physical damage to home and personal property from fire, tornado, vandalism, or other causes Direct loss vs. indirect loss – A direct loss is a financial loss that results from the physical damage, destruction, or theft of the property, such as fire damage to a restaurant – An indirect loss results indirectly from the occurrence of a direct physical damage or theft loss, such as lost profits due to inability to operate after a fire Liability risks involve the possibility of being held liable for bodily injury or property damage to someone else – There is no maximum upper limit with respect to the amount of the loss – A lien can be placed on your income and financial assets – Defense costs can be enormous Burden of Risk on Society The presence of risk results in three major burdens on society: – In the absence of insurance, individuals would have to maintain large emergency funds – The risk of a liability lawsuit may discourage innovation, depriving society of certain goods and services – Risk causes worry and fear Methods of Handling Risk Avoidance Loss control – Loss prevention refers to activities to reduce the frequency of losses – Loss reduction refers to activities to reduce the severity of losses Retention – An individual or firm retains all or part of a loss – Loss retention may be active or passive Non-insurance transfers – A risk may be transferred to another party through contracts, hedging, or incorporation Insurance Definition of Insurance Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insured for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk Basic Characteristics of Insurance Pooling of losses – Spreading losses incurred by the few over the entire group – Risk reduction based on the Law of Large Numbers Payment of fortuitous losses – Insurance pays for losses that are unforeseen, unexpected, and occur as a result of chance Risk transfer – A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position Indemnification – The insured is restored to his or her approximate financial position prior to the occurrence of the loss Requirements of an Insurable Risk Large number of exposure units – to predict average loss Accidental and unintentional loss – to control moral hazard – to assure randomness Determinable and measurable loss – to facilitate loss adjustment insurer must be able to determine if the loss is covered and if so, how much should be paid. No catastrophic loss – to allow the pooling technique to work – exposures to catastrophic loss can be managed by: dispersing coverage over a large geographic area using reinsurance catastrophe bonds Calculable chance of loss – to establish an adequate premium Economically feasible premium – so people can afford to buy – Premium must be substantially less than the face value of the policy Based on these requirements: – Most personal, property and liability risks can be insured – Market risks, financial risks, production risks and political risks are difficult to insure Adverse Selection and Insurance Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates If not controlled, adverse selection result in higher-than-expected loss levels Adverse selection can be controlled by: – careful underwriting (selection and classification of applicants for insurance) – policy provisions (e.g., suicide clause in life insurance) Insurance vs. Gambling Insurance Insurance is a technique for handing an already existing pure risk Insurance is socially productive: – both parties have a common interest in the prevention of a loss Gambling Gambling creates a new speculative risk Gambling is not socially productive – The winner’s gain comes at the expense of the loser Insurance vs. Hedging Insurance Risk is transferred by a contract Insurance involves the transfer of insurable risks Insurance can reduce the objective risk of an insurer through the Law of Large Numbers Hedging Risk is transferred by a contract Hedging involves risks that are typically uninsurable Hedging does not result in reduced risk Types of Insurance Private Insurance – Life and Health – Property and Liability Government Insurance – Social Insurance – Other Government Insurance Private Insurance Life and Health – Life insurance pays death benefits to beneficiaries when the insured dies – Health insurance covers medical expenses because of sickness or injury – Disability plans pay income benefits Property and Liability – Property insurance indemnifies property owners against the loss or damage of real or personal property – Liability insurance covers the insured’s legal liability arising out of property damage or bodily injury to others – Casualty insurance refers to insurance that covers whatever is not covered by fire, marine, and life insurance Private insurance coverages can be grouped into two major categories – Personal lines coverages that insure the real estate and personal property of individuals and families or provide protection against legal liability – Commercial lines coverages for business firms, nonprofit organizations, and government agencies Property and Casualty Insurance Coverages 3175159385 -1691640114935 Government Insurance Social Insurance Programs – Financed entirely or in large part by contributions from employers and/or employees – Benefits are heavily weighted in favor of low-income groups – Eligibility and benefits are prescribed by statute – Examples: Social Security, Unemployment, Workers Comp Other Government Insurance Programs – Found at both the federal and state level – Examples: Federal flood insurance, state health insurance pools Social Benefits of Insurance Indemnification for Loss – Contributes to family and business stability Reduction of Worry and Fear – Insureds are less worried about losses Source of Investment Funds – Premiums may be invested, promoting economic growth Loss Prevention – Insurers support loss-prevention activities that reduce direct and indirect losses Enhancement of Credit – Insured individuals are better credit risks than individuals without insurance Social Costs of Insurance Cost of Doing Business – Insurers consume resources in providing insurance to society – An expense loading is the amount needed to pay all expenses, including commissions, general administrative expenses, state premium taxes, acquisition expenses, and an allowance for contingencies and profit Fraudulent and Inflated Claims – Payment of fraudulent or inflated claims results in higher premiums to all insureds, thus reducing disposable income and consumption of other goods andservices ESTABLISHING AN APPROPRIATE CREDIT RISK ENVIRONMENT (CONT.) Banks should establish overall credit limits at the level of individual borrowers and counterparties, and groups of connected counterparties that aggregate in comparable and meaningful manner different types of exposures, both in the banking and trading book and on and off the balance sheet. An important element of credit risk management is the establishment of exposure limits on single counterparties and groups of connected counterparties. Such limits are usually based in part on the internal risk rating assigned to the borrower or counterparty, with counterparties assigned better risk ratings having potentially higher limits. Limits should also be established for particular industries or economic sectors, geographic regions and specific products. Such limits are needed in all areas of the bank’s activities that involve credit risk. These limits will help to ensure that the bank’s credit-granting activities are adequately diversified. As mentioned earlier, much of the credit exposure faced by some banks comes from activities and instruments in the trading book and off the balance sheet. Limits on such transactions are particularly effective in managing the overall credit risk or counterparty risk of a bank. In order to be effective, limits should generally be binding and not driven by customer demand. Effective measures of potential future exposure are essential for the establishment of meaningful limits, placing an upper bound on the overall scale of activity with, and exposure to, a given counterparty, based on a comparable measure of exposure across a bank’s various activities (both on and off-balance-sheet). Banks should consider the results of stress testing in the overall limit setting and monitoring process. Such stress testing should take into consideration economic cycles, interest rate and other market movements, and liquidity conditions. Bank’s credit limits should recognize and reflect the risks associated with the near term liquidation of positions in the event of counterparty default. Where a bank has several transactions with a counterparty, its potential exposure to that counterparty is likely to vary significantly and discontinuously over the maturity over which it is calculated. Potential future exposures should therefore be calculated over multiple time horizons. Limits should also factor in any unsecured exposure in a liquidation scenario. Banks should monitor actual exposures against established limits and have in place procedures for increasing monitoring and taking appropriate action as such limits are approached. Many individuals within a bank are involved in the credit-granting process. These include individuals from the business origination function, the credit analysis function and the credit approval function. In addition, the same counterparty may be approaching several different areas of the bank for various forms of credit. Banks may choose to assign responsibilities in different ways; however, it is important that the credit granting process coordinate the efforts of all of the various individuals in order to ensure that sound credit decisions are made. In order to maintain a sound credit portfolio, a bank must have an established formal evaluation and approval process for the granting of credits. Approvals should be made in accordance with the bank’s written guidelines and granted by the appropriate level of management. There should be a clear audit trail documenting that the approval process was complied with and identifying the individual (s) and/or committee (s) providing input as well as making the credit decision. Banks often benefit from the establishment of specialist credit groups to analyze and approve credits related to significant product lines, types of credit facilities and industrial and geographic sectors. Banks should invest in adequate credit decision resources so that they are able to make sound credit decisions consistent with their credit strategy and meet competitive time and structuring pressures. Each credit proposal should be subject to careful analysis by a credit analyst with expertise commensurate with the size and complexity of the transaction. An effective evaluation process establishes minimum requirements for the information on which the analysis is to be based. There should be policies in place regarding the information and documentation needed to approve new credits, renew existing credits and/or change the terms and conditions of previously approved credits. The information received will be the basis for any internal evaluation or rating assigned to the credit andits accuracy and adequacy is critical to management making appropriate judgments about the acceptability of the credit. Credit Analysis & Risk Management – Banks must develop a corps of experienced officers who have the experience, knowledge and background to exercise prudent judgment in taking credit risks. A bank’s credit-granting approval process should establish accountability for decisions taken and designate who has the authority to approve credits or changes in credit terms. Banks typically utilize a combination of individual signature authority, dual or joint authorities, and a credit approval group or committee, depending upon the size and nature of the credit. Approval authorities should be commensurate with the expertise of the individuals involved. All extensions of credit must be made on an arm’s-length basis. In particular, credits to related companies and individuals must be monitored with particular care and other appropriate steps taken to control or mitigate the risks of connected lending. Extensions of credit should be made subject to the criteria and processes described above. These create a system of checks and balances that promote sound credit decisions. Therefore, directors, senior management and other influential parties (e.g. shareholders) should not seek to override the established credit-granting and monitoring processes of the bank. A potential area of abuse arises from granting credit to connected and related parties, whether companies or individuals. Consequently, it is important that banks grant credit to such parties on an arm’s-length basis and that the amount of credit granted is monitored. Such controls are most easily implemented by requiring that the terms and conditions of such credits not be more favorable than credit granted to non-related borrowers under similar circumstances and by imposing strict limits on such credits. Another method of control is the public disclosure of the terms of credits granted to related parties. The bank’s credit-granting criteria should not be altered to accommodate related companies and individuals. Material transactions with related parties should be subject to the approval of the board of directors (excluding board members with conflicts of interest), and in certain circumstances (e.g. a large loan to a major shareholder) reported to the banking supervisory authorities. CREDIT ADMINISTRATION, MEASUREMENT & MONITORING PROCESS Principle 1: Banks should have in place a system for the ongoing administration of their various credit risk-bearing portfolios. Credit administration is a critical element in maintaining the safety and soundness of a bank. Once a credit is granted, it is the responsibility of the business function, often in conjunction with a credit administration support team, to ensure that the credit is properly maintained. This includes keeping the credit file up to date, obtaining current financial information, sending out renewal notices and preparing various documents such as loan agreements. Given the wide range of responsibilities of the credit administration function, its organizational structure varies with the size and sophistication of the bank. In larger banks, responsibilities for the various components of credit administration are usually assigned to different departments. In smaller banks, a few individuals might handle several of the functional areas. Where individuals perform such sensitive functions as custody of key documents, wiring out funds, or entering limits into the computer database, they should report to managers who are independent of the business origination and credit approval processes. In developing their credit administration areas, banks should ensure: the efficiency and effectiveness of credit administration operations, including monitoring documentation, contractual requirements, legal covenants, collateral, etc.; the accuracy and timeliness of information provided to management information systems; the adequacy of controls over all “back office” procedures; and compliance with prescribed management policies and procedures as well as applicable laws and regulations. For the various components of credit administration to function appropriately, senior management must understand and demonstrate that it recognises the importance of this element of monitoring and controlling credit risk. The credit files should include all of the information necessary to ascertain the current financial condition of the borrower or counterparty as well as sufficient information to track the decisions made and the history of the credit. For example, the credit files should include current financial statements, financial analyses and internal rating documentation, internal memoranda, reference letters, and appraisals. The loan review function should determine that the credit files are complete and that all loan approvals and other necessary documents have been obtained. Principle 2: Banks must have in place a system for monitoring the condition of individual credits, including determining the adequacy of provisions and reserves. Banks need to develop and implement comprehensive procedures and information systems to monitor the condition of individual credits and single obligors across the bank’s various portfolios. These procedures need to define criteria for identifying and reporting potential problem credits and other transactions to ensure that they are subject to more frequent monitoring as well as possible corrective action, classification and/or provisioning. An effective credit monitoring system will include measures to: ensure that the bank understands the current financial condition of the borrower or counterparty; ensure that all credits are in compliance with existing covenants; follow the use customers make of approved credit lines; ensure that projected cash flows on major credits meet debt servicing requirements; ensure that, where applicable, collateral provides adequate coverage relative to the obligor’s current condition; and identify and classify potential problem credits on a timely basis. Specific individuals should be responsible for monitoring credit quality; including ensuring that relevant information is passed to those responsible for assigning internal risk ratings to the credit. In addition, individuals should be made responsible for monitoring on an ongoing basis any underlying collateral and guarantees. Such monitoring will assist the bank in making necessary changes to contractual arrangements as well as maintaining adequate reserves for credit losses. In assigning these responsibilities, bank management should recognize the potential for conflicts of interest, especially for personnel who are judged and rewarded on such indicators as loan volume, portfolio quality or short-term profitability. Principle 3: Banks should develop and utilize internal risk rating systems in managing credit risk. The rating system should be consistent with the nature, size and complexity of a bank’s activities. An important tool in monitoring the quality of individual credits, as well as the total portfolio, is the use of an internal risk rating system. A well-structured internal risk rating system is a good means of differentiating the degree of credit risk in the different credit exposures of a bank. This will allow more accurate determination of the overall characteristics of the credit portfolio, concentrations, problem credits, and the adequacy of loan loss reserves. More detailed and sophisticated internal risk rating systems, used primarily at larger banks, can also be used to determine internal capital allocation, pricing of credits, and profitability of transactions and relationships. Typically, an internal risk rating system categorizes credits into various classes designed to take into account the gradations in risk. Simpler systems might be based on several categories ranging from satisfactory to unsatisfactory; however, more meaningful systems will have numerous gradations for credits considered satisfactory in order to truly differentiate the relative credit risk they pose. In developing their systems, banks must decide whether to rate the riskiness of the borrower or counterparty, the risks associated with a specific transaction, or both. Internal risk ratings are an important tool in monitoring and controlling credit risk. In order to facilitate early identification, the bank’s internal risk rating system should be responsive to indicators of potential or actual deterioration in credit risk. Credits with deteriorating ratings should be subject to additional oversight and monitoring, for example, through more frequent visits from credit officers and inclusion on a watchlist that is regularly reviewed by senior management. The internal risk ratings can be used by line management in different departments to track the current characteristics of the credit portfolio and Help determine necessary changes to the credit strategy of the bank. Consequently, it is important that the board of directors and senior management also receive periodic reports on the condition of the credit portfolios based on such ratings. The ratings assigned to individual borrowers or counterparties at the time the credit is granted must be reviewed on a periodic basis and individual credits should be assigned a new rating when conditions either improve or deteriorate. Because of the importance of ensuring that internal ratings are consistent and accurately reflect the quality of individual credits, responsibility for setting or confirming such ratings should rest with a credit review function independent of that which originated the credit concerned. Principle 4: Banks must have information systems and analytical techniques that enable management to measure the credit risk inherent in all on- and off-balance sheet activities. The management information system should provide adequate information on the composition of the credit portfolio, including identification of any concentrations of risk. Banks should have methodologies that enable them to quantify the risk involved in exposures to individual borrowers or counterparties. Banks should also be able to analyze credit risk at the portfolio level in order to identify any particular sensitivities or concentrations. The measurement of credit risk should take account of: the specific nature of the credit (loan, derivative, facility, etc.) and its contractual and financial conditions (maturity, reference rate, etc.); the exposure profile until maturity in relation to potential market movements; the existence of collateral or guarantees; and(iv) the internal risk rating and its potential evolution during the duration of the exposure. The analysis of credit risk should be undertaken at an appropriate frequency with the results reviewed against relevant limits. Banks should use measurement techniques that are appropriate to the complexity and level of the risks involved in their activities, based on robust data, and subject to periodic validation. The effectiveness of a bank’s credit risk measurement process is highly dependent on the quality of management information systems. The information generated from such systems enables the board and all levels of management to fulfill their respective oversight roles, including determining the adequate level of capital that the bank should be holding. Therefore, the quality, detail and timeliness of information are critical. In particular, information on the composition and quality of the various portfolios, including on a consolidated basis, should permit management to assess quickly and accurately the level of credit risk that the bank has incurred through its various activities and determine whether the bank’s performance is meeting the credit risk strategy. It is also important that banks have a management information system in place to ensure that exposures approaching risk limits are brought to the attention of senior management. All exposures should be included in a risk limit measurement system. The bank’s information system should be able to aggregate credit exposures to individual borrowers and counterparties and report on exceptions to credit risk limits on a meaningful and timely basis. Banks should have information systems in place that enable management to identify any concentrations of risk within the credit portfolio. The adequacy of scope of information should be reviewed on a periodic basis by business line managers, senior management and the board of directors to ensure that it is sufficient to the complexity of the business. Increasingly, banks are also designing information systems that permit additional analysis of the credit portfolio, including stress testing. Principle 5: Banks must have in place a system for monitoring the overall composition and quality of the credit portfolio. Traditionally, banks have focused on oversight of individual credits in managing their overall credit risk. While this focus is important, banks also need to have in place a system for monitoring the overall composition and quality of the various credit portfolios. A continuing source of credit-related problems in banks is concentrations within the credit portfolio. Concentrations of risk can take many forms and can arise whenever a significant number of credits have similar risk characteristics. Concentrations occur when, among other things, a bank’s portfolio contains a high level of direct or indirect credits to a single counterparty, a group of connected counterparties11, a particular industry or economic sector, a geographic region, an individual foreign country or a group of countries whose economies are strongly interrelated, a type of credit facility, or a type of security. Concentrations also occur in credits with the same maturity. Concentrations can stem from more complex or subtle linkages among credits in the portfolio. The concentration of risk does not only apply to the granting of loans but to the whole range of banking activities that, by their nature, involve counterparty risk. A high level of concentration exposes the bank to adverse changes in the area in which the credits are concentrated. In many instances, due to a bank’s trade area, geographic location or lack of access to economically diverse borrowers or counterparties, avoiding or reducing concentrations may be extremely difficult. In addition, banks may want to capitalize on their expertise in a particular industry or economic sector. A bank may also determine that it is being adequately compensated for incurring certain concentrations of risk. Consequently, banks should not necessarily forego booking sound credits solely on the basis of concentration. Banks may need to make use of alternatives to reduce or mitigate concentrations. Such measures can include pricing for the additional risk, increased holdings of capital to compensate for the additional risks and making use of loan participations in order to reduce dependency on a particular sector of the economy or group of related borrowers. Banks must be careful not to enter into transactions with borrowers or counterparties they do not know or engage in credit activities they do not fully understand simply for the sake of diversification. Banks have new possibilities to manage credit concentrations and other portfolio issues. These include such mechanisms as loan sales, credit derivatives, securitization programs and other secondary loan markets. However, mechanisms to deal with portfolio. Concentration issues involve risks that must also be identified and managed. Consequently, when banks decide to utilize these mechanisms, they need to have policies and procedures, as well as adequate controls, in place. Principle 7: Banks should take into consideration potential future changes in economic conditions when assessing individual credits and their credit portfolios, and should assess their credit risk exposures under stressful conditions. An important element of sound credit risk management involves discussing what could potentially go wrong with individual credits and within the various credit portfolios, and factoring this information into the analysis of the adequacy of capital and provisions. This “what if” exercise can reveal previously undetected areas of potential credit risk exposure for the bank. The linkages between different categories of risk that are likely to emerge in times of crisis should be fully understood. In case of adverse circumstances, there may be a substantial correlation of various risks, especially credit and market risk. Scenario analysis and stress testing are useful ways of assessing areas of potential problems. Stress testing should involve identifying possible events or future changes in economic conditions that could have un-favourable effects on a bank’s credit exposures and assessing the bank’s ability to withstand such changes. Three areas that banks could usefully examine are: economic or industry downturns; market-risk events; and liquidity conditions. Stress testing can range from relatively simple alterations in assumptions about one or more financial, structural or economic variables to the use of highly sophisticated financial models. Typically, the latter are used by large, internationally active banks. Whatever the method of stress testing used, the output of the tests should be reviewed periodically by senior management and appropriate action taken in cases where the results exceed agreed tolerances. The output should also be incorporated into the process for assigning and updating policies and limits. The bank should attempt to identify the types of situations, such as economic downturns, both in the whole economy or in particular sectors, higher than expected levels of delinquencies and defaults, or the combinations of credit and market events that could produce substantial losses or liquidity problems. Such an analysis should be done on a consolidated basis. Stress-test analyses should also include contingency plans regarding actions management might take given certain scenarios. These can include such techniques as hedging against the outcome or reducing the size of the exposure. Ensuring Adequate Controls over Credit Risk Principle 8: Banks should establish a system of independent, ongoing credit review and the results of such reviews should be communicated directly to the board of directors and senior management. Because individuals throughout a bank have the authority to grant credit, the bank should have an efficient internal review and reporting system in order to manage effectively the bank’s various portfolios. This system should provide the board of directors and senior management with sufficient information to evaluate the performance of account officers and the condition of the credit portfolio. Internal credit reviews conducted by individuals independent from the business function provide an important assessment of individual credits and the overall quality of the credit portfolio. Such a credit review function can help evaluate the overall credit administration process, & determine the accuracy of internal risk ratings and judge whether the account officer is properly monitoring individual credits. The credit review function should report directly to the board of directors, a committee with audit responsibilities, or senior management without lending authority. Principle 9: Banks must ensure that the credit-granting function is being properly managed and that credit exposures are within levels consistent with prudential standards and internal limits. Banks should establish and enforce internal controls and other practices to ensure that exceptions to policies, procedures and limits are reported in a timely manner to the appropriate level of management. The goal of credit risk management is to maintain a bank’s credit risk exposure within parameters set by the board of directors and senior management. The establishment and enforcement of internal controls, operating limits and other practices will help ensure that credit risk exposures do not exceed levels acceptable to the individual bank. Such a system will enable bank management to monitor adherence to the established credit policies. Limit systems should ensure that granting of credit exceeding certain predetermined levels receive prompt management attention. An appropriate limit system should enable management to control credit risk exposures, initiate discussion about opportunities and risks, and monitor actual risk taking against predetermined credit risk tolerances. Internal audits of the credit risk processes should be conducted on a periodic basis to determine that credit activities are in compliance with the bank’s credit policies and procedures, that credits are authorized within the guidelines established by the bank’s board of directors and that the existence, quality and value of individual credits are accurately being reported to senior management. Such audits should also be used to identify areas of weakness in the credit administration process, policies and procedures as well as any exceptions to policies, procedures and limits. Principle 10: Banks must have a system in place for managing problem credits and various other workout situations. One reason for establishing a systematic credit review process is to identify weakened or problem credits. A reduction in credit quality should be recognized at an early stage when there may be more options available for improving the credit. A bank’s credit risk policies should clearly set out how the bank will manage problem credits. Banks differ on the methods and organization they use to manage problem credits. Responsibility for such credits may be assigned to the originating business function, a specialized workout section, or a combination of the two, depending upon the size and nature of the credit and the reason for its problems. Effective workout programs are critical to managing risk in the portfolio. When a bank has significant credit-related problems, it is important to segregate the workout function from the area that originated the credit. The additional resources, expertise and more concentrated focus of a specialized workout section normally improve collection results. A workout section can help develop an effective strategy to rehabilitate a troubled credit or to increase the amount of repayment ultimately collected. An experienced workout section can also provide valuable input into any credit restructurings organized by the business function. The Role of Supervisors Principle 1: Supervisors should require that banks have an effective system in place to identify, measure, monitor and control credit risk as part of an overall approach to risk management. Supervisors should conduct an independent evaluation of a bank’s strategies, policies, practices and procedures related to the granting of credit and the ongoing management of the portfolio. Supervisors should consider setting prudential limits to restrict bank exposures to single borrowers or groups of connected counterparties. Although the board of directors and senior management bear the ultimate responsibility for an effective system of credit risk management, supervisors should, as part of their ongoing supervisory activities, assess the system in place at individual banks to identify, measure, monitor and control credit risk. This should include an assessment of any measurement tools (such as internal risk ratings and credit risk models) used by the bank. In addition, they should determine that the board of directors effectivelyoversees the credit risk management process of the bank and that management monitors risk positions, and compliance with and appropriateness of policies. Supervisors should take particular note of whether bank management recognises problem credits at an early stage and takes the appropriate actions. Supervisors should monitor trends within a bank’s overall credit portfolio and discuss with senior management any marked deterioration. Supervisors should also assess whether the capital of the bank, in addition to its provisions and reserves, is adequate related to the level of credit risk inherent in the bank’s various on- and off-balance sheet activities. In reviewing the adequacy of the credit risk management process, home country supervisors should also determine that the process is effective across business lines, subsidiaries and national boundaries. It is important that supervisors evaluate the credit risk management system not only at the level of individual businesses or legal entities but also across the wide spectrum of activities and subsidiaries within the consolidated banking organization. Supervisors should consider setting prudential limits (e.g., large exposure limits) that would apply to all banks, irrespective of the quality of their credit risk management process. Such limits would include restricting bank exposures to single borrowers or groups of connected counterparties. Supervisors may also want to impose certain reporting requirements for credits of a particular type or exceeding certain established levels. In particular, special attention needs to be paid to credits granted to “connected” counterparties. Common Sources of Major Credit Problems Most major banking problems have been either explicitly or indirectly caused by weaknesses in credit risk management. In supervisors’ experience, certain key problems tend to recur. Severe credit losses in a banking system usually reflect simultaneous problems in several areas, such as concentrations, failures of due diligence and inadequate monitoring. Banking supervisors should have specific regulations limiting concentrations to one borrower or set of related borrowers, and, in fact, should also expect banks to set much lower limits on single-obligor exposure. Most credit risk managers in banks also monitor industry concentrations. Many banks are exploring techniques to identify concentrations based on common risk factors or correlations among factors. While small banks may find it difficult not to be at or near limits on concentrations, very large banking organizations must recognize that, because of their large capital base, their exposures to single obligors can reach imprudent levels while remaining within regulatory limits. Credit Process Issues Many credit problems reveal basic weaknesses in the credit granting and monitoring processes. While shortcomings in underwriting and management of market-related credit exposures represent important sources of losses at banks, many credit problems would have been avoided or mitigated by a strong internal credit process. Many banks find carrying out a thorough credit assessment (or basic due diligence) a substantial challenge. For traditional bank lending, competitive pressures and the growth of loan syndication techniques create time constraints that interfere with basic due diligence. Globalization of credit markets increases the need for financial information based on sound accounting standards and timely macroeconomic and flow of funds data. When this information is not available or reliable, banks may dispense with financial and economic analysis and support credit decisions with simple indicators of credit quality, especially if they perceive a need to gain a competitive foothold in a rapidly growing foreign market. Finally, banks may need new types of information, such as risk measurements, and more frequent financial information, to assess relatively newer counterparties, such as institutional investors and highly leveraged institutions. The absence of testing and validation of new lending techniques is another important problem. Adoption of untested lending techniques in new or innovative areas of the market, especially techniquesthat dispense with sound principles of due diligence or traditional benchmarks for leverage, have led to serious problems at many banks. Sound practice calls for the application of basic principles to new types of credit activity. Any new technique involves uncertainty about its effectiveness. That uncertainty should be reflected in somewhat greater conservatism and corroborating indicators of credit quality. An example of the problem is the expanded use of credit-scoring models in consumer lending in the United States and some other countries. Large credit losses experienced by some banks for particular tranches of certain mass-marketed products indicate the potential for scoring weaknesses. Some credit problems arise from subjective decision-making by senior management of the bank. This includes extending credits to companies they own or with which they are affiliated, to personal friends, to persons with a reputation for financial acumen or to meet a personal agenda, such as cultivating special relationships with celebrities.