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Dissertation
Credit risk management system in a CB in the UK

Table of content

Table of content ................................................................................................................................... 1
List of figures 3
List of tables 4
Chapter 1. Introduction .................................................................................................................. 5
1.1 Research background ................................................................................................... 5
1.1.1 Credit risk management in banking sector..................................................................... 5
1.1.2 Historical trends in UK bank capital and credit ............................................................. 6
1.2 Research motivation and objectives ............................................................................. 8
1.3 Research structure ........................................................................................................ 8
Chapter 2. Literature Review......................................................................................................... 9
2.1 Credit risk of commercial banks .................................................................................. 9
2.1.1 Definition ....................................................................................................................... 9
2.1.2 Causes of credit risk ..................................................................................................... 10
2.2 Credit risk management of commercial banks........................................................... 14
2.2.1 Definition of credit risk management .......................................................................... 14
2.2.2 Objective of credit risk management ........................................................................... 14
2.2.3 Principles of credit risk management ........................................................................... 15
2.3 Credit risk management experience ........................................................................... 16
2.3.1 Organization model of credit operations...................................................................... 16
2.3.2 Business process .......................................................................................................... 17
Chapter 3. Methodology .............................................................................................................. 19
3.1 Research characteristics ............................................................................................. 19
3.2 Research Data ............................................................................................................ 20
3.2.1 Secondary Data ............................................................................................................ 20
3.2.2 Primary Data ................................................................................................................ 21
3.3 Data Collection Methods ........................................................................................... 22
Chapter 4. Results and Discussion .............................................................................................. 25
4.1 Credit risks to the UK banking system ...................................................................... 25
4.1.1 International risk .......................................................................................................... 26
4.1.2 Domestic risk ............................................................................................................... 29
4.2 Credit risks management practices in major UK banks ............................................. 35
4.2.1 RBS, Barclays practices ............................................................................................. 35
4.2.2 Bradford&Bingley Practices and Northern Rock ........................................................ 46
4.3 Expected credit management trend in UK banking sector......................................... 56
4.3.1 Credit Delinquencies .................................................................................................... 56
4.3.2 Credit Supply and Demand .......................................................................................... 57
4.3.3 Interest Rates ................................................................................................................ 58
4.3.4 Trends for 2013 ............................................................................................................ 59
4.3.5 Customer Management ................................................................................................ 59
Chapter 5. Conclusion ................................................................................................................. 61
References 63


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List of figures

Figure 1-1 Trends in lending and capital adequacy for the UK ............................................ 6
Figure 4-1 Major UK banks’ credit exposures to selected euro-area countries .................. 26
Figure 4-2 International GDP growth forecasts .................................................................. 27
Figure 4-3 Tier 1 capital ratios for selected European banking systems ............................ 30
Figure 4-4 UK household debt and capital gearing ............................................................ 32
Figure 4-5 UK household income gearing .......................................................................... 32
Figure 4-6 Arrears and possessions rates on secured lending to UK households ............... 33
Figure 4-7 Loan to value ratios on UK borrowers’ outstanding secured debt .................... 33
Figure 4-8 UK corporate debt and capital gearing .............................................................. 34
Figure 4-9 Ratio of total debt to total global turnover by UK company sector .................. 35
Figure 4-10 Major UK banks intra-system large exposure ................................................. 36
Figure 4-11 Predicting of credit supply and demand .......................................................... 58
Figure 4-11 Predicting of interest rates ............................................................................... 59
Figure 4-11 Credit risk management trend in 2013 ............................................................ 60
Figure 4-11 Predicting of customer management ............................................................... 61

List of tables

Table 4-1 Selected sovereign credit default swap premia .................................................. 24
Table 4-2 UK-owned banks’ foreign claims ...................................................................... 25

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Chapter 1. Introduction

1.1 Research background
1.1.1 Credit risk management in banking sector
Financial Institutions (FIs) play significant role in every single economy. The significance
of these institutions is considered as the blood artery of human body due to the function of
pumping other institutions and organization capital resources for the development and
economic growth (Blommestein and Spencer, 1993; Frey and Stutzer, 2001; Jackson, 2010).
Commercial banks (CBs) are financial institutions as well as main financial information
suppliers for any economy. They are especially important to emerging economies in which
the borrowers find it hard to access capital market (Hawkins and Mihaljek, 2001; Starr and
Yilmaz, 2007; Mondragon-Velez and Glen, 2011). It is proved that CBs with effective
functions contribute to improve economic growth; meanwhile, ineffective ones prevent
economic growth and even exacerbate the poverty, in literature (Khan, 2012; Liang and
Reichert, 2012; Miller, 2012).
Wetmore and Brick (2004) indicated that CBs may have to deal with three categories of
risks, including financial risk (credit risk), operational risk, and strategic risk, and as a
consequence, CBs’ performance will be affected. According to Altman and Saunders (1997),
the influence of credit risk on CBs is relatively huge and severe in comparison with other
factors, leading to the failure of the banks. Through years, the number of bank problems is
significantly increasing in not only matured economies but emerging ones as well. After
many studies, the researchers can identify the causes of these mentioned problems. Regarding
credit issues, the weakness of credit risk management (CRM) is attributed as one main cause
of banking trouble. Loans may contribute much to credit risk because the loans of the banks
are often 10 or 15 times higher than banks’ equity (Duffie and Singleton, 2003; Bessis,
2011). Accordingly, banks will have to deal with more difficulties due to such a small decline
in loan quality only. The root of poor loan quality comes from the mechanism of information
processing. According to the observations of Mondragon-Velez and Glen (2011), developing
nations are now dealing with these issues at the acute level. Kim et al. (2011) adds that these
problems start from the stage of loan application, and then expand at the stages of loan
approval, monitoring, and control when there is no existence of the guidelines of credit risk
management regarding credit processing policies or procedures or these guidelines are weak
or incomplete.
1.1.2 Historical trends in UK bank capital and credit
Reviewing the tendency about real credit activities of the UK in the last 25 years will aim
to reflect the stages of slowdown and in a broader range, to identify which factors
contributing to these stages of slowdown. According to Figure 1-1, there is the presentation
about credit activities (which contribute to GDP) as well as the risk-weighted capital ratio
among banks of the UK from Quarter IV of 1989 to end 2007. It is obviously shown that
there was a slowdown of the outstanding credit from early 1990s to 1996, and then, the
supply of credit went up again. And credit activities experienced such a rapid growth rate
during 2002 till 2008.

Source: Francis and Osborne (2012)
Figure 1-1 Trends in lending and capital adequacy for the UK
Between 1990 and 1991, economic output faced such a considerable decrease, and thus, it
contributed to one part of decreasing credit formation at the same time. Nevertheless, at that
time, there was obviously an upward trend of the risk-weighted capital ratios among banks.
The cause may possibly result from the advent of the Basel I capital mechanism during the
early 1990s. According to the Figure 1, high capital requirement under the context of the
Basel I might dampen the lending growth in the first years of the 1990s. One more
characteristic of those trends is the lack of corresponding capital increase to the non-risk-
weighted asset ratios at the same periods of time. Actually, it is noticeable that from 1989 to
2007, the increase of the risk-weighted ratios is relative to that of the non-risk-weighted
ratios. This reflects that banks made some adjustments to their balance sheets with a view to
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achieving the favourable treatment in the context of the Basel I mechanism. On the contrary,
the period of 1999-2007, there was a quick growth of credit activities contributing much to
GDP and it is in coincidence with the decline of the risk-weighted as well as the non-risk-
weighted capital ratios across the banking sector in the UK. These trends reveal that
increasing leverage across banking sector in the UK helps to sustain lending growth. Indeed,
according to global regulators, the credit boom generated from increasing leverage has been
considered as one key reason contributing to the beginning of financial crisis in 2007.
There are many different causes related to the changes of credit activities and thus, it is
hard to identify the impacts of capital requirements on these changes if the assessment just
relies on aggregate data only. Obviously, banks decrease the level of lending when facing
poor macroeconomic performance and thus, it will affect the level of bank capital.
Nevertheless, this is partially due to decreasing investment activities or profitable lending
chances, resulting in the drop of overall credit demand. Our study aims to clarify to what
extent banking sector decides to shift the loans supple as a measure to address such
increasing regulatory pressure on capital sufficiency.
Contraction credit supply in the 1990s as well as the time of 2008-2009 can be explained
by the “bank capital channel” in transmitting financial shock into real economy. It is because
there is no excess capital among banks and thus, sustaining the supply of credit during and
after the financial shocks faces many difficulties such as tighter capital regulations or
monetary policies, or the declines in the value of assets. Moreover, such an imperfect market
for bank equity does not exist, and thus, raising new capital costs banks much or credit
supply of banks may be affected by financial structure of banks Van den Heuvel, 2004).
Therefore, it is essential for banks for find out the optimal measures. For instance, raising the
regulatory capital standards can be done among banks with a view to reducing the growth in
the highly risk-weighted assets through the increase of lending rate, the requirement of high
collaterals, or the limit of credits at current rates. Those responses can possibly change
macroeconomic results when both businesses and consumers have high dependence on the
credits of banking sector.
1.2 Research motivation and objectives
Credit risk is considered as one of the basic risks that banks or financial intermediaries
often have to deal with (Altman and Saunders, 1997; Duffie and Singleton, 2003).
According to Podobnik et al. (2010), due to the fact that credit risk may force banks into
bankruptcy, the management and control of this risk has become the most predominant
challenge to run the banks. Credit risk management aims at achieving maximum risk-
adjusted rate of return based on the identification of credit risk in banking transactions and
portfolios and the control of credit risk exposure at a reasonable level. Efficient and
effective credit risk management is very important for such a comprehensive access to risk
control as well as long-term development and success of banks (Bessis, 2011). Till now,
there are some studies which have made contributions to the literature of credit risk
management in banking system, including the study of Caprio (1998); Pastor (2002);
Maccario et al. (2004); Minton et al. (2005); Bernanke (2006); Godbillon-Camus and
Godlewski (2006); Weber et al. (2008); Pesta (2010). Nevertheless, most studies focus on
such aspects of bank credit risk management as provisioning, the use of credit derivatives,
or the measurement of credit risk, but not on the whole picture. Added to this, all studies
are related to banks’ performance in the United States; meanwhile, the performance of
banks in the UK is not well focused. Accordingly, this thesis chooses to make an emphasis
on credit risk management in British banks and there will be a whole review about
management techniques and practices.
1.3 Research structure
Credit risk management plays an important role in the optimization of financial
institutions’ performance. In recognition of this significant role, the thesis will focus on the
understanding about credit risk management system in a CB in the UK – one of developed
economies and propose one model for further testing. The structure of this study contains
four main sections: first section with the literature on the research issue; second section with
the representation of the issue and methodology; third section with the discussion about the
study results; forth section with the conclusion and the implications of the results.

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