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Banks and Bank Risks Credit Risk
Banks and Bank Risks Credit Risk
Banks are exposed to a significant number of risks, which can be categorised into:
• credit risk
• operational risk
• liquidity risk
• market risk
How a bank defines these risks is important, as the definitions are the basis for both the
qualitative and quantitative assessment of the bank’s exposure to the risks. As a result,
the generally accepted definitions have been continually refined over the years, helped
in no small part by supervisory authorities imposing capital charges and related
requirements against these risks.
This perceived asymmetry in risks means that banks tend to focus on identifying and
managing the key risk drivers that are more likely to result in losses. For example, when
conducting stress tests of their portfolios, they focus on the negative aspects of an
exposure. In the case of:
• credit risk, stress tests focus more on economic recessions than recoveries
• equity prices, stress tests focus more on stock market crashes than booms
• interest rates, stress tests focus more on increases than decreases
The chart below illustrates the significance of credit risk relative to market and
operational risks in over 200 of the largest internationally active banks as of the end of
June 2016. Each segment in the pie charts reflects the proportion of minimum required
capital accounted for by each risk type. As you can see, credit risk accounts for over
80%, on average.
Credit risk is found in all banking activities where the profitability of that activity (for
example, lending to individuals) depends on whether or not the counterparty or borrower
repays the debt. For most banks, loans are the largest and most obvious source of credit
risk.
Unlike a bank’s exposure to credit risk through a loan, where the exposure is unilateral
and only the lending bank faces the risk of loss, counterparty credit risk creates a
bilateral risk of loss. The market value of the transaction can be positive or negative to
either the bank or its counterparty. It is uncertain and can vary over time with the
movement of underlying market factors.
Derivatives transactions, such as interest rate and currency swaps, credit default swaps
(CDS) and equity derivatives, are examples of transactions that give rise to counterparty
credit risk.
Best Bank has a loan portfolio of USD 10,000, consisting of 10 loans with a principal
amount of USD 1,000 each and a maturity of one year.
The annual interest rate on each loan is 10%, with interest payable on maturity. Let's
calculate the total interest revenue on the loan portfolio.
If the annual interest rate on each loan is 10%, with interest payable on maturity,
what is the total interest revenue on the loan portfolio?
• USD 100
• USD 1,000 (correct answer)
• USD 1,100
• USD 10,000
The interest collected on each loan would be USD 100 (10% x USD 1,000), for total
interest revenue on the loan portfolio of USD 1,000.
This table illustrates how the total interest revenue on the loan portfolio amounts to USD
1,000.
• The effect will be minimal as the interest revenue will only be reduced by USD
100.
• The loss on this loan will exceed the bank’s interest revenue and considerably
reduce the portfolio’s revenue. (correct answer)
In addition to forgoing the interest revenue (USD 100), Best Bank must write off the
principal amount of the loan (USD 1,000). As a result, the loss on this one loan has
wiped out the expected interest revenue on the entire loan portfolio.
This table illustrates how the loss on one loan has wiped out the expected interest
revenue on the entire loan portfolio.
While this example has been simplified for the purposes of illustration, it does
demonstrate that default by even a small number of borrowers can generate significant
losses for a bank. At the extreme, it can lead to a bank’s insolvency.
Because of the greater risk involved, long-term loans are generally priced higher than
short-term loans. They are also more likely to be secured and will generally be subject to
regular amortisation, which requires the loan to be repaid over time in periodic
instalments of principal and interest. Amortisation results in a declining principal balance
such that the loan is fully repaid by the time it matures.
Secured
A loan is secured when the borrower gives the bank a security interest in an asset (for example, a car
or house that the loan was used to purchase) which the bank can then use in settlement of the loan if
the borrower defaults.
Banks are also exposed to credit risk from a variety of non-lending products, activities
and services, such as:
Letters of Credit
A letter of credit is a credit instrument issued by a bank on behalf of its customer, often an importer,
guaranteeing payment to a third party, often an exporter, up to a specified amount, provided that the
specified terms and conditions are met.
Financial Guarantees
When a bank issues a financial guarantee on behalf of a client, it is guaranteeing to a third party (the
beneficiary) that the liabilities of its client to that third party will be met. If the client fails to settle its
debt to the third party, the bank will step in and cover it.
• The bank purchases GBP 100 million gilts (UK government securities).
(correct answer)
• The bank buys GBP 5 million worth of shares in a beverage company that is
listed on the London Stock Exchange.
• The bank has a contingent liability of GBP 5 million due to a legal suit filed by a
customer.
Credit risk arises when the bank buys GBP 100 million in gilts, even though the potential
for the UK government defaulting on its debt obligations may be regarded as extremely
low. Purchasing shares in the beverage company exposes the bank to market risk, not
credit risk. In this case, the contingent liability (a liability that may occur, depending on
the outcome of an uncertain event) is an example of legal risk, which is a form of
operational risk.