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Credit Risk

Principles For The Assessment Of Banks Management of
Credit Risk
Practical Study of A Bank
Data Collection Methods
SWOT Analysis of Banking Industry

Credit risk is most simply deIined as the potential that a bank borrower or counterparty will Iail
to meet its obligations in accordance with agreed terms. The goal oI credit risk management is to
maximize a bank`s risk-adjusted rate oI return by maintaining credit risk exposure within acceptable
parameters. Banks need to manage the credit risk inherent in the entire portIolio as well as the risk in
individual credits or transactions. Banks should also consider the relationships between credit risk and
other risks. The eIIective management oI credit risk is a critical component oI a comprehensive
approach to risk management and essential to the long-term success oI any banking organization.
For most banks, loans are the largest and most obvious source oI credit risk; however, other
sources oI credit risk exist throughout the activities oI a bank, including in the banking book and in the
trading book, and both on and oII the balance sheet. Banks are increasingly Iacing credit risk (or
counterparty risk) in various Iinancial instruments other than loans, including acceptances, interbank
transactions, trade Iinancing, Ioreign exchange transactions, Iinancial Iutures, swaps, bonds, equities,
options, and in the extension oI commitments and guarantees, and the settlement oI transactions.
The sound practices set out in this document speciIically address the Iollowing areas:
stablishing an appropriate credit risk environment.
perating under a sound credit granting process.
Maintaining an appropriate credit administration, measurement and monitoring process.
nsuring adequate controls over credit risk.
Although speciIic credit risk management practices may diIIer among banks depending upon the
nature and complexity oI their credit activities, a comprehensive credit risk management program will
address these Iour areas.
A Iurther particular instance oI credit risk relates to the process oI settling Iinancial transactions.
II one side oI a transaction is settled but the other Iails, a loss may be incurred that is equal to the
principal amount oI the transaction. ven iI 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 oI a Iinancial transaction will Iail to take place as expected) thus includes
elements oI liquidity, market, operational and reputational risk as well as credit risk. The level oI risk is
determined by the particular arrangements Ior settlement. Factors in such arrangements that have a
bearing on credit risk include: the timing oI the exchange oI value; payment/settlement Iinality; and the
role oI intermediaries and clearing houses.

Following are the principals that are to be Iollowed by the Banks in order to manage the risk oI
Establishing An Appropriate Credit Risk Environment:
Principle 1: The board oI directors should have responsibility Ior approving and periodically
reviewing the credit risk strategy and signiIicant credit risk policies oI the bank. The strategy should
reIlect the bank`s tolerance Ior risk and the level oI proIitability the bank expects to achieve Ior
incurring various credit risks.
Principle 2: Senior management should have responsibility Ior implementing the credit risk strategy
approved by the board oI directors and Ior developing policies and procedures Ior identiIying,
measuring, monitoring and controlling credit risk. Such policies and procedures should address credit
risk in all oI the bank`s activities and at both the individual credit and portIolio levels.
Principle 3: Banks should identiIy and manage credit risk inherent in all products and activities.
Banks should ensure that the risks oI products and activities new to them are subject to adequate
procedures and controls beIore being introduced or undertaken, and approved in advance by the board
oI directors or its appropriate committee.
Operating Under A Sound Credit Granting Process:
Principle 4: Banks must operate under sound, well-deIined credit-granting criteria. These criteria
should include a thorough understanding oI the borrower or counterparty, as well as the purpose and
structure oI the credit, and its source oI repayment.
Principle 5: Banks should establish overall credit limits at the level oI individual borrowers and
counterparties, and groups oI connected counterparties that aggregate in a comparable and meaningIul
manner diIIerent types oI exposures, both in the banking and trading book and on and oII the balance
Principle 6: Banks should have a clearly-established process in place Ior approving new credits as
well as the extension oI existing credits.
Principle 7: All extensions oI 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 oI connected lending.

Maintaining An Appropriate Credit Administration, Measurement
And Monitoring Process:
Principle 8: Banks should have in place a system Ior the ongoing administration oI their various
credit risk-bearing portIolios.
Principle 9: Banks must have in place a system Ior monitoring the condition oI individual credits,
including determining the adequacy oI provisions and reserves.
Principle 10: 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 oI a bank`s activities.
Principle 11: Banks must have inIormation systems and analytical techniques that enable
management to measure the credit risk inherent in all on- and oII-balance sheet activities. The
management inIormation system should provide adequate inIormation on the composition oI the credit
portIolio, including identiIication oI any concentrations oI risk.
Principle 12: Banks must have in place a system Ior monitoring the overall composition and quality
oI the credit portIolio.
Principle 13: Banks should take into consideration potential Iuture changes in economic conditions
when assessing individual credits and their credit portIolios, and should assess their credit risk
exposures under stressIul conditions.
Ensuring Adequate Controls Over Credit Risk:
Principle 14: Banks should establish a system oI independent, ongoing credit review and the results
oI such reviews should be communicated directly to the board oI directors and senior management.
Principle 15: Banks must ensure that the credit-granting Iunction is being properly managed and that
credit exposures are within levels consistent with prudential standards and internal limits. Banks should
establish and enIorce internal controls and other practices to ensure that exceptions to policies,
procedures and limits are reported in a timely manner to the appropriate level oI management.
Principle 16: Banks must have a system in place Ior managing problem credits and various other
workout situations.
The Role Of Supervisors:
Principle 17: Supervisors should require that banks have an eIIective system in place to identiIy, to
measure, monitor and control credit risk as part oI an overall approach to risk management. Supervisors
should conduct an independent evaluation oI a bank`s strategies, policies, practices and procedures
related to the granting oI credit and the ongoing management oI the portIolio. Supervisors should
consider setting prudential limits to restrict bank exposures to single borrowers or groups oI connected

Muslim Commercial Bank Limited, with more than 60 years oI experience as one oI the
leading banks in Pakistan, was incorporated on 1uly 9 in 1947. The bank has journeyed remarkable
tenure oI more than halI a century oI competitively edged and well positioned heights oI success by
deploying quality banking, heads on technological developments, proIessionally leading management
and prudent and ethical work methodologies. MCB was nationalized along with other private banks in
1974 as part oI Government oI Pakistan's economic reIorm movement and was later privatized to
Nishat Group lead consortium in 1991.
MCB is reputed as one oI the soundest Iinancial institution and as one oI the leading banks in
Pakistan with a deposit base oI PKR. 462 bln (apprx.) and total assets oI PKR 605 bln (apprx.). The
bank is versed as one oI the oldest and most responsible banks in Pakistan and has played pivotal role
in representing the country on global platIorms while being one oI the Iew institutions that are
recognized and traded in the international market.
To be the leading Iinancial services provider, partnering with the customers Ior a more
prosperous and secure Iuture.
A team oI committed proIessionals, providing innovative and eIIicient Iinancial solutions to
create and nurture long-term relationships with the customers. In doing so, they ensure that the
shareholders can invest with conIidence in them.
The State Bank oI Pakistan deIines the Credit Risk as,
~Credit risk arises from the potential that an obligor is either unwilling to perform
on an obligation or its ability to perform such obligation is impaired resulting in
economic loss to the bank.
In a bank`s portIolio, losses stem Irom outright deIault due to inability or unwillingness oI a
customer or counter party to meet commitments in relation to lending, trading, settlement and other
Iinancial transactions. Alternatively losses may result Irom reduction in portIolio value due to actual or
perceived deterioration in credit quality. Credit risk emanates Irom a bank`s dealing with individuals,
corporate, Iinancial institutions or a sovereign. For most banks, loans are the largest and most obvious
source oI credit risk; however, credit risk could stem Irom activities both on and oII balance sheet.
In addition to direct accounting loss, credit risk should be viewed in the context oI economic
exposures. This encompasses opportunity costs, transaction costs and expenses associated with a non-
perIorming asset over and above the accounting loss.
Credit risk can be Iurther sub-categorized on the basis oI reasons oI deIault. For instance the
deIault could be due to country in which there is exposure or problems in settlement oI a transaction.
Credit risk not necessarily occurs in isolation. The same source that endangers credit risk Ior the
institution may also expose it to other risk. For instance a bad portIolio may attract liquidity problem.
A typical Credit Risk Management Iramework in a Iinancial institution is categorized into
Iollowing main components:
Board and senior Management`s versight.
rganizational structure.
Systems and procedures Ior identiIication, acceptance, measurement, monitoring and control
Board and Senior Management`s Oversight:
It is the overall responsibility oI bank`s Board to approve bank`s credit risk strategy and
signiIicant policies relating to credit risk and its management which should be based on the bank`s
overall business strategy. To keep it current, the overall strategy has to be reviewed by the board,
preIerably annually. The responsibilities oI the Board with regard to credit risk management shall
O elineate its overall risk tolerance in relation to Credit Risk.
O nsure that bank`s overall credit risk exposure is maintained at prudent levels and consistent
with the available capital.
O nsure that top management as well as individuals responsible Ior credit risk management
possess sound expertise and knowledge to accomplish the risk management Iunction.
O nsure that the bank implements sound Iundamental principles that Iacilitate the identiIication,
measurement, monitoring and control oI credit risk.
O nsure that appropriate plans and procedures Ior credit risk management are in place.

The very Iirst purpose oI bank`s credit strategy is to determine the risk appetite oI the bank.
nce it is determined the bank could develop a plan to optimize return while keeping credit risk within
predetermined limits. The bank`s credit risk strategy thus should spell out:
O The institution`s plan to grant credit based on various client segments and products, economic
sectors, geographical location, currency and maturity.
O Target market within each lending segment, preIerred level oI diversiIication/concentration.
O Pricing strategy.
It is essential that banks give due consideration to their target market while devising credit risk
strategy. The credit procedures should aim to obtain an in depth understanding oI the bank`s clients,
their credentials & their businesses in order to Iully know their customers.
The strategy should provide continuity in approach and take into account cyclic aspect oI
country`s economy and the resulting shiIts in composition and quality oI overall credit portIolio. While
the strategy would be reviewed periodically and amended, as deemed necessary, it should be viable in
long term and through various economic cycles.
The senior management oI the bank should develop and establish credit policies and credit
administration procedures as a part oI overall credit risk management Iramework and get those
approved Irom board. Such policies and procedures shall provide guidance to the staII on various types
oI lending including corporate, SM, consumer, agriculture, etc. At minimum the policy should
O etailed and Iormalized credit evaluation/ appraisal process.
O Credit approval authority at various hierarchy levels including authority Ior approving
O Risk identiIication, measurement, monitoring and control.
O Risk acceptance criteria.
O Credit origination and credit administration and loan documentation procedures.
O Roles and responsibilities oI units/staII involved in origination and management oI credit.
O Guidelines on management oI problem loans.
In order to be eIIective these policies must be clear and communicated down the line. Further
any signiIicant deviation/exception to these policies must be communicated to the top
management/board and corrective measures should be taken. It is the responsibility oI senior
management to ensure eIIective implementation oI these policies.
Organizational Structure:
To maintain bank`s overall credit risk exposure within the parameters set by the board oI
directors, the importance oI a sound risk management structure is second to none. While the banks may
choose diIIerent structures, it is important that such structure should be commensurate with
institution`s size, complexity and diversiIication oI its activities. It must Iacilitate eIIective
management oversight and proper execution oI credit risk management and control processes.
ach bank, depending upon its size, should constitute a Credit Risk Management Committee
(CRMC), ideally comprising oI head oI credit risk management epartment, credit department and
treasury. This committee reporting to bank`s risk management committee should be empowered to
oversee credit risk taking activities and overall credit risk management Iunction. The CRMC should be
mainly responsible Ior:
O The implementation oI the credit risk policy / strategy approved by the Board.
O Monitor credit risk on a bank-wide basis and ensure compliance with limits approved by the
O Recommend to the Board, Ior its approval, clear policies on standards Ior presentation oI credit
proposals, Iinancial covenants, rating standards and benchmarks.
O ecide delegation oI credit approving powers, prudential limits on large credit exposures,
standards Ior loan collateral, portIolio management, loan review mechanism, risk
concentrations, risk monitoring and evaluation, pricing oI loans, provisioning, regulatory/legal
compliance, etc.
Further, to maintain credit discipline and to enunciate credit risk management and control process there
should be a separate Iunction independent oI loan origination Iunction. Credit policy Iormulation,
credit limit setting, monitoring oI credit exceptions / exposures and review /monitoring oI
documentation are Iunctions that should be perIormed independently oI the loan origination Iunction.
For small banks where it might not be Ieasible to establish such structural hierarchy, there should be
adequate compensating measures to maintain credit discipline introduce adequate checks and balances
and standards to address potential conIlicts oI interest. Ideally, the banks should institute a Credit Risk
Management epartment (CRM). Typical Iunctions oI CRM include:
O To Iollow a holistic approach in management oI risks inherent in banks portIolio and ensure the
risks remain within the boundaries established by the Board or Credit Risk Management
O The department also ensures that business lines comply with risk parameters and prudential
limits established by the Board or CRMC.
O stablish systems and procedures relating to risk identiIication, Management InIormation
System, monitoring oI loan / investment portIolio quality and early warning. The department
would work out remedial measure when deIiciencies/problems are identiIied.
O The epartment should undertake portIolio evaluations and conduct comprehensive studies on
the environment to test the resilience oI the loan portIolio.
Notwithstanding the need Ior a separate or independent oversight, the Iront oIIice or loan
origination Iunction should be cognizant oI credit risk, and maintain high level oI credit discipline and
standards in pursuit oI business opportunities.
SWOT Analysis Of Banking Industry

SWOT analyses take into account the strengths, weaknesses, opportunities and threats Iacing a
business, organization or operation, in terms oI serving customers, stakeholders and their own
employees. A SWOT analysis oI the banking industry will list these Iour components and illustrate Ior
executives and management the areas the industry is perIorming not so well in. The SWOT also
highlights the areas where there is opportunity to develop Iurther and areas where there is potential to
be hurt in the Iuture.

The "Strengths" portion oI the banking industry`s SWT analysis is a list oI the internal
operational elements where the banking industry is succeeding or excelling. These elements need to
reIer to Ieatures the industry can control and has a direct power to change. For example, the banking
industry`s strengths can include record-high annual returns, diversiIied investment portIolio oIIerings,
decreases in transaction and trading Iees, an increase in the number oI ATM machines and increased
market share.
The "Weaknesses" element oI the banking industry`s SWT analysis is a list oI the internal
operational elements the banking industry needs to improve upon. These elements need to reIer to
Ieatures the industry can control and has a direct power to change. For example, the banking industry's
weaknesses can include high loan rates, low bond credit ratings, an increased number oI outstanding
junk bonds, an increase in loan-sharking activity and an increased number oI high-risk investment
The "Opportunities" part oI the banking industry`s SWT analysis is a list oI the external
environmental elements the banking industry can potentially take advantage oI in the near Iuture or
long-term. These external environmental elements should not reIlect the internal components oI the
industry, but rather the Iactors or Ieatures outside the industry`s control. For example, the banking
industry`s opportunities can include a growing economy, banking deregulation, increased client
borrowing, an increase in the number oI banks, an increase in the money supply, low government-set
credit rates and larger customer checking account balances.
The "Threats" component oI the banking industry`s SWT analysis is a list oI the external
environmental elements that can potentially harm the banking industry. These external environmental
elements do not reIlect the internal components oI the industry, but the Iactors or Ieatures outside the
industry`s control. For example, the banking industry`s threats could include a declining economy,
increased banking regulations, larger capital gains taxes, new high-risk investment vehicles or higher
health care costs. It`s important to realize these examples are not black and white. For example, 'new
high-risk investment vehicles are inherently a liability because they include increased risk, but
depending on the Iinancial stake and position, it could be an opportunity or threat.
SWOT analyses Ieature a two-by-two chart, where one oI the Iour topics is listed in one oI the
Iour boxes. Strengths and weaknesses appear in the top row, with the strengths on the leIt and
weaknesses on the right. pportunities and threats appear in the bottom row, with opportunities on the
leIt and threats on the right.