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Credit Risk Management in Commercial Banks

However, the major cause of serious banking problems continues to be directly related to lax credit standards for borrowers and counterparts, poor portfolio risk management, r lack of a watchful eye to the changes In economic or other circumstances that can lead to deterioration in the credit standing of a bank’s counterparts. This paper aims at highlighting the factors influencing credit risk management practices among commercial banks In Kenya.

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This Is an empirical review of studies carried out related to the objectives of this paper.

In pursuit of developing this paper the following critical factors that Influence credit risk management practices by banks are reviewed: effectiveness of credit risk management practices put in place by immemorial banks in Kenya in controlling the level of credit risk exposure, the factors that determine credit risk management practices put in place to mitigate credit risk exposure; the effectiveness of each of these factors in controlling the level of credit risk exposure; and lastly the Impact of credit appraisal process enforced on the organization’s growth and profitability and lastly it intends to conclude by bringing to light the barriers to effective credit risk management practices among commercial banks In Kenya. TABLE OF CONTENTS 1. 0 Background of the study 4 2. 0 The problem statement 7 . 0 Literature reviews 4. 0 Conclusion 15 5. 0 Recommendations 16 6. 0 References 17 1. 0 Background of the study Depression of the sass.

Brenan and Loons’ classic article on the credit crunch in the Brooking Papers (as cited in Mizzen, 2008)documents not only the decline in the supply of credit for the 1990-91 recession, controlling for the stage of the business cycle, but also considers five previous recessions going back to the sass.

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The combined effect of the shortage of financial capital and declining quality of borrowers’ financial health caused banks to cut the loan supply in the sass. Predetermine(2009) further asserts that the financial crisis from 2007 to 201 Owes the worst financial crisis since the Great Depression of the sass. It was triggered by a liquidity shortfall in the United States banking system and has resulted in the collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world.

The bursting of the housing bubble, which peaked in 2006, was the first major sign that the values of securities tied to U. S. Real estate pricing would plummet and damage major financial institutions such as; Lehman Brothers, Merrill Lynch, Alga globally (Predetermine,2009). Questions regarding bank solvency, declines in credit availability and damaged investor confidence had an impact on global stock markets, where securities suffered large losses during late 2008 and early 2009. Predetermine further asserts that economies worldwide slowed during this period as credit tightened, international trade declined and banks were forced to write down several hundred billion dollars in bad loans caused by mortgage delinquencies.

Traditional banking model, in which he issuing banks hold loans until they are repaid, was replaced by the ‘originate and distribute’ banking model, in which loans are pooled, and resold via serialization (Lowly Institute for International Policy, 2009). The Lowly Institute’s policy paper further argues that this presence of new securities facilitated the large capital inflows from abroad as mechanical phenomena (domino effects due to the linkages between many of these financial institutions), resulted in simultaneous spread worldwide. A study done by Mega (2010), on the contagion effects of the global financial crisis with preference to Kenya and other developing economies indicates that these economies experienced significant slowdowns.

Mega further states that there had been a big debate on the likely impacts of the global financial crisis on Kenya with some quarters saying that, the Kenya economy would be badly affected while on the other hand, the ministry of Finance and Central Bank postulating that the impacts will be indirect and most likely small. The central bank of Kenya for-example argued that Kenya is primarily a rural agro- based economy with only a small minority of the population such as tourism and immemorially oriented agriculture such as horticulture, tea and coffee directly interfacing with the developed world. Indirectly, foreign exchange volatility, cost and availability of inputs would be impacted (Mega, 2010). Kiloton(2009) had initially argued that, in general, African banking sectors and financial markets were insulated from foreign finance.

These sectors according to Kiloton relied on domestic deposits and lending and thus did not have derivatives or asset-based securities among their portfolio. Even though some banks have significant foreign ownership, the parent ankhs are typically not from the US and the foreign ownership share is relatively small. However, as the crisis spread into Europe and Asia Kiloton and Mega both stock markets. In terms of ownership structure, foreign banks comprise about a quarter of all banks in the country. These banks account for about 40% of commercial banks core capital thus as soon as the parent companies were affected the effects began to trickle down to the subsidiaries (Mega, 2010).

Hitherto, the financial industry has always been affected by unsystematic changes such as changes in the economic situation (uncertain interest rates, foreign exchange rates), political changes, social changes and systematic risk such as internal controls, corporate governance and information technology systems as well (Carrey, 2001). Risk management and in particular credit risk management, according to Pyle (1997) has thus become a main topic for commercial banks which are in the financial services industry and whose nature of activities is related to conditions of uncertainty. Commercial Banks and other financial institutions are exposed to a large number of risks through their activities (Pyle, 1997).

In order to promote confidence amongst a banks stakeholders and shareholders, Carrey (2001) and Pyle (1997) insist that these institutions must invest money into a credit risk management system and promote strong credit risk management procedures within their organization. 2. 0 The problem statement Most Kenya banks have already indicated their willingness to embrace the enhanced risk and capital management practices that come with Basel committee’s recommendations (Central Bank of Kenya Basel II Implementation Survey, 2008). However, in addition Carrey (2001) explores on the need for commercial banks to rather create a new model for banking built on the principles of; Proper credit granting process, Effective credit risk environment and putting in place well- structured systems to administer, measure and control credit risk exposure.

This, according to Carrey and Pyle forms the foundation of the credit risk management procedures which will help to mitigate credit risk. These principles according to Carrey and Pyle will be achieved by looking at factors such as; Transparency, Organization Culture and Governance Structures. Fatima and Glam (2000) argue that credit risk arises from uncertainty in a given counterparts ability to meet its obligations. The increasing variety in the types of counterparts and the ever- expanding variety in the forms of obligations (from auto loans to complex derivatives transactions) has meant that credit risk management has Jumped to the forefront of risk management activities carried out by firms in the financial services industry.

This paper in adherence to Carry’s and Pile’s and others’ proposals, intends to carry out an investigation of the factors that have been put in place to ensure effective credit risk management practices by commercial banks in Kenya. 3. 0 Literature review 3. Shareholder Value Minimization Shareholder value minimization requires a firm to engage in risk management practices only if doing so enhances the value of the firm and, by implication, its value to shareholders. This value enhancement can arise from one of three sources: minimization of the possibility that the firm may be forced to forego positive NP projects, because it lacks the internally generated funds to do so (I. E. Minimizing the probability of the occurrence of the under-investment problem) Sandstorm(1995).

According to Pyle (1997), in contrast to the shareholder value minimization, the managerial risk aversion hypothesis (which is based on an agency argument) holds that managers will seek to maximize their own personal well being. This means that managers may, at times, engage in risk management practices at the expense of shareholders. Specifically, when the interests of shareholders are not perfectly aligned with those of the managers, managers may pursue risk management strategies designed to insulate their own personal wealth from the effects of changes in interest rates, commodity prices, or foreign currency values. These steps may be taken without regard to the consequences of these decisions for shareholders’ lath.

It follows, therefore, that regardless of whether shareholder value minimization or managerial risk aversion is the driving force, engagement in risk management practices is to be observed. One of the most important forms of these practices pertains to the management of credit risk, particularly for banks and other firms in the financial services industry. 3. 2 Financial Disasters Financial disasters in financial and non-financial firms and in governmental agencies point up the need for various forms of risk management. Financial misadventures are hardly a new phenomenon, but the rapidity with which economic entities can get into ruble is high (Pyle, 1997).

Pyle (1997) notes that banks and similar financial institutions need to meet forthcoming regulatory requirements for risk measurement and capital. However, it is a serious error to think that meeting regulatory requirements is the sole or even the most important reason for establishing a sound, scientific risk management system. Managers, according to Pyle need; reliable risk measures to direct capital to activities with the best risk/reward ratios, estimates of the size of potential losses to stay within limits imposed by readily available liquidity y creditors, customers, and regulators as well as mechanisms to monitor positions and create incentives for prudent risk-taking by divisions and individuals.

Sandstorm(1995) in his analysis on the commercial banking industry recognizes that an institution need not engage in business in a manner that unnecessarily imposes risk upon it, nor should it absorb risk that can be efficiently transferred to other participants. Rather, it should only manage risks at the firm level that are more efficiently managed there than by the market itself or by their owners in their own portfolios. In short, Sandstorm insists that banks should accept only those risks that are uniquely a part of their array of services. Banks and other financial institutions have continued to face difficulties over the years for a multitude of reasons. However, or a lack of attention to changes in economic or other circumstances that can lead to deterioration in the credit standing of a banks counterparts (Basel Committee of the Bank of International Settlements, 2000). 3. Factors influencing credit risk management practices in commercial banks in Kenya 3. 3. Commitment and Support The concern and tone for credit risk management must start at the top. While the overall responsibility of risk management rests with the BODY, it is the duty of senior management to transform strategic directions set by the board in the shape of policies and procedures that institute an effective hierarchy to execute and implement those policies. Moreover, communication should be enhanced to ensure proper formulation of policies relating to risk management. Senior management has to ensure that these policies are embedded in the culture of the organization.

Prepared and Phenomena (2004) acknowledges the essence of top management purport related to effective decision-making to manage risk and to authorize business process change. A crucial part of a successful financial institution is top management support, the benefit of which is related to improving decision making in order to manage risk. Successful mitigation or bearing of risk is a contingent upon commitment and support from top management. Moreover, it is argued that an organization uses risk management to anticipate the probability of a negative impact and that risk management needs top-level management support. Risk management requires the acknowledgement that risk is a reality and the commitment to identify ND manage risk lies within the mechanisms setup by top management to mitigate it. 3. 3. Information Technology (IT) Banks should have in place a system for monitoring the condition of individual credits, including determining the adequacy of provisions and reserves. Moreover, they need to develop and implement comprehensive procedures and information systems to monitor the condition of individual credits and single obligators across the banks various portfolios. These procedures need to define criteria for identifying and reporting potential problem credits and other transactions to ensure that they are abject to more frequent monitoring as well as possible corrective action. In addition to that, banks should develop and utilize an internal risk rating system in managing credit risk. The rating system should be consistent with the nature, size and complexity of a banks activities. Basel Committee of the Bank of International Settlement, 2005) 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 oratorio, concentrations, problem credits, and the adequacy of loan loss reserves. In larger banks, the more detailed and sophisticated internal risk rating systems are used to determine internal capital allocation, pricing of credits, and profitability of transactions and relationships. According to Sandstorm (1995) banks should 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 reedit portfolio, including identification of any concentrations of risk. Effectiveness of a banks 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. 3. 3. 3 Transparency can be achieved by looking at information and disclosure.

Information would be provided with sufficient frequency and timeliness to give a meaningful picture of the institution’s financial position and prospects (Basel Committee of the Bank of International Settlement, 2005). Credit exposures in trading activities may for instance deserve more frequent reporting than credit exposures in traditional banking activities, such as lending since the variability of the portfolio composition typically is higher in the trading book. Nevertheless, to be relevant, information should also keep pace with financial innovation and developments in credit risk management techniques, e. G. reedit risk modeling. Further, information on credit risk should include a reasonable degree of caution and reflect realistic and prudent measurements Allen, Steve L. Wiley.

Regarding comparability of information, market participants and other users need information that can be compared across institutions and countries over time. Differences in the measurement of credit exposures and the establishment of credit loss allowances across countries, as well as the need to apply a degree of Judgment in making those determinations, makes comparable disclosures in the area of credit risk particularly important. Information disclosure should be adapted to the size and nature of an institution’s activities in accordance with the concept of materiality. Information is material if its omission or misstatement could change or influence the assessment or decision of a user relying on that information.

Banks’ financial reports should thus present each material item separately. This implies that larger, internationally active banks with complex operations would be expected to provide much more information than smaller and medium-sized domestic banks with simpler business activities. Whilst it is important hat information which fulfills the criteria described above is disclosed, it is not intended that banks should disclose proprietary information. Proprietary information encompasses information (for example on customers, products or systems), the sharing of which with competitors would render a banks investment in these products/systems less valuable, and hence undermine its competitive position.

However, the non – disclosure concept does not imply that banks should withhold useful information as this would form an impediment to transparency which in turn would disadvantage it in the market as it would reflect an unfavorable risk profile Sandstorm 1995). 3. 3. 4 Communication Prepared and Phenomena (2004) Risk measurement and assessment should be conducted and necessary recommendations made on an aggregate basis. When evaluating derivative credit risk, bank management should consider this exposure in the context of the banks total credit exposure to the counterparts. This is for management to communicate effectively, the nature of counterparts activities.

Reports should be tailored to the intended audience. These reports will often cover the same subject, but the level of detail will vary depending on the recipient. Reports should be meaningful, timely, and accurate. They should be generated from sources independent of the dealing function, and distributed to all appropriate levels of management for implementation purposes. Banks should be able to combine the loan equivalent figures with other credit risks to determine the aggregate risk of each counter party. Monthly reports that detail portfolio information on industry to pre-settlement exposure should be tabled and discussed during the various committees’ meetings. 4. Conclusion The study concludes that heads of the risk department and the board of directors should establish credit risk management practices and that Senior Management would play a role in ensuring that an effective credit risk environment is maintained. Further organizations should support credit risk management policy by allocating resources and that organization structure influences the effective management of credit risk. Moreover, the study concludes that information disclosure should be adapted to the size and nature of institution activities in accordance with the concept of materiality and that information should be provided with sufficient frequency and timeliness to give a meaningful picture of the institutions financial position and prospects.

Additionally, the study concludes that banks should develop and utilize internal risk rating systems in managing credit risk and the rating system should be consistent with the nature, size and complexity of banks activities and those banks must have in place a system for monitoring the condition of individual credits, including determining the adequacy of provisions and reserves. Finally, training offered within organizations in addressing Credit Risk Environment practices should be satisfactory. 5. 0 Recommendation The study recommends that top management support should ensure effective session-making to manage risk and authorize business process change.

This will enable the institutions to improve decision making with respect to risk management. The study further recommends that the top management should acknowledge risk as a reality and have commitment to identify and manage risk within the mechanisms setup to mitigate it. The study recommends that banks should choose structures that commensurate with institution’s size, complexity and diversification of its activities. Further, these structures must facilitate effective management oversight and proper execution of credit risk management and control recesses depending upon each bank size, should constitute a credit risk management committee comprising of the head of risk management department, credit department and treasury.

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Credit Risk Management in Commercial Banks. (2020, Jun 01). Retrieved from http://studymoose.com/credit-risk-management-in-commercial-banks-new-essay

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