PRMIA: Practices for Credit and Counterparty Credit Risk Management: A Primer for Professional Risk Managers in Financial Services

By Justin McCarthy

Practices for Credit and Counterparty Credit Risk Management provides a primer on sound practices of credit and counterparty credit risk management. Covering topics from classic credit instruments and the credit lifecycle to complex credit derivatives, securitization, credit risk modeling, portfolio management, counterparty credit basics, risk m

• Language: English
• Publisher: Professional Risk Managers' International Ass
• Release date: Feb 20, 2023
• ISBN: 9798987654927

Book preview

Chapter 1—Introduction to Credit Risk

Justin McCarthy

Credit Risk Basics

Credit Risk

Credit risk can be defined as the risk of financial loss arising from a borrower, guarantor, or counterparty that may fail to meet their obligations in accordance with agreed terms. Credit risk arises anytime a credit institution extends funds to another party. However, if credit institutions do not extend such funds with the expectation of a return, then they cannot expect to be rewarded and make an income for their firm. Thus, the making of loans and their ongoing management are core to the activities of many banks.

Credit risk, in turn, can be seen to have four sub-categories.

Inherent Credit Risk

Inherent credit risk relates most closely to the definition already given above—the risk of financial loss from, for example, a counterparty who fails to meet agreed-upon obligations. Inherent credit risk is assessed without considering the credit risk management processes, practices, and controls that are explored throughout the rest of this book. Thus, inherent credit risk is the probability of a lending-related loss arising out of circumstances related to the bank’s activities and environment, in the absence of any successful risk management.

Concentration of Credit Risk

Credit concentration risk may arise due to credit risk exposures that have common characteristics. These may be exposure, for example, to a certain industry and/or geographic exposure, and may be within or across different asset categories. These become a concern if there are:

Losses that are large enough to threaten the bank’s financial stability.

Losses that threaten the bank’s ability to maintain its core operations.

Losses that bring about a material change in a bank’s risk profile.

A good example would be a bank with several large customers that make up a large part of the loan book; a measure of such a risk may be to calculate the sum of the value of the top 10 biggest loans or customers as a percentage of the total loan book. If this percentage is too high, especially in comparison to other peer banks, then concentration of credit risk may be an issue. Again, the measures used to manage this risk will be covered in the practices and controls explored in the rest of this book.

Sovereign Risk

Sovereign risk arises when a sovereign state or country defaults on its obligations. These obligations usually relate to sovereign bonds, which are used to raise the funds to sometimes fund a country’s economy. How a country is performing, both in its domestic economy and in international trade, may have a great impact on this risk. The spending for public services, the ways in which these services are funded, how this relates to the political stability of the country and other such political items are often part of the assessment of the country’s risk. Bonds and measurements such as yield-to-maturity are covered in the Classic Credit Instruments section of this book.

Starting in the 1960s, many Latin American countries such as Brazil and Argentina began to borrow large amounts of money through the international debt markets. These loans were to be used to develop the economies of these countries through huge infrastructure projects. These projects were hugely popular with the citizens of these countries and helped maintain the position of sometimes less-than-popular governments. On the supply side of this business was an increasing appetite for investors to invest in sovereign debt. A popular justification for the continuing investment in such borrowing was the dictum that sovereign countries never default.

However, a combination of a global recession in the late 1970s and early 1980s, aligned with inflation-related interest rate increases and currency movements against the Latin American countries, resulted in increasing difficulties in the repayment of these huge loans. The situation came to a head in 1982 when Mexico announced that it could no longer service the huge debts it had built up with a related plea for a break from repayments, restructuring of existing debt, and requests for new loans to help pay for existing obligations.

With a sudden realization that sovereign countries may default, banks suddenly reduced or, in some cases, halted lending to Latin American countries. As debts came due, the crisis spread to other countries in Latin America that suddenly found that they could not refinance their positions. In a bid to mitigate the crisis, the International Monetary Fund (IMF) intervened and in return for restructuring debt and organizing new lending, the Latin American countries had to agree to restructure their economies to match the new reality of their financial situation.

The impact on the affected Latin American countries included stagnating economies, increased unemployment, and lower incomes. However, the impact on lenders in the international debt markets ranged from losses on loans that were restructured or not paid to a new understanding of sovereign risk. However, with the 1998 Russian financial crisis (with the understanding that even nuclear powers can default when the Russian Government put a moratorium on payments to international creditors) and more recently the European sovereign debt crisis, sovereign debt continues to be a risk that must be managed by financial institutions.

Box 1: Latin America Default Crisis

Tools such as credit default swaps are one way to manage this kind of risk, and this is covered in more detail in the Credit Derivatives and Securitization part of this book. Credit rating agencies can also be used to measure sovereign risk as well as credit risk related to a firm. Due to their importance across the financial services industry, these are covered in the Wholesale Credit Analysis part of this section of the book.

Quality of Control of Credit Risk

Credit risk controls are put in place to reduce the inherent credit risk to the bank. The effectiveness of these controls should help to ensure that the bank is not overly exposed to particular counterparties, sectors, or types of products. These are core to the management of credit risk of a bank and will be covered through the rest of this book. They should ensure broad principles such as:

Default by one customer, or of one loan, should not threaten the stability of the bank.

Customers and loans should be as financially independent as possible.

Credit risk should be monitored with the aim that loss rates become predictable—for example, changes in the behavior of a retail customer can be noted and acted upon (e.g., not making a minimum payment one month).

Most borrowings will be repaid in full and on time and will thus contribute to the financial success of the bank. However, sometimes this may not be the case, and this is where credit control becomes important. Later, the book will explore how banks should seek to:

Minimize the risk to bank assets by adopting a rapid and intelligent response to counterparty loan issues.

Ensure that counterparties in arrears are managed within the bank, and that they are notified in a standard and timely manner about their arrears and are given the same opportunities to make good their debts.

Any legal steps to be followed should be well thought through with legal advisors to ensure that errors do not result in further losses during the recovery process.

The underwriting of loans and the controls on limits and quality are one of the most important parts of credit risk management. An example of this was the emergence of so called NINA and NINJA mortgages in the United States in the run-up to the 2007 subprime mortgage crisis. With NINA standing for No Income No Asset and NINJA standing for No Income No Job No Assets, these loans were made by aggressive lenders who wanted to vastly increase the volume of mortgages they were originating, with scant regard for the quality of the loans being made.

Such lending was often related to flipping real estate with borrowers using such loans to buy properties with the intention of selling them shortly afterwards for large profits. With an expectation that property prices would continue to rise and adjustable-rate mortgages (ARM) that charged very low interest rates to start and then vastly increased interest rates after perhaps six months or a year, such loans were not expected to last long. Thus, the issues with poor credit quality were ignored.

However, once house prices in markets such as Las Vegas stumbled and defaults rapidly increased, the poor nature of such lending was exposed.

Box 2: NINA and NINJA Loans

Credit Risk Management

Released at the end of 1999, the consultative paper titled Principles for the Management of Credit Risk was issued by the Basel Committee on Banking Supervision and provides a set of principles that can be applied even today to aid in the management of credit risk. At a high level, these principles were grouped together under several headings.

Establishing an Appropriate Credit Risk Environment

From the board of directors and on through the bank, there should be a strategy that includes credit risk, and which is then reflected in the bank's risk tolerance (now usually called the risk appetite statement), and in the credit risk policies. These documents should be regularly reviewed and, in turn, used by the senior management of the bank to implement the credit risk-related activities of the bank. This should be done both at the portfolio level and with individual credit risk exposures and products; activities and profits should reflect this.

Operating Under a Sound Credit Granting Process

Banks should ensure that there is a standard set of accepted credit-granting criteria. These should include an understanding of the borrowing party, the purpose and structure of the lending, and the source of the repayments. There should be credit limits, and these should be mindful of connected borrowing parties and the aggregate exposure that these may cause.

Maintaining an Appropriate Credit Administration, Measurement, and Monitoring Process

Banks must have in place a credit risk system for monitoring the condition of individual lending, as well as the larger portfolios of lending. There should be good information systems and data to ensure credit risk is understood and managed, and that there are corresponding and adequate provisions and reserves in place. Such a risk system should be able to consider potential future changes in economic conditions and should allow the understanding of credit risk exposures under stressful conditions.

Ensuring Adequate Controls over Credit Risk

Banks should establish a system of independent and ongoing credit reviews that are reported to the board of directors and senior management. Banks should establish and enforce their internal controls and other credit risk management practices to ensure that any exceptions to policies, procedures, and limits are reported in a timely manner. Lastly, for any issues with borrowers starting to struggle with meeting their obligations, banks must have a system in place for managing these problem lending arrangements.

Finally, there is the role of supervisors to ensure that banks have an effective system in place to identify, measure, monitor, and control credit risk as part of their overall approach to risk management.

The Credit Life Cycle

The rest of this chapter continues with the steps of the credit life cycle. This is the set of activities that all banks follow in the business of lending:

Origination, including the selection of which sectors and prospects to pursue.

Assessment, including the process of analyzing potential borrowers and counterparties and the approval of any lending which leads to the drawdown.

Monitoring, including the ongoing review of the quality of lending and the early warning and engagement with any borrowing parties before lending becomes delinquent.

Workout, including the successful servicing and pay-off of a loan, the need to restructure a loan to keep it performing, or at worst the write-off of a failed loan and the related legal challenges.

DESCRIBE HERE

Figure 1: Credit life cycle steps

The Classic Credit Risk Methodology chapter of this book, in particular, takes the theory from the rest of this chapter and applies it to common practices in banking.

Origination Phase

No lender just makes loans to anybody that comes to them. The origination phase involves making decisions on which borrowers or counterparties to pursue and how to identify which to target. In addition, controls such as limits and concentration also must be considered—a good prospect may need to be measured against what is best overall for the bank.

Lending Strategy

Whether in the overall strategic plan or in some other document or process, banks will choose a particular group of customers to pursue. Traditionally, banks would have lent to their local citizens and/or businesses with short-term lending and mortgages. In an increasingly global world, banks such as HSBC have gone on to do business in dozens of countries around the world, with numerous products and sectors being served. The decision on whether to do this can be as much about the resources available to lend as it is about deciding on whom to lend to, where to lend, and how to lend.

The Royal Bank of Scotland Group plc (RBS) is a large British banking and insurance company based in Edinburgh, Scotland. Formed in the mid-20th century from the merger of several older Scottish banks, through a series of acquisitions, both domestically and internationally, it grew by the mid-2000s to be one of the, if not the, biggest bank in the world. In the United States alone, this included the acquisition of Rhode Island-based Citizens Financial Group and Charter One Bank; this resulted in RBS becoming one of the largest banks in the United States banking market.

However, it was the purchase of ABN AMRO—itself also one of the largest banks in the world—that radically increased RBS’s exposure to risky asset categories, reduced an already low capital ratio, increased potential liquidity strains, and given RBS’s role as the consortium leader and consolidator, created additional potential and perceived risks. RBS’s board decided to fund the acquisition primarily with debt (most of which was short-term) rather than equity, accepting a reduction in capital ratios below RBS’s own 5.25% core tier 1 target with intention to rebuild gradually over the subsequent years. RBS’s board continued to assure its investors that there were no plans for inorganic capital raising on the horizon. The losses continued to mount, and finally in April 2008 the bank was forced to ask its shareholders for GBP 12 billion to stay afloat, with assurance that the funds would be sufficient for a year. Ultimately, it was the unwillingness of wholesale money market providers to meet RBS’s funding needs that left it reliant on Bank of England Emergency Liquidity Assistance (ELA). From 7 October 2008 until 16 December 2008, RBS was funded in part by ELA provided by the Bank of England.

Also in October 2008, to help stabilize the bank, it was announced that the British Government would take a stake of over 57% in the Group in exchange for a large capital injection. In return, the British Government was given some control over the bank. In subsequent years, RBS has divested many of its previous acquisitions including such diverse units as a train company and its factoring business, as it rebuilt its capital base to focus on banking closer to its Scottish and UK roots.

Box 3: RBS and Overreach

Among the decisions that a bank can make are:

Type of lending: The decision may be as fundamental as to whether a bank lends to the main street with retail lending, or to commercial or public entities in wholesale lending.

Counterparties: A bank may choose to lend, or indeed not lend, to certain businesses—this may be due to previous poor experience or may be driven by more formal methods such as credit scores.

Industries: Some banks will pride themselves on lending to certain industrial sectors, be it aviation, property development, or government sectors, to name a few.

Products: Allied with the industry, certain products may be pushed for sales to certain customers—i.e., factoring to small and medium enterprises, aviation finance to airlines, or simpler items such as motor loans to retail customers.

Countries: A bank may lend within a certain part of a country or region, or they may wish to become global lenders with customers in dozens of countries.

While some of these may be selected based on a desire to lend to certain parties, these decisions may in turn be driven by other factors:

Limits and Concentration: The bank may have certain internal limits that have to be adhered to—for example, the bank may choose to keep motor lending to a certain percentage of the loan book. However, if business is good in a sector and there appears to be good prospects, then it may be tempting to allow these limits to be ignored, with the possibility of concentration risk emerging in the loan book.

Regulation: Regulation may also result in some curtailment of certain lending. This may include such measures as a maximum loan size as a percentage of assets, limits on the duration of loans and limits on lending to customers that have had loans recently rescheduled.

Of these, regulation may have the most consequences if it is ignored. In recent years, conduct risk—the risk the bank poses to its customers—has come increasingly to the forefront in banking. Thus, regulations on how customers can be marketed to, what information needs to be in a lending advertisement, and other items cannot be ignored.

Credit Risk Assessment

The most important activity in the credit life cycle is the initial credit risk assessment. It is at this point that a potential customer or counterparty is assessed as to their creditworthiness. If they are deemed to be creditworthy, then lending can be extended, and a return can be made for the bank. However, if this assessment results in someone who is not creditworthy being extended a loan, then the bank may suffer from a loss of income and possibly much worse: the loss of the entire amount of lending extended.

Guidance related to this was released by the Basel Committee on Banking Supervision in June 2006 in the document Sound credit risk assessment and valuation for loans. A summary of principle 2, A bank should have a system in place to reliably classify loans on the basis of credit risk, gets to the core of what is needed for successful credit risk assessment:

Policies and Procedures: Effective credit risk assessment and loan accounting practices should be performed in a systematic manner and in accordance with established policies and procedures. To be able to prudently value loans and to determine appropriate loan loss provisions, it is particularly important that banks have a system in place to reliably classify loans based on credit risk. Larger loans should be classified based on a credit risk grading system. Smaller loans may be classified on the basis of either a credit risk grading system or payment delinquency status.

Structured Approach: A well-structured credit risk grading system is an important tool in differentiating the degree of credit risk in the various credit exposures of a bank. This allows for a more accurate determination of the overall characteristics of the loan portfolio, probability of default and, ultimately, the adequacy of provisions for loan losses. In describing a credit risk grading system, a bank should address the definitions of each credit risk grade and the delineation of responsibilities for the design, implementation, operation, and performance of the system.

Financial Conditions of the Borrower: Credit risk grading systems typically consider a borrower’s current financial condition and paying capacity, the current value and realizability of collateral, and other borrower and facility-specific characteristics that affect the prospects for collection of principal and interest. Because these characteristics are not used solely for one purpose (e.g., credit risk or financial reporting), a bank may assign a single credit risk grade to a loan regardless of the purpose for which the grading is used.

Ongoing Review: Credit risk ratings should be reviewed and updated whenever relevant new information is received. Loans to which credit risk grades are assigned should receive a periodic formal review (e.g., at least annually) to reasonably assure that those grades are accurate and up-to-date. Credit risk grades for individually assessed loans that are either large, complex, higher-risk, or problem credits should be reviewed more frequently.

This guidance especially—that is related to the structure approach and financial condition of the borrower—can in turn be applied to both retail and wholesale credit analysis.

Retail Credit Analysis

Retail credit risk is the lending made to consumers—for example, credit cards, mortgages, car loans and overdrafts, to name a few. The characteristic of retail credit risk is there should be low concentration risk, as the lending portfolio should be well-diversified. Thus, a default by one borrower, or indeed a relatively large set of borrowers, should not threaten the entire bank with collapse. However, lenders to retail customers are vulnerable to systemic risks, e.g., the recent financial crisis affected a large part of the retail credit portfolios of many lenders.

There are several approaches to retail credit analysis that can be used or combined to allow a decision to be made about the creditworthiness of a member:

Customer details: The basic details of the customer can be gathered during the application stage. Of note here would be attributes such as the customer’s employment status (dependence on non-core pay such as overtime or allowances), age, and marital status.

Ability to repay: The capacity to repay method of assessment determines if the customer will be able to repay the loan. This can be determined by establishing their member’s income and outgoings and seeing how the new lending may affect this. Income can be proven with items such as recent pay slips or audited accounts, and outgoing can be proven with items such as evidence of recent rent payments.

Financial History: The history of the customer’s success or failure in repaying previous loans can be an assessment method.

Credit References: A bank may use a credit reference agency to perform a credit check to assess the customer’s credit risk. A credit check will usually provide the repayment record for current and more recent loans.

Stress testing: Stress testing can be used to examine whether the lending could still be serviced should the customer’s financial situation deteriorate. What-if scenarios can be applied to the customer’s existing financial situation and a determination made on if they would still have the capacity to repay their debts. Such scenarios could include a decline in the customer’s income, or an increase in other lending commitments such as an existing mortgage.

Scorecards: These are data-based approaches for assigning a score that conveys the creditworthiness of that customer. In turn, through back-testing, the predicted probability that the customer will become delinquent, or default can be proven, or else the model behind the scorecard can be adapted to be more accurate. To calculate the score, numerous data sources—most already mentioned—can be used, e.g., credit reference, ability to repay, financial history, etc. Thus, a credit scorecard can be used to combine multiple assessment approaches into one score. Once the score is assigned, a certain score is required to be eligible for the requested lending.

Not all assessments can be made automatically through such methods. Sometimes, the decision may be passed to a credit officer or credit committee for further assessment. However, the output of such methods is of great use to such a follow-on assessment and allows a quick but more human review of the creditworthiness of the customer.

Wholesale Credit Analysis

Commercial credit risk can be a major risk for many banks due to the size and complexity of the related lending. It is possible for lenders to expose themselves to a small set of borrowers or to a certain sector. Many banks will develop their own credit rating system to perform a review of a commercial borrower and make a determination on the possibility of default and the possible exposure if this should happen. Typical elements of such a commercial credit rating system may be:

Management Assessment: A review of the leadership of the borrower and day-to-day management.

Industry assessment and tier within industry: An assessment of the borrower's industry overall and success within it.

Financial statement quality: A review of the accounting and auditing of the borrower.

Country risk: An assessment of the borrower’s economic and political exposures due to geographic position or markets.

Loan structure: The loan may be affected by the collateral put in place and any other obligations agreed.

Cross-check with agency ratings: The assessment made within the lender can be checked against the rating given by external credit rating agencies.

DESCRIBE HERE

Figure 2: Comparative Credit Grades (Source: Fitch, S&P, Moody’s)

It is the external credit rating agencies mentioned in the last point that many will be familiar with. These firms, such as Moody’s, Fitch, and S&P, perform an assessment of the creditworthiness of organizations and then publish an opinion on the creditworthiness of a firm. However, smaller borrowers would usually not be included in the credit rating agencies’ systems and thus, as already mentioned, many lenders will have their own credit rating system to perform a review of a potential but small borrower.

Credit rating agencies follow their own internal methods to assign a grade to a firm, using techniques which do have some overlap with the elements listed above.

These agencies typically assign letter grades to indicate ratings. S&P, for example, has a credit rating scale ranging from AAA (the best rating) down to C and D. A debt instrument such as a bond with a rating below BBB is considered to be speculative-grade or a junk bond.

DESCRIBE HERE

Figure 3: 2012 One-Year Corporate Transition Rates (Source: S&P)

The accuracy of agency ratings can be assessed by reviewing multiyear rating transition matrices, which show the probability of a firm migrating from one rating to another in a year. Thus, an AAA-rated item may be seen to have a very high probability of being at that rating or perhaps something nearby, like AA-rated, within a year. The converse is that a low-rated item at a rating such as CCC is likely to have defaulted in the coming year. Such tables are used as the foundation of many credit risk management products that have been adopted in the industry in recent decades.

There has been some criticism of credit rating agencies in recent years. These relate to the good ratings given to later failing organizations such as Lehman Brothers being rated AAA and AA up to the time of their collapse. In addition, mortgage-related securities were rated as investment-grade with minimal or very low credit risk. With their later failure due to the collapse of the US housing market and the follow-on impact on banks’ investment portfolios, many have questioned the ratings that are bestowed by these agencies.

However, credit rating agencies cannot move too quickly on changing a rating and some criticism subsequent to the Lehman Brothers issue was that they had moved too quickly to downgrade some sovereign lenders. Either way, prior to changing a grade, a credit rating agency can put an entity on a negative or positive watch, which can announce the possibility of a change in the future, but not apply it straight away.

Drawdown

Once a decision is made to extend the credit, several items may be required before the loan is drawn down.

Method of repayment

A loan may be repaid in several ways, with many loans having an equal payment made up of principal and interest during the life of the loan.

However, an amortizing loan is used in many situations, such as a mortgage. This is a loan where there may be a set of equal payments, but the principal of the loan is increasingly paid down over the life of the loan while the proportion of the payment made up of interest decreases.

In contrast, a bullet payment occurs when the payment of the entire principal of the loan and sometimes the principal and interest is made at the end of the lending term.

Loan documentation

A loan agreement of some sort will be drawn up and signed between the borrower and lender. Typical items included in such agreements include repayment provisions, interest and interest periods, securitization provisions, and provisions for penalties. Ensuring this documentation is in place and properly stored may become key if the loan enters into any difficulties. In wholesale lending, a covenant will usually be required. This lists the conditions the borrower is expected to meet and may also forbid the borrower from undertaking certain actions such as the sale of certain assets. Again, this may become key for the lender if the loan enters into any difficulties. Once all these elements are in place, the lending may be drawn down and the ongoing servicing and monitoring of the loan can begin.

Monitoring Phase

The ongoing review of the lending made by a bank can be extremely important in both better understanding the customer and getting early warning of any potential credit control issues with lending.

Surveillance

Once lending enters into the business as usual phase of being repaid, keeping a near-constant view of the state of the lending is important. As with many surveillance functions, this is a process made more effective and efficient through access to detailed, up-to-date information on the performance of the loan book. Details such as any missed payments, arrears, and other failures to meet payment obligations can be a warning that the lending may be about to enter difficulties.

However, for some lending, especially in retail lending, monitoring the lending in more qualitative ways can provide early warning of potential delinquency. This can be made easier if the customer has many banking products such as their current account and credit card with the lending bank:

A change in the method of payment for other obligations can show emerging credit issues, e.g., usually paying a mobile phone bill through direct debit and then making a payment on a credit card.

Missing a minimum payment on some other form of lending product, e.g., a customer who also has a mortgage missing their credit card minimum payments.

Frequent delays in making the payment on the lending being monitored.

The same principles can be applied to wholesale lending, e.g., emerging issues with payments on lending. For some loans, the covenant may include that financial reporting is made available to the lender. However, this can be supplemented by more publicly available information, e.g., media stories about the state of the business and any business failures that they may have had.

Once a borrower or counterparty is noted in such a process, the bank might contact them to receive more detail on any issues and, if required, submit the lending to a watch list for review as part of a potential credit control intervention.

Bad debts represent a potential future financial loss to the bank. For this reason, banks are obliged to set aside a bad debt provision for loans that are in arrears, have been rescheduled, or have unusual repayment methods.

A variety of techniques may be used to calculate the amount to be put aside for these doubtful debts. Usually, this amount is some portion of a bank's loan portfolio and will become useful if any lending should become irrecoverable. At that point, the loan will be removed from the balance sheet, and the related bad debt provision is used to cover this change in the financial situation of the banks and its balance sheet.

Box 4: Bad Debt Provisions

Loan Book Reviews

Loan reviews are a more structured and less frequent method of getting a detailed assessment of the overall loan book. Riskier loans are identified and assessed on an individual basis to ensure that the bad debt provisions of the bank are sufficient. They also allow a bank an opportunity to identify weaknesses or areas of concern with recent lending or the ongoing credit control in the bank.

This, again, is a data-driven process, and once the full loan book is extracted and prepared, the following items can be highlighted for review:

Top 10, 100, or 1000 loans

Loans with high arrears

Loans with no payment in more than 6 or 12 months

Rescheduled loans from the previous 6 or 12 months

Once a population of loans is available, a sample set of loans is selected for review. The loans are reviewed according to a number of different attributes, including current loan outstanding, interest due, any arrears, last of payment, expected completion date, security, etc. However, the more qualitative details of the loan and borrower may be more important here—information obtained from discussions with the credit controller, details on the customer in their file or publicly available, etc. A loan, through a quantitative review, may look like it is performing, but details such as the status of the borrower’s business may have more impact on the status of the loan. Once the assessments are completed, the results can be collated, and a decision made on if the bad debt provision is sufficient against the current state of the overall loan book. An expected outcome would be a list of loans where additional provisions are required, as well as an overall summary for the management and board of the bank.

DESCRIBE HERE

Figure 4: Example Summary of Loan Book Review

In addition, a brief memo to senior management and the board should describe the technique used for the review (including the sample used), the results of the review regarding the loan book, and the changes, if any, required by the provisions.

Workout Phase

The expected and most welcome outcome for lending, when it comes to the end of the credit life cycle, is that it is paid off and new facilities are provided to the customer. However, this may not always be the case, and processes and procedures should be put in place to work out these less desirable outcomes as well.

Repayment and Servicing

If the lending continues as normal toward its natural maturity, then usually at regular intervals the interest and some part of the principle is paid off. The bank or an agency engaged to do this work will need to maintain a record of these payments and the resulting balances, update payment instructions as required, and other such administrative items.

Credit Control

While the assessment of credit risk and the extension of funds to good borrowers or counterparties are important, the other important aspect of the credit life cycle is to respond to any lending that begins to fail. Banks need to have documented credit control policies and procedures to ensure that the credit control function is managed in a consistent and efficient manner.

There are several commonly used definitions for an economic recession; a recession may be defined as two consecutive quarters of declines in quarterly inflation adjusted (real) gross domestic product (GDP). However, whatever the definition, a recession should be seen as a period in which there is a sustained and significant decline in economic activity. It will last at least several months and will see a decline in consumer confidence, a related decline in sales, and possibly an increase in unemployment.

Again, there are several different commonly used definitions for an economic depression. Some can be an extension of the recession definition above—thus, it may be a recession that lasts 2 years or more, or a decline in GDP of over 10%.

However, an even more common definition is:

When your neighbor loses their job, it is a recession.

When you lose your job, it is a depression.

What is key here is that economic circumstances such as these will result in increasing difficulty for lending to be serviced, and the related bank will need to ensure credit control is resourced and ready for such activity and its management.

Box 5: Recessions and Depressions

Sometimes, as simple a measure as ensuring a borrower or counterparty is contacted as early as possible may be effective in recovering the lending to its agreed behavior.

As economic conditions change, this may involve deploying more resources to credit control to help with the inevitable increase in credit issues that emerge when economic conditions impact a borrower or counterparty. It is vital that sufficient resources are employed in this area to ensure that arrears are identified at an early stage, appropriate action taken, and defaulters steadily monitored. Having a consistent approach to engagement with such borrowers or counterparties is valuable.

DESCRIBE HERE

Figure 5: Approach to a retail borrower not meeting obligations.

The above example could be used to bring a consistent approach to a retail borrower who is not meeting their agreed obligations for a loan. Obviously, a preference will be to not have the issue passed over to legal representatives, but often even just the threat of this may be necessary to resolve the issue with the lending.

Restructuring

Restructured lending is where the repayment terms and conditions have been altered from the original terms and conditions of the lending. This is usually the first attempt made to recover the condition of failing lending. The aim here is to engage with the borrower or counterparty, discuss their current financial status and come to some new agreement on how the loan will be repaid. Shorter-term arrangements can sometimes be made to allow reduced payments or a repayment holiday for a period. However, any such arrangements that last more than 3 or 4 months are normally taken into the restructuring process.

The related engagement with the borrower or counterparty is best taken as a repeat of the earlier credit risk assessment, however with a new set of inputs based on the current financial state. It is assumed that something has occurred to result in the difficulty in servicing the debt, and so the full details of this have to be gathered and assessed. This is also a time for honesty from the borrower or counterparty. A truthful declaration of their financial situation, other debt obligations, and other such elements would be of use at this time.

There is little good in a new agreement being made on repayments and other