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Literature review on credit risk management in banks

The advancement of information and communicative technology ICT is given credit for the evolution of banking services, in particular, online banking.

The development in ICT has not only provided vast banking opportunities previously beyond reach, but also heightens the competition and risks faced by banks in the financial system Voon-Choong et al. Risk is the deviation of the expected outcome.

In one way, risk can be classified as business risk and financial risk. Financial risk arises from possible losses in financial markets due to movements in financial variables Jorion and Sarkis, 1996. It is usually associated with leverage with the risk that obligations and liabilities cannot be met with current assets Gleason, 2000. Another way of decomposing risk is systematic risk and unsystematic risk. Systematic risk is associated with the overall market or the economy and it can be mitigated in a large diversified portfolio, whereas unsystematic risk is linked to a specific asset or firm and cannot be diversified though its parts can be reduced through mitigation and transferring techniques Santomero, 1997.

However, some risks cannot be eliminated or transferred and must be absorbed by the banks. The first is due to the complexity of the risk and difficulty in separating it from asset. The second risk is accepted by the financial institutions as these are central to their business. These risks are accepted because the banks are specialized in dealing with them and get rewarded accordingly. The objective of financial institutions is to maximize profit and shareholder value-added by providing different literature review on credit risk management in banks services mainly by managing risks Khan and Ahmad, 2001.

Bangladesh Bank, the prime supervisory authority of the financial sector implemented the new capital standard — Basel II from January 2009 in parallel with Basel I.

From January 01, 2010 Basel II has been solely implemented in the banking sector. Basel II requires addressing and managing the market risk and operational risk in addition to the existing as per Basel I credit risk. In response to the new capital accord Basel IIrisk management process within the bank has been introduced supporting the principles of more risk sensitive approach to capital adequacy.

Most of the parties involved in bank-dealings suffer from the following limitations: Literature review on credit risk management in banks these necessity call for an in-depth investigation on risk management practices and here lies the justification of this study. Risks faced by banks Risk, in this context, may be defined as reductions in firm value due to changes in the business environment David H. Typically, the major sources of value loss are identified as: Market risk is the change in net asset value due to changes in underlying economic factors such as interest rates, exchange rates, and equity and commodity prices.

Credit risk is the change in net asset value due to changes the perceived ability of counter- parties to meet their contractual obligations. Operational risk results from costs incurred through mistakes made in carrying out transactions such as settlement failures, failures to meet regulatory requirements, and untimely collections. Performance risk encompasses losses resulting from the failure to properly monitor employees or to use appropriate methods David H. Generally, commercial Banks face the following risks: Credit Risk Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms http: It is the potential loss arising from the failure of a borrower to meet its obligations in accordance with agreed terms.

Literature review on credit risk management in banks

Credit risk is one of the oldest and most vital forms of risk faced by banks as financial intermediaries Broll, et al, 2002. Commercial banks are most likely to make a loss due to credit risk Bo, et al. Generally, the greater the credit risk, the higher the credit premiums to be charged by banks, leading to an improvement in the net interest margin Hanweck and Ryu, 2004.

Market Risk The risk of loss from adverse movement in financial market rates interest and literature review on credit risk management in banks rate and bond, equity or commodity prices. The risk of changes in income of the bank as a result of movements in market interest rates. Interest rates risk is a major concern for banks due to the nominal nature of their assets and the asset-liability maturity mismatch Hasan and Sarkar, 2002.

Some researchers emphasized that higher interest rates had positive impact on banks Hanweck and Ryu, 2004; Hyde, 2007. It arises from potential change in earnings resulted from exchange rate fluctuations, adverse exchange positioning or change in the market prices managed by the Treasury Division. Equity Risk It is the risk of loss due to adverse change in market price of equities held by the bank.

Equity risk is "the financial risk involved in holding equity in a particular investment. The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods.

The standard deviation will delineate the normal fluctuations one can expect in that particular security above and below the mean, or average.

However, since most investors would not consider fluctuations above the average return as "risk", some economists prefer other means of measuring it en. Operational Risk The potential financial loss as a result of a breakdown in day-to-day operational processes.

These caused are largely uncontrollable and unpredictable. Moreover, human or technological errors, lack of control to prevent unauthorized or inappropriate transactions being made, fraud and faulty reporting may lead to further losses caused by internal process, people and operating system Medova, 2001. Money Laundering Risk It arises from the practice of disguising the origins of illegally-obtained money drug dealing, corruption, accounting fraud and other types of fraud, and tax evasion, etc.

Information Technology Risk It is related to IT, such as network failure, lack of skills, hacking, virus attack and poor integration of system. Liquidity Risk It literature review on credit risk management in banks from the failure or inability to meet current and future financial obligations by bank due to shortfall of cash or cash equivalent assets. Banks are exposed to liquidity risk where the more liquidity is generated, the greater are the possibility and severity of losses associated with having to dispose of illiquid assets to meet the liquidity demands of depositor Diamond 1999; Allen and Jagtiani, 1996.

However, besides depositors, revealed that banks that make commitments to lend are exposed to the risk of unexpected liquidity demands from their borrowers Gatev, 2006. Marketing Risk This risk is related to the different aspects of the promotion and branding of the bank, including image management, product promotion and advertising. Human Resource Risk This type of risk is generated within the bank from failure to recruit the right people in the right place, inappropriate means of recruitment, failure to provide feedback to the employees on performance, over-reliance on key personnel, inappropriate training and development etc.

Techniques of Risk Management GAP Analysis It is an interest rate risk management tool based on the balance sheet which focuses on the potential variability of net-interest income over specific time intervals. These schedules are then used to generate indicators of interest-rate sensitivity of both earnings and economic value to changing interest rates.

After choosing the time intervals, assets and liabilities are grouped into these time buckets according to maturity for fixed rates or first possible re-pricing time for flexible rates. The assets and liabilities that can be re-priced are called rate sensitive assets RSAs and rate sensitive liabilities RSLs respectively.

Positive GAP indicates that an increase in future interest rate would increase the net interest income as the change in interest income is greater than the change in interest expenses and vice versa Cumming and Beverly, 2001. Duration-GAP Analysis It is another measure of interest rate risk and managing net interest income derived by taking into consideration all individual cash inflows and outflows.

Duration is value and time weighted measure of maturity of all cash flows and represents the average time needed to recover the invested funds.

Duration analysis can be viewed as the elasticity of the market value of an instrument with respect to interest rate.

When interest rate increases by comparable amounts, the market value of assets decrease more than that of liabilities resulting in the decrease in the market value of equities and expected net-interest income and vice versa Cumming and Beverly, 2001.

Value at Risk VaR It is one of the newer risk management tools. The Value at Risk VaR indicates how much a firm can lose or make with a certain probability in a given time horizon. VaR summarizes financial risk inherent in portfolios into a simple number. Though VaR is used to measure market risk in general, it incorporates many other risks like foreign currency, commodities, and equities Jorion, 2001. As economic capital protects financial institutions against unexpected losses, it is vital to allocate capital for various risks that these institutions face.

Risk Adjusted Rate of Return on Capital RAROC analysis shows how much economic capital different products and businesses need and determines the total return on capital of a firm.

Though Risk Adjusted Rate of Return can be used to estimate the capital requirements for market, credit and operational risks, it is used as an integrated risk management tool Crouhy and Robert, 2001 Securitization It is a procedure studied under the systems of structured finance or credit linked notes.

The bank pools a group of income-earning assets like mortgages and sells securities against these in the open market, thereby transforming illiquid assets into tradable asset backed securities. As the returns from these securities depend on the cash flows of the underlying assets, the burden of repayment is transferred from the originator to these pooled assets.

Sensitivity Analysis It is very useful when attempting to determine the impact, the actual outcome of a particular variable will have if it differs from what was previously assumed. By creating a given set of scenarios, the analyst can determine how changes in one variable s will impact the target variable.

Internal Rating System An internal rating system helps financial institutions manage and control credit risks they face through lending and other operations by grouping and managing the credit-worthiness of borrowers and the quality of credit transactions. Conclusion In order to make the risk management effective in the selected commercial banks operating in Bangladesh, the major types of risks, e.

Centre for Financial Research, 1-23. Cumming, Christine and Beverly J.

Literature review on management

A Theory of Banking. National Bureau of Economic Research, 1-55. Review of Derivatives Research, 5 3213-250. Managing Bank Liquidity Risk: National Bureau of Economic Research, 1-38.