Risk management

Running head: RISK MANAGEMNT 1

RISK MANAGEMENT 13

Risk Management

Student’s Name

Institution Affiliation

Task 1: Credit Risk Management

a. Credit risk Management Procedure

Individuals and companies approach banks for credit facilities. However, banks apply prudent credit management policies which outline procedures that the credit management team needs to follow to determine whether an individual/ entity qualifies for a loan or not. Among the three main types of risks experienced by banks, credit risks is one of them. Credit risk is the probability that an individual or an institution that has borrowed money from the banks fails to meet the obligations as stated on the terms and conditions that were used to advance the loan to the borrower (Al Ghassani, Al Lawati & Ananda, 2017). In particular, failure of the borrower to repay the full amount by the agreed date or partial repayment that do not correspond to terms of the agreement during the loan application and approval process or defaulting the entire loan all amount to credit risk.

Credit risks could lead to potential loss to the organization. Similarly, credit risk can lead to the problem of nonperforming loans. Practically, every business experience some amount of risk but the risk must be within an acceptable level to prevent the possibility of jeopardizing the operations of the business entity. Therefore, banks will always experience credit risks but should be within manageable levels. As a result of this, credit risk management is undertaken by the banks with aim of bringing down credit risk and maximizing the bank’s risk-adjusted rate of return.

Whenever a credit request is made similar to the Samiha case, the request is subjected through the credit risk management process to determine whether an individual qualify for an applied credit facility or not. There are 5 stages of credit risk management which should be followed to eventually establish whether Samiha will be granted a loan or not.

In stage 1, the bank will seek to understand the purpose of credit (Al Ghassani, Al Lawati & Ananda, 2017). Banks are cautious when issuing credit. Borrowers are required to truthfully explain how they will use the loan. This is important because borrowers need to take loans with a plan and put into good use which would generate returns that would help to repay or loan or whose is equivalent to the amount of loan. For Samiha, she wants a loan to replace equipment and furnish her shop and also increase her working capital. Stage 2, banks analyze the finances of the borrower and assign credit score (Al Ghassani, Al Lawati & Ananda, 2017). When a good credit score is assigned to a borrower, chances of securing a loan are high and vice versa is true. Stage 3, the repayment capacity of borrowers is determined (Al Ghassani, Al Lawati & Ananda, 2017). The bank establishes sources of funds for the borrower, expenses that must be met and returns generated to determine whether the borrower can repay the loan applied for. Stage 4, structure of the credit facility is evaluated, that is terms and conditions applicable. Each credit is differently structured from another because they designed to serve different needs. Therefore, will have to assess terms and conditions applicable to the applied credit facility by Samiha to determine whether she qualifies or not. Lastly, the security attached to the loan is evaluated (Al Ghassani, Al Lawati & Ananda, 2017). When the bank is satisfied with the security attached to the credit facility Samiha, will walk home with a credit facility.

b. List of Documents Used in Credit Risk Management

For the bank to successfully undertake the credit risk management process the following documents will be needed:

· Certificate of ownership and existence of the business.

· Most recent credit reports and credit classification of each facility.

· Audited financial statements

· Report on returns generated by Samiha.

· Account receivables and payables report.

· Personal finance details.

· Loan covenant.

· Collateral.

· Insurance information

Task 2: Credit Risk Exposure

Banks suffer from credit, operational and market risks. In this particular task, attention is paid to credit risks. Banks issue credit facilities to different types of clients, some repay loans, others partially while others fully default the loan. All the banks, nationally and internationally operating, are highly regulated to keep banks off or minimize credit exposure. Four detailed analysis, the subject matter will be covered in four sections in this particular task.

a. Reasons for managing credit risk exposure

Managing credit risk exposure is potentially important not only to the banks but also to the economy in general. Individuals and business entities depend on the banks to transact their businesses and carry out their daily operations. Similarly, banks have offered employment opportunities to many people hence contributing to the growth and development of the economy. This means when a bank is exposed to credit risk, the source of livelihoods that depends on the banks are put at risk, businesses and individuals that have invested with the bank are put at risk and the economy, in general, is exposed to risk. Therefore, managing credit exposure help to save the economy, investors, and employees that depend on the banks as a source of livelihood.

Second, managing credit risk exposure help banks to set credit risk within the standard and acceptable limits. Essentially, it is extremely hard to eliminate all amounts of credit risk but when it is managed, banks can have it set within logically and reasonable limits which they can be allowed to occur without jeopardizing the operations of banks. It is within this principle credit risk models have been developed that are used to determine business entities that qualify for credit facilities and those that do not. CBO released a circular to all banks which demands them to use five parameters to classify retail and commercial loans, which demonstrates a commitment to tighten the regulatory belt to aim to manage credit risk exposure. Category one standard entails loans and advances which do not indicate financial weakness. This means interest and principal payment are current. Category two is a special mention that entails loans that demonstrates financial weaknesses (CBO, 2004). Loans that are put in this category demand intervention of management to assess the quality of assets. Whenever the bank credit management team realizes that the advanced loans correctly fit as special mention, it will be necessary to move with speed failure to which would deteriorate repayment position narrowing down to adverse classification of loans. Therefore, appropriate management of credit risk exposure would prevent special mention falling into the trap of adverse classification of loans.

Category three is substandard which entails loans and advances which have a well-defined financial weakness and repayment of the loan cannot is in the pathways (CBO, 2004). Essentially, the ability of the borrower to make timely repayment is compromised. Whenever a bank recognizes that an advanced credit facility fits within this category, some loss by be experienced unless measures are taken in good time to correct the problem. Category four and five are doubtful and loss respectively. Doubtful are loans which have weaknesses graduated from substandard while loss are uncollectible loans (CBO, 2004). In most cases, substandard, doubtful and loss loans are put in a single class known as non-performing loans. Therefore, managing credit risk exposure can help banks from falling culprits of non-performing loans if interventions are taken at the special mention category.

Lastly, managing is credit risk exposure is necessary for the process of developing a credit risk strategy which constitutes goals used to identify quality credit. Banks are in the business to make profit. Giving out credit is one way to generate profit and earning through credit creation. However, managing credit risk exposure enable banks to determine types of credit facilities whose risks are minimal and would help the bank to generate earnings.

b. Credit risk management framework

Credit risk management is the process that is used to manage risk to minimize risks and maximize the risk-adjusted rate of return. For the banks in Oman, the following credit risk management framework is followed:

First, banks must outline the procedure to assess whether an individual qualifies for a loan or not using five stages. Stage 1, the bank will seek to understand the purpose of credit (Al Ghassani, Al Lawati & Ananda, 2017). In this stage, the borrower is required to explain how he/she intend to use the loan. This helps banking institutions to establish whether the reasons put forward are economically viable and reasonable to guarantee the issuance of the loan. Stage 2, banks analyze the finances of the borrower and assign credit score (Al Ghassani, Al Lawati & Ananda, 2017). Banks calculate credit risk using the following terms- probability of risk, exposure at default, recovery rate loss given default (Al Ghassani, Al Lawati & Ananda, 2017). These computations plus credit bureaus reports are used to assign a credit score to borrowers. When a good credit score is assigned to the borrower, chances of securing a loan is high and vice versa is true. Stage 3, the repayment capacity of borrowers is determined (Al Ghassani, Al Lawati & Ananda, 2017). The bank establishes sources of funds for the borrower, expenses that must be met and returns generated to determine whether the borrower can repay the loan applied for. Stage 4, the structure of the credit facility is evaluated- entails terms and conditions applicable to the credit facility. Each credit is differently structured from another because they designed to serve different needs. Lastly, the security attached to the loan is evaluated (Al Ghassani, Al Lawati & Ananda, 2017). When the bank is satisfied with the security attached to the credit facility Samiha, will walk home with the credit facility.

Second, tools for credit risk management are applied by the bank to determine the creditworthiness of the applicant. Central Bank of Oman require banks to use the following credit risk management tools: lending ratio set at 87.5% of customer deposits; exposure caps – counterparty should not exceed 15% of the total capital of the bank, related parties not exceed 10% of total bank capital and government entities should not exceed 25% of total bank capital.; retailing lending restrictions with debt burden ratio should not be more than 50% of customer account; banking should demand audited financial statement to customers with credit limits that sum to OMR 250,000; separation authorities between lending and classification accounts, credit reports for all credit facilities; classification of borrowers into standard, special mention and substandard, doubtful and loss accounts (Al Ghassani, Al Lawati & Ananda, 2017). Third, credit facilities should be reviewed annually and lastly, quantitative ceilings and controls to contain credit risk appetite.

c. Credit Risk Culture

The great financial crisis was partially blamed on loose regulations by lending institutions. Since then, lending re-examined lending policies and processes which govern risk management. Leaders of lending institutions have taken measures aimed at creating a strong credit risk culture by rolling out internal programs that train and equip employees with knowledge on the credit risks. A strong credit risk culture is created when an organization develops a set of values and beliefs which are shared by the employees on the approach of the organization on the credit risk and acceptable standards in making lending decisions(Moody Analytics, n.d). To build strong credit risks culture, the following factors will need to be taken into consideration: exemplary organization leadership that develops a vision that guides lending activities of banking institution; enhancing credit skills through credit training; developing organization structure that embodies lending-related roles; designing policies and processes that empower employees in all levels to make credit lending decisions and lastly, creating an environment that promotes shared responsibility for credit risks (Moody Analytics, n.d).

d. Credit Risk Mitigants

Banking institutions employ various measures to mitigate credit risks. The creation of strong credit risk culture is one of the ways which lending institutions can take to mitigate credit risks (Moody Analytics, n.d). Implementation of risk classification rolled out by CBO in 2004 is another instrument which can be used by the lending institutions to mitigate credit risks. It would be expected that lending institutions would take corrective measures for credit facilities are deemed to fit in special mention and substandard categories. Implementation of credit risk management procedure where banks evaluate whether borrowers qualify for loans applying five stages is another tool to mitigate credit risk (Al Ghassani, Al Lawati & Ananda, 2017). To the applicants that successfully through the five stages, they qualify for the loan. Credit risk management is paramount in determining the creditworthiness of the buyer.

Task 3: Liquidity Management

a. Importance of Sound Liquidity Management

Bank liquidity is an important fundamental which promotes smooth operation for the lending institutions. Daily and smooth operations depend on whether have adequate liquidity. For banking institutions, liquidity refers to a condition where organizations have adequate finances to meet increases in the assets and obligations that come without incurring unacceptable losses.

Sound liquidity management helps to ensure that the banks are capable of cash flow obligations, which are uncertain because they are affected by external events and the agent’s behavior. (BIS, 2008). Adequate liquidity ensures that customers smoothly make their withdrawals, banks can meet credit demand also meet other short-term expenses which demand cash payments. The financial health of lending institutions is determined by the level of liquidity position held by banks.

Sound management of liquidity is of great importance to the lending institutions. Essentially, whenever there is a shortfall in the liquidity, could lead to system-wide consequences (BIS, 2008). For instance, when lending institutions have a liquidity shortfall, it may not be able to meet credit demand. This denies individuals and companies opportunities to access credit. Lack of credit facilities reduces investment and consumption because some individuals needed credit to undertake some level of consumption while others depend on credit to finance investment activities.

Sound Liquidity management ensures that there is available cash that promotes the functioning of the financial market and banking sectors (BIS, 2008). However, when liquidity is inadequate, banks are put under pressure and stress because their smooth operation is severely affected. For instance, during the great financial crisis, banks and lending institutions had inadequate liquidity which was necessitated by a lack of effective liquidity management which ours banks into stress resulting in collapse and closure of some banks while others had to be bailed out and supported by the government to give life to them. Therefore, such eventualities that paralysis lending and banking institutions can be avoided when banks institute proper liquidity management.

Lastly, sound liquidity management helps banks and lending institutions sufficient liquidity that is needed to help banks withstand a wide range of stress such as those emanating from loss or impairment of secured and unsecured sources of funding (BIS, 2008). Banks should take appropriate measures to maintain adequate liquidity which is needed to protect depositors and also cushion the financial system from potential damage (BIS, 2008).

b. Sources, Types, Measurement, and Management of Liquidity Risks

Liquidity risks occur when banking institutions do not have adequate cash flows to meet prevailing or obligations which are due. In other words, whenever liquidity needs are greater than expected, such occurrence amounts to liquidity risk.

The occurrence of market, credit and operational risks prompt the occurrence of liquidity risks. Market risks arise due to fluctuation in the value of assets which might be caused by fluctuation in interest rates, exchange rates, changes in stock prices and inflation. Credit risks occur when a borrower defaults to pay credit facility advanced to him/ her. Operational risks occur due to failed internal processes, processes, mistakes made by people and even from external sources. Essentially, the occurrence of the three types of risks is the potential cause of liquidity risks.

Some types of liquidity risks are funding risk, market liquidity and episodic risk. Funding liquidity risk is one that banks are not able to meet short-term financial obligations that are due. Market liquidity risk-banks sales of asset or mortgage is not equal to prevailing market prices while episodic liquidity risk occurs due to sudden withdrawals of customer deposit or sudden use credit limits granted to a counterparty.

Banks and other institutions have put in place processes and methods to measure liquidity risks. Some techniques to measure liquidity risks include targeted liquidity ratios (current and quick ratios), interest rates, and foreign exchange exposures and lastly, value at risk (BIS, 2008).

Bank and lending institutions are required to put in place measures to manage liquidity risks. Some approaches that can be used to manage liquidity risks are the development of liquidity strategy which defines what liquidity means to an organization and how it is integrated into business strategy; setting limits for an acceptable amount of liquidity risks; instituting a board of management that oversees, understand sources of risks and institute measures to address each type of risk and lastly, operationalization of sound liquidity risk management practices (BIS, 2008). Most importantly, banks should develop a working structure to manage liquidity risk which comprises of four components- management structure to execute liquidity strategy, Bank Board of directors to come up with policies and strategies to manage liquidity, agreed strategy for day to day management of liquidity and lastly, banks need to have adequate information systems to monitor, control and report liquidity risks (BIS, 2008).

References

Al Ghassani, A. M., Al Lawati, A. M., & Ananda, S. (2017). Banking Sector in Oman Strategic Issues, Challenges and Future Scenarios. Retrieved from http://www.cbfs.edu.om/UploadsAll/Annexure%2013%20Edited%20Book%20on%20Banking%20Sector%20in%20Oman%20-%202017.pdf

BIS. (2008).Principles for Sound Liquidity Risk Management and Supervision. Retrieved from https://www.bis.org/publ/bcbs144.pdf

CBO. (2004). CIRCULAR BM – 977. Risk Classification of Loans. Retrieved from https://dokumen.tips/documents/cbo-bm977pdf.html

Moody Analytics. (n.d). Building a Strong Credit Culture: Best Practices for Modern Banks. Retrieved from https://www.moodysanalytics.com/-/media/building-a-strong-credit-culture.pdf