Impact of Credit Risk on Bank's Profitability: The Case of Barclays Bank Ghana

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GHANA INSTITUTE OF MANAGEMENT AND PUBLIC

ADMINISTRATION

“The Impact Of Credit Risk Management On

Banks’ Profitability”: The Case of BBG

By

Godwin Kwabla Ekpe

2011

A Project work presented in part consideration for the award of Master of

Business degree in Finance (MBA Finance)

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MBA Degree Project: The Impact of Credit Risk Management on Banks’ Profitability, 2011

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DECLARATION

I hereby declare that this project report submitted by me to the Ghana Institute of Management and Public Administration is my own work carried out under the guidance of Dr. George Owusu-Antwi towards the MBA-Finance degree. I further declare that, to the best of my knowledge, it contains no material previously published by another person nor material which has been accepted for the award of any degree by any University, except where due acknowledgement has been made in the report.

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DEDICATION

Through it all, I have learnt to trust in you, Jesus. Your love for me overcame the cross and the grave to find my soul. You have brought me this far, giving me strength and guidance through the journey. To you be all the glory and adoration now and forever more. Amen

To the memory of my late dad, and to my mom, siblings and the family. God bless you for your support. You have been my encouragement.

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ACKNOWLEDGEMENT

I wish to express my heartfelt gratitude to Dr. George Owusu-Antwi, my supervisor. Your counsel was very valuable. I appreciate your expert guidance and patience.

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2.4.7 Strategic Risk ... 32

2.5 Credit and Credit Risk Management ... 33

2.5.1 Credit ... 33

2.5.2 Credit Risk ... 35

2.5.3 Approaches To Credit Risk Management ... 36

2.6 SUPERVISORY AUTHORITY OF BANK CREDIT RISK MANAGEMENT ... 43

CHAPTER THREE ... 47

CONCEPTUAL FRAMEWORK ... 47

3.1 FRAMEWORKS FOR IDENTIFYING THE PRESENCE OF A SOUND CREDIT RISK POLICY ... 47

3.2 DATA SOURCE ... 49

3.3 QUANTITATIVE ANALYTICAL TOOLS ... 49

3.3.1 Financial Ratios ... 50

3.3.2 Graphs and Charts ... 51

3.4 STANDARDS AND BENCHMARKS ... 51

3.5.1 Credit Culture ... 52

3.5.2 Credit Organization ... 55

3.5.3 Credit Policies ... 57

3.6 COMPANY PROFILE ... 59

3.6.1 INTRODUCTION OF COMPANY-AN OVERVIEW ... 60

3.6.2 MISSION/VISION/OBJECTIVES/GOALS... 61 3.6.3 CORE VALUES ... 62 3.6.4 PRODUCTS ... 64 3.6.5 GENERIC STRATEGY ... 65 3.6.6 MARKETING ANALYSIS/STRATEGY ... 67 CHAPTER FOUR ... 69

PROJECT EXECUTION-ASSESSMENT OF BANK ... 69

4.1 ENVIRONMENTAL ANALYSIS OF THE BANKING INDUSTRY ... 69

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7 4.2 THE MICRO-ENVIRONMENTAL FACTORS-THE PORTER’S FIVE FORCES INDUSTRY ANALYSIS MODEL

... 79

4.2.1 SWOT ANALYSIS OF BARCLAYS BANK OF GHANA LTD (BBG) ... 87

4.3 SUMMARY OF INDUSTRY ANALYSIS AND CRITICAL SUCCESS FACTORS IN THE GHANAIAN BANKING INDUSTRY ... 91

4.3.1 Key Highlights from the Ghanaian Banking Industry ... 91

4.3.2 Key Success Factors of Banking Industry in Ghana ... 93

4.4 STRATEGY AND PERFORMANCE OF BBG (2006-2010) ... 96

4.4.1 Financial Performance Of BBG And Identification Of Managerial Issue (2005-2010) ... 98

4.4.2 The Managerial Issue of Concern-What Went Wrong in BBG? ... 103

4.5 CREDIT ADMINISTRATION PROCESS AND MATTERS ARISING FROM BBG’S 207/08 AGGRESSIVE LENDING CAMPAIGN - FINDINGS ... 109

CHAPTER FIVE ... 118

CONCLUSIONS AND RECOMMENDATIONS ... 118

5.1 SUMMARY OF FINDINGS AND CONCLUSIONS ... 118

5.2 RECOMMENDATIONS... 121

REFERENCES ... 129

APPENDIX A: Glossary of key financial terms and ratios ... 133

APPENDIX B: Signs of a Distorted Credit Culture ... 135

APPENDIX C: Principles for the Assessment of Banks’ Management of Credit Risk ... 137

LIST OF ABBREVIATIONS ... 139

LIST OF TABLES Table 1.1: Summary of BBG‘s performance in Ghanaian banking industry ... 16

Figure 2.5.1. Relationship between Creditor and Debtor (Adapted from Colquitt 2007, 2) ... 34

Fig 2.5.3 Credit Analysis Process Flow (Caouette, Altman, Narayanan, Nimmo 2008, 108) ... 37

Table 2.5.3.1.2 Strategies for Reducing and Coping with Portfolio Credit Risk ... 40

Table 2.6: Top 10 Least Risky Sovereign Credits Risk Rankings (Least risky countries), Score out of 100 ... 46

Table 3.1: Ratios in assessing credit risks ... 50

Figure 3.5.2. Credit Cycle (Adapted from Colquitt 2007, 24) ... 56

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Fig. 4.2.1. Macro-environmental Factors --- The PESTEL (Adapted from Kojo Aboagye-Debrah,

2007) ... 71

Table 4.2. Performance of Ghana’s Economy in Election Years ... 74

Table 4.1.1.6. Some Major Banking and Financial Laws in Ghana ... 78

Fig 4.2.2: Porter’s Five Competitive Forces ... 80

Table 4.4.1. Some Profitability and Asset Quality Ratios-BBG vs. Industry ... 99

Table.4.4.2. BBG’s PBT, IMP CHG, Operating Expense and their Rate of improvement (+)/deterioration (-) ... 103

Table 4.4.2.1. BBG’s Gross Loans And Advances in GH¢ '000 ... 105

Table 4.4.2.2. BBG’s Impairment vs. Profitability... 106

Table 4.5. Summaries of credit risk management techniques and practices at Barclays ... 110

Fig. 4.5. BBG’s Retail Credit End to End Process Flow ... 113

LIST OF FIGURES Fig 2.5.1 Relationship between Creditor and Debtor...……….……….34

Fig 2.5.3 Credit Analysis Process Flow ………...37

Fig 3.5.2 Credit Cycle (Adapted from Colquitt 2007, 24) ....….……….…...56

Fig. 4.2.1 Macro-environmental Factors --- The PESTEL...………71

Fig 4.2.2 Porter’s Five Competitive Forces ………80

Fig. 4.5. Retail Credit End to End Process Flow …..………113

LIST OF CHARTS Chart 1.2: Summary of BBG’s performance in terms of profitability ...17

Chart 4.1.1.3 Ghana’s Population Growth Rate (%)…..……….….…….75

Chart 4.2. Market Share Analysis-Dwindling Market share of 1st_{Quartile Banks in Ghana ……...86}

Chart 4.4.1 BBG and Industry comparison of Performance Indicators ………100

Chart. 4.4.1.1. Profitability on Bank Assets ………..101

Chart 4.4.1.2 Trend Analysis of BBG’s Profitability and Efficiency Ratios.. ………...102

Chart 4.4.2.2 BBG’s Impairment-Profitability Comparison ….……….107

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ABSTRACT

Banking as a business or subject is a profession whose practice has evolved over the ages from the primordial stone-age, through the Victorian-age to the Technology-based internet-age banking, making use of Point Of Sale (POS) devices, Automatic Teller Machines (ATMs), Credit and Debit Cards.

The banking industry across the world is becoming more and more competitive. And as such management of various banks are faced with the arduous task of improving the bank’s competitiveness and profitability. Being a service industry, bank managers seek to optimize profit and service through protection of stakeholders’ investment and provision of consistent and enhanced customer service. However, a major threat to achieving this is Credit Risk which is thought as most serious risk faced by banks as it impacts directly on banks’ net worth.

Credit risk is always considered as a great hurdle not only to the banking industry but to all in the business circles as the risk of counterparties not fulfilling their obligations in full on the due date can have severe consequences on operations of any business entity.

However credit risk is very inherent in a bank’s lending and trading activities such that if not well managed, it can cause a bank to even go bankrupt, which can be proved by various bank failure cases, most recent examples coming from the 2008 credit crunch.

For banks, managing credit risk is not a simple task since comprehensive considerations and practices are needed for identifying, measuring, controlling and minimizing credit risk.

The focus of this study is to have a better picture of the foundations through which banks manage their credit risk, right from credit generation through credit administration to problem loan recovery and the overall impact on banks’ profitability. The study uses Barclays Bank of Ghana (BBG) as a model bank and a case study on the Ghanaian Banking Industry. In this light, the study in its first section gives a background to the study and the second part is a detailed literature review on bank credit and credit risk management tools and assessment models. The third part of this study provides the conceptual framework and the analytical tools used in assessing the managerial issue of credit expansion and its inherent risk and impact on profitability, which is the subject matter of the project. Chapter four which is the main part of the project assesses the performance of the bank vis-à-vis its credit operation and credit risk management processes. Chapter Five includes conclusion and proposed recommendations, based on the assessment done. The study revealed the bank lost the balance between profitability and growth on one hand and the basics of sound credit management in banking on the other hand as income considerations overshadowed that of credit risk considerations leading to historic losses in 2008 and 2009.

One key conclusion is that banks that adhere to proper implementation of good credit risk management policies have a lower loan default rate and relatively higher interest income based on the observed negative relationship between profitability and impairment charges.

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CHAPTER ONE

INTRODUCTION

1.0 BACKGROUND OF THE STUDY

Effective management of credit risk in financial institutions (FIs) is extremely crucial for the survival and growth of the FIs. The recent financial meltdown and previous bank failures have lent credence to this in that these failures have been blamed principally on the weaknesses of the regulatory frameworks and the credit risk management practices of the financial institutions1_.

Financial institutions primarily serve as intermediaries by channeling funds from those with surplus funds (mostly households) to those with shortages of funds (mostly firms and government units). Examples of financial institutions include: Commercial banks, Thrift intuitions, Insurance companies, Investment companies (operating mutual funds), Pension funds, Finance companies, Securities brokers and dealers, Mortgage companies and Real estate investment trusts.

Banks basically engage in the business of safeguarding money and other valuables for their clients. They also provide loans, credit and payment services such as checking accounts, money orders and cashier’s checks. With the advent of the Financial Services Modernization Act, 1999, banks have the freedom to provide a wide range of financial intermediation services which they

1_{As put forward by some professionals and scholars such as Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, at}

the 7th Annual India Business Forum Conference, London Business School, London, 23 April 2009 and Gabriele Sabato (August, 2009).

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11 previously could not engage in.

Some of these include the following: Information production, Asset diversification, Liquidity function, Investment services (indirect transfer), Brokerage services, Asset transformation (unbundling of investments), Reduction of transaction costs, Maturity intermediation, Denomination intermediation (investment size and foreign currencies), Provision of payment services and Risk management (insurance services).

The provision of any one or combination of these services comes with an inherent associated risk. Depending on the type of services mix being offered a bank may be faced with any of the following risks generally faced by banks:

I. Credit risk II. Liquidity risk III. Interest rate risk IV. Market risk

V. Off-balance sheet risk VI. Foreign exchange risk VII. Country or sovereign risk VIII. Technology and operational risk

IX. Insolvency risk

However among the risks that banks are faced with, credit risk is one of greatest concern to most banks since for many commercial/universal banks around the globe, credit creation remains the major income generating activity. Credit risk has proven to be the risk that can easily prompt bank failure. The greatest impact of the financial crisis experience over the years has been on the banking industry, where some banks which were previously performing well suddenly announced large losses with some of them having had to be bailed out by State or National governments.

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12 Some reasons put forward as accounting for these failures border on the failures in risk management with limited role of risk management in the granting of loans in most banks as they are unable to influence business decisions and the fact that their considerations are subordinate to increased interest incomes or profitability interests and lack of capacity to adequately make timely and accurate forecasts. Often times banks fail to observe good credit due diligence in their credit/lending generation and operations. This has resulted in the breach of basic risk management rules such as avoiding strong concentrations of assets, sub-standard loans and minimizing the volatility of returns.

The growth of the Ghanaian banking industry in 2008 suggests that global financial crisis did not have severe impact on the Ghanaian banking industry in 2008. In spite of the global financial crisis, the Ghana banking industry remained stable. Industry return on equity (ROE) and return on assets (ROA) remained at 22% and 2% respectively. Net interest income and net profit after tax for the industry increased by 38% and 32% respectively.2_{However, the deterioration of asset}

quality (impairment charge / gross loans and advances) of the banks in Ghana, from about 1.5% to 4.2%, over the 2007/2009 period due to significant balances of bad and doubtful debts on their books is an indication that all is not well with the sector. In fact one single most surprising non-performance in the Ghanaian banking industry in recent times was experienced by Barclays Bank of Ghana Ltd (BBG). The 2009 Banking Survey Report by PricewaterhouseCoopers, Ghana describes BBG as having fallen from grace, recording a profit before tax margin of -6.3% in 2008, a sharp fall from 36.8% in 2007.

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13 It is in this light that the assessment in chapter four will attempt to find out whether BBG’s abysmal performance was significantly caused by the case of an overriding quest for expanded interest income overshadowing strict adherence to basic lending rules that ensure effective credit operations and robust credit risk management practices.

Credit risk arises from the possibility that borrowers, bond issuers, and counterparties in derivative transactions may default (Hull, 2007). Credit risk affects financial institutions (FI) that make loans or buy bonds. It is the risk that the loans or bonds held by the FI will go into default.

It is also the risk that the promised cash flows from loans and other securities held as investment by FI may not be paid on due date or anytime thereafter. It includes the risk that claims made against an insurance policy may not be met.

The fact that credit risk has always been the biggest threat to any bank’s performance and “the principal cause of bank failures” (Greuning & Bratanovic 2009,) cannot be overemphasized. Therefore, a sound credit risk management framework is indispensable to a healthy and profitable banking institution.

Risk management is a structured approach to managing uncertainty and its adverse effects in an organization as well as on the value of financial products.

The process includes risk identification, risk measurement, risk monitoring and risk controlling. Controlling risk involves ensuring that policies, processes and procedures to control and/or mitigate material risks are in place. Banks should periodically review their risk limitation and

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14 control strategies and should adjust their risk profile accordingly using appropriate strategies, in light of their overall risk appetite and profile.

The strategies for managing risk include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk and accepting some or all of the consequences of a particular risk. In specific instances, an organization may choose to increase exposure to risk in order to take advantage of higher expected yield.

Given the issues that occasioned the global credit crunch in 2008 and its probable impact on the Ghanaian banking industry where the quality of banks’ loans and advances deteriorated in 2009 with the industry’s average impairment charge to gross loans almost doubled from 2.2% in 2008 to 4.2% in 2009, the scope of this project is to take a quick look at credit administration and Credit Risk Management in the Ghanaian banking industry using BBG as prototype/model bank representative of the industry.

1.1 JUSTIFICATION OF CHOICE OF INSTITUTION

Barclays Bank of Ghana Ltd (BBG) was chosen for this study because of the uniqueness and the relevance of its experience to this study. Firstly, Barclays as a strong and unique brand has a long standing reputation as being one of the biggest banks in Ghana’s banking industry. In BBG’s over 95 years of operations in Ghana, the bank has consistently posted strong performance in terms of profit, share of industry deposits, net operating assets, net loans and advances etc. Such sterling performance was also exhibited even during the last decade or more when competition in

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15 the industry soared up with the entrance of more banks and innovation. The bank has therefore maintained a place among the first quartile banks of the industry over the years. According to the 2008 Banking Survey Report released by PricewaterhouseCoopers Ghana in collaboration with the Ghana Association of Bankers, the blue eagle (BBG) finally soared higher than the golden eagle (GCB) – Barclays unseated GCB as Ghana’s biggest bank, a position held by GCB until 2007. BBG is ranked the first largest bank in terms of operating assets contributing 15.42% to total operating assets of the banking industry followed closely by GCB with 15.37% in 2007.

BBG, GCB, SCB and EBG continued to hold a large part of the industry’s deposits as their total deposits constituted about 50% of the industry’s total deposits in 2008. BBG continued to hold the largest share of industry deposits in 2008 although it lost part of its previous year’s share of the industry’s deposits (i.e. A fall from 17.2% in 2007 to 13.3% in 2008). BBG‘s share of industry assets, deposits, and loans and advances, over the last four years, are indicated in table 1.1 below.

The table below shows that BBG has had a strong showing in the industry over the period with rankings alternating mostly between first and second. However, one can also deduce a worsening position in percentage contribution to the industry with the bank losing three places to a 5th position in terms of loans and advances. This phenomenon of falling from grace was evident in the bank’s unprecedented losses in 2008 and 2009 with profit before tax margins (PBTM) of -6.3% and -13.8% respectively having previously posted PBTM of 36.8% in 2007.

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16 Table 1.1: Summary of BBG‘s performance in Ghanaian banking industry

2010 2009 2008 2007 2006 Performance Index % Cont R % Cont R % Cont R % Cont R % Cont R Share of Industry

Gross Loans and

Advances 6.50 5 8.80 2 13.30 2 16.52 2 15.78 2 Share of Industry

Deposits 10.60 2 12.10 2 15.70 1 18.60 1 15.10 2 Share of Industry

Assets 9.80 3 10.80 2 13.40 2 15.67 1 12.68 3

Cont = Contribution. R = Ranking

Source: Own construction using data from 2008 to 2011Ghana Banking Survey Reports by PricewaterhouseCoopers Ghana

Impairment charge/ gross loans and advances worsened from 0.8% in 2007 to 9.8% in 2009 before subsiding to 3.8% in 2010. These give an indication of some problems with the soundness of its credits. In the light of the above, I consider the bank to be an appropriate case for this study.

1.2 STATEMENT OF THE PROBLEM

The advent of the Financial Services Modernization Act of 1999 has led to a broadening of financial services being provided by banks. The fever caught up with banks in the Ghanaian industry with the introduction of the Universal Banking License in 2003 which permitted banks with GH¢7 million in capital to carry out any form of banking. This provides several avenues for banks to diversify their operations to provide myriad of services. But this diversification could be very risky if it is pursued without the necessary prudence.

The very nature of the banking business is so sensitive because more than 85% of their liability is deposits from depositors (Saunders & Cornett, 2005). These deposits are used in their

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17 money/credit creation activity which is exposed to risk. Though the global economic depression that hit almost all big economies throughout the world in the past 4 years did not have much impact on developing economies such as Ghana, there were some disturbing signals experienced on the Ghanaian banking sector. These signals were more pronounced in BBG as it posted a record successive loss in 2008 and 2009. The Chart below depicts a picture of the BBG story.

Chart 1.2: Summary of BBG’s performance in terms of profitability

Source: Own construction with PBT figures from BBG annual reports for 2007-2010

The Ghana banking survey 2009 reported that, despite the global financial crisis, the Ghana banking industry remained stable. Whiles this assertion might be true in terms of the general averages of the industry, the picture portrayed by the Chart 1.1 above for a traditionally top most performer as BBG gives cause to worry. Not only did profit erode between the 2007-2009 period but BBG’s asset quality deteriorated considerably over the period with Impairment allowance/ gross loans and advances sky-rocketing from 2.6% in 2007 to 8% in 2008 and then to 17.7% in 2009. Impairment charge/ gross loans and advances over the period had consequently seen

2006 2007 2008 2009 2010 PBT 45,589.00 52,436.00 (10,240.00) (23,506.00) 81,349.00 (40,000.00) (20,000.00) 20,000.00 40,000.00 60,000.00 80,000.00 100,000.00 PB T i n '00 0s o f Gh ab a C e d is

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18 unprecedented increment over the period, moving from 0.8% in 2007 to 6.0% and 9.8% in 2008 and 2009 respectively. The industry’s average impairment charge to gross loans almost doubled from 2.2% in 2008 to 4.2% in 2009 after increasing from 1.5% in 2007.

A closer look at the financial statements of BBG over the period thus revealed that the losses were largely due to losses incurred on impairment. The source of the impairment losses over the 2007-2009 periods has been traced to a massive expansion undertaken by the bank in 2007/08 spearheaded by an aggressive lending.

As stated earlier, BBG, as a subsidiary of Barclays PLC, is a model bank with great reputation of being a consistent top most performer. As such it is thought to have in place the requisite mechanisms to avoid lending disasters. However such huge losses recorded following its aggressive lending gives cause for a further probe to ascertain what went wrong and whether or not BBG really has the right and robust processes, procedures and policies in place to withstand major shocks that often accompany such massive credit expansion. Also, could the high default rates be due to lack of proper Credit/Borrower Due Diligence? Or was it due to lack of proper macro-economic forecast accompanied by deteriorated economic condition of borrowers?

In order to ascertain what really went wrong, there is the need to do a thorough assessment of the adequacy of BBG’s internal processes of credit generation, administration and risk management practices and frameworks put in place to handle the credit risk it is exposed to as well as the key factors in the external environment that affect its lending business. In addition this assessment

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19 will also ascertain the extent to which the Bank’s performance (profitability) can be augmented by proper credit risk management policies and strategies.

1.3 OBJECTIVE OF THE STUDY

The general objective of this study is to look at a broader picture of how banks approach their lending/credit generation activities to minimize the associated credit risk so as to avoid lending disasters and bank failures. The specific objectives of the study are thus two fold, which are to assess:

I. BBG’s profile of credit generation and administration practices over the 2007-2009 period. This also involves an assessment of the income statement and balance sheet, using various tools (ratios, charts and tables) to ascertain the level of credit risks the bank is exposed to and to identify the extent to which credit risk affects the size of the bank’s profitability.

II. The effectiveness of the bank’s credit risk management framework for managing credit risk it is exposed to. This involves an assessment of:

a. the robustness of governance structure in place,

b. the adequacy of policies, procedures, tools and skills and people issues, c. the effectiveness of control measures, and

d. the available information management systems to support timely and accurate information delivery to manage risk.

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20 The assessment here also includes an evaluation of the bank’s entire credit cycle and risk management practices vis-à-vis current recommended standards and best practices by the Basel Committee on Banking Credit Risk Management.

1.4 SIGNIFICANCE OF THE STUDY

An assessment of BBG’s credit generation cycle and credit risk management framework provided the state of the bank‘s ability to handle the inherent risks in its credit operations. The assessment revealed what went wrong when the bank chose aggressive lending as a growth strategy for its massive expansion. Also deviations from international best practices were also identified and alternatives recommended. The bank’s ability to deal with significant shocks and avoid losses during crisis periods was also tested.

Since there is not much structural and operational difference amongst the banks in Ghana, it is hoped that this study will provide an indication of how credit administration and credit risk management landscape would look like in Ghanaian banking sector when banks decide to pursue growth using massive credit expansion with or without much credit due diligence. In addition, it will provide a guide for further studies on asset quality and credit risk management in the industry.

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1.5 SCOPE AND LIMITATION OF THE STUDY

In carrying out a credit risk-based analysis of Barclays Bank of Ghana Ltd, information was mainly gathered from financial statements and other disclosures contained in the bank‘s annual reports and reports by the industry regulator and other watchers/analysts. In this regard, annual reports of the last four years (2010, 2009, 2008, and 2007) were considered to ensure consistency in the value used. This is because the bank shifted from the use of International Accounting Standards (IAS) to International Financial Reporting Standards (IFRS), in conformity with requirements by The Institute of Chartered Accountants (Ghana) for companies to prepare their financial statements for the year ended 31st December 2007 and beyond. The bank’s credit risk and collections management policy manuals and other independent reports on its performance were used to gather relevant information concerning the bank’s past and present credit operations, financial health and capacity to regain its rightful position at the top in the face of the difficulties it faced during the 2007-2009 period and the instability in the industry and the global economy as a whole.

The bank however considers most information, except those contained in the annual report and official releases, sensitive and for that matter detailed but relevant information was not available for use. As such some disclosures gathered through informal interview sections with some staff in the Credit Operations & Collections, Retail Credit Risk and Retail Business Units of the bank were taken into consideration in the analysis.

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22 Finally, due to lack of adequate comparable data on other players in the Ghanaian banking industry, the study was unable to provide a complete picture of the adequacy and performance of BBG’s risk management framework in relation to peer group trends and industry norms in all cases. However, in cases where industry data was available comparative analysis was undertaken.

1.5 ORGANIZATION OF THE STUDY

The project is divided into five chapters. Chapter one deals with the introduction of the study. It focuses on the background, justification of choice of company, statement of the problem, objectives, significance, scope and limitation of the study. Chapter Two is on literature review on commercial banks credit and credit risk management. It provides an integrative review of past studies that relate to the subject matter of credit operations and credit risk management. Chapter Three discusses the Conceptual Framework of the study. The chapter provides the framework/methodology and the analytical tools used in assessing the managerial issue of credit expansion and its inherent risk and impact on profitability which is the subject matter of the project. The Fourth Chapter contains the assessment of the performance of the bank vis-à-vis its credit operation and credit risk management processes. It also contains the analysis of the bank in terms of its vision and mission, environmental and SWOT analyses in the light of the bank’s attempted expansion in 2007. Chapter five concludes the study with a summary describing the major findings of the study, limitations and some useful recommendations based on the assessment done.

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CHAPTER TWO

LITERATURE REVIEW

2.0 INTRODUCTION

As stated in the introductory chapter, the scope of this project is to study the impact of credit administration and credit risk on banks’ performance. This chapter reviews the literature on credit and the associated credit risk management in banking. It firstly however considers topics on risk management from different points of view in general, touching on other related banking risks. Latter the review is narrowed down to credit administration and credit risk practices in commercial banks and with the view of giving a theoretical basis to the project.

2.1 MANAGEMENT OF RISK IN BANKING

According to Schmidt and Roth (1990), risk management involves undertaking activities designed to minimize the negative impact (cost) of uncertainty (risk) regarding possible losses. It is apparent that for such risk management activities to be potent they have to be designed based on a clearly anticipated losses. Redja (1998) therefore defines risk management as an organized method of identification and assessment of pure loss exposure faced by an organization or an individual, and for the selection and execution of the most suitable techniques for treating such exposure. In effect, the process involves: identification, measurement, and management of the risk. Bessis (2010) also indicates that risk management, apart from it being a process also entails the use of a set of tools and models for measuring and controlling risk.

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24 It is a major task for banks to ensure a sound risk management operating environment, where there is reduced impact of uncertainty and potential losses. Bank managers therefore need dependable risk measures to direct capital to activities with the best risk/reward ratios. They need estimates of the size of potential losses to stay within limits set through careful internal considerations and by regulators. They also need systems to monitor positions and fashion incentives for prudent risk taking by departments, units and individuals within the bank.

Identifying key risks, acquiring consistent, understandable, operational risk measures, choosing which risks to reduce or to increase and by what means, and setting up procedures to monitor resulting risk positions constitute the process by which managers satisfy these needs identified in the paragraph above. This is what Pyle (1997) considers as risk management. Bessis (2010), also points to fact that the objective of risk management is to evaluate risks in order to monitor and control them. According to Bessis, having a firm grip on risk enables the bank to pursue other important functions such as providing reliable forecast and projections, designing appropriate business policy, developing competitive advantages by calculating appropriate pricing and the formulation of other differentiation strategies based on customers‘ risk profiles all aimed towards achieving the bank wide ultimate strategy.

Many banking firms rely on carefully ordered steps to execute a risk management system which usually contain four components. These components include standards and reports, position limits or rules, investment guidelines or strategies, incentive contracts and compensation. According to Santomero (1995), these tools are normally established to evaluate exposure, define

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25 procedures to manage these exposures, limit individual positions to tolerable levels, and encourage decision makers to manage risk in a manner that is consistent with the firm's goals and objectives.

2.2 MOTIVATION FOR RISK MANAGEMENT IN

BANKING

Banking business is one of the riskiest worldwide and this demands a vigorous management of all associated risks so as to achieve optimum maximization of shareholder wealth. Many authors including Oldfield and Santomero (1995), Stulz (1984), Smith et al (1990) and Froot et al (1993) have offered reasons why bank managers should constantly engage in the active management of risks in their organizations.

According to Oldfield and Santomero (1995), a review of the literature over the years points to four main reasons for risk management. These are managerial/self-interest; lower tax incentives; avoidance of low profits and prevention of possible financial meltdown.

Managers’ limited ability to diversify their investments in the firm and their quest to boost their own utility in the firm provide the needed urge to ensure stability of the firm’s earnings by minimizing volatility.

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26 Managers are also motivated to pursue activities which lesson the volatility of reported taxable income since expected tax burden are reduced when income smoothens. This also helps to enhance shareholders’ value and is plausible during progressive tax regimes.

Bank managers also pursue risk management by embarking on profit variability reducing strategies in order to avoid the undesirable option of going for high cost external sources of funding, especially in an imperfect capital markets, owing to low profits.

Finally and arguably the most important rationale for managers to manage risk with the aim of reducing the unpredictability of profits is the cost of potential financial distress which may include loss of confidence by stakeholders the firm‘s operations, loss of strategic position in the industry, withdrawal of license or charter and even bankruptcy.

It is believed that any of the above mentioned rationales is sufficient to motivate management to concern itself with risk and embark upon a careful assessment of both the level of risk inherent with any financial product and possible risk mitigation techniques.

2.3 RISK MANAGEMENT TYPES

A key characteristic of the banking business is the bundle and unbundling of risks. Some of these risks are systematic whiles others are unsystematic (Merton, 1989). According to Oldfield and Santomero (1995) risk facing financial institutions can be defragmented into three separable groupings from management perspective: avoidable risks; transferrable risks and internally

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27 manageable risks. This segregation helps managers in developing the appropriate strategies to mitigate risk. Those risks that can be eliminated by simple business practices such as ensuring customer, borrower and credit due diligence, hedging, reinsurance, and diversification constitute avoidable risks. This project is chiefly about this type of risk management where credit risk is considered to be more proactively managed through credit due diligence and subsequent effective credit administration.

Handling some risks internally gives no value-addition or competitive urge to the firm and such risks are better managed by transferring them to third parties.

The third category of risk management applies to risks that by nature put the firm in a competitively disadvantageous position if details on them are divulged to non-firm interests or competitors. Such risk also are central to the firm‘s business purpose because they are the raison d‘être of the firm. Such risks as those inherent with holding complex illiquid and proprietary assets are therefore actively managed internally. As alluded to by Oldfield & Santomero (1995) and Allen & Santomero (1996) banking firms should only accept those risks that are uniquely a part of the bank’s range of unique value-added services and this requires monitoring of such business activities and associated risks and returns.

2.4 KEY RISKS IN BANKING

The focus of this project is credit risk. However, it noteworthy to briefly consider other important risks associated with the provision of various banking services. These risks can be classified broadly as financial and non-financial risk. The financial risks include credit risk and

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28 market risks (which includes liquidity risk, interest rate risk and foreign exchange risk). The non-financial risk include operational risks which sometimes include legal risk, technology risk, political risk, people risk and more recently, strategic risk.

2.4.1 Credit Risk

Credit risk is the probability that a debtor or issuer of a financial instrument— whether an individual, a company, or a country— will not repay principal and other investment-related cash flows according to the terms specified in a credit agreement (Greuning and Bratanovic, 2009). Inherent to banking, credit risk means that payments may be delayed or not made at all, which can cause cash flow problems and affect a bank‘s liquidity. The goal of credit risk management is to maximize a bank‘s risk-adjusted rate of return by keeping credit risk exposure within tolerable parameters.

More than 70 percent of a bank‘s balance sheet generally relates to credit risk and hence considered as the principal cause of potential losses and bank failures. Often time, inadequate diversification of credit risk has been the principal culprit for bank failures. The dilemma is that banks have a comparative advantage in advancing credit to entities with whom they have an ongoing relationship, thereby creating excessive concentrations in geographic and industrial sectors.

Credit risk includes both the risk that a obligor or counterparty fails to comply with their obligation to service debt (default risk) and the risk of a decline in the credit standing of the obligor or counterparty. According to Bessis (2010), whilst default triggers a total or partial loss,

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29 a deteriorated credit standing of a borrower also has a high tendency of resulting in a loss as it elicits an upward shift of the required market yield to compensate the higher risk and this leads to a value decline.

In order to curtail the incidence of both partial and total losses banks normally consider the financial condition and the suitability of any underlying collateral of a potential borrower as key components in assessing the credit risks of obligors or counterparties (Santomero, 1997). Greuning and Bratanovic (2009), also consider as a vital ingredient in credit risk management, formal policies implemented by management as put in place by the board of directors of banks. Consistent with general practice, banking firms rely on credit or lending policies to manage their credit portfolios as these policies outline the scope of investment and financing assets, how they are to be originated, appraised, supervised, and collected.

2.4.2 Market Risks

According to Pyle (1997), market risk is the change in net asset value of a firm owing to changes in underlying economic factors such as interest rates, exchange rates, and equity and commodity prices. Several research works have identified three common market risk factors to banks and these are liquidity, interest rates and foreign exchange rates. In general, market risks consist in the probability of the variability of the value of a portfolio, either an investment portfolio or a trading portfolio, caused by adverse changes in market factors.

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30 2.4.3 Liquidity Risk

Liquidity is the ability of a bank to fund increases in assets and meet obligations as they become due, without incurring undesirable losses (The Basel Committee on Bank Supervision, June 2008). Bessis (2010), in one his expositions, consider liquidity risk as a situation where short-term asset values are not sufficient to match short short-term liabilities or unexpected outflows.

According to Anthony Saunders and Marcia M. Cornett (2009) Liquidity risk arises when depositors demand cash payment from their deposits in unexpected increasing proportions resulting in withdrawals that may require the bank to liquidate its assets in short order and often, at less than market prices. This can set in motion a vicious circle of liquidity crisis which can lead to bankruptcy. The root cause of such bankruptcy is what Greuning and Bratanovic, (2009) consider as potential funding crisis that banks need to guard against by planning for growth of funds and unexpected credit expansion.

2.4.4 Interest Rate Risk

For banks, the mismatching of the maturities of assets and liabilities create interest rate risk exposure not only on the bank’s net interest income but also net worth. The potential for changes in interest rates to reduce a bank‘s earnings or value is referred to as interest rate risk. There are two risks associated with changes in interest rates: Income Risk and Investment Risk.

Income Risk refers to loss of net interest income, caused by a mismatch of borrowing and lending rates and Investment Risk is occasioned by loss of net worth, which results when the value of bank assets fall more than liabilities. Most of the assets (receivables) and liabilities

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31 (payables) of the balance sheet of banks produce revenues and costs that are driven by interest rates and since interest rates are not stable, so are such earnings. According to (Bessis, 2010) interest rate risk does not apply only in variable exchange regimes but also in fixed rate deals due to the opportunity cost that emanates from market movements. Though there are complexities in managing interest rate risk, a more knowledgeable use of interest rate derivatives— such as financial futures and interest rate swaps— can help bank managers to control and lessen the interest rate exposure that is associated with their business (Greuning and Bratanovic, 2009).

2.4.5 Foreign Exchange Risk

Foreign exchange risk is the risk that a bank will suffer a loss due to an adverse movement in the value of a foreign currency on which an international transaction is denominated. An increase in the value of the foreign currency, for example, will increase the cost of money borrowed in that foreign currency – even if interest rates have not changed. In simple terms, Bessis (2010) views foreign exchange risk as incurring losses due to fluctuations in exchange rates. Greuning and Bratanovic (2009) see it as speculative and can therefore result in a gain or a loss, depending on the direction of exchange rate shifts and whether a bank has long or short net positions.

To hedge foreign exchange risk, a bank may institute a currency swap, currency futures, or options.

2.4.6 Operational Risk

Banks all over the world seek to optimize profit and service through protection of stakeholders’ investment and provision of consistent and enhanced customer service. A major threat to

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32 achieving this is operational risk which transcends all bank transactions and activities and is at the heart of all other risks faced by banks.

Operational risk is the possibility of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events (The Basel Accord (2007). For (Bessis, 2010), operational risks is a function of failed and malfunctioning information and reporting systems, internal monitoring rules and internal procedures put in place to take appropriate remedial actions, or the non-compliance with the internal risk policy rules. Because of the diverse and complex activities in which modern banks are engaged, the intensity of operational risk in banks has reached alarming heights (Greuning and Bratanovic, 2009). As will be seen in chapter 4 of this work, operational lapses have dire consequences on credit losses that translate in to poor bank performance.

2.4.7 Strategic Risk

This is one risk currently considered as having the potential of greatly destroying shareholders’ value and yet bank managers have not yet been able to develop comprehensive and potent tools and techniques to address it. According to Emblemsvåg and Kjølstad (2002), strategic risk arises from the uncertainties inherent in a firm pursuit of its business objectives either by exploiting opportunities and/or reducing threats. These uncertainties are not directly financial in nature and may arise from adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes. Slywotzky and Drzik (2005), consider strategic risk as the series of external events and trends that can ravage a company‘s growth course and shareholder value. In effect strategic risk is a function of the compatibility of a firm’s strategic goals, the

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33 corporate strategy so outlined to realize those goals, the resource allocation against these goals, and the quality of implementation.

In their bid to develop framework for assessing a firm’s strategic risks and develop counter measures to address them, Slywotzky and Drzik (2005) came out with a categorization of strategic risk events which include industry margin squeeze, threat of technology shift which has the possibility of driving some products and services out of the market, brand erosion, emergence of one-of-a-kind competitor to seize the lion share of value in the market, customer priority shift, new project failure and market stagnation. Going by these categorizations, managers should be able to allocate sufficient capital against each risk event according to how risky they consider them.

2.5 Credit and Credit Risk Management

A thorough comprehension of credit and credit process, and the source of credit risk in banks are paramount to understanding credit risk management. Such an understanding informs the components of the credit risk management strategy bank managers adopt and what policies and procedures are needed to ensure effective implementation.

2.5.1 Credit

According to the Economist Dictionary of Economics, credit is the use or possession of goods or services without immediate payment. Credit serves as conduit between the production and sale of goods. As a result, credit gives rise to a debt that a debtor owes to the creditor. As depicted in the

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34 figure 2.5.1. below, the debtor/borrower pays the creditor/lender interest on the amount borrowed over time agreed on.

Figure 2.5.1. Relationship between Creditor and Debtor (Adapted from Colquitt 2007, 2)

Largely in every economy there are firms or individuals that provide loanable funds to those who are in need of such funds to finance their businesses/investments. But ordinarily the demand and supply of loanable funds do not automatically satisfy each other. Banks therefore act as bridge between credit suppliers and those who demand it. As stated by Colquitt (2007), many other non-bank financial institutions such as insurance companies, mutual funds, investment finance companies, etc. have joined the credit supplier group. However banks have remained the leading source that both individuals and corporate institutions request credit from.

Individuals may fall under: home mortgages, installment loans (e.g. consumer loans, educational loans, auto loans…etc), credit card revolving loans, revolving credits (e.g. overdrafts), etc. According to Crouhy et al (2006, 207-208), there are two main types of credit services based on customer categories offered by banks. These include retail credit and wholesale credit. While

Pays the creditor extra money earned from

reinvestments of the credit amount

Gives the debtor time and takes back a return

for supplying the credit

Debtor

Creditor

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35 retail credit deals with individuals, wholesale lending, on the other hand, involves firms as the borrowers and therefore is of much higher value, more complicated and poses more risk to the banks.

2.5.2 Credit Risk

Previous sections of this project have seen credit risk mentioned or even defined. It is however considered in much detail in this section. Credit risk arises when the debtor is unable to repay part or whole of the debt to the creditor as agreed in the mutual contract. As appropriately and professional stated by Colquitt (2007), “credit risk arises whenever a lender is exposed to loss from a borrower, counterparty, or an obligor who fails to honor their debt obligation as they have agreed or contracted”. This loss may derive from deterioration in the counterparty’s credit quality, which consequently leads to a loss to the value of the debt. According to Crouhy et al, the worst case of credit risk is experienced when the borrower defaults when he/she is unwilling or unable to fulfill the obligations.

Bank’s cash flows, liquidity, profit, shareholders’ dividends and net worth are directly and significantly impacted by credit risk. The major bank failures experienced over the years were all mostly due to what banks call ‘bad debts’. Credit risk, occasioned by bad debts, is so critical to banks because most of their business activities, ranging from lending, dealings in treasury products, reinsuring insurance risks, cross-border exposure, and guarantees or bonds are all exposed to some forms of credit risk which is “the principal cause of bank failures” (Greuning & Bratanovic 2009, 161). This therefore calls for banks to put in place a robust credit risk management framework to adequately deal with the threat posed by credit risk.

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2.5.3 Approaches To Credit Risk Management

In banking, the importance of credit risk management cannot be overemphasized. A commercial bank can only ignore the inherent risk in its lending business at its own peril. Credit risk management is simply the procedures implemented by organizations with the aim of diminishing or avoiding credit risk. (Luy D. D. 2010)

Credit risk management has been a burning topic of debate as it is one of the fastest evolving practices thanks to institutional developments in the credit market, diversification of financial institutions participating in the lending business and modern technologies. According to Caouette, Altman, Narayanan, Nimmo (2008) credit risk management consist of a specialist analysis system, whose objective is to “look at both the borrower and the lending facility being proposed and to assign a risk rating”. Figure 2.5.3 on the next page shows a summary of the analyzed information. Among the evaluated data, financial ratios are perceived to be very important. The idea espoused by Caouette, Altman, Narayanan and Nimmo is that credit risk management is a kind of engineering in which “models and structures are fashioned that either prevent financial failure or else provide safeguards against it”.

Portfolio based approach to banking credit risk management where homogenous product and customers are classified into either retail and commercial portfolio is considered more appropriate by Crouhy, Galai & Mark (2006). According to these authors, this is more time, cost and effort efficient than managing every single customer.

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37 Does the borrower have a

repayment strategy? What other services are needed by the borrower?

Motivation:

Why does the company need to borrow?

Does the lender have an appetite for the industry geography? Is the risk reward ratio acceptable? (Credit Culture)

Business and Strategy Review: Does the company have a clear sense of direction and how to get there? Is it

doable?

Management Analysis: Competence, integrity, depth

Industry Analysis: Position in the industry, market share, price leadership, innovation trends Financial Statement Analysis:

Balance Sheet Analysis & Cash Flow Analysis

- Efficiency & costs - Profitability - Leverage

Assess the financial and competitive strength

Assumptions for projections

Qualitative arguments to be used in credit memorandum Financial Simulation Breakeven Pricing Stress Testing

Risk Rating, Covenants Loan documentation Legal Opinions

Loan Administration Set up, Data Systems Funding Schedule

Negotiations Credit Presentation Credit Approval

Loan Documentation Other Legal Work Closing

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2.5.3.1 MODERN PORTFOLIO APPROACHES

Modern Portfolio Theory involves the use of some numerical measures such as earnings at risk (EAR) and value at risk (VAR) to manage exposures arising from interest and market risks. According to William Margrabe (2007), despite the fact that credit risk continues to be the principal risk faced by banks, the use of MPT to credit risk has not seen much preeminence.

However, lately Banks have come to realize the adverse effect of credit concentrations on their performance and have consequently been developing tools to measure credit risk in a portfolio framework. In addition, credit derivatives are also being used to transfer risk efficiently while preserving customer relationships. The combination of these developments has become a basis for managing credit risk in a portfolio context over the past several years.

2.5.3.1.1 Asset-by-asset Approach

Though banks may have some differences in the method, the asset-y-asset approach involves assessing the credit quality of loans and other credit exposures from time to time by applying a credit risk rating, cumulating the results to help identify a portfolio’s expected losses. It is asserted that a sound loan review and internal credit risk rating system is the basis of the asset-by-asset approach. When this approach is properly applied, management is able to identify changes in individual credits and portfolio trends in a timely manner which helps them develop and adapt appropriate strategies to improve their portfolios and also increase the supervision of credits in a timely manner.

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2.5.3.1.2 Portfolio Approach

Banks are widely believed to seek to complement the asset-by-asset approach with a quantitative portfolio review using a credit model. This is based on the notion that the asset-by-asset approach does not adequately identify and measure credit concentration. Concentration risk is considered an extra portfolio risk resulting from increased exposure to a borrower, or to a group of correlated borrowers. Since the asset-by-asset approach is incapable of providing a complete view of portfolio credit risk, banks are pursuing the portfolio approach with strategies for reducing and coping with portfolio credit risk as summarized in Table 2.5.3.1.2 below on the next page.

2.5.3.2 Traditional Approaches

Much of the literature here seems to suggest that there exists only a very thin line between the traditional approach and the new approaches because the latter contains many of the ideas of the former. The following sub-sections take a brief look at the four classes of models under the traditional approach.

2.5.3.2.1 Expert Systems

Under this model, credit officers are empowered to use their expertise and judgment alongside what has come to be known as the five “Cs” in arriving at credit decisions and granting of loans. These five “C” are; Character, Credibility, Capital, Collateral of the borrower and the Cycle of economic conditions. Another critical factor that a credit or lending officer could consider is the interest rate. It is expected that when a good job is done at this stage of the credit cycle, credit risk is proactively minimized as the loans booked would be of high quality.

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2.5.3.2.2 Artificial Neural Networks

This is a model designed to simulate the human learning process inferred from the human expert’s decision process. It is designed to overcome the challenges of excessive time consumption and error- prone nature of the computerized expertise system. The Artificial Neural Networks model repetitively samples input/output information to fish out the nature of the link between inputs and outputs.

Table 2.5.3.1.2 Strategies for Reducing and Coping with Portfolio Credit Risk

Technique Advantages Disadvantages Implication

Geographic Diversification External shocks (climate, Price, natural disasters, etc.) are not likely to affect the

entire portfolio if there

is spatial

diversification.

If the country is small or the

Institution is capital constrained, it may not be

able to apply this principle. It will become vulnerable to

covariate risk, which is high

in agriculture. Loan Size Limits

(Rationing) Prevents the institution from being vulnerable to nonperformance on a few large loans.

Can be carried to the extreme

where loan size does not fit

the business needs of the

client and results in

Protects asset

quality in the short run but creates

client retention problems in the

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41 suboptimal use and

lower

positive impact by client.

Client could become dissatisfied

long run. Inimical to relationship banking. Over Collateralization Assures the institution that enough liquidation value

will exist for foreclosed assets.

Excludes poor, low-income

clients who are the vast majority of the market. Not a recommended technique if goal is to better serve the low- and moderate income clients Credit Insurance Bank makes

clients purchase credit insurance. In event of default, bank collects from insurer.

Databases and credit bureaus

may not exist to permit insurer to engage in this line of business in cost-effective manner. Portfolio Securitization Lender bundles and sells loans to a third party. Transfers default risk and Requires well documented

loans and long time series of performance data to permit Requires a well developed secondary market, standardized underwriting

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42 improves liquidity so that it can continue to lend. Allows lender to develop expertise in analyzing creditworthiness in one sector or niche. ratings and reliable construction of financial projections practices, and existence of rating companies.

Source: Publication of the Inter-American Development Bank, May 2007.

2.5.3.2.3 Banks Internal Rating

Banks have developed internal rating codes that they assign to loans at various levels of performance. They make provisioning of reserves against the probability of such performing loans going into default.

2.5.3.2.4 Credit Scoring Systems

A credit score refers to a statistical number used to represent the creditworthiness of a borrower. It is derived from statistical analysis of a borrower’s credit history. Lending institutions normally rely on such scores to appraise the potential risk associated with each loan applicant and to mitigate losses due to bad debt. In a nut shell, the use of credit scores helps financial institutions establish the eligibility and suitability of a loan applicant, the rate of interest, the loan tenure and the credit limits that should be extended to the loan applicant.

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2.6 SUPERVISORY AUTHORITY OF BANK CREDIT RISK

MANAGEMENT

The place of supervision in ensuring quality of credit portfolio has been in the spotlight following the general recognition that credit risk has the potential of causing bank failures. In line with this the Bank of International Settlement (BIS) on November 28th 2005 issued what has come to be known as the ten principles on Sound Credit Risk Assessment and valuation for Loans that is believed when properly observed would greatly mitigate credit risk in the banking industry. They are as follows;

Principle 1: The bank’s board of directors and senior management are responsible for ensuring that the banks have appropriate credit risk assessment processes and effective internal controls to consistently determine provisions for loan losses in accordance with the bank’s stated policies and procedures, the applicable accounting framework and supervisory guidance commensurate with the size, nature and complexity of the bank’s lending operations.

Principle 2: Banks should have a system in place to reliably classify loans on the basis of credit risk.

Principle 3: A bank’s policies should appropriately address validation of any internal credit risk assessment models.