Credit Risk Management in the UK Banking Sector

Background 3

Literature Review 7

Ascertaining why and how banking credit risk exposure is evolving recently 8

Seeing how banks use credit risk evaluation and assessment tools to mitigate their credit risk exposure 11

The steps and methodologies used by banks to identify, plan, map out, define a framework, develop an analysis and mitigate credit risk 13

Determine the relationship between the theories, concepts and models of credit risk management and what goes on practically in the banking world 17

Ascertain the scope to which resourceful credit risk management can perk up bank performance 19

To evaluate how regulators and government are assisting the banks to identify, mitigate credit risk, and helping to adopt the risk-based strategies to increase their profitability, and offering assistance on continuous basis 20

Research Methodology 21

Analysis 23

Ascertaining why and how banking credit risk exposure is evolving recently 23

Seeing how banks use credit risk evaluation and assessment tools to mitigate their credit risk exposure 25

The steps and methodologies used by banks to identify, plan, map out, define a framework, develop an analysis and mitigate credit risk 31

Determine the relationship between the theories, concepts and models of credit risk management and what goes on practically in the banking world 35

Ascertain the scope to which resourceful credit risk management can perk up bank performance 38

To evaluate how regulators and government are assisting the banks to identify, mitigate credit risk, and helping to adopt the risk-based strategies to increase their profitability, and offering assistance on continuous basis 40

Primary Survey 45

Conclusions 46

Recommendations 50

Bibliography 56

Background

The sub-prime mortgage meltdown that hit the global banking sector in 2007, was a result of circumstances, actions and repercussions that began years earlier (Long, 2007). It, the sub-prime mortgage crisis, was based on unsound ground from its inception. Sub-prime mortgages represent loans made to borrowers that have lower ratings in their credit than the norm (investopedia, 2007). Due to the lower borrower credit rating, they do not qualify for what is termed as a conventional mortgage due to default risk (investopedia, 2007). Sub-prime mortgages thus carry a higher interest rate to off set the risk increase, which helped to fuel the United States economy through increased home ownership, and the attendant spending that accompanies it (Bajaj and Nixon, 2006). Implemented by the Bush administration in the United States to get the economy rolling after the recession fuelled by the September 11^th air attacks, the entire plan began to backfire as early as 2004 as a result of the continued building of new housing without the demand (Norris, 2008). The new construction glutted the market bringing down house prices. This, coupled with a slowing economy in the United States resulted in layoffs, as well as many subprime mortgage holders defaulting on their loans, and the crisis ballooned.

Some attribute the over lending of subprime mortgages to predatory lending (Squires, 2004, pp. 81-87) along with the underlying faults of using it as an economic stimulus package that did not control the limits on new housing (Cocheo, 2007). That set of circumstances represented the cause of the subprime mortgage crisis that spread globally as a result of the tightening of credit due to defaulted loan sell offs and restricted banking lending ceilings caused by the Basel II Accords (Peterson, 2005). The complexity of the foregoing shall be further explained in the Literature Review section of this study. The preceding summary journey through the subprime mortgage crisis was conducted to reveal the manner in which banking credit crunches can and do occur. The significance of the foregoing to this study represents an example to awaken us to the external factors that can and do cause banking credit crisis situations, thus revealing that despite good management practices such events can manifest themselves. It is also true that poor or lax banking practices can have the same effects.

Credit risk management represents the assessing of the risk in pursuing a certain course, and or courses of action (Powell, 2004). In addition to the foregoing U.S. created subprime mortgage crisis, the appearance of new forms of financial instruments has and is causing a problem in credit risk management with regard to the banking sector. As the world’s second largest financial centre, the United Kingdom is subject to transaction volumes that increase the risks the banking sector takes as so many new forms of financial instruments land there first. McClave (1996, p. 15) provides us with an understanding of bank risk that opens the realm to give us an overview of the problem by telling us:

Banks must manage risk more objectively, using quantitative skills to understand portfolio data and to predict portfolio performance. As a result, risk management will become more process-oriented and less dependent on individuals.

Angelopoulos and Mourdoukoutas (2001, p. 11) amplify the preceding in stating that Banking risk management is both a philosophical and an operational issue. They add:

As a philosophical issue, banking risk management is about attitudes towards risk and the payoff associated with it, and strategies in dealing with them. As an operational issue, risk management is about the identification and classification of banking risks, and methods and procedures to measure, monitor, and control them. (Angelopoulos and Mourdoukoutas, 2001, p. 11)

In concluding, Angelopoulos and Mourdoukoutas (2001, p. 11) tell us that the two approaches are in reality not divorced, and or independent form each other, and that attitudes concerning risk contribute to determining the guidelines for the measurement of risk as well as its control and monitoring. The research that has been conducted has been gathered to address credit risk management in the United Kingdom banking sector. In order to equate such, data has been gathered from all salient sources, regardless of their locale as basic banking procedures remain constant worldwide. References specific to the European Union and the United Kingdom were employed in those instances when the nuances of legislation, laws, policies and related factors dictated and evidenced a deviance that was specific.

In terms of importance, credit risk is one of the most important functions in banking as it represents the foundation of how banks earn money from deposited funds they are entrusted with. This being the case, the manner in which banks manage their credit risk is a critical component of their performance over the near term as well as long term. The implications are that today’s decisions impact the future, thus banks cannot approach current profitability without taking measures to ensure that decisions made in the present do not impact them negatively in the future (Comptroller of the Currency, 2001). A well designed, functioning and managed credit risk rating system promotes the safety of a bank as well as soundness in terms of making informed decisions (Comptroller of the Currency, 2001). The system works by measuring the different types of credit risk through dividing them into groups that differentiate risk by the risk posed. This enables management as well as bank examiners to monitor trends and changes to risk exposure, and this minimise risk through diversifying the types of risk taken on through separation (Comptroller of the Currency, 2001).

The types of credit risks a bank faces represents a broad array of standard, meaning old and establishes sources, as well as new fields that are developing, gaining favour, and or impacting banks as a result of the tightness of international banking that creates a ripple effect. The aforementioned subprime crisis had such an effect in that the closeness of the international banking community accelerated developments. The deregulation of banking has increased the risk stakes for banks as they now are able to engage in a broad array of lending and investment practices (Dorfman, 1997, pp. 67-73). Banking credit risk has been impacted by technology, which was one of the contributing factors in the subprime crisis (Sraeel, 2008). Technology impacts banks on both sides of the coin in that computing power and new software permits banks to devise and utilise historical risk calculations in equating present risk forms. However, as it is with all formulas, they are only as effective as the parameters entered (Willis, 2003).

The interconnected nature of the global banking system means that bank risk has increased as a result of the quick manner in which financial instruments, credit risk transfer, and other systems, and or forms of risk are handled. The Bank for International Settlements led a committee that looked into Payment and Settlement Systems, which impacts all forms of banking credit risk, both new forms as well as long standing established ones in loans, investments and other fields (TransactionDirectory.com, 2008). The report indicates that while technology and communication systems are and have increased the efficiency of banking through internal management as well as banking systems, these same areas, technology and communications systems also have and are contributing to risk.

The complexity of the issues that arise in a discussion of credit risk management means that there are many terms that are applicable to the foregoing that are banking industry specific to this area. In presenting this material, it was deemed that these special terms would have more impact if they were explained, in terms of their context, as they occur to ease the task of digesting the information. This study will examine credit risk management in the UK banking sector, and the foregoing thus will take into account banking regulations, legislation, external and internal factors that impact upon this.

Literature Review

The areas to be covered by this study in relationship to the topic area Credit Risk Management in the UK Banking Sector entails looking at as well as examining it using a number of assessment and analysis points, as represented by the following:

Ascertaining why and how banking credit risk exposure is evolving recently.

Seeing how banks use credit risk evaluation and assessment tools to mitigate their credit risk exposure.

The steps and methodologies used by banks to identify, plan, map out, define a
framework, develop an analysis and mitigate credit risk.

Determine the relationship between the theories, concepts and models of credit risk management and what goes on practically in the banking world.

Ascertain the scope to which resourceful credit risk management can perk up bank performance.

To evaluate how regulators and government are assisting the banks to identify, mitigate credit risk, and helping to adopt the risk-based strategies to increase their profitability, and offering assistance on continuous basis.

The foregoing also represents the research methodology, which shall be further examined in section 3.0. These aspects have been included here as they represented the focus of the Literature Review, thus dictating the approach. The following review of literature contains segments of the information found on the aforementioned five areas, with the remainder referred to in the Analysis section of this study.

Ascertaining why and how banking credit risk exposure is evolving recently.

In a report generated by the Bank for International Settlements stated that while transactional costs have been reduced as a result of advanced communication systems, the other side of this development has seen an increase with regard to … the potential for disruptions to spread quickly and widely across multiple systems … (TransactionDirectory.com, 2008). The Report goes onto add that concerns regarding the speed in which transactions occur is not reflected adequately in risk controls, stress tests, crisis management procedures as well as contingency funding plans (TransactionDirectory.com, 2008). The speed at which transactions happen means that varied forms of risk can move through the banking system in such a manner so as to spread broadly before the impact of these transactions is known, as was the case with the subprime mortgage crisis debt layoff.

One of the critical problems in the subprime crisis was that it represented a classic recent example of the ripple effect caused by rapid interbanking communications, and credit risk transfer. When the U.S. housing bubble burst, refinance terms could not cover the dropping house prices thus leading to defaults. The revaluation of housing prices as a result of overbuilding forced a correction in the U.S. housing market that drove prices in many cases below the assessed mortgage value (Amadeo, 2007). The subprime mortgage problem was further exacerbated by mortgage packages such as fixed rate, balloon, adjustable rate, cash-out and other forms that the failure of the U.S. housing market impacted (Demyanyk and Van Hemert, 2007). As defaults increased banks sold off their positions in bad as well as good loans they deemed as risks as collateralised debt obligations and sold them to differing investor groups (Eckman, 2008). Some of these collateralised debt obligations, containing subprime and other mortgages, were re-bundled and sold again on margin to still another set of investors looking for high returns, sometimes putting down $1 million on a $100 million package and borrowing the rest (Eckman, 2008). When default set in, margins calls began, and the house of cards started caving in.

Derivatives represent another risk form that has increased banking exposure. The preceding statement is made because new forms of derivatives are being created all of the time (Culp. 2001, p. 215). Derivatives are not new, they have existed since the 1600’s in a rudimentary form as predetermined prices for the future delivery of farming products (Ivkovic, 2008). Ironically, derivatives are utilised in today’s financial sector to reduce risk via changing the financial exposure, along with reducing transaction costs (Minehan and Simons, 1995). In summary, some of the uses of derivatives entail taking basic financial instruments as represented by bonds, loans and stocks, as a few examples, and then isolating basic facets such as their agreement to pay, agreements to receive or exchange cash as well as other considerations (financial) and packaging them is financial instruments (Molvar, et al, 1995). While derivatives, in theory, help to spread risk, spreading risk is exactly what caused the subprime meltdown as the risk from U.S. mortgage were bundled and sold, repackaged, margined, and thus created a raft of exposure that suffered from the domino effect when the original house of cards came crashing down.

Other derivative forms include currency swaps as well as interest rate derivatives that are termed as over the counter (Cocheo, 1993). The complexity of derivatives has increased to the point where:

…auditors will need to have special knowledge to be able to evaluate the derivative’s measurement and disclosure so they conform with GAAP. For example, features embedded in contracts or agreements may require separate accounting as a derivative, while complex pricing structures may make assumptions used in estimating the derivative ‘s fair value more complex, too. (Coppinger and Fitzsimons, 2002)

The preceding brings attention to the issues in evaluating the risks of derivatives, and banks having the proper staffing, financial programs and criteria to rate derivative risks on old as well as the consistently new forms being developed. Andrew Crockett, the former manager for the Bank of International Settlements, in commenting on derivatives presented the double-edged sword that these financial instruments present, and thus the inherent dangers (Whalen, 2004)

When properly used, (derivatives) can be a powerful means of controlling risk that allows firms to economize on scarce capital. However, it is possible for new instruments to be based on models, which are poorly designed or understood, or for the instruments to give rise to a high degree of common behaviour in traded markets. The result can be large losses to individual firms or increased market volatility.

The foregoing provides background information that relates to understanding why and how banking credit risk exposure has and is evolving. The examples provided have been utilised to illustrate this.

Seeing how banks use credit risk evaluation and assessment tools to mitigate their credit risk exposure.

As credit risk is the focal point throughout this study, a definition of the term represents an important aspect. Credit risk is defined as (Investopedia, 2008):

The risk of loss of principal orloss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.

Risk, in terms of investments, is closely aligned with the potential return being offered (Investopedia, 2008). The preceding means that the higher the risk, the higher the rate of return expected by those investing in the risk. Banks utilise a variety of credit risk evaluation and assessment tools to apprise them of credit risk probabilities so that they can mitigate, and or determine their risk exposure. There are varied forms of credit risk models, which are defined as tools to estimate credit risk probability in terms of losses from banking operations in specific as well as overall areas (Lopez and Saidenburg, 2000, pp. 151-165).

Lopez and Saidenberg (1999) advise us that the main use of models by banks is to provide forecasts concerning the probability of how losses might occur in the credit portfolio, and the manner in which they might happen. They advise that the aforementioned credit risk model projection of loss distribution is founded on two factors (Lopez and Saidenberg, 1999):

the multivariate, which means …having more than one variable (Houghton Mifflin, 2008) distribution concerning the credit losses in terms of all of the credits in the bank’s portfolio, and

the weighting vector, meaning the direction, characterising these credits.

As can be deduced, the ability to measure credit risk is an important factor in improving the risk management capacity of a bank. The importance of the preceding is contained in the Basel II Accord that states the capital requirement is three times the projected maximum loss that could occur in terms of a portfolio position (Vassalou, M., Xing, Y., 2003). Risk models and risk assessment tools form and are a structural part of the new Basel II Accord in that banks are required to adhere to three mechanisms for overall operational risk that are set to measure and control liquidity risk, of which credit risk is a big component (Banco de Espana, 2005). The key provisions of the Basel II Accord set forth that (Accenture, 2003):

the capital allocation is risk sensitive,

separation of operational risk, from credit risk,

vary the capital requirements in keeping with the different types of business it conducts, and

encourage the development and use of internal systems to aid the bank in arriving at capital levels that meet requirements

An explanation of the tools utilised by banks in terms of evaluation as well as assessment will be further explored in the Analysis segment of this study.

The steps and methodologies used by banks to identify, plan, map out, define a framework, develop an analysis and mitigate credit risk.

The process via which banks identify, plan, map out, define frameworks, develop analyses, and mitigate credit risk represent areas as put forth by the Basel II Accord, which shall be defined in terms of the oversight measures and degrees of autonomy they have in this process. In terms of the word autonomy, it must be explained that the Basel II Accord regulates the standard of banking capital adequacy, setting forth defined measures for the analysis of risk that must meet with regulatory approval (Bank for International Settlements, 2007). This is specified under the three types of capital requirement frameworks that were designed to impact on the area of pricing risk to make the discipline proactive. The rationale for the preceding tiered process is that it acts as an incentive for banks to seek the top level that affords them with a lowered requirement for capital adequacy as a result of heightened risk management systems and processes across the board (Bank for International Settlements, 2007). The foregoing takes into account liquidity (operational) risk as well as credit risk management and market risk.

The risk management active foundation of the Basel II Accord separates operational risk from credit risk, with the foundation geared to making the risk management process sensitive, along with aligning regulatory and economic capital aspects into closer proximity to reduce arbitrage ranges (Schneider, 2004). The process uses a three-pillar foundation that consists of minimum capital requirements along with supervisory review as well as market discipline to create enhanced stability (Schneider, 2004). The three tiers in the Basel II Accord, consist of the following, which are critical in understanding the steps, and methodologies utilised by banks to identify, plan, map, define frameworks, analyse and mitigate risk (Bank for International Settlements, 2007):

Standardised Approach

This is the lowest level of capital adequacy calculation, thus having the highest reserves. Via this approach risk management is conducted in what is termed as a standardised manner, which is founded on credit being externally assessed, and other methods consisting of internal rating measures. In terms of banking activities, they are set forth under eight business categories (Natter, 2004):

agency services,

corporate finance,

trading and sales,

asset management,

commercial banking,

retail banking,

retail brokerage,

payment and settlement

The methodology utilised under the standardised approach is based on operational risk that is computed as a percentage of the bank’s income that is derived from that line of business.

Foundation Internal Rating Based Approach (IRB) (Bank for International Settlements, 2007)

The Foundational IRB utilises a series of measurements in the calculation of credit risk. Via this method, banks are able to develop empirical models on their own for use in estimating default probability incidence for clients. The use of these models must first be reviewed and cleared by local regulators to assure that the models conform to standards that calculate results in a manner that is in keeping with banking processes in terms of outcomes and inputs to arrive at the end figures. Regulators require that the formulas utilised include Loss Given Default (LGD), along with parameters consisting of the Risk Weighted Asset (RWA) are part of the formulas used. Banks that qualify under this tier are granted a lower capital adequacy holding figure than those under the first tier.

Advanced Internal Rating Based Approach (IRB) (Bank for International Settlements, 2007)

Under this last tier, banks are granted the lowest capital adequacy requirements, if they qualify by the constructing of empirical models that calculate the capital needed to cover credit risk. The techniques, personnel and equipment needed to meet the foregoing are quite extensive, requiring a substantial investment of time, materials, funds, and personnel to accomplish the foregoing, thus this measure generally applies to the largest banks, that have the capability to undertake these tasks. As is the case under the Foundation Internal Rating Based Approach, the models developed must meet with regulator approval. Under this aspect of the Basel II provisions for this tier, banks are permitted to create quantitative models that calculate the following (Bank for International Settlements, 2007):

Exposure at Default (EAD),

the Risk Weighted Asset (RWA)

Probability of Default (PD), and

Loss Given Default (LGD).

The above facets have been utilised to provide an understanding of the operative parameters put into place by Basel II that define the realm in which banks must operate. These tiers also illustrate that the depth of the manner in which banks identify, plan, map out, define frameworks, analyse and mitigate credit risks, which varies based upon these tiers. Under the Standardised Approach the formulas are devised by the regulators, with banks having the opportunity to devise their own models. Graphically, the preceding looks as follows:

Chart 1 – Basel II Three Pillars

(Bank for International Settlements, 2007)

Determine the relationship between the theories, concepts and models of credit risk management and what goes on practically in the banking world.

The Basel Committee on Banking Supervision (2000) states that the … goal of credit risk management is to maximise a bank’s risk adjusted rate of return by maintaining credit risk exposure within acceptable parameters. The foregoing extends to its entire portfolio, along with risk as represented by individual credits, and with transactions (Basel Committee on Banking Supervision, 2000). In discussing risk management theories, Pyle (1997)/span> states it … is the process by which managers satisfy these needs by identifying key risks, obtaining consistent, understandable, operational risk measures, choosing which risks to reduce, and which risks to increase and by what means, and establishing procedures to monitor the resulting risk position. The preceding statement brings forth the complex nature of credit risk management. In understanding the application of risk it is important to note that … credit risks are defined as changes in portfolio value due to the failure of counter parties to meet their obligations, or due to changes in the market’s perception of their ability to continue to do so (Pyle, 1997).

In terms of practice, banks have traditionally utilised credit scoring, credit committees, and ratings in an assessment of credit risk (Pyle, 1997). Bank regulations treat market risk and credit risk as separate categories. J.P. Morgan Securities, Inc. (1997) brought forth the theory that the parallel treatment of market risk and credit risk would increase risk management by gauging both facets would aiding in contributing to the accuracy of credit risk by introducing external forces and influences into the equation that would reveal events and their correlation with credit risk. Through incorporating the influence and effect of external events via an historical perspective, against credit risk default rates, patterns and models result that can serve as useful alerts to pending changes in credit risk as contained in Pyle’s (1997)/span> statement that ended in …due to changes in the market’s perception of their ability to continue to do so.

The Plausibility Theory as developed by Wolfgang Spohn represents an approach to making decisions in the face of unknowable risks (Value Based Management, Inc., 2007). Prior to the arrival of the Plausibility Theory, Bayesian statistics was utilised to predict and explain decision making which was based upon managers making decisions through weighing the likelihood of differing events, along with their projected outcomes (Value Based Management, Inc., 2007). Strangely, the foregoing this theory was not applied to banking. The ‘Risk Threshold of the Plausibility Theory’ assesses a range of outcomes that may be possible, however it does focus … on the probability of hitting a threshold point, such as net loss relative to acceptable risk (Value Based Management, Inc., 2007). The new Basel II Accord employs a variant of the foregoing that is termed as ‘Risk Adjusted Return on Capital’ which is a measurement as well as … management framework for measuring risk adjusted financial performance and for providing a consistent view of profitability across business (units – divisions) (Value Based Management, Inc., 2007). The foregoing theory of including external events in a calculative model with business lines credit risks is yet to be fully accepted as the variables from external predictive models to result in scenarios along with credit risk models is a daunting set of equations.

Ascertain the scope to which resourceful credit risk management can perk up bank performance.

In equating how and the scope in which resourceful credit risk management can improve bank performance, one needs to be cognizant that credit risk represents the primary type of financial risk in the bank sector as well as existing in almost all areas that are income generating (Comptroller of the Currency, 2001). From the preceding it flows that a credit risk rating system that is managed and run well will and does promote bank soundness as well as safety through helping to make and implement decision making that is informed (Comptroller of the Currency, 2001). Through the construction and use of the foregoing, banking management as well as bank examiners and regulators are able to monitor trends as well as changes occurring in risk levels (Comptroller of the Currency, 2001). Through the preceding, management is able to better manage risk, thus optimising returns (Comptroller of the Currency, 2001).

The improvement of credit risk management in terms of identification and monitoring, the process when operated effectively can improve bottom line performance through laying off risk identified as potentially being problematic in the future (KPMG, 2007). Zimmer (2005) helps us to understand the nuances of transferring credit risk by telling us:

A bank collects funds and originates loans. It might only be able to attract funds if it holds some risk capital that finances losses and saves the bank from insolvency if parts of its loan portfolio default. If the bank faces increasing costs of raising external finance, CRT has a positive effect on the lending capacity of the bank. Providing the bank with additional risk capital, CRT lowers the bank’s opportunity cost of additional lending and increases its lending capacity.

As has been covered herein, credit risk represents a potential income loss area for banks in that default subtracts from income, thus lowering a bank’s financial performance. The Bank for International Settlements (2003) advises that the principle cause of banking problems is directly related to credit standards that are lax, which is termed as poor risk management. The preceding reality has been documented by the The Bank for International Settlements (2003) that advises that poor credit risk management procedures and structures rob bank’s of income as they fail to identify risks that are in danger of default, and thus taking the appropriate actions. A discussion of the means via which resourceful credit risk management enhance bank performance in delved into under the Analysis segment of this study.

To evaluate how regulators and government are assisting the banks to identify, mitigate credit risk, and helping to adopt the risk-based strategies to increase their profitability, and offering assistance on continuous basis.

In delving into banking credit risk management in the United Kingdom, legislation represents the logical starting place as it sets the parameters and guidelines under which the banking sector must operate. The Basel II Accord represents the revised i