Literature Review

Introduction

As discussed in chapter one, the main objective of this research is to portray the contemporary practices of managing credit risk in banking industry and comparing the practices between banks in UK and Bangladesh. To achieve the prime objective the research will also critically investigate the nature of credit risk for banks and evaluate the risk as a cause of major bank failures in history. The study will also explore various methods of bank credit risk management especially the Basel framework. Finally the research will try to formulate a set of best practices for credit risk management in Bangladeshi and British banks. This section of the study contains the relevant literatures and review of previous works on bank credit risk management which are present as following.

An Overview of Risks in Banking Business

Risk denotes uncertainty that might trigger losses. As our financial system is market based, it requires an effective risk management framework. Risks in financial markets have changed in the past three decades reflecting the changing nature of financial intermediation (Machiraju, 2008). A modern bank has to deal with various types of risks. These major categories of risks are credit risk, interest rate risk, foreign exchange risk, liquidity risk, operational risk and systematic risk. A brief discussion on these risks are presented below –

Credit Risk

Credit risk is the risk of losing money when loans default (Machiraju, 2008). When the borrowers fail to repay the loan or interest it becomes bad. Bad loans are one of the prime reasons of bank losses. Credit risk is the largest element of risk in the books of most banks which if not managed in a wiser way, may break down individual banks or may cause widespread financial instability by endangering the whole banking system (Jackson and Perraudin, 1999). For this reason in banking industry credit risk is a critical issue and needs careful management.

Interest Rate Risk

Interest rate risk management may be approached either by on balance adjustment or off-balance sheet adjustment or a combination of both. On-balance sheet adjustment involves changes in banks portfolio of assets and liabilities as interest rates change. When medium or long-term loans are funded by short-term deposits, a rise in the rate of interest will increase the cost of funds but the earnings on the assets will not, thereby reducing the margin or spread on the assets.

Liquidity Risk

Liquidity risk refers to the bank’s ability to meet its cash obligations to depositors and borrowers. A liability sensitive position than to assets of interest rates reduces the liquidity position of a bank. The mismatch between short-term liabilities and long-term assets creates a severe funding problem as the liabilities mature. Again if the duration of assets exceeds the duration of liabilities the ability to realize liquidity from the assets of the bank is reduced. Liquidity needs are increasingly met by deposit and non-deposit sources of funds paying market rates of interest (Machiraju, 2008).

Operational Risk

Operational risk is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems from external events. Operational risks -include – information technology risk, human resources risk, loss to assets risk and relationship risk (Balthazar, 2006).

Foreign Exchange Risk

Foreign exchange risk arises out of the fluctuations in value of assets, liabilities, income or expenditure when unanticipated changes in exchange rates occur. An open foreign exchange position implies a foreign exchange risk.

Credit Risk and its Categories

Credit risk, as discussed above, is defined as the probability that borrower of a bank or counterparty debtor will fail to meet its obligations in accordance with agreed term (Bessel, 1999). It may also be defined as the risk arising from the uncertainty of an obligor’s capability and willingness to carry out its contractual obligations. Here obligors are any party that has direct or indirect financial obligations inside the contract. Following are major categories of credit risk –

Risk of Default

Traditional credit risk is involved with default on a repayment of loans. And a likelihood of the default is called the probability of default. When a default occurs, the amount at risk may be as much as the whole liability, which can be recovered later, depending on factors like the creditors’ legal status. However, later collections are generally difficult or even impossible in that huge outstanding obligations or losses are usually the reasons why organizations fail.

Pre-settlement Risk

The possibility that the counterparty may default once a contract has been entered into but a settlement is still to occur is called pre-settlement risk. Through this period, the contract will have unrealized gains. This signifies the risk. The probable loss to the bank is dependent on the magnitude of change in market rates after the origination of the original contract. Such risk can be assessed in terms of existing and probable exposure to the organization (Horcher, 2005).

Risk of Counterparty Settlement

Settlement risk is common the interbank market and the risk arise when one party to a contract fails to pay funds or deliver assets to other one during the time of settlement. Such risk can be associated with any timing differences in settlement (Casu et al, 2006). Counterparty settlement risk is usually associated with foreign exchange trading, where “payments in different money centers are not made simultaneously and volumes are huge”. German bank Herstatt failure in 1974 created similar scenario as it received payments from its foreign exchange counterparties but never made payments to counterparty financial institutions as it ceased to operate before that.

Sovereign Risk

Sovereign risks are borne from the impact of crises in economic and/or socio-political situation in foreign severing nations. Such risk is prevalence on transactions with overseas nations and refers to the uncertainty when governments for some reason declares debt to foreign lenders void or adjust the profit, interest and capital movement (Casu et al, 2006). Evidence demonstrates that sovereign governments have both temporarily and permanently exercised controls on capital, stopped cross-border payments and cancelled debt repayments.

Fundamental Risk Management Practices in Banks

Banking industry has its own methods of managing different types of risk. A brief summary of each risk management practice is given below –

Risks in Banking Busines