1. The most serious financial problems in the banking sector have been either explicitly or indirectly caused by lax in regulations in credit management. In supervisors' experience, certain key problems tend to recur. Severe credit losses in a banking system usually reflect recurrent problems in a number of areas, such as concentrations, failures of due diligence and inadequate monitoring.
This appendix summarises some of the most common problems related to the broad areas of concentrations, credit processing, and market- and liquidity-sensitive credit exposures.
Concentrations
2. This is without doubt the single-most significant cause of major credit problems. Credit concentrations are behind some of the major banking disasters in history. Credit concentrations are viewed as any exposure where the potential losses are large relative to the bank's capital, its total assets or, where adequate measures exist, the bank's overall risk level. The destructive power of credit concentrations depends on the degree of correlation among borrowers under various economic conditions. Correlations often only become apparent when economic conditions turn sour, which is why concentrations are a particularly hot topic now as interest rates rise and property values soften.
3. Credit concentrations can further be grouped roughly into two categories:
ï‚•ï€ Conventional credit concentrations would include concentrations of credits to
Single borrowers or counterparties, a group of connected counterparties, and sectors or industries, such as commercial real estate, and oil and gas.
ï‚•ï€ Concentrations based on common or correlated risk factors reflect subtler factors which can often can be exposed through analysis.
Close linkages among up-and-coming markets under stress conditions and previously undetected correlations between market and credit risks, including between those liquidity risk, can lead to widespread failures, the recent disturbances in Asia and Russia illustrates how this is possible.
4. Factors such as leverage, optionality, correlation of risk factors and structured financings are examples of concentrations based on the potential for unusually deep losses often. For example, powerful borrowers will probably come up with larger credit losses for a given economic shock than a less powerful borrower whose capital can absorb a significant portion of any loss. The beginnings of exchange rate devaluations in late 1997 in Asia revealed the correlation between exchanges rate devaluation and declines in financial condition of foreign exchange derivative counterparties resident in the devaluing country, producing very substantial losses relative to notional amounts of those derivatives. The risk in a pool of assets can be concentrated in a securitisation into subordinated tranches and claims on leveraged special purpose vehicles, which in a downturn would suffer substantial losses.
5. The recurrent nature of credit concentration problems, especially involving conventional credit concentrations, raises the issue of why banks allow concentrations to develop. First, in developing their business strategy, most banks face an inherent trade-off between choosing to specialise in a few key areas with the goal of achieving a market 14 Losses are equal to the exposure times the percentage loss given the event of default.24 leadership position and diversifying their income streams, especially when they are engaged in some volatile market segments. This trade-off has been exacerbated by intensified competition among banks and non-banks alike for traditional banking activities, such as providing credit to investment grade corporations. Concentrations appear most frequently to arise because banks identify "hot" and rapidly growing industries and use overly optimistic assumptions about an industry's future prospects, especially asset appreciation and the potential to earn above-average fees and/or spreads. Banks seem most susceptible to overlooking the dangers in such situations when they are focused on asset growth or market share.
6. Banking managers should have precise guidelines that limit concentrations to a single borrower or related set of borrowers, and in fact, should also expect lending institutions to set lower limits on single-obligor exposure. Most credit risk managers in banks also monitor industry concentrations. Many banks are exploring techniques to identify concentrations based on common risk factors or correlations among factors. While small banks may find it difficult not to be at or near limits on concentrations, very large banking organisations must recognise that, because of their large capital base, their exposures to single obligors can reach imprudent levels while remaining within regulatory limits.
Credit Process Issues
7. Many credit problems reveal that there are fundamental flaws in the way banks grant and monitor their credit issue. These shortcomings in underwriting and management of market-related credit exposures is characterised by significant sources of losses at banks, many credit problems would have been avoided by banks being in a position to measure, recognise asses and being able to remove these risks.
8. the increased need to lend, competitive pressures from other banking institutions and the growth of loan syndication techniques and time constraints have led to many traditional banks failing to carrying out these thorough credit assessment (or basic due diligence). Globalisation of credit markets strengthens the need for financial information based on unassailable accounting standards and suitable macroeconomic and flow of funds data. When this information is not available or reliable, banks may dispense with financial and economic analysis and support credit decisions with simple indicators of credit quality, especially if they perceive a need to gain a competitive grip in a rapidly growing foreign market. New types of information, such as risk measurements, and more frequent financial information, to assessment newer counterparties, such as institutional investors and highly leveraged institutions may b required by banks to aid in monitoring of credit processes.
9. Another significant problem is the lack of testing and validation of new lending techniques. Some financial institutions adopt untested lending techniques in new or pioneering areas of the market, especially techniques that dispense with sound principles of due diligence or traditional benchmarks for leverage, have led to serious problems at many banks. Sound practice calls for the application of basic principles to new types of credit activity. Any modern method involves ambiguity about its efficiency which can be reflected in somewhat greater conservatism and corroborating indicators of credit quality. Increased use of credit-scoring models in consumer lending in the United States and some other countries are perfect examples of such techniques. Large credit losses experienced by some traditional banks for individual tranches of certain mass-marketed products points towards the potential for credit scoring weaknesses.
10. Subjective decision-making by senior management within the bank may also be a serious source of credit problem. A good example includes bank managers giving credit to companies they personally own or with25 which are owned by people whom they have personal affiliations such as personal friends and family, or to persons with a good reputation for financial acumen or to meet a personal agenda, such as cultivating special relationships with celebrities without subjecting these individual
to the institutions tested scoring system. This may not always work as their personal and financial circumstances may have changed.
11. Lack of an effective credit review process (and indeed, many banks had no credit review function) as experienced by many banks with asset quality problems in the 1990s. Larger banks have a department made up of analysts, independent of the lending officers, who make an independent assessment of the quality of a credit based on documentation such as financial statements, credit analysis provided by the account officer and collateral appraisals. At smaller banks, this role may be more limited and is usually carried out by internal or external auditors. The fundamental purpose of credit review is to provide checks to ensure that credits are made in accordance with bank policy and to provide an independent judgement of asset quality, uninfluenced by relationships with the borrower. Effective credit review helps to detect poorly underwritten credits and prevent weak credits from being granted, since credit officers are likely to be more thorough if they are aware that their work will be subject to review and monitoring.
12. A common and very important problem among troubled banks in the early 1990s was their failure to monitor borrowers or collateral values. Failure by many banks to obtain periodic financial information from borrowers or real estate appraisals in order to evaluate the quality of loans on their books and the adequacy of collateral. As a result, many banks failed to recognise early signs that asset quality was deteriorating thus missing the opportunity to work with borrowers to reduce their financial deterioration and to protect the bank's position. This led to a costly process by senior management to control the dimension and severity of the problem loans and resulted in large losses.
13. The failure by banks to perform sufficient financial analysis and to monitor the borrower can result in a breakdown of controls to detect credit-related fraud. For example, banks experiencing fraud-related losses have neglected to inspect collateral, such as goods in a warehouse or on a showroom floor, have not authenticated or valued financial assets presented as collateral, or have not required audited financial statements and carefully analysed them. An effective credit review department and independent collateral appraisals are important protective measures, especially to ensure that credit officers and other insiders are not colluding with borrowers.
14. The lack of use of risk-sensitive pricing by some banks may pose recurring problems in credit scoring decisions as they may analyse credits and decide on non price credits. Banks that lack a sound pricing methodology and the discipline to follow consistently such a methodology will tend to attract a disproportionate share of under-priced risks as opposed to banks that have superior pricing skills, hence an increasing disadvantage.
15. The failure to use sufficient caution with certain leveraged credit arrangements by a number of banks have led to increased credit losses. When credit is extended to highly leveraged borrowers there is likelihood of large losses in default. Similarly, leveraged structures such as some debt restructuring strategies, or structures involving customer-written options, generally introduce concentrated credit risks into the bank's credit portfolio and should only be used with financially strong customers. Often, however, such structures are most appealing to weaker borrowers because the financing enables a substantial upside gain if all goes well, while the borrower's losses are limited to its net worth.
16. In lending against real collateral real assets, many banks have failed to make an sufficient assessment of the correlation between the financial circumstance of the borrower and the price changes and liquidity of the market26 for the collateral assets. Much asset-based business lending (i.e. commercial finance, equipment leasing, and factoring) and commercial real estate lending appear to involve a relatively high correlation between borrower creditworthiness and asset values. Since the borrower's income, the principal source of repayment, is generally tied to the assets in question, deterioration in the borrower's income stream, if due to industry or regional economic problems, is likely to be accompanied by declines in asset values for the collateral. Some asset based consumer lending (i.e. home equity loans, auto financing) exhibits a similar, if weaker, relationship between the financial health of consumers and the markets for consumer assets.
17. A related problem is that many banks do not take sufficient account of business
Cycle effects in lending. Credit analysis may incorporate overly optimistic assumptions as income prospects and asset values rise in the ascending portion of the business cycle. Businesses that often experience strong cyclical effects are retailing, commercial real estate and real estate investment trusts, utilities, and consumer lending. Sometimes the cycle is less associated to general business form than the product cycle in a relatively new, rapidly growing sector, such as health care and telecommunications. Effective stress testing which takes account of business or product cycle effects is one approach to incorporating into credit decisions a fuller understanding of a borrower's credit risk.
18. The absence of a thoughtful consideration of downside scenarios often experience strong cyclical effects is. In addition to the business cycle, borrowers may be vulnerable to changes in risk factors such as specific commodity prices, shifts in the competitive landscape and the uncertainty of success in business strategy or management direction. Many lenders fail to "stress test" or analyse the credit using sufficiently adverse assumptions and thus fail to detect vulnerabilities.
Market and Liquidity-Sensitive Credit Exposures
19. Market and liquidity-sensitive exposures present special challenges to the credit processes at lending institutions. Foreign exchange and financial derivative contracts are examples of market-sensitive exposures while margin and collateral agreements with periodic margin calls, liquidity back-up lines is an example of liquidity-sensitive exposures that include, commitments and some letters of credit, and some unwind provisions of securitisations. The subjective nature of the exposure in these tools present the need for the bank to have the capability to calculate the probability distribution of the size of actual exposure in the future and its impact on both the borrower's and the bank's leverage and liquidity.
20. The need to develop meaningful measures of exposure that can be compared readily with loans and other credit exposures is another aspect faced by nearly all the financial institutions. Basel Committee's January 1999 study of exposures to highly leveraged institutions.15. describes this problem at some length
21. Market-sensitive instruments require a careful analysis of the customer's willingness and ability to pay. Most market-sensitive instruments, such as financial derivatives, are viewed as relatively sophisticated instruments, requiring some effort by both the bank and the customer to ensure that the contract is well understood by the customer. The link to changes in asset prices in financial markets means that the value of such instruments can change very sharply and adversely to the customer, usually with a small, but non-zero probability. Effective stress testing can reveal the potential for large losses, which sound practice suggests should be disclosed to the customer. When banks take insufficient care to ensure that the customer fully understood the transaction at origination, and the small print, banks incur major losses and subsequently large adverse price shifts leave the customer owing the bank a substantial amount.
22. Liquidity-sensitive credit arrangements or instruments require a careful analysis of the customer's vulnerability to liquidity stresses, since the bank's funded credit exposure can grow rapidly when customers are subject to such stresses. Such increased pressure to have sufficient liquidity to meet margin agreements supporting over-the-counter trading activities or clearing and settlement arrangements may directly reflect market price volatility. In other instances, liquidity pressures in the financial system may reflect credit concerns and a constricting of normal credit activity, leading borrowers to utilise liquidity backup lines or commitments. Liquidity pressures can also be the result of inadequate liquidity risk management by the customer or a decline in its creditworthiness, making an assessment of a borrower's or counterparty's liquidity risk profile another important element of credit analysis.
23. Market- and liquidity-sensitive instruments change in riskiness with changes in the underlying distribution of price changes and market conditions. For market-sensitive instruments, for example, increases in the volatility of price changes effectively increases potential exposures. Consequently, banks should conduct stress testing of volatility assumptions.
24. The probabilistic nature of the Market-and -Liquidity sensitive exposures can be linked with the creditworthiness of the borrower. This is a crucial lesson learnt from the market turmoil in Asia, Russia and elsewhere in the course of 1997 and 1998. That is, the same reason that changes the value of a market- or liquidity sensitive instrument can also affect the borrower's financial health and future projection. Therefore it is fundamental that banks do analyse the relationship between market- and liquidity-sensitive exposures and the default risk of the borrower. Stress testing shocking the market or liquidity factors is a strategic component in facilitating that analysis.
