Credit Risk for Financial Institutions: What You Should Know

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Risk management is an important feature of the CFA® exams. Since many candidates work for or aspire to work for banks, an understanding of credit risk is critical, simply because credit risk is the main risk-exposure element of the vast majority of banks in any country. Take a look, for example, at the following extract from the banking book of an Austrian regional bank, with a balance sheet around EUR 10,000,000,000. It shows its November 2014 regulatory capital requirement breakdown:

  • Credit risk: 92%
  • Other: 1%
  • Operational risk: 1%
  • Market risk: 6%

This shows credit risk to be the highest material risk exposure on the balance sheet. This is by no means an extreme example, and amply illustrates the point.

Bad Debts and Write-Offs

It’s important to first understand how banks deal with credit risk. A main accounting operating item for banks is provisioning and write-offs against bad debts. This is mainly a loan book item, but of course can apply anywhere on the asset side of the balance sheet (including sovereign bonds).

As expected, credit write-offs run cyclically with the business cycle. Customer cash flows decline as the economy slows. This is expressed in various ways across sectors (e.g., rising unemployment reduces retail customer income and increases retail loan defaults).

In recession, asset values also decline, which impacts the value of collateral taken as security against loans (e.g., mortgages). Banks mitigate this risk with “haircuts” against security (e.g., loan-to-value levels for mortgages), but a 10% deposit for a retail mortgage can easily be wiped out in a recession.

And then there are interest rates: A slowing economy means base interest rates are cut and, all else being equal, this often reduces net interest income (NII). In fact, a big challenge for banks now is addressing a persistent low-interest environment.

Balance Sheet: Credit Risk

As the major—indeed for most banks, the only—large risk for banks is credit risk, the risk of loan loss due to customer default represents the primary risk to the balance sheet. This risk applies in the first instance to the loan portfolio, but also to counterparty exposure on securities and derivatives contracts. Basel III, also featured in the CFA curriculum, recognizes this with a large increase in counterparty credit risk charges for IB exposures.

A first-cut look at credit risk would be to observe the size of loan-loss provision as a percentage of the loan book, and loan-loss provision as percentage of pre-provision profit. But these are not totally transparent, as loan assets are themselves growing as a recession approaches; higher leverage must also be considered. The real risks lie almost invariably in the asset classes/sectors/regions experiencing the fastest growth, observed in concentration risk, and growth into areas outside the bank’s area of genuine expertise.

Typically, a bank monitors the following as measures of credit risk, which all CFA candidates need to know about:

  • Loan-loss provisions as a percentage of loans
  • Non-performing loans (NPLs) as a percentage of loans
  • Loan-loss provisions relative to NPLs (“coverage ratio”)

US banks also report net charge-offs, charges taken when the loan is actually written off on the balance sheet as opposed to simply provided for.

To break it down, provision is taken at the point where the bank feels interest and full principal of the loan is not collectible. This is a subjective management action, so a conservative approach is recommended. On provision, the bank reduces profit and reduces the value of the loan. The provision value as a percentage of the loan takes into account any collateral provided and the expected loss-given-default (LGD). Loan-loss provisions reported are the net provision after provisions “written back” (e.g., through recoveries on a previous bad loan). An NPL is defined as a loan that is 90 days past due. Ultimately, the best credit risk mitigation is sound origination policy.

The Role of ALCOs

Now, in a financial institution, credit-risk management is the responsibility of the Asset and Liability Committee (ALCO), also referred to in the CFA curriculum. The operating model recommended by CFA is that the ALCO have effective authority to monitor, and ultimately approve, all operational aspects that impact the balance sheet.

Individual business lines will manage their respective credit risks under the direction of the credit risk committee, which also sets the firm-wide policy. Management of credit exposure (at the balance sheet level) is frequently undertaken by the treasury or ALM department. But, as stated, the ALCO plays a paramount role in bank risk management and overall life-cycle sustainability. And in a financial institution, credit-risk management is the responsibility of the ALCO.

The nature of ALCO oversight is technical: capital, liquidity, market and non-traded market, and other cash flow impacts on the balance sheet. Given this core aspect of the role of the ALCO, the CFA philosophy is clear: establish a technical subcommittee of the ALCO, perhaps called The Balance Sheet Management Committee (BSMCO), chaired by the treasurer, that reviews the balance sheet and, when necessary, escalates issues to the ALCO. The membership of the BSMCO is at one level below the senior executives (CEO, CFO, CRO), with the exception of the treasurer. The importance of a BSMCO was highlighted in the “Dear CEO” letter of the UK regulatory authority in January 2011, and hence represents best practice.

About the Author

Edward Bace, CFA, is a finance professional specializing in training and consulting. He has extensive experience in finance, credit, and equity analysis, having worked for international financial and educational institutions including S&P, Lehman Brothers, CFA Institute, and Middlesex University London. He is currently advising on banking and finance at Watan First Institute, a training and consultancy firm based in Riyadh, KSA. In addition to the CFA charter, he possesses the MCSI and PGCHE qualifications, a finance MBA from NYU, and a PhD from the University of Michigan.

Edward Bace