Introduction
In the current global finance market, the issue credit risk management has become very important as banks try to ensure that they are not dangerously exposed to bad debts that may affect their sustainability. The 2008 global financial crisis and the credit crunch which followed created pressure among international banks to redefine the approach they take in credit risk management (Anolli et al. 45). Vaidyanathan defines credit risk (CR) as “the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms” (41). A number of large international firms have been brought down because of their inability to manage risks in an appropriate manner. International banks cannot avoid credit risks. The primary source of income of most banks is the various loan products that they often offer to their customers.
Sometimes it may be practically impossible for a financial institution to predict whether a given customer will fail to pay the loan as per the terms of the agreement. However, Aalabaf advises that although it may be possible to identify the possible defaulters, it is the responsibility of every firm to make an attempt of conducting thorough investigations of a client’s ability to pay the loan before closing the deal (54). There are many other ways of managing credit risks. Anolli et al. defines credit risk management (CRM) as “the practice of mitigating those losses by understanding the adequacy of both a bank’s capital and loan loss reserves at any given time” (97). Success of any financial institution depends on how effective it is in managing risks. This is particularly so because a number of the clients who often make requests for loans are unable to repay the loan in one way or the other, exposing these firms to the risk of bad debts. In this paper, the researcher seeks to conduct a research on credit risk management in international banks.
Research Objectives
It is important to clearly define the research objective in this study in order to clarify what this paper seeks to achieve. International banks operate in a highly competitive and very sensitive market. One of the biggest challenges that these firms face in the international market is credit risk management. In this paper, the following are the specific research objectives that this study seeks to achieve.
- To identify the specific credit risks that international banks face in their normal operations
- To determine how international banks are dealing with the credit risks in their operations
- To come up with recommended approach international banks can use to manage credit risks
Research Questions
Developing effective research questions will help in guiding the nature of data that will be collected from the field. In this case, the focus will be on credit risk management in international banks. Based on the above research questions set above, the following are the specific research objectives that will define primary and secondary data that will be collected.
- What are the specific credit risks that international banks face in their normal operations?
- How are international banks dealing with the credit risks in their normal operations?
- What are the common mistakes that international banks commit when managing credit risks?
To respond to the above statements effectively, the researcher will use both primary and secondary sources of data. The next chapter will focus on a detailed review of literatures.
Literature Review
According to a study by Vaidyanathan, financial institutions are currently experiencing a number of challenges that they had not dealt with before because of the emerging trends (65). In the past, some of the leading international banks controlled the global financial market because of the relatively low level of competition. However, competition has become a single most important threat to sustainability of some of these financial institutions. As such, most of them are forced to come up with unique ways of achieving competitive revenue in the market. As Aalabaf notes, the most appropriate approach that these financial institutions can achieve competitive edge is to increase their sources of revenue (45). As competition puts strain on the traditional sources of revenue, these international banks are forced to invent new sources of revenues that can increase their income and profits. Some of the new products that these financial institutions often embrace may be profitable but they come with a number of risks.
A good example is the subprime lending that has become very common among a number of international banks. Subprime loans or mortgages are products offered to the customers who, in one way or the other, may have difficulty in repaying the loan because of their nature of income. These are loans often offered to the middle class whose sole source of income is their employment. It means that the ability of such a client to repay the loan depends on whether or not he or she retains the job. If for one reason or the other such clients losses their job, it becomes almost impossible for them to repay their loan. The outcome will be a bad debt that the bank must write off. With the currently unpredictable global financial conditions, international banks are not assured that all their customers will retain their jobs for the entire period of servicing their loans. In the United States and parts of Europe, firms are now considering relocating their operations to other countries such as China and India where the cost of operation is relatively low (Anolli et al. 73). It means that even in some of the developed countries in North America and Europe, the threat of customers losing their jobs is real, and that exposes these banks to credit risks.
According to Bessis, most of these financial institutions have no means of avoiding these high risk products (11). Under normal circumstances, any business entity may want to avoid high risk products that may jeopardize their operations in the market. Firms prefer being safe from risks that may have significant disruption in their operations. However, Vaidyanathan says that things are not as normal as banks would prefer in the global financial market (48). The stiff competition and strict government regulations in some of the markets have left most of these firms with no choice but to take risks that may expose them to financial harm if not well managed. International banks are forced to offer products that may not yield the expected returns because of the limited options they currently have. They find themselves in very complex positions in the market where they have to make very difficult decisions.
Case of Lehman Brothers
Lehman Brothers was one of the leading international investment banks in the global market within the final months of its operations in the market. According to Vaidyanathan, Lehman Brothers was the fourth largest investment banks in the United States before its collapse (94). It was one of the financial institutions considered very successful in the market. It was trusted by both customers and investors as an institution that secured their investments and savings. It was considered too large an institution to fall as such an incident had never been witnessed before in the United States. However, what many investors and customers failed to understand was that Lehman Brothers, just like many other giant financial institutions in the global market, was facing stiff competition and had to come up with new products in the market.
One of the new products that this firm focused on was the subprime mortgages. In the few years preceding the 2008 global financial crisis, the financial market was faced by a number of challenges partly because of the heavy expenses that the United States was making in the war against terror in the Middle East. Lehman Brothers, in its attempt to increase its product portfolio, started offering subprime mortgages to the middle class who wholly relied on their employment to service their loans. In paper, the financial position of this firm appeared very attractive based on the assumption that all its debtors were capable and willing to repay their debts and accumulated interests. However, the truth was that Americans were losing their jobs. It was in this period that giant auto firms and technology companies started shifting their production to other countries such as Mexico and China because of the growing cost of operation in the United States.
As firms continued to shift their operations from the United States to other countries around the world, many Americans started losing their jobs. The group worst affected by this trend was the middle class. These were mostly the skilled and semi-skilled individuals that could not be easily absorbed into other companies. Moreover, more companies in the United States were downsizing their operations as a way of cutting costs for purposes of sustainability (Bessis 71). It meant that more people in the middle class were losing their jobs. Given that these people wholly relied on their salaries to repay the mortgages, loss of job meant that they were incapable of repaying their loans. The rate at which Lehman Brothers customers who were offered subprime mortgages stated defaulting on their repayment became very high.
As the 2008 global financial crisis set in, it became apparent that most of these customers would not be able to repay their loans. This was one of the main problems that Lehman Brothers faced in its final years of operations. Given that the management of this company had not clear way of addressing this and a few other problems that the firm was facing, Lehman Brothers was finally forced out of operation. A once very powerful and successful financial institution in the global market was forced to shut down its doors because it was not ready for hence unable to manage credit risks (Anolli et al. 81). This incident has forced many firms to reevaluate the approach they take in credit risk management. It passed a clear message to international banks that failing to have a proper approach of managing risks may expose a firm to serious threat in the market.
Collateralized Debt Obligations
Collateralized debt obligation (CDOs) is another product that has gained popularity in the financial market as firms try to invent new products as a way of increasing sources of income. According to Anolli et al., credit debt obligation was a product that was originally developed specifically for the corporate debt-market (79). However, it evolved over time and currently it encompasses the mortgage market. This is happened as firms struggled to find ways of enhancing their profitability in the market. However, this is a very complex product based on how it is often structured and some firms often take advantage of their clients who are unable to understand how it works. Goldman Sachs, one of the leading American financial institutions, was once subjected to litigation because of using CDOs to expose other parties to serious risks unfairly. It is a clear indication that some of the emerging products that firms are currently offering may expose them to serious risks. These new product promises international banks new sources of revenue, but the nature of risks associated with them is worrying.
According to Vaidyanathan, one of the factors that often forces major financial institutions to consider offering some of these new risky products to their customers is the need to remain relevant to change and appear sensitive to the emerging needs of customers (56). Change as a force is very strong and cannot be ignored in any industry. As such, financial institutions often try to respond to change in the best way possible as a means of remaining relevant. Ignoring change may render a firm irrelevant in terms of products that it offers to its customers. Image also matters a lotto firms as they operate in the market. when a firm ignores a new product that appears to be more customer-focused than the existing ones, then the clients may develop a perception that such a firm is not keen on meeting their needs in the best way possible. Customers may consider switching loyalty to other firms primarily because they may be convinced that their needs may not be met in the best way possible at such firms. As such, a firm may be forced to introduce such a product into its portfolio not because it will generate the desired revenues and profits but because of the need to be relevant in the market and to protect its image.
Challenges to Effective Credit Risk Management
According to Bessis, credit risk management is important for international banks as they seek to achieve sustainability in their operations (92). Challenges often arise that hinders effective credit risk management. It is important for a firm to understand these risks and to know how to management them in order to successfully manage credit risks. The following are some of the main challenges that hinder effective credit risk management.
Inefficient management of data
As Aalabaf says, in the modern business environment where competition is very stiff, information is power (78). Ability of a firm to overcome market challenges and to achieve success depends on how first it can get access to information and act upon it ahead of market rivals. However, problems arise when a firm is unable to get access to the right data at the right time. It means that such a firm may fail to take an action when it is most needed, or make a decision without putting into consideration fundamental issues that matter most to its success. A firm that is not able to get the needed data within the right time may find it almost impossible to achieve success in the market. To address this problem, a firm should have intelligence gathering unit that will help it access needed data about credit risks before an important decision is made. Having the right data helps a firm to determine the kind of credit it should avoid based on the associated risks.
Poor risk modeling framework
Managing credit risks, according to Anolli et al., requires teamwork among employees within a firm (55). It requires a framework that guides the process of investigating the trustworthiness of a customer before a credit can be offered to them. Some banks have poor group-wide risk modeling framework that defines how different parties can coordinate their activities to ensure that the company is protected from bad debts. In such cases, it becomes difficult to effectively identify the risks and manage them in a way that will eliminate or significantly reduce the potential losses. Vaidyanathan advises that a firm should have a clear risk modeling framework that provides a clear guideline on how a firm plans to manage the associated risks (83).
Constant rework
In a poorly coordinated workplace environment, it is common to find cases where specific tasks are duplicated. Duplication of work is a sign of overlaps in assignment which may result into conflict of interest. It may also lead to cases where other tasks are not addressed because of the poor coordination. In such an environment, oversight problems may be very common. The company may fail to identify obvious issues with a specific creditor that makes him or her less qualified for a given loan (Anolli et al. 113). Lack of thorough investigation caused by overlaps of assignments may lead to instances where a bank offers loans to individuals who are very likely to default. This problem should be addressed by clear assignment of tasks within an organization.
Insufficient risk tools in a firm
Credit risk management requires the right risk solutions that can help in identifying portfolio concentrations and in re-grading the portfolio in order to give priority to the most attractive ones and avoid those that pose serious risks. Lack of these tools would mean that a bank will not have a way of identifying products that should be avoided and those that should be given priority. In such an environment, Bessis says that making a mistake is very easy (21). It is such mistakes that may expose a bank to serious credit risks. It is, therefore, important for a firm to develop appropriate risk tools that will guide its operations in the market.
Cumbersome approach of reporting
Many companies have structured way of reporting, some of which are now outdated given the emerging trends in technology. When the reporting system is cumbersome, then it becomes very challenging to address some of the common problems that junior officers face. The junior employees are forced to report to their supervisors who in turn will report to the mid-managers before the information can reach the top managers responsible for policy development. In such a lengthy process, it is often very likely that the message gets distorted along the channel of communication. It also takes a very long time for the company to respond to a given issue. Aalabaf says that firms should consider embracing open-door policy where junior employees can be allowed to interact with top managers once in a while to help in addressing urgent and very important issues (112).
Methodology
When planning to conduct a research, it is important to develop a clear method of collecting and analyzing data from reliable sources. In this study, the researcher collected data from both secondary and primary sources. Secondary sources of data used in this paper included books, journal articles, and reliable websites. These secondary sources of data provided the background for this study. The findings obtained from the secondary sources are discussed in the literature review section above. The second source of data in this study was the primary sources. It was important to collect data from respondents in order to address the research gaps identified in the literature review. The researcher identified specific people with the relevant information needed for this study to take part in the data collection process.
Sampling Method
Credit risk management is an issue of concern to all financial institutions not only in the Kingdom of Saudi Arabia but also all other countries across the globe. Senior bank officials and officers working in the risk management department of various banks qualify to be participants in this study because they have in one way or the other been forced to deal with the problem of credit risks. It may not be practically possible for the researcher to collect data from all the respondents in across the globe. In fact, it is not possible given the time constraint in this study, for the researcher to collect data from the entire population within the city of Riyadh. As such, it became apparent for the researcher to come up with a manageable sample of respondents to participate in this study. The researcher sampled fifty participants from two different banks within the city of Riyadh. The two banks included Samba Financial Group and Deutsche Bank. From each bank, the researcher sampled ten respondents. Stratified sampling method was used to identify specific participants to be involved in the collection of primary data.
Instrument of Data Collection
According to Tracy, after identifying the participants in a given study, a researcher should come up with an effective instrument of collecting data from them (78). The instrument should capture all the important areas of research to ensure that the needed data is obtained. In this study, the researcher used a questionnaire to collect data from the participants. The questionnaire captured the demographical factors, including age, level of education, and experience of the participants in their respective positions. The questionnaire was developed based on the research questions and objectives. The questions focused on creating an understanding of credit risk management, understanding challenges that firms face when managing credit risks, and identifying ways through which these risks can be addressed in the most appropriate way possible in order to enhance success within a firm.
Data Collection
Using the questionnaire as the instrument of the study, the researcher conducted a face-to-face interview with the respondents. It was necessary to meet the respondents physically when collecting data. According to Aalabaf, face-to-face interview is important because it makes it possible for the researcher to address any concern that the researcher may have before collecting data from them (98). It also enhances credibility of the outcome because chances of getting misleading answers are eliminated. In case the respondent’s answer is unclear for the researcher, it is possible to ask for clarification. Although it is a time consuming method, the researcher considered it the most appropriate method of collecting data from the respondents.
Data Analysis
Data collected from the respondents was analyzed in order to come up with findings for the study. When analyzing data, Tracy advises that a researcher should use qualitative, quantitative, or mixed research methods (56). The focus of this paper is to develop an understanding about credit risk management in international banks. To achieve the research objectives for this study, both qualitative and quantitative methods of data analysis were used. Qualitative methods provided explanatory data while quantitative methods provided the statistics needed for to support the explanations.
Ethical Considerations
Ethics is very important when conducting a research. Tracy warns that in academic research, one should not ignore the need to protect the identity of the respondents (43). The respondents’ views may contradict the views of the majority. It is possible for them to be subjected to unfair treatment by the majority of the population if it is established that they had a varying opinion from that of the rest of the population. As such, it was necessary to ensure that their identity remained unknown throughout the study as a way of ensuring that they are protected. The researcher assigned each respondent letters of alphabet to ensure that their names are not revealed. Before conducting the interview, the researcher briefed the respondents in advance to ensure that they understand the purpose of the study. This was necessary to ensure that they were adequately prepared for the process of data collection.
Results
The primary data collected from the respondents were analyzed both qualitatively and quantitatively as explained in the section above. In this section, the focus will be to present the results of the analysis based on the three primary questions that were used in this study. The first question sought to capture the specific credit risks that a financial institution may face in its normal operations.
What are the specific credit risks that international banks face in their normal operations?
The participants responded to this question by identifying a number of factors that may pose risks to a bank’s normal operation. It is important to note that these are risks which occur when a borrower fails to make required payments as per the agreement. The graph below identifies the factors based on their severity.
As shown in the above figure, when a borrower fails to make payments as agreed upon when the loan was awarded, a bank may face a number of risks. The most severe risk, as shown in the figure above, is a total loss of principal. This is a case where the borrower fails to repay the initial amount awarded to them as loan and the interest that was charged. Such losses may easily lead to a collapse of a firm if they occur frequently. Loss of interest is another common credit risk that international banks face. It occurs when the borrower is able to repay the interest but for one reason or the other fails to pay the interest. In such cases, the bank will run at loss because the interest is meant to cover the cost of operation. Disruption of cash flow within a firm is another major concern that is associated with credit risk. It occurs when a bank is unable to get the expected cash from the borrowers at the right time. In the repayment schedule, banks often expect specific amounts of money from their borrowers as specified in the agreement.
When a borrower fails to pay the specified amounts at an expected time, then there might be disruptions of a firm’s cash flow. Such an institution may be forced to go for interbank loans to ensure that it can meet its financial obligation to customers and investors. It means that such a bank will be operating at a loss. In most of the cases, banks often ask for collaterals when extending loans. In case of a default, they are forced to go for the collateral as a way of recovering their loan. Although the approach may protect the bank from loss of principal and interest, it is a costly process. Paying the auctioneers and many other costs of liquidating the asset may lower profitability of the firm. Some of the respondents also noted that the approach may harm the image of the firm in the market. The public watching such a bank reclaiming their money through auctioning of the asset of their clients may avoid such banks because of the perception that the bank is ruthless. They may develop a fear that in future they may face the same fate in the market.
The next question focused on the approach that international banks are currently using to deal with credit risks in the most appropriate way possible.
How are international banks dealing with the credit risks in their normal operations?
This was a question that required a detailed explanation from the respondents. Each of the respondents was asked to explain how their firms are trying to manage this risk to avert the associated losses that a firm may incur. From the interview conducted, the most common approach that most of these banks use to counter the problem is by conducting a thorough audit of the borrowers’ capability to repay the loan before extending the credit to them. Banks earn most of their incomes from the loans to their customers. Failure of these customers to repay the loan on time may expose these firms to massive losses. As such, these firms have mechanisms to thoroughly conduct investigation about the ability of their clients to repay the loans. This includes investigating credit worthiness of the customer based on the past loans from the same bank or other financial institutions. A customer who failed to repay a loan in a different bank is likely to be a defaulter. In the Kingdom of Saudi Arabia, financial institutions have come up with mechanisms that allow them to share data amongst themselves. This move is specifically meant to ensure that a customer who has failed to repay his or her loan with one bank is blacklisted so that he or she cannot get loan from other banks.
The strategy, as stated by the respondents, helps in reducing cases of handling high risk loans. Some banks, as explained by the respondents, ask for collaterals that can easily be converted to cash when offering high-risk loans to their clients. This is common when extending a loan to businesses or individuals who lack institutions that can act as a guarantor to their loans. The collateral may be liquidated in case they fail to pay the loan as per the agreed upon terms. It was noted, from the response of the participants, that some banks are now taking insurance cover against some of the high risk loans. It occurs when a bank is not assured of the ability of the client to repay the loan and such a client lacks any tangible collateral that can be used to reclaim the loan. As such, the insurance company offers to compensate the bank for any loss that may accrue due to lack of payment of the loan by the client. In return, the insurance company receives premiums from the bank as per the terms agreed upon when signing the contract.
The question below focused on determining the common mistakes that international banks commit when managing credit risks.
What are the common mistakes that international banks commit when managing credit risks?
When asked about these mistakes, the respondents stated that over expectation is one of the most common problems. Sometimes the bank may have very high expectations of a client’s ability to repay the loan. It may be because the client has landed a well paying job or the past records show that such a borrower has a reputation in repaying the loans in time. As such, the firm may consider extending a loan to them without taking due consideration about the possible risks. For instance, the bank may consider giving huge amount of unsecured loans to such clients believing that based on their past records they shall pay in time. When such clients fail to pay for various possible reasons, then the bank is left with no possible way of recovering their money. These are some of the cases that often result in loss of both the principal and interest as mentioned above.
One of the respondent stated that one of the main problems that often create credit risks is corruption and nepotism. It is common to find cases where loan is extended to an undeserving candidate basically because he or she is known to the manager. There are cases where the loan is granted to a customer because they were willing to pay the officers responsible for conducting the audit. In such cases, these officers fail to take into consideration important factors when conducting the audit. The outcome is a case where one is given loan without factoring in their ability to repay such loans in time.
Discussion
Credit risk management is critical for international banks as they struggle with new and traditional challenges in the financial markets. The 2008 global economic recession that led to the collapse of Lehman Brothers, one of the giant financial institutions in the global market, was a clear indication that indeed there is no single firm that can be considered too big to fall (Greuning and Brajovic 32). The market is very competitive and firms are faced with numerous challenges. Credit risks are some of the most common and very dangerous risks that firms have to deal with in the market. A number of financial institutions, other than the Lehman Brothers, have collapsed because of their inability to understand how to manage credit risks. Subprime mortgages have been a common problem for many financial institutions despite its growing popularity.
As Bessis says, extending loans to customers is not wrong (27). However, it is important for a firm to ensure that for every loan extended to its clients, there is a clear mechanism of getting the principal and interest from the client even if they decide to default. Traditionally, firms have used collaterals as a way of securing the loans they extend to the customers. However, Vaidyanathan says that this approach limited the ability of young investors who lacked assets to access loans from the banks (21). As such, banks were forced to come up with alternative approaches of securing loans. Insuring the loans is one of the common approaches that firms are using to protect themselves from credit risks. Although the approach increases the overall cost of every loan hence reduces profitability, it is an approach that eliminated the associated risks.
The primary and secondary data collected in this study both strongly proposes a need to ensure that loans are extended to clients after conducting a thorough evaluation of the customer’s ability to repay the loan. Malpractice such as corruption or nepotism may affect a bank’s ability to deal with these risks. Evaluation of the customers should be done in an impartial manner and without any hidden motive. Those trusted with responsibilities of managing credits should understand that success of the firm lies in their hands. They have to be committed to ensuring that the firm is protected from any foreseeable risks associated with the credit offered to the customers.
Conclusion and Recommendation
International banks operate in a highly competitive business environment. One of the most common challenges that these firms face is the credit risk. These banks rely on the interest they charge on their loans to earn profits. However, sometimes it becomes very challenging for them to determine whether or not a give loan would be declared bad debt. Failure of a borrower to repay the loan may result into serious losses for the firm. As such, it is important for international banks to come up with effective ways of managing credit as a way of avoiding possible losses that may result. The following are some of the recommendations that these international banks should consider taking into account.
- For every loan that is extended to a customer, there should be a way of recovering the principal and the interest even if the client decides not to repay.
- These banks should conduct a comprehensive background check of their clients before giving them loans.
- In case of a high risk high profit loans, these bans should consider taking insurance cover.
Works Cited
Aalabaf, Morteza. “Journal of the Royal Statistical Society. Series A.” Journal of the Royal Statistical Society, vol. 172, no. 4, 2009, pp. 941–941.
Anolli, Mario, et al. Retail Credit Risk Management. Palgrave Macmillan, 2013.
Bessis, Joel. Risk Management in Banking. Wiley & Sons Publishers, 2014.
Greuning, Hennie , and Bratanovic Brajovic. Analyzing Banking Risk: A Framework for Assessing Corporate Governance and Risk Management. World Bank, 2009.
Tracy, Sarah. Qualitative Research Methods: Collecting Evidence, Crafting Analysis, Communicating Impact. Wiley-Blackwell, 2013.
Vaidyanathan, Kenzo. Credit Risk Management for Indian Banks. Wiley & Sons Publishers, 2013.
