Banks and credit risk management
April 7th, 2009 Ogbuotobo Chuks || chuks@stockmarketnigeria.com
Banks as most people would tell you are all about receiving deposits from and giving out loans to customers. This is very correct with respect to their primary functions amongst many other things that they do. The banking sector however is a very risky one. The level to which any bank mitigates its risk just like other businesses determines its level of profitability. However, unlike most other businesses, banks are obligated to give out loans to customers for various purposes. These loans are meant to be paid back with interest which would add up to the bank’s profits. In as much as this is the expected norm, customers sometimes default by not paying as at when due or not even paying at all. This gives rise to credit risk management.
Credit risk arises when an obligor fails to perform its obligations under a trading or loan contract. It could also arise when the obligor’s ability to perform such obligations is impaired. It does not only arise when a borrower defaults on payment of a loan or settlement but also when its payment capability decreases. This being the case, a bank has to fashion out a way to manage this potential risk.
Based on the possibility of default by the borrower, banks are mandated to make provisions to cover loans given out in the event of a default. This ensures that even if the borrower defaults, such an event would not seriously impact its operations. Generally, loans are termed as either performing loans or non-performing loans.
Performing loans are loans that range from 1 to 89 days past the contractual due date. A provision of 1% is made for these loans.
Non-performing loans are loans with payment past due contractual date of 90 days and above. They are classified as
1. Substandard Loans: loans ranging between 79 days to 179 days past due payment date. A provision of 10% is made against these loans.
2. Doubtful Loans: are loans ranging between 180 days to 359 days past due payment dates. A provision of 50% is made against these loans to cover up for any default.
3. Lost loans: these are loans past due payment date in excess of 360 days. It is assumed that these loans cannot be recovered and as such, a provision of 100% is made.
Why is it important?
It is important that the investor knows the credit risk of a bank, if he has investments in any bank or is contemplating making one. The ratio of non-performing loans to total loans should be on the decrease. This indicates that the bank is recovering most of its loans and as such is maximizing its assets to generate profits.
The loan profile detailing amount of performing and non-performing loans could be gotten from their annual reports and accounts statements.
(Note: the accounting principle used here is with respect to Nigerian banks and may differ from one country to another)
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Quite enlightening
kindly limelight on credit management in the nigeria banks, a case study of First Bank of Nigeria plc. Thanks.