Risk in banking sector

Risks Associated with Lending

According to the OCC’s supervision by risk philosophy, risk is the potential
that events, expected or unexpected, may have an adverse impact on the
Loan Portfolio Management 4 Comptroller’s Handbook

bank’s earnings or capital. The OCC has defined nine categories of risk for
bank supervision purposes. These risks, which are defined in other
Comptroller’s Handbook sections, are credit, interest rate, liquidity, price,
foreign exchange, transaction, compliance, strategic, and reputation. Banks
with international operations are also subject to country risk and transfer risk.
These risks are not mutually exclusive; any product or service may expose the
bank to multiple risks. For analysis and discussion, however, the OCC
identifies and assesses the risks separately.

A key challenge in managing risk is understanding the interrelationships of
the nine risk factors. Often, risks will be either positively or negatively
correlated to one another. Actions or events will affect correlated risks
similarly. For example, reducing the level of problem assets should reduce
not only credit risk but also liquidity and reputation risk. When two risks are
negatively correlated, reducing one type of risk may increase the other. For
example, a bank may reduce overall credit risk by expanding its holdings of
one- to four-family residential mortgages instead of commercial loans, only to
see its interest rate risk soar because of the interest rate sensitivity and
optionality of the mortgages.

Lending can expose a bank’s earnings and capital to all of the risks.
Therefore, it is important that the examiner assigned LPM understands all the
risks embedded in the loan portfolio and their potential impact on the
institution. How each of these categories relates to a bank’s lending function
is detailed in the following sections.

Credit Risk

For most banks, loans are the largest and most obvious source of credit risk.
However, there are other pockets of credit risk both on and off the balance
sheet, such as the investment portfolio, overdrafts, and letters of credit. Many
products, activities, and services, such as derivatives, foreign exchange, and
cash management services, also expose a bank to credit risk.
The risk of repayment, i.e., the possibility that an obligor will fail to perform
as agreed, is either lessened or increased by a bank’s credit risk management
practices. A bank’s first defense against excessive credit risk is the initial
credit-granting process S sound underwriting standards, an efficient, balanced approval process, and a competent lending staff. Because a bank cannot
easily overcome borrowers with questionable capacity or character, these
factors exert a strong influence on credit quality. Borrowers whose financial
performance is poor or marginal, or whose repayment ability is dependent
upon unproven projections can quickly become impaired by personal or
external economic stress. Management of credit risk, however, must
continue after a loan has been made, for sound initial credit decisions can be
undermined by improper loan structuring or inadequate monitoring.

Traditionally, banks have focused on oversight of individual loans in
managing their overall credit risk. While this focus is important, banks
should also view credit risk management in terms of portfolio segments and
the entire portfolio. The focus on managing individual credit risk did not
avert the credit crises of the 1980s. However, had the portfolio approach to
risk management augmented these traditional risk management practices,
banks might have at least reduced their losses.

Effective management of the loan portfolio’s credit risk requires that the board
and management understand and control the bank’s risk profile and its credit
culture. To accomplish this, they must have a thorough knowledge of the
portfolio’s composition and its inherent risks. They must understand the
portfolio’s product mix, industry and geographic concentrations, average risk
ratings, and other aggregate characteristics. They must be sure that the
policies, processes, and practices implemented to control the risks of
individual loans and portfolio segments are sound and that lending personnel
adhere to them.

Banks engaged in international lending face country risks that domestic
lenders do not. Country risk encompasses all of the uncertainties arising from
a nation’s economic, social, and political conditions that may affect the
payment of foreigners’ debt and equity investments. Country risk includes
the possibility of political and social upheaval, nationalization and
expropriation of assets, governmental repudiation of external indebtedness,
exchange controls, and currency devaluation or depreciation. Unless a
nation repudiates its external debt, these developments might not make a
loan uncollectible. However, even a delay in collection could weaken the
lending bank.
Transfer risk, which is a narrower form of country risk, is the possibility that
an obligor will not be able to pay because the currency of payment is
unavailable. This unavailability may be a matter of government policy. For
example, although an individual borrower may be very successful and have
sufficient local currency cash flow to pay its foreign (e.g., U.S. dollar) debt,
the borrower’s country may not have sufficient U.S. dollars available to
permit repayment of the foreign indebtedness. The transfer risk associated
with banks’ exposures in foreign countries is evaluated by the Interagency
Country Exposure Review Committee (ICERC). For examination purposes,
the transfer risk rating assigned to a country by the ICERC applies to all bank
assets in that country. However, examiners may classify individual loans and
other assets more severely for credit risk reasons.
Strategies for managing country risk will be discussed in “Country Risk
Management,” a separate booklet in the Comptroller’s Handbook.