ECO20045 Banking

Answer 1

a) Techniques used for Credit Risk Management

Credit risk is described as the potential, which the bank’s counterparty or borrower will fail to meet the obligations as per the terms agreed. The main goal of the credit risk management is maximizing the risk-adjusted rate of return of the bank with the help of maintaining the credit risk exposure within the acceptable framework. Increasingly, the financial institutions and companies are highly investing in the credit risk management to better assess the credit risks, keeping the default rates low, and lessen the severity of losses (Byanjankar, Heikkilä and Mezei 2015). Some of the techniques used by the banks for managing credit risks are as stated below:

Risk-Based Pricing: It is the fundamental tenet of the risk management. It is when the lenders charge higher rate of interest to the borrower deemed of the moderate risk. The banks must develop the scientific systems to price the credit risk that must have a bearing on likely default probability. Risk-based pricing is quite ideal for the lenders or banks, which are having large reserve of loan, so in the event of default, there is availability of the capital. Hence, by monitoring these risky loans on continuous basis, the lenders can be proactive in making request for the payment or can change the terms to lessen hazards (Kurawa and Garba 2014).

MIS Reporting: The lenders can request for the periodic MIS reporting for managing the credit risks. Hence, in this particular scenario, borrower is asked to periodically submit the pre-determined financial statement to the lender. It allows the bank to regularly monitor the current financial status of the borrowers and their ability of paying loans. A bank must have strong MIS for the purpose of monitoring, reporting, and controlling the risks. A requirement for establishing an effective risk management system is an existence of the robust MIS that is consistent in the quality. However, MIS needs significant upgradation as well as strengthening of the data collection machinery for ensuring reliability and integrity of the data (Brown and Moles 2014).

b) Moral Hazard Explaining the Financial Structure

The 2008 financial crisis was an outcome of various inefficiencies of market, lack of the transparency, as well as the bad practices in financial sector. The market participants were engaged in the behavior, which put the financial sector into the edge of collapse. The products, such as subprime mortgages or COD were the root of the problem. However, knowingly trading and selling these products requires the moral hazard (Anginer and Demirguc-Kunt 2018).

Moral hazard is referred as a situation in which a party gets engaged in the risky event by knowing that the event is protected against the risk, while other party bears the cost in the event of the unfavorable outcome. This situation occurs when both the parties are having incomplete information regarding each other. There involves a risk in the financial market that the borrower might gets engage in the activities, which are not desirable from the point of view of the lender, as they make her or him less likely to pay back the loan (Zhang et al. 2016).

The problem of moral hazard in the banks can be viewed as the banks’ financial structure and shifting of risks. In a certain circumstance, if the assets and capital of the bank are believed to be specified, then alteration in the lending portfolio of the bank would deduce that in the attempt to earn high returns. The shareholders shift the risk to the debt holders. Moreover, in due course, eventually higher risk-taking yields to be profitable, but any kind of losses are mainly borne by the deposit holders. The shareholders are having higher risk shifting tendency if they are having lower stakes of equity. Thinly capitalized equity holders of banks are having stronger tendency of the unnecessary risk-taking. Ultimately, the moral hazard conflict between the depositors and shareholders gets high when the banks are less capitalized and it has raised the riskier lending. The banks are having the incentive to reduce the capital as well as increase the assets’ risk because of the fact that the deposit insurance institution usually guarantee any risk of loss, but the owner of bank get benefits when bank makes the profit.

The banks that are characterized by the lower expected default rates offers large credit amount and isolate the loans supply from the changes in the monetary policy. The banks including corporate risks are mainly affected by the information asymmetries, followed by the moral hazards (Duran and Lozano-Vivas 2015).

Reference 

Anginer, D. and Demirguc-Kunt, A., 2018. Bank runs and moral hazard: A review of deposit insurance.

Brown, K. and Moles, P., 2014. Credit risk management. K. Brown & P. Moles, Credit Risk Management, 16.

Byanjankar, A., Heikkilä, M. and Mezei, J., 2015, December. Predicting credit risk in peer-to-peer lending: A neural network approach. In 2015 IEEE Symposium Series on Computational Intelligence (pp. 719-725). IEEE.

Duran, M.A. and Lozano-Vivas, A., 2015. Moral hazard and the financial structure of banks. Journal of International Financial Markets, Institutions and Money, 34, pp.28-40.

Kurawa, J.M. and Garba, S., 2014. An evaluation of the effect of credit risk management (CRM) on the profitability of Nigerian banks. Journal of Modern Accounting and Auditing, 10(1), p.104.

Zhang, D., Cai, J., Dickinson, D.G. and Kutan, A.M., 2016. Non-performing loans, moral hazard and regulation of the Chinese commercial banking system. Journal of Banking & finance, 63, pp.48-60.

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