Basic Situation Of Credit Approval Process-Credit and Risk Managment-Lecture Notes, Study notes of Credit and Risk Management

Download Basic Situation Of Credit Approval Process-Credit and Risk Managment-Lecture Notes and more Study notes Credit and Risk Management in PDF only on Docsity! LECTURE – 13 BASIC SITUATION OF CREDIT APPROVAL PROCESS The vast majority of credit institutions serve a number of different customer segments. This segmentation is mostly used to differentiate the services offered and to individualize the respective marketing efforts. As a result, this segmentation is based on customer demands in most cases. Based on its policy, a bank tries to meet the demands of its customers in terms of accessibility and availability, product range and expertise, as well as personal customer service. In practice, linking sales with the risk analysis units is not an issue in many cases at first. The sales organization often determines the process design in the risk analysis units. Thus, the existing variety of segments on the sales side is often reflected in the structure and process design1 of the credit analysis units. While classifications in terms of customer segments are, for example, complemented by product- specific segments, there appears to be no uniform model. Given the different sizes of the banks, the lack of volume of comparable claims in small banks renders such a model inadequate also for reasons of complexity, efficiency, and customer orientation. Irrespective of a bank’s size, however, it is essential to ensure a transparent and comprehensive presentation as well as an objective and subjective assessment of the risks involved in lending in all cases. Therefore, the criteria that have to be taken into account in presenting and assessing credit risks determine the design of the credit approval processes. If the respective criteria result in different forms of segmentation for sales and analysis, this will cause friction when credit exposures are passed on from sales to processing. A risk analysis or credit approval processing unit assigned to a specific sales segment may not be able to handle all products offered in that sales segment properly in terms of risk (e.g. processing residential real estate finance in the risk analysis unit dealing with corporate clients). Such a situation can be prevented by making the interface between sales and processing more flexible, with internal guidelines dealing with the problems mentioned here. Making this interface more flexible to ease potential tension can make sense in terms of risk as well as efficiency. Accounting for Risk Aspects The quality of the credit approval process from a risk perspective is determined by the best possible identification and evaluation of the credit risk resulting from a possible exposure. The credit risk can distributed among four risk components which have found their way into the new Basel Capital Accord (in the following referred to as Basel II). a. Probability of default (PD) b. Loss given default (LGD) c. Exposure at default (EAD) d. Maturity (M) Probability of Default Reviewing a borrower’s probability of default is basically done by evaluating the borrower’s current and future ability to fulfill its interest and principal repayment obligations. This evaluation has to take into account various characteristics of the borrower (natural or legal person), which should lead to a differentiation of the credit approval processes in accordance with the borrowers served by the bank. Furthermore, it has to be taken into account that — for certain finance transactions — interest and principal repayments should be financed exclusively from the cash flow of the object to be financed without the possibility for recourse to further assets of the borrower. In this case, the credit review must address the viability of the underlying business model, which means that the source of the cash flows required to meet interest and principal repayment obligations has to be included in the review. docsity.com Loss Given Default The loss given default is affected by the collateralized portion as well as the cost of selling the collateral. Therefore, the calculated value and type of collateral also have to be taken into account in designing the credit approval processes. Exposure at Default (EAD) In the vast majority of the cases described here, the exposure at default corresponds to the amount owed to the bank.5 Thus, besides the type of claim, the amount of the claim is another important element in the credit approval process. Thus, four factors should be taken into account in the segmentation of credit approval processes: 1. Type of borrower 2. Source of cash flows 3. Value and type of collateral 4. Amount and type of claim Approaches to the Segmentation of Credit Approval Processes The following subsections present possible segmentations to include the four factors mentioned above in structuring the credit approval process. The lending business in which banks engage is highly heterogeneous in terms of volume and complexity; this makes it impossible to define an optimal model, and therefore we will not show model segmentation. After the description of possible segmentations, two principles are dealt with that have to be included in the differentiation of the credit approval processes along the four risk components to ensure an efficient structure of the credit approval processes. 1. Distinction between standard and individual processes in the various segments; 2. taking into account asset classes under Basel II Type of Borrower In general, type of borrower is used as the highest layer in credit approval processes. This is due to the higher priority of reviewing legal and economic conditions within the substantive credit review process. The way in which the economic situation is assessed greatly depends on the available data. The following segments can be distinguished: 1. Sovereigns 2. Other public authorities (e.g. regional governments, local authorities) 3. Financial services providers (incl. credit institutions) 4. Corporates 5. Retail Usually, at least the segments of corporate and retail customers are differentiated further (e.g. by product category). Source of Cash Flows The distinction of so-called specialized lending from other forms of corporate finance is based on the fact that the primary, if not the only source of reducing the exposure is the income from the asset being financed, and not so much the unrelated solvency of the company behind it, which operates on a broader basis. Therefore, the credit review has to focus on the asset to be financed and the expected cash flow. In order to account for this situation, the segmentation of the credit approval processes should distinguish between: 1. credits to corporations, partnerships, or sole proprietors; and 2. specialized lending Credit institutions have to distinguish between the following forms of specialized lending in the calculation of regulatory capital. 1. Project finance 2. Object finance 3. Commodities finance 4. Finance of income-producing commercial real estate docsity.com