Generally, credit risk is related to the traditional bank lending activities, while it also comes from holding bonds and other securities. Basel (1999) reports that for most banks, loans are the largest and most obvious source of credit risk; however, throughout the activities of a bank, which include in the banking book as well as in the trading book, and both on and off the balance sheet, there are also other sources of credit risk. Various financial instruments including acceptances, inter-bank transactions, financial futures, guarantees, etc increase banks’ credit risk. Therefore, it is indispensable to identify all the credit exposures— the possible sources of credit risk for most banks, which can also serve as a starting point for the following parts of this work.
1. On-balance Sheet Exposures
Commercial and industrial, real estate, consumer and others are the most common types of loans. Commercial and industrial loans can be made for periods from a few weeks to several years for financing firms’ working capital needs or credit needs respectively. Real estate loans are primarily mortgage loans whose size, price and maturity differ widely from commercial and industrial loans. Consumer loans refer to those such as personal and auto loans while the so called other loans include a wide variety of borrowers such as other banks, non-blank financial institutions and so on.
Credit risk is the predominant risk in bank loans. Over the decades the credit quality of many banks’ lending has attracted a large amount of attention. The only change is on the focus of the problems from bank loans to less developed countries and commercial real estate loans to auto loans as well as credit cards, which is an American example. Since the default risk is usually present to some degrees in all loans, the individual loan and loan portfolio management is undoubtedly crucial in banks’ credit risk management.
Besides lending, credit risk also exists in banks’ traditional area of debt securities investing. Debt securities are debt instruments in the form of bonds, notes, certificates of deposits, etc, which are issued by governments, quasi-government bodies or large corporations to raise capital. In general, the issuer promises to pay coupon on regular basis through the life of the instrument and the stated principal will be repaid at maturity time. However, the likelihood that the issuer will default always exists, resulting in the loss of interest or even the principal to banks, which can be a damaging impact.
2. Off-Balance Sheet Exposures
Since the 1980s, off-balance sheet commitments have grown rapidly in major banks, among which there are swaps, forward rate agreements, bankers’ acceptances, revolving underwriting facilities, etc. Those commitments give rise to new types of credit risk from the possibility of default by the counter party. In this section, some of the off-balance sheet credit exposures will be introduced, among which the first one is related to derivative contracts.
- Derivatives Contracts: Banks can be dealers of derivatives that act as counter-parties in trades with customers for a fee. Contingent credit risk is quite likely to be present when banks expand their positions in derivative contracts. Since the counter party may default on payment obligations to truncate current and future losses, risk will arise, which leaves the banks unhedged and having to substitute the contract at today’s interest rates and prices. This is also more likely to happen when the banks are in the money and the counter party is losing heavily on the contract. Comparatively, the type of credit (default) risk is more serious for forward contracts and swap contracts, which are nonstandard ones entered into bilaterally by negotiating parties. While trading in options, futures or other similar contracts may expose banks to lower credit risk since contracts are held directly with the exchange and there are margining requirements. However, the credit risk is also not negligible.
- Guarantees and Acceptances: Bank Guarantee is an undertaking from the bank which ensures that the liabilities of a debtor will be met, while a bankers’ acceptance is an obligation by a bank to pay the face value of a bill of exchange on maturity. It is mentioned by Basel (1986) that since guarantees and acceptances are obligations to stand behind a third party, they should be treated as direct credit substitutes, whose credit risk is equivalent to that of a loan to the ultimate borrower or to the drawer of the instrument. In this sense, it is clear that there is a full risk exposure in these off balance sheet activities.
- Interbank Transactions: Banks send the bulk of the wholesale dollar payments through wire transfer systems such as the Clearing House InterBank Payments System (CHIPS). The funds or payments messages sent on the CHIPS network within the day are provisional, which are only settled at the end of the day. Therefore, when a major fraud is discovered in a bank’s book during the day, which may cause an immediate shutting down, its counter party bank will not receive the promised payments and may not be able to meet the payment commitments to other banks, leaving a serious plight. The essential feature of the above kind of settlement risk in interbank transactions is that, “banks are exposed to a within-day, or intraday, credit risk that does not appear on its balance sheet”, which needs to be carefully dealt with.
- Loan Commitments: A loan commitment is a formal offer by a lending bank with the explicit terms under which it agrees to lend to a firm a certain maximum amount at given interest rate over a certain period of time. In this activity, contingent credit risk exists in setting the interest or formula rate on a loan commitment. Banks often add a risk premium based on its current assessment of the creditworthiness of the borrower, and then in the case that the borrowing firm gets into difficulty during the commitment period, the bank will be exposed to dramatic declines in borrower creditworthiness, since the premium is preset before the downgrade.