Credit Risk Management in British Banks

Abstract

Credit risk is a common banking risk. Banks always strive to avoid this risk by adopting sound credit management policies. There are numerous examples showing the impact that poor credit risk management has on banks. Indeed, many banks, have been rendered bankrupt, liquidated and at best, lost their credibility because of poor credit risk management. Indeed, this paper highlights a few countries which have suffered severe banking crises that have been occasioned by poor credit risk management.

However, there is a lot of information about how credit risk management is practiced in countries north of the Atlantic but very few literatures focus on how credit risk management is practiced in British banks. For example, there is a lot of literature regarding the way American and Canadian banks practice credit risk management but there is insufficient information regarding the way Europe does the same. This paper takes the initiative to fill this literature gap by analyzing four British banks as a representative sample of the British banking sector to investigate credit risk management practices in British banks.

This paper demonstrates that British Banks have a risk conscious-culture and their credit risk management techniques are a combination of traditional and new ways of credit risk management. The structure of credit risk management is also well articulated in the British banking sector with most credit risk management decisions confined within banking boards. Except for the lack of adequate credit risk management information for some of the banks sampled, this paper demonstrates that British banks show a relatively high compliance with Basel regulations, although there is still room for improvement.

Introduction

“What is the big deal with a low credit management score?” This is the question many people ask when they investigate the importance of credit risk management in the banking sector. The answer to this question lies on the impact that poor credit risk management has on banking operations. For example, in 2004, there was a Zimbabwean banking crisis which saw many banks close because of poor credit risk management (Njanike 2011). This banking crisis dented a huge blow to the Zimbabwean banking industry because it reduced the number of players in the market from 41 to a mere 29 (between December 2003 and December 2004) (Njanike 2011). By any standard, such a drastic reduction in the number of industry players is dramatic (Mexico and Venezuela have also experienced similar banking crises).

Basel Committee on Banking Supervision (1999) explains that the proportions of banking failures which have occurred in G-10 countries are similar to those that have occurred in non-G10 countries. The sheer number of countries that have experienced banking failures is just an example to show how poor credit risk management can impact a country’s banking industry.

Historically, banks have been faced with many problems ranging from poor economic performance, poor downgrades of credit standings to poor portfolios in risk management. There is however a strong consensus among many analysts that despite the multitude of problems that banks continue to face today, the biggest problem centres on the laxity in formulating high credit standards to ensure banks do not suffer from the devastating impact of credit risks (Rose and Hudgins 2008). The entire basis of a sound credit risk management framework is to maximize a bank’s profitability (in lending) while minimizing the risk exposure.

As mentioned in earlier sections of this study, the importance of credit risks management cannot be understated because credit risks are also related to other risks and if both risk categories occur, the impact on a company may be disastrous. Many experts therefore recommend that credit risk management should be done within a wider risk management portfolio (Rose and Hudgins 2008).

Market failures (combined with poor credit risk management) have cause drastic banking failures. Arsov and Gizycki (2003) explains that ordinarily, credit risk failures are caused by a myriad of factors including a high level of insider loans trading, speculative lending and the non-diversification of lending to different economic sectors. The failure of institutions to practice proper credit risk management also tends to exacerbate the negative consequences of credit risks.

Recently, Europe has fallen victim to major credit risk management failures and consequently, major European banks are riling from the effects of bad credit risk management. For example, SAS Institute (2011) explains that the level which major U.K banks are writing off bad debts today has reached unsustainable levels. It states that “In the third quarter of 2009 alone, the Bank of England reported bad debts to the tune of £1.6 billion – exactly half of the £3.2 billion credit risks in recorded for 2008 as a whole” (SAS Institute 2011, p. 1).

The high level of bad debts in the UK banking system (and its subsequent losses) heralds a new period of risk management for banks. Indeed, these are serious times for the banking sector and banks need to effectively evaluate their credit risk operations to avoid credit defaults and bad debts. Based on this importance, this paper investigates how British banks undertake their credit risk management plans because there is a gap in literature showing how British banks manage credit risks. Most of the literatures available focus on how American and Canadian banks do so but there is little focus and understanding regarding the way credit risk management in British banks is applied. This paper aims at address this gap through an outline of the following objectives:

• To investigate how credit risk management in British banks compares to the Basel Approach
• To evaluate the credit granting process in British banks
• To investigate the differences in credit risk management for small and large British banks
• To establish the credit risk management governance of British banks
• To find out how British banks manage their credit risk exposures
• To evaluate the credit risk mitigation and measurement methods for British banks

Literature Review

Undoubtedly, credit risk has been termed by many experts as the largest risk element in banking (Rose and Hudgins 2008). Therefore, many bankers caution against poor management of credit risk because it may potentially weaken not only the concerned banks but also an entire banking system. The effectiveness of managing credit risks vary across different countries, banks, regions and even jurisdictions (Jackson 2001).

However, there are a few commonalities that financial experts have identified to inform the process of formulating proper credit risk management procedures. Basel’s approach to credit risk management has however been the most popular among financial analysts and it stipulates that credit risk managers should establish an appropriate credit risk environment, operate under a sound credit granting process, maintain an appropriate credit administration, measurement, and monitoring process and ensure adequate controls over credit risk are employed (Morris 2008).

Ensuring that an appropriate credit risk environment is maintained largely depends on a bank’s accuracy in identifying its credit risks and formulating the right policies and strategies that should govern the management of such risks. Concisely, the process of identifying the right credit risk management strategies depends on a bank’s ability to understand the characteristics of its credit risks and its credit granting activities. This process is especially important in understanding new credit risks. Zhao (2007) explains that once banks are able to formulate the right designs for developing credit granting decisions, they will have touched the cornerstone of sound credit risk management. Ideally, a credit risk strategy is supposed to show the different types of credit that a bank can give its target customers and the characteristics of the associated credit portfolio (Zhao 2007).

Establishing the right credit risk practices ensures there is an acceptable standard for managing credit risks but most importantly, it helps inculcate a culture of credit risk responsibility which is defined by the employees’ understanding of the acceptable ways that credit risk is managed by banks (Duffee and Zhou 2001). This process is closely linked with the credit granting process where prospective lenders are vetted to ensure that banks only provide credit to creditworthy customers. The above statement defines the screening process and it characterizes the first step that credit risk managers take to prevent credit risks. Usually, a bank’s credit criterion shapes the types and characteristics of its lenders so that bank officials can easily identify who to give credit or not.

The credit granting process forms part of a bank’s credit administration, monitoring and measurement process. Glantz and Mun (2008) explain that a bank’s credit administration, monitoring and measurement process forms an integral part of maintaining a sound lending culture. From this understanding, Bessis (2011) cautions banks against understating the importance of their credit lending administration. Part of the credit administration philosophy involves the correct measurement of credit risks so that banks can estimate correctly the credit risk exposure to individuals and different credit risk portfolios (Njanike 2011).

Introducing a sound credit measuring framework is only part of a two-faced strategy that analysts recommend bankers should follow if they are to ensure their credit risk management strategies are to yield the desired outcomes (Gagnon 2010). The last strategy focuses on credit risk monitoring where banks should follow up on their customers to ensure they are still in a position to meet their credit obligations. According to Hibbeln (2010), this is a necessary step to ensure banks are still in control of their credit qualities and it is also a necessary step to ensure the credit review process is in line with the company’s credit policies. It is important to ensure that independent judgments inform the credit review process.

Credit Risk Ratings

Credit risk ratings are often done to assess an individual or bank’s creditworthiness. The credit rating process is often based on a myriad of factors but the financial history, current liabilities and current assets of an organization stand tall among the list of possible assessment factors (Hopkin 2010). For many banks, external and internal credit rating systems are used to predict an organization’s credit risk (Ghosh 2012).

The quality of a bank’s loans usually determine the credit risk rating for these banks (performing loans are normally given higher ratings). The quality of a bank’s loans can be regarded as monotonic transforms to determine the probability of defaults and inform future organizational policies regarding risk management or procedures (Arsov and Gizycki 2003). The internal credit rating system is often used to differentiate the level of risk among different financial exposures such as loans. Basel II assessment on credit risk exposure has supported the adoption of internal credit rating systems and equally encouraged its adoption as a useful strategy for banks to further develop their risk management portfolios (SAS Institute 2011).

Apart from the internal credit rating system, external credit rating agencies also evaluate a company’s credit risk. Notable credit rating agencies are like Fitch and Standard & Poor (Dash 2011). These credit rating agencies are usually more concerned about a company’s long term credit rating (after assessing their financial structures and fundamental strengths) (Hong Kong Institute of Bankers 2012). Since these credit rating agencies are more concerned about a company’s long-term credit portfolio, they are less inclined to take note of short-term credit risk fluctuations. Only significant credit quality changes are likely to be considered by such credit rating agencies.

Albeit the long-term nature of credit risk perceptions by such credit risks agencies, the risk agencies are still strongly considered as accurate assessors of credit risk prices. According to Basel II accord, it is possible for banks to slot assets into weighting bands but as far as external credit rating agencies are concerned, it is highly unlikely that the future role of external credit ratings will increase (Woods 2012). The following table shows the bands used by credit rating agencies today

Credit Risk Models

Credit risk models are characterized by the Basel approach to be crucial in providing an accurate assessment of a bank’s credit risks across geographic and product lines. These models are very important in assessing a bank’s economic capital and the risk management portfolio (Van-Gestel 2008). Existing credit risk models may be different in structure or methodologies but all of them work towards the purpose of identifying the probability loss distribution function in the credit risk management portfolio (Peura and Jokivuolle 2004). Their importance in the banking is sector is only exemplified by Basel as informative tools that offer banks “a framework for examining credit risk in a timely manner, centralizing data on global exposures and analyzing marginal and absolute contributions to risk” (Zhao 2007, p. 56). Among the most commonly known models for credit risk management are the Merton based models.

Merton based models

Merton based models are sometimes known as structure based models because they mainly analyze the balance between a company’s assets and liabilities (Hull and White 2004, p. 3). In detail, these models show that when a company’s liabilities exceed their assets, there is a financial problem to be realized. Zhao (2007) explains that “Merton has modelled a firm’s asset value as lognormal process, with the equity modelled as a call option on the underlying assets, and the default is allowed at only a future time t” (p. 70).

From the above statement, it is easy to establish the likelihood that a potential loan borrower fails to meet his credit obligations because a combination of the vulnerability of the organization’s assets and the past credit history of the customer inform the creditworthiness of a customer (Chapman 2005). Basel Committee on Banking Supervision (1999) explains that Merton based models have been used as a framework for the development of other models such as Moody’s KMV model and from this background, Merton based models have provided the right ground work for the development of term structures for default risk probabilities (but more importantly, they have led to the understanding of the concept of ‘distance to default’ in financial management). The distance to default concept

“is calculated from the market assets value of the firm, the volatility as well as the default point term structure, and the model derives the actual probability of default—the Expected Default Frequency for each obligor instead of relying on the average historical transition frequencies produced by the rating agencies” (Zhao 2007, p. 67)

Rating Based Models

The credit Metrics from JP Morgan is among the most common form of rating based model which is used to assess portfolio risk by assessing the changes in debt value (Rose and Hudgins 2008). The changes in debt value may be occasioned by changes in obligator credit quality among other factors. Powell (2004) explains that changes in obligor quality can be expressed by evaluating the probability of a standard nominal value which is derived from evaluating critical credit values which lie between a debtor’s historical credit record and the current credit standing. The measurement structure of credit metrics is defined by the diagram below

A major weakness identified as a shadow to the accuracy of the credit metrics model is its transition probabilities which rely on average historical frequencies of credit defaults and migration. The reliance on these two variables is known to affect the accuracy of the model.

Actuarial Models

Actuarial models constitute another model group of statistical techniques used in credit risk management. Here, the default rate of a given risk group is assumed to follow a Poisson distribution (Basel Committee on Banking Supervision 1999). According to actuarial models, the loan development process is characterized by two eventualities – the loan is paid or there is a default. Profits or losses which may be realized from credit migrations are insignificant in this regard.

Macroeconomic Models

Among all microeconomic models, the credit portfolio view is the most commonly used model. This model is informed by a myriad of factors which may also be influenced by causal observations (Crouhy and Mark 2000). Default risks are the most commonly analyzed credit risk factors (according to the credit portfolio view). The time series of default rates is also considered with equal importance. The time series for default rates and default risks are ultimately used to simulate macroeconomic scenarios which are then used to estimate the conditional distribution of default probabilities (Correia 2012).

Reliance on Basel Framework

Comprehensively, credit risk management takes different shapes and structures and according to an organization’s banking structure, the appropriate credit management model is chosen. However, the main banking framework that this paper relies on is the Basel framework. This framework will be explained in subsequent sections of this paper as an international banking framework for credit risk management. Therefore, this paper’s findings will be compared to the Basel approach and appropriate recommendations made.

Research Design

The selection of the research design was guided by the importance of accommodating an expansive scope of the research problem. Based on this understanding, this paper adopted the qualitative research design. The qualitative research design was preferred because at the onset of the research process, the scope and nature of the research problem was ambiguous. Chapman (2005) explains that the qualitative research design is best used when the scope and nature of the research problem is ambiguous.

The importance of the qualitative research design is crucial to this research process because it acts as the launch-pad for future research designs which may seek to investigate further an outcome of this research process. In detail, the qualitative research design provides initial insight into the research topic and later, other research designs (such as the quantitative research design) can be used to investigate further a specific dynamic of the research problem.

Since this paper explores the use of case study information, the qualitative research design provided a proper framework for integrating such information. Affirmatively, Gagnon (2010) explains that case studies are crucial in gaining initial insight into the research problem. The use of case study information is especially beneficial to this study because this paper employs the study of credit risk management practices in Britain by analyzing credit risk management techniques of Barclays Bank, Northern Rock, Bradford & Bingley and Royal Bank of Scotland Group as representative corporate entities in Britain.

These case studies are crucial for guiding the research to gain a deeper and practical understanding of the credit risk management practices adopted by British banks. Based on the above complementary features of the qualitative research design, it is important to point out that the qualitative research design was the most appropriate research design for this paper.

Data Collection

The data collection process was guided by the goal of having a comprehensive understanding of the research problem. From this understanding, this paper used a two-faced strategy for data collection which was based on the collection of secondary data and the collection of primary data. Secondary data was collected through the inclusion of published data and it was preferably used in this study because of its easy accessibility and relative cheapness. For purposes of this study, the secondary data collected was used to complement the primary data. Indeed, Vartanian (2010) explains that secondary data makes primary data more specific by identifying the specific gaps in research and providing crucial guidelines on how to fill these deficiencies.

Based on the known weaknesses of secondary data paper this paper incorporated online research sources as a form of published text to supplement the input of books and journals as the main sources of secondary research data. However, emphasis was made to include only credible online research data (such as corporate publications, ‘.edu’ and ‘.org’ sites). Nonetheless, books and journals will be the main sources of secondary data because they have a high credibility.

The primary research will be collected using online questionnaires. The online questionnaires will be included in this research because of their relative ease in administration. They will be mainly administered as a survey to explore varying dynamics of the research problem. Unlike non-virtual questionnaires, online questionnaires are easily administered and availed to the respondents without any physical presence of the researcher. Indeed, once a researcher designs and provides the questionnaire to the respondents, his/her work is almost completely done. Besides, the relative ease in administration, the online questionnaires were desirable for this paper because they collected a large sample of information from the respondents.

Its relatively high accuracy (when compared to non-virtual questionnaires) was also another motivation for adopting the questionnaires because online questionnaires tend to accept only valid information. In detail, online questionnaires are presented in a virtual platform where softwares analyze the authenticity of the information keyed-in. This advantage prevents the possibility of including out-of-range responses from the respondents and similarly, it makes it easier for the researcher to analyze the information obtained.

Comprehensively, it is important to highlight that the primary and secondary research data methods were strategically adopted to provide a self-check mechanism where information obtained from each data source was correctly compared against the other. Significant disparities between both data collection methods (primary and secondary) could easily be detected in this manner and a subsequent analysis made to investigate such disparities. Nonetheless, this strategic comparison of both data collection methodologies worked towards improving the credibility of the data analysis process and subsequently, the credibility of the overall outcomes of the study.

Sampled Data

The sampled data comprised of different pieces of company information regarding credit risk. The financial data relating to different credit risk management was analyzed from the managerial level down to the way risk management was managed at a divisional level. Here, different company information such as the structure of risk management and company group structures were analyzed to evaluate how risk is controlled within the organizations sampled. In addition, the fraud alert system for the companies sampled also provided valuable information regarding their risk detection processes.

To evaluate the history and efficiency of company risk management systems, this paper relied on credit risk scores to compare the credit risk performance of different banks with industry standards. Here, emphasis was made to evaluate company internal and external credit rating systems viz-a-viz industry standards. From the same initiative, earlier sections of this paper demonstrate the reliance on Basel approaches to evaluate the credit risk management approaches for the different banks sampled.

Statistically, this paper also analyzed company annual reports like the balance sheet to identify how effective the risk management systems worked towards preventing financial losses realized from credit risks. Financial data regarding bad debts, current liabilities, debtors and overall company profitability informed the effectiveness of the risk management process.

Sample Population

The sample population was comprised of knowledgeable experts and professionals in the operations of the four banks sampled. The sample population comprised of 12 respondents who were sourced from the four banks sampled. Each bank had three respondents. All respondents were sourced from the finance departments of the four banks sampled and therefore, they were assumed to have the experience and knowledge of the risk management processes in their respective banks. When seeking these respondents, the main goal was to contact the finance manager but whenever there was a difficulty in doing so, their deputies were consulted. The emphasis on knowledge and experience was intentionally considered to be part of the evaluation criterion because the findings of the study are expected to be well-informed, dynamic and comprehensive. It was therefore assumed that the respondents would provide such quality information.

Data Analysis and Validity

Based on the quality of the respondents and the measures taken to ensure that all secondary information was valid, it is important to highlight that the first step to ensure the validity of the findings was achieved. In detail, the quality of the secondary research consulted was guaranteed from the quality of sources obtained (books, journals and credible online sources). Some of the journals obtained were peer-reviewed while all the books used were assumed to be subjected to a thorough publishing process. Comprehensively, the information contained from books and journals was assumed to be error-free and reliable. The quality of the primary data obtained was also guaranteed by the credibility of the respondents obtained.

The analysis techniques incorporated in the data review process also strengthened the validity of the data obtained because two credible research analysis techniques were used (coding and member-check techniques). As an interpretive tool, the coding technique was used to sort and evaluate the expansive information obtained from the secondary data analysis process. Indeed, the secondary data obtained included divergent information regarding the research topic but the coding technique aided in sorting out this information and categorizing them into easily-understandable data. The coding technique works by assigning different codes to related pieces of information (Chapman 2005).

Since the secondary information obtained was diverse, the coding technique helped to assign codes to related information such that, it was easier for the researcher to analyze related literature. The coding technique was beneficial in providing a structured impression of the overall findings.

The member-check technique provided a complementary role to the coding technique by evaluating the credibility, transferability and accuracy of the information analyzed (from the coding technique). In detail, after the coding technique helped categorize the sourced data into related subjects (and a code assigned); the member-check technique ensured that the information sourced was factual. The member check technique works by evaluating any areas of disparities between the outcomes of the data analysis process and the initial sources of information. This data analysis technique was used to evaluate both primary and secondary data sources.

Regarding the analysis of the primary research information, the member check technique ensured that the findings of the data analysis process reflected the opinions, ideas, context and attitudes of the respondents. The same process was used to evaluate the secondary research data because the member check technique ensured that there were no significant disparities between the sources of the data and the overall outcome of the data analysis process.

Limitations of the Research

The limitations of this paper were mainly confined to the nature of the methodology and the scope of the research topic. The use of the secondary research data limited the scope of this research paper to the objectives of the authentic (first) researcher. Some of the objectives of the initial researcher may not have properly coagulated with the objectives of this paper. In addition, apart from the nature of the research sources (books, journals and reputable online publications), there was no other way to guarantee the accuracy of the information obtained. Lastly, the number of respondents sampled in this paper limits this study to the views of only a few professionals in the field. A larger population sample would have represented the views of the wider banking industry, but this was not the case.

Findings and Analysis

This chapter centres on evaluating the outcomes of the literature review process and highlighting specific issues of credit risk management that exists among the four banks sampled. To arrive at a comprehensive understanding of the credit risk management practices at B&B, Northern rock, RBS and Barclays, the findings of this study categorizes the analysis into two discussion groups comprised of two banks each. On one category, B&B and Northern Rock will be analyzed as representatives of small banks in Britain while the last category involves the analysis of Barclays and RBS as representatives of large British banks.

The latter analysis will highlight discussions into the credit risk management governance, credit granting process, quantitative credit risk management, credit risk exposure management, credit quality management and the credit risk mitigation methods as the main highlights to the credit management process for Barclays and RBS. Credit approval, credit risk measurement, credit exposure and qualitative management, credit risk mitigation, and credit risk governance processes for B&B and Northern Rock constitutes their credit risk management analysis.

Bradford & Bingley and Northern Rock

For a long time, Bradford & Bingley (B & B) has been in the UK corporate scene; first with a strong foothold in the mortgage industry and later in the provision of financial products. B&B ventured into the banking sectors after it converted from a building society in 2000 (Zhao 2007). Northern Rock also ventured into the banking scene in similar fashion. Now, Northern Rock mainly engages in the provision of mortgage products for residential property owners (among other personal unsecured lending products).

Credit risk governance

At B & B, the board of governors is usually mandated with the task of defining the management structure and responsibilities of the risk management committee. The credit risk committee practices under the umbrella of the group risk committee by evaluating and monitoring all credit risks. The line managers are mandated with the task of identifying, measuring and managing all credit risks that fall within their line of operations. This way, the functions of the line managers, credit managers and the risk group manager complement one another.

At Northern Rock, the managerial influence in the credit risk management process is immense because board members determine the company’s risk appetite and delegates the responsibility of monitoring the company’s credit risks to smaller subcommittees. These committees guarantee the internal risk control mechanisms for the organization.

Credit Approval Process

At B&B the credit approval process for issuing credit is firmly undertaken under the supervisory policies formulated by the company’s board. This process is supported by the inclusion of credit scoring techniques to inform the credit approval process for the organization (Zhao 2007). There is a limiting framework that is also used to screen all potential loan borrowers. For example, the company’s board recently formulated a credit policy requiring all potential loan borrowers to meet Moody’s A2 credit rating (this standard is set out for long-term credit review processes). For short-term credit reviews, Moody’s P2 credit rating comes into effect. Therefore, potential loan borrowers are supposed to meet these requirements (or their equivalents) to be considered for credit by the organization.

However, still at Northern Rock, a more thorough credit approval process exists where two credit review departments are mandated to vet different customer profiles. Practically, the two groups ensure that adequate skills and resources are allocated to the correct customer profile review process. Notably, the company requirements demand that for credit approval processes to be guaranteed, the loan size, geographical spread and the value of the loan be considered before credit is approved.

Credit Risk Measurement

At B&B, there is an internal credit risk rating system which is characterized by four categories – negligible risk, low risk, medium/low risk and medium risk (the risk categorization process depends on varying characteristics of the risk such as the quality of the securities and the analysis of relative risk). At Northern rock, there are two main credit risk models that guide the credit risk management process – probability of Default (PD) and Loss Given Default (LGD) models. Depending on the risk category (negligible risk, low risk, medium/low risk and medium risk), the appropriate credit risk model is chosen.

Credit Exposure and Quality Management

Albeit the small proportion that credit risks constitute in the financial books of B&B and Northern Rock, both companies have clearly identified their credit risk exposures.

Credit Risk Mitigation

The credit risk mitigation process for Northern Rock and B&B are closely similar because both companies adopt traditional methods of credit risk mitigation (although evidence exists of varied applications of these models across the companies). However, at Northern Rock, the company has gone a notch higher and adopted other credit risk mitigation processes such as margining and master netting. The amount of credit derivatives used in Northern Rock’s credit risk management process is however elusive.

Royal Bank of Scotland (RBS) and Barclays

The Royal Bank of Scotland is among UK’s largest and leading banks. RBS was founded in 1727 and now boasts to be among the world’s largest banks (according to total assets) (Woods 2012). Currently, the bank’s total assets are in-excess of £871,432 million while its annual total credit is estimated to be about £466,893 million. RBS has a series of substitute banks, including “Royal Bank of Scotland, National Westminster Bank, Adam & Company, Child & Co, Citizens, Coutts & Co, Direct Line, Drummonds, Isle of Man Bank and Ulster Bank” (Zhao 2007, p. 71). Currently, RBS has a huge global presence not only in Europe and America but also in Asia. Barclay’s market is however strongly entrenched in its home market – the UK.

Barclay’s reputation closely follows RBS’s because it is also ranked among the world’s top 25 banks with a customer pool of about 27 million customers and a global market presence in about 50 countries (Hopkin 2010). The company’s ,main business niche is in retail and wholesale banking but other specialties also include personal banking investment banking, and wealth management (Correia 2012, p. 17). About half of the company’s total profit comes from the global market and recent estimates show that the company’s total assets are in excess of £996,787 million (about a third of this amount is given out to customers as credit) (Correia 2012).

Credit Risk Management Governance

Like RBS, the credit risk management practices at Barclays are aimed at reducing risks. The plans and limits which this process is undertaken are mainly controlled by the companies’ boards and subsequently, small sub-committees are left to implement the wishes of the board. At RBS, the group credit management is given the task of overseeing the implementation of the wishes of the board and it is empowered to delegate authority to smaller subcommittees. The functions of the Group Credit Risk Management are supported by a strong Group Internal Audit which ensures that all the functions and tasks given to the groups are well operational within the policy governance of the company.

All risks are managed within this framework (including credit risks) while standards for credit risks management are also developed within the same philosophy. This framework is known as the credit risk framework. At Barclays, most of the credit risk management tasks are done at the divisional level and the main tasks of the divisional managers is to ensure that the credit risk management procedures reflect the company’s policies and regulations governing the same. Divisional managers are also tasked with the responsibility of managing all organizational assets to ensure they conform to the company’s policies on the same. Reporting is done in a structured manner where the divisional head reports to the divisional CEO and the same communication is relayed to the Head of Group Credit risk (through the divisional Chief Risk Officer).

At Barclays, the Board Risk committee is mandated with task of monitoring the company’s risk profile and every officer is given different responsibilities according to the different risk profiles in the company’s credit risk pool. The Group CEO and the supporting directors sit at the apex of the risk management committee and therefore, all subordinates are required to inform them of developments in the risk management process. Barclays also has an internal credit risk management process which consist of five steps that define the responsibilities and procedures that need to be undertaken in the credit risk management process.

Credit Granting Process

At RBS, before the company approves credit to any individual or organization, they have to investigate the purpose of taking the credit and the repayment methods proposed by the potential borrower. This process is characterized by the consideration of other microeconomic and macroeconomic factors such as the current business environment, risk-adjusted return, repayment capacity, repayment history and other factors which may affect the credit repayment agreement.

Within this credit review process, different customer profiles are treated separately because different skill sets have been established within each department to aid in the credit review process. In addition, the credit risk assessments undertaken at RBS vary immensely depending on the type of clients the company engages with. For instance, the credit risk assessments for corporate and individual customers differ.

Quantitative Credit Risk Measurement

The credit risk measurement process for RBS mainly involves the use of credit risk models. These models are developed by RBS’s divisional credit risk departments and are used for credit granting, monitoring, and portfolio level analysis and reporting. The modes are specifically tailored for different types of borrowers and credit risks but before they are used, they have to be approved by the credit risk management team to ensure they reflect the credit risk policies and guidelines of the organization. At RBS, four types of credit models are used: probability of default, exposure of default, loss given default, and credit risk exposure measurement.

Besides the four credit models used by RBS in quantitative credit risk measurement, the company also has an internal credit risk rating system to assess borrower’s credit worthiness. This process is usually done in tandem with the results obtained from the PD models. After a thorough review of the credit risks, all potential customers are vetted and slated into a rating group which is then used as a reflection on asset quality scale. The annual probability of defaults is thereafter obtained in this manner.

At Barclays, an internal credit rating system is also established where the PD values are set at a minimum of one and a maximum of 21. This rating is normally used for wholesale credit lending but small-scale credit lending may only incorporate the use of a single credit model. External credit rating mechanisms are also used to supplement the input or efficiency of the internal credit rating system.

Credit Risk Exposure Management

The management of credit risks at RBS is very articulate because the company’s policy of credit risks management is defined by the credit risk asset portfolio which characterizes the organization’s credit risk exposure to its customers. The credit risk asset distribution is evenly distributed across geographic regions, customer types, and industry sectors so that the potential concentration of risk across each geographic or customer pool is identified. Once the potential risk profiles are identified, the organization can prepare itself accordingly.

At Barclays, all credit risk exposures are also well documented after a thorough credit review process is undertaken because the company’s risk management covers a wide pool of risks including “customer loans and advances, loan commitments, contingent liabilities, debt securities and other exposures in trading activities” (Zhao 2007, p. 76). These risk profiles are always well documented in the company’s credit risk reports.

The credit risk assessment process at Barclays is the same as RBS because both organizations consider the geographic dispersion of risks and the inherent risks that exist among different customer profiles as an important measure for determining the credit risk exposures for the two companies. However, unlike RBS, Barclays includes maturity analysis as part of its credit risk assessment process. Credit concentration is an important component of Barclay’s credit risk management projects because it is uniquely highlighted in its credit report as the “credit concentration” part. In addition, there is a framework that sets the limit that the bank can lend in the U.K commercial property scene. This limit is also applied to the maturity period that the bank can give credit. The limit is set at seven years.

Credit Quality Management

As mentioned in earlier sections of this study, RBS uses its internal risk control mechanisms to establish whether to give credit to a customer or not. However, when the company intends to give statistical information about its credit risk assets, it avails a detailed description of how such assets are distributed. Most of the credit risk exposures at RBS are directly attributed to counterparties rated AQ4 or higher (which when compared to external ratings conforms to standard & poor’s rating of ‘B’). At Barclays, such details were not available for scrutiny.

The loan impairment process at Barclays and RBS shows that loans are often differentiated into two groups. The first group is known as the “risk element in lending” (REIL) and it defines those loans that are non-accruing (or specific loans that have accrued past a 90-day window) while the second risk category is named “Potential problem loans” (PPL) and it defines those loans that do not fall in the REIL category but which the management has doubt about because of the inadequacies in the availability of sufficient information about them. Barclays also uses a dual approach for classifying loans using the NPL and PPL categories. The NPL category defines those loans that have a partial or full default rate while potential problem loans (PPL) loans defines loans that are still performing (but there are some serious doubts regarding their future payment potential).

Provision analyses at RBS are designed for different purposes but mainly, their characteristics are informed by the nature of the credit risk portfolio. Automated systems are hereby used to detect small problems in customers’ credit risk portfolios but a case-by-case analysis is used in identifying errors in the customer profile for corporate entities. Both risk analysis categories are beneficial in helping the company identify possible risks in advance. Losses are minimized in this regard.

However, there are three kinds of provision assessments which are used by RBS – individually assessed provisions, collectively assessed provisions, and latent loss provisions. At Barclays, there is no evidence to show that the company has such allowance assessment methodologies in its credit risk assessment process. However, the most crucial issue worth mentioning is that the company uses an individual impairment method for assessing significant assets while a group assessment approach is used for measuring homogenous assets. This way, it is easy to point out that Barclays Plc. shares the same asset impairment approaches as RBS.

Credit Risk Mitigation Methods

Unfortunately, it was difficult to point out any identifiable risk mitigation process for RBS. After the analysis of the country’s annual reports, it was discovered that the company still relies on traditional methods of risk mitigation. Such traditional methods included credit limits and the provision of collateral. However, after reviewing the financial management practices for the company and the responses given by the company’s management regarding their credit risk mitigation methods, it was difficult to establish whether the company had any diversification strategies or practices aimed at defining different loan portfolios. The failure to identify these credit risk mitigation methods at RBS elevated Barclay’s credit risk mitigation standard because its diversification strategies and loan portfolio assessments were present. For example, the company has a provision for assessing a customer’s credit repayment ability and still, the same customers are supposed to provide collateral for the loans.

In unique cases, netting agreements and covenants are signed between the company and its customers. Furthermore, at an internal level, the company has diversified its risks within different groups. This is done by identifying different types of counterparties and the identification of maximum exposure limits (so that the company cannot be hit by extreme losses or risks which may be devastating to its bottom-line). Unwanted concentration of risks is also minimized in this regard. In addition, complementary methods in credit risk management are also adopted in this regard but such methods are only used as complementary approaches to the above mentioned risk management approaches.

Discussions

This chapter focuses on comparing the credit risk management practices for the four banks sampled with Basel principles. Basel principles are used in this analysis because this paper conceives them as the benchmark for global banking practices. Here, there is more emphasis to compare the credit risk management practices for the four banks analyzed according to Basel II principles. The Basel II principles were formulated to control or supervise banks’ capital allocations so that they can withstand credit risks exposures (Jackson 2001).

In today’s world of great financial instability and the ongoing financial crises in Europe, the Basel II principles comes into sharp focus because they were formulated to maintain a sound international banking system that should prevent calamities such as banks collapsing because of credit risk crises (Glantz and Mun 2008). The comparison of the four banks’ credit systems to Basel principles is therefore informed by the focus on Basel’s principles to lending and investment risks (because the principles are meant to safeguard banks against such risks). In detail, the credit risk environment, credit granting process, and the control over credit risks for the four banks sampled constitute the main focus for this analysis.

Credit Risk Environment

According to Basel principles, the establishment of an appropriate credit risk environment is the focal-point for developing a sound credit risk management framework and all the four banks analyzed in this paper have recognized this fact. When we analyze the establishment of a credit risk environment for Barclays and RBS, we see that both companies have been able to establish a sound credit risk environment which complies with the Basel approach (Powell 2004). Indeed, at Barclays and RBS, existing credit risks are clearly identified and a systemic way of handling such risks is also established. Furthermore, both banks have delegated credit risk management responsibilities smartly across all relevant departments. Risk monitoring and control are also effectively administered within these frameworks.

Northern Rock and B&B also have a clear understanding of existing credit risks and therefore, they have a clear mechanism of managing them. For example, the maximum credit risk exposure for both banks is defined and the frameworks for managing any risk eventualities are also explained. Through the analysis of both categories of banks (large and small banks), the only difference between the two banking groups lie in their sophistication of banking systems but overall, their systems demonstrate that they understand existing credit risks. Comprehensively, this analysis shows that British banks have inculcated a credit risk-conscious culture.

Credit Granting Process

There is no readily available evidence showing Barclay’s credit granting process. However, at RBS, there is an agreement that assessments are often made to different counterparties, but issues to do with credit risk assessments are not openly available for scrutiny. Therefore, there is no clear evidence to show that the bank complies with Basel requirements (principle four). According to Basel II, there is no clear framework showing particular recommendations about credit risk management exposure and therefore, the ambiguity in explaining whether Barclays and RBS meet the Basel’s requirements exists.

At Northern Rock and B&B, the same ambiguity in establishing the credit granting process (as Barclays and RBS) exists. However, the evidences gathered from Northern Rock and B&B shows that both banks have a significant sound level of credit granting system. The evidence is derived from the proper consideration of the nature of relationships for group borrowers, nature of counterparties and existing credit limits in the bank’s decision-making process (thereby demonstrating that both banks adopt a comprehensive understanding of the credit granting process according to Basel’s approach) (Hong Kong Institute of Bankers 2012).

Control over Credit Risk

Although it is already established that RBS and Barclays have a well delegated system of credit review, it is difficult to point out whether both banks have a valid and efficient credit review system because there is insufficient evidence to support this claim. Therefore, it is unclear whether the banks’ controls over credit risks indeed follow Basel’s requirements (or not). Like Barclays and RBS, the established controls over credit risk for Northern Rock and B&B show that different levels of functions for their systems are considered in their credit risk management processes. Indeed, both banks have appropriate credit reviews which support their compliance to Basel requirements although it is doubtful whether these credit reviews are timely (Van-Gestel 2008).

Conclusion

After weighing the findings of this paper, credit risk stands out as a major risk for the British banking sector. Indeed, globally, very few banks have evaded the negative and devastating impact of poor credit risk management. However, it should be understood that banks cannot rightly know the credit risk potential that different customers have; therefore, it is important to have a sound credit risk management system in place. This paper analyzes a sample of the credit risk management system of four British banks (which represent the credit risk management practices for small and large banks) and demonstrates that both banks have a significant understanding of the existing credit risks and how they should be managed.

The analysis of small and large banks has been deliberately used to draw the similarities and differences in credit risk management practices for the small and large banks in Britain. From the findings of this paper, we see that British banks have a relatively steady credit risk management framework which is informed by their consistency in adopting sound credit risk management practices. This steady performance is also highlighted by the comprehensive way that large banks in the UK manage their risks more comprehensively than the smaller banks. The compliance standards to the Basel approach are also commendable for the large banks and similarly, there have been very innovative in devising multiple credit management strategies for their organizations.

The smaller British banks are seen to have a smaller risk tolerance and therefore they emphasize their credit risk management process to the risk granting process (such that they eliminate possible credit risk very early in the credit risk management process). However, for all the credit guarantees that the small banks engage in, very little focus is given to subsequent credit risk management processes (as the large banks do). Comprehensively, this paper shows that British banks are doing well in the credit risk management systems.

Hong Kong Institute of Bankers (2012) affirms this fact by demonstrating that UK’s credit score is only second to a few European countries like France and Germany, but overall, it is doing better than other financial giants like the US. Recent global economic developments have only reinforced this fact because European financial giants like Greece and Spain are experiencing poor financial health while the US is only recovering from a bad economic downswing. However, there is still room for improvement in this regard because not all the regulations stipulated in the Basel approach are effectively met by the large and small banks.

Nonetheless, most of the banks have met some of the requirements (of the Basel approach) but the differences in the way these banks operate give way for several weaknesses and flaws which overshadow the effective implementation of Basel principles in the British banking sector.

Credit disclosure stands out as a very conspicuous concept of credit risk management because this paper demonstrates that British banks fail to effectively abide by credit disclosures stipulated by the Basel approach. For example, there are certain financial data that are unavailable in the banks’ credit reports and therefore, it is easy to conclude that the bank’s risk management processes are ineffective or incomprehensive. Again, the large banks have fared better at disclosing the risk exposures than smaller banks but overall, there is a strong need for all the British banks to improve in this regard.

Finally, as mentioned in earlier sections of this study, there are a few assumptions and limitations that surround the methodology for this paper but going forward, these weaknesses are expected to be improved. Moreover, there are other crucial concepts and issues to be discussed about credit risk management in the British banking sector which are not effectively addressed in this paper, such as, the impact of accounting rules, entities which are made for certain special purposes, and the moral hazards in the banking industry (among a myriad of other pertinent issues in credit risk management) which need to be addressed in future studies.

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Appendix

Questionnaire

I am a student of ******University carrying out an academic research on the topic “Credit Risk Management in British Banks”. You have been selected to participate in the study and are therefore kindly requested to provide an appropriate answer by either ticking the best option or give an explanation where applicable. The answers provided will only be used for academic purposes and will be treated with utmost confidentiality.

NB: do not write your name anywhere on this paper.

Credit Risk Management Governance

Do you believe your credit risk management techniques are effective?

• Strongly
• Agree
• Agree
• Not Sure
• Disagree
• Strongly Disagree
• Why.………………………………………………………

Credit Granting Process

How would you rate the effectiveness of your credit granting process?

• Very Strong
• Strong
• Not Sure
• Weak
• Very weak
• Why?…………………………………………………………………………….

Credit risk mitigation and measurement

How would you rate the credit risk mitigation and measurement processes in your organization?

• Very Strong
• Strong
• Not Sure
• Weak
• Very weak
• Please elaborate…………………………………………………………………………………………

Credit risk exposures

Do you believe your financial management practices for minimizing the credit risk exposures need to be improved?

• Strongly agree
• Agree
• Neutral
• Disagree
• Strongly disagree
• Why?……………………………………………………………………..

Comparison with Basel Approach

How do you compare your credit risk management practices with the Basel Recommendations?

……………………………………………………………………………………………