Credit Risk and Value Creation

Credit Risk and Value Creation

“To understand how something works, figure out how to break it.”

Nassim Nicholas Taleb, The Bed of Procrustes

One of the main criteria to assess a bank’s performance is the return on capital (RoC) or Return on Equity (RoE). The RoC can be decomposed in different elements that are interdependent: the structure and size of a banking portfolio, its financing, and its risk.

Here is a simplified view on the different components that impact the RoC:

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At the top, the bank defines a strategy for their asset and liability management based on the bank’s commercial strategy, risk appetite and target RoC. As you can see from the picture above, the effect of these decisions will be affecting both the risk side (through the risk-weighted assets) and the profitability side (through the interest margins). The cost of risk will be impacted by the asset side and have a direct impact also on the profitability of the bank as it impacts directly the Net Income.

On the asset side, the bank can target specific asset volumes and asset mix. Asset volumes refer to the amount of loans, investments and money market operations. Obviously, the success of this target is dependent on the market demand, market conditions (e.g. interest rates) and on the competitive landscape (how the bank positions against its competitors). The asset mix corresponds to the mix of products, client segments and levels of risk that the bank wants to assume. Here is a brief overview of a typical commercial bank’s client segment and products:

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Commercial and Retail Banking typically target mass markets covering all lending activities to individuals (credit cards, consumer and mortgage loans) and also small enterprises (small business loans). More details on the classification of these segment are given in specific articles covering the regulatory segments.

Investment banking is the domain of large transactions customized to the needs of large corporate and financial institutions. Standard corporate lending transactions under the generic name CIB (Corporate and Investment Banking) include overnight loans, short-term loans (less than one year), revolving facilities, term loans, committed lines of credit or large commercial loans.?

Activities of specialized finance are also conducted by dedicated units within the bank includes project finance, asset financing, commodities finance, commercial real estate. Additionally, securitizations are also one of the fields of specialized finance that I cover in a separate article as it is covered by a completely different regulatory framework.?

In all my recent article, I’ve been approaching different aspects of credit risk in a common bank, including risk parameters (PD, LGD, CCF), the calculation of Risk Weighted Assets, capital management and also IFRS 9 regulations (incl. calculation of Expected Credit Losses). All of these have a direct impact in the value creation for a bank. A simplified version of the areas affected is presented below:

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It is therefore important to retain that each of the pieces I’ve been referring to in terms of credit risk in my articles has a material impact on the final value created. It’s a complex system of dynamic interdependencies that I have been trying to present step by step and that will culminate in the production of a book about credit risk. The main target is to give a quick and holistic view of the different functions that help a bank creating value to the persons interested in banking, already part of one of these functions or not.

I hope that the book to be launched in the next months will bring an easy to understand perspective about the different pieces of the puzzle in order to inspire some of you to bring some new ideas to an industry that is key in the development of the economy and that also has a big down-side for the citizens when not managed appropriately.

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Sources:

Jo?l Bessis, Risk Management in Banking, 4th Edition.

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