What is Credit Risk?
According to the Basel III framework, credit risk is defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.
Credit risk assessment is the assessment of the credit risk of a counterparty against the financial institution’s credit acceptance criteria, to ascertain the counterparty’s ability and willingness to honour its credit obligations, either at origination or at any point during the lifetime of a credit.
The goal of credit risk management is to maximise a bank’s risk-adjusted rate of return, by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio, as well as the risk in individual credits or transactions.
Robust credit risk management is an integral component of the long-term viability of financial institutions. This is also critical for the sustainable development of the real economy.
Although the board and senior management play a key role in credit risk oversight, the responsibility for credit risk management is spread throughout a financial institution.
Business lines are primarily responsible for managing credit risks inherent in day-to-day activities, such as where credit officers evaluate customers for potential credit opportunities.
The risk management function provides an independent perspective on credit risk management issues,including credit decisions and overall credit quality. The internal audit function provides assurance on the quality and effectiveness of the institution’s internal controls, systems and processes for credit risk oversight.
Credit exposure covers all direct and indirect claims, commitments, and contingent liabilities, arising from on- and off-balance sheet transactions which include, but are not limited to:
(a) outstanding loans, financing, advances and receivables;
(b) deposit and investment account placements, and margins held withcounterparties;
(c) debt securities held;
(d) exposures arising from securities financing transactions and derivativetransactions; and
(e) exposures arising from off-balance sheet facilities.
Significant credit exposure is a credit exposure, or a set of similar credit exposures, that has a material impact on a financial institution’s credit risk profile, including where:
(a) the credit exposure is currently, or expected to be, large relative to the financial institution’s total credit portfolio; and
(b) a default of, significant deterioration in credit risk of, or adverse news about a counterparty, may have significant financial or reputational implications on the financial institution;
The board and senior management
The board has the overall responsibility to promote a sound credit risk management environment, to support prudent credit decision-making.
The board must annually approve the financial institution’s credit risk strategy, which articulates the financial institution’s overall direction for its credit activities.
An effective credit risk strategy must ultimately support the long-term viability of the financial institution through an optimal balance between the credit quality, profitability and growth objectives.
The board must consider the interactions between the credit risk strategy and institution-specific factors, such as the financial institution’s risk appetite, existing levels of capital and provisioning needs in business-as-usual and stressed scenarios, adequacy of internal resources, as well as the wider operating environment.
Senior management must be collectively responsible for the effectivemanagement of credit risk in line with the financial institution’s approvedcredit risk strategy.
Senior management must ensure that thecredit risk strategy is implemented effectively, including by establishing aboard-approved credit risk policy.
The credit risk policy must be periodically reviewed andupdated to reflect changes to the credit risk strategy or the financialinstitution’s wider operating environment, and any review or update must beapproved by the board.
Appropriate remedial or disciplinaryactions must be taken if the credit risk policy is not complied with, supportedby clear avenues to report to the board on any credit risk management issuesand breaches in a timely manner.
A financial institution must establish sound and well-defined creditacceptance criteria to facilitate an ex-ante evaluation of prospective credits.
The credit acceptance criteria must take into consideration common creditcharacteristics for distinct categories of counterparties or facilities, and theboundaries of the credit risk strategy and credit risk policy.
A financial institution must primarily focus on the counterparty’s ability andwillingness to honour its credit obligations in a timely manner under normaland stressed conditions, when undertaking the credit risk assessment for acredit facility.
Credit risk monitoring refers to the ongoing monitoring of the performance ofindividual credit exposures, and the overall credit portfolio.
Having a robustframework to support monitoring activities is essential for a financialinstitution to identify changes in its credit risk profile in a timely manner.
Well-defined reporting structures will ensure that key monitoringoutcomes, such as those relating to significant credit exposures, areescalated appropriately to support oversight and decision-making by theboard and senior management.
Learning from the Annual Reports
Credit risk, important parts from the 2021 Annual Report, Lloyds Banking Group plc
Credit risk is defined as the risk that parties with whom the Group hascontracted fail to meet their financial obligations (both on and off balancesheet).
EXPOSURES
The principal sources of credit risk within the Group arise from loansand advances, contingent liabilities, commitments, debt securities andderivatives to customers, financial institutions and sovereigns.
In terms of loans and advances (for example mortgages, term loansand overdrafts) and contingent liabilities (for example creditinstruments such as guarantees and documentary letters of credit),credit risk arises both from amounts advanced and commitments toextend credit to a customer or bank. With respect to commitments toextend credit, the Group is also potentially exposed to an additionalloss up to an amount equal to the total unutilised commitments.
However, the likely amount of loss may be less than the totalunutilised commitments, as most retail and certain commerciallending commitments may be cancelled based on regular assessmentof the prevailing creditworthiness of customers. Most commercialterm commitments are also contingent upon customers maintainingspecific credit standards.
Credit risk exposures in the Insurance and Wealth division relatemostly to bond and loan assets which, together with some relatedswaps, are used to fund annuity commitments within Shareholderfunds; plus balances held in liquidity funds to manage Insurancedivision’s liquidity requirements, and exposure to reinsurers.
Loans and advances, contingent liabilities, commitments, debtsecurities and derivatives also expose the Group to refinance risk.Refinance risk is the possibility that an outstanding exposure cannotbe repaid at its contractual maturity date.
If the Group does not wishto refinance the exposure, then there is refinance risk if the obligor isunable to repay by securing alternative finance. This may occur for anumber of reasons which may include: the borrower is in financialdifficulty, because the terms required to refinance are outsideacceptable appetite at the time or the customer is unable to refinanceexternally due to a lack of market liquidity.
Refinance risk exposuresare managed in accordance with the Group’s existing credit riskpolicies, processes and controls, and are not considered to bematerial given the Group’s prudent and through-the-cycle credit riskappetite. Where heightened refinance risk exists exposures areminimised through intensive account management and, whereappropriate, are classed as impaired and/or forborne.
MEASUREMENT
The process for credit risk identification, measurement and control isintegrated into the Board-approved framework for credit risk appetiteand governance.
Credit risk is measured from different perspectives using a range ofappropriate modelling and scoring techniques at a number of levelsof granularity, including total balance sheet, individual portfolio,pertinent concentrations and individual customer - for both newbusiness and existing exposure. Key metrics, which may include totalexposure, expected credit loss (ECL), risk-weighted assets, newbusiness quality, concentration risk and portfolio performance, arereported monthly to Risk Committees and Forums.
Measures such as ECL, risk-weighted assets, observed creditperformance, predicted credit quality (usually from predictive creditscoring models), collateral cover and quality, and other credit drivers(such as cash flow, affordability, leverage and indebtedness) havebeen incorporated into the Group's credit risk management practicesto enable effective risk measurement across the Group.
The Group has also continued to strengthen its capabilities andabilities for identifying, assessing and managing climate-related risksand opportunities, recognising that Climate change is likely to resultin changes in the risk profile and outlook for the Group's customers,the sectors the Group operates in and collateral/asset valuations.
In addition, stress testing and scenario analysis are used to estimateimpairment losses and capital demand forecasts for both regulatoryand internal purposes and to assist in the formulation of credit riskappetite.
As part of the ‘three lines of defence’ model, the Risk division is thesecond line of defence providing oversight and independentchallenge to key risk decisions taken by business management. TheRisk division also tests the effectiveness of credit risk managementand internal credit risk controls.
This includes ensuring that the controland monitoring of higher risk and vulnerable portfolios and sectors isappropriate and confirming that appropriate loss allowances forimpairment are in place. Output from these reviews helps to informcredit risk appetite and credit policy.
As the third line of defence, Group Internal Audit undertakes regularrisk-based reviews to assess the effectiveness of credit riskmanagement and controls.
MITIGATION
The Group uses a range of approaches to mitigate credit risk.
Prudent, through-the-cycle credit principles, risk policies andappetite statements: the independent Risk division sets out thecredit principles, credit risk policies and credit risk appetitestatements. These are subject to regular review and governance, withany changes subject to an approval process. Risk teams monitor creditperformance trends and the outlook. Risk teams also test theadequacy of and adherence to credit risk policies and processesthroughout the Group. This includes tracking portfolio performanceagainst an agreed set of credit risk appetite tolerances.
Limitations on concentration risk: there are portfolio controls oncertain industries, sectors and products to reflect risk appetite as wellas individual, customer and bank limit risk tolerances. Credit policiesand appetite statements are aligned to the Group’s risk appetite andrestrict exposure to higher risk countries and potentially vulnerablesectors and asset classes.
Exposures aremonitored to prevent both an excessive concentration of risk andsingle name concentrations. These concentration risk controls are notnecessarily in the form of a maximum limit on exposure, but mayinstead require new business in concentrated sectors to fulfiladditional minimum policy and/or guideline requirements. TheGroup’s largest credit limits are regularly monitored by the Board RiskCommittee and reported in accordance with regulatory requirements.
Defined country risk management framework: the Group sets abroad maximum country risk appetite. Risk-based appetite for allcountries is set within the independent Risk division, taking intoaccount economic, financial, political and social factors as well as theapproved business and strategic plans of the Group.
Specialist expertise: credit quality is managed and controlled by anumber of specialist units within the business and Risk division, whichprovide for example: intensive management and control; securityperfection; maintenance of customer and facility records; expertise indocumentation for lending and associated products; sector-specificexpertise; and legal services applicable to the particular marketsegments and product ranges offered by the Group.
Stress testing: the Group’s credit portfolios are subject to regularstress testing. In addition to the Group-led, PRA and other regulatorystress tests, exercises focused on individual divisions and portfoliosare also performed.
Frequent and robust credit risk assurance: assurance of credit risk isundertaken by an independent function operating within the Riskdivision which are part of the Group’s second line of defence. Theirprimary objective is to provide reasonable and independentassurance and confidence that credit risk is being effectively managedand to ensure that appropriate controls are in place and beingadhered to. Group Internal Audit also provides assurance to the AuditCommittee on the effectiveness of credit risk management controlsacross the Group’s activities.
COLLATERAL
The principal types of acceptable collateral include:
• Residential and commercial properties
• Charges over business assets such as premises, inventory, andaccounts receivable
• Financial instruments such as debt securities vehicles
• Cash
• Guarantees received from third parties
The Group maintains appetite parameters on the acceptability ofspecific classes of collateral.
For non-mortgage retail lending to small businesses, collateral mayinclude second charges over residential property and the assignmentof life cover.
Collateral held as security for financial assets other than loans andadvances is determined by the nature of the underlying exposure.Debt securities, including treasury and other bills, are generallyunsecured, with the exception of asset-backed securities and similarinstruments such as covered bonds, which are secured by portfolios offinancial assets.
Collateral is generally not held against loans andadvances to financial institutions. However, securities are held as partof reverse repurchase or securities borrowing transactions or where acollateral agreement has been entered into under a master nettingagreement.
Derivative transactions with financial counterparties aretypically collateralised under a Credit Support Annex (CSA) inconjunction with the International Swaps and Derivatives Association(ISDA) Master Agreement. Derivative transactions with non-financialcustomers are not usually supported by a CSA.
The requirement for collateral and the type to be taken at originationwill be based upon the nature of the transaction and the credit quality,size, and structure of the borrower. For non-retail exposures, ifrequired, the Group will often seek that any collateral includes a firstcharge over land and buildings owned and occupied by the business,a debenture over the assets of a company or limited liabilitypartnership, personal guarantees, limited in amount, from thedirectors of a company or limited liability partnership and key maninsurance.
The Group maintains policies setting out which types ofcollateral valuation are acceptable, maximum loan to value (LTV) ratiosand other criteria that are to be considered when reviewing anapplication. The fundamental business proposition must evidence theability of the business to generate funds from normal business sourcesto repay a customer or counterparty’s financial commitment, ratherthan reliance on the disposal of any security provided.
Although lending decisions are primarily based on expected cashflows, any collateral provided may impact the pricing and other termsof a loan or facility granted. This will have a financial impact on theamount of net interest income recognised and on internal loss givendefault estimates that contribute to the determination of asset qualityand returns.
The Group requires collateral to be realistically valued by anappropriately qualified source, independent of both the creditdecision process and the customer, at the time of borrowing. Incertain circ*mstances, for Retail residential mortgages this mayinclude the use of automated valuation models based on market data,subject to accuracy criteria and LTV limits.
Where third parties areused for collateral valuations, they are subject to regular monitoringand review. Collateral values are subject to review, which will varyaccording to the type of lending, collateral involved and accountperformance. Such reviews are undertaken to confirm that the valuerecorded remains appropriate and whether revaluation is required,considering, for example, account performance, market conditionsand any information available that may indicate that the value of thecollateral has materially declined.
In such instances, the Group mayseek additional collateral and/or other amendments to the terms ofthe facility. The Group adjusts estimated market values to takeaccount of the costs of realisation and any discount associated withthe realisation of the collateral when estimating credit losses.The Group considers risk concentrations by collateral providers andcollateral type with a view to ensuring that any potential undueconcentrations of risk are identified and suitably managed by changesto strategy, policy and/or business plans.
The Group seeks to avoid correlation or wrong-way risk wherepossible. Under the Group’s repurchase (repo) policy, the issuer of thecollateral and the repo counterparty should be neither the same norconnected. The same rule applies for derivatives. The Risk division hasthe necessary discretion to extend this rule to other cases where thereis significant correlation. Countries with a rating equivalent to AA- orbetter may be considered to have no adverse correlation between thecounterparty domiciled in that country and the country of risk (issuerof securities).
Additional mitigation for Retail customers
The Group uses a variety of lending criteria when assessingapplications for mortgages and unsecured lending. The generalapproval process uses credit acceptance scorecards and involves areview of an applicant’s previous credit history using internal data andinformation held by Credit Reference Agencies (CRA).
The Group also assesses the affordability and sustainability of lendingfor each borrower. For secured lending this includes use of anappropriate stressed interest rate scenario. Affordability assessmentsfor all lending are compliant with relevant regulatory and conductguidelines. The Group takes reasonable steps to validate informationused in the assessment of a customer’s income and expenditure.
In addition, the Group has in place quantitative limits such asmaximum limits for individual customer products, the level ofborrowing to income and the ratio of borrowing to collateral. Some ofthese limits relate to internal approval levels and others are policylimits above which the Group will typically reject borrowingapplications. The Group also applies certain criteria that areapplicable to specific products, for example applications for buy-to-letmortgages.
For UK mortgages, the Group’s policy permits owner occupierapplications with a maximum LTV of 95 per cent. This can increase to100 per cent for specific products where additional security isprovided by a supporter of the applicant and held on deposit by theGroup. Applications with an LTV above 90 per cent are subject toenhanced underwriting criteria, including higher scorecard cut-offsand loan size restrictions.
Buy-to-let mortgages within Retail are limited to a maximum loan sizeof £1,000,000 and 75 per cent LTV. Buy-to-let applications must pass aminimum rental cover ratio of 125 per cent under stressed interestrates, after applicable tax liabilities. Portfolio landlords (customerswith four or more mortgaged buy-to-let properties) are subject toadditional controls including evaluation of overall portfolio resilience.
The Group’s policy is to reject any application for a lending productwhere a customer is registered as bankrupt or insolvent, or has arecent County Court Judgment or financial default registered at aCRA used by the Group above de minimis thresholds. In addition, theGroup typically rejects applicants where total unsecured debt, debt-to-income ratios, or other indicators of financial difficulty exceedpolicy limits.
Where credit acceptance scorecards are used, new models, modelchanges and monitoring of model effectiveness are independentlyreviewed and approved in accordance with the governance frameworkset by the Group Model Governance Committee.
Additional mitigation for Commercial customers
Individual credit assessment and independent sanction ofcustomer and bank limits: with the exception of small exposures toSME customers where certain relationship managers have limiteddelegated sanctioning authority, credit risk in commercial customerportfolios is subject to sanction by the independent Risk division,which considers the strengths and weaknesses of individualtransactions, the balance of risk and reward, and how credit risk alignsto the Group and divisional risk appetite.
Exposure to individualcounterparties, groups of counterparties or customer risk segments iscontrolled through a tiered hierarchy of credit authority delegationsand risk-based credit limit guidances per client group for largerexposures. Approval requirements for each decision are based on anumber of factors including, but not limited to, the transactionamount, the customer’s aggregate facilities, any risk mitigation inplace, credit policy, risk appetite, credit risk ratings and the natureand term of the risk.
The Group’s credit risk appetite criteria forcounterparty and customer loan underwriting is generally the same asthat for loans intended to be held to maturity. All hard loan/bondunderwriting must be sanctioned by the Risk division. A pre-approvedcredit matrix may be used for ‘best efforts’ underwriting.
Counterparty credit limits: limits are set against all types of exposurein a counterparty name, in accordance with an agreed methodologyfor each exposure type. This includes credit risk exposure onindividual derivatives and securities financing transactions, whichincorporates potential future exposures from market movementsagainst agreed confidence intervals. Aggregate facility levels bycounterparty are set and limit breaches are subject to escalationprocedures.
Daily settlement limits: settlement risk arises in any situation where apayment in cash, securities or equities is made in the expectation of acorresponding receipt in cash, securities or equities. Daily settlementlimits are established for each relevant counterparty to cover theaggregate of all settlement risk arising from the Group’s markettransactions on any single day. Where possible, the Group usesContinuous Linked Settlement in order to reduce foreign exchange(FX) settlement risk.
MONITORING
In conjunction with the Risk division, businesses identify and defineportfolios of credit and related risk exposures and the key behavioursand characteristics by which those portfolios are managed andmonitored. This entails the production and analysis of regularportfolio monitoring reports for review by senior management. TheRisk division in turn produces an aggregated view of credit risk acrossthe Group, including reports on material credit exposures,concentrations, concerns and other management information, which ispresented to the divisional risk committees and forums, Group RiskCommittee and the Board Risk Committee.
Models
The performance of all models used in credit risk is monitored in linewith the Group’s model governance framework.
Intensive care of customers in financial difficulty
The Group operates a number of solutions to assist borrowers whoare experiencing financial stress. The material elements of thesesolutions through which the Group has granted a concession, whethertemporarily or permanently, are set out below.
Forbearance
The Group’s aim in offering forbearance and other assistance tocustomers in financial distress is to benefit both the customer and theGroup by supporting its customers and acting in their best interestsby, where possible, bringing customer facilities back into a sustainableposition.
The Group offers a range of tools and assistance to supportcustomers who are encountering financial difficulties. Cases aremanaged on an individual basis, with the circ*mstances of eachcustomer considered separately and the action taken judged as beingappropriate and sustainable for both the customer and the Group.
Forbearance measures consist of concessions towards a debtor that isexperiencing or about to experience difficulties in meeting its financialcommitments. This can include modification of the previous terms andconditions of a contract or a total or partial refinancing of a troubleddebt contract, either of which would not have been required had thedebtor not been experiencing financial difficulties.
The provision and review of such assistance is controlled through theapplication of an appropriate policy framework and associatedcontrols. Regular review of the assistance offered to customers isundertaken to confirm that it remains appropriate, alongsidemonitoring of customers’ performance and the level of paymentsreceived.
The Group classifies accounts as forborne at the time a customer infinancial difficulty is granted a concession. However, where customerswere temporarily impacted by COVID-19, the Group looked to followregulator principles and guidance on the granting of concessionsresulting from the impact of the pandemic.
Balances in default or classified as Stage 3 are always considered tobe non-performing. Balances may be non-performing but not indefault or Stage 3, where for example they are within their nonperformingforbearance cure period.
Non-performing exposures can be reclassified as performing forborneafter a minimum 12-month cure period, providing there are no pastdue amounts or concerns regarding the full repayment of theexposure.
A minimum of a further 24 months must pass from the datethe forborne exposure was reclassified as performing forborne beforethe account can exit forbearance. If conditions to exit forbearance arenot met at the end of this probation period, the exposure shallcontinue to be identified as forborne until all the conditions are met.
You may also visit:
The Role of the Risk Officer: https://www.risk-officer.com/Role_Of_Risk_Officer.html
Credit Risk: https://www.risk-officer.com/Credit_Risk.htm
Market Risk: https://www.risk-officer.com/Market_Risk.htm
Operational Risk: https://www.risk-officer.com/Operational_Risk.htm
Systemic Risk: https://www.risk-officer.com/Systemic_Risk.htm
Political Risk: https://www.risk-officer.com/Political_Risk.htm
Strategic Risk: https://www.risk-officer.com/Strategic_Risk.htm
Conduct Risk: https://www.risk-officer.com/Conduct_Risk.htm
Reputation Risk: https://www.risk-officer.com/Reputation_Risk.htm
Liquidity Risk: https://www.risk-officer.com/Liquidity_Risk.htm
Cyber Risk: https://www.risk-officer.com/Cyber_Risk.htm
Climate Risk: https://www.risk-officer.com/Climate_Risk.htm
Emerging Risk: https://www.risk-officer.com/Emerging_Risk.htm
