Credit risk in commercial banks


Banking is topic, practice or profession almost as old as the very existence of man,but literarily it can be rooted deep back the days of the renaissance (bye the Florentine bankers).It has sprouted from the very primitive stone-age banking, through the Victorian-age to the technology -driven google-age banking, encompassing automatic teller machines(ATMs), credit and debit cards,correspondent and internet banking.
Credit risk has always been a vicinity of concern not only to bankers but to all in the business world because the risks of a trading partner not fulfilling his obligations in full on due date can seriously jeopardize the affaires of the other partner.

The axie of his study is to have clearer picture of how banks manage their credit risk. In this light, the study in its first section gives a background to the study and the second part is a detailed literature review on banking and credit risk management tools and assessment models. The third part of this study is on hypothesis testing and use is made of a sample regession model. This leads us to conclude in the last section that banks with good credit risk management policies have a lower loan default rate and relatively higher interest income. A commercial bank is a type of financial intermediary and a type of bank. After the great deression , the U.S congress required banks only engage in banking activities, whereas investment banks were limited to capital market activites. Since the two no longer have to be under separate ownership, some use the term commercial bank to refer to a bank or a division of a bank primarily dealing with deposits and loans from corporation or large business. Commercial bank is the term used for a normal bank distinguish it from an investment bank.

This is what people normally call a bank the term commercial was used to distinguish it from an investment bank. Sicne the two types of banks no longer have to be separate companies, some have used the term commercial bank to refer to banks which focus mainly on companies . in some English speaking countries outside nort America the tem trading bank was and is used to denote a commercial bank. During the great depression and after the stock market crash of 1929, the U.S congress passed the Glass steagall Act 1930 (khambata,1996) requiring that commercial banks only engage in banking activities (accepting deposits and making loans. As well as other fee based services), whereas investment banks were limited to capital markets activites. This separation is no longer mandatory. It raises funds by collecting deposits from business and consumers via checkable deposits, savings deposits and time (or term) deposits. It makes loans to business and consumers. It also buys corporate bonds and government bonds. Its primary liabilities are deposits and primary assets are loans and bonds. Commercial baning can also refer to a bank or a division of a bank that mostly deals with deposits and loans from corporations or large business, as opposed to normal individual members of the public(retail banking).


The name bank derives from the Italian word banco desk/bench used during the renaissance bye Florentine bankers who used to make their transactions above a desk covered by a green tablecloth (de Albuquerque, Martim, 1855) however, there are traces of banking activit even in ancient times.
In fact, the word traces its origins back to the ancient roman empire, where moneylenders would set up their stalls in the middle of enclosed courtyards called macella on a long bench called a bancu from which the words banco and bank are derived. As a moneychanger. The merchant at the bancu did not so much invest money as merely convert the foreign currency into the only legal tender in Rome-that of the imoerial mit (Matysdzak and Philip,2007)
In the most basic terms, commercial banks take deposits from individual and institutional customes, which they then use to extend credit to other customers. They make money by earning more in interest from borrowers banks and brokerages in that kinds of institutions focus on underwriting selling and trading corporate and municipal securities.

The balance sheet: A baks balance sheet is different from that of a typical company.
You wont find inventory , account receivable, or accounts payable. Instead under assets you will see mostly loans and investments, and on the liabilities side you will see deposits and borrowings.

Loans represent the majorityof a banks (saunders and cornett,2005).A bank can typically earn a higher interest rate on loans than on securities, roughly 6%-8% loands,however come with risk. If the bank makes bad loans to consumers or business, the bank will take a hit when those loans aren't rapaid. Because loans are banks bread and butter its crical to understand a bank book of loans, other asset including property and equipment, represent only a small fraction of assets. A bank can generate large revenues with very few hard assets. Compare this to some other companies, where plant property, and equipment (pp and E) is a major asset.

Surprisingly, cash represents only about 2% of assets. That's because the bank wants to put its money to work earning interest. If the bank simply sticks its cash in a vault and forgets about it, it will have a hard time making a profit. Thus a bank keeps most of its money tied up in loans and investments, which are called earning assets in bank- speak because they earn interest. Banks don't like putting their assets into fixed- income securities because they yields than cash, so its always prudent for a bak to keep securites on hand in case they need to free up some liquidity.

Assesting Assets: A bank assets are its meal ticket so its critical for investors to understand how its assets are invested, how much risk they are taking and how much liquidity the bank has in securities as a shield against unforeseen problems. In general investors should pay attention to asset growth the composition of assets between cash, securities and loans and the composition of the loan book also investors should note a bank asset/equity (equity multiplier) ratio which measures how many times a dollar of equity is leveraged.

The liability side of a bank balance sheet is made up of various types of deposits accounts and other forms of borrowings used to fund their investments. A major difference between banks and other is their high leverage or debt to asset ratio.

Assets and liability management (ALM is the management of the structure of a banks balance sheet in such a way that interest related earnings are maximized with in the overall risk tolerance of the banks management ( j.s.g Wilson 1998).


The main objective of the study is to have a bigger picture of how banks manage their credit risk. Thus attention is geared towards.
I- Ascertaining why and how banking credit exposure is evolving recently.
II- Seeing how banks use credit risk evaluation and assessment tools to , mitigate their credit risk exposure.
III- The steps and methodologies used by banks to identify,plan map out, define a framework, develop an analysis and mitigate credit risk(steps in the risk management process).
IV- Determine the relationship between the theories, concepts and modelss of credit risk management and what goes on pratically in the banking world.
V- Ascertain the scope to which resourceful credit risk management can perk up bank performance.


This is a technique used to estimate the probability of portfolio based on the statistical analysis of historical price trends and volatilities.
Value at risk commonly used by banks, security firms and companies that are involved in trading energy and other commodities. VAR is able to measure risk while it happens and is an important consideration when firms make trading or heding decision (simon manganelli and Robert engle, 2001)

Some people have described VAR as the new science of risk management but you do not need to be a scientist to use VAR. here we look at the idea behind VAR and the three basic methods of calculatig it. Basically, VAR is represented by,
VAR=(dollar value of position)
(price sensitivity)
Potential adverse move in pirce/yield.

For financial institutions, risk is about the odds of losing money given out as loans, and VAR is based on that common- sense fact. By assuming financial institution care about the odds of a really big loss on loans, VAR answers the questions, what is my worstcase scenario? Or how much coud I lose in a really bad month?

To be more specific a VAR statistic has three components a time period a confidence level and a loss amount (or loss percentage). Keep thee three e lets take note of this as we give some examples of variations of the questions that VAR answers:

What is the most I can with a 95%or99% level of confidence expect to lose in default on loan repayment over the next month?

What is the maximum percentage I can with 95% or 99% confidence- expect to lose over the next year?

We can see how the VAR question has three elements: a relatively high level of confidence (typically either 95%or99% ) a time period (a day a month a year) and an estimate of lose on loan default (expressed either in dollar or percentage terms) (David harper,2008).



Since the 1980s, banks have successfully applied modern portfolio theory (MPT) to market risk. Many banks are now using earnings at risk (EAR) and value at risk (VAR) models to manage their interest rate and market risk exposures . unfortunately, however even though credit risk remains the largest risk facing most banks the practical of MPT to credit risk has lagged (William Margrabe,2007)

Banks recognize how credit concentrations can adversely impact financial performance. As a result, a number of sophisticated institutions are actively pursuing quantitative approaches to credit risk measurement, while data problems remain an obstacle. This industry is also making significant progress toward developing tools that measure credit risk in a portfolio context. They are also using credit derivatives tools to transfer risk efficiently while preserving customer relationship. The combination of these two developments has precipitated vastly accelerated progress in managing credit risk in a portfolio context over the past several years.


Traditionally, banks have taken asset by asset approach to credit risk management. While each banks method vaies in general this approach involves periodically evaluating the credit quality of loans and other credit exposures applyting a credit risk rating, and aggregating the results of this analysis to identify a portfolio expected losses. The foundation of the asset by asset approach is a sound loan review and internal credit risk rating system. A loan review and credit risk rating system enable management to identify changes in individual credits or portfolio trends in a timely manner. Based on the results of its problem loan identification loan reviews and credit risk rating system management can make necessary modifications to portfolio strategies or increase the supervision of credits in a timely manner.,


This study shows that there is a significant relationship between bank performance (in terms of profitability) and credit risk management(in terms of loan performance). Better credit risk management results in better bank performance. Thus, it is of crucial importance that banks practice prudent credit risk management and safeguarding the assets of the banks and protect the investors interests.
The study summarizes that banks used different credit risk management tools techniques and assessment models to manage their credit risk, and that they all have one main objective, i.e. to reduce the amount of loan default which is principal cause of bank failure.
The study also reveals that banks with good or sound credit risk management policies have lower loan default ratios(bad loans) and higher interest income(profitability).The study also reveals banks with higher profit potentials can better absorb credit losses whenever they crop up and therefore record better performances.


1. Caoutte (1998). Scholarly Article on “frequently isused ratios in credit analysis”
2. Dara Khambata (1996). The practices of multinational banking Macro-policy issues and key concepts. Quorum books pub.1996.
3. David Harper (2008). Introduction to value at risk, investopedia.
4. Declan Makongho Fotoh (2005). Dissertation on commercial bank management. And profitability, the case of Cameroon bank.
5. Gilbert Odoi Boateng (2004). Dissertation on credit risk management in banks.
6. J.S.G Wilson (1998). Bank asset and liability management.

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