Insights into Credit portfolios

Banks are not the only businesses exposed to credit risk. Any business whose customers have received some benefit (e.g. a loan, clothing, furniture, cell phone coverage) for which customers will only pay in the future is exposed to credit risk. Organisations with credit risk exposure benefit from understanding their lending books in more detail.

An important step in managing credit risk is understanding the broad states into which debtors fall, also known as the credit states.                                  

Probability of Default (PD) models are an important tool for understanding the “Performing” (up-to-date on contractual payments) and “Underperforming” (increase in risk, but not yet in default) books. They assess the likelihood that accounts migrate to the “Non-Performing” book.

Defaults are generally inevitable, but a high proportion of a loan book in default can be a problem for lenders. Lenders, therefore try to keep the size of their non-performing loan books at an acceptable level in comparison to their total loan books. This article describes approaches to managing non-performing loans.

Expected credit losses under the International Financial Reporting Standards need to be calculated over the lifetime of each credit exposure for accounts in Stage 2 and Stage 3.

For long-dated exposures, it is possible that the borrower could default more than once. Lenders should account for expected credit losses over the full lifetime and therefore need to consider all default events.

Reporting Standard (IFRS) requires segmentation of accounts into three stages; Stage 1 (performing), Stage 2 (underperforming) and Stage 3 (non-performing). The allocation of accounts between the various stages are often based on quantitative and qualitative criteria.Trends in the distribution of accounts between Stage 1 and Stage 2 provide insight into the riskiness of the credit portfolio.

Under IFRS 9, lenders allocate clients to different stages, which reflect different levels of risk. While it is possible for clients to move from Stage 1 to Stage 2 or from Stage 2 to Stage 3, accounts can also improve, i.e. cure out of Stage 3 to Stage 2 or out of Stage 2 to Stage 1.

Collateral offers lenders a secondary means of recovery should borrowers fail to meet their financial obligations. In this way, collateral plays an important role in reducing credit risk. The effectiveness of collateral, however, hinges on various factors such as its enforceability, asset quality, market conditions and maintaining an accurate valuation.