Credit Risk Practices for Retail Banking II

Question 1

What do money laundering regs affect?

Answer 1

• All banks, BSocs and other credit institutions that accept deposits and offer lending and leasing
• All individuals and firms engaging in investment business within the meaning of the Financial Services Act 1986
• All insurance companies covered by the European Life Directives, including the life business of Lloyds of London
• Bureaux de Change, cheque encashment facilities, and money transmission services etc

Question 2

What do the regs require of financial institutions?

Answer 2

• Ask new customers to prove their identity
• Check sources of any one off transactions exceeding £10,000
• Check the sources of seperate or linked transactions over £10,000
• Keep adequate records showing evidence of the customers identity and transactions for 5 years
• Maintain internal reporting procedures with one member of staff responsible for recieiving reports of suspicious transactions who should inform and cooporate with the police - the Money Laundering Officer

Breach of these regs can result in imprisonment and/or a fine

Question 3

What are the significant risks in relation to mortgage lending?

Answer 3

1. Repayment risk - ability of the customer to meet future payments
2. Property risk - value of the house itself and quality of the registered title

Question 4

What other factors come into the assessment of a mortgage application?

Answer 4

• Conduct of accounts
• Evidence of savings
• Income and expendature profile
• Conduct of previous mortgage or tenancy agreement
• Previous credit history
• Employment and salary

Question 5

What information is required to assess the ability to repay the mortgage and to see that the risk is acceptable?

Answer 5

• The level of borrowing and loan-to-value
• The level of contribution form the applicant and its availability
• The term of the loan
• The property and its condition (including any restrictions of title)
• Credit worthiness of the applicant

Question 6

Why might credit scoring not be a satisfactory credit risk assessment for high networth customers?

How is financial analysis carried out for high net worth customers?

Answer 6

• Their asset base and income is substantially above either the national or average for the typical bank so that a manual assesment may be required in addition to credit scoring
• By consulting info about the customers assets and liabilities and their income and expendature

Question 7

What information do you want from High Net Worth people?

Answer 7

• Assets & Liabilities inc. statement of net worth
• Income & Expenditure

Question 8

What should you do when analysing the Statement of Net Worth for a high net worth customer?

Answer 8

• Establish the assets and liabilites of the customer
• Confirm their acuracy in both value and ownership
• Assess the liquidity risk - the current ratio and quick ratio
• Assess appropriateness of the debt structure
• Assess the liklihood of contingents crystalising

Question 9

What is Net Worth % = ?

Answer 9

NW% = 100* Net Worth / Total Tangible Assets

where Net Worth = Assets - Liabilities

This shows their stake in a credit proposal

Question 10

What is the time boundary for a liability to be current?

Answer 10

Due in less than 12 months.

Question 11

What types of income are there?

Answer 11

• Earned - e.g. salary
• Unearned - e.g. investment returns

Question 12

Give an example of a contingent asset and contingent liability.

Answer 12

• Contingent asset - inheritance (contingent as the inheritor may die first, or the will may change)
• Contingent liability - guarantee

Contingents are not included in the statement of net worth, but their liklihood should be analysed.

Question 13

What questions is the Statement of Assets and Liabilities a useful prompt for?

Answer 13

• Property asset details will allow you to establish income streams from rented properties and allow you to check on the servicing costs to ensure that they are included in the customers expenses
• Income from rented properties should be net of estate agents or letting agents fees, and tax
• You will be able to establish if the customer is allowing for rental voids during the year
• Ascertain if there are any assets free of mortgages which could be available as security if you feel it is needed
• Expiry of credit facilities at your bank or another credit competitor can alert you to an imminent and potential new borrowing need of your customer

Question 14

What are the 5 P’s of credit?

Answer 14

1. Person
2. Purpose
3. Payment
4. Protection
5. Premium

Question 15

What does person entail in the 5 P’s of credit?

Answer 15

• Is your customer trustworthy? if not stop your analysis at this point and do not commit to lending
• Does the credit risk at the macro and overall levels appear logical, reasonable and make sense?
• Does the customers profile fit with your own banks strategic and marketing objectives?
• Is your customer nearing retirement or do they have a young family which may explain the lack of elasticity in the surplus of income less expendature?
• What industry sector is the customer employed in? Is it stable or vulnerable to economic downturns?
• What is the net worth surplus percentage? Do they have high or low gearing or leverage?

Question 16

What does purpose entail in the 5 P’s of credit?

Answer 16

• Is the purpose for which the credit facilities are being granted legal and within your banks credit policy?
• Regarding legal risk, you need to ensure that the documentation for the credit facilities and for any security provides a legal and binding contract
• Is the borrowing properly structured?
• Is there a logical fit between the purpose for which the asset is being financed and the source of repayment?

Question 17

What does payment entail in the 5 P’s of credit?

Answer 17

• A major part of credit risk assessment is making sure that the interest cost can be met and repayments made as arranged
• Having the income to repay you mandated to the bank is a comfort
• The primary source for servicing the borrowing and meeting loan payments is usually from the surplus of income over expenditure

Question 18

What does protection entail in the 5 P’s of credit?

Answer 18

This comes initially from the income and assets of the customer. If these do not repay you, then you may need to resort to the security held.

• The risk can be mitigated by setting formal triggers (covenants or agreements) in the loan documentation
• Have you satisfactarily covered the external market risks?
• Insurance is used to mitigate an unforeseen event and the aim is to cover the customer personally and their assets
• Have arrangements been made to regularly review the facilities during their lifetime to meet audit risk requirements?
• Are insurance policies still in place, adequate to cover the assets and have premiums been paid?
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Question 19

What does premium entail in the 5 P’s of credit?

Answer 19

• What is the credit risk/reward ratio? are you charging sufficient interest to cover the credit risk your bank is being asked to take?
• Your bank may have a pricing model that will assist you in establishing the hurdle interest rate and arrangement fee to be charged for the facilities
• You will recall that a bank must manage its return on capital employed to ensure that adequate returns are made to meet its costs and provide the returns shareholders expect