A critical study of credit risk management in the First Bank of Dissertation - 2

A critical study of credit risk management in the First Bank of Nigeria PLC - Dissertation Example All types of transactions have risk factors attached to them. If considered as an isolated case, then the loss can be treated as standalone. However, if a portfolio is considered like financial instruments and loans, there is the diversification effect which means risks of individual transactions get diluted. This is because every individual transaction cannot become a bad debt, and it is also not possible that all financial instruments of a trading book will end up as losses caused by market movements. It is universally accepted that the â€Å"sum of individual risks is less than the risk of the sum.† There is also the concept of dependency, i.e. inter-related events which determines the effects of diversification. For instance, a loan can become a bad debt depending on some common factors like the economic condition of market. Therefore to compute the risk of portfolios, it is necessary that these common factors be monitored (Bessis, 2011, pp.25-26). Credit risk can be defin ed as the non-ability of a debtor or issuer of any financial instrument to make payment of the principal amount as per the terms and conditions of the credit agreement (Greuning & Bratanovic, 2009, p.161). The loss that occurs is related to the valuation of the financial instruments and their liquidity. The financial instruments can reduce at high rate if the default is totally unexpected. The resultant loss is the â€Å"difference between the pre- and post-default prices.† (Bessis, 2011, p.29) Banks are most vulnerable regarding credit risk issue since default or delay of payments can lead to cash flow problems or can cause liquidity of the bank. Although there are many aspects of finance, in the balance sheet of the bank 70 percent of it is related to credit risk management. Out of many factors that are responsible for a bank’s failure, credit risk is the most common factor. A bank’s credit risk is mostly determined by its loan portfolio, yet it is equally imp ortant to assess the creditworthiness of any debtor or issuer of financial instruments to understand the potential credit risk. Financial analysts and supervisory agencies of banks give much importance to credit policies designed by the Board of Directors, and how they are implemented by the managers. A credit policy needs to give a framework of the credit structure of bank, i.e. allocation of credit and management of credit portfolio. For instance, the policy should give information about how investments and financing assets are supervised, managed and reviewed. A credit policy need not be excessively conditional, so that proposals for consideration can be placed before the board even if those proposals do not strictly follow the guidelines of the policy. A bank’s credit policy should have enough flexibility to be able to adapt to the changing relations between the bank’s standing assets and the market fluctuations (Greuning & Bratanovic, 2009, pp.161-162). There are certain standard theories of a bank’s credit management and they are – 1) identification and assessment of potential credit risks, 2) credit policies that define the bank’s perspective of risk management, and 3) the parameters of the policies within which credit risk will be monitored. Generally there are three kinds of credit risk management policies. The first one has the objective of minimizing any potential risk and includes policies on â€Å"concentration and large exposures, diversification, lending to connected parties, and overexposure.† The second set of policies targets at classifying assets. These policies make it compulsory to do periodic monitoring of the â€Å"collectibility of the portfolio of credit instruments.† The third set of policies is designed in the manner to set