Banks should take into consideration potential future changes in economic conditions when assessing individual credits and their credit portfolios, and should assess their credit risk exposures under stressful conditions. This will enable them to review their credit portfolio and assess its resilience under “worst case” scenario. For this purpose, banks should adopt robust stress testing techniques. The stress testing of credit portfolio will enable banks to proactively analyze any inherent potential risks in individual credits or the overall credit portfolio or any components thereof. This will also enable them to identify any possible events or future changes in economic conditions that have unfavorable effects on their credit exposures and assessing their ability to withstand such effects. Such detection of any potential events or risks which are likely to materialize in times of stress, will also enable the banks to take timely corrective actions before the situation may get out of control.
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Some of the common sources of credit risk which should, inter alia, be analyzed by banks are mentioned hereunder for their guidance:
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| | i. | Credit concentrations are probably the single most important cause of major credit problems. Credit concentrations are viewed as any exposure where the potential losses are large relative to the bank’s capital, its total assets or the bank’s overall risk level. Credit concentrations can further be grouped roughly into two categories: (i) Conventional credit concentrations e.g. concentrations of credits to single borrowers or counterparties, a group of connected counterparties, and sectors or industries; (ii) Concentrations based on common or correlated risk factors reflecting subtler or more situation-specific factors e.g. correlations between market and credit risks, as well as between those risks and liquidity risk, etc.; |
| | ii. | Weakness in the credit granting and monitoring processes including e.g. shortcomings in credit appraisal processes as well as in underwriting and management of market-related credit exposures; |
| | iii. | Excessive reliance on name lending i.e. granting loans to persons with a reputation for strong financial condition or financial acumen, without conducting proper credit appraisal as done for other borrowers; |
| | iv. | Credit to related parties which are affiliated, directly or indirectly, with the bank; |
| | v. | Lack of an effective credit review process to provide appropriate checks and balances and independent judgment to ensure compliance of bank’s credit policy and prevent weak credits being granted; |
| | vi. | Failure to monitor borrowers or collateral values to recognize and stem early signs of financial deterioration; |
| | vii. | Failure to take sufficient account of business cycle effects whereby the credit analysis may incorporate overly optimistic assumptions relating to income prospects and asset values of the borrowers in the ascending portion of the business cycle; |
| | viii. | Challenges posed by the market-sensitive and liquidity-sensitive exposures to the credit processes at banks. Market-sensitive exposures (e.g. foreign exchange and financial derivative contracts) require a careful analysis of the customer’s willingness and ability to pay. Liquidity-sensitive exposures (e.g. margin and collateral agreements with periodic margin calls, liquidity back-up lines, commitments and some letters of credit, etc.) require a careful analysis of the customer’s vulnerability to liquidity stresses, since the bank’s funded credit exposure can grow rapidly when customers are subject to such stresses. Market- and liquidity-sensitive instruments change in riskiness with changes in the underlying distribution of price changes and market conditions;
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Stress testing should involve identifying possible events or future changes in economic conditions that could have unfavorable effects on a bank’s credit exposures and assessing the bank’s ability to withstand such changes. Three areas that banks could usefully examine are: (i) economic or industry downturns; (ii) market-risk events; and (iii) liquidity conditions. Stress testing can range from relatively simple alterations in assumptions about one or more financial, structural or economic variables to the use of highly sophisticated financial models. Whatever the method of stress testing used, the output of the tests should be reviewed periodically by senior management and appropriate action taken in cases where the results exceed agreed tolerances. The output should also be incorporated into the process for assigning and updating policies and limits.
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Detailed guidance on stress testing of credit risk has been provided in the SAMA Rules on Stress Testing issued on 23 November 2011. Banks are required to take into account the requirements of these SAMA Rules in stress testing of their credit portfolio.
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