Credit Risk in Retail Banking
Credit risk is defined as the probability that borrowers will not be able to make payments on borrowed funds. Credit risk combines both the uncertainty regarding the failure of a borrower to make the payments, as well as the expected time taken to make the payments .
Retail Banking, more commonly known as Consumer Banking, is offering banking and financial products and services to individual investors or customers. Consequently, there are different types of credit risks involved that these institutions have to deal with. This includes cases in which a customer is unable to make the due payments at a specified time as per the contract. Since retail banks extend different types of credit facilities to its customers to enable them to spend money they do not currently have, or acquire assets for which they cannot make a lump-sum payment to become its owner .
Typically, a standard retail bank offers, in addition to the basic savings and checking accounts, offer
Credit cards to customers it considers to have the monthly income and net-worth required to successfully utilize the facility in the long run. Banks assess the extent of the credit limit that different customers will be allowed and this depends to a large extent on the number of sources of income, and the consolidated monthly income an individual reports . The risk here is that the customer ends up using the credit limit on the card but then becomes unable to settle the remaining debt to the bank.
Personal loans offered by banks also work along the same principle but the risk of default and the bank’s exposure are greater. This is because personal loans are usually handed out as a onetime large scale payment to a customer, amortized over 5 to 7 years. Since neither the credit limit extended nor the loan amount offered is secured by an asset, credit risk to the bank is at the maximum.
Mortgage facilities that allows people to raise capital by putting up their existing properties as security or collateral, against which a consumer bank lends them a loan of a fixed maturity, amount and interest rate . A mortgage can also be obtained through a partial down payment made against which a person is allowed to use a property, and pay off the remaining value of the real estate asset over an agreed upon period of time and rate of interest. The credit risk is lower here since the bank can foreclose or ‘reacquire’ the property that had been put up as collateral and hence recover at least a major chunk of their investment in case the borrower is no longer able to honor his debt.
Home and auto finance loans offered by retail banks also work along the principle of mortgages explained above. Being the lending institution or provider of funds, the retail bank retains ownership of the asset until the customer settles the entire outstanding balance and interest payments. While it is impossible to completely eliminate the credit risk of defaulted payments, since the asset is only allowed for use to the customer, the bank has the legal right to take back the asset and sell it off if it wants to generate the funds that would have come through installment payments .
Credit Risk in Corporate Banking
Corporate Banking or Business Banking is defined as the provision of financial products and services that are specifically tailored to suit the objectives, investment goals and risk management and growth targets of businesses. From small and medium enterprises to large-scale multi-national corporations, a corporate bank has a diverse customer base, and the worth of each of its accounts in terms of monetary value is far greater than those in retail banks.
Similar to retail banks, corporate banks also face the credit risks associated with extending a line of credit to a business or allowing accounts payables to accrue if the business suffers from cash flow problems and is unable to make the loan payments. However, given the varied credit services that corporate banks offer to its high value customers, there are some additional types of risks that they face .
The most important of these is equipment lending on loans and leases forms an integral part of the business functions provided by corporate banks. They structure and develop leasing contracts that allow business to use manufacturing and other types of equipment for a limited time in exchange for rental payments . While these lending arrangements pose less of a credit risk since the lending institution’s exposure is limited to the user’s default on the lease payments, there are certain types of lease arrangement in which there is a clause for the transfer of ownership to the lessee at the end of the lease tenure, once the principal balance as well as the interest has been paid off. In these contracts the risk is more because if the lessee is unable to sustain the payments, then the bank loses out since they were charging a lower interest and also end up bearing the depreciation cost of the machine .
Bank of America’s Retail and Corporate Services and Risk Management Policies
Bank of America’s retail financial product and service portfolio is broadly categorized into four groups. These include banking services such as savings and checking accounts, credit cards, loans for personal expenses, buying a house or a car, refinancing loan services, mortgages and investment options in retirement and pension plans. .
The bank’s corporate banking division provides global business opportunities in emerging as well as established markets by helping businesses expand, offering cost-efficient working capital, managing cash flows and liquidity, insuring businesses against market and operational risks and hedge fund services .
For both its retail and corporate banking divisions, Bank of America has a comprehensive credit risk assessment and mitigation plan in place. The process starts with the Credit Risk Department determining the financial health of prospective individual borrowers using its in-house software to develop credit scorecards for each credit application received. Credit scorecards factor in a person’s current net worth, possible future cash flows, and their historic credit rating to determine whether it will be feasible for the bank to take on their credit risk .
The banks minimizes its risk by charging a high rate of return on risky products risk-based pricing policies) such as unsecured loans and mortgages, while in the case of revolving products such as credit cards and overdrafts, the bank’s exposure is restricted by setting a ceiling on the credit a customer can use in a given period (credit tightening policies).
For its corporate customers, a process of credit analysis, which is far more comprehensive than credit scoring is utilized . The borrowing institution’s income and cash flow statements, along with their balance sheets for the last five years are requested and analyzed to determine the liquidity and debt to asset and equity ratios; this involves considerable human judgement on the part of credit risk assessors. Once the process is complete, a credit rating is assigned to the borrowing institution and those with the highest ratings achieved are extended the credit products or services requested.
References
Altman, E. (2004). Credit risk measurement: Developments over the last 20 years. Journal of Banking and Finance, 1721-1742.
Corporation, 2. B. (2016, April 28). Solutions Focused On Results. Retrieved from Bank of America Corporation: https://www.bankofamerica.com/
Perez, S. (2014, September 1). An investor's guide to banking risks. Retrieved from Market Realist: http://marketrealist.com/2014/09/overview-need-know-banking-risks/
Wagner, C. (2002). An Introduction to Credit Risk Modeling. New York: Chapman & Hall/CRC.
