TOPIC: THE IMPACT OF CREDIT RISK CONTROL ON BANKS IN GHANA: A CASE STUDY OF FIRST ATLANTIC MERCHANT BANK LIMITED

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BACKGROUND TO THE STUDY PROBLEM STATEMENT RESEARCH OBJECTIVES RESEARCH QUESTIONS RELEVANCE OF THE STUDY THE SCOPE AND LIMITATIONS OF THE STUDY ORGANISATION OF THE THESIS

1.0

BACKGROUND TO THE STUDY

Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximise a bank's risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Banks should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organisation. For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank. Banks are increasingly facing credit risk (or counterparty risk) in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions,

financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions. (Saidenberg & Schuermann, 2003).

The Basel Committee on Banking Supervision (1999) defines credit risk as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is therefore to maximize a bank's risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters since effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organization.

This proposal study explores financial credit risk control assessment. Credit risk is an important part of bank management. Additionally, credit risk is the risk that a financial contract will not be honoured according to the original set of terms or expectations. Credit risk occurs whenever a bank lends money or invests in securities. Whenever a bank lends and for some reason finds that repayments and interest payments are not taking place, there is double impact on the banks finances. One, bank will have to stop accruing interest on the doubtful loans and therefore there is an immediate income loss to the bank. Second, the bank will have to make provisions for the non performing loans and this has to be made from the net interest income which the bank is currently earning, which implies that profit will be reduced.

In a world with simple debt contracts between risk-neutral borrowers and lenders, the presence of limited liability of borrowers imparts a preference for risk among borrowers, and a corresponding aversion to risk among lenders. This is because limited liability on the part of borrowers implies that lenders bear all the downside risk. On the other hand, all returns above the loan repayment obligation accrue to borrowers.

Raising interest rates then affects the profitability of low risk borrowers disproportionately, causing them to drop out of the applicant pool. This leads to an adverse compositional effect higher interest rates increase the average riskiness of the applicant pool. At very high interest rates, the only applicants are borrowers who could potentially generate very high returns (but presumably with small probability). Since lenders preferences over project risk run counter to those of borrowers, they may hold interest rates at levels below market-clearing and ration borrowers in order to achieve a better composition and lower risk in their portfolio. Excess demand in the credit market may persist even in the face of competition and flexible interest rates (Ghosh P., Mookherjee D. and Ray D., 1999). It is difficult to imagine another sector of the economy where as many risks are managed jointly as in banking. By its very nature, banking is an attempt to manage multiple and seemingly opposing needs. Banks stand ready to provide liquidity on demand to depositors through the current account and to extend credit as well as liquidity to their borrowers through lines of credit (Kashyap, Rajan, and Stein, 1999).

The AGI Business Barometer, 3rd Quarter 2009 report says in part that: access to credit from banks has been identified as the biggest challenge facing businesses in Ghana (accessed online on 01/03/2011 @ : http://www.agighana.org/CMSPages/GetFile.aspx?guid=c999376c-efa0-4667-936c-0574ebe72444).

The main purpose of this study is to assess the risk management practices of financial institutions in Ghana especially bank loans and overdraft in First Atlantic Merchant Bank. The study will seek to assess credit risk management practices in financial institutions in Ghana by comparing credit risk management practices to a set of criteria generated from "The principles for the management of credit risk" a consultative paper issued by the Basel Committee on Banking Supervision in 1999. Credit risk management is very broad and many researchers have conducted extensive studies into a variety of

concepts under this subject matter and also into the credit risk management practices of financial institutions in developed economy. Financial institutions exist to improve the efficiency of the financial markets and in the process come into contact with a lot of risks. This can result in the loss of a substantial portion of their profits and consequently their equity if these risks are not effectively managed. According to Eccles el al. (2001) financial institutions have different types of risk exposures, but in quantifying and disclosing these risks, they focus primarily on three categories; Market risk, Credit risk and Operational risk.

Firm managers might justify the need for risk management due to managerial self interest, tax effects, the cost of financial distress and capital market imperfections. Shareholders value can however only be maximized if firms engage in risk management practices that would enhance the value of the firm itself. This value enhancement can arise from one of the following sources: (1) minimization of the costs of financial distress, (2) minimization of taxes, (3) minimization of the possibility that the firm may be forced to forego positive net present value (NPV) projects, because it lacks the internally generated funds to do so (i.e. minimizing the probability of the occurrence of the under-investment problem) and (4) minimizing the managerial risk aversion hypothesis (which is based on an agency argument) which holds that managers will seek to maximise their own personal well being at the expense of shareholder value maximization. It follows that regardless of what the motivation is engagement in risk management practices is a must. One of the most important forms of these practices pertains to the management of credit risk, particularly for banks and other firms in the financial services industry is the increasing variety in the types of counterparties (from individuals to sovereign governments) and the ever-expanding variety in the forms of obligations (from auto loans to complex derivatives transactions) have meant that credit

risk management has jumped to the forefront of risk management activities carried out by firms in the financial services industry (Fatemi and Fooladi 2006).

For example, in Ghana the golden age of business being encouraged by the government with the resulting increase in economic activity and the number of individuals requiring funds to do business and also the increased competition in the Ghanaian banking industry which has also resulted in wide variety of banking products being developed by these banks to stay ahead of the competition means that credit risk management is crucial for financial institutions in the country. According to The Basel Committee on Banking Supervision (1999) loans are the largest and most obvious source of credit risk for most banks. The committee therefore advices banks and their supervisors to develop a keen interest in the need to identify, measure, monitor and control credit risk as well as hold adequate capital against these risks and that they are adequately compensated for risks incurred since exposure to credit risk continues to be the leading source of problems in banks worldwide. Although banks have faced difficulties over the years for a number of reasons, the major cause of serious banking problems has been identified to be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank's counterparties.

The Bank for International Settlements through the Basel Committee on banking supervision has therefore issued a consultative paper in order to encourage banking supervisors globally to promote sound practices for managing credit risk. This paper outlines 17 principles that should guide credit risk management practices of all banks.

1.1 PROBLEM STATEMENT 5

Financial Institutions in Ghana's Risk Management Departments although faced with the problem of inaccurate and unreliable information provided by potential credit counterparties which result in downgraded assessment and credit grading as a result of some level of subjectivity involved in credit grading by loan officers, wrong customer/borrower selection by First Atlantic Merchant Bank. Unexpected downturns in the general economy and in the borrowers industry and the unwillingness of the borrower to repay the credit amongst other factors all increase the probability of default by a given counterparty and a subsequent loss of profit since the capital invested by Financial Institutions would not be fully recovered. The high and unstable nature of bad debts and loans recovery globally of which Ghana is not exception raises questions about problems in the credit risk management departments in Financial Institutions in Ghana. The best way to minimize the reduction in profitability as a result of these bad debts and loans is therefore to have an effective credit risk management system that can identify, measure and quantify Financial Institutions' credit risk exposures accurately as well as maintain systems to effectively monitor and control those credits that have the potential of becoming problem credits and implement workout situations to recover such credits. In addition, these should be adequate control over credit risk as well as maintaining an appropriate credit administration, measurement and monitoring process. The problem of the study can thus be stated as: what are the impacts of credit risk management practices of First Atlantic
Merchant Bank and are these practices in line with recommended sound practices?

1.2 RESEARCH OBJECTIVES The main objective of this study is to assess the credit risk management practices at The Bank (the bank refers to First Atlantic Merchant Bank). Since exposure to credit risk continues to be the leading source of problems in banks world-wide, banks and their supervisors should be able to draw useful lessons from past experiences. Banks should now have a keen awareness of the need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they 6

are adequately compensated for risks incurred. Although the principles contained in this paper are most clearly applicable to the business of lending, they should be applied to all activities where credit risk is present.

Related objectives are to: 1. Identify the main sources of Banks risk exposures and the hedging techniques in place to reduce these exposures. 2. Assess the Credit Risk Management Processes of the Bank. 3. Compare Financial Institutions' Credit Risk Management practices with the Banks practices. 4. Make appropriate recommendations to policy makers based on the outcome of the research

1.3 RESEARCH QUESTIONS The questions that will be addressed include the following:
1. Why it has become more difficult to obtain adequate credit facilities to rescue viable businesses? 2. How do we recognize a good or bad credit rating system (on business basis) as given by Bank of

Ghana?
3. Should credit firms (banks) be rational and reach a decision on the basis of what they know and

subjective assessment with the unfolding evidence? 4. How to control credit risks in a financial management? What are the proper risk management tools and techniques to apply?
5. What are the risks associated with loan/overdraft recovery?

6. What is the relationship between credit risk and general bank performance?
7. Do banks have an appropriate credit risk environment? 8. Are banks operating under a sound credit-granting process?

Although specific credit risk management practices may differ among banks depending upon the nature and complexity of their credit activities, a comprehensive credit risk management program will address these eight areas. These practices should also be applied in conjunction with sound practices related to the assessment of asset quality, the adequacy of provisions and reserves, and the disclosure of credit risk

1.4

RELEVANCE OF THE STUDY

Risk is a significant aspect of business activities in a market economy. As risk taking or transformation of risks constitutes a major characteristic of the banking business, it is especially important for banks to address risk management issues. Banks have the responsibility of taking decisions in the best interest of their stakeholders. The owners are interested in the continued existence of the bank as they expect a reasonable return on their investment and wish to avoid capital losses. Also the bank's employees, customers and lenders also have an interest in its survival. Banks should therefore follow the due process to avoid taking on risk that adversely affects the resources of their stakeholders (Christl and Pribil 2006).

According to the Bank Supervision Department of the Bank of Japan, in recent years, risks inherent in the operations of financial institutions have become much more diversified and complicated generally categorized as the following: credit risk, market risk, liquidity risk, operational risk, electronic data processing (EOP) risk, and management risk. Credit risk management is a prominent issue given the degree of impact it will have on a financial institution's management and operations should it emerge. Reflecting on the experience of the nonperforming-asset problem following the bursting of the economic "bubble," the enhancement of credit risk management systems has become one of the major issues facing financial institutions in Japan. Consequently, the strength of credit risk management systems at financial institutions has naturally become one of the most important aspects in assessing the safety and soundness 8

of financial institutions during the Bank of Japan's on-site examinations. (Checklist of Risk Management [revised edition], 2006)

According to Mr. Van Lare Dosoo, Deputy Governor of Bank of Ghana, the effectiveness of the risk based supervision would invariably depend on banks' preparedness in certain critical areas, such as quality and reliability of data, soundness of systems and technology, appropriateness of risk control mechanism, supporting human resources and organisational back-up. The risk based supervision process in my estimation involves continuous monitoring and evaluation of the risk profiles of banks in relation to their business strategies and exposures. This assessment will be facilitated by the construction of a risk matrix for each institution, and thus creates the room for focused supervision in relation to available resources. The current shift in focus is in line with the introduction of the New Basel Capital Accord (Basel II) to include operational risk. This puts further emphasis on supervisory review process and market discipline, which borders on transparency and full disclosure of financial information. These are intended to provide clear bases for effective management of risks and allocation of capital to cover them with the view to making safe and sound institutions (Bank of Ghana online: April, 2006).

Also due to the deregulation and increased competition in the Ghanaian banking industry and the reduction in the Ghana Government Treasury Bill rate in recent times it has resulted in most banks resorting to giving out loans to makeup annual profits. Furthermore loans account for the highest source of credit risk exposure and thus banks need to put credit risk management to the forefront of their risk management activities. Therein lays the justification for this study.

1.5

THE SCOPE AND LIMITATIONS OF THE STUDY

The study would be conducted at the Risk Management Department of First Atlantic Merchant Banks headquarters in Accra - this study will be limited to the Credit Administration Department. This is because the Credit Administration Department is located only at the headquarters and all the bank's branches have to forward their loan applications there for credit rating, and forwarding to senior management or the board for approval. Furthermore, credit risk control is a specialized field and so the Credit Administration Department will be the best place to conduct the study.

Secondly, risk management and for that matter credit risk management is a very sensitive area that is secretly kept by all banks to stay ahead of competition. It is therefore extremely difficult to get access to vital information from sources such as the problem loan files and the credit risk management policy and procedure manual of banks in general in Ghana this may be a limitation.

1.6

ORGANISATION OF THE THESIS

The research will be subdivided into five main chapters as follows: Chapter 1: This will be built around the present proposal, is dedicated to background information to credit risk management and would consist of the following: statement of the problem, research objectives, relevance of the study, scope and limitations as well as the organization of the study. Chapter 2: Relevant literature related to credit risk management would be previewed here. It will give an overview of the basic concepts related to the subject and standards used as best practices in dealing with the issue. it will also include an outline of First Atlantic Merchant Bank. Chapter 3: This will outline First Atlantic Banks Credit Administration Processes to give the general framework and techniques used to manage credit risk exposures and the methodology used for the data collection.

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Chapter 4: Will be devoted to the discussion and analysis of the main results and findings of the data collected in relation to credit risk management. Chapter 5: This chapter will give the general conclusion, recommendations and summary to the study.

A time frame of two weeks will be used to collect the data from bank staff. A time frame of three weeks will be given to customers who will be given questionnaires to complete and submit. Contacts of customers to be administered with questionnaires will have to be collected for a follow on completing the form as well as to remind them to submit completed forms within the stipulated three weeks. Bank tellers can have the questionnaire to distribute to all interested customers as they come to transact business at the tellers point. The total of such distributed questionnaire should be 30 and that for staff should be 20 with a sample size of 50 to be used.

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CHAPTER 3 3.1 3.1.1 3.1.2 3.2 3.3 3.4 METHODOLOGY RESEARCH DESIGN POPULATION, SAMPLE FRAME AND SAMPLE SIZE SAMPLING TECHNIQUE DATA COLLECTION TOOLS AND PROCEDURE DATA ANALYSIS/PRESENTATION PROCEDURE

3.1 METHODOLOGY The research methodologies of the thesis will include a combination of a theoretical analysis through a critical perspective to the Credit Risk Control literature and an empirical study based on questionnaires to be administered.

3.1.1 RESEARCH DESIGN The data to be presented will be collected both from primary and secondary sources. The primary sources will be retrieved through interviews and first hand document from First Atlantic Merchant Bank on the processes and procedures for Loan/overdraft disbursement. The secondary sources will be retrieved from annual reports, books, journals, internet and magazines.

A theoretical approach, where, the Value at Risk (VaR) method will be used in calculating credit risk will be the approach. Value at risk is a quantitative tool to measure the market risk. VaR is widely used by almost all the famous financial institutions including banks, hedge funds and private equity firms to measure risk. There are three basic approaches of computing Value at Risk, though there are numerous

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variations within each approach. The measure can be computed analytically by making assumptions about return distributions for market risks, and by using the variances in and co-variances across these risks. It can also be estimated by running hypothetical portfolios through historical data or from Monte Carlo simulations. (Available at: http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/VAR.pdf and http://www.answers.com/value+at+risk?cat=biz-fin)

The first method of VaR calculation is variance-covariance, or delta-normal methodology. This model was popularized by J.P Morgan (now J.P. Morgan Chase) in the early 1990s when they published the Risk Metrics Technical Document.

The second method is the Historical simulation it is the simplest way of estimating the Value at Risk for many portfolios. According to this approach, the VaR for a portfolio is estimated by creating a hypothetical time series of returns on that portfolio, obtained by running the portfolio through actual historical data and then computing the changes that would have occurred in each period.

Monte Carlo Simulations or the bootstrapping technique, the last of the methods, also happen to be useful in assessing Value at Risk, with the focus on the probabilities of losses exceeding a specified value rather than on the entire distribution. It will be seen that this simulation method is quite similar to the Variance Co-variance method as the first two steps in a Monte Carlo simulation mirror the first two steps in the Variance-covariance method where we identify the markets risks that affect the asset or assets in a portfolio and convert individual assets into positions in standardized instruments.

In addition to quantitative analysis, qualitative analysis will also be used for this thesis. Qualitative inquiry employs different knowledge claims, strategies of inquiry, and methods of data collection and analysis. It 13

then could provide a deeper understanding of the research. Qualitative analysis prioritizes the study of perception, meanings and emotions as well as behaviour which aims to figure out authentic insights and study how phenomena are constructed. Qualitative research includes interviews, observation, texts, audio or video recordings and so on. In this project, we will mainly use interviews and secondary material such as company website, presentation, annual report etc.

The best way to learn peoples subjective experience is to ask them about it and listen carefully to what they say. That is also a powerful method of producing knowledge. In this case study, we will chose interview as our major research method and conduct two formal interviews with the head of Risk Management dept as well as other staff members in the credit administration department of the bank.

For the secondary material, the research will mainly focus on the company website, some presentation slides and the last 3 years Annual Report as well as data from Bank of Ghana. However, there can be some limitation on the secondary materials as it might be out-dated for some presentations or website.

3.1.2 POPULATION, SAMPLE FRAME AND SAMPLE SIZE The population for the study will be all staff and customers of First Atlantic apart from unstructured interviews to be conducted among risk control expects. The sample frame will be staffs of Credit Administration as well as customers who have taken loans or any form of credit before or any potential credit customer. The sample size will be 50 consisting of 20 staff and 30 customers. Also unstructured interview with executive director of Credit Administration of the bank and renowned credit risk analyst expect will be conducted.

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3.2

SAMPLING TECHNIQUE

Sampling techniques for research are used to represent the targeted population. Sampling starts by defining the target population. If the entire population is available for research, it is referred to as a census study. A sampling is obtained when it is impossible to test or survey everyone in the group being researched. The decision of who will be included in the sampling is called the sampling technique. The results obtained through these samplings are the basis of a generalized conclusion that represents the entire population (Source: http://www.ehow.com/info_7893250_ampling-techniques-thesis-writing.html).

Both the population and sample will be based on staff and customers of First Atlantic. Questionnaire will be administered as a structured form of interview using a sample of 50 participants. The work force will be stratified into 2 groups; top management on one hand and middle and lower level staff of Credit Administration department on the other. Possibly all staff, especially, all accounts managers in Credit Administration department must be included in the sample. An expect account of the topic will be sought from credit risk experts from both within and without First Atlantic Merchant Bank. A simple random sampling method will be used. In simple random sampling, each element in the population has a known and equal probability of selection. Furthermore, each possible sample of a given size (n) has a known and equal probability of being the sample actually selected. This implies that every element is selected independently of every other element. The sample is drawn by a random procedure from a sampling frame. A simple random sampling method is random/probability sampling type. There are two sub-methods of simple random sampling stratified random and systematic sampling (Malhatra, 2007). The stratified random method would be used staff would be stratified into top management and other staff. Top management would be one stratum and the other stratum will be strictly credit risk administration staff.

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However, for the 30 customers to be selected, a systematic sampling would be administered. A systematic sampling is a probability sampling technique in which the sample is chosen by selecting a random starting point and then picking every ith element in succession from the sampling frame. The third customer to each teller (on the day of distribution) will be considered the ith element in this case. Three tellers will each be given ten questionnaires for distribution.

3.3 DATA COLLECTION TOOLS AND PROCEDURE The main methods of data collection are primary and secondary data searches. The primary data will be the administration of questionnaires and interviews. The secondary data will be divided into two subsources namely, internal sources from sources such as books of First Atlantic Merchant Bank and external sources such as information from the internet as well as data from Bank of Ghana. Data from Bank of Ghana will be mainly on the credit risk administration in general and that of other financial institutions in comparison with First Atlantic Merchant Bank Limited.

3.4 DATA ANALYSIS/PRESENTATION PROCEDURE The primary data collected will initially be edited to detect and correct any omissions and errors to ensure consistency and completeness. Again the edited data will be coded and analyzed using Statistical Package for the Social Sciences (SPSS) software. The analyzed data will be presented in the form of descriptive statistics in frequency distribution, simple percentages, charts and averages, tables and so on.

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LIST OF REFERENCES Bank Supervision Department of the Bank of Japan. (1998). Utilization of Financial Institutions: Self-Assessment in Enhancing Credit Risk Management [online]. Available at: www.boj.or.ip/en/type/ronbun/ron/research/ron9802a.htm [Accessed 28 February 2011].

Basel Committee on Banking Supervision (1999). Principles for the management of credit risk Consultative paper [online]. Available at: www.bis.org/publ/bcbs54.htm [Accessed 28 February 2011].

Christl, J. and Pribil, K. (2006). Guidelines on bank wide risk management: Internal Capital Adequacy Assessment Process [online]. Oesterreichische National Bank and Austrian Financial Market Authority. Available at: www.oenb.at/de/img/lf_icaap_englisch_gesamt tcm 14- 39190.pdf [Accessed 28 February 2011].

Eccles, R., Herz, R., Keegan, M. and Phillips, D. (2001). The risk of risk. Balance Sheet, 9 (3), August, pp28 - 33. Edelberg, W. (2004). Testing for Adverse Selection and Moral hazard in Consumer Loan Markets - Working Paper [online]. Available at: www.federalreserve.gov/pllbs/teds/2004/200409/200409pap.pdf [Accessed 28 February 2011].

Fatemi, A and Fooladi, I. (2006). Credit Risk Management; a survey of practices. Managerial Finance, 32 (3), 2006, pp227 - 233.

Ghosh, P., Mookherjee, D., and Ray, D. (1999). Credit rationing in developing countries: an overview of the theory [online]. Available at:

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http://www.nyu.edu/econ/user/debraj/Papers/Gmr.pdf [Accessed 28 February 2011].

Kashyap, Anil K., Raghuram Rajan, and Jeremy C. Stein, 1999, "Banks As Liquidity Providers: An Explanation for the Co-existence of Lending and Deposit-Taking," NBER Working Paper Series #6962. A Study On Financial Ratios Of Major Commercial Banks ( Dr. Y. Sree Rama Murthy, Director Research & Senior Faculty Member , College of Banking & Financial Studies, Sultanate of Oman Research Studies 2003

Malhotra, Naresh K. (2007), Marketing Research, 5th Edition,pp 346-347, Pearson Education International

Regional Seminar On Risk-Based Supervision for Anglophone West Africa, held at the Cresta Royale Hotel, Accra on 24/04/2006 (Accessed on 28 Feb 2011, available online at:
http://www.bog.gov.gh/privatecontent/File/PublicAffairs/s%20speech%20%20Regional%20Seminar%20on%20Risk-based%20Supervsion.doc).

Saidenberg, Marc, Schuermann, Til (2003) The New Basel Capital Accord and Questions for Research Federal Reserve Bank of New York 33 Liberty St. New York, NY 10045 {marc.saidenberg, til.schuermann}@ny.frb.or

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Websites: The AGI Business Barometer, 3rd Quarter 2009 report (accessed online on 01/03/2011 @ : http://www.agighana.org/CMSPages/GetFile.aspx?guid=c999376c-efa0-4667-936c-0574ebe72444)

Value at Risk (VaR) method of calculating credit risk (Available at: http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/VAR.pdf and http://www.answers.com/value+at+risk?cat=biz-fin)

A ehow article on sampling techniques. Source: http://www.ehow.com/info_7893250_amplingtechniques-thesis-writing.html).

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