29. Bank’s credit risks: methods of evaluation and minimization.

Liquidity Risk

Liquidity is the ability to pay, whether it is to pay a bill, to give a depositor their money, or to lend money as part of a credit line. A basic expectation of any bank is to provide funds on demand, such as when a depositor withdraws money from a savings account, or a business presents a check for payment, or borrowers may want to draw on their credit lines. Another need for liquidity is simply to pay bills as they come due.

The main problem in liquidity management for a bank is that, while bills are mostly predictable, both in timing and amount, customer demands for funds are highly unpredictable, especially demand deposits (checking accounts).

Another major liquidity risk is off-balance sheet risks, such as loan commitments, letters of credit, and derivatives. A loan commitment is a line of credit that a bank provides on demand. Letters of credit includecommercial letters of credit, where the bank guarantees that an importer will pay the exporter for imports and a standby letter of credit which guarantees that an issuer of commercial paper or bonds will pay back the principal.

Derivatives are a significant off-balance sheet risk, as evidenced by the collapse of American International Group (AIG) in 2008. Banks participate in 2 major types of derivatives: interest rate swaps and credit default swaps. Interest rate swapsare agreements where one party exchanges fixed interest rate payments for floating rates. Credit default swaps (CDSs) are agreements where one party guarantees the principal payment of a bond to the bondholder.

Liquidity management is achieved by asset and liability management. Asset management requires keeping cash and keeping liquid assets that can be sold quickly at little cost. Liability management is borrowing.

Asset Management

The primary key to using asset management to provide liquidity is to keep both cash and liquid assets. Liquid assets can be sold quickly for what they are worth minus a transaction cost or bid/ask spread. Hence, liquid assets can be converted into a means of payment for little cost.

The primary liquidity solution for banks is to have reserves, which are also required by law. Reserves are the amount of money held either as vault cash or as cash held in the bank's account at the Federal Reserve, often referred to as federal funds. It can also include cash that a bank has in an account at a correspondent bank. In the United States, the Federal Reserve determines the amount of required reserves (aka legal reserves, primary reserves), which is expressed as arequired reserve ratio, which is the amount of reserves as a percentage of the bank's demand deposits. A bank may even keep excess reserves in its Federal Reserve account for greater liquidity, especially since the Federal Reserve has started paying interest on these accounts since October, 2008.

Although reserves provide liquidity, they earn little or no money. Vault cash pays no interest at all and Federal Reserve accounts have paid 1% or less. By buying liquid assets, a bank can earn money while maintaining liquidity. The most liquid—and safest—asset is United States Treasuries, of which banks are major buyers.

Banks can also sell loans, especially those that are regularly securitized, such as mortgages, credit card and auto loan receivables.

A bank can also increase liquidity by not renewing loans. Many loans are short-term loans that are constantly renewed, such as when a bank buys commercial paper from a business. By not renewing the loan, the bank receives the principal. However, most banks do not want to use this method because most short-term borrowers are business customers, and not renewing a loan could alienate the customer, prompting them to take their business elsewhere.

Liability Management

A bank can increase liquidity by borrowing, either by taking out a loan or by issuing securities. Banks predominantly borrow from each other in an interbank market known as the federal funds market where banks with excess reserves loan to banks with insufficient reserves. Banks can also borrow directly from the Federal Reserve, but they only do so as a last resort.

Banks are big users of a debt instrument known as a repurchase agreement (aka repo), which is a short-term collateralized loan where the borrower exchanges collateral for the loan with the intent of reversing the transaction at a specified time, along with the payment of interest. Most repos are overnight loans, and the most common collateral is Treasury bills. Repos are usually made with institutional investors, such as investment and pension funds, who often have cash to invest.

The major security that banks sell is the large certificate of deposit (CD), which is highly negotiable, and can be easily sold in the money markets. A large CD is a time deposit of $100,000 or more. (Banks also sell small CDs to retail customers, but these can't be sold in the financial markets.) Other major securities sold by banks include commercial paper and bonds.

Credit Risks

Credit default risk occurs when a borrower cannot repay the loan. Eventually, usually after a period of 90 days of nonpayment, the loan is written off. Banks are required by law to maintain an account for loan loss reserves to cover these losses.

Banks reduce credit risk by screening loan applicants, requiring collateral for a loan, credit risk analysis, and by diversification.

Banks can substantially reduce their credit risk by lending to their customers, since they have much more information on them than on others, which helps to reduce adverse selection. Checking and savings accounts can reveal how well the customer handles money, their minimum income and monthly expenses, and the amount of their reserves to hold them over financially stressful times. Banks will also verify incomes and employment history, and get credit reports and credit scores from credit reporting agencies.

Collateral for a loan greatly reduces credit risk not only because the borrower has greater motivation to repay the loan, but also because the collateral can be sold to repay the debt in case of default.

When banks make loans to others who are not customers, then the bank has to rely more on credit risk analysis to determine the credit risk of the loan applicant. Credit risk analysis is the determination of how much risk a potential borrower poses and what interest rate should be charged. The potential risk of a borrower is quantified into a credit ratingthat depends on information about the borrower and well as statistical models of the business or individual applicant. There are credit rating agencies for businesses, such as Moody's or Standard Poor for larger entities and Dun & Bradstreet for smaller businesses and Experian, TransUnion, and Equifax for individuals. Most of these credit reporting agencies assign a number or other code that signifies the potential risk of the borrower. A bank will also look at other information, such as the borrower's income and history.

A bank can also reduce credit risk by diversifying—making loans to businesses in different industries or to borrowers in different locations.