Credit Risk Management: Lending Disasters Essay

Question:

Discuss about the Credit Risk Management for Lending Disasters.

Answer:

Introduction

As a senior auditor in the firm of EA Partners, I would like to select Barclays Plc. in order to prepare a risk assessment report. Barclays is a banking firm that operates in the credit cards, retail, wholesale, mortgage lending, wealth management and investment banking sectors (Barclays PLC ADR. 2016). Along with this, the report would be helpful to represent the broad scope of risk in an effective way. The report would also be helpful to illustrate main financial risks faced by the firm. Moreover, the report would also be beneficial to develop control elements to mitigate the impact of risks in an effective way. Overall, this report will provide a complete assessment of risk exposure of Barclays Plc.

Inherent Key Financial Risks

The current business environment is very risky due to the increased volatility, unpredictability, and complexities. Moreover, business risks are increasing on the regular basis. The major inherent financial risks of Barclays are as below:

Credit Risk:

Credit risk is the risk that generates due to the failure of business debtors to fulfill their contractual obligations and to pay the credit. Barclays also faces credit risk because of its clients, customers, debtors, and market counterparties are not succeed to honor their financial obligations in a specific time period. On the other hand, it should be noted down that Barclays provide advanced credit facilities to its customers (Amiti & Weinstein, 2011). On the basis of the financial data of the firm, it should be noted down that, in the financial year 2015, the firm has provided loan of 2.11 billion to its customers. This may create credit risk to the organization (Barclays PLC ADR. 2016).

On the other hand, the firm is also obliged to monitor that advanced credit provided by Barclays will not be defaulted by its clients. Moreover, loans and advance credit provided by Barclays are the major source of credit risk to the business. Apart from this, debt securities, inter-bank loans, reverse repurchase loans, loan commitments and settlement balances with parties are also considered the major sources of credit risk to the company.

Liquidity Risk:

Liquidity risk is a risk that occurs when a corporation faces trouble to sell its assets to offer capital in order to meet its short-term financial obligations in an effective and a significant way. Along with this, Barclays also faces liquidity risk because of the cash provided by the firm defaulted by its customers as well as counterparties. Moreover, it should also be noted down that, Barclays provides advanced credit to its clients and this excessive cash outflow becomes the major reason of illiquidity risk to the company (Johnstone, Gramling & Rittenberg, 2015). On the basis of the financial data of the firm, it should be noted down that, in the financial year 2015, Barclays has 1.06 trillion as liabilities to pay, that may create liability risk to the organization (Barclays PLC ADR. 2016).

On the other hand, asset sales as well as high costs of raising funds also make a reduction in the balance sheet of the firm that also creates liquidity risk to the organization. Apart from this, illiquid markets force the firm to hold its financial assets because of this would be beneficial for the firm in order to reduce liquidity risks in an effective and a more comprehensive manner.

Foreign Exchange Risk/Market Risk:

Foreign exchange risk or market risk is a type of risk that occurs due to adverse movements in foreign exchange markets or rates. Along with this, this type of risk confiscates the potential profits as well as asset value of a firm that operates in the international market. This is also an inherent risk to Barclays. It is because of interest rates, inflation rates, foreign exchange levels, commodity prices, and equity & bond prices influence the business as well as operational activities of the organization (Huang, Zhou & Zhu, 2009). In this way, it can be said that, the above discussed are the major inherent risks that have an impact on the overall performance, productivity, profitability, market position and market share of the organization.

Control Elements/Strategies to Mitigation Risk

It is true that each and every business firm has some inherent risks that are dangerous for the growth and success of the organizations. Moreover, business firms adopt and implement numerous effective strategies in order to reduce the negative impacts of these inherent risks in an effective way (Colquitt, 2007). Along with this, the major control elements or strategies that Barclays may adopt and implement to mitigate the impact of inherent risks are described as below:

Credit Risk

Credit default swaps and credit linked note are two major strategies that are helpful to mitigate credit risk to the company.

Credit Default Swaps: This strategy permits a customer to acquire a contract and to make regular payments to the seller. The CDS strategy also works as a speculative strategy. As per this strategy, the buyer is obliged to pay to the seller (Chaumont, 2013). The buyer would also be unable to hold the payment of the seller.

Credit Linked Note: This strategy is helpful to reduce credit risk exposures to the corporation. The CLN strategy also permits investors to accept higher returns if there is a situation of any risk (Pickett, 2006). Moreover, the CLN presents a hedge for borrowers in opposition to explicit risks.

Liquidity Risk

The major strategies that are helpful to mitigate liquidity risk are internal pricing & incentives and liquidity limits.

Internal Pricing & Incentives: Barclays can manage its liabilities by transferring the liquidity premiums in the internal business units in a direct way (Gray & Manson, 2007). Moreover, these types of transfers are helpful to make sure that liquidity risk management framework of the firm is well designed to reduce the liquidity risk of the firm in an effective way.

Liquidity Limits: The firm must develop a liquidity risk management framework in order to set liquidity limits of the firms. This framework takes help of assets and liabilities to set the liquidity limits in an effective and an appropriate manner (Mistrulli, 2011).

Foreign Exchange/Market Risk

Barclays may adopt and implement the below given strategies to mitigate the market risk/foreign exchange risk in an effective way.

Forward Rate Agreements: The FRA permits a party to forfeit a fixed interest rate and also get a floating rate that is equal to the pre-determined date of contract (Huang, Zhou & Zhu, 2009).

Forwards Contract: Barclays would be able to determine the value of transaction, the exercise & exchange date, and payment procedure in advance.

Money Market Operation: Barclays should perform all its business and operational activities as per the pre-determined rules & regulations of the money market. Moreover, if Barclays will follow all the guidelines then it will be able to reduce the market risk or foreign risk in a proper way (Pritchard, 2010).

Interest Rate Swaps: This is an agreement between parties to swap a set of future cash flows. Moreover, with the help of this, Barclays may make agreements with its counterparties in order to escape itself from the interest rate exposures.

Conclusion

The above risk assessment report of the firm has demonstrated the major areas in which Barclays have need of effective risk management. Along with this, the risk assessment report of firm has described different components of risk assessment process as well as risks exposures. For that reason, it is suggested that Barclays should develop effective risk management to mitigate the risks in an appropriate way.

References

Amiti, M., & Weinstein, D. E. (2011). Exports and financial shocks. The Quarterly Journal of Economics, 126 (4), 1841-1877.

Barclays PLC ADR. (2016). Annual Financials for Barclays PLC ADR. Retrieved From:

Chaumont, M. (2013). The risk-based audit approach: Auditing. Germany: GRIN Verlag.

Colquitt, J. (2007). Credit Risk Management: How to Avoid Lending Disasters and Maximize Earnings. New York: McGraw-Hill.

Gray, I., & Manson, S. (2007). The Audit Process: Principles, Practice and Cases. Australia: Cengage Learning EMEA.

Huang, X., Zhou, H., & Zhu, H. (2009). A framework for assessing the systemic risk of major financial institutions. Journal of Banking & Finance, 33(11), 2036-2049.

Johnstone, K., Gramling, A., & Rittenberg, L.E. (2015). Auditing: A Risk Based-Approach to Conducting a Quality Audit. USA: Cengage Learning.

Mistrulli, P. E. (2011). Assessing financial contagion in the interbank market: Maximum entropy versus observed interbank lending patterns. Journal of Banking & Finance, 35 (5), 1114-1127.

Pickett, K.H.S. (2006). Audit Planning: A Risk-Based Approach. USA: John Wiley & Sons.

Pritchard, C. L. (2010). Risk Management: Concepts and Guidance 4th edition. Australia: Taylor & Francis.

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