Managing Credit Risk

Managing Credit risk

In conjunction with the calculation of the PAR, the analyst should evaluate the adequacy of the reserve for possible losses. These reserves are funded through a change to earnings in the current period as specific, or general, provision of current loans or as accrued interest that may become uncollectible in the future. A MFI should have clear policies for creating loss reserves that accurately reflect the level of risk in the portfolio and for subsequently writing off loans and accrued interest against those reserves.
The reserve ratio, which compares the reserves with the current portfolio, can serve as a quick check on the adequacy of MFI's reserve policies, especially when analyzed in relation to the loss ratio. The reserve ratio compares the total reserve for possible losses on the balance sheet with the current portfolio, whereas the loss ratio compares the amount of principal and accrued interest written off during the period with the average portfolio balance during the period.

Reserve Ratio

Reserve for Possible Losses/Current Portfolio .
The percentage of reservable liabilities that commercial banks are required to hold in-house rather than lend to or invest in. The central bank of the nation, in this case the Federal Reserve in the United States, sets this criterion. It is often referred to as the ratio of cash reserves.

Loss Ratio

Amount Written Off in Period/Average Portfolio in Period .
Is a mathematical formula that divides the total amount of claims that have been reported to the carrier by the amount of premiums earned (this refers to the amount of the insurance premium that has been used up over the policy's term).

To calculate the loss ratio accurately, losses must be applied to the period from which losses arose, not necessarily the period in which they were written off. In this paper, it is assumed that loans are written off in a disciplined manner, and that the write-off occurred in the period that the losses arose. The net amount of loans written off can be determined from the balance sheet by taking the balance in the reserve for possible losses at the beginning of the period, adding to it the provision for possible losses from the Income Statement of the period, and subtracting the balance in the reserve at the end of the period, also from the balance sheet. The result will be the net amount of the loans written off during the period.
The actual loan losses should be compared with the reserve set aside on an annual basis. Reserve should be significantly greater than write-offs. If the reserves are deficient, this is a sign of improper, or too optimistic, approach to setting the level of the reserve. Many MFI do not write offs loans on a timely basis and, thus, tend to under-reserve for losses. If a MFI stops writing off defaulted loans, the portfolio results in a higher percentage of loans that will ultimately have to be written off, thus decreasing true value of portfolio. MFIs must manage them at risk loans carefully and constantly evaluate and adjust their reserve to cover potential losses.
Credit risk represents the potential loss resulting from the poor quality of the MFI's assets, particularly its loan portfolio. Credit risk is by far a most important of risk categories and is discussed below under delinquency management.

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