CHAPTER ONE INTRODUCTION
- BACKGROUND TO THE STUDY
It is difficult to imagine another sector of the economy where as many risks are managed jointly as in Banking. Banks and banking activities have evolved significantly through time. With the introduction of money, financial services like acceptance of deposits, lending money, currency exchange and money transfers became important because of the central role of money, Banks had had and still have an important role in the economy. Like any other firm banks are exposed to classical operational risks like infrastructure breakdown, problems, environmental risks e.t.c. More typical and important for a bank re the financial risk it takes by the transformation and brokage function.
By its very nature, banking is an attempt to manage multiple and seemingly oozing needs. Bank stands ready to provide liquidity on demand to depositors through the checking account and to extend credit as well as liquidity to their borrowers through lines of credit (Kashyap, Rajan, and Stein 1999). Because of these fundamental roles, banks have always been concerned with both solvency and liquidity. Traditionally, Banks held capital as a buffer against insolvency and they held liquid assets like cash and securities to guard against unexpected withdrawals by depositors or draw downs by borrowers. Banks are germane to economic development through the financial services they provide. Their intermediation role can be said to be a catalyst for economic growth. In recent years, risk management at banks has come under increasing scrutiny. Banks have attempted to sell sophisticated credit risk management systems that account for borrowers risk
and perhaps the risk reducing benefits of diversification across borrowers in a large portfolio. Banks that manage their credit risk (buy and sell loans) hold more risky loan than banks that merely sell loans or banks that merely buy loans. For banks, credit risk typically resides in the assets in its banking books (loans and bonds held to maturity). Credit risk refers to the risk that a borrower will default on any type of debt by failing to make required payments. The risk is primarily that of the lender and includes lost principal and interest, disruption to cash flows and increased collection costs. The loss may be complete partial and can rise in a number of circumstances for example consumer may fail to make a payment due on mortgage loan, credit card, or other loan. Traditionally, the five c‟s representing the borrowers characters, capacity, collateral and conditions have been recommended.