Early diagnostics of loan portfolio’s quality

Abstract

Purpose – The research aims to explore methods for early diagnostics of the loan portfolio’s quality in commercial banks and provide recommendations for practical application of the credit ratings system based on the model elaborated by Mortgage Bank.

Design/methodology/approach – The requirements of supervisors of the banking sector, theoretical and applied methods, and their suitability for timely identification of loan portfolio’s risks were examined. The credit rating model was reviewed as part of Internal Ratings Based (IRB) approach used for assessment of loan portfolio’s quality. A hypothetical loan portfolio was established to evaluate the risk diagnostics system of Mortgage Bank.

Findings – A comparison of practical results with theoretical requirements leads to a conclusion that the credit ratings model established at Mortgage Bank is suitable for early diagnostics of changes to the loan portfolio’s quality, though it could be improved to reflect more varied results.

Research limitations – The conclusions were drawn based on a hypothetical (not fully representative) loan portfolio compiled by selecting real entrepreneurs whose data complied with all the requirements of the rating model.

Practical implications – A commercial bank having a well-developed early diagnostics of loan portfolio’s quality can assess the level of credit risk more accurately. As a result, the bank has a loan portfolio of enhanced quality and more stable financial indices. The author, based on experience of Mortgage Bank, provides recommendations on how to use the credit ratings for assessment of the borrowers and consummate of exhaustive credit ratings system.

Social implications – Good quality risk management system expands the spectrum of borrowers and riskier projects in the branches crucial for the national economy of Latvia. In this way the banks promote development of the national economy and employment.

Originality/value – Experience of Mortgage Bank demonstrates that wisely applied and well-maintained credit rating system is an efficient tool not only in early diagnostics of loan portfolio’s quality, but also in generation of supplementary advantages.