Credit Risk: Models, Derivatives, and Management

Credit risk refers to the allocation of financial losses that can occur based on unpredictable changes related to credit quality in terms of a financial agreement. The nature of credit loss distribution is sophisticated because the default probability resulting from failure to adhering to the financial agreement is presented. In order to evaluate the default probability, the specification regarding the type of investor uncertainty, the available information, and the definition of the default issue must be explored more deeply . While default probabilities are insufficient for explaining credit securities, there is an urgent need for adding several models to default recovery, as well as for premium investors that require compensation for credit risk monitoring. The credit premium introduces veritable default probabilities that are included in market prices. In this respect, specifications are needed to price securities, which are affected by credit risk issues, as well as to evaluation of aggregated portfolio for credit risk. A model that connects financial failures of several entities should be introduced to evaluate the above-presented issues.

There are three main models for analyzing credit. First, the structural approach makes explicit assumptions concerning the nature and dynamics of company’s assets, including its debts, capital structure, and share distribution. A company can undergo financial risks when its does not have the assets to cover its liabilities. Second, the reduced form technique is silent concerning the reason for company’s default. Rather, the default dynamics is analyzed through default rates and intensity. In the context of this approach, the credit-sensitive securities and their price can be identified in the context of free default through an interest rate, which is risk free and is measured by the intensity. The incomplete data techniques introduce the reduced and structural form approaches. In order to eliminate these challenges, the model chooses the most appropriate features of both approaches, both the intuitive and economic appeal to the structural model, as well as the empirical relevance of the reduced form approach.

Modeling credit risks generally focuses on default modeling, which is simplistic in the majority of cases. In balanced credit risk portfolios, major risk refers to the occurrence of many joint defaults. For defining the loss distribution, attention should be paid to the connection between defaults, which are as significant as the analysis of individual default probabilities. There are a number of types of defaults related to latent models and mixture models. The simplifications refer to a two-state model, which implies the presence or absence of a default . All ideas generalize models that differ in terms of credit-quality classes. Probabilistic ideas are easily understood when it relates to two-state models. The modeling of exposures introduces the main messages that do not provide changes while different loss-given-defaults or exposures are revealed.

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There is a great variety of credit models, depending on the presence of interest rates and risk free opportunities. In this respect, the main essence of structural credit models consists in corporate liabilities being the contingent claims regarding the company’s assets. An organization’s market value is the major reason for ambiguous uncertainty risk. Structural models include the classical approach, first-passage approach, excursion approach, dependent defaults, and credit premium analysis. Reduced form credit models assert that default happens without precaution at an external default rate. The nature of the proposed rate is identified in regards to pricing probability. The intensity model derives from prices established at the market. The reduced form approach is not premised on a model definition default. The nature of default is predetermined at an exogenous level, controlled by pricing probability Q. The problem might consist of the framework of the point aspects. Taking into consideration the random default time, it is also possible to define the default process. The rating and modeling stochastic structure of the default issue are essential because of other types of credit rating techniques, including rating transitions.

As soon as the intensity model is specified, the problem of calculating default probability comes to the fore. Attention should also be paid to defining the expectation over the pricing trend. This model can be evaluated easily with the application of deterministic intensities, but the affine framework introduces a powerful group of intensity frameworks that offer everything from a closed-form solution up to the solution related to a common differential equation. Additionally, the description and evaluation of default dynamics via the market-implied default intensity focuses on tractable valuation formulas. There are several aspects of these formulas related to the various units that define the value recovered by investors. The calculation can be determined by first introducing a common example that renders the general results. For instance, a zero coupon bony that is worth 1 unit at maturity T is possible in cases where no default is detected, and R at if the company defaults prior to the accepted time T. In this case, the variable R = [0,1] defines the recovery of the bond value . Further, the zero-recovery claim is also calculated with regard to the interest rate, time zero and expected pay off . The recovery payment at default can be calculated in different units. During the recovery of face value network, the recovery issue is represented in correlation with the security’s face value. In general, the unpredicted nature of default focuses on another important outcome. In connection with the empirical analysis, the model credit price of security can decrease to the recovery value upon default. This is considered to be indirect confrontation with structural models by means of which the price converts its default value.

While analyzing credit risk modeling in UAE banks, there are specific standards for managing capital adequacy. As such, the Central Bank of UAE adheres to the Basel II framework, which was first introduced in the country in 2009 . The Basel II framework is composed of three stages, or pillars. The first pillar is associated with control of capital calculated for three main elements of risk analysis, such as operational risk, credit risk, and market risk. Other related risks were not included into the phase. The second pillar permits banks to analyze whether it can own additional capital for covering all types of risks mentioned in the first pillar. The bank’s internal assessment and internal models encourage the problem. The second stage focuses on the regulatory responses to the first pillar, providing rules that could improve instruments that are available in capital management scheme of Basel I framework. In addition, Pillar I provides an approach to deliver other risks, including strategic risk, liquidity risk, legal risk, system risk and other types of risks. It also provides numerous approaches to controlling and governing various models of credit risk rating.

The third pillar embraces external communication of threats, as well as capital information stored in the bank’s systems. The main purpose of the third stage is to permit the market sector to operate by compelling banks to disclose details on the scope of risk exposures, and capital risks assessment . The pillar must correlate with how the board of directors evaluate and govern the risks of the bank. The bank is required to cover all material threats. All information mentioned in Pillar 3 is introduced in the Basel II framework.

While analyzing Abu Dhabi Central Bank’s approach to pillar one, it should be stressed that it is used for managing credit risk by calculating capital requirements. The approach provides banks with the utilization of external ratings drawn from designated credit rating agencies to determine the seriousness of risks. The risk level is defined by the asset class and by the external rating of the counterparty. The subsequent exposure covers off exposure of balance sheets once they have been employed to credit conversion factors .

The pillars designed for disclosures have been introduced in compliance with regulatory rates and concepts in accordance with International Financial Reporting Standards. In this respect, some information disclosures are not compared with the information presented in the Annual Accounts 2012. This is introduced for the risk management, in which credit exposure has been defined as the maximum loss that the Central Bank has estimated under specific aspects. In such way, all these opportunities differ significantly from the information mentioned in the annual accounts. Furthermore, the exposures related to off balance sheet are converted after the credit is taken and might not reveal the actual exposures that have been introduced in annual accounts.

While analyzing the credit risk exposure, attention should also be paid to the analysis and presentation of risk information. The disclosures are related to the Bank’s assets in regards to gross exposures, and capital requirements and other indices. For understanding these disclosures, credit exposure is represented as the degree to which financial institutions can be sensitive to contemporary risks when the counterparty default is presented, or when the asset value changes. Where this document focuses on credit exposures, a bank should adhere to the scope of Pillar 1 that is based on the analysis of capital adequacy calculations according to Basel II, as it has been published by the Central Bank. Risk management should also relate to the employment of disciplined and systematic approach to improving and evaluating the effectiveness of ADCB’s risk management and governmental control. The report on risk management is composed of tasks that are aimed at evaluating different portfolio, operational qualities and internal group audits. Finally, the audits will also ensure that the operations encountered by the Abu Dhabi Commercial Bank are carried out in accordance with applicable regulatory requirements, and in compliance with the bank’s internal procedures, reducing the probability of illegal and fraudulent practices.

While analyzing the basic guidelines directed at reducing the probability of credit risk, attention should be focused on the standardized approach to managing and mitigating risks. Specifically, the Central Bank of UAE has issued guidelines called Basel II Capital Accord that focus on the relevant issues for the UAE banking organizations. Considering foreign interest rates requires specific attention. Foreign exchange interest rate agreements should be considered because banks can avoid credit risks in the event of full adoption of this contract, as well as the potential cost substituting the cash-flow in case county-party defaults. Foreign exchange agreements include forward contracts, which are outrights and swaps, foreign current futures, cross-currency interest rates, and foreign currency solutions. When it concerns interest rate-related agreements, an emphasis should be placed on the analysis of the influence of foreign-current exchange on the banking institutions in UAE.

The organization and development of the banks are also predetermined by the necessity to protect them from credit risks and defaults. In this respect, the Central Bank is composed of five branches with the headquarters in Abu Dhabi, Shariah, Ras Al Khaimah, Al Ain, and Fujairah. Through these branches, the bank has a possibility to foster inter-bank transactions with the Central Bank. Each branch is composed of several sections that are responsible for different functions, including Accounts, Administrative Affairs and Banking Operations. Further, Central Bank is divided into seven departments: Banking Operations, Banking Supervision, Financial Control, Research and Statistics, Treasure, Administrative Affairs, and Internal Audit. It has also seven divisions, such as Human Resources, IT, Correspondent Banking, General Secretariat, and Public Relations . Correspondent Banking takes responsibility for controlling credit risks and fill in the gaps related to default and credit-related risks. There are also projects related to risk management in the Central bank, which is connected with eliminating systemic risks.

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Credit Risk Derivatives

Due to the fact that risk is a significant overhand in any commercial relations, banking institutions work with lawyers to create techniques that would allow for mitigating credit exposures via derivatives. To begin with, these techniques are premised on the concept of netting that can take different forms, with reliance on the organizations involved. For instance, if banks have a number of important interest rate contracts, some of those agreements can include cash flows on similar day. In this respect, a netting agreement would compel the bank to single out net cash flows at a specific date into root payment. Further, DEF may be premised on the bank to develop certain collateral agreements against the swap market value. This is similar to the concept of margining which is used on the exchange of the futures. As soon as the market value moves against the bank after a pre-set threshold, it can agree to sign collateral account. DEF might ask to establish a third-party guarantee, at this point, the bank should define neutral mediator that can ensure payment to DEF and highlight the difference between the contract value before and after a negative credit event. With regard to the above, credit risk evaluation is an important element in introducing derivatives transactions. Due to the presence of significant risk, dealers must take into consideration this fact while conducting swap transactions through their counter-parties.

The credit derivative introduces various techniques and tools aimed at separate the credit risk of default to sovereign borrower, transmitting it to the entity. In order to understand the term in more detail, the reference to the case study can be made. The transactions made by American Insurance Group (AIG) require specific attention because it is affected by global credit defaults and financial problems. In this case, it was recognized that few experts could understand the value of credit derivatives or the full risks imposed on the U.S. economy. Amerman introduced a brief, but accurate explanation of the nature and dynamics of credit derivatives . Hence, the major investor has the chance to invest in a venture that always involves certain risk. For example, an insurance company can take advantage of lending to another organization, but it is still concerned about the financial stability of this organization. The company would obviously prefer to see positive returns from that money integration. Therefore, an employee of a firm creates financial derivatives, which are also called credit swaps, which implies taking a risk for a fee. The company makes assertions and estimations of the risk and based on those estimations, the employee should determine whether this commercial activity would be profitable for the company’s chief. Further, employees should take a deeper understanding and analysis of those profits to receive sufficient bonus for getting company into the lucrative transaction. In this respect, credit derivatives are just the means for protecting the bank and the insurance company from the predict risks.

While analyzing the importance and roles of credit risk derivatives, the focus should be on the influence of those models on banks. Credit-default swaps are among the types of derivates used in banks to render credit risks of their debts to others, decreasing the probability of defaulting loans that ignite the bank’s financial challenges. Due to the fact that credit derivatives are considered to be more flexible for imposing risks compared to more established tools, such as loan sales deprived of recourse, these tools simplify the circumvention of the problems, which was predetermined by the superior information on the credit nature and dynamics of loans. However, the analysis of credit risk derivatives is not justified because it can cause the recession of other markets due to the risk of loan sharing. In this respect, Duffee and Zhou argue, “credit derivatives’ flexibility in repackaging risks can, in some circumstances, allow banks to trade previously untradeable credit risks” . As a result, the analysis demonstrates that the nature of the private information concerning the bank’s loan is essential when it relates to the uncertainty in paying off a loan, which can be split into components for the bank to take a relatively small advantage, as well as for the components that provide the bank with greater informational advantage. In this case, the bank can resort to a credit-derivative agreement to impose the former risks on outsiders, while maintaining the previous risks at the bank. The above-presented assumption suggests that credit derivatives use for effective credit risks management can be advantageous for banks.

Credit risk mitigation in UAE banks is carried out via the promotion of credit risk derivatives. The planned rate of exchange of credit risk derivatives should be congruent with all relevant laws to guarantee the adequate regulation of the industrial sector. According to Hunter, “Derivatives inspire about as much fear and anxiety among financial firms and regulators as they do giddy conversations of the growth potential of an industry that is approaching a quadrillion dollars in size and growing fast” . At this point, the significant aspect in credit risk mitigation refers to the increased awareness of the probability. Furthermore, credit risk derivatives are the best option in subprime mortgage issues. For instance, Abu Dhabi Commercial Bank, along with other financial institutions, including Dubai Mashreqbank experienced a significant financial loss due to soured investments.

The Gulf Cooperation Council countries, including UAE, are the largest exporters of oil. Therefore, banks should also cooperate with foreign partners. In this respect, the use of derivatives is among the safest means for protecting the institutions from potential financial failures. Additionally, it should be stressed that the banking activities in the GCC countries are enhanced through the board by means of capital adequacy ratios which are above the minimum CARS, and introduce comfortable ratios in an international context. The Capital Adequacy sector of the Islamic banks introduces the lowest level of risk management in GCC district. Nonetheless, UAE banks are supported by the government, which play a pivotal role for improving operations in the banking sphere. In general, the banking sector is sensitive to the creation of the credit risk management, and it is controversial with regard to the real-estate sector, counting about 25% of loans in the household. The commercial sector is an important area in banking because it secures 13% of the loans. The financial portfolio, therefore, is focused on the corporate sector, which possesses over 70% of all total loans . However, the financial sector seeks to take control of private groups, where there is an increased concentration of credit risk due to the intensified activities in family-owned businesses, as well as in large-scale governmental institutions.

In general, credit derivatives have contributed greatly to the evolution of management and trading of credit risks. They have simplified the process for banks, which have been the source of credit risk taking, and make it easier for them to diversify their credit risks. Credit derivatives have also allowed for creating the products that can be customized in terms of risk-return. As a result, credit derivatives have introduced novelties to both investors and hedgers, which have become a major factor in the augmentation and expansion of credit derivatives market. Since the middle of the 1990s, the amount of credit derivatives market has expanded rapidly and now surpasses the amount of the credit bond market. In order to understand the essence of credit derivatives markets, it is essential to understand the functions of credit derivatives.

There are a great number of functions and roles of credit derivatives. To begin with, credit risk derivatives can contribute to a lower rate of credit risks, as well as to the credit exposure, being a means of introducing a negative outlook on credit market. Further, the majority of credit derivatives are unfunded, which means that credit derivative agreement does not require preliminary payment as bonds do. Therefore, credit derivate is more beneficial in financial terms. Credit derivatives raise liquidity risk by introducing illiquid assets and transferring them into a form of better matches by risk-reward investors and profiles. Credit derivatives ensure better analysis of credit risk taking because the breadth and liquidity of the market is higher compared to the bond market. Credit derivatives contribute to the transparency of credit risk pricing by increasing the variety of traded credits, along with their liquidity. Specifically, the main purpose of credits is to incorporate risk and reduce the possibility of bank default.

Credit Risk of UAE Banks

Risk management algorithm is indispensable for banking institutions. In correlations with the proposed frameworks, the main risk management cycle refers to the practice of defining, evaluating, measuring, and highlighting the acceptable risks level via risk transfer and risk control. In this respect, financial risk management follows a sequence of four main processes. First, risk management implies identifying the events into several broad categories of credit, market, and other risks and placing them into specific sub-categories. Second, risk management should be monitored by specific models that control data. Further, risk control can be accomplished by the higher levels of the managerial hierarchy. Financial instructions should ensure that the risk highlighted by banking groups is managed within the comprehensive models of risk management. As a result, the board of directors must be committed to a specific scheme of mitigating credit risks, including management mission, exposure identification, strategy development, and product monitoring. All these aspects are essential for promoting accurate reduction of potential threats to banking activities. To be more exact, Rosman proposes a range of rules and principles promoting effective credit risk management . To begin with, the banks should conduct a comprehensive diligence review. Further, banking institutions should develop a pertinent methodology for evaluating and reporting the credit risks exposures. Finally, there should be complaint credit risks that negotiate various techniques.

In order to understand credit risk issues in UAE banks, it is also important to consider concrete cases. As such, Commercial Bank International (CBI) is exposed to credit risks by means of various lending activities, such as non-funded and funded institutions. The bank’s credit risk control depends largely on the business to promote integrity of the credit agreements and encourage risks evaluation procedures. Additionally, CBI has introduced the credit approval algorithm to meet customer, sector, product, and exposure types . The Risk Group’s Credit Manual is presented to ensure timely guidelines for new approvals of credit, along with shifts and renewals in the current conditions and terms of the former credit policies. The bank relies on a team of committed and experienced professionals who are able to define the risk and take resolute measures to reduce the impact.

In addition to the above-presented risk management analysis, Abu Dhabi Commercial bank provides unique approaches for taking control of the credit risks. In particular, it is associated with the standard approach for managing basic risks. When it relates to the credit factor of 100%, all direct credit options, including all types of guaranty instruments and general guarantees, such as acceptances and standard letters of credit, and supporting the financial duties and responsibilities of other parties are taken into consideration . Further, credit risk management also relies on credit derivatives, particularly credit default swaps which are provided for protecting banks. Purchasing and resale contracts, as well as asset sales should be promoted, particularly when it concerns credit risks that are imposed on the bank. Forwarding deposits and assets purchases of the partially paid securities represents obligations with particular draw-downs. The credit conversion factor that is equal to 50% involves other operations and activities that mitigate credit risks. In particular, there are transaction contingent items, such as bid bonds, performance bonds, and letters of credits associated to specific transactions should be introduced . Further, the bank also resorts to underwriting commitments and revolving facilities, as well as to the commitments that were cancelled without any reliance on commitment. The factors associated with credit risk mitigation are less limited, but they focus on the instances of unconditional credit cancellation. In addition, there are several approaches for negotiating credit risks, including the introduction of credit derivatives, collaterals, and guarantees.

It should be stressed that there is a tangible difference between how Islamic and non-Islamic banks manage their credit risks. A study by Masood, Al Suwaldi, and Thapa, analyzed six commercial banks in the Emirates and compared them to three Islamic banks and 148 managers controlling credit risks procedures . The main purpose of the study was to explore the aspects that provide distinction between Islamic and non-Islamic banking institutions. The research concluded that credit risk managers from Islamic banking institutions do not pay attention to personal experience and common credit risks evaluations. Rather, the Islamic banks tend to practice and develop modern and up to date techniques to complement the existing traditional approaches to reduce the credit risks. In contrast, non-Islamic organizations search for the possibility to introduce improvements in the existing techniques of credit risk management.

Credit Risk Analysis of UAE Banks: An Empirical Approach

The main problem involves the governance of credit risk management in Emirati banks, as well as the restrictions imposed on those who take interest while getting deposits from the clients. In this respect, they are forced to participate in business activities and should be able to share profits and losses because interest-related investments are prohibited in the Asian sector. In this respect, UAE banks are prohibited from imposing fines that do not relate to clients’ operations. This means that UAE banks can undergo risks and more returns because of the introduced assets. As a consequence, it can be concluded that UAE banks suffer from credit risks more so than traditional banks. Credit risks related to traditional banks introduce a range of risks. In particular, banks can experience risks related to bank agreements and loans. The risks of protected areas on loan are presented as credit risk. The majority of banks provide the sources of credit risks because it is possible that a borrower could fail to carry out an obligation. Islamic financial institutions are spread out over 300 countries; currently $800 is deposited in mutual funds, Islamic banks, and insurance schemes of conventional banks. By contrast, the market was valued at $140 billion in 2000.

International banks have experienced growth while developing a range of services and products. The tendencies in advancing products have delivered the scope of new global approaches to risk management and control. International banks are increasingly involved in a wide array of financial risks, including foreign exchange risks, interest rate risk, liquidity risk, and derivative risks. Specifically, the growth of derivative operations outlines the constantly changing nature and extent of sophistication related to international banking. For instance, the current estimations conducted by the Bank for International Settlement show that the notional size of percentage rate derivatives amounted to $74 trillion in 2003. Due to the fact that the derivative operations amplify the influence of the traditional risk channels, including interest rates, market, current rates, it is essential to evaluate the exposure of MENA banks in regard to the volatility of their risk drivers . In the study by Hakim and Neaime, the exchange rate indicator is much larger in the Middle East because of the influence of the current rates controlled by U.S. currency. The interest rate betas are more fixed and UAE banks highlight a negative interest rate, demonstrating that their stock performance is sensitive to rising rates . Additionally, the researchers found that beta coefficient are beneficial for ranking individual banks and understanding their risk factors. At the same time, the sample varies and involves countries that are similar in terms of legislation, governance, size, market structure, and taxation. Such a resemblance is peculiar of UAE banks, in which the stock market betas introduce common relations and magnitudes. Nonetheless, the interest rates in UAE banks are relatively negative in comparison its neighboring countries Kuwait and Bahrain. As a result, there is a duration gap between bank liabilities and interest rate increase in regard to banking institutions in each country. In this respect, UAE banks experience difficulties because of the interest rate increase, whereas other banks adequately face the problem.

Further analysis of credit risk rating in UAE involves the Dubai Islamic Bank (DIB), which is the largest financial institution in the country. The bank also introduces many services and products, such as credit cards, electronic accounts, and other banking services. Additionally, DIB offers services to commercial, retail, corporate, and institutional clients. When it comes to risk management, there is a board of directors who are responsible for managing risks related to the bank’s assets and liabilities. DIB deals with credit risk by means of a diversification strategy, investing and financing various activities to eliminate the foci of risks while dealing with new customer groups. Rating models are delivered through banking internal rating activities that are aimed at contracting. In this respect, in order to mitigate the credit risk, the principle aspects of Islamic investing and financing involve mortgages over commercial properties, charges imposed on business assets, financial instruments, and corporate guarantees.

There are many other studies related to the analysis of credit risk management in UAE banks. While the study of Abdelrahim focuses its analysis on the credit issues at Saudi banking institutions, there is nonetheless enough data on the status of banks in UAE to make it relevant to this paper. In particular, the literature overview demonstrates that the exploration of credit risks is possible to the extent to which Emirati banks introduce risk management while considering different types of risks, not mentioning risk management in national and foreign banks. It is also associated with the three major strategies of business practices, transferring risk of other management issues at a relevant risk. The research involved a questionnaire as a primary tool for gathering data with regard to credit risk management, as well as risks encountered by the UAE banks. The findings suggest that foreign exchange risk, credit risk, and operational risk are three major problems encounter by UAE banks. Additionally, it was found that UAE banks experience problems from loan default, but they succeeded in evaluating, controlling and identifying the problems of credit risk assessment, which makes a tangible difference between UAE banks and foreign financial institutions.

While providing a comparative analysis of banks, Gakure, Ngugi, Ndwiga, and Waithaka introduced an analysis of UAE banks, stating that “UAE banks are somewhat efficient in analyzing and assessing risk and there is a significant difference between UAE national and foreign banks in the practice of risk analysis and assessment” . The findings also suggest that that risk assessment and analysis affect other risk management practices. Therefore, UAE banks should reassess their policies to introduce more effective frameworks, such as Basel III framework, which is more flexible.

There are many opportunities for analyzing the peculiarities and strategies of managing credit risks in UAE banks. Al-Tamimi and Al-Mazrooei focus on a comparative analysis of commercial banks in UAE to define whether these aspects could be used for further analysis of credit risk management. In order to understand the extent to which UAE banks are affected, attention should be paid to other risks, the stakeholders, and other aspects of the banking activities in the country. This is of particular concern to the liquidity risks because they also affect operations and values in conventional UAE banks.

Effective bank operation and timely credit risk mitigation is the key factor that contributes to the stability of banking networks because it helps banks to invest into its operations, reduce the risk and augment profit levels. In such a way, banks can also attract more investors, encouraging more effective operation. For instance, the Sharia banking system takes advantage of operating activities in accordance with four different business laws. The first one involves the principle of borrower and lender sharing profits and losses. The second includes charges that have been established beforehand. The third resorts to no interest estimating, and, finally, the fourth is based on the collaboration between the lender and the borrower.

The efficiency of work in UAE banks can also be estimated with regard to future perspectives, as well as the analysis of innovative approaches introduced to manage credit risk problems. Once again, the attention should be paid to the laws and regulations established with the bank. In the Central Banks in UAE, there is a range of interest rates that are subject to different categories, relying on the financial status of the client. However, it is important to note that the highest interest rate is charged within the category and it is posted on the board. Banks can impose interest rates that are lower than those rates presented by the board. However, they are not permitted to charge on a higher level of interest rate. Additionally, the bank can introduce penalties on an individual loan because this agreement is arranged by the borrower and constitutes a part of a loan agreement. Interest rate is imposed on individual loans, which should be calculated with regard to the number of days in a month.

In order to avoid credit risks, the Central Bank can resort to penalty rates when the amount of penalty interest is revealed to the borrower and the board is informed about this fact. The bank that penalizes interest with reliance on the default balance should do everything possible to reimburse its legal costs and waive penalties on preliminary payments. However, such a waiver could be revealed to the board. Under these circumstances, the bank is obliged to reveal “zero” on the board in terms of penalty on preliminary payments.

Further, the Central Bank of UAE has introduced the principle of personal loan ceiling for each individual. The purpose of this rule is to avoid risks. In similar way, the European Union has introduced a limit of ECU 20,000, whereas Kuwait has decided to impose a limit of 10,000 dinar. The ceiling imposed on individual loans does not involve credit cart issues, which are usually not secured and are not considered to be personal loans but are instead connected with service indemnity and salary issues. All personal loans are delivered to individual borrowers, but this process should be considered from the perspective of consolidated risks basis and should be within the aggregate limit of Dhs. 250,000 would violate of the Circular in case both loans are protected by the salary . Banks should also be reasonable and consistent while considering the principle amount of loans, including monthly installment in regard to the individual salary. The courts have provided banks with a limited amount that stems from the interest rate of monthly salary, which can presented it as repayment of an individual loan. The Circular should be analyzed for guidance based on loan installment.


While analyzing credit risk modelling in UAE banks, several peculiarities should be highlighted. Specifically, there are certain limitations imposed on interest rate management in Islamic banks. UAE banks do not have the right to impose interest rates on credits and, therefore, the risk of financial loss is increased. In response to this problem, credit derivatives could be used to avoid credit risk and promote transparency in pricing. Further, UAE banking systems have a sub-system that deals with different problems. The empirical analysis of UAE banks showed that the banks are currently working in accordance with Basel II principles, which are out of date compared to the Western banking systems. Nonetheless, the standardized approaches to credit risk mitigation is still encouraged. In general, credit risk management is well organized in Islamic banks that strive to constantly innovate their systems and protect them from defaults. It should also be stated that the Emirati banks, in contrast to traditional banks, undergo great credit risk exposures. Such a position is explained by the fact that traditional banks reduce risk by introducing greater percentage rates, whereas UAE banks are less likely to use this approach because of the fixed tradition in managing deposits, credits, and loans. In the future, the attention should still be placed on the analysis of new means and tools for solving the problem of credit risk taking.

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