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An Over-view of Credit Risk Management in the Banking Sector
Article Source: http://EzineArticles.com/547436
Over the years, banks have been involved in a process of
upgrading their risk management
capabilities. In doing so, the most important part of upgrading
has been the development of
the methodologies, with introduction of more rigorous control
practices, in measuring and
managing risk. However, the by far the biggest risk faced by the
banks today, remains to be
the credit risk, a risk evolved through the dealings of the
banks with their customers or
counterparties. To site few examples, between the late 1980's
and early 1990's, banks in
Australia have had aggregate loan losses of $25 billion. In
1992, the banking sector
experienced the first ever negative return on equity, which this
has never happened before.
There have been many other banks in the industrial countries,
where losses reached
unprecedented levels.
The analysis of credit risk was limited to reviews of individual
loans, which the banks kept in
their books to maturity. The banks have stride hard to manage
credit risk until early 1990s.
The credit risk management today, involves both, loan reviews
and portfolio analysis. With
the advent of new technologies for buying and selling risks, the
banks have taken a course
away from the traditional book-and-hold lending practice. This
has been done in favour of a
wider and active strategy that requires the banks to analyse the
risk in the best mix of
assets in the existing credit environment, market conditions,
and business opportunities.
The banks have now found an opportunity to manage portfolio
concentrations, maturities,
and loan sizes, eliminating handling of the problem assets
before they start making losses.
With the increased availability of financial instruments and
activities, such as, loan
syndications, loan trading, credit derivatives, and creating
securities, backed by pools ofassets (securitisation), the banks,
importantly, can be more active in management of risk.
As an example, activities on trading in credit derivatives
(example - credit default swap) has
grown exceptionally over the last ten years, and presently
stands at $18 trillion, in notional
terns. As it stands now, the notional value of the credit
default swap (a swap designed to
transfer the credit exposure of fixed income products between
parties) on many established
corporate, exceeds the value of trading in the primary debt
securities, received from the
same corporate. Loan syndications grew from $700 billion to more
than $2.5 trillion
between 1990 and 2005, and the same period saw a growth of loan
trading, which grew
from less than $10 billion to more than $160 billion. For the
banks, securities pooled and
reconstituted from loans or other credit exposures (asset-backed
securitisation), provided
the means to reduce credit risk in their portfolios. This could
be made possible by the sale ofloans in the capital market. This
became especially viable in case of loans on homes and
commercial real estate.
The banks are now more equipped in handling credit risk, in the
allocation of its on-going
credit allocation activities. Some of the banks use a more
comprehensive credit risk
management system, by critically analysing the credits,
considering both, the probability of
default and the expected loss in the possibility of a default.
More sophisticated banks use
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the criteria given in Basel II accord in determining credit
risk. In here the banks take credit
decisions by increased expert judgment, using quantitative,
model-based techniques.
Banks, which used to sanction credits to individuals relying
mainly on the personal
judgment of the loan sanctioning officers, now use a more
advanced method of
srutinisation, applying the statistical model to data, such as
credit scores of that individual.
The lending activity of a bank has its credit risk invariably
embedded, as one finds in themarket risk. It all such cases, banks
need to monitor risks by managing it efficiently,
absorbing the risk involved.
Pricings of relevant risks are needed when-ever a bank moves in
a lending contract with a
corporate borrower. New analytical tools now enable banking
organizations to quantify
lending risks more precisely. Through these tools, banks can
estimate the measure of risk
that it is taking on the fund, in order to earn its
risk-adjusted return on capital. This allows
the bank to price the risk before originating the loan. Banks
often use internal debt rating,
or third party systems, that uses market data to evaluate the
measure of risk involved,
when lending to corporate issuing stocks.
The financial Pundits of the banking sector have discussed
diverse range of subjects and
issues, and have arrived on four main themes for a better credit
risk management.
The first theme is concerned with a rapid evolution of
techniques to manage credit risk. This
evolution of techniques have been greatly supported by the
technological advancement
made, with low cost computing being made available, making
analyzing, measuring, and
controlling credit risk in a far better way. This has allowed
introducing a more rigorous
credit risk management system. However, despite the thoughts of
the utilization of the
techniques evolved, implementation of these practices still has
a long way to go for the bulk
of the banks. However, it is expected that the pace at which the
changes are required to be
introduced, will soon accelerate. With competition growing in
the provision of financial
services, there is a need for the banking and financial
institutions to identify new and
profitable business opportunities, and as such, it is inevitable
that the policies on credit
management have to change.
The second theme considered that, the ability to measure,
control, and manage credit risk,
is likely to be the criteria as to how the banking sector grows
in the future. Widespread
cross-subsidization has introduced significant negative impact
on the net interest margin of
all the banks, with a profitable business supporting the cause
of otherwise non-profitable
activities. The matter of cross-subsidization has been an
intentional business decision by the
management of the institutions. However, this has introduced
problems in cash flow, withthe inability to accurately measure risk
and return. With the banks getting on to improve on
their ability to measure risk and return on the activities, it
is inevitable that the
characteristic of the internal subsidies will become
clearer.
The third theme considered the interaction between the
management and the improved
credit risk measurement. The theme also looked into the
possibility of using alternative risk
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measurement techniques within the regulatory environment. There
were certain issues that
emerged.
1. The role of the supervision of a bank or a financial
institution, in a more competitive and
a much more advanced financial environment.
2. At what extent are the banks' risk supervisory efforts and
their relevant policies, keeping
pace with the initiatives and developments taking place in the
market.
3. The urgent need to align the supervisory methodologies
conceived, with the newly
emerging risk measurement practices. In this issue, a general
sense of optimism exists,
where the alignment between the banking sector and the
regulatory authority, regarding
the approached towards the risk management practices, would
happen over time. However,
there is an obstacle in meeting the objective. The banks need to
demonstrate with
confidence, that they have in place well defined, and well
tested rigorous risk management
models, which are completely integrated into their operational
system.
The fourth and the last theme that evolved, was the need to have
a firm commitment from
the banking sector, relating to the management of risks in all
its forms, and the need to
have a strong orientation of the credit management policy
embedded within the culture of
banking. Without such a firm commitment coming from the higher
levels in the banking
sector, the alignment between the regulatory authorities and the
banking institution,
relating to strong credit management principles, is hard to
achieve. It needs to be
mentioned here that, today, unless banking institutions do not
take a firm committed step
towards a viable credit management system, and integrate the
policies within their
operational culture, it will be difficult for the sector to meet
any broader objective, which
importantly includes improved shareholder returns.
In the matter to be better aligned, there is a necessity of
accurate measure of the credit risk
involved in any transaction that the bank makes, and such a
measure is bound to alter the
risk-taking behavior, both, at the individual and at the
institutional levels within the bank.
So long we have been talking about the state-of-the-art
technology and its use in rigorous
credit risk modeling. With this, it should be borne in mind
that, improved measurement
techniques are not automatically evolved without the application
of proper judgment and
experience; where-ever credit or other forms of risks are
involved.
[email protected]
Over twenty two years experience in Oracle. Significant
development & Management skills
viz.,technical writing, project planning and execution, project
management, Oracle sql,pl/sql, data flow design, database design,
datawarehousing, Oracle applications viz.,
manufacturing, scm, crm, financials, hrms,workflow, Oracle
discoverer, forms, reports, etc.,having expertise in Business
Analysis. Presently a Sr. Program Manager with a Large IT
organization in London, looking after 10 Oracle applications
project in Europe, andmanaging offshore development partners.
mailto:[email protected]:[email protected]
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Education:
1. Fellow - Institute of Electronics & Communication
Engineers.
2. MSc. Eng (Computer Science), University of London.3. BSc. Eng
(Electronics), University of London.
Hobby: Writing
[email protected]
Article Source: http://EzineArticles.com/?expert=Prabir_Sen
Article Source: http://EzineArticles.com/547436
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