An Over-view of Credit Risk Management in the Banking Sector
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 of assets
(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 of loans 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 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 the market 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,
with the 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 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.
prabirsenuk@yahoo.co.uk
* * *
Over twenty two years experience
in Oracle. Significant development & Management skills viz.,technical
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Education:
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Electronics & Communication Engineers.
2. MSc. Eng (Computer Science), University of London.
3. BSc. Eng (Electronics), University of London.
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prabirsenuk@yahoo.co.uk
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