Credit Risk Management: How Banks Manage Credit Risks
While they recognize counterparty and legal risks, they view them as less central to their concerns. Where counterparty risk is significant, it is evaluated using standard credit risk procedures and often within the credit department.
Likewise, most bankers would view legal risks arising from their credit decisions or, more likely, proper processes not employed in financial contracting.
To illustrate how this is achieved. This review of firm-level risk management begins with discussion of risk management controls in each area.
The more difficult issue of summing over these risks and adding still other, more amorphous ones, such as legal, regulatory, or reputational risk, will be left to the end.
Table of Contents
Management of Credit risk
Management of credit risk is the bread and butter of most commercial banks. An increase in credit risk will raise the marginal cost of debt and equity, increasing the cost of funds for the banks. Loan quality problems are an important cause of banks’ failure.
Credit Risk Decisions: Retail vs. Corporate:
Good risk management of retail and corporate lending is essential to minimize banks’ aggregate credit risks. The principles used in model credit risk and the methods used to minimize risk for the retail and corporate sectors are given below:
- Pricing the loan
- Credit limits
- Collateral or security
- Credit derivation and assets securitization
Assessing the defaults of individual loans:
1. Qualitative approach
Five C’s are used in a qualitative approach. These are –
- Character: Is the borrower willing to repay the loan?
- Cash flow: Is the borrower reasonably liquid?
- Capital: What assets or capital docs do the borrowers have?
- Collateral: Can the borrower keep the security?
- Conditions: Is the business in good condition to do a profitable business?
2. Quantitative approach
For the quantitative approach, financial data are required for credit analysis.
Here, data from observed borrower behavior estimate the possibility of default and sort borrowers into different risk classes. The type of listed information is gathered, and a weight is applied.
Aggregate credit risk exposure and management
All banks want to manage their aggregate credit exposure. A heavy concentration of loans in one sector can potentially treat the banks’ survival.
Default Model Approach
The default model approach used modem portfolio theory to measure a bank’s aggregate credit exposure for non-traded assets. Some important assumptions are-
- Either there is a default on the loan or no default.
- The probability of one loan default is independent of the probability of default on all the loans.
- The risk is being measured. Here the focus is on credit risk.
- The holding period is defined.
- If there is no security on loan and the loan is completely written off, their loss will be more than the amount loaned.
- The repayment schedule makes it relatively straightforward if all the loan is taken for granted.
Credit Value at Risk
- A credit VaR focuses on a loan loss value and/or a risk-return trade-off for a debt portfolio. In the VaR approach, there is more than one single credit migration.
- The credit VaR model is more appropriate for bond portfolios traded in the market, receive a debt rating, and are reasonably liquid.