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