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

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