Economics
Credit Risk Management
Credit risk management refers to the process of assessing, mitigating, and monitoring the potential for borrowers to default on their financial obligations. It involves evaluating the creditworthiness of borrowers, setting appropriate credit limits, and implementing strategies to minimize the risk of financial loss due to default. Effective credit risk management is crucial for maintaining the stability and profitability of financial institutions.
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10 Key excerpts on "Credit Risk Management"
eBook - PDFEnterprise Risk Management
From Incentives to Controls
- James Lam(Author)
- 2014(Publication Date)
- Wiley(Publisher)
SECTION Three Risk Management Applications 175 CHAPTER 12 Credit Risk Management T he effective management of credit risk is a challenge faced by all com- panies, and a critical success factor for financial institutions and energy firms faced with significant credit exposures. Most obviously, banking insti- tutions face the risk that institutional and individual borrowers may default on loans. Banks must therefore underwrite and price each loan according to its credit risk and ensure that the overall portfolio of loans is well diversified. However, both financial and non-financial institutions also face credit risk exposures besides the default risk associated with lending activities. For example, the sellers of goods and services face credit risk embedded in their accounts receivable. Investors may see significant decreases in the value of debt instruments held in their portfolios as a result of default or credit deterioration. Sellers and buyers of capital markets products will only get paid on any profitable transaction if their counterparties fulfill their obligations to them. Furthermore, the increasing mutual de- pendence involved under arrangements such as outsourcing and strate- gic alliances exposes companies to the credit condition of their business partners. Given this multiplicity of phenomena, there is obviously a need for a clear definition of credit risk. Credit risk can be defined as the economic loss suffered due to the default of a borrower or counterparty. Default does not necessarily mean the legal bankruptcy of the other party, but merely failure to fulfill its contractual obligations in a timely manner, due to inability or unwillingness.
eBook - PDFCorporate Financial risk management
A Practical Approach for Emerging Markets
- Scott Stanley(Author)
- 2019(Publication Date)
- Society Publishing(Publisher)
Credit Risk Management and Control CHAPTER 4 “The world economy would collapse if a significant number of people were to realize and then act on the realization that it is possible to enjoy many if not most of the things that they enjoy without first having to own them.” — Mokokoma Mokhonoama CONTENTS 4.1. Introduction To Credit Risk Management .......................................... 86 4.2. Traditional Approach To Manage The Credit Risk ............................... 90 4.3. Business Risk .................................................................................... 95 4.4. Financial Risk ................................................................................. 100 4.5. Transaction Risk .............................................................................. 103 4.6. Market Imperfections ...................................................................... 106 4.7. Conclusion ..................................................................................... 112 References ............................................................................................. 113 Corporate Financial risk management: A Practical Approach for Emerging Markets 86 This chapter describes Credit Risk Management and the various components that comprise it. Different ways to handle Credit Risk Management have been explained in detail, with a brief description of financial risk, business risk and transactional risk between counterparties. Strategies like credit limits, netting agreements, and collateral agreements provide support in measurement and control of overall risk. Risk mitigation strategies with immense knowledge of business through PEST and SWOT analysis provide proof to manage the credit risk. Various tips for a good credit manager have been described to handle the issues related to them and in addition to that market imperfections and measures to it have been discussed to eliminate it.
eBook - PDF- Christian Bluhm, Ludger Overbeck, Christoph Wagner(Authors)
- 2016(Publication Date)
- Chapman and Hall/CRC(Publisher)
Chapter 1 The Basics of Credit Risk Management Why is Credit Risk Management an important issue in banking? To answer this question let us construct an example which is, although simplified, nevertheless not too unrealistic: Assume a major building company is asking its house bank for a loan in the size of 100 million Euro. Somewhere in the bank’s credit department a senior analyst has the difficult job of deciding if the loan will be given to the customer or if the credit request will be rejected. Let us further assume that the analyst knows that the bank’s chief credit officer has known the chief executive officer of the building company for many years, and to make things even worse, the credit analyst knows from recent default studies that the building industry is under hard pressure and that the bank-internal rating 1 of this particular building company is just on the way down to a low subinvestment grade (low credit quality). What should the analyst do? Well, the most natural answer would be that the analyst should reject the deal based on the information she or he has about the company and the current market situation. An alternative would be to grant the loan to the customer but to insure the loss potentially arising from the engagement by means of some Credit Risk Management instrument (e.g., a so-called credit derivative ). Admittedly, we intentionally exaggerated in our description, but sit-uations like the one just constructed happen from time to time and it is never easy for a credit officer to make a decision under such difficult circumstances. A brief look at any typical banking portfolio will be suf-ficient to convince people that defaulting obligors belong to the daily business of banking the same way as credit applications or ATM ma-chines. Banks therefore started to think about ways of loan insurance 1 A rating is an indication of creditworthiness; see Section 1.1.1.1. 1
eBook - PDFFinancial Risk Management
Identification, Measurement and Management
- Francisco Javier Población García(Author)
- 2017(Publication Date)
- Palgrave Macmillan(Publisher)
Part III Credit Risk 9 Credit Risk: Measurement 9.1 Basic Concepts As stated at the beginning of this book, risk can be defined as the degree of uncertainty about future net earnings which can take various forms, one of which is credit risk. In recent years, especially given the international financial crisis, credit risk has become one of the main challenges in risk management. More formally, it can be concluded that credit risk arises from the possibility that borrowers, bond issuers or counterparties in derivative transactions will not meet their obligations. In addition, the very formal definition is as follows: credit risk is defined as the possibility of losses arising from the counterparty’s total or partial failure to meet their con- tractual obligations in terms of the total amount or the due date. The main consequence of this is the replacement cost of the relinquished cash flows. As credit exposure has increased, so has the need for sophisticated techniques to measure and manage credit risk. However, before starting to develop the various techniques for measuring credit risk, it is necessary Electronic Supplementary Material: The online version of this article (DOI 10.1007/978-3-319- 41366-2_9) contains supplementary material, which is available to authorized users. 201 © The Author(s) 2017 F.J. Población García, Financial Risk Management, DOI 10.1007/978-3-319-41366-2_9 to understand the main cause of credit risk, credit events or default and the relationship between credit risk and other risks, primarily market risk. 9.1.1 Credit Risk Versus Market Risk The credit event is a dichotomous phenomenon, as it may or may not occur; this is the main difference between credit risk and market risk, where risk originates from market variables, generally prices, which can take a continuum of values, usually between zero and infinity. For this reason, as will be seen in this chapter, the study of credit risk will be very different from that of market risk.
eBook - PDF- Aparna Gupta(Author)
- 2016(Publication Date)
- CRC Press(Publisher)
With the above distinctions in sight between retail and commercial credit risk, we need to define the goals and objectives of Credit Risk Management, and develop methods for measuring and tools to effect the management of it. Since banking, both consumer and commercial, plays a fundamental role in supporting the economic activity in an economy, several of these goals are also driven by the regulatory environment in place for the proper functioning of the banking sector. Regulators recognize the differences in the characteristics of retail and commercial credit, and appropriately respond to the needs for risk management. In Chapter 3, the evolution of the Bank for International Settlements (BIS) supported Basel Accord was briefly reviewed. The Accord’s central focus on credit risk will repeatedly emerge in this chapter. Measures for credit risk are developed based on three important statistical Credit Risk Management 329 quantities. The three statistical measures summarize credit risk both at indi-vidual exposure level, as well as at the portfolio level, and can be combined to create measures for the overall impact of credit risk on a credit portfolio or a bank. The statistical quantities are as follows. Probability of default (PD): This measure is an estimate of the likelihood of a default to occur for an underlying contract in a given period of time. Default refers to a debtor not meeting his or her legal obligations ac-cording to the debt contract, for instance, being unable or unwilling to make a scheduled payment, or violating a condition as per the debt contract. When the underlying is a credit portfolio, the probability of default would further need to be specified as probability of first default, second default, and so on. Probability of n th default refers to the likeli-hood of n th default to occur in a portfolio in a period of time, no matter which specific units cause the n defaults.
eBook - ePubFoundations of Financial Risk
An Overview of Financial Risk and Risk-based Financial Regulation
- Richard Apostolik, Christopher Donohue(Authors)
- 2015(Publication Date)
- Wiley(Publisher)
Chapter 5 takes a deeper look at how banks manage credit risk, starting with portfolio risks and credit exposure. Credit portfolio modeling is complex, and while some banks do build their own models, most use commercially available models; Section 5.3 provides a brief description of such tools. Credit monitoring was described in Chapter 4 in Section 4.6 on the credit process, but it features here again along with early warning signals, given their important role in the management of the portfolio credit risk profile. Section 5.8 explains remedial management and provides a framework of next steps in the event of distressed loans. The final section discusses the Basel III Accord's guidelines to measure and manage credit risk.Chapter Outline- 5.1 Portfolio Management
- 5.2 Techniques to Reduce Portfolio Risk
- 5.3 Portfolio Credit Risk Models
- 5.4 Credit Monitoring
- 5.5 Credit Rating Agencies
- 5.6 Alternative Credit Risk Assessment Tools
- 5.7 Early Warning Signals
- 5.8 Remedial Management
- 5.9 Managing Default
- 5.10 Practical Implications of the Default Process
- 5.11 Credit Risk and the Basel Accords
Key Learning Points- Portfolio management involves determining the contents and the structure of the portfolio, monitoring its performance, making any changes, and deciding which assets to acquire and which assets to divest.
- Key portfolio risks are concentration risk, correlation risk, and contagion risk.
- Banks use various techniques to reduce the overall risk of their loan portfolios.
- Effective credit monitoring is an important part of the credit process and enables a bank to recognize changes in the creditworthiness of credits within the portfolio and to minimize migration risk.
- Credit rating agencies provide independent credit assessments, which can be used to independently verify a counterparty's creditworthiness and also to monitor credit.
- Market-derived ratings can identify where market sentiment may differ from an internal or external credit rating and may indicate a warning signal to a portfolio manager.
- Portfolio managers should learn to recognize the signals of increasing default risk.
eBook - PDFRisk Management and Shareholders' Value in Banking
From Risk Measurement Models to Capital Allocation Policies
- Andrea Sironi, Andrea Resti(Authors)
- 2007(Publication Date)
- Wiley(Publisher)
41 To this critique, one could object that the management of the two risks is typically carried out in a separate way within financial institutions. The unit required to measure/manage market risks is generally independent of the unit concerned with measuring and managing credit risk. 42 Some of these models are used for pricing credit derivatives. 43 The model thus allows analysts to treat floating-rate instruments without utilizing “ loan equivalent ” exposures (see Chapter 16). Portfolio Models 445 Box 14.1: The opinion of The Economist Model Behaviour Banks’ credit-risk models are mind-boggingly complex. But the question they try to answer is actually quite simple: how much of a bank’s lending might plausibly turn bad? Armed with the answer, banks can set aside enough capital to make sure they stay solvent should the worst happen. No model, of course, can take account of every possibility. Credit risk models try to put a value on how much a bank should realistically expect to lose in the 99.9 % or so of the time that passes for normality. This requires estimating three different things: the likelihood that any given borrower will default; the amount that might be recoverable if that happened; and the likelihood that the borrower will default at the same time others are doing so. This last factor is crucial. In effect, it will decide whether some unforeseen event is likely to wreck the bank. Broadly speaking, the less likely it is that many loans will go bad at the same time – that is, the lower the correlation of the individual risks – the lower the risk will be of a big loss from bad loans. None of this is easy to do. Many of the banking industry’s brightest rocket scientists have given over the task. Credit Suisse Financial Products has launched “CreditRisk+”, which attempts to provide an actuarial model of the likelihood that a loan will turn bad, much as an insurance firm would produce a forecast of likely claims.
eBook - PDFFundamentals of Finance
Investments, Corporate Finance, and Financial Institutions
- Mustafa Akan, Arman Teksin Tevfik(Authors)
- 2020(Publication Date)
- De Gruyter(Publisher)
– Technological risk . Risk that new technologies introduced into the entity may have negative results. – Operational risks . Risks that the current infrastructure of the entity will not sup-port the healthy functioning of the entity. – Insolvency risks . Risk that the capital of the entity is not enough to support a sudden decline in the value of its assets. Due to the introductory nature of this book, we will briefly summarize the credit risk, interest rate risk, market risk, foreign exchange risk, technology and opera-tional risk, country (sovereign) risk, liquidity risk, and hedging instruments. The management of risk in financial institutions is known as asset and liabili-ties management (ALM). ALM includes a set of tools that ensure that value is created for shareholders and that risks are under control. 2 The ultimate goal of ALM is to manage risks associated with mismatches between assets and liabilities. 3 16.3 Managing Credit Risk A major part of the business of financial institutions is making loans. The major risk with loans is that the borrower will not repay the loan and or the interest. Credit risk is the risk that a borrower will not repay a loan according to the terms of the loan, either defaulting entirely or making late payments of interest or principal. Once again, the concepts of adverse selection and moral hazard will provide our framework to understand the principles that financial managers must follow to minimize credit risk. Adverse selection is a problem in the market for loans because those with the highest credit risk have the biggest incentives to borrow from others. 2 J. Dermine and Y. F. Bissade, Asset & Liability Management: A Guide to Value Creation and Risk Control , FT Prentice-Hall, 2002, p. ix. 3 The Hong Kong Institute of Bankers, Bank Asset and Liability Management , Wiley-Singapore, 2018, p. 4. 340 16 Risk Management in Financial Institutions
eBook - PDF- E. Banks(Author)
- 2016(Publication Date)
- Palgrave Macmillan(Publisher)
From a credit risk perspective, this centered on several different areas: DERIVATIVES, CREDIT, AND RISK MANAGEMENT 62 ᔢ Consistency: credit risks must be treated uniformly. “Like” products (for example, loans, bonds, and derivatives) that have the same economic characteristics should be treated the same – or else opportu- nities for “internal arbitrage” will appear. For instance, pricing, capital, and accounting policies for the credit risk embedded in the loan book, credit derivatives desk, or bond trading desk should be treated consis- tently. ᔢ Credit quality: capital allocation must be linked to credit quality (that is, probability of default), rather than credit type (that is, the arbitrary categorization/bucketing approach). The original 1988 Accord obligor “bucket approach” failed to properly link into actual credit risks (for example, OECD credits, regardless of creditworthiness, receive certain weightings, non-OECD credits less favorable weightings). An appro- priate framework must take account of the credit rating process and the value that it adds. ᔢ Transaction dynamics: dynamic credit risk exposures and maturities must be incorporated. The derivative market, in particular, is based on constantly changing variables and parameters that should be reflected in the analytic framework. ᔢ Risk mitigation: a broad array of risk mitigating devices must be considered. Even after the 1994–5 enhancements only basic close-out netting was accepted, while other strategies, such as termination options and recouponing, were ignored. Since that time even more instruments, such as credit derivatives, collateralized debt obligations (CDOs), and other securitization vehicles have been employed to manage credit risk exposures. 5 Ultimately, these forces led to collaboration between the industry and regu- lators in creating new approaches to the capital treatment of credit risks.
eBook - PDFUnderstanding Risk
The Theory and Practice of Financial Risk Management
- David Murphy(Author)
- 2008(Publication Date)
- Chapman and Hall/CRC(Publisher)
Certainly, this withdrawal highlights the need to balance proprietary trading opportunities against perceptions from clients that one might act in a hostile manner towards them. One could see this as a challenge in reputational risk management. Exercise . A trader in a financial institution buys a corporate bond. The trader pays USD for the bond, holds it for a week and then sells it, again in USD, to a client. The bank accounts and funds in EUR. Outline all the operational and reputational risks you can think of in the transaction. 1.3.2 The Aims of Risk Management We have seen that extreme market movements happen with some regularity and that financial risk can be taken in many ways, some of them rather complex. There is a long and inglorious history of financial losses resulting from failing to manage these financial risks. Sharehold-ers, regulators and other stakeholders have very little tolerance for bad news. At its broadest, then, risk management is a process to ensure that undesirable events do not occur. Good risk management requires: An understanding of the risks being taken; A comprehensive definition of the firm’s risk appetite; Allowing opportunities to be exploited within the risk appetite; But ensuring that risks outside it are not taken. So specifically there are three components: Risk Measurement : discovering what risks the organisation is running; Action , if required; Culture to ensure that the process works. Often institutions suffer risk management problems when only the first of these receives suffi cient attention. 1.3.2.1 Risk information For many markets, risks positions are valued every day: they are marked to market . In this context, it is important to understand: What factors actually drive the daily P/L? What could cause a large negative P/L? • • • • • • • • • •
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