Credit Risk Management Framework (Actions to be taken by the Credit Risk…
Credit Risk Management Framework
Credit Risk - The risk that a counter-party will fail to perform on an obligation.
- the risk that the customer fails to make payments to the bank as agreed in the
– this can also be called settlement risk and covers the situation where the other party to the contract does not deliver an asset that underlies a contract. An example of this would be where the customer fails to deliver the agreed security to the bank.
– the risk that the other party defaults on the contract before settlement is due
– the risk that the other party does not make payment when due under the terms of the contract.
The credit risk management objectives of a typical bank are to:
Ensure that risk-reward objectives are met
Monitor credit risk and adherence to agreed controls and limits
Control and plan credit risk taking in line with external stakeholder expectations avoiding undesirable concentrations of risk
Identify, assess and measure credit risk clearly and accurately across the activities of the bank within each of its separate business from the level of individual facilities up to the total portfolio
Establish a framework of controls to ensure credit risk taking is based on sound credit risk management principles
Typical Credit Risk Policies
Credit Risk Committee
The largest credit exposures would be approved at the Credit Committee at the Group Risk level.
Impairment and provisioning policies
to ensure that measurement of impairment accurately reflects incurred losses and that clear governance procedures are in place for the calculation and approval of impairment allowances
Repayment plans policy
for setting the standards for repayment plans and restructures within retail portfolios
Expected loss policies
to set out the approaches for the calculation of the bank’s expected loss.
Country risk policies
to specify risk appetite by country
Maximum individual exposure
Breaking credit risk exposure into these different levels is a very useful management tool, as it highlights
where high levels of credit risk are concentrated.
Internal subsidiary – Business lending division, personal lending division etc.
Internal division – Secured loans, structured finance, syndicated loans etc.
Size – Small and medium sized enterprises, large corporates, multinationals etc.
Industry – Retail, oil, construction etc.
Local region – Split by town, county, city etc.
Country – Germany, Turkey, Brazil etc.
Geographic region – Asia, Europe, South America etc.
Key Risk Indicators
A key risk indicator is a measure used to indicate how risky an activity is.
Such models are intended to aid banks in quantifying, aggregating and managing risk across geographical and product lines
Provisioning and impairment
Capital provisioning is exactly what has been suggested by many governments and central banks during the credit crisis – making sure that banks are financially strong enough to withstand potential future credit crises by holding enough capital by way of provision.
Impairment simply refers to a worsening credit risk situation – for example, more of a firm’s mortgage customers progressively failing to pay their monthly instalments in times of general economic downturn and general hardship.
Formal risk modelling is required under Basel for all the major international banking institutions by the various national depository institution regulators.
The main determining factor would be the availability and quality of security offered by the customer. Therefore, a sanctioning officer may have a lower limit for unsecured loans and a higher limit if the customer has provided good quality security.
This type of analysis has become increasingly widespread and has been taken up by various regulatory bodies as a regulatory requirement on certain financial institutions to ensure adequate capital allocation levels to cover potential losses incurred during extreme, but plausible, events.
Stress testing and scenario analysis must address:
Portfolio-specific characteristics – tests should reflect the actual instruments to which a firm is exposed. For example when selling derivatives, owing to the in-built leverage, only a small market movement might generate large potential losses.
Changes in correlations – any observed incidence of factors becoming more correlated or less so and thus impacting the benefits of diversification
Changes in liquidity – for example periods of volatility, credit lending squeezes
Major economic moves, e.g. stock market crashes, interest rates spikes
Stress testing is a form of testing that is used to determine the stability of a given system, process or entity.
Difficulties with stress testing include being able to identify the firm’s particular sensitivities and choosing the most appropriate stresses to model
The idea of stress testing is that it enables potential losses or gains to be assessed
The role of segmentation is an attempt to improve the performance of scoring systems. When the credit characteristics and risk characteristics of different groups of clients or counterparties are addressed, by identifying the appropriate sub-groups, the characteristics that are most predictive in isolating risk are optimised for that group.
Basel sound practices
Supervisory evaluation of credit risk assessment for loans, controls and capital adequacy
Banking regulators should consider credit risk assessment and valuation policies and practices when assessing a bank’s capital adequacy.
Banking regulators should be satisfied that the methods employed by a bank to calculate loan loss provisions produce a reasonable and prudent measurement of estimated credit losses in the loan portfolio that are recognised in a timely manner.
Banking regulators should periodically evaluate the effectiveness of a bank’s credit risk policies and practices for assessing loan quality.
Supervisory expectations concerning sound credit risk assessment and valuation for loans
A bank’s credit risk assessment process for loans should provide the bank with the necessary tools, procedures and observable data to use for assessing credit risk, accounting for loan impairment and determining regulatory capital requirements.
A bank’s use of experienced credit judgement and reasonable estimates are an essential part of the recognition and measurement of loan losses.
A bank’s aggregate amount of assessed loan loss provisions should be adequate to absorb estimated credit losses in the loan portfolio.
A bank should adopt and document a sound loan loss methodology
A bank’s policies should appropriately address validation of any internal credit risk assessment models.
A bank should have a system in place to reliably classify loans on the basis of credit risk.
A bank’s board of directors and senior management are responsible for ensuring that the bank has appropriate credit risk assessment processes.
Credit risk policy development, modelling and control
Actions to be taken by the Credit Risk Management department
Providing information for the assessment of the firm’s capital adequacy
To monitor and liaise with the board and external agencies with respect to the firms’ own credit rating from external agencies
To recommend and provide input to the board on the collateral management policy of the firm
To monitor market issues and to address any developing credit or sovereign risk problems
To provide input and reporting to the firms’ credit committee by escalating credit risk issues to senior management
Designing a credit scoring model for the use by the firm in granting credit to clients. The models should be assessed carefully and be stress tested to ensure that no model risk existed
Monitoring and making use of external resources such as those of ratings agencies
Recommending and implementing risk mitigation techniques to reduce and transfer risk
Analysing and managing credit risk exposure
Ensuring with the board that the credit risk policy is followed
Making recommendations to the board of the firm with respect to credit policy
Carrying out regular reviews of all credit assessments
Monitoring, reviewing and reporting credit limits, credit events
Recommendation of credit limits for counterparties and customers
Credit risk assessment of counterparties and customers