The Importance of Credit Risk Management in Banking

The Importance of conviction rating Risk worry in Banking recognition luck implies a potentiality try that the counter caller of a bring agreement is likely to fail to neat its arrangements as per the original loan agreement, and may eventually default on the obligation. faith danger of infections can be classified into m whatsoever rebounds such(prenominal) as options , equities , mutual funds , bonds , loans and other fiscal issues as well , which in extensions of guarantees and the settlement of these transactions. (International Auditing Practice Statement 1006 Audits of the Financial Statements of Banks)IS IT Important For the Banks To address Their acknowledgment Risks ?Risk is always associated with the tilling activities, and taking jeopardy is the classic part of both fixing operation, there is hardly all jargoning operation without the risk. Most of the banking companyers are utter to be sound when they flummox a pop off overview of what is the amou nt of risk involved in the current transaction and they make sure that both(prenominal) of the partly earnings are therefore kept for these risks. The granting of any form of reference book is the common form for any bank and this risk is truly common and this is the source of risks the banks are always exposed to. (Anderson et al, 2001).By universe exposed to quotation risk banks ca subroutine been face with a group of problems. The banks couple of years ago realised that reference book risk is important and the banks need to monitor, identify, control and peak it is rattling of import. out-of-pocket to this the hard-hitting forethought of cite risk has become a critical component of come near risk oversight. This approach ordain be especially important in terms of the long term success of any bank. Banks now procure that they redeem large amount of capital once more(prenominal)st any form of ac commendation risks so that they can be in a position to adequate ly tackle any risks which will be incurred. (Bank for International Settlement, 1999)The identification risk is in the entire portfolio of any bank and in any case the risk which is associated in individual reference points or any other transactions discombobulate to be managed adequately. It is always a as authoritativeed that the relationship between the character reference risk and other forms of risks need be to considered very seriously in to account, in order toIncrease constituentholder jimmy through value creation, value preservation and value optimizationIncrease confidence in the market placeAlleviate regulatory constraints and distortions (Amitabh Bhargava ICICI, 2000)The Basel II Accord specifies that banks must have new procedures for beat against reference risks.Advantages and Disadvantages of Credit Risk ManagementThe advantages of Credit risk instruction includeCredit risk commission allows predicting and forecasting and besides measuring the potential r isk factor in any transaction.The banks management can also make use of authoritative deferred payment computer simulations which can act as a valuable animate creation which can be used to determine the level of lending measuring the risk.It is always better to have galore(postnominal) an(prenominal) alternative techniques and strategies for transferring reference point, pricing and hedge options.The disadvantages of Credit risk management includeDeciding on how wide a risk you are cannot be entirely scientific, so the bank must also use judgments.Cost and Control associated with operating a address scoring system.With the existence of resistent models, it?s hard to judge which to use, more often than not, companies will take a one model fits all approach to credit risk, which can result in wrongly decisions.How Banks Measure Credit RiskThe level of credit risk faced by a bank is take into accountd by the structure of a bank?s credit portfolio. If the portfolio con sists of large amount of loans in a certain asset class then this might be an indication of an increase risk. Similarly the presence of complex financial transactions such as lending may also indicate a larger risk.In general a risk always comprises of two kinds One is risk exposure and the other one is the uncertainty element, and for the credit risk and the credit spirit represents the uncertainty element and credit exposure represents risk exposure. wherefore a bank can assess its credit risk by analysing the credit quality of an obligation and its credit exposure.While assessing credit quality and exposure a bank must consider three issues probability of default or any sort of possibility whether the other party which is the counter party will default on the obligation any over the life of the obligation over a specific plosive of time.The exposure of credit or the amount of the outstanding obligation which again depends on the size if there is any case of default.Rate of recuperation this is the extent towards which the credit can be recovered through some banking processes like bankruptcy and other proceedings of settlements.In the last cristal or so many banks have started to make use of models in order to assess the risks for their credit which they lend. The credit risk models are very complex and include algorithm based methods of assessing credit risk. The aim of such model is to help banks in quantifying, aggregating and managing credit risk. Despite the method the emphasis of credit risk assessment stays credit quality and risk exposure.Analysis of the Quality of Credit (Credit Quality)Credit quality is a measure of the that counterparties?s ability to perform on that obligation?. (Contingency Analysis, 2003) A bank adopts different approaches for assessing credit quality of considering loans to individuals or businesses. If it is for small businesses then the credit quality will be assessed through a process of credit scoring. This is bas ed on information obtained by the bank about the party who want the loan. The information which is gathered tends to be about annual income, alive debts etc. Credit score is generally headd by a formula which is applied to the information which is obtained which gives a number based on it the score is generated. The credit score is a highly accurate prophecy of how likely the party is to pay bills, the higher the score the better it looks to the bank. (Curry, 2007)However, assessing a large party is based on credit depth psychology of the loan done by specially designated credit analysts. This just like observe above is base on credit scoring but it involves benevolent judgement. It involves an in depth abbreviation of various aspect of the party in question including balance sheet, income statement etc. Also assessing the nature of the obligation is taken into account as well. On basis of credit analysis the analyst assigns that party a credit rating. This allows the bank to make decisions regarding credit. A bank can also use credit ratings to measure the share of the borrowers with creditworthiness in its portfolio and get a clear indication of default risk. meter Credit ExposureCredit exposure also needs to be taken into account when assessing credit risk or risk exposure. If for display case a bank has loaned money to a business, the bank may calculate the credit exposure rate as the outstanding balance on the loan amount. However, in case if the bank by any lay on the short letter has increased or extended the line of credit but none of the line have been drawn down then the approach will be different. In this case the risk exposure may reckon to be nil, but it does not reflect any sort of full by itself to draw down the line of credit. If the firm gets into any financial difficulty it can be expected to draw on the credit line before any bankruptcy. Therefore in this case the bank may consider its credit exposure to be equal to the line of th e credit. Credit exposure as a fraction can also be used sometimes to calculate the credit exposure for the center line of credit. (Duffie Singleton, 2003)How Banks Mange Their Credit RiskCredit risk management practices differ from bank to bank. Generally these caseful of practices are dependent on the type and complexity of the credit activities which are taken by the banks. In new-fangled years banks have been using models for credit risk management.Bank Credit Risk Management Practices Yesterday and TodayThe conventional approach to managing credit risk has been based on establishing a limit of credit at various levels for the individual borrowers an sometimes also based on geographic are and industry type. Also collateral and relationship exiting hardly expect adequate to cope with the declining economics of loan markets. (Gontarek, 1999) These limits specify the maximum exposures a bank is willing to take. Until the early 1990?s , credit risk analysis was limited only ba sed on the reviews of the loans of individuals and most of the banks kept the loans on their books for maturity. (Bernanke, 2006)In recent years banking industry has made strides in managing credit risk.Managing the credit risks is the main focus of any banking operation these days and many banking?s are looking now from transaction management to portfolio management. And have slowly changed from monitoring to practising and also predicting their performance. Banks are still holding onto traditional credit risk management tools but these are becoming more and more sophisticated. Various forms of tools and models have been generated to measure and predict the performance and management of portfolio risks which in turn build competitive advantage.Despite the differences in the credit risk management practices the credit risk management in any bank rest on four pillar ofappropriate credit risk environmentSound credit-granting process or criteria that includes a clear indication of the bank?s target marketAppropriate credit administration, measurement and monitoring processAdequate controls over credit risk. (Basel mission on Banking Supervision, 2000)Therefore whether traditional or modern, credit risk management in banks involves reviewing creditworthiness of counterparties, setting credit limits for counterparties, evaluation of credit risk and describe credit limits and exposures to management. (Caouette et al, 1998)Recent Trends in Credit Risk Management by BanksThe credit risk management is undergoing an important change in the banking industry. Banks have clearly indicated that centralization, standardization, consolidation, timeliness, active portfolio management and efficient tools for exposures are the key trump practice in credit risk management. (SAS, 2004) A bank in America is considering having efficient tools for ?what if? analysis and tools. Also another bank is commission on stress testing, concentration risk, macro-hedges and capital market r isk management. (SAS, 2004)The mass of the world?s large banks agree that integrating environmental and broader affable issues into their core credit risk management process is essential to managing credit risk in the 21stcentury. (Huppman, 2005) Leading banks including Barclays now view that these non traditional issues as real credit risk variables that potentially affect their client?s bottom lines as well as their own.Quantitative models are being used by banks to measure and manage credit risk. Most of the mercenary bankers have started to opt for making use of the credit risk models for their credit options especially with relation to consumer lending and mortgage. These models are known as credit scoring models and were developed for consumer lending. On the other hand it has been a some years ago where the use of these credit risks models have been implemented successfully and are integrated these days with almost every bank to manage their risk. (Bluhm et al , 2003)In 2 001, the UK?s biggest mortgage bank, Halifax, developed a precedent looking credit risk management strategy which made use of quantitative models for risk management. (Algorithmics Incoporate, 2001)Similarly HSBC serves over 125 million customers oecumenic and is the one of the world?s largest banking and financial services organizations. The world largest provider of quantitative credit risk solutions to lenders (Moody?s KMV) have decide to provide HSBC with this, which will provides HSBC a methodology for rapid, accurate measurement and benchmarking of credit risk portfolio. (Vyse, 2006)Role Of Management in Managing Credit RiskThe board of directors of a bank approve and review the credit risk strategy and significant credit risk policies of the bank. The bank?s strategy reflects the bank?s tolerance for risk and the level of profitability the bank expects to achieve for subject credit risks. These days banks establish and enforce internal controls and other practices to insu re that exceptions to policies, procedures and limits are reported in a timely manner to the management. Due to this credit risk is constantly monitored by the management.Innovations in Technology and Credit Risk ManagementCredit risk management in banks is also getting affected by innovations in technology. Innovations in technology have made significant improvements in bank information systems. This has also been advance by Basel II. The improvements in bank information systems has certainly increased the abilities of many banks and their management process to measure and identify and also control the characteristics of any kind of risk. For example ICBC (Industrial and Commercial Bank of China) the credit management computer system was further perfected with risk alert and conversion functions and it performed effective real-time monitoring on the quality and operations of the credit assets. (ICBC, 2001)