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 transactions 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 thousand. In 1992, the banking sector experienced the first ever negative return on fairness, which it’s never happened before. There have been many other banks in the industrial countries, where losses reached freakish levels.

The analysis of credit risk was limited to reviews of individual loans, how the banks kept in their books to maturation. The banks have stride hard to manage credit risk until early 1990s. The credit risk management today, involves both, loan reviews and Standby Letter of Credit. collection analysis. With the advent of new technologies for buying and selling risks, the banks have taken an application away from the traditional book-and-hold lending practice. It’s been done in favour of a broader and active strategy that needs the banks to study the risk in the best mix of assets in the existing credit environment, market conditions, and work from home opportunities. The banks have at the moment found to be able to manage collection levels, maturities, and loan sizes, eliminating handling of the problem assets before they start making losses.

With the increased accessibility to financial instruments and activities, such as, loan syndications, loan trading, credit derivatives, and creating sec, backed by costly of assets (securitisation), the banks, important, can be more active in management of risk. As an example, activities on trading in credit derivatives (example — credit default swap) has exploded exceptionally during the last a decade, and presently stands at $18 trillion, in notional terns. As it stands now, the notional value of the credit default replace (a replace designed to transfer the credit exposure of fixed income products between parties) on many established corporate, is higher than the value of trading in the primary debt sec, received from the same corporate. Loan syndications grew from $700 thousand to more than $2. 5 trillion between 1990 and 2005, and the same period saw a rise of loan trading, which grew from less than $10 thousand to more than $160 thousand. For the banks, sec pooled and reconstituted from loans or other credit exposures (asset-backed securitisation), provided the way to reduce credit risk in their portfolios. This could be authorized 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 allowance of its on-going credit allowance activities. Some of the banks use a more comprehensive credit risk management system, by critically studying 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 conform 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 counting mainly on the personal judgment of the loan sanctioning reps, now use a more advanced method of srutinisation, applying the statistical model to data, such as credit scores of these individual. The lending activity of a bank has its credit risk invariably embedded, as you finds in the market risk. It all such cases, banks need to monitor risks by managing it efficiently, ingesting the risk involved.

Pricings of relevant risks are essential when-ever a bank moves in a lending contract with a corporate borrower. New analytical tools now enable banking organizations to calibrate 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 permits the bank to price the risk before originating the loan. Banks often use internal debt rating, or alternative party systems, that uses market data to gauge the measure of risk involved, when lending to corporate giving stocks.

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