While taking a journey through the world of credit risk, Mitali Kalita discovers that the survivors are the ones who make the quick, mature and right decision at the right time

Chennai: Managing credit risk has always been the most risky business in the financial services industry. If we look back into the past, we will find that poor management of credit risk was the root cause behind most of the major banking disasters.

Being the oldest risk in the market, it was not given much attention and almost remained aloof to the advent of technology until the late 1990s. With the introduction of banking regulations, there is an awareness in the industry now to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against this risk. Credit risk not only affects the lenders but also any company that receives funds for products or services.

After operational risk, the biggest challenge facing the industry is credit risk because large-scale borrower defaults may even force a bank into bankruptcy. As the market has turned increasingly competitive with the mushrooming of new players, it is quite evident that companies are taking on more credit risk. But for a more transparent market and healthy competition, the financial services industry must turn credit risk into an opportunity.

This article takes a journey through the world of credit risk. It gives readers a view of how to manage the most significant risks and lists the challenges and benefits of implementing a credit risk management practice across an enterprise. The article concludes with a glimpse of the current scenario regarding the evolving trend of credit risk mitigation.

Management tactics
Most significant among all the other risks, credit risk is applicable to all banks as they give loans, take guarantees for the performance of other loans or pass on the line of credit to the customers. According to Basel II, banks must measure credit risk for credit in corporate, inter-bank, government, retail, project finance and equity.

The financial services industry must manage credit risk at both individual and portfolio levels. However, individual management of credit risks requires relevant and specific knowledge of the counterparty's business and financial status. In the area of personal credit, compared to the UK, the financial services organisations in the US have gained considerable experience in the evaluation of credit defaults by using models and the advanced risk management methods.

Over the years, these models have evolved significantly and today they are accepted by the industry as stable and accurate. The sad part of the story is that the operation of these models requires a huge amount of data. An industry estimate reports that for a good model, at least 500 defaults and 500 normal credits must be entered into the system for accurate and reliable predictions. Thus, it is likely that only large banks will be capable of using the advanced risk management practices laid down by Basel II.

The internal ratings-based (IRB) requirements of Basel II are quite painstaking and once a bank elects to use the IRB approach in one portion of its loan book, it must do so for all of its loans. This universal application will challenge most banks because they typically run their lending businesses by department or branch.

While the industry has made rapid progress in solving the individual aspects of the credit risk management problem, a consistent strategy to manage all sources of credit risk has not been taken up. Even the biggest financial organisations are yet to integrate disparate components of credit risk for an enterprise-wide credit risk framework.

It may be mentioned here, that the sources of credit risk are diverse including corporate and government bonds, credit derivatives, over-the-counter derivatives (such as interest rate swaps) to syndicated loans, middle market and small business commercial loans, to retail mortgages and credit cards. So, the move from the silo approach towards an integrated one will be a daunting task.

Realisation challenges

• Required data needs to be aggregated from a variety of disparate systems using enterprise application integration (EAI) techniques. At the moment, there are many different approaches to EAI and each of them involves a fair amount of customisation to the firm's systems and operations. These efforts are quite involved and costly and if a firm changes a system or parts of its operations, it may have an impact on the proper collection of the necessary aggregation of credit risk data.
  
• Though there are a variety of standards for measuring credit risk, there is not a clear favourite one. Each firm needs to choose an approach for measuring their credit risk since the EAI efforts will be coordinated to aggregate data for this method. If the approach that they choose falls out of favour or is not appropriate for the evolution of their business, then they may need to repeat their efforts for a new method - and this could prove costly.
  
• Since this area is relatively new, there is a shortage of experienced enterprise-wide credit risk management systems and specialists.

Realisation benefits
The irony is that these difficulties will bear fruits in the future as the benefits of implementing an enterprise-wide credit risk framework includes:

• A healthy transfer of credit risk pricing between the origination and the portfolio management function.
  
• Reduction of credit losses and volatility of credit value.
  
• Better opportunity for liquidity of credit risky instruments for trading and hedging decision.
  
• More effective management of regulatory and economic capital.
  
• Proficient distribution of credit risk capital through the comparison of myriad business eventualities.
  
• A transparent picture to the shareholders and the regulators.
  
• Increased internal leverage of human resources, systems, methodologies and data.

As a result, banks are expected to undergo a huge cultural shift as they attempt to consolidate the lending risk. Besides changing practices that have until now been based on qualitative factors, the need for hard numbers will engulf many currently used technologies.

According to a study conducted by the UK-based Institute of Financial Services and commissioned jointly by IBM and SAP, the financial industry will face significant challenges in successfully coordinating a complex systems integration project, building a data model and database to support credit risk and developing the risk/quantitative models.

Acquiring people with the necessary skills to carry out the projects was also highlighted as a key concern. For credit risk, most institutions (93 per cent) see it as vital to achieve at least some form of internal ratings based measurement from day one so they stand a chance of cutting their capital charge and to show the analysts that they have adequate credit risk systems.

Mitigation scenario
For decades mitigation of credit risk has been mainly achieved through selecting and monitoring borrowers and through creating a well-diversified loan portfolio. More recently, new financial instruments and risk sharing markets have evolved; in particular, markets for credit derivatives virtually exploded during the 1990s.

The Bank for International Settlements in its annual report said that in the early 1990s, the market for credit-risk transfer from banks on to the buyers of securities and loans involved few billion dollars-worth of loans; by 2002, that figure had grown to more than $2 trillion.

Credit derivatives have helped financial organisations to transfer credit risk from one party to another to effectively manage credit risk. Now, banks and investors can isolate credit risk from the inherent influences of the underlying lending relationship. This new opportunity also helps the personal credit sector to expect significantly reduced capital charges.

Studies published by the Bank for International Settlements demonstrate that, for a given sample of international banks, capital charges will fall down an average of 33 per cent. Certain banks can expect a much greater reduction. Savings of 33 per cent of capital will permit the extension of 33 per cent more credit, and, therefore, lead to a significant rise in a bank's profitability.

The Basel II regulation is likely to add fuel to this trend because new rules on how much capital banks must hold, will make a few lending decisions even more profitable - for example loans to medium-sized institutions. Fitch, one of the big three credit-rating agencies, quizzed 150 participants in the credit-derivatives market and found that banks in the US and Europe are net buyers of credit protection, to the tune of nearly $190 billion; insurance companies and other financial organisations are net sellers, to the tune of $300 billion.

Optimistic development?
Experts say the recent wave of transferring credit risk could be considered as an optimistic development. In general, the mitigation of any kind of unwanted risk is an optimistic development. The rapid growth of the credit derivatives market serves to further validate the view that credit risk is an undesirable risk.

"However, it should be noted that credit derivatives do not perfectly eliminate credit risk. Instead, a credit derivative only serves to exchange a credit exposure to one risky counterparty with another exposure to a less risky counterparty - for a negotiated price based on their risk ratings," says Mark Engelhardt, director (business development), Pinnacle Systems, a New Jersey-based technology consulting and solutions provider to Capital Markets firms.

The perceived risks of these counterparties are based on a variety of methods and industry research - much of which requires appropriate disclosure by the respective firms. The moves in the industry to regulate the management and disclosure of credit exposures will lead to more accurate assessments of counterparty risk. And, this in turn should support a more efficient and transparent derivatives market. Overall, it can be said that the existence of an efficient and transparent credit derivatives market is a good development for credit mitigation needs of the firms that participate in that market.

Conclusion
From the above report, we can quite safely conclude that the financial services industry has had sleepless nights. The industry is heading towards large-scale challenges such as the collection of all the necessary data, integration of all the various risks and upgrading of legacy systems. Extending credit risk across the organisation will also bring a huge internal cultural change in the industry. But all of these changes will come at the cost of huge investments in technology and human resources.

Though it is expected that the end result will definitely help to build a safer and more transparent global financial system, for the time being organisations must prioritise their needs of the hour and work accordingly. In this complex global financial market, it is the age of 'survival of the fittest' and those that want to survive and thrive must make the quick, mature and right decision at the right time.