Credit risk refers to the possibility that a debtor will not repay the principal or other cash flows as per the terms of the credit agreement. In banking, credit risk refers to the possibility that repayments by debtors may be delayed or never paid, therefore, affecting a bank’s liquidity and operations (Greuning & Bratanovic 2009). Managing risk is very important for banks because this will make the difference between the success and failure of the organization. The emphasis in credit management in banking is on loans, determining the creditworthiness of a person seeking a loan, and evaluating the policies of other companies that offer credit and other financial instruments. Effective credit risk management aims to identify, quantify and monitor a certain risk profile. (Bank for International Settlements 1999)
Banks and credit risk
Banks operate in a very volatile environment therefore the banking industry presents lucrative opportunities that would enhance profitability for the banks if this opportunity is taken. On the other hand, the banking industry entails major risks which cannot be dealt with using the traditional method of banking. Banks must be up to date with the latest and most relevant approach to use in managing risk. This is the only way the banks can survive in the face of competition and an ever-changing business environment (Greuning & Bratanovic 2009).
According to Graham & Coyle (2000), banks have to come up with policies that assist management to identify high-risk clients. They assert that many of the bad debts faced by banks originate during periods when the economy is solid and the micro and macro environments are favorable for increased profitability. During such periods banks are more willing to give loans to increase business. Loans are granted easily to individuals and companies. However, when the economic conditions deteriorate, the banks are faced with the problem of late or lack of repayment. Businesses with decreased operations find it hard to repay their loan commitments while individuals struggle to repay the loans they took. A major dilemma faced by banks is to find out if a customer will present a risky situation during the period of recession. (Baesens & Gestel 2009)
The Internal rating based approach
The internal ratings-based (IRB) approach was proposed by the Basel Committee on Banking in 2004. This approach allows banks to use their measurement and policies for the main drivers of credit risk. However, this is subject to certain provisions and approval from supervisors. The internal ratings-based approach is primarily used to gauge the probability that a customer will default in paying the principal and interests according to the credit agreement. (Basel Committee on Banking Supervision 2005)
The main input parameters used in the internal-rating approach are the loss given default (LGD), exposure at risk (EAD), and the probability of default. Management has the responsibility to certify all these parameters in the process of approving a loan or other financial instrument are followed. Internal rating and the processes of estimating the risk of a particular borrower should be subjected to evaluation to find out whether or not they are effective. The rating system that is adopted by a company depends on various factors such as the type of borrower, how substantial the risk exposure is, the availability of information about the borrower, and ratings from external sources. The process of validating a borrower is very difficult and it requires a vast knowledge of the rating systems and procedures (Basel Committee on Banking Supervision 2005)
Banks that have received the go-ahead can use the internal rating-based approach to estimate risks. Therefore, they use their internal measures and computations of capital requirements for a specific level of risk. The extent of the unexpected losses and the expected losses is useful for the internal rating system. (Moodys Investors Service 1999)
The standardized approach
The standardized approach was brought forward under the Basel II capital adequacy policies for banks. It is a method of measuring the credit risk that a bank or financial institution may be exposed to. This method requires the banks to manage their credit risk using ratings from the External Credit Rating Agencies and not their rates to compute the riskiness of a certain venture. It is a simpler method than the techniques which require the bank to come up with its internal rating procedure. (Basel Committee on Banking Supervision 2005)
The standardized approach uses a more diverse risk weight scale and recognizes more ways to diminish credit risk. The capital ratios that are generated are more representative of the actual risks in the market. The rating scale for the standardized rating is assigned a credit assessment which is in the form of a group of letters. From excellent to poor, the letters are as follows: AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. Different types of risk weights are assigned to different types of borrowers considering their assessment levels.
AAA is allocated 0% risk weight because it is assumed that the risk involved is minimal. A rating that is below B- is given the highest risk weight of 150% because there is a high chance that the client will be unable to pay back the loan. The better the credit rating and financial position of a client the lower the risk weight attached. (Basel Committee on Banking Supervision 2005)
How banks stack up against the two approaches
For the banks to come up with useful information concerning the possibility that a borrower will be able to pay back the money borrowed, relevant data is required. Data is important in developing an appropriate rating system that can be used in credit risk management. This is especially important for the internal rating approach. Australian banks ensure that they have access to shared databases which will provide them with credit rating information for individuals or companies from several banks. Access to information from different banks will enable a specific bank to come up with an average rating that is at par with that of other banks in the industry. (Basel Committee on Banking Supervision 2005)
Banks using the internal rating system use the current data in the market so as to obtain up-to-date information. If the data used is historical, up to three years is used. The data used is usually updated often especially if there are major changes in the current market environment. This can be due to changes in the inflation rates, interest rates, or other conditions in the economy. The data obtained is kept in secure conditions and is put in the internal model in a timely and accurate manner. Any data that has errors or does not show the actual situation in the market is deleted. Although the current data is very useful, banks find it necessary to have enough historical data so as to monitor the volatility of assets that are given as collateral. (Basel Committee on Banking Supervision 2005)
Research is very useful in assisting Australian banks to access relevant data that can be used for decision-making. Researchers carry out studies to find out the probability of default by firms in a certain industry, individuals with specific traits, and other entities. In addition, the research is done to find out the factors that affect default by companies and individuals in repaying loans. This information is used to create credit portfolio models. (Basel Committee on Banking Supervision 2005)
External supervision is necessary for ensuring that the Australian bank’s decisions are regulated. This also earns the bank credibility. It is necessary to have another party involved because this will ensure that the bankers are not involved in dishonest activities during the process of rating. (Basel Committee on Banking Supervision 2005)
Banks using the internal rating system have to meet certain requirements in order to come up with reliable internal models which can be used to estimate the risk that they will face. The integrity and reliability of a bank’s risk management systems are very important. These systems can assist the bank in identifying and dealing with risk. Banks also stack up against the internal rating approach by ensuring that the employees who are charged with the responsibility of risk management and the rating process are well educated and skilled. (Reserve Bank of Australia 1999)
The internal rating system can only be effective if the models that are created are useful and accurate. Banks ensure that the models that are used to gauge the borrowers are accurate in finding out how risky it is to engage in business with them. There are also various internal control measures that are put in place by Australian banks. This ensures that there is integrity and accountability in all the relevant internal processes. The banks have to meet the minimum criteria prescribed by the Committee so that they can be permitted to employ the internal rating system. (Reserve Bank of Australia 1999)
Australian banks using the internal rating system have a validation process for the internal processes. This process specifies the tests and procedures which are carried out by the bank to ensure that the model is reliable. The validation process also considers the broadness of the model so that it covers all the products of the bank that can bring about a certain degree of credit risk. (Basel Committee on Banking Supervision 2005)
The standardized approach requires that the banks consistently use the risk weightings from a specific External Credit Rating Agency. The banks do not use rates provided by different External Credit Rating Agencies. The banks usually disclose the risk weightings that they use. Supervisors are in charge of determining the type of rating that is to be used by a certain bank for a specific institution. (Basel Committee on Banking Supervision 2005)
When a bank receives security for a certain loan, it has to follow certain stipulated standards. Banks in Australia have to ensure that the legal procedure to verify the ownership of the asset is carried out. Collateral is usually sold to recover the money lent if the borrower is unable to pay back due to bankruptcy or inability to pay. Banks have to fulfill all the contractual requirements such as registration with the registrar. In addition, the banks seek legal guidance concerning the enforceability of certain security. Banks often revalue the assets and marketable securities that are offered as collateral periodically. (Basel Committee on Banking Supervision 2005)
Banks categorize the exposure to risk into classes so as to assign a specific client of the right group with the corresponding risk level. These classes are corporate, bank, retail, sovereign, and equity. The different groups have specific risk weights which are used to assess the risk level of customers seeking loans. This division is important because it enables and eases the process of rating and enhances the bank’s ability to adhere to the set method of credit risk management. (Reserve Bank of Australia 1999)
When computing the sovereign risk weight of a particular country, banks consider the internal environment of the country. This includes the country’s economy, the political environment, and the future financial prospects of the country. For individuals, a bank considers the financial capabilities of the person and if his or her income will support a continual payback plan. Businesses have to show the ability to generate enough income to ensure that the loan is repaid. Therefore the balance sheet, the cash flow statement, and the income statement have to be in a sound financial position. By doing this the banks are protecting themselves from credit risk. (Basel Committee on Banking Supervision 2005)
Banks are free to use either the standardized system or the internal rating approach. However, this should be subject to the conditions in the markets and the trend in the market. The method that is employed should be one that best estimates the risk that will be faced by the firm. This will reduce the chances of the bank suffering losses from credit risk if clients are unable to pay back the principal and the interest.
List of References
Basel Committee on Banking Supervision 2005, International Convergence of Capital Measurement and Capital Standards, Revised Framework, Commonwealth Treasury Economic Round Up. Commonwealth Treasury, Canberra.
Gestel, T & Baesens, B 2009, Credit risk management: basic concepts: financial risk components, rating analysis, models, economic and regulatory capital, Oxford University Press, New York.
Graham, A & Coyle, B 2000, Measuring credit risk, Fitzroy Dearborn Publishers, London.
Greuning HV & Bratanovic SB 2009, Analyzing Banking Risk: A Framework for Assessing Corporate Governance and Risk Management, World Bank Publications, Washington.
Moodys Investors Service 1999, Bank credit risk in emerging markets. Web.
Reserve Bank of Australia 1999, Bulletin and Annual Reports, Reserve Bank of Australia, Sydney.