Credit Risk: What We Know, What We Don’t Know And What We Should Know

What we know

Credit risk has been for a long time been accredited to a number of financial crises in the world most recently the collapse of asset backed commercial paper (ABCP) in 2006 and 2007 which was caused by massive defaults of mortgages which had been issued by various financial institutions in the US with very high rates. This collapse set out a chain of happenings to result in a very serious global financial crisis ever since the Great Depression in the 1930s. This has been one of the major negative impacts of credit risk to organizations. Improper management of credit risk has led to fall of major financial institutions in the world e.g. Lehman Brothers.

In this essay credit risk and Credit Risk Grading (CRG) will be discussed and the importance of CRG to an organization will be spelt out.

CRG is a very crucial activity which organization needs to include in their risk management processes. We all know that no type of risk can be completely eliminated but organizations should continually pursue ways in which they can mitigate its impacts incase the unexpected happens.

Credit Risk

This is the possibility that a counter party or borrower will not meet the agreed upon obligations. More than 50% of the entire risk elements in banks and financial institutions worldwide are Credit risk alone. Managing credit risk in attaining efficient management of financial institutions has increasingly become an important task. Management of credit risk is about identifying, measuring, matching mitigations, monitoring and controlling of the exposures of credit risk (Nickell, et al 1998).

Credit risk mostly does not happen in isolation. For instance, an interest rate rise can be detrimental to the creditworthiness of the issuer of the bond hence increasing the credit risk of the financial institution holding the bonds. On the other hand a fall in the bond value increases the market risk for the financial institution.

What we don’t know

Credit Risk Grading

Credit risk grading (CRG) refers to a pre-specified scale which reflects the credit risk which is underlying for a given level of exposure. Credit risk uses employs the use of alphabet/symbol/number which represents the risks associated with a certain credit exposure. CRG is the appropriate module for establishing a system of credit risk management.

Credit Risk Grading is a crucial element that helps in the process of credit risk management as it helps the various financial institutions in understanding the dimensions of risk that come along when dealing with credit transactions. This task of credit risk grading of lines of business, borrowers and business activities provides a better view of the credit portfolio quality of a financial institution. Credit risk grading systems are important in taking appropriate decisions at both post and pre-sanction stages (Carey, 1998).

Credit grading helps at the pre-sanction stage to sanction authority in deciding on whether to lend or not, the extent of exposure, what the lending price should be, the various facilities, appropriate credit facility and the numerous risk mitigation techniques to put a cap on the level of risk (Lopez, 1999a).

CRG can be beneficial at the post-sanction stage in helping financial institutions decide about the depths of the renewal or review, the frequency of the review, frequency of the grading and several other measures to be taken. CRG should be invoked at the start of lending and it should be updated annually. Grading of credit risk should however be reviewed in instances of adverse events. Portfolio monitoring entails that financial institutions should come up with reports concerning credit risk exposure by risk grade. Enough migration and trend analysis should be done to come up with any credit facility deterioration. Accuracy and consistency of the grading of the credit risk should be periodically examined by a function for instance an independent credit review.

What we should know

Functions of Credit Risk Grading

CRG systems that are well managed promote soundness and safety in financial institutions through enhancing decision making which is informed. Credit risk is measured by grading systems which also differentiates groups and individual credits by the risks they offer. CRG allows management and examiners of financial institutions to observe trends and changes in their levels of risk. CRG further allows the management of financial institutions to efficiently manage risk and optimize their results (Kupiec, 1995).

Use of Credit Risk Grading

The CRG matrix allows the use of standards which are uniform to credits in order to attain a common standardized view in order to easily asses the credit portfolio of a business, unit, line or the financial institution as a whole, or the quality of individual obligor.

Grading of credit risk would be relevant in monitoring and surveillance and assessing the risk profile of a financial institution.

The CRG provides a measurement of risk which is quantitative which gives the level 0f risk of the borrower hence enabling fast decision making.

CRG offers a quantitative framework used for assessing the requirement in provisioning of the portfolio of credits of financial institutions.

The CRG results are relevant for credit selection at individual level, as borrowers and their risk exposure is already rated (Carey, 1998).

In summary

In taking lessons from the sub-prime mortgage lending crisis also commonly known as ‘mortgage meltdown’ or ‘mortgage mess’ that started in the US mortgage market, financial institutions can now understand better the concept of credit risk that existed in the sub-prime borrowing by individuals and lending by financial institutions.

After considering the importance of credit risk grading, it is therefore a noble idea for players in the financial system to develop carefully a model for grading credit risk which is in line with the objective outlined above (Berkowitz, 1999).

References

Altman, E.& Saunders, A., (1997). “Credit Risk Measurement: Developments over the Last Twenty Years,” Journal of Banking and Finance, 21, 1721-1742.

Basle Committee on Banking Supervision, (1999). “Credit Risk Modelling: Current Practices &Applications,” Basle Committee on Banking Supervision, Basle. (http://www.bis.org/press/index.htm)

Berkowitz, J., (1999). “Evaluating the Forecasts of Risk Models,” Manuscript, Trading Risk Analysis Group, Federal Reserve Board of Governors.

Carey, M., (1998). “Credit Risk in Private Debt Portfolios,” Journal of Finance, 53, 1363-1388.

Diebold, F.X., Gunther, T. & Tay, S., (1997). “Evaluating Density Forecasts with Applications to Financial Risk Management,” International Economic Review, 39, 863-883.

Diebold, F.X., Hahn, J. &Tay, A.S., (1998). “Real-Time Multivariate Density Forecast Evaluation and Calibration: Monitoring the Risk of High-Frequency Returns on Foreign Exchange,” Manuscript, Department of Economic, University of Pennsylvania.

Diebold, F.X. and Lopez, J.A., (1996). “Forecast Evaluation and Combination,” in Maddala, G.S. and Rao, C.R., eds., Handbook of Statistics, Volume 14: Statistical Methods in Finance, 241-268.Amsterdam: North-Holland.

Diebold, F.X. and Mariano, R., (1995). “Comparing Predictive Accuracy,” Journal of Business and Economic Statistics, 13, 253-264.

Kupiec, P., (1995). “Techniques for Verifying the Accuracy of Risk Measurement Models,” Journal of Derivatives, 3, 73-84.

Lopez, J.A., (1999a). “Regulatory Evaluation of Value-at-Risk Models,” Journal of Risk, forthcoming.

Lopez, A., (1999b). “Methods for Evaluating Value-at-Risk Estimates,” Federal Reserve Bank of San Francisco Economic Review, forthcoming.

Nickell, P., Perraudin, W. & Varotto, S., (1998). “Ratings- Versus Equity-Based Credit Risk

Modelling: An Empirical Analysis.” Manuscript, Conference on Credit Risk Modelling & Regulatory Implications.