Over the past few years, financial institutions have faced severe difficulties due to various reasons. However, the major cause of the banking problem is directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances leading to a deterioration in the credit standing of a bank’s counterparties.
Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximize a bank’s risk adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions.
When Credit Risk Arises
For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off the balance sheet. Banks are increasingly facing credit risk (or counterparty risk) in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions. The two most important factors to consider when evaluating credit risk are:
- Counterparty creditworthiness
- Portfolio concentrations
Counterparty credit risk can be identified by application of traditional counterparty credit analysis and monitoring.
Ratings agencies such as S&P and Moody’s assign credit ratings to companies by analyzing factors such as industry, size, leverage, quality of assets, management, strategy, earnings, growth, diversification, and country.
We can project expected future probabilities of default and ratings migrations for each credit rating using historical data of defaults and ratings changes. Another important factor to consider in assessing creditworthiness is projected recovery rate in the event of default.
To find hidden concentrations in portfolios, we analyze common factors that affect the well-being of firms, such as industry, sensitivity to commodity prices, and sensitivity to interest rates. In the end, an understanding of the credit risks will help portfolio managers to better identify pockets of concentration and opportunities for diversification better.
Integration of Market and Credit risk
An important area of research these days is the integration of credit and market risk.
An example here is the case of the bond, in which you have both credit as well as market risk. The credit risk comes in because of defaults, downgrades, and upgrades, and the market risk comes because of the fact that you can have spreads moving against or for you, and also the interest rate component moving against or for you.
An integration of these two components to come up with a capital which you’ll allocate to this entire position which you’ll have both market and credit risk components is an important area of focus.