Credit Risk
There is always
uncertainty in a counterparty's ability
to meet its obligations.
According to the Basel Committee on Banking Supervision,
Principles for the Management of Credit Risk:
The major cause of
serious banking problems continues to be 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 that can lead to a deterioration
in the credit standing of a bank's counterparties. This experience
is common in both G-10 and non-G-10 countries.
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
maximise 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. Banks should also consider the
relationships between credit risk and other risks.
The effective management of credit risk
is a critical component of a comprehensive approach to risk
management and essential to the long-term success of any banking
organisation.
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.
Since exposure to credit risk continues to be the leading source
of problems in banks world-wide, banks and their supervisors
should be able to draw useful lessons from past experiences.
Banks should now have a keen awareness of
the need to identify, measure, monitor and control credit risk as
well as to determine that they hold adequate capital against these
risks and that they are adequately compensated for risks incurred.
The sound practices specifically address
the following areas:
(i) establishing an appropriate credit
risk environment;
(ii) operating under a sound
credit-granting process;
(iii) maintaining an appropriate credit
administration, measurement and monitoring process; and
(iv) ensuring adequate controls over
credit risk.
Although specific credit risk management
practices may differ among banks depending upon the nature and
complexity of their credit activities, a comprehensive credit risk
management program will address these four areas.
These practices should also be applied in
conjunction with sound practices related to the assessment of
asset quality, the adequacy of provisions and reserves, and the
disclosure of credit risk, all of which have been addressed in
other recent Basel Committee documents.
While the exact approach chosen by individual supervisors will
depend on a host of factors, including their on-site and off-site
supervisory techniques and the degree to which external auditors
are also used in the supervisory function, all members of the
Basel Committee agree that the principles set out in this paper
should be used in evaluating a bank's credit risk management
system.
Supervisory
expectations for the credit risk management approach used
by individual banks should be commensurate with the scope and
sophistication of the bank's activities. For smaller or less
sophisticated banks, supervisors need to determine that the credit
risk management approach used is sufficient for their activities
and that they have instilled sufficient risk-return discipline in
their credit risk management processes.
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