Credit Risk
There is always
uncertainty in a counterparty's ability
to meet its obligations.
While banks and
financial institutions have faced difficulties over the years
for many reasons, 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 Basel
Committee is issuing this document in order to encourage banking
supervisors globally to promote sound practices for managing
credit risk.
Although the
principles contained in this paper are most clearly applicable
to the business of lending, they should be applied to all
activities where credit risk is present.
The sound
practices set out in this document 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.
The Committee stipulates in Sections II through VI of the paper,
principles for banking supervisory authorities to apply in
assessing bank's credit risk management systems. In addition,
the appendix provides an overview of credit problems commonly
seen by supervisors.
A further particular instance of
credit risk relates to the process of settling financial
transactions.
If one side of
a transaction is settled but the other fails, a loss may be
incurred that is equal to the principal amount of the
transaction.
Even if one
party is simply late in settling, then the other party may incur
a loss relating to missed investment opportunities.
Settlement risk
(i.e. the risk that the completion or settlement of a financial
transaction will fail to take place as expected) thus includes
elements of liquidity, market, operational and reputational risk
as well as credit risk.
The level of
risk is determined by the particular arrangements for
settlement.
Factors in such arrangements that have a bearing on
credit risk include: the timing of the exchange of value;
payment/settlement finality; and the role of intermediaries and
clearing houses.
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According to
the Basel iii framework, banks should
have methodologies that enable them to assess the credit risk
involved in exposures to individual borrowers or counterparties
as well as at the portfolio level.
Banks should
assess exposures, regardless of whether they are rated or
unrated, and determine whether the risk weights applied to such
exposures, under the Standardised Approach, are appropriate for
their inherent risk.
In those
instances where a bank determines that
the inherent risk of such an
exposure, particularly if it is unrated,
is significantly
higher than that implied by the risk weight to which it is
assigned, the bank should consider the higher degree of credit
risk in the evaluation of its overall capital adequacy.
For more
sophisticated banks, the credit review assessment of capital
adequacy, at a minimum, should cover four areas: risk rating
systems, portfolio analysis/aggregation, securitisation/complex
credit derivatives, and large exposures and risk concentrations.
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