Credit Risk Measurement

Credit risk is a common buzz word in many of the financial institutions. Many of such financial institutions come across various problems over the years for a number of reasons.

And the prime reason for the serious banking problems is plainly linked with the negligent credit standards for the borrowers and counterparties, poor risk management and several such factors which lead to the weakening of the credit standing of a bank’s counterparties. This is a common situation in both the G10 countries and non-G10 countries.

The term credit risk is defined as the risk that a counter party to a transaction fails to execute agreeing to the terms and conditions of the contract and thus effecting claim holder to bear a loss. In simple words credit risk is the risk that a borrower will not be able to pay back its debts. The main intention of the credit risk management is to increase the bank’s risk adjusted rate of return. This is done by asserting credit risk revelation within the acceptable guidelines. Banks need to handle the permanent existing problem of credit risk in the portfolio and even in the risks involved in individual credits or transactions. Banks should even manage the risks that are related to the credit risks and other risks. The effective administration of the credit risk is a crucial element in extensive approach to the risk management. This is also an effective means for the long-term success of the bank.

The huge and the most palpable source of the credit risk in many of the banking systems are loans. However many other sources of this risk originate through the activities of bank including in the bank booking and in the trading book. This list also includes acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, equities, options, and settlements of transactions. As this credit risk is an alarming problem in banks world-wide, so the banks and their supervisors should be in a position to get all the required lessons from the past experiences. Banks should also be able to determine measure, monitor and control credit risk and perhaps be in a state to hold adequate capital against these risks and be able to compensate the risks that would occur. A committee named Basel committee has issued a document in regard to encourage the supervisors around the globe to practice the solutions for the risks.

There are several areas in which the practices of the credit risk in the Basel committees document. The various fields include establishing an appropriate credit risk environment, operating under a sound credit-granting process, maintaining an appropriate credit administration; measurement and monitoring process, and ensuring adequate controls over credit risks. It is not that necessarily all banks follow these solutions as it depends on the nature and complexity of the bank’s credit activities. All the members in the Basel committee should agree to the principles that are laid down to resolve and evaluate the bank’s credit risk management system. Thus this approach differs for various banks.