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Credit Risk - Essay Example

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Credit Risk

There has to be experience to scrutinize all the credit information and interpret the same. However good the analyses may have been, the bank will be in no position to distinguish a good borrower from a bad borrower, who has no intention of repaying the loan. Despite all the caution, bad loans do creep into the banks accounts. Thus, evaluation and pricing decisions should be followed up with periodic review of the account and the credit rating of the borrower. Any fall in the rating will increase the credit risk. Credit risks persist from the time the loan is granted throughout its life period and continuous review during this period will help in the early detection of the problem loans.
The above information is for monitoring the credit risk exposure at a micro level. If a broader outlook of the credit risk exposure and its position is to be determined, then a macro level approach has to be adopted. This is made possible through the use of the Capital Adequacy Ration (CAR). The capital adequacy of a bank, which is the ratio of its capital to its risk weighted assets (RWAs), provides information about the extent to which the possible losses can be absorbed by the capital. Normally, the ultimate defense against credit risk that a bank possesses will be its equity capital or net worth. If from an earnings position, it turns out into an operating losses position, it would be the equity capital account that absorbs such losses, thereby giving management time to reach to the situation. Therefore, it can be said that the higher the CAR the better it is for the financial institution.
The main aim of the credit policy of a bank will be to screen out the best proposals for acceptance. The Capital Adequacy rate provides a benchmark for monitoring the risk level considering the total assets of the company.
Commercial banks provide capital market related services, depository services, advises on portfolio management or investment counseling, etc. Many banks have now started offering investment services to the retail customer, which is essentially advice and execution of mutual fund investments and redemptions.

Advice on debt and equity is restricted primarily to new issues, with secondary market investments being discouraged. There are no charges for this service; in fact, customers are paid incentives/commissions for investing through them. The bank essentially gets its income from the mutual fund/broker directly and also cross-sells other banking products. Arbitrage, stock lending are products, which are beyond traditional asset management but still many banks are offering them to retain their customers ((ICMR), Commercial Banking, 2003).
Portfolio Management Services offered by banks can be differentiated into discretionary and non-discretionary services. Discretionary portfolio management allows the portfolio manager to take investment decisions on behalf of his/her clients within the broad parameters of asset allocation. Non-discretionary services of the type provided by banks essentially mean that the client has to authorize, every transaction done on his/her behalf. The non-discretionary services offered by a banker can be listed as follows:
Advisory services - Flexible, unbiased ...Show more


When there is a counter-party failure in performing the repayment obligation on due date, it gives rise to low quality assets which in turn lead to Credit Risk. Like the interest rate risk and liquidity risk, credit risk is also an inherent feature of any from that is into the business of lending funds either to individuals or to a corporate (ICMR), Credit Management, 2004).
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