Credit Risk Models in Financial Institutions - Essay Example

The most critical factor that affects the 3Cs of a bank is 'Credit Risk'. Banking is a domain where 'risk-free' activity is an unknown concept. Particularly in the field of credit appraisal, risk is associated with every decision made by the portfolio analyst. Although it is not possible to wipe out risk altogether, it can be reduced to a manageable level. Stated simply, 'zero-risk' situation is impossible to be achieved in banking. There have been considerable discussions regarding the role of the portfolio analysts and credit officers in banks.

It has been noted that in several cases, officers are forced to 'take' a decision rather than 'making' a decision due to the lack of freedom to analyze and make a decision based on the merits of the case. There are two ways of reaching to a decision; subjective and objective. A subjective decision is based on the impression the bank has about the counterparty. Although this method has a substantial role to play in the decision making process, an objective analysis instils a certain degree of integrity, security and refinement.

Credit Risk Management is an activity of paramount importance for any bank. Effective risk management increases the stakeholder value by providing for 'value creation', 'value preservation' and 'capital optimization'. Credit Risk Modelling is the first step towards implementing a robust risk mitigation environment. Credit risk models are intended to aid banks in quantifying, aggregating and managing risk across geographical and product lines (BIS, 1999). The pith of the report will cover various aspects of credit risk modelling such as 'techniques to measure risk', 'building an assessment model' and the various prevalent credit risk models being used world wide.

In the process the report also throws light on subjects such as banking risks and credit risk parameters.What is Credit RiskRisk taking is a synonymous with credit appraisal. Risk taking is not an activity that takes place by chance; rather it is a deliberate action in the process of financial decision making. Risk is a factor, which, if it takes effect, produces undesirable outcomes for the bank. Bhargava (Bhargava, 2000) presents an insightful pie chart describing the main financial risks that are prevalent in the banking industry.

Figure: Pie Chart showing the proportion of Financial Risks (Bhargava, 2000)It can be clearly seen that Credit Risks occupy a major portion of the pie and a bane for most bankers across the world.Risk Management Group of the Basel Committee on Banking Supervision defines credit risk as "potential that a borrower or counterparty of a financial institution will fail to meet the obligations in accordance with the agreed terms" (bcbs54, 2000). In other words, the probability that the receiver of the loan will not pay back in full, within the specified time frame, the complete repayment amount {including any interest and service charge} is called credit risk.

Lack of appropriate lending discipline and inadequate system of control generally results in setbacks to banks. Several major banks such as Enron have collapsed due to poor transaction management, incomplete credit information and