Differences in Assessing and Managing Credit Risk in Investment Banking and Commercial Banking - Essay Example

Running Head: Credit risk in Investment Banking and Commercial Banking Differences in Assessing and Managing Credit Risk in Investment Banking and Commercial Banking Differences in Assessing and Managing Credit Risk in Investment Banking and Commercial Banking The two different branches of banking namely commercial banking and investment banking have different purposes and though both involve credit risk which is fundamental in their operations, the methods of assessing and managing them differ. Investment banking deals with raising of funds in the capital market (both debt and equity) by issuing and selling securities. They help public and private corporations, governments and their agencies in raising funds in the primary market as well as provide advisory services for acquisitions, mergers and other such financial transactions and they also act as intermediaries in trading for their clients. Investment banking is one of the rapidly increasing financial businesses globally and global investment banking revenue increased concecutively for the third year running in 2005, to $52.8bn. Commercial banking involves borrowing and lending money to individuals and corportions.. It accepts and holds cash deposits legally and lending loans is also a legally binding act between the bank and the borrower. Commercial banking undertakes less capital market risk compared to its total capital. For commercial banking credit risk is more important than the market risk. Both the financial operations involve risks, which can be broadly classified in to operational risks, credit risks, liquidity risks, business risks and market risks. Though market risks are higher for investment banking, determining credit risk is also crucial. Credit risk represents the possibility of loss due to the inability of the obligor to fulfill the terms in the financial obligation (bond, note, lease, installment debt etc.). The credit risk is known by slightly different terms in investment and commercial backings. Counterparty credit risk is important for investment banking mainly in trading operations and loan credit risk is crucial in commercial banking. Though both may be caused by the same reason, default, they are managed differently. Credit risk becomes a very serious issue if accompanied by poor banking operations. Proper systems and controls should be in place for effectively assessing and managing credit risks in both type of banking operations. Assessing Credit risk in Investment Banking and Commercial Banking Credit risk arises when a borrower of a loan fails to repay it (in commercial banking) or when an issuer of a security or a bond fails to fulfill his financial obligation (a corporate who issued a bond may go bankrupt) to the borrower (in investment banking). For assessment of credit risks in the financial products the investment banking firms (which is more complex compared to assessment in commercial banking) rely on the credit rating (considered as the representation of the financial strength of the issuer or the product that is issued to meet its financial obligations) assigned to the issuer by the major credit rating companies. To arrive at the credit rating, the agencies carry out a research and an assessment of the account statements (income and expenditure, balance sheet), quality of the management, previous business and financial track records, the potential business and financial risks and the ability of the management to mitigate them effectively. Based on the data collected and analysis of the same, the agencies issue a credit rating, which is a qualitative judgment of the ability of the issuer to meet his financial obligations. Standard & Poor, Moody's (US) and Fitch-IBCA (UK) are some of the leading and reputed credit rating agencies whose ratings carry more value in the financial market. The companies/products who exhibit least risk are given investment grades and with increasing possibilities of risk, the rating is graded down to the ones with definite possibility for default are termed as speculative grades. These are otherwise known as external ratings also. Investment banking firms use credit spreads and the credit spread yield curves to compare the credit risks between different instruments of the same class and also to price the value of defaultable securities. This is not an easy option as an equivalent product with the same features should be compared. Hence credit spread yield curves for a range of products with same raring are constructed to spot the pricing anomalies, pricing credit default swaps and help as a base for treading strategy. Comparison with risk free bonds is done using fixed income analysis. Another important aspect of measuring and managing credit risk in investment banking is to use rating transitions (change in the rating of an instrument) and the frequency of defaults. Transition matrices which show the proportion of bonds that migrate from one rating to another over a fixed time period are used to find rating transitions. Plotting the transition of bonds from their initial rating to speculative grade at the end of 1st, 2nd 3rd year etc. help to find the annual defaults as a percentage of issued ones which is known as Empirical Default Frequency (EDF). The default rates and transition rates are not constant and vary with industry and place and hence it is difficult to arrive at a correlation between the two. Whenever a credit is made, it is essential to have an idea of the extent of loss that may arise due to default at a given tolerance over a given time frame which other wise can be termed as measurement of the credit losses or the credit value at risk (C-VaR). This needs a credit portfolio model, which includes rating transitions and their impact in the distribution of credit risk. Many models are used by the investment banking firms to determine the above and their impact on the credit risk. Credit Metrics, a tool for credit risk modeling was developed by the risk management company of JP Morgan .To determine distribution of credit risk of a portfolio and to determine the VaR, it calculates the changes in the portfolio value due to defaults and credit migrations over a fixed time frame using credit spreads, transition matrices and recovery distributions. It calculates the expected and the variability of losses and gives the total VaR integrating both market and credit risks. KMV credit monitor is useful to find EDF, movement in which necessitates the monitoring of investments more closely and thus facilitates active credit management (By reducing exposures / altering the internal ratings). For commercial banks, the assessment of credit risk involves deciding whether to lend, the amount, rate, the amount of exposure on the balance sheet and how much can be shared with other banks to reduce the risk. Banks too use different tools to handle this. One is credit rating and credit scoring techniques and the other is internal ratings. The lending activities of commercial banks involve two spheres. Retail - large portfolios of similar and small exposures like personal loans, credit cards, mortgages, vehicle loans and other small business lending). Large loans to medium or big corporate and sovereign borrowers through a direct line of credit or syndicated loans. For assessing the credit risk in retail exposures, credit scoring and related techniques are used. Personal and professional details such as age, health, marital status, nature of job, employment history, housing details (own/rented), income, past history of loan repayments etc. of the borrower are collected. For loans to large corporate, commercial banks use the external credit ratings assigned to them by the credit rating agencies and use their profit and loss accounts to judge the performance, ability to repay debt, liquidity and details of other debts. These are constantly monitored throughout the period of their loan. Internal ratings are another system adopted by the commercial banks for assessing and managing credit risks. Depending on the borrower's financial ability and possibility of default over a specified time frame, the banks assign numeric ratings from 1, where 1 represents a safest exposure and the higher the number goes, it represents the highest possibility of default and credit risk. Internal ratings are changed frequently depending on probability of default and the change in economic conditions whereas the external ratings assigned by the credit rating agencies are changed (enhanced or brought down) only when the financial strength of the firm changes considerably. The credit rating agencies help the commercial banks to map their internal ratings with the external ratings. The Basel committee on Banking Supervision and regulation has also endorsed the internal ruing system of commercial banks. Neural network (modern non linear techniques to predict default), Logit / Probit (estimates probability of default for homogeneous exposure), Discriminant analysis, CSFB CreditRisk (system for modeling distribution of defaults in a portfolio) are also some tools used by bank risk mangers for assessing and managing credit risk. Managing Credit Risk Investment banking firms have dedicated credit risk approval departments who monitor the credit risk of the banking firm towards the institutions it deals with. Credit limits are set for trade dealings. The counterparty risk involved in the trading operations of investment banking are managed by 1. Netting - this is legal arrangement in which to offsetting exposures are reduced in size and treated as a single exposure in one direction from a legal perspective. Netting among the actively traded instruments can reduce the risk to a greater extent. 2. Exposure limits - monitoring and setting a limit to the exposure to individual counterparties across the institution. 3. Credit derivatives - These are contracts in which conditional payments are made on some credit event occurring like a credit agency re rating. Default swaps and total return swaps are some examples for this. 4. Collateral and margins - One of the parties involved in the financial contract commits through a legal arrangement and when he fails, the collateral is claimed. This is useful for short time lending but very expensive for long-term exposures. Commercial banks differ from investment banks in concentrating on their credit exposures to individual sectors rather than to institutions. The unexpected losses rather than the expected losses create more risk in commercial banking. To manage this, commercial banks Charge higher interest rates in sectors where the default probabilities are more. Securing guarantees in the form of collaterals or mortgages, setting credit limits Monitor the activities of borrower companies and interfering in the management if required Participation: The banks help the potential defaulter by offering financial counseling to overcome their monetary issues. This helps to minimize the losses and at the same time wins the borrower's good will. Thus assessing and managing credit risk in both types of banking is crucial to minimize losses and to improve returns. Both have variety of systems in place to tackle the credit risk component of banking. 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