Credit Risk Management - Coursework Example

Introduction The latter paper is a case study for a bank which faces the need to implement effective credit risk management policy. A number of factors have to be considered and this may depend on the nature of a respective enterprise, its priorities and its area of operations. All these dynamics will be critically analysed in the subsequent sections of the essay. (Investment Bank Watch, 2008) Key issues For effective credit risk management, banks ought to consider a wide range of issues. Experts within the region's banking industry agree that in order for this to be done, and then there should be sound business processes and robust technology. In other words, the bank has to incorporate technological processes in the identification of risk. Credit risk management must start from a particular point and this is determination of where the problem is. (Reserve bank of Vanuatu, 2007) No effective solution can be worked out if the bank does not understand the full magnitude of its problems. Additionally, banks that fail to understand the dynamics involved in counterparty risks are also likely to fail in managing that risk. Technology is also essential in the measurement of risk because through the latter, the bank can have standardised ways of dealing with it. Besides these, robust technology is also critical in the actual process of managing the risk. (Damiano and Massimo, 2006) The latter facts may seem quite basic to the bank, however, a word of caution is necessary when dealing with this issue. Because of forces of globalisation and the technology wave, many banks and financial instructions are merely rushing to the latest IT products without due consideration of their personal needs. This is the point at which these financial institutions go wrong; the most sophisticated form of IT can be worthless if it does not meet the needs of the bank. Consequently, there should be more emphasis on the process rather than the product in this regard. If all a bank needs is a simple IT tool to meet their needs, then they should opt for only what they need. In certain cases less is more; credit risk management ought to take precedence over other systems that are required to implement them. Numerous companies tend to operate from the wrong side thus making it increasingly difficult to proceed with one's choices. A research conducted by a certain investment bank (Lepus) about the importance of information technology in implementing effective credit risk management found out the following: Importance of technology in credit risk management 0% 5% 10% 15% 20% 25% 30% 35% 40% Just a tool Enhances efficiency and effectiveness Eradicates manual processes Promotes data transparency Smoothens Global credit risk Active management of portfolio Source: Lepus Investment Bank (2007): Effective risk management, available at http://www.sas.com/ accessed on 27th November As it can be seen above, the most important function among these bankers is the management and development of a bank's portfolio. Information technology is therefore a vital tool in effecting strategies for effective risk management. Aside from technology, a bank needs to have a comprehensive strategic policy for achievement of effective credit risk management. It should be noted that this forms the backbone of successful credit risk management. The principles and guidelines provide a background against which banks can operate in a sound environment. These policies serve as directional pointers to financial institutions because they are a set of rules that can be applied in a series of credit situations facing them. (Brigo and Pallavicini, 2007) The bank under study needs to put in mind the fact that those companies that have failed in their credit risk management endeavours have done so because of a lack of commitment to their policies and procedures. Having a set of rules that have been smartly laid out by a series of credit risk management experts is just one side of the story. The other side is largely composed of a commitment to management of this policy. At the end of the day, policies and procedures are just rules that have been agreed upon. What makes the fundamental difference is when those rules become part of the day to day operation of a financial institution. Consequently, the bank's credit risk management policy can be deemed effective when backed by the commitment of the bank's employees. (Pykhtin, 2003) Additionally, credit risk policy should not be examined through structural perspectives alone. Many countries have specific guidelines for credit risk policies and so do certain categories of institutions. If these policies are adhered to blindly, then chances are that they may be just an ineffective as not having the policies themselves. Consequently, the case study should have a vision and strategy for their credit policy. When a company operates under a long term strategy, then they eliminate the risk of getting caught in every day nifty gritty and can instead focus their attention on the more visionary aspects of their credit policies. The reason behind this is that if banks have strategies for other aspects of their business such as human resource management, marketing IT etc, then they should also have a strategy for a very important part of their portfolio which is its credit risk policy. (Bluhm, Overbeck and Wagner, 2002) It is imperative for banks to have the ability to accurately predict their exposure to credit risk. By doing this, such banks can be well on their way to managing this problem. The bank under consideration needs to focus on the following two items -Exposure to risk on portfolio level -Exposure to risk on counterparty level The former mentioned level is important because it can be treated as a form of self evaluation. Most of the time, this is much easier to do than effecting the latter mentioned procedure. Consequently, banks need to use all the available data in the past and present to determine the future outlook of their credit risk situations. In order for the case study to effect sound credit risk policies, then they have to integrate it with robust analytics. In other words, this process must be done in an accurate manner and also on time. As mentioned earlier, there are a series of tools available to the company to implement their business goals. Care should be taken to ensure that greater emphasis is given to business solutions rather than adoption of latest techniques. When the latter bank has a dependable system for conducting risk analysis, then they are likely to make more informed choices. The bank is likely to balance their rewards and their risks properly and this will definitely produce better performance. Long term profitability in many successful banks has been possible through the institution of robust analytics that give room to effective balancing. (Henderson, 2002) Many banks usually focus on the above mentioned elements and then forget about certain ethical issues. As it has been stated earlier, if there is a lack of commitment among stakeholders within the financial institutions to the credit risk policies and procedures, then the bank will not have changed any aspect in terms of the latter portfolio. Banks without transparent credit risk systems are likely to develop problems in management of the above because some unscrupulous members of the organisation may choose to circumvent these guidelines in order to meet their selfish needs. Consequently, in order to minimise this, there is need to institute measures that will encourage and facilitate transparency. In certain third world banks such as those ones in Nigeria, twenty five banks have been closed over the past five years. This is largely as a result of credit fraud brought on by lack of transparency. (Miller, Appleby & Edelman, 2003) In certain circumstances, some experts argue that transparency is a reflection of the operating environment's values. Adherents to this school of thought believe that when a specific society is not very ethical, then they are likely to bring these traits forward into their credit risk management endeavours and consequently very little can be done about it. However, this school of thought disregards the fact that a number of people have operated within seemingly corrupt environments but still managed to rise above these fraudulent systems to set their own standards. By making positive efforts towards creating ethical credit risk procedures, then the latter bank will enhance its effectiveness in the area. In many bank, credit decision processes are largely carried out by a number of individuals. This can bring out a lot of time wastage and confusion if the processes required to make those decisions are not well understood. In fact, experts assert that a key role within any successful financial institution is a thorough knowledge of the roles that an employee is required to take up and the processes required to achieve them. (Servigny and Renault, 2004) In order to effectively do this, the case study must make sure that they effectively communicate these procedures both to their employees and external stakeholders working with the company. It should also be noted that sound leadership will also be necessary in providing a direction over the most effective way of making decisions. When this is streamlined, then hitches that arise out of enquiries, misunderstandings and lack of uniformity can be adequately ironed out to offer the most effective credit risk management policy possible. (BOM, 2007) Stress testing is also another vital element in provision of effective credit risk management. This is especially the case when a new procedure has been introduced or a modification on the current one has been enacted. The ability of credit risk plans to withstand all market dynamics can be determined by its ability to withstand some of the pressures that arise out challenges within the market. No service or product offering can be regarded as effective if it is not completed within a specific time frame. Whenever risks are being measured or calculated, there must be a timeline attached to them because failure to do so may lead to accurate but delayed responses. The measure of a credit risk management endeavour is in the quality and quantity of work done. Consequently, when one area has been overemphasised without the other, then this could result in overall decline of its performance. Banks need to establish timelines for credit risk analysis and management because this places people on a more developed pathway in relation to these aspects. Most of the assertions made can be transformed to fit these policies and procedures and this goes a long way in providing better analyses. (BOJ, 2002) Sometimes certain banks may also consider strategies and long term goals without translating it into day to day conduction of the business. Bank employees need to be promoted to stick to these long term visions by working on short term goals too. These may include Submitting reports on time Conducting credit analysis on time Identifying credit risk within specified time frames In order to have effective credit risk management, banks must also be able to identify and prioritise their most effective drivers for credit management. This can be done through a series of channels. First of all, banks can choose to impose capital charges in instances when procedural errors have been undermined. Additionally, this can be effected by minimising operational risks and limits on violations. People within the bank need to be given pressure to ensure that they comply with organisational rules on credit risk management and this can only be possible through the use of the latter mentioned strategies. (BOM, 2007) Conclusion and recommendations Some banks have managed to deal with the issue of credit risk through the utilisation of regulations and this is their priority. Others have placed greater precedence to a deeper understanding of their credit risk process or others have concentrated on the development of transparency in their institutions. One would therefore wonder which aspect should take precedence over the other. According to a recent survey carried out in the UK, it had been found that most banks prefer using sound practices as their baseline for effective risk management. These can be done through the following; -Establishment of sound credit risk environments -Operation conducted in sound granting processes -Maintenance of effective measurement, monitoring and appropriate administration of credit -Controlling credit risk more adequately (Fleming, 2006) A number of discussants have looked into the issues surrounding credit risk management and most of them have asserted that if banks are more rigorous in the process of assessment, then chances are that they may develop better mechanisms of dealing with the issue. Additionally, it has also been put forward that through effective assessment, a bank can know its appetite for credit thus necessitating sterner actions or actions to mitigate it presently. References Investment Bank Watch (2008): Principles for the management of credit risk from the Bank for International Settlement; Counterparty risk report Henderson, T. (2002): Counterparty Risk and the Subprime Fiasco; Free Press Brigo, D. and Pallavicini, A. (2007): Counterparty Risk under Correlation between Default and Interest Rates; Palgrave Publishers Miller, J., Appleby, J. & Edelman, D. (2003): Numerical Methods for Finance; Chapman Hall publishers Bluhm, C., Overbeck, L. and Wagner, C. (2002): An Introduction to Credit Risk Modelling; Chapman Hall Publishers Damiano, B. and Massimo, M. (2006): Risk Neutral Pricing of Counterparty Risk; Routledge Pykhtin, M. (2003): Counterparty Credit Risk Modelling - Risk Management, Regulation & Pricing; Risk Books Servigny, A. and Renault, O. (2004): The Standard & Poor's Guide to Measuring and Managing Credit Risk; McGraw-Hill Darrell, D. And Singleton, K. (2003): Credit Risk: Pricing, Management and Measurement; Princeton University Press BOJ (2002): Credit risk management'; retrieved from http://www.boj.org.jm/pdf/ accessed on 27th November Reserve bank of Vanuatu (2007): Guidelines for credit risk management, International Bank Prudential Guide, No. 1 Fleming, J. (2006): Credit risk management forum for financial services, retrieved from http://www.privatebanking.com/ accessed on 27th November BOM (2007): Credit risk management guidelines, retrieved from http://www.bom.intnet.mu.pdf/ Read More