Risk Measurement and Management - Do We Need a New Beginning?
Credit risk is defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximise a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. This is the straightforward and simple definition that provides the framework for risk management policies and procedures within banking organisations. There is also operational risk, which is defined as ‘the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events’. In addition the Basel Accord made scientific effort to define the way in which provisions should be made or handled for the market risk that arises due to legitimate business operations of the bank.
At the outset, it all seems to suggest the way in which a model should be built to arrive at the required safety capital in the form of tier one and two. No doubt the committee approach was far more superior to its own assessment at the Basel I level and created a robust mechanism to assess the bank’s financial health covering business, operations and market risk dimensions. It is believed that compared to the current scenario these approaches would have helped banks to not only improve the bottom line on the balance sheet, but to also improve the way the business is done. It would help the banks to organise their internal systems, people, and processes to ensure that their business is not jeopardized due to failures in operational or credit risk monitoring practices.
As stated earlier, operation risk management has been an important aspect of bank management prescribed by the Accord. The committee approach for the loss distribution suggested that the bank estimate for each business line/risk type the probability distribution functions of the single event impacting the business for the next (one) year based on its internal data to compute the probability distribution function of the cumulative operational loss. This approach had two important intentions in helping the bank management mitigate any risk of unexpected as well as expected losses that has an impact on the capital structure.
Although the Basel II Accord prescribed how banks should approach the risk and develop a mitigation framework, the industry is not clear as to how much proactive thinking has gone into developing enterprise-wide operational risk framework at the banks’ operational level. Recent debacles, including US home lending and sub-prime crises, indicate that there is a missing link between instrument pricing, valuation, and business priorities. The missing link between the definition of what constitutes an operational risk and what constitutes a market risk is one of the key reasons for today’s financial problems.
Unwinding incidents and continued sub-prime loss event hitting the balance sheet on every new batch run of mark to market calculations, indicate that banks have not achieved significant improvement in their processes to integrate their risk definition (both credit, markets and operational risk), data collection exercises (enterprise-wide border and cross border), risk assessment and management (balance sheet as well as off balance sheet) in addition to capital allocation and governance mechanisms.
With business being good and growth being propelled through the derivatives desk, often these processes that existed on paper did not translate into operations. My view is that the single largest reason for this is the lack of definition clarity in addition to the investment made in building middle and back office systems to create synchronised MIS reports cutting across the businesses and product lines.
In addition, the qualitative nature of the banks’ approach to manage the operational risk did not lead itself to meaningful information. Since the definition of ‘operations’ failure covered unscrupulous activities by individuals or groups of individuals and failure to adhere to the norms prescribed for the businesses, it did not help to unearth the potential risk introduced through the pricing of instruments that did not have robust reference markets.
| Corp Borrowers | Middle market borrowers | Private borrowers | Small business | Commercial real estate | Residential real estate | Consumer |
|---|---|---|---|---|---|---|
| Publicly traded, extensive disclosure | Publicly traded. Moderate disclosure | No public debt Privately held, lack of info | Un-audited financial statement | Approval based on cash flow | Approval based on cash flow | No Financial statement, fewer info, reliance on credit bureau |
| Low monitoring (annual cycle) | Greater emphasis on management |
Reliance on financial statement Close monitoring |
Information problem Close onitoring | Moderate monitoring | Moderate monitoring | Reliance on collateral (consumer durables) |
| Potential for higher use of credit scoring models because of better data | Low use of credit scoring model |
Reliance on collateral and covenants Limited use of credit scoring model |
Reliance on collateral and covenants Limited use of credit scoring model |
Reliance on collateral Limited use of credit scoring model |
Reliance on collateral Limited use of credit scoring model |
Heavy use of credit scoring model |
As detailed in the table, banks often rely on the information that is made available through known sources or the documents made available to them. In addition, the following table describes the key definition of various risks.
It is interesting to note that although counterparties/products and business are classified as a risk type, severity wise it is to a large extent defined as medium. It is also true that this approach did not take any note of sophisticated financial instruments and products which do not have robust reference markets from pricing perspective and it certainly did not take underlying cash flows of products into account. This is the single largest reason why banks are unable to understand the contamination effect of bad loans and good advances.
Though these models and criteria helped the bank to mitigate the credit risk to an extent, it is evident that this did not suffice to identify the risk raised through new product development such as credit derivatives. From the perspective of the risk managers and practitioner, it is important to develop different ways of measuring both expected and unexpected losses. Following two approaches can be added into the well-laid foundation of Basel II:
These two approaches are simple in nature to understand and implement but can help risk managers to better prepare themselves to handle unexpected loss events when they occur.