Credit risk (also called counterparty risk) arises when a debtor (the counterparty) is no longer able or willing to pay its financial obligations to its creditor as they become due in accordance with the legal documentation signed by both parties.
Credit risk lies at the forefront of the risks borne by financial institutions since lending money is core to banking activities and represents its most significant source of potential losses. Any financial institution that lends money to a low-rated government, company, or individual bears the risks not to get all its money back (capital and interests) when due. Credit risk is dependant upon the borrower’s creditworthiness.
In the worst case scenario, the counterparty goes bust and the financial institution bears losses whose severity depends upon several factors, including:
- the exposure at default
- the realization of financial guarantees required by the financial institution at the deal’s inception
- the outcome of the debt recovery process.
Within financial institutions, credit risk can arise under a variety of circumstances:
- upon a given counterparty’s default, as stated above
- upon a given counterparty’s rating downgrade (migration risk)
- upon the spread widening of a given issuer (credit spread risk)
- when contracting OTC derivatives contracts with a counterparty (capital markets counterparty risks)
- when the credit quality of a given portfolio deteriorates (portfolio credit risk). In this case, the financial institution will have to write off the expected loss
- concentration risk that arises when a financial institution’s commitments to a specific sector or geographic area proves material relative to its capital base
- country risk that arises when lending to a given counterparty domiciled in a country that faces political and financial instability (e.g. the Asian crisis in the late 90’s), etc…
In order to withstand the detrimental consequences triggered by these risks, financial institutions must hold sufficient regulatory capital that will be loss-absorbing. That is the key objective of Basel II and Basel III (implemented from January, 1st 2013 onwards) banking regulations.
Efficient credit risk management policies are crucial to adequately manage all other bank-related risks and to ensure any financial institution’s long term viability. Credit risk prevention requires to set up efficient decision-making processes involving relationship managers, credit analysts as well as credit risk control officers. Such structures are supported by simulation and credit risk pricers derived from statistical models. They use both qualitative and quantitative data on counterparties that are subsequently used as input for valuation models.
To recap, the prevalence of potential losses caused by credit risk over market or operational losses makes credit risk management critical in the ongoing volatile macroeconomic environment. Reliable, state of the art tools together with competent and proactive credit risk management teams are essential to preserve a financial institution’s profitability.
In that respect, R2M Partners provides assistance to its clients in the definition and implementation of an optimal credit risk strategy. Our expertise in the area of credit risk management covers the following:
- audit and enhancement of credit approval processes
- analysis of Basel II/Basel III credit- related subjects (assistance to get approval from the banking regulator to use internal rating models…)
- definition of calculation methodologies of key Basel II parameters (EEPE, EAD, LGD, PD, RWA) according to the various approaches (standard, IRBF, IRBA)
- review of existing internal rating models, construction of new models and back-testing
- creation of associated reportings (COREP, FINREP…) and IT systems (Fermat, Calypso…)
On a wider spectrum, through its risk management offer, R2M Partners can assist you at various levels:
- governance & Strategy
- project management
- advisory and business analysis
- production support
- audit & validation
- change management.
