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Credit Risk Management in the UK Banking Sector

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Background 3

Literature Review 7

Ascertaining why and how banking credit risk exposure is evolving recently 8

Seeing how banks use credit risk evaluation and assessment tools to mitigate their credit risk exposure 11

The steps and methodologies used by banks to identify, plan, map out, define a framework, develop an analysis and mitigate credit risk 13

Determine the relationship between the theories, concepts and models of credit risk management and what goes on practically in the banking world 17

Ascertain the scope to which resourceful credit risk management can perk up bank performance 19

To evaluate how regulators and government are assisting the banks to identify, mitigate credit risk, and helping to adopt the risk-based strategies to increase their profitability, and offering assistance on continuous basis 20

Research Methodology 21

Analysis 23

Ascertaining why and how banking credit risk exposure is evolving recently 23

Seeing how banks use credit risk evaluation and assessment tools to mitigate their credit risk exposure 25

The steps and methodologies used by banks to identify, plan, map out, define a framework, develop an analysis and mitigate credit risk 31

Determine the relationship between the theories, concepts and models of credit risk management and what goes on practically in the banking world 35

Ascertain the scope to which resourceful credit risk management can perk up bank performance 38

To evaluate how regulators and government are assisting the banks to identify, mitigate credit risk, and helping to adopt the risk-based strategies to increase their profitability, and offering assistance on continuous basis 40

Primary Survey 45

Conclusions 46

Recommendations 50

Bibliography 56


The sub-prime mortgage meltdown that hit the global banking sector in 2007, was a result of circumstances, actions and repercussions that began years earlier (Long, 2007). It, the sub-prime mortgage crisis, was based on unsound ground from its inception. Sub-prime mortgages represent loans made to borrowers that have lower ratings in their credit than the norm (investopedia, 2007). Due to the lower borrower credit rating, they do not qualify for what is termed as a conventional mortgage due to default risk (investopedia, 2007). Sub-prime mortgages thus carry a higher interest rate to off set the risk increase, which helped to fuel the United States economy through increased home ownership, and the attendant spending that accompanies it (Bajaj and Nixon, 2006). Implemented by the Bush administration in the United States to get the economy rolling after the recession fuelled by the September 11th air attacks, the entire plan began to backfire as early as 2004 as a result of the continued building of new housing without the demand (Norris, 2008). The new construction glutted the market bringing down house prices. This, coupled with a slowing economy in the United States resulted in layoffs, as well as many subprime mortgage holders defaulting on their loans, and the crisis ballooned.

Some attribute the over lending of subprime mortgages to predatory lending (Squires, 2004, pp. 81-87) along with the underlying faults of using it as an economic stimulus package that did not control the limits on new housing (Cocheo, 2007). That set of circumstances represented the cause of the subprime mortgage crisis that spread globally as a result of the tightening of credit due to defaulted loan sell offs and restricted banking lending ceilings caused by the Basel II Accords (Peterson, 2005). The complexity of the foregoing shall be further explained in the Literature Review section of this study. The preceding summary journey through the subprime mortgage crisis was conducted to reveal the manner in which banking credit crunches can and do occur. The significance of the foregoing to this study represents an example to awaken us to the external factors that can and do cause banking credit crisis situations, thus revealing that despite good management practices such events can manifest themselves. It is also true that poor or lax banking practices can have the same effects.

Credit risk management represents the assessing of the risk in pursuing a certain course, and or courses of action (Powell, 2004). In addition to the foregoing U.S. created subprime mortgage crisis, the appearance of new forms of financial instruments has and is causing a problem in credit risk management with regard to the banking sector. As the world's second largest financial centre, the United Kingdom is subject to transaction volumes that increase the risks the banking sector takes as so many new forms of financial instruments land there first. McClave (1996, p. 15) provides us with an understanding of bank risk that opens the realm to give us an overview of the problem by telling us:

Banks must manage risk more objectively, using quantitative skills to understand portfolio data and to predict portfolio performance. As a result, risk management will become more process-oriented and less dependent on individuals.

Angelopoulos and Mourdoukoutas (2001, p. 11) amplify the preceding in stating that Banking risk management is both a philosophical and an operational issue. They add:

As a philosophical issue, banking risk management is about attitudes towards risk and the payoff associated with it, and strategies in dealing with them. As an operational issue, risk management is about the identification and classification of banking risks, and methods and procedures to measure, monitor, and control them. (Angelopoulos and Mourdoukoutas, 2001, p. 11)

In concluding, Angelopoulos and Mourdoukoutas (2001, p. 11) tell us that the two approaches are in reality not divorced, and or independent form each other, and that attitudes concerning risk contribute to determining the guidelines for the measurement of risk as well as its control and monitoring. The research that has been conducted has been gathered to address credit risk management in the United Kingdom banking sector. In order to equate such, data has been gathered from all salient sources, regardless of their locale as basic banking procedures remain constant worldwide. References specific to the European Union and the United Kingdom were employed in those instances when the nuances of legislation, laws, policies and related factors dictated and evidenced a deviance that was specific.

In terms of importance, credit risk is one of the most important functions in banking as it represents the foundation of how banks earn money from deposited funds they are entrusted with. This being the case, the manner in which banks manage their credit risk is a critical component of their performance over the near term as well as long term. The implications are that today's decisions impact the future, thus banks cannot approach current profitability without taking measures to ensure that decisions made in the present do not impact them negatively in the future (Comptroller of the Currency, 2001). A well designed, functioning and managed credit risk rating system promotes the safety of a bank as well as soundness in terms of making informed decisions (Comptroller of the Currency, 2001). The system works by measuring the different types of credit risk through dividing them into groups that differentiate risk by the risk posed. This enables management as well as bank examiners to monitor trends and changes to risk exposure, and this minimise risk through diversifying the types of risk taken on through separation (Comptroller of the Currency, 2001).

The types of credit risks a bank faces represents a broad array of standard, meaning old and establishes sources, as well as new fields that are developing, gaining favour, and or impacting banks as a result of the tightness of international banking that creates a ripple effect. The aforementioned subprime crisis had such an effect in that the closeness of the international banking community accelerated developments. The deregulation of banking has increased the risk stakes for banks as they now are able to engage in a broad array of lending and investment practices (Dorfman, 1997, pp. 67-73). Banking credit risk has been impacted by technology, which was one of the contributing factors in the subprime crisis (Sraeel, 2008). Technology impacts banks on both sides of the coin in that computing power and new software permits banks to devise and utilise historical risk calculations in equating present risk forms. However, as it is with all formulas, they are only as effective as the parameters entered (Willis, 2003).

The interconnected nature of the global banking system means that bank risk has increased as a result of the quick manner in which financial instruments, credit risk transfer, and other systems, and or forms of risk are handled. The Bank for International Settlements led a committee that looked into Payment and Settlement Systems, which impacts all forms of banking credit risk, both new forms as well as long standing established ones in loans, investments and other fields (TransactionDirectory.com, 2008). The report indicates that while technology and communication systems are and have increased the efficiency of banking through internal management as well as banking systems, these same areas, technology and communications systems also have and are contributing to risk.

The complexity of the issues that arise in a discussion of credit risk management means that there are many terms that are applicable to the foregoing that are banking industry specific to this area. In presenting this material, it was deemed that these special terms would have more impact if they were explained, in terms of their context, as they occur to ease the task of digesting the information. This study will examine credit risk management in the UK banking sector, and the foregoing thus will take into account banking regulations, legislation, external and internal factors that impact upon this.

Literature Review

The areas to be covered by this study in relationship to the topic area Credit Risk Management in the UK Banking Sector entails looking at as well as examining it using a number of assessment and analysis points, as represented by the following:

Ascertaining why and how banking credit risk exposure is evolving recently.

Seeing how banks use credit risk evaluation and assessment tools to mitigate their credit risk exposure.

The steps and methodologies used by banks to identify, plan, map out, define a
framework, develop an analysis and mitigate credit risk.

Determine the relationship between the theories, concepts and models of credit risk management and what goes on practically in the banking world.

Ascertain the scope to which resourceful credit risk management can perk up bank performance.

To evaluate how regulators and government are assisting the banks to identify, mitigate credit risk, and helping to adopt the risk-based strategies to increase their profitability, and offering assistance on continuous basis.

The foregoing also represents the research methodology, which shall be further examined in section 3.0. These aspects have been included here as they represented the focus of the Literature Review, thus dictating the approach. The following review of literature contains segments of the information found on the aforementioned five areas, with the remainder referred to in the Analysis section of this study.

Ascertaining why and how banking credit risk exposure is evolving recently.

In a report generated by the Bank for International Settlements stated that while transactional costs have been reduced as a result of advanced communication systems, the other side of this development has seen an increase with regard to ... the potential for disruptions to spread quickly and widely across multiple systems ... (TransactionDirectory.com, 2008). The Report goes onto add that concerns regarding the speed in which transactions occur is not reflected adequately in risk controls, stress tests, crisis management procedures as well as contingency funding plans (TransactionDirectory.com, 2008). The speed at which transactions happen means that varied forms of risk can move through the banking system in such a manner so as to spread broadly before the impact of these transactions is known, as was the case with the subprime mortgage crisis debt layoff.

One of the critical problems in the subprime crisis was that it represented a classic recent example of the ripple effect caused by rapid interbanking communications, and credit risk transfer. When the U.S. housing bubble burst, refinance terms could not cover the dropping house prices thus leading to defaults. The revaluation of housing prices as a result of overbuilding forced a correction in the U.S. housing market that drove prices in many cases below the assessed mortgage value (Amadeo, 2007). The subprime mortgage problem was further exacerbated by mortgage packages such as fixed rate, balloon, adjustable rate, cash-out and other forms that the failure of the U.S. housing market impacted (Demyanyk and Van Hemert, 2007). As defaults increased banks sold off their positions in bad as well as good loans they deemed as risks as collateralised debt obligations and sold them to differing investor groups (Eckman, 2008). Some of these collateralised debt obligations, containing subprime and other mortgages, were re-bundled and sold again on margin to still another set of investors looking for high returns, sometimes putting down $1 million on a $100 million package and borrowing the rest (Eckman, 2008). When default set in, margins calls began, and the house of cards started caving in.

Derivatives represent another risk form that has increased banking exposure. The preceding statement is made because new forms of derivatives are being created all of the time (Culp. 2001, p. 215). Derivatives are not new, they have existed since the 1600's in a rudimentary form as predetermined prices for the future delivery of farming products (Ivkovic, 2008). Ironically, derivatives are utilised in today's financial sector to reduce risk via changing the financial exposure, along with reducing transaction costs (Minehan and Simons, 1995). In summary, some of the uses of derivatives entail taking basic financial instruments as represented by bonds, loans and stocks, as a few examples, and then isolating basic facets such as their agreement to pay, agreements to receive or exchange cash as well as other considerations (financial) and packaging them is financial instruments (Molvar, et al, 1995). While derivatives, in theory, help to spread risk, spreading risk is exactly what caused the subprime meltdown as the risk from U.S. mortgage were bundled and sold, repackaged, margined, and thus created a raft of exposure that suffered from the domino effect when the original house of cards came crashing down.

Other derivative forms include currency swaps as well as interest rate derivatives that are termed as over the counter (Cocheo, 1993). The complexity of derivatives has increased to the point where:

...auditors will need to have special knowledge to be able to evaluate the derivative's measurement and disclosure so they conform with GAAP. For example, features embedded in contracts or agreements may require separate accounting as a derivative, while complex pricing structures may make assumptions used in estimating the derivative 's fair value more complex, too. (Coppinger and Fitzsimons, 2002)

The preceding brings attention to the issues in evaluating the risks of derivatives, and banks having the proper staffing, financial programs and criteria to rate derivative risks on old as well as the consistently new forms being developed. Andrew Crockett, the former manager for the Bank of International Settlements, in commenting on derivatives presented the double-edged sword that these financial instruments present, and thus the inherent dangers (Whalen, 2004)

When properly used, (derivatives) can be a powerful means of controlling risk that allows firms to economize on scarce capital. However, it is possible for new instruments to be based on models, which are poorly designed or understood, or for the instruments to give rise to a high degree of common behaviour in traded markets. The result can be large losses to individual firms or increased market volatility.

The foregoing provides background information that relates to understanding why and how banking credit risk exposure has and is evolving. The examples provided have been utilised to illustrate this.

Seeing how banks use credit risk evaluation and assessment tools to mitigate their credit risk exposure.

As credit risk is the focal point throughout this study, a definition of the term represents an important aspect. Credit risk is defined as (Investopedia, 2008):

The risk of loss of principal orloss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.

Risk, in terms of investments, is closely aligned with the potential return being offered (Investopedia, 2008). The preceding means that the higher the risk, the higher the rate of return expected by those investing in the risk. Banks utilise a variety of credit risk evaluation and assessment tools to apprise them of credit risk probabilities so that they can mitigate, and or determine their risk exposure. There are varied forms of credit risk models, which are defined as tools to estimate credit risk probability in terms of losses from banking operations in specific as well as overall areas (Lopez and Saidenburg, 2000, pp. 151-165).

Lopez and Saidenberg (1999) advise us that the main use of models by banks is to provide forecasts concerning the probability of how losses might occur in the credit portfolio, and the manner in which they might happen. They advise that the aforementioned credit risk model projection of loss distribution is founded on two factors (Lopez and Saidenberg, 1999):

the multivariate, which means ...having more than one variable (Houghton Mifflin, 2008) distribution concerning the credit losses in terms of all of the credits in the bank's portfolio, and

the weighting vector, meaning the direction, characterising these credits.

As can be deduced, the ability to measure credit risk is an important factor in improving the risk management capacity of a bank. The importance of the preceding is contained in the Basel II Accord that states the capital requirement is three times the projected maximum loss that could occur in terms of a portfolio position (Vassalou, M., Xing, Y., 2003). Risk models and risk assessment tools form and are a structural part of the new Basel II Accord in that banks are required to adhere to three mechanisms for overall operational risk that are set to measure and control liquidity risk, of which credit risk is a big component (Banco de Espana, 2005). The key provisions of the Basel II Accord set forth that (Accenture, 2003):

the capital allocation is risk sensitive,

separation of operational risk, from credit risk,

vary the capital requirements in keeping with the different types of business it conducts, and

encourage the development and use of internal systems to aid the bank in arriving at capital levels that meet requirements

An explanation of the tools utilised by banks in terms of evaluation as well as assessment will be further explored in the Analysis segment of this study.

The steps and methodologies used by banks to identify, plan, map out, define a framework, develop an analysis and mitigate credit risk.

The process via which banks identify, plan, map out, define frameworks, develop analyses, and mitigate credit risk represent areas as put forth by the Basel II Accord, which shall be defined in terms of the oversight measures and degrees of autonomy they have in this process. In terms of the word autonomy, it must be explained that the Basel II Accord regulates the standard of banking capital adequacy, setting forth defined measures for the analysis of risk that must meet with regulatory approval (Bank for International Settlements, 2007). This is specified under the three types of capital requirement frameworks that were designed to impact on the area of pricing risk to make the discipline proactive. The rationale for the preceding tiered process is that it acts as an incentive for banks to seek the top level that affords them with a lowered requirement for capital adequacy as a result of heightened risk management systems and processes across the board (Bank for International Settlements, 2007). The foregoing takes into account liquidity (operational) risk as well as credit risk management and market risk.

The risk management active foundation of the Basel II Accord separates operational risk from credit risk, with the foundation geared to making the risk management process sensitive, along with aligning regulatory and economic capital aspects into closer proximity to reduce arbitrage ranges (Schneider, 2004). The process uses a three-pillar foundation that consists of minimum capital requirements along with supervisory review as well as market discipline to create enhanced stability (Schneider, 2004). The three tiers in the Basel II Accord, consist of the following, which are critical in understanding the steps, and methodologies utilised by banks to identify, plan, map, define frameworks, analyse and mitigate risk (Bank for International Settlements, 2007):

Standardised Approach

This is the lowest level of capital adequacy calculation, thus having the highest reserves. Via this approach risk management is conducted in what is termed as a standardised manner, which is founded on credit being externally assessed, and other methods consisting of internal rating measures. In terms of banking activities, they are set forth under eight business categories (Natter, 2004):

agency services,

corporate finance,

trading and sales,

asset management,

commercial banking,

retail banking,

retail brokerage,

payment and settlement

The methodology utilised under the standardised approach is based on operational risk that is computed as a percentage of the bank's income that is derived from that line of business.

Foundation Internal Rating Based Approach (IRB) (Bank for International Settlements, 2007)

The Foundational IRB utilises a series of measurements in the calculation of credit risk. Via this method, banks are able to develop empirical models on their own for use in estimating default probability incidence for clients. The use of these models must first be reviewed and cleared by local regulators to assure that the models conform to standards that calculate results in a manner that is in keeping with banking processes in terms of outcomes and inputs to arrive at the end figures. Regulators require that the formulas utilised include Loss Given Default (LGD), along with parameters consisting of the Risk Weighted Asset (RWA) are part of the formulas used. Banks that qualify under this tier are granted a lower capital adequacy holding figure than those under the first tier.

Advanced Internal Rating Based Approach (IRB) (Bank for International Settlements, 2007)

Under this last tier, banks are granted the lowest capital adequacy requirements, if they qualify by the constructing of empirical models that calculate the capital needed to cover credit risk. The techniques, personnel and equipment needed to meet the foregoing are quite extensive, requiring a substantial investment of time, materials, funds, and personnel to accomplish the foregoing, thus this measure generally applies to the largest banks, that have the capability to undertake these tasks. As is the case under the Foundation Internal Rating Based Approach, the models developed must meet with regulator approval. Under this aspect of the Basel II provisions for this tier, banks are permitted to create quantitative models that calculate the following (Bank for International Settlements, 2007):

Exposure at Default (EAD),

the Risk Weighted Asset (RWA)

Probability of Default (PD), and

Loss Given Default (LGD).

The above facets have been utilised to provide an understanding of the operative parameters put into place by Basel II that define the realm in which banks must operate. These tiers also illustrate that the depth of the manner in which banks identify, plan, map out, define frameworks, analyse and mitigate credit risks, which varies based upon these tiers. Under the Standardised Approach the formulas are devised by the regulators, with banks having the opportunity to devise their own models. Graphically, the preceding looks as follows:

Chart 1 - Basel II Three Pillars

(Bank for International Settlements, 2007)

Determine the relationship between the theories, concepts and models of credit risk management and what goes on practically in the banking world.

The Basel Committee on Banking Supervision (2000) states that 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. The foregoing extends to its entire portfolio, along with risk as represented by individual credits, and with transactions (Basel Committee on Banking Supervision, 2000). In discussing risk management theories, Pyle (1997)/span> states it ... is the process by which managers satisfy these needs by identifying key risks, obtaining consistent, understandable, operational risk measures, choosing which risks to reduce, and which risks to increase and by what means, and establishing procedures to monitor the resulting risk position. The preceding statement brings forth the complex nature of credit risk management. In understanding the application of risk it is important to note that ... credit risks are defined as changes in portfolio value due to the failure of counter parties to meet their obligations, or due to changes in the market's perception of their ability to continue to do so (Pyle, 1997).

In terms of practice, banks have traditionally utilised credit scoring, credit committees, and ratings in an assessment of credit risk (Pyle, 1997). Bank regulations treat market risk and credit risk as separate categories. J.P. Morgan Securities, Inc. (1997) brought forth the theory that the parallel treatment of market risk and credit risk would increase risk management by gauging both facets would aiding in contributing to the accuracy of credit risk by introducing external forces and influences into the equation that would reveal events and their correlation with credit risk. Through incorporating the influence and effect of external events via an historical perspective, against credit risk default rates, patterns and models result that can serve as useful alerts to pending changes in credit risk as contained in Pyle's (1997)/span> statement that ended in ...due to changes in the market's perception of their ability to continue to do so.

The Plausibility Theory as developed by Wolfgang Spohn represents an approach to making decisions in the face of unknowable risks (Value Based Management, Inc., 2007). Prior to the arrival of the Plausibility Theory, Bayesian statistics was utilised to predict and explain decision making which was based upon managers making decisions through weighing the likelihood of differing events, along with their projected outcomes (Value Based Management, Inc., 2007). Strangely, the foregoing this theory was not applied to banking. The 'Risk Threshold of the Plausibility Theory' assesses a range of outcomes that may be possible, however it does focus ... on the probability of hitting a threshold point, such as net loss relative to acceptable risk (Value Based Management, Inc., 2007). The new Basel II Accord employs a variant of the foregoing that is termed as 'Risk Adjusted Return on Capital' which is a measurement as well as ... management framework for measuring risk adjusted financial performance and for providing a consistent view of profitability across business (units - divisions) (Value Based Management, Inc., 2007). The foregoing theory of including external events in a calculative model with business lines credit risks is yet to be fully accepted as the variables from external predictive models to result in scenarios along with credit risk models is a daunting set of equations.

Ascertain the scope to which resourceful credit risk management can perk up bank performance.

In equating how and the scope in which resourceful credit risk management can improve bank performance, one needs to be cognizant that credit risk represents the primary type of financial risk in the bank sector as well as existing in almost all areas that are income generating (Comptroller of the Currency, 2001). From the preceding it flows that a credit risk rating system that is managed and run well will and does promote bank soundness as well as safety through helping to make and implement decision making that is informed (Comptroller of the Currency, 2001). Through the construction and use of the foregoing, banking management as well as bank examiners and regulators are able to monitor trends as well as changes occurring in risk levels (Comptroller of the Currency, 2001). Through the preceding, management is able to better manage risk, thus optimising returns (Comptroller of the Currency, 2001).

The improvement of credit risk management in terms of identification and monitoring, the process when operated effectively can improve bottom line performance through laying off risk identified as potentially being problematic in the future (KPMG, 2007). Zimmer (2005) helps us to understand the nuances of transferring credit risk by telling us:

A bank collects funds and originates loans. It might only be able to attract funds if it holds some risk capital that finances losses and saves the bank from insolvency if parts of its loan portfolio default. If the bank faces increasing costs of raising external finance, CRT has a positive effect on the lending capacity of the bank. Providing the bank with additional risk capital, CRT lowers the bank's opportunity cost of additional lending and increases its lending capacity.

As has been covered herein, credit risk represents a potential income loss area for banks in that default subtracts from income, thus lowering a bank's financial performance. The Bank for International Settlements (2003) advises that the principle cause of banking problems is directly related to credit standards that are lax, which is termed as poor risk management. The preceding reality has been documented by the The Bank for International Settlements (2003) that advises that poor credit risk management procedures and structures rob bank's of income as they fail to identify risks that are in danger of default, and thus taking the appropriate actions. A discussion of the means via which resourceful credit risk management enhance bank performance in delved into under the Analysis segment of this study.

To evaluate how regulators and government are assisting the banks to identify, mitigate credit risk, and helping to adopt the risk-based strategies to increase their profitability, and offering assistance on continuous basis.

In delving into banking credit risk management in the United Kingdom, legislation represents the logical starting place as it sets the parameters and guidelines under which the banking sector must operate. The Basel II Accord represents the revised international capital framework for the management of banking credit risk through an improvement to the first Basel Accord that represented the standard for bank capital (Brealey et al, 2001, p. 5). The Basel Accord represented the standard that European banks were required to follow in the computation of capital ratios, and it made a formal allowance with respect to risk (Brealey et al, 2001, p. 5)/span>. The increased complexity of banking caused a revision to the original Basel Accord that was not prepared to deal with the explosion of complex new financial instruments. FDIC Chairman Donald Powell in commenting on the old Basel Accord stated "The activities of the largest banks have reached a degree of complexity not easily addressed under the existing Capital Accord (Blount, 2003).

The regulatory factors involved in the process of mitigating credit risk on the part of regulators as well as governments is an involved subject that is covered in the Analysis segment of this study as it provides an in depth look into this facet.

Research Methodology

As brought forth in the Literature Review segment of this study, the examination of credit risk management in the UK banking sector has been approached using the following fields of focus:

Ascertaining why and how banking credit risk exposure is evolving recently.

Seeing how banks use credit risk evaluation and assessment tools to mitigate their credit risk exposure.

The steps and methodologies used by banks to identify, plan, map out, define a
framework, develop an analysis and mitigate credit risk.

Determine the relationship between the theories, concepts and models of credit risk management and what goes on practically in the banking world.

Ascertain the scope to which resourceful credit risk management can perk up bank performance.

To evaluate how regulators and government are assisting the banks to identify, mitigate credit risk, and helping to adopt the risk-based strategies to increase their profitability, and offering assistance on continuous basis.

The preceding directions were taken as they looked at differing approaches to the context. The research methodology undertaken herein entailed some historical information, as regulations, legislation and developments emanated from this perspective, in addition to contemporary information that formed the bulk of the foregoing. This study engaged the use of primary information as well as secondary sources to delve into the preceding five focus points. The primary questionnaire was constructed to seek opinions on aspects directly associated with the five focal pints. This was further supported by secondary research conducted on these points as well that permitted examining many differing points of view to look for commonalities that provided a direction in finding the answers, and or most utilised facets within the industry. To guard against the possibility or potential of bias on the part of the authors, at least two sources were obtained to provide a consensus.

The study also utilised a combination of qualitative and quantitative research in combination with primary, and secondary sources. Qualitative research is defined as a means of inquiry, which encompasses differing disciplines, along with subject matter (Newman and Benz, 1998, p. 12). Qualitative research represents understanding human behaviour, along with the reasons for that behaviour, and it delves into the why, along with the how as to decision-making (Newman and Benz, 1998, p. 12). Qualitative research seeks the answers to what, why and when (Newman and Benz, 1998, p. 12).

Secondary research entailed the use of books, journal articles, magazines articles as well as the Internet. The benefit of secondary sources is that it provides access to a broad array of opinions and materials that can be reviewed in a reasonable time frame. However, the overwhelming amount of material available meant that all sources could not be researched. This left open the possibility that newer or more apt sources of information might potentially have been missed or left out. As indicated, the research methodology attempted to minimise this possibility by using at least two sources, wherever possible, to validate information and seek to assure it was contemporary.

4.0 Analysis

In terms of the six focal points of this study as brought forth in the Literature Review, and Research Methodology, the following represents an analysis of these points built upon uncovering salient points.

4.1 Ascertaining why and how banking credit risk exposure is evolving recently

The speed at which new financial instruments are being developed, along with their risk and ripple effect consequences is outstripping the ability of examiners and banks to adequately forecast and equate risk exposure. In fact, the Basel II Accord, in a strange way, has something to do with the proliferation of new derivative forms. The capital adequacy provision of the Accord sets limits for banks in terms of its risk exposure, thus banks have an incentive to minimise risk by developing new derivative forms that lay off this risk in varied forms. This has created a new market within a market has banks devise new derivative forms, along with outside development. The question as the effectiveness of the Basel II Accord capital adequacy standards has been and is a subject of debate in the academic as well as financial communities. Rojas-Suarez and Weisbrod (1997, Pp. 112-123) advise that the summary of banking risk rests in the equation that represents a composite assessment of market risks and credit as represented by the capital to risk weighted asset ratio. Rojas-Suarez (2003) tells us:

The capital ratio can take the function of a summary statistic for risk because, at least in theory, enforcement of each of the other supervisory ratios implies an adjustment in the value of assets and liabilities that ultimately affects the size of the bank's capital account.

Thus, the Basel II Accord makes it attractive as well as in the bank's best interest to reduce risk exposure, thus prompting banks to find measures to achieve this outcome. Therein lies the problem that the solution was created to solve. This dichotomy in terms of cross-purposes lies at the heart of the new Basel Accord, which is serving to create another issue. The Bank for International Settlements in a document titled Credit Rick Transfer (2003) explains that the Techniques for transferring credit risk, such as financial guarantees and credit insurance, have been a long-standing feature of financial markets. The foregoing is a result of increased emphasis on risk management, along with (Bank for International Settlements, 2003)/span>:

... a more rigorous approach to risk/return judgments by lenders and investors and an increasing tendency on the part of banks to look at their credit risk exposures on a portfolio-wide basis; efforts by market intermediaries to generate fee income; a generally low interest rate environment, which has encouraged firms to search for yield pickup through broadening the range of instruments they are prepared to hold; and arbitrage opportunities arising from different regulatory capital requirements applied to different kinds of financial firm.

Credit risk transfer constitutes a part of international banking, and thus another aspect of risk exposure that in today's fast paced environment that can get out of hand as a result of the lack of proper identification of inherent risk problems that could escalate into another subprime crisis. The preceding ties back into the speed that transactions can be conducted in today's interbanking system that links major financial institutions globally as well as regional banks into the major institutions. The examples brought forth in this segment have been utilised to illustrate the problem of the pitfalls offered by rapid interbanking technology that while benefiting the industry in terms of spreading information as well as reducing transaction costs, also has the downside of working to the disadvantage of the industry in terms of spreading credit risk issues. This is a core aspect in delving into the facet of how banking credit risk exposure has and is evolving. New forms of risk as a result of financial instruments will always be developing, thus the crisis as represented by the example of the subprime mortgage meltdown are singular events that can and will repeat themselves unless means are found to deal with the fast moving transaction systems in international banking.

4.2 Seeing how banks use credit risk evaluation and assessment tools to mitigate their credit risk exposure

The types of credit risk models, in general, fall into two general categories, models that seek to determine the measurement of losses that will or would potentially occur from default, termed as 'default mode models', and those models that calculate gains, along with losses that arise from changes in credit quality and defaults, which are termed as multi-state and or mark-to-market (Gordy, 2000, pp. 119-149). In both models, losses are projected over a future horizon in accordance with the analysis of the bank, with the usual period representing one year (Gordy, 2000, pp. 119-149). The model seeks to determine defaults, and or credit quality changes from a projected date to a projected date, with other probabilities used as well (Gordy, 2000, pp. 119-149).

One problem with the foregoing is that the model cannot, or does not take into account economic variables whose impact on the preceding can change the equations and thus outcomes. An example is the subprime mortgage crisis, which started in mid 2003, and continued through 2007 with the magnitude of the problem hidden by risk layoffs that masked the underlying problem being sold off. The Basel II capital adequacy accord represents an important facet in equating banking credit risk evaluation and assessment tools to mitigate credit risk exposure in that the Accord calls for capital adequacy requirements to ensure financial stability in the bank sector (Banco de Espana, 2005). Such means being able to measure the risk of default which has a number of structural models that hone in on the stochastic method of the assets of the obligor, and then project the probability of default when the foregoing pass a threshold (Resti and Sironi, 2004, Pp. 183-208). In examining credit risk models, six were selected, based upon the analytic work of Merton (1974, Pp. 449-470). Leland (2002) tells us that the differences in the outcomes and performances of models is represented by the manner in which they handle two key components of debt characteristics, ... the default-trigger value of assets, and the dead weight cost incurred at the time of default (Leland, 2002). In explaining the foregoing Leland (2002)/span> advises of the following:

Endogenous Default Models

Under these types of models the preceding two characteristics are in line with respect to the market estimate of the recovery rate for default, along with a number of borrower features. These models imply the default boundary goes up in the default cost that follows the theory that default rates as well as losses have a tendency to move along the same directional lines.

Exogenous Default Models

In these models an ad hoc boundary is suggested for the default cost and boundary, whereby the foregoing characteristics of debt are calculated to have consistency with the default recovery rate, but have little dependency on borrower features.

Leland (2002)/span> advises that the preceding explains the differences in how credit outlooks are viewed, thus leading in many cases to underestimate default horizons. Huang and Haung (2003) utilise a different approach, they calculate the models based on the default rates being observed in the market, then look at the credit risk premiums. Lopez and Saidenberg (1999) tells us that credit risk models are utilised by banks and financial institutions to measure the degree, amount, and values of credit risk that they hold in their portfolios, which is utilised in many facets of the bank's operations such as loans, the measurement of risk adjusted profit and portfolio management. There are a broad variety of credit risk models in use by the banking sector, with their differences represented by the fundamental assumptions being used. Those assumptions are represented by such factors as (Lopez and Saidenberg, 1999):

the manner in which they define credit losses,

the default line models that are utilised to define credit losses, as evidenced by loan defaults, etc..

Basel II revised the original Basel Accord to mitigate risks through better minimum capital adequacy standards via closer alignment or the foregoing to individual banking risk (Stein, 2004). The Bank for International Settlements (2006) on the subject of risk assessment tools states that banks should have:

systems in place that appropriately address the validation of its ... internal credit risk assessment models (Bank for International Settlements, 2006).

the policies of the bank should address as well as document a loan / loss methodology addressing its credit risk assessment, those procedures as well as controls, and the manner in which it identifies problem loans, along with the determination of the loan loss provisions accompanying the preceding that address these areas in a timely manner.

the risk assessment process utilised by the bank needs to provide it with the necessary procedures, tools as well as data to assess credit risk, taking in accounting for loan impairment as well as capital requirements.

In terms of banking supervision, bank management should (Bank for International Settlements, 2006)/span>:

conduct periodic evaluations of the effectiveness of credit risk practices and policies,

consider whether the bank's risk assessment as well as valuation practices and policies are in keeping with the latest methods, and

be assured that the bank's assessment tools are meeting pre-set criteria.

In analysing banking risk Greuning and Bratanovic (2003) tell us that the process entails a number of factors that should be used in conjunction with each other to represent a cross checking methodology to supports each area via inputs from others. To accomplish the foregoing, Greuning and Bratanovic (2003) advise that the following tools should be utilised in the process, representing a methodology that implements the following:

Output Summary Report

This represents a copulation of ratios, tables as well as graphs that brings all of the elements of the analysis into one format to provide a detailed report of all pertinent factors. The Report also will include income statement and balance sheet information, and projections based upon differing risk variables in terms of outcomes and impact.

Ratio Analysis

Ratios represent a tool utilised in financial analysis that is essential in the examination of risk management. Greuning and Bratanovic (2003) tell us that the foregoing, in general, usually provide information that leads to additional analysis as changes in ratios generally represent clues to areas of investigation. Areas that are covered by credit risk evaluation and assessment present:

balance sheet structure

bank profitability,

capital adequacy,

credit risk,

market risk,

bank liquidity, and

currency risk.

Utilisation of Tools

The preceding areas are augmented by, as well as utilise the aforementioned tool for evaluation and assessment, as shown by the following:

Table 1 - Utilisation of Bank Evaluation and Assessment Tools

(Greuning and Bratanovic, 2003)

Analytical Phase

Source and Tools Available


Data collection

Financial data tables

Completed input data and

financial data tables

Manipulation of data

Financial data tables

Data manipulated by models

Analysis and interpretation

of manipulated and original input data

Manipulated data

Analytical results as represented by the summary report, graphs, tables

Off site analysis of bank's financial condition

Analytical results

Report on banks risk management and financial condition

Focused follow up in terms of the on site examination, including an audit

Off site report and terms of reference

On site report

Institutional strengthening

On site report

Results in better functioning operation

Greuning and Bratanovic (2003) advise that through approaching the evaluation and assessment of the bank's credit risk via many differing tools, models and techniques, the process avoids self-serving results that are usually a product of doing things in only one way. They add that questioning analysing and looking at data from many different standpoints provides the framework and foundation to look for areas of risk that are or might be developing out of skew from accepted norms. The process represents one of consistent analysis and re-analysis, with more details concerning these points covered under discussions of the Basel II Accord.

4.3 The steps and methodologies used by banks to identify, plan, map out, define a framework, develop an analysis and mitigate credit risk.

Credit risk exposure represents a critical aspect of bank operations in that it must be identified, in terms of risk exposure prior to putting funds into any financial package, and then monitored through its effective life until repaid. The preceding aspects have set forth the means via which banks under Basel II are categorised for this facet, comprising the methodologies they work under. In terms of methodologies via which banks in the UK identify, plan, map out, define frameworks, analyse and mitigate credit risks, Standard & Poors (2004)/span> in their document Credit Risk Tracker UK set forth one manner in which these aspects are approached. It should be noted that since banks devise their own internal methodologies, this guide is being utilised as it represents a broad based system that encompasses applicability in most banking situations. The Credit Risk tracker represents an information database that contains the preceding elements that provide ongoing and consistent creditworthiness indicators on companies, containing probabilities of default (PD), along with what are termed as ... quantitatively derived rating estimates (Standard & Poors, 2004).

The Credit Risk Tracker UK is based upon ... an industry specific approach ... representing fourteen differing industry classifications for the United Kingdom (Standard & Poors, 2004). Each of the models utilised contains industry specific risk profiles that ,,, incorporates the appropriate drivers of default (Standard & Poors, 2004). In order to identify these parameters, most banks must subscribe to outside vendors to provide up-to-date information to augment their own historical data to guard against limited, and or skewed data. The Credit Risk Tracker UK uses a broad based and extensive database to enhance model accuracy in the estimation of default risk.

The Basel II Accord represented the foundational premise for the development of the Credit Risk Tracker UK default definition, thus it complies with the precepts herein indicated (Standard & Poors, 2004). The calculation of the default rate used by the Credit Risk Tracker UK takes into account broad credit events, including defaults that have led to bankruptcy thus enhancing its projective accuracies (Standard & Poors, 2004). Through the use of modelling techniques, along with its huge and up-to-date database, the Credit Risk Tracker UK informational content exceeds the capabilities banks in that it extends to the universe of company activities as opposed to the singular in-house experience database of a bank thus offering industry sector performances and comparative information (Standard & Poors, 2004). Developed by Standard & Poors (2004), the Credit Risk Tracker UK is based upon an acknowledged industry leader in company database collection, which aids in the assurance that its information is relevant as well as trustworthy, a critical component in credit risk estimations.

The Credit Risk Tracker UK utilises... three main formats ... (Standard & Poors, 2004), with the format dependent upon the company's size, and larger companies, in general, disclosing more information. The three formats indicated are (Standard & Poors, 2004):

Summarised Accounts

Represent when only abbreviated balance sheet information is available that does not included data from profit and loss statements.

Medium Accounts

This category includes a balance sheet that is more complete, along with a portion of items from the profit and loss statement.

Full Accounts

This segment represents the inclusion of a detailed balance sheet as well as a ... complete profit and loss statement ... (Standard & Poors, 2004).

For public companies, banks have their full audited disclosure documents as well as past market performances to utilise. Banks, of course, obtain additional information from credit users to supplant the preceding information, which is factored into another set of modelling formulas. Differences in reporting formats as well as externally available outside information poses challenges to banks in the development of credit risk models in that missing information skews the results. The foregoing can result in estimates that are not reflective of the default and credit worthiness of the fields being examined, thereby impacting accuracy. Listed companies are required by the European Commission to provide financial statements in accordance with IAS (International Accounting Standards) (Foster, 2004).

As mentioned herein, each bank, with the exception of those under tier one of the Basel II Accord, Standardised Approach, develop their own frameworks, with regulatory approval, for modelling and calculating credit risk. This eliminates the possibility of reporting in a general format that fits all instances. Medova (2004) comments on the foregoing by advising there is no standardised approach applicable to the identification, planning, mapping, defining, analysis development, and mitigation of credit risk. She further states that while the Basel II Accord was formulated to enhance risk management, all three of the tiers lack specifics (Medova, 2004). The Operational risk provisions of the Basel II Accord addresses credit risk in its regulatory capital ratio, whereby the total capital ratio of banks, representing a minimum 8%, is calculated as (Medova, 2004):

Total capital


Credit Risk + 12.5 (market Risk + Operational Risk)

Atiya (2001) states that calculating the credit risk management equation needs to include the computation of the probability of full default, and bankruptcy into modeling techniques to provide a correlation on estimation that takes into account the worst case scenarios. The ratios utilised in this approach have applicability to aiding banks identify, plan, map out, define, analyze, and thus mitigate credit risk (Atiya, 2001)/span>. In calculating the models used to estimate credit risk, Atiya (2001) states that the following financial ratios represent important inputs:

working capital to total assets

earnings prior to interest to total assets

retained earnings to total assets

sales to total assets, and

market capitalization to total assets.

The approaches reviewed all have the same foundational premise in common, access to information from which to input into models. Data, represents the foundational core of bank calculations to mitigate risks, and the plan as put forth by the Credit Risk Tracker UK sets a methodology that portends an operative strategy.

4.4 Determine the relationship between the theories, concepts and models of credit risk management and what goes on practically in the banking world.

Credit risk is the risk inherent in traditional instruments such as loans, bonds and/or currency trading is represented by the amount that is obligated to be repaid, thus the risk equals the principal (International Financial Risk Institute, 2006). Today's credit risk takes in more complex issues such as derivatives, whereby risk is harder to determine. This is due to the fact that derivatives ... derive their value from an underlying asset or index ..., thus the credit risk posed by derivatives does not equal the principal amount as represented by the trade, it amounts to the replacement cost of the contract in the event of default by the counterparty (International Financial Risk Institute, 2006). This replacement value over time fluctuates, and it consists of the present replacement as well as potential costs of replacement (International Financial Risk Institute, 2006).

The concept in the utilisation of derivative replacement cost under the Basel Committee for Banking Supervision is recommended as ... the current mark to market value of the contract (International Financial Risk Institute, 2006). The preceding recommendation is based upon the fact that the potential cost of replacement is factored by the maturity period remaining, along with expected volatility as well as the underlying asset price, both of which can fluctuate greatly. (International Financial Risk Institute, 2006). Industry practice, however favours the utilisation of the Monte Carlo and or historical simulation, as well as option valuation, or probability analysis (International Financial Risk Institute, 2006). The preceding are based upon taking the volatility with regard to the underlying assets and modelling these, along with the impact of variable movements in terms of the derivatives contract (International Financial Risk Institute, 2006). The foregoing is generally utilised to produce two potential exposure measures, which are termed as the expected or average exposure, along with the worse case and or maximum exposure (International Financial Risk Institute, 2006).

The Basel Committee on Banking Supervision (1999) on the subject of credit risk modelling has exercised caution in arriving at a formal process of setting up regulatory capital requirements as regulators have expressed concern at the conceptual soundness, empirical validity, and whether they could, and or can generate ... capital requirements that are comparable across institutions. In terms of the status of credit risk modelling, the Basel Committee on Banking Supervision (1999) indicates:

Credit risk modelling suffers from data limitations as a result of most credit instruments not being marked to the market, thus the models predictive facet is not derived .... from a statistical projection of future prices based on a comprehensive record of historical prices (Basel Committee on Banking Supervision, 1999). Importantly, there is a relative scarcity in terms of available data via which to perform credit risk model estimates, which is attributed to default events having infrequency as well as the time horizons that are longer term that are applicable to credit risk measurement. The underlying problem is risk sensitivity that represents a component of data availability, and the time frame horizon.

Model validation in terms of credit risk is more difficult, owing to the time horizons of a year or more than a year as part of the operative parameters. The problem is represented by this longer hold period whereby the external variable projections have decidedly more components that need to be factored in as possibilities. The risk time frame horizon also represents a problem in model validity as when holding period's increase, accuracy becomes a problem due to variables that could impact at any point through a longer time frame thus making reliability a factor the further out time is projected.

Ferguson (2001) brings up the problem of the fact that market liquidity is not factored into credit risk models and points out that market liquidity problems can impact credit risk. Newer models include measures of liquidity risk, and Ferguson (2001) adds that the treatment variations need to become more consistent in order for the entire credit risk-modelling framework to have a more secure foundation. The benefits of credit risk models encompass a number if beneficial aspects as represented by (Basel Committee on Banking Supervision, 1999):

the fact that banking risk usually cuts across varied product lines and geographical locations, thus credit risk models provide a means to examine these risks in comparison to each other and minimise over saturation in any one type.

The models can or may provide estimates on unexpected loss, thus providing insights to strategic investment decisions.

Credit risk models can by design be either sensitive to or responsive to variables such as shifts in business lines, market variables, credit quality as well as the economic environment. These facets provide for an array of modelling examples to use in the overall risk model equations.

Models also offer the possibilities of improving data collection as well as systems through probability forecasts, provide enhanced risk accuracy, and offer a means to initial an improved foundation concerning capital allocation.

However, credit risk modelling faces some conceptual issues that are categorised as (Basel Committee on Banking Supervision, 1999):

the differing approaches regarding credit loss as a result of the default mode paradigm whereby loss is indicated only when default occurs in the planned horizon. The second factor is the mark to market paradigm whereby the deterioration of credit that falls short of actual default is incorporated into models.

Present credit risk models utilise differing methods to measure exposure as well as loss given default, this is evidenced by some banks using a judgement approach to estimate loan recovery values in default, whereby other institutions use techniques that are empirically based.

There are differing approaches utilised to aggregation of credit risk. This is explained as being measured on an individual asset plane that is generally utilised in the case of large instruments and corporations. The pooled data technique is generally utilised for smaller loans.

4.5 Ascertain the scope to which resourceful credit risk management can perk up bank performance.

Resourceful credit risk management re

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