Credit Risk Management: Objectives and Techniques

Introduction

The financial industry, because of its nature, is susceptible to risk, and has been marked by it over the last twenty years. As a consequence, the financial industry has employed risk management techniques on a global basis, across business functions, lines and the different kinds of risks. This is because as financial institutions expand into foreign market, it becomes more prone to increased global risk (Jorian, 2007, pp. 557). The different kinds of such risks are credit risk, market risk, operational risk, liquidity risks, interest rate risks, and many more. Another risk that is overlooked by most institutions is the interactions that these risks have (Jorian, 2007, pp. 557).

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This paper will focus on such risks, and highlight and explain the different techniques of managing them. Each risk will be better explained with the help of examples.

Discussion

Financial institutions are prone to many different kinds of risks, as mentioned earlier. To better manage these risks and for minimal exposure to them, first of all, institutions must understand the risks. They must understand the objectives for managing risk so that they know what they want out of it. This will enable them to manage risks more effectively. Once they are aware of the objectives, they must know the different methods of measuring risks. Once risks are measures, they must be monitored and managed then. The different kinds of risks, objectives of their management and management techniques are discussed below.

Credit Risk

Credit risk is defined as a risk of loss due to the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms (Coen, 2009). For most financial institutions, this simply means that counterparties fail to pay back borrowed money. For example, if Anna takes a loan from a bank, and promises to pay back by December 12, 2008. Suppose if she fails to meet this deadline, she has failed to meet her contractual obligations. Therefore, this causes credit risk for the bank.

For most banks, this kind of credit risk, where the source is loans, is the major source of all credit risks. However, there are many different sources such as acceptances, inter-bank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions (Coen, 1999).

Objectives of Credit Risk Management

For this reason, it is of utmost importance for financial institutions to manage credit risk. The objective and goals of credit risk management is “to maximise a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters” (Coen, 1999). This risk is not only prevalent in individual transactions but also in portfolios.

Credit Risk Management Techniques

The most obvious and instinctive technique to managing this kind of risk is to extract valuable lessons from past experiences. For example, it would be foolish on an institution’s part to give loan to a creditor again who has previously failed to meet his contractual agreement terms. Therefore, a bank can also make a model based on such experiences which would define the kinds of creditors most likely to default. Banks and financial institutions must firstly identify and measure credit risk. After which they must monitor and control it. They must also determine a way to hold sufficient capital against these risks and that they are effectively compensated for risks incurred (Coen, 1999).

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The techniques discussed above are mainly used to reduce credit risk from individual transactions. On the portfolio side, banks and institutions can reduce this risk by diversifying across different geographic regions and borrower types (Kidwell et al, 2007). For example, a bank must give loans to people in different countries rather than only in let’s say Pakistan. This is because the profiles of these clients will be different and so will their ability to pay back on time.

Other factors that have an impact on credit risk are the timing of transactions, settlement determination and the role of intermediaries. All these must be monitored and managed effectively also in order to face minimum credit risk. For example, banks must rely on the bank trading pattern, or maintain effective relationships with all intermediaries involved to hedge the risk from the aforementioned factors.

Foreign Exchange Risk

Objectives of Foreign Risk Management

The main purpose of the risk analysis procedures is being able to avoid risk or fight the consequences of the risk manifestation timely and properly. The foreign exchange market is especially susceptible to risk, and therefore risk analysis is of utmost importance for the exchange market players. Foreign exchange risks must be given more consideration because these risks determine the rate of profitability, or loss, that companies might suffer because of the exchange rates fluctuations and changes (Theil & Ferguson, 2003).

Foreign exchange risk is the risk of loss from unanticipated changes in exchange rates (Osei-Kuffour, 2000). For example, this includes the risk of loss from exchange rate depreciation, difficulties of foreign players to convert money from one currency to another one, problems in exchanging a specific currency in a specific region, and dependence of national currency on foreign currency, for example the Pakistani rupee is rather dependent on American dollars for the smooth functioning of its economy. An appreciation in the value of dollar in terms of rupee will and has been causing inflation in the Pakistani economy.

Foreign Exchange Risk Management Techniques

The most common techniques to hedge foreign exchange risks include the forward market hedging and currency futures (Barrese & Scordis, 2003, p. 26). This is when an exporter and importer get into contract to trade at a fixed foreign exchange rate for a given period with the help of a financial institution. This is probably the most direct means of hedging foreign exchange risk. If a Pakistani exporter sells to an American importer goods worth 1 million Dollars at an exchange rate of 1 USD to 82 Rupees, the Pakistani exporter may get into contract with a financial institution to deliver 1 Million Dollars in Exchange for payment of 82 million rupees over let’s say, 60 days. So no matter what happens to the exchange rate, the exporter will still be able to exchange 1 million dollars for 82 million rupees, and vice versa. (International Trade Administration 2008)

The currency futures technique is similar to the forward hedging contract in that it acts as a form of insurance for companies in case there are any shifts in currency exchange rates. What happens in a future contract is that the payment in such a situation is carried out according to the exchange rate fixed in the futures agreement (Osei-Kuffour, 2000, p. 42).

Operational Risk

Operational risk is defined as the risk of loss resulting from inadequate or unsuccessful business functions; internal processes, people and systems, or from external events. For example, in the real world this could include insufficient monitoring, human errors, manual data entry errors, fraud or embezzlement, defective controls, management ineffectiveness. Such risk may also be faced when intermediaries exceed their authority and carry out business in a risky manner (BIS, 1998).

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Banks and/or other financial institutions are even more prone to this risk as they expand their operations in the global market. Larger operations become difficult to monitor and manage. Also, there are increased chances of fraud as the institution opens operations in new markets, where the environment may be uncertain.

The reason why institutions face operational risk, in the first place, is due to lack of effective monitoring. Once all functions, lines, and borrowers are efficiently monitored, operational risk becomes manageable. Therefore, the first step in hedging this risk is to have effective monitoring parameters and tools in place. Secondly, automation could lead to fewer human and data entry errors. Also, it makes financial processes more efficient and accurate. For this reason, banks must invest in systems that integrate information from the different business functions and allow automation. Integration of information also allows the management to have a holistic view of all its operations. Since banks are more susceptible to fraud than most other institutions, it must also insist on strong legal departments, and take legal assistance from the best legal consultants and firms.

Objectives of Operational Risk Management

The goal of operational risk management must be to enhance the banks understanding of its business functions and analyze exposures. After having had adopted some of the above mentioned risk management techniques, a bank should have such understanding about its operations and the different risks it may be exposed to.

Operational Risk Management Techniques

To improve management efficiency, along with internal processes, it is of utmost important for top and middle managers to understand the different kinds of risk that the bank may face, and an understanding of how to measure, monitor and manage this risk. Other than this, natural hazards or other external factors may also have an impact on operational efficiency of a bank. However, these are difficult to detect. Even if they are detected, it is difficult to fight them. Nonetheless, many solution providers market solutions that allow business to prepare for such hardships.

Banks may also invest in Operational Risk Management software that allows them to have a “continual cyclic process which includes risk assessment, risk decision making, and implementation of risk controls, which results in acceptance, mitigation, or avoidance of risk.” As a result, this leads to diminution in operational loss, early recognition of illegal activities and lower compliance costs (Wikipedia, 2009).

According to Jorian (2007, pp. 564), Internal operational risk can be minimized by separation of functions. This means that accounting transactions will be carried out by accountants only and no one else. There should be dual entry and reconciliation, which means that inputs and output must be matched from different sources, respectively. Tickler Systems must be used to enter important dates into a calendar that generates automatic reminder messages before the due date. Finally, there should be strict control over any amendments in the original deal tickets through Control of Amendments.

According to Jorian (2007, pp. 564), there are also a number of external controls that an institution can make use of. These include confirmations of the counterparty for a check on the transaction. Verification of prices means that prices must be obtained from a number of external sources before processing such transactions. Other external controls include authorizations, settlements, and internal and external audits. Counterparties must know which transactions they can perform, and through which personnel, and audits help to identify the weak areas.

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Market Risk

Market risk is defined as the risk of loss due to changes in market price and volatilities of prices in the market. This kind of risk is mostly measured as the potential gain or loss in a position or portfolio in response to a price movement of a given probability over a specific time period. This is known as value at risk or, simply VAR. For example, “An institution with a 10-day VAR of $100 million at 99% confidence will suffer a loss in excess of $100 million in one fortnightly period out of 20.” (IFRI, 2000)

Market Risk Management Objectives

The goal of market risk management is to minimize an institutions exposure to market prices, and helping it increase profits when prices and volatilities are favorable.

Market Risk Management Techniques

VAR is recognized as a market risk management technique. Since 1994, it has become the primary quantitative measure of market risk especially for fixed income, equity and foreign exchange positions (IMF, 2007).

Interest Rate Risk

Interest rate risk is the loss from changes in interest rates. This affects future cash flows or the fair values of financial tools. Interest rate risk is also the risk of loss from fluctuations in security prices (Kidwell et al 2007). As an example, if the interest rates go up, the value of the loan will also increase. This means that the cost of borrowing is now higher, so an increase in the value of loan is good news for the lender but is more costly for the borrower.

Interest Rate Risk Management Objectives

The goal of managing interest rate risk is minimal exposure to fluctuations in interest rates, and using this to earn profit or minimize losses (Kidwell et al 2007).

Interest Rate Risk Management Techniques

For an institution to manage interest rate risk, it must have a clear understanding of the impact of changes in interest rates on the institution’s risk position. Techniques such as Gap analysis, duration analysis and VAR, again, are used to measure interest rate risk. Gap analysis is the difference between the amount of interest earning assets and interest bearing liabilities over a specified time horizon. The greater the size of these gaps, the more the bank is susceptible to interest rate risk (Kidwell et al 2007). Duration gap analysis is measured as a difference between the duration of bank’s assets and the duration of its liabilities. VAR has been discussed above.

Now that the institutions have a understanding of how to measure interest rate risk, they must know how to control it. Three techniques can be used to manage this kind of risk. These include future contracts, options and swaps.

There is an indirect relationship between the price of financial futures contract and interest rates. So, if interest rates go up, futures contract will go down. Therefore, if interest rates in fact do go up, the bank will increase earnings in the short term because of it. However, it’s future contract value will go down. Secondly, options can reduce the interest rate risk by creating ceilings and floors in interest rates. This controls interest rates and hence, minimizes the exposure that a bank may face in response to interest rate fluctuations. This is because they can change only within a specified value. However, it is important to note that these options come at a higher cost. Finally, swaps allow financial institutions to exchange variable rate cost of funds for fixed rate cost of funds. This reduces their future exposure to interest rate risk (Juttner et al, 1997).

Conclusion

There is another very inherent risk also, that most institutions fail to take into account. This is the risk that is caused by the interaction between different kinds of risks. These risks are not separate. In fact, one kind of risk has an effect on another. For example, operational risk can cause credit risk. Credit risk can cause liquidity risk or systematic risk. Therefore, managers must be aware of this interaction and must look at their organization taking a holistic approach. This helps them to see what risks they are exposed to, and what risks these risks can in turn cause. This will guide them into better risk management for all kinds of risks.

References

BIS (1998). Operational Risk Management. Bank for International Settlements [Internet]. 2009. Web.

Coen, W. (1999). Principles for the Management of Credit Risk. Bank for International Settlements [Internet]. 2009. Web.

IFRI (2000). Overview: Market Risk. IFRI [Internet]. 2009. Web.

IFRI (2000). Types of Financial Risks. IFRI [Internet]. 2009. Web.

IMF (2007). Do Market Risk Management Techniques Amplify Systematic Risk? IMF [Internet]. Web.

Jorian, P. (2007) Financial Risk Management. New Jersey, USA. John Wiley & Sons.

Juttner, D. & Hawtrey, K. (1997). Financial Markets Money and Risk. Australia. Addison Wesley Longman.

Kidwell, D., Brimble, M., Beal, D. & Willis.D. (2007). Financial Markets Institutions and Money. Australia. John Wiley & Sons.

Osei-Kuffour, P. (2000, November) Managing Foreign Exchange Risk. New African 41.

Ribeiro, J. (2008) Global Risk Management. Financial Services [Internet]. Web.

Theil, M., & Ferguson, W. L. (2003) Risk Management as a Process: An International Perspective. Review of Business, 24(3).

Trade.gov (2008). International Trade Administration. US Department of Commerce [Internet]. Web.

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