Looking back into the past, poor management of credit risk was the root cause behind most of the major banking disasters. But being the oldest risk in the market, it was not given much attention and almost remained aloof to the advent of technology until the late 1990s. With the introduction of banking regulations, there is now awareness in the industry to identify, measure, monitor and control credit risk, as well as to determine that adequate capital is held against this risk. Credit risk not only affects lenders but also any company that receives funds for products or services.
After operational risk, credit risk is the biggest challenge facing the industry – large-scale borrower defaults may even force a bank into bankruptcy. As the market has turned increasingly competitive with the mushrooming of new players, it is evident that companies are taking on more credit risk. But for a more transparent market and healthy competition, the financial services industry must turn credit risk into an opportunity.
Credit risk is relevant to all banks as they give loans, take guarantees for the performance of other loans, or pass on a line of credit to customers. According to Basel II, banks must measure risk for credit in corporate, inter-bank, government, retail, project finance and equity.
Credit risk must be managed at both individual and portfolio levels. However, individual management of credit risks requires relevant and specific knowledge of the counterparty's business and financial status. Financial services organizations in the US have gained considerable experience in the evaluation of credit defaults by using models and advanced risk management methods. Over the years, these models have evolved significantly and today they are accepted by the industry as stable and accurate. Unfortunately, the operation of these models requires a huge amount of data – for a good model, it is estimated that at least 500 defaults and 500 normal credits must be entered into the system for accurate and reliable predictions. Therefore it is likely that only large banks will be capable of using the advanced risk management practices laid down by Basel II.