In the morden society, risk is not an unfamiliar state for no matter individuals or Financial Institutions. Especially for investment banks, risk is an essential factor for daily operating activities. If there is no risk in bank’s daily operations, the value of the bank’s investment could only be the risk-free returns, which violates the final targets of investment banks, that is, making shareholder’s profit maximization. Thus, to increase the returns of shareholders, banks should not only take the risk and get higher returns, but also control risk to a certain level to avoid unnecessary deficit.
Many banking risks arise from mismatching. If banks achieved perfect matching, the only risk would be credit risk(obviously, mismatching is an essential feature of banking and a source of profit opportunities), as a result, credit risk is a specific risk of banking systems and becomes increasingly significant as well. Furthermore, loan portfolio, as a key source leading to credit risk, is accounted for a large amount of bank’s asset. Hence, a sufficient and suitable measurement and management method of credit risk for specific investment banks should be implemented to ensure bank’s stability and prevent banks from insolvency.
Traditional ways to measure credit risk has revealed some drawbacks using classic processes. To be more specific, quantity of the loan is not enough to measure whole credit risk, we should also consider the counterparty’s credit standing. Also, it is not available for measuring the cumulative credit risk over financial trades. (Barbara Casu, Claudia Girardone & Philip Molyneux, 2006). It is indicates that investment banks should explore more precisely approach to measure and manage credit risk. This essay will analysis the accurate ways measuring and managing credit risk and discuss the extent to which the methods that are used by investment banks to control credit risk is actually effective.
2. Modern tools of credit risk measurement
2.1 The significance of measuring credit risk accuratly
Credit risk is the risk that a borrower will fail to service debt as promised, or that the counterparty will deteriorate in its credit standing. Specifically, credit risk is synonymous with default risk. Default occours when a loan or a fixed-income security fails to make a promised payment due to the debtor’s inability or unwillingness to pay. In fact, Casu, Girardone and Molyneux (2006, P.283) believed there are four main factors why more precise tools should be considered to measure credit risk:
• the growth of the securitised loan and secondary loan trading market; • recent evolution of credit derivatives business;
• increased emphasis on risk-adjusted performance measurement systems and the desire to trade credit risk; • the desire of companies to manage the risk/return characteristics of their debt funding more effectively.
2.2 Credit Ratings
Inorder to decrease the credit risk and therefore improving the shareholder’s profit, an efficient measure which defined as Credit Rating should be addressed to control credit risk. It quatifies credit risk and is the assessment of risk of loss due to failure by a borrower to pay as promised. Also, it usually can be clssified to Internal Ratings and External Credit Ratings. To be more precise, Internal Ratings have a wider coverage than external and not usually revealed to outsiders. It cantains three main process: - Statistical based process: Default probability models e.g. Credit scoring, linear probability models (Casu, Girardone and Molyneux, 2006, P.287) - Constrained expert systems: Combination of quantitative and judgmental factors in assessing default risk. - Expert judgement based processes: these are used in the absence of publicly available information on the quality of the borrower. The bank manager uses his/...