‘In light of the recent proposals for toughening the Basel III bank rules you are required to critique recommendations for both credit and market risk measurement and management. Your work should summarise the available methods, giving an indication of their strengths and weaknesses and importantly, show how these methods should be implemented as part of an effective risk management policy. You should include references to the academic authorities relied upon.’ Basel III is, ‘the third set of banking rules agreed by central bankers and regulators from around the world at meetings in Basel, Switzerland, hence the name. In Basel III, banks will have to increase their core tier- one capital ratio to 4.5% by 2015’ (guardian, 2010). Banks will be required to hold an increased amount of capital to safeguard against another financial crisis.
There are many different risks that need to be effectively measured and managed in a financial institution. Two of the main risks are credit risk and market risk. The difference between credit risk and market risk is that, ‘in credit risk there needs to be a default or failure by a counterparty to fulfil an obligation, whereas in market risk we deal simply with changes in the prices that investors are willing to pay’ (Marrison, C.I) Credit risk also known as default risk is, according to Basel (1999), ‘the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms’. Whereas market risk is, ‘the risk to an institution’s financial condition resulting from adverse movements in the level or volatility of market prices’ (Basel 1999) According to Marrison, C.I (2002), risk measurement endeavours to answer the following four questions: * How much could we lose?
* Can we absorb a significant loss without going bankrupt? * Is the return high enough for us to take that risk?
* How can we reduce the risk without significantly reducing the return? Credit risk measurement is extremely important as the majority of banking failures have been due to credit risk issues rather than other forms of risk, for example the collapse of Northern Rock in 2008. In this situation, Northern Rock suffered massive losses due to mortgage borrowers struggling to repay (BBC NEWS) . This means that risk based capital requirements to cushion against credit risk losses are higher than for market risk. (Statman.S , 2006) This risk needs to be measured as it gives the banks much needed information such as, the probability of a borrower defaulting, the amount that it is possible to recover in the event of a default and the likelihood of more than one borrower defaulting. In many financial institutions, third parties such as Moody’s provide the credit risk information. ‘Moody’s is an essential component of the global capital markets, providing credit ratings, research, tools and analysis that contribute to transparent and integrated financial markets’ (Moody’s Corporation, 2011). Moody’s uses historical data to calculate a risk level for individual companies, ranging from Aaa, which is the highest available rating, down to C, which means the company is either in default or has a very high risk of entering default in the near future (See Appendix A for full table). According to Moody (2003), their ratings are, ‘opinions of the credit quality of individual obligations or of an issuer’s general creditworthiness, without respect to individual debt obligations or other specific securities’. Companies can be up or down-graded in this system depending on their performance. When a bank is considering providing a loan to a company, they have to consider the probability of default, exposure of credit and the estimated rate of recovery. These three factors have to be considered in microscopic detail to ensure that the bank is not taking an unjustifiable risk. These considerations can firstly be undertaken by using credit scoring. Credit scoring is, ‘the application...
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