The challenging economic environment has put significant pressure on banks and corporates to address credit risk management in a more effective and risk-averse way. This principle lies behind upcoming regulations such as Basel III and Solvency II, both of which are expected to introduce tougher rules on risk management, including credit risk.
To be able to fully grasp the implications of these changes for the banking and corporate sectors, it is essential to understand the challenges facing organisations when it comes to managing credit risk.
Credit risk represents the potential that a bank borrower or counterparty might fail to meet the credit obligations as defined in pre-agreed terms. Therefore, the process of managing credit risk involves reducing credit risk exposure within acceptable limits to ensure that even in a situation of a default, the loss will not threaten the organisation’s core operations and business activities.
However, credit risk is influenced by multiple factors including macroeconomic indicators such as inflation, growth rate, political stability and microeconomic factors such as supply and demand, prices, internal business resources, etc. Furthermore, banks and enterprises need to manage credit risk across their entire portfolio and in relation to other types of risk such as product risk, customer risk, etc. This poses significant challenges, particularly when you consider that many of the factors affecting credit risk are constantly changing, thus reinforcing the need for continuous monitoring, measuring and modelling of credit risk.
The effective management of credit risk requires a comprehensive approach that enables banks and corporates to monitor, measure and control credit risk as part of an overall risk management strategy. This approach should enable organisations to achieve auditability with existing policies and procedures and enforce the best risk management practices across the organisation, thus mitigating credit risk exposure.
The Regulatory Challenges
One of the underlying purposes of Basel III is to substantially strengthen the counterparty credit risk framework which means that banks will have to meet more stringent requirements for measuring credit risk exposure, capturing risk and managing risk concentrations. The new capital and liquidity demands within Basel III and Solvency II are already putting financial pressure on banks and insurance companies to achieve real-time performance and risk management, in order to minimise the risk and cost of managing liquidity and solvency.
As banks need to manage credit risk in relation to other risk types, which are geographic, customer and product-specific, they need to enable agility in changing risk ratings and streamline IT processes to ensure auditability and control. However, there are a number of challenges that make this process daunting. For example, how do you ensure credit risk visibility across multiple geographies, customer types and lines of business? And even if you do, how do you measure the effect of different risk types on credit risk and ensure the created risk models meet the highest regulatory standards?
Understanding Credit Risk
Managing credit risk starts with understanding risk within the organisation. It requires in-depth knowledge of all internal factors that can affect credit risk exposures and identification of all assets of the organisation that are exposed to credit risk. As financial institutions and businesses are lending money, goods or services to third party borrowers, customers or trading partners, they need effective solutions to adequately monitor and measure credit risk in relation to their counterparties.
Technology can step in and aid organisations in this process. By automating business processes and compliance practices and evaluating each action against different types of risk, organisations will be able to ensure better auditability and mitigate credit risk. A business process management (BPM) framework will allow organisations to easily design processes and develop the strategic measurement necessary to ensure proper performance and reduce operational risk. Once the mechanisms for measuring financial exposure have been put in place, limits can be set to automatically track and calculate credit risk in accordance with pre-defined requirements.
These automated rules and processes can be extended across all operational layers of the organisation, making it easier to address credit risk as part of the overall risk strategy. Such an approach allows banks and businesses to manage credit risk through a single platform with specifications based on risk type, regulatory requirements, geography, product category and line of business. This is particularly important for multinational organisations where the synchronisation of disparate processes, regulatory requirements and risk management practices is often hindered by the complexity and scope of business activities across multiple locations. Different rules may apply to different lines of business or countries but a global view is necessary to manage risk.
Furthermore, BPM allows the automation of manual credit risk calculations and quality review processes, and for the adjustment of these processes to changing economic or regulatory requirements. This offers great flexibility and enables organisations to introduce quick and effective changes in the way they manage, approve and audit calculations for credit risk, without having to transform internal IT systems.
Such an approach allows credit risk management to be extended to other types of risk and lines of businesses such as customer on-boarding and even sales. For example, an automated mechanism for approval of credit limits and calculation of loss exposure can help front line facing staff in banks to handle credit requests or other related issues faster than ever before. Additionally, the system can route more complex cases to credit officers and enforce compliance with regulatory standards. And because this automated rules-driven engine is linked to the organisation’s back-end systems, it evaluates customer information against risk management and compliance data, helping credit officers or sales managers take more informed decisions regarding credit risk.
Technology and Auditability
Another important facet of credit risk is the issue of auditability. By monitoring business processes, customer interactions and predefined risk indicators, technology can aid the faster detection and resolution of credit issues and significantly reduce credit and compliance risk exposure. By automating and applying the best risk management practices across the organisation, businesses and financial institutions can ensure compliance with existing regulatory standards.
Providing banks and corporates with real-time reporting on their financial assets and anything outside the parameters of risk tolerance via a centralised rules-driven engine which actively monitors and analyses processes can help firms manage credit risk exposure more effectively.
Know Your Customer
As credit risk is directly linked to third party uses, the so called counterparties, organisations need to constantly assess credit risk in relation to their customers or borrowers. Knowing your customers and business partners is essential to effectively managing credit risk. Technology can be of great help here by actively monitoring all customer interactions, behaviour and history and comparing customer risk against credit risk. By classifying customers in different credit risk profiles and notifying credit officers of high risk customers and abnormal activities, technology can help banks and corporates reduce risk exposure to a minimum.
Identifying risky customers and financial behaviour can enable banks and businesses to proactively address the financial difficulties of the relevant customer group and prevent critical situations. For example, a bank can programme its IT system to identify customers who regularly delay mortgage payments or have requested to switch to an interest-only loan. Then credit advisors can review each customer case and proactively contact the customers who need financial advice and support. Such an approach will not only improve the relationship with the customer but will also reduce credit risk by tackling problematic cases before they have become a financial burden to the organisation.
Tackling Different Types of Credit Risk
Default risk is not the only type of credit risk facing financial and business organisations. Quite often organisations are faced with concentration risk, arising from focusing all of their financial resources on one business activity and geographic location, or country risk which is related to national political and economic factors. To avoid such risks, organisations can use technology to identify and analyse risk correlations across borders and provide them with useful insights into potential opportunities for growth and business diversification.
The current economic crisis across Europe is already putting significant pressure on banks and businesses to offset country and concentration risks. This means that establishing mechanisms within organisations that actively monitor, measure and analyse credit risk against foreign macroeconomic factors is vital to ensure that the market is going in the right direction.
Technology can help in these areas by providing exposure reports by geography and industry, and analytics of price against the market. Another important use of technology would be to help organisations understand what the impact of a default would be and how to recover from it. Modelling the potential impact of a default can help organisations take appropriate preventive measures and better calculate and monitor the limits of risk exposure.
This is invaluable for any bank or large scale organisation that is looking to protect its assets from financial risk. As financial service providers and businesses are under increasing pressure to comply with strict regulatory standards and maintain competitiveness on the market, it becomes increasingly important to implement effective technological solutions to help them manage credit risk. Technology can aid organisations in this process by providing reliable solutions for measuring, monitoring and controlling credit risk.
By adopting a BPM framework for credit risk management, organisations can tackle credit risk from a single platform and better integrate this process into their overall risk management strategy. BPM allows organisations to implement a streamlined credit risk platform with easy extendibility to build an enterprise-wide risk platform. By linking credit risk with other risk types and macroeconomic factors, they will be able to better understand risk and take more effective preventive actions to offset the impact of a default, as well as ensure compliance to complex regulatory requirements.
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