Page 84 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 5: Credit Risk Management

dealing with individuals, corporate, financial institutions or a sovereign. For most banks, loans Notes
are the largest and most obvious source of credit risk; however, credit risk could stem from
activities both on and off balance sheet.
In addition to direct accounting loss, credit risk should be viewed in the context of economic
exposures. This encompasses opportunity costs, transaction costs and expenses associated with
a non-performing asset over and above the accounting loss.
Credit risk can be further sub-categorized on the basis of reasons of default. For instance the
default could be due to country in which there is exposure or problems in settlement of a
transaction. Credit risk not necessarily occurs in isolation. The same source that endangers
credit risk for the institution may also expose it to other risk. For instance a bad portfolio may
attract liquidity problem.
In assessing credit risk from a single counterparty, an institution must consider three issues:

Default probability: What is the likelihood that the counterparty will default on its
obligation either over the life of the obligation or over some specified horizon, such as a
year? Calculated for a one-year horizon, this may be called the expected default frequency.
Credit exposure: In the event of a default, how large will the outstanding obligation be
when the default occurs?

Recovery rate: In the event of a default, what fraction of the exposure may be recovered
through bankruptcy proceedings or some other form of settlement?

Example: The effective management of credit risk is a critical component of a
comprehensive approach to risk management and essential to the long-term success of any
banking organisation.
Banking is nothing but financial intermediation. There are people in the market with surplus
capital looking for safe investment opportunities. Simultaneously there are entrepreneurs
desirous of building up productive assets but with no matching capital resource. Yet the ‘savers’
do not want to directly lend to capital seeking entrepreneurs as they are not certain of safety.
There can be no risk-free or zero risk oriented business. Risk in its pragmatic sense, therefore,
involves both threats that may be materialized and opportunities which can be exploited.

Caselet Credit Risk Management at J P Morgan

J P Morgan Chase (JP), the second largest financial services company in the US, is exposed
to credit risk through its lending, trading and capital market activities. J P’s credit risk
management practices are designed to preserve the independence and integrity of the
risk assessment process. JP has taken various steps to ensure that credit risks are adequately
assessed, monitored and managed. In early 2003, JP has combined its Credit Risk Policy
and Global Credit Management functions to form Global Credit Risk Management
consisting of the five primary functions – Credit Risk Management, Credit Portfolio
Group, Policy & Strategic Group, Special Credits Group and Chase Financial Services
(CFS) Consumer Credit Management Risk.
Source: http://www.icmrindia.org

LOVELY PROFESSIONAL UNIVERSITY 79