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Unit 5: Credit Risk Management

commensurate with the scope and sophistication of the bank’s activities. For smaller or less Notes
sophisticated banks, supervisors need to determine that the credit risk management approach
used is sufficient for their activities and that they have instilled sufficient risk-return discipline
in their credit risk management processes.
A further particular instance of credit risk relates to the process of settling financial transactions.
If one side of a transaction is settled but the other fails, a loss may be incurred that is equal to the
principal amount of the transaction. Even if one party is simply late in settling, then the other
party may incur a loss relating to missed investment opportunities.
Settlement risk (i.e. the risk that the completion or settlement of a financial transaction will fail
to take place as expected) thus includes elements of liquidity, market, operational and
reputational risk as well as credit risk. The level of risk is determined by the particular
arrangements for settlement. Factors in such arrangements that have a bearing on credit risk
include: the timing of the exchange of value; payment/settlement finality; and the role of
intermediaries and clearing houses.

Self Assessment

Fill in the blanks:
7. Losses may result from reduction in ………………value due to actual or perceived
deterioration in credit quality.

8. Credit Risk is the major component of ………………system and this should receive special
attention of the Top Management of the bank.
9. The ……………….risk arises out of internal factors such as machinery breakdown, labour
strike, new competitors who are quite specific to the activities in which the borrower is
engaged.
10. ………………mechanism advocates that the amount of portfolio value should be viewed
not just in terms of likelihood of default, but also in terms of credit quality over time of
which default is just a specific case.

5.4 Approaches to Credit Risk Measurement: Intrinsic Risk

There are three basic approaches to credit risk measurement at individual loan intrinsic level
that are used for various types of loans such as commercial loans, project and infrastructure
finance, consumer and retail loans. They are:

Expert Systems,
Credit Rating, and
Credit Scoring.

5.4.1 Expert Systems

In an expert system, the decision to lend is taken by the lending officer who is expected to
possess expert knowledge of assessing the credit worthiness of the customer. Accordingly the
success or failure very much depends on the expertise, judgment and the ability to consider
relevant factors in the decision to lend.
One of the most common expert systems is the five “Cs” of credit. The five ‘C’ are as under
(Saunders, 1999):

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