Page 156 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 11: Credit Derivatives

information for review and management of loan portfolio. Within the rating framework, banks Notes
can proscribe certain level of standards or critical arameters, beyond which no proposals should
be entertained. A separate rating framework may also be developed for large corporates, small
borrowers, and traders, that exhibit varying nature and degree for risk.
Internal risk rating systems are thus pivotal to credit risk management. These ratings serve as
important tools in monitoring and controlling credit risk. The rating assigned to individual
borrowers or counterparties at the time the credit is granted must be reviewed on a periodic
basis and individual credits should be assigned a new rating when conditions improve or
deteriorate. The bank's risk rating system should be responsive to the indicators of potential or
actual deterioration in credit quality. Advances with deteriorating ratings should be subject to
continuously evaluating the credit portfolio and determining the necessary changes to be
introduced in the credit strategy of the bank.

11.4.4 Risk Pricing

Risk-return pricing of loans is a fundamental tenet of risk management. Returns on loans must
be measured by a degree of risk. In a deregulated environment, competition will force banks to
accept more risk but the returns may not always be commensurate. If loans are not priced right,
banks run the risk of either underpricing their loans or losing their business to other competitors
in case of overpricing . In a risk-return setting, a borrower with a lower rating will be placed in
a high risk category and hence priced higher and vice versa.

The systems to price credit risk should be scientific and take into account the expected probability
of default. The pricing of loans is normally linked to risk rating or credit quality. Hence, risk
rating, especially in the case of commercial loans, will be the anchor for pricing loans. However,
this may be duly supplemented and supported by other factors, such as:

1. Market forces and competition
2. Portfolio/industry exposure
3. Value of collateral
4. Value of account, both short-term and long-term
5. Strategic reasons such as additional business potential or threat of loss of business, past
conduct of account, etc.

11.4.5 Portfolio Management

Banks, in general focus on oversight of individual credits in managing their overall credit risk.
While this focus is important, banks also need to have in place a system for overall composition
and quality of the various credit portfolios.

A continuing source of credit related problems in banks in concentration within the credit
portfolio. Concentration of risk can take many forms and can arise whenever a significant
number of credits have similar risk characteristics. Concentration occurs when, among other
things, a bank's portfolio contains a high level of direct or indirect credits to
1. A single counterparty
2. A group of connected counterparties

3. A particular industry
4. A geographic region

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