Ch08 Exposure Assessment.docx

EXPOSURE ASSESSMENT After reviewing borrower rating, other credit assessment factors, and the collateral, it is possible to assess the borrower’s creditworthiness with regard to the proposed exposure. The final assessment of the exposure risk can only be made (especially in the corporate customer business) after a comprehensive evaluation of all sub-processes of credit review. The results of the valuation of the collateral will also be included in this assessment which has to be made by the employees handling the exposure. The credit form should thus provide appropriate fields. Here, it is important to make sure that the internal guidelines contain clear rules on the level of detail and the form in which the explanation has to be presented. In practice, it has proven useful to compare the positive and negative assessment criteria. In addition, the form should provide a field for a concluding summary. Here, too, the use of text modules appears appropriate to avoid longwinded and vague statements. The assessment of the employees in charge of processing the exposure is the basis for the subsequent credit decision. This must be done in line with the decision-making structure for the credit decision stipulated in the internal guidelines. Automated Decision The standardized retail business in particularly does mostly without individual interventions in the credit decision process, with the result of the standardized credit rating process being the major basis for the credit decision. As these processes are used only for small credit volumes, the data are often entered by a sales employee. Deviations can be found mostly in residential real estate finance, as it is possible to set up specialized risk analysis units for this usually highly standardized process. In both cases, the credit decision can be made by a single vote up to a volume to be defined in the internal guidelines in order to curb the complexity and thus increase the efficiency of the process. Increasingly, mostly automated decision processes are also used in the small business segment. The prerequisite is a clear definition of and the data to be maintained for this customer segment. This makes it possible to create the conditions to derive a discriminatory analysis function. In some cases, it is left to the credit applicant to enter the data necessary to carry out the credit review (so-called online applications). However, the limited database and lack of more personal contact with the credit applicant limit the application of this option. The most important success factor in the use of mostly automated processes is the bank’s ability to take precautions against the credit applicant entering wrong data or to identify such wrong entries in time. In Choosing a Process as the IRB approach provides for a calculation of the regulatory capital requirement on the basis of credit standing, the credit rating process has to be adapted to the requirements of the IRB approach. The application of the formulas to calculate the regulatory capital requirement stipulated in the IRB approach under Basel II requires banks to derive the default parameters needed to quantify the risk. Both the basic approach and the advanced IRB approach require the calculation of the probability of default (PD) of a claim/a pool of claims. Therefore, the credit rating of individual exposures has an immediate impact on the capital requirement. The probability of default of retail exposures can be determined on the basis of pools of claims which combine a number of comparable individual exposures. Thus, it is not necessary to classify every single borrower into different categories. Under Basel II, it is possible — under certain circumstances — to treat corporate exposures with a total volume of no more than 1m as retail exposures. Based on what has been said so far, it would theoretically also be possible to assess such exposures by using a mostly automated credit decision process (at least from a perspective of compatibility of the credit rating process with the calculation of the capital requirement). In practice, this will have to be qualified for two major reasons: The profitability of the small business segment is highly dependent on the price structure. This, in turn, is one of the decisive competitive factors. Therefore, it is necessary to delineate the risk associated with an exposure as precisely as possible to be able to set a price commensurate with the risk involved. Homogeneous data pools are required for the application of empirical statistical models. In practice, the borrowers in the small business segment show a high degree of heterogeneity, which means that this requirement can only be met by setting up many, thus smaller pools of claims. The decreasing size of pools of claims and the resulting increase in the processes to be applied thus effectively limit the application of this method. This is especially true for small institutions. Preparation of Offers, Credit Decision and Documentation After reviewing and determining the applicant’s creditworthiness in the course of assessing the exposure, the process leading up to disbursement of the credit can be initiated. Thus, this covers all aspects ranging from preparing an offer to actually disbursing the amount stipulated in the credit agreement. With some restrictions, what was said in pervious LECTUREs also applies to the individual process steps in this context. These steps are basically designed in a way as to prevent procedural errors in the credit approval process. Therefore, this focuses on the risk-mitigating design of selected process components. Preparation of Offers When preparing a firm offer, costing this offer plays a central role. From a procedural point of view, special emphasis has to be placed on clearly defining the authority to set conditions and the coordination process between sales and risk analysis. Authority to Set Conditions The internal guidelines have to lay down the responsibility for the final decision concerning conditions. If a calculation of the conditions in line with the risk involved is carried out by automated systems, sales can have the sole authority to set conditions. The sales department is fully responsible for earnings and should thus have the authority to decide on the conditions. If the systems do not allow a precise calculation of the risk- adequate conditions, the person in charge of risk analysis should be included in the final decision on the conditions. The internal guidelines should contain specific instructions governing the assignment of responsibility for this case. This entails an explicit definition of the escalation criteria. These should be identical for sales and risk analysis. This helps avoid situations in which people at different hierarchical levels have to decide on conditions of an individual exposure. If this is not done properly, such a hierarchical relation (even if it only exists indirectly) may have a negative impact on the required balance in forming an opinion. One of the prerequisites for the identical design of the authority to set conditions. CREDIT DECISION-MAKING STRUCTURE If a set-up of the specific credit exposure was agreed upon in the course of preparing the offer, this is followed by a formal internal approval of the individual exposure as part of the credit approval process. The essential risk-related issue of this process step is the definition of credit authority, particularly with regard to the coordination of sales and risk analysis. Credit authority describes the authorization granted by the management those discretion in making credit decisions up to a certain amount. In order to comply with the of our-eyes principle, this authority can as a rule only be exercised jointly by two or more decision makers. Moreover, a credit decision should always involve people that do not belong to the sales department (double vote). In addition, the level of authority should be commensurate with the experience of the employees in charge of assessing the credit exposure. Looking at decision-making authority, we will now discuss an idealized decision- making structure. Special emphasis is placed on the determining factors to allow an adaptation to different business models. Basic Guidelines Covering the Creation of a Decision-making Structure After looking at the risk level of the pending decision, the structure should be subdivided based on the nature of the object of the decision. Three categories are usually formed here: non-standardized credits standardized credits short-term overdrafts (all instances in which credit lines are exceeded in the short term) In addition, the decision-making structure may contain specific rules on further issues (e.g., authority to set conditions, minor changes within an exposure). From a conceptual point of view, it makes sense to refer to the credit risk associated with the individual exposures when drawing up the decision-making structure for non-standardized credits. Accordingly, the factors to be taken into account in drawing up the decision-making structure are the following: level of exposure value of collateral type of borrower probability of default Basel Accord & Credit Risk Management Along the lines of the proposals in the consultative paper to the new capital adequacy framework issued in June 1999, the risk weighted assets in the standardized approach will continue to be calculated as the product of the amount of exposures and supervisory determined risk weights. As in the current Accord, the risk weights will be determined by the category of the borrower: sovereign, bank, or corporate. Unlike in the current Accord, there will be no distinction on the sovereign risk weighting depending on whether or not the sovereign is a member of the Organization for Economic Coordination and Development (OECD). Instead the risk weights for exposures will depend on external credit assessments. The treatment of off-balance sheet exposures will largely remain unchanged, with a few exceptions. Sovereign Risk Weights The Committee retains its proposal to replace the current Accord with an approach that relies on the sovereign assessments of eligible ECAIs. Claims on sovereigns determined to be of the very highest quality will be eligible for a 0% risk weight. The assessments used should generally be in respect of the sovereigns long-term domestic rating for domestic currency obligations and foreign rating for foreign currency obligations. The Committee acknowledges the concerns expressed by some commentators regarding the use of external credit assessments, especially credit ratings. However, no alternative has been yet proposed that would be both superior to the current Accords OECD/non-OECD distinction and as risk-sensitive as the current proposal. It has also been indicated that the Committee could mitigate concerns on the use of external credit assessments by providing strict guidance and explicit criteria governing the use of credit assessments. The Committee has clarified the criteria set out in the first Consultative Paper Following the notation used in the June 1999 Consultative Paper, the risk weights of sovereigns would be as follows: AAA A+ BBB+ BB+ Below Credit Assessments To to to to Unrated B AA A BBB B Risk Weights 0% 20% 50% 100% 150% 100% At national discretion, a lower risk weight may be applied to banks. Exposures to the sovereign of incorporation denominated in domestic currency and funded in that currency. Where this discretion is exercised, other national supervisory authorities may also permit their banks to apply the same risk weight to domestic currency exposures to this sovereign (or central bank) funded in that currency. To address at least in part the concern expressed over the use of credit ratings and to supplement private sector ratings for sovereign exposures, the Committee is currently exploring the possibility of using the country risk ratings assigned to sovereigns by Export Credit Agencies (ECAs). The key advantage of using publicly available export credit agencies. Risk scores for sovereigns are that ECA risk scores are available for a far larger number of sovereigns than are private ECAI ratings. A primary function of the ECAs is to insure the country risk, and sometimes also the commercial risk, attached to the provision of export credit to foreign buyers. In April 1999 the OECD introduced a methodology for setting benchmarks for minimum export insurance premiums for country risk. This methodology has been adopted by various countries. Based on an econometric model of three groups of quantitative indicators, the methodology produces a risk classification by assigning individual countries to one of seven risk scores. The Committee proposes that supervisors may recognize the country risk scores assigned to sovereigns by Export Credit Agencies that subscribe to the OECD 1999 methodology and publish their risk scores. Banks may then choose to use the risk scores produced by an ECA (or ECAs) recognized by their supervisor. The OECD 1999 methodology establishes seven risk score categories associated with minimum export insurance premiums. As detailed below, each of those ECA risk scores will correspond to a specific risk weight category Where only a risk score which is not associated with a minimum premium is indicated, it will not be recognized for risk weighting purposes. The Committee is proposing that the risk scores will be slotted into the risk weighting categories as in the table. ECA risk Scores 1 2 3 4 to 6 7 Risk Weights 0% 20% 50% 100% 150% Given the similarity in risk profiles, claims on central banks are assigned the same risk weight as that applicable to their sovereign governments. The Bank for International Settlements (BIS), the International Monetary Fund (IMF), the European Central Bank (ECB) and the European Community will receive the lowest risk weight applicable to sovereigns and central banks. After further reflection, the Committee is no longer calling for adherence to the SDDS set out by the IMF as a pre-condition for preferential risk weights. Judging compliance with these standards is a qualitative exercise and an all-or-nothing judgment may be overly simplistic. Therefore, the Committee does not wish to create a structure in which a sovereigns or supervisors compliance with these fundamental standards would be assessed in a purely mechanical fashion. RISK WEIGHTS FOR NON-CENTRAL GOVT. PUBLIC SECTOR ENTITIES (PSES) Claims on domestic PSEs will be treated as claims on banks of that country. Subject to national discretion, claims on domestic PSEs may also be treated as claims on the sovereigns in whose jurisdictions the PSEs are established. Where this discretion is exercised, other national supervisors may allow their banks to risk weight claims on such PSEs in the same manner. Non-central government PSEs can include different types of institutions, ranging from government agencies and regional governments to government owned corporations. In order to provide some guidance and to delineate the circumstances in which PSEs may receive the more favorable bank or sovereign treatment, the example below shows how PSEs might be categorized, looking at one particular aspect of the PSEs, the revenue raising powers. It should be noted that, given the wide range of PSEs and the significant differences in government structures among different jurisdictions, this is only one example for supervisory authorities in exercising their national discretion. There may be other ways of determining the different treatments for different types of PSEs, for example by focusing on the extent of guarantees provided by the central government. Regional governments and local authorities could qualify for the same treatment as claimson the central government if these governments and local authorities have specific revenue-raising powers and have specific institutional arrangements the effect of which is to reduce their risks of default. Administrative bodies responsible to central governments, regional governments or to local authorities and other non-commercial undertakings owned by the governments orlocal authorities may not warrant the same treatment as claims on their sovereign if the entities do not have revenue raising powers or other arrangements as described above. If strict lending rules apply to these entities and a declaration of bankruptcy is not possible because of their special public status, it may be appropriate to treat these claims in the same manner as claims on banks. Commercial undertakings owned by central governments, regional governments or by localauthorities may be treated as normal commercial enterprises. If these entities function as a corporate in competitive markets even though the state, a regional authority or a local authority is the major shareholder of these entities, supervisors may decide to attach the risk weights applicable to corporate. Risk weights for multilateral development banks (MDBs) The risk weights applied to MDBs will be based on external credit assessments as set out under option 2 for treating bank claims explained further. A 0% risk weight will be applied to claims on highly rated MDBs that fulfill to the Committees satisfaction the criteria provided below. The Committee will continue to evaluate eligibility on a case-by-case basis. The eligibility criteria for MDBs risk weighted at 0% are: very high quality long-term issuer ratings, i.e. a majority of an MDBs external assessments must be AAA; shareholder structure comprised of a significant proportion of high quality sovereigns with long term issuer credit assessments of AA or better; strong shareholder support demonstrated by the amount of paid-in capital contributed by the shareholders; the amount of callable capital the MDBs have the right to call, if required, to repay their liabilities; and continued capital contributions and new pledges from sovereign shareholders; adequate level of capital and liquidity (a case-by-case approach is necessary in order to assess whether each institutions capital and liquidity are adequate), and strict statutory lending requirements and conservative financial policies, which would include among other conditions a structured approval process, internal creditworthiness and risk concentration limits (per country, sector, and individual exposure and credit category), large exposures approval by the board or a committee of the board, fixed repayment schedules,effective monitoring of use of proceeds, status review process, and rigorous assessment of risk and provisioning to loan loss reserve. The Committee considers that the MDBs currently eligible for a 0% risk weight are: The World Bank Group comprised of the International Bank for Reconstruction and Development (IBRD) and the International Finance Corporation (IFC), The Asian Development Bank (ADB), The African Development Bank (AFDB), The Council of Europe Development Bank (CEDB), and The European Bank for Reconstruction and Development (EBRD), The Inter-American Development Bank (IADB), The European Investment Bank (EIB), The Nordic Investment Bank (NIB), The Caribbean Development Bank (CDB), Risk Weights for Banks As was proposed in the June 1999 Consultative Paper, there will be two options for deciding the risk weights on exposures to banks. National supervisors will apply one option to all banks in their jurisdiction. No claim on an unrated bank may receive a risk weight less than that applied to its sovereign of incorporation. Under this option, as shown in the table below, all banks incorporated in a given country will be assigned a risk weight one category less favorable than that assigned to claims on the sovereign of incorporation. Credit A+ BBB+ BB+ Below AAA to AA to to to Unrated Assessments B A BBB B Risk Weights 0% 20% 50% 100% 150% 100% The Committee is reducing the scope of claims that would receive the preferential risk weight from those with original maturity of 6 months or less, as was proposed in the June 1999 Consultative Paper, to those with original maturity of 3 months or less. This change reflects analysis completed by the Committee which suggests that in practice the upper maturity bound in the short-term inter-bank market is generally three months. The Committee understands that there are cases where a bank or a corporate can have a higher assessment than the sovereign assessment of its home country and that risk weighting exposures to those entities based on such assessments can be justified. Therefore, it will not retain the sovereign floor that was proposed in the June 1999 Consultative Paper. Risk weights for securities firms Claims on securities firms may be treated as claims on banks provided they are subject to supervisory and regulatory arrangements comparable to those under the new capital adequacy framework (including, in particular, risk-based capital requirements). The Committee is no longer proposing to include the implementation of the 30 Objective and Principles of Securities Regulation set out by IOSCO and referenced in the first consultative paper as a condition for receiving a risk weight less than 100%. Risk Weights for Corporates The table provided below illustrates the risk weighting of rated corporate claims, including claims on insurance companies. Credit AAA to A+ BBB+ Below to Unrated Assessment AA to BB BB A Risk Weights 20% 50% 100% 150% 100% As with the case of exposure to banks, the Committee will not adopt the sovereign floor that was proposed in the June 1999 Consultative Paper, recognising that there are legitimate cases where a corporate can have a higher assessment than the sovereign assessment of its home country. The standard risk weight for unrated claims on corporates will be 100%. No claim on an unrated corporate may be given a risk weight preferential to that assigned to its sovereign of incorporation. MARKETING SYSTEMS IN LIFE INSURANCE AND INSURANCE AND RISK An agency building system is a system by which an insurer builds its own agency force by recruiting, financing, training, and supervising new agents General agency system The general agent is an independent contractor who represents only one insurer, and receives a commission based on the amount of business produced Insurer provides some financial assistance, but the general agent is responsible for recruiting, training, and motivating new agents Managerial system Branch offices are established in various areas The branch manager is responsible for hiring and training new agents, and receives a commission from the insurer Insurer pays expenses of the branch office Managerial system Branch offices are established in various areas The branch manager is responsible for hiring and training new agents, and receives a commission from the insurer Insurer pays expenses of the branch office Marketing Systems in Life Insurance A non-building agency system is a marketing system by which an insurer sells its products through established agents – A personal-producing general agent is a successful agent who is hired primarily to sell insurance under a contract Under a direct response system, insurance is sold directly to customers without the services of an agent Marketing Systems in Property and Liability Insurance The independent agency is a business firm that usually represents several unrelated insurers – Agents are paid a commission based on the amount of business produced, which vary by the line of insurance – Agency owns the expirations or renewal rights to the business Under the exclusive agency system, the agent represents only one insurer or group of insurers under common ownership – Agents do not usually own the expirations or renewal rights to the policies – Agents are generally paid a lower commission rate on renewal business than on new business Marketing Systems in Property and Liability Insurance A direct writer is an insurer in which the salesperson is an employee of the insurer, not an independent contractor. – Employees are usually compensated on a “salary plus” arrangement A direct response insurer sells directly to the consumer by television or some other media – Used primarily to sell personal lines of insurance Many property and casualty insurers use multiple distribution systems Group Insurance Marketing Many insurers use group marketing methods to sell individual insurance policies to: – Employer groups – Labor unions – Trade associations Some property and liability insurers use mass merchandising plans to market their insurance Employees pay for insurance by payroll deduction Insurance Company Operations Rate making Rate making refers to the pricing of insurance – Total premiums charged must be adequate for paying all claims and expenses during the policy period – Rates and premiums are determined by an actuary, using the company’s past loss experience and industry statistics Underwriting Underwriting refers to the process of selecting, classifying, and pricing applicants for insurance – The objective is to produce a profitable book of business A statement of underwriting policy establishes policies that are consistent with the company’s objectives, such as – Acceptable classes of business – Amounts of insurance that can be written A line underwriter makes daily decisions concerning the acceptance or rejection of business There are three important principles of underwriting: – The underwriter must select prospective insureds according to the company’s underwriting standards – Underwriting should achieve a proper balance within each rate classification In class underwriting, exposure units with similar loss-producing characteristics are grouped together and charged the same rate – Underwriting should maintain equity among the policyholders Underwriting starts with the agent in the field Information for underwriting comes from: – The application – The agent’s report – An inspection report – Physical inspection – A physical examination and attending physician’s report – MIB report After reviewing the information, the underwriter can: – Accept the application – Accept the application subject to restrictions or modifications – Reject the application Production refers to the sales and marketing activities of insurers – Agents are often referred to as producers – Life insurers have an agency or sales department – Property and liability insurers have marketing departments An agent should be a competent professional with a high degree of technical knowledge in a particular area of insurance and who also places the needs of his or her clients first Claim Settlement The objectives of claims settlement include: – Verification of a covered loss – Fair and prompt payment of claims – Personal assistance to the insured Some laws prohibit unfair claims practices, such as: – Refusing to pay claims without conducting a reasonable investigation – Not attempting to provide prompt, fair, and equitable settlements – Offering lower settlements to compel insureds to institute lawsuits to recover amounts due The claim process begins with a notice of loss Next, the claim is investigated – A claims adjustor determines if a covered loss has occurred and the amount of the loss The adjustor may require a proof of loss before the claim is paid The adjustor decides if the claim should be paid or denied – Policy provisions address how disputes may be resolved Reinsurance Reinsurance is an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer part or all of the potential losses associated with such insurance – The primary insurer is the ceding company – The insurer that accepts the insurance from the ceding company is the re-insurer – The retention limit is the amount of insurance retained by the ceding company – The amount of insurance ceded to the re-insurer is known as a cession Reinsurance is used to: – Increase underwriting capacity – Stabilize profits – Reduce the unearned premium reserve – The unearned premium reserve represents the unearned portion of gross premiums on all outstanding policies at the time of valuation – Provide protection against a catastrophic loss – Retire from business or from a line of insurance or territory – Obtain underwriting advice on a line for which the insurer has little experience There are two principal forms of reinsurance: – Facultative reinsurance is an optional, case-by-case method that is used when the ceding company receives an application for insurance that exceeds its retention limit – Treaty reinsurance means the primary insurer has agreed to cede insurance to the reinsurer, and the reinsurer has agreed to accept the business Under a quota-share treaty, the ceding insurer and the re-insurer agree to share premiums and losses based on some proportion Under a surplus-share treaty, the re-insurer agrees to accept insurance in excess of the ceding insurer’s retention limit, up to some maximum amount An excess-of-loss treaty is designed for catastrophic protection A reinsurance pool is an organization of insurers that underwrites insurance on a joint basis Reinsurance Alternatives Some insurers use the capital markets as an alternative to traditional reinsurance Securitization of risk means that an insurable risk is transferred to the capital markets through the creation of a financial instrument, such as a futures contract Catastrophe bonds are corporate bonds that permit the issuer of the bond to skip or reduce the interest payments if a catastrophic loss occurs Investments Because premiums are paid in advance, they can be invested until needed to pay claims and expenses Investment income is extremely important in reducing the cost of insurance to policy-owners and offsetting unfavorable underwriting experience Life insurance contracts are long-term; thus, safety of principal is a primary consideration In contrast to life insurance, property insurance contracts are short-term in nature, and claim payments can vary widely depending on catastrophic losses, inflation, medical costs, etc Other Insurance Company Functions The electronic data processing area maintains information on premiums, claims, loss ratios, investments, and underwriting results. The accounting department prepares financial statements and develops budgets. In the legal department, attorneys are used in advanced underwriting and estate planning. Property and liability insurers provide numerous loss control services. OBJECT OF REVIEW AND EXPOSURE MANAGEMENT Credit approval processes are started on behalf of a credit applicant. Especially in the context of lending to corporate customers, it is often necessary to include several (natural or legal) persons in the credit rating process. This will be required if these (natural and legal) persons are to be considered one economic unit and would thus probably have a mutual impact on each other’s credit standing. In practice, granting an individual loan often involves a large number of (natural and legal) persons. This has to be borne in mind throughout the entire credit approval process, but particularly in the course of the credit review. Credit approval for groups of companies should be designed in a manner which is specific to the risk involved and efficient and should aim to focus the review on the actual risk-bearer, that (natural or legal) person whose legal and economic situation ultimately determines the ability to fulfill the obligations under the credit agreement. In any case, Basel II requires the assessment of the borrower’s credit standing. Especially in complex and far-reaching company networks, the link to the respective credit institution may often go beyond pure sales contacts (e.g. a foreign holding company and a domestic subsidiary). In practice, this often results in vague guidelines in terms of exposure management within credit approval processes. From a risk perspective, the overall risk of the risk-bearer should always be aggregated over the bank as a whole and then presented to the decision makers; the internal guidelines should contain provisions which clearly define the risk-bearer. This classification is usually based on loss-sharing arrangements or legal interdependences. Also, it should be stipulated whether aggregation should be effected by one person in charge (at group level) in processing or risk analysis, or in a decentralized fashion by each unit itself. Overview of the Credit Approval Process The order of the following subsections reflects the sequence of steps in the credit approval process, with the credit approval process for new customers serving as the general framework. Credit approval processes for existing customers will be addressed explicitly if they contain process steps that are not found in the credit approval process for new customers at least in a similar form. The definition of exposure segments is an important prerequisite to handle credit approval processes in a manner which is specific to the risk involved and efficient. Many of the risk mitigation measures described here can only take full effect if they account for the specific characteristics of the credit applicants. Therefore, the segmentation of the credit approval processes is a central component of risk mitigation. While the risk mitigation measures should be designed in accordance with the specifics of each segment, there is a uniform basic structure of these measures which are discussed in the following subchapters. A presentation of the specific design of these measures would only be possible with reference to a detailed definition of the individual segments. Such a definition is impossible due to the great heterogeneity among the banks addressed by this guideline to begin with and can thus only be established for each bank separately. Thus, the following LECTUREs will primarily discuss the basic structure of the risk mitigation measures and the way in which they work. At some points, the distinction between standard and individual processes is pointed out as this distinction is a central element in the design of credit approval processes nowadays. In case differences in the process design are considered essential for the effectiveness of the risk mitigation measures, this design will be described in more detail. Integration of Sales and IT in the Process Design An early integration of sales and IT is an essential prerequisite for the success of a reorientation of the credit approval process. In order to facilitate their implementation, changes in processes have to be reflected in the bank’s IT structure. The extensive planning and alignment effort involved in IT projects (in particular the coordination the IT interfaces to all organizational units that use data from the credit approval processes) makes it necessary to check at an early stage whether the project is feasible and can be financed. This depiction Credit Analysis & Risk Management – of the credit approval processes is highly relevant not only for risk analysis and processing, but has a particular significance for sales. “and” Changes in processes, in particular the introduction of mostly automated credit decisions, entail a considerable change in the user interface in sales applications. Therefore, the success of the implementation is highly dependent on the extent to which employees accept such changes. Process Steps Leading up to the Credit Review The execution of the credit review is based on external and internal data on the credit applicant. Especially for extensive exposures, considerable resources may be tied up in the process of collecting the data, checking the data for completeness and plausibility, and passing on the data to people in charge of handling, analyzing, and processing the exposure within the bank. These steps can also lead to a large number of procedural errors. As the data included form the basis for the credit review, errors in collecting, aggregating, and passing them on are especially relevant also from a risk perspective. The subchapter thus focuses on measures to avoid such procedural errors. EXPOSURE ASSESSMENT After reviewing borrower rating, other credit assessment factors, and the collateral, it is possible to assess the borrower’s creditworthiness with regard to the proposed exposure. The final assessment of the exposure risk can only be made (especially in the corporate customer business) after a comprehensive evaluation of all sub-processes of credit review. The results of the valuation of the collateral will also be included in this assessment which has to be made by the employees handling the exposure. The credit form should thus provide appropriate fields. Here, it is important to make sure that the internal guidelines contain clear rules on the level of detail and the form in which the explanation has to be presented. In practice, it has proven useful to compare the positive and negative assessment criteria. In addition, the form should provide a field for a concluding summary. Here, too, the use of text modules appears appropriate to avoid longwinded and vague statements. The assessment of the employees in charge of processing the exposure is the basis for the subsequent credit decision. This must be done in line with the decision-making structure for the credit decision stipulated in the internal guidelines. Automated Decision The standardized retail business in particularly does mostly without individual interventions in the credit decision process, with the result of the standardized credit rating process being the major basis for the credit decision. As these processes are used only for small credit volumes, the data are often entered by a sales employee. Deviations can be found mostly in residential real estate finance, as it is possible to set up specialized risk analysis units for this usually highly standardized process. In both cases, the credit decision can be made by a single vote up to a volume to be defined in the internal guidelines in order to curb the complexity and thus increase the efficiency of the process. Increasingly, mostly automated decision processes are also used in the small business segment. The prerequisite is a clear definition of and the data to be maintained for this customer segment. This makes it possible to create the conditions to derive a discriminatory analysis function. In some cases, it is left to the credit applicant to enter the data necessary to carry out the credit review (so-called online applications). However, the limited database and lack of more personal contact with the credit applicant limit the application of this option. The most important success factor in the use of mostly automated processes is the bank’s ability to take precautions against the credit applicant entering wrong data or to identify such wrong entries in time. In Choosing a Process as the IRB approach provides for a calculation of the regulatory capital requirement on the basis of credit standing, the credit rating process has to be adapted to the requirements of the IRB approach. The application of the formulas to calculate the regulatory capital requirement stipulated in the IRB approach under Basel II requires banks to derive the default parameters needed to quantify the risk. Both the basic approach and the advanced IRB approach require the calculation of the probability of default (PD) of a claim/a pool of claims. Therefore, the credit rating of individual exposures has an immediate impact on the capital requirement. The probability of default of retail exposures can be determined on the basis of pools of claims which combine a number of comparable individual exposures. Thus, it is not necessary to classify every single borrower into different categories. Under Basel II, it is possible — under certain circumstances — to treat corporate exposures with a total volume of no more than 1m as retail exposures. Based on what has been said so far, it would theoretically also be possible to assess such exposures by using a mostly automated credit decision process (at least from a perspective of compatibility of the credit rating process with the calculation of the capital requirement). In practice, this will have to be qualified for two major reasons: The profitability of the small business segment is highly dependent on the price structure. This, in turn, is one of the decisive competitive factors. Therefore, it is necessary to Credit Analysis & Risk Management – delineate the risk associated with an exposure as precisely as possible to be able to set a price commensurate with the risk involved. Homogeneous data pools are required for the application of empirical statistical models. In practice, the borrowers in the small business segment show a high degree of heterogeneity, which means that this requirement can only be met by setting up many, thus smaller pools of claims. The decreasing size of pools of claims and the resulting increase in the processes to be applied thus effectively limit the application of this method. This is especially true for small institutions. Preparation of Offers, Credit Decision and Documentation After reviewing and determining the applicant’s creditworthiness in the course of assessing the exposure, the process leading up to disbursement of the credit can be initiated. Thus, this covers all aspects ranging from preparing an offer to actually disbursing the amount stipulated in the credit agreement. With some restrictions, what was said in pervious LECTUREs also applies to the individual process steps in this context. These steps are basically designed in a way as to prevent procedural errors in the credit approval process. Therefore, this focuses on the risk-mitigating design of selected process components. Preparation of Offers When preparing a firm offer, costing this offer plays a central role. From a procedural point of view, special emphasis has to be placed on clearly defining the authority to set conditions and the coordination process between sales and risk analysis. Authority to Set Conditions The internal guidelines have to lay down the responsibility for the final decision concerning conditions. If a calculation of the conditions in line with the risk involved is carried out by automated systems, sales can have the sole authority to set conditions. The sales department is fully responsible for earnings and should thus have the authority to decide on the conditions. If the systems do not allow a precise calculation of the risk- adequate conditions, the person in charge of risk analysis should be included in the final decision on the conditions. The internal guidelines should contain specific instructions governing the assignment of responsibility for this case. This entails an explicit definition of the escalation criteria. These should be identical for sales and risk analysis. This helps avoid situations in which people at different hierarchical levels have to decide on conditions of an individual exposure. If this is not done properly, such a hierarchical relation (even if it only exists indirectly) may have a negative impact on the required balance in forming an opinion. One of the prerequisites for the identical design of the authority to set conditions, viz. the congruent design of the sales and the risk analysis organization, is dealt with separately in next LECTUREs.