Ch06 Risk Management.docx

RISK MANAGEMENT Risk Management is a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss occurs – E.g., a plant that may be damaged by an earthquake, or an automobile that may be damaged in a collision New forms of risk management consider both pure and speculative loss exposures Objectives of Risk Management Risk management has objectives before and after a loss occurs Pre-loss objectives: – Prepare for potential losses in the most economical way – Reduce anxiety – Meet any legal obligations Post-loss objectives: – Ensure survival of the firm – Continue operations – Stabilize earnings – Maintain growth – Minimize the effects that a loss will have on other persons and on society Risk Management Process Identify potential losses Evaluate potential losses Select the appropriate risk management technique Implement and monitor the risk management program 308610019050Steps in the Risk Management Process Identifying Loss Exposures Property loss exposures Liability loss exposures Business income loss exposures Human resources loss exposures Crime loss exposures Employee benefit loss exposures Foreign loss exposures Market reputation and public image of company Failure to comply with government rules and regulations Risk Managers have several sources of information to identify loss exposures: Questionnaires Physical inspection Flowcharts Financial statements Historical loss data Industry trends and market changes can create new loss exposures. e.g., exposure to acts of terrorism Analyzing Loss Exposures Estimate the frequency and severity of loss for each type of loss exposure – Loss frequency refers to the probable number of losses that may occur during some given time period – Loss severity refers to the probable size of the losses that may occur Once loss exposures are analyzed, they can be ranked according to their relative importance Loss severity is more important than loss frequency: – The maximum possible loss is the worst loss that could happen to the firm during its lifetime – The maximum probable loss is the worst loss that is likely to happen Select the Appropriate Risk Management Technique Risk control refers to techniques that reduce the frequency and severity of losses Methods of risk control include: – Avoidance – Loss prevention – Loss reduction Risk Control Methods – Avoidance means a certain loss exposure is never acquired, or an existing loss exposure is abandoned The chance of loss is reduced to zero It is not always possible, or practical, to avoid all losses – Loss prevention refers to measures that reduce the frequency of a particular loss e.g., installing safety features on hazardous products – Loss reduction refers to measures that reduce the severity of a loss after is occurs e.g., installing an automatic sprinkler system Select the Appropriate Risk Management Technique Risk financing refers to techniques that provide for the funding of losses Methods of risk financing include: – Retention – Non-insurance Transfers – Commercial Insurance Risk Financing Methods: Retention Retention means that the firm retains part or all of the losses that can result from a given loss – Retention is effectively used when: No other method of treatment is available The worst possible loss is not serious Losses are highly predictable – The retention level is the dollar amount of losses that the firm will retain A financially strong firm can have a higher retention level than a financially weak firm The maximum retention may be calculated as a percentage of the firm’s net working capital – A risk manager has several methods for paying retained losses: Current net income: losses are treated as current expenses Unfunded reserve: losses are deducted from a bookkeeping account Funded reserve: losses are deducted from a liquid fund Credit line: funds are borrowed to pay losses as they occur – A captive insurer is an insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposures – A single-parent captive is owned by only one parent – An association or group captive is an insurer owned by several parents – Many captives are located in the Caribbean because the regulatory environment is favorable – Captives are formed for several reasons, including: The parent firm may have difficulty obtaining insurance Costs may be lower than purchasing commercial insurance A captive insurer has easier access to a reinsurer A captive insurer can become a source of profit – Premiums paid to a captive may be tax-deductible under certain conditions – Self-insurance is a special form of planned retention – Part or all of a given loss exposure is retained by the firm – A more accurate term would be self-funding – Widely used for workers compensation and group health benefits – A risk retention group is a group captive that can write any type of liability coverage except employer liability, workers compensation, and personal lines – Federal regulation allows employers, trade groups, governmental units, and other parties to form risk retention groups – They are exempt from many state insurance laws Advantages – Save money – Lower expenses – Encourage loss prevention – Increase cash flow Disadvantages – Possible higher losses – Possible higher expenses – Possible higher taxes Risk Financing Methods: Non-insurance Transfers A non-insurance transfer is a method other than insurance by which a pure risk and its potential financial consequences are transferred to another party – Examples include: Contracts, leases, hold-harmless agreements Risk Financing Methods: Non-insurance Transfers Advantages – Can transfer some losses that are not insurable – Save money – Can transfer loss to someone who is in a better position to control losses Disadvantages – Contract language may be ambiguous, so transfer may fail – If the other party fails to pay, firm is still responsible for the loss – Insurers may not give credit for transfers Risk Financing Methods: Insurance Insurance is appropriate for loss exposures that have a low probability of loss but for which the severity of loss is high – The risk manager selects the coverages needed, and policy provisions: A deductible is a provision by which a specified amount is subtracted from the loss payment otherwise payable to the insured An excess insurance policy is one in which the insurer does not participate in the loss until the actual loss exceeds the amount a firm has decided to retain – The risk manager selects the insurer, or insurers, to provide the coverages – The risk manager negotiates the terms of the insurance contract A manuscript policy is a policy specially tailored for the firm – Language in the policy must be clear to both parties The parties must agree on the contract provisions, endorsements, forms, and premiums – The risk manager must periodically review the insurance program Advantages – Firm is indemnified for losses – Uncertainty is reduced – Insurers may provide other risk management services – Premiums are tax-deductible Disadvantages – Premiums may be costly Opportunity cost should be considered – Negotiation of contracts takes time and effort – The risk manager may become lax in exercising loss control 85 Credit Analysis & Risk Management – Implement and Monitor the Risk Management Program Implementation of a risk management program begins with a risk management policy statement that: – Outlines the firm’s risk management objectives – Outlines the firm’s policy on loss control – Educates top-level executives in regard to the risk management process – Gives the risk manager greater authority – Provides standards for judging the risk manager’s performance A risk management manual may be used to: – Describe the risk management program – Train new employees A successful risk management program requires active cooperation from other departments in the firm The risk management program should be periodically reviewed and evaluated to determine whether the objectives are being attained – The risk manager should compare the costs and benefits of all risk management activities Benefits of Risk Management Pre-loss and post-loss objectives are attainable A risk management program can reduce a firm’s cost of risk – The cost of risk includes premiums paid, retained losses, outside risk management services, financial guarantees, internal administrative costs, taxes, fees, and other expenses Reduction in pure loss exposures allows a firm to enact an enterprise risk management program to treat both pure and speculative loss exposures Society benefits because both direct and indirect losses are reduced Personal Risk Management Personal risk management refers to the identification of pure risks faced by an individual or family, and to the selection of the most appropriate technique for treating such risks The same principles applied to corporate risk management apply to personal risk management MARKET AND LIQUIDITY SENSITIVE CREDIT EXPOSURES Market and liquidity-sensitive exposures pose special challenges to the credit processes at banks. Market-sensitive exposures include foreign exchange and financial derivative contracts. Liquidity-sensitive exposures include margin and collateral agreements with periodic margin calls, liquidity back-up lines, commitments and some letters of credit, and some unwind provisions of securitizations. The contingent nature of the exposure in these instruments requires the bank to have the ability to assess the probability distribution of the size of actual exposure in the future and its impact on both the borrower’s and the bank’s leverage and liquidity. An issue faced by virtually all financial institutions is the need to develop meaningful measures ofexposure that can be compared readily with loans and other credit exposures. This problem isdescribed at some length in the Basel Committee’s January 1999 study of exposures to highly leveraged institutions. Market-sensitive instruments require a careful analysis of the customer’s willingness and ability topay. Most market-sensitive instruments, such as financial derivatives, are viewed as relativelysophisticated instruments, requiring some effort by both the bank and the customer to ensure that the contract is well understood by the customer. The link to changes in asset prices in financial markets means that the value of such instruments can change very sharply and adversely to the customer, usually with a small, but non-zero probability. Effective stress testing can reveal the potential for large losses, which sound practice suggests should be disclosed to the customer. Banks have suffered significant losses when they have taken insufficient care to ensure that the customer fully understood the transaction at origination and subsequent large adverse price movements left the customer owing the bank a substantial amount. Liquidity-sensitive credit arrangements or instruments require a careful analysis of the customer’slnerability to liquidity stresses, since the bank’s funded credit exposure can grow rapidly whencustomers are subject to such stresses. Such increased pressure to have sufficient liquidity to meet margin agreements supporting over-the-counter trading activities or clearing and settlement arrangements may directly reflect market price volatility. In other instances, liquidity pressures in the financial system may reflect credit concerns and a constricting of normal credit activity, leading borrowers to utilize liquidity backup lines or commitments. Liquidity pressures can also be the result of inadequate liquidity risk management by the customer or a decline in its creditworthiness, making an assessment of a borrower’s or counterparty’s liquidity risk profile another important element of credit analysis. Market- and liquidity-sensitive instruments change in riskiness with changes in the underlying distribution of price changes and market conditions. For market-sensitive instruments, for example, increases in the volatility of price changes effectively increases potential exposures. Consequently, banks should conduct stress testing of volatility assumptions. Market- and liquidity-sensitive exposures, because they are probabilistic, can be correlated with the creditworthiness of the borrower. This is an important insight gained from the market turmoil in Asia, Russia and elsewhere in the course of 1997 and 1998. That is, the same factor that changes the value of a market- or liquidity-sensitive instrument can also influence the borrower’s financial health and future prospects. Banks need to analyze the relationship between market- and liquidity-sensitive exposures andthe default risk of the borrower. Stress testing shocking the market or liquidity factors — is a keyelement of that analysis. Credit Approval Process The individual steps in the process and their implementation have a considerable impact on the risks associated with credit approval. Therefore, this chapter presents these steps and shows examples of the shapes they can take. However, this cannot mean the presentation of a final model credit approval process, as the characteristics which have to be taken into consideration in planning credit approval processes and which usually stem from the heterogeneity of the products concerned are simply too diverse. That said, it is possible to single out individual process components and show their basic design within a credit approval process optimized in terms of risk and efficiency. Thus, the risk drivers in carrying out a lending and rating process essentially shape the structure of this chapter. First of all, we need to ask what possible sources of error the credit approval process must be designed to avoid. The errors encountered in practice most often can be put down to these two sources: Substantive errors:These comprise the erroneous assessment of a credit exposure despitecomprehensive and transparent presentation. Procedural errors:Procedural errors may take one of two forms: On the one hand, theprocedural-structural design of the credit approval process itself may be marked by procedural errors. These errors lead to an incomplete or wrong presentation of the credit exposure. On the other hand, procedural errors can result from an incorrect performance of the credit approval process. These are caused by negligent or intentional misconduct by the persons in charge of executing the credit approval process. In the various instances describing individual steps in the process, this chapter refers to the fundamental logic of error avoidance by adjusting the risk drivers; in doing so, however, it does not always reiterate the explanation as to what sources of error can be reduced or eliminated depending on the way in which they are set up. While credit review, for example, aims to create transparency concerning the risk level of a potential exposure (and thus helps avoid substantive errors), the design of the other process components laid down in the internal guidelines is intended to avoid procedural errors in the credit approval process. Still, both substantive and procedural errors are usually determined by the same risk drivers. Thus, these risk drivers are the starting point to find the optimal design of credit approval processes in terms of risk. Segmentation of Credit Approval Processes In order to assess the credit risk, it is necessary to take a close look at the borrowers’ economic and legal situation as well as the relevant environment (e.g. industry, economic growth). The quality of credit approval processes depends on two factors, i.e. a transparent and comprehensive presentation of the risks when granting the loan on the one hand, and an adequate assessment of these risks on the other. Furthermore, the level of efficiency of the credit approval processes is an important rating element. Due to the considerable differences in the nature of various borrowers (e.g. private persons, listed companies, sovereigns, etc.) and the assets to be financed (e.g. residential real estate, production plants, machinery, etc.) as well the large number of products and their complexity, there cannot be a uniform process to assess credit risks. Therefore, it is necessary to differentiate, and this section describes the essential criteria which have to be taken into account in defining this differentiation in terms of risk and efficiency. BASIC SITUATION OF CREDIT APPROVAL PROCESS The vast majority of credit institutions serve a number of different customer segments. This segmentation is mostly used to differentiate the services offered and to individualize the respective marketing efforts. As a result, this segmentation is based on customer demands in most cases. Based on its policy, a bank tries to meet the demands of its customers in terms of accessibility and availability, product range and expertise, as well as personal customer service. In practice, linking sales with the risk analysis units is not an issue in many cases at first. The sales organization often determines the process design in the risk analysis units. Thus, the existing variety of segments on the sales side is often reflected in the structure and process design1 of the credit analysis units. While classifications in terms of customer segments are, for example, complemented by product-specific segments, there appears to be no uniform model. Given the different sizes of the banks, the lack of volume of comparable claims in small banks renders such a model inadequate also for reasons of complexity, efficiency, and customer orientation. Irrespective of a bank’s size, however, it is essential to ensure a transparent and comprehensive presentation as well as an objective and subjective assessment of the risks involved in lending in all cases. Therefore, the criteria that have to be taken into account in presenting and assessing credit risks determine the design of the credit approval processes. If the respective criteria result in different forms of segmentation for sales and analysis, this will cause friction when credit exposures are passed on from sales to processing. A risk analysis or credit approval processing unit assigned to a specific sales segment may not be able to handle all products offered in that sales segment properly in terms of risk (e.g. processing residential real estate finance in the risk analysis unit dealing with corporate clients). Such a situation can be prevented by making the interface between sales and processing more flexible, with internal guidelines dealing with the problems mentioned here. Making this interface more flexible to ease potential tension can make sense in terms of risk as well as efficiency. Accounting for Risk Aspects The quality of the credit approval process from a risk perspective is determined by the best possible identification and evaluation of the credit risk resulting from a possible exposure. The credit risk can distributed among four risk components which have found their way into the new Basel Capital Accord (in the following referred to as Basel II). Probability of default (PD) Loss given default (LGD) Exposure at default (EAD) Maturity (M) Probability of Default Reviewing a borrower’s probability of default is basically done by evaluating the borrower’s current and future ability to fulfill its interest and principal repayment obligations. This evaluation has to take into account various characteristics of the borrower (natural or legal person), which should lead to a differentiation of the credit approval processes in accordance with the borrowers served by the bank. Furthermore, it has to be taken into account that — for certain finance transactions — interest and principal repayments should be financed exclusively from the cash flow of the object to be financed without the possibility for recourse to further assets of the borrower. In this case, the credit review must address the viability of the underlying business model, which means that the source of the cash flows required to meet interest and principal repayment obligations has to be included in the review. Loss Given Default The loss given default is affected by the collateralized portion as well as the cost of selling the collateral. Therefore, the calculated value and type of collateral also have to be taken into account in designing the credit approval processes. Exposure at Default (EAD) In the vast majority of the cases described here, the exposure at default corresponds to the amount owed to the bank.5 Thus, besides the type of claim, the amount of the claim is another important element in the credit approval process. Thus, four factors should be taken into account in the segmentation of credit approval processes: Type of borrower Source of cash flows Value and type of collateral Amount and type of claim Approaches to the Segmentation of Credit Approval Processes The following subsections present possible segmentations to include the four factors mentioned above in structuring the credit approval process. The lending business in which banks engage is highly heterogeneous in terms of volume and complexity; this makes it impossible to define an optimal model, and therefore we will not show model segmentation. After the description of possible segmentations, two principles are dealt with that have to be included in the differentiation of the credit approval processes along the four risk components to ensure an efficient structure of the credit approval processes. Distinction between standard and individual processes in the various segments; taking into account asset classes under Basel II Type of Borrower In general, type of borrower is used as the highest layer in credit approval processes. This is due to the higher priority of reviewing legal and economic conditions within the substantive credit review process. The way in which the economic situation is assessed greatly depends on the available data. The following segments can be distinguished: Sovereigns Other public authorities (e.g. regional governments, local authorities) Financial services providers (incl. credit institutions) Corporates Retail Usually, at least the segments of corporate and retail customers are differentiated further (e.g. by product category). Source of Cash Flows The distinction of so-called specialized lending from other forms of corporate finance is based on the fact that the primary, if not the only source of reducing the exposure is the income from the asset being financed, and not so much the unrelated solvency of the company behind it, which operates on a broader basis. Therefore, the credit review has to focus on the asset to be financed and the expected cash flow. In order to account for this situation, the segmentation of the credit approval processes should distinguish between: credits to corporations, partnerships, or sole proprietors; and specialized lending Credit institutions have to distinguish between the following forms of specialized lending in the calculation of regulatory capital. Project finance Object finance Commodities finance Finance of income-producing commercial real estate This subdivision of Basel II primarily serves to determine the required capital correctly, but it can also prove useful from a procedural point of view. This chapter does not separately address the specific design of credit approval processes in specialized lending transactions. The general procedural provisions that should be heeded to minimize the risk also apply to the forms of finance collectively referred to as _specialized lending. Value and Type of Collateral Value and type of collateral have a significant impact on the risk involved in lending. Of particular relevance in this context are those types of collateral which afford the lender a claim in rem on the collateral, and those product constructions under which the lender has legal and economic ownership of the asset to be financed. Two forms of finance are particularly relevant in practice: mortgage finance and leasing finance Mortgage finance and leasing are those forms of finance which often give the lender a substantial degree of control over the asset being financed. The strong legal position resulting from such collateral may warrant special treatment of the relevant forms of finance. Level of Exposure The level of exposure has an immediate impact on the exposure at default (EAD). Therefore, any increase in the level of exposure should trigger a more detailed credit review of the respective borrower. This aspect and the risk minimization that can be achieved by standardization and automation are the rationale behind the separation of low-volume and high-volume lending business that can often be found in the way in which credit approval processes are designed. In practice, the ensuing sub-segmentation within the claims segments is now commonly referred to as standard process and individual process. Standard and Individual Processes The distinction between standard and individual processes does not create a separate segment. It is rather a common process differentiation within claims segments which are defined in accordance with the criteria described above. In the vast majority of cases, the level of engagement is the decisive element in the differentiation between standard and individual processes. In addition to the level of exposure, it is possible to describe some general differentiating criteria that characterize the process type in question. Generally speaking, the objective of establishing standard processes is more efficient process execution. As most segments show concentrations of certain product specifications, it is possible to develop processes that specifically address these characteristics. Standard processes are characterized by the fact that they are only intended and suitable for handling certain credit products with limited features and options. Limiting the process to certain products and maximum exposure volumes allows for simplifications and automations within the process (in particular with regard to credit decisions by vote and highly automated credit decisions). Individual processes are characterized by an adaptive design which makes it possible to deal with a variety of products, collateral, and conditions. Typically, this will be required especially for high-volume corporate customer business, as both the borrowers_ characteristics to be taken into account in the credit review and the specifics of the products wanted are very heterogeneous. The higher risk involved with loans examined in an individual process should be addressed by using a double vote (one vote by the front office, and one vote by the back office). Asset Classes under Basel II As already mentioned above, the new Basel Capital Accord — in its incorporation into European and thus Austrian law — presents mandatory rules for the regulatory capital requirements of claims under any and all banking book transactions of credit institutions and investment firms. Basel II provides two approaches to determine the capital requirement: a standardized approach and an internal ratings-based approach (IRB approach) The IRB approach allows a more risk-sensitive calculation (based on the Bank’s internal estimates) of the capital required to cover the risks associated with claims than was or will be possible under Basel I and the newly modified standardized approach. The goal is to use the capital required from an economic point of view as the yardstick for the regulatory capital requirement. However, this will only happen if the banks measure the risks in accordance with the regulatory criteria. The IRB approach distinguishes & asset classes: 1. sovereign exposures 2. bank exposures 3. corporate exposures 4. retail exposures 5. equity exposures securitization fixed assets If banks decide to apply the IRB approach in calculating the capital requirements, these asset classes and the respective sub-segments of corporate and retail exposures have to be accounted for in the segmentation process. Thus, it would make sense to harmonize and match the segmentation and the asset classes mentioned above to allow an efficient design of credit approval processes. In most cases, it will be necessary to refine the segmentation further to address a bank’s business orientation. Under Basel II, type of borrower is the only criterion at first (asset classes 1—3), but this changes for retail exposures (asset class). Claims on individuals belong to the retail portfolio. Besides loans to individuals, the retail portfolio can also contain credits to SMEs provided the total exposure of the bank, or more specifically of the credit institution group, vis-à-vis each of these enterprises is less than one million euro. Furthermore, such SMEs must not be treated in the same way as large enterprises within the bank’s internal credit (risk) processes. The allocation to the retail asset class is effected by means of the processes most appropriate in terms of business and from a risk perspective. Finally, retail exposures must also show a sufficient granularity. This means that an individual exposure needs to be part of a large number of exposures which are managed by the bank in the same way. This differentiation of the retail segment from the other asset classes is highly significant, as Basel II allows a so-called pooling approach in meeting the capital requirements for retail exposures. Under this approach, deriving the risk parameters13 is not based on an individual exposure, but on a pool of homogenous exposures. Simplified credit rating processes may be used (only) in this segment. 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 others 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. DATA COLLECTION The assessment of a credit applicant’s credit standing is based on different data sources and data types in accordance with the type of borrower. In any case, a bank must always be interested in having comprehensive and current data on the economic and personal situation of the borrower. In order to ensure consistent customer service, the respective account manager will typically coordinate the gathering of information. The credit review incorporates not only economic data but also qualitative information concerning the borrower. The account manager should thus include a complete and critical picture of the borrower. In order to ensure that all the information gathered by the account manager is passed on to the person in charge of the credit review, it would be advisable to prepare standardized and structured reports on customer visits. In practice, this has proven effective in directing conversations with customers as desired (function as conversation guide). This procedure ensures that information is gathered in its entirety and in an efficient manner. The layout of the visit reports should be specified for each segment and should be included in the internal guidelines. To make sure that the data collected is complete, mandatory lists showing what data are required should be used. These lists then have to be adapted to the requirements of the credit review process conforming to the type of borrower in each case. In addition to individual borrower data, many cases will require general information on the economic situation of a region or an industry to allow a comprehensive assessment of credit application; here, the bank can make use of external sources. If a bank’s credit portfolio shows a focus on certain industries or regions, banks are advised to conduct their own analyses of the economic situation in these fields — this is particularly true if the available external information lacks the necessary detail and/or currency. Plausibility Check and Preliminary Review Before a credit exposure is subjected to a comprehensive credit review, the employee initially in charge should conduct a plausibility check and preliminary review. This check should look at the completeness and consistency of the documents filed by the borrower to minimize any process loops and the need for further inquiries with the customer. In addition, sales should carry out an initial substantive check based on a select few relevant criteria. The objectives include the creation of awareness and active assumption of responsibility for credit risk on the part of the sales department. The preliminary check is especially significant in segments with high rejection rates, as a comprehensive credit review ties up considerable resources in these segments. The preliminary check should prevent exposures which will most likely be rejected from tying up capacities in risk analysis. The resulting reduction in number of cases dealt with by risk analysis allows a more detailed scrutiny of promising exposures and is thus desirable it terms of risk as well as efficiency. In practice, the distinction between two types of check criteria has proven successful: red criteria, which, if fulfilled, lead to an outright rejection of the exposure (alsoreferred to as knock-out criteria) yellow criteria, which, if fulfilled, require the sales staff to present a plausibleand well, documented justification of the respective situation. If this justification cannot be made, the exposure also has to be rejected. Credit Analysis & Risk Management – -25401143000 Passing on Data Making sure that information is passed on in its entirety is relevant from a risk perspective and concerns those processes in which the credit approval process is not concluded by the account manager himself. If the internal guidelines provide for a transfer of responsibility, or if the credit review is conducted by two or more people, it is necessary to ensure that the complete set of relevant documents is handed over. It would be advisable to prepare handover reports for this purpose. Handover reports should fully reflect changes in responsibility in the course of the credit approval process as well as any interface occurring in the process. In practice, a modular structure has proven particularly effective for such forms. If possible, they should be kept electronically18 or, alternatively, as the first page of the respective credit folder. The sales employee has to use the module (table or text module) provided for handing over the exposure to the respective process. This contains, among other things, an enumeration of the documents required for the respective risk analysis segment (completeness checklist). On the one hand, this ensures a smooth transfer of the documents, and on the other, it prevents incomplete files from being handed over to risk analysis. In addition, further modules, e.g. notes taken during customer appointments, should be included in the handover reports. Furthermore, appropriate modules should be included for all other interfaces between sales and risk analysis, or between different persons in processing. To facilitate a consistent application of the handover reports, it would be advisable to prepare detailed interface plans, which should, in particular, show the interfaces between sales and risk analysis. The internal guidelines have to stipulate the responsibilities along the interface plans in detail, which should ensure a consistent application and minimize the procedural risks resulting from the change in responsibility (e.g. loss of documents). Furthermore, this list serves to clearly assign specific responsibilities. This can help avoid errors in the credit approval process that could result from unclear responsibilities (e.g. failure to carry out a required process step). Credit Analysis & Risk Management – CREDIT REVIEW AND VALUATION OF COLLATERAL Exposure assessment involves the credit review and a valuation of the collateral based on the data provided by the credit applicant. These steps aim at making the risks resulting from the exposure transparent and allowing a final assessment of the exposure. The credit review basically consists of two process components: Standardized models of data evaluation Documentation and evaluation of other credit assessment factors Credit reviews are increasingly marked by standardized procedures. These procedures support and sometimes even replace the subjective decision making process in assessing credit standing. In practice, we can also find credit review processes that are completely based on standardized and automated models and thus do not provide for any manual documentation and assessment of other credit assessment factors beyond that. After establishing and assessing the risk involved in lending, the collateral offered by the applicant is examined and evaluated. The collateralized portion does not affect the applicant’s probability of default19; and its impact on assessing the exposure thus has to be dealt with independently of the credit review. Standardized Models of Data Evaluation (Rating Models) Today, we have many different models for the standardized evaluation of credit assessment data. These models can basically be divided into heuristic models, empirical statistical models, and causal models. In addition, hybrid models are used in practice that is based on two or three of the models mentioned. Heuristic models attempt to take experiences and use them as a basis to methodically gain new insights. These experiences can stem from: conjectured business interrelationships, subjective practical experiences and observations, business theories related to specific aspects. In terms of credit review, this means that experience from the lending business is used to try to predict a borrower’s future credit standing. Heuristic models thus depend on the fact that the subjective experiences of the credit experts are reflected appropriately. Thus, not only the credit assessment factors are determined heuristically, but also their impact and their weighting with reference to the final decision are based on subjective experiences. Empirical statistical models, by contrast, try to assess a borrower’s credit standing on the basis of objectifying processes. For this purpose, certain credit review criteria of the exposure under review are compared to the existing database which was established empirically. This comparison makes it possible to classify the credit exposure. The goodness of fit of an empirical statistical model depends to a great extent on the quality of the database used in developing the system. First, the database must be sufficiently large to allow significant findings. In addition, it must be ensured that the data used also represent the credit institution’s future business adequately. Causal models derive direct analytical Links to creditworthiness on the basis of finance theory. They do not use statistical methods to test hypotheses on an empirical basis. Hybrid models try to combine the advantages of several systems. Empirical statistical models are used only for those assessment factors for which a database exists which is sufficient in terms of quality. The other credit assessment factors which have to be included in the model are assessed by means of heuristic systems, while causal analysis models are typically not used. The following subsections deal with the integration of these models in credit decision processes. The basic distinction made here is whether further steps are carried out in addition to the standardized data evaluation to assess the credit standing (individual decision), or whether the standardized data evaluation essentially forms the basis for a credit decision (mostly automated decision). Credit Analysis & Risk Management – Individual Decision In an individual decision, the standardized data evaluation is complemented by further process steps to assess the credit standing. After the credit review, the collateral is evaluated. An integrated look at the detailed results leads to an individual credit decision which is not directly contingent on the results of the individual process components. Standardized Credit Review (Rating) A typical rating process consists of two components: financial rating (or quantitative rating) qualitative rating Financial rating comprises an analysis of the financial data available for the credit applicant. The analysis of annual financial statements (backward-looking approach) has a central position in this context. Increasingly, however, the analysis of business planning (forward-looking approach) is being employed in the credit review process. Usually, automated programs are used to calculate indicators from the annual financial statements or the business plan. In most cases, the financial rating is carried out by credit analysts that are not related to sales in terms of organizational structure. The degree of specialization of these employees depends on the volume and the complexity of each bank’s business activities. In the conventional corporate customer business most elements of the financial rating are carried out by specialized employees. There may be additional specialized units that furnish those employees which are primarily responsible with certain analyses (modular system). In many banks, for example, it is possible to find units specializing in the analysis of foreign companies or real estate finance. Setting up a separate unit should be considered whenever the analysis requires the development of special know-how and the number of the analyses to be handled renders a complete specialization of employees feasible in terms of efficiency. If analyses that were drawn up by employees other than those primarily responsible for the credit approval process, it is essential to make sure that the administrative process involved is as efficient as possible. There should be a general guideline stipulating that the analysis is confirmed by the person in charge of the organizational unit supplying the module for the credit analysis when this module is handed over to the credit officer managing the exposure. The common practice of having the people in charge of every single organizational unit involved in the credit approval process also confirm the completed credit application is rejected as inefficient and does not seem necessary in terms of risk, either. In contrast to financial rating, which requires specific technical know-how, qualitative rating requires comprehensive knowledge of the borrower to be successful. In the course of the rating, the qualitative factors are also evaluated in a standardized fashion by means of one of the models described above. Accordingly, this is typically done by the sales employee. As qualitative rating may be interested in characteristics that go beyond the borrower in question itself (e.g. product positioning within the competitive environment), it is possible to provide for the integration of additional organizational units within the bank. This could, for example, be units specializing in the evaluation of product markets. What was said above also applies to the inclusion of these modules. Using a weighting function, financial and qualitative ratings are combined, with the result usually referred to as base rating. Credit Analysis & Risk Management – CREDIT REVIEW AND VALUATION OF COLLATERAL (CONT.) In addition to the process components discussed so far, it is possible to include further information in the credit rating process. In particular, this comprises a bank’s internal information on the respective applicant’s conduct in the past (e.g. overdrafts) as well as additional information concerning the industry in which the company operates. In practice, the result is often referred to as company rating. If companies are affiliated, it is necessary to look at possible loss-sharing arrangements in the rating process. The inclusion of loss-sharing arrangements makes it possible to determine the risk-bearing entities. The inclusion of a loss sharing arrangement can affect the assessment of the probability of default of the company on which the rating is based positively and negatively. Positive effect: assumption of support for the company in case of a crisis Negative effect: spillover of a crisis to the company The inclusion of loss-sharing arrangements should be done in accordance with the relevant members of the sales and credit analysis departments. This typically marks the end of the rating process. The final result is also referred to as borrower rating. The final borrower rating should be awarded and confirmed together by the sales and risk analysis employees primarily in charge of the exposure. The employees should carry out mutual plausibility checks. In addition, external ratings should also be used in the plausibility check. If it is not possible to come to an agreement, the managers in charge look at the exposure, but the final decision should not be left in the hands of the front office. The need for a formal arrangement is underscored by the significance which will be attributed to the rating under the IRB approach in the future. 317514795500 Credit Analysis & Risk Management – Overriding Rating Results The internal guidelines should contain rules governing the circumstances under which it is permissible to interfere manually in the standardized credit rating models. This might, for example, be necessary in the course of a financial rating if a meaningful ratio analysis is precluded due to a special structure of the enterprise to be examined. Any changes made must be subject to strict documentation requirements to ensure complete transparency of the process. The authority to do so must be stipulated in the decision- making structure. Furthermore, the number of overrides represents an indicator of the reliability of the credit rating processes. Therefore, the documentation is also required for validation purposes. Documentation of Other Credit Assessment Factors In addition to the factors evaluated by means of the standardized credit rating process, the employees handling the exposure could include further data/factors in the credit review. The need to offer at least the option to add a description and evaluation of the exposure results from the fact that the standardization of the credit rating process makes it necessary to limit the extent to which all existing credit assessment factors are presented. Ideally, the processes should adequately reflect all factors necessary to assess the credit standing, and the need for a separate description should arise only as an exception. The description and assessment of these factors should be carried out in accordance with clear rules in the internal guidelines. In practice, the credit applications show fields that help document these factors. Five categories are usually distinguished: Legal situation Market situation Economic situation Project evaluation Debt service capacity The documentation of the factors to be considered in these categories should contain clear and unambiguous statements describing their potential impact on credit standing. The design of the forms should already be apt to prevent or reduce longwinded descriptions of the factors and unclear assessments with regard to the impact on credit standing. This can be achieved by using standardized text modules and limited field sizes. Valuation of Collateral The valuation of the collateral provided by the credit applicant is an essential element in the credit approval process and thus has an impact on the overall assessment of the credit risk involved in a possible exposure. The main feature of a collateralized credit is not only the borrower’s personal credit standing, which basically determines the probability of default (PD), but the collateral which the lender can realize in case the customer defaults and which thus determines the banks loss. Via the risk component of loss given default (LGD) and other requirements concerning credit risk mitigation techniques, the value of the collateral is included in calculating the capital requirement under Basel II. In order to calculate the risk parameters under Basel II correctly, it is important for the valuation of the collateral to be effected completely independently of the calculation of the borrower’s PD in the credit rating process. This should ensure that the probability of default and the loss given default are shown separately in order to meet the Basel requirements of splitting up the review into a customer rating which reflects only the PD on the one hand, and a transaction valuation which also contains a valuation of the collateral to support the credit decision on the other. Collateral is generally divided into personal and physical collateral. In the case of personal collateral, the provider is basically liable with his entire fortune. Examples of personal collateral are the following: surety ship guarantee and letter of support collateral promise Credit Analysis & Risk Management – In the case of physical collateral, the bank receives a specific security interest in certain assets of the borrower or the collateral provider. Examples of physical collateral are the following: mortgage pledge of movable assets (on securities, goods, bills of exchange) security assignment retention of title The internal guidelines (collateral catalog) should lay down the type of collateral which each bank generally accepts. Banks should take a close look at that collateral whose value is subject to particularly strong fluctuations and/ or whose realization is longwinded or often cumbersome. Liens, for example, usually pose relatively few problems for their holders and provide them with a rather strong creditor position, as the related value of the collateral given is generally easier to assess/value than the personal liability fund of a guarantor. The collateral catalog has to include appropriate instructions on assessing the collateral potentially accepted by the bank as well as determining its collateral value. A description of the processes and principles in determining the collateral value for each type of collateral will primarily have to be drawn up in accordance with the business orientation of each bank and the complexity of the approved collateral. General principles governing the valuation of collateral such as accounting for sustainable value or valuing the collateral based on the liquidation principle should be included in the determination of collateral value; similarly, it should also include general risk deductions (haircuts) as well as deductions for procedural cost (e.g. long time required to sell the collateral).