Bank Of International Settlements Credit Risk Measurement Approach And Challenges For Credit Valuation Adjustment

Credit Risk Management Approach

The main purpose of this assessment is to analyze the Bank of International Settlements (BIS)’s most preferred credit risk measurement approach for other banks. The assessment considers the operations of Bank of International Settlements (BIS) which is engaged in the business of providing financial services and maintaining financial cooperation in business organization (Laurent, 2014). The assessment considers the best practices which can be taken by bank for the purpose of reducing the credit risks which are faced by most of the banks. The risks which banks faces are mostly credit risks as defaults in credit facilities has increased in recent times. The assessment also deals with the challenges which are faced by Banking Institutions in relation to Credit value adjustment and how the same can have impact the banks.

In a banking sector, the initial step which is followed by banks while providing credit to any business or individual is assessment of the credit risk. The credit risks assessment allows the bank to appropriately decide whether the credit facility would be offered to that particular client or not. As per the internal business analysis of Bank of International Settlements (BIS) follows the credit ratings of the clients in order to decide whether the credit facility is to be offered to the client or not (Bluhm, Overbeck & Wagner, 2016). Every business or clients who have take loan in past has credit record which is considered by Bank of International Settlements (BIS) and if the same is shown to be favorable than only the loan amount is approved and sanctioned by the bank.

Credit risk is general terms is defined as the potential that a borrower of a bank would not be able to meet the obligations of the loan within agreed term. The goal of credit risk management is to maximize the bank’s risk adjusted rate of return (Bielecki & Rutkowski, 2013). The credit risks have significantly enhanced during the recent years which is a consideration. As per the policy of Bank of International Settlements (BIS), a key element in risk measurement approach is that the role of credit rating system in a business organization (Ang & Longstaff, 2013). In case of measuring credit risks of a business, the basic thing which need to establish is that some measure of dispersion of possible future outcomes can be made available for the purpose of taking decisions. In case of an individual bank, the dispersion of future returns on its own portfolio is a matter of concern while in case of policymaker, the dispersion of future return is concern and the same is also linked with financial stability of a business (Van Deventer, Imai & Mesler, 2013).

Credit Risk Ratings

The Bank of International Settlements (BIS) is of the opinion that an appropriate rating system for the loans is an important consideration which should be considered by banks before making any credit allowances to individuals or businesses. The two types of rating system which is available to the bank is the market-based rating system and other road set of information. The market-based rating system requires banks to assess the credit ratings of the clients before a significant amount of loan is offered. There are a lot of credit risk models which are present such as JP Morgan’s Credit Metrics, McKinsey’s Credit Portfolio view and similar other models. The common building blocks for all such models ate in most case the same. The building blocks of credit risk assessment are made up of two elements which are finding out the credit worthiness of individual borrowers and the second factor which is considered is the transition matrix which consider that the credit rating of the borrowers would change over time horizon (Fredrick, 2013). It is also prescribed to international banks that they should have first have a background check on the clients to whom credit facility is being offered. This can be done by banks by strictly following and implementing the Know your Customers norms. These norms allow banks to appropriately keep tabs about the customers and also helps banks in conducting a background check for the banks. The Know Your Customers norms of a business would enable the business to have an access to the track record of the customer to whom the loan amount is provided. The rating system of the customers would appropriately act as a guide to the banks as to which customers are to be offered loans.

Figure 1: (Chart showing expected Default frequency of US companies)

Source: ()

The above figure shows the default rate frequency of US companies and the rate is shown to be high as per 2002 estimates. The default rate for credits for banks has been rising as per the figure which is shown (Noh, 2013). Therefore, the credit ratings analysis is necessary so that all such defaults in appropriate servicing of credit can be prevented,

The historical background of Credit Value Adjustment (CVA) can be traced back to Counterparty credit risk which was developed during the financial crisis of 2007-08. Counterparty credit risks is closely related credit risks but are not strictly. Counterparty credit risks is referred to the risk where counterparty defaults before honouring the engagement which has been entered not. The special thing about Counterparty credit risks is that it inherits both market and credit risks. The Counterparty credit risks are somewhere between credit risks and market risks. This was further developed into credit valuation risks in 2004 after accounting standards was introduced for counterparty (Blankespoor et al., 2015). After this process, banks started using a measure called credit valuation adjustment which is on monthly basis. During the financial crisis, banks suffered significantly for counterparty credit risk (CCR) losses on their OTC derivatives portfolios. The majority of these losses came not from counterparty defaults but also significantly from losses which the banks suffered from derivatives. The value of outstanding derivative assets was written down as it became apparent that counterparties were less likely than expected to meet their obligations

Credit Value Adjustment (CVA)

 Credit value adjustments is the difference between the risk free portfolio value and the true portfolio value that takes into consideration any default situation which can arise. Under the Basel II regulations of Credit Value Adjustment is being analyzed in order to identify the advantages and limitation of the same. The Basel II regulations would be evaluate Credit Value Adjustment for the purpose of supervising the adjustments which are undertaken by banks. There are various challenges which are present while following and implementing Credit Value Adjustment and the same are listed below in details:

• There is a lack of good credit management system or tool which can appropriately measure counterparty credit files, rates and also their respective ratings. In addition to this, there is also a lack of appropriate management tool.
• The management of counterparty credit risks is a difficult process and there is also difficulty in calculating and reporting potential futures exposures for a business.
• There is also a practical difficulty in managing accounting for credit valuation adjustments as no appropriate accounting standards has that risk assessment capability.

In addition to the above points, the credit valuation adjustments are a bit complicated to understand as the same has the attributes of market risks and credit risks. The credit valuation adjustments are difficult to implement in banks.

Conclusion

The above discussion also shows that the functions of Bank of International Settlements (BIS) and the most preferred credit risks measurements which is advisable for banks. The credit risk management system is an important aspect and the same needs to be performed by banks for the purpose of measuring the capacity of parties. The credit ratings policy of banks is an efficient way for managing and minimizing the credit risks of a business. The discussion shows that analyzing the credit ratings of the borrower is a good way to minimize the credit risks which banks faces. The analysis above also shows Credit valuation adjustments which have are done by banks for maintaining credit and market risks in the business.

Reference

Ang, A., & Longstaff, F. A. (2013). Systemic sovereign credit risk: Lessons from the US and Europe. Journal of Monetary Economics, 60(5), 493-510.

Bielecki, T. R., & Rutkowski, M. (2013). Credit risk: modeling, valuation and hedging. Springer Science & Business Media.

Blankespoor, E., Linsmeier, T. J., Petroni, K. R., & Shakespeare, C. (2013). Fair value accounting for financial instruments: Does it improve the association between bank leverage and credit risk?. The Accounting Review, 88(4), 1143-1177.

Bluhm, C., Overbeck, L., & Wagner, C. (2016). Introduction to credit risk modeling. Chapman and Hall/CRC.

Fredrick, O. (2013). The impact of credit risk management on financial performance of commercial banks in Kenya. DBA Africa Management Review, 3(1).

Laurent, J. P. (2014). Credit risk models. Wiley StatsRef: Statistics Reference Online.

Noh, J. (2013). BASEL III counterparty risk and credit value adjustment: Impact of the wrong-way risk. Global Economic Review, 42(4), 346-361.

Van Deventer, D. R., Imai, K., & Mesler, M. (2013). Advanced financial risk management: tools and techniques for integrated credit risk and interest rate risk management. John Wiley & Sons.