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1. While financial institutions have faced difficulties over the years for a multitude of reasons, the major cause of serious banking problems continues to be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank’s counterparties. This experience is common in both G-10 and non-G-10 countries.
Principle 11: Banks must have information systems and analytical techniques that
enable management to measure the credit risk inherent in all on- and off-balance sheet
activities. The management information system should provide adequate information on
the composition of the credit portfolio, including identification of any concentrations of
risk.
61. Banks should have methodologies that enable them to quantify the risk involved in
exposures to individual borrowers or counterparties. Banks should also be able to analyse
credit risk at the product and portfolio level in order to identify any particular sensitivities or
concentrations. The measurement of credit risk should take account of (i) the specific nature
of the credit (loan, derivative, facility, etc.) and its contractual and financial conditions
(maturity, reference rate, etc.); (ii) the exposure profile until maturity in relation to potential
market movements; (iii) the existence of collateral or guarantees; and (iv) the potential for
default based on the internal risk rating. The analysis of credit risk data should be undertaken
at an appropriate frequency with the results reviewed against relevant limits. Banks should
use measurement techniques that are appropriate to the complexity and level of the risks
involved in their activities, based on robust data, and subject to periodic validation.
62. The effectiveness of a bank’s credit risk measurement process is highly dependent on
the quality of management information systems. The information generated from such
systems enables the board and all levels of management to fulfil their respective oversight
roles, including determining the adequate level of capital that the bank should be holding.
Therefore, the quality, detail and timeliness of information are critical. In particular,
information on the composition and quality of the various portfolios, including on a
consolidated bank basis, should permit management to assess quickly and accurately the level
of credit risk that the bank has incurred through its various activities and determine whether
the bank’s performance is meeting the credit risk strategy.
63. Banks should monitor actual exposures against established limits. It is important that
banks have a management information system in place to ensure that exposures approaching
risk limits are brought to the attention of senior management. All exposures should be
included in a risk limit measurement system. The bank’s information system should be able to
aggregate credit exposures to individual borrowers and counterparties and report on
exceptions to credit risk limits on a meaningful and timely basis.
64. Banks should have information systems in place that enable management to identify
any concentrations of risk within the credit portfolio. The adequacy of scope of information
should be reviewed on a periodic basis by business line managers and senior management to
ensure that it is sufficient to the complexity of the business. Increasingly, banks are also
designing information systems that permit additional analysis of the credit portfolio, including
stress testing.
Principle 12: Banks must have in place a system for monitoring the overall composition
and quality of the credit portfolio.
65. Traditionally, banks have focused on oversight of contractual performance of
individual credits in managing their overall credit risk. While this focus is important, banks
also need to have in place a system for monitoring the overall composition and quality of the
various credit portfolios. This system should be consistent with the nature, size and
complexity of the bank's portfolios.
66. A continuing source of credit-related problems in banks is concentrations within the
credit portfolio. Concentrations of risk can take many forms and can arise whenever a
significant number of credits have similar risk characteristics. Concentrations occur when,
among other things, a bank’s portfolio contains a high level of direct or indirect credits to (i) a
single counterparty, (ii) a group of connected counterparties11, (iii) a particular industry or
economic sector, (iv) a geographic region, (v) an individual foreign country or a group of
countries whose economies are strongly interrelated, (vi) a type of credit facility, or (vii) a
type of collateral. Concentrations also occur in credits with the same maturity. Concentrations
can stem from more complex or subtle linkages among credits in the portfolio. The
concentration of risk does not only apply to the granting of loans but to the whole range of
banking activities that, by their nature, involve counterparty risk. A high level of
concentration exposes the bank to adverse changes in the area in which the credits are
concentrated.
67. In many instances, due to a bank’s trade area, geographic location or lack of access
to economically diverse borrowers or counterparties, avoiding or reducing concentrations may
be extremely difficult. In addition, banks may want to capitalise on their expertise in a
particular industry or economic sector. A bank may also determine that it is being adequately
compensated for incurring certain concentrations of risk. Consequently, banks should not
necessarily forego booking sound credits solely on the basis of concentration. Banks may
need to make use of alternatives to reduce or mitigate concentrations. Such measures can
include pricing for the additional risk, increased holdings of capital to compensate for the
additional risks and making use of loan participations in order to reduce dependency on a
11 See footnote 5.
Credit risk management
22
particular sector of the economy or group of related borrowers. Banks must be careful not to
enter into transactions with borrowers or counterparties they do not know or engage in credit
activities they do not fully understand simply for the sake of diversification.
68. Banks have new possibilities to manage credit concentrations and other portfolio
issues. These include such mechanisms as loan sales, credit derivatives, securitisation
programs and other secondary loan markets. However, mechanisms to deal with portfolio
concentration issues involve risks that must also be identified and managed. Consequently,
when banks decide to utilise these mechanisms, they need to first have policies and
procedures, as well as adequate controls, in place.
Principle 13: Banks should take into consideration potential future changes in economic
conditions when assessing individual credits and their credit portfolios, and should
assess their credit risk exposures under stressful conditions.
69. An important element of sound credit risk management involves discussing what
could potentially go wrong with individual credits and within the various credit portfolios,
and factoring this information into the analysis of the adequacy of capital and provisions. This
“what if” exercise can reveal previously undetected areas of potential credit risk exposure for
the bank. The linkages between different categories of risk that are likely to emerge in times
of crisis should be fully understood. In case of adverse circumstances, there may be a
substantial correlation of various risks, especially credit and market risk. Scenario analysis
and stress testing are useful ways of assessing areas of potential problems.
70. Stress testing should involve identifying possible events or future changes in
economic conditions that could have unfavourable effects on a bank’s credit exposures and
assessing the bank’s ability to withstand such changes. Three areas that banks could usefully
examine are: (i) economic or industry downturns; (ii) market-risk events; and (iii) liquidity
conditions. Stress testing can range from relatively simple alterations in assumptions about
one or more financial, structural or economic variables to the use of highly sophisticated
financial models. Typically, the latter are used by large, internationally active banks.
71. Whatever the method of stress testing used, the output of the tests should be
reviewed periodically by senior management and appropriate action taken in cases where the
results exceed agreed tolerances. The output should also be incorporated into the process for
assigning and updating policies and limits.
72. The bank should attempt to identify the types of situations, such as economic
downturns, both in the whole economy or in particular sectors, higher than expected levels of
delinquencies and defaults, or the combinations of credit and market events, that could
produce substantial losses or liquidity problems. Such an analysis should be done on a
consolidated bank basis. Stress-test analyses should also include contingency plans regarding
actions management might take given certain scenarios. These can include such techniques as
hedging against the outcome or reducing the size of the exposure.
V. Ensuring Adequate Controls over Credit Risk
Principle 14: Banks must establish a system of independent, ongoing assessment of the
bank’s credit risk management processes and the results of such reviews should be
communicated directly to the board of directors and senior management.
73. Because various appointed individuals throughout a bank have the authority to grant
credit, the bank should have an efficient internal review and reporting system in order to
manage effectively the bank’s various portfolios. This system should provide the board of
directors and senior management with sufficient information to evaluate the performance of
account officers and the condition of the credit portfolio.
74. Internal credit reviews conducted by individuals independent from the business
function provide an important assessment of individual credits and the overall quality of the
credit portfolio. Such a credit review function can help evaluate the overall credit
administration process, determine the accuracy of internal risk ratings and judge whether the
account officer is properly monitoring individual credits. The credit review function should
report directly to the board of directors, a committee with audit responsibilities, or senior
management without lending authority (e.g., senior management within the risk control
function).
Principle 15: Banks must ensure that the credit-granting function is being properly
managed and that credit exposures are within levels consistent with prudential
standards and internal limits. Banks should establish and enforce internal controls and
other practices to ensure that exceptions to policies, procedures and limits are reported
in a timely manner to the appropriate level of management for action.
75. The goal of credit risk management is to maintain a bank’s credit risk exposure
within parameters set by the board of directors and senior management. The establishment
and enforcement of internal controls, operating limits and other practices will help ensure that
credit risk exposures do not exceed levels acceptable to the individual bank. Such a system
will enable bank management to monitor adherence to the established credit risk objectives.
76. Limit systems should ensure that granting of credit exceeding certain predetermined
levels receive prompt management attention. An appropriate limit system should assist
management in controlling credit risk exposures, initiating discussion about opportunities and
risks, and monitoring actual risk taking against predetermined credit risk tolerances.
77. Internal audits of the credit risk processes should be conducted on a periodic basis to
determine that credit activities are in compliance with the bank’s credit policies and
procedures, that credits are authorised within the guidelines established by the bank’s board of
directors and that the existence, quality and value of individual credits are accurately being
reported to senior management. Such audits should also be used to identify areas of weakness
in the credit risk management process, policies and procedures as well as any exceptions to
policies, procedures and limits.
Principle 16: Banks must have a system in place for early remedial action on
deteriorating credits, managing problem credits and similar workout situations.
78. One reason for establishing a systematic credit review process is to identify
weakened or problem credits.12 A reduction in credit quality should be recognised at an early
stage when there may be more options available for improving the credit. Banks must have a
disciplined and vigorous remedial management process, triggered by specific events, that is
administered through the credit administration and problem recognition systems.
79. A bank’s credit risk policies should clearly set out how the bank will manage
problem credits. Banks differ on the methods and organisation they use to manage problem
credits. Responsibility for such credits may be assigned to the originating business function, a
specialised workout section, or a combination of the two, depending upon the size and nature
of the credit and the reason for its problems.
80. Effective workout programs are critical to managing risk in the portfolio. When a
bank has significant credit-related problems, it is important to segregate the workout function
from the area that originated the credit. The additional resources, expertise and more
concentrated focus of a specialised workout section normally improve collection results. A
workout section can help develop an effective strategy to rehabilitate a troubled credit or to
12 See footnote 6.
increase the amount of repayment ultimately collected. An experienced workout section can
also provide valuable input into any credit restructurings organised by the business function.
VI. The Role of Supervisors
Principle 17: Supervisors should require that banks have an effective system in place to
identify, measure, monitor and control credit risk as part of an overall approach to risk
management. Supervisors should conduct an independent evaluation of a bank’s
strategies, policies, procedures and practices related to the granting of credit and the
ongoing management of the portfolio. Supervisors should consider setting prudential
limits to restrict bank exposures to single borrowers or groups of connected
counterparties.
81. Although the board of directors and senior management bear the ultimate
responsibility for an effective system of credit risk management, supervisors should, as part of
their ongoing supervisory activities, assess the system in place at individual banks to identify,
measure, monitor and control credit risk. This should include an assessment of any
measurement tools (such as internal risk ratings and credit risk models) used by the bank. In
addition, they should determine that the board of directors effectively oversees the credit risk
management process of the bank and that management monitors risk positions, and
compliance with and appropriateness of policies.
82. To evaluate the quality of credit risk management systems, supervisors can take a
number of approaches. A key element in such an evaluation is the determination by
supervisors that the bank is utilising sound asset valuation procedures. Most typically,
supervisors, or the external auditors on whose work they partially rely, conduct a review of
the quality of a sample of individual credits. In those instances where the supervisory analysis
agrees with the internal analysis conducted by the bank, a higher degree of dependence can be
placed on the use of such internal reviews for assessing the overall quality of the credit
portfolio and the adequacy of provisions and reserves13. Supervisors or external auditors
should also assess the quality of a bank’s own internal validation process where internal risk
13 The New Capital Adequacy Framework anticipates that, subject to supervisory approval, banks’ internal rating
methodologies may be used as a basis for regulatory capital calculation. Guidance to supervisors specific to this purpose
will be published in due course.
ratings and/or credit risk models are used. Supervisors should also review the results of any
independent internal reviews of the credit-granting and credit administration functions.
Supervisors should also make use of any reviews conducted by the bank’s external auditors,
where available.
83. Supervisors should take particular note of whether bank management recognises
problem credits at an early stage and takes the appropriate actions.14 Supervisors should
monitor trends within a bank’s overall credit portfolio and discuss with senior management
any marked deterioration. Supervisors should also assess whether the capital of the bank, in
addition to its provisions and reserves, is adequate related to the level of credit risk identified
and inherent in the bank’s various on- and off-balance sheet activities.
84. In reviewing the adequacy of the credit risk management process, home country
supervisors should also determine that the process is effective across business lines,
subsidiaries and national boundaries. It is important that supervisors evaluate the credit risk
management system not only at the level of individual businesses or legal entities but also
across the wide spectrum of activities and subsidiaries within the consolidated banking
organisation.
85. After the credit risk management process is evaluated, the supervisors should address
with management any weaknesses detected in the system, excess concentrations, the
classification of problem credits and the estimation of any additional provisions and the effect
on the bank’s profitability of any suspension of interest accruals. In those instances where
supervisors determine that a bank’s overall credit risk management system is not adequate or
effective for that bank’s specific credit risk profile, they should ensure the bank takes the
appropriate actions to improve promptly its credit risk management process.
86. Supervisors should consider setting prudential limits (e.g., large exposure limits) that
would apply to all banks, irrespective of the quality of their credit risk management process.
Such limits would include restricting bank exposures to single borrowers or groups of
connected counterparties. Supervisors may also want to impose certain reporting requirements
for credits of a particular type or exceeding certain established levels. In particular, special
attention needs to be paid to credits granted to counterparties “connected” to the bank, or to
each other.
14 See footnote 6.
Appendix
Common Sources of Major Credit Problems
1. Most major banking problems have been either explicitly or indirectly caused by
weaknesses in credit risk management. In supervisors’ experience, certain key problems tend
to recur. Severe credit losses in a banking system usually reflect simultaneous problems in
several areas, such as concentrations, failures of due diligence and inadequate monitoring.
This appendix summarises some of the most common problems related to the broad areas of
concentrations, credit processing, and market- and liquidity-sensitive credit exposures.
Concentrations
2. Concentrations are probably the single most important cause of major credit
problems. Credit concentrations are viewed as any exposure where the potential losses are
large relative to the bank’s capital, its total assets or, where adequate measures exist, the
bank’s overall risk level. Relatively large losses15 may reflect not only large exposures, but
also the potential for unusually high percentage losses given default.
3. Credit concentrations can further be grouped roughly into two categories:
Conventional credit concentrations would include concentrations of credits to
single borrowers or counterparties, a group of connected counterparties, and sectors
or industries, such as commercial real estate, and oil and gas.
Concentrations based on common or correlated risk factors reflect subtler or
more situation-specific factors, and often can only be uncovered through analysis.
Disturbances in Asia and Russia in late 1998 illustrate how close linkages among
emerging markets under stress conditions and previously undetected correlations
between market and credit risks, as well as between those risks and liquidity risk, can
produce widespread losses.
4. Examples of concentrations based on the potential for unusually deep losses often embody factors such as leverage, optionality, correlation of risk factors and structured financings that concentrate risk in certain tranches. For example, a highly leveraged borrower
15 Losses are equal to the exposure times the percentage loss given the event of default.
will likely produce larger credit losses for a given severe price or economic shock than a less leveraged borrower whose capital can absorb a significant portion of any loss. The onset of exchange rate devaluations in late 1997 in Asia revealed the correlation between exchange rate devaluation and declines in financial condition of foreign exchange derivative counterparties resident in the devaluing country, producing very substantial losses relative to
notional amounts of those derivatives. The risk in a pool of assets can be concentrated in a securitisation into subordinated tranches and claims on leveraged special purpose vehicles, which in a downturn would suffer substantial losses.
5. The recurrent nature of credit concentration problems, especially involving conventional credit concentrations, raises the issue of why banks allow concentrations to develop. First, in developing their business strategy, most banks face an inherent trade-off between choosing to specialise in a few key areas with the goal of achieving a market leadership position and diversifying their income streams, especially when they are engaged
in some volatile market segments. This trade-off has been exacerbated by intensified
competition among banks and non-banks alike for traditional banking activities, such as
providing credit to investment grade corporations. Concentrations appear most frequently to
arise because banks identify “hot” and rapidly growing industries and use overly optimistic
assumptions about an industry’s future prospects, especially asset appreciation and the
potential to earn above-average fees and/or spreads. Banks seem most susceptible to
overlooking the dangers in such situations when they are focused on asset growth or market
share.
6. Banking supervisors should have specific regulations limiting concentrations to one
borrower or set of related borrowers, and, in fact, should also expect banks to set much lower
limits on single-obligor exposure. Most credit risk managers in banks also monitor industry
concentrations. Many banks are exploring techniques to identify concentrations based on
common risk factors or correlations among factors. While small banks may find it difficult not
to be at or near limits on concentrations, very large banking organisations must recognise that,
because of their large capital base, their exposures to single obligors can reach imprudent
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