Risk means a deliberate interaction with uncertainty. That means an intentional commitment to situations belonging to the future over which one cannot exercise mastery. Risk results when one gets involved with uncertainty.
Credit risk is the oldest form of risk in the financial markets. It is the chance that the loan granted to someone which one is expected to returned will not be returned. Credit risk is as old as lending itself, which means that it dates back to around 1800 BCE.
It is still much of what it was during the ancient Egyptian times. Now as then, there is always an element of uncertainty as to whether a given borrower will repay a particular loan. But the success of any financial institution lies on its effectiveness at mitigating credit risks and recovering loans.
Think about the leading financial institutions in the world. What keeps them at the top of their game? Their strength lies in their competence at credit management. Interestingly such competence is not mysterious. It is something any financial institution can develop.
Risk management must be effective, must be efficient, and it must contribute decisively to the control environment within the business. There are two questions for determining this: Does it provide value for the cost of risk management; and does it result in a cost of risk that is within the business’s capacity to absorb and within the parameters established by management?
To achieve this, management will have to develop the right risk culture in the organization. This means creating the right context for the organization’s risk management activities.
First, management clearly defines the credit risk philosophy of the institution describing their approach to risk management. The corporate risk philosophy of a financial institution is the set of ideas, facts and convictions of the institution as it relates to credit risk. It is this philosophy that defines the dimensions of their commitment to uncertainties.
Clearly every leading financial institution in the world has a clearly defined risk philosophy. For J P Morgan Chase in a recent annual report, the “ability to properly identify, measure, monitor and report risk is critical to both its soundness and profitability.”
Barclays bank, in its 2006 annual report, notes that risk management “is a fundamental part of Barclay’s business activity and an essential component of its planning process. This is achieved by keeping risk management at the centre of the executive agenda and by building a culture in which risk management is embedded in everyday management of the business.”
Once management has clearly defined its risk philosophy, it then will need to set goals and measures based on this philosophy. These goals have to be inspiring, objective and measurable. If you think that taking credit risk is a measure of your effectiveness in business and a core determinant of your profitability, you will naturally set goals to guide your corporate thought and activities. Otherwise there will be no strategic direction. The credit risk goals must be aligned with the credit risk philosophy otherwise the philosophy will have no real life effect on the institution.
The next thing is to articulate the credit risk appetite of the institution. Credit risk appetite refers to the credit risk the institution is willing to accept in the pursuit of its credit risk goals and before an action is deemed necessary to mitigate the risk. These boundaries and restrictions which complement compulsory regulatory requirements are self imposed.
A common way for management to describe credit risk appetite is to identify the investment that they are willing to commit to risk management. The extent of their resource allocation should match their risk management goals and appetite.
Next management need to set clear key credit risk policies. Credit risk policies go beyond legal requirements to include such issues as avoidance of risk concentration, avoiding all conflicts of interest and avoiding exposures to related parties. These policies are what define the uniqueness of a financial institution.
Finally is the assignment of credit risk management function. Management will have to determine the role and scope credit risk management functions. They need to determine the structure and decision rights of the risk function. They also need to decide the technical and organizational capabilities they wish to allocate to the risk function.
All of these decisions about the risk function have to be consistent with the institutions’ approach to risk and approach to risk management generally.
There should be alignment between the resourcing allocated and power delegated to the risk function and the expectation about how it will influence the performance of the company.
Since banking business entails some degree of risk, every bank or financial institution must decide just how much risk it is prepared to take and to be totally honest about how they are faring in business at all times. Senior management must establish a comfort zone for risk taking and ensure that people within the organization understand it and remain within it. Outside this zone, the potential consequences of losing are more severe than the potential satisfaction from winning.
Brian Reuben
