Market Intelligence to mitigate credit risk in banks
Banking system has wellfortified internal risk management system to mitigate diversified range of risks. They are well documented taking into consideration bank’s own risk appetitebuilt upon central bank guidelines.
The documented blue print of risk management is fixed in short and medium term and is revised usually in long term. But in a dynamic globally integrated business environment, banking risks change shades frequently and manifest differently in line with the developments taking place in external environment and international technological developments.
The product innovations and application of robotics and artificial intelligence changed the entire ecosystem of grasping risk sensitivity. More sophisticated technology in remittances keep increasing risk sensitivity towards credit risk.
The cyber risk is an added point of risk which is ubiquitous in all forms of risks. Banks have the challenge to remain well prepared to change their risk mitigation strategies in short term though virtually they do not have any control to change the evolving risk dynamics. In a virtual banking world, moving risk management to real time framework is essential. Among the different risks, predominant risk for banks is credit risk as major deployment is in credit. Assessment of credit risk is a function of evaluating credit worthiness of potential borrowers and to assess default risk.
Both banks and borrowers work in collaboration with markets. Therefore appraising a loan proposal based on systems and procedures laid down in bank’s internal instruction manual may not be able to fully link credit worthiness to ongoing market dynamics.
An effort is therefore made through a systematic credit appraisal process to precisely assess credit worthiness of potential borrower. It is an assessment of Credit risk linked to the ability of banks to find out the probability that a bank borrower or counterparty will not fail to meet its obligations in accordance with agreed terms so as to improve the safety of bank’s funds.
The goal of credit risk management is to maximize a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters.
Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Banks should also consider the symbiotic relationship between credit risk and other forms of risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the longterm success of banks in the credit market.
The technique of credit appraisal is based on the bankability of the underlying project. Bankability of the project is assessed from the information provided by the borrower. Before a loan is sanctioned, the information provided by the borrower will always be projectfriendly highlighting strengths and undermining the weaknesses.
Banks are usually dependent upon information which may be skewed in favor of borrower, unless there is a prescribed norm to cross-verify many data points from market sources. In view of increasing connect of borrowers with the markets, it is essential that banks integrate risk management strategies with external sources of information to affirm its authenticity with an intention to make risk management more comprehensive and realistic. In managing credit risk, it has to be borne in mind that even if one party is simply late in settling, then the other party may incur a loss relating to missed investment opportunities.
The chain reaction in the industry is a risk to be recognized and mitigated. Settlement risk (i.e. the risk that the completion or settlement of a financial transaction will fail to take place as expected) thus includes elements of liquidity, market, operational and reputational risk as well as credit risk. The level of risk is determined by the particular arrangements for settlement. Factors in such arrangements that have a bearing on credit risk include: the timing of the exchange of value; payment/settlement finality; and the role of intermediaries and clearing houses. Hence risks are never to be considered in isolation but a holistic view is essential.
It is process of connecting bank to external information system. It refers to the information, primarily qualitative in nature, which banks need to gather through direct interaction and dialogue with market participants. Market Intelligence (MI) seeks to increase understanding of activities that are conducted by peer banks and design of operations of the unit.
MI may not be a definitive guide of best practice but can rather demonstrate that gathering such market centric information can equip banks with ability to understand a number of different business models operating in the system. Its remit, size and resources and implications on the borrower performance in future.
It also highlights the purpose and importance of MI to banks and borrowing entities. When operating in an integrated work environment, accessing information across industry is equally important and worthwhile to mitigate risks. The recent evolution of MI tools have assumed greater importance due to their established utility in managing risks across geographies. Next, the MI outlines different organizational models for the collection, synthesis and dissemination of external data points and helps discuss various other aspects of how it is put to use. Banks have to incorporate details of how they deal with the information they collect, including how it is recorded and distributed, as well as the treatment of sensitive or confidential information contained in it.
The information gathered from MI is able to supplement and cross check the data provided by prospective borrowers to improve quality of credit appraisal. It is the external data collected by a bank about a specific market with which it gets exposed. It could relate to macroeconomics, industry information, performance and financials of group of similar companies, government policies, their implications and prospects of future vision. A comparison with peer units, their past credentials and future prospects. When it is seen in the context of risk appetite, exposure and risk adjusted return, banks will be able to take an informed credit decision. Basic purpose of using MI tools is to reinforce industry information with current set of data to better corroborate the credit worthiness and preparedness of the applicant to operate and compete in the markets.
MI CAN BE AN EFFECTIVE TOOL TO CURB THE ESCALATION IN CREDIT RISK AS IT FEEDS ONGOING INFORMING IMPACTING BUSINESS THE TECHNIQUE OF CREDIT APPRAISAL IS BASED ON THE BANKABILITY OF THE UNDERLYING PROJECT
Bank seeks borrower information in fixed template. It is supported by supplementary information drawn from industry and MI sources. But the quality of analysis of integrated data system should be able to improve the appraisal quality. It requires great analytical skills, application of foresight, vision by credit managers to moderate the data impact. Conditioning the MI to improve its utility to mitigate risk is important. Application of suitable data filters is to be institutionalized and frequency of updating of data should be well designed to bring harmony between internal and external data drawn from MI. The end state use of MI is to improve the quality of credit risk management and not to dissuade line managers from taking risks. It is an effort to identify measures to encourage and institutionalize culture of taking informed credit decision and not based on the haze of information provided by prospective borrowers. MI can be an effective tool to curb the escalation in credit risk as it feeds ongoing informing impacting business. Therefore more sophisticated MI is in making to help industry to foresee and act to mitigate credit risk.
(The author is Director, Institute of Banking Studies and Corporate Management – NIBSCOM, Noida, National Capital Region, Delhi,
India. The views are his own)