Advanced Credit Risk Analysis and Management

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Credit Risk Diversification

Credit portfolio risks can be mitigated by deploying various tools such as caps, uncorrelated diversification, risk transfer and removal of the credit asset from the portfolio, all aimed at creating a ‘shock-proof’ portfolio.

History is replete with credit institutions – mainly banks – suffering immense losses or collapse due to an unbalanced portfolio structure. The London based early gold (smith) banks of the 1800s failed not because they were actually bankrupt but because they became illiquid due to improper portfolios, resulting in inability to convert assets into gold, consequent upon maturity mismatches. The recurrence of such instances resulted in the Bank of England (Central Bank) taking responsibility as re-discounter and lender of last resort.

As the 19th and 20th centuries wore on, Central Banks began to introduce several tools and measures to ensure stability by controlling credit risks of banks, paramount among which were credit portfolio risk mitigants. The Basel Committee, too, focuses on credit portfolio risk mitigation while prescribing capital adequacy norms. Even now, bank and financial institution crashes and problems created by illiquid or unbalanced portfolios due to inherent portfolio risks are not uncommon. A few such instances are given below:

• Many banking crashes in Japan in the 1990s were traceable to the concentration (or overexposure) of the portfolio in real estate.
• The collapse of Barings Bank was also the result of ...