Banks and financial institutions are in the business of underwriting risks. In order to survive as a viable enterprise, it is not only essential to have appropriate risk identification and mitigation strategies, but an adequate risk pricing mechanism is also vital. A financial institution engaged in multiple lines of risk underwriting must ensure that every risk is priced adequately, based on the type of risks underwritten. Appropriate risk pricing is key to the success of all risk underwriting business irrespective of whether it is credit risk, derivative risk, insurance risk or equity risk.
Credit risk pricing can often be challenging. Modern day credit products are becoming complex, hence the pricing of various types of structured products such as CDO, credit derivatives and credit risk insurance products requires in-depth understanding and analysis. For example, AIG, the largest US insurance company earned just 15% of total revenue from its Financial Products Division during 2008. This division primarily offered CDS, i.e. credit insurance and collected premiums. CDS is a complex product where both credit and insurance risks are involved and, if not priced properly, could have disastrous consequences. AIG had inappropriately priced in the credit risk element in CDS, which ultimately led AIG to the brink of bankruptcy during 2008.
As we have seen in Chapter 1, a bank/FI enjoying an interest margin (net spread) of 2%, if it suffers a credit loss of $1m, will ...