In this chapter we introduce the credit risk measurement framework in a banking operation. Credit‐risky lending is the core business of a bank and its key to profitability. It is also the biggest driver of a bank's regulatory capital requirement. As credit risk exposure is what banks do, it cannot be avoided, so it must be well managed. Strategy, decision‐making, risk–reward optimisation, diversification, and minimisation of loss are not possible without extensive and thorough credit risk management. The bank must use all of its qualitative and quantitative judgement capabilities to best assess credit risk.

This chapter is a long one and focuses on the risk management process and its principles. Regulatory capital requirements, which are driven primarily by credit risk exposure, are considered in Chapter 15.

The business of banking – lending money to and transacting with counterparties who carry default risk – creates credit risk exposure on the bank's balance sheet. This must be managed actively. In many cases, once a loan is originated, it cannot be removed from the balance sheet, so the discipline of credit risk management is essentially one of trying one's hardest to get the loan origination decision right, and avoiding concentration.

The other side of the approach to credit risk management is to sell loans where possible, to remove them from the balance sheet via securitisation, or to use credit derivatives. This ...

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