The Principles of Banking

Chapter 3

Banking and Credit Risk

In Chapter 1 we observed that the essence of bank risk management is effective supervision of liquidity risk and credit risk. Liquidity risk is reviewed in detail in Part III. In this chapter we provide a primer on understanding and managing credit risk. We look first at the elements of credit risk exposure; we then consider credit risk limit setting policy and principles of loan origination standards. We also look at the approach and methodology of applying credit ratings to obligors, both internally within a bank and externally at the credit rating agencies.

Credit Risk Principles

While the concept of “credit risk” is as old as banking itself, it would appear that bank management are less aware of it during periods of economic growth, only to become reacquainted with its principles following an economic downturn, which increases dramatically the level of loan losses.

For example, consider the following developments:

credit spreads tightened during 1992–1999 and again during 2002–2007, to the point where blue-chip companies were being offered syndicated loans for as little as 10–12 bps over Libor. To maintain margin, or the increased return on capital, banks increased lending to lower rated corporates, thereby increasing their credit risk both overall and as a share of overall risk;

investors were finding fewer opportunities in interest rate ...