Risk-
Risk is the exposure to uncertainty. There are different kinds of
risks which are faced by various organizations or individuals. These
include-
Market Risk- This risk arises when
stock or bond prices drop and investors appear to lose money on
their investment.
Inflation Risk- This risk arises
when the rising cost of inflation outpaces the growth of your investment
over a period of time.
Company Risk- This is the risk that
is incurred when the company that one has invested in fails to perform
as expected.
Maturity Risk- This is specific to bonds, where the value
of a bond may change from the time it is issued to when it matures.
Legislative Risk- Because the laws
of the land can be changed at any time, there is always a risk that
the laws that favors one today may no exist tomorrow. Such risk
is known as legislative risk.
Global Risk- Because there is a
greater risk involved in investing abroad rather than at home, investors
are often advised about Global risks.
Credit Risk- Credit risk is the
risk that can be incurred if the counterparty isn't able to fulfill
its financial obligations in a timely manner. Among the risks that
face financial institutions, credit risk is the one with which we
are most familiar.
For banks & other lending institution, loans are the largest
source of credit risk. However increasingly these lending institutions
face credit risks (or counterparty risk) in various financial instruments
other than loans, including acceptances, interbank transactions,
trade financing, foreign exchange transactions, financial futures,
swaps, bonds, equities, options, and in the extension of commitments
and guarantees, and the settlement of transactions.
Management of risk is fundamental to the banking business and is
an essential element of the group's operations.
The group structures the levels of credit risk it undertakes by
placing limits on the amount of risk accepted in relation to one
borrower, or groups of borrowers, and to industry (and geographical)segments.
Limits on the level of credit risk by borrower and product (or by
industry sector or by region) are approved by the Credit Committee.
The exposure to any one borrower including banks and brokers is
further restricted by sub-limits covering on and off-balance sheet
exposures which are set by the Credit Committee.
The term credit analysis is used to describe any process for assessing
the credit quality of counterparty.
Economic Capital Framework for Credit Risk
Quantification- There are two metrics required to quantify
Credit Risk. The first metric is called expected loss (EL). EL in
statistical terms is the average amount of credit losses per period
that a credit manager should expect to lose. Since this is an expectation
it is not risk and should be built into the cost of a transaction.
The second metric gets to the heart of credit risk and is referred
to as economic capital (EC). Where EL measures the anticipated average
loss from a portfolio over the relevant time horizon, EC captures
the variance or the uncertainty of the losses around the average.
With its focus on uncertainty, EC quantifies the portfolio credit
risk. |
