Part - I

1.1      Risk is inherent in all aspects of a commercial operation and covers areas such as customer services, reputation, technology, security, human resources, market price, funding, legal, regulatory, fraud and strategy. However, for banks and financial institutions, credit risk is the most important factor to be managed. Credit risk is defined as the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk, therefore, arises from the banks' dealings with or lending to a corporate, individual, another bank, financial institution or a country. Credit risk may take various forms, such as:

• in the case of direct lending, that funds will not be repaid;

• in the case of guarantees or letters of credit, that funds will not be forthcoming from the customer upon crystallization of the liability under the contract;

• in the case of treasury products, that the payment or series of payments due from the counterparty under the respective contracts is not forthcoming or ceases;

• in the case of securities trading businesses, that settlement will not be effected;

• in the case of cross-border exposure, that the availability and free transfer of currency is restricted or ceases.

1.1.2      The more diversified a banking group is, the more intricate systems it would need, to protect itself from a wide variety of risks. These include the routine operational risks applicable to any commercial concern, the business risks to its commercial borrowers, the economic and political risks associated with the countries in which it operates, and the commercial and the reputational risks concomitant with a failure to comply with the increasingly stringent legislation and regulations surrounding financial services business in many territories. Comprehensive risk identification and assessment are therefore very essential to establishing the health of any counterparty.

1.1.3      Credit risk management enables banks to identify, assess, manage proactively, and optimise their credit risk at an individual level or at an entity level or at the level of a country. Given the fast changing, dynamic world scenario experiencing the pressures of globalisation, liberalization, consolidation and disintermediation, it is important that banks have a robust credit risk management policies and procedures which is sensitive and responsive to these changes.

1.1.4      The quality of the credit risk management function will be the key driver of the changes to the level of shareholder return. Industry analysts have demonstrated that the average shareholder return of the best credit performance US banks during 1989 - 1997 was 56% higher than their peers. Low loan loss banks stage a quicker share price recovery than their peers, and in a credit downturn, the market rewards the banks with the best credit performance with a moderate price decline relative to their peers.

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Compiled by CoolAvenues Knowledge Management Team