The Best Practice Network

Monitoring Credit Risks
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Having systematic data policies for measurement of risk exposure in banking systems and individual banks is an essential best practice. There is a need to ensure compliance with data collection strategies, financial instruments and adapt to their characteristics.

According to IMF data, over the years the figures for outstanding global credit derivatives have increased drastically. Therefore, it has become a challenge for financial institutes like banks to monitor financial stability.

Banks are the forerunners in the market. They transfer substantial credit risk to individual participants in the market. The instruments they implement in order to achieve credit transfer are complex. Sometimes, understanding risk-returns becomes impossible without restructuring the system. A reference portfolio is also required in most cases.

To achieve compliance with requirements for monitoring credit risks, three best practices are recommended. These are:

Individual Transaction Risk

A systematic financial approach ensures security and a better financial-return. You have to think about what kinds of risks are associated with any individual transaction. You also have to evaluate who will face the consequences of the associated risk. The data required for this practice is very demanding and challenging. For best practices and proper data assessment, the following information about individual security is required:

Type of Asset
Worth of Each Asset
The Credit Associated with Individual Assets
Expected Rate of Financial Recovery

If these requirements are not fulfilled, managers can use a reference portfolio for reference. This is an effective best practice that helps issue timely financial reports. Besides this, one can also include compliance with new security protocols. This will help establish a reliable portfolio and standards that investors can follow. Moreover, this will guarantee quality, rating coverage, diversity, obligator concentration, standard security rate and standard recovery rate.

Individual Bank Risk

After individual transaction risks are identified with best practices, it is important to monitor the impact of certain transactions on the risk position. This has a direct impact on financial institutions like banks.

There are two effects of individual transactions on individual banks that must be considered:

Does the bank take risks associated with financial transfers?
Does a transaction alter the bank’s leverage on default probability?

Note: The second scenario may occur if securitization proceeds are utilized for debt holders or to pay equity. It is also likely to occur when payments are in portions other than what was previously agreed.

Systemic risk

After risk assessment is successfully completed through compliance, systemic risk evaluation follows. There are mutual interactions between investors and financial institutions that must be observed. It is important to determine who takes the systemic risk. Besides, you have to assess whether the risk is transferred outside to other financial sectors.

These best practices involved in monitoring credit risk provide a clear understanding about credit risk transfer and financial stability.

Scrutinizing Country Credit Risk
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Industries that get engaged in international lending or that acquire cross-border exposure, undertake country risk. That’s because the transaction involves two countries taking a risk. Therefore, there is greater need for skilled risk management strategies in international companies.

The country of the industry involved is the key factor that differentiates the concept of domestic and international lending. Country risk encompasses every form of risk and uncertainty arising from political, economic and social conditions of the country. These factors can lead to constraints for the industry, preventing it from fulfilling its obligations to international clients. As a result, the pressure on people implementing best practices increases.

In addition to the above risks, it is also likely that country risk may result due to expropriation or nationalization. Moreover, exchange control, devaluation of currency and government repudiation also contribute to country credit risk. As a result, constraints on decision-makers of the company increase. To ensure best practices for risk management, they are forced to refrain from delivering the goods across border. Instead, they resolve to trade within the country to mitigate losses.

However, the plus point here is that country risk is one that industries can influence directly. International companies, therefore, must ensure that they utilize adequate technology and systems to manage cross-border exposure. In order to ensure risk management, CEO’s should concentrate on best practices to avoiding risk in the first place.

The success and sophistication of risk management systems implemented depend on the complexity of cross-border exposure.

Forms of Country Risks

International companies are liable to exposure to six main forms of country risks. These include:

Sovereign risk: This denotes the willingness and capacity of foreign governments to repay direct or indirect financial obligations. These are usually in foreign currency.

Transfer risk: This form of risk denotes the inability of a borrower to obtain foreign exchange to be able to fulfill external obligations. This often happens because of social, economic and political problems. The consequence of which is drained foreign currency reserves of the country. As a result, borrowers cannot convert local currency funds to foreign currency.

Contagion risk: This risk results when adverse conditions of one country cause negative impact on the credit of other countries in its region. This can happen regardless of whether neighboring countries are credit worthy or not.

Currency Risk: This is a risk associated with the probability of cash flow and domestic currency reserves becoming inadequate, due to devaluation.

Indirect Risk: This is when the ability to pay cross-border is endangered due to economic, social and political reasons.

Macroeconomic Risk: When interests go high due to failing economy, the borrower’s risk increases. This leads to constraints in best practices for international businesses that cause increase in country risk.

Therefore, it is country risk management that is important, as far as country credit risk is concerned. Banks plan an important part in this and must implement the best risk management strategies.

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