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:

  1. Does the bank take risks associated with financial transfers?
  2. 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.

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