Credit Risk Management

Assume a major building
company is asking its house bank for a loan in the size of ten billion
Euro. Somewhere in the bank’s credit department a senior analyst has
the difficult job to decide if the loan will be given to the customer or
if the credit request will be rejected. Let us further assume that the
analyst knows that the bank’s chief credit officer has known the chief
executive officer of the building company for many years, and to make
things even worse, the credit analyst knows from recent default studies
that the building industry is under hard pressure and that the bankinternal
rating1 of this particular building company is just on the way
down to a low subinvestment grade.
What should the analyst do? Well, the most natural answer would
be that the analyst should reject the deal based on the information
she or he has about the company and the current market situation. An
alternative would be to grant the loan to the customer but to insure the
loss potentially arising from the engagement by means of some credit
risk management instrument (e.g., a so-called credit derivative).
Admittedly, we intentionally exaggerated in our description, but situations
like the one just constructed happen from time to time and it
is never easy for a credit officer to make a decision under such difficult
circumstances. A brief look at any typical banking portfolio will be sufficient
to convince people that defaulting obligors belong to the daily
business of banking the same way as credit applications or ATM machines.
Banks therefore started to think about ways of loan insurance
many years ago, and the insurance paradigm will now directly lead us
to the first central building block credit risk management.


Situations as the one described in the introduction suggest the need
of a loss protection in terms of an insurance, as one knows it from car or
health insurances. Moreover, history shows that even good customers
have a potential to default on their financial obligations, such that an
insurance for not only the critical but all loans in the bank’s credit
portfolio makes much sense.