On The Practical Application Of Quantitative And Rating Of Credit Risk In The Modern Commercial Banks

The development of credit risk management is now facing the challenges from both the upheavals of financial market competition and the strict constraints of financial regulations. Such trend and interactive effect seems to be more obvious for those commercial banks which have been experiencing the stormy market turmoil during recent years. The concept of credit risk, i.e., the probability of not able to receive the fund which is on due, may not be unfamiliar for all of us. Meanwhile, people have realized that almost every business unit in the financial sector shall proactively take necessary measures and procedures to prevent the credit risk to happen. No matter whether it is the result, or the derivatives, of credit risk management, the tools and technologies for credit risk management evolves to be more and more complicated today.As early as in the second half of the 20th century, the credit risk quantification and credit risk rating has been adopted by those largest banks in western developed countries, and was gradually developed to be the main tools for credit risk monitoring, and the best practice for Enterprise Risk Management ("ERM"). Initially, the bankers were heavily reliant on the results of external credit rating by the independent credit rating institutions (such as the Moody's, the Standard & Poor's, and the Fitch) for their evaluation on relevant credit risks. And it was due to the various constraints during that period, the banks are not capable of measuring the credit risk basing on their own internal rating systems, not to mention the real application for those internal rating results.Nevertheless, ever since the burst-out of the sub-prime crisis in 2007, which was finally evolved to be the world-wide financial crunch, the used-to-be reliable external credit ratings became to be under the limelight for various blames. Therefore, people have urged the banking industry to accelerate the progress for developing its own internal rating systems. This phenomenon has provided a good opportunity for those local banks in China, which have been reforming its internal risk control mechanism, to take advantage of the valuable achievements from the world leading banks, in an effort to strengthen its capacity in weathering the market turmoil.The Basel II (the "New Capital Accord") sets standards and guidelines which reflect an increasingly sophisticated banking practice by emphasizing the sensitivity on credit risk evaluation to a large extent. It is deemed to be integrated into the regular day-to-day business operation and risk monitoring of banks. The challenges this process poses, including its opportunities and problems, are the issues this thesis mainly addresses. One of the challenges, perhaps the most important, is the attention to be paid by senior management, loans officers, traders and investment experts to newly established credit rating systems based on Basel II. This has been a deliberate choice, rather than focusing on the fine print of Basel II, which is anyway published by the Basel Committee on Banking Supervision.Based on an extensive research, the thesis is written for discussing on how the optimization of credit rating infrastructure, contributes to the enhancement of the internal risk control and management efficiency within the banking industry.The thesis consists of 7 chapters which are divided among five parts.Part 1 (chapter 1), gives an overview of credit risk management (including defaults and their management) under the twenty-first banking industry background, discusses the critical role which credit rating now plays in the definition of regulatory requirement on risk management and measurement, including the well-known parameters such as Probability of Default (PD), Loss Given Default (LGD), and Expected Loss (EL) etc., outlines the benefits to be derived from consistent risk measurement methodology and standards across industry and countries, which in turn ensures timely and effective internal control, risk monitoring, warning and reporting within the bank.The theme of Part 2 (Chapter 2 to Chapter 4), is a detailed illustration of the newly proposed Credit Rating infrastructure - whether done by independent rating agencies, under the standard method of Basel II, or by the bank itself under the Foundation internal ratings-based (IRB) approach and the Advanced IRB approach. Various parameters, e.g., Probability of Default (PD), Loss Given Default (LGD), and Expected Loss (EL), associated to Basel II rating requirement and the need for interactive rating and risk measurement analysis, add to the sophistication of required solutions.Part 3 (Chapter 5) addresses the roles played and methods used in connection to credit risk mitigation (CRM) tools, expounding the need for a modern technological infrastructure of CRM measurement, which must be steadily reviewed and updated.Part 4 (Chapter 6) interrelated the Measurement of Risk Weighted Assets and allocation of Risk Capital in line with the credit rating results. To help the reader get ahead of the curve in technology, the thesis is striving to cover the issue of most up-to-date methodologies among the banking industry, particularly solutions which can assist both in IRB implementation and in risk measurement through practical examples to master IRB, and treating Equities & Account Receivables, supervisory weights and the handling of Securitized Assets as special themes covered by stand-alone topics.Part 5 (Chapter 7) treats regulatory and application issues which, for any practical purpose, are indivisible. It outlines the role played by the growing number of transnational banks and supervisory authorities in the extensive application of credit rating results and its associated parameters and variables that have integrated into the global landscape of banking industry and financial markets. Part 5 also brings to the reader's attention the difficulties and complicity in credit rating applications, especially for those native banks in China whose internal control system is yet not sufficiently established to sustain too sophisticated internal rating approaches. These are deemed to be very timely issues as it concludes with the challenge of reforming the risk governance among those native banks.