Credit Risk Management: A Prudent Approach
In an effort to ensure the stability and soundness of the financial system, credit institutions must adhere to stringent regulations regarding credit extensions. This policy paper outlines key guidelines for establishing overall credit limits, exposure limits, and adequate documentation.
Establishment of Credit Limits
Credit institutions must establish overall credit limits at the individual borrower level, as well as for groups of connected counterparties and related companies and individuals. These limits must comply with supervisory directives on:
- “Large Exposures to a Group of Connected Counterparties”
- “Exposure Limits”
Exposure Limits
In addition to overall credit limits, institutions must establish exposure limits for specific industries or economic sectors. Concentrations of risk are present when a portfolio contains a high level of direct or indirect credits to:
- A single counterparty
- Group of connected counterparties
- Industry
- Sector
- Country
- Maturity
Adequate Documentation
Credit institutions must maintain accurate and complete records of all credit extensions, including documentation on the specific nature of the credit, such as:
- Contractual and financial conditions
- Exposure profile until maturity
- Collateral or guarantees
- Potential for default
- Monitoring of actual exposures against established limits
Management Information Systems (MIS)
Institutions must establish MIS that enable management to measure credit risk inherent in all on- and off-balance sheet activities. These systems should:
- Identify concentrations of risk
- Monitor actual exposures against established limits
- Perform stress testing and scenario analyses to identify potential areas of credit risk exposure
Assessment and Monitoring of Credit Portfolio
Credit institutions must develop a system for assessing the overall composition and quality of their credit portfolio, including the identification of any concentrations of risk. This system should also identify measures to reduce or mitigate concentrations, such as:
- Pricing for additional risk
- Increased holdings of capital
- Loan participations
- Loan sales
- Credit derivatives
Stress Testing and Scenario Analysis
Institutions must perform stress testing and scenario analyses to assess the impact of potential future changes in economic conditions on their credit portfolio. These analyses should consider situations such as:
- Economic downturns
- Higher than expected levels of delinquencies and defaults
- Combinations of credit and market events that could produce substantial losses or liquidity problems
Independent Credit Reviews
Credit institutions must establish a system of independent, ongoing review of their credit risk management processes and results. These reviews should:
- Evaluate the overall credit administration process
- Assess the quality of the credit portfolio
- Determine the accuracy of internal risk ratings
- Assess the adequacy of monitoring individual credits by account officers
Early Remedial Action
Institutions must have a system in place for early remedial action on deteriorating credits and managing problem credits. This includes:
- Establishing a specialized workout section responsible for developing effective strategies to rehabilitate troubled credits or increase the amount of repayment ultimately collected.
By following these guidelines, credit institutions can ensure prudent management of credit risk, maintain stability and soundness, and contribute to the overall health of the financial system.