(a) What are the key factors used to assess credit risk using the traditional qu
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Question
(a) What are the key factors used to assess credit risk using the traditional qualitative approach to credit risk assessment? (b) Describe how credit spreads may be used to estimate the probability of default for an obligor. How effective do you consider this method to be to arrive at an estimate of the probability of default? Give reasons. (c) What other alternative approaches could be used to estimate the level of credit risk that a bank is exposed to? Compare and contrast the usefulness of these with the approaches in (a) and (b) above
Explanation / Answer
Credit risk is a type of risk when a borrower is unable to repay its loan or debt amount. It is basically a risk of loss which can occur when borrower is unable to meet its contractual obligations.
A. In traditional qualitative approach to credit risk assessment, it is to determine the risk and earning on each credit exposure. The qualititative risk assesment involves the collection and updating the data relating to the financial responsibility of debtor, which determines the real purpose of loan and identify what risks the borrower may face. The key factors used to asses credit risk are
1. Strong credit worthiness
2. Sustainability of business model.
3. Early detection of distressed loans.
4. Data, reporting and audit.
5. Process efficiency.
6. Market environment
7. Infrastructure
8. Linking the financial accounting software of borrower directly with the bank records.
9. Prediction of cash flows.
10. Models
11. Credit quality
Some external factors that can be used to assess credit risk are technological factors, economic factors, legal factors, legislative and regulatory factors, and competition and market trends.
B. Credit spreads may be used to estimate the probability of default for an obligor as it reduces the risk and also able to make the risk quantified and versatile. It allows to limit the risk and determine profit potential.
Effectiveness-Credit spreads tells the risk rating of the company. It tells whether a loan os secured by the assets of the company or is unsecured. It may get widen or tighten following the ability of borrower to pay its scheduled intrests and principal payments on time.
C. The main problem in banks is the exposure to credit risk. There is a need to identify, measure, monitor and control credit risk. It can be done through adopting the following-
1. Reviewing the credit risk strategies and policies.
2. Implementing the approved credit risk strategy.
3. Adequate risk management procedures
4. Proper understanding of target market, borrower, purpose and source of credit and its source of payment.
5. Establishment of credit limits.
6. Renewals and refinancing of existing credits.
7. Credit monitoring.
8. Managing credit risk through internal risk rating system.
9. Credit risk controls
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