Credit risk management is essential to protect capital, sustain earnings, and enable prudent growth across credit cycles, making it a foundational pillar of safe and sound banking practice.
Need for a framework
A formal credit risk management framework ensures risks are consistently identified, measured, monitored, controlled, and reported across the credit lifecycle, aligning day-to-day lending with board-approved risk appetite and regulatory expectations. A structured framework reduces unexpected losses by embedding sound credit-granting standards, continuous monitoring, and independent control functions that are tested through internal review and supervisory assessments. Modern frameworks emphasize forward-looking analytics PD (Probability of Default), LGD (Loss Given Default), and EAD (Exposure at Default) are key parameters in credit risk management used to quantify the potential loss on a loan or credit facility. PD measures the likelihood of a borrower defaulting, EAD estimates the total amount a bank is exposed to when a default occurs, and LGD represents the percentage of that exposure the bank expects to lose if a default happens. These metrics are crucial inputs for calculating expected losses and determining capital requirements, particularly under Basel Accords. PD/LGD/EAD, stress scenarios, Expected Credit Loss (ECL) and concentration controls, enabling resilience to macro shocks and correlated defaults.
Credit risk culture
Credit risk culture refers to the shared values, norms, attitudes, competencies, and behaviors that shape how institutions perceive, discuss, take, and manage credit risk, ultimately determining consistency of decisions under pressure. Strong cultures are led from the top and reinforced by governance, clear accountability, and incentives, combining leadership, organizational structure, policies/processes, and people capabilities to sustain prudent risk-taking. When culture is effective, policies are applied as intended, early warnings are escalated, and underwriting quality and recoveries improve through cycle discipline.
Building blocks of credit risk
Core building blocks span the entire lifecycle and should be explicitly embedded in policies, processes, data, and technology to ensure coherence and auditability.
- Risk identification: Systematically surface borrower, product, sectoral, geographic, counterparty, and concentration risks using qualitative and quantitative inputs, early-warning indicators, and cross-functional information flows. Broader techniques—surveys, interviews, historical analysis, and benchmarking—help reveal latent and emerging risks beyond the credit function’s line of sight.
- Risk assessment and credit granting: Apply disciplined appraisal and approval standards that evaluate capacity, collateral, conditions, and governance, anchored in documented criteria within loan policies and committee charters. Consistency with a clearly articulated risk appetite and limits ensures origination quality and portfolio shape remain aligned to strategy.
- Risk measurement: Quantify exposures with PD, LGD, and EAD to compute expected loss and inform pricing, provisions, and capital allocation, supported by robust data and model governance. Portfolio metrics should capture concentration and correlation, with scenarios and stress tests linking macro drivers to credit outcomes.
- Monitoring and administration: Conduct ongoing reviews of ratings, covenants, collateral, and behavioral signals, with early-warning triggers and timely remediation paths for watchlist and problem assets. Credit administration must maintain accurate documentation, perfected security, and lifecycle controls to avoid slippage in enforceability.
- Risk mitigation and control: Use collateral, guarantees, covenants, limits, hedging, and diversification to reduce loss volatility while maintaining independent oversight, segregation of duties, and periodic validation. Counterparty and concentration risk policies should set pre-settlement and settlement exposures, connected counterparty treatment, and large exposure limits.
- Reporting and MIS: Provide timely, accurate, and aggregated management information that supports decision-making, limit stewardship, and board oversight, aligned with principles for risk data governance. Forward-looking dashboards should integrate stress results, staging movements, and vintage trends to anticipate deterioration.
- Governance and independent review: Define roles of the board, risk committees, first/second/third lines, and model risk functions, with ongoing independent assessment of credit processes and controls. Regular internal audits and supervisory evaluations reinforce adherence to principles and continuous improvement.
- Aligning with global principles
Supervisory principles emphasize four pillars: establishing a suitable risk environment, sound credit-granting processes, robust administration/measurement/monitoring, and adequate controls, which remain the global baseline with updated terminology and expectations. Recent updates elevate forward-looking data, counterparty and concentration risk treatment, and consistency with the consolidated Basel framework and risk data aggregation guidance.
Risk Management Articles related to Model ‘B’ of CAIIB –Elective paper:
