Introduction

Financial institutions are associated with different risks, mainly, interest rate risk, market risk, foreign exchange risk and credit risk. All these risks have a significant impact on financial organizations business performance. This paper mainly discusses the exposure of credit risk to financial institutions. It defines the need for credit risk and the current strategies that are used by financial institutions for measuring and managing credit risk. Additionally, it also discusses the value of credit derivatives for financial institutions with the consideration of the impacts of interest rates on derivative products. In last, it defines the positives and negatives of credit risk and the way credit can be applied to attain benefits.

Evaluation of Need for Credit Risk

Mainly, credit risk arises in the situation, when a borrower fails to repay his/her loan or fails’ to meet a contractual obligation (Sounders & Cornett, 2008). Thus, it is the loss of principal or a financial reward due to the failure of borrowers to pay their loans. Further, it can adversely impact on financial performance of financial institutions due to loss of principal amount. Therefore, it indicates that there is need for these institutions to manage and measure credit risk, so that they can minimize the adverse impact of these risks on business. There are several approaches and strategies, which are used by financial institutions for measuring and managing the credit risk.

Financial organizations develops an effective credit risk environment, in which board of directors and senior management is responsible for implementing the credit risk strategies in terms of developing appropriate policies and processes for identifying, measuring and controlling credit risks (Douglas, 2010).  In addition to this, financial institutions establish a sound credit/loan granting process in order to manage the credit risk. They also maintain a suitable credit administration, assessment and control over the credit risk. Currently, a minimal risk approach is used by financial institutions for the purpose of measuring and managing credit risk.

In this approach, for managing the risk, different loans, securities and other assets are divided into two groups. In the first group, those assets and loans are included that have not associated with any defalut risk, while in the other groups, those assets are included, which presents a risk that a credit might not be redeemed or an investment will not provide a good return on investment (Fight, 2004). Additionally, in order to meausre the credit risk, this approach also relies on three Cs of credit; character, capacity and capital. First of all, financial instituations measures borrowers’ character, in which they examine the record of person or organiztaion that they has regularly paid their obligations without any difficulty. These instituations also analyze financial performance of the borrower and the purpose of loan before allowing for any loan. All these help banks in identifying the borrowers, which can cause to credit risk. Thus, by following this approach managers can avoid such kind of risk.

Another approach for managing credit risk is risk pricing approach. Under this approach, in order to manage the credit risk, financial institutions include the cost of risk in the cost of a loan (Gestel & Baesens, 2008). For example, these institutions charge more interest on loan with greater risk in comparison of the loan with lower risk.  Along with this, there are also some common credit risk management techniques including diversification of risk, limits on loan size, over collateralization, analysis of savings or profits before allowing for credit and credit insurance that are used by financial institutions for measuring and managing credit risk (Wenner, Navajas, Trivelli & Tarazona, 2007).

Value of Credit Derivatives for Financial Institutions

Credit derviaties provides a new mechanism to financial institutions for managing the credit risk. Use of such derivatives enables participants to offset different credit risks. With the consideration of importance of credit risk, credit derivatives create the value for financial organizations. Credit derivatives such as SWAPs and options are contractual agreements, which are based on credit performance in terms of non-payment of loan obligations, default, insolvency or bankruptcy (Horcher, 2011). Credit derivatives provide several benefits to financial institutions and thus, have a significant contribution to create value for such organizations. Main benefit of using credit derivatives is that they allow financial institutions to transfer credit risk to other parties. Further, this transfer of credit risk helps these institutions to free up their capital from risky assets and allows them to use this capital in other productive processes (Bellalah, 2010).

For instance, a financial institution, which perceives its credit protfolio too risky can enter into credit derivative contracts for transferring some part of credit risk to another organiztaion and can refine the underlying portfolio (Horcher, 2011). In addition to this benefit, credit derivatives also support financial institutions in separating the credit risk from the market risk. In regard to this, credit derivatives support financial organiztaions in the situation, where credit risk needs to be mitigated without altering the transactions that created the risk at the initial level (Bellalah, 2010). In contrary to this, such derivatives also provide some additional price transaparency to the business of credit. Therefore, it creates value for participants in the fianncial market to make a better understanding to the business of credit

Generally, credit derivatives includes three classes of instruments inclduing total return swaps, credit-default instruments and credit-spread instruments. Companies can use total return swaps for transferring the credit risk to the counterparty. On the other hand, upon the occurance of a default risk, credit-default instruments give a ceratin payoff to financial instituations (Schlösser, 2011). Beside these, credit-spreads instruments are often in the form of contracts either forward or options on credit sensitive assets. All these credit derivatives permits financial instituations and investors to access new markets by providing them restructuring of the risk and return profile.

For maximizing the value of credit derivatives, it is necessary for financial instituations to analyze the impact of interest rates on derivative products. Interest rates have a significant impact on derivative products and it is the reason that pricing and risk management of derivatives depend on interest rates (Eisenlohr, 2010). There are two types of derivative products; first class of products include those derivatives, which depend on interest rates and the second class include products those derivatives on the other assets such as equity and commodities. The main impact of interest rates can be seen on prices of derivative products, as interest rate component is considered, while determining the prices of derivative products. In order to avoid adverse impact of interest rate on these derivative products, many participants use stochastic model for interest rates for proper pricing and risk management (Ekstrand, 2011). In this way, by considering the impact of interest rate on derivative products, financial institutions can effectively use cash derivatives for managing the credit risk.

Positives and Negatives of Credit Risk

It is analyzed that source of risks are common to all assets that can capture the associated risk premiums. For example, investment in UST-bond exposes participants towards interest rate risk and investement in bond is associated with both interest rate risk and credit risk (Lhabitant, 2011). Besides this, investement in distressed securities hedge funds cause to only credit risk and slightly interest rate risk. In this way, overall credit risk depends on the firm’s assest portfolio. Credit risk has a both positive and negative impacts on financial instituations. If participants are negative on credit risk, then they should reduce their overall credit risk allocation, while if they are positive, they can increase it.By using appropriate risk management techniques, companies can reduce the adverse impact of negative of credit risk. In financial risk management, risk transfer is a logical element, which provides several benefits to the company (Joseph, 2006). Risk transfer helps companies in reducing the financial organiztaion’s capital cost that is associated with the full risk-exposure loan assets. Another benefit of the risk transfer is the diversification of risk.

Businesses can apply credit for their benefits. In this concern, it is analyzed that business needed credit for different purposes such as for meeting day-to-day activities, finance long-term projects such as expansion, new product development, etc. In order to apply credit for benefits, it is necessary that companies provide true financial information about their profitability and future earning capabilities to the financial organizations (Bucci, 2011). Additionally, to maximize benefits, firms can also implement effective strategies such as ensure adequate payments to the investor and use of credit in productive processes.

Conclusion

From the above discussion, it can be discussed that by following effective business strategies such as risk pricing startegies, minimal risk approach, etc. financial organizations can effectively measure and manage the credit risks. One of the effective techniques for credit risk management is the use of credit derivatives, which allow financial instituations to transfer the credit risk to other parties. Credit risk is associated with both positive and negative aspects, for maximizing business profits it is necessary to put necessary controls, if firm’s has negative on credit risk.

References

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