Survey: how banks are managing credit risk in a volatile and dynamic landscape

In an era of economic uncertainty and rapid technological advancements, staying ahead of credit risk is essential for financial institutions to protect their assets and maintain stability.
12 Sep, 2023

In the fast-paced and ever-evolving financial world of today, banks must master credit risk management to navigate market volatility. Effective credit risk management involves assessing and mitigating this risk through rigorous analysis, diversification of portfolios, and prudent lending practices. In an era of economic uncertainty and rapid technological advancements, staying ahead of credit risk is essential for financial institutions to protect their assets and maintain stability. Proactive risk assessment, real-time monitoring, and adaptive strategies are crucial to thrive in this dynamic landscape, ensuring both profitability and resilience in the face of unpredictable market shifts.

This survey was conducted during a webinar hosted by Quantifi and Asia Risk on ‘Navigating Market Turmoil with Robust Credit Risk Management’.  More than 200 individuals registered for the webinar and were invited to participate in the survey. The guest speakers were Trevor Laight, Chief Risk Officer, CIMB; Michael Monteforte, Partner, Financial Risk Management, KPMG; Thomas Oliver, Head of Model Validation, Quantifi, and Michael Heck Wai Yap, Head of Credit Model Validation, Maybank Malaysia.

When establishing credit risk limits, which factor is given most consideration?

One of the standout findings from the survey is that a large number of banks (41%) prioritise the monitoring and updating of credit risk limits based on market conditions as a central component of their risk management strategy. This involves reviewing and adjusting credit limits for counterparties based on their creditworthiness and market conditions. This highlights the importance of real-time assessment and adaptability in managing credit risk. It also underscores the need for robust data analytics and monitoring tools to track borrowers’ credit profiles continuously.

The survey also revealed that 26% of respondents employ periodic reviews and stress tests to assess PFE. This underscores the importance of scenario analysis in credit risk management. By simulating various adverse scenarios, institutions can develop contingency plans and allocate resources more effectively to mitigate potential losses.

An important element of credit risk management is the establishment of exposure limits on single and groups of connected counterparties. Setting exposure limits is a proactive approach that enables banks to maintain a balanced and diversified credit portfolio. It helps prevent overconcentration of risk and reduces the potential impact of credit defaults. Such limits are frequently based in part on the internal risk rating assigned to the borrower or counterparty, with counterparties assigned better risk ratings having potentially higher exposure limits. Of the respondents, 22% give establishing credit-based exposure limits for counterparties the most consideration.

Effective measures of potential future exposure (PFE) are essential for the establishment of meaningful limits. Credit limits should recognise and reflect the risk associated with near-term liquidation of positions in the event of counterparty default. Where a bank has several transactions with a counterparty, its potential exposure to that counterparty is likely to vary significantly and discontinuously over the maturity over which it is calculated. Of those surveyed, 11% use advanced risk models to calculate PFE. Leveraging advanced risk models, like those provided by Quantifi, allow banks to make more accurate assessments of their exposure, taking into account factors such as market volatility and credit migration, and make informed decisions about capital allocation and risk mitigation strategies.

What is best practice for effective credit risk assessment?

Effective credit risk assessment is a multifaceted process, involving a combination of strategies and practices. The majority (48%) of respondents believe regular portfolio reviews and stress testing are key best practices for effective credit risk assessment.

Whatever the method of stress testing used, the output of the tests should be reviewed periodically, and appropriate action taken in cases where the results exceed agreed tolerances. The output should also be incorporated into the process for assigning and updating policies and limits. The combination of portfolio reviews and stress testing allows financial institutions to adapt swiftly to changing market conditions and minimise their exposure to credit risk.

The results reveal that 19% of respondents prioritise implementing advanced analytics and predictive models as a best practice for effective credit risk assessment. In an era driven by data, leveraging technology and sophisticated algorithms has become a game-changer in credit risk management. Quantifi provides the fastest, most accurate and comprehensive library of pricing and risk models available. By combining advanced analytics with the latest technology, Quantifi is at the forefront of helping banks optimise their risk exposures, improve performance, and accelerate growth.

What are the top two implications of XVA in volatile markets?

XVA is the umbrella term referring to the different “valuation adjustments” banks must make when assessing the value of derivative contracts that they have entered into. Accurate XVA calculations are paramount to ensure that banks can navigate volatile markets while maintaining financial stability.

The majority of responses (59%) emphasised the significance of real-time risk monitoring and analysis as a key implication of XVA in volatile markets. Volatile market conditions can change rapidly, and this dynamic environment necessitates constant vigilance. Banks must employ advanced risk monitoring tools and systems that can provide up-to-the-minute insights into their exposure and potential vulnerabilities. Real-time risk analysis enables timely decision-making and risk mitigation, helping banks navigate volatile markets more effectively.

Nearly half of the responses (44%) highlighted that one of the foremost implications of XVA in volatile markets is the increased complexity in pricing and risk management. This complexity arises from the need to account for various factors such as counterparty credit risk, funding costs, and market volatility when pricing financial transactions. In volatile markets, where uncertainties are heightened, the accurate assessment of these factors becomes even more crucial. Financial institutions must adapt by developing sophisticated pricing models and risk management strategies to address this increased complexity effectively.

Given the strategic importance of XVA, banks require enhanced capabilities and modern infrastructures to calculate the required credit, funding, and capital adjustments. As banks look to reduce, mitigate, and optimise XVA and other capital charges, they are investing in XVA capabilities to solve the computational challenge of simulating a full universe of risk factors. Quantifi addresses this need with an integrated counterparty credit risk and XVA solution. Market leading models provide fast, accurate results for all XVA measures, including CVA, DVA, FVA, KVA, MVA and economic capital.

While the above two implications were identified as the top priorities, it is important to note that other factors also gained significant attention in the survey.

A large number of responses (41%) expressed concerns about the potential impact of XVA on profitability and capital requirements. The impact can vary widely depending on factors such as the size and complexity of a bank’s derivatives portfolio, the quality of its risk management practices, the prevailing market conditions, and regulatory changes. Properly managing XVA is crucial for balancing the trade-off between profitability and risk.

The survey highlighted an increased focus on hedging and counterparty credit risk management (37%) as a significant implication of XVA in volatile markets. In volatile environments, the importance of hedging to mitigate risk and protect against adverse market movements becomes more pronounced. Furthermore, careful management of counterparty credit risk is essential to ensure the stability of financial transactions and minimise potential losses.

Is your company prepared for the SA-CVA implementation?

Although the official deadline of 1st January, 2023 was initially set, it became apparent early on that banks would be unable to meet this deadline. As a result, significant adjustments have been made to implementation schedules in recent years. These divergent timelines have posed notable challenges for the industry. Within the European Union, the United Kingdom, and the Asia-Pacific (APAC) region, individual local jurisdictions have the authority to set their own timelines, leading to a fragmented approach. In APAC, for instance, timelines range from 2024 to 2025. Furthermore, local banks in the United States are becoming increasingly concerned due to the absence of published timelines or interpretations of the rules.

Fragmented timelines have led to a situation where no entity is eager to adopt FRTB ahead of others. Each jurisdiction is aligning its schedule with the actions of other jurisdictions. This approach introduces additional hurdles, as regional participants lack clarity regarding implementation dates. Moreover, this fragmentation is resulting in diverse interpretations of the rules, potentially adding complexity to the overall implementation process.

The majority of banks (39%) reported that their companies are currently in the process of preparing for SA-CVA implementation, while another 23% have made some preparations. This indicates that a significant portion of banks are actively working on readiness measures, recognising the importance of being adequately prepared.

A significant number of banks have yet to start (19%), whilst 15% of banks have only just started preparing. This indicates the need for increased awareness and urgency regarding the impending regulatory changes. It is advisable for companies to assess their readiness and take appropriate measures to ensure compliance with SA-CVA requirements within the specified timelines.

With only 4% of banks thoroughly prepared for the implementation, this highlights the significant challenges that lie ahead. It underscores the urgency for banks to prioritise compliance efforts and accelerate their preparations.

Smaller banks unaccustomed to complex data and modelling requirements are now having to re-examine their underlying system architecture and data model to satisfy the new demands of FRTB. Most banks will need to invest significant time, money, and resource to alter legacy architecture and applications. Banks in this situation may be better off with off-the-shelf solutions and outsourcing of expertise. The more advanced banks should not underestimate the mammoth task ahead.

As banks adopt the SA-CVA method, they will be interested in fast and accurate CVA sensitivity calculations. Sophisticated technology providers like Quantifi, can provide various approaches for increasing efficiency of CVA calculations like streaming, cash-flow optimisation, and analysing dependency graphs.

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