Risk Management in the Lending Environment

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Risk Management in the Lending Environment

Risk refers to uncertainty about future outcomes . Traditional market risk management deals almost exclusively with portfolio value changes driven by trading returns . Trading returns are calculated from mid-price , and hence the assessed market risk corresponds to an idealized market with no friction in obtaining the fair price . However risk in many markets possesses an additional liquidity component traders do not realize the mid price when liquidating a position quickly or when the

market is moving against them . Instead they realize the mid price less the bid-ask spread (Michel Crouhy ,57

Credit risk is the oldest form of risk in the financial markets . Credit risk is as old as lending itself , which means that it dates back at least as far as 1800 B .C , it is essentially unchanged from ancient Egyptian times now as then , there is always an element of uncertainty as to whether a given borrower will repay a particular loan . This report is about how financial institutions are using new tools and techniques to reshape , price and distribute this ancient form of financial risk (Sergio M . Focardi , 17-19

Ever since banks as we know them were organized in Florence seven hundred years ago , they have been society 's primary lending institutions . Managing credit risk has formed the core of their expertise . Traditionally bankers and other lenders have handled credit evaluation in must the same way that tailors approach the creation of a custom made suite by carefully measuring the customer 's need and capacities to make sure that the financing is a good fit . Today 's approach does not differ fundamentally from the one used by the earliest banks

It is easier to design a suit for a customer you already know . Because of the very nature of this approach , banks have been drawn to relationship banking . Typically they are more concerned about their relationship with a customer than they are about the profitability of a specific loan or about the effect this transaction may have on their overall loan portfolio . In recent decades this traditional approach has led to unacceptable results , banks have done a rather poor job of pricing and managing credit risk

The counterpart to credit risk is market risk - the change that an investment 's value will change in price as a result of marketplace forces . Market risk has affected financial institutions ever since markets were created . In contrast to credit risk , however techniques for managing market risk have undergone a radical change (John B . Caouette 165 ) Anyone who tours a large trading floor at a bank or an investment bank can see that the management of market risk has been in focus of tremendous technological development . Major break though have turned this aspect of risk management into something of a science - one that is applied to both entities and debt instruments

This is not to suggest that market risk has been eliminated . In the case of...