If these banks are to continue, surely they require more robust credit risk analysis, rather than a set of complicated rules which may not be enough to ensure that these collapses are never seen again? Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.
In the banking system, many entities run a credit risk department where the financial well-being of their customers is assessed. They may use in house programs to advise on avoiding, reducing and transferring risk. Most lenders employ their own models by means of credit scoring to rank potential and existing customers according to risk, and then apply appropriate strategies. However, are these methods of assessment appropriate, considering the demise of our great institutions? What should the credit risk department really measure? Should it measure the worthiness of its customer based on previous experience of that customer or the risk of default of a certain product the customer wishes to purchase?
To gain a more valuable insight of a particular product, banks need to use more sophisticated methodologies in their assessments. With so much data currently available in real time, credit risk analysis requires the extraction of many model specific variables not yet accounted for. Credit risk needs to be modelled using the macroeconomic environment measured as a financial accounting system, taking into account all debtors, creditors and other balance sheet items which can be accounts can be presented in nominal or real amounts, with real amounts adjusted to remove the effects of price changes over time. The accounts are derived from a wide variety of statistical source data including surveys, administrative and census data, regulatory data which are integrated and harmonised in a conceptual framework. Credit risk is positively correlated with to bank asset quality and considered responsible for bank failures and credit worthiness needs to allow for the accounting in the macroeconomic world as these factors exert a significant influence on the credit risk of any banking system.
Together with the updated regulatory rules in assessing credit risk, the inclusion of major economic cash flows is a new and positive dawn to gain a more robust result in risk analysis. If companies and banks accept that macroeconomics using cash flows plays an important role in the conceptual framework, we may reduce the systemic risk seen in previous years.
Dr. Victor Chukwuemeka
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