Measuring and Managing Credit Risk presents modern techniques of credit risk management used within banks. Writing a comprehensive book on credit risk is becoming increasingly difficult every day given the exponential growth in knowledge and in techniques that have been developed by the industry and academia. As a result we have had to make choices. In this book we focus on issues that we consider to be crucial, while skipping other topics. In particular we are more focused on credit risk management rather than on credit pricing, which has already received considerable attention in other books.
The clear objective of this book is to blend three types of experiences in a single text. We always aim to consider the topics from an academic standpoint as well as from a banking angle, and from the specific perspective of a rating agency.
Our review goes beyond a simple list of tools and methods. In particular, we try to provide a robust framework regarding the implementation of a credit risk management system. In order to do so, we analyze the most widely used methodologies in the banking community and point out their relative strengths and weaknesses. We also offer insight from our experience of the implementation of these techniques within financial institutions.
Another feature of this book is that it surveys significant amounts of empirical research. Chapters dealing with loss given default or correlations, for example, are illustrated with recent statistics that allow the reader to have a better grasp of the topic and to understand the practical difficulties of implementing credit risk models empirically.
Although the book deals with techniques, it also aims at bringing a high level of understanding of core issues about the strategic management of banks. This specific contribution is devised to bring a perspective on credit risk to the senior management of banks. Bank managers indeed appear to be divided between those who are reluctant to apply quantitative techniques and those who are very keen. We believe that presenting the merits and the limitations of the various techniques in an objective way will help managers understand how these tools can help their bank to control risks and where the strategic insight of managers is most needed.
This book is divided into 10 chapters. We begin with microeconomics and describe the functions performed by banks as well as the environment in which they operate (Chapter 1). We then focus on ratings developed internally by banks or supplied by rating agencies (Chapter 2). This enables us to describe the value of qualitative assessments for credit purposes. In Chapter 3 we present quantitative techniques to assess the credit quality of firms. We focus in particular on the structural approach to credit risk and on scoring models. We stress some very important elements of default probability models and define robust criteria to evaluate the performance of these models.
In Chapter 4, we consider a rather unexplored territory: recovery rates with a specific empirical and international focus. In Chapter 5, we study default correlation, which has been an active area of empirical and theoretical research. A sound understanding of default dependencies is key to the implementation of modern risk management based on diversification.
Chapter 6 gathers all the building blocks developed in previous chapters to construct portfolio models. Competing approaches (analytical versus simulation-based) are presented and compared. The output of these models is used to compute risk-adjusted performance measures.
In Chapter 7 we consider credit risk management from the point of view of the senior executives of banks. We move away from the bottom-up approach developed in previous chapters and show that this approach has to be complemented by market information and a top-down perspective. In Chapter 8 we introduce the determinants and dynamics of credit spreads, while in Chapter 9 we review credit derivatives and securitization products that are designed to mitigate or isolate credit risk.
Finally, Chapter 10 concludes this book by reviewing credit risk regulation from a practical and a theoretical point of view. Regulatory reform, and in particular the Basel II framework and the new International Accounting Standard rules, have been key drivers in the development of credit risk management tools.
Our hope is that this book will help practitioners and students gain a broad understanding of the key issues and techniques linked to the measurement and management of credit risk.