Credit risk is undoubtedly the new frontier in finance, just as interest rate risk and asset and liability management were 15 years ago.
Providing a comprehensive treatment of credit risk is proving increasingly difficult every day, given the volume of ongoing research being carried out globally on this topic. In addition, not all the techniques currently being developed will result in significant breakthroughs. For instance, extreme value theory was very fashionable a few years ago, but its contribution to credit risk management is proving much more limited than initially expected.
In this book we therefore have had to make some hypotheses about what is likely to become central to credit risk management, and we have minimized the focus on what we think may not be as important. Thus there is some subjectivity in our presentation, just as in all other surveys. Overall, however, we have tried to provide a clear idea of the state of the art and to report major developments.
Credit risk is not a discipline arising from a void. It draws from microeconomics, banking theory, and finance theory. Progress is this field is, however, hampered by the lack of data, and many recent credit risk models would have been impossible to test until recently.
The increased level of transparency brought by the collection of data by banks in recent years has boosted the development of a wide range of risk management products such as credit derivatives and CDOs, as banks become better able to measure their impact as well as their interest.
The development of this new set of skills does not mean that bank risk management is now fully mastered. Available tools indeed tend to display robust results under normal macroeconomic conditions. Their performance under stressed environments can prove more critical, in particular when the benefit of portfolio diversification vanishes when it matters most. In this respect the volatility of the credit risk (and of the related performance) of a business over time and through crises remains difficult to assess. There is therefore still a need for more work in this respect, and the recent focus on risk attached to procyclicality has provided strong incentive for banks and academics alike to embark on research in that direction.
The speed at which regulatory requirements have been developed is also remarkable. Although there is room for criticism about what is currently being promoted, the reactivity of regulators is quite impressive. The progress toward Basel II has led to the dissemination of a new credit risk culture among banks in less than 5 years. As a consequence, banks tend to lead insurance companies and asset managers in the credit field.
The major drawback of the Basel II initiative is that it is often associated with high costs rather than improved competitiveness. Although it is true that the banking business is becoming ever more like a heavy industry, the new set of credit risk measurement and management tools provides significant flexibility in order to improve bank performance.
Banks have recently learned that an appropriate management of their customer basis, as well as the development of a wide product distribution network, is key to obtaining a high performance level. What the new credit risk techniques mean to them is that investing in the acquisition and the development of large databases, advanced tools, and methodologies will be critical to maintain their advantage. We anticipate that in the coming years the level of techniques within the lending activity of banks will become a major criterion to assess the critical mass and rationale for mergers.
Ultimately we have observed over the past years a significant trend toward tying credit risk measurement to market pricing. We believe that such linkage makes a lot sense and will help to increase market depth and stability. There is, however, one key function fulfilled by banks that needs to be assessed in conjunction with this trend: the intermediation of liquidity. Banks indeed offer a very valuable service in providing liquidity where financial markets do not exist or have dried up. This service is possible as long as banks do not react like financial markets. Such duality between market focus and an appropriate service to the economy is difficult to handle. Based on the limited knowledge of the financial community regarding liquidity behavior, we think that there is room for research there in order to work out a solution that protects the stability of the international financial system.