How can you measure the impact of credit risk on your bank's profitability? (2024)

One of the first steps in measuring credit risk is to assess the creditworthiness of each borrower, based on their financial situation, credit history, and repayment capacity. This can be done using various techniques, such as credit scoring, rating systems, or internal models. Based on these assessments, banks can assign a probability of default (PD) and a loss given default (LGD) to each borrower or loan portfolio. These two parameters indicate the likelihood and the severity of a credit loss, respectively.

Another step in measuring credit risk is to adjust the interest rate or the fee that the bank charges to each borrower, according to their risk profile. This is known as credit risk adjustment (CRA), and it aims to compensate the bank for the expected loss (EL) that it faces from lending to a risky borrower. The EL is calculated by multiplying the PD and the LGD. The CRA can be either explicit or implicit, depending on whether it is disclosed to the borrower or not. The CRA can also vary depending on the type and maturity of the loan.

A third step in measuring credit risk is to set aside a portion of the bank's income or capital to cover the potential losses from credit events, such as defaults, delinquencies, or restructurings. This is known as credit risk provisioning, and it can be either specific or general. Specific provisions are made for individual loans or portfolios that are identified as impaired or doubtful, based on objective evidence of deterioration. General provisions are made for loans or portfolios that are not impaired but still carry some inherent credit risk, based on historical or statistical data.

A fourth step in measuring credit risk is to determine the minimum amount of capital that the bank needs to hold to absorb the unexpected losses (UL) that may arise from credit risk. The UL is calculated by subtracting the EL from the total loss (TL), which is estimated using a confidence level and a time horizon. The credit risk capital is based on the regulatory framework that the bank follows, such as the Basel Accords, which set the standards and rules for capital adequacy and risk management for banks worldwide.

A fifth step in measuring credit risk is to report and disclose the results of the credit risk measurement and management processes to the relevant stakeholders, such as shareholders, regulators, auditors, or rating agencies. This is known as credit risk reporting, and it aims to provide transparent and accurate information about the bank's credit risk profile, exposure, performance, and strategy. Credit risk reporting can be done using various formats and indicators, such as financial statements, risk reports, credit risk metrics, or stress tests.

A final step in measuring credit risk is to use the information and insights gained from the previous steps to optimize the bank's credit risk strategy and operations. This is known as credit risk optimization, and it involves making decisions and actions that enhance the bank's profitability, while maintaining or reducing its credit risk exposure. Credit risk optimization can be done using various methods and tools, such as portfolio diversification, loan pricing, credit risk mitigation, or credit risk transfer.

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

Banking Relationships

+ Follow

Thanks for your feedback

Your feedback is private. Like or react to bring the conversation to your network.