Credit Analysis & Risk Management –
LECTURE – 13
EXPOSURE ASSESSMENT
After reviewing borrower rating, other credit assessment factors, and the collateral, it is possible to
assess the borrower’s creditworthiness with regard to the proposed exposure. The final assessment
of the exposure risk can only be made (especially in the corporate customer business) after a
comprehensive evaluation of all sub-processes of credit review.
The results of the valuation of the collateral will also be included in this assessment which has to be
made by the employees handling the exposure. The credit form should thus provide appropriate
fields. Here, it is important to make sure that the internal guidelines contain clear rules on the level
of detail and the form in which the explanation has to be presented.
In practice, it has proven useful to compare the positive and negative assessment criteria. In
addition, the form should provide a field for a concluding summary. Here, too, the use of text
modules appears appropriate to avoid longwinded and vague statements.
The assessment of the employees in charge of processing the exposure is the basis for the
subsequent credit decision. This must be done in line with the decision-making structure for the
credit decision stipulated in the internal guidelines.
Automated Decision
The standardized retail business in particularly does mostly without individual interventions in the
credit decision process, with the result of the standardized credit rating process being the major basis
for the credit decision.
As these processes are used only for small credit volumes, the data are often entered by a sales
employee. Deviations can be found mostly in residential real estate finance, as it is possible to set up
specialized risk analysis units for this usually highly standardized process.
In both cases, the credit decision can be made by a single vote up to a volume to be defined in the
internal guidelines in order to curb the complexity and thus increase the efficiency of the process.
Increasingly, mostly automated decision processes are also used in the small business segment. The
prerequisite is a clear definition of and the data to be maintained for this customer segment. This
makes it possible to create the conditions to derive a discriminatory analysis function.
In some cases, it is left to the credit applicant to enter the data necessary to carry out the credit
review (so-called online applications). However, the limited database and lack of more personal
contact with the credit applicant limit the application of this option.
The most important success factor in the use of mostly automated processes is the bank’s ability to
take precautions against the credit applicant entering wrong data or to identify such wrong entries in
time. In Choosing a Process as the IRB approach provides for a calculation of the regulatory capital
requirement on the basis of credit standing, the credit rating process has to be adapted to the
requirements of the IRB approach.
The application of the formulas to calculate the regulatory capital requirement stipulated in the IRB
approach under Basel II requires banks to derive the default parameters needed to quantify the risk.
Both the basic approach and the advanced IRB approach require the calculation of the probability of
default (PD) of a claim/a pool of claims.
Therefore, the credit rating of individual exposures has an immediate impact on the capital
requirement. The probability of default of retail exposures can be determined on the basis of pools
of claims which combine a number of comparable individual exposures. Thus, it is not necessary to
classify every single borrower into different categories.
Under Basel II, it is possible — under certain circumstances — to treat corporate exposures with a
total volume of no more than 1m as retail exposures. Based on what has been said so far, it would
theoretically also be possible to assess such exposures by using a mostly automated credit decision
process (at least from a perspective of compatibility of the credit rating process with the calculation
of the capital requirement).
In practice, this will have to be qualified for two major reasons:
1. The profitability of the small business segment is highly dependent on the price
structure. This, in turn, is one of the decisive competitive factors. Therefore, it is
necessary to
Credit Analysis & Risk Management –
delineate the risk associated with an exposure as precisely as possible to be able to set a
price commensurate with the risk involved.
2. Homogeneous data pools are required for the application of empirical statistical models.
In practice, the borrowers in the small business segment show a high degree of
heterogeneity, which means that this requirement can only be met by setting up many,
thus smaller pools of claims. The decreasing size of pools of claims and the resulting
increase in the processes to be applied thus effectively limit the application of this
method. This is especially true for small institutions.
Preparation of Offers, Credit Decision and Documentation
After reviewing and determining the applicant’s creditworthiness in the course of assessing the
exposure, the process leading up to disbursement of the credit can be initiated.
Thus, this covers all aspects ranging from preparing an offer to actually disbursing the amount
stipulated in the credit agreement. With some restrictions, what was said in pervious LECTUREs
also applies to the individual process steps in this context. These steps are basically designed in a
way as to prevent procedural errors in the credit approval process. Therefore, this focuses on the
risk-mitigating design of selected process components.
Preparation of Offers
When preparing a firm offer, costing this offer plays a central role. From a procedural point of view,
special emphasis has to be placed on clearly defining the authority to set conditions and the
coordination process between sales and risk analysis.
Authority to Set Conditions
The internal guidelines have to lay down the responsibility for the final decision concerning
conditions. If a calculation of the conditions in line with the risk involved is carried out by
automated systems, sales can have the sole authority to set conditions.
The sales department is fully responsible for earnings and should thus have the authority to decide
on the conditions. If the systems do not allow a precise calculation of the risk- adequate conditions,
the person in charge of risk analysis should be included in the final decision on the conditions.
The internal guidelines should contain specific instructions governing the assignment of
responsibility for this case. This entails an explicit definition of the escalation criteria. These should
be identical for sales and risk analysis. This helps avoid situations in which people at different
hierarchical levels have to decide on conditions of an individual exposure.
If this is not done properly, such a hierarchical relation (even if it only exists indirectly) may have a
negative impact on the required balance in forming an opinion. One of the prerequisites for the
identical design of the authority to set conditions, viz. the congruent design of the sales and the risk
analysis organization, is dealt with separately in next LECTUREs.