Managing Bank Capital: Capital Allocation and Performance Measurement, 2nd Edition

11

Modelling Credit Risk

Techniques for modelling credit risk have developed rapidly over the past ten years. Although this is by far the biggest risk class for most banks, and has been around since the start of banking, techniques and understanding still lag behind the market risk class. Indeed, it is really only since the development of market-risk models that banks have started to work on credit risk. This was due to a number of factors. Firstly, credit risk is more complicated than market risk, and to a certain extent the development of value-at-risk models for market risk was a necessary precursor of the intellectual tools required for credit-risk models. Secondly, much of the development of credit-risk modelling started in the market-risk area—in modelling exposure on derivatives contracts. As most of the bright young financial mathematicians wanted to work in the dealing room environment, the traditional credit area was at first neglected. The knowledge and experience gained in the market-risk area could then be carried across to credit risk. Thirdly, most banks believed (and many still do today) that they understood credit risk; the dealing room, on the other hand, was a much more recent development, and little understood by career bankers, and so much of the technical resources were directed at this area. This is despite the fact that history shows that it is bad management of credit risk which is most likely to lead to bank failure.

While it might be understandable ...