Identification of Credit Risk
7.1 MARKET RISK AND CREDIT RISK RELATIONSHIP
Volatility in market risk factors, like changes in interest rates and exchange rates, generates credit risk, as was clearly evident during the Asian financial crisis of 1997 to 1998. The debt burden of the banks’ clients, who had obtained foreign currency loans, increased substantially in terms of the domestic currency when the exchange rates depreciated appreciably, which led to large-scale credit defaults that resulted in the financial crisis. The credit risk of banks increased substantially due to the increase in interest rates and depreciation in the exchange rate.
Credit risk denotes the probability of default in meeting financial commitments, and market risk denotes the possibility of erosion in the value of assets or earnings. Between credit and market risks, it is not possible to say with certainty which has relatively greater impact on banks. It largely depends on the asset composition, the macroeconomic condition of the economy, the volatility of the financial and capital markets, and the overall operational environment. Where loans and advances constitute a significant portion of the balance sheet, and the operating environment is not conducive to the development of sound business, and the legal system in support of the lender is weak, the intensity of credit risk is likely to be of a larger magnitude.
There are certain distinguishing characteristics between credit and market risks ...