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Managing Risks in Commercial and Retail Banking by AMALENDU GHOSH

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CHAPTER 12

Credit Risk Measurement Model

12.1 RISK RATING AND RISK MEASUREMENT MODELS

The development of credit risk measurement models has two dimensions. The first dimension is the establishment of credit risk rating models, and the second is the development of techniques for measuring potential loss on the bank's total credit exposure. Risk rating itself is a tool such that once a rating is assigned to a counterparty or a credit facility, it indicates the quantum of potential credit loss that can arise if the default occurs. If the quantum of potential loss from a rated counterparty approximately matches the actual loss in the event of default, the accuracy of the rating is validated. For example, if an obligor is assigned the AAA rating, which implies very low credit risk, it is inferred that credit loss from exposures to the counterparty will be small. Consequently, banks prescribe a lower risk weight for the calculation of regulatory capital, a lower interest rate for lending, and a lower loan loss reserve for AAA-rated credit exposures. There is an inverse relationship between the risk rating and the quantum of credit loss; that is, the higher the rating signifying lower risk from the exposure, the lower the expected quantum of potential credit loss. This relationship is likely to hold good only if the rating model is very robust and produces accurate rating grades. The rating model should include multidimensional criteria and recognize both the counterparty-specific and ...

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