Motivation

Banks are expanding their operation around the world; they are entering new
markets; they are trading new asset types; and they are structuring exotic products.
These changes have created new opportunities along with new risks. While banking
is always evolving, the current fast rate of change is making it a challenge to respond
to all the new opportunities.
Changes in banking have brought both good and bad news. The bad news includes
the very frequent and extreme banking debacles. In addition, there has been a
divergence between international and domestic regulation as well as between regulatory
capital and economic capital. More subtly, banks have wasted many valuable resources correcting problems and repairing outdated models and methodologies.
The good news is that the banks which are responding to the changes have been
rewarded with a competitive advantage. One response is the investment in risk
management. While risk management is not new, not even in banking, the current
rendition of risk management is new.
Risk management takes a firmwide view of the institution’s risks, profits, and
opportunities so that it may ensure optimal operation of the various business units.
The risk manager has the advantage of knowing all the firm’s risks extending across
accounting books, business units, product types, and counterparties. By aggregating
the risks, the risk manager is in the unique position of ensuring that the firm
may benefit from diversification. Risk management is a complicated, multifaceted
profession requiring diverse experience and problem-solving skills (see Bessis, 1998).
The risk manager is constantly taking on new challenges. Whereas yesterday a
risk manager may have been satisfied with being able to report the risk and return
characteristics of his firm’s various business units, today he or she is using that
information to improve his firm’s business opportunities.
Credit risk is traditionally the main risk of banks. Banks are in the business of
taking credit risk in exchange for a certain return above the riskless rate. As one
would expect, banks deal in the greatest number of markets and types of products.
Banks above all other institutions, including corporations, insurance companies,
and asset managers, face the greatest challenge in managing their credit risk. One
of the credit risk managers’ tools is the credit risk management model.