Introduction

The financial crisis had a devastating effect on the financial sector and, in turn, the global economy. After the dust settled, it became clear that many firms had failed to invest enough resources to formulate effective early warning systems, which are critical in detecting the initial signs of credit deterioration and default. Although capital markets are returning to conditions suggesting that the crisis is finally subsiding, the best institutions should remain cautious. All banks should continue to strengthen these early warning indicators, which necessitates proactive and dynamic systems and metrics that are regularly updated.

Key Findings

• Strengthening Early Warning Systems – Though the banks have adopted different methodologies to strengthen their early warning systems, all the participating banks have realised the importance of early identification of deteriorating credit in insuring the bank’s longevity.

• Metrics and Forecasting – The respondents use a variety of variables, CDS spreads being the primary one, to detect credit decline of counterparties, industries and regions.

• External Data – Internal findings receive precedence over external data sources. External data, however, still plays a big part in the participating banks’ methodologies. External data is used mostly as a marker to check the consistency of internal methodologies.

• Results – All of the responding banks have processes in place to escalate risk to senior management. Only three of the participating banks, however, are confident that these results are being used to influence the setting of risk appetite and business strategy.

Conclusion

All of the four participating banks are currently rectifying the various weaknesses in the detection of credit deterioration, which the financial crisis exposed forcefully. This is being done through the strengthening of existing systems or the development of new ones. Whilst one of the participating banks is still developing its systems, another created an independent group in 2008, which is specifically tasked with managing emerging risks proactively. At the other two banks, internal credit methodologies have been strengthened over the last 36 months, which should lead to much more proactive credit risk management.

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Tagged with: credit risk, early warning indicators, emerging markets, external data, risk, risk management, risk metrics