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UMAD5W Credit Risk Analysis And Management

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UMAD5W Credit Risk Analysis And Management

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Course Code: UMAD5W
University: University Of The West Of England

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Country: United Kingdom

Question:

You have recently secured a junior analyst job with one of the three largest credit rating agencies. Your first assignment was to investigate the recent sovereign debt crisis with a view to reassessing the sovereign ratings of EU countries. Your assessment will have far reaching implications on the banks’ exposures with the region. 
Ensuring financial stability:
Using the Davies and Ng (2011) article on “the rise of sovereign credit risk: implications for financial stability” as the starting point[1], write a 2,000-word business report on the following:

a. Discuss critically the background to the recent sovereign debt crisis in the EU.
How has the crisis impacted on banks’ credit risk exposures especially as it concerns making capital provisions for their credit portfolios?
What are the wider implications for policy makers both within the region and globally

Answer:

This report contains the discussion of the most current dictatorial debt crisis with the concept of the reassessment of the sovereign rate of Europe. The report contains detailed discussion and in-depth analysis of the recent sovereign debt crisis and its reflection over the banking sectors in the European countries. Further the capital provisioning of the portfolio, implications of the policy makers, impact of the crisis and the responses of the policy has been scrutinise and discussed.
             The annual risk conference the External Commercial Borrowing is important of development and successful management system in the economic sector. Further, the report will greatlyshowcase the challenges and the risk management that the central banks and private financial institutions are facing collectively. The major reason of such continuous challenges is the change in the nature of the financing problems. The financing is a giant process, which consists of influential factors that affect the financing and its associated risk.
In the financial year 2007 to 2009, the shortage of current asset is highly complicated in balance sheet which indicates the high level of uncertainty and volatility in the assets. Further, in the late 2009 and 2010 the large fiscal imbalances resulted in the high levels of volatility. In both the financial events, the financial sector assumed the risk involvement of the debtors or some market participantswill not honour the obligations, which will directly, increase the associated credit risk. The word credit risk comprises of two elements, firstly the risk involved in the defaulting of the security holders, and secondly the counterpart risk involved in the over-the-counter transactions. The report contains the detailed discussion regarding the think on the management of such risk in general and in central banks (Afonso and Leal 2017).
General Principal in the management of credit risk:
            The deviation and the established principals of the financial institutions in managing the risk is the witness of the financial crisis since mid-2007, which is widely accepted but not appropriately emphasized. The work credit monument is the mixture of various features and management practises such as “know your counterparties”, “invest only in products you understand”, “do not outsource credit risk management by relying exclusively on external credit assessments”, “and do not rely exclusively on quantitative models. It is interesting to recall the E. Gerald Corrigan and Stephen G.’s original counterparty risk management policy, which will provide a better knowledge of the risk management factors that depends on the counterparty representations.
It is essential to re-establish these principals of risk management for the resilience of the financial systems. Further, a particular trend is required to be highlighted that is witnessed in the previous years that the reliability on the external assessment for the management of the credit risk of many market participants. A few authorised institutions have often provided these assessments. To deal with the current crisis the role of the credit rating agency has become absolute role model. In addition to this, credit rating agency has faced question on the methodology for the assessment of the interest that has been fixed in the business, in the transparency and the area of the finance. Furthermore, the performance assessment of last two years hasraised a popular matter of concern.
Widespread of the credit rating in constitution, regulations, and other executive policies has become very important in the event of financing that it will be agreeable that the financial policy of any financingagency ensure the diligence of the investors. It works as the official seal of trust of the approval and ratification of the behaviour of the investor in repayment of the financing. This one of the most praised regulation that the entire financing agency will be connected to fund the debts in the immediate future(Amstad and Packer 2015).
How central banks address credit risk:
            As the central banks do not face any financial risk of its’ own currency.They are unique participants in the markets. Nevertheless, they also attracts the matter of credit risk. The defaulters of one of their counterparties or a security issuer causes losses that buffers their financial portfolios. By the implementation of the financial policy and safeguarding of the financial stability, the central bank can control the lack of financial resources and the damages that are cause by defaults in payment. In case the recapitalization becomes necessary for the government, the central bank could jeopardise the independency of the monetary authority.t
            The development of the risk of management framework is not required as the central bank follows conservative policy in managing the risk. Moreover, in crisis the central banks perform as a risk taker. In the event of financialcrisis, the central bank performer’s fundamental transformation of the risk tolerance earn the other participants which tends to follow the long and conservative approach. When all the factor of financing such as (probabilities of the default of collateral issuers and counterparties, correlations, expected loss, were cut down by the financial institutions they became reliable on the interbank market by increasing the margin of requirements. This signifies the importance of risk management framework of central bank in crisis(Amstad and Packer 2015).
Credit assessment in euro system:
            The euro-system is to strengthen the risk assessment framework operations in the financial crisis period. Regardless some important information management by the euro-system is contextual to its own credit operations. As per article(18.1),the European System of Central Banks, all the systems must be organized on adequate and collateral basis that are performed by the External Commercial Borrowing and the National Central Banks (NCBs). Moreover, such policy or operations should form in a way to support the required high credit standards.
Further, credit assessment framework (the European Credit Assessment Framework – ECAF) is designed by the euro-system to meet the required standards. In the assertion of credit assessment information the euro-system relies on differentiated identical sources. The example of dependable sources of information of the external credit assessment institutions (ECAIs), counterparties’ internal ratings based (IRB) systems and third-party providers’ rating tools (RTs) and private enterprises. Further, the national central banks’ In-house Credit Assessment Systems (ICASs) also provide information to the euro-system.
In addition to the euro-system, the assessment of the credit standards considers the institutional criteria or providing guarantee and protection to the instruments holders that are similar in nature. Euro-system closely monitors all the accepted credit assessment system performance. An annualised data is analysed to determine the rate of defalcation to realise all the eligible debtors that are assessed in a particular process, which is contrasted with a stated credit quality of euro-system. Obtaining this process results in to credit assessment that are comparable across the system and sources(Cohn 2016).
In accordance with the ECAI, the assessment of the rating agency is not automatically followed by the euro-system. Euro-system reserve the necessary rights for the clarification purpose as considered necessary on the assessments that are formed on the public ratings. A number of transparency requirements are imposed in case of asset-backed securities. 
Ratings must describe the details of pre-sale or new issued report, including inter alia, a comprehensive analysis of structural and legal aspects, a detailed collateral pool assessment, an analysis of the transaction participants. Further other relevant transaction particulars are to be assessed and elaborated. After regular interval of time a surveillance report containing the data of transaction e.g. composition of the collateral pool, transaction participants, capital structure, of the asset backed securities must be developed and published by the ECAIs , this publication must include the performance data.
The euro-system collateral framework, a public consultation has been launched by  the information of loan, which requirements for the Asset- Backed Securities (ABSs) for the better understanding of the assets in the securitised transaction. The improvement of disclosure and standards in regards to the securitisation market has been promoted by ECB by the help of this initiative. The highly set standards will impose the adequate analysis of the risk involvement in the asset pools of ABSs and will not be dependent on the assessments that are provided by the third parties in the crisis period (Cohn 2016).
            Moreover, another important element of this framework allows the euro-system to work beyond the ratings that are provided by the ECAI in the credit assessments, where the system reserve rights to assess the risk management prospective depending on the fulfilment of the assets that are compelled with high credit standards. On 3rd May, 2010 ECB dines the credit operation of Euro system is in the case of marketable debt instruments issued or guaranteed by the Greek government as they are not fulfilling the collateral eligibility requirements therefore the application is denied.
In The Commission of Europe and the International Monetary Fund of the economic Government of Greek and financial structural adjustment programme the governing council of the ECB decided  suspension on the positive assessment basis. The programme, was an example of the ability, and will of the ECB to make an independent credit assessment in regards to the measurement of the strong commitment of the Greek government that had been implemented (De Santis 2014).
The connection between credit and liquidity risk:
            In the matter of credit risk management the concept of liquidity risk needs to be elaborated. The deficiency of some financial institution to provide the funding of some complex assets triggered the financial crisis. From the traditional thoughts, it must be clearly distinguishable from an insolvency in the situations, which may put the institution in strain. However, in the last three years it is found that the distinction was far from simple. Further, in some emergency cases the institutions may have to sell some assets and may incur profits or loss to meet the liquidity requirements. If the central bank fails to address and control the situation the liquidity problem may lead to insolvency of the institution.
The Basel committee had issued a consultative management and standards document with holding international framework for liquidity management to recognise the importance of the liquidity risk and systematic implication in the liquidity crisis.Both the liquidity risk, standards and set of tools are advised by the documents for the monitoring of liquidity risk exposer and information that are exchanged by the supervisor. The following are the two liquidity standards:

a global minimum ‘liquidity coverage ratio:

This elaborated the banks should hold enough liquefied assets to meet the short-term requirements say for one month.

the longer term ‘net stable funding ratio:

This emphasis and instructs the bank to hold more fund for themselves to form a stable source of structure by implementation of the minimum amount of stay able to fund,which depends on financial institutions liquidity characteristics on assets and activities for one-year.
The discussions so far has triggered some concerned matter that are in relation to calibration of the standardswhich might generate significant negative representation in the context of real economy, in the money market and interbank markets as well as some banks business model. Central bank is the prime regulatory body that monitors and considers the required assets that are to be maintained by the banks to meet its short-term liquidity.However, the proposal is not adequate to serve in the stressful situations, which may lead to concentration of higher risk, and the higher risk factors are not considered. Further, in case of making standards for long term prospective this may lead to inefficiency to the banks to match the assets and liabilities with the intermediary requirements of economy.
The External Commercial Borrowing holds potential interest on the submission that is conveyed by the Basel committee as this connects the liquidity risk standards that are needed to be implemented in the monetary policy, which will make direct impact on the money market and iterate the consequence of financing in the European sub-continent. The proposed risk management policy clearly signifies the relevance of holdings of liquid assets by the banks to meet the crisis of its short-term requirements and decreasing the reliability on the short-term volatile sources.
Further the proposed liquidity standards are required to be reconciled and the comments of the public consultations and the imposition impact on the banking sector, financial sector and the overall economy is too accounted. Further, it is advisable for the banks to hold strong balance sheet without compromising its codes of operation and relying more on the central banking guidelines, policy and funding (De Santis 2014).
Conclusion:
             From the above detailed discussion,it could be remarked as in case of appurtenance of periods of “irrational exchilaration” may be lead to disobey the well-established practises how to manage the risk prudently. In the context of crises, the role of the central banks and the monetary policy is required to be conducted and compelledwith. Further, the central bank identified its own potential risk that are associated with the crises, and have made remedial policy and standards to build barriers to defend such challenges. In addition to that, with wilful intention the central bank will influence price stability and safeguarding of the financial stability.
References and Bibliography
Afonso, A. and Leal, F., 2017. Sovereign yield spreads in the EMU: crisis and structural determinants.
Amstad, M. and Packer, F., 2015. Sovereign ratings of advanced and emerging economies after the crisis.
Bekaert, G., Ehrmann, M., Fratzscher, M. and Mehl, A., 2014. The global crisis and equity market contagion. The Journal of Finance, 69(6), pp.2597-2649.
Brooks, S.M., Cunha, R. and Mosley, L., 2015. Categories, creditworthiness, and contagion: how investors’ shortcuts affect sovereign debt markets. International Studies Quarterly, 59(3), pp.587-601.
Cohn, T.H., 2016. Global political economy: Theory and practice. Routledge.
De Santis, R.A., 2014. The euro area sovereign debt crisis: Identifying flight-to-liquidity and the spillover mechanisms. Journal of Empirical Finance, 26, pp.150-170.
Kalemli-Özcan, ?., Reinhart, C. and Rogoff, K., 2016. Sovereign debt and financial crises: theory and historical evidence. Journal of the European Economic Association, 14(1), pp.1-6.
Singh, M.K., Gómez-Puig, M. and Sosvilla-Rivero, S., 2016. Sovereign-bank linkages: Quantifying directional intensity of risk transfers in EMU countries. Journal of International Money and Finance, 63, pp.137-164.

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