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Lay out what makes up a bank's capacity to manage credit risk, and list the questions its board of directors should be asking.

FRM® Part II · Credit Risk Measurement and Management · Credit Risk Management · FRM2.CR.3.j

The idea

A bank's capacity to manage credit risk combines governance, people, processes and capital. Governance means a board-approved risk appetite and credit policy, a clear committee structure, and a credit risk function independent of the business lines, with authority to challenge. People means skilled credit staff with incentives that do not reward volume alone. Processes include validated rating systems and models, good data, management information, early-warning indicators, limit monitoring, portfolio reporting and stress testing. Financial capacity means capital and liquidity to absorb unexpected losses and reserves for expected ones. The board should ask whether risk appetite fits strategy and capital, where the concentrations are, how provisions are set, what stress tests show, which limits were breached, and whether the credit function is independent and resourced.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which question is most appropriate for a bank's board of directors to ask about credit risk?

  1. Is the portfolio, including concentrations, within risk appetite and supported by capital? - correct
  2. Which individual borrowers should receive loans this week?Why not: A day-to-day credit decision delegated to management.
  3. What interest rate should be quoted to each retail applicant?Why not: Operational pricing, not a board-level oversight question.
  4. How should the credit function be budgeted and directed by the heads of the business lines?Why not: Making credit report to business lines would impair independence.

The board sets strategy and risk appetite and oversees management. Individual credit decisions and pricing quotes are management matters.

A harder one

A bank's chief credit officer reports to the head of lending, and relationship managers' bonuses are driven by loan volume. Which weakness in the bank's capacity to manage credit risk does this show?

  1. Insufficient regulatory capital.Why not: Nothing in the facts concerns capital.
  2. Lack of independence of the credit function and incentives not aligned with risk. - correct
  3. Poor data quality in the rating models.Why not: The facts concern structure and incentives, not data.
  4. Excessive diversification of the loan book.Why not: Diversification is not mentioned and is not a weakness in governance.

Credit oversight should be independent of the units that originate loans, and compensation should reflect risk-adjusted performance. Both are governance weaknesses, not capital or data issues.

The hardest tier

A bank has Tier 1 capital of USD 1,200 million. Its board has set an appetite that economic capital for credit risk may use at most 60 percent of capital, and the portfolio consumes economic capital of 8 percent of exposure. The largest portfolio consistent with the appetite is:

  1. USD 9,000 million - correct
  2. USD 15,000 millionWhy not: Uses all of the capital and ignores the 60 percent appetite limit.
  3. USD 6,000 millionWhy not: Uses 40 percent of capital instead of 60 percent.
  4. USD 58 millionWhy not: Multiplies capital by 60 percent and 8 percent instead of dividing by 8 percent.

Capital available for credit risk = 60% x 1,200 = 720. Maximum portfolio = 720 / 8% = 9,000.

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