Although the principles contained in this paper are most clearly applicable to the business of lending, they should be applied to all activities where credit risk is present. The sound practices set out in this document specifically address the following areas: (i) establishing an appropriate credit risk environment; (ii) operating under a sound credit-granting process; (iii) maintaining an appropriate credit administration, measurement and monitoring process; and (iv) ensuring adequate controls over credit risk.
Although specific credit risk management practices may differ among banks depending upon the nature and complexity of their credit activities, a comprehensive credit risk management program will address these four areas.
In the latter case, the paper introduces a type of floating interest rate, in which the rate is set in arrears, based on a composite index for the systematic risk.
This increases the efficiency of risk sharing between borrowers, lenders and the capital market.
The paper shows how financial contracts might be redesigned to allow for banks to manage the idiosyncratic component for their own accounts, while allowing the systematic component to be handled separately.
The systematic component can be retained, passed off to the capital markets, or shared with the borrower.
These practices should also be applied in conjunction with sound practices related to the assessment of asset quality, the adequacy of provisions and reserves, and the disclosure of credit risk, all of which have been addressed in other recent Basel Committee documents. While the exact approach chosen by individual supervisors will depend on a host of factors, including their on-site and off-site supervisory techniques and the degree to which external auditors are also used in the supervisory function, all members of the Basel Committee agree that the principles set out in this paper should be used in evaluating a bank's credit risk management system.
Supervisory expectations for the credit risk management approach used by individual banks should be commensurate with the scope and sophistication of the bank's activities.
The paper has several practical implications that are of value for financial engineers, loan market participants, financial regulators, and all economic agents concerned with credit risk.
It could lead to a new class of structured notes being traded in the market.