Effective application of sophisticated credit risk management tools requires an integrative approach to the measurement and management of credit risk. As presented in this article, this approach is based on a holistic framework that links the initial assessment of credit risk, the ongoing monitoring of credit risk, and the exception reporting and management of credit risk throughout the transaction life cycle.

Continual assessment of credit risk creates an early warning system for effective loan portfolio management. Effective assessment, however, comes only after the integration of three phases of the credit risk measurement and management framework--initial assessment of credit risk, ongoing reassessment of credit risk, and exception reporting and monitoring of credit risk. The figure on thc following page illustrates this integration.

The basis of credit risk measurement and management is found in the probability and financial consequences of obligor default. These components can be represented by the borrower's risk rating. Thus, proper definition of risk ratings is essential to effective credit risk measurement and management. Risk ratings also provide a basis for transaction- and portfolio-level decisions, as well as business strategy decisions. Risk ratings may be factored into transaction pricing decisions to achieve effective risk-based pricing.

Increasingly sophisticated tools are being introduced to help in the entire process as portfolio managers move from judgmental assessment toward greater reliance on quantitative assessment. As comfort levels in using risk-rating metrics increase, portfolio managers are using these metrics to drive such activities as the implementation of a quantified allowance for loan loss methodology, development and implementation of risk/return models at the transaction level and also the portfolio level, as well as the implementation of business portfolio management strategies.

The level of rigor in credit risk measurements should correlate with the sophistication of the transactions in the portfolio. But key to any effort is a foundation of accurate, consistent, and complete data. Missing or inaccurate data leads to inaccurate results, which ultimately can lead to inappropriate management decisions.

Risk/return metrics also may be factored into portfolio-level buying or selling decisions. The transaction-level and portfoliolevel risk/return metrics increase in sophistication with the added quantification- and formula-based tools to measure credit risk.

Risk Rating Assessments

Initial assessment of a borrower's risk rating should be based on documented risk-rating definitions. The definitions should include the following quantitative criteria:

* Financial statement ratios.

* Transaction-specific credit quality indicators, such as loan structure and loan covenants.

* Cash flow and ability to repay the debt.

* Historical payment history.

Definitions also should include the following qualitative criteria:

* Borrower's industry risk.

* Competitive position.

* Reputation.

Risk-rating definitions should be customized to the uniqueness of the transactions for the specific portfolio being assessed. Riskrating definitions, as well as other transaction assessment criteria, should be documented and modified as transactions evolve.

* Management capability.

The initial assessment criteria are the starting point and an integral part of the ongoing reassessment process. To effectively integrate the initial assessment dimensions into the ongoing processes, the initial criteria should be documented and used as the framework for the reassessment process. Additional steps include establishing key metrics, a definition of critical success factors, indicators of being out of compliance, and early warning signals of potential credit quality deterioration. …