Impacts of selected methods of credit risk management on bank's performance

Abstract

The paper deals with the quantification of potential impacts of credit risk management approaches on the financial performance using collaterals as techniques to reduce credit risk of commercial bank. The requirement to coordinate regulation of the capital adequacy has resulted from fears of central banks of the most developed countries that the capital held by banks to cover even a small loss is not sufficient. Due to the interconnection of financial markets, there is a possibility that transfer problems of individual banks and problems caused by external shocks could threaten the entire system. The article is focused on quantitative analyses of selected methods of credit risk management using collaterals in the intention of Basel II and quantification of their impact on determining the amount of equity that bank must hold. To set the optimal amount of equity related with the risk portfolio is the one of the most important precondition to increase efficiency and competitiveness of commercial banks. To explain better the usage of internal rating models and techniques reducing credit risk, the amount of capital requirements for the simulated portfolio are calculated and the obtained results within a standardized and foundation IRB approaches are compared. The achievement of higher capital requirements of Basel II doesn't automatically mean that a bank would be safe and also profitable. The equity growth is a necessary but not sufficient condition for achieving greater security of the banking sector. In the article, methods of analysis, synthesis, and analysis of causes, induction and deduction are used. In the empirical analysis two methods of Basel II have been used and the results of calculating capital requirements have been calculated. Finally, the methods of comparison have been applied and the question which method provides the highest demand for capital has been raised and compared with other methods. A simple and a comprehensive approach of Standardized Approach and foundation approaches of Internal Rating Based Approach with and without collateral instruments have been put into this comparison. The equation of approaches to credit risk management confirmed the specified hypothesis that quality internal rating system strongly supports the bank's financial performance. The calculations of the working team show that the use of internal rating models brings a significant increase in earnings and profitability through a significant saving in equity in banking practice. The current results demonstrate that the requirement of capital could decrease by approximately 30 %, which means using of an internal rating model could increase the profitability on equity up to 13 %, depending on the structure of the assets, the amount of the interest margins and the profitability ratio. Even saving capital through "the improved credit risk management", which was considered one of the important stabilizing elements in this system, does not work in banking practice and therefore the system of internal ratings should be adjusted to the new regulatory conditions.