Jeffrey R. Bohn and Roger M. Stein
Prudent credit risk management within a bank requires that a number of agents within the firm communicate, agree, and act in a concerted fashion to manage credit risk both at the individual exposure level and at the broader portfolio level. This can be challenging, given the nature of credit portfolios. Even if highly diversified, credit portfolios display heavily skewed loss distributions that imply relatively long quiescent periods (during which losses are lower than their mathematical expectations and the benefits of risk management less visible) and occasional periods of much higher losses. This phenomenon makes it difficult to maintain focus on the impact of individual trades or loans on the longer-term risk of portfolio losses, particularly in large organizations. In this nontechnical paper, which draws on and extends portions of Bohn and Stein (2009), we reflect on some of these challenges and discuss mechanisms, such as credit-transfer pricing, by which banks can better align the behaviors of underwriters, risk managers, and senior managers within large institutions while also increasing the communications between these groups. This approach grew out of industry practice and is currently in use to varying degrees by a number of large banks worldwide. While many challenges still persist in its implementation, innovations in both extending credit and modeling credit continue to evolve to address them, making implementation more practically feasible.