Journal of Applied Finance & Banking, vol. 4, no.

4, 2014, 107-125
ISSN: 1792-6580 (print version), 1792-6599 (online)
Scienpress Ltd, 2014

Credit Risk Management in the Financial Markets

Mehmet Nar 1

Abstract
The main task of the financial system is to ensure the flow of resources from sectors with
an excess of funds to those with a gap in funds. The developments of the past twenty
years in particular, have paved the way for new turnovers in the field of finance and with
the globalization phenomenon, foreign capital flows are transported rapidly to the farthest
corners of the world. In addition, more complex market structures emerge on the agenda
as well as complex financial tools and crises and their impact becomes more permanent.
Taking into consideration the dimensions global financial markets have reached, it is
evident that problems occurring from the inefficiency of financial risk management have
continued to grow. The search for a solution to ‘risk management in the financial markets’
- and particularly ‘credit risk management’ and its application - has gained importance.
With reference to these determinants, our study focuses on ‘credit risk’ and ‘management’
and while the Basel III standards are the topic of discussion in terms of risk activities for
the banking sector, an inquiry is made into how effective the models and arrangements
put forth to prevent risk are.

JEL classification numbers: G18, G32, F30.

Keywords: financial markets, risk management, credit, derivatives markets, Basel
standards.

1 Financial Markets
Markets are places where buying and selling procedures are carried out and explained as
based on a consensual exchange of goods and services (Hahnel, 2002). Financial markets
are mechanisms which enable the realization of capital and credit in the economy. At this
point, the financial markets separate into both money and capital markets. While the
Money markets comprise short term loans, the capital markets represent long term debt
instruments. The stock market, bond market, commodity market, foreign exchange
markets are all examples of the financial markets (Downes & Goodman, 1998).

1
Artvin Çoruh University, Türkiye. Assistant Professor, Faculty of Economics and Administrative
Sciences, Department of Economics.

Article Info: Received : March 25, 2014. Revised : April 28, 2014.
Published online : July 1, 2014
108 Mehmet Nar

Figure 1 below, depicts the classification of the market structures. Accordingly, the
capital markets consist of two types of elements: the primary and the secondary. The first
element named as the primary market, consists of the money collection process of private
or corporate organizations such as commercial companies, state organizations or non-
governmental organizations (NGOs). In other words, the primary market consists of
securities issued by private or legal institutions and markets where account owners realize
first-hand procurement. The secondary market consists of buying and selling of shares,
bonds, and securities between investors after the initial sale (Williams, 2011).
The basic financial activity on the primary markets, where the financial instruments meet
their buyers for the first time, consists of short or usually long term debt securities
undertaken by investment banks or underwriters and puts equity capital instruments on
the market. Investment banks do not execute banking activities in the sense that we
perceive banking activities. These organizations may engage in underwriting without any
risks or may prefer to buy the financial entities from the disposing company and sell them
to investors on a subsequent market. On the other hand, the existence of various trading
venues enabling the repeated buying and selling of financial entities on the secondary
market is extremely important. This trade is carried out in (i) organized stock markets (ii)
over the counter markets through a computer network and telephone connections or (iii)
the shadow markets (Kocaman, 2003).
For this reason, the main task of the financial system is to ensure the flow of resources
from sectors with an excess of funds to those with a gap in funds. As the finance sector
realizes these two main basic functions the following is realized: (1) computation costs
are decreased, (2) trade is diversified, and (3) risk is managed (Haan, Oosterloo &
Schoenmaker, 2009).
Credit Risk Management in the Financial Markets 109

Figure 1: Taxonomy of Markets1

Source: (Williams, 2011).

2 The Development of Risk Management on Financial Markets

An overall review of the financial markets in the post WWII period: this period is defined
as a period with no capital mobility, different standards between countries are applied,
geographical obstructions are important because of technological limitations, central
banks control money supply and the exchange rate of currencies, when full-blown
financial crises are practically unknown and a term when a major percentage of existing
problems were contained on national markets. However, with the conclusion of the
Bretton Woods system or the fixed foreign currency system in 1971-1972, the
aforementioned structure started to change2. Developed continents and countries such as
North America, Europe and Japan replaced the fixed currency system with the fluctuating
110 Mehmet Nar

exchange system. In addition to the liberalization of capital accounts, this situation has
functionalized the cross border flows of financial investments. At the same time, these
countries have started to release new forms of financial activity methods (instruments) to
enhance the competition of their own national financial organizations. The 1970's and
1980's were decades when cross border flows of capital, as well as credit from
international banking activities, grew steadily. The year 1989 - when the Berlin Wall fell -
started a new term for the financial markets. Particularly, the loss of national control over
interest and currency exchange and the rapid developments in digital communication have
defined efficient globalization. During this process, local, regional, and national financial
market definitions began to lose their meaning and corrode. While developing markets
and the transition economies of the former Soviet block participated in the financial
liberalization efforts, the open incentives from IMF and the World Bank foreign capital
flows became rapidly transportable to the most remote corners of the world (Barton,
Newell, & Wilson, 2003; Kindleberger & Aliber, 2005).
Especially, the significant progress in information technologies as of the 1990's, incurred
new transitions in the area of finance. In parallel with the exponential growth of trade
new, derivative market structures have been intensely observed on the agenda and
complex financial instruments emerged3. Securitization took its place among the outlooks
of the modern capitalist era in parallel with rapid globalization (Kyrtsis, 2010).
In such a complex environment, financial crises have become more frequent and their
impact more extensive. The financial markets have been released from the rigorous
inspection of government bodies and inadequacies in terms of banking audits, lack of
transparent accounting and financial reporting standards in terms of the financial markets,
inadequacies in the legal infrastructure and insufficient corporate structure are significant
indicators at this point (Barton, Newell, & Wilson, 2003).
In response to the increasing uncertainty in financial markets, risk management has gone
through a significant revolution in the past twenty years.. One of the most important
reasons has been major financial crises. While the World Bank determined 45 major
systemic banking crises in the 1980’s, this number increased to 63 in the 1990's. While
the mentioned crises destroyed most if not all the capital of the banking system, it caused
serious harm to the economies of the countries involved. The collapse of large and
significant finance organizations such as Barings (1995), LongTerm Capital Management
(1998), Enron (2001), Worldcom (2002), Parmalat (2003) and LehmanBrothers (2008) is
extremely indicative at this point. While such financial crises cause great losses, the
volatility in a country or region threatens all global economies due to its contagiousness.
Considering the extent of global financial markets, risk management problems arising
from the lack of inadequate risk management have reached significant dimensions
(Barton, Newell, & Wilson, 2003; Gregory, 2010).
The basic models developed around financial risk management focus on the necessity to
analyze risks correctly. In order to achieve specified targets, it is necessary primarily to
make a correct analysis of potential risks encountered among the various groups.
Subsequently by using tools and methodologies aiming at proactive risk management, we
can target variables for risk groups that aim to make mutual affiliations under risk
management more visible (Silvia, 2011).
Credit Risk Management in the Financial Markets 111

3 Types of Risks in the Financial Markets

Risk is the concept used to define the potential hazards which might emerge in the future
and also includes the possibility of winning or losing. However, the general tendency and
usage is in the form of ‘entering a loss’. Risk management defines the policies and recipes
for procedures needing to be applied in order to prevent losses from existing risks or to
minimize them (Wild, 2006).
The success of risk management is dictated primarily by the necessity to determine the
source of the risk. Subsequently, grading the types of risks listed below, must be carried
out and it is necessary to include even the weakest risk possibilities in terms of sensitive
factors. Consequently, it is possible to list the most evident types of risks on the financial
markets as follows (Kobeissi, 2013).

3.1 Market Risk

This type of risk is caused by the fluctuation of the prices on the market. It emerges as the
result of the short term mobility of market prices (Haan, Oosterloo & Schoenmaker,
2009). A market risk can be a linear risk created by the risks in the prices of basic
variables such as stock prices, interest rates, exchange rates, commodity prices and credit
costs. Or alternatively, it may be a non-linear risk arising from the exposure to market
volatility as might arise in a hedged position. Market risk has been the most studied
financial risk of the past two decades, with quantitative risk management techniques
widely applied in its measurement and management (Gregory, 2010).

3.2 Liquidity Risk

Liquidity risk is normally characterized in two ways. (i)Asset liquidity risk includes the
risk that assets cannot be converted into cash as well as any incurred losses when assets
are converted under the market price (Duffy & Germani, 2013). (ii) Funding liquidity risk
is a type of risk encountered due to the imbalance between the input and output of the
company’s cash resulting in the inability to fund its payments (Gregory, 2010).

3.3 Operational Risk

Operational risk is a status of avoiding uncertainty and arises from people, systems,
internal and external events. It includes human error (such as trade entry mistakes), failed
processes (such as settlement of trades), model risk (inaccurate or poorly calibrated
models), fraud (such as rogue traders) and legal risk (such as the inability to enforce legal
agreements). Whilst some operational risk losses may be moderate and common
(incorrectly booked trades, for example), the most significant losses are likely to be a
result of highly improbable scenarios or even a ‘‘perfect storm’’ combination of events
(Gregory, 2010; Satchell, 2007).

3.4 Value-At-Risk
Value-at-risk (VAR) has been a key risk management measure over the last two decades.
Initially designed as a metric for market risk, it has been subsequently used across many
financial areas as a means for efficiently summarizing risk through a single quantity
112 Mehmet Nar

(Gregory, 2010). The VAR measure summarizes the expected maximum loss (i.e., Value
at Risk) over a target horizon of N days within a given confidence interval of X percent.
The Basel capital framework calculates capital for a bank’s trading book using the VaR
measure with N=10 and X=99%. This means that the bank is ninety-nine percent certain
that the loss level over 10 days will not exceed the VaR measure. So the bank’s loss is
expected to exceed the VaR measure in only one out of every hundred trading days
(Haan, Oosterloo &Schoenmaker, 2009).

3.5 Credit Risk

Indicates the possibility of the failure of a credit customer to fulfill the provisions of the
contract in time and fail to pay the capital and/or interest payments (Duffy & Germani,
2013). In addition to the basic risk types listed here, there are various types of risks listed
under sub-titles such as: interest rate risk, contagion risk, volatility risk, reinvestment risk,
purchasing power risk (Kobeissi, 2013), country related risks - stemming from the risk of
the debtor country's economic, social and political environment, or incorrect or
inadequate regulatory changes which constitute a legal risk (Haan, Oosterloo &
Schoenmaker, 2009). In addition, the concept of credit risk - the significance of which
increases with each passing day - is the main theme of our subject.

4 Credit Risk
Credit risk is no stranger to investors these days. The U.S burst subprime lending crisis in
2008. Dubai burst a credit crisis in 2009. Europe burst sovereign debt crisis in 2010. The
investors suffered huge losses in these crisises. So, credit risk has become another kind of
risk investors have to face on top of market risk (Dash Wu, Olson & Birge, 2011). For
this reason, credit risk will remain one of the most important types of risks in the future
for both the banking sector as well as operations. Sometimes, even if commercial interests
manage to prevail over risk management, credit risk and risk management will always get
the attention they deserve (Grinsven, 2010).

4.1 The Scope of Credit Risk

Credit risk is the most common type of risk encountered by creditors, the individual or
organization giving the loan. The credit risk is indicated by the inability of the debtor to
comply with the provisions of the contract which could incur a loss for the creditor
(Albrecher et al. 2013). In other words, credit risk covers risks due to upgrading or
downgrading a borrower’s credit worthiness (Tapiero, 2004). In general, the magnitude of
credit risk depends on two factors: the size of the cash flows owed and the default
probability of the counterparty to the transaction (Dubil, 2004).
Credit risk here refers only to default risk. The other main aspect of credit risk is spread
risk or the risk of a change in value due to a change in the spread covered by market risk.
For banks, credit risk is often the largest risk in the form of a number of loans to
individuals and small businesses. Another major source of credit risk for many banks is
counter-party risk for derivative trades. This is the risk that the opposite side to a
derivative transaction will be unable to make a payment if it suffers a loss on that
Credit Risk Management in the Financial Markets 113

transaction. In addition, an economic downturn (economic risk) is likely to increase the

risk of default, and particularly for quoted credits an increased risk of default will be
higher when the value of the equity stock is lower. For life and non-life insurance
companies, the main credit risk faced is the risk of reinsurer failure. However, the greatest
credit risk for most pension schemes is the risk of sponsor insolvency (Sweeting 2011).
It is necessary to emphasize once again credit risk consists of the unilateral status of the
inability to fulfill the contract provisions of the debtor or the borrower (Haan, Oosterloo
& Schoenmaker, 2009). Whereas the counterpart of a credit risk consists of any counter-
party of the contract (buyer-to seller or debtor-creditor) who may be in default because
the contract provisions were not fulfilled. An overall assessment reveals that Counter-
party risk arises from securities financing transactions such as repos and the vast and
often complex OTC (over-the-counter)4 derivatives market. For this reason because of a
derivative function which was realized one of the parties is both creditor and debtor which
means that it is possible to hold the position of both a buyer and seller which reveals the
importance of the counterparty credit risk. Until yesterday, counter-party risk was
considered as a subset of the traditional credit risk. However, in 2007 we experienced the
worst financial crisis since the 1930s. It spread from the USA to all the financial markets.
Some financial institutions failed including the extremely high profile bankruptcy of the
investment bank Lehman Brothers (founded in 1850). In addition, many other large
financial institutions (for example, Bear Stearns, AIG, Fannie Mae, Freddie Mac, Merrill
Lynch, Royal Bank of Scotland). For this reason, the first ten years of the 21st century
were disastrous in terms of the risk management of derivative markets. Therefore, the
counter-party risk5 was accepted and graded with the status of a basic financial risk type
by participants in the financial market (Gregory, 2010).
Within this scope, various models and applications were incepted in order to measure
credit risks correctly. The objective is to eliminate the possibility of incurring a loss or to
minimize it. Even if the five major decision variables ‘credit, liquidity, interest rate, cost,
capital’ management understanding comprises the basis of the applications established
around risk management, it is evident that significant changes have been observed in
understanding the management of these variables. New methods and technological
developments have enabled a capability for deeper analysis of the affiliation between
more access and variables for the existing data. The measurement methods of credit risk
also vary within this understanding (Grinsven, 2010).

5 Methods used in the Measurement of Credit Risks

Many different approaches regarding the measurement of credit risk have been observed
during the years. Some of those methods are mentioned below. Prominent application
methods can be listed as: Traditional methods, modern methods, portfolio measurement
models, innovations brought within the scope of the Basel standards. The aim here is to
make a consistent or sufficient evaluation regarding the risk of inability to repay credit or
fall into default (Porteous & Tapadar, 2006).
114 Mehmet Nar

5.1 Traditional Methods

Traditional methods used to measure credit risk, new applications and methods on which
the development of techniques are based. These are: (i) Credit Risk measurement with
expertise method: This method, which is a subject assessment method, utilizes a series of
factor analysis. Although numerous factor or factors may be taken into consideration in
the assessment, basically the factors of 5C - which are Cycle Economic Conditions,
Character, Capital, Capacity, Collateral - carry weight in decisions involving credit (Dash
Wu, Olson & Birge, 2011). (ii) Credit Scoring Models: Credit scoring systems can be
found in virtually all types of credit analysis, from consumer credit to commercial loans.
The idea is to identify certain key factors that determine the probability of default (as
opposed to repayment) and combine or weigh them into a quantitative score. In some
cases, the score can be interpreted as a probability of default; in others, the score can be
used as a classification system, placing a potential borrower into either a good or a bad
group, based on a score and a cutoff point (Saunders & Allen, 2010).

5.2 Modern Methods in Credit Risk Measurement

5.2.1 Merton Based Models
According to this model of the firm, if the value of assets is less than the value of
liabilities, the firm sets off with the understanding that it may be exposed to the risk of
nonpayment. In other words, the possibility exists for risk if the assets of the firm cannot
compensate for its debts. In this model, the changes in asset values is initially taken into
consideration and ‘threshold levels’ or ‘base levels’ according to normal distribution
criteria are determined. The default or nonpayment probabilities of the debtor can be
calculated in accordance with the assets remaining under this level (Satchell, 2007).

5.2.2 Credit Rating Agencies and Historical Default Rate Approach

The most interesting characteristics of the historical default rate model is the historical
assessment of the credit risk analysis; in other words, determination of the credit risk by
basing it on historical data (Sweeting 2011). In this model, the credit rating agencies base
their scoring by taking the ‘default rates of bonds’ and ‘time to maturity’ into
consideration (Altman, 1989).
The measurement and management of financial risks is a major function of financial
intermediation. In credit risk monitoring, when the traditional role of banks is taken into
consideration and the monitoring of debtors with all forms of developed information,
technology has also facilitated the existing progress in risk management. Within this
context, it was endeavored to exploit statistical analysis in order to establish reliable
methods for the processing of financial data. The most well known of these methods is the
final grade given by credit rating agencies and these grades are the sole assessment tools
in acquiring historical default rates (Haan, Oosterloo & Schoenmaker, 2009). Thus the
credit rating process involves quantitative and qualitative analysis of a company’s balance
sheet, operating performance, and business profile (Kobeissi, 2013).
Some of the relevant rating agencies-Fitch, Moody and Standard & Poor - are important
instruments particularly for assessing the credit risks of governments from the perspective
of monetary and non-monetary companies. Available assessments are expressed as letters
and numbers on a statistical scale (Table 1). For the assessment measurement of Standard
Credit Risk Management in the Financial Markets 115

& Poor rating, for example: a rating system consists of AAA leading from the highest
rating to AA, A, BBB, BB, B, CCC, CC, C, D as the lowest levels.

Table 1: Credit Ratings

Source: (Albrecher et al. 2013).

This system includes the rating grades used in the credit risk assessments by investors
(creditors). Regardless of the erroneous or inconsistent results of the grading system, it
has a significant impact in terms of both scope and avoiding time consuming procedures
as well as enabling investors to carry out desirable and reliable grading in areas which
require special expertise6. This status is particularly important when companies are
determining historical default levels. Especially the statistical (scores) methods
presented by rating agencies enable comparison in credit risk analysis and measuring
(Haan, Oosterloo & Schoenmaker, 2009).

5.2.3 Risk Adjusted Return on Capital

The main risk types for banks are credit risk, market risk, and operational risk. The
concept of economic capital can be used for measuring different risks in a comparable
way. Economic capital is defined as the amount of capital a bank needs in order to be able
to absorb losses over a certain time interval with a certain confidence level. Banks usually
choose a time horizon of one year. The confidence interval depends on the bank’s
objectives. A common objective for a large international bank is to maintain an AA credit
rating. Companies rated AA have a one-year probability of default of 0.03 per cent. This
results in a confidence level of 99.97 per cent. Economic capital can be used to calculate
the risk adjusted return on capital (RAROC) that is given by: (Haan, Oosterloo &
Schoenmaker, 2009):

𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 − 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 − 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝜋𝜋

𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸
116 Mehmet Nar

5.3 Credit Portfolio Risk Measurement Models

To be able to manage credit risk on portfolio level, banks must measure the portfolio risk.
Popular tools for measuring credit risk are: CreditMetrics, CreditPortfolioView, Credit
Risk+ and CreditPortfolio Manager. The focus of these systems is on downside outcomes
- ie. payment problems, failure, etcetera. Measures of risk therefore tend to focus on the
likelihood of losses rather than the characterization of the entire distribution of possible
future outcomes. All these models try to measure the potential loss that a portfolio of
credit exposures could suffer with a predetermined confidence level within a specified
time horizon, commonly one year (Grinsven, 2010).

5.3.1 CreditMetrics and Credit Risk+ Models

CreditMetrics Model is a model developed by the international investment bank JP
Morgan and Sponsors in 1997 within the framework of “value at risk VAR” for the risk
measurement of entities such as credits not entities bought and sold or for the risk
measurement of company bonds (Crouhy, Galai & Mark, 2000). CreditMetrics is based
on credit migration. Fundamentally, its objective is to measure the annual change
probability in the credit quality of customers. Credit Risk+ Model (credit risk plus model)
is a comprehensive method estimating the probable distribution of losses from the default
rate expected in credits as well as the losses which incur if the default is realized.
Contrary to CreditMetrics, Credit Risk+ method focuses on the estimation of the amount
of capital necessary to fulfill the losses over a specific amount by banks. Credit
PortfolioView Model focuses on the estimation of risks potentially incurred during the
return of credits by taking various possibilities incurring in economic conditions into
consideration. Credit Portfolio Manager Model indicates that credit risks can be
minimized by applying the portfolio diversification method (Gregory, 2010; Grinsven,
2010).

5.3.2 KMV Model

One of the credit portfolio risk measurements models is the Moody's KMV (Kealhofer-
McQuown-Vasicek) Model. This model focuses on risk estimations by taking default
frequency into consideration rather than the possibility of default (PD) itself. Particular
changes in the credit qualities of companies, payment frequencies, improvement rates in
payment frequencies and assessments acquired for the improvement rate distribution are
very important in credit ratings (Gup, 2005).

5.3.3 Stress Tests

In addition, another method executes a credit risk measurement through stress tests. Stress
tests are an entity consisting of methodological data often used to analyze financial risks
of events involving the likelihood of exceptional events or those with a practically non-
existent frequency. Although displaying the exceptional, it also provides guidance service
for worst case scenarios. Presently, it serves as a guide in the measurement and
assessment of the fragility of the financial system (Kolb & Overdahl, 2010).
These models have proven their usefulness over the long run and continue to be utilized
and improved upon as new modeling developments are incorporated into the fundamental
models. Respectively (Saunders & Allen, 2010):
Credit Risk Management in the Financial Markets 117

(i) Mortality rate systems: Mortality rate systems, following the insurance industry’s
approach: Mortality models utilize techniques commonly used in the insurance industry.
Based on a portfolio of loans or bonds and their historic default experience, a mortality
rate system develops a table that can be used in a predictive sense for one-year, or
marginal, mortality rates (MMR) and for mult- year, or cumulative, mortality rates
(CMR). Combining such calculations with LGD (loss given default) can produce
estimates of expected losses.
(ii) Neural network systems: The development of a computerized expert system to
forecast the probability of default requires acquisition of the human expert’s knowledge.
Since this is often a time-consuming and error-prone task, many systems use induction to
infer the human experts’ decision processes by studying their decisions.

5.4 Basel Standards

Bank for International Settlements. The BIS, founded in 1930, and located in Basel, is the
most important (Malz, 2011). Recognizing that financial institutions in general, and banks
in particular, play a critical role in the global integration of markets, an important
component of the international regulatory effort in recent years has been the work of the
Basel Committee on Banking Supervision and the resulting BaselAccord. Adopted in
1988, the risk-based capital standards have as their purpose to make regulatory capital
requirements responsive to the credit risk in banks’ portfolios of assets and off-balance
sheet activities and to establish among the member countries’ banks a uniform definition
and minimum regulatory level of capital. Over time, the 1988 Accord has become the
standard for banks worldwide, having been adopted in over 100 countries. A cornerstone
of the Basel Committee’s framework is the 1988 Capital Accord (Basel I) which provided
for a minimum capital requirement of 8% for internationally active banks in order to 1)
ensure an adequate level of capital and 2) competitive equality. Basel I focused
exclusively on credit risk (Gup, 2005).
118 Mehmet Nar

Table 2: The Structure of the Basel II Capital Accords

Source: (Saunders and Allen, 2010).

The proposed goal of the new Basel Capital Accord (known as Basel II or BIS II) is to
correct the mispricing inherent in Basel I (or BIS I) and incorporate more risk-sensitive
credit exposure measures into bank capital requirements without changing aggregate
capital requirements7. The fluctuations on the market in particular, as well as financial
risks from new derivative products and the crises in the banking field, were the reasons
for the implementation of the new Basel Capital Accord (2007). Within the scope of Basel
II, the regulating and supervising role of the state was enhanced and simple accounting
techniques were applied to execute the procedures both on the part of the borrower as well
as the lender in a more transparent environment (Table 2). The objective was to protect
the capital structures of the by enabling the necessary arrangements with the equity capital
according to the risk levels of the credits given by the banks. In addition, more stringent
and deterrent measures were applied in order to ensure that businesses used the credit they
took for its intended use. Furthermore, in credit rating, the companies are endeavored to
establish a multi faceted perspective in credit risk rating by including credit repayment
levels in addition to financial table analyses and calculations for structural factors such as
investment amounts and market shares. In this context, the current Basel Committee
framework requires three elements, referred to as “pillars”:
1. Minimum capital requirements
2. Supervision of banks
3. Disclosure, leading to stronger market discipline. Table 2, Most of the details in the
June 2006 proposals relate to pillar 1, whereas pillars 2 and 3 are generally left to the
discretion of national bank regulators. Inasmuch as the global financial crises of 2007-
2009 inspired the reconsideration of the Basel II proposals (Malz, 2011; Saunders &
Allen, 2010).
Credit Risk Management in the Financial Markets 119

Efforts have been made to eliminate the deficiencies of Basel II by means of introducing
Basel III accepted in the 12th of September 2010 and planned to be applied gradually until
2019. One of the most significant changes made within the scope of Basel III increased
the legal capital requirements of banks significantly compared to Basel II8. A regulatory
“leverage ratio,” a simple measure based on the size of a bank’s balance sheet, putting a
floor under regulatory capital ratios, is also under discussion. Finally, regulatory liquidity
ratios, which would go beyond capital standards, are contemplated. Within this context,
the objective is to increase the core capital to 4,5% to strengthen the capital and increase
the rate of the total core capital to 6%. Furthermore, going for new regulations regarding
minimum liquidity rates in addition to increasing minimum capital rates, further
aggravating the applications dealing with the auditing of banking and the implementation
of efficient methods in the calculation of counterparty risks are noteworthy basic changed
incepted within the scope of Basel III (Malz, 2011).

6 Credit Risk Management

When considered in general terms the basic content of our study is the status of the credit
risk being managed by the institutions. Within this context, even if possible to mention
numerous financial organizations, a detailed analysis is limited to four main categories.
These can be sequenced as (i) banks (ii) insurance companies (iii) pension schemes and
(iv) foundations and endowments; however, our basic inspection area consists of banks.
Within this scope, it is possible to separate banking risks into two as ‘systematic’ and
‘non-systematic’ risks (Bliss & Kaufman, 2008; Fumagalli & Mezzadra, 2010).
Accordingly, systematic risks consist of risks caused by the market or from cyclical
fluctuations; exchange rate risks and interest rate risks can be considered among
systematic risks. On the contrary, non-systematic risks (pertaining to the operation)
consist of bank assets, staff quality, customer quality, and risks pertaining to operations
(such as the organization capability of banks), the concepts of credit risk, liquidity risk,
and operational risks are grouped under this title. At this point, it is important to
understand the nature of risk very well in order to manage it (it is important to understand
their nature). For this reason, the term ‘risk management’ indicates a very extensive
approach and accordingly risks must be assessed according to the following phases:

• recognizing the context;

• identifying the risks;
• assessing and comparing the risks with the risk appetite;
• deciding on the extent to which risks are managed;
• taking the appropriate action; and
•reporting on and reviewing the action taken (Porteous & Tapadar, 2006; Sweeting,
2011).

It is very important that those responsible for risk management take decision variables
such as liquidity, credit, interest rate, cost, capital into consideration when preparing a
road map. For this purpose (i) it is necessary to comply with the standards specified in the
law, legislation and regulation in risk management (ii) those responsible for risk
management must have the wherewithal to make an adequate, reliable and correct
‘rational decision’ regarding the return of the credit, the status of the borrower on the
120 Mehmet Nar

market, the efficiency of measures if the credit is not repaid, (iii) it is clear that a common
outlook in the decisions to be taken must be achieved, (iv) it is necessary to adjust the risk
conditions according to the existing regulations (v) it is necessary to clearly state who are
responsible for the application (in most cases only one person is responsible), in other
words responsibility and accountability must be stated clearly. Because of this, the
individuals, processes, and systems must be defined fully and clearly. What measures will
be taken when, which methods will be applied for this purpose and who are responsible
for their application must be individually determined ‘in writing and clearly’ (Grinsven,
2010).
In general, it is very important that banks benefit from high tech technology and expand
their utilization networks. Thus it will be possible to fill any existing gaps in terms of
information and execute correct and timely financial assessments and prepare appropriate
risk models (Marc, 2010). In addition, it is also important that banks give careful
consideration to and comply with the determined regulatory precautions. It is particularly
important that the loan repayment capacity of companies is analyzed well. In addition it is
essential that the status of the companies on the market and the probable impact incurred
by new entries on the existing market are assessed. The policies of companies in terms of
the markets as a result of the globalization of markets, corporate management capacities,
market specialization levels, rating analyses including financial tables, capital and
collateral9 structures, features such as techno-organizational inefficiencies, moral
hazard10, and operational errors must be monitored carefully. In order to eliminate lack of
confidence it is necessary that instabilities due to political-geopolitical reasons, dynamics
affected by internal and external shocks, and risks incurring from the inadequacy of
justice systems, must be analyzed properly (Kyrtsis, 2010). Finally, methods such as (i)
the current exposure method (CEM) (ii) the standardized method (SM) (iii) the internal
model method (IMM) must be exploited sufficiently in the calculation of EAD (Exposure
At Default) in terms of the derivative markets (Gregory, 2010).

7 Conclusion
Credit risk management consists of solutions to prevent or minimize the risks of
organizations (particularly banks) which base their activities on credit transactions. For
this purpose after Basel II, the innovations brought by the Basel III process are considered
important in terms of the healthy functioning of loaning process for banks as well as for
companies. Arrangements such as the strengthening of the capital structures of banks and
drawing the high leverages rates (high debt) to acceptable levels are among the
noteworthy base features within the scope of Basel III. Furthermore, it is clear that the
application of the relevant process will weaken when government controls and inspections
are insufficient. Furthermore, various experimental approaches show that a part of the
methods based on credit risk measurement have a limited practical success. Models may
be inadequate when different data requirements are taken into consideration (for example
credit spread data). What is more, ‘credit risk management’, more frequently encountered
in financial risk management during the past years, becomes more pronounced as a hazard
from the extreme use of quantitative methods. On the other hand, the difficulty of
acquiring information may develop into a moral hazard limiting the monitoring of the real
behavior of debtors. Within this context, controlling the compliance of business
proprietors with financial regulations is vital. In addition, high coordination costs may be
Credit Risk Management in the Financial Markets 121

a disappointment for banks in terms of controlling credit risks. It is particularly important

that developing countries are more sensitive to the credit risk arising from the
dollarization of the financial sector.
In this process, the recent downturn and incurred losses suggest that proactive credit risk
management is not common yet. It is evident that the application of existing measures do
not go beyond being short-lived. It is important that financial statements and reporting
standards presented as an important tool in risk control become efficient management
tools within the scope of internal and external rules. It is necessary to diversify risks and
enhance the customer base in order to minimize the concentration of the risks banks are
exposed to as well as enabling the efficiency allocation of credits to the markets.
This is why it has become necessary to benefit from credit derivatives in terms of credit
risk management in the international area. It is particularly evident that the rapidly
growing credit default swap market may provide some beneficial tools in terms of risk
protection. Furthermore, the increase of the legal capital adequacy of banks within the
scope of Basel III in comparison with Basel II is a comprehensive approach. Thus, while
it becomes possible to take more credit risks, it also has a stimulating and positive impact
on investments, growth and employment. Although there are encouraging applications
within the scope of Basel III in terms of better risk management for banks, it is clear that
the inception of such applications will take time. On the other hand, it should not be
forgotten that ‘control’ is an element of good risk management. In addition, it is also
extremely important in the improvement of credit risk management and credit risk
mitigation that the legislative changes of legal systems are adapted to the current
conditions. On the other hand, taking the diligent consideration of applying ‘collateral’
against risks is one of the basic conditions of achieving successful credit risk
management.

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Appendix
Markets segment into primary versus secondary and cash versus derivative to highlight
different aspects of their purpose.
One may distinguish two overall periods in the post-WW2 world economy financial
system; the Bretton Woods period, and the ‘free capital’ period. Much can be said about
these two periods and their financial regimes.
Financial derivatives are financial instruments that are linked to a specific financial
instrument or indicator or commodity through which specific financial risks can be traded
in financial markets in their own right; their value derives from the price of the underlying
item (i.e. thereference price) and, unlike debt instruments, no principal amount is
advanced to be repaid and no investment income accrues.
Over-the-counter (OTC). Any financial transaction that is arranged or traded away from a
formal exchange. dealing may be done in telephonic form or in electronic form (via
electronıc communıcatıons networks and other network-based platforms), and may
feature varying degrees of price transparency. Most trading in fıxed ıncome, foreıgn
exchange, and customized derivatives occurs otc rather than via exchange.
There are many ways to mitigate counterparty risk. These include netting, margining (or
collateralisation) and hedging. All can reduce counterparty risk substantially but at
additional operational cost. Central counterparties may act as intermediaries to reduce
counterparty risk but create moral hazard issues and give rise to greater systemic risks
linked to their own failure. Furthermore, the mitigation of counterparty risk creates other
financial risks such as operational risk and liquidity risk. This means that the full
understanding of counterparty risk involves the appreciation of all aspects of financial
risks and the interplay between them.
A series of financial market crises from the mid-1990s onwards led to growing debate
about the reliability of ratings, and whether they were slow to give warning of impending
trouble. After the enron debacle, which again the ratings agencies had failed to predict,
some critics argued that the big three agencies had formed a cosy oligopoly and that
encouraging more competition was the way to improve ratings.
The Basel Committee on Banking Supervision began its deliberations on how to address
the shortcomings of Basel I in the late 1990s, and it has issued a steady stream of
pronouncements and proposals beginning in 2001. In June 2004, the Basel II guidelines
were announced that rely on a combination of capital requirements, supervisory review,
and market discipline to reign in bank risk taking. Van Deventer and Imai (2003) point
out the biggest weakness of the Basel II approach: Capital ratios, however derived, are
weak predictors of the safety and soundness of financial institutions and they significantly
underperform models like the Loss Distribution Model of the Federal Deposit Insurance
Corporation .
See, Basel Committee On Banking Supervision, Part 1: Minimum capital requirements
and buffers .
Collateralization has become an important feature of the derivative market. The best-
known example of this is the collateralised debt obligation (CDO). This provides a ways
of turning a bank’s loans into a form of security held at arm’s length from the bank. As a
result, the risk and reward of the loans is transferred from the bank to a range of investors
The detrimental effect most commonly pointed to is the potential for moral hazard
involving increased risk taking, to exploit the benefits of a guarantee, with potentially
adverse consequences for financial system stability.
Credit Risk Management in the Financial Markets 125

Selecting an equilibrium without taking account of debtor’s behaviour is inappropriate if

different solutions to the creditor co-ordination problem alter incentives of the sovereign
debtor. If the probability of project termination were reduced to zero, for instance, this
could have the perverse consequence of actually increasing the possibility of sovereign
debt crises, as the sovereign debtor uses the money borrowed from creditors unwisely. It
is possible, therefore, that a positive probability of termination may be needed to solve the
debtor moral hazard problem.

Figure 2: Sovereign borrowing with moral hazard

This is shown in Figure where BB, the schedule showing expected payoffs to bad effort, is
steeper than GG which gives the expected payoff to good effort. If the probability of
continuation 1_ , was equal to 0, second-period payoffs would of course be irrelevant. As
1_ increases to one, however, the prospect of continuation with high private benefits
makes bad effort (“shirking”) more attractive.