Risk Management and Banking Crisis Essay Example | Topics and Well Written Essays - 2000 words

Risk Management and Banking Crisis - Essay Example The Banks & Financial Institutions avail the benefits of higher interest rates by lending to Sub-Prime customers but expose the capital to higher risks. The Banks used a mechanism of distributing the risk of the lending to the investors outside the Banking system through a process called "Securitization" (A phenomenon that occurred in the booming Credit Derivative Market). This phenomenon occurred extensively in the US Sub-Prime Mortgage Market that helped the banks to increase the number of risky products but still reduce the liabilities on their balance sheets (apparently!!) because the money is flowing through so called "conduits" from investors to the borrowers. As per experts the primary drawbacks have been imperfections in the Credit Markets given poor valuation of assets acquired against the credit instruments thus resulting in uncertain asset valuation & high credit risk exposure. Even the rating agencies couldn't predict the Sub-Prime crisis through their valuations because the securitization process was too complex and the Bank's risk assessment was inadequate in screening the borrowers and informing the investors about the risks in the securitized products. The system became so huge that the root of the risks was completely covered by hyped data and analytics about the new credit instruments. [Schmitz, Michael. C and Forray, Susan J. pp28-30; Clerc, Laurent. 2008. pp1-4] In this paper, the process of Credit & Liquidity risk measurement by the Banks is presented with a discussion on how they have contributed to the overall Financial Crisis faced by the world. A brief on Credit and Liquidity Risk Management practiced by Banks Every bank has a native underwriting process to support the "Credit Approval System" for evaluation of credit risk resulting from a possible exposure when scrutinizing a loan application. As per Basel Capital Accord (Basel-II), the primary parameters that are assessed during scrutiny of a loan application are: Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Maturity