Credit Risk Management According to New Basel Capital Accord

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The Markowitz Portfolio Theory

Mean-variance theory is an important model of investment based on decision theory. The theory was developed in the 50’s and 60’s by Markowitz, Tobin and Sharpe. It shows how investors select assets when only the mean and variance of portfolio returns is considered. The theory relies on some assumptions. First, investors consider expected rates of return for alternative assets. Second, investment decisions are based on the levels of expected return and the expected risk. Third, investors prefer assets with higher expected returns for any given risk level, or with lower risk for any given expected return level (Brown & Reilly, 2005).
It is stated in the theorem that risk should be taken in the proportion to the risk premium nd in reverse proportion with variance and risk aversion. Investor can reduce portfolio risk by diversifying assets, meaning by holding assets that are not perfectly correlated.
Diversification can allow the same portfolio return with reduced risk. Risk-averse investors are predicted to have more diversified portfolios that can minimize the risks associated with variance of returns. Efficient portfolios (or Markowitz portfolios) are defined as the ones providing minimum variance for a given expected return or maximum expected return for a given variance (Markowitz, 1952).
Graphically, efficient portfolios are shown on the expected return/standard deviation (or risk) dimensions because according to the theory those parameters can summarize all the information about a portfolio of assets. In the diagram below the shaded area represents the set of parameter pairs of feasible portfolios. Along the upper edge of the feasible set is the efficient frontier. Each point on this line represents an efficient portfolio, that is, the portfolio that has the highest expected return for a given level of risk. From the point on the vertical axis at the rate of return on the risk-free asset and tangent to the efficient frontier runs the linear asset allocation line. At the point of tangency is located the superefficien portfolio parameter (Damodaran, 2001).
Sharpe (1964) stated that the investors’ optimal portfolio can lie on the line tangent to the efficient frontier and intersecting the vertical axis at the risk-free rate of return. Tobin’s (1958) main finding was that the asset allocation line that divides portfolio into the part of investment into risky assets and the part of investment into risk-free assets.

Credit and Country Risk

Risk is defined as the possible outcomes when their probabilities are known, but the exact future consequences are unknown. Uncertainty is defined as the probability distribution, and thus th consequences for different outcomes are unknown. Credit risk is defined as the default by the borrower to repay lent money. It is the uncertainty associated with borrower’s loan repayment (Arunkumar & Kotreshwar, 2005). This remains the most important risk to manage.
Lending represents the main activity within the commercial banking industry. Asset holdings are dominated by loans and loans generate the largest part of operating income. Pricing a loan requires arrangers to evaluate the risk inherent in a loan. The principal credit risk factors that banks and institutional investors contend with in buying loans are default risk and loss-given-default risk. Among the primary ways that accounts judge these risks are ratings, credit statistics, industry sector trends, management strength, and sponsor. All of these, together, determine loan terms and conditions (Yang & Watters, 2008). In order to define the probability of default, credit analysis that is based on quantitative and qualitative data can be implemented. 70% of credit risk is determined by
the default risk, while 30% can be determined by both market risk (market price fluctuations) and operational risk (internal control failure for example) (Arunkumar & Kotreshwar, 2005).
Intrinsic risk, transaction risk and concentration risk constitute credit risk. Transaction risk emphasizes vulnerability in the quality of credit, and changes in earnings that result from the way banks underwrite transactions of individual loans. Intrinsic risk focuses on the risk inherent in certain lines of business and loans to certain industries. It addresses the susceptibility to historic, predictive, and lending risk factors that characterize an industry or line of business. The mixture of intrinsic and transaction risks is called concentration risk of portfolio and may result from absence of diversification by geographic region, loan taker or business area. It determines extend of problems the bank can experience under adverse conditions (Arunkumar & Kotreshwar, 2005).

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1 Introduction
1.1 Background of the Study .
1.2 Purpose
1.3 Organization of the Study
1.4 Methodology
1.5 Literature Review
2 Theoretical Framework
2.1 The Markowitz Portfolio Theory.
2.2 Credit and Country Risk
2.3 Business Risk Factors and Components
2.4 Country Risk in Emerging Markets
2.5 Risk Assessment Framework
2.6 Credit Risk Management According to New Basel Capital Accord
2.7 Credit Risks and Risk Rating Systems
3 Data and Statistical Method
3.1 Data .
3.2 Statistical Method
3.3 Limitations of the Approach
4 Analysis
5 Results
6 Conclusions and Suggestions