Credit risk management priority, study of Russian banking system

Introduction
For a commercial bank, the risks inherent in its core business are the traditional ones of credit risk, market risk and funding risk. All three of these risks are contained within its loan book Credit risk is one of the oldest and most important forms of risk faced by banks as financial intermediaries. The risk of borrower default carries the potential of wiping out enough of a banks capital to force it into bankruptcy. Managing this kind of risk through selecting and monitoring borrowers and through creating a diversified loan portfolio has always been one of the predominant challenges in running a bank. Brief risk management overview Risk can be defined as the combination of the probability of an event and its consequences (ISO/IEC Guide 73). In all types of undertaking, there is the potential for upside and downside consequences but management of financial risk is focused on prevention and mitigation of harm. (http://www.theirm.org/) A risk management system is a complex of scientific techniques aimed at identifying and measurement and mitigation of risks within a financial institution, which relies on sophisticated methods and approaches to promote the banks stability, financial operation integrity and long term profitability. Risk management is ranked high on many individuals agendas as it is being increasingly recognised as an integral part of business strategy. Essentially, a risk management approach does not involve complete risk avoidance; instead it encourages preserving a certain level of active operations profitability within the tolerated risk corridor. Additionally, risk management ultimate purpose is achieved through protecting the stakeholders interest in the company by means of preventing major financial losses and cases of insolvency. In general terms a risk management process is aimed to address the following objectives Maintaining the optimal ratio of banking activities return and level of risks involved. The rate of return is one of the main criteria in funds allocating decisions, yet the higher rates or return are associated with higher risk, and vice versa low risks normally yields low incomes. Achieving the optimal balance in the highlights of this inverse relation is the key priority of risk management process. Sustaining the sufficient level of liquidity along with profit optimization refers to the ability to meet both predicted and unexpected demand for cash required to settle the liabilities.

Meeting the capital adequacy requirements, recommended by the central bank regulations, and setting aside the reserves necessary for contingency cost coverage all together have an impact on the amount of risk taken on. Additionally, bank capital acts the leading role in sustaining the stability and efficiency within a bank. As a part of equity it is required in the initial start up phase of any financial institution. The reserves generated in the course of daily operations also contribute to soundness and solvency and their size can be adjusted at the will of the management board. Another source of emergency funds can be provided by the Central Bank in form of stabilizing credits.

Credit risk management emphasis Credit risk importance can not be underestimated as most of the failures of even larger financial organisations and corporations bearing high credit rating historically have occurred as a result of credit risk mishandling. A vivid example of organisations becoming insolvent due to credit risk mismanagement is demonstrated by the largest corporations such as Enron, Pacific Gas and Electric (PG&E co) and leading banks including Continental Illinois (CI), Nippon Credit Bank (NCB), Hokkaido Takushoku Bank (HTB), Long Term Credit Bank of Japan (LTCB) and Bank of Credit and Commerce International (BCCI). (Basel Committee on Banking Supervision (BCBS), 2004) Credit risk related issues make up 80 % of losses in Russia, while the market and operating risks account for 15 % and 5 % correspondingly. According to BMO analytics report the major sources of risks encountered by financial institutions are distributed in the following proportion, with the credit risk scoring just under 40% of total risks. (BMO Financial Group, 2006)

credit 38% market 24% operational 22% business 16%

business operational market credit

Proportion of risk exposure sources

Overall, the components of effective credit risk management comprise active board and senior management oversight; sufficient policies, procedures and limits; adequate risk measurement, monitoring and management information systems and comprehensive internal controls.

At the same time its worth noticing that all bank operations and risks related to them are closely interconnected and hence the credit risk management system must be capable of identifying the correlating bonds between them as well as of tracing the market dynamics impact. Indeed, numerous structural links between the firms and deteriorating general state of the economy can initiate multiple chains of consequent failures in case of single large firm failure. Credit risk definition Although the idea behind the origin of credit risk is quite simple, attaining a clear understanding of credit risk nature is one of the basic steps towards implementing a successful risk management strategy. Indeed, the vast scope of risk management concept requires clear formulation of its core elements definition. Above all, the credit risk notion clarification may help avoid misunderstanding of key business processes, typical among customers and staff. In simple terms credit risk refers to the possibility of a loss occurring due to the financial failure to meet contractual debt obligations. Credit risk arises from uncertainty that promised cash flows on financial obligations such as bonds notes, leases and instalment debts held by a bank will not be paid in full and on time. (Saunders, 2006) As quoted from Investopedia Risk that a borrower will not pay a loan as called for in the original loan agreement, and may eventually default on the obligation. Credit risk is one of the primary risks in bank lending, in addition to interest rate risk (http://www.investopedia.com/) Credit risk properties are reflected by its impact on financial stability; meanwhile probability of default is a closely related term of measuring credit risk parameters. Credit risk exposure is a value used to express the volume of risk and can be calculated by multiplying the probability of default and total volume of loss, usually reflected by capitalat-risk and value-at-risk. (http://syque.com/improvement/a_encyclopedia.htm)

Literature review
In order to provide the brief survey of vast credit risk management aspects, the study is aimed to address the most up-to-date sources, most commonly available from online databases and credited authorities. Subsequently, as proposed in the title of the academic work, this research analyses international credit risk management theories and compares them with the particular practice implementation, considering bankig system of Russian Federation as an example of international credit risk management standards employement. A case study of a Russian public limited bank Avangard is intended to back up the findings with the supporting arguments. In the spotlight of updating regulatory standards, the topic emphasises the importance of credit risk management in the global finance environment and particular economies. According to the Harvard referencing system, the academic work is structured and referenced to provide a clear understanding of the constituent logic and argument support. Supplying with enchanced visual representation, charts and graphs allow to describe the empirical statistic data and determine the underlying factors behind the processes driving

the finance system. In regards to requirements, the article is divided into five parts, which consist of Introduction, Literature Review, Methodology, Analyses and Conclusion, followed by the reference list and bibliography

Methodology
Credit risk measurement methods
Introducing variety of risk management approaches At present the majority of contemporary risk management methodologies measure risks beginning with identification and valuation of assets, followed by assessment of threats and probabilities of their occurrence in order to work out appropriate countermeasures. In the context of risk analysis process two alternative measurement schemes can be applied to risk constituents, either quantitative or qualitative. Whereas quantitative approach articulates risk in numerical values, on the contrary qualitative approach results are usually rendered in terms like low, medium and high. Quantitative risk management category In the modern world, challenges, such as dynamic market environment, ever growing use of complex financial instruments, intense competition and intricate technical problems can only be addressed by development of automated tool packages, which boost the productivity of risk management by minimizing workload and analysis duration, as well as normalize dissimilarities of individual competence. Quantitive methods require large amount of information to be collected and a number of extremely complex calculations to be performed. Quantitative methods of risk measurement The vast category of quantitative risk management techniques embraces vendor-marketed models such as Algorithmics, JP Morgans CreditMetrics, CSFPs CreditRisk+, KMV's Portfolio Manager, Loan Pricing Corporation, and McKinsey's Credit Portfolio View. Besides, a wide range of credit scoring models and in-house proprietory tools also belongs to quantitative risk measurement methods. Quite frequently these models are further tweaked and adapted to meet particular needs of the company business operations. Qualitative risk management category What is qualitative risk management? In common sense, it is form of risk management dealing with the quality side of risk. Apparently, qualitative factors are fundamentally inherent in the very nature of risks, and hence the models designed to assess them. Indeed, the qualitative element is a complex category usually operating with intangible parameters of risk, to which quantitative methods of analysis are practically inapplicable. In view of that, the assessment and review of the qualitative aspects demands the application of management skills, judgment and experience to hard-to-quantify factors. (Bob McDowall, 2006)

For instance, deciding on financial modeling parameters, as well as the selection and character of the source data are some important judgmental factors, based on the subjective expertise of managers. Furthermore, most banks acquire relevant information internally or from external credit risk rating agencies regarding borrower-specific factors, such as credit history, capital leverage, volatility of earnings and loan collateral. Considering market-specific factors risk managers pay attention to the business cycle of the economy and the level of interest rates. Weighted altogether these factors eventually allow the manager to reach a subjective credit decision. Also known as expert systems, qualitative models provide a valuable addition to risk management techniques (Saunders, 2006) Qualitative risk management advantages Systematic assessment of the qualitative aspects significantly augments the reliability of risk management, as it helps identify any potential flaws in model specifications, as well as spot the source of errors during result testing stage. Most importantly, qualitative risk management applies an exogenous uncertainties analysis to the quantitative risk management models. In addition, pro-active qualitative management secures a premium element to risk management in terms of reviewing the efficiency of quantitative models in use. In this way it might be used to adjust the initial quantitative model to the particular environment needs and continuously shifting customer behaviour. However, the pro-active approach can only produce the beneficial gain when used in conjunction with quantitative method and is primarily dependent on the underlying quantitative risk model. (Bob McDowall, 2006) CRAMM tool used for qualitative risk analysis CRAMM is a qualitative risk analysis and management tool designed for financial security examination, identifying contingency requisites and proposal of countermeasures. CRAMM methodology is based on meetings, interviews and structured questionnaires for data collection . Qualitative character of the applied method means it has no numeric value and is usually opinion dependent, with the decisive role of the management expertise. Principles and methodology of the approach Within the scope and extent of the model empirical analysis, the levels of threat and vulnerability are investigated against selected asset groups, inclusive of data, application software and physical assets. In the next stage, CRAMM evaluates risks for each asset group against the threats to which it is vulnerable by weighing asset values to estimated potential exposure levels. After the analysis stage findings have been identified, CRAMM suggests a range of practical countermeasures to manage possible risks. Finally, management team are presented with a summary of the findings and conclusions, which reveal areas of weakness or over-provision, and are responsible to implement, intensify or withdraw the recommended countermeasures. The demand for efficient risk analysis and management facing with excalating challenges of the modern information technology age makes the application of instruments like CRAMM an integral part of risk management strategy. Ultimately financial institutions should however decide, preferably at the senior managerial level, for the best suitable

solution to meet their needs and requirements, either in form of specific toolset or a combined approach mode. (Zeki Yazar, 2003) Concluding commentary Qualitative risk management procures an overall enhancement to risk management, which cannot be provided by quantitative approach alone. At the same time both management strategies are of equal importance to consistent risk management in a financial institution. Management expertise in terms of judgment and experience enables lending institutions to make the most of financial stability and successful business operations potential. And a final remark by Governor Susan Shmidt to all risk management specialists While the enhanced quantitative dimensions of risk measurement may be quite visible, their implications for the qualitative aspects of risk management may be less apparent. In practice, though, these qualitative aspects are no less important to the successful operation of a business--as events continue to demonstrate. As risk measurement practices advance, the full range of risk management practices needs to keep pace. (Susan Schmidt Bies, 2004) Loan Portfolio and risk concentration models Calculating the credit risk exposure to the borrowing counterparty is the primary step in the risk management process and yet it is one of the trickiest. Although the modern theory boasts a large variety of credit risk evaluation techniques, neither of them gives a 100% level of confidence. Specifically, each type of methods has its own purpose and no universal approach practically exists. In practice, both qualitative and quantitative have their best area of use and it is up to the chief executive and managing personnel to ensure that the appropriate techniques are employed. Among the commonly used methods the following should be highlighted expected and unexpected loss measures portfolio management measures current and potential exposure calculations.

A chart constructed by a credit SAS rating agency clearly illustrates the top five methods used to measure credit risks

Current and potential exposure KMV's PortfolioManagement Credit VaR Expected and unexpected losses Survival analysis 0% 10% 13% 13% 20% 30% 40% 50% 60% 50%

63%

63%

70%

Methods used to measure credit risk Current and potential exposure models, used by the majority of banks, enable the assessment of credit risk concentration and additionally help to verify the compliance of any given firms portfolio with its policies and guidelines. The method generally assumes simulating future market values in order to measure the current and future exposure of asset portfolio and, subsequently, use a collateral to mitigate exposures. The widely appreciated Monte Carlo Value-at-Risk and Moodys KMV models are incorporated in risk management practice of over 60 % of banks. The rest of the commonly used techniques to measure credit risk include survival analysis, and expected and unexpected loss. The sole purpose of calculating expected credit loss is to determine expected net returns of the portfolio. Unexpected credit losses are used to estimate the extreme credit losses that might be suffered in the worst case scenario. Brief portfolio modeling systems overview One of the first portfolio modeling systems introduced to the market by J.P. Morgan, CreditMetrics proposed a methodology for assessing a portfolio's value at risk (VAR), which can be calculated by combining the volatilities of individual assets values in order to model the volatility of the aggregate portfolio, and hence evaluate the maximum risk exposure arising from changes in counterparty credit quality at a confidence level lying within 95% to 99%. Later on, Credit Suisse Group adapted this methodology in their Creditrisk+ model to facilitate setting loan loss provisions for homogenous, mostly retail and institutional, portfolios with illiquid loans, which are normally held to maturity. (Credit risk management: a survey of practices, 2006) Another famous brand of credit risk modeling, KMV's Portfolio Manager measures the risk and return characteristics of a portfolio in response to changing the composition and proportion of its comprising assets in order to review the optimal tactics and strategy and also propose the size and allocation of economic capital. Finally, McKinsey's Credit Portfolio View key purpose is designated to modeling an empirical relationship between counterparty credit and migration risks pattern and the macroeconomic parameters, varying across industries and countries due to the altering phases of business cycle. (Uwe Wehrspohn, 2002-2003)

Credit scoring model systems In simple terms, credit scoring models are an instrument for economical and rapid assessment of various clinet groups, ranked into a number of default risk bands according to their key economic characteristics. Such a comprehensive classification allows banks to service the customers respectively and achieve an overall performance accuracy of 85 percent, as the expert statistics demonstrates. Above all, scredit scoring models enchance risk measurement automation and suggest effective management treatment and depending on the degree of technical complexity can be attributed to the following types (Edward I Altman, 2002) Qualitative based on subjective management expertise Univariate simplier model class, primarily based on single parameter calculation Multivariate a class including Discriminant, Logit, Probit Models and Non-Linear Models Discriminant and Logit Models in Use actually encompass Consumer Models for Fair Isaacs; Z-Score for manufacturing; ZETA Score for industrials; Private Firm Models; EM Score used for Emerging Markets and Other models used in Bank Specialized Systems Artificial Intelligence Systems such as Expert Systems and Neural Networks Option/Contingent Models, that include Risk of Ruin and KMV Credit Monitor Model

Application of quantitative credit risk models A survey of the largest banking organisations across the US conducted by Emerald group, indicates that identifying counterparty default risk is the dominant purpose of the credit risk models employed in around 90% of cases. Another highly important purpose served by the models is related to counterpartys migration risk assessment, highlighted by nearly a half of the respondent banks. Finally, using models for either purpose at the portfolio level, although quite common, is spread to a much smaller extent. The results of the survey by Emerald are summarised in the chart below
Migration risk at portfolio level Default risk at portfolio level Counter party migration risk Counter party default risk 0% 10% 20% 30% 40% 50% 60% 70% 29% 38% 48% 90% 80% 90% 100%

The types of risk the bank's credit risk m odel is designed to identify

While all of the portfolio level credit risk management tools marketed by external vendors are widely acclaimed, KMV portfolio manager and CreditMetrics are those most commonly

preffered for non-traded loan management among the ranks of financial companies. In addition to the outsourced market models, a number of banks also develop in-house proprietory models mainly to assist market traded assets management, but still around 62% of the banks often use both types of models simultaneously. As far as the purpose of credit risk portfolio system pursued by the banks is concerned, the top priority is given to the assignment of economic capital on the portfolio level, followed by pricing of individual transactions. Assignment of economic capital for individual transations appears to be less common objective accomplished through a portfolio management approach.
Assignment of EC for individual transations Pricing of individual transations Assignment of EC for portfolio 48% 62% 81% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

The purpose served by the credit risk portfolio m odelling system EC= econom capital ic

As a part of their business strategy for the future, banks plan to improve and expand the use of the models available to them. In addition, some of them have demonstrated an intention to introduce daily stress-testing and utilize multi-factor analysis. It worth noticing that, although the discussed models are highly popular among banks, the absolute range is not limited to them and, more importantly, new models are constantly being introduced as the experience in risk management continues to accumulate. (Link

Credit risk management techniques

Risk management and exposure control techniques Evidently, initial risk identification and measurement is only one part of the process; another involves risk control and management process itself. As for the techniques available to deal with risk exposures and negative outcomes, they fall into two large domains passive mitigation techniques and active methods of risk management. Basically, all counteractions that can be undertaken to deal with risks can be classified as follows Acceptance of risks is common, when the necessary countermeasures are cost-ineffective and technically overcomplicated, making the actual mitigation unfeasible and unaffordable Aversion of risks is often the only solution, when the potential risks are extremely high; asset liquidation in fire sale order might be required if the borrowing counter party credit quality deteriorates dramatically, or the company is faced by severe liquidity shortage or excess overall exposure

Actual risk mitigation is intended to cushion the impact of risk associated losses and also offset the riskiest postions in credit portfolio, simultaneously diversifying its profile. Passive risk mitigation techniques As a matter of fact, this broad domain involves a variety of approaches and methods that are concentrated around promoting economically resilient environment and healthy financial parameters, that allow a company to withstand critical situations and soften the impact of potential lossesins. Obviously, regulatory compliance with financial requirements, maintaining a sound credit pricing policy and following a general portfolio diversification pattern are just some of the examples of passive risk management techniques. It is worth noticing, that passive risk control methods are of no less importance to long term profitability of the company than the active management actually is. Setting credit extention limits Effectively, in order to avoid the threat of overexposure and risk concentration in a specific sector of the economy, banks need to set credit extension limits for every customer group in their asset portfolio. In fact, establishing multiple limit credit profile can help attain better overall portfolio diversification and furthermore is a mandatory required by regulatory authorities. Indeed, as prescribed by the Basel Committee proposals, banks must limit the extent of lending to any one counterparty by industry sector, geographic region, particular customer and country. It is important to notice, that banks must also take into account the credit limits imposed by economic and political risks associated with such areas as emerging markets and less developed countries (LDC), as long the highest level of risk originates from in this domain. All in all, a thorough comprehension of every aspect of the borrowing counterparty greatly assists the proper limit setting and depends on the availability of relevant information, which can be obtained from a variety of sources, including credit rating agencies, companies annual reports, market analytics briefings and internet databeses. In the framework of modern worlds complex and abundantly interconnected economic environment, which is commonly prone to the risk of contagion and migration in a particular business sector, banks might pay a high toll for carelessly underestimating the value of such limits. Reserve provision and capital requirements In general terms, all financial institutions are prone to credit risk losses and other contingencies in regular course of business and thus must retain reserves and accumulate provisions in order to compensate for the financial detriment. In most cases, expected financial losses can be offset by regular provision assignments, the volume of which largerly depends on the credit quality of the underlying assest and respective provision ratio. Furthermore, unexpected losses require that credit organisations hold a certain amount of capital to cover the financial damage to the maximum extent possible. Under this assumption, in order to accetrain that financial organisations have sufficient level of capital Bank for International Settlement (BIS) establishes the minimum limit, also known as

regulatory capital. In addition to this, most lending organisations also refer to internal capital guideline specifications, commonly termed economic capital, to enhance their lending performance and capital allocation. Finally, capital adequacy, allocation and structure transparency as well as availability of borrowed capital and leverage capacity are the most important areas in companys strategic management and business sustainability. Accurate loan pricing and risk-adjusted intrest rate Basically, accurate loan pricing lies in the core of banks intrest rate income, but on the other hand it also affects the rate of loan repayment, since the borrowed funds do not necessarily generate high rates of return on investment. Deffinitely, too high an intrest rate might well render the borrower insolvent and loan going default, which results in undesired losses to the financial institution. Basic loan pricing guidelines suggest that the intrest rate is calculated upon the initial LIBOR rate adjusted for expected losses and include the fees and profit for banks services; however more sophisticated loan pricing technologies might consider risk-adjusted intrest rate for particular groups of customers and large corporate clients, which incorporates risk-contributory borrower specific extra. As intended, this technique allows to discriminate among customer groups relatively to their credit qualities, so that banks can give an incentive to new clients and offer a discount to long-standing, trusted counterparties. Active risk mitigation techniques A most unfavourable situation, when constituents of portfolio exceed acceptable credit limits or lead to undesirably high concentration of risks in single section of aggregated portfolio can have hazardous consequences, unless treated by a manger responsible for risk mitigation. Although such adverse a financial position is not uncommon, it should be addressed by rebalancing the portfolio before it deteriorates further, possibly leading to crisis. A portfolio with negative financial positions can be restructured by a wide variety of techniques, normally associated with transferring a portion of risk or comprising assets to other financial intermidearies by means of credit derivatives, a collective term for various types of insurance contracts protecting against credit risks losses. Asset securitisation, loan sales and collateralised debt obligation Another means to secure companys financial position can be realised through banks pooling assets of homogenous nature and stadardised risk characteristics together and then selling parts of the pool to other banks, commonly known as asset securitisation. Alternatively, this process is called asset backed securities issue or creation of collateralised debt obligations and so far has seen considerable growth, especially in home mortgages and automobile loans segment, due to relatively safe and attractive nature of these investment vehicles. On the other hand a situation when a bank originally makes a large credit and then sell the small tranches of outstanding loan to other banks is known as loan sales. Also being a renowned source of funding capacity replenishment, loan sales are very popular in take over financing, where banks with restrained loan origination capability obtain shares of loan from largest institutional and money-center banks. In particular loans sales are attractive, because they allow banks engaged in loan trading to save on the regulatory

costs of on-balance-sheet funding, such as minimum reserve requirements, minimum capital adequacy ratio, and the cost of federal deposit insurance. However, in the situations where fractional and hetorogenous character of credit assets makes tranche loan sales or securitisation problematic, an alternative technique employing derivative instruments comes into play. (A. Burak Gner, 2006) Credit loan transferring, insurance and credit derivatives deployement Use of derivative fincial instruments, also termed hedging, create new opportunities for tactical risk manipulation through innovative structures, such as forward contracts, credit default swaps, options and debt obligations. Above all, credit derivatives greately augment the scope and flexibility of portfolio management strategies, allowing to offset excessive exposures, free up additional economic capital and achieve better assets diversification. In general terms hedging techniques secure a number of avantages to firms employing them, inclusive of Transfer of credit risk: a synthetic credit derivative structure enables a proportion of credit risk in a loan book to be passed to a third party at the cost of transaction originating from initial credit derivative pricing of the underlying assets, thus reducing unwanted risk exposure Capital relief: financial institutions can alleviate regulatory capital burden by transferring lower-yield corporate credit risk off their balance sheet, thus extending their high yield investment opportunities Insurance protection: credit insurance policy purchase delegates all responsibilities for potential risks and incurred losses to institutions that issue the financial cover contracts, so that if a default occurs the seller of protection makes good the loss.

Actually, in the normal course of business use of derivatives to reshape credit profile is a value-enhancing activity; when it is adminstred carefully and carried out straight; otherwise it might result in contagious risk migration across financial industry sectors and ultimately hamper national financial stability. Extreme cases of risks and derivative instruments mismanagement, epecially those of non financial nature, can not only render one organisation insolvent, but also initiate a chain of dramatic failures in banking, insurance and securities sector. (Udo Broll, Thilo Pausch, Peter Welzel, 2002) Advantages provided by credit derivatives In support of this statement, one of the largest credit rating agencies, namely Fitch Investors Service (Fitch), carried out the research in the field of creit derivative market statistics to find out that banking structures in the United States and Europe are net buyers of credit protection, to the total volume of nearly 190 billion US dollars (USD), and insurance companies are the net sellers of security, purchasing credit derivatives to the tune of over 300 billion USD. According to the research findings, credit derivatives deployement in some bank has significantly reduced its financial markets credit risk, to be pricise from 70 to 45 percent. Scale of derivative instruments expansion

Its no exaggeration to say these products have revolutionised global finance, surging from roughly a zero to, according to the latest estimates of International Swaps and Derivatives Association (ISDA), total notional worth of some 236 trillion USD, a sum about eight times the GDP of the entire planet, in the past twenty years. In other words, it is a bubble larger than the world itself, creating largest uncertainty ever evidenced. As far as the very essence of derivative produtcs allows credit risk to be shared among so many investors in such small proportions that everyone will usually survive in case of a crisis, the global financial market becomes like a spider web; interconnected with quite weak individual links to form a more resilient cumulative structure. Dubious nature of global derivative web Adding to the extremely risky nature of global credit derivative net structure is the fact that the hedge funds and banks, that trade all types of credit derivatives, including collaterrised debt obligations (CDOs), credit default swaps (CDSs), asset backed credit default swaps (ABCDSs) and synthetic CDOs, make extensive use of leverage to improve the returns, associated with taking on very large supply of borrowed funds. Besides, the ISDA reports numerous errors and unconfirmed trade records in around 20 percent of credit-derivative transactions. And most importantly, sophisticated mathematic models designed for credit derivative management are flawed with technical comlexity and imperfections, making liquidity drain risks and major movements in asset prices hard to predict and practically impossible to analyse within the models. (Cris Sholto Heaton, 2006) A derivative bubble collapse scenario A major precident for a derivative originated collapse of world financial markets occured due to a crisis in Long-Term Capital Management (LTCM) hedge fund, in which a total 100 billion USD worth of derivative securities was put at risk; a crisis that large, it could have cascaded through the markets, spreading panic and liquidity shortage, with losses being multiplied and amplified by the widespread use of derivatives and leverage capital. A majority authoritative financial analysts find the derivative instruments market to be so huge and complex and at the same time have such poor supervision, that another fatal system crisis of this scale is inevitable. In spite of theoretical model assumptions, financial practice reveals that derivatives are not a zero-sum game, but a game in which the actual odds themselves follow long patterns of boom and bust and where any hint of a crisis could spark panic and cause mass-selling, amplified by further derivatives losses, sending asset markets in general into meltdown; a scenario in which global losses could easily spiral beyond the maximum gross credit exposure of the derivatives world. In support of this, Warren Buffett once referred to derivatives as financial weapons of mass destruction. (Bill Bonner, 2006)

Risk management quality and control

Mechanisms for identification and management of risks are only a part of required components on the way to sustainable success, another vital factor is the monitoring of managerial processes and quality assurance of active business operations. Components of a quality risk management encompass supervisory committees, external audit agency assistance, effective human resource management and employee motivation, optimized

organisation structure and consistency of risk management techniques throughout the enterprise. Best practices in credit risk management Effective credit risk management is a critical component of a banks overall risk management strategy and is essential to the long-term success of any banking organization. Overall, the components of effective credit risk comprise active Board and Senior Management oversight; sufficient policies, procedures and limits; adequate risk measurement, monitoring and managing information systems; and comprehensive internal controls. The development and deployment of a successful credit risk management strategy depends on the specific elements listed below (Effective Credit Risk Management, FSI): Effective Credit Risk Management Enterprise View of Credit Risk Strategy, Policy and Business Processes Alignment Active Management of Credit Risk

Effective Credit Risk Management While the evolution of credit risk management is driven by regulatory requirements, there are plenty of reason to improve its performance and quality. An effective credit risk management system could ultimately provide a competitive advantage to the major financial companies. Consequent risk management quality advancement is required to provide comprehensive guidelines to better address credit risk management practices. As can be seen from the Lepus agency research, risk management practices differ from bank to bank, depending on the individual nature of their lending operations. According to Basel regulation, prudent practices should primarily target the following areas: (i) establishing an appropriate credit risk environment (ii) operating under a sound credit-granting process (iii) maintaining an appropriate credit administration, measurement and monitoring process; and (iv) ensuring adequate controls over credit risk. (Basel II, 2006) Enterprise View of Credit Risk It is evident that, although responsibility for enterprise risk management lies upon the management team, there is a need for formal bodies such as internal audit and audit committees, which operate on a company-wide basis to enhance data processing procedures within the enterprise. The responsibilities of credit risk managing and implementing a credit policy should not rest on the credit department alone. Senior management and members of the board must also accept the responsibility. Chief executive officers need to be well aware of the current state of affairs, which requires a tight cooperation of the risk management bodies within a company. In addition, they should receive printed summary reports, and should be encouraged to use on-line systems capable of accessing the underlying information, to investigate any specific concerns rapidly and easily. Overall concept of enterprise-wide risk management can be visually illustrated by the chart below

Comprehensive company structure

Enterprise-Wide Risk Management Effective processes and techniques

Qualified Professionals

A most important point in risk management effectiveness is bound to the quality and availability of skilled personnel, since the techniques and managerial operations framework are ultimately executed by the finance specialists, each being responsible for their part of business. A case of fraud or negligence could cancel out the progress of the entire enterprise process, and while no person makes flawless decisions, appropriate motivation and systematic training schemes can substantially cut the number of incidents down. Nevertheless, strict staff selection procedures and high-quality corporate culture standards are of no less importance than the technical aspects of risk management and a large number of financial organisations are constantly looking for new better staff. Strategy, Policy and Business Processes Alignment Developing an orderly business policy is just one side of the coin, the other covers the tricky task of policy adherence monitoring and timely reviewing of underlying principles to keep the company in pace with the technical progress and universal theoretical standards. In order to address this, banks use a variety of methods, some of which include limit checking, credit inspection, predeal checking, global system alignment, education and training. Also pressured by competition and regulators banks are encouraged to support theoretical studies in finance as well as to closely cooperate with regulatory authorities. Active Management of Credit Risk As some of the acknowledged investment banks state, active credit risk management is a fundamental process of proactively measuring, monitoring and managing risk. Indeed, no matter how effectively the risks have been assessed prior to portfolio construction, the course of time, changing market environment and other unforeseen circumstances can render the underlying assests quality inappropriate and demand urget portfolio restructurisation. But prior to realising this fact, a banking firms needs to be monitoring

their internal indicators and portfolion performance in order to spot the threats in time. As soon as the problem is identified, the bank might attempt to resolve through hedging their credit risk exposure by selling, offsetting or insuring unfavourable financial positions through credit derivative tools. Also referred to as active credit risk management, this activity can also mitigate future crisis precedents and deliver strategic financial benefits. (SAS Institute, 2004) Concluding commentary In order to summarise the quality risk management aspects, such as enterprise-wide risk management, contemporary strategies and methodologies and personnel qualification a chart demonstrating economic capital relief by SAS analytics is presented
No change 1% to 10% 11% to 20% 21% to 30% Over 30% 0% 10% 8% 19% 20% 30% 40% 50% 19% 7% 47%

expected reduction of economic capital

On the whole, effective risk management can grant substantial economic advantages, such as reduction of economic capital. According to the survey conducted by SAS agency over 47% percent of responding banks reported expected reduction of capital, with the average improvement of 10%. True, if applied to a large retail bank, this value could result in over a hundred million dollar saving per year. All in all, if deployed correctly and effectively, credit risk management can be a value-enhancing activity that goes beyond regulatory compliance and can provide a competitive advantage to institutions that execute it appropriately. (SAS Institute, 2004)

Obstacles to successful risk management

Issues with data management Consistent, accurate and reliable data forms the base of successful credit risk management. Inability to provide such kind of data can cast dramatic consequences on the course of current and future business prospects. All the banks repeatedly come across numerous problems with data integrity maintenance as the database technologies and risk management techniques constantly advance. Among the most commonly encountered data management issues banks can name data quality and standardization, assembling accurate data with minimum need to reassess the information, the constant need for the centralised client database and concurrency of data generated under multiple systems (Lepus, 2004)

Issues with analytics Analytics issues concern a high proportion of banks, with almost three quarters of surveyed respondents confirming this fact. Complex credit derivatives, portfolio analysis and system-defined dissimilarities, as well as adopting a standardised approach pose only some of the threats to seamless and efficient analyses in banking industry.
13% 13% yes no no comment

74%

Are there any issues with analytics? Introduction of new product lines requires the use of up-to-date methods of analyses, which can only be implemented with the help of dedicated team of specialists, whose task is to assist in new analytic technology utilization. Issues with reporting
25% 38% yes no no comment 38%

Are there any issues with reporting? Accurate and transparent reporting is a prerequisite for good reputation and internal management precision. Main challenges, as stated by many banks, often relate to punctual reporting and consistency of terminology across the board. Some banks complain about the overwhelming number of reports, which result in delays and working behind the schedule. This obstacle could possibly be overcome through consolidating existing reporting systems so that an enterprise-wide reporting tool can be created. Besides, the actual problems of timely reporting are amplified by any existing issues with data, and hence the quality of the coverage of the report can be drastically hindered. In fact the problem can only be addressed by enhancing a financial institutions reporting infrastructure and establishing an enterprise-wide reporting system. Summary

Taking SAS analytics agency experience into account, it looks clear that the obstacles facing finance companies have not changed substantially over the recent years, despite the vast theoretical advances in the field of risk management. Moreover, the same key implementation issues persist on the agenda of the majority of the organisations. A survey conducted by SAS analytics in 2004 clearly illustrates the distribution of the obstacles across the most common factors in terms of importance. (SAS and Risk magazine 2004)
Data and data history Consistency of risk rating approaches across portfolios Requires extra resources and budget Integration of system across departm s ents Core IT infrastructure to support data m anagem requirem ent ents Reporting technology and infrastructure to support Basel II projects operate across departm and across enterprise ent Analytics for calculation of capital charges Disclosure 0% 1% 1% 2% 2% 3% 2% 2% 3% 3% 4% 3% 3% 3% 3% 3% 3%

1= importance 4= no high importance

Potential obstacles to successful im plem entation of credit risk m anagem ent system s

As it has been before, the lack of data remains the number one obstacle, since all financial organisations must hold a minimum of five years counter-party data history. Second obstacle on the list is related to consistency of risk rating approaches across portfolios. As a matter of fact plenty of organizations still lack a systematic and unified approach to calculating probability of default, exposure at default and loss given default across all lines of business and geographical divisions. The next problem faced on the way to success is connected to integration of systems across departments.

Drivers of risk management development

Regulatory framework impact on credit risk management development Regulatory framework dictates the current shape and the direction of risk management development on the scope of the entire industry. Effectively, all of the financial institutions have to settle their business operations in accordance with the legal standards. Observance of the regulatory principles is uniformly compulsory; failure to meet the legal standards might result in penalty sanctions, and in extreme cases can lead to withdrawal of the licence. Introducing Basel II accord

Introduction of Basel II accord has globally reshaped the approach to credit risk management. The new legislation has created additional pressures on the banks due to disciplinary capital charges for operation mishandling, standards violations and unnecessary operational risks. And the new management controls are bound to enforce the observance of legal framework. The impact of new legislation Nevertheless these regulations are intended to improve the risk management procedures from top to bottom of the industry. First of all, Basel II stipulates more detailed disclosures of financial organisations annual reports a major contribution to business transparency. Under this assumption banks must reveal information on its strategies, character of undertaken risks as well as detailed report on the quality of risk management. Secondly, Basel II defines the key elements of credit risk management in banks world-wide, such as more rigid assessment of credit risk tolerance, technically intensive approach towards the counterparties financial position analysis and superior portfolio risk management. Anticipated compliance with Basel II alternative approach options And finally, it is worth noticing, that the new regulatory act implies various degrees of compliance to the managerial requirements within the three distinct levels. Indeed, despite the global nature of Basel II regulations, the actual manner of use and implementation varies across the world regions. For instance, the European Union set the standards of Basel II as default in 2007, with further plans to deploy advanced Internal Ratings-Based (IRB) approach. Whereas only the largest international banks in the United States will be able to use the IRB advanced standards by the beginning of 2009. Accordingly, the chart illustrates the intention to install the new methods within the credit companies across the world
Basel II IRB approach Basel II Standardized approach Not planning to use Basel II methods Other Basel II IRB Foundation approach 0% 5% 11% 10% 15% 20% 25% 30% 35% 40% 20% 18% 24% 36%

How organisations plan to use Basel II

Role of Central Banks and supervisory agencies

While the regulatory framework contains the standards for banking activities, the responsibility to enforce appropriate handling of the principles ultimately lies on the central banks and supervisory agencies. Furthermore, the prerogative to select the fundamental regulatory legislation is originally credited to the central banks. Within the power of their authorities, central banks can set up risk management structure for domestic enterprises and arrange sound legal environment. Typically, government also establishes supervisory bodies, normally collaborating with national banks in attempt to segregate their functions and enhance the overall performance. Altogether central regulator and supervisory authorities are in charge of enforcing key financial parameters conformity, sutastainable financial stability, crises prevention and maintaining business ethics and national reputation. Notable example of supervisory authorities organisation excellence For example, the Bank of England financial stability division works in tight cooperation with HM Treasury and Financial Services Authority (FSA), contributing to the financial stability and theoretical research in the sphere of risk management. For instance, some of the basic functions of these authorities include conducting comprehensive control over credit organisations, detailed monitoring and timely reporting on the key financial indicators as well as issuing various directives addressing public risk management practice. Combined together under the terms of the Memorandum of Understanding, their efforts have consecutively resulted in international attractiveness of UK financial system and worldwide recognition of its competitive welfaring. Role of internal audit and board committee within a company In the highlight of regulatory compliance within a banking firm, the key role to determine, whether it is accomplishing the control objectives stated in business policy and providing sufficient level of disclosure practices, is delegated to such internal bodies as internal audit and Board Committee. It is important to underscore that line management is in charge of identifying risks and developing efficient mitigating techniques, however the responsibility to revise and approve regular risk management performance rests on an independent group, namely internal audit. Finally the progress of both risk management floor and internal audit department are to be reported to the board committee for ratification at least quarterly.In their way, the regulatory organs direct the risk management evolution on the microlevel of the company. However, excessive concentration of managerial, monitoring and regulatory functions in one particular area of the company might lead to fatal concequences, corporate culture abuse and management corruption. Summary on regulatory framework impact In conclusion, the legal framework and regulations carried out by regulatory authorities defines the direction of risk management evolution. Being one of the primary forces driving the development of managerial practices it contributes to national financial stability and global uniformity of risk management standards.

Analyses
Background on the russian banking system

As the matter of fact risk management was limited and mainly conducted on the individual basis, by traders or at best served a supplementary role in strategic management department or treasury before the 1990s. Despite the recent economic progress and decentralisation in financial regulation, this situation is still present in several banks of Russia. In the early 90s, while the first risk management systems were being established, all major types of risks were to be assessed separately and the resulting data was inconsistent. (Banking and systems report - Russian Federation, 2007) The introduction of risk management as of the fundamental technique in the financial sector falls on the mid 1990s, due to a number of trends and events that had dramatically transformed not only the approaches to the risk management process but the financial system on the whole. In particular, among them is the world economy globalization, finance and credit system deregulation, emerging derivatives market, technological breakthroughs in all aspects of objective reality. (Shoichi Kurosaka, 2001) Drivers of risk management development Later on, the rapid growth of financial services volume forced all major Russian banks to revise their risk management approaches. Some of the larger banks have closely approached the international standards of risk management, but the further development is halted by the lack of statistical data in the relatively young financial market. According to the expert rating agency Expert RA research, there are two key factors determining volume and direction of risk management development in Russian banking. The first and the most important factor is due to the ever changing market environment along with newly arising fields of business activities. With the expanding range of business activities, the organisations formerly dedicated to serving the consolidated finance and industrial groups, received the opportunity to become full value financial institutions, which offer a wide range of services to both corporate and individual clients. Having increased the client base and consequently the lending activities, these financial intermediaries were obliged to create adequate risk management systems, especially in the divisions involved in retail and small commercial lending. (http://eng.expert.ru/expertra/) The other crucial factor affecting the makeup of the banking risk management is the upcoming prospects of joining the Basel-II accord by Russia in the nearest future. (http://eng.expert.ru/) All mentioned above refers mainly to the larger Russian banks, whereas the medium and smaller banks still have little motivation to improve their risk management techniques, since their business is not progressing as rapidly as to grant adequate compensation to cover the costs of implementing new systems and the basic compliance with regulatory requirements seems to be sufficient. Besides, small and some of the medium sized banks see little incentive to incorporate costly risk management technologies, as not only might it reduce their profits but also lower level of competitiveness related to other banks, which do not employ sophisticated risk management due to the specific nature of their business; those banks so far rely on the virtue of the often subjective experience based decision making. (http://www.risk-manage.ru/) The leading role of central bank

The role of central bank in bank capital regulation is defined by the Instruction of Central bank of Russian Federation dated 16.01.2004 no.110-I On mandatory banks standards (http://www.cbr.ru/eng/) Zero risk group encompasses financial instruments issued by central banks and governments of highly developed countries or those backed by the securities and collateral of highly developed countries. Low risk financial instruments group consists of obligations in any type of currency issued by government of Russian Federation and other countries with a total level of risk of approximately 0.25 % Medium risk group includes financial liabilities of longer maturity periods, which typically range from 6 to 24 months. The maximum tolerated level of risk for this group is upper limited to 1,00 %. High risk instruments are defined as those of the mid risk group with average maturity period of 24 months and above. These financial obligations have an average 1,60 % risk rate estimate. Very high risk group comprises financial instruments of 8,00 % risk rate which do not meet the criteria of the other groups mentioned in points 1-4.

Current state of financial sphere credit risk exposure The Expert RA rating agency estimates the average level of risks in banking system of Russia as moderate, while the largest proportion of risks is mainly concentrated in credit and lending activities. Logically, this is due to the rapidly developing retail and consumer credit sector. But despite the low level of credit risks and conservative credit policies, the resilience to the external shocks remains doubtful and a streak of bank failures might reoccur following the 2004 crisis of trustworthiness. Unstable condition of interbank lending market and limited amount of borrowing available through the lender of last resort both negatively affect the stability of the banking system on the whole. Lending structure and credit provision expansion opportunities Nearly two thirds of the outstanding credits volume accounts for large industrial organisations funding, nevertheless this sphere has already been shared by the larger banking structures, which form consolidated finance and industrial groups with those enterprises and trace long term relationship bonds behind them. Since the large business lending sector is already claimed banks seek to extend the scope of their operations in the retail, small and medium enterprises lending, and promoting services in the previously unexplored regions. Credit scoring models importance But on the other hand, recent rapid development of retail lending has resulted in the increasing number of overdue and defaulted loans, which raises a growing concern over the core component of the retail risk management, so called scoring models. One of the

major obstacles faced by the retail banking was the general appropriateness of international credit scoring models in the realm of Russian business environment. Obstacles to credit scoring models implementation Basically, the investment behaviour of domestic credit product consumers substantially differs from that of the western borrowers. Secondly, the implementation of the credit scoring models depends on the availability of accumulated statistics databases on various groupings of credit services users. The proper adjustment of the scoring models is currently not attainable given the lack of domestic statistical data, but this goal will come true in the nearest future with the assistance of the credit history bureaus. Credit history bureaus to faciliate credit scoring methods The key element of credit scoring models construction is based on the successfully functioning credit history bureaus, which help accumulate the precious statistics data related to the customer base. But all recent efforts to implement these advanced data processing facilities have been halted by the lack of cooperation of larger banks, who are unwilling to disclose their clients privacy. As a result some of the largest banks set up credit bureaus of their own and are unlikely to share the information with their closest rivals. Small and medium enterprise lending sector Another vacant niche in lending is presented by the small and medium enterprise funding where the demand satisfied only by 15-20%. And the barrier to entering the sector is set by the intransparent nature of small and medium businesses resulting in the unclear view of inherent risks. While one approach is based upon individual analysis of clients like in the case of large enterprises, the other promotes the principles used in the retail level. However neither of the mentioned techniques allow for sustainable accuracy and profitability. Prospects of exploring the regional lending As for the regional lending expansion, many credit managers admit that it is associated with a different type of risks and thus requires adequate approaches and methods. It worth noticing, that the regional lending still remains an unexplored area and might very likely result in losses if attempted without the due preparations. (Risk management in Russian banks, 2006)

Quality of risk management

Core elements of risk management process The classic risk management approach acknowledged universally and approved in Russia involves four stages identification of risk

risk evaluation risk management control and monitoring

At the stage of risk identification the major sources of financial hazards, which could inflict severe losses, are revealed. Risk evaluation stage assumes that through various economic models and expert assessment the total risk exposure and the probability of loss are predicted. Once the major sources of financial threats and potential amount of losses are identified and given an estimate, the counter measures of aversion, mitigation and diversification of risks can be worked out, which generally comprises the process of risk management. Finally, the fourth stage of risk management, known as control and monitoring, is aimed to ensure that all the previous steps instructions are properly accomplished and adhered to and provides overall risk management performance evaluation. Systematic and consistent implementation of these four basic steps recommendations in fact defines the quality of risk management process in a commercial bank. (Lavrushin, 2006) Apart from the above mentioned core risk management process, there are a number of key principles and guidelines based on the international standards. Establishing a risk management strategy A detailed risk management strategy coordinated with the general business strategy of a company is indispensable to any financial institution. On the compulsory basic, this strategy must be documented in the regulating records of the company and enclosed with classification of various types of risks, optimal risk tolerance level and the outline of the credit policy principles, applicable in the various stages of risk management. Adequacy of the organisational structure An adequate organisation structure is the key feature in the course of adequate conducting the credit risk management. Such an appropriate structure should guarantee a distinct responsibility distribution within the company, enabling prompt response to the dynamic environment. Apparently, the target organisational structure effectiveness can only be achieved by means of establishing centralised risk management system throughout the company and its divisions. Any banking organisation should at least have a board member overseeing the risk management process, a division responsible for regulatory and monitoring functions, such as an internal audit department, and a speciallised full time credit risk management body. Principle of joint leadership Joint leadership principle basically involves coordination of the most important decisions with main credit risk departments and the board. Secondly, it implies a strong high-grade corporate culture and responsibilities. Thirdly, in order to ensure the achievement of the set goals various committees may be summoned among the ranks of one organisation. Finally, it is worth noticing that this element of effective management is widely recognised across the world and is often referred as to enterprise-wide risk management.

Separating the conflict of interests It is well known, that any business may be characterized by two opposite characteristics: the return and the risk exposure associated with the current business activity. A rule of thumb suggests that the higher the return the riskier can the operations be. An evident contradiction may arise between the general lending division, whose main agenda is the maximization of profit, and the risk management department with the ultimate task of maintaining business stability set in mind. Therefore a distinct boundary must be set between the opposing goals of the company in favour of long term financial stability over instantaneous profit margin. This technique is also know as setting up the chineese walls, which help segregate the general lending division and the risk management department. Personnel motivation Adopting systems of personnel motivation in the sphere of risk management is by all means harder than in any other divisions capable of generating profits. Nevertheless, this component is extremely important, since the good nature of operations and honesty of the staff directly affects the banking business soundness. No need to mention the amount of damage that could be caused by dishonest practices and corrupt employees, especially in the overall shadowy nature of economy in Russia. The main issue with good performance motivation derives from the vague definition of efficiency in the field of risk mitigation. In the general course of matters the following parameters can be assessed to oversee the risk managers performance Compliance with the internally set operating guidelines requires consideration of estimate level of overdue loans in credit portfolios issued to individuals and corporations a check for following the recommended limits VAR exposure adherence validation All above mentioned principles of credit risk management realisation should be followed Overall effective organisation of credit risk management department in terms of processes execution alongside with effective response system

Bank AKB Avangard case study

In 2006, the bank has kept the pace of steady credit portfolio growth, increasing its total volume by 45 % compared to the previous year. At the same time the rate of bad loans does not exceed the 1,20 % of the total funds lent (http://www.rusrating.ru/ru/ratings) AKB Avangard established in 1994 is a medium-sized private join-stock commercial bank oriented to medium sized corporate and retail customers service, consecutively demonstrating management systems effectiveness and leadership positions in large-scale

leasing and project financing. A head of Avangard-leasing the commercial bank is the core of a large finance and industrial group and a participant of deposit insurance system. While mataining liaisons with international financial institutions, AKB Avangard takes 37 position in the russian banks official ratings and is awarded BB+ credit rating. (http://www.banki.ru/) Range of operations and credit portfolio structure Concerning the structure and composition of credit portfolio, about 25 % of it is concentrated in loans, backed by equipment and machinery collateral. As a part of banks lending policy the most of the funding is allocated to financing current assets of enterprises and capital investments and modernisation in heavy, mineral resource, oil&gas, engineering and defence industries. A recent trend has also reflected an increase in export-import transactions and growing foreign liaisons. Correspondent relations expansion remains one of the priority business strategies and owing to the success in this area the bank managed to double its foreign currency turnover. Currently, the correspondent network counts over 120 international and Commonealth of Independent States (CIS) banks. (http://www.avangard.ru/) Another broad field of activities lies in large scale leasing backed by international banks insurance. According the rating agencies reports, the leasing companies group headed by the Avangard bank is the third largest in Russia with a total of 310 outstanding contracts. Retail sector and credit card development has experienced a significant boost in 2006, which was stimulated by the introduction of new products and wider cooperation with money transfer systems such as western union, resulting in a fivefold increase in amount of consumer loans. The new types of auto purchase loans and vast plastic card campaign also contributed to the expansion. (http://www.bdm.ru/) Risk management strategy in AKB Avangard Risk management acts a crucial role in the general course of running business in AKB Avangard. Among the notable risks faced by banks management team are credit risks, risks of liquidity, interest and market risks. Following the typical feature of negligible operating risks in russian banking practice, the bank does not specify it to any of the groups. As to maintain optimal management performance, the organisational structure of the company is comprised of the Treasury, which serves as the internal monitoring body, a risk management department performing daily risk management operations and the Board committee, empowered to make final decisions. As a means of extra security, credit risk exposure can be assessed with the help external audit company or by the means of peer bank management and then the loan is referred to one of the four risk groups, similar to those defined in Central Bank regulations (http://boss-kadrovik.com.ua/) Zero risk group relatively safe loans that require a total of 1-5 % reserve assignation ratio Moderate risk group, also know as non standard loans, needs 20 % reserve provision ration

High risk group questionable loans might require up to 50 % set aside for reserve provision Despairing loans group with almost no chance of returning the loan, with 100 % compensation provision requirement

Risk classification is based on the throughout examination of the borrowing counterparty financial state indicators and intangible quality facotrs, that is carried out by means of a wide range of domestically and internationally acknowledged approaches in the risk management practice, previously described in the paper. Credit risk minimisation Credit risk minimization is achieved through high standards of prudent lending and corporate responsibility. To ensure that these standards are duly fulfilled, the company employs highly qualified personnel and regularily runs training programs among the staff. As far as executive oversight is concerned, the managing board awareness of the current company state and recent achievements in the industry has continuously led to the stable record of success. Fundamentally, strict adhesion to the regulatory principles set by the Central Bank allows for establishing good reputation of AKB Avangard in the banking community and gaining strengthening public credit. Among the most commonly used risk minimisation techniques in the bank is the provision of collateral, sufficient to cover the losses in case of the counterpartys default or partial inability to meet obligations. Another method relies on regular reserve allocation, based on the particular risk rate of the given loan. And finally the largest risks, for instance those associated with international leasing, can be insured against the default exposure. All in all, the diversification of credit risks among various sectors of economy can prove beneficial to any type of credit organisation. AKB Avangard economic performance overview An overall image of bank performance parameters is demonstrated in the consolidated chart below gives a clear understanding of the main income generating areas of activity, reserve allocation and collateral provison volume and profitability dynamics. Notably, the bank concentrates in customer lending, which generates nearly three quarters of the banks gross income; second in terms of the importance are the foreign exchange and currency trading, providing almost 10 percent of banks receipts; finally commission and fees make up just under a tenth of combined revenues. As for the structure of credit portfolio it is very well diversified across industry sectors with a relatively small segmenent of retail sector of around 2-3 percent. Additionally, AKB Avangard is involved in derivative securities and precious metals trading, which all added together grants it steady financial position and influence potential on the market. (http://www.rbcdaily.ru/)

AKB Avangard financial indicators Total outstanding loan vaule Interest rate income Intrest income on loans to clients Intrest income on loans to banks Intrest income on repo agreements Intrest income on trading securities Inrest rate expenses Resrve provision volume Collateral provision structure Loans, backed by equipment collateral Loans, pledged by property rights Loans, secured by bank bills Loans, backed by commodities Loans, covered by corporate liabilities Other collateral types Loans, secured by mortgage collateral Unsecured loans Net currency exchange income Fees and commission income Operating income Net total profit

total value in 2005 6414791 965189 843394 37689 70333 13773 286349 97346 precent of total 55,9 n/a 5,1 12,3 6,4 4,7 n/a 14,9 122630 110519 840576 71782

total value in 2006 11647766 1222827 1030859 57791 130085 4092 400177 215242 percent of total 25,4 17,1 5,5 14,3 5,8 3,8 2,7 14,9 131307 123255 952632 262511

percent change

percent change 17,1%

2,7%

Although initial banks strategy was based on industrial sector lending, the priority of exploring other industry segments has been indentified and highlighted by the management board. As a head of joint banking group, AKB Avangard leasing division provides extra large in terms of money equipment investment contracts to industrial corporations with the support of largest international banks. Information technology and human resources management Attracting qualified personnel and appropriate further disposition that takes individual potential and specific experience into account lies in the foundation of the commercial joint-stock bank human resource strategy. Along with career advancement, productivity incentive schemes and corporate values culture qualified personnel is the heart and soul of AKB Avangard. Aligned with the banks expansion campaign is the recruitment policy, under which additional 16 % labour force has been attracted in 2006; meanwhile over 15 percent of former management have attended professional training programs in leading domestic centres and abroad.

What concerns the most important contemporary technological aspects, the bank carried on the major directions in internal security and data integrity aspirations. Basically, enhanced performance professional banking industry oriented servers and networks have been installed, new customer service terminals have been introduced; a variety of financial trading and accounting solutions have been implemented, automated customer support centre undergone further modifications (http://bo.bdc.ru/) Information systems and database security have been improved throught the enterprise Accomplished customer information technology services development Expanded further the automated financial modeling packages

Recent achievements and list of success history Among the lastest achievements of the public limited bank is the increasing recognition of bank 'Avangard' brand by foreign and domestic financial instituitions, as the number of the correpsondent banks more than trippled in 2006 and the unsecured credit limits were granted by american, italian and swiss banks. (http://harvardbusinessonline.hbsp.harvard.edu) Moreover, the bank has initiated large scale projects financing along with participating international companies, such as IFC, TUSRIF, OPIC, DEG, EBRD. And recently the short term credit rating of the bank has been improved, acknowledged by international rating agency Fitch at the higher level of B/B-, which is considered stable by international stadards. (http://www.fitchratings.com/) Anticipated improvements and further development direction As seen by the managing board, and senior executives the banks should extend its expansion in retail sector as well as secure the wholesale C&I lending positions. In the view of upcoming transition to international banking regulation standards, internal risk management principles should be optimised along with new credit policy approval to meet the new national requirements of Central Bank. Introduction of the new measures is intended to faciliate credit risk minimization and establish better reputation in banking sphere.

Conclusion
The increasing variety in the types of counterparties, ranging from individuals to sovereign governments, and the ever expanding variety in the forms of obligations, has meant that credit risk management has jumped to the forefront of risk management activities carried out by firms in the financial services industry What emerged from the evening as a whole was the recognition that risk management is fundamental to all aspects of a bank's activities and, done well, can provide a competitive advantage. It is also important to ensure that risk management programmes address the training needs of all staff involved. In addition, the subject is so diverse and open to widely

differing interpretations that a basic risk management framework which everybody understands is an essential pre-requisite for developing appropriate policies and procedures. Nevertheless, it is important to keep in perspective that, however good the system, what really counted was the quality of the risk managers. A better perception of credit risk character can be discovered through reflection of its impact on financial stability Although the credit risk management standards establishment keeps at pace with the European and American counterparts and the general mild risk situation in the economy, the course of practice reveals, that the Central Bank of Russia ultimately is not playing the role of the Lender of Last Resort, especially in the times of major financial crises. In the recent perspective credit risk management reality in russian financial institutions has show an improvement, despite the hardship of crises and gradually reestablishing stability in the past decade.

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