What’s Wrong With Modern Credit Risk Management?

Abstract

This paper explores the processes of provisioning a bank’s allowance for credit losses from the point of statistics and insurance. It is shown the similarity of protection against credit risk by banks and insured risk by insurance companies. It is shown that the banking protection against credit risk implies an implicit hidden insurance contract. An approach has been developed to address this shortcoming. So, to increase the transparency of lending, a borrower and a bank should sign an explicit insurance contract. Such a contract should negotiate a credit premium and an insurance amount. The agreed-upon insurance amount allows dropping the burden on a borrower in a case of its default. The consistent use of the principle “An allowance for expected credit losses should fully cover realized losses within the expected ones” allows also dropping the burden on a bank. As far as, the bank does not bear any additional expenses for the provisioning of allowance in a case of borrowers’ defaults. A bank's capital should cover a part of credit losses that exceed the expected ones. It is considered the influence of fiscal and monetary policies on the systemic level of defaults in the economy.