The Development of Corporate Credit Risk Management in German Banks1

Empirical Evidence

M. Steiner / A. Friesenegger / C. Miehle / A. Rathgeber (October 2007)

Corresponding Author: Dr. Andreas Rathgeber Department of Finance and Banking, School of Business, Augsburg University Universittsstrae 16, D-86159 Augsburg Phone: (0821) 598-4429 Fax: (0821) 598-4223 E-Mail: andreas.rathgeber@wiwi.uni-augsburg.de

Prof. Dr. Manfred Steiner Department of Finance and Banking, School of Business, Augsburg University Universittsstrae 16, D-86159 Augsburg Phone: (0821) 598-4125 Fax: (0821) 598-4223 E-Mail: manfred.steiner@wiwi.uni-augsburg.de Dr. Christian Miehle Department of Finance and Banking, School of Business, Augsburg University Universittsstrae 16, D-86159 Augsburg Alexander Friesenegger Department of Finance and Banking, School of Business, Augsburg University Universittsstrae 16, D-86159 Augsburg

This work was partly sponsored by the German Research Foundation (DFG). Helpful comments from Michael Anklam, Dr. Wolfgang Mader, Dr. Thomas Dittmar, Dr. Jochen Klement, Dr. Nikolaus Starbatty, Dr. Christian Tietze and Dr. Matthias Wagatha are gratefully acknowledged. A special thanks goes to Dr. Christian Willinsky who contributed significantly to the surveys this work is based on.
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Credit Risk Management in German Banks

The Development of Corporate Credit Risk Management in German Banks Empirical Evidence
Abstract On three occasions in the last seven years, standardised questionnaires were sent out to more than 100 German banks of different sectors interviewing them about their current credit risk management systems and their possible future developments. The aim of this survey was firstly to analyse to what extent the modern tools for credit risk are nowadays being used in the banking sector, and secondly to assess the development of the usage of these tools over time. The main result of this survey was that different modern tools are applied in different ways in German banks. Central influencing factors include the size of the banks, the bank sector specifics and the regulatory requirements.

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Executive Summary For a long time credit risk management was less developed than market risk management. In science as well as partly in practise in the last years, modern complex and sophisticated concepts and models were developed to enable adequate measuring and controlling of credit risks as well as to help close the gap between credit and market risk management. On three occasions in the last seven years, standardised questionnaires were sent out to more than 100 German banks of different sectors interviewing them about their current credit risk management systems and their possible future developments. The aim of this survey was firstly to analyse to what extent the modern tools for credit risk are nowadays being used in the banking sector, and secondly to assess the development of the usage of these tools over time. Furthermore, we wanted to find out which factors are influencing this development. The main result of this survey was that different modern tools are applied in different ways in German banks. Central influencing factors include the size of the banks, the bank sector specifics and the regulatory requirements.

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1 Introduction
Credit risk seems to be one of the most important risk types affecting banks (Saunders, and Cornett 2003, p. 142). Promoted by the use of modern information technology systems new credit risk models have been developed mostly by researchers, sometimes by practitioners. Besides, regulating institutions like the Basel Committee, the European Union and the German Regulation Institution BAFIN aim at a more detailed regulation of loans. In the new accord of the Basel Committee, referred to as Basel II, new capital adequacy rules for loans were defined (Basel Committee on Banking Supervision 2006). However, there was the opinion in literature that credit risk measurement systems in banks are less sophisticated than market risk systems (Shimko 1999, p. XIII). This survey was meant to find out how the acceptance of credit risk systems in German has changed in recent years. Different aspects of risk management in German banks have been the main body of many surveys about risk management. Some of the surveys concentrate on regulation (Bigus, and Matzke 2000), some on internal rating systems (Elsas, Ewert, Krahnen, Rudolph, and Weber 1999 and Norden 2002) and others on the usage of financial statement analysis (Meyer 2000). Credit risk management instruments like credit derivatives are often investigated independently of their usage in the credit risk management process (Brtting, Weber, and Heidenreich 2003a and Burghof, Henke, and Schirm 2000a). The following Table 1 shows a review of the different surveys.
Table 1: Review of studies about credit risk management Author (Year of publication) Betsch, Brmmer, Hartmann, and Wittberg (1997) Poppensieker Target population (Time of survey) 106 banks with different sizes (1996) 7 of the 100 Target topic Important results

Credit analysis of corporate customers

Trend to a credit analysis based on systematic data

Market risk measurement

Extendable measurement of

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(1997)

biggest German banks (1996)

concepts and banks global risk management

Elsas, Ewert, Krahnen, Rudolph, and Weber (1999) Weber, Krahnen, and Vossmann (1999)

4 banks (19921997)

Credit risk management

market risk, mainly with the concept of VaR Wide spread use of internal rating systems, seldom CVaR Sometimes market risk management with RAPM Dominance of scoring models Trend to securitization

4 banks (19921997)

Internal rating (part of Elsas, Ewert, Krahnen, Rudolph, and Weber 1999)

Bigus, and Matzke (2000)

100 biggest banks Regulatory capital (1999)

Bcker (2000)

136 public banks (1999)

Credit analysis of corporate customers

Burghof, Henke, 61 banks and Schirm (2000a)2 Gnther, and Grning (2000) 1002 German banks (19961997)

Market for credit derivatives

Bankruptcy prediction models

Meyer (2000)

10 leading German banks (1990 and 2000)

Financial statement analysis

Kirme (2002)

Over 110 banks, Credit derivatives in risk unions and management institutions (2000)

Norden (2002)

12 special banks in Germany (2001)

Internal Rating for regulatory purposes

Existence of a rating momentum Higher migration probability for internal bank ratings than for external bond ratings Loss of importance of financial statement analysis Some usage of internal risk models Subordinated importance of market risk systems No complete usage of all information in credit analysis Insufficient future orientation of the data base Usage of credit derivatives at larger banks High restrictions combined with high potentials Rising usage of multivariate discriminance analysis Nonimportance of neuronal networks Long-term experience in running systems Usage of traditional financial statement analysis in different types Frequent usage of discriminance analysis in 2000 Partial use of expert systems in 2000 Optimistic view on market development Low importance in practise High restrictions, e.g. information asymmetries Rare and different fulfilment of regulatory requirements Existence of more sophisticated rating systems for consumer credits

See also Burghof, Henke, and Schirm (2000b).

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Brtting, Weber, 100 biggest banks and Heidenreich (2002) (2003a and 2003b) Kramer (2005) 34 German Banks

Market for credit derivatives (comparable to Burghof, Henke, and Schirm 2000a) Rating of special customers like start-ups, hospitals or non-profit organisations

Still increasing usage of credit derivatives at large banks Some market restrictions Heterogeneous methods for classification of special customers Need to adjust standard methods Rare usage of external ratings for special customers

All these studies either rely on a small sample of banks or analyse a special part of the credit risk management process in detail with special empirical methods or both. Therefore there is obviously the need to survey the credit risk management process as a whole in a broad study at different points of time. Altogether the following should be pointed out: 1. What is the state of the art of credit risk management in German Banks? 2. Which developments have occurred in the last years? 3. Which factors influenced these developments? To answer these questions we interviewed the 100 biggest German banks, in terms of total assets, in a broad study. The outline of this paper is as follows: In section 2 the structure and design of the study is described. Thereafter the results are presented in section 3 starting with the measurement of expected defaults, followed by unexpected defaults and cost accounting and ending with the managing of credit risks. Section 6 summarises the results.

2 Structure and Design of the Survey

2.1 Credit Risk Management Process as an Object of Survey
The process of credit risk management can be divided into two parts: The measurement of credit risk and the management of credit risk (Saunders, and Cornett 2003, p. 259). On the one hand the measurement involves the identification and quantification of credit

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risk including the estimation of expected defaults as a result of exposure at default, loss given default and default probability (e.g. Ong 1999, p. 94). On the other hand the measurement involves the estimation of unexpected defaults, especially of loan portfolios. In the following the unexpected default is defined as the negative deviation from the expected default. To measure the expected defaults it is common practise in science to classify the loans on an ordinal scale with the help of ratings (e.g. Allen, Boudoukh, and Saunders 2004, p. 124). Footing on the classification in a rating system the rating transition of loans can be computed with a rating migration analysis (Altman 1998, p. 1232). To measure the unexpected defaults the value at risk has been established in the researching community (Saunders, and Cornett 2003, p. 305). It is referred to as credit value at risk (CVaR). Moreover the Basel II approach to calculate the risk weight function is also based on the CVaR methodology (Rose 2002, p. 498). Additionally, credit portfolio models have been further developed during the last years. Furthermore, commercial credit portfolio models were brought to market (e.g. Saunders, and Allen 2002, p. 67). Based on the expected defaults, expected costs can be assigned to loans. This can serve as the basis for the so called default risk expenses (Koch, and MacDonald 2003, p. 672). Besides rating based costing, other traditional cost accounting systems like segment based cost accounting are mentioned in literature (e.g. Saunders, and Cornett 2003, p. 287). The option based cost accounting is one of the latest methods applied in the banking industry. By the application of this method the default probability is estimated and the costs are assigned in one step (Merton 1974, p. 452).

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As regards the management of credit risk, it refers to the buying and selling of credit risks, whereby the former can be done via lending or selling of a credit derivative. The decision can be made to incorporate default risk expenses in the lending rates (e.g. Koch, and MacDonald 2003, p. 682.). The selling of credit risk can be achieved by settling a credit insurance or buying a credit derivative. Furthermore, diversification effects can be realized by selling credit derivatives. Especially in such cases it might be helpful to trade in bundles of credit risk positions or in macro derivatives (Br 2002). In the following the whole credit risk process is analysed in general. However, emphasis is put on areas where the biggest difference between theory and practise could be expected or where the development in theory was fastest, in order to enable us to answer our questions.

2.2 Design of Interviews

To achieve our goals a complete investigation of the German banking sector was not practical. Therefore we decided on a target group of 100 banks out of the whole banking sector. The target group contains the 100 biggest banks as ranked according to their total assets corrected by sector specifics (see Hoppenstedt 1999 and Hoppenstedt 2002 and Hoppenstedt 2005). The reason for selecting the 100 biggest banks was that these banks were expected to have the most complex lending business and data structure. For this matter, our target group most likely applies the new management instruments and techniques which are our object of investigation (Betsch, Brmmer, Hartmann, and Wittberg 1997, p. 150). The ranking of the 100 biggest banks was modified in two ways. Firstly, because we wanted to analyse credit risk management systems in corporate lending, we considered only those banks dealing in the business of corporate lending. We concentrated on

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corporate lending on account that the application of such systems is particularly cost efficient in this sector. Secondly, in order to avoid redundancies we omitted all banks which were real subsidies of investigated banks. Since we wanted to investigate the development as well as the influencing factors, we conducted investigations during the years 2000, 2003 and 2007. In the second and third round one purpose was to have the most similar sample possible compared to the first round. However, in these rounds the sample had to be changed because several banks had merged and did not exist anymore. Furthermore the size of several banks in the original sample had changed, such that some of the banks which belonged to the 100 biggest banks in 2000 did not do so anymore. In the light of these changes we extended the sample to include the 125 biggest banks in round two and three. A slight change in the sample had to be made, because we planned sectoral analysis of the data for the private, the public and the cooperative sector. However, within the top 100 and top 125 banks only a few banks belonged to the cooperative sector. To make sectoral analysis more meaningful, we included the next 12 biggest cooperative banks in our target group in 2003 and the next 7 biggest cooperative banks in 2007. The sectoral quotas of the responding banks are depicted in Figure 1.
Figure 1: Sectoral analysis of the responding banks in 2000, 2003 and 2007
Sectoral quotas 2000 Sectoral quotas 2003
23%

Sectoral quotas 2007

21%

29%

54% 23%

54% 28%

51%

17%

Private Banks

Public Banks

Cooperative Banks

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The questionnaires were sent out in the first round to 103 banks, in the second round to 118 banks and in the third round to 110 banks. In 2000 73 banks responded, which implies a response rate of 71%. In 2003 there were 62 banks thereby implying a response rate of 53%. With 54 banks responding, the response rate in 2007 was 49%. In order to consider differences between banks of different size, the banks have been divided into four groups according to their total assets. Table 2 gives an overview of the size of the responding banks.
Table 2: Size of the responding banks Total assets [bn ] above 50 10 50 5 10 below 5 2000 27% 32% 25% 16% 2003 24% 27% 32% 17% 2007 17% 33% 19% 31%

The questions were mostly answered by members of the departments credit risk management and controlling. Prior to the tests we constructed a questionnaire considering possible answers for openended questions. Therefore we interviewed ten banks. Additionally we collected possible answers of another seven banks (see for the methodology e.g. Dillman 2000) in a pre-test. Hereafter questionnaires were sent out in three rounds. The first round took place in August and September 2000, the second round from May to July 2003 and the third round in August and September 2007. The respondents had to answer 34 entirely closed-ended questions in the first two rounds. In the third round some of the questions had to be omitted because they did not make sense anymore. In most cases this was due to changes in the regulatory framework. Therefore the third questionnaire comprised 29 questions. Because readers followed a navigational path to avoid order effects, the order

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of the answers presented in the following does not correspond to the order in the questionnaire.

3 Measurement of Expected Defaults using Rating Systems

3.1 Completeness and Ability of Classification of Internal Rating Systems
As a prime instrument for measuring expected defaults, rating systems were analysed. The application of rating systems is one of the key methods, which were suggested by the Basel Committee (Basel Committee of Banking Supervision 2006).3 91% of the respondents in the first round reported that in their bank an internal rating system was already implemented. This figure increased in 2003 to 95% and in 2007 to 96%. The performance of a rating system depends on to what extend it is applied to customers and on the ability to classify customers correctly. In regard to the first aspect 71% of all banks categorised generally every customer in their rating systems in 2000.4 This value increased in 2003 to 74% and in 2007 to 84%. Regarding the second aspect an ex post test to assess the ability of a rating system to categorise customers was not practical (see Weber, Krahnen, and Vossmann 1999, p. 127 for small samples and Meyer 2000, p. 2487). Therefore, ex ante rating principles of the rating process were defined, which could be used to asses this feature (Krahnen, and Weber 2001, p. 10). The criteria we used here are the granularity, the up-to-dateness,

See Basel Committee on Banking Supervision (2001a, p. 26) or Basel Committee on Banking Supervision (2006, p. 19). Because the consultative document changed with time, different versions of the document at different survey dates could be relevant. However, in many cases the documents content remained the same, so there is only one version cited.
4

Treacy, and Carey (2000, p. 179) reported in their sample of American corporate and retail banks in 1997 a value of 50% up to 60%.

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the intersubjectivity as well as the staff who takes part in the rating process (see also Basel Committee on Banking Supervision 2006). Since rating systems are assigned by bank staff, human judgement is inevitable in the estimation of immanent credit risk. The responsibility for the rating can either depend on the sales department or on other departments, including the possibility of more than one department being involved in the rating process. In 2000, 83% of the banks responded that their customers were not or not only rated by their sales department.5 This value rose to 93% in 2003 and 91% in 2007.
Figure 2: Completeness and independence of the rating process in 2000, 2003 and 2007
100%

80%

60%

40%

20%

2000

2003

2007

2000

2003

2007

Completeness of the rating system

Public Banks Private Banks

Rating process independent from the sales department

Cooperative Banks Total

It should be noted that if corporate clients are rated correctly at one point in time, risk factors influencing these ratings may change with time. To comply with this change, the companies' ratings must be updated when new company data is published minimum once a year. In 2000 88% of all respondents updated their customers' ratings once in a year or even more often. In 2003 95% had this practise. This figure changed

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insignificantly to 98% in 2007. According to more than 80% in the first two rounds and 73% in the third one, the trigger for rating updates was mostly a new company report. The next criterion was the granularity. The more rating classes there are, the better a differentiation between customers can be achieved. On the other hand few rating classes make the rating process easier (see Altman, and Saunders 1998, p. 1723). Furthermore, in classes with more subjects discrimination might often be more significant. 23% of the banks distinguished between less than 6 classes in 2000.6 These banks had to change their rating classes to fulfil the criteria of Basel II (see Basel Committee on Banking Supervision 2001a, p. 46). In 2003 only 13% had less than 6 classes. This is attributed to the fact that 81% of the banks reported that they had changed the number of grades in their systems. For comparison the number of grades at 56% of the top 50 US-banks was less than 6 in 2000 (Treacy, and Carey 2000, p. 174). When the third round of the survey started, the legal framework had changed and it was no longer suggested to differentiate between at least 6 classes but to do so with at least 8 classes.7 Due to this change in the framework, answers to the question whether a bank differentiated between at least 6 classes would not have been comparable with former results and therefore this question was omitted in the questionnaire in 2007. To guarantee the intersubjectivity of the rating, quantitative information like liquidity or profitability should be considered in the rating process. In 2000 95% of the responding banks based their decisions on quantitative information, all of them did so in 2003 and 98% in 2007.

For comparison, in 40% of the US-banks the primary responsibility lied with the relationship managers (Treacy, and Carey 2000, p. 179).
6 7

The most homogeneity can be viewed in the cooperative sector. See 110 Abs.2 Solvabilittsverordnung (SolvV).

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Figure 3 gives an overview of the rating principles and their fulfilment:

Figure 3: Actuality and intersubjectivity in 2000, 2003 and 2007
100%

80%

60%

40%

20%

2000

2003

2007

2000

2003

2007

Rating updates minimum once a year

Public Banks Private Banks

Usage of financial statement data in the rating process

Cooperative Banks Total

Without differentiating by sectors the criterion usage of quantitative risk factors is nearly fulfilled by all banks. The completeness principle is the least fulfilled criteria. Moreover, the increase of this value during the research period was rather moderate. To test the significance of the results Chi2-Tests were applied. In some cases the expected frequencies were too small to meet the generally accepted conditions postulated by Cochran (1952). In those cases where the Chi2-Test indicated significance of the results but the pre-conditions for the test were not completely fulfilled, an exact test according to Freeman and Halton (1951) was applied.
Table 3: Tests for independence of rating criteria and sectors, bank sizes and development (Significance 1%-Level ***, 5%-Level **, 10%-Level *, P-Value of Freeman-Halton-Test)
Chi-Test for 2000 Rating in general 1.10 Sectors (p-value) [p-value FH] 2003 1.70 2007 2.77 2000 3.49 Bank size (p-value) [p-value FH] 2003 4.34 2007 4.18 1.14 Developments (p-value) [p-value FH]

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Completeness Dependence from sales department Rating updates Number of rating classes Usage of financial statements

5.66* (5.89%) 0.93 0.27 2.33

5.25* (7.23%) [7.84%] 2.83 0.59 0.46

0.40

5.55

12.86*** (0.5%) [0.41%] 1.53 1.05 2.28

2.58

4.26

2.00 2.78 -

3.25 1.88 10.72** (1.33%) [0.43%] 3.00

2.12 2.14 -

4.55 4.51 -

1.10

2.75

2.04

2.81

According to Table 3 the sectoral analysis showed only minor, mostly not significant differences. Only the principle completeness somehow differed among sectors in 2003. By that time, private banks graded their customers more consequently (86%) than banks of the other sectors, especially of the public sector (56%). This is a remarkable result because regarding all other principles the public banks increased their levels more than other sectors during the period between the first two rounds. However, the percentage of public banks grading every customer jumped up to 88% in 2007 and therefore was the same as that for private banks (89%). Altogether, between 2000 and 2007 the percentage of fulfilment increased by 20%. Therefore, in 2007 nearly three quarters of the banks fulfilled all the criteria mentioned so far. The main reason for this development seems to be the regulatory forces.

3.2 Migration Analysis upon Rating Systems

Footing on the rating systems, banks could apply migration analysis. In 2000 every second bank analysed the migration of rating through time. Additional 31% planned the introduction of a migration analysis. In 2003 the picture changed. The vast majority of the banks (61%) used migration analysis. Furthermore, the planners rate remained constant. This development indicated the growing importance of migration analysis for most banks. The result in 2007, however, was remarkable. 89% of the banks reported

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that they used migration analysis, another 4% were planning to do so. Obviously, those banks that had planned to use migration analysis in 2003 had implemented it by 2007. Figure 4 depicts the sectoral analysis.
Figure 4: Migration analysis in 2000, 2003 and 2007
100%

80%

60%

40%

20%

Implemented 2000

Discussed 2000

Implemented 2003

Discussed 2003

Implemented 2007

Discussed 2007

Public Banks Private Banks

Cooperative Banks Total

Migration analysis was used in the public sector more often in 2003. In this sector there was also the highest increase with 20 points. This is attributed to the planning situation. In 2000 more than 30% of all public banks discussed the introduction of the systems in question. In 2007 all pubic banks had such a system. In the other sectors the percentage of migration analysis users remained nearly constant.
Table 4: Tests for independence of migration analysis and sectors, bank sizes and development (Significance 1%-Level ***, 5%-Level **, 10%-Level *, P-Value of Freeman-Halton-Test)
Chi-Test for 2000 Migration Analysis 0.19 Sectors (p-value) [p-value FH] 2003 4.90* (8.61%) 2007 7.48** (2.37%) [0.73%] 2000 7.06* (7.00%) Bank size (p-value) [p-value FH] 2003 3.42 2007 4.10 Developments (p-value) [p-value FH] 19.98*** (0.005%)

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All in all rating migration analysis was much more often used in 2007 than in 2000. The reason can again be found in the Basel Committee's proposals and according to Table 4 sectoral forces (Basel Committee on Banking Supervision 2001a, p. 60).

4 Measurement of Unexpected Defaults using CVaR

4.1 Application of CVaR
For the measurement of the unexpected defaults the CVaR can be used. In 2000 only about one quarter of the banks were using this concept. Further 25% were not using and not planning to use the concept. The remaining 47% planned to introduce CVaR. In 2003 the situation changed. Nearly every second bank (48%) was already using CVaR and further 34% planned to do the same. This shows a rapid growth in use of this methodology, especially when we include former studies like Poppensieker (1997). The author found out that the use of CVaR in 1996 was 2 over 7. In 2007 the percentage of the banks using CVaR had further increased to 76% and another 11% were planning to use it. The total of banks using CVaR or planning to do so remained more or less on the same level (82% versus 87%), allowing for the conclusion that the majority of those banks planning to use the concept in 2003 did use it in 2007. Table 5 depicts the use of CVaR in banks of different sizes:
Table 5: Use of CVaR in 2000, 2003 and 2007 2000 Balance sheet [bn ] above 50 10 50 5 10 below 5 average Usage 37% 38% 17% 9% 26% Plan 58% 33% 50% 45% 47% Usage 53% 60% 45% 27% 48% 2003 Plan 33% 20% 40% 45% 34% Usage 78% 82% 80% 63% 76% 2007 Plan 0% 6% 20% 19% 11%

In 2000 the bigger banks applied the CVaR-concept more often. The growth rate of the use of the concept was about 20% in all classes, which indicates a growing percentage

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of use in all classes. Although especially the bigger banks used the CVaR-concept, the difference in general decreased.

4.2 Factors for Calculating CVaR

To calculate the CVaR of a credit portfolio it is possible either to calculate the deviations of the expected default probability or after having assigned a market value to each loan, the CVaR can be computed by measuring the deviation of the value of the credit portfolio (Saunders, and Cornett 2003, p. 305). When using the first approach the so called default frequency based CVaR is defined as the maximum loss of defaults which is not exceeded with a certain probability within a fixed time interval. The so called loan value based CVaR refers to the maximum loss based on changes of market value. The applied CVaR concept determines the complexity of the measurement concept and the potential use of so called commercial credit models (see Bluhm, Overbeck, and Wagner 2003, p. 66). For instance in the case of loan value based CVaR data on credit spread movements in relation to credit quality change is inevitable. In 2000 90% of the banks, which already used the CVaR concept, reported that they applied a default frequency based concept. Furthermore, among the banks which planned to introduce the CVaR, a majority of 62% wanted to use a default oriented CVaR. This implies that most banks understand the CVaR as default frequency based CVaR. Therefore, it is no wonder that in 2003 79% of all CVaR users and planners had a default frequency based concept. Four years later in 2007, this proportion decreased to 75%. Thus the conclusion can be drawn that there is a light tendency to the more sophisticated loan value based CVaR.

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In this light it pays to take a closer look at the sectoral analysis of the CVaR-concept. If one concentrates on the banks which are using or planning to use the CVaR, there are big differences between the banking sectors as depicted in Figure 5:
Figure 5: Default oriented CVaR in 2000, 2003 and 2007
100% 80% 60% 40% 20%

Public Banks

Cooperative Banks 2000 2003

Private Banks 2007

Total

From 2000 to 2003, the number of banks with default frequency based CVaR was increasing in the private and cooperative sector while in the public sector fewer banks used this concept. There was a significant difference between sectors in 2003 regarding the use of the default frequency based CVaR as depicted in Table 6. As the number of banks using this concept slightly increased until 2007 in the public sector and decreased in the private and cooperative sector, the difference between sectors was still noticeable but no longer significant in 2007. The overall use of the default frequency based CVaR was rather constant in the period under consideration, though slightly decreasing.
Table 6: Tests for independence of CVaR and sectors, bank sizes and development (Significance 1%-Level ***, 5%-Level **, 10%-Level *, P-Value of Freeman-Halton-Test)
Chi-Test for 2000 Use of CVaR 3.18 Sectors (p-value) [p-value FH] 2003 4.03 2007 1.20 2000 6.81* (7.84%) [8.78%] Bank size (p-value) [p-value FH] 2003 4.66 2007 1.99 30.01*** Developments (p-value) [p-value FH]

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CVaR-concept

3.01

7.18** (2.75%) [1.79%]

3.36

3.19

5.74

3.29

0.94

Especially public banks (34%) applied a loan value based concept in 2007, which is a remarkable increase in relation to 2000. Compared with the result in 2003, private and cooperative banks used this concept a bit more often in 2007 but still considerably less than public banks. The reason for these big differences can be found in the bank policy. As it seems, commercial products are often bought for a whole sector.

5 Default Risk Expenses

5.1 Use of Cost Accounting Systems
After the quantification of the expected defaults banks compute default risk expenses (see also Basel Committee on Banking Supervision 2001b, p. 48 which defines it as one of its goals). One third of the banks which responded to our questionnaire computed their expenses in 2000. Additional 51% planned to do the same. In 2003 the situation changed dramatically with the number of banks calculating risk expenses rising to 82%. Further 11% planned to do so until 2007. That means nearly all banks which planned to introduce an accounting system fulfilled their plans in the period from 2000 to 2003. Secondly, all banks which rated their corporate customers also computed their expenses. However, in 2007 the situation remained more or less unchanged with 85% calculating risk expenses and another 8% with such plans. It is not sure whether all the banks that had planned to calculate risk expenses by 2007 actually realized their plans but the proportion of the banks that calculate risk expenses is still growing. There is an interesting result regarding the dependence of bank size and cost accounting especially when this relation is regarded over time, which is demonstrated in Table 7.
Table 7: Accounting of default risk expenses depending on bank size 2000 2003 2007

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Total assets [bn ] above 50 10 50 5 10 below 5 average

Usage 68% 33% 17% 0% 33%

Plan 32% 46% 61% 73% 51%

Usage 100% 81% 80% 64% 82%

Plan 0% 13% 15% 18% 11%

Usage 100% 88% 89% 63% 85%

Plan 0% 6% 11% 19% 8%

In 2000 there was a remarkable correlation between bank size and cost accounting system (see also Table 8). Especially among the group with total assets of 50 bn or more, 68% had a system in place. Contrarily, in the group with total assets of less than 5 bn no bank used such a system. In 2003 the correlation fell. However, there was still a tendency: In the group of the biggest banks all had a cost accounting system, as in the group of the smallest banks 64%. The situation in 2007 was almost the same as in 2003. Among the banks of large or medium size the number of those calculating risk expenses is still growing. It is particularly noticeable that after a remarkable increase from 2000 to 2003 the proportion of small banks that calculate risk expenses remained nearly unchanged in 2007.

5.2 Methods for Calculating Expenses - Option Pricing Theory

There are different methodologies for cost accounting, which are systematised depending on their source and the use of data for calculating defaults. Beside the direct use of market data like credit spreads, methodologies basing on historical default data are often found in literature (e.g. Saunders, and Cornett 2003, p. 281). In 2003 market data based methodologies were hardly applied. 71% of all banks computed their default risk expenses basing on historical default frequencies. This did not change in 2007 with a large majority of 79% using this methodology. Nowadays option based systems are more and more under review. In 2000 only 6% of all banks were using option based pricing models. Additional 12% were planning to introduce such models. This figure rose to 11% in 2003. Further 9% planned the

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introduction of such models. Hereby the so called Merton-model was mostly used. Further developments like the Longstaff/Schwartz-model are only applied in rare cases (see e.g. Cossin 1997). However, in 2007 only 8% of the banks were using option based pricing models and another 6% were planning to do so. These complex models were hardly applied in the period under consideration and there seems to be no significant trend that this will change in the near future.
Table 8: Independence of cost accounting / option pricing and sectors, bank sizes and development (Significance 1%-Level ***, 5%-Level **, 10%-Level *, P-Value of Freeman-Halton-Test)
Chi-Test for 2000 Cost accounting systems Option Pricing Models 2.63 Sectors (p-value) [p-value FH] 2003 4.39 2007 7.34** (2.55%) [1.78%] 1.48 2000 14.33*** (0.25%) [0.19%] 12.03*** (0.73%) [1.32%] Bank size (p-value) [p-value FH] 2003 4.09 2007 4.94 7.34** (2.55%) Developments (p-value) [p-value FH]

4.16

4.06

3.96

3.97

1.21

It is noticeable that in 2000 these models were significantly more often applied in banks with total assets of more than 50 bn . In the meantime 8% of the banks with total assets of more than 10 bn but less than 50 bn were using these models. However, in the group of the biggest banks 33% were using option based pricing models, which is according to Table 8 significantly more. Although the total of banks using option based pricing models decreased from 2003 to 2007, it can still be observed that these models are used noticeably more often by those banks with total assets of more than 50 bn (25%) while smaller banks hardly do so (5%). This can probably be attributed to the high complexity of these models (Saunders, and Cornett 2003, p. 297). All in all, cost accounting systems in general have become important for most banks over the last few years while option pricing models are hardly used, nor is there a significant trend that this will change in the near future.

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6 Control of Credit Risks

6.1 Lending Rates Incorporating Default Risk Expenses
Having discussed the measurement of risk, the next step is to consider the control of risk. In order to control risk, the first move when issuing credits is to risk adjust the lending rates. This implies that riskier borrowers pay more interest and vice versa. In fact, in 2000 83% of all banks which computed default risk expenses set their conditions risk adjusted. In a pre-test in 1999 the result was completely different. At that time banks responded that the high competition prevented them from charging directly for default risks. In 2000 this figure fell to 4%. In 2003 slightly more, namely 86% of the banks which computed credit risk expenses, set their lending rates risk adjusted. The remaining 14% planned to do the same. Including the increase in banks which used cost accounting systems, the unconditional value of such banks rose enormously. Regarding risk adjusted pricing, the situation in 2007 did not change dramatically compared to 2003. Again, 86% of the banks computing risk expenses set their rates risk adjusted. A minority of 4% was of the opinion that this was not feasible for competitive reasons. Furthermore, the reasons for these customer policy changes are interesting. Differentiating the results in bank groups of different size, the following results are obtained:
Table 9: Risk adjusted lending rates for different bank sizes 2000 Balance sheet [bn ] above 50 10 50 5 10 below 5 average Usage 92% 78% 50% 83% Plan 0% 22% 50% 13% Usage 87% 85% 81% 100% 86% 2003 Plan 13% 15% 19% 0% 14% Usage 82% 88% 100% 77% 86% 2007 Plan 9% 6% 0% 15% 10%

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As depicted in Table 9, in 2000 risk adjusted lending rates were only found in the group of the big banks, which is a significant dependence between bank size and lending rates.
Table 10: Tests for risk adjusted lending rates in banks of different size and sectors (Significance 1%-Level ***, 5%-Level **, 10%-Level *, P-Value of Freeman-Halton-Test)
Chi-Test for 2000 Lending Rates 0.12 Sectors (p-value) [p-value FH] 2003 0.32 2007 4.08 2000 18.43*** (0.04%) [0.02%] Bank size (p-value) [p-value FH] 2003 3.55 2007 5.85 17.31*** (0.06%) Developments (p-value) [p-value FH]

A reason for this could be sought in the customer structure of these big banks. With lower entrance barriers to the German capital market these customers got the possibility to raise capital in these markets, where rates respectively credit spreads are automatically risk adjusted (see Reading, and Lam 1993, p. 574.). Especially high rated customers exploited this situation and the affected banks had to react. If we abstract from the group of the smallest banks, in 2003 risk adjusted lending rates were standard in over 80% throughout all classes. The reason for this sharp increase can be found in the goals of Basel II, which supports risk adjusted lending rates (Basel Committee on Banking Supervision 2001b, p. 48.). In 2007, the picture was basically unaltered. Most banks adjusted their lending rates to the specific risk, irrespective of the banks size.

6.2 Use of Credit Derivatives

A possibility of growing importance for controlling credit risk is the use of credit derivatives. In 2000 only 19% of the banks answered that they were already optimising their credit portfolios using credit derivatives. Moreover, every second bank planned to do the same. This result is in line with the result found by Kirme (2002, p. 312). Nevertheless, about a quarter of the banks wanted to completely avoid the use of such instruments. In 2003 24% controlled their credit risk using credit derivatives. 36%

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planned to use this instrument. On the other hand the number of avoiders also grew. Four years later, 38% of the banks used credit derivatives to control credit risk and 15% are still planning to do so. The number of those refusing the use of this instrument did not change perceptibly. According to Table 11 the use of credit derivatives is largely determined by the banks size.8
Table 11: Application of credit derivatives depending on bank size 2000 Total assets [bn ] above 50 10 50 5 10 below 5 average Usage 32% 13% 12% 20% 19% Plan 63% 50% 53% 45% 54% Usage 40% 44% 10% 0% 24% 2003 Plan 40% 19% 40% 46% 36% Usage 67% 41% 20% 31% 38% 2007 Plan 11% 29% 20% 0% 15%

Among the banks with total assets of more than 50 bn the use of credit derivatives rose from 32% to 67% and in the group lower than 50 bn from 13% to 41%. Among the smaller banks, controlling credit risk via credit derivatives was less popular in 2000 than it was in 2007. This relation is in line with Burghof, Henke, and Schirm (2000a, p. 536) and Brtting, Weber, and Heidenreich (2003a, p. 758), who analysed trading in credit derivatives in general. Nevertheless, it is surprising that among the banks with total assets of less than 5 bn none used credit derivatives in 2003. However, since there were only a few responses to this question, the result has to be taken with a pinch of salt.
Table 12: Tests for independence of credit derivatives and sectors, bank sizes and development (Significance 1%-Level ***, 5%-Level **, 10%-Level *, P-Value of Freeman-Halton-Test)
Chi-Test for 2000 Sectors (p-value) [p-value FH] 2003 2007 2000 Bank size (p-value) [p-value FH] 2003 2007 Developments (p-value) [p-value FH]

An analysis of groups showed smaller significances.

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Credit derivatives

2.35

9.56*** (0.84%)

0.24

2.96

11.02** (1.16%) [0.85%]

4.87

5.72

The difference in the use of credit derivatives was significantly dependent on the bank size in 2003 (see Table 12). It seems that bigger banks used credit derivatives earlier and more commonly than smaller ones. In 2007, this dependency was still noticeable but insignificant as shown in Table 11. Accordingly, among the group of the biggest banks 67% applied credit derivatives and another 11% planned to do so by 2010. If these plans are realised, about 80% of the banks with total assets of more than 50 bn will be controlling their credit risk using derivatives; quite a high figure compared to smaller banks with 30% to 40% of users and planners. The reason probably is the high volumes in which derivatives are traded (see Rose 2002, p. 295). Another point may be that up to now there are no standard models which could be applied to price and hedge credit derivatives. Looking at the more sophisticated market oriented CVaR, it can be observed that in 2003 95% of all applicants controlled their credit risk using credit derivatives (for the application see Bluhm, Overbeck, and Wagner 2003, p. 211). In 2007 this figure decreased to 73%, however, this is still remarkably more than the average. Altogether the use of credit derivatives seems to depend on the size of the bank as well as its know how in measuring credit risk.

7 Summary and Outlook

In a study conducted in 2000, 2003 and 2007, more than 100 German banks from different sectors were sent questionnaires with standardised questions concerning their credit risk management. The goal of this study was to evaluate the use, the historical

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developments as well as the major drivers of innovations in the credit risk management systems. In this work different elements of the credit risk management process were analysed with a focus on the measurement and the management of credit risks. As regards in the measurement of expected defaults only a relatively slow growth was observed starting at a high level. This coincides with relatively low dynamic in science in account to the analysis of the classification and discrimination methods in the 1970ties. Contrarily the application frequency of CVaR has sharply increased. In this field, rapid growth of new theoretical models can be constated. Looking at the cost accounting systems, a huge difference between the currently used methods and the option pricing methods favoured by the science community can be observed. In controlling credit risk, risk adjusted lending rates are increasingly applied, especially by banks of medium size. A remarkable growth can be observed in the use of credit derivatives. This trend is generally attributed to the application in banks with total assets higher than 10 bn . All in all, we observed a distinguished picture of the new credit risk systems applied in banks. Depending on the instrument in question, either a sharp increase or a stagnation can be observed. The size of the banks and specifics of the banking sector are factors that determine these growth rates. Besides, changes in the regulatory framework are apparently a driving force of the recent developments. However, it seems that legal obligation is not the only driver. Market forces appear to play an important role as well. This becomes obvious when considering the use of CVaR or risk adjusted lending rates. These concepts have become very popular over the last years although there is currently no legal obligation to apply CVaR or risk adjusted lending rates.

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8 References
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