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Credit Risk ManagementCredit Risk Management
Enhancing Your Steady ProfitabilityEnhancing Your Steady Profitability
Dr. Bin ZhouSchool of Finance and StatisticsEast China Normal University
bzhou@stat.ecnu.edu.cn
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Credit risk case study in a Chinese bankCredit risk case study in a Chinese bank
Credit Risk Management Research
Agenda
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Credit risk case study in a Chinese bankCredit risk case study in a Chinese bank
To explore the characteristics and causes of credit risk in ChinTo explore the characteristics and causes of credit risk in Chineseese
commercial banks, analysis is made of 800 million RMB bad debts,commercial banks, analysis is made of 800 million RMB bad debts,which are written off between 1998 and 2005 in statewhich are written off between 1998 and 2005 in state--ownedowned
commercial banks in a Chinese city.commercial banks in a Chinese city.
Given the specific financial background in China, studies are caGiven the specific financial background in China, studies are carriedrried
out in the field of the causes of credit risk which can be classout in the field of the causes of credit risk which can be classifiedified
into 3 categories:into 3 categories:
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Enterprise operation: operation and management, techniques, fundEnterprise operation: operation and management, techniques, fund,,brand, credibility and so on.brand, credibility and so on.
Bank management: investigation in specific enterprises before loBank management: investigation in specific enterprises before loansans
are granted, management of loans after grant, bank structures.are granted, management of loans after grant, bank structures.
External factors: government intervention, market volatility, crExternal factors: government intervention, market volatility, crediteditenvironment, force majeure.environment, force majeure.
Factor analysis shows that government intervention, enterpriseFactor analysis shows that government intervention, enterprisemanagement and bank structures, market volatility are main factomanagement and bank structures, market volatility are main factorsrs
responsible for 368 doubtful debts being written off as bad debtresponsible for 368 doubtful debts being written off as bad debts.s.
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f und
6%
cr edi bi l i t y
11%
t echni ques
9%
poor oper at i on
and management
20%l oans management
af t er gr ant ed4%
i nvest i gat i on,
exami nat i on and
appr oval by banks
5%
poor bank
st r uct ur e
12%
mar ket vol at i l i t y
13%
gover nmenti nt er vent i on
20%
Credit risk factor analysis
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It is necessary to establish an allIt is necessary to establish an all--dimensional evaluation systemdimensional evaluation system
as the current system focuses too much on financial indicators.as the current system focuses too much on financial indicators.
The system should include the following 4 modules:The system should include the following 4 modules:
1. Business performance evaluation:1. Business performance evaluation: Based on the dataBased on the dataprovided by annual financial statements, the evaluation ratiosprovided by annual financial statements, the evaluation ratios areare
calculated which represent the repaying capacity, assetscalculated which represent the repaying capacity, assets
operation and development as well as financial performance ofoperation and development as well as financial performance of
enterprises. By making good use of these ratios, we carry outenterprises. By making good use of these ratios, we carry out
comprehensive evaluation of enterprises. Thus financial analysiscomprehensive evaluation of enterprises. Thus financial analysis isis
improved and the development edge of enterprises is valued inimproved and the development edge of enterprises is valued in
quantified terms.quantified terms.
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2. Individual industry risk:2. Individual industry risk: The current credit evaluation systemThe current credit evaluation system
does not take industry risk into consideration, though in a markdoes not take industry risk into consideration, though in a marketet
economy, the rise and fall of an industry has a direct bearing oeconomy, the rise and fall of an industry has a direct bearing onn
the prospects of enterprises within the industry and helps shapethe prospects of enterprises within the industry and helps shapethe development of enterprises in related industries. The rise athe development of enterprises in related industries. The rise andnd
fall of an industry has increasingly become an important index ofall of an industry has increasingly become an important index off
macro economy, acting as a significant guide for investmentmacro economy, acting as a significant guide for investment
decision and credit allocation. As for the Chinese market economdecision and credit allocation. As for the Chinese market economy,y,
characterized by evident cyclical macrocharacterized by evident cyclical macro--controlcontrolthe economythe economy
waxes and wanes not only with market conditions but also withwaxes and wanes not only with market conditions but also with
government policies. The prospects of industries are neithergovernment policies. The prospects of industries are neither
deterministic nor predictabledeterministic nor predictablewhich has a direct impact on thewhich has a direct impact on the
safety of loans granted by banks.safety of loans granted by banks.
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3.3. Government risk evaluationGovernment risk evaluationgovernment intervention is a major cause ofgovernment intervention is a major cause of
bad loans in Chinese commercial banks,bad loans in Chinese commercial banks, and local government policies andand local government policies and
actions should be taken into account during the process of crediactions should be taken into account during the process of credit risk evaluation.t risk evaluation.Case studies show that local government intervenes strongly duriCase studies show that local government intervenes strongly during the wholeng the whole
process of credit even in the dealing of bad loans.process of credit even in the dealing of bad loans.
Making use of their administrative power, governments clamp downMaking use of their administrative power, governments clamp down on bankson banks
to grant credit to particular projectsto grant credit to particular projects
Governments appropriate credit and change the destination of itGovernments appropriate credit and change the destination of it
Governments transfer credit assets and avoid paying debts in theGovernments transfer credit assets and avoid paying debts in the name ofname ofreorganization, merger and bankruptcy;reorganization, merger and bankruptcy;
GovernmentsGovernments establish barriers when banks chase debts and attempt to dealestablish barriers when banks chase debts and attempt to deal
with collateral legally.with collateral legally.
4.Enterprise moral risk evaluation4.Enterprise moral risk evaluation: evaluating creditability by examining an: evaluating creditability by examining an
enterpriseenterprises performance in tax obligations, complying with contracts,s performance in tax obligations, complying with contracts,
presenting statements faithfully and paying debts on time .presenting statements faithfully and paying debts on time .
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Multidimensional credit risk evaluation system
frame diagram
Business performance evaluationBusiness performance evaluation
Individual industry riskIndividual industry risk
Government risk evaluationGovernment risk evaluation
No-risk
Low-risk
moderate-risk
Moderate-high-risk
High-risk
..Enterprise moral riskEnterprise moral risk
evaluationevaluation
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Companies are exposed to significant levels of credit risk emanaCompanies are exposed to significant levels of credit risk emanating fromting from
different sourcesdifferent sources
Accounts ReceivablesAccounts Receivables
Other Notes ReceivablesOther Notes Receivables
Buyer and Franchise FinancingBuyer and Franchise Financing
With Recourse FinancingWith Recourse Financing
Project FinanceProject Finance
Structured TransactionsStructured Transactions
Leases with RecourseLeases with Recourse
Derivatives ExposuresDerivatives Exposures
FX, Interest Rate Risk, Commodities etc.FX, Interest Rate Risk, Commodities etc.
Collateral RiskCollateral Risk
Parent or Third Party GuaranteesParent or Third Party Guarantees
Commercial and Standby Letters of CreditCommercial and Standby Letters of Credit
Note also that Critical Suppliers to the company may pose specifNote also that Critical Suppliers to the company may pose specific creditic credit
riskrisk
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Credit Risk Management Research
Credit Risk Background
An uncertain and volatile economic environmentAn uncertain and volatile economic environmentsignificantly impacts this abilitysignificantly impacts this ability
The desire for growth and for producing outstandingThe desire for growth and for producing outstandingresults has a tendency to put pressure on the checksresults has a tendency to put pressure on the checks
and balances within the businessesand balances within the businesses
Thorough identification and accurate measurement ofThorough identification and accurate measurement ofcredit risk, supported by strong risk management cancredit risk, supported by strong risk management can
help improve the bottom linehelp improve the bottom line
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Each financial product has different credit riskEach financial product has different credit risk
characteristicscharacteristics
-- CreditorCreditors right (loans, finance and option)s right (loans, finance and option)-- Credit (Credit (Swaps,forwardsSwaps,forwards))
Risk Exposure, Default Correlation andRisk Exposure, Default Correlation andrecovery rates differs from each other,recovery rates differs from each other,
especially in a portfolio. Default correlationespecially in a portfolio. Default correlation
must be considered. Default correlation andmust be considered. Default correlation andrecovery rate may also correlate with riskrecovery rate may also correlate with risk
exposure.exposure.
Assess the complexity of credit risk
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Credit Policies
& Procedures
Analysis &Risk
Management
Governance, Controland Implementation
Measurement
MethodologiesTechnology &Data Integrity
Credit Strategy
& RiskTolerance
A complete and coherent risk managementA complete and coherent risk managementframework contains the following elementsframework contains the following elements
Reassessment
Credit Strategy & Risk Tolerance
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Saleschannels
Contracts &Documentation
Creditanalysis
Credit limitPricing &terms
Credit Analysis
CreditDecisions
Collections
CREDIT POLICY
Collateralacceptance
Portfoliomanagement
Financialanalysis
Disposal /Risk
mitigation
Collateralmanagement
Customermanagement
Exposuremeasurement
Managementreporting
Exposureaggregation
Recoveries
Creditscoring
Risk rating
RISK MANAGEMENT
Credit Risk Managements Inter-related Activities
Compliance
Origination
Reporting
Transactions
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Credit Risk Areas to ConsiderCredit Risk Areas to Consider
Credit PolicyCredit Policy Credit ApprovalCredit Approval
AuthorityAuthority
Limit SettingLimit Setting
Pricing TermsPricing Termsand Conditionsand Conditions
Documentation:Documentation:Contracts andContracts and
CovenantsCovenants
Collateral andCollateral andSecuritySecurity
Collections,Collections,DelinquenciesDelinquencies
and Workoutsand Workouts
ExposureExposureManagementManagement AggregationAggregation ControlControl
Periodic AccountPeriodic Account
ReviewsReviews Payments/Payments/AgeingAgeing
Credit ConditionCredit Condition
Compliance withCompliance withCovenants, TermsCovenants, Terms
Technology/ReportsTechnology/Reports Transactions/Transactions/
BookingsBookings RiskRisk--adjustedadjusted
ReturnReturn
SalesSalesChannelsChannels
Risk StrategyRisk Strategy
UnderwritingUnderwriting
StandardsStandards
CreditCreditApplicationApplication
AnalysisAnalysis
Business/Business/IndustryIndustry
FinancialFinancial
CreditCredit
CreditCredit
Scoring andScoring andRatingsRatings
Origination/
AssessmentAdministration Monitoring/
Control
RiskManagement
PortfolioPortfolioManagementManagement
ConcentrationConcentration
DiversificationDiversification
AllowanceAllowancefor Badfor BadDebtsDebts
RiskRiskMitigationMitigation
ObjectivesObjectives
Type ofType ofExposureExposure
Instruments orInstruments orMethodsMethods
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Credit Strategy & Risk ToleranceCredit Strategy & Risk Tolerance
Specific Quantifiable Objectives
Management ReviewMethodology
Credit Objectivesand Risk
TolerancesCredit Policies
Credit RiskManagementProcesses
Improve Profitability
Reporting
Credit
Str
ategy/Plan
Commo
n
Performance
Metrics
Credit Strategy Statement andRisk Tolerance
Coordination with BusinessPlan
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Foundation: Credit Rating and Underwriting StandardsFoundation: Credit Rating and Underwriting Standards
Risk Identification, Origination, Credit Administration, etc.
Short Term: Managing Expected LossShort Term: Managing Expected Loss
Risk Identification, Transaction
Structuring, Approval & Pricing Decisions, Reserving, etc.
Near Term: Managing Economic Capital / Credit VaRNear Term: Managing Economic Capital / Credit VaR
Portfolio Risk Concentration, Risk Based Limits, etc.
Vision:Vision: Managing Risk/ReturnManaging Risk/Return
Pricing decisions, Performance measurement,
business and customer segmentation,
compensation, etc.
A business model view of Credit Risk Infrastructurecomponents
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Businesses have to contend with Expected andBusinesses have to contend with Expected and
Unexpected LossesUnexpected Losses
Expected LossesExpected Losses AnticipatedAnticipated
Cost of doing businessCost of doing business
Charged to provisionsCharged to provisions
Captured in pricingCaptured in pricing Relatively easier toRelatively easier to
measuremeasure
Assessing expected lossAssessing expected lossincludes determining exposure,includes determining exposure,
default probability anddefault probability and
severityseverity
Unexpected LossesUnexpected Losses
Unanticipated butUnanticipated but
inevitableinevitable
Must be planned forMust be planned for
Covered by reservesCovered by reserves
Allocated to businessesAllocated to businesses
Difficult to measureDifficult to measure
Assessing unexpected lossAssessing unexpected lossrequires making qualitativerequires making qualitative
judgments around potentialjudgments around potential
volatility of average lossesvolatility of average losses
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Data Issue in Credit Risk Analysis Historical Data, e.g. financial data, creditHistorical Data, e.g. financial data, credit
ratings.ratings.
Market Data, e.g. Price of corporate securities,Market Data, e.g. Price of corporate securities,
stock price and price of credit derivativesstock price and price of credit derivatives
At present, data availability quality is the majorAt present, data availability quality is the major
problem in credit risk management.problem in credit risk management.
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55 Cs:Cs:
11CharacterCharacter
22CapacityCapacity
33CapitalCapital
44CollateralCollateral
55ConditionCondition
The classic credit risk management
methodology
5 Ws5 Ws
11WhoWho
22WhyWhy
33WhenWhen
44WhatWhat
55HowHow
5 Ps5 Ps
11PersonalPersonal
22PurposePurpose
33PaymentPayment
44ProtectionProtection
55PerspectivePerspective
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Credit rating system, all individual borrowers (debtors?) have tCredit rating system, all individual borrowers (debtors?) have theirheir
own credit rating, which partially determines their asset priceown credit rating, which partially determines their asset price andand
discount rate.discount rate.
The borrowers (debtors?) with the same credit rating should haveThe borrowers (debtors?) with the same credit rating should have
the same migration and default possibility.the same migration and default possibility. Movement in assetMovement in asset--return is caused by both systematic risk andreturn is caused by both systematic risk and
individual risk (?) (individual credit risk for each debtor). Syindividual risk (?) (individual credit risk for each debtor). Systematicstematic
risks are reflected in country and industry index, individual derisks are reflected in country and industry index, individual debtorbtorss
stock earning ratio should be similar their asset return .stock earning ratio should be similar their asset return .
Spot and forward interest rate is normally fixed, hence the modeSpot and forward interest rate is normally fixed, hence the model isl is
not sensitive to the interest rate movement.not sensitive to the interest rate movement.
Basic assumptions used in Credit Risk
Management methodologies
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Classic methodClassic method Based on historical dataBased on historical data
Uses traditional statisticalUses traditional statistical
modelsmodels
Modern methodModern method Based on the movementBased on the movement
in market variables, e.g.in market variables, e.g.
Asset, Share Price,Asset, Share Price,Interest Rate and ForeignInterest Rate and Foreign
Exchange RateExchange Rate
Uses Contingent ClaimUses Contingent Claimpricing modelpricing model
Comparison between classic and moderncredit analysis methodology
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Classic methodsClassic methods SetSet--up credit limitup credit limit
Establish credit ratingEstablish credit rating
systemsystem
Adopt credit improvementAdopt credit improvement
tools (Collateral, thirdtools (Collateral, third
party guarantee, Creditparty guarantee, Credit
Agreement)Agreement)
Modern methodsModern methods Credit rating on riskCredit rating on risk
exposureexposure
Active use of creditActive use of credit
derivatives to migrate orderivatives to migrate or
diversify riskdiversify risk
Comparison between classic and moderncredit risk management methodologies
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Credit derivatives can be treated as a tool to transfer riskCredit derivatives can be treated as a tool to transfer risk
from one party to anotherfrom one party to another
In market risk management, overall risk has beenIn market risk management, overall risk has been
transferred (interest rate risk, foreign exchange risk,transferred (interest rate risk, foreign exchange risk,
securities risk, and etc.)securities risk, and etc.)
Within Credit Risk management, only credit related risksWithin Credit Risk management, only credit related risks
can been transferredcan been transferred
Credit Derivatives
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High dependency in company default is the hot topic inHigh dependency in company default is the hot topic in
credit risk analysis. This is critical to the portfoliocredit risk analysis. This is critical to the portfolio
investment in company debts and credit derivative pricing.investment in company debts and credit derivative pricing.
Default dependency is influenced by both micro and macroDefault dependency is influenced by both micro and macro
factors.factors.
Companies are running in similar macro economicCompanies are running in similar macro economic
environments. If the cause of default is caused byenvironments. If the cause of default is caused bymacroeconomic factors, e.g. interest rate, inflation rate,macroeconomic factors, e.g. interest rate, inflation rate,
inflation rate and utility price, the dependency is calledinflation rate and utility price, the dependency is called
default correlation.default correlation.
If the company defaults because of its own management orIf the company defaults because of its own management or
production problems, e.g. goods supply and asset holdings,production problems, e.g. goods supply and asset holdings,
the dependency is called default contagion.the dependency is called default contagion.
Hot topics in Credit Risk Analysis
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Credit risk management is more related to insuranceCredit risk management is more related to insurancethan to hedging risk.than to hedging risk.
One should diversify the credit risk for portfolios, so toOne should diversify the credit risk for portfolios, so to
avoid concentrationavoid concentration
When the systematic factors (interest rate, foreignWhen the systematic factors (interest rate, foreign
exchange rate) are identified, credit derivatives can beexchange rate) are identified, credit derivatives can be
used to achieve the objectives of credit risk management.used to achieve the objectives of credit risk management.
Conclusions in Credit riskmanagement
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Dr. Zhou previously held several senior positions at many named
organizations, such as Chief Economic Analyst at a foreign financial group
(Great China), Manager at investment consulting firm under domestic
securities company, head of investment consultation department in
Securities Company and Analyst in D&R department in head office of a
local bank.
Dr. Zhou has extensive board of knowledge, specializing in knowledge in
Macroeconomics Analysis, Investment Analysis, Corporate Financial
Planning, Operation in Capital Market, Risk Management and Insurance.
Dr. Zhou is working with East China Normal University as head of the
department of risk management and insurance in the Faculty of Finance
and Statistics.
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Thanks