8 to 12 Credit Risk Management-E

8/3/2019 8 to 12 Credit Risk Management-E

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Credit risk management Credit risk management ModuleModule --44Session No. 8 to 12Session No. 8 to 12


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Unexpected Vs Expected lossesUnexpected Vs Expected losses

Credit produce Income as well as RiskCredit produce Income as well as RiskExpected Vs Unexpected lossesExpected Vs Unexpected lossesExpected loss is statistical tool which will occurExpected loss is statistical tool which will occuron an averageon an averageUnexpected loss is deviation from averageUnexpected loss is deviation from averageDefault riskDefault risk--Probability of default Probability of default Exposure riskExposure risk- -Exposure at default Exposure at default Recovery riskRecovery risk- -Loss given default Loss given default EL=PDXEADXLGDEL=PDXEADXLGD


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Yearly default rates and ratings Yearly default rates and ratings

Moody s ratingsMoody s ratings Yearly default rate Yearly default rate

AAA AAA 0.02%0.02%

AA AA 0.04%0.04% A A 0.08%0.08%

BBBBBB 0.20%0.20%

BBBB 1.80%1.80%

BB 8.30%8.30%


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Credit riskCredit risk--examplesexamples

Direct lendingDirect lending- - repayment is not maderepayment is not madeNon fundNon fund-- funds not forthcoming onfunds not forthcoming oncrystallization of LC/BGcrystallization of LC/BGSeries of payment due from bonds are not Series of payment due from bonds are not forthcoming on due datesforthcoming on due datesSecurity tradingSecurity trading- - settlement not settlement not forthcomingforthcomingCross border exposureCross border exposure- - currencycurrencymovement not taking placemovement not taking place


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Defining credit riskDefining credit risk

Bank borrower or counter party will fail to meet Bank borrower or counter party will fail to meet its obligation in accordance with the agreedits obligation in accordance with the agreedtermsterms

Also include credit rating down grades of Also include credit rating down grades of borrowersborrowersBank need to manageBank need to manage Risk in Individual Credit Risk in Individual Credit

Credit risk in entire portfolioCredit risk in entire portfolio Other source of credit risk such as guarantees,Other source of credit risk such as guarantees,

acceptances, forex business etc.acceptances, forex business etc.


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Risk in individual credit Risk in individual credit

Seven Cs of credit decisionSeven Cs of credit decisionSet a limit for each loan by screeningSet a limit for each loan by screeningCharacterCharacter

CapacityCapacityCapitalCapitalCreditworthinessCreditworthinessCollateralsCollateralsConvenants/conditionsConvenants/conditionsCredit RatingsCredit Ratings Internal and ExternalInternal and External


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Credit risk in the portfolioCredit risk in the portfolio

Upside and down side risk in investment Upside and down side risk in investment but only down side risk in loansbut only down side risk in loans

Diversification across industry, geography,Diversification across industry, geography,sectorssectorsConcentration riskConcentration risk

Exposure norms for sectorsExposure norms for sectors Exposure norms for individualsExposure norms for individuals Exposure norms for groupExposure norms for group


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Credit risk from other sourcesCredit risk from other sources

Bank may face credit risk other than loanBank may face credit risk other than loanand advances sayand advances say

Acceptances (letter of credit) Acceptances (letter of credit) Inter bank transactionsInter bank transactions Trade financingTrade financing Foreign exchange transactionsForeign exchange transactions Future, swaps, options etc.Future, swaps, options etc.


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Basel guidelines for Credit riskBasel guidelines for Credit risk

management management Establishing a credit risk environment Establishing a credit risk environment Sound credit granting processSound credit granting process

Maintaining a credit administration,Maintaining a credit administration,measurement and monitoring processmeasurement and monitoring processEnsuring adequate control on credit riskEnsuring adequate control on credit risk

Assessment of assets quality, adequacy of Assessment of assets quality, adequacy of provisions and disclosure of credit riskprovisions and disclosure of credit risk


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Credit Risk Measurement Credit Risk Measurement Basel II guidelinesBasel II guidelines

Standard approachStandard approach

Foundation internal rating based approachFoundation internal rating based approach

Advance internal rating based approach Advance internal rating based approach


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Credit RatingCredit Rating

Bench mark criterion for investors,Bench mark criterion for investors,borrowers, banks, financial institutionsborrowers, banks, financial institutionsRatings helps to compare performanceRatings helps to compare performanceUsed as a decision making toolUsed as a decision making toolTrend Started in 1970Trend Started in 1970- - two internationaltwo internationalagency Standard & Poor and Moody sagency Standard & Poor and Moody sInvestor serviceInvestor serviceCRICIL, ICRA, FITCH etc are ratingCRICIL, ICRA, FITCH etc are ratingagencies in Indiaagencies in India


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Credit RatingCredit Rating

Information to investorsInformation to investors- -Investors riskInvestors riskperception to Actual Credit Ratingperception to Actual Credit Rating- - investor mayinvestor mayinvest or hold the securityinvest or hold the securityBank use to support lending decision or stayingBank use to support lending decision or stayinginvested or charging rate of interest invested or charging rate of interest Issuers also see benefits and pay for it Issuers also see benefits and pay for it

RegulatorsRegulators- - capital market investment and bankcapital market investment and bankto rate borrower and risk weight of assets forto rate borrower and risk weight of assets forcapital adequacycapital adequacy


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Rating system in banksRating system in banks

Credit appraisalCredit appraisal key skill is to identifykey skill is to identifyrisk, assess their severity and ensure theyrisk, assess their severity and ensure theyare mitigated so that lender is comfortableare mitigated so that lender is comfortableBanks rate their customers both internallyBanks rate their customers both internallyand externallyand externallyBasel II has made the external ratingBasel II has made the external ratingmandatory of loan above cut off mandatory of loan above cut off


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RecoveryRecovery

Warning systemWarning system Signal of borrower healthSignal of borrower health Reminders & reviewReminders & reviewLoan work out Loan work out RestructuringRestructuring RehabilitationRehabilitation

CompromiseCompromise Scaling down of debt Scaling down of debt Going to court for recoveryGoing to court for recovery


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Credit risk modelCredit risk model

Basic modelBasic model NPA written off on the bank s profit NPA written off on the bank s profit

PBT/NPAPBT/NPA Will wipe out bank profit Will wipe out bank profit Margin of safetyMargin of safety


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Credit risk modelCredit risk model

Credit scoring modelCredit scoring model Traditionally system of loan analysisTraditionally system of loan analysis Credit score modelCredit score model Probability of default (PD) to expected lossProbability of default (PD) to expected loss

(EL)(EL)Empirical techniquesEmpirical techniques- - historical default historical default

raterateMarket based modelsMarket based models- - Counter partyCounter partymarket data to infer likelihood of default market data to infer likelihood of default


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Credit risk transferCredit risk transfer

Loan SyndicationLoan Syndication Sharing of loan with other banksSharing of loan with other banks

Earning fee based income through syndicationEarning fee based income through syndicationParticipation CertificatesParticipation Certificates IBPC with recourseIBPC with recourse- -remain in balance sheet remain in balance sheet IBPC without recourseIBPC without recourse Move out of balanceMove out of balance

sheet sheet


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Securitization definedSecuritization defined Process of selling loansProcess of selling loans Homogeneous pool of loan assets that generates a predictableHomogeneous pool of loan assets that generates a predictable

stream of future cash flowstream of future cash flow Remove assets from bank s bookRemove assets from bank s bookProcessProcess Originators to sell loan to a SPV (special purpose vehicle)Originators to sell loan to a SPV (special purpose vehicle) Converted into securitiesConverted into securities - - ABS (assets based securities) ABS (assets based securities) Sold to investors without recourseSold to investors without recourse Interest of investor is saved through over collateralization, senorInterest of investor is saved through over collateralization, senor

/ subordinated structure , credit enhancement / subordinated structure , credit enhancement BenefitsBenefits Mitigates credit risk, lower interest rate risk, profitabilityMitigates credit risk, lower interest rate risk, profitability

enhancement enhancement


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CLO, CBOCLO, CBOOriginating bank transfer pool of loans, theOriginating bank transfer pool of loans, thebonds that emerge are called collateralized loanbonds that emerge are called collateralized loantransfer (CLO)transfer (CLO)Originating bank transfer a pool of bonds,Originating bank transfer a pool of bonds,securitize them, these are called collateralizedsecuritize them, these are called collateralizedbond transfer (CBO)bond transfer (CBO)Generic name of CLO and CBO is CREDITGeneric name of CLO and CBO is CREDITDEFAULT OPTIONDEFAULT OPTION

Typical securitization is purpose is liquidityTypical securitization is purpose is liquiditywhereas in CLO/CBO risk transfer, capital relief,whereas in CLO/CBO risk transfer, capital relief,arbitrage, balance sheet optimizationarbitrage, balance sheet optimization


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Credit derivativesCredit derivatives Way to insure credit lossesWay to insure credit losses Pay off linked to credit related event such asPay off linked to credit related event such as

borrower default, credit rating down grades,borrower default, credit rating down grades,value of security going downvalue of security going down

Bank transferring credit risk is calledBank transferring credit risk is calledprotection buyer and counter party (ready toprotection buyer and counter party (ready tobear credit risk) is called protection sellerbear credit risk) is called protection seller

Are typically unfunded Are typically unfunded- - protection seller needprotection seller neednot invest money upfront not invest money upfront


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Credit risk transferCredit risk transferCredit derivativesCredit derivatives- -Typical products areTypical products are CDO (credit default options) Already discussedCDO (credit default options) Already discussed CDS (credit default swaps)CDS (credit default swaps)Credit Defaults SwapsCredit Defaults Swaps Priced on the bases of Expected Losses (EL)Priced on the bases of Expected Losses (EL) Bank A agrees to pay Bank B fee for being pootection sellerBank A agrees to pay Bank B fee for being pootection seller Bank B agrees to pay Bank A preBank B agrees to pay Bank A pre- -determined value baseddetermined value based

amount ( as % value of the assets) if default occursamount ( as % value of the assets) if default occurs Settlement is done either by cash or physical settlement Settlement is done either by cash or physical settlement In physical settlement protection seller will get possession of theIn physical settlement protection seller will get possession of the

physical assetsphysical assets


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Why do the bank use credit Why do the bank use credit

derivatives?derivatives?Easy and cost effective means to hedge portfolioEasy and cost effective means to hedge portfolioriskriskPermit substantial flexibility and increasePermit substantial flexibility and increase

profitability efficiencyprofitability efficiencyHedge against interest rate riskHedge against interest rate riskEfficient than loan salesEfficient than loan salesBank action is not visible to borrowers andBank action is not visible to borrowers andmarket, hence remaining secret market, hence remaining secret Loan sale call for substantial information andLoan sale call for substantial information andbank to incur more cost and obligationsbank to incur more cost and obligations


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Yearly default rates and ratings Yearly default rates and ratings

Moody s ratingsMoody s ratings Yearly default rate Yearly default rate

AAA AAA 0.02%0.02%

AA AA 0.04%0.04% A A 0.08%0.08%

BBBBBB 0.20%0.20%

BBBB 1.80%1.80%

BB 8.30%8.30%

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8 to 12 Credit Risk Management-E

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