Credit Risk .

• Credit Risk

https://store.theartofservice.com/the-credit-risk-toolkit.html

Peer-to-peer lending - Credit risk

1 Peer-to-peer lending also attracts borrowers who, because of their

credit status or the lack of thereof, are unqualified for traditional bank

loans



1 It seemed initially that one of the appealing characteristics of peer-to-peer lending for investors was low default rates, e.g. Prosper's default rate was quoted to be only at about

2.7 percent in 2007.



1 The actual default rates for the loans originated by Prosper in 2007 were in

fact higher than projected



1 Since inception, Lending Club’s default rate ranges from 1.4% for top-rated three-year loans to 9.8%

for the riskiest loans.



1 The UK peer-to-peer lenders quote the ratio of bad loans at 0.84% for Zopa of the £200m during its seven year lending

history. As of November 2013, Funding Circle’s current bad debt level was 1.5%, with an average 5.8% return after all bad

debt and fees. This is comparable to the 3-5% ratio of mainstream banks and the

result of modern credit models and efficient risk management technologies used by P2P

companies.https://store.theartofservice.com/the-credit-risk-toolkit.html

Interest - Interest rates and credit risk

1 It is increasingly recognized that the business cycle, interest rates and credit risk are tightly interrelated. The Jarrow-Turnbull model was the first model of credit risk that explicitly had random

interest rates at its core. Lando (2004), Darrell Duffie and Singleton (2003), and van Deventer and Imai (2003) discuss interest rates when the issuer of the

interest-bearing instrument can default.


Credit risk

1 'Credit risk' refers to the risk that a borrower will default (finance)|default on any type of

debt by failing to make required payments. The risk is primarily that of the lender and includes

lost principal sum|principal and interest, disruption to cash flows, and increased

collection costs. The loss may be complete or partial and can arise in a number of

circumstances.[http://www.riskglossary.com/link/credit_risk.htm Risk Glossary: Credit Risk] For

example:


Credit risk

1 * A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other

loan


Credit risk

1 * A company is unable to repay

asset-secured fixed or floating charge

debthttps://store.theartofservice.com/the-credit-risk-toolkit.html

Credit risk

1 * A business or consumer does not pay

a trade credit|trade invoice when due


Credit risk

1 * A business does not pay an employee's

earned wages when due


Credit risk

1 * A business or government Bond (finance)|bond issuer does not make

a payment on a Coupon (bond)|coupon or principal payment when

due


Credit risk

1 * An insolvent insurance company does not pay a policy

obligation


Credit risk

1 * An insolvent bank won't return funds to a

depositor


Credit risk

1 * A government grants bankruptcy protection to an insolvency|insolvent consumer or

business


Credit risk

1 To reduce the lender's credit risk, the lender may perform a credit check on the prospective borrower, may require the borrower to take out appropriate

insurance, such as mortgage insurance or seek Security (finance)|security or

guarantees of third parties. In general, the higher the risk, the higher will be the

interest rate that the debtor will be asked to pay on the debt.


Credit risk - Types of credit risk

1 Credit risk can be classified as follows:[https://www.unicreditgroup.e

u/en/investors/risk-management/credit.html Credit Risk Classification]



1 * Credit default risk — The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or

the debtor is more than 90 days past due on any material credit obligation;

default risk may impact all credit-sensitive transactions, including loans, securities and Derivative

(finance)|derivatives.



1 * Concentration risk — The risk associated with any single exposure

or group of exposures with the potential to produce large enough losses to threaten a bank's core

operations. It may arise in the form of single name concentration or

industry concentration.



1 * Country risk — The risk of loss arising from a sovereign state

freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk); this type of risk is prominently

associated with the country's macroeconomic performance and its

political stability.


Credit risk - Assessing credit risk

1 Significant resources and sophisticated programs are used to

analyze and manage risk.[ http://www.bis.org/publ/bcbs126.htm

BIS Paper:Sound credit risk assessment and valuation for loans]

Some companies run a credit risk department whose job is to assess

the financial health of their customers, and extend credit (or not)

accordinglyhttps://store.theartofservice.com/the-credit-risk-toolkit.html


1 Most lenders employ their own models (credit scorecards) to rank potential and existing customers according to risk, and

then apply appropriate strategies.[ http://www.crc.man.ed.ac.uk/conference/archive/2007/papers/

huang-and-scott.pdf Huang and Scott:Credit Risk Scorecard Design, Validation and User Acceptance] With products such as unsecured personal loans or mortgages, lenders charge a

higher price for higher risk customers and vice versa.[ http://www.investopedia.com/terms/r/risk-

based_mortgage_pricing.asp Investopedia: Risk-based mortgage pricing][

http://www.crc.man.ed.ac.uk/conference/archive/2003/presentations/edelman.pdf Edelman: Risk based pricing for personal

loans] With revolving products such as credit cards and overdrafts, risk is controlled through the setting of credit limits



1 Credit scoring models also form part of the framework used by banks or

lending institutions to grant credit to clients


Credit risk - Sovereign risk

1 Sovereign risk is the risk of a government being unwilling or unable to meet its loan

obligations, or reneging on loans it guarantees. Many countries have faced sovereign risk in

the late-2000s global recession. The existence of such risk means that creditors should take a two-stage decision process when deciding to

lend to a firm based in a foreign country. Firstly one should consider the sovereign risk quality

of the country and then consider the firm's credit quality.



1 Five macroeconomic variables that affect the probability of sovereign debt rescheduling

are:



1 * Variance of export revenue



1 The probability of rescheduling is an increasing function of debt service

ratio, import ratio, variance of export revenue and domestic money supply

growth


Credit risk - Counterparty risk

1 A counterparty risk, also known as a default risk, is a risk that a

counterparty will not pay as obligated on a bond (finance)|bond,

credit derivative, trade credit insurance or payment protection

insurance contract, or other trade or transaction.Investopedia


Credit risk - Counterparty risk

1 Counterparty risk increases due to positively correlated risk factors.

Accounting for correlation between portfolio risk factors and

counterparty default in risk management methodology is not

trivial.[http://ssrn.com/abstract=926067 Related SSRN Research Paper]


Credit risk - Mitigating credit risk

1 Lenders mitigate credit risk using

several methods:



1 * 'Risk-based pricing': Lenders generally charge a higher interest

rate to borrowers who are more likely to default, a practice called 'risk-based pricing'. Lenders consider

factors relating to the loan such as loan purpose, credit rating, and loan-

to-value ratio and estimates the effect on yield (credit spread (bond)|

credit spread).https://store.theartofservice.com/the-credit-risk-toolkit.html


1 * 'Covenants':[http://moneyterms.co.uk/debt_covenants/ Debt covenants]

Lenders may write stipulations on the borrower, called 'loan covenant|

covenants', into loan agreements:



1 ** Refrain from paying dividends, share repurchase|repurchasing

shares, borrowing further, or other specific, voluntary actions that

negatively affect the company's financial position



1 ** Repay the loan in full, at the lender's request, in certain events such as changes in the borrower's

debt-to-equity ratio or times interest earned|interest coverage ratio



1 * 'Credit insurance' and 'credit derivatives': Lenders and bond (finance)|

bond holders may Hedge (finance)#Hedging credit risk|hedge their credit risk by purchasing 'credit

insurance' or 'credit derivatives'. These contracts transfer the risk from the

lender to the seller (insurer) in exchange for payment. The most common credit derivative is the 'credit default swap'.



1 * 'Tightening': Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a Distribution (business)|distributor selling its products to a troubled

retailer may attempt to lessen credit risk by reducing payment terms from

net 30 to net 15.



1 * 'Diversification':[http://www.businessinsider.com/mba-mondays-diversification-2010-6 MBA Mondays:Risk Diversification] Lenders to a small number of borrowers (or kinds of borrower) face a high degree of systematic

risk#Unsystematic_risk|unsystematic credit risk, called 'concentration risk'.

Lenders reduce this risk by Diversification (finance)|diversifying the borrower pool.



1 * 'Deposit insurance': Many governments establish 'deposit insurance' to guarantee bank

deposits in the event of insolvency and encourage consumers to hold

their savings in the banking system instead of in cash.


Credit risk - Credit risk related acronyms

1 * 'CCR' Counterparty Credit Risk



1 * 'CVA' Credit valuation adjustment



1 * 'LGD' Loss given default



1 * 'PD' Probability of default



1 * 'PFE' Potential future exposure


Government bonds - Credit risk

1 Government bonds in a country's own currency are sometimes taken as an

approximation of the theoretical risk-free bond, because it is assumed that the government

can raise taxes or create additional currency in order to redeem the bond at Maturity

(finance)|maturity. There have been instances where a government has Default (finance)|

defaulted on its domestic currency debt, such as Russia in 1998 (the 1998 Russian financial crisis|ruble crisis) (see national bankruptcy).


Mortgage-backed security - Credit risk

1 The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying the promised cash flows (principal and interest) on time. The credit rating of MBS is fairly

high because:



1 # Most mortgage loan|mortgage originations include research on the

mortgage borrower's ability to repay, and will try to lend only to the

creditworthy. An important exception to this is no-doc or low-doc loans.



1 # Some MBS issuers, such as Fannie Mae, Freddie Mac, and Ginnie Mae,

guarantee against homeowner default risk



1 # Pooling many mortgages with uncorrelated default probabilities creates a bond with a much lower probability of total

default, in which no homeowners are able to make their payments (see Copula

(statistics)|Copula). Although the risk neutral credit spread (bond)|credit spread is theoretically identical between a mortgage ensemble and the average mortgage within

it, the chance of catastrophic loss is reduced.



1 # If the property owner should default, the property remains as

collateral (finance)|collateral. Although real estate prices can move below the value of the original loan,

this increases the solidity of the payment guarantees and deters

borrower default.



1 If the MBS was not underwritten by the original real estate and the

issuer's guarantee, the rating of the bonds would be much lower. Part of the reason is the expected adverse

selection against borrowers with improving credit (from MBSs pooled by initial credit quality) who would

have an incentive to refinance (ultimately joining an MBS pool with

a higher credit rating).https://store.theartofservice.com/the-credit-risk-toolkit.html

Standardized approach (credit risk)

1 The term 'standardized approach' (or 'standardised approach') refers to a

set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking

institutions.



1 Under this approach the banks are required to use ratings from External

Credit Rating Agencies to quantify required capital for credit risk. In many countries this is the only

approach the regulators are planning to approve in the initial phase of

Basel II Implementation.



1 The Basel Accord proposes to permit banks a choice between two broad methodologies for calculating their capital requirements for credit risk. The other alternative is based on

internal ratings.


Standardized approach (credit risk) - The summary of risk weights in standardized approach

1 There are some options in weighing risks for some claims, below are the summary as it might be likely to be

implemented.



1 'NOTE': For some unrated risk weights, banks are encouraged to

use their own internal-ratings system based on Foundation IRB and

Advanced IRB in Internal-Ratings Based approach with a set of

formulae provided by the Basel-II accord. There exist several

alternative weights for some of the following claim categories published

in the original Framework text.https://store.theartofservice.com/the-credit-risk-toolkit.html


1 *'Claims on banks and securities companies'



1 ::Related to assessment of sovereign as banks and securities companies are

regulated.



1 *'Claims on retail products'



1 ::This includes credit card, overdraft, auto loans, personal finance and small business.



1 *'Claims secured by residential property'



1 *'Claims secured by commercial real estate'



1 ::150% for provisions that are less than 20% of the outstanding amount



1 ::100% for provisions that are between 20% - 49% of the outstanding

amount



1 ::100% for provisions that are no less than 50% of the outstanding amount,

but with supervisory discretion are reduced to 50% of the outstanding

amount


Internal Ratings-Based Approach (Credit Risk)

1 This is known as the 'Internal Ratings-Based (IRB) Approach' to

capital requirements for credit risk


Internal Ratings-Based Approach (Credit Risk) - Overview

1 The IRB approach relies on a bank's own assessment of its counterparties

and exposures to calculate capital requirements for credit risk. The

Basel Committee on Banking Supervision explained the rationale

for adopting this approach in a consultative paper issued in 2001.

[ http://www.bis.org/publ/bcbsca05.pdf

BCBS:The Internal Ratings-Based Approach] Such an approach has two

primary objectives -



1 *Risk sensitivity - Capital requirements based on internal

estimates are more sensitive to the credit risk in the bank's portfolio of

assets



1 *Incentive compatibility - Banks must adopt better risk management

techniques to control the credit risk in their portfolio to minimize

regulatory capital



1 To use this approach, a bank must take two

major steps:



1 *Categorize their exposures into various asset classes as defined by the Basel II accord



1 *Estimate the risk parameters—probability of default (PD), loss given

default (LGD), exposure at default (EAD), maturity (M)—that are inputs to risk-weight functions designed for each asset class to arrive at the total

risk-weighted asset|risk weighted assets(RWA)



1 The regulatory capital for credit risk is then calculated as 8% of the total RWA under Basel

II.


Internal Ratings-Based Approach (Credit Risk) - Categorization of Exposures

1 Each banking exposure is

categorized into one of these broad asset

classeshttps://store.theartofservice.com/the-credit-risk-toolkit.html

Internal Ratings-Based Approach (Credit Risk) - Categorization of Exposures

1 These corporate and retail classes are further divided into five and three

sub-classes, respectively. Further, both these classes have a separate

treatment for purchased receivables, which might apply subjectivity to

certain conditions.


Internal Ratings-Based Approach (Credit Risk) - Corporate

1 An exposure to a corporation, partnership or proprietorship falls under this category. Some special

guidelines may apply if the corporation is small or medium-sized

entity (Small and medium enterprises|SME). As noted above,

there are five sub-classes of specialized lending under this asset

class -https://store.theartofservice.com/the-credit-risk-toolkit.html


1 *Project Finance - financing industrial projects based upon the projected cash flows of the particular project



1 *Object Finance - financing physical assets based upon the projected

cash flows obtained primarily through the rental or lease of the

particular assets



1 *Structured Trade Commodity Finance|Commodities Finance -

financing the reserves, receivables or inventories of exchange-traded

commodities where the exposure is paid back based on the sale of the

commodity rather than by the borrower from independent funds



1 *Income-producing real estate - financing real—estate that is usually rented or leased out by the debtor to

generate cash flow to repay the exposure



1 *High-volatility commercial real estate - financing commercial real estate, which demonstrate a much

higher volatility of loss rates as compared to other forms of

specialized lending


Internal Ratings-Based Approach (Credit Risk) - Sovereign

1 This generally refers to a loan made to a particular country. Under the Basel II

guidelines, this class also includes the central banks of various countries,

certain government-owned corporation|public sector enterprises (PSEs) and the multilateral development banks (MDBs)

that meet the criteria for a 0% risk weight under the Standardized approach

(credit risk)|standardized approach.


Internal Ratings-Based Approach (Credit Risk) - Bank

1 Loans made to banks or securities firms subject to regulatory capital

requirements come under this category. Certain domestic PSEs or MDBs that do not meet the criteria

for a 0% risk weight under the standardized approach also fall in

this category.


Internal Ratings-Based Approach (Credit Risk) - Retail

1 Loans made to individuals fall under this category. Credit cards, overdrafts

or mortgage loan|residential mortgages are some of the common

retail lending products treated as part of this category in the IRB

approach. Subject to a maximum of 1 million euros, exposures to small

businesses managed as retail exposures also fall under this

category.https://store.theartofservice.com/the-credit-risk-toolkit.html


1 Retail exposures are usually not managed by the bank on an

individual basis for risk rating purposes, but as groups of exposures with similar risk characteristics. The sub-classes of exposures falling into

this category are -



1 *Qualifying revolving exposure (QREs)

[http://www.fsa.gov.uk/pubs/international/exposures.pdf FSA Staff

Paper:Qualifying Revolving Retail Exposures] - unsecured revolving

exposures where the undrawn portion of the exposure is

unconditionally cancellable by the bank


Internal Ratings-Based Approach (Credit Risk) - Equity

1 Direct ownership interests in the assets and income of a financial institution, or indirect interests

through for example derivatives come under this category. For an

exposure to qualify under this category, the return of the funds

invested on the equities can be only realized through their sale or by liquidation of the issuer of these

equities.https://store.theartofservice.com/the-credit-risk-toolkit.html

Internal Ratings-Based Approach (Credit Risk) - Foundation and advanced approaches

1 To calculate capital requirements for all banking exposures, there are three main

elements



1 *Risk parameters - Probability of default(PD), Exposure at default(EAD), Loss Given Default(LGD), Maturity(M)



1 *Risk-weight functions - Functions provided as part of the Basel II

regulatory framework, which maps the risk parameters above to risk-

weighted assets



1 *Minimum requirements - Core minimum standards that a bank must

satisfy to use the Internal Ratings-Based Approach



1 In this approach, banks calculate their own PD parameter while the

other risk parameters are provided by the bank's national supervisor



1 In this approach, banks calculate their own risk parameters subject to meeting some minimum guidelines.



1 However, the foundation approach is not available

for Retail exposures.



1 For equity exposures, calculation of risk-weighted assets not held in the

trading book can be calculated using two different ways: a PD/LGD approach or a market-based

approach.


Internal Ratings-Based Approach (Credit Risk) - Minimum Requirements

1 To adopt the IRB approach and its continued use, a bank must satisfy

certain minimum requirements that it can demonstrate to the national

supervisor. They are described in the following twelve sub-sections.


Internal Ratings-Based Approach (Credit Risk) - Composition

1 The minimum requirements state that

estimates of risk parameters must



1 * Provide for a meaningful

differentiation of risk



1 * Be accurate and consistent in the estimation of risk



1 The risk parameters must also be consistent with their use in making risk management

decisions.



1 The minimum requirements apply to all

asset classes.


Internal Ratings-Based Approach (Credit Risk) - Compliance

1 To adopt the IRB approach, a bank must demonstrate ongoing compliance with the minimum requirements. If a bank does not satisfy the minimum requirements at any

point of time, they must submit to the supervisor a plan outlining how they intend to return to compliance along with definite

timelines. Supervisors may take appropriate action or require the banks to hold additional capital in case of non-

compliance.https://store.theartofservice.com/the-credit-risk-toolkit.html

Internal Ratings-Based Approach (Credit Risk) - Rating System Design

1 Rating system refers to the entire mathematical and technological

infrastructure a bank has put in place to quantify and assign the risk

parameters. Banks are allowed to use multiple ratings systems for

different exposures, but the methodology of assigning an

exposure to a particular rating system must be logical and

documented; banks are not allowed to use a particular rating system to

minimize regulatory capital requirements.



1 A rating system must be designed

based on two dimensions



1 *Borrower characteristics indicating the propensity of the borrower to default



1 *Transaction specific factors like the nature of the product, terms of repayment, collateral,

etc.



1 For retail exposures, delinquent exposures should be identified separately from those

that are not.



1 A rating system typically assigns a borrower to a particular grade based

on their probability of default. To avoid excessive concentration of

borrowers in one particular grade, a bank must have a minimum of seven

borrower grades for non-defaulted exposures and one for those that

default. For retail exposures, banks should be able to quantify the risk

parameters for each pool of exposures.



1 Rating systems must be clear and well documented. They must enable

a third party, like internal audit or independent reviewer, to replicate the assignment of ratings and their appropriateness. All relevant up to

date information must be used in the assignment of ratings. A bank must be conservative in its estimates if

there is a lack of data to accurately quantify the risk parameters.



1 Credit scoring models are allowed to play a role in the estimaton of the

risk parameters as long as sufficient human judgment not captured by the model is taken into account to assign

the final rating to a borrower


Internal Ratings-Based Approach (Credit Risk) - Rating System Operations

1 The requirements state that for corporate, sovereign or bank exposures all borrowers and

guarantors must be assigned a rating as part of the loan approval process.

The process by which a rating is assigned and the actual ratings

assigned must be reviewed periodically by a body independent

of those making loan approval decisions. Ratings must be reviewed

at least once a year.



1 All data relevant to assignment of ratings must be collected and

maintained by the bank. The data collected is not only beneficial for

improving the credit risk management process of the bank on an ongoing basis, but also required for necessary supervisory reporting.



1 Banks are also required to regularly stress test their rating systems considering economic downturn

scenarios, market risk based events or liquidity conditions that may

increase the level of capital held by the bank. These stress tests should

not only consider the relevant internal data of the bank, but also macro-economic factors that might

affect the accuracy of the rating system.


Internal Ratings-Based Approach (Credit Risk) - Corporate Governance and Oversight

1 The rating systems should be approved by the Bank's board of

directors and they should be familiar with the management reports

created as part of the rating systems. Senior management should regularly review the rating system and identify

areas needing improvement. Reporting is required to include



1 *a comparison of the actual default rates against the expected as predicted by the

rating system



1 Banks must have independent functions responsible for

development and ongoing monitoring of the rating systems.



1 An internal audit function, or equally independent function, must review the rating system at least once a year and the findings from such a

review must be documented.


Internal Ratings-Based Approach (Credit Risk) - Use of Internal Ratings

1 Banks must satisfy the 'use test',[http://www.bis.org/publ/bcbs_nl9.pdf The

IRB Use Test] which means that the ratings must be used internally in the risk management

practices of the bank. A rating system solely devised for calculating regulatory capital is not

acceptable. While banks are encouraged to improve their rating systems over time, they are required to demonstrate the use of risk

parameters for risk management for at least three years prior to obtaining qualification.


Internal Ratings-Based Approach (Credit Risk) - Risk Quantification

1 Overall requirements



1 *Except for retail exposures, PD for a particular grade must be a long-run average of one year default rates for

that grade



1 *For those bankings using the advanced approach, a long run

default-weighted average EAD must also be estimated



1 *The internal estimates must take into account all relevant internal and external data

available



1 *The estimates must be based on sound historical and empirical evidence and not

purely judgmental



1 *A layer of conservatism should be added to the parameter estimates to

control for errors during their estimation



1 Definition of default



1 *Borrower is unlikely to pay its credit obligations in full



1 *Borrower is 90 days past due on payment - for overdrafts, a breach on

provided credit limit results in it being 'past due'



1 *Borrower has been placed in bankruptcy

protection



1 *For retail exposures, a borrower defaulting on a particular exposure need not result in all exposures to

the borrower being in default



1 Loss, when estimating LGD, is economic loss and not accounting loss. This means that all material

direct and indirect costs, as well as recoveries, must be discounted back

to the point of default. The bank must clearly demonstrate the choice of the discount rate to the supervisor.



1 Important considerations in quantifying risk parameters

include:



1 *PD estimates may be derived based on one or more of the following

techniques - internal default experience, mapping to external data, statistical default models.



1 *For retail exposures, the primary driver of PD estimates must be internal data.



1 *Seasoning effects should be considered for

retail exposures.



1 *LGD estimates should be based on economic downturn

conditions.



1 *LGD estimates should be based on historical recoveries as well as any existing collateral.



1 *For exposures already in default, LGD should be estimated as the best

estimate of expected loss on the asset considering the current

economic climate.



1 *For closed-end exposures, EAD must not be lower than the current

outstanding balance owed to the bank.



1 *For revolving exposures, EAD should take into account any undrawn commitments.



1 *For corporate, sovereign or bank exposures, LGD and EAD estimates should be based on a full economic

cycle and must not be shorter than a period of seven years.



1 *For retail exposures, the estimates should be based on minimum five years of data unless the bank can demonstrate that recent data is a better predictor of the estimates.


Internal Ratings-Based Approach (Credit Risk) - Validation of internal estimates

1 Banks must have well-defined processes to estimate the accuracy

and consistency of their rating systems.


Internal Ratings-Based Approach (Credit Risk) - Supervisory LGD and EAD estimates

1 Banks using the foundation approach use supervisory estimates of EAD and LGD. However, they must be

meet the minimum requirements of the standardized approach for

recognition of eligible collateral.


Internal Ratings-Based Approach (Credit Risk) - Requirements for recognition of leasing

1 Leases other than those that expose the bank to residual value risk are accorded the same treatment as

exposures collateralised by the same type of collateral.


Internal Ratings-Based Approach (Credit Risk) - Calculation of capital charges for equity exposures

1 The capital charge for equity exposures is defined in the Basel Accord as follows -



1 The capital charge is equivalent to the potential loss on the institution’s

equity portfolio arising from an assumed instantaneous shock

equivalent to the 99th



1 percentile, one-tailed confidence interval of the difference between

quarterly returns and an appropriate risk-free rate computed over a long-

term sample period.



1 Further requirements are

summarized below -



1 *Estimated losses should be based on sound statistical judgment and should be stable under adverse

market movements



1 *Models should be adjusted to demonstrate that it provides a

conservative estimate of long-run loss experience



1 *The Accord does not require the use of a particular kind of model but

requires that all risk be embedded in the process.



1 *Stress testing taking into account various assumptions on volatility and

hypothetical scenarious should be conducted



1 *The models should be integrated into the risk management process; including setting hurdle rates and

evaluating risk-adjusted performance



1 *The models must be regularly monitored by an independent team and all assumptions

verified


Internal Ratings-Based Approach (Credit Risk) - Disclosure requirements

1 Banks must meet the disclosure requirements as mandated by the market discipline|third pillar of the Basel framework. Failure to meet

these requirements makes the bank ineligible to use the IRB approach.


Internal Ratings-Based Approach (Credit Risk) - Treatment of Expected Losses and Recognition of Provision

1 A bank is required to compare the total expected losses with the total eligible provisions. If the expected

loss amount is less than the provisions, the supervisor must

consider if this is a true picture of reality, and then include the

difference in Tier II capital. The expected losses for equity exposures

under the PD/LGD approach is deducted 50% from Tier I and 50%

from Tier II capital.


Financial risk - Credit risk

1 An investor can also assume credit risk through direct or indirect use of

Leverage (finance)|leverage


Financial risk - Financial / Credit risk related acronyms

1 'KMV' quantitative credit analysis solution developed by credit rating agency Moody's


Financial risk - Financial / Credit risk related acronyms

1 VaR value at risk, a common methodology for measuring risk due to market movements


Subprime crisis background information - Credit risk

1 Traditionally, lenders (who were primarily savings and loan

association|thrifts) bore the credit risk on the mortgages they issued



1 This originate to distribute model means that investors holding MBS

and CDOs also bear several types of risks, and this has a variety of

consequences. In general, there are five primary types of risk:Robin

Blackburn, [http://www.newleftreview.org/?getpdf=NLR28403pdflang=en

Subprime Crisis], New Left Review, March–April 2008.



1 By the beginning of the 21st century, these innovations had created an originate to distribute model for mortgages, which means that

mortgage became almost as much securities as they were loans.

Because subprime loans have such high repayment risk, the origination of large volumes of subprime loans by thrift institutions or commercial

banks was not possible without securitization.



1 From a systemic perspective, the dominance of securitization has made the risks of the mortgage

market similar to the risks of other securities markets, particularly non-

regulated securities markets. In general, there are five primary types

of risk in these markets:



1 This means that in the mortgage market, borrowers no longer have to default and reduce cash flows very significantly before credit risk rises

sharply



1 Investors in MBS can insure against credit risk by buying CDS, but as risk

rises, counterparties in CDS contracts have to deliver collateral and build up reserves in case more

payments become necessary


Loan origination - Decisioning credit risk

1 The Mortgage loan|mortgage business consists of a few people:

the borrower, the lender, and sometimes the mortgage broker



1 Not only does one's credit score affect their qualification, the fact of the matter also lies in the question,

Can I (the borrower) afford this mortgage? In most cases the

borrower can afford their mortgage



1 Example: if the borrower owes $1,500 in credit card payments and makes $3,000 in a month: his DTI ratio would be - 50%. But if the

borrower owes $1,500 in payments and makes $2,000 in a month, his

DTI ratio would be - 75%. This ratio is seen by many lenders as high and

too risky a person to lend to and may or may not be able to afford the

mortgage.https://store.theartofservice.com/the-credit-risk-toolkit.html


1 So that covers qualification, now on to the important appraising of the collateral.


Country risk - Partial list of credit risk rating agencies

1 * [http://businessmonitor.c

om Business Monitor International]


Default risk - Assessing credit risk

1 Significant resources and sophisticated programs are used to

analyze and manage risk.[http://www.bis.org/publ/bcbs126

.htm BIS Paper:Sound credit risk assessment and valuation for loans]

Some companies run a credit risk department whose job is to assess

the financial health of their customers, and extend credit (or not)

accordinglyhttps://store.theartofservice.com/the-credit-risk-toolkit.html

Default risk - Assessing credit risk

1 Most lenders employ their own models (credit scorecards) to rank potential and existing customers according to risk, and

then apply appropriate strategies.[http://www.crc.man.ed.ac.uk/conference/archive/200

7/papers/huang-and-scott.pdf Huang and Scott:Credit Risk Scorecard Design, Validation and User Acceptance] With

products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice

versa.[http://www.investopedia.com/terms/r/risk-based_mortgage_pricing.asp Investopedia: Risk-based

mortgage pricing][http://www.crc.man.ed.ac.uk/conference/archive/2003/

presentations/edelman.pdf Edelman: Risk based pricing for personal loans] With revolving products such as credit cards and overdrafts, risk is controlled through the setting of credit

limits


Consumer credit risk

1 The following article is based on UK market, other

countries may differ.


Consumer credit risk

1 'Consumer Credit Risk' (AKA 'Retail Credit Risk') is the risk of loss due to

a customer's non re-payment (default) on a consumer credit product, such as a mortgage,

unsecured personal loan, credit card, overdraft etc. (the latter two options being forms of unsecured banking

credit).


Consumer credit risk - Consumer Credit Risk Management

1 Most companies involved in lending to consumers have departments dedicated to the measurement,

prediction and control of losses due to credit risk. This field is loosely

referred to consumer/retail credit risk management, however the word

management is commonly dropped.


Consumer credit risk - Scorecards

1 See full article (Credit Scorecards)



1 A common method for predicting credit risk is through the credit scorecard. The scorecard is a statistically based model for

attributing a number (score) to a customer (or an account) which

indicates the predicted probability that the customer will exhibit a

certain behaviour. In calculating the score, a range of data sources may

be used, including data from an application form, from credit

reference agencies or from products the customer already holds with the

lender.



1 The most widespread type of scorecard in use is the 'application scorecard', which lenders employ

when a customer applies for a new credit product



1 Other scorecard types may include 'behavioural scorecards' - which try

to predict the probability of an existing account turning bad;

'propensity scorecards' - which try to predict the probability that a

customer would accept another product if offered one; and

'collections scorecards' - which try to predict a customer's response to different strategies for collecting

owed money.


Consumer credit risk - Credit Strategy

1 Credit strategy is concerned with turning predictions of customer

behaviour (as provided by scorecards) into a decision whether

to accept their custom.



1 To turn an application score into a Yes/No decision, cut-offs are generally used



1 Application score is also used as a factor in deciding such things as an

overdraft or credit card limit. Lenders are generally happier to extend a

larger limit to higher scoring customers than to lower scoring

customers, because they are more likely to pay borrowings back.



1 Alongside scorecards lie policy rules which apply regulatory requirements

(such as making sure there is no lending to under 18s) and other

lending policy (such as many lenders will not lend to customers who have

a County court judgment|CCJ registered against them).



1 Credit Strategy is also concerned with the ongoing management of a customer's account, especially with revolving credit products such as credit cards, overdrafts and flexible loans, where the customer's balance can go up as

well as down. Behavioural scorecards are used (usually monthly) to provide an updated

picture of the credit-quality of the customer/account. As the customer's profile

changes, the lender may choose to extend or contract the customer's limits.


Consumer credit risk - Underwriting

1 Not all decisions can be made automatically through the methods mentioned above. This may be for a number of reasons;

insufficient data, regulatory requirements, or a borderline decision. In such cases

highly trained professionals called underwriters manually review the case and make a decision. This is more common in

highly regulated products such as mortgages, especially when large sums are

involved.https://store.theartofservice.com/the-credit-risk-toolkit.html

Simple interest - Interest rates and credit risk

1 It is increasingly recognized that during the business cycle, interest

rates and credit risk are tightly interrelated. The Jarrow-Turnbull

model was the first model of credit risk that explicitly had random interest rates at its core. Lando

(2004), Darrell Duffie and Singleton (2003), and van Deventer and Imai (2003) discuss interest rates when the issuer of the interest-bearing

instrument can default.


Person-to-person lending - Credit risk

1 Peer-to-peer lending also attracts borrowers who, because of their

credit status or the lack thereof, are unqualified for traditional bank loans


Person-to-person lending - Credit risk

1 The actual default rates for the loans originated by Prosper in 2007 were in

fact higher than projected


For More Information, Visit:

• https://store.theartofservice.com/the-credit-risk-toolkit.html

The Art of Servicehttps://store.theartofservice.com





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