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The Credit Risks and Credit Life Cycle

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    CHAPTER 16

    Introduction to Credit Risk 

    What is in this Chapter?

    INTRODUCTION

    OURCE O! CREDIT RI" 

    THE CREDIT #I!E C$C#E

    WH$ %EAURE CREDIT RI"?

     

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    INTRODUCTION 

    The taking of credit risk has always been a core activity fo

    r banks

    Over the last 10 years, quantitative measurement has beenadopted by banks to improve their processes for selecting a

    nd pricing credit transactions

    Quantitative measurement has become even more importan

    t since it was adopted by the Basel ommittee on Banking

    as the basis for setting regulatory capital!

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    "n this chapter, we review the process for granting credit a

    nd the ways in which risk measurement supports credit de

    cisions

    "n subsequent chapters, we review the different types of cr edit instruments, risk measurement for a single loan, risk

    measurement for a portfolio, and how the results are used

    for decision support!

    #ost of the discussion focuses on estimating the economi

    c capital, but we finish the credit$risk section with the Bas

    el ommittee%s new framework for setting regulatory capit

    al!

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    OURCE O! CREDIT RI" 

    redit risk arises from the possibility that borrowers or co

    unterparties will fail to honor commitments that they have

    made to pay the bank!

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    OURCE O! CREDIT RI" 

    redit$related losses can occur in the following w

    ays& ' customer fails to repay money that was lent by the b

    ank! The bank holds a debt security (e!g!, a bond or loan) an

    d the credit quality of the security issuer falls, causing

    the value of the security to fall! *ere, a default has not

    occurred, but the increased possibility of a default mak es the security less valuable!

     

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    The bank holds a debt security, and the market%s price for

    risk changes!

    +or eample, the price for all BB$rated bonds may fall bec

    ause the market is less willing to take risks!"n this case, there is no credit event, -ust a change in mark 

    et sentiment!

    This risk is therefore typically treated as market risk in the

    trading .a/ calculator 

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    OURCE O! CREDIT RI" 

    There is a gray area between market and credit risks! enerally, changes in value due to defaults and downgrades are% c

    onsidered to be credit risk because they depend on the behavior o

    f the specific company!

    hanges in value due to changes in the risk$free interest$rate or changes in credit spread for a given grade are considered to be mar 

    ket risk because they depend on general market sentiment!

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    THE CREDIT #I!E C$C#E

    The customer then applies for credit and supplies some inf 

    ormation about his or her creditworthiness

    "n the case of a retail customer, it is personal information

    such as income"n the case of a commercial customer, it is balance$%sheet i

    nformation such as total assets

    Based on this information, the bank%s credit department de

    termines the riskiness of the customer and assigns a creditgrade, which is a form of risk score!

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    THE CREDIT #I!E C$C#E

    Often, banks will supplement their grading processes with

    information from eternal rating agencies

    +or retail customers, data is provided by credit bureaus w

    ho collect information from many banks and collate it forresale to any bank considering lending to an individual!

    "n the nited 2tates the main credit bureaus are 3quifa,

    T/4, and 3perian

    The information includes personal details, such as income, and financial information, such as the total number of cr 

    edit cards and whether the customer has defaulted!

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    THE CREDIT #I!E C$C#E

    +or lending to corporations, the main credit$rating agencies for large

    corporations in the nited 2tates are 2tandard 5 6oor%s, #oody%s, and

    +itch "B'

    +or the middle market, 7unn and Bradstreet is the primary rating age

    ncy!They take information on a company and an associated facility (a part

    icular bond, for eample), and they rate the facility based on sub-ectiv

    e -udgments and ob-ective models

    The models use information on the company%s balance sheet and profi

    tability! The result is a letter grade that indicates the 8riskiness8 of thefacility!

    There are also companies (principally, 9#., now owned by #ood

    y%s) who rate corporations based on the volatility of their equity price

    s, which we will later discuss in depth

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    THE CREDIT #I!E C$C#E

    Based on the grade, the bank decides whether to offer cre

    dit to the customer, in what amount, at what interest rate,

    and with what terms

    The difference between the risk$free rate and the rate char ged to the customer is called the spread!

    The customer decides whether to accept the given price, a

    nd then there may be a final round of bank approval befor 

    e the deal is closed! The process up to closing the actual d

    eal is called origination!

    'fter the deal is closed, a series of disbursements are mad

    e to the borrower, and the loan becomes part of the bank%s

     portfolio of assets

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    THE CREDIT #I!E C$C#E

    The portfolio is managed to minimi:e the risk;return ratio

    of the portfolio!

    3ventually, most of the loans are paid back by the custom

    ers, but some default and go to the collections department,who takes time to recover as much of the outstanding amo

    unt as possible

    The collections department may also be called the workou

    t group or the special assets group!

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    WH$ %EAURE CREDIT RI"?

    Before launching into the analysis and calculation of credi

    t risk, let us first consider what risk measurements would

     be useful to support the decisions in the process we discus

    sed above

    There are three main sets of decisions& Origination

     portfolio optimi:ation

     capitali:ation!

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    WH$ %EAURE CREDIT RI"?

    2upporting Origination 7ecisions The most basic decision is whether to accept a new ass

    et into the portfolio! The origination decision can be fr 

    amed in two possible ways& iven the risk and a fied price, is the asset worth t

    aking<

    iven the risk, what price is required to make the a

    sset worth buying<

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    WH$ %EAURE CREDIT RI"?

    The first is more often asked in a rigid system where th

    ere is little opportunity to modify the price, and therefo

    re the decision becomes 8yes;no!=

     This is the type of decision made when dealing with alarge volume of retail customers!

    The question can be recast as, 8"s the epected return o

    n capital for this transaction greater than the bank%s mi

    nimum return on capital

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    WH$ %EAURE CREDIT RI"?

    The second approach is typically used in a fleible, liq

    uid trading environment, or in negotiating rates and fee

    s for a corporate loan

    *ere, we start with the capital consumed and the known hurdle rate for the return on capital to calculate the m

    inimum acceptable return for the overall loan

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    WH$ %EAURE CREDIT RI"?

    2upporting 6ortfolio Optimi:ation "n optimi:ing a portfolio, the manager seeks to minimi:e the ratio

    of risk to return

    To reduce the portfolio%s risk, the manager must know where ther 

    e are concentrations of risk and how the risk can be diversified This requires a credit$portfolio model that includes all the correlat

    ions between assets to show where there are concentrations of ass

    ets that are highly correlated

    The high correlation may arise from being in the same industry or

    geography, or because they are driven by the same economic factors, such as oil prices!

    The portfolio model must show the current risk concentrations an

    d allow the manager to try 8what$if8 analyses to test strategies for

    diversifying the portfolio!

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    WH$ %EAURE CREDIT RI"?

    2upporting apital #anagement iven the risk in the portfolio, the +O needs to set th

    e provisions for epected losses over the net year, and

    the reserves, in case losses are unusually bad The +O also needs to ensure that the total economic c

    apital available is sufficient to maintain the bank%s targ

    et credit rating given the risks

    "f it is insufficient, the bank must (1) raise more capital, (>) reduce the risk, or (?) epect to be downgraded

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    WH$ %EAURE CREDIT RI"?

    To set the provisions, the +O needs to know the aver 

    age losses that are to be epected

    To set reserves, it is necessary to know the loss that co

    uld be eperienced in an unusually bad year, e!g!, losses that have a l$in$>0 chance (@A) of happening

    To set capital, we need the loss level that could be ep

    erienced in an etraordinarily bad year, e!g!, losses that

    have a l$in$1000 (0!1A) chance of happening

    These statistics can be obtained if we can calculate the

     probability$density function for the portfolio$loss rate,

    which is the focus of the net few chapters

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