The Credit Risks and Credit Life Cycle

8/17/2019 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 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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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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+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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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 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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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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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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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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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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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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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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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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The Credit Risks and Credit Life Cycle

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