View
216
Download
0
Category
Preview:
Citation preview
8/17/2019 The Credit Risks and Credit Life Cycle
1/19
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"?
8/17/2019 The Credit Risks and Credit Life Cycle
2/19
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!
8/17/2019 The Credit Risks and Credit Life Cycle
3/19
"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$risk section with the Bas
el ommittee%s new framework for setting regulatory capit
al!
8/17/2019 The Credit Risks and Credit Life Cycle
4/19
OURCE O! CREDIT RI"
redit risk arises from the possibility that borrowers or co
unterparties will fail to honor commitments that they have
made to pay the bank!
8/17/2019 The Credit Risks and Credit Life Cycle
5/19
OURCE O! CREDIT RI"
redit$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!
8/17/2019 The Credit Risks and Credit Life Cycle
6/19
The bank holds a debt security, and the market%s price for
risk changes!
+or eample, the price for all BB$rated bonds may fall bec
ause the market is less willing to take risks!"n this case, there is no credit event, -ust a change in mark
et sentiment!
This risk is therefore typically treated as market risk in the
trading .a/ calculator
8/17/2019 The Credit Risks and Credit Life Cycle
7/19
OURCE O! CREDIT RI"
There is a gray area between market and credit risks! enerally, changes in value due to defaults and downgrades are% c
onsidered to be credit risk because they depend on the behavior o
f the specific company!
hanges in value due to changes in the risk$free interest$rate or changes in credit spread for a given grade are considered to be mar
ket risk because they depend on general market sentiment!
8/17/2019 The Credit Risks and Credit Life Cycle
8/19
THE CREDIT #I!E C$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$%sheet i
nformation such as total assets
Based on this information, the bank%s credit department de
termines the riskiness of the customer and assigns a creditgrade, which is a form of risk score!
8/17/2019 The Credit Risks and Credit Life Cycle
9/19
THE CREDIT #I!E C$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!
8/17/2019 The Credit Risks and Credit Life Cycle
10/19
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
8/17/2019 The Credit Risks and Credit Life Cycle
11/19
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
8/17/2019 The Credit Risks and Credit Life Cycle
12/19
THE CREDIT #I!E C$C#E
The portfolio is managed to minimi:e the risk;return ratio
of the portfolio!
3ventually, most of the loans are paid back by the custom
ers, but some default and go to the collections department,who takes time to recover as much of the outstanding amo
unt as possible
The collections department may also be called the workou
t group or the special assets group!
8/17/2019 The Credit Risks and Credit Life Cycle
13/19
WH$ %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!
8/17/2019 The Credit Risks and Credit Life Cycle
14/19
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<
8/17/2019 The Credit Risks and Credit Life Cycle
15/19
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
8/17/2019 The Credit Risks and Credit Life Cycle
16/19
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
8/17/2019 The Credit Risks and Credit Life Cycle
17/19
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!
8/17/2019 The Credit Risks and Credit Life Cycle
18/19
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
8/17/2019 The Credit Risks and Credit Life Cycle
19/19
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
Recommended