1. Credit Risk Management Enhancing Your Steady Profitability Dr. Bin Zhou school of finance and statistics East China Normal University bzhou@stat.ecnu.edu.cn

2. Credit risk case study in a Chinese bank Credit risk case study in a Chinese bank Credit Risk Management Research Agenda

3. Credit risk case study in a Chinese bank Credit risk case study in a Chinese bank To explore the characteristics and causes of credit risk in Chinese commercial banks, analysis is made of 800 million RMB bad debts, which are written off between 1998 and 2005 in state-owned commercial banks in a Chinese city. To explore the characteristics and causes of credit risk in Chinese commercial banks, analysis is made of 800 million RMB bad debts, which are written off between 1998 and 2005 in state-owned commercial banks in a Chinese city. Given the specific financial background in China, studies are carried out in the field of the causes of credit risk which can be classified into 3 categories: Given the specific financial background in China, studies are carried out in the field of the causes of credit risk which can be classified into 3 categories:

4. Enterprise operation: operation and management, techniques, fund, brand, credibility and so on. Enterprise operation: operation and management, techniques, fund, brand, credibility and so on. Bank management: investigation in specific enterprises before loans are granted, management of loans after it, bank structures. Bank management: investigation in specific enterprises before loans are granted, management of loans after it, bank structures. External factors: government intervention, market volatility, credit environment, force majeure. External factors: government intervention, market volatility, credit environment, force majeure. Factor analysis shows that government intervention, enterprise management and bank structures,market volatility are main factors responsible for the 368 doubt debts being written off as bad debts. Factor analysis shows that government intervention, enterprise management and bank structures,market volatility are main factors responsible for the 368 doubt debts being written off as bad debts.

5. Credit risk factor analysis

6. It is necessary to establish an all-dimensional evaluation system since the current system is focusing too much on financial indicators. The system should include the following 4 modules: It is necessary to establish an all-dimensional evaluation system since the current system is focusing too much on financial indicators. The system should include the following 4 modules: 1. Business performance evaluation: Based on the data provided by annual financial statements, the evaluation ratios are calculated which represent the repaying capacity, assets operation and development as well as financial performance of enterprises. By making good use of these ratios, we carry out comprehensive evaluation of enterprises. Thus financial analysis is improved and the development edge of enterprises are valued in quantified terms.

7. 2. Individual industry risk: The current credit evaluation system does not take industry risk into consideration though in market economy, the rise and fall of an industry has a direct bearing on the prospects of enterprises within the industry and helps shape the development of enterprises in related industries. The rise and fall of an industry has increasingly become an important index of macro economy, acting as a significant guide for investment decision and credit allocation. As for Chinese market economy characterized by evident cyclical macro-control the economy waxes and wanes with not only market conditions but also government policies. The prospects of industries are neither deterministic nor predictable which has a direct impact on the safety of loans granted by banks.

8. 3. Government risk evaluation government intervention is a major cause of bad loans in Chinese commercial banks because of which local government policies and actions should be made account of during the process of credit risk evaluation. Many a case indicate that local government intervenes strongly during the whole process of credit even in the dealing of bad loans. Making use of administrative power, governments clamp down on banks to grant credit to particular projects Making use of administrative power, governments clamp down on banks to grant credit to particular projects Governments appropriate credit and change the destination of it Governments appropriate credit and change the destination of it Governments transfer credit assets and avoid paying debts in the name of reorganization, merger and bankruptcy; Governments transfer credit assets and avoid paying debts in the name of reorganization, merger and bankruptcy; Governments establish varieties of barriers when banks dun for debts and deal with collateral legally. Governments establish varieties of barriers when banks dun for debts and deal with collateral legally. 4.Enterprise moral risk evaluation: evaluating creditability by examing enterprise s performance on carrying tax obligation, complying with contracts, presenting statements faithfully and paying debts on time.

9. Multidimensional credit risk evaluation system frame diagram Business performance evaluation Individual industry risk Government risk evaluation None-risk Low-risk moderate-risk Moderate-high-risk High-risk. Enterprise moral risk evaluation

10. Companies are exposed to significant levels of credit risk emanating from different sources Accounts Receivables Other Notes Receivables Buyer and Franchise Financing With Recourse Financing Project Finance Structured Transactions Leases with Recourse Derivatives Exposures FX, Interest Rate Risk, Commodities etc. Collateral Risk Parent or Third Party Guarantees Commercial and Standby Letters of Credit Note also that Critical Suppliers to the company may pose specific credit risk

11. Credit Risk Management Research Credit Risk Background An uncertain and volatile economic environment significantly impacts this ability An uncertain and volatile economic environment significantly impacts this ability The desire to grow and turn in outstanding results has a tendency to put pressure on the checks and balances within businesses The desire to grow and turn in outstanding results has a tendency to put pressure on the checks and balances within businesses Thorough identification and accurate measurement of credit risk, supported by strong risk management can help improve the bottom line Thorough identification and accurate measurement of credit risk, supported by strong risk management can help improve the bottom line

12. Each financial product has different credit risk characteristics - Creditors right ( loans, finance and option) - Credit (Swap, forward) Risk Exposure, Default Correlation and recovery rate differs from each other, especially in a portfolio. Default correlation is necessary to be considered. Default correlation and recovery rate may correlate with risk exposure as well. Assess the complexity of credit risk

13. Credit Policies & Procedures Analysis & Risk Management Governance, Control and Implementation Measurement Methodologies Technology & Data Integrity Credit Strategy & Risk Tolerance A complete and coherent risk management framework contains the following elements

14. Sales channels Contracts & Documentation Credit analysis Credit limit Pricing & terms Credit Analysis Credit Decisions Collections CREDIT POLICY Collateral acceptance Portfolio management Financial analysis Disposal / Risk mitigation Collateral management Customer management Exposure measurement Management reporting Exposure aggregation Recoveries Credit scoring Risk rating RISK MANAGEMENT Credit Risk Managements Inter-related Activities Compliance Origination Reporting Transactions

15. Credit Risk Areas to Consider Credit Policy Credit Policy Credit Approval Authority Credit Approval Authority Limit Setting Limit Setting Pricing Terms and Conditions Pricing Terms and Conditions Documentation: Contracts and Covenants Documentation: Contracts and Covenants Collateral and Security Collateral and Security Collections, Delinquencies and Workouts Collections, Delinquencies and Workouts Exposure Management Exposure Management –Aggregation –Control Periodic Account Reviews Periodic Account Reviews –Payments/Aging –Credit Condition Compliance with Covenants, Terms Compliance with Covenants, Terms Technology/Reports Technology/Reports –Transactions/ Bookings –Risk-adjusted Return Sales Channels Sales Channels Risk Strategy Risk Strategy Underwriting Standards Underwriting Standards Credit Application Credit Application Analysis Analysis Business/ Industry Business/ Industry Financial Financial Credit Credit Credit Scoring and Ratings Credit Scoring and Ratings Origination/ Assessment Administration Monitoring/ Control Risk Management Portfolio Management Portfolio Management Concentration Concentration Diversification Diversification Allowance for Bad Debts Allowance for Bad Debts Risk Mitigation Risk Mitigation Objectives Objectives Type of Exposure Type of Exposure Instruments or Methods Instruments or Methods

16. Credit Strategy & Risk Tolerance Specific Quantifiable Objectives Management Review Methodology Credit Strategy Statement and Risk Tolerance Coordination with Business Plan

17. Foundation: Credit Rating and Underwriting Standards Risk Identification, Origination, Credit Administration, etc. Short Term: Managing Expected Loss Risk Identification, Transaction Structuring, Approval & Pricing Decisions, Reserving, etc. Near Term: Managing Economic Capital / Credit VaR Portfolio Risk Concentration, Risk Based Limits, etc. Vision: Managing Risk/Return Pricing decisions,Performance measurement, business and customer segmentation, compensation, etc. A business model view of Credit Risk Infrastructure components

18. Businesses have to contend with Expected and Unexpected Losses Expected Losses Expected Losses –Anticipated –Cost of doing business –Charged to provisions –Captured in pricing –Relatively easier to measure Assessing expected loss includes determining exposure, default probability and severity Assessing expected loss includes determining exposure, default probability and severity Unexpected Losses Unexpected Losses –Unanticipated but inevitable –Must be planned for –Covered by reserves –Allocated to businesses –Difficult to measure Assessing unexpected loss requires making qualitative judgments around potential volatility of average losses Assessing unexpected loss requires making qualitative judgments around potential volatility of average losses

19. Data Issue in Credit Risk Analysis Historical data, e.g. Financial data, credit ratings. Historical data, e.g. Financial data, credit ratings. Market Data, e.g. Price of corporate securities, stock price and price of credit derivatives Market Data, e.g. Price of corporate securities, stock price and price of credit derivatives At present, data availability quality is the major problem in credit risk management. At present, data availability quality is the major problem in credit risk management.

20. 5 Cs (: 1 Character 1 Character 2 Capacity 2 Capacity 3 Capital 3 Capital 4 Collateral 4 Collateral 5 Condition 5 Condition 5 Ws 5 Ws 1 Who 1 Who 2 Why 2 Why 3 When 3 When 4 What 4 What 5 How 5 How 5 Ps 5 Ps 1 Personal 1 Personal 2 Purpose 2 Purpose 3 Payment 3 Payment 4 Protection 4 Protection 5 Perspective 5 Perspective The classic credit risk management methodology

21. Credit rating system, all individual borrower (debtors?) has their own credit rating, which partially determines their asset price and discount rate. Credit rating system, all individual borrower (debtors?) has their own credit rating, which partially determines their asset price and discount rate. The borrowers (debtors?) in the same credit rating should have the same migration and default possibility. The borrowers (debtors?) in the same credit rating should have the same migration and default possibility. Movement in asset-return is caused by both systematic risk and individual risk (?) (individual credit risk for each debtor). Systematic risks are reflected in country and industry index, individual debtors stock earning ratio should be similar their asset return. Movement in asset-return is caused by both systematic risk and individual risk (?) (individual credit risk for each debtor). Systematic risks are reflected in country and industry index, individual debtors stock earning ratio should be similar their asset return. Spot and forward interest rate is normally fixed, hence the model is not sensitive to the interest rate movement. Spot and forward interest rate is normally fixed, hence the model is not sensitive to the interest rate movement. Basic assumption used in Credit Risk Management methodologies

22. Classic method Based on historical data Based on historical data Adopt traditional statistical models Adopt traditional statistical models Modern method Based on the movement in market variables, e.g. Asset, Share Price, Interest Rate and Foreign Exchange Rate Based on the movement in market variables, e.g. Asset, Share Price, Interest Rate and Foreign Exchange Rate Adopt Contingent Claim pricing model Adopt Contingent Claim pricing model Comparison between classic and modern credit analysis methodology

23. Classic methods Set-up credit limit Set-up credit limit Establish credit rating system Establish credit rating system Adopt credit improvement tools (Collateral, third party guarantee, Credit Agreement) Adopt credit improvement tools (Collateral, third party guarantee, Credit Agreement) Modern methods Credit rating on risk exposure Credit rating on risk exposure Active use of credit derivatives to migrate or diversify risk Active use of credit derivatives to migrate or diversify risk Comparison between classic and modern credit risk management methodologies

24. Credit derivatives can be treated as a tool to transfer risk from one party to another Credit derivatives can be treated as a tool to transfer risk from one party to another In market risk management, overall risk has been transferred ( interest rate risk, foreign exchange risk, securities risk, and etc.) In market risk management, overall risk has been transferred ( interest rate risk, foreign exchange risk, securities risk, and etc.) Within Credit Risk management, only credit related risks can been transferred Within Credit Risk management, only credit related risks can been transferred Credit Derivatives

25. High dependency in company default is the hot topic in credit risk analysis. This is critical in the portfolio investment in company debts and credit derivative pricing. High dependency in company default is the hot topic in credit risk analysis. This is critical in the portfolio investment in company debts and credit derivative pricing. Default dependency is influenced by both micro and macro factors. Default dependency is influenced by both micro and macro factors. As companies are running in similar macro economy environment. If the cause to default is caused by macroeconomic factors, e.g. interest rate, inflation rate, inflation rate and utility price, the dependency is called default correlation. As companies are running in similar macro economy environment. If the cause to default is caused by macroeconomic factors, e.g. interest rate, inflation rate, inflation rate and utility price, the dependency is called default correlation. If the company defaults because of its own management or production, e.g. goods supply and asset holdings, the dependency is called default contagion. If the company defaults because of its own management or production, e.g. goods supply and asset holdings, the dependency is called default contagion. Hot topics in Credit Risk Analysis

26. Credit risk management is more related to insurance but not hedging risk. Credit risk management is more related to insurance but not hedging risk. It is suggested to diversify the credit risk for portfolios, to avoid concentration It is suggested to diversify the credit risk for portfolios, to avoid concentration When the systematic factors (interest rate, foreign exchange rate) are identified, credit derivatives can be used to achieve the purpose of credit risk management. When the systematic factors (interest rate, foreign exchange rate) are identified, credit derivatives can be used to achieve the purpose of credit risk management. Conclusions in Credit risk management

27. 27 Dr. Zhou previously held several senior positions at many named organizations, such as Chief Economic Analyst at a foreign financial group (Great China), Manager at investment consulting firm under domestic securities company, head of investment consultation department in Securities Company and Analyst in D&R department in head office of a local bank. Dr. Zhou has extensive board of knowledge, specializing in knowledge in Macroeconomics Analysis, Investment Analysis, Corporate Financial Planning, Operation in Capital Market, Risk Management and Insurance. Dr. Zhou is working with East China Normal University as head of the department of risk management and insurance in the Faculty of Finance and Statistics.

28. Thanks