Presentation on theme: "CHAPTER 16 Introduction to Credit Risk"— Presentation transcript:
1 CHAPTER 16 Introduction to Credit Risk What is in this Chapter?INTRODUCTIONSOURCES OF CREDIT RISKTHE CREDIT LIFE CYCLEWHY MEASURE CREDIT RISK?
2 INTRODUCTIONThe taking of credit risk has always been a core activity for banksOver the last 10 years, quantitative measurement has been adopted by banks to improve their processes for selecting and pricing credit transactionsQuantitative measurement has become even more important since it was adopted by the Basel Committee on Banking as the basis for setting regulatory capital.
3 In this chapter, we review the process for granting credit and the ways in which risk measurement supports credit decisionsIn subsequent chapters, we review the different types of credit instruments, risk measurement for a single loan, risk measurement for a portfolio, and how the results are used for decision support.Most of the discussion focuses on estimating the economic capital, but we finish the credit-risk section with the Basel Committee's new framework for setting regulatory capital.
4 SOURCES OF CREDIT RISKCredit risk arises from the possibility that borrowers or counterparties will fail to honor commitments that they have made to pay the bank.
5 SOURCES OF CREDIT RISKCredit-related losses can occur in the following ways:A customer fails to repay money that was lent by the bank.The bank holds a debt security (e.g., a bond or loan) and the credit quality of the security issuer falls, causing the value of the security to fall. Here, a default has not occurred, but the increased possibility of a default makes the security less valuable.
6 The bank holds a debt security, and the market's price for risk changes. For example, the price for all BB-rated bonds may fall because the market is less willing to take risks.In this case, there is no credit event, just a change in market sentiment.This risk is therefore typically treated as market risk in the trading VaR calculator
7 SOURCES OF CREDIT RISKThere is a gray area between market and credit risks.Generally, changes in value due to defaults and downgrades are' considered to be credit risk because they depend on the behavior of the specific company.Changes in value due to changes in the risk-free interest-rate or changes in credit spread for a given grade are considered to be market risk because they depend on general market sentiment.
8 THE CREDIT LIFE CYCLEThe customer then applies for credit and supplies some information about his or her creditworthinessIn the case of a retail customer, it is personal information such as incomeIn the case of a commercial customer, it is balance-'sheet information such as total assetsBased on this information, the bank's credit department determines the riskiness of the customer and assigns a credit grade, which is a form of risk score.
9 THE CREDIT LIFE CYCLEOften, banks will supplement their grading processes with information from external rating agenciesFor retail customers, data is provided by credit bureaus who collect information from many banks and collate it for resale to any bank considering lending to an individual.In the United States the main credit bureaus are Equifax, TRW, and ExperianThe information includes personal details, such as income, and financial information, such as the total number of credit cards and whether the customer has defaulted.
10 THE CREDIT LIFE CYCLEFor lending to corporations, the main credit-rating agencies for large corporations in the United States are Standard & Poor's, Moody's, and Fitch IBCAFor the middle market, Dunn and Bradstreet is the primary rating agency.They take information on a company and an associated facility (a particular bond, for example), and they rate the facility based on subjective judgments and objective modelsThe models use information on the company's balance sheet and profitability. The result is a letter grade that indicates the "riskiness" of the facility.There are also companies (principally, KMV, now owned by Moody's) who rate corporations based on the volatility of their equity prices, which we will later discuss in depth
11 THE CREDIT LIFE CYCLEBased on the grade, the bank decides whether to offer credit to the customer, in what amount, at what interest rate, and with what termsThe difference between the risk-free rate and the rate charged to the customer is called the spread.The customer decides whether to accept the given price, and then there may be a final round of bank approval before the deal is closed. The process up to closing the actual deal is called origination.After the deal is closed, a series of disbursements are made to the borrower, and the loan becomes part of the bank's portfolio of assets
12 THE CREDIT LIFE CYCLEThe portfolio is managed to minimize the risk/return ratio of the portfolio.Eventually, most of the loans are paid back by the customers, but some default and go to the collections department, who takes time to recover as much of the outstanding amount as possibleThe collections department may also be called the workout group or the special assets group.
13 WHY MEASURE CREDIT RISK? Before launching into the analysis and calculation of credit risk, let us first consider what risk measurements would be useful to support the decisions in the process we discussed aboveThere are three main sets of decisions:Originationportfolio optimizationcapitalization.
14 WHY MEASURE CREDIT RISK? Supporting Origination DecisionsThe most basic decision is whether to accept a new asset into the portfolio. The origination decision can be framed in two possible ways:Given the risk and a fixed price, is the asset worth taking?Given the risk, what price is required to make the asset worth buying?
15 WHY MEASURE CREDIT RISK? The first is more often asked in a rigid system where there is little opportunity to modify the price, and therefore the decision becomes "yes/no.“This is the type of decision made when dealing with a large volume of retail customers.The question can be recast as, "Is the expected return on capital for this transaction greater than the bank's minimum return on capital?"To support this decision, we need to know the expected return, adjusted for expected losses and expenses, and the amount of capital that this transaction will consume
16 WHY MEASURE CREDIT RISK? The second approach is typically used in a flexible, liquid trading environment, or in negotiating rates and fees for a corporate loanHere, we start with the capital consumed and the known hurdle rate for the return on capital to calculate the minimum acceptable return for the overall loan
17 WHY MEASURE CREDIT RISK? Supporting Portfolio OptimizationIn optimizing a portfolio, the manager seeks to minimize the ratio of risk to returnTo reduce the portfolio's risk, the manager must know where there are concentrations of risk and how the risk can be diversifiedThis requires a credit-portfolio model that includes all the correlations between assets to show where there are concentrations of assets that are highly correlatedThe 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 and allow the manager to try "what-if" analyses to test strategies for diversifying the portfolio.
18 WHY MEASURE CREDIT RISK? Supporting Capital ManagementGiven the risk in the portfolio, the CFO needs to set the provisions for expected losses over the next year, and the reserves, in case losses are unusually badThe CFO also needs to ensure that the total economic capital available is sufficient to maintain the bank's target credit rating given the risksIf it is insufficient, the bank must (1) raise more capital, (2) reduce the risk, or (3) expect to be downgraded
19 WHY MEASURE CREDIT RISK? To set the provisions, the CFO needs to know the average losses that are to be expectedTo set reserves, it is necessary to know the loss that could be experienced in an unusually bad year, e.g., losses that have a l-in-20 chance (5%) of happeningTo set capital, we need the loss level that could be experienced in an extraordinarily bad year, e.g., losses that have a l-in-1000 (0.1%) chance of happeningThese statistics can be obtained if we can calculate the probability-density function for the portfolio-loss rate, which is the focus of the next few chapters