23-0 BBK3253 | Risk Management Prepared by Dr Khairul Anuar L5 - Credit Risk Management - Systematic and Unsystematic Risk - Principle of Diversification

23-1 Content 1. Credit risk definition 2.Credit Risk vs. Market Risk 3.Credit Risk vs. Market Risk 4.Credit Products — Loans vs. Bonds 5.Understanding Credit Risk — A Simple Loan 6.Managing Credit Risk 7.Risk Diversification: Systematic and Unsystematic Risk 8.Portfolio Diversification 9.The Principle of Diversification 10.Diversification and risk 11.Systematic Risk Principle 12.Common Versus Independent Risk

Credit risk definition The potential for loss due to failure of a borrower to meet its contractual obligation to repay a debt in accordance with the agreed terms  Example: A homeowner stops making mortgage payments Commonly also referred to as default risk Credit events include bankruptcy, failure to pay, loan restructuring, loan moratorium, accelerated loan payments For banks, credit risk typically resides in the assets in its banking book (loans and bonds held to maturity) Credit risk can arise in the trading book as counterparty credit risk

Credit Risk vs. Market Risk Market risk is the potential loss due to changes in market prices or values  Assessment time horizon: typically one day Credit risk is the potential loss due to the non-performance of a financial contract, or financial aspects of non-performance in any contract Assessment time horizon: typically one year Credit risk is generally more important than market risk for banks

Credit Risk vs. Market Risk Many credit risk drivers relate to market risk drivers, such as the impact of market conditions on default probabilities. Differs from market risk due to obligor behavior considerations The five “C’s” of Credit — Capital, Capacity, Conditions, Collateral, and Character Both credit and market risk models use historical data, forward looking models and behavioral models to assess risks

Credit Products — Loans vs. Bonds Loans A contractual agreement that outlines the payment obligation from the borrower to the bank May be secured with either collateral or payment guarantees to ensure a reliable source of secondary repayment in case the borrower defaults Often written with covenants that require the loan to be repaid immediately if certain adverse conditions exist, such as a drop in income or capital Generally reside in the bank’s banking book or credit portfolio Although banks may sell loans another bank or entity investing in loans

Credit Products — Loans vs. Bonds Bonds A publicly traded loan — an agreement between the issuer and the purchasers Collateral support, payment guarantees, or secondary sources of repayment may all support certain types of bonds Structuring characteristics that determine a bond investor’s potential recovery in default Generally reside in the bank’s trading book

Understanding Credit Risk — A Simple Loan  Contractually, how a loan should work:

Understanding Credit Risk — A Simple Loan  Credit risk arises because there is the possibility that the borrower will not repay the loan as obligated

Managing Credit Risk  The following 2 concepts will provide a framework to understand the principles financial managers must follow to minimize credit risk, yet make successful loans: adverse selection and moral hazard  Adverse selection - refers to a market process in which undesired results occur when buyers and sellers have asymmetric information (access to different information); the "bad" products or services are more likely to be selected.asymmetric information  A moral hazard is a situation in which a party is more likely to take risks because the costs that could result will not be borne by the party taking the risk. In other words, it is a tendency to be more willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place.financial transaction

Managing Credit Risk  Solving Asymmetric Information Problems: 1.Screening and Monitoring: ─collecting reliable information about prospective borrowers. This has also lead some institutions to specialize in regions or industries, gaining expertise in evaluating particular firmsreliableinformation ─also involves requiring certain actions, or prohibiting others, and then periodically verifying that the borrower is complying with the terms of the loan contract.

Managing Credit Risk  Specialization in Lending helps in screening. It is easier to collect data on local firms and firms in specific industries. It allows them to better predict problems by having better industry and location knowledge.

Managing Credit Risk  Monitoring and Enforcement also helps. Financial institutions write protective covenants into loans contracts and actively manage them to ensure that borrowers are not taking risks at their expense.

Managing Credit Risk 2.Long-term Customer Relationships: past information contained in checking accounts, savings accounts, and previous loans provides valuable information to more easily determine credit worthiness.

Managing Credit Risk 3.Loan Commitments: arrangements where the bank agrees to provide a loan up to a fixed amount, whenever the firm requests the loan. 4.Collateral: a pledge of property or other assets that must be surrendered if the terms of the loan are not met ( the loans are called secured loans).

Managing Credit Risk 5.Compensating Balances: reserves that a borrower must maintain in an account that act as collateral should the borrower default. 6.Credit Rationing:  lenders will refuse to lend to some borrowers, regardless of how much interest they are willing to pay, or  lenders will only finance part of a project, requiring that the remaining part come from equity financing.

Risk Diversification: Systematic and Unsystematic Risk  Risk has two parts:  Systematic risk  Unsystematic risk  Total risk = Systematic risk + Unsystematic risk 16

Risk Diversification: Systematic and Unsystematic Risk Systematic risk arises on account of the economy-wide uncertainties and the tendency of individual securities to move together with changes in the market. This part of risk cannot be reduced through diversification. It is also known as market risk.  Includes such things as changes in GDP, inflation, interest rates, etc.) 17

23-18 Unsystematic risk arises from the unique uncertainties of individual securities. It is also called unique risk. Unsystematic risk can be totally reduced through diversification. Also known as unique risk and asset- specific risk  Includes such things as labor strikes, part shortages, etc Risk Diversification: Systematic and Unsystematic Risk

Portfolio Diversification Portfolio diversification is the investment in several different asset classes or sectors Diversification is not just holding a lot of assets  For example, if you own 50 internet stocks, you are not diversified However, if you own 50 stocks that span 20 different industries, then you are diversified

The Principle of Diversification Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion

Diversification and risk

Diversifiable Risk  The risk that can be eliminated by combining assets into a portfolio  Often considered the same as unsystematic, unique or asset-specific risk  If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away

Systematic Risk Principle  There is a reward for bearing risk  There is not a reward for bearing risk unnecessarily  The expected return on a risky asset depends only on that asset’s systematic risk since unsystematic risk can be diversified away

Common Versus Independent Risk  Example: Theft vs. earthquake insurance  Consider two types of home insurance: theft insurance and earthquake insurance.  Assume that the risk of each of these two hazards is similar for a given home in KL – each year there is about a 1% chance the home will be robbed, and also a 1% chance the home will be damaged by an earthquake.  Suppose an insurance company writes 100,000 policies of each type of insurance for homeowners in KL; are the risks of the two portfolios of policies similar? 24

Common Versus Independent Risk  Example: Theft vs. earthquake insurance  Why are the portfolios of insurance policies so different when the individual policies themselves are quite similar? ─Intuitively, the key difference between them is that an earthquake affects all houses simultaneously, so the risk is linked across homes – common risk. ─The risk of theft is not linked across home, some homeowners are unlucky, others lucky – independent risk.  Diversification: The averaging out of independent risk in a large portfolio. 25

Summary of Types of Risk 26