Credit risk management Module -4 Session No.

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Unexpected Vs Expected losses

       

Credit produce Income as well as Risk Expected Vs Unexpected losses Expected loss is statistical tool which will occur on an average Unexpected loss is deviation from average Default risk-Probability of default riskExposure risk-Exposure at default riskRecovery risk-Loss given default riskEL=PDXEADXLGD
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Yearly default rates and ratings

Moody s ratings AAA AA A BBB BB B
1/8/2012

Yearly default rate 0.02% 0.04% 0.08% 0.20% 1.80% 8.30%

3

Credit risk-examples riskDirect lending- repayment is not made lending Non fund- funds not forthcoming on fundcrystallization of LC/BG  Series of payment due from bonds are not forthcoming on due dates  Security trading- settlement not tradingforthcoming  Cross border exposure- currency exposuremovement not taking place

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Defining credit risk



 

Bank borrower or counter party will fail to meet its obligation in accordance with the agreed terms Also include credit rating down grades of borrowers Bank need to manage
Risk in Individual Credit Credit risk in entire portfolio Other source of credit risk such as guarantees, acceptances, forex business etc.

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Risk in individual credit Seven Cs of credit decision

Set a limit for each loan by screening  Character  Capacity  Capital  Creditworthiness  Collaterals  Convenants/conditions  Credit Ratings Internal and External
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Credit risk in the portfolio

Upside and down side risk in investment but only down side risk in loans  Diversification across industry, geography, sectors  Concentration risk


Exposure norms for sectors Exposure norms for individuals Exposure norms for group
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Credit risk from other sources



Bank may face credit risk other than loan and advances say
Acceptances (letter of credit) Inter bank transactions Trade financing Foreign exchange transactions Future, swaps, options etc.

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Basel guidelines for Credit risk management

Establishing a credit risk environment  Sound credit granting process  Maintaining a credit administration, measurement and monitoring process  Ensuring adequate control on credit risk  Assessment of assets quality, adequacy of provisions and disclosure of credit risk


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Credit Risk Measurement Basel II guidelines



Standard approach Foundation internal rating based approach Advance internal rating based approach

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Credit Rating
Bench mark criterion for investors, borrowers, banks, financial institutions  Ratings helps to compare performance  Used as a decision making tool  Trend Started in 1970- two international 1970agency Standard & Poor and Moody s Investor service  CRICIL, ICRA, FITCH etc are rating agencies in India

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Credit Rating


  

Information to investors-Investors risk investorsperception to Actual Credit Rating- investor may Ratinginvest or hold the security Bank use to support lending decision or staying invested or charging rate of interest Issuers also see benefits and pay for it RegulatorsRegulators- capital market investment and bank to rate borrower and risk weight of assets for capital adequacy
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Rating system in banks

Credit appraisal key skill is to identify risk, assess their severity and ensure they are mitigated so that lender is comfortable  Banks rate their customers both internally and externally  Basel II has made the external rating mandatory of loan above cut off


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Recovery


Warning system
Signal of borrower health Reminders & review

Loan work out

Restructuring Rehabilitation Compromise Scaling down of debt

Going to court for recovery

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Credit risk model



Basic model
NPA written off on the bank s profit PBT/NPA Will wipe out bank profit Margin of safety

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15

Credit risk model



Credit scoring model

Traditionally system of loan analysis Credit score model Probability of default (PD) to expected loss (EL)

Empirical techniques- historical default techniquesrate  Market based models- Counter party modelsmarket data to infer likelihood of default

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Credit risk transfer



Loan Syndication
Sharing of loan with other banks Earning fee based income through syndication

Participation Certificates
IBPC with recourse-remain in balance sheet recourseIBPC without recourse Move out of balance sheet

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Credit risk transfer



Securitization defined
Process of selling loans Homogeneous pool of loan assets that generates a predictable stream of future cash flow Remove assets from bank s book

Process
Originators to sell loan to a SPV (special purpose vehicle) Converted into securities - ABS (assets based securities) Sold to investors without recourse Interest of investor is saved through over collateralization, senor / subordinated structure , credit enhancement

Benefits
Mitigates credit risk, lower interest rate risk, profitability enhancement

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Credit risk transfer CLO, CBO



 

Originating bank transfer pool of loans, the bonds that emerge are called collateralized loan transfer (CLO) Originating bank transfer a pool of bonds, securitize them, these are called collateralized bond transfer (CBO) Generic name of CLO and CBO is CREDIT DEFAULT OPTION Typical securitization is purpose is liquidity whereas in CLO/CBO risk transfer, capital relief, arbitrage, balance sheet optimization
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Credit risk transfer



Credit derivatives
Way to insure credit losses Pay off linked to credit related event such as borrower default, credit rating down grades, value of security going down Bank transferring credit risk is called protection buyer and counter party (ready to bear credit risk) is called protection seller Are typically unfunded- protection seller need unfundednot invest money upfront

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Credit risk transfer



Credit derivatives-Typical products are derivativesCDO (credit default options) Already discussed CDS (credit default swaps)

Credit Defaults Swaps

Priced on the bases of Expected Losses (EL) Bank A agrees to pay Bank B fee for being pootection seller Bank B agrees to pay Bank A pre-determined value based preamount ( as % value of the assets) if default occurs Settlement is done either by cash or physical settlement In physical settlement protection seller will get possession of the physical assets

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Why do the bank use credit derivatives?

     

Easy and cost effective means to hedge portfolio risk Permit substantial flexibility and increase profitability efficiency Hedge against interest rate risk Efficient than loan sales Bank action is not visible to borrowers and market, hence remaining secret Loan sale call for substantial information and bank to incur more cost and obligations
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1/8/2012

Yearly default rates and ratings

Moody s ratings AAA AA A BBB BB B
1/8/2012

Yearly default rate 0.02% 0.04% 0.08% 0.20% 1.80% 8.30%

23