28. Managing credit risk Flashcards
Outline the credit risk management process
- Policy and infrastructure
- Credit granting
- Exposure monitoring, management and reporting
- Portfolio management
- Credit review
What is the purpose of policy and infrastructure?
- Ensures credit policies + procedures are documented to ensure effective identification, measurement, monitoring, control and reporting.
What are the 5 elements of policy infrastructure
- Establish appropriate credit environment
- Adopt credit risk policies and procedures
- Appropriate to business context
- Addressing range of topics
- Adopted by senior management
- Implement credit risk policies and procedures
- Communicate to all relevant employees
- Review at least annually ro reflect changes
- Develop methodologies and models, with appropriate systems
- Define data standards and conventions
What is credit granting?
- Extending credit to customers and other counterparties, esp
o Credit analysis/rating
o Credit approval
o Pricing and setting t+cs for credit
o Documentataion
What are the characteristics of an efficient credit rating process
- Needs to balance effectiveness and efficiency
- Based on pure judgement or deterministic modelling
- Must respond to changes in circumstances of counterparties – reviews etc
- Must reflect factors incl.:
o Repayment history
o Analysis of ability to pay
o Reputation
o Availability of guarantees or collateral
What will monitoring, managing and reporting on credit risk achieve?
- Prevent undue exposure to one counterparty
- Ensure appropriate portfolio diversification (eg by industry, location) and
- Provide early warning of possible adverse credit events (eg monitoring credit spreads and stock price volatility)
What is credit exposure
- Current – amount at risk today if all credit transactions were settled and credit assets sold
- Potential – amount that may be at risk in future- likely to be function of time to maturity and volatility of underlying
What are the uses of exposure limits?
- Pay attention to concentration risk and set limits for groups etc
- Uses of exposure limits
o Risk control – limits engagement in overly risky business activities
o Allocating risk-bearing capacity – limits must reflect mgmt’s assmt of risk/return trade-offs
o Delegating authority – ensures credit decisions are made by those with appropriate skill and delegated authority
o Regulatory compliance – regulators maintain close scrutiny of credit risk controls
Outline the best practices in credit risk reporting
Must be:
* Relevant and timely
* Reliable
* Comparable
* Material
Must include:
* Trends
* Risk-adjusted profitability
* Large individual exposures
* Aggregate exposures
* Exceptions to standard policies, limits etc
How can portfolio management be used to manage credit risk
Portfolio management function aims to optimise desired risk/return trade-offs by defining a target portfolio.
Credit policy will document strategies and financial vehicles that can be used, including:
* Buying / selling assets
* Securitising assets
* Hedging risk using derivatives
* Transferring risks
Outline how a credit review is carried out
- Separate group must:
* Review sample of transactions and associated documentation to ensure data is correct
* Test that systems are working
* Enforce uw standards
* Check policies and procedures are being followed - Must communicate to mgmt.
List credit risk management techniques
- Underwriting
- Due diligence
- Credit insurance
- Credit derivatives
- Credit Default Swaps
- Total Rate of Return Swaps
- Securitisation
- Credit-linked note
Explain securitisation
- Involves the pooling together with group of assets, combined with issue with one or more tranches of asset-backed securities.
- Cashflows generated by pool of assets are used to service interest and capital payments on asset-backed securities
What is a credit-linked note
- Collateralised vehicle consisting of bond with an embedded credit default swap
What is a TRORS
- Hedge price and default risk
- Total return from one asset or group of assets is swapped for return on another.
- If can’t short a security, might be able to hedge long position by paying TROR in a TRORS
Explain how a CDS works
- Want to reach internal credit limit but wish to maintain their relationship with that client
- Involves payment of a fee (single or regular) by party looking to hedge their risk (protection buyer) to the party that is selling protection.
- In exchange for fee, seller of protection will make a credit default protection payment if a credit default event on reference occurs within the term of contract.
- Only hedges default risk not price risk.
- Can be cash or physical settlement
What is cash settlement in a CDS?
payment is difference between original price of reference asset and recovery value of reference asset.
What is a physical settlement in a CDS?
protection seller pays par value of security and receives the defaulted security
What are the benefits of securitisation
o Converts a bundle of assets into structured financial instrument which is then negotiable.
o In doing so, it offers
Way for a company to raise money, that is linked directly to the cashflow receipts that it anticipates receiving in the future
An alternative source of finance to issuing “normal” secured or unsecured bonds
Way of passing risk in assets to 3rd party, removing them from balance sheet and reducing required capital
Way of effectively selling (exposure to) what may be an otherwise un-marketable pool of assets
How would you manage creditworthiness
- Can adjust
o Capital structure
o Mix and volume business it writes
