Ch1 - Fundamentals of Credit Risk

Question 1

Credit Risk

Answer 1

The possibility of losing money due to the inability, unwillingness, or nontimeliness of a counterparty to honor a financial obligation

Question 2

Three concepts associated with credit risk

Answer 2

1. Insolvency - the financial state of an obligor whose liabilities exceed its assets
2. Default - failure to meet a contractual obligation, such as a through payment
3. Bankruptcy - when a court steps in upon default after a company files for protection under legislation

Question 3

Types of transactions that create credit risk

Answer 3

• Lending
• Leases
• Sale of a product/service
• Prepayment of goods/services
• A party’s claim on an asset in the custody of or under the management of another party (e.g. bank deposit)
• Contingent claims
• Derivative transactions (indirect exposure)

Question 4

Who has the largest exposure to credit risk?

Answer 4

1. Financial institutions
2. Federal government, then state and local govs
3. Foreign entities
4. Households
5. Non-financial companies

Question 5

Exposure to credit risk: Banks

Answer 5

• Largest exposure, therefore largest risk management
• Are increasingly turning to cap markets to hedge exposure
• After loans, derivatives generate the largest credit risk exposure

Question 6

Exposure to credit risk: Insurance companies

Answer 6

• Exposed in two main areas: investment portfolio and the reinsurance recoverables
• Their balance sheets are characterised by large amounts of claims reserves on the liab side and corresponding investment positions on the asset side

Question 7

Exposure to credit risk: Corporates

Answer 7

• Biggest source of CR is account receivables
• Second biggest source is where they have significant amounts of cash to invest
• Derivative trading activities
• Some companies provide financing to their clients

Question 8

Why manage credit risk?

Answer 8

• Important aspect is that it IS controllable
• CR is also the product of human behaviour (decisions)
• Long-term key to survival is a sufficiently high equity capital complemented by prudent risk management

Question 9

Tutorial1: What is the amount of credit risk? How much can be lost of what is the total cost if the obligor fails to repay/perform?

Answer 9

• The total amount of the principal and interest accrued to date with any attached fees and charges the bank deems appropriate.
• Aus has full recourse system: the obligor is responsible for the full amount, the bank will not forfeit its claim on the individual’s assets until full amount paid
• US has non-recourse: homeowner simply vacates premises and bank would sell the house to recover amount

Question 10

Tutorial1: What is the default probability (PD) of the counterparty? What is the likelihood that the obligor fails to pay/peforform?

Answer 10

• Every counterparty’s PD ranges from 0-100%. Based on their credit assessment the bank will determine the PD of their counterparty and subsequently decide to extend/decline the loan request.
• This is done through the credit scoring system
• If the obligor fails to pay, the bank will look to what security there is available to partially/fully recover any outstanding debts.

Question 11

Tutorial1: Who much can be recovered in the case of bankruptcy?

Answer 11

Banks may not recover more than what is owed to them, inclusive of interest, fees and charges

Question 12

Tutorial1: In the case of non-payment or non-performance, what is the remedy and how much can be recovered, in what time frame and at what expense?

Answer 12

• Has to be within a narrow time frame. Once the bank decides to foreclose the loan, it needs to be executed immediately.
• Sometimes banks incur costs to liquidate assets and such costs are sometimes recovered when the asset it liquidated.