Chapter 1 - Credit Risk Flashcards
What is the overall responsibility of the board of directors in credit risk management?
The board is responsible for all risks of the bank and sets strategy, policy, and limits.
What is the role of the Risk Management sub-committee?
It includes the CEO and heads of management from various risk management committees and ensures a coordinated approach to risks.
Who should ideally chair the Credit Policy Committee?
An independent chair, usually a non-executive independent board member.
List the responsibilities of the Credit Policy Committee.
- Credit risk management framework
- Formulating standards for credit proposals
- Credit analysis
- Ratings
- Loan structures, covenants and collateral
- Setting or sense checking credit pricing policy
- Delegating credit approval authority
- Monitoring, risk management and reporting
- Measuring and monitoring credit risk
- Maintaining credit risk within approved risk appetite limits
- Managing the credit portfolio
- Establishing a review mechanism for loans
- Setting policy for provisioning
- Devising a process for loan workout
- Ensuring compliance with regulatory requirements.
What is a risk appetite statement?
A document that sets out the risk profile by identifying risks and boundaries that the bank is prepared to assume.
True or False: The risk appetite statement should be signed off by the board.
True.
What factors are considered when setting highest level limits for risk exposure?
- Impact on regulatory capital
- Probabilities of default
- Expected losses under different scenarios.
What is the purpose of limits in credit risk management?
- Policing against intolerable risks
- Early warning system for increased risk.
What does a credit-capacity or credit-risk-profile tool illustrate?
It illustrates the impact of the cost of credit and expected credit losses based on the quality of credit originated.
What characterizes a benign credit environment?
- Low default rates
- Low loss rates
- Low cost of credit
- High liquidity for credit assets.
What management focus is typical during stressed macroeconomic conditions?
Limiting exposure to segments most susceptible to increased default and loss rates.
What is the importance of credit policies in banking?
They create a framework for lending and guide credit activities.
Fill in the blank: A credit policy includes sections on ___ and recovery management.
[credit management cycle].
What are some key governance aspects included in a credit policy?
- Articulation of ‘no go’ areas
- Understanding when a deal is ‘out of policy’.
What is the minimum requirement for information in the credit authorisation process?
Client identity verification and financial data.
What are the characteristics of macro-economic stress conditions?
- High unemployment
- High interest rates
- Low GDP
- Low consumer spending.
List some possible sub-departments of the credit risk management department.
- Credit Portfolio
- Credit Modelling
- Monitoring and Collection
- Collateral Management
- Restructuring.
What is the aim of credit capacity analysis?
To test the credit portfolio’s performance against the risk appetite set by the board.
What should be included in the credit management cycle of a credit policy?
- Underwriting criteria
- Legislation
- Approvals
- Managing exceptions.
What is the purpose of out-of-policy deals in credit portfolios?
To track deals outside of norms and standards and maintain this part of the credit portfolio to an acceptable smaller level, usually capped at 10% of the portfolio due to higher risk nature.
Out-of-policy deals generally involve higher risk and are monitored to ensure they do not exceed acceptable limits.
What are the minimum requirements for information and analysis in the credit authorisation process?
- Client identity verification
- Financial data (e.g. payslip for individual, audited financials for SME/corporate)
These requirements may vary depending on regulatory standards and internal policies.
Who typically approves larger and more complicated loans?
Credit committees.
The client officer sponsors the loan proposal memorandum and is responsible for its completeness.
What is one key function of monitoring the credit authorisation process?
Tracking processing time and cost per approval.
Monitoring can yield business insights and highlight areas for improvement.
What is the primary objective of credit risk management?
To assess the willingness and ability of a borrower to repay credit extended.
This objective holds true for both retail and non-retail credit.
How is retail credit typically characterized?
High volume and low value with minimal complexity.
Retail credit often involves automated processes for rapid decision-making.
What distinguishes non-retail credit from retail credit?
Low volumes with high deal values and varying degrees of complexity.
Non-retail credit often requires more customer interaction and negotiation.
What is the definition of default in retail credit?
90 days past due (three monthly payments missed).
This aligns with regulatory and Basel definitions.
What is the typical collections process for retail credit?
Largely automated and follows well-defined strategies starting with soft collections.
This can escalate to legal action if necessary.
What are the three models used in capital and provisioning for retail credit?
- Exposure at default (EAD)
- Probability of default (PD)
- Loss given default (LGD)
These models help banks assess risk and set appropriate capital levels.
What key factors do banks consider when extending credit to corporations?
- Market share
- Quality of products and services
- Innovation
- Brand
- Operating efficiency
Macroeconomic and industry factors also play a significant role.
What are the four main categories of financial ratios used in credit analysis?
- Leverage ratios
- Liquidity ratios
- Profitability ratios
- Efficiency ratios
These ratios help assess a company’s financial health and creditworthiness.
What is a line of credit?
Credit availability is established but approval is needed for each drawdown.
This is often used for short-term borrowing needs.
What is the purpose of covenants and guarantees in credit?
To mitigate credit risk by providing additional security for the lender.
These measures can lower expected losses associated with a loan.
What does qualitative analysis in credit risk assessment aim to determine?
The borrower’s ability and willingness to repay credit extended.
This includes assessing factors like management quality and industry outlook.
What is the typical repayment definition for non-retail credit?
Can range between 90 days past due to 120 days past due.
This varies based on the product and type of relationship with the borrower.
What are the characteristics of a revolving line of credit?
Allows for continuous borrowing up to a limit with repayments allowing automatic borrowing back up to the limit.
Credit cards are a common example of revolving credit.
What is the role of the relationship manager in non-retail credit collections?
To manage collections activities and discuss repayment terms with the corporate entity.
This approach allows for a more tailored collection strategy.
What is assessed to establish a borrower’s ability to repay credit?
Qualitative factors including management quality, labor relations, regulatory sensitivity, industry outlook, product quality, and brand quality
Qualitative factors help identify risks a borrower may face over the loan term.
How can the quality of senior management be rated?
From very strong to very weak
What is a key drawback of qualitative analysis in credit assessment?
It can be harder to justify and communicate due to its subjective nature
What is a credit score?
A numerical expression of creditworthiness generated by a statistical model
Credit scores are often used in retail lending, which relies on automated scoring.
What must banks satisfy supervisors about regarding credit scores?
Data relevance, model track record, and governance of credit score use
What basic information is included in credit reports?
- Identity of the counterparty
- Trade lines
- Credit enquiries
- Public records
- Collection items
What has changed in credit reporting practices regarding negative information?
Scheduled repayment of debt is now used as a positive factor
What is the minimum information required for a credit report?
One undisputed account opened for 6 months or more
What types of information are credit reports prohibited from containing?
- Race
- Religion
- National origin
- Sex
- Marital status
- Location of residence
- Age
- Income and employment history
What are potential sources of mistakes in credit score data?
- Lender error in recording payments
- Incorrect data submissions
- Identity theft
- Ex-spouse’s credit issues linked
Who pioneered the FICO credit scoring system?
Fair, Isaac and Company in the 1950s
What steps can consumers take to improve their credit scores?
- Paying bills on time
- Catching up on missed payments
- Reducing debt
- Avoiding opening new accounts unnecessarily
- Maintaining active accounts
What is the estimated weighting of factors in credit scoring?
- Payment history: 35%
- Debt-to-credit ratio: 30%
- Average age of accounts: 15%
- Types of credit: 10%
- Enquiries: 10%
What are the benefits of credit scores?
- Speed
- Objectivity
- Accuracy
- Forward looking
- Better differentiation
- Heightened competition
What is a cut-off score in lending?
A set score below which loan applicants are generally rejected
What is RAROC?
Risk-adjusted return on capital, measuring profitability after considering all costs
What does the RAROC formula include?
- Income
- Capital benefit
- Operating costs
- Funding costs
- Expected loss
What is EVA in banking?
Economic Value Added, which is net profit less the cost of economic capital
How is net interest margin calculated?
Difference between interest income earned and interest paid out, divided by average interest-earning assets
What factors influence changes in net interest margin?
- Supply and demand for funding
- Lending conditions
- Monetary policies
What determines the value of provisions for expected credit losses?
Application of International Financial Reporting Standards 9 (IFRS 9)
What complicates the impact of provisions in relation to economic conditions?
Lag between changes in economic conditions and changes in defaults and losses
What is the impact of changing economic conditions on provisions?
Provisions may not be appropriate for current or future economic conditions due to a lag between changes in economic conditions and changes in defaults and losses.
Management overlays or overrides to models may be applied if provision models do not reflect current economic conditions.
How do arrears rates affect the value of provisions?
The value of provisions held will increase when the arrears rate of the balance sheet increases, and vice versa.
Higher levels of arrears generally lead to an increase in provisions.
What are the three stages defined in IFRS 9 for categorizing assets based on credit risk?
Stage 1, Stage 2, Stage 3.
Each stage reflects different levels of credit risk and corresponding expected credit losses (ECLs).
What characterizes assets in Stage 1 under IFRS 9?
Assets are performing with no significant increase in credit risk since origination. ECLs are estimated for a default in the next 12 months.
This stage indicates a low level of credit risk.
What is the definition of Stage 2 assets in IFRS 9?
Assets are performing but have experienced a significant increase in credit risk since origination, with ECLs estimated on a lifetime basis.
This indicates a higher likelihood of default compared to Stage 1.
What defines assets in Stage 3 according to IFRS 9?
Assets are considered credit-impaired and present a high likelihood of default or have defaulted. ECLs are estimated on a lifetime basis.
This stage requires significant provisions for losses.
What are forward-looking provisions in the context of IFRS 9?
Provisions for losses that may arise due to macroeconomic conditions, updated regularly to account for changes.
They aim to smooth losses over time if modeled accurately.
What is the importance of collateral in banking?
Collateral acts as a risk mitigant and is essential for securing loans.
It protects lenders against borrower default.
What is required for a bank to have clear rights over collateral?
The bank must be able to liquidate or take possession of the collateral in a timely manner in the event of default.
This process is known as ‘perfecting’ an interest in the collateral.
List the factors that influence the amounts and types of collateral.
- Client risk
- Facility risk and maturity
- Available collateral
- Volatility of collateral value
- Liquidity of collateral
- Legal terms.
These factors are negotiated between the lender and borrower.
What is the role of a dedicated collateral management department?
Responsibilities include monitoring collateral amounts and value, collecting additional collateral, and monitoring collateral concentrations.
This ensures the bank remains protected against potential losses.
What is credit portfolio monitoring?
A standard process for validation and review of credit risk models, assessing accuracy and consistency of ratings.
It includes back-testing and benchmarking against external sources.
What are the key objectives of credit portfolio management?
- Optimize the credit portfolio
- Use quality data to assess performance
- Monitor portfolio performance
- Identify potential future risks.
Effective management helps in maintaining profitability and controlling risk.
What strategies can be employed to manage credit concentration risk?
- Setting concentration limits
- Diversification of credit assets.
Diversification can be achieved across asset classes, geography, and industries.
What are early warning indicators in credit risk management?
Signals that help identify potential future losses before they occur, allowing lenders to take preemptive actions.
Examples include changes in consumer income or spending habits.
Define default in the context of loans.
Default is when a borrower fails to meet the conditions of a loan, which may involve missed payments or breaches of covenants.
Default is distinct from insolvency and bankruptcy.
What is the purpose of consumer debt counselling?
To provide budget advice, negotiate with credit providers, and restructure debt for consumers facing financial difficulties.
This process is established under the National Credit Act in South Africa.
What is vintage analysis in credit risk assessment?
Grouping similar loans from different time periods to assess performance and understand risk trends.
This method helps in forecasting repayment rates and delinquencies.
What is the significance of behavioural scoring in credit risk management?
It assesses credit risk based on patterns of activity and recent trends in borrower behavior.
Negative behaviors can indicate financial difficulties.
What is the primary purpose of the National Credit Act in South Africa?
To establish a debt counselling process for consistent debt restructuring.
This Act helps consumers manage their debts effectively.
What are the four key expectations of debt counselling?
- Pay manageable levels of principal and interest
- Incur reasonable debt counselling fees
- Be given fair expectations of what can be achieved
- Receive education and help with budgeting
These expectations aim to prevent future financial problems.
What must a creditor do before applying for court permission to institute repossession?
Send the customer a written notice of options to repay or seek debt counselling.
This requirement ensures that consumers are aware of their options.
What is the first step a bank typically takes in corporate debt restructuring?
Attempt to refinance debt by extending the maturity and reducing payments.
This can help avoid default or bankruptcy.
What is a workout plan in the context of corporate debt restructuring?
A plan created to rehabilitate the company and make debt levels serviceable.
This often involves negotiations between creditors and the company.
What is the role of the model validation team in a bank?
To provide an independent review of the model development process to minimize model and operational risk.
This ensures the validity of model outputs.
Fill in the blank: Securitisation is a financial structure that creates a new security consisting of a collection of existing _______.
[credit assets]
Examples include mortgages and credit card receivables.
What are some challenges lenders face when managing a Special Purpose Vehicle (SPV)?
- Lack of transparency
- Difficulty managing the SPV
- High costs of underwriting, legal, and marketing
- Inaccurate risk assessment
These challenges can complicate the securitisation process.
True or False: Credit derivatives can affect the capital required under a regulatory framework.
True
Banks must have proper systems in place to manage these derivatives.
What is a Credit Default Swap (CDS)?
A derivative used to hedge against specific credit risks by allowing a lender to sell credit risk to another party.
It operates similarly to insurance.
What are credit-linked notes used for?
To protect against a credit event of another party by linking the note to a reference asset.
They can be redeemed for the recovery value if a credit event occurs.
List the two most common types of leasing.
- Financial leasing
- Operational leasing
The distinction is based on the transfer of risk and reward.
What is the main credit risk associated with leasing?
The risk that the lessee will default on payments due.
Recovery rates of leased assets can also be lower than expected.
What does green finance promote?
Environmentally-responsible investments and low-carbon technologies.
It focuses on projects that reduce greenhouse gas emissions.
What does a payment moratorium grant to a borrower?
The opportunity to halt repayments and continue at a later stage.
This can help prevent default during financial hardships.
What is the main risk factor for commercial real estate loans?
The risk of payments not being made and the loss once default occurs.
Factors like property value fluctuations and liquidity risk increase this risk.
What are covenants in the context of credit risk mitigation?
Conditions set for borrowers to fulfil, ensuring they exclude certain activities.
They are typically used in larger loans.
What is the purpose of a model validation report?
To provide assurance that the model development process has been independently reviewed.
It highlights key findings and risks identified during validation.
What is green finance?
Financial products and services that promote environmentally-responsible investments and stimulate low-carbon technologies, projects, industries, and businesses.
Green finance encompasses climate finance, which focuses on financing costs related to climate change adaptation and greenhouse gas emissions reduction.
List some types of projects and industries that utilize green financing.
- Waste processing and recycling
- Biodiversity protection
- Water sanitation
- Renewable energies (solar, wind)
- Energy efficiency
- Sustainable transport
- Social impact projects
These projects aim to foster sustainable practices and reduce environmental impact.
True or False: A positive correlation has been found between a borrower’s credit rating and their environmental, social, and governance (ESG) scores.
True
This indicates that borrowers promoting ESG-friendly projects may have a lower credit risk profile.
What are some factors lenders of green finance need to consider in assessing credit risk?
- Unpredictable government and policy support
- Availability of government guarantees
- Lack of sufficient data and history
- Volatility of renewable energy production
- Low consumer demand for green products
- Technology risks
- Length of time for projects to deliver returns
Each factor can significantly impact the feasibility and profitability of green projects.
What is development finance?
Provision of financing to projects or segments not typically serviced by regular capital markets, often with social benefits exceeding commercial metrics.
Development finance is usually conducted by development financial institutions (DFIs).
What roles do development financial institutions (DFIs) play?
- Provide riskier loans, equity participation, and guarantees
- Focus on infrastructure enhancement, SME financing, agriculture, and climate-related projects.
DFIs are crucial in developing countries, often operating as non-profit organizations.
Fill in the blank: DFIs usually have a set of objectives that include financing _______.
[infrastructure enhancement, SME financing, climate-related projects]
These objectives aim to enhance socio-economic impacts in various sectors.
What credit risk metrics are important in development finance?
- Probability of Default (PD)
- Loss Given Default (LGD)
- Exposure At Default (EAD)
These metrics help assess and manage the higher risks associated with development financing.
What changes might a bank make to its credit origination policy during a benign credit environment?
- Approve more credit applications
- Lower collateral requirements
- Increase auto-approvals
- Consider more manual judgments
- Widen target markets
A benign environment indicates lower risk, allowing for more aggressive lending strategies.
How does data quality influence a bank’s origination strategy?
Good-quality data allows for better credit-scoring models, leading to more accurate risk assessments and competitive advantages.
Poor quality data can result in conservative lending decisions and missed opportunities.
What are the implications of actual default rates being consistently lower than expected Probability of Default (PD)?
It may indicate an emerging benign environment, suggesting a need to reassess and recalibrate PD models.
This could also imply that current credit policies are too restrictive.
What does it imply if Loss Given Default (LGD) is consistently higher than expected?
- Indicates a strained macro-economic environment
- Suggests a need to reassess LGD models
- Implies underestimation of provisions for bad debt
Higher LGDs can lead to more volatile profit releases over time.
