Chapter 4: Credit Risk Flashcards
What is credit risk
The risk of loss caused by failure of a counterparty or issuer to meet its obligations. The party that has the financial obligation is called the obligor.
What are the forms of credit risk
Counter party risk and issuer risk
What is counterparty risk
The risk that a counterparty fails to fulfil its contractual obligations
What is issuer risk
The risk that the issuer of the bind could default on its obligation to pay coupons or repay the principle bond
What causes concentration risk
An uneven distribution of exposures to individual issuers or counterparties or within industry sectors and geographical regions
What are the differences between issuer and counterparty risk
A broker could fail to deliver a bond issued by a company which is paying its coupons and redeeming its bonds - counterparty risk
The same broker could deliver the required bond, but the company may not pay its coupons or redeem its bonds - this is issuer risk
Sources of credit risk?
Loans
Extension of commitments and guarantees
Interbank transactions
Futures, options, swaps, bonds etc.
Settlement of transactions
What is settlement risk
The risk that only one party will deliver their end of the transaction
What is pre-settlement risk
The risk that an institution defaults before the settlement of the transaction, where the traded instrument has a positive economic value to the other party - typically takes place on interest rate swaps
What is systemic risk
A possible breakdown of the entire financial system rather than simply the failure of an individual firm
What should be considered when banks are developing their credit administration areas
Internal processes
Systems
people
What is credit exposure
The amount that can potentially be lost if a debtor defaults on its obligations. Used to quantitatively assess the severity of credit risk from counterparties and portfolios
What two parts does credit exposure consist of
Current exposure and potential future exposure
What is current exposure
The current outstanding obligation
What is potential future exposure
An estimate of the likely loss at some point in the future
Why is potential future exposure difficult to calculate
Uncertainty arising from credit facilities and financial instruments which have different economic futures according to future events
What is a credit risk premium
The difference between the interest rate a firm pays when it borrows and the interest rate on a default-free security e.g. government bond. The premium is the extra compensation the market or financial institution requires for lending to a firm that has a risk of defaulting
Who are the nominated regulators in the UK
Fitch Ratings
Moody’s
Standard and Poor’s
Dominion Bond Rating Service
What is a sovereign rating
similar to a credit rating but is for a country as a whole. Takes into account the current economic and political situation of a country
What is a long term rating?
Analyses and assesses a company’s ability to meet its responsibilities with respect to all of its issued securities
What is a short term rating
Focuses on the specific securities’ ability to perform, given the country’s current financial condition and general industry performance conditions
What are the faults of credit agencies?
Companies not downgraded fast enough
Having close relationships with certain companies
Errors when rating some structured products
Formula for expected loss
Probability of default (%)exposure at defaultloss given default (%)
What is LGD
Loss Given Default is the percentage of the actual loan amount which is not mitigated by guarantees or collateral with the lender
What is PD
Probability of Default is a measure of the likelihood of their failing to pay what they owe
What is EAD
The exposure at default is the amount which a bank will be exposed to in the future at the point of potential default.
Formula for recovery rate
RR = 100% - LGD
What is wrong way risk
Also known as wrong way exposure, it is the risk that occurs when exposure to a counterparty is adversely correlated with the credit quality of that counterparty
What are non-performing assets
Loans whose repayments are not being paid on time. If a loan is late for a short time, its classified as past due, after 90 days, it becomes non-performing
What are credit limits
Maximum limits for all aspects of credit exposure set by financial institutions. Firms must establish overall credit limits at the level of:
Individual borrowers
Counterparties
Groups of connected counterparties
What are the limitations of credit risk management
Using simplified calculations of potential exposure
A lack of recognition of the time period of credit risk
A lack of recognition of portfolio diversification
Financial institutions use probabilities which are a best ‘guestimate’ of the future
What are underwriting standards
The standards that financial institutions apply to borrowers in order to evaluate their creditworthiness and, therefore, manage the risk of default
What is a netting agreement
Allows two parties that exchange multiple cash flows during a given day to agree bilaterally to net those cash flows to one payment per currency.
Benefits of a netting agreement
Reduces each parties settlement risk
reduces transaction costs
reduces communication expenses
What is a unilateral arrangement (Collateral)
One party gives collateral to the other
What is a bilateral arrangement (Collateral)
Both parties may post collateral
What is diversification
Ensuring that the portfolio is spread across borrowers in different, negatively correlated industry sectors that have an inverse economic relationship to each other
Difference between CDS and CDO
A CDO is similar to a CDS. Both are shifting the underlying debt instrument from lender to investor, but, instead of doing so for a corporate loan or swap from a single borrower as in a CDS, they do so for a series of loans which allows for diversification
Advantages of CDSs
Buy or sell insurance to mitigate credit risk
improve diversification
Customize credit exposure to another party without having direct relationship
Transfer credit risk without affecting customer relationship
What is a loan sale
Instead of simply relying on the underlying income stream as a source o revenue, the lender can sell loans for a lump sum
Another form of loan sale is securitization - an issuer acquiring assets from originator and issuing bonds to finance the purchase of securitized loans.
What is an SPV
A special purpose vehicle is a company that has been specifically been set up for the purpose of the securitization
What are CCPs
The use of Central counter parties or clearing house is a method used by many exchanges to reduce credit risk. The clearing house acts as a guarantor of all transactions, limiting the exposure of its clearing members by protecting them from defaults.
How do CCPs obtain capital
Their members
Fees generated by the exchange
Other parties that do not have a direct relationship with their market
What is a ‘haircut’
the extra amount added to a collaterals value. The amount depends on the volatility of the asset serving as collateral e.g., government bond might be 3%
The measurement of credit risk should take account of:
Specific nature of credit
Exposure profile until maturity
existence of collateral or guarantees
The potential for default
What is a credit scoring system
For retail customers , systems include using questionnaires and standard credit request application forms. Questions include:
Age
credit history
Amount owed
Occupation
Years in current job
Home owner or renting
What are financial inputs
Include an assessment of each firm’s earnings, cash flow, asset values, liquidity, leverage, financial size and debt capacity.
What are non financial inputs
Will include each firm’s:
management quality
governance quality
Industry characteristics
Country risk
Credit rating
What are extraordinary inputs
Court actions
Other one off factors that emerge
Key areas for stress testing are:
Economic or industry downturns
Interest rate or other market movements
Market-risk events
liquidity conditions
Evidence of impairment
Information about significant financial difficulties
Breach of contract
High probability of bankruptcy
What is provisioning
When a firm sets aside an allowance for loss in its accounts due to loan impairment
What KRIs should be displayed in a management dashboard
Number of debtors
Clients breaching covenants
Credit downgrades
What is the HHI
The Herfindahl-Hirschman Index is the sum of all squared relative portfolio shares of the exposures. Does not take into account borrowers credit exposure
