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Risk In Financial Services > Chapter 4: Credit Risk > Flashcards

Chapter 4: Credit Risk Flashcards

1
Q

What is credit risk

A

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.

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2
Q

What are the forms of credit risk

A

Counter party risk and issuer risk

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3
Q

What is counterparty risk

A

The risk that a counterparty fails to fulfil its contractual obligations

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4
Q

What is issuer risk

A

The risk that the issuer of the bind could default on its obligation to pay coupons or repay the principle bond

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5
Q

What causes concentration risk

A

An uneven distribution of exposures to individual issuers or counterparties or within industry sectors and geographical regions

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6
Q

What are the differences between issuer and counterparty risk

A

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

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7
Q

Sources of credit risk?

A

Loans
Extension of commitments and guarantees
Interbank transactions
Futures, options, swaps, bonds etc.
Settlement of transactions

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8
Q

What is settlement risk

A

The risk that only one party will deliver their end of the transaction

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9
Q

What is pre-settlement risk

A

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

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10
Q

What is systemic risk

A

A possible breakdown of the entire financial system rather than simply the failure of an individual firm

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11
Q

What should be considered when banks are developing their credit administration areas

A

Internal processes
Systems
people

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12
Q

What is credit exposure

A

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

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13
Q

What two parts does credit exposure consist of

A

Current exposure and potential future exposure

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14
Q

What is current exposure

A

The current outstanding obligation

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15
Q

What is potential future exposure

A

An estimate of the likely loss at some point in the future

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16
Q

Why is potential future exposure difficult to calculate

A

Uncertainty arising from credit facilities and financial instruments which have different economic futures according to future events

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17
Q

What is a credit risk premium

A

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

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18
Q

Who are the nominated regulators in the UK

A

Fitch Ratings
Moody’s
Standard and Poor’s
Dominion Bond Rating Service

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19
Q

What is a sovereign rating

A

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

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20
Q

What is a long term rating?

A

Analyses and assesses a company’s ability to meet its responsibilities with respect to all of its issued securities

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21
Q

What is a short term rating

A

Focuses on the specific securities’ ability to perform, given the country’s current financial condition and general industry performance conditions

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22
Q

What are the faults of credit agencies?

A

Companies not downgraded fast enough
Having close relationships with certain companies
Errors when rating some structured products

23
Q

Formula for expected loss

A

Probability of default (%)exposure at defaultloss given default (%)

24
Q

What is LGD

A

Loss Given Default is the percentage of the actual loan amount which is not mitigated by guarantees or collateral with the lender

25
Q

What is PD

A

Probability of Default is a measure of the likelihood of their failing to pay what they owe

26
Q

What is EAD

A

The exposure at default is the amount which a bank will be exposed to in the future at the point of potential default.

27
Q

Formula for recovery rate

A

RR = 100% - LGD

28
Q

What is wrong way risk

A

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

29
Q

What are non-performing assets

A

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

30
Q

What are credit limits

A

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

31
Q

What are the limitations of credit risk management

A

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

32
Q

What are underwriting standards

A

The standards that financial institutions apply to borrowers in order to evaluate their creditworthiness and, therefore, manage the risk of default

33
Q

What is a netting agreement

A

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.

34
Q

Benefits of a netting agreement

A

Reduces each parties settlement risk
reduces transaction costs
reduces communication expenses

35
Q

What is a unilateral arrangement (Collateral)

A

One party gives collateral to the other

36
Q

What is a bilateral arrangement (Collateral)

A

Both parties may post collateral

37
Q

What is diversification

A

Ensuring that the portfolio is spread across borrowers in different, negatively correlated industry sectors that have an inverse economic relationship to each other

38
Q

Difference between CDS and CDO

A

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

39
Q

Advantages of CDSs

A

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

40
Q

What is a loan sale

A

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.

41
Q

What is an SPV

A

A special purpose vehicle is a company that has been specifically been set up for the purpose of the securitization

42
Q

What are CCPs

A

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.

43
Q

How do CCPs obtain capital

A

Their members
Fees generated by the exchange
Other parties that do not have a direct relationship with their market

44
Q

What is a ‘haircut’

A

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%

45
Q

The measurement of credit risk should take account of:

A

Specific nature of credit
Exposure profile until maturity
existence of collateral or guarantees
The potential for default

46
Q

What is a credit scoring system

A

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

47
Q

What are financial inputs

A

Include an assessment of each firm’s earnings, cash flow, asset values, liquidity, leverage, financial size and debt capacity.

48
Q

What are non financial inputs

A

Will include each firm’s:

management quality
governance quality
Industry characteristics
Country risk
Credit rating

49
Q

What are extraordinary inputs

A

Court actions
Other one off factors that emerge

50
Q

Key areas for stress testing are:

A

Economic or industry downturns
Interest rate or other market movements
Market-risk events
liquidity conditions

51
Q

Evidence of impairment

A

Information about significant financial difficulties
Breach of contract
High probability of bankruptcy

52
Q

What is provisioning

A

When a firm sets aside an allowance for loss in its accounts due to loan impairment

53
Q

What KRIs should be displayed in a management dashboard

A

Number of debtors
Clients breaching covenants
Credit downgrades

54
Q

What is the HHI

A

The Herfindahl-Hirschman Index is the sum of all squared relative portfolio shares of the exposures. Does not take into account borrowers credit exposure

Risk In Financial Services (7 decks)

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