Chapter 4 - Credit Risk Flashcards
What is credit risk?
Who is the obligator?
The risk of loss caused by the failure of a counterparty or issuer to meet its obligation.
The party that has the financial obligation is called the obligator.
what are the two forms of credit risk?
Counterparty risk
- the risk that the counterparty is unable to fulfil its obligation
Issuer risk
- the risk that the issuer of the bonds could default on its obligations to pay coupons or repay principal amount of bond.
what is concentration risk?
Arises through an uneven distribution of exposure to individual issuers or counterparties (single-name concentration) or within industry (sectorial concentration)
What is the main areas of exposure of credit risk to banks.
Loans
what do the banking books and the trading books include?
The extension of commitment, interbank transactions, financial instruments, settlements
what is transaction settlement?
Example of a settlement risk
counterparty risk because its the risk that the buyer and seller exchange the instrument and the cash to pay for it.
Settlement risk = forward contract. risk that the firm will fail to make its payment.
Pre settlement risk = the risk that an institution defaults before the settlement of transaction, where the traded instrument has a positive economic value (interest rate swap)
What are the credit risk boundary issues identified by Basel
Basel describes the following operational “boundary” risks to be considered:
- Internal processes - efficiency and effectiveness of the credit administration operations
- systems - the accuracy and timeliness of credit risk information provided to management information systems
- people - adequate segregation of duties.
what is credit exposure? what’s it used to assess the severity of credit risk?
the amount that can potentially be lost if a debtor defaults on its obligations. It is used to assess the severity of credit risk from:
- counterparties, portfolios
what are the two parts of credit exposure?
current exposure = current obligation outstanding which is normally straightforward to calculate.
Potential failure exposure = estimate of likely loss at some point in the future. harder to calculate because of uncertainty of credit facilities, financial instruments with different values.
It is calculated by statistical techniques, such as value-at-risk VaR modelling.
what is credit risk premium?
Difference between the interest rate a firm pays when it borrows and the interest rate on a default-free security.
The premium is the extra compensation the market and financial institution requires for lending.
Credit rating
The higher a rating is, the more creditworthy, cost of borrowing is less.
Measures of credit risk:
- analysis on financial statements
- quality of management, competitiveness, growth
- individual issues.
how many credit rating agencies in the world.
the credit rating agencies in UK
the credit rating agencies in Germany
how are they rated by Uk ones?
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UK Regulators
- Fitch Ratings
- Moody’s
- Standards and Poor’s
- Dominion Bond rating service
Germany
- UK Four, and Japan Credit Rating agency
Rated
- AAA = highest S&P rating.
- Investment grade and speculative grade describe the categories.
what are sovereign credit ratings?
Sovereign credit ratings are grades given to countries to show how likely they are to repay their debts.
what are long-term ratings and short-term ratings?
long-term ratings = analyse and assess a company’s ability to meet responsibilities with respect to all its securities issued.
short-term ratings = focus on the specific securities ability to perform, given the company’s current financial condition and general industry performance conditions.
What are the specific criticisms of Credit rating?
- Companies have not been downgraded fast enough
- some rating companies are bias
- credit ratings often make errors
- immense public scrunity
what can you say for credit risks associated with loan defaults?
Expected Loss = PD X EAD X LGD
what is LGD?
LOSS GIVEN DEFAULT. the percentage of the actual loan amount which is not mitigated by (percentage of loss from the defaulter after collateral)
what is PD? how does the bank estimate this
Probability of default. Measure of the likelihood of borrower failing to pay what they owe. The bank estimates this by using historical experience and empirical evidence.
What is EAD?
Exposure at default. Amount which a bank will be exposed to in future at the point of potential default.
what does EAD depend on?
Maturity or “time to completion” of the loan arrangements. The longer the time to maturity, the larger the probability that the credit quality decreases.
what is recovery value? what is it in percentage? formula?
the amount a lender can recover through bankruptcy. If expressed as a percentage, its called Recovery Rate RR.
RR = 100% - LGD
what does the term credit event include?
Bankruptcy, insolvency, receivership, failure to meet obligations, credit-rating downgrade.
what is wrong way risk defined as?
Internal swaps and derivatives call it “exposure to a counterparty is adversely correlated with the credit quality of that counterparty”
what are non-performing assets?
when a payment becomes really late (over 90 days) and the loan is called non-performing.
What are credit limits? who are they established for?
The max limit for all aspects of credit exposure set by financial institutions. They need to establish credit limits of:
- individual borrowers
- counterparties
- groups of connected counterparties
The better quality, the higher lending limit.
what are the main limits of credit risk measurement?
- using simplified calculations of potential exposure (notional amount not always true measure)
- lack of recognition of the time period of credit risk
- lack of recognition of portfolio diversification
- financial institutions use probabilities which is a guest estimate.
what is underwriting standards in example of credit risk mitigation?
standards that financial institutions apply to borrowers in order to evaluate their creditworthiness, and manage risk of default
This requires an evaluation:
- review of cash flow
- industry variables
what are garentees?
When a borrower gets a third party or another organization to guarantee the debt. This means if borrower cant pay, the guarantee will.
Typically smaller companies make use of guarantees from third parties to obtain loans.
This will result in borrower paying fees, but they get access to lower-cost funding.
what is a nettled agreement?
what does this help?
Arrangement between two or more parties that allows them to offset, or combine their financial obligations, so they only settle for the difference rather than original amount.
This helps reduce each parties settlement risk, reduces transaction costs and communication expenses.
what is collateral?
why is it used and for what transactions?
an asset promised by a borrower to secure a loan, ensuring a repayment will occur in event of default.
Used to mitigate credit risk, for different transactions, such as foreign exchange forwards, securities lending and derivatives.
what are the types of collateral agreements?
Unilateral arrangement - one party gives collateral to the other
Bilateral arrangement - both parties make a promise to each other, such as a swap or foreign exchange forward.
Netted arrangement - allows parties to offset their mutual obligations and settle for the difference.
Typical arrangement - collateral is marked-to-market (present value is calculated using current market prices/rates) and the amount is adjusted to reflect change in value.
what is a credit default swap?
why is it used?
why is it sometimes bad?
what type of contract is it?
Insurance for a loan. For example, a bank will pay a premium to a third party who will agree to protect the bank in event of default.
Used to increase/decrease credit exposure, attractive bc:
- insurance to protect
- improve portfolio diversification
- transfer credit risk
But - expose to operational, counterparty, liquidity, legal.
IT IS A BILATERAL FINANCIAL CONTRACT.
What is a collateralized debt obligation?
what is a loan sale?
Financial product that bundles together a bunch of different loans, like mortgages, corp bonds into one big package. Then they are sold to investors, who can earn profits on the interest payments of the loans.
Investors can choose to sell the loans on to another institution in order to receive an immediate “lump sum” payment. = Loan Sale.
What is a form of a loan sale?
Securitisation = process of turning bundle of loans into tradeable securities that can be bought and sold by investors.
The originator = firm whos assets being securilsed
The Issuer = creates and sells the securities to investors.
the issuer
The role of SPV
What do they ensure?
This is commonly a company who is specially set up for the purpose, known as special purpose vehicle (SPV).
The creation of an SPV ensures that the underlying asset pool is help separately from the other assets as the originator. The assets will not be affected if bankruptcy.
Advantages and disadvantages of Securilsation?
Advantage = originators can access cheaper debt capital markets by using lower-rated entities.
It can be complex if underlying loans default.
what is a central counterparty/clearing house?
what do clearing houses need to cope with defaults?
Acting as an intermediaries between buyers and sellers, they act as a guarantor of transactions, reducing exposure to defaulting.
They need
- their members
- fees generated by exchange
- other parties that do not have direct relationship w their market.
what is a haircut? why is it used?
Haircut is an extra amount added to the collateral’s value incase the collateral value drops/defaults.
Calculated as = original amount + (original amount x haircut) =
what is the role of credit risk management?
credit risk management function is responsible for ensuring the firm’s credit risk is properly managed, and it will NOT own any risk itself.
Sound credit risk policy includes:
- owning the credit policy
- reviewing credit limits
- decisions on granting credit are made independently of the trading areas
- assessment on capital adequacy
- know your customer
What is the credit risk policy development?
Board of directors
senior management
How can it be effective?
Basel states that the board of directors should approve and review (annually) the firm’s credit risk strategy and significant credit risk policies. Strategy should include risk tolerance, level of profits.
Senior management - implements credit risk strategy.
To be effective: Communicated, implemented through appropriate procedures, monitored and revised.
what should the measurement of credit risk take account of?
1) specific nature of credit
2) exposure profile until maturity in relation to market movement
3) existence of collateral or guarantees
4) potential default based on internal risk rating
what are examples of measurement techniques as stated by Basel?
- data quality assurance
- model validation review
- reviews of underlying model assumptions
what is credit scoring system?
using questionnaires and standard credit request application forms which are scored. Includes:
- age
- credit history
- amount owed
- occupation
- years in current job
- home owner or renting
- result of stress testing
What are the different factor inputs?
Financial inputs - assessment of each firms earnings, cash-flows, liquidity, assets, debt
Non-financial inputs - management quality, governance structure, industry characteristics, country risk, credit rating
extraordinary inputs - court actions, one-off factors
What is stress testing in terms of credit?
What does the BIS recommend that banks could usefully examine?
commonly used by?
How should they be reviewed?
How are they used?
involves identifying possible events of future changes in economic conditions that could have unfavorable effects on banks credit exposure, or accessing banks ability to withstand.
Are:
- economic or industry downturns
- interest rate and other market movements
- market-risk events
-liquidity conditions
Typically used by large, international banks
Reviewed periodically and outputs incorporated into process for assigning and updating policies.
Used to form action plans that management can use to hedge against outcome, or reduce size of exposure.
What does the Basel Committee state about Segmentation? what should it be based on?
Retail banking attracts less capital compared to commercial banking.
Segmentation should be based on:
- credit scores
- time the transaction has been on bank books.
problems with external rating agencies?
- limited value
- too historic
- slow in response
- not detailed enough
what will lead to concentration risk?
Lending with no limit to high rating credit limit counterparties
what is one of Basel aims?
why?
what is a split-rating?
Incentive banks to improve their risk management by creating internal credit rating.
Why?
- differianate the degree of credit risk in different credit exposure. This will = accurate determination of credit portfolio.
- Determine internal capital allocation, pricing, profits
- categories credits into various classes
Split-rating = when a counterparty or financial instrument attracts different external ratings, leaves question of who to pick
what is the evidence of impairment?
- info about financial difficulties of a borrower
- breach of contract
- high profitability of bankruptcy
- granting by the lender to the borrower
what would a management dashboard display?
Key statistics and Key performance indicators:
- number of debtors pass due
- client breaching covenants
- credit downgrades
Key info about concentration risk
Concentration risk = arises through uneven distribution of exposure to indiv borrowers (single-name) or within industry sectors and geographical regions (sectorial concentration)
main problems with concentration risk
- bank needs to know the relationship between various counterparties
- the loan exposure to counterparties may only be half the picture.
how to measure concentration?
Advs and Disadvs
Herfindahl-Hirschman Index (HHI) = The sum of all squared relative (percentage) portfolio shares of the exposure.
work out - change into percentage, add them up.
+ = simple, moderate data requirements
- = doesn’t consider borrowers credit quality.
How to work out the VaR on a bond?
- establish which variable we want to measure (usually it is the value of a bond in one year time)
What is credit mitigation and standard deviation?
CP = actions taken to reduce credit risk with a bond.
SD = enables us to plot a distribution and read off the value at the required probability.
what is used for a portfolio bonds?
what is confidence intervals?
Correlations need to be taken into account to define any diversification benefit.
Confidence intervals = expressed as a percentage that a given value will not exceed.
For example, 95% confidence level = only 5% chance that we will loss more than £5 million.
where is concentration risk most likely to be found?
credit portfolio
Why is VaR used?
to control risk in trading books
what is most exposed to issuer credit risk?
fixed income fund (corporate bond fund)
