Credit risk

Question 1

What is credit risk?

Answer 1

it is the greatest risk run by banking institutions

Credit risk is inherent part of a bank’s business, e.g. lending and borrowing

 (Some) banks play a systemic role in the economic system, their balance sheet structures being driven by credit risk

 Credit risks gone bad, e.g. bankruptcies, are always highly disruptive, threatening and
spectacular (hence associated with high media presence)

Question 2

Credit risk: Definition

Answer 2

The risk of loss arising from nonpayment of installments due by a debtor to a creditor under a contract.

Question 3

Credit risk: Typology

Answer 3

1. Default risk
2. Creditworthiness risk
3. Issuer/borrower risk
4. Counterparty risk

Question 4

Credit risk formula

Answer 4

Credit risk = exposure x probability of default x (1- recovery rate)

Question 5

Credit risk: Characteristics

Answer 5

Systemic risk: Cyclical, influenced by the overall economic climate

Specific risk: Idiosyncratic component, i.e. specific to the borrower

Asymmetric risk: Unlike other market risks, its profitability structure is asymmetric

Question 6

How can credit risk be measured?

Answer 6

1) Regulatory framework: Outlook BASEL IV
2) Ratings & rating agencies
3) Credit spread

Question 7

How is the fair credti spread calculated?

Answer 7

S = q(1-R)
probability of default 𝒒 and recovery rate R
𝑆 increases with 𝑞 and decreases R

Question 8

Credit risk management

Answer 8

Micro management: Structuring each single transaction
Macro management: Portfolio level limits

Question 9

Counterparty risk management

Answer 9

Organised derivative markets: Institutional arrangements reduce CP risk
OTC (Over-The-Counter) markets

Question 10

Three “kinds” of capital

Answer 10

Accounting capital: The bank’s physical, e.g. equity, long-term subordinated debt, …
 Regulatory capital: Minimum capital required by regulator
 Economic capital: Target capital required to back all transactions and to maintain solvency

Question 11

Micro management

Answer 11

Structuring each single transaction

Appropriate pricing, with the risk premium compensating the potential loss
 Syndication, i.e. spreading the risk over the syndicate of lenders
 Ensure top seniority to be first to receive proceeds of a liquidation in case of default
 Ensure collateral to have first claim of certain assets
 Introduce credit/rating triggers to account for deterioration of creditworthiness of borrower (like step-up
coupons, collateral clauses, repayment, margin calls)

Question 12

Macro management

Answer 12

Avoid concentration effects by limiting credit risk as per region, country, industry, sector, rating (i.e.
risk) category: Diversification of idiosyncratic credit risks
 Account for correlations between credit risks
 Adjust global credit limits to account for changes in overall systemic credit risk

Question 13

What ist the Goal of the management of the credit portfolio of a bank?

Answer 13

maximise shareholder value, i.e. to
maximise the risk-adjusted return, the efficient use of economic capital

Question 14

How is Economic capital is determined?

Answer 14

Economic capital is determined using probability density functions (PDF) of credit losses
 Measures the probability of the losses on the risk portfolio exceeding the solvency threshold
 Loss may be modelled binary, i.e. default/non-default, or continuously as evolution of creditworthiness
 Very much like VaR, but: Timescale is different, ~some days for market risk vs. ~1y for credit risk
 Determine solvency threshold depends on risk aversion, financial soundness of bank, the tolerated
confidence interval of the PDF

Question 15

Ratings & rating agencies: Problems

Answer 15

Data coverage incomplete, insufficient, not global (especially historical)
 Categorising of credit risk neglects idiosyncratic risk of borrower
 Providing an outlook regarding the credit quality by extrapolation of historical data poses a problem in
general
 Due to the fundamental approach, ratings only adapt slowly and hence do not reflect a rapid deterioration
of the credit quality
 Structurally unable to predict “sudden death” of borrower, e.g. because of fraud (Enron)
 Conflict of interest, strong incentive to sell “good” ratings (“rating-shopping”, “rating arbitrage”)
 Market monopoly of the big three agencies makes it even more difficult to get an “independent” credit
quality assessment
 All of the big three agencies are U.S. companies, political independence challenged

Question 16

How does “traditional” credit risk management work?

Answer 16

“Traditional” credit risk management works ex post by reacting only after credit losses have occurred

Question 17

How does Economic credit risk management work?

Answer 17

Economic credit risk management anticipates losses ex ante and accounts for risk diversification on
portfolio level

Question 18

Which compnents does credit risk have?

Answer 18

Credit risk has a systemic and an idiosyncratic component, defaults happen rarely but with huge
impact (asymmetric risk, fat tail)

Question 19

How is credit risk measuret on protfolio level?

Answer 19

Measuring portfolio credit risk is done by calculating a probability density function of losses (e.g. via Monte Carlo simulation) and is used to quantify the unexpected loss which needs to be backed by economic capital