Credit risk

Question 1

What is credit risk?

Answer 1

Risk that borrower defaults and is unable to pay their debt obligations.

Question 2

What are the constituents of credit risk?

Answer 2

Default risk, Exposure risk, Recovery risk and Migration risk.

Question 3

What is Default risk within credit risk.

Answer 3

It is the risk which occurs from a borrower missing their payment obligations.

Question 4

What is Exposure risk within credit risk.

Answer 4

It is the amount of risk if default occurs and excludes the recoveries.

Question 5

What is Recovery risk within credit risk.

Answer 5

It is the amount of money which can be collected back after default of a borrower.

Question 6

What is Migration risk within credit risk.

Answer 6

It is the risk of a drop in the credit standing of a borrower.

Question 7

Explain credit rating systems.

Answer 7

They help to rate the risk quality of a borrower by measuring the probability of default and the amount of recoveries in the event of default.

Ranked using ordinal measures like letter grades A, B, C instead of quantitative measures of risk quality.

Question 8

What are the 2 types of credit rating systems?

Answer 8

Internal and External

Question 9

Explain Internal Ratings

Answer 9

Uses internal risk models which are tailored to the risk appetite of the banks and help to support their banking functions e.g. loan approvals.

Includes components to separate default risk from recovery risk.

Question 10

What are the main internal rating processes?

Answer 10

1. Statistical process using default probability model using quantitative (financial ratios) and qualitative factors (payment history). E.g. credit scoring
2. Expert Judgement based processes where rater has deciding power

Question 11

Explain external ratings

Answer 11

External rating companies provide independent and objective credit ratings. Mainly for larger companies and banks that issue debt securities in the capital markets.

Uses fundamental analysis.

Question 12

What are the problems with external ratings?

Answer 12

May be too simplistic and the rating agencies have too much power without accountability.

E.g. for structured products like CDOs, can be engineered to improve the credit rating of the product despite having low credit quality products in it. Led to the credit crunch crisis as many people trusted in the rating agencies and blindly bought various structured products.

Question 13

What are credit risk models?

Answer 13

Mainly uses quantitative models to measure probability of default using attributes of borrowers.

Dependent on availability, quality and cost of information. Banks can collect internal info on clients while corporate borrowers already have public info.

Only use qualitative model when limited public info. Based off subjective judgment of bank employees.

Question 14

What are the types of credit risk model?

Answer 14

Credit scoring model, term structure model and option-based model

Question 15

Explain Credit scoring models.

Answer 15

Predict borrower performance with little resources and help speed up decision making e.g. loan approvals. Best used for smaller borrowers since not much info available.

Use statistical model to fit observable variables like financial data and age of borrower to predict default rating.

Question 16

What are the 3 types of credit scoring models?

Answer 16

Linear probability model, Logit model and Discriminant model

Question 17

Explain the Linear probability model

Answer 17

Uses a simple regression model to input past data to identify variables that lead to defaults of borrowers. Can then use the variables to predict default probability of new borrowers.

Question 18

What are the cons of Linear Probability model?

Answer 18

Can be statistically incorrect as it follows normal distribution assumption but may not always be the case. Also allows estimated probabilities to be below 0% or above 100% which is impossible

Question 19

What is the Logit Model

Answer 19

A type of credit scoring model. Similar to Linear probability model but is better. Solves the problem of Linear probability by limiting probability to zero-one interval.

Question 20

Explain the discriminant model.

Answer 20

Uses Z-score to discriminates borrowers using observed characteristics into high and low default classes. Higher Z-score = lower risk of default. Dependent on factors like financial ratios and the weighted importance of these ratios. The weightage is based off past observed data of defaulting and non-defaulting firms.

Question 21

What are the cons and limitations of the discriminant model of credit scoring models?

Answer 21

Only consider 2 extreme cases of default and non-default when in reality there are other types such as delay of payments.

Ignores some important factors such as reputation and business cycle effects.

No linkage to any financial theory.

Question 22

What is the main difference between credit scoring models and credit ratings systems?

Answer 22

Credit ratings are more on larger corporate borrowers where there are more information about them. They use fundamental analysis to rate. Uses ordinal measures like A, B, C to rate instead of qualitative measures.

Credit scoring models more focused on statistical models using observable variables to predict the behaviour of borrower and the probability of default. Uses both qualitative and quantitative measures to quantify.

Question 23

What are some ways to manage credit risk?

Answer 23

Screening, Monitoring, Restricting loans to high risk borrowers, Collaterals and Covenants, Diversification over different types of risky borrowers

Question 24

How to use credit allocation decision making when undergoing risk management?

Answer 24

3 main principles:
Selection, Limitation and Diversification

Selection: Who to lend to? Do screening and evaluate who lower probability of default

Limitation: How much to lend? Limit max amount risk of bank capital can be loaned out to limit losses.

Diversification: How spread lending across different borrowers? Avoid concentration by lending to different borrowers across countries, economic sectors.

Question 25

How does credit enhancement help in managing risk?

Answer 25

Helps to reduce losses by increasing recovery rate.

Usage of tools such as collateral (if default can seize collateral), covenants (restrict borrower. Prompt repayment if borrower breach terms) and guarantees (3rd party pay if borrower defaults).

Question 26

How does loan sales help with credit risk management?

Answer 26

Bank can remove the loans from the balance sheet by packaging it and selling it to outside buyer. Sale with no recourse means no liability to the bank after sale. Buyer take all the credit risk.

Question 27

How does the term structure model work?

Answer 27

Usage of financial market data. Mainly for large corporate borrowers. Analysis of risk premium through comparison of the yield on corporate debt and risk free bond. Higher risk premium/ spread = higher risk = higher implied default probability.

Cons: Only of large borrowers as small companies do not have corporate bonds in the financial markets due to lack of reputation and therefore demand for it.

Question 28

Explain option based models.

Answer 28

Usage of option pricing theory and financial market data to determine risk premium. Used for large corporate borrowers.

Theory that Hold equity = hold call option on value of borrower’s asset. Because if firm defaults, will relinquish asset to debt holder so max loss is limited to amount of equity invested in firm. But if success, borrower keep upside and pay principal + debt interest. Interest= option premium. Same payoff as call option.

Theory that payoff of debtholder = writing put option on value of borrower’s asset. Because max amount debt holders receive is amount of loan given. They repay if firm asset value more than debt repayment. Repay principal + interest = principal + option premium from writing the put. If asset value less than repayment, will choose to default. Same characteristic as writing put option.

Therefore, can adjust risk premium using borrower’s leverage and asset risk changes to estimate risk premium and default probability.

Question 29

What are the cons of option based models? and how to solve?

Answer 29

May be hard to observe market value and volatility of firm’s asset. Hard to practically implement.

Solution: Moody’s KMV approach.
Use equity market info to extract implied market value of firm asset and volatility. Let equity value = call option on firm asset value. Calculate distribution of possible asset value wrt current debt obligations. Will tell us probability of firm market value falling below repayments on short-term debt liabilities. This will be the expected default frequency and tells us chances of insolvency.

Question 30

What are the concerns with these products?

Answer 30

Financial instability cause bank runs and financial system breakdown.

Question 31

What are the similarities between securitisation and credit derivatives?

Answer 31

Both are useful products in aiding credit risk management of banks

Question 32

What are the differences between securitisation and credit derivatives?

Answer 32

Securitisation is more used for funding purposes while credit derivatives are more for hedging purposes.

Securitisation will not keep the assets under the balance sheet, so will improve capital adequacy ratio. Credit derivatives keep asset under balance sheet. Allow them to maintain good long-term relationship with customer without full exposure to the risk.