Credit risk Flashcards
Credit models and credit ratings
What is credit risk?
Risk that borrower defaults and is unable to pay their debt obligations.
What are the constituents of credit risk?
Default risk, Exposure risk, Recovery risk and Migration risk.
What is Default risk within credit risk.
It is the risk which occurs from a borrower missing their payment obligations.
What is Exposure risk within credit risk.
It is the amount of risk if default occurs and excludes the recoveries.
What is Recovery risk within credit risk.
It is the amount of money which can be collected back after default of a borrower.
What is Migration risk within credit risk.
It is the risk of a drop in the credit standing of a borrower.
Explain credit rating systems.
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.
What are the 2 types of credit rating systems?
Internal and External
Explain Internal Ratings
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.
What are the main internal rating processes?
- Statistical process using default probability model using quantitative (financial ratios) and qualitative factors (payment history). E.g. credit scoring
- Expert Judgement based processes where rater has deciding power
Explain external ratings
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.
What are the problems with external ratings?
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.
What are credit risk models?
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.
What are the types of credit risk model?
Credit scoring model, term structure model and option-based model
Explain Credit scoring models.
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.
What are the 3 types of credit scoring models?
Linear probability model, Logit model and Discriminant model
Explain the Linear probability model
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.
What are the cons of Linear Probability model?
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
What is the Logit Model
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.
Explain the discriminant model.
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.
What are the cons and limitations of the discriminant model of credit scoring models?
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.
What is the main difference between credit scoring models and credit ratings systems?
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.
What are some ways to manage credit risk?
Screening, Monitoring, Restricting loans to high risk borrowers, Collaterals and Covenants, Diversification over different types of risky borrowers
How to use credit allocation decision making when undergoing risk management?
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.
