Credit Risk Flashcards
why is credit risk so important?
Credit risk is important because borrowing is a large part of what commercial banks do (in their day to day activities)
What is the simplest definition of Credit risk
It is the risk that the borrower will fail to fulfil their financial obligations as agreed
How many types of loans are there?
There are 3 Types of loans
What are the 3 Types of loans?
1) Commercial and industrial
2) Real estate loans
3) Consumer Loans
List the 5 Commercial and industrial loans
1) Syndicated loan
2) Secured loan
3) Unsecured loan
4) Spot loan
5) Commercial paper
Name a real estate loan
Adjustable-rate mortgage
Name a consumer loan
Revolving loan
What is a syndicated loan?
It is a loan provided by a group of FIs as opposed to a single lender
What is a Secured loan?
loan backed by a first claim on certain assets of borrower
What is an unsecured loan?
It is a loan that has only general claim to assets of borrower
What is a spot loan?
It is a loan amount withdrawn by borrower immediately
what is a Commercial paper?
It is an unsecured short-term debt instrument
what is an adjustable-rate mortgage?
It is a mortgage whose IR adjusts with market movements
what is a revolving loan?
It is a credit line on which borrower can draw and repay many times
Will more adjustable-rate mortgages be originated in high- or low-interest rate environments? Why?
High
Once financial institutions decide to grant a loan, they need to decide on the price thereof (i.e the interest rate)
What components must the Pricing include?
The Pricing must include perceived credit risk and any additional fees backing the loan
How many factors impact loan returns ?
There are 5 factors that impact loan returns
What are the 5 Factors that impact loan returns?
1) Base lending rate (prime lending rate – 7% can also be linked to JIBAR)
2) Fees relating to the loan
3) Credit risk premium (low credit score results in high-risk premium)
4) Collateral backing the loan
5. Compensating balance (% of loan that borrower must hold)
Instead of the Base lending rate What rate was previously used globally? Why is it not used anymore?
LIBO
It is not used anymore because it was manipulated
What is credit rationing?
It refers to how FIs group clients into categories of loan quantity restrictions rather than IR
In simple terms, Credit rationing is the bank refusing to issue the loan if too risky as opposed to just charging a higher interest rate
At wholesale level what do FIs use control credit risk?
At wholesale level FIs use both IR and credit quantity to control credit risk
What interest rates are Lower-risk borrowers charged?
Lower-risk borrowers are charged IR below prime rate
What interest rates are higher-risk borrowers charged?
Higher-risk borrowers are charged a risk premium
At low rates what kind of risk do borrowers need to take?
Low or high risk
At low rates (k) borrowers do not need to take high risk and
can use FI funds.
At high rates what kind of risk borrowers do need to take?
At high rates (k) borrowers may need to switch to high-risk
investment projects.
What happens when IR rise above (k) (the contractually
promised loan
rate (k) percen)
When IR rise above (k) – the additional expected return earned by FI is offset by higher Probability of default
Beyond a certain IR level, what must FIs do?
Beyond a certain IR level, FIs must credit ration their wholesale loans
How can financial institutions measure Probability of default of clients?
by means of CVaR
How can financial institutions measure credit risk at retail level?
They can gather information from credit agencies
How can financial institutions measure credit risk at wholesale level?
use publicly available data e.g. stock prices, annual reports
Will it be more costly for FIs to assess the default risk exposure of publicly traded companies or small, single proprietor firms?
small, single proprietor firms because they have less available data.
List the 2 types of default risk models
Qualitative and quantitative measures
How many factors do qualitative models Consider when making credit decisions
They consider 2 factors when making credit decisions
List the 2 factors qualitative models Consider when making credit decisions
1) Borrower-specific factors
2) Market-specific factors
What are Borrower-specific factors? (as a qualitative default risk model)
These are factors that are idiosyncratic (peculiar) to the individual borrower
List 4 examples of Borrower-specific factors?
1) Reputation
2) leverage
3) volatility of earnings
4) collateral
What are Market-specific factors?
These are factors that have an impact on all borrowers at time of decision
List 2 examples of Market-specific factors?
1) Business cycle
2) interest rates
How many types of Quantitative models? (as default risk models) exist?
There are 4 Quantitative models
List the 4 Quantitative models? (as default risk models)
1) Credit Scoring Models
2) Logistic Regression
3) Multivariate Logistic Regression
4) RAROC models
What are Credit Scoring Models? (as quantitative default risk models)
Here, observed borrower characteristics are used to calculate Probability of default or sort into a class
What techniques are Credit Scoring Models based on ?
They are based on statistical pattern-recognition techniques
What are the 4 things the Credit Scoring Model (as a quantitative default risk model) enable FIs to do?
This method enables FIs to:
1) Establish which factors are important in explaining default risk
2) Evaluate the degree of each factor’s importance
3) Improve the pricing of default
4) Better screen out bad loan applicants
What is Logistic Regression? ( as a quantitative default risk model)
It is the most favoured in practice – almost no assumptions but for missing values and multicollinearity
what are the benefits of logistic regression?
It is easy to compute and implement
What is the goal of logistic regression?
It is to find the best fitting model to describe the relationship between one/more variables
What is the Primary difference between linear regression and logistic regression?
It is the use of a
binary/dichotomous dependent variable (in logistic regression)
Why can we not use a linear regression model as a default risk model ?
Since our main aim is to get a 1 or a 0, we cannot fit a straight line through the data, therefore we cannot use a linear regression model
What is Multivariate Logistic Regression?
When there is more than one independent variable, we use multivariate logistic regression
What are the 2 kinds of variables of Multivariate Logistic Regression
1) discreet variables
2) categorical variables
What is a RAROC model?
Rather than evaluating ROA, with RAROC, the FI balances expected interest and fee income, less cost of funds, against the loan’s expected risk
If using a RAROC model, when is a loan approved?
A Loan is only approved if RAROC is sufficiently high relative to benchmark (ROE)
Therefore, Loan should only be made if risk-adjusted return on loan adds to FIs equity as measured by ROE
What is the numerator of the RAROC model?
The numerator is net income
What is the denominator of the RAROC model?
The denominator is capital at risk since loan losses must be written off against FIs capital
