Credit Risk Control Techniques

Question 1

What is probability of default?

Answer 1

The likelihood the borrower will default.

Question 2

What is exposure at default (EAD)?

Answer 2

The total exposure the lender could have at the time of default.

Question 3

What is the recovery rate (RR)?

Answer 3

The % of the loan the lender expects to recover.

Question 4

What is the loss given default (LGD)?

Answer 4

The actual loss the lender suffers in the weak of a default. It is function (1-RR) * EAD.

Question 5

What expected loss (EL)?

Answer 5

The loss given default multiplied by the probability of default.

Question 6

What is Concentration Risk?

Answer 6

Lending to one type of customer or customers in a specific geographic area, industry or company type.

Question 7

How can concentration risk be controlled?

Answer 7

-Diversify loan portfolio.
-Sell loans from a specific borrower to another bank.

Question 8

What is default correlation risk?

Answer 8

The risk that default of one borrower is affected by the default of another borrower.

Question 9

What is a positive default correlation risk?

Answer 9

Two companies that are not part of the same corporate or group structure but are trade creditors to each other.

Question 10

What is a negative default correlation risk?

Answer 10

Two competitors where the default of one takes capacity out of the market and possibly provides some pricing or volume improvement for the remaining company.

Question 11

What are the techniques to reduce portfolio risk?

Answer 11

1. Syndication - other banks take part of a loan. Reduces exposure to one single bank.
2. Whole loan sales - sale of a loan to another financial institution to reduce exposure. Also helps reduce the capital requirements and frees up funds for other things.
3. Securitisation - Transfer or sell the securitized loan to an issuer affiliated with the bank. The issuer bundles them and sells securities backed by them. Payments on the pool of loans are used to pay off the securities. If the transfer or sale of securities is without recourse, then this process reduces the bank’s default risk.
4. Credit Default Swaps - Insurance if the borrower defaults.

Question 12

What risk factors do portfolio credit models consider?

Answer 12

1. Default risk - non payment of the principal or interest.
2. Recovery risk - change value of the collateral or recoverability of the collateral.
3. Spread risk - change price of credit without a change in the underlying rating.
4. Migration risk - change in the internal or external credit rating of the borrower.

Question 13

How can lenders assess the credit worthiness of borrowers?

Answer 13

Credit ratings agencies and market derived ratings.W

Question 14

What are some of the early warning signs of a defaulter?

Answer 14

1. Accounting issues - aggressive company structure, early recognition of revenues, capitalising operating costs.
2. Company issues - strong growth trends of a highly acquisitive company may ask lagging sales. Above market returns, complex organisational structure.
3. Management issues - unethical behaviour, lack of transparency.
4. Liquidity issues - Does the company have the ability to repay the loan, does the company have access to alternative cash flows, increased use of overdrafts.
5. Industry/peers - Reputational questions of companies in an industry, fines, enforcement by regulators, ratings downgrades.

Question 15

What can a borrower if fears it will default?

Answer 15

3Rs

Repayment - Get funds to cover interest and debt. Explore alternative sources of liquidity.

Restructure - change management team, focus on core operations.

Reschedule - Debt restructuring to avoid default and protect customer relationship.