Mod 28: Management of credit risk

Question 1

List the five stages in the credit risk management process ©

Answer 1

The credit risk management process
1. policy and infrastructure
2. credit granting
3. exposure monitoring, management and reporting
4. portfolio management
5. credit review

Question 2

Outline the key elements of the policy and infrastructure stage of the credit risk management process
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Answer 2

Policy and infrastructure
This stage includes the foundations for controlling credit risk:
* establishing an appropriate credit environment
* adopting and implementing credit risk policies and procedures
* developing methodologies and models, with appropriate systems
* defining data standards and conventions.

The documented policies and procedures (aimed at ensuring credit risk can be identified, measured, monitored, controlled and reported) must be:
* appropriate to the company’s business context
* adopted by senior management
* communicated to all relevant employees
* reviewed at least annually.
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Question 3

Outline the key elements of the credit granting stage of the credit risk management process

Answer 3

This stage considers extending of credit to counterparties. It considers:
* credit analysis / rating of counterparties
* credit approval
* pricing and setting terms and conditions for credit
* documentation.
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Question 4

Outline the key characteristics of a credit risk rating system

Answer 4

• A credit rating may apply to an individual transaction or counterparty.
• Any credit rating / scoring system needs to balance effectiveness (accurate, consistent and timely) and efficiency (low cost).
• Ratings may be based on judgement or modelling or both.
• Credit ratings should be regularly reviewed and respond to changes in circumstances of the counterparty.

Credit ratings will reflect a variety of factors, including:
* the borrower’s repayment history
* an analysis of the borrower’s ability to pay
* their reputation
* the availability and enforceability of guarantees or collateral.

Question 5

State the canons of lending (factors to consider when lending money)

Answer 5

Canons of lending (CASPAR)

• Character and ability of borrower
• Amount
• Security
• Purpose
• Ability to repay
• Risk and return

Question 6

Define credit exposure and suggest how it could be monitored

Answer 6

Monitoring credit exposure
There are two types of credit exposure:
* current exposure – the amount at risk today if all credit transactions were settled and credit assets sold
* potential exposure – the amount that may be at risk in future, which is likely to be a function of time to maturity and volatility of the underlying.

Exposure may be calculated from the current exposure or using some rule of thumb, but it is important to take a consistent approach across the firm.
Monitoring should:
* be at the portfolio level
* be in respect of specific individuals, industries or geographies
* aim to limit concentrations and ensure appropriate diversification
* track risk indicators such as credit spreads and stock price volatility to provide early warning of possible adverse credit events.

Question 7

With regard to credit risk management, outline:
 types of exposure limits
 the four uses of exposure limits ©

Answer 7

Credit risk management: exposure limits
Exposure limits should be set for single counterparties, connected counterparties and other groupings (eg geographic regions).
Exposure limits have four uses:
1. risk control – limits prevent the company from engaging in overly risky business activities
2. allocation of risk-bearing capacity – limits should reflect management’s assessment of risk / return trade-offs
3. delegation of authority – limits can ensure that credit decisions are made by those with the appropriate skill and delegated authority
4. regulatory compliance – regulators maintain close scrutiny of credit risk controls.

Question 8

State the key characteristics of best practice credit risk reporting

Answer 8

Credit risk reporting
Best practice credit risk reporting is:
* relevant
* timely
* reliable
* comparable
* material
and includes:
* trends
* risk-adjusted profitability
* exposures (large individual, aggregate)
* exceptions (to standard policies, limits etc).

Question 9

Outline the aims and activities of a (credit risk) portfolio management function

Answer 9

Portfolio management function
The portfolio management function’s aims to optimise the desired risk / return trade-offs by defining a target portfolio through its credit policy.
This credit policy will document the strategies and financial vehicles that can be used, which may include:
* buying or selling assets
* securitising assets
* hedging risks using derivatives
* transferring risks.
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Question 10

State the activities of a credit review group ©

Answer 10

Credit review group
* review a sample of transactions and associated documentation to ensure data is correct
* test systems are working
* enforce standards of underwriting
* check compliance with policies and procedures
* communicate results of the review to management, highlighting any exceptions or deficiencies along with the established timeframes for their resolution
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Question 11

Outline the benefits of best practice credit risk management ©

Answer 11

Benefits of best practice risk management
* credit approval and pricing decisions are improved at the individual transaction and portfolio level
* concentration is controlled at the portfolio level to prevent large, unexpected losses
* Earnings may be smoother as a result of better reserving and projections of credit losses
* management decision-making is improved and better actions taken as a result of advanced credit metrics and reporting
* the risk-return profile of the credit portfolio may be improved by active portfolio management and risk transfer strategies
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Question 12

Outline the features of best practice credit risk management

Answer 12

Features of best practice credit risk management

1. credit risk ratings
   − risks managed at individual transaction and portfolio level
2. modelling
   −sophisticated tools, including simulation models, scenario analysis and planning, advanced credit scoring, surveillance and migration models
3. credit risk function
   −centralised active portfolio management aims to optimise portfolio risk / return
   −strong credit risk culture ©

Question 13

State what facilitates choices between available responses to credit risk, and state the three main options regarding credit risk transfer

Answer 13

Responses to credit risk
* underwriting and due diligence facilitate decisions as to the appropriate type(s) of response to a particular credit-risk exposure
* transfer of credit risk is often achieved using:
1. credit insurance
2. credit derivatives
3. securitisation of assets ©

Question 14

Describe the main purposes and most common methods of assessing the creditworthiness of a loan application
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Answer 14

Credit underwriting

Credit underwriting will determine:
* whether the loan application is approved or denied
* what terms should be placed on the loan − eg rate of interest, requirement to provide collateral.
Methods of assessing the creditworthiness of a loan application include:
* credit-scoring approach
* principal component analysis techniques
* third-party ratings.
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Question 15

Describe the main outcomes from, and the scope of, a due-diligence process

Answer 15

Due diligence
Possible outcomes from a due-diligence process are:
* avoidance of exposure to the counterparty
* acting to limit exposure, eg through careful payment scheduling.
A due-diligence process:
* considers what damage may occur if the agreement goes wrong
* depends on the type of relationship and value of the transaction
* generally covers a very wide range of factors such as publicly available information, internal documents and subjective information (eg interviews with management or other stakeholders)
* can be an expensive and time-consuming process

Question 16

State the potential benefits of credit insurance

Answer 16

Benefits of credit insurance
1. protection against some or all bad debts cover for some or all debtors
2. cover for domestic or international trade −
international cover may include country risk, debt recovery services and any losses on forward foreign exchange commitments
3. specialist advice based on the experience of the insurer
4. cover for expenses incurred
5. credit insurance may enable the company to secure better terms for financing, which offsets the cost of the insurance
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Question 17

State how the risks of providing credit insurance may be managed by the insurer
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Answer 17

Managing the risks of providing credit insurance

1. The insurance premium will take into account:
   * the industry sector
   * the country risk
   * the nature of the goods and services
   * the terms of trade
   * the track record of existing buyers.
2. When underwriting claims, the insurer will ensure that:
   * credit limits have not been exceeded
   * the insurance premium has been paid.
   * the goods and services have actually been provided
   * the debt exists

Question 18

Describe a credit default swap

Answer 18

Credit default swap (CDS) 
* a fee is paid by the protection buyer to protection seller
* the seller will make a payment if a specified credit default event on the reference asset occurs within the term of the contract
* eg credit events include: downgrade, failure to pay a coupon, cross-default, bankruptcy, repudiation
* payment made is either: −
1. full notional amount, in exchange for the defaulted security (physical settlement)
2. original price, less the recovery value (cash settlement)
* the default risk is hedged, but the price risk may not be
* typically used by banks who have reached their internal credit limit with a particular client, but wish to maintain a relationship with that client

Question 19

Describe how and why a total return swap might be used to manage credit risk

Answer 19

Total (rate of) return swaps (TRORS)
* The total return from one asset (or group of assets) is swapped for the return on another.
* This creates a hedge for both market (price) risk and credit (default) risk of the reference asset(s).
* Investors who cannot ‘short’ securities may be able to hedge a long position by paying the total rate of return in a TRORS.
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Question 20

State the key advantage and disadvantage of credit derivatives when compared to the alternative action of selling the underlying credit risk
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Answer 20

Key advantage and disadvantage of credit derivatives
+ better liquidity than the underlying assets
- exposure to counterparty risk
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Question 21

Outline what is meant by a securitisation of assets ©

Answer 21

Key features of a securitisation
* pool together relatively unmarketable assets with reasonably predictable cashflows
* sell assets to a (bankruptcy remote) special purpose vehicle (SPV)
* issue one or more tranches of asset-backed securities (ABS)
* a multi-tranche arrangement is called a collateralised debt obligation (CDO) and might consist of senior, mezzanine and/or equity tranches (in decreasing priority of claims on cashflows)
* cashflows generated by the pool of assets are used to service (and secure) the interest and capital payments on the ABS
* securitisation therefore converts a bundle of relatively unmarketable assets into structured financial instruments which are then negotiable
* credit risks of different instruments are combined into a portfolio which is then divided and repackaged as several new securities with different credit risk features
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Question 22

Outline the benefits of securitisation ©

Answer 22

Benefits of securitisation
Securitisation converts a bundle of assets into a structure financial instrument, which is then negotiable. It:
* enables a company to raise money, that is linked directly to the cashflow receipts that it anticipates receiving in the future
* is an alternative source of finance to issuing ‘normal’ secured or unsecured bonds
* is a way of passing the risk in the assets to a third-party, removing them from the balance sheet and reducing required capital
* is a way of effectively selling exposure to what may be an otherwise unmarketable pool of assets.
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Question 23

Outline what is meant by a credit-linked note

Answer 23

Credit-linked note (CLN)
* A CLN is a collateralised vehicle consisting of a bond with an embedded CDS.
* The holder of corporate bonds (the protection buyer) transfers credit risk on those bonds (the reference asset) to other investors by setting up an SPV, which sells CLNs to investors and uses the proceeds to buy Government bonds. At the same time, the SPV also sells a credit default swap, based on the original corporate bonds to the original bondholder.
* The buyers of the CLNs receive a total return based on the CDS premium and the yield on the Government bonds. In return for this enhanced return, their capital is at risk and may be required to recompense the protection buyer in the event of a default on the reference bonds.

Question 24

State reasons why an investor might buy a CLN ©

Answer 24

Reasons an investor might buy a CLN
* If the CLNs are in a multi-tranche format then they provide not only a convenient way of buying credit risk (and the associated higher expected return) but also a means of buying repackaged credit risk.
* Such a collateralisation may be attractive to investors (as protection sellers) who are not able to sell credit derivatives but who are able to buy CLN’s (if classified as bonds rather than credit derivatives).
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Question 25

Outline how investment banks typically manage their own creditworthiness

Answer 25

Managing creditworthiness: investment banks

Investment banks typically work backwards from the volumes of business they expect to write and their target credit rating to determine the amount of debt capital they need to hold.

Question 26

Outline how a business (whose capital base is fixed in the short term) can improve its creditworthiness
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Answer 26

Managing creditworthiness: other organisations

Generally speaking, most organisations cannot change their capital base as readily as investment banks, however, creditworthiness can be improved by:
* writing less of the same business, and hence conserving capital
* changing the mix within each particular class of business, which may have a diversifying effect (eg improving geographic spread)
* changing the mix between the various classes of business, again to diversify across classes with low correlations.
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