Module 28: Management of credit risk Flashcards
4 General methods of managing credit risk
- avoid bad risks in the first place!
- diversify credit exposure across a number of counterparties
- monitor exposure regularly
- take immediate action if and when default occurs
5 Steps of the credit risk management process
- Policy and infrastructure
- Credit grating
- Exposure monitoring, management and reporting
- Portfolio management
- Credit review
Steps of the credit risk management process:
Policy and infrastructure (4)
This stage sets the foundations for controlling credit risk:
- establishing an appropriate credit environment
- adopting credit risk policies and procedures
- appropriate to the company’s business context
- addressing a range of topics
- adopted by senior management
• implementing credit risk policies and procedures
- communicated to all relevant employees
- reviewed at least annually to reflect any change in the business context
- developing methodologies and models, with appropriate systems
- defining data standards and conventions
Steps of the credit risk management process: Credit granting (5)
This stage considers extending of credit to counterparties. It considers:
• credit analysis / rating of counterparties
• credit approval
• setting terms and conditions for credit
• pricing
• documentation
Credit ratings need to: (3)
- balance effectiveness and efficiency
- be based on judgement, modelling, or both, and reflect:
- – the borrowers repayment history, ability to pay and their reputation
- – any guarantees or collateral
• be reviewed regularly
Steps of the credit risk management process:
Exposure monitoring, management and reporting
It is important to calculate current exposure and potential exposure consistently across the organisation.
Monitoring should: (4)
- 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 (eg credit spreads) to provide early warning of possible adverse credit events
Exposure limits facilitate: (4)
- risk control
- allocation of risk-bearing capacity
- delegation of authority
- regulatory compliance
Best practice credit risk reporting includes: (4)
- trends
- risk-adjusted profitability
- exposures
- exceptions
Aim of the portfolio management function
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 to actively manage the credit portfolio.
A credit review group should:
- review a sample of transactions,
• test systems,
• enforce standards,
• check compliance with policies and procedures.
The results of each review should be communicated to management, highlighting any exceptions or deficiencies along with the established timeframes for their resolution.
Credit risk granting and review decision are facilitated by: (6)
- underwriting
- – determining whether to approve or deny the application
- – setting the terms for the loan
- – using credit-scoring, categorisation models, third-party ratings
- due diligence
- – care a reasonable person should take before entering into any agreement or transaction with another party
- – considers what could go wrong (including incidental credit risk and other-counterparty risks)
- – based on a wide range of factors including subjective information.
Credit risk transfer may be achieved using: (3)
- credit insurance
- credit derivatives
- securitisation of assets
Credit risk transfer:
credit insurance
can be used to mitigate large exposures of particular types of credit risk (especially incidental credit risks, ie those not related to core business).
Credit risk transfer:
credit derivatives
- – involve exposure to counterparty risk, but are more liquid than the referenced asset
- – credit default swaps hedge default risk and are often used by banks who have reached their internal credit limit with a particular client but wish to maintain their relationship with that client
- – total rate of return swaps hedge both price and default risk
- – credit-linked notes are a bond with an embedded credit default swap