Risk Management Framework I Flashcards
1
Q
What functions do the Credit Risk Management Team carry out?
A
- Analyse and manage credit risk exposure
- Regularly review credit limits and credit events
- Escalate credit issues to senior management
- Design a credit-scoring model
- Ensure with the board that credit risk policy is followed
- Recommend and implement risk mitigation techniques
- Work with external agencies to assess client credit and the firms’ own credit rating
- Recommend credit limits for clients
2
Q
What is the Risk Management Framework Process?
A
- Basic Structure – independently assess if a client should be granted credit
- Policy – is created by credit risk team but approved by the board
- Credit assessment tools – rating agencies, external reports and scoring models
-
Mitigate risk – using appropriate techniques
- Collateral
- Netting
- Credit Limits
- Central Counterparties
- Monitor Exposure – credit risk should be monitored every day, reported and managed
- Review – regular review of credit lines is essential
3
Q
What are the Basel Committee’s 10 Principles wrt Credit Risk Assessment?
A
Supervisory Expectations:
- Board of directors and senior management are responsible for ensuring that the bank has appropriate credit risk assessment processes
- System should be in place to reliably classify loans
- Internal credit risk assessment models should be validated
- Documented loan loss methodology
- Loan loss provision should be able to absorb estimated credit losses
- Expert and experienced credit judgement should be used
- Bank should have the tools, procedures and data to assess credit risk
Supervisory Evaluation:
- Periodic evaluation of credit risk policies
- Regulators should be satisfied that loan loss provisions estimates are reasonable and prudent
- Supervisors should consider credit risk and valuation policies and practices when assessing a bank’s capital adequacy
4
Q
What types of Risk Modelling are there?
A
- Credit Scoring – helps lender decide if they should accept the application and the rate to charge
- Segmentation – putting clients into groups to isolate risk
- Stress Testing – flexing the model to observe results in different scenarios
5
Q
What are the Inputs into Risk Models?
A
- Client Details – credit history, employment details, outstanding credit, income etc.
- Factor Inputs – risk, premiums, economic factors and interest rates
- External Ratings – the views of specialist ratings agencies
6
Q
What are the Outputs of Risk Models?
A
- Limits and Caps – setting credit limits to match the firms risk appetite
- Provisioning and impairment – setting aside provisions for future credit issues
- Key Risk Indicators (KRI) Reporting – early warning signs of changes in risk profile
7
Q
What is Credit Risk?
A
Credit risk is the risk that a counterparty will fail to perform an obligation:
- Settlement Risk – counterparty does not make a contractual payment
- Pre-settlement Risk – counterparty defaults before the contract settlement
- Delivery Risk – counterparty does not deliver an asset that underlies a contract
- Payment Risk – counterparty fails to make contractual payments
8
Q
What Mitigation Strategies can reduce Credit Risk?
A
- Guarantees – e.g. a parent company guaranteeing a subsidiary
- Credit Limits – managing the maximum exposure to a client
- Collateral – taking assets as security to offset credit risk e.g. charges/mortgages, lien, pledge, transfer and set-off
- Netting – setting off liabilities against net amounts owed from clients
- Diversification – spreading the portfolio across different assets
- Central Counterparties – novation (substitution of an old contract for a new one) allows banks to clear trades with one central counterparty (an org that acts as the ‘middle-man’ between buyers and sellers – novation is used where the single contract between buyer and seller is replaced by 2: (buyer-CCP-seller). This transfers the credit risk to the CCP. The CCP ensures they aren’t unduly exposed by Netting, i.e. being the widely used middle-man, they will have other dealings with the buyer & seller)
9
Q
What different levels of risk are there associated to Loan Portfolio Risk?
A
- High Risk – concerns over borrower’s ability to make payments due, and doubts over the value of collateral provided
- Satisfactory – high likelihood of the asset being recovered, even if there is no collateral
- Strong – very high likelihood of the asset being recovered in full
10
Q
What Group Credit Risk Policies should be employed?
A
- Max exposure guidelines - to limit exposure to an invidual counterparty
- Country risk policies - to specify risk apptite by country and avoid excessive concentration
- Aggregation policies - to set out circumstances in which counterparties should be grouped
- Expected loss policies - to set out approaches for the calculation of bank’s expected loss
- Repayment plans policy - for setting standard for repayment plans and restructures within retail portfolios
- Impairment and provisioning - to ensure measurement of impairment reflects losses and clear governance is in place for the calculation of provisioning
11
Q
Give examples of Credit Events.
A
A credit event is the financial term used to describe a general default related to a legal entity’s previosuly agreed financial obligation
- Bankruptcy
- Failure to pay
- Restructuring
- Repudiation (a party does not intend to live up to their obligations in a contract)/Moratorium (legal authorisation to defer payments)
- Obligation acceleration
- Obligation default
12
Q
How does one Measure Default Risk?
A
The following are discounted at a Recovery Rate
- Loss Given Default (LGD) – the loss that actually occurs at default, measured as a % of the exposure. e.g. a £10 loan isn’t necessarily a £10 loss to the bank if collateral is held.
- Probability of Default (PD) – the likelihood, expressed as a %, that an asset will go into default
- Exposure at Default (EAD) – the gross amount of exposure at the time when the default occurs i.e. would ignore collateral
13
Q
What is the Trading Book?
A
The trading book is the portfolio of financial instruments held by a firm.
- Value at Risk is a widely used measure of the risk of loss on a portfolio
- Confidence Intervals are used to indicate the reliability of an estimate
- Concentration risk is the spread of outstanding loans over debtors
14
Q
What are limitations of Credit Risk Management?
A
- Cannot always be accurate as there are always unknowns
- Risks can be hard to measure
- Models used are only as good as the data fed in
- External ratings aren’t always reliable
15
Q
What is Asset Liability Management (ALM)?
A
Asset reliability management is a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates.
The central theme of ALM is the coordinated management of a bank’s entire balance sheet
- ALM aims to increase profitability and long term viability – interest rates can adversely affect a bank’s net interest income and affect the market value of equity.
- ALM is a systematic approach aiming to minimise asset/liability risk – models are used to measure any mismatches between assets/liabilities across different maturities, with a target of zero mismatches
