Week 7: Credit Risk (Part 1)

Question 1

How is credit risk managed?

Answer 1

– Price a loan correctly;
– Set appropriate limits on the amount of credit
extended to any one borrower (or, the loss
exposure it accepts from any counterparty).
⇒credit rationing (restriction on the quantity of loans
made available to an individual borrower)

Question 2

How is credit risk managed in retail market?

Answer 2

– Small dollar size loans with higher cost associated
with collection of information.
– Standard loan rate is usually charged.
– Credit risk controlled through credit rationing; usually
an accept or reject decision.

Question 3

How is credit risk managed in wholesale market?

Answer 3

– Credit risk controlled through both interest rates and
credit quantities.
– A very high contractual interest rate may induce moral
hazard behaviour.  Better to credit ration the
wholesale loans beyond some interest rate level.

Question 4

explain borrower-specific factors of the Qualitative Model

Answer 4

– Reputation
• An implicit contract for long-term customer relationship.
• Disadvantage to small, newer borrowers. (Higher information asymmetry. Explain higher costs of debt IPO by small firms)
– Leverage (capital structure)
• A high D/E ratio increases the probability of default.
– Volatility of earnings
• A highly volatile earnings stream increase the probability of
default.
– Collateral
• Reduces the negative impact in the event of default.

Question 5

explain market-specific factors of the Qualitative Model

Answer 5

– Business cycle
• FIs are more likely to increase degree of credit rationing in
recessionary phases.
– High level of interest rates
• Funding is scarcer and more expensive.
• May induce moral hazard behaviours. (Encourage taking excess risk and/or encourage only the most risky customers to borrow)

Question 6

What are the Five Cs

Answer 6

• Character: customer’s willingness to meet credit obligations
• Capacity: customer’s ability to meet credit obligations
• Capital: customer’s financial reserve
• Collateral: a pledged asset in case of default
• Conditions: general economic conditions in the customer’s line of
business.

Question 7

Explain Credit scoring model

Answer 7

• Quantitative models that use observed borrower
characteristics to:
– Calculate score as a proxy of borrower’s default
probability, or
– Sort borrowers into different default classes.
• Objective economic and financial measures of risk are
identified, and then a statistical technique is used to
quantify or score the default risk probability or
classification.
– Consumer debt: income, assets, age, occupation, location,
etc.
– Commercial debt: cash flow, financial ratios, etc.

Question 8

Weaknesses of Altman’s Z score?

Answer 8

– Broad distinction between borrower categories, that is,
good and bad borrowers.
– Weights in any credit scoring model unlikely to be constant
over longer periods of time.
– Variables in any credit scoring model unlikely to be
constant over longer periods of time.
– Models ignore hard-to-quantify factors such as borrower
reputation.
– No centralised database on defaulted business loans.