11/23/2019

Credit Risk Analytics

Session 14

Dilip Kumar 1

Exposure at Default
The amount of loss that a financial institution/bank may face
due to default.
For a term loan: Fixed based on the repayment schedule
For a line of credit (e.g. guarantee, overdraft, letter of credit, etc.):
Bank can only set the upper limit. Needs to be estimated based on the
limit, outstanding value and covenants.
For fixed exposures such as term loans and instalment loans, the
EAD is equal to the Outstanding Loan.
EAD = Outstanding

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Another way of calculating EAD

Credit Conversion Factor (CCF):
EAD = Outstanding + CCF * (Limit – Outstanding)
Where Credit conversion factor (CCF), =
Outt = Outstanding at default at time t
Outt-1 = Outstanding at a date one year prior to default
Limitt-1 = Limit to the borrower at a date one year prior to default
Example:
• Outt = 103
• Outt-1 = 99
• Limitt-1 = 105
• CCF = (103 – 99)/(105 – 99) = 66.67%, EAD = 103 + 66.67%*2 = 104.33
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Another way of calculating EAD

Upper limit is given for many off balance sheet (OBs) lending products
(like cash credit, overdraft, revolving line of credit (e.g. credit card) and
working capital loan): An obligor close to default generally tends to
increase its utilization, while the bank will have to reduce the available
limits to control its exposure risk.
From risk management point of view, the bank has to predict the undrawn portion
and include it in the EAD estimation.
The unutilized portion is converted into the equivalent credit exposure by applying
a regulatory prescribed credit conversion factor.
CCF usually lies between 0 and 1.

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Regulatory Perspective on EAD

CCF for corporate, sovereign, and bank exposures:
Commitments with an original maturity up to one year (Cash credit) and
commitments with an original maturity over one year (bonds, warrants, standby
letters of credit for few transactions) will receive a CCF of 20% and 50%,
respectively. However, any commitments that are unconditionally cancelable at
any time by the bank without prior notice will receive a 0% CCF.
For retail exposure:
Both on- and off-balance sheet retail exposures are measured gross of specific
provisions or partial write-offs. The EAD on drawn amounts should not be less than
the sum of (i) the amount by which a bank’s regulatory capital would be reduced if
the exposure were written-off fully, and (ii) any specific provisions and partial
write-offs.
For retail off-balance sheet items, banks must use their own estimates of CCFs.
• For LCs, guarantees of loans, the CCF = 100%
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Regulatory Perspective on EAD

For retail exposure:
For retail exposures with uncertain future drawdown such as credit cards, banks
must take into account their history and/or expectation of additional drawings
prior to default in their overall calibration of loss estimates. In particular, where a
bank does not reflect conversion factors for undrawn lines in its EAD estimates, it
must reflect in its LGD estimates the likelihood of additional drawings prior to
default. Conversely, if the bank does not incorporate the possibility of additional
drawings in its LGD estimates, it must do so in its EAD estimates.
For OTC derivatives:
EAD = 1.4 * (Replacement Cost + Potential future exposure)
Replacement Cost = Current exposure
Potential future exposure = notional amount and a look-up CCF (depending on the
maturity and the underlying class)

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Regulatory Perspective on EAD

The motivation for estimating CCF comes from the fact that if an account
defaults in the future, the balance at default is expected to equal the
balance today plus a fraction of the undrawn amount. For example, an
overdraft typically becomes defaulted because the balance has exceeded
the limit by a material amount for three consecutive months. Thus, the
exposure of the overdraft facility at default is expected to be greater than
the current balance because not only has none of the current balance
been repaid but additional withdrawals may further increase the loan
outstanding amount. Hence, EAD should be the drawn amount plus the
estimated amount of future draws. Unpaid interest and fees can also be
added to EAD.

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Historical EAD Calculation

Variable Time Horizon Approach:
Reference points are considered at different time periods prior to the
default point. Many EADs may be calculated corresponding to different
periods like 3/6/9 months prior to default. It is a better method but it
is extremely data intensive.
Fixed Time Horizon Approach:
It is a special case of variable time horizon approach. The reference
point is the Fixed no. of days before default date, normally one year.
Cohort Approach:
Cohort of defaulted exposures belonging to certain prefixed period.
Reference point is selected at the beginning of the period. However,
the reference points, if set during normal time is better.
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Historical EAD Calculation

Cohort Approach:
Measuring CCF in historical years before default help us to see if the
EAD has increased in past as it approaches to default.
Depending on the frequency of available data, banks can undertake
the cohort analysis even at high frequency.
EAD can be estimated based on the trend.
Historical studies have found that borrowers going into default tend to
draw down more than healthy companies.
Fixed horizon approach is more conservative than cohort if Borrower tend
to withdraw more and more as default approaches as the time window
for Fixed Horizon method on average will be longer than cohort method.

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Loan Facilities of Banks

Fund-based:
It involves certain movement of funds, e.g. cash credit (short-term
loan: can withdraw money from current account without having credit
balance. Can be for working capital), overdraft (can withdraw more
money than the available balance), packing credit (loans for exporters
and sellers), bills purchased (receive the sales value immediately and
bank collect the sum from the buyer), bills discounted (less value is
paid by bank immediately to seller and bank collect the full value from
the buyer), term loan (loan with repayment schedule) and working
capital demand loan.

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Loan Facilities of Banks

Non-fund-based: It comes in the form of commitments by the
bank to the party and are fee-based.
Bank guarantees:
• A bank guarantee is a promise from a bank or other lending institution that if a
particular borrower defaults on a loan, the bank will cover the loss.
Letters of credit:
• A Letter of Credit is a promise from a financial institution to honour the
financial obligations of the buyer, and this then eliminates any risk of the buyer
not fulfilling the payments. As a result, it is often used to mitigate the risk of
not being paid post-delivery. LC is issued to the buyer after carrying out the
necessary due diligence and collecting sufficient collateral to cover the
guaranteed amount. The Letter is then presented to the seller as proof of the
buyer’s credit quality.
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Expected and Unexpected Credit Loss

Expected Credit Loss or Expected Loss (EL):
EL of an asset is the average loss the bank can expect to lose over 1-year horizon.
= × ×
It is used to set reserve requirements for doubtful accounts, calculation of PLR
(default premium), pricing credit risky instruments (bonds and exotic options), and
for calculation of risk-adjusted profitability.
It is a measure of the mean of the credit loss distribution.
Unexpected Credit Loss or Unexpected Loss (UL):
UL is the estimated volatility of the potential loss in value of the asset around its EL.
It is UL that creates the need for economic capital.
= × × × 1−
The capital base is required to absorb the UL.

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Expected and Unexpected Credit Loss

Suppose a bank gives loan of worth Rs 50 crores to an entity
rated as A-. The probability of default of a firm is given as 2%.
The recovery rate is 60%. Find the expected credit loss and
unexpected credit loss associated with the loan.
PD = 2%, LGD = 1 – RR = 1 – 60% = 40%, and EAD = 50
EL = PD x LGD x EAD = 2% x 40% x 50 = 0.4 Crore.
= × × × 1−
= 50 × 40% × 2% × 1 − 2% = 2.8
VaR = EL + UL = 0.4 + 2.8 = 3.2 Crore

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Credit Portfolio Risk

Credit portfolio losses are of two types:
Portfolio expected loss (ELP)
Portfolio unexpected loss (ULP).
The EL is a linear variable and can be added directly (based on the
constituents of a portfolio) to estimate the EL of a portfolio.
The portfolio expected loss for the two assets (A and B) can be written as:

More generally, for N risky assets/borrowers i = 1, 2, …., N, we have

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Credit Portfolio Risk

A bank is exposed to a portfolio of risky assets that are each subject to
default risk of varying degrees and severity. Therefore, portfolio volatility
(or UL) of two assets A and B can be expressed as:

The correlation of default ρa,b is very important when assessing the true
risk of a portfolio as quantified by the ULP.

Actually, ρ < 1 and hence:

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Credit Portfolio Risk

For many assets in a portfolio, the portfolio unexpected credit
loss is given as:

Because of the diversification effect, the total unexpected loss

of a portfolio will be less than the sum of the unexpected losses
of the individual assets.

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Risk Contribution
It indicates the incremental risk a single risky asset contributes to
the portfolio as a whole.
Two kinds of risk contributions:
Average risk contribution (ARC)
Marginal risk contribution (RC)
Average risk contribution (ARC):
It is the ratio of the Expected loss of the risky asset with respect to the
expected loss of the portfolio.

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Risk Contribution
Marginal risk contribution (RC):
The incremental risk that the exposure of a single asset contributes to
the portfolio’s risk.
Marginal risk contribution helps in analyzing how much risk a particular
borrower brings to the portfolio.
It is given as:

For two asset portfolio:

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Example: Portfolio Credit Risk Calculation

Borrower X (AA-rated) Borrower Y (BBB-rated)
Probability of Default 0.5% 1%
Loss given default 40% 60%
Loan amount 100 Crore 50 Crore
Interest rate 13% 15%
Default Correlation between X and Y loan 10%
EL (Expected Credit Loss) 0.5% x 40% x 100 = 0.2 Cr 1% x 60% x 50 = 0.3 Cr
UL (Unexpected Loss) 2.82 Crore 2.98 Crore
Portfolio Expected Loss 0.2 + 0.3 = 0.5 Crore
Portfolio Unexpected Loss 2.82 + 2.98 + 2 ∗ 10% ∗ 2.82 ∗ 2.98 = 4.307 Crore

Average Risk Contribution 0.2/0.5 = 40% 60%

Marginal Risk Contribution 2.043 Crore 2.264 Crore
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