05 - Ind - L1 - ch5 - July06

5 The nature of credit risk
Chapter 1 provided an overview of credit risk and introduced a number

of methods used to mitigate it. It also discussed the Basel I Capital
Adequacy Framework, outlined Basel II and introduced credit risk
management.
This chapter provides a more detailed discussion of the nature of credit risk.
It looks at important credit risk portfolios and discusses in general terms the
types of models banks commonly use to identify the different risks in each
portfolio.
This chapter also seeks to illustrate that the treatment of credit risk in
Basel II is ‘evolutionary’ and that it builds on existing ‘good practices’ for
credit risk management. This will enable the student to put the more
sophisticated approaches for calculating credit risk capital into context.
On completion of this chapter the candidate will have a basic understanding

of:
the nature of credit risk

the basic techniques used to assess sovereign credit risk, corporate
credit risk and retail credit risk
how to establish counterparty credit risk exposure
the origin and use of credit analysis
the fundamental concepts behind options-based models of credit risk
the fundamental concepts behind portfolio measurement and
management of credit risk
credit risk and Basel II.
5.1 The nature of credit risk
Credit risk is defined as the risk of losses associated with the possibility
that a counterparty will fail to meet its obligations when they fall due; in
other words the risk that a borrower won’t repay what is owed.
All investors and companies will be familiar with credit risk. For example,
personal investors risk their savings in pursuit of profits when they invest
in something other than ‘cash’ products, (e.g. a bank deposit, a bond, or
shares). For their part, companies will incur credit risk in the form of
receivables due from their customers. They will be owed money in return
for providing goods or services. Banks are particularly subject to credit risk
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Part B: An introduction to market, credit and operational risk
because of the very nature of their lending-based business. Banks are

highly geared institutions and any rise in default rates by borrowers has
the potential to erode their capital very rapidly.
Example Peregrine Investment Holdings
In January 1998 Peregrine Investment Holdings, the former high-flying Hong

Kong investment bank, went into liquidation. It collapsed partly as a result of
the Asian financial crisis, but also because it had lent USD 265 million to an
Indonesian taxi and bus operator that defaulted on the loan. The Indonesian
company was unable to repay the loan when the Indonesian currency, the
1
rupiah, collapsed.
Historically banks have built their credit appraisal techniques for

corporate borrowers largely from methodologies commonly used by
investors to appraise the investment potential of non-government
borrowers.
Investors looking for higher returns played an important part in the

evolution of these appraisal techniques. The growth of institutional
investors such as insurance companies and pension funds contributed
significantly to the growth of the professional investment management
industry. This in turn led to increased investment in equities and bonds
issued by non-government entities such as major companies. Growth
was particularly strong in the US where institutional investors could
invest in ‘securitized’ bond issues based on mortgages, car loans and
credit card receivables. Consequently professional investment managers
needed to improve not only their understanding of credit risk, but how to
measure it as well.
5.1.1 Sovereign credit risk

Until recently international bond markets were dominated by bonds
issued by the central governments of countries. Sovereign risk is the
risk of losses associated with the possibility that a government fails to
pay either interest or principal on its borrowings. While the outright
default on such debt is rare, the rescheduling of such debt is not
uncommon. The International Monetary Fund (IMF) plays a major role in
assisting countries with debt payment problems.
When faced with creating inflation, or defaulting on its debts

denominated in its domestic currency, the Russian government chose in
1998 to default on both domestic and foreign currency debt.
1
See Financial Times, July 22, 2000.
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Chapter 5: The nature of credit risk
Example Russian government bonds
In 1998 the Russian government effectively defaulted on its domestic bonds

2
leaving foreign investors with losses of approximately USD 33 billion.
At the time Russian government securities offered a very high yield. To cover
their foreign exchange exposure investing banks hedged the exposures
partially, if not completely, using forward contracts. Unfortunately many of
these contracts were with Russian banks, which only increased their Russian
exposure.
While apparently assuming that governments did not default on their debts
denominated in their national currency, the investing institutions also seemed
to forget, or in fact overlook, the earlier Russian default in 1917 as well as the
African and South American defaults in the late 1960s and 1970s.
Domestic currency and foreign currency debt
A useful distinction in sovereign debt bond issues is usually drawn

between:
the debt countries owe which is denominated in their domestic

currency, and where a default is rare largely because countries have
the power to print their domestic currency, and
debt denominated in foreign currency where the currency must be
earned by the debtor country.
It is worth noting that many of the world's largest economies rarely

borrow in anything but their domestic currency, although their bonds are
held internationally. For example the role of the US dollar as a reserve
currency means that many countries with surplus foreign currency
earnings hold significant amounts of US sovereign debt as foreign
currency reserves.
Financial ratio analysis
Sovereign risk is usually assessed much in the same way as corporate

debt with models designed to determine the ability of a country’s
government to service its debts. The debt service ratio is the critical
ratio of such models and is defined as the future interest and principal
repayments due on foreign currency borrowing divided by the income
from exports and capital inflows.
As with corporate debt appraisal there are a number of other ratios that
can help assess the debt service capability of a country. However it
should be noted that ratio analysis does not tell the whole story because
the future prospect of individual economies may differ significantly
despite having similar financial ratios at any point in time.
2
Peachey, Alan. Great Financial Disasters of Our Time. Berlin: BERLIN
VERLAG Arno Spitz GmbH, 2002.
of Risk Professionals, Inc. &Inc.
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Inward investment
Inward investment has become a growing area of analysis for investors

and banks particularly when it is combined with domestic economic
policies to create so-called ‘bubbles’ (high valuations of specific assets
that cannot be sustained in the long term).
Examples of recent bubbles include Tokyo’s soaring commercial

property prices in the early 1990s, and the high technology company
valuations in the US and Europe from the late 1990s until 2002. Such
bubbles also played a role in the Asian debt crisis of the mid-1990s
when both commercial property prices and equity values in many
Southeast Asian countries reached levels that could not be sustained in
the long term.
Other factors
There are also other factors to consider when assessing sovereign risk,
although the poor quality of government data has often made the
process difficult. Furthermore, not all currency borrowing is carried out
by governments. Private sector borrowing in foreign currency can also
affect the total size of a country’s debt service requirements/obligations,
and data on this type of borrowing is often very poor.
Qualitative factors
There are a number of qualitative factors to consider when assessing

sovereign risk, such as:
the efficiency of the banking system in allocating capital to productive

enterprises
the efficiency of the tax system in raising government revenue
the ability of the central bank to affect exchange rates
the role of high domestic interest rates which not only encourages
private foreign currency borrowing, but which can also contribute
significantly to inflationary pressures within an economy
the transparency of the economy and the clear separation of roles
and powers among the government, central bank, supervisors, the
legal system and business.
The interplay of a number of these qualitative factors can be seen in the

Asian economic crisis of 1996-1997 which affected Thailand, Indonesia,
Malaysia, the Philippines and South Korea.
Sovereign risk and country risk
While sovereign risk and country risk are often considered synonymous it
is better to view sovereign risk as a subset of country risk. Country risk
covers the domestic legal, political and economic environment and how
these all affect the private sector economy. Country risk analysis is
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particularly important when looking at inward investment which involves

cross-border lending to companies, individuals or projects.
Other factors to consider when assessing country risk include:
the legal system especially laws on property ownership and

bankruptcy
the stability of the political system although this does not refer to the
stability of any one government
the rules surrounding access to foreign currency especially if
exchange controls are prevalent.
Basel II and sovereign risk
The above factors highlight the need to ensure that sovereign risk is
carefully appraised. In the Basel I Accord sovereign risk was measured
using a simple risk weight based primarily on the nature of the borrower,
(e.g. government) and the type of instrument, (e.g. guarantee, loan,
etc.). Under Basel II, the Standardised Approach uses publicly available
credit ratings to appraise and control sovereign risk. This change
impacts on the regulatory credit risk capital required for sovereign risk.
Many governments are publicly rated as are nearly all issuers of public
debt in one form or another. In contrast, very few corporate borrowers
are rated.
5.1.2 Corporate credit risk
Corporate credit makes up a large part of what is referred to as ‘risky

debt’ in contrast to sovereign debt which is supposedly ‘risk-free’ debt.
Corporate credit risk comprises the default risk in the debt obligations
issued by companies. Stockholders are the last stakeholders to be paid
out when a company is liquidated. For example in all jurisdictions
corporate bonds and bank loans are paid out prior to equity holders, but
still after preferred creditors such as employees (for unpaid wages) and
the government (for unpaid taxes).
Many banks claim that they understand corporate credit risk far better
than many of the other risks they take, and in many economies it is the
most important category of credit risk for banks. Where deep and liquid
markets for capital do not exist, in practice virtually everywhere outside
the US, the role of banks in recycling savings from private individuals to
productive enterprises (a process known as financial intermediation) is
vital for economic growth.
The credit appraisal techniques many banks use when lending to

companies stem from methods used to evaluate investments. Indeed, the
use of financial ratio analysis as the basis for the models used to make
corporate lending decisions is widespread. Such techniques have become
highly sophisticated since the 1930s, although they’ve been used since joint
stock companies were first created nearly 400 years ago.
Basel II includes incentives for banks to add greater discipline to these

credit appraisal techniques through the extensive use of statistical
methods for calibration and ‘backtesting’ of credit grading models. Basel
II also encourages banks to add information through the use of options-
based models where the availability of data makes their use appropriate.
Options models can be substituted for more conventional models when

the relevant corporate credit is widely traded through such instruments
as bonds, commercial paper and common stock, and when information
on the debt structure and trading performance of the company is readily
available and up to date. However, such models can produce volatile
credit grades. Most commercial banks are likely to use them to
supplement financial ratio based models. (Section 5.2 highlights the
importance of their role.)
5.1.3 Retail credit risk
Many commercial banks consider that the credit standing of individual

retail customers is just as important as corporate credit risk. In many
countries the techniques for personal credit appraisal have changed
significantly as banks have moved away from branch-based lending to
centralized lending. In branch-based lending branch managers were
primarily responsible for lending decisions which were based on
personal knowledge of their customers.
Centralized lending decisions are made by inputting ‘standardized’

customer information into credit ‘scoring’ models. Product development
has changed the market for personal finance, which is now increasingly
split between credit secured against real estate (houses) and credit that
is unsecured consumer finance (increasingly credit card-based).
Housing finance has traditionally been equated with mortgage finance.

The sale and purchase of mortgages by professional investors, including
pension funds and investment management companies through the
issues of securitized bonds (see Section 1.3), has led to the
development of highly sophisticated models to calculate the value of
different mortgage securitization bonds. These calculations include the
credit standing of the bonds. The importance of such factors as
affordability and loan-to-value will be covered later in this chapter.
Outside of the US there has been increasing development of customer

accounts where a broad range of borrowings can be secured against
property on a continuing basis. This can include a mortgage, car loan,
home improvement loan, other consumer finance and even credit card
borrowings. Although such loans cannot qualify as a mortgage in some
countries, the development of these accounts represents an important
innovation in personal finance. They have the potential not only to
reduce borrowing costs for customers, but to reduce risk for banks as
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well. With its extensive recognition of collateral Basel II seems to permit

and even encourage innovations such as this.
Unsecured consumer finance has been greatly influenced by

developments in models that measure the credit standing of individuals,
so-called ‘credit scoring’ models. Such models have in turn been greatly
influenced by the credit card industry. In this fiercely competitive
business the specific features of individual models are carefully guarded
commercial secrets. However, the fundamental features of these models
include cash flow assessment, employment history and asset cover.
These are discussed later in this chapter along with the importance of
credit agencies and credit history.
5.1.4 Probability of default
All the models discussed in Sections 5.1.1, 5.1.2, and 5.1.3 are used by
banks to support a lending decision. Lending decisions may be
characterized as ‘binary’ (lend or don’t lend). Unfortunately this is too
simplistic because in practice banks are interested in the risks, the
reward, (e.g. the margin and fees on the loan) and, under Basel II, the
capital being held against the loan.
Lending/investing decisions are made by balancing risk and reward,

because at some price any risk may be worth taking – the greater the
risk the greater the reward. A simplistic binary approach does not help
banks in making commercial decisions. However, grading models are
one way of creating a risk/reward framework for supporting
lending/investing decisions.
Basel II, through the use of public credit grades in the Standardised
Approach and bank specific grading models in the Internal Rating-Based
approaches, encourages banks to use credit appraisal models to
establish risk/reward decision frameworks. All the models discussed so
far in this chapter can be used as a basis for Basel II compliant credit
grading models.
5.1.5 Systemic credit risk
Credit risk and liquidity risk are considered the most fundamental risks in
banking. In Basel I the focus was solely on credit risk. While liquidity
crises in commercial banks are rare today, credit risk can still prove very
problematic, not simply for banks themselves but for central banks,
supervisors and governments as well.
The Japanese credit boom of the 1990s and the ‘bubble’ it created in
commercial property prices, resulted in a level of bad debts estimated at
in excess of 10% of the assets of many Japanese domestic banks.
Example The Japanese domestic lending crisis
Throughout the 1990s the Japanese banking system suffered catastrophic

losses due to its domestic lending policies, which led to the collapse or near
collapse of several high profile banks. The crisis resulted in Japan’s 17
largest banks writing off JPY 51 trillion over eight years, equivalent to about
3
10% of Japan’s gross domestic product during that period.
At the end of 1989 the Japanese stock market collapsed and an economic
slump ensued. The real estate ‘bubble’ also burst and values fell dramatically.
As a result of the economic downturn Japanese banks were left with non-
performing loans backed by collateral that was relatively worthless.
In 1997 Hokkaido Takushoku Bank collapsed with debts in excess of JPY 1

4
trillion.
In early 1999, Nippon Credit Bank was nationalized becoming Aozora Bank,
5
with the Japanese government injecting JPY 284 billion into the bank. In
2000 Aozora was sold to a consortium of private investors. Shortly after the
takeover the Aozora president committed suicide.
In May 1999 Japanese supervisors declared Kofuku Bank insolvent with

losses of JPY 229 billion. In 2000 it was sold to a US buy out specialist,
6
Wilbur Ross, for JPY 30 billion.
In October 2000 Nippon Shipman, Japan’s largest credit card company,

announced it was liquidating Inter-Lease, its leasing subsidiary, after losing a
ten-year battle to keep it afloat. At the time Inter-Lease was estimated to have
liabilities of approximately JPY 800 billion. Although a leasing company Inter-
Lease, like many other non-bank financial institutions, had lent large amounts
7
to Japanese corporates in the 1980s.
In 2001 Mitsubishi Tokyo Financial reported a net loss of JPY 125 billion for
st
the year ending March 31 . The main reason for the loss was the cost of bad
loans which amounted to JPY 800 billion. At the time industry analysts
8
estimated the total of bad loans across the sector at JPY 17,000 billion.
In China supervisors are concerned that a similar percentage of bad

debts prevails in some banks. Such high bad debt levels can lead to
systemic risk, the great fear of central banks and governments. Any
bank suffering a high level of defaults in its lending portfolio is a problem
for supervisors and central banks. However, if all banks are suffering at
the same time the economy will suffer. This could potentially result in a
severe economic downturn because the banking system will not have
sufficient capital (bad debts must be deducted from bank capital).
Consequently banks will be unable to extend the credit needed to
facilitate economic expansion.
3
See Financial Times, February 2, 2000.
4
See The New York Times, October 30, 1998.
5
See Financial Times, April 22, 2003.
6
See Financial Times, May 19, 2000.
7
See Financial Times, October 14, 2000.
8
See Financial Times, May 25, 2001.
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5.1.6 Traded markets counterparty credit risk
Market risk results from the mark-to-market value of a traded market

contract such as a foreign exchange contract or an interest rate related
contract. A bank that undertakes market transactions will either make a
profit, or the counterparty with whom they contract will profit depending
on the mark-to-market value of the contract. It is the classic ‘zero sum
game’, only one party can gain from the individual contract.
Traded markets counterparty credit risk is generated when the

counterparty does not immediately pay the amount owed in a
transaction. For example in many businesses ‘cash on delivery’
arrangements avoid credit risk. However in many banking transactions
the amount due, (e.g. the loan) will only be paid when the contract
matures. With many market related products the amount owed to the
counterparty may change during the life of the contract. It is not unknown
for the flow of payments to reverse as a result of movements in the
market price of the contract. In practice the level of counterparty credit
risk can be reduced by:
the making of regular payments between the parties to the contract

the debtor pledging security to back what is owed (collateral)
‘netting’.
Netting is the process of offsetting gains and losses across a number of

the same type of contract or even across different contract types.
In market risk, marking-to-market is the process of using current market

prices to revalue a trading position. However, mark-to-market valuations
are also the basis of calculating counterparty credit risk. The extent of
counterparty credit risk is a function of market movements and is not
directly related to changes in the credit standing of the counterparty.
In all other respects a traded markets counterparty is considered the

same as any other counterparty, and will be evaluated using the same
credit appraisal techniques.
5.2 The origin and use of credit analysis
5.2.1 Analysis of creditworthiness – sovereign risk

The analysis of sovereign risk has increased greatly as a new
international financial market has become established – the so-called
‘emerging market’ issuers of debt.
A major area of work undertaken by public rating agencies is the existing

credit analysis of sovereign risk, the most well known being carried out
by Standard & Poors, Moodys Investors Service and FitchRatings. Many
governments also have agencies, called Export Credit Agencies (ECAs),
which guarantee sovereign risk for exporting companies. There are

agreed principles and practices for credit appraisal under which such
agencies must work.
In addition to the above agencies banks also undertake their own

analysis of sovereign risk. Such analysis usually looks at a series of
quantitative and qualitative factors. These typically cover:
the country itself

the economic environment (savings, investment and growth
statistics)
natural resources and raw materials
labor market efficiency and the quality of skills and education
efficiency of capital and banking markets
the government
macro economic policy (exchange rate and interest rate policies)
external trade and payments balances
inflation history and outlook
foreign direct investment flows
government funding and spending policies
the political environment
stability and adaptability of the political process
degree of consensus on social and economic aims
legal environment (property rights, creditors’ rights)
the banking system
policy and control of the banking sector
the independence of bank supervisors
the role of the central bank and support mechanisms for the banking
system.
It should be noted that legal risk is pervasive in that it does not only
affect sovereign lending. It is just as important when lending to
companies or persons domiciled in the country concerned.
When considering sovereign risk an analytical framework can be created

either from reliable quantitative figures, or from ranking the more
qualitative criteria in the above list. The BIS publishes reliable
quantitative figures; however the lack of such figures could be indicative
of the level of risk in a particular country.
A grading model can be created by comparing the average (mean) data

of a cohort (group) of similar countries, or by more sophisticated so-
called ‘multivariate analysis’ which creates a single ‘score’ by combining
a number of such ratios.
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5.2.2 Analysis of creditworthiness – corporate risk

When offering borrowing facilities to corporate customers, all banks need
to determine the ability of the company to repay the debt. Traditional
approaches have centered on analyzing the financial performance of the
company that wants to borrow. This is termed credit analysis. The
techniques used in credit analysis have their origin in the individual stock
analysis techniques found in the investment management industry.
‘Stock picking’ and ‘credit appraisal’ have much in common. They both
seek to establish whether a company can provide a good return on the
money invested in it, be that equity in the case of the investor or debt for
the bank lender. Both investors and banks are seeking stability and
soundness in a company measured by:
its ability to pay dividends regularly and over a sustained period of

time
a ratio of debt to equity that is not very high so that if it suffered a
shock from an unforeseen event (such as the collapse of a major
customer), it would be able to cut its costs, (e.g. dividends) and still
be able to pay its creditors (lenders) thus avoiding potential
liquidation
other criteria such as the ratio of current assets to current liabilities,
which shows the company's ability to generate net cash flow.
Corporate credit analysis
Corporate credit analysis in commercial banks is still predominantly

undertaken using financial ratio analysis and models built on its
principles. Such analysis examines the following elements of a
company’s financial statements:
balance sheet
profit and loss account (income statement)
cash flow statement
tax statement.
The analysis will typically focus on three years’ historical performance.

To add a predictive capability to the credit appraisals the results are
analyzed to identify any trends.
Key ratios
The ratios typically used during corporate credit analysis cover a

company’s:
operating performance
debt service capability
financial gearing (leverage)
liquidity.
Examples of typical ratios are:
for operating performance: net income divided by net worth and

sales divided by fixed assets
for debt service capability: cash flow divided by interest on debt
for financial gearing: long-term debt divided by capital
for liquidity: current assets divided by current liabilities.
Ratios can be used to develop grading models. For example, ratios can
simply be compared to some defined industry average, which is known
as univariate analysis, or built into a scoring system referred to earlier as
multivariate analysis.
Company valuations
The focus on corporate credit analysis has changed in recent years as

worries about the ability of companies to manipulate earnings figures
have increased. Today company valuations are often based on such
tangible factors as dividends plus net assets per share, rather than
earnings. Assessing a company’s financial performance through
financial ratio analysis is still very important as this form of analysis can
help in avoiding ‘bubble’ valuations and thus inappropriate lending.
Example The South Sea Company
Perhaps one of the best early examples of correctly valuing a company is

provided by Archibald Hutcheson, a British Member of Parliament, who in the
1720s attempted to warn investors of the danger of investing in the South
Sea Company (the notorious South Sea Bubble). Hutcheson produced a
series of stock valuation techniques that are still relevant today. (Students
wishing to learn more about the South Sea Bubble and Hutcheson’s
techniques should read "The First Crash" by Richard Dale, Princeton
University Press, 2004.)
5.2.3 New options-based techniques

In recent years the limitations of stock valuation techniques have become
apparent. Today, sophisticated credit rating models form the basis of much
credit analysis. This is especially the case for markets which are highly
‘liquid’ and where information on companies is widely available and up to
date.
The most obvious proponents of credit rating models are the bond rating
agencies though they do not disclose, in detail, the workings of their
models. These models incorporate investment appraisal analysis as well
as more sophisticated techniques such as those relating to the work of
Robert Merton the Nobel prize-winning economist. Merton is credited
with the development of an options-based approach to modeling credit.
The Merton approach is remarkably simple yet very incisive. Merton

characterizes a loan to a company as the purchase by the company of a
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right (an option) to transfer (‘put’) the firm's assets to the bank when the
value of the firm becomes negative. This is assumed to happen when the
‘present value’ of the equity of the firm, less the present value of its debt
becomes negative. In other words when this occurs the owner of company
has no incentive to retain ownership of the company and ‘walks away’ and
leaves the company in the hands of the bank, lenders and bondholders.
The difference between the valuation of equity and debt can be used to
calculate the probability of default. The nearer to zero this net valuation is
the more likely the owner is to ‘walk away’. At this point the equity has no
value because the firm owes the debt holders more than the company is
worth.
The Merton approach has greatly influenced the latest grading models
used to predict the probability of a credit default. Along with such
additional metrics as loss given default, exposure at default and
backtesting methods focusing on expected and unexpected loss, it forms
the basis for Basel II compliance under the Internal Rating-Based
approaches. (Loss given default and exposure at default are discussed
later in the Certificate program. Expected and unexpected losses are
explained in Chapter 6.)
An in depth explanation of Merton-based options models is beyond the

scope of the Certificate. However it is important that students
understand the basic concepts behind such models.
5.2.4 Analysis of credit risk – personal credit risk
Personal credit risk covers two major areas of personal finance:

finance secured against real estate (primarily mortgage lending) and
unsecured lending (mainly consumer finance).
Personal budgets
Lending to an individual, whether secured against housing or unsecured,

requires an understanding of personal budgets. Since such budgets are
based on the amount of cash coming into a household and cash spent
by a household, a bank account is an excellent source for the required
historical information.
Credit scoring models
The financial information that a bank has available from a customer’s

account gives it an advantage over other banks wishing to extend credit
to the customer. This advantage restricted competition in the consumer
credit market and led to the development of so-called credit scoring
models. A credit scoring model enables a bank to extend credit to
individuals even though the bank does not already provide all their
banking arrangements. Banks ‘feed’ the details of a person’s credit
history, along with other details provided by the potential customer, into
scoring models that estimate creditworthiness.
Credit reference agencies
Credit reference agencies have played an essential role in the growth of

consumer lending. These agencies maintain a record of a person’s
credit history and ideally require all potential lenders to be parties to their
arrangements. The growth of such agencies has significantly increased
unsecured lending competition in a number of markets where they have
become established.
The importance of such agencies to the retail banking industry has been
increasingly recognized and such agencies now exist in a number of
emerging markets including China.
Lifetime consumption
Confidence in the debt service capability of an individual over time

requires a forward looking approach. This in turn requires an
assessment of what the lifetime income and expenditure profile of the
borrower is. A simple illustration of this is the difference between
granting a mortgage to someone who is 30 years old and someone who
is 60. The sources of repayment may differ significantly.
Net assets
Income and expenditure is only one dimension of a person’s financial

viability; the other is a person’s assets and liabilities. Clearly a high level
of net personal assets, such as shares or bonds, could have been a
potential source of repayment for the older person in the example above.
The role of insurance
In addition to net income and net assets the ability to sustain payments
over time will also depend on the level and type of insurance coverage
the borrower has. For example health insurance could be used to
sustain payments should either person in the above example become
sick and unable to work.
Affordability assessment
In assessing the affordability of a mortgage banks typically consider the

following:
free disposable income, on an individual or joint income basis

income after mortgage payments are deducted
income multiples and ability to sustain payments in the future
the certainty of the interest rate charged on the mortgage
threats to income and insurance cover (health, unemployment)
asset insurance (house, home contents)
loan to house value
mortgage indemnity insurance.
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In assessing the affordability of consumer finance, credit analysis will

look closely at the individual’s free disposable income, as is the case
with mortgage lending. The value of assets is less relevant, although
they are considered in the case of auto loans. Such assets often have a
high and reliable value in relation to the outstanding loan amount and
thus will significantly reduce or even eliminate the outstanding debt in
the event of borrower default.
5.2.5 Portfolio management

The development of portfolio management theory has led to a far better
understanding of the benefits of considering not only the risk associated
with any single loan, but also the importance of the change in the risk of
a whole portfolio of loans as a result of making an additional loan. The
main effect of taking loan correlations into account has been to dissuade
banks from concentrating lending in any one area of business either by
geographic, industry or credit grades. This is known as credit
concentration risk.
Concentration risk is covered in Basel II where it states “risk

concentrations are arguably the single most important cause of major
problems in banks”. Such concentrations are not covered in the Pillar 1
capital charge, but rather in Pillar 2. Under Pillar 2 banks are required to
have effective internal policies, systems and controls to identify
measure, monitor and control their credit risk concentrations. Banks are
also required to consider the extent of their credit risk concentrations in
their assessment of capital adequacy under Pillar 2 and to conduct
stress testing accordingly. (Pillar 2 is discussed in more detail in Chapter
7.) Such concentrations include significant exposures to:
an individual counterparty or group of related counterparties

economic sector or geographical region
reliance on an activity or commodity
collateral type or single counterparty.
The text in Basel II notes that many national supervisors impose limits
on large exposures (in relation to the amount of lending to any one
counterparty) as a percentage of a bank’s capital.
Concentration risk can be analyzed by looking at the cohorts of the

portfolio. A cohort is a grouping of the assets by different criteria. For
example a portfolio can be grouped by industrial classification, by
geographical area and/or by credit grade. All represent different ways of
grouping a portfolio and will give distinct information when analyzing the
concentration risk contained in the overall portfolio.
5.3 Credit risk and Basel II
Pillar 1 of Basel II requires banks to calculate their capital requirements

for credit risk, market risk and operational risk. The requirement for
credit risk regulatory capital was intrinsic in the original Basel I Accord.
Under Basel II banks can adopt three different approaches for

calculating their credit risk capital requirements. In addition to describing
the mechanics of each approach Basel II also defines the minimum
criteria a bank must meet to use the more advanced approaches.
The more sophisticated Internal Ratings-Based (IRB) approaches

require the approval of the national supervisor before they can be used.
A fundamental regulatory requirement is that the Internal Ratings-Based
Approach is used to make credit decisions internally, as well as to
measure credit risk.
It is this feature of the IRB Approach that differentiates Basel II from

Basel I. It also differentiates the three approaches for calculating credit
risk capital permitted in Basel II. Under the IRB approaches banks are
not simply using credit risk measurement methodologies, they are
installing a credit risk management process.
Measurement and management must, under the IRB approaches, come

together. Adapting current processes to the minimum criteria required by
the IRB approaches is fundamental to achieving compliance. Therefore
banks seeking to use any of these approaches need to undertake a
thorough review of existing processes including a review of their
strengths and weaknesses against IRB requirements.
B : 52 © Global
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Sample questions
1. Under Basel II the credit risk of most government debt will be

recognized as:
a) Risk-free c) Related to its PD

b) Related to its public credit d) Related to its risk weight
grade
2. Most corporate credit risk is established through:
a) Financial ratio analysis c) Public credit grades

b) Options models d) Distance to default models
3. Retail customer credit standing is established through:
a) Personal knowledge c) Financial ratio models

b) Credit scoring models d) Cash flow modeling
4. Portfolio management looks at the total portfolio risk by:
a) Adding the risk of the c) Offsetting risks between

individual assets cohorts
b) Adding the assets across d) Looking at the total risk
cohorts change from adding an
additional asset to the
portfolio
Answers can be found in the Appendix.
Summary
This chapter has introduced a number of key concepts and issues

involved in the nature of credit risk. Students should review this
summary before proceeding.
The nature of credit risk
Credit risk is defined as the risk of losses associated with the

possibility that a counterparty will fail to meet its obligations when
they fall due; in other words the risk that a borrower won’t repay what
is owed.
Personal investors risk their savings in pursuit of profits when they
invest.
In the course of business companies will incur credit risk in the form
of receivables due from their customers – they will be owed money
for providing goods or services.
Banks are highly geared (leveraged) institutions and any rise in
default rates by borrowers can potentially erode their capital very
rapidly.
Historically banks have largely built their credit appraisal techniques
for corporate borrowers from methodologies commonly used for
investment appraisal of non-government borrowers.
Sovereign risk is the risk of losses associated with the probability
that a country fails to pay either interest or principal on its
borrowings.
Many of the world's largest economies rarely borrow in anything but
their domestic currency, although their bonds are held internationally.
Country risk covers the domestic legal, political and economic
environment and how they affect the private sector.
Country risk analysis is particularly important when looking at inward
investment, which involves cross-border lending to companies,
individuals or projects.
The appraisal and control of sovereign risk is significantly affected
through the Basel II Standardised Approach’s use of publicly
available credit grades.
Corporate credit risk comprises the risk in the debt issued by
companies.
Many banks claim that they understand corporate credit risk far
better than many of the other risks they take.
Basel II includes incentives for banks to add greater discipline to
credit appraisal techniques through the extensive use of statistical
methods for calibration and ‘backtesting’ of credit grading models.
Many banks consider that the credit standing of individual retail
customers is just as important as corporate credit risk.
Unsecured consumer finance has been greatly influenced by
developments in credit scoring models.
Lending decisions may be characterized as ‘binary’ (lend or don’t
lend).
B : 54 © Global
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Manajemen Risiko
Binary decisions are too simplistic because in practice banks are

interested in the risk, the reward, (e.g. the margin and fees on the
loan) and, under Basel II, the capital being held against the loan.
Through the use of public credit grades Basel II moves banks
towards the widespread use of credit appraisal models to establish
risk/reward decision frameworks.
Credit risk and liquidity risk are considered the most fundamental
risks in banking.
Traded market counterparty credit risk is generated when the
counterparty does not immediately pay the sum owed in a
transaction.
The level of traded market counterparty credit risk can be reduced
either by the making of regular payments between the parties to the
contract, by the debtor pledging security to back what is owed
(collateral), or by ‘netting’.
The origin and use of credit analysis
Many governments have agencies, referred to as Export Credit

Agencies (ECAs), that guarantee sovereign risk for exporting
companies.
When considering sovereign risk an analytical framework can be
created, either from reliable quantitative figures or from ranking the
more qualitative criteria.
Reliable quantitative figures are published by the BIS; however the lack
of such figures could be indicative of the level of risk in a particular
country.
When offering borrowing facilities to corporate customers, all banks
are faced with the need to determine the ability of the company to
repay the debt. This is termed credit analysis.
The analysis of financial performance through financial ratio analysis
is still very important as this form of analysis can help in avoiding
‘bubble’ valuations and thus inappropriate lending.
The use of options valuation concepts has greatly influenced the
creation of the latest grading models used to predict the probability of
a credit default.
Personal credit risk covers two major areas of personal finance:
finance secured against housing (primarily mortgage lending), and
unsecured lending (mainly consumer finance).
Lending to individuals, whether secured against housing or
unsecured, requires an understanding of personal budgets.
Income and expenditure is only one dimension of a person’s financial
viability; the other is a person’s assets and liabilities.
When assessing the affordability of consumer finance the credit
analysis will look closely at the free disposable income, as is the
case with mortgage lending. The value of the assets is of less
relevance, although they are considered in the case of auto loans.
The main effect of taking loan correlations into account has been to
dissuade banks from concentrating lending in any one area of
business, thus avoiding concentration risk.
Credit risk and Basel II
Pillar 1 of Basel II requires banks to calculate their capital

requirements for credit risk.
Under Basel II banks can adopt three different approaches for
calculating their credit risk capital requirements.
As with market and operational risk, Basel II advanced credit risk
measurement approaches also require implementation of credit risk
management approaches.
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5 The nature of credit risk

Chapter 1 provided an overview of credit risk and introduced a number

On completion of this chapter the candidate will have a basic understanding

the nature of credit risk

5.1 The nature of credit risk

because of the very nature of their lending-based business. Banks are

Example Peregrine Investment Holdings

In January 1998 Peregrine Investment Holdings, the former high-flying Hong

Historically banks have built their credit appraisal techniques for

Investors looking for higher returns played an important part in the

5.1.1 Sovereign credit risk

When faced with creating inflation, or defaulting on its debts

Example Russian government bonds

In 1998 the Russian government effectively defaulted on its domestic bonds

Domestic currency and foreign currency debt

A useful distinction in sovereign debt bond issues is usually drawn

the debt countries owe which is denominated in their domestic

It is worth noting that many of the world's largest economies rarely

Financial ratio analysis

Sovereign risk is usually assessed much in the same way as corporate

Inward investment has become a growing area of analysis for investors

Examples of recent bubbles include Tokyo’s soaring commercial

There are a number of qualitative factors to consider when assessing

the efficiency of the banking system in allocating capital to productive

The interplay of a number of these qualitative factors can be seen in the

Sovereign risk and country risk

particularly important when looking at inward investment which involves

Other factors to consider when assessing country risk include:

the legal system especially laws on property ownership and

Basel II and sovereign risk

5.1.2 Corporate credit risk

Corporate credit makes up a large part of what is referred to as ‘risky

The credit appraisal techniques many banks use when lending to

Basel II includes incentives for banks to add greater discipline to these

Options models can be substituted for more conventional models when

5.1.3 Retail credit risk

Many commercial banks consider that the credit standing of individual

Centralized lending decisions are made by inputting ‘standardized’

Housing finance has traditionally been equated with mortgage finance.

Outside of the US there has been increasing development of customer

well. With its extensive recognition of collateral Basel II seems to permit

Unsecured consumer finance has been greatly influenced by

5.1.4 Probability of default

Lending/investing decisions are made by balancing risk and reward,

5.1.5 Systemic credit risk

Example The Japanese domestic lending crisis

Throughout the 1990s the Japanese banking system suffered catastrophic

In 1997 Hokkaido Takushoku Bank collapsed with debts in excess of JPY 1

In May 1999 Japanese supervisors declared Kofuku Bank insolvent with

In October 2000 Nippon Shipman, Japan’s largest credit card company,

In China supervisors are concerned that a similar percentage of bad

5.1.6 Traded markets counterparty credit risk

Market risk results from the mark-to-market value of a traded market

Traded markets counterparty credit risk is generated when the

the making of regular payments between the parties to the contract

Netting is the process of offsetting gains and losses across a number of

In market risk, marking-to-market is the process of using current market

In all other respects a traded markets counterparty is considered the

5.2 The origin and use of credit analysis

5.2.1 Analysis of creditworthiness – sovereign risk

A major area of work undertaken by public rating agencies is the existing

which guarantee sovereign risk for exporting companies. There are

In addition to the above agencies banks also undertake their own