Measurement of Credit Risk

Introduction
Concept of Risk Measurement
Difficulties involved in Modeling
Benefits of Credit Modeling
Modern Approaches to Risk Measurement
Shortcomings of Credit Risk Measurement Models
Summary/Conclusion

Introduction

Banks over the years have adopted a qualitative approach to the measurement of credit risk.
In recent times however, there have been attempts by some of the world’s major banks to
develop sophisticated systems to model their credit risk exposures.
Such models are intended to aid the banks in quantifying, aggregating and managing risk across
geographical and product lines.
Introduction
The initial interest in credit risk models has stemmed from the desire to develop more rigorous
quantitative estimates of the amount of economic capital needed to support a bank’s risk taking
activities.
Introduction – Role of Models
These models play increasingly important roles in a bank’s risk management and performance
management processes, including performance-based compensation, customer profitability
analysis, risk based pricing and active portfolio management and capital structure decisions.
The concern of regulators is that the models are conceptually sound, empirically validated, and
produce capital requirements comparable across institutions.
The Concept of Quantification of Risk
Risk is essentially related to the variability of outcomes.
For that matter, statistical tools and principles have been employed as a means of measuring risk.
The main statistical tools and techniques include probability theory, standard deviation,
covariance and correlation.
Without understanding these concepts, a foray into the realm of credit risk modeling would be
fraught with much confusion    and haziness.
Risk Adjusted Pricing
Once the risk has been quantified, it makes it possible to adjust the bank’s pricing based on the
risk.
A facility’s risk will hinge on the risk of the industry and the risk associated with the customer.
A high estimated risk will attract a higher margin over base rate to compensate for the risk
Risk Adjusted Performance Measures
Traditional measures used in performance management such as return on assets and return on
equity have been considered to have some short comings.
Book value of equity for example is a poor indicator of a bank’s risk
Return on equity is also bank wide and not defined for individual risk
Return on Capital is considered a more meaningful measure when estimated at the firm wide,
business-line or transaction level
Return on Capital
ROC = revenue – Expenses/ capital charges
Bankers Trust was the initiator of this approach to measuring a risk adjusted performance
measure for all business units of the bank.
Since then many Risk Adjusted Performance Measures have been used. (RAPM)
The most common used is the RAROC – risk adjusted return on capital
RAROC
RAROC = revenue –expenses – Expected Loss +Income from Capital Allocated
Where
Expected Loss is the mean of the loss distribution associated with activity
Income from capital is risk free rate e.g. Treasury Bill rate multiplied by the Capital allocated to
the business line
In Ghana the Expected Loss may be considered as the General provision for that specific line of
business
Difficulties of Credit Models
Credit models are not simple extensions of models employed by market risk analysts for two
major reasons:
Data limitations
Model validations
Data Limitations
Data modelers have complained generally about lack of sufficient data.
This scarcity may stem partly from the infrequent nature of default events and the longer term
nature of time horizons used in measuring credit risk.
Credit models therefore involve using many simplifying assumptions and proxy data.
A wrong credit model could have significant repercussions on the bank’s solvency
Model Validation
It is much easier to validate market risk models than the case of credit risk models.
Whilst market risk models employ a horizon of a few days, credit risk models rely on a time
frame of a year or more.
It is therefore more difficult to assess the accuracy of credit risk models
Potential Benefits of Credit Risk Models
The use of credit models gives the bank a framework for examining the risk in a timely manner,
centralizing data on global exposures and analyzing marginal and absolute contributions to risk.
This would help to improve the bank’s overall ability to identify, measure and manage risk
Benefits of Credit Modeling
Credit risk models may provide an estimate of credit risk that reflects individual portfolio
composition.
In this way they may provide a better reflection of concentration risk compared to the non-
portfolio approaches.
Credit modeling is a very responsive and informative tool for risk management in that it enables
the bank to understand the influence of shifts in credit quality, market variables and the economic
environment on the credit portfolio.
Benefits of Credit Modeling
Credit models may also offer:
An incentive to improve systems and data collection efforts
A more informed setting of limits and reserves
More accurate risk and performance-based pricing, which may contribute to a more transparent
decision-making process and
A more consistent bases for economic capital allocation.
Benefits of Credit Modeling
A models-based approach can bring capital requirements into closer alignment with the
perceived riskiness of underlying assets and portfolio concentrations.
This would allow a more comprehensive measure of capital requirements for credit risk and an
improved distribution of capital within the financial system.
The Concept of Economic Capital Allocation
The key ingredient for estimating a bank’s economic capital requirement is the credit portfolio’s
Probability Density Function of Credit Losses (PDF)
A bank’s credit risk model is used in estimating such a PDF
The model distinguishes between expected credit loss and unexpected loss
Expected and Unexpected Loss
Expected loss is the amount of credit loss the bank would expect to experience on its credit
portfolio over a chosen time horizon.
This would normally be the mean loss experienced over the time horizon.
Unexpected loss on the other hand is the amount by which actual losses exceed expected loss.
This is normally expressed by measures such as the standard deviation of losses, or the
difference between the expected loss and some selected target credit loss quantile.
Measuring Credit Loss
Generally, a portfolio’s credit loss is defined as the difference between
The portfolio’s current value
Its future value at the end of some time horizon
The estimation of the current portfolio’s PDF involves estimating
The portfolio’s current value
The probability distribution of its future value at the end of the planning horizon
Conceptual Models of Credit Loss
Banks tend to employ either of two conceptual definitions of credit loss:
Default mode paradigm (DM)
Mark to Market paradigm (MTM)
Time Horizon
Most banks often adopt a one year time horizon across all asset classes, whilst a minority utilize
a five-year approach, or modeled losses over the maturity of the exposure.
Considerations for the choice of one year include:
Time to raise new capital
Loss mitigation action
Revelation of new obligor information
Publication of default data
Internal budgeting time horizon
Time for review of credits.
Default Mode Paradigm
With the DMF paradigm, a credit loss arises only if a borrower defaults within the planning
horizon.
For example with a standard term loan, in the absence of a default, no credit loss would be
incurred.
In the event that the borrower defaults, the credit risk would reflect the difference between the
bank’s credit exposure (the amount it is owed at the time of default and the present values of net
recoveries (cash payments from borrower less workout expenses)
Default Mode Paradigm
The current value of a term loan is the bank’s credit exposure
The future value would depend    on whether the borrower defaults or not.
If the borrower does not default, the loan’s future value would be measured as the bank’s credit
exposure at the end of the planning horizon, adjusted to add back any principal payments made
over the period.
Default Mode Paradigm
If the borrower were to default, the loan’s future value (per dollar of current value at the
beginning of the horizon) would be measured as one minus its loss rate given default.
The lower the LGD the higher the recovery rate.
Mean/Standard Deviation Approach
Some systems for allocating economic capital against credit risk typically assume that the shape
of the PDF is well-approximated by some family of distributions e.g. (beta distribution) that
could be parametised by the mean and standard deviation of the portfolio’s credit losses.
This methodology is generally termed as the Unexpected Loss Approach.
Under the UL approach, the economic capital is set at some multiple of the estimated standard
deviation of the portfolio’s credit losses.
Portfolio’s Expected Credit Losses
A portfolio’s expected credit loss (µ) over the assumed time horizon equals the summation of the
expected losses for the individual credit facility

µ = �i=1�n�PDi� EADi LGDi

Where for the ith facility:

PD = probability of default
EAD = Exposure at Default
LGD = Expected Loss Given Default
Portfolio’s Standard Deviation
The portfolio’s standard deviation of credit losses (σ) can be decomposed into the contribution
from each of the individual credit facilities:
(2) σ = �𝑖=1�𝑁�𝜎𝑖𝜌𝑖    �                 
Where σi = stand-alone standard deviation of credit losses for the ith facility
ρi = correlation between credit losses on the ith facility and those on the overall portfolio
The Impact of Correlation
The parameter ρi    captures the ith facility’s correlation/diversification effects with the other
instruments in the bank’s credit portfolio
All things being equal, higher correlations among credit instruments – represented by a higher ρi 
lead to a higher standard deviation of credit losses for the portfolio as a whole.
Standard Deviation of the ith Facility
Under further assumptions that
Each facility’s exposure is known with certainty
Customer defaults and LGDs are independent of one another
LGDs are independent across borrowers,
Stand alone standard deviation of credit losses for the ith facility may be expressed as:
σi    = EAD ��𝑃𝐷𝑖 �1−𝑃𝐷𝑖�𝐿𝐺𝐷2+𝑃𝐷𝑖 𝑉𝑂𝐿2�     
Where
VOL = The standard deviation of the facility’s LGD
Usefulness of Model
Provides a convenient way of summarizing the overall portfolio’s credit risk    (within the DM
framework) in terms of each instrument’s PD, ρ, LGD, VOL AND EAD.
They also help to highlight those aspects of credit risk modeling process that determine its
overall reliability, namely
Accuracy of parameter estimates as representations of the future
Validity of the model’s underlying assumptions such as assumptions of independence among
random variables, assumptions that certain variables are known with certainty and the
distributional assumptions regarding unexpected loss.
Mark to Market Paradigm
In contrast to the DM paradigm, a credit loss can arise in response to deterioration in an asset’s
credit quality short of default.
In effect the MTM paradigm treats the credit portfolio as being marked to market (or more
accurately, marked to model) at the beginning and end of the planning horizon, with the concept
of credit loss reflecting the difference between these valuations
Estimation of Parameters
Four main types of credit events may contribute to the level of credit losses in credit risk models:
A change in LGD
A change in creditworthiness (reflecting a change in a credit rating migration or a change in PD
A change in applicable credit spread for MTM models
A change in a bank’s exposure with respect to a particular credit facility.
Assumptions
Credit risk models tend to be modular in the sense that they involve separate sub-models for each
of the four credit event.
While correlation between obligors due to credit events are introduced in various ways, most
models assume zero correlation between credit events of different types.
Loss Given Default
Parameters may be estimated from data on the historical performance of individual loans or
corporate bonds or from time-series data for pools of loan
LGD Assumptions
Within the current generation of credit risk models, LGDs are assumed to hinge on a limited set
of variables including type of product, seniority, collateral and country of origination.
Models assume zero correlation among the LGDs of different borrowers, and for that matter no
systematic risk to LGD volatility
It is also assumed that LGDs associated with the same borrower are independent.
Estimation of LGD
The parameters of probability distribution for LGDs are generally deduced by pooling
information from a number of sources including:
Internal data on the bank’s own historical LGDs by risk segment
Loss data from trade association reports and publicly available regulatory reports
Consultants’ proprietary data on client LGDs
Published rating agency data on the historical LGDs of corporate bonds
The intuitive judgments of experienced lending officers
Default/Ratings Migration
Credit risk models generally relate the process of determining customer defaults from two main
types of parameters:
For each customer the P
Default/Ratings Migration
Credit risk models generally relate the process of determining customer defaults from two main
types of parameters:
For each customer the PD or rating transition matrix
Across customers, the correlations among defaults and ratings migrations
Procedure for Estimating PD
Two main methods are used for mapping observable data historically to customer-specific
PD/EDF transition matrices, namely actuarial-based methods and equity based methods.
Actuarial-based Methods
The basic approach involves using historical data on the default rates of borrowers to predict the
expected default rates/rates migration for customers having similar characteristics.
Some methods use credit scoring models to predict PDs
Equity Based Methods
This approach is used in exclusively estimating the PDs of large and middle-market business
customers, and is often used to cross-check estimates generated by actuarial-based methods.
It involves using publicly available information on a firm’s liabilities, the historical and current
market value of its equity and the historical volatility of its equity to estimate the level, rate of
change and volatility (at an annual rate) of the economic value of the firm’s assets
Equity Based Methods
Under the assumption that default occurs when the value of a firm’s assets falls below its
liabilities, expected default probabilities can be inferred from option models.
Alternatively it is possible to calculate the number of standard deviations the current asset value
is away from the default threshold
Given a firm’s estimated distance to default, its PD is calculated as the historical default
frequency for firms having the same distance to default derived from a Proprietary KMV
database on the historical default experience of publicly rated businesses
Validation Policies and Issues
The components of a validation model can be grouped into four broad categories
Back-testing – verifying that the ex-ante estimation of expected and un expected losses is
consistent with ex-post experience.
Stress testing, or analyzing the results of model output given various economic scenarios
Assessing the sensitivity of credit risk estimates to underlying parameters and assumptions
Ensuring the independence of independent review and oversight of a model.
Back-testing
It is much easier to back-test market risk Var than credit risk models due to data constraints
Whilst market risk back-testing requires a minimum of 250 trading days of forecasts and realized
losses, a similar standard model would require an impractical number of years of data
considering the models’ longer time horizon
Stress Testing
Stress tests aim to overcome some of the major uncertainties in credit risk models such as the
estimation of default rates or the joint probability distribution of risk factors, by specifying
particular economic scenarios and judging the adequacy of bank capital against those scenarios,
regardless of the probability that such events may occur.
Stress tests could cover a range of scenarios, including the performance of certain sectors during
crisis or the magnitude of losses at extreme points of the credit cycle.
Sensitivity Analysis
This is the practice of testing the responsiveness of model output to parameter values or to
critical assumptions.
A number of banks conduct sensitivity analysis    on a number of factors including:
EDF and volatility of PD
LGD and
Assignment of internal rating categorite.
Management Oversight and Reporting
Senior management    oversight, proficiency of loan officers, the quality of internal controls and
other traditional features of credit culture play major role in the risk modeling framework.

Summary/Conclusion
The lesson of Continental Illinois and the recent sub-prime mortgage crisis    are sufficient to
motivate financial institutions to pay more attention to identifying, measuring and managing the
credit risks that they are exposed to in their efforts to grow their advances book and meet the
expectations of their shareholders
Credit portfolio risk modeling is a nascent area in risk management is becoming more and more
fine-tuned by the day.
It is imperative for modern day banks to develop models suitable to their terrain and in this way
promote the long term viability of their institutions

THE END

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