INTRODUCTION TO CREDIT RISK

Sources and Types of Risks

Source Type or Nature
International Exchange Rate Changes
Host Government Regulations
Political Unrest
Expropriation of Assets
Domestic Recession
Inflation or Deflation
Interest Rate Changes
Demographic Changes
Political Changes
Industry Technology
Competition
Availability of Raw Materials and Labor
Unionization

Firm-Specific Management Competence

Strategic Direction
Lawsuits
 CREDIT FUNCTION
• Lenders (creditors) and borrowers (debtors)
Who borrows?
Individuals (retail lending)
Business (corporate lending)
Government (sovereign)

3 situations when lender may lose even if debtor meets commitment

Inflation exceeds interest rate
Devaluation of currency in which debt is denominated
Non-compliance with anti-money laundering measures implemented by the
Central Bank
 WHO NEEDS CREDIT?

• Both ‘demand’ and ‘supply’ sides of the economy need credit.

• On the demand side, Consumers need bank finance for basic needs –
housing, consumption, purchase of durables, etc.

• Corporates and the Government require funds for manufacturing, trading,

services – for day to day operations, or long term capital investment.

4
 SUPPLIERS OF CREDIT

• Commercial Banks: central banks monitor NPAs

• Term lending/ Development Institutions: project finance

• Public debt market: role of CRAs

• Other institutions in credit financing: NBFCs, Insurance cos

• Trade credit: suppliers line of credit

 MERITS OF CREDIT

• Wealth creation and maximization

• Tax planning tool-trading on equity

• Convenience

• Business Control

• Socio-economic advantages
 DEMERITS OF CREDIT

• Reduced profitability

• Default and bad reputation

• Bankruptcies

• Propensity to overspend
 BUSINESS RISKS
 Market Risk
 Credit Risk
Operational Risk

CREDIT RISK
It is the distribution of financial losses due to unexpected
changes in the credit quality of an issuer of debt instrument in a
financial agreement.
 RELEVANCE OF CREDIT RISK

• Development of new credit instruments warrants a check on the credit

quality of the issuer

• Decisions on asset allocation-portfolio management

• Integrated risk management systems

• Growth in market for derivatives

• Adoption of Basel Capital Accord

 Credit Risk

“Credit Risk” is defined as the probability / potential that the borrower or counter-
party may fail to meet its obligations in accordance with agreed terms.
 
Credit Risk is made up of two components
• Transaction Risk (or Default Risk), which represents the risk arising from
individual credit exposures and
• Portfolio Risk, which represents the risk inherent in the portfolio of credit assets
(concentration of assets, correlation among portfolios, etc.)

Credit Risk faced by a bank depends on both external factors and internal factors.
External factors arise from situations, which are beyond the control of the bank
but the consequences of which need to be managed in order to mitigate their
impact on the bank. On the other hand, internal factors are unique to the bank,
which are within the control of the bank.
 Credit Risk
• Credit risk refers to the probability of the loss (due to non recovery of)
emanating from the credit extended as a result of the non-fulfillment of
contractual obligations arising from the unwillingness or inability of the
counterparty or for any other reason.

• Credit risk can be defined as ‘the potential that a contractual party will fail to
meet its obligations in accordance with the agreed terms’. Credit risk is also
variously referred to as default risk, performance risk or counterparty risk.
These all fundamentally refer to the same thing: the impact of credit effects on a
firm’s transactions.
There are three characteristics that define credit risk:

1. Exposure (to a party that may possibly default or suffer an adverse change in its
ability to perform).

2. The likelihood that this party will default on its obligations (the default
probability).

3. The recovery rate (that is, how much can be retrieved if a default takes place).

Credit risk Exposure=Probability of default* (1-Recovery rate)

In common parlance credit risk exists whenever a
product or service is obtained with out paying for it
FOOD FOR THOUGHT
 Types of Credit Risks

• Credit risks in loans

• Credit risks in bonds

• Credit risks in derivative instruments

• Portfolio credit risk

• Sovereign Risk
 CREDIT CREATION

• Credit creation=Initial Deposit (1-r)/r

• Where r=reserve ratio

 Credit Risks
• Two components of credit risk
Default risk and
loss severity (1-Recovery rate)

• Expected loss=Default probability*Loss severity given default

Credit-related risks are
• Spread risk: Yield spread widen because of (1) decline in an issuer’s creditworthiness (2) An
increase in market liquidity risk
 Credit migration risk or downgrade risk: risk that the bond issuer’s creditworthiness
deteriorates , leading investors to believe that the risk of default is higher thus causing yield
spread to widen and price of bond falls
 Market liquidity risk: risk that the price at which investors can actually transact may differ
from the price indicated in the market. To compensate investors for the risk that there may not
be sufficient market liquidity for them to buy or sell bonds , in the quantity they desire , the
spread or yield premium on corporate bonds includes a market liquidity component, in
addition to credit risk component. Two main issuer-specific factors impacting market
liquidity risk are (1) size of the issuer and (2) credit quality of the issuer
 THREE MAIN CREDIT RISKS
• Credit default risk: The risk of loss arising from a debtor being unlikely to pay its loan
obligations in full or the debtor is more than 90 days past due on any material credit
obligation; default risk may impact all credit-sensitive transactions, including loans,
securities and derivatives.
• Concentration risk: The risk associated with any single exposure or group of exposures
with the potential to produce large enough losses to threaten a bank's core operations. It
may arise in the form of single name concentration or industry concentration.
• Country risk: The risk of loss arising from a sovereign state freezing foreign currency
payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk);
this type of risk is prominently associated with the country's macroeconomic performance
and its political stability.
 Causes of Credit risk

Unsystematic risk
Systematic risk

Socio- Economic risk Business Financial

political risks risks
risk

Other
exogenous risks
 What is Credit Analysis?

It is the study from the perspective of a supplier of credit of a present/prospective claim

on another agent in the form of debt .

Credit Analysis is pertinent to

• Banks/ FIs: corporate/ retail

• Mutual Funds/ Insurance companies: Invest in debt

• Manufacturer/Trader: credit to customers

• Hedge Funds: buy distressed debt

• Potential customer/buyer: survival of firm

• Auditor: “meeting going concern concept”

• Borrowers
 Framework for credit analysis

Credit analysis includes financial and non-financial factors, and these factors
are all interrelated. These factors include:

• the environment,

• the industry,

• competitive position,

• financial risks,

• management risks,

• loan structure and documentation issues.

 Overview of Credit Analysis Process

04/11/11
SIGNIFICANCE OF CRA(CREDIT RISK ANALYSIS)
Prudence
Increase in bankruptcies
Increase in competition
Volatility of Collateral/ Asset values
Poor asset quality
High impact of credit losses
Proliferation of limited liability entities
Risk vs return matching
Disintermediation
Off Balance Sheet transactions
 CHALLENGES OF CRA

• Reliability of data

• Profitability/ Business Considerations

• Unpredictable future

• Reliability of risk models

 Credit risk

• Credit risks in project financing

• Credit risks in working capital

• Credit portfolio risks

CREDIT RISK MANAGEMENT
 Credit Risk Management

Credit risk management is the process of controlling the potential

consequences of credit risk. The process follows a standard risk
management framework: namely identification, evaluation and
management. That is, the cause of the risk has to be identified, the
extent of the risk has to be evaluated and decisions have to be made
as to how this risk is to be managed.*
OBJECTIVES OF CREDIT RISK MANAGEMENT

• Maximising benefit from potential credit opportunities

• Pricing credit risk adequately

• Minimizing bad loans

• Adherence to credit policies

• Maintenance of a reliable database

 Strategic Position of Credit Risk Management

• Operational Risks

• Market Risks

• Legal Risks

• Computer Risks

• Reputation Risks

• Liquidity Risks
 Credit Risk Appetite Statement

• Target Market

• Minimum Credit Standards

• Sectors

No Appetite/ Reduce

Grow

Selective Growth

• Products Offered
 STAGES OF CRM IN FINANCIAL INTERMEDIARIES

• Nature and purpose of credit

• Types of credit facilities

• Capacity to borrow

• Security

• Analyze borrowers financial status

• Forecasting the repayment capacity

• Profitability

• Structure the credit facility, including conditions and covenants

• Constant Monitoring
 CREDIT RISK MANAGEMENT PROCESS

• Finalise overall credit risk appetite

• Establish objectives and strategy

• Roll out credit risk infrastructure to facilitate measurement and ownership of credit risk

• Identify the right people and ensure proper communication behavior and incentivisation

• Implement appropriate credit risk models

 What are credit events?
The market that has developed in credit risk transfer, known as credit derivatives, has led to
the formalisation of what constitutes credit events.
The following list gives the principal types as usually defined in the documentation for these
instruments.

• Bankruptcy or insolvency under corporate law: in this case the legal entity is dissolved,
having been declared bankrupt or insolvent by a commercial court.
• Credit upon a merger: assets are transferred (with a negative impact on the ability to pay)
or the legal entity is consolidated into another company.
• Cross-acceleration: other obligations of the legal entity become due prior to maturity
owing to a breach of contract. (In debt contracts, covenants –which are legally binding
requirements on the borrower –are breached, which leads to repayment being mandated.)
• Cross-default: obligations of the legal entity have been declared in default. Under
debt contracts, failure of one set of obligations to perform leads to the automatic
declaration of other obligations to be in default, even if these obligations have not
experienced any breach of contract (covenant).
• Currency convertibility: foreign exchange controls in a particular country or
countries prevent repayments in the affected currency or currencies. Note that
currency convertibility is usually linked with currency risk. Country risk is the risk
associated with lending to a particular country, whereas default risk is usually
company specific.
• Downgrade: the situation where an obligor has a downward, hence adverse, change
made in the independently and publicly available credit opinion (known as a credit
rating) on the obligor. This can include the cancellation of the available rating. A
downgrade may lead to holders having to sell the obligor’s debt securities.
• Restructuring: the legal entity defers or reschedules outstanding debt(s):
reduces the interest payable, postpones payments, changes the obligation’s
seniority or extends its maturity.
• Failure to pay: the legal entity is not able to or does not make the contractual
payment.
• Government action: any action(s) by a government or an agency of
government that results in outstanding claims becoming unenforceable against
the legal entity.
• Market disruption: the situation where the tradable securities of the obligor
cease trading.
• Moratorium on debts: the legal entity declares a standstill on its existing debts
and interest payments.
• Obligation acceleration: a contractual obligation becomes payable before
its due maturity owing to default by the legal entity. This is similar to, but
not identical to, cross-default, since it refers to a direct obligation with an
affected party (whereas cross-default refers to a third party).
• Obligation default: an event of default has occurred in the legal entity’s
obligations.
• Repudiation: the legal entity disaffirms or disclaims its debts.
 Mitigation of Credit Risk

• Risk-Based Pricing

• Credit insurance and credit derivatives

• Covenants

• Diversification
 ELEMENTS OF CREDIT RISK ANALYSIS

• Character

• Capital

• Capacity

• Conditions

• Collateral