Credit risk

Qualitative measures

Business Studies Department, BUKC

 Newer Models of Credit Risk Measurement and Pricing
• Term Structure Derivation of Credit Risk
• Mortality Rate Derivation of Credit Risk
• RAROC Models
• Option Models of Default Risk

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 Term Structure Based Methods
• If we know the risk premium we can infer the probability of
default. Expected return equals risk free rate after accounting
for probability of default.
p (1+ k) = 1+ i
• May be generalized to loans with any maturity or to adjust for
varying default recovery rates.
• The loan can be assessed using the inferred probabilities from
comparable quality bonds.

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 Probability of Default on a One-Period Debt Instrument
• Example 10-4

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 Mortality Rate Models
• Similar to the process employed by insurance companies to price
policies. The probability of default is estimated from past data on
defaults.
• Marginal Mortality Rates:
MMR1 = (Value Grade B default in year 1)/(Value Grade B outstanding
yr.1)
MMR2 = (Value Grade B default in year 2)/(Value Grade B outstanding
yr.2)
• Many of the problems associated with credit scoring models such as
sensitivity to the period chosen to calculate the MMRs

Business Studies Department, BUKC

 RAROC Models
• Risk adjusted return on capital. This is one of the more widely
used models.
• Incorporates duration approach to estimate worst case loss in
value of the loan:
• DLN = -DLN x LN x (DR/(1+R)) where DR is an estimate of
the worst change in credit risk premiums for the loan class
over the past year.
• RAROC = one-year income on loan/DLN

Business Studies Department, BUKC

 Option Models:
• Employ option pricing methods to evaluate the option to
default.
• Used by many of the largest banks to monitor credit risk.
• KMV (now part of Moody’s) Corporation markets this model
quite widely.

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 Applying Option Valuation Model
• Merton showed value of a risky loan
F(t) = Be-it[(1/d)N(h1) +N(h2)]
• Written as a yield spread
k(t) - i = (-1/t)ln[N(h2) +(1/d)N(h1)]
where k(t) = Required yield on risky debt
ln = Natural logarithm
i = Risk-free rate on debt of equivalent maturity.
t = remaining time to maturity

Business Studies Department, BUKC

 CreditMetrics
• “If next year is a bad year, how much will I lose on my loans and loan
portfolio?”
VAR = P × 1.65 × s
• Neither P, nor s observed.
Calculated using:
• (i)Data on borrower’s credit rating; (ii) Rating transition matrix; (iii)
Recovery rates on defaulted loans; (iv) Yield spreads.

Business Studies Department, BUKC

 Credit Risk
• Developed by Credit Suisse Financial Products.
• Based on insurance literature:
• Losses reflect frequency of event and severity of loss.
• Loan default is random.
• Loan default probabilities are independent.
• Appropriate for large portfolios of small loans.
• Modeled by a Poisson distribution.

Business Studies Department, BUKC

 Qualitative models
• In the absence of publicly available information on the quality of
borrowers, the FI manager has to assemble information from private
sources—such as credit and deposit files—and/or purchase such
information from external sources—such as credit rating agencies.
• This information helps a manager make an informed judgment on the
probability of default of the borrower and price the loan or debt
correctly.

Business Studies Department, BUKC

 Qualitative models
• Number of key factors enter into the credit decision, these include:
1. borrower-specific factors, which are idiosyncratic to the individual
borrower, and
2. Market-specific factors, which have an impact on all borrowers at
the time of the credit decision.

Business Studies Department, BUKC

 Borrower-Specific Factors
1. Reputation: The borrower’s reputation involves the borrowing–
lending history of the credit applicant. If, over time, the borrower has
established a reputation for prompt and timely repayment, this
enhances the applicant’s attractiveness to the FI.
2. Leverage: A borrower’s leverage or capital structure—the ratio of
debt to equity— affects the probability of its default because large
amounts of debt, such as bonds and loans, increase the borrower’s
interest charges and pose a significant claim on its cash flows.

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 Borrower-Specific Factors
3. Volatility of Earnings: As with leverage, a highly volatile earnings
stream increases the probability that the borrower cannot meet fixed
interest and principal charges for any given capital structure.
Consequently, newer firms or firms in high-tech industries with a high
earnings variance over time are less attractive credit risks than are those
with long and more stable earnings histories.
Business Studies Department, BUKC
 Borrower-Specific Factors
4. Collateral: A key feature in any lending and loan-pricing decision is
the degree of collateral, or assets backing the security of the loan. Many
loans and bonds are backed by specific assets should a borrower default
on repayment obligations.

Business Studies Department, BUKC

 Market-Specific Factors
1. The Business Cycle: The position of the economy in the business cycle
phase is enormously important to an FI in assessing the probability of
borrower default. For example, during recessions, firms in the consumer
durable goods sector that produce autos, refrigerators, or houses do
badly compared with those in the nondurable goods sector producing
clothing and foods.
2. The Level of Interest Rates: High interest rates indicate restrictive
monetary policy actions by the central banks (SBP). FIs not only find
funds to finance their lending decisions scarcer and more expensive but
also must recognize that high interest rates are correlated with higher
credit risk in general.

Business Studies Department, BUKC

 References
• Saunders, A. & Cornett, M.M. (2017). Credit risk: Individual loan risk
(9th edition), Financial institutions management: A risk management
approach. McGraw-Hill Education.

Business Studies Department, BUKC