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Credit Risk Management

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					   Credit Risk Management
Enhancing Your Steady Profitability
            Dr. Bin Zhou
     School of Finance and Statistics
      East China Normal University

         bzhou@stat.ecnu.edu.cn
 Agenda


• Credit risk case study in a Chinese bank
• Credit Risk Management Research
Credit risk case study in a Chinese bank

• To explore the characteristics and causes of credit risk in Chinese
   commercial banks, analysis is made of 800 million RMB bad debts,
   which are written off between 1998 and 2005 in state-owned
   commercial banks in a Chinese city.
• Given the specific financial background in China, studies are carried
   out in the field of the causes of credit risk which can be classified
   into 3 categories:
• Enterprise operation: operation and management, techniques, fund,
   brand, credibility and so on.
• Bank management: investigation in specific enterprises before loans
   are granted, management of loans after grant, bank structures.
• External factors: government intervention, market volatility, credit
   environment, force majeure.


• Factor analysis shows that government intervention, enterprise
   management and bank structures, market volatility are main factors
   responsible for 368 doubtful debts being written off as bad debts.
                           f und
                             6%                    gover nm ent
    cr edi bi l i t y                            i nt er vent i on
         11%                                            20%

  t echni ques
       9%
                                                        ar
                                                       m ket vol at i l i t y
                                                             13%


poor oper at i on
and managem  ent                                   poor bank
     20%                                           st r uct ur e
         l oans m  anagem ent     i nvest i gat i on, 12%
           af t er gr ant ed           i
                                 exam nat i on and
                   4%           appr oval by banks
                                          5%



                 Credit risk factor analysis
•    It is necessary to establish an all-dimensional evaluation system
     as the current system focuses too much on financial indicators.
     The system should include the following 4 modules:
1.   Business performance evaluation: Based on the data
     provided by annual financial statements, the evaluation ratios are
     calculated which represent the repaying capacity, assets
     operation and development as well as financial performance of
     enterprises. By making good use of these ratios, we carry out
     comprehensive evaluation of enterprises. Thus financial analysis is
     improved and the development edge of enterprises is valued in
     quantified terms.
2.   Individual industry risk: The current credit evaluation system
     does not take industry risk into consideration, though in a market
     economy, the rise and fall of an industry has a direct bearing on
     the prospects of enterprises within the industry and helps shape
     the development of enterprises in related industries. The rise and
     fall of an industry has increasingly become an important index of
     macro economy, acting as a significant guide for investment
     decision and credit allocation. As for the Chinese market economy,
     characterized by evident cyclical macro-control the economy
     waxes and wanes not only with market conditions but also with
     government policies. The prospects of industries are neither
     deterministic nor predictable which has a direct impact on the
     safety of loans granted by banks.
3. Government risk evaluation government intervention is a major cause of
   bad loans in Chinese commercial banks, and local government policies and
   actions should be taken into account during the process of credit risk evaluation.
   Case studies show that local government intervenes strongly during the whole
   process of credit even in the dealing of bad loans.

      Making use of their administrative power, governments clamp down on banks
      to grant credit to particular projects

       Governments appropriate credit and change the destination of it

       Governments transfer credit assets and avoid paying debts in the name of
       reorganization, merger and bankruptcy;

       Governments establish barriers when banks chase debts and attempt to deal
       with collateral legally.


4.Enterprise moral risk evaluation: evaluating creditability by examining an
   enterprise’s performance in tax obligations, complying with contracts,
   presenting statements faithfully and paying debts on time .
                            Business performance evaluation

                                                              No-risk
                                                              Low-risk
                                                              moderate-risk
                                                              Moderate-high-risk
                                                              High-risk


                                                 Individual industry risk
.Enterprise moral risk
evaluation




                             Government risk evaluation



             Multidimensional credit risk evaluation system
                           frame diagram
Companies are exposed to significant levels of credit risk emanating from
different sources
          Accounts Receivables
          Other Notes Receivables
          Buyer and Franchise Financing
          With Recourse Financing
               Project Finance
               Structured Transactions
               Leases with Recourse
          Derivatives Exposures
               FX, Interest Rate Risk, Commodities etc.
          Collateral Risk
               Parent or Third Party Guarantees
               Commercial and Standby Letters of Credit
     Note also that Critical Suppliers to the company may pose specific credit
     risk
Credit Risk Management Research
Credit Risk Background

• An uncertain and volatile economic environment
    significantly impacts this ability
•   The desire for growth and for producing outstanding
    results has a tendency to put pressure on the checks
    and balances within the businesses
•   Thorough identification and accurate measurement of
    credit risk, supported by strong risk management can
    help improve the bottom line
  Assess the complexity of credit risk

Each financial product has different credit risk
  characteristics
- Creditor’s right (loans, finance and option)
- Credit (Swaps,forwards)

Risk Exposure, Default Correlation and
  recovery rates differs from each other,
  especially in a portfolio. Default correlation
  must be considered. Default correlation and
  recovery rate may also correlate with risk
  exposure.
A complete and coherent risk management
framework contains the following elements

                            Credit Strategy
                                & Risk
                              Tolerance            Governance, Control
  Credit Policies                                  and Implementation
  & Procedures


Measurement                   Analysis &               Technology &
                                 Risk
Methodologies                 Management               Data Integrity




                             Reassessment
                    Credit Strategy & Risk Tolerance
Credit Risk Management’s Inter-related Activities

CREDIT POLICY                                                                   RISK MANAGEMENT
                                                             Reporting
                                                                                            Disposal /
   Origination             Credit Analysis                   Management
                                                                            Recoveries         Risk
                                                              reporting
                                                                                            mitigation
      Sales          Financial             Credit
    channels         analysis             analysis
                                                                                   Collections
                                                              Exposure
                                                             aggregation
                                           Credit
                     Risk rating
                                          scoring
                                                          Exposure           Customer       Portfolio
                                                         measurement        management     management


      Credit
      Decisions                                                                    Compliance

                                                                                            Collateral
                                                                           Transactions
                                                                                           management
         Pricing &                              Collateral
                           Credit limit
          terms                                acceptance

                                                                            Contracts &
                                                                           Documentation
Credit Risk Areas to Consider

  Origination/                               Monitoring/         Risk
                      Administration
  Assessment                                 Control             Management

  Sales           • Credit Policy   • Exposure                   Portfolio
  Channels                            Management                 Management
                  • Credit Approval    – Aggregation
  Risk Strategy       Authority             – Control            Concentration

  Underwriting    •   Limit Setting    •   Periodic Account      Diversification
  Standards       •   Pricing Terms        Reviews
                      and Conditions        – Payments/          Allowance
  Credit                                       Ageing            for Bad
  Application     •   Documentation:        – Credit Condition   Debts
                      Contracts and
  Analysis                             •   Compliance with       Risk
                      Covenants            Covenants, Terms      Mitigation
     Business/    •   Collateral and   •   Technology/Reports    Objectives
     Industry
                      Security              – Transactions/
     Financial                                 Bookings          Type of
     Credit       •   Collections,                               Exposure
                                            – Risk-adjusted
                      Delinquencies            Return            Instruments or
  Credit                                                         Methods
  Scoring and         and Workouts
  Ratings
Credit Strategy & Risk Tolerance
    Credit Strategy Statement and                      Specific Quantifiable Objectives
    Risk Tolerance
                                                       Management Review
    Coordination with Business                         Methodology
    Plan
                                       Improve Profitability
  Strategy/ Plan




                                                                               Performance
                                                                                Common
                                                                                  Metrics
                   Credit Objectives                            Credit Risk
      Credit




                      and Risk              Credit Policies     Managem  ent
                     Tolerances                                  Processes



                                              Reporting
A business model view of Credit Risk Infrastructure
components



                         Vision: Managing Risk/Return
                  Pricing decisions, Performance measurement,
                      business and customer segmentation,
                                compensation, etc.


       Near Term: Managing Economic Capital / Credit VaR
           Portfolio Risk Concentration, Risk Based Limits, etc.

               Short Term: Managing Expected Loss
                      Risk Identification, Transaction
         Structuring, Approval & Pricing Decisions, Reserving, etc.


    Foundation: Credit Rating and Underwriting Standards
      Risk Identification, Origination, Credit Administration, etc.
Businesses have to contend with Expected and
Unexpected Losses


 • Expected Losses                  • Unexpected Losses
                                       – Unanticipated but
    –   Anticipated
                                         inevitable
    –   Cost of doing business
                                       – Must be planned for
    –   Charged to provisions
                                       – Covered by reserves
    –   Captured in pricing
                                       – Allocated to businesses
    –   Relatively easier to
                                       – Difficult to measure
        measure

 • Assessing expected loss          • Assessing unexpected loss
   includes determining exposure,     requires making qualitative
   default probability and            judgments around potential
   severity                           volatility of average losses
Data Issue in Credit Risk Analysis
• Historical Data, e.g. financial data, credit
   ratings.
• Market Data, e.g. Price of corporate securities,
   stock price and price of credit derivatives
• At present, data availability quality is the major
   problem in credit risk management.
 The classic credit risk management
 methodology

5 Cs:             5 Ws           5 Ps
  1 Character       1 Who             1 Personal
  2 Capacity        2 Why             2 Purpose
  3 Capital         3 When            3 Payment
  4 Collateral      4 What            4 Protection
  5 Condition       5 How             5 Perspective
 Basic assumptions used in Credit Risk
 Management methodologies

• Credit rating system, all individual borrowers (debtors?) have their
   own credit rating, which partially determines their asset price and
   discount rate.
• The borrowers (debtors?) with the same credit rating should have
   the same migration and default possibility.
• Movement in asset-return is caused by both systematic risk and
   individual risk (?) (individual credit risk for each debtor). Systematic
   risks are reflected in country and industry index, individual debtor’s
   stock earning ratio should be similar their asset return .
• Spot and forward interest rate is normally fixed, hence the model is
   not sensitive to the interest rate movement.
Comparison between classic and modern
credit analysis methodology

Classic method                   Modern method
• Based on historical data       • Based on the movement
• Uses traditional statistical     in market variables, e.g.
  models                           Asset, Share Price,
                                   Interest Rate and Foreign
                                   Exchange Rate
                                 • Uses Contingent Claim
                                   pricing model
Comparison between classic and modern
credit risk management methodologies

Classic methods              Modern methods
• Set-up credit limit        • Credit rating on risk
• Establish credit rating      exposure
  system                     • Active use of credit
• Adopt credit improvement     derivatives to migrate or
  tools (Collateral, third     diversify risk
  party guarantee, Credit
  Agreement)
 Credit Derivatives


• Credit derivatives can be treated as a tool to transfer risk
  from one party to another
• In market risk management, overall risk has been
  transferred (interest rate risk, foreign exchange risk,
  securities risk, and etc.)
• Within Credit Risk management, only credit related risks
  can been transferred
 Hot topics in Credit Risk Analysis
• High dependency in company default is the hot topic in
  credit risk analysis. This is critical to the portfolio
  investment in company debts and credit derivative pricing.
• Default dependency is influenced by both micro and macro
  factors.
• Companies are running in similar macro economic
  environments. If the cause of default is caused by
  macroeconomic factors, e.g. interest rate, inflation rate,
  inflation rate and utility price, the dependency is called
  default correlation.
• If the company defaults because of its own management or
  production problems, e.g. goods supply and asset holdings,
  the dependency is called default contagion.
 Conclusions in Credit risk
 management

• Credit risk management is more related to insurance
  than to hedging risk.
• One should diversify the credit risk for portfolios, so to
  avoid concentration
• When the systematic factors (interest rate, foreign
  exchange rate) are identified, credit derivatives can be
  used to achieve the objectives of credit risk management.
Dr. Zhou previously held several senior positions at many named
organizations, such as Chief Economic Analyst at a foreign financial group
(Great China), Manager at investment consulting firm under domestic
securities company, head of investment consultation department in
Securities Company and Analyst in D&R department in head office of a
local bank.
Dr. Zhou has extensive board of knowledge, specializing in knowledge in
Macroeconomics Analysis, Investment Analysis, Corporate Financial
Planning, Operation in Capital Market, Risk Management and Insurance.
Dr. Zhou is working with East China Normal University as head of the
department of risk management and insurance in the Faculty of Finance
and Statistics.

                                     27
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posted:5/16/2012
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