Credit Risk Management in Banks (PDF) by tmingw

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									Credit Risk Management
Systems in Banks

Amitabh Bhargava
Feb 10, 2000
Risk Vision: Why Manage Credit

l Increase shareholder value
   l value creation
   l value preservation
   l capital optimization
l Instill confidence in the market place
l Alleviate regulatory constraints and distortions
Definition of Economic Capital

                                     ECONOM C
                                    E C O N O M II C   REGULATORY
C A P II T A L                       C A P II T A L
                                      CAP TAL            CAPITAL

      Economic capital is the amount of capital
      that the firm has put at risk to cover potential
      l o s s e s * under extreme market conditions
                 * arising from all kinds of risk
Risk Appetite

     Operational     Other
     Risk            Risks


                             Credit Risk


           Economic Capital at Risk
 Risk Management Structure
Centralized risk management with integrated treasury

        Board               Set risk limits

 Risk Mgmt Committee        1. Identify, monitor, measure
                            2. Develop policies &
                            3. Verify pricing models
                            4. Review risk models
                            5. Identify new risks
                            6. Risk limits in terms of
    Risk Management Structure

                  Risk Mgmt Committee

Asset Liability                     Credit Policy
Management Committee                Committee

Market risk policies and          Loan policies and
procedures                        procedures
     Risks in Lending

Interest rate                                    Counterparty     Country
                Forex risk        Credit risk
     risk                                            risk           risk

                   Default risk               Portfolio risk

                             Intrinsic risk          Concentration risk
Risks in Lending

l Intrinsic Risks              l Concentration risks
   l Deficiencies in Loan         l State of economy
      policies and                l Volatility in
      procedures                      l Equity markets
   l Absence of prudential            l Commodity markets
      credit conc. Limits             l FX markets
   l Inadequately defined             l Interest rates
      lending limits              l Trade restrictions
   l Deficiency in appraisal
                                  l Economic sanctions
   l Excessive dependence         l Govt. Policies
      on collateral
   l Inadequate risk pricing
   l Absence of post
      sanction surveillance
Instruments of Credit Risk Management

l Credit approving authority
l Prudential limits
l Risk Rating
l Risk Pricing
l Portfolio management
l Loan review mechanism
Credit Risk Management : Stages of
l Transaction management pursues value creation
l Portfolio management pursues value
             Portfolio               VAR
            Management              Models

     Deal Pricing
         and                                  Models

                                                         Ratings and
    Risk                                                  Migration
   Rating                                                  Models

Risk rating

l Rating reflects underlying credit risk of loan book
l Encompass industry risk, business risk, financial
  risk, management risk
l Specify cutoff standards / critical parameters
l Separate rating framework for large corporates,
  small borrowers, traders etc
l Account for unhedged market risk exposures of
Global Development of Rating Agencies

                                                   Year      Market        Long-term Rating
Agency Name                                        Founded   Orientation   Symbols
Australian Ratings (S&P)                             1981        Local          AAA to C
Canadian Bond Rating Service (CBRS)                  1972        Local           A++ to D
Credit Rating Services of India Limited (CRISIL)     1988        Local          AAA to D
Japan Credit Rating Agency                           1985        Local           Aaa to D
Korean Investor Service                              1985        Local          AAA to D
International Bank Credit Analysis (UK)              1979       Banks             A to E
Duff & Phelps                                        1932        Local           1 to 17
Moody's Investor Service                             1900       Global           Aaa to C
Standard & Poor's                                    1941       Global          AAA to D
`The current risk weighing of assets results, at best,
in   a   crude   measure   of   economic    risk,   primarily
because degrees of credit risk exposure are not
sufficiently calibrated as to adequately differentiate
between borrowers’ differing default risk.’

                     BIS Committee on Banking Supervision
The existing framework

l Zero risk weightage for OECD Sovereign
  e x p o s u r e s , 1 0 0 % w e i g h t a g e f o r N o n- O E C D
  - Singapore (S&P               AAA)
  - Turkey (S&P            B)

l 20% risk weightage for OECD bank exposure,
  1 0 0 % w e i g h t a g e f o r N o n- O E C D b a n k s .

l 100% risk weightage for all loan exposures
  irrespective of credit quality, collateral value, or
  credit enhancement structures
T h e p r o p o s e d f r a m e w o r k : R i s k - weighting the 8% regulatory
capital charge using external ratings

                          AAA to       A+ to        BBB+to       BB+
                            A A-         A-         BBB-         to B-      Below B-      Unrated

       Sovereigns           0%         20%          50%        100%           150%        100%

                           20%         50%          100%       100%          150%         100%
       Option 2
                  2        20%        50%      3
                                                    50%    3
                                                               100% 3        150%         50%      3

       Corporates          20%        100%          100%       100%          150%         100%

       Risk weighting based on risk weighting of sovereign in which the bank is incorporated
       Risk weighting based on the assessment of the individual bank
       Claims on banks of a short original maturity, e.g., less than six months, would receive a
       weighting that is one category more favorable than the usual risk weight on the
       bank’s claim
Why risk based pricing ?

l C r e d i t m a r k e t s a n d m a r k e t- d e t e r m i n e d p r i c i n g o f
   credit assets is a relatively recent in India
l Steep learning curve for market participants
l M i s- p r i c i n g m a y r e s u l t i n
     l adverse selection
     l earnings volatility for the financial institution
     l threaten economic viability of the bank/FI
     l impact the credit rating of the bank/FI
Why risk based pricing?

l Pricing: a tool to determine
   l proactive provisioning (as opposed to
     regulatory provisioning)
   l optimal allocation of capital
l How to earn adequate return on capital?
l Risk based economic capital allocation
l Input for the credit portfolio model
l Building block for RAROC
l Aids strategic planning
 • Necessary for value creation and preservation
 • Aligns the incentives of the business executives
    with the riskiness of their business
Credit exposure determination

l Measure all credit exposures in the bank’s
  various books (loan book, investment book,
  trading books)
l For derivatives positions, model the potential
  peak exposure, and express it as a Loan
  Equivalent Exposure
l Aggregate the exposures

  Need good systems that allows data capture
  and update of exposures at frequent intervals
   Risk based pricing framework

                Credit Exposure

                 Risk based       Volatility of
Default Rates
                   pricing        Default rates

                Recovery rates
Credit Risk Loss Distribution

                                     As per the Risk
                                 Appetite determined by
                                    the Management

                                            99th percentile


                2%                                  11%
                         Percent Loss
RAROC based credit pricing

    Credit                   Risk based             Administration
                 =                          +
    Pricing                    Spread                  Costs

                                             Return on
    Expected Loss Charge
                                      Economic Capital Allocated

                1- R e c o v e r y                       Economic
 Default Rate                         Hurdle Rate
                    Rate                                  Capital
Expected Loss

   Credit                   Risk based             Administration
                =                          +
   Pricing                    Spread                  Costs

                                            Return on
   Expected Loss Charge
                                     Economic Capital Allocated

               1- R e c o v e r y                       Economic
Default Rate                         Hurdle Rate
                   Rate                                  Capital
Return on Unexpected Loss

   Credit                   Risk based             Administration
                =                          +
   Pricing                    Spread                  Costs

                                            Return on
   Expected Loss Charge
                                     Economic Capital Allocated

               1- R e c o v e r y                       Economic
Default Rate                         Hurdle Rate
                   Rate                                  Capital
Hurdle rate and unexpected loss

l Unexpected loss depends on the confidence limit
   a n d t h e r i s k a p p e t i t e s e t b y t h e m a n a g e m e n t --
   usually tied to the risk rating targeted by the
l S h a p e o f t h e l o s s d i s t r i b u t i o n -- n o t a n o r m a l
   d i s t r i b u t i o n , f a t -t a i l e d d i s t r i b u t i o n
l Hurdle rate depends on the targeted return on
   capital set by the management
Risk based pricing: Implementation

l Lack of data on default rates and recovery rates
  of various rating categories
l Lack of quick remedies under judicial system
  leads to absence of trading in defaulted debt
Motivating Portfolio Management
l Changing Economics of Traditional Products
    l L e s s d e m a n d d u e t o d i s -intermediation
    l More supply due to capital mobility
    l Lower returns and increased importance of risk

l   New business opportunities, different
  l Syndicated lending
  l Project / structured finance
  l Leveraged finance
l New opportunities to manage portfolio, e.g.
  l Securitization
  l Credit derivatives
  l Secondary loan trading
Strategic Questions

 In addition to transaction underwriting skills,
 management focus on two strategic questions

  l Given the new business opportunities, what is
    the optimum business mix needed to reach the
    organisation’s objectives

  l Given the relative increased importance of risk,
    what is the optimum portfolio composition
Improvement Potential

l O p t i m i s e b a l a n c e- s h e e t s t r u c t u r e
     l using actuarial methods based reserving policy
     l fully leveraging aggregate risk capital within
       regulatory constraints
l Optimize business mix by
     l measuring (risk adjusted) performance
     l allocating risk capital between business units
     l managing concentrations
l Improve tactical, risk-adjusted pricing of credit
Questions for Consideration

l What is the risk of a given portfolio?
   l What are its expected losses?
   l How much risk capital is needed?

l What is the impact of changing the portfolio mix?
   l What is the marginal and absolute risk contribution
     of a new position?
   l What diversification benefits comes from changing
     mix? Industry mix?

l What factors, if any, affect the portfolio’s risk
  Comparing the Portfolio Models*
                   CreditMetricsT M         Credit View T M      CreditRisk +

Risk Definition     Delta Mkt Value        Delta Mkt Value      Default Losses

 Risk Drivers        Asset Values           Macro Factors       Default Rates

 Volatility of
Credit Events          Constant                 Cyclical           Random

Correlation of    Multivariate Normal     Factor Loadings        Conditional
Credit Events        Asset Returns      Corr of Residual Risk   Independence

Recovery Rates          Random                 Random             Constant

  Numerical            Simulation            Simulation         Closed Form
  Approach         (One Period VAR)       (One Period VAR)        Solution

            * This summary adapted from Tony Saunders/NYU.
CreditMetrics T M M e t h o d o l o g y -- 3
 l What are the “states” of an issuer’s credit
   quality? What are the probabilities of migrating
   between these states?
       l Credit rating, transition matrices

 l What is the value of a credit instrument in all
   possible future states?
       l mark-t o- market
       l revaluation of bonds, loans, swaps, etc.

 l How do different issuers migrate together?
       l correlations
     Transition Matrix
                             N e x t Y e a r’ s   RatIng

T      %       AAA      AA           A        BBB       BB        B       CCC       Default
o     AAA      90.81   8.33        0.68       0.06     0.12      0.00      0.00      0.00
a      AA       0.70   90.65       7.79       0.64     0.06      0.14      0.02      0.00
y’     A        0.09   2.27       91.05       5.52     0.74      0.26      0.02      0.06
      BBB       0.02   0.33        5.95      86.93     5.30      1.17      0.12      0.18

R      BB       0.03   0.14        0.67       7.73    80.53      8.84      1.00      1.06
       B        0.00   0.11        0.24       0.43     6.48     83.46      4.07      5.20
i     CCC       0.22   0.00        0.22       1.30     2.38     11.24     64.86      19.79
     Default    0.00   0.00        0.00       0.00     0.00      0.00      0.00     100.00

                                    Adapted from CreditMetrics Technical Document

               A transition matrix tells us how likely is an
               issuer to change credit rating over a given
               time horizon based on historical ratings data
… allows us to treat a variety of product types
within the same framework

   Instrument type             Information requirement

   Bonds                       Credit spreads by rating
   Loans                       Credit spreads

   Receivables                 Credit spreads

   Letters of credit           Credit spreads

   Loan commitments            Credit spreads, comm. Fees,
                               expected drawdown in new
                               rating or default
   Market driven instruments   Credit spreads, exposures
   (swaps, forwards, etc.)     based on volatility of
                               underlying market rates
  Transition probabilities and
    …. completely describe the distribution of value for a
    single instrument
                                     End of Period
                                     Ratings Values*   Future Value
                                                        Depends on:
                                      A A A 106.10
                                                       l Ratings
                                       A A 106.10      l Market conditions
                                                       l Loan price &
                                         A   106.10
                                                        - revolver vs. term
 Current                                                - spread & fees
 Value                                B B B 106.07      - tenor
 100.00                                                 - amortization
                                                        - collateral
                                        B B 105.80
                                                        - options
                                                         - prepayment
                                         B   105.10      - term - o u t
                                                         - re- price/grids
                                      CCC    98.00

*including current interest & fees
                                         D   70.00
    Correlation-- H o w d o i s s u e r s m i g r a t e
           Assuming a connection between firm asset
           value and firm credit rating …...

   Downgrade to B                          Upgrade to BBB    Downgrade to BBB                             Upgrade to AA
                           remains                                                         Firm
                           BB                                                              remains

Firm defaults                                               Firm defaults

           Def   CCC   B             BBB   A   AA   AAA                Def   CCC B   BBB             AA    AAA

         Asset return over one year Firm 1                           Asset return over one year Firm 2

            … correlation of asset values give us
            correlation of credit quality changes.
      Correlation (cont’d)
            Correlations are built by mapping counterparties
            to common country and industry indices

                       70         US          30

                       15         UK          10

                               Germany         60

  GE                                                           Siemens

                       20        Finance                              10
                        05     Technology      10

                                  Auto                           Specific
                        50                                       Firm Risk
Firm Risk
                             Cons. Products     40
Thank You

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