P2.T6. Credit Risk Measurement & Management Jonathan Golin and Philippe Delhaise, The Bank Credit Analysis Handbook Bionic Turtle FRM Study Notes By David Harper, CFA FRM CIPM www.bionicturtle.com
Golin, Chapter 1: The Credit Decision DEFINE CREDIT RISK AND EXPLAIN HOW IT ARISES USING EXAMPLES.... 3 EXPLAIN THE COMPONENTS OF CREDIT RISK EVALUATION.... 4 2
Golin, Chapter 1: The Credit Decision Define credit risk and explain how it arises using examples. Explain the components of credit risk evaluation. Describe, compare and contrast various credit risk mitigants and their role in credit analysis. Compare and contrast quantitative and qualitative techniques of credit risk evaluation. Compare the credit analysis of consumers, corporations, financial institutions, and sovereigns. Describe quantitative measurements and factors of credit risk, including probability of default, loss given default, exposure at default, expected loss, and time horizon, Compare bank failure and a bank insolvency. Define credit risk and explain how it arises using examples. For purposes of practical analysis, credit risk may be defined as the risk of monetary loss arising from any of the following four circumstances: 1. The default of a counterparty on a fundamental financial obligation. 2. An increased probability of default on a fundamental financial obligation. 3. A higher than expected loss severity arising from either a lower than expected recovery or higher than expected exposure at the time of default. 4. The default of a counterparty with respect to the payment of funds for goods or services that have already been advanced (settlement risk). The variables most directly affecting relative credit risk include: 1. The capacity and willingness of the obligor (borrower, counterparty, issuer, etc.) to meet its obligations 2. The external environment (operating conditions, country risk, business climate, etc.) insofar as it affects the probability of default, loss severity, or exposure at default 3. The characteristics of the relevant credit instrument (product, facility, issue, debt security, loan, etc.) 4. The quality and sufficiency of any credit risk mitigants (collateral, guarantees, credit enhancements, etc.) utilized Credit risk is also influenced by The length of time over which exposure exists. At the portfolio level, o Correlations among particular assets and o Level of concentration of particular assets. 3
Explain the components of credit risk evaluation. As a practice, credit risk evaluation is a process of asking questions about four variables: Obligor s Capacity and Willingness to Repay External environment Attributes of Obligation (Characteristics of the relevant credit instrument) Quality of any credit risk mitigants The Obligor s Capacity and Willingness to Repay (suggestive inquiry) What is the capacity of the obligor to service its financial obligations? How likely will it be to fulfill that obligation through maturity? What is the type of obligor and usual credit risk characteristics associated with its business niche? What is the impact of the obligor s corporate structure, critical ownership, or other relationships and policy obligations upon its credit profile? Willingness to pay is difficult to assess. Ultimately, judgments about this attribute, and the criteria on which they are based, are highly subjective in nature. Willingness to Repay: Character and Reputation First-hand awareness of a prospective borrower s character affords a stepping-stone on which to base a credit decision. Where direct familiarity is lacking, a sense of the borrower s reputation provides alternative footing upon which to ascertain the obligor s disposition to make good on a promise. Reliance on reputation can be perilous, however, since a dependence upon second-hand information can easily descend into so-called name lending. Name lending can be defined as the practice of lending to customers based on their perceived status within the business community instead of on the basis of facts and sound conclusions derived from a rigorous analysis of the prospective borrowers actual capacity to service additional debt. Willingness to Repay: Credit Record Assessing a borrower s integrity and commitment to perform an obligation requires making unverifiable, even intuitive, judgments. Rather than put a foot wrong into a miasma of imponderables, creditors have long taken a degree of comfort not only in collateral and guarantees, but also in a borrower s verifiable history of meeting its obligations. As compared with the prospective borrower who remains an unknown quantity, a track record of borrowing funds and repaying them suggests that the same pattern of repayment will continue in the future. If available, a borrower s payment record, provided for example through a credit bureau, can be an invaluable resource for a creditor. Of course, while the past provides some reassurance of future willingness to pay, here as elsewhere, it cannot be extrapolated into the future with certainty in any individual case. 4
The External Conditions (suggesting inquiry) How do country risk (sovereign risk) and operations conditions, including systematic risk, impinge upon the credit risk to which the obligee is exposed? What cyclical or secular changes are likely to affect the level of that risk? The obligation (product): What are its credit characteristics? The Attributes of Obligation from Which Credit Risk Arises (suggestive inquiry) What are the inherent risk characteristics of that obligation? Aside from general legal risk in the relevant jurisdiction, is the obligation subject to any legal risk specific to that product? What is the tenor (maturity) of the product? Is the obligation secured; i.e., are credit risk mitigants embedded in the product? What priority (e.g., senior, subordinated, unsecured) is assigned to the creditor (obligee)? How do specific covenants and terms benefit each party thereby increasing or decreasing the credit risk to which the obligee is exposed? For example, are there any call provisions allowing the obligor to repay the obligation early; does the obligee have any right to convert the obligation to another form of security? What is the currency in which the obligation is denominated? Is there any associated contingent/derivative risk to which either party is subject? The Credit Risk Mitigants Are any credit risk mitigants such as collateral utilized in the existing obligation or contemplated transaction? If so, how do they impact credit risk? If there is a secondary obligor, what is its credit risk? Has an evaluation of the strength of the credit risk mitigation been undertaken? 5