P2.T6. Credit Risk Measurement & Management Bionic Turtle FRM Practice Questions Michael Crouhy, Dan Galai and Robert Mark, The Essentials of Risk Management, 2nd Edition By David Harper, CFA FRM CIPM www.bionicturtle.com
CROUHY, CHAPTER 9: CREDIT SCORING AND RETAIL CREDIT RISK MANAGEMENT... 3 P2.T6.603. RETAIL BANKING CREDIT RISKS... 3 2
Crouhy, Chapter 9: Credit Scoring and Retail Credit Risk Management P2.T6.603. Retail banking credit risks P2.T6.604. Retail credit scoring models P2.T6.605. Risk-based pricing in financial services P2.T6.603. Retail banking credit risks Learning Objectives: Analyze the credit risks and other risks generated by retail banking. Explain the differences between retail credit risk and corporate credit risk. Discuss the dark side of retail credit risk and the measures that attempt to address the problem. 603.1. Retail exposures include the following: credit cards, installment loans (e.g., personal finance, educational loans, auto loans, leasing), revolving credits (e.g., overdrafts, home equity lines of credit), and residential mortgages. Each of the following tends to be a stronger feature of retail credit risk rather than corporate credit risk EXCEPT which is more typical of corporate credit risk? a) Portfolio tends to behave like a well-diversified portfolio is normal markets b) Default by a single customer is never expensive enough to threaten a bank c) A rise in defaults is often signaled in advance by a change in customer behavior d) Portfolio risk is dominated by risk that credit losses will rise to unexpected level due to concentrations of exposures 3
603.2. Crouhy writes "The dark side of retail risk management has FOUR prime causes: 1. Not all innovative retail credit products can be associated with enough historical loss data to make their risk assessments reliable. 2. Even well-understood retail credit products might begin to behave in an unexpected fashion under the influence of a sharp change in the economic environment, particularly if risk factors all get worse at the same time (the so-called perfect storm scenario). For example, in the mortgage industry, one ever-present worry is that a deep recession combined with higher interest rates might lead to a rise in mortgage defaults at the same time that house prices, and therefore collateral values, fall very sharply. 3. The tendency of consumers to default (or not) is a product of a complex social and legal system that continually changes. For example, the social and legal acceptability of personal bankruptcy, especially in the United States, is one factor that seemed to influence a rising trend in personal default during the 1990s. 4. Any operational issue that affects the credit assessment of customers can have a systematic effect on the whole consumer portfolio. Because consumer credit is run as a semiautomated decision-making process rather than as a series of tailored decisions, it s vital that the credit process be designed and operated correctly." Which measure(s) attempt to address the problem of the dark side of retail risk management? a) Banks should attempt to assign a risk number to these types of wild-card risks b) Banks should avoid these new types of risks such that they are excluded from the retail portfolio c) Banks should use stress tests to gauge how devastating each plausible worst-case scenario might be. d) Banks should allocate (or originate) less than 15.0% of their total mortgage loan portfolio to "qualified mortgages" which are deemed riskier according to quantitative and qualitative criteria; ie, qualified mortgages by definition do not demonstrate "ability to repay" 4
603.3. The principal risk for a retail credit business is credit risk, but retail banking is subject to a host of other risks. In addition to reputation risk, Crouhy et all list the following four non-credit risks which are faced by retail banking: interest-rate risk, asset valuation risks, operational risks, and business risks. These are described below, but without explicit identification: I. This risk is generated on both the asset and liability side of the balance sheet. This risk is generally transferred from the retail business line to the treasury of a retail bank, where it is managed as part of the bank s asset/liability and liquidity risk management II. III. IV. These risks in retail banking are generally managed as part of the business in which they arise. For example, fraud by customers is closely monitored and new processes, such as fraud detection mechanisms, are put in place when they are economically justified. These risks are one of the primary concerns of senior management. These risks include business volume risks (e.g., the rise and fall of mortgage business volumes when interest rates go up and down), strategic risks (such as the growth of Internet banking or new payments systems), and decisions about mergers and acquisitions. This class of risk is a special form of market risk and it impacts the profitability of a retail business line. It includes prepayment risk in mortgage banking, which describes the portfolio's exposure to a drop in interest rates. The hedging of retail assets that are subject to prepayment risk is complex because it relies on assumptions about customer behavior that are hard to validate. Another example is the estimation of the residual value of automobiles in auto leasing business lines. Where this kind of risk is explicitly recognized, it tends to be managed centrally by the treasury unit of the retail bank. Which of the following CORRECTLY matches the risk to its description? a) I. Asset valuation risks, II. Business risks, III. Interest-rate risk, IV. Operational risks b) I. Asset valuation risks, II. Interest-rate risk, III. Operational risks, IV. Business risks c) I. Interest-rate risk, II. Asset valuation risks, III. Operational risks, IV. Business risks d) I. Interest-rate risk, II. Operational risks, III. Business risks, IV. Asset valuation risks 5
Answers: 603.1. D. This tends to be a feature of CORPORATE credit risk: portfolio risk is dominated by risk that credit losses will rise to unexpected level due to concentrations of exposures Crouhy: "The Nature of Retail Credit Risk: The credit risks generated by retail banking are significant, but they are traditionally regarded as having a different dynamic from the credit risk of commercial and investment banking businesses. The defining feature of retail credit exposures is that they arrive in bite-sized pieces, so that default by a single customer is never expensive enough to threaten a bank. Corporate and commercial credit portfolios, by contrast, often contain large exposures to single names and also concentrations of exposures to corporations that are economically intertwined in particular geographical areas or industry sectors. The tendency for retail credit portfolios to behave like well-diversified portfolios in normal markets makes it easier to estimate the percentage of the portfolio the bank expects to default in the future and the losses that this might cause. This expected loss number can then be treated much like other costs of doing business, such as the cost of maintaining branches or processing checks. The relative predictability of retail credit losses means that the expected loss rate can be built into the price charged to the customer. By contrast, the risk of loss from many commercial credit portfolios is dominated by the risk that credit losses will rise to some unexpected level. Of course, this distinction between retail and corporate lending can be overstated, and sometimes diversification can prove to be a fickle friend. The 2007 2009 financial crisis demonstrated that, at the end of a long credit boom, housing prices could fall at about the same time right across even a large economy such as the United States...." In regard to (A), (B) and (C), each is a tendency of retail credit risk. 6
603.2. C. TRUE: Banks should use stress tests to gauge how devastating each plausible worst-case scenario might be. Crouhy: "Almost by definition, it s difficult to put a risk number to these kinds of wild-card risk [i.e., the dark side to retail risk]. Instead, banks have to try to make sure that only a limited number of their retail credit portfolios are especially vulnerable to new kinds of risk, such as subprime lending. A little exposure to uncertainty might open up a lucrative business line and allow the bank to gather enough information to measure the risk better in the future; a lot makes the bank a hostage to fortune. Where large conventional portfolios such as mortgage portfolios are vulnerable to sharp changes in multiple risk factors, banks must use stress tests to gauge how devastating each plausible worst-case scenario might be." In regard to false (D), Qualified mortgages features include: No excess upfront points and fees No toxic loan features; e.g., negative amortization loans, terms > 30 years, interest-only loans for a specified period of time Cap on how much income can go toward debt; e.g., debt to income (DTI) < 43% No loans with balloon payments Ability to repay calls for a lender to consider eight underwriting standards: Current employer status Current income or assets Credit history Monthly payment for mortgage Monthly payments on any other loans associated with the property Monthly payments on any mortgage-related obligations (such as property taxes) Other debt obligations The monthly DTI ratio (or residual income) the borrower would be taking on with the mortgage 7
603.3. D. I. Interest-rate risk, II. Operational risks, III. Business risks, IV. Asset valuation risks Crouhy: "In the main text, we focus on credit risk as the principal risk of retail credit businesses. But just as in commercial banking, retail banking is subject to a whole range of market, operational, business, and reputation risks. Interest-rate risk is generated on both the asset and liability side whenever the bank offers specific rates to both borrowers and depositors. This risk is generally transferred from the retail business line to the treasury of a retail bank, where it is managed as part of the bank s asset/ liability and liquidity risk management (see Chapter 8). Asset valuation risks are really a special form of market risk, where the profitability of a retail business line depends on the accurate valuation of a particular asset, liability, or class of collateral. Perhaps the most important is prepayment risk in mortgage banking, which describes the risk that a portfolio of mortgages might lose its value when interest rates fall because consumers who are intent on remortgaging pay down their existing mortgage unexpectedly quickly, removing its value. The valuation and the hedging of retail assets that are subject to prepayment risk is complex because it relies on assumptions about customer behavior that are hard to validate. Another example of a valuation risk is the estimation of the residual value of automobiles in auto leasing business lines. Where this kind of risk is explicitly recognized, it tends to be managed centrally by the treasury unit of the retail bank. Operational risks in retail banking are generally managed as part of the business in which they arise. For example, fraud by customers is closely monitored and new processes, such as fraud detection mechanisms, are put in place when they are economically justified. Under Basel II and III, banks allocate regulatory capital against operational risk in both retail and wholesale banking. A sub-discipline of retail operational risk management is emerging that makes use of many of the same concepts as bank operational risk at a firm-wide level (see Chapter 14). Business risks are one of the primary concerns of senior management. These include business volume risks (e.g., the rise and fall of mortgage business volumes when interest rates go up and down), strategic risks (such as the growth of Internet banking or new payments systems), and decisions about mergers and acquisitions. Reputation risks are particularly important in retail banking. The bank has to preserve a reputation for delivering on its promises to customers. But it also has to preserve its reputation with regulators, who can remove its business franchise if it is seen to act unfairly or unlawfully. " Discuss in forum here: https://www.bionicturtle.com/forum/threads/p2-t6-603-retail-bankingcredit-risks-crouhy.9239/ 8