Risk ManagementUniversity of Economics, Kraków, 2012

Tomasz Aleksandrowicz

credit risk management

credit risk definitioncredit bureau and rating agencies

credit risk management

credit risk

Rating

• evaluation or assessment of something• quality rating• quantity rating• combined rating

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credit rating

• estimation of credit worthiness• ability of debt repayment by potential borrower• credit rating assigned to:– private individual– security (e.g. bond, derivative)– security issuer (e.g. corporation, government,

municipalities, SPV, NGO)• provided by credit bureau / rating agency

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personal rating

credit bureau

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credit bureau

• credit bureau / consumer credit reporting agency (UK)• target private individuals• evaluation made on overall credit history and current assets

and liabilities• data collected from credit institutions (banks, credit unions,

corporations)• users of rating pays for rating

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criteria for private credit score

• debt• usage of credit lines (i.e. credit cards)• ability to pay a loan• saving patterns• spending patterns• interest• other (equality issues)

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FICO credit score formula

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corporate and sovereign rating

Rating agency

• assigns credit ratings for issuers of certain types of debt obligations

• target non-individuals: enterprises, organisations and governments

• evaluation made on company data (annual/quarterly reports)• analysis of company statement using financial analysis tools

and methods• short term and long term debt rating• debt issuer pays for rating

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rating agencies

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Long-term credit ratings (I)(S&P)investment grade• AAA: the best quality borrowers, reliable and stable (many of

them governments)• AA: quality borrowers, a bit higher risk than AAA. Includes:

– AA+: equivalent to Moody's and Fitch Aa1– AA: equivalent to Aa2– AA-: equivalent to Aa3

• A: economic situation can affect finance – A+: equivalent to A1– A: equivalent to A2

• BBB: medium class borrowers, which are satisfactory at the moment

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Long-term credit ratings (II)(S&P)non-investment grade• BB: more prone to changes in the economy• B: financial situation varies noticeably

• CCC: currently vulnerable and dependent on favorable economic conditions to meet its commitments

• CC: highly vulnerable, very speculative bonds• C: highly vulnerable, perhaps in bankruptcy or in arrears but

still continuing to pay out on obligations• CI: past due on interest

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Long-term credit ratings (III)(S&P)non-investment grade

• R: under regulatory supervision due to its financial situation• SD: has selectively defaulted on some obligations• D: has defaulted on obligations and S&P believes that it will

generally default on most or all obligations• NR: not rated

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Short term credit ratings (I)(S&P)

• A-1: obligor's capacity to meet its financial commitment on the obligation is strong

• A-2: is susceptible to adverse economic conditions however the obligor's capacity to meet its financial commitment on the obligation is satisfactory

• A-3: adverse economic conditions are likely to weaken the obligor's capacity to meet its financial commitment on the obligation

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Short term credit ratings (II)(S&P)

• B: has significant speculative characteristics. The obligor currently has the capacity to meet its financial obligation but faces major ongoing uncertainties that could impact its financial commitment on the obligation

• C: currently vulnerable to nonpayment and is dependent upon favorable business, financial and economic conditions for the obligor to meet its financial commitment on the obligation

• D: is in payment default. Obligation not made on due date and grace period may not have expired. The rating is also used upon the filing of a bankruptcy petition.

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Rating classes comparation

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rating agencies criticism

• not downgraded companies promptly enough• too familiar a relationship with rated company management• errors of judgment in rating structured products• oligopoly allegations

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credit risk management

standardized (default) approach

• risk depends on exposure type• banks are using ratings from external Credit Rating Agencies• ratings used for quantification of required capital for credit

risk• in many countries it is the only method used by regulators

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standardized approach - risk weights

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Key elements of IRB methods

• EC (economic capital) = EL (expected loss) + UL (unexpected loss)

• PD (probability of default)• EAD (exposure-at-default)• LGD (and other parameters)

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expected and unexpected loss (I)

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expected and unexpected loss (II)

• EL (expected loss) = PD x EAD x LGD • When default occurs, the actual loss is the combination of

– exposure at default– loss given default

• UL (expected loss) – complex calculations

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PD

• default –an event when counterparty is stopped its debt payment

• usually after 90 days• state for the counterparty—is in default or not• depends on counterparty characteristics• could be simplistic or modular• could be based on banks’s own data or data bought from

outside vendor

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EAD

• credit exposure• economic value of the claim on the counterparty at the time

of default• depends on type of exposure (i.e. credit, derivative)

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LGD

• represents the fractional loss due to default• LGD = 1 – recovery rate• strictly empirical issue• recovery rate depends mainly on:

– exposure characteristics– seniority/status of the debt– economy cycle

• importance of collateral / collateral seniority

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foundation internal ratings-based approach (F-IRB)• banks are using internal rating system• rating system is self-developed (based on bank’s data)• bank’s own model to calculate PD (probability of default)• regulators calculated LGD (and other parameters)• risk-weighted assets (RWA) is calculated• regulatory capital is fixed percentage of risk-weighted assets

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advanced internal ratings-based approach (A-IRB)• banks are using internal rating system• rating system is self-developed (based on bank’s data)• bank’s own model to calculate

– PD (probability of default)– EAD (exposure-at-deafult)– LGD (loss-given-default)

• risk-weighted assets (RWA) is calculated• regulatory capital is fixed percentage of risk-weighted assets

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credit risk models

• no universal solution• best known models

– CreditMetrics (JP Mogran)– CreditRisk+ (Credit Suisse)– KMV (Moody’s KMV)– CreditPf.View (McKinsey)

• many banks has its own models/variations

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