Credit Risk Management

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Credit Risk Management
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Integrated Risk Management in a Bank

• What is Integrated Risk Management?
• Measure, monitor and manage all the risks across
  the bank.
• Bank wide integrated risk management
  infrastructure in terms of people, policies and
  systems
• Common and consistent risk measurement and
  quantification methodologies across all risk
  categories
• Aggregation of risks and estimation of economic
  capital to assist in risk/ return decision making

Organisation Structure
Policies
Systems Processes
Integrated Risk Management
People
Culture
Methodologies
Compliance
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RIZICNI KAPITAL
ELocekivani gubitak (prosecna verovatnoca
defaulta x iznos kredita u default
(EAD) SDstandardna devijacija u vrednosti
(voaltilnost) Rizicni kapital (neocekivani
gubitak) iznos gubitka odredjen verovatnocom
default-a
Ucestalost
SD
EL
Rizicni kapital (neocekivani gubitak)
3bp
Obecana Ocekivana
Vrednost portfolija Vrednost vrednost
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Reducing Costs managing risk financing
Probability of loss
Loss value ()
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Perceived advantages of IRM

• Facilitates strategic value creation
• Key to regulatory compliance
• Mechanism for efficient allocation of economic
  capital
• Enables bank to maximise returns
• Lower capital costs
• Better decision making due to scenario analysis
• Risk adjusted pricing
• Loss reduction due to understanding of
  correlations
• Elimination of unwanted exposures

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Risk Implementation Important Facets
MIS
IT Infrastructure
Risk Communication and Control
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IRM Challenges identification of gaps in
existing risk management practices
Reviewing and improving existing
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IRM Challenges - measurement of risks

• Credit Risk
• Probability of Default
• Loss Given Default
• Exposure at Default
• Market Risk
• Trading Book (VaR)
• Interest Rate Risk on Banking Book
• Operational Risk (evolving)

Requires collection of data over time,
development of measurement models, back testing
of models
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IRM Challenges Risk Aggregation
Correlations among risk silos
OVERALL ECONOMIC CAPITAL
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IRM Challenges - modelling of correlations across
risk categories risk silos

• Modelling correlations requires data and is not
  easy
• Fat tails in credit risk create problems

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Evolutionary structure for credit risk
PD Probability of default, LGD Loss given
default, EAD Exposure at default, M Maturity
RISK DRIVERS
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Categorisation of exposures

• Under the IRB approach, banks must categorise
  banking-book exposures into broad classes of
  assets with different underlying risk
  characteristics, subject to the defitinitions set
  out below.
• The asset classes are corporate, sovereign,
  bank, retail and equity
• Within the corporate assets class 5 sub classes
  of specialised lending are separately identified.
• Within the retail asset class 3 sub classes are
  separetly identified

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Corporate exposures

• Project finance
• Object finance
• Commodities finance
• Income producing real estate
• High volatility commercial real estate

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Retail exposures

• Exposures to individuals (such as revolving
  credits and lines of credit as well as personal
  term loans and leases instalment loans, auto
  loans annd leases, student and educational loans,
  personal finance, and other exposures with
  similar characteristics)
• Residential mortgage loans (including first and
  subsequent lines, term loans and revolving home
  equity lines of credit)
• Loans extended to small business and managed as
  retail exposures less than 1 mill euro

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For more sophisticated banks

• THE CREDIT REVIEW ASSESSMENT OF CAPITAL ADEQUACY,
  AT A MINIMUM, SHOULD COVER FOUR AREAS
• Risk rating systems
• Portfolio analysis/aggregation
• Securitization/complex credit derivatives
• Large exposures and risk concentration

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External Rating Agency Equivalents
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There are two types of economic credit costs
which should be managed and accounted for
Economic credit costs
Expected credit costs
Unexpected credit costs
A cost of doing business covered by provisions
An undesirable event the major reason why
capital is needed
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A credit capital allocation process
Example business loans
Consumer portfolio diversification
Default histories by grade
Judgemental top down input
Factors by grade, size and tenor
Monte Carlo simulation model
LGD distributions (by size)
Group-wide loss distribution
Sub-portfolio results
Capital by loan, customer, business unit,
division group
Individual customer exposures
Portfolio data
More than 2000 factors are specified for one
banks loan graded portfolio
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Risk measurement is a primary building block of
credit risk management
Risk Migration
Concentration policy

• Loan reviews
• Exposure monitoring
• Portfolio reporting

Pricing, Loan valuation
Active portfolio management
Risk measurement
Commitment decision
Dynamic provisioning (reserving)
Capital allocation
Risk adjusted performance measurement
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RISK RATING PROCESSES
RISK RATING PROCESSES
ASSIGNEMENT OF RATINGS
USE OF RATINGS
Factors considering In rating
QUANTITATIVE LOSS CHARACTERISTICS -portfolio
monitoring -loan loss reserve analysis -loan/busin
ess line pricing and profitability
analysis -internal capital allocation and return
on capital analysis

• -Financial
• analysis
• -Industry
• analysis
• -Quality of
• financial data
• -Analytical tools
• -Firm size/value
• Management
• Terms of
• facility/LIED
• -Other

Ratings criteria
Written/formal elements Subjective/ informal elem
ents Raters own experience and judgement
Preliminary rating proposed for loan approval proc
ess
Approval process (per policy) assigns final
rating
GENERAL CREDIT QUALITY CHARACTERISTICS -assessing
attractiveness of customer relationship -evaluatio
n of rater effectiveness -administrative and
monitoring requirements -frequency of loan
review
RM and/or credit staff
RISK RATING
REVIEW PROCESSES
Line/credit review
Watch process
Loan review

• ongoing review by initial
• rater
• -periodic review of each
• customer relationship
• -aimed at reviewing
• profitability/desirability
• as well as condition
• -generally conducted by
• same authorities that
• approve loans

• -Quartely process focused
• on loans that exibit current
• or prospective problems
• Aimed at identifying best
• path to improve or exit credit
• at lowest cost
• -Conducted by same
• authorities to improve loans
• although others may
• participate as well (work
• out group)

• -Review of adequacy of
• underwriting and
• monitoring from random
• sample
• -sample weighted toward
• higer risk loans
• -loan review judgement is
• final say
• negative consequences
• for initial rater if
• consistent disagreements

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RELATIONSHIP MANAGER (REFERENT KLIJENTA) Radi
obradu kreditnog zahteva i utvrdjuje rejting
klijenta VEOMA JE VAAN PROCES UTVRDJIVANJA REJ
TINGA KLIJENTA
KREDITNA FUNKCIJA U BANCI
ODBOR ZA UPRAVLJANJE KREDITNIM RIZIKOM
KOMERCIJALNO BANKARSTVO
RISK MANAGEMENT
ODELJENJE ZA UPRAVLJANJE KREDITNIM RIZIKOM
MARKETING PROIZVODA KONTAKT SA KLIJENTOM KREDITNI
ARANMANI (REFERENT KLIJENTA)
RATING (CREDIT STAFF)
DODELJIVANJE REJTINGA (REFERENT
KLIJENTA) monitoring
mala srednja - velika
MONITORING MANAGEMENT (CREDIT STAFF)
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L1 Limit koji ima referent klijenta L2 Limit
koji ima filijala i njen KO po klijentu L3
Limit koji ima Kreditni odbor Centrale po
klijentu L4 Limit iznad kojeg odlucuje
Upravni Odbor Banke REC JE O KRATKOROCNOM KREDIT
IRANJU L1 i L2 SE ODNOSE NA MALA I
SREDNJA PREDUZECA L3 i L4 SE ODNOSE UGLAVNOM NA
VELIKA PREDUZECA VELIKA PREDUZECA SE VODE I
OBRADJUJU U CENTRALI BAN KE SVAKI KLIJENT
U FILIJALI MORA IMATI SVOG REFERENTA KOJI JE
ZADUEN ZA NJEGA I VODI NJEGOV DOSIJE
LIMITI
iznosi
30 mil
1 mil
150.000
L1
L2
L3
L4
limiti
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Banka obracun kamate dostavlja klijentu
najkasnije 5 dana od isteka roka za koji se vri
obracun Rok za placanje kamate je 7 dana od
dana obracuna
NAPLATA DOSPELIH POTRAIVANJA
Dospela obaveza
Dospela neizmirena obaveza
Prenos DNO na Ispravku vrednosti
Predmet prelazi u work out
Dani u mesecu
90
8 30
30/1
Referent klijenta aktivira instrument naplate pot
raivanja
Referent klijenta aktivira instrument obezbedjen
ja naplate
Referent klijenta i filijala nisu uspeli da
naplate potraivanje i ono prelazi u work out i
dobija klasifikaciju v
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Basel Accord assumptions
The existing function
Actual function how measurement should develop
PD
Idiosyncratic larger weights Macroeconomic
smaller weights
Optimum weights (this will require Advancement in
credit portfolio manag.
LGD
Consant linked to collateralization ratio or LGD
grades
EAD, collateral, collateral seniority and
macroeconomic factors
Maturity
Two steps Effective maturity (duration for
some exposures is assumed to be constant for its
impact on capital requirements). Capital
estimates are linked to PD
Duration, credit spread curve, Mark to market, VAR
correlation
PD
Macroeconomic factors, idiosyncratic factors
Credit loss
Ex ante loss
Ex post losses
Credit Mitigation
Exposure and PD to the extent there is not
maturity mismatch
Available mitigants reduce EAD and LGD (expected
and volatility)
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Reducing Costs managing risk financing
Probability of loss
Loss value ()
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Credit Risk Management
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• Increased reliance on objective risk assessment

• Credit process differentiated on the basis of
  risk, not size

• Investment in workflow automation / back-end
  processes

• Align Risk strategy Business Strategy

• Active Credit Portfolio Management

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• Credit Credit Risk Policies should be
  comprehensive

• Credit organisation - Independent set of people
  for Credit function Risk function / Credit
  function Client Relations

• Set Limits On Different Parameters

• Separate Internal Models for each borrower
  category and mapping of scales to a common scale

• Ability to Calculate a Probability of Default
  based on the Internal Score assigned

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It provides well structured ready to use
value statements to fairly capture and mirror
the Rating officers risk assessment under each
specific risk factor as part of the Internal
Rating Model
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Credit Rating System consists of all of the
methods, processes, controls and data collection
and IT systems that support the assessment of
credit risk, the assignment of internal risk
ratings and the quantification of default and
loss estimates.
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ONE DIMENSIONAL
Rating reflects Expected Loss
CRISILs modified TWO DIMENSIONAL approach
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CREDIT CAPITAL (Portfolio Credit Risk
Management Model)
The portfolio approach to credit risk management
integrates the key credit risk components of
assets on a portfolio basis, thus facilitating
better understanding of the portfolio credit
risk. The insight gained from this can be
extremely beneficial both for proactive credit
portfolio management and credit-related decision
making.
1. It is based on a rating (internal rating of
banks/ external ratings) based methodology.
Internal Credit Rating Framework with rating of
all instruments and facilities as the basis for
credit risk management. It is primarily based on
a credit rating framework and therefore can be
implemented with minimal modification to Banks
internal systems        2. Being based on a loss
distribution (CVaR) approach, it easily forms a
part of the Integrated risk management framework.
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Create frameworks for Loan Pricing using
Portfolio credit risk methodologies
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• Quantitative model to predict default risk
  dynamically
• Model is constructed by using the hybrid approach
  of combining Factor model Structural model
  (market based measure)
• The inputs used include Financial ratios,
  default statistics, Capital Structure Equity
  Prices.
• The present coverage include listed Crisil
  rated companies
• The product development work related to private
  firm model portfolio management model is in
  process
• The model is validated internally
• The most complicated product developed and with
  the help of in-house technology.

• Derivation of Asset value volatility
• Calculated from Equity Value , volatility for
  each company-year
• Solving for firm Asset Value Asset Volatility
  simultaneously from 2 eqns. relating it to equity
  value and volatility
• Calculate Distance to Default
• Calculate default point (Debt liabilities for
  given horizon value)
• Simulate the asset value and Volatility at
  horizon
• Calculate Default probability (EDF)
• Relating distance to default to actual default
  experience
• Use QRM Transition Matrix
• Calculate Default probability based on Financials
• Arrive at a combined measure of Default using
  both

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Credit Portfolio Risks
Different Hedging Techniques
Total Return Swap
Basket Credit Swap
Securitisation
Interest Rate Risk
Spread Risk
Credit Spread Swap
Default Risk
Credit Default Swap
. . . as we go along, the extensive use of credit
derivatives would become imminent
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• Credit culture refers to an implicit
  understanding among bank personnel that certain
  standards of underwriting and loan management
  must be maintained.

• Strong incentives for the individual most
  responsible for negotiating with the borrower to
  assess risk properly

• Sophisticated modelling and analysis introduce
  pressure for architecuture involving finer
  distinctions of risk

• Strong review process aim to identify and
  discipline among relationship managers