Credit Risk

Management
Objective

At the end of the session, you will be able to :

Interpret the credit risk
Measuring credit risk
Interpret settlement risk
Various aspects of expected return on loans
Interpret models to estimate default probabilities

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Credit risk

Credit risk is the risk of an economic loss from the failure

of counterparty to fulfill its contractual obligation
It involves the probability of non payment, either on a
future obligation or during a transaction

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Counterparty credit risk

Pre settlement risk

It is the risk of loss due to the counterpartys failure to
perform on an obligation during the life of settlement
Settlement risk
It is due to the exchange of cash flows and is of a much
shorter-term nature

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Credit risk Vs Market risk
Area Market risk Credit risk

Sources of risk Market risk only Default risk ,

recovery risk and
market risk

Distribution Mainly symmetric Skewed to the left

Time horizon Short term Long term

Aggression Business /trading Whole firm Vs

unit counterparty

Legal Issues Not applicable Very important

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Return on Credit

The return on a loan for a financial Institution is a

function of
Interest rate on the loan
Loan related fees
Credit risk premium on the loan
Any collateral Backing the loan
Others

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Drivers of credit risk

Credit risk measurement systems attempt to quantify the

risk of losses due to counter party default
The distribution of credit risk can be viewed as a
compound process driven by following variables
Probability of default
Credit exposure
Loss given default

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Estimation of credit loss

Probability of default
There are 2 types
Qualitative
Quantitative

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Qualitative Models

The amount of information acquire to asses the default

probabilities is directly related to the size of the loan
and the cost of data collection
The following factors affect the quality of the loan
Borrower Specific
Market Specific

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Factors

Borrower Specific factors

Collateral
Leverage
Volatility of earnings
Reputation
Market specific factors
Business cycle
Level of interest rate

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Quantitative model

Quantitative Credit scoring model

Computing credit risk
With the help of yield curve
Cumulative default probability for a multiyear instrument
Mortality Rate approach
RAROC approach

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Credit scoring model

Factors to be consider
Consumer debt
Income
Assets
Age
Occupation
location
Corporate Debt
Financial ratios

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Credit scoring model

Linear probability model

It uses linear regression with financial ratios to explain the
pattern of repayment
For example, there are two observed characteristics of the
borrower
Fixed cost percentage
Leverage
Than, the probability of default for borrower is represented
by following equation
Z = 0.45Fc +0.2(D/A)
Limitation
It can yield probabilities greater than one
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Credit scoring model

Logit model
Altmans model
Variables are actually ratios
22 variables were originally studied
5 Categories
Liquidity
Profitability
Leverage
Solvency
Activity

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Criteria

Zones of Discrimination:
Z>2.99 Safe Zone
1.8<Z<2.99 Grey Zone
Z<1.80 Distress Zone
Likely to go bankrupt in the next 2 years
Score below 1.80 means a company is in financial
distress, and likely to declare bankruptcy

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Accuracy

Altman reports that his model identified 95% of total first

sample correctly
From statements one year before their bankruptcy
When it becomes 2 years, it is 72% accurate
To test accuracy further, he used a second sample
In this sample, the model was 96% correct

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 Example : Kraft foods

Metric Value
Current Assets 12,454,000,000
Current Liabilities 11,491,000,000
Total Assets 66,714,000,000
Retained Earnings 14,636,000,000
EBIT 5,524,000,000
Market Cap 52,960,000,000
BV Debt (Long term debt) 18,024,000,000
Sales (Revenue) 40,386,000,000

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Solution

Coefficient Variable (Ratio)

(Current Assets-Current
1.2 Liabilities)/Total Assets
1.4Retained Earnings/Total Assets

3.3EBIT/Total Assets
0.6Market Cap/BV Debt
0.999Sales/Total Assets
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Case study

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The PE ratio of the firm is 10 times 24
 Limitation
Two state world
Stability of factor weightings
No quantifiable variables
Data

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Yield curve

Generally a financial institution requires at least the

same return as the return on risk free asset (t Bills )
The relationship used to determine the probability of
default on one year corporate debt is
P(1+k) =1+i
Where, k =return on corporate debt
I =return on government security

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Example

Calculate the implied probability of default if the one

year T bill rate is 9.0% and the rate on one year
corporate bonds is 15.5%

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Mortality Rate approach

The mortality rate for a bond or loan is based on historic

default behavior
MMR =
total value of grade AAA bonds in year t of issue
Total value of grade AAA bonds outstanding in year t of issue ,
adjusted for defaults, calls, sinking fund redemptions and prior
year maturities

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RAROC Approach

Risk Adjusted return on capital

RAROC = 1 year income on a loan
Loan asset risk or risk capital

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Computation of credit loss

Credit loss (Expected loss)

Credit exposure * (1-recovery rate) * probability of default
Example
A bank has granted unsecured loan to a company. This loan will
be paid off by a single payment of Rs. 50 million. The company
has a 3% chance of defaulting over the life of the transaction. A
bank indicates that if the company will default than 70% would
be recovered. if the bank is required to hold a reserve equal to
your expected credit loss, how much the bank should hold ?
0.45 million

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Example

An investor holds a portfolio of Rs. 100 million. This

portfolio consists of A rated bonds (Rs.40 million) and
BBB rated bond (Rs. 60 million) . Assume that the
probability of default for A rated bond and BBB rated
bond is 3% and 5% respectively. If the recovery value for
A rate d bond and for BBB rated bond is 70% and 45%
respectively, what is the one year expected credit loss
from this portfolio ?

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Recap

At the end of the session you learned to:

Interpret the credit risk
Interpret settlement risk
Overview of credit risk
Describe characteristics of individual loan types
Specify the factors that affect expected return on loans
Interpret models to estimate default probabilities
Measuring credit risk

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Questions

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Thank you

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