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US Federal Reserve Chairman Mr. Alan Greenspan in April 2004 had made an interesting comment before the Senate Committee:
Only through steady and continued progress in measuring and understanding risk will our banking institutions remain vibrant, healthy and competitive in meeting the growing financial demands of the nation. Therefore, the regulatory authorities must provide the industry with proper incentives to invest in risk management systems that are necessary to compete successfully in an increasingly competitive and efficient global market.
Risk management is, first and foremost, a science. If you use accurate data, reliable financial models and the best analytical tools - you can minimize risk and make the odds work in your favour.
Basel II has made a real contribution by motivating an enormous amount of effort on the part of banks (and regulators) to build (evaluate) credit risk models that involve scoring techniques, default and loss estimates, and portfolio approaches to credit risk problem.
Credit risk is risk resulting from uncertainty in a counterpartys ability or willingness to meet its contractual obligations. Credit risk is the probability of losses associated with changes in the credit quality or borrowers or counterparties. These losses could arise due to outright default by counterparties or deterioration in credit quality.
If credit can be defined as nothing but the expectation of a sum of money within some limited time, then credit risk is the chance that expectation will not be met.
Estimation of the average (mean expected) losses due to credit is commonly used to:
1) set reserve requirements for doubtful accounts; 2) establish minimum pricing levels at which new credit exposures to an obligor may be undertaken; 3) price credit risky instruments such as corporate bonds or credit default swaps; and 4) calculate risk adjusted performance measures such as RAROC.
Exposure at Default (EAD): In the event of default, how large will be the outstanding obligations if the default takes place. EAD gives an estimate of the amount outstanding (drawn amount plus likely future drawdowns of yet undrawn lines) in case the borrower defaults. Probability of Default (PD): The probability that the obligator or counterparty will default on its contractual obligations to repay its debt. PD per rating grade is the average percentage of obligors that default in this rating grade in the course of one year. Loss Given Default (LGD): The percentage of exposure the bank might lose in case the borrower defaults. Usually it is taken as: 1-recovery rate Credit Migration: Short of a default, the extent to which the credit quality of the obligator or counterparty improves or deteriorates. Maturity: Time Horizon (Usually a time horizon of 1 year is considered).
Definition of Default/NPA
In the Indian parlance the defaulted loan is titled as Non Performing Asset (NPA). A loan is defined NPA on which
The gathering of data for credit risk is a challenging task. IT system should be built in such a way that data on different aspects of operation of a loan flows into a central database that can be used for credit risk analysis.
opinion on the inherent credit quality of a company and or the credit instrument.
A Two-Tier Rating System Obligor Rating-indicates the chance of the borrower as a legal entity defaulting
Facility
Rating-indicates the loss of principal and/or interest on that facility; specific to the advance cum collateral
Linear probability model: is based on linear regression, and uses a number of accounting variables to predict default probability. Logit model: assumes default probability is logistically distributed, and applies accounting variables as well as non-financial factors to predict default probability. Probit Model: is similar to logit model, except that the probit model arises from assuming that the probability distribution is normally distributed. Discriminant analysis model (e.g., Z-score): is based on finding a linear function of accounting and market based variables that best discriminates between firms that fail and those that do not.
Z
Example:
j 1
X ij error
Suppose there were two factors influencing the past default behavior of borrowers: the leverage or D/E and the sales/assets ratio (S/A). Based on past default (repayment) experience, the linear probability model is estimated as:
Both logit and probit models are very close and rarely lead to different qualitative conclusions, so that it is difficult to distinguish between them statistically.
MDA Analysis: Example Altmans Z Score Multiple Discriminant Altman, for the first time, applied
Analysis (MDA) in response to shortcomings of traditional
univariate financial ratio analysis. MDA models are developed in the following steps :
Establish a sample of two mutually exclusive groups: firms which
have failed and those which are still continuing to trade successfully Collect financial ratios for each of these companies belonging to both of these groups Identify financial ratios which best discriminate between groups (Ftest/ Wilks Lambda test). Establish a Z score based on these ratios.
> 2.99 - firm is in a good shape - warning signal trouble; firm could be heading towards
2.99>Zscore>1.81 1.81>Zscore-big
bankruptcy
Therefore,
the greater a firms distress potential, the lower its discriminant score
model One of the most frequently asked question is How did he determine the coefficients or weights? Altman answers: The weights are objectively determined by the computer algorithm and not by the analyst. As such they will be different if the sample changes or if new variables are utilized.
Relies on experts insights into the borrowers financial health. Encompass financial, industry, business & management risk Projections and Sensitivity analysis Specify cut-off standards
Separate rating frameworks for large/mid corporates, small borrowers, retail loans, NBFCs etc.
External
Internal
Industry Risk
Financial Risk
Business Risk
Management Risk
Facility Risk
Point: The threshold value of firms assets (somewhere between total liabilities & current liabilities) at which the firm defaults
Relevant Networth = Mkt. Value of Assets - Default Pt. Default: Relevant Networth = 0
from DD
5.00
4.00
Rs. Billion
3.00
DP MVA
2.00
1.00
Thank You