One of the major risks that banks must measure, monitor and
manage is credit or default risk. Credit risk is
'the potential a bank borrower or counterparty will fail to meet
its obligations in accordance with agreed terms.
Individual loan credit risk
- When lenders offer mortgages, credit cards, or other types of
loans, there is a risk that the borrower may not repay the loan.
Similarly, if a company offers credit to a customer, there is a
risk that the customer may not pay their invoices. Credit risk also
describes the risk that a bond issuer may fail to make payment when
requested or that an insurance company will be unable to pay a
claim.
- Credit risks are calculated based on the borrower's overall
ability to repay a loan according to its original terms. To assess
credit risk on an individual consumer loan, lenders look at the
five Cs: credit history, capacity to repay, capital, the loan's
conditions, and associated collateral.
- All the financial institutions including companies have
established departments solely responsible for assessing the credit
risks of their current and potential customers. Significant
resources and sophisticated programs are used to analyze and manage
risk.
- The lender may also use the third party provided intelligence.
Companies like Standard & Poor's, Moody's, Fitch Ratings, Rapid
Ratings International etc. provide such information for a fee.
- Individual (Consumer) Loans are of following types :-
• Consumer loans: personal, home, auto, credit card
– Non-revolving loans :- Automobile, mobile home, personal
loans
– Revolving loans :- Credit card debt (i.e., Visa,
MasterCard)
Proprietary cards, such as Sears and AT&T
- Other loans include:
– Farm loans
– Other banks
– Nonbank FIs, such as broker margin loans
– Foreign banks and sovereign governments
– State and local governments
- Availability, quality, and cost of information are critical
factors in credit risk assessment of individual loans.
- Qualitative models consider borrower specific factors as well
as market, or systematic, factors. Borrower-specific factors
include reputation, leverage, volatility of earnings, and
collateral of the individual borrower. Market specific factors
include business cycle and interest rate levels of the borrowing
firm.
- Credit scoring models/ linear probability models are
quantitative models that use borrower characteristics to gauge an
applicant’s probability of default.
There are also other credit risk measuremnet modesl i.e. Logit
models – It overcomes weakness of the linear probability model by
restricting the estimated range of default probabilities from the
linear regression model to lie between 0 and 1. Quality of credit
scoring models have improved over time, providing positive impact
on controlling write-offs and default.
- Another credit risk measuring model is Mortality Rate Models.
In this model, similar to the process employed by insurance
companies to price policies; the probability of default (or
mortality rate) is estimated from past data on defaults. Marginal
Mortality Rates:-
MMR1 = (Value Grade B default in the year 1) / (Value
Grade B outstanding year 1)
MMR2 = (Value Grade B default in year 2) / (Value Grade B
outstanding year 2)
- One of the widely used credir risk measurement model is
Risk-adjusted return on capital (RAROC). Loan risk is estimated
from loan default rates, or using duration.For denominator of
RAROC, duration approach is used to estimate loss in value of the
loan.
Credit risk differs from banking portfolio and trading
portfolio. Some of the financial products where credit defaults can
take place are loans given to the retail customers, small or medium
(SME) businesses or large borrowers. In the banking portfolio risk
of default of a small number of important customers can generate
higher losses which may potentially lead to insolvency of a
financial institution. Such defaults can be of different types such
as, a) default in payment obligation, b) restructuring of loan due
to major deterioration of the credit standing of the borrower, or
c) bankruptcies of the borrowing fiems.
For the majority of banks loans given to individuals or corporate
firms are the most obvious source of credit risk; however banks may
face credit risk in trading portfolio i.e. in security market,
foreign exchange transactions, financial futures, swaps, etc.
Unlike the loans in banking book, the credit risk of traded debts
is indicated by the agencies' ratings, assessing the quality of
public debt issues or through changes in the value of stock
market.
Lenders mitigate Individual loan credit risk in a number of
ways, including:
- Risk-based pricing – Lenders may charge a
higher interest rate to borrowers who are more likely to default, a
practice called risk-based pricing.
- Covenants – Lenders may write stipulations on
the borrower, called covenants, into loan
agreements, such as:- Periodically report its financial
condition,
Refrain from paying dividends, repurchasing shares, borrowing
further, or other specific, voluntary actions that negatively
affect the company's financial position, and
Repay the loan in full, at the lender's request, in certain events
such as changes in the borrower's debt-to-equity ratio or interest
coverage ratio.
- Credit insurance and credit
derivatives – Lenders may hedge their credit risk by
purchasing credit insurance or credit
derivatives. The most common credit derivative is the
credit default swap.
Loan Portfolio Credit Risk
- Loan portfolios are the major asset of banks, thrifts, and
other lending institutions. The value of a loan portfolio depends
not only on the interest rates earned on the loans, but also on the
quality or likelihood that interest and principal will be paid. A
portfolio loan is a loan that is serviced by the
lender that issued the money.
- In many cases, loans that are issued by a lender are packaged
together with other loans and sold in the secondary market to form
loan portfolio.
- Typically, those loans that have a good credit score and are
considered to be a good credit risk are those that are considered
to be eligible for being part of a portfolio. Lenders like to keep
those loans that have a good credit history on hand because it
lowers the amount of risk in the portfolio.
- Freddie Mac and Fannie Mae are two of the most prominent
players in this market; they purchase portfolios of loans, which
originate as residential mortgages, from banks and credit unions.
This, in turn, helps these financial institutions improve their
liquidity by turning loans into cash, which can then be used to
make additional loans. Freddie Mac and Fannie Mae perform due
diligence on the pooled loans to make sure that they meet their
credit requirements and are appropriately documented.
- A financial institution can diversify part of the credit risk
by an intelligent composition of the loan portfolio across regions,
industries and countries. Thus in order to assess credit risk of a
loan portfolio, a bank must not only investigate the
creditworthiness of its clients, but also identify the
concentration risks and possible co-movements of risk factors in
the portfolio.
- For an appropriate measure of risk/return on the portfolio loan
exposure, we need to accurately measure the credit loss volatility.
Only then can we price an exposure appropriately. The loss
volatility is optimum when the portfolio is diversified.
- Correlation is an important measure of credit risk. The
classical linear correlation coefficient is an inadequate measure
of dependence between defaults in a portfolio of loans.
Correlation is of two types – correlation across the borrowers on
credit loss or credit drivers, and correlation of credit drivers
with each other.
- Management of credit risk in a loan (asset) portfolio comprises
of following steps:-
Setting credit exposure limits
Regulatory approaches to measuring credit risk
NAIC has set limits for different types of assets and borrowers in
insurers’ portfolios.
- To manage credit risk of portfolio of loans, there are two loan
concentration models:-
Migration analysis - It tracks credit rating
changes within sector or pool of loans . Uses Rating transition
matrix which reflects history of ratings changes. This analysis is
widely applied to commercial loans, credit card portfolios, and
consumer loans.
Cincentration Analysis - Concentration limits are
placed on loans to individual borrower or sector. Concentration
limit = maximum loss / loss rate ; ( Maximum loss expressed as
percent of capital) .
FIs typically set geographic concentration limits.
- One example credit risk measure for loan portfolio developed by
Credit Suisse Financial Products based on insurance
literature.
In this measure :- Losses reflect frequency of event and severity
of loss, Loan default is random, Loan default probabilities are
independent. This measure is appropriate for large portfolios of
small loans This measure is modeled by a Poisson distribution.
Managing Risks at Portfolio Level
The two-step treatment for portfolio risks is as follows:
Portfolio/correlation risks
Step I: Identify risk concentration at the
portfolio level (as a first level to recognize correlation)
- Use of securitization
- Use of credit derivatives
Step II: Measure concentration risks
- Assume, either explicitly or implicitly, average correlations
across the whole or large parts of the credit portfolios. While
this approach is sensitive to large, single exposures, it is
insensitive to the build-up of industry and geographic risk
concentrations.
- Estimate credit quality correlations based on a multi-factor
analysis of equity market prices. The problem here is averaging out
of correlation over a period of time.
There can be two types of loan portfolios : a portfolio whose
repayment is driven by the income generated by the assets or, a
portfolio whose repayment is driven by income generation and sale
of the collateral.
Traditionally, banks have focused on oversight of
individual loans in managing their overall credit risk. While this
focus is important, banks should also view credit risk management
in terms of portfolio segments and the entire
portfolio.
Effective management of the loan portfolio’s credit risk requires
that the board and management understand and control the bank’s
risk profile and its credit culture. To accomplish this, they must
have a thorough knowledge of the portfolio’s composition and its
inherent risks, the portfolio’s product mix, industry and
geographic concentrations, average risk ratings, and other
aggregate characteristics. They must be sure that the policies,
processes, and practices implemented to control the risks of
individual loans and portfolio segments are sound and that lending
personnel adhere to them.