CHAPTER 16

Introduction to Credit Risk

What is in this Chapter?

INTRODUCTION
SOURCES OF CREDIT RISK
THE CREDIT LIFE CYCLE
WHY MEASURE CREDIT RISK?

INTRODUCTION
Thetakingofcreditriskhasalwaysbeenacoreactivityfo
rbanks
Overthelast10years,quantitativemeasurementhasbeen
adoptedbybankstoimprovetheirprocessesforselectinga
ndpricingcredittransactions
Quantitativemeasurementhasbecomeevenmoreimportan
tsinceitwasadoptedbytheBaselCommitteeonBanking
asthebasisforsettingregulatorycapital.

Inthischapter,wereviewtheprocessforgrantingcredita
ndthewaysinwhichriskmeasurementsupportscreditde
cisions
Insubsequentchapters,wereviewthedifferenttypesofcr
editinstruments,riskmeasurementforasingleloan,risk
measurementforaportfolio,andhowtheresultsareused
fordecisionsupport.
Mostofthediscussionfocusesonestimatingtheeconomi
ccapital,butwefinishthecredit-risksectionwiththeBas
elCommittee'snewframeworkforsettingregulatorycapit
al.

SOURCES OF CREDIT RISK

Creditriskarisesfromthepossibilitythatborrowersorco
unterpartieswillfailtohonorcommitmentsthattheyhave
madetopaythebank.

SOURCES OF CREDIT RISK

Credit-relatedlossescanoccurinthefollowingw
ays:

Acustomerfailstorepaymoneythatwaslentbytheb
ank.
Thebankholdsadebtsecurity(e.g.,abondorloan)an
dthecreditqualityofthesecurityissuerfalls,causing
thevalueofthesecuritytofall.Here,adefaulthasnot
occurred,buttheincreasedpossibilityofadefaultmak
esthesecuritylessvaluable.

Thebankholdsadebtsecurity,andthemarket'spricefor
riskchanges.
Forexample,thepriceforallBB-ratedbondsmayfallbec
ausethemarketislesswillingtotakerisks.
Inthiscase,thereisnocreditevent,justachangeinmark
etsentiment.
Thisriskisthereforetypicallytreatedasmarketriskinthe
tradingVaRcalculator

SOURCES OF CREDIT RISK

Thereisagrayareabetweenmarketandcreditrisks.

Generally,changesinvalueduetodefaultsanddowngradesare'c
onsideredtobecreditriskbecausetheydependonthebehavioro
fthespecificcompany.
Changesinvalueduetochangesintherisk-freeinterest-rateorc
hangesincreditspreadforagivengradeareconsideredtobemar
ketriskbecausetheydependongeneralmarketsentiment.

THE CREDIT LIFE CYCLE

Thecustomerthenappliesforcreditandsuppliessomeinf
ormationabouthisorhercreditworthiness
Inthecaseofaretailcustomer,itispersonalinformation
suchasincome
Inthecaseofacommercialcustomer,itisbalance-'sheeti
nformationsuchastotalassets
Basedonthisinformation,thebank'screditdepartmentde
terminestheriskinessofthecustomerandassignsacredit
grade,whichisaformofriskscore.

THE CREDIT LIFE CYCLE

Often,bankswillsupplementtheirgradingprocesseswith
informationfromexternalratingagencies
Forretailcustomers,dataisprovidedbycreditbureausw
hocollectinformationfrommanybanksandcollateitfor
resaletoanybankconsideringlendingtoanindividual.
IntheUnitedStatesthemaincreditbureausareEquifax,
TRW,andExperian
Theinformationincludespersonaldetails,suchasincom
e,andfinancialinformation,suchasthetotalnumberofcr
editcardsandwhetherthecustomerhasdefaulted.

THE CREDIT LIFE CYCLE

Forlendingtocorporations,themaincredit-ratingagenciesforlarge
corporationsintheUnitedStatesareStandard&Poor's,Moody's,and
FitchIBCA
Forthemiddlemarket,DunnandBradstreetistheprimaryratingage
ncy.
Theytakeinformationonacompanyandanassociatedfacility(apart
icularbond,forexample),andtheyratethefacilitybasedonsubjectiv
ejudgmentsandobjectivemodels
Themodelsuseinformationonthecompany'sbalancesheetandprofi
tability.Theresultisalettergradethatindicatesthe"riskiness"ofthe
facility.
Therearealsocompanies(principally,KMV,nowownedbyMood
y's)whoratecorporationsbasedonthevolatilityoftheirequityprice
s,whichwewilllaterdiscussindepth

THE CREDIT LIFE CYCLE

Basedonthegrade,thebankdecideswhethertooffercre
dittothecustomer,inwhatamount,atwhatinterestrate,
andwithwhatterms
Thedifferencebetweentherisk-freerateandtheratechar
gedtothecustomeriscalledthespread.
Thecustomerdecideswhethertoacceptthegivenprice,a
ndthentheremaybeafinalroundofbankapprovalbefor
ethedealisclosed.Theprocessuptoclosingtheactuald
ealiscalledorigination.
Afterthedealisclosed,aseriesofdisbursementsaremad
etotheborrower,andtheloanbecomespartofthebank's
portfolioofassets

THE CREDIT LIFE CYCLE

Theportfolioismanagedtominimizetherisk/returnratio
oftheportfolio.
Eventually,mostoftheloansarepaidbackbythecustom
ers,butsomedefaultandgotothecollectionsdepartment,
whotakestimetorecoverasmuchoftheoutstandingamo
untaspossible
Thecollectionsdepartmentmayalsobecalledtheworkou
tgrouporthespecialassetsgroup.

WHY MEASURE CREDIT RISK?

Beforelaunchingintotheanalysisandcalculationofcredi
trisk,letusfirstconsiderwhatriskmeasurementswould
beusefultosupportthedecisionsintheprocesswediscus
sedabove
Therearethreemainsetsofdecisions:

Origination
portfoliooptimization
capitalization.

WHY MEASURE CREDIT RISK?

SupportingOriginationDecisions

Themostbasicdecisioniswhethertoacceptanewass
etintotheportfolio.Theoriginationdecisioncanbefr
amedintwopossibleways:
Giventheriskandafixedprice,istheassetwortht
aking?
Giventherisk,whatpriceisrequiredtomakethea
ssetworthbuying?

WHY MEASURE CREDIT RISK?

Thefirstismoreoftenaskedinarigidsystemwhereth
ereislittleopportunitytomodifytheprice,andtherefo
rethedecisionbecomes"yes/no.
Thisisthetypeofdecisionmadewhendealingwitha
largevolumeofretailcustomers.
Thequestioncanberecastas,"Istheexpectedreturno
ncapitalforthistransactiongreaterthanthebank'smi
nimumreturnoncapital?"
Tosupportthisdecision,weneedtoknowtheexpecte
dreturn,adjustedforexpectedlossesandexpenses,an
dtheamountofcapitalthatthistransactionwillconsu
me

WHY MEASURE CREDIT RISK?

Thesecondapproachistypicallyusedinaflexible,liq
uidtradingenvironment,orinnegotiatingratesandfee
sforacorporateloan
Here,westartwiththecapitalconsumedandtheknow
nhurdlerateforthereturnoncapitaltocalculatethem
inimumacceptablereturnfortheoverallloan

WHY MEASURE CREDIT RISK?

SupportingPortfolioOptimization

Inoptimizingaportfolio,themanagerseekstominimizetheratio
ofrisktoreturn
Toreducetheportfolio'srisk,themanagermustknowwherether
eareconcentrationsofriskandhowtheriskcanbediversified
Thisrequiresacredit-portfoliomodelthatincludesallthecorrelat
ionsbetweenassetstoshowwherethereareconcentrationsofass
etsthatarehighlycorrelated
Thehighcorrelationmayarisefrombeinginthesameindustryor
geography,orbecausetheyaredrivenbythesameeconomicfact
ors,suchasoilprices.
Theportfoliomodelmustshowthecurrentriskconcentrationsan
dallowthemanagertotry"what-if"analysestoteststrategiesfor
diversifyingtheportfolio.

WHY MEASURE CREDIT RISK?

SupportingCapitalManagement

Giventheriskintheportfolio,theCFOneedstosetth
eprovisionsforexpectedlossesoverthenextyear,and
thereserves,incaselossesareunusuallybad
TheCFOalsoneedstoensurethatthetotaleconomicc
apitalavailableissufficienttomaintainthebank'starg
etcreditratinggiventherisks
Ifitisinsufficient,thebankmust(1)raisemorecapita
l,(2)reducetherisk,or(3)expecttobedowngraded

WHY MEASURE CREDIT RISK?

Tosettheprovisions,theCFOneedstoknowtheaver
agelossesthataretobeexpected
Tosetreserves,itisnecessarytoknowthelossthatco
uldbeexperiencedinanunusuallybadyear,e.g.,losse
sthathaveal-in-20chance(5%)ofhappening
Tosetcapital,weneedthelosslevelthatcouldbeexp
eriencedinanextraordinarilybadyear,e.g.,lossesthat
haveal-in-1000(0.1%)chanceofhappening
Thesestatisticscanbeobtainedifwecancalculatethe
probability-densityfunctionfortheportfolio-lossrate,
whichisthefocusofthenextfewchapters