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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.
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
Generally,changesinvalueduetodefaultsanddowngradesare'c
onsideredtobecreditriskbecausetheydependonthebehavioro
fthespecificcompany.
Changesinvalueduetochangesintherisk-freeinterest-rateorc
hangesincreditspreadforagivengradeareconsideredtobemar
ketriskbecausetheydependongeneralmarketsentiment.
Origination
portfoliooptimization
capitalization.
Themostbasicdecisioniswhethertoacceptanewass
etintotheportfolio.Theoriginationdecisioncanbefr
amedintwopossibleways:
Giventheriskandafixedprice,istheassetwortht
aking?
Giventherisk,whatpriceisrequiredtomakethea
ssetworthbuying?
Thefirstismoreoftenaskedinarigidsystemwhereth
ereislittleopportunitytomodifytheprice,andtherefo
rethedecisionbecomes"yes/no.
Thisisthetypeofdecisionmadewhendealingwitha
largevolumeofretailcustomers.
Thequestioncanberecastas,"Istheexpectedreturno
ncapitalforthistransactiongreaterthanthebank'smi
nimumreturnoncapital?"
Tosupportthisdecision,weneedtoknowtheexpecte
dreturn,adjustedforexpectedlossesandexpenses,an
dtheamountofcapitalthatthistransactionwillconsu
me
Thesecondapproachistypicallyusedinaflexible,liq
uidtradingenvironment,orinnegotiatingratesandfee
sforacorporateloan
Here,westartwiththecapitalconsumedandtheknow
nhurdlerateforthereturnoncapitaltocalculatethem
inimumacceptablereturnfortheoverallloan
Inoptimizingaportfolio,themanagerseekstominimizetheratio
ofrisktoreturn
Toreducetheportfolio'srisk,themanagermustknowwherether
eareconcentrationsofriskandhowtheriskcanbediversified
Thisrequiresacredit-portfoliomodelthatincludesallthecorrelat
ionsbetweenassetstoshowwherethereareconcentrationsofass
etsthatarehighlycorrelated
Thehighcorrelationmayarisefrombeinginthesameindustryor
geography,orbecausetheyaredrivenbythesameeconomicfact
ors,suchasoilprices.
Theportfoliomodelmustshowthecurrentriskconcentrationsan
dallowthemanagertotry"what-if"analysestoteststrategiesfor
diversifyingtheportfolio.
Giventheriskintheportfolio,theCFOneedstosetth
eprovisionsforexpectedlossesoverthenextyear,and
thereserves,incaselossesareunusuallybad
TheCFOalsoneedstoensurethatthetotaleconomicc
apitalavailableissufficienttomaintainthebank'starg
etcreditratinggiventherisks
Ifitisinsufficient,thebankmust(1)raisemorecapita
l,(2)reducetherisk,or(3)expecttobedowngraded
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