BBK3253 | Risk Management
Prepared by Dr Khairul Anuar
L5
- Credit Risk Management
- Systematic and Unsystematic Risk
- Principle of Diversification
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Content
1. Credit risk definition
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Credit Risk vs. Market Risk
Credit Risk vs. Market Risk
Credit Products — Loans vs. Bonds
Understanding Credit Risk — A Simple Loan
Managing Credit Risk
Risk Diversification: Systematic and Unsystematic Risk
Portfolio Diversification
The Principle of Diversification
Diversification and risk
Systematic Risk Principle
Common Versus Independent Risk
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1. Credit risk definition
• The potential for loss due to failure of a borrower to meet its
contractual obligation to repay a debt in accordance with the
agreed terms

Example: A homeowner stops making mortgage payments
• Commonly also referred to as default risk
• Credit events include bankruptcy, failure to pay, loan
restructuring, loan moratorium, accelerated loan payments
• For banks, credit risk typically resides in the assets in its
banking book (loans and bonds held to maturity)
• Credit risk can arise in the trading book as counterparty credit
risk
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2. Credit Risk vs. Market Risk
• Market risk is the potential loss due to changes in market prices
or values

Assessment time horizon: typically one day
• Credit risk is the potential loss due to the non-performance of a
financial contract, or financial aspects of non-performance in
any contract
• Assessment time horizon: typically one year
• Credit risk is generally more important than market risk for
banks
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3. Credit Risk vs. Market Risk
• Many credit risk drivers relate to market risk drivers, such as
the impact of market conditions on default probabilities.
• Differs from market risk due to obligor behavior considerations
• The five “C’s” of Credit — Capital, Capacity, Conditions,
Collateral, and Character
• Both credit and market risk models use historical data, forward
looking models and behavioral models to assess risks
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4. Credit Products — Loans vs. Bonds
Loans
• A contractual agreement that outlines the payment
obligation from the borrower to the bank
• May be secured with either collateral or payment
guarantees to ensure a reliable source of secondary
repayment in case the borrower defaults
• Often written with covenants that require the loan to be
repaid immediately if certain adverse conditions exist,
such as a drop in income or capital
• Generally reside in the bank’s banking book or credit
portfolio • Although banks may sell loans another bank or
entity investing in loans
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4. Credit Products — Loans vs. Bonds
Bonds
• A publicly traded loan — an agreement between the
issuer and the purchasers
• Collateral support, payment guarantees, or secondary
sources of repayment may all support certain types of
bonds
• Structuring characteristics that determine a bond
investor’s potential recovery in default
• Generally reside in the bank’s trading book
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5. Understanding Credit Risk — A Simple Loan
 Contractually, how a loan should work:
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5. Understanding Credit Risk — A Simple Loan
 Credit risk arises because there is the possibility that the
borrower will not repay the loan as obligated
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6. Managing Credit Risk
 The following 2 concepts will provide a framework to
understand the principles financial managers must
follow to minimize credit risk, yet make successful
loans:
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adverse selection and
•
moral hazard

Adverse selection - refers to a market process in which undesired results occur when buyers and
sellers have asymmetric information (access to different information); the "bad" products or services
are more likely to be selected.

A moral hazard is a situation in which a party is more likely to take risks because the costs that
could result will not be borne by the party taking the risk. In other words, it is a tendency to be more
willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in
whole or in part, by others. A moral hazard may occur where the actions of one party may change to
the detriment of another after a financial transaction has taken place.
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6. Managing Credit Risk
 Solving Asymmetric Information Problems:
1. Screening and Monitoring:
─ collecting reliable information about prospective
borrowers. This has also lead some institutions to
specialize in regions or industries, gaining expertise
in evaluating particular firms
─ also involves requiring certain actions, or prohibiting
others, and then periodically verifying that the
borrower is complying with the terms of the loan
contract.
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6. Managing Credit Risk
 Specialization in Lending helps in screening. It
is easier to collect data on local firms and firms in
specific industries. It allows them to better predict
problems by having better industry and location
knowledge.
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6. Managing Credit Risk
 Monitoring and Enforcement also helps.
Financial institutions write protective covenants
into loans contracts and actively manage them to
ensure that borrowers are not taking risks at their
expense.
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6. Managing Credit Risk
2. Long-term Customer Relationships: past
information contained in checking accounts,
savings accounts, and previous loans provides
valuable information to more easily determine
credit worthiness.
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6. Managing Credit Risk
3. Loan Commitments: arrangements where the
bank agrees to provide a loan up to a fixed
amount, whenever the firm requests the loan.
4. Collateral: a pledge of property or other assets
that must be surrendered if the terms of the loan
are not met ( the loans are called secured
loans).
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6. Managing Credit Risk
5. Compensating Balances: reserves that a borrower
must maintain in an account that act as collateral should
the borrower default.
6. Credit Rationing:

lenders will refuse to lend to some borrowers,
regardless of how much interest they are willing to
pay, or

lenders will only finance part of a project, requiring
that the remaining part come from equity financing.
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7. Risk Diversification: Systematic and Unsystematic Risk
 Risk has two parts:
 Systematic risk
 Unsystematic risk
 Total risk = Systematic risk + Unsystematic
risk
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7. Risk Diversification: Systematic and Unsystematic Risk
•
Systematic risk arises on account of the economy-wide
uncertainties and the tendency of individual securities to
move together with changes in the market. This part of
risk cannot be reduced through diversification. It is also
known as market risk.
 Includes such things as changes in GDP, inflation,
interest rates, etc.)
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7. Risk Diversification: Systematic and Unsystematic Risk
•
Unsystematic risk arises from the unique uncertainties
of individual securities. It is also called unique risk.
Unsystematic risk can be totally reduced through
diversification. Also known as unique risk and assetspecific risk
 Includes such things as labor strikes, part shortages,
etc.
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8. Portfolio Diversification
• Portfolio diversification is the investment in several
different asset classes or sectors
• Diversification is not just holding a lot of assets
 For example, if you own 50 internet stocks, you are not
diversified
• However, if you own 50 stocks that span 20 different
industries, then you are diversified
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9. The Principle of Diversification
• Diversification can substantially reduce the variability of
returns without an equivalent reduction in expected
returns
• This reduction in risk arises because worse than
expected returns from one asset are offset by better
than expected returns from another
• However, there is a minimum level of risk that cannot be
diversified away and that is the systematic portion
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10. Diversification and risk
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10. Diversifiable Risk
 The risk that can be eliminated by combining assets into
a portfolio
 Often considered the same as unsystematic, unique or
asset-specific risk
 If we hold only one asset, or assets in the same
industry, then we are exposing ourselves to risk that we
could diversify away
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11. Systematic Risk Principle
 There is a reward for bearing risk
 There is not a reward for bearing risk unnecessarily
 The expected return on a risky asset depends only on
that asset’s systematic risk since unsystematic risk can
be diversified away
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12. Common Versus Independent Risk
 Example: Theft vs. earthquake insurance
 Consider two types of home insurance: theft insurance
and earthquake insurance.
 Assume that the risk of each of these two hazards is
similar for a given home in KL – each year there is about
a 1% chance the home will be robbed, and also a 1%
chance the home will be damaged by an earthquake.
 Suppose an insurance company writes 100,000 policies
of each type of insurance for homeowners in KL; are the
risks of the two portfolios of policies similar?
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12. Common Versus Independent Risk
 Example: Theft vs. earthquake insurance
 Why are the portfolios of insurance policies so different
when the individual policies themselves are quite similar?
─ Intuitively, the key difference between them is that an
earthquake affects all houses simultaneously, so the risk is
linked across homes – common risk.
─ The risk of theft is not linked across home, some
homeowners are unlucky, others lucky – independent risk.
 Diversification: The averaging out of independent risk in a
large portfolio.
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Summary of Types of Risk
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