• Credit Risk
https://store.theartofservice.com/the-credit-risk-toolkit.html
Peer-to-peer lending - Credit risk
Peer-to-peer lending also attracts
borrowers who, because of their credit
status or the lack of thereof, are
unqualified for traditional bank loans
1
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Peer-to-peer lending - Credit risk
1
It seemed initially that one of the appealing
characteristics of peer-to-peer lending for
investors was low default rates, e.g.
Prosper's default rate was quoted to be
only at about 2.7 percent in 2007.
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Peer-to-peer lending - Credit risk
1
The actual default rates for the loans
originated by Prosper in 2007 were in
fact higher than projected
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Peer-to-peer lending - Credit risk
1
Since inception, Lending Club’s default
rate ranges from 1.4% for top-rated threeyear loans to 9.8% for the riskiest loans.
https://store.theartofservice.com/the-credit-risk-toolkit.html
Peer-to-peer lending - Credit risk
The UK peer-to-peer lenders quote the
ratio of bad loans at 0.84% for Zopa of the
£200m during its seven year lending
history. As of November 2013, Funding
Circle’s current bad debt level was 1.5%,
with an average 5.8% return after all bad
debt and fees. This is comparable to the
3-5% ratio of mainstream banks and the
result of modern credit models and
efficient risk management technologies
used by P2P companies.
1
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Interest - Interest rates and credit risk
1
It is increasingly recognized that the
business cycle, interest rates and
credit risk are tightly interrelated. The
Jarrow-Turnbull model was the first
model of credit risk that explicitly had
random interest rates at its core.
Lando (2004), Darrell Duffie and
Singleton (2003), and van Deventer
and Imai (2003) discuss interest rates
when the issuer of the interest-bearing
instrument can default.
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Credit risk
'Credit risk' refers to the risk that a
borrower will default (finance)|default
on any type of debt by failing to make
required payments. The risk is primarily
that of the lender and includes lost
principal sum|principal and interest,
disruption to cash flows, and increased
collection costs. The loss may be
complete or partial and can arise in a
number of
circumstances.[http://www.riskglossar
y.com/link/credit_risk.htm Risk
Glossary: Credit Risk] For example:
1
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Credit risk
1
* A consumer may fail to make a payment
due on a mortgage loan, credit card, line
of credit, or other loan
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Credit risk
* A company is
unable to repay
asset-secured fixed
or floating charge
debt
1
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Credit risk
1
* A business or consumer
does not pay a trade
credit|trade invoice when
due
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Credit risk
1
* A business does not pay
an employee's earned
wages when due
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Credit risk
* A business or government Bond
(finance)|bond issuer does not make a
payment on a Coupon (bond)|coupon or
principal payment when due
1
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Credit risk
* An insolvent insurance
company does not pay a policy
obligation
1
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Credit risk
1
* An insolvent bank won't
return funds to a depositor
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Credit risk
1
* A government grants bankruptcy protection to an
insolvency|insolvent consumer or business
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Credit risk
To reduce the lender's credit risk, the
lender may perform a credit check on the
prospective borrower, may require the
borrower to take out appropriate
insurance, such as mortgage insurance or
seek Security (finance)|security or
guarantees of third parties. In general, the
higher the risk, the higher will be the
interest rate that the debtor will be asked
to pay on the debt.
1
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Credit risk - Types of credit risk
Credit risk can be classified as
follows:[https://www.unicreditgroup.eu/en/i
nvestors/risk-management/credit.html
Credit Risk Classification]
1
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Credit risk - Types of credit risk
* Credit default risk — The risk of loss
arising from a debtor being unlikely to pay
its loan obligations in full or the debtor is
more than 90 days past due on any
material credit obligation; default risk may
impact all credit-sensitive transactions,
including loans, securities and Derivative
(finance)|derivatives.
1
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Credit risk - Types of credit risk
1
* Concentration risk — The risk associated
with any single exposure or group of
exposures with the potential to produce
large enough losses to threaten a bank's
core operations. It may arise in the form of
single name concentration or industry
concentration.
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Credit risk - Types of credit risk
1
* Country risk — The risk of loss arising
from a sovereign state freezing foreign
currency payments (transfer/conversion
risk) or when it defaults on its obligations
(sovereign risk); this type of risk is
prominently associated with the country's
macroeconomic performance and its
political stability.
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Credit risk - Assessing credit risk
1
Significant resources and sophisticated
programs are used to analyze and
manage risk.[
http://www.bis.org/publ/bcbs126.htm
BIS Paper:Sound credit risk
assessment and valuation for loans]
Some companies run a credit risk
department whose job is to assess the
financial health of their customers, and
extend credit (or not) accordingly
https://store.theartofservice.com/the-credit-risk-toolkit.html
Credit risk - Assessing credit risk
1
Most lenders employ their own models (credit scorecards) to
rank potential and existing customers according to risk, and
then apply appropriate strategies.[
http://www.crc.man.ed.ac.uk/conference/archive/2007/papers/
huang-and-scott.pdf Huang and Scott:Credit Risk Scorecard
Design, Validation and User Acceptance] With products such
as unsecured personal loans or mortgages, lenders charge a
higher price for higher risk customers and vice versa.[
http://www.investopedia.com/terms/r/riskbased_mortgage_pricing.asp Investopedia: Risk-based
mortgage pricing][
http://www.crc.man.ed.ac.uk/conference/archive/2003/present
ations/edelman.pdf Edelman: Risk based pricing for personal
loans] With revolving products such as credit cards and
overdrafts, risk is controlled through the setting of credit limits
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Credit risk - Assessing credit risk
1
Credit scoring models also form part of
the framework used by banks or
lending institutions to grant credit to
clients
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Credit risk - Sovereign risk
Sovereign risk is the risk of a
government being unwilling or unable to
meet its loan obligations, or reneging on
loans it guarantees. Many countries have
faced sovereign risk in the late-2000s
global recession. The existence of such
risk means that creditors should take a
two-stage decision process when
deciding to lend to a firm based in a
foreign country. Firstly one should
consider the sovereign risk quality of the
country and then consider the firm's
1
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Credit risk - Sovereign risk
1
Five macroeconomic variables that affect the
probability of sovereign debt rescheduling are:
https://store.theartofservice.com/the-credit-risk-toolkit.html
Credit risk - Sovereign risk
1
* Variance of export
revenue
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Credit risk - Sovereign risk
1
The probability of rescheduling is an
increasing function of debt service
ratio, import ratio, variance of export
revenue and domestic money supply
growth
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Credit risk - Counterparty risk
1
A counterparty risk, also known as a
default risk, is a risk that a
counterparty will not pay as obligated
on a bond (finance)|bond, credit
derivative, trade credit insurance or
payment protection insurance
contract, or other trade or
transaction.Investopedia
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Credit risk - Counterparty risk
Counterparty risk increases due to
positively correlated risk factors.
Accounting for correlation between
portfolio risk factors and counterparty
default in risk management
methodology is not
trivial.[http://ssrn.com/abstract=926
067 Related SSRN Research Paper]
1
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Credit risk - Mitigating credit risk
1
Lenders mitigate
credit risk using
several methods:
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Credit risk - Mitigating credit risk
1
* 'Risk-based pricing': Lenders generally
charge a higher interest rate to borrowers
who are more likely to default, a practice
called 'risk-based pricing'. Lenders
consider factors relating to the loan such
as loan purpose, credit rating, and loan-tovalue ratio and estimates the effect on
yield (credit spread (bond)|credit spread).
https://store.theartofservice.com/the-credit-risk-toolkit.html
Credit risk - Mitigating credit risk
*
'Covenants':[http://moneyterms.co.uk/debt
_covenants/ Debt covenants] Lenders may
write stipulations on the borrower, called
'loan covenant|covenants', into loan
agreements:
1
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Credit risk - Mitigating credit risk
1
** Refrain from paying dividends, share
repurchase|repurchasing shares,
borrowing further, or other specific,
voluntary actions that negatively affect the
company's financial position
https://store.theartofservice.com/the-credit-risk-toolkit.html
Credit risk - Mitigating credit risk
** 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
times interest earned|interest coverage
ratio
1
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Credit risk - Mitigating credit risk
* 'Credit insurance' and 'credit
derivatives': Lenders and bond
(finance)|bond holders may Hedge
(finance)#Hedging credit risk|hedge
their credit risk by purchasing 'credit
insurance' or 'credit derivatives'.
These contracts transfer the risk from
the lender to the seller (insurer) in
exchange for payment. The most
common credit derivative is the
'credit default swap'.
1
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Credit risk - Mitigating credit risk
1
* 'Tightening': Lenders can reduce credit
risk by reducing the amount of credit
extended, either in total or to certain
borrowers. For example, a Distribution
(business)|distributor selling its products to
a troubled retailer may attempt to lessen
credit risk by reducing payment terms from
net 30 to net 15.
https://store.theartofservice.com/the-credit-risk-toolkit.html
Credit risk - Mitigating credit risk
*
'Diversification':[http://www.businessinsider
.com/mba-mondays-diversification-2010-6
MBA Mondays:Risk Diversification]
Lenders to a small number of borrowers
(or kinds of borrower) face a high degree
of systematic
risk#Unsystematic_risk|unsystematic
credit risk, called 'concentration risk'.
Lenders reduce this risk by Diversification
(finance)|diversifying the borrower pool.
1
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Credit risk - Mitigating credit risk
* 'Deposit insurance': Many
governments establish 'deposit
insurance' to guarantee bank deposits
in the event of insolvency and
encourage consumers to hold their
savings in the banking system instead
of in cash.
1
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Credit risk - Credit risk related acronyms
1
* 'CCR' Counterparty Credit Risk
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Credit risk - Credit risk related acronyms
1
* 'CVA' Credit valuation adjustment
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Credit risk - Credit risk related acronyms
1
* 'LGD' Loss given default
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Credit risk - Credit risk related acronyms
1
* 'PD' Probability of default
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Credit risk - Credit risk related acronyms
1
* 'PFE' Potential future
exposure
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Government bonds - Credit risk
Government bonds in a country's own
currency are sometimes taken as an
approximation of the theoretical risk-free
bond, because it is assumed that the
government can raise taxes or create
additional currency in order to redeem the
bond at Maturity (finance)|maturity. There
have been instances where a government
has Default (finance)|defaulted on its
domestic currency debt, such as Russia in
1998 (the 1998 Russian financial crisis|ruble
crisis) (see national bankruptcy).
1
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Mortgage-backed security - Credit risk
The credit risk of mortgage-backed
securities depends on the likelihood of
the borrower paying the promised cash
flows (principal and interest) on time.
The credit rating of MBS is fairly high
because:
1
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Mortgage-backed security - Credit risk
# Most mortgage loan|mortgage
originations include research on the
mortgage borrower's ability to repay,
and will try to lend only to the
creditworthy. An important exception
to this is no-doc or low-doc loans.
1
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Mortgage-backed security - Credit risk
# Some MBS issuers, such as Fannie
Mae, Freddie Mac, and Ginnie Mae,
guarantee against homeowner default risk
1
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Mortgage-backed security - Credit risk
# Pooling many mortgages with
uncorrelated default probabilities
creates a bond with a much lower
probability of total default, in which
no homeowners are able to make their
payments (see Copula
(statistics)|Copula). Although the risk
neutral credit spread (bond)|credit
spread is theoretically identical
between a mortgage ensemble and the
average mortgage within it, the
chance of catastrophic loss is
1
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Mortgage-backed security - Credit risk
1
# If the property owner should default, the
property remains as collateral
(finance)|collateral. Although real estate
prices can move below the value of the
original loan, this increases the solidity of
the payment guarantees and deters
borrower default.
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Mortgage-backed security - Credit risk
1
If the MBS was not underwritten by the
original real estate and the issuer's
guarantee, the rating of the bonds would
be much lower. Part of the reason is the
expected adverse selection against
borrowers with improving credit (from
MBSs pooled by initial credit quality) who
would have an incentive to refinance
(ultimately joining an MBS pool with a
higher credit rating).
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Standardized approach (credit risk)
1
The term 'standardized approach' (or
'standardised approach') refers to a
set of credit risk measurement
techniques proposed under Basel II
capital adequacy rules for banking
institutions.
https://store.theartofservice.com/the-credit-risk-toolkit.html
Standardized approach (credit risk)
Under this approach the banks are
required to use ratings from External
Credit Rating Agencies to quantify
required capital for credit risk. In
many countries this is the only
approach the regulators are planning
to approve in the initial phase of Basel
II Implementation.
1
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Standardized approach (credit risk)
The Basel Accord proposes to permit
banks a choice between two broad
methodologies for calculating their capital
requirements for credit risk. The other
alternative is based on internal ratings.
1
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Standardized approach (credit risk) - The summary of risk weights in standardized
approach
1
There are some options in weighing risks
for some claims, below are the summary
as it might be likely to be implemented.
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Standardized approach (credit risk) - The summary of risk weights in standardized
approach
'NOTE': For some unrated risk
weights, banks are encouraged to use
their own internal-ratings system
based on Foundation IRB and
Advanced IRB in Internal-Ratings
Based approach with a set of formulae
provided by the Basel-II accord. There
exist several alternative weights for
some of the following claim
categories published in the original
1
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Standardized approach (credit risk) - The summary of risk weights in standardized
approach
1
*'Claims on banks and
securities companies'
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Standardized approach (credit risk) - The summary of risk weights in
standardized approach
1
::Related to assessment of sovereign as banks
and securities companies are regulated.
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Standardized approach (credit risk) - The summary of risk weights in standardized
approach
1
*'Claims on retail
products'
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Standardized approach (credit risk) - The summary of risk weights in
standardized approach
1
::This includes credit card, overdraft, auto loans,
personal finance and small business.
https://store.theartofservice.com/the-credit-risk-toolkit.html
Standardized approach (credit risk) - The summary of risk weights in standardized
approach
1
*'Claims secured by
residential property'
https://store.theartofservice.com/the-credit-risk-toolkit.html
Standardized approach (credit risk) - The summary of risk weights in
standardized approach
*'Claims secured by
commercial real estate'
1
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Standardized approach (credit risk) - The summary of risk weights in standardized
approach
::150% for provisions that are
less than 20% of the outstanding
amount
1
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Standardized approach (credit risk) - The summary of risk weights in standardized
approach
1
::100% for provisions that
are between 20% - 49% of
the outstanding amount
https://store.theartofservice.com/the-credit-risk-toolkit.html
Standardized approach (credit risk) - The summary of risk weights in standardized
approach
1
::100% for provisions that are no less than
50% of the outstanding amount, but with
supervisory discretion are reduced to 50%
of the outstanding amount
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Internal Ratings-Based Approach (Credit Risk)
1
This is known as the 'Internal RatingsBased (IRB) Approach' to capital
requirements for credit risk
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Internal Ratings-Based Approach (Credit Risk) - Overview
1
The IRB approach relies on a bank's own
assessment of its counterparties and
exposures to calculate capital
requirements for credit risk. The Basel
Committee on Banking Supervision
explained the rationale for adopting this
approach in a consultative paper issued in
2001.[
http://www.bis.org/publ/bcbsca05.pdf
BCBS:The Internal Ratings-Based
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Internal Ratings-Based Approach (Credit Risk) - Overview
1
*Risk sensitivity - Capital requirements
based on internal estimates are more
sensitive to the credit risk in the bank's
portfolio of assets
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Internal Ratings-Based Approach (Credit Risk) - Overview
1
*Incentive compatibility - Banks must
adopt better risk management
techniques to control the credit risk in
their portfolio to minimize regulatory
capital
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Internal Ratings-Based Approach (Credit Risk) - Overview
To use this approach, a
bank must take two major
steps:
1
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Internal Ratings-Based Approach (Credit Risk) - Overview
1
*Categorize their exposures into various asset
classes as defined by the Basel II accord
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Internal Ratings-Based Approach (Credit Risk) - Overview
1
*Estimate the risk parameters—probability
of default (PD), loss given default (LGD),
exposure at default (EAD), maturity (M)—
that are inputs to risk-weight functions
designed for each asset class to arrive at
the total risk-weighted asset|risk weighted
assets(RWA)
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Internal Ratings-Based Approach (Credit Risk) - Overview
The regulatory capital for credit risk is then
calculated as 8% of the total RWA under Basel II.
1
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Internal Ratings-Based Approach (Credit Risk) - Categorization of Exposures
1
Each banking exposure
is categorized into one
of these broad asset
classes
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Internal Ratings-Based Approach (Credit Risk) - Categorization of Exposures
1
These corporate and retail classes are
further divided into five and three subclasses, respectively. Further, both
these classes have a separate
treatment for purchased receivables,
which might apply subjectivity to
certain conditions.
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Internal Ratings-Based Approach (Credit Risk) - Corporate
1
An exposure to a corporation, partnership
or proprietorship falls under this category.
Some special guidelines may apply if the
corporation is small or medium-sized entity
(Small and medium enterprises|SME). As
noted above, there are five sub-classes of
specialized lending under this asset class -
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Internal Ratings-Based Approach (Credit Risk) - Corporate
1
*Project Finance - financing industrial
projects based upon the projected cash
flows of the particular project
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Internal Ratings-Based Approach (Credit Risk) - Corporate
*Object Finance - financing physical
assets based upon the projected cash
flows obtained primarily through the rental
or lease of the particular assets
1
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Internal Ratings-Based Approach (Credit Risk) - Corporate
*Structured Trade Commodity
Finance|Commodities Finance - financing
the reserves, receivables or inventories of
exchange-traded commodities where the
exposure is paid back based on the sale of
the commodity rather than by the borrower
from independent funds
1
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Internal Ratings-Based Approach (Credit Risk) - Corporate
1
*Income-producing real estate - financing
real—estate that is usually rented or
leased out by the debtor to generate cash
flow to repay the exposure
https://store.theartofservice.com/the-credit-risk-toolkit.html
Internal Ratings-Based Approach (Credit Risk) - Corporate
1
*High-volatility commercial real estate financing commercial real estate, which
demonstrate a much higher volatility of
loss rates as compared to other forms of
specialized lending
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Internal Ratings-Based Approach (Credit Risk) - Sovereign
1
This generally refers to a loan made to a
particular country. Under the Basel II
guidelines, this class also includes the
central banks of various countries, certain
government-owned corporation|public
sector enterprises (PSEs) and the
multilateral development banks (MDBs)
that meet the criteria for a 0% risk weight
under the Standardized approach (credit
risk)|standardized approach.
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Internal Ratings-Based Approach (Credit Risk) - Bank
Loans made to banks or securities
firms subject to regulatory capital
requirements come under this
category. Certain domestic PSEs or
MDBs that do not meet the criteria for a
0% risk weight under the standardized
approach also fall in this category.
1
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Internal Ratings-Based Approach (Credit Risk) - Retail
1
Loans made to individuals fall under this
category. Credit cards, overdrafts or
mortgage loan|residential mortgages are
some of the common retail lending
products treated as part of this category in
the IRB approach. Subject to a maximum
of 1 million euros, exposures to small
businesses managed as retail exposures
also fall under this category.
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Internal Ratings-Based Approach (Credit Risk) - Retail
Retail exposures are usually not
managed by the bank on an individual
basis for risk rating purposes, but as
groups of exposures with similar risk
characteristics. The sub-classes of
exposures falling into this category
are 1
https://store.theartofservice.com/the-credit-risk-toolkit.html
Internal Ratings-Based Approach (Credit Risk) - Retail
*Qualifying revolving exposure
(QREs)
[http://www.fsa.gov.uk/pubs/internat
ional/exposures.pdf FSA Staff
Paper:Qualifying Revolving Retail
Exposures] - unsecured revolving
exposures where the undrawn portion
of the exposure is unconditionally
cancellable by the bank
1
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Internal Ratings-Based Approach (Credit Risk) - Equity
Direct ownership interests in the assets
and income of a financial institution, or
indirect interests through for example
derivatives come under this category. For
an exposure to qualify under this category,
the return of the funds invested on the
equities can be only realized through their
sale or by liquidation of the issuer of these
equities.
1
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Internal Ratings-Based Approach (Credit Risk) - Foundation and advanced
approaches
1
To calculate capital requirements for all banking
exposures, there are three main elements
https://store.theartofservice.com/the-credit-risk-toolkit.html
Internal Ratings-Based Approach (Credit Risk) - Foundation and advanced
approaches
*Risk parameters - Probability of
default(PD), Exposure at default(EAD),
Loss Given Default(LGD), Maturity(M)
1
https://store.theartofservice.com/the-credit-risk-toolkit.html
Internal Ratings-Based Approach (Credit Risk) - Foundation and advanced
approaches
*Risk-weight functions - Functions
provided as part of the Basel II
regulatory framework, which maps the
risk parameters above to risk-weighted
assets
1
https://store.theartofservice.com/the-credit-risk-toolkit.html
Internal Ratings-Based Approach (Credit Risk) - Foundation and advanced
approaches
*Minimum requirements - Core
minimum standards that a bank must
satisfy to use the Internal RatingsBased Approach
1
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Internal Ratings-Based Approach (Credit Risk) - Foundation and advanced
approaches
In this approach, banks calculate
their own PD parameter while the
other risk parameters are provided by
the bank's national supervisor
1
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Internal Ratings-Based Approach (Credit Risk) - Foundation and advanced approaches
1
In this approach, banks calculate their own
risk parameters subject to meeting some
minimum guidelines.
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Internal Ratings-Based Approach (Credit Risk) - Foundation and advanced approaches
However, the foundation
approach is not available for
Retail exposures.
1
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Internal Ratings-Based Approach (Credit Risk) - Foundation and advanced approaches
1
For equity exposures, calculation of riskweighted assets not held in the trading
book can be calculated using two different
ways: a PD/LGD approach or a marketbased approach.
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Internal Ratings-Based Approach (Credit Risk) - Minimum Requirements
To adopt the IRB approach and its
continued use, a bank must satisfy
certain minimum requirements that it
can demonstrate to the national
supervisor. They are described in the
following twelve sub-sections.
1
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Internal Ratings-Based Approach (Credit Risk) - Composition
1
The minimum requirements
state that estimates of risk
parameters must
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Internal Ratings-Based Approach (Credit Risk) - Composition
* Provide for a
meaningful
differentiation of
risk
1
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Internal Ratings-Based Approach (Credit Risk) - Composition
1
* Be accurate and consistent in the
estimation of risk
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Internal Ratings-Based Approach (Credit Risk) - Composition
1
The risk parameters must also be consistent
with their use in making risk management
decisions.
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Internal Ratings-Based Approach (Credit Risk) - Composition
The minimum
requirements apply to all
asset classes.
1
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Internal Ratings-Based Approach (Credit Risk) - Compliance
To adopt the IRB approach, a bank
must demonstrate ongoing
compliance with the minimum
requirements. If a bank does not
satisfy the minimum requirements at
any point of time, they must submit to
the supervisor a plan outlining how
they intend to return to compliance
along with definite timelines.
Supervisors may take appropriate
action or require the banks to hold
additional capital in case of non1
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Internal Ratings-Based Approach (Credit Risk) - Rating System Design
Rating system refers to the entire
mathematical and technological
infrastructure a bank has put in place to
quantify and assign the risk parameters.
Banks are allowed to use multiple ratings
systems for different exposures, but the
methodology of assigning an exposure to
a particular rating system must be logical
and documented; banks are not allowed to
use a particular rating system to minimize
1
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Internal Ratings-Based Approach (Credit Risk) - Rating System Design
1
A rating system must
be designed based on
two dimensions
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Internal Ratings-Based Approach (Credit Risk) - Rating System Design
1
*Borrower characteristics indicating the
propensity of the borrower to default
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Internal Ratings-Based Approach (Credit Risk) - Rating System Design
1
*Transaction specific factors like the nature of the
product, terms of repayment, collateral, etc.
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Internal Ratings-Based Approach (Credit Risk) - Rating System Design
For retail exposures, delinquent exposures
should be identified separately from those that
are not.
1
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Internal Ratings-Based Approach (Credit Risk) - Rating System Design
A rating system typically assigns a
borrower to a particular grade based on
their probability of default. To avoid
excessive concentration of borrowers in
one particular grade, a bank must have a
minimum of seven borrower grades for
non-defaulted exposures and one for
those that default. For retail exposures,
banks should be able to quantify the risk
parameters for each pool of exposures.
1
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Internal Ratings-Based Approach (Credit Risk) - Rating System Design
1
Rating systems must be clear and well
documented. They must enable a third
party, like internal audit or
independent reviewer, to replicate the
assignment of ratings and their
appropriateness. All relevant up to
date information must be used in the
assignment of ratings. A bank must be
conservative in its estimates if there
is a lack of data to accurately quantify
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Internal Ratings-Based Approach (Credit Risk) - Rating System Design
1
Credit scoring models are allowed to
play a role in the estimaton of the risk
parameters as long as sufficient
human judgment not captured by the
model is taken into account to assign
the final rating to a borrower
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Internal Ratings-Based Approach (Credit Risk) - Rating System Operations
The requirements state that for
corporate, sovereign or bank
exposures all borrowers and
guarantors must be assigned a rating
as part of the loan approval process.
The process by which a rating is
assigned and the actual ratings
assigned must be reviewed periodically
by a body independent of those making
loan approval decisions. Ratings must
1
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Internal Ratings-Based Approach (Credit Risk) - Rating System Operations
All data relevant to assignment of
ratings must be collected and
maintained by the bank. The data
collected is not only beneficial for
improving the credit risk management
process of the bank on an ongoing
basis, but also required for necessary
supervisory reporting.
1
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Internal Ratings-Based Approach (Credit Risk) - Rating System Operations
1
Banks are also required to regularly stress
test their rating systems considering
economic downturn scenarios, market risk
based events or liquidity conditions that
may increase the level of capital held by
the bank. These stress tests should not
only consider the relevant internal data of
the bank, but also macro-economic factors
that might affect the accuracy of the rating
system.
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Internal Ratings-Based Approach (Credit Risk) - Corporate Governance and Oversight
1
The rating systems should be approved by
the Bank's board of directors and they
should be familiar with the management
reports created as part of the rating
systems. Senior management should
regularly review the rating system and
identify areas needing improvement.
Reporting is required to include
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Internal Ratings-Based Approach (Credit Risk) - Corporate Governance and Oversight
1
*a comparison of the actual default rates against
the expected as predicted by the rating system
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Internal Ratings-Based Approach (Credit Risk) - Corporate Governance and
Oversight
Banks must have independent
functions responsible for development
and ongoing monitoring of the rating
systems.
1
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Internal Ratings-Based Approach (Credit Risk) - Corporate Governance and Oversight
1
An internal audit function, or equally
independent function, must review the
rating system at least once a year and
the findings from such a review must
be documented.
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Internal Ratings-Based Approach (Credit Risk) - Use of Internal Ratings
Banks must satisfy the 'use
test',[http://www.bis.org/publ/bcbs_nl9.pdf
The IRB Use Test] which means that the
ratings must be used internally in the risk
management practices of the bank. A rating
system solely devised for calculating
regulatory capital is not acceptable. While
banks are encouraged to improve their rating
systems over time, they are required to
demonstrate the use of risk parameters for
risk management for at least three years prior
to obtaining qualification.
1
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
Overall requirements
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*Except for retail exposures, PD for a
particular grade must be a long-run
average of one year default rates for
that grade
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
*For those bankings using the
advanced approach, a long run
default-weighted average EAD must
also be estimated
1
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*The internal estimates must take into account all
relevant internal and external data available
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*The estimates must be based on sound
historical and empirical evidence and not
purely judgmental
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*A layer of conservatism should be added
to the parameter estimates to control for
errors during their estimation
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
Definition of default
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*Borrower is unlikely to pay its
credit obligations in full
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
*Borrower is 90 days past due on
payment - for overdrafts, a breach on
provided credit limit results in it being
'past due'
1
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*Borrower has been
placed in bankruptcy
protection
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
*For retail exposures, a borrower
defaulting on a particular exposure
need not result in all exposures to the
borrower being in default
1
https://store.theartofservice.com/the-credit-risk-toolkit.html
Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
Loss, when estimating LGD, is economic
loss and not accounting loss. This means
that all material direct and indirect costs,
as well as recoveries, must be discounted
back to the point of default. The bank must
clearly demonstrate the choice of the
discount rate to the supervisor.
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
Important considerations in
quantifying risk parameters
include:
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*PD estimates may be derived based on
one or more of the following techniques internal default experience, mapping to
external data, statistical default models.
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*For retail exposures, the primary driver of PD
estimates must be internal data.
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
*Seasoning effects
should be considered for
retail exposures.
1
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*LGD estimates should be based
on economic downturn conditions.
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*LGD estimates should be based on historical
recoveries as well as any existing collateral.
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*For exposures already in default, LGD
should be estimated as the best estimate
of expected loss on the asset considering
the current economic climate.
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*For closed-end exposures, EAD must
not be lower than the current
outstanding balance owed to the bank.
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
1
*For revolving exposures, EAD should take into
account any undrawn commitments.
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Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
*For corporate, sovereign or bank
exposures, LGD and EAD estimates
should be based on a full economic cycle
and must not be shorter than a period of
seven years.
1
https://store.theartofservice.com/the-credit-risk-toolkit.html
Internal Ratings-Based Approach (Credit Risk) - Risk Quantification
*For retail exposures, the estimates
should be based on minimum five
years of data unless the bank can
demonstrate that recent data is a better
predictor of the estimates.
1
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Internal Ratings-Based Approach (Credit Risk) - Validation of internal estimates
Banks must have well-defined
processes to estimate the accuracy and
consistency of their rating systems.
1
https://store.theartofservice.com/the-credit-risk-toolkit.html
Internal Ratings-Based Approach (Credit Risk) - Supervisory LGD and EAD estimates
1
Banks using the foundation approach use
supervisory estimates of EAD and LGD.
However, they must be meet the minimum
requirements of the standardized
approach for recognition of eligible
collateral.
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Internal Ratings-Based Approach (Credit Risk) - Requirements for recognition of leasing
1
Leases other than those that expose the
bank to residual value risk are accorded
the same treatment as exposures
collateralised by the same type of
collateral.
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Internal Ratings-Based Approach (Credit Risk) - Calculation of capital charges for equity
exposures
1
The capital charge for equity exposures is
defined in the Basel Accord as follows -
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Internal Ratings-Based Approach (Credit Risk) - Calculation of capital charges
for equity exposures
The capital charge is equivalent to the
potential loss on the institution’s equity
portfolio arising from an assumed
instantaneous shock equivalent to the 99th
1
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Internal Ratings-Based Approach (Credit Risk) - Calculation of capital charges for equity
exposures
1
percentile, one-tailed confidence interval
of the difference between quarterly returns
and an appropriate risk-free rate computed
over a long-term sample period.
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Internal Ratings-Based Approach (Credit Risk) - Calculation of capital charges for equity
exposures
Further
requirements are
summarized below 1
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Internal Ratings-Based Approach (Credit Risk) - Calculation of capital charges for equity
exposures
1
*Estimated losses should be based on
sound statistical judgment and should be
stable under adverse market movements
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Internal Ratings-Based Approach (Credit Risk) - Calculation of capital charges
for equity exposures
*Models should be adjusted to
demonstrate that it provides a
conservative estimate of long-run loss
experience
1
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Internal Ratings-Based Approach (Credit Risk) - Calculation of capital charges
for equity exposures
1
*The Accord does not require the use of
a particular kind of model but requires
that all risk be embedded in the
process.
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Internal Ratings-Based Approach (Credit Risk) - Calculation of capital charges
for equity exposures
1
*Stress testing taking into account various
assumptions on volatility and hypothetical
scenarious should be conducted
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Internal Ratings-Based Approach (Credit Risk) - Calculation of capital charges
for equity exposures
1
*The models should be integrated into
the risk management process;
including setting hurdle rates and
evaluating risk-adjusted performance
https://store.theartofservice.com/the-credit-risk-toolkit.html
Internal Ratings-Based Approach (Credit Risk) - Calculation of capital charges for equity
exposures
1
*The models must be regularly monitored by an
independent team and all assumptions verified
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Internal Ratings-Based Approach (Credit Risk) - Disclosure requirements
Banks must meet the disclosure
requirements as mandated by the market
discipline|third pillar of the Basel
framework. Failure to meet these
requirements makes the bank ineligible to
use the IRB approach.
1
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Internal Ratings-Based Approach (Credit Risk) - Treatment of Expected Losses and
Recognition of Provision
1
A bank is required to compare the total
expected losses with the total eligible
provisions. If the expected loss amount
is less than the provisions, the
supervisor must consider if this is a
true picture of reality, and then include
the difference in Tier II capital. The
expected losses for equity exposures
under the PD/LGD approach is
deducted 50% from Tier I and 50% from
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Financial risk - Credit risk
1
An investor can also assume credit risk
through direct or indirect use of Leverage
(finance)|leverage
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Financial risk - Financial / Credit risk related acronyms
1
'KMV' quantitative credit analysis solution developed
by credit rating agency Moody's
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Financial risk - Financial / Credit risk related acronyms
1
VaR value at risk, a common methodology for
measuring risk due to market movements
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Subprime crisis background information - Credit risk
1
Traditionally, lenders (who were primarily
savings and loan association|thrifts) bore
the credit risk on the mortgages they
issued
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Subprime crisis background information - Credit risk
This originate to distribute model
means that investors holding MBS and
CDOs also bear several types of risks,
and this has a variety of
consequences. In general, there are
five primary types of risk:Robin
Blackburn,
[http://www.newleftreview.org/?getp
df=NLR28403pdflang=en Subprime
Crisis], New Left Review, March–
1
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Subprime crisis background information - Credit risk
1
By the beginning of the 21st century,
these innovations had created an
originate to distribute model for
mortgages, which means that
mortgage became almost as much
securities as they were loans. Because
subprime loans have such high
repayment risk, the origination of
large volumes of subprime loans by
thrift institutions or commercial
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Subprime crisis background information - Credit risk
From a systemic perspective, the
dominance of securitization has made
the risks of the mortgage market
similar to the risks of other securities
markets, particularly non-regulated
securities markets. In general, there
are five primary types of risk in these
markets:
1
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Subprime crisis background information - Credit risk
1
This means that in the mortgage market,
borrowers no longer have to default and
reduce cash flows very significantly before
credit risk rises sharply
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Subprime crisis background information - Credit risk
1
Investors in MBS can insure against
credit risk by buying CDS, but as risk
rises, counterparties in CDS contracts
have to deliver collateral and build up
reserves in case more payments
become necessary
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Loan origination - Decisioning credit risk
The Mortgage loan|mortgage business
consists of a few people: the borrower, the
lender, and sometimes the mortgage
broker
1
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Loan origination - Decisioning credit risk
1
Not only does one's credit score affect
their qualification, the fact of the
matter also lies in the question, Can I
(the borrower) afford this mortgage?
In most cases the borrower can afford
their mortgage
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Loan origination - Decisioning credit risk
1
Example: if the borrower owes $1,500
in credit card payments and makes
$3,000 in a month: his DTI ratio would
be - 50%. But if the borrower owes
$1,500 in payments and makes $2,000
in a month, his DTI ratio would be 75%. This ratio is seen by many lenders
as high and too risky a person to lend
to and may or may not be able to afford
the mortgage.
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Loan origination - Decisioning credit risk
1
So that covers qualification, now on to the important
appraising of the collateral.
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Country risk - Partial list of credit risk rating agencies
*
[http://businessmonitor.
com Business Monitor
International]
1
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Default risk - Assessing credit risk
1
Significant resources and sophisticated
programs are used to analyze and
manage
risk.[http://www.bis.org/publ/bcbs126.htm
BIS Paper:Sound credit risk assessment
and valuation for loans] Some companies
run a credit risk department whose job is
to assess the financial health of their
customers, and extend credit (or not)
accordingly
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Default risk - Assessing credit risk
Most lenders employ their own models (credit
scorecards) to rank potential and existing customers
according to risk, and then apply appropriate
strategies.[http://www.crc.man.ed.ac.uk/conference/a
rchive/2007/papers/huang-and-scott.pdf Huang and
Scott:Credit Risk Scorecard Design, Validation and User
Acceptance] With products such as unsecured personal
loans or mortgages, lenders charge a higher price for
higher risk customers and vice
versa.[http://www.investopedia.com/terms/r/riskbased_mortgage_pricing.asp Investopedia: Risk-based
mortgage
pricing][http://www.crc.man.ed.ac.uk/conference/arc
hive/2003/presentations/edelman.pdf Edelman: Risk
based pricing for personal loans] With revolving
products such as credit cards and overdrafts, risk is
controlled through the setting of credit limits
1
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Consumer credit risk
1
The following article is
based on UK market,
other countries may
differ.
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Consumer credit risk
1
'Consumer Credit Risk' (AKA 'Retail Credit
Risk') is the risk of loss due to a
customer's non re-payment (default) on a
consumer credit product, such as a
mortgage, unsecured personal loan, credit
card, overdraft etc. (the latter two options
being forms of unsecured banking credit).
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Consumer credit risk - Consumer Credit Risk Management
1
Most companies involved in lending to
consumers have departments
dedicated to the measurement,
prediction and control of losses due to
credit risk. This field is loosely referred
to consumer/retail credit risk
management, however the word
management is commonly dropped.
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Consumer credit risk - Scorecards
See full article
(Credit Scorecards)
1
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Consumer credit risk - Scorecards
1
A common method for predicting credit
risk is through the credit scorecard.
The scorecard is a statistically based
model for attributing a number (score)
to a customer (or an account) which
indicates the predicted probability that
the customer will exhibit a certain
behaviour. In calculating the score, a
range of data sources may be used,
including data from an application
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Consumer credit risk - Scorecards
1
The most widespread type of scorecard in
use is the 'application scorecard', which
lenders employ when a customer applies
for a new credit product
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Consumer credit risk - Scorecards
Other scorecard types may include
'behavioural scorecards' - which try to
predict the probability of an existing
account turning bad; 'propensity
scorecards' - which try to predict the
probability that a customer would
accept another product if offered one;
and 'collections scorecards' - which try
to predict a customer's response to
different strategies for collecting owed
1
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Consumer credit risk - Credit Strategy
1
Credit strategy is concerned with turning
predictions of customer behaviour (as
provided by scorecards) into a decision
whether to accept their custom.
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Consumer credit risk - Credit Strategy
1
To turn an application score into a Yes/No decision,
cut-offs are generally used
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Consumer credit risk - Credit Strategy
1
Application score is also used as a factor
in deciding such things as an overdraft or
credit card limit. Lenders are generally
happier to extend a larger limit to higher
scoring customers than to lower scoring
customers, because they are more likely
to pay borrowings back.
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Consumer credit risk - Credit Strategy
1
Alongside scorecards lie policy rules which
apply regulatory requirements (such as
making sure there is no lending to under
18s) and other lending policy (such as
many lenders will not lend to customers
who have a County court judgment|CCJ
registered against them).
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Consumer credit risk - Credit Strategy
Credit Strategy is also concerned with
the ongoing management of a customer's
account, especially with revolving credit
products such as credit cards, overdrafts
and flexible loans, where the customer's
balance can go up as well as down.
Behavioural scorecards are used
(usually monthly) to provide an updated
picture of the credit-quality of the
customer/account. As the customer's
profile changes, the lender may choose
to extend or contract the customer's
limits.
1
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Consumer credit risk - Underwriting
Not all decisions can be made
automatically through the methods
mentioned above. This may be for a
number of reasons; insufficient data,
regulatory requirements, or a borderline
decision. In such cases highly trained
professionals called underwriters manually
review the case and make a decision. This
is more common in highly regulated
products such as mortgages, especially
when large sums are involved.
1
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Simple interest - Interest rates and credit risk
It is increasingly recognized that
during the business cycle, interest
rates and credit risk are tightly
interrelated. The Jarrow-Turnbull
model was the first model of credit
risk that explicitly had random
interest rates at its core. Lando (2004),
Darrell Duffie and Singleton (2003),
and van Deventer and Imai (2003)
discuss interest rates when the issuer
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Person-to-person lending - Credit risk
Peer-to-peer lending also attracts
borrowers who, because of their credit
status or the lack thereof, are
unqualified for traditional bank loans
1
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Person-to-person lending - Credit risk
1
The actual default rates for the loans
originated by Prosper in 2007 were in
fact higher than projected
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