Chap 4 Credit Risk

Financial Intermediation Chapter 7 - Analysing
Bank’s Performance
Chapter 2
Banking Regulations
-Bank runs and how to
over come it
Chapter 1 - Theories of
Financial Intermediation
-What do banks do? Chapter 3 - Risks in
Banking
-Introduction to other
risks Chapter 4 - Credit Risks
Credit Chapter 6 - Risk

Transfer Securitization
Country
& Credit Derivatives
Market
Interest Chapter 8 - Risk

Management with
Liquidity derivatives
Chapter 5
ALM –Liquidity, Interest Operations
rate Risk
Solvency
Prepared by Adam Wong
Chapter 4 – Credit Risks

Constituents of credit risk
Default risk
Exposure Article on rating Agencies
Recovery http://www.ceps.eu/files/article/2011/10/Forum.pdf
Expected loss – risk measurement
Types Lending risks

Obligor risk
Facility risk
Credit rating systems – determine PD

Internal credit rating systems
Qualitative model
Constrained expert judgment based model
Quantitative model
Scoring model
Linear probability model
Logit model
Term structure model
Option based model
External credit rating systems
International rating agencies
National rating agencies
Types of errors
Credit Risk management

Credit allocation
Credit enhancement
Loan sales
Risk based pricing – chapter 7
Credit derivatives – chapter 6
2
3
Aims
• Demonstrate the importance of credit risk within banks
• Explain the distinction between internal and external credit rating

systems
• Introduce the three elements of credit risk and the issue of risk or
rating migration
• Illustrate the various possible approaches to credit risk management

and modeling.
4
5
Learning Outcomes
Be able to:
• Describe and evaluate the importance of credit risk
• Describe and evaluate the role of internal and external credit ratings
• Explain the alternative methods available to banks for credit risk

modeling and management.
6
Chapter Summary
Definition of Credit Risk
Default Risk
Constituents of Credit Risks Exposure Risk Expected Loss
Migration Risks Recovery Risk
Credit Risk Models

Types of Risk • Qualitative
Internal • Quantitative
Risk Assessment System
Rating System
• Linear probability
External • Logit
• Linear discriminate
System • Term structure
• Option based
• Credit Allocation
Credit Risk Management • Credit Enhancement Errors
• Loan Sales
• Risk Based Pricing
• Credit Derivatives
7
8
Introduction
• Credit risk definition – the potential that a bank borrower or
counterparty will fail to meet its obligations in accordance with
agreed terms
• Credit risk is measured by exposure (i.e. the amount that can

potentially be lost if a borrower defaults).
EL = PD x EAD x (1-R)
• Amount could differ from the actual loss in the event of default
because of possible recoveries.
• Credit risk also depends on the probability of default occurring and

the extent to which the risk can be mitigated in order to reduce loss
should default occur.
Amount
owing at Recoverable due
Borrower default to collateral
Events Default EAD
Actual Loss
Probability?
9
Prepared by Adam Wong Mitigation Actions
Need to know what the

components are and how the
risk of each component can be
Definition of Credit Risk managed
Default Risk
Types of Risk Credit Risk Models

Internal • Qualitative
Risk Assessment System • Quantitative
Rating System
External • Logit
• Option based
• Loan Sales
10
Migration Risk is NOT a
constituent of Credit Risk
L = D x X x (1-R)
11
Summary - Components of Credit Risks
Credit risk constitutes three elements:
1. Default Risk (D)
2. Exposure Risk (X)

Expected Loss
Loss Given Default
3. Recovery Risk (1-R)

EL = D x X x (1-R)
Loss Rate
The loss given default is comprised
of an uncertain exposure (X) and an
Details of each component in the following slides
uncertain recovery rate (R).
12
EL = D X EAD X (1-R)
Definition of Default
• Default can be defined in several ways:
1. missing a payment obligation,

Events of Default
2. breaking a covenant (agreement on something),
3. entering a legal procedure (e.g. appointment of a judicial manager) or

economic default.
• occurs when the economic value of assets falls below the value of
outstanding debts.
• Default does not necessarily lead to immediate losses (to lenders),

but may increase the likelihood of bankruptcy (of the borrower).
• Credit rating agencies - consider that default has occurred when a

contractual payment has been missed for at least three months.
13
Effects of Event of Default Occurring
• Borrower has no obligation to repay loans until it is due for

repayment.
Date Amount Due Obligation to pay this installment
Now Jan-16 10,000
Feb-16 10,000
Mar-16 10,000
Apr-16 10,000
May-16 10,000
Jun-16 10,000
Jul-16 10,000 No obligation to repay these amounts
Aug-16 10,000
Sep-16 10,000
which are not due
Oct-16 10,000
• When event of default occurs, the loan maturity is accelerated
Time of Event Date Amount Due

Jan-16 10,000
of Default is
Feb-16 10,000
declared Mar-16 10,000
Apr-16 10,000
May-16 10,000
Jun-16 10,000
All future installments becomes
Jul-16 10,000 repayable when event of default
Aug-16 10,000 occurs
Sep-16 10,000
Oct-16 10,000 14
Factors Affecting Default
The probability of default depends on factors such as

• Market outlook,
• Company size,
• Competitive factors,
• Quality of management,
• Quality of shareholders.
Details on Risk Analysis in later slides
15
How Ratings Are Correlated to Other Factors?
Summary We can use credit

rating to give us an idea
of probability of default
Reflect
Further discussion on
Default rating system later
Probability
Credit
Ratings
Impact
Borrowing
cost
16
Relationship Between Credit Ratings and Default

What is a Credit Rating?
• Common measures of the probability of default are either credit ratings
or historical statistics on defaults.
What does it do?
• A credit rating is a summary indicator of the risk inherent in an
individual credit
• Credit ratings rank the credit standing of debt issuers.
Reflect
Default
Probability
Credit
Ratings
Impact
Borrowing
cost
17
1-Correlation Between Ratings And Default Frequencies
e
30
25
20
Investment 15
Grade 10
5
0
Aaa ……………………………….Caa1-c
Speculative
Grade

18 c
Interpretation of Table
a) Default rates are close to zero for the best risk qualities (highest
ratings - Aaa), especially over short horizons.
b) The rates increase to around 20 per cent within one year for the
lowest rating categories → Caa1-C.
c) For investment grade borrowers, the default rate is below 1.5 per
cent (even up to eight years hence).
d) Rate for speculative grade borrowers ranges from 3.7 per cent after
one year to 28.7 per cent after eight years.
e) The default rate increases exponentially as the ratings worsen.
19
How Ratings Are Correlated to Other Factors
Summary
Reflect
Default
Probability
Credit
Ratings
Impact
Borrowing
cost
20
2-Correlation Between Ratings and Borrowing Cost
• External rating plays an important role in the cost of borrowing

– This has been a major factor in the expansion of ratings over recent
years.
• Typically, the better the rating, the lower the cost of borrowing (i.e.
the lower the yield to maturity).
Moody’s long-term US corporate bond yields (%) for different rating Categories
Rating Category Oct 00 Dec 05 Dec 08 Diff bet

Aaa 7.44 5.26 4.74 lowest &
Aa1 7.75 0.85 5.41 0.95 5.48 3.31 highest
Aa2 8.06 5.47 6.32 rate
Baa 8.29 6.21 8.05
Further discussion on internal vs external ratings in later slides

21
Default Risk Management
• Higher rates on loans for more risky borrowers. (Risk Based Pricing)
• Diversify across different types of borrowers
Default Risk
Management
Risk Exposure Risk

Management Management
Recovery Risk
Management
22
23
Definition of Exposure Risk - EAD
• Exposure risk is the amount at risk* in the event of default excluding

recoveries.
• Since default occurs at an unknown future date, the risk is

generated by the uncertainty regarding future amounts at risk.
estimate
Unused
Additional
Amount
Bank usage given
($60)
Commitment default
EAD -
to Lend ($50)
exposure at
($100)
Current default = $90
Outstanding * the amount that
($40) can potentially be
lost
Drawn amount Factors affecting the

amount of exposure at
Agreement by the bank to lend up to a certain amount default – (see next
slide)
24
Factors Affecting Exposure Risk
Depends on loan structure
The type of commitment given by the bank to the borrower sets an

upper limit on possible future exposures.
• Amortised loans
• Revolving lines
1. Amortised Loans - Lines of credit with a repayment schedule,

exposure risk is reduced over time.
– Exposure can be considered small towards tail end of loan life.
Types of repayment schedule - Details in next slide
25
Amortised Balloon Bullet

Repayment Repayment Repayment
Princ Princ Princ
P Outstanding Repayment P Outstanding Repayment P Outstanding Repayment
Now 100,000 100,000 100,000
End yr 1 90,000 10,000 98,000 2,000 100,000 -
End yr 2 80,000 10,000 96,000 2,000 100,000 -
End yr 3 70,000 10,000 94,000 2,000 100,000 -
End yr 4 60,000 10,000 80,571 13,429 100,000 -
End yr 5 50,000 10,000 67,143 13,429 100,000 -
End yr 6 40,000 10,000 53,714 13,429 100,000 -
End yr 7 30,000 10,000 40,286 13,429 100,000 -
End yr 8 20,000 10,000 26,857 13,429 100,000 -
End yr 9 10,000 10,000 13,429 13,429 100,000 -
End yr 10 - 10,000 - 13,429 - 100,000
100,000 100,000 100,000
80,000 80,000 80,000
60,000 60,000 60,000
40,000 40,000 40,000
20,000 20,000 20,000
- - -
Amortised Balloon Bullet

Repayment Repayment Repayment
26
Factors Affecting Exposure Risk
2. Revolving lines - Borrower may draw on these lines of credit

within a limit set by the bank, as borrowing needs arise.
– Possibility of 100% utilisation of credit limit.
100%
Loan
amount
utilised
0%
Time
EAD Video 27
Exposure Risk Management
• Restricting / rationing loans to more risky borrowers
• Credit allocation
– Set max amount at risk with borrowers
– Limit system - Centralized information on authorised amount and line
usage
Default Risk
Management
Risk Exposure Risk

Management Management
Recovery Risk
Management
EAD Video 28
29
Default Risk
Management
Exposure Risk
Risk Management
Management
Recovery Risk
Management
30
Recognition of Risk Mitigation Techniques Under
Basel II
• Basle II Accord on banks’ capital requirements (see Chapter 2)

provides capital reductions for various forms of transactions that
reduce risk.
• The Accord grants recognition of credit risk mitigation techniques,

including
– collateral and Recovery Risk Management
– guarantees.
See next slide for

further details
31
32
Linkages with Various Chapters Chapter 6
Chapter 4
Securitisation
2-Limitation
Chapter 3
Principles of
1-Selection Credit risk 3-Diversification
Management
4-Enhancement
Chapter 4
Chapter 4 Collateral
Guarantee Chapter 6
Covenants Credit derivatives
Components of EL used
Chapter 4 in regulatory capital
Chapter 3
Chapter 2
33
Recovery In The Event of Default (by Borrower) EL = D X EAD X (1-R)
Recoveries in the event of default are unpredictable.

E.g breech of minor covenants v.s non
repayment due to business failure
• Recoveries depends on the type of default and the collateral /

guarantees received from the borrower.
• Recoveries require legal procedures, expenses and a significant

lapse of time. Recovery outcome is improved by the use of credit
enhancements.
• Typical Credit Enhancement are:

– Collateral,
– Guarantees, Details in next slide
– Covenants, 34
Recovery Risk Management
Risk Mitigation Techniques
There are further detailed discussion in the last section on Credit Risk Management
Transform Credit risk into

Collateral
Asset Risk
Third-Party Risk shift from borrower to

Guarantee borrower + guarantor
Pre-emptive → Reduce
Covenants
Moral Hazard of Borrower.
35
Use of Collateral to ↑ Recovery
• Collateral reduces credit risk
– if it can be taken over and sold at significant value.
• Collateral can take the form of cash, financial assets or fixed assets.
• Collateral transform credit risk into

1. asset value risk
• the realisable value of collateral. Asset Value
- Recovery Cost
Net realisable value
2. recovery risk
• disposal and the costs incurred in realising its value.
Example of asset value risks

• Cash : collateral risk is zero
• Financial assets (e.g. shares) : subject to market risks which impact
realisable value.
• Property : Market risk + Agent cost to sell
36
Realization of Collateral Value
• Valuation
– Depends on types of assets taken as collateral
• Priority in the event of multiple creditors

1. Secured creditors
2. Preferential creditors (in the case of winding up)
3. Unsecured creditors
i. Senior creditors
ii. Junior creditors (subordinated debts)
Summary – Realised value of collateral
1. Asset value – recovery cost = net realisable value

2. Relative ranking in order of value distribution
37

Collateral
Asset Risk

Pre-emptive → Proactive
Covenants
corrective action.
38
Use of Guarantee to ↑ Recovery
• Guarantees are contingencies given by third parties to banks.
• For example, the parent within a group of companies may guarantee

to honour the obligations of one of its subsidiaries in the event of
default.
• For guarantee to be effective, guarantor must have a lower PD than

the borrower.
Bank
Loan Guarantee
(Lender)
Borrower Guarantor
(Higher PD) (Lower PD)
e.g. subsidiary e.g. parent co
Guarantee received a bank

v.s
39
Guarantee given by a bank

Collateral
Asset Risk

Pre-emptive → Proactive
Covenants
corrective action.
Acts that borrower must or must not do to prevent moral hazard by the
borrower
Detailed discussion in last section under Credit Risk Management - Credit Enhancement
40
Examples of Covenants
Financial Non-Financial
Affirmative The borrower shall The borrower shall
maintain its current ensure that its assets
ratio exceeding 1.3 are adequately insured
x at all times
Negative The borrower shall The borrower shall not
not allow its gearing disposed of its assets
ratio (Total without the consent of
Liabilities / Equity) the lender
to exceed 3 x
41
Result
42
How Is Expected Loss Determined EL = D X EAD X (1-R)
Amount
Percentage
Probability owing when
of loss from
of borrower borrower
expected
defaulting defaults
exposure
PD LR
EL = X EAD X Loss Rate
Probability
Expected Exposure at Default
of Default
Loss at Default (1-recovery
over 1 year
rate)
Default Exposure Recovery

Risk Risk Risk
43
Computation of Expected Loss
Collateral Value 300,000
Dependent on Facility type, maturity, structure R= EAD
= 80% x 1,000,000
Credit Rating
Line Limit 1,000,000.00 1 Bank's internal model PD
Assumed usage at default 80% A 0.50%
Collateral value 300,000.00 37.5% 2 B 0.90%
Credit rating C C 1.10%
D 1.50%
E 1.90%
F 2.0%
Default Risk PD 1.1%

1
Exposure Risk EAD (Assumed usage at Default x line limit) 800,000.00
2
Recovery Risk LR (1-R) 62.5%
EL = PD x EAD x LR 5,500.00
The loss given default is comprised

of an uncertain exposure (X) and an
uncertain recovery rate (R).
44
Application of Expected Loss
• For a single loan, the expected loss never materializes as the loan
value is either its book value or its LGD [ EAD x (1-R) ]
• However, since no one knows which loan will default in the future, it
makes sense to set aside a fraction of each loan to absorb the
aggregated expected loss of the portfolio.
The EL concept is relevant at portfolio level.

• For a portfolio, the expected losses are additive and derived by
summing up individual expected losses.
• The regulations impose that such expected losses be provisioned.
• The regulatory capital measures unexpected losses in excess of

expected loss.
(Bessis – page 209, 210)
45
L1 10 Loans = $1,000 L10
EAD= $100
PDEAD=
= 10% $100 10% chance of default
PDEAD=
= 10% $100
(1-R)
PDEAD=
==100%10%$100
(1-R)
PD EAD=
= 100%
== 10%$100
EL = $10EAD=
(1-R) 100%$100
EL = PD == 10%
$10EAD= $100 1 out of 10 loans will default
(1-R)
EL = PD 100%
$10== 10%
(1-R)
EL = PD 100%
$10== 10%
EL(1-R)
= $10 =100%
(1-R) 100%
EL = $10
EL = $10 $100
Absorb the losses

EL Pot
Sum of EL = $100
Provision for bad debts
46
Drivers of EL
EL = PD X $ loss @ default
Likely hood of default occurring: EAD 1-R

Covenants – control
borrower’s behaviour Line limit x Usage at Default Asset value
Guarantor will improve PD Cost to recover
if it is of good credit Types of commitment
standing, better than the
borrower
Amortised Revolving
Loan Loan
Because amount repaid

cannot be re-drawn. EAD <
current o/s < 100% of line Usage Control
limit
Very lax controls;
usage at default =
100%
Very tight controls;

usage & default <
100% eg. 80%
47
Default Risk
Credit Risk Models

Rating System
External • Logit
• Option based
• Loan Sales
48
Shows how risk
changes over time
49
Migration Risk - Definition
• The probability that a borrower migrates from one risk class to any
other risk class.
• “A” → “Aa” - Improvements of the credit standing translate into

lower default probabilities.
• “A” → “Baa” – Deteriorations of the credit standing translate into

higher default probabilities.
• Migration probabilities arise from historical data.
50
Another Definition of Migration Risk
• The risk of a change in value caused by a deviation of the actual

probability of a future default by an obligor from the expected
probability of future default, adversely affecting the present value of
the contract with the obligor today.
from Solvency II Glossary (2007)

by European Commission
51
Changes in Migration States
• Default is one of the migration states.
• Migration to any state other than the default state does not trigger
any loss in book value, but the default probability changes.
• Default rates do not remain constant over time.
• Credit risk changes over time,

– these shifts can be captured in the transition matrices between rating
classes that are provided by the leading rating agencies.
Example of transition matrix in next slide
52
Transition Matrix of a Particular Portfolio
Averages of Annual Values Over Two Decades
79.2% of co rated Baa

remained in same grade 6.48% of Baa downgraded to Ba
6.02% of Baa migrated upward A
d
c
a) Concentration of high percentage age along the diagonal
Expected pattern
– indicating that a high proportion of ratings remain unchanged over each calendar year.
b) Transitions occur mostly in the neighboring classes of ratings.
c) +ve correlation between the initial rating and the proportion of defaults. (Good initial
ratings – lower default rate, Poorer initial higher – higher default rate)
d) Probability of default within a year far higher for the lower/poorer rating categories.
53
Empirical Findings
Average Cumulative Default Rates by Rating, 1983-2001 (An update of Subject Guide Table 4.3)
0.31% of Aaa companies defaulted after 6 years
a. Default frequencies
increase much more
Rating Year
than proportionally
a 1 2 3 4 5 6 7 8 when moving from
Aaa 0.00 0.00 0.00 0.07 0.22 0.31 0.41 0.53 low to high risk
Aa1 0.00 0.00 0.00 0.23 0.23 0.38 0.38 0.38 classes.
Aa2 0.00 0.00 0.06 0.19 0.42 0.51 0.61 0.73
Aa3 0.05 0.09 0.16 0.24 0.34 0.46 0.46 0.46
b. Cumulative default
A1 0.00 0.02 0.27 0.43 0.54 0.67 0.73 0.86
rates increase less
A2 0.04 0.10 0.28 0.57 0.77 0.98 1.12 1.51 than proportionally
A3 0.00 0.11 0.21 0.29 0.42 0.64 0.96 1.03 with horizon for
Baa1 0.12 0.40 0.69 1.10 1.52 1.81 2.16 2.37 good ratings, and
Baa2 0.09 0.39 0.76 1.46 2.18 2.98 3.68 4.20 more than
Baa3 0.37 0.88 1.51 2.47 3.26 4.40 5.57 6.72 proportionally for
Ba1 0.62 2.03 3.68 5.83 7.67 9.51 10.76 11.99 poorer ratings.
Ba2 0.62 2.43 4.75 7.33 9.55 11.27 13.29 14.81
Ba3 2.43 6.81 11.95 16.64 21.04 25.46 29.23 33.25 c. Default rates relate
B1 3.47 9.81 15.99 21.64 27.26 32.49 38.27 42.19 proportionately to
B2 7.18 15.65 22.96 28.87 33.57 36.80 39.43 41.18 the default rate
B3 12.45 21.81 29.63 35.80 41.13 45.05 47.94 52.04 volatility of each risk
Caa1-C 21.61 34.23 44.04 52.18 57.44 62.52 66.37 71.17 class.
Investment (default rates are low
grade 0.06 0.20 0.40 0.69 0.96 1.25 1.51 1.77 for the ratings which
Speculative are less volatile)
grade 3.99 9.07 13.96 18.33 22.23 25.64 28.72 31.39
All 1.34 3.02 4.62 6.04 7.24 8.27 9.17 9.92

Recap 1
1. What are the components / constituents of Credit

Risks
2. What is Default risks?
3. What is exposure risk?
4. What is recovery risk?
5. What is expected loss?
6. What is migration risk?
55
A15 Q4
Explain the constituents of credit risk and discuss how these risks
could be managed.
56
Default Risk
Constituents of Credit Risks Exposure Risk

Expected Loss
Credit Risk Models

Rating System
External • Logit
• Option based
• Loan Sales
57
58
Different Types of Risks - Overview
1. Obligor Risk (Intrinsic Risk) Ratings - the intrinsic rating of the

borrower
– Default risk of the borrower
– Assessment of supporting entity if any
2. Facility Risk Ratings

– recovery risk associated with each facility. (i.e. under what conditions
can the bank facility be used)
Details in following slides
59
Different Types of Lending Risks - Summary
Borrower’s Risks
Obligor's Risks
Supporting
Types of Entity’s Risks
Lending
Risks
Facility Risks
If a guarantee from a
third party is received
by the bank
60
Obligor’s Risks
Also know as Obligor or
intrinsic risk
Borrower’s risks
• assessment of the borrower’s strengths, weaknesses, competitive
advantage and financial data.
Supporting entity’s risk 4 Cs

• support can be formal (e.g. government owned companies) or Character
Capacity
• informal (e.g. the link between a holding company and a Condition
subsidiary) Capital
• Eventual internal rating should include Details in later slides
– intrinsic rating of the borrower,
– rating of the support entity
• assessment of any guarantees in place
61
Different Types of Lending Risks - Summary
Borrower’s Risks
Obligor's Risks
Supporting
Types of Entity’s Risks
Lending
Risks
Facility Risks
62
Facility Risks
Facility Risks is determined by:
• Type of exposure (facility type)
• How the facility is structured
• Mitigants e.g. seniority Facility Risks
Lower Risk Higher Risk

Type of Trade Finance Overdraft
exposure
(facility type)
How the Usage of funds must be Usage of funds at any time

facility is supported by confirmed
structured sales order
Mitigants e.g. Secured facility Unsecured facility

seniority
63
Relationship Between Obligor Risk & Facility Risk
Brand new Lending Decision

Startup Co
High
 
Obligor
Risk
Unlikely to
occur 
Low
Eg Singtel Low Facility High

Risk
Unsecured OD
100% secured loan 64
Default Risk

Expected Loss
Credit Risk Models

Rating System
External • Logit
• Option based
• Loan Sales
65
General
discussion
Objectives of rating
systems
66
Grades vs Marks
Similar to credit score Similar to credit rating
Marks Grade
67
Credit Rating vs Credit Score
Credit Ratings Credit Score
Poor Good
Ratings Ratings
Source: Credit Bureau Singapore
68
EL = PD x EAD x (1-R)
Rating System
Credit
Internal External
Rating International Rating
Rating System Rating System
Systems Agencies
Categories of Internal Rating System National Rating

(identified by the Models Task Force of the Basel Agencies
(Subjective Committee on Banking Supervision)
Approach)
(Objective Approach)
Expert judgment Constrained expert

Statistical based
judgment based
based process process process
Quantitative Model
Qualitative
Model
Credit Scoring Other Models
Models
Credit Risk Models
Option
Linear Discriminate Based
Probability Analysis
Credit Scoring
Logit Term Option
Structure Based
69
Applications of Credit Ratings
1. Approving of loans - Tool for credit policy within banks.

– E.g. example, some minimum rating, such as investment grade
of AA- or above, might be required for granting a loan.
– Positive correlation between ratings & default frequencies
– Banks can use very similar models to assess the probabilities of

default on both bonds and loans.
• Both bond yields and loan rates usually reflect risk premiums that
vary with:
– the perceived credit quality of the borrower and
– the collateral or security backing of the debt.
example in later chapter
70
Credit rating
Applications of Credit Ratings – cont’d
PD x EAD x (1-R)
2. Profitability and loan pricing analysis Income – EL

– Positively correlated with borrowing cost Capital
– PD used in risk based pricing
3. Portfolio monitoring - Some countries’ regulators use ratings to

restrict or prohibit banks’ purchases of low-grade securities.
– For instance, in the USA the Office of the Comptroller of the Currency
ruled that banks were not allowed to purchase securities with a
speculative grade rating since this could threaten bank solvency and
ultimately destabilize the financial system.
71
4. Regulatory use of ratings - determine the adequacy of loan loss

reserves or capital
• Role of Credit Ratings in Basel - ratings are the basis for defining
default probabilities which in turn determines the RWA
Ratings
Standardised
Basel II Foundation
IRB RWA Capital
Advanced
RWA x 8%
Example in next slide

72
Determining RWA under Basel – Slide from Chapter 2
Standardised Approach
Credit
Ratings Risk Weight
PD (1-R) EAD M
Internal
Foundation Bank MAS MAS MAS
Ratings Based
Approach Advanced Bank Bank Bank Bank
73 Risk Weighted Asset

B17 Q6
Compare and contrast internal and external credit rating systems, and
analyse their roles in capital adequacy regulation.
74
5. Ratings have a key role in the process of dis-intermediation.
– In pass-through securitization transactions, ratings of the

originating bank and of the securitized assets play a crucial role.
Securitization
3
Further discussion in chapter 6
Credit Rating
2
Securities 4
Issuer Investors
5 cash
1
Pool of loans
Repayments from borrowers
6
75
Rating Systems Overview
76
Rating Systems
Score
Credit Rating Default Profile
Default Probability
0% …………….…..100% Defaulter Non-Defaulter
77
Internal Ratings – What it is
In-house ratings systems
• System customised for the specific bank’s needs.
• Grades* assigned to borrowers or facilities ranking their relative risk.
• Number of grades* on internal scales varies across banks
• Definitions of each grade* and the procedures used to assign and

review ratings also varies across banks.
• Most bank clients are not rated by external credit rating agencies but
are rated internally due to
– large volume and
– cost considerations
*a.k.a ratings
78
Internal vs External Ratings
• Internal ratings systems differ significantly from external ratings
– in their design and operation,
because
– internal ratings are assigned by bank personnel and are not revealed to
outsiders. Further discussion in later slides
• When designing internal ratings, references are made to external

ratings. Example in next page
79
Bank’s
Rating
80
Factors Affecting Accuracy of Rating System
• The probability of borrower default is a quantitative measure of

default risk. It’s accuracy is dependent on the level of information
available on the borrower.
 the amount of information collected will depend on

1. the size of the debt and
2. the cost of information collection.
 the type of information includes

1. borrower specific, and
2. market specific and interpreted by bank employees using their subjective judgment.
Further discussion in later slide

Further discussion in next slide
81
Sources of Information for Credit Models - for Different

Customer Segments
1. Retail customers – bank collect information internally or from
specialist credit agencies.
2. Larger corporate borrowers - publicly available information such

as:
– company accounts,
– stock and bond prices and
– analysts’ reports.
Availability of more information along with the lower average cost of

collecting such information, allows banks to use more sophisticated and
usually more quantitative methods in assessing default probabilities for
large borrowers compared to small borrowers. (Relate back to delegated
monitoring)
3. Smaller corporate borrowers - quantitative assessments of small

borrowers are becoming increasingly feasible and less costly.
82
Default Risk

Expected Loss
Credit Risk Models

Types of Risk
• Qualitative
Internal
Risk Assessment • Quantitative
System
Rating System
External • Linear probability

System  Logit
• Term structure
• Credit Enhancement • Option based
Credit Risk Management
• Loan Sales
Errors
83
84
Categories of Credit Risk Models - Used in Internal Ratings
The Models Task Force of the Basle Committee on Banking Supervision

identified 3 categories of internal rating systems:
Expert Constrained Statistical

judgement expert judgement based process
based process based process
Expert judgement Combination Statistical based

based of quantitative High reliance on
Reliance on the and judgmental quantitative
personal experience factors techniques
and expertise of
loan and credit
officers
Used to determine PD
Details in later slides

85
Categories of Credit Risk Models

Expert judgement In-between the two end Statistical based

based
Usually for
Qualitative
large
models
corporates
86
Qualitative Models – Sources & Amount of Information
• Information processing relies heavily on qualitative analysis and

hence the subjective judgment of bank employees
• Limited publicly available information - so bank has to draw on:

a) Internal sources ↔ information on the borrower’s credit and deposit
accounts with the bank.
b) External sources ↔ Purchase from credit agencies.
• Amount of information collected depend on the size of the debt and

the cost of information collection.
• Qualitative model - Usually adopted for very large corporate deals

where very detailed credit analysis has to be carried out.
87
Qualitative Models – Types of information
1. Borrower-specific (unique to the individual borrower)

– reputation, 5 Cs
Character
– leverage, Capacity
– volatility of earnings Condition
– collateral Capital
Collateral
2. Market-specific (i.e. factors that have an impact on all borrowers)

– business cycle
– level of interest rates
Further expansion on above in the next slide
88
Credit Assessment Framework
- For Corporate Lending
89

90
Quantitative Models
Quantitative credit risk models focus on determining the default

probability based on the observable attributes of borrowers.
• Accuracy of model depends on the level of information available on

the borrower.
• Models makes use of the borrower characteristics (attributes)

– To calculate a score that represents
 the applicant’s probability of default or
 to sort borrowers into different default risk classes.
• Credit scoring models have been widely & successfully used in the
evaluation of smaller consumer loans, such as credit card
applications and small business lending.
91
Attributes Used In Credit Scoring Models
• Objective economic and financial measures (attributes) of risk for

different classes of borrower must be identified.
• Classes of borrowers:
– retail
– corporates
1. Retail Borrowers - commonly used factors:

– Income, assets, age, occupation and location.
– Scoring applies well to this segment, because of the large volume of
data.
2. Commercial / Corporate borrowers - commonly used factors:

– cash flow information and financial ratios
92
Techniques Used to Quantify Default Risk
Linear probability Models
Logit Models Scoring Models
Linear Discriminant Analysis
Term structure Model
Option Based Model
93
Overview of Credit Scoring – 2 Different Paths

Probability
Attributes of Default
• Linear Probability Models

• Logit Models
Details in Score
next slide • Linear Discriminant Analysis
Defaulter /
Non-
Defaulter
• Once the appropriate factors have been identified, a statistical technique is

used to quantify or score the default risk probability or default risk
classification.
– Linear Probability Models / Logit Models - Scoring techniques that provides
‘default probabilities’
– Linear Discriminant Analysis - Credit scoring uses techniques for discriminating

between defaulters and non-defaulters.
94
1 - Linear Probability Model – How it works
• The linear probability model
– uses past data as inputs to a model
– to explain the repayment experience (whether or not default occurred)
on pre-existing loans.
Factor A Does not explain repayment experience on existing loan
Factor B,C Does explain repayment experience on existing loan
Use factors B & C to forecast repayment probabilities on new loans

Credit Card Application
Form
• The relative importance of different factors (weightage)

– used to explain past repayment performance
– Is then used to forecast repayment probabilities on new loans.
Y = α +βX +ε
Credit Card Stats Credit Score Card Development PD = ∑ βiX +
95
Techniques Used Analyse Factors & To Quantify

Default Risk
Scoring Models
Logit Models
Option Based Model
96
2 - Logit Model
• The logit model represents an adjustment to the linear probability

model
– to ensure that the estimated range of default probabilities lies between
zero and one.
PD = Xi1 + Xi2
Score Logistic
PD
Original Score
97

Default Risk
Scoring Models
Logit Models
Option Based Model
98
3 - Linear Discriminant Models
• Linear discriminant models

– classify borrowers into high or low default-risk classes
– contingent on their observed characteristics.
• Problem - the models usually discriminate only between two

extreme cases of borrower behavior.
– Likely default
– not default.
Criticism of Discriminant Models

• In practice, various classes of default exist such as:
– non-payment
– delay of interest payments
– outright default on all promised interest and principal payments.
99
Other Approaches To Credit Risk Modelling
• More recent approaches to credit risk modeling have sought to:

– apply financial theory and utilise financial market data to produce default
probabilities.
• This is an area of considerable current research effort by banks.
100
Default Risk
Scoring Models
Logit Models
Option Based Model
101
Overview of Term Structure Model
1
Empirical evidence of
relationship between
bond yields and
credit rating 3 Methodology
Analyse
Premiums Paid by
borrower
2 Conclusion :
High Yield
correlates with
poor ratings
4 Obtain the
perceived credit
risk
Details in next 2 slides
102
Term Structure Models
• Analyse the risk premiums inherent in the current structure of yields

on corporate debt or loans to similar risk-rated borrowers.
(Yields on zero-coupon corporate bonds)

less → credit risk premiums
(zero-coupon Treasury bonds) ↓
implied default probabilities.
• The analysis is based on the difference (spread) between the yields

on risk-free discount bonds (e.g. US or UK Treasury) and the yields
on discount bonds issued by corporate borrowers of differing quality.
• The differing spreads for different quality borrowers’ bonds reflect

perceived credit risk exposures of the corporate borrowers for single
Yield
payments in the future
Yield
Yield
Treasury Bond Co A’s Bond Co B’s Bond

103
Relationship Between Ratings And Yield

• Positive correlation between corporate bond yields & level of credit
risk.
• Higher risk borrower (poorer rated) pays a higher price for debt
• Credit rating is a function of default probabilities
Bond Yields
Rating Category Oct 00 Dec 05 Dec 08
AAA 7.44 5.26 4.74
AA 7.75 5.41 5.48
A 8.06 5.47 6.32
Baa 8.29 6.21 8.05
104
Default Risk

Approaches
to Credit
Logit Models Scoring
Option Based Model
105
Introduction to Options Strategies
106
Types of Options
Buy Option Sell Option
Option Buyer has right Option seller gives buyer

Call Option but not obligation to Buy the right but not
an underlying asset @ obligation to buy an
strike price underlying asset from
him @ strike price
Option seller gives

Option Buyer has right
buyer the right but not
Put Option but not obligation to Sell
obligation to Sell an
an underlying asset @
underlying asset to
strike price
him@ strike price
107
Buy a Call Option – Have the right but not the obligation to BUY an
asset @ strike price
A Call Option conveys to the Buyer of the option

• a right without an obligation to BUY something
• @ an agreed price (Exercise price)
• for an agreed duration (Maturity)
• by paying a consideration (Premium)
Option Payoff Graph

• Buy 3 mth call
option on IBM
stock Starting Strike
position Price
• Strike price of + ve At the money
Profit Graph
$1.20 and
Option payoff –
costs $0.10.
Payoff
premium paid
• Current IBM 0
stock price is Current
$1.00. Price 1.20
1.00 out the money in the money
Share price
movement
Excel - Call Exercise call option after this
point. 108
Sell a Call Option – Gives others the right but not the obligation
to BUY an asset from you @ strike price
Call Put
Buy Type 1 Type 3
Sell (Write) Type 2 Type 4
Starting Strike
position Price
Payoff Level
+ ve
in the money out the money
0
Current Profit Graph
Share price
Price Option payoff +
movement
1.00 premium paid
- ve 1.20
Option Payoff Graph
Share Price
Excel - Call
Buy a Put Option – Have the right but not the obligation to SELL an
asset @ strike price
An option conveys to the Buyer of the option
• a right without an obligation to SELL something Call Put
• @ an agreed price (Exercise price) Buy Type 1 Type 3
• for an agreed duration (Maturity) Sell (Write) Type 2 Type 4
• by paying a consideration (Premium)
?
$1.5 ← $1.5 →
Option Payoff Graph
Strike 1 - Starting
Price position
Payoff Level
+ ve 2 - Pay premium
upfront
Share Price
0
In the money Out the money
Current
Profit Graph 1.20 Share price
Option payoff –
Price
movement
premium paid Excel - Put
1.50
110
Sell a Put Option – Gives others the right but not the obligation
to SELL an asset to you @ strike price
Call Put
?
Buy Type 1 Type 3
$1.5 ← $1.5 →
Sell (Write) Type 2 Type 4
Strike Starting
Price position
+ ve
Out the In the
Payoff
money money
0
Current
Share price Price
1.20 movement
1.50
- ve
Option Payoff Graph

Profit Graph
Option payoff +
premium paid
Excel - Put
111
BUY SELL
Have the right but not the obligation to
• BUY an asset @ strike price Call
• SELL an asset @ strike price Put
BUY SELL
Gives others the right but not the obligation to
• BUY an asset from you @ strike price Call
• SELL an asset to you @ strike price Put
112
End - Introduction to Options
Next
Basic Intuition Behind the Option Based Models
113
Option Based Models
• A class or risk models based on the framework developed by Merton

(1974) using the principles of option pricing.
114
Equity Holder
$2m Equity
Company $8m
Lender
(Borrower) loan
$10m
Vendor
Assets
115
If business succeed Equity Holder’s Perspective

• Assets = $A1 (> $8m)
• Company repays loan.
• Keeps the surplus.
Equity Holder
$2m Equity
Equity Holder enjoys upside
Surplus = $A1– $8m - $2m
Company $8m
Lender
(Borrower) loan
$10m
Vendor
If business fails
• Assets = $A2 (< $8m). Assets
• Company can choose to
default on loan.
• Company surrender
assets to lender. Due to the principle of limited liability for shareholders, loss is
limited on the downside by the amount of equity invested in the
company.
Equity Holder’s loss is

limited to equity of $2m
• Shareholder has potential upside and limited downside (loss of capital

invested).
• He is similar to buying a call option on firm’s assets @ the strike price of
the loan.
• The capital is similar to the premium paid.
116
Prepared by Adam Wong A2 A1
If business succeed Lender’s Perspective
• Assets = $A1 (> $8m).
Company repays loan.
• Keeps the surplus.
Equity Holder
$2m Equity
Lender earns a small fixed
return = interest
Company $8m
Lender
(Borrower) loan
$10m
Vendor
If business fails
• Assets = $A2 (< $8m). Assets
• Company can choose to
default on loan.
• Company surrender
assets to lender. $8m
B
The payoff function for the debt
Lender’ loss = $8m – $A2 holder (lender) resembles that of
• writing (selling) a put option on
If asset value = 0, lender the value of the borrower’s
loose entire p + i assets
• with an exercise price equal to Asset Value < B Asset Value > B
the face value of the debt (B) default No default
maturity equal to the life of
the debt Asset Value
117
Debt Holder’s Payoff – Numerical Example

Loan Principal 100
Loan Interest 10
Asset value 0 20 40 60 80 100 120 140 160 180 200 220 240
P+I due 110 110 110 110 110 110 110 110 110 110 110 110 110
Net Gain / Loss
Total -110 -90 -70 -50 -30 -10 10 10 10 10 10 10 10
Default occurs when Assets of

20
firm < debt. Lender can only 10 Borrower will rationally only repay the
recover remaining asset value 0 loan if the value of its assets exceeds
• Asset value = $80 -10 0 20 40 60 80 100 120 140 160 180 200 220 240
-20 the value of promised debt
• P&I loss = $30
-30 repayments.
-40 • Asset value > $110
-50 • Lender recover principal of $100
-60
-70 and earns interest of $10. [ It earns
-80 a small fixed return, similar to the
-90 premium on a put option ]
-100
-110
-120
Firm with no remaining assets results in lender losing all p+i

• Asset value = 0
• Lender loose principal of $100 + interest of $10 = $110
118
Analogy
• The payoff function for the debt

holder (lender) resembles that of
– writing (selling) a put option on
the value of the borrower’s Lender gives the borrower the
assets right but not the obligation to “sell
– with an exercise price equal to the lender the assets at the
to the face value of the debt agreed price of the loan amount”
(B)
– maturity equal to the life of the
debt
119
Key Learning
The key point from Merton (1974) is that the lender should adjust the required
risk premium as the borrower’s
• leverage and
• asset risk change (asset value volatility) – reasons in next slide
120
with higher leverage, the
probability of “borrower’s
asset value being less than Lender’s payoff – like writing a put
the value of the promised
debt repayment” is greater, • High leverage
leading higher probability of • Low asset value
default
Default Risk
if the value of the firm’s probability premium
assets is low, the probability
of “borrower’s asset value
being less than the value of
the promised debt Borrower’s
repayment” is also greater, • market value of assets and
leading higher probability of • asset risk (asset volatility)
default and therefore, higher are key variables to focus in credit risk evaluation
risk premium
Therefore if we know the market value of the firm’s assets
and the volatility of the market value of the firm’s asset, we
can estimate the risk premiums and default probabilities
However, the market value of a firm’s assets and the

volatility of a firm’s assets are not directly observable.
Moody’s KMV
121
higher
Further explanation: - Merton – “the lender should leverage
adjust the required risk premium as the borrower’s
leverage and asset risk change”. A
D2
• With higher leverage, the probability of “asset value < the value D1
of the promised debt repayment” is greater, leading higher
probability of default original leverage
• With lower asset value, the probability of “asset value < the
value of the promised debt repayment” is also greater, leading
higher probability of default A1
A2 D
• Therefore risk to lender in both above cases is higher,
justifying a higher risk premium.
The above implies that the borrower’s market value

of assets and its asset volatility are key variables to
focus in credit risk evaluation. The closer the
value the higher
Therefore if we know the market value of the firm’s the probability of
assets and the volatility of the market value, we can default
estimate the default probabilities (the frequency of
“asset value < the value of the promised debt
repayment”)
But, the market value of a firm’s assets and the

volatility of a firm’s assets are not directly
122
observable.
Moody’s KMV Model
The KMV model treats the value of equity in a firm (from a stockholder’s
perspective) as equivalent to holding a call option on the assets of the firm
1 Use the stock market 2 derive the implied market
value of the firm’s shares value of the firm’s assets
and and
volatility of the value of the the implied asset volatility
firm’s shares
Market value of firm’s shares Value of firm’s assets
$ $
Time Time
4 The resulting expected default 3 The likely distribution of possible asset
frequency (EDF) reflects the values of the firm relative to its current
probability that debt obligations can then be calculated.
the market value of the firm’s
assets will fall below the Current value of
debt obligation
promised repayments on its
short-term debt liabilities within
Frequency
Implied Asset
one year. Value
$
123 EDF
Summary Recap
5
Like holding a call
option on the asset
Shareholder Like writing a put
option on the 6
1 capital assets
Borrower loan
Lender
(Company) 2
3
Asset value > debt? 4
Assets n y
Repay P + I
Borrowing Co Shareholder keep remaining assets
default on loan
Surrenders
assets

Summary
Borrower’s inputs
attributes
Credit scoring credit score

credit rating
Estimated
PD
Option based output
credit risk
modeling
Equity
inputs
market
information EL = PD x EAD x (1-R)
125
B12 Q4
Compare and contrast credit scoring and option-based credit risk
modelling.
A10 Q4
Compare and contrast credit rating systems, credit scoring, and option-
based credit risk models.
A11 A Q4
Explain the characteristics of credit scoring, expected loss, and option-
based credit risk modelling.
A16 Q4
Discuss the methods used by banks to model and manage credit risk.
126
Short Comings of The 3 Types of Models
Logit Models Scoring Models
Option Based Model
• None of them measure or look at affordability.
• That is, whether the customer can afford to repay the loan (e.g. sub-
prime lending in the US).
• Researchers are currently building new models to encompass this.
127
Qualitative Constrained Quantitative

Models expert judgement Models
based
Expert judgement In-between the two ends Statistical Based

based
128
Constrained Expert Judgment-based Processes.
Characteristics
• The most extensively used type of internal rating process.
• Ratings are assigned using considerable judgmental elements.
• Relative importance given to each of them is not formally

constrained.
• Statistical models may still have a role to play, though this may vary
widely across institutions.
• The rater has the discretion to significantly deviate from statistical

model indications in assigning a grade.
129
Constrained Expert Judgment-based Processes
How the constrained expert judgment process works
• Ratings based primarily on statistical default/credit scoring models

or specified objective financial analysis,
– but allow those assigning a rating to adjust it to an explicitly limited
degree based on judgmental factors.
• A quantitative tool determines the grade

– raters may adjust the final grade up or down based on their judgment.
Alternatively,
• Quantitative and judgmental factors are explicitly assigned a weight
in the final rating,
– thereby effectively limiting the influence of judgmental considerations.
130
Recap 2
7. What are the different types of lending risks?

8. What is a credit rating?
9. What is the role of credit ratings in Basel II?
10.What are the types of credit ratings system?
11.What are the categories of credit risks models
used in internal rating?
11a. What is the key difference between credit scoring
models and option based models?
131
132
External Ratings
• Widely known credit rating systems.
• Role - evaluate and quantify credit risks, within a context of effective

benchmarking of risks across industries and countries.
• Aim - provide lenders and investors with independent and objective

credit opinions.
• Plays an increasing regulatory role – Regulatory Capital

requirements & the Basel II & III
133
Growth in External Ratings
• Considerable recent growth in the market for external ratings

(particularly in Europe).
• Four-fold increase in the sovereign borrowers rated over the 1990s.
134
Types of External Rating Agencies
External Credit
Ratings Agencies
International Agencies National Agencies
http://www.smecreditrating.sg/
Source: Table created using data from the Financial Times Credit Ratings International and Financial
Times Credit Ratings in Emerging Markets. www.ftinteractivedata.com
135
Problems with Rating Agencies - Summary From Two Videos

• Accuracy of analysis (S&P) ?
– Lack of historical data to conduct a rating on some of the CDOs
– Yet the rating agency went ahead to rate
• Conflict of interest
– Company pays to be rated – is the rating agency really independent?
– Rating agencies needs to make a profit
– Pressure to keep up the profit levels at the rating agencies
• Rating agencies enshrined in regulations
• Possible revamp to the Rating Agencies business model

– Call by certain parties to remove the mandate to be required by
regulations to use rating agencies
– Create competition
• However, with monopoly or duopoly – Rating agencies can be independent
136
137
International Agencies vs National Agencies

Use the same rating Rating scale normally based on
scale across countries. the ceiling of the local sovereign’s
Best rating.
e.g. AA rating of a Singapore Cannot be compared with one

issuer implies the same credit risk another (i.e. between
quality as an AA for a Japanese countries)
issuer.
Not directly comparable with
ratings based on an international
rating scale
Example of ratings scale in next slide
138
Rating Scale Comparison S&P vs Moody’s
The top quality AAA / Aaa

rating represents the
highest capacity to pay
interest and
repay principal.
Long-term ratings of BBB-

/ Baa3 and above are
deemed investment grade.
Ratings below this level

are deemed speculative
grade (also known as
high-yield debt or ‘junk’
bonds).
D represents default.
139
International Agencies vs National Agencies

Take into account Country & Does not address direct sovereign
sovereign risks risks, e.g - possible imposition of
foreign exchange controls,
Less precise in the relative Provide more precise ranking of

ranking of entities within a relative credit risk within a
particular country country
Especially in countries where the

typical credit attributes of most
obligors tend to concentrate
around international scale ratings
in the medium- to low-grade
categories.eg cluster around BBB,
BBB- or BB+
Example in next slide
140
National Rating by An Agency in Pakistan
National Rating
Agency’s Rating
Moody’s Rating
AAA: Highest credit quality.
AA: Very high credit quality.
A: High credit quality. .
BBB: Good credit quality.
BB: Speculative.
B: Highly speculative.
CCC, High default risk
CC, High default risk
C: High default risk.
Companies within Pakistan
can only fall into one of the 5 Under the ratings by Pakistan’s
Grades under Moody’s rating own national rating agency
companies can be classified
They cannot be rated higher into 9 Grades
than the sovereign rating
141
Internal Vs External Ratings

Internal Ratings External Ratings
Objective Determine default frequency Determine default frequency
Usage • Customised for the specific • Provide lenders and investors with
bank’s needs independent and objective credit
• Internal usage by bank opinions
• Used by many third parties for different
purposes
Methodology Not revealed to outsiders Published in public domain
Size of entities Large, medium & small companies Usually large companies
rated
Grades & Varies across banks Standardised
Definitions
Performance / Unknown Widely published
Accuracy
Exposure Banks (rater) are exposed to the Rater not exposed to the parties rated
parties rated Stand between borrower and investor
Review System Rater Committee system
142
Types Entities Rated and Ratings Given External Rating
Agencies
Types (Scope) of entities Types of ratings
rated US ratings downgrade
• Debt Issues
• sovereign, state and
municipal governments • Issuers
• financial institutions • Counterparties
• corporates. • Preferred Stock
Examples in following slides • Bank Loans
• Structured Financing
• Claims-paying ability of
Insurance Companies.
143
Examples of Ratings - Banks
144
Examples of Ratings - Corporates
Standard & Poor's (S&P) has raised its long-term issuer credit rating on
General Motors Financial (GM Financial) to BB from B+. It also raised the
issue-level rating on the company's senior unsecured debt to BB- from B. At
the same time, it removed the ratings from creditwatch, where they were
placed with positive implications on 30 September 2011. The outlook is
stable.
"The upgrade of GM Financial reflects our view that the company remains a
strategically important subsidiary of General Motors," said S&P credit analyst
Rian Pressman. "Based on this view, the issuer credit rating on GM
Financial is two notches higher than its standalone credit profile of b+."
Strategically important subsidiaries can receive up to three notches of
support, but they cannot be rated the same as their parents.
145
Examples of Ratings – Singapore Bond Issue
• Issuer: Global Logistic Properties Limited

• Issue: SGD Perpetual Capital Securities
• Issuer Ratings: Baa2, stable (Moody's) / BBB+, stable (Fitch)
• Expected Issue Rating: BBB- (Fitch)
146
Assessment Criteria - Sovereign
Criteria for assessing the risk of a sovereign borrower include:

• Political risk,
• Economic structure,
• Growth prospects,
• Fiscal flexibility,
• Public debt burden,
• Price stability,
• Balance of payments
• External debt.
147
Assessment Criteria - Corporate
Criteria for assessing a corporate borrower would include:

• Country risk,
• Industry risk,
• Market position,
• Management quality,
• Profitability,
• Capital structure
• Relevant financial ratios.
148
Assessment Criteria – Financial Institution
Criteria for assessing financial institutions would include:

• Policy of regulating bodies,
• Riskiness of activities,
• Sources of funding,
• Capital and reserves,
• Performance and earnings,
• Market environment.
149
B11 Q4
Explain the characteristics of credit rating systems, credit scoring and
expected loss.
A10 Q4
3 Compare and contrast credit rating systems, credit scoring, and option-
based credit risk models.
B10 Q3
2 Compare and contrast internal and external credit rating systems, and
analyse their roles in capital adequacy regulation.
P15 Q1
1 Critically analyse the merits and applications of internal and external
credit rating systems.
150
Short Comings of External Ratings
• External ratings depend on fundamental analysis where ratings

assess the borrower ‘through the economic cycle’.
– Ratings for a given borrower do not change frequently under normal
conditions
– Short-term deviations to current circumstances are not relevant if they
do not materially change the credit standing of the obligor.
• External ratings exist only for large listed companies.

– Statistical analysis of default can be misleading
• sample of borrowers rated by agencies is usually not representative of
banks’ portfolios. http://www.smecreditrating.sg/
• As a result  Banks must rely on internal rating for small and

medium-sized corporate counterparties.
Problems of external
ratings for small
companies
151
Default Risk

Expected Loss
Credit Risk Models

Internal • Constrained expert judgement
Risk Assessment System • Quantitative
Rating System
External • Logit
• Option based
• Loan Sales
152
153
Types of Decision Errors

Danger
Type I error
• Accepting bad credits.
– Result in a full loss of principal and
interest should risk materialise.
G - Accept Type I 
Credit
Type II error Score
• Rejecting good credits. B - Reject  Type II
– Result in opportunity costs relating to
missed profitable opportunities. B G
Actual Credit Situation
Implications
• Cost of a Type II error is much lower
than that of a Type I error.
• Systems may typically be designed

with a greater tolerance of Type II
errors than of Type I errors.
154
Recap 3
12. What is the difference between internal ratings and

external ratings systems?
13. What is credit scoring?
14. Explain the different types of statistical based
methods used in internal ratings?
15. What are the categories of errors produced by
rating systems?
16. What are the types of external rating agencies?
17. What is the main difference between International
Rating Agencies and National Rating Agencies?
18. What are the main differences between internal &
external ratings process?
155
Analyse the processes of risk measurement, risk management and

performance measurement within banks.
156
Tools of Credit Risk Management (Decisions affecting
the portfolio as a whole)
Summary of Tools – Details in following slides
1. Credit Allocation - Limititation
2. Credit Enhancement - Collateral
3. Loan Sales – Diversification (to be covered in chapter 6)
4. Risk Based Pricing - Selection
5. Credit Derivatives (to be covered in chapter 6) – Shedding Risk
See Appendix 1 for a summary of points by various authors
157
Chap 6 Chap 8
Chap 7
158
1 - Credit Allocation Decision
Link back to Chapter 3 – Credit risk
management principles
CAR = Capital / RWA

• Limit system - Bank sets the maximum amount
Capital
limits the
at risk with borrowers.
– aim to limit losses in the event of default.
Total Basel III limits the total assets a bank can have – leverage ratio
Lending • The bank’s capital sets a limit to lending, given

diversification considerations and/or credit policy
guidelines.
Limit System
• Limit systems comprise centralised information
about borrowers, including authorisations and
credit line usage.
Actual Lending
Actual Lending
Actual Lending • This serves to control the amount at risk, and
Actual Lending
also ensures compliance with appropriate
diversification and other guidelines.
159
Chap 6 Chap 8
Chap 7
160
2 - Credit Enhancement
• Aim - seeks to reduce the amount of loss in the event of default

through increasing the recovery rate.
• Types of credit enhancement :

– Covenants
– Guarantees Details in following slides
– Collateral
161
2.1 - Credit Enhancement - Covenants
• Covenants - designed to aid the active monitoring of risks and thus

trigger pre-emptive actions when a borrower’s credit standing
deteriorates.
• Prevent moral hazard of borrowers
• Covenants create the incentive for the borrower to comply with

specified conditions, such as constraining the debt/equity ratio.
• The aim is to initiate negotiations before default, rather than to

cause default.
162
2.2 Covenants
• Loan covenants are set in place to extricate the lender from the
relationship should “undesirable events/actions” occurs.
Loan Agreement Definitions

Purpose of loan
General Amount of credit / currency
Representation & warranties
Pre-conditions Positive covenants
Covenants
Negative covenants
Events of Default
Market events
Acceleration Breach of any terms in loan agreement
Events that MAY lead to non-payment
Rights of Lender Non-payment
Loan Operations Drawdown

Repayment
Interest rate / fees
Waiver of default
163
2.3 Examples of Covenants
Non
Financial Financial
Ensure that Current Ratio Ensure that the required

exceeds 120% at all times licenses are renewed on
Affirmative time
Will not allow LTV to Not to give security for any

exceed 70% at all times new loans taken
Negative
164
2.4 - Credit Enhancement - Types Guarantee
Bank Guarantee Corporate Guarantee Personal Guarantee

• Guarantee by another • Joint & Several
interested corporate. • Proportionate
• Parent guarantees the
subsidiary’s debt
• Operating subsidiary
guarantees parent’s
borrowings (investment
holding co)
Guarantor
Guarantee
Loan Lender
Borrower
165
2.5 - Credit Enhancement - Types of Collateral
• Property
• Equipment
• Marketable Securities
• Cash
• Other tangible collateral
Basel II
120. Where banks take eligible financial collateral, they are allowed to reduce
their credit exposure to a counterparty when calculating their capital
requirements to take account of the risk mitigating effect of the collateral.
166
Various instruments and techniques designed to
separate and then transfer the credit risk of the
underlying instrument.
167
EL = PD x EAD X (1-R)
Earnings - Risk
Risk Adjusted Earnings

= Risk Adjusted Return on Capital
Capital (RAROC)
Details covered in Chapter 7
168
Chap 7
Chap 6/8
Chap 6
169
Prepared by Adam Wong Credit Risk Management
Loan Sales – Individual Loans Makes the loan
• Bank originates a loan and then sells it, either with or without
recourse, to an outside buyer.
– Non-Recourse Sale - bank has no explicit liability if the loan eventually

becomes bad (i.e. default occurs).
• Buyer of the loan bears all the credit risk.
– With-Recourse Sale - under certain conditions the buyer can put the
loan back to the selling bank.
– The selling bank retains a contingent credit risk liability.
• In practice, most loan sales are without recourse because the loan
should only be removed from the balance sheet when the buyer has
no future credit risk claim on the originating bank.
170
Loan Sales – Securitisation
• Selling a portfolio of loans to another entity
Further details in chapter 6
171
Various instruments and techniques designed to

separate and then transfer the credit risk of the
underlying instrument.
172
Types of Credit Derivative Products
1. Credit default swap

2. Total return swap
3. Credit Forwards
4. Credit Spread Options
Further details in Chapter 8
173
Recap 4
19. How do banks manage their credit risks?
174
A15 Q4
Explain the constituents of credit risk and discuss how these risks could
be managed.
A16 Q4
Discuss the methods used by banks to model and manage credit risk.
175
End
176

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Chap 4 Credit Risk

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Financial Intermediation Chapter 7 - Analysing

Credit Chapter 6 - Risk

Interest Chapter 8 - Risk

Prepared by Adam Wong

Chapter 4 – Credit Risks

Types Lending risks

Credit rating systems – determine PD

Credit Risk management

• Demonstrate the importance of credit risk within banks

• Explain the distinction between internal and external credit rating

• Illustrate the various possible approaches to credit risk management

• Explain the alternative methods available to banks for credit risk

Definition of Credit Risk

Constituents of Credit Risks Exposure Risk Expected Loss

Migration Risks Recovery Risk

Credit Risk Models

• Credit risk is measured by exposure (i.e. the amount that can

• Credit risk also depends on the probability of default occurring and

Need to know what the

Constituents of Credit Risks Exposure Risk Expected Loss

Migration Risks Recovery Risk

Types of Risk Credit Risk Models

Summary - Components of Credit Risks

Credit risk constitutes three elements:

1. Default Risk (D)

2. Exposure Risk (X)

3. Recovery Risk (1-R)

• Default can be defined in several ways:

1. missing a payment obligation,

2. breaking a covenant (agreement on something),

3. entering a legal procedure (e.g. appointment of a judicial manager) or

• Default does not necessarily lead to immediate losses (to lenders),

• Credit rating agencies - consider that default has occurred when a

• Borrower has no obligation to repay loans until it is due for

• When event of default occurs, the loan maturity is accelerated

Time of Event Date Amount Due

The probability of default depends on factors such as

Details on Risk Analysis in later slides

How Ratings Are Correlated to Other Factors?

Summary We can use credit

Relationship Between Credit Ratings and Default

Prepared by Adam Wong

e) The default rate increases exponentially as the ratings worsen.

How Ratings Are Correlated to Other Factors

• External rating plays an important role in the cost of borrowing

Rating Category Oct 00 Dec 05 Dec 08 Diff bet

Further discussion on internal vs external ratings in later slides

Default Risk Management

Risk Exposure Risk

• Exposure risk is the amount at risk* in the event of default excluding

• Since default occurs at an unknown future date, the risk is

Drawn amount Factors affecting the

The type of commitment given by the bank to the borrower sets an

1. Amortised Loans - Lines of credit with a repayment schedule,

Amortised Balloon Bullet

100,000 100,000 100,000

80,000 80,000 80,000