Professional Documents
Culture Documents
The Credit Risks and Credit Life Cycle
The Credit Risks and Credit Life Cycle
INTRODUCTION
Thetakingofcreditriskhasalwaysbeenacoreactivityfo
rbanks
Overthelast10years,quantitativemeasurementhasbeen
adoptedbybankstoimprovetheirprocessesforselectinga
ndpricingcredittransactions
Quantitativemeasurementhasbecomeevenmoreimportan
tsinceitwasadoptedbytheBaselCommitteeonBanking
asthebasisforsettingregulatorycapital.
Inthischapter,wereviewtheprocessforgrantingcredita
ndthewaysinwhichriskmeasurementsupportscreditde
cisions
Insubsequentchapters,wereviewthedifferenttypesofcr
editinstruments,riskmeasurementforasingleloan,risk
measurementforaportfolio,andhowtheresultsareused
fordecisionsupport.
Mostofthediscussionfocusesonestimatingtheeconomi
ccapital,butwefinishthecredit-risksectionwiththeBas
elCommittee'snewframeworkforsettingregulatorycapit
al.
Acustomerfailstorepaymoneythatwaslentbytheb
ank.
Thebankholdsadebtsecurity(e.g.,abondorloan)an
dthecreditqualityofthesecurityissuerfalls,causing
thevalueofthesecuritytofall.Here,adefaulthasnot
occurred,buttheincreasedpossibilityofadefaultmak
esthesecuritylessvaluable.
Thebankholdsadebtsecurity,andthemarket'spricefor
riskchanges.
Forexample,thepriceforallBB-ratedbondsmayfallbec
ausethemarketislesswillingtotakerisks.
Inthiscase,thereisnocreditevent,justachangeinmark
etsentiment.
Thisriskisthereforetypicallytreatedasmarketriskinthe
tradingVaRcalculator
Generally,changesinvalueduetodefaultsanddowngradesare'c
onsideredtobecreditriskbecausetheydependonthebehavioro
fthespecificcompany.
Changesinvalueduetochangesintherisk-freeinterest-rateorc
hangesincreditspreadforagivengradeareconsideredtobemar
ketriskbecausetheydependongeneralmarketsentiment.
Origination
portfoliooptimization
capitalization.
Themostbasicdecisioniswhethertoacceptanewass
etintotheportfolio.Theoriginationdecisioncanbefr
amedintwopossibleways:
Giventheriskandafixedprice,istheassetwortht
aking?
Giventherisk,whatpriceisrequiredtomakethea
ssetworthbuying?
Thefirstismoreoftenaskedinarigidsystemwhereth
ereislittleopportunitytomodifytheprice,andtherefo
rethedecisionbecomes"yes/no.
Thisisthetypeofdecisionmadewhendealingwitha
largevolumeofretailcustomers.
Thequestioncanberecastas,"Istheexpectedreturno
ncapitalforthistransactiongreaterthanthebank'smi
nimumreturnoncapital?"
Tosupportthisdecision,weneedtoknowtheexpecte
dreturn,adjustedforexpectedlossesandexpenses,an
dtheamountofcapitalthatthistransactionwillconsu
me
Thesecondapproachistypicallyusedinaflexible,liq
uidtradingenvironment,orinnegotiatingratesandfee
sforacorporateloan
Here,westartwiththecapitalconsumedandtheknow
nhurdlerateforthereturnoncapitaltocalculatethem
inimumacceptablereturnfortheoverallloan
Inoptimizingaportfolio,themanagerseekstominimizetheratio
ofrisktoreturn
Toreducetheportfolio'srisk,themanagermustknowwherether
eareconcentrationsofriskandhowtheriskcanbediversified
Thisrequiresacredit-portfoliomodelthatincludesallthecorrelat
ionsbetweenassetstoshowwherethereareconcentrationsofass
etsthatarehighlycorrelated
Thehighcorrelationmayarisefrombeinginthesameindustryor
geography,orbecausetheyaredrivenbythesameeconomicfact
ors,suchasoilprices.
Theportfoliomodelmustshowthecurrentriskconcentrationsan
dallowthemanagertotry"what-if"analysestoteststrategiesfor
diversifyingtheportfolio.
Giventheriskintheportfolio,theCFOneedstosetth
eprovisionsforexpectedlossesoverthenextyear,and
thereserves,incaselossesareunusuallybad
TheCFOalsoneedstoensurethatthetotaleconomicc
apitalavailableissufficienttomaintainthebank'starg
etcreditratinggiventherisks
Ifitisinsufficient,thebankmust(1)raisemorecapita
l,(2)reducetherisk,or(3)expecttobedowngraded
Tosettheprovisions,theCFOneedstoknowtheaver
agelossesthataretobeexpected
Tosetreserves,itisnecessarytoknowthelossthatco
uldbeexperiencedinanunusuallybadyear,e.g.,losse
sthathaveal-in-20chance(5%)ofhappening
Tosetcapital,weneedthelosslevelthatcouldbeexp
eriencedinanextraordinarilybadyear,e.g.,lossesthat
haveal-in-1000(0.1%)chanceofhappening
Thesestatisticscanbeobtainedifwecancalculatethe
probability-densityfunctionfortheportfolio-lossrate,
whichisthefocusofthenextfewchapters