Credit Risk

Banks’ Inherent Risk

umermushtaqlone@uok.edu.in
 Defining Credit Risk

“the possibility that an unexpected change in a counterparty’s creditworthiness

may generate a corresponding unexpected change in the market value of the
associated credit exposure”.
 Components of Credit Risk Definition

1. Default risk and migration risk: The first thing represents the risk of loss resulting from the borrower’s
actual insolvency (whereby payments are interrupted), while the second represents the risk of loss resulting from
a mere deterioration in its credit rating.

2. Risk as an unexpected event: A second concept implicit in the original definition is that in order to be
considered as a risk, the variation in the counterparty’s credit rating must be unexpected.

3. Credit Exposure: A third point to be considered relates to the concept of credit exposure. Credit risk is by no
means limited to the “classic” forms of credit granted by a bank (on-balance-sheet loans and securities), but also
includes off-balance-sheet operations such as guarantees, derivative contracts traded over the counter
Components of Credit Risk Definition

Finally, it should be noted that our initial definition refers to the market value of credit exposures. This poses two
problems.

a) Many credit exposures are recorded into financial institution’s books at historical value, not at market value.

b) The majority of the credit exposures of a financial institution consist of illiquid assets, for which no developed
secondary market exists; the market value can therefor only be estimated on the basis of an internal asset-
pricing model
Expected and Unexpected Loss
Expected Loss:
 This is the mean value of the probability distribution of future losses.
 Being expected, it does not strictly represent a risk.
 In practice, the expected loss is estimated ex ante by the lender, which hedges its risk by adding a
suitable spread to the interest rate charged on the loan
Three parameters for estimation of EL
1. EAD - Exposure at Default. A random variable represented by the current exposure plus the possible
variation in the size of the loan which may take from now to the date of possible default
2. PD: The probability that the borrower will default
3. LGD – The expected loss rate in the event of default – Loss Given Default:
 The percentage of exposure that the bank forecasts that it will be unable to recover (e.g. by seizing collateral,
calling in guarantees or proving the debt in bankruptcy)
 It is equal to one minus the expected recovery rate (RR) on the exposure (i.e. 1-RR = LGD)
To sum up EL = EAD . PD . LGD
EAD: Drawn Commitment and
Undrawn Commitment
 EAD is equal to the current amount outstanding in case of fixed exposures like term loans. For
revolving exposures like lines of credit, EAD can be divided into drawn and undrawn
commitments.

 Typically the drawn commitment is known whereas the undrawn commitment needs to be
estimated to arrive at a value of EAD

 A credit conversion factor (CCF) must also be estimated, which represents the percentage of the
undrawn portion that could be used by the borrower close to the time of default* (i.e., CCF x
Current undrawn amount)

Thus, EAD = Current drawn amount + (CCF x Current undrawn amount)

Expected and Unexpected Loss

Unexpected Loss: The true credit risk (i.e.. the risk that the loss will prove greater than
originally estimated) is associated with unexpected loss. In general terms, this can be
defined as the variability of the loss around its mean value, i.e. around the EL

ELs covered by provisions and ULs covered by economical capital estimations.

Main Types of Credit Risk
1. Default Risk
2. Migration Risk/Downgrading Risk
3. Spread Risk
4. Recovery Risk
5. Pre-settlement/Substitution Risk: Indicates the risk that the bank’s counterparty in an OTC (over-the-counter)
derivative will become insolvent before the maturity of the contract, thus forcing the bank to “replace” it at new (and
potentially less favorable) market conditions

6. Country Risk
7. Concentration Risk
Credit Risk Drivers
Exposure Risk

Credit Events
Value of Credit
Migration Risk Migrations
and
Loss given
defaults
Default Risk
‘Lgd’

Recovery Risk
 Exposure Risk (EAD)
 The first ingredient of credit risk is exposure, which is the amount at risk with the counterparty.
(Exposure is the ‘quantity’ of risk)

 Exposure is the most common information variable for credit risk

 Credit risk management imposes limits on exposures by firm, industry or region

 Exposures are either at book value or at mark-to-model values

 Valuation of losses under book value ignores migration risk, and results in loss under default only

 Marking-to-model exposures serve for valuing migrations, by discounting future flows from assets
at a discount rate, adding the credit risk spread to the risk-free rate.
Default & Migration Risk
Default Risk Migration Risk

 Default risk is the probability of  Migrations are either deteriorations or

the event of default. improvements of the credit standing of
obligors

 Several events qualify as ‘default’

 These translate, respectively, into higher
or lower default probabilities

 For default events, losses are

readily observable
 For migrations, the valuation of risk
necessitates a mark-to-market valuation
 Defining Default
 Missing a payment obligation for a few days*

 Missing a payment obligation for more than 90 days

 Filing for bankruptcy

 Restructuring imposed by lenders

 Breaking a covenant triggering a cross-default for all lenders to the same entity
 Defining Default

 Another view on default is ‘economic’. It occurs when the value of the assets of the borrower
dips below the value of the debt. This is economic default under the Merton (1974) model,
implemented in instrumental default models such as KMV Credit Monitor.

 Rating agencies usually consider that default occurs when missing a contractual payment. The
New Basel Accord includes bankruptcy and restructuring as default events, and makes it
necessary to build up histories of such events as well.
Default and Migration Probabilities
 The probability that default occurs during a given period characterizes default risk

 The probability that a firm migrates from one risk class to any other is a migration

 Default is one of these migration states (or absorbing state)

 Under default, the loss materializes and is the amount at risk less recovery

 Valuing migrations is different. The migration probabilities result from historical data. Nevertheless a migration to
any state other than the default state does not trigger any loss in book value, although the default probability changes

Historical data provide default frequencies according to a specific definition of defaults. Rating agencies provide
historical frequencies of defaults of payments exceeding 90 days.
 Recovery Risk
The traditional credit culture stipulates that lending is primarily dependent on the credit standing
of borrowers, not on covenants or guarantees. The rationale behind this prudent rule is that there
is always a residual, small or significant, risk whatever the guarantees.

However, ignoring the value of guarantees would be misleading

The loss in the event of default is the amount at risk at default

time less recoveries
 Major Guarantees
as recognized by New Basel Accord

Collaterals: They serve to limit both the lender’s loss under default and the borrower’s
risk-taking propensity. A borrower is reluctant to give up the collateral whenever it has more
value than the debt. Whenever the borrower’s upside is higher than the value of debt, he has a
powerful incentive to comply with the covenants

Third-Party Protections: A third-party guarantee does not provide any incentive

for the lender to limit his risk propensity. However, it does reduce the probability of default,
since default occurs only when both the primary borrower and the guarantor default. This is
the ‘double default’ or ‘joint default’

Covenants: Helps to prevent further risk deterioration

Risk-Enhancing Impact of Guarantees

Transform Credit Risk into

Collateral
Asset Risk

Third-Party Risk Transfer to

Protection Borrower + Guarantor

Pre-emptive – Proactive
Covenants
Corrective Actions
 Binomial Model of Credit Risk
Measurement

Binomial Distribution
A binomial distribution summarizes the number of trials, or observations, when each trial has
the same probability of attaining one particular value. 

For example, flipping a coin would create a binomial distribution. This is because each trial can
only take one of two values (heads or tails), each success has the same probability (i.e. the
probability of flipping a head is 0.50) and the results of one trial will not influence the results of
another.
 Binomial Model of Credit Risk
Measurement

Credit

Solvent Default

PS PD

PS or 1 – PD In solvency state L = 0 So loss is conditional upon

Default
PD + PS = 1 In default state L>0
 Binomial Model of Credit Risk
Measurement (Derivation of EL Eq.)
EL = PS x L + PD x L or

EL = PS x LGD + PD x LGD

Considering Mutually Exclusive Events. Loss in a solvency state is 0 (zero).

EL = PS x 0 + PD x LGD
The bank assigns to every customer a default
probability (DP), a loss fraction called the loss given
default (LGD), describing the fraction of the loan’s
EL = PD x LGD exposure expected to be lost in
case of default, and the exposure at default (EAD) subject
to be lost in the considered time period. The loss of any
obligor is then defined by
EL = EAD x PD x LGD a loss variable
 The Loss Given Default

The LGD of a transaction is more or less determined by “1 minus recovery rate”, i.e., the LGD
quantifies the portion of loss the bank will really suffer in case of default.
 Practical Problem

Take the case of an outstanding retail loan worth rupees 5 lakhs having rupees 2.95 lakhs security
(collateral) and default probability of 2 %.

Expected loss calculation can be shown as below:-

(in absolute terms)
LGD = (1-recovery rate)
EL = PD * EAD * LGD
Recover Rate = 2.95/5.00
EL = 0.02 * 5,00,000 * (1 - 0.59) = 59% 0r 0.59
EL = 4,100
(in percentage terms) LGD = (1-0.59)
=0.41 or 41%
EL = PD * LGD
EL = 0.02 * (1 – 0.59)
EL = 0.82 %
 Unexpected Loss
The unexpected loss is the average total loss over and above the mean loss. The unexpected losses can take any
value. It is calculated as a standard deviation from the mean at a certain confidence level. It is also referred to as
Credit VaR.

The Unexpected Loss (UL) for an individual transaction is derived as under:

UL = EAD x
 Unexpected Loss
At the portfolio level, the ULs depend on the diversification of the portfolio if a portfolio is well
diversified then the probability of large Unexpected Losses is reduced. If a distribution of losses
is drawn up, the Expected Losses would be somewhere near the center of the distribution. In a
well-diversified portfolio the tail of the loss distribution gets shortened.

A fatter tail - Indicating

less diversified portfolio

The tail is short.

The portfolio is
well-diversified

Expected Loss
Credit Loss Distribution
 Characteristics of Credit Loss
Distribution
 It is not symmetrical. There is a limited upside because the best scenario is when
there is no loss. However, there is extremely large downside, that is, the losses can be
huge.

 It is highly skewed. The distribution is more concentrated toward small losses, with
very few chances of large losses.

 The distribution has heavy tail, i.e., the probability of large losses reduces very
slowly.
 Practical Problem on UL

Earnings at Exposure ₹82,50,000

PD 0.15%
sPD 3.87%
LGD 50%
sLGD 25%
Portfolio Unexpected Loss