Credit Risk For Banking Transactions

 

Loss = D x X x (1-R)

 DEFAULT RISK

 ·       Quantitative measure : default probability

·       Proxies of Default :

§  Ratings/Historical statistics on defaults

§  Estimate of default probability based on some corporation’s characteristic.

 

Historical Frequencies of Default

·      Ratings & default frequencies post significant correlation.

·       Internal rating scale + agencies rating scale = internal ratings and historical default frequencies.

 §  Rating Agencies provides :

¨      frequencies of defaults

¨      volatility across time of yearly frequencies - changes gen. economic conditions.

¨      transition matrices between rating classes

 §  Best risk qualities - default rate close to zero

§  Relationship between ratings  and default rates is far from proportional.

§  Default rate increase, ratings decline - exponential shape.

§  Improve rating class - improve overall solvency of the bank (theoretically).

 

Default Rates Volatility

 §  Default rates unstable through time.

§  Volatility of yearly historical default rates is measured by standard deviation.

§  Volatility increase, default rates increase, rating diminish.

§  High default rates - significant SD.

§  Basis to measure the unexpected loss for loan portfolios.

§  Proportional to unexpected loss

§  Expected Loss is proportionate to Average Default Rate.

 

Historical Default Rates and Horizon

§  Cumulated default rates increase with the horizon though the growth is not proportional.

§  High ratings, growth is more proportional

§  Transition matrices.

 

EXPOSURE RISK

1. The amount of risk in the event of default without considering recoveries.
2. Considers only future amount of risk (default occurs at unknown future date).

  ·       The Balance Sheet

§  Time profile of exposure - there is a contractual repayment schedule.

§  Committed LOC (not yet 100% utilised) are given contingencies recorded off balance sheet.

·       Contingencies Given

 §  Risks appear conditionally upon the initiative of counterparty.

§  Given Contingencies are options exercised by the customer.

§  Received Contingencies are options exercised at the initiative of the bank.

§  Risk generated off balance sheet are conditional risks, not certain risks.

§  use a 50% weight to value potential risk generated by Off Balance Sheet transaction.

 

·       The Time Profile of Expected Exposure

§  Amortising Loan, Bullet Loan/Committed LOC, Project Finance

§  Shapes - Stairs, box, hill

§  y = exposure, x = time

 

RECOVERY RISK

 ·       Guarantee & Covenants diminish risk - they reduce loss in the event of default.

·       All guarantees subject to legal risk.

·       Collateral can be seized and sold - reduce/cancel the loss - thus original credit risk is turned to recovery risk plus asset value risk.

·       depends on nature, location, integrity and legal environment of assets.

·       Risk of liquidation = zero if cash.

·       Real Estates, Machines, vehicles less easy-need judgement based on the characteristics of assets.

·       Third Party guarantee - Legal Risk & Default Risk

·       Covenants allow preventive action - more proactive than guarantee (like insurance).

  

CREDIT RISK & POTENTIAL LOSSSES

 ·       Loan Given Default (LGD) = default probability, exposure & recoveries.

 

Expected Loss

 §  LDG x default probability

§  Exposure x ( 1-recovery rate%) x default probability(%).

  

Unexpected Loss & Risk Based Capital

 §  Dispersion around the average of observed default rates is measured by the historical volatility of observed default rates.

§  Derived from deviations of default rates.

  

DEFAULT PROBABILITIES OVER VARYING HORIZONS

 ·    The probability of default over various time periods can be used to assess the credit risk of a loan up to maturity.

·       Default Probability changes over time - risk changes over time-transition across rating.

·       nPd = n x 1Pd