Credit Risk Measurement & Management

Traditional approaches to measuring credit risk The traditional approaches to measuring credit risk are the use of expert judgement, rating systems and credit scoring systems. Expert judgment The oldest approach to credit risk assessment involves an expert judgement by a loan officer based on the 5Cs of credit. The five Cs are character, capital, capacity, conditions

and collateral.

Rating systems Rating systems can be one-dimensional or bidimensional. One-dimensional rating scales provide one rating that combines an assessment of the creditworthiness of the loan and the collateral. Bidimensional ratings, on the other hand, separately assess the creditworthiness of the loan and the quality of collateral. Credit scoring models The mathematical models used in credit scoring are broadly of four types, namely the linear probability model, the logic model, the profit model and the linear discriminant model.

Altman Model:
Z = .12X1 + .014 X2 + .033X3 + .006X4 +---------------0.999X5 Where: Z = Overall Score Working Capital X 1 = ------------------Total Assets

(measure of liquidity)

Retained Earnings X2 = ----------------------( Measure of earnings against investment in Total Assets X3 Earnings before interest & taxes = ------------------------------------------Total Assets ( measure of profitability)

total assets)

Market value of equity X4 = ----------------------------------Book Value of Total debts Sales = ------------------Total Assets

( measure of firms financial structure or leverage)

X5

( measure of sale generating ability of the firms assets)

Given the ratio data (Xi) of a borrower, the Z score can be

calculated using the weights derived in Altmans model. This score can be used to differentiate borrowers. The cut-off points for the total Z score are as under: 1) Z score greater than 2.99 classifies healthy units with the

lower probability of failure and default.

2) Z score less than 1.81 and 2.99 represents grey area with both bankruptcy possibilities. 3) Z score less than 1.81 indicates financially distressed and bankrupt units.

RAROC: (risk adjusted return on capital)

The measurement of credit risk entails quantification of the following components of credit risk: Probability of Default (PD) Exposure at Default (EAD) Loss Given Default (LGD) Maturity or Tenor of the Exposure (real not contractual) Level of diversification in banks loan portfolio (using credit risk correlation between the different borrowers in a portfolio)

Correlation between credit risk and other risk factors.

The Expected loss ((EL) is a product of Probability of Default (PD), loss Given Default (LGD) and the Exposure at Default (EAD) and can be expressed symbolically as under:

EL = PD X LGD X EAD Let us suppose that the bank has given a loan of Rs. 100 to a borrower. The chances of the borrower defaulting in a oneyear horizon or the Probability of Default is 2%. When the default occurs, the loss (or the Loss given default) is likely to be 50%. In such a situation the Expected Loss on the transaction is .02 x 100 x .5 or Rs.1. UL = EAD X (PD X 2 LGD + LGD 2 X 2 PD) As the above equation shows the Unexpected Loss (UL) arises due to the variance ( 2 ) of the LGD and the PD. In case 2 LGD and 2 PD are zero, i.e., there is no variance in PD or in LGD, the above expression becomes zero and the UL is zero. In other words, the unexpected losses will be equal to the expected losses.

KMV model to estimate default probability1. Estimation of asset value and asset volatility form equity value and volatility of equity return. 2. Calculation of distance from default. 3. Calculation of expected default frequency. Other models to measure health of units Dr. L.C. Gupta and Prof. S.S. Srivastava Earnings before depreciation, interest & taxes (EBDIT) ----------------------------------------------------------------------Sales (net of excise) Operating Cash Flow (OCF) ---------------------------------Sales (net of excise) Earnings before depreciation, interest and taxes (EBDIT) ------------------------------------------------------------------------Total assets + Accumulated depreciation

 Operating Cash Flow

-------------------------Total assets + Accumulated depreciation Earnings before depreciation, interest and taxes (EBDIT) ------------------------------------------------------------------------Interest + 0.25 Debt.

(i) Dr. Guptas study also revealed other interesting findings: EBIT measure proved inferior to both EBDIT and OCF. The worst among the profitability ratios were those related to net worth, * (PBT/ NW & PAT/NW). There was a definite relationship between incidence of sickness and inadequacy of equity base.

all the liquidity ratios have poor predictive power.

* PBT = Profit before tax PAT = Profit after tax NW = Net worth

MEASURING CREDIT RISK THE VaR APPROACH

The distribution of future values compared to the future

value assuming that no credit event occurs yields a

distribution of changes in exposure values over the horizon.

This distribution of future value changes yields a credit risk measure. A specified percentile of the loss distribution can be used as the magnitude of unexpected loss owing to credit risk.

Current future value of exposure of bank to counterparty Changes in rating of counterparty over horizon Distribution of future values of exposure of bank to counterparty

Changes in term Structure of credit spreads relevant to counterparty

Loss given default rate

Change in exposure to counterparty

Distribution of credit losses over the time horizon Chosen percentile Magnitude of unexpected credit losses

Changes in Credit Rating The first step in measuring credit risk is defining a credit loss. Two different paradigms of credit loss are used in credit models. The default mode paradigm recognizes a fall in value

of the credit only when the counterparty defaults on its

payment obligations. The mark to market paradigm, on the other hand, recognizes loss even when a rating downgrade happens even though there might not be any default in payments.

Changes in Credit Spreads This risk premium is measured by the yield spread between rated corporate paper and government securities. Just as a term structure exists for risk free securities, term structures for credit spreads can be modeled for different rating

categories. Changes in credit spreads are a source of risk

independent to the changes in ratings.

MEASURING CREDIT RISK - OTHER APPROACHES

An alternative approach to measuring credit risk is to use the concept of options and their pricing to value loans given by a financial intermediary. Loans given by a financial intermediary pay a fixed return of interest. The financial intermediary does not benefit from the residual profits of the borrower. In case the value of the firm is higher than its liabilities, the owners of the borrowing firm have an incentive to pay off their debt and keep the remainder value for themselves.

CREDIT RISK MANAGEMENT

Credit Risk Management encompasses four activities, namely establishing an appropriate credit risk environment; operating a sound credit granting process; maintaining appropriate credit administration, measurement and monitoring processes; and ensuring adequate controls over credit risk.

CREDIT RISK ENVIRONMENT

The most important component of a healthy credit risk environment is the overview by the board of directors (BOD) and senior management. The senior management is responsible for the development and implementation of these strategies and policies and procedures. The credit risk strategy should state the banks goals of credit quality, earnings and growth.

A statement of the banks willingness to grant credit to different economic, geographic, currency and maturity profiles along with different product and profitability profiles should be included in the strategy.

Establishing an appropriate Credit risk environment

Operating a sound credit granting process

Ensuring adequate controls over credit risk

Maintaining appropriate credit administration, measurement and processes

It is the senior managements responsibility to develop written procedures and policies to identify, measure, monitor and control credit risk. The senior management should lay down procedures to identify measure, monitor and control credit risk. Credit Granting Process The credit granting decisions should be made within overall credit limits at the individual and group levels integrated across exposure types. A well-defined process should exist for new approvals, amendments, renewals and refinance of existing exposures.

The credit limit for a single borrower is fixed at 15% of the banks capital funds. The credit limit for a group is 40% of the banks capital funds. This limit can be overshot up to 5% for individual and 10% for group borrowers in the case of lending for infrastructure projects.

Credit Administration, Measurement and Monitoring

A system for ongoing administration of credit risk should cover credit bearing portfolios and individual credits. A risk rating system should be developed and utilized for risk measurement. Management information systems and analytical techniques should be used to measure credit risk. The risk measurement system should be able to consider potential future changes in economic conditions and stressful conditions.

The credit monitoring system should enable the bank to understand the current financial condition of an existing borrower. The monitoring of the quality of credit should be done through the use of an internal risk rating system. The rating system should have an adequate number of grades to capture all credit quality categories. Controls over Credit Risk
The control system should focus in particular on the adequacy of the credit granting process and the implementation of exposure limits. Exceptions should be reported by the control process. It should also focus on early remedial action on deteriorating credits and problem credits.