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Management
Prof. Partha Saha
1.
Standardized Approach
(External Ratings)
Minimum
Capital
Requirement
Standardized Approach
Based on Assessment of External Credit
Assessment Institutions
External Credit
Assessments
Sovereigns
Banks/
Securities
Firms
Corporat
es
PublicSector
Entities
(PSEs)
Asset
Securitization
Programs
Standardized Approach:
New Risk Weights (June 1999)
Assessment
Claim
AAA to
A+ to A-
AA-
Sovereigns
1 Risk
0%
BBB+ to
BB+ to
BBB-
B-
Below B-
Unrated
20%
50%
100%
150%
100%
Option 11 20%
Banks
Option 22 20%
50%
3
50%
100%
3
50%
100%
3
100%
150%
150%
100%
3
50%
Corporates
100%
100%
100%
150%
100%
20%
Standardized Approach:
New Risk Weights (January 2001)
Assessment
Claim
AAA to
A+ to A-
AASovereigns
Banks
BBB-
0%
20%
50%
100%
150%
100%
Option 11
20%
50%
100%
100%
150%
100%
Option 22
20%
50%
50%
100%
100%
100%
Corporates
1
BBB+ to
20%
50%(100%)
150%
150%
50% 3
100%
Risk weighting based on risk weighting of sovereign in which the bank is incorporated.
Internal Ratings-Based
Approach
Two-Tier Ratings System:
Obligor Rating
Represents Probability of Default by a Borrower
Facility Rating
Represents Expected Loss of Principal and/or
Interest
Pillar 1
Opportunities for a
Regulatory Capital
Advantage
Example: 30 year Corporate Bond
Standardized
Model
Internal
Model
Capital
Market
Credit
98 Rules
Standardized Approach
4
RATING
4.5
5.5
CCC
BB-
BB+
BBB
A-
A+
S&P:
AA
1.6
0
AAA
6.5 7
Internal ModelAdvantages
Example: Portfolio
of
100 $1 bonds
diversified across
industries
Standardized
approach
AAA
0.26
1.6
AA
0.77
1.6
1.00
1.6
BBB
2.40
1.6
BB
5.24
8.45
CCC
10.26
Internal Ratings-Based
Approach
Three elements:
PD set by Bank
LGD, EAD set by Regulator
50% LGD for Senior Unsecured
Will be reduced by collateral (Financial or Physical)
Advanced Approach
Notes
Consideration is being given to Incorporate Maturity explicitly into the Advanced
Approach
Granularity Adjustment will be made. [not correlation, not models]
Will not recognize Industry, Geography.
Based on Distribution of Exposures by RR.
Adjustment will Increase or Reduce Capital based on Comparison to a Reference Portfolio
[different for Foundation vs. Advanced.]
EXPECTED
LOSS
Rs.
Probability of
Default
Loss Severity
Given Default
Loan Equivalent
Exposure
(PD)
(Severity)
(Exposure)
Rs
What is the
Probability of the
Counterparty
Defaulting?
If Default occurs,
how Much of this
Do we Expect to
Lose?
If Default occurs,
how Much
Exposure do we
expect to have?
Assumptions in Contingent
Claim Approach
The Risk-Free Interest Rate is constant
The firm is in Default if the value of its
Assets falls below the Value of Debt.
Default can occur only at the Maturity Time
of Bond
Payouts in case of Bankruptcy follow
Strict Absolute Priority
Shortcoming of Contingent
claim approach
A Risk-Neutral World is Assumed
Prior default experience suggests that a
firm Defaults long before its assets fall
below the value of Debt
This is one reason why the Analytically
Calculated Credit spreads are Much
Smaller than Actual spreads from
Observed Market Prices.
KMV Approach
KMV derives the actual individual probability of
default for each obligor , which in KMV
terminology is then called Expected Default
Frequency or EDF.
Three steps
Estimation of the Market Value and the
Volatility of Firms Assets
Calculation of the Distance-to-Default (DD)
which is an Index measure of Default Risk
Translation of the DD into Actual Probability of
Default using a default database.
An Actuarial Model:
CreditRisk+
The Derivation of the Default Loss
Distribution in this model comprises the
following steps
Modeling the Frequencies of Default for the
portfolio (Likelihood of Default)
Modeling the Severities in the case of Default
(Risk Impact)
Linking these Distributions together to obtain the
Default Loss Distribution (Risk Distribution)
Yield Curve
A yield curve is a line that plots the Interest rates, at a set
point in Time, of bonds having Equal Credit Quality but
Differing Maturity Dates.
Three-Month, Two-Year, Five-Year and 30-year U.S.
Treasury Debt.
Benchmark for other debt in the market (such as mortgage
rates or bank lending rates)
Typical Pattern
Baa/BBB
Spread
over
Treasuries
A/A
Aa/AA
Aaa/AAA
Maturity
Risk-free
yield
Corporate
bond yield
5%
5.25%
5%
5.50%
5%
5.70%
5%
5.85%
5%
5.95%
Example
One-year risk-free bond (principal=1) sells for
e
0 .051
0.951229
or at a 0.2497% discount
This indicates that the holder of the
corporate bond expects to lose 0.2497%
from Defaults in the First year
Example continued
Similarly the holder of the corporate bond
expects to lose
e 0.05 2 e 0.0550 2
e
0.05 2
0.009950
Example continued
Similarly the bond holder expects to lose
2.0781% in the first three years; 3.3428%
in the first four years; 4.6390% in the first
five years
The expected losses per year in
successive years are 0.2497%,
0.7453%, 1.0831%, 1.2647%, and
1.2962%
Summary of Results
(Table 26.1, page 612)
Maturity
(years)
Cumul. Loss.
%
Loss
During Yr (%)
0.2497
0.2497
0.9950
0.7453
2.0781
1.0831
3.3428
1.2647
4.6390
1.2962
Recovery Rates
Class
Mean(%) SD (%)
Senior Secured
52.31
25.15
Senior Unsecured
48.84
25.01
Senior Subordinated
39.46
24.59
Subordinated
33.71
20.78
Junior Subordinated
19.69
13.85
Probability of Default
Assuming No Recovery
Q(T )
y* ( T )T
or
Q(T ) 1 e [
e y(T )T
y* ( T )T
y( T ) y* ( T )]T
Probability of Default
Prob. of Def. (1 - Rec. Rate) Exp. Loss%
Exp. Loss%
Prob of Def
1 - Rec. Rate
If Rec Rate 0.5 in our example, probabilities
of default in years 1, 2, 3 , 4, and 5 are 0.004994,
0.014906, 0.021662, 0.025294, and 0.025924
Measure 1
One commonly used default correlation
measure is the correlation between
1. A variable that equals 1 if company A defaults
between time 0 and time T and zero otherwise
2. A variable that equals 1 if company B defaults
between time 0 and time T and zero otherwise
Measure 1 continued
Denote QA(T) as the probability that company A will
default between time zero and time T, QB(T) as the
probability that company B will default between
time zero and time T, and PAB(T) as the probability
that both A and B will default. The default
correlation measure is
AB (T )
PAB (T ) Q A (T )Q B (T )
[Q A (T ) Q A (T ) 2 ][Q B (T ) Q B (T ) 2 ]
Measure 2
Based on a Gaussian copula model for time to default.
Define tA and tB as the times to default of A and B
The correlation measure, rAB , is the correlation between
uA(tA)=N-1[QA(tA)]
and
uB(tB)=N-1[QB(tB)]
where N is the cumulative normal distribution function
continued
continued
Measure 1 vs Measure 2
Measure 1 can be calculated from Measure 2 and vice versa :
PAB (T ) M [u A (T ), u B (T ); r AB ]
and
AB (T )
M [u A (T ), u B (T ); r AB ] QA (T )QB (T )
[QA (T ) QA (T ) 2 ][QB (T ) QB (T ) 2 ]
Modeling Default
Correlations
Two alternatives models of default
correlation are:
Structural model approach
Reduced form approach
RETAIL
SME
CORPORATE
Retail scoring
models
Expert
Judgment
Based Internal
Ratings
Internal Rating
Models
Pooled PD
Mapping to External
Rating Models
Data quality
Credit Risk
Mitigation
Collateral
Guarantees
Credit Derivatives
Collateral
Two Approaches
Simple Approach
(Standardized only)
Comprehensive Approach
'Risk-Based Haircut'
A Haircut is the Difference between prices at which
a Market maker can buy and sell a Security.
Market makers can trade at such a thin Spread
'Risk-Based Haircut'
A reduction in the recognized value of an asset in order to
produce an estimate for the level of margin or
financial leverage that is acceptable to use when
purchasing or continuing to own the asset.
An analyst undertaking a Risk-based Haircut of an asset
attempts to determine the chances of the asset's value
falling below its current level, so that a sufficient
buffer can be established to protect against a margin
call
Collateral
Comprehensive Approach
Coverage of residual risks through
Haircuts
(H)
Weights
(W)
Collateral
Comprehensive Approach
H (Haircut)- should reflect the Volatility of
the Collateral
W (Weight)- should reflect Legal
Uncertainty and Other Residual Risks.
Collateral Example
Rs1,000 loan to BBB Rated Corporate
Rs. 800 Collateralized by Bond
issued by AAA rated bank
Residual Maturity of Both: 2 years
Collateral Example
Simple Approach
Collateralized claims receive the risk weight
applicable to the collateral instrument,
subject to a floor of 20%
Example: Rs1,000 Rs.800 = Rs.200
Rs.200 x 100% = Rs.200
Rs.800 x 20% = Rs.160
Risk Weighted Assets: Rs.200+Rs.160 =
Rs.360
Collateral Example
Comprehensive Approach
C
Rs800
CA
Rs.770
1 H E H C 1 .04 .06
Collateral Example
Comprehensive Approach
Calculation of risk weighted assets based
on following formula:
r* x E = r x [E-(1-w) x CA]
Collateral Example
Comprehensive Approach
r* = Risk weight of the position taking into
Collateral Example
Comprehensive Approach
Rs.800
C A Rs.770
1 0.04 0.06
Risk Weighted Assets
34.5% x Rs.1,000 = 100% x [Rs.1,000 - (1-0.15) x Rs.770]
= Rs.345
Collateral Example
Approach
No Collateral
Simple
Comprehensive
Risk Weighted
Assets
1000
360
345
Capital
Charge
80.0
28.8
27.6