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5.1 The nature of credit risk

5.1 The nature of credit risk

Credit risk is defined as the risk of losses associated with

the possibility that a counterparty will fail to meet its
obligations when they fall due, in other words the risk that
a borrower wont repay what is owed.
5 The nature of credit risk All investors and companies will be familiar with credit risk. For
example, personal investors risk their savings in pursuit of profits
when they invest in something other than cash products, (e.g. a
bank deposit, a bond, or shares). Companies will incur credit risk in
the form of receivables due from their customers. They will be
owed money in return for providing goods or services.
5.1 The nature of credit risk
Banks are particularly subject to credit risk because of the very
nature of their lending-based business. Banks are highly geared
institutions and any rise in default rates by borrowers has the
For internal use only potential to erode their capital very rapidly.
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5.1 The nature of credit risk 5.1 The nature of credit risk

5.1 The nature of credit risk example 5.1 The nature of credit risk

Investors looking for higher returns played an important part in the

Peregrine Investment Holdings evolution of credit appraisal techniques.

In January 1998 Peregrine Investment Holdings, one of Asias
biggest independent investment houses, based in Hong Kong,
went into liquidation with outstanding debts of approximately
USD 400m.
It was brought down partly by the financial turmoil throughout the
Asian market, but more particularly because it lent some USD200m
20% of its capital base to Steady Safe, an Indonesian taxi and
bus operator which became insolvent.
The development of institutional investors such as insurance
companies and pension funds contributed significantly to the
growth of the professional investment management industry.
This in turn led to increased investment in equities and bonds
issued by non-government entities such as major companies.
Growth was particularly strong in the US where institutional
investors could invest in securitized bond issues based on
mortgages, car loans and credit card receivables.

Consequently professional investment managers needed to

improve not only their understanding of credit risk, but how to
3 measure it as well. 4

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5.1 The nature of credit risk
5.1.1 Sovereign credit risk
Until recently international bond markets were dominated
by bonds issued by the central governments of countries.
Sovereign risk is the risk of losses associated with the
possibility that a country fails to pay either interest or
principal on its borrowings. While the outright negation of
such debt is rare (Russia in 1917 and 1998 and the
African and South American defaults in the late 1960s
and 1970s), the rescheduling of such debt is not
uncommon. The International Monetary Fund (IMF) plays
a major role in assisting countries with debt payment
problems.
When faced with creating inflation or defaulting on its debts
denominated in its domestic currency the Russian government
chose in 1998 to default on both domestic and foreign currency
debt.
5.1 The nature of credit risk
5.1.1 Sovereign credit risk domestic currency and
foreign currency debt
A useful distinction in sovereign debt bond issues is usually drawn
between:
the debt countries owe which is denominated in their domestic
currency, and where a default is rare largely because countries
have the power to print their domestic currency
debt denominated in foreign currency where the currency must be
earned by the debtor country.
It is worth noting that many of the world's largest economies rarely
borrow in anything but their domestic currency, although their
bonds are held internationally. However the role of the US dollar as
a reserve currency means that many countries with surplus foreign
currency earnings hold significant amounts of US sovereign debt
as foreign currency reserves.
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5.1 The nature of credit risk
5.1.1 Sovereign credit risk example
Russian government bonds
In 1998 foreign investors in Russian government domestic bonds
were left facing losses estimated at USD 33bn because of the
governments effective default.
All of the major financial institutions that suffered losses appeared to
have ignored the fact that the greater the return, the greater the risk.
The domestic Russian government securities offered a very high
yield.
Banks hedged their foreign exchange exposure partially, if not
completely by means of forward contracts, many with Russian banks
which only increased their Russian exposure.
These institutions took the view that governments did not default on
5
their debts, overlooking the defaults shown earlier. 6
5.1 The nature of credit risk
5.1.1 Sovereign credit risk financial ratio analysis
Sovereign risk is usually assessed much in the same way
as corporate debt with models designed to determine the
ability of a countrys government to service its debts.
The debt service ratio comprises the critical ratio of such
models and is defined as the future interest and principal
repayments due on foreign currency borrowing divided by
the income from exports and capital inflows.
As with corporate debt appraisal there are a number of
other ratios that can help assess the debt service
capability of a country.
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5.1 The nature of credit risk
5.1.1 Sovereign credit risk inward investment
Inward investment has become a growing area of analysis for
investors and banks particularly when it is combined with domestic
economic policies to create so-called bubbles (high valuations of
specific assets that cannot be sustained in the long-term).
Examples of recent bubbles include Tokyos soaring commercial
property prices in the early 1990s, and the high technology
company valuations in the US and Europe from the late 1990s until
2002.
Such bubbles also played a role in the Asian debt crisis of the mid-
1990s as both commercial property prices and equity values in
many Southeast Asian countries reached levels that could not be
sustained in the long term.
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5.1 The nature of credit risk
5.1.1 Sovereign credit risk qualitative factors
There are also a number of qualitative factors to consider when
assessing sovereign risk such as:
the efficiency of the banking system in allocating capital to
productive enterprises
the efficiency of the tax system in raising government revenue
the ability of the central bank to affect exchange rates
the role of high domestic interest rates which both incentivizes
private foreign currency borrowing, and which can contribute
significantly to inflationary pressures within an economy
the transparency of the economy and the clear separation of roles
and powers between the government, central bank, supervisors,
the legal system and business.
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5.1 The nature of credit risk
5.1.1 Sovereign credit risk other factors
The poor quality of government data has often made the process of
assessing sovereign risk difficult.
As not all currency borrowing is carried out by governments, private
sector borrowing in foreign currency can also affect the total size of
a countrys debt service requirements/obligations and data on this
type of borrowing is often very poor.
5.1 The nature of credit risk
5.1.1 Sovereign credit risk sovereign risk and country
risk
Whilst sovereign risk and country risk are often
considered synonymous it is better to view sovereign risk
as a subset of country risk.
Country risk covers the domestic legal, political and
economic environment and how these affect the private
sector within the economy.
Country risk analysis is particularly important when
looking at inward investment which involves cross-border
lending to companies, individuals or projects.
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5.1 The nature of credit risk
5.1.1 Sovereign credit risk sovereign risk and country
risk
Other factors to consider when assessing country risk include:
the legal system especially laws on property ownership and
bankruptcy
the stability of the political system; although this does not refer to
the stability of any one government
the rules surrounding access to foreign currency especially if
exchange control is prevalent.
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5.1 The nature of credit risk
5.1.2 Corporate credit risk
Many banks claim that they understand corporate credit risk far
better than many of the other risks they take and in many
economies it is the most important category of credit risk for banks.
The role of banks in recycling savings from private individuals to
productive enterprises (a process known as financial
intermediation) is vital for economic growth.
The credit appraisal techniques many banks use when lending to
companies stem from methods used to evaluate investments.
Indeed, the use of financial ratio analysis as the basis for the
models used to make corporate lending decisions is widespread.
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5.1 The nature of credit risk
5.1.2 Corporate credit risk
Corporate credit, by its nature carries a higher risk than
sovereign debt which is supposedly risk free debt.
Corporate credit risk comprises of the default risk in the
debt issued by companies.
The most common form of such debt is common stock,
which bears the highest risk of loss. Stockholders are the
last stakeholders to be paid out when a company is
liquidated.
In all jurisdictions corporate bonds and bank loans are
paid out prior to equity holders, but still after preferred
creditors such as employees (for unpaid wages) and the
government (for unpaid taxes).
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5.1 The nature of credit risk
5.1.2 Corporate credit risk
Options models could be substituted for more conventional models
where the relevant corporate credit is widely traded through such
instruments as bonds, commercial paper and common stock and
when information on the debt structure and trading performance of
the company is readily available and up to date.
However, such models can produce volatile credit grades. Most
commercial banks are likely to use them to supplement financial
ratio based models.
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5.1 The nature of credit risk
5.1.3 Retail customer credit risk
Many commercial banks consider the credit standing of individual
retail customers as important to their business as corporate credit
risk. The techniques for personal credit appraisal have in many
countries been changing significantly as banks have moved away
from branch-based lending to centralized lending.
In branch-based lending the branch manager was primarily
responsible for lending decisions based on personal knowledge of
their customers. Centralized lending decisions are made by
inputting standardized customer information into credit scoring
models.
Product development has changed the market for personal finance,
which is now increasingly split between credit secured against real
estate (houses) and credit that is unsecured consumer finance
(increasingly credit card based).
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5.1 The nature of credit risk
5.1.3 Retail customer credit risk
Unsecured consumer finance has been greatly influenced by
developments in models which measure the credit standing of
individuals, so called credit scoring models.
Such models have in turn been greatly influenced by the credit card
industry. In this fiercely competitive business the specific features
of individual models are carefully guarded commercial secrets.
However, the fundamental features of these models include cash
flow assessment, employment history and asset cover. These are
discussed later in this chapter along with the importance of credit
agencies and credit history.
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5.1 The nature of credit risk
5.1.3 Retail customer credit risk
Outside of the US there has been increasing development of
customer accounts where a broad range of borrowings can be
secured against property on a continuing basis. This can include a
mortgage, car loan, home improvement loan, other consumer
finance and even credit card borrowings.
Although such loans cannot qualify as a mortgage in some
countries, the development of these accounts represents an
important innovation in personal finance. They have the potential
not only to reduce borrowing costs for customers and but to reduce
risk for banks as well.
With its extensive recognition of collateral Basel II seems to permit
and even encourage innovations such as this.
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5.1 The nature of credit risk
5.1.4 Probability of default
All the models discussed previously are used by banks to support a
lending decision. Lending decisions may be characterized as
bimodal (lend or dont lend).
Unfortunately this is too simplistic because in practice banks are
interested in the risks, the reward, (e.g. the margin and fees on the
loan) and, under Basel II, the capital being held against the loan.
Lending/investing decisions are made by balancing risk and
reward, because at some price any risk may be worth taking - the
greater the risk the greater the reward.
A simplistic bimodal approach does not help banks in making
commercial decisions. However, grading models are one way of
creating a risk/reward framework for supporting lending/investing
decisions. 20
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5.1 The nature of credit risk
5.1.5 Systemic credit risk
Credit risk and liquidity risk, are considered the most
fundamental risks in banking. In Basel I the focus was
solely on credit risk.
While liquidity crises in commercial banks are rare today,
credit risk can still prove very problematic, not simply for
banks themselves but for central banks, supervisors and
governments as well.
The Japanese credit boom of the 1990s and the bubble it created
in commercial property prices, led to a level of bad debts estimated
at in excess of 10% of the assets of many Japanese domestic
banks.
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5.1 The nature of credit risk
5.1.6 Traded markets counterparty credit risk
Market risk results from the mark-to-market value of a traded
market contract such as a foreign exchange contract or an interest
rate related contract.
A bank that undertakes market transactions will either make a
profit, or the counterparty with whom they contract will profit
depending on the mark-to-market value of the contract.
It is the classic zero sum game, only one party can gain from the
individual contract.
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5.1 The nature of credit risk
5.1.5 Systemic credit risk
In China supervisors are concerned that a similar percentage of
bad debts prevails in some banks. Such high bad debt levels can
lead to systemic risk, the great fear of central banks and
governments.
Any bank suffering a high level of defaults in its lending portfolio is
a problem for supervisors and central banks. However, if all banks
are suffering at the same time the economy will suffer. This could
potentially result in a severe economic downturn because the
banking system will not have sufficient capital (bad debts must be
deducted from bank capital).
Consequently banks will be unable to extend the credit needed to
facilitate economic expansion.
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5.1 The nature of credit risk
5.1.6 Traded markets counterparty credit risk
Traded markets counterparty credit risk is generated
when the counterparty does not immediately pay the
amount owed in a transaction. For example in many
businesses cash on delivery arrangement avoids credit
risk. However in many banking transactions the sum due
(e.g. the loan) will only be paid when the contract
matures. With many market related products the amount
owed to the counterparty may change during the life of
the contract. It is not unknown for the flow of payments to
reverse as a result of movements in the market price of
the contract.
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5.1 The nature of credit risk 5.1 The nature of credit risk

5.1.6 Traded markets counterparty credit risk 5.1.6 Traded markets counterparty credit risk

In practice the level of counterparty credit risk can be reduced by:

In market risk, marking-to-market is the process of using current
the making of regular payments between the parties to the market prices to revalue a trading position. However, mark-to-
contract market valuations are also the basis of calculating counterparty
credit risk.
the debtor pledging security to back what is owed (collateral)
The extent of counterparty credit risk is a function of market
netting. movements and is not directly related to changes in the credit
standing of the counterparty.

Netting is the process of offsetting gains and losses In all other respects a traded markets counterparty is considered
across a number of the same type of contract or even the same as any other counterparty, and will be evaluated using the
across different contract types. same credit appraisal techniques.

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5.2 The origin and use of credit analysis

5.2.1 Analysis of creditworthiness sovereign risk

In addition to the above agencies banks also undertake their own

analysis of sovereign risk. Such analysis usually looks at a series
of quantitative and qualitative factors. These typically cover:
5 The nature of credit risk the country itself
economic environment (savings, investment and growth statistics)
natural resources and raw materials
labor market efficiency and the quality of skills and education
efficiency of capital and banking markets
the government
5.2 The origin and use of credit macro economic policy (exchange rate and interest rate policies)
external trade and payments balances
analysis inflation history and outlook

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5.2 The origin and use of credit analysis
5.2.1 Analysis of creditworthiness sovereign risk
foreign direct investment flows
government funding and spending policies
the political environment
stability and adaptability of the political process
degree of consensus on social and economic aims
legal environment (property rights, creditors rights)
the banking system
policy and control of banking sector
independence of bank supervisors
role of central bank and support mechanisms for the banking
system.
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5.2 The origin and use of credit analysis
5.2.2 Analysis of creditworthiness corporate risk
When offering borrowing facilities to corporate customers,
all banks need to determine the ability of the company to
repay the debt.
Traditional approaches have centered on analyzing the
financial performance of the company that wants to
borrow. This is termed credit analysis.
The techniques used in credit analysis have their origin in
the individual stock analysis techniques found in the
investment management industry.
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5.2 The origin and use of credit analysis
5.2.1 Analysis of creditworthiness sovereign risk
When considering sovereign risk an analytical framework can be
created either from reliable quantitative figures or from ranking the
more qualitative criteria in the above list. Reliable quantitative
figures are published by the BIS; however the lack of such figures
could be indicative of the level of risk in a particular country.
A grading model can be created by comparing the average (mean)
data of a cohort (group) of similar countries, or by more
sophisticated so-called multivariate analysis which creates a
single score by combining a number of such ratios.
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5.2 The origin and use of credit analysis
5.2.2 Analysis of creditworthiness corporate risk
Both investors and banks are seeking stability and soundness in a
company measured by:
its ability to pay dividends regularly and over a sustained period of
time.
a ratio of debt to equity that is not very high so that if it suffered a
shock from an unforeseen event (such as the collapse of a major
customer), it would be able to cut its costs (e.g. dividends) and still
be able to pay its creditors (lenders/suppliers) thus avoiding
potential liquidation.
other criteria such as the ratio of current assets to current
liabilities, which shows the company's ability to generate net cash
flow.
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5.2 The origin and use of credit analysis
5.2.2 Analysis of creditworthiness corporate risk
Corporate credit analysis
Corporate credit analysis in commercial banks is still predominantly
undertaken using financial ratio analysis and models built on its
principles. Such analysis examines the following elements of a
companys financial statements:
balance sheet
profit and loss account (income statement)
cash flow statement
tax statement
The analysis will typically focus on three years historic
performance. To add a predictive capability to the credit appraisals
the results are analyzed to identify any trends.
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5.2 The origin and use of credit analysis
5.2.2 Analysis of creditworthiness corporate risk
Company valuations
The focus on corporate credit analysis has changed in recent
years, as worries about the ability of companies to manipulate
earnings figures have increased.
Today company valuations are often based on such tangible factors
as dividends plus net assets per share, rather than earnings.
Assessing a companys financial performance through financial
ratio analysis is still very important as this form of analysis can help
in avoiding bubble valuations and thus inappropriate lending.
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5.2 The origin and use of credit analysis
5.2.2 Analysis of creditworthiness corporate risk
Key ratios
The ratios typically used during corporate credit analysis cover a
companys:
operating performance net income divided by net worth an sales
divided by fixed assets
debt service capability cash flow divided by interest on debt
financial gearing (leverage) long-term debt divided by capital
liquidity current assets divided by current liabilities
Ratios can be used to develop grading models. For example, ratios
can simply be compared to some defined industry average, which
is known as univariate analysis, or built into a scoring system
referred to earlier as multivariate analysis.
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5.2 The origin and use of credit analysis
5.2.3 New options-based techniques
The Merton approach is remarkably simple yet very incisive.
Merton characterizes a loan to a company as the purchase by the
company of a right (an option) to transfer (put) the firm's assets to
the bank when the value of the firm becomes negative. This is
assumed to happen when the present value of the equity of the
firm, less the present value of its debt becomes negative.
When this occurs the owner of company has no incentive to retain
ownership of the company and walks away and leaves the
company in the hands of the bank, lenders and bondholders.
The difference between the valuation of equity and debt can be
used to calculate the probability of default. The nearer to zero this
net valuation is the more likely the owner is to walk away. At this
point the equity has no value because the firm owes the debt
holders more than the company is worth.
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5.2 The origin and use of credit analysis
5.2.3 New options-based techniques
The Merton approach has greatly influenced the latest grading
models used to predict the probability of a credit default. Along with
such additional metrics as loss given default, exposure at default
and backtesting methods focusing on expected and unexpected
loss, it forms the basis for Basel II compliance under the Internal
Rating-Based approaches.
An in depth explanation of Merton-based options models is beyond
the scope of the course, but it is important to understand the basic
concepts behind such models.
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5.2 The origin and use of credit analysis
5.2.4 Analysis of creditworthiness personal credit risk
Credit scoring models
The financial information that a bank has available from a
customers account gives it an advantage over other banks wishing
to extend credit to the customer. This advantage restricted
competition in the consumer credit market and led to the
development of so-called credit scoring models.
A credit scoring model enables a bank to extend credit to
individuals even though the bank does not already provide all their
banking arrangements.
Banks feed the details of a persons credit history, along with other
details provided by the potential customer, into scoring models that
estimate credit worthiness.
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5.2 The origin and use of credit analysis
5.2.4 Analysis of creditworthiness personal credit risk
Personal credit risk covers two major areas of personal
finance: finance secured against real estate (primarily
mortgage lending) and unsecured lending (mainly
consumer finance).
Personal budgets
Lending to an individual, whether secured against housing or
unsecured, requires an understanding of personal budgets. As
such budgets are based on the amount of cash coming into a
household and cash spent by a household, a bank account is an
excellent source for the required historical information.
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5.2 The origin and use of credit analysis
5.2.4 Analysis of creditworthiness personal credit risk
Credit reference agencies
Credit reference agencies have played an essential role in the
growth of consumer lending. These agencies maintain a record of a
persons credit history and ideally require all potential lenders to be
parties to their arrangements.
The growth of such agencies has significantly increased unsecured
lending competition in a number of markets where they have
become established.
The importance of such agencies to the retail banking industry has
been increasingly recognized and such agencies now exist in a
number of emerging markets including China.
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5.2 The origin and use of credit analysis
5.2.4 Analysis of creditworthiness personal credit risk
Lifetime consumption
Confidence in the debt service capability of an individual over time
requires a forward looking approach. This in turn requires an
assessment of what the lifetime income and expenditure profile of
the borrower is.
A simple illustration of this is the difference between granting a
mortgage to someone who is 30 years old and someone who is 60.
The sources of repayment may differ significantly.
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5.2 The origin and use of credit analysis
5.2.4 Analysis of creditworthiness personal credit risk
Affordability assessment
In assessing the affordability of a mortgage banks typically consider
the following:
free disposable income, on an individual or joint income basis
income after mortgage payments are deducted
income multiples and ability to sustain payments in the future
the certainty of the interest rate charged on the mortgage
threats to income and insurance cover (health, unemployment)
asset insurance (house, home contents)
loan to house value
mortgage indemnity insurance.
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5.2 The origin and use of credit analysis
5.2.4 Analysis of creditworthiness personal credit risk
Net assets
Income and expenditure is only one dimension of a persons
financial viability; the other is a persons assets and liabilities.
Clearly a high level of net personal assets, such as shares or
bonds, could have been a potential source of repayment for the
older person in the example above.
The role of insurance
In addition to net income and net assets the ability to sustain
payments over time will also depend on the level and type of
insurance coverage the borrower has. For example health
insurance could be used to sustain payments should either person
in the above example become sick and unable to work.
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5.2 The origin and use of credit analysis
5.2.5 Portfolio management
The development of portfolio management theory has led
to a far better understanding of the benefits of considering
not only the risk associated with any single loan, but also
the importance of the change in the risk of a whole
portfolio of loans as a result of making an additional loan.
The main effect of taking loan correlations into account
has been to dissuade banks from concentrating lending in
any one area of business either by geographic, industry
or credit grades. This is known as credit concentration
risk.
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5.2 The origin and use of credit analysis 5.2 The origin and use of credit analysis

5.2.5 Portfolio management 5.2.5 Portfolio management

Concentration risk is covered in Basel II where it states risk
concentrations are arguably the single most important cause of
major problems in banks.
Such concentrations are not covered in the Pillar 1 capital charge,
but rather in Pillar 2. Under Pillar 2 banks are required to have
effective internal policies, systems and controls to identify measure
and monitor and control their credit risk concentrations.
Banks are also required to consider the extent of their credit risk
concentrations in their assessment of capital adequacy under Pillar
2 and to conduct stress test accordingly.
Such concentrations include significant exposures to:
an individual counterparty or group of related counterparties
economic sector or geographic region
reliance on an activity or commodity
collateral type or single counterparty
Many national supervisors impose large exposure limits in relation
to the amount of lending to any one counterparty as a percentage
of a banks capital.

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5.2 The origin and use of credit analysis

5.2.5 Portfolio management

Concentration risk can be analyzed by looking at the

cohorts of the portfolio. A cohort is a grouping of the
assets by different criteria.
For example a portfolio can be grouped by industrial
classification, by geographic area and by credit grade.
All represent different ways of grouping a portfolio and will
give distinct information when analyzing the concentration
risk contained in the overall portfolio.

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