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Credit Risk
Credit Risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counter parties. Traditionally, the credit risk is thought of as having two components1) Liquidity 2) Solvency
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a) b) c)
Credit risk also includes three other risks: Counter party risk Portfolio risk Country risk
Concentrations:
Credit concentrations are viewed as any exposure where the potential losses are large relative to the banks capital its total assets or where adequate measures exceed, the banks overall risk level. ---- why concentrations develop?
Concentrations:
Principles for management and control of risk concentrations RBI guidelines on exposure norms Techniques to check credit concentrations
Analysis: Higher the value of Z , the lower is the default risk The value of Z less than 1.81 is considered as high default risk
Case:
The financial position of the ABC Ltd is as under: Particulars Amount (in lakhs) Working capital 400 Retained earnings 50 Total Assets 1000 Earning before Interest and Tax 100 Sales 1500 MVE to Long term debts 0.15 Calculate the Z score of this company using Altmans Z score model and take a decision regarding the credit risk of ABC Ltd.
RAROC Model
Risk adjusted return on capital (RAROC) model includes default risk in pricing of loan. RAROC = one year income on loan capital at risk or loan risk There are two methods for calculation of loan at risk.
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First Method:
Rupee capital risk exposure = Duration of loan x loan amount x expected change in credit premium L = DL X L X (R/1 + R)
The main feature of this method of to find out the maximum change in the credit risk premium on loan by next year. (based on rating)
Case:
Suppose a bank wants to calculate RAROC for a loan of Rs.100 crore earning net income including a fee of Rs.1.5crore, with duration of 3.2 years. The current market rate of interest for such loans is 12% and change in risk premium is 3.5%.
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Second Method: EL = PD * LGD * EAD EL= expected loss PD= probability of default LGD= loss given default EAD= exposure at default
Case
Sound Bank has given a loan of Rs.100 crore to a borrower. The chances of the borrower defaulting in a one year horizon is 2%. When the default occurs, the loss is likely to be 50%. Calculate the Expected Loss on this transaction.
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Unexpected loss: UL = PD * LGD * CAR
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