Credit Risk Management

The critical function of bank is to lend money. This carries risk on borrower for non payment of borrowed funds The credit department analyzes general financial conditions of firm to assess quality of their management and whether they will be likely customers for wide variety of services provided by the bank The process of credit evaluation got evolved over the years Traditional method involves financial analysis of balance sheet and income statement Currently along with traditional more analytical, statistical models are used to find probability of credit deterioration of the firm such as credit score, credit rating etc. Credit scoring Uses statistical, operational research and data mining models to determine credit risk of prospective borrowers It is number that is computed to help making credit decisions The major advantage is increase in speed in taking decisions, consistency and accuracy of decisions

Credit Risk Management

Usage of credit scoring model Controlling risk selection Managing credit risk Evaluating new loan programs and processing time for loan approval Ensuring existing credit criteria Improving profitability For example Credit score for consumer credit and home mortgage loan based on past performance of groups of borrowers similar to one being scored. The variables associated with this are default risk, past due performance, debt load relative to income, employment status etc. In general high credit score signals low credit risk. The score is designed to rank likelihood of borrowers default on a loan, 90 days past due on at least one loan or filing for bankruptcy within ascertain amount of time Major factors considered are
Payment history =>Are bills paid on time? Amount owed on all accounts Length of credit history=>time from which credit accounts established New credit=> more debt Type of credit in use

Credit Risk Management

Credit scoring can be used for small business in which generally factors such as past due credits, number of accounts, time period of active credit are considered For large businesses, model try to predict credit default swap rates are used i.e. predicting probability of default (PD) based on difference in interest rates or Moddys KMV model to by evaluating financial statements and other variables to predict PD for company as a whole rather than valuation of debt Credit Rating The credit rating agencies such as CRISIL, ICRA etc provides credit rating services that reflect their opinion about general credit worthiness of debt and equity issuer in the capital markets. The rating takes into account type of security, collateral etc. Financial Analysis This is the traditional way that bank evaluates business loans It helps to determine financial condition, credit worthiness of potential and existing customers & also to monitor the financial behavior post credit disbursement Perspective for analysis differs with the intention of doing it. The bankers may look more into liquidity and cash flows, equity analyst are interested in growth in and profitability

Credit Risk Management

Financial manager might try to look into from optimistic perspective obviously with more insider information available Quality of data=>typically year end data is used for analysis while interim data is used for monitoring purpose. The data requires compilation (presenting in form of financial statement), review (performing inquiry and analytical procedures)and audit(evaluation of evidence by competent, independent person) also takes place. Data distortion => The distorted data can cause an impact such as inflation Accounting practices between firms may distort comparison e.g FIFO/LIFO method Ratios Return on assets =NI/Total Assets=>It is the most comprehensive measure for profitability measuring productivity for creditors, share holders etc Return on equity = NI/Equity=> preferred stocks are quasi debt instruments or hybrid debt instrument and technically these type of share holders are owner of firm and receive dividend before distributing it to common equity holders and hence should be removed before computing this ratio ROE = ROA X Leverage Ratio=> NI/Equity=(NI/TA) *(A/E) Thus ROE is function of both net income and leverage ratio (LR) Net profit margin=Net income/Net sales

Credit Risk Management

EPS = NI available for common stock/ no. of shares outstanding Dividend pay out ratio is not strictly speaking measure of profitability but useful to find out strategy of business from retention of earning perspective Liquidity Ratios Net Working capital =CA-CL Current ratio and acid test ratio Average collection period=Acc receivable/credit sale per day Average payment ratio = Acc payable/credit purchase per day => lower level is useful? Efficiency ratios Inventory turn over ratio = Cost of goods sold /Inventory Asset turnover ratio = Net sales / Total Assets Financial leverage ratios Debt ratio = Total liabilities/total assets Long term loans as % of total assets Time earned interest = EBIT/Interest income

Credit Risk Management

Evaluation of loan request 6 Cs to be considered Character (personal characteristics of borrower, willing and commitment to repay loans, honesty etc) Capacity (borrowers success in running business cash flow) Capital (financial conditions of borrower net worth) Collateral safety in case of default Conditions(economic) Compliance (with laws and regulations) Credit Risk Models Credit returns are highly skewed and rarely conforms to normal distribution Those are highly skewed i.e. lenders benefits are limited when there is an upgrade in credit quality of borrower but losses are higher in case of down grade or default Complex calculation to estimate credit quality changes among group of comparable borrowers These models help in decision making and making risk return mixture optimistic Good credit risk model is expected to give credit risk of portfolio giving probability distribution of losses, marginal credit risk i.e. increase in credit risk with addition of asset and optimum portfolio mixture for risk-return phenomena

Credit Risk Management

Expected loss for the bank on single borrower depends on three factors probability of default (PD), Loss given default (LGD) and Exposure at Default (EAD) Assigning PD to each borrower is not easy. One can use internal studies to assign values or used credit rating agencies migration values or use models for generating PDs. Thus internally generated data or historical data of credit spread of traded product or models such as KMV can be used for generation of PD. EAD is exposure of borrower to bank. It is not merely outstanding credit but also should consider undrawn portion of promised credit limits assigned to customer Typically it has been observed that customer has tendency to use undrawn committed lines just before entering into financial distress. Thus bank has outstanding as well as undrawn committed portion at risk EAD= Current exposure + Loan equivalency factor*unutilized portion of limit If out of total limit a% is current utilization of credit lines and b% will be utilization at default then LEF is (b%-a%)/(100-a%) LGD is proportion of EAD lost and can calculated as 1-recovery rate(RR). RR depends on quality of collateral, seniority of the banks claim on borrowers asset Recovery rate for simplicity being considered as independent of probability of default but in real time actually RR decreases with increase in PD i.e. in case of deteriorating economic conditions

Credit Risk Management

Credit migration approach (Credit Metrics view) This is well known model based on migration analysis for credit risk measurement The model computes full 1 year fwd distribution of values for the portfolio with considering impact of credit migration and interest rates in deterministic way manner Credit VaR is then derived as percentage of distribution corresponding to confidence level chosen Transition matrix shows probability of an existing loan getting upgraded or downgraded or defaulting during 1 year Each cell contains probability values. These probabilities are real world probabilities i.e. based on historical data with specified data period Specifying credit risk horizon generally taken as 1 year for convenience Revaluing loan is done as per size of migration matrix with two conditions i.e. in case of default use RR or otherwise use transition matrix Thus it creates distribution at each rating migration as well as default required for valuation of loan The capital of bank is closely aligned to banks credit risk and hence quantification of credit risk becomes necessary

Credit Risk Management

Credit migration approach (Credit portfolio view model) It is methodology developed by McKinsey Based on relationship between macroeconomic factors and banks credit risk in loan portfolio The conditional values are based on levels of macroeconomic factors used are GDP, unemployment rate, level of long term interest rate, exchange rates, government expenditure, savings rate etc The computation involves determination of state of economy, estimation of PD and generate loss distribution Deficiencies of models discussed above All borrowers included in same rating assume same default risk Historical default rate being used All borrowers carry same migration parameters KMV model Tried to overcome these shortcomings assumptions KMV relates probability of default for firm with market value of firms assets, risk of the assets and leverage Black Scholes, Merton approach helped for building these type of models

Credit Risk Management

Merton approach Let firm has debt of L to be repaid at time T and let value of firm be V at time T then cashflow D to lender D=Min (L,V) Value to Equity holder after paying debt will be E=max(V-L,0) V=D+E=Max(V-L,0)+Min(L,V) Thus equity holders have an option to purchase firm from lenders by paying face value of debt L at time T i.e. strike price is L Thus we can price value of equity at time t with r as risk free interest rate as follows E=Max (V-L,0) E= V*N(d1)-L*N(d2) d1 = ln(V/L)+(r+(sigma^2)/2)*T /(sigma*sqrt(T)) Distance to default is d2 i.e. probability of default is 1- probability of equity option to be exercised i.e. N(-d2) or 1-N(d2) The same framework extended by Vasicek and Kealhofer (VK model) which is used in KMV model to obtain asset value and related volatility while default point term structure is derived empirically

Treasury
Treasury is the source of substantial profit to bank and hence creates substantial value to shareholders Treasury is responsible for managing liquidity, assets & liabilities,, trading in currencies and developing new products It is required to identify and mitigate market risk due to movement in interest rates, FX, credit curves, equity prices, commodities and liquidity crunches Treasury Functions Investment advise and assistance to customers typically for off balance sheet items and tax efficient loans Structuring products to hedge banks capital Market maker in various products, buying and selling of securities for own as well as on behalf of customers Trading i.e. speculation of different assets Sources of treasury profits Foreign exchange business=> Spot/fwd and swaps Money market business => Repo/Tbills/CDs/CPs/Call/Term money Fixed income securities market=>Gsec, Corporate bonds, SG bonds, PSU bonds Derivatives => IRS, CCS and designed products, options, futures

Market Risk
Treasury activities give rise to market risk on account of change in price affecting portfolio adversely There should be market risk policy in place specifying objectives, definitions and positions handled in treasury function It should also mention about risk measurement, monitoring and control procedure for risk management It should also address mark to model, mark to market, valuation validations, back testing methodology for various models used for computation Risk measurement Stop Loss for trading portfolios Sensitivities for trading portfolios such as delta/PV01 analysis Term structure risk measurement Greeks measurement for derivatives portfolio such as gamma, vega, volga etc Position criteria Potential future loss measurement

Market Risk
Limits on trading portfolio Earning perspective
Stop Loss limit Tenor wise PV01 limit Tenor wise Greek limits such as delta/gamma and vega limits Net open position limit Intraday position limit (day light limit) Aggregate gap limit and individual gap limit Value at Risk limits

Sensitivity perspective

Position Limits

Future potential loss limit

VaR is now commonly used one of the measures for computation of market risk. It tries to predict what could be the loss bank can make for given observation period during holding period at considered confidence level. Basic concept in VaR methodology Ascertain market risk facto for given position

Market Risk
Decide the holding period interval and compute change/volatility in market risk factors Compute risk sensitive measure for unit change Apply computed volatility to compute P&L rather loss at pre decided confidence level VaR methodology Historical VaR (HS) Variance Covariance VaR (Parametric) Monte Carlo VaR (MC) Back testing of VaR model It actually checks change in MTM of the portfolio across holding period i.e. if holding period is 1 day then MTM as on yesterday and MTM as on today keeping position same or constant between two days This is always with a time lag upto holding period VaR predicts future losses and it should cover the losses given by backtesting results. Ir backtesting loss exceeds VaR then it is treated as breach Stress testing is also an important risk management tool used to predict losses under stress conditions and has become mandatory for all banks .

Market Risk
Appropriate Market Risk limits must be monitored on daily basis with defined hierarchies Any limit breach at any level can be handled as follows Approval to run positions from next authority in hierarchy Hedge the positions by reducing sensitivities of the positions Cut down positions Design of market Risk Limits Based on risk appetite of the bank Budgeted earnings Capital employment and cost of it