Credit Risk….

Default of the borrower;

Deterioration in credit standing.
What constitutes default?

• Missing a payment obligation;

• Filing for bankruptcy;
• Death;
• Violation of loan covenants;
• Debt Restructuring.
Default definition:
• A demand loan facility of Rs 50 lakh was
availed by a corporate entity on January 1 st
2011 for 5 years repayable in equal monthly
installments of principal and interest. The
repayment were serviced smoothly till
February, 2011. The repayment due on March
31st was however not made and also no further
repayments thereafter. When will the facility
be classified as default?
Migration explained…

• A Rs 100 bond with a AAA rating faces a 10

paisa loss on its rating review. This happens
because the new rating is one notch worse than
the existing rating..
Credit Risk Management:

• Ex – ante approach;

• Ex – post approach;
Various Types of Credit Risk:
• Exposure Risk;

• Migration Risk;

• Default Risk;

• Recovery Risk.
Credit Risk Components:

• Exposure at Default or EAD;

• Default Probability or PD;

• Loss Given Default or LgD;

• Maturity or M;

• Granularity;

• Correlation.
Types of Credit Losses:

• Expected Loss, EL;

• Unexpected Loss, UL.

 Measurement of EL & UL:

EL = EAD x PD x LGD; UL = EAD x sqrt(PD x σ2LGD + LGD2 x σ2PD)

Measurement of EAD:
Measurement of EAD:
Let us assume, for example, that a 10 lakh credit
line has been granted, with a drawn portion of 6
lakh and a CCF of 60%, In this case, EAD of the
facility is:
Measurement of EAD:

EAD  ounstandin g  CCF  freelimit

free limit  max 0; limit  outstanding 

 outstandin g d  outstandin g d 1 
CCF  0; 
 limit d 1  outstandin g d 1 
Measurement of CCF:
• A defaulted cash credit facility allowed by a
bank in favour of one of its clients reads the
following details:

• Date of sanction of the facility: 01-06-2008

• Date of Default: 31-03-2009
• Maximum credit limit: 25 lakh
• Outstanding on 31-03-2009: 20 lakhs
• Outstanding on 31-12-2008 16 lakhs
Measurement of PD:
• Credit Scoring Models, like, Wilk’s Lamda,
Altman’s Z Score, Logit-Probit Models.

• Market Based Models, like Merton’s Option

based model, KMV’s model,

• Rating Transition Matrix

 Transition Matrix

Grade at T+1
A
AA A
A ... B C
CC D
A
AA

A
A

radeatT .
G
.
.
.

C
CC
Rating Agencies…..
What is a Transition Matrix?

• A transition matrix tells us how likely is an issuer to change

credit rating over a given time horizon based on historical
ratings data.

• Can be constructed through Mortality analysis/Cohort

analysis.
One-year Transition Matrix-
CRISIL

Source: CRISIL
Measurement of LGD:

• Market LGD

• Workout LGD
Measurement of LGD:

• LGD = 1 – RR*

*RR stands for Recovery Rate

Valuing credit protections:

• Collaterals;

• Third Party protections;

• Covenants.
Economic LGD Computation
A basic equation might be:

Re cov eries t  Costst


(1  r ) t
LGD  1 
EAD

This is 1-all the recoveries (workout cost deducted) discounted back at

the time of default by the EAD.
Measurement of workout LGD:
A customer defaults on a rupee 20 lakh loan.
Over the following 4 years, the bank manages to
recover 18 lakh rupees, 20% of which have been
absorbed by legal administrative expenses. The
duration of the recovery process has been 3
years. The average discount rate over the recovery
period can be set at 8%, annually compounded.
Compute the recovery rate on the defaulted loan?
Take the case of an outstanding retail loan worth rupees 5 lakhs having
rupees 2.95 lakhs security (collateral) and default probability of 2 %.

Expected loss calculation can be shown as below:-

(in absolute terms)

EL = PD * EAD * LGD
LGD = (1-recovery rate)
EL = 0.02 * 5,00,000 * (1 - 0.59)
EL = 4,100 Recover Rate = 2.95/5.00
(in percentage terms) = 59% 0r 0.59

LGD = (1-0.59)
EL = PD * LGD =0.41 or 41%

EL = 0.02 * (1 – 0.59)
EL = 0.82 %