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Basic Principles for Credit Risk Management

Basic Principles for Credit Risk Management

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Basic Principles for Credit Risk Management

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  1. Basic Principles for Credit Risk Management Prof. Dan Galai

  2. Types of Financial Risks

  3. Types of financial risks • Components of financial risks Market Financial risks Credit Operational Liquidity Human Factor Legal & Regulatory 8/13/98 10:26 AM \\israel98.ppt

  4. ETN 49 1/2 PJF 98 5/8 CM 40 3/4 9.25% 8.75% Yield % 5 yrs Term to Maturity Types of financial risks • Market risk is multidimensional Equity risk Financial risks Market risk Interest rate risk Currency risk Commodity risk 8/13/98 10:26 AM \\israel98.ppt

  5. Types of financial risks • One can “slice and dice” these multiple dimensions of risks Interest rate Market risk Commodity prices Currency risk Equity risk Transaction risk Credit risk Financial risks Portfolio concentration risk Process risk Operational risk Infrastructural or Leverage risk Model risk 8/13/98 10:26 AM \\israel98.ppt

  6. The old regulatory environment: BIS 1988 or the Accord

  7. BIS 88 Capital adequacy requirements 1. Assets to capital multiple (overall measure of the bank’s capital adequacy) Total assets (including specified off-balance sheet items) / capital < 20 2.Risk based capital ratio (solvency ratio which focuses on credit risk associated with on-and off-balance sheet exposures) Capital >8% of Risk Weighted Assets (RWA) 8/13/98 10:26 AM \\israel98.ppt

  8. BIS 88 Risk weighted amount= S Assets * WA + S Credit equivalent * WCE 8/13/98 10:26 AM \\israel98.ppt

  9. BIS 88 • Risk capital weights by broad on-balance sheet asset category (WA) 8/13/98 10:26 AM \\israel98.ppt

  10. BIS 88 Calculating BIS risk-weighted amounts for derivative products Step 1: Credit-equivalent amount Current replacement cost Add-on amount Credit equivalent + = 8/13/98 10:26 AM \\israel98.ppt

  11. BIS 88 Add-on factors by type of underlying and maturity 8/13/98 10:26 AM \\israel98.ppt

  12. BIS 88 Calculating BIS risk-weighted amounts for derivative products Step 1: Credit-equivalent amount Current replacement cost Add-on amount Credit equivalent + = Step 2: Risk weighted amount Counterparty risk weighting Risk weighted amount Credit equivalent x = 8/13/98 10:26 AM \\israel98.ppt

  13. BIS 88 • Risk capital weights for off balance credit equivalents by type of counterparty (WCE) 8/13/98 10:26 AM \\israel98.ppt

  14. BIS 88 Counterparty Risk for Portfolio 1 (with a corporate counterparty) Replacement cost = 0 (at-the-money swap) Add-on = 100M USD x 1.5% = 1,500,000 USD Risk-weighted amount = 1,500,000 USD x 50% = 750,000 USD Capital charge = 750,000 USD x 8% = 60,000 USD 8/13/98 10:26 AM \\israel98.ppt

  15. BIS 88 • The Accord is flawed. • The Accord does not address complex issues like: • portfolio diversification (credit risk is partially offset by diversification across issuers, industries and geographical locations • netting 8/13/98 10:26 AM \\israel98.ppt

  16. BIS 88 • The Accord produces a distorted assessment of actual risks and a misallocation of capital: • ignores market risk for tradable securities • generates regulatory arbitrage opportunities 8/13/98 10:26 AM \\israel98.ppt

  17. (1) Assume Libor (L) = 5.2% 13.75% = (L+50) x $100 - (L-20) x $92 $8 The New Regulatory and Corporate Environment Regulatory Arbitrage is forcing Regulators to move away from standardized approach toward internal models approach Example of Regulatory Arbitrage: High Quality Bank A Funding Cost Libor -20 bp (on 92% of nominal) Libor + 50 bp XYZ$100M Capital Charge = 8% Net revenue = $1.1M Return on capital = 13.7% (1) 8/13/98 10:26 AM \\israel98.ppt

  18. The New Regulatory and Corporate Environment • Long a corporate loan and long a credit swap from an OECD Bank to hedge credit risk exposure. Example of Regulatory Arbitrage: • Capital treatment: • full offsetting of credit risk related to XYZ loan, no capital charge against loan package • capital add-on = Principal x risk weight (OECD Bank) x 8% = $100m x 20% x 8% = $1.6m 8/13/98 10:26 AM \\israel98.ppt

  19. (2) 17.5% = $1.6 The New Regulatory and Corporate Environment Example of Regulatory Arbitrage: } } 50 bp High Quality Bank A Lower QualityBank B Seller of credit derivative Buyer of credit derivative Zero No default or Default Par - recovery Libor + 50 bp XYZ$100M Funding cost Libor - 20 bp (on 98.4 % of nominal) Net Capital charge = 1.6% Net revenue = $280,000 Return on capital = 17.5% (2) (L+50) x $100 - 50bp x $100 - (L-20) x $98.4 8/13/98 10:26 AM \\israel98.ppt

  20. BIS 88 • Regulators are slowly beginning to acknowledge that standardized regulatory measures such as growth in Risk Weighted Assets (RWA) fail to provide meaningful transparency in terms of measuring the Amount at Risk. 8/13/98 10:26 AM \\israel98.ppt

  21. BIS 88 Growth in RWA does not tell the whole story • Example 1: Revolvers less than one year do not require any RWA • Example 2: Loan to GE requires 5 times as much RWA as a loan to a Japanese City bank • Example 3: Loan to AA counterparty receives same RWA as a loan to BB counterparty • Example 4: RWA do not reflect concentration Risk 8/13/98 10:26 AM \\israel98.ppt

  22. BIS 88 Example: A single $100 loan to a BB counterparty receives same amount of RWA as 100 different $1 loans to 100 different BB counterparties Total Risk Specific Risk Systematic Risk Increasing Diversification 8/13/98 10:26 AM \\israel98.ppt