Module 5 - Credit Risk

COLUMBIA UNIVERSITY

School of Professional Studies

Credit Risk and Insurance Risk Management

Instructor: Ken Radigan

Definitions

  • Probability of Default (POD):

    • Definition: The likelihood that a borrower will fail to pay back a debt.

    • Application: FICO scores are utilized to gauge the credit risk of individuals while credit ratings assess the credit risk of companies.

  • Loss Given Default (LGD):

    • Definition: The amount of money a lender loses when a borrower defaults on a loan.

    • Representation: Often depicted as a percentage of the total exposure at the time of default.

  • Country Risk:

    • Definition: The risk occurring when a country freezes its foreign currency payment obligations, leading to defaults on its obligations.

    • Influencing Factors: Associated with a country’s political instability and macroeconomic performance, which may negatively impact asset values or operating profits.

    • Business Environment Changes: These changes can affect all companies operating within a specific country.

Credit Risk

  • Definition: Credit risk arises when a borrower fails to meet their debt obligations, defined as the probability that a lender will not receive principal and interest payments for a debt obligation.

  • Loss Types: Loss may be partial (e.g., only some amount is lost) or complete (full amount lost).

  • Lender Costs: Lenders may incur collection costs as a result of borrower default.

  • Interest Rates: The interest rate charged on a loan compensates the lender for accepting credit risk.

    • Higher rates are charged for high-risk loans, while lower rates are associated with lower-risk, high-quality loans.

  • Risk Assessment Methods: Lenders can utilize various methods to evaluate the level of credit risk associated with a potential borrower to minimize losses and avoid delays in payments.

Credit Exposure

  • Instruments/Obligations Responsible for Credit Exposure:

    1. Loans, bonds, or credit notes.

    2. Cash payments or goods/services owed by the debtor.

    3. Long-term supply contracts.

    4. Derivatives and other off-balance-sheet contracts.

    5. Reinsurance contracts.

Expected Credit Loss

  • Formula for Expected Credit Loss (ECL):
    extExpectedCreditLoss=extProbabilityofDefaultimesextExposureatDefaultimesextLossGivenDefaultext{Expected Credit Loss} = ext{Probability of Default} imes ext{Exposure at Default} imes ext{Loss Given Default}

  • Calculation of Loss Given Default:
    extLossGivenDefault=1−extRecoveryRateext{Loss Given Default} = 1 - ext{Recovery Rate}

  • Pricing of Credit Losses: Expected credit losses are typically factored into product pricing, while unexpected losses are addressed through risk capital.

Typical Credit Portfolio Loss Distribution

  • Characteristics:

    • The distribution of losses is not symmetrical.

    • Limited upside with a significant potential downside.

    • Distribution is heavily skewed, indicating a large likelihood of small losses.

    • Heavy-tailed distribution leading to a small probability of large losses.

Impact of Correlations on Economic Capital

  • Correlation/Concentration:

    • Economic capital for high correlation/concentration is illustrated for a 99% threshold.

    • Expected Loss (EL) = 1% for both high and low correlation/concentration distributions.

    • Correlation/concentration levels impact the assessment of economic capital variability.

Credit Risk & Corporate Rating Model

  • Assessment Approach:

    • Individual assessment is vital.

    • Includes:

    • Financial assessment (considers financial data).

    • Economic assessment (considers the entity's position within the market).

    • The model rating is revised by a credit analyst.

    • Rating Scales for Non-Retail:

    • Moody's and S&P ratings shown for various grades, with associated 1-Year Probability of Default (PD) rates.

  • Rating Examples:

    • Aaa (0.01%)

    • A1 (0.03%)

    • B2 (7.76%)

    • Caa3 (20.44%)

    • Default (100%)

Credit Rating Scale: Speculative vs. Investment Grade

  • Moody's, Fitch Ratings, S&P Global Ratings Scale Overview:

  • Investment Grade Ratings:

    • Aaa, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, etc.

  • Speculative Grade Ratings:

    • BB+, BB, BB-, B+, B, B-, CCC+, CCC, CCC-, etc.

  • Key Rating Descriptions:

    • Highest credit quality: Lowest level of credit risk.

    • Speculative: Substantial credit risk with a real possibility of default.

    • Default Classifications:

    • Default (D), Selective Default (SD), Restricted Default (RD).

  • Default Rates by Ratings:

    • AAA: 0.17%

    • AA+: 0.31%

    • BBB+: 2.08%

    • BB+: 7.13%

    • B: 24.16%

    • CCC: 29.90%

Key Responsibilities of a Credit Risk Manager

  • Review Strategic Credit Positions: Analyze overall credit exposure and positions across the organization.

  • Set Credit Limits: Establish maximum allowable exposures to prevent excessive risk.

  • Measure Credit Exposures: Quantitatively assess the level of credit risk associated with borrowers.

  • Credit Reporting: Maintain accurate records and reports on credit exposures and their performance.

  • Stress and Scenario Analysis: Conduct analyses to gauge potential vulnerabilities under different scenarios or stress conditions.

  • Provisions and Documentations: Ensure appropriate reserves are allocated for potential credit losses and maintain necessary documentation.

  • Credit Protection: Implement strategies to hedge against credit risks.

Components of a Good Credit Report

  • Inclusions in a Good Credit Report:

    • A list of the largest individual counterparty exposures.

    • Analysis of credit risk concentrations by sector/industry.

    • Country-specific exposures outlining geographical risk.

    • Exposures categorized by product type.

    • Monitoring of time evolution of credit exposure.

    • Shifts in risk parameters over time.

    • A watchlist for transactions or counterparties necessitating additional oversight.