The taking of credit risk has always been a core activity for banks. Over the last 10 years, quantitative measurement has been adopted by banks to improve their processes for selecting and pricing credit transactions. Quantitative measurement has become even more important since it was adopted by the Basel Committee on Banking as the basis for setting regulatory capital. In this chapter, we review the process for granting credit and the ways in which risk measurement supports credit decisions. In subsequent chapters, we review the different types of credit instruments, risk measurement for a single loan, risk measurement for a portfolio, and how the results are used for decision support. Most of the discussion focuses on estimating the economic capital, but we finish the credit-risk section with the Basel Committee’s new framework for setting regulatory capital.
Credit risk arises from the possibility that borrowers or counterparties will fail to honor commitments that they have made to pay the bank. Credit-related losses can occur in the following ways:
• A customer fails to repay money that was lent by the bank.
• A customer enters into a derivative contract with the bank in which the payments are based on market prices, then the market moves so that the customer owes money, but the customer fails to pay.
• The bank holds a debt security (e.g., a bond or loan) and the credit quality of the security issuer falls, causing the value of the security to fall. Here, a default has not occurred, but the increased possibility of a default makes the security less valuable.
• The bank holds a debt security, and the market’s price for risk changes. For example, the price for all BB-rated bonds may fall because the market is less willing to take risks. In this case, there is no credit event, just a change in market sentiment. This risk is therefore typically treated as market risk in the trading VaR calculator.
There is a gray area between market and credit risks. Generally, changes in value due to defaults and downgrades are considered to be credit risk because they depend on the behavior of the specific company. Changes in value due to changes in the risk-free interest-rate or changes in credit spread for a given grade are considered to be market risk because they depend on general market sentiment.
To set the stage for examining credit-risk management, let us begin by considering the life cycle of a single loan. The process begins with business development, in which the lending group targets a potential customer. The customer then applies for credit and supplies some information about his or her creditworthiness. In the case of a retail customer, it is personal information such as income. In the case of a commercial customer, it is balance-sheet information such as total assets.
Based on this information, the bank’s credit department determines the riskiness of the customer and assigns a credit grade, which is a form of risk score. Often, banks will supplement their grading processes with information from external rating agencies. For retail customers, data is provided by credit bureaus who collect information from many banks and collate it for resale to any bank considering lending to an individual. In the United States the main credit bureaus are Equifax, TRW, and Experian. The information includes personal details, such as income, and financial information, such as the total number of credit cards and whether the customer has defaulted.
For lending to corporations, the main credit-rating agencies for large corporations in the United States are Standard & Poor’s, Moody’s, and Fitch IBCA. For the middle market, Dunn and Bradstreet is the primary rating agency. These rating agencies carry out a process that is very similar to that of a credit analyst in a bank. They take information on a company and an associated facility (a particular bond, for example), and they rate the facility based on subjective judgments and objective models. The models use information on the company’s balance sheet and profitability. The result is a letter grade that indicates the “riskiness” of the facility. There are also companies (principally, KMV, now owned by Moody’s) who rate corporations based on the volatility of their equity prices, which we will later discuss in depth.
Based on the grade, the bank decides whether to offer credit to the customer, in what amount, at what interest rate, and with what terms. The difference between the risk-free rate and the rate charged to the customer is called the spread. The terms can include the requirement for collateral and the right of the bank to change the price or loan amount if the customer’s credit quality changes. The customer decides whether to accept the given price, and then there may be a final round of bank approval before the deal is closed. The process up to closing the actual deal is called origination.
After the deal is closed, a series of disbursements are made to the borrower, and the loan becomes part of the bank’s portfolio of assets. The portfolio is managed to minimize the risk/return ratio of the portfolio. This may require selling the loan to another bank, either stand-alone, or packaged with other loans into an asset-backed security. The portfolio management process may also influence the decision to originate new loans that create diversification or concentration in the portfolio.
Eventually, most of the loans are paid back by the customers, but some default and go to the collections department, who takes time to recover as much of the outstanding amount as possible. The collections department may also be called the workout group or the special assets group.
The process described above is generally applicable when the granting of credit is the main purpose of the transaction. However, in transactions such as derivatives trading, credit risk is an unwelcome by-product of the transaction. In this case, the emphasis is much more about setting limits on exposure and mitigating the exposure through collateral. The decision is couched in terms of the expected profit to be made by trading with the counterparty and the limit on the maximum exposure (or “line”) that the bank can risk having with any one counterparty.
Two types of limits are set: the total exposure and the daily settlement limit. The total exposure is the net present value of all the transactions that the bank has with a counterparty. If all trades were completed and then the counterparty defaulted, the amount lost would be the total exposure minus any later recoveries.
The daily settlement limit is the amount that the bank is prepared to exchange with the counterparty on any given day. This limits the Herstatt risk, i.e., the loss if the bank makes one side of a payment, but the counterparty defaults midway through settlement and fails to make the payment for the other side of the transaction.
Before launching into the analysis and calculation of credit risk, let us first consider what risk measurements would be useful to support the decisions in the process we discussed above. There are three main sets of decisions: origination, portfolio optimization, and capitalization.
The most basic decision is whether to accept a new asset into the portfolio. The origination decision can be framed in two possible ways:
• Given the risk and a fixed price, is the asset worth taking?
• Given the risk, what price is required to make the asset worth buying?
The first is more often asked in a rigid system where there is little opportunity to modify the price, and therefore the decision becomes “yes/no.” This is the type of decision made when dealing with a large volume of retail customers. The question can be recast as, “Is the expected return on capital for this transaction greater than the bank’s minimum return on capital?” To support this decision, we need to know the expected return, adjusted for expected losses and expenses, and the amount of capital that this transaction will consume.
The second approach is typically used in a flexible, liquid trading environment, or in negotiating rates and fees for a corporate loan. Here, we start with the capital consumed and the known hurdle rate for the return on capital to calculate the minimum acceptable return for the overall loan.
In optimizing a portfolio, the manager seeks to minimize the ratio of risk to return. To reduce the portfolio’s risk, the manager must know where there are concentrations of risk and how the risk can be diversified. This requires a credit-portfolio model that includes all the correlations between assets to show where there are concentrations of assets that are highly correlated. The high correlation may arise from being in the same industry or geography, or because they are driven by the same economic factors, such as oil prices. The portfolio model must show the current risk concentrations and allow the manager to try “what-if” analyses to test strategies for diversifying the portfolio.
Given the risk in the portfolio, the CFO needs to set the provisions for expected losses over the next year, and the reserves, in case losses are unusually bad. The CFO also needs to ensure that the total economic capital available is sufficient to maintain the bank’s target credit rating given the risks. If it is insufficient, the bank must raise more capital, reduce the risk, or expect to be downgraded. To set the provisions, the CFO needs to know the average losses that are to be expected. To set reserves, it is necessary to know the loss that could be experienced in an unusually bad year, e.g., losses that have a 1-in-20 chance of happening. To set capital, we need the loss level that could be experienced in an extraordinarily bad year, e.g., losses that have a 1-in-1000 chance of happening. These statistics can be obtained if we can calculate the probability-density function for the portfolio-loss rate, which is the focus of the next few chapters.
In this chapter, we introduced readers to the concept of credit risk. Next, we detail the most common credit structures as a foundation for quantifying the risk.