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Credit Risk Management

Kevin F. Ellis

FIN507 – Bank Management

Colorado State University – Global Campus

May 31, 2015

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Introduction

Credit is an extremely useful tool for individuals, businesses, and governments. Through

credit, parties can exchange goods and services with a promise to provide payment at a future

date. This tool gives borrowers the convenience of not having to have cash in order to make

purchases. In addition, credit helps create wealth by providing income to secondary, tertiary, and

other parities that they may not have earned if the original borrower did not make the original

purchase. However, there are drawbacks to using credit for lenders and borrowers. The

convenience of not having to cash on hand to make purchases can lead borrowers to over-spend

and “max-out” there credit. This is problematic when a downturn in economy occurs and

individuals do not have income this can lead to default and possibly bankruptcy. Anytime a

borrower takes out credit, purchases items, and doesn’t make payments to the lender; that

borrower will have defaulted on its credit causing issues to the lender.

Therefore, lenders need to take caution when providing credit to borrowers. They must

consider several factors beyond just the credit history of the borrower or terms of the contract

and be able to mitigate credit risk at the origination of the line of credit. These individual credit

extensions create credit portfolios that carry their own risks. Banks and other lenders can face

problems if the portfolios have credit assets with borrowers in the same industry or in the same

business cycle. Taking caution in extending credit and careful credit portfolio management needs

to be conducted; however, that is not sufficient to prevent lenders from ending up with their own

financial problems. When borrowers default on their debt, they lenders need to ensure that they

have adequate capital to help cover their expenses. Various regulations have increased the

amount of capital banks and other financial institutions must maintain in the case of expected

losses; however, economic capital can help lenders in the event of unexpected losses. It is

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through reducing credit risk at origination, credit portfolio management, and capital allocation

banks and financial intuitions can help manage their credit risk.

Credit Risk Mitigation at Origination

Managing credit risk at origination is key for banks and other financial institutions to

maintain financially strong. Typically, financial institutions can survive if the obligors

(individuals or corporations under contract to make payments or perform services) going into

insolvency and survive if the obligors goes bankrupt. However, if a pattern of poor extensions of

credit is present the financial institution may not be able to survive. Therefore, before issuing

credit they must make sure the transaction is in the best interest of the company and properly

measure the amount of credit risk in the transaction.

Is the Transaction Worthwhile?

Banks and other financial institutions need to ensure that any new credit transactions fit

within their current credit portfolio. This requires establishing limits for credit risk exposure

within the portfolio. These limits are created by analyzing several factors including the

“counterparties, industries, products, and countries” (Bouteille & Coogan-Pushner, 2013). If

adding the transaction exceeds the risk exposure limits in their portfolio and the transaction

financial institution still believes the transaction is profitable, they may want to partake in the

hedge against the risk through swaps or hedging techniques. In addition, if the credit transaction

is within the credit limits, banks and financial institutions want to credit portfolio ensure that

their portfolio is well diversified. A credit portfolio that is heavily weighted in one sector or

industry will require a higher amount of capital to cover losses if the entire sector or industry

becomes insolvent.

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While ensuring the credit transaction is within leadership’s limits and strategy, there are

characteristics that make credit transactions good. First, the obligor needs to have the authority to

request funds whether that is by age or through the legal authority through the business. Second,

the obligor should have good character. When requesting credit, the obligor needs clearly state

the reason for the request and be willing to pay back the borrowed funds. However, being willing

to pay back borrowed funds; does not mean the person or corporation has the ability to pay back

funds. Therefore, individuals and corporations need to have enough income or free cash flow to

afford the payments of the borrowed funds. For individuals, the FICO score can help determine

if they have good character and have ability to pay funds back. For corporations who do not have

a credit rating, financial statement and trend analysis can be extremely helpful in determining if

the corporation is able to pay back borrowed funds (Rose & Hudgins, 2013).

Having good character and the ability to pay back funds may not be enough to make a

good credit decision if the obligor suffers due to stressful financial or economic conditions.

Therefore banks and financial institutions need to consider if there is enough collateral to cover

potential losses. Careful valuation of collateral needs to be applied when originating credit,

dependent on the nature of collateral. Cash reserves can be taken at face value; however, not all

individuals and companies have cash reserves. If the collateral is an asset, will the value of it

increase or decrease? For example, corporations maintain different levels of inventory based on

the industry and projected sales. However, if the corporations sales are not met and the product is

no longer wanted in the market; the value of collateral will decline sharply and the bank may

only be able to collect on the individual parts in the product. Finally, in the event the obligor

defaults on the credit transaction, the collateral pledged “should be durable, easy to identify,

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marketable, stable in value, and standardized as much as possible to permit easy of recovery and

sale” (Rose & Hudgins, 2013).

Measuring Credit Risk

“Credit risk is the risk of loss of due to a ‘credit event’” (Choudhry, 2012). Credit events

refer to a number of different things, but in its basic form is nonpayment, downgrade in the

individuals or corporations credit rating, or other predetermined event established in the credit

transaction contract. Banks typically use four main areas to determine the amount of credit risk

in any transaction or credit portfolio (i.e. exposure, probability of default, recovery rate, and

term). While banks have used statistical models and credit ratings to help aid in the measurement

of credit risk, credit risk can’t be reduced to a single number. Therefore, careful analysis of these

elements is necessary to determine their true risk exposure.

Exposure is simply the amount of money that could be lost. However, calculating the

actual amount of money at risk is a more complex task. The maximum amount of money the

bank can lose is called the gross exposure. Calculating net exposure is the next step and equals

gross exposure less any collateral pledged. For example, if the bank issues a car loan they can

subtract the appraisal price from the gross exposure amount for a more realistic view of the

potential credit loss. Finally, banks need to calculate the adjusted exposure (as known as

exposure at default), which is net exposure “multiplied by the expected usage given default”

(Bouteille & Coogan-Pushner, 2013). The usage given default is the proportion unused credit

that an individual or corporation has available divided by the total amount of credit available to

them (Bouteille & Coogan-Pushner, 2013). While following this process provides a good

estimate of the exposure risk, it requires banks and other financial institutions to carefully

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appraise collateral and determine unused portions of credit. Therefore, human judgement and

quantitative analysis is crucial to determining the true exposure risk.

The probability of default is the likelihood of a borrower defaulting (typically measured

within one year). It is important to note, that no matter how financial strong an individual or

corporation there still is a probability that they will default. For example, in the 2007-2009

Financial Crisis, Lehman Brothers was the “fourth-largest investment bank by asset size with

over $600 billion in assets and 25,000 employees, filed, for bankruptcy, making it the largest

bankruptcy filing in the U.S. history” (Mishkin, 2013). Therefore, the size or perceived financial

strength of the individual or company does not mean the company will be able to fulfil its

financial obligations. In addition, figure

1 displays how time plays a factor in the

probability of defaulting. If the value of

the liabilities increases faster than the

value of its assets the point where these

values intercepts is the default point.

While this not always be the case in

default, the longer time an individual has

to pay off the credit contract the greater the probability that individual will default (due to

unwillingness to pay, economic conditions, bad financial decisions, etc…).

Another area that banks and other financial institutions need to analyze is the recovery

rate of the obligor. Recovery rate refers to the amount of money that the bank can recover in the

event the obligor defaults. The amount that can be recovered depends on several different

factors, examples include but not limited to the type of credit given, size of the company,

Figure 1: Timeline for Default Point

Source: Joseph, C. (2013). Advanced Credit Risk.

Chichester, West Sussex, United Kingdom:

John Wiley & Sons, Ltd.,.

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collateral, liquidation of assets. To aid in the calculation of the recovery rate, banks can compare

the obligor’s credit rating to historical recovery rates for obligors with similar credit ratings and

conduct stress testing for various financial and economic scenarios. In relation to the credit

rating, the “recovery rates of low credit quality firms, in the case of distress, tend to be higher

than recovery rates in high credit quality firms” (Joseph, 2013).

When measuring credit risk, it is important to look at the exposure of the credit

transaction, the credit rating of the obligor, the recovery rate, and the length of time until the

contract has been fulfilled. These elements of credit risk are simple principles; however,

inaccurately measuring them can make a bad transaction seem like a good transaction. Therefore,

professional judgement and financial analysis should be conducted in tandem when analyzing

credit risk.

Credit Portfolio Management

An individual credit transaction may not be a large risk for a bank or other financial

institution; however, an entire portfolio of credit transactions can have profound effect on the

financial well-being of them. Credit portfolios have certain risks that need to be managed to

mitigate losses and are typically broken down between systematic risk and diversifiable risk.

However, through analyzing the economic conditions, ensuring proper diversification,

maintaining capital dedicated to mitigating risk, and applying portfolio management tools can

lead to a strong credit portfolio position.

Major Portfolio Risks

The first type of risks that after credit portfolios are the systematic risks. These risks can

not be reduced by diversifying with other portfolios or assets because systematic risks after the

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entire economy. These risks are typically triggered after an economic expansion followed by a

decline in the price of an asset and an increase in the uncertainty of the market. If banks and

financial institutions do not recognize the potential decline in assets or sectors this can lead to a

much bigger problem for them. For example, in the 2007-2009 Financial Crisis some backs

failed to see the declining value of mortgages and mortgaged-backed securities leading them to

end up in financial trouble.

The second major type of credit risks are the diversifiable risks. The risk contains several

different sub-categories of risk (e.g. concentration, maturity, correlation). Concentration risk

refers to having a credit portfolio heavily exposed to a single element (e.g. industry, region,

exposure, collateral, or currency). Creating credit portfolios with heavily concentrations in any

one element can cause financial distress on the bank if that element losses revenue streams,

value, or fails. For example, if the entire portfolio is in the retail industry and a recession occurs;

individual spending will decrease, leading to a decrease in retail sales, which could lead to retail

establishments defaulting on their credit. Even if the bank diversifies amongst different

industries, regions, collateral, etc… they may fall victim to correlation risks. Correlation refers to

the statistical concept that uses the covariance of two elements and divides that by the product of

their standard deviation. This calculation provides a range of possible solutions between -1 and

1, with -1 meaning there is a strong negative correlation between the elements. When

constructing a credit portfolio banks and other financial institutions should look for elements that

have a negative correlation to reduce risk. Finally, maturity can play a large role in the financial

strength of a bank or other financial institution. If the credit terms are mismatched between short

term and long term, the bank may not have the ability to cash on hand for depositors. For

example, “during the 2008 Credit Crisis, worries about the strength of US banks or financial

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institutions caused the money and capital markets to freeze, resulting in troubles for institutions

who relied on these markets to manage maturity mismatches” (Joseph, 2013).

Mitigating Portfolio Risks

While diversification of credit assets can help reduce credit risk in portfolios, banks can

also trade credit assets and use derivatives to reduce risk as well. Trading credit assets has other

benefits besides reducing risk; it can also help in the reporting and generating income and help

maintain the capital requirements. Credit derivatives were designed to help hedge against risk or

reduction in value in the credit assets. These three tools are common ways banks and other

financial institutions help mitigate their portfolio credit risks.

Banks can trade credit assets in the form of securitization, which packages several credit

transactions into a single account and then issues bonds and securities while maintaining

documentation of which transactions are linked to the individual bonds and securities. If the bank

wants to sell off the account, they can benefit by transferring the risks to the party that is gaining

the account and by gaining income from the sale itself. Buyers of these accounts will gain

income through fees. In addition, this can help banks reduce the amount of capital required to

keep in reserves. For example, asset backed securities (a form of securitization) are rated on the

riskiness of the accounts. “Since AAA rated assets required less capital charge in Basel II, the

demand for such assets was generally strong from banks and financial institutions” (Joseph,

2013).

Credit derivatives can be a great asset for banks. Banks can buy protection from credit

risk of a credit transaction or portfolio by finding an individual (seller) who will acquire that risk

for periodic payments. Therefore, the bank can eliminate credit risk and will not need to cover

derivatives with capital. In addition, if the obligor defaults on the original transaction with the

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bank; the seller will pay the bank after a credit event occurs. Credit events can be anything pre-

determined in contract, but typically refers to non-payment, bankruptcy, or default. Credit

derivatives are available to banks and other financial institutions and can take many different

forms such as credit default swaps, credit options, credit spread options. Using these options

requires careful analysis of the risk being traded; however, if used properly increase the financial

strength of banks.

Capital Allocation

The Basel Committee of Banking Supervision established the Basel accords, which

requires banks to maintain certain levels of capital. While banks need to have regulatory capital,

they should also invest in and maintain economic capital. Economic capital is used in order to

protect the bank from unexpected losses from risk taking activists. The amount of capital

required will vary; however, more risk in the credit transaction requires more capital.

One common way to determine the amount of economic capital required is to create a

loss distribution. Figure 2, pictures this distribution covering expected losses (EL), unexpected

losses (Economic Capital), and the

insolvency range. It should be noted

that there are various different models

that can help calculate this function

(e.g. Guassian Credit Loss Model,

Value at Risk, Monte Carlo, etc…)

and use of these models should be

familiar with the assumptions in each

model. However, once the distribution has been created, banks will be able to determine how

Figure 2: Credit Loss Distribution

Source: Joseph, C. (2013). Advanced Credit Risk.

Chichester, West Sussex, United Kingdom:

John Wiley & Sons, Ltd.,.

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much economic capital is needed to ensure they remain solvent. It’s only through proper analyze

and financial properly allocating capital can banks can reduce the consequences of risk in

portfolios.

Conclusion

The ability to use credit is necessary for the economy to grow and prosper. It provides

many functions such as delaying payment, not needing to have cash available for the purchase,

and helps create wealth. However, when companies extend credit to individuals or corporations

they are putting themselves at the risk the obligor will not fulfill the requirements in the credit

contract. Therefore, lenders need to take caution when providing credit services to ensure that the

transaction is worthwhile. Bank leaders need to establish credit limits and develop an effective

strategy. Bank lenders need to ensure that the obligor has good character, ability to pay back the

loan funds, and collateral. In addition, banks need to measure the credit risk of the obligor by

analyzing their exposure, probability of default, recovery rate, and term of the individuals or

corporations and of the portfolios. However, credit portfolio managers also have to analyze the

risks of the entire portfolio and ensure that it is properly diversified, doesn’t contain correlations,

isn’t heavily concentrated, and maturity is diversified. If the portfolio managers find that they

need to mitigate risks they can trade credit assets or even use credit derivatives to reduce that

risk. Finally, banks should have enough capital to cover the expected losses and the unexpected

losses in their credit transactions. Managing credit is a very complex and professional analyze

and judgement should be conducted to ensure that the bank remains solvent and is able to

produce profits for the shareholders.

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References

Bouteille, S., & Coogan-Pushner, D. (2013). The Handbook of Credit Risk Management.

Hoboken: John Wiley & Sons, Inc.,.

Choudhry, M. (2012). The Principles of Banking. Singapore: John Wiley & Sons Singapore Pte.

Ltd.

Hennessey, L. M., & Bennett, S. J. (2012). Lessons Learned from the First Decade of Credit

Portfolio Management. The RMA Journal, 42-47, 11.

Hill, J. (2015). Credit Risk Rating System A Dynamic Management Tool. New Jerey Banker, 18-

21.

Joseph, C. (2013). Advanced Credit Risk. Chichester, West Sussex, United Kingdom: John Wiley

& Sons, Ltd.,.

Kupiec, P. H. (2007). Capital Allocation for Portfolio Credit Risk. Journal of Financial Services

Research, 103-122.

Mishkin, F. (2013). The Economics of Money, Banking, and Financial Markets. Upper Saddle

River, New Jersey: Pearson Education, Inc.

Rose, P. S., & Hudgins, S. C. (2013). Bank Management & Financial Services. New York:

McGraw-Hill .

Saita, F. (1999). Allocation of Risk Capital in Financial Institutions. Financial Management, 95-

111.

Zerbs, M., Mudge, D., & Hansen, M. (2008). Current Practices in Obligor and Portfolio Credit

Risk Management. The RMA Journal, 66-71, 9-10.