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Credit Portfolio Risks
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What is Portfolio Credit
Risk? Credit exposure to a group of similar
borrowers is called portfolio credit risk
While firm-level credit risk analysis focuseson micro-credit risk or borrower level, creditportfolio risk analysis focuses on the macro-credit risks or studies the credit risk
behaviour of a group of borrowers / creditassets
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Why Portfolio Credit
Analysis Credit portfolio cannot be managed
efficiently unless portfolio credit risks areknown
Awareness of portfolio is a must to identify,monitor, and control risk concentrations andcorrelations on an ongoing basis
To monitor the credit quality of the loan
portfolio All banks with sizeable credit portfolio desire
to have optimum diversification
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Benefits of Portfolio
Credit Risk Study Proper management of portfolio credit risk can
reduce the portfolio risk below the total or averageof firm credit risks
Facilitates active credit portfolio management Enables maturity matching Optimises liquidity Helps Sales and Marketing Gives insights into sectoral/ industrial risk
exposures To calculate the risk based capital requirement Helps in devising portfolio management strategies
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Basel Accords and Credit
Portfolio Basel accords adopt a portfolio
approach in determining credit risks
and fixing capital needsAt portfolio level, controls are imposed
in the form of risk weights
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Credit portfolio Risk
Variables
Credit Portfolio Risk
Systematic Risk Non- Systematic Risk
Asset Class
Collateral RiskCurrency Risk
Maturity RiskQuality Risk
Location RiskIndustry Risk
Exposure RiskExternal Risks
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Systematic Risks
Systematic Risk is common to the economy orcountry as a whole,
Cannot be eliminated by combining the assets in a
large and well diversified portfolio Hence, known as non- diversifiable risk
Examples are economic shocks and foreignexchange crises
In depth awareness of systematic risks helps thebank to design appropriate policies to protect andenhance the quality of the portfolio, ensuringadequate returns
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Diversifiable Risks
1.Asset Class:
Credit assets are derived from many types
of customers
small, medium and large. Each type of customers shows distinct
features
If the credit portfolio consists mainly of oneasset class, portfolio risk tends to berelatively higher
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Diversifiable Risks
2. Exposure Risk:
The amount exposed to s credit risk is
termed as exposure risk
Even when the firm credit risk isacceptable, concentration of exposures
in a few customers can spell doom
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Diversifiable Risks
3. Industry Risks:
An ideal portfolio ought to be balanced, with
a differing mix of obligors originating fromdifferent industries, and of various sizes andtypes
Modern methods determine scientifically thetype and extent of diversification required inthe portfolio.
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Diversifiable Risks
4. Region / Location/ CountryRisks
Portfolio scattered over a wide areaoffers comfort from the portfolio riskspoint of view
If the external credit exposure has asignificant role, it is better to disperseamong several countries
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Diversifiable Risks
5. Quality Risks
Ideally, it is better to fill the credit portfolio withAAA category credit assets.
Usually, banks have a target quality of portfolio inmind- say 92% to 95% of the total portfolio oughtto be higher than BBB (medium credit risk) anddevise strategies to attain this
Both default and migration probabilities of aparticular industry sector or a group of customersor different risk grades should be studied tounderstand the quality risk of the portfolio
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Diversifiable Risks
6. Maturity Risks:
The average maturity of the portfolio
should be effectively managed in orderto avoid liquidity problems
Maturity depends on the nature of the
business Constant watch on the asset-liability
situation is necessary
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Diversifiable Risks
7. Currency Risks
When obligations to be met from the
realisation of credit assets are denotedin different currencies, currency riskimpacts
Diversification and hedging areconsidered effective solutions tocurrency risks
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Diversifiable Risks
8. Collateral Risk
If the banks accept only one kind of security, asharp fall in the value of the security impacts the
portfolio risk Market correlation among the collateral securities
the concentration risks of the collateral portfolioand
The capacity of the market to absorb the sale of thecollateral in times of counter party default,
Necessitates diversification of collaterals
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Firm Risks and Portfolio
Risks Portfolio Risks and firm credit risks are interlinked,
Because a portfolio does not exist unless there areseveral credit assets
Portfolio credit risk is the agglomeration of severalindividual firm risks
The major milestones on the road to credit loss aremigration, default, loss given default an ultimate
write offs A study of the above helps the bank in assessing
the firm and portfolio credit risks
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Impact of Portfolio Credit
Risks In the case of a reasonably spread portfolio, not all
firm credits will default at the same time
By intelligent diversification, the portfolio risks can
be lowered below the sum of the individual creditrisks
Study of migration risks, default risk and credit lossat portfolio level is often linked to the stages of thebusiness cycle
Portfolio managers try to rein in migration risks byshuffling portfolio, seeking altered collaterals andby using other portfolio management measures
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Portfolio Credit risk
Mitigants Traditionally, all unsystematic risks can be diversified The three principal types of diversification are:1.Counter- party limit : The central bank usually stipulates
maximum credit to a specific party. For example, it may be
stipulated that a single credit exposure to any counter- partyshould not exceed 10% of the TNW of the creditor
2.Region wise restriction: Usually large and multinational banksadopt this
3.Industry Limit: Industries are categorised according risks andexposures to each industry is regulated according to this
Credit Derivatives have been heralded as path-breakingproducts that enable financial institutions to manage creditrisks
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