1

CREDIT RISK
2
The banking book covers credit risk arising from :
 commercial loans
 loans to sovereigns and public sector entities
Credit risk  consumer (retail) loans
may appear  Some financial instruments that give rise to credit risk
do not appear on a bank's books.
in Banking  These off-balance sheet items include loan commitments
and trading and lines of credit.
books  They may be converted later to on-balance sheet items.
The trading book covers credit risk arising from
 exchange traded instruments and
 OTC derivatives.
 The Building blocks of Credit Risk
3 Management

¨Probability of default ¨Exposure at default

• Refers to the likelihood of • Maximum amount an institution
borrower not honoring can lose if a borrower or
contractual obligations; is a counterparty defaults. (ED)
measure of the expected default
frequency. (PD)

¨Loss given default

• The percentage of an
outstanding claim that cannot be
recovered in the event of a
default. (LGD)
4 UBS: Credit Exposure
 UBS: Distribution of exposures
5
6
 UBS: Credit ratings
7
8  There are two main effects that determine the credit
exposure over time for a single transaction or for a
portfolio of transactions with the same counterparty:
 Diffusion
EXPOSURE AT  Amortization.
DEFAULT:  As time passes, the “diffusion effect” tends to increase the
DIFFUSION exposure.
 There is greater variability and, hence, greater potential
AND for market price factors to move significantly away from
AMORTIZATIO current levels.
 The “amortization effect” in contrast, tends to decrease
N the exposure over time.
 This is because it reduces the remaining cash flows that
are exposed to default.
9 Arriving at counterparty exposure

¨There are three main components

in calculating the distribution of
counterparty-level credit
exposure:
• Scenario generation
• Instrument valuation
• Portfolio aggregation
10 SCENARIO GENERATION

¨There are two ways that we can generate possible future values of the price
factors.

¨The first is to generate a “path” of the market factors through time, so that each
simulation describes a possible trajectory from time t=0 to the longest simulation
date, t=T.

¨The other method is to simulate directly from time t=0 to the relevant simulation
date t.
11

The second step in credit exposure calculation is to

value the instrument at different future times using the
simulated scenarios.
Instrument The valuation models used to calculate exposure could
be very different from the front-office pricing models.
Valuation  Typically, analytical approximations or simplified
valuation models are used.
The front office can afford to spend several minutes or
even hours for a trade valuation, but valuations in the
credit exposure framework must be done much faster,
because each instrument in the portfolio must be
valued at many simulation dates for a few thousand
market risk scenarios.
12
 LGD is the percentage of the credit exposure that the
lender will lose if the borrower defaults.

 It is also referred to as loss 'severity'.

Loss Given  The recovery rate is the percentage of the

exposure that is recovered when an obligor

Default defaults.

 The higher the recovery rate, the lower the

LGD.

 LGD is better represented by a distribution

than by a single figure

 There is uncertainty about recovery both

due to quantifiable as well as fuzzy factors
like bargaining power of debtors, creditors.
13
•There are two commonly used measures of
recovery.

•The ultimate recovery

• Measurement is difficult.
MEASURIN
• Only way out in case of illiquid bank
G loans.
RECOVERY
•The price of debt just after default
• Measurement is easy provided the debt
is traded.
• Often applicable to bonds.
 Factors affecting LOSS GIVEN
14
DEFAULT (LGD)

¨SENIORITY ¨COLLATERAL ¨TYPE OF ¨INDUSTRY ¨JURISDICTIO

BORROWER/OBLI N
GATION
15
• Two simple rules:
• 1) Older the debt, difficult it is to recover
• 2) Lower the debt cushion, lower is the recovery rate.

• Seniority is certainly one of the key determinants of the level of recovery.

SENIORITY •Another concept introduced by Keisman and Van de Castle is

debt cushion. The more debt is junior to a given bond, higher the
recovery rate.

• According to their study, when the debt cushion is 75% or more, 89% of the loans
have a present value of recoveries of over 90%.

• When the debt cushion is under 20%, 40% of the loans show a present value of
recoveries of under 60%.

• This argument does not hold when there are multiple commitments to
different creditors with the same seniority.
16

• Collateral is useful but should not lead to

complacency.

• From a regulatory standpoint, it may have an

COLLATERA adverse impact on bank monitoring.

L • For lenders, the value of the collateral may

drop when there is an economic downturn and
more firms start defaulting.

• Collateral does not guarantee full recovery.

17

• Assets that can be readily used by other parties have higher

liquidation values.

INDUSTRY • Firms in some industries have large quantities of real estate that
can be sold in the market.

•Other sectors may be more labour intensive.

•Some industries are plagued by structural problems

and hence are not competitive.

• More competitive industries are associated with higher

recovery.
18

 Bankruptcy proceedings in the UK and US take

less time.

 In Continental Europe it can take much longer.

Jurisdiction  In India, the proceedings can take even more

time! (in years).

 Things have improved after introduction of

NCLAT & Bankruptcy code.
 CORRELATION BETWEEN PROBABILITY
19 OF DEFAULT (PD) AND LOSS GIVEN
DEFAULT (LGD)
• PD and LGD are influenced to some extent
by the same macroeconomic variables.

• As an economy enters a period of recession,

default rates increase.

• This leads to a large quantity of assets being

liquidated at a time when demand and
consequently prices are low.

• So recovery rates also tend to be low.

20
Expected, unexpected and stress losses
21 Expected Loss

• The expected loss (EL) is the amount that an institution expects to lose on a credit exposure over a given
time horizon.

• EL = PD x LGD x EAD (Exposure at default or ED)

• How should we deal with expected losses?

• In the normal course of business, a financial institution can set aside an amount equal to the expected loss as a
provision.

• Expected loss can be built into the pricing of loan products.

22 Unexpected loss

• Unexpected loss is the amount by which potential credit losses might exceed the expected loss.

• Traditionally, unexpected loss is the standard deviation of the portfolio credit losses, but this is not a good risk
measure for fat-tail distributions, which are typical for credit risk.

• To minimize the effect of unexpected losses, institutions are required to set aside a minimum amount of
regulatory capital.

• Apart from holding regulatory capital, however, many banks also have sophisticated ways to estimate the
necessary economic capital to sustain these unexpected losses
23 Stress Losses
 Stress losses are those that occur in the tail region of the
portfolio loss distribution.
 They occur as a result of exceptional or low probability
events (a 0.1% or 1 in 1,000 probability in the distribution
below).
 While these events may be exceptional, they are also
plausible and their impact is severe.
 Additional capital will come in handy in such situations.
 Measuring Credit loss
24

• In simple terms, a credit loss can be described as a decrease in the value of a

portfolio over a specified period of time.

• So we must estimate both the current value and the future value of the
portfolio at the end of a given time horizon.

• There are two conceptual approaches for measuring credit

loss:
– Default mode paradigm
– Mark-to-market paradigm
 Default mode paradigm
25

 A credit loss occurs only in the event of default..

 This approach is sometimes referred to as the two-state model.

 The borrower either defaults or does not default. (two states)

 If no default occurs, the credit loss is obviously zero.

 If default occurs, exposure at default (ED) and loss given default (LGD)
must be estimated.

 Credit Risk Plus is based on this paradigm.

26 Mark-to-market (MTM) paradigm

 Here, a credit loss occurs if:

 the borrower defaults
 the borrower's credit quality deteriorates (credit migration)

 This is therefore a multi-state paradigm.

 There can be an economic impact even if there is no default.

 Credit Metrics is based on this paradigm.

27 DM MODEL vs MTM MODEL
28
Mark-to-market paradigm
approaches
There are two well-known approaches in the mark-to-market paradigm :
 the discounted contractual cash flow approach
 the risk-neutral valuation approach
 Discounted Contractual Cash flow Approach
29 The current value of a non-defaulted loan is measured as the present
value of its future cash flows.

The cash flows are discounted using market-determined credit spreads

for obligations of the same grade.

If external market rates cannot be applied, spreads implied by

internal default history can be used.

The future value of a non-defaulted loan is dependent on the risk rating

at the end of the time horizon and the credit spreads for that rating.

Therefore, changes in the value of the loan are the result of credit
migration or changes in market credit spreads.

In the event of a default, the future value is determined by the recovery
rate, as in the default mode paradigm.
30 Risk-Neutral Valuation Approach
 Prices are an expectation of the discounted future cash flows in a risk-neutral market.

 These default probabilities are therefore called risk-neutral default probabilities and are
derived from the asset values in a risk-neutral option pricing approach.

 Each cash flow in the risk-neutral approach depends on there being no default.

 For example, if a payment is contractually due on a certain date, the lender receives
the payment only if the borrower has not defaulted by this date.

 If the borrower defaults before this date, the lender receives nothing.

 If the borrower defaults on this date, the value of the payment to the lender is determined
by the recovery rate (1 - LGD rate).

 The value of a loan is equal to the sum of the present values of these cash
flows.
 Risk neutral vs Actual probability of default
31
• The risk-neutral default intensity that is used to price a company’s risky debt is not the
same as the company’s actual default intensity.

• A company’s risk-neutral intensity contains an adjustment for risk, and thus it is

typically higher than its actual intensity in order to incorporate investors’ aversion to
bearing the risk of default.

• Intuitively, reduced-form pricing models use risk-neutral probabilities to essentially

pretend that the probability of an undesirable event (such as default) is actually higher
than the true probability.

• If we analyze the difference between the actual default intensity and the risk-neutral
default intensity, we arrive at an indicator of how much compensation investors require to
bear default risk.

• If this difference is large, then investors demand a large premium

for bearing credit risk and credit spreads are wide.
32 Structural Models
Structural models look at the values of the assets and liabilities of the firm.

The focus is on the structure of a company’s assets and liabilities.

Default occurs when assets are not sufficient to meet liabilities.

 Structural models also form the basis of Moody’s KMV model.

In these models, the assets of the company are lognormally distributed or the
logs of the assets are normally distributed.

The number of standard deviations between the log of the current value of
the company’s assets and the log of its liabilities is referred to as the
company’s distance to default.
33 Popular Credit Risk Models

Merton
Moody's KMV
Credit Metrics
Credit Risk+
Credit Portfolio View
 KMV Model
34
 Default tends to occur when the market value of the firm’s assets drops below
a critical point that typically lies
– Below the book value of all liabilities
– But above the book value of short term liabilities

 The model identifies the default point d used in the computations.

 The distance to default, d2 is a proxy measure for the probability of default.

 As the distance to default decreases, the company becomes more likely to default.

 As the distance to defaultincreases, the company becomes less likely to default.

 The KMV model, unlike the Merton Model does not use a normal distribution.

 Instead, it assumes a proprietary algorithm based on historical default rates.

 For example, in the database, if 0.8 percent of companies with a distance to default of
2 defaulted within one year, then the expected default frequency (EDF) of a company
with a distance to default of 2 is 0.8 percent.
 KMV Model
35

Using the KMV model involves the following steps:

– Identification of the default point, D.
– Identification of the firm value V and volatility 
– Identification of the number of standard deviation
moves that would result in firm value falling below D.
– Use KMV database to identify proportion of firms
with
distance-to-default, δ who actually defaulted in a year.
– This is the expected default frequency.
– KMV takes D as the sum of the face value of the all short term
liabilities (maturity < 1 year) and 50% of the face value of longer
36
How Trafigura manages credit risk
 Trafigura has a formal credit process by which it establishes credit limits for each
counterparty.

 Besides “soft” information, the company also uses the KMV Moody’s
methodology.

 Credit officers are located across the world to make a firsthand assessment of
the credit risk.

 Where credit exposure to a counterparty exceeds the prescribed limit, Trafigura

purchases payment guarantee or insurance from prime financial institutions.

 The company also purchases political risk cover in specific geographies.

 Trafigura also monitors credit risk concentration by industry and geography

closely.
37 How Trafigura manages credit risk
 85% of the company’s derivatives are exchange traded or centrally
cleared.
 In case of OTC trades which make up the remaining 15%,
Trafigura deals with blue chip banks and market participants.
 Credit limits and collateral are used to minimize credit risk
exposure.
The use of standardized contracts is another risk mitigation
technique.
 Problem
38
Given the following figures, compute the distance to default:

– Book value of liabilities $5.95 billion

: $4.15 billion
– Estimated default point $12.4 billion
:
– Market value of equity $18.4 billion
:
24%
Solution
– Market value of firm
:
Distance to default (in terms of value) = 18.4 – 4.15 billion = $14.25
– Volatility of firm value
:
Standard deviation = (.24) (18.4) = $4.416 billion

Distance to default (in terms of ) = 14.25/4.42 = 3.23

 Problem
39

A firm's assets are currently valued at $700 million, its current

liabilities are $120 million, and long-term liabilities are $150
million. The standard deviation of expected asset value is $76
million. What will be the appropriate distance to default
measure when utilizing Moody’s KMV Model?
Distance to default = (700 – 120 – 150)/76 = 430/76 = 5.66
  Consider the following figures for a company. What is the
distance to default?
40
– Book value of all liabilities : $2.4 billion
Problem – Estimated default point, D : $1.9 billion
– Market value of equity : $11.3 billion
– Market value of firm : $13.8 billion
– Volatility of firm value : 20%
Solution

 Distance to default (in terms of value) = 13.8 – 1.9 = $11.9 billion

 Standard deviation = volatility * Market value = (0.20) (13.8) = $2.76 billion

 Distance to default (in terms of standard deviation) = 11.9/2.76 = 4.31

41
Problem  There are 10 bonds in a portfolio. The
probability of default for each of the bonds
over the coming year is 5%. These probabilities
are independent of each other. What is the
probability that exactly one bond defaults?
Solution
Required probability
= (10)(0.05)(.95)9
= 0.3151
= 31.51%
42
Problem  A Credit Default Swap (CDS) portfolio consists of
5 bonds with zero default correlation. One year
default probabilities are 1%, 2%, 5%,10% and 15%
respectively. What is the probability that that the
protection seller will not have to pay
compensation?
Solution
Probability of no default
= (.99)(.98)(.95)(.90)(.85)
= .7051
= 70.51%
43 Problem

 If the probability of default is 6% in year 1 and 8% in year 2,

what is the cumulative probability of default during the two
years? Assume default does not lead to bankruptcy.
Solution
Probability of default not happening in both years
= (.94) (.92)
= 0.8648
Required probability = 1 － .8648
= 0.1352
= 13.52%
44
Problem  The 5 year cumulative probability of default for a
bond is 15%. The marginal probability of default for
the sixth year is 10%. What is the six year
cumulative probability of default?
 Solution
 Required probability
= 1- (.85)(.90)
= .235
= 23.5%
45

Calculating probability
of default from bond
yields

How can we do this?

What is the significance of yield?
 Problem
46
 Calculate the implied probability of default if the one year T Bill yield is 9% and a 1
year zero coupon corporate bond is fetching 15.5%. Assume no amount can be recovered
in case of default.

 Solution:

 Let the probability of default be p

 Returns from corporate bond = 1.155 (1-p) + (0) (p)
46  Returns from treasury = 1.09.
 To prevent arbitrage, 1.155(1-p) = 1.09
 p = 1- 1.09/1.155 = 1- 0.9437
 Probability of default = .0563 = 5.63%
 47 Problem

 The T Bill yield is 2.9% and the corporate bond yield is 5.6%.
Assuming zero recovery, what is the implied probability of default?

 Solution
47  1.029= (1-p)(1.056)

 Or p = 2.56%
48 Problem (Example of pricing the loan
considering probability of default)
 A loan of $ 10 million is made to a counterparty with probability of default 2% and
recovery rate of 40%. If the cost of funds is LIBOR, what should be the price of the loan?
 Solution
 0.02 = spread/[1-0.4]
 Spread = .02x.6 = .012 = 1.2 % = 120 basis points
 So quote will be LIBOR + 120 bp.
49 Problem

If 1 year and 2 year T Bills are fetching 11% and 12% and 1 year and 2 year corporate
bonds are yielding 16.5% and 17%, what is the marginal probability of default
for the corporate bond in the second year? Assume the recovery is zero.
 Yield during the 2nd year can be worked out as follows:
 Corporate bonds: (1.165) (1+i) = (1.17)2
 I =17.5 %
 Treasury : (1.11) (1+i) = (1.12)2
 I=13%
 P=1-0.9617
 Default probability = 3.83%
 Problem
50
The spread between the yield on a 3 year corporate bond and the yield on
a similar risk free bond is 50 basis points. The recovery rate is 30%. What is
the cumulative probability of default over the three year period?

 Spread = (Probability of default) (loss given default)

 or .005 = (p) (1-.3)

 or p = .005/0.7 = .00714
= .71% per year

 No default over 3 years = (.9929) (.9929) (.9929)

= .9789

 So cumulative probability of default = 1 – .9789 =

51 Problem
 The spread between the yield on a 5 year bond and that on a similar risk free
bond is 80 basis points. If the loss given default is 60%,estimate the average
probability of default over the 5 year period. If the spread is 70 basis points for
a 3 year bond, what is the probability of default over years 4,5?

Probability of default over the 5 year period= 0.008/0.6 = 0.0133

Probability of default over the 3 year period= 0.007/0.6 = 0.01167

 (1-0.0133)5 = (1-0.01167)3 (1-p)2

 or (1-p)2 = 0.9352/0.9654 = 0.9688
 or 1–p = 0.9842
 or p = 0.0158 = 1.58%
52 Problem

 A bond with a face value of 300 will be redeemed in 10 years .

The market value of the bond is currently 150. If the risk free
rate is 5%, find the yield spread.
150 X e^(10r) = 300
e^ (10r) = 2
10 r = ln 2
r = 0.0693 = 6.93%
Spread = 6.93% – 5% = 1.93%
53
Problem

A bank has made a loan commitment of $2,000,000 to a customer. Of

this, $ 1,200,000 has been disbursed. There is a 1% default probability and
40% loss given default. In case of default, drawdown is expected to be 75%
of the undrawn balance. What is the expected loss?

Solution:

Drawdown in case of default = (2,000,000 – 1,200,000) (0.75)= 600,000

Adjusted exposure = 1,200,000 + 600,000= 1,800,000
Expected loss = (0.01) (0.4) (1,800,000)= $ 7,200
 Problem

Suppose a bank has three transactions worth of $10 million, $30 million, and −$25 million.

What is the exposure with netting and without netting?

54 Solution:

Without netting, the exposure is (10 + 30 = $40 million.

With netting, the exposure is (10 + 30 - 25)= $15 million.

 Problem
A diversified portfolio of OTC derivatives has a gross marked
to market value of 4,000,000 and a net value of $ 1,000,000.
If there is no netting agreement in place, calculate the current
credit exposure.
 x + y = 4,000,000
 x - y = 1,000,000
 So x = 2,500,000 and y = 1,500,000
 So credit exposure to counterparty = $ 2,500,000.
 Problem
A bond with a face value of $100,000 has a 40% probability of
default with a recovery rate of 50%. The bond is selling for $
70,000. Calculate the mean loss rate and the risk neutral
mean loss rate.
Mean loss rate = Expected loss = 0.5*0.4*100,000/100,000
= 20,000/100000 = 0.2=
20%
Risk neutral loss mean rate = (100,000-70,000)/100,000 = 0.3
= 30%
 Problem

 A bank makes a $100,000,000 loan at a fixed interest rate of 8.5% per

annum.

 The cost of funds for the bank is 6.0%, while the operating cost is $800,000.

 The economic capital needed to support the loan is $8 million which is

invested in risk free instruments at 2.8%.

 The expected loss for the loan is 15 basis points per year.

 What is the risk adjusted return on capital?

 Net profit =100,000,000 (0.085 - 0.060 - 0.0015) – 800,000 + (8,000,000)

= 23,50,000 – 800,000 + 224,000=$1,774,000
(0.028)
Risk adjusted return on capital =1.774/8 = .22175 = 22.175%