The importance of managing credit risk in the market - Free Essay Example

Managing Credit Risk is very important. Managing risk as well as returns is very crucial in order to sustain organization. In order to attract a large pool of customers variety of products with different options, advantages need to be offered. Bank must have ample amount of capital as reserves to meet sudden requirements. Risk can arise if borrowers who are not creditworthy are given loan extensions, this can also lead to liquidity problems for the bank and financial institutions. In order to avoid such situations banks need to monitor various parameters on regular basis. Risk may arise due to macroeconomic factors such as depression or recession in economy, changes in the interest rates, risk may arise due to counterparty default on terms of principal or interest payments. Managing Credit risk becomes important because in this globalized era everyone financial institution is linked to many financial firms. Decline in rating of one or delinquency by one institution may lead to catastrophe all over. Timely management of credit risk not only prevents personals associated but also helps in sustaining overall equity of the firm. 1.2. Purpose of the study: To analyze what type of risk one can face in terms of credit risk. How to asses these risks in a timely manner and how to take preventive measures when risk arises. Several Risk Mitigation techniques have been explained which showcase how one can mitigate risk after reaching a certain threshold. Different methods and models have been discussed 1.3. Significance of the study: Through this we will be able to differentiate what type of risk an organization is facing and what measures need to be taken. One understands how important it is to measure risk in timely manner. Different models have different limitations and need to be used properly so that gaps may get covered up. 2. LITERATURE REVIEW 2.1 Credit is defined as the terms, or an obligation to present resources, cash or other forms of funds (on- and off-balance sheet), secured or unsecured to a counterparty who is obliged to pay back, the amount along with the fee and interest thereon. 2.2 Credit Risk is the Financial Risk arising when counterparty is not able to meet the scheduled payments in accordance with agreed terms. Investor in such case losses on principal payments, Interest payments, reduced cashflow and incurs receivables expenses. Some examples: When a business is not able to pay an employee its wages. A consumer is not able to make interest or principal payments in case of mortgage. A firm/company declares insolvency. 2.3 Credit Risk can be broadly categorized into following three categories: Default Risk Credit Spread Risk Downgrade Risk Default Risk is when a borrower has not met his/her legal obligations as written down in the indenture. A default is when one fails or is unwilling to pay back the debt amount. It includes all debt obligations bonds, mortgages, loans, and promissory notes. Distinction from insolvency and bankruptcy Default is a condition in which one has not paid debt which he is obliged to. Insolvency incorporates legality when a debtor skips one or more scheduled payments. Bankruptcy involves supervision by court of law to proceed over any financial dealings in case of default or Insolvency. Credit Spread Risk is the difference in yield between securities arising due to different ratings assigned. It depicts the additional yield one earns from security with more credit risk as compared to a security which has lesser risk. The credit spread is often quoted with reference to the yield on a risk-free benchmark. There are several methods for measuring credit spread risk such as Z-spread and OAS. Downgrade Risk is the risk when a security/bond or any financial instrument faces down trigger of credit ratings assigned by well known and certified rating agencies such as Crisil, Moodys etc. The risk arises from declining situation of a corporation. 2.4 CREDIT RISK MANAGEMENT PROGRAMME Managing Credit Risk is of supreme importance and is properly assessed by all Financial Institutions. Good Credit Risk Mitigation techniques involve properly maintaining risk adjusted return across various dimensions such as maturity, interest rates, liquidity, currency exchanges etc. A broad credit risk management programme involves: ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Effectively identifying existing Financial Risk and promptly finding solutions. ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Establish effective processes to have a good documentation, receivables and credit rating processes. ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Credit Portfolio should be assessed on regular basis and regressed against various parameters in order to mitigate risk and align other parameters in sync with the environment. 2.5 CREDIT RISK ASSESSMENT Several Methods have been adopted worldwide in order to asses risk arising from various activities. 2.5.1 Credit Rating Agencies: Ratings are given by external and internal agencies. External Sources: Crisil, Fitch, SP any many such rating organizations evaluate creditworthiness of bond issuers. Ability of the debtor is assessed as to how timely he can make principal and interest payments and ratings are granted accordingly. Internal Sources give ratings which are at the point and through the cycle. Through the cycle assessment provides default probability at the worst condition in the business cycle and is useful in making lending decisions. At the point approaches assessment relate to changes in cyclical conditions and are more appropriate for capital allocation. Some basic points considered while assigning ratings by these agencies: The amount and composition of existing debt. The stability of issuers cash flow. The issuers ability to meet scheduled payments of interest and principal on its debt obligation. Asset protection Management Capability. Measures used to measure Credi t Risk are LGD (Loss Given Default), Probability of Default (PD). Traditional Measures to asses Credit risk using PD are- 2.5.2 Expert System: It is based on the opinion of experts and evaluates on the basis of 5 Cs. Character: It refers to management integrity and its commitment to repay the loans. Capital: It examines the relationship between equity and debt. Capacity: refers the ability of borrower to generate cashflow or liquidate short term assets to repay its debt obligation. Collateral: It includes the assets offered as security for the debt as well as other assets controlled by the issuer. Cycle: It considers how the current state of economy will impact exposure to credit risk. This is a subjective method. In order to minimize subjectivity we go for Neural Network which are flexible systems that include various conditions in a streamlined way in the final decision making process. Weights are updated based on the historical data input; this helps in training Neural Networks. This is very costly process and data may over fit. 2.5.3 Credit Scoring Models: These models they basically help in calculating Probability of default and Loss Given Default which is required to calculate Credit VAR. Expected Loss and Unexpected Loss are calculated by banks in order to mitigate risk arising from the counterparty. Expected Losses are covered through reserves maintained by the banks. Unexpected losses are met through economic capital. Threshold is reserved through VAR analysis at 99% confidence interval over a 1 year horizon period. VAR (Credit Risk) = Z (Value) x sigma x Value of the firm x .08 Economic Capital = VAR (at 99% Confidence Interval) Expected Loss. According to Basel 2 a minimum of 8% needed to be reserved in lieu to protect against credit risk. 1) Losses are marked in the x-axis; y-axis denotes percentage return. 2) Loss more than the Credit VAR is defined as the tail losses. They have very low probability of occurrence. Basel II IRB, area is 1-99.9% = 0.1% with 1 year horizon. 3).EC (confidence) = Credit V AR (confidence) Expected Loss (EL). EC refers to the region between EL and Credit VAR. 2.5.4 Merton Model: It showcases that value of equity is equivalent to a call option on firms assets where strike price of the assets is equal to the value of the debt. At expiration, the value of equity is equal to either zero or the difference between the value of the assets and the value of the debt, whichever is greater. The value of the equity is the function of following inputs: Market value of the assets Volatility of the market value of the assets Risk free rate The time until the option expires The exercise price As for the calculation part let us suppose the firms only debt issue is a zero coupon bond with a face value of F, due to maturity date of T. If the firm is unable to pay the principal at T, then the firm is bankrupt and the equity claimants receive nothing. Alternatively, if the firm value at T, V(t) is large enough to pay the principal amount, then the equity holders have claim to the balance, V(t) F. These two pay off possibilities are the same as the payoffs for a call option, with the firm value as the underlying asset and the principal amount as the exercise price. The value of the equity at T is: S (t) = Max (V (t) F,0) The value of debt is D (t) = F Max (F V (t), 0) Calculating Probability of Default Intensity based models assume defaults occur randomly and a hazard rate determines the probability of default. Intensity based models decompose the credit spread on debt to provide estimates of both the PD and the loss given default by utilizing the following relationship: CS = PD x LGD CS represents the credit spread, which is the difference between the yield on risky debt and the risk free rate. This is essentially a measure of expected loss since it is the spread that exceeds the risk free rate. Thus a researcher can approximate the probability of default from the credit spread and the loss given default. Recall that loss given default is equal to one minus the recovery rate. Probability of default could also be calculated using the following expression (assuming LGD = 100%) Market Price of Bond = [(Face value of bond) x (1 PD)}] / (1 + risk free rate) 2.6 Mitigating credit risk Risk-based pricing: Those borrowers who are prone to defaults are charged higher rates of interest by Lenders. Various parameters such as purpose of loan , Ratings assigned by agencies, Loan-Value ratio and yields (spreads) are evaluated. Covenants: A note in an indenture, or any agreement stating that these activities will be carried out and these will not be. Financial Analysis is done at regular intervals Due to significant change in certain Financial Ratios lender can request the borrower to repay the loan in full. Credit Insurance: Lenders can hedge counterparty risk by purchasing Insurance. This process helps in transfer of risk from Lenders to Insurance Firms (Third party) Credit Default Swap is a type of instrument in which one party makes payments to other party. The purchaser of the CDS seeks credit protection and will make fixed payments to the seller of the CDS for the life of the swap, or until a credit event occurs. Tightening: By lowering the amount of credit extended, Lenders can mitigate risk fully or partially. Say for Example, a distributor tries to lessen his credit risk by reducing payment scheme from 30 to 15 to a retailer. Diversification: Diversifying to a large number of borrowers reduces the risk plus lending it to different sectored departments further lowers the credit risk. Deposit insurance: Central Government in many countries has established a process known as Deposit Insurance so that the bank can derive some monetary benefit from the Central Bank. This scheme prevents a run on the bank situation. Credit risk mitigation (CRM) It helps in managing credit risk in an efficient and mechanized way. Offers a widespread approach so that can be used across range of institutions. Offers great amount of flexibility and is consistent with the environment. 2.7 Some of the Methods to Mitigate Credit Risk are: 2.7.1 Collaterals: An institution/Bank or any Financial Services firm has a credit exposure which is safeguard by cash or any equivalent Financial Instrument serving as Collateral. Some part of the total Loan or the full amount is collateralized in the process. No collateral requirement higher than secured issue should be posted. These reduce the risk by a larger amount as in case of adverse events these collaterals can be encashed to meet the sudden liquidity, cashflow risk arising due to counterparty risk. 2.7.2 Netting: It is a legal agreement that enables counterparties with multiple derivative contracts to net their obligations. This reduces credit and liquidity risk exposures by eliminating large fund transfers resulting from each individual transaction. Instead of large transfers, smaller net payments are made by the counterparty with the net liability. Let us consider Bank XYZ has a portfolio of N derivatives contracts with counterparty MNO, and suppose that no default value of the i th contract is equal to V (i). Furthermore, the amount recovered if default occurs is the recovery rate times the no default exposure. If netting clauses were not enforced, the financial institution would suffer losses of: LGD x (i=1 to N) SIGMA (Max (V, 0)) When the netting credit risk mitigation technique is implemented, the net loss would be: LGD x Max ( (i =1 to N ) SIGMA (V ( i ),0 ) ) 2.7.3 Guarantees and Credit Derivatives Guarantee given by certain Institutions which specializes in that particular sector. Some initial coverage or protection is provided by these institutions. 2.7.4 Downgrade Triggers: When the rating of a certain party falls below specified levels, a trigger is set and this enables the counterparty to clear off the contract at its current market value. 2.8 Credit Risk Management Process 2.8.1 Credit Processing/Appraisal In this process all the required information is gathered and screening of applicants is undertaken. The next step in line is to assess the obligors how efficiently they can make scheduled payments. These institutions should ensure that benefits are only given to those creditworthy customers who have ensured that they can timely deliver and have stability of the cashflow. These institutions generally accept collateral from borrowers so as to mitigate risk. These institutions then relax in their drilling process; they become less efficient in collecting information from borrowers. They should have in mind that securing loan through collateral does not signify that stability of cashflow from the client/counterparty will be timely. The working capital should not be derived from collaterals or guarantees. The working capital should be based on proper analysis of sales, historical background, stress testing and Scenario Analysis. Some measures should be adopted as follows: Pe riodic valuation of the collaterals should be done. Legal issues and credit downgrade issues should be tackled immediately. Regular audit of financial statements should be undertaken. 2.8.2 Credit-approval/Sanction A set of guidelines should be written down by all the institutions based on which decision will be taken. Every blueprint developed should be approved by the senior members. Regular checking should be done by board of members. Decisions such as renewal of credit ters, analysis of existing credit policies and proposition of new terms is carried out. Some points to be kept in mind: Committee/personnel handling credit approval task should be kept away from the CRM responsibility. Approval should be structurized and should consist of a well defined hierarchy; who should be responsible for screening the entire process depending on the size and nature of credit. 2.8.3 Credit Documentation This process is important and is required for every step in the credit cycle. Activities such as credit rating, monitoring, valuation etc. are documented. A standardized report regarding every step need to be drafted and should be made available to every person in the concerned department. 2.8.4 Credit Administration Following should be done to administer credit risk: Files and related documents should not be moved from their respective locations and should be kept in order; The obligor is making regular and apt payments. Collaterals are properly valued and monitored thereon. Timely and accurate information is conveyed to the top officials. Proper Role Allocation is done. Back office, front office and middle levels are in sync with each other. 2.8.5 Disbursement A letter should be delivered to the customer to make him aware of all the terms and condition. A duplicate letter should be signed by the client and should be submitted to the institution. No funds should be released prior approval by the concerned authorities. 2.8.6 Monitoring and Control of Individual Credits Funds if allotted for a particular client should only be used for his purpose and not anywhere else. Obligors should comply with bounded promises; Manage audit reports and financial statements. Budgeting and Projections 2.8.7 Monitoring the Overall Credit Portfolio (Stress Testing) Economy Downturn: Continuous evaluation of the economy is to be carried out because recession, interest rates, inflation etc have severe impact on the portfolio. Market Risk need to be evaluated because in the era of globalization various markets are inter-related and have strong dependencies. Liquidity Mismatch may arise due to cashflow instability, this needed to be tracked and projections regarding such instances should be made well in advance. Contingency plans should be developed and reviewed by senior management periodically. 2.8.8 Managing Problem Credits/Recovery Recovery Process with respect to Customers: Seniority: It determines the priority order of the claimants with respect to the assets when the firm defaults. Higher the seniority higher will be the recovery rate. Collateralization: It showcases how different assets have been assigned to different claimants in the event of default. The allocation value and liquidity of the assets will determine the recovery rate. Some of the recovery Functions used: Beta Distribution: Two input statistical parametric distribution using mean and variance. This is a very flexible process. Kernel Estimation: A non parametric technique which uses probabilistic method to assign probabilities to events. Conditional Recovery model: Parametric technique that uses multiple factors to asses recovery. Covariances, volatility, mean etc are calculated. 2.9 Credit Risk Portfolio Models: Credit Risk+: It measures risk for every obligor using a set of risk factors. It is a two outcome model; default or no default. Each obligors PD is based on its credit rating and sensitivity to each risk factor. The defaults are uncorrelated across obligors. The risk parameters are supposed to follow a definite distribution such as gamma distribution. Credit Metrics: The first step is to determine credit ratings. Then use historical transition rating matrix to determine PD. Use 1 year forward rate to get current price of zero coupon bond and then calculate VAR at a given confidence level. This method totally relies on co-relation analysis. KMV Portfolio Manager: Expected default probabilities for each obligor are calculated. This method gives us what is the firms value and volatility. This method uses current equity in the model which integrates current event to the model. There is minimal lag regarding updating of these ratings. Expected return is calculated using CAPM which factorizes the correlation structure. Credit Portfolio View: They depict macroeconomic changes using transition matrices, also economic cycle is being included in the data to be analyzed. An econometric model is used to asses the risk. Autoregressive process measurement is done. Next step is to compose sector indices for the variables. Index value is used to estimate default rates. Simulated values are regressed against historical values and results are used to make decision making process. KMV Award Approach: This model is used to determine default rates. Basic steps to be followed are: There is one issue of equity and debt, and the debt is in the form of a zero-coupon bond that matures at a given date. Default can only occur at the maturity date. The value of the firm is observable and follows a lognormal diffusion process. The risk free rate is constant through time. There is no negotiation between equity and bondholders. There is no need to adjust for li quidity. Default point is then calculated as follows: Short Term Liabilities + 0.5 x Long Term Liabilities Short Term Liabilities + (0.7 x Long Term Liabilities 0.3 x Short term Liabilities) 3. SUMMARY AND CONCLUSION This seminar paper guides us through Credit Risk and its type. We learn what credit risk is and what its scope is, also we come across different types of risk and segregate among them this helps particularly banks in setting aside reserves for each department to meet daily requirements and safeguard against adverse events. Next most important thing we have analyzed is the credit risk management technique which involves process oriented scheme to prepare data and evaluate with the help of seniors, to document the findings and properly asses that factors are in sync with the stated data. The next learning sector was the credit risk mitigation techniques such as netting. Netting is a widely used concept in which an obligor having multiple exposures to counterparty reduces his exposure by paying net amount rather than submitting full amount. Collateralization is yet another concept learnt through this seminar paper. Collaterals are posted as security by borrowers in order to safe guard investors. These collaterals should be properly valued and any change in its value should be reflected in the documents. Guarantees and promissory notes are provided in order to facilitate investor and keep him away of the potential threats. Next we learnt how actually firms/ banks and financial institutions Mitigate risk through a standardized process. Firstly risk factors are analyzed, weights are assigned and their sensitivity is analyzed. Reports are documented and presented to the senior officials. We have learnt that the entire process is error free and accurate if followed, minimal chances of fraud etc are to be seen. Every step adds value to the process and any sudden change is included using various models such as KMV, Merton. These models give an insight as to how industry officials actually asses such a widespread risk. This gives an insight as to how models relate real world risk and integrate theoretical knowledge to the sector. Various concepts such as expe cted loss, unexpected loss, economic capital, VAR were seen and understood. In the end it is enough to conclude that credit risk management is a very important process which every firm needs to carry out in order to sustain in this competitive world. Risk Mitigation is complex and requires stress testing and scenario analysis with reference to historical data side by side as well.