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Unit - 05 - Credit Risk Measurement and Management

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68 views

Unit - 05 - Credit Risk Measurement and Management

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Jacob Peralta
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© © All Rights Reserved
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UNIT - 05

CREDIT RISK MEASUREMENT AND MANAGEMENT


WHAT IS CREDIT RISK?

Credit risk is when a lender lends money to a borrower but may not be paid
back. Loans are extended to borrowers based on the business or the
individual’s ability to service future payment obligations (of principal and
interest).

Lenders go to great lengths to understand a borrower’s financial health and


to quantify the risk that the borrower may trigger an event of default in the
future.
THE 5 CS OF CREDIT

Character
Capacity
Capital
Collateral
Conditions
MANAGING CREDIT RISK

Measurement
Mitigation
MEASURING CREDIT RISK

Understanding what’s going on in the business environment and the


broader economy
Analyzing the industry in which the borrower operates
Evaluating the business itself – including its competitive advantage(s)
and management’s growth strategies
Analyzing and understanding the management team and ownership (if
the business is privately owned). Management’s reputation and owner’s
personal credit scores will be included in the analysis.
CREDIT STRUCTURE

Credit risk can be partially mitigated through credit structuring


techniques.
Elements of credit structure include the amortization period, the use of
(and the quality of) collateral security, LTVs (loan-to-value), and loan
covenants, among others.
For example, if a borrower is riskier, they may have to accept a shorter
amortization period than the norm. Perhaps a borrower will be required
to provide more frequent (or more robust) financial reporting.
SENSITIVITY ANALYSIS

Sensitivity analysis is when a lender changes certain variables in the


proposed credit structure to see what the borrower’s credit risk would
look like if the hypothetical conditions became a reality. Examples
include:
Suppose a lender intends to extend credit at a 5% interest rate; they
may wish to see what the borrower’s credit metrics look like at 7% or
8% (in the event that rates ever increase materially). It is sometimes
called a “qualifying rate.”
PORTFOLIO-LEVEL CONTROLS

Financial institutions and non-bank lenders may also employ portfolio-


level controls to mitigate credit risk.

Strategies include monitoring and understanding what proportion of


the total loan book is a particular type of credit or what proportion of
total borrowers are a certain risk score.
EXAMPLES

Example 1: The risk management team at a bank unanimously agrees


that the housing market will face headwinds over the next 12-18
months. To be proactive, they may restrict residential mortgages with
high-risk profiles (as a proportion of total firm-wide exposure) to not
greater than X% of all credit outstanding.
Example 2: Based on the economic cycle, the risk management team
anticipates that a recession may be looming. It may seek to restrict
extending loans to certain borrowers with a risk score of less than X.
MEASURING CREDIT RISK IN BANKING
TRANSACTIONS

Credit Scoring: This is a statistical analysis that assigns a numerical score to a borrower
based on their credit history, income, debt levels, and other factors. A higher score
indicates a lower credit risk
Financial Ratio Analysis: Banks analyze various financial ratios of a borrower, like the debt-
to-equity ratio or the current ratio, to assess their financial health and ability to repay the
loan.
Credit Rating Agencies: External agencies like Moody's or S&P Global Ratings evaluate the
creditworthiness of borrowers and assign credit ratings (AAA, BBB, etc.). These ratings
indicate the agency's opinion on the likelihood of default.
Scenario Analysis: Banks might use simulations to assess how a borrower's ability to repay
might be impacted by various economic scenarios, like a recession or rising interest rates.
FACTORS AFFECTING CREDIT RISK
BORROWER-SPECIFIC FACTORS

Credit History: A history of late payments or defaults indicates a higher risk.


Financial Strength: Income stability, debt levels, and asset holdings all play a role.
Industry and Business Conditions: The borrower's industry and its overall health can
impact repayment ability.
TRANSACTION-SPECIFIC FACTORS

Loan Purpose: Loans for business expansion might carry a higher risk than home loans.
Loan-to-Value Ratio (LTV): This ratio compares the loan amount to the value of collateral.
A higher LTV indicates a riskier loan.
Loan Terms: Longer loan terms and lower interest rates can increase credit risk.
EXTERNAL FACTORS

Economic Conditions: A strong economy generally leads to lower credit risk, while a
recession can increase defaults.
Regulatory Environment: Government regulations on lending practices can impact credit
risk.
TYPES OF ASSETS
TECHNIQUES TO MEASURE AND MANAGE CREDIT
RISK
PRINCIPLES FOR THE MANAGEMENT OF CREDIT RISK

https://www.bis.org/publ/bcbsc125.pdf
CHALLENGES AND BEST PRACTICES
QUALITATIVE OR QUANTITATIVE RISK ASSESSMENT
CREDIT SCORING MODELS
REFERENCE

https://www.dripcapital.com/en-
us/resources/finance-guides/credit-facilities

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