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Risk Management – Credit Risk

Introduction to Credit Risk Management:

Risk is inherent in all aspects of a commercial operation and covers areas such as customer services,
reputation, technology, security, human resources, market price, funding, legal, and regulatory, fraud and
strategy. However, for banks and financial institutions credit risk is the most important factor to be
managed.

The term credit risk is defined, “as the potential that a borrower or counter-party will fail to meet its
obligations in accordance with agreed terms”.

In simple terms it is the probability of loss from a credit transaction.

Loans are the largest and most obvious source of credit risk. Loans are given by banks in the form of
corporate lending, sovereign lending, project financing and retail lending. However other sources of credit
risk exists throughout the activities of banks, including in the banking book and in the trading book and both
on and off the balance sheet. Banks are increasingly facing credit risk in various instruments other than
loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions,
financial futures, swaps, bonds, equities, options and in the extension of commitments and guarantees, and
the settlement of transactions. Credit risk encompasses both default risk and market risk. Default risk is the
objective assessment of the likelihood that counterparty will default. Market risk measures the financial loss
that will be experienced should the client default. Credit risk includes not only the current replacement value
but also the potential loss from default. For example:-

1. A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other
loan.
2. A company is unable to repay asset-secured fixed or floating charge debt.
3. A business or consumer does not pay a trade invoice when due.
4. A business does not pay an employee's earned wages when due.
5. A business or government bond issuer does not make a payment on a coupon or principal payment
when due.
6. An insolvent insurance company does not pay a policy obligation.
7. An insolvent bank won't return funds to a depositor.
8. A government grants bankruptcy protection to an insolvent consumer or business.

Definition of Credit Risk:

 Possibility of losses associated with decline in the credit quality of borrowers or counterparties.
 Default due to inability or unwillingness of a customer or counterparty to meet commitments in
relation to lending, trading, settlement and other financial transactions.
 Loss from reduction in portfolio value (actual or perceived).
 Possibility that borrowers may not meet their obligation in terms of the loan agreed terms and
conditions.
 Probability of loss from a credit transaction.

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Risk Management – Credit Risk

Components of Credit Risk:

1. Credit growth in the organization and composition of the credit folio in terms of sectors, centers and
size of borrowing activities so as to assess the extent of credit concentration.
2. Credit quality in terms of standard, sub-standard, doubtful and loss-making assets.
3. Extent of the provisions made towards poor quality credits.
4. Volume of off-balance-sheet exposures having a bearing on the credit portfolio.

According to Reserve Bank of India, the following are the forms of credit risk:

1. Non-repayment of the principal of the loan and/or the interest on it.

2. Contingent liabilities like letters of credit/guarantees issued by the bank on behalf of the client and
upon crystallization – amount not deposited by the customer.
3. In the case of treasury operations, default by the counter-parties in meeting the obligations.
4. In the case of securities trading, settlement not taking place when it is due.
5. In the case of cross-border obligations, any default arising from the flow of foreign exchange and/or
due to restrictions imposed on remittances out of the country.

Sources of Credit Risk:

Credit risk arises from the potential that a borrower or counterparty will fail to perform on an obligation. For
most banks, loans are the largest and most obvious source of credit risk. However, there are other sources of
credit risk both on and off the balance sheet. Off-balance sheet items include letters of credit unfunded loan
commitments, and lines of credit. Other products, activities, and services that expose a bank to credit risk
are credit derivatives, foreign exchange, and cash management services.

Classification of Credit Risk:

A. Default risk:
- It is the probability of an event of default
- Depends upon credit standing of the counter party.
- Default probability cannot be measured directly.
- Guidance from historical statistics on large sample over long period of time.
- Bank faces difficulty in obtaining accurate historical data.
B. Exposure risk:
- Uncertainty associated with future amounts ,
- Credit lines- repayment schedule- exposure risk small
- Other lines of credit - OD, project financing, guarantees etc. - risk cannot be predicted
accurately.
C. Recovery risk:
- Recoveries in the event of default not predictable
- Depend upon type of default ,
- Availability of collaterals and third party guarantees
- Circumstances surrounding the default.

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Risk Management – Credit Risk

Based on above Credit risk can be classified as follows:-

1. Credit default risk — The risk of loss arising from a debtor being unlikely to pay its loan
obligations in full or the debtor is more than 90 days past due on any material credit obligation;
default risk may impact all credit-sensitive transactions, including loans, securities and derivatives.
2. Concentration risk — the risk associated with any single exposure or group of exposures with the
potential to produce large enough losses to threaten a bank's core operations. It may arise in the form
of single name concentration or industry concentration.
3. Country risk — The risk of loss arising from a sovereign state freezing foreign currency payments
(transfer/conversion risk) or when it defaults on its obligations (sovereign risk); this type of risk is
prominently associated with the country's macroeconomic performance and its political stability.
4. Default Risk - Default risk is the risk that the issuer will go belly up and not be able to pay its
obligations of interest and principle. To help measure this risk, an investor can look at default rates.
A default rate is the percentage of a population of bonds that are expected to default. Another ratio
that an investor can look at is the recovery rate. This rate indicates how much and investor can
expect to get back if a default occurs.
5. Credit Spread Risk - This second type of credit risk deals with how the spread of an issue over the
treasury curve will react. For example, Ford five-year bonds may trade at 50 basis points above the
current five-year treasury. If the five-year bond is trading at 3.5%, then the Ford bonds are trading at
a yield of 4%. If this spread of 50 bps widens out compared to other bond issues, it would mean that
the Ford bonds are not performing as well as the other bonds in the marketplace. Spreads tend to
widen in poor performing economies.
6. Downgrade Risk - The credit risk deals with the rating agencies. These agencies, such as Moody's,
S&P and Fitch, give an issuer a rating or grade that indicates the possibility of default. On the more
secure side, the ratings range from AAA, which is the best rating to AA, A, BBB. These are the
ratings for investment-grade bonds. Once bonds dip into the BB, B, CCC ranges they become junk
bonds or, in politically correct language, high yield securities. If one of these rating agencies
downgrades a company's rating, it may be harder for the corporation to pay. This will typically cause
its market value to decrease.

When we speak of the credit quality of an obligation, this refers generally to the counterparty‟s ability to
perform on that obligation. This encompasses both the obligation‟s default probability and anticipated
recovery rate.

To place credit exposure and credit quality in perspective, recall that every risk comprise two elements:
exposure and uncertainty. For credit risk, credit exposure represents the former, and credit quality represents
the latter. For loans to individuals or small businesses, credit quality is typically assessed through a process
of credit scoring. Prior to extending credit, a bank or other lender will obtain information about the party
requesting a loan. In the case of a bank issuing credit cards, this might include the party‟s annual income,
existing debts, whether they rent or own a home, etc. A standard formula is applied to the information to
produce a number, which is called a credit score. Based upon the credit score, the lending institution will
decide whether or not to extend credit. The process is formulaic and standardized.

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Risk Management – Credit Risk

Factors affecting Credit Risk:

A. Internal factors – Bank specific:-
- Adopting proactive loan policy.
- Good quality credit analysis.
- Loan monitoring.
- Sound credit culture.
B. External factors – State of economy, size of fiscal deficit etc:-
- Diversified loan portfolio.
- Scientific credit appraisal for assessing financial and commercial viability of loan proposal.
- Norms for single and group borrowers.
- Norms for sectoral deployment of funds.
- Strong monitoring and internal control systems.
- Delegation and accountability.

Credit Risk Management as per RBI:-

I. Measurement of risk through credit scoring.
II. Quantifying risk through estimating loan losses.
III. Risk pricing – Prime lending rate which also accounts for risk.
IV. Risk control through effective Loan Review Mechanism and Portfolio Management.

Principles of Credit Risk Management:

a) Board of directors of a bank has to take responsibility for approving and periodically reviewing
credit risk strategy.
b) Senior management has to take the responsibility to implement the credit risk strategy.
c) Bank has to identify and manage credit risk of all banking products and activities.

Prudential Norms for Credit Risk:

a. Capital adequacy norms.
b. Exposure norms
- Credit exposure and investment exposure norms to borrowers (individuals and group)
- Capital market exposures
- Individual bank‟s internal exposure limits
c. Bank‟s internal risk assessment committee norms.
d. Credit rating system and risk pricing policy.
e. Asset liability management requirements.
f. Bank‟s loan policy norms.

Expected Losses & Unexpected Losses:

 EL depends upon default probability (PD), Loss given default (LGD) & exposure at risk (EAD).
 EL = PD x LGD x EAD.
 Unexpected losses (UL): It is the uncertainty around EL and it is Standard deviation of EL.

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Risk Management – Credit Risk

Process of Credit Risk Management:

Tools of Credit Risk Management: The instruments and tools, through which credit risk management is
carried out, are detailed below:
 Exposure Ceiling: Prudential Limit is linked to Capital Funds – say 15% for individual borrower
entity, 40% for a group with additional 10% for infrastructure projects undertaken by the group,
Threshold limit is fixed at a level lower than Prudential Exposure; Substantial Exposure, which is the
sum total of the exposures beyond threshold limit should not exceed 600% to 800% of the Capital
Funds of the bank (i.e. six to eight times).
 Review/Renewal: Multi-tier Credit Approving Authority, constitution wise delegation of powers,
Higher delegated powers for better-rated customers; discriminatory time schedule for
review/renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal based
on risk rating, etc are formulated.
 Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point scale. Clearly
define rating thresholds and review the ratings periodically preferably at half yearly intervals. Rating
migration is to be mapped to estimate the expected loss.
 Risk based scientific pricing: Link loan pricing to expected loss. High-risk category borrowers are
to be priced high. Build historical data on default losses. Allocate capital to absorb the unexpected
loss. Adopt the RAROC framework.
 Portfolio Management: The need for credit portfolio management emanates from the necessity to
optimize the benefits associated with diversification and to reduce the potential adverse impact of
concentration of exposures to a particular borrower, sector or industry. Stipulate quantitative ceiling
on aggregate exposure on specific rating categories, distribution of borrowers in various industry,
business group and conduct rapid portfolio reviews. The existing framework of tracking the non-
performing loans around the balance sheet date does not signal the quality of the entire loan book.
There should be a proper & regular on-going system for identification of credit weaknesses well in
advance to preserve the desired portfolio quality and integrate portfolio reviews with credit decision-
making process.

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Risk Management – Credit Risk

 Loan Review Mechanism: This should be done independent of credit operations. It is also referred
as Credit Audit covering review of sanction process, compliance status, review of risk rating, pick up
of warning signals and recommendation of corrective action with the objective of improving credit
quality. It should target all loans above certain cut-off limit ensuring that at least 30% to 40% of the
portfolio is subjected to LRM in a year so as to ensure that all major credit risks embedded in the
balance sheet have been tracked. This is done to bring about qualitative improvement in credit
administration. Identify loans with credit weakness. Determine adequacy of loan loss provisions.
Ensure adherence to lending policies and procedures. The focus of the credit audit needs to be
broadened from account level to overall portfolio level. Regular, proper & prompt reporting to Top
Management should be ensured. Credit Audit is conducted on site, i.e. at the branch that has
appraised the advance and where the main operative limits are made available. However, it is not
required to visit borrowers factory/office premises.

Functionality of Good Credit: “The secret of successful banking is to distribute resources between the
various forms of assets in such a way as to get a sound balance between liquidity and profitability, so that
there is cash (on hand or quickly realizable) to meet every claim, and at the same time enough income for
the bank to pay it way and earn profits for its shareholders.” But modern bankers also consider a few other
essentials which are discussed below.

1. Liquidity: One of the essentials of a sound banking system is to have a higher degree of liquidity.
The bank holds a small proportion of its assets in cash. Therefore, its other assets must possess the
criterion of liquidity so that they may be turned into such easily. A commercial bank is under an
obligation to pay its depositors cash on demand. This is only possible if the bank possesses such
securities which can be easily liquidated. Central banks have made it obligatory on the commercial
banks to keep a certain proportion of their assets in cash to ensure liquidity.
2. Safety: Another essential of a sound banking system is that it must be safe. Since the bank keeps the
deposits of the people, it must ensure the safety of their money. So it should make safe loans and
investments and avoid unnecessary risks. If the debtors of the banks do not repay the loans in time
and it loses on its investments, the bank shall become insolvent. As a result, its depositors lose
money and suffer hardships. Thus the bank must ensure the safety of its deposits.
3. Stability: A sound banking system must be stable. It should operate rationally. There should neither
be undue contraction nor expansion of credit. If the bank restricts the creation of credit when trade
and industry need it the most, it will harm the interests of the business community. On the other
hand, if it expands credit when the economic conditions do not permit, it will lead to boom and
inflation. So the banking system should follow a stable lending policy. The central bank of the
country can help in achieving stability in the banking operations of the commercial banks by a
judicious credit control policy.
4. Elasticity: But the stability of banking operations should not be interpreted as rigidity. Rather, the
banking system should have sufficient elasticity in its lending operations. It should be in a position
to expand and contract the supply of loanable funds with ease in accordance with the directives of
the central bank of the country.

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Risk Management – Credit Risk

5. Profitability: A sound banking system should be able to earn sufficient profits. Profits are essential
for it to be viable. It has to pay the corporation tax like any other company, pay interest to its
depositors, dividend to share-holders, salaries to the staff and meet other expenses. So unless the
bank earns, it cannot operate soundly. For this purpose, it must adopted judicious loan and
investment policies.
6. Reserve Management: Sound banking system must follow the principle of efficient reserve
management. A bank keeps some amount of money in reserve for meeting the demand of its
customers in case of emergency. Though the money kept in reserve is idle money, yet the bank
cannot afford the risk of keeping a small amount in reserve. There are, however, some statutory
limits laid down by the central bank in maintaining minimum reserves with itself and with the bank.
But how much reserve money should a bank maintain is governed by its own wisdom, experience
and the size of the bank. It has to balance between profitability and safety.
7. Expansion: A sound banking system must be spread throughout the country. It should not be
concentrated only in big towns and cities but in rural areas and backward regions. It is only by
widespread expansion of the banking system that the deposits can be mobilized and credit facilities
can be made available to trade, industry, agriculture, etc. This is especially the case in a developing
country where the banking system must provide these facilities through its expansion in all areas.
This is essential for capital formation and economic growth.

Framework for Credit Risk Management:

A. Policy Framework:
1. Strategy and Policy:
o Documented policy specifying target markets.
o Statement of risk acceptance criteria.
o Credit approval authority.
o Credit follow up procedures.
o Guidelines for portfolio management.
o Systems of loan restructuring to manage problem loans.
o Follow up procedures and provisioning of non-performing loans and advances.
o Consistent approach towards early problem recognition.
o Classification of exposures in problem loans.
o Maintain a diversified portfolio of loans in line with the desired capital.
o Procedures and systems for monitoring financial performance of customers.
o Controlling outstanding loan performance so that the non-performance is within limits.
2. Organization Structure:
o Independent group responsible for credit risk management.
o Formulation of credit policies.
o Procedures and controls of all credit risk functions
 Corporate banking, Treasury function, Credit cards
 Personal banking, Portfolio finance., Securities finance
 Payment and settlement systems

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o Credit management team responsibility for overall credit risk

o Board is in charge of the overall risk management policy of the bank
 Credit
 Liquidity
 Interest rate
 Foreign exchange
 Price risk
o Credit Risk Management Committee: Integration of credit risk management committee with
market risk management committee, operations risk management committee and asset liability
management committee
3. Operations / Systems support:
o Relationship management phase: Business development, Product development and System
development phase.
o Transaction management phase: Risk assessment, Pricing, Structuring of the credit
operations, internal approvals, Documentation, Loan administration and Credit monitoring and
measurement.
o Portfolio management phase: Monitoring of portfolio and Management of problem loans.

B. Credit risk rating framework

1. Credit rating models.
2. Credit rating analysts.
3. Loans to individuals or small businesses.
4. Credit quality assessed through credit scoring.
 Annual income, Existing debt, Asset ownership details and Family status.

C. Credit Risk Limits:

1. Credit limits exposure for each client (borrowers and counterparties).
2. Total credit limits exposure for a firm.
3. Total credit limits exposure for an industry.
4. Total credit limits exposure for a region / division.
5. Total credit limits exposure for the bank.
6. Reserve Bank of India Guidelines:
 not more than 15% of capital to individual borrower
 not more than 40% of capital to a group borrower
 Aggregate ceiling in unsecured advances not to exceed 15% of total demand and time
liability (DTL) of the bank.
7. Threshold limits:
 Credit rating of the borrower
 Past financial records
 Willingness and ability to repay
 Borrower‟s future cash flow projections

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Risk Management – Credit Risk

D. Credit Risk Modeling:

1. Altman’s Z score model: Altman Z-Score variables developed to measure the financial strength
of a firm: - Z score = a1 x V1 + a2 x V2 + a3 x V3 + a4 x V4 + a5 x V5 (Explained in detail)
2. Credit Metrics Model: Assessment of portfolio risk due to changes in debt value caused by
changes in credit quality.
Applications:-
a. Reduces portfolio risk
b. Sets exposure limits
c. Identify correlations across portfolio
 Reduce potential risk concentration
 Results in diversified portfolio
 Reduction of total risk

3. Value-at-Risk Model:
 Estimate of potential loss in loan portfolio over a given holding period at a given
level of confidence.
 Probability distribution of a loan portfolio value reducing by an estimated amount
over a given time horizon.
 Time horizon estimate is over a daily, weekly or monthly basis.

4. Merton Model:
o Bank would default only if its asset value falls below certain level (default point), which is a
function of its liability.
o Estimates the asset value of the bank and its asset volatility from the market value and the debt
structure in the option theoretic framework.
o A measurement that represents the number of standard deviation that the bank‟s asset value
would be away from the default point.
o (Merton‟s (1973))

Model:
a. Historical default experience to compute Expected Default Frequency (EDF)
b. Distance from Default (DFD) is the estimation of asset value and asset volatility and
volatility of equity return.
c. DFD = (Expected asset value – Default point) / (Asset value x Asset volatility)
d. Expected default frequency (EDF) is arrived at from historical data in terms of number of
banks that have DFD values similar to the bank‟s DFD in relation to the total number of
banks considered for evaluation.

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Risk Management – Credit Risk

Model Efficiency Difference between the estimated default values and actual default rate

E. Credit Risk Pricing: Risk Adjusted Rate of Capital for Banks (RAROC)
o Mark-to-market concept
o Allocates capital to a transaction at an amount equal to the maximum expected loss (at a 99
percent confidence level)
o Basic risk categories
o Interest rate risk
o Credit risk
o Operational risk
o Foreign exchange risk

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Model:
 Quantify the risk in each category
 Risk factor = 2.33 x weekly volatility x square root of 52 x (1 – tax rate)
o 2.33 gives the volatility at 99% confidence level
o 52 weekly price movement is annualized
o (1 – tax rate) converts this to an after-tax basis
 Capital required for each category
 Multiplying the risk factor by the size of the position

F. Credit Risk Mitigation:

1. Credit risk mitigation reduces exposure of credit risk
 Safety net of tangible assets
 Safety from realizable (marketable) securities
 Reduces exposure of risk from counterparty dealings in guarantees and insurance
2. Risk mitigation measures
 Collateral securities, Guarantees, Credit derivatives, Balance sheet netting

G. Credit Audit:
o Compliance with pre-sanction & post-sanction processes - external & internal audit committee
o Special compliance requirement by the credit risk management committee of the Board of
Directors of the bank
o Bank credit audit:-
 Quality of credit portfolio, Review of loan process, Compliance status of large loans
 Report on regulatory compliance, Independent audit of credit risk measurement
 Identification of loan distress signals, Review of employee credit skills
 Review of loan restructuring decisions in terms of distress loans
 Review of credit quality and Review of credit administration

RBI Guidelines on Credit Exposure and Management:

1. Bank cannot grant loans against security of its own shares.
2. Prohibition on remission (remitting) of debts for Urban Cooperative Banks (UCBs) without prior
approval of RBI.
3. Restrictions on loans and advances to Directors and their relatives.
4. Ceiling on advances to Nominal Members – With deposits up to ` 50 crore (` 50,000/- per borrower)
and ` 1,00,000/- for above ` 50 crore.
5. Prohibition on Urban Cooperative Banks (UCBs) for bridge loans including that against capital /
debenture issues.
6. Loans and advances against shares, debentures.
a. UCBs are prohibited to extend any facilities to stock brokers.
b. Margin of 40 per cent to be maintained on all such advances.
7. Restriction on advances to real estate sector
a. Genuine construction and not for speculative purposes.
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Different approaches to the Credit Evaluation Process:

1. Approach Methodology: Judgmental methods apply the assessor‟s experience and understanding of
the case to the decision to extend or refuse credit.
2. Expert systems (e.g. lending committees) use a panel approach to judge the case or formalize
judgmental decisions via lending system and procedures.
3. Analytic models use a set of analytic methods, usually on quantitative data, to derive a decision.
4. Statistical models (e.g. credit scoring) uses statistical inference to derive appropriate relationships for
decision making.
5. Behavioral models observe behavior over time to derive appropriate relationships for reaching a
decision.
6. Market models rely on the informational content of financial market prices as indicators of financial
solvency.

Risk Rating Model: Credit Audit is conduced on site, i.e. at the branch that has appraised the advance and
where the main operative limits are made available. However, it is not required to risk borrowers‟
factory/office premises. As observed by RBI, Credit Risk is the major component of risk management
system and this should receive special attention of the Top Management of the bank. The process of credit
risk management needs analysis of uncertainty and analysis of the risks inherent in a credit proposal. The
predictable risk should be contained through proper strategy and the unpredictable ones have to be faced and
overcome. Therefore any lending decision should always be preceded by detailed analysis of risks and the
outcome of analysis should be taken as a guide for the credit decision. The need for the adoption of the
credit risk-rating model is on account of the following aspects.
 Disciplined way of looking at Credit Risk.
 Reasonable estimation of the overall health status of an account captured under Portfolio approach as
contrasted to stand-alone or asset based credit management.
 Impact of a new loan asset on the portfolio can be assessed. Taking a fresh exposure to the sector in
which there already exists sizable exposure may simply increase the portfolio risk although specific
unit level risk is negligible/minimal.
 The co-relation or co-variance between different sectors of portfolio measures the inter relationship
between assets. The benefits of diversification will be available so long as there is no perfect positive
corelation between the assets, otherwise impact on one would affect the other.
 Concentration risks are measured in terms of additional portfolio risk arising on account of increased
exposure to a borrower/group or co-related borrowers.
 Need for Relationship Manager to capture, monitor and control the over all exposure to high value
customers on real time basis to focus attention on vital few so that trivial many do not take much of
valuable time and efforts.
 Instead of passive approach of originating the loan and holding it till maturity, active approach of
credit portfolio management is adopted through secuitisation/credit derivatives.
 Pricing of credit risk on a scientific basis linking the loan price to the risk involved therein.
 Rating can be used for the anticipatory provisioning. Certain level of reasonable over-provisioning
as best practice.

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The risk-rating model should capture various types of risks such as Industry/Business Risk, Financial Risk
and Management Risk, associated with credit. Industry/Business risk consists of both systematic and
unsystematic risks which are market driven. The systematic risk emanates from General political
environment, changes in economic policies, fiscal policies of the government, infrastructural changes etc.
The unsystematic risk arises out of internal factors such as machinery breakdown, labour strike, new
competitors who are quite specific to the activities in which the borrower is engaged. Assessment of
financial risks involves appraisal of the financial strength of a unit based on its performance and finacial
indicators like liquidity, profitability, gearing, leverage, coverage, turnover etc. It is necessary to study the
movement of these indicators over a period of time as also its comparison with industry averages wherever
possible. The key ingredient of credit risk is the risk of default that is measured by the probability that
default occurs during a given period. Probabilities are estimates of future happenings that are uncertain. We
can narrow the margin of uncertainty of a forecast if we have a fair understanding of the nature and level of
uncertainty regarding the variable in question and availability of quality information at the time of
assessment. The expected loss/unexpected loss methodology forces banks to adopt new Internal Ratings
Based approach to credit risk management as proposed in the Capital Accord II. Some of the risk rating
methodologies used widely are briefed below:

 Altman‟s Z score Model involves forecasting the probability of a company entering bankruptcy. It
separates defaulting borrower from non-defaulting borrower on the basis of certain financial ratios
converted into simple index.

 Credit Metrics focuses on estimating the volatility of asset values caused by variation in the quality
of assets. The model tracks rating migration which is the probability that a borrower migrates from
one risk rating to another risk rating.

 Credit Risk +, a statistical method based on the insurance industry, is for measuring credit risk. The
model is based on acturial rates and unexpected losses from defaults. It is based on insurance
industry model of event risk.

 KMV, through its Expected Default Frequency (EDF) methodology derives the actual probability of
default for each obligor based on functions of capital structure, the volatility of asset returns and the
current asset value. It calculates the asset value of a firm from the market value of its equity using an
option pricing based approach that recognizes equity as a call option on the underlying asset of the
firm. It tries to estimate the asset value path of the firm over a time horizon. The default risk is the
probability of the estimated asset value falling below a pre-specified default point.

 Mckinsey‟s credit portfolio view is a multi factor model which is used to stimulate the distribution of
default probabilities, as well as migration probabilities conditioned on the value of macro economic
factors like the unemployment rate, GDP growth, forex rates, etc. In to-days parlance, default arises
when a scheduled payment obligation is not met within 180 days from the due date and this cut-off
period may undergo downward change. Exposure risk is the loss of amount outstanding at the time
of default as reduced by the recoverable amount. The loss in case of default is D* X * (I-R) where D
is Default percentage, X is the Exposure Value and R is the recovery rate.

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Risk Management – Credit Risk

Credit Risk Management Models:

1. Altman Z-Score Management Model: The Z-score formula for predicting bankruptcy was
published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at
New York University. The formula may be used to predict the probability that a firm will go into
bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate
control measure for the financial distress status of companies in academic studies. The Z-score uses
multiple corporate income and balance sheet values to measure the financial health of a company.

The Z-score is a linear combination of four or five common business ratios, weighted by
coefficients. The coefficients were estimated by identifying a set of firms which had declared
bankruptcy and then collecting a matched sample of firms which had survived, with matching by
industry and approximate size (assets). Altman applied the statistical method of discriminant
analysis to a dataset of publicly held manufacturers. The estimation was originally based on data
from publicly held manufacturers, but has since been re-estimated based on other datasets for private
manufacturing, non-manufacturing and service companies.

The original Z-score formula was as follows:

Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.99T5.

- T1 = Working Capital / Total Assets. (Measures liquid assets in relation to the size of the
company.)
- T2 = Retained Earnings / Total Assets. (Measures profitability that reflects the company's age and
earning power.)
- T3 = Earnings before Interest and Taxes / Total Assets. (Measures operating efficiency apart from
tax and leveraging factors. It recognizes operating earnings as being important to long-term
viability.)
- T4 = Market Value of Equity / Book Value of Total Liabilities. (Ads market dimension that can
show up security price fluctuation as a possible red flag.)
- T5 = Sales/ Total Assets. (Standard measure for total asset turnover (varies greatly from industry
to industry).)

Altman found that the ratio profile for the bankrupt group fell at -0.25 avg, and for the non-bankrupt
group at +4.48 avg.

A. Public Limited Company:-

(Ratios are stated above to calculate T1 to T5)
Z score bankruptcy model:
Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5
Zones of Discrimination:
Z > 2.99 -“Safe” Zones, 1.81 < Z < 2.99 -“Grey” Zones, Z < 1.81 -“Distress” Zones

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B. Private Firms:
T1 = (Current Assets − Current Liabilities) / Total Assets
T2 = Retained Earnings / Total Assets
T3 = Earnings before Interest and Taxes / Total Assets
T4 = Book Value of Equity / Total Liabilities
T5 = Sales/ Total Assets
Z' Score Bankruptcy Model:
Z' = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5
Zones of Discrimination:
Z' > 2.9 -“Safe” Zone, 1.23 < Z' < 2.9 -“Grey” Zone, Z' < 1.23 -“Distress” Zone

C. Non-Manufacturers & Emerging Markets:

T1 = (Current Assets − Current Liabilities) / Total Assets
T2 = Retained Earnings / Total Assets
T3 = Earnings before Interest and Taxes / Total Assets
T4 = Book Value of Equity / Total Liabilities
Z-Score bankruptcy model:
Z = 6.56T1 + 3.26T2 + 6.72T3 + 1.05T4
Zones of discriminations:
Z > 2.6 -“Safe” Zone, 1.1 < Z < 2.6 -“Grey” Zone, Z < 1.1 -“Distress” Zone

2. KMV Approach: The KMV approach follows the same logic as the structural approach to a point,
i.e., the firm defaults when the value of assets falls below a certain level. But as an end product, it
comes up with the expected default frequency (EDF) (i.e. the probability of default). Much of the
workings of the KMV approach are proprietary and available only to KMV customers, and we need
to focus on a conceptual understanding of the approach. Similar to what was explained for the
structural approach, default happens when the value of assets falls below a certain value, called the
„default point‟. (The „default point‟ under KMV is not the same as the point where the value of the
assets falls below the value of the total debt.) Over time, the assets of the firm will earn a certain
return and trend with a given mean and volatility. Under KMV, the value of the firm‟s assets is
assumed to be log-normally distributed, i.e. the returns on the assets are normally distributed.

There are essentially three steps to the credit risk assessment process under the KMV approach:

Step 1: Determine the value of assets (V) and their volatility (σ)
The value of equity (as represented by the stock price, S) is driven by:

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 Value of the firm‟s assets (V)

 The volatility of the assets (σ)
 The leverage ratio (L)
 The coupon on long term debt (c) and
 The risk-free rate (r)

Of the above, the last three are known variables, and so is the stock price. The only unknown
variables are V and σ. The volatility of the assets is not the same as the volatility of the stock price,
as the latter is driven by the value of the assets. KMV uses an iterative approach to find out V and σ,
given knowledge of the S, L, c and r.

Step 2: Calculate the ‘distance to default’ (DD)

A key concept underlying the KMV approach is the recognition that a firm does not have to default
the moment its asset value falls below the face value of debt – in fact default happens when value of
the firm‟s assets falls somewhere between the value of the short term debt and the value of the total
debt. In other words, it is possible to not have default even if the value of the assets has fallen to less
than the total debt. This is natural because it is generally the current cash needs (driven by short
term debt) that cause default – the firm may have enough cash to keep paying all liabilities as they
come due even though the total liabilities may be greater than the total assets. KMV sets the default
point as somewhere between short term debt (STD) and the total debt as the total of the short term
debt and half the value of the long term debt.

Next, the KMV approach determines what the „distance-to-default‟ is. The distance to default is the
number of standard deviations assets have to lose before getting to the default point (DPT). It is
calculated as follows:

Where, σ is the standard deviation of future asset returns. Each of the terms in the equation above is
explained below:

This can be expressed another way – as a multiple of the standard deviation of the expected returns.

Where, μ and σ are the mean and volatility of the asset returns.

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Step 3: Determination of the EDFs

The last step is the determination of the expected default frequencies – which is a mapping of the
distance-to-default to probabilities of default based upon a proprietary database (provided to
customers using the „Credit Monitor‟ service). Based upon what was explained in 2 above, EDFs are
affected by:

 Stock price
 Leverage ratio and
 Asset volatility.

Harry Markowitz Modern Portfolio Theory – Review:-

MPT was developed in the 1950s through the early 1970s and was considered an important advance in the
mathematical modeling of finance. Since then, some theoretical and practical criticisms have been leveled
against it. These include evidence that financial returns do not follow a Gaussian distribution or indeed any
symmetric distribution, and that correlations between asset classes are not fixed but can vary depending on
external events (especially in crises).

Further, there remains evidence that investors are not rational and markets may not be efficient. Finally, the
low volatility anomaly conflicts with CAPM's trade-off assumption of higher risk for higher return; it states
that a portfolio consisting of low volatility equities (like blue chip stocks) reaps higher risk-adjusted returns
than a portfolio with high volatility equities (like illiquid penny stocks). A study conducted by Myron
Scholes, Michael Jensen, and Fischer Black in 1972 suggests that the relationship between return and beta
might be flat or even negatively correlated.

The Harry Markowitz Model: MPT - Modern Portfolio Theory - represents the mathematical formulation of
risk diversification in investing, that aims at selecting a group of investment assets which have collectively
lower risk than any single asset on its own. This becomes possible, since various asset types frequently
change in value in opposite directions. Actually investing, being a tradeoff between risk and return,
presupposes that risky assets have the highest expected returns.

Thus, MPT shows how to choose a portfolio with the maximum possible expected return for the given
amount of risk. It also describes how to choose a portfolio with the minimum possible risk for the given
expected return. Therefore, Modern Portfolio Theory is viewed as a form of diversification which explains
the way of finding the best possible diversification strategy.

Harry Markowitz model (HM model), also known as Mean-Variance Model because it is based on the
expected returns (mean) and the standard deviation (variance) of different portfolios, helps to make the most
efficient selection by analyzing various portfolios of the given assets. It shows investors how to reduce their
risk in case they have chosen assets not “moving” together.

MPT Assumptions Modern Portfolio Theory relies on the following assumptions and fundamentals
that are the key concepts upon which it has been constructed:

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 For buying and selling securities there are no transaction costs.

 No tax paid.
 An investor has a chance to take any position of any size and in any security. The market liquidity is
infinite and no one can move the market.
 While making investment decisions the investor does not consider taxes and is indifferent towards
receiving dividends or capital gains.
 Investors are generally rational and risk adverse.
 The risk-return relationships are viewed over the same time horizon. Both long term speculator and
short term speculator share the same motivations, profit target and time horizon.
 Investors share identical views on risk measurement.
 Investors seek to control risk only by the diversification of their holdings.
 In the market all assets can be bought and sold including human capital.
 Politics and investor psychology have no influence on market.
 The risk of portfolio depends directly on the instability of returns from the given portfolio.
 An investor gives preference to the increase of utilization.
 An investor either maximizes his return for the minimum risk or maximizes his portfolio return for a
given level of risk.
 Analysis is based on a single period model of investment.

Choosing the Best Portfolio: Two essential decisions are necessary to be made to choose the best portfolio
from a number of possible portfolios, each with its risk and return opportunities:

1. Determine a set of efficient portfolios.

2. Select the best portfolio out of the efficient set.

Determining the Efficient Set: A portfolio that gives maximum return for a given risk, or minimum risk for
given return is an efficient portfolio. Thus, portfolios are selected as follows:

(a) From the portfolios that have the same return, the investor will prefer the portfolio with lower risk, and
(b) From the portfolios that have the same risk level, an investor will prefer the portfolio with higher rate of
return.

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As the investor is rational, they would like to have higher return. And as he is risk averse, he wants to have
lower risk. In Figure 1, the shaded area PVWP includes all the possible securities an investor can invest in.
The efficient portfolios are the ones that lie on the boundary of PQVW. For example, at risk level x2, there
are three portfolios S, T, U. But portfolio S is called the efficient portfolio as it has the highest return, y2,
compared to T and U. All the portfolios that lie on the boundary of PQVW are efficient portfolios for a
given risk level. The boundary PQVW is called the Efficient Frontier. All portfolios that lie below the
Efficient Frontier are not good enough because the return would be lower for the given risk. Portfolios that
lie to the right of the Efficient Frontier would not be good enough, as there is higher risk for a given rate of
return. All portfolios lying on the boundary of PQVW are called Efficient Portfolios. The Efficient Frontier
is the same for all investors, as all investors want maximum return with the lowest possible risk and they are
risk averse.

The above figure shows the risk-return indifference curve for the investors. Indifference curves C1, C2 and
C3 are shown. Each of the different points on a particular indifference curve shows a different combination
of risk and return, which provide the same satisfaction to the investors. Each curve to the left represents
higher utility or satisfaction. The goal of the investor would be to maximize his satisfaction by moving to a
curve that is higher. An investor might have satisfaction represented by C2, but if his satisfaction/utility
increases, he/she then moves to curve C3 Thus, at any point of time, an investor will be indifferent between
combinations S1 and S2, or S5 and S6.

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The investor's optimal portfolio is found at the point of tangency of the efficient frontier with the
indifference curve. This point marks the highest level of satisfaction the investor can obtain. This is shown
in Figure 3. R is the point where the efficient frontier is tangent to indifference curve C3, and is also an
efficient portfolio. With this portfolio, the investor will get highest satisfaction as well as best risk-return
combination (a portfolio that provides the highest possible return for a given amount of risk). Any other
portfolio, say X, isn't the optimal portfolio even though it lies on the same indifference curve as it is outside
the feasible portfolio available in the market. Portfolio Y is also not optimal as it does not lie on the best
feasible indifference curve, even though it is a feasible market portfolio. Another investor having other sets
of indifference curves might have some different portfolio as his best/optimal portfolio.

All portfolios so far have been evaluated in terms of risky securities only, and it is possible to include risk-
free securities in a portfolio as well. A portfolio with risk-free securities will enable an investor to achieve a
higher level of satisfaction. This has been explained in Figure 4.

R1 is the risk-free return, or the return from government securities, as government securities have no risk.
R1PX is drawn so that it is tangent to the efficient frontier. Any point on the line R1PX shows a
combination of different proportions of risk-free securities and efficient portfolios. The satisfaction an
investor obtains from portfolios on the line R1PX is more than the satisfaction obtained from the portfolio P.
All portfolio combinations to the left of P show combinations of risky and risk-free assets, and all those to
the right of P represent purchases of risky assets made with funds borrowed at the risk-free rate. In the case
that an investor has invested all his funds, additional funds can be borrowed at risk-free rate and a portfolio
combination that lies on R1PX can be obtained. R1PX is known as the Capital Market Line (CML). this line
represents the risk-return trade off in the capital market. The CML is an upward sloping curve, which means
that the investor will take higher risk if the return of the portfolio is also higher. The portfolio P is the most
efficient portfolio, as it lies on both the CML and Efficient Frontier, and every investor would prefer to
attain this portfolio, P. The P portfolio is known as the Market Portfolio and is also the most diversified
portfolio. It consists of all shares and other securities in the capital market. In the market for portfolios that
consists of risky and risk-free securities, the CML represents the equilibrium condition. The Capital Market
Line says that the return from a portfolio is the risk-free rate plus risk premium. Risk premium is the product
of the market price of risk and the quantity of risk, and the risk is the standard deviation of the portfolio.

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The CML equation is : RP = IRF + (RM - IRF)σP/σM

Where,
RP = Expected Return of Portfolio
RM = Return on the Market Portfolio
IRF = Risk-Free rate of interest
σM = Standard Deviation of the market portfolio
σP = Standard Deviation of portfolio
(RM - IRF)/σM is the slope of CML. (RM - IRF) is a measure of the risk premium, or the reward for holding
risky portfolio instead of risk-free portfolio. σM is the risk of the market portfolio. Therefore, the slope
measures the reward per unit of market risk.

The characteristic features of CML are:

1. At the tangent point, i.e. Portfolio P, is the optimum combination of risky investments and the
market portfolio.
2. Only efficient portfolios that consist of risk free investments and the market portfolio P lie on the
CML.
3. CML is always upward sloping as the price of risk has to be positive. A rational investor will not
invest unless he knows he will be compensated for that risk.

Figure 5 shows that an investor will choose a portfolio on the efficient frontier, in the absence of risk-free
investments. But when risk-free investments are introduced, the investor can choose the portfolio on the
CML (which represents the combination of risky and risk-free investments). This can be done with
borrowing or lending at the risk-free rate of interest (IRF) and the purchase of efficient portfolio P. The
portfolio an investor will choose depends on his preference of risk. The portion from IRF to P, is investment
in risk-free assets and is called Lending Portfolio. In this portion, the investor will lend a portion at risk-free
rate. The portion beyond P is called Borrowing Portfolio, where the investor borrows some funds at risk-frer
rate to buy more of portfolio P.

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Under the model:

 Portfolio return is the proportion-weighted combination of the constituent assets' returns.
 Portfolio volatility is a function of the correlations ρij of the component assets, for all asset pairs (i, j).

In general:
 Expected return:

Where is the return on the portfolio, is the return on asset i and is the weighting of
component asset (that is, the proportion of asset "i" in the portfolio).
 Portfolio return variance:

Where is the correlation coefficient between the returns on assets i and j. alternatively the
expression can be written as:

,
Where for i=j.
 Portfolio return volatility (standard deviation):

For a two asset portfolio:

 Portfolio
return:
 Portfolio variance:
For a three asset portfolio:

 Portfolio return:
 Portfolio
variance:

An investor can reduce portfolio risk simply by holding combinations of instruments that are not perfectly
positively correlated (correlation coefficient -1 \le \rho_{ij} < 1). In other words, investors can reduce their
exposure to individual asset risk by holding a diversified portfolio of assets. Diversification may allow for
the same portfolio expected return with reduced risk. These ideas have been started with Markowitz and
then reinforced by other economists and mathematicians such as Andrew Brennan who have expressed ideas
in the limitation of variance through portfolio theory.

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Risk Management – Credit Risk

Credit Risk Management in Banks - Introduction: Banks in the process of financial intermediation are
confronted with various kinds of financial and non-financial risks viz., credit, interest rate, foreign exchange
rate, liquidity, equity price, commodity price, legal, regulatory, reputational, operational, etc. These risks are
highly interdependent and events that affect one area of risk can have ramifications for a range of other risk
categories. Thus, top management of banks should attach considerable importance to improve the ability to
identify measure, monitor and control the overall level of risks undertaken.

The broad parameters of risk management function should encompass:

- Organizational structure; and comprehensive risk measurement approach;
- Risk management policies approved by the Board which should be consistent with the broader
business strategies, capital strength, management expertise and overall willingness to assume risk;
- The guidelines and other parameters used to govern risk taking including detailed structure of
prudential limits.
- Strong MIS for reporting, monitoring and controlling risks;
- Well laid out procedures, effective control and comprehensive risk reporting framework;
- Separate risk management framework independent of operational Departments and with clear
delineation of levels of responsibility for management of risk; and
- Periodical review and evaluation.

Credit Risk – Introduction: Lending involves a number of risks. In addition to the risks related to
creditworthiness of the counterparty, the banks are also exposed to interest rate, forex and country risks.
Credit risk or default risk involves inability or unwillingness of a customer or counterparty to meet
commitments in relation to lending, trading, hedging, settlement and other financial transactions. The Credit
Risk is generally made up of transaction risk or default risk and portfolio risk.

The portfolio risk in turn comprises intrinsic and concentration risk. The credit risk of a bank‟s portfolio
depends on both external and internal factors.

The external factors are the state of the economy, wide swings in commodity/equity prices, foreign
exchange rates and interest rates, trade restrictions, economic sanctions, Government policies, etc. The
internal factors are deficiencies in loan policies/administration, absence of prudential credit concentration
limits, inadequately defined lending limits for Loan Officers/Credit Committees, deficiencies in appraisal of
borrowers‟ financial position, excessive dependence on collaterals and inadequate risk pricing, absence of
loan review mechanism and post sanction surveillance, etc. Another variant of credit risk is counterparty
risk. The counterparty risk arises from nonperformance of the trading partners.

The non-performance may arise from counterparty‟s refusal/inability to perform due to adverse price
movements or from external constraints that were not anticipated by the principal. The counterparty risk is
generally viewed as a transient financial risk associated with trading rather than standard credit risk.

The management of credit risk should receive the top management‟s attention and the process should
encompass:

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- Measurement of risk through credit rating/scoring;

- Quantifying the risk through estimating expected loan losses i.e. the amount of loan losses that bank
would experience over a chosen time horizon (through tracking portfolio behavior over 5 or more
years) and unexpected loan losses i.e. the amount by which actual losses exceed the expected loss
(through standard deviation of losses or the difference between expected loan losses and some
selected target credit loss quantile);
- Risk pricing on a scientific basis; and
- Controlling the risk through effective Loan Review Mechanism and portfolio management.

Instruments of Credit Risk Management in Banks:

1. Credit Approving Authority: Each bank should have a carefully formulated scheme of delegation
of powers. The banks should also evolve multi-tier credit approving system where the loan proposals
are approved by an „Approval Grid‟ or a „Committee‟. The credit facilities above a specified limit
may be approved by the „Grid‟ or „Committee‟, comprising at least 3 or 4 officers and invariably one
officer should represent the CRMD, who has no volume and profit targets. Banks can also consider
credit approving committees at various operating levels i.e. large branches (where considered
necessary), Regional Offices, Zonal Offices, Head Offices, etc. Banks could consider delegating
powers for sanction of higher limits to the „Approval Grid‟ or the „Committee‟ for better rated /
quality customers. The quality of credit decisions should be evaluated within a reasonable time, say
3 – 6 months, through a well-defined Loan Review Mechanism.

2. Prudential Limits: In order to limit the magnitude of credit risk, prudential limits should be laid
down on various aspects of credit:
a) Stipulate benchmark current/debt equity and profitability ratios, debt service coverage ratio
or other ratios, with flexibility for deviations. The conditions subject to which deviations are
permitted and the authority therefor should also be clearly spelt out in the Loan Policy;
b) Substantial exposure limit i.e. sum total of exposures assumed in respect of those single
borrowers enjoying credit facilities in excess of a threshold limit, say 10% or 15% of capital
funds. The substantial exposure limit may be fixed at 600% or 800% of capital funds,
depending upon the degree of concentration risk the bank is exposed;
c) Maximum exposure limits to industry, sector, etc. should be set up. There must also be
systems in place to evaluate the exposures at reasonable intervals and the limits should be
adjusted especially when a particular sector or industry faces slowdown or other
sector/industry specific problems. The exposure limits to sensitive sectors, such as, advances
against equity shares, real estate, etc., which are subject to a high degree of asset price
volatility and to specific industries, which are subject to frequent business cycles, may
necessarily be restricted.
d) Banks may consider maturity profile of the loan book, keeping in view the market risks
inherent in the balance sheet, risk evaluation capability, liquidity, etc.
e) Single/group borrower limits, which may be lower than the limits prescribed by Reserve
Bank to provide a filtering mechanism;

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3. Risk Rating: Banks should have a comprehensive risk scoring / rating system that serves as a single
point indicator of diverse risk factors of counterparty and for taking credit decisions in a consistent
manner. To facilitate this, a substantial degree of standardization is required in ratings across
borrowers. The risk rating system should be designed to reveal the overall risk of lending, critical
input for setting pricing and non-price terms of loans as also present meaningful information for
review and management of loan portfolio. The risk rating system should be drawn up in a structured
manner, incorporating, inter alia, financial analysis, projections and sensitivity, industrial and
management risks. The banks may use any number of financial ratios and operational parameters
and collaterals as also qualitative aspects of management and industry characteristics that have
bearings on the creditworthiness of borrowers. Banks can also weigh the ratios on the basis of the
years to which they represent for giving importance to near term developments. Within the rating
framework, banks can also prescribe certain level of standards or critical parameters, beyond which
no proposals should be entertained. Banks may also consider separate rating framework for large
corporate / small borrowers, traders, etc. that exhibit varying nature and degree of risk.

4. Risk Pricing: Risk-return pricing is a fundamental tenet of risk management. In a risk-return setting,
borrowers with weak financial position and hence placed in high credit risk category should be
priced high. Thus, banks should evolve scientific systems to price the credit risk, which should have
a bearing on the expected probability of default. The pricing of loans normally should be linked to
risk rating or credit quality. Under RAROC framework, lender begins by charging an interest mark-
up to cover the expected loss – expected default rate of the rating category of the borrower. The
lender then allocates enough capital to the prospective loan to cover some amount of unexpected
loss- variability of default rates. Generally, international banks allocate enough capital so that the
expected loan loss reserve or provision plus allocated capital cover 99% of the loan loss outcomes.

5. Portfolio Management: The existing framework of tracking the Non-Performing Loans around the
balance sheet date does not signal the quality of the entire Loan Book. Banks should evolve proper
systems for identification of credit weaknesses well in advance. Most of international banks have
adopted various portfolio management techniques for gauging asset quality. The CRMD, set up at
Head Office should be assigned the responsibility of periodic monitoring of the portfolio. The
portfolio quality could be evaluated by tracking the migration (upward or downward) of borrowers
from one rating scale to another. This process would be meaningful only if the borrower-wise ratings
are updated at quarterly / half-yearly intervals. Data on movements within grading categories
provide a useful insight into the nature and composition of loan book.

6. Loan Review Mechanism (LRM): LRM is an effective tool for constantly evaluating the quality of loan
book and to bring about qualitative improvements in credit administration. Banks should, therefore, put
in place proper Loan Review Mechanism for large value accounts with responsibilities assigned in
various areas such as, evaluating the effectiveness of loan administration, maintaining the integrity of
credit grading process, assessing the loan loss provision, portfolio quality, etc.

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The main objectives of LRM could be:

a) To identify promptly loans which develop credit weaknesses and initiate timely corrective
action;
b) To evaluate portfolio quality and isolate potential problem areas;
c) To provide information for determining adequacy of loan loss provision;
d) To assess the adequacy of and adherence to, loan policies and procedures, and to monitor
compliance with relevant laws and regulations; and
e) To provide top management with information on credit administration, including credit sanction
process, risk evaluation and post-sanction follow-up.

Credit Risk Derivatives: Credit Default Swaps, Credit Default Index Swaps (CDS index), Collateralized
Debt Obligations, Total Return Swaps, Credit Linked Notes, Asset Swaps, Credit Default Swap Options,
Credit Default Index Swaps Options and Credit Spread Forwards/Options.

1. Credit Default Swaps: In a credit default swap the seller agrees, for an upfront or continuing
premium or fee, to compensate the buyer when a specified event, such as default, restructuring of the
issuer of the reference entity, or failure to pay, occurs. Buyers of credit default swaps can remove
risky entities from their balance sheets without selling them. Sellers can gain higher returns from
investments or diversify their portfolios by entering markets that are otherwise difficult to get into.
The value of a default swap depends not only on the credit quality of the underlying reference entity
but also on the credit quality of the writer, also referred to as the counterparty. If the counterparty
defaults, the buyer of a default swap will not receive any payment if a credit event occurs.

2. Credit-Linked Notes: A credit-linked note, also known as a credit default note, is a fixed or floating
rate note where the principal and/or coupon payments are referenced to a credit or a basket of
credits. If there is no credit event of the reference credit(s), all the coupons and principals will be
paid in full. However, if there is a credit event, the payments of the principal and, possibly, also the
coupon of the note will be reduced.

3. Total Return Swaps: A total return swap is a means to transfer the total economic exposure,
including both market and credit risk, of the underlying asset. The payer of a total return swap can
confidentially remove all the economic exposure of the asset without having to sell it. The receiver
of a total return swap, on the other hand, can access the economic exposure of the asset without
having to buy the asset. Typical reference assets of total return swaps are corporate bonds, loans and
equities.

4. Credit Default Swap Options: A credit default swap option is also known as a credit default
swaption. It is an option on a credit default swap (CDS). A CDS option gives its holder the right, but
not the obligation, to buy (call) or sell (put) protection on a specified reference entity for a specified
future time period for a certain spread. The option is knocked out if the reference entity defaults
during the life of the option. This knock-out feature marks the fundamental difference between a
CDS option and a vanilla option. Most commonly traded CDS options are European style options.
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Risk Management – Credit Risk

5. Credit Spread Options and Forwards: Credit spread options are options where the payoffs are
dependent on changes to credit spreads. The transaction may be either based on changes in a credit
spread relative to a risk-free benchmark (e.g. LIBOR or US Treasury) or changes in the relative
spread between two credit instruments. A credit spread option may be a vanilla option or an exotic
option, such as an Asian option, a loopback option, etc. The option style may be European or
American.

6. Credit Default Index Swap Options: A credit default index swap option (CD index swap option, or
CD index swaption, or CDS index option) is an option to buy or sell the underlying CDIS at a
specified date. A payer swaption gives the holder of the option the right to buy protection (pay
premium) and a receiver swaption gives the holder of the option the right to sell protection (receive
premium). Unlike a CD index swap, which is a natural extension of a CDS on a single-entity to a
CDS on a portfolio of entities, a CD index swaption is significantly different from a CDS option, an
option on a single-entity CDS. In the case of an option on a single-entity, if the reference entity
defaults before the option's expiry, the option will be knocked out and become worthless. For an
option on a CDIS, when a reference entity defaults before the option's expiry, the loss will be paid
by the protection seller to the protection buyer when the option is exercised.

7. Asset Swaps: An asset swap is a combination of a defaultable bond with a fixed-for-floating interest
rate swap that swaps the coupon of the bond into the cash flows of LIBOR plus a spread. In the case
of a cross currency asset swap, the principal cash flow may also be swapped. In a typical asset swap,
a dealer buys a bond from a customer at the market price and sells to the customer a floating rate
note at par. The dealer then enters into a fixed-for-floating swap with another counterparty to offset
the floating rate obligation and the bond cash flows.

8. Synthetic Collateralized Debt Obligations (CDOs): Synthetic CDOs are credit derivatives on a
pool of reference entities that are "synthesized" through more basic credit derivatives, mostly, credit
default swaps (CDSs) and credit linked notes (CLNs). A common structure of CDOs involves slicing
the credit risk of the reference pool into a few different risk levels. The level with a higher credit risk
supports the levels with lower credit risks. The risk range of two adjacent risk levels is called a
tranche. The lower bound of the risk level of a tranche is often referred to as an attachment point and
the upper bound a detachment point. The most common CDO credit derivatives are CDSs on CDO
tranches and CDO notes (tranche-linked notes or CLN on tranches). The most popular synthetic
CDOs are the so-called standardized CDOs (sometimes are simply called standardized tranches).

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