Lecture 12

Credit Risk Management

 What is credit risk
• The risk that a borrower will be unable to
make payment of interest or principal in a
timely manner.

• In case of a bank, how much % of the total

assets is invested in credit assets?
Traditional models of credit risk analysis
• There are broadly four classes of models as
comprising the traditional approach:
• (1) expert systems;
• (2) neural networks;
• (3) rating systems, including bank internal rating
systems; and
• (4) credit scoring systems.
 EXPERT SYSTEMS
• In an expert system, the credit decision is left to
the local or branch lending officer or relationship
manager
• Implicitly, this person’s expertise, subjective
judgment, and weighting of certain key factors
are the most important determinants in the
decision to grant credit.
• one of the most common expert systems—the
five “Cs” of credit analyzes five key factors
 EXPERT SYSTEMS
• 1. Character. A measure of the reputation of the firm, its
willingness to repay, and its repayment history. In particular, it
has been established empirically that the age of a firm is a good
proxy for its repayment reputation.

• 2. Capital. The equity contribution of owners and its ratio to

debt (leverage). These are viewed as good predictors of
bankruptcy probability. High leverage suggests a greater
probability of bankruptcy.

• 3. Capacity. The ability to repay, which reflects the volatility of

the borrower’s earnings. If repayments on debt contracts
follow a constant stream over time, but earnings are volatile (or
have a high standard deviation), there may be periods when
the firm’s capacity to repay debt claims is constrained.
 EXPERT SYSTEMS
• 4. Collateral. In the event of default, a banker has
claims on the collateral pledged by the borrower.
The greater the priority of this claim and the greater
the market value of the underlying collateral, the
lower the exposure risk of the loan

• 5. Cycle (or Economic) Conditions. The state of the

business cycle; an important element in determining
credit risk exposure, especially for cycle-dependent
industries.
 General Interest Rates
• In addition to these five “Cs,” an expert might
take into account the level of interest rates.

• The relationship between the level of interest

rates and the expected return on a loan is highly
nonlinear because of (1) adverse selection and
(2) risk shifting.
 Problems in Expert systems
• Although many banks still use expert systems as
part of their credit decision process, these
systems face two main problems:

• 1. Consistency. What are the important common

factors to analyze across different types of
borrowers?

• 2. Subjectivity. What are the optimal weights to

apply to the factors chosen?
 Problems in Expert systems
• quite different standards can be applied by credit
officers, within any given bank or FI, to similar
types of borrowers.

• This disparity in ability across experts has led to

the development of computerized expert
systems, such as artificial neural networks, that
attempt to incorporate the knowledge of the
best human experts.
 ARTIFICIAL NEURAL NETWORKS
• Neural networks are characterized by three
architectural features:
• inputs,
• weights,
• and hidden units
• The n inputs, x1, x2, . . . , xn represent the data
received by the system (for example, company
financial ratios for the bankruptcy prediction
• Each piece of information is assigned a weight (w11,
w21, . . . , wn1) that designates its relative
importance to each hidden unit (yi).
 ARTIFICIAL NEURAL NETWORKS
• These weights are “learned” by the network over
the course of “training.”
• For example, by observing the financial
characteristics of many bankrupt firms (the
training process), each hidden unit computes the
weighted sum of all inputs and transmits the
result to other hidden units.
• In parallel, the other hidden units are weighting
their inputs so as to transmit their signal to all
other connected hidden units.
 ARTIFICIAL NEURAL NETWORKS
• Receipt of the signal from other hidden units
further transforms the output from each node,
and the system continues to iterate until all the
information is incorporated.

• This model incorporates complex correlations

among the hidden units to improve model fit
• Varetto (1994) find that neural networks have
about the same level of accuracy as do credit
scoring models.
• Podding (1994)claims that neural networks
outperform credit scoring models in bankruptcy
prediction.
• Related research can be found in Yang, Platt, and
Platt (1999), Hawley, Johnson, and Raina (1990),
Kim and Scott (1991)
• A major disadvantage of neural networks is their
lack of transparency
 CREDIT SCORING SYSTEMs
• Pre-identify certain key factors that determine
the probability of default (as opposed to
repayment), and combine or weight them into a
quantitative score
• The score can be used as a classification system:
it places a potential borrower into either a good
or a bad group, based on a score and a cut-off
point.
 CREDIT SCORING SYSTEMs
• Full reviews of the traditional approach to credit
scoring, and the various methodologies, can be
found in Caouette, Altman, and Narayanan
(1998) and Saunders (1997).
• A good review of the worldwide application of
credit-scoring models can be found in Altman
and Narayanan (1997).
 Altman- Z score
• One of the oldest credit scoring model is the
Altman-Z model developed by Altman
• Customers who have a Z-score below a critical
value (in Altman’s initial study, 1.81), they would
be classified as “bad” and the loan would be
refused.
• The choice of the optimal cut-off credit score can
incorporate changes in economic conditions.
 Credit Risk – Basel II Aproach
• As we know, Basel II is based on three pillars:

– 1. Minimum capital requirements for:

• Market risk
• Credit risk
• Operational risk

– 2. Market discipline
– 3. Supervisory review
 Credit Risk – Basel II Aproach
• Basel II agreement requires that banks should
hold at least 8% capital for risk weighted assets

• The capital can be either Tier 1 or Tier 2

• Basel II provides the flexibility to either follow a
standardized approach of assigning risk weights
or to use an internal rating-based model
developed by a bank itself
 Standardized approach
• The standardized approach solves a major
problem of the original Accord: the original Basel
barely differentiates risks.

• Under the Basel II standardized approach, an

exposure is multiplied by a risk weighting to
derive a risk-weighted asset (RWA). 
• The risk weight depends on the rating assigned
by a external rating assessment institution and the
type of borrower
 Risk weights in standardized approach
• Claims on sovereigns
• Claims on sovereigns and their central banks will
be risk weighted as follows:
 Risk weights in standardized approach
• Claims on banks
• There are two options for claims on banks.
• Under the first option, all banks incorporated in a
given country will be assigned a risk weight one
category less favourable than that assigned to
claims on the sovereign
• The second option bases the risk weighting on
the external credit assessment of the bank
Risk weights in standardized approach
 Risk weights in standardized approach
• Claims on securities firms
• Claims on securities firms may be treated as
claims on banks provided these firms are subject
to supervisory and regulatory arrangements.
• Otherwise such claims would follow the rules for
claims on corporates.
 Risk weights in standardized approach
• Claims on corporate
• The table provided below illustrates the risk
weighting of rated corporate claims,
• including claims on insurance companies
 Risk weights in standardized approach
• Claims secured by residential property
• Lending fully secured by mortgages on residential
property that is or will be occupied by the borrower, or
that is rented, will be risk weighted at 35%.

• Claims secured by commercial real estate

• In view of the experience in numerous countries that
commercial property lending has been a recurring cause
of troubled assets in the banking industry over the past
few decades, the Basel Committee holds to the view that
mortgages on commercial real estate do not, in principle,
justify other than a 100% weighting of the loans secured
 Risk weights in standardized approach
• Past due loans
• The unsecured portion of any loan (other than a qualifying
residential mortgage loan) that is past due for more than 90
days, net of specific provisions (including partial writeoffs), will
be risk-weighted as follows:

• 150% risk weight when specific provisions are less than 20% of the
outstanding amount of the loan;

• 100% risk weight when specific provisions are no less than 20% of
the outstanding amount of the loan;

• 100% risk weight when specific provisions are no less than 50% of
the outstanding amount of the loan, but with supervisory discretion
to reduce the risk weight to 50%.
• Higher-risk categories
• The following claims will be risk weighted at
150% or higher:
• Claims on sovereigns, PSEs, banks, and securities
firms rated below B-.
• Claims on corporates rated below BB-.
• Past due loans as set out in paragraph 75.
• Securitization tranches that are rated between BB+
and BB- will be risk weighted at 350%
• Other assets
• The standard risk weight for all other assets will
be 100%.

• The standardized approach takes credit risk

mitigation into account by adjusting the
transaction’s EAD (Exposure at default) to reflect
collateral, credit derivatives, guarantees, and
offsetting on-balance-sheet netting
 Off-balance sheet items
• Off-balance sheet items
• Off-balance-sheet items under the standardized
approach will be converted into credit exposure
equivalents through the use of credit conversion factors
(CCF).

• Commitments with an original maturity up to one year

and commitments with an original maturity over one
year will receive a CCF of 20% and 50%, respectively
 Off-balance sheet items
• Any commitments that are unconditionally cancellable
at any time by the bank without prior notice, or that
effectively provide for automatic cancellation due to
deterioration in a borrower’s creditworthiness, will
receive a 0% CCF.

• Direct credit substitutes, e.g. general guarantees of

indebtedness and acceptances will receive a CCF of
100%.
 Off-balance sheet items
• Sale and repurchase agreements and asset sales
with recourse where the credit risk remains with
the bank will receive a CCF of 100%.

• For short-term self-liquidating trade letters of

credit arising from the movement of goods (e.g.
documentary credits collateralised by the
underlying shipment), a 20% CCF will be applied
to both issuing and confirming banks.
 Internal ratings-based approach

• The IRB approach includes three elements (risk

components, risk-weight function, and minimum
requirements). The components are estimates of
risk parameters:
• PD: probability of default
• EAD: exposure at default
• LGD: loss given default
• M: maturity
 IRB: Basel II
• Banks that evolve over time and develop more
advanced system for measuring and managing
risk, they can migrate from standardized
approaches to internally developed advanced
approaches to credit risk management
• Under internal rating based approaches, bank
can use either:
– Foundation approach
– Advanced approach
 IRB: Basel II
• For many of the asset classes, the Committee has made available
two broad approaches: a foundation and an advanced.
• Under the foundation approach, as a general rule, banks provide
their own estimates of PD and rely on supervisory estimates for
other risk components.

• Under the advanced approach, banks provide more of their own

estimates of PD, LGD and EAD, and their own calculation of M,
subject to meeting minimum standards.

• For both the foundation and advanced approaches, banks must

always use the risk-weight functions provided in this Framework
for the purpose of deriving capital requirements.
 The functional form of IRB

1   1  M  2.5  b( PD)
K   LGD * N  N 1 ( PD) *  N 1 (99.9%) *   LGD * PD  *
1  1   1  1.5 * b( PD)

• Where