CREDIT RISK MANAGEMENT

DEFINITION OF CREDIT RISK

Economic loss suffered due to the default of counterparty, or inability or unwillingness to
fulfill contract obligations.

KEY RISK CONCEPTS OF CREDIT RISK

1. Exposure, severity, default
2. Expected loss
3. Unexpected loss
4. Reserves and economic capital
5. Off-balance sheet credit risk
a. Credit risk of options;
Call option -> the buyer is exposed to credit risk
b. Credit risk of swaps
Paucity of defaults in swaps
Estimated by x% of nominal amount at mark to market value
Or estimate a range of yield to find possible values of swap and estimate the
expected exposure

THE CREDIT RISK MANAGEMENT PROCESS

STEP 1 Credit Policy;

POLICY AND INFRASTRUCTURE Credit risk philosophy and principles
credit analysis and approval processes
Credit rating system and linkage to reserve and
economic capital requirements
Credit monitoring and auditing processes
delegation of lending authority and exposure limits
Development of methodologies and models
Policies should be documented, approved and revised at
least annual by the senior management and board

STEP 2 Credit analysis/rating of counterparties (creditworthiness)

CREDIT GRANTING o Analysis of company financials, industrial trend, credit
outlook
o Use external rating agencies credit ratings
o Use vendor supplied to internal credit rating model
o To consider:
Nature of the credit
Risk profile of the counterparty and its sensitivity to
 economic and market developments
Reputation of the issuer or counterparty
Analyze capacity to fulfill obligations under various
scenario
Borrowers repayment history
Credit approval by appropriate authorities with view to
balance credit operations, review and approval
Pricing and terms and conditions of the transactions

STEP 3 To ensure portfolio diversification

MONITORING AND EXPOSURE Early warning signals of potentials adverse credit events
MANAGEMENT Risk reporting
Comparison with policy limits
Determination of required level of credit reserves and
economic capital

Two types of credit exposure: current exposure and potential

exposure; should allow for any risk reducing features.

Important to note that consistency is important in exposure

measurement because we are to aggregate the risk as a whole.

Concentration kills

Establishment of exposure limit to ensure appropriate

diversification of firms credit portfolio. It serves 4 main
interrelated credit processes.
1. Risk control; manage operational risk exposure
2. Allocation should be rationalized
3. Delegation of authority; credit decisions are made by people
with skills and appropriate authority
4. Regulatory compliance

Credit reporting process provides relevant information to help

management/board of directors effectively do their fiduciary
function and oversight. The information should be:
1. Relevant and timely
2. Reliable
3. Comparable
4. Material

STEP4 A portfolio management function should be responsible for

PORTFOLIO MANAGEMENT optimizing the risk/return characteristics of the overall credit
portfolio

Optimized by:
1. The use of origination targets
 Determine which kinds of credit exposure the organization
can take on
2. Pricing
Ensure that it is adequately rewarded for taking on such
exposures
3. Risk transfer strategies
Reduce or eliminate undesirable or inefficient risk

STEP 5 To ensure compliance with the established credit policies

CREDIT R EVIEW and processes
Help to detect potential credit problems
Identifications of exceptions or violations to credit policies
and procedures
Help decision making, such re-pricing or change in terms and
so on
 BEST PRACTICE IN CREDIT RISK MANAGEMENT

BASIC PRACTICE
Credit management function is mainly credit policy, approval, monitoring function.
Performance is measured by charge-offs and delinquent loans

STANDARD PRACTICE
Credit risk management function is more integrated with the loan origination function, tying
the associated risk with pricing, reserve, and capital requirement
In addition to charge-offs and delinquent loans, also influenced by how they contributed to
growth and risk-adjusted profitability of the business units.

BEST PRACTICE
1. Integrated credit exposure measurement
To include complex credit exposures like swaps, forwards, credit lines with Monte Carlo
and add up to the rest of exposure, allowing for a more accurate measurement
2. Scenario analysis and planning
3. Advance credit risk management tools
Counterparty creditworthiness and probability of default over time
Early warning signals
Credit migration models
Risk adjusted pricing
Optimal asset allocation
4. Active portfolio management
Building best practice credit risk management capability is expensive; requires highly
skilled staff, and extensive systems investments

Benefits
1. Credit approval and pricing decisions improve at transaction level
2. Concentration of credit risk at portfolio level are controlled to prevent large UL
3. Smoother earnings due to more accurate projections
4. Facilitate management decisions and actions before credit problems deteriorate further
5. Optimize risk and return of the credit portfolio