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 Credit risk philosophy and principles
INFRASTRUCTURE 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

CREDIT GRANTING (creditworthiness)
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 Early warning signals of potentials adverse credit
EXPOSURE 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

STEP 4 A portfolio management function should be

PORTFOLIO responsible for optimizing the risk/return
MANAGEMENT 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

CREDIT REVIEW policies 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