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Level 27

Credit Risk Management


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Credit risk
possibility that borrower will not meet the scheduled repayments and default on their loan
lender
who holds the primary risk
risk
includes lost principal and interest, disruption to cash flows, and increased collection costs
collection costs
any cost associated with recovering debt on which the borrower has defaulted on his obligation to pay
accounts receivable
assets, what is owed to you
deferred revenue
cash in advance, money deferred to a future period where you actually earn it
Assets
Accounts receivable, what others owe to you
amortization
payment of an obligation in a series of installments or transfers
depreciation
decrease in value of an asset due to obsolescence or use
Income Statement
Record cash dividends from the investee's retained earnings. Do not recognize stock dividends (Memo entry only).
Balance Sheet
statements of assets and liabilities
Liabilities
amounts owed; the legal claims against a business or household by non-owners; the sources of funds for financial intermediaries
Equity
Stake of Ownership
cash flow statement
reconciliation between income statement and balance sheet
accounts payable
an accounting entry that represents an obligation to pay off a short term debt to creditors
fair value
what is the current market value
historical value
what you paid
Risk Management
The process of making and implementing decisions that will minimize the adverse effects of accidental losses on an organization
Risk identification
Risk management involves three major undertaking:
Components of Risk Management
Risk identification: Identify and Inventory assets, Classify and prioritize assets, and Identify and prioritize threats.
Asset Identification and Inventory
Iterative process; begins with identification of assets, including all elements of an organization's system (people, procedures, data and information, software, hardware, networking)‏
People, Procedures, and Data Asset Identification
Human resources, documentation, and data information assets are more difficult to identify
Hardware, Software, and Network Asset Identification
What information attributes to track depends on:
Data Classification and Management
Variety of classification schemes used by corporate and military organizations
Classifying and Prioritizing Information Assets
Many organizations have data classification schemes (e.g., confidential, internal, public data)‏
Information Asset Valuation
Questions help develop criteria for asset valuation
Identifying and Prioritizing Threats
Realistic threats need investigation; unimportant threats are set aside
Vulnerability Identification
Specific avenues threat agents can exploit to attack an information asset are called vulnerabilities
Risk Assessment
Risk assessment evaluates the relative risk for each vulnerability
Likelihood
The probability that a specific vulnerability will be the object of a successful attack
Risk is
Risk Identification Estimate Factors
The resulting ranked list of risk ratings for the three vulnerabilities is as follows:
Asset B has a value of 100 and has two vulnerabilities: vulnerability #2 has a likelihood of 0.5 with a current control that addresses 50% of its risk; vulnerability # 3 has a likelihoo…
Identify Possible Controls
For each threat and associated vulnerabilities that have residual risk, create preliminary list of control ideas
Documenting the Results of Risk Assessment
Final summary comprised in ranked vulnerability risk worksheet
Risk Control Strategies-
Once ranked vulnerability risk worksheet complete, must choose one of five strategies to control each risk:
Defend
Attempts to prevent exploitation of the vulnerability
Transfer
Control approach that attempts to shift risk to other assets, processes, or organizations
Mitigate
Attempts to reduce impact of vulnerability exploitation through planning and preparation
Accept
Doing nothing to protect a vulnerability and accepting the outcome of its exploitation
Terminate
Directs the organization to avoid those business activities that introduce uncontrollable risks
Selecting a Risk Control Strategy
Level of threat and value of asset play major role in selection of strategy
Cost Benefit Analysis (CBA)‏
Feasibility Studies Cost Benefit Analysis (CBA)‏
ROSI: Risk Assessment TIPS
Get a hold on what you have
Evaluation, Assessment, and Maintenance of Risk Controls
Selection and implementation of control strategy is not end of process
Quantitative versus Qualitative Risk Control Practices
Performing the previous steps using actual values or estimates is known as quantitative assessment
Benchmarking and Best Practices
An alternative approach to risk management
Recommended Risk Control Practices
Convince budget authorities to spend up to value of asset to protect from identified threat
Main goal of credit assessment process
To approve acceptable loan applications, reject clients that will probably default in the future, and set up loan pricing so that credit losses are covered by collected credit margins
Expected Loss
Expected Loss = PD*EAD*LGD
How are the AR, CAP, and AUC related?
The AR (aka Gini's Coefficient) is obtained from the CAP and AUC.
Accuracy Ratio (AR)
the probability of good discrimination minus the probability of wrong discrimination; measures the quality of the rating system measured
Area Under Curve (AUC)
the probability of good discrimination plus one half the probability of no discrimination; measures the ratio of good decisions from all attempts
Cumulative Accuracy Profile (CAP)
an arbitrary rating model that produces a rating score (high rating score -> low default probability)
Receiver Operating Characteristic Curve (ROC)
illustrates distributions of rating scores for defaulting and non-defaulting debtors
KS Statistic
the maximum distance of the ROC from the diagonal multiplied by √2
Confusion Matrix
splits the totoal number of applications into actual goods and bads; the actual goods into those that are predicted as good (approved), and those that are predicted as bad (rejected), and the actual bads …
Type 1 and Type 2 Errors in Confusion Matrix
Type 1 Error: When hypothesis is true (and borrower is good), but the system predicts otherwise (that the borrower is bad)
Hosmer-Lemeshow Test
calculates a weighted sum of normalized squared differences between the forecast probabilities and the realized default rates
Binomial Test
only for one grade, one-sided, with forecast probability of default PDs; test overestimates the significance of deviations in the realized default rate from the forecast default rate, so if there is a positive correlation, …
Key Financial Ratios
Operating Performance (ROE, ROA, Operating Margin, Net Profit Margin, Effective tax rate, S…
Through the Cycle Rating (TTC) vs. Point in Time (PIT) Rating
PIT - the rating expresses the actual expected PD conditional on current economic conditions
Internal Analytics Raings
Asset based - emphasis is put on valuation of borrower's assets; unsecured general corporate lending or product lending - emphasis is put on the borrower's ability to generate future cash flows
Examples of Econometric Models
classification trees, linear and multiple discriminant analysis, linear, logit and probit regression
Shadow rating
used when default data are rare, but there are external ratings from respected rating agencies; try to mimic analytical (external) rating systems; based on a database of rating decisions of an external rating agency ra…
Neural networks; rule-based/expert systems; structural models
Neural networks - try to mimic functioning of human brain
Altman's Z-score
a linear scoring function assigns to a company a linear combination of financial ratios and other explanatory variables in order to discriminate between good and bad borrowers
Logit vs. Probit
Tails are heavier for logit; logit is numerically more efficient; logit provides log odds
Weight of Evidence (WoE)
can be used to replace categorical variables with continuous variables; if positive, it increases log odds, negative decreases log odds
Information Value (IV)
measures an overall discriminatory power of the variable; always a positive number
Survival Analysis
Allows us to estimate probability of default in different time horizons at the same time; graphs illustrate that profiles differ, not sufficient to only focus on one year PD, especially if you want to esti…
Hazard Function
gives the rate at which objects that have survived until the time t, exit right right at time t; its derivative is approximately the probability of exit in the time interval, provided the objec…
What is the difference between survival analysis and logistical regression analysis ?
Logistic regression analysis does not capture well the time of the default dynamics, Sometimes we need to predict default in a short time horizon, in other situations, in a long time horizon. To model…
Survival Function vs. Hazard Function
A survival function gives the probability of survival until time t, whereas the hazard function gives the probability of exit in the time interval, provided that the object is still alive at time t.
Markov Chain Models
An alternative way to capture default dynamics; allows to estimate PDs for longer time horizons
Markowitz Portfolio Theory
Models risk vs. expected return; there is a diversification effect if the correlation between two assets with similar return is less than 1
Credit VaR (Value at Risk)
Credit loss of a credit portfolio can be measured in different ways:
Credit VaR Models
CreditMetrics, CreditRisk+, CreditPortfolio View, KMV portfolio Manager, Vasicek Model - Basel II
CreditMetrics
Based on ratings that are assumed to determine the values of the individual debt instruments; rating migration correlations modeled as asset correlations; asset return decomposed into a systematic and idiosyncratic parts; published by JP Morgan
CreditMetrics Bond Valuation
Simulated forward values require calculation of implied forward discount rates for individual ratings
CreditMetrics Recovery Rates
models the recovery rates as deterministic or independent on the rate of defaults but a number of studies show a negative correlation
Merton's Structural Model (Credit Migration)
Default occurs If assets < debt
Merton's Structural Model
The rating or its change is determined by the distance to the default threshold or its change
Default Rate and Recovery Rate Correlations
There is a negative correlation between default rate and recovery rate (negative correlation between PD and LGD)
CreditRisk+
Analytic "actuarial" approach; exposures are adjusted by fixed LGDs; discrete treatment; allows a scale of ratings and PDs - simulating overall mean number of defaults with a Gamma distribution; portfolio can be divided into indepen…
Advantage of CreditRisk+ over CreditMetrics
Calculations can be done analytically, without the Monte Carlo simulation
CreditPortfolio View
Ties rates of default to macroeconomic factors (only difference from CreditMetrics); created by Wilson and McKinsey
KMV Portfolio Manager
Idea of KMV is to use information from stock market in order to deduce information we cannot see - market value of assets (rather than book value)
KMV Portfolio Manager Relationship
There is a 1-to-1 relationship between stock price and its volatility and (latent) asset value and its volatility
Overview of KMV Model
based on Equity data to determine initial asset values and volatilities
PD Callibration
the distance to default is calibrated to PDs based on historical default observations
Why use risk neutral probabilities?
The calibrated PDs are historical, but we need risk neutral in order to value the loans because it is more consistent to use the risk-free rate.
Comparison of 3 Models
Different models can give different results due to the logic of the model as well as different inputs required by the models.
Vasicek's Model
Mathematical model describing the evolution of interest rates; the instantaneous interest rate follows the stochastic differential equation; if you multiply UDR (unexpected default rate) by a constant LGD and EAD, you get a "simple" esti…
Basel II Problems
Procyclicality: capital requirement becomes high in bad times as PD goes up; causes banks to be much more willing to provide new loans at good times than bad times -> deepens crisis during bad times
Basel III Improvements
higher capital requirements