Credit Risk
This syllabus area will provide approximately 15 of the 100 examination questions
Chapter Summary
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1. Identification of Credit Risk
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2. Credit Risk Measurement
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3. Credit Risk Management
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Credit Risk
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Chapter Summary
The original Basel Accord focused on credit risk in recognition of its primary importance in the risk profile of many financial institutions. This chapter introduces the basic methods of credit risk measurement and presents some common mitigation techniques.
At the most basic level, credit risk is simply the risk that, having extended a loan to another party, it is not repaid as agreed. Therefore, this chapter introduces techniques that can be used to assess the probability that third parties default (ie, fail to repay). These techniques can be applied to individual third parties (known as counterparties) or the industry within which they operate, or even the country within which they are based. This is because the likelihood of a counterparty defaulting is strongly correlated with the success of their industry, and the economic state of their home country.
Larger counterparties are credit-rated by firms known as ratings agencies: the higher the rating the better the credit risk – or to put it another way, the lower the likelihood of default. Smaller firms are not rated by an agency, and so lending institutions have to perform their own assessment of the likelihood of default. This is also true for retail customers.
Another important consideration when assessing credit risk is the quality of any assets that have been used as security in the event of default. The higher the quality, the less concerned is the lending institution about default because the underlying security (perhaps the house of one of the borrowing company’s directors) can be sold to recoup the loss.
1.
Identification of Credit Risk
1.1
Key Components of Credit Risk
Learning Objective
4.1.1 Understand the key components of credit risk and how they arise: counterparty risk, issuer risk and concentration risk
Credit risk is the risk of loss caused by the failure of a counterparty or issuer to meet its obligations. The party that has the financial obligation is called the obligor. The goal of credit risk management is to maximise a firm’s risk-adjusted rates of return by maintaining credit risk exposure within acceptable parameters.
• Credit risk exists in two broad forms: counterparty risk and issuer risk. Counterparty risk is the risk that a counterparty fails to fulfil its contractual obligations. A counterparty is one of the parties to a transaction – either the buyer or the seller. Examples of counterparty credit risk from a bank’s perspective would include:
• the risk that a customer fails to pay back a loan
• the risk that a company with whom the bank does business declares bankruptcy before having paid for goods or services supplied by the bank
In the third of the above examples, the bond itself also carries issuer risk. This is the risk that the issuer of the bond could default on its obligations to pay coupons or repay the principal on the bond.
Concentration risk arises through an uneven distribution of exposures to individual issuers or
counterparties (single-name concentration) or within industry sectors and geographical regions (sectorial concentration).
For example, if a bank is overly-dependent on a small number of counterparties – single-name concentration risk – then, if any of those counterparties default, the bank’s revenues could drop by a significant amount. Over-concentration at the country, sector or industry levels also holds risk for a bank – if, for example, the country in which it is overly concentrated suffers an economic downturn, then its revenues will again be adversely affected compared to competitors who are better diversified.
1.2
Counterparty and Issuer Risk Exposures
Learning Objective
4.1.2 Know the main areas of exposure of counterparty, systemic and issuer risk within banking, securities and investment functions
It can be seen then that credit risk consists of counterparty and issuer risk, and that the following differences exist between them.
1. A broker could fail to deliver a bond issued by a good quality company that is currently paying its coupons and redeeming its bonds. This is counterparty risk.
2. The same broker could deliver the bond exactly as required, but the issuing company, previously assessed as being of high quality, runs into trouble. It declares bankruptcy and stops paying its interest on bonds. This is issuer risk.
Some examples of different firms and combinations of credit risk will help to illustrate the main areas of exposure of counterparty and issuer risk within banking, securities and investment functions.
1. A fixed income fund is exposed to issuer credit risk in its holdings of financial instruments whose values are based on the continuation of the commitments made by the original issuers. So, for example, if a fund holds bonds or other forms of corporate debt, and the issuers of any of the bonds
Credit Risk
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For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off the balance sheet. These sources include:
• the extension of commitments and guarantees • interbank transactions
• financial instruments such as futures, options, swaps and bonds • the settlement of these and other transactions.
Transaction settlement is a key source of counterparty risk. This is the point at which the buyer and seller exchange the instrument and the cash to pay for it. There is a risk that one party delivers, but the other fails to do so.
Ideally, the transfer of the purchased item and the transfer of cash would occur at exactly the same time, and there are electronic settlement systems to ensure that this happens. However, this is not always possible – and even when it is, there is always the chance that the mechanism may fail and one party to the agreement is still owed what they were due.
Another example of settlement risk is when an investment company has a forward contract to exchange euros for US dollars with a foreign firm. On the contract’s maturity date, the investment company makes its euro payment but, because of time differences, there is a delay in the foreign firm making its corresponding dollar payment. Because it is possible that the firm will fail to make its payment, the corporation faces settlement credit risk.
Certain financial instruments also carry ‘pre-settlement risk’. This is the risk that an institution defaults before the settlement of the transaction, where the traded instrument has a positive economic value to the other party.
This can occur during an interest rate swap. This is an agreement between two counterparties where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to a well-known published interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap. However, if interest rates then move in favour of counterparty A, the other counterparty B will owe a net obligation. Failure to perform on this obligation creates pre-settlement risk for counterparty A.