Managing Credit Risk: An Overview

Banks grant credits to produce profits. In the process, they also assume and accept risks. In
evaluating risks, banks should assess the likely downside scenarios and their possible impact on
the borrowers and their debt servicing capacity. Two types of losses are possible in respect of
any borrower; expected losses and unexpected losses.

Expected Loss versus Unexpected Loss:

Although credit losses are typically dependent on time and economic condition, it is
theoretically possible to measure a statistically long run average loss level. Assume that based
on historical performance, a bank expects around 1% of its loans to default every year, with an
average recovery rate of 50%. In that case the bank’s expected losses for a credit portfolio of
BDT 1000 crores is BDT 5 crores (BDT 1000 crores × 1% × 50%). Therefore, expected loss is
based on three parameters:

 The likelihood that default will take place over a specified time horizon (Probability of
default)
 The amount owned by the counterparty at the moment of default (Exposure at default)
 The fraction of the exposure and net of any recoveries, which will be lost following a
default event ( Loss given default)

Since probability of default is normally specified on a one year basis, the product of these three
factors is the one year expected loss.

Expected loss = PD × EAD × LGD

In fact, credit risk emerges from adverse variations in the actual loss levels, which give rise to
the unexpected loss. Statistically, unexpected loss is simply the standard deviation of expected
loss.

Credit Risk:

Credit risk is most simply defined as the probability that a bank’s borrower or counterparty will
fail to meet its obligations in accordance with agreed terms. The effective management of credit
risk is a critical component of a comprehensive approach to risk management and essential to
the long-run success. The goal of credit risk management should be maximizing a bank’s risk-
adjusted rate of return by maintaining credit risk exposure within acceptable parameters.
Hence, a bank needs to manage the following:

 The risk in individual credits or transactions

 The credit risk inherent in the entire portfolio
 The relationship between credit risks and other risks
Elements of Credit Risk:

Probability of Default- the risk

Standalone that borrower will not service the
Risk debt
Loss Given Default- the extent of
loss in case the borrower defaults

Transition Risk- the probability

Credit and value impact of changes in
Risk borrower's default probability
Default Correlation- the extent to
Credit which the default risks of
Portfolio Risk borrowers are related

Exposure- the magnitude of

portfolio exposed to
borrower/counterparty default
risk

Measuring Credit Risk:

A simple method of estimating credit risk is to assess the impact of non-performing assets
(NPA) write offs on the banks profit. This can be achieved through dividing the ‘Profit before
Tax (PBT)’ by the NPAs. Here, PBT is more relevant since losses written off typically enjoy tax
shields.

Another method of presenting this concept is to work from the net income of the bank and treat
both the net income and the NPAs as a proportion of average total assets of the bank.
Accordingly, this simple measure of credit risk can be presented in the following forms:

1. 𝑃𝐵𝑇/𝑇𝐴 2. 𝑃𝐴𝑇[1 − 𝑡] 3. 𝑃𝐵𝑇

𝑁𝑃𝐴/𝑇𝐴 𝑇𝐴 𝑁𝑃𝐴
𝑁𝑃𝐴
𝑇𝐴
Interpretations of the result:

If the above measure yields a result of say, 0.7, it simply means that if 70% of the NPAs turn into
‘Loss Assets’ and are written off, the bank’s PBT would be eroded completely. For this reason,
the resultant proportion is also called the ‘Margin of safety’.
Credit Risk Transfers:

Hedging reduces portfolio risk by offsetting one risk against another. Diversification reduces
risk because risks are uncorrelated. How portfolio hedges are structured will vary according to
the bank’s goal on hedging credit risk. In the present scenario, banks grow their business by
expanding loan assets, but these assets are sold off to other agencies or offloaded in the
secondary loan market. In this manner banks get risky loans off their books. Such loan sales
provide liquidity to the selling banks and also represent a valuable portfolio management tool,
which minimizes risk through diversification.

Some prominent forms of loan sales include the following:

 Syndication:

Syndication spreads the credit risk in the transaction among the banks in the syndicate. Let us
assume a borrower wants a loan of BDT 10,000 crores of a large project. If Bank X is nominated
as the lead bank for the syndication, Bank X will negotiate the documents with the borrower
and solicit a group of banks to share the credit exposure. Bank X will generally hold the
maximum exposure and claims a fee for its efforts in syndication.

 Novation:

In the above example, Bank X assigns its rights to one or more buyer banks. These buyer banks
then become original signatories to the loan agreement. Thus, the borrower would have
contracted with Bank X for the BDT 10,000 crores loan. Post novation, Bank X would hold, say,
BDT 2000 crores of credit exposure to the borrower and the three buyer banks would hold the
remaining BDT 8000 crores share among themselves in a mutually agreed proportion. Unlike
syndication, three banks would enter into separate loan agreements with the borrower.

 Participation:

In this case, Bank X transfers to other participating banks the right to receive pro rata payments
from the borrower. Typically, the seller of the participation- Bank X – will have to consult the
other banks before agreeing to changes in the terms of the loan (principal, interest, repayment
terms, guarantees, collaterals, interest rate, fees and other covenants).

 Securitization:

This is one of the most popular and prominent forms of loan sale. Securitization involves the
transfer of assets and other credit exposure from the ‘originator’ (the bank) through pooling and
re-packaging by a Special Purpose Vehicle (SPV) into securities that can be sold to investors. It
involves legally isolating the underlying exposures from the originating bank. A ‘traditional
securitization’ happens where the assets are typically transferred from the originator’s Balance
Sheet to the issuer of the securities.
For instance, a bank makes auto loans and sells these loans to a SPV that structures these assets
into a homogenous assets pool. The SPV retains the loan as collateral, sells the pool to investors
and pays the bank for the loans bought from it with the proceeds from the sale of the securities.
At the end of the tenure of securitization, the residual assets are passed on to the investors. If
the asset quality declines, the investors have to bear the loss. The investors receive variable
coupon payments depending upon the risk they decide to bear.

A Typical Securitization Process:

Cash Flow to
Originator
Originator Obligors

Passes cash to Proceeds of Sale

SPV less Fees of Securities

SPV

Cost of the Securities

Coupon and
Final Payment

Senior Investors
Tranche
Junior Investors s

Securitization can be seen as the method of turning un-tradable and illiquid assets into various
types of securities, which can be sold to different investors with different risk appetites. These
different types of securities with different inherent risks are known as ‘tranches’. Technically,
securitization is defined as a transaction involving one or more underlying credit exposures
from which tranches that reflect different degrees of credit risk are created. The securities sold
to investors are called ‘Asset-backed Securities’ (ABS), since they are backed by the
homogenous pool of underlying assets.
Credit Derivatives:

Due to the difficulties experienced by the bankers with alternative methods of dealing with
credit risk, another alternative has emerged; ‘credit derivatives’- a more specialized way to
insure against credit related losses.

Credit derivatives are an effective means of protecting against credit risk. In credit derivatives,
there is a party (or a bank) trying to transfer credit risk, called protection buyer and there is a
counterparty (another bank) trying to acquire credit risk, called protection seller. These
derivatives are typically unfunded- the protection seller is not required to put in any money
upfront. The protection buyer generally pays a periodic premium. However, credit derivatives
may be funded in some cases. There are different types of credit derivatives.

Categorization of Credit Risk Transfer Instruments

Conventional Credit Insurance

Instruments
Syndicated
Loan/Participation/
Novation
Credit Risk
Trasfer Market Structured Instruments Securitization
Instruments Oriented •Asset-backed securities, Mortgage-backed
Instruments securities and others
Colleteralized Debt Obligations

'Pure' Credit Credit default swaps

Derivatives

Hypbrid Instruments Credit linked notes

Other Instruments Loan sales/ asset sawps

etc.

 Collateralized Debt Obligations:

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). A

CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the
cash flow the CDO collects from the pool of bonds or other assets it owns.
The CDO is "sliced" into ‘tranches’, which "catch" the cash flow of interest and principal
payments in sequence based on seniority. If some loans default and the cash collected by the
CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer
losses first. The last to lose payment from default are the safest, most senior tranches.
Consequently, coupon payments (and interest rates) vary by tranche with the safest/most
senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to
compensate for higher default risk.

 Credit Default Swap (CDS):

The CDS provides protection against specific credit related events and bears more resemblance
to a financial bank guarantee or a standby letter of credit, then to a swap. Under this agreement,
the protection buyer pays the protection seller only a fixed periodic amount over the life of the
agreement.
  Credit Linked Note (CLN):

CLNs are created through a Special Purpose Company (SPC), or trust, which is collateralized
with AAA-rated securities. Investors buy securities from a trust that pays a fixed or
floating coupon during the life of the note. At maturity, the investors receive par unless the
referenced credit defaults or declares bankruptcy, in which case they receive an amount equal
to the recovery rate. The trust enters into a default swap with a deal arranger. In case of default,
the trust pays the dealer par minus the recovery rate in exchange for an annual fee which is
passed on to the investors in the form of a higher yield on the notes.