Bank Management

Chapter 3
Credit Risk Management

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3.1 Managing Treasury
3.1.1 Requirement reserve
Reserve requirements are the amount of
cash that banks must have, in their vaults or
at the closest State Bank, in line with
deposits made by their customers. Set by the
SBV's board of governors, reserve
requirements are one of the three main tools
of monetary policy — the other two tools
are open market operations and the discount
rate.

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3.1 Managing Treasury
3.1.1 Requirement reserve
◼ The reserve requirement is the amount of
funds a bank must have on hand each
night. It is a percent of the bank's deposits.
The nation's central bank sets the
percentage rate.
◼ The central bank controls the reserve
requirement for member banks. The bank
can hold the reserve either as cash in
its vault or as a deposit at the state bank.
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3.1 Managing Treasury
3.1.1 Requirement reserve
The reserve ratio is
expressed as a percentage of the bank's total
deposits. The reserve ratio exists to ensure that
the bank is able to pay
an unusually high number of withdrawals on
demand accounts should that event occur. It
also helps ensure that the bank does not over-
leverage itself. In some countries, increasing
or decreasing reserve ratios may be used to
help control the money supply.
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 3.1 Managing Treasury
3.1.1 Requirement reserve
Decision No. 1158/QD-NHNN dated May 29th, 2018 of the
State Bank of Vietnam (SBV) on reserve requirement ratios
applicable to credit institutions and foreign banks’ branches:
In VND In Foreign currencies

Demand Demand
Term
Credit Institutions deposits and
deposits of at All deposits of
deposits and Term deposits
term deposits term deposits of of at least 12
least 12 foreign CIs
of less than 12 less than 12 months
month
months months

1. People’s credit funds and

micro-finance institutions
0% 0% 0% 0% 0%

2. Agribank and Co-op Bank 3% 1% 1% 7% 5%

3. Other Banks 3% 1% 1% 8% 6%

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3.1 Managing Treasury
3.1.1 Requirement reserve
Example:
• If a bank mobilizes VND100 billion from a
six-month deposit, it has to hold VND3
billion in its reserve and can use VND97
billion to lend or improve liquidity.
• If the deposit comes with a tenor of over 12
months, the lender should hold VND1 in
their reserve.

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3.1 Managing Treasury
3.1.1 Requirement reserve
Example:
◼ At present, the local banking system reports
an estimated total mobilization of around
VND4,000 trillion (US$178 billion), mostly
from less-than-12-month deposits.
So, total reserves at banks are put at
VND100-120 trillion.

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3.1 Managing Treasury
3.1.1 Requirement reserve
The lower RR ratio for banks that carry out
restructuring plans or participate in the
restructuring of ailing lenders will help them
cut borrowing cost, improve earnings and
lower interest rates for loans. The rule also
encourages healthy banks to join the
restructuring of weak banks, thus speeding
up the banking sector restructuring plan.

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3.1 Managing Treasury
3.1.2 Excess reserve
Money a bank keeps in addition to the legally
required reserves. Most banks have keep little or
nothing in excess reserves because they earn no
interest on excess reserves.
The reserves held by the bank in excess of what
is required by the central bank. Large excess
reserves indicate a potential for credit expansion
and reduced interest rates that could prove
beneficial to the security markets.

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3.1 Managing Treasury
3.1.3

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3.1 Managing Treasury
3.1.3 Equity capital
◼ Equity capital Capital is the owner’s stake in a firm
and is a source of financing—albeit a relatively costly
source of financing.
◼ Capital provides the buffer needed to absorb
unanticipated losses and allow the firm to continue
(i.e., it provides a safety margin).
◼ Capital is the scarce resource. When a financial
institution maximizes profit (or maximizes
shareholder value), it does so subject to a constraint.
And capital is that constraint.

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3.1 Managing Treasury
3.1.3 Regulatory capital
◼ Regulatory capital refers to the risk-based
capital requirement under the Capital
Accord. The purpose of regulatory capital is
to ensure adequate resources are available
to absorb bank-wide unexpected losses.
Although the regulatory requirement is
calculated based on the risk of the assets,
it was never intended to produce accurate
capital allocations at the transaction level.

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3.2 Managing Credit
Credit risk assessment:
Traditional lending products
• Seasonal lines of credit
Short-term • Special purpose loans (temporary needs)
Loans • Secured or unsecured

• Mature in more than 1 year

Mid & Long-term • Purchase fixed assets or another company,
Loans refinance debt, etc.
• Often secured

Revolving • Like a seasonal credit line

Loans • Interest rate usually “floats”

• Bonds, debentures, notes

Public Debt • Sinking fund and call provisions
• Covenants

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6-13
 Credit analysis:
Evaluating the borrower’s ability to repay
Step 1: • Business model and strategy
Understand • Key risks and success factors
the business • Industry competition

Step 2: Evaluate • Spot potential distortions

accounting quality • Adjust reported numbers as needed

Step 3: • Examine ratios and trends

Evaluate current • Look for changes in profitability, financial
profitability and health conditions, or industry position.

Step 4: Prepare “pro forma” • Develop financial statement forecasts

cash flow forecasts • Assess financial flexibility

Step 5:
Due diligence • Kick the tires

Step 6: • Likely impact on ability to pay

Comprehensive risk
• Assess loss if borrower defaults
assessment • Set loan terms
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6-14
The Credit Rating Process
More risk
Investor’s belief about credit
risk influence the price paid
Less investors
– and thus the amount are willing to
borrowed pay

Three agencies (Moody’s, Standard &

Poor’s, and Fitch) assess and grade the
The higher the creditworthiness of companies and public
credit rating
entities that sell debt to investors. Credit
ratings are letter-based grades (AAA, BBB)
The lower is that express the rating agency’s opinion
the default risk about default risk.

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6-15
Standard & Poor’s Ratings

6-16
3.2 Managing Credit
3.2.1 Credit Risk
• Risk is inherent in banking and is unavoidable.
The basic function of bank management is risk
management.
• Credit risk arises when a bank cannot get back
the money from loan or investment.
• Credit risks in banking activity mean loss which
able to happen with respect to debts of banks
because customers fail to implement or have no
capacity to implement part or whole their
obligations as committed.

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 3.2 Managing Credit
3.2.1 Credit Risk
◼ Credit risk is the risk caused by the eventual
default of borrowers on their obligations to
the bank and is also the risk of loss of
present bond values due to the degradation
of the issuer. This last one is also called risk
of degradation.

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 3.2 Managing Credit
3.2.1 Credit Risk
The level of non performing loans is recognized
as a critical indicator for assessing banks’ credit
risk, asset quality and efficiency in the allocation
of resources to productive sectors. Non-
performing assets are a leading indicator of credit
quality. Include:
• Non-accrual loans are those whose cash flows stream is so
uncertain that the bank does not recognize income until
cash is received
• Restructured loans are those whose interest rate has been
lowered on the maturity increased because of problem with
borrower.
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3.2 Managing Credit
3.2.1 Credit Risk
The assets of a bank whether a loan or investment carries
credit risk. Credit risk is the risk of losing money when loans
default. Credit risk or default risk gives rise to problems to
bank management. The principal reason for bank failures is
bad loans. Banks can raise their credit standards to avoid
high risk loans. Guarantees and collateral can reduce risk.
After the loan is made compliance can be ensured by
monitoring the behavior of the borrower which reduces risk.
Credit risk can be transferred by selling standardized loans.
Loans portfolio can be diversified by making loans to a variety
of firms whose returns are not perfectly and positively
correlated.

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 3.2 Managing Credit
3.2.1 Credit Risk
The banks should put in place the loan
policy covering the methodology for
measurement, monitoring and control of
credit risk.
Banks are expected to evolve
comprehensive credit rating system that
serves as a single point indicator of diverse
risk factors of counter parties in relation to
credit and investment decisions.
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 3.2 Managing Credit
3.2.1 Credit Risk
 NATURE OF CREDIT RISK
Among the transactions risk the most important are
liquidity risk and credit risk. Credit risk is inherent
in banking. Banks are successful when the risks
they take are reasonable, controlled and within
their financial resources and competence. Credit
risk covers all risks related to a borrower not
fulfilling his obligations on time. Even where assets
are exactly matched by liabilities of same maturity,
the same interest rate conditions and the same
currency, the only on balance sheet risk remaining
would be credit risk.
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3.2 Managing Credit
3.2.1 Credit Risk
 NATURE OF CREDIT RISK
Credit risk exposure is measured by the current
mark to market value. The magnitude of credit risk
depends on the likelihood of default by the counter
party, the potential value of outstanding contracts,
the extent to which legally enforceable netting
arrangements allow the value of offsetting contracts
with that counter party to be netted against each
other or the value of the collateral held against the
contracts.

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 3.2 Managing Credit
3.2.1 Credit Risk
Chart for credit risk management

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 3.2 Managing Credit
3.2.1 Credit Risk
Chart for credit risk management

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 3.2 Managing Credit
3.2.1 Credit Risk
The 6 C’s of Credit
The evaluation of the loan request by the bank involves the
6 C’s of credit.
• Character (borrowers personal characteristics such as
honesty, attitudes about willingness and commitment to pay
debts).
• Capacity (the success of business).
• Capital (financial condition).
• Collateral.
• Conditions (economic).
• Compliance (laws and regulations).

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 3.2 Managing Credit
3.2.1 Credit Risk
◼ Granting credit and monitoring the resulting
default risk is the primary activity of banks.
As credit risk is difficult to “hedge” or remove
from the balance sheet (for most banks in
the world anyway), it is self-evident that the
most effective credit risk management policy
is to operate a sound loan origination policy.

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 3.2 Managing Credit
3.2.2 Classification of assets
❖ Interpretation of terms
◼ Risk provisions mean the amounts set up and
accounted into the operational cost in order to provide for
losses which may happen for debts of credit institutions,
foreign banks’ branches. Risk provisions include specific
provisions and general provisions.
• Specific provisions mean the amount set up in order to
provide for losses which may happen for each specific
debt.
• General provisions mean the amounts set up in order to
provide for losses which may happen but have not
defined when setting up specific provisions.
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3.2 Managing Credit
3.2.2 Classification of assets
❖ Interpretation of terms
◼ Overdue debt means a debt which part or
whole of its principal and interest has become
overdue.
◼ Bad debt (NPL) means debts which have been
classified as those in Groups 3, 4 and 5.
◼ Rate of bad debt means rate of bad debts in
comparison with total debts of from group 1 to
group 5.

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 3.2 Managing Credit
3.2.2 Classification of assets
◼ Banks have been instructed that they should
not charge and take interest on non-
performing assets to the income account.
◼ Classification of assets into these categories
had to be done taking into account the degree
of well-defined credit weaknesses and extent
of dependence on collateral security for
realization of dues. The health code system of
classification of assets would, however
continue as a management information tool.
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 3.2 Managing Credit
3.2.2 Classification of assets
◼ Banks implement classification of debts (excluding
payments under off-balance sheet commitments)
according to 05 groups as follows:
a) Group 1 (standard debts)
b) Group 2 (debts, which need attention)
c) Group 3 (sub-standard debts)
d) Group 4 (doubtful debts)
e) Group 5 (potentially irrecoverable debts)

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3.2 Managing Credit
3.2.2 Classification of assets
Taking into account the time-lag
between an account becoming doubtful
of recovery, its recognition as such, the
realization of the security and the
erosion over time in the value of security
charged to the banks, banks are
required to make provision against sub-
standard assets, doubtful assets and
loss assets.
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 3.2 Managing Credit
3.2.2 Classification of assets
❖ Specific levels of setting up provisions:
◼ Amount of specific provision required to set up for
each customer shall be calculated under the
following formula:
Ri = (Ai - Ci) x r
• Ai: The original balance i;
• Ci: the deducted value of security assets, financial leasing
assets (hereinafter referred to as security assets) of debt i;
• r: rate of specific provisions required to set up under group
as prescribed in clause 2 this Article.
• If Ci > Ai, Ri shall be calculated equal to 0.
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3.2 Managing Credit
3.2.2 Classification of assets
❖ Specific levels of setting up provisions:
◼ Ratio of specific provisions required to set up for
each debt group (r) as follows:
a) Group 1: 0%;
b) Group 2: 5%;
c) Group 3: 20%;
d) Group 4: 50%;
e) Group 5: 100%.

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 3.2 Managing Credit
3.2.2 Classification of assets
❖ Specific levels of setting up provisions:
❑ The maximum deduction rate for security assets:
a) Deposit of customer in Vietnam dong: 100%;
b) Gold bar, except gold bar specified in point i this clause;
deposit of customer in foreign currency: 95%;
c) The Government’s bonds, negotiable instruments, valuable
papers which are issued by itself; saving card, deposit
certificates, exchange bills, treasury bills issued by other credit
institutions, foreign banks’ branches:
- With remaining term of less than 1 year: 95%;
- With remaining term of between 1 year and 5 years: 85%;
- With remaining term of more than 5 years: 80%. 35
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 3.2 Managing Credit
3.2.2 Classification of assets
❖ Specific levels of setting up provisions:
❑ The maximum deduction rate for security assets:
d) Securities which are issued by other credit institutions and
listed on the Stock Exchange: 70%;
dd) Securities which are issued by other enterprises and listed
on the Stock Exchange: 65%;
e) Securities which are unlisted on the Stock Exchange,
valuable papers, except clauses specified in point c this clause,
and issued by credit institutions which have registered
securities listing on the Stock Exchange: 50%;
Securities which are unlisted on the Stock Exchange, valuable
papers, and issued by credit institutions which fail to register
36
securities
12/16/2023 listing on the Stock Exchange: 30%;
3.2 Managing Credit
3.2.2 Classification of assets
❖ Specific levels of setting up provisions:
❑ The maximum deduction rate for security assets:
g) Securities which are unlisted on the Stock Exchange,
valuable papers issued by enterprises which have registered
securities listing on the Stock Exchange: 30%;
Securities which are unlisted on the Stock Exchange,
valuable papers issued by enterprises which fail to register
securities listing on the Stock Exchange: 10%;
h) Real estate: 50%;
i) Gold bar which has no listing price, other gold and other
security assets: 30%.

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3.2 Managing Credit
3.2.2 Classification of assets
❖ The general provision :
The amount of general provision which have to set
up is defined by 0.75% of total balances of debts
from group 1 to group 4.

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 3.2.3 Managing Credit Risk
◼ Most of a bank’s funds are used either to make
loans or to purchase debt securities, which
expose the bank to credit risk.
◼ Tradeoff between credit risk and expected return
 Because a bank cannot simultaneously maximize
return and minimize credit risk, it must compromise
◼ It will select some assets that generate high returns
but are subject to a high degree of credit risk
◼ It will select some assets that are very safe but offer
a lower rate of return
 The bank attempts to earn a reasonable return and
maintain credit risk at a tolerable level.
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 3.2.3 Managing Credit Risk
◼ Tradeoff between credit risk and expected return
How the loan allocation decision affects return and
risk?
Ex: Credit cards and consumer loans offer the
highest margins above the bank’s cost of funds.
But, Credit cards and consumer loans will experience
more defaults than other types of loans.
Many banks have adopted more lenient
credit standards to generate credit card
business.
For banks that were too lenient, the wide
spread between the return on credit card
loans and the cost of funds has been offset
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3.2.3 Managing Credit Risk
◼ Tradeoff between credit risk and expected return
◼ Banks adjust their asset portfolio according to
changes in economic conditions
Banks generally reduce loans and
increase purchases of low-risk securities
when the economy is weak
When economy conditions began to
improve, banks were more willing to
provide more loans subject to more risk.

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3.2.3 Managing Credit Risk
◼ Measuring credit risk
 Banks employ credit analysts who review the
financial information of corporations applying for
loans and evaluate their creditworthiness.
 Determining the collateral: The bank must decide
whether to require collateral than can back the loan
 Determining the loan rate:
◼ Ratings are used to determine the premium to be
added to the base rate according to credit risk.
◼ Some loans to high-quality customers are
commonly offered at rates below the prime rate.

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3.2.3 Managing Credit Risk
◼ Diversifying credit risk
 Banks should diversify their loans to make
sure their customers are not dependent on a
common source of income.
 Applying portfolio theory to loan portfolios
◼ The variance of an asset portfolio’s return
is:
◼ The covariance measures the degree to
which asset returns move in tandem

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3.2.3 Managing Credit Risk
◼ Diversifying credit risk
The covariance is equal to the correlation
coefficient between asset returns times the
standard deviation of each asset’s return, so:
◼ The portfolio variance is positively
related to the correlations between
asset returns
◼ If a bank’s loans are driven by one
particular economic factor, the returns
will be highly correlated
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3.2.3 Managing Credit Risk
◼ Diversifying credit risk (cont’d)
 Industry diversification of loans
◼ If one particular industry experiences weakness,
loans to other industries will be insulated
◼ Diversifying loans across industries has limited
effectiveness when economic conditions are
weak
 Geographic diversification of loans
◼ Diversification of loans across districts could
achieve significant risk reduction in loan
portfolios because of low correlations

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3.2.3 Managing Credit Risk
◼ Diversifying credit risk (cont’d)
International diversification of loans
◼ Diversification of loans across
countries can reduce exposure to any
one country.
◼ Banks should assess a country’s risk
and focus on countries with a high
country risk rating.

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3.2.3 Managing Credit Risk
◼ Diversifying credit risk (cont’d)
 Selling loans
◼ Banks can eliminate loans that are causing
excessive risk in their portfolios by selling them in
the secondary market
◼ Loan sales often enable the bank originating the
loan to continue servicing the loan
 Revising the loan portfolio in response to economic
conditions
◼ When economic conditions deteriorate, a bank’s
loan portfolio may be heavily exposed to economic
conditions even if it has purchased additional
Treasury securities.
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3.2.3 Managing Credit Risk
◼ Methods for Reduction of Credit Risk: Banks can
reduce credit risk by
• Raising credit standards to reject risky loans.
• Obtain collateral and guarantees.
• Ensure compliance with loan agreement.
• Transfer credit risk by selling standardized loans.
• Transfer risk of changing interest rates by hedging in
financial futures, options or by using swaps.
• Create synthetic loans through a hedge and interest
rate futures to convert a floating rate loan into a fixed
rate loan.
• Make loans to a variety of firms whose returns are
48
not perfectly positively correlated.
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3.2.3 Managing Credit Risk
◼ Credit derivatives:
❑ Definition: Credit derivatives are bilateral
financial contracts that isolate specific
aspects of credit risk from an underlying
instrument and transfer that risk between
two parties. In so doing, credit derivatives
separate the ownership and management
of credit risk from other qualitative and
quantitative aspects of ownership of
financial assets.
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3.2.3 Managing Credit Risk
◼ Credit derivatives:
❑ Features:
(a) A credit derivative is a derivative security
that is primarily used to transfer, hedge or
manage credit risk.
(b) A credit derivative is a derivative security
whose payoff is materially affected by
credit risk.

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3.2.3 Managing Credit Risk
❖ Credit Default Swaps (CDS)
◼ The Credit Default Swap is a bilateral
financial contract in which one counterparty
(the Protection Buyer) pays a periodic fee,
typically expressed in basis points per
annum, paid on the notional amount, in
return for a Contingent Payment by the
Protection Seller following a Credit Event
with respect to a Reference Entity.
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 3.2.3 Managing Credit Risk
❖ Credit Default Swaps (CDS)
◼ A Credit Event is defined as the occurrence
of one or more of the following:
• Failure to meet payment obligations when
due
• Bankruptcy or Moratorium
• Repudiation
• Material adverse restructuring of debt
• Obligation Acceleration or Obligation Default
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3.2.3 Managing Credit Risk
❖ Credit Default Swaps (CDS)
◼ Credit default swaps are the most liquid
instruments in the credit derivatives
markets.
◼ In a CDS, the protection buyer pays a
premium to the protection seller in exchange
for a contingent payment in case a credit
event involving a reference security occurs
during the contract period.

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 3.2.3 Managing Credit Risk
❖ Credit Default Swaps (CDS)
◼ The premium (default swap spread) reflects
the credit risk of the bond issuer, and is
usually quoted as a spread over a reference
rate such as LIBOR or the swap rate, to be
paid either up front, quarterly, or
semiannually.

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3.2.3 Managing Credit Risk
❖ Credit Default Swaps (CDS)

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 3.2.3 Managing Credit Risk
❖ Credit Default Swaps (CDS)
◼ The protection buyer (người được bảo vệ) delivers
the reference security (or equivalent one) to the
protection seller (người bảo vệ) and receives the
par amount (khoản tiền gốc). With cash
settlement (thanh lý bù tiền), the protection buyer
receives a payment equal to the difference
between par and the recovery value of the
reference security, the latter determined from a
dealer poll or from price quote services.

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3.2.3 Managing Credit Risk
❖ Credit Default Swaps (CDS)

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 3.2.3 Managing Credit Risk
• Seciritizing assets, seling loan and ussuing
standby credits can help to reduce not only
interest-rate risk exposure but also
exposure to credit risk.
• It is more efficient to reduce credit risk with
a comparatively new financial instruments –
the credit derivative – an over-the-counter
agreement offering protection against loss
when default occurs on a loan, bond, or
other debt instrument.
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 3.2.3 Managing Credit Risk
• Example: Credit default swap on Daimler
Chrysler.
The trade At time t =0, A and B enter a credit
default swap on Daimler Chrysler, A as
protection buyer and B as protection seller.
They have agreed on:
(i) The reference credit: Daimler Chrysler AG.
(ii) The term of the credit default swap: 5 years.
(iii) The notional of the credit default swap: $20m
(iv) The credit default swap fee: s =116 bp.
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 3.2.3 Managing Credit Risk
• Example:
These are the most important items in the
specification. For the other details of the
specification of the contract we assume that
A and B follow the specifications proposed
by the ISDA (International Swap Dealers
Association). The settlement period for the
trade is three business days from the trade
date, this is when the first fee payment
period and the default protection begin.
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3.2.3 Managing Credit Risk
◼

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 3.2.3 Managing Credit Risk
• Example:
These payments are stopped and the CDS is
unwound as soon as a default of Daimler Chrysler
occurs.
Determining a credit event
The credit events (bankruptcy, failure to pay,
obligation acceleration, repudiation/ moratorium or
restructuring) are defined in the CDS contract with
respect to a large set of bonds issued by the
reference entity, Daimler Chrysler. Let us assume
these are all senior unsecured USD and EUR-
denominated bonds issued by Daimler Chrysler
with an issue size of at least 10mUSD or 10m
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3.2.3 Managing Credit Risk
• Example:
Let us (hypothetically) assume that at date t =τ ,
Daimler Chrysler has failed to pay a coupon that
was due at this date on one of the bonds listed
above. This could potentially constitute a credit
event according to the CDS contract, if some
conditions are met. First, the disputed amount
must exceed a materiality threshold, and second,
it must remain unpaid after ace period of some
days. If these conditions are satisfied then the
protection buyer A will notify the protection seller B
of the occurrence of a credit event and the credit
63
default swap contract is unwound.
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 3.2.3 Managing Credit Risk
• Example: The default payment
First, A pays the remaining accrued fee. If the default
occurred two months after the last fee payment, A
will pay 116000 × 2/6. The next step is the
determination of the default payment. If physical
settlement has been agreed upon, A will deliver
Daimler Chrysler bonds to B with a total notional of
USD 20m (the notional of the CDS). The set of
deliverable obligations has been specified in the
documentation of the CDS. As liquidity in defaulted
securities can be very low, this set usually
contains more than one bond issue by the
64
reference credit.
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 3.2.3 Managing Credit Risk
• Example:
Naturally A will choose to deliver the bond with the
lowest market value, unless he has an underlying
position of his own that he needs to unwind. (Even
then he may prefer to sell his position in the market
and buy the cheaper bonds to deliver them to B.)
This delivery option enhances the value of his
default protection. B must pay the full notional for
these bonds, i.e. USD 20m in our example. If cash
settlement has been agreed upon, a robust
procedure is necessary to determine the market
value of the bonds after default.
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 3.2.3 Managing Credit Risk
• Example:
If there were no liquidity problems, it would be
sufficient to ask a dealer to give a price for
these bonds, and use that price, but liquidity
and manipulation are a very real concern in the
market for distressed securities. Therefore not
one, but several, dealers are asked to provide
quotes, and an average is taken after
eliminating the high stand lowest quotes. This
is repeated, sometimes several times, in order
to eliminate the influence of temporary liquidity
holes.
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 3.2.3 Managing Credit Risk
• Example:
Thus the price of the defaulted bonds is
determined, e.g. 430 USD for a bond of 1000
USD notional. Now, the protection seller pays
the difference between this price and the par
value for a notional of 20m USD, i.e.
(1000−430) / 1000 × 20m USD = 11.4m USD
Whichever settlement procedure is agreed
upon, the CDS settles very quickly in a matter
of only a few weeks (usually around six
weeks) after the credit event notice.
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 3.2.3 Managing Credit Risk
• Example:
This is much quicker than the determination of
the final recovery rate through the
bankruptcy courts.

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3.2.3 Managing Credit Risk
◼ Credit Swaps:
Two lenders agree to exchange a portion of
their customer’s loan repayments.
For example, Bank A and B may find a dealer
such as large insurance company, that agrees
to draw up a credit swap contract between the
two banks. Bank A then transmits an amount
(perhaps $100 million) in interest and principal
payment that it collect from its credit customers
make to the same dealer.
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3.2.3 Managing Credit Risk
◼ Credit Swaps:
Bank B also sends all or a portion of the loan
payments its custormers make to the same
dealer.
The dealer will ultimately pass these payments
along to the other bank that sign a swap
contract. The dealer levies a fee for the service
of bringing these two swap partners together
and may also guarantee each swap partner’s
performance for an additional charge.
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3.2.3 Managing Credit Risk
◼ Credit Swaps:
Each bank is granted the opportunity to
further spread out the risk in its loan
portfolio.
A credit swap permits each institution to
broaden the number of markets from which
its collects loan revenues and principle.
Thus reducing each institution’s dependence
on one or a narrow set of market areas.

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3.2.3 Managing Credit Risk
◼ Credit Swaps:
For example, a swap dealer may guarantee
Bank A a return on its business loans that is
3 percentage points higher than the long-
term government bond rate. In this instance
Bank A would have exchanged the risky
return from a portion of its loans for a much
more stable rate of reward based upon the
return from a government securities.

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 3.2.3 Managing Credit Risk
◼ Credit Swaps:

Another example that Bank A then agrees to pay

Bank B the total return earned on the loans (including
interest and principle payments). Bank B agrees to
pay A the LIBOR plus a small interest rate spread and
to compensate A for any depreciation that occur in the
market value.
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3.2.3 Managing Credit Risk
◼ Credit swap:

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 3.2.3 Managing Credit Risk
◼ Credit options:
◼ Credit Options are put or call options on the price of
either (a) a floating rate note, bond, or loan or (b) an
“asset swap” package, which consists of a credit-
risky instrument with any payment characteristics
and a corresponding derivative contract that
exchanges the cash flows of that instrument for a
floating rate cash flow stream. In the case of (a), the
Credit Put (or Call) Option grants the Option Buyer
the right, but not the obligation, to sell to (or buy
from) the Option Seller a specified floating rate
Reference Asset at a prespecified price (the “Strike
Price”).
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3.2.3 Managing Credit Risk
◼ Credit options:
The credit options, which guards losses in the
value of a credit assets or helps to offset
higher borrowing costs that may occur due to
changes in credit rating.
For example, a depository institution worried
about default on a large $100 million loan it
has just made might approach an option
contract that pays off if the loan declines in
value or turns bad.
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 3.2.3 Managing Credit Risk
◼ Credit options:
If the borrowing customer pays off as promised. The
lender collects the loan revenue it expected to
gather and the option issued by the dealer does
unused. The lender lose premium it paid to the
dealer writing the option.
Many financial institution will take out similar credit
option to protect the value of securities held in their
investment portfolio should the securities’ issuer fail
to pay or should the securities decline significantly
value due to a change in credit standing.
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3.2.3 Managing Credit Risk
◼ Credit options:

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3.2.3 Managing Credit Risk
◼Collateralized Debt Obligations (CDO):
(NGHĨA VỤ NỢ CÓ/ĐƯỢC THẾ CHẤP)
A collateralized debt obligation (CDO) is
a structured financial product that pools together
cash flow-generating assets and repackages this
asset pool into discrete tranches that can be sold
to investors. A collateralized debt obligation is
named for the pooled assets — such as
mortgages, bonds and loans — that are
essentially debt obligations that serve
as collateral for the CDO.
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3.2.3 Managing Credit Risk
◼ Collateralized Debt Obligations (CDO):
The tranches in a CDO vary substantially in
their risk profiles. The senior tranches are
generally safer because they have first priority
on payback from the collateral in the event of
default. As a result, the senior tranches of a
CDO generally have a higher credit rating and
offer lower coupon rates than the junior
tranches, which offer higher coupon rates to
compensate for their higher default risk.
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3.2.3 Managing Credit Risk
◼ Collateralized Debt Obligations (CDO):
CDOs may contain pool of high-yield
corporate bonds, stocks, commercial
mortgages, or other financial instruments
contributed by business interested in
strengthening their balance sheets and raising
new funds.

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Collateralized debt obligation (CDOs)

◼ Ex : Collateralized loan obligations.

Bank

Loans
Sale or assignment

Special purpose
vehicle
Loans Issues asset-
backed certificates
 3.2.3 Managing Credit Risk
❖ Credit Risk Modeling
◼ When the bank has indications that a loan might not
be fully, it should recognize the loss and create
provisions. This operation decreases the value of
the loan (negative value on the side of asset) and
creates costs (which imply a decrease in net profits
and equity). For this purpose, the bank estimates so
called expected loss (EL). The expected loss is
based on the value of the loan (i.e. the exposure at
default, EAD) multiplied by the probability, that the
loan will default (i.e. probability of default, PD).
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3.2.3 Managing Credit Risk
❖ Credit Risk Modeling
◼ In addition, the bank takes into account that
even when the default occurs, it might still
get back some part of the loan (e.g. due to
the bankruptcy procedure). Hence, the
previous gure is further multiplied by the
estimation of the part of the loan which will
be lost in case that a default occurs (i.e. loss
given default, LGD).

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3.2.3 Managing Credit Risk
❖ Credit Risk Modeling

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3.2.3 Managing Credit Risk

❖ Risk Modeling:
EL = PD * LGD * EAD = PD * (1-RR) * EAD
- EL : Expected loss.
The expected loss part of the interest is as expected and the return
is as desired.
- PD : Probability of default forecast by the rating systems.
- LGD : Loss given default.
- EAD : Exposure at default.
- RR: Recover Rate (RR = 1 – LGD)
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3.2.3 Managing Credit Risk
❖ Risk Modeling:

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3.2.3 Managing Credit Risk

❖ Risk Modeling:
◼ PD : The Probability of Default is a financial
term describing the likelihood of a default over
a particular time horizon. It provides an
estimate of the likelihood that clients of a
financial institution will be unable to meet their
debt obligations. The PD is a key parameter
used in the calculation of regulatory capital
under Basel II and Basel III for a banking.
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 3.2.3 Managing Credit Risk
❖ Credit Risk Modeling:
◼ LGD : Loss Given Default is a common parameter in
Risk Models and also a parameter used in the
calculation of the regulatory capital under Basel II
and Basel III for a banking institution. This is an
attribute of any exposure on a bank’s client. The
exposure is the amount that one may lose in an
investment. A bank must provide an estimate of the
LGD for each corporate, sovereign and bank
exposure.
◼ For example: if the LGD equals 20 % one might lose
20 % of the exposure in case of a default. 89
❖ Credit Risk Modeling:

90
❖ Credit Risk Modeling:

91
❖ Credit Risk Modeling:
Normal loss distribution.

92
❖ Drill 1:
We illustrate by means of an example,
Example (calculation of EL).
• Loan portfolio EAD = $10 million;
• LGD = 10 percent;
• PD = 15 basis points (i.e., 0.15 percent)
• EL = PD * LGD * EAD
EL= 0.0015 *0.10 * $10 million = $1,500.
→ This means that the portfolio is expected
to lose $1,500 at the end of the loan period.
93
❖ Drill 2:
• If PD = 2%
• RR = 60%
• EAD = $10,000
• EL = PD * LGD * EAD
EL= 0.02 *(1 - 0.6) * $10,000 = $80.
EL can also be measured as a percentage of EAD:

→ EL% = PD * LGD = 0.02 * 0.4 = 0.8%

Expected loss as a percentage of EAD would
be equal to EL% = 0.8%
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 3.2.3 Managing Credit Risk

EAD is equal to the current amount outstanding in case of

fixed exposures like term loans.
•For revolving exposures like lines of credit :
EAD Drawn
•With : LEQ (Loan equivalent) is the percentage of unused
loan commitment drawn down by the borrower.

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3.2.3 Managing Credit Risk
• Theoretically, LGD is calculated in different ways, but the most
popular is 'Gross' LGD, where total losses are divided by
exposure at default.
Total losses
LGD
EAD

• With : Total losses = EAD – Loan recover.

• So : Loan
Loan recovery recover
rate
EAD
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 Credit risk management
◼ The credit management process :
Pre-assessment Reject

Accept
Model
Credit grading:

PD LGD EAD Correlations

CR Measurement

CR Management

Pricing Provisioning Capital allocation Grooming

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 3.2.3 Credit risk management
◼ Credit capital calculation :
RWA 12.5K

• RWA : Risk weighted assets. The Risk-Weighted Assets

are the bank’s exposures, weighted according to risk. This
asset calculation is used in determining the capital
requirement under Basel II and Basel III.
• K : Capital requirement.
• EAD : Exposure at default.

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 3.2.3 Credit risk management

• The multiplication of the capital requirement (K)

by 12.5 (1/12.5 = 0.08) is to ensure capital is no
less than 8% of RWA.

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