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Unit 8 Managing Credit Risk - An Overview

Managing credit risk is important for banks. There are expected losses which can be budgeted for, and unexpected losses which require adequate capital reserves. Credit risk is defined as the probability of default on loan obligations. The goals of credit risk management are to maximize risk-adjusted returns while keeping credit risk exposure within acceptable parameters. Banks must manage risk at the individual loan level as well as within their overall loan portfolios.

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57 views16 pages

Unit 8 Managing Credit Risk - An Overview

Managing credit risk is important for banks. There are expected losses which can be budgeted for, and unexpected losses which require adequate capital reserves. Credit risk is defined as the probability of default on loan obligations. The goals of credit risk management are to maximize risk-adjusted returns while keeping credit risk exposure within acceptable parameters. Banks must manage risk at the individual loan level as well as within their overall loan portfolios.

Uploaded by

Subha Ranjani
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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UNIT 8 MANAGING CREDIT RISK AN OVERVIEW

Losses

Types of losses
Expected
Can

losses

be budgeted and provisions created (offsets adverse effects on banks balance sheet)

Unexpected
Can

losses

be managed by holding adequate capital

Unexpected Loss is the standard deviation of expected losses

Expected losses
EL = PD * EAD * LGD

EL = Expected loss PD = probability of default (the risk that borrower will not service the debt) EAD = Exposure at default LGD = Loss Given Default = (Exposure Recovery)

Credit Risk

Credit risk is defined as the probability that a bank borrower will fail to meet its obligations in accordance with agreed terms Expected losses are already taken into account during loan pricing Unexpected losses arise when there is variation in actual loss level

Credit Risk

Goal of credit risk management


Maximizing

banks risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters

Criteria for the bank to manage credit risk


The

risk in individual credits or transactions The credit risk inherent in the entire portfolio The relationship between credit risk and other risks

Elements of Credit Risk


Credit Risk Standalone/single party risk PD Migration or transition risk LGD

Credit portfolio risk

Default correlations
exposure

Credit risk of the portfolio

Factors for consideration by banks


Loan

pricing to compensate for the risk Concentration of loans in specific industry or economic activity (to mitigate this risk central bank will propose an optimum exposure rate for the banks in specific industries)

Relationship between credit risk and other risks


Largest

source of credit risk loans Other sources acceptances, inter-bank transactions, forex transactions, trade financing, futures, options, swaps etc.

BASEL Committees principles of Credit Risk Management

Credit risk program activities


Establishing

an appropriate credit risk environment Operating with sound credit granting process Good credit administration, measurement and monitoring process Adequate controls over credit risks

Classifying impaired loans (Impaired loans also called criticized assets) Categories of impaired loans
Special

mentioned loans

BASEL Committees principles of Credit Risk Management

Categories of impaired loans


Special

mentioned loans Sub-standard assets Doubtful assets Loss assets Partially charged off loans

Credit risk models

Markowitz portfolio analysis model equity portfolios For debt portfolio, appropriate models have not been developed
Debt

default can happen suddenly Loan pricing including expected losses can be misjudged Banks are highly leveraged entities

Credit concentration

When the banks portfolio contains a high level of direct or indirect credit to
A

single borrower Group of associated borrowers


Specific

conventional credit concentrations

industry/ economic activity Geographic region Specific country One type of credit facility Specific type of security

Measuring credit risk Basic Model

Assessing impact of NPAs and write-offs on Banks profits PBT/NPAs or (PBT/TA) / (NPA/TA) ((PAT/(1-t)) / TA) / (NPA/TA) When PBT/NPA = .7 (called margin of safety)
Means

70 % of NPAs turn into loss assests

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