Risk Management in Banking Credit Risk Department of Banking and Financial Management M.Sc. in Financial Analysis for Executives Piraeus 2012

Contents Introduction Rating Systems Credit Risk: Historical Dates Using Quant Methods to Assess Credit Risk Credit Risk Analysis using Bloomberg

Credit Risk Definition Example Credit Events: The potential for loss due to a failure of a borrower to meet its contractual obligation to repay a debt in accordance with the agreed terms Credit Risk is also referred to as Default Risk Example Greece stops making payments to Greek bond holders A homeowner stops making mortgage payments A company fails to repay corporate lending Credit Events: Bankruptcy Failure to pay Loan restructuring Loan moratorium Accelerated loan payments

Credit Risk versus Market Risk Potential loss due to changes in market prices Usually assessed for a day Credit Risk Potential loss due to the nonperformance of a financial contract Usually assessed for a year Credit risk is generally more important for Banks Credit Products: Loans, Bonds Many credit risk drivers relate to market risk drivers Credit and Market Risk models, to assess risks, both use: Historical data Forward looking models Behavioral models

Credit Risk - Drivers Exposure Probability of Default Migration Risks Size of amount at risk with the counterparty – Direct valuation Probability of Default Size of the probability of the event of default – Direct valuation Migration Risks Deteriorations or improvements of the credit standing. Needs mark-to-market valuation Recovery Risk Take into account guarantees that protects lender from large exposures

Credit Risk – Rating Systems Credit standing of debt issues using coded letters Relative ranking, not absolute assessment of the level of risk External Ratings Third party view on the credit risk of debt Moody’s, S&P, Fitch Rates debt issues and not issuers SWOT Analysis Strengths Weaknesses Opportunities Threats Large listed companies and sovereign debt

Credit Risk – Rating Systems Credit standing of debt issues using coded letters Relative ranking, not absolute assessment of the level of risk Contrasts with probability of default which quantifies the likelihood of default over a given horizon External Ratings Third party view on the credit risk of debt Moody’s, S&P, Fitch Rates debt issues and not issuers SWOT Analysis Strengths Weaknesses Opportunities Threats Large listed companies and sovereign debt

Credit Risk – Rating Systems Internal Ratings Borrowers are usually medium or small businesses/households External rating not available Internal Ratings Based approach: strong tendency towards harmonization Includes: Borrowers risk Potential support Facility risk Financial attributes for credit standing: Size Operating Profitability Financial Profitability Financial Structure Cash Flow Operating Efficiency Operating Leverage Liquidity Market Value Volatility of earnings and sales

Credit Risk – Historical Data Yearly Default Rates Yearly default rates and ratings – Figure 36.1

Credit Risk – Historical Data Cumulative Default Rates Average Cumulative Default Rates by letter rating from 1 to 20 years (1920-1999) (%) – Figure 36.2

Credit Risk – Historical Data Cumulative Default Rates Average Cumulative Default Rates by letter rating from 1 to 20 years (1920-1999) (%) – Figure 36.2

Credit Risk – Historical Data Recovery rates by seniority level of debt Table 36.3

Credit Risk – Historical Data All- corporate rating transition matrix Table 36.4

Credit Risk – Quant Models Rating models assigns ratings from linking credit status to observable attributes of borrowers Default risk models are based on similar attributes to derive the default probability Credit Scoring (discriminate between defaulters and non-defaulters) Econometric techniques (model default rates of “portfolio segments” or subpopulations of firms by risk class) Neural Networks (non linear relations) Scoring Analysis Discriminant Analysis (Fischer) The Zeta Score (Altman’s model)