Basic Principles for Credit Risk Management Prof. Dan Galai

Types of Financial Risks

Types of financial risks Components of financial risks Market Financial risks Credit Operational Risk refers to the degree of uncertainty of future net returns. This uncertainty takes many forms: a useful classification of risks is based on the source of the underlying uncertainty. Market risk involves the uncertainty of future earnings resulting from changes in market conditions (prices of financial assets, interest rates, volatility). Credit risk estimates the potential loss due to the inability of a counterparty to meet his/her obligations. Liquidity risk is related to the market impact of buying and selling a financial instrument. Operational risk results from dysfunctions in the process (ie. breakdown of internal controls as for barings, Daiwa and Sumitomo, errors that can be made in instructing payments reporting a trade or settling transactions) or from model errors when revaluing OTC positions. Liquidity Human Factor Legal & Regulatory 8/13/98 10:26 AM \\israel98.ppt

Types of financial risks Market risk is multidimensional CM 40 3/4 PJF 98 5/8 ETN 49 1/2 Equity risk Financial risks Market risk Yield % Term to Maturity 5 yrs 9.25% 8.75% Interest rate risk Currency risk Commodity risk 8/13/98 10:26 AM \\israel98.ppt

Types of financial risks One can “slice and dice” these multiple dimensions of risks Interest rate Market risk Commodity prices Currency risk Equity risk Transaction risk Financial risks Credit risk Portfolio concentration risk Process risk Operational risk Infrastructural or Leverage risk Model risk 8/13/98 10:26 AM \\israel98.ppt

The old regulatory environment: BIS 1988 or the Accord

Capital >8% of Risk Weighted Assets (RWA) BIS 88 Capital adequacy requirements 1. Assets to capital multiple (overall measure of the bank’s capital adequacy) Total assets (including specified off-balance sheet items) / capital < 20 2. Risk based capital ratio (solvency ratio which focuses on credit risk associated with on-and off-balance sheet exposures) Capital >8% of Risk Weighted Assets (RWA) 8/13/98 10:26 AM \\israel98.ppt

BIS 88 Risk weighted amount = S Assets * WA + S Credit equivalent * WCE 8/13/98 10:26 AM \\israel98.ppt

BIS 88 Risk capital weights by broad on-balance sheet asset category (WA) 8/13/98 10:26 AM \\israel98.ppt

BIS 88 Step 1: Credit-equivalent amount Calculating BIS risk-weighted amounts for derivative products Step 1: Credit-equivalent amount Current replacement cost Add-on amount Credit equivalent + = 8/13/98 10:26 AM \\israel98.ppt

Add-on factors by type of underlying and maturity BIS 88 Add-on factors by type of underlying and maturity 8/13/98 10:26 AM \\israel98.ppt

BIS 88 Calculating BIS risk-weighted amounts for derivative products Step 1: Credit-equivalent amount Current replacement cost Add-on amount Credit equivalent + = Step 2: Risk weighted amount Credit equivalent Counterparty risk weighting Risk weighted amount x = 8/13/98 10:26 AM \\israel98.ppt

BIS 88 Risk capital weights for off balance credit equivalents by type of counterparty (WCE) 8/13/98 10:26 AM \\israel98.ppt

Counterparty Risk for Portfolio 1 (with a corporate counterparty) BIS 88 Counterparty Risk for Portfolio 1 (with a corporate counterparty) Replacement cost = 0 (at-the-money swap) Add-on = 100M USD x 1.5% = 1,500,000 USD Risk-weighted amount = 1,500,000 USD x 50% = 750,000 USD Capital charge = 750,000 USD x 8% = 60,000 USD 8/13/98 10:26 AM \\israel98.ppt

BIS 88 The Accord is flawed. The Accord does not address complex issues like: portfolio diversification (credit risk is partially offset by diversification across issuers, industries and geographical locations netting 8/13/98 10:26 AM \\israel98.ppt

BIS 88 The Accord produces a distorted assessment of actual risks and a misallocation of capital: ignores market risk for tradable securities generates regulatory arbitrage opportunities 8/13/98 10:26 AM \\israel98.ppt

The New Regulatory and Corporate Environment Regulatory Arbitrage is forcing Regulators to move away from standardized approach toward internal models approach Example of Regulatory Arbitrage: High Quality Bank A Funding Cost Libor -20 bp (on 92% of nominal) Libor + 50 bp XYZ $100M Capital Charge = 8% Net revenue = $1.1M Return on capital = 13.7% (1) 13.75% = (L+50) x $100 - (L-20) x $92 $8 (1) Assume Libor (L) = 5.2% 8/13/98 10:26 AM \\israel98.ppt

The New Regulatory and Corporate Environment Example of Regulatory Arbitrage: Long a corporate loan and long a credit swap from an OECD Bank to hedge credit risk exposure. Capital treatment: full offsetting of credit risk related to XYZ loan, no capital charge against loan package capital add-on = Principal x risk weight (OECD Bank) x 8% = $100m x 20% x 8% = $1.6m 8/13/98 10:26 AM \\israel98.ppt

The New Regulatory and Corporate Environment Example of Regulatory Arbitrage: } } High Quality Bank A 50 bp Lower Quality Bank B Seller of credit derivative Buyer of credit derivative Zero No default or Default Par - recovery Libor + 50 bp XYZ $100M Funding cost Libor - 20 bp (on 98.4 % of nominal) Net Capital charge = 1.6% Net revenue = $280,000 Return on capital = 17.5% (2) (2) 17.5% = $1.6 (L+50) x $100 - 50bp x $100 - (L-20) x $98.4 8/13/98 10:26 AM \\israel98.ppt

BIS 88 Regulators are slowly beginning to acknowledge that standardized regulatory measures such as growth in Risk Weighted Assets (RWA) fail to provide meaningful transparency in terms of measuring the Amount at Risk. 8/13/98 10:26 AM \\israel98.ppt

BIS 88 Growth in RWA does not tell the whole story Example 1: Revolvers less than one year do not require any RWA Example 2: Loan to GE requires 5 times as much RWA as a loan to a Japanese City bank Example 3: Loan to AA counterparty receives same RWA as a loan to BB counterparty Example 4: RWA do not reflect concentration Risk 8/13/98 10:26 AM \\israel98.ppt

BIS 88 Increasing Diversification Example: A single $100 loan to a BB counterparty receives same amount of RWA as 100 different $1 loans to 100 different BB counterparties Total Risk Specific Risk Systematic Risk Increasing Diversification 8/13/98 10:26 AM \\israel98.ppt