1. Basic Principles for Credit Risk Management
Prof. Dan Galai

2. Types of Financial Risks

3. 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
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4. 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
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5. 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
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6. The old regulatory environment:
BIS 1988 or the Accord

7. 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)
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8. BIS 88 Risk weighted amount = S Assets * WA +
S Credit equivalent * WCE
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9. BIS 88
Risk capital weights by broad on-balance sheet asset category (WA)
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10. 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 + =
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11. Add-on factors by type of underlying and maturity
BIS 88
Add-on factors by type of underlying and maturity
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12. 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 =
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13. BIS 88
Risk capital weights for off balance credit equivalents by type of counterparty (WCE)
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14. 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
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15. 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
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16. 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
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17. 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%
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18. 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
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19. 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) % =
$1.6
(L+50) x $ bp x $100 - (L-20) x $98.4
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20. 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.
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21. 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
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22. 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
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