Basic Principles for Credit Risk Management Prof Dan

Basic Principles for Credit Risk Management Prof. Dan Galai

Types of Financial Risks

Types of financial risks n Components of financial risks Market Financial risks Credit Operational Liquidity Human Factor Legal & Regulatory Montrea 3. ppt 3

Types of financial risks n Market risk is multidimensional Equity risk Financial risks Market risk ETN PJF 49 1/2 98 5/ 8 CM 40 3/4 9. 25% Interest rate risk Yield 8. 75% % 5 yrs Term to Maturity Currency risk Commodity risk Montrea 3. ppt 4

Types of financial risks n One can “slice and dice” these multiple dimensions of risks Interest rate Market risk Commodity prices Currency risk Equity risk Financial risks Montrea 3. ppt Transaction risk Credit risk Portfolio concentration risk Operational risk Process risk Infrastructural or Leverage risk Model risk 5

The old regulatory environment: BIS 1988 or the Accord

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 offbalance sheet exposures) Capital >8% of Risk Weighted Assets (RWA) 8/13/98 10: 26 AM \israel 98. ppt

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

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

BIS 88 Calculating BIS risk-weighted amounts for derivative products Step 1: Credit-equivalent amount Current replacement cost + Add-on amount = Credit equivalent 10

BIS 88 Add-on factors by type of underlying and maturity 11

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 x Counterparty risk weighting = Risk weighted amount 12

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

BIS 88 Counterparty Risk for Portfolio 1 (with a corporate counterparty) Replacement cost = 0 (at-the-money swap) Add-on = 100 M 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 14

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

BIS 88 n 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 \israel 98. 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: Libor + 50 bp High Quality Bank A Funding Cost Libor -20 bp (on 92% of nominal) XYZ $100 M (1) Assume Libor (L) = 5. 2% 13. 75% = (L+50) x $100 - (L-20) x $92 $8 8/13/98 10: 26 AM \israel 98. ppt Capital Charge = 8% Net revenue = $1. 1 M Return on capital = 13. 7% (1)

The New Regulatory and Corporate Environment Example of Regulatory Arbitrage: n Long a corporate loan and long a credit swap from an OECD Bank to hedge credit risk exposure. Capital treatment: n full offsetting of credit risk related to XYZ loan, no capital charge against loan package n capital add-on = Principal x risk weight (OECD Bank) x 8% = $100 m x 20% x 8% = $1. 6 m 18

The New Regulatory and Corporate Environment Example of Regulatory Arbitrage: High Quality Bank A } Buyer of credit derivative 50 bp Zero or Par - recovery No default Default Lower Quality Bank B } Seller of credit derivative Libor + 50 bp XYZ $100 M (2) 8/13/98 10: 26 AM 17. 5% = Funding cost Libor - 20 bp (on 98. 4 % of nominal) (L+50) x $100 - 50 bp x $100 - (L-20) x $98. 4 $1. 6 \israel 98. ppt Net Capital charge = 1. 6% Net revenue = $280, 000 Return on capital = 17. 5% (2)

BIS 88 n 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 \israel 98. ppt

BIS 88 Growth in RWA does not tell the whole story n n 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 \israel 98. ppt

BIS 88 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 8/13/98 10: 26 AM \israel 98. ppt Increasing Diversification