Credit Risk

Risk Assessment

Article

Risk assessment is a step in a risk management procedure. Risk assessment is the determination of quantitative or qualitative value of risk related to a concrete situation and a recognized threat (also called hazard). Quantitative risk assessment requires calculations of two components of risk (R):, the magnitude of the potential loss (L), and the probability (p) that the loss will occur. In all types of engineering of complex systems sophisticated risk assessments are often made within Safety engineering and Reliability engineering when it concerns threats to life, environment or machine functioning. The nuclear, aerospace, oil, rail and military N. industries have a long history of dealing with risk assessment. Also, medical, hospital, and food industries control risks and perform risk assessments on a continual basis. Methods for assessment of risk may differ between industries and whether it pertains to general financial decisions or environmental, ecological, or public health risk assessment.

 

Credit risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do. The risk is primarily that of the lender and include lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial and can arise in a number of circumstances.

For example:

  • A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan
  • A company is unable to repay amounts secured by a fixed or floating charge over the assets of the company
  • A business or consumer does not pay a trade invoice when due
  • A business does not pay an employee's earned wages when due
  • A business or government bond issuer does not make a payment on a coupon or principal payment when due
  • An insolvent insurance company does not pay a policy obligation
  • An insolvent bank won't return funds to a depositor
  • A government grants bankruptcy protection to an insolvent consumer or business

 

To reduce the lender's credit risk, the lender may perform a credit check on the prospective borrower, may require the borrower to take out appropriate insurance, such as mortgage insurance or seek security or guarantees of third parties, besides other possible strategies. In general, the higher the risk, the higher will be the interest rate that the debtor will be asked to pay on the debt.

 

 

Types of credit risk

                                                                                              

Credit risk can be classified in the following way:

 

  • Credit default risk - The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or the debtor is more than 90 days past due on any material credit obligation; default risk may impact all credit-sensitive transactions, including loans, securities and derivatives.
  • Concentration risk - The risk associated with any single exposure or group of exposures with the potential to produce large enough losses to threaten a bank's core operations. It may arise in the form of single name concentration or industry concentration.
  • Country risk - The risk of loss arising from a sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk).

 

Assessing credit risk

 

Credit analysis and Consumer credit risk

 

Credit analysis - is the method by which one calculates the creditworthiness of a business or organization. The audited financial statements of a large company might be analyzed when it issues or has issued bonds. Or, a bank may analyze the financial statements of a small business before making or renewing a commercial loan. The term refers to either case, whether the business is large or small.

 

Credit analysis involves a wide variety of financial analysis techniques, including ratio and trend analysis as well as the creation of projections and a detailed analysis of cash flows. Credit analysis also includes an examination of collateral and other sources of repayment as well as credit history and management ability. Analysts attempt to predict the probability that a borrower will default on its debts, and also the severity of losses in the event of default. Credit spreads--the difference in interest rates between theoretically "risk-free" investments such as U.S. treasuries or LIBOR and investments that carry some risk of default--reflect credit analysis by financial market participants.

 

Before approving a commercial loan, a bank will look at all of these factors with the primary emphasis being the cash flow of the borrower. A typical measurement of repayment ability is the debt service coverage ratio. A credit analyst at a bank will measure the cash generated by a business (before interest expense and excluding depreciation and any other non-cash or extraordinary expenses). The debt service coverage ratio divides this cash flow amount by the debt service (both principal and interest payments on all loans) that will be required to be met. Commercial Bankers like to see debt service coverage of at least 120 percent. In other words, the debt service coverage ratio should be 1.2 or higher to show that an extra cushion exists and that the business can afford its debt requirements

 

 

Consumer Credit Risk Management - Most companies involved in lending to consumers have departments dedicated to the measurement, prediction and control of losses due to credit risk. This field is loosely referred to consumer/retail credit risk management; however the word management is commonly dropped.

 

Scorecards - A common method for predicting credit risk is through the credit scorecard. The scorecard is a statistically based model for attributing a number (score) to a customer (or an account) which indicates the predicted probability that the customer will exhibit a certain behaviour. In calculating the score, a range of data sources may be used, including data from an application form, from credit reference agencies or from products the customer already holds with the lender.

The most widespread type of scorecard in use is the application scorecard, which lenders employ when a customer applies for a new credit product. The scorecard tries to predict the probability that the customer, if given the product, would become "bad" within a given timeframe, incurring losses for the lender. The exact definition of what constitutes "bad" varies across different lenders, product types and target markets, however examples may be "missing three payments within the next 18 months" or "default within the next 12 months". The score given to a customer is usually a three or four digit integer, and in most cases is proportional to the natural logarithm of the odds (or logit) of the customer becoming "bad". In general a low score indicates a low quality (a high chance of going "bad") and a high score indicates the opposite.

Other scorecard types may include behavioural scorecards - which try to predict the probability of an existing account turning "bad"; propensity scorecards - which try to predict the probability that a customer would accept another product if offered one; and collections scorecards - which try to predict a customer's response to different strategies for collecting owed money.

Credit Strategy - Credit strategy is concerned with turning predictions of customer behaviour (as provided by scorecards) into a decision whether to accept their custom.

To turn an application score into a Yes/No decision, "cut-offs" are generally used. A cut-off is a score at and above which customers have their application accepted and below which applications are declined. The placement of the cut-off is closely linked to the price Annual Percentage Rate (Application score is also used as a factor in deciding such things as an overdraft or credit card limit. Lenders are generally happier to extend a larger limit to higher scoring customers than to lower scoring customers, because they are more likely to pay borrowings back. Alongside scorecards lie policy rules which apply regulatory requirements (such as making sure there is no lending to under 18s) and other lending policy (such as many lenders will not lend to customers who have a County Court Judgment (CCJ) registered against them). Credit Strategy is also concerned with the ongoing management of a customer's account, especially with revolving credit products such as credit cards, overdrafts and flexible loans, where the customer's balance can go up as well as down. Behavioural scorecards are used (usually monthly) to provide an updated picture of the credit-quality of the customer/account. As the customer's profile changes, the lender may choose to extend or contract the customer's limits.

Comments:

Significant resources and sophisticated programs are used to analyze and manage risk. Some companies run a credit risk department whose job is to assess the financial health of their customers, and extend credit (or not) accordingly. They may use in house programs to advise on avoiding, reducing and transferring risk. They also use third party provided intelligence. Companies like Standard & Poor's, Moody's, Fitch Ratings, and Dun and Bradstreet provide such information for a fee.

Most lenders employ their own models (credit scorecards) to rank potential and existing customers according to risk, and then apply appropriate strategies. With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa.  With revolving products such as credit cards and overdrafts, risk is controlled through the setting of credit limits. Some products also require security, most commonly in the form of property.

Credit scoring models also form part of the framework used by banks or lending institutions grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively. Once this information has been fully reviewed by credit officers and credit committees, the lender provides the funds subject to the terms and conditions presented within the contract (as outlined above).

Credit risk has been shown to be particularly large and particularly damaging for very large investment projects, so-called megaprojects. This is because such projects are especially prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays, etc. – the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt.

Sovereign risk - is the risk of a government becoming unwilling or unable to meet its loan obligations, or reneging on loans it guarantees.  Many countries have faced sovereign risk in the late-2000s global recession. The existence of such risk means that creditors should take a two-stage decision process when deciding to lend to a firm based in a foreign country. Firstly one should consider the sovereign risk quality of the country and then consider the firm's credit quality.

Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:

  • Debt service ratio
  • Investment ratio
  • Domestic money supply growth

The probability of rescheduling is an increasing function of debt service ratio, import ratio, variance of export revenue and domestic money supply growth.

Counterparty risk - A counterparty risk, also known as a default risk, is a risk that a counterparty will not pay what it is obligated to do on a bond, credit derivative, trade credit insurance or payment protection insurance contract, or other trade or transaction when it is supposed to. Financial institutions may hedge or take out credit insurance of some sort with a counterparty, which may find themselves unable to pay when required to do so, either due to temporary liquidity issues or longer term systemic reasons.

Large insurers are counterparties to many transactions, and thus this is the kind of risk that prompts financial regulators to act, e.g., the bailout of insurer AIG.

 

  • Covenants:  Lenders may write stipulations on the borrower, called covenants, into loan agreements:
    • Periodically report its financial condition
    • Refrain from paying dividends, repurchasing shares, borrowing further, or other specific, voluntary actions that negatively affect the company's financial position
    • Repay the loan in full, at the lender's request, in certain events such as changes in the borrower's debt-to-equity ratio or interest coverage ratio
  • Tightening: Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30 to net 15.
  • Deposit insurance: Many governments establish deposit insurance to guarantee bank deposits of insolvent banks. Such protection discourages consumers from withdrawing money when a bank is becoming insolvent, to avoid a bank run, and encourages consumers to hold their savings in the banking system instead of in cash.

 

ACPM  - Active credit portfolio management

  • EL - Expected loss
  • LGD - Loss given default
  • KMV - quantitative credit analysis solution acquired by credit rating agency Moody's
  • EL = PD * EAD * LGD - Expected Loss formula

Activity

Benefit

Governance and sustainability

  • Enable strong alignment between strategic objectives, risk management, and compliance activities to create stakeholder value
  • Minimize fragmentation of governance, risk, and compliance (GRC ) information
  • R educe redundant efforts and resources spent on multiple GRC requirements
  • Provide a foundation for risk-return portfolio optimization, business performance optimization, business control, transparency, and predictability

Risk management

  • Improve management’s ability to achieve strategic objectives by monitoring operational data to automatically identify risks and reduce them through effective controls
  • Understand the key risks the organization faces to help ensure that a comprehensive strategy is in place to manage risks in the best possible manner
  • Gain new insights for decision making and capital allocation across various risk classes (for example, insurance, operational, external, and financial)
  • Reduce the probability of default, credit downgrade, or serious financial loss

Business process control

  • Maximize strategic and operational effectiveness by monitoring performance and managing risk for key business processes
  • Help ensure compliance with corporate governance and regulations by unifying control management across the enterprise through a single system of record that can adapt to changing business needs
  • Gain insight by aligning controls with strategic objectives by operating within risk appetite
  • Save money and effort by automating control testing and accelerate time to resolution with remediation case management
  • Reduce cost by streamlining manual evaluation, issue identification, and remediation
  • Provide real-time visibility of control effectiveness and remediation of key issues, eliminating surprises
  • Enable more timely and accurate financial close processes and reporting
  • Proactively enforce global and local data privacy policies throughout the extended enterprise using business rules and applications with the IT infrastructure and networking

Access and authorization control

  • Enable all corporate compliance stakeholders to collaboratively manage the enforcement of proper segregation of duties (SoD)
  • Detect and resolve violations of segregation of duties and user authorization control by removing access or mitigating situations in which duties cannot be segregated
  • Jump-start compliance setup with a comprehensive library of best practices and rules for SoD
  • Help ensure efficient and compliant provisioning of user access throughout the employee life cycle
  • Provide users with privileged but controlled access to quickly address emergency requirements
  • Address access and authorization issues at their inception using enterprise role management

Global trade services

  • Help ensure vigilant trade compliance and help facilitate tighter national security
  • Streamline electronic communications with customs authorities
  • Enhance process efficiency through tight integration into inbound and outbound processes
  • Maximize opportunities offered by trade preference agreements
  • Mitigate the financial risk of international trade with letter of credit management

Environment, health, and safety (EHS) management

  • Manage operational and financial risks with an integrated management and operational tool that helps govern and execute a company’s EHS compliance and risk management strategy
  • Overcome challenges created by best-of-breed systems and reduce costs of global EHS compliance by harmonizing and automating processes with one comprehensive application across the entire organization
  • Reduce energy use by identifying opportunities to implement energy conservation projects

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Published under: Credit Risk
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