AC959 Bank Strategy and Risk

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AC959 Bank Strategy and Risk

• Lecture 6
• Credit risk (Recent developments)

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Aims of lecture

• Understand the key recent developments in credit
  risk management
• Understand the importance of credit ratings to
  credit risk
• Explain how the following assist in managing
  credit risk
• Credit default swaps
• Asset securitisation
• Credit risk modelling

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Credit ratings

• Rating categories
• Types of bonds
• Historical default rates

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Credit derivatives

• Credit derivatives are financial contracts that
  involve a potential exchange of payments in which
  at least one of the cash flows is linked to the
  performance of a specified underlying
  credit-sensitive asset. So credit derivatives are
  financial contracts that enable participants to
  trade in credit as an asset, as they isolate and
  transfer credit risk.

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Credit Events

• Bankruptcy
• Failure to Pay
• Obligation Acceleration
• Obligation Default
• Debt Moratorium
• Restructuring and Modified Restructuring

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Example of Credit Default Swap (CDS)
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Benefits of CDS to banks

• Transfer credit risk / reduce credit exposure
• Reference credit is unaware protect
  relationships
• Transfer risk on illiquid assets
• Protection seller obtains access to credit risk
  of reference assets diversify own portfolio

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Asset Securitisation

• The process whereby loans, receivables and other
  financial assets are pooled together, with their
  cash flows or economic values redirected to
  support payments on related securities. These
  securities, which are generally referred to as
  asset-backed securities or ABS are issued and
  sold to investors by issuers, who utilise
  securitisation to finance their business
  activities.
• European Securitisation Forum

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Securitisation - Impact on bank B/S
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Benefits of securitisation

• Remove poorly performing assets from the balance
  sheet enhance profitability
• Provide capital
• Transfer credit risk OBS
• Protect relationships
• Transfer illiquid assets
• Buyer of ABS obtains access to new asset classes

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Credit Risk Modelling

• Move from individual credit risks to modelling
  the credit risk of the portfolio
• Lower regulatory capital charge
• Off the shelf models
• CreditMetrics
• CreditRisk
• KMV Portfolio Manager
• Bespoke models

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Key modelling terms

• Exposure at default (EAD)
• Loss given default (LGD)
• LGD EAD X (1-recovery rate )
• Default probability (DP)

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Recovery rate percentages
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Credit modelling example

• Two-asset portfolio
• Asset 1 BBB rated bond
• Asset 2 A rated bond
• Risk horizon One-year

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Transition matrix
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BBB bond transition matrix
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BBB bond future value
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BBB bond value and probability
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BBB bond probability distribution
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A bond values in one year
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A bond transition matrix
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Possible portfolio values
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Joint probability likelihoods correlation 0.3
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Joint probability distribution
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Benefits of credit risk modelling

• Expands credit risk approaches to measure and
  model portfolio credit risk
• Calculate appropriate capital
• Calculate marginal credit risk of a new asset in
  the portfolio
• Monitor the relationships between different assets

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Concerns with credit risk modelling

• Forecast accuracy of models
• Require regular evaluation of the model
  back-testing
• Only as good as the specification
• Rely on historical data
• Costly for smaller banks to implement