FIN10109-4 CREDIT RISK.ppt

FIN10109FinancialServicesRiskManagement Unit4CreditRiskofFinancialServiceInstitutions Learningoutcomes tounderstandwhatcreditriskis tolearnthreecomponentsofcreditriskandtheirowncontributionstocreditrisk toquantifythecreditrisk thebasiccreditriskmeasurementmodelsandtheirapplications RecommendedReading J Bessis 1998 Ch 7 SaundersandCornett 2006 Ch 11 CreditQualityProblems Problemswithjunkbonds LDCloans residentialandfarmmortgageloans Morerecently creditcardandautoloans CrisesinAsiancountriessuchasKorea Indonesia Thailand andMalaysia DefaultofonemajorborrowercanhavesignificantimpactonvalueandreputationofmanyFIsEmphasizesimportanceofmanagingcreditrisk Whatiscreditrisk Creditriskisdefinedbythelossesintheeventofdefaultoftheborrowersorintheeventofadeteriorationoftheborrowers creditquality Ordefinedasthe thepotentialthatabankborrowerorcounterpartywillfailtomeetitsobligationsinaccordancewithagreedterms BasleCommitteeonBankingSupervision 2000 CreditQualityProblems Overtheearlytomid1990s improvementsinNon PerformingLoans NPLs forlargebanksandoverallcreditquality Late1990sconcernovergrowthinlowqualityautoloansandcreditcards declineinqualityoflendingstandards ExposuretoEnron Late1990sandearly2000s telecomcompanies techcompanies Argentina Brazil Russia SouthKoreaMid2000s economicgrowthaccompaniedbyreductioninNPLsNewtypesofcreditriskrelatedtoloanguaranteesandoff balance sheetactivities Increasedemphasisoncreditriskevaluation LoanGrowthandAssetQuality TypesofLoans Commercial Industrialloans securedandunsecuredSyndication extremelylargeloansituations onelendercanprovidealargeloanwhilemaintainingamoreprudentandmanageablecreditexposurebecausethelenderisn ttheonlycreditorSpotloans LoancommitmentsDeclineinC Iloansoriginatedbycommercialbanksandgrowthincommercialpapermarket DowngradesofFord GeneralMotorsandTycoREloans primarilymortgagesFixed rate ARMMortgagescanbesubjecttodefaultriskwhenloan to valuedeclines Consumerloans Individual consumer loans personal auto creditcard Non revolvingloansAutomobile mobilehome personalloansGrowthincreditcarddebtVisa MasterCardProprietarycardssuchasSears AT TConsolidationamongcreditcardissuersBankofAmerica MBNARisksaffectedbycompetitiveconditionsandusuryceilings AnnualNetCharge OffRatesonLoans Otherloans Otherloansinclude FarmloansOtherbanksNon bankFIsBrokermarginloansForeignbanksandsovereigngovernmentsStateandlocalgovernments ReturnonaLoan Factors interestpayments fees creditriskpremium collateral otherrequirementssuchascompensatingbalancesandreserverequirements Return inflow outflowkisthepromisedgrossreturnof directfees originationfees BR baserate orbankrateintheUK m riskpremiumb CompensatingbalanceRR ReserveRate1 k 1 of BR m 1 b 1 RR ReturnonaLoan cont Expectedreturn E r p 1 k 1wherepequalsprobabilityofrepaymentNotethatrealizedandexpectedreturnmaynotbeequal LendingRatesandRationing Atretail Usuallyasimpleaccept rejectdecisionratherthanadjustmentstotherate Creditrationing Ifaccepted customerssortedbyloanquantity Formortgages discriminationvialoantovalueratherthanadjustingratesAtwholesale Usebothquantityandpricingadjustments MeasuringCreditRisk Availability qualityandcostofinformationarecriticalfactorsincreditriskassessmentFacilitatedbytechnologyandinformationQualitativemodels borrowerspecificfactorsareconsideredaswellasmarketorsystematicfactors Specificfactorsinclude reputation leverage volatilityofearnings covenantsandcollateral Marketspecificfactorsinclude businesscycleandinterestratelevels The quantity ofriskdepends TheoutstandingbalancelenttotheborrowerThe quality ofriskdepends ThechancesthatthedefaultoccursTheguaranteesthatreducethelossintheeventofdefaultTheoutstandingbalanceatthedateofdefault lossintheeventofdefaultPotentialrecoveriesThird partyguaranteesCollateralThecapabilityofnegotiatingwiththeborrowerThefundavailable MeasuringCreditRisk CreditRiskanditsunderlyingrisks DefaultriskMissingapaymentobligationBreakingacovenantEnteringalegalprocedurePurelyeconomicreasonsMeasurementofdefaultrisk DefaultProbabilityTheprobabilitythatdefaultoccursduringagivenperiodoftime Howdowemeasuredefaultprobability Orcanwemeasureit Defaultrisk Defaultriskdependson thecreditstandingofaborrowerSuchcreditstandingdependson BorrowerspecificfactorsReputation theborrowing lendinghistoryofthecreditapplicantLeverage Aborrower sratioofdebttoequityVolatilityofearning ahighlyvolatileearningsstreamvs fixedinterestandprincipalchargesforanygivencapitalstructure Defaultrisk cont 2 Market specificfactorsThebusinesscycle thepositionoftheeconomyinthebusinessescyclephase e g recessionThelevelofinterestrateMeasurementofDefaultProbabilityDefaultprobabilitycannotbemeasureddirectly Historicalstatisticsofdefaultscanbeused NormallyagenciesrateisusedThequalityofdefaultriskisdefinedasthe severityoflosses whichdependsuponbothdefaultprobabilityandrecoveries Defaultrisk cont Generatedbytheuncertaintyprevailingwithfutureamountsatrisk Anestimationoftheextenttowhichabankmaybeexposedtoacounterpartyintheeventof andatthetimeof thatcounterparty sdefaultExposureriskcanalmostbeneglected creditlineswitharepaymentscheduleHowever cannotbeignoredin OverdraftbalancesProjectfinancingAlltheoff balancesheetitems Exposurerisk Notpredictable Dependsupon ThetypeofdefaultCollateralriskTheexistenceofcollateralTypesofcollateralsThevalueofcollateralThirdpartyguaranteesriskBoththeborrowerandtheguarantordefaultatthesametime LegalriskAllcommitmentsoftheborrowerwillbesuspendedRecoveryisdelayedNorecoveryatall Recoveryrisk DifferentmodelstoassessthedefaultriskVaryfromrelativelyqualitativetothehighlyquantitativemodelsNotmutuallyexclusive mayusemorethanonemodeltoreachacreditpricingorloanquantityrationingdecision Measurementofcreditrisk Qualitativemodels Informationfromprivatesources creditanddepositfilesUsingtheborrower specificfactorsandmarket specificfactorsWeightthesefactorssubjectivelyMakeaninformedjudgmentontheprobabilityofdefaultExpertsystems CreditscoringmodelsUseborrowercharacteristicstocalculateascoreRepresentingprobabilityofdefaulttosortborrowersintodifferentdefaultriskclassesImportanceofcreditscoringmodels 1 Numericallyestablishwhichfactorsareimportant2 Evaluatetherelativedegreeofimportanceofthesesfactors3 Improvethepricingofdefaultrisk4 toquantifytheneededreserves Quantitativemodels Usespastdata suchasfinancialratios asinputsintoamodelTherelativeimportanceofthefactorsusedinexplainingpastrepaymentperformanceThenforecastrepaymentprobabilitiesonnewloans theestimatedimportanceofthejthvariableinexplainingpastrepaymentexperience asetofjvariablesthatreflectquantitativeinformation Linearprobabilitymodels Supposethereweretwofactorsinfluencingthepastdefaultbehaviourofborrowers theleverageordebt equityratio D E andthesales assetratio S A Basedonpastdefault repayment experience thelinearprobabilitymodelisestimatedas AssumeaprospectiveborrowerhasaD E 0 3andanS A 2 0 Itsexpectedprobabilityofdefault PD canthenbeestimatedas Linearprobabilitymodels example Issueswithlinearprobabilitymodels Statisticallyunsoundsincethedefaultprobabilitiesobtainedarenotnecessarilyprobabilitiesbut Superiorstatisticaltechniquesexistwhicharereadilyavailable thereforelittlejustificationforemployinglinearprobabilitymodels OtherCreditScoringModels Logitmodels overcomeweaknessofthelinearprobabilitymodelsusingatransformation logisticfunction thatrestrictstheprobabilitiestothezero oneinterval OtheralternativesincludeProbitandothervariantswithnonlinearindicatorfunctions Qualityofcreditscoringmodelshasimprovedprovidingpositiveimpactoncontrollingwrite offsanddefault Discriminantmodelsdivideborrowersintohighorlowdefaultriskclassescontingentontheirobservedcharacteristics Altman sdiscriminantfunction credit classificationmodel Where workingcapital totalassets retainedearnings totalassets earningsbeforeinterestandtaxes totalassets marketvalueofequity bookvalueoflong termdebt sales totalassets LinearDiscriminantmodels 2 Historic Backsimulation approach Thehigherthevalueof thelowerthedefaultrisk E g Supposethatthefinancialratiosofapotentialborrowingfirmtookthefollowingvalues 0 2 0 0 20 0 10 2 Fortheborrowerinquestion CriticalvalueofZ 1 81 AccordingtoAltman screditscoringmodel anyfirmwithaZscorelessthan1 81shouldbeplacedinthehighdefaultriskregion LinearDiscriminantmodels cont LinearDiscriminantModel Problems Onlyconsiderstwoextremecases default nodefault Weightsneednotbestationaryovertime Ignoreshardtoquantifyfactorsincludingbusinesscycleeffects Databaseofdefaultedloansisnotavailabletobenchmarkthemodel TermStructureBasedMethods Ifweknowtheriskpremiumwecaninfertheprobabilityofdefault Expectedreturnequalsriskfreerateafteraccountingforprobabilityofdefault p 1 k 1 iMaybegeneralizedtoloanswithanymaturityortoadjustforvaryingdefaultrecoveryrates Theloancanbeassessedusingtheinferredprobabilitiesfromcomparablequalitybonds MortalityRateModels Similartotheprocessemployedbyinsurancecompaniestopricepolicies Theprobabilityofdefaultisestimatedfrompastdataondefaults MarginalMortalityRates MMR1 ValueGradeBdefaultinyear1 ValueGradeBoutstandingyr 1 MMR2 ValueGradeBdefaultinyear2 ValueGradeBoutstandingyr 2 ManyoftheproblemsassociatedwithcreditscoringmodelssuchassensitivitytotheperiodchosentocalculatetheMMRs RAROCModels Riskadjustedreturnoncapital Thisisoneofthemostwidelyusedmodels RAROC oneyearnetincomeonloan loanrisk Loanriskestimatedfromloandefaultrates orusingduration UsingDurationtoEstimateLoanRisk FordenominatorofRAROC durationapproachusedtoestimateworstcaselossinvalueoftheloan DLN DLNxLNx DR 1 R whereDRisanestimateoftheworstchangeincreditriskpremiumsfortheloanclassoverthepastyear RAROC one yearincomeonloan DLN OptionModels Employoptionpricingmethodstoevaluatetheoptiontodefault Usedbymanyofthelargestbankstomonitorcreditrisk KMVCorporationmarketsthismodelquitewidely ApplyingOptionValuationModel MertonshowedvalueofariskyloanF t Be it 1 d N h1 N h2 Writtenasayieldspreadk t i 1 t ln N h2 1 d N h1 wherek t Requiredyieldonriskydebtln Naturallogarithmi Risk freerateondebtofequivalentmaturity t remainingtimetomaturity CreditRisk DevelopedbyCreditSuisseFinancialProducts Basedoninsuranceliterature Lossesreflectfrequencyofeventandseverityofloss Loandefaultisrandom Loandefaultprobabilitiesareindependent Appropriateforlargeportfoliosofsmallloans ModeledbyaPoissondistribution Whatiscreditrisk TheoutstandingbalancelenttotheborrowerthechancesthatthedefaultoccurstheguaranteesthatreducethelossintheeventofdefaultCreditriskanditsunderlyingrisksDefaultrisk exposurerisk recoveryriskMeasurementofcreditriskQualitativemodels quantitativemodels creditscoringmodels SummaryofUnit AssetBackedSecurities ABS CreditDefaultObligations CDO andtheCreditCrunchof2007 U S RealEstatePrices 1987to2008 S P Case ShillerComposite 10Index Whathappened Startingin2000 mortgageoriginatorsintheUSrelaxedtheirlendingstandardsandcreatedlargenumbersofsubprimefirstmortgages This combinedwithverylowinterestrates increasedthedemandforrealestateandpricesrose TocontinuetoattractfirsttimebuyersandkeeppricesincreasingtheyrelaxedlendingstandardsfurtherFeaturesofthemarket 100 mortgages ARMs teaserrates NINJAs liarloans non recourseborrowing Whathappened MortgageswerepackagedinfinancialproductsandsoldtoinvestorsBanksfounditprofitabletoinvestintheAAAratedtranchesbecausethepromisedreturnwassignificantlyhigherthanthecostoffundsandcapitalrequirementswerelowIn2007thebubbleburst Someborrowerscouldnotaffordtheirpaymentswhentheteaserratesended Othershadnegativeequityandrecognizedthatitwasoptimalforthemtoexercisetheirputoptions U S realestatepricesfellandproducts createdfromthemortgages thatwerepreviouslythoughttobesafebegantobeviewedasriskyTherewasa flighttoquality andcreditspreadsincreasedtoveryhighlevels AssetBackedSecurity Simplified A waterfall definesthepreciserulesforallocatingcashflowstotranches TheWaterfall EquityTranche ABSCDOsorMezzCDOs Simplified LossestoAAATrancheofABSCDO AMoreRealisticStructure KeyMistakesMadeBytheMarket Assumptionthatfactorsarenormallydistributed Thisisequivalenttoassumingthattheprobabilitydistributionofthedefaultratehasthintails AssumptionthataBBBtrancheislikeaBBBbond NeedtoAlignInterestsofOriginatorsandInvestors ThereisevidencethatmortgageoriginatorsusedlaxlendingstandardsbecausetheyknewloanswouldbesecuritizedForarebirthofsecuritizationitisnecessarytoaligntheinterestsoforiginatorsandinvestorsSuggestion whencreditriskisbeingtransferredoriginatorsshouldberequiredkeepsomepercentage say20 ofeachinstrumentcreated RoleofCompensationPlans Shorttermcompensation theend of yearbonus isthemostimportantpartofthecompensationformanyemployeesoffinancialinstitutionsThiscreatesshorttermhorizonsfordecisionmakingBonusesshouldbebasedonperformanceoveralongerperiodthanoneyear e g 5years Transparency ABSsandABSCDOswerecomplexinter relatedproductsOncetheAAAratedtrancheswereperceivedasriskytheybecameverydifficulttotradebecauseinvestorsrealizedtheydidnotunderstandtherisksArguablytheonusshouldbeonthecreatorsoftheproductstoprovideawayforpotentialpurchaserstoassesstherisks e g byprovidingsoftware NeedforModels Mostfinancialinstitutionsdidnothavemodelstovaluethetranchestheytraded Itappearsthattheydidnotfollowtheirownproceduresonthis ABSCDOshavethesamestructureasCDOsquaredswhichsyntheticCDOtradersfinddifficulttovalueWithoutavaluationmodelriskmanagementisvirtuallyimpossible