2. What Is Credit Risk?
• Credit risk is the possibility of a loss resulting from a
borrower's failure to repay a loan or meet contractual
obligations. Traditionally, it refers to the risk that a
lender may not receive the owed principal and interest,
which results in an interruption of cash flows and
increased costs for collection. Excess cash flows may be
written to provide additional cover for credit risk.
When a lender faces heightened credit risk, it can be
mitigated via a higher coupon rate, which provides for
greater cashflows.
3. Importance of credit risk management
• The major benefit of integrated, quantitative credit risk management is to reduce
revenue losses. Monitoring your credit risk allows your executive management
team to understand which potential clients may come at too high a risk and above
your pre-identified risk tolerance.
• Credit risk, if correctly identified and managed, can be leveraged as a strategic
opportunity. Through effective credit risk management your business is able to
greatly improve overall performance and secure a competitive advantage. This
was demonstrated by South African banks being less affected by the global
financial crisis than their international counterparts. This was due to rigorous and
highly effective credit risk identification, assessment and management.
4. Three main Factors Affecting Credit Risk are
1 .Probability of Default:-
• The probability of default,
sometimes abbreviated as POD
or PD, expresses the likelihood
the borrower will not maintain
the financial capability to make
scheduled debt payments. For
individual borrowers, default
probability is most represented
as a com
5. 2.Exposure at Default
• Similar in concept to LGD, exposure at default, or EAD, is an assessment of the total loss
exposure a lender is exposed to at any point in time. Even though EAD is almost always
used in reference to a financial institution, the total exposure is an important concept for
any individual or entity with extended credit.
3. Loss Given Default:-
• Imagine two borrowers with identical credit scores and identical debt-to-income ratios.
The first borrower takes a $5,000 loan, and the second borrows $500,000. Even if the
second individual has 100 times the income of the first, their loan represents a greater
risk. This is because the lender stands to lose a lot more money in the event of default on
a $500,000 loan. This principle underlies the loss given default, or LGD, factor in
quantifying risk.
6. What is the Purpose of Credit Risk Analysis?
• The main purpose of credit risk analysis is to quantify the level
of credit risk that the borrower presents to the lender. It involves
assigning measurable numbers to the estimated
• Credit risk analysis is a form of analysis performed by a credit
analyst on potential borrowers to determine their ability to meet
debt obligations. The main goal of credit analysis is to determine
the credit worthiness of potential borrowers and their ability to
honour their debt obligations.
• If the borrower presents an acceptable level of default risk, the
analyst can recommend the approval of the credit application at
the agreed terms. The outcome of the credit risk analysis
determines the risk rating that the borrower will be assigned and
their ability to access credit
7. Building a framework to manage credit risk
• Most institution have had some credit risk in their portfolios, even before the
financial crisis, in the form of bank deposits or corporate bonds with the purpose
of enhancing return within well-defined risk parameters. The financial crisis and
its aftermath created awareness among the central bank community regarding
two different situations. First, the reputation of the credit rating agencies suffered
as a result of the inaccuracies they had before the financial crisis, particularly in
the space of structured securities. Second, government debt issued by developed
countries was no longer risk-free. As a result, central banks have had to develop
some internal infrastructure to make a better assessment of the credit risk in their
portfolios.
8. TOOLS FOR MANAGING CREDIT RISK
• 1. Information Source and
Analytical Approach.
• 2. A Traffic Light System for
the Assessment of Credit
Risk.
9. 1.Information
sources and
analytical
approach:-
• A broader information set can help make better
investment decisions, but too much information can be
overwhelming and lead to conflicting results. Therefore
the information used in a credit risk assessment tool
should be carefully chosen so that it reflects the most
relevant risk factors for each type of issuer. The credit
risk assessment tool outlined below is based only on
quantitative information. The most important advantage
of quantitative signals is that they are objective
measures and, consequently, more useful to support
investment decisions. When using quantitative
measures, the role of the analysts is to make sure that
each variable is relevant and that the signal is correctly
calculated, leaving less room for discretional decisions.
The latter can also cover a wider universe of issuers
without an in-depth analysis about each of them.
10. 2.A traffic lights
system for the
assessment of
credit risk:-
• The credit risk assessment tool that is proposed in
this paper can also be called a “traffic lights system”.
The goal of this system is to identify the issuers that
have a high (red), a moderate (yellow), or low (green)
probability of having a ratings downgrade below the
minimum accepted rating, within the issuers that
meet the minimum rating requirements. This system
would flag alerts about specific issuers and is based
on the idea that a combination of different signals
can help identify “bad apples”. The most important
advantages of this approach is a focus on avoiding
credit events (type II error of credit rating agencies)
and the fact that it is not necessary to assign a rating
to each individual issuer in the portfolio.
