06.2 credit risk controls

Copyright © 2018 CapitaLogic Limited
Chapter 6
Credit Risk Controls
This presentation file is prepared in accordance with
Chapter 6 of the text book
“Managing Credit Risk Under The Basel III Framework, 3rd ed”
Website : https://sites.google.com/site/crmbasel
E-mail : crmbasel@gmail.com

Copyright © 2018 CapitaLogic Limited 2
Declaration
 Copyright © 2018 CapitaLogic Limited.
 All rights reserved. No part of this presentation file may be
reproduced, in any form or by any means, without written
permission from CapitaLogic Limited.
 Authored by Dr. LAM Yat-fai (林日辉),
Director, CapitaLogic Limited,
Adjunct Professor of Finance, City University of Hong Kong,
Doctor of Business Administration,
CFA, CAIA, CAMS, FRM, PRM.

Outline
 Why mitigating credit risk
 Risk controls for single debts
 Risk controls for debt portfolios
 Appendix

Why mitigating credit risk?
 Return driven by risk
 Why mitigating credit risk?
 Lock in earned but unrealized profit
 Stop unrealized loss
 Risk increased above tolerance level
 Change of risk aptitude

Credit risk vs credit risk factors
 Single debt
 Debt portfolio
k k k k
Credit risk = EL
EAD × LGD × PD × RM
EAD ,LGD ,PD ,RM ,
Credit risk = Function
Concentration,Dependency

 
 
 

Credit risk factors and measurements
Credit
risk
EAD
LGD
PD
RM
Concen
-tration
Default
depend
-ency
(+)
(+) (+)
(+)
(+)
(+)

Manipulation of credit risk factors
 EAD reduction
 Bilateral netting
 Principal amortization
 LGD reduction
 Collateral
 Margining
 PD reduction
 Credit guarantee
 CDS
 RM reduction
 Downgrade trigger
 Call provision
 Concentration reduction
 Smaller EAD to more
borrowers
 Dependency reduction
 Smaller segmental EAD to
more borrower segments
 Portfolio reduction
 Credit securitization
 Integrated control
 Credit limit


Outline
 Risk controls for single debts
 Appendix

Bilateral netting
 Two banks own each other monies
 When one bank defaults
 Without bilateral netting agreement
 Survival bank must surrender the borrowing EAD
immediately to liquidator
 Survival bank then collects the lending EAD from
liquidator
 EAD = Principal + Accrued interest
 With bilateral netting agreement
 Net EAD = Max[Lending EAD - Borrowing EAD, 0]
Example 6.1

Principal amortization
 For large EAD with long initial RM
 Principal paid partially on a regular basis
 To offset the default chance arising from long
initial RM by reducing EAD on a scheduled
basis
 Example: mortgage
 Fixed monthly payment
= Interest + Partial principal

Collateral
 Borrower surrenders the legal ownership of his
assets to lender
 Lender sells assets to compensate part of the EAD in
case the borrower defaults
 Debt collection continues if assets are sold below the
EAD
 Common collaterals
 Property, land, equity, car, equipment … red wine
 Preferred collaterals
 Low mobility – land and property
 High liquidity – financial instruments

LGD with collaterals
 
Default loss
LGD = × 100%
EAD
Max EAD - Collaterals, 0
= × 100%
EAD
Collaterals
=Max 1 - , 0 × 100%
EAD
 
 
 
Example 6.2

Margining
 To top up collaterals with additional cash up
to a certain threshold
 e.g. lending amount + potential maximum
decrease of collateral value in a short period
 Higher collateral volatility => more margin
 Margin lending for foreign currency contract
 5% initial margin
 3% maintenance margin
 1% liquidation margin
Example 6.3

Credit guarantee
 Default insurance of a debt
 Guarantor sourced by the borrower at
origination of a debt
 Credit guarantor has
 a credit quality higher than that of the borrower
 a positive view on the credit quality of the
borrower

Credit default swap
 Default insurance of a debt
 Insurer sourced by lender at any time during
the lending period
 Lender pays insurer an insurance premium
 A bet between lender and insurer

Downgrade trigger
 Borrower has to return the EAD to the lender
 When the borrower is downgraded materially by
major credit rating agencies
 Lender to
 Take debt collection actions before default
 Accelerate the default of borrower

Call provision
 Borrower has to return the EAD to the lender when
failing to meet any positive provisions, e.g.
 Maintain its credit rating at investment grade by major
global credit rating agencies
 Deposit sufficient collaterals to the lender
 Meet certain sales and/or profit targets every quarter
 Complete a project following a scheduled timeline
 Demonstrate a sufficient improvement in financial
condition within a certain period of time

Outline
 Risk controls for individual debts
 Appendix

Debt portfolio
 For the same portfolio EAD
 Diversification reduces risk by
 Lower concentration of debts
 Larger no. of borrowers
 Lower default dependency among borrowers
 Larger no. of lending segments
 Different countries, industries and/or professions

Concentration reduction
 Herfindahl-Hirschman index
 Alternative form
k k k k k
NOB
2
k
k=1
2
NOB
k
k=1
NOB
2
k
k=1
2
NOB
k
k=1
EL EAD LGD PD RM
EL
HHI =
EL
Outstnding debt amount
HHI =
Outstnding debt amount
   
 
 
 
 
 
 




Example 6.4

Dependency reduction
 Herfindahl-Hirschman index
 Alternative form
 
k
k
M
k k,h k,h k,h k,h
h=1
N
2
k
k=1
2
N
k
k=1
M
k k,h
h=1
N
2
k
k=1
N
k
k=1
EL EAD LGD PD RM
EL
HHI =
EL
Outstanding debt amount Outstanding debt amount
Outstanding debt amount
HHI =
Outstanding debt amount
   
 
 
 










2




Credit securitization
 To sell illiquid debts in a debt portfolio
 Individual illiquid debts
 No market for disposal
 Tranching
 To reschedule certainty of cash flows
 To match investors with different risk-return
preferences

Credit limit
 To cap the default loss of the lender
 When many borrowers default together in one
year
 Under an extreme situation

Credit limit
 For a homogeneous portfolio
Portfolio EAD × LGD × XCDR = XCL
Portfolio credit limit × LGD × XCDR = MPDL
Example 6.5
MPDL
Portfolio credit limit =
LGD × XCDR
MPDL
Borrower credit limit =
NOB × LGD × XCDR

Credit limit
 For a heterogeneous portfolio
k
k k
MPDL
Borrower credit limit =
NOB × LGD × XCDR

Credit risk controls
Risk factor Control Implementation Limitation
EAD
Netting
At debt origination
Portfolio amortization
LGD
Collateral
Margining
PD
Credit guarantee
Credit default swap Any time Existence of insurer
RM
Downgrade trigger
At debt origination
Availability of credit rating
Call provision
Concentration
of debts
Smaller EAD to
more borrowers
Higher operating cost
Default
dependency
Smaller segmental EAD to
more market segments
All
Credit securitization Any time
Existence of a liquid credit
securitization market
Credit limit At debt origination

Outline
 Risk controls for individual debts
 Appendix

The instant LGD
   
 
2 0 1
2
0
1
2 1
LGD t = Φ(-d ) - q exp μt Φ(-d )
σ
ln q + μ + t
2
d =
σ t
d = d - σ t
 
 
 
 t
Collateral value at time t
Max 1 - , 0 = Max 1 - q , 0
EAD at time t
 
 
 

Hazard rate
 
 
 
T
λ = - ln 1 - PD
Expected no. of survival borrowers after T years
= Initial no. of borrowers × 1 - PD
= Initial no. of borrowers × exp -λT

The average LGD
 
 
 
T 2 0 1
0
Φ(-d ) - q exp μt Φ(-d )
× exp -λt × λdt
1 - exp -λT
  


06.2 credit risk controls

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