Credit risk management

1. Managing Credit Risk Under The Basel III Framework 11
Copyright 2018 CapitaLogic Limited
Credit Risk Factors and Measures
1
KEY CONCEPTS
• Credit
• Default risk
• Risk factor
• Risk measure
1 Credit risk factors and measures
1.1 Introduction
Credit risk is by far the largest risk exposure in the banking industry. Thus the
management of credit risk is critical to the success of a bank. This chapter starts with an
introduction to the contemporary approach of credit risk management in a bank.
1.1.1 Funding source
Lending is one of the core businesses of a bank. Through lending and deposits taking, a
bank generates profits from the spread between the higher interest rate that the bank
charges borrowers who collect monies from the bank and the lower interest rate that the
bank pays depositors who place monies into the bank.
Individual persons borrow from banks in the form of term loans, credit cards, mortgages,
etc.. In addition to traditional bank lending, corporations can raise funds by issuing
bonds to debt investors. Bonds are essentially tradable loans with transferable ownership.
Thus loans and bonds are collectively referred to as debts. In this regard, borrowers and
bond issuers are collectively referred to as debt issuers while lenders and bond investors
are collectively referred to as debt investors.
1.1.2 Credit
Central to “credit” is the idea that a borrower, either an individual person or institution,
uses other people’s monies in pursuit of his1
financial needs. Credit enables a borrower
to spend with a lender’s monies today but pay the lender in the future. In return, the
lender charges the borrower interest: (i) to compensate the time value of monies over the
lending period; (ii) to cover the potential loss if the borrower defaults; and (iii) as a
service charge for arranging temporary funds to the borrower.
1
To simplify the presentation in this book, the pronouns “he”, “him” and “his” are used when referring to
any gender.

2. 12 Managing Credit Risk Under The Basel III Framework
Copyright 2018 CapitaLogic Limited
1.1.3 Time value of money
Monies depreciate over time as a result of inflation. If a lender plans to lend to a
borrower in an economy at an inflation rate 3 percent, to maintain the purchasing power
of the loan amount at maturity, the lender must charge the borrower a normal yield higher
than 3 percent regardless whom the borrower is.
1.1.4 Default
When a borrower fails to pay to the lender the interest and/or principal in full on schedule,
the borrower is considered in default. Debt collection efforts will then be initiated by the
lender upon default of the borrower to recover the whole or part of the principal plus
interest.
1.1.5 Credit risk2
In this book, the term “credit risk” means the risk of loss to a lender caused by the default
of a debt owned by the lender. The lender invests with an intention to hold the debt until
maturity or for a medium to longer period of time, i.e., one year or longer.
To compensate for taking the credit risk, a lender invariably demands that a borrower pay
a nominal yield higher than the risk-free rate. The larger the credit risk, the higher the
nominal yield the lender will seek from the borrower.
1.1.6 Credit risk management ★★★★★★★★★★★★3
Under the Basel III framework, credit risk management comprises four building blocks:
Figure 1.1 Credit risk management
2
In the broadest sense, credit risk comprises default, rating migration and credit spread risks.
3
Critical sections in this book are highlighted with “★★★” next to the title.