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Basic fundamentals of Credit risk estimation

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  2. 2. Overview <ul><li>Credit Risk Definition </li></ul><ul><li>Estimation of Credit Risk : Standardised Approach of Basel-II </li></ul><ul><li>Estimation of default probabilities </li></ul><ul><li>Reducing credit exposure </li></ul><ul><li>Credit Ratings Migration </li></ul><ul><li>Credit Default Correlation </li></ul><ul><li>Credit Value-at-Risk Models </li></ul>
  3. 3. Credit Risk Definition <ul><li>Credit risk is defined as the potential that a bank borrower or counterparty fail to meet its obligations in accordance with agreed terms. </li></ul><ul><li>Objective of Credit Risk </li></ul><ul><ul><li>Maximising Bank‘s Risk-adjusted Return </li></ul></ul><ul><ul><li>Keeping the overall credit risk exposure within acceptable level. </li></ul></ul><ul><ul><li>Provision of Capital for Credit Risk </li></ul></ul><ul><ul><li>Regulators require banks to keep capital reflecting the credit risk as per Basel II. </li></ul></ul>
  4. 4. Capital Estimation for Credit Risk <ul><li>Basel-II : Standardized Approach </li></ul><ul><li>Asset Category </li></ul><ul><li>Sovereign </li></ul><ul><li>PSEs </li></ul><ul><li>Banks </li></ul><ul><li>Corporates </li></ul><ul><li>Commercial Real Estate </li></ul><ul><li>Residential Property </li></ul><ul><li>Regulatory Retail Portfolio </li></ul><ul><li>Consumer credit </li></ul><ul><li>HTM </li></ul><ul><li>Equity Investment   </li></ul>
  5. 5. Capital Estimation for Credit Risk <ul><li>As per RBI’s guidelines all credit with minimum disbursement of Rs.2 lakh need to be rated. </li></ul><ul><li>Rating Agency </li></ul><ul><ul><li>Internal Process by the bank itself </li></ul></ul><ul><ul><li>External agencies </li></ul></ul><ul><li>On the basis of rating risk-weight, as given by the RBI, need to be factored with the loan amount for estimation of RWAs. </li></ul><ul><li>Risk Weighted Assets </li></ul><ul><li>(Loan Amount- Market value of Collateral) * RW </li></ul>
  6. 6. Capital Estimation for Credit Risk <ul><li>Capital Structure of Bank A </li></ul><ul><li>Paid Up Capital : 400 IPDI :25 </li></ul><ul><li>Reserves & Surplus :5000 Investment in Subsidiary : 80 </li></ul><ul><li>Revaluation Reserves :26 General Provisions :10 </li></ul><ul><li>Sub- ordinated Term Debt :900 </li></ul><ul><li>Estimate the CRAR for Credit Risk. </li></ul>
  7. 7. Capital Estimation for Credit Risk
  8. 8. Credit Risk : Default Probability <ul><li>Expected Versus Unexpected Losses </li></ul><ul><li>It is the long-run average losses to each category of loan portfolio. </li></ul><ul><li>Expected loss does not by itself constitute the risk. </li></ul><ul><li>The cost of expected losses are generally factored in the loan pricing policy. </li></ul><ul><li>It is the unexpected losses for which capital is provided. </li></ul><ul><li>Unexpected losses are the variations in the actual losses over time. </li></ul><ul><li>To estimate the Unexpected Losses Basel-II has designed Probability of Default. </li></ul>
  9. 9. Credit Risk : Default Probability <ul><li>Probability of default is the likelihood that a particular category of loan would not be re-paid over a specified time horizon. </li></ul><ul><li>As per the Basel-II Nomrs: </li></ul><ul><ul><li>Expected Losses = PD * EAD*LGD </li></ul></ul><ul><ul><li>QUESTION: HOW TO ESTIMATE THE “PD” </li></ul></ul><ul><ul><li>It is generally estimated through Rating Migration Matrix </li></ul></ul>
  10. 10. Credit Ratings Migration
  11. 11. Estimation of Default Probability: Rating Approach <ul><li>From the Migration of each rating Category to Default category need to know from the rating migration matrix </li></ul><ul><li>Each year PD need to be estimated </li></ul><ul><li>Avg. PD need to be estimated from the yearly PD from 5 to 10 years of annual probability for each rating category. </li></ul>
  12. 12. Estimation of Default Probability: Rating Approach <ul><li>Annual Probability of Default: </li></ul><ul><ul><li>No. of Firms default in each rating category </li></ul></ul><ul><ul><li>Total firms in that rating category </li></ul></ul><ul><li>Average Probability of Default: </li></ul><ul><ul><li>PD = Weighted average annual rating in each category over the </li></ul></ul>
  13. 13. Estimation of Default Probability
  14. 14. Estimation of Default Probability
  15. 15. EAD & LGD <ul><li>EAD= outstanding loans + Accrued Interest </li></ul><ul><li>LGD is the portion of EAD which cannot be recovered. </li></ul><ul><li>LGD = EAD – Recovery Amount </li></ul><ul><li>LGD= 100% - Recovery Rate </li></ul><ul><li>Recovery Rate = (Recovery amount)/EAD </li></ul><ul><li>Recovery : Collateral Sell + Cash Recovery </li></ul><ul><li>- Cost of legal process </li></ul>
  16. 16. Loss Given Default
  17. 17. Loss Given Default
  18. 18. Altman’s Z-Score <ul><li>Altman’s Z-Score came as a response to the need for identifying the financial health of any business based on observable accounting and market ratios. </li></ul><ul><li>This original measure was developed in 1968 by Edward Altman, whose Z-Score is available in various forms. </li></ul>
  19. 19. Banks’ Health using Logit Model <ul><li>Dependent Variable : Health: H </li></ul><ul><ul><ul><li>H=0 if Net NPA > 6% ( Bad) </li></ul></ul></ul><ul><ul><ul><li>H=1 if Net NPA< 6% ( Good) </li></ul></ul></ul><ul><li>Independent Variables </li></ul><ul><li>x 1 = Return on Assets </li></ul><ul><li>x 2 = Income to Assets </li></ul><ul><li>x 3 = Networth to Assets </li></ul><ul><li>x 4 = Operating Expenditure to Assets </li></ul><ul><li>x 5 = Operating Profit to Assets </li></ul><ul><li>x 6 = Regulatory Capital to Risk Weighted Assets </li></ul>
  20. 20. Banks’ Health using Logit Model <ul><ul><ul><li>Log (Health) = 1.87+3.45*x1-2.26*x2-0.27*x3-4.39*x4+1.26*x5 +0.17*x6 </li></ul></ul></ul><ul><ul><ul><li>Ratios considered are </li></ul></ul></ul><ul><ul><ul><li>Return on Assets (x1) </li></ul></ul></ul><ul><ul><ul><li>Total Income to Total Assets(x2) </li></ul></ul></ul><ul><ul><ul><li>Networth to Total Assets (x3) </li></ul></ul></ul><ul><ul><ul><li>Operating Expenditure to Total Assets(x4) </li></ul></ul></ul><ul><ul><ul><li>Operating Profit to Total Assets(x5) </li></ul></ul></ul><ul><ul><ul><li>Regulatory Capital to Risk Weighted Assets(x6) </li></ul></ul></ul>