The science of Risk management has been developing and evolving continuously. Various other financial instruments such as interbank transaction, trade financing, foregin exchange transactions, financial futures, optins, swaps, bonds can also have credit risk. Credit Risk modelling.
Credit Exposure is the amount of risk during the life of a financial instrument. Upon default it is called exposure at default. In the event of default how large would be the expected outstanding obligations.
When banks assign PD to a borrower they are predicting the likelihood of default over a time period horizon.
LGD(Loss Given default)- is the share of the asset which is lost when a borowwer defaults.
Credit Risk Drivers: Deterioration in credit quality of a obligor may take place over a period of time owing to poor management, changes in the financials of unit, adverse changes in business cycles such as inflation, recession and competition.
The important risk drivers are: -
Concentration Risk: Concentration risk may arise due to exposure above a certain limit to individual borrower, group borrowers, industries or sector.
Default Risk: Inability or unwillingness of obligor to pay the contractual obligation.
Risk of Recovery: The offered security may not fetch the estimated price assumed at the time of sanction of a loan.
Correlation Risk: A common factor which may trigger simultaneous default of different borrowers, industries or sectors.
Credit Risk Assessment and Mitigation: Credit Risk measurement involves identification of certain risk components as under :
Ø Probability of Default (PD): It refers to the probability of a borrower defaulting on the payment of the credit obligations, within a given time horizon, usually one year.
Ø Exposure At Default (EAD): It refers to the amount that is exposed to the default risk.
Ø Loss Given Default (LGD): It refers to the loss suffered in the event of a default occurring in an exposure.
Ø Expected Loss (EL): It is that part of the average anticipated credit loss that happens in the normal course of business due to default in exposures and for which banks have to either make Provisions or price these effects into their loans.
Ø Unexpected Loss (UL): It is that part of credit loss that cannot be estimated or priced into the product and hence banks have to provide Capital by risk-weighting their assets.
Banks use a number of techniques to mitigate the credit risks to which they are exposed. Banks adopt the Comprehensive Approach, which allows fuller offset of Collaterals against Exposures. Banks, which take eligible financial Collateral (e.g. Cash or Securities) are allowed to reduce their Credit exposure to a Counterparty when calculating their Capital requirements to the extent of the Risk mitigating effect of the Collateral.
Credit Risk Variants
Concentration risk has been the largest risk to banks.
RAROC
Risk Adjustment Return on Capital is one of the most important performance measurement tools which is widely accepted by large banks and investment banks.
Shareholder Value analysis must be done considering growth return and risk.
absolute amount also. We will take one example for better understanding There are two Banks ABC and XYZ which generates 20% return on 100 Crore capital an 15% return on 600 Crore capital respectively. We are assuming that Cost of capital for both the institutions is 10%. Now For Bank ABC and XYZ “Contribution to shareholder value” would be 10 Crore and 30 Crore respectively. As per RAROC in percentage term, Bank ABC generates better return in compare to Bank XYZ, but Bank XYZ can be considered better to the overall health of institution considering its large contribution to shareholder value. Now we have clear understanding of Risk Adjusted Return on Capital and contribution to shareholder value. So, the shareholder value analysis must be analyzed considering Growth, return and Risk. These three are key drivers which affect shareholder value.
The Expected Loss for exposures would have to be priced in (by calculating the estimated Risk premia) and recovered or, alternatively, provided for from the P&L account for that year. The estimated Unexpected Loss would be the Capital charge for the given exposure.
Under the Standardized Approach of computation of Credit risk capital charge the computation is done broadly based on the External Rating of the borrower, for the corporate borrowers.
The Internal Rating Based Approach allows banks, subject to the approval of central Bank, to use their own internal estimates for some or all of the credit risk components [Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Effective Maturity (M)] in determining the capital requirement for a given credit exposure.
The IRB approach is classified into Foundation IRB (FIRB) approach and Advanced IRB (AIRB) approach. Under the FIRB Approach the capital charge is computed based on the PD, LGD, EAD and M factors for the account. The source of this value is specified below:-
Risk Components | Source |
PD | As per Banks internal calculation |
LGD | Supervisory Value |
EAD | Supervisory Value |
Maturity | Supervisory Value |
Advanced Internal Rating Based (A-IRB) Approach
Under A- IRB approach also the computation of capital charge is based on the PD, LGD, EAD and M values. The source of this value is specified below:-
Risk Components | Source |
PD | Banks own estimate |
LGD | Banks own estimate |
EAD | Banks own estimate |
Maturity | Banks own estimate |
Comments
Post a Comment