Book 2. Credit Risk

FRM Part 2

CR 5. Introduction to Credit Risk Modeling and Assessment

Presented by: Sudhanshu

Module 1. Credit Risk Modeling and Regulatory Framework

Module 2. Credit Risk Assessment Approaches

Module 1. Credit Risk Modeling and Regulatory Framework

Topic 1. Evaluating a Bank’s Financial Condition

Topic 2. Credit Risk Factors

Topic 3. Capital Adequacy Ratio

Topic 1. Evaluating a Bank’s Financial Condition

• A bank's financial condition is often evaluated using the CAMELS rating system, an internationally recognized framework used by supervisory authorities. This system assigns a score from 1 (best) to 5 (worst) for six key factors. A lower score indicates a stronger financial institution.

  • C - Capital Adequacy: Measures a bank's ability to absorb losses and maintain operations. It ensures the bank has enough capital to withstand financial shocks.

  • A - Asset Quality: Assesses the credit risk in a bank's loan and investment portfolios. It evaluates the performance of a bank's assets, with a focus on problem loans and other-than-performing assets.

  • M - Management: Determines the quality of the bank's management team and their ability to react to financial stress, manage risks, and comply with regulations.

  • E - Earnings: Analyzes the bank's profitability and its ability to sustain activities and expand.

  • L - Liquidity: Evaluates a bank's capacity to meet its short-term obligations and its ability to convert assets into cash.

  • S - Sensitivity to Market Risk: Assesses how changes in market conditions, such as interest rates, can affect the bank's earnings and capital.

Practice Questions: Q1

Q1. Which subcomponent of the CAMEL analysis tool is focused on delinquent loans?

A. Liquidity.

B. Earnings.

C. Asset quality.

D. Capital adequacy.

Practice Questions: Q1 Answer

Explanation: C is correct.

Asset quality focuses on bank assets that are performing or showing signs of
delinquency. Capital adequacy relates to minimum capital reserves as set by
regulation. Earnings reviews are focused on core earnings with an emphasis on
stability, net interest margin, return on assets, and future earnings potential.
Liquidity focuses more on short-term liquidity risk than on longer-term focused interest rate risk although both are considered.

Topic 2. Credit Risk Factors

• Credit risk is the potential for a borrower to default on their obligations, leading to a financial loss for the lender. The expected loss from credit risk is a product of three key factors:
• Expected Loss = PD × LGD × EAD

  • Probability of Default (PD): This is the likelihood that a borrower will fail to repay their debt in full or on time. It is a core component of credit risk assessment and is used to estimate potential losses and set loan terms.

  • Loss Given Default (LGD): The percentage of an asset's value that is lost if a borrower defaults. LGD is the loss the lender faces after considering any recoveries from collateral or other means. It is often calculated as 1 - Recovery Rate.

  • Exposure at Default (EAD): The total value a lender is exposed to when a borrower defaults. It includes the outstanding loan balance plus any committed but undrawn amounts at the time of default.

Practice Questions: Q2

Q2. A credit risk analyst is trying to determine the percentage of a loan that is expected to be lost if a specific borrower were to default. Which of the following metrics should he apply?

A. Loss given default.

B. Exposure at default.

C. Probability of default.

D. Recovery default rate.

Practice Questions: Q2 Answer

Explanation: A is correct.

Expected loss has three subcomponents (probability of default, exposure at default, and loss given default). The probability of default is the likelihood that a borrower is delinquent for more than 90 days. The exposure at default is the expected dollar loss if the loan defaults. The loss given default is the percentage of the loan that is
estimated to be lost if a default occurs.

Topic 3.  Capital Adequacy Ratio

• The Capital Adequacy Ratio (CAR) is a measure of a bank's capital in relation to its risk-weighted assets. This ratio is also known as the Capital to Risk-Weighted Assets Ratio (CRAR). Regulators use it to ensure banks have enough of a capital buffer to absorb a reasonable amount of losses and remain solvent.
• The CAR is calculated by dividing a bank's total capital by its total risk-weighted assets: CAR = (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets

  • Tier 1 Capital: This is a bank's core capital and the primary cushion against unexpected losses. It is a permanent and readily available source of funds that includes common shares, retained earnings, and other disclosed reserves.

  • Tier 2 Capital: This is a supplementary capital that provides a lesser degree of protection to depositors. It can absorb losses in the event a bank is winding up and includes items like undisclosed reserves and subordinated debt.

  • Risk-Weighted Assets (RWA): This represents the bank's assets weighted according to their credit, market, and operational risk. For example, a loan to a government might have a 0% risk weighting, while a personal loan could have a 100% risk weighting, reflecting a higher credit risk. The specific risk weightage factors are set by regulatory bodies.

Practice Questions: Q3

Q3. The internal ratings-based (IRB) approach for calculating a bank’s capital adequacy ratio (CAR) has several underlying elements. Which of the following statements relates to the IRB approach?

A. Idiosyncratic risk is explicitly factored into the model.

B. Estimates of probability of default are made by regulators.

C. Maturity adjustments should be higher for borrowers with high probabilities of default.

D. The maturity parameter reflects that capital requirements should increase with maturity.

Practice Questions: Q3 Answer

Explanation: D is correct.

The IRB approach considers several elements based on the bank’s customized historical record. The parameters do not relect regulatory norms because they are customized to each bank. This approach assumes that the credit portfolio is well diversified and that no idiosyncratic risk remains. The maturity adjustment has two components. First, capital requirements should increase with maturity because the risk of default increases as maturity increases. Second, borrowers with low probabilities of default (PD) should have higher adjustments than high PD borrowers. A borrower with a high PD already has a higher instance of default factored into their estimates.

Module 2. Credit Risk Assessment Approaches

Topic 1. Predicting Default in Credit Risk Models

Topic 2. Default Probability Using the Merton Model

Topic 3. Additional Credit Risk Modeling Approaches

Topic 4. Risk-Adjusted Return on Capital

Topic 1. Predicting Default in Credit Risk Models

• There are three primary approaches to assessing the probability of default:

  • Judgmental Models: These models rely on the perspective of internal experts. They are based on a qualitative assessment of the borrower.

  • Empirical Models: These are data-driven models that use historical data to predict future outcomes.

  • Financial Models: These are quantitative models that use financial data and theoretical frameworks to assess the probability of default. The Merton model is a type of financial model.

Practice Questions: Q1

Q1. A financial analyst and a risk manager are discussing ways to derive the probability of default for a bank’s loan portfolio. The analyst says that he prefers models that rely on the perspectie of
internal experts. The manager adds that while internal experts have good perspectives in the risk management process, she prefers a model that is data-driven and one that can assess loans for
both consumer and corporate customers. The analyst and manager are referring to which type of credit risk assessment?

Practice Questions: Q1 Answer

Explanation: C is correct.

A judgmental model uses the perspectives of experts to assess the probability of default. It can be applied to both consumer and corporate loans. An empirical model uses historical data to estimate relationships between variables and risk outcomes. This can also be applied to both consumer and corporate customers. The financial model uses market data to detect trends and risk estimates. Because financial market data is the primary input, this method can only be used for corporate customers.

Topic 2. Default Probability Using the Merton Model

• The Merton Model is a financial model that treats a firm's equity as a call option on its assets. The model is used to estimate the default probability of a firm. The model's variables are:

  • Asset Value: The current value of the firm's assets.

  • Asset Volatility: The volatility of the firm's asset value.

  • Default Point: The value of the firm's debt, which is the point at which the firm defaults if its asset value falls below it.

  • Time to Maturity: The time until the firm's debt matures.

The model calculates the probability that the firm's asset value will fall below the default point at the debt's maturity.

Topic 3. Additional Credit Risk Modeling Approaches

• In addition to the Merton model, there are other credit risk models that focus on different aspects of credit risk:

  • Moody's-KMV Model: This model is an extension of the Merton model that uses an extensive database of historical defaults to calculate the expected default frequency (EDF).

  • CreditMetrics Model: This model uses a value-at-risk (VaR) framework to measure the potential change in the value of a credit portfolio due to credit events such as default, migration, and recovery rates.

  • CreditRisk+ Model: This model focuses on the number of defaults in a portfolio over a given time period and uses a statistical approach based on a Poisson distribution to model the default probability.

Practice Questions: Q2

Q2. The Merton model is different from Moody's-KMV Expected Default Frequency approach in two key areas. Which of the following statements refers to one of those differences?

A. The Merton model factors the market value of the borrower's equity, while Moody's-KMV model uses book value.

B. The Merton model uses the risk-free rate to calculate the distance to default, while Moody'sKMV model uses a customized value.

C. Moody's-KMV model uses a default point with short-term debt and half of long-term debt, while the Merton model only uses short-term debt.

D. The Merton model uses historical data to derive a distribution of default frequencies, while Moody's-KMV model uses standardized expectations.

Practice Questions: Q2 Answer

Explanation: C is correct.

One key difference is that Merton sets the default point as only short-term debt and Moody's-KMV model adds in half of long-term debt. Another key difference is that Moody's-KMV model uses historical data to derive a personalized distribution of default probabilities, while the Merton model uses standardized normal distribution values. In the distance to default formula, the rate of change in historical assets replaces the risk-free rate, and both models use the market value of equity.

Practice Questions: Q3

Q3. A credit risk manager is looking for a method to estimate default risk that considers volatility, credit scores, and comparisons to similar borrowers to enhance predictions. Which of the following methods should this manager select?

A. Merton model.

B. CreditRisk+ model.

C. CreditMetrics model.

D. Moody's-KMV model.

Practice Questions: Q3 Answer

Explanation: C is correct.

The CreditMetrics model is the option for peer comparisons. It considers bond issuer credit ratings (unlike the CreditRisk+ model). The Merton model uses option pricing theory to calculate the default rate, but it only considers shortterm debt. Moody's-KMV model adds some long-term debt to the theory behind the Merton model, but the CreditMetrics model is the best option due to peer comparison demands.

Topic 4. Risk-Adjusted Return on Capital

• The Risk-Adjusted Return on Capital (RAROC) is a profitability metric that measures the return on a loan relative to the unexpected risk it presents. It helps a bank determine if a loan will be profitable.
• The formula for RAROC is:
• RAROC = (Loan Revenues - Expected Loss) / Unexpected Loan Loss

  • Loan Revenues: The total income generated by the loan.

  • Expected Loss: The probability of default (PD) multiplied by the loss given default (LGD) and the exposure at default (EAD).

  • Unexpected Loan Loss: The amount of capital needed to cover potential losses beyond the expected loss.

An alternative method for estimating unexpected loan loss uses the following formula: Unexpected Loan Loss = α × LGD × EAD

• LGD: Loss Given Default

• EAD: Exposure at Default

• α: An adjustment factor for unexpected default rates, derived from the distribution of historical default rates. If the distribution is normal, α can be set to 2.6σ at a 99.5% confidence level. However, for most loan distributions, a higher value (e.g., 5 or 6) is more commonly used.

Practice Questions: Q4

Q4. ABC Bank has a loan with a value of $750,000. There is an associated commission of 0.15%, the spread between the loan's interest rate and the bank's cost of capital is 0.45%, the estimate of operating costs is 0.3%, and their estimated tax rate is 12 %. This loan is expected to be a performing loan with no risk of default.

Additionally, this loan has a duration of 2.85 and an interest rate of 9.5%. Interest rates are expected to increase by 1.25%. What is this loan's risk-adjusted return on capital (RAROC)?

A. 4.92 %.

B. 6.01 %.

C. 7.64 %.

D. 8.11 %.

Practice Questions: Q4 Answer

Explanation: D is correct.

The estimated loan revenue is $1,980 and the estimated capital at risk is $24,400.68. This results in a RAROC of 8.11%. As long as the bank's own interest rate is less than this value, then the loan will be profitable.