Book 2. Credit Risk

FRM Part 2

CR 1. Fundamentals of Credit Risk

Presented by: Sudhanshu

Module 1. Credit Risk Definition and Transaction Types

Module 2. Credit Risk Exposure

Module 1. Credit Risk Definition and Transaction Types

Topic 1. Credit Risk

Topic 2. Insolvency vs. Default vs. Bankruptcy

Topic 3. Transactions that Generate Credit Risk

Topic 1. Credit Risk

• Definition: Credit risk is the probability that one party (a creditor or lender) will lose money if a counterparty (a borrower or obligor) fails to honor its financial obligation. This can be due to an inability, unwillingness, or nontimeliness of payment.

• How it Arises:

  • Inability to Repay: This is the most common reason. It could be due to a company's product becoming obsolete, capital expansion failure, or unanticipated events like macroeconomic shocks (e.g., the COVID-19 pandemic).

  • Unwillingness to Repay: A deliberate refusal to pay, often due to a dispute over the original contract. A sovereign state defaulting on its international debt is an example of this.

  • Nontimeliness of Obligation: Even a delay in payment can create credit risk for the creditor by contributing to lost interest or investment income.

  • General Principle: The longer the term of a contract, the greater the credit risk to creditors.

Practice Questions: Q1

Q1. Which of the following set of factors is most critical in helping creditors assess credit risk?
A. Amount of credit risk, probability of counterparty default, recovery amount/timing.
B. Foreign currency exposure, amount of credit risk, amount of illiquid counterparty assets.
C. Probability of counterparty default, counterparty management strength, recovery amount.
D. Recovery amount/timing, amount of uninsured assets, probability of counterparty insolvency.

Practice Questions: Q1 Answer

Explanation: A is correct.

While all factors listed are helpful in assessing credit risk, the three most important factors creditors want to assess are (1) the amount of credit risk, (2) the probability of counterparty default, and (3) the recovery amount and timing of payment receipt.

Topic 2. Insolvency vs. Default vs. Bankruptcy

• Insolvency: A financial state where an entity's liabilities (L) exceed its total assets (A), resulting in a negative net worth ( L > A). Key characteristics include:

  • It is a condition of financial distress, not an action or event.

  • A firm can be insolvent on paper but still avoid default if it has sufficient cash flow to meet its obligations.

  • It serves as a strong indicator of high future credit risk.​

• Default: A contractual event that occurs when a borrower violates a term of their loan agreement. Key characteristics include:

  • Payment Default: The most common type, which is the failure to make a payment on time.

  • Technical Default: Occurs when a borrower violates a non-payment clause, such as failing to maintain a certain financial ratio or not providing required financial statements.

  • It is a breach of contract and is the event that typically precedes bankruptcy.

• ​Bankruptcy: A formal legal procedure that is a court-supervised process for a debtor who can no longer meet their financial obligations. Key characteristics include:

  • It is the final legal consequence of prolonged insolvency and default.

  • Liquidation: The business ceases to exist as a court-appointed trustee sells off the company's assets to pay creditors.

• • Reorganization: The business continues to operate under a court-approved plan to repay debts over time.

• ​Summary: Insolvency is the underlying financial condition, default is the triggering event of a breach of contract, and bankruptcy is the legal remedy for the unresolvable financial situation.

Topic 3. Transactions that Generate Credit Risk

• Lending: This is the most direct source of credit risk. A bank loans funds to a borrower, and the bank is exposed to the risk of non-repayment if the borrower cannot or will not pay.

• Leases: A lessor (the asset owner) is exposed to the credit risk that the lessee (the asset user) will not make all scheduled lease payments.

• Receivables: When a corporation sells goods or services on credit, it creates an account receivable. The seller is exposed to the risk of not receiving payment from the buyer. This is a significant source of credit risk for many businesses.

• Prepayments: Paying for goods or services in advance exposes the paying party to the risk that the goods or services will not be delivered. This is a form of credit risk faced by both individuals and corporations. For example, a homeowner paying a contractor for a job that is never completed faces credit risk.

• Deposits: Individuals and corporations that hold deposits in a bank are exposed to potential losses if the bank faces liquidity distress or fails.

• Contingent Claims: These are claims that depend on a future event. An example is an insurance policyholder who faces credit risk that the insurer won't make a payment when a claim is submitted.

• Derivatives: Over-the-counter (OTC) contracts like forwards and swaps create counterparty credit risk on both sides.

  • Each party is exposed to the risk that the other will default on their obligation, forcing the non-defaulting party to re-enter the market at a potentially less favorable price.

  • For instance, a corporation using a forward contract to hedge against currency fluctuations would face credit risk if the counterparty defaults

Practice Questions: Q2

Q2. Acquaria Corporation’s year-end balance sheet shows $280 million in assets and $320 million in debt to creditors. Acquaria’s management estimates that it will continue to be able to meet its upcoming payment obligations. The company is best characterized as being:
A. bankrupt.
B. insolvent.
C. in default.
D. nonperforming.

Practice Questions: Q2 Answer

Explanation: B is correct.

Acquaria is best described as being insolvent, meaning its liabilities exceed the value of its assets. Acquaria continues to perform on its contractual obligations.
Default occurs when an entity fails to meet its contractual obligations. Bankruptcy occurs when an entity seeks legal protection through a court.

Module 2. Credit Risk Exposure

Topic 1. Financial Institutions

Topic 2. Corporations

Topic 3. Individuals

Topic 4. Managing Credit Risk

Topic 1. Financial Institutions

• Banks

  • Primary Exposure: Default/nonpayment by individual and corporate borrowers.

  • Collateralized Transactions (e.g., Repurchase Agreements): Risk that collateral value declines and no longer covers the amount owed if the counterparty defaults.

  • Derivatives: Counterparty credit risk exposure through hedges and trading portfolios.

• Asset Managers & Pension Funds

  • Exposure: Credit risk on behalf of clients/members due to potential nonpayment or default of the entities they invest in (corporate and government securities).

  • Mitigation: Managed by sophisticated risk management teams that assess creditworthiness.

• Hedge Funds

  • Approach: Often view default as an investment opportunity rather than a risk to avoid.

• Exposure Types:

  • Direct investment in risky instruments (private debt, distressed securities).

  • Short-selling securities of companies in distress.

  • Selling credit protection (e.g., via Credit Default Swaps).

• ​Insurance Companies

  • Underwriting: Risk of losses on investments used to cover future policy claims.

  • Investments: Manage significant assets; major losses can damage reputation, even in segregated accounts.

  • Reinsurance: Face credit risk from the reinsurer (the company that takes on a portion of policy claims) not making timely payments.

Topic 2. Corporations

• Account Receivables

  • Exposure: Risk that customers are unable or unwilling to pay for goods/services purchased on credit.

  • Mitigation Strategies:

    • Buying insurance on receivables.

    • Selling receivables to another company (Factoring).

    • Securing foreign transactions via documentary credit (guarantees).

• Short-Term Investments and Deposits

  • Investments: Risk that the issuer of short-term securities fails to meet interest or principal obligations.

  • Bank Deposits: Risk that the bank faces liquidity distress and cannot pay out deposits.

  • Mitigation: Diversifying deposits across several banks.

• ​Derivatives: Exposure: Mainly through Over-the-Counter (OTC) contracts like forwards and swaps. Futures create less risk due to margin requirements and clearinghouses.

  • Consequence: Counterparty default may force the corporation to replace the hedge at an unfavorable market price.

• Vendor Financing

  • Exposure: Credit risk from customer default/nonpayment when the corporation's financing arm helps customers buy or lease its products on credit.

• Supply Chain

  • Exposure: Relying on a single supplier creates credit risk if that supplier defaults, causing significant operational losses for the corporation.

Practice Questions: Q1

Q1. A bank has entered into a $25 million, 6-month repurchase agreement with an investment grade corporate client, collateralized by $26 million notional value, 10-year state bonds. The bank has:
A. no credit risk because the repurchase agreement matures before the bonds.
B. no credit risk because the client is rated investment grade; therefore, counterparty default is unlikely.
C. no credit risk because the notional value of the bonds exceeds the value of the repurchase agreement.
D. credit risk because if the client defaults, the bank may not be able to sell the bonds to cover the full amount of the repurchase agreement.

Practice Questions: Q1 Answer

Explanation: D is correct.

The repurchase agreement exposes the bank to the risk that the client will not repay its obligation or will default. Although the collateral mitigates this risk, in a stressed or unfavorable market, the collateral value may decline and no longer sufficiently cover the amount owed to the bank under the repurchase agreement.

Topic 3. Individuals

• Direct Credit Risk Exposure

  • Prepayments: Risk of loss when prepaying for goods or services (e.g., rent, contracting work) that are not delivered in the future.

• Indirect Credit Risk Exposure

• • Bank Deposits: Exposure to credit risk if their bank fails.

    • Mitigation: This risk is often mitigated through federal deposit insurance in many countries.

  • Investments: Exposure through investments managed by asset managers and pension funds, which are subject to the credit risk of the underlying securities.

Topic 4. Managing Credit Risk

• Credit Risk as Controllable Exposure: Credit risk arises from company/management decisions, making it a controllable risk.

  • Improper management can lead to costly consequences for the company and shareholders.

• ​Primary Motivations for Managing Credit Risk

  • 1. Survival: Avoiding large, catastrophic losses that could lead to bankruptcy.

  • 2. Profitability: Minimizing credit losses directly increases overall profitability.

  • 3. Return on Equity (ROE): Successful companies find the optimal balance between debt and equity to maximize ROE, requiring careful management of the associated credit risk.

• ​Key Management Tactic

  • Equity Buffer: Maintain sufficient equity to absorb both anticipated and unanticipated credit losses.

  • Assessment Focus: Creditors typically assess:

    • The amount of credit risk.

    • The probability of counterparty default.

    • The recovery amount and timing of payment receipt.

• Credit Analysis: Thoroughly assessing the creditworthiness of a counterparty before engaging in a transaction is essential. This involves analyzing financial statements, credit ratings, and industry trends to determine the likelihood of default.

• Diversification: Spreading credit exposure across multiple counterparties, industries, and geographic regions reduces the impact of a single default.

• Monitoring: Continuously monitoring the financial health and payment behavior of existing counterparties allows a firm to identify potential problems early and take corrective action.

Topic 3. Managing Credit Risk

Practice Questions: Q2

Q2. Which of the following options would a corporation least likely select to mitigate its receivables credit risk?
A. Factoring.
B. Insurance.
C. Derivatives.
D. Documentary credit.

Practice Questions: Q2 Answer

Explanation: C is correct.

Corporations typically mitigate receivables credit risk in one of following three ways:

• Buying insurance on their account receivables
• Selling their receivables to another company (i.e., factoring)
• Securing foreign transactions through documentary credit