Banking Lecture 8 – Credit risk

Magda PečenáInstitute of Economic Studies, Faculty of Social Science,

Charles University in Prague, Czech Republic

November 21, 2012

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Contents

1. Credit risk – definition

2. Basic debt instruments

3. Macro assessment of credit risk, esp. CR

4. Credit registers

5. Assessment of credit risk, country risk

6. Micro assessment of credit risk - loan granting process

7. Loan pricing

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Credit risk - definition

Credit risk• risk to the bank of losses resulting from the

failure of a counterparty to meet its obligations in accordance with the terms of a contract under which the bank has become a creditor of the counterparty (CNB),

Credit risk represents 50–70% of all banking risks.

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Credit risk

Total Assets Total Liabilities

Assets non-sensitive tocredit risk (tangible andintangible assets, cashdeposited at the centralbank etc.)

Equity

Assets sensitive to creditrisk (granted loans,investments in bonds,equity etc.)

Liabilities

Loans - Non-standard contracts difficult to transfer to third parties

Securities (Tradable securities) - Standard contract easy to transfer to third parties

Credit risk measurement

Credit rating

Credit scoring

PD (probability of default)

NPL (non-performing loans)

LGD

Models (combining all of this)

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Credit risk Corporate defaults 1970-2008

Source: Moody’s

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Credit risk Annual Speculative-Grade Default Rates, 1920-2008

Source: Moody’s

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Credit risk Average Annual Upgrade-to-Downgrade Ratios, 1970-2008

Source: Moody’s

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Contents

1. Credit risk – definition

2. Basic debt instruments

3. Macro assessment of credit risk, esp. CR

4. Credit registers

5. Assessment of credit risk, country risk

6. Micro assessment of credit risk - loan granting process

7. Loan pricing

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Credit risk – Basic debt instruments

A simple loan

Fixed-payment loan contract

Coupon bond

Discount bond (or zero-coupon bond)

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Credit risk – Basic credit/debt types

Corporate financing (corporate loans, securities)

Retail financing (retail loans, loans to households = individuals + trades)

Consumer credits

Mortgages

Etc.

Government and public financing

Loans to financial institutions

Project financing and other structured financing (of corporate or public projects)

Etc.

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Contents

1. Credit risk – definition

2. Basic debt instruments

3. Macro assessment of credit risk, esp. CR

4. Credit registers

5. Assessment of credit risk, country risk

6. Micro assessment of credit risk - loan granting process

7. Loan pricing

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Credit risk – credit growth, euro area

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Credit risk – loan portfolio in the Czech Republic

Source: www.cnb.cz, Financial Market Supervision Report, 2008, 2011

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Credit risk – Loan portfolio structure, CR

Source: Financial market supervision report, 2011

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Credit risk – credit growth, CR

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Credit risk – Retail financing in CR

Source: Financial market supervision report, 2008, 2011

Loans to individuals by time and type:

Total housing loans represent 76% of all loans provided to individuals.

Out of these 85 % are mortgages (2011), the portion of morgages is slightly incerasing.

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Credit risk – Measurement of credit risk (CNB)

Provisions for client loans assessed individually.

Source: www.cnb.cz, Decree of CNB No. 123/2007 Coll. as amended by Decree of CNB No. 282/2008 Coll.

CategoryArrears

(overdue)Probability of

PaymentUnderlying Financial

Position

CNB Required

Provision (%)

Provision permitted by

Tax Authority (%)

Standard < 31 days No Doubts No debts restructured in the last 2 years

0 0

Watch 30-90 days Expected No Debt rescheduled in the last 6 months

1 0

Sub-standard

90-180 days Partial Payment Expected

20 1

Doubtful 180-360 days

Full repayment very unlikely, partial possible

50 10

Loss >360 days Highly unlikely A receivable from a debtor in composition proceedings, debtor has declared bankruptcy

100 20

Watch loans – until December 2004 the loan loss provision for watch loans amounted 5 %.

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Credit risk – Measurement of credit risk (CNB)

DefaultA debtor is in default at the moment when it is probable that he will not repay his obligations in a proper

and timely manner, or when at least one repayment of principal is more than 90 days past due.

substandard, doubtful and loss loans – „loans in default“ or non-performing loans

Source: www.cnb.cz, Decree of CNB No. 123/2007 Coll. as amended by Decree of CNB No. 282/2008 Coll.

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Credit risk – Measurement of credit risk (CNB)

Since 2005, banks have been able to use the portfolio-based approach (statistically based) to calculate provisions (allowances) for certain loan types (particularly in the retail banking segment).

(Provisions (allowances) assessed on portfolio basis increased dramatically in course of 2007 (in 2006 they represent 2 % of total allowances and in 2007 14,5 % of total allowances)), also due to the fact that more receivables are assessed on the portfolio basis, but slightly declined in course of 2008.

……allowances for individually assessed loans are increasing since 2008

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Credit risk – Loan portfolio quality (1992 – 2005)

1992* 1993* 1995 1999 2001 2003 2005

Total gross credits (CZK bn) 585 702 961 914 944 950 1.185

Watch (%) na 2.4 6.3 9.8 8 6.8 6.8

Substandard (%) na 7 4.2 4.2 3.4 2 1.5

Doubtful (%) na 6.7 4.5 4.1 3.1 0.7 0.6

Loss (%) na 5.6 21.3 12.8 7.6 2.5 1.8

Total Problem Loans (%) 19 21.7 36.3 32.2 22.1 12 10.7

Total Provisions and res.(CZK bn) 90 121 117 104 79 38 29.8

As % of All Problem Loans 81 79 33 36 38 33 23.3

As % of Loss Loans na 307 57 86 110 162 138

Provision Gap (CZK bn)** 21 31.7 232 187 131 76 98

As % of Equity na 33 151 151 87 111 142

As % of Operating Profit na 79 773 na. 348

Loss Loan Provision Gap (CZK bn)*** na -81.2 88 17 -7 -14.6 -8.3

As % of Equity na na 57 14 -5 -21.4 -11.8

As % of Operating Profit na na 293 na. -35

As a % of GDP

All Problem Loans (%) 14 18 28 15 10 6,7 6.8

Loss Loans (%) na 5 16 6 3 1.3 1.1 * 1992 and 1993 loan classifications reported according to definitions in use before July 1994 CNB provision** Provision Gap (unweighted) = Total Problem Loans – Provisions and Reserves,*** Loss Loan Provision Gap = Loss Loans – TOTAL Provisions (for all categories of loans)

Source: Merrill Lynch (1997) p.21 for 1992–5, World Bank 1999, CNB Banking Supervision Report (2005), authors

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Credit risk – Loan portfolio quality (2006 – 2011)

Source: Financial market supervision report, 2008, 2011

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Credit risk – Loan portfolio quality

Source: Financial market supervision report, 2008, 2011

Total value of the sector´s balance sheet – CZK 4 476 billions

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Contents

1. Credit risk – definition

2. Basic debt instruments

3. Macro assessment of credit risk, esp. CR

4. Credit registers

5. Assessment of credit risk, country risk

6. Micro assessment of credit risk - loan granting process

7. Loan pricing

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Credit registers

Banking sector – significant exposure to risk due to high information assymetry (moral hazard and adverse selection)

One of the way to reduce credit risk is to improve the information background of banks – to share information - with the help of registers of credits

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Credit registers

Source: Financial market supervision report, 2007

Central Register of Credits (CRC) - pools information on the credit commitments of individual entrepreneurs and legal entities, in operations since 2002 (created and operated by CNB)

Banking Register of Client Information - specialises in natural persons, private citizens and sole traders, operated by the Czech Banking Credit Bureau, a.s., founded by commercial banks

SOLUS (Association for the Protection of Leasing and Loans to Consumers)

Non-Banking Register of Client Information (NBRKI)

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Contents

1. Credit risk – definition

2. Basic debt instruments

3. Macro assessment of credit risk, esp. CR

4. Credit registers

5. Assessment of credit risk, country risk

6. Micro assessment of credit risk - loan granting process

7. Loan pricing

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Credit risk management models

,

Credit risk assessment

Scoring

Altman Z-score

Rating

Credit risk models

Credit Monitor Model (KMV Moody´s)

Credit Margin Models

CreditMetrics (based on VaR methodology)

RAROC

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Credit risk assessment - Scoring

Scoring (scoring models, scoring functions)

used for the credit assessment of small companies or individuals

credit risk of individuals is assessed using more or less simple scoring function with independent variables such as income, age, number of children etc. Scoring functions are used for products like consumer credit or mortgage.

Credit risk of small companies is (usually) based on scoring function with financial ratios ad independent variables

scoring does not look at qualitative issues, as it would be inefficient (large number of credits with relatively low nominal value).

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Credit risk assessment - Rating

Rating (more qualitative issues included)

Rating agencies – Moody´s, Standard & Poor´s, FITCH

Short-term rating (for debt instruments with a maturity less than one year)

Moody’s Standard & Poor’s

Prime-1 A-1Prime-2 A-2Prime-3 A-3

BNot Prime C

D

Investment grade

Speculative grade

Note: It is worthwhile to recall that there is a big jump between a rating of BB– and BBB+. It is a small difference in rating, but as it divides the rating scale between investment and speculative grade, it receives special attention from the investor community.

Long-term rating (maturity of more than 1 year)

Standard & Poor´s (AAA, AA, A, BBB, BB…..D), or with + - refinements

Moody´s (Aaa, Aa, ….Baa, Ba, ….)

Credit risk of the countries - Sovereign risk

Source: www.cnb.cz, Financial Stability Report 2011/2012

What would you say about local currency rating ?

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Credit risk Lessons from the past crisesSweden & Japan

Source: FITCH

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Credit risk Credit ratings = assessment of credit riskSovereign ratings 2005-Q2 2009

Source: FITCH

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Credit risk Sovereign ratings reflected in 5-year CDS spreads...

Source: FITCH/Thompson Datastream

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Credit risk Sovereign ratings - average ratings in emerging markets as of 28 October 2009

Source: FITCH

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Credit risk Deteriorating bank ratings

Source: FITCH

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Contents

1. Credit risk – definition

2. Basic debt instruments

3. Macro assessment of credit risk, esp. CR

4. Credit registers

5. Assessment of credit risk, country risk

6. Micro assessment of credit risk - loan granting process

7. Loan pricing

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Loan granting process

General level –

Credit strategy (approved by Board of Directors)

Organizational issues (departments involved in credit process)

Internal norms

Credit limits

Credit risk management

Controlling and audit

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Loan granting process

Individual loan level –

Loan/client acquisition

Loan/client valuation

Collateral valuation

Credit approval

Loan/client monitoring

Loan/client classification and provisioning

(Work-out)

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Contents

1. Credit risk – definition

2. Basic debt instruments

3. Macro assessment of credit risk, esp. CR

4. Credit registers

5. Assessment of credit risk, country risk

6. Micro assessment of credit risk - loan granting process

7. Loan pricing

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Loan princing

,

Traditional approach (Cost-plus-profit approach)

RAROC (Risk-adjusted return on capital (risk adjusted profitability measure where the volatility of losses is taken into account)

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Sources