creditriskmeasurement_mumbai-020510 .txt

8/11/2019 creditriskmeasurement_mumbai-020510 .txt

1/128


2/128

SourcesofrisksMarketRiskFebruary8,20102CreditRiskOperationalRiskReputationRiskFISourcesofrisksMarketRiskFebruary8,20102CreditRiskOperationalRiskReputationRiskFI


3/128

IncreasedimportanceofCreditRiskMarketconditionsRegulatoryrequirementsimpactofBasleAccords;

primarilyBasleIIFebruary8,20103IncreasedimportanceofCreditRiskMarketconditionsRegulatoryrequirementsimpactofBasleAccords;primarilyBasleIIFebruary8,20103


4/128

BasisofCreditRiskManagementTheoreticallyavoidablepracticallyonehastolivewithitAppropriatemeasurement

MitigationFebruary8,20104BasisofCreditRiskManagementTheoreticallyavoidablepracticallyonehastolivewithitAppropriatemeasurementMitigationFebruary8,20104


5/128

SeparationofRiskManagement&Lending

RiskManagement

.Responsiblefordevelopingacredit

strategy&approvingallcreditrisks.Responsibleforongoingmonitoringofa

clientscreditworthiness&creditexposure.Establishesandmaintainscreditratings.DeterminescredittermsandconditionsLendingGroups

.Responsibleformanaging

clientrelationships.


6/128

Marketloanproductsloanproducts.Market

.Originate,structureandexecutetransactionsFebruary8,2010


7/128

CreditRiskManagement-Objectives

.Atthetransactionlevel.Establishanappropriatecreditrisk

environment.Operateunderasoundcreditapprovalprocess.Maintainanappropriate

creditadministration,measurementandmonitoringprocesssophisticatedtools/techniquestoenablecontinuous

.EmployEmploysophisticatedtools/techniquestoenablecontinuousriskevaluationona

scientificbasis


8/128

.Adequatepricingtooptimizerisk-return

relationship.Attheportfoliolevel.Developmethodologiesandnormsto

evaluateandmitigaterisksarisingfromconcentrationbyindustry,groupetc..Ensure

adherencetoregulatoryguidelines.DriveassetgrowthstrategyFebruary8,2010


9/128


10/128


11/128

CreditRiskManagementRequirementsMeetthedraftBISguidelinesincreditriskmanagementFebruary8,20108MeettherequirementsstipulatedintheRBIguidelinesforriskmanagementsystemsinbanks

MeetinternallimitsCreditRiskManagementRequirementsMeetthedraftBISguidelinesincreditriskmanagementFebruary8,20108MeettherequirementsstipulatedintheRBIguidelinesforriskmanagementsystemsinbanksMeetinternallimits


12/128


13/128

ageneralpurposeevaluationoftheevaluation

oftheborrower

.Notaonetimeassessmentof

creditworthinessoftheborrower.Notnecessarilyco-relatedtoEquitymarkets/

SharePriceetc.February8,2010


14/128

CreditRatingFramework

.CreditRating:Anopiniononabilityandwillingnesstopayin

fullandintimelymannerallfinancialobligations.Theproposedanalyticalframework

dividesvariousissuesthatimpactcreditriskintoseparatecategories.Ensurescomprehensivenessallrelevantissuesarecovered.Ensuresstandardizationandcomparability-increases

consistency.Enables


15/128

bettercommunicationButframeworkhastobe

usedonlyasabroadguidelineandnotrigidly.Casespecificissues

needmodificationinparametersandrelativeimportanceofthevariouselements.

February8,2010


16/128

CreditRatingFramework

.Ability:Riskofcashgenerationandextentofobligationsthathave

tobemetfromthesecashflows.Cashgenerationabilityinturn

dependsupon.Macro:Economyandindustryrisk.Micro:Companyscompetitivepositionintheindustry.MarketpositionRevenuegenerationriskPrice

&volumerisk


17/128

.OperatingefficiencyCostandproduction

risk.Extentofobligation:MeasuredbyFinancialRisk(Liabilitysidefocus)

.Fullandtimely:Financialflexibilityandcashflowadequacy.Willingness:An

indexofManagementRisk.Alltheseelementsdeterminethestandalonecreditquality..Further,ifthecompanyisowned/partofastrongparent/

group,itcan


18/128


19/128

Whatshouldbedone

.Buildingabottom-upviewofthebusiness.Silo

approachinconceptlargenumberofinterlinkagesinpractice.Natureand

strengthofsuchinterlinkagesiskeytoappreciatingbusinessdynamicsgy

yppinthiscontext,thekeyquestionstoconsiderare:

.Where


20/128

isthecompanytoday?.Whattargets

havetheysetthemselves?.Whatstrategywilltheyadopttoachieve

it?.Howwilltheexternalenvironmentrespond?.Howhasmanagementresponded

totheenvironmentinthepast?Whatwilltheydonow?February8,2010


21/128

Banksvs.CreditRatingAgencies

.CRAsusecashflowbasedassessments.Banksmayusesecurity

basedassessments.CRAscarryoutcashflowprojections/sensitivities.Banksmay

dolikewisebasedoncompanyprojections.CRAsassessunderlyingsecurityonlyasanadditionalassessunderlyingsecurityonlyasanadditional.CRAsfactor

(tonotch


22/128

up)

.Banksuseunderlying

securitycentrally.Banksmayusetimelypaymenthistorycentrally.CRAs

usetimelypaymenthistoryonlyasahygienefactor.Typically,CRAsfocus

mainlyonassessingProbabilityofDefault.BanksfocusonassessingexpectedlossesFebruary8,2010


23/128

PDvs.ELApproach

.PDApproach.PDapproachfocusesonlyontimelypayments.

PDismorerelevantatismorerelevantat.PDhigherrating

levels

.Recoveryprospectsmaybeaddressedinseparatescale.ELApproach.ELapproachfactorsinrecoveryfromunderlyingsecurityand

othercreditenhancements


24/128

.ELismorerelevantatlower

ratinglevels.OnescaleaddressesbothPDandELFebruary8,

2010


25/128

Cashflowsvs.ProfitsProfitscanmaskpotentialproblemsinanaccrualbasedapproach

Futurecashgenerationfromthebiilldbfibusinesswillrepaydebt,notprofitsBusinesscashflowshavetobeunderstoodinthecontextof:MaturingdebtobligationsFuturecapitalexpenditurerequirementsWorkingcapitalneedstosupportgrowthFebruary8,201015Cashflowsvs.Profits

ProfitscanmaskpotentialproblemsinanaccrualbasedapproachFuturecashgenerationfromthebiilldbfibusinesswillrepaydebt,notprofitsBusinesscashflowshavetobeunderstoodinthecontextof:MaturingdebtobligationsFuturecapitalexpenditurerequirements

WorkingcapitalneedstosupportgrowthFebruary8,201015


26/128

DefaultRates

.Indicates

theprobabilityofdefault(PD)foragivenratingovera

givenperiodoftime.E.g.Aratinghasa3.8%PD

over2years.Eachratinghasastringofprobabilityoveritslife.E.g.0.9%in1-year,3.8%in2-yrs,7.8%in3

yrs,andso


27/128

on.ThTheparadoxofone

instrumentover1000instrumentsdfitt1000it

.Forsingleinvestment,investorcaneithergethismoneyornot!(Binary)

.Butifheholds1000investmentsofsamerating,9or38maydefault(9correspondsto1yeardefaultand38corresponds

toa2


28/128

yeardefault).Distinctionisimportantfor

severalcriteria,particularlyinstructuredfinanceFebruary8,2010


29/128

TransitionRates

.Indicates

probabilityoftransitionfromoneratingtoanotheroveragivenperiod

oftime.E.g.ProbabilityofAAAmovingtoAA

over1-yearis3.5%.ProbabilityProbabilityofanyratingmovingtoofanyratingmovingtoDoveragivenagiven

.Dover


30/128


31/128

ORAFrameworkOverallRiskAssessmentsheetcapturesallthefactorsthatinfluencethebusinessrisk,financialriskassessmentinaconcisemannerassessmentinaconcisemannerEnablesa

snapshotappreciationofallinterlinkagesFebruary8,201018ORAFrameworkOverallRiskAssessmentsheetcapturesallthefactorsthatinfluencethebusinessrisk,financialriskassessmentinaconcisemannerassessmentinaconcisemannerEnablesasnapshotappreciationofallinterlinkagesFebruary8,201018


32/128

CreditRiskManagement:Existing

.HistoricalApproaches:.PrudentialexposuresnormsIndividual,group,and,Industry

wise.MeasurementofriskthroughCreditRating/CreditScoring.Emphasis

oncollaterals.Loanreviewmechanism.Pii:StddidhProvisions:Standardizedapproach

.Riskcapital:Standardized

approach.Newer


33/128

Approaches:.Quantificationofrisk(bothborrower

andfacility).Riskpricing(andpartlythroughHedging).Portfolio

approach:Estimatingexpectedloanlossesandunexpectedloanlosses.Estimatingcapitalrequirements

February8,2010


34/128


35/128

IRBframework:Keyelements

.Riskcomponents:estimatesriskparametersprovidedbybankssomeofwhich

aresupervisoryestimates.Riskweightfunctions:riskcomponentsaretransformedinto

riskweightedassetstransformedintoriskweightedassets

.Minimumrequirements:minimumstandardsthatmustbemetinorderforabank

tousethe


36/128

IRBapproachforagivenassetclass.

February8,2010


37/128


38/128

RiskweightfunctionsCorrelation(R)0.12*(1-exp(-50*pd)

)/(1-exp(-50))+0.24*(1-(

1-exp(-50*PD))/(1-exp(-50))Maturityadjustment(

b)(0.11852-0.05478*ln(PD))^2(0.118520.05478ln(PD))2Capitalrequirement(K)LGD*N((1-R)^0.5*G(PD)+(R/(1-

R))^


39/128

0.5*G(0.999))-PD*LGD)*(

1-1.15*b)^-1*(+(M-2.5)*b)RiskweightedAssets(RWA)

K*12.5*EADFebruary8,201023RiskweightfunctionsCorrelation(R)0.12*(1-exp(-50*pd))/(1-exp(-50)

)+0.24*(1-(1-exp(-50*PD))/(1-exp(-50))Maturityadjustment(b)(0.11852-0.05478*ln(PD))^

2(0.118520.05478ln(PD)


40/128

)2Capitalrequirement(K)LGD*N((1-R)

^0.5*G(PD)+(R/(1-R))^0.5*G(

0.999))-PD*LGD)*(1-1.15*b)^-1*(+(

M-2.5)*b)RiskweightedAssets(RWA)K*12.5*EADFebruary8,201023


41/128

CreditScoringModelsLinearprobabilitymodelandlogitmodelLinearDiscriminantanalysis:AltmansZ-

scoreFebruary8,201024CreditScoringModelsLinearprobabilitymodelandlogitmodelLinearDiscriminantanalysis:AltmansZ-scoreFebruary8,201024


42/128


43/128

CreditRatingSystemsExternalcreditratingsInternalcreditratingsystemFebruary8,201026CreditRatingSystems

ExternalcreditratingsInternalcreditratingsystemFebruary8,201026


44/128

ExternalRatings

.Internationally

S&P,andMoodysareprovidingtheseservices.Theyratebothfinancialinstruments

andcompanies..InIndia,CRISIL,ICRA,CAREandFitcharetheexternal

creditratingagencies..Ratingisaprocessofcategorizingcompaniesandinstrumentsintodiscreteratingcategoriesthatcorrespondtotheestimatedlikelihoodofthe

companyfailingto


45/128


46/128

RatingIssues

.Solicited

rating:Acompanyapproachestheratingagencyforratingofeitherinstrument

orthecompany.Ratingisbasedonbothpubliclyavailableinformationandthe

privilegedinformation.Unsolicitedrating:Ratingonthebasisofpurelypublishedinformationanddisclosingitinthepublicinterestinformationanddisclosingitinthe

publicinterest.


47/128

Issuercreditrating:Theratingisan

opinionontheobligorsoverallcapacitytomeetitsfinancialobligations.The

opinionisnotspecifictoanyparticularliabilityofthecompanynordoes

itconsiderthemeritsofhavingguarantorsforsomeoftheobligations.Counterpartyratings,corporatecreditratings,andsovereigncreditratingsarepartof

issuercreditratings.


48/128

.

February8,2010


49/128

RatingIssues

.Issue

SpecificCreditRating:Theratingagencydistinguishesfinancialinstrumentsintoshortterm

andlongterm..Theratingprocessincludesquantitative,qualitative,andlegalanalyses.

.Thequantitativeanalysisismainlyfinancialanalysisandisbasedonthefirmsfinancialreports..Thequalitativeanalysisisconcernedwiththequality

ofmanagement,and


50/128


51/128


52/128

AssignAnalyticalTeamConductBasicResearchMeetIssuerRatingCommitteeMeetingIssueRatingSurveillanceRequestforRatingAssignAnalyticalTeamConductBasicResearchMeetIssuerRatingCommitteeMeetingIssueRatingSurveillanceReque

stforRatingStandardandPoorsDebtRatingProcess

Source:CrouhyMichael,

DanGalai,RobertMark(2001),RiskManagement,,McGraw-Hill

February8,

2010

31


53/128

InternalRatingSystems

.

Aninternalratingreferstoasummaryindicatorofriskinherentin

anindividualcredit.Ratingstypicallyembodyanassessmentoftheriskofloss

duetofailurebygivenborrowertopayaspromised,basedonconsiderationofrelevantcounterpartyandfacilitycharacteristics..Aratingsystemincludes

theconceptualmethodology,


54/128

managementprocesses,andsystemsthatplaya

roleintheassignmentofrating..BorrowerVsFacilityRating:Borrower

ratingfacilitiesestimationofProbabilityofDefault(PD),whereasfacilityratingor

transactionratingfacilitatesestimationofLossGivenDefault(LGD)also..PointinTimeorThroughtheCycleapproach:PointinTimeis

ratingonthe


55/128

basisofborrowercurrentconditions.Underthrough

thecycleapproachborrowersexpectedconditioninadownwardeventisprimarily

considered.ThroughtheCycleapproachmaybeappropriateforlongtermloans.February

8,2010


56/128

RiskFactors

.Financial

risk:Analysisoffinancialstatementsandcalculationofvariousratios.Industry

risk:Competition,technology,exportpotential,barrierstoentry,productcharacteristicsetc.Management

risk:Professionalexperienceofmanagement,Labourrelations,Professionalqualificationsofmanagement,financialdisciplineofborrowers,CorporategovernanceetcFebruary8,2010


57/128

RiskGrades

.Grades

areaneffectivewayofexpressingdifferentiationofriskcategorizationofentire

loanportfolio..Differentiationofriskandloanpricingareintimatelyrelatedand

alsohelpfulinfixationofexposurenorms..Somegradesmaybecategorizedaspassgradesandygpggsomemaybecategorized

aswatchingcategory


58/128

.Largenumberofgrades

ontheratingscaleisexpensivetooperate.Frequencyoflegitimatedisagreements

aboutratingsislikelytobehigherwhenratingsystemshavelargenumber

ofgradesFebruary8,2010


59/128

HowtoImprovetheQualityof

LoanPortfolio:OpportunitiesforAction

.Choosetherightrisk

indicators.Accuracy.Abilitytoincludeallrisks.Dataavailabilityand

quality.Relevance.Refinethetraditionalcreditratingprocess.FinancialAnalysis.IndustryAnalysis:Aforwardlookingperspective.AuditsandInspectionsto

refinequantitativeanalysis


60/128

.Finetuningfordowngrades.

Gradingthecustomerforpricingandriskmanagement.Compromisingwiththe

creditratingsystem.Improvetheskillsoflinecreditofficers.Validate

thecreditmanual.Tightenthecontroloverthedecisionmakingprocess.Enforcethetrueriskbasedpricing.Introducesimpleboardlevelrisk

reportsfornon-risk


61/128

expertsFebruary8,2010


62/128

CreditScoringModelsFebruary8,201036CreditScoringModelsFebruary8,201036


63/128

LinearProbabilityModel

.

TheLinearprobabilitymodelusespastdatasuchasfinancialratios,as

inputsintoamodeltoexplainrepaymentexperienceonoldloans..

Loansaredividedintotwoobservationalgroups:thosethatdefaultedandthosethatdidgroups:thosethatdefaultedandthosethatdidnotdefault.

.


64/128

Relatetheseobservationsbylinearregressionto

asetofcasualvariablesthatreflectquantitativeinformationabouttheborrower

suchasleverage.February8,2010


65/128


66/128

1LogistictransformationofthevalueofPDarrivedinthelinearprobitmodelbypluggingthePDintothefollowingformulaPDiiePDF-+=11)(February8,2010391LogistictransformationofthevalueofPDarrivedinthelinearprobitmod

elbypluggingthePDintothefollowingformulaPDiiePDF-+=11)(February8,201039


67/128

TheLogitModelThemodelfitsY=V+WX+

errortermYhavingaspecificcategoricalvalueas:as:P(Y)=1/((1+exp(

-Y))LogisticProbabilityDistributionFebruary8,201040TheLogitModelThemodelfitsY=V+WX+errortermYhavingaspecificcategoricalvalueas:

as:P(Y)=1/((1+exp(-Y))

LogisticProbabilityDistributionFebruary8,201040


68/128

TheProbitModelP(Y)=cdf(Y)

=cdf(Y=V+WX+error)IfCDFis1.55meanstheP(Y)=93.94%

withthecumulativeStandardisednormaldistributionnormaldistributionFebruary8,201041TheProbitModelP(Y)=cdf(Y)=cdf(Y=V+WX+

error)IfCDFis1.55meanstheP(Y)=93.94%withthecumulativeStandardisednormaldistributionnormaldistributionFebruary8,201041


69/128

Linear-DiscriminantModel:AltmansOriginalEquationZ=1.2x1+1.4X2+

3.3X3+0.6X4+1.0X5X=WC/TAX1WC/

TAX2=RE/TAX3=EBIT/TAX4=MVofEquity/BVofLiabilities

X5=Sales/TAFebruary8,201042Linear-DiscriminantModel:AltmansOriginalEquationZ=1.2x1+1.4X2+3.3X3+0.6X4+1.0X5X=WC/TAX1WC/TAX2=RE/

TAX3=


70/128

EBIT/TAX4=MVofEquity/BVofLiabilitiesX

5=Sales/TAFebruary8,201042


71/128

Firmswithhighscores(orabovecut-offvalue)ofZcouldbeclassifiedasnon-defaultersandwithlowZscoresasdefaulters.

Classificationproceedswithfunctionsthatgeneratestheprobabilityofbeinginagivengroupbasedonthescorevalue.February8,201043Firmswithhighscores(orabovecut-offvalue)ofZcouldbeclassifiedasnon-defaultersandwithlowZscoresasdefaulters.Classificationproceedswithfunctionsthatgeneratestheprobabilityofbeinginagivengro

upbasedonthescorevalue.February8,201043


72/128

ROCCurve

.The

RecoveryOperatingCharacteristic(ROC)AccuracyRatioiscomputedbycomparingthe

pairs.Theaccuracyratioistherelationshipbetweenallpossiblepointsandthe

maximumbfithihiltthtt

numberofpointswhichisequaltothetotallnumberof

samplepoints.


73/128

.Amodelwhichhasthe

highestROCscoreisconsideredasthebestmodelamongothers

February8,2010


74/128

Estimating PDsScores arrived in this process can be transformed in toposterior probabilities which makes the model as defaultprediction model. Here finding the default probability isconditional score Zgreater than the value zobtainedfor a particular firm. With the help of Bayes theorem

conditional (a priori probability) probabilities can beconverted in to conditional posterior probabilities.February 8, 2010 45


75/128

C re d i t Ri s kM o d e l s46CreditRiskModels46


76/128


77/128

TermStructureApproachRiskpremiumsareinherentincurrentstructureofyieldsoncorporatedebt.Thisgivesexpecteddefaultratesfromthecurrenttermstructureofinterestrates.


78/128


79/128

-cyyf111*11fisrecoveryrateyisyieldonTreasurySecurityYcisyieldonCorporatebondFebruary8,201048TermStructureApproachRiskpremiumsareinherentincurrentstructureofyieldsoncorporatedebt.

Thisgivesexpecteddefaultratesfromthecurrenttermstructureofinterestrates.


80/128

---


81/128

-cyyf111*11fisrecoveryrateyisyieldonTreasurySecurityYcisyieldonCorporatebondFebruary8,201048


82/128

LimitationsListedcorporatebondsareveryfewPoorliquidityofcorporatebondsFebruary8,201049Limitations

ListedcorporatebondsareveryfewPoorliquidityofcorporatebondsFebruary8,201049


83/128

MortalityRateDerivationofCreditRisk

.DefaultprobabilitiesarederivedfromMarginalMortalityRate(

MMR)..MMRofYear1=TotalvalueofgradeA

bondsdefaultinginyear1ofIssue/TotalvalueofgradeBbondsoutstandinginyear2ofissue.Itproduceshistoricor

backwardlooking..


84/128

Implieddefaultprobabilitiesmaybehighlysensitive

totheselectedperiod.February8,2010


85/128


86/128

publiclytraded.(example:CreditMetricsTM).

This

approachalsocalledasVaRapproach

February

8,2010


87/128

ComponentsrequiredAvailabledataonaborrowerscreditratingRatingtransitionmatrix

RecoveryratesondefaultedloansYieldspreadsinthebondmarketpFebruary8,201052ComponentsrequiredAvailabledataonaborrowerscreditratingRatingtransitionmatrixRecoveryratesondefaultedloansYieldspreadsinthebondmarketpFebruary8,201052


88/128

Mark-toMarketApproach

.

Acreditlosscanariseinresponsetodeteriorationinanassets

creditquality..TheMTMapproachtreatsthecreditportfolioisbeingmarked

tomarketatthebeginningandendoftheplanninghorizon.Creditlossisthedifferencebetweenthesevaluations.Thesemodelsmustalso

incorporatecreditrating


89/128


90/128

ProblemsinApplicationofVaRtoloansMarketValueofLoansarenotavailableasloansarenotnon-tradableNotimeseriestocalculatethevolatility(Y)

NormalDistributionisroughapproximationFebruary8,201054ProblemsinApplicationofVaRtoloansMarketValueofLoansarenotavailableasloansarenotnon-tradableNotimeseriestocalculatethevolatility(Y)NormalDistributionisroughapproximationFebruary8,201054


91/128


92/128

Thuscreditriskexistsaslongas

thePr.(VT0(probabilityofdefault).ThisThisimplies

thatattime0,Bimpliesthatattime0B0

creditriskmeasurement_mumbai-020510 .txt

Documents