Module 28: Management of credit risk

Question 1

4 General methods of managing credit risk

Answer 1

• avoid bad risks in the first place!
• diversify credit exposure across a number of counterparties
• monitor exposure regularly
• take immediate action if and when default occurs

Question 2

5 Steps of the credit risk management process

Answer 2

1. Policy and infrastructure
2. Credit grating
3. Exposure monitoring, management and reporting
4. Portfolio management
5. Credit review

Question 3

Steps of the credit risk management process:

Policy and infrastructure (4)

Answer 3

This stage sets the foundations for controlling credit risk:

• establishing an appropriate credit environment
• adopting credit risk policies and procedures
• appropriate to the company’s business context
• addressing a range of topics
• adopted by senior management

• implementing credit risk policies and procedures

• communicated to all relevant employees
• reviewed at least annually to reflect any change in the business context
• developing methodologies and models, with appropriate systems
• defining data standards and conventions

Question 4

Steps of the credit risk management process:
Credit granting (5)

Answer 4

This stage considers extending of credit to counterparties. It considers:
• credit analysis / rating of counterparties
• credit approval
• setting terms and conditions for credit
• pricing
• documentation

Question 5

Credit ratings need to: (3)

Answer 5

• balance effectiveness and efficiency
• be based on judgement, modelling, or both, and reflect:
• – the borrowers repayment history, ability to pay and their reputation
• – any guarantees or collateral

• be reviewed regularly

Question 6

Steps of the credit risk management process:

Exposure monitoring, management and reporting

Answer 6

It is important to calculate current exposure and potential exposure consistently across the organisation.

Question 7

Monitoring should: (4)

Answer 7

• be at the portfolio level
• be in respect of specific individuals, industries or geographies
• aim to limit concentrations and ensure appropriate diversification
• track risk indicators (eg credit spreads) to provide early warning of possible adverse credit events

Question 8

Exposure limits facilitate: (4)

Answer 8

• risk control
• allocation of risk-bearing capacity
• delegation of authority
• regulatory compliance

Question 9

Best practice credit risk reporting includes: (4)

Answer 9

• trends
• risk-adjusted profitability
• exposures
• exceptions

Question 10

Aim of the portfolio management function

Answer 10

To optimise the desired risk/return trade-offs by defining a target portfolio through its credit policy.

This credit policy will document the strategies and financial vehicles that can be used to actively manage the credit portfolio.

Question 11

A credit review group should:

Answer 11

• review a sample of transactions,
  • test systems,
  • enforce standards,
  • check compliance with policies and procedures.

The results of each review should be communicated to management, highlighting any exceptions or deficiencies along with the established timeframes for their resolution.

Question 12

Credit risk granting and review decision are facilitated by: (6)

Answer 12

• underwriting
• – determining whether to approve or deny the application
• – setting the terms for the loan
• – using credit-scoring, categorisation models, third-party ratings
• due diligence
• – care a reasonable person should take before entering into any agreement or transaction with another party
• – considers what could go wrong (including incidental credit risk and other-counterparty risks)
• – based on a wide range of factors including subjective information.

Question 13

Credit risk transfer may be achieved using: (3)

Answer 13

• credit insurance
• credit derivatives
• securitisation of assets

Question 14

Credit risk transfer:

credit insurance

Answer 14

can be used to mitigate large exposures of particular types of credit risk (especially incidental credit risks, ie those not related to core business).

Question 15

Credit risk transfer:

credit derivatives

Answer 15

• – involve exposure to counterparty risk, but are more liquid than the referenced asset
• – credit default swaps hedge default risk and are often used by banks who have reached their internal credit limit with a particular client but wish to maintain their relationship with that client
• – total rate of return swaps hedge both price and default risk
• – credit-linked notes are a bond with an embedded credit default swap

Question 16

Credit risk transfer:

securitisation of assets

Answer 16

• – converts a bundle of risky assets into negotiable structured financial instruments with different risk features
• – transfers risk, may be a way to sell exposure to relatively unmarketable assets, and can be an alternative source of finance.

Question 17

A company can manage the level of credit-risk to which it exposes its own stakeholders by adjusting: (2)

Answer 17

• its capital structure

- the mix and volume of business it writes

Question 18

Outline the characteristics of an effective and efficient credit analysis / rating process

Answer 18

Any credit risk rating system:

• needs to strike a balance between effectiveness (accurate, consistent and timely) and efficiency (low cost)
• may be based on pure judgement or deterministic modelling
• should respond to changes in the circumstances of the counterparties,
  ratings being regularly reviewed, particularly if a party’s creditworthiness is deteriorating.

Question 19

Credit ratings will reflect: (4)

Answer 19

• the borrower’s repayment history
• an analysis of the borrower’s ability to pay
• their reputation
• the availability and enforceability of guarantees or collateral

Question 20

Credit risk management process:

Describe the aim of the monitoring stage

Answer 20

• to prevent undue exposure to an individual counterparty
• to ensure appropriate portfolio diversification (eg by industry, location, etc)
• to provide early warning of possible adverse credit events (eg monitoring indicators such as credit spreads and stock price volatility)

Question 21

2 types of credit exposure

Answer 21

• current exposure
  the amount at risk today if all credit transactions were settled and credit assets sold
• potential exposure
  the amount that may be at risk in the future, which is likely to be a function of time to maturity and volatility of the underlying instrument

Question 22

Define due diligence

Answer 22

The care a reasonable person should take before entering into any agreement or transaction with another party.

Question 23

Describe 7 potential benefits of obtaining credit insurance

Answer 23

1. Protection against some or all bad debts.
2. Cover for some or all debtors.
3. Cover for domestic or international trade.
4. Specialist advice based on the experience of the insurer.
5. Cover for expenses incurred.
6. International cover for country risk, debt recovery services and any losses on forward foreign exchange commitments.
7. An ability to secure better terms for financing (helping to offset the cost of the insurance).

Question 24

The cost of credit insurance will take into account: (5)

Answer 24

• the industry sector
• the country risk
• the nature of the goods and services
• the terms of trade
• track record of existing buyers

Question 25

Describe 5 types of credit event

Answer 25

1. bankruptcy
   (insolvency, winding-up, appointment of a receiver)
2. a rating downgrade
3. repudiation - when the debt issuer simply chooses to cancel all of the outstanding interest payments and the capital repayment of the debt.
4. failure to pay a particular coupon.
5. cross-default.
   A cross-default clause on a bond means that a credit event on another security of the issuing firm will also be considered as a credit event on the reference bond.

Question 26

Credit default swap (CDS)

Answer 26

Involves the payment of a fee (single or regular) by the party that is looking to hedge their credit risk (the protection buyer) to the party that is selling the protection.

In exchange for this fee, the seller of the protection will make a credit default protection payment if a credit default event on the reference asset occurs within the term of the contract.

This hedges the default risk but does not explicitly hedge the price risk.

Question 27

4 Specific examples of asset-backed securities

Answer 27

1. Residential and commercial mortgage-backed securities (MBS) where payments are secured or collateralised on the interest and capital payments made under mortgages used to buy property.
2. Credit card receivables (CCABS) based on the payments made by credit card holders to the credit card company.
3. Collateralised loan, bond and debt obligations, which are typically collateralised on existing bank loans, bonds and a mixture of both bank loans and bonds.
4. Insurance securitisations, where a financial security is created that is backed by the receivables arising from an insurance book.

Question 28

Credit-linked note (CLN)

Answer 28

A collateralised vehicle consisting of a bond with an embedded credit default swap.