Advanced Risk Management

Gustavo Peralta Rassi, PhD, FRM

Chapter 1: Introduction to credit risk and background
Agenda

1.Introduction to credit risk

2. Key components of credit risk

3. Obligor credit risk and portfolio perspective

4. Regulatory framework: capital requirements and credit risk

provision

Chapter 1: Introduction to credit risk 2

1. Introduction to credit risk

What does “Credit” means?

• The expectation (upon which a lender acts) that funds advanced to a borrower in a
financial transaction will be repaid in accordance with the agreement made between
the party lending the funds and the party borrowing those funds.

• This expectation relies on borrower’s behavior:

• His willing to repay its debts.

• His capacity to repay its debts.

No simple YES/NO answers to these analyses; instead, a judgment of probability is

required.

Chapter 1: Introduction to credit risk 3

1. Introduction to credit risk

What does “Credit risk” mean?

• Credit risk is defined as the likelihood that the borrower will not fulfill its financial
obligations in accordance with the terms of the credit agreement, potentially resulting in
economic losses for the lender.

• It is present in many business context:

• Most non-financial firms face varying degrees of credit risk when offering credit to
buyers to facilitate sales, except when there is a simultaneous exchange of goods/services
for cash (Trade Credits).

• Financial firms (Banks) cannot avoid credit risk since it is part of their core business.
Their success relies on performing financial intermediation activities and managing the
corresponding credit risk.
Chapter 1: Introduction to credit risk 4
1. Introduction to credit risk
What are the sources of credit risk?
Obligor
• Capacity to repay debts
• Willingness to repay debts

Environment
• Macroeconomic performance
• Country risk
• Legal system

Credit Instrument
• Loans
• Credit cards and credit lines
• Debt security

Credit Mitigants
• collaterals
• Additional guarantees

Chapter 1: Introduction to credit risk 5

1. Introduction to credit risk
What are the sources of credit risk?
Obligor
• Capacity to repay debts Obligor/Borrower
• Willingness to repay debts

It refers to the agent who is obligated to return the funds

advanced by the lender.
Environment
• Macroeconomic performance
• Country risk The assessment of obligors requires analyzing their i) capacity
• Legal system
and ii) willingness to repay their debts.
Credit Instrument
• Loans i) Capacity to repay
• Credit cards and credit lines
• Debt security
• It is a highly quantitative evaluation that usually relies on
past, current and forecasted economic and financial data
Credit Mitigants
• Collateral
from the borrower.
• Additional guarantees
• The focus is to assess the extent to which a debtor has the
capacity to perform its financial obligations by analyzing its
assets, current and future debts, cash flows, etc.

Chapter 1: Introduction to credit risk 6

1. Introduction to credit risk
What are the sources of credit risk?
Obligor
• Capacity to repay debts
• Quantitative assessments based on financial data have
• Willingness to repay debts limitations:

 The historical nature of economic and financial

Environment
• Macroeconomic performance
data means that it is never entirely up to date at the
• Country risk moment of analysis.
• Legal system

 Accurate financial forecasting is challenging. No

Credit Instrument
• Loans
matter how sophisticated the projection models are, they
• Credit cards and credit lines are prone to errors and distortions.
• Debt security

 Inevitable gap between financial reporting and

Credit Mitigants
• Collateral
financial reality.
• Additional guarantees o Financial reporting is an imperfect attempt to
describe the economic reality in extremely simplified
reports.

o The amount of discretion allowed by the accounting

Chapter 1: Introductionstandard results in financial reports that require7
to credit risk
some degree of interpretation.
1. Introduction to credit risk
What are the sources of credit risk?
Obligor
• Capacity to repay debts
ii) Willingness to pay
• Willingness to repay debts
• It is a highly subjective and qualitative evaluation related
to the borrower’s reputation and character to fulfill its
Environment
• Macroeconomic performance
obligations.
• Country risk
• Legal system
• This assessment is closely linked to the borrower’s past
behavior by relying on their credit records.
Credit Instrument
• Loans
• Credit cards and credit lines • Historically, moral obligations were fundamental to assess
• Debt security
the willingness to pay. In modern societies, mora obligations
have been replaced by legal obligations.
Credit Mitigants
• Collateral
• Additional guarantees • The effectiveness of legal systems in enforcing debt
repayment reduces, to some extent, the importance of the
willingness to pay assessment. However, an effective but
cost-inefficient legal system reduces the protection for
lenders.
Chapter 1: Introduction to credit risk 8
1. Introduction to credit risk
What are the sources of credit risk?
Obligor
• Capacity to repay debts Environment
• Willingness to repay debts

It refers to the external conditions affecting the obligor’s

capacity and willingness to meet his financial obligations.
Environment
• Macroeconomic performance
• Country risk Among the most relevant environmental factors impacting the
• Legal system
borrower’s ability to repay its obligations, we should mention:
Credit Instrument
• Loans
• Recent an expected macroeconomic performance.
• Credit cards and credit lines
• Debt security
• Regional, industrial and sector perspectives.
Credit Mitigants
• Collateral
• Country risk and systemic risk.
• Additional guarantees
• Effectiveness and cost-efficiency of the legal system.

Chapter 1: Introduction to credit risk 9

1. Introduction to credit risk
What are the sources of credit risk?
Obligor
• Capacity to repay debts Credit Instrument
• Willingness to repay debts

It refers to the specific set of attributes of the financial

obligation from which credit risk arises.
Environment
• Macroeconomic performance
• Country risk Among the most relevant aspects characterizing the
• Legal system
underlying transaction, we should mention:
Credit Instrument
• Loans
• Maturity and currency
• Credit cards and credit lines
• Debt security
• Purpose of the transaction.
Credit Mitigants
• Collateral
• Type of interest (fixed or adjustable rates)
• Additional guarantees
• Specific covenants affecting the credit exposure

• Existence and types of credit mitigants (see next point)

Chapter 1: Introduction to credit risk 10

1. Introduction to credit risk
What are the sources of credit risk?
Obligor
• Capacity to repay debts Credit Mitigants
• Willingness to repay debts

It refers to the various mechanisms attached to the

Environment transaction with the purpose of limiting its credit risk.
• Macroeconomic performance
• Country risk
• Legal system
Mitigants allow to circumvent, to some extent, the difficulties of
conducting an effective borrower's risk assessment by
Credit Instrument replacing it with an analysis of the mitigants.
• Loans
• Credit cards and credit lines
• Debt security
• Secured lending refers to the use of credit risk mitigants to
ensure the repayment of financial obligations.
Credit Mitigants
• Collateral • Main types of mitigants:
• Additional guarantees

o Collateral
o Additional guarantees

Chapter 1: Introduction to credit risk 11

 1. Introduction to credit risk
What are the sources of credit risk?
Obligor
• Capacity to repay debts Collateral
• Willingness to repay debts

o Assets deposited or assigned to the lender proving the

right to obtain full or partial possession to satisfy the
Environment
• Macroeconomic performance corresponding financial obligation in case of the borrower’s
• Country risk default.
• Legal system

o The lender receiving the collateral becomes a secured

Credit Instrument
• Loans
creditor and has legal rights over the designated assets to
• Credit cards and credit lines ensure the repayment of the financial obligation.
• Debt security

o In case of default, the lender takes possession of the asset

Credit Mitigants
• Collateral
through foreclosure1 and sells it to satisfy the outstanding
• Additional guarantees obligation.

o Since collateral can be valued with some degree of accuracy,

the credit decision is considerably simplified, thus
alleviating the need to assess the borrower’s willingness and
1. It refers to the legal process through which a lender attemptsChapter
to recover capacity
1: the
Introduction to
outstanding repay.
tobalance
credit risk
of a financial obligation by repossessing and selling the 12
pledged collateral.
1. Introduction to credit risk
What are the sources of credit risk?
Obligor
• Capacity to repay debts
Guarantees
• Willingness to repay debts
o It refers to the promise by a third party, the guarantor, to
accept the liability for the debts granted to the primary
Environment
• Macroeconomic performance
obligor in the case of his default.
• Country risk
• Legal system

o Unlike collateral, the use of guarantees does not eliminate

Credit Instrument
• Loans
the need to perform a credit analysis. Actually, it requires to
• Credit cards and credit lines take into account the solvency of the primary borrower
• Debt security
and his guarantor.
Credit Mitigants
• Collaterals
• Additional guarantees o Typically, the guarantor has greater creditworthiness (or
easier to analyze) than the primary borrower to materially
reduce the credit risk.

Chapter 1: Introduction to credit risk 13

1. Introduction to credit risk

How can we measure credit risk?

Default risk – Probability of Default (PD): likelihood that the
borrower will be unable to meet debt obligations within a certain time
horizon (usually 1 year).
Default
risk
Migration risk – Transition matrix: captures the potential
deterioration of the credit quality (increased PD) of a financial
obligation/borrower within a certain time horizon (usually 1 year).
Correlati Migration
on risk
Credi risk
Recovery risk – Loss Given Default (LGD): relates to the possibility
that, in the event of borrower’s default, the recovered amount would be

t risk lower than the full outstanding amount due.

Exposure risk – Exposure at Default (EAD): results from a more

Exposure Recovery severe loss than expected due to a greater than expected exposure as a
risk risk consequence of the uncertainty of the future amounts that can be lost at
the unknown time of default. It is strongly dependent on the nature of
cash flows of the financial obligation.

Correlation risk (portfolio level): refers to the risk of simultaneous

Chapterdefaults of borrowers.
1: Introduction to credit risk 14
1. Introduction to credit risk

How can we measure credit risk?

Distribution of Credit Losses

o It refers to the probability distribution of losses

incurred by a lender due to borrower defaults (credit
events).

o Main characteristics:

o Highly asymmetric distribution with fat tails: small

losses are the most frequent events while extreme
negative events present higher than normal
probabilities.

o Standard deviation is not an adequate proxy of credit

risk. Chapter 1: Introduction to credit risk 15
1. Introduction to credit risk

How can we measure credit risk?

Expected Credit Loss (ECL)

o Average economic loss due to credit events over a specified

time horizon (typically one year).

ECL = PD x LGD x EAD

o Usually considered as another “production cost” associated

with the supply of financing products.

o A Bank typically covers the ECL by incorporating a credit

loss allowance (portfolio level) in their accounting figures.

Chapter 1: Introduction to credit risk 16

1. Introduction to credit risk

How can we measure credit risk?

Unexpected Credit Loss (UCL)

o Actual credit losses can significantly deviate from

expected losses, seriously compromising the Bank’s
solvency (fat-tail distribution).

o Credit risk can be measured by the Credit VaR (C-VaR),

defined as the difference between the maximum loss at a
specific confidence level (a quantile of the Loss
Distribution) and the ECL:

o The failure of a Bank is limited to catastrophic losses

with a probability of occurrence no higher than the
significance level of the C-VaR.

o Banks maintain economic capital expressed

Chapter into terms
1: Introduction credit risk 17
1. Introduction to credit risk

How can we measure credit risk? Exercise 1

In 2006, Bank Alpha provided a loan to John Doe to buy a house with a principal of €100,000.
Since the collateral (house) was initially valued at €120,000, the loan was overcollateralized.
Due to a bad economic cycle, the economy entered a recession, leading to John Doe being fired
and eventually defaulting on his loan.

This is an example of:

a) Default risk
b) Migration risk
c) Recovery risk
d) Exposure risk
e) Correlation risk

Chapter 1: Introduction to credit risk 18

1. Introduction to credit risk

How can we measure credit risk? Exercise 2

Continuing with the example of John Doe, as a consequence of the default, Bank Alpha exercised
its right to foreclose his house and sell it to recover the debt. At the time of the sale, the
outstanding loan amount was €90.000, whereas the value of the collateral was €75.000.

This is an example of:

a) Default risk
b) Migration risk
c) Recovery risk
d) Exposure risk
e) Correlation risk

Chapter 1: Introduction to credit risk 19

1. Introduction to credit risk

How can we measure credit risk? Exercise 3

Bank A granted a credit line of 1 million euros to a small start-up firm named Apex. At the
beginning, everything seems to be going well for Apex. However, recently, Bank A noticed that
the firm has been suffering from financial problems.

Bank A had initially estimated its exposure to Apex to be €0.3 million; however, this number has
increased to €0.6 million due to a more intense use of the credit line.

This is an example of:

a) Default risk
b) Migration risk
c) Recovery risk
d) Exposure risk
e) Correlation risk

Chapter 1: Introduction to credit risk 20

1. Introduction to credit risk

How can we measure credit risk? Exercise 4

Bank A is evaluating its exposure to credit risk arising from the mortgage loan portfolio. The
outstanding amount of this portfolio as of the end of the previous month reached to €20.000
millions, its average PD is 3% and its LGD is 45%.

What is the ECL of the portfolio?

Chapter 1: Introduction to credit risk 21

1. Introduction to credit risk

How is credit risk evolving recently?

Chapter 1: Introduction to credit risk 22

1. Introduction to credit risk

How is credit risk evolving recently?

Chapter 1: Introduction to credit risk 23

1. Introduction to credit risk

How is credit risk evolving recently?

Chapter 1: Introduction to credit risk 24

1. Introduction to credit risk

How is credit risk evolving recently?

Chapter 1: Introduction to credit risk 25

Agenda

1. Introduction to credit risk

2.Key components of credit risk

3. Obligor credit risk and portfolio perspective

4. Regulatory framework: capital requirements and credit risk

provision

Chapter 1: Introduction to credit risk 26

2. Key components of credit risk

How can we measure credit risk?

Default risk – Probability of Default (PD): likelihood that the
borrower will be unable to meet debt obligations within a certain time
horizon (usually 1 year).
Default
risk
Migration risk – Transition matrix: captures the potential
deterioration of the credit quality (increased PD) of a financial
obligation/borrower within a certain time horizon (usually 1 year).
Correlati Migration
on risk
Credi risk
Recovery risk – Loss Given Default (LGD): relates to the possibility
that, in the event of a borrower's default, the amount recovered may be

t risk less than the total outstanding amount due.

Exposure risk – Exposure at Default (EAD): results from a more

Exposure Recovery severe loss than expected due to a greater than expected exposure as a
risk risk consequence of the uncertainty of the future amounts that can be lost at
the unknown time of default. It is strongly dependent on the nature of
cash flows of the financial obligation.

Correlation risk (portfolio level): refers to the risk of simultaneous

Chapterdefaults of borrowers.
1: Introduction to credit risk 27
 Default
risk

2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Expos Recov
ure ery
Risk risk

A default (credit event) represents a situation where the borrower is unable to make the
required payments on its debts and default risk represents the likelihood of such an
event.

• Probability of Default (PD) quantifies Default risk by measuring the likelihood of a

borrower’s default over a specified time horizon (usually 1 year).

• There are two main approaches to estimate PD (see chapter 2):

• Structural approach: based on economic and financial theoretical assumptions describing

the path to default. The methodology estimate PDs from market data of publicly listed
firms

• Reduced-Form approach: empirical estimation based on historical default frequencies of

borrowers’ homogenous asset classes.
Chapter 1: Introduction to credit risk 28
 Default
risk

2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Expos Recov
ure ery
Risk risk

Life cycle of a
default
Loan First unpaid Default Start Non-default
Approva cash flow Status Repayments Status
l

Default entering Default period Probation period

period

Default Default is usually considered as 90 days past due. In addition, there might be subjective default
status considerations included by the management.

Non-default
A transaction returns to a non-default status once the probation period ends (for example 6 months).
status

Chapter 1: Introduction to credit risk 29

 Default
risk

2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Expos Recov
ure ery
Risk risk

Time-dimension perspectives
of PD
• Point-in-Time (PIT): probability of defaults are conditional on the economic cycle and
varies over time. Specifically used in IFRS9 models to compute accounting credit loss
provisions.

• Through-the-cycle (TTC): probability of defaults are averaged across economic cycles,

capturing the long-term level. Specifically used in IRB models to compute minimum
capital requirements. PD PIT

TTC

Time

Chapter 1: Introduction to credit risk 30

 Default
risk

2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Expos Recov
ure ery
Risk risk

Migration risk captures the potential deterioration of the credit quality (increased PD) of a
financial obligation/borrower within a certain time horizon (usually 1 year).

• This risk is measured by means of the transition matrix, a non-symmetric matrix with
components known as transition frequencies.

• Transition frequencies capture the rate of movements from a specific rating grade assigned
at the beginning of the observation period to the rating grade observed at the end of that period
(typically 1 year).

• The default state is modeled as an absorbing state, which means that once an obligor reaches
that state, he remains there.

Chapter 1: Introduction to credit risk 31

 Default
risk

2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Expos Recov
ure ery
Risk risk

Moody’s 1 year transition matrix (average 1983-2005). Note that:

Source: Bessi (2011)

 Next to the last column provides the frequency

of defaults per rating grade (highlighted in
green).

 All transition probabilities plus WR sum up to

1 across columns (representing all possible
future states from a given starting rating
grade).

 Transitions rates between neighboring ratings

are more frequent than between distant
ratings and the observed frequencies of
remaining
Chapter 1: Introduction to credit risk in the same rating are the highest
32
(highlighted in blue).
 Defaul
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2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Expos
Recove
ure
ry risk
Risk

Recovery risk relates to the possibility that, in the event of a borrower's default, the amount
recovered may be less than the total outstanding amount due, taking into account the proceeds
from guarantees and the liquidation of collateral.

• Recovered funds are specific to the nature of the transaction, guarantees and pledge
collateral rather than borrower's characteristics.

• Recovery risk is quantified by the risk parameter Severity or Loss Given Default (LGD)
defined as the proportion of non-recovered amount of the Exposure at Default (EAD) once the
work-out process is completed. Recovery rate (RR) is the proportion of EAD that is actually
recovered (RR = 1 – LGD).
Null recovery
LGD = 100% and RR =
𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑖𝑒𝑠 0%
𝐿𝐺𝐷=1 − 𝑅𝑅=1 −
𝐸𝐴𝐷
Full recovery
LGD = 0% and RR = 100%

Chapter 1: Introduction to credit risk 33

 Defaul
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2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Expos
Recove
ure
ry risk
Risk

Three mythological alternatives to measure LGD (Schermann,

2003)
Market LGD Workout LGD Implied market LGD

LGD is estimated based on observed LGD is based on the internally estimated LGD derived from risky (but not defaulted)
market prices of defaulted bonds or cash flows resulting from the workout bond prices using a theoretical asset
marketable loans soon after the actual process, properly discounted. pricing model.
default occured.
Recovery rates by seniority The workout process refers to the set of
level of debt – Average 1982- actions put in place in order to recover a The main intuition is that credit spreads of
2005 fixed-income assets above the risk free rate
position that has defaulted.
contains information about PD and LGD.
The timing of recovery cashflows (Rt) and
recovery costs (Ct) has relevant impacts on
the estimation of LGD. See more of this approach in Chapter 2.

∑ 𝑅𝑡 − 𝐶𝑡
𝑡 =1
𝐿𝐺𝐷=1 −
𝐸𝐴𝐷

Chapter 1: Introduction to credit risk 34

 Defaul
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2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Expos
Recove
ure
ry risk
Risk

LGD Estimation using workout approach – Exercise 5

Compute the RR and LGD for a mortgage loan that defaulted in January 2012, with a workout
process initiated at that time and continuing until December 2014, moment at which the
underlying collateral was sold for €65.000. The EAD is €115,000, the applicable annual discount
rate is 2% and the recovered cash flows are:
EAD 115,000
Annual Discount Rate 2.000%

Workout Cash flows 2012-06 2012-12 2013-06 2013-12 2014-06 2014-12

Client repayment 1,200 7,000 1,500
Collateral Sale 65,000
Cost of workout process - 300 - 300 - 300 - 300 - 300 - 300
Cost of foreclosure - 5,000
Total 900 6,700 1,200 - 300 - 300 59,700

Chapter 1: Introduction to credit risk 35

 Defaul
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2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Expos
Recove
ure
ry risk
Risk

The impact of collateral on LGD

• A major determinant of LGD relates to the existence (or absence) of pledged collateral to the
transaction, transforming credit risk into asset risk.

• Asset risk refers to the impact of market movements on the value of the collateral, which
poses a threat to the actual recoveries in the event of borrowers' default.

• Good-quality collaterals refer to assets that can be easily liquidated in broad and liquid
markets, preventing any potential loss at the time of sale that might result when the
collateral value does not cover the EAD.

• Poor-quality collaterals refer to assets whose market present a limited liquidity that
could lead to potential losses for the financial firm if the workout process involves its
liquidation.
Chapter 1: Introduction to credit risk 36
 Defaul
t risk

2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Expos
Recove
ure
ry risk
Risk

The impact of collateral on LGD

• The collaterals are fundamental for the risk assessment of a transaction at two different stages:

1. At origination: imposing a maximum principal amount when granting any new

transaction expressed as a percentage of the current collateral value which leads to Loan-
To-Value ratio (LTV).
Example: A bank whose policies establish a LTV = 80% means that the maximum loan
amount that could be obtained to purchase a house of €300.000 is €240.000.

Loan to
Value
ratio

Collater
al value

Loan
granting

Chapter 1: Introduction to credit risk 37

 Defaul
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2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Expos
Recove
ure
ry risk
Risk

The impact of collateral on LGD

• The collaterals are fundamental for the risk assessment of a transaction at two different stages:

2. Continues monitoring of collateral coverage: the coverage ratio measures the degree
to which the transaction is properly collateralized after considering the asset risk
associated to the collateral through a haircut.
Haircut represents a percentage reduction in the value of the underlying collateral
serving as a buffer against adverse market movement.

Loan to Haircut
Value
ratio
Coverag
Collater e
al value
Liquidati
Loan on Value
granting

Chapter 1: Introduction to credit risk 38

 Defaul
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2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Recov
Exposu
ery
re Risk
risk

Exposure is the maximum potential loss at the time of borrower’s default and Exposure Risk
results from a more severe loss than expected due to a greater than expected exposure as a
consequence of the uncertainty of the future amounts that can be lost at the unknown time of
default.
• The risk parameter measuring exposure risk is the Exposure At Default (EAD) which is
strongly dependent on the nature of the transaction: Loan-Type products vs Credit Line-Type
products.
Products with predefined repayment schedules (amortization table) that establish the evolution of the
contractual outstanding principal amount throughout the life of the transaction. Exposure risk mainly
Loan-Type
arises from the borrower’s prepayment behavior.
products
Typical examples: mortgage loans, consumer loans.

Products with a predetermined maximum funding limit. There is no specified repayment deadline.
Borrowers can decide on the amounts to be drawn from the credit line representing the on-balance
Credit Line- exposure, while the remaining undrawn amount represents the off-balance exposure. Exposure risk
type product mainly arises from the borrower’s behavior.

Typical examples: credit card, lines of credits.

Chapter 1: Introduction to credit risk 39
 Defaul
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2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Recov
Exposu
ery
re Risk
risk

Exposure for Loan-Type products

• For a constant-payments loan, the “contractual” outstanding amount for a transaction with n
remaining payment periods is given by
Where:
• is the initial principal
𝐶𝑂𝐴𝑛 = 𝑃 𝑥
(
( 1 − (1+𝑟 )−𝑛 )
( 1− (1+ 𝑟 )− 𝑁 )) • is the periodic interest rate.
• is the number remanning of payment
periods
• is the number of total payment periods
• Given that the borrower is usually allowed (by contract) to anticipate the repayment of his
debt, the EAD at time t is calculated taking into account the prepayment rate (PR) as follows:
𝑡
𝐸𝐴𝐷 𝑡 =𝐶𝑂𝐴𝑡 ∏ ( 1 − 𝑃𝑅 𝑠 ) Where:
• is the prepayment rate at time
𝑠=1
s

Chapter 1: Introduction to credit risk 40

 Defaul
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2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Recov
Exposu
ery
re Risk
risk

Estimation of EAD for a Loan-Type transaction – Exercise 6

For a 12 year constant payment loan with principal €100.000, annual interest rate of 5% and an
annual prepayment rate of 1%, compute the path of EAD through the life of the transaction.

Chapter 1: Introduction to credit risk 41

 Defaul
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2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Recov
Exposu
ery
re Risk
risk

Exposure for Credit-line type products

• Products typically defined by a maximum amount of funds (Limit) committed by the Bank in
favor of a borrower without any specific repayment date until the maturity of the transaction.

• At any point in time during the life of the transaction, borrowers determine the drawn amounts
(cash effectively borrowed), which represent on-balance exposures, and the undrawn amounts
(the remaining fraction of the limit), which represent off-balance exposures.

• Drawn and Undrawn amounts are conditional on borrower’s behavior and, therefore, unknown
in advance at the potential default time, giving raise to exposure risk.

• The EAD of these type of products is calculated using the risk parameter Credit Conversion
Factor (CCF).

𝐸𝐴𝐷=𝐷𝑟𝑎𝑤𝑛+ 𝐶𝐶𝐹 ∗ ( 𝐿𝑖𝑚𝑖𝑡 − 𝐷𝑟𝑎𝑤𝑛 )

Chapter 1: Introduction to credit risk 42

 Defaul
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2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Recov
Exposu
ery
re Risk
risk

Credit Conversion Factor (CCF)

The risk parameter CCF measures the percentage of undrawn funds that are expected to be
drawn at the moment a borrower defaults, exceeding the usual amount drawn funds during
normal times.
Credit Limit

Average undrawn
amount (A)
𝐵
Excess drawn amount 𝐶𝐶𝐹 =
Drawn
funds in at default (B) 𝐴
default
Drawn stae
Drawn
Drawn funds
Drawn funds
funds Drawn Average Drawn
funds funds
amount

Time Normal Defau

situation lt

Chapter 1: Introduction to credit risk 43

 Defaul
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2. Key components of credit risk

Correl Migrat
ation ion
risk Credit risk

Risk
Recov
Exposu
ery
re Risk
risk

Estimation of EAD for a Credit Line-Type transaction – Exercise 7

• Compute the average CCF across normal periods for a credit line with a limit of €3,000 that
presents the following drawn amounts before borrower’s default.

• Use the previous estimate of CCF to calculate the EAD for another transaction with a limit
€15,000 and drawn funds of €7,650.
Time to Drawn
Limit
default amount

12 3,000 50

11 3,000 76

10 3,000 120
Normal periods

9 3,000 250

8 3,000 300

7 3,000 300

6 3,000 350

5 3,000 350 Chapter 1: Introduction to credit risk 44

Agenda

1. Introduction to credit risk

2. Key components of credit risk

3.Obligor credit risk and portfolio perspective

4. Regulatory framework: capital requirements and credit risk

provision

Chapter 1: Introduction to credit risk 45

 Defaul
t risk

3. Obligor credit risk and portfolio perspective

Correl Migrat
ation ion
risk Credit risk

Risk
Expos Recov
ure ery
Risk risk

• From a portfolio perspective (two or more financial transactions), it is important to consider

the possibility of simultaneous defaults resulting from economic and financial
interconnections among agents.

• Credit event dependency indicates that the default of an agent is not independent of the
default of another agent. This is particularly relevant at the portfolio level when a third party
act as guarantor (risk mitigant).
The risk mitigation effect of a guarantee results from transforming the standalone default probability of the borrower
into a joint default probability of the borrower and the guarantor (double default). This, in turn, significantly reduces
the probability of default of the transaction.

• The concept of credit dependency is measured by means of two related quantities:

 Joint Default Probability

Chapter 1: Introduction to credit risk 46
 Default correlation
 Defaul
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3. Obligor credit risk and portfolio perspective

Correl Migrat
ation ion
risk Credit risk

Risk
Expos Recov
ure ery

Measuring credit dependencies

Risk risk

• Consider two agents, A and B, whose “standalone” probability of default are P A and PB,
respectively.

• For the case of independent default events, the joint probability of default is PAB = PA x PB is
much lower than the standalone PD of either agent. In addition, Bayes’ rule dictates that P A/B =
PA and PB/A = PB.

• Due to economic links between borrowers, defaults tend to be positively correlated and PAB
is higher than what would be expected from the assumption of independence. In this case, the
PAB
=
joint probability of default is given by: P A/B
x P B
= P B/A
x
PA

• When PA/B > PA implies a tendencyChapter

to observe a simultaneous default between A and B.
1: Introduction to credit risk 47
 Defaul
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3. Obligor credit risk and portfolio perspective

Correl Migrat
ation ion
risk Credit risk

Risk
Expos Recov
ure ery

Measuring credit dependencies

Risk risk

• This relationship between PAB and (correlation of default) is formalized by the following
expression
Excess default probability above
independency assumption

x +

• Note that:
• The joint probability of default is greater than the product of the standalone probability of
default whenever .

• There is a linear and positive relationship between and .

• Since, there is a minimum level for

Chapter 1: Introduction to credit risk 48
 Defaul
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3. Obligor credit risk and portfolio perspective

Correl Migrat
ation ion
risk Credit risk

Risk
Expos Recov
ure ery

Measuring credit dependencies

Risk risk

As expected, the joint probability of default tends to be lower than standalone

probabilities of defaults. However, it increases with the default correlation .

x +
Chapter 1: Introduction to credit risk 49
 Defaul
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3. Obligor credit risk and portfolio perspective

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Expos Recov
ure ery

Measuring credit dependencies – Exercise 8

Risk risk

Assume the unconditional PD are PA = 7%, PB = 5% and the correlation of default is = 10%.
Calculate

• Joint probability of default

• Conditional probability of default of B given A () and Conditional probability of default of A given
B ()

Chapter 1: Introduction to credit risk 50

Agenda

1. Introduction to credit risk

2. Key components of credit risk

3. Obligor credit risk and portfolio perspective

4.Regulatory framework: capital requirements and credit

risk provision

Chapter 1: Introduction to credit risk 51

4. Regulatory framework

Given the relevance of credit risk for the Banking industry and its potential threat to the
financial stability, there are currently two regulatory bodies in place establishing the
standards/perspectives to deal with it:
Regulatory
Objective Credit risk measurement Impacting on
Body(1)
Promoting transparency and
reliability in financial Focused on the expected
Accounting
Financial reporting by providing credit losses (ECL) on IFRS 9
Provision on
Reporting unbiased, transparent, and financial assets from a developed by
financial
Standards relevant information about forward-looking the IASB.
statements
the economic performance of perspective
businesses.

Focused on the
Promoting the safety and
unexpected credit
soundness of financial Minimum
losses capturing the risk Basel Accords
Prudential institutions in order to capital
that actual losses may be developed by
Regulation enhance financial stability requirement
higher than expected by BCBS
and risk management in the s
relying on through-the-
banking sector.
cycle perspective.
(1) IASB refers to International Accounting Standards Board. BCBS refers to Basel Committee on Banking Supervision.

Chapter 1: Introduction to credit risk 52

4. Regulatory framework
Minimum capital requirements and credit risk accounting provisions have different roles.

ECL (mean of the Credit

Loss distribution) must be
covered by an accounting
provision.

UCL (difference between a

high percentile of the
Credit Loss distribution and
Catastrophic the mean) must be covered
loss is not with capital.
covered Chapter 1: Introduction to credit risk 53
4. Regulatory framework
IFRS 9 – Accounting standard (1/2)
• The last financial crisis (2007-2009) exposed the limitations of the “incurred loss model”
established by the accounting standard in place at that time (IAS 39) where banks recognized
credit losses too late and in insufficient amounts (too little, too late).

• IFRS 9 goes live in 2018 and the innovations required banks to go through a profound revision
in terms of business interpretation, analytical and computational skills and IT infrastructure
related to credit risk.

• One of the most important changes introduced by IFRS9 was the shift from the "backward-
incurred-losses" perspective to the "forward-looking ECL" perspective for calculating
banks' provisions.

• Additionally, the new accounting standard introduced a risk classification mechanism for
transactions (Staging), considering three
Chapter main buckets
1: Introduction and their corresponding Expected 54
to credit risk
4. Regulatory framework
IFRS 9 – Accounting standard (2/2)
ECL
Significant increase in credit risk (SICR)
Stage Type of transactions Calculatio
n
The identification of SICR plays a fundamental role in
IFRS9:
- No significant increase in credit
risk since recognition • SICR occurs when the PD at the reporting date
Stage
1-Year ECL increases relative to the PD at origination.
1
- Classified as “Low Credit Risk” at
the reporting date
• Professional judgment is applied in determining the
relevant threshold for the increase in PD.
Stage Significant increase in credit risk Lifetime
2 since recognition ECL
• The quantitative approach is complemented with
qualitative indicators (rating downgrade, reduction in
collateral value, etc.).
Stage Objective evidence of impairment at Lifetime
3 the reporting date ECL
• Presumption of SICR:
 Low credit risk portfolio are assumed not to
show SICR
Chapter 1: Introduction to credit risk
 30-days-past-due transactions are assumed55
to
4. Regulatory framework
Basel Accords – Minimum capital requirements
Basel Accords are regulatory frameworks that aim to ensure financial stability by establishing
minimum credit risk capital requirements for banks worldwide.

Basel I (1998)
- Primary focused on credit risk Basel II (2004)
- Set a minimum capital adequacy - Revised version of the Basel III (2023)
ratio of 8% of risk-weighted Standardized Approach for credit
assets. risk
- Revision of Standardized approach
- Standardized approach for - Introduces IRB Approach
calculating credit risk capital based (Foundational and Advance) to - Restriction on the use of IRB
on fixed risk weights for different calculate credit risk capital based models
asset classes. on internal models.
- New eligibility criterion on capital
- Capital requirements for market instruments
and operational risks in addition to
credit risk - New capital buffers:
Countercyclical Buffer and Globally
Systemically important Banks
buffer (G-SIBs)
Chapter 1: Introduction to credit risk 56
4. Regulatory framework
Minimum capital requirements
The Basel Accords are implemented in the EU through the Capital Requirements Regulation
(CRR), which establishes the methodologies for calculating the minimum amount of capital that
a financial entity must hold to cover credit losses.

Total Credit Risk Capital

Where

• RWA (Risk Weighted Assets) refers to the sum of a bank’s on-balance and off-balance
exposurea that are weighted according to their risk. There are two main methodologies to
compute RWA:

 Standardized approach

 IRB Approach

• Capital Adequacy Ratio, which isChapter

equal 1: to 8% to credit risk
Introduction 57
4. Regulatory framework
Minimum capital requirements - Approaches
• Default approach used by entities to compute RWA

Standardize • Risk weights assigned to exposures are computed by supervisors and

d Approach are conditional on external ratings.
(SA)
• Easy to implement; however, it may lead to high capital charges.

• More complex mythology and requires the development and maintenance

Internal of an internal rating system.
Rating-
Based • Risk weights are defined according to a mathematical expression based
Approach on internal estimates of PD and LGD for different segments of the
(IRB) portfolio.

• The process is subject to supervisory approval (prio implementation) and

ongoing validation.
Chapter 1: Introduction to credit risk 58
4. Regulatory framework
Minimum capital requirements – Standardized Approaches
• The fundamental component of the methodology is the element RW (Risk Weight), which
represents the regulatory percentage to be applied to a specific exposure.

R
• RW introduces risk sensitivities to the approach. In this sense, riskier exposures have
higher RW, resulting in greater risk-weighted assets (RWA).

• Basel II provides RW for different categories of exposures, which are characterized by:

• Type of Borrowers
• Type of Transactions
• Credit quality level as stated by ratings issued by external credit agencies (equivalence).
Chapter 1: Introduction to credit risk 59
4. Regulatory framework
Minimum capital requirements – Standardized Approaches

Ratings equivalence
Level of
S&P Moody's Fitch
Credit risk
Several RWs attached to a
1 AAA, AA Aaa, Aa AAA, AA
2 A A A
given exposures are
Long-term 3 BBB Baa BBB conditional to the level of risk
Evaluation 4 BB Ba BB as determined by external
5
6
B
CCC or lower
B
Caa or lower
B
CCC or lower
ratings.

1 A-1+ P-1 F1+

Short-term 2 A-1 P-2 F1
Evaluation 3 A-2, A-3 P-3 F2, F3
4 Lower than A-3 NP Lower than F-3

Chapter 1: Introduction to credit risk 60

4. Regulatory framework
Minimum capital requirements – Standardized Approaches
Principal RW for the Standardized Approach
Level of
Credit 1 2 3 4 5 6
Risk
Financial Entities % 20 50 50 100 100 150
Corporates % 20 50 100 100 150 150
Corporates - No rating % 100

Retail - Residential mortgages % 35

Retail - Commercial real estate
mortgages % 50
Retail - Rest (Including SME) % 75

Central Governments and central

banks % 0

Chapter 1: Introduction to credit risk 61

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4. Regulatory framework
ation ion
risk Credit risk

Risk
Expos Recov
ure ery

Minimum capital requirements – Standardized Approaches

Risk risk

– Exercise 9
Consider a Bank with the following exposures at the end of the year. Compute the RWA and the
total capital following the standardized approach considering a Capital Adequacy Ratio of 8%:

Exposure

Loan to another Bank (Rating AAA) 15

Corporate (no rating) 20

Credit to SMEs 25

Residential mortgages 57

Consumer Loans 30

Chapter 1: Introduction to credit risk 62

 4. Regulatory framework
Minimum capital requirements – IRB Approaches
• Similar the Standardized Approach (SA), for IRB models, the fundamental component that
introduces risk sensitivity is RW.

R
• However, the main difference with respect to SA is that RW is given by a mathematical
formula that depends on the on the estimated risk parameters PD and LGD of different
exposures.

• Additionally, there is a distinction between IRB-Basic where RW is computed by relying only

on internal estimation of PD (LGD is provided by supervisor), while for the IRB-Advanced, the
bank is allowed to compute RW with the internal estimations of both PD and LGD.

Chapter 1: Introduction to credit risk 63

4. Regulatory framework
Minimum capital requirements – IRB Approaches

Financial Entities
• Banks with credit portfolios presenting low credit
risk, can benefit from a reduction in capital
charges compared to SA
Why is there so much
interest in
implementing IRB
models?
Supervisors
• Better capital allocation is achieved as the
approach is more risk-sensitive.

• Implementing IRB models leads to improved the

knowledge and control of credit risk by the Entity.

Chapter 1: Introduction to credit risk 64

4. Regulatory framework
Minimum capital requirements – IRB Approaches
• Depending on the type of exposure, the regulation established different mathematical
expressions. For the case of Retail Exposure, the formula of RW is given by:

[
𝑅 𝑊 = 𝐿𝐺𝐷∗ 𝑁
( 1
√ 1− 𝑅 √
∗ 𝐺 ( 𝑃𝐷 ) +
1
1− 𝑅 ) ]
∗ 𝐺 ( 0,999 ) − 𝐿𝐺𝐷∗ 𝑃𝐷 ∗12 , 5 ∗1 , 06

{
0 ,15 𝑓𝑜𝑟 𝑚𝑜𝑟𝑡𝑔𝑎𝑔𝑒𝑠
𝑅=
0 , 03 ∗
1 − exp ( −35 ∗ 𝑃𝐷 )
1 −exp ( − 35 ) (
+ 0 ,16 ∗ 1−
1 −exp (− 35 ∗ 𝑃𝐷 )
1− exp ( − 35 ) ) 𝑜𝑡h𝑒𝑟 𝑐𝑎𝑠𝑒𝑠

Where:
• N(x) = Standard Normal Distribution
• G(x) = Inverse Standard Normal Distribution
• PD = 1-year probability of default
• LGD = Loss given default Chapter 1: Introduction to credit risk 65
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ation ion
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Risk
Expos Recov
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Minimum capital requirements – IRB Approaches

Risk risk

– Exercise 10
Consider that the supervisor authorized Bank A to calculate the Credit Risk Capital using the IRB
model exclusively for the retail mortgage portfolio. By relying on internal estimations, the
relevant PD and LGD of this portfolio are 1% and 45%, respectively. Additionally, the current
exposure of this segment is 1,300M€ and the Capital Adequacy Ratio is 8%.

Calculate the credit risk capital for the mortgage portfolio.

Chapter 1: Introduction to credit risk 66

4. Regulatory framework

Comparison between IFRS9 vs IRB modeling of credit risk

IFRS9 Models IRB Models

Loss perspective Expected credit loss Unexpected credit loss

Time horizon 1 year or lifetime depending on the stage 1 year

Adjustment to PIT approach considering the current TTC approach considering the entire
the economic macroeconomic situation and a short term economic cycle and a long-term
cycle perspective perspective

Forward –looking Including adjustment on risk parameters

No adjustments required
information based macroeconomic projections.

Chapter 1: Introduction to credit risk 67

Main references

1. Giacomo De Laurentis, Renato Maino, and Luca Molteni, Developing, Validating and Using
Internal Ratings: Methodologies and Case Studies (West Sussex, UK: John Wiley & Sons,
2010). Chapter 2: “Classifications and Key Concepts of Credit Risk”

2. Bessis, Joel. Risk management in banking. (John Wiley & Sons, 2011). Chapter 18: “Credit
Risk,” Chapter 19: “Credit Risk Data” and Chapter 23: “Credit Event Dependency”

3. Jonathan Golin and Philippe Delhaise, The Bank Credit Analysis Handbook, 2nd Edition
(Hoboken, NJ: John Wiley & Sons, 2013). Chapter 1: “The Credit Decision,”

4. Michel Crouhy, Dan Galai and Robert Mark, The Essentials of Risk Management, 2nd Edition
(New York, NY: McGraw-Hill, 2014). Chapter 3: “Banks and their regulators”

5. Schermann, T. 2003. What do we know about loss given default? Federal Reserve Bank of
New York

Chapter 1: Introduction to credit risk 68

www.uc3m.es/masterfinance