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Risk In Financial Services > Chapter 4: Credit Risk > Flashcards

Chapter 4: Credit Risk Flashcards

1
Q

what is credit risk?

A

risk caused by the failure of a counterparty or issuer to meet its obligations

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2
Q

what is goal of credit risk management?

A

maximize a firms risk-adjusted rates of return by maintaining credit risk exposure within acceptable parameters

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3
Q

what two broad forms does credit risk exist in?

A

counterparty risk (risk that a counterparty fails to fulfill its contractual obligations) and issuer risk (risk that the issuer of a security fails to pay out its coupons)

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4
Q

what is settlement risk?

A

when one party delivers in a contractual agree however, the other party does not

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5
Q

what is pre settlement risk?

A

risk that occurs when an institution defaults before the settlement of the transaction

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6
Q

what is systematic risk?

A

possible breakdown of the entire financial system rather than simply a failure of an individual firm

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7
Q

what key operational risks need to be considered when banks are developing credit admin areas?

A

internal processes (including the efficiency and effectiveness of credit admin operations) and systems (which help with the accuracy and timeline of credit risk information provided to management information systems) people (adequate segregation of duties)

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8
Q

what are the basic techniques for measuring credit risk?

A

measuring:
- credit exposure
- credit risk premium
- credit ratings

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9
Q

what is credit exposure?

A

the amount that can potentially be lost if a debtor defaults on its obligations, used to quantitively assess the severity of credit risk

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10
Q

what two areas can credit risk be split into?

A

current exposure, potential future exposure

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11
Q

what is potential future exposure?

A

estimate of the likely loss at some point in the future, harder to calculate due to uncertainty

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12
Q

how is potential future exposure calculated?

A

through the use of VaR modelling

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13
Q

what is a credit risk premium?

A

difference between the interest rate a firm pays when it borrows and the interest rate on a default free security e.g., a bond. extra compensation required for lending to a firm that has a risk of defaulting

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14
Q

what is the relationship between credit risk premium/ cost of borrowing and credit ratings?

A

cost of borrowing (credit premium) will be less for a higher rated firm as a reflection of its lower likelihood to default

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15
Q

what are some of the merits of using credit rating agencies?

A
  • take into account the overall economic conditions of the country
  • companies use them to determine whether they will further consider specific companies/ business
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16
Q

what are some of the drawbacks of credit rating agencies?

A
  • ratings only measure credit quality don’t capture the risk of a decline in market value
  • rating is just an opinion
  • takes time to change the ratings on companies
  • rating agencies have very familiar relationships with company management
  • they make errors in rating some structured products
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17
Q

how is expected loss in counterparty credit risk calculated?

A

EL = PD x EAD x LGD

PD= probability of default
EAD= Expected loss at default
LGD= loss given default

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18
Q

what is LGD?

A

loss given default, percentage of the actual loan amount that has not been mitigated for

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19
Q

what is PGD

A

probability given default, measure of the likelihood of the counterparty failing to pay what they owe, estimated by historical experience and empirical evidence

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20
Q

what is EAD?

A

exposure at default, depends on the maturity, ‘time to completion’ longer the time to maturity the larger the probability that the credit quality will decrease

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21
Q

why is it important that firms know when a credit risk has materialised?

A

will trigger certain actions on the part of the bank and other creditors of the bankrupt firm

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22
Q

what is a credit event?

A

recognised industry trigger that does not have a precise definition, includes bankruptcy, insolvency, can also simply be a credit-rating downgrade

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23
Q

what is ‘wrong way risk’?

A

risk that occurs when ‘exposure to counterparty is adversely correlated with the credit quality of that counterparty’. modelled independently

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24
Q

what is a non-performing asset?

A

loans whose repayments are not being made on time (usually 90 days)

25
Q

why may some banks have more non-performing assets?

A

they may have more high-risk customers, compensate for this by charging higher interest rates

26
Q

what are credit limits?

A

maximum limits for all aspects of credit exposure set by financial institutions

27
Q

what levels to firms need to establish credit limits of?

A

individual borrowers, counterparties, groups of connected counterparties

28
Q

what relation is there to counterparties and lending limit?

A

the better quality the counterparty, the higher the lending limit will be, frequently based in part on the internal risk rating assigned

29
Q

how can credit limits be effective?

A

must be binding and not driven by customer demand

30
Q

what are some of the limitations of credit risk measurement?

A
  • use simplified calculations of potential exposure
  • lack of recognition of the time period of credit risk
  • lack of recognition of portfolio diversification
  • use probabilities
31
Q

what are underwriting standards?

A

standards that financial institutions apply to borrowers in order to evaluate their credit worthiness and manage the risk of default

32
Q

what are guarantees?

A

when issuers arrange for another organisation, generally with strong finances to guarantee the debt

33
Q

what is a netting agreement?

A

allows two parties to exchange multiple cash flows during a given day and agree to net those cash flows into one payment per currency, reduces settlement risk and transaction costs

34
Q

what is collateral?

A

asset held by a lender on behalf of an obligor as security for a loan, can be a physical asset or in the form of cash/securities

35
Q

what is a unilateral agreement?

A

when one party given collateral to another

36
Q

what is a bilateral agreement?

A

allows for two-sided collateral obligations e.g., during a forex forward deal

37
Q

what is diversification?

A

the reduction of portfolio credit risk by ensuring that the portfolio is spread across borrowers in different, negatively correlated sectors

38
Q

what is a loan sale?

A

where lenders can create an income stream from loans as long as they are performing, can choose to sell the loan to another institution in order to receive a lump sum

39
Q

what is securitisation?

A

where an issuer of a loan acquires assets from an originator and issues bonds to finance the purchase of the securitised loans that they are marketing, income stream from the loans is then used to repay the bondholders

40
Q

what are CCPs?

A

central counterparties, method used to reduce credit risk. CCP acts a s a guarantor to all transactions, limiting exposure

41
Q

how is collateral adequacy calculated?

A

value of the collateral will be set to equal the value of stock lent out, if the price of the stock drops then the lending firm will not be able to realise its true value. to overcome this potential loss, extra amount (haircut) added to collaterals value

42
Q

what does the size of the haircut depend on?

A

the volatility of the asset serving as collateral e.g., for a bond it might be 3%

43
Q

what is the role of the credit risk management function?

A

responsible for ensuring that the firms credit risk is properly managed although it will not own any risk itself

44
Q

what does a sound credit risk management policy include?

A
  • owning and adhering to policy
  • credit limits
  • monitoring credit events
  • measuring daily exposure
  • performing credit analysis
  • regulatory KYC checks
45
Q

what do procedures on credit risk management need to define?

A

criteria for identifying and escalating potential counterparty issues to senior management. possible corrective action, classification and provisioning

46
Q

what are the basel key stages of credit risk policy development

A
  • identify the specific nature of the credit
  • exposure profile until maturity (related to market movements)
  • establishing collateral or guarantees
  • potential for default based on internal risk rating
47
Q

what methods can be used to manage credit risk for retail customers?

A

questionnaires and forms which are then scored, standardised credit profiles based on multiple factors

48
Q

what methods can be used to manage credit risk for firms?

A

financial and non financial inputs plus extraordinary inputs

49
Q

what is stress testing?

A

identifying possible events or future changes in economic conditions that could have unfavourable effects on a banks credit exposures. should be periodically reviewed

50
Q

what is segmentation?

A

clearly differentiated segments of portfolios. should be based on credit scores and time the transaction has been on the banks books

51
Q

what are internal credit risk rtings?

A

categorises counterparties credit into various classes designed to take into account differences in risk

52
Q

what does evidence of impairment include?

A
  • information about financial difficulties
  • breach of contract
  • high probability of bankruptcy
53
Q

what is provisioning?

A

where the firm sets aside an allowance for the loss on its accounts as a result of loan impairment

54
Q

what should the management dashboard cover?

A

all KPIs

55
Q

what is concentration risk?

A

where there is an uneven distribution of exposures to individual borrowers or within industry sectors in a credit portfolio

56
Q

what can be done to counteract concentration risk?

A

limits to govern the extent to which loans can be extended across specific countries and sectors,

57
Q

what is the HHI?

A

Herfindahl-Hirschman Index. it is the sum of all squared relative (i.e., percentage) portfolio shares of the exposures

58
Q

how is HHI calculated?

A

computing the fractional exposures in percentage terms and then summing up their squares. restricted between zero and one. one is full concentration to one counterparty

59
Q

what are some of the positives/negatives of the HHI?

A
  • computational simplicity, moderate data requirements
  • doesn’t consider borrowers credit quality

Risk In Financial Services (10 decks)

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