Chapter 4: Credit Risk

Question 1

What is credit risk

Answer 1

The risk of loss caused by failure of a counterparty or issuer to meet its obligations. The party that has the financial obligation is called the obligor.

Question 2

What are the forms of credit risk

Answer 2

Counter party risk and issuer risk

Question 3

What is counterparty risk

Answer 3

The risk that a counterparty fails to fulfil its contractual obligations

Question 4

What is issuer risk

Answer 4

The risk that the issuer of the bind could default on its obligation to pay coupons or repay the principle bond

Question 5

What causes concentration risk

Answer 5

An uneven distribution of exposures to individual issuers or counterparties or within industry sectors and geographical regions

Question 6

What are the differences between issuer and counterparty risk

Answer 6

A broker could fail to deliver a bond issued by a company which is paying its coupons and redeeming its bonds - counterparty risk
The same broker could deliver the required bond, but the company may not pay its coupons or redeem its bonds - this is issuer risk

Question 7

Sources of credit risk?

Answer 7

Loans
Extension of commitments and guarantees
Interbank transactions
Futures, options, swaps, bonds etc.
Settlement of transactions

Question 8

What is settlement risk

Answer 8

The risk that only one party will deliver their end of the transaction

Question 9

What is pre-settlement risk

Answer 9

The risk that an institution defaults before the settlement of the transaction, where the traded instrument has a positive economic value to the other party - typically takes place on interest rate swaps

Question 10

What is systemic risk

Answer 10

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

Question 11

What should be considered when banks are developing their credit administration areas

Answer 11

Internal processes
Systems
people

Question 12

What is credit exposure

Answer 12

The amount that can potentially be lost if a debtor defaults on its obligations. Used to quantitatively assess the severity of credit risk from counterparties and portfolios

Question 13

What two parts does credit exposure consist of

Answer 13

Current exposure and potential future exposure

Question 14

What is current exposure

Answer 14

The current outstanding obligation

Question 15

What is potential future exposure

Answer 15

An estimate of the likely loss at some point in the future

Question 16

Why is potential future exposure difficult to calculate

Answer 16

Uncertainty arising from credit facilities and financial instruments which have different economic futures according to future events

Question 17

What is a credit risk premium

Answer 17

The difference between the interest rate a firm pays when it borrows and the interest rate on a default-free security e.g. government bond. The premium is the extra compensation the market or financial institution requires for lending to a firm that has a risk of defaulting

Question 18

Who are the nominated regulators in the UK

Answer 18

Fitch Ratings
Moody’s
Standard and Poor’s
Dominion Bond Rating Service

Question 19

What is a sovereign rating

Answer 19

similar to a credit rating but is for a country as a whole. Takes into account the current economic and political situation of a country

Question 20

What is a long term rating?

Answer 20

Analyses and assesses a company’s ability to meet its responsibilities with respect to all of its issued securities

Question 21

What is a short term rating

Answer 21

Focuses on the specific securities’ ability to perform, given the country’s current financial condition and general industry performance conditions

Question 22

What are the faults of credit agencies?

Answer 22

Companies not downgraded fast enough
Having close relationships with certain companies
Errors when rating some structured products

Question 23

Formula for expected loss

Answer 23

Probability of default (%)exposure at defaultloss given default (%)

Question 24

What is LGD

Answer 24

Loss Given Default is the percentage of the actual loan amount which is not mitigated by guarantees or collateral with the lender

Question 25

What is PD

Answer 25

Probability of Default is a measure of the likelihood of their failing to pay what they owe

Question 26

What is EAD

Answer 26

The exposure at default is the amount which a bank will be exposed to in the future at the point of potential default.

Question 27

Formula for recovery rate

Answer 27

RR = 100% - LGD

Question 28

What is wrong way risk

Answer 28

Also known as wrong way exposure, it is the risk that occurs when exposure to a counterparty is adversely correlated with the credit quality of that counterparty

Question 29

What are non-performing assets

Answer 29

Loans whose repayments are not being paid on time. If a loan is late for a short time, its classified as past due, after 90 days, it becomes non-performing

Question 30

What are credit limits

Answer 30

Maximum limits for all aspects of credit exposure set by financial institutions. Firms must establish overall credit limits at the level of: Individual borrowers Counterparties Groups of connected counterparties

Question 31

What are the limitations of credit risk management

Answer 31

Using simplified calculations of potential exposure A lack of recognition of the time period of credit risk A lack of recognition of portfolio diversification Financial institutions use probabilities which are a best 'guestimate' of the future

Question 32

What are underwriting standards

Answer 32

The standards that financial institutions apply to borrowers in order to evaluate their creditworthiness and, therefore, manage the risk of default

Question 33

What is a netting agreement

Answer 33

Allows two parties that exchange multiple cash flows during a given day to agree bilaterally to net those cash flows to one payment per currency.

Question 34

Benefits of a netting agreement

Answer 34

Reduces each parties settlement risk reduces transaction costs reduces communication expenses

Question 35

What is a unilateral arrangement (Collateral)

Answer 35

One party gives collateral to the other

Question 36

What is a bilateral arrangement (Collateral)

Answer 36

Both parties may post collateral

Question 37

What is diversification

Answer 37

Ensuring that the portfolio is spread across borrowers in different, negatively correlated industry sectors that have an inverse economic relationship to each other

Question 38

Difference between CDS and CDO

Answer 38

A CDO is similar to a CDS. Both are shifting the underlying debt instrument from lender to investor, but, instead of doing so for a corporate loan or swap from a single borrower as in a CDS, they do so for a series of loans which allows for diversification

Question 39

Advantages of CDSs

Answer 39

Buy or sell insurance to mitigate credit risk improve diversification Customize credit exposure to another party without having direct relationship Transfer credit risk without affecting customer relationship

Question 40

What is a loan sale

Answer 40

Instead of simply relying on the underlying income stream as a source o revenue, the lender can sell loans for a lump sum Another form of loan sale is securitization - an issuer acquiring assets from originator and issuing bonds to finance the purchase of securitized loans.

Question 41

What is an SPV

Answer 41

A special purpose vehicle is a company that has been specifically been set up for the purpose of the securitization

Question 42

What are CCPs

Answer 42

The use of Central counter parties or clearing house is a method used by many exchanges to reduce credit risk. The clearing house acts as a guarantor of all transactions, limiting the exposure of its clearing members by protecting them from defaults.

Question 43

How do CCPs obtain capital

Answer 43

Their members Fees generated by the exchange Other parties that do not have a direct relationship with their market

Question 44

What is a 'haircut'

Answer 44

the extra amount added to a collaterals value. The amount depends on the volatility of the asset serving as collateral e.g., government bond might be 3%

Question 45

The measurement of credit risk should take account of:

Answer 45

Specific nature of credit Exposure profile until maturity existence of collateral or guarantees The potential for default

Question 46

What is a credit scoring system

Answer 46

For retail customers , systems include using questionnaires and standard credit request application forms. Questions include: Age credit history Amount owed Occupation Years in current job Home owner or renting

Question 47

What are financial inputs

Answer 47

Include an assessment of each firm's earnings, cash flow, asset values, liquidity, leverage, financial size and debt capacity.

Question 48

What are non financial inputs

Answer 48

Will include each firm's: management quality governance quality Industry characteristics Country risk Credit rating

Question 49

What are extraordinary inputs

Answer 49

Court actions Other one off factors that emerge

Question 50

Key areas for stress testing are:

Answer 50

Economic or industry downturns Interest rate or other market movements Market-risk events liquidity conditions

Question 51

Evidence of impairment

Answer 51

Information about significant financial difficulties Breach of contract High probability of bankruptcy

Question 52

What is provisioning

Answer 52

When a firm sets aside an allowance for loss in its accounts due to loan impairment

Question 53

What KRIs should be displayed in a management dashboard

Answer 53

Number of debtors Clients breaching covenants Credit downgrades

Question 54

What is the HHI

Answer 54

The Herfindahl-Hirschman Index is the sum of all squared relative portfolio shares of the exposures. Does not take into account borrowers credit exposure